2014 FASB UPDATE INTERMEDIATE ACCOUNTING 15TH EDITION BY DONALD KIESO, JERRY WEYGANDT, TERRY WARFIELD SOLUTION MANUAL CHAPTER 1 Financial Accounting and Accounting Standards ASSIGNMENT CLASSIFICATION TABLE (By Topic) Topics
Questions
Cases
1.
Subject matter of accounting.
1
4
2.
Environment of accounting.
2, 3, 28
6, 7
3.
Role of principles, objectives, standards, and accounting theory.
4, 5, 6, 7
1, 2, 3, 5
4.
Historical development of GAAP.
8, 9, 10, 11
8
5.
Authoritative pronouncements and rulemaking bodies.
12, 13, 14, 15, 16, 17, 18, 19, 20, 21
3, 9, 11, 12, 14
6.
Role of pressure groups.
22, 23, 24, 25, 26, 27
10, 16, 17
7.
Ethical issues.
29
13, 15
ASSIGNMENT CLASSIFICATION TABLE (By Learning Objective) Learning Objectives 1. Identify the major financial statements and other means of financial reporting. 2. Explain how accounting assists in the efficient use of scarce resources. 3. Identify the objective of financial reporting.
Questions 1, 2
4. 5.
Explain the need for accounting standards. Identify the major policy-setting bodies and their role in the standard-setting process.
6 8, 9, 10, 11,13, 14, 15, 16, 19
6.
Explain the meaning of generally accepted accounting principles (GAAP) and the role of the codification for GAAP. Describe the impact of user groups on the rulemaking process. Describe some of the challenges facing financial reporting. Understand issues related to ethics and financial accounting.
12, 14, 18, 19, 20, 21
7. 8. 9.
Cases CA1-4, CA1-5
3, 5 4, 7
CA1-2, CA1-3, CA1-4, CA1-5, CA1-6 CA1-3, CA1-7, CA1-9 CA1-1, CA1-2, CA1-3, CA1-7, CA1-8, CA1-9, CA1-11, CA1-14 CA1-2, CA1-3, CA1-7, CA1-8, CA1-12
17, 22, 23, 24, 25, 26, 27 28
CA1-10, CA1-11, CA113, CA1-16, CA1-17
16, 17, 29
CA1-6, CA1-13, CA1-15
ASSIGNMENT CHARACTERISTICS TABLE
Item
Description
Level of Difficulty
Time (minutes)
CA1-1 CA1-2 CA1-3 CA1-4 CA1-5 CA1-6 CA1-7 CA1-8 CA1-9 CA1-10 CA1-11 CA1-12 CA1-13 CA1-14 CA1-15 CA1-16 CA1-17
FASB and standard-setting. GAAP and standard-setting. Financial reporting and accounting standards. Financial accounting. Objective of financial reporting. Accounting numbers and the environment. Need for GAAP. AICPA’s role in rule-making. FASB role in rule-making. Politicalization of GAAP. Models for setting GAAP. GAAP terminology. Rule-making Issues. Securities and Exchange Commission. Financial reporting pressures. Economic consequences. GAAP and economic consequences.
Simple Simple Simple Simple Moderate Simple Simple Simple Simple Complex Simple Moderate Complex Moderate Moderate Moderate Moderate
15–20 15–20 15–20 15–20 20–25 10–15 15–20 20–25 20–25 30–40 15–20 30–40 20–25 30–40 25–35 25–35 25–35
SOLUTIONS TO CODIFICATION EXERCISES CE1-1 The information at this link describes the elements offered in The FASB Accounting Standards Codification. As indicated, the website offers several resources to enhance your working knowledge of the Codification and the Codification Research System. This page includes links to help pages which describe specific functions and features of the Codification. Links to frequently asked questions, the FASB Learning Guide, and the Notice to Constituents are also available on this page. Help pages FAQ Learning Guide About the Codification—Notice of Constituents
CE1-2 The following information is provided at the Providing Feedback link: The Codification includes a feature which can be used to submit content-related feedback or general, system-related comments. The feedback system is not designed for comments on proposed Accounting Standards Updates. Content-related feedback As a registered user of the FASB Accounting Standards Codification Research System website, you are able and are encouraged to provide feedback, at the paragraph level, to the FASB about any content-related matters. For specific information about the Codification and the feedback process, please read the Notice to Constituents. To provide content-related feedback: Click the Submit feedback button beneath the paragraph for which you want to provide feedback. Enter or copy/paste your comments in the text box. Note that formatting (lists, bold, etc.) is not retained and there is a 4,000 character limit on feedback submissions. Click SUBMIT. Your comments are sent to the FASB and reviewed by FASB staff. You can also submit multiple comments for any given paragraph, if, for example, you determine that more information would be useful to the FASB staff. General feedback Click here to provide general feedback on the Codification in general, the Codification Research System website, and other system-related items that are not content specific.
CE1-3 The “What’s New” page provides links to Codification content that has been recently issued. During the verification phase, updates may result from either the issuance of Codification update instructions that accompany new Standards or from changes to the Codification due to incorporation of constituent feedback.
ANSWERS TO QUESTIONS 1. Financial accounting measures, classifies, and summarizes in report form those activities and that information which relate to the enterprise as a whole for use by parties both internal and external to a business enterprise. Managerial accounting also measures, classifies, and summarizes in report form enterprise activities, but the communication is for the use of internal, managerial parties, and relates more to subsystems of the entity. Managerial accounting is management decision oriented and directed more toward product line, division, and profit center reporting. 2. Financial statements generally refer to the four basic financial statements: balance sheet, income statement, statement of cash flows, and statement of changes in owners’ or stockholders’ equity. Financial reporting is a broader concept; it includes the basic financial statements and any other means of communicating financial and economic data to interested external parties. Examples of financial reporting other than financial statements are annual reports, prospectuses, reports filed with the government, news releases, management forecasts or plans, and descriptions of an enterprise’s social or environmental impact. 3. If a company’s financial performance is measured accurately, fairly, and on a timely basis, the right managers and companies are able to attract investment capital. To provide unreliable and irrelevant information leads to poor capital allocation which adversely affects the securities market. 4. The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in decisions about providing resources to the entity through equity investments and loans or other forms of credit. Information that is decision-useful to capital providers (investors) may also be useful to other users of financial reporting who are not investors. 5. Investors are interested in financial reporting because it provides information that is useful for making decisions (referred to as the decision-usefulness approach). When making these decisions, investors are interested in assessing the company’s (1) ability to generate net cash inflows and (2) management’s ability to protect and enhance the capital providers’ investments. Financial reporting should therefore help investors assess the amounts, timing, and uncertainty of prospective cash inflows from dividends or interest, and the proceeds from the sale, redemption, or maturity of securities or loans. In order for investors to make these assessments, the economic resources of an enterprise, the claims to those resources, and the changes in them must be understood. 6. A common set of standards applied by all businesses and entities provides financial statements which are reasonably comparable. Without a common set of standards, each enterprise could, and would, develop its own theory structure and set of practices, resulting in noncomparability among enterprises. 7. General-purpose financial statements are not likely to satisfy the specific needs of all interested parties. Since the needs of interested parties such as creditors, managers, owners, governmental agencies, and financial analysts vary considerably, it is unlikely that one set of financial statements is equally appropriate for these varied uses.
Questions Chapter 1 (Continued) 8. The SEC has the power to prescribe, in whatever detail it desires, the accounting practices and principles to be employed by the companies that fall within its jurisdiction. Because the SEC receives audited financial statements from nearly all companies that issue securities to the public or are listed on the stock exchanges, it is greatly interested in the content, accuracy, and credibility of the statements. For many years the SEC relied on the AICPA to regulate the profession and develop and enforce accounting principles. Lately, the SEC has assumed a more active role in the development of accounting standards, especially in the area of disclosure requirements. In December 1973, in ASR No. 150, the SEC said the FASB’s statements would be presumed to carry substantial authoritative support and anything contrary to them to lack such support. It thereby supports the development of accounting principles in the private sector. 9. The Committee on Accounting Procedure was a special committee of the American Institute of CPAs that, between the years of 1939 and 1959, issued 51 Accounting Research Bulletins dealing with a wide variety of timely accounting problems. These bulletins provided solutions to immediate problems and narrowed the range of alternative practices. But, the Committee’s problem-by-problem approach failed to provide a well-defined and well-structured body of accounting theory that was so badly needed. The Committee on Accounting Procedure was replaced in 1959 by the Accounting Principles Board. 10. The creation of the Accounting Principles Board was intended to advance the written expression of accounting principles, to determine appropriate practices, and to narrow the differences and inconsistencies in practice. To achieve its basic objectives, its mission was to develop an overall conceptual framework to assist in the resolution of problems as they became evident and to do substantive research on individual issues before pronouncements were issued. 11. Accounting Research Bulletins were pronouncements on accounting practice issued by the Committee on Accounting Procedure between 1939 and 1959; since 1964 they have been recognized as accepted accounting practice unless superseded in part or in whole by an opinion of the APB or an FASB standard. APB Opinions were issued by the Accounting Principles Board during the years 1959 through 1973 and, unless superseded by FASB Statements, are recognized as accepted practice and constitute the requirements to be followed by all business enterprises. FASB Statements are pronouncements of the Financial Accounting Standards Board and currently represent the accounting profession’s authoritative pronouncements on financial accounting and reporting practices. 12. The explanation should note that generally accepted accounting principles or standards have “substantial authoritative support.” They consist of accounting practices, procedures, theories, concepts, and methods which are recognized by a large majority of practicing accountants as well as other members of the business and financial community. Bulletins issued by the Committee on Accounting Procedure, opinions rendered by the Accounting Principles Board, and statements issued by the Financial Accounting Standards Board constitute “substantial authoritative support.” 13. It was believed that FASB Pronouncements would carry greater weight than APB Opinions because of significant differences between the FASB and the APB, namely: (1) The FASB has a smaller membership, (2) full-time compensated members; (3) the FASB has greater autonomy, (4) increased independence; (5) the FASB has broader representation than the APB. 14. The technical staff of the FASB conducts research on an identified accounting topic and prepares a “preliminary views” that is released by the Board for public reaction. The Board analyzes and evaluates the public response to the preliminary views, deliberates on the issues, and issues an “exposure draft” for public comment. The preliminary views merely present all facts and alternatives related to a specific topic or problem, whereas the exposure draft is a tentative “statement.” After studying the public’s reaction to the exposure draft, the Board may reevaluate its position, revise the draft, and vote on the issuance of a final statement.
Questions Chapter 1 (Continued) 15. Statements of financial accounting standards contained in Accounting Standards updates constitute generally accepted accounting principles and dictate acceptable financial accounting and reporting practices as promulgated by the FASB. The first standards statement was issued by the FASB in 1973. Statements of financial accounting concepts do not establish generally accepted accounting principles. Rather, the concepts statements set forth fundamental objectives and concepts that the FASB intends to use as a basis for developing future standards. The concepts serve as guidelines in solving existing and emerging accounting problems in a consistent, sound manner. Both the standards statements and the concepts statements may develop through the same process from discussion memorandum, to exposure draft, to a final approved statement. 16. Rule 203 of the Code of Professional Conduct prohibits a member of the AICPA from expressing an opinion that financial statements conform with GAAP if those statements contain a material departure from an accounting principle promulgated by the FASB, or its predecessors, the APB and the CAP, unless the member can demonstrate that because of unusual circumstances the financial statements would otherwise have been misleading. Failure to follow Rule 203 can lead to a loss of a CPA’s license to practice. This rule is extremely important because it requires auditors to follow FASB standards. 17. The chairman of the FASB was indicating that too much attention is put on the bottom line and not enough on the development of quality products. Managers should be less concerned with shortterm results and be more concerned with the long-term results. In addition, short-term tax benefits often lead to long-term problems. The second part of his comment relates to accountants being overly concerned with following a set of rules, so that if litigation ensues, they will be able to argue that they followed the rules exactly. The problem with this approach is that accountants want more and more rules with less reliance on professional judgment. Less professional judgment leads to inappropriate use of accounting procedures in difficult situations. In the accountants’ defense, recent legal decisions have imposed vast new liability on accountants. The concept of accountant’s liability that has emerged in these cases is broad and expansive; the number of classes of people to whom the accountant is held responsible are almost limitless. 18. FASB Staff Positions (FSP) are used to provide interpretive guidance and to make minor amendments to existing standards. The due process used to issue a FSP is the same used to issue a new standard. 19. The Emerging Issues Task Force often arrives at consensus conclusions on certain financial reporting issues. These consensus conclusions are then looked upon as GAAP by practitioners because the SEC has indicated that it will view consensus solutions as preferred accounting and will require persuasive justification for departing from them. Thus, at least for public companies which are subject to SEC oversight, consensus solutions developed by the Emerging Issues Task Force are followed unless subsequently overturned by the FASB. It should be noted that the FASB took greater direct ownership of GAAP established by the EITF by requiring that consensus positions be ratified by the FASB.
Questions Chapter 1 (Continued) 20. The Financial Accounting Standards Board Accounting Standards Codification (Codifications) is a compilation of all GAAP in one place. Its purpose is to integrate and synthesize existing GAAP and not to create new GAAP. It creates one level of GAAP which is considered authoritative. The FASB Codification Research Systems (CRS) is an-on-line real time data base which provides easy access to the Codification. The Codification and the related CRS provide a topically organized structure which is subdivided into topic, subtopics, sections, and paragraphs. 21. Hopefully, the codification will help users to better understand what GAAP is. If this occurs, companies will be more likely to comply with GAAP and the time to research accounting issues will be substantially reduced. In addition, through the electronic web-based format, GAAP can be easily updated which will help users stay current. 22. The sources of pressure are innumerable, but the most intense and continuous pressure to change or influence accounting principles or standards come from individual companies, industry associations, governmental agencies, practicing accountants, academicians, professional accounting organizations, and public opinion. 23. Economic consequences means the impact of accounting reports on the wealth positions of issuers and users of financial information and the decision-making behavior resulting from that impact. In other words, accounting information impacts various users in many different ways which leads to wealth transfers among these various groups. If politics plays an important role in the development of accounting rules, the rules will be subject to manipulation for the purpose of furthering whatever policy prevails at the moment. No matter how well intentioned the rule maker may be, if information is designed to indicate that investing in a particular enterprise involves less risk than it actually does, or is designed to encourage investment in a particular segment of the economy, financial reporting will suffer an irreplaceable loss of credibility. 24. No one particular proposal is expected in answer to this question. The students’ proposals, however, should be defensible relative to the following criteria: (1) The method must be efficient, responsive, and expeditious. (2) The method must be free of bias and be above or insulated from pressure groups. (3) The method must command widespread support if it does not have legislative authority. (4) The method must produce sound yet practical accounting principles or standards. The students’ proposals might take the form of alterations of the existing methodology, an accounting court (as proposed by Leonard Spacek), or governmental device. 25. Concern exists about fraudulent financial reporting because it can undermine the entire financial reporting process. Failure to provide information to users that is accurate can lead to inappropriate allocations of resources in our economy. In addition, failure to detect massive fraud can lead to additional governmental oversight of the accounting profession. 26. The expectations gap is the difference between what people think accountants should be doing and what accountants think they can do. It is a difficult gap to close. The accounting profession recognizes it must play an important role in narrowing this gap. To meet the needs of society, the profession is continuing its efforts in developing accounting standards, such as numerous pronouncements issued by the FASB, to serve as guidelines for recording and processing business transactions in the changing economic environment.
Questions Chapter 1 (Continued) 27. The following are some of the key provisions of the Sarbanes-Oxley Act: Establishes an oversight board for accounting practices. The Public Company Accounting Oversight Board (PCAOB) has oversight and enforcement authority and establishes auditing, quality control, and independence standards and rules. Implements stronger independence rules for auditors. Audit partners, for example, are required to rotate every five years and auditors are prohibited from offering certain types of consulting services to corporate clients. Requires CEOs and CFOs to personally certify that financial statements and disclosures are accurate and complete and requires CEOs and CFOs to forfeit bonuses and profits when there is an accounting restatement. Requires audit committees to be comprised of independent members and members with financial expertise. Requires codes of ethics for senior financial officers. In addition, Section 404 of the Sarbanes-Oxley Act requires public companies to attest to the effectiveness of their internal controls over financial reporting. 28. Some major challenges facing the accounting profession relate to the following items: Nonfinancial measurement—how to report significant key performance measurements such as customer satisfaction indexes, backlog information and reject rates on goods purchased. Forward-looking information—how to report more future oriented information. Soft assets—how to report on intangible assets, such as market know-how, market dominance, and well-trained employees. Timeliness—how to report more real-time information. 29. Accountants must perceive the moral dimensions of some situations because GAAP does not define or cover all specific features that are to be reported in financial statements. In these instances accountants must choose among alternatives. These accounting choices influence whether particular stakeholders may be harmed or benefited. Moral decision-making involves awareness of potential harm or benefit and taking responsibility for the choices.
TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 1-1 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to answer questions about FASB and standard setting. CA 1-2 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to answer questions about FASB and standard setting. CA 1-3 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to answer questions about financial reporting and accounting standards topics. CA 1-4 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to distinguish between financial accounting and managerial accounting, identify major financial statements, and differentiate financial statements and financial reporting. CA 1-5 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to explain the basic objective of financial reporting. CA 1-6 (Time 10–15 minutes) Purpose—to provide the student with an opportunity to describe how reported accounting numbers might affect an individual’s perceptions and actions. CA 1-7 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to evaluate the viewpoint of removing mandatory accounting rules and allowing each company to voluntarily disclose the information it desired. CA 1-8 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to explain the evolution of accounting rule-making organizations and the role of the AICPA in the rule making environment. CA 1-9 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to identify the sponsoring organization of the FASB, the method by which the FASB arrives at a decision, and the types and the purposes of documents issued by the FASB. CA 1-10 (Time 30–40 minutes) Purpose—to provide the student with an opportunity to focus on the types of organizations involved in the rule making process, what impact accounting has on the environment, and the environment’s influence on accounting. CA 1-11 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to focus on what type of rule-making environment exists in the United States. In addition, this CA explores why user groups are interested in the nature of GAAP and why some groups wish to issue their own rules. CA 1-12 (Time 30–40 minutes) Purpose—to provide the student with an opportunity to identify and define acronyms appearing in the first chapter. Some are self-evident, others are not so.
Time and Purpose of Concepts for Analysis (Continued) CA 1-13 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to consider the ethical dimensions of implementation of a new accounting pronouncement. CA 1-14 (Time 30–40 minutes) Purpose—to provide the student with an assignment that explores the role and function of the Securities and Exchange Commission. CA 1-15 (Time 25–35 minutes) Purpose—to provide the student with a writing assignment concerning the ethical issues related to meeting earnings targets. CA 1-16 (Time 25–35 minutes) Purpose—to provide the student with the opportunity to discuss the role of Congress in accounting rulemaking. CA 1-17 (Time 25–35 minutes) Purpose—to provide the student with an opportunity to comment on a letter sent by business executives to the FASB and Congress on the accounting for derivatives.
SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 1-1 1. 2. 3. 4.
True False. Any company claiming compliance with GAAP must comply with all standards and interpretations, including disclosure requirements. True False. In establishing financial accounting standards, the FASB relies on two basic premises: (1) the FASB should be responsive to the needs and viewpoints of the entire economic community, not just the public accounting profession, and (2) it should operate in full view of the public through a “due process” system that gives interested people ample opportunities to make their view known.
CA 1-2 1. 2. 3. 4.
False. In addition to providing decision-useful information about future cash flows, management also is accountable to investors for the custody and safekeeping of the company’s economic resources and for their efficient and profitable use; however, this is not considered an objective. False. The objective of financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions in their capacity as capital providers. False. The FASB follows the same due process procedures for interpretations and standards. True
CA 1-3 1. 2. 3. 4. 5. 6. 7. 8.
(d) (d) (d) (a) (a) (b) (d) (b)
CA 1-4 (a) Financial accounting is the process that culminates in the preparation of financial reports relative to the enterprise as a whole for use by parties both internal and external to the enterprise. In contrast, managerial accounting is the process of identification, measurement, accumulation, analysis, preparation, interpretation, and communication of financial information used by the management to plan, evaluate, and control within an organization and to assure appropriate use of, and accountability for, its resources. (b) The financial statements most frequently provided are the balance sheet, the income statement, the statement of cash flows, and the statement of changes in owners’ or stockholders’ equity.
CA 1-4 (Continued) (c) Financial statements are the principal means through which financial information is communicated to those outside an enterprise. As indicated in (b), there are four major financial statements. However, some financial information is better provided, or can be provided only, by means of financial reporting other than formal financial statements. Financial reporting (other than financial statements and related notes) may take various forms. Examples include the company president’s letter or supplementary schedules in the corporate annual reports, prospectuses, reports filed with government agencies, news releases, management’s forecasts, and descriptions of an enterprise’s social or environmental impact.
CA 1-5 (a) In accordance with Statement of Financial Accounting Concepts No. 1, “Objectives of Financial Reporting by Business Enterprises,” the objectives of financial reporting are to provide information to investors, creditors, and others 1. that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. The information 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. 2. to help present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption, or maturity of securities or loans. Since investors’ and creditors’ cash flows are related to enterprise cash flows, financial reporting should provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows to the related enterprise. 3. about the economic resources of an enterprise, the claims to those resources (obligations of the enterprise to transfer resources to other entities and owners’ equity), and the effects of transactions, events, and circumstances that change its resources and claims to those resources. (b) Statement of Financial Accounting Concepts No. 1 established standards to meet the information needs of large groups of external users such as investors, creditors, and their representatives. Although the level of sophistication related to business and financial accounting matters varies both within and between these user groups, users are expected to possess a reasonable understanding of accounting concepts, financial statements, and business and economic activities and are expected to be willing to study and interpret the information with reasonable diligence.
CA 1-6 Accounting numbers affect investing decisions. Investors, for example, use the financial statements of different companies to enhance their understanding of each company’s financial strength and operating results. Because these statements follow generally accepted accounting principles, investors can make meaningful comparisons of different financial statements to assist their investment decisions. Accounting numbers also influence creditors’ decisions. A commercial bank usually looks into a company’s financial statements and past credit history before deciding whether to grant a loan and in what amount. The financial statements provide a fair picture of the company’s financial strength (for example, short-term liquidity and long-term solvency) and operating performance for the current period and over a period of time. The information is essential for the bank to ensure that the loan is safe and sound.
CA 1-7 It is not appropriate to abandon mandatory accounting rules and allow each company to voluntarily disclose the type of information it considered important. Without a coherent body of accounting theory and standards, each accountant or enterprise would have to develop its own theory structure and set of practices, and readers of financial statements would have to familiarize themselves with every company’s peculiar accounting and reporting practices. As a result, it would be almost impossible to prepare statements that could be compared. In addition, voluntary disclosure may not be an efficient way of disseminating information. A company is likely to disclose less information if it has the discretion to do so. Thus, the company can reduce its cost of assembling and disseminating information. However, an investor wishing additional information has to pay to receive additional information desired. Different investors may be interested in different types of information. Since the company may not be equipped to provide the requested information, it would have to spend additional resources to fulfill such needs; or the company may refuse to furnish such information if it’s too costly to do so. As a result, investors may not get the desired information or they may have to pay a significant amount of money for it. Furthermore, redundancy in gathering and distributing information occurs when different investors ask for the same information at different points in time. To the society as a whole, this would not be an efficient way of utilizing resources.
CA 1-8 (a) One of the committees that the AICPA established prior to the establishment of the FASB was the Committee on Accounting Procedures (CAP). The CAP, during its existence from 1939 to 1959, issued 51 Accounting Research Bulletins (ARB). In 1959, the AICPA created the Accounting Principles Board (APB) to replace the CAP. Before being replaced by the FASB, the APB released 31 official pronouncements, called APB Opinions. (b) Although the ARBs issued by the CAP helped to narrow the range of alternative practices to some extent, the CAP’s problem-by-problem approach failed to provide the well-defined, structured body of accounting principles that was both needed and desired. As a result, the CAP was replaced by the APB. The APB had more authority and responsibility than did the CAP. Unfortunately, the APB was beleaguered throughout its 14-year existence. It came under fire early, charged with lack of productivity and failing to act promptly to correct alleged accounting abuses. The APB also met a lot of industry and CPA firm opposition and occasional governmental interference when tackling numerous thorny accounting issues. In fear of governmental rule making, the accounting profession investigated the ineffectiveness of the APB and replaced it with the FASB. Learning from prior experiences, the FASB has several significant differences from the APB. The FASB has: (1) smaller membership, (2) full-time, compensated membership, (3) greater autonomy, (4) increased independence, and (5) broader representation. In addition, the FASB has its own research staff and relies on the expertise of various task force groups formed for various projects. These features form the bases for the expectations of success and support from the public. In addition, the due process taken by the FASB in establishing financial accounting standards gives interested persons ample opportunity to make their views known. Thus, the FASB is responsive to the needs and viewpoints of the entire economic community, not just the public accounting profession.
CA 1-8 (Continued) (c) The AICPA has supplemented the FASB’s efforts in the present standard-setting environment. The issue papers, which are prepared by the Accounting Standards Executive Committee (AcSEC), identify current financial reporting problems for specific industries and present alternative treatments of the issue. These papers provide the FASB with an early warning device to insure timely issuance of FASB standards, Interpretations, and Staff Positions. In situations where the FASB avoids the subject of an issue paper, AcSEC may issue a Statement of Position to provide guidance for the reporting issue. AcSEC also issues Practice Bulletins which indicate how the AICPA believes a given transaction should be reported. Recently, the role of the AICPA in standard-setting has diminished. The FASB and the AICPA agreed, that after a transition period, the AICPA and AcSEC no longer will issue authoritative accounting guidance for public companies.
CA 1-9 (a) The Financial Accounting Foundation (FAF) is the sponsoring organization of the FASB. The FAF selects the members of the FASB and its Advisory Council, funds their activities, and generally oversees the FASB’s activities. The FASB follows a due process in establishing a typical FASB Statement of Financial Accounting Standards. The following steps are usually taken: (1) A topic or project is identified and placed on the Board’s agenda. (2) A task force of experts from various sectors is assembled to define problems, issues, and alternatives related to the topic. (3) Research and analysis are conducted by the FASB technical staff. (4) A preliminary views document is drafted and released. (5) A public hearing is often held, usually 60 days after the release of the preliminary views. (6) The Board analyzes and evaluates the public response. (7) The Board deliberates on the issues and prepares an exposure draft for release. (8) After a 30-day (minimum) exposure period for public comment, the Board evaluates all of the responses received. (9) A committee studies the exposure draft in relation to the public responses, reevaluates its position, and revises the draft if necessary. (10) The full Board gives the revised draft final consideration and votes on issuance of a Standards Statement. The passage of a new accounting standard in the form of an FASB Statement requires the support of five of the seven Board members. (b) The FASB issues three major types of pronouncements: Standards and Interpretations, Financial Accounting Concepts, and Technical Bulletins. Financial accounting standards issued by the FASB are considered GAAP. In addition, the FASB also issues interpretations that represent modifications or extensions of existing standards and APB Opinions. These interpretations have the same authority as standards and APB Opinions in guiding current accounting practices. The Statements of Financial Accounting Concepts (SFAC) help the FASB to avoid the “problemby-problem approach.” These statements set forth fundamental objectives and concepts that the Board will use in developing future standards of financial accounting and reporting. They are intended to form a cohesive set of interrelated concepts, a body of theory or a conceptual framework, that will serve as tools for solving existing and emerging problems in a consistent, sound manner. The FASB may issue a technical bulletin when there is a need for guidelines on implementing or applying FASB Standards or Interpretations, APB Opinions, Accounting Research Bulletins, or emerging issues. A technical bulletin is issued only when (1) it is not expected to cause a major change in accounting practice for a number of enterprises, (2) its cost of implementation is low, and (3) the guidance provided by the bulletin does not conflict with any broad fundamental accounting principle.
CA 1-9 (Continued) In addition, the FASB’s Emerging Issues Task Force (EITF) issues statements to provide guidance on how to account for new and unusual financial transactions that have the potential for creating diversity in reporting practices. The EITF identifies controversial accounting problems as they arise and determines whether they can be quickly resolved or whether the FASB should become involved in solving them. In essence, it becomes a “problem filter” for the FASB. Thus, it is hoped that the FASB will be able to work on more pervasive long-term problems, while the EITF deals with shortterm emerging issues.
CA 1-10 (a) 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 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.
CA 1-10 (Continued) 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 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.
CA 1-10 (Continued) (c) 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 accounting principles.
CA 1-11 (a) The public/private mixed approach appears to be the way rules are established in the United States. In many respects, the FASB is a quasi-governmental agency in that its pronouncements are required to be followed because the SEC has provided support for this approach. The SEC has the ultimate power to establish GAAP but has chosen to permit the private sector to develop these rules. By accepting the standards established by the FASB as authoritative, it has granted much power to the FASB. (It might be useful to inform the students that not all countries follow this model. For example, the purely political approach is used in France and West Germany. The private, professional approach is employed in Australia, Canada, and the United Kingdom). (b) Publicly reported accounting numbers influence the distribution of scarce resources. Resources are channeled where needed at returns commensurate with perceived risk. Thus, reported accounting numbers have economic effects in that resources are transferred among entities and individuals as a consequence of these numbers. It is not surprising then that individuals affected by these numbers will be extremely interested in any proposed changes in the financial reporting environment. (c) The Accounting Standards Executive Committee (AcSEC of the AICPA), among other groups, has presented a potential challenge to the exclusive right of the FASB to establish accounting principles. Also, Congress has been attempting to legislate certain accounting practices, particularly to help struggling industries. Some possible reasons why other groups might wish to establish GAAP are: 1. As indicated in the previous answer, these rules have economic effects and therefore certain groups would prefer to make their own rules to ensure that they receive just treatment. 2. Some believe the FASB does not act quickly to resolve accounting matters, either because it is not that interested in the subject area or because it lacks the resources to do so. 3. Some argue that the FASB does not have the competence to legislate GAAP in certain areas. For example, many have argued that the FASB should not legislate GAAP for not-for-profit enterprises because the problems are unique and not well known by the FASB.
CA 1-12 (a) AICPA. American Institute of Certified Public Accountants. The national organization of practicing certified public accountants. (b) CAP. Committee on Accounting Procedure. A committee of practicing CPAs which issued 51 Accounting Research Bulletins between 1939 and 1959 and is a predecessor of the FASB. (c) ARB. Accounting Research Bulletins. Official pronouncements of the Committee on Accounting Procedure which, unless superseded, remain a primary source of GAAP. (d) APB. Accounting Principles Board. A committee of public accountants, industry accountants and academicians which issued 31 Opinions between 1959 and 1973. The APB replaced the CAP and was itself replaced by the FASB. Its opinions, unless superseded, remain a primary source of GAAP. (e) FAF. Financial Accounting Foundation. An organization whose purpose is to select members of the FASB and its Advisory Councils, fund their activities, and exercise general oversight. (f)
FASAC. Financial Accounting Standards Advisory Council. An organization whose purpose is to consult with the FASB on issues, project priorities, and select task forces.
(g) SOP. Statements of Position. Statements issued by the AICPA (through the Accounting Standards Executive Committee of its Accounting Standards Division) which are generally devoted to emerging problems not addressed by the FASB or the SEC. (h) GAAP. Generally accepted accounting principles. A common set of standards, principles, and procedures which have substantial authoritative support and have been accepted as appropriate because of universal application. (i)
CPA. Certified public accountant. An accountant who has fulfilled certain education and experience requirements and passed a rigorous examination. Most CPAs offer auditing, tax, and management consulting services to the general public.
(j)
FASB. Financial Accounting Standards Board. The primary body which currently establishes and improves financial accounting and reporting standards for the guidance of issuers, auditors, users, and others.
(k) SEC. Securities and Exchange Commission. An independent regulatory agency of the United States government which administers the Securities Acts of 1933 and 1934 and other acts. (l)
IASB. International Accounting Standards Board. An international group, formed in 1973, that is actively developing and issuing accounting standards that will have international appeal and hopefully support.
CA 1-13 (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. (b) Yes. Because the FASB rule results in a fairer representation, it should be implemented as soon as possible—regardless of its impact on net income. SEC Staff Bulletin No. 74 (December 30, 1987) requires a statement as to what the expected impact of the standard will be.
CA 1-13 (Continued) (c) The accountant’s responsibility is to provide financial statements that present fairly the financial condition of the company. By advocating early implementation, Weller fulfills this task. (d) Potential lenders and investors, who read the financial statements and rely on their 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).
CA 1-14 (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.
CA 1-15 (a) The ethical issue in this case relates to making questionable entries to meet expected earnings forecasts. As indicated in this chapter, businesses’ concentration on “maximizing the bottom line,” “facing the challenges of competition,” and “stressing short-term results” places accountants in an environment of conflict and pressure. (b) Given that Normand has pleaded guilty, he certainly acted improperly. Doing the right thing, making the right decision, is not always easy. Right is not always obvious, and the pressures to “bend the rules,” “to play the game,” “to just ignore it” can be considerable. (c) No doubt, Normand was in a difficult position. I am sure that he was concerned that if he failed to go along, it would affect his job performance negatively or that he might be terminated. These job pressures, time pressures, peer pressures often lead individuals astray. Can it happen to you? One individual noted that at a seminar on ethics sponsored by the CMA Society of Southern California, attendees were asked if they had ever been pressured to make questionable entries. This individual noted that to the best of his recollection, everybody raised a hand, and more than one had eventually chosen to resign. (d) Major stakeholders are: (1) Troy Normand, (2) present and potential stockholders and creditors of WorldCom, (3) employees, and (4) family. Recognize that WorldCom is the largest bankruptcy in United States history, so many individuals are affected.
CA 1-16 (a) Considering the economic consequences of GAAP, it is not surprising that special interest groups become vocal and critical (some supporting, some opposing) when rules are being formulated. The FASB’s derivative accounting pronouncement is no exception. Many from the banking industry, for example, criticized the rule as too complex and leading to unnecessary earnings volatility. They also indicated that the proposal may discourage prudent risk management activities and in some cases could present misleading financial information. As a result, Congress is often approached to put pressure on the FASB to change its rulings. In the stock option controversy, industry was quite effective in going to Congress to force the FASB to change its conclusions. In the derivative controversy, Rep. Richard Baker introduced a bill which would force the SEC to formally approve each standard issued by the FASB. Not only would this process delay adoption, but could lead to additional politicalization of the rule-making process. Dingell commented that Congress should stay out of the rule-making process and defended the FASB’s approach to establishing GAAP. (b) Attempting to set GAAP by a political process will probably lead to the following consequences: (a) Too many alternatives. (b) Lack of clarity that will lead to inconsistent application. (c) Lack of disclosure that reduces transparency. (d) Not comprehensive in scope. Without an independent process, GAAP will be based on political compromise. A classic illustration is what happened in the savings and loan industry. Applying generally accepted accounting principles to the S&L industry would have forced regulators to restrict activities of many S&Ls. Unfortunately, accounting principles were overridden by regulatory rules and the resulting lack of transparency masked the problems. William Siedman, former FDIC Chairman noted later that it was “the worst mistake in the history of government.” Another indication of the problem of government intervention is shown in the accounting standards used by some countries around the world. Completeness and transparency of information needed by investors and creditors is not available in order to meet or achieve other objectives.
CA 1-17 (a) The “due process” system involves the following: 1. Identifying topics and placing them on the Board’s agenda. 2. Research and analysis is conducted and preliminary views of pros and cons issued. 3. A public hearing is often held. 4. Board evaluates research and public responses and issues exposure draft. 5. Board evaluates responses and changes exposure draft, if necessary. Final statement is then issued. (b) Economic consequences mean the impact of accounting reports on the wealth positions of issuers and users of financial information and the decision-making behavior resulting from that impact. (c) Economic consequences indicated in the letter are: (1) concerns related to the potential impact on the capital markets, (2) the weakening of companies’ ability to manage risk, and (3) the adverse control implications of implementing costly and complex new rules imposed at the same time as other major initiatives, including the Year 2000 issues and a single European currency. (d) The principal point of this letter is to delay the finalization of the derivatives standard. As indicated in the letter, the authors of this letter urge the FASB to expose its new proposal for public comment, following the established due process procedures that are essential to acceptance of its standards
CA 1-17 (Continued) and providing sufficient time for affected parties to understand and assess the new approach. (Authors note: The FASB indicated in a follow-up letter that all due process procedures had been followed and all affected parties had more than ample time to comment. In addition, the FASB issued a follow-up standard, which delayed the effective date of the standard, in part to give companies more time to develop the information systems needed for implementation of the standard). (e) The reason why the letter was sent to Congress was to put additional pressure on the FASB to delay or drop the issuance of a rule on derivatives. Unfortunately, in too many cases, when the business community does not like the answer proposed by the FASB, it resorts to lobbying members of Congress. The lobbying efforts usually involve developing some type of legislation that will negate the rule. In some cases, efforts involve challenging the FASB’s authority to develop rules in certain areas with additional Congressional oversight.
FINANCIAL REPORTING PROBLEM (a) The key organizations involved in rule making in the U.S. are the AICPA, FASB, and SEC. See also (c). (b) Different authoritative literature pertaining to methods recording accounting transactions exists today. Some authoritative literature has received more support from the profession than other literature. The literature that has substantial authoritative support is the one most supported by the profession and should be followed when recording accounting transactions. These standards and procedures are called generally accepted accounting principles (GAAP). With implementation of the Codification, what qualifies as authoritative is any literature contained in the Codification. The Codification changes the way GAAP is documented, presented, and updated. It creates one level of GAAP which is considered authoritative. All other accounting literature is considered non-authoritative. What happens if the Codification does not cover a certain type of transaction or event? In this case, other accounting literature should be considered which includes FASB Concepts Statements, international financial reporting standards and other professional literature. (c) Rule-making in the U.S. has evolved through the work of the following organizations: 1. American Institute of Certified Public Accountants (AICPA)—it is the national professional organization of practicing Certified Public Accountants (CPAs). Outgrowths of the AICPA have been the Committee on Accounting Procedure (CAP) which issued Accounting Research Bulletins and the Accounting Principles Board (APB) whose major purposes were to advance written expression of accounting principles, determine appropriate practices, and narrow the areas of difference and inconsistency in practice. 2. Financial Accounting Standards Board (FASB)—the mission of the FASB is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, which includes issuers, auditors, and users of the financial information.
FINANCIAL REPORTING PROBLEM (Continued) 3. Securities and Exchange Commission (SEC)—the SEC is an independent regulatory agency of the United States government which administers the Securities Act of 1933, the Securities Exchange Act of 1934, and several other acts. The SEC has broad power to prescribe the accounting practices and standards to be employed by companies that fall within its jurisdiction. (d) The SEC and the AICPA have been the authority for compliance with GAAP. 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.
PROFESSIONAL RESEARCH (a) CON 1, Par. 32. The objectives begin with a broad focus on information that is useful in investment and credit decisions; then narrow that focus to investors’ and creditors’ primary interest in the prospects of receiving cash from their investments in or loans to business enterprises and the relation of those prospects to the enterprise’s prospects; and finally focus on information about an enterprise’s economic resources, the claims to those resources, and changes in them, including measures of the enterprise’s performance, that is useful in assessing the enterprise’s cash flow prospects. (b) CON 1, Par. 7. Financial reporting includes not only financial statements but also other means of communicating information that relates, directly or indirectly, to the information provided by the accounting system—that is, information about an enterprise’s resources, obligations, earnings, etc. Management may communicate information to those outside an enterprise by means of financial reporting other than formal financial statements either because the information is required to be disclosed by authoritative pronouncement, regulatory rule, or custom or because management considers it useful to those outside the enterprise and discloses it voluntarily. Information communicated by means of financial reporting other than financial statements may take various forms and relate to various matters. Corporate annual reports, prospectuses, and annual reports filed with the Securities and Exchange Commission are common examples of reports that include financial statements, other financial information, and nonfinancial information. News releases, management’s forecasts or other descriptions of its plans or expectations, and descriptions of an enterprise’s social or environmental impact are examples of reports giving financial information other than financial statements or giving only nonfinancial information. (c) CON 1, Par, 24 and 25: 24. Many people base economic decisions on their relationships to and knowledge about business enterprises and thus are potentially interested in the information provided by financial reporting. Among the potential users are owners, lenders, suppliers, potential investors and creditors, employees, management, directors, customers, financial analysts and advisors, brokers, underwriters, stock exchanges, lawyers, economists, taxing authorities, regulatory authorities,
PROFESSIONAL RESEARCH (Continued) legislators, financial press and reporting agencies, labor unions, trade associations, business researchers, teachers and students, and the public. Members and potential members of some groups—such as owners, creditors, and employees—have or contemplate having direct economic interests in particular business enterprises. Managers and directors, who are charged with managing the enterprise in the interest of owners (paragraph 12), also have a direct interest. Members of other groups—such as financial analysts and advisors, regulatory authorities, and labor unions—have derived or indirect interests because they advise or represent those who have or contemplate having direct interests. Potential users of financial information most directly concerned with a particular business enterprise are generally interested in its ability to generate favorable cash flows because their decisions relate to amounts, timing, and uncertainties of expected cash flows. To investors, lenders, suppliers, and employees, a business enterprise is a source of cash in the form of dividends or interest and perhaps appreciated market prices, repayment of borrowing, payment for goods or services, or salaries or wages. They invest cash, goods, or services in an enterprise and expect to obtain sufficient cash in return to make the investment worthwhile. They are directly concerned with the ability of the enterprise to generate favorable cash flows and may also be concerned with how the market’s perception of that ability affects the relative prices of its securities. To customers, a business enterprise is a source of goods or services, but only by obtaining sufficient cash to pay for the resources it uses and to meet its other obligations can the enterprise provide those goods or services. To managers, the cash flows of a business enterprise are a significant part of their management responsibilities, including their accountability to directors and owners. Many, if not most, of their decisions have cash flow consequences for the enterprise. Thus, investors, creditors, employees, customers, and managers significantly share a common interest in an enterprise’s ability to generate favorable cash flows. Other potential users of financial information share the same interest, derived from investors, creditors, employees, customers, or managers whom they advise or represent or derived from an interest in how those groups (and especially stockholders) are faring.
PROFESSIONAL SIMULATION (a)
The term “accounting principles” in the auditor’s report includes not only accounting principles but also the 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 connote, however, rules from which there can be no deviation. In some cases the question is which of several partially relevant principles are applicable. 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.
(b)
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. The CPA is responsible for collecting the available evidence of authoritative support and judging whether it is sufficient to bring the practice within the bounds of generally accepted accounting principles. With implementation of the Codification, what qualifies as authoritative is any literature contained in the Codification. The Codification changes the way GAAP is documented, presented, and updated. It creates one level of GAAP which is considered authoritative. All other accounting literature is considered non-authoritative. What happens if the Codification does not cover a certain type of transaction or event? In this case, other accounting literature should be considered which includes FASB Concepts Statements, international financial reporting standards and other professional literature.
PROFESSIONAL SIMULATION (Continued) For example, other evidence of authoritative support may be found in the published opinions of the committees of the American Accounting Association and the affirmative opinions of practitioners and academicians in articles, textbooks, and expert testimony. Similarly, the views of stock exchanges, commercial and investment bankers, and regulatory commissions influence the general acceptance of accounting principles and, hence, are considered in determining whether an accounting principle has substantial authoritative support. Business practice also is a source of evidence. Finally, because they influence business practice, the tax code and state laws are sources of evidence too.
IFRS CONCEPTS AND APPLICATION IFRS 1-1 The two organizations involved in international standard-setting are IOSCO (International Organization of Securities Commissions) and the IASB (International Accounting Standards Board.) The IOSCO does not set accounting standards, but ensures that the global markets can operate in an efficient and effective manner. Conversely, the IASB’s mission is to develop a single set of high quality, understandable and international financial reporting standards (IFRSs) for general purpose financial statements. IFRS 1-2 The standards issued by these organizations are sometimes principlesbased, rules-based, tax-oriented, or business-based. In other words, they often differ in concept and objective. IFRS 1-3 A single set of high quality accounting standards ensures adequate comparability. Investors are able to make better investment decisions if they receive financial information from a U.S. company that is comparable to an international competitor. IFRS 1-4 The international standards must be of high quality and sufficiently comprehensive. To achieve this goal, the IASB and the FASB have set up an extensive work plan to achieve the objective of developing one set of world-class international standards. This work plan actually started in 2002, when an agreement was forged between the two Boards, where each acknowledged their commitment to the development of high-quality, compatible accounting standards that could be used for both domestic and cross-border financial reporting (referred to as the Norwalk Agreement).
IFRS 1-4 (Continued) At that meeting, the FASB and the IASB 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 achieved, compatibility is maintained. This document was reinforced in 2006 when the parties issued a memorandum of understanding (MOU) which highlighted three principles: Convergence of accounting standards can best be achieved through the development of high-quality common standards over time. Trying to eliminate differences between two standards that are in need of significant improvement is not the best use of the FASB’s and the IASB’s resources—instead, a new common standard should be developed that improves the financial information reported to investors. Serving the needs of investors means that the Boards should seek convergence by replacing standards in need of improvement with jointly developed new standards. Subsequently, in 2009 the Boards agreed on a process to complete a number of major projects by 2011, including monthly joint meetings. As part of achieving this goal, it is critical that the process by which the standards are established be independent. And, it is necessary that the standards are maintained, and emerging accounting issues are dealt with efficiently. The SEC has directed its staff to develop and execute a plan (“Work Plan”) to enhance both the understanding of the SEC’s purpose and public transparency in this area. Execution of the Work Plan (which addresses such areas as independence of standard-setting, investor understanding of IFRS, and auditor readiness), combined with the completion of the convergence projects of the FASB and the IASB according to their current work plan, will position the SEC in 2011 to make a decision on required use of IFRS in the U.S. issuers. After reviewing the progress related to the Work Plan studies, the SEC will decide, sometime in 2011, whether to mandate the use of IFRS. It is likely that not all companies would be required immediately to change to IFRS, but there would be a transition period in which this would be accomplished.
IFRS1-5 (a) The International Accounting Standards Board is an independent, privately funded accounting standards setter based in London, UK. The Board is committed to developing, in the public interest, a single set of high quality, understandable and enforceable global accounting standards that require transparent and comparable information in general purpose financial statements. In addition, the Board cooperates with national accounting standards setters to achieve convergence in accounting standards around the world. (b) In summary, the following groups might gain most from convergence of financial reporting: Investors, investment analysts and stockbrokers: to facilitate international comparisons for investment decisions. Credit grantors: for similar reasons to bullet point above. Multinational companies: as preparers, investors, appraisers of products or staff, and as movers of staff around the globe; also, as raisers of finance on international markets (this also applies to some companies that are not multinationals). Governments: as tax collectors and hosts of multinationals; also interested are securities markets regulators and governmental and nongovernmental rule makers. (c) The fundamental argument against convergence is that, to the extent that international differences in accounting practices result from underlying economic, legal, social, and other environmental factors, harmonization may not be justified. Different accounting has grown up to serve the different needs of different users; this might suggest that the existing accounting practice is “correct” for a given nation and should not be changed merely to simplify the work of multinational companies or auditors. There does seem to be strength in this point particularly for smaller companies with no significant multinational activities or connections. To foist upon a small private family company in Luxembourg lavish disclosure requirements and the need to report a “true and fair” view may be an expensive and unnecessary piece of convergence.
IFRS1-5 (Continued) The most obvious obstacle to harmonization is the sheer size and deep rootedness of the differences in accounting. These differences have grown up over the previous century because of differences in users, legal systems, and so on. Thus, the differences are structural rather than cosmetic, and require revolutionary action to remove them. IFRS 1-6 (a) As indicated in paragraph 12 of the Framework, “The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions.” (b) According to paragraph 21 of the Framework, notes and supplementary schedules serve in this role. For example, they may contain additional information that is relevant to the needs of users about the items in the statement of financial position and income statement. They may include disclosures about the risks and uncertainties affecting the entity and any resources and obligations not recognised in the statement of financial position (such as mineral reserves). Information about geographical and industry segments and the effect on the entity of changing prices may also be provided in the form of supplementary information. (c) As indicated in paragraphs 13 and 14, financial statements prepared to meet the objective of financial reporting meet the common needs of most users. However, financial statements do not provide all the information that users may need to make economic decisions since they largely portray the financial effects of past events and do not necessarily provide non-financial information. In addition, financial statements also show the results of the stewardship of management, or the accountability of management for the resources entrusted to it. Those users who wish to assess the stewardship or accountability of management do so in order that they may make economic decisions; these decisions may include, for example, whether to hold or sell their investment in the entity or whether to reappoint or replace the management.
IFRS1-7 (a) Operating retail stores (clothing, home, and food). (b) Operations are primarily in the UK, China, Czech Republic, Greece, Hungary, India, Indonesia, Jersey, Kuwait, Latvia, Lithuania, Malaysia, Malta, Oman, Philippines, Poland, Qatar, Republic of Ireland, Romania, Russia, Saudi Arabia, Serbia, Singapore, Slovakia, Slovenia, South Korea, Spain, Switzerland, Taiwan, Thailand, Turkey, UAE, and Ukraine. (c) Waterside House, 35 North Wharf Road, London W2 1NW. (d) Pound.
CHAPTER 2 Conceptual Framework for Financial Reporting ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics
Questions
1.
Conceptual framework– general.
1, 7
2.
Objective of financial reporting.
2
3.
Qualitative characteristics of accounting.
3, 4, 5, 6, 8
4.
Elements of financial statements.
5. 6.
Brief Exercises
Exercises
Concepts for Analysis 1, 2
1, 2
3
1, 2, 3, 4
2, 3, 4
4, 9
9, 10, 11
6, 10, 12
5
Basic assumptions.
12, 13, 14
5, 7
6, 7
Basic principles: a. Measurement. b. Revenue recognition. c. Expense recognition. d. Full disclosure.
15, 16, 17, 18 19, 20, 21, 22, 23 24 25, 26, 27
8, 9, 11 8 8, 11 8, 11
6, 7 7 6, 7 6, 7, 8
7.
Accounting principles– comprehensive.
8.
Cost constraint.
9.
Assumptions, principles, and constraints.
5 5 5, 6, 7, 8, 10 10
9, 10 28, 29, 30
3, 6, 7 10
6, 7
11
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives
Questions
1.
Describe the usefulness of a conceptual framework.
1
2.
Describe the FASB’s efforts to construct a conceptual framework.
3.
Understand the objectives of financial reporting.
2
4.
Identify the qualitative characteristics of accounting information.
3, 4, 5, 6, 8
5.
Define the basic elements of financial statements.
6.
Brief Exercises
Exercises
Concepts for Analysis
1, 2
CA2-1 CA2-1, CA22, CA2-3
1, 2
CA2-2, CA23
1, 2, 3, 4, 5
2, 3, 4
CA2-4, CA25
7, 10, 11, 26, 27
6, 12
5
Describe the basic assumptions of accounting.
9, 12, 13, 14, 25
7, 10, 11
6, 7
7.
Explain the application of the basic principles of accounting.
15, 16, 17, 18, 19, 20, 21, 22, 23, 24, 26, 27, 28, 29, 30
8, 9, 11
6, 7, 8, 9, 10
CA2-5, CA26, CA2-7, CA2-8, CA29, CA2-10, CA2-11
8.
Describe the impact that the cost constraint has on reporting accounting information.
28, 29, 30
11
3, 6, 7
CA2-11
ASSIGNMENT CHARACTERISTICS TABLE Level of Difficulty
Time (minutes)
Simple Simple
15–20 15–20
Moderate Simple Simple Simple Moderate Complex Moderate Moderate
25–30 15–20 15–20 15–20 20–25 20–25 20–25 20–25
Conceptual framework–general. Conceptual framework–general. Objective of financial reporting. Qualitative characteristics. Revenue recognition principle.
Simple Simple Moderate Moderate Complex
20–25 25–35 25–35 30–35 25–30
Expense recognition principle. Expense recognition principle. Expense recognition principle. Qualitative characteristics. Expense recognition principle. Cost Constraint.
Complex Moderate Moderate Moderate Moderate Moderate
20–25 20–25 20–30 20–30 20–25 30–35
Item
Description
E2-1 E2-2 E2-3 E2-4 E2-5 E2-6 E2-7 E2-8 E2-9 E2-10
Usefulness, objective of financial reporting. Usefulness, objective of financial reporting, qualitative characteristics. Qualitative characteristics. Qualitative characteristics. Elements of financial statements. Assumptions, principles, and constraint. Assumptions, principles, and constraint. Full disclosure principle. Accounting principles–comprehensive. Accounting principles–comprehensive.
CA2-1 CA2-2 CA2-3 CA2-4 CA2-5 CA2-6 CA2-7 CA2-8 CA2-9 CA2-10 CA2-11
SOLUTION TO CODIFICATION EXERCISES CE2-1 (a)
The master glossary provides three definitions of fair value that are found in GAAP: Fair Value—The amount at which an asset (or liability) could be bought (or incurred) or settled in a current transaction between willing parties, that is, other than in a forced or liquidation sale. Fair Value—The fair value of an investment is the amount that the plan could reasonably expect to receive for it in a current sale between a willing buyer and a willing seller, that is, other than in a forced or liquidation sale. Fair value shall be measured by the market price if there is an active market for the investment. If there is no active market for the investment but there is a market for similar investments, selling prices in that market may be helpful in estimating fair value. If a market price is not available, a forecast of expected cash flows, discounted at a rate commensurate with the risk involved, may be used to estimate fair value. The fair value of an investment shall be reported net of the brokerage commissions and other costs normally incurred in a sale. 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.
(b)
Revenue—Revenue earned by an entity from its direct distribution, exploitation, or licensing of a film, before deduction for any of the entity’s direct costs of distribution. For markets and territories in which an entity’s fully or jointly-owned films are distributed by third parties, revenue is the net amounts payable to the entity by third party distributors. Revenue is reduced by appropriate allowances, estimated returns, price concessions, or similar adjustments, as applicable. The glossary references a revenue definition for the SEC: (Revenue (SEC))—See paragraph 942-235-S599-1, Regulation S-X Rule 9-05(c)(2), for the definition of revenue for purposes of Regulation S-X Rule 9-05. This definition relates to segment reporting requirements for public companies.
(c)
Comprehensive Income is defined as the change in equity (net assets) of a business entity during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.
CE2-2 The FASB Codification’s organization is closely aligned with the elements of financial statements, as articulated in the Conceptual Framework. This is apparent in the lay-out of the “Browse” section, which has primary links for Assets, Liabilities, Equity, Revenues, and Expenses.
ANSWERS TO QUESTIONS 1. A conceptual framework is a coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and financial statements. A conceptual framework is necessary in financial accounting for the following reasons: (1) It enables the FASB to issue more useful and consistent standards in the future. (2) New issues will be more quickly solvable by reference to an existing framework of basic theory. (3) It increases financial statement users’ understanding of and confidence in financial reporting. (4) It enhances comparability among companies’ financial statements. 2. The basic objective is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity. 3. “Qualitative characteristics of accounting information” are those characteristics which contribute to the quality or value of the information. The overriding qualitative characteristic of accounting information is usefulness for decision making. 4. Relevance and faithful representation are the two primary qualities of useful accounting information. For information to be relevant, it should should be 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. Faithful representation of a measure rests on whether the numbers and descriptions match what really existed or happened. 5. The concept of materiality refers to the relative significance of an amount, activity, or item to informative disclosure, proper presentation of financial position, and the results of operations. Materiality has qualitative and quantitative aspects; both the nature of the item and its relative size enter into its evaluation. An accounting misstatement is said to be material if knowledge of the misstatement will affect the decisions of the average informed reader of the financial statements. Financial statements are misleading if they omit a material fact or include so many immaterial matters as to be confusing. In the examination, the auditor concentrates efforts in proportion to degrees of materiality and relative risk and disregards immaterial items. The relevant criteria for assessing materiality will depend upon the circumstances and the nature of the item and will vary greatly among companies. For example, an error in current assets or current liabilities will be more important for a company with a flow of funds problem than for one with adequate working capital. The effect upon net income (or earnings per share) is the most commonly used measure of materiality. This reflects the prime importance attached to net income by investors and other users of the statements. The effects upon assets and equities are also important as are misstatements of individual accounts and subtotals included in the financial statements. The auditor will note the effects of misstatements on key ratios such as gross profit, the current ratio, or the debt/equity ratio and will consider such special circumstances as the effects on debt agreement covenants and the legality of dividend payments.
Questions Chapter 2 (Continued) There are no rigid standards or guidelines for assessing materiality. The lower bound of materiality has been variously estimated at 5% to 20% of net income, but the determination will vary based upon the individual case and might not fall within these limits. Certain items, such as a questionable loan to a company officer, may be considered material even when minor amounts are involved. In contrast a large misclassification among expense accounts may not be deemed material if there is no misstatement of net income. 6. Enhancing qualities are qualitative characteristics that are complementary to the fundamental qualitative characteristics. These characteristics distinguish more-useful information from lessuseful information. Enhancing characteristics are comparability, verifiability, timeliness, and understandability. 7. In providing information to users of financial statements, the Board relies on general-purpose financial statements. The intent of such statements is to provide the most useful information possible at minimal cost to various user groups. Underlying these objectives is the notion that users need reasonable knowledge of business and financial accounting matters to understand the information contained in financial statements. This point is important. It means that in the preparation of financial statements a level of reasonable competence can be assumed; this has an impact on the way and the extent to which information is reported. 8. Comparability facilitates comparisons between information about two different enterprises at a particular point in time. Consistency, a type of comparability, facilitates comparisons between information about the same enterprise at two different points in time. 9. At present, the accounting literature contains many terms that have peculiar and specific meanings. Some of these terms have been in use for a long period of time, and their meanings have changed over time. Since the elements of financial statements are the building blocks with which the statements are constructed, it is necessary to develop a basic definitional framework for them. 10. Distributions to owners differ from expenses and losses in that they represent transfers to owners, and they do not arise from activities intended to produce income. Expenses differ from losses in that they arise from the entity’s ongoing major or central operations. Losses arise from peripheral or incidental transactions. 11. Investments by owners differ from revenues and gains in that they represent transfers by owners to the entity, and they do not arise from activities intended to produce income. Revenues differ from gains in that they arise from the entity’s ongoing major or central operations. Gains arise from peripheral or incidental transactions. 12. The four basic assumptions that underlie the financial accounting structure are: (1) An economic entity assumption. (2) A going concern assumption. (3) A monetary unit assumption. (4) A periodicity assumption. 13. (a) In accounting it is generally agreed that any measures of the success of an enterprise for periods less than its total life are at best provisional in nature and subject to correction. Measurement of progress and status for arbitrary time periods is a practical necessity to serve those who must make decisions. It is not the result of postulating specific time periods as measurable segments of total life.
Questions Chapter 2 (Continued) (b) The practice of periodic measurement has led to many of the most difficult accounting problems such as inventory pricing, depreciation of long-term assets, and the necessity for revenue recognition tests. The accrual system calls for associating related revenues and expenses. This becomes very difficult for an arbitrary time period with incomplete transactions in process at both the beginning and the end of the period. A number of accounting practices such as adjusting entries or the reporting of corrections of prior periods result directly from efforts to make each period’s calculations as accurate as possible and yet recognizing that they are only provisional in nature. 14. The monetary unit assumption assumes that the unit of measure (the dollar) remains reasonably stable so that dollars of different years can be added without any adjustment. When the value of the dollar fluctuates greatly over time, the monetary unit assumption loses its validity. The FASB in Concept No. 5 indicated that it expects the dollar unadjusted for inflation or deflation to be used to measure items recognized in financial statements. Only if circumstances change dramatically will the Board consider a more stable measurement unit. 15. Some of the arguments which might be used are outlined below: (1) Cost is definite and reliable; other values would have to be determined somewhat arbitrarily and there would be considerable disagreement as to the amounts to be used. (2) Amounts determined by other bases would have to be revised frequently. (3) Comparison with other companies is aided if cost is employed. (4) The costs of obtaining replacement values could outweigh the benefits derived. 16. Fair value is defined 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.” Fair value is therefore a market-based measure. 17. The fair value option gives companies the option to use fair value (referred to as the fair value option as the basis for measurement of financial assets and financial liabilities.) The Board believes that fair value measurement for financial instruments provides more relevant and understandable information than historical cost. It considers fair value to be more relevant because it reflects the current cash equivalent value of financial instruments. As a result companies now have the option to record fair value in their accounts for most financial instruments, including such items as receivables, investments, and debt securities. 18. The fair value hierarchy provides insight into the priority of valuation techniques that are used to determine fair value. The fair value hierarchy is divided into three broad levels. Fair Value Hierarchy Level 1: Observable inputs that reflect quoted prices for identical assets or liabilities in active markets.
Least Subjective
Level 2: Inputs other than quoted prices included in Level 1 that are observable for the asset or liability either directly or through corroboration with observable data. Level 3: Unobservable inputs (for example, a company’s own data or assumptions).
Most Subjective
Questions Chapter 2 (Continued) As indicated, Level 1 is the most reliable because it is based on quoted prices, like a closing stock price in the Wall Street Journal. Level 2 is the next most reliable and would rely on evaluating similar assets or liabilities in active markets. At the least-reliable level, Level 3, much judgment is needed based on the best information available to arrive at a relevant and reliable fair value measurement. 19. The revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. In the case of services, revenue is recognized when the services are performed. In the case a selling a product, the performance obligation is met when the product is delivered. Companies follow a five-step process to analyze revenue arrangements to determine when revenue should be recognized: (1) Identify the contract(s) with the customer; (2) Identify the separate performance obligations in the contract; (3) Determine the transaction price; (4) Allocate the transaction price to separate performance obligations; and (5) Recognize revenue when each performance obligation is satisfied. 20. A performance obligation is a promise to deliver a product or provide a service to a customer. The revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. In the case of services, revenue is recognized when the services are performed. In the case of selling a product, the performance obligation is met when the product is delivered. 21. The five steps in the revenue recognition process are: Step 1 Identify the contract(s) with the customer. A contract is an agreement between two parties that creates enforceable rights or obligations. Step 2 Identify the separate performance obligations in the contract. A performance obligation is ether a promise to provide a service or deliver a product, or both. Step 3. Determine the transaction price. Transaction price is the amount of consideration that a company expects to receive from a customer in exchange for transferring a good or service. Step 4. Allocate the transaction price to separate performance obligations. This is usually done by estimating the value of consideration attributable to each product or service. Step 5. Recognize revenue when each performance obligation is satisfied. This occurs when the service is provided or the product is delivered. Note that many revenue transactions pose few problems because the transaction is initiated and completed at the same time. 22. Revenues are recognized when a performance obligation is met. The most common time at which these two conditions are met is when the product or merchandise is delivered or services are rendered to customers. Therefore, revenue for Selane Eatery should be recognized at the time the luncheon is served. 23. The president means that the “gain” should be recorded in the books. This item should not be entered in the accounts, however, because it has not been realized. 24. The cause and effect relationship can seldom be conclusively demonstrated, but many costs appear to be related to particular revenues and recognizing them as expenses accompanies recognition of the revenue. Examples of expenses that are recognized by associating cause and effect are sales commissions and cost of products sold or services provided.
Questions Chapter 2 (Continued) Systematic and rational allocation means that in the absence of a direct means of associating cause and effect, and where the asset provides benefits for several periods, its cost should be allocated to the periods in a systematic and rational manner. Examples of expenses that are recognized in a systematic and rational manner are depreciation of plant assets, amortization of intangible assets, and allocation of rent and insurance. Some costs are immediately expensed because the costs have no discernible future benefits or the allocation among several accounting periods is not considered to serve any useful purpose. Examples include officers’ salaries, most selling costs, amounts paid to settle lawsuits, and costs of resources used in unsuccessful efforts. 25. The four characteristics are: (1) Definitions—The item meets the definition of an element of financial statements. (2) Measurability—It has a relevant attribute measurable with sufficient reliability. (3) Relevance—The information is capable of making a difference in user decisions. (4) Reliability—The information is representationally faithful, verifiable, and neutral. 26. (a) To be recognized in the main body of financial statements, an item must meet the definition of an element. In addition the item must have been measured, recorded in the books, and passed through the double-entry system of accounting. (b) Information provided in the notes to the financial statements amplifies or explains the items presented in the main body of the statements and is essential to an understanding of the performance and position of the enterprise. Information in the notes does not have to be quantifiable, nor does it need to qualify as an element. (c) Supplementary information includes information that presents a different perspective from that adopted in the financial statements. It also includes management’s explanation of the financial information and a discussion of the significance of that information. 27. The general guide followed with regard to the full disclosure principle is to disclose in the financial statements any facts of sufficient importance to influence the judgment of an informed reader. The fact that the amount of outstanding common stock doubled in January of the subsequent reporting period probably should be disclosed because such a situation is of importance to present stockholders. Even though the event occurred after December 31, 2014, it should be disclosed on the balance sheet as of December 31, 2014, in order to make adequate disclosure. (The major point that should be emphasized throughout the entire discussion on full disclosure is that there is normally no “black” or “white” but varying shades of grey and it takes experience and good judgment to arrive at an appropriate answer). 28. Accounting information is subject to the cost constraint. Information is not worth providing unless the benefits exceed the costs of preparing it. 29. The costs of providing accounting information are paid primarily to highly trained accountants who design and implement information systems, retrieve and analyze large amounts of data, prepare financial statements in accordance with authoritative pronouncements, and audit the information presented. These activities are time-consuming and costly. The benefits of providing accounting information are experienced by society in general, since informed financial decisions help allocate scarce resources to the most effective enterprises. Occasionally new accounting standards require presentation of information that is not readily assembled by the accounting systems of most companies. A determination should be made as to whether the incremental or additional costs of providing the proposed information exceed the incremental benefits to be obtained. This determination requires careful judgment since the benefits of the proposed information may not be readily apparent.
Questions Chapter 2 (Continued) 30. In general, conservatism should not be the basis for determining the accounting for transactions. (a) Acceptable if reasonably accurate estimation is possible. To the extent that warranty costs can be estimated accurately, they should be matched against the related sales revenue. (b) Not acceptable. Most accounts are collectible or the company will be out of business very soon. Hence sales can be recorded when made. Also, other companies record sales when made rather than when collected, so if accounts for Landowska Co. are to be compared with other companies, they must be kept on a comparable basis. However, estimates for uncollectible accounts should be recorded if there is a reasonably accurate basis for estimating bad debts. (c) Not acceptable. A provision for the possible loss can be made through an appropriation of retained earnings but until judgment has been rendered on the suit or it is otherwise settled, entry of the loss usually represents anticipation. Recording it earlier is probably unwise legal strategy as well. For the loss to be recognized at this point, the loss would have to be probable and reasonably estimable. (See FASB ASC 450-10-05 for additional discussion if desired.) Note disclosure is required if the loss is not recorded; however, conservatism is not part of the conceptual framework.
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 2-1 (a) (b) (c) (d) (e)
5. Comparability 8. Timeliness 3. Predictive value 1. Relevance 7. Neutrality
BRIEF EXERCISE 2-2 (a) (b) (c) (d) (e)
5. Faithful representation 8. Confirmatory value 3. Free from error 2. Completeness 4. Understandability
BRIEF EXERCISE 2-3 (a)
If the company changed its method for inventory valuation, the consistency, and therefore the comparability, of the financial statements have been affected by a change in the method of applying the accounting principles employed. The change would require comment in the auditor’s report in an explanatory paragraph.
(b)
If the company disposed of one of its two subsidiaries that had been included in its consolidated statements for prior years, no comment as to consistency needs to be made in the CPA’s audit report. The comparability of the financial statements has been affected by a business transaction, but there has been no change in any accounting principle employed or in the method of its application. (The transaction would probably require informative disclosure in the financial statements).
BRIEF EXERCISE 2-3 (continued) (c)
If the company reduced the estimated remaining useful life of plant property because of obsolescence, the comparability of the financial statements has been affected. The change is not a matter of consistency; it is a change in accounting estimate required by altered conditions and involves no change in accounting principles employed or in their method of application. The change would probably be disclosed by a note in the financial statements. If commented upon in the CPA’s report, it would be as a matter of disclosure rather than consistency.
BRIEF EXERCISE 2-4 (a) (b) (c) (d)
Verifiability Comparability Comparability (consistency) Timeliness
BRIEF EXERCISE 2-5 Companies and their auditors for the most part have adopted the general rule of thumb that anything under 5% of net income is considered not material. Recently, the SEC has indicated that it is okay to use this percentage for the initial assessment of materiality, but other factors must be considered. For example, companies can no longer fail to record items in order to meet consensus analyst’s earnings numbers, preserve a positive earnings trend, convert a loss to a profit or vice versa, increase management compensation, or hide an illegal transaction like a bribe. In other words, both quantitative and qualitative factors must be considered in determining when an item is material. (a)
Because the change was used to create a positive trend in earnings, the change is considered material.
(b)
Each item must be considered separately and not netted. Therefore each transaction is considered material.
(c)
In general, companies that follow an “expense all capital items below a certain amount” policy are not in violation of the materiality concept. Because the same practice has been followed from year to year, Damon’s actions are acceptable.
BRIEF EXERCISE 2-6 (a) (b) (c) (d) (e) (f) (g) (h) (i) (j)
Equity Revenues Equity Assets Expenses Losses Liabilities Distributions to owners Gains Investments by owners
BRIEF EXERCISE 2-7 (a) (b) (c) (d)
Periodicity Monetary unit Going concern Economic entity
BRIEF EXERCISE 2-8 (a) (b) (c) (d)
Revenue recognition Expense recognition Full disclosure Measurement (historical cost)
BRIEF EXERCISE 2-9 Investment 1—Level 3 Investment 2—Level 1 Investment 3—Level 2 BRIEF EXERCISE 2-10 (a)
Net realizable value.
(b)
Would not be disclosed. Liabilities would be disclosed in the order to be paid.
BRIEF EXERCISE 2-10 (continued) (c)
Would not be disclosed. Depreciation would be inappropriate if the going concern assumption no longer applies.
(d)
Net realizable value.
(e)
Net realizable value (i.e., redeemable value).
BRIEF EXERCISE 2-11 (a) (b) (c)
Full disclosure Expense recognition Historical cost
BRIEF EXERCISE 2-12 (a)
Should be debited to the Land account, as it is a cost incurred in acquiring land.
(b)
As an asset, preferably to a Land Improvements account. The driveway will last for many years, and therefore it should be capitalized and depreciated.
(c)
Probably an asset, as it will last for a number of years and therefore will contribute to operations of those years.
(d)
If the fiscal year ends December 31, this will all be an expense of the current year that can be charged to an expense account. If statements are to be prepared on some date before December 31, part of this cost would be expense and part asset. Depending upon the circumstances, the original entry as well as the adjusting entry for statement purposes should take the statement date into account.
(e)
Should be debited to the Building account, as it is a part of the cost of that plant asset which will contribute to operations for many years.
(f)
As an expense, as the service has already been received; the contribution to operations occurred in this period.
SOLUTIONS TO EXERCISES EXERCISE 2-1 (15–20 minutes) (a) (b)
(c)
(d) (e) (f)
True. False – General-purpose financial reports helps users who lack the ability to demand all the financial information they need from an entity and therefore must rely, at least partly, on the information in financial reports. False – Standard-setting that is based on personal conceptual frameworks will lead to different conclusions about identical or similar issues. As a result, standards will not be consistent with one another, and past decisions may not be indicative of future ones. False – Information that is decision-useful to capital providers may also be useful to users of financial reporting who are not capital providers. False – An implicit assumption is that users need reasonable knowledge of business and financial accounting matters to understand the information contained in the financial statements. True.
EXERCISE 2-2 (15–20 minutes) (a) (b) (c) (d) (e) (f)
False – The fundamental qualitative characteristics that make accounting information useful are relevance and faithful representation. False – Relevant information must also be material. False – Information that is relevant is characterized as having predictive or confirmatory value. False – Comparability also refers to comparisons of a firm over time (consistency). False – Enhancing characteristics relate to both relevance and faithful representation. True.
EXERCISE 2-3 (20–30 minutes) (a) (b) (c) (d) (e) (f)
Confirmatory Value. Cost/Benefit. Neutrality. Comparability (Consistency.) Neutrality. Relevance and Faithful representation.
(g) (h) (i) (j)
Timeliness. Relevance. Comparability. Verifiability.
(h) (i)
Materiality. Relevance and Faithful representation. Relevance and Faithful representation. Timeliness
EXERCISE 2-4 (15–20 minutes) (a) (b) (c) (d) (e) (f) (g)
Comparability. Confirmatory Value. Comparability (Consistency.) Neutrality. Verifiability. Relevance. Comparability, Verifiability, Timeliness, and Understandability.
(j) (k)
EXERCISE 2-5 (15–20 minutes) (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l)
Gains, losses. Liabilities. Investments by owners, comprehensive income. (also possible would be revenues and gains). Distributions to owners. (Note to instructor: net effect is to reduce equity and assets). Comprehensive income (also possible would be revenues and gains). Assets. Comprehensive income. Revenues, expenses. Equity. Revenues. Distributions to owners. Comprehensive income.
EXERCISE 2-6 (15–20 minutes) (a) (b) (c) (d) (e) (f) (g)
7. 5. 8. 2. 1. 4. 3.
Expense recognition principle. Measurement (historical cost principle.) Full disclosure principle. Going concern assumption. Economic entity assumption. Periodicity assumption. Monetary unit assumption.
EXERCISE 2-7 (20–25 minutes) (a) (b) (c) (d) (e) (f) (g) (h)
Measurement (historical cost) (i) Full disclosure principle. principle. (j) Expense recognition and Full disclosure principle. revenue recognition principles. Expense recognition principle. (k) Economic entity assumption. Materiality. (l) Periodicity assumption. (m) Measurement (fair value) Measurement (fair value) principle. principle. Economic entity assumption. (n) Measurement (historical cost) Full disclosure principle. principle. Revenue recognition principle. (o) Expense recognition principle.
EXERCISE 2-8 (a)
It is well established in accounting that revenues and cost of goods sold must be disclosed in an income statement. It might be noted to students that such was not always the case. At one time, only net income was reported but over time we have evolved to the present reporting format.
(b)
The proper accounting for this situation is to report the equipment as an asset and the notes payable as a liability on the balance sheet. Offsetting is permitted in only limited situations where certain assets are contractually committed to pay off liabilities.
EXERCISE 2-8 (Continued) (c)
According to GAAP, the basis upon which inventory amounts are stated (lower of cost or market) and the method used in determining cost (LIFO, FIFO, average cost, etc.) should also be reported. The disclosure requirement related to the method used in determining cost should be emphasized, indicating that where possible alternatives exist in financial reporting, disclosure in some format is required.
(d)
Consistency requires that disclosure of changes in accounting principles be made in the financial statements. To do otherwise would result in financial statements that are misleading. Financial statements are more useful if they can be compared with similar reports for prior years.
EXERCISE 2-9 (a)
This entry violates the economic entity assumption. This assumption in accounting indicates that economic activity can be identified with a particular unit of accountability. In this situation, the company erred by charging this cost to the wrong economic entity.
(b)
The historical cost principle indicates that assets and liabilities are accounted for on the basis of cost. If we were to select sales value, for example, we would have an extremely difficult time in attempting to establish a sales value for a given item without selling it. It should further be noted that the revenue recognition principle provides the answer to when revenue should be recognized. Revenue should be recognized when (1) realized or realizable and (2) earned. In this situation, an earnings process has definitely not taken place.
(c)
The expense recognition principle indicates that expenses should be allocated to the appropriate periods involved. In this case, there appears to be a high uncertainty that the company will have to pay. FASB Statement No. 5 requires that a loss should be accrued only (1) when it is probable that the company would lose the suit and (2) the amount of the loss can be reasonably estimated. (Note to instructor: The student will probably be unfamiliar with FASB Statement No. 5. The purpose of this question is to develop some decision framework when the probability of a future event must be assumed.)
EXERCISE 2-9 (Continued) (d)
At the present time, accountants do not recognize price-level adjustments in the accounts. Hence, it is misleading to deviate from the measurement principle (historical cost) principle because conjecture or opinion can take place. It should also be noted that depreciation is not so much a matter of valuation as it is a means of cost allocation. Assets are not depreciated on the basis of a decline in their fair market value, but are depreciated on the basis of systematic charges of expired costs against revenues. (Note to instructor: It might be called to the students’ attention that the FASB does encourage supplemental disclosure of price-level information.)
(e)
Most accounting methods are based on the assumption that the business enterprise will have a long life. Acceptance of this assumption provides credibility to the measurement principle (historical cost) principle, which would be of limited usefulness if liquidation were assumed. Only if we assume some permanence to the enterprise is the use of depreciation and amortization policies justifiable and appropriate. Therefore, it is incorrect to assume liquidation as Gonzales, Inc. has done in this situation. It should be noted that only where liquidation appears imminent is the going concern assumption inapplicable.
(f)
The answer to this situation is the same as (b).
EXERCISE 2-10 (a)
Depreciation is an allocation of cost, not an attempt to value assets. As a consequence, even if the value of the building is increasing, costs related to this building should be matched with revenues on the income statement, not as a charge against retained earnings.
(b)
A gain should not be recognized until the inventory is sold. Accountants follow the measurement principle (historical cost) approach and write-ups of assets are not permitted. It should also be noted that the revenue recognition principle states that revenue should not be recognized until it is realized or realizable and is earned.
EXERCISE 2-10 (Continued) (c)
Assets should be recorded at the fair value of what is given up or the fair market value of what is received, whichever is more clearly evident. It should be emphasized that it is not a violation of the measurement principle (historical cost) principle to use the fair value of the stock. Recording the asset at the par value of the stock has no conceptual validity. Par value is merely an arbitrary amount usually set at the date of incorporation.
(d)
The gain should be recognized at the point of sale. Deferral of the gain should not be permitted, as it is realized and is earned. To explore this question at greater length, one might ask what justification other than the controller’s might be used to justify the deferral of the gain. For example, the rationale provided in APB Opinion No. 29, noncompletion of the earnings process, might be discussed.
(e)
It appears from the information that the sale should be recorded in 2015 instead of 2014. Regardless of whether the terms are f.o.b. shipping point or f.o.b. destination, the point is that the inventory was sold in 2015. It should be noted that if the company is employing a perpetual inventory system in dollars and quantities, a debit to Cost of Goods Sold and a credit to Inventory is also necessary in 2015.
TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 2-1 (Time 20–25 minutes) Purpose—to provide the student with the opportunity to comment on the purpose of the conceptual framework. In addition, a discussion of the Concepts Statements issued by the FASB is required. CA 2-2 (Time 25–35 minutes) Purpose—to provide the student with the opportunity to identify and discuss the benefits of the conceptual framework. In addition, the most important quality of information must be discussed, as well as other key characteristics of accounting information. CA 2-3 (Time 25–35 minutes) Purpose—to provide the student with some familiarity with the Conceptual Framework. The student is asked to indicate the broad objective of accounting, and to discuss how this statement might help to establish accounting standards. CA 2-4 (Time 30–35 minutes) Purpose—to provide the student with some familiarity with the Conceptual Framework. The student is asked to describe various characteristics of useful accounting information and to identify possible tradeoffs among these characteristics. CA 2-5 (Time 25–30 minutes) Purpose—to provide the student with the opportunity to indicate and discuss different points at which revenues can be recognized. The student is asked to discuss the “crucial event” that triggers revenue recognition. CA 2-6 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to assess different points to report costs as expenses. Direct cause and effect, indirect cause and effect, and rational and systematic approaches are developed. CA 2-7 (Time 20–25 minutes) Purpose—to provide the student with familiarity with the expense recognition principle in accounting. Specific items are then presented to indicate how these items might be reported using the expense recognition principle. CA 2-8 (Time 20–30 minutes) Purpose—to provide the student with a realistic case involving association of costs with revenues. The advantages of expensing costs as incurred versus spreading costs are examined. Specific guidance is asked on how allocation over time should be reported. CA 2-9 (Time 20–30 minutes) Purpose—to provide the student with the opportunity to discuss the relevance and faithful representation of financial statement information. The student must write a letter on this matter so the case does provide a good writing exercise for the students. CA 2-10 (Time 20–25 minutes) Purpose—to provide the student with the opportunity to discuss the ethical issues related to expense recognition. CA 2-11 (Time 30–35 minutes) Purpose—to provide the student with the opportunity to discuss the cost constraint.
SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 2-1 (a) A conceptual framework is like a constitution. Its objective is to provide a coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and financial statements. A conceptual framework is necessary so that standard setting is useful, i.e., standard setting should build on and relate to an established body of concepts and objectives. A well-developed conceptual framework should enable the FASB to issue more useful and consistent standards in the future. Specific benefits that may arise are: (1) A coherent set of standards and rules should result. (2) New and emerging practical problems should be more quickly soluble by reference to an existing framework. (3) It should increase financial statement users’ understanding of and confidence in financial reporting. (4) It should enhance comparability among companies’ financial statements. (5) It should help determine the bounds for judgment in preparing financial statements. (6) It should provide guidance to the body responsible for establishing accounting standards. (b) The FASB has issued eight Statements of Financial Accounting Concepts (SFAC) that relate to business enterprises. Their titles and brief description of the focus of each Statement are as follows: (1) SFAC No. 1, “Objectives of Financial Reporting by Business Enterprises,” presents the goals and purposes of accounting. (2) SFAC No. 2, “Qualitative Characteristics of Accounting Information,” examines the characteristics that make accounting information useful. (3) SFAC No. 3, “Elements of Financial Statements of Business Enterprises,” provides definitions of the broad classifications of items in financial statements. (4) SFAC No. 5, “Recognition and Measurement in Financial Statements,” sets forth fundamental recognition and measurement criteria and guidance on what information should be formally incorporated into financial statements and when. (5) SFAC No. 6, “Elements of Financial Statements,” replaces SFAC No. 3, “Elements of Financial Statements of Business Enterprises,” and expands its scope to include not-for-profit organizations. (6) SFAC No. 7, “Using Cash Flow Information and Present Value in Accounting Measurements,” provides a framework for using expected future cash flows and present values as a basis for measurement. (7) SFAC No. 8, Chapter 1, “The Objective of General Purpose Financial Reporting,” and Chapter 3, “Qualitative Characteristics of Useful Financial Information,” replaces SFAC No. 1 and No. 2.
CA 2-2 (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.
CA 2-2 (Continued) (b) The most important quality for accounting information is 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. (1) 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. (2) 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). (3) 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).
CA 2-3 (a) The basic objective is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity. (b) The purpose of this statement is to set forth fundamentals on which financial accounting and reporting standards may be based. Without some basic set of objectives that everyone can agree to, inconsistent standards will be developed. For example, some believe that accountability should be the primary objective of financial reporting. Others argue that prediction of future cash flows is more important. It follows that individuals who believe that accountability is the primary objective may arrive at different financial reporting standards than others who argue for prediction of cash flow. Only by establishing some consistent starting point can accounting ever achieve some underlying consistency in establishing accounting principles. It should be emphasized to the students that the Board itself is likely to be the major user and thus the most direct beneficiary of the guidance provided by this pronouncement. However, knowledge of the objectives and concepts the Board uses should enable all who are affected by or interested in financial accounting standards to better understand the content and limitations of information provided by financial accounting and reporting, thereby furthering their ability to use that information effectively and enhancing confidence in financial accounting and reporting. That knowledge, if used with care, may also provide guidance in resolving new or emerging problems of financial accounting and reporting in the absence of applicable authoritative pronouncements.
CA 2-4 (a) (1) Relevance is one of the two primary decision-specific characteristics of useful accounting information. Relevant information is capable of making a difference in a decision. Relevant information helps users to make predictions about the outcomes of past, present, and future events, or to confirm or correct prior expectations. Information must also be timely in order to be considered relevant. (2) Faithful representation is one of the two primary decision-specific characteristics of useful accounting information. Reliable information can be depended upon to represent the conditions and events that it is intended to represent. Representational faithfulness is correspondence or agreement between accounting information and the economic phenomena it is intended to represent stemming from completeness, neutrality, and free from error. (3)
Understandability is a user-specific characteristic of information. Information is understandable when it permits reasonably informed users to perceive its significance. Understandability is a link between users, who vary widely in their capacity to comprehend or utilize the information, and the decision-specific qualities of information.
(4) Comparability means that information about enterprises has been prepared and presented in a similar manner. Comparability enhances comparisons between information about two different enterprises at a particular point in time. (5) Consistency means that unchanging policies and procedures have been used by an enterprise from one period to another. Consistency enhances comparisons between information about the same enterprise at two different points in time. (b) (Note to instructor: There are a multitude of answers possible here. The suggestions below are intended to serve as examples). (1) Forecasts of future operating results and projections of future cash flows may be highly relevant to some decision makers. However, they would not be as free from error as historical cost information about past transactions. (2) Proposed new accounting methods may be more relevant to many decision makers than existing methods. However, if adopted, they would impair consistency and make trend comparisons of an enterprise’s results over time difficult or impossible. (3) There presently exists much diversity among acceptable accounting methods and procedures. In order to facilitate comparability between enterprises, the use of only one accepted accounting method for a particular type of transaction could be required. However, consistency would be impaired for those firms changing to the new required methods. (4) Occasionally, relevant information is exceedingly complex. Judgment is required in determining the optimum trade-off between relevance and understandability. Information about the impact of general and specific price changes may be highly relevant but not understandable by all users. (c) Although trade-offs result in the sacrifice of some desirable quality of information, the overall result should be information that is more useful for decision making.
CA 2-5 (a)
The “crucial event” in determining when revenue is recognized is when a performance obligation is satisfied. In the case of subscriptions, the performance obligation is met when the magazines are delivered (including ads contained therein). The new director suggests that this principle does not apply in the magazine business and that revenue from subscription sales and advertising should be recognized in the accounts when the difficult task of selling is accomplished and not when the magazines are published and delivered to fill the subscriptions or to carry the advertising. The director’s view that there is a single crucial event in the process of earning revenue in the magazine business is questionable even though the amount of revenue is determinable when the subscription is sold. Although the firm cannot prosper without good advertising contracts and while advertising rates depend substantially on magazine sales, it also is true that readers will not renew their subscriptions unless the content of the magazine pleases them. Unless subscriptions are obtained at prices that provide for the recovery in the first subscription period of all costs of selling and filling those subscriptions, the editorial and publishing activities are as crucial as the sale in the earning of the revenue. Even if the subscription rate does provide for the recovery of all associated costs within the first period, however, the editorial and publishing activities still would be important since the firm has an obligation (in the amount of the present value of the costs expected to be incurred in connection with the editorial and publication activities) to produce and deliver the magazine. Not until this obligation is fulfilled should the revenue associated with it be recognized in the accounts since the revenue is the result of delivering on a promise (selling and filling subscriptions) and not just the first one. The director’s view also presumes that the cost of publishing the magazines can be computed accurately at or close to the time of the subscription sale despite uncertainty about possible changes in the prices of the factors of production and variations in efficiency. Hence, only a portion–not most–of the revenue should be recognized in the accounts at the time the subscription is sold.
(b)
Recognizing in the accounts all the revenue in equal portions with the publication of the magazine every month is subject to some of the same criticism from the standpoint of theory as the suggestion that all or most of the revenue be recognized in the accounts at the time the subscription is sold. Although the journalistic efforts of the magazine are important in the process of earning revenue, the firm could not prosper without magazine sales and the advertising that results from paid circulation. Hence, some revenue could be recognized in the accounts at the time of the subscription sale, to the extent that part of the performance obligation to the subscriber and advertisers has been met. That is, the ads are in the public domain. This approach requires the magazine to allocate the proportion of the revenue related to advertising from that related to subscriptions. For this reason, and because the task of estimating the amount of revenue associated with the subscription sale often has been considered subjective, recognizing revenue in the accounts with the monthly publication of the magazine has received support even though it does not meet the tests of revenue recognition as well as the next alternative.
(c)
Recognizing in the accounts a portion of the revenue at the time a cash subscription is obtained and a portion each time an issue is published meets the tests of revenue recognition better than the other two alternatives. A portion of the net income is recognized in the accounts at the time of each major or crucial event – that is, when a performance obligation has been met. Each crucial event is clearly discernible and is a time of interaction between the publisher and subscriber. A legal sale is transacted before any revenue is recognized in the accounts. Prior to the time the revenue is recognized in the accounts, it already has been received in distributable form. Finally, the total revenue is measurable with more than the usual certainty, and the revenue attributable to each crucial event is determinable using reasonable (although sometimes conceptually unsatisfactory) assumptions about the relationship between revenue and costs when the costs are indirect.
(Note to instructor: CA 2-5 might also be assigned in conjunction with Chapter 18.)
CA 2-6 (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. (b) 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) and 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. (c) 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.
CA 2-6 (Continued) (d) 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. (e) 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.
CA 2-7 (a) Costs should be recognized as expiring in a given period if they are not chargeable to a prior period and are not applicable to future periods. Recognition in the current period is required when any of the following conditions or criteria are present: (1) A direct identification of association of charges with revenue of the period, such as goods shipped to customers. (2) An indirect association with the revenue of the period, such as fire insurance or rent. (3) A period charge where no association with revenue in the future can be made so the expense is charged this period, such as officers’ salaries. (4) A measurable expiration of asset costs during the period, even though not associated with the production of revenue for the current period, such as a fire or casualty loss. (b) (1) Although it is generally agreed that inventory costs should include all costs attributable to placing the goods in a salable state, receiving and handling costs are often treated as cost expirations in the period incurred because they are irregular or are not in uniform proportion to sales. The portion of the receiving and handling costs attributable to the unsold goods processed during the period should be inventoried. These costs might be more readily apportioned if they are assigned by some device such as an applied rate. Abnormally high receiving and handling costs should be charged off as a period cost. (2) Cash discounts on purchases are treated as “other revenues” in some financial statements in violation of the expense recognition principles (or matching). Revenue is not recognized when goods are purchased or cash disbursed. Furthermore, inventories valued at gross invoice price are recorded at an amount greater than their cash outlay resulting in misstatement of inventory cost in the current period and inventory cost expirations in future periods. Close adherence to the expense recognition principle (or matching) requires that cash discounts be recorded as a reduction of the cost of purchases and that inventories be priced at net invoice prices. Where inventories are priced at gross invoice prices for expediency, however, there is a slight distortion of the financial statements if the beginning and ending inventories vary little in amount.
CA 2-8 (a) The preferable treatment of the costs of the sample display houses is expensing them over more than one period. These sample display houses are assets because they represent rights to future service potentials or economic benefits. According to the expense recognition principle, the costs of service potentials should be amortized as the benefits are received. Thus, costs of the sample display houses should be matched with the revenue from the sale of the houses which is receivable over a period of more than one year. As the sample houses are left on display for three to seven years, Daniel Barenboim apparently expects to benefit from the displays for at least that length of time. The alternative of expensing the costs of sample display houses in the period in which the expenditure is made is based primarily upon the expense recognition principle. These costs are of a promotional nature. Promotional costs often are considered expenses of the period in which the expenditures occur due to the uncertainty in determining the time periods benefited (do they meet the definition of an asset?). It is likely that no decision is made concerning the life of a sample display house at the time it is erected. Past experience may provide some guidance in determining the probable life. A decision to tear down or alter a house probably is made when sales begin to lag or when a new model with greater potential becomes available. There is uncertainty not only as to the life of a sample display house but also as to whether a sample display house will be torn down or altered. If it is altered rather than torn down, a portion of the cost of the original house may be attributable to the new model. (b) If all of the shell houses are to be sold at the same price, it may be appropriate to allocate the costs of the display houses on the basis of the number of shell houses sold. This allocation would be similar to the units-of-production method of depreciation and would result in a good matching of costs with revenues. On the other hand, if the shell houses are to be sold at different prices, it may be preferable to allocate costs on the basis of the revenue contribution of the shell houses sold. There is uncertainty regarding the number of homes of a particular model which will be sold as a result of the display sample. The success of this amortization method is dependent upon accurate estimates of the number and selling price of shell houses to be sold. The estimate of the number of units of a particular model which will be sold as a result of a display model should include not only units sold while the model is on display but also units sold after the display house is torn down or altered. Cost amortization solely on the basis of time may be preferable when the life of the models can be estimated with a great deal more accuracy than can the number of units which will be sold. If unit sales and selling prices are uniform over the life of the sample, a satisfactory matching of costs and revenues may be achieved if the straight-line amortization procedure is used.
CA 2-9 Date Dear Uncle Carlos, I received the information on Neville Corp. and appreciate your interest in sharing this venture with me. However, I think that basing an investment decision on these financial statements would be unwise because they are neither relevant nor representationally faithful. One of the most important characteristics of accounting information is that it is relevant, i.e., it will make a difference in my decision. To be relevant, this information must be timely. Because Neville’s financial statements are a year old, they have lost their ability to influence my decision: a lot could have changed in that one year. Another element of relevance is predictive value. Once again, Neville’s accounting information proves irrelevant. Shown without reference to other years’ profitability, it cannot help me predict future profitability because I cannot see any trends developing. Closely related to predictive value is confirmatory value. These financial statements do not provide feedback on any strategies which the company may have used to increase profits. These financial statements are also not representationally faithful. In order to be representationally faithful, their assertions must be verifiable by several independent parties. Because no independent auditor has verified these amounts, there is no way of knowing whether or not they are represented faithfully. For instance, I would like to believe that this company earned $2,424,240, and that it had a very favorable debt-to-equity ratio. However, unaudited financial statements do not give me any reasonable assurance about these claims. Finally, the fact that Mrs. Neville herself prepared these statements indicates a lack of neutrality. Because she is not a disinterested third party, I cannot be sure that she did not prepare the financial statements in favor of her husband’s business. I do appreciate the trouble you went through to get me this information. Under the circumstances, however, I do not wish to invest in the Neville bonds and would caution you against doing so. Before you make a decision in this matter, please call me. Sincerely, Your Nephew/Niece
CA 2-10 (a) The stakeholders are investors, creditors, etc.; i.e., users of financial statements, current and future. (b) Honesty and integrity of financial reporting, job protection, profit. (c) Applying the expense recognition principle and recording expense during the plant’s life, or not applying it. That is, record the mothball costs in the future.
CA 2-10 (Continued) (d) The major question may be whether or not the expense of mothballing can be estimated properly so that the integrity of financial reporting is maintained. Applying the expense recognition principle will result in lower profits and possibly higher rates for consumers. Could this cost anyone his or her job? Will investors and creditors have more useful information? On the other hand, failure to apply the matching principle means higher profits, lower rates, and greater potential job security. (e) Students’ recommendations will vary. Note: Other stakeholders possibly affected are present and future consumers of electric power. Delay in allocating the expense will benefit today’s consumers of electric power at the expense of future consumers.
CA 2-11 1.
Information about competitors might be useful for benchmarking the company’s results but if management does not have expertise in providing the information, it could be highly subjective. In addition, it is likely very costly for management to gather sufficiently verifiable information of this nature.
2.
While users of financial statements might benefit from receiving internal information, such as company plans and budgets, competitors might also be able to use this information to gain a competitive advantage relative to the disclosing company.
3.
In order to produce forecasted financial statements, management would have to make numerous assumptions and estimates, which would be costly in terms of time and data collection. Because of the subjectivity involved, the forecasted statements would not be faithful presentations, thereby detracting from any potential benefits. In addition, while management’s forecasts of future profitability or balance sheet amounts could be of benefit, companies could be subject to shareholder lawsuits, if the amounts in the forecasted statements are not realized.
4.
It would be excessively costly for companies to gather and report information that is not used in managing the business.
5.
Flexible reporting allows companies to “fine-tune” their financial reporting to meet the information needs of its varied users. In this way, they can avoid the cost of providing information that is not demanded by its users.
6.
Similar to number 3, concerning forecasted financial statements, if managers report forwardlooking information, the company could be exposed to liability if investors unduly rely on the information in making investment decisions. Thus, if companies get protection from unwarranted lawsuits (called a safe harbor), then they might be willing to provide potentially beneficial forwardlooking information.
FINANCIAL REPORTING PROBLEM From note 1: (a)
Revenue Recognition Sales are recognized when revenue is realized or realizable and has been earned. Most revenue transactions represent sales of inventory. The revenue recorded is presented net of sales and other taxes we collect on behalf of governmental authorities. The revenue includes shipping and handling costs, which generally are included in the list price to the customer. Our policy is to recognize revenue when title to the product, ownership and risk of loss transfer to the customer, which can be on the date of shipment or the date of receipt by the customer. A provision for payment discounts and product return allowances is recorded as a reduction of sales in the same period that the revenue is recognized. Trade promotions, consisting primarily of customer pricing allowances, merchandising funds and consumer coupons, are offered through various programs to customers and consumers. Sales are recorded net of trade promotion spending, which is recognized as incurred, generally at the time of the sale. Most of these arrangements have terms of approximately one year. Accruals for expected payouts under these programs are included as accrued marketing and promotion in the accrued and other liabilities line item in the Consolidated Balance Sheets.
(b) Historical Cost Buildings, Machinery and equipment. Fair Value On July 1, 2009, we adopted the provisions of the fair value measurement accounting and disclosure guidance related to nonfinancial assets and liabilities recognized or disclosed at fair value on a non-recurring basis. Assets and liabilities subject to this new guidance primarily include goodwill, indefinite-lived intangible assets and other long-lived assets measured at fair value for impairment assessments and non-financial assets and liabilities measured at fair
FINANCIAL REPORTING PROBLEM (Continued) value in business combinations. There were no significant assets or liabilities that were re-measured at fair value on a non-recurring basis during the fiscal year ended June 30, 2010. (c)
P&G has the following sub-section: Principles prepared on a consistent basis New Accounting Pronouncements and Policies Other than as described below, no new accounting pronouncement issued or effective during the fiscal year has had or is expected to have a material impact on the Consolidated Financial Statements.
(d)
Accounting Policy Related to Advertising Selling, general and administrative expense (SG&A) Advertising costs, charged to expense as incurred, include worldwide television, print, radio, internet and in-store advertising expenses and were $8,576 in 2010, $7,519 in 2009 and $8,520 in 2008.
COMPARATIVE ANALYSIS CASE (a)
Primary Lines of Business Coke Description of Business The Coca-Cola Company is the world's largest beverage company. We own or license and market more than 500 nonalcoholic beverage brands, primarily sparkling beverages but also a variety of still beverages such as waters, enhanced waters, juices and juice drinks, ready-to-drink teas and coffees, and energy and sports drinks. We own and market four of the world's top five nonalcoholic sparkling beverage brands: Coca-Cola, Diet Coke, Fanta and Sprite. Finished beverage products bearing our trademarks, sold in the United States since 1886, are now sold in more than 200 countries. Operating Segments The business of our Company is nonalcoholic beverages. Our geographic operating segments (Eurasia and Africa; Europe; Latin America; North America; and Pacific) derive a majority of their revenues from the manufacture and sale of beverage concentrates and syrups and, in some cases, the sale of finished beverages. PepsiCo Our Divisions We manufacture or use contract manufacturers, market and sell a variety of salty, convenient, sweet and grain-based snacks, carbonated and non-carbonated beverages, dairy products and other foods in over 200 countries and territories with our largest operations in North America (United States and Canada), Russia, Mexico and the United Kingdom.
COMPARATIVE ANALYSIS CASE (Continued) Our Operations We are organized into four business units, as follows: 1) 2) 3) 4)
PepsiCo Americas Foods (PAF), which includes Frito- Lay North America (FLNA), Quaker Foods North America (QFNA) and all of our Latin American food and snack businesses (LAF); PepsiCo Americas Beverages (PAB), which includes all of our North American and Latin American beverage businesses; PepsiCo Europe, which includes all beverage, food and snack businesses in Europe; and PepsiCo Asia, Middle East and Africa (AMEA), which includes all beverage, food and snack businesses in AMEA.
Our four business units are comprised of six reportable segments (referred to as divisions), as follows: FLNA, QFNA; LAF; PAB; Europe; AMEA. (b)
Dominant Position - Beverage Sales: Coke or Pepsi Coca-Cola: Net operating revenues for 2011 were $46,542 million, comprised primarily of beverage sales. Pepsi: Net revenue for 2011 was $66,504 million, of which soft drinks are estimated at $22,418 million (PepsiCo Americas Beverages) and food and beverage sales of $13,560 million for Europe and $7,392 million for AMEA. Thus, Coca-Cola has the dominant position for beverage sales.
(c)
Inventories, cost allocation method, affect on comparability Coke Inventories Inventories consist primarily of raw materials and packaging (which includes ingredients and supplies) and finished goods (which include concentrates and syrups in our concentrate operations, and finished beverages in our finished products operations). Inventories are valued at the lower of cost or market. We determine cost on the basis of the average cost or first-in, first-out methods. Refer to Note 4.
COMPARATIVE ANALYSIS CASE (Continued) Pepsi Inventory In the first quarter of 2011, Quaker Foods North America (QFNA) changed its method of accounting for certain U.S. inventories from the last-in, first-out (LIFO) method to the average cost method. This change is considered preferable by management as we believe that the average cost method of accounting for all U.S. foods inventories will improve our financial reporting by better matching revenues and expenses and better reflecting the current value of inventory. In addition, the change from the LIFO method to the average cost method will enhance the comparability of QFNA's financial results with our other food businesses, as well as with peer companies where the average cost method is widely used. The impact of this change on consolidated net income in the first quarter of 2011 was approximately $9 million (or less than a penny per share). Prior periods were not restated as the impact of the change on previously issued financial statements was not considered material. (d)
Change in accounting policy (2009) Coke Recently Issued Accounting Guidance Principles of Consolidation The information presented above reflects the impact of the Company's adoption of accounting guidance issued by the Financial Accounting Standards Board (“FASB”) related to VIEs in June 2009. This accounting guidance resulted in a change in our accounting policy effective January 1, 2010. Among other things, the guidance requires more qualitative than quantitative analyses to determine the primary beneficiary of a VIE, requires continuous assessments of whether an enterprise is the primary beneficiary of a VIE, enhances disclosures about an enterprise's involvement with a VIE, and amends certain guidance for determining whether an entity is a VIE.
COMPARATIVE ANALYSIS CASE (Continued) Pepsi Recent Accounting Pronouncements In June 2009, the Financial Accounting Standards Board (FASB) amended its accounting guidance on the consolidation of variable interest entities (VIE). Among other things, the new guidance requires a qualitative rather than a quantitative assessment to determine the primary beneficiary of a VIE based on whether the entity (1) has the power to direct matters that most significantly impact the activities of the VIE and (2) has the obligation to absorb losses or the right to receive benefits of the VIE that could potentially be significant to the VIE. In addition, the amended guidance requires an ongoing reconsideration of the primary beneficiary. The provisions of this guidance were effective as of the beginning of our 2010 fiscal year, and the adoption did not have a material impact on our financial statements.
FINANCIAL STATEMENT ANALYSIS CASE—WAL-MART (a)
(1) In the year of the change, Wal-Mart will reverse the revenue recognized in prior periods for layaway sales that are not complete. This will reduce income in the year of the change. (2) In subsequent years, after the adjustment in the year of the change, as long as Wal-Mart continues to make layaway sales at the same levels, income levels should return to prior levels (except for growth). That is, the accounting change only changes the timing of the recognition, not the overall amount recognized.
(b)
By recognizing the revenue before delivery, Wal-Mart was recognizing revenue before the earnings process was complete. In addition, if customers did not pay the remaining balance owed, the realizability criterion is not met either. While Wal-Mart likely could estimate expected deliveries and payments, it is not apparent that this was done.
(c)
Even if all retailers used the same policy, it still might be difficult to compare the results for layaway transactions. For example what if retailers have different policies as to how much customers have to put down in order for the retailer to set aside the merchandise. Note that the higher (lower) the amount put down, the more (less) likely the customer will complete the transaction. The concern under the prior rules is that retailers might give very generous layaway terms in order to accelerate revenue recognition. Investors would be in for a surprise if customers do not complete the transactions and the revenue recorded earlier must be reversed, thereby lowering reported income.
Note to instructor: The requirements for this case relate to Walmart accounting policies for revenue recognition prior to implementation of the new revenue standard. The new standard and its provisions are addressed are addressed in more detail in Chapter 18.
ACCOUNTING, ANALYSIS, AND PRINCIPLES Accounting Caddie Shack Company Statement of Financial Position May 31, 2014 Assets Cash Building Equipment
Total Assets
Liabilities $15,100 Advertising payable 6,000 Utilities payable 800 Owners’ Equity Contributed capital Retained Earnings Total Liabilities & $21,900 Equity
$
150 100
20,000 1,650 $21,900
Accrual income = $4,700 – $1,000 – $750 – $400 – $100 = $2,450 Earned capital balance = $0 + $2,450 - $800 = $1,650 Murray might conclude that his business earned a profit of $1,650 because that is his earned capital at the end of the month. The conclusion that his business lost $4,900 might come from the change in the business’s cash balance, which started at $20,000 and ended the month at $15,100.
Analysis The income measure of $2,450 is most relevant for assessing the future profitability and hence the payoffs to the owners. For example, charging the cost of the building and equipment to expense in the first month of operations understates income in the first month. These costs should be allocated to future periods of benefit through depreciation expense. Similarly, although not paid, the utilities were used to generate revenues so they should be recognized when incurred, not when paid.
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) Principles GAAP income is the accrual income computed above as $2,450. The key concept illustrated in the difference between the loss of $4,900 and profit of $1,650 is the expense recognition principle, which calls for recognition of expenses when incurred, not when paid. Excluding the cash withdrawal from the measurement of income (the difference between income measures in parts c and d) is an application of the definition of basic elements. Cash withdrawals are distributions to owners, not an element of income (expenses or losses).
PROFESSIONAL RESEARCH Search Strings: concept statement, “materiality”, “articulation” (a)
According to Concepts Statement 2 (CON 2): Qualitative Characteristics of Accounting Information, “Glossary”: “Materiality is defined as the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.”
(b)
CON 2, Appendix C—See Table 1—refers to several SEC cases which apply materiality. Students might also research SEC literature (e.g. Staff Accounting Bulletin No. 99), although SEC literature is not in the FARS database. SFAC No. 2, 128. provides the following examples of screens that might be used to determine materiality: “ a. An accounting change in circumstances that puts an enterprise in danger of being in breach of covenant regarding its financial condition may justify a lower materiality threshold than if its position were stronger. b. A failure to disclose separately a nonrecurrent item of revenue may be material at a lower threshold than would otherwise be the case if the revenue turns a loss into a profit or reverses the trend of earnings from a downward to an upward trend. c. A misclassification of assets that would not be material in amount if it affected two categories of plant or equipment might be material if it changed the classification between a noncurrent and a current asset category. d. Amounts too small to warrant disclosure or correction in normal circumstances may be considered material if they arise from abnormal or unusual transactions or events.”
PROFESSIONAL RESEARCH (Continued) However, according to CON 2, Pars. 129, 131 the FASB notes that more than magnitude must be considered in evaluating materiality: Almost always, the relative rather than the absolute size of a judgment item determines whether it should be considered material in a given situation. Losses from bad debts or pilferage that could be shrugged off as routine by a large business may threaten the continued existence of a small one. An error in inventory valuation may be material in a small enterprise for which it cut earnings in half but immaterial in an enterprise for which it might make a barely perceptible ripple in the earnings. Some of the empirical investigations referred to in Appendix C throw light on the considerations that enter into materiality judgments. SFAC No. 2, Par. 131. Some hold the view that the Board should promulgate a set of quantitative materiality guides or criteria covering a wide variety of situations that preparers could look to for authoritative support. That appears to be a minority view, however, on the basis of representations made to the Board in response to the Discussion Memorandum, Criteria for Determining Materiality. The predominant view is that materiality judgments can properly be made only by those who have all the facts. The Board’s present position is that no general standards of materiality could be formulated to take into account all the considerations that enter into an experienced human judgment. (c)
SFAC No. 3, Par. 15. The two classes of elements are related in such a way that (a) assets, liabilities, and equity are changed by elements of the other class and at any time are their cumulative result and (b) an increase (decrease) in an asset cannot occur without a corresponding decrease (increase) in another asset or a corresponding increase (decrease) in a liability or equity. Those relationships are sometimes collectively referred to as “articulation.” They result in financial statements that are fundamentally interrelated so that statements that show elements of the second class depend on statements that show elements of the first class and vice versa.
PROFESSIONAL SIMULATION Explanation 1.
Most accounting methods are based on the assumption that the business enterprise will have a long life. Acceptance of this assumption provides credibility to the historical cost principle, which would be of limited usefulness if liquidation were assumed. Only if we assume some permanence to the enterprise is the use of depreciation and amortization policies justifiable and appropriate. Therefore, it is incorrect to assume liquidation as the company has done in this situation. It should be noted that only where liquidation appears imminent is the going concern assumption inapplicable.
2.
The company is too conservative in its accounting for this transaction. The expense recognition principle indicates that expenses should be allocated to the appropriate periods involved. In this case, there appears to be a high uncertainty that the company will have to pay. FASB Codification, Section 450-20, requires that a loss should be accrued only (1) when it is probable that the company would lose the suit and (2) the amount of the loss can be reasonably estimated. (Note to instructor: The student will probably be unfamiliar with these requirements. The purpose of this question is to develop some decision framework when the probability of a future event must be assumed).
3.
This entry violates the economic entity assumption. This assumption in accounting indicates that economic activity can be identified with a particular unit of accountability. In this situation, the company erred by charging this cost to the wrong economic entity.
Research According to Concepts Statement 8 (CON 8) par. QCII: 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 Board cannot specify a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation.
IFRS CONCEPTS AND APPLICATION IFRS2-1 The IASB framework makes two assumptions. One assumption is that financial statements are prepared on an accrual basis; the other is that the reporting entity is a going concern. The FASB discuss accrual accounting extensively but does not identify it as an assumption. The going concern concept is only briefly discussed. The going concern concept will undoubtedly be debated as to its place in the conceptual framework. IFRS2-2 While there is some agreement that the role of financial reporting is to assist users in decision-making, the IASB framework has had more of a focus on the objective of providing information on management’s performance—often referred to as stewardship. It is likely that there will be much debate regarding the role of stewardship in the conceptual framework. IFRS2-3 The FASB differentiates gains and losses from revenue and expenses where gains and losses are incidental transactions of the entity. Further, the FASB includes changes in equity as elements: investment by owners, distributions to owners, and comprehensive income. IFRS2-4 As indicated, the measurement project relates to both initial measurement and subsequent measurement. Thus, the continuing controversy related to historical cost and fair value accounting suggests that this issue will be controversial. The reporting entity project that addresses which entities should be included in consolidated statements and how to implement such consolidations will be a difficult project. Other difficult issues relate to the trade off between highly relevant information that is difficult to verify? Or how do we define control when we are developing a definition of an asset? Or is a liability the future sacrifice itself or the obligation to make the sacrifice?
IFRS2-5 The IASB and FASB frameworks are strikingly similar. This is not surprising, given that the IASB framework was adopted after the FASB developed its framework (the IASB framework was approved in April 1989). In addition, the IASC, the predecessor to the IASB, was formed to facilitate harmonization of accounting standards across countries. This objective could be aided by adopting a similar conceptual 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. There is also no distinction in the IASB framework between gains and revenues and losses and expenses. Note to Instructors—These differences may be resolved as the FASB and IASB work on their performance reporting projects. IFRS2-6 Search Strings: “materiality”, “completeness” (a)
According to the Framework (para. 30): Information is defined to be material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements.
(b)
(1)
According to the Framework, (para. 29–30):
29 The relevance of information is affected by its nature and materiality. In some cases, the nature of information alone is sufficient to determine its relevance. For example, the reporting of a new segment may affect the assessment of the risks and opportunities facing the entity irrespective of the materiality of the results achieved by the new segment in the reporting period. In other cases, both the nature and materiality are important, for example, the amounts of inventories held in each of the main categories that are appropriate to the business.
IFRS2-6 (Continued) 30 Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful. (2)
With respect to Completeness (para. 30): To be reliable, the information in financial statements must be complete within the bounds of materiality and cost. An omission can cause information to be false or misleading and thus unreliable and deficient in terms of its relevance.
This statement indicates that excluding immaterial items will not affect the completeness of the financial statements. (c)
According to the Framework (para. 22): Accrual basis In order to meet their objectives, financial statements are prepared on the accrual basis of accounting. Under this basis, the effects of transactions and other events are recognized when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate. Financial statements prepared on the accrual basis inform users not only of past transactions involving the payment and receipt of cash but also of obligations to pay cash in the future and of resources that represent cash to be received in the future. Hence, they provide the type of information about past transactions and other events that is most useful to users in making economic decisions.
IFRS2-7 Marks and Spencer plc (a)
Revenue Recognition Revenue Revenue comprises sales of goods to customers outside the Group less an appropriate deduction for actual and expected returns, discounts and loyalty scheme vouchers, and is stated net of value added tax and other sales taxes. Revenue is recognised when goods are delivered and the significant risks and rewards of ownership have been transferred to the buyer.
(b)
Historical Cost -Property, plant, and equipment The Group’s policy is to state property, plant and equipment at cost less accumulated depreciation and any recognised impairment loss. Property is not revalued for accounting purposes. Intangible Assets -B. Brands Acquired brand values are held on the statement of financial position initially at cost. Defined life intangibles are amortised on a straightline basis over their estimated useful lives. Indefinite life intangibles are tested for impairment at least annually. Any impairment in value is recognised immediately in the income statement. Fair Value Trade receivables, trade payables, investments and other financial assests, loan notes A. Goodwill Goodwill arising on consolidation represents the excess of the consideration transferred and the amount of any non-controlling interest in the acquiree over the fair value of the identifiable assets and liabilities (including intangible assets) of the acquired entity at the date of the acquisition. Goodwill is recognised as an asset and assessed for impairment at least annually. Any impairment is recognised immediately in the income statement.
IFRS2-7 (Continued) (c)
New Accounting Pronoucements and Policies None listed under Accounting Policies.
(d)
Accounting policy related to refunds and loyalty schemes E. Refunds and loyalty scheme accruals Accruals for sales returns and loyalty scheme redemptions are estimated on the basis of historical returns and redemptions and these are recorded so as to allocate them to the same period as the original revenue is recorded. These accruals are reviewed regularly and updated to reflect management’s latest best estimates, however, actual returns and redemptions could vary from these estimates.
CHAPTER 3 The Accounting Information System ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Brief Exercises
Exercises
Problems
1, 2
1, 2, 3, 4, 17
1
2, 3, 4
1, 2
5, 6, 7, 8, 9, 10, 20
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 12
11, 12, 15, 22, 23
1, 2, 4, 6
13, 14, 16
1, 4, 9, 10, 12
Topics
Questions
1.
Transaction identification.
1, 2, 3, 5, 6, 7, 8
2.
Nominal accounts.
4, 7
3.
Trial balance.
6, 10
4.
Adjusting entries.
8, 11, 13, 14
5.
Financial statements.
6.
Closing.
12
7.
Inventory and cost of goods sold.
9
8.
Comprehensive accounting cycle.
*9.
Cash vs. accrual Basis.
15, 16, 17
12
18, 19
*10.
Reversing entries.
18
13
20
*11.
Worksheet.
19
3, 4, 5, 6, 7, 8, 9, 10
11
14, 15 1, 2, 6, 12
*These topics are dealt with in an Appendix to the Chapter.
21, 22, 23
11
12
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives
Questions
Brief Exercises
Exercises
Problems
1.
Understand basic accounting terminology.
1, 2, 4, 7
2.
Explain double-entry rules.
1, 2, 3, 4, 5, 7
3.
Identify steps in accounting cycle.
2, 3
4.
Record transactions in journals, post to ledger accounts, and prepare a trial balance.
6, 10
1, 2, 3, 4, 5, 6, 7
1, 2, 3, 4, 17
1, 4, 9, 10
5.
Explain the reasons for preparing adjusting entries and identify major types of adjusting entries.
11, 16
3, 4, 5, 6, 7, 8, 9, 10
5, 6, 7, 8, 9, 10, 20
2, 3, 4, 5, 6, 7, 8, 9, 10, 12
6.
Prepare financial statements from the adjusted trail balance.
10
11, 12
1, 2, 4, 6, 7, 8, 9, 10, 12
7.
Prepare closing entries.
8, 12, 13, 14
13, 14, 16
1, 4, 9, 10, 12
8.
Prepare financial statements for a merchandising company.
9
13, 14, 15
4, 10
*9.
Differentiate the cash basis of accounting from the accrual basis of accounting.
15, 17
12
18, 19
11
*10.
Identify adjusting entries that may be reversed.
18
13
20
*11.
Prepare a 10-column worksheet.
19
*These topics are dealt with in an Appendix to the Chapter.
11
21, 22, 23
12
ASSIGNMENT CHARACTERISTICS TABLE Level of Difficulty
Time (minutes)
Simple Simple Simple Simple Moderate Moderate Complex Moderate Moderate Complex Moderate Moderate Simple Moderate Simple Moderate Moderate
15–20 10–15 15–20 10–15 10–15 10–15 15–20 10–15 15–20 25–30 20–25 20–25 10–15 10–15 10–15 10–15 10–15
*E3-18 *E3-19 *E3-20 *E3-21 *E3-22 *E3-23
Transaction analysis–service company. Corrected trial balance. Corrected trial balance. Corrected trial balance. Adjusting entries. Adjusting entries. Analyze adjusted data. Adjusting entries. Adjusting entries. Adjusting entries. Prepare financial statements. Prepare financial statements. Closing entries. Closing entries. Missing amounts. Closing entries for a corporation. Transactions of a corporation, including investment and dividend. Cash to accrual basis. Cash and accrual basis. Adjusting and reversing entries. Worksheet. Worksheet and balance sheet presentation. Partial worksheet preparation.
Moderate Moderate Complex Simple Moderate Moderate
15–20 10–15 20–25 10–15 20–25 10–15
P3-1 P3-2 P3-3 P3-4 P3-5 P3-6 P3-7 P3-8 P3-9 P3-10 *P3-11 *P3-12
Transactions, financial statements–service company. Adjusting entries and financial statements. Adjusting entries. Financial statements, adjusting and closing entries. Adjusting entries. Adjusting entries and financial statements. Adjusting entries and financial statements. Adjusting entries and financial statements. Adjusting and closing. Adjusting and closing. Cash and accrual basis. Worksheet, balance sheet, adjusting and closing entries.
Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Complex
25–35 35–40 25–30 40–50 15–20 25–35 25–35 25–35 30–40 30–35 35–40 40–50
Item
Description
E3-1 E3-2 E3-3 E3-4 E3-5 E3-6 E3-7 E3-8 E3-9 E3-10 E3-11 E3-12 E3-13 E3-14 E3-15 E3-16 E3-17
ANSWERS TO QUESTIONS 1. Examples are: (a) Payment of an accounts payable. (b) Collection of an accounts receivable from a customer. (c) Transfer of an accounts payable to a note payable. 2. Transactions (a), (b), (d) are considered business transactions and are recorded in the accounting records because a change in assets, liabilities, or owners’/stockholders’ equity has been effected as a result of a transfer of values from one party to another. Transactions (c) and (e) are not business transactions because a transfer of values has not resulted, nor can the event be considered financial in nature and capable of being expressed in terms of money. 3. Transaction (a): Accounts Receivable (debit), Service Revenue (credit). Transaction (b): Cash (debit), Accounts Receivable (credit). Transaction (c): Supplies (debit), Accounts Payable (credit). Transaction (d): Delivery Expense (debit), Cash (credit). 4. Revenue and expense accounts are referred to as temporary or nominal accounts because each period they are closed out to Income Summary in the closing process. Their balances are reduced to zero at the end of the accounting period; therefore, the term temporary or nominal is given to these accounts. 5. Andrea is not correct. The double-entry system means that for every debit amount there must be a credit amount and vice-versa. At least two accounts are affected and debits must equal credits. It does not mean that each transaction must be recorded twice. 6. Although it is not absolutely necessary that a trial balance be taken periodically, it is customary and desirable. The trial balance accomplishes two principal purposes: (1) It tests the accuracy of the entries in that it proves that debits and credits of an equal amount are in the ledger. (2) It provides a list of ledger accounts and their balances which may be used in preparing the financial statements and in supplying financial data about the concern. 7. (a) Real account; balance sheet. (b) Real account; balance sheet. (c) Inventory is generally considered a real account appearing on the balance sheet. (Note: Inventory has the elements of a nominal account when the periodic inventory system is used. It may appear on the income statement when the multiple-step format is used under a periodic inventory system.) (d) Real account; balance sheet. (e) Real account; balance sheet. (f) Nominal account; income statement. (g) Nominal account; income statement. (h) Real account; balance sheet. 8. At December 31, the three days’ wages due to the employees represent a current liability. The related expense must be recorded in this period to properly reflect the expense incurred. 9. (a) In a service company, revenues are service revenues and expenses are operating expenses. In a merchandising company, revenues are sales revenues and expenses consist of cost of goods sold plus operating expenses. (b) The measurement process in a merchandising company consists of comparing the sales price of the merchandise inventory to the cost of goods sold and operating expenses.
Questions Chapter 3 (Continued) 10. (a) No change. (b) Before closing, balances exist in these accounts; after closing, no balances exist. (c) Before closing, balances exist in these accounts; after closing, no balances exist. (d) Before closing, a balance exists in this account exclusive of any dividends or the net income or net loss for the period; after closing, the balance is increased or decreased by the amount of net income or net loss, and decreased by dividends declared. (e) No change. 11. Adjusting entries are prepared prior to the preparation of financial statements in order to bring the accounts up to date and are necessary (1) to achieve a proper recognition of revenues and expenses in measuring income and (2) to achieve an accurate presentation of assets, liabilities and stockholders’ equity. 12. Closing entries are prepared to transfer the balances of nominal accounts to capital (retained earnings) after the adjusting entries have been recorded and the financial statements prepared. Closing entries are necessary to reduce the balances in nominal accounts to zero in order to prepare the accounts for the next period’s transactions. 13. Cost – Salvage Value = Depreciable Cost: $4,000 – $0 = $4,000. Depreciable Cost ÷ Useful Life = Depreciation Expense For One Year $4,000 ÷ 5 years = $800 per year. The asset was used for 6 months (7/1 – 12/31), therefore 1/2-year of depreciation expense should be reported. Annual depreciation X 6/12 = amount to be reported on 2014 income statement: $800 X 6/12 = $400. 14. December 31 Interest Receivable ...............................................................................................10,000 Interest Revenue ......................................................................................... (To record accrued interest revenue on loan)
10,000
Accrued expenses result from the same causes as accrued revenues. In fact, an accrued expense on the books of one company is an accrued revenue to another company. *15. Under the cash basis of accounting, revenue is recorded only when cash is received and expenses are recorded only when paid. Under the accrual basis of accounting, revenue is recognized when a performance obligation is met expenses are recognized when incurred, without regard to the time of the receipt or payment of cash. A cash-basis balance sheet and income statement are incomplete and inaccurate in comparison to accrual-basis financial statements. The accrual basis matches effort (expenses) with accomplishment (revenues) in the income statement while the cash basis only presents cash receipts and cash disbursements. The accrual basis balance sheet contains receivables, payables, accruals, prepayments, and deferrals while a cash-basis balance sheet shows none of these. *16. Salaries and wages paid during the year will include the payment of any wages attributable to the prior year but unpaid at the end of the prior year. This amount is an expense of the prior year and not of the current year, and thus should be subtracted in determining salaries and wages expense. Similarly, salaries and wages paid during the year will not include any salaries and wages attributable to hours worked during the current year but not actually paid until the following year. This should be added in determining salaries and wages expense. *17. Although similar to the strict cash basis, the modified cash basis of accounting requires that expenditures for capital items be charged against income over all the periods to be benefited. This is done through conventional accounting methods, such as depreciation and amortization. Under the strict cash basis, expenditures would be recognized as expenses in the period in which the corresponding cash disbursements are made.
Questions Chapter 3 (Continued) *18. Reversing entries are made at the beginning of the period to reverse accruals and some deferrals. Reversing entries are not required. They are made to simplify the recording of certain transactions that will occur later in the period. The same results will be attained whether or not reversing entries are recorded. *19. Disagree. A worksheet is not a permanent accounting record and its use is not required in the accounting cycle. The worksheet is an informal device for accumulating and sorting information needed for the financial statements. Its use is optional in helping to prepare financial statements.
SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 3-1 May
1 3 13 21
Cash ............................................................. Common Stock.....................................
4,000
Equipment.................................................... Accounts Payable ................................
1,100
Rent Expense............................................... Cash ......................................................
400
Accounts Receivable .................................. Service Revenue ..................................
500
4,000 1,100 400 500
BRIEF EXERCISE 3-2 Aug.
2
7 12
15 19
Cash............................................................... Equipment ..................................................... Owner’s Capital .....................................
12,000 2,500
Supplies......................................................... Accounts Payable..................................
500
Cash............................................................... Accounts Receivable.................................... Service Revenue....................................
1,300 670
Rent Expense................................................ Cash .......................................................
600
Supplies Expense ......................................... Supplies ($500 – $270) ..........................
230
14,500 500
1,970 600 230
BRIEF EXERCISE 3-3 July Dec.
1 31
Prepaid Insurance......................................... Cash........................................................
15,000
Insurance Expense ....................................... Prepaid Insurance ($15,000 X 1/2 X 1/3)...........................
2,500
15,000
2,500
BRIEF EXERCISE 3-4 July Dec.
1 31
Cash............................................................... Unearned Service Revenue...................
15,000
Unearned Service Revenue.......................... Service Revenue ($15,000 X 1/2 X 1/3)...........................
2,500
15,000
2,500
BRIEF EXERCISE 3-5 Feb. June
1 30
Prepaid Insurance......................................... 720,000 Cash........................................................
720,000
Insurance Expense ....................................... 150,000 Prepaid Insurance ($720,000 X 5/24) ................................
150,000
BRIEF EXERCISE 3-6 Nov. Dec.
1 31
Cash............................................................... Unearned Rent Revenue .......................
2,400
Unearned Rent Revenue............................... Rent Revenue ($2,400 X 2/3)......................................
1,600
2,400
1,600
BRIEF EXERCISE 3-7 Dec.
Jan.
31
2
Salaries and Wages Expense...................... Salaries and Wages Payable ($8,000 X 3/5).....................................
4,800
Salaries and Wages Payable....................... Salaries and Wages Expense...................... Cash ......................................................
4,800 3,200
4,800
8,000
BRIEF EXERCISE 3-8 Dec. Feb.
31 1
Interest Receivable ...................................... Interest Revenue ..................................
300
Cash.............................................................. Notes Receivable.................................. Interest Receivable............................... Interest Revenue ..................................
12,400
300 12,000 300 100
BRIEF EXERCISE 3-9 Aug.
31 31 31 31
Interest Expense .......................................... Interest Payable....................................
300
Accounts Receivable................................... Service Revenue...................................
1,400
Salaries and Wages Expense...................... Salaries and Wages Payable ...............
700
Bad Debt Expense ....................................... Allowance for Doubtful Accounts .......
900
300 1,400 700 900
BRIEF EXERCISE 3-10 Depreciation Expense ................................................ Accumulated Depreciation—Equipment ...........
2,000
Equipment................................................................... Less: Accumulated Depreciation—Equipment .......
$30,000 2,000
2,000 $28,000
BRIEF EXERCISE 3-11 Sales Revenue ............................................................ Interest Revenue ........................................................ Income Summary ................................................
808,900 13,500
Income Summary ....................................................... Cost of Goods Sold............................................. Administrative Expenses.................................... Income Tax Expense...........................................
780,300
Income Summary ....................................................... Retained Earnings...............................................
42,100
Retained Earnings ...................................................... Dividends.............................................................
18,900
822,400 556,200 189,000 35,100
42,100 18,900
*BRIEF EXERCISE 3-12 (a)
(b)
Cash receipts..................................................... + Increase in accounts receivable ($18,600 – $13,000)..................................... Service revenue.................................................
$142,000
Payments for operating expenses ................... – Increase in prepaid expenses ($23,200 – $17,500)..................................... Operating expenses ..........................................
$ 97,000
5,600 $147,600
(5,700) $ 91,300
*BRIEF EXERCISE 3-13 (a) (b) (c)
Salaries and Wages Payable ................................ Salaries and Wages Expense........................
4,200
Salaries and Wages Expense ............................... Cash................................................................
7,000
Salaries and Wages Payable ................................ Salaries and Wages Expense ............................... Cash................................................................
4,200 2,800
4,200 7,000
7,000
SOLUTIONS TO EXERCISES EXERCISE 3-1 (15–20 minutes) Apr.
2
Cash................................................................ Equipment ...................................................... Owner’s Capital ......................................
32,000 14,000 46,000
2
No entry—not a transaction.
3
Supplies.......................................................... Accounts Payable...................................
700
Rent Expense ................................................. Cash.........................................................
600
Accounts Receivable..................................... Service Revenue.....................................
1,100
Cash................................................................ Unearned Service Revenue....................
3,200
Cash................................................................ Service Revenue.....................................
2,300
Insurance Expense ........................................ Cash.........................................................
110
Salaries and Wages Expense........................ Cash.........................................................
1,160
Supplies Expense .......................................... Supplies ..................................................
120
Equipment ...................................................... Owner’s Capital ......................................
6,100
7 11 12 17 21 30 30 30
700 600 1,100 3,200 2,300 110 1,160 120 6,100
EXERCISE 3-2 (10–15 minutes) Wanda Landowska Company Trial Balance April 30, 2014 Debit Cash ...................................................................... Accounts Receivable ........................................... Prepaid Insurance ($700 + $100) ......................... Equipment............................................................. Accounts Payable ($4,500 – $100) ...................... Property Taxes Payable ....................................... Owner’s Capital ($11,200 + $1,500) ........................... Owner’s Drawing................................................... Service Revenue................................................... Salaries and Wages Expense .............................. Advertising Expense ($1,100 + $300) .................. Property Tax Expense ($800 + $100)...................
Credit
$ 4,800 2,750 800 8,000 $ 4,400 560 12,700 1,500 6,690 4,200 1,400 900 $24,350
$24,350
EXERCISE 3-3 (15–20 minutes) The ledger accounts are reproduced below, and corrections are shown in the accounts. Bal. (1)
Bal.
Bal.
Cash 5,912 (4) 450
190
Accounts Payable Bal.
7,044
Accounts Receivable 5,240 (1) 450
Common Stock Bal.
8,000
Retained Earnings Bal.
2,000
Supplies 2,967
EXERCISE 3-3 (Continued) Bal. (2)
Equipment 6,100 3,200
Bal.
Service Revenue Bal. (3) (5)
5,200 2,025 80
Office Expense 4,320 (2)
3,200
Blues Traveler Corporation Trial Balance (corrected) April 30, 2014 Debit Cash ...................................................................... Accounts Receivable ........................................... Supplies ................................................................ Equipment............................................................. Accounts Payable................................................. Common Stock ..................................................... Retained Earnings ................................................ Service Revenue................................................... Office Expense .....................................................
Credit
$ 6,172 4,790 2,967 9,300 $ 7,044 8,000 2,000 7,305 1,120 $24,349
$24,349
EXERCISE 3-4 (10–15 minutes) Watteau Co. Trial Balance June 30, 2014 Debit Cash ($2,870 + $180 – $65 – $65) ..................................... Accounts Receivable ($3,231 – $180) .............................. Supplies ($800 – $500) ...................................................... Equipment ($3,800 + $500) ............................................... Accounts Payable ($2,666 – $206 – $260)........................ Unearned Service Revenue ($1,200 – $325) .................... Common Stock.................................................................. Dividends........................................................................... Retained Earnings............................................................. Service Revenue ($2,380 + $801 + $325).......................... Salaries and Wages Expense ($3,400 + $670 – $575) ..... Office Expense ..................................................................
Credit
$ 2,920 3,051 300 4,300 $ 2,200 875 6,000 575 3,000 3,506 3,495 940 $15,581
$15,581
EXERCISE 3-5 (10–15 minutes) 1. 2. 3.
4. 5.
Depreciation Expense ($250 X 3) ............................. Accumulated Depreciation—Equipment ..........
750
Unearned Rent Revenue ($9,300 X 1/3).................... Rent Revenue .....................................................
3,100
Interest Expense........................................................ Interest Payable .................................................
500
Supplies Expense...................................................... Supplies ($2,800 – $850)....................................
1,950
Insurance Expense ($300 X 3) .................................. Prepaid Insurance..............................................
900
750 3,100
500
1,950 900
EXERCISE 3-6 (10–15 minutes) 1. 2. 3.
4. 5.
Accounts Receivable ..................................................... Service Revenue .....................................................
750
Utilities Expenses........................................................... Accounts Payable ...................................................
520
Depreciation Expense .................................................... Accumulated Depreciation – Equipment...............
400
Interest Expense............................................................. Interest Payable.......................................................
500
Insurance Expense ($12,000 X 1/12) ............................. Prepaid Insurance ...................................................
1,000
Supplies Expense ($1,600 – $500)................................. Supplies ...................................................................
1,100
750 520 400 500 1,000 1,100
EXERCISE 3-7 (15–20 minutes) (a)
Ending balance of supplies Add: Adjusting entry Deduct: Purchases Beginning balance of supplies
(b)
Total prepaid insurance Amount used (6 X $400) Present balance
$700 950 850 $800 $4,800 2,400 $2,400
($400 X 12)
The policy was purchased six months ago (August 1, 2013) (c)
The entry in January to record salary and wages expense was Salaries and Wages Expense .............................. Salaries and Wages Payable ............................... Cash ................................................................
1,800 700 2,500
EXERCISE 3-7 (Continued) The “T” account for salaries payable is Salaries and Wages Payable Paid 700 Beg. Bal. ? January End Bal. 800 The beginning balance is therefore
(d)
Ending balance of salaries and wages payable Plus: Reduction of salaries and wages payable Beginning balance of salaries and wages payable
$ 800 700 $1,500
Service revenue Cash received Unearned revenue reduced
$2,000 1,600 $ 400
Ending unearned revenue January 31, 2014 Plus: Unearned revenue reduced Beginning unearned revenue December 31, 2013
$ 750 400 $1,150
EXERCISE 3-8 (10–15 minutes) 1. 2. 3. 4.
Salaries and Wages Expense ......................................... Salaries and Wages Payable ...................................
1,900
Utilities Expense.............................................................. Accounts Payable ....................................................
600
Interest Expense ($30,000 X 8% X 1/12)......................... Interest Payable .......................................................
200
Telephone and Internet Expense ................................... Accounts Payable ....................................................
117
1,900 600 200 117
EXERCISE 3-9 (15–20 minutes) (a)
10/15
10/17
10/20
(b)
10/31
10/31
10/31
10/31
Salaries and Wages Expense........................... Cash ........................................................... (To record payment of October 15 payroll)
800
Accounts Receivable........................................ Service Revenue........................................ (To record revenue for services performed for which payment has not yet been received)
2,400
Cash................................................................... Unearned Service Revenue ...................... (To record receipt of cash for services not yet performed)
650
Supplies Expense ............................................. Supplies ..................................................... (To record the use of supplies during October)
470
Accounts Receivable........................................ Service Revenue........................................ (To record revenue for services performed for which payment has not yet been received)
1,650
Salaries and Wages Expense........................... Salaries and Wages Payable .................... (To record liability for accrued payroll)
600
Unearned Service Revenue.............................. Service Revenue........................................ (To reduce the Unearned Service Revenue account for service that has been performed)
400
800
2,400
650
470
1,650
600
400
EXERCISE 3-10 (25–30 minutes) (a)
1. Aug. 31 Insurance Expense ($4,500 X 3/12) ............ Prepaid Insurance................................ 2. Aug. 31 3. Aug. 31
5. Aug. 31 6. Aug. 31 7. Aug. 31
1,125
Supplies Expense ($2,600 – $450) ............. 2,150 Supplies................................................ Depreciation Expense................................. 1,080 Accumulated Depreciation— Buildings ........................................... ($120,000 – $12,000 = $108,000; $108,000 X 4% = $4,320 per year; $4,320 X 1/4 = $1,080)
Aug. 31 Depreciation Expense................................. Accumulated Depreciation— Equipment ......................................... ($16,000 – $1,600 = $14,400; $14,400 X 10% = $1,440; $1,440 X 1/4 = $360) 4. Aug. 31
1,125
2,150
1,080
360 360
Unearned Rent Revenue............................. Rent Revenue.......................................
3,800
Salaries and Wages Expense..................... Salaries and Wages Payable...............
375
Accounts Receivable .................................. Rent Revenue.......................................
800
Interest Expense ......................................... Interest Payable ................................... [($60,000 X 8%) X 1/4]
1,200
3,800 375 800 1,200
EXERCISE 3-10 (Continued) (b)
Greco Resort Adjusted Trial Balance August 31, 2014 Debit
Cash ......................................................................... Accounts Receivable .............................................. Prepaid Insurance ($4,500 – $1,125) ...................... Supplies ($2,600 – $2,150) ...................................... Land.......................................................................... Buildings.................................................................. Accumulated Depreciation—Buildings.................. Equipment................................................................ Accumulated Depreciation—Equipment................ Accounts Payable.................................................... Unearned Rent Revenue ($4,600 – $3,800) ............ Salaries and Wages Payable .................................. Interest Payable....................................................... Mortgage Payable.................................................... Common Stock ........................................................ Retained Earnings ................................................... Dividends ................................................................. Rent Revenue ($76,200 + $3,800 + $800)................ Salaries and Wages Expense ($44,800 + $375) ..... Utilities Expenses.................................................... Maintenance and Repair Expense.......................... Insurance Expense.................................................. Supplies Expense.................................................... Depreciation Expense—Buildings ......................... Depreciation Expense—Equipment ....................... Interest Expense......................................................
Credit
$ 19,600 800 3,375 450 20,000 120,000 $
1,080
16,000 360 4,500 800 375 1,200 60,000 91,000 9,000 5,000 80,800 45,175 9,200 3,600 1,125 2,150 1,080 360 1,200 $249,115
$249,115
EXERCISE 3-11 (20–25 minutes) (a)
ANDERSON COOPER CO. Income Statement For the Year Ended December 31, 2014
Revenues Service revenue ................................................... Expenses Salaries and wages expense............................... Rent expense ....................................................... Depreciation expense.......................................... Interest expense .................................................. Net Income...................................................................... (b)
$11,590 $6,840 2,260 145 83
ANDERSON COOPER CO. Statement of Retained Earnings For the Year Ended December 31, 2014
Retained earnings, January 1........................................................... Add: Net income................................................................................ Less: Dividends................................................................................. Retained earnings, December 31 ..................................................... (c)
9,328 $ 2,262
$11,310 2,262 13,572 3,000 $10,572
ANDERSON COOPER CO. Balance Sheet December 31, 2014
Assets Current Assets Cash ................................................................ Accounts receivable ...................................... Prepaid rent .................................................... Total current assets.................................. Property, plant, and equipment Equipment....................................................... Accumulated depreciation – equipment ..................................................... Total assets ...................................................................
$19,472 6,920 2,280 28,672 $18,050 (4,895)
13,155 $41,827
EXERCISE 3-11 (Continued) Liabilities and Stockholders’ Equity Current liabilities Accounts payable............................................. Interest payable ................................................ Notes payable ................................................... Total current liabilities................................ Stockholders’ equity Common stock.................................................. Retained earnings ............................................ Total liabilities and stockholders’ equity ......................
$ 5,472 83 5,700 11,255 $20,000 10,572*
30,572 $41,827
*Beg. Balance + Net Income – Dividends = Ending Balance $11,310 + $2,262 – $3,000 = $10,572 EXERCISE 3-12 (20–25 Minutes) (a)
SANTO DESIGN AGENCY Income Statement For the Year Ended December 31, 2014
Revenues Service revenue ..................................................... Expenses Salaries and wages expense................................. Depreciation expense ............................................ Rent expense.......................................................... Supplies expense................................................... Insurance expense................................................. Interest expense..................................................... Total expenses ................................................ Net income ........................................................................
$61,500 $11,300 7,000 4,000 3,400 850 500 27,050 $34,450
SANTO DESIGN AGENCY Statement of Retained Earnings For the Year Ended December 31, 2014 Retained earnings, January 1 ............................................................ Add: Net income................................................................................. Retained earnings, December 31 ......................................................
$ 3,500 34,450 $37,950
EXERCISE 3-12 (Continued) (a) Continued
SANTO DESIGN AGENCY Balance Sheet December 31, 2014
Assets Cash ................................................................................... Accounts receivable ......................................................... Supplies ............................................................................. Prepaid insurance ............................................................. Equipment.......................................................................... Less: Accumulated depreciation – equipment .................... Total assets..............................................................
$11,000 21,500 5,000 2,500 $60,000 35,000
25,000 $65,000
Liabilities and Stockholders’ Equity Liabilities Notes payable .......................................................... Accounts payable.................................................... Interest payable ....................................................... Unearned service revenue ...................................... Salaries and wages payable ................................... Total liabilities................................................... Stockholders’ equity Common stock ........................................................ Retained earnings ................................................... Total liabilities and stockholders’ equity ........
$ 5,000 5,000 150 5,600 1,300 $17,050 $10,000 37,950
47,950 $65,000
(b) (1) Based on interest payable at December 31, 2014, interest is $25 per month or 0.5% of the note payable. 0.5% X 12 = 6% interest per year. (2) Salaries and Wages Expense, $11,300 less Salaries and Wages Payable 12/31/14, $1,300 = $10,000. Total payments, $17,500 – $10,000 = $7,500 Salaries and Wages Payable 12/31/13.
EXERCISE 3-13 (10–15 minutes) (a)
(b)
Sales revenue ....................................................... Less: Sales returns and allowances ................... Sales discounts.......................................... Net sales ...............................................................
$800,000 $24,000 15,000
Sales...................................................................... Income Summary ..........................................
800,000
Income Summary.................................................. Sales Returns and Allowances .................... Sales Discounts ............................................
39,000
39,000 $761,000 800,000 24,000 15,000
EXERCISE 3-14 (10–15 minutes) Sales Revenue ...................................................... Sales Returns and Allowances .................... Sales Discounts ............................................ Income Summary ..........................................
350,000
Income Summary.................................................. Cost of Goods Sold....................................... Delivery Expense .......................................... Insurance Expense ....................................... Rent Expense ................................................ Salaries and Wages Expense .......................
308,000
Income Summary.................................................. Retained Earnings.........................................
21,000
EXERCISE 3-15 (10–15 minutes) (a) $9,000 (b) $25,000 (c) $10,000
(d) $100,000 (e) $57,000
13,000 8,000 329,000 208,000 7,000 12,000 20,000 61,000 21,000
EXERCISE 3-16 (10–15 minutes) Sales Revenue.......................................................... Cost of Goods Sold........................................... Sales Returns and Allowances ........................ Sales Discounts ................................................ Selling Expenses .............................................. Administrative Expenses ................................. Income Tax Expense......................................... Income Summary ..............................................
410,000 225,700 12,000 15,000 16,000 38,000 30,000 73,300
(or) Sales Revenue.......................................................... Income Summary ..............................................
410,000
Income Summary ..................................................... Cost of Goods Sold........................................... Sales Returns and Allowances ........................ Sales Discounts ................................................ Selling Expenses .............................................. Administrative Expenses ................................. Income Tax Expense.........................................
336,700
Income Summary ..................................................... Retained Earnings.............................................
73,300
Retained Earnings.................................................... Dividends...........................................................
18,000
410,000 225,700 12,000 15,000 16,000 38,000 30,000
73,300 18,000
EXERCISE 3-17 (10–15 minutes) Date Mar.
Account Titles and Explanation 1 Cash
Ref.
Debit
J1 Credit
50,000 Common Stock (Investment of cash in business)
50,000
3 Land Buildings Equipment Cash (Purchased Michelle Wie’s Golf Land)
10,000 22,000 6,000
5 Advertising Expense Cash (Paid for advertising)
1,600
6 Prepaid Insurance Cash (Paid for one-year insurance policy)
1,480
10 Equipment Accounts Payable (Purchased equipment on account)
2,500
18 Cash
1,200
38,000
1,600
1,480
2,500
Service Revenue (Received cash for services performed)
1,200
25 Dividends Cash (Declared and paid a $500 cash dividend)
500
30 Salaries and Wages Expense Cash (Paid wages expense)
900
30 Accounts Payable Cash (Paid creditor on account) 31 Cash
500
900
2,500 2,500
750 Service Revenue (Received cash for services performed)
750
*EXERCISE 3-18 (15–20 minutes) Jill Accardo, M.D. Conversion of Cash Basis to Accrual Basis For the Year 2014 Excess of cash collected over cash disbursed ($142,600 – $55,470) Add increase in accounts receivable ($9,250 – $15, 927) Deduct increase in unearned service revenue ($2,840 – $4,111) Add decrease in accrued liabilities ($3,435 – $2,108) Add increase in prepaid expenses ($1,917 – $3,232) Net income on an accrual basis
$87,130 6,677 (1,271) 1,327 1,315 $95,178
Alternate solution: Jill Accardo, M.D. Conversion of Income Statement Data from Cash Basis to Accrual Basis For the Year 2014 Cash Adjustments Basis Add Deduct Collections from customers: –Accounts receivable, Jan. 1 +Accounts receivable, Dec. 31 +Unearned service revenue, Jan. 1 –Unearned service revenue, Dec. 31 Service revenue Disbursements for expenses: –Accrued liabilities, Jan. 1 +Accrued liabilities, Dec. 31 +Prepaid expenses, Jan. 1 –Prepaid expenses, Dec. 31 Operating expenses Net income—cash basis Net income—accrual basis
Accrual Basis
$142,600 $9,250 $15,927 2,840 4,111 $148,006 55,470 3,435 2,108 1,917 3,232 $ 87,130
52,828 $ 95,178
*EXERCISE 3-19 (10–15 minutes) (a)
Wayne Rogers Corp. Income Statement (Cash Basis) For the Year Ended December 31, 2013 $295,000 225,000 $ 70,000
2014 $515,000 272,000 $243,000
Wayne Rogers Corp. Income Statement (Accrual Basis) For the Year Ended December 31, 2013 $485,000 277,000 $208,000
2014 $445,000 255,000 $190,000
Sales revenue Expenses Net income (b)
Sales* revenue Expenses** Net income *2013: 2014: **2013: 2014:
$295,000 + $160,000 + $30,000 = $485,000 $355,000 + $90,000 = $445,000 $185,000 + $67,000 + $25,000 = $277,000 $40,000 + $160,000 + $55,000 = $255,000
*EXERCISE 3-20 (20–25 minutes) (a)
Adjusting Entries: 1. Insurance Expense ($5,280 X 5/24) .................... Prepaid Insurance ........................................ 2. 3. 4.
1,100 1,100
Rent Revenue ($1,800 X 1/3) ............................... Unearned Rent Revenue..............................
600
Supplies ............................................................... Advertising Expense....................................
290
Interest Expense.................................................. Interest Payable ...........................................
770
600 290 770
*EXERCISE 3-20 (Continued) (b)
Reversing Entries: 1. No reversing entry required. 2. 3. 4.
Unearned Rent Revenue..................................... Rental Revenue............................................
600
Advertising Expense........................................... Supplies........................................................
290
Interest Payable................................................... Interest Expense ..........................................
770
600 290 770
*EXERCISE 3-21 (10–15 minutes) Accounts Cash Inventory Sales Revenue Sales Returns and Allowances Sales Discounts Cost of Goods Sold
Adjusted Trial Balance
Income Statement
Dr. 9,000 80,000
Dr.
Cr.
450,000 10,000 5,000 250,000
Cr.
450,000 10,000 5,000 250,000
Balance Sheet Dr. 9,000 80,000
Cr.
*EXERCISE 3-22 (20–25 minutes) Ed Bradley Co. Worksheet (partial) For the Month Ended April 30, 2014
Account Titles Cash Accounts Receivable Prepaid Rent Equipment Accum. Depreciation – Equipment Notes Payable Accounts Payable Common Stock Retained Earnings Dividends Service Revenue Salaries and Wages Expense Rent Expense Depreciation Expense Interest Expense Interest Payable Totals Net income Totals
Adjusted Trial Balance
Income Statement
Dr. 18,972 6,920 2,280 18,050
Dr.
Cr.
Cr.
Balance Sheet Dr. 18,972 6,920 2,280 18,050
4,895 5,700 4,472 34,960 1,000
4,895 5,700 4,472 34,960 1,000
6,650
6,650 12,590
6,840 3,760 145 83 63,700
Cr.
12,590 6,840 3,760 145 83
83 63,700 10,828 12,590 52,872 1,762 12,590 12,590 52,872
83 50,110 1,762 52,872
EXERCISE 3-22 (Continued) Ed Bradley Co. Balance Sheet April 30, 2014 Assets Current Assets Cash................................................................ Accounts receivable...................................... Prepaid rent.................................................... Total current assets.............................. Property, plant, and equipment Equipment ...................................................... Accumulated depreciation – equipment .................................................... Total assets ...................................................................... Liabilities and Stockholders’ Equity Current liabilities Notes payable ................................................ Accounts payable .......................................... Interest payable ............................................. Total current liabilities ......................... Stockholders’ equity Common Stock .............................................. Retained earnings.......................................... Total liabilities and Stockholders’ equity.......................
$18,972 6,920 2,280 28,172 $18,050 (4,895)
13,155 $41,327
$ 5,700 4,472 83 10,255 34,960 (3,888)
*Beg. Balance – Dividends + Net Income = Ending Balance $1,000 – $6,650 + $1,762 = ($3,888)
31,072* $41,327
*EXERCISE 3-23 (10–15 minutes) Jurassic Park Co. Worksheet (partial) For Month Ended February 28, 2014
Trial Balance Account Titles Supplies
Dr.
Cr.
Adjustments Dr.
Cr.
1,756
Adjusted
Income
Balance
Trial Balance
Statement
Sheet
Dr.
Dr.
Dr.
Cr.
715
Cr.
Cr.
(a)
1,041
715
6,939
(b)
257
7,196
7,196
150
(c)
50
200
200
Accumulated depreciation – equipment Interest payable Supplies expense
(a) 1,041
1,041
1,041
Depreciation expense
(b)
257
257
257
(c)
50
50
50
Interest expense
The following accounts and amounts would be shown in the February income statement: Supplies expense Depreciation expense Interest expense
$1,041 257 50
TIME AND PURPOSE OF PROBLEMS Problem 3-1 (Time 25–35 minutes) Purpose—to provide an opportunity for the student to post daily transactions to a “T” account ledger, take a trial balance, prepare an income statement, a balance sheet and a statement of owners’ equity, close the ledger, and take a post-closing trial balance. The problem deals with routine transactions of a professional service firm and provides a good integration of the accounting process. Problem 3-2 (Time 35–40 minutes) Purpose—to provide an opportunity for the student to prepare adjusting entries, and prepare financial statements (income statement, balance sheet, and statement of retained earnings). The student also is asked to analyze two transactions to find missing amounts. Problem 3-3 (Time 25–30 minutes) Purpose—to provide an opportunity for the student to prepare adjusting entries. The adjusting entries are fairly complex in nature. Problem 3-4 (Time 40–50 minutes) Purpose—to provide an opportunity for the student to prepare adjusting entries and an adjusted trial balance and then prepare an income statement, a retained earnings statement, and a balance sheet. In addition, closing entries must be made and a post-closing trial balance prepared. Problem 3-5 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to determine what adjusting entries need to be made to specific accounts listed in a partial trial balance. The student is also required to determine the amounts of certain revenue and expense items to be reported in the income statement. Problem 3-6 (Time 25–35 minutes) Purpose—to provide the student with an opportunity to prepare year-end adjusting entries from a trial balance and related information presented. The problem also requires the student to prepare an income statement, a balance sheet, and a statement of owners’ equity. The problem covers the basics of the end-of-period adjusting process. Problem 3-7 (Time 25–35 minutes) Purpose—to provide an opportunity for the student to figure out the year-end adjusting entries that were made from a trial balance and an adjusted trial balance. The student is also required to prepare an income statement, a statement of retained earnings, and a balance sheet. In addition, the student needs to answer a number of questions related to specific accounts. Problem 3-8 (Time 25–35 minutes) Purpose—to provide an opportunity for the student to figure out the year-end adjusting entries that were made from a trial balance and an adjusted trial balance. The student is also required to prepare an income statement, a statement of retained earnings, and a balance sheet. In addition, the student needs to answer a number of questions related to specific accounts. Problem 3-9 (Time 30–40 minutes) Purpose—to provide an opportunity for the student to prepare adjusting, and closing entries. This problem presents basic adjustments including a number of accruals and deferrals. It provides the student with an integrated flow of the year-end accounting process. Problem 3-10 (Time 30–35 minutes) Purpose—to provide an opportunity for the student to prepare adjusting and closing entries from a trial balance and related information. The student is also required to post the entries to “T” accounts.
Time and Purpose of Problems (Continued) *Problem 3-11 (Time 35–40 minutes) Purpose—to provide an opportunity for the student to prepare and compare (a) cash basis and accrualbasis income statements, (b) cash-basis and accrual-basis balance sheets, and (c) to discuss the weaknesses of cash basis accounting. *Problem 3-12 (Time 40–50 minutes) Purpose—to provide an opportunity for the student to complete a worksheet and then prepare a classified balance sheet. In addition, adjusting and closing entries must be made and a post-closing trial balance prepared.
SOLUTIONS TO PROBLEMS PROBLEM 3-1 (a)
(Explanations are omitted.) and (d)
Cash Sept. 1 20,000 Sept. 4 8 1,690 5 20 980 10 18 19 30 30 30 Bal 12,133
Sept. 14 25 Bal. 30
Accounts Receivable 5,820 Sept. 20 2,110 6,950
Equipment 680 942 430 3,600 3,000 1,800 85
Sept.
Sept.
2
19
17,280
Owner’s Capital 3,000 Sept. Bal.
4
Sept. 5 Bal. 30
Supplies 942 Sept. 30 612
Sept.
20,000 6,007
30
23,007
2
17,280
30
13,680
8 14 25
1,690 5,820 2,110 9,620
980 Sept.
18
Accounts Payable 3,600 Sept. Bal.
Rent Expense 680 Sept. 30
1 30
680 Service Revenue 330
Sept.
30
9,620 Sept.
9,620 Office Expense Sept. 10 30
430 Sept. 85 515
30
Sept.
Salaries and Wages Expense 30 1,800 Sept. 30
Sept.
Supplies Expense 330 Sept. 30
30
Accumulated Depreciation—Equipment 515 515
1,800
330
Sept.
30
288
PROBLEM 3-1 (Continued) Depreciation Expense Sept.
30
288 Sept. 30
Income Summary 288
Sept.
30 30 30 30 30 30 Inc.
680 Sept. 515 1,800 330 288 6,007 9,620
(b)
30
9,620
9,620
YASUNARI KAWABATA, D.D.S. Trial Balance September 30 Debit Cash ........................................................................ $12,133 Accounts Receivable ............................................. 6,950 Supplies.................................................................. 612 Equipment .............................................................. 17,280 Accumulated Depreciation—Equipment .............. Accounts Payable .................................................. Owner’s Capital...................................................... Service Revenue .................................................... Rent Expense ......................................................... 680 Office Expense ....................................................... 515 Salaries and Wages Expense................................ 1,800 Supplies Expense .................................................. 330 Depreciation Expense............................................ 288 Totals............................................................ $40,588
Credit
$ 288 13,680 17,000 9,620
$40,588
PROBLEM 3-1 (Continued) (c)
YASUNARI KAWABATA, D.D.S. Income Statement For the Month of September Service revenue ........................................................ Expenses: Salaries and wages expense..................... Rent expense ............................................. Supplies expense ...................................... Depreciation expense................................ Office expense ........................................... Total expenses....................................... Net income ................................................................
$9,620 $1,800 680 330 288 515 3,613 $6,007
YASUNARI KAWABATA, D.D.S. Statement of Owners’ Equity For the Month of September Owner’s capital September 1 ............................................... Add: Net income ................................................................. Less: Withdrawal by owner ................................................. Owner’s capital September 30 .............................................
$20,000 6,007 26,007 3,000 $23,007
YASUNARI KAWABATA, D.D.S. Balance Sheet As of September 30 Assets Cash .............................. $12,133 Accounts receivable .... 6,950 Supplies ........................ 612 Equipment. ................... 17,280 Accum. depreciation— equipment................. (288) Total assets .......... $36,687
Liabilities and Owners’ Equity Accounts payable .............. $13,680 Owner’s capital .................... 23,007
Total liabilities and owners’ equity .................. $36,687
PROBLEM 3-1 (Continued) (d)
YASUNARI KAWABATA, D.D.S. Post-Closing Trial Balance September 30 Debit Cash ............................................................. Accounts Receivable .................................. Supplies ....................................................... Equipment.................................................... Accumulated Depreciation—Equipment ... Accounts Payable ....................................... Owner’s Capital ........................................... Totals .................................................
Credit
$12,133 6,950 612 17,280
$36,975
$ 288 13,680 23,007 $36,975
PROBLEM 3-2
(a)
Dec. 31 31 31 31
31 31 31 (b)
Accounts Receivable ................................... Service Revenue ...................................
3,500
Unearned Service Revenue ......................... Service Revenue ...................................
1,400
Supplies Expense ........................................ Supplies.................................................
5,400
Depreciation Expense.................................. Accumulated Depreciation— Equipment ..........................................
5,000
Interest Expense .......................................... Interest Payable ....................................
150
Insurance Expense ...................................... Prepaid Insurance.................................
850
Salaries and Wages Expense ...................... Salaries and Wages Payable................
1,300
3,500 1,400 5,400
5,000
150 850 1,300
MASON ADVERTISING AGENCY Income Statement For the Year Ended December 31, 2014 Revenues Service revenue.................................. Expenses Salaries and wages expense ............. Supplies expense ............................... Depreciation expense ........................ Rent expense ...................................... Insurance expense ............................. Interest expense ................................. Total expenses............................. Net income ....................................................
$63,500 $11,300 5,400 5,000 4,000 850 500 27,050 $36,450
PROBLEM 3-2 (Continued) MASON ADVERTISING AGENCY Statement of Retained Earnings For the Year Ended December 31, 2014 Retained earnings, January 1 .................................. Add: Net income....................................................... Retained earnings, December 31 .............................
$ 3,500 36,450 $39,950
MASON ADVERTISING AGENCY Balance Sheet December 31, 2014 Assets Cash.............................................................................. Accounts receivable .................................................... Supplies........................................................................ Prepaid insurance........................................................ Equipment .................................................................... $60,000 Less: Accumulated depreciation—equipment ......... 33,000 Total assets ...................................................
$11,000 23,500 3,000 2,500 27,000 $67,000
Liabilities and Stockholders’ Equity Liabilities Notes payable..................................................... $ 5,000 Accounts payable .............................................. 5,000 Unearned service revenue ................................ 5,600 Salaries and wages payable.............................. 1,300 Interest payable .................................................... 150 Total liabilities ............................................. $17,050 Stockholders’ equity Common stock ..................................................... $10,000 Retained earnings.............................................. 39,950 49,950 Total liabilities and stockholders’ equity ....................................................... $67,000 (c) 1. Interest is $50 per month or 1% of the note payable. 1% X 12 = 12% interest per year. 2. Salaries and Wages Expense, $11,300 less Salaries and Wages Payable 12/31/14, $1,300 = $10,000. Total Payments, $12,500 – $10,000 = $2,500 Salaries and Wages Payable 12/31/13.
PROBLEM 3-3
1.
Dec. 31 Salaries and Wages Expense ............................. 2,120 Salaries and Wages Payable................... (5 X $700 X 2/5) = $1,400 (3 X $600 X 2/5) = 720 Total accrued salaries $2,120
2,120
2.
31 Unearned Rent Revenue ................................... 94,000 Rent Revenue........................................... 94,000 (5 X $6,000 X 2) = $60,000 (4 X $8,500 X 1) = 34,000 Total rent recognized $94,000
3.
31 Advertising Expense ........................................... 4,900 Prepaid Advertising ................................. (A650 – $500 per month for 8 months) = $4,000 (B974 – $300 per month for 3 months) = 900 Total advertising expense $4,900
4.
31 Interest Expense.................................................. 4,200 Interest Payable ($60,000 X 12% X 7/12).........................
4,900
4,200
PROBLEM 3-4
(a)
Nov. 30 Supplies Expense.................................... Supplies............................................
4,000
30 Depreciation Expense ............................. Accumulated Depreciation— Equipment ....................................
15,000
30 Interest Expense...................................... Interest Payable ...............................
11,000
4,000
15,000 11,000
PROBLEM 3-4 (Continued) (b)
BELLEMY FASHION CENTER Adjusted Trial Balance November 30, 2014 Dr. Cash............................................................... $ 28,700 Accounts Receivable.................................... 33,700 Inventory ....................................................... 45,000 Supplies ........................................................ 1,500 Equipment..................................................... 133,000 Accumulated Depr.— Equipment ............... Notes Payable ............................................... Accounts Payable......................................... Common Stock ............................................. Retained Earnings ........................................ Sales Revenue .............................................. Sales Returns and Allowances.................... 4,200 Cost of Goods Sold ...................................... 495,400 Salaries and Wages Expense ...................... 140,000 Advertising Expense .................................... 26,400 Utilities Expenses......................................... 14,000 Maintenance and Repairs Expense ............. 12,100 Delivery Expense.......................................... 16,700 Rent Expense................................................ 24,000 Supplies Expense......................................... 4,000 Depreciation Expense .................................. 15,000 Interest Expense........................................... 11,000 Interest Payable ............................................ Totals....................................................... $1,004,700
Cr.
$
39,000 51,000 48,500 90,000 8,000 757,200
11,000 $1,004,700
PROBLEM 3-4 (Continued) (c)
BELLEMY FASHION CENTER Income Statement For the Year Ended November 30, 2014 Sales revenue Sales ................................................... $757,200 Less: Sales returns and allowances .............................. 4,200 Net sales ............................................. 753,000 Cost of goods sold ....................................... 495,400 Gross profit ................................................... 257,600 Operating expenses Selling expenses Salaries and wages expense ($140,000 X 70%) .................... $98,000 Advertising expense .................... 26,400 Rent expense ($24,000 X 80%) ........................ 19,200 Delivery expense .......................... 16,700 Utilities expenses ($14,000 X 80%) ........................ 11,200 Depreciation Expense .................. 15,000 Supplies expense ....................... 4,000 Total selling expenses ....... $190,500 Administrative expenses Salaries and wages expense ($140,000 X 30%) ................... 42,000 Maintenance and Repairs Expense .................................. 12,100 Rent expense ($24,000 X 20%) ..................... 4,800 Utilities expenses ($14,000 X 20%) ..................... 2,800 Total admin. expenses....... 61,700 Total oper. expenses.... 252,200 Income from operations.............................. 5,400 Other expenses and losses Interest expense................................. 11,000 Net loss ........................................................ ($ 5,600)
PROBLEM 3-4 (Continued) BELLEMY FASHION CENTER Retained Earnings Statement For the Year Ended November 30, 2014 Retained earnings, December 1, 2013 ............ Less: Net loss .................................................. Retained earnings, November 30, 2014 ..........
$8,000 5,600 $2,400
BELLEMY FASHION CENTER Balance Sheet November 30, 2014 Assets Current assets Cash........................................................... $28,700 Accounts receivable ................................. 33,700 Inventory ................................................... 45,000 Supplies..................................................... 1,500 Total current assets......................... $108,900 Property, plant, and equipment Equipment ................................................. 133,000 Accumulated depreciation— equipment ........................................ 39,000 94,000 Total assets...................................... $202,900 Liabilities and Stockholders’ Equity Current liabilities Notes payable due next year.................... Accounts payable ..................................... Interest payable ........................................ Total current liabilities..................... Long-term liabilities Notes payable ........................................... Total liabilities.................................. Stockholders’ equity Common stock.......................................... Retained earnings..................................... Total liabilities and stockholders’ equity ............................................
$30,000 48,500 11,000 $ 89,500 21,000 110,500 90,000 2,400
92,400 $202,900
PROBLEM 3-4 (Continued) (d) Nov. 30 30
30
(e)
Sales Revenue .............................................. 757,200 Income Summary ..................................
757,200
Income Summary ......................................... 762,800 Sales Returns and Allowances ............ Cost of Goods Sold............................... Salaries and Wages Expense............... Advertising Expense............................. Utilities Expense ................................... Maintenance and Repair Expense ....... Delivery Expense .................................. Rent Expense ........................................ Supplies Expense ................................. Depreciation Expense........................... Interest Expense ...................................
4,200 495,400 140,000 26,400 14,000 12,100 16,700 24,000 4,000 15,000 11,000
Retained Earnings........................................ Income Summary ..................................
5,600 5,600
BELLEMY FASHION CENTER Post-Closing Trial Balance November 30, 2014 Debit Cash .................................................................... Accounts Receivable ......................................... Inventory ............................................................. Supplies .............................................................. Equipment........................................................... Accumulated Depreciation—Equipment........... Notes Payable..................................................... Accounts Payable............................................... Interest Payable .................................................. Common Stock ................................................... Retained Earnings ..............................................
Credit
$ 28,700 33,700 45,000 1,500 133,000
$241,900
$ 39,000 51,000 48,500 11,000 90,000 2,400 $241,900
PROBLEM 3-5
(a)
-1Depreciation Expense.............................................. Accumulated Depreciation—Equipment (1/16 X $168,000) ........................................... -2Interest Expense....................................................... Interest Payable ($90,000 X 8% X 72/360) ................................ -3Admissions Revenue ............................................... Unearned Admissions Revenue (2,000 X $30) ..................................................
10,500 10,500 1,440* 1,440*
60,000 60,000
-4Prepaid Advertising ................................................. Advertising Expense.........................................
1,100
-5Salaries and Wages Expense .................................. Salaries and Wages Payable ............................
4,700
(b) 1. 2. 3. 4.
1,100
4,700
Interest expense, $2,840 ($1,400 + $1,440). Admissions revenue, $320,000 ($380,000 – $60,000). Advertising expense, $12,580 ($13,680 – $1,100). Salaries and wages expense, $62,300 ($57,600 + $4,700).
*Note to instructor: If 30-day months are assumed, interest expense = $1,400 ($90,000 X 8% X 70/360).
PROBLEM 3-6
(a)
-1Service Revenue ........................................................ Unearned Service Revenue ...............................
6,000
-2Accounts Receivable................................................. Service Revenue.................................................
4,900
-3Bad Debt Expense ..................................................... Allowance for Doubtful Accounts .....................
1,430
-4Insurance Expense .................................................... Prepaid Insurance ..............................................
480
-5Depreciation Expense ............................................... Accumulated Depreciation—Equipment ($25,000 X 0.10)............................................... -6Interest Expense ........................................................ Interest Payable ($7,200 X 0.10 X 30/360)..................................
6,000
4,900
1,430
480 2,500 2,500 60 60
-7Prepaid Rent .............................................................. Rent Expense......................................................
750
-8Salaries and Wages Expense.................................... Salaries and Wages Payable .............................
2,510
750
2,510
PROBLEM 3-6 (Continued) (b)
YORKIS PEREZ, CONSULTING ENGINEER Income Statement For the Year Ended December 31, 2014 Service revenue ($100,000 – $6,000 + $4,900) .......... Expenses Salaries and wages expense ($30,500+$2,510) ............................................. Rent expense ($9,750 – $750) ............................ Depreciation expense......................................... Bad debt expense............................................... Utilities expenses ............................................... Office expense .................................................... Insurance expense ............................................. Interest expense ................................................. Total expenses............................................... Net income ..................................................................
$98,900 $33,010 9,000 2,500 1,430 1,080 720 480 60 48,280 $50,620
YORKIS PEREZ, CONSULTING ENGINEER Statement of Owners’ Capital For the Year Ended December 31, 2014 Onwer’s Capital, January 1 ........................................ Add: Net income ......................................................... Less: Withdrawals ...................................................... Owner’s capital, December 31 ...................................
$ 52,010a 50,620 (17,000) $ 85,630
(a)
$ 35,010 17,000 $ 52,010
Owner’s capital—trial balance.............................. Withdrawals during the year ................................. Owner’s capital, as of January 1, 2014 ..................
PROBLEM 3-6 (Continued) YORKIS PEREZ, CONSULTING ENGINEER Balance Sheet December 31, 2014 Assets Current assets Cash ........................................... $29,500 Accounts receivable ($49,600 + $4,900) .................... $54,500 Less: Allowance for doubtful accounts .......... 2,180* 52,320 Supplies ..................................... 1,960 Prepaid insurance ($1,100 – $480) ....................... 620 Prepaid rent ............................... 750 Total current assets............ $ 85,150 Equipment......................................... 25,000 Less: Accumulated depreciation ... 8,750** 16,250 Total assets......................... $101,400
Liabilities and owners’ equity Current liabilities Notes payable ............................ Unearned service revenue ........ Salaries and wages payable ..... Interest payable ......................... Owner’s Capital ($35,010 + $50,620) ....................... Total liabilities and owners’ equity................. *($750 + $1,430) **($6,250 + $2,500)
$7,200 6,000 2,510 60
$ 15,770
85,630 $101,400
PROBLEM 3-7 (a)
Sep. 30 30 30 30 30 30 30 (b)
Accounts Receivable......................................... Service Revenue.........................................
600
Rent Expense ..................................................... Prepaid Rent ...............................................
900
Supplies Expense .............................................. Supplies ......................................................
1,020
Depreciation Expense ....................................... Accumulated Depreciation—Equipment...
350
Interest Expense ................................................ Interest Payable ..........................................
50
Unearned Rent Revenue ................................... Rent Revenue .............................................
200
Salaries and Wages Expense............................ Salaries and Wages Payable .....................
600
600 900 1,020 350 50 200 600
ROLLING HILLS GOLF INC. Income Statement For the Quarter Ended September 30, 2014 Revenues Service revenue.................................................. Rent revenue ...................................................... Total revenue ............................................... Expenses Salaries and wages expense ............................. Rent expense...................................................... Supplies expense ............................................... Utilities expenses............................................... Depreciation expense ........................................ Interest expense................................................. Total expenses .............................................. Net income..................................................................
$14,700 900 $15,600 $9,400 1,800 1,020 470 350 50 13,090 $ 2,510
PROBLEM 3-7 (Continued) ROLLING HILLS GOLF INC. Retained Earnings Statement For the Quarter Ended September 30, 2014 Retained earnings, July 1, 2014 ............................................ Add: Net income..................................................................... Less: Dividends...................................................................... Retained earnings, September 30, 2014 ...............................
$
0 2,510 600 $1,910
ROLLING HILLS GOLF INC. Balance Sheet September 30, 2014 Assets Current assets Cash............................................ Accounts receivable .................. Supplies...................................... Prepaid rent expense................. Total current assets ............ Equipment ......................................... Less: Accumulated depreciation.... Total assets ......................... Liabilities and Stockholders’ Equity Current liabilities Notes payable ............................ Accounts payable ...................... Unearned rent revenue.............. Salaries and wages payable ..... Interest payable ......................... Stockholders’ Equity Common stock.................................. Retained earnings ............................ Total stockholders’ equity Total liabilities and stockholders’ equity .........
$ 6,700 1,000 180 900 $ 8,780 15,000 350
$ 5,000 1,070 800 600 50
14,650 $23,430
$ 7,520
14,000 1,910 15,910 $23,430
PROBLEM 3-7 (Continued) (c) The following accounts would be closed: Service Revenue, Rent Revenue, Salaries and Wages Expense, Rent Expense, Utilities Expenses, Depreciation Expense, Supplies Expense, Interest Expense, Dividends. (d) Interest of 12% per year equals a monthly rate of 1%; monthly interest is $50 ($5,000 X 1%). Since total interest expense is $50, the note has been outstanding one month.
PROBLEM 3-8 (a) Dec. 31 Accounts Receivable ......................................... Service Revenue ......................................... 31 31 31 31 31 31 (b)
3,500 3,500
Supplies Expense .............................................. Supplies ......................................................
2,900
Insurance Expense ............................................ Prepaid Insurance.......................................
1,560
Depreciation Expense........................................ Accumulated Depreciation—Equipment...
5,000
Interest Expense ................................................ Interest Payable ..........................................
560
Unearned Service Revenue ............................... Service Revenue .........................................
1,900
Salaries and Wages Expense............................ Salaries and Wages Payable......................
820
2,900 1,560 5,000 560 1,900 820
VEDULA ADVERTISING AGENCY Income Statement For the Year Ended December 31, 2014 Revenues Service revenue.................................................. Expenses Salaries and wages expense ............................. Depreciation expense ........................................ Rent expense ...................................................... Supplies expense ............................................... Insurance expense ............................................. Interest expense ................................................. Total expenses............................................... Net income..................................................................
$63,000 $9,820 5,000 4,350 2,900 1,560 560 24,190 $38,810
PROBLEM 3-8 (Continued) VEDULA ADVERTISING AGENCY Retained Earnings Statement For the Year Ended December 31, 2014 Retained earnings, January 1 ............................... Add: Net income .................................................... Less: Dividends ..................................................... Retained earnings, December 31 ..........................
$ 5,500 38,810 10,000 $34,310
VEDULA ADVERTISING AGENCY Balance Sheet December 31, 2014 Assets Current assets Cash........................................................... $11,000 Accounts receivable ................................. 19,500 Supplies..................................................... 6,500 Prepaid insurance..................................... 1,790 Total current assets ........................... Equipment........................................................ 60,000 Less: Accumulated depreciation.................... 30,000 Total assets ........................................ Liabilities and Stockholders’ Equity Current liabilities Notes payable.................................................. Accounts payable ........................................... Unearned service revenue.............................. Salaries and wages payable ........................... Interest payable...............................................
$ 8,000 2,000 3,100 820 560
Stockholders’ Equity Common stock .................................................... 20,000 Retained earnings ............................................. 34,310 Total stockholders’ equity........................ Total liabilities and stockholders’ equity .......................
$38,790 30,000 $68,790
$ 14,480
54,310 $68,790
PROBLEM 3-8 (Continued) (c) Service Revenue, Salaries and Wages Expense, Depreciation Expense, Rent Expense, Supplies Expense, Insurance Expense, Interest Expense, Dividends. (d) Interest is $56 per month or 0.7% of the note payable ($56 ÷ $8,000). 0.7% X 12 = 8.4% interest per year. (e) Salaries and Wages Expense, $9,820, less Salaries and Wages Payable 12/31/14, $820 = $9,000. Total payments, $10,500 – $9,000 = $1,500 Salaries and Wages Payable 12/31/13.
PROBLEM 3-9
(a) , (b), (d) Cash Bal.
Prepaid Insurance Bal.
15,000
9,000 Adj. 5,500
Salaries and Wages Expense 3,500
Bal. Adj.
80,000 Close 3,600 83,600
83,600 83,600
Common Stock Bal.
Accounts Receivable Bal.
Retained Earnings Bal. 82,000 Inc. 31,640 113,640
13,000
Allow. for Doubtful Accts. Bal. Adj.
1,100 460 1,560
Land Bal.
350,000
120,000
Adj. Cls.
8,900 Bal. 191,100 200,000
Depr. Expense 200,000
Green Fees Revenue Close 5,900 Bal. 5,900 Rent Revenue Close
19,200 Bal. Adj.
Bal.
54,000 Close
Adj.
Bad Debt Expense 460 Close
$1,600
4,000 Close 15,000 19,000
19,000
Equipment Bal.
150,000
Accum. Depr.—Equipment 17,600 1,600 19,200
Bal. Adj.
Utilities Expenses
Rent Receivable Adj.
Adj. Adj.
200,000
19,200
Accum. Depr.—Buildings Bal. 38,400 Adj. 4,000 42,400
Maintenance and Repairs Expense Bal. 24,000 Close 24,000
Dues Revenue
Buildings Bal.
400,000
70,000 15,000 85,000
Insurance Expense 54,000
460
Adj.
Exp. Inc.
3,500 Close
3,500
Income Summary 184,560 216,200 31,640 216,200 216,200
PROBLEM 3-9 (Continued) Salaries and Wages Payable Adj. 3,600
(b)
Unearned Dues Revenue Adj.
8,900
-1Depreciation Expense.............................................. Accumulated Depreciation—Buildings (1/30 X $120,000) ........................................... -2Depreciation Expense.............................................. Accumulated Depreciation—Equipment (10% X $150,000) ........................................... -3Insurance Expense................................................... Prepaid Insurance............................................. -4Rent Receivable ....................................................... Rent Revenue (1/11 X $17,600) ............................................. -5Bad Debt Expense.................................................... Allowance for Doubtful Accounts [($13,000 X 12%) – $1,100] ............................
4,000 4,000 15,000 15,000 3,500 3,500 1,600 1,600 460 460
-6Salaries and Wages Expense .................................. Salaries and Wages Payable ............................
3,600
-7Dues Revenue .......................................................... Unearned Dues Revenue..................................
8,900
3,600
8,900
PROBLEM 3-9 (Continued)
(c)
CRESTWOOD GOLF CLUB, INC. Adjusted Trial Balance December 31, XXXX Dr. Cash.................................................................. $ 15,000 Accounts Receivable....................................... 13,000 Allowance for Doubtful Accounts................... Prepaid Insurance............................................ 5,500 Land .................................................................. 350,000 Buildings .......................................................... 120,000 Accum. Depreciation—Buildings.................... Equipment ........................................................ 150,000 Accum. Depreciation—Equipment ................. Salaries and Wages Payable........................... Common Stock ................................................ Retained Earnings ........................................... Dues Revenue .................................................. Green Fees Revenue ....................................... Rent Revenue................................................... Utilities Expenses ............................................ 54,000 Salaries and Wages Expense.......................... 83,600 Maintenance and Repairs Expense ................ 24,000 Bad Debt Expense ........................................... 460 Unearned Dues Revenue................................. Rent Receivable ............................................... 1,600 Depreciation Expense ..................................... 19,000 Insurance Expense .......................................... 3,500 Totals...................................................... $839,660
Cr. $
1,560
42,400 85,000 3,600 400,000 82,000 191,100 5,900 19,200
8,900
$839,660
PROBLEM 3-9 (Continued) (d)
-Dec. 31Dues Revenue ............................................................... 191,100 Green Fees Revenue................................................ 5,900 Rent Revenue ........................................................... 19,200 Income Summary .............................................. -31Income Summary ..................................................... Utilities Expenses ............................................. Bad Debt Expense ............................................ Salaries and Wages Expense........................... Maintenance and Repairs Expense ................. Depreciation Expense....................................... Insurance Expense ........................................... -31Income Summary ..................................................... Retained Earnings ............................................
216,200
184,560 54,000 460 83,600 24,000 19,000 3,500 31,640 31,640
PROBLEM 3-10 (a), (b), (c) Bal.
Cash 18,500
Bal.
Inventory 80,000
Accounts Receivable Bal. 32,000
Bal.
Prepaid Insurance Bal. 5,100 Adj. 2,550 2,550 Common Stock Bal. 80,600 Salaries and Wages Expense (Sales) Bal. 50,000 Cls. 52,400 Adj. 2,400 52,400 52,400
Notes Payable Bal.
Cls.
Bal.
Interest Payable Adj. 3,360
Adj.
Adj.
Retained Earnings Bal. 10,000 Inc. 45,790 Bal. 55,790
Accum. Depr.—Equipment Bal. 35,000 Adj. 12,000 47,000
28,000
Sales Revenue 600,000 Bal. 600,000
Advertising Expense Bal. 6,700 Adj. 700 Cls. 6,000 6,700 6,700
Bad Debt Expense Adj. 1,400 Cls. 1,400
Supplies 1,500
Equipment 84,000
Supplies Expense 5,000 Adj. 1,500 Cls. 3,500 5,000 5,000 Depr. Exp. 12,000 Cls.
Allow. for Doubtful Accts. Bal. 700 Adj. 1,400 2,100
12,000
Salaries and Wages Payable Adj. 2,400
Cost of Goods Sold Bal. 408,000 Cls. 408,000
Adj.
Interest Expense 3,360 Cls. 3,360
Insurance Expense Adj. 2,550 Cls. 2,550 Salaries and Wages Expense (Administrative) Adj. 65,000 Cls. 65,000
Prepaid Advertising Adj. 700
Exp. Inc.
Income Summary 554,210 Sales 600,000 45,790 600,000 600,000
PROBLEM 3-10 (Continued) (b)
-1Bad Debt Expense.................................................... Allowance for Doubtful Accounts....................
1,400
-2Depreciation Expense ($84,000 ÷ 7) ........................ Accumulated Depreciation—Equipment .........
12,000
-3Insurance Expense................................................... Prepaid Insurance.............................................
2,550
-4Interest Expense ...................................................... Interest Payable ................................................
3,360
-5Salaries and Wages Expense (Sales) ..................... Salaries and Wages Payable ............................
2,400
-6Prepaid Advertising ................................................. Advertising Expense.........................................
700
-7Supplies .................................................................... Supplies Expense .............................................
1,500
1,400
12,000
2,550
3,360
2,400
700
1,500
PROBLEM 3-10 (Continued) (c)
Dec. 31 Sales Revenue ......................................................... 600,000 Income Summary ..........................................
600,000
Dec. 31 Income Summary ................................................. 554,210 Cost of Goods Sold....................................... Advertising Expense..................................... Salaries and Wages Expense (Admin.)........ Salaries and Wages Expense (Sales) .......... Supplies Expense ......................................... Insurance Expense ....................................... Bad Debt Expense.........................................
408,000 6,000 65,000 52,400 3,500 2,550 1,400
Depreciation Expense................................... Interest Expense ........................................... Dec. 31 Income Summary ................................................. Retained Earnings.........................................
12,000 3,360
45,790 45,790
*PROBLEM 3-11
(a)
ARKANSAS SALES AND SERVICE Income Statement For the Month Ended January 31, 2014 (1) Cash Basis
(2) Accrual Basis
$ 75,000
$98,400*
Revenues................................................ Expenses Cost of computers & printers: Purchased and paid .............. Cost of goods sold ................ Salaries and wages ..................... Rent .............................................. Other operating expenses .......... Total expenses .................... Net income (loss)...................................
*($2,550 X 30) + ($3,600 X 4) + ($500 X 15) **($1,500 X 40) + ($2,500 X 6) + ($300 X 25) ***($1,500 X 30) + ($2,500 X 4) + ($300 X 15)
82,500** 9,600 6,000 8,400 106,500 $(31,500)
59,500*** 12,600 2,000 10,400 84,500 $13,900
*PROBLEM 3-11 (Continued)
(b)
ARKANSAS SALES AND SERVICE Balance Sheet As of January 31, 2014 (1) Cash Basis
(2) Accrual Basis
$58,500a
$ 58,500a 23,400 23,000b 4,000 $108,900
Assets Cash ................................................. Accounts receivable........................ Inventory .......................................... Prepaid rent ..................................... Total assets ................................ Liabilities and owners’ Equity Salaries and wages payable ........... Accounts payable............................ Owner’s capital ................................ Total liabilities and owner’s equity .......................................
a
Original investment Cash sales Cash purchases Rent paid Salaries paid Other operating expenses Cash balance Jan. 31
b
c
$58,500
$ $58,500c
3,000 2,000 103,900d
$58,500
$108,900
$ 90,000 75,000 (82,500) (6,000) (9,600) (8,400) $ 58,500
(10 @ $1,500) + (2 @ $2,500) + (10 @ $300).
Initial investment minus net loss: $90,000 – $31,500.
d
Initial investment plus net income: $90,000 + $13,900.
*PROBLEM 3-11 (Continued) (c)
1. The $23,400 in receivables from customers is an asset and a future cash flow resulting from sales that is ignored. The cash basis understates the amount of revenues and inflow of assets in January from the sale of computers and printers by $23,400. 2.
The cost of computers and printers sold in January is overstated by $23,000. The unsold computers and printers are an asset of $23,000 in the form of inventory.
3.
The cash basis ignores $3,000 of the salaries that have been earned by the employees in January and will be paid in February.
4.
Rent expense on the cash basis is overstated by $4,000. This prepayment is an asset in the form of two months’ future right to the use of office, showroom, and repair space and should appear on the balance sheet.
5.
Other operating expenses on a cash basis are understated by $2,000 as is the liability for the unpaid portion of these expenses incurred in January.
(a)
COOKE COMPANY Worksheet For the Year Ended September 30, 2014
Account Titles
Trial Balance Dr.
Cr.
Dr.
Cr.
Cash
37,400
Supplies
18,600
(b)
Prepaid Insurance
31,900
(a)
Land Equipment
80,000 120,000 36,200
Accounts Payable Unearned Service Rev. Mortgage Payable Common Stock Dividends Retained Earnings Service Revenue Sal. and Wages Exp. Maintenance and Repairs Expense Advertising Expense
14,600 2,700 50,000 107,700
(c) (d)
Dr.
Cr.
Income Statement
Balance Sheet
Dr.
Dr. 37,400
14,400
4,200
4,200
28,000
3,900
3,900
80,000 120,000
80,000 120,000
5,800
2,000
14,000 (d)
42,000
14,600 700 50,000 107,700
14,600 700 50,000 107,700 14,000
2,000 280,500
2,000
2,000 280,500
109,000
109,000
109,000
30,500 9,400
30,500 9,400
30,500 9,400
16,900
Prop. Tax Expense
18,000
16,900
16,900
(e)
3,000
21,000
21,000
(f)
6,000
12,000
12,000
Insurance Expense
(a)
28,000
28,000
28,000
Supplies Expense
(b)
14,400
14,400
14,400
Interest Expense Totals
6,000 491,700
Cr.
42,000
14,000 2,000 278,500
Utilities Expenses
Cr.
37,400
491,700
Interest Payable Depreciation Expense
(c)
6,000
(e)
3,000
5,800
Prop. Taxes Payable Totals
(f)
59,200
6,000 5,800
59,200
6,000 5,800
3,000 506,500
506,500
3,000 247,000
Net Income
33,500
Totals
280,500
280,500
259,500
226,000
280,500
259,500
259,500
33,500
Key: (a) Expired Insurance; (b) Supplies Used; (c) Depreciation Expensed; (d) Service Revenue Recognized; (e) Accrued Property Taxes; (f) Accrued Interest Payable.
*PROBLEM 3-12
Accum. Depr.-Equip.
Adjusted Trial Balance
Adjustments
*PROBLEM 3-12 (Continued) (b)
COOKE COMPANY Balance Sheet September 30, 2014 Assets Current assets Cash .............................................. Supplies ........................................ Prepaid insurance ........................ Total current assets ............ Property, plant, and equipment Land .............................................. Equipment..................................... Less: Accum. depreciation – equipment ................................... Total assets .........................
$37,400 4,200 3,900 $ 45,500 80,000 $120,000 42,000
78,000
158,000 $203,500
Liabilities and Stockholders’ Equity Current liabilities Accounts payable ................................................ $14,600 Current maturity of long-term debt ................. 10,000 Interest payable ................................................ 6,000 Property taxes payable .................................... 3,000 Unearned service revenue .................................. 700 Total current liabilities ............................ $ 34,300 Long-term liabilities Mortgage payable ............................................. 40,000 Total liabilities ......................................... 74,300 Stockholders’ equity Common stock 107,700 Retained earnings ($2,000 + $33,500 – $14,000) .......................... 21,500 129,200 Total liabilities and owners’ equity ........ $203,500
*PROBLEM 3-12 (Continued) (c) Sep. 30
Insurance Expense ............................... Prepaid Insurance..........................
28,000
30 Supplies Expense ................................ Supplies.........................................
14,400
30 Depreciation Expense........................... Accum. Depreciation— Equipment ..................................
5,800
30 Unearned Service Revenue .................. Service Revenue ............................
2,000
30 Property Tax Expense .......................... Property Taxes Payable ................
3,000
30 Interest Expense .................................. Interest Payable .............................
6,000
(d) Sep. 30 Service Revenue .................................. Income Summary..........................
280,500
30 Income Summary ................................. Salaries and Wages Expense....... Maintenance and Repairs Expense...................................... Insurance Expense ....................... Property Tax Expense .................. Supplies Expense ......................... Utilities Expenses ......................... Interest Expense ........................... Advertising Expense .................... Depreciation Expense ..................
247,000
30 Income Summary ................................ Retained Earnings .......................
33,500
30 Retained Earnings............................... Dividends......................................
14,000
28,000 14,400
5,800 2,000 3,000 6,000 280,500 109,000 30,500 28,000 21,000 14,400 16,900 12,000 9,400 5,800 33,500 14,000
*PROBLEM 3-12 (Continued) (e)
COOKE COMPANY Post-Closing Trial Balance September 30, 2014 Debit Cash ............................................................... $ 37,400 Supplies ......................................................... 4,200 Prepaid Insurance ......................................... 3,900 Land................................................................ 80,000 Equipment...................................................... 120,000 Accumulated Depreciation – Equipment ..... Accounts Payable.......................................... Unearned Service Revenue .......................... Interest Payable ............................................. Property Tax Payable .................................... Mortgage Payable.......................................... Common Stock .............................................. Retained Earnings ......................................... $245,500
Credit
$ 42,000 14,600 700 6,000 3,000 50,000 107,700 21,500 $245,500
FINANCIAL REPORTING PROBLEM (a)
June 30, 2011 total assets: $138,354 million. June 30, 2010 total assets: $128,172 million.
(b)
June 30, 2011 cash and cash equivalents: $2,768 million.
(c)
2011 research and development costs: $2,001 million. 2010 research and development costs: $1,950 million.
(d)
2011 net sales: $82,559 million. 2010 net sales: $78,938 million.
(e)
An adjusting entry for deferrals is necessary when the receipt/disbursement precedes the recognition in the financial statements. Accounts such as prepaid insurance and prepaid rent may be included in the Prepaid Expenses and Other Current Assets ($4,408 million at June 30, 2011). Both of these accounts would require an adjusting entry to recognize the proper amount of expense incurred during the period. In addition, depreciation expense is an adjusting entry related to a deferral. An adjusting entry for an accrual is necessary when recognition in the financial statements precedes the cash receipt/disbursement, such as interest or taxes payable. Other adjusting entries probably made by P&G include interest revenue and expense and interest receivable and interest payable. P&G reports $9,290 million of Accrued and Other Liabilities at June 30, 2011.
(f)
2011 Depreciation and amortization expense: $2,838 million 2010 Depreciation and amortization expense: $3,108 million 2009 Depreciation and amortization expense: $3,082 million (From the Statement of Cash Flows)
COMPARATIVE ANALYSIS CASE (a)
The Coca-Cola Company percentage increase is computed as follows: Total assets (December 31, 2011) ............................................ Total assets (December 31, 2010) ............................................ Difference ..................................................................................
$79,974 72,921 $ 7,053
$7,053 ÷ $72,921 = 9.7% PepsiCo, Inc.’s percentage increase is computed as follows: Total assets (December 29, 2011) ............................................ Total assets (December 30, 2010) ............................................ Difference ..................................................................................
$72,882 68,153 $ 4,729
$4,729 ÷ $68,153 = $6.9% Coca-Cola Company had the larger increase. (b) 5-Year Growth Rate Net sales Income from continuing operations (c)
The Coca-Cola Company 12.69%
PepsiCo, Inc. 13.92%
9.41%
3.30%
The Coca-Cola Company had depreciation and amortization expense of $1,954 million; PepsiCo, Inc. had depreciation and amortization expense of $2,737 million.
COMPARATIVE ANALYSIS CASE (Continued) PepsiCo has substantially more property, plant, and equipment than does Coca-Cola. PepsiCo is engaged in three different types of businesses: soft drinks, snack-food, and juices. As a result, it has more tangible fixed assets. PepsiCo also has substantially more amortizable intangible assets. Amortizable intangible assets for Coke and Pepsi increase the amount of amortization expense recorded in income. The amount of property, plant, and equipment and amortizable intangible assets reported for these two companies is as follows: (000,000) The Coca-Cola Company Property, plant, and equipment (net) Amortizable intangible assets (net)
PepsiCo, Inc.
$ 14,939
$19,698
1,250 $16,189
1,888 $21,586
FINANCIAL STATEMENT ANALYSIS (a)
Sales
(b)
2011
2010
2009
% Change 2011
% Change 2010
$13,198
$12,397
$12,575
6.46%
-1.42%
Gross Profit %
41.28%
42.66%
42.87%
-3.23%
-0.49%
Operating Profit
1,976
1,990
2,001
-0.70%
-0.55%
Net Cash Flow less Capital Expenditures
1,001
534
1,266
87.45%
-57.82%
Net Earnings
1,231
1,247
1,212
-1.28%
2.89%
Kellogg experienced an improvement in sales in the current year which followed a decline in the previous year. The gross-profit percentage decreased slightly after a flat change in the prior year. This coincides with a flat operating profit but a solid increase in cash flows, compared to prior years, suggest it faces a challenging period and might be starting to recover. This may bode well for the strength and flexibility of its business model.
ACCOUNTING, ANALYSIS, AND PRINCIPLES Accounting Depreciation Expense ..........................................
9,500 9,500
Accumulated Depreciation—Equipment ..... ($9,500 = ($192,000 – $40,000) ÷ 16) Interest Expense...................................................
8,250
Interest Payable ............................................ $8,250 = ($90,000 X 0.10) X 11/12) Unearned Service Revenue .................................
8,250
10,000
Service Revenue ........................................... ($10,000 = ($50 X 200)) Advertising Expense ............................................
10,000
2,500
Prepaid Advertising ...................................... Salaries and Wages Expense .............................. Salaries and Wages Payable ........................
2,500 3,500 3,500
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) Analysis
Service revenue Less: Depreciation expense Advertising expense Salaries and wages expense Interest expense Net income
Income before Adjustments $360,000
Adjustments $10,000
Income after Adjustments $370,000
(18,680)
(9,500) (2,500)
(9,500) (21,180)
(3,500) (8,250)
(71,100) (9,650) $258,570
(67,600) (1,400) $272,320
Without recording the adjusting entries, Amato’s income is overstated. In addition, without the adjustments, Amato’s current liabilities and current assets are misstated, which could affect evaluation of Amato's liquidity. Principles The tradeoffs are between the timeliness of the reports, which contributes to relevance, and verifiability, the lack of which detracts from faithful representation. That is, by preparing reports more frequently, the company provides more timely information, which can make a difference to a statement reader who needs to make a decision. However, preparing statements more frequently requires more subjective estimates, which reduces faithful representation.
PROFESSIONAL RESEARCH
(a) The three essential characteristics of assets. Search String: asset and characteristics. CON6, Par26. 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 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. (b) Three essential characteristics of liabilities. Search String: liability and characteristic. CON6, Par36. A liability has three essential characteristics: (a) 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, (b) the duty or responsibility obligates a particular entity, leaving it little or no discretion to avoid the future sacrifice, and (c) the transaction or other event obligating the entity has already happened. (c) Uncertainty, and its effects on financial statements. Search Strings: “uncertainty”, effect of uncertainty. CON6, Par44. Uncertainty about economic and business activities and results is pervasive, and it often clouds whether a particular item qualifies as an asset or a liability of a particular entity at the time the definitions are applied. The presence or absence of future economic benefit that can be obtained and controlled by the entity or of the entity’s legal, equitable, or constructive obligation to sacrifice assets in the future can often be discerned reliably only with hindsight. As a result, some items that with hindsight actually qualified as assets or liabilities of the entity under the definitions may, as a practical matter, have been recognized as expenses, losses, revenues, or gains or
PROFESSIONAL RESEARCH (Continued) remained unrecognized in its financial statements because of uncertainty about whether they qualified as assets or liabilities of the entity or because of recognition and measurement considerations stemming from uncertainty at the time of assessment. Conversely, some items that with hindsight did not qualify under the definitions may have been included as assets or liabilities because of judgments made in the face of uncertainty at the time of assessment. CON6, Par45. An effect of uncertainty is to increase the costs of financial reporting in general and the costs of recognition and measurement in particular. Some items that qualify as assets or liabilities under the definitions may therefore be recognized as expenses, losses, revenues, or gains or remain unrecognized as a result of cost and benefit analyses indicating that their formal incorporation in financial statements is not useful enough to justify the time and effort needed to do it. It may be possible, for example, to make the information more reliable in the face of uncertainty by exerting greater effort or by spending more money, but it also may not be worth the added cost. Note to instructors: The FASB codification does not contain the Concepts Statements. However, the Concepts Statements can be accessed at another link on the FASB website. (d) The difference between realization and recognition Search String: realization, recognition. CON6, Par143. Realization in the most precise sense means the process of converting noncash resources and rights into money and is most precisely used in accounting and financial reporting to refer to sales of assets for cash or claims to cash. The related terms realized and unrealized therefore identify revenues or gains or losses on assets sold and unsold, respectively. Those are the meanings of realization and related terms in the Board’s conceptual framework. Recognition is the process of formally recording or incorporating an item in the financial statements of an entity. Thus, an asset, liability, revenue, expense, gain, or loss may be recognized (recorded) or unrecognized (unrecorded). Realization and recognition are not used as synonyms, as they sometimes are in accounting and financial literature.
PROFESSIONAL SIMULATION Journal Entries Depreciation Expense.............................................. Accumulated Depreciation—Equipment.........
7,000
Unearned Advertising Revenue .............................. Advertising Revenue ........................................
1,400
Accounts Receivable ............................................... Advertising Revenue ........................................
1,500
Supplies Expense (Art) ............................................ Supplies.............................................................
3,400
Salaries and Wages Expense .................................. Salaries and Wages Payable............................
1,300
7,000
1,400
1,500
3,400
1,300
Financial Statements BUTLER ADVERTISING AGENCY Income Statement For the Year Ended December 31, 2014 Revenues Advertising revenue.......................................... Expenses Salaries and wages expense ............................ Depreciation expense ....................................... Rent expense..................................................... Supplies expense .............................................. Total expenses ............................................. Net income.................................................................
$61,500 $11,300 7,000 4,000 3,400 25,700 $35,800
PROFESSIONAL SIMULATION (Continued) BUTLER ADVERTISING AGENCY Balance Sheet December 31, 2014 Assets Cash ........................................................ Accounts receivable .............................. Supplies .................................................. Equipment............................................... Less: Accumulated depreciation ......... Total assets...................................... Liabilities and Stockholders’ Equity Liabilities Accounts payable................................... Unearned advertising revenue .............. Salaries and wages payable .................. Stockholders’ Equity Common stock........................................ Retained earnings .................................. Total stockholders’ equity Total liabilities and stockholders’ equity ...............
$11,000 21,500 5,000 60,000 (35,000)
$5,000 5,600 1,300
25,000 $62,500
$11,900
10,000 40,600 50,600 $62,500
Explanation After the financial statements are prepared, Butler must prepare the closing entries and post the journal entries to the general ledger. Then, a postclosing trial balance is prepared. Some companies may also prepare and post reversing entries.
IFRS CONCEPTS AND APPLICATION IFRS3-1 The date of transition is the beginning of the earliest period for which full comparative IFRS information is provided. The date of reporting is the closing balance sheet date for the first IFRS financial statements. IFRS3-2 When countries accept IFRS for use as accepted accounting policies, companies need guidance to ensure that their first IFRS financial statements contain high quality information. Specifically, IFRS 1 requires that information in a company’s first IFRS statements (1) be transparent, (2) provide a suitable starting point, and (3) have a cost that does not exceed the benefits. IFRS3-3 A company follows these steps: 1. Identify the timing of its first IFRS statements. 2. Prepare an opening balance sheet at the date of transition to IFRS. 3. Select accounting principles that comply with IFRS, and apply these principles retrospectively. 4. Make extensive disclosures to explain the transition to IFRS IFRS3-4 The date of the opening balance sheet is January 1, 2014. The IFRS financial statements will include years ended December 31, 2015 and 2014. IFRS3-5 (a)
Assets 53
The future economic benefit embodied in an asset is the potential to contribute, directly or indirectly, to the flow of cash and cash equivalents to the entity. The potential may be a productive one that is part of the operating activities of the entity. It may also take the form of convertibility into cash or cash equivalents or a capability to reduce cash outflows, such as when an alternative manufacturing process lowers the costs of production.
IFRS3-5 (Continued) 54
An entity usually employs its assets to produce goods or services capable of satisfying the wants or needs of customers; because these goods or services can satisfy these wants or needs, customers are prepared to pay for them and hence contribute to the cash flow of the entity. Cash itself renders a service to the entity because of its command over other resources.
55
The future economic benefits embodied in an asset may flow to the entity in a number of ways. For example, an asset may be: a. used singly or in combination with other assets in the production of goods or services to be sold by the entity; b. exchanged for other assets; c. used to settle a liability; or d. distributed to the owners of the entity.
(b)
Liabilities 60
An essential characteristic of a liability is that the entity has a present obligation. An obligation is a duty or responsibility to act or perform in a certain way. Obligations may be legally enforceable as a consequence of a binding contract or statutory requirement. This is normally the case, for example, with amounts payable for goods and services received. Obligations also arise, however, from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner. If, for example, an entity decides as a matter of policy to rectify faults in its products even when these become apparent after the warranty period has expired, the amounts that are expected to be expended in respect of goods already sold are liabilities.
61
A distinction needs to be drawn between a present obligation and a future commitment. A decision by the management of an entity to acquire assets in the future does not, of itself, give rise to a present obligation. An obligation normally arises only when the asset is delivered or the entity enters into an irrevocable agreement to acquire the asset. In the latter case, the irrevocable nature of the agreement means that the economic consequences of failing to honour the obligation, for example, because of the existence of a substantial penalty, leave the entity with little, if any, discretion to avoid the outflow of resources to another party.
IFRS3-5 (continued) 62
The settlement of a present obligation usually involves the entity giving up resources embodying economic benefits in order to satisfy the claim of the other party. Settlement of a present obligation may occur in a number of ways, for example, by: a. b. c. d. e.
(c)
payment of cash; transfer of other assets; provision of services; replacement of that obligation with another obligation; or conversion of the obligation to equity.
Accrual basis 22 In order to meet their objectives, financial statements are prepared on the accrual basis of accounting. Under this basis, the effects of transactions and other events are recognised when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate. Financial statements prepared on the accrual basis inform users not only of past transactions involving the payment and receipt of cash but also of obligations to pay cash in the future and of resources that represent cash to be received in the future. Hence, they provide the type of information about past transactions and other events that is most useful to users in making economic decisions.
IFRS3-6 (a)
March 31, 2012 total assets: £7,273.3 million. April 2, 2011 total assets: £7,344.1 million.
(b)
March 31, 2012 cash and cash equivalents: £196.10 million.
(c)
2012 selling and marketing expense: £3,021.9 million. 2011 selling and marketing expense: £2,959.7 million.
(d)
2012 revenue: £9,934.3 million. 2011 revenue: £9,740.3 million.
IFRS3-6 (Continued) (e)
An adjusting entry for deferrals is necessary when the receipt/disbursement precedes the recognition in the financial statements. Accounts such as prepaid pension contributions and prepaid leasehold premiums are included in the Trade and other receivables section. Both of these accounts would require an adjusting entry to recognize the proper amount of expense incurred during the period. In addition, depreciation expense is an adjusting entry related to a deferral. An adjusting entry for an accrual is necessary when recognition in the financial statements precedes the cash receipt/disbursement, such as interest or taxes payable. Other adjusting entries probably made by M&S include finance income and finance costs and bank and other interest receivable and interest payable.
(f)
2012 Depreciation and amortization expense: £479.70 million 2011 Depreciation and amortization expense: £467.50 million
CHAPTER 4 Income Statement and Related Information ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics 1.
Income measurement concepts.
2.
Computation of net income from balance sheets and selected accounts.
3.
Single-step income statements; earnings per share.
4.
Questions
Brief Exercises
Exercises
Problems
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 18, 22, 23, 30, 33, 34, 35
Concepts for Analysis 2, 3, 4, 6
1
1, 2, 3, 8
11, 19, 25, 26
1, 2, 8
4, 5, 7, 8, 10, 11, 13, 17
2, 3, 4, 5
Multiple-step income statements.
12, 17, 19, 20
3, 4
5, 6, 7, 9
1, 4
5.
Extraordinary items; accounting changes; discontinued operations; prior period adjustments; errors.
13, 14, 15, 16, 22, 29, 31, 37
4, 5, 6, 7
6, 8, 10, 11, 13, 14
3, 5, 6, 7
6.
Retained earnings statement.
32
9, 10, 11
9, 12, 16, 17
1, 2, 4, 5, 6
7.
Intraperiod tax allocation.
21, 24, 27, 28, 29
9, 11, 13, 14, 17
3, 5, 7
8.
Comprehensive income.
36
9.
Disposal of a component (discontinued operations).
31, 37
11
15, 16, 17
1, 5
1, 2, 4, 5, 6
7 1, 3, 6, 7
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives
Questions
Brief Exercises
Exercises
Problems
Concepts for Analysis
1.
Understand the uses and limitations of an income statement.
1, 2, 6, 7, 9
CA4-1, CA4-2, CA4-3
2.
Describe the content and format of the income statement.
5, 8, 10
4, 5
1, 2, 3, 4, 5, 6, 7
3.
Prepare an income statement.
8, 11, 12, 19, 20, 17
1, 2, 3, 4, 5
4, 5, 6, 7, 8, 9, 11, 15, 17
1, 2, 3, 4, 5, 7
CA4-6
4.
Explain how to report various income items.
3, 4, 13, 21, 22, 23, 24, 27, 28, 29, 30, 31, 33, 17
4, 5
2, 3, 6, 8, 9, 11, 17
1, 3, 4, 5, 6, 7
CA4-4
5.
Identify where to report earnings per share information.
25, 26
8
6, 7, 8, 9, 10, 11, 13, 14, 17
1, 2, 3, 4, 5, 7
CA4-4
6.
Understand the reporting of accounting changes, and errors.
14, 15, 16, 18
6, 7, 10
14
4, 5, 6, 7
CA4-2
7.
Prepare a retained earnings statement.
32
9, 10
9, 12, 16, 17
1, 2, 4, 5, 6
CA4-6
8.
Explain how to report other comprehensive income.
34, 35, 36, 37
11
15, 16, 17
CA4-5, CA4-6
CA4-7
ASSIGNMENT CHARACTERISTICS TABLE Level of Difficulty
Time (minutes)
Simple Simple Simple Moderate Simple Moderate Moderate Simple Simple Simple Moderate
18–20 10–15 25–35 20–25 30–35 30–35 30–40 15–20 30–35 20–25 20–25
E4-12 E4-13 E4-14 E4-15 E4-16 E4-17
Computation of net income. Compute income measures. Income statement items. Single-step income statement. Multiple-step and single-step. Multiple-step and extraordinary items. Multiple-step and single-step. Income statement, EPS. Multiple-step statement with retained earnings. Earnings per share. Condensed income statement—periodic inventory method. Retained earnings statement. Earnings per share. Change in accounting principle. Comprehensive income. Comprehensive income. Various reporting formats.
Simple Moderate Moderate Simple Moderate Moderate
20–25 15–20 15–20 15–20 15–20 30–35
P4-1 P4-2 P4-3 P4-4 P4-5 P4-6 P4-7
Multiple-step income, retained earnings. Single-step income, retained earnings, periodic inventory. Irregular items. Multiple- and single-step income, retained earnings. Irregular items. Retained earnings statement, prior period adjustment. Income statement, irregular items.
Moderate Simple Moderate Moderate Moderate Moderate Moderate
30–35 25–30 30–40 45–55 20–25 25–35 25–35
CA4-1 CA4-2 CA4-3 CA4-4 CA4-5 CA4-6 CA4-7
Identification of income statement deficiencies. Earnings management. Earnings management. Income reporting items. Identification of income statement weaknesses. Classification of income statement items. Comprehensive income.
Simple Moderate Simple Moderate Moderate Moderate Simple
20–25 20–25 15–20 30–35 30–40 20–25 10–15
Item
Description
E4-1 E4-2 E4-3 E4-4 E4-5 E4-6 E4-7 E4-8 E4-9 E4-10 E4-11
SOLUTIONS TO CODIFICATION EXERCISES CE4-1 According to the Glossary: (a) A change in accounting estimate is a change that has the effect of adjusting the carrying amount of an existing asset or liability or altering the subsequent accounting for existing or future assets or liabilities. Changes in accounting estimates result from new information. Examples of items for which estimates are necessary are uncollectible receivables, inventory obsolescence, service lives and salvage value of depreciable assets, and warranty obligations. A change in accounting estimate is a necessary consequence of the assessment, in conjunction with the periodic presentation of financial statements, of the present status and expected future benefits and obligations associated with assets and liabilities. (b) A change in accounting principle reflects a change from one generally accepted accounting principle to another generally accepted accounting principle when there are two or more generally accepted accounting principles that apply or when the accounting principle formerly used is no longer generally accepted. A change in the method of applying an accounting principle also is considered a change in accounting principle. A “Change in Accounting Estimate Effected by a Change in Accounting Principle” is a change in accounting estimate that is inseparable from the effect of a related change in accounting principle. An example of a change in estimate effected by a change in principle is a change in the method of depreciation, amortization, or depletion for longlived, nonfinancial assets. (c) Comprehensive Income is defined as the change in equity (net assets) of a business during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.
CE4-2 The master glossary provides the term “Unusual Nature”, a link from which yields the following: Glossary Term Usage The glossary term is used in the following locations. Unusual Nature • 225 Income Statement > 20 Extraordinary and Unusual Items > 45 Other Presentation – 225 Income Statement > 20 Extraordinary and Unusual Items > 45 Other Presentation > General, paragraph 45-2. Following this link yields the following paragraph: 45-2 Extraordinary items are events and transactions that are distinguished by their unusual nature and by the infrequency of their occurrence. Thus, both of the following criteria shall be met to classify an event or transaction as an extraordinary item: a.
Unusual nature. The underlying event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking into account the environment in which the entity operates (see paragraph 225-20-55-1).
CE4-2 (Continued) b.
Infrequency of occurrence. The underlying event or transaction should be of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates (see paragraph 225-20-55-2).
Thus, “unusual nature” is one of the criterion that determines whether an item meets the definition of an extraordinary item.
CE4-3 Entering “extraordinary item” and “interim” into the search window, yields the following guidance (FASB ASC 225-20-50-4): Interim Reporting 50-4 As indicated in paragraph FASB ASC 270-10-50-5, extraordinary items shall be disclosed separately and included in the determination of net income for the interim period in which they occur. In determining materiality, extraordinary items shall be related to the estimated income for the full fiscal year. Effects of disposals of a component of an entity and unusual and infrequently occurring transactions and events that are material with respect to the operating results of the interim period but that are not designated as extraordinary items in the interim statements shall be reported separately. In addition, matters such as unusual seasonal results and business combinations shall be disclosed to provide information needed for a proper understanding of interim financial reports. Extraordinary items, gains or losses from disposal of a component of an entity, and unusual or infrequently occurring items shall not be pro-rated over the balance of the fiscal year.
CE4-4 Entering “effect of preferred stock” in the search window yields the following link (FASB ASC 260-10S55): 260 Earnings per Share > 10 Overall > S55 Implementation Guidance and Illustrations. General Effect of Preferred Stock Dividends and Accretion of Carrying Amount of Preferred Stock on Earnings Per Share S55-1 See paragraph 225-10-S99-5, SAB . . . views on this topic. Following that link yields the following guidance: Income or Loss Applicable to Common Stock S99-5 The following is the text of SAB Topic 6.B, Accounting Series Release 280—General Revision Of Regulation S-X: Income Or Loss Applicable To Common Stock. Facts: A registrant has various classes of preferred stock. Dividends on those preferred stocks and accretions of their carrying amounts cause income applicable to common stock to be less than reported net income. Question: In ASR 280, the Commission stated that although it had determined not to mandate presentation of income or loss applicable to common stock in all cases, it believes that disclosure of that amount is of value in certain situations. In what situations should the amount be reported, where should it be reported, and how should it be computed?
CE4-4 (Continued) Interpretive Response: Income or loss applicable to common stock should be reported on the face of the income statement (FN1) when it is materially different in quantitative terms from reported net income or loss (FN2) or when it is indicative of significant trends or other qualitative considerations. The amount to be reported should be computed for each period as net income or loss less: (a) dividends on preferred stock, including undeclared or unpaid dividends if cumulative; and (b) periodic increases in the carrying amounts of instruments reported as redeemable preferred stock (as discussed in Topic 3.C) or increasing rate preferred stock (as discussed in Topic 5.Q). (FN1) If a registrant elects to follow the encouraged disclosure discussed in paragraph 23 of Statement 130, and displays the components of other comprehensive income and the total for comprehensive income using a one-statement approach, the registrant must continue to follow the guidance set forth in the SAB Topic. One approach may be to provide a separate reconciliation of net income to income available to common stock below comprehensive income reported on a statement of income and comprehensive income. (FN2) The assessment of materiality is the responsibility of each registrant. However, absent concerns about trends or other qualitative considerations, the staff generally will not insist on the reporting of income or loss applicable to common stock if the amount differs from net income or loss by less than ten percent.
ANSWERS TO QUESTIONS 1. The income statement is important because it provides investors and creditors with information that helps them predict the amount, timing, and uncertainty of future cash flows. It helps investors and creditors predict future cash flows in a number of different ways. First, investors and creditors can use the information on the income statement to evaluate the past performance of the company. Second, the income statement helps users of the financial statements to determine the risk (level of uncertainty) of income—revenues, expenses, gains, and losses—and highlights the relationship among these various components. It should be emphasized that the income statement is used by parties other than investors and creditors. For example, customers can use the income statement to determine a company’s ability to provide needed goods or services, unions examine earnings closely as a basis for salary discussions, and the government uses the income statements of companies as a basis for formulating tax and economic policy. 2. Information on past transactions can be used to identify important trends that, if continued, provide information about future performance. If a reasonable correlation exists between past and future performance, predictions about future earnings and cash flows can be made. For example, a loan analyst can develop a prediction of future performance by estimating the rate of growth of past income over the past several periods and project this into the next period. Additional information about current economic and industry factors can be used to adjust the trend rate based on historical information. 3. Some situations in which changes in value are not recorded in income are: (a) Unrealized gains or losses on available-for-sale investments, (b) Changes in the fair values of long-term liabilities, such as bonds payable, (c) Changes (increases) in value of property, plant and equipment, such as land, natural resources, or equipment, (d) Changes (increases) in the values of intangible assets such as customer goodwill, brand value, or intellectual capital. Note that some of these omissions arise because the items (e.g., brand value) are not recognized in financial statements, while others (value of land) are recorded in financial statements but measurement is at historical cost. 4. Some situations in which application of different accounting methods or estimates lead to comparison problems include: (a) Inventory methods—LIFO vs. FIFO, (b) Depreciation Methods—straight-line vs. accelerated, (c) Accounting for long-term contracts—percentage-of-completion vs. completed-contract, (d) Estimates of useful lives or salvage values for depreciable assets, (e) Estimates of bad debts, (f) Estimates of warranty costs. 5. The transaction approach focuses on the activities that have occurred during a given period and instead of presenting only a net change, a description of the components that comprise the change is included. In the capital maintenance approach, only the net change (income) is reflected whereas the transaction approach not only provides the net change (income) but the components of income (revenues and expenses). The final net income figure should be the same under either approach given the same valuation base.
Questions Chapter 4 (Continued) 6. Earnings management is often defined as the planned timing of revenues, expenses, gains and losses to smooth out bumps in earnings. In most cases, earnings management is used to increase income in the current year at the expense of income in future years. For example, companies prematurely recognize sales in order to boost earnings. Earnings management can also be used to decrease current earnings in order to increase income in the future. The classic case is the use of “cookie jar” reserves, which are established by using unrealistic assumptions to estimate liabilities for such items as loan losses, restructuring charges and warranty returns. 7. Earnings management has a negative effect on the quality of earnings if it distorts the information in a way that is less useful for predicting future cash flows. Within the Conceptual Framework, useful information is both relevant and representationally faithful. However, earnings management reduces the reliability of income, because the income measure is biased (up or down) and/or the reported income is not representationally faithful to that which it is supposed to report (e.g., volatile earnings are made to look more smooth). 8. Caution should be exercised because many assumptions and estimates are made in accounting and the net income figure is a reflection of these assumptions. If for any reason the assumptions are not well-founded, distortions will appear in the income reported. The objectives of the application of generally accepted accounting principles to the income statement are to measure and report the results of operations as they occur for a specified period without recognizing any artificial exclusions or modifications. 9. The term “quality of earnings” refers to the credibility of the earnings number reported. Companies that use aggressive accounting policies report higher income numbers in the short-run. In such cases, we say that the quality of earnings is low. Similarly, if higher expenses are recorded in the current period, in order to report higher income in the future, then the quality of earnings is also considered low. 10. The major distinction between revenues and gains (or expenses and losses) depends on the typical activities of the company. Revenues can occur from a variety of different sources, but these sources constitute the entity’s ongoing major or central operations. Gains also can arise from many different sources, but these sources occur from peripheral or incidental transactions of an entity. The same type of distinction is made between expenses and losses. 11. The advantages of the single-step income statement are: (1) simplicity and conciseness, (2) probably better understood by the layperson, (3) emphasis on total costs and expenses, and net income, and (4) does not imply priority of one revenue or expense over another. The disadvantages are that it does not show the relationship between sales revenue and cost of goods sold and it does not show other important relationships and information, such as income from operations, income before income tax, etc. 12. Operating items are the expenses and revenues which relate directly to the principal activity of the concern; they are revenues realized from, or expenses which contribute to, the sale of goods or services for which the company was organized. The nonoperating items result from secondary activities of the company. They are not directly related to the principal activity of the company but arise from incidental activities. 13. The current operating performance income statement contains only the revenues and usual expenses of the current year, with all unusual gains or losses or material corrections of prior periods’ revenues and expenses appearing in the retained earnings statement. The modified all-inclusive income statement includes most items including irregular ones, as part of net income. The retained earnings statement then would include only the beginning balance (adjusted for the effects of errors and changes in accounting principle), the net amount transferred from income summary, dividends, and transfers to and from appropriated retained earnings.
Questions Chapter 4 (Continued) GAAP recommends a modified all-inclusive income statement, excluding from the income statement only those items, few in number, which meet the criteria for prior period adjustments and which would thus appear as adjustments to the beginning balance in the retained earnings statement. Subsequently a number of pronouncements have reinforced this position. Recently, changes in accounting principle are also adjusted through the beginning retained earnings balance. 14. Items considered corrections of errors should be charged or credited to the opening balance of retained earnings. 15. (a) This might be shown in the income statement as an extraordinary item if it is a material, unusual, and infrequent gain realized during the year. However, in general and in accordance with FASB ASC 225-20 this transaction would normally not be considered extraordinary, but would be shown in the nonoperating section of a multiple-step income statement. If unusual or infrequent but not both, it should be separately disclosed in the income statement. (b) The bonus should be shown as an operating expense in the income statement. Although the basis of computation is a percentage of net income, it is an ordinary operating expense to the company and represents a cost of the service received from employees. (c) If the amount is immaterial, it may be combined with the depreciation expense for the year and included as a part of the depreciation expense appearing in the income statement. If the amount is material, it should be shown in the retained earnings statement as an adjustment to the beginning balance of retained earnings. (d) This should be shown in the income statement. One treatment would be to show it in the statement as a deduction from the rent expense, as it reduces an operating expense and therefore is directly related to operations. Another treatment is to show it in the other revenues and gains section of the income statement. (e) Assuming that a provision for the loss had not been made at the time the patent infringement suit was instituted, the loss should be recognized in the current period in computing net income. It may be reported as an unusual loss. (f) This should be reported in the income statement, but not as an extraordinary item because it relates to usual business operations of the firm. 16. (a) The remaining book value of the equipment should be depreciated over the remainder of the five-year period. The additional depreciation ($425,000) is not a correction of an error and is not shown as an adjustment to retained earnings. The change is considered a change in estimate. (b) The loss should be shown as an extraordinary item, assuming that it is unusual and infrequent. (c) The write-off should be shown either as other expenses and losses or in a separate section, appropriately labeled as an unusual item, if unusual or infrequent but not both. It should not be shown as an extraordinary item. (d) Assuming that a receivable had not been recorded in the previous period, the gain should be recognized in the current period in computing net income, but not as an extraordinary item. (e) A correction of an error should be considered a prior period adjustment and the beginning balance of Retained Earnings should be restated, if material. (f) The cumulative effect of the change is reported as an adjustment to beginning retained earnings. Prior years’ statements are recast on a basis consistent with the new standard. 17. (a) Other expenses and losses section or in a separate section, appropriately labeled as an unusual item, if unusual or infrequent but not both. (b) Operating expense section or other expenses and losses section or in a separate section, appropriately labeled as an unusual item, if unusual or infrequent but not both. FASB ASC 225-20 specifically states that the effect of a strike does not constitute an extraordinary item. (c) Operating expense section, as a selling expense, but sometimes reflected as an administrative expense. (d) Separate section after income from continuing operations, entitled discontinued operations.
Questions Chapter 4 (Continued) (e) Other revenues and gains section or in a separate section, appropriately labeled as an unusual item, if unusual or infrequent but not both. (f) Other revenues and gains section. (g) Operating expense section, normally administrative. If a manufacturing concern, may be included in cost of goods sold. (h) Other expenses and losses section or in separate section, appropriately labeled as an unusual item, if unusual or infrequent but not both. 18. Perlman and Sheehan should not report the sales in a similar manner. This type of transaction appears to be typical of Perlman’s central operations. Therefore, Perlman should report revenues of $160,000 and expenses of $100,000 ($70,000 + $30,000). However, Sheehan’s transaction appears to be a peripheral or incidental activity not related to its central operations. Thus, Sheehan should report a gain of $60,000 ($160,000 – $100,000). Note that although the classification is different, the effect on net income is the same ($60,000 increase). 19. You should tell Greg that a company’s reported net income is the same whether the single-step or multiple-step format is used. Either way, the company has the same revenues, gains, expenses, and losses; they are simply organized in a different format. 20. Both formats are acceptable. The amount of detail reported in the income statement is left to the judgment of the company, whose goal in making this decision should be to present financial statements which are most useful to decision makers. We want to present a simple, understandable statement so that a reader can easily discover the facts of importance; therefore, a single amount for selling expenses might be preferable. However, we also want to fully disclose the results of all activities; thus, a separate listing of expenses may be preferred. Note that if the condensed version is used, it should be accompanied by a supporting schedule of the eight components in the notes to the financial statements. 21. Intraperiod tax allocation should not affect the reporting of an unusual gain. The FASB specifically prohibits a “net-of-tax” treatment for such items to insure that users of financial statements can easily differentiate extraordinary items from material items that are unusual or infrequent, but not both. “Net-of-tax” treatment is reserved for discontinued operations, extraordinary items, and prior period adjustments. 22. (a) A loss on discontinued operations is reported net of tax in the income statement between income from continuing operations and net income. (b) Noncontrolling interest allocation is reported in the income statement after the net income, (c) Earnings per share are shown in the income statement after the noncontrolling interest allocation. (d) A gain on sale of equipment in shown under other revenues and gains in the income statement. 23. Lebron presents the income information as follows: Net income Less: Net income attributed to the noncontrolling interest Net income attributable to Lebron Company
$ 124,700 30,000 $ 94,700
24. Intraperiod tax allocation has no effect on reported net income, although it does affect the amounts reported for various components of income. The effects on these components offset each other so net income remains the same. Intraperiod tax allocation merely takes the total income tax expense and allocates it to the various items which affect the tax amount.
Questions Chapter 4 (Continued) 25. If Neumann has preferred stock outstanding, the numerator in its computation may be incorrect. A better description of “earnings per share” is “earnings per common share.” The numerator should include only the earnings available to common shareholders. Therefore, the numerator should be: net income less preferred dividends. The denominator is also incorrect if Neumann had any common stock transactions during the year. Since the numerator represents the results for the entire year, the denominator should reflect the weighted-average number of common shares outstanding during the year, not the shares outstanding at one point in time (year-end). 26. The earnings per share trend is not favorable. Extraordinary items are one-time occurrences which are not expected to be reported in the future. Therefore, earnings per share on income before extraordinary items is more useful because it represents the results of ordinary business activity. Considering this EPS amount, EPS has decreased from $7.21 to $6.40. 27. Tax allocation within a period is the practice of allocating the income tax for a period to such items as income before extraordinary items, extraordinary items, and prior period adjustments. The justification for tax allocation within a period is to produce financial statements which disclose an appropriate relationship, for example, between income tax expense and (a) income before extraordinary items, (b) extraordinary items, and (c) prior period adjustments (or of the opening balance of retained earnings). 28. Tax allocation within a period (intraperiod) becomes necessary when a firm encounters such items as discontinued operations, extraordinary items, or corrections of errors. Such allocation is necessary to bring about an appropriate relationship between income tax expense and income from continuing operations, discontinued operations, income before extraordinary items, extraordinary items, etc. Tax allocation within a period is handled by first computing the tax expense attributable to income before extraordinary items, assuming no discontinued operations. This is simply computed by ascertaining the income tax expense related to revenue and expense transactions entering into the determination of such income. Next, the remaining income tax expense attributable to other items is determined by the tax consequences of transactions involving these items. The applicable tax effect of these items (extraordinary, prior period adjustments) should be disclosed separately because of their materiality. 29. LISELOTTE COMPANY Partial Income Statement For the Year Ended December 31, 2014 Income before tax and extraordinary item.................................... Income tax................................................................................... Income before extraordinary item ................................................ Extraordinary item—gain on sale of plant (condemnation)........... Less: Applicable income tax ................................................ Net income ..................................................................................
$1,500,000 510,000 990,000 $450,000 135,000
315,000 $1,305,000
30. The damages would probably be reported in Frazier Corporation’s financial statements in the other expenses and losses section. If the damages are unusual in nature, the damage settlement might be reported as an unusual item. The damages would not be reported as a correction of an error (prior period adjustment).
Questions Chapter 4 (Continued) 31. The assets, cash flows, results of operations, and activities of the plants closed would not appear to be clearly distinguishable, operationally or for financial reporting purposes, from the assets, results of operations, or activities of the Linus Paper Company. Therefore, disposal of these assets is not considered to be a disposal of a component of a business that would receive special reporting. 32. The major items reported in the retained earnings statement are: (1) adjustments of the beginning balance for corrections of errors or changes in accounting principle, (2) the net income or loss for the period, (3) dividends for the year, and (4) restrictions (appropriations) of retained earnings. It should be noted that the retained earnings statement is sometimes composed of two parts, unappropriated and appropriated. 33. Generally accepted accounting principles are ordinarily concerned only with a “fair presentation” of business income. In contrast, taxable income is a statutory concept which defines the base for raising tax revenues by the government, and any method of accounting which meets the statutory definition will “clearly reflect” taxable income as defined by the Internal Revenue Code. It should be noted that the Code prohibits use of the cash receipts and disbursements method as a method which will clearly reflect income in accounting for purchases and sales if inventories are involved. The cash receipts and disbursements method will not usually fairly present income because: (1) The completed transaction, not receipt or disbursement of cash, increases or diminishes income. Thus, a sale on account produces revenue and increases income, and the incurrence of expense reduces income without regard to the time of payment of cash. (2) The expense recognition principle generally results in costs being matched against related revenues produced. In most situations the cash receipts and disbursements method will violate this principle. (3) Consistency requires that accountable events receive the same accounting treatment from accounting period to accounting period. The cash receipts and disbursements method permits manipulation of the timing of revenues and expenses and may result in treatments which are not consistent, detracting from the usefulness of comparative statements. 34. Problems arise both from the revenue side and from the expense side. There sometimes may be doubt as to the amount of revenue under our common rules of revenue recognition. However, the more difficult problem is the determination of costs expired in the production of revenue. During a single fiscal period it often is difficult to determine the expiration of certain costs which may benefit several periods. Business is continuous and estimates have to be made of the future if we are to systematically apportion costs to fiscal periods. Examples of items which present serious obstacles include such items as institutional advertising costs. Accountants have established certain rules for handling revenues and costs which are applied consistently and in a systematic manner. From period to period, application of these rules generally results in a satisfactory matching of costs and revenues unless there are large changes from one period to another. These rules, influenced by conservatism in the face of the uncertainties involved, tend to charge costs to expense earlier than might be ideally desirable if we had more knowledge of the future. Costs or expenses of the types mentioned above, by their very nature, defy any attempt to relate them to revenues of a specific period or periods. Although it is known that institutional advertising will yield benefits beyond the present, both the amount of such benefits and when they will be enjoyed are shrouded in uncertainty. The degree of certainty with which their time distribution can be forecast is so small and the results, therefore, so unreliable that the accountant writes them off as applicable to the period or periods in which the expense was incurred.
Questions Chapter 4 (Continued) 35. Elements are the basic ingredients which comprise the income statement; that is, revenues, gains, expenses, and losses. Items are descriptions of the elements such as rent revenue, rent expense, etc. In order to predict the future, the amounts of individual items may have to be reported. For example, if “income from continuing operations” is significantly lower this year and is reported as a single amount, users would not know whether to attribute the decrease to a temporary increase in an expense item (for example, an unusually large bad debt), a structural change (for example, a change in the relationship between variable and fixed expenses), or some other factor. Another example is income data that are distorted because of large discretionary expenses. 36. Other comprehensive income must be displayed (reported) in one of two ways: (1) a single continuous income statement or (2) two separate but consecutive statements of net income and other comprehensive income (two statement approach). 37. The results of continuing operations should be reported separately from discontinued operations, and any gain or loss from disposal of a component of a business should be reported with the related results of discontinued operations and not as an extraordinary item. The following format illustrates the proper disclosure: Income from continuing operations before income tax.............................. Income tax................................................................................................ Income from continuing operations........................................................... Discontinued operations Gain (loss) on disposal of Division X less applicable income taxes of $– ..................................................... Net income ...............................................................................................
$XXX XXX XXX XXX $XXX
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 4-1 STARR CO. Income Statement For the Year 2014 Revenues Sales revenue......................................................
$540,000
Expenses Cost of goods sold .................................................. $330,000 Salaries and wages expense.............................. 120,000 Other operating expenses .................................. 10,000 Income tax expense ................................................ 25,000 Total expenses ...........................................
485,000
Net income .....................................................................
$ 55,000
Earnings per share ........................................................
$0.55*
*$55,000 ÷ 100,000 shares. Note: The increase in value of the company reputation and the unrealized gain on the value of patents are not reported.
BRIEF EXERCISE 4-2 BRISKY CORPORATION Income Statement For the Year Ended December 31, 2014 Revenues Net sales........................................................ Interest revenue ............................................ Total revenues....................................... Expenses Cost of goods sold ....................................... Selling expenses........................................... Administrative expenses.............................. Interest expense ........................................... Income tax expense* .................................... Total expenses .....................................
$2,400,000 31,000 2,431,000 $1,450,000 280,000 212,000 45,000 133,200 2,120,200
Net income ..............................................................
$ 310,800
Earnings per share**...............................................
$4.44
*($2,431,000 – $1,450,000 – $280,000 – $212,000 – $45,000) X 30% = $133,200. **$310,800 ÷ 70,000 shares.
BRIEF EXERCISE 4-3 BRISKY CORPORATION Income Statement For the Year Ended December 31, 2014 Net sales ............................................................... Cost of goods sold ............................................... Gross profit ................................................ Selling expenses .................................................. Administrative expenses ..................................... Income from operations....................................... Other revenue and gains Interest revenue ......................................... Other expenses and losses Interest expense......................................... Income before income tax ................................... Income tax expense ............................................. Net income ............................................................
$2,400,000 1,450,000 950,000 $280,000 212,000
492,000 458,000
31,000 45,000
Earnings per share ...............................................
14,000 444,000 133,200 $ 310,800 $4.44*
*$310,800 ÷ 70,000 shares. BRIEF EXERCISE 4-4 Income from continuing operations.................... Discontinued operations Loss from operation of discontinued restaurant division (net of tax) ............... Loss from disposal of restaurant division (net of tax) ................................. Net income ............................................................ Earnings per share ............................................... Income from continuing operations .......... Discontinued operations, net of tax........... Net income................................................... *Rounded
$10,600,000
$315,000 189,000
504,000 $10,096,000 $1.06 (0.05)* $1.01
BRIEF EXERCISE 4-5 Income before income tax and extraordinary item........................................................................... $6,300,000 Income tax expense .................................................... 1,890,000 4,410,000 Income before extraordinary item.............................. Extraordinary item—loss from casualty .................... $770,000 Less: Applicable income tax ............................. 231,000 539,000 Net income................................................................... $3,871,000 Earnings per share Income before extraordinary item..................... $0.88* Extraordinary loss, net of tax ............................ (0.11)* $0.77 Net income.......................................................... *Rounded
BRIEF EXERCISE 4-6 Income before income tax Income tax (30%) Net Income
2014 $180,000 54,000 $126,000
2013 $145,000 43,500 $101,500
2012 $170,000 51,000 $119,000
BRIEF EXERCISE 4-7 Vandross would not report any cumulative effect because a change in estimate is not handled retrospectively. Vandross would report bad debt expense of $120,000 in 2014.
BRIEF EXERCISE 4-8 $1,000,000 – $250,000 = $3.95 per share 190,000
BRIEF EXERCISE 4-9 PORTMAN CORPORATION Retained Earnings Statement For the Year Ended December 31, 2014 Retained earnings, January 1 ......................................... Add: Net income............................................................ Less: Cash dividends..................................................... Retained earnings, December 31 ...................................
$ 675,000 1,400,000 2,075,000 75,000 $2,000,000
BRIEF EXERCISE 4-10 PORTMAN CORPORATION Retained Earnings Statement For the Year Ended December 31, 2014 Retained earnings, January 1, as reported.................... Correction for overstatement of expenses in prior period (net of tax)......................................... Retained earnings, January 1, as adjusted ................... Add: Net income............................................................ Less: Cash dividends..................................................... Retained earnings, December 31 ...................................
$ 675,000 80,000 755,000 1,400,000 2,155,000 75,000 $2,080,000
BRIEF EXERCISE 4-11 (a)
Net income (Dividend revenue) .............................
$3,000
(b)
Net income.............................................................. Unrealized holding gain (net of tax) ...................... Comprehensive income .........................................
$3,000 4,000 $7,000
(c)
Unrealized holding gain (net of tax) (Other comprehensive income).............................
$4,000
(d)
Accumulated other comprehensive income, January 1, 2014................................................... Unrealized holding gain (net of tax) ...................... Accumulated other comprehensive income, December 31, 2014 .............................................
$
0 4,000
$4,000
SOLUTIONS TO EXERCISES EXERCISE 4-1 (18–20 minutes) Computation of net income Change in assets: $79,000 + $45,000 + $127,000 – $47,000 = $204,000 Increase Change in liabilities:
$ 82,000 – $51,000 =
Change in stockholders’ equity:
31,000 Increase $173,000 Increase
Change in stockholders’ equity accounted for as follows: Net increase Increase in common stock Increase in paid-in capital in excess of par Decrease in retained earnings due to dividend declaration Net increase accounted for Increase in retained earnings due to net income
$ 173,000 $125,000 13,000 (19,000) (119,000) $ 54,000
EXERCISE 4-2 (10–15 minutes) Sales revenue ......................................................................... Cost of goods sold ................................................................. Gross profit............................................................................. Selling administrative expenses ...........................................
$310,000 140,000 170,000 50,000 120,000
Other revenues and gains Gain on sale of plant assets ......................................... Income from operations......................................................... Interest expense ..................................................................... Income from continuing operations...................................... Loss on discontinued operations ......................................... Net Income .............................................................................. Allocation to noncontrolling interest ....................................
30,000 150,000(a) 6,000 144,000 (12,000) 132,000(b) (40,000)
Net income attributable to controlling shareholders ...........
$ 92,000(c)
Net income ..............................................................................
$132,000
Unrealized gain on available-for-sale investments ..............
10,000
Comprehensive income .........................................................
$142,000(d)
Net income ..............................................................................
$132,000
Dividends ................................................................................
(5,000)
12/31/14 Retained earnings ...................................................
$127,000(e)
EXERCISE 4-3 (25–35 minutes) (a) Total net revenue: Sales revenue Less: Sales discounts Sales returns Net sales Dividend revenue Rent revenue Total net revenue (b) Net income: Total net revenue (from a) Expenses: Cost of goods sold Selling expenses Administrative expenses Interest expense Total expenses Income before income tax Income tax Net income (c) Dividends declared: Ending retained earnings Beginning retained earnings Net increase Less: Net income Dividends declared
$390,000 $ 7,800 12,400
20,200 369,800 71,000 6,500 $447,300
$447,300 184,400 99,400 82,500 12,700 379,000 68,300 31,000 $ 37,300
$134,000 114,400 19,600 37,300 $ 17,700
EXERCISE 4-3 (Continued) ALTERNATE SOLUTION Beginning retained earnings Add: Net income Less: Dividends declared Ending retained earnings
$114,400 37,300 151,700 ? $134,000
Dividends declared must be $17,700 ($151,700 – $134,000) (d) Income attributed to controlling stockholders = (Net income – Allocation to noncontrolling interest) $37,300 - $ $17,000 = $ 20,300
EXERCISE 4-4 (20–25 minutes) LEROI JONES INC. Income Statement For Year Ended December 31, 2014 Revenues Net sales ($1,250,000(b) – $17,000) ................ Expenses Cost of goods sold......................................... 500,000 Selling expenses............................................ 400,000(c) Administrative expenses............................... 100,000(a) Interest expense............................................. 20,000 Total expenses ...................................... Income before income tax ....................................... Income tax ......................................................
$1,233,000
1,020,000 213,000 63,900
Net income ...............................................................
$ 149,100
Earnings per share...................................................
$
*Rounded
7.46*
EXERCISE 4-4 (Continued) Determination of amounts (a)
Administrative expenses
= 20% of cost of good sold = 20% of $500,000 = $100,000
(b)
Gross sales X 8%
= administrative expenses = $100,000 ÷ 8% = $1,250,000
(c)
Selling expenses
= four times administrative expenses. (operating expenses consist of selling and administrative expenses; since selling expenses are 4/5 of operating expenses, selling expenses are 4 times administrative expenses.) = 4 X $100,000 = $400,000
Earnings per share $7.46 ($149,100 ÷ 20,000) Note: An alternative income statement format is to show income tax part of expenses, and not as a separate item. In this case, total expenses are $1,083,900.
EXERCISE 4-5 (30–35 minutes) (a)
Multiple-Step Form P. BRIDE COMPANY Income Statement For the Year Ended December 31, 2014 (In thousands, except earnings per share)
Sales revenue ................................................... Cost of goods sold........................................... Gross profit.......................................................
$96,500 60,570 35,930
Operating Expenses Selling expenses Sales commissions .............................. Depr. of sales equipment ..................... Delivery expense .................................. Administrative expenses Officers’ salaries .................................. Depr. of office furn. and equip............. Income from operations................. Other Revenues and Gains Rent revenue ..............................................
$7,980 6,480 2,690
$17,150
4,900 3,960
8,860
26,010 9,920
17,230 27,150
Other Expenses and Losses Interest expense .........................................
1,860
Income before income tax ............................... Income tax .................................................. Net income........................................................
25,290 9,070 $16,220
Earnings per share ($16,220 ÷ 40,550) ............
$.40
EXERCISE 4-5 (Continued) (b)
Single-Step Form P. BRIDE COMPANY Income Statement For the Year Ended December 31, 2014 (In thousands, except earnings per share)
Revenues Net sales......................................................................... Rental revenue............................................................... Total revenues .........................................................
$ 96,500 17,230 113,730
Expenses Cost of goods sold ........................................................ Selling expenses ........................................................... Administrative expenses............................................... Interest expense ............................................................ Total expenses.........................................................
60,570 17,150 8,860 1,860 88,440
Income before income tax .................................................. Income tax............................................................................ Net income .....................................................................
25,290 9,070 $ 16,220
Earnings per share ..............................................................
$.40
Note: An alternative income statement format for the single-step form is to show income tax a part of expenses, and not as a separate item. (c)
Single-step: 1. Simplicity and conciseness. 2. Probably better understood by users. 3. Emphasis on total costs and expenses and net income. 4. Does not imply priority of one revenue or expense over another.
EXERCISE 4-5 (Continued) Multiple-step: 1. Provides more information through segregation of operating and nonoperating items. 2. Expenses are matched with related revenue. Note to instructor: Students’ answers will vary due to the nature of the question; i.e., it asks for an opinion. However, the discussion supporting the answer should include the previous points.
EXERCISE 4-6 (30–35 minutes) MARIA CONCHITA ALONZO CORP. Income Statement For the Year Ended December 31, 2014 Sales Revenue Sales revenue ......................................................... Less: Sales returns and allowances ..................... Sales discounts ........................................... Net sales ................................................................. Cost of goods sold ................................................. Gross profit on sales ...................................................
$1,380,000 $150,000 45,000
195,000 1,185,000 621,000 564,000
Operating Expenses Selling expenses ................................................. Administrative and general expenses ............... Income from operations...............................................
194,000 97,000
291,000 273,000
EXERCISE 4-6 (Continued) Other Revenues and Gains Interest revenue.......................................................
86,000 359,000
Other Expenses and Losses Interest expense ......................................................
60,000
Income before income tax and extraordinary item ....... Income tax ($299,000 X .34) .................................... Income before extraordinary item.................................. Extraordinary item—loss from earthquake damage.......... $150,000 Less: Applicable income tax reduction
299,000 101,660 197,340
($150,000 X .34) ........................................................... Net income.......................................................................
99,000 $ 98,340
Per share of common stock: Income before extraordinary item ($197,340 ÷ 100,000).............................................. Extraordinary item (net of tax) ................................ Net income ($98,340 ÷ 100,000) .............................. *Rounded
51,000
$1.97* (.99) $ .98
EXERCISE 4-7 (30–40 minutes) (a)
Multiple-Step Form LATIFA SHOE CO. Income Statement For the Year Ended December 31, 2014
Net sales ....................................................... Cost of goods sold....................................... Gross profit on sales ...................................
$980,000 496,000 484,000
Operating Expenses Selling expenses Salaries and Wages.......................... Depr. exp. (70% X $65,000) .............. Supplies ............................................ Administrative expenses Wages and salaries .......................... Other admin. expenses .................... Depr. exp. (30% X $65,000) .............. Income from operations............................... Other Revenues and Gains Rent revenue ..........................................
$114,800 45,500 17,600 $177,900 135,900 51,700 19,500
207,100
385,000 99,000
29,000 128,000
Other Expenses and Losses Interest expense .....................................
18,000
Income before income tax ........................... Income tax .............................................. Net income....................................................
110,000 37,400 $ 72,600
Earnings per share ($72,600 ÷ 20,000) ........
$3.63
EXERCISE 4-7 (Continued) (b)
Single-Step Form LATIFA SHOE CO. Income Statement For the Year Ended December 31, 2014
Revenues Net sales........................................................................ Rent revenue................................................................. Total revenues ........................................................
$ 980,000 29,000 1,009,000
Expenses Cost of goods sold ....................................................... Selling expenses .......................................................... Administrative expenses ............................................. Interest expense ........................................................... Total expenses........................................................
496,000 177,900 207,100 18,000 899,000
Income before income tax ................................................. Income tax..................................................................... Net income ..........................................................................
110,000 37,400 $ 72,600
Earnings per share ($72,600 ÷ 20,000) ..............................
$3.63
Note: An alternative income statement format for the single-step form is to show income tax as part of expenses, and not as a separate item. (c)
Single-step: 1. Simplicity and conciseness. 2. Probably better understood by users. 3. Emphasis on total costs and expenses and net income. 4. Does not imply priority of one revenue or expense over another.
EXERCISE 4-7 (Continued) Multiple-step: 1. Provides more information through segregation of operating and nonoperating items. 2. Expenses are matched with related revenue. Note to instructor: Students’ answers will vary due to the nature of the question, i.e., it asks for an opinion. However, the discussion supporting the answer should include the above points.
EXERCISE 4-8 (15–20 minutes) (a) Net sales Cost of goods sold Administrative expenses Selling expenses Discontinued operations-loss Income before income tax Income tax ($110,000 X .30) Net income
$ 540,000 (210,000) (100,000) (80,000) (40,000) 110,000 33,000 $ 77,000
(b) Income from continuing operations before income tax Income tax ($150,000 X .30) Income from continuing operations Discontinued operations, less applicable income tax of $12,000 Net income
$150,000* 45,000 105,000 (28,000) $ 77,000
*$110,000 + $40,000 Earnings per share: Income from continuing operations ($105,000 ÷ 10,000) Loss on discontinued operations, net of tax Net Income ($77,000 ÷ 10,000)
$10.50 (2.80) $ 7.70
EXERCISE 4-9 (30–35 minutes) (a)
IVAN CALDERON CORP. Income Statement For the Year Ended December 31, 2014
Sales Revenue Net sales.................................................................... Cost of goods sold ................................................... Gross profit ....................................................
$1,300,000 780,000 520,000
Operating Expenses Selling expenses.................................................. $65,000 Administrative expenses..................................... 48,000 Income from operations................................................. Other Revenues and Gains Dividend revenue ................................................. Interest revenue ...................................................
20,000 7,000
Other Expenses and Losses Write-off of inventory due to obsolescence............ Income before income tax and extraordinary item ........... Income tax ............................................................ Income before extraordinary item ................................. Extraordinary item Casualty loss............................................... 50,000 Less: Applicable income tax 17,000 ($50,000 .34) ......................................... Net income ...................................................................... $ Per share of common stock: Income before extraordinary item ($233,640 ÷ 60,000) ........................................... Extraordinary item, net of tax.............................. Net income ($200,640 ÷ 60,000)........................... *Rounded
113,000 407,000
27,000 434,000 80,000 354,000 120,360 233,640
(33,000) 200,640
$3.89* (.55) $3.34
EXERCISE 4-9 (Continued) (b)
IVAN CALDERON CORP. Retained Earnings Statement For the Year Ended December 31, 2014
Retained earnings, Jan. 1, as reported ...................................... Correction for overstatement of net income in prior period (depreciation error) (net of $18,700 tax) .......................... Retained earnings, Jan. 1, as adjusted...................................... Add: Net income.......................................................................... Less: Dividends declared ........................................................... Retained earnings, Dec. 31.........................................................
$
980,000
(36,300) 943,700 200,640 1,144,340 45,000 $1,099,340
EXERCISE 4-10 (20–25 minutes) Computation of net income: 2014 net income after tax................................ 2014 net income before tax [$33,000,000 ÷ (1 – .34)] ............................... Add back major casualty loss ........................ Income from operations............................ Income tax (34% X $68,000,000) ..................... Income before extraordinary item .................. Extraordinary item: Casualty loss ............................................. $18,000,000 Less: Applicable income tax reduction ...... 6,120,000 Net income.......................................................
$33,000,000 50,000,000 18,000,000 68,000,000 23,120,000 44,880,000
(11,880,000) $33,000,000
EXERCISE 4-10 (Continued) Net income ........................................................................... Less: Provision for preferred dividends (8% of $4,500,000)............................................................
$33,000,000
Income available to common stockholders....................... Common stock shares ........................................................ Earnings per share ..............................................................
32,640,000 ÷10,000,000 $3.26*
360,000
Income statement presentation
a
Per share of common stock: Income before extraordinary item ..........................
$4.45a
Extraordinary item, net of tax ................................. Net income ...............................................................
(1.19)b $3.26
$44,880,000 – $360,000 = $4.45* 10,000,000
*Rounded
b
$11,880,000 = $1.19* 10,000,000
EXERCISE 4-11 (20–25 minutes) SPOCK CORPORATION Income Statement For the Year Ended December 31, 2014 Net sales(a) ............................................................... Cost of goods sold(b) ............................................... Gross profit........................................................ Selling expenses(c) .................................................. Administrative expenses(d) ..................................... Income from operations.................................... Rent revenue ........................................................... Interest expense...................................................... Income before income tax ...................................... Income tax ($434,000 X .34) .............................. Income before extraordinary item.......................... Extraordinary loss................................................... Less: Applicable income tax ............................ Net income...............................................................
$4,162,000 2,665,000 1,497,000 $636,000 491,000 240,000 (176,000)
70,000 23,800
Earnings per share ($900,000 ÷ $10 par value = 90,000 shares) Income before extraordinary item ($286,440 ÷ 90,000) ......... Extraordinary item, net of tax ................................................. Net income...............................................................................
1,127,000 370,000 64,000 434,000 147,560 286,440 46,200 $ 240,240
$3.18* (.51)* $2.67
*Rounded Supporting computations (a) Net sales: $4,275,000 – $34,000 – $79,000 = $4,162,000 (b) Cost of goods sold: $535,000 + ($2,786,000 + $72,000 – $27,000 – $15,000) – $686,000 = $2,665,000 (c) Selling expenses: $284,000 + $83,000 + $69,000 + $54,000 + $93,000 + $36,000 + $17,000 = $636,000 (d) Administrative expenses: $346,000 + $33,000 + $24,000 + $48,000 + $32,000 + $8,000 = $491,000
EXERCISE 4-12 (20–25 minutes) (a)
EDDIE ZAMBRANO CORPORATION Retained Earnings Statement For the Year Ended December 31, 2014
Balance, January 1, as reported............................................. Correction for depreciation error (net of $10,000 tax) .......... Cumulative decrease in income from change in inventory methods (net of $14,000 tax) ....................... Balance, January 1, as adjusted............................................. Add: Net income...................................................................... Less: Dividends declared ....................................................... Balance, December 31 ............................................................
$225,000* (15,000) (21,000) 189,000 144,000** 333,000 100,000 $233,000
*($40,000 + $125,000 + $160,000) – ($50,000 + $50,000) **[$240,000 – (40% X $240,000)]
(b) Total retained earnings would still be reported as $233,000. A restriction does not affect total retained earnings; it merely labels part of the retained earnings as being unavailable for dividend distribution. Retained earnings would be reported as follows: Retained earnings: Appropriated Unappropriated Total
$ 70,000 163,000 $233,000
EXERCISE 4-13 (15–20 minutes) Net income: Income from continuing operations before income tax.......................................... $23,650,000 Income tax (35% X $23,650,000) ....................... 8,277,500 Income from continuing operations................. 15,372,500 Discontinued operations Loss before income tax............................... $3,225,000 Less: Applicable income tax (35%) ............ 1,128,750 (2,096,250) Net income......................................................... $13,276,250 Preferred dividends declared: ................................
$ 1,075,000
Weighted average common shares outstanding......
4,000,000
Earnings per share Income from continuing operations................. Discontinued operations, net of tax................. Net income......................................................... *($15,372,500 – $1,075,000) ÷ 4,000,000. (Rounded) **$2,096,250 ÷ 4,000,000. (Rounded) ***($13,276,250 – $1,075,000) ÷ 4,000,000.
$3.57* (.52)** $3.05***
EXERCISE 4-14 (15–20 minutes) (a)
2014 $450,000 157,500 $292,500
Income before income tax Income tax (35%) Net Income (b)
Year 2012 2013
Cumulative effect for years prior to 2014. WeightedAverage $370,000 390,000
Tax Rate FIFO Difference (35%) Net Effect $395,000 $25,000 430,000 40,000 Total $65,000 $22,750 $42,250
(c) Income before income tax Income tax (35%) Net income
2014 2013 2012 $450,000 $430,000 $395,000 157,500 150,500 138,250 $292,500 $279,500 $256,750
EXERCISE 4-15 (15–20 minutes) (a) ROXANNE CARTER CORPORATION Statement of Comprehensive Income For the Year Ended December 31, 2014 Sales revenue ......................................................................... Cost of goods sold ................................................................. Gross profit............................................................................. Selling and administrative expenses .................................... Net income .............................................................................. Unrealized holding gain, net of tax ....................................... Comprehensive income .........................................................
$1,200,000 750,000 450,000 320,000 130,000 18,000 $ 148,000
(b) ROXANNE CARTER CORPORATION Income Statement and Comprehensive Income Statement For the Year Ended December 31, 2014 Sales........................................................................................ Cost of goods sold................................................................. Gross profit............................................................................. Selling and administrative expenses .................................... Net income.............................................................................. Comprehensive Income Net income.............................................................................. Unrealized holding gain ......................................................... Comprehensive income .........................................................
$1,200,000 750,000 450,000 320,000 $ 130,000 $ 130,000 18,000 $ 148,000
EXERCISE 4-16 (15–20 minutes) C. REITHER CO. Statement of Stockholders’ Equity For the Year Ended December 31, 2014 Accumulated Other
Beginning balance
Retained
Comprehensive
Common
Total
Earnings
Income
Stock
$520,000
$ 90,000
$80,000
$350,000
120,000
120,000
Comprehensive income Net income* Other comprehensive income Unrealized holding loss
(60,000)
(60,000)
Comprehensive income Dividends Ending balance
(10,000)
(10,000)
$570,000
$200,000
*($700,000 – $500,000 – $80,000).
$20,000
$350,000
EXERCISE 4-17 (30–35 minutes) (a)
ROLAND CARLSON INC. Income Statement For the Year Ended December 31, 2014
Revenues Sales revenue .......................................................................... Rent revenue............................................................................ Total revenues............................................................... Expenses Cost of goods sold........................................................ Selling expenses........................................................... Administrative expenses.............................................. Total expenses ..................................................... Income from continuing operations before income tax.................................................................. Income tax ............................................................ Income from continuing operations............................. Discontinued operations Loss on discontinued operations ....................... $75,000 Less: Applicable income tax reduction .............. 25,500 Income before extraordinary items .............................. Extraordinary items: Extraordinary gain................................................ 95,000 Less: Applicable income tax ............................... 32,300 Extraordinary loss................................................ Less: Applicable income tax reduction .............. Net income .....................................................................
60,000 20,400
Per share of common stock: Income from continuing operations ($363,000 ÷ 100,000)....... Loss on discontinued operations, net of tax....................... Income before extraordinary items ($313,500 ÷ 100,000) ........ Extraordinary gain, net of tax ............................................... Extraordinary loss, net of tax ............................................... Net income ($336,600 ÷ 100,000) .........................................
$1,900,000 40,000 1,940,000
850,000 300,000 240,000 1,390,000 550,000 187,000 363,000
(49,500) 313,500
62,700 376,200 (39,600) $ 336,600 $3.63 (.49) 3.14 .63 (.40) $3.37
EXERCISE 4-17 (Continued) (b)
ROLAND CARLSON INC. Comprehensive Income Statement For the Year Ended December 31, 2014
Net income.............................................................................. Other comprehensive income Unrealized holding gain, net of tax ................................. Comprehensive income ......................................................... (c)
$336,600 15,000 $351,600
ROLAND CARLSON INC. Retained Earnings Statement For the Year Ended December 31, 2014
Retained earnings, January 1........................................................ Add: Net income............................................................................. Less: Dividends declared .............................................................. Retained earnings, December 31 ..................................................
$600,000 336,600 936,600 150,000 $786,600
TIME AND PURPOSE OF PROBLEMS Problem 4-1 (Time 30–35 minutes) Purpose—to provide the student with an opportunity to prepare a multi-step income statement and a retained earnings statement. A number of special items such as loss from discontinued operations, unusual items, and ordinary gains and losses are presented in the problem for analysis purposes. Problem 4-2 (Time 25–30 minutes) Purpose—to provide the student with an opportunity to prepare a single-step income statement and a retained earnings statement. The student must determine through analysis the ending balance in retained earnings. Problem 4-3 (Time 30–40 minutes) Purpose—to provide the student with an opportunity to analyze a number of transactions and to prepare a partial income statement. The problem includes discontinued operations, an extraordinary item, and the cumulative effect of a change in accounting principle. Problem 4-4 (Time 45–55 minutes) Purpose—to provide the student with the opportunity to prepare multiple-step and single-step income statements and a retained earnings statement from the same underlying information. A substantial number of operating expenses must be reported in this problem unlike Problem 4-1. As a consequence, the problem is time-consuming and emphasizes the differences between the multiple-step and singlestep income statement. Problem 4-5 (Time 20–25 minutes) Purpose—to provide the student with a problem on the income statement treatment of (1) a change that is usual but infrequently occurring, (2) an extraordinary item and its related tax effect, (3) a correction of an error, and (4) earnings per share. The student is required not only to identify the proper income statement treatment but also to provide the rationale for such treatment. Problem 4-6 (Time 25–35 minutes) Purpose—to provide the student with an opportunity to prepare a retained earnings statement. A number of special items must be reclassified and reported in the income statement. This problem illustrates the fact that ending retained earnings is unaffected by the choice of disclosing items in the income statement or the retained earnings statement, although the income reported would be different. Problem 4-7 (Time 25–35 minutes) Purpose—to provide the student with a problem to determine the reporting of several items, which may get special treatment as irregular items. This is a good problem for a group assignment.
SOLUTIONS TO PROBLEMS PROBLEM 4-1
DICKINSON COMPANY Income Statement For the Year Ended December 31, 2014 Sales revenue ............................................................... $25,000,000 Cost of goods sold....................................................... 16,000,000 Gross profit................................................................... 9,000,000 Selling and administrative expenses.......................... 4,700,000 Income from operations............................................... 4,300,000 Other revenues and gains Interest revenue ................................................. $ 70,000 Gain on the sale of investments ....................... 110,000 180,000 Other expenses and losses Write-off of goodwill .......................................... 820,000 Income from continuing operations before income tax ......................................................................... 3,660,000 Income tax .................................................................... 1,244,000 Income from continuing operations ........................... 2,416,000 Discontinued operations Loss on operations, net of applicable tax........ 90,000 Loss on disposal, net of applicable tax ........... 440,000 (530,000) Income before extraordinary item............................... 1,886,000 Extraordinary item—loss from flood damage, net of applicable tax.................................. 390,000 Net income.................................................................... $ 1,496,000 Earnings per share: Income from continuing operations .................. Discontinued operations Loss on operations, net of tax .................. Loss on disposal, net of tax ...................... Income before extraordinary item...................... Extraordinary loss, net of tax ............................. Net income...........................................................
$ 4.67a $(0.18) (0.88)
(1.06) 3.61b (0.78) $ 2.83c
PROBLEM 4-1 (Continued) DICKINSON COMPANY Retained Earnings Statement For the Year Ended December 31, 2014 Retained earnings, January 1 ................................ Add: Net income .................................................. Less Dividends declared on: Preferred stock ............................................ Common stock ............................................ Retained earnings, December 31 ..........................
a
$2,416,000 – $80,000 500,000 shares
=
$4.67
$1,886,000 – $80,000 500,000 shares
=
$3.61
=
$2.83
b
c
$1,496,000 – $80,000 500,000 shares
$
$ 80,000 250,000
980,000 1,496,000 2,476,000
330,000 $ 2,146,000
PROBLEM 4-2
THOMPSON CORPORATION Income Statement For the Year Ended December 31, 2014 Revenues Net sales ($1,100,000 – $14,500 – $17,500) ..... $1,068,000 Gain on disposal of land ................................. 30,000 Rent revenue .................................................... 18,000 Total revenues ........................................ Expenses Cost of goods sold* ......................................... Selling expenses.............................................. Administrative expenses................................. Total expenses........................................
645,000 232,000 99,000 976,000
Income before income tax ......................................... Income tax........................................................ Net income.................................................................. Earnings per share ($86,100 ÷ 30,000) ...................... *Cost of goods sold: Can be verified as follows: Inventory, Jan. 1 .................................................... Purchases .............................................................. Less: Purchase discounts ................................... Net purchases........................................................ Add: Freight-in..................................................... Inventory available for sale .................................. Less: Inventory, Dec. 31 ...................................... Cost of goods sold .............................................
$1,116,000
140,000 53,900 $ 86,100 $2.87
$ $610,000 10,000 600,000 20,000
89,000
620,000 709,000 64,000 $ 645,000
PROBLEM 4-2 (Continued) THOMPSON CORPORATION Retained Earnings Statement For the Year Ended December 31, 2014 Retained earnings, January 1 .............................................. Add: Net income ................................................................ Less: Cash dividends.......................................................... Retained earnings, December 31 ........................................
$160,000 86,100 246,100 45,000 $201,100
PROBLEM 4-3
MAHER INC. Income Statement (Partial) For the Year Ended December 31, 2014 Income from continuing operations before income tax.................................................. $838,500(a) Income tax...................................................... 220,350(b) Income from continuing operations ....................... 618,150 Discontinued operations Loss from disposal of recreational division ....................................................... $115,000 (1) Less: Applicable income tax reduction....... 34,500 (80,500) Income before extraordinary item........................... 537,650 Extraordinary item: Major casualty loss........................................ 90,000 (2) (48,600) Less: Applicable income tax reduction....... 41,400 Net income................................................................ $489,050 (1) $115,000 30% (2) $90,000 46% Per share of common stock: Income from continuing operations ............. Discontinued operations, net of tax ............. Income before extraordinary items .............. Extraordinary item, net of tax ....................... Net income ($489,050 ÷ 120,000)...................
$5.15* (0.67)* 4.48 (0.40) $4.08
*Rounded (a)
Computation of income from cont. operations before taxes: As previously stated................................................ Loss on sale of securities ....................................... Gain on proceeds of life insurance policy ($150,000 – $46,000) ................................. Error in computation of depreciation As computed ($54,000 ÷ 6) ......................................... $9,000 Corrected ($54,000 – $9,000) ÷ 6 ................................ (7,500) As restated...................................................................
$790,000 (57,000) 104,000
1,500 $838,500
PROBLEM 4-3 (Continued) (b)
Computation of income tax: Income from continuing operations before taxes .......... Nontaxable income (gain on life insurance) ................... Taxable income................................................................. Tax rate ............................................................................. Income tax.........................................................................
$838,500 (104,000) 734,500 X .30 $220,350
Note: No adjustment is needed for the inventory method change, since the new method is reported in 2014 income. The cumulative effect on prior years of retroactive application of the new inventory method will be recorded in retained earnings.
PROBLEM 4-4
(a)
TWAIN CORPORATION Income Statement For the Year Ended June 30, 2014 Sales Sales revenue ........................................... Less: Sales discounts............................. Sales returns and allowances...... Net sales ................................................... Cost of goods sold......................................... Gross profit .................................................... Operating Expenses Selling expenses Sales commissions .............................. Salaries and wages expense ............... Travel expense ..................................... Delivery expense.................................. Entertainment expense........................ Telephone and Internet expense......... Maintenance and repairs expense ...... Depreciation expense .......................... Bad debt expense................................. Miscellaneous selling expenses .........
Administrative Expenses Maintenance and repairs expense ............ Property tax expense .................................... Depreciation expense ................................ Supplies expense....................................... Telephone and Internet expense............... Office expenses ......................................... Income from operations ................................
$1,578,500 $31,150 62,300
97,600 56,260 28,930 21,400 14,820 9,030 6,200 4,980 4,850 4,715
9,130 7,320 7,250 3,450 2,820 6,000
93,450 1,485,050 896,770 588,280
248,785
35,970 303,525
PROBLEM 4-4 (Continued) Other Revenues and Gains Dividend revenue ............................................
38,000
Other Expenses and Losses Interest expense..............................................
18,000
Income before income tax .................................. Income tax ....................................................... Net income........................................................... Earnings per common share [($221,525 – $9,000) ÷ 80,000].........................
323,525 102,000 $221,525 $2.66*
*Rounded TWAIN CORPORATION Retained Earnings Statement For the Year Ended June 30, 2014 Retained earnings, July 1, 2013, as reported....... Correction of depreciation understatement, net of tax............................................................. Retained earnings, July 1, 2013, as adjusted ...... Add: Net income ...................................................
$337,000 (17,700) 319,300 221,525 540,825
Less: Dividends declared on preferred stock ...... Dividends declared on common stock....... Retained earnings, June 30, 2014.........................
$ 9,000 37,000
46,000 $494,825
PROBLEM 4-4 (Continued) (b)
TWAIN CORPORATION Income Statement For the Year Ended June 30, 2014 Revenues Net sales ............................................................. Dividend revenue ............................................... Total revenues ........................................... Expenses Cost of goods sold............................................. Selling expenses ................................................ Administrative expenses ................................... Interest expense ................................................. Total expenses .......................................... Income before income tax............................................ Income tax .......................................................... Net income .................................................................... Earnings per common share........................................
$1,485,050 38,000 1,523,050 896,770 248,785 35,970 18,000 1,199,525 323,525 102,000 $ 221,525 $2.66
TWAIN CORPORATION Retained Earnings Statement For the Year Ended June 30, 2014 Retained earnings, July 1, 2013, as reported...... Correction of depreciation understatement, net of tax............................................................ Retained earnings, July 1, 2013 as adjusted ...... Add: Net income ..................................................
$337,000 (17,700) 319,300 221,525 540,825
Less: Dividends declared on preferred stock .... Dividends declared on common stock ..... Retained earnings, June 30, 2014........................
$ 9,000 37,000
46,000 $494,825
PROBLEM 4-5
1.
The usual but infrequently occurring charge of $8,500,000 should be disclosed separately, assuming it is material. This charge is shown above income before extraordinary items and would not be reported net of tax. This item should be separately disclosed to inform the users of the financial statements that this item is nonrecurring and therefore may not impact next year’s results. Furthermore, trend comparisons may be misleading if such an item is not highlighted and adjustments made. The item should not be considered extraordinary because it is usual in nature.
2.
The extraordinary item of $6,000,000 should be reported net of tax in a separate section for extraordinary items. An adjustment should be made to income taxes to report this amount at $21,400,000. The $2,000,000 tax effect of this extraordinary item should be reported with the extraordinary item. The reason for the separate disclosure is much the same as that given above for the separate disclosure of the usual, but infrequently occurring item. Readers must be informed that certain revenue and expense items may be unusual and infrequent, and that their likelihood for affecting operations again in the future is unlikely.
3.
The adjustment required for correction of an error is inappropriately labeled and also should not be reported in the retained earnings statement. Changes in estimate should be handled in current and future periods through the income statement. Catch-up adjustments are not permitted. To restate financial statements every time a change in estimate occurred would be extremely costly. In addition, adjusting the beginning balance of retained earnings is inappropriate as the increased charge in this case affects current and future income statements.
4.
Earnings per share should be reported on the face of the income statement and not in the notes to the financial statements. Because such importance is ascribed to this statistic, the profession believes it necessary to highlight the earnings per share figure. In this case the company should report both income before extraordinary item and net income on a per share basis.
PROBLEM 4-6
(a)
ACADIAN CORP. Retained Earnings Statement For the Year Ended December 31, 2014 Retained earnings, January 1, as reported ................................ $257,600 Correction of error from prior period (net of tax) ................... 25,400 Adjustment for change in accounting principle (net of tax) ................................................................................ (23,200) Retained earnings, January 1, as adjusted..................................259,800 Add: Net income ..................................................................... 52,300* Less: Cash dividends declared ................................................. 32,000 Retained earnings, December 31 ...............................................$280,100 *$52,300 = ($84,500 + $41,200 + $21,600 – $35,000 – $60,000)
(b) 1. Gain on sale of investments—body of income statement. This gain should not be shown net of tax on the income statement. 2. Refund on litigation with government—body of income statement, possibly unusual item. This refund should not be shown net of tax on the income statement. 3. Loss on discontinued operations—body of the income statement, following the caption, “Income from continuing operations.” 4. Write-off of goodwill—body of income statement, possibly unusual item. The write-off should not be shown net of tax on the income statement.
PROBLEM 4-7
WADE CORP. Income Statement (Partial) For the Year Ended December 31, 2014 Income from continuing operations before income tax .................................... $1,200,000* Income tax .......................................... 456,000** Income from continuing operations........... 744,000 Discontinued operations Loss from operations of discontinued subsidiary ................ $ 90,000 Less: Applicable income tax reduction ($90,000 .38).... 34,200 $ 55,800 Loss from disposal of subsidiary ........100,000 Less: Applicable income tax reduction ($100,000 .38).. 38,000 62,000 (117,800) Income before extraordinary item .............. 626,200 Extraordinary item: Gain on condemnation....................... 125,000 Less: Applicable income tax ............ 50,000* 75,000 Net income ................................................... $ 701,200 * $125,000 40% Per share of common stock: Income from continuing operations.................................. Discontinued operations, net of tax.................................. Income before extraordinary item ..................................... Extraordinary item, net of tax ............................................ Net income ($701,200 ÷ 150,000) .......................................
$4.96 (0.79) 4.17 0.50 $4.67
PROBLEM 4-7 (Continued) *Computation of income from continuing operations before income tax: As previously stated Loss on sale of equipment [$40,000 – ($80,000 – $30,000)] Restated
$1,210,000 (10,000) $1,200,000
**Computation of income tax: $1,200,000 X .38 = $456,000 Note: The error related to the intangible asset was correctly charged to retained earnings.
TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 4-1 (Time 20–25 minutes) Purpose—to provide the student with the opportunity to comment on deficiencies in an income statement format. The student is required to comment on such items as inappropriate heading, incorrect classification of special items, proper net of tax treatment, and presentation of per share data. CA 4-2 (Time 20–25 minutes) Purpose—to provide the student an illustration of how earnings can be managed. The case allows students to see the effects of warranty expense timing on the trend of income and illustrates the potential use of accruals to smooth earnings. CA 4-3 (Time 15–20 minutes) Purpose—to provide the student an illustration of how earnings can be managed by how losses are reported, including ethical issues. CA 4-4 (Time 30–35 minutes) Purpose—to provide the student with an unstructured case to comment on the reporting of discontinued operations and extraordinary items. In addition, the student is asked to comment on materiality considerations and earnings per share implications. CA 4-5 (Time 30–40 minutes) Purpose—to provide the student with the opportunity to comment on deficiencies in an income statement. This case includes discussion of extraordinary items, discontinued items, and ordinary gains and losses. The case is complete and therefore provides a broad overview to a number of items discussed in the textbook. CA 4-6 (Time 20–25 minutes) Purpose—to provide the student with a variety of situations involving classification of special items. This case is different from CA 4-5 in that an income statement is not presented. Instead, short factual situations are described. A good comprehensive case for discussing the presentation of special items. CA 4-7 (Time 10–15 minutes) Purpose—to provide the student with an opportunity to show how comprehensive income should be reported.
SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 4-1 The deficiencies of O’Malley Corporation’s income statement are as follows: 1.
The heading is inappropriate. The heading should include the name of the company and the period of time for which the income statement is presented.
2.
Gain on recovery of insurance proceeds should be classified as an extraordinary item in a separate section of the income statement.
3.
Cost of goods sold is usually listed as the first expense, followed by selling, administrative, and other expenses.
4.
Advertising expense is a selling expense and should usually be classified as such, unless this expense is unusually different from previous periods.
5.
Loss on obsolescence of inventories might be classified as an unusual item and separately disclosed if it is unusual or infrequent but not both.
6.
Loss on discontinued operations requires a separate classification after income from continuing operations and before presentation of income before extraordinary item.
7.
Intraperiod income tax allocation is required to relate income tax expense to income from continuing operations, loss on discontinued operations, and the extraordinary item.
8.
Per share data is a required presentation for income from continuing operations, discontinued operations, income before extraordinary item, extraordinary item, and net income.
CA 4-2 (a) Earnings management is often defined as the planned timing of revenues, expenses, gains and losses to smooth out bumps in earnings. In most cases, earnings management is used to increase income in the current year at the expense of income in future years. For example, companies prematurely recognize sales in order to boost earnings. Earnings management can also be used to decrease current earnings in order to increase income in the future. The classic case is the use of “cookie jar” reserves, which are established, by using unrealistic assumptions to estimate liabilities for such items as loan losses, restructuring charges and warranty returns. (b) Proposed Accounting Income before warranty expense Warranty expense Income
2011
2012
2013
$20,000
$25,000
$30,000
2014 $43,000 7,000 $36,000
2015 $43,000 3,000 $40,000
Assuming the same income before warranty expense for both 2014 and 2015 and total warranty expense over the 2-year period of $10,000, this proposed accounting results in steadily increasing income over the two-year period.
CA 4-2 (Continued) (c) Appropriate Accounting Income before warranty expense Warranty expense Income
2011
2012
2013
$20,000
$25,000
$30,000
2014 $43,000 5,000 $38,000
2015 $43,000 5,000 $38,000
The appropriate accounting would be to record $5,000 of warranty expense in 2014, resulting in income of $38,000. However, with the same amount of warranty expense in 2015, Bobek no longer shows an increasing trend in income. Thus, by taking more expense in 2014, Bobek can save some income (a classic case of “cookie-jar” reserves) and maintain growth in income.
CA 4-3 (a) The ethical issues involved are integrity and honesty in financial reporting, full disclosure, accountant’s professionalism, and job security for Charlie. (b) If Charlie believes the losses are relevant information important to users of the income statement, he should disclose the losses separately. If they are considered incidental to the company’s normal activities—i.e., the major activities of the Kelly Corporation do not include selling equipment—the transactions should be reported among any gains and losses that occurred during the year.
CA 4-4 (a) It appears that the sale of the Casino Knights Division would qualify as a discontinued operation. The operation of gambling facilities appears to meet the criteria for discontinued operations for Simpson Corp. and, therefore, the accounting requirements related to discontinued operations should be followed. Although the financial vice-president might be correct theoretically, professional pronouncements require that such segregation be made. The controller is incorrect in stating that the disposal of the Casino Knights Division should be reported as an extraordinary item. A separate classification is required for disposals meeting the requirements of discontinued operations. If this disposal did not meet the requirements for disposal of a component of a business, extraordinary item treatment might be considered appropriate. (b) The “walkout” or strike should not be reported as an extraordinary item. Events of this nature are a general risk that any business enterprise takes and should not warrant extraordinary item treatment. FASB ASC 225-20-45 specifically indicates that the effects of a strike should not be reported as an extraordinary item. (c) The financial vice-president is incorrect in his/her observations concerning the materiality of extraordinary items. The materiality of each extraordinary item must be considered individually. It is not appropriate to consider only the materiality of the net effect. Each extraordinary item must be reported separately on the income statement. (d) Earnings per share for income from continuing operations, discontinued operations, income before extraordinary items, extraordinary items, and net income must be reported on the face of the income statement.
CA 4-5 The income statement of Walters Corporation contains the following weaknesses in classification and disclosure: 1.
Sales taxes. Sales taxes have been erroneously included in both gross sales and cost of goods sold on the income statement of Walters Corporation. Failure to deduct these taxes directly from customer billings results in a deceptive inflation of the amount of sales. These taxes should be deducted from gross sales because the corporation acts as an agent in collecting and remitting such taxes to the state government.
2.
Purchase discounts. Purchase discounts should not be treated as revenue by being lumped with other revenues such as dividends and interest. A purchase discount is more logically a reduction of the cost of purchases because revenue is not created by purchasing goods and paying for them. In a cash transaction, cost is measured by the amount of the cash consideration. In a credit transaction, however, cost is measured by the amount of cash required to settle immediately the obligation incurred. The discount should reduce the cost of goods sold to the amount of cash that would be required to settle the obligation immediately.
3.
Recoveries of accounts written off in prior years. These collections should be credited to the allowance for doubtful accounts unless the direct write-off method was used in accounting for bad debt expense. Generally, the direct write-off method is not allowed.
4.
Delivery expense. Although delivery expense (sometimes referred to as freight-out) is an expense of selling and is therefore reported properly in the statement, freight-in is an inventoriable cost and should have been included in the computation of cost of goods sold. The value assigned to inventory should represent the value of the economic resources given up in obtaining goods and readying them for sale.
5.
Loss on discontinued styles. This type of loss, though often substantial, should not be treated as an extraordinary item because it is apparently typical of the customary business activity of the corporation. It should be reported in “Costs and expenses” as an operating expense.
6.
Loss on sale of marketable securities. This item should be reported as a separate component of income from continuing operations and not as an extraordinary item. The conditions of unusual in nature and infrequent in occurrence are not met.
7.
Loss on sale of warehouse. This type of item is specifically excluded by FASB ASC 225-20-45 from treatment as an extraordinary item unless such a loss is the direct result of a major casualty, an expropriation, or a prohibition under a newly enacted law or regulation. This item should be separately disclosed as an unusual item, if either unusual in nature or infrequent in occurrence.
8.
Federal Income taxes. The provision for federal income taxes and intraperiod tax allocation are not presented in the income statement. This omission implies that the federal income tax is a distribution of net income instead of an operating expense and a determinant of net income. This assumption is not as relevant to the majority of financial statement users as the concept of net income to investors, stockholders, or residual equity holders. Also, by law the corporation must pay federal income taxes whether the benefits it receives from the government are direct or indirect. Finally, those who base their decisions upon financial statements are thought to look to net income as being a more relevant measure of income than income before taxes.
CA 4-6 Classification
Rationale Error has “washed out”; that is, subsequent income statement compensated for the error. However, prior year income statements should be restated.
1.
No disclosure.
2.
Extraordinary item section.
Material, unusual in nature, and infrequent in occurrence.
3.
Depreciation expense in body of income statement, based on new useful life.
Material item, but change in estimated useful life is considered part of normal business activity.
4.
No separate disclosure unless material.
Change in estimate, considered part of normal business activity.
5.
Reported in body of the income statement, possibly as an unusual item.
Sale 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.
Reported in body of the income statement, possibly as an unusual item.
Loss on preparation of such proposals is not considered extraordinary in nature.
8.
Reported in body of the income statement, possibly as an unusual item.
Strikes are not considered extraordinary in nature.
9.
Prior period adjustment, adjust beginning retained earnings.
Corrections of errors are shown as prior period adjustments.
10.
Extraordinary item section.
Material, unusual in nature, and infrequent in occurrence.
11.
Discontinued operations section.
Division’s assets, results of operations, and activities are clearly distinguishable physically, operationally, and for financial reporting purposes.
CA 4-7 (a) Separate Statement . . . income components . . . Net income ......................................................................... Comprehensive Income Statement Net income ......................................................................... Unrealized gains................................................................. Comprehensive income ...................................................... (b) Combined Format . . . income components . . . Net income ......................................................................... Other comprehensive income Unrealized gains................................................................. Comprehensive income ...................................................... (c)
Current Year
Prior Year
$400,000
$410,000
$400,000 15,000 $415,000
$410,000
$400,000
$410,000
15,000 $415,000
$410,000
$410,000
Nelson can choose either approach, according to FASB ASC 220-10-45. The method chosen should be based on which one provides the most useful information. For example, Nelson should not choose the combined format because the gains result in an increasing trend in comprehensive income, while net income is declining.
FINANCIAL REPORTING PROBLEM (a) P&G uses the multiple-step income statement because it separates operating from nonoperating activities. A multiple-step income statement is used to recognize additional relationships related to revenues and expenses. P&G recognizes a separation of operating transactions from nonoperating transactions. As a result, trends in income from continuing operations should be easier to understand and analyze. Disclosure of operating income may assist in comparing different companies and assessing operating efficiencies. (b) P&G operates in the consumer products market. The company separates its operations into six global segments: (sales by segment) Fabric and Home Care, 30% Beauty, 24% Baby and Family Care, 19% Health Care, 14% Snacks and Pet Care, 4% Grooming, 9% (c) P&G’s gross profit (Net Sales – Cost of Products Sold) was $41,791 million in 2011, $41,019 million in 2010, and $38,004 million in 2009. P&G’s gross profit increased by 2% in 2011 compared to 2010. The gross profit percentage declined slightly from 2010 to 2011 due primarily to higher commodity and energy costs. (see MD&A). (d) P&G probably makes a distinction between operating and nonoperating revenue for the reasons mentioned in the solution to Part (a). By separating out these revenue and expense items, the statement reader can see the separate impacts of operating and financing activities. (e) P&G reports the following ratios in its 11-year “Financial Summary” section: Net earnings margin and Earnings and Dividends per share. The Financial Summary also reports income statement items, such as advertising and research and development expenses and operating income.
COMPARATIVE ANALYSIS CASE (a)
Both companies are using the multiple-step format in presenting income statement information. Companies use the multiple-step income statement to recognize additional relationships related to revenues and expenses. Both companies distinguish between operating and nonoperating transactions. As a result, trends in income from continuing operations should be easier to understand and analyze. Disclosure of operating income may assist in comparing different companies and assessing operating efficiencies. The Coca-Cola Company shows an additional intermediate component of income—gross profit. PepsiCo does not report this information on its income statement.
(b)
The gross profit, operating profit, and net income for these two companies are as follows: PepsiCo Net revenue ............ Cost of sales........... Gross profit ............
2011 $66,504 31,593 34,911
2010 $57,838 26,575 31,263
2009 $43,232 20,099 23,133
% Change 53.83% 57.19% 50.91%
Operating profit ......
9,633
8,332
8,004
20.35%
Net income..............
6,443
6,320
5,946
8.36%
Coca-Cola Sales ....................... Cost of sales........... Gross profit ............
2011 $46,542 18,216 28,326
2010 $35,119 12,693 22,426
2009 $30,990 11,088 19,902
% Change 50.18% 64.29% 42.33%
Operating income...
10,154
8,449
8,231
23.36%
Net income..............
$8,572
$11,809
$6,824
25.62%
As shown in the table above, however, Coca-Cola had greater growth in net income from 2009 to 2011. PepsiCo reported stronger growth in net sales over the three-year period. Both companies are doing well.
COMPARATIVE ANALYSIS CASE (Continued) (c)
Coca-Cola has reported gains on the equity transactions related to bottling operations. PepsiCo reported gains on its equity investments. PepsiCo provided the following disclosure for Items Affecting Comparability: ITEMS AFFECTING COMPARABILITY The year-over-year comparisons of our financial results are affected by the following items: 53rd Week In 2011, we had an additional week of results (53rd week), Our fiscal year ends on the last Saturday of each December, resulting in an additional week of results every five or six years. The 53rd week increased 2011 net revenue by $623 million and operating profit by $109 million ($64 million after-tax or $0.04 per share). Inventory Fair Value Adjustments In 2011, we recorded $46 million ($28 million after-tax or $0.02 per share) of incremental costs in cost of sales related to fair value adjustments to the acquired Inventory included in WBD’s balance sheet at the acquisition date and hedging contracts included in PBG’s and PAS’s balance sheets at the acquisition date. In 2010, we recorded $398 million ($333 million after-tax or $0.21 per share) of incremental costs related to fair value adjustments to the acquired inventory and other related hedging contracts included in PBG’s and PAS’s balance sheets at the acquisition date. Substantially all of these costs were recorded in cost of sales. Venezuela Currency Devaluation As of the beginning of our 2010 fiscal year, we recorded a one- time $120 million net charge related to our change to hyperinflationary accounting for our Venezuelan businesses and the related devaluation of the bolivar. $129 million of this net charge was recorded in corporate unallocated expenses, with the balance (income of $9 million) recorded in our PAB segment. In total, this net charge had an after-tax impact of $120 million or $0.07 per share.
COMPARATIVE ANALYSIS CASE (Continued) Asset Write- Off In 2010, we recorded a $145 million charge ($92 million after- tax or $0.06 per share) related to a change in scope of one release in our ongoing migration to SAP software. This change was driven, in part, by a review of our North America systems strategy following our acquisitions of PBG and PAS. This change does not impact our overall commitment to continue our Implementation of SAP across our global operations over the next few years. Foundation Contribution In 2010, we made a $100 million ($64 million after- tax or $0.04 per share) contribution to The PepsiCo Foundation, Inc., in order to fund charitable and social programs over the next several years. This contribution was recorded in corporate unallocated expenses. Debt Repurchase In 2010, we paid $672 million in a cash tender offer to repurchase $500 million (aggregate principal amount) of our 7.90% senior unsecured notes maturing in 2018. As a result of this debt repurchase, we recorded a $178 million charge to interest expense ($114 million after- tax or $0.07 per share), primarily representing the premium paid in the tender offer. Non-GAAP Measures Certain measures contained in this Annual Report are financial measures that are adjusted for items affecting comparability (see “Items Affecting Comparability” for a detailed list and description of each of these items), as well as, in certain instances, adjusted for foreign currency. These measures are not in accordance with Generally Accepted Accounting Principles (GAAP). Items adjusted for currency assume foreign currency exchange rates used for translation based on the rates in effect for the comparable prioryear period. In order to compute our constant currency results, we multiply or divide, as appropriate, our current year U.S. dollar results by the current year average foreign exchange rates and then multiply or divide, as appropriate, those amounts by the prior year average foreign exchange rates. We believe investors should consider these nonGAAP measures in evaluating our results as they are more indicative of
COMPARATIVE ANALYSIS CASE (Continued) our ongoing performance and with how management evaluates our operational results and trends. These measures are not, and should not be viewed as, a substitute for U.S. GAAP reporting measures. In the discussions of net revenue and operating profit below, effective net pricing reflects the year-over-year impact of discrete pricing actions, sales incentive activities and mix resulting from selling varying products in different package sizes and in different countries. Additionally, acquisitions and divestitures reflect all mergers and acquisitions activity, including the impact of acquisitions, divestitures and changes in ownership or control in consolidated subsidiaries and nonconsolidated equity investees. Servings Since our divisions each use different measures of physical unit volume (i.e., kilos, gallons, pounds and case sales), a common servings metric is necessary to reflect our consolidated physical unit volume. Our divisions' physical volume measures are converted into servings based on U.S. Food and Drug Administration guidelines for single- serving sizes of our products. In 2011, total servings increased 6% compared to 2010. Excluding the impact of the 53rd week, total servings increased 5% compared to 2010. In 2010, total servings increased 7% compared to 2009. 2011 servings growth reflects an adjustment to the base year (2010) for divestitures that occurred in 2011, as applicable.
FINANCIAL STATEMENT ANALYSIS CASE 1 (a)
Depending on the company chosen, student answers will vary. Given the ready availability, the analysis for Walgreens is provided below:
Z-Score Analysis Z = Working Capital Total Assets
X 1.2 + Retained Earnings X 1.4 + Total Assets
EBIT Sales X 3.3 + Total Assets Total Assets
X .99 +
MV Equity X 0.6 Total Liabilities
Walgreens ($ 000,000) 2011
2010
Total Assets
$27,454
$26,275
Current Assets
$12,322
$11,922
Current Liabilities
$ 8,083
$ 7,433
$ 4,239
$4,489
Multiple
0.154
0.171
$18,877
$16,848
0.688
0.641
$ 4,365
$ 3,458
0.159
0.132
$72,184
$67,420
2.629
2.566
MV Equity
$31,880
$26,159
Total Liabilities
$12,607
$11,875
Liabilities
2.529
Market Price (8/31/11)
Z-Score
Z-Score
2011
2010
1.2
0.1853
0.2050
1.4
0.9626
0.8977
3.3
0.525
0.434
0.99
2.603
2.540
2.203
0.6
1.517
1.323
35.21
26.88
Z-Score
5.793
5.400
(8/31/10) ycharts.com
905.42
973.18
Total Equity
$14,847
$14,400
Working Capital Working Capital/Assets Retained Earnings Retained Earnings/Assets EBIT EBIT/Assets Sales Sales/Assets
MV Equity/Total
FINANCIAL STATEMENT ANALYSIS CASE 1 (Continued) Deere & Co. ($ 000,000) Oct. 31,
Oct. 31,
2011
2010
Total Assets
48,207.4
43,266.8
Current Assets
38,816.7
33,366.8
Current Liabilities
17,720.5
14,364.0
21,096.20
19,002.80
Weights
0.438
0.439
1.2
0.526
0.527
14,519.4
12,353.1
0.301
0.286
1.4
0.421
0.400
$6,904.80
$5,661.90
0.143
0.131
3.3
0.472
0.432
29,466.1
23,573.2
0.611
0.545
0.99
0.605
0.540
MV Equity
$30,505.90
$32,552.45
Total Liabilities
41,392.50
36,963.40
0.737
0.881
0.6
0.442
0.529
2.466
2.426
Working Capital Working Capital/Assets Retained Earnings
Z-Score
Z-Score
2011
2010
Retained Earnings/ Assets EBIT EBIT/Assets Sales Sales/Assets
MV Equity*/Total Liabilities
Total *Market price X Shares Outstanding Market Price (10/31/11 and 10)
$73.70
$76.80
Share Outstanding
413.92
423.86
Total Equity
6,814.9
6,303.4
FINANCIAL STATEMENT ANALYSIS CASE 1 (Continued) (b)
Walgreens’ Z-score in 2011 has increased but is still well above the cutoff score for companies that are unlikely to fail. The company has improved on just about all components of the Z-score. Deere’s Z-score analysis indicates its likelihood of bankruptcy is more tenuous. Its value in 2011 is below the likely cutoff but above the very likely cutoff. The Z-score has increased slightly in 2011. Note to instructors—as an extension, students could be asked to conduct the analysis on companies which are in financial distress (e.g., Xerox) to examine whether their financial distress could have been predicted in advance.
(c)
EBIT is an operating income measure. By adding back items less relevant to predicting future operating results (interest, taxes), it is viewed as a better indicator of future profitability.
FINANCIAL STATEMENT ANALYSIS CASE 2 Earnings (loss) per common share Earnings from continuing operations ($97,700,000 ÷ 177,636,000)............................................ Discontinued operations........................................................ Earnings before extraordinary item ...................................... Extraordinary items................................................................ Net earnings ($56,100,000 ÷ 177,636,000) ..................... *$.01 rounding difference.
$0.55 (0.20) 0.35 (0.03)* $0.32
FINANCIAL STATEMENT ANALYSIS CASE 3 (a)
Assumptions and estimates related to items such as bad debt expense, warranties, or the useful lives or residual values for fixed assets could result in income being overstated.
(b)
See the table below. December 31, 2011 Tootsie Roll Hershey
(c)
Price $23.67 61.78
EPS $0.76 2.85
Sales per Share $ 9.13 $36.95
P/E 31.1 21.7
PSR 2.59 1.67
Tootsie Roll has a higher P/E relative to Hershey by 43%. Tootsie Roll’s PSR is also higher than Hershey’s but by much more than 30%. Thus, Tootsie Roll’s stock may be overpriced.
ACCOUNTING, ANALYSIS, AND PRINCIPLES
Accounting COUNTING CROWS, INC. Income Statement For the Year Ending December 31, 2014 Revenues Sales revenue Rent revenue Total revenues Expenses Cost of goods sold Selling expenses Administrative expenses Income tax expense Total expenses Income from continuing operations Discontinued operations Loss on discontinued operations Less: Applicable income tax reduction Income before extraordinary items Extraordinary items: Extraordinary gain Less: Applicable income tax Net income Per share of common stock: Income from continuing operations ($363,000 ÷ 100,000) Loss on discontinued operations, net of tax Income before extraordinary items ($313,500 ÷ 100,000) Extraordinary gain, net of tax Net income ($376,200 ÷ 100,000)
$1,900,000 40,000 1,940,000
850,000 300,000 240,000 187,000 1,577,000 363,000 $75,000 25,500
95,000 32,300
(49,500) 313,500
62,700 $ 376,200 $3.63 (0.50) 3.13 0.63 $3.76
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) COUNTING CROWS, INC. Retained Earnings Statement For the Year ended December 31, 2014 Retained earnings, January 1 $600,000 Net income 376,200 Dividends declared (80,000) Retained earnings, December 31 $896,200 COUNTING CROWS, INC. Statement of Comprehensive Income For the Year ended December 31, 2014 Net income $376,200 Other comprehensive income: Unrealized holding gain, net of tax 15,000 Comprehensive income $391,200 Analysis The multiple-step income statement recognizes important relationships between income statement elements. For example, by separating operating transactions from nonoperating transactions, the statement user can distinguish between elements with differing implications for future operating results. In addition, the multiple-step format generally groups costs and expenses with related revenues (e.g., cost of goods sold with sales revenue to yield a gross profit measure). Finally, the multiple-step format highlights certain intermediate components of income that analysts use to compute ratios for assessing the performance of the company. Principles Pro forma reporting is inconsistent with the conceptual framework’s qualitative characteristic of comparability. For example, similar to the discussion in the opening story, if Counting Crows Inc. classifies some items in a pro forma manner but other companies do not, investors and creditors will not be able to compare the reported incomes. This is the reason the SEC issued Regulation G, which requires companies that issue pro forma income reports to provide a reconciliation to net income measured under GAAP, which interested parties can then compare across companies.
PROFESSIONAL RESEARCH (a)
FASB ASC 220 – Presentation, Comprehensive Income. The predecessor standard for this topic is FAS No. 130 Reporting Comprehensive Income (Issued June, 1997). By following this Codification String: Presentation > 220 Comprehensive Income > 10 Overall > 5 Background and then click on Printer-Friendly with sources, FAS 130 is identified; you can then go to www.fasb.org/st/ to find the issue date.
(b)
The definition of comprehensive income (Master Glossary of ASC): The change in equity (net assets) of a business entity during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.
(c)
Classifications within net income and examples (FASB ASC 220-10-45-7): 45-7 [Items included in net income are displayed in various classifications. Those classifications can include income from continuing operations, discontinued operations and extraordinary items. This Subtopic does not change those classifications or other requirements for reporting results of operations.]
(d)
The classifications within other comprehensive income (220-10-45-13): 45-13 [Items included in other comprehensive income shall be classified based on their nature. For example, other comprehensive income shall be classified separately into foreign currency items, gains or losses associated with pension or other postretirement benefits, prior service costs or credits associated with pension or other postretirement benefits, transition assets or obligations associated with pension or other postretirement benefits, and unrealized gains and losses on certain investments in debt and equity securities. Additional classifications or additional items within current classifications may result from future accounting standards.
PROFESSIONAL RESEARCH (Continued) (e)
Reclassification adjustments (FASB ASC 220-10-45-15) 45-15 Reclassification adjustments shall be made to avoid double counting in comprehensive income items that are displayed as part of net income for a period that also had been displayed as part of other comprehensive income in that period or earlier periods. For example, gains on investment securities that were realized and included in net income of the current period that also had been included in other comprehensive income as unrealized holding gains in the period in which they arose must be deducted through other comprehensive income of the period in which they are included in net income to avoid including them in comprehensive income twice (see paragraph 320-10-40-2).
PROFESSIONAL SIMULATION Explanation As indicated in the income statement below, the loss on abandonment is reported as an “other expense and loss.” The gain on disposal of a business component is reported as part of discontinued operations, net of tax. The change in inventory costing from FIFO to average cost is a change in accounting principle. The cumulative effect of a change in accounting principle is adjusted through the beginning balance of retained earnings. Measurement Answers are revealed in the income statement below. JUDE LAW CORPORATION Income Statement For the Year Ended December 31, xxxx Sales............................................................................ $3,200,000 Cost of goods sold ..................................................... 1,920,000 Gross profit................................................................. 1,280,000 (a) Selling expenses ........................................................ $340,000 Administrative expenses ........................................... 280,000 620,000 Income from operations............................................. 660,000 Other revenues and gains Interest revenue................................................... 10,000 Other expenses and losses Loss from plant abandonment ........................... 40,000 (30,000) Income from continuing operations before income tax................................................ 630,000 (b) Income tax (30% X $630,000) ..................................... 189,000 Income from continuing operations.......................... 441,000 (c) Discontinued operations Gain on disposal of component of business .... 90,000 Less: Applicable income tax ............................. 27,000 63,000
PROFESSIONAL SIMULATION (Continued) Income before extraordinary item................................. Extraordinary item Loss from earthquake ........................................... 40,000 Less: Applicable income tax................................ 12,000 Net income...................................................................... Per share of common stock Income from continuing operations.......................... Discontinued operations, net of tax.......................... Income before extraordinary item............................. Extraordinary item, loss from earthquake, net of tax ... Net income..............................................................
504,000 28,000 $476,000 (d) $4.41 .63 5.04 (0.28) $4.76 (e)
Note to instructor: The change for inventory costing is reflected in the current year’s cost of goods sold. If comparative statements are presented, prior year’s income statements would be recast as under the new method. The cumulative effect of the change in accounting principle is shown as an adjustment to beginning retained earnings.
IFRS CONCEPTS AND APPLICATION
IFRS4-1 Companies are required to present an analysis of expenses classified either by their nature (such as cost of materials used, direct labor incurred, delivery expense, advertising expense, employee benefits, depreciation expense, and amortization expense) or their function (such as cost of goods sold, selling expenses, and administrative expenses).
IFRS4-2 (a)
A loss on discontinued operations is reported, net of tax in a separate section between income from continuing operations and net income.
(b)
Noncontrolling interest is reported as a separate item below net income or loss as an allocation of the net income or loss (not as an item of income or expense).
IFRS4-3 Bradshaw should report this item similar to other unusual gains and losses. While under U.S. GAAP, companies are required to report an item as extraordinary if it is unusual in nature and infrequent in occurrence, extraordinary item reporting is prohibited under IFRS.
IFRS4-4 Sales revenue ........................................................... Cost of goods sold................................................... Selling and administrative expenses .................... Gain on sale of plant assets ................................... Income from operations .......................................... Interest expense ....................................................... Income from continuing operations ...................... Discontinued operations......................................... Net income ................................................................
$310,000 140,000 50,000 30,000 150,000 6,000 144,000 (12,000) $132,000
(b)
Attributable to: Non-controlling interest ........................................ Controlling shareholders ......................................
(40,000) 92,000
(c)
Retained earnings, beginning of year.................. Net income............................................................... $132,000 Unrealized gain on non-trading equity 10,000 securities................................................................ Comprehensive income......................................... Dividends declared and paid................................. Retained earnings, end of year.............................
$
(a)
0
142,000 142,000 (5,000) $137,000
(d) (e)
IFRS4-5 (a)
Some of the differences are: 1. Units of currency—Avon reports in pounds sterling and Earnings per share in pence. 2. Terminology—Interest revenue and expense are referred to as “Finance Income” and “Finance costs”, and Avon uses the term “exceptional for unusual items. This should not be confused with the term “extraordinary” in U.S. GAAP. IFRS does not allow extraordinary item reporting. 3. Avon provides a breakout of operating profit into before exceptional items and exceptional items in 2010. The details for these items are explained in the footnotes (see http://www.avon-rubber.com/ corporate/reports/Avon_Rubber_Report_Account_11.pdf). They are comprised of such items as profit on disposal of fixed assets and fixed asset impairments.
IFRS4-5 (Continued) (b)
Both the “Exceptional items” and the “Discontinued operations” are example of irregular items. As in the U.S., these items are included in the measurement of income but they are separate from “Operating Profit”, likely due to their non-recurring nature. IFRS companies also report interest revenue and expense under a separate heading in the income statement. This distinguishes income from the operating and financing activities of the company.
IFRS4-6 (a)
International Accounting Standard 1, Presentation of Financial Statements addresses the statement of comprehensive income reporting. This standard was issued in September 2007 and includes subsequent amendments resulting from IFRSs issued up to 30 November 2008. Its effective date is 1 January 2009.
(b)
Total comprehensive income is the change in equity during a period resulting from transactions and other events, other than those changes resulting from transactions with owners in their capacity as owners. Total comprehensive income comprises all components of ‘profit or loss’ and of ‘other comprehensive income’ (Paragraph 7).
(c)
Paragraphs 85 and 86 provide the rationale for presenting additional information: An entity shall present additional line items, headings and subtotals in the statement of comprehensive income and the separate income statement (if presented), when such presentation is relevant to an understanding of the entity’s financial performance (Para. 85).
IFRS4-6 (Continued) Because the effects of an entity’s various activities, transactions and other events differ in frequency, potential for gain or loss and predictability, disclosing the components of financial performance assists users in understanding the financial performance achieved and in making projections of future financial performance. An entity includes additional line items in the statement of comprehensive income and in the separate income statement (if presented), and it amends the descriptions used and the ordering of items when this is necessary to explain the elements of financial performance. An entity considers factors including materiality and the nature and function of the items of income and expense. For example, a financial institution may amend the descriptions to provide information that is relevant to the operations of a financial institution. An entity does not offset income and expense items unless the criteria in paragraph 32 are met (Para. 86). (d)
When items of income or expense are material, an entity shall disclose their nature and amount separately (Para. 97). Circumstances that would give rise to the separate disclosure of items of income and expense include: a. write-downs of inventories to net realisable value or of property, plant and equipment to recoverable amount, as well as reversals of such write-downs; b. restructurings of the activities of an entity and reversals of any provisions for the costs of restructuring; c. disposals of items of property, plant and equipment; d. disposals of investments; e. discontinued operations; f. litigation settlements; and g. other reversals of provisions. (Para. 98).
IFRS4-7 (a)
M&S uses a condensed format income statement. This format provides highlights of a company’s performance without presenting unnecessary detailed computations.
(b)
M&S’s primary revenue sources are from General merchandise (£4,195.1m) and from Food (£4,673.1m).
(c)
M&S’s gross profit was £3,724.7m in 2011 and increased to £3,755.2m in 2012. Gross profit increased in 2012 because Revenue increased £194m while cost of sales increased only £163.5m.
(d)
M&S reports operating profit separately from nonoperating profit because nonoperating profit is non-recurring and not expected to arise in the future. In order to make valid comparisons between companies and years, nonoperating must be reported separately from operating profit.
(e)
M&S did report Non-GAAP measures. The adjusted profit and earnings per share measures provide additional useful information for shareholders on the underlying performance of the business. M&S provided the following disclosure: Non-GAAP performance measures The directors believe that the underlying profit and earnings per share measures provide additional useful information for shareholders on the underlying performance of the business. These measures are consistent with how underlying business performance is measured internally. The underlying profit before tax measure is not a recognised profit measure under IFRS and may not be directly comparable with adjustment profit measures used by other companies. The adjustments made to reported profit before tax are to exclude the following: —profits and losses on the disposal of properties; —significant and one-off impairment charges that distort underlying trading; —costs relating to strategy changes that are not considered normal operating costs of the underlying business; —one-off pension credits arising on changes of the defined benefit pension scheme rules; and —non-cash fair value movements in financial instruments.
CHAPTER 5 Balance Sheet and Statement of Cash Flows ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics
Questions
1.
Disclosure principles, uses of the balance sheet, financial flexibility.
1, 2, 3, 4, 5, 6, 7, 10, 18, 21, 30, 31
2.
Classification of items in the balance sheet and other financial statements.
11, 12, 13, 14, 15, 16, 18, 19
3.
Preparation of balance sheet; issues of format, terminology, and valuation.
4, 7, 8, 9, 16, 17, 20, 29, 32
4.
Statement of cash flows.
21, 22, 23, 24, 25, 26, 27, 28
Brief Exercises
Exercises
Problems
Concepts for Analysis 3, 4
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11
12, 13, 14, 15, 16
1, 2, 3, 8, 9, 10
1, 2
4, 5, 6, 7, 11, 12, 17
1, 2, 3, 4, 5, 6, 7
2, 3, 4
13, 14, 15, 16, 17, 18
6, 7
5
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Brief Exercises
Exercises
Problems
Learning Objectives
Questions
1.
Explain the uses and limitations of a balance sheet.
1, 2, 3, 4, 5, 6, 7, 18
2.
Identify the major classifications of the balance sheet.
6, 8, 9,11, 12, 13, 14, 15, 16, 17, 18, 19
3.
Prepare a classified balance sheet using the report and account formats.
9, 10, 14, 20
4.
Indicate the purpose of the statement of cash flows.
21
5.
Identify the content of the statement of cash flows.
22, 23, 24, 26
6.
Prepare a basic statement of cash flows.
25
12, 13, 14, 15
14, 15, 16, 17, 18
6, 7
7.
Understand the usefulness of the statement of cash flows.
26, 27, 28
12, 16
15, 16, 18
6, 7
8.
Determine which balance sheet information requires supplemental disclosure.
30, 31, 32
9.
Describe the major disclosure techniques for the balance sheet.
29
7
1, 2, 3, 4, 6, 8, 9, 10 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11
1, 2, 3, 4, 5, 6, 7, 9, 10, 11, 12, 17
Concepts for Analysis CA5-2, CA5-3 CA5-2, CA5-3
1, 2, 3, 4, 5, 6, 7
CA5-1
CA5-4
13
CA5-4, CA5-5
4
ASSIGNMENT CHARACTERISTICS TABLE Level of Difficulty
Time (minutes)
Balance sheet classifications. Classification of balance sheet accounts. Classification of balance sheet accounts. Preparation of a classified balance sheet. Preparation of a corrected balance sheet. Corrections of a balance sheet. Current assets section of the balance sheet. Current vs. long-term liabilities. Current assets and current liabilities. Current liabilities. Balance sheet preparation. Preparation of a balance sheet. Statement of cash flows—classifications. Preparation of a statement of cash flows. Preparation of a statement of cash flows. Preparation of a statement of cash flows. Preparation of a statement of cash flows and a balance sheet. Preparation of a statement of cash flows, analysis.
Simple Simple Simple Simple Simple Complex Moderate Moderate Complex Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate
15–20 15–20 15–20 30–35 30–35 30–35 15–20 10–15 30–35 15–20 25–30 30–35 15–20 25–35 25–35 25–35 30–35
Moderate
25–35
Preparation of a classified balance sheet, periodic inventory. Balance sheet preparation. Balance sheet adjustment and preparation. Preparation of a corrected balance sheet. Balance sheet adjustment and preparation. Preparation of a statement of cash flows and a balance sheet. Preparation of a statement of cash flows and balance sheet.
Moderate
30–35
Moderate Moderate Complex Complex Complex
35–40 40–45 40–45 40–45 35–45
Complex
40–50
Reporting for financial effects of varied transactions. Identifying balance sheet deficiencies. Critique of balance sheet format and content. Presentation of property, plant, and equipment. Cash flow analysis.
Moderate Moderate Simple Simple Complex
20–25 20–25 20–25 20–25 40–50
Item
Description
E5-1 E5-2 E5-3 E5-4 E5-5 E5-6 E5-7 E5-8 E5-9 E5-10 E5-11 E5-12 E5-13 E5-14 E5-15 E5-16 E5-17 E5-18 P5-1 P5-2 P5-3 P5-4 P5-5 P5-6 P5-7
CA5-1 CA5-2 CA5-3 CA5-4 CA5-5
SOLUTIONS TO CODIFICATION EXERCISES CE5-1 (a) Current assets is used to designate cash and other assets or resources commonly identified as those that are reasonably expected to be realized in cash or sold or consumed during the normal operating cycle of the business. (b) Intangible assets are assets (not including financial assets) that lack physical substance. (The term intangible assets is used to refer to intangible assets other than goodwill.) Clicking on the first link yields the following FASB ASC string: 350 Intangibles—Goodwill and Other > 10 Overall. (c) Cash equivalents are short-term, highly liquid investments that have both of the following characteristics: a.
Readily convertible to known amounts of cash
b.
So near their maturity that they present insignificant risk of changes in value because of changes in interest rates.
Generally, only investments with original maturities of three months or less qualify under that definition. Original maturity means original maturity to the entity holding the investment. For example, both a three-month U.S. Treasury bill and a three-year Treasury note purchased three months from maturity qualify as cash equivalents. However, a Treasury note purchased three years ago does not become a cash equivalent when its remaining maturity is three moths. Examples of items commonly considered to be cash equivalents are Treasury bills, commercial paper, money market funds, and federal funds sold (for an entity with banking operations). (d) Financing activities include obtaining resources from owners and providing them with a return on, and a return of, their investment; receiving restricted resources that by donor stipulation must be used for long-term purposes; borrowing money and repaying amounts borrowed, or otherwise settling the obligation; and obtaining and paying for other resources obtained from creditors on long-term credit.
CE5-2 See FASC ASC 210-10-45 (Other Presentation Matters) Classification of Current Liabilities 45-5 A
Total of current liabilities shall be presented in classified balance sheets.
45-6
The concept of current liabilities shall include estimated or accrued amounts that are expected to be required to cover expenditures within the year for known obligations the amount of which can be determined only approximately (as in the case of provisions for accruing bonus payments) or where the specific person or persons to whom payment will be made cannot as yet be designated (as in the case of estimated costs to be incurred in connection with guaranteed servicing or repair of products already sold).
CE5-2 (Continued) 45-7
Section 470-10-45 includes guidance on various debt transactions that may result in current liability classification. These transactions are the following: a. b. c.
Due on demand loan agreements Callable debt agreements Short-term obligations expected to be refinanced.
CE5-3 The following discussion is provided at 235-10-50 Disclosure > Accounting Policies Disclosure 50-1
Information about the accounting policies adopted by an entity is essential for financial statement users. When financial statements are issued purporting to present fairly financial position, cash flows, and results of operations in accordance with generally accepted accounting principles (GAAP), a description of all significant accounting policies of the entity shall be included as an integral part of the financial statements. In circumstances where it may be appropriate to issue one or more of the basic financial statements without the others, purporting to present fairly the information given in accordance with GAAP, statements so presented also shall include disclosure of the pertinent accounting policies.
> Accounting Policies Disclosure in Interim Periods 50-2
The provisions of the preceding paragraph are not intended to apply to unaudited financial statements issued as of a date between annual reporting dates (for example, each quarter) if the reporting entity has not changed its accounting policies since the end of its preceding fiscal year.
> What to Disclose 50-3
Disclosure of accounting policies shall identify and describe the accounting principles followed by the entity and the methods of applying those principles that materially affect the determination of financial position, cash flows, or results of operations. In general, the disclosure shall encompass important judgments as to appropriateness of principles relating to recognition of revenue and allocation of asset costs to current and future periods; in particular, it shall encompass those accounting principles and methods that involve any of the following: a. b. c.
A selection from existing acceptable alternatives Principles and methods peculiar to the industry in which the entity operations, even if such principles and methods are predominantly followed in that industry Unusual or innovative applications of GAAP.
> Examples of Disclosures 50-4
Examples of disclosures by an entity commonly required with respect to accounting policies would include, among others, those relating to the following: a. b.
Basis of consolidation Depreciation methods
CE5-3 (Continued) c. d. e. f.
Amortization of intangibles Inventory pricing Accounting for recognition of profit on long-term construction-type contracts Recognition of revenue from franchising and leasing operations.
> Avoid Duplicate Details of Disclosures 50-5
Financial statement disclosure of accounting policies shall not duplicate details (for example, composition of inventories or of plant assets) presented elsewhere as part of the financial statements. In some cases, the disclosure of accounting policies shall refer to related details presented elsewhere as part of the financial statements; for example, changes in accounting policies during the period shall be described with cross-reference to the disclosure required by Topic 250.
> Format 50-6
This Subtopic recognizes the need for flexibility in matters of format (including the location) of disclosure of accounting policies provided that the entity identifies and describes its significant accounting policies as an integral part of its financial statements in accordance with the provisions of this Subtopic. Disclosure is preferred in a separate summary of significant accounting policies preceding the notes to financial statements, or as the initial note, under the same or a similar title.
CE5-4 The following section: 230-10-05 Overview and Background provides a discussion of the objectives for the Statement of Cash Flows. 05-1
The Statement of Cash Flows Topic presents standards for reporting cash flows in generalpurpose financial statements.
05-2
Specific guidance is provided on all of the following: a. b. c. d.
Classifying in the statement of cash flows of cash receipts and payments as either operating, investing, or financing activities Applying the direct method and the indirect method of reporting cash flows Presenting the required information about noncash investing and financing activity and other events Classifying cash receipts and payments related to hedging activities.
230-10-10 Objectives 10-1
The primary objective of a statement of cash flows is to provide relevant information about the cash receipts and cash payments of an entity during a period.
CE5-4 (Continued) 10-2
The information provided in a statement of cash flows, if used with related disclosures and information in the other financial statements, should help investors, creditors, and others (including donors) to do all of the following: a. b. c. d.
Assess the entity’s ability to generate positive future net cash flows Assess the entity’s ability to meet its obligations, its ability to pay dividends, and its needs for external financing Assess the reasons for differences between net income and associated cash receipts and payments Assess the effects on an entity’s financial position of both its cash and noncash investing and financing transactions during the period.
ANSWERS TO QUESTIONS 1. The balance sheet provides information about the nature and amounts of investments in enterprise resources, obligations to enterprise creditors, and the owners’ equity in net enterprise resources. That information not only complements information about the components of income, but also contributes to financial reporting by providing a basis for (1) computing rates of return, (2) evaluating the capital structure of the enterprise, and (3) assessing the liquidity and financial flexibility of the enterprise. 2. Solvency refers to the ability of an enterprise to pay its debts as they mature. For example, when a company carries a high level of long-term debt relative to assets, it has lower solvency. Information on long-term obligations, such as long-term debt and notes payable, in comparison to total assets can be used to assess resources that will be needed to meet these fixed obligations (such as interest and principal payments). 3. Financial flexibility is the ability of an enterprise to take effective actions to alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities. An enterprise with a high degree of financial flexibility is better able to survive bad times, to recover from unexpected setbacks, and to take advantage of profitable and unexpected investment opportunities. Generally, the greater the financial flexibility, the lower the risk of enterprise failure. 4. Some situations in which estimates affect amounts reported in the balance sheet include: (a) allowance for doubtful accounts. (b) depreciable lives and estimated salvage values for plant and equipment. (c) warranty returns. (d) determining the amount of revenues that should be recorded as unearned. When estimates are required, there is subjectivity in determining the amounts. Such subjectivity can impact the usefulness of the information by reducing the faithful representation of the measures, either because of bias or lack of verifiability. 5. An increase in inventories increases current assets, which is in the numerator of the current ratio. Therefore, inventory increases will increase the current ratio. In general, an increase in the current ratio indicates a company has better liquidity, since there are more current assets relative to current liabilities. Note to instructors—When inventories increase faster than sales, this may not be a good signal about liquidity. That is, inventory can only be used to meet current obligations when it is sold (and converted to cash). That is why some analysts use a liquidity ratio—the acid-test ratio—that excludes inventories from current assets in the numerator. 6. Liquidity describes the amount of time that is expected to elapse until an asset is converted into cash or until a liability has to be paid. The ranking of the assets given in order of liquidity is: (1) (d) Short-term investments. (2) (e) Accounts receivable. (3) (b) Inventory. (4) (c) Buildings. (5) (a) Goodwill. 7. The major limitations of the balance sheet are: (a) The values stated are generally historical and not at fair value. (b) Estimates have to be used in many instances, such as in the determination of collectibility of receivables or finding the approximate useful life of long-term tangible and intangible assets. (c) Many items, even though they have financial value to the business, presently are not recorded. One example is the value of a company’s human resources.
Questions Chapter 5 (Continued) 8. Some items of value to technology companies such as Intel or IBM are the value of research and development (new products that are being developed but which are not yet marketable), the value of the “intellectual capital” of its workforce (the ability of the companies’ employees to come up with new ideas and products in the fast changing technology industry), and the value of the company reputation or name brand (e.g., the “Intel Inside” logo). In most cases, the reasons why the value of these items are not recorded in the balance sheet concern the lack of faithful representation of the estimates of the future cash flows that will be generated by these “assets” (for all three types) and the ability to control the use of the asset (in the case of employees). Being able to reliably measure the expected future benefits and to control the use of an item are essential elements of the definition of an asset, according to the Conceptual Framework. 9. Classification in financial statements helps users by grouping items with similar characteristics and separating items with different characteristics. Current assets are expected to be converted to cash within one year or the operating cycle, whichever is longer—property, plant and equipment will provide cash inflows over a longer period of time. Thus, separating long-term assets from current assets facilitates computation of useful ratios such as the current ratio. 10. Separate amounts should be reported for accounts receivable and notes receivable. The amounts should be reported gross, and an amount for the allowance for doubtful accounts should be deducted. The amount and nature of any nontrade receivables, and any amounts designated or pledged as collateral, should be clearly identified. 11. No. Available-for-sale securities should be reported as a current asset only if management expects to convert them into cash as needed within one year or the operating cycle, whichever is longer. If available-for-sale securities are not held with this expectation, they should be reported as longterm investments. 12. The relationship between current assets and current liabilities is that current liabilities are those obligations that are reasonably expected to be liquidated either through the use of current assets or the creation of other current liabilities. 13. The total selling price of the season tickets is $20,000,000 (10,000 X $2,000). Of this amount, $8,000,000 has been earned by 12/31/14 (16/40 X $20,000,000). The remaining $12,000,000 should be reported as unearned revenue, a current liability in the 12/31/14 balance sheet (24/40 X $20,000,000). 14. Working capital is the excess of total current assets over total current liabilities. This excess is sometimes called net working capital. Working capital represents the net amount of a company’s relatively liquid resources. That is, it is the liquidity buffer available to meet the financial demands of the operating cycle. 15. (a) (b) (c) (d) (e) (f) (g) (h) (i)
Stockholders’ Equity. “Treasury stock (at cost).” Note: This is a reduction of total stockholders’ equity (reported as contra-equity). Current Assets. Included in “Cash.” Long-Term Investments. “Land held as an investment.” Long-Term Investments. “Sinking fund.” Long-term debt (adjunct account to bonds payable). “Unamortized premium on bonds payable.” Intangible Assets. “Copyrights.” Investments. “Employees’ pension fund,” with subcaptions of “Cash” and “Securities” if desired. (Assumes that the company still owns these assets.) Stockholders’ Equity. “Additional paid-in capital.” Investments. Nature of investments should be given together with parenthetical information as follows: “pledged to secure loans payable to banks.”
Questions Chapter 5 (Continued) 16. (a) (b) (c) (d) (e) (f) (g) (h) (i)
Allowance for doubtful accounts should be deducted from accounts receivable in current assets. Merchandise held on consignment should not appear on the consignee’s balance sheet except possibly as a note to the financial statements. Advances received on sales contract are normally a current liability and should be shown as such in the balance sheet. Cash surrender value of life insurance should be shown as a long-term investment. Land should be reported in property, plant, and equipment unless held for investment. Merchandise out on consignment should be shown among current assets under the heading of inventory. Franchises should be itemized in a section for intangible assets. Accumulated depreciation of plant and equipment should be deducted from the equipment account. Materials in transit should not be shown on the balance sheet of the buyer, if purchased f.o.b. destination.
17. (a) Trade accounts receivable should be stated at their estimated amount collectible, often referred to as net realizable value. The method most generally followed is to deduct from the total accounts receivable the amount of the allowance for doubtful accounts. (b) Land is generally stated in the balance sheet at cost. (c) Inventories are generally stated at the lower of cost or market. (d) Trading securities (consisting of common stock of other companies) are stated at fair value. (e) Prepaid expenses should be stated at cost less the amount apportioned to and written off over the previous accounting periods. 18. Assets are defined as probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. If a building is leased under a capital lease, the future economic benefits of using the building are controlled by the lessee (tenant) as the result of a past event (the signing of a lease agreement). 19. Battle is incorrect. Retained earnings is a source of assets, but is not an asset itself. For example, even though the funds obtained from issuing a note payable are invested in the business, the note payable is not reported as an asset. It is a source of assets, but it is reported as a liability because the company has an obligation to repay the note in the future. Similarly, even though the earnings are invested in the business, retained earnings is not reported as an asset. It is reported as part of shareholders’ equity because it is, in effect, an investment by owners which increases the ownership interest in the assets of an entity. 20. The notes should appear as long-term liabilities with full disclosure as to their terms. Each year, as the profit is determined, notes of an amount equal to two-thirds of the year’s profits should be transferred from the long-term liabilities to current liabilities until all of the notes have been liquidated. 21. The purpose of a statement of cash flows is to provide relevant information about the cash receipts and cash payments of an enterprise during a period. It differs from the balance sheet and the income statement in that it reports the sources and uses of cash by operating, investing, and financing activity classifications. While the income statement and the balance sheet are accrual basis statements, the statement of cash flows is a cash basis statement—noncash items are omitted. 22. The difference between these two amounts may be due to increases in current assets (e.g., an increase in accounts receivable from a sale on account would result in an increase in revenue and net income but have no effect yet on cash). Similarly a cash payment that results in a decrease in an existing current liability (e.g., accounts payable would decrease cash provided by operations without affecting net income).
Questions Chapter 5 (Continued) 23. The difference between these two amounts could be due to noncash charges that appear in the income statement. Examples of noncash charges are depreciation, depletion, and amortization of intangibles. Expenses recorded but unpaid (e.g., increase in accounts payable) and collection of previously recorded sales on credit (i.e., now decreasing accounts receivable) also would cause cash provided by operating activities to exceed net income. 24. Operating activities involve the cash effects of transactions that enter into the determination of net income. Investing activities include making and collecting loans and acquiring and disposing of debt and equity instruments; property, plant, and equipment and intangibles. Financing activities involve long-term liability and stockholders’ equity items and include obtaining capital from owners and providing them with a return on (dividends) and a return of their investment and borrowing money from creditors and repaying the amounts borrowed. 25. (a)
Net income is adjusted downward by deducting $5,000 from $90,000 and reporting cash provided by operating activities as $85,000.
(b)
The issuance of the preferred stock is a financing activity. The issuance is reported as follows: Cash flows from financing activities Issuance of preferred stock ............................................................ $1,150,000
(c)
Net income is adjusted as follows: Cash flows from operating activities Net income .......................................................................................... Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ..................................................................... Bond premium amortization ............................................................ Net cash provided by operating activities .............................................
(d)
$90,000 14,000 (5,000) $99,000
The increase of $20,000 reflects an investing activity. The increase in Land is reported as follows: Cash flows from investing activities: Purchase Land ............................................................................... $(20,000)
26. The company appears to have good liquidity and reasonable financial flexibility. Its current cash $1,200,000 debt coverage is 1.20 , which indicates that it can pay off its current liabilities in a $1,000,000 given year from its operations. In addition, its cash debt coverage is also good at $1,200,000 0.80 , which indicates that it can pay off approximately 80% of its debt out of current $1,500,000 operations. 27. Free cash flow = $860,000 – $75,000 – $30,000 = $755,000. 28. Free cash flow is net cash provided by operating activities less capital expenditures and dividends. The purpose of free cash flow analysis is to determine the amount of discretionary cash flow a company has for purchasing additional investments, retiring its debt, purchasing treasury stock, or simply adding to its liquidity and financial flexibility.
Questions Chapter 5 (Continued) 29. Some of the techniques of disclosure for the balance sheet are: (a) Parenthetical explanations. (b) Notes to the financial statements. (c) Cross references and contra items. (d) Supporting schedules. 30. A note entitled “Summary of Significant Accounting Policies” would indicate the basic accounting principles used by that enterprise. This note should be very useful from a comparative standpoint, since it should be easy to determine whether the company uses the same accounting policies as other companies in the same industry. 31. General debt obligations, lease contracts, pension arrangements and stock option plans are four items for which disclosure is mandatory in the financial statements. The reason for disclosing these contractual situations is that these commitments are of a long-term nature, are often significant in amount, and are very important to the company’s well-being. 32. The profession has recommended that the use of the term “surplus” be discontinued in balance sheet presentations of stockholders’ equity. This term has a connotation outside accounting that is quite different from its meaning in the accounts or in the balance sheet. The use of the terms capital surplus, paid-in surplus, and earned surplus is confusing to the nonaccountant and leads to misinterpretation.
SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 5-1 Current assets Cash ................................................................... Accounts receivable ......................................... Less: Allowance for doubtful accounts..... Inventory............................................................ Prepaid insurance............................................. Total current assets ..............................
$ 30,000 $110,000 8,000
102,000 290,000 9,500 $431,500
BRIEF EXERCISE 5-2 Current assets Cash ................................................................... Equity Investments (Trading)........................... Accounts receivable ......................................... Less: Allowance for doubtful accounts..... Inventory............................................................ Prepaid insurance............................................. Total current assets ..............................
$ $90,000 4,000
7,000 11,000
86,000 30,000 5,200 $139,200
BRIEF EXERCISE 5-3 Long-term investments Debt investments .............................................. Land held for investment ................................. Note receivables (long-term)............................ Total investments........................................
$ 56,000 39,000 42,000 $137,000
BRIEF EXERCISE 5-4 Property, plant, and equipment Land ................................................................... Buildings............................................................ Less: Accumulated depreciation ............... Equipment ......................................................... Less: Accumulated depreciation .............. Timberland......................................................... Total property, plant, and equipment.....
$ 71,000 $207,000 45,000 $190,000 19,000
162,000 171,000 70,000 $474,000
BRIEF EXERCISE 5-5 Intangible assets Goodwill............................................................. Patents ............................................................... Franchises ......................................................... Total intangible assets................................
$150,000 220,000 130,000 $500,000
BRIEF EXERCISE 5-6 Intangible assets Goodwill............................................................. Franchises ......................................................... Patents ............................................................... Trademarks........................................................ Total intangible assets................................
$ 50,000 47,000 33,000 10,000 $140,000
BRIEF EXERCISE 5-7 Current liabilities Notes payable.................................................... Accounts payable ............................................. Salaries and wages payable ............................. Income taxes payable ....................................... Total current liabilities ..........................
$ 22,500 72,000 4,000 7,000 $105,500
BRIEF EXERCISE 5-8 Current liabilities Accounts payable ............................................. Unearned rent revenue ..................................... Salaries and wages payable............................. Interest payable................................................. Income tax payable ........................................... Total current liabilities ..........................
$220,000 41,000 27,000 12,000 29,000 $329,000
BRIEF EXERCISE 5-9 Long-term liabilities Bonds payable .................................................. Less: Discount on bonds payable ............. Pension liability................................................. Total long-term liabilities ......................
$400,000 29,000
$371,000 375,000 $746,000
BRIEF EXERCISE 5-10 Stockholders’ equity Common stock .................................................. Paid-in capital in excess of par ........................ Retained earnings ............................................. Accumulated other comprehensive loss......... Stockholders’ equity – Hawthorn Corporation ..................................................... Noncontrolling interest..................................... Total stockholders’ equity..........................
$750,000 200,000
$950,000 120,000 (150,000) 920,000 35,000 $955,000
BRIEF EXERCISE 5-11 Stockholders’ equity Preferred stock.................................................. Common stock .................................................. Additional paid-in capital.................................. Retained earnings ............................................. Stockholders’ equity – Stowe Company.......... Noncontrolling interest..................................... Total stockholders’ equity ..........................
$152,000 55,000 174,000 114,000 495,000 63,000 $558,000
BRIEF EXERCISE 5-12 Cash Flow Statement Operating Activities Net income .......................................................... Depreciation expense......................................... Increase in accounts receivable........................ Increase in accounts payable ............................ Net cash provided by operating activities .....
$40,000 $ 4,000 (10,000) 7,000
Investing Activities Purchase of equipment ...................................... Financing Activities Issue notes payable ........................................... Property dividends ............................................. Net cash flow from financing activities....... Net increase in cash ($41,000 – $8,000 + $15,000).....
1,000 41,000
(8,000) $20,000 (5,000) 15,000 $48,000
Free Cash Flow = $41,000 (Net cash provided by operating activities) – $8,000 (Purchase of equipment) – $5,000 (Dividends) = $28,000.
BRIEF EXERCISE 5-13 Cash flows from operating activities Net income.......................................................... Adjustments to reconcile net income to net cash provided by operating activities Depreciation expense .................................. Increase in accounts payable...................... Increase in accounts receivable.................. Net cash provided by operating activities ........
$151,000 $44,000 9,500 (13,000)
40,500 $191,500
BRIEF EXERCISE 5-14 Sale of land and building ......................................... Purchase of land ...................................................... Purchase of equipment............................................ Net cash provided by investing activities ........
$191,000 (37,000) (53,000) $101,000
BRIEF EXERCISE 5-15 Issuance of common stock ..................................... Purchase of treasury stock ..................................... Payment of cash dividend ....................................... Retirement of bonds ................................................ Net cash used by financing activities ...............
$147,000 (40,000) (95,000) (100,000) $ (88,000)
BRIEF EXERCISE 5-16 Free Cash Flow Analysis Net cash provided by operating activities.............. Purchase of equipment ............................... Purchase of land*......................................... Dividends...................................................... Free cash flow ..........................................................
$400,000 (53,000) (37,000) (95,000) $215,000
*If the land were purchased as an investment, it would be excluded in the computation of free cash flow.
SOLUTIONS TO EXERCISES EXERCISE 5-1 (15–20 minutes) (a)
If the equity investment (preferred stock) is readily marketable and held primarily for sale in the near term to generate income on shortterm price differences, then the account should appear as a current asset and be included with trading securities. If, on the other hand, the preferred stock is not a trading security, it should be classified as available-for-sale. Available-for-sale securities are classified as current or noncurrent depending upon the circumstances.
(b)
If the company accounts for the treasury stock on the cost basis, the account should properly be shown as a reduction of total stockholders’ equity.
(c)
Stockholders’ equity.
(d)
Current liability.
(e)
Property, plant, and equipment (as a deduction).
(f)
If the warehouse in process of construction is being constructed for another party, it is properly classified as an inventory account in the current assets section. This account will be shown net of any billings on the contract. On the other hand, if the warehouse is being constructed for the use of this particular company, it should be classified as a separate item in the property, plant, and equipment section.
(g)
Current asset.
(h)
Current liability.
(i)
Retained earnings.
EXERCISE 5-1 (Continued) (j)
Current asset.
(k)
Current liability.
(l)
Current liability.
(m)
Current asset (inventory).
(n)
Current liability.
EXERCISE 5-2 (15–20 minutes) 1. 2. 3. 4. 5 6. 7. 8. 9. 10.
h. d. f. f. c. a. f. g. a. a.
11. 12. 13. 14. 15. 16. 17. 18. 19. 20.
b. f. a. h. c. b. a. a. g. f.
EXERCISE 5-3 (15–20 minutes) 1. 2. 3. 4. 5 6. 7. 8. 9.
a. b. f. a. f. h. i. d. a.
10. 11. 12. 13. 14. 15. 16. 17. 18.
f. a. f. a. or e. (preferably a.) c. and N. f. X. f. c.
EXERCISE 5-4 (30–35 minutes) Denis Savard Inc. Balance Sheet December 31, 20– Assets Current assets Cash ............................................................ Less: Cash restricted for plant expansion........................................... Accounts receivable .................................. Less: Allowance for doubtful accounts............................................. Notes receivable......................................... Receivables—officers ................................ Inventories Finished goods ..................................... Work in process ................................... Raw materials ....................................... Total current assets........................ Long-term investments Preferred stock investments ..................... Land held for future plant site ................... Restricted cash (plant expansion) ............ Total long-term investments.......... Property, plant, and equipment Buildings..................................................... Less: Accum. depreciation— buildings ............................................ Intangible assets Copyrights .................................................. Total assets..........................................
$XXX XXX XXX
$XXX
XXX
XXX XXX XXX
XXX XXX XXX
XXX $XXX
XXX XXX XXX XXX
XXX XXX
XXX
XXX $XXX
EXERCISE 5-4 (Continued) Liabilities and Stockholders’ Equity Current liabilities Salaries and wages payable .......................... Notes payable, short-term ............................. Unearned subscriptions revenue .................. Unearned rent revenue................................... Total current liabilities .............................
$XXX XXX XXX XXX $XXX
Long-term debt Bonds payable, due in four years ................. Less: Discount on bonds payable................. Total liabilities........................................... Stockholders’ equity Capital stock: Common stock.......................................... Additional paid-in capital: Paid-in capital in excess of par (common stock) ...................................... Total paid-in capital ............................ Retained earnings .......................................... Total paid-in capital and retained earnings............................. Less: Treasury stock, at cost ................. Equity attributable to Denis Savard, Inc. ...... Equity attributed to noncontrolling interest . Total stockholders’ equity ................. Total liabilities and stockholders’ equity ........................
$XXX (XXX)
XXX XXX
XXX
XXX XXX XXX XXX (XXX) XXX XXX XXX $XXX
Note to instructor: An assumption made here is that cash included the restricted cash for plant expansion. If it did not, then a subtraction from cash would not be necessary or the cash balance would be “grossed up” and then the restricted cash for plant expansion deducted.
EXERCISE 5-5 (30–35 minutes) Uhura Company Balance Sheet December 31, 2014 Assets Current assets Cash ........................................................ Equity investments (trading) ................. Accounts receivable .............................. Less: Allowance for doubtful accounts......................................... Inventory, at lower-of-average
$230,000 120,000 $357,000 17,000
cost-or-market ..................................... Prepaid expenses................................... Total current assets .........................
401,000 12,000 $1,103,000
Long-term investments Land held for future use ........................ Cash surrender value of life insurance ............................................. Property, plant, and equipment Buildings................................................. Less: Accum. depr.—buildings ....... Equipment............................................... Less: Accum. depr.—equipment..... Intangible assets Goodwill .................................................. Total assets......................................
340,000
175,000 90,000
$730,000 160,000 265,000 105,000
265,000
570,000 160,000
730,000
80,000 $2,178,000
EXERCISE 5-5 (Continued) Liabilities and Stockholders’ Equity Current liabilities Accounts payable.................................. Notes payable (due next year) .............. Rent payable .......................................... Total current liabilities ....................
$ 135,000 125,000 49,000 $309,000
Long-term liabilities Bonds payable ....................................... $500,000 Add: Premium on bonds payable......... 53,000 Pension obligation ................................ Total liabilities.................................. Stockholders’ equity Common stock, $1 par, authorized 400,000 shares, issued 290,000 shares.................................................. Additional paid-in capital ...................... Retained earnings ................................. Total stockholders’ equity .............. Total liabilities and stockholders’ equity ..................... *$2,178,000 – $944,000 – $450,000
290,000 160,000
$ 553,000 82,000
635,000 944,000
450,000 784,000* 1,234,000 $2,178,000
EXERCISE 5-6 (30–35 minutes) Geronimo Company Balance Sheet July 31, 2014 Assets Current assets Cash ....................................................... Accounts receivable ................................. $38,700** Less: Allowance for doubtful accounts........................................ Inventory ................................................ Total current assets ........................
3,500
$60,000*
35,200 65,300*** $160,500
Long-term investments Bond sinking fund ................................. Property, plant, and equipment Equipment.............................................. Less: Accumulated depreciation— equipment .............................. Intangible assets Patents ................................................... Total assets..................................... *($69,000 – $15,000 + $6,000) **($44,000 – $5,300) ***($60,000 + $5,300)
15,000
112,000 28,000
84,000
21,000 $280,500
EXERCISE 5-6 (Continued) Liabilities and Stockholders’ Equity Current liabilities Notes and accounts payable ......................... Income taxes payable..................................... Total current liabilities .............................
$ 44,000 6,000 $ 50,000
Long-term liabilities .............................................
75,000
Total liabilities...........................................
125,000
Stockholders’ equity ............................................
155,500
Total liabilities and stockholders’ equity .......................................
$280,500
EXERCISE 5-7 (15–20 minutes) Current assets Cash ................................................................... Less: Restricted cash (plant expansion) ......... Trading securities at fair value (cost, $31,000) ........................................................... Accounts receivable (of which $50,000 is
$ 87,000* 50,000
$ 37,000 29,000
pledged as collateral on a bank loan) ........... Less: Allowance for doubtful accounts........... Interest receivable [($40,000 X 6%) X 8/12]...... Inventories at lower of cost (determined using LIFO) or market
161,000 12,000
Finished goods ............................................ Work in process .......................................... Raw materials .............................................. Total current assets...............................
52,000 34,000 207,000
149,000 1,600
293,000 $509,600
*An acceptable alternative is to report cash at $37,000 and simply report the restricted cash (plant expansion) in the investments section.
EXERCISE 5-8 (10–15 minutes) 1.
Dividends payable of $2,375,000 will be reported as a current liability [(1,000,000 – 50,000) X $2.50].
2.
Bonds payable of $25,000,000 and interest payable of $3,000,000 ($100,000,000 X 12% X 3/12) will be reported as a current liability. Bonds payable of $75,000,000 will be reported as a long-term liability.
3.
Customer advances of $17,000,000 will be reported as a current liability ($12,000,000 + $30,000,000 – $25,000,000).
EXERCISE 5-9 (30–35 minutes) (a)
Allessandro Scarlatti Company Balance Sheet (Partial) December 31, 2014 Current assets Cash ........................................................ Accounts receivable............................... Less: Allowance for doubtful accounts.................................. Inventory ................................................. Prepaid expenses ................................... Total current assets..........................
$ 34,396* $ 91,300**
*Cash balance Add: Cash disbursement after discount ($39,000 X 98%) Less: Cash sales in January ($30,000 – $21,500) Cash collected on account Bank loan proceeds ($35,324 – $23,324) Adjusted cash **Accounts receivable balance Add: Accounts reduced from January collection ($23,324 ÷ 98%)
7,000
84,300 159,000*** 9,000 $286,696 $ 40,000 38,220 78,220 (8,500) (23,324) (12,000) $ 34,396 $ 89,000
Deduct: Accounts receivable in January Adjusted accounts receivable
23,800 112,800 (21,500) $ 91,300
***Inventory Less: Inventory received on consignment Adjusted inventory
$171,000 12,000 $159,000
EXERCISE 5-9 (Continued) Current liabilities Accounts payable ........................................... Notes payable ................................................. Total current liabilities.............................. a
Accounts payable balance Add: Cash disbursements Purchase invoice omitted ($27,000 – $12,000) Adjusted accounts payable
b
(b)
$115,000a 55,000b $170,000 $ 61,000 $39,000 15,000
Notes payable balance Less: Proceeds of bank loan Adjusted notes payable
Adjustment to retained earnings balance: Add: January sales discounts [($23,324 ÷ 98%) X .02] .......................... Deduct: January sales ....................................... January purchase discounts ($39,000 X 2%)................................... December purchases .......................... Consignment inventory....................... Change (decrease) to retained earnings ...........
54,000 $115,000 $ 67,000 12,000 $ 55,000
$
476
$30,000 780 15,000 12,000
(57,780) $(57,304)
EXERCISE 5-10 (15–20 minutes) (a)
In order for a liability to be reported for threatened litigation, the amount must be probable and payment reasonably estimable. Since these conditions are not met an accrual is not required.
(b)
A current liability of $150,000 should be recorded.
(c)
A current liability for accrued interest of $4,000 ($600,000 X 8% X 1/12) should be reported. Also, the $600,000 note payable should be a current liability if payable in one year. Otherwise, the $600,000 notes payable would be a long-term liability.
(d)
Although Bad Debt Expense of $300,000 should be debited and the Allowance for Doubtful Accounts credited for $300,000, this does not result in a liability. The allowance for doubtful accounts is a valuation account (contra asset) and is deducted from accounts receivable on the balance sheet.
(e)
A current liability of $80,000 should be reported. The liability is recorded on the date of declaration.
(f)
Customer advances of $110,000 ($160,000 – $50,000) will be reported as a current liability.
EXERCISE 5-11 (25–30 minutes) Kelly Corporation Balance Sheet December 31, 2014 Assets Current assets Cash ..................................................................... Supplies ............................................................... Prepaid insurance ............................................... Total current assets...................................... Equipment.................................................................. Less: Accumulated depreciation—equipment ........ Trademark.................................................................. Total assets...................................................
$ 6,850 1,200 1,000 $ 9,050 48,000 4,000
44,000 950 $54,000
Liabilities and Stockholders’ Equity Current liabilities Accounts payable................................................ Salaries and wages payable ............................... Unearned service revenue ..................................
$10,000 500 2,000
Total current liabilities ................................
$12,500
Long-term liabilities Bonds payable ..................................................... Total liabilities...................................................... Stockholders’ equity Common stock..................................................... Retained earnings ($25,000 – $2,500*) ............... Total stockholders’ equity ............................ Total liabilities and stockholders’ equity ......... *[$10,000 – ($9,000 + $1,400 + $1,200 + $900)]
9,000 21,500 10,000 22,500 32,500 $54,000
EXERCISE 5-12 (30–35 minutes) Scott Butler Corporation Balance Sheet December 31, 2014 Assets Current assets Cash ...................................................... Debt investments (Trading) ................. Accounts receivable ............................ $435,000 Less: Allowance for doubtful accounts..................................... (25,000) Inventory ............................................... Total current assets ...................... Long-term investments Debt investments ................................. Equity investments .............................. Total long-term investments........ Property, plant, and equipment Land ...................................................... Buildings ................................................ 1,040,000 Less: Accum. depreciation— building ....................................... (152,000) Equipment............................................ 600,000 Less: Accum. depreciation— equipment ................................... (60,000) Total property, plant, and
$197,000 153,000
410,000 597,000 1,357,000
299,000 277,000 576,000
260,000
888,000
540,000
equipment ................................... Intangible assets Franchises .................................................... Patents .................................................. Total intangible assets................... Total assets.....................................
1,688,000
160,000 195,000 355,000 $3,976,000
EXERCISE 5-12 (Continued) Liabilities and Stockholders’ Equity Current liabilities Accounts payable............................ Notes payable (short-term) ............. Dividends payable ........................... Accrued liabilities............................ Total current liabilities ............ Long-term debt Notes payable (long-term) .............. Bonds payable ................................. Total long-term liabilities ........... Total liabilities............................ Stockholder’s equity Paid-in capital Common stock ($5 par) ............. $1,000,000 Additional paid-in capital .......... 80,000 Retained earnings* .......................... Total paid-in capital and retained earnings.................. Less: Treasury stock....................... Total stockholders’ equity ...... Total liabilities and stockholders’ equity .............
$ 455,000 90,000 136,000 96,000 $ 777,000
900,000 1,000,000 1,900,000 2,677,000
1,080,000 410,000 1,490,000 191,000 1,299,000 $3,976,000
EXERCISE 5-12 (Continued) *Computation of Retained Earnings: Sales revenue Investment revenue Extraordinary gain Cost of goods sold Selling expenses Administrative expenses Interest expense Net income
$8,100,000 63,000 80,000 (4,800,000) (2,000,000) (900,000) (211,000) $ 332,000
Beginning retained earnings Net income Ending retained earnings
$ 78,000 332,000 $410,000
Or ending retained earnings can be computed as follows: Total stockholders’ equity Add: Treasury stock Less: Paid-in capital in excess of par Ending retained earnings
$1,299,000 191,000 1,080,000 $ 410,000
Note to instructor: There is no dividends account. Thus, the 12/31/14 retained earnings balance already reflects any dividends declared.
EXERCISE 5-13 (15–20 minutes) (a) (b) (c) (d) (e)
4. 3. 4. 3. 1.
(f) (g) (h) (i) (j)
1. 5. 4. 5. 4.
(k) 1. (l) 2. (m) 2.
EXERCISE 5-14 (25–35 minutes) Constantine Cavamanlis Inc. Statement of Cash Flows For the Year Ended December 31, 2014 Cash flows from operating activities Net income ...........................................................
$44,000
Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense.................................... Increase in accounts receivable ................... Increase in accounts payable ....................... Net cash provided by operating activities .........
$ 6,000 (3,000) 5,000
Cash flows from investing activities Purchase of equipment ....................................... Cash flows from financing activities Issuance of common stock................................. Payment of cash dividends ................................ Net cash used by financing activities ................ Net increase in cash.................................................. Cash at beginning of year......................................... Cash at end of year ...................................................
8,000 52,000 (17,000)
20,000 (23,000) (3,000) 32,000 13,000 $45,000
EXERCISE 5-15 (25–35 minutes) (a)
Zubin Mehta Corporation Statement of Cash Flows For the Year Ended December 31, 2014
Cash flows from operating activities Net income...........................................................
$160,000
Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ................................... Loss on sale of investments......................... Decrease in accounts receivable ................. Decrease in current liabilities ....................... Net cash provided by operating activities .........
$17,000 10,000 5,000 (17,000)
15,000 175,000
Cash flows from investing activities Sale of investments............................................. 12,000 [($74,000 – $52,000) – $10,000] Purchase of equipment .......................................... (58,000) Net cash used by investing activities ................ Cash flows from financing activities Payment of cash dividends ................................ Net increase in cash.................................................. Cash at beginning of year......................................... Cash at end of year ................................................... (b)
(46,000) (30,000) 99,000 78,000 $177,000
Free Cash Flow Analysis
Net cash provided by operating activities ............... Less: Purchase of equipment ................................. Dividends ........................................................ Free cash flow ...........................................................
$175,000 (58,000) (30,000) $ 87,000
EXERCISE 5-16 (20–25 minutes) (a)
Shabbona Corporation Statement of Cash Flows For the Year Ended December 31, 2014
Cash flows from operating activities Net income ............................................................
$125,000
Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense..................................... Increase in accounts receivable .................... Decrease in inventory .................................... Decrease in accounts payable....................... Net cash provided by operating activities .......... Cash flows from investing activities Sale of land ........................................................... Purchase of equipment ........................................ Net cash used by investing activities ................. Cash flows from financing activities
$27,000 (16,000) 9,000 (13,000)
7,000 132,000
39,000 (60,000)
Payment of cash dividends ................................. Net increase in cash................................................... Cash at beginning of year.......................................... Cash at end of year .................................................... Noncash investing and financing activities Issued common stock to retire $50,000 of bonds outstanding
(21,000) (60,000) 51,000 22,000 $ 73,000
EXERCISE 5-16 (Continued) (b) Current cash debt coverage = Net cash provided by operating activities =
Average current liabilities $132,000
=
($34,000 + $47,000) / 2
=
3.26 to 1
Cash debt coverage = Net cash provided by operating activities Average total liabilities
$132,000 ÷
$184,000 + $247,000
=
=
2
.61 to 1
Free Cash Flow Analysis Net cash provided by operating activities .........................
$132,000
Less: Purchase of equipment ........................................... Dividends .................................................................. Free cash flow .....................................................................
(60,000) (60,000) $ 12,000
Shabbona has excellent liquidity. Its financial flexibility is good. It might be noted that it substantially reduced its long-term debt in 2014 which will help its financial flexibility.
EXERCISE 5-17 (30–35 minutes) (a)
Grant Wood Corporation Statement of Cash Flows For the Year Ended December 31, 2014
Cash flows from operating activities Net income .............................................................. Adjustments to reconcile net income to net cash provided by operating activities: Loss on sale of equipment............................... $ 2,000* Depreciation expense....................................... 13,000 Patent amortization .......................................... 2,500 Increase in current assets (other than cash)...... (29,000) Increase in current liabilities ........................... 13,000 Net cash provided by operating activities ............
$55,000
1,500 56,500
Cash flows from investing activities Sale of equipment................................................... 10,000 Addition to building................................................ (27,000) Investment in stock ................................................ (16,000) Net cash used by investing activities ...................
(33,000)
Cash flows from financing activities Issuance of bonds .................................................. 50,000 Payment of dividends............................................. (30,000) Purchase of treasury stock.................................... (11,000) Net cash provided by financing activities............. Net increase in cash.....................................................
9,000 $32,500a
*[$10,000 – ($20,000 – $8,000)] a An additional proof to arrive at the increase in cash is provided as follows: Total current assets—end of period Total current assets—beginning of period Increase in current assets during the period Increase in current assets other than cash Increase in cash during year
$296,500 [from part (b)] 235,000 61,500 29,000 $ 32,500
EXERCISE 5-17 (Continued) (b)
Grant Wood Corporation Balance Sheet December 31, 2014
Assets $296,500b Current assets ................................................ 16,000 Equity investments (Long-term).................... Property, plant, and equipment Land .......................................................... $ 30,000 Building ($120,000 + $27,000).................. $147,000 Less: Accum. depreciation—building (34,000) 113,000 ($30,000 + $4,000) .................................. Equipment ($90,000 – $20,000)................ 70,000 Less: Accum. depreciation—equipment (12,000) 58,000 ($11,000 – $8,000 + $9,000) ................... Total property, plant, and equipment..... 201,000 Intangible assets—patents ($40,000 – $2,500) .................................. 37,500 Total assets........................................ $551,000 Liabilities and Stockholders’ Equity Current liabilities ($150,000 + $13,000) ...................... Long-term liabilities Bonds payable ($100,000 + $50,000).................... Total liabilities ................................................. Stockholders’ equity Common stock ...................................................... Retained earnings ($44,000 + $55,000 – $30,000) ...... Total paid-in capital and retained earnings...... Less: Cost of treasury stock ................................ Total stockholders’ equity .............................. Total liabilities and stockholders’ equity ....... b The
$163,000 150,000 313,000 $180,000 69,000 249,000 11,000 238,000 $551,000
amount determined for current assets could be computed last and then is a “plug” figure. That is, total liabilities and stockholders’ equity is computed because information is available to determine this amount. Because the total assets amount is the same as total liabilities and stockholders’ equity amount, the amount of total assets is determined. Information is available to compute all the asset amounts except current assets and therefore current assets can be determined by deducting the total of all the other asset balances from the total asset balance (i.e., $551,000 – $37,500 – $201,000 – $16,000). Another way to compute this amount, given the information, is that beginning current assets plus the $29,000 increase in current assets other than cash plus the $32,500 increase in cash equals $296,500.
EXERCISE 5-18 (25–35 minutes) (a)
Madrasah Corporation Statement of Cash Flows For the Year Ended December 31, 2014
Cash flows from operating activities Net income ........................................................... Adjustment to reconcile net income to net cash provided by operating activities: Depreciation......................................................... Increase in accounts payable ............................. Increase in accounts receivable......................... Net cash provided by operating activities .........
$44,000
$ 6,000 5,000 (18,000)
Cash flows from Investing activities Purchase of equipment ....................................... Cash flows from financing activities Issuance of stock ................................................ Payment of dividends.......................................... Net cash used by financing activities ................ Net increase in cash.................................................. Cash at beginning of year......................................... Cash at end of year ...................................................
(17,000) 20,000 (33,000) (13,000) 7,000 13,000 $20,000 2014 6.3 $126,000 $ 20,000
(b) Current ratio
(7,000) 37,000
2013 6.73 $101,000 $ 15,000
Free Cash Flow Analysis Net cash provided by operating activities ........................... Less: Purchase of equipment.............................................. Pay dividends ............................................................. Free cash flow .......................................................................
$ 37,000 (17,000) (33,000) $ (13,000)
(c) Although, Madrasah’s current ratio has declined from 2013 to 2014, it is still in excess of 6. It appears the company has good liquidity and financial flexibility.
TIME AND PURPOSE OF PROBLEMS Problem 5-1 (Time 30–35 minutes) Purpose—to provide the student with the opportunity to prepare a balance sheet, given a set of accounts. No monetary amounts are to be reported. Problem 5-2 (Time 35–40 minutes) Purpose—to provide the student with the opportunity to prepare a complete balance sheet, involving dollar amounts. A unique feature of this problem is that the student must solve for the retained earnings balance. Problem 5-3 (Time 40–45 minutes) Purpose—to provide an opportunity for the student to prepare a balance sheet in good form. Emphasis is given in this problem to additional important information that should be disclosed. For example, an inventory valuation method, bank loans secured by long-term investments, and information related to the capital stock accounts must be disclosed. Problem 5-4 (Time 40–45 minutes) Purpose—to provide the student with the opportunity to analyze a balance sheet and correct it where appropriate. The balance sheet as reported is incomplete, uses poor terminology, and is in error. A challenging problem. Problem 5-5 (Time 40–45 minutes) Purpose—to provide the student with the opportunity to prepare a balance sheet in good form. Additional information is provided on each asset and liability category for purposes of preparing the balance sheet. A challenging problem. Problem 5-6 (Time 35–45 minutes) Purpose—to provide the student with an opportunity to prepare a complete statement of cash flows. A condensed balance sheet is also required. The student is also required to explain the usefulness of the statement of cash flows. Because the textbook does not explain in Chapter 5 all of the steps involved in preparing the statement of cash flows, assignment of this problem is dependent upon additional instruction by the instructor or knowledge gained in elementary financial accounting. Problem 5-7 (Time 40–50 minutes) Purpose—to provide the student with an opportunity to prepare a balance sheet in good form and a more complex cash flow statement.
SOLUTIONS TO PROBLEMS PROBLEM 5-1 COMPANY NAME Balance Sheet December 31, 20XX Assets Current assets Cash on hand (including petty cash) ............. Cash in bank .................................................... Debt investments (trading) ............................. Accounts receivable........................................ Less: Allowance for doubtful accounts ......................................... Interest receivable ........................................... Advances to employees.................................. Inventory (ending) ........................................... Prepaid rent ..................................................... Total current assets...................................
$XXX XXX XXX XXX
Intangible assets Copyrights ....................................................... Patents ............................................................. Total intangible assets .............................. Total assets......................................................
XXX XXX XXX XXX XXX $XXX
Long-term investments Bond sinking fund ........................................... Cash surrender value of life insurance.......... Land for future plant site ................................ Total long-term investments..................... Property, plant, and equipment Land.................................................................. Buildings .......................................................... Less: Accum. depreciation—buildings...... Equipment........................................................ Less: Accum. depreciation—equipment .... Total property, plant, and equipment.......
$XXX XXX
XXX XXX XXX XXX XXX XXX XXX XXX XXX
XXX XXX XXX XXX XXX XXX $XXX
PROBLEM 5-1 (Continued) Liabilities and Stockholders’ Equity Current liabilities Notes payable ................................................. Payroll taxes payable ..................................... Salaries and wages payable .......................... Dividends payable.......................................... Unearned subscriptions revenue .................. Total current liabilities ............................. Long-term debt Bonds payable................................................ Add: Premium on bonds payable ........... Pension liability .............................................. Total long-term liabilities ......................... Total liabilities .......................................... Stockholders’ equity Capital stock Preferred stock (description)................... Common stock (description) ................... Paid-in capital in excess of par – Preferred stock Total paid-in capital.................................. Retained earnings .......................................... Total paid-in capital and retained earnings.................................. Accumulated other comprehensive income....................................................... Less: Treasury stock..................................... Equity attributable to Stockholders’ equity – Company...................................... Equity attributable to Noncontrolling interest ....................................................... Total stockholders’ equity ....................... Total liabilities and stockholders’ equity..............................
$XXX XXX XXX XXX XXX $XXX
$XXX XXX
XXX XXX XXX XXX
XXX XXX
XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX $XXX
PROBLEM 5-2
MONTOYA, INC. Balance Sheet December 31, 2014 Assets Current assets Cash .................................................. Equity investments (trading) ........... Notes receivable ............................... Income taxes receivable .................. Inventory ........................................... Prepaid expenses ............................. Total current assets.................... Property, plant, and equipment Land................................................... Buildings ........................................... $1,640,000 Less: Accum. depreciation— buildings .......................... 270,200 Equipment......................................... 1,470,000 Less: Accum. depreciation— equipment ........................ 292,000 Intangible assets Goodwill ............................................ Total assets.................................
$ 360,000 121,000 445,700 97,630 239,800 87,920 $1,352,050
480,000 1,369,800 1,178,000
3,027,800
125,000 $4,504,850
PROBLEM 5-2 (Continued) Liabilities and Stockholders’ Equity Current liabilities Accounts payable............................... Notes payable (to banks) ................... Payroll taxes payable ......................... Income taxes payable ........................ Rent payable....................................... Total current liabilities .................
$ 490,000 265,000 177,591 98,362 45,000 $1,075,953
Long-term liabilities Notes payable (long-term) ...................................... Bonds payable ....................................... $300,000 Less: Discount on bonds payable................................ 15,000 Rent payable (long-term) .................. Total liabilities .............................. Stockholders’ equity Capital stock Preferred stock, $10 par; 20,000 shares authorized, 15,000 shares issued ............................ Common stock, $1 par; 400,000 shares authorized, 200,000 issued ........................... Retained earnings ($1,063,897 – $350,000) ................... Total stockholders’ equity ($4,504,850 – $3,440,953) .......... Total liabilities and stockholders’ equity..................
1,600,000 285,000 480,000
2,365,000 3,440,953
150,000 200,000
350,000 713,897 1,063,897 $4,504,850
PROBLEM 5-3
EASTWOOD COMPANY Balance Sheet December 31, 2014 Assets Current assets Cash ...................................................... $ 41,000 Accounts receivable............................. $163,500 Less: Allowance for doubtful accounts .............................. 8,700 154,800 Inventory (LIFO cost)............................ 208,500 Prepaid insurance ................................ 5,900 Total current assets........................ Long-term investments Equity investments ($120,000 have been pledged as security for notes payable)— at fair value ........................................ Property, plant, and equipment Cost of uncompleted plant facilities Land................................................. Construction in process (building) ..................................... Equipment............................................. Less: Accum. depreciation— equipt.................................... Intangible assets Patents (less $4,000 amortization) ...... Total assets.....................................
$ 410,200
339,000
85,000 124,000 400,000
209,000
240,000
160,000
369,000
36,000 $1,154,200
PROBLEM 5-3 (Continued) Liabilities and Stockholders’ Equity Current liabilities Notes payable (secured by investments of $120,000).................... Accounts payable................................. Accrued liabilities................................. Total current liabilities ................... Long-term liabilities 8% bonds payable, due January 1, 2025.................................. Less: Discount on bonds payable...... Total liabilities ................................ Stockholders’ equity Common stock Authorized 600,000 shares of $1 par value; issued and outstanding, 500,000 shares ........... $500,000 Paid in capital in excess of par—common stock ......................... 45,000 Retained earnings ................................ Total liabilities and stockholders’ equity....................
$ 94,000 148,000 49,200 $ 291,200
200,000 20,000
545,000 138,000
180,000 471,200
683,000 $1,154,200
PROBLEM 5-4
KISHWAUKEE CORPORATION Balance Sheet December 31, 2014 Assets Current assets Cash ..................................................... Accounts receivable............................ Inventory .............................................. Total current assets....................... Long-term investments Assets allocated to trustee for expansion: Cash in bank ................................. Debt investments (held-to-maturity) ......................
$175,900 170,000 312,100 $ 658,000
70,000 138,000
Property, plant, and equipment Land...................................................... Buildings .............................................. $1,070,000a Less: Accum. depreciation— 410,000 buildings ............................. Total assets....................................
208,000
950,000
660,000
1,610,000 $2,476,000
Liabilities and Stockholders’ Equity Current liabilities Notes payable—current installment .... Income taxes payable.......................... Total current liabilities ..................
$100,000 75,000 $ 175,000
PROBLEM 5-4 (Continued) Long-term liabilities Notes payable ....................................... Total liabilities ................................. Stockholders’ equity Common stock, no par; 1,000,000 shares authorized and issued; 950,000 shares outstanding............... Retained earnings ................................. Less: Treasury stock, at cost (50,000 shares) ............................ Kishwankee stockholders’ ................... Equity attributable to Noncontrolling interest ............................................... Total stockholders’ equity .............. Total liabilities and stockholders’ equity.....................
500,000b 675,000
1,150,000 683,000c 1,833,000 87,000 1,746,000 55,000 1,801,000 $2,476,000
a
$1,640,000 – $570,000 (to eliminate the excess of appraisal value over cost from the Buildings account. Note that the appreciation capital account is also deleted).
b
$600,000 – $100,000 (to reclassify the currently maturing portion of the notes payable as a current liability).
c
$803,000 – $120,000 (to remove the value of goodwill from retained earnings. Note 2 indicates that retained earnings was credited. Note that the goodwill account is also deleted).
Note: As an alternate presentation, the cash restricted for plant expansion would be added to the general cash account and then subtracted. The amount reported in the investments section would not change.
PROBLEM 5-5
SARGENT CORPORATION Balance Sheet December 31, 2014 Assets Current assets Cash ..................................................... Equity investments (Trading) ............. Accounts receivable............................ $ 170,000 Less: Allowance for doubtful accounts ............................. 10,000 Inventory (lower-of-FIFOcost-or-market) ................................ Total current assets....................... Long-term investments Equity investments (available-for-sale) (at fair value)..... Bond sinking fund ............................... Cash surrender value of life insurance .......................................... Land held for future use...................... Property, plant, and equipment Land...................................................... Buildings .............................................. 1,040,000 Less: Accum. depreciation— buildings ............................. 360,000 Equipment............................................ 450,000 Less: Accum. depreciation— equipment ........................... 180,000 Intangible assets Franchise ............................................. Goodwill ............................................... Total assets....................................
$150,000 80,000 160,000 180,000 $ 570,000
270,000 250,000 40,000 270,000
830,000
500,000 680,000 270,000
165,000 100,000
1,450,000
265,000 $3,115,000
PROBLEM 5-5 (Continued) Liabilities and Stockholders’ Equity Current liabilities Accounts payable................................ Notes payable ...................................... Income taxes payable ......................... Unearned rent revenue ....................... Total current liabilities ...................
$ 140,000 80,000 40,000 5,000 $ 265,000
Long-term liabilities Notes payable ...................................... 7% bonds payable, due 2022 ............. $1,000,000 Less: Discount on bonds payable.... 40,000 Total liabilities ................................ Stockholders’ equity Capital stock Preferred stock, no par value; 200,000 shares authorized, 70,000 issued and outstanding...... Common stock, $1 par value; 400,000 shares authorized, 100,000 issued and outstanding.... Paid-in capital in excess of par— common stock [100,000 X ($10.00 – $1.00)]............................ Retained earnings ............................... Total stockholders’ equity ............. Total liabilities and stockholders’ equity....................
120,000 960,000
1,080,000 1,345,000
450,000 100,000
900,000
1,450,000 320,000 1,770,000 $3,115,000
PROBLEM 5-6
(a)
LANSBURY INC. Statement of Cash Flows For the Year Ended December 31, 2014
Cash flows from operating activities Net income ........................................................... Adjustments to reconcile net income to net cash provided by operating activities Depreciation expense.................................... Gain on sale of investments ......................... Increase in account receivable ($41,600 – $21,200) ..................................... Net cash provided by operating activities .........
$32,000 $ 11,000 (3,400) (20,400)
Cash flows from investing activities Sale of investments............................................. Purchase of land.................................................. Net cash used by investing activities ................
15,000 (18,000)
Cash flows from financing activities Issuance of common stock................................. Retirement of notes payable............................... Payment of cash dividends ................................ Net cash used by financing activities ................
20,000 (16,000) (8,200)
(12,800) 19,200
(3,000)
Net increase in cash.................................................. Cash at beginning of year......................................... Cash at end of year ................................................... Noncash investing and financing activities Land purchased through issuance of $30,000 of bonds
(4,200) 12,000 20,000 $32,000
PROBLEM 5-6 (Continued) (b)
LANSBURY INC. Balance Sheet December 31, 2014 Assets
Cash Accounts receivable Equity investments Plant assets (net) Land
$32,000 41,600 20,400 (1) 70,000 (2) 88,000 (3) $252,000
Liabilities and Stockholders’ Equity Accounts payable $30,000 Notes payable (long-term) 25,000 (4) Bonds payable 30,000 (5) Common stock 120,000 (6) Retained earnings 47,000 (7) $252,000
(1) $32,000 – ($15,000 – $3,400) (2) $81,000 – $11,000 (3) $40,000 + $18,000 + $30,000 (4) $41,000 – $16,000 (5) $0 + $30,000 (6) $100,000 + $20,000 (7) $23,200 + $32,000 – $8,200 (c) Cash flow information is useful for assessing the amount, timing, and uncertainty of future cash flows. For example, by showing the specific inflows and outflows from operating activities, investing activities, and financing activities, the user has a better understanding of the liquidity and financial flexibility of the enterprise. Similarly, these reports are useful in providing feedback about the flow of enterprise resources. This information should help users make more accurate predictions of future cash flow. In addition, some individuals have expressed concern about the quality of the earnings because the measurement of the income depends on a number of accruals and estimates which may be somewhat subjective. As a result, the higher the ratio of cash provided by operating activities to net income, the more comfort some users have in the reliability of the earnings. In this problem the ratio of cash provided by operating activities to net income is 60% ($19,200 ÷ $32,000).
PROBLEM 5-6 (Continued) An analysis of Lansbury’s free cash flow indicates it is negative as shown below: Free Cash Flow Analysis Net cash provided by operating activities ........................... Less: Purchase of land ....................................................... Dividends................................................................... Free cash flow .......................................................................
$19,200 18,000 8,200 $ (7,000)
$19,200 Its current cash debt coverage is 0.64 to 1 and its cash debt $30,000 $71,000 + $85,000 , which are reasonable. coverage is 0.25 to 1 $19,200 ÷ 2 Overall, it appears that its liquidity position is average and overall financial flexibility and solvency should be improved.
PROBLEM 5-7
(a)
AERO INC. Statement of Cash Flows For the Year Ended December 31, 2014
Cash flows from operating activities Net income........................................................... Adjustments to reconcile net income to net cash provided by operating activities Depreciation expense ................................... Loss on sale of investments......................... Increase in accounts payable ($40,000 – $30,000) .................................. Increase in accounts receivable ($42,000 – $21,200) .................................. Net cash provided by operating activities .........
$35,000 $12,000 5,000 10,000 (20,800)
6,200 41,200
Cash flows from investing activities Sale of investments............................................. 27,000 Purchase of land ...................................................... (38,000) Net cash used by investing activities ................
(11,000)
Cash flows from financing activities Issuance of common stock................................. 30,000 Payment of cash dividends ..................................... (10,000) Net cash provided by financing activities .........
20,000
Net increase in cash.................................................. Cash at beginning of year......................................... Cash at end of year ................................................... Noncash investing and financing activities Land purchased through issuance of $30,000 of bonds
50,200 20,000 $70,200
PROBLEM 5-7 (Continued) (b)
AERO INC. Balance Sheet December 31, 2014 Assets
Cash Accounts receivable Plant assets (net) Land
$ 70,200 42,000 69,000 (1) 108,000 (2) $289,200
Liabilities and Stockholders’ Equity Accounts payable $ 40,000 Bonds payable 71,000 (3) Common stock 130,000 (4) Retained earnings 48,200 (5) $289,200
(1) $81,000 – $12,000 (2) $40,000 + $38,000 + $30,000 (3) $41,000 + $30,000 (4) $100,000 + $30,000 (5) $23,200 + $35,000 – $10,000 (c)
An analysis of Aero’s free cash flow indicates it is negative as shown below: Free Cash Flow Analysis
Net cash provided by operating activities ............................ Less: Purchase of land .......................................................... Dividends ..................................................................... Free cash flow ........................................................................
$41,200 38,000 10,000 $ (6,800)
PROBLEM 5-7 (Continued) $41,200 . Overall, it appears Its current cash debt coverage is 1.18 to 1 $35,000* that its liquidity position is average and overall financial flexibility should be improved. *($30,000 + $40,000) ÷ 2 (d)
This type of information is useful for assessing the amount, timing, and uncertainty of future cash flows. For example, by showing the specific inflows and outflows from operating activities, investing activities, and financing activities, the user has a better understanding of the liquidity and financial flexibility of the enterprise. Similarly, these reports are useful in providing feedback about the flow of enterprise resources. This information should help users make more accurate predictions of future cash flow. In addition, some individuals have expressed concern about the quality of the earnings because the measurement of the income depends on a number of accruals and estimates which may be somewhat subjective. As a result, the higher the ratio of cash provided by operating activities to net income, the more comfort some users have in the reliability of the earnings.
TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 5-1 (Time 20–25 minutes) Purpose—to provide a varied number of financial transactions and then determine how each of these items should be reported in the financial statements. Accounting changes, additional assessments of income taxes, prior period adjustments, and changes in estimates are some of the financial transactions presented. CA 5-2 (Time 30–35 minutes) Purpose—to present the asset section of a partial balance sheet that must be analyzed to assess its deficiencies. Items such as improper classifications, terminology, and disclosure must be considered. CA 5-3 (Time 20–25 minutes) Purpose—to present a balance sheet that must be analyzed to assess its deficiencies. Items such as improper classification, terminology, and disclosure must be considered. CA 5-4 (Time 20–25 minutes) Purpose—to present the student an ethical issue related to the presentation of balance sheet information. The reporting involves “net presentation” of property, plant and equipment. CA 5-5 (Time 40–50 minutes) Purpose—to present a cash flow statement that must be analyzed to explain differences in cash flow and net income, and sources and uses of cash flow and ways to improve cash flow.
SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 5-1 1.
The new estimate would be used in computing depreciation expense for 2014. No adjustment of the balance in accumulated depreciation at the beginning of the year would be made. Instead, the remaining depreciable cost would be divided by the estimated remaining life. This is a change in an estimate and is accounted for prospectively (in the current and future years). Disclosure in the notes to the financial statements is appropriate, if material.
2.
The additional assessment should be shown on the current period’s income statement. If material it should be shown separately; if immaterial it could be included with the current year’s tax expense. This transaction does not represent a prior period adjustment.
3.
The effect of the error at December 31, 2013, should be shown as an adjustment of the beginning balance of retained earnings on the retained earnings statement. The current year’s expense should be adjusted (if necessary) for the possible carryforward of the error into the 2014 expense computation.
4.
Generally, an entry is made for a cash dividend on the date of declaration. The appropriate entry would be a debit to Retained Earnings (or Dividends) for the amount to be paid, with a corresponding credit to Dividends Payable. Dividends payable is reported as a current liability.
CA 5-2 1. Unclaimed payroll checks should be shown as a current liability if these are claims by employees. 2. Debt investments (trading) should be reported at fair value, not cost. 3. Bad Debt Reserve is an improper terminology; Allowance for Doubtful Accounts is considered more appropriate. The amount of estimated uncollectibles should be disclosed. 4. Next-in, First-out (NIFO) is not an acceptable inventory valuation method. 5. Heading “Tangible assets” should be changed to “Property, Plant and Equipment”; also label for corresponding $630,000 should be changed to “net property, plant, and equipment.” 6. Land should not be depreciated. 7. Buildings and equipment and their related accumulated depreciation balances should be separately disclosed. 8. The valuation basis for stocks should be disclosed (fair value or equity) and the description should be Equity investment (Available-for-Sale) or Equity investment in X Company. 9. Treasury stock is not an asset and should be shown in the stockholders’ equity section as a deduction. 10. Discount on bonds payable is not an asset and should be shown as a deduction from bonds payable. 11. Sinking fund should be reported in the long-term investments section.
CA 5-3 Criticisms of the balance sheet of the Sameed Brothers Corporation: 1. The basis for the valuation of marketable securities should be shown. Marketable securities are valued at fair value. In addition, they should be classified as either trading securities, available-forsale securities, or held-to-maturity securities. 2. An allowance for doubtful accounts receivable is not indicated. 3. The basis for the valuation and the method of pricing for Inventory are not indicated. 4. A stock investment in a subsidiary company is not ordinarily held to be sold within one year or the operating cycle, whichever is longer. As such, this account should not be classified as a current asset, but rather should be included under the heading “Investments.” The basis of valuation of the investment should be shown. 5. Treasury stock is not an asset. It should be presented as a deduction in the shareholders’ equity section of the balance sheet. The class of stock, number of shares, and basis of valuation should be indicated. 6. Buildings and land should be segregated. The Reserve for Depreciation should be shown as a subtraction from the Buildings account only. Also, the term “reserve for” should be replaced by “accumulated.” 7. Cash Surrender Value of Life Insurance would be more appropriately shown under the heading of “Investments.” 8. Reserve for Income Taxes should appropriately be entitled Income Tax Payable. 9. Customers’ Accounts with Credit Balances is an immaterial amount. As such, this account need not be shown separately. The $1,000 credit could readily be netted against Accounts Receivable without any material misstatement. 10. Unamortized Premium on Bonds Payable should be appropriately shown as an addition to the related Bonds Payable in the long-term liability section. The use of the term deferred credits is inappropriate. 11. Bonds Payable is inadequately disclosed. The interest rate, interest payment dates, and maturity date should be indicated. 12. Additional disclosure relative to the Common Stock account is needed. This disclosure should include the number of shares authorized, issued, and outstanding. 13. Earned Surplus should appropriately be entitled Retained Earnings. Also, a separate heading should be shown for this account; it should not be shown under the heading “Common Stock.” A more appropriate heading would be “Shareholders’ Equity.” 14. Cash Dividends Declared should be disclosed on the retained earnings statement as a reduction of retained earnings. Dividends Payable, in the amount of $8,000, should be shown on the balance sheet among the current liabilities, assuming payment has not occurred.
CA 5-4 (a). The ethical issues involved are integrity and honesty in financial reporting, full disclosure, and the accountant’s professionalism. (b). While presenting property, plant, and equipment net of depreciation on the balance sheet may be acceptable under GAAP, it is inappropriate to attempt to hide information from financial statement users. Information must be useful, and the presentation Keene is considering would not be. Users would not grasp the age of plant assets and the company’s need to concentrate its future cash outflows on replacement of these assets. This information could be provided in a note disclosure. Because of the significant impact on the financial statements of the depreciation method(s) used, the following disclosures should be made. a. b. c. d.
Depreciation expense for the period. Balances of major classes of depreciable assets, by nature and function. Accumulated depreciation, either by major classes of depreciable assets or in total. A general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets.
CA 5-5 Date President Kappeler, CEO Kappeler Corporation 125 Wall Street Middleton, Kansas 67458 Dear Mr. Kappeler: I have good news and bad news about the financial statements for the year ended December 31, 2014. The good news is that net income of $100,000 is close to what we predicted in the strategic plan last year, indicating strong performance this year. The bad news is that the cash balance is seriously low. Enclosed is the Statement of Cash Flows, which best illustrates how these situations occurred simultaneously. If you look at the operating activities, you can see that no cash was generated by operations due to the increase in accounts receivable and inventory and reduction in accounts payable. In effect, these events caused net cash flow provided by operating activities to be lower than net income; they reduced your cash balance by $116,000. The corporation made significant investments in equipment and land. These were paid from cash reserves. These purchases used 75% of the company’s cash. In addition, the redemption of the bonds improved the equity of the corporation and reduced interest expense. However, it also used 25% of the corporation’s cash. It is normal to use cash for investing and financing activities. But when cash is used, it must also be replenished. Operations normally provide the cash for investing and financing activities. Since there is a finite amount of assets to sell and funds to borrow or raise from the sale of capital stock, operating activities are the only renewable source of cash. That is why it is important to keep the operating cash flows positive. Cash management requires careful and continuous planning.
CA 5-5 (Continued) There are several possible remedies for the current cash problem. First, prepare a detailed analysis of monthly cash requirements for the next year. Second, investigate the changes in accounts receivable and inventory and work to return them to more normal levels. Third, look for more favorable terms with suppliers to allow the accounts payable to increase without loss of discounts or other costs. Finally, since the land represents a long-term commitment without immediate plans for use, consider shopping for a low interest loan to finance the acquisition for a few years and return the cash balance to a more normal level. If you have additional questions or need one of our staff to address this problem, please contact me at your convenience. Sincerely yours, Partner in Charge
FINANCIAL REPORTING PROBLEM
(a)
P&G could use the account form or report form. P&G uses the account form.
(b)
The techniques of disclosing pertinent information include (1) parenthetical explanations, (2) notes, (3) cross-reference and contra items, and (4) supporting schedules. P&G uses parenthetical explanations and notes (see notes to financial statements section) and supporting schedules.
(c)
While there are no Investments reported on P&G’s balance sheet, Note 1 (Significant Accounting Policies) states that Investments are readily marketable debt and equity securities. These securities are reported at fair value. Unrealized gains and losses on trading securities are recognized in income. Unrealized gains and losses relating to investments classified as available-for-sale are recorded as a component of accumulated other comprehensive income in shareholders’ equity. As of June 30, 2011, P&G had negative working capital (current assets less than current liabilities) of $5,323 million. At June 30, 2010, P&G’s negative working capital was $5,500 million.
(d)
The following table summarizes P&G’s cash flows from operating, investing, and financing activities in the 2009–2011 time period (in millions).
Net cash provided by operating activities Net cash used in investing activities Net cash used in financing activities
2011 $ 13,231 (3,482) (10,023)
2010 2009 $16,072 $ 14,919 (597) (2,353) (17,255) (10,814)
FINANCIAL REPORTING PROBLEM (Continued) P&G’s net cash provided by operating activities increased slightly from 2009 to 2010, and increased by 18% from 2010 to 2011. When accounts payable, accrued and other liabilities increase, cost of goods sold and operating expenses are higher on an accrued basis than they are on a cash basis. To convert to net cash provided by operating activities, the increase in accounts payable, and accrued and other liabilities must be added to net income. (e)
1.
Net Cash Provided by Operating Activities ÷ Average Current Liabilities = Current Cash Debt Coverage $13,231 ÷
2.
($27,293 + $24,282) 2
Net Cash Provided by Operating Activities ÷ Average Total Liabilities = Cash Debt Coverage $13,231÷ ($70,353 + $66,733) 2
3.
= .51:1
= 0.19:1
Net cash provided by operating activities less capital expenditures and dividends Net cash provided by operating activities ....... Less: Capital expenditures .............................. Dividends................................................ Free cash flow ...................................................
$13,231 $3,306 5,767
9,073 $ 4,158
Note that P&G also used cash ($7,039 million) to repurchase common stock, which reduces its free cash flow to negative $2,881 million. P&G’s financial position appears adequate. 19% of its total liabilities can be covered by the current year’s operating cash flow and its free cash flow position indicates it is easily meeting its capital investment and financing demands from current free cash flow.
COMPARATIVE ANALYSIS CASE
(a)
Both the Coca-Cola Company and PepsiCo, Inc. use the report form.
(b) The Coca-Cola Company has working capital of $1,214 million ($25,497 million – $24,283 million): PepsiCo, Inc. has working capital of $(713) million ($17,441 million – $18,154 million). The Coca-Cola Company indicates in its management discussion and analysis section that its ability to generate cash from operating activities is one of its fundamental financial strengths. This posture, coupled with use debt financing lowers the overall cost of capital and increases the return on shareowners’ equity. PepsiCo has a similar strategy (see discussion in “Liquidity and Capital Resources.”) (c)
The most significant difference relates to intangible assets. The CocaCola Company has Trademarks, Goodwill, and Other Intangible Assets of $27,669 million (35% of assets); PepsiCo, Inc. has Intangible Assets, net of amortization of $31,357 million (or 43% of assets). PepsiCo carries higher levels of property, plant, and equipment (27% of assets), while Coca-Cola’s property, plant, and equipment is just 18.7% of assets. Coca-Cola has higher investments in unconsolidated subsidiaries (10.5% > 2% of assets).
(d) Total assets
Annual
Five-Year
The Coca-Cola Company PepsiCo, Inc.
49.81% 10.7%
84.8% 25.6%
177.54% 170.26%
316.7 389.4%
Long-term debt The Coca-Cola Company PepsiCo, Inc. (e)
The Coca-Cola Company has increased net cash provided by operating activities from 2009 to 2011 by $1,288 million or 15.73%. PepsiCo, Inc. has increased net cash provided by operating activities by $2,148 million or 31.6%. Coca-Cola has a favorable trend in the generation of internal funds from operations. PepsiCo is more level.
COMPARATIVE ANALYSIS CASE (Continued) (f)
The Coca-Cola Company Current Cash Debt Ratio $9,474 ÷ $24,283 + $18,508 = 0.44:1 2 Cash Debt Coverage Ratio $9,474 ÷
$48,053 + $41,604 2
= 0.21:1
($ millions) Free cash flow Net cash provided by operating activities ................ Less: Capital expenditures....................................... Dividends......................................................... Free cash flow ............................................................
$9,474 2,920 4,300 $2,254
Coca-Cola Company’s free cash flow is $2,254. Note that Coca-Cola is also using cash to repurchase shares ($4,513 million in 2011). PepsiCo, Inc. Current Cash Debt Coverage $8,944 ÷
$18,154 + $15,892 = 0.53:1 2
Cash Debt Coverage $8,944 ÷
$51,983 + $46,667 = 0.18:1 2
COMPARATIVE ANALYSIS CASE (Continued) Free cash flow Net cash provided by operating activities................... Less: Capital spending ................................................ Dividends............................................................ Free cash flow ...............................................................
$8,944 3,339 3,157 $2,448
PepsiCo also used cash to repurchase shares (only $2.5 million in 2011). Both companies have strong liquidity and financial flexibility.
FINANCIAL STATEMENT ANALYSIS CASE 1
(a)
The raw materials price increase is not a required disclosure. However, the company might well want to inform shareholders in the management discussion and analysis section, especially as a means for company management to point out an area of success. If the company had not been able to successfully meet the challenge, then the reporting in the discussion and analysis section would be for the purpose of explaining poorer than expected operating results.
(b) The information in item (2) should be reported as follows: The $4,000,000 outstanding should, of course, be included in the balance sheet as a part of liabilities (current- or long-term, depending on the terms of the loan). The fact that an additional $11,000,000 or so is available for borrowing should be disclosed in the notes to the financial statements, as also should the fact that the loan is based on the accounts receivable.
FINANCIAL STATEMENT ANALYSIS CASE 2
(a)
These accounts are shown in the order in which Sherwin-Williams actually presented the accounts. The order shown may be modified somewhat; however, cash should certainly be listed first and other current assets last within the current assets category; common stock should be listed first and retained earnings last in the stockholders’ equity category. For the remaining items, the order may be different than that shown. CURRENT ASSETS Cash and cash equivalents Short-term investments Accounts receivable, less allowance Finished goods inventories Work in process and raw materials inventories Other current assets LONG-TERM ASSETS Land Buildings Machinery and equipment Intangibles and other assets CURRENT LIABILITIES Accounts payable Employee compensation payable Taxes payable Other accruals Accrued taxes LONG-TERM LIABILITIES Long-term debt Postretirement obligations other than pensions Other long-term liabilities STOCKHOLDERS’ EQUITY Common stock Other capital Retained earnings
FINANCIAL STATEMENT ANALYSIS CASE 2 (Continued) (b)
There is some latitude for judgment in this question. The general answer is that the assets and liabilities specific to the automotive division will decrease and that cash will increase. Some students may be aware that retained earnings will increase or decrease, depending upon whether the assets were sold above or below historical cost. Cash and cash equivalents—increase from the sale of the assets Accounts receivable, less allowance—decrease from the sale of the Automotive Division’s receivables Finished goods inventories—decrease Work in process and raw materials inventories—decrease Land—decrease Buildings—decrease Machinery and equipment—decrease Long-term debt—decrease Retained earnings—increase or decrease, depending on whether the assets were sold above or below cost
FINANCIAL STATEMENT ANALYSIS CASE 3
(a)
Working Capital, Current Ratio Without Contractual Obligations Working Capital
Current Ratio
$27,208 – $15,922 = $11,286
$27,208 ÷ $15,922 = 1.71
With Contractual Obligations Off-balance sheet current obligations = $3,275 ($3,172 + $100 + $3) Working Capital
Current Ratio
$27,208 – ($15,922 + $3,275) = $8,011
$27,208 ÷ ($15,922 + $3,275) = 1.42
Without information on contractual obligations, an analyst would overstate Deere’s liquidity, as measured by working capital and the current ratio. (b)
1.
Based on the analysis in Part (a), Deere has a pretty good liquidity cushion. It would be able to pay a loan of up $8,011 billion, if due in one year.
2.
Additional contractual obligations of $8,600 in years 2 and 3 and $3,631 in years 4 and 5 are relevant to assessing whether Deere can repay a loan maturing in 5 years. In evaluating a longer term loan, an analyst would need to develop a prediction of Deere’s cash flows over the next 5 years that would be used to repay a longer term loan. In summary, the schedule of contractual obligations provides information about off-balance sheet obligations—both the amounts and when due. This helps the analyst assess both liquidity and solvency of a company.
FINANCIAL STATEMENT ANALYSIS CASE 4
(a)
($ in millions) Current assets .................................... Total assets ........................................ Current liabilities ................................ Total liabilities .................................... (1) Cash provided by operations....... (2) Capital expenditures..................... (3) Dividends paid .............................. Net Income (loss) ............................... Sales.................................................... Free Cash Flow................................... (1) – (2) – (3)
Current Year $3,373 4,363 2,532 3,932 702 216 0 190 10,711
Prior Year $2,929 3,696 1,899 3,450 733 204 0 359 8,490
486
529
As indicated above, Amazon’s free cash flow in the current and prior year was $486 million and $529 million respectively. Amazon shows a declining trend in profitability and cash provided by operations. Depending on the investment required to build the warehouses, it appears they might not be able to finance the warehouses with internal funds. (b) Cash provided by operations has decreased in current year relative to the prior year by $31 million. This is due to lower profitability combined with a net increase in working capital and other non-cash income adjustments.
ACCOUNTING, ANALYSIS, AND PRINCIPLES
Accounting Hopkins Company Balance Sheet December 31, 2014 Assets Current assets Cash ($75,000 – $15,000) Accounts receivable ($52,000 – $9,000) Less: Allowance for doubtful accounts ($13,500 – $9,000) Inventory Total current assets Long-term investments Bond sinking fund Property, plant, and equipment Equipment Less: Accumulated depreciation—equipment Intangible assets Patents Total assets
$ 60,000 $ 43,000 4,500
15,000 112,000 28,000
84,000 15,000 $277,800
Liabilities and Stockholders’ Equity Current liabilities Notes and accounts payable Long-term liabilities Notes payable (due 2016) Total liabilities Stockholders’ equity Common stock Retained earnings Total stockholders’ equity Total liabilities and stockholders’ equity
38,500 65,300 163,800
$ 52,000 75,000 127,000 $100,000 50,800 150,800 $277,800
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) Analysis The classified balance sheet provides subtotals for current assets and current liabilities, which are assets expected to be converted to cash (or liabilities expected to be paid from cash) in the next year or operating cycle (also referred to as liquidity). Thus, an analysis of current assets relative to current liabilities provides information relevant to assessing Hopkins’ ability to repay a loan within the next year. Specifically, current assets in excess of current liabilities (working capital) is $111,800 ($163,800 – $52,000.) This seems to be a safe liquidity cushion relative to an additional loan of $45,000. Of course, the loan officer also would evaluate Hopkins’ earnings and cash flows in the analysis.
Principles The primary objection that the bank is likely to raise about this supplemental information is the subjectivity (which reduces faithful representation) of the estimates of fair values for the long-lived assets and the internally generated intangibles. In addition, the loan officer might not consider information about these long-term assets to be that relevant to the loan decision, because the loan is short-term.
PROFESSIONAL RESEARCH
(a)
Codification String: FASB ASC 235-10-05—Presentation > 235 Notes to Financial Statements > 10 Overall > 05 Background (Predecessor Standard – [APB 22])
(b)
Codification String: Presentation > 235 Notes to Financial Statements > 10 Overall > 05 Background 05-3 The accounting policies of an entity are the specific accounting principles and the methods of applying those principles that are judged by the management of the entity to be the most appropriate in the circumstances to present fairly financial position, cash flows, and results of operations in accordance with generally accepted accounting principles (GAAP) and that, accordingly, have been adopted for preparing the financial statements.
(c)
Codification String: Presentation > 235 Notes to Financial Statements > 10 Overall > 50 Disclosure 50-3 Disclosure of accounting policies shall identify and describe the accounting principles followed by the entity and the methods of applying those principles that materially affect the determination of financial position, cash flows, or results of operations. In general, the disclosure shall encompass important judgments as to appropriateness of principles relating to recognition of revenue and allocation of asset costs to current and future periods; in particular, it shall encompass those accounting principles and methods that involve any of the following: a. b. c.
A selection from existing acceptable alternatives. Principles and methods peculiar to the industry in which the entity operates, even if such principles and methods are predominantly followed in that industry. Unusual or innovative applications of GAAP.
PROFESSIONAL RESEARCH (Continued) (d)
50-4 Codification String: Presentation > 235 Notes to Financial Statements > 10 Overall > 05 Background Examples of disclosures by an entity commonly required with respect to accounting policies would include, among others, those relating to the following: a. b. c. d. e. g.
Basis of consolidation Depreciation methods Amortization of intangibles Inventory pricing Accounting for recognition of profit on long-term construction-type contracts Recognition of revenue from franchising and leasing operations.
PROFESSIONAL SIMULATION
FINANCIAL STATEMENT SOLO HOPE COMPANY Balance Sheet December 31, 2014 Assets Current assets Cash ($50,000 – $20,000)..................................... Accounts receivable ($38,500 + $13,500)........... Less: Allowance for doubtful accounts........ Inventory .............................................................. Total current assets ........................................
$ 30,000 $ 52,000 13,500
Long-term investments Plant expansion fund .......................................... Property, plant, and equipment Equipment............................................................ Less: Accumulated depreciation— equipment ............................................
38,500 65,300 133,800
20,000 132,000 28,000
Intangible assets Patents ................................................................. Total assets .....................................................
104,000
25,000 $282,800
Liabilities and Stockholders’ Equity Current liabilities Notes payable ...................................................... Accounts payable................................................ Income taxes payable.......................................... Total current liabilities ....................................
17,000 $ 32,000 8,000 $ 57,000
PROFESSIONAL SIMULATION (Continued) Long-term liabilities Bonds payable (9%, due June 30, 2022) ............ Total liabilities ................................................. Stockholders’ equity Common stock ($1 par) ....................................... Additional paid-in capital .................................... Retained earnings................................................ Total liabilities and stockholders’ equity...........
100,000 157,000
50,000 55,000 20,800
125,800 $282,800
ANALYSIS Z = Working capital X 1.2 + Retained earnings X 1.4 Total assets Total assets +
Sales Total assets
+
X 0.99 +
= ($133,800 – $57,000) X 1.2 + $20,800 X 1.4 $282,800 $282,800
EBIT Total assets
MV equity X 0.6 Total liabilities
+ $14,000 X 3.3 $282,800
+ $210,000 X 0.99 + $225,000 X 0.6 $282,800 $157,000 = .3259 + .1030 + .1634 + .7351 + .8599 = 2.1873
X 3.3
PROFESSIONAL SIMULATION (Continued) Hope’s Z-Score is above the “likely-to-fail” level of 1.81 but also below the unlikely-to-fail value of 3.0. Hope should be concerned about his company’s situation. RESEARCH Search string: “accounting policies” and disclosure APB 22: Disclosure of Accounting Policies 12. Disclosure of accounting policies should identify and describe the accounting principles followed by the reporting entity and the methods of applying those principles that materially affect the determination of financial position, changes in financial position, or results of operations. In general, the disclosure should encompass important judgments as to appropriateness of principles relating to recognition of revenue and allocation of asset costs to current and future periods; in particular, it should encompass those accounting principles and methods that involve any of the following: a.
A selection from existing acceptable alternatives;
b.
Principles and methods peculiar to the industry in which the reporting entity operates, even if such principles and methods are predominantly followed in that industry;
c.
Unusual or innovative applications of generally accepted accounting principles (and, as applicable, of principles and methods peculiar to the industry in which the reporting entity operates).
Examples of disclosures by a business entity commonly required with respect to accounting policies would include, among others, those relating to basis of consolidation, depreciation methods, amortization of intangibles, inventory pricing, accounting for research and development costs (including basis for amortization), translation of foreign currencies, recognition of profit on long-term construction-type contracts, and recognition of revenue from franchising and leasing operations. This list of examples is not all-inclusive.
IFRS CONCEPTS AND APPLICATION
IFRS5-1 In general, the disclosure requirements related to the statement of financial position (balance sheet) and the statement of cash flows are much more extensive and detailed in the U.S. IAS 1, “Presentation of Financial Statements,” provides the overall IFRS requirements for balance sheet information. IAS 7, “Cash Flow Statements,” provides the overall IFRS requirements for cash flow information.
IFRS5-2 Among the similarities between IFRS and U.S. GAAP related to statement of financial position presentation are as follows: IAS 1 specifies minimum note disclosures. These must include information about (1) accounting policies followed, (2) judgments that management has made in the process of applying the entity’s accounting policies, (3) and the key assumptions and estimation uncertainty that could result in a material adjustment to the carrying amounts of assets and liabilities within the next financial year. Comparative prior-period information must be presented and financial statements must be prepared annually. Current/non-current classification for assets and liabilities is normally required. In general, post-financial statement events are not considered in classifying items as current or non-current. Differences include (1) IFRS statements may report property, plant, and equipment first in the statement of financial position. Some companies report the sub-total “net assets”, which equals total assets minus total liabilities; (2) While the use of the term “reserve” is discouraged in U.S. GAAP, there is no such prohibition in IFRS.
IFRS5-3 The IASB and the FASB are working on a project to converge their standards related to financial statement presentation. This joint project will establish a common, high-quality standard for presentation of information in the financial statements, including the classification and display of line items. A key feature of the proposed framework for financial statement presentation is that each of the statements will be organized in the same format to separate an entity’s financing activities from its operating and other activities (investing) and further separates financing activities into transactions with owners and creditors. Thus, the same classifications used in the statement of financial position would also be used in the income statement and the statement of cash flows. IFRS5-4 Rainmaker Company will report a net revaluation gain of $165,000 ($200,000 – $35,000), which will be recoded as an adjustment to these assets with the net gain recorded in equity. Each reporting period the property and equipment are revalued to approximate fair value. The use of revaluations is prohibited in GAAP. IFRS5-5 (a)
Some of the differences are: 1.
2. 3.
4.
Report form and subtotals—Tomkins uses a modified report form with current liabilities deducted from current assets to determine net current assets and remaining liabilities deducted from total assets less current liabilities to arrive at “net assets”. This amount balances with total “Capital and Reserves”. Classifications—the classifications are not arranged according to decreasing liquidity. For example, “Fixed assets” are listed first, then “Current assets”. Cash is not listed as the first current asset. Terminology—For example, Contributed capital is referred to as “Ordinary share capital” and “Share premium” account, rather than Common Stock and Additional paid-in capital. “Accumulated deficit” is used instead of Retained Earnings. Units of currency—Tomkins reports in pounds sterling.
IFRS5-5 (Continued) (b)
Although there are differences in terminology and some groupings and subtotals are different, the British balance sheet does group assets and liabilities with similar characteristics together (Fixed assets, Current assets and Current liabilities). For the most part, the classifications are similar in that they are related to the liquidity of the balance sheet items. By netting liabilities against assets, a measure of solvency is provided.
Note to instructors: A final difference not mentioned above is the “Capital redemption reserve” account in the Capital and reserves section of Tomkins’ Balance sheet. This account in the U.K. corresponds to “Additional Paid-in Capital—Treasury Stock in the U.S. setting.
IFRS5-6 (a)
International Accounting Standard 8 covers the disclosure of accounting policies.
(b)
Accounting policies are the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements (para. 5).
(c)
An entity shall select and apply its accounting policies consistently for similar transactions, other events and conditions, unless an IFRS specifically requires or permits categorisation of items for which different policies may be appropriate. If an IFRS requires or permits such categorisation, an appropriate accounting policy shall be selected and applied consistently to each category. (para. 13) An entity shall change an accounting policy only if the change: a. is required by an IFRS; or b. results in the financial statements providing reliable and more relevant information about the effects of transactions, other events or conditions on the entity’s financial position, financial performance or cash flows. (para. 14)
IFRS5-6 (Continued) (d)
Disclosure When initial application of an IFRS has an effect on the current period or any prior period, or would have such an effect except that it is impracticable to determine the amount of the adjustment, or might have an effect on future periods, an entity shall disclose: a. the title of the IFRS; b. when applicable, that the change in accounting policy is made in accordance with its transitional provisions; c. the nature of the change in accounting policy; d. when applicable, a description of the transitional provisions; e. when applicable, the transitional provisions that might have an effect on future periods; f. for the current period and each prior period presented, to the extent practicable, the amount of the adjustment: (i) for each financial statement line item affected; and (ii) if IAS 33 Earnings per Share applies to the entity, for basic and diluted earnings per share; g. the amount of the adjustment relating to periods before those presented, to the extent practicable; and h. if retrospective application required by paragraph 19(a) or (b) is impracticable for a particular prior period, or for periods before those presented, the circumstances that led to the existence of that condition and a description of how and from when the change in accounting policy has been applied. Financial statements of subsequent periods need not repeat these disclosures. (para. 28)
IFRS5-6 (Continued) When a voluntary change in accounting policy has an effect on the current period or any prior period, would have an effect on that period except that it is impracticable to determine the amount of the adjustment, or might have an effect on future periods, an entity shall disclose: a. the nature of the change in accounting policy; b. the reasons why applying the new accounting policy provides reliable and more relevant information; c. for the current period and each prior period presented, to the extent practicable, the amount of the adjustment: (i) for each financial statement line item affected; and (ii) if IAS 33 applies to the entity, for basic and diluted earnings per share; d. the amount of the adjustment relating to periods before those presented, to the extent practicable; and e. if retrospective application is impracticable for a particular prior period, or for periods before those presented, the circumstances that led to the existence of that condition and a description of how and from when the change in accounting policy has been applied. Financial statements of subsequent periods need not repeat these disclosures (para. 29). IFRS5-7 (a)
M&S could have adopted the account form or report form. M&S uses the report form.
(b)
The techniques of disclosing pertinent information include (1) parenthetical explanations, (2) cross-reference and contra items, and (3) notes to the financial statements. M&S uses notes.
(c)
Investments are reported on M&S’s statement of financial position as non-current assets. Note 1 (Accounting Policies) states that Investments are classified as either available-for-sale, or fair value through profit or loss. These securities are valued at fair value. On March 31, 2012, M&S had negative working capital (current assets less than current liabilities) of £545.3 million. On April 2, 2011, M&S’s negative working capital was £568.5 million.
IFRS5-7 (Continued) (d)
The following table summarizes M&S’s cash flows from operating, investing, and financing activities in 2012 and 2011 (in millions).
Net cash provided by operating activities Net cash used in investing activities Net cash used in financing activities
2012 £1.203.0 757.8 511.0
2011 £1,199.9 490.5 647.4
M&S’s net cash provided by operating activities increased by 3% from 2011 to 2012. Changes in accounts payable and in accrued and other liabilities is added to net income because these changes reduce income but not cash flow. (e)
Current Cash Debt £1,203 ÷ £2,005.4 + £2,210.2 = 0.57:1 2 Cash Debt Coverage £1,203 ÷
£4,494.5 + £4,666.7 = 0.26:1 2
Free cash flow Net cash provided by operating activities................. Less: Capital expenditures........................................ Dividends.......................................................... Free cash flow .............................................................
£1,203.0 564.3 267.8 £ 370.9
M&S’s financial position appears adequate. Over 26% of its total liabilities can be covered by the current year’s operating cash flow and its free cash flow position indicates it is easily meeting its capital investment demands and the current level of dividends from current free cash flow.
CHAPTER 6 Accounting and the Time Value of Money ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Brief Exercises
Exercises
13, 14
8
1
a. Unknown future amount.
7, 19
1, 5, 13
2, 3, 4, 7
b. Unknown payments.
10, 11, 12
6, 12, 15, 17
8, 16, 17
2, 6
4, 9
10, 15
2
Topics
Questions
1.
Present value concepts.
1, 2, 3, 4, 5, 9, 17
2.
Use of tables.
3.
Present and future value problems:
c. Unknown number of periods.
Problems
d. Unknown interest rate.
15, 18
3, 11, 16
9, 10, 11, 14
2, 7
e. Unknown present value.
8, 19
2, 7, 8, 10, 14
3, 4, 5, 6, 8, 12, 17, 18, 19
1, 4, 7, 9, 13, 14
4.
Value of a series of irregular deposits; changing interest rates.
3, 5, 8
5.
Valuation of leases, pensions, bonds; choice between projects.
6
6.
Deferred annuity.
16
7.
Expected Cash Flows.
15
7, 12, 13, 14, 15
3, 5, 6, 8, 9, 10, 11, 12, 13, 14, 15
20, 21, 22
13, 14, 15
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives
Questions
Brief Exercises
Exercises
Problems
1.
Identify accounting topics where the time value of money is relevant.
1, 3, 17
2.
Distinguish between simple and compound interest.
1, 3, 4, 17, 18
2
3.
Use appropriate compound interest tables.
4, 5, 13, 14
1
4.
Identify variables fundamental to solving interest problems.
6, 7, 10, 11, 12
5.
Solve future and present value of 1 problems.
2, 7, 8, 10, 11, 12
1, 2, 3, 4, 7, 8
2, 3, 6, 9, 10, 15
1, 2, 3, 5, 7, 9, 10
6.
Solve future value of ordinary and annuity due problems.
8, 9, 10, 11, 13
5, 6, 9, 13
3, 4, 6, 15, 16
2, 7
7.
Solve present value of ordinary and annuity due problems.
12, 14
10, 11, 12, 14, 16, 17
3, 4, 5, 6, 11, 12, 17, 18, 19
1, 2, 3, 4, 5, 7, 8, 9, 10, 13, 14
8.
Solve present value problems related to deferred annuities and bonds.
2, 12, 15, 16
15
7, 8, 13, 14
6, 11, 12, 15
9.
Apply expected cash flows to present value measurement.
19
20, 21, 22
13, 14, 15
ASSIGNMENT CHARACTERISTICS TABLE
Item
Description
Level of Difficulty
Time (minutes)
E6-1 E6-2 E6-3 E6-4 E6-5 E6-6 E6-7 E6-8 E6-9 E6-10 E6-11 E6-12 E6-13 E6-14 E6-15 E6-16 E6-17 E6-18 E6-19 E6-20 E6-21 E6-22
Using interest tables. Simple and compound interest computations. Computation of future values and present values. Computation of future values and present values. Computation of present value. Future value and present value problems. Computation of bond prices. Computations for a retirement fund. Unknown rate. Unknown periods and unknown interest rate. Evaluation of purchase options. Analysis of alternatives. Computation of bond liability. Computation of pension liability. Investment decision. Retirement of debt. Computation of amount of rentals. Least costly payoff. Least costly payoff. Expected cash flows. Expected cash flows and present value. Fair value estimate.
Simple Simple Simple Moderate Simple Moderate Moderate Simple Moderate Simple Moderate Simple Moderate Moderate Moderate Simple Simple Simple Simple Simple Moderate Moderate
5–10 5–10 10–15 15–20 10–15 15–20 12–17 10–15 5–10 10–15 10–15 10–15 15–20 15–20 15–20 10–15 10–15 10–15 10–15 5–10 15–20 15–20
P6-1 P6-2 P6-3 P6-4 P6-5 P6-6 P6-7 P6-8 P6-9 P6-10 P6-11 P6-12 P6-13 P6-14 P6-15
Various time value situations. Various time value situations. Analysis of alternatives. Evaluating payment alternatives. Analysis of alternatives. Purchase price of a business. Time value concepts applied to solve business problems. Analysis of alternatives. Analysis of business problems. Analysis of lease vs. purchase. Pension funding. Pension funding. Expected cash flows and present value. Expected cash flows and present value. Fair value estimate.
Moderate Moderate Moderate Moderate Moderate Moderate Complex Moderate Complex Complex Complex Moderate Moderate Moderate Complex
15–20 15–20 20–30 20–30 20–25 25–30 30–35 20–30 30–35 30–35 25–30 20–25 20–25 20–25 20–25
SOLUTIONS TO CODIFICATION EXERCISES CE6-1 (a) According to the Master Glossary, present value is a tool used to link uncertain future amounts (cash flows or values) to a present amount using a discount rate (an application of the income approach) that is consistent with value maximizing behavior and capital market equilibrium. Present value techniques differ in how they adjust for risk and in the type of cash flows they use. (b) The discount rate adjustment technique is a present value technique that uses a risk-adjusted discount rate and contractual, promised, or most likely cash flows. (c) Other codification references to present value are at (1) FASB ASC 820-10-35-33 and (2) FASB ASC 820-10-55-55-4. Details for these references follow. 1.
820 Fair Value Measurements and Disclosures > 10 Overall > 35 Subsequent Measurement 35-33 Those valuation techniques include the following: a. Present value techniques b. Option-pricing models (which incorporate present value techniques), such as the Black-Scholes-Merton formula (a closed-form model) and a binomial model (a lattice model) c. The multiperiod excess earnings method, which is used to measure the fair value of certain intangible assets.
2.
820 Fair Value Measurements and Disclosures > 10 Overall > 55 Implementation General, paragraph 55-4 >>> Present Value Techniques 55-4 FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements, provides guidance for using present value techniques to measure fair value. That guidance focuses on a traditional or discount rate adjustment technique and an expected cash flow (expected present value) technique. This Section clarifies that guidance. (That guidance is included or otherwise referred to principally in paragraphs 39–46, 51, 62–71, 114, and 115 of Concepts Statement 7.) This Section neither prescribes the use of one specific present value technique nor limits the use of present value techniques to measure fair value to the techniques discussed herein. The present value technique used to measure fair value will depend on facts and circumstances specific to the asset or liability being measured (for example, whether comparable assets or liabilities can be observed in the market) and the availability of sufficient data.
CE6-2 Answers will vary. By entering the phrase “present value” in the search window, a list of references to the term is provided. The site allows you to narrow the search to assets, liabilities, revenues, and expenses. (a) Asset reference: 350 Intangibles—Goodwill and Other > 20 Goodwill > 50 Disclosure > Goodwill Impairment Loss > Information for Each Period for Which a Statement of Financial Position Is Presented
CE6-2 (Continued) 50-1 The changes in the carrying amount of goodwill during the period shall be disclosed, including the following (see Example 3 [paragraph 350-20-55-24]): a. The aggregate amount of goodwill acquired. b. The aggregate amount of impairment losses recognized. c. The amount of goodwill included in the gain or loss on disposal of all or a portion of a reporting unit. Entities that report segment information in accordance with Topic 280 shall provide the above information about goodwill in total and for each reportable segment and shall disclose any significant changes in the allocation of goodwill by reportable segment. If any portion of goodwill has not yet been allocated to a reporting unit at the date the financial statements are issued, that unallocated amount and the reasons for not allocating that amount shall be disclosed. > Goodwill Impairment Loss 50-2 For each goodwill impairment loss recognized, all of the following information shall be disclosed in the notes to the financial statements that include the period in which the impairment loss is recognized: a. A description of the facts and circumstances leading to the impairment. b. The amount of the impairment loss and the method of determining the fair value of the associated reporting unit (whether based on quoted market prices, prices of comparable businesses, a present value or other valuation technique, or a combination thereof). c. If a recognized impairment loss is an estimate that has not yet been finalized (see paragraphs 350-20-35-18 through 19), that fact and the reasons therefore and, in subsequent periods, the nature and amount of any significant adjustments made to the initial estimate of the impairment loss. (b) Liability reference: 410 Asset Retirement and Environmental Obligations > 20 Asset Retirement Obligations > 30 Initial Measurement Determination of a Reasonable Estimate of Fair Value 30-1 An expected present value technique will usually be the only appropriate technique with which to estimate the fair value of a liability for an asset retirement obligation. An entity, when using that technique, shall discount the expected cash flows using a credit-adjusted risk-free rate. Thus, the effect of an entity’s credit standing is reflected in the discount rate rather than in the expected cash flows. Proper application of a discount rate adjustment technique entails analysis of at least two liabilities—the liability that exists in the marketplace and has an observable interest rate and the liability being measured. The appropriate rate of interest for the cash flows being measured must be inferred from the observable rate of interest of some other liability, and to draw that inference the characteristics of the cash flows must be similar to those of the liability being measured. Rarely, if ever, would there be an observable rate of interest for a liability that has cash flows similar to an asset retirement obligation being measured. In addition, an asset retirement obligation usually will have uncertainties in both timing and amount. In that circumstance, employing a discount rate adjustment technique, where uncertainty is incorporated into the rate, will be difficult, if not impossible. See paragraphs 410-20-55-13 through 55-17 and Example 2 (paragraph 410-20-55-35).
CE6-2 (Continued) (c) Revenue or Expense reference: 720 Other Expenses> 25 Contributions Made> 30 Initial Measurement 30-1 Contributions made shall be measured at the fair values of the assets given or, if made in the form of a settlement or cancellation of a donee’s liabilities, at the fair value of the liabilities cancelled. 30-2 Unconditional promises to give that are expected to be paid in less than one year may be measured at net settlement value because that amount, although not equivalent to the present value of estimated future cash flows, results in a reasonable estimate of fair value.
CE6-3 Interest cost includes interest recognized on obligations having explicit interest rates, interest imputed on certain types of payables in accordance with Subtopic 835-30, and interest related to a capital lease determined in accordance with Subtopic 840-30. With respect to obligations having explicit interest rates, interest cost includes amounts resulting from periodic amortization of discount or premium and issue costs on debt. According to the discussion at: 835 Interest> 30 Imputation of Interest 05-1
This Subtopic addresses the imputation of interest.
05-2
Business transactions often involve the exchange of cash or property, goods, or services for a note or similar instrument. When a note is exchanged for property, goods, or services in a bargained transaction entered into at arm’s length, there should be a general presumption that the rate of interest stipulated by the parties to the transaction represents fair and adequate compensation to the supplier for the use of the related funds. That presumption, however, must not permit the form of the transaction to prevail over its economic substance and thus would not apply if interest is not stated, the stated interest rate is unreasonable, or the stated face amount of the note is materially different from the current cash sales price for the same or similar items or from the market value of the note at the date of the transaction. The use of an interest rate that varies from prevailing interest rates warrants evaluation of whether the face amount and the stated interest rate of a note or obligation provide reliable evidence for properly recording the exchange and subsequent related interest.
05-3
This Subtopic provides guidance for the appropriate accounting when the face amount of a note does not reasonably represent the present value of the consideration given or received in the exchange. This circumstance may arise if the note is non-interest-bearing or has a stated interest rate that is different from the rate of interest appropriate for the debt at the date of the transaction. Unless the note is recorded at its present value in this circumstance, the sales price and profit to a seller in the year of the transaction and the purchase price and cost to the buyer are misstated, and interest income and interest expense in subsequent periods are also misstated.
ANSWERS TO QUESTIONS 1. Money has value because with it one can acquire assets and services and discharge obligations. The holding, borrowing or lending of money can result in costs or earnings. And the longer the time period involved, the greater the costs or the earnings. The cost or earning of money as a function of time is the time value of money. Accountants must have a working knowledge of compound interest, annuities, and present value concepts because of their application to numerous types of business events and transactions which require proper valuation and presentation. These concepts are applied in the following areas: (1) sinking funds, (2) installment contracts, (3) pensions, (4) long-term assets, (5) leases, (6) notes receivable and payable, (7) business combinations, (8) amortization of premiums and discounts, and (9) estimation of fair value. 2. Some situations in which present value measures are used in accounting include: (a) Notes receivable and payable—these involve single sums (the face amounts) and may involve annuities, if there are periodic interest payments. (b) Leases—involve measurement of assets and obligations, which are based on the present value of annuities (lease payments) and single sums (if there are residual values to be paid at the conclusion of the lease). (c) Pensions and other deferred compensation arrangements—involve discounted future annuity payments that are estimated to be paid to employees upon retirement. (d) Bond pricing—the price of bonds payable is comprised of the present value of the principal or face value of the bond plus the present value of the annuity of interest payments. (e) Long-term assets—evaluating various long-term investments or assessing whether an asset is impaired requires determining the present value of the estimated cash flows (may be single sums and/or an annuity). 3. Interest is the payment for the use of money. It may represent a cost or earnings depending upon whether the money is being borrowed or loaned. The earning or incurring of interest is a function of the time, the amount of money, and the risk involved (reflected in the interest rate). Simple interest is computed on the amount of the principal only, while compound interest is computed on the amount of the principal plus any accumulated interest. Compound interest involves interest on interest while simple interest does not. 4. The interest rate generally has three components: (a) Pure rate of interest—This would be the amount a lender would charge if there were no possibilities of default and no expectation of inflation. (b) Expected inflation rate of interest—Lenders recognize that in an inflationary economy, they are being paid back with less valuable dollars. As a result, they increase their interest rate to compensate for this loss in purchasing power. When inflationary expectations are high, interest rates are high. (c) Credit risk rate of interest—The government has little or no credit risk (i.e., risk of nonpayment) when it issues bonds. A business enterprise, however, depending upon its financial stability, profitability, etc. can have a low or a high credit risk. Accountants must have knowledge about these components because these components are essential in identifying an appropriate interest rate for a given company or investor at any given moment. 5. (a) Present value of an ordinary annuity at 8% for 10 periods (Table 6-4). (b) Future value of 1 at 8% for 10 periods (Table 6-1). (c) Present value of 1 at 8% for 10 periods (Table 6-2). (d) Future value of an ordinary annuity at 8% for 10 periods (Table 6-3).
Questions Chapter 6 (Continued) 6. He should choose quarterly compounding, because the balance in the account on which interest will be earned will be increased more frequently, thereby resulting in more interest earned on the investment. This is shown in the following calculation: Semiannual compounding, assuming the amount is invested for 2 years: n=4 $1,500 X 1.16986 = $1,755 i=4 Quarterly compounding, assuming the amount is invested for 2 years: n=8 $1,500 X 1.17166 = $1,758 i=2 Thus, with quarterly compounding, Jose could earn $3 more. 7. $26,898 = $20,000 X 1.34489 (future value of 1 at 21/2% for 12 periods). 8. $44,671 = $80,000 X .55839 (present value of 1 at 6%% for 10 periods). 9. An annuity involves (1) periodic payments or receipts, called rents, (2) of the same amount, (3) spread over equal intervals, (4) with interest compounded once each interval. Rents occur at the end of the intervals for ordinary annuities while the rents occur at the beginning of each of the intervals for annuities due. 10. Amount paid each year = $40,000 (present value of an ordinary annuity at 12% for 4 years). 3.03735 Amount paid each year = $13,169. 11. Amount deposited each year = $200,000 (future value of an ordinary annuity at 10% for 4.64100 4 years). Amount deposited each year = $43,094. 12. Amount deposited each year = $200,000 [future value of an annuity due at 10% for 4 years 5.10510 (4.64100 X 1.10)]. Amount deposited each year = $39,177. 13. The process for computing the future value of an annuity due using the future value of an ordinary annuity interest table is to multiply the corresponding future value of the ordinary annuity by one plus the interest rate. For example, the factor for the future value of an annuity due for 4 years at 12% is equal to the factor for the future value of an ordinary annuity times 1.12. 14. The basis for converting the present value of an ordinary annuity table to the present value of an annuity due table involves multiplying the present value of an ordinary annuity factor by one plus the interest rate.
Questions Chapter 6 (Continued) 15. Present value = present value of an ordinary annuity of $25,000 for 20 periods at? percent. $245,000
= present value of an ordinary annuity of $25,000 for 20 periods at? percent.
Present value of an ordinary annuity for 20 periods at? percent =
$245,000 = 9.8. $25,000
The factor 9.8 is closest to 9.81815 in the 8% column (Table 6-4). 16.
4.96764 Present value of ordinary annuity at 12% for eight periods. (2.40183) Present value of ordinary annuity at 12% for three periods. 2.56581 Present value of ordinary annuity at 12% for eight periods, deferred three periods. The present value of the five rents is computed as follows: 2.56581 X $20,000 = $51,316..
17. (a) (b) (c) (d)
Present value of an annuity due. Present value of 1. Future value of an annuity due. Future value of 1.
18. $27,600 = PV of an ordinary annuity of $6,900 for five periods at? percent. $27,600 = PV of an ordinary annuity for five periods at? percent. $6,900 4.0 = PV of an ordinary annuity for five periods at? 4.0 = approximately 8%. 19. The IRS argues that the future reserves should be discounted to present value. The result would be smaller reserves and therefore less of a charge to income. As a result, income would be higher and income taxes may therefore be higher as well.
SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 6-1 8% annual interest i = 8% PV = $15,000
FV = ?
0
1
2
3
n=3 FV = $15,000 (FVF3, 8%) FV = $15,000 (1.25971) FV = $18,896 8% annual interest, compounded semiannually i = 4% PV = $15,000
0
FV = ?
1
2
3
4
n=6 FV = $15,000 (FVF6, 4%) FV = $15,000 (1.26532) FV = $18,980
5
6
BRIEF EXERCISE 6-2 12% annual interest
i = 12% PV = ?
FV = $25,000
0
1
2 n=4
3
4
PV = $25,000 (PVF4, 12%) PV = $25,000 (.63552) PV = $15,888
12% annual interest, compounded quarterly i = 3% PV = ?
0
FV = $25,000
1
2
14 n = 16 PV = $25,000 (PVF16, 3%) PV = $25,000 (.62317) PV = $15,579
15
16
BRIEF EXERCISE 6-3 i=? PV = $30,000
0
1
FV = $150,000
2
19
20
21
n = 21 FV = PV (FVF21, i)
PV = FV (PVF21, i) OR
$150,000 = $30,000 (FVF21, i)
$30,000 = $150,000 (PVF21, i)
FVF21, i = 5.0000
PVF21, i = .20000
i = 8%
i = 8%
BRIEF EXERCISE 6-4 i = 5% PV = $10,000
FV = $17,100
0
? n=?
FV = PV (FVFn, 5%)
PV = FV (PVFn, 5%) OR
$17,100 = $10,000 (FVFn, 5%)
$10,000 = $17,100 (PVFn, 5%)
FVFn, 5% = 1.71000
PVFn, 5% = .58480
n = 11 years
n = 11 years
BRIEF EXERCISE 6-5 First payment today (Annuity Due) i = 12% FV – AD =
R= $8,000 $8,000 $8,000
0
1
$8,000 $8,000
2
18
19
?
20
n = 20 FV – AD = $8,000 (FVF – OA20, 12%) 1.12 FV – AD = $8,000 (72.05244) 1.12 FV – AD = $645,590
First payment at year-end (Ordinary Annuity) i = 12% FV – OA = ? $8,000 $8,000 $8,000
$8,000 $8,000
0
1
2
18
19
n = 20 FV – OA = $8,000 (FVF – OA20, 12%) FV – OA = $8,000 (72.05244) FV – OA = $576,420
20
BRIEF EXERCISE 6-6 i = 11%
0
R=?
?
?
FV – OA = ? $250,000
1
2
8
9
10
n = 10 $250,000 = R (FVF – OA10, 11%) $250,000 = R (16.72201) $250,000 =R 16.72201 R = $14,950 BRIEF EXERCISE 6-7 12% annual interest i = 12% PV = ?
0
FV = $300,000
1
2
3 n=5
PV = $300,000 (PVF5, 12%) PV = $300,000 (.56743) PV = $170,229
4
5
BRIEF EXERCISE 6-8 With quarterly compounding, there will be 20 quarterly compounding periods, at 1/4 the interest rate: PV = $300,000 (PVF20, 3%) PV = $300,000 (.55368) PV = $166,104
BRIEF EXERCISE 6-9 i = 10% FV – OA = R=
$100,000
$16,380 $16,380
0
1
$16,380
2
n n=?
$100,000 = $16,380 (FVF – OAn, 10%) $100,000 FVF – OAn, 10% = = 6.10501 16,380 Therefore, n = 5 years
BRIEF EXERCISE 6-10 First withdrawal at year-end i = 8% PV – OA = R = ? $30,000 $30,000
0
1
$30,000 $30,000 $30,000
2
8
9
10
n = 10 PV – OA = $30,000 (PVF – OA10, 8%) PV – OA = $30,000 (6.71008) PV – OA = $201,302 First withdrawal immediately i = 8% PV – AD = ? R= $30,000 $30,000 $30,000
0
1
$30,000 $30,000
2
8
9
n = 10 PV – AD = $30,000 (PVF – AD10, 8%) PV – AD = $30,000 (7.24689) PV – AD = $217,407
10
BRIEF EXERCISE 6-11 i=? PV = $793.15
R= $75
$75
$75
$75
$75
0
1
2
10
11
12
n = 12 $793.15 = $75 (PVF – OA12, i) $793.15 PVF12, i = = 10.57533 $75 Therefore, i = 2% per month or 24% per year.
BRIEF EXERCISE 6-12 i = 8% PV = $300,000 R = ?
0
1
?
?
?
?
2
18
19
20
n = 20 $300,000 = R (PVF – OA20, 8%) $300,000 = R (9.81815) R = $30,556
BRIEF EXERCISE 6-13 i = 12% R= $30,000 $30,000
$30,000 $30,000 $30,000
12/31/11 12/31/12 12/31/13
12/31/17 12/31/18 12/31/19 n=8
FV – OA = $30,000 (FVF – OA8, 12%) FV – OA = $30,000 (12.29969) FV – OA = $368,991
BRIEF EXERCISE 6-14 i = 8% PV – OA =
R=
?
0
$25,000 $25,000
1
2
3
4
5
n=4
$25,000 $25,000
6
11
12
n=8
PV – OA = $25,000 (PVF – OA12–4, 8%)
PV – OA = $25,000 (PVF – OA8, 8%)(PVF4, 8%) OR
PV – OA = $25,000 (7.53608 – 3.31213)
PV – OA = $25,000 (5.74664)(.73503)
PV – OA = $105,599
PV – OA = $105,599
BRIEF EXERCISE 6-15 i = 8% PV = ? PV – OA = R = ? $140,000 $140,000
0
1
$2,000,000 $140,000 $140,000 $140,000
2
8
9
10
n = 10 $2,000,000 (PVF10, 8%) = $2,000,000 (.46319) = $ 926,380 $140,000 (PVF – OA10, 8%) = $140,000 (6.71008) = 939,411 $1,865,791
BRIEF EXERCISE 6-16 PV – OA = $20,000 $4,727.53 $4,727.53
0
1
$4,727.53 $4,727.53
2
5
$20,000
= $4,727.53 (PV – OA6, i%)
(PV – OA6, i%) (PV – OA6, i%) Therefore, i%
= $20,000 ÷ $4,727.53 = 4.23054 = 11
6
BRIEF EXERCISE 6-17 PV – AD = $20,000 $? $?
$?
$?
0
2
5
1
$20,000 = Payment (PV – AD6, 11%) $20,000 ÷ (PV – AD6, 11%) = Payment $20,000 ÷ 4.6959 = $4,259
6
SOLUTIONS TO EXERCISES EXERCISE 6-1 (5–10 minutes)
1. a. b. c.
(a) Rate of Interest 9% 3% 5%
(b) Number of Periods 9 20 30
2. a. b. c.
9% 5% 3%
25 30 28
EXERCISE 6-2 (5–10 minutes) (a)
Simple interest of $1,600 per year X 8 Principal Total withdrawn
(b)
Interest compounded annually—Future value of 1 @ 8% for 8 periods Total withdrawn
(c)
Interest compounded semiannually—Future value of 1 @ 4% for 16 periods Total withdrawn
EXERCISE 6-3 (10–15 minutes) (a)
$7,000 X 1.46933 = $10,285.
(b)
$7,000 X .43393 = $3,038.
(c)
$7,000 X 31.77248 = $222,407.
(d)
$7,000 X 12.46221 = $87,235.
$12,800 20,000 $32,800 1.85093 X $20,000 $37,018.60
1.87298 X $20,000 $37,459.60
EXERCISE 6-4 (15–20 minutes) (a)
(b)
(c)
(d)
Future value of an ordinary annuity of $4,000 a period for 20 periods at 8% Factor (1 + .08) Future value of an annuity due of $4,000 a period at 8% Present value of an ordinary annuity of $2,500 for 30 periods at 10% Factor (1 + .10) Present value of annuity due of $2,500 for 30 periods at 10% Future value of an ordinary annuity of $2,000 a period for 15 periods at 10% Factor (1 + 10) Future value of an annuity due of $2,000 a period for 15 periods at 10% Present value of an ordinary annuity of $1,000 for 6 periods at 9% Factor (1 + .09) Present value of an annuity date of $1,000 for 6 periods at 9%
$183,047.84 ($4,000 X 45.76196) X 1.08 $197,692
$23,567 ($2,500 X 9.42691) X 1.10 $25,924 (Or see Table 6-5 which gives $25,924.03) $63,544.96 ($2,000 X 31.77248) X 1.10 $69,899
$4,485.92 ($1,000 X 4.48592) X 1.09
$4,890
EXERCISE 6-5 (10–15 minutes) (a)
$30,000 X 4.96764 = $149,029.
(b)
$30,000 X 8.31256 = $249,377.
(c)
($30,000 X 3.03735 X .50663) = $46,164. or (5.65022 – 4.11141) X $30,000 = $46,164.
(Or see Table 6-5)
EXERCISE 6-6 (15–20 minutes) (a) (b)
(c)
Future value of $12,000 @ 10% for 10 years ($12,000 X 2.59374) = Future value of an ordinary annuity of $600,000 at 10% for 15 years ($600,000 X 31.77248) Deficiency ($20,000,000 – $19,063,488) $70,000 discounted at 8% for 10 years: $70,000 X .46319 = Accept the bonus of $40,000 now.
EXERCISE 6-7 (12–17 minutes) (a)
$50,000 X .31524 + $5,000 X 8.55948
= =
$15,762 42,797 $58,559
(b)
$50,000 X .23939 + $5,000 X 7.60608
= =
$11,970 38,030 $50,000
(c)
$50,000 X .18270 + $5,000 X 6.81086
= =
$ 9,135 34,054 $43,189
$31,125 $19,063,488 $936,512
$32,423
EXERCISE 6-8 (10–15 minutes) (a)
(b)
Present value of an ordinary annuity of 1 for 4 periods @ 8% Annual withdrawal Required fund balance on June 30, 2017 Fund balance at June 30, 2017 Future value of an ordinary annuity at 8% for 4 years
3.31213 X $20,000 $66,243 $66,243 4.50611
= $14,701
Amount of each of four contributions is $14,701
EXERCISE 6-9 (10 minutes) The rate of interest is determined by dividing the future value by the present value and then finding the factor in the FVF table with n = 2 that approximates that number: $123,210 = $100,000 (FVF2, i%) $123,210 ÷ $100,000 = (FVF2, i%) 1.2321 = (FVF2, i%)—reading across the n = 2 row reveals that i = 11%.
EXERCISE 6-10 (10–15 minutes) (a)
The number of interest periods is calculated by first dividing the future value of $1,000,000 by $92,296, which is 10.83471—the value $1.00 would accumulate to at 10% for the unknown number of interest periods. The factor 10.83471 or its approximate is then located in the Future Value of 1 Table by reading down the 10% column to the 25-period line; thus, 25 is the unknown number of years Mike must wait to become a millionaire.
(b)
The unknown interest rate is calculated by first dividing the future value of $1,000,000 by the present investment of $182,696, which is 5.47357—the amount $1.00 would accumulate to in 15 years at an unknown interest rate. The factor or its approximate is then located in the Future Value of 1 Table by reading across the 15-period line to the 12% column; thus, 12% is the interest rate Sally must earn on her investment to become a millionaire.
EXERCISE 6-11 (10–15 minutes) (a)
Total interest = Total payments—Amount owed today $162,745 (10 X $16,274.53) – $100,000 = $62,745.
(b)
Sosa should borrow from the bank, since the 9% rate is lower than the manufacturer’s 10% rate determined below. PV–OA10, i% = $100,000 ÷ $16,274.53 = 6.14457—Inspection of the 10 period row reveals a rate of 10%.
EXERCISE 6-12 (10–15 minutes) Building A—PV = $600,000. Building B— Rent X (PV of annuity due of 25 periods at 12%) = PV $69,000 X 8.78432 = PV $606,118 = PV Building C— Rent X (PV of ordinary annuity of 25 periods at 12%) = PV $7,000 X 7.84314 = PV $54,902 = PV Cash purchase price PV of rental income Net present value
$650,000 – 54,902 $595,098
Answer: Lease Building C since the present value of its net cost is the smallest.
EXERCISE 6-13 (15–20 minutes) Time diagram: George Hincapie, Inc. i = 5%
PV = ? PV–OA = ?
$110,000
0
Principal $2,000,000 interest $110,000 $110,000 $110,000
$110,000 $110,000
1
2
3
28
29
30
n = 30 Formula for the interest payments: PV– OA = R (PVF–OAn, i) PV–OA = $110,000 (PVF–OA30, 5%) PV–OA = $110,000 (15.37245) PV– OA = $1,690,970 Formula for the principal: PV = FV (PVFn, i) PV = $2,000,000 (PVF30, 5%) PV = $2,000,000 (0.23138) PV = $462,760 The selling price of the bonds = $1,690,970 + $462,760 = $2,153,730.
EXERCISE 6-14 (15–20 minutes) Time diagram: i = 8% R= PV–OA = ?
0
1
$700,000
2 n = 15
15
16 n = 10
$700,000 $700,000
24
25
Formula: PV–OA = R (PVF–OAn, i) PV–OA = $700,000 (PVF–OA25–15, 8%) PV–OA = $700,000 (10.67478 – 8.55948) PV–OA = $700,000 (2.11530) PV–OA = $1,480,710 OR Time diagram: i = 8% R= PV–OA = ?
0 1 FV(PVn, i)
$700,000
2
15 16 (PV–OAn, i)
$700,000 $700,000
24
25
EXERCISE 6-14 (Continued) (i)
Present value of the expected annual pension payments at the end of the 10th year: PV–OA = R (PVF–OAn, i) PV–OA = $700,000 (PVF–OA10, 8%) PV– OA = $700,000 (6.71008) PV–OA = $4,697,056
(ii)
Present value of the expected annual pension payments at the beginning of the current year: PV = FV (PVFn, i) PV = $4,697,056 (PVF15,8%) PV = $4,697,056 (0.31524) PV = $1,480,700* *$10 difference due to rounding. The company’s pension obligation (liability) is $1,480,700.
EXERCISE 6-15 (15–20 minutes) (a) i = 8% PV = $1,000,000
0
FV = $1,999,000
1
2
n=?
FVF(n, 8%) = $1,999,000 ÷ $1,000,000 = 1.999 reading down the 8% column, 1.999 corresponds to 9 periods. (b)
By setting aside $300,000 now, Andrew can gradually build the fund to an amount to establish the foundation. PV = $300,000
0 FV
FV = ?
1
2
8
9
= $300,000 (FVF9, 8%) = $300,000 (1.999) = $599,700—Thus, the amount needed from the annuity: $1,999,000 – $599,700 = $1,399,300.
0
$?
$?
$? FV = $1,399,300
1
2
8
Payments = FV ÷ (FV–OA9, 8%) = $1,399,300 ÷ 12.48756 = $112,056.
9
EXERCISE 6-16 (16–16 minutes) Amount to be repaid on March 1, 2022. Time diagram: i = 6% per six months PV = $70,000
3/1/12
FV = ?
3/1/13
3/1/14
3/1/20
3/1/21
n = 20 six-month periods
Formula: FV = PV (FVFn, i) FV = $70,000 (FVF20, 6%) FV = $70,000 (3.20714) FV = $224,500 Amount of annual contribution to retirement fund. Time diagram: R R=?
R ?
3/1/17 3/1/18
i = 10% R R ? ?
3/1/19
R ?
3/1/20 3/1/21
FV–AD = $224,500
3/1/22
3/1/22
EXERCISE 6-16 (Continued) 1. 2. 3. 4.
Future value of ordinary annuity of 1 for 5 periods at 10% Factor (1 + .10) Future value of an annuity due of 1 for 5 periods at 10% Periodic rent ($224,500 ÷ 6.71561)
EXERCISE 6-17 (10–15 minutes) Time diagram: i = 11% PV–OA = $365,755
0
R ?
R ?
R ?
1
24
25
n = 25 Formula:
PV–OA = R (PV–OAn, i) $365,755 = R (PVF–OA25, 11%) $365,755 = R (8.42174) R = $365,755 ÷ 8.42174 R = $43,430
6.10510 X 1.10000 6.71561 $33,430
EXERCISE 6-18 (10–15 minutes) Time diagram: i = 8% PV–OA = ? $300,000
0
1
$300,000
2
$300,000 $300,000 $300,000
13
14
15
n = 15 Formula:
PV–OA = R (PVF–OAn, i) PV–OA = $300,000 (PVF–OA15, 8%) PV–OA = $300,000 (8.55948) R = $2,567,844
The recommended method of payment would be the 15 annual payments of $300,000, since the present value of those payments ($2,567,844) is less than the alternative immediate cash payment of $2,600,000.
EXERCISE 6-19 (10–15 minutes) Time diagram: i = 8% PV–AD = ? R= $300,000 $300,000 $300,000
0
1
$300,000 $300,000
2
13
14
15
n = 15 Formula: Using Table 6-4
Using Table 6-5
PV–AD = R (PVF–OAn, i)
PV–AD = R (PVF–ADn, i)
PV–AD = $300,000 (8.55948 X 1.08)
PV–AD = $300,000 (PVF–AD15, 8%)
PV–AD = $300,000 (9.24424)
PV–AD = $300,000 (9.24424)
PV–AD = $2,773,272
PV–AD = $2,773,272
The recommended method of payment would be the immediate cash payment of $2,600,000, since that amount is less than the present value of the 15 annual payments of $300,000 ($2,773,272).
EXERCISE 6-20 (20–20 minutes) Expected Cash Flow Probability Cash Estimate X Assessment = Flow (a) $ 4,800 20% $ 960 6,300 50% 3,150 7,500 30% 2,250 Total Expected Value $ 6,360 (b) $ 5,400 7,200 8,400
(c) $(1,000) 3,000 5,000
30% 50% 20% Total Expected Value
$ 1,620 3,600 1,680
10% 80% 10% Total Expected Value
$ (100) 2,400 500
$ 6,900
$ 2,800
EXERCISE 6-21 (10–15 minutes) Estimated Cash Probability Expected Outflow X Assessment = Cash Flow $200 10% $ 20 450 30% 135 600 50% 300 750 10% 75 X PV Factor, n = 2, i = 6% $ 530 X 0.89
Present Value $472
EXERCISE 6-22 (15–20 minutes) (a)
This exercise determines the present value of an ordinary annuity or expected cash flows as a fair value estimate. Cash flow Probability Expected Estimate X Assessment = Cash Flow $ 380,000 20% $ 76,000 630,000 50% 315,000 750,000 30% 225,000
X PV Factor, n = 8, I = 8% Present Value $ 616,000 X 5.74664 = $3,539,930
The fair value estimate of the trade name exceeds the carrying value; thus, no impairment is recorded. (b)
This fair value is based on unobservable inputs—Killroy’s own data on the expected future cash flows associated with the trade name. This fair value estimate is considered Level 3, as discussed in Chapter 2.
TIME AND PURPOSE OF PROBLEMS Problem 6-1 (Time 15–20 minutes) Purpose—to present an opportunity for the student to determine how to use the present value tables in various situations. Each of the situations presented emphasizes either a present value of 1 or a present value of an ordinary annuity situation. Two of the situations will be more difficult for the student because a noninterest-bearing note and bonds are involved. Problem 6-2 (Time 15–20 minutes) Purpose—to present an opportunity for the student to determine solutions to four present and future value situations. The student is required to determine the number of years over which certain amounts will accumulate, the rate of interest required to accumulate a given amount, and the unknown amount of periodic payments. The problem develops the student’s ability to set up present and future value equations and solve for unknown quantities. Problem 6-3 (Time 20–30 minutes) Purpose—to present the student with an opportunity to determine the present value of the costs of competing contracts. The student is required to decide which contract to accept. Problem 6-4 (Time 20–30 minutes) Purpose—to present the student with an opportunity to determine the present value of two lottery payout alternatives. The student is required to decide which payout option to choose. Problem 6-5 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to determine which of four insurance options results in the largest present value. The student is required to determine the present value of options which include the immediate receipt of cash, an ordinary annuity, an annuity due, and an annuity of changing amounts. The student must also deal with interest compounded quarterly. This problem is a good summary of the application of present value techniques. Problem 6-6 (Time 25–30 minutes) Purpose—to present an opportunity for the student to determine the present value of a series of deferred annuities. The student must deal with both cash inflows and outflows to arrive at a present value of net cash inflows. A good problem to develop the student’s ability to manipulate the present value table factors to efficiently solve the problem. Problem 6-7 (Time 30–35 minutes) Purpose—to present the student an opportunity to use time value concepts in business situations. Some of the situations are fairly complex and will require the student to think a great deal before answering the question. For example, in one situation a student must discount a note and in another must find the proper interest rate to use in a purchase transaction. Problem 6-8 (Time 20–30 minutes) Purpose—to present the student with an opportunity to determine the present value of an ordinary annuity and annuity due for three different cash payment situations. The student must then decide which cash payment plan should be undertaken.
Time and Purpose of Problems (Continued) Problem 6-9 (Time 30–35 minutes) Purpose—to present the student with the opportunity to work three different problems related to time value concepts: purchase versus lease, determination of fair value of a note, and appropriateness of taking a cash discount. Problem 6-10 (Time 30–35 minutes) Purpose—to present the student with the opportunity to assess whether a company should purchase or lease. The computations for this problem are relatively complicated. Problem 6-11 (Time 25–30 minutes) Purpose—to present the student an opportunity to apply present value to retirement funding problems, including deferred annuities. Problem 6-12 (Time 20–25 minutes) Purpose—to provide the student an opportunity to explore the ethical issues inherent in applying time value of money concepts to retirement plan decisions. Problem 6-13 (Time 20–25 minutes) Purpose—to present the student an opportunity to compute expected cash flows and then apply present value techniques to determine a warranty liability. Problem 6-14 (Time 20–25 minutes) Purpose—to present the student an opportunity to compute expected cash flows and then apply present value techniques to determine the fair value of an asset. Problems 6-15 (Time 20–25 minutes) Purpose—to present the student an opportunity to estimate fair value by computing expected cash flows and then applying present value techniques to value an asset retirement obligation.
SOLUTIONS TO PROBLEMS PROBLEM 6-1
(a)
Given no established value for the building, the fair market value of the note would be estimated to value the building. Time diagram: i = 9% PV = ?
1/1/12
FV = $240,000
1/1/13
1/1/14
1/1/15
n=3 Formula: PV = FV (PVFn, i) PV = $240,000 (PVF3, 9%) PV = $240,000 (.77218) PV = $185,323
Cash equivalent price of building .................................. Less: Book value ($250,000 – $100,000)....................... Gain on disposal of the building ...............................
$185,323 150,000 $ 35,323
PROBLEM 6-1 (Continued) (b)
Time diagram: i = 11%
PV – OA = ? $27,000
$27,000
$27,000
Principal $300,000 Interest $27,000
1/1/14
1/1/16
1/1/23
1/1/24
1/1/15
n = 10 Present value of the principal FV (PVF10, 11%) = $300,000 (.35218) ....................
= $105,654
Present value of the interest payments
(c)
R (PVF – OA10, 11%) = $27,000 (5.88923) .............
= 159,009
Combined present value (purchase price) ................
$264,663
Time diagram: i = 8% PV – OA = ? $4,000
0
1
$4,000
$4,000
$4,000
$4,000
2
8
9
10
n = 10 Formula: PV – OA = R (PVF – OAn,i) PV – OA = $4,000 (PVF – OA10, 8%) PV – OA = $4,000 (6.71008) PV – OA = $26,840 (cost of machine)
PROBLEM 6-1 (Continued) (d)
Time diagram: i = 12% PV – OA = ? $20,000 $5,000
0
1
$5,000
$5,000
$5,000
$5,000
$5,000
$5,000
$5,000
2
3
4 n=8
5
6
7
8
Formula: PV – OA = R (PVF – OAn,i) PV – OA = $5,000 (PVF – OA8, 12%) PV – OA = $5,000 (4.96764) PV – OA = $24,838 Cost of tractor = $20,000 + $24,838.20 = $44,838 (e)
Time diagram: i = 11% PV – OA = ? $120,000 $120,000
0
1
$120,000 $120,000
2
8 n=9
Formula: PV – OA = R (PVF – OAn, i) PV – OA = $120,000 (PVF – OA9, 11%) PV – OA = $120,000 (5.53705) PV – OA = $664,446
9
PROBLEM 6-2
(a)
Time diagram: FV – OA = $90,000
i = 8%
0
R R=?
R ?
R ?
R ?
R ?
R ?
R ?
R ?
1
2
3
4 n=8
5
6
7
8
Formula:
FV – OA = R (FVF – OAn,i) $90,000 = R (FVF – OA8, 8%) $90,000 = R (10.63663) R = $90,000 ÷ 10.63663 R = $8,461
(b)
Time diagram: i = 12% R R=?
R ?
R ?
R ?
40
41
42
64 n = 25
FV – AD = 500,000
65
PROBLEM 6-2 (Continued) 1. 2. 3. 4.
(c)
Future value of an ordinary annuity of 1 for 25 periods at 12% .............................................. Factor (1 + .12)...................................................... Future value of an annuity due of 1 for 25 periods at 12% ...................................................
133.33387 X 1.1200 149.33393
Periodic rent ($500,000 ÷ 149.33393)...................
$3,348
Time diagram: i = 9% PV = $20,000
0
FV = $47,347
1
2
3
n
Future value approach
Present value approach
FV = PV (FVFn, i)
PV = FV (PVFn, i) or
$47,347 = $20,000 (FVFn, 9%) FVFn, 9%
= $47,347 ÷ $20,000 = 2.36735
2.36735 is approximately the value of $1 invested at 9% for 10 years.
$20,000 = $47,347 (PVFn, 9%) PVFn, 9%
= $20,000 ÷ $47,347 = .42241
.42241 is approximately the present value of $1 discounted at 9% for 10 years.
PROBLEM 6-2 (Continued) (d)
Time diagram: i=? PV = $19,553
0
FV = $27,600
1
2 n=4
3
4
Future value approach
Present value approach
FV = PV (FVFn, i)
PV = FV (PVFn, i) or
$27,600 = $19,553 (FVF4, i)
FVF4, i
= $27,600 ÷ $19,553 = 1.41155
1.41155 is the value of $1 invested at 9% for 4 years.
$19,553 = $27,600 (PVF4, i)
PVF4, i
= $19,553 ÷ $27,600 = .70844
.70844 is the present value of $1 discounted at 9% for 4 years.
PROBLEM 6-3 Time diagram (Bid A): i = 9% $69,000 PV – OA = R = ?
3,000
3,000
3,000
3,000
69,000
3,000
3,000
3,000
3,000
0
0
1
2
3
4
5 n=9
6
7
8
9
10
Present value of initial cost 12,000 X $5.75 = $69,000 (incurred today) ..................
$ 69,000
Present value of maintenance cost (years 1–4) 12,000 X $.25 = $3,000 R (PVF – OA4, 9%) = $3,000 (3.23972) ............................
9,719
Present value of resurfacing FV (PVF5, 9%) = $69,000 (.64993)....................................
44,845
Present value of maintenance cost (years 6–9) R (PVF – OA9–5, 9%) = $3,000 (5.99525 – 3.88965) .........
6,317
Present value of outflows for Bid A ...............................
$129,881
PROBLEM 6-3 (Continued) Time diagram (Bid B): i = 9% $126,000 PV – OA = R = ?
1,080
1,080
1,080
1,080
1,080
1,080
1,080
1,080
1,080
0
0
1
2
3
4
5
6
7
8
9
10
n=9 Present value of initial cost 12,000 X $10.50 = $126,000 (incurred today) ..........
$126,000
Present value of maintenance cost 12,000 X $.09 = $1,080 R (PV – OA9, 9%) = $1,080 (5.99525) ..........................
6,475
Present value of outflows for Bid B ...........................
$132,475
Bid A should be accepted since its present value is lower.
PROBLEM 6-4
Lump sum alternative: Present Value = $500,000 X (1 – .46) = $270,000. Annuity alternative: Payments = $36,000 X (1 – .25) = $27,000. Present Value = Payments (PV – AD20, 8%) = $27,000 (10.60360) = $286,297. Long should choose the annuity payout; its present value is $16,297 greater.
PROBLEM 6-5
(a)
The present value of $55,000 cash paid today is $55,000.
(b)
Time diagram: i = 21/2% per quarter PV – OA =
R=
?
$4,000
$4,000
$4,000
$4,000
$4,000
0
1
2
18
19
20
n = 20 quarters Formula: PV – OA = R (PVF – OAn, i) PV – OA = $4,000 (PVF – OA20, 21/2%) PV – OA = $4,000 (15.58916) PV – OA = $62,357 (c)
Time diagram: i = 21/2% per quarter $18,000 PV – AD = R = $1,800
$1,800
$1,800
$1,800
$1,800
0
1
2
38
39
n = 40 quarters Formula: PV – AD = R (PVF – ADn, i) PV – AD = $1,800 (PVF – AD40, 21/2%) PV – AD = $1,800 (25.73034) PV – AD = $46,315 The present value of option (c) is $18,000 + $46,315, or $64,315.
40
PROBLEM 6-5 (Continued) (d)
Time diagram: i = 21/2% per quarter PV – OA = ? PV – OA = R = ? $4,000
0
1
$4,000
$4,000
11
12
n = 12 quarters
R= $1,500
$1,500
13
14
$1,500 $1,500
36
37
n = 25 quarters
Formulas: PV – OA = R (PVF – OAn,i) PV – OA = $4,000 (PVF – OA12, 21/2%)
PV – OA = R (PVF – OAn,i) PV – OA = $1,500 (PVF – OA37–12, 21/2%)
PV – OA = $4,000 (10.25776)
PV – OA = $1,500 (23.95732 – 10.25776)
PV – OA = $41,031
PV – OA = $20,549
The present value of option (d) is $41,031 + $20,549, or $61,580. Present values: (a)
$55,000.
(b)
$62,357.
(c)
$64,315.
(d)
$61,580.
Option (c) is the best option, based upon present values alone.
PROBLEM 6-6
Time diagram: i = 12% PV – OA = ? R = ($39,000)
0
($39,000) $18,000 $18,000 $68,000 $68,000 $68,000 $68,000 $38,000 $38,000 $38,000
1
5
6
10 11
12
29
30 31
39 40
n=5
n=5
n = 20
n = 10
(0 – $30,000 – $9,000)
($60,000 – $30,000 – $12,000)
($110,000 – $30,000 – $12,000)
($80,000 – $30,000 – $12,000)
Formulas: PV – OA = R (PVF – OAn, i)
PV – OA = R (PVF – OAn, i)
PV – OA = R (PVF – OAn, i)
PV – OA =R (PVF – OAn, i)
PV – OA = ($39,000)(PVF –
PV – OA = $18,000 (PVF –
PV – OA = $68,000 (PVF –
PV – OA = $38,000 (PVF –
OA5, 12%)
OA10-5, 12%)
OA30–10, 12%)
OA40–30, 12%)
PV – OA = ($39,000)(3.60478) PV – OA = $18,000 (5.65022 – PV – OA = $68,000 (8.05518 PV – OA = $38,000 (8.24378 – 3.60478) PV – OA = ($140,586)
– 5.65022)
8.05518)
PV – OA = $18,000 (2.04544) PV – OA = $68,000 (2.40496) PV – OA = $38,000 (.18860) PV – OA = $36,818
PV – OA = $163,537
Present value of future net cash inflows: $(140,586) 36,818 163,537 7,167 $ 66,936 Stacy McGill should accept no less than $66,936 for her vineyard business.
PV – OA = $7,167
PROBLEM 6-7 (a)
Time diagram (alternative one): i=? PV – OA = $600,000
R= $80,000
$80,000
$80,000
$80,000
$80,000
1
2
10
11
12
0
n = 12 Formulas: PV – OA = R (PVF – OAn, i) $600,000 = $80,000 (PVF – OA12, i) PVF – OA12, i = $600,000 ÷ $80,000 PVF – OA12, i = 7.50
7.50 is present value of an annuity of $1 for 12 years discounted at approximately 8%.
Time diagram (alternative two): i=? PV = $600,000
0
FV = $1,900,000
1
2
11 n = 12
12
PROBLEM 6-7 (Continued) Future value approach
Present value approach
FV = PV (FVFn, i)
PV = FV (PVFn, i) or
$1,900,000 = $600,000 (FVF12, i)
$600,000 = $1,900,000 (PVF12, i)
FVF12, I = $1,900,000 ÷ $600,000
PVF12, i = $600,000 ÷ $1,900,000
FVF12, I = 3.16667
PVF12, i = .31579
3.16667 is the approximate future value of $1 invested at 10%
.31579 is the approximate present value of $1 discounted at 10% for 12 years.
for 12 years.
Dubois should choose alternative two since it provides a higher rate of return. (b)
Time diagram: i=? ($824,150 – $200,000) PV – OA = R = $624,150 $76,952
0
1
$76,952
$76,952
8 9 n = 10 six-month periods
$76,952
10
PROBLEM 6-7 (Continued) Formulas: PV – OA = R (PVF – OAn, i) $624,150 = $76,952 (PVF – OA10, i) PV – OA10, i = $624,150 ÷ $76,952 PV – OA10, i = 8.11090
8.11090 is the present value of a 10-period annuity of $1 discounted at 4%. The interest rate is 4% semiannually, or 8% annually. (c)
Time diagram: i = 5% per six months
PV = ? PV – OA = R= ? $32,000
0
1
$32,000
2
$32,000
$32,000 $32,000 ($800,000 X 8% X 6/12)
8 9 10 n = 10 six-month periods [(7 – 2) X 2]
Formulas: PV – OA = R (PVF – OAn, i)
PV = FV (PVFn, i)
PV – OA = $32,000 (PVF – OA10, 5%)
PV = $800,000 (PVF10, 5%)
PV – OA = $32,000 (7.72173)
PV = $800,000 (.61391)
PV – OA = $247,095
PV = $491,128
Combined present value (amount received on sale of note): $247,095 + $491,128 = $738,223
PROBLEM 6-7 (Continued) (d)
Time diagram (future value of $200,000 deposit) i = 21/2% per quarter
PV = $200,000
FV = ?
12/31/14
12/31/15
12/31/23
12/31/22
n = 40 quarters Formula: FV = PV (FVFn, i) FV = $200,000 (FVF40, 2 1/2%) FV = $200,000 (2.68506) FV = $537,012 Amount to which quarterly deposits must grow: $1,300,000 – $537,012 = $762,988. Time diagram (future value of quarterly deposits) i = 21/2% per quarter R R=?
12/31/14
R ?
R ?
R ?
R ?
12/31/15
12/31/23
n = 40 quarters
R ?
R ?
R ?
R ?
12/31/22
PROBLEM 6-7 (Continued) Formulas:
FV – OA = R (FVF – OAn, i) $762,988 = R (FVF – OA40, 2 1/2%) $762,988 = R (67.40255) R = $762,988 ÷ 67.40255 R = $11,320
PROBLEM 6-8 Vendor A:
$ 18,000 payment X 6.14457 (PV of ordinary annuity 10%, 10 periods) $ 110,602 + 55,000 down payment + 10,000 maintenance contract $ 175,602 total cost from Vendor A
Vendor B:
$ 9,500 semiannual payment X 18.01704 (PV of annuity due 5%, 40 periods) $ 171,162
Vendor C:
$ 1,000 X 3.79079 (PV of ordinary annuity of 5 periods, 10%) $ 3,791 PV of first 5 years of maintenance $ 2,000 [PV of ordinary annuity 15 per., 10% (7.60608) – X 3.81529 PV of ordinary annuity 5 per., 10% (3.79079)] $ 7,631 PV of next 10 years of maintenance $ X $
3,000 [(PV of ordinary annuity 20 per., 10% (8.51356) – .90748 PV of ordinary annuity 15 per., 10% (7.60608)] 2,722 PV of last 5 years of maintenance
Total cost of press and maintenance Vendor C: $ 150,000 cash purchase price 3,791 maintenance years 1–5 7,631 maintenance years 6–15 2,722 maintenance years 16–20 $ 164,144 The press should be purchased from Vendor C, since the present value of the cash outflows for this option is the lowest of the three options.
PROBLEM 6-9 (a)
Time diagram for the first ten payments: i = 10%
PV–AD = ? R= $800,000 $800,000 $800,000 $800,000
0
1
2
$800,000 $800,000 $800,000
3
7
8
9
10
n = 10 Formula for the first ten payments: PV – AD = R (PVF – ADn, i) PV – AD = $800,000 (PVF – AD10, 10%) PV – AD = $800,000 (6.75902) PV – AD = $5,407,216
Formula for the last ten payments: PV – OA = R (PVF – OAn, i) PV – OA = $400,000 (PVF – OA19 – 9, 10%) PV – OA = $400,000 (8.36492 – 5.75902) PV – OA = $400,000 (2.6059) PV – OA = $1,042,360 Note: The present value of an ordinary annuity is used here, not the present value of an annuity due.
PROBLEM 6-9 (Continued) The total cost for leasing the facilities is: $5,407,216 + $1,042,360 = $6,449,576. OR Time diagram for the last ten payments: i = 10% PV = ?
0
R=
1
2
$400,000
9
10
R (PVF – OAn, i)
FVF (PVFn, i)
Formulas for the last ten payments: (i)
Present value of the last ten payments: PV – OA = R (PVF – OAn, i) PV – OA = $400,000 (PVF – OA10, 10%) PV – OA = $400,000 (6.14457) PV – OA = $2,457,828
$400,000 $400,000 $400,000
17
18
19
PROBLEM 6-9 (Continued) (ii) Present value of the last ten payments at the beginning of current year: PV = FV (PVFn, i) PV = $2,457,828 (PVF9, 10%) PV = $2,457,828 (.42410) PV = $1,042,365* *$5 difference due to rounding. Cost for leasing the facilities $5,407,216 + $1,042,365 = $6,449,581 Since the present value of the cost for leasing the facilities, $6,449,581, is less than the cost for purchasing the facilities, $7,200,000, McDowell Enterprises should lease the facilities. (b)
Time diagram: i = 11%
PV – OA = ? R= $15,000 $15,000 $15,000
0
1
2
3
$15,000 $15,000 $15,000 $15,000
6
n=9
7
8
9
PROBLEM 6-9 (Continued) Formula: PV – OA = R (PVF – OAn, i) PV – OA = $15,000 (PVF – OA9, 11%) PV – OA = $15,000 (5.53705) PV – OA = $83,056 The fair value of the note is $83,056. (c)
Time diagram: Amount paid = $792,000
0
10
30 Amount paid = $800,000
Cash discount = $800,000 (1%) = $8,000 Net payment = $800,000 – $8,000 = $792,000 If the company decides not to take the cash discount, then the company can use the $792,000 for an additional 20 days. The implied interest rate for postponing the payment can be calculated as follows: (i)
Implied interest for the period from the end of discount period to the due date: Cash discount lost if not paid within the discount period Net payment being postponed = $8,000/$792,000 = 0.010101
PROBLEM 6-9 (Continued) (ii) Convert the implied interest rate to annual basis: Daily interest = 0.010101/20 = 0.00051 Annual interest = 0.000505 X 365 = 18.43% Since McDowell’s cost of funds, 10%, is less than the implied interest rate for cash discount, 18.43%, it should continue the policy of taking the cash discount.
PROBLEM 6-10
1.
Purchase.
Time diagrams:
Installments i = 10% PV – OA = ? R= $350,000
$350,000
$350,000
$350,000
$350,000
1
2
3 n=5
4
5
0
Property taxes and other costs
i = 10% PV – OA = ? R= $56,000 $56,000
0
1
2
$56,000
9
n = 12
$56,000 $56,000 $56,000
10
11
12
PROBLEM 6-10 (Continued) Insurance i = 10% PV – AD = ? R= $27,000 $27,000 $27,000
0
1
$27,000 $27,000 $27,000
2
9
10
11
12
n = 12
Salvage Value i = 10% PV = ?
0
FV = $500,000
1
2
9
n = 12 Formula for installments: PV – OA = R (PVF – OAn, i) PV – OA = $350,000 (PVF – OA5, 10%) PV – OA = $350,000 (3.79079) PV – OA = $1,326,777
10
11
12
PROBLEM 6-10 (Continued) Formula for property taxes and other costs: PV – OA = R (PVF – OAn, i) PV – OA = $56,000 (PVF – OA12, 10%) PV – OA = $56,000 (6.81369) PV – OA = $381,567 Formula for insurance: PV – AD = R (PVF – ADn, i) PV – AD = $27,000 (PVF – AD12, 10%) PV – AD = $27,000 (7.49506) PV – AD = $202,367 Formula for salvage value: PV = FV (PVFn, i) PV = $500,000 (PVF12, 10%) PV = $500,000 (0.31863) PV = $159,315
PROBLEM 6-10 (Continued) Present value of net purchase costs:
2.
Down payment........................................................ Installments ............................................................
$ 400,000 1,326,777
Property taxes and other costs............................. Insurance ................................................................
381,567 202,367
Total costs .............................................................. Less: Salvage value .............................................. Net costs.................................................................
$2,310,711 159,315 $2,151,396
Lease. Time diagrams: Lease payments i = 10% PV – AD = ? R= $270,000 $270,000 $270,000
0
1
2
$270,000 $270,000
10
11
12
n = 12 Interest lost on the deposit i = 10% PV – OA = ? R= $10,000 $10,000
0
1
2
$10,000 $10,000 $10,000
10
n = 12
11
12
PROBLEM 6-10 (Continued) Formula for lease payments: PV – AD = R (PVF – ADn, i) PV – AD = $270,000 (PVF – AD12, 10%) PV – AD = $270,000 (7.49506) PV – AD = $2,023,666 Formula for interest lost on the deposit: Interest lost on the deposit per year = $100,000 (10%) = $10,000 PV – OA = R (PVF – OAn, i) PV – OA = $10,000 (PVF – OA12, 10%) PV – OA = $10,000 (6.81369) PV – OA = $68,137* Cost for leasing the facilities = $2,023,666 + $68,137 = $2,091,803 Dunn Inc. should lease the facilities because the present value of the costs for leasing the facilities, $2,091,803, is less than the present value of the costs for purchasing the facilities, $2,151,396. *OR: $100,000 – ($100,000 X .31863 [PV12, 10%]) = $68,137
PROBLEM 6-11 (a)
Annual retirement benefits.
Jean–current salary
$ 48,000 X 2.56330 (future value of 1, 24 periods, 4%) 123,038 annual salary during last year of work X .50 retirement benefit % $ 61,519 annual retirement benefit
Colin–current salary
$ 36,000 X 3.11865 (future value of 1, 29 periods, 4%) 112,271 annual salary during last year of work X .40 retirement benefit % $ 44,909 annual retirement benefit
Anita–current salary
$ 18,000 X 2.10685 (future value of 1, 19 periods, 4%) 37,923 annual salary during last year of work X .40 retirement benefit % $ 15,169 annual retirement benefit
Gavin–current salary
$ 15,000 X 1.73168 (future value of 1, 14 periods, 4%) 25,975 annual salary during last year of work X .40 retirement benefit % $ 10,390 annual retirement benefit
PROBLEM 6-11 (Continued) (b)
Fund requirements after 15 years of deposits at 12%. Jean will retire 10 years after deposits stop. $ 61,519 annual plan benefit [PV of an annuity due for 30 periods – PV of an X 2.69356 annuity due for 10 periods (9.02181 – 6.32825)] $ 165,705
Colin will retire 15 years after deposits stop. $ 44,909 annual plan benefit X 1.52839 [PV of an annuity due for 35 periods – PV of an annuity due for 15 periods (9.15656 – 7.62817)] $ 68,638
Anita will retire 5 years after deposits stop. $ 15,169 annual plan benefit X 4.74697 [PV of an annuity due for 25 periods – PV of an annuity due for 5 periods (8.78432 – 4.03735)] $ 72,007
Gavin will retire the beginning of the year after deposits stop. $ 10,390 annual plan benefit X 8.36578 (PV of an annuity due for 20 periods) $ 86,920
PROBLEM 6-11 (Continued) $165,705 Jean 68,638 Colin 72,007 Anita 86,920 Gavin $393,270 Required fund balance at the end of the 15 years of deposits. (c)
Required annual beginning-of-the-year deposits at 12%: Deposit X (future value of an annuity due for 15 periods at 12%) = FV Deposit X (37.27972 X 1.12) = $393,270 Deposit = $393,270 ÷ 41.75329 Deposit = $9,419.
PROBLEM 6-12 (a)
The time value of money would suggest that NET Life’s discount rate was substantially higher than First Security’s. The actuaries at NET Life are making different assumptions about inflation, employee turnover, life expectancy of the work force, future salary and wage levels, return on pension fund assets, etc. NET Life may operate at lower gross and net margins and it may provide fewer services.
(b)
As the controller of STL, Brokaw assumes a fiduciary role to the present and future retirees of the corporation. As a result, he is responsible for ensuring that the pension assets are adequately funded and are adequately protected from most controllable risks. At the same time, Brokaw is responsible for the financial condition of STL. In other words, he is obligated to find ethical ways of increasing the profits of STL, even if it means switching pension funds to a less costly plan. At times, Brokaw’s responsibility to retirees and his responsibility to the corporation can be in conflict, especially if Brokaw is a member of a professional group such as CPAs or CMAs.
(c)
If STL switched to NET Life The primary beneficiaries of Brokaw’s decision would be the corporation and its many stockholders by virtue of reducing 8 million dollars of annual pension costs. The present and future retirees of STL may be negatively affected by Brokaw’s decision because the chance of losing a future benefit may be increased by virtue of higher risks (as reflected in the discount rate and NET Life’s weaker reputation). If STL stayed with First Security In the short run, the primary beneficiaries of Brokaw’s decision would be the employees and retirees of STL given the lower risk pension asset plan. STL and its many stakeholders could be negatively affected by Brokaw’s decision to stay with First Security because of the company’s inability to trim 8 million dollars from its operating expenses.
PROBLEM 6-13
Cash Flow Probability Estimate X Assessment = Expected Cash Flow 2015 $2,500 20% $ 500 4,000 60% 2,400 5,000 20% 1,000 X PV Factor, n = 1, I = 5% Present Value $3,900 X 0.95238 = $ 3,714 2016
2017
$3,000 5,000 6,000
30% 50% 20%
$ 900 2,500 1,200
$4,000 6,000 7,000
30% 40% 30%
$1,200 2,400 2,100
X PV Factor, n = 2, I = 5% Present Value $4,600 X 0.90703 = $ 4,172
X PV Factor, n = 3, I = 5% Present Value $5,700 X 0.86384 = $ 4,924 Total Estimated Liability $12,810
PROBLEM 6-14
Cash Flow Probability Estimate X Assessment = Expected Cash Flow 2015 $6,000 40% $2,400 9,000 60% 5,400 X PV Factor, n = 1, I = 6% Present Value $7,800 X 0.9434 = $7,359 2016
$ (500) 2,000 4,000
20% 60% 20%
$ (100) 1,200 800
$1,900 Scrap Value Received at the End of 2016 $
500 900
50% 50%
$ 250 450
X PV Factor, n = 2, I = 6% Present Value X 0.89 = $1,691
X PV Factor, n = 2, I = 6% Present Value $ 700 X 0.89 = $ 623 Estimated Fair Value $9,673
PROBLEM 6-15 (a)
The expected cash flows to meet the asset retirement obligation represent a deferred annuity. Developing a fair value estimate requires determining the present value of the annuity of expected cash flows to be paid in three years and then determine the present value of that amount today. Cash Flow Probability Estimate X Assessment = Expected Cash Flow $15,000 10% $ 1,500 22,000 30% 6,600 25,000 50% 12,500 30,000 10% 3,000 X PV Factor, n = 3, I = 5% Present Value (deferred 10 yrs) $23,600 X 2.72325 = $64,269 The value today of the annuity payments to commence in ten years is: $ 64,269 Present value of annuity X .61391 PV of a lump sum to be paid in 10 periods. $ 39,455 Alternatively, the present value of the deferred annuity can be computed as follows: $ 23,600 Expected cash outflows X 1.67184 [PV of an ordinary annuity for 13 periods – PV of an annuity due for 10 periods (9.39357 – 7.72173)] $ 39,455
(b)
This fair value estimate is based on unobservable inputs—Murphy’s own data on the expected future cash flows associated with the obligation to restore the site. This fair value estimate is considered Level 3, as discussed in Chapter 2.
FINANCIAL REPORTING PROBLEM
(a)
1.
Long-lived assets, goodwill
For impairment of goodwill and long-lived assets, fair value is determined using a discounted cash flow analysis.
(b)
2.
Short-term and long-term debt
3.
Postretirement benefit plans
4.
Employee stock ownership plans
(1) The following rates are disclosed in the accompanying notes: Debt Weighted-Average Effective Interest Rate At December 31 Short-Term Long-Term
2011 .09% 3.4%
2010 .04% 3.6%
FINANCIAL REPORTING PROBLEM (Continued) Benefit Plans Pension Benefits United States 2011 2010 Assumptions used to determine net periodic benefit cost. Discount rate Expected return on assets
5.3% 7.0%
6.0% 7.1%
Stock-Based Compensation Assumptions Weighted average interest rate used in Stock Option Valuation
2011 3.4%
Other Retiree Benefits 2011 2010
5.4% 9.2%
2010 3.7%
6.4% 9.1%
2009 3.6%
(2) There are different rates for various reasons: 1. The maturity dates—short-term vs. long-term. 2. The security or lack of security for debts—mortgages and collateral vs. unsecured loans. 3. Fixed rates and variable rates. 4. Issuances of securities at different dates when differing market rates were in effect. 5. Different risks involved or assumed. 6. Foreign currency differences—some investments and payables are denominated in different currencies.
FINANCIAL STATEMENT ANALYSIS CASE
(a)
Cash inflows of $375,000 less cash outflows of $125,000 = Net cash flows of $250,000. $250,000 X 2.48685 (PVF – OA3, 10%) = $621,713
(b)
Cash inflows of $275,000 less cash outflows of $155,000 = Net cash flows of $120,000. $120,000 X 2.48685 (PVF – OA3,10%) = $298,422
(c)
The estimate of future cash flows is very useful. It provides an understanding of whether the value of gas and oil properties is increasing or decreasing from year to year. Although it is an estimate, it does provide an understanding of the direction of change in value. Also, it can provide useful information to record a write-down of the assets.
ACCOUNTING, ANALYSIS, AND PRINCIPLES Accounting (a)
The present value of the note is presumably equal to the fair-value of the inventory. The note has 20 semi-annual periods to maturity. $679,517 = $50,000 X PVF-OA20,i PVF-OA20,i = $679,517 ÷ $50,000 PVF-OA20,i = 13.5903 Searching across the interest rate columns on the 20-period row reveals that the interest rate is 4% semi-annually or 8 percent annually.
(b)
Johnson should initially record the note at its fair-value, $679,517.
Analysis If interest rates increase, the fair-value of the note will decline. This is because the remaining cash flows are being discounted at a higher rate. That is, the present value of the future cash flows is less at a higher discount rate.
Principles Fair-value versus historical cost potentially involves a trade-off between the primary qualities of relevance and faithful representation. The fairvalues of various assets (and liabilities) is potentially more relevant to financial statement readers. However, it is often a more subjective measure than historical cost. Thus, fair-value may not be less neutral and less free from error as historical cost. Fair-value is more subjective because it often must be estimated, requiring assumptions about discount rates and, as later chapters illustrate, about the amounts and timing of future cash flows.
PROFESSIONAL RESEARCH
Search strings: “present value”, present and value, Present value $, “best estimate”, “estimated cash flow”, “expected cash flow”, “fresh-start measurement”, “interest methods of allocation” (a) Statement of Financial Accounting Concepts No. 7, “Using Cash Flow Information and Present Value in Accounting Measurements (FASB 2000). (b) See Appendix B: APPLICATIONS OF PRESENT VALUE IN FASB STATEMENTS AND APB OPINIONS, CON7, Par. 119 119. . . . The accompanying table is presented to assist readers in understanding the differences between the conclusions reached in this Statement and those found in FASB Statements and APB Opinions that employ present value techniques in recognition, measurement, or amortization (period-to-period allocation) of assets and liabilities in the statement of financial position. Some examples are: Debt payable and related premium or discount Asset acquired by incurring liabilities in a business combination—“An asset acquired by incurring liabilities is recorded at cost—that is, at the present value of the amounts to be paid” (paragraph 67(b)). APB Opinion No. 21, Interest on Receivables and Payables—Note exchanged for property, goods, or services. Capital lease or operating lease— . . . The lessee’s incremental borrowing rate is used unless (a) the lessor’s implicit rate can be determined and (b) the implicit rate is less than the incremental borrowing rate. FASB Statement No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Lease . . . Origination fees and costs are reflected over the life of the loan as an adjustment of the yield on the net investment in the loan.
PROFESSIONAL RESEARCH (Continued) FASB Statement No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions . . . Effective settlement rate—“. . . as opposed to ‘settling’ the obligation, which incorporates the insurer’s risk factor, ‘effectively settling’ the obligation focuses only on the time value of money and ignores the insurer’s cost for assuming the risk of experience losses” (paragraph 188). FASB Statement No. 121, Accounting for the Impairment of LongLived Assets and for Long-Lived Assets to Be Disposed Of . . . The objective is to estimate the fair value of the impaired asset. . . . (c) 1. CON7, Glossary of terms: Best estimate: The single most-likely amount in a range of possible estimated amounts; in statistics, the estimated mode. In the past, accounting pronouncements have used the term best estimate in a variety of contexts that range in meaning from “unbiased” to “most likely.” This Statement uses best estimate in the latter meaning, as distinguished from the expected amounts described below. 2. CON7, Glossary of terms: Estimated Cash Flow and Expected Cash Flow: In the past, accounting pronouncements have used the terms estimated cash flow and expected cash flow interchangeably. In this Statement: Estimated cash flow refers to a single amount to be received or paid in the future. Expected cash flow refers to the sum of probability-weighted amounts in a range of possible estimated amounts; the estimated mean or average. 3. CON7, Glossary of terms: Fresh-Start Measurements: Measurements in periods following initial recognition that establishes a new carrying amount unrelated to previous amounts and accounting conventions. Some fresh-start measurements are used every period, as in the reporting of some marketable securities at fair value under FASB Statement No.115, Accounting for Certain Investments in Debt and Equity Securities. In other situations, fresh-start measurements are prompted by an exception or “trigger,” as in a remeasurement of assets under FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.
PROFESSIONAL RESEARCH (Continued) 4. CON7, Glossary of terms: Interest Methods of Allocation: Reporting conventions that use present value techniques in the absence of a fresh-start measurement to compute changes in the carrying amount of an asset or liability from one period to the next. Like depreciation and amortization conventions, interest methods are grounded in notions of historical cost. The term interest methods of allocation refers both to the convention for periodic reporting and to the several approaches to dealing with changes in estimated future cash flows. Note to instructor: The concepts statements are not in the codification. Thus, the references to previous FASB standards above do not have codification sections indicated. A good extension of this research case would have students track down codification references for the items above.
PROFESSIONAL SIMULATION
Measurement i = 12%
PV – OA = ?
$10,000
0
1
$10,000
$10,000
$10,000
Principal $100,000 Interest $10,000
2
3 n=5
4
5
Present value of the principal FV (PVF5, 12%) = $100,000 (.56743)
= $56,743
Present value of the interest payments R (PVF – OA5, 12%) = $10,000 (3.60478)
= 36,048
Combined present value (purchase price)
$92,791
i = 8%
PV – OA = ? $10,000
0
1
$10,000
2
$10,000
$10,000
Principal $100,000 Interest $10,000
4
5
3 n=5
Present value of the principal FV (PVF5, 8%) = $100,000 (.68058)
= $ 68,058
Present value of the interest payments R (PVF – OA5, 8%) = $10,000 (3.99271) Combined present value (Proceeds)
=
39,927 $107,985
PROFESSIONAL SIMULATION (Continued) 12% Inputs:
5
12
?
–10,000
–10,000
N
I
PV
PMT
FV
Answer:
92,790.45
8% Inputs:
5
8
?
–10,000
–10,000
N
I
PV
PMT
FV
Answer:
107,985.42 Note: Calculators generally round to the nearest cent.
Valuation A
B
C
D
E
F
G
1 2
Bond Amortization Schedule
3 Carrying
4
Date
Cash Interest
Interest
Bond Discount
Value of
Expense
Amortization
Bonds
5
Year 0
6
Year 1
10,000.00
$11,134.85
$1,134.85
93,925.30
7
Year 2
10,000.00
11,271.04
1,271.04
95,196.34
8
Year 3
10,000.00
11,423.56
1.423.56
96,619.90
9
Year 4
10,000.00
11,594.39
1,594.39
98,214.29
10
Year 5
10,000.00
11,785.71
1,785.71
100,000.00
$92,790.45
11 12 13 14 15
The following formula is entered in the cells in this column: =+C6-B6.
The following formula is entered in the cells in this column: =+E5*0.12.
The following formula is entered in the cells in this column: =+E5+D6
CHAPTER 7 Cash and Receivables ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Brief Exercises
Exercises
Problems
1, 2, 3, 4, 22
1
1, 2
1
Accounting for accounts receivable, bad debts, other allowances.
5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15, 16, 20
2, 3, 4, 5
3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 14
2, 3, 4, 5, 6
1, 2, 3, 4, 9, 10, 11
3.
Accounting for notes receivable.
14, 15
6, 7
18, 19
8, 9, 10
5, 6, 7, 8
4.
Assignment and factoring of accounts receivable.
17, 18, 19
8, 9, 10, 11, 12
12, 13, 14, 15, 16, 17, 21
7, 11
4, 5, 7
5.
Analysis of receivables.
21
13
20, 21
1
*6.
Petty cash and bank reconciliations.
23
14, 15, 16
22, 23, 24, 25
12, 13, 14
*7.
Loan impairments
24, 25
17
26, 27
15
Topics
Questions
1.
Accounting for cash.
2.
*This material is covered in an Appendix to the chapter.
Concepts for Analysis
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives Questions
Brief Exercises
Exercises
1
1, 2
1.
Identify items considered cash.
1
2.
Indicate how to report cash and related items.
2, 3, 4
3.
Define receivables and identify the different types of receivables.
4.
Explain accounting issues related to recognition of accounts receivable.
5, 6
5.
Explain accounting issues related to valuation of accounts receivable.
6.
Problems
Concepts for Analysis
1 3, 4
6
2, 3
3, 4, 5, 6, 12
6
CA7-4, CA7-9
7, 8, 9, 10, 11, 12, 13, 14
4, 5
7, 8, 9, 10, 11, 12, 14
2, 3, 4, 5, 6
CA7-1, CA7-3, CA7-10
Explain accounting issues related to recognition and valuation of notes receivable.
15
6, 7
18, 19
8, 9, 10
CA7-2, CA7-4, CA7-6, CA77,CA7-8,
7.
Explain the fair value option.
16
8.
Explain accounting issues related to disposition of accounts and notes receivable.
17, 18, 19
8, 9, 10, 11, 12
12, 13, 14, 15, 16, 17, 21
7, 11
CA7-2, CA7-5
9.
Describe how to report and analyze receivables.
20, 21, 22
13
20
11
*10.
Explain common techniques employed to control cash.
23
14, 15, 16
22, 23, 24, 25
12, 13, 14
*11.
Describe the accounting for a loan impairment.
24, 25
17
26, 27
15
19
ASSIGNMENT CHARACTERISTICS TABLE
Item
Description
Level of Difficulty
Time (minutes)
E7-1 E7-2 E7-3 E7-4 E7-5 E7-6 E7-7 E7-8 E7-9 E7-10 E7-11 E7-12 E7-13 E7-14 E7-15 E7-16 E7-17 E7-18 E7-19 E7-20 E7-21 *E7-22 *E7-23 *E7-24 *E7-25 *E7-26 *E7-27
Determining cash balance. Determining cash balance. Financial statement presentation of receivables. Determining ending accounts receivable. Recording sales gross and net. Recording sales transactions. Recording bad debts. Recording bad debts. Computing bad debts and preparing journal entries. Bad-debt reporting. Bad debts—aging. Journalizing various receivable transactions. Assigning accounts receivable. Journalizing various receivable transactions. Transfer of receivables with recourse. Transfer of receivables with recourse. Transfer of receivables without recourse. Note transactions at unrealistic interest rates. Notes receivable with unrealistic interest rate. Analysis of receivables. Transfer of receivables. Petty cash. Petty cash. Bank reconciliation and adjusting entries. Bank reconciliation and adjusting entries. Impairments Impairments
Moderate Moderate Simple Simple Simple Moderate Moderate Simple Simple Simple Simple Simple Simple Simple Simple Moderate Simple Simple Moderate Moderate Moderate Simple Simple Moderate Simple Moderate Moderate
10–15 10–15 10–15 10–15 15–20 5–10 10–15 5–10 8–10 10–12 8–10 15–20 10–15 15–18 10–15 15–20 10–15 10–15 20–25 10–15 10–15 5–10 10–15 15–20 15–20 15–25 15–25
P7-1 P7-2 P7-3 P7-4 P7-5 P7-6 P7-7 P7-8 P7-9 P7-10 P7-11 *P7-12 *P7-13 *P7-14 *P7-15
Determine proper cash balance. Bad-debt reporting. Bad-debt reporting—aging. Bad-debt reporting. Bad-debt reporting. Journalize various accounts receivable transactions. Assigned accounts receivable—journal entries. Notes receivable with realistic interest rate. Notes receivable journal entries. Comprehensive receivables problem. Income effects of receivables transactions. Petty cash, bank reconciliation. Bank reconciliation and adjusting entries. Bank reconciliation and adjusting entries. Loan impairment entries
Simple Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Complex Moderate Moderate Moderate Moderate Moderate
20–25 20–25 20–30 25–35 20–30 25–35 25–30 30–35 30–35 40–50 20–25 20–25 20–30 20–30 30–40
ASSIGNMENT CHARACTERISTICS TABLE (Continued) Item
Description
CA7-1 CA7-2 CA7-3 CA7-4 CA7-5 CA7-6 CA7-7
Bad-debt accounting. Various receivable accounting issues. Bad-debt reporting issues. Basic note and accounts receivable transactions. Sale of notes receivable. Zero-interest-bearing note receivable. Reporting of notes receivable, interest, and sale of receivables. Accounting for zero-interest-bearing note. Receivables management. Bad-debt reporting, ethics.
CA7-8 CA7-9 CA7-10
Level of Difficulty
Time (minutes)
Simple Simple Moderate Moderate Moderate Moderate Moderate
10–15 15–20 25–30 25–30 20–25 20–30 25–30
Moderate Moderate Moderate
25–30 25–30 25–30
SOLUTIONS TO CODIFICATION EXERCISES CE7-1 From the Master Glossary (a) Consistent with common usage, cash includes not only currency on hand but demand deposits with banks or other financial institutions. Cash also includes other kinds of accounts that have the general characteristics of demand deposits in that the customer may deposit additional funds at any time and also effectively may withdraw funds at any time without prior notice or penalty. All charges and credits to those accounts are cash receipts or payments to both the entity owning the account and the bank holding it. For example, a bank’s granting of a loan by crediting the proceeds to a customer’s demand deposit account is a cash payment by the bank and a cash receipt of the customer when the entry is made. (b) Securitization is the process by which financial assets are transformed into securities. (c) Recourse is the right of a transferee of receivables to receive payment from the transferor of those receivables for any of the following: a. Failure of debtors to pay when due b. The effects of prepayments c. Adjustments resulting from defects in the eligibility of the transferred receivables.
CE7-2 According to FASB ASC 450-20-05 (Accruals of Loss Contingencies Do Not Provide Financial Protection) 05–8 Accrual of a loss related to a contingency does not create or set aside funds to lessen the possible financial impact of a loss. Confusion exists between accounting accruals (sometimes referred to as accounting reserves) and the reserving or setting aside of specific assets to be used for a particular purpose or contingency. Accounting accruals are simply a method of allocating costs among accounting periods and have no effect on an entity’s cash flow. Those accruals in no way protect the assets available to replace or repair uninsured property that may be lost or damaged, or to satisfy claims that are not covered by insurance, or, in the case of insurance entities, to satisfy the claims of insured parties. Accrual, in and of itself, provides no financial protection that is not available in the absence of accrual. 05–9
An entity may choose to maintain or have access to sufficient liquid assets to replace or repair lost or damaged property or to pay claims in case a loss occurs. Alternatively, it may transfer the risk to others by purchasing insurance. The accounting standards set forth in this Subtopic do not affect the fundamental business economics of that decision. That is a financial decision, and if an entity’s management decides to do neither, the presence or absence of an accrued credit balance on the balance sheet will have no effect on the consequences of that decision. Insurance or reinsurance reduces or eliminates risks and the inherent earnings fluctuations that accompany risks. Unlike insurance and reinsurance, the use of accounting reserves does not reduce or eliminate risk. The use of accounting reserves is not an alternative to insurance and reinsurance in protecting against risk. Earnings fluctuations are inherent in risk retention, and they are reported as they occur.
CE7-3 According to FASB ASC 860-10-05 (Overview and Background) > Types of Transfers 05–6
Transfers of financial assets take many forms. This guidance provides an overview of the following types of transfers discussed in this Topic: a. Securitizations b. Factoring c. Transfers of receivables with recourse d. Securities lending transactions e. Repurchase agreements f. Loan participations g. Banker’s acceptances
>> Factoring 05–14 Factoring arrangements are a means of discounting accounts receivable on a nonrecourse, notification basis. Accounts receivable are sold outright, usually to a transferee (the factor) that assumes the full risk of collection, without recourse to the transferor in the event of a loss. Debtors are directed to send payments to the transferee. >> Transfers of Receivables with Recourse 05–15 In a transfer of receivables with recourse, the transferor provides the transferee with full or limited recourse. The transferor is obligated under the terms of the recourse provision to make payments to the transferee or to repurchase receivables sold under certain circumstances, typically for defaults up to a specified percentage. >> Securities Lending Transactions 05–16 Securities lending transactions are initiated by broker-dealers and other financial institutions that need specific securities to cover a short sale or a customer’s failure to deliver securities sold. Securities custodians or other agents commonly carry out securities lending activities on behalf of clients. >> Repurchase Agreements 05–19 Government securities dealers, banks, other financial institutions, and corporate investors commonly use repurchase agreements to obtain or use short-term funds. Under those agreements, the transferor (repo party) transfers a security to a transferee (repo counterparty or reverse party) in exchange for cash and concurrently agrees to reacquire that security at a future date for an amount equal to the cash exchanged plus a stipulated interest factor. Instead of cash, other securities or letters of credit sometimes are exchanged. Some repurchase agreements call for repurchase of securities that need not be identical to the securities transferred. >> Loan Participations 05–22 In certain industries, a typical customer’s borrowing needs often exceed its bank’s legal lending limits. To accommodate the customer, the bank may participate the loan to other banks (that is, transfer under a participation agreement a portion of the customer’s loan to one or more participating banks).
CE7-3 (Continued) >> Banker’s Acceptances 05–24 Banker’s acceptances provide a way for a bank to finance a customer’s purchase of goods from a vendor for periods usually not exceeding six months. Under an agreement between the bank, the customer, and the vendor, the bank agrees to pay the customer’s liability to the vendor upon presentation of specified documents that provide evidence of delivery and acceptance of the purchased goods. The principal document is a draft or bill of exchange drawn by the customer that the bank stamps to signify its acceptance of the liability to make payment on the draft on its due date.
CE7-4 According to FASB ASC 210-20-45 > Right of Setoff Criteria 45-1
A right of setoff exists when all of the following conditions are met: a. Each of two parties owes the other determinable amounts. b. The reporting party has the right to set off the amount owed with the amount owed by the other party. c. The reporting party intends to set off. d. The right of setoff is enforceable at law.
45-2
A debtor having a valid right of setoff may offset the related asset and liability and report the net amount.
45-3
If the parties meet the criteria specified in paragraph 210-20-45-1, specifying currency or interest rate requirements is unnecessary. However, if maturities differ, only the party with the nearer maturity could offset because the party with the longer term maturity must settle in the manner that the other party selects at the earlier maturity date.
45-4
If a party does not intend to set off even though the ability to set off exists, an offsetting presentation in the statement of financial position is not representationally faithful.
45-5
Acknowledgment of the intent of set off by the reporting party and, if applicable, demonstration of the execution of the setoff in similar situations meet the criterion of intent.
ANSWERS TO QUESTIONS 1. Cash normally consists of coins and currency on hand, bank deposits, and various kinds of orders for cash such as bank checks, money orders, travelers’ checks, demand bills of exchange, bank drafts, and cashiers’ checks. Balances on deposit in banks which are subject to immediate withdrawal are properly included in cash. Money market funds that provide checking account privileges may be classified as cash. There is some question as to whether deposits not subject to immediate withdrawal are properly included in cash or whether they should be set out separately. Savings accounts, time certificates of deposit, and time deposits fall in this latter category. Unless restrictions on these kinds of deposits are such that they cannot be converted (withdrawn) within one year or the operating cycle of the entity, whichever is longer, they are properly classified as current assets. At the same time, they may well be presented separately from other cash and the restrictions as to convertibility reported. 2. (a) Cash (b) Trading securities. (c) Temporary investments. (d) Accounts receivable. (e) Accounts receivable, a loss if uncollectible. (f) Other assets if not expendable, cash if expendable for goods and services in the foreign country. (g) Receivable if collection expected within one year; otherwise, other asset.
(h) Investments, possibly other assets. (i) Cash. (j) Trading securities. (k) Cash. (l) Cash. (m) Postage expense, or prepaid expense, or supplies inventory. (n) Receivable from employee if the company is to be reimbursed; otherwise, prepaid expense.
3. A compensating balance is that portion of any demand deposit maintained by a corporation which constitutes support for existing borrowing arrangements of a corporation with a lending institution. A compensating balance representing a legally restricted deposit held against short-term borrowing arrangements should be stated separately among the cash and cash equivalent items. A restricted deposit held as a compensating balance against long-term borrowing arrangements should be separately classified as a noncurrent asset in either the investments or other assets section. 4. Restricted cash for debt redemption would be reported in the long-term asset section, probably in the investments section. Another alternative is the other assets section. Given that the debt is long term, the restricted cash should also be reported as long term. 5. The seller normally uses trade discounts to avoid frequent changes in its catalogs, to quote different prices for different quantities purchased, and to hide the true invoice price from competitors. Trade discounts are not recorded in the accounts because the price finally quoted is generally an accurate statement of the fair market value of the product on that date. In addition, no subsequent changes can occur to affect this value from an accounting standpoint. With a cash discount, the buyer receives a choice and events subsequent to the original transaction dictate that additional entries may be needed.
Questions Chapter 7 (Continued) 6. Two methods of recording accounts receivable are: 1. Record receivables and sales gross. 2. Record receivables and sales net. The net method is desirable from a theoretical standpoint because it values the receivable at its net realizable value. In addition, recording the sales at net provides a better assessment of the revenue that was recognized from the sale of the product. If the purchasing company fails to take the discount, then the company should reflect this amount as income. The gross method for receivables and sales is used in practice normally because it is expedient and its use does not generally have any significant effect on the presentation of the financial statements. 7. The basic problems that relate to the valuation of receivables are (1) the determination of the face value of the receivable, (2) the probability of future collection of the receivable, and (3) the length of time the receivable will be outstanding. The determination of the face value of the receivable is a function of the trade discount, cash discount, and certain allowance accounts such as the Allowance for Sales Returns and Allowances. 8. The theoretical superiority of the allowance method over the direct write-off method of accounting for bad debts is two-fold. First, since revenue is considered to be recognized at the point of sale on the assumption that the resulting receivables are valid liquid assets merely awaiting collection, periodic income will be overstated to the extent of any receivables that eventually become uncollectible. The proper matching of revenue and expense requires that gross sales in the income statement be partially offset by a charge to bad debt expense that is based on an estimate of the receivables arising from gross sales that will not be converted into cash. Second, accounts receivable on the balance sheet should be stated at their estimated net realizable value. The allowance method accomplishes this by deducting from gross receivables the allowance for doubtful accounts. The latter is derived from the charges for bad debt expense on the income statement. 9. The percentage-of-sales method. Under this method Bad Debt Expense is debited and Allowance for Doubtful Accounts is credited with a percentage of the current year’s credit or total sales. The rate is determined by reference to the relationship between prior years’ credit or total sales and actual bad debts arising therefrom. Consideration should also be given to changes in credit policy and current economic conditions. Although the rate should theoretically be based on and applied to credit sales, the use of total sales is acceptable if the ratio of credit sales to total sales does not vary significantly from year to year. The percentage-of-sales method of providing for estimated uncollectible receivables is intended to charge bad debt expense to the period in which the corresponding sales are recorded and is, therefore, designed for the preparation of a fair income statement. Due to annually insignificant but cumulatively significant errors in the experience rate which may result in either an excessive or inadequate balance in the allowance account, however, this method may not accurately report accounts receivable in the balance sheet at their estimated net realizable value. This can be prevented by periodically reviewing and, if necessary, adjusting the balance in the allowance account. The materiality of any such adjustment would govern its treatment for reporting purposes. The necessity of such adjustments of the allowance account indicates that bad debt expenses have not been accurately matched against related sales. Further, even when the experience rate does not result in an excessive or inadequate balance in the allowance account, this method tends to have a smoothing effect on reported periodic income due to year-to-year differences between the amounts of bad debt write-offs and estimated bad debts.
Questions Chapter 7 (Continued) The aging method. With this method each year’s debit to the expense account and credit to the allowance account are determined by an evaluation of the collectibility of open accounts receivable at the close of the year. An analysis of the accounts according to their due dates is the usual procedure. For each of the age categories established in the analysis, average percentage rates may be developed on the basis of past experience and applied to the accounts in the respective age categories. This method may also utilize individual analysis for some accounts, especially those that are considerably past due, in arriving at estimated uncollectible receivables. On the basis of the foregoing analysis the balance in the valuation account is then adjusted to the amount estimated to be uncollectible. This method of providing for uncollectible accounts is quite accurate for purposes of reporting accounts receivable at their estimated net realizable value in the balance sheet. From the standpoint of the income statement, however, the aging method may not match accurately bad debt expenses with the sales which caused them because the charge to bad debt expense is not based on sales. The accuracy of both the charge to bad debt expense and the reported value of receivables depends on the current estimate of uncollectible accounts. The accuracy of the expense charge, however, is additionally dependent upon the timing of actual write-offs. 10. A major part of accounting is the measurement of financial data. Changes in values should be recognized as soon as they are measurable in objective terms in order for accounting to provide useful information on a periodic basis. The very existence of accounts receivable is based on the decision that a credit sale is an objective indication that revenue should be recognized. The alternative is to wait until the debt is paid in cash. If revenue is to be recognized and an asset recorded at the time of a credit sale, the need for fairness in the statements requires that both expenses and the asset be adjusted for the estimated amounts of the asset that experience indicates will not be collected. The argument may be persuasive that the evidence supporting write-offs permits a more accurate decision than that which supports the allowance method. The latter method, however, is “objective” in the sense in which accountants use the term and is justified by the need for fair presentation of receivables and income. The direct write-off method is not wholly objective; it requires the use of judgment in determining when an account has become uncollectible. 11. Because estimation of the allowance account balance requires judgment, management could either over-estimate or under-estimate the amount of uncollectible accounts depending on whether a higher or lower earnings number is desired. For example, Sun Trust bank (referred to in the chapter) was having a very profitable year. By over-estimating the amount of bad debts, Sun Trust could record a higher allowance and expense, thereby reducing income in the current year. In a subsequent year, when earnings are low, they could under-estimate the allowance, record less expense and get a boost to earnings. 12. The receivable due from Bernstein Company should be written off to an appropriately named loss account and reported in the income statement as part of income from operations. Note that the profession specifically excludes write-offs of receivables from being extraordinary. In this case, classification as an unusual item would seem appropriate. The loss may properly be reduced by the portion of the allowance for doubtful accounts at the end of the preceding year that was allocable to the Bernstein Company account. Estimates for doubtful accounts are based on a firm’s prior bad debt experience with due consideration given to changes in credit policy and forecasted general or industry business conditions.
Questions Chapter 7 (Continued) The purpose of the allowance method is to anticipate only that amount of bad debt expense which can be reasonably forecasted in the normal course of events; it is not intended to anticipate bad debt losses which are abnormal and nonrecurring in nature. 13. If the direct write-off method is used, the only alternative is to debit Cash and credit a revenue account entitled Uncollectible Amounts Recovered. If the allowance method is used, then the accountant would debit Accounts Receivable and credit the Allowance for Doubtful Accounts. An entry is then made to credit the customer’s account and debit Cash upon receipt of the remittance. 14. The journal entry on Lombard’s books would be: Notes Receivable ............................................................................. Discount on Notes Receivable .................................................... Sales Revenue ...........................................................................
1,000,000 360,000 640,000*
*Assumes that seller is a dealer in this property. If not, the property might be credited, and a loss on sale of $50,000 would be recognized. 15. Imputed interest is the interest ascribed or attributed to a situation or circumstance which is void of a stated or otherwise appropriate interest factor. Imputed interest is the result of a process of interest rate estimation called imputation. An interest rate is imputed for notes receivable when (1) no interest rate is stated for the transaction, or (2) the stated interest rate is unreasonable, or (3) the stated face amount of the note is materially different from the current cash price for the same or similar items or from the current market value of the debt instrument. In imputing an appropriate interest rate, consideration should be given to the prevailing interest rates for similar instruments of issuers with similar credit ratings, the collateral, and restrictive covenants. 16. The fair value option gives companies the option of using fair value as the measurement basis for financial instruments. The Board believes that fair value measurement for financial instruments provides more relevant and understandable information than historical cost. If companies choose the fair value option, the receivables are recorded at fair value, with unrealized gains or losses reported as part of net income. 17. A company might sell receivables because money is tight and access to normal credit is not available or prohibitively expensive. Also, a company may have to sell its receivables, instead of borrowing, to avoid violating existing lending arrangements. In addition, billing and collection of receivables are often time-consuming and costly. 18. The financial components approach is used when receivables are sold but there is continuing involvement by the seller in the receivable. Examples of continuing involvement are recourse provisions or continuing rights to service the receivable. A transfer of receivables should be recorded as a sale when the following three conditions are met: (a) The transferred asset has been isolated from the transferor (put beyond reach of the transferor and its creditors). (b) The transferees have obtained the right to pledge or exchange either the transferred assets or beneficial interests in the transferred assets. (c) The transferor does not maintain effective control over the transferred assets through an agreement to repurchase or redeem them before their maturity.
Questions Chapter 7 (Continued) 19. Recourse is a guarantee from Moon that if any of the sold receivables are uncollectible, Moon will pay the factor for the amount of the uncollectible account. This recourse obligation represents continuing involvement by Moon after the sale. Under the financial components model, the estimated fair value of the recourse obligation will be reported as a liability on Moon’s balance sheet. 20. Several acceptable solutions are possible depending upon assumptions made as to whether certain items are collectible within the operating cycle or not. The following illustrates one possibility: Current Assets Accounts receivable—Trade (of which accounts in the amount of $75,000 have been assigned as security for loans payable) ($523,000 + $75,000) .......................................................................................... Federal income tax refund receivable .................................................................. Advance payments on purchases ........................................................................ Investments Advance to subsidiary.......................................................................................... Other Assets Travel advance to employees .............................................................................. Notes receivable past due plus accrued interest..................................................
$598,000 15,500 61,000 45,500 22,000 47,000
21. The accounts receivable turnover ratio is computed by dividing net sales by average net receivables outstanding during the year. This ratio is used to assess the liquidity of the receivables. It measures the number of times, on average, receivables are collected during the period. It provides some indication of the quality of the receivables and how successful the company is in collecting its outstanding receivables. 22. Because the restricted cash cannot be used by Woodlawn to meet current obligations, it should not be reported as a current asset—it should be reported in investments or other assets. Thus, although this item has cash in its label, it should not be reflected in liquidity measures, such as the current or acid-test ratios. *23. (1) The general checking account is the principal bank account of most companies and frequently the only bank account of small companies. Most if not all transactions are cycled through the general checking account, either directly or on an imprest basis. (2)
Imprest bank accounts are used to disburse cash (checks) for a specific purpose, such as dividends, payroll, commissions, or travel expenses. Money is deposited in the imprest fund from the general fund in an amount necessary to cover a specific group of disbursements.
(3)
Lockbox accounts are local post office boxes to which a multi-location company instructs its customers to mail remittances. A local bank is authorized to empty the box daily and credit the company’s accounts for collections.
*24. A loan is considered impaired when it is probable that the creditor will be unable to collect all amounts due (both principal and interest) according to the contractual terms of the loan. If a loan is considered impaired, the loss due to impairment should be measured as the difference between the investment in the loan and the expected future cash flows discounted at the loan’s historical effective-interest rate. The loss is recorded on the books of the creditor. The debtor would not be aware of the entry made by the creditor and would not make an entry until settlement or if a modification of terms resulted. *25. A loan is impaired when there is a reduction in the likelihood of collecting the interest and principal payments as originally scheduled. An impairment should be recorded by a creditor when it is “probable” that the payment will not be collected as scheduled. Debtors do not record impairments.
SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 7-1 Cash in bank—savings account ................................ Cash on hand .............................................................. Checking account balance......................................... Cash to be reported ....................................................
$68,000 9,300 17,000 $94,300
BRIEF EXERCISE 7-2 June 1 June 12
Accounts Receivable ........................... Sales Revenue.............................
50,000
Cash...................................................... Sales Discounts ................................... Accounts Receivable ..................
48,500* 1,500
50,000
50,000
*$50,000 – ($50,000 X .03) = $48,500 BRIEF EXERCISE 7-3 June 1 June 12
Accounts Receivable ........................... Sales Revenue.............................
48,500*
Cash...................................................... Accounts Receivable ..................
48,500
48,500
48,500
*$50,000 – ($50,000 X .03) = $48,500 BRIEF EXERCISE 7-4 Bad Debt Expense ...................................................... Allowance for Doubtful Accounts ($1,400,000 X 2%) ............................................
28,000 28,000
BRIEF EXERCISE 7-5 (a)
(b)
Bad Debt Expense ........................................... Allowance for Doubtful Accounts [(10% X $250,000) – $2,400].................
22,600
Bad Debt Expense ........................................... Allowance for Doubtful Accounts ($24,600 – $2,400) ................................
22,200
22,600
22,200
BRIEF EXERCISE 7-6 11/1/14 12/31/14
5/1/15
Notes Receivable .................................... Sales Revenue ...............................
30,000
Interest Receivable ................................. Interest Revenue ($30,000 X 6% X 2/12)..................
300
Cash......................................................... Notes Receivable ........................... Interest Receivable ........................ Interest Revenue ($30,000 X 6% X 4/12)...................
30,900
30,000
300 30,000 300 600
BRIEF EXERCISE 7-7 Notes Receivable ..................................................... Discount on Notes Receivable....................... Cash .................................................................
20,000
Discount on Notes Receivable ................................ Interest Revenue $16,529 X 10% ..............................................
1,653
Discount on Notes Receivable ................................ Interest Revenue ($16,529 + $1,653) X 10% .............................
1,818
Cash .......................................................................... Notes Receivable ............................................
20,000
3,471 16,529
1,653
1,818 20,000
BRIEF EXERCISE 7-8 Chung, Inc. Cash........................................................................ Interest Expense ($1,000,000 X 2%)...................... Notes Payable ...............................................
730,000 20,000 750,000
Seneca National Bank Notes Receivable ................................................... Cash............................................................... Interest Revenue ($1,000,000 X 2%) ............
750,000 730,000 20,000
BRIEF EXERCISE 7-9 Wood Cash........................................................................ Due from Factor ..................................................... Loss on Sale of Receivables................................. Accounts Receivable....................................
138,000 9,000* 3,000** 150,000
*6% X $150,000 = $9,000 **2% X $150,000 = $3,000 Engram Accounts Receivable............................................. Due to Customer (Wood).............................. Interest Revenue........................................... Cash...............................................................
150,000 9,000 3,000 138,000
BRIEF EXERCISE 7-10 Wood Cash........................................................................ Due from Factor ..................................................... Loss on Sale of Receivables................................. Accounts Receivable.................................... Recourse Liability ......................................... *6% X $150,000 = $9,000 **2% X $150,000 = $3,000 + $7,500 = $10,500
138,000 9,000* 10,500** 150,000 7,500
BRIEF EXERCISE 7-11 Cash $250,000 – [$250,000 X (.05 + .04)]............... Due from Factor ($250,000 X .04) .......................... Loss on Sale of Receivables ................................. Accounts Receivable .................................... Recourse Liability .........................................
227,500 10,000 20,500* 250,000 8,000
*($250,000 X .05) + $8,000 BRIEF EXERCISE 7-12 The entry for the sale now would be: Cash $250,000 – [($250,000 X (.05 + .04)] ............. Due from Factor ($250,000 X .04) .......................... Loss on Sale of Receivables ................................. Account Receivable ...................................... Recourse Liability .........................................
227,500 10,000 16,500* 250,000 4,000
*($250,000 X .05) + $4,000 This lower estimate for the recourse liability reduces the amount of the loss—this will result in higher income in the year of the sale. Arness’s liabilities will be lower by $4,000. BRIEF EXERCISE 7-13 The accounts receivable turnover ratio is computed as follows: Net Sales Average Trade Receivables (net)
=
$12,442,000,000 = 13.34 times $912,000,000 + $953,000,000 2
The days outstanding (average collection period) for accounts receivable in days is 365 days = 365 Accounts Receivable Turnover 13.34
= 27.36 days
As indicated from these ratios, General Mills’ accounts receivable turnover ratio appears quite strong.
*BRIEF EXERCISE 7-14 Petty Cash ....................................................................... Cash........................................................................
200
Supplies........................................................................... Miscellaneous Expense.................................................. Cash Over and Short ...................................................... Cash ($200 – $15)...................................................
94 87 4
200
185
*BRIEF EXERCISE 7-15 (a) (b) (c) (d) (e)
Added to balance per bank statement (1) Deducted from balance per books (4) Added to balance per books (3) Deducted from balance per bank statement (2) Deducted from balance per books (4)
*BRIEF EXERCISE 7-16 (b) (c)
(e)
Office Expense........................................................ Cash................................................................
25
Cash......................................................................... Interest Revenue............................................
31
Accounts Receivable.............................................. Cash................................................................
377
25 31 377
Thus, all “Balance per books” adjustments in the reconciliation require a journal entry. *BRIEF EXERCISE 7-17 National American Bank (Creditor): Bad Debt Expense ........................................................ 225,000 Allowance for Doubtful Accounts .....................
225,000
SOLUTIONS TO EXERCISES EXERCISE 7-1 (10–15 minutes) (a)
(b)
Cash includes the following: 1. Commercial savings account— First National Bank of Yojimbo 1. Commercial checking account— First National Bank of Yojimbo 2. Money market fund—Volonte 5. Petty cash 11. Commercial Paper (cash equivalent) 12. Currency and coin on hand Cash reported on December 31, 2014, balance sheet
$ 600,000 900,000 5,000,000 1,000 2,100,000 7,700 $8,608,700
Other items classified as follows: 3.
Travel advances (reimbursed by employee)* should be reported as receivable—employee in the amount of $180,000.
4.
Cash restricted in the amount of $1,500,000 for the retirement of long-term debt should be reported as a noncurrent asset identified as “Cash restricted for retirement of long-term debt.” An IOU from Marianne Koch should be reported as an account receivable in the amount of $190,000. The bank overdraft of $110,000 should be reported as a current liability.** Certificates of deposits of $500,000 each should be classified as temporary investments. Postdated check of $125,000 should be reported as an accounts receivable. The compensating balance requirement does not affect the balance in cash. A note disclosure indicating the arrangement and the amounts involved should be described in the notes.
6. 7. 8. 9. 10.
EXERCISE 7-1 (Continued) *If not reimbursed, charge to prepaid expense. **If cash is present in another account in the same bank on which the overdraft occurred, offsetting is required.
EXERCISE 7-2 (10–15 minutes) 1.
Cash balance of $925,000. Only the checking account balance should be reported as cash. The certificates of deposit of $1,400,000 should be reported as a temporary investment, the cash advance to subsidiary of $980,000 should be reported as a receivable, and the utility deposit of $180 should be identified as a receivable from the gas company.
2.
Cash balance is $584,650 computed as follows: Checking account balance Overdraft Petty cash Coins and currency
$600,000 (17,000) 300 1,350 $584,650
Cash held in a bond sinking fund is restricted. Assuming that the bonds are noncurrent, the restricted cash is also reported as noncurrent.
EXERCISE 7-2 (Continued) 3.
Cash balance is $599,800 computed as follows: Checking account balance Certified check from customer
$590,000 9,800 $599,800
The postdated check of $11,000 should be reported as an account receivable. Cash restricted due to compensating balance should be described in a note indicating the type of arrangement and amount. Postage stamps on hand are reported as part of supplies or prepaid expenses. 4.
Cash balance is $85,000 computed as follows: Checking account balance Money market mutual fund
The NSF check received from customer should account receivable. 5.
Cash balance is $700,900 computed as follows: Checking account balance Cash advance received from customer
$37,000 48,000 $85,000 be reported as an
$700,000 900 $700,900
Cash restricted for future plant expansion of $500,000 should be reported as a noncurrent asset. Short-term Treasury bills of $180,000 should be reported as a temporary investment. Cash advance received from customer of $900 should also be reported as a liability; cash advance of $7,000 to company executive should be reported as a receivable; refundable deposit of $26,000 paid to federal government should be reported as a receivable.
EXERCISE 7-3 (10–15 minutes) Current assets Accounts receivable Customers Accounts (of which accounts in the amount of $40,000 have been pledged as security for a bank loan) Installment accounts collectible
$79,000
due in 2014 Installment accounts collectible due after December 31, 2014* Other** ($2,640 + $1,500)
23,000 34,000
$136,000 4,140
$140,140
Investments Advance to subsidiary company
81,000
*This classification assumes that these receivables are collectible within the operating cycle of the business. **These items could be separately classified, if considered material.
EXERCISE 7-4 (10–15 minutes) Computation of cost of goods sold: Merchandise purchased Less: Ending inventory Cost of goods sold
$320,000 90,000 $230,000
EXERCISE 7-4 (Continued) Selling price = 1.4 (Cost of good sold) = 1.4 ($230,000) = $322,000 Sales on account Less: Collections Uncollected balance Balance per ledger Apparent shortage
$322,000 198,000 124,000 82,000 $ 42,000 —Enough for a new car
EXERCISE 7-5 (15–20 minutes) (a) (1) June 3 Accounts Receivable—Chester .................
3,000 3,000
Sales Revenue.................................... June 12 Cash ............................................................. Sales Discounts ($3,000 X 2%)................... Accounts Receivable—Chester ........
2,940 60
(2) June 3 Accounts Receivable—Chester ................. Sales Revenue ($3,000 X 98%) ..........
2,940
June 12
Cash ............................................................. Accounts Receivable—Chester ........
3,000
2,940 2,940 2,940
EXERCISE 7-5 (Continued) (b)
July 29 Cash ......................................................... Accounts Receivable—Chester ..... Sales Discounts Forfeited ..............
3,000 2,940 60
(Note to instructor: Sales discounts forfeited could have been recognized at the time the discount period lapsed. The company, however, would probably not record this forfeiture until final cash settlement.)
EXERCISE 7-6 (5–10 minutes) July 1
Accounts Receivable........................................20,000 Sales Revenue ...................................
July 10
20,000
Cash ................................................................. 19,400* Sales Discounts........................................... Accounts Receivable ........................
600 20,000
*$20,000 – (.03 X $20,000) = $19,400 July 17
July 30
Accounts Receivable .................................. 200,000 Sales Revenue ...................................
200,000
Cash ............................................................. 200,000 Accounts Receivable ........................
200,000
EXERCISE 7-7 (10–15 minutes) (a)
Bad Debt Expense......................................... Allowance for Doubtful Accounts.......
8,500 8,500*
*.01 X ($900,000 – $50,000) = $8,500 (b)
Bad Debt Expense......................................... Allowance for Doubtful Accounts.......
*Step 1: Step 2:
3,000 3,000*
.05 X $100,000 = $5,000 (desired credit balance in allowance account) $5,000 – $2,000 = $3,000 (required credit entry to bring allowance account to $5,000 credit balance)
EXERCISE 7-8 (15–20 minutes) (a)
Allowance for Doubtful Accounts ..................... Accounts Receivable ................................
6,000 6,000
(b)
Accounts Receivable Less: Allowance for Doubtful Accounts Net realizable value
$800,000 40,000 $760,000
(c)
Accounts Receivable Less: Allowance for Doubtful Accounts Net realizable value
$794,000 34,000 $760,000
EXERCISE 7-9 (8–10 minutes) (a)
(b)
Bad Debt Expense.............................................. Allowance for Doubtful Accounts............ ($90,000 X 4%) + $1,750 = $5,350
5,350
Bad Debt Expense.............................................. Allowance for Doubtful Accounts............ $680,000 X 1% = $6,800
6,800
5,350
6,800
EXERCISE 7-10 (10–12 minutes) (a)
The direct write-off approach is not theoretically justifiable even though required for income tax purposes. The direct write-off method does not match expenses with revenues of the period, nor does it result in receivables being stated at estimated realizable value on the balance sheet.
(b)
Bad Debt Expense – 2% of Sales = $44,000 ($2,200,000 X 2%) Bad Debt Expense – Direct Write-Off = $31,330 ($7,800 + $6,700 + $7,000 + $9,830) Net income would be $12,670 ($44,000 – $31,330) lower under the percentage-of-sales approach.
EXERCISE 7-11 (8–10 minutes) Balance 1/1 ($700 – $155) 4/12 (#2412) ($1,710 – $1,000 – $300*) 11/18 (#5681) ($2,000 – $1,250)
$ 545 Over one year 410 Eight months and 19 days 750 One month and 13 days $1,705
*($790 – $490) Inasmuch as later invoices have been paid in full, all three of these amounts should be investigated in order to determine why Hopkins Co. has not paid them. The amounts in the beginning balance and #2412 should be of particular concern.
EXERCISE 7-12 (15–20 minutes) 7/1
Accounts Receivable—Harding Co.............. Sales Revenue ($8,000 X 98%) ............
7,840
7/5 Cash [$9,000 X (1 – .09)]................................ Loss on Sale of Receivables ........................ Accounts Receivable ($9,000 X 98%).. Sales Discounts Forfeited ...................
8,190 810
7,840
8,820 180
(Note: It is possible that the company already recorded the Sales Discounts Forfeited. In this case, the credit to Accounts Receivable would be for $9,000. The same point applies to the next entry as well.)
EXERCISE 7-12 (Continued) 7/9
7/11
Accounts Receivable..................................... Sales Discounts Forfeited ($9,000 X 2%).....................................
180
Cash ............................................................... Interest Expense ($6,000 X 6%) .................... Notes Payable .......................................
5,640 360
Account Receivable—Harding Co. ............... Sales Discounts Forfeited.................... ($8,000 X 2%)
160
180
6,000
160
This entry may be made at the next time financial statements are prepared. Also, it may occur on 12/29 when Harding Company’s receivable is adjusted. 12/29 Allowance for Doubtful Accounts ................ Accounts Receivable—Harding Co. ...... [$7,840 + $160 = $8,000; $8,000 – (10% X $8,000) = $7,200]
7,200 7,200
EXERCISE 7-13 (10–15 minutes) (a)
Cash ................................................................... Interest Expense ............................................... Notes Payable ..........................................
192,000 8,000* 200,000
*2% X $400,000 = $8,000 (b)
Cash ................................................................... Accounts Receivable ...............................
350,000 350,000
EXERCISE 7-13 (Continued) (c)
Notes Payable................................................ Interest Expense ........................................... Cash ......................................................
200,000 5,000* 205,000
*10% X $200,000 X 3/12 = $5,000 EXERCISE 7-14 (15–18 minutes) 1.
Cash ................................................................ Loss on Sale of Receivables ......................... ($25,000 X 10%)
22,500 2,500
Accounts Receivable ............................ 2.
3.
25,000
Cash ................................................................
50,600
Interest Expense ($55,000 X 8%) ................... Notes Payable........................................
4,400
Bad Debt Expense .......................................... Allowance for Doubtful Accounts ........
6,220
55,000
6,220
[($82,000 X 5%) + $2,120] 4.
Bad Debt Expense .......................................... Allowance for Doubtful Accounts ........ ($430,000 X 1.5%)
6,450 6,450
EXERCISE 7-15 (10–15 minutes) Computation of net proceeds: Cash received Less: Recourse liability Net proceeds
$160,000 1,000 $159,000
EXERCISE 7-15 (Continued) Computation of gain or loss: Carrying value Net proceeds Loss on sale of receivables The following journal entry would be made: Cash ................................................................... Loss on Sale of Receivables ............................ Recourse Liability ..................................... Accounts Receivable ................................
$200,000 159,000 $ 41,000
$160,000 41,000 1,000 200,000
EXERCISE 7-16 (15–20 minutes) (a) To be recorded as a sale, all of the following conditions would be met: (1) The transferred asset has been isolated from the transferor (put beyond reach of the transferor and its creditors). (2) The transferees have obtained the right to pledge or to exchange either the transferred assets or beneficial interests in the transferred assets. (3) The transferor does not maintain effective control over the transferred assets through an agreement to repurchase or redeem them before their maturity. (b) Computation of net proceeds: Cash received ($175,000 X 94%) Due from factor ($175,000 X 4%) Less: Recourse liability Net proceeds
$164,500 7,000
$171,500 2,000 $169,500
EXERCISE 7-16 (Continued) Computation of gain or loss: Carrying value Net proceeds Loss on sale of receivables The following journal entry would be made: Cash ............................................................ Due from Factor.......................................... Loss on Sale of Receivables ..................... Recourse Liability............................... Accounts Receivable..........................
$175,000 169,500 $ 5,500
164,500 7,000 5,500 2,000 175,000
EXERCISE 7-17 (10–15 minutes) (a) July 1
Cash ....................................................... Due from Factor ..................................... Loss on Sale of Receivables................. Accounts Receivable....................
283,500 12,000* 4,500** 300,000
*(4% X $300,000) = $12,000 **(1 1/2% X $300,000) = $4,500 (b) July 1
Accounts Receivable............................. Due to JFK Corp. .......................... Interest Revenue........................... Cash...............................................
300,000 12,000 4,500 283,500
EXERCISE 7-18 (10–15 minutes) 1.
7/1/14
Notes Receivable ................................. 1,101,460.00 Discount on Notes Receivable .. Land............................................. Gain on Disposal of Land ..........
401,460.00 590,000.00 110,000.00
($700,000 – $590,000) Computation of the discount $1,101,460 Face value of note .63552 Present value of 1 for 4 periods at 12% $ 700,000 Present value of note 1,101,460 Face value of note $ 401,460 Discount on notes receivable 2.
7/1/14
Notes Receivable ................................... 400,000.00 Discount on Notes Receivable .. Service Revenue.........................
178,836.32 221,163.68
Computation of the present value of the note: Maturity value $400,000.00 Present value of $400,000 due in 8 years at 12%—$400,000 X .40388 $161,552.00 Present value of $12,000 payable annually for 8 years at 12% annually—$12,000 X 4.96764 Present value of the note Discount on notes receivable
59,611.68 221,163.68 $178,836.32
EXERCISE 7-19 (20–25 minutes) (a)
Notes Receivable ............................................. Discount on Notes Receivable ............... Service Revenue ....................................
200,000 34,710 165,290*
*Computation of present value of note: PV of $200,000 due in 2 years at 10% $200,000 X .82645 = $165,290 (b)
Discount on Notes Receivable ........................ Interest Revenue ....................................
16,529 16,529*
*$165,290 X 10% = $16,529 (c)
Discount on Notes Receivable ........................ Interest Revenue .....................................
18,181* 18,181
*$34,710 – $16,529 (or [$165,290 + $16,529] X 10%) Cash .................................................................. Notes Receivable ...................................
200,000 200,000
EXERCISE 7-20 (10–15 minutes) (a) Accounts Receivable ......................................... Sales Revenue ...........................................
100,000
Cash .................................................................... Accounts Receivable ................................
70,000
100,000
70,000
EXERCISE 7-20 (Continued) (b)
Accounts Receivable Turnover
=
Net Sales Average Trade Receivables (net)
Net Sales $100,000 = 3.33 times = Average Trade Receivables (net) ($15,000 + $45,000*)/2 *$15,000 + $100,000 – $70,000 Days to collect accounts receivable
(c)
=
365 = 110 days 3.33
Jones Company’s turnover ratio has declined significantly. That is, it is turning receivables 3.33 times a year and collections on receivables took 110 days. In the prior year, the turnover ratio was almost double (6.0) and collections took only 61 days. This is a bad trend in liquidity. Jones should consider offering early payment discounts and/or tightened credit and collection policies.
EXERCISE 7-21 (a) Cash [$25,000 X (1 – .09)]................................... Due from Factor.................................................. Loss on Sale of Accounts Receivable .............. Accounts Receivable ................................ Recourse Liability .....................................
22,750 1,250 2,200 25,000 1,200
Computation of cash received Accounts receivable .................................. Less: Due from factor (5% X $25,000)....... Finance charge (4% X $25,000) ...... Cash received ...................................... Computation of net proceeds (cash and other assets received, less any liabilities incurred) Cash received............................................. Due from factor .......................................... Less: Recourse liability ............................. Net proceeds........................................
$25,000 1,250 1,000 $22,750
$22,750 1,250
$24,000 1,200 $22,800
EXERCISE 7-21 (Continued) Computation of loss Carrying (Book) value ................................ Less: Net proceeds .................................... Loss on sale of receivables ................ (b)
Accounts Receivable Turnover
=
$25,000 22,800 $ 2,200
Net Sales Average Trade Receivables (net)
Net Sales $100,000 = 5.71 times = Average Trade Receivables (net) ($15,000 + $20,000*)/2 *($15,000 + $100,000 – $70,000 – $25,000) Days to collect accounts receivable =
365
= 63.92 days
5.71
With the factoring transaction, Jones Company’s turnover ratio still declines but by less than in the earlier exercise. While Jones’ collections have slowed, by factoring the receivables, Jones is able to convert them to cash. The cost of this approach to converting receivables to cash is captured in the Loss on Sale of Accounts Receivable account.
*EXERCISE 7-22 (5–10 minutes) 1.
2.
3.
April 1
Petty Cash............................................ Cash ............................................
200
April 10 Freight-In (or Invertory).......................
60
Supplies Expense................................ Postage Expense................................. Accounts Receivable—Employees .... Miscellaneous Expense ...................... Cash Over and Short ........................... Cash ($200 – $27) .......................
25 33 17 36 2
Petty Cash............................................ Cash ............................................
100
April 20
200
173
100
*EXERCISE 7-23 (10–15 minutes) Accounts Receivable—Employees........................ ($40.00 + $34.00)
74.00
Owner’s Drawings* ................................................. Maintenance and Repairs Expense ....................... Postage Expense ($20.00 – $2.90) ......................... Supplies Expense ................................................... Cash Over and Short .............................................. Cash ($300.00 – $15.20).................................
170.00 14.35 17.10 2.90 6.45
*Note: This debit might also be made to the capital account.
284.80
*EXERCISE 7-24 (15–20 minutes) (a)
Angela Lansbury Company Bank Reconciliation July 31
Balance per bank statement, July 31 Add: Deposits in transit Deduct: Outstanding checks Correct cash balance, July 31
$8,650 2,350a (1,100)b $9,900
Balance per books, July 31 Add: Collection of note Less: Bank service charge NSF check Correct cash balance, July 31
$9,250 1,000 $ 15 335
a
Computation of deposits in transit Deposits per books Deposits per bank in July Less deposits in transit (June) Deposits mailed and received in July Deposits in transit, July 31
$5,810 $5,000 (1,540) (3,460) $2,350
b
Computation of outstanding checks Checks written per books Checks cleared by bank in July $4,000 Less outstanding checks (June)* (2,000) Checks written and cleared in July Outstanding checks, July 31 *Assumed to clear bank in July
$3,100
(2,000) $1,100
(350) $9,900
*EXERCISE 7-24 (Continued) (b) Cash .................................................................... Office Expenses—bank service charges.......... Accounts Receivable ......................................... Notes Receivable.......................................
650 15 335 1,000
*EXERCISE 7-25 (15–20 minutes) (a)
Logan Bruno Company Bank Reconciliation, August 31, 2014 County National Bank
Balance per bank statement, August 31, 2014 Add: Cash on hand Deposits in transit
$ 8,089 $ 310 3,800
4,110
Deduct: Outstanding checks
12,199 1,050
Correct cash balance
$11,149
Balance per books, August 31, 2014 ($10,050 + $35,000 – $34,903) Add: Note ($1,000) and interest ($40) collected Deduct: Bank service charges Understated check for supplies Correct cash balance (b) Cash ........................................................................... Notes Receivable.............................................. Interest Revenue .............................................. (To record collection of note and interest)
$10,147 1,040 11,187 $
20 18
38 $11,149
1,040 1,000 40
*EXERCISE 7-25 (Continued) Office Expense—bank service charges ................... Cash .................................................................. (To record August bank charges)
20
Supplies Expense...................................................... Cash ..................................................................
18
20
(To record error in recording check for supplies) (c) The correct cash balance of $11,149 would be reported in the August 31, 2014, balance sheet.
18
*EXERCISE 7-26 (15-25 minutes) (a)
Journal entry to record issuance of loan by Paris Bank: December 31, 2014 Notes Receivable ........................................................... 100,000 Discount on Notes Receivable....................... Cash.................................................................
37,908 62,092
$100,000 X Present value of 1 for 5 periods at 10% $100,000 X .62092 = $62,092 (b)
Note Amortization Schedule (Before Impairment)
Date 12/31/14 12/31/15 12/31/16
Cash Received (0%) $0 0
Interest Revenue (10%) $6,209 6,830
Increase in Carrying Amount
Carrying Amount of Note
$6,209 6,830
$62,092 68,301 75,131
Computation of the impairment loss: Carrying amount of investment (12/31/16)................. Less: Present value of $75,000 due in 3 years at 10% ($75,000 X .75132) ................................ Loss due to impairment ..............................................
$75,131 56,349 $18,782
The entry to record the loss by Paris Bank is as follows: Bad Debt Expense ..................................................... Allowance for Doubtful Accounts ...................
18,782 18,782
Note: Iva Majoli Company, the debtor, makes no entry because it still legally owes $100,000.
*EXERCISE 7-27 (15-25 minutes) (a) Cash received by Conchita Martinez Company on December 31, 2014: Present value of principal ($1,000,000 X .56743)....... Present value of interest ($100,000 X 3.60478).......... Cash received .............................................................. (b)
$567,430 360,478 $927,908
Note Amortization Schedule (Before Impairment)
Date 12/31/14 12/31/15 12/31/16
Cash Received (10%) $100,000 100,000
Interest Revenue (12%) $111,349 112,711
Increase in Carrying Amount
Carrying Amount of Note
$11,349 12,711
$927,908 939,257 951,968
(c) Loss due to impairment: Carrying amount of loan (12/31/16) ................ Less: Present value of $600,000 due in 3 years ($600,000 X .71178) ................. Present value of $100,000 payable annually for 3 years ($100,000 X 2.40183) ................. Loss due to impairment ..................................
$951,968 427,068 240,183
667,251 $284,717
TIME AND PURPOSE OF PROBLEMS Problem 7-1 (Time 20–25 minutes) Purpose—to provide the student with an understanding of the balance sheet effect that occurs when the cash book is left open. In addition, the student is asked to adjust the present balance sheet to an adjusted balance sheet, reflecting the proper cash presentation. Problem 7-2 (Time 20–25 minutes) Purpose—to provide the student with the opportunity to determine various items related to accounts receivable and the allowance for doubtful accounts. Five independent situations are provided. Problem 7-3 (Time 20–30 minutes) Purpose—to provide a short problem related to the aging of accounts receivable. The appropriate balance for doubtful accounts must be determined. In addition, the manner of reporting accounts receivable on the balance sheet must be shown. Problem 7-4 (Time 25–35 minutes) Purpose—the student prepares an analysis of the changes in the allowance for doubtful accounts and supports it with an aging schedule. Problem 7-5 (Time 20–30 minutes) Purpose—a short problem that must be analyzed to make the necessary correcting entries. It is not a pencil-pushing problem but requires a great deal of conceptualization. A good problem for indicating the types of adjustments that might occur in the receivables area. Problem 7-6 (Time 25–35 minutes) Purpose—to provide the student with a number of business transactions related to notes and accounts receivable that must be journalized. Recoveries of receivables, and write-offs are the types of transactions presented. The problem provides a good cross section of a number of accounting issues related to receivables. Problem 7-7 (Time 25–30 minutes) Purpose—a short problem involving the reporting problems associated with the assignment of accounts receivable. The student is required to make the journal entries necessary to record an assignment. A straightforward problem. Problem 7-8 (Time 30–35 minutes) Purpose—to provide the student with a simple note receivable problem with no imputation of interest. Problem 7-9 (Time 30–35 minutes) Purpose—to provide the student with a problem requiring the imputation of interest. The student is required to make journal entries on a series of dates when note installments are collected. A relatively straightforward problem. Problem 7-10 (Time 40–50 minutes) Purpose—the student calculates the current portion of long-term receivables and interest receivable, and prepares the long-term receivables section of the balance sheet. Then the student prepares a schedule showing interest income. The problem includes interest-bearing and zero-interest-bearing notes and an installment receivable. Problem 7-11 (Time 20–25 minutes) Purpose—to provide the student the opportunity to record the sales of receivables with and without recourse and to determine the income effects.
Time and Purpose of Problems (Continued) *Problem 7-12 (Time 20–25 minutes) Purpose—to provide the student the opportunity to do the accounting for petty cash and a bank reconciliation. *Problem 7-13 (Time 20–30 minutes) Purpose—to provide the student with the opportunity to prepare a bank reconciliation which is reconciled to a corrected balance. Traditional types of adjustments are presented. Journal entries are also required. *Problem 7-14 (Time 20–30 minutes) Purpose—to provide the student with the opportunity to prepare a bank reconciliation which goes from balance per bank to corrected balance. Traditional types of adjustments are presented such as deposits in transit, bank service charges, NSF checks, and so on. Journal entries are also required. *Problem 7-15 (Time 30–40 minutes) Purpose—to provide the student with a loan impairment situation that requires entries by both the debtor and the creditor and an analysis of the loss on impairment.
SOLUTIONS TO PROBLEMS PROBLEM 7-1
(a)
December 31 Accounts Receivable ($17,640 + $360) ..... Sales Revenue ............................................ Cash ................................................... Sales Discounts.................................
18,000 28,000 45,640 360
December 31 Cash ............................................................ Purchase Discounts ................................... Accounts Payable .............................
22,200 250 22,450 Per Balance After Adjustment Sheet
(b) Current assets Cash ($39,000 – $45,640 + $22,200)..... Accounts Receivable ($42,000 + $18,000) .......................... Inventory ............................................... Total................................................
$ 39,000
$ 15,560
42,000 67,000 (1) 148,000
60,000 67,000 142,560
Current liabilities Accounts payable ($45,000 + $22,450) .......................... 45,000 Other current liabilities ....................... 14,200 Total................................................ (2) 59,200 Working capital.................................... (1) – (2) $ 88,800
67,450 14,200 81,650 $ 60,910
Current ratio............................................... (1) ÷ (2)
1.75 to 1
2.5 to 1
PROBLEM 7-2
1. Net sales ................................................................................ Percentage............................................................................. Bad debt expense .................................................................
$1,200,000 1 1/2% $ 18,000
2. Accounts receivable ............................................................. Amounts estimated to be uncollectible ............................... Net realizable value ...............................................................
$1,750,000 (180,000) $1,570,000
3. Allowance for doubtful accounts 1/1/14 .............................. Establishment of accounts written off in prior years ......... Customer accounts written off in 2014................................ Bad debt expense for 2014 ($2,400,000 X 3%) .................... Allowance for doubtful accounts 12/31/14 ..........................
$
$
17,000 8,000 (30,000) 72,000 67,000
4. Bad debt expense for 2014 ................................................... Customer accounts written off as uncollectible during 2014 ........................................................................ Allowance for doubtful accounts balance 12/31/14 ............
$
84,000
$
(24,000) 60,000
Accounts receivable, net of allowance for doubtful Accounts....................................................... Allowance for doubtful accounts balance 12/31/14 ............ Accounts receivable, before deducting allowance for doubtful accounts...................................... 5. Accounts receivable ............................................................. Percentage............................................................................. Bad debt expense, before adjustment................................. Allowance for doubtful accounts (debit balance) ............... Bad debt expense, as adjusted ............................................
$ 950,000 60,000 $1,010,000 $ 310,000 3% 9,300 14,000 $ 23,300
PROBLEM 7-3 (a)
The Allowance for Doubtful Accounts should have a balance of $45,000 at year-end. The supporting calculations are shown below:
Expected Days Account Percentage Outstanding Amount Uncollectible 0–15 days $300,000 .02 16–30 days 100,000 .10 31–45 days 80,000 .15 46–60 days 40,000 .20 61–75 days 20,000 .45 Balance for Allowance for Doubtful Accounts
Estimated Uncollectible $ 6,000 10,000 12,000 8,000 9,000 $45,000
The accounts which have been outstanding over 75 days ($15,000) and have zero probability of collection would be written off immediately by a debit to Allowance for Doubtful Accounts for $15,000 and a credit to Accounts Receivable for $15,000. It is not considered when determining the proper amount for the Allowance for Doubtful Accounts. (b)
Accounts receivable ($555,000 – $15,000) ........................ Less: Allowance for doubtful accounts ........................... Accounts receivable (net) ..................................................
(c)
The year-end bad debt adjustment would decrease before-tax income $20,000 as computed below: Estimated amount required in the Allowance for Doubtful Accounts ...................................................... Balance in the account after write-off of uncollectible accounts but before adjustment ($40,000 – $15,000)..... Required charge to expense................................................
$540,000 45,000 $495,000
$45,000 25,000 $20,000
PROBLEM 7-4 (a)
FORTNER CORPORATION Analysis of Changes in the Allowance for Doubtful Accounts For the Year Ended December 31, 2014
Balance at January 1, 2014 ............................................... Provision for doubtful accounts ($9,000,000 X 2%) ........ Recovery in 2014 of bad debts written off previously ....
$130,000 180,000 15,000 325,000 150,000
Deduct write-offs for 2014 ($90,000 + $60,000)................ Balance at December 31, 2014 before change in accounting estimate.................................................. Increase due to change in accounting estimate during 2014 ($263,600 – $175,000) ............................... Balance at December 31, 2014 adjusted (Schedule 1) ....
175,000 88,600 $263,600
Schedule 1 Computation of Allowance for Doubtful Accounts at December 31, 2014 Aging Category Nov.–Dec. 2014 July–Oct. Jan.–June Prior to 1/1/14
Balance
%
$1,080,000 650,000 420,000 90,000(a)
2 10 25 80
Doubtful Accounts $ 21,600 65,000 105,000 72,000 $263,600
(a) $150,000 – $60,000 (b) The journal entry to record this transaction is as follows: Bad Debt Expense ......................................... Allowance for Doubtful Accounts............. (To increase the allowance for doubtful accounts at December 31, 2014, resulting from a change in accounting estimate)
$88,600 $88,600
PROBLEM 7-5 Bad Debt Expense ................................................... Accounts Receivable...................................... (To correct bad debt expense and write off accounts receivable)
3,240
Accounts Receivable............................................... Unearned Sales Revenue ............................... (To reclassify credit balance in accounts receivable)
4,840
Allowance for Doubtful Accounts........................... Accounts Receivable...................................... (To write off $3,700 of uncollectible accounts)
3,700
3,240
4,840
3,700
(Note to instructor: Many students will not make this entry at this point. Because $3,700 is totally uncollectible, a write-off immediately seems most appropriate. The remainder of the solution therefore assumes that the student made this entry.) Allowance for Doubtful Accounts........................... Bad Debt Expense .......................................... (To reduce allowance for doubtful account balance)
7,279.64
Balance ($8,750 + $18,620 – $3,240 – $3,700) ........ Corrected balance (see below) ............................... Adjustment ...............................................................
$20,430.00 13,150.36 $ 7,279.64
7,279.64
Age
Balance
Aging Schedule
Under 60 days 60–90 days 91–120 days Over 120 days
$172,342 141,330 ($136,490 + $4,840) 36,684 ($39,924 – $3,240) 19,944 ($23,644 – $3,700)
1% 3% 6% 25%
$ 1,723.42 4,239.90 2,201.04 4,986.00 $13,150.36
PROBLEM 7-5 (Continued) If the student did not make the entry to record the $3,700 write-off earlier, the following would change in the problem. After the adjusting entry for $7,279.64, an entry would have to be made to write off the $3,700. Balance ($8,750 + $18,620 – $3,240) ................ Corrected balance (see below)......................... Adjustment ........................................................
$24,130.00 16,850.36 $ 7,279.64
Age
Balance
Aging Schedule
Under 60 days 60–90 days 91–120 days Over 120 days
$172,342 141,330 36,684 23,644
1% 3% 6% —
*$3,700 + (25% X $19,944)
$ 1,723.42 4,239.90 2,201.04 8,686.00* $16,850.36
PROBLEM 7-6
–1– Cash .......................................................................... Sales Discounts........................................................ Accounts Receivable ......................................
136,800* 1,200 138,000
*[$138,000 – ($60,000 X 2%)] –2– Accounts Receivable ............................................... Allowance for Doubtful Accounts .................. Cash .......................................................................... Accounts Receivable ...................................... –3– Allowance for Doubtful Accounts ........................... Accounts Receivable ...................................... –4– Bad Debt Expense .................................................... Allowance for Doubtful Accounts .................. *($17,300 + $5,300 – $17,500 = $5,100; $20,000 – $5,100 = $14,900)
5,300 5,300 5,300 5,300 17,500 17,500 14,900 14,900*
PROBLEM 7-7
July 1, 2014 Cash .................................................................................. Interest Expense (.005 X $150,000) ................................. Notes Payable (80% X $150,000) ............................
119,250 750
July 31, 2014 Notes Payable................................................................... Accounts Receivable ..............................................
80,000
Interest Expense............................................................... Interest Payable (.005 X $70,000) ........................... August 31, 2014 Notes Payable................................................................... Cash* ................................................................................. Interest Expense (.005 X [$150,000 – $80,000 – $50,000]) ........................................................ Interest Payable................................................................ Accounts Receivable .............................................. *Total cash collection....................................................... Less: Interest payable (from previous entry) ................ Interest expense (current month) [(.005 X $150,000 – $80,000 – $50,000)] ........................... Notes payable (balance) ($120,000 – $80,000)..... Cash collected ..................................................................
120,000
80,000 350 350 40,000 9,550 100 350 50,000 $50,000 (350) (100) (40,000) $ 9,550
PROBLEM 7-8
10/1/14 12/31/14
Notes Receivable ................................... Sales Revenue...............................
120,000
Interest Receivable ................................ Interest Revenue ...........................
2,400*
120,000
2,400
*$120,000 X .08 X 3/12 = $2,400 10/1/15
Cash ........................................................ Interest Receivable ....................... Interest Revenue ...........................
9,600* 2,400 7,200**
*$120,000 X .08 = $9,600 **$120,000 X .08 X 9/12 = $7,200 12/31/15 10/1/16
Interest Receivable ................................ Interest Revenue ...........................
2,400
Cash ........................................................ Interest Receivable ....................... Interest Revenue ...........................
9,600
Cash ........................................................ Notes Receivable ..........................
120,000
2,400 2,400 7,200
120,000
Note: Entries at 10/1/15 and 10/1/16 assume reversing entries were not made on January 1, 2015 and January 1, 2016.
PROBLEM 7-9
(a)
December 31, 2014 Cash....................................................................... Notes Receivable.................................................. Discount on Notes Receivable ................... Service Revenue..........................................
40,000 80,000 17,951 102,049
To record revenue at the present value of the note plus the immediate cash payment: PV of $20,000 annuity @ 11% for 4 years ($20,000 X 3.10245)............ $ 62,049 Down payment ................................... 40,000 Capitalized value of services............ $102,049 (b)
December 31, 2015 Cash............................................................................ Notes Receivable..............................................
20,000 20,000
Discount on Notes Receivable ................................. Interest Revenue...............................................
6,825 6,825
Schedule of Note Discount Amortization
a
Date
Cash Received
Interest Revenue
Carrying Amount of Note
12/31/14 12/31/15 12/31/16 12/31/17 12/31/18
— $20,000 20,000 20,000 20,000
— $6,825a 5,376 3,768 1,982
$62,049 48,874b 34,250 18,018 —
$6,825 = $62,049 X 11% $48,874 = $62,049 + $6,825 – $20,000.00
b
PROBLEM 7-9 (Continued) (c)
December 31, 2016 Cash ........................................................................... Notes Receivable.............................................. Discount on Notes Receivable ................................. Interest Revenue ..............................................
(d)
December 31, 2017 Cash ........................................................................... Notes Receivable.............................................. Discount on Notes Receivable ................................. Interest Revenue ..............................................
(e)
December 31, 2018 Cash ........................................................................... Notes Receivable.............................................. Discount on Notes Receivable ................................. Interest Revenue ..............................................
20,000 20,000 5,376 5,376 20,000 20,000 3,768 3,768 20,000 20,000 1,982 1,982
PROBLEM 7-10
(a)
BRADDOCK INC. Long-Term Receivables Section of Balance Sheet December 31, 2014
9% note receivable from sale of division, due in annual installments of $500,000 to May 1, 2016, less current installment................. 8% note receivable from officer, due Dec. 31, 2016, collateralized by 10,000 shares of Braddock, Inc., common stock with a fair value of $450,000 ............................... Zero-interest-bearing note from sale of patent, net of 12% imputed interest, due April 1, 2016 ......................................................... Installment contract receivable, due in annual installments of $45,125 to July 1, 2018, less current installment ...................................... Total long-term receivables ............................. (b)
$ 500,000
(1)
400,000
86,873
(2)
110,275 $1,097,148
(3)
BRADDOCK INC. Selected Balance Sheet Balances December 31, 2014
Current portion of long-term receivables: Note receivable from sale of division ................... Installment contract receivable ............................. Total current portion of long-term receivables....................................................
$529,725
Accrued interest receivable: Note receivable from sale of division ................... Installment contract receivable ............................. Total accrued interest receivable ....................
60,000 7,700 $ 67,700
$500,000 29,725
(1) (3)
(4) (5)
PROBLEM 7-10 (Continued) (c)
BRADDOCK INC. Interest Revenue from Long-Term Receivables For the Year Ended December 31, 2014
Interest revenue: Note receivable from sale of division ........................ Note receivable from sale of patent ........................... Note receivable from officer ....................................... Installment contract receivable from sale of land..... Total interest revenue for year ended 12/31/14 ...
$105,000 7,173 32,000 7,700 $151,873
(6) (2) (7) (5)
Explanation of Amounts (1) Long-term Portion of 9% Note Receivable at 12/31/14 Face amount, 5/1/13 .............................................. Less: Installment received 5/1/14 ........................ Balance, 12/31/14................................................... Less: Installment due 5/1/15 ................................ Long-term portion, 12/31/14.................................. (2) Zero-interest-bearing Note, Net of Imputed Interest at 12/31/14 Face amount 4/1/14 ............................................... Less: Imputed interest [$100,000 – ($100,000 X 0.797)] ................. Balance, 4/1/14....................................................... Add: Interest earned to 12/31/14 ($79,700 X 12% X 9/12) ............................... Balance, 12/31/14...................................................
$1,500,000 500,000 1,000,000 500,000 $ 500,000
$ 100,000 20,300 79,700 $
7,173 86,873
PROBLEM 7-10 (Continued) (3)
(4)
(5)
(6)
(7)
Long-term Portion of Installment Contract Receivable at 12/31/14 Contract selling price, 7/1/14................................. Less: Down payment, 7/1/14 ................................ Balance, 12/31/14 ................................................... Less: Installment due, 7/1/15 [$45,125 – ($140,000 X 11%)]...................... Long-term portion, 12/31/14 ..................................
$ 200,000 60,000 140,000 29,725 $ 110,275
Accrued Interest—Note Receivable, Sale of Division at 12/31/14 Interest accrued from 5/1 to 12/31/14 ($1,000,000 X 9% X 8/12).....................................
$
60,000
Accrued Interest—Installment Contract at 12/31/14 Interest accrued from 7/1 to 12/31/14 ($140,000 X 11% X 1/2)........................................
$
7,700
$
45,000
Interest Revenue—Note Receivable, Sale of Division, for 2014 Interest earned from 1/1 to 5/1/14 ($1,500,000 X 9% X 4/12)..................................... Interest earned from 5/1 to 12/31/14 ($1,000,000 X 9% X 8/12)..................................... Interest income ...................................................... Interest Revenue—Note Receivable, Officer, for 2014 Interest earned 1/1 to 12/31/14 ($400,000 X 8%) ...................................................
60,000 $ 105,000
$
32,000
PROBLEM 7-11
SANDBURG COMPANY Income Statement Effects For the Year Ended December 31, 2014 Expenses resulting from accounts receivable assigned (Schedule 1) .............................................. Loss resulting from accounts receivable sold ($300,000 – $270,000) ....................................... Total expenses .......................................................
$22,320 30,000 $52,320
Schedule 1 Computation of Expense for Accounts Receivable Assigned Assignment expense: Accounts receivable assigned.............................. Advance by Keller Finance Company .................. Interest expense........................................................... Total expenses .......................................................
$400,000 X 80% 320,000 X 3%
$ 9,600 12,720 $22,320
*PROBLEM 7-12 (a)
(b)
Petty Cash ................................................................ Cash.................................................................
250.00
Postage Expense ..................................................... Supplies.................................................................... Accounts Receivable (Employees) ......................... Freight-Out ............................................................... Advertising Expense................................................ Miscellaneous Expense ........................................... Cash ($250.00 – $26.40) ..................................
33.00 65.00 30.00 57.45 22.80 15.35
Petty Cash ................................................................ Cash.................................................................
50.00
Balances per bank: .................................................. Add: Cash on hand .................................................. Deposit in transit.............................................
250.00
223.60
50.00 $6,522 $ 246 3,000
Deduct: Checks outstanding................................... Correct cash balance, May 31 ........................ Balance per books: .................................................. Add: Note receivable (collected with interest) ......
3,246 9,768 850 $8,918 $8,015* 930 8,945 27 $8,918
Deduct: Bank service charges ............................... Correct cash balance, May 31 ........................ *($8,850 + $31,000 – $31,835)
(c)
Cash .......................................................................... Notes Receivable ............................................ Interest Revenue .............................................
930
Office Expense (bank charges) ............................... Cash.................................................................
27
$8,918 + $300 = $9,218.
900 30 27
*PROBLEM 7-13 (a)
AGUILAR CO. Bank Reconciliation June 30, 2014
Balance per bank, June 30 ......................................... Add: Deposits in transit ............................................. Deduct: Outstanding checks ..................................... Correct cash balance, June 30 ...................................
$4,150.00 3,390.00 (2,136.05) $5,403.95
Balance per books, June 30 ....................................... Add: Error in recording deposit ($90 – $60)............. $ 30.00 Error on check no. 747 523.80 ($582.00 – $58.20) .......................................... Note collection ($1,200 + $36) .......................... 1,236.00
$3,969.85
Deduct: NSF check..................................................... Error on check no. 742 ($491 – $419)............ Bank service charges ($25 + $5.50) ............
1,789.80 5,759.65
253.20 72.00 30.50
Correct cash balance, June 30 ...................................
(355.70) $5,403.95
(b) Cash .......................................................................... 1,789.80 Accounts Receivable ...................................................................30.00* Accounts Payable ......................................................................523.80** Notes Receivable............................................ 1,200.00 Interest Revenue ............................................ 36.00 Accounts Receivable ........................................... 253.20 Accounts Payable .......................................................... 72.00*** Office Expense (bank charges) ........................... 30.50 Cash ................................................................
355.70
*Assumes sale was on account and not a cash sale. **Assumes that the purchase of the equipment was recorded at its proper price. If a straight cash purchase, then Equipment should be credited instead of Accounts Payable. ***If a straight cash purchase, then Equipment should be debited instead of Accounts Payable.
*PROBLEM 7-14
(a)
HASELHOF INC. Bank Reconciliation November 30
Balance per bank statement, November 30 .... Add: Cash on hand, not deposited ..................... Deduct: Outstanding checks #1224 ...................................................... $ #1230 ...................................................... #1232 ...................................................... #1233 ...................................................... Correct cash balance, Nov. 30 .........................
$56,274.20 1,915.40 58,189.60
1,635.29 2,468.30 2,125.15 482.17
Balance per books, November 30 .................... Add: Bond interest collected by bank ................ Deduct: Bank charges not recorded in books ........ $ Customer’s check returned NSF ................ Correct cash balance, Nov. 30 .........................
6,710.91 $51,478.69 $50,478.22* 1,400.00 51,878.22
27.40 372.13
*Computation of balance per books, November 30 Balance per books, October 31 ................... $ 41,847.85 Add receipts for November ......................... 173,523.91 215,371.76 Deduct disbursements for November......... 164,893.54 Balance per books, November 30 ............... $ 50,478.22
399.53 $51,478.69
*PROBLEM 7-14 (Continued) (b)
November 30 Cash................................................................................1,400.00 Interest Revenue .............................................. November 30 Office Expense (bank charges) ................................ Cash ..................................................................
27.40
November 30 Accounts Receivable ................................................ Cash ..................................................................
372.13
1,400.00
27.40
372.13
*PROBLEM 7-15 (a)
The entries for the issuance of the note on January 1, 2014: The present value of the note is: $1,200,000 X .68058 = $816,700 (Rounded by $4). Botosan Company (Debtor): Cash .................................................................... 816,700 Discount on Notes Payable ................................ 383,300 Notes Payable ...........................................
1,200,000
National Organization Bank (Creditor): Notes Receivable ............................................. 1,200,000 Discount on Notes Receivable................. Cash...........................................................
383,300 816,700
(b) The amortization schedule for this note is: SCHEDULE FOR INTEREST AND DISCOUNT AMORTIZATION— EFFECTIVE-INTEREST METHOD $1,200,000 Note Issued to Yield 8%
Date 1/1/14 12/31/14 12/31/15 12/31/16 12/31/17 12/31/18 Total
Cash Paid $0 0 0 0 0 $0
Interest Expense $ 65,336* 70,563 76,208 82,305 88,888 $383,300
*$816,700 X 8% = $65,336. **$816,700 + $65,336 = $882,036.
Discount Amortized $ 65,336 70,563 76,208 82,305 88,888 $383,300
Carrying Amount of Note $ 816,700 882,036** 952,599 1,028,807 1,111,112 1,200,000
*PROBLEM 7-15 (Continued) (c)
The note can be considered to be impaired only when it is probable that, based on current information and events, National Organization Bank will be unable to collect all amounts due (both principal and interest) according to the contractual terms of the loan.
(d) The loss is computed as follows: Carrying amount of loan (12/31/15).......................... Less: Present value of $800,000 due in 3 years at 8% .............................................. Loss due to impairment ............................................ a
$952,599a 635,064b $317,535
See amortization schedule from answer (b) on page 7-62. $800,000 X .79383 = $635,064.
b
December 31, 2015 National Organization Bank (Creditor): Bad Debt Expense............................................... 317,535 Allowance for Doubtful Accounts ............ Note: Botosan Company (Debtor) has no entry.
317,535
TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 7-1 (Time 10–15 minutes) Purpose—to provide the student with the opportunity to discuss the deficiencies of the direct write-off method, the justification for two allowance methods for estimating bad debts, and to explain the accounting for the recoveries of accounts written off previously. CA 7-2 (Time 15–20 minutes) Purpose—to provide the student with the opportunity to discuss the accounting for cash discounts, trade discounts, and the factoring of accounts receivable. CA 7-3 (Time 25–30 minutes) Purpose—to provide the student with the opportunity to discuss the advantages and disadvantages of handling reporting problems related to the Allowance for Doubtful Accounts balance. Recommendations must be made concerning whether some type of allowance approach should be employed, how collection expenses should be handled, and finally, the appropriate accounting treatment for recoveries. A very complete case which should elicit a good discussion of this issue. CA 7-4 (Time 25–30 minutes) Purpose—to provide the student the opportunity to discuss when interest revenue from a note receivable is reported. In Part 2, the student is asked to contrast the estimation of bad debts based on credit sales with that based on the balance in receivables, and to describe the reporting of the allowance account and the bad debts expense. CA 7-5 (Time 20–25 minutes) Purpose—to provide the student with a discussion problem related to notes receivable sold without and with recourse. CA 7-6 (Time 20–30 minutes) Purpose—to provide the student the opportunity to account for a zero-interest-bearing note is exchanged for a unique machine. The student must consider valuation, financial statement disclosure, and factoring the note. CA 7-7 (Time 25–30 minutes) Purpose—to provide the student the opportunity to calculate interest revenue on an interest-bearing note and a zero-interest-bearing note, and indicate how the notes should be reported on the balance sheet. The student discusses how to account for collections on assigned accounts receivable and how to account for factored accounts receivable. CA 7-8 (Time 25–30 minutes) Purpose—to provide the student with a case related to the imputation of interest. One company has overstated its income by not imputing an interest element on the zero-interest-bearing note receivable that it received in the transaction. We have presented a short analysis to indicate what the proper solution should be. It is unlikely that the students will develop a journal entry with dollar amounts, but they should be encouraged to do so. CA 7-9 (Time 25–30 minutes) Purpose—to provide the student with a case to analyze receivables irregularities, including a shortage. This is a good writing assignment. CA 7-10 (Time 25–30 minutes) Purpose—to provide the student with a case to analyze ethical issues inherent in bad debt judgments.
SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 7-1 (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 direct write-off method does not match bad debts expense with the revenues generated by sales in the same period. (b) 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. The other allowance method estimates bad debts based on the balance in the trade accounts receivable account. The method focuses on the balance sheet and attempts to value the accounts receivable at their net realizable value. (c) The company should account for the collection of the specific accounts previously written off as uncollectible as follows:
Reinstatement of accounts by debiting Accounts Receivable and crediting Allowance for Doubtful Accounts. Collection of accounts by debiting Cash and crediting Accounts Receivable.
CA 7-2 (a) 1. Kimmel should account for the sales discounts at the date of sale using the net method by recording accounts receivable and sales revenue at the amount of sales less the sales discounts available. Revenues should be recorded at the cash-equivalent price at the date of sale. Under the net method, the sale is recorded at an amount that represents the cash-equivalent price at the date of exchange (sale). 2. There is no effect on Kimmel’s sales revenues when customers do not take the sales discounts. Kimmel’s net income is increased by the amount of interest (discount) earned when customers do not take the sales discounts. (b) Trade discounts are neither recorded in the accounts nor reported in the financial statements. Therefore, the amount recorded as sales revenues and accounts receivable is net of trade discounts and represents the cash-equivalent price of the asset sold. (c) To account for the accounts receivable factored on August 1, 2014, Kimmel should decrease accounts receivable by the amount of accounts receivable factored, increase cash by the amount received from the factor, and record a loss. Factoring of accounts receivable on a without recourse basis is equivalent to a sale. The difference between the cash received and the carrying amount of the receivables is a loss. (d) Kimmel should report the face amount of the interest-bearing notes receivable and the related interest receivable for the period from October 1 through December 31 on its balance sheet as noncurrent assets. Both assets are due on September 30, 2016, which is more than one year from the date of the balance sheet.
CA 7-2 (Continued) Kimmel should report interest revenue from the notes receivable on its income statement for the year ended December 31, 2014. Interest revenue is equal to the amount accrued on the notes receivable at the appropriate rate for three months. Interest revenue is realized with the passage of time. Accordingly, interest revenue should be accounted for as an element of income over the life of the notes receivable.
CA 7-3 (1) Allowances and charge-offs. Method (a) is recommended. In the case of this company which has a large number of relatively small sales transactions, it is practicable to give effect currently to the probable bad debt expense. Whenever practicable, it is advisable to accrue probable bad debt charges and apply them in the accounting periods in which the related sales are credited. If the percentage is based on actual long-run experience, the allowance balance is usually adequate to bring the accounts receivable in the balance sheet to realizable values. However, the method does not preclude a periodic review of the accounts receivable for the purpose of estimating probable losses in relation to the allowance balance and adjustment for an inadequate or excessive allowance. Therefore method (b) is technically not wrong, but perhaps could be used in conjunction with method (a). Method (b) does not seem as appropriate here because of the probable large number of accounts involved and therefore a percentage-of-sales basis should provide a better “matching” of expenses with revenues. (2) Collection expenses. Method (a) or (b) is recommended. In the case of this company, one strong argument for method (a) is that it is advisable to have the Bad Debt Expense account show the full amount of expense relating to efforts to collect and failure to collect balances receivable. On the other hand, an argument can be made to debit the Allowance account on the theory that bad debts (including related expenses) are established at the time the allowance is first established. As a result, the allowance account already has anticipated these expenses and therefore as they occur they should be charged against the allowance account. It should be noted that there is no “right answer” to this question. It would seem that alternatives (c) and (d) are not good alternatives because the expense is not identified with bad debts, which it should be. (3) Recoveries. Method (c) is recommended. This method treats the recovery as a correction of a previous write-off. It produces an allowance account that reflects the net experience with bad debts. Method (a) might be acceptable if the provision for bad debts were based on experience with losses without considering recoveries, but in this case it would be advisable to use one account with a specific designation rather than the broad designation “other revenue.” As indicated in the textbook, recoveries are usually handled by reestablishing the receivable and allowance account and then payment recorded. Method (c) is basically that approach.
CA 7-4 Part 1 Since Wallace Company is a calendar-year company, six months of interest should be accrued on 12/31/14. The remaining interest revenue should be recognized on 6/30/15 when the note is collected. The rationale for this treatment is: the accrual basis of accounting provides more useful information than does the cash basis. Therefore, since interest accrues with the passage of time, interest earned on Wallace’s note receivable should be recognized over the life of the note, regardless of when the cash is received.
CA 7-4 (Continued) Part 2 (a) The use of the allowance method based on credit sales to estimate bad debts is consistent with the expense recognition 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 doubtful accounts is ignored when computing bad debt expense. The allowance method based on the balance in accounts receivable is not consistent with the expense recognition 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 a composite percentage. Bad debt expense is determined in the same manner as when 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 Wallace’s balance sheet, the allowance for doubtful accounts is presented as a contra account to accounts receivable with the resulting difference representing the net accounts receivable (i.e., their net realizable value). Bad debt expense would generally be included on Wallace’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 debt expense as a financial expense.
CA 7-5 (a) The appropriate valuation basis of a note receivable at the date of sale is its discounted present value of the future amounts receivable for principal and interest using the customer’s market rate of interest, if known or determinable, at the date of the equipment’s sale. (b) Corrs should increase the carrying amount of the note receivable by the effective-interest revenue recognized for the period February 1 to May 1, 2014. Corrs should account for the sale of the note receivable without recourse by increasing cash for the proceeds received, eliminating the carrying amount of the note receivable, and recognizing a loss (gain) for the resulting difference. This reporting is appropriate since the note’s carrying amount is correctly recorded at the date it was sold and the sale of a note receivable without recourse has occurred. Thus the difference between the cash received and the carrying amount of the note at the date it is sold is reported as a loss (gain). (c) 1. For notes receivable not sold, Corrs should recognize bad debt expense. The expense equals the adjustment required to bring the balance of the allowance for doubtful accounts equal to the estimated uncollectible amounts less the fair values of recoverable equipment. 2. For notes receivable sold with recourse, at the time of sale, Corrs would have recorded a recourse liability. This liability measures the estimated bad debts at the time of the sale and increases the loss on the sale.
CA 7-6 (a) 1. It was not possible to determine the machine’s fair value directly, so the sales price of the machine is reported at the note’s September 30, 2013 fair value. The note’s September 30, 2013 fair value equals the present value of the two installments discounted at the buyer’s September 30, 2013 market rate of interest. 2. Rolen reports 2013 interest revenue determined by multiplying the note’s carrying amount at September 30, 2013 times the buyer’s market rate of interest at the date of issue, times threetwelfths. Rolen should recognize that there is an interest factor implicit in the note, and this interest is recognized with the passage of time. Therefore, interest revenue for 2013 should include three months’ revenue. The rate used should be the market rate established by the original present value, and this is applied to the carrying amount of the note. (b) To report the sale of the note receivable with recourse, Rolen should decrease notes receivable by the carrying amount of the note, increase cash by the amount received, record a recourse liability for possible customer defaults (the recourse liability is reported on the balance sheet at 12/31/14) and report the difference as a loss or gain as part of income from continuing operations. (c) Rolen should decrease cash, increase notes (accounts) receivable past due for all payments caused by the note’s dishonor and eliminate the recourse liability. The note (accounts) receivable should be written down to its estimated recoverable amount (or an allowance for doubtful accounts established), and a loss on uncollectible notes should be recorded for the excess of this difference over the amount of the recourse liability previously recorded.
CA 7-7 (a) 1. For the interest-bearing note receivable, the interest revenue for 2014 should be determined by multiplying the principal (face) amount of the note by the note’s rate of interest by one half (July 1, 2014 to December 31, 2014). Interest accrues with the passage of time, and it should be accounted for as an element of revenue over the life of the note receivable. 2. For the zero-interest-bearing note receivable, the interest revenue for 2014 should be determined by multiplying the carrying value of the note by the prevailing rate of interest at the date of the note by one third (September 1, 2014 to December 31, 2014). The carrying value of the note at September 1, 2014 is the face amount discounted for two years at the prevailing interest rate from the maturity date of August 31, 2016 back to the issuance date of September 1, 2014. Interest, even if unstated, accrues with the passage of time, and it should be accounted for as an element of revenue over the life of the note receivable. (b) The interest-bearing note receivable should be reported at December 31, 2014 as a current asset at its principal (face) amount. The zero-interest-bearing note receivable should be reported at December 31, 2014 as a noncurrent asset at its face amount less the unamortized discount on the note at December 31, 2014. (c) Because the trade accounts receivable are assigned, Moresan should account for the subsequent collections on the assigned trade accounts receivable by debiting Cash and crediting Accounts Receivable. The cash collected should then be remitted to Indigo Finance until the amount advanced by Indigo is settled. The payments to Indigo Finance consist of both principal and interest with interest computed at the rate of 8% on the balance outstanding.
CA 7-7 (Continued) (d) Because the trade accounts receivable were factored on a without recourse basis, the factor is responsible for collection. On November 1, 2014, Moresan should credit Accounts Receivable for the amount of trade accounts receivable factored, debit Cash for the amount received from the factor, debit a Receivable from Factor for 5% of the trade accounts receivable factored, and debit Loss on Sale of Receivables for 3% of the trade accounts receivable factored.
CA 7-8 The controller of Engone Company cannot justify the manner in which the company has accounted for the transaction in terms of sound financial accounting principles. Several problems are inherent in the sale of Henderson Enterprises stock to Bimini Inc. First, the issue of whether an arm’s-length transaction has occurred may be raised. The controller stated that the stock has not been marketable for the past six years. Thus, the recognition of revenue is highly questionable in view of the limited market for the stock; i.e., has an exchange occurred? Secondly, the collectibility of the note from Bimini is open to question. Bimini appears to have a liquidity problem due to its current cash squeeze. The lack of assurance about collectibility raises the question of whether revenue should be recognized. Central to the transaction is the issue of imputed interest. If we assume that an arm’s-length exchange has taken place, then the zero-interest-bearing feature masks the question of whether a gain, no gain or loss, or a loss occurred. For a gain to occur, the interest imputation must result in an interest rate of about 5% or less. To illustrate: Present value of an annuity of $1 at 5% for 10 years = 7.72173; thus the present value of ten payments of $400,000 is $3,088,692. The cost of the investment is $3,000,000; thus, only an $88,692 gain is recognized at 5%. Selecting a more realistic interest rate (in spite of the controller’s ill-founded statements about “no cost” money since he/she is ignoring the opportunity cost) of 8% finds the present value of the annuity of $400,000 for ten periods equal to $2,684,032 ($400,000 X 6.71008). In this case a loss of $315,968 must be recognized as illustrated by the following journal entry: Notes Receivable ................................................................................. Loss on Disposal of Investment............................................................ Equity Investment (Henderson Stock).................................... Discount on Notes Receivable ...............................................
CA 7-9 To:
Mark Price, Branch Manager
From:
Accounting Major
Date:
October 3, 2014
Subject:
Discrepancy in the Accounts Receivable Account
4,000,000 315,968 3,000,000 1,315,968
CA 7-9 (Continued) While performing a routine test on accounts receivable balances today, I discovered a $2,000 discrepancy. I believe that this matter deserves your immediate attention. To compute the overage, I determined that the accounts receivable balance should have been based on the amount of inventory which has been sold. When we opened for business this year, we purchased $360,000 worth of merchandise inventory, and this morning, the balance in this account was $90,000. The $270,000 difference plus the 40% markup indicates that sales on account totaled $378,000 [$270,000 + ($270,000 X .40)] to date. I subtracted the payments of $188,000 made on account this year and calculated the ending balance to be $190,000. However, the ledger shows a balance of $192,000. I realize that this situation is very sensitive and that we should not accuse any one individual without further evidence. However, in order to protect the company’s assets, we must begin an immediate investigation of this disparity. Aside from me, the only other employee who has access to the accounts receivable ledger is Kelly Collins, the receivables clerk. I will supervise Collins more closely in the future but suggest that we also employ an auditor to check into this situation. Note to Instructors: This situation could result from 1) Collins colluding with a customer, or 2) a lack of segregation of duties where Collins is also involved with collections.
CA 7-10 (a)
(1) Steps to Improve Accounts Receivable Situation
(2) Risks and Costs Involved
Establish more selective creditgranting policies, such as more restrictive credit requirements or more thorough credit investigations.
This policy could result in lost sales and increased costs of credit evaluation. The company may be all but forced to adhere to the prevailing credit-granting policies of the industry.
Establish a more rigorous collection policy either through external collection agencies or by its own personnel.
This policy may offend current customers and thus risk future sales. Increased collection costs could result from this policy.
Charge interest on overdue ac- This policy could result in lost counts. Insist on cash on deliv- sales and increased administrative ery (COD) or cash on order costs. (COO) for new customers or poor credit risks.
CA 7-10 (Continued) (b) No, the controller should not be concerned with Marvin Company’s growth rate in estimating the allowance. The accountant’s proper task is to make a reasonable estimate of bad debt expense. In making the estimate, the controller should consider the previous year’s write-offs and also anticipate economic factors which might affect the company’s industry and influence Marvin’s current write-off. (c) Yes, the controller’s interest in disclosing financial information completely and fairly conflicts with the president’s economic interest in manipulating income to avoid undesirable demands from the parent company. Such a conflict of interest is an ethical dilemma. The controller must recognize the dilemma, identify the alternatives, and decide what to do.
FINANCIAL REPORTING PROBLEM
(a)
Under “Cash Equivalents” in its notes to the consolidated financial statements, P&G indicates: “Highly liquid investments with remaining stated maturities of three months or less when purchased are considered cash equivalents and recorded at cost.”
(b)
P&G has $2.768 billion in cash and cash equivalents. As disclosed in the Consolidated Statement of Cash Flows, P&G indicates that in 2011 cash was used for capital expenditures ($3,306 million) and cash dividends were paid ($5,767 million), and treasury stock was purchased ($7,039).
(c)
As indicated in Note 1, the company’s products are sold primarily through retail operations including mass merchandisers, grocery stores, membership club stores, drug stores, department stores, salons and high-frequency stores. In fact, in its segment note (Note 11), P&G indicates that 15% of its sales in 2011 were to a single large customer—Wal-Mart. Thus, to the extent that its customers have credit profiles similar to Wal-Mart, it is reasonable that bad debt expense might not be material.
COMPARATIVE ANALYSIS CASE
(a)
Cash and cash equivalents: ($ millions): Coca-Cola, 12/31/11 $12,803
PepsiCo, 12/11/11 $4,067
Coca-Cola classifies cash equivalents as “marketable securities that are highly liquid and have maturities of three months or less at the date of purchase.” PepsiCo classifies cash equivalents as “investments with original maturities of three months or less which we do not intend to rollover beyond three months.” (b)
Accounts receivable (net): Coca-Cola, 12/31/11 $4,920
PepsiCo, 12/31/11 $6,912
Allowance for doubtful accounts:
(c)
Coca-Cola, 12/31/11
PepsiCo, 12/25/11
Balance, $83 Percent of receivables, 1.69%
Balance, $157 Percent of receivables, 2.27%
Accounts Receivable turnover ratio and days outstanding for receivables:
Coca-Cola $46,542 = 9.96 times $4,920 + $4,430 2 365 ÷ 9.96 = 36.6 days
PepsiCo $66,504
= 10.05 times
$6,912 + $6,323 2 365 ÷ 10.05 = 36.3 days
PepsiCo’s turnover ratio is slightly higher, resulting in fewer days in receivables. It is likely that these companies use similar receivables management practices.
FINANCIAL STATEMENT ANALYSIS CASE 1
(a)
Cash may consist of funds on deposit at the bank, negotiable instruments such as money orders, certified checks, cashier’s checks, personal checks, bank drafts, and money market funds that provide checking account privileges.
(b)
Cash equivalents are short-term, highly liquid investments that are both (a) readily convertible to known amounts of cash, and (b) so near their maturity that they present insignificant risk from changes in interest rates. Generally, only investments with original maturities of 3 months or less qualify. Examples of cash equivalents are Treasury bills, commercial paper, and money market funds.
(c)
A compensating balance is that portion of any cash deposit maintained by an enterprise which constitutes support for existing borrowing arrangements with a lending institution. A compensating balance representing a legally restricted deposit held against short-term borrowing arrangements should be stated separately among cash and cash equivalent items. A restricted deposit held as a compensating balance against long-term borrowing arrangements should be separately classified as a noncurrent asset in either the investments or other assets section.
(d)
Short-term investments are investments held temporarily in place of cash which can be readily converted to cash when current financing needs make such conversion desirable. Examples of short-term investments include stock, Treasury notes, and other short-term securities. The major differences between cash equivalents and short-term investments are (1) cash equivalents typically have shorter maturity (less than three months) whereas short-term investments either have a longer maturity (e.g., short-term bonds) or no maturity date (e.g., stock), and (2) cash equivalents are readily convertible to known amounts of cash whereas a company may have a gain or loss when selling its short-term investments.
FINANCIAL STATEMENT ANALYSIS CASE 1 (Continued) (e)
Occidental would record a loss of $30,000,000 as following entry to record the transaction: Cash.................................................... Loss on Sale of Receivables............. Accounts Receivable .............. Recourse Liability ...................
revealed in the
345,000,000 30,000,000 360,000,000 15,000,000
(f) The transaction in (e) will decrease Occidental’s liquidity position. Current assets decrease by $15,000,000 and current liabilities are increased by the $15,000,000 (for the recourse liability).
FINANCIAL STATEMENT ANALYSIS CASE 2 Part 1 (a)
Cash equivalents are short-term, highly liquid investments that can be converted into specific amounts of cash. They include money market funds, commercial paper, bank certificates of deposit, and Treasury bills. Cash equivalents differ in that they are extremely liquid (that is, easily turned into cash) and have very low risk of declining in value while held.
(b) (in millions) (1) Current ratio (2) Working capital
Microsoft $74,918 $28,774
= 2.60
$74,918 – $28,774 = $46,144
Oracle $39,174 $14,192
= 2.76
$39,174 – $14,192 = $24,982
While Oracle’s current ratio is slightly higher, Microsoft’s working capital is significantly higher than Oracle’s. Based on these measures, Microsoft is considered more liquid than Oracle. (c)
Yes, a company can have too many liquid assets. Liquid assets earn little or no return. Microsoft’s investors are accustomed to returns of 30% on their investment. Thus, Microsoft’s large amount of liquid assets may eventually create a drag on its ability to meet investor expectations.
FINANCIAL STATEMENT ANALYSIS CASE 2 (Continued) Part 2
(a)
Receivables Turnover
2011 $69,943
=
($14,987 + $13,014)/2
$69,943 = 5.0 times $14,001
Or a collection period of 73 days (365 ÷ 5.0). (b)
(c)
Bad Debt Expense................................................ Allowance for Doubtful Accounts ..............
14
Allowance for Doubtful Accounts ....................... Accounts Receivable ..................................
56
14
56
Accounts receivable is reduced by the amount of bad debts in the allowance account. This makes the denominator of the turnover ratio lower, resulting in a higher turnover ratio.
ACCOUNTING, ANALYSIS, AND PRINCIPLES ACCOUNTING (a)
Accounts Receivable: Beginning balance
$46,000
Credit sales during 2014
255,000
Collections during 2014
(228,000)
Charge-offs Factored receivables Ending balance
(1,600) (10,000) $61,400
Allowance for Doubtful Accounts: Beginning balance
$550
Charge-offs
(1,600)
2014 Bad Debt Expense*
2,585
Ending balance
$1,535
*2014 Bad Debt Expense is the amount needed to make the ending balance in the Allowance for Doubtful Accounts equal to $1,535 ($61,400 X 2.5%). In other words, $550 – $1,600 + Bad Debt Expense = $1,535. Therefore, Bad Debt Expense = $1,535 + $1,600 – $550 = $2,585. (b)
Current assets section of December 31, 2014 The Flatiron Pub’s balance sheet: Cash Accounts receivable (net of $1,535 allowance for uncollectibles) Interest receivable Due from factor Note receivable Postage stamps Other Total current assets
$ 5,575 59,865 50 200 5,000 110 3,925 $74,725
ACCOUNTING, ANALYSIS, AND PRINCIPLES (continued)
Calculations: Cash = $1,575 + $4,000 = $5,575 Accounts receivable, net = $61,400 – $1,535 = $59,865 Interest receivable = ($5,000 X 0.12)(1/12) = $50 Due from factor = ($10,000 X 0.02) = $200 ANALYSIS (a)
2013 current ratio = ($2,000 + $46,000 - $550 + $8,500) ÷ $37,000 = 1.51 2014 current ratio = $74,725 ÷ ($44,600 + $400) = 1.66 Accounts Receivable Turnover
$255,000 $255,000 = = 4.84 times [($46,000 – $550) + 59,865] $52,658 2
Both the current ratio and the accounts receivable turnover ratio suggest that Flatiron’s liquidity has improved relative to 2013. (b)
With a secured borrowing, the receivables would stay on The Flatiron Pub’s books and a note payable would be recorded. This would reduce both the current ratio and accounts receivable turnover ratio.
PRINCIPLES The expense recognition principle requires that bad debt expense be recorded in the period of the sale. Otherwise, income will be overstated by the amount of bad debt expense. In addition, reporting the receivables net of the allowance provides a more representationally faithful reporting (at net realizable value) of this asset.
PROFESSIONAL RESEARCH: FASB CODIFICATION (a)
Transfer of receivables is addressed in FASB ASC 860-10: Codification String: Broad Transactions > 860 Transfers and Servicing > 10 Overall > 05 Background > The predecessor literature can be accessed by clicking on “PrinterFriendly with sources” and the retrieve the previous standard at www.fasb.org/st/ The previous statement that addressed transfers of receivables: Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (September 2000).
(b) The objectives associated with transfers: (FASB ASC 860-10-10) 10-1 An objective in accounting for transfers of financial assets is for each entity that is a party to the transaction to recognize only assets it controls and liabilities it has incurred, to derecognize assets only when control has been surrendered, and to derecognize liabilities only when they have been extinguished. For example, if a transferor sells financial assets it owns and at the same time writes an at-the-money put option (such as a guarantee or recourse obligation) on those assets, it should recognize the put obligation in the same manner as would another unrelated entity that writes an identical put option on assets it never owned. However, certain agreements to repurchase or redeem transferred assets maintain effective control over those assets and should therefore be accounted for differently than agreements to acquire assets never owned.
PROFESSIONAL RESEARCH: FASB CODIFICATION (Continued) (c) Definitions: (Codification String: Broad Transaction > 860 Transfers and Servicing > 10 Overall > 20 Glossary) Transfer The conveyance of a noncash financial asset by and to someone other than the issuer of that financial asset. A transfer includes the following: a. Selling a receivable b. Putting a receivable into a securitization trust c. Posting a receivable as collateral. A transfer excludes the following: a. The origination of a receivable b. Settlement of a receivable c. The restructuring of a receivable into a security in troubled debt restructuring. Recourse The right of a transferee of receivables to receive payment from the transferor of those receivables for any of the following: a. Failure of debtors to pay when due b. The effects of prepayments c. Adjustments resulting from defects in the eligibility of the transferred receivables. Collateral Personal or real property in which a security interest has been given.
PROFESSIONAL RESEARCH: FASB CODIFICATION (Continued) (d) Other examples (besides recourse and collateral) that qualify as continuing involvement: 05-4 The following are examples of continuing involvement discussed in this Topic: (Codification String: Broad Transactions > 860 Transfers and Servicing > 10 Overall > 05 Background) a. Recourse b. Servicing c. Agreements to reacquire transferred assets d. Options written or held e. Pledges of collateral. Transfers of financial assets with continuing involvement raise issues about the circumstances under which the transfers should be considered as sales of all or part of the assets or as secured borrowings and about how transferors and transferees should account for sales and secured borrowings. This Topic establishes standards for resolving those issues.
PROFESSIONAL SIMULATION Measurement Trade Accounts Receivable Beginning balance $ 40,000 Credit sales during 2014 550,000 Collections during 2014 (500,000) Change-offs (2,300) Factored receivables (47,700) Ending balance $ 40,000
Allowance for Doubtful Accounts Beginning balance $ 5,500 Charge-offs (2,300) 2014 provision (0.8% X $550,000) 4,400 Ending balance $ 7,600
Financial Statements Current assets Cash*.................................................................... Trade accounts receivable ................................. Allowance for doubtful accounts ................... Customer receivable (post-dated checks) ........ Interest receivable**............................................ Due from factor*** ............................................... Notes receivable ................................................. Inventory.............................................................. Prepaid postage .................................................. Total current assets ........................................
$ 12,900 $40,000 (7,600)
32,400 2,000 2,750 2,862 50,000 80,000 100 $183,012
*($15,000 – $2,000 – $100) **($50,000 X 11% X 1/2) ***($47,700 X 6%) Analysis 2013 Current ratio = ($139,500* ÷ $80,000) = 1.74 Accounts Receivable turnover = 10.37 times
2014 ($183,012 ÷ $86,000) $550,000
= 2.13 = 16.4 times
($34,500 + $32,400)/2
*($20,000 + $40,000 – $5,500 + $85,000) Both ratios indicate that Horn’s liquidity has improved relative to the prior year.
PROFESSIONAL SIMULATION (Continued) Explanation With a secured borrowing, the receivables would stay on Horn’s books and Horn would record a note payable. This would reduce both the current ratio and the accounts receivable turnover ratio.
IFRS CONCEPTS AND APPLICATION IFRS7-1 A receivable is considered impaired when a loss event indicates a negative impact on the estimated future cash flows to be received from the customer. The IASB requires that the impairment assessment should be performed as follows. 1. Receivables that are individually significant are considered for impairment separately. If impaired, the company recognizes then impairment. Receivables that are not individually significant may also be assessed individually, but it is not necessary to do so. 2. Any receivable individually assessed that is not considered impaired is included with a group of assets with similar credit-risk characteristics and collectively assessed for impairment. 3. Any receivables not individually assessed are collectively assessed for impairment IFRS7-2 Both the IASB and the FASB have indicated that they believe that financial statements would be more transparent and understandable if companies recorded and reported all financial instruments at fair value. That said, in IFRS 9, which was issued in 2009, the IASB created a split model, where some financial instruments are recorded at fair value but other financial assets, such as loans and receivables, can be accounted for at amortized cost if certain criteria are met. Critics say that this can result in two companies with identical securities accounting for those securities in different ways. A proposal by the FASB would require that nearly all financial instruments, including loans and receivables, be accounted for at fair value.
IFRS7-3 (a)
Date
12/31/14 12/31/15 12/31/16
Note Amortization Schedule (Before Impairment) Cash Interest Increase in Received Revenue Carrying (0%) (10%) Amount $0 0
$6,209 6,830
$6,209 6,830
Computation of impairment loss: Carrying amount of investment (12/31/16) Less: Present value of $75,000 due in 3 years At 10% ($75,000 X 0.75132) Loss due impairment (a)
$75,131 56,349 $18,782
December 31, 2016 Bad Debt Expense ...................................... Allowance for Doubtful Accounts ....
(b)
Carrying Amount of Note $62,092 68,301 75,131
18,782 18,782
March 31, 2017 Allowance for Doubtful Accounts ............. Bad Debt Expense .............................
18,782 18,782
IFRS7-4 (a)
IAS 39, paragraphs 18-28 addresses derecognition of financial assets.
(b)
According to paragraph 19, “An entity transfers a financial asset if, and only if, it either:
(c)
a.
transfers the contractual rights to receive the cash flows of the financial asset; or
b.
retains the contractual rights to receive the cash flows of the financial asset, but assumes a contractual obligation to pay the cash flows to one or more recipients in an arrangement that meets the conditions in paragraphs 19.”
The amortised cost of a financial asset or financial liability is the amount at which the financial asset or financial liability is measured at initial recognition minus principal repayments, plus or minus the cumulative amortisation using the effective interest method of any difference between that initial amount and the maturity amount, and minus any reduction (directly or through the use of an allowance account) for impairment or uncollectibility.
IFRS7-5 (a)
M&S’s cash and cash equivalents include short-term deposits with banks and other financial institutions, with an initial maturity of three months or less and credit card payment received within 48 hours.
(b)
As of March 31, 2012, M&S had 196.1 million pounds in cash and cash equivalents. The major uses of cash were purchase of property, plant and equipment, redemption of medium term notes, and equity dividends paid.
(c)
M&S reports trade receivables of 115.8 million pounds and 114.6 million pounds (net) in 2012. M&S has trade receivables of 2.5 million pounds that were past due but not impaired.
CHAPTER 8 Valuation of Inventories: A Cost-Basis Approach ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics
Questions
1.
Inventory accounts; determining quantities, costs, and items to be included in inventory; the inventory equation; balance sheet disclosure.
1, 2, 3, 4, 5, 6, 8, 9
2.
Perpetual vs. periodic.
3.
Recording of discounts.
10, 11
4.
Inventory errors.
7
5.
Flow assumptions.
12, 13, 16, 18, 20
6.
Inventory accounting changes.
7.
Dollar-value LIFO methods.
14, 15, 17, 18, 19
Brief Exercises
Exercises
Problems
Concepts for Analysis
1, 3
1, 2, 3, 4, 5, 6
1, 2, 3
1, 2, 3, 5
2
9, 13, 17, 20
4, 5, 6
7, 8
3
4
5, 10, 11, 12
2
5, 6, 7
9, 13, 14, 15, 16, 17, 18, 19, 20, 21, 22
1, 4, 5, 6, 7
5, 6, 7, 8, 11
18
7
6, 7, 10
22, 23, 24, 25, 26
1, 8, 9, 10, 11
8, 9
8, 9
4
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives Questions
Brief Exercises
Exercises
Problems
Concepts for Analysis
1.
Identify major classifications of inventory.
1
1
2.
Distinguish between perpetual and periodic inventory systems.
3
2
4, 9, 13, 17
4, 5, 6
3.
Determine the goods included in inventory and the effects of inventory errors on the financial statements.
4, 5, 6, 7
4
5, 10, 11, 12
2
CA8-3, CA8-5
4.
Understand the items to include as inventory cost.
8
3
1, 2, 3, 4, 5, 6, 7, 8
1, 2, 3
CA8-1, CA8-2, CA8-4
5.
Describe and compare the cost flow assumptions used to account for inventories.
9, 10, 11, 12
5, 6, 7
9, 13, 14, 15, 16, 17, 18, 19, 20, 22
1, 4, 5, 6, 7
CA8-6, CA8-7, CA8-10
6.
Explain the significance and use of a LIFO reserve.
13, 18
7.
Understand the effect of LIFO liquidations.
20
8.
Explain the dollar-value LIFO method.
14, 15, 17, 19
9.
Identify the major advantages and disadvantages of LIFO.
16
10.
Understand why companies select given inventory methods.
2
21
8, 9
22, 23, 24, 25, 26
CA8-11
1, 8, 9, 10, 11
CA8-9 CA8-6, CA8-8, CA8-10
ASSIGNMENT CHARACTERISTICS TABLE
Item
Description
Level of Difficulty
Time (minutes)
E8-1 E8-2 E8-3 E8-4 E8-5 E8-6 E8-7 E8-8 E8-9 E8-10 E8-11 E8-12 E8-13 E8-14 E8-15 E8-16 E8-17 E8-18 E8-19 E8-20 E8-21 E8-22 E8-23 E8-24 E8-25 E8-26
Inventoriable costs. Inventoriable costs. Inventoriable costs. Inventoriable costs—perpetual. Inventoriable costs—error adjustments. Determining merchandise amounts—periodic. Purchases recorded net. Purchases recorded, gross method. Periodic versus perpetual entries. Inventory errors—periodic. Inventory errors. Inventory errors. FIFO and LIFO—periodic and perpetual. FIFO, LIFO and average-cost determination. FIFO, LIFO, average-cost inventory. Compute FIFO, LIFO, average-cost—periodic. FIFO and LIFO—periodic and perpetual. FIFO and LIFO; income statement presentation. FIFO and LIFO effects. FIFO and LIFO—periodic. LIFO effect. Alternate inventory methods—comprehensive. Dollar-value LIFO. Dollar-value LIFO. Dollar-value LIFO. Dollar-value LIFO.
Moderate Moderate Simple Simple Moderate Simple Simple Simple Moderate Simple Simple Moderate Moderate Moderate Moderate Moderate Simple Simple Moderate Simple Moderate Moderate Simple Simple Moderate Moderate
15–20 10–15 10–15 10–15 15–20 10–20 10–15 20–25 15–25 10–15 10–15 15–20 15–20 20–25 15–20 15–20 10–15 15–20 20–25 10–15 10–15 25–30 5–10 15–20 20–25 15–20
P8-1 P8-2 P8-3 P8-4 P8-5 P8-6
Various inventory issues. Inventory adjustments. Purchases recorded gross and net. Compute FIFO, LIFO, and average-cost. Compute FIFO, LIFO, and average-cost. Compute FIFO, LIFO, and average-cost—periodic and perpetual. Financial statement effects of FIFO and LIFO. Dollar-value LIFO. Internal indexes—dollar-value LIFO. Internal indexes—dollar-value LIFO. Dollar-value LIFO.
Moderate Moderate Simple Complex Complex Moderate
30–40 25–35 20–25 40–55 40–55 25–35
Moderate Moderate Moderate Complex Moderate
30–40 30–40 25–35 30–35 40–50
P8-7 P8-8 P8-9 P8-10 P8-11
ASSIGNMENT CHARACTERISTICS TABLE (Continued) Item
Description
Level of Difficulty
CA8-1 CA8-2 CA8-3 CA8-4 CA8-5 CA8-6 CA8-7 CA8-8 CA8-9 CA8-10 CA8-11
Inventoriable costs. Inventoriable costs. Inventoriable costs. Accounting treatment of purchase discounts. General inventory issues. LIFO inventory advantages. Average-cost, FIFO, and LIFO. LIFO application and advantages. Dollar-value LIFO issues. FIFO and LIFO. LIFO Choices
Moderate Moderate Moderate Simple Moderate Simple Simple Moderate Moderate Moderate Moderate
Time (minutes) 15–20 15–25 25–35 15–25 20–25 15–20 15–20 25–30 25–30 30–35 20–25
SOLUTIONS TO CODIFICATION EXERCISES CE8-1 (a)
Inventory is the aggregate of those items of tangible personal property that have any of the following characteristics: a. Held for sale in the ordinary of business. b. To process of production for such sale. c. To be currently consumed in the production of goods or services to be available for sale. The term inventory embraces goods awaiting sale (the merchandise of a trading concern and the finished goods of a manufacturer), goods in the course of production (work in process), and goods to be consumed directly or indirectly in production (raw materials and supplies). This definition of inventories excludes long-term assets subject to depreciation accounting, or goods which, when put into use, will be so classified. The fact that a depreciable asset is retired from regular use and held for sale does not indicate that the item should be classified as part of the inventory. Raw materials and supplies purchased for production may be used or consumed for the construction of long-term assets or other purposes not related to production, but the fact that inventory items representing a small portion of the total may not be absorbed ultimately in the production process does not require separate classification. By trade practice, operating materials and supplies of certain types of entities such as oil producers are usually treated as inventory.
(b)
A customer is a reseller or a consumer, either an individual or a business that purchases a vendor’s products or services for end use rather than for resale. This definition is consistent with paragraph 280-10-50-42, which states that a group of entities known to a reporting entity to be under common control shall be considered as a single customer, and the federal government, a state government, a local government (for example, a country or municipality), or a foreign government each shall be considered as a single customer.
(c)
Customer includes any purchaser of the vendor’s products at any point along the distribution chain, regardless of whether the purchaser acquires the vendor’s products directly or indirectly (for example, from a distributor) from the vendor. For example, a vendor may sell its products to a distributor who in turn resells the products to a retailer. In that example, the retailer—not the distributor—is a customer of the vendor.
(d)
A product financing arrangement is a transaction in which an entity sells and agrees to repurchase inventory with the repurchase price equal to the original sale price plus carrying and financing costs, or other similar transactions.
CE8-2 According FASB ASC 605-45-45-19 through 21 [Shipping and Handling Fees and Costs]: 45-19 Many sellers charge customers for shipping and handling in amounts in amounts that exceed the related costs incurred. The components of shipping and handling costs, and the determination of the amounts billed to customers for shipping and handling, may differ from entity to entity. Some entities define shipping costs and handling costs as only those costs incurred for a third-party shipper to transport products to the customer. Other entities include as shipping and handling costs a portion of internal costs, for example, salaries and overhead related to the activities to prepare goods for shipment. In addition, some entities charge customers only for amounts that are a direct reimbursement for shipping and, if discernible, direct incremental handling costs; however, many other entities charge customers for shipping and handling in amounts that are not a direct pass-through of costs.
CE8-2 (Continued) 45-20 For those entities that determine under the indicators listed in paragraphs 605-45-45-4 through 45-18 that shipping and handling fees shall be reported gross, all amounts billed to a customer in a sale transaction related to shipping and handling represent revenues earned for the goods provided and shall be classified as revenue. 45-21 Also, shipping and handling costs shall not be deducted from revenues (that is, netted against shipping and handling revenues).
CE8-3 FASB ASC 330-10-35-1 and 15 with respect to adjustments to Lower of Cost or Market: 35-1
A departure from the cost basis of pricing the inventory is required when the utility of the goods is no longer as great as their cost. Where there is evidence that the utility of goods, in their disposal in the ordinary course of business, will be less than cost, whether due to physical deterioration, obsolescence, changes in price levels, or other causes, the difference shall be recognized as a loss of the current period. This is generally accomplished by stating such goods at a lower level commonly designated as market.
With respect to Stating Inventories Above Cost: 35-15 Only in exceptional cases may inventories properly be stated above cost. For example, precious metals having a fixed monetary value with no substantial cost of marketing may be stated at such monetary value; any other exceptions must be justifiable by inability to determine appropriate approximate costs, immediate marketability at quoted market price, and the characteristic of unit interchangeability.
CE8-4 FASB ASC 330-10-S99-3 (SAB Topic 11.F, LIFO Liquidations) The following is the text of SAB Topic 11.F, LIFO Liquidations. Facts: Registrant on LIFO basis of accounting liquidates a substantial portion of its LIFO inventory and as a result includes a material amount of income in its income statement which would not have been recorded had the inventory liquidation not taken place. Question: Is disclosure required of the amount of income realized as a result of the inventory liquidation? Interpretive Response: Yes. Such disclosure would be required in order to make the financial statements not misleading. Disclosure may be made either in a footnote or parenthetically on the face of the income statement.
ANSWERS TO QUESTIONS 1. In a retailing concern, inventory normally consists of only one category that is the product awaiting resale. In a manufacturing company, inventories consist of raw materials, work in process, and finished goods. Sometimes a manufacturing or factory supplies inventory account is also included. 2. (a) Inventories are unexpired costs and represent future benefits to the owner. A statement of financial position includes a listing of all unexpired costs (assets) at a specific point in time. Because inventories are assets owned at the specific point in time for which a statement of financial position is prepared, they must be included in order that the owners’ financial position will be presented fairly. (b) Beginning and ending inventories are included in the computation of net income only for the purpose of arriving at the cost of goods sold during the period of time covered by the statement. Goods included in the beginning inventory which are no longer on hand are expired costs to be matched against revenues recognized during the period. Goods included in the ending inventory are unexpired costs to be carried forward to a future period, rather than expensed. 3. In a perpetual inventory system, data are available at any time on the quantity and dollar amount of each item of material or type of merchandise on hand. A physical inventory is a physical count of inventory on hand at a point in time. In a periodic system, the inventory is periodically counted (at least once a year) but that up-to-date records are not necessarily maintained. Discrepancies often occur between the physical count and the perpetual records because of clerical errors, theft, waste, misplacement of goods, etc. 4. No, Mishima, Inc. should not report this amount on its balance sheet. As consignee, it does not own this merchandise and therefore it is inappropriate for it to recognize this merchandise as part of its inventory. 5. Product financing arrangements are essentially off-balance-sheet financing devices. These arrangements make it appear that a company has sold its inventory or never taken title to it so they can keep loans off their balance sheet. A product financing arrangement should not be recorded as a sale. Rather, the inventory and related liability should be reported on the balance sheet. 6. (a) (b) (c) (d) (e) (f)
Inventory. Not shown, possibly in a note to the financial statements if material. Inventory. Inventory, separately disclosed as raw materials. Not shown, possibly a note to the financial statements. Inventory or manufacturing supplies.
7. This omission would have no effect upon the net income for the year, since the purchases and the ending inventory are understated in the same amount. With respect to financial position, both the inventory and the accounts payable would be understated. Materiality would be a factor in determining whether an adjustment for this item should be made as omission of a large item would distort the amount of current assets and the amount of current liabilities. It, therefore, might influence the current ratio to a considerable extent. 8. 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 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. Freight charges applicable to the product are considered a cost of the goods.
Questions Chapter 8 (Continued) 9. By their nature, product costs “attach” to the inventory and are recorded in the inventory account. These costs are directly connected with the bringing of goods to the place of business of the buyer and converting such goods to a salable condition. Such charges would include freight charges on goods purchased, other direct costs of acquisition, and labor and other production costs incurred in processing the goods up to the time of sale. Period costs are not considered to be directly related to the acquisition or production of goods and therefore are not considered to be a part of inventories. Conceptually, these expenses are as much a cost of the product as the initial purchase price and related freight charges attached to the product. While selling expenses are generally considered as more directly related to the cost of goods sold than to the unsold inventory, in most cases, though, the costs, especially administrative expenses, are so unrelated or indirectly related to the immediate production process that any allocation is purely arbitrary. Interest costs are considered a cost of financing and are generally expensed as incurred, when related to getting inventories ready for sale. 10. Cash discounts (purchase discounts) should not be accounted for as financial income when payments are made. Income should be recognized when the earning process is complete (when the company sells the inventory). Furthermore, a company does not earn revenue from purchasing goods. Cash discounts should be considered as a reduction in the cost of the items purchased. 11. $60.00, $63.00, $61.80. (Freight-In not included for discount.) 12. 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. Arguments against 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 homogeneous group. (4) It may not be a meaningful method of assigning costs in periods of changing price levels. 13. 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 they are incurred. As a result, the inventories are stated at the latest costs. Where 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
Questions Chapter 8 (Continued) 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 income is not fully available since a part of it must be used to replace inventory at higher cost. The results achieved by the average-cost 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 average-cost method 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 average-cost 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 is 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 income figures because it eliminates paper income and losses on inventory and smoothes 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 figures can be artificially 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. 14. A company may obtain a price index from an outside source (external index)—the government, a trade association, an exchange—or by computing its own index (internal index) using the double extension method. Under the double extension method the ending inventory is priced at both base-year costs and at current-year costs, with the total current cost divided by the total base cost to obtain the current year index. 15. Under the double extension method, LIFO inventory is priced at both base-year costs and currentyear costs. The total current-year cost of the inventory is divided by the total base-year cost to obtain the current-year index. The index for the LIFO pool consisting of product A and product B is computed as follows: Base-Year Cost Product Units Unit Total A 25,500 $10.20 $260,100 B 10,350 $37.00 382,950 December 31, 2014 inventory $643,050 Current-Year Cost Base-Year Cost
=
$1,007,460 $643,050
Current-Year Cost Unit Total $21.00 $ 535,500 $45.60 471,960 $1,007,460
= 156.67, index at 12/31/14.
Questions Chapter 8 (Continued) 16. The LIFO method results in a smaller net income because later costs, which are higher than earlier costs, are matched against revenue. Conversely, in a period of falling prices, the LIFO method would result in a higher net income because later costs in this case would be lower than earlier costs, and these later costs would be matched against revenue. 17. The dollar-value method uses dollars instead of units to measure increments, or reductions in a LIFO inventory. After converting the closing inventory to the same price level as the opening inventory, the increases in inventories, priced at base-year costs, is converted to the current price level and added to the opening inventory. Any decrease is subtracted at base-year costs to determine the ending inventory. The principal advantage is that it requires less record-keeping. It is not necessary to keep records or make calculations of opening and closing quantities of individual items. Also, the use of a base inventory amount gives greater flexibility in the makeup of the base and eliminates many detailed calculations. The unit LIFO inventory costing method is applied to each type of item in an inventory. Any type of item removed from the inventory base (e.g., magnets) and replaced by another type (e.g., coils) will cause the old cost (magnets) to be removed from the base and to be replaced by the more current cost of the other item (coils). The dollar-value LIFO costing method treats the inventory base as being composed of a base of cost in dollars rather than of units. Therefore a change in the composition of the inventory (less magnets and more coils) will not change the cost of inventory base so long as the amount of the inventory stated in base-year dollars does not change. 18. (a)
LIFO layer—a LIFO layer (increment) is formed when the ending inventory at base-year prices exceeds the beginning inventory at base-year prices.
(b) LIFO reserve—the difference between the inventory method used for internal purposes and LIFO. (c) 19.
LIFO effect—the change in the LIFO reserve (Allowance to Reduce Inventory to LIFO) from one period to the next.
December 31, 2014 inventory at December 31, 2013 prices, $1,053,000 ÷ 1.08................$975,000 Less: Inventory, December 31, 2013 ................................................................................ 800,000 Increment added during 2014 at base prices .....................................................................$175,000 Increment added during 2014 at December 31, 2014 prices, $175,000 X 1.08 ..................$189,000 Add: Inventory at December 31, 2013 ................................................................................ 800,000 Inventory, December 31, 2014, under dollar-value LIFO method .......................................$989,000
20. Phantom inventory profits occur when the inventory costs matched against sales are less than the replacement cost of the inventory. The cost of goods sold therefore is understated and profit is considered overstated. Phantom profits are said to occur when FIFO is used during periods of rising prices. High inventory profits through involuntary liquidation occur if a company is forced to reduce its LIFO base or layers. If the base or layers of old costs are eliminated, strange results can occur because old, irrelevant costs can be matched against current revenues. A distortion in reported income for a given period may result, as well as consequences that are detrimental from an income tax point of view.
SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 8-1 RIVERA COMPANY Balance Sheet (Partial) December 31 Current assets Cash .................................................................. Receivables (net).............................................. Inventories Finished goods......................................... Work in process ....................................... Raw materials ........................................... Prepaid insurance ............................................ Total current assets .................................
$ 190,000 400,000 $170,000 200,000 335,000
705,000 41,000 $1,336,000
BRIEF EXERCISE 8-2 Inventory (150 X $34) ................................................ Accounts Payable ............................................
5,100
Accounts Payable (6 X $34)...................................... Inventory...........................................................
204
Accounts Receivable (125 X $50)............................. Sales .................................................................
6,250
Cost of Goods Sold (125 X $34) ............................... Inventory...........................................................
4,250
5,100 204 6,250 4,250
BRIEF EXERCISE 8-3 December 31 inventory per physical count............. Goods-in-transit purchased FOB shipping point.... Goods-in-transit sold FOB destination.................... December 31 inventory....................................
$ 200,000 25,000 22,000 $ 247,000
BRIEF EXERCISE 8-4 Cost of goods sold as reported.............................................. Overstatement of 12/31/13 inventory ..................................... Overstatement of 12/31/14 inventory ..................................... Corrected cost of goods sold........................................
$1,400,000 (110,000) 35,000 $1,325,000
12/31/14 retained earnings as reported.................................. Overstatement of 12/31/14 inventory ..................................... Corrected 12/31/14 retained earnings ...........................
$5,200,000 (35,000) $5,165,000
BRIEF EXERCISE 8-5
Ending inventory 400 X $11.85 =
$11,850 = $ 11.85 1,000 $ 4,740
Cost of goods available for sale Deduct ending inventory Cost of goods sold (600 X $11.85)
$11,850 4,740 $ 7,110
Weighted average cost per unit
BRIEF EXERCISE 8-6 April 23 April 15 Ending inventory Cost of goods available for sale Deduct ending inventory Cost of goods sold
350 X $13 = $ 4,550 50 X $12 = 600 $ 5,150 $11,850 5,150 $ 6,700
BRIEF EXERCISE 8-7 April 1 April 15 Ending inventory Cost of goods available for sale Deduct ending inventory Cost of goods sold
250 X $10 = $ 2,500 150 X $12 = 1,800 $ 4,300 $11,850 4,300 $ 7,550
BRIEF EXERCISE 8-8 2013 2014
$100,000 $119,900 ÷ 1.10 = $109,000 $100,000 X 1.00 ............................................................ $9,000* X 1.10...............................................................
$100,000 9,900 $109,900
*$109,000 – $100,000 2015
$134,560 ÷ 1.16 = $116,000 $100,000 X 1.00 ............................................................ $9,000 X 1.10 ................................................................ $7,000** X 1.16 .............................................................
$100,000 9,900 8,120 $118,020
**$116,000 – $109,000
BRIEF EXERCISE 8-9 2014 inventory at base amount ($22,140 ÷ 1.08) 2013 inventory at base amount Increase in base inventory 2014 inventory under LIFO Layer one $19,750 X 1.00 Layer two $ 750 X 1.08
$ 20,500 (19,750) $ 750
2015 inventory at base amount ($25,935 ÷ 1.14) 2014 inventory at base amount Increase in base inventory 2015 inventory under LIFO Layer one $19,750 X 1.00 Layer two $ 750 X 1.08 Layer three $ 2,250 X 1.14
$ 22,750 20,500 $ 2,250
$ 19,750 810 $ 20,560
$ 19,750 810 2,565 $ 23,125
SOLUTIONS TO EXERCISES EXERCISE 8-1 (15–20 minutes) Items 1, 3, 5, 8, 11, 13, 14, 16, and 17 would be reported as inventory in the financial statements. The following items would not be reported as inventory: 2. Cost of goods sold in the income statement. 4. Not reported in the financial statements. 6. Cost of goods sold in the income statement. 7. Cost of goods sold in the income statement. 9. Interest expense in the income statement. 10. Advertising expense in the income statement. 12. Office supplies in the current assets section of the balance sheet. 15. Not reported in the financial statements. 18. Short-term investments in the current asset section of the balance sheet.
EXERCISE 8-2 (10–15 minutes) Inventory per physical count Goods in transit to customer, f.o.b. destination Goods in transit from vendor, f.o.b. seller Inventory to be reported on balance sheet
$441,000 + 38,000 + 51,000 $530,000
The consigned goods of $61,000 are not owned by Jose Oliva and were properly excluded. The goods in transit to a customer of $46,000, shipped f.o.b. shipping point, are properly excluded from the inventory because the title to the goods passed when they left the seller (Oliva) and therefore a sale and related cost of goods sold should be recorded in 2014. The goods in transit from a vendor of $83,000, shipped f.o.b. destination, are properly excluded from the inventory because the title to the goods does not pass to Oliva until the buyer (Oliva) receives them.
EXERCISE 8-3 (10–15 minutes) 1.
Include. Ownership of the merchandise passes to customer only when it is shipped.
2.
Do not include. Title did not pass until January 3.
3.
Include in inventory. Product belonged to Harlowe Inc. at December 31, 2014.
4.
Include in inventory. Under invoice terms, title passed when goods were shipped.
5.
Do not include. Goods received on consignment remain the property of the consignor.
EXERCISE 8-4 (10–15 minutes) 1. 2.
Raw Materials Inventory ................................ Accounts Payable .................................
8,100
Raw Materials Inventory ................................ Accounts Payable .................................
28,000
8,100 28,000
3.
No adjustment necessary.
4.
Accounts Payable .......................................... Raw Materials Inventory .......................
7,500
Raw Materials Inventory ................................ Accounts Payable .................................
19,800
5.
7,500 19,800
EXERCISE 8-5 (15–20 minutes) (a)
Inventory December 31, 2014 (unadjusted) Transaction 2 Transaction 3 Transaction 4 Transaction 5 Transaction 6 Transaction 7 Transaction 8 Inventory December 31, 2014 (adjusted)
(b)
Transaction 3 Sales Revenue.............................................. Accounts Receivable .......................... (To reverse sale entry in 2014) Transaction 4 Purchases (Inventory).................................. Accounts Payable ............................... (To record purchase of merchandise in 2014) Transaction 8 Sales Returns and Allowances.................... Accounts Receivable ..........................
$234,890 13,420 -0-08,540 (10,438) (10,520) 1,500 $237,392
12,800 12,800
15,630 15,630
2,600 2,600
EXERCISE 8-6 (10–20 minutes)
Sales Sales Returns Net Sales Beginning Inventory Ending Inventory Purchases Purchase Returns and Allowances Freight-in Cost of Good Sold Gross Profit
2013
2014
2015
$290,000 (11,000) 279,000 20,000 (32,000*) 242,000 (5,000) 8,000 (233,000) $ 46,000
$360,000 (13,000) 347,000 32,000 (37,000) 260,000 (8,000) 9,000 (256,000) $ 91,000
$410,000 (20,000) 390,000 37,000** (44,000) 298,000 (10,000) 12,000 (293,000) $ 97,000
*This was given as the beginning inventory for 2014. **This was calculated as the ending inventory for 2014.
EXERCISE 8-7 (10–15 minutes) (a)
May 10
May 11
May 19 May 24
Purchases......................................... Accounts Payable ................... ($15,000 X .98)
14,700
Purchases......................................... Accounts Payable ................... ($13,200 X .99)
13,068
Accounts Payable ............................ Cash.........................................
14,700
Purchases......................................... Accounts Payable ($11,500 X .98) .......................
11,270
14,700
13,068
14,700
11,270
EXERCISE 8-7 (Continued) (b)
May 31
Purchase Discounts Lost .............................. Accounts Payable ($13,200 X .01) .................................... (Discount lost on purchase of May 11, $13,200, terms 1/15, n/30)
132 132
EXERCISE 8-8 (20–25 minutes) (a)
Feb. 1
Feb. 4
(b)
9,720
Accounts Payable [$2,500 – ($2,500 X 10%)] ............................................ 2,250 Inventory............................................
2,250
Feb. 13
Accounts Payable ($9,720 – $2,250) .............. 7,470 Inventory (3% X $7,470) .................... 224.10 Cash ................................................... 7,245.90
Feb. 1
Purchases [$10,800 – ($10,800 X 10%)]......... 9,720 Accounts Payable .............................
9,720
Accounts Payable [$2,500 – ($2,500 X 10%)] ............................................................ 2,250 Purchase Returns and Allowances ....
2,250
Feb. 4
Feb. 13
(c)
Inventory [$10,800 – ($10,800 X 10%)]........... 9,720 Accounts Payable .............................
Accounts Payable ($9,720 – $2,250) .............. 7,470 Purchase Discounts (3% X $7,470)..... 224.10 Cash ................................................... 7,245.90
Purchase price (list) Less: Trade discount (10% X $10,800) Price on which cash discount based Less: Cash discount (3% X $9,720) Net price
$10,800.00 1,080.00 9,720.00 291.60 $ 9,428.40
EXERCISE 8-9 (15–25 minutes) (a)
Jan. 4 Jan. 11 Jan. 13 Jan. 20 Jan. 27 Jan. 31
Accounts Receivable .......................... Sales Revenue(80 X $8) .............
640
Purchases ($150 X $6) ........................ Accounts Payable ......................
900
Accounts Receivable .......................... Sales Revenue (120 X $8.75) .....
1,050
Purchases (160 X $7) .......................... Accounts Payable ......................
1,120
Accounts Receivable .......................... Sales Revenue (100 X $9) ..........
900
Inventory ($7 X 110) ............................ Cost of Goods Sold............................. Purchases ($900 + $1,120) ........ Inventory (100 X $5) ...................
770 1,750*
640 900 1,050 1,120 900
*($500 + $2,020 – $770) (b)
Sales revenue ($640 + $1,050 + $900) Cost of goods sold Gross profit
$2,590 1,750 $ 840
2,020 500
EXERCISE 8-9 (Continued) (c)
Jan. 4
Jan. 11 Jan. 13
Jan. 20 Jan. 27
(d)
Accounts Receivable .......................... Sales Revenue (80 X $8) ............
640
Cost of Goods Sold............................. Inventory (80 X $5) .....................
400
Inventory.............................................. Accounts Payable (150 X $6) ......
900
Accounts Receivable .......................... Sales Revenue (120 X $8.75) .....
1,050
Cost of Goods Sold............................. Inventory ([(20 X $5) + (100 X $6)] ................................
700
Inventory.............................................. Accounts Payable (160 X $7).....
1,120
Accounts Receivable .......................... Sales Revenue (100 X $9) ..........
900
Cost of Goods Sold............................. Inventory [(50 X $6) + (50 X $7)] ..................................
650
Sales revenue Cost of goods sold ($400 + $700 +$650) Gross profit
640 400 900 1,050
700
$2,590 1,750 $ 840
1,120 900
650
EXERCISE 8-10 (10–15 minutes)
1.
Working capital Current ratio Retained earnings Net income
Current Year Overstated Overstated Overstated Overstated
Subsequent Year No effect No effect No effect Understated
2.
Working capital Current ratio Retained earnings Net income
No effect Overstated* No effect No effect
No effect No effect No effect No effect
3.
Working capital Current ratio Retained earnings Net income
Overstated Overstated Overstated Overstated
No effect No effect No effect Understated
*Assume that the correct current ratio is greater than one. EXERCISE 8-11 (10–15 minutes) (a)
$370,000
= 1.85 to 1
$200,000 (b)
$370,000 + $22,000 – $13,000 + $3,000 $382,000 = = 2.06 to 1 $200,000 – $15,000 $185,000
(c) 1. 2. 3. 4.
Event Understatement of ending inventory Overstatement of purchases Overstatement of ending inventory Overstatement of advertising expense; understatement of cost of goods sold
Effect of Error Decreases net income
Adjust Income Increase (Decrease) $22,000
Decreases net income Increases net income
15,000 (13,000)
0 $24,000
EXERCISE 8-12 (15–20 minutes) Errors in Inventories Net Income Per Books
Year 2009 2010 2011 2012 2013 2014
$ 50,000 52,000 54,000 56,000 58,000 60,000 $330,000
Add Overstatement Jan. 1
Deduct Understatement Jan. 1
Deduct Add OverstateUnderstatement Dec. 31 ment Dec. 31 $3,000 9,000
$3,000 9,000
$11,000 $11,000 2,000 2,000
8,000
Corrected Net Income $ 47,000 46,000 74,000 45,000 60,000 50,000 $322,000
EXERCISE 8-13 (15–20 minutes) (a)
Units in ending inventory Beginning balance Purchase Goods available Sales Ending balance
(b)
300 1,300 1,600 (1,000) 600
(1)
Cost of Goods Sold LIFO 500 @ $13 = $ 6,500 500 @ $12 = 6,000 $12,500
Ending Inventory 300 @ $10 = $3,000 300 @ $12 = 3,600 $6,600
(2)
FIFO
300 @ $10 = 700 @ $12 =
$ 3,000 8,400 $11,400
500 @ $13 = 100 @ $12 =
LIFO
100 @ $10 = 300 @ $12 = 200 @ $13 =
$ 1,000 3,600 2,600 $ 7,200
$6,500 1,200 $7,700
EXERCISE 8-13 (Continued) (c)
Sales revenue
$25,400 = ($24 X 200) + ($25 X 500) + ($27 X 300) 11,400 = (200 @ $10) + (100 @ $10) $14,000 + (400 @ $12) + (300 @ $12)
Cost of Goods Sold Gross Profit (FIFO)
Note: FIFO periodic and FIFO perpetual provide the same gross profit and inventory value. (d)
LIFO matches more current costs with revenue. When prices are rising (as is generally the case), this results in a higher amount for cost of goods sold and a lower gross profit. As indicated in this exercise, prices were rising and cost of goods sold under LIFO was higher.
EXERCISE 8-14 (20–25 minutes) (a)
(1)
LIFO
600 @ $6.00 = $3,600 100 @ $6.08 = 608 $4,208
(2)
Average cost Total cost = Total units
$33,655* = $6.35 average cost per unit 5,300
700 @ $6.35 = $4,445 *Units 600 1,500 800 1,200 700 500 5,300
@ @ @ @ @ @
Price $6.00 $6.08 $6.40 $6.50 $6.60 $6.79
= = = = = =
Total Cost $ 3,600 9,120 5,120 7,800 4,620 3,395 $33,655
EXERCISE 8-14 (Continued) (b)
(1)
FIFO
500 @ $6.79 = $3,395 200 @ $6.60 = 1,320 $4,715
(2)
LIFO
100 @ $6.00 = $ 600 100 @ $6.08 = 608 500 @ $6.79 = 3,395 $4,603
(c)
Total merchandise available for sale Less: Inventory (FIFO) Cost of goods sold
(d)
FIFO.
$33,655 4,715 $28,940
EXERCISE 8-15 (15–20 minutes) (a)
Shania Twain Company COMPUTATION OF INVENTORY FOR PRODUCT BAP UNDER FIFO INVENTORY METHOD March 31, 2014
March 26, 2014 February 16, 2014 January 25, 2014 (portion) March 31, 2014, inventory (b)
Units 600 800 200 1,600
Unit Cost $12.00 11.00 10.00
Total Cost $ 7,200 8,800 2,000 $18,000
Shania Twain Company COMPUTATION OF INVENTORY FOR PRODUCT BAP UNDER LIFO INVENTORY METHOD March 31, 2014
Beginning inventory January 5, 2014 (portion) March 31, 2014, inventory
Units 600 1,000 1,600
Unit Cost $8.00 9.00
Total Cost $ 4,800 9,000 $13,800
EXERCISE 8-15 (Continued) (c)
Shania Twain Company COMPUTATION OF INVENTORY FOR PRODUCT BAP UNDER WEIGHTED-AVERAGE INVENTORY METHOD March 31, 2014 Units 600 1,200 1,300 800 600 4,500
Beginning inventory January 5, 2014 January 25, 2014 February 16, 2014 March 26, 2014
Weighted average cost ($44,600 ÷ 4,500)
Unit Cost $ 8.00 9.00 10.00 11.00 12.00
Total Cost $ 4,800 10,800 13,000 8,800 7,200 $44,600
$ 9.91*
March 31, 2014, inventory *Rounded off.
1,600
$ 9.91
$15,856
EXERCISE 8-16 (15–20 minutes) (a)
(1) 2,100 units available for sale – 1,400 units sold = 700 units in the ending inventory. 500 @ $4.58 = $2,290 200 @ 4.60 = 920 700 $3,210 Ending inventory at FIFO cost. (2) 100 @ $4.10 = 600 @ 4.20 = 700
$ 410 2,520 $2,930 Ending inventory at LIFO cost.
(3) $9,240 cost of goods available for sale ÷ 2,100 units available for sale = $4.40 weighted-average unit cost. 700 units X $4.40 = $3,080 Ending inventory at weighted-average cost.
EXERCISE 8-16 (Continued) (b)
(1) LIFO will yield the lowest gross profit because this method will yield the highest cost of goods sold figure in the situation presented. The company has experienced rising purchase prices for its inventory acquisitions. In a period of rising prices, LIFO will yield the highest cost of goods sold because the most recent purchase prices (which are the higher prices in this case) are used to price cost of goods sold while the older (and lower) purchase prices are used to cost the ending inventory. (2) LIFO will yield the lowest ending inventory because LIFO uses the oldest costs to price the ending inventory units. The company has experienced rising purchase prices. The oldest costs in this case are the lower costs.
EXERCISE 8-17 (10–15 minutes) (a)
(b)
(1)
400 @ $30 = 160 @ $25 =
$12,000 4,000 $16,000
(2)
400 @ $20 = 160 @ $25 =
$ 8,000 4,000 $12,000
(1)
FIFO
$16,000 [same as (a)]
(2)
LIFO
100 @ $20 = 60 @ $25 = 400 @ $30 =
$ 2,000 1,500 12,000 $15,500
EXERCISE 8-18 (15–20 minutes) First-in, first-out Sales revenue Cost of goods sold: Inventory, Jan. 1 Purchases Cost of goods available Inventory, Dec. 31 Cost of goods sold Gross profit Operating expenses Net income
$1,050,000 $120,000 592,000* 712,000 (235,000**)
*Purchases 6,000 @ $22 = 10,000 @ $25 = 7,000 @ $30 =
**Computation of inventory, Dec. 31: First-in, first-out: 7,000 units @ $30 = 1,000 units @ $25 =
***Last-in, first-out: 6,000 units @ $20 = 2,000 units @ $22 =
Last-in, first-out $1,050,000 $120,000 592,000 712,000 (164,000***)
477,000 573,000 200,000 $ 373,000
$132,000 250,000 210,000 $592,000
$210,000 25,000 $235,000
$120,000 44,000 $164,000
548,000 502,000 200,000 $ 302,000
EXERCISE 8-19 (20–25 minutes) Sandy Alomar Corporation SCHEDULES OF COST OF GOODS SOLD For the First Quarter Ended March 31, 2014
Beginning inventory Plus purchases Cost of goods available for sale Less: Ending inventory Cost of goods sold
Schedule 1 First-in, First-out $ 40,000 146,200* 186,200 61,300 $124,900
Schedule 2 Last-in, First-out $ 40,000 146,200 186,200 56,800 $129,400
*($33,600 + $25,500 + $38,700 + $48,400) Schedules Computing Ending Inventory Units 10,000 34,000 44,000 30,000 14,000
Beginning inventory Plus purchases Units available for sale Less sales ($150,000 ÷ 5) Ending inventory
The unit computation is the same for both assumptions, but the cost assigned to the units of ending inventory are different. First-in, First-out (Schedule 1) 11,000 at $4.40 = $48,400 3,000 at $4.30 = 12,900 14,000 $61,300
Last-in, First-out (Schedule 2) 10,000 at $4.00 = $40,000 4,000 at $4.20 = 16,800 14,000 $56,800
EXERCISE 8-20 (10–15 minutes) (a)
FIFO Ending Inventory 12/31/14 76 @ $10.89* = $ 827.64 24 @ $11.88** = 285.12 $1,112.76 *[$11.00 – .01 ($11.00)] **[$12.00 – .01 ($12.00)]
(b)
LIFO Cost of Goods Sold—2014 76 @ $10.89 = $ 827.64 84 @ $11.88 = 997.92 90 @ $14.85* = 1,336.50 15 @ $15.84** = 237.60 $3,399.66 *[$15.00 – .01 ($15)] **[$16.00 – .01 ($16)]
(c)
FIFO matches older costs with revenue. When prices are declining, as in this case, this results in a higher amount for cost of goods sold. Therefore, it is recommended that FIFO be used by Johnny Football Shop to minimize taxable income.
EXERCISE 8-21 (10–15 minutes) (a)
The difference between the inventory used for internal reporting purposes and LIFO is referred to as the Allowance to Reduce Inventory to LIFO or the LIFO reserve. The change in the allowance balance from one period to the next is called the LIFO effect (or as shown in this example, the LIFO adjustment).
(b)
LIFO subtracts inflation from inventory costs by charging the items purchased recently to cost of goods sold. As a result, ending inventory (assuming increasing prices) will be lower than FIFO or average cost.
EXERCISE 8-21 (Continued) (c)
Cash flow was computed as follows: Revenue $3,200,000 Cost of goods sold (2,800,000) Operating expenses (150,000) Income taxes (75,600) Cash flow $ 174,400 If the company has any sales on account or payables, then the cash flow number is incorrect. It is assumed here that the cash basis of accounting is used.
(d)
The company has extra cash because its taxes are less. The reason taxes are lower is because cost of goods sold (in a period of inflation) is higher under LIFO than FIFO. As a result, net income is lower which leads to lower income taxes. If prices are decreasing, the opposite effect results.
EXERCISE 8-22 (25–30 minutes) (a)
(1)
Ending inventory—Specific Identification Date No. Units Unit Cost December 2 July 20
(2)
Ending inventory—FIFO Date No. Units December 2 September 4
(3)
100 50 150
100 50 150
Ending inventory—LIFO Date No. Units January 1 March 15
100 50 150
Total Cost
$30 25
$3,000 1,250 $4,250
Unit Cost
Total Cost
$30 28
$3,000 1,400 $4,400
Unit Cost
Total Cost
$20 24
$2,000 1,200 $3,200
EXERCISE 8-22 (Continued) (4)
Ending inventory—Average-Cost Date
Explanation
January 1 March 15 July 20 September 4 December 2
Beginning inventory Purchase Purchase Purchase Purchase
No. Units
Unit Cost
Total Cost
100 300 300 200 100 1,000
$20 24 25 28 30
$ 2,000 7,200 7,500 5,600 3,000 $25,300
$25,300 ÷ 1,000 = $25.30 Ending Inventory—Average-Cost No. Units Unit Cost Total Cost 150 $25.30 $3,795 (b)
Double Extension Method Base-Year Costs
Units 150
Base-Year Cost Per Unit $20
Current Costs Total $3,000
Units 100 50
Current-Year Cost Per Unit $30 $28
Total $3,000 1,400 $4,400
Ending Inventory for the Period at Current Cost $4,400 = = 1.4667 Ending Inventory for the Period at Base-Year Cost $3,000 Ending inventory at base-year prices ($4,400 ÷ 1.4667) Base layer (100 units at $20) Increment in base-year dollars Current index Increment in current dollars Base layer (100 units at $20) Ending inventory at dollar-value LIFO
$3,000 (2,000) 1,000 1.4667 1,467 2,000 $3,467
EXERCISE 8-23 (5–10 minutes) $97,000 – $92,000 = $5,000 increase at base prices. $98,350 – $92,600 = $5,750 increase in dollar-value LIFO value. $5,000 X Index = $5,750. Index = $5,750 ÷ $5,000. Index = 115
EXERCISE 8-24 (15–20 minutes) (a)
(b)
12/31/14 inventory at 1/1/14 prices, $140,000 ÷ 1.12 Inventory 1/1/14 Inventory decrease at base prices
$125,000 160,000 $ 35,000
Inventory at 1/1/14 prices Less decrease at 1/1/14 prices Inventory 12/31/14 under dollar-value LIFO method
$160,000 35,000 $125,000
12/31/15 inventory at base prices, $172,500 ÷ 1.15 12/31/14 inventory at base prices Inventory increment at base prices
$150,000 125,000 $ 25,000
Inventory at 12/31/14 Increment added during 2015 at 12/31/15 prices, $25,000 X 1.15 Inventory 12/31/15
$125,000 28,750 $153,750
EXERCISE 8-25 (20–25 minutes)
2011 2012 2013 2014 2015 2016
Current $ $ 80,000 115,500 108,000 122,200 154,000 176,900
Price Index 1.00 1.05 1.20 1.30 1.40 1.45
Base Year $ $ 80,000 110,000 90,000 94,000 110,000 122,000
Change from Prior Year — $+30,000 (20,000) +4,000 +16,000 +12,000
EXERCISE 8-25 (Continued) Ending Inventory—Dollar-value LIFO: 2011
$80,000
2012
$80,000 @ 1.00 = 30,000 @ 1.05 =
$ 80,000 31,500 $111,500
2013
$80,000 @ 1.00 = 10,000 @ 1.05 =
$ 80,000 10,500 $ 90,500
2014
$80,000 @ 1.00 = 10,000 @ 1.05 = 4,000 @ 1.30 =
$ 80,000 10,500 5,200 $ 95,700
2015
$80,000 @ 1.00 = 10,000 @ 1.05 = 4,000 @ 1.30 = 16,000 @ 1.40 =
$ 80,000 10,500 5,200 22,400 $118,100
2016
$80,000 @ 1.00 = 10,000 @ 1.05 = 4,000 @ 1.30 = 16,000 @ 1.40 = 12,000 @ 1.45 =
$ 80,000 10,500 5,200 22,400 17,400 $135,500
EXERCISE 8-26 (15–20 minutes) Date Dec. 31, 2010 Dec. 31, 2011 Dec. 31, 2012 Dec. 31, 2013 Dec. 31, 2014
Current $ $ 70,000 90,300 95,120 105,600 100,000
Price Index 1.00 1.05 1.16 1.20 1.25
Base-Year $ $70,000 86,000 82,000 88,000 80,000
Change from Prior Year — $+16,000 (4,000) +6,000 (8,000)
EXERCISE 8-26 (Continued) Ending Inventory—Dollar-value LIFO: Dec. 31, 2010 $70,000 Dec. 31, 2011 $70,000 @ 1.00 = 16,000 @ 1.05 =
$70,000 16,800 $86,800
Dec. 31, 2012 $70,000 @ 1.00 = 12,000 @ 1.05 =
$70,000 12,600 $82,600
Dec. 31, 2013 $70,000 @ 1.00 = 12,000 @ 1.05 = 6,000 @ 1.20 =
$70,000 12,600 7,200 $89,800
Dec. 31, 2014 $70,000 @ 1.00 = 10,000 @ 1.05 =
$70,000 10,500 $80,500
TIME AND PURPOSE OF PROBLEMS Problem 8-1 (Time 30–40 minutes) Purpose—to provide a multipurpose problem with trade discounts, goods in transit, computing internal price indexes, dollar-value LIFO, comparative FIFO, LIFO, and average cost computations, and inventoriable cost identification. Problem 8-2 (Time 25–35 minutes) Purpose—to provide the student with eight different situations that require analysis to determine their impact on inventory, accounts payable, and net sales. Problem 8-3 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to prepare general journal entries to record purchases on a gross and net basis. Problem 8-4 (Time 40–55 minutes) Purpose—to provide a problem where the student must compute the inventory using a FIFO, LIFO, and average cost assumption. These inventory value determinations must be made under two differing assumptions: (1) perpetual inventory records are kept in units only and (2) perpetual records are kept in dollars. Many detailed computations must be made in this problem. Problem 8-5 (Time 40–55 minutes) Purpose—to provide a problem where the student must compute the inventory using a FIFO, LIFO, and average cost assumption. These inventory value determinations must be made under two differing assumptions: (1) perpetual inventory records are kept in units only and (2) perpetual records are kept in dollars. This problem is very similar to Problem 8-4, except that the differences in inventory values must be explained. Problem 8-6 (Time 25–35 minutes) Purpose—to provide a problem where the student must compute cost of goods sold using FIFO, LIFO, and weighted average, under both a periodic and perpetual system. Problem 8-7 (Time 30–40 minutes) Purpose—to provide a problem where the student must identify the accounts that would be affected if LIFO had been used rather than FIFO for purposes of computing inventories. Problem 8-8 (Time 30–40 minutes) Purpose—to provide a problem which covers the use of inventory pools for dollar-value LIFO. The student is required to compute ending inventory, cost of goods sold, and gross profit using dollar-value LIFO, first with one inventory pool and then with three pools. Problem 8-9 (Time 25–35 minutes) Purpose—the student computes the internal conversion price indexes for a LIFO inventory pool and then computes the inventory amounts using the dollar-value LIFO method. Problem 8-10 (Time 30–35 minutes) Purpose—to provide the student with the opportunity to compute inventories using the dollar-value approach. An index must be developed in this problem to price the new layers. This problem will prove difficult for the student because the indexes are hidden. Problem 8-11 (Time 40–50 minutes) Purpose—to provide the student with an opportunity to write a memo on how a dollar-value LIFO pool works. In addition, the student must explain the step-by-step procedure used to compute dollar value LIFO.
SOLUTIONS TO PROBLEMS PROBLEM 8-1
1.
$175,000 – ($175,000 X .20) = $140,000; $140,000 – ($140,000 X .10) = $126,000, cost of goods purchased
2.
$1,100,000 + $69,000 = $1,169,000. The $69,000 of goods in transit on which title had passed on December 24 (f.o.b. shipping point) should be added to 12/31/14 inventory. The $29,000 of goods shipped (f.o.b. shipping point) on January 3, 2015, should remain part of the 12/31/14 inventory.
3.
Because no date was associated with the units issued or sold, the periodic (rather than perpetual) inventory method must be assumed. FIFO inventory cost:
1,000 units at $24 1,000 units at 23 Total
$ 24,000 23,000 $ 47,000
LIFO inventory cost:
1,500 units at $21 500 units at 22 Total
$ 31,500 11,000 $ 42,500
Average cost:
1,500 at $21 2,000 at 22 3,500 at 23 1,000 at 24 8,000
$ 31,500 44,000 80,500 24,000 $180,000
Totals
$180,000 ÷ 8,000 = $22.50 Ending inventory (2,000 X $22.50) is $45,000.
PROBLEM 8-1 (Continued) 4.
Computation of price indexes: 12/31/14
$264,000 = 1.10 (110) $240,000
12/31/15
$286,720 = 1.12 (112) $256,000
Dollar-value LIFO inventory 12/31/14: Increase $240,000 – $200,000 = 12/31/14 price index Increase in terms of 110 Base inventory Dollar-value LIFO inventory
$ 40,000 X 1.10 44,000 2014 Layer 200,000 $244,000
Dollar-value LIFO inventory 12/31/15: Increase $256,000 – $240,000 = 12/31/15 price index Increase in terms of 112 2014 layer Base inventory Dollar-value LIFO inventory 5.
$ 16,000 X 1.12 17,920 2015 Layer 44,000 200,000 $261,920
The inventoriable costs for 2015 are: Merchandise purchased ................................. Add: Freight-in ............................................... Deduct: Purchase returns ............................. Purchase discounts......................... Inventoriable cost ...........................................
$909,400 22,000 931,400 $16,500 6,800
23,300 $908,100
PROBLEM 8-2
DIMITRI COMPANY Schedule of Adjustments December 31, 2014
Initial amounts Adjustments: 1. 2. 3. 4. 5. 6. 7. 8. Total adjustments Adjusted amounts
Inventory $1,520,000
Accounts Payable $1,200,000
Net Sales $8,150,000
NONE 76,000 30,000 32,000 26,000 27,000 NONE 4,000 195,000 $1,715,000
NONE 76,000 NONE NONE NONE NONE 56,000 8,000 140,000 $1,340,000
(40,000) NONE NONE (47,000) NONE NONE NONE NONE (87,000) $8,063,000
1.
The $31,000 of tools on the loading dock were properly included in the physical count. The sale should not be recorded until the goods are picked up by the common carrier. Therefore, no adjustment is made to inventory, but sales must be reduced by the $40,000 billing price.
2.
The $76,000 of goods in transit from a vendor to Dimitri were shipped f.o.b. shipping point on 12/29/14. Title passes to the buyer as soon as goods are delivered to the common carrier when sold f.o.b. shipping point. Therefore, these goods are properly includable in Dimitri’s inventory and accounts payable at 12/31/14. Both inventory and accounts payable must be increased by $76,000.
3.
The work-in-process inventory sent to an outside processor is Dimitri’s property and should be included in ending inventory. Since this inventory was not in the plant at the time of the physical count, the inventory column must be increased by $30,000.
PROBLEM 8-2 (Continued) 4.
The tools costing $32,000 were recorded as sales ($47,000) in 2014. However, these items were returned by customers on December 31, so 2014 net sales should be reduced by the $47,000 return. Also, $32,000 has to be added to the inventory column since these goods were not included in the physical count.
5.
The $26,000 of Dimitri’s tools shipped to a customer f.o.b. destination are still owned by Dimitri while in transit because title does not pass on these goods until they are received by the buyer. Therefore, $26,000 must be added to the inventory column. No adjustment is necessary in the sales column because the sale was properly recorded in 2015 when the customer received the goods.
6.
The goods received from a vendor at 5:00 p.m. on 12/31/14 should be included in the ending inventory, but were not included in the physical count. Therefore, $27,000 must be added to the inventory column. No adjustment is made to accounts payable, since the invoice was included in 12/31/14 accounts payable.
7.
The $56,000 of goods received on 12/26/14 were properly included in the physical count of inventory; $56,000 must be added to accounts payable since the invoice was not included in the 12/31/14 accounts payable balance.
8.
Since one-half of the freight-in cost ($8,000) pertains to merchandise properly included in inventory as of 12/31/14, $4,000 should be added to the inventory column. The remaining $4,000 debit should be reflected in cost of goods sold. The full $8,000 must be added to accounts payable since the liability was not recorded.
PROBLEM 8-3
(a)
1.
2.
8/10 Purchases ........................................................... Accounts Payable......................................
12,000
8/13 Accounts Payable .............................................. Purchase Returns and Allowances ..........
1,200
8/15 Purchases ........................................................... Accounts Payable......................................
16,000
8/25 Purchases ........................................................... Accounts Payable......................................
20,000
8/28 Accounts Payable .............................................. Cash ...........................................................
16,000
12,000
1,200
16,000
20,000
16,000
Purchases—addition to beginning inventory in cost of goods sold section of income statement. Purchase returns and allowances—deduction from purchases in cost of goods sold section of the income statement. Accounts payable—current liability in the current liabilities section of the balance sheet.
(b)
1.
8/10 Purchases ........................................................... Accounts Payable ($12,000 X .98) ............ 8/13 Accounts Payable .............................................. Purchase Returns and Allowances ($1,200 X .98)...........................................
11,760 11,760 1,176 1,176
PROBLEM 8-3 (Continued)
2.
3.
8/15 Purchases............................................................ Accounts Payable ($16,000 X .99) .............
15,840
8/25 Purchases............................................................ Accounts Payable ($20,000 X .98) .............
19,600
8/28 Accounts Payable ............................................... Purchase Discounts Lost ................................... Cash ............................................................
15,840 160
8/31 Purchase Discounts Lost ................................... Accounts Payable (.02 X [$12,000 – $1,200]) ........................
15,840
19,600
16,000 216 216
Same as part (a) (2) except: Purchase Discounts Lost—treat as financial expense in income statement.
(c) The second method is better theoretically because it results in the inventory being carried net of purchase discounts, and purchase discounts not taken are shown as an expense. The first method is normally used, however, for practical reasons.
PROBLEM 8-4
(a)
Purchases Total Units April 1 (balance on hand) April 4 April 11 April 18 April 26 April 30 Total units Total units sold Total units (ending inventory)
Sales Total Units 100 400 300 200 600 200 1,800 1,450 350
April 5 April 12 April 27 April 28 Total units
300 200 800 150 1,450
Assuming costs are not computed for each withdrawal: 1.
2.
First-in, first-out. Date of Invoice April 30 April 26
No. Units 200 150
Unit Cost $5.80 5.60
Total Cost $1,160 840 $2,000
Last-in, first-out. Date of Invoice April 1 April 4
No. Units 100 250
Unit Cost $5.00 5.10
Total Cost $ 500 1,275 $1,775
PROBLEM 8-4 (Continued) 3.
Average-cost. Cost of Part X available. Date of Invoice No. Units April 1 100 April 4 400 April 11 300 April 18 200 April 26 600 April 30 200 Total Available 1,800
Unit Cost $5.00 5.10 5.30 5.35 5.60 5.80
Total Cost $ 500 2,040 1,590 1,070 3,360 1,160 $9,720
Average cost per unit = $9,720 ÷ 1,800 = $5.40. Inventory, April 30 = 350 X $5.40 = $1,890. (b) Assuming costs are computed for each withdrawal: 1.
First-in, first out. The inventory would be the same in amount as in part (a), $2,000.
PROBLEM 8-4 (Continued) 2.
Last-in, first-out. Purchased Date
No. of units
Unit cost
April 1
100
April 4
400
Unit cost
Amount
$5.00
100
$5.00
$
5.10
100
5.00
400
5.10
April 26
100
5.00
100
5.10
300
100
5.00
100
5.10
300
5.30
100
5.00
100
5.10
100
5.30
100
5.00
100
5.10
100
5.30
200
5.35
100
5.00
100
5.10
100
5.30
200
5.35
600
5.60
100
5.00
100
5.10
100
5.30
$5.10
5.30
200
200
600
5.60
800
April 28 150 200
5.30
5.35
April 27
April 30
Unit cost
300
April 12
April 18
No. of units
Balance* No. of units
April 5 April 11
Sold
5.80
600 @
5.60
200 @
5.35
100 @
5.30
100
5.00
50 @
5.10
50
5.10
100
5.00
50 200
5.10 5.80
500 2,540 1,010
2,600
1,540
2,610
5,970
1,540
755
1,915
Inventory, April 30 is $1,915. *The balance on hand is listed in detail after each transaction.
PROBLEM 8-4 (Continued) 3.
Average-cost. Purchased Date
No. of units
Unit cost
April 1
100
April 4
400
No. of units
Unit cost*
Amount
$5.00
100
$5.0000
$ 500.00
5.10
500
5.0800
2,540.00
200
5.0800
1,016.00
500
5.2120
2,606.00
300
5.2120
1,563.60
300 300
Unit cost
Balance No. of units
April 5 April 11
Sold
$5.0800
5.30
April 12
200
5.2120
April 18
200
5.35
500
5.2672
2,633.60
April 26
600
5.60
1,100
5.4487
5,993.57
April 27
800
5.4487
300
5.4487
1,634.61
April 28
150
5.4487
150
5.4487
817.30
350
5.6494
1,977.30
April 30
200
5.80
Inventory, April 30 is $1,977.33 *Four decimal places are used to minimize rounding errors.
PROBLEM 8-5
(a) Assuming costs are not computed for each withdrawal (units received, 5,700, minus units issued, 4,700, equals ending inventory at 1,000 units): 1.
2.
3.
First-in, first-out. Date of Invoice Jan. 28
No. Units 1,000
Unit Cost $3.50
Total Cost $3,500
Last-in, first-out. Date of Invoice Jan. 2
No. Units 1,000
Unit Cost $3.00
Total Cost $3,000
Unit Cost $3.00 3.20 3.30 3.40 3.50
Total Cost $ 3,600 1,920 3,300 4,420 5,600 $18,840
Average-cost. Cost of goods available: Date of Invoice No. Units Jan. 2 1,200 Jan. 10 600 Jan. 18 1,000 Jan. 23 1,300 Jan. 28 1,600 Total Available 5,700
Average cost per unit = $18,840 ÷ 5,700 = $3.31 Cost of inventory Jan. 31 = 1,000 X $3.31 = $3,310 (b) Assuming costs are computed at the time of each withdrawal: Under FIFO—Yes. The amount shown as ending inventory would be the same as in (a) above. In each case the units on hand would be assumed to be part of those purchased on Jan. 28. Under LIFO—No. During the month the available balance dropped below the ending inventory quantity so that the layers of oldest costs were partially liquidated during the month.
PROBLEM 8-5 (Continued) Under Average-Cost—No. A new average cost would be computed each time a withdrawal was made instead of only once for all items purchased during the year. The calculations to determine the inventory on this basis are given below. 1.
First-in, first-out. The inventory would be the same in amount as in part (a), $3,500.
2.
Last-in, first-out. Received Date
No. of units
Unit cost
Jan. 2
1,200
$3.00
Jan. 7 Jan. 10
600
500 1,000
1,300
3.30
Jan. 31
300
3.20 3.30
700
3.30
100
3.20
300
3.00
800 1,600
$3.00
3.40
Jan. 26 Jan. 28
Unit cost
3.20
Jan. 20
Jan. 23
No. of units 700
Jan. 13 Jan. 18
Issued
3.40
3.50
1,300
Inventory, January 31 is $3,350.
3.50
Balance No. of units
Unit cost*
Amount
1,200
$3.00
$3,600
500
3.00
1,500
500
3.00
600
3.20
500
3.00
100
3.20
500
3.00
100
3.20
700
3.30
200 200
3.00 3.00
1,300
3.40
200
3.00
500
3.40
200
3.00
500
3.40
1,600
3.50
200
3.00
500 300
3.40 3.50
3,420 1,820
4,130
600 5,020 2,300
7,900
3,350
PROBLEM 8-5 (Continued) 3.
Average-cost. Received Date
No. of units
Unit cost
Jan. 2
1,200
$3.00
Jan. 7 Jan. 10
600 1,000 1,300
3.30
$3.0000
No. of units
Unit cost*
Amount
1,200
$3.0000
$3,600
500
3.0000
1,500
1,100
3.1091
3,420
3.1091
600
3.1091
1,865
300
3.2281
1,300
3.2281
4,197
1,100
3.2281
200
3.2281
646
1,500
3.3773
5,066
3.3773
700
3.3773
2,364
3.4626
2,300 1,000
3.4626 3.4626
7,964 3,463
800 1,600
Balance
500
3.40
Jan. 26 Jan. 28 Jan. 31
Unit cost
3.20
Jan. 20 Jan. 23
No. of units 700
Jan. 13 Jan. 18
Issued
3.50 1,300
Inventory, January 31 is $3,463. *Four decimal places are used to minimize rounding errors.
PROBLEM 8-6
(a)
(b)
(c)
(d) Date 1/1 2/4
Beginning inventory ......................... 1,000 Purchases (2,000 + 3,000) ............... 5,000 Units available for sale ..................... 6,000 Sales (2,500 + 2,200)........................ (4,700) Goods on hand ................................ 1,300 Periodic FIFO 1,000 X $12 = 2,000 X $18 = 1,700 X $23 = 4,700
$12,000 36,000 39,100 $87,100
Perpetual FIFO Same as periodic:
$87,100
Periodic LIFO 3,000 X $23 = 1,700 X $18 = 4,700
$69,000 30,600 $99,600
Perpetual LIFO Purchased
Sold
Balance 1,000 X $12 1,000 X $12
2,000 X $18 = $36,000
2,000 X $18 2/20
2,000 X $18
500 X $12 500 X $12
3,000 X $23 = $69,000
3,000 X $23 11/4
2,200 X $23
}
$12,000 $48,000
} $42,000
500 X $12 4/2
=
= $50,600
500 X $12 800 X $23
$92,600
=
$ 6,000
}
$75,000
}
$24,400
PROBLEM 8-6 (Continued) (e)
(f)
Periodic weighted-average 1,000 X $12 = $ 12,000 2,000 X $18 = 36,000 3,000 X $23 = 69,000 $117,000 ÷ 6,000 = $19.50
4,700 X $19.50 $91,650
Perpetual moving average Date
Purchased
Sold
Balance
1/1
1,000 X $12 = $12,000
2/4
2,000 X $18 = $36,000
2/20
2,500 X $16 =
4/2
$40,000
2,200 X $22 =
48,400 $88,400
a
500 X $16 = $ 8,000 3,000 X $23 = 69,000 3,500
$77,000
($77,000 ÷ 3,500 = $22)
48,000
500 X $16 =
8,000
a
3,000 X $23 = $69,000
11/4
3,000 X $16 = 3,500 X $22 =
77,000
1,300 X $22 =
28,600
PROBLEM 8-7 The accounts in the 2015 financial statements which would be affected by a change to LIFO and the new amount for each of the accounts are as follows:
(1) (2) (3) (4) (5)
New amount for 2015 $176,400 120,000 226,400 792,000 101,600
Account Cash Inventory Retained earnings Cost of goods sold Income taxes
The calculations for both 2014 and 2015 to support the conversion to LIFO are presented below. Income for the Years Ended
12/31/14
12/31/15
Sales revenue Less: Cost of goods sold Other expenses Income before taxes Income taxes (40%) Net income
$900,000 525,000 205,000 730,000 170,000 68,000 $102,000
$1,350,000 792,000 304,000 1,096,000 254,000 101,600 $ 152,400
Cost of Goods Sold and Ending Inventory for the Years Ended
12/31/14
12/31/15
Beginning inventory Purchases Cost of goods available Ending inventory Cost of goods sold
$120,000 525,000 645,000 (120,000) $525,000
( 40,000 X $3.00) (150,000 X $3.50) ( 40,000 X $3.00)
( 40,000 X $3.00) (180,000 X $4.40) ( 40,000 X $3.00)
$120,000 792,000 912,000 (120,000) $792,000
Determination of Cash at
12/31/14
12/31/15
Income taxes under FIFO Income taxes as calculated under LIFO Increase in cash Adjust cash at 12/31/15 for 2014 tax difference Total increase in cash Cash balance under FIFO Cash balance under LIFO
$ 76,000 68,000 8,000
$116,000 101,600 14,400
— 8,000 130,000 $138,000
8,000 22,400 154,000 $176,400
PROBLEM 8-7 (Continued) Determination of Retained Earnings at
12/31/14
12/31/15
Net income under FIFO Net income under LIFO Reduction in retained earnings Adjust retained earnings at 12/31/15 for 2014 reduction Total reduction in retained earnings Retained earnings under FIFO Retained earnings under LIFO
$114,000 (102,000) 12,000
$174,000 (152,400) 21,600
— 12,000 200,000 $188,000
12,000 33,600 260,000 $226,400
PROBLEM 8-8
(a)
1.
2.
3.
Ending inventory in units Portable 6,000 + 15,000 – 14,000 = Midsize 8,000 + 20,000 – 24,000 = Flat-screen 3,000 + 10,000 – 6,000 =
Ending inventory at current cost Portable 7,000 X $110 = Midsize 4,000 X $300 = Flat-screen 7,000 X $500 =
Ending inventory at base-year cost Portable 7,000 X $100 = Midsize 4,000 X $250 = Flat-screen 7,000 X $400 =
4.
Price index $5,470,000 ÷ $4,500,000 = 1.2156
5.
Ending inventory $3,800,000 X 1.0000 = 700,000* X 1.2156 =
7,000 4,000 7,000 18,000
$ 770,000 1,200,000 3,500,000 $5,470,000
$ 700,000 1,000,000 2,800,000 $4,500,000
$3,800,000 850,920 $4,650,920
*($4,500,000 – $3,800,000 = $700,000) 6.
Cost of goods sold Beginning inventory................................................. Purchases [(15,000 X $110) + (20,000 X $300) + (10,000 X $500)] ..................................................... Cost of goods available ........................................... Ending inventory ...................................................... Cost of goods sold .............................................
$ 3,800,000
12,650,000 16,450,000 (4,650,920) $11,799,080
PROBLEM 8-8 (Continued) 7.
(b)
1.
Gross profit Sales revenue [(14,000 X $150) + (24,000 X $405) + (6,000 X $600)] .......................................................... Cost of goods sold ...................................................... Gross profit..................................................................
$15,420,000 11,799,080 $ 3,620,920
Ending inventory at current cost restated to base cost Portable $ 770,000 ÷ 1.10a = $ 700,000 b Midsize 1,200,000 ÷ 1.20 = $ 1,000,000 c Flat-screen 3,500,000 ÷ 1.25 = $ 2,800,000 a. $110 ÷ $100 b. $300 ÷ $250 c. $500 ÷ $400
2.
3.
4.
Ending inventory Portable $ 600,000 X 1.00 = 100,000 X 1.10 = Midsize 1,000,000 X 1.00 = Flat-screen 1,200,000 X 1.00 = 1,600,000 X 1.25 =
$
600,000 110,000 1,000,000 1,200,000 2,000,000 $ 4,910,000
Cost of good sold Cost of good available ................................................ Ending inventory ......................................................... Cost of goods sold ................................................
$16,450,000 (4,910,000) $11,540,000
Gross profit Sales revenue .............................................................. Cost of goods sold ...................................................... Gross profit..................................................................
$15,420,000 11,540,000 $ 3,880,000
PROBLEM 8-9
(a)
BONANZA WHOLESALERS INC. Computation of Internal Conversion Price Index for Inventory Pool No. 1 Double Extension Method
Current inventory at current-year cost Product A Product B
17,000 X $36 = 9,000 X $26 =
Current inventory at base cost Product A Product B
17,000 X $30 = 9,000 X $25 =
2014 $612,000 234,000 $846,000
$510,000 225,000 $735,000
Conversion price index $846,000 ÷ $735,000 = 1.15
(b)
13,000 X $30 = 10,000 X $25 =
$390,000 250,000 $640,000
$840,000 ÷ $640,000 = 1.31
BONANZA WHOLESALERS INC. Computation of Inventory Amounts Under Dollar-Value LIFO Method for Inventory Pool No. 1 at December 31, 2014 and 2015 Current Inventory at base cost
December 31, 2014 Base inventory 2012 layer ($735,000 – $525,000) Total
$525,000 210,000 $735,000
December 31, 2015 Base inventory 2012 layer (remaining) Total
$525,000 115,000 $640,000
(a) (b)
13,000 X $40 = 10,000 X $32 =
2015 $520,000 320,000 $840,000
Conversion price index 1.00 1.15
(a)
$525,000 241,500 $766,500
(a)
$525,000 132,250 $657,250
(a)
(b) (a)
1.00 1.15
Inventory at LIFO cost
Per schedule for instruction (a). After liquidation of $95,000 base cost ($735,000 – $640,000).
PROBLEM 8-10
Base-Year Cost December 31, 2013 January 1, 2013, base December 31, 2013, layer
December 31, 2014 January 1, 2013, base December 31, 2013, layer December 31, 2014, layer
December 31, 2015 January 1, 2013, base December 31, 2013, layer December 31, 2014, layer December 31, 2015, layer
*$62,700 ÷ $56,000 **$87,300 ÷ $68,400 ***$90,800 ÷ $70,000
Index %
Dollar-Value LIFO
$45,000 11,000 $56,000
100 112*
$45,000 12,320 $57,320
$45,000 11,000 12,400 $68,400
100 112 128**
$45,000 12,320 15,872 $73,192
$45,000 11,000 12,400 1,600 $70,000
100 112 128 130***
$45,000 12,320 15,872 2,080 $75,272
PROBLEM 8-11
(a) Schedule A
2010 2011 2012 2013 2014 2015
A
B
C
Current $ $ 80,000 111,300 108,000 128,700 147,000 174,000
Price Index 1.00 1.05 1.20 1.30 1.40 1.45
Base-Year $ $ 80,000 106,000 90,000 99,000 105,000 120,000
D Change from Prior Year — +$26,000 (16,000) +9,000 +6,000 +15,000
Schedule B Ending Inventory-Dollar-Value LIFO: 2010 2011
2012
2013
$80,000 @ $1.00 = 26,000 @ 1.05 = $80,000 @ 1.00 = 10,000 @ 1.05 = $80,000 @ 1.00 = 10,000 @ 1.05 = 9,000 @ 1.30 =
$ 80,000 $ 80,000 27,300 $107,300 $ 80,000 10,500 $ 90,500 $ 80,000 10,500 11,700 $102,200
2014
$80,000 @ $1.00 = 10,000 @ 1.05 = 9,000 @ 1.30 = 6,000 @ 1.40 =
2015
$80,000 @ 10,000 @ 9,000 @ 6,000 @ 15,000 @
1.00 = 1.05 = 1.30 = 1.40 = 1.45 =
$ 80,000 10,500 11,700 8,400 $110,600 $ 80,000 10,500 11,700 8,400 21,750 $132,350
PROBLEM 8-11 (Continued) (b) To:
Richardson Company
From:
Accounting Student
Subject:
Dollar-Value LIFO Pool Accounting
Dollar-value LIFO is an inventory method which values groups or “pools” of inventory in layers of costs. It assumes that any goods sold during a given period were taken from the most recently acquired group of goods in stock and, consequently, any goods remaining in inventory are assumed to be the oldest goods, valued at the oldest prices. Because dollar-value LIFO combines various related costs in groups or “pools,” no attempt is made to keep track of each individual inventory item. Instead, each group of annual purchases forms a new cost layer of inventory. Further, the most recent layer will be the first one carried to cost of goods sold during this period. However, inflation distorts any cost of purchases made in subsequent years. To counteract the effect of inflation, this method measures the incremental change in each year’s ending inventory in terms of the first year’s (base year’s) costs. This is done by adjusting subsequent cost layers, through the use of a price index, to the base year’s inventory costs. Only after this adjustment can the new layer be valued at current-year prices. To do this valuation, you need to know both the ending inventory at yearend prices and the price index used to adjust the current year’s new layer. The idea is to convert the current ending inventory into base-year costs. The difference between the current year’s and the previous year’s ending inventory expressed in base-year costs usually represents any inventory which has been purchased but not sold during the year, that is, the newest LIFO layer. This difference is then readjusted to express this most recent layer in current-year costs.
PROBLEM 8-11 (Continued) 1.
Refer to Schedule A. To express each year’s ending inventory (Column A) in terms of base-year costs, simply divide the ending inventory by the price index (Column B). For 2010, this adjustment would be $80,000/ 100% or $80,000; for 2011, it would be $111,300/105%, etc. The quotient (Column C) is thus expressed in base-year costs.
2.
Next, compute the difference between the previous and the current years’ ending inventory in base-year costs. Simply subtract the current year’s base-year inventory from the previous year’s. In 2011, the change is +$26,000 (Column D).
3.
Finally, express this increment in current-year terms. For the second year, this computation is straightforward: the base-year ending inventory value is added to the difference in #2 above multiplied by the price index. For 2011, the ending inventory for dollar-value LIFO would equal $80,000 of base-year inventory plus the increment ($26,000) times the price index (1.05) or $107,300. The product is the most recent layer expressed in current-year prices. See Schedule B.
Be careful with this last step in subsequent years. Notice that, in 2012, the change from the previous year is –$16,000, which causes the 2011 layer to be eroded during the period. Thus, the 2012 ending inventory is valued at the original base-year cost $80,000 plus the remainder valued at the 2011 price index, $10,000 times 1.05. See 2012 computation on Schedule B. When valuing ending inventory, remember to include each yearly layer adjusted by that year’s price index. Refer to Schedule B for 2013. Notice that the +$9,000 change from the 2013 ending inventory indicates that the 2011 layer was not further eroded. Thus, ending inventory for 2013 would value the first $80,000 worth of inventory at the base-year price index (1.00), the next $10,000 (the remainder of the 2011 layer) at the 2011 price index (1.05), and the last $9,000 at the 2013 price index (1.30). These instructions should help you implement dollar-value LIFO in your inventory valuation.
TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 8-1 (Time 15–20 minutes) Purpose—a short case designed to test the skills of the student in determining whether an item should be reported in inventory. In addition, the student is required to speculate as to why the company may wish to postpone recording this transaction. CA 8-2 (Time 15–25 minutes) Purpose—to provide the student with four questions about the carrying value of inventory. These questions must be answered and defended with rationale. The topics are shipping terms, freight–in, weighted-average cost vs. FIFO, and consigned goods. CA 8-3 (Time 25–35 minutes) Purpose—to provide a number of difficult financial reporting transactions involving inventories. This case is vague and much judgment is required in its analysis. Right or wrong answers should be discouraged; rather emphasis should be placed on the underlying rationale to defend a given position. Includes a product versus period cost transaction, proper classification of a possible inventory item, and a product financing arrangement. CA 8-4 (Time 15–25 minutes) Purpose—the student discusses the acceptability of alternative methods of reporting cash discounts. Also, the student identifies the effects on financial statements of using LIFO instead of FIFO when prices are rising. CA 8-5 (Time 20–25 minutes) Purpose—to provide a broad overview to students as to why inventories must be included in the balance sheet and income statement. In addition, students are asked to determine why taxable income and accounting income may be different. Finally, the conditions under which FIFO and LIFO may give different answers must be developed. CA 8-6 (Time 15–20 minutes) Purpose—to provide the student with the opportunity to discuss the rationale for the use of the LIFO method of inventory valuation. The conditions that must exist before the tax benefits of LIFO will accrue also must be developed. CA 8-7 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to discuss the cost flow assumptions of average cost, FIFO, and LIFO. Student is also required to distinguish between weighted-average and movingaverage and discuss the effect of LIFO on the B/S and I/S in a period of rising prices. CA 8-8 (Time 25–30 minutes) Purpose—to provide the student with the opportunity to discuss the differences between traditional LIFO and dollar-value LIFO. In this discussion, the specific procedures employed in traditional LIFO and dollar-value LIFO must be examined. This case provides a good basis for discussing LIFO conceptual issues. CA 8-9 (Time 25–30 minutes) Purpose—to provide the student with an opportunity to discuss the concept of a LIFO pool and its use in various LIFO methods. The student is also asked to define LIFO liquidation, to explain the use of price indexes in dollar-value LIFO, and to discuss the advantages of using dollar-value LIFO.
Time and Purposes of Concepts for Analysis (Continued) CA 8-10 (Time 30–35 minutes) Purpose—to provide the student with an opportunity to analyze the effect of changing from the FIFO method to the LIFO method on items such as ending inventory, net income, earnings per share, and year-end cash balance. The student is also asked to make recommendations considering the results from computation and other relevant factors. CA 8-11 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to analyze the ethical implications of purchasing decisions under LIFO.
SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 8-1 (a) Purchased merchandise in transit at the end of an accounting period to which legal title has passed should be recorded as purchases within the accounting period. If goods are shipped f.o.b. shipping point, title passes to the buyer when the seller delivers the goods to the common carrier. Generally when the terms are f.o.b. shipping point, transportation costs must be paid by the buyer. This liability arises when the common carrier completes the delivery. Thus, the client has a liability for the merchandise and the freight. (b) Inventory............................................................................................... Accounts Payable (Supplier)............................................................. Inventory............................................................................................... Accounts Payable (Transportation Co.) ............................................
35,300 35,300 1,500 1,500
(c) Possible reasons to postpone the recording of the transaction might include: 1. Desire to maintain a current ratio at a given level which would be affected by the additional inventory and accounts payable. 2. Desire to minimize the impact of the additional inventory on other ratios such as inventory turnover. 3. Possible tax ramifications.
CA 8-2 (a) If the terms of the purchase are f.o.b. shipping point (manufacturer’s plant), Strider 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. (b) 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. (c) 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. (d) Products on consignment represent inventories owned by Strider Enterprises, which are physically transferred to another enterprise. However, Strider Enterprises retains title to the goods until their sale by the other company (Chavez Inc.). The goods consigned are still included by Strider Enterprises in the inventory section of its balance sheet. Often the inventory is reclassified from regular inventory to consigned inventory (Note to instructor: Additional coverage of consignments is presented in chapter 18.
CA 8-3 (a) According to FASB ASC 330-10-30-1: “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.” The discussion includes the following: “Selling expenses constitute no part of the inventory costs.” To the extent that warehousing is a necessary function of importing merchandise before it can be sold, certain elements of warehousing costs might be considered an appropriate cost of inventory in the warehouse. For example, if goods must be brought into the warehouse before they can be made ready for sale, the cost of bringing such goods into the warehouse would be considered a cost of inventory. Similarly, if goods must be handled in the warehouse for assembly or for removal of foreign packaging, etc., it would be appropriate to include such costs in inventory. However, costs involved in storing the goods for any additional period would appear to be period costs. Costs of delivering the goods from the warehouse would appear to be selling expenses related to the goods sold, and should not under any circumstances be allocated to goods that are still in the warehouse. In theory, warehousing costs are considered a product cost because these costs are incurred to maintain the product in a salable condition. However, in practice, warehousing costs are most frequently treated as a period cost. Under the Tax Reform Act of 1986, warehousing and off-site storage of inventory, including finished goods, are specifically included in the “production and resale activities” that are to be capitalized for tax purposes. (b) It is correct to conclude that obsolete items are excludable from inventory. Cost attributable to such items is “nonuseful” and “nonrecoverable” cost (except for possible scrap value) and should be written off. If the cost of obsolete items was simply excluded from ending inventory, the resultant cost of goods sold would be overstated by the amount of these costs. The cost of obsolete items, if immaterial, should be commingled with cost of goods sold. If material, these costs should be separately disclosed. (c) The primary use of the airplanes should determine their treatment on the balance sheet. Since the airplanes are held primarily for sale, and chartering is only a temporary use, the airplanes should be classified as current assets. Depreciation would not be appropriate if the planes are considered inventory. FASB ASC Glossary entry for “Inventory” states in part that the term Inventory “excludes long-term assets subject to depreciation accounting, or goods which, when put into use, will be so classified.” (d) The transaction is a product financing arrangement and should be reported by the company as inventory with a related liability. The substance of the transaction is that inventory has been purchased and the fact that a trust is established to purchase the goods has no economic significance. Given that the company agrees to buy the coal over a certain period of time at specific prices, it appears clear that the company has the liability and not the trust.
CA 8-4 (a) Cash discounts should not be accounted for as financial income when payments are made. Income should be recognized when the earnings process is complete (when the company sells the inventory). Furthermore, cash discounts should not be recorded when the payments are made because in order to properly match a cash discount with the related purchase, the cash discount should be recorded when the related purchase is recorded.
CA 8-4 (Continued) (b) Cash discounts should not be accounted for as a reduction of cost of goods sold for the period when payments are made. Cost of goods sold should be reduced when the earnings process is complete (when the company sells the inventory which has been reduced by the cash discounts). Furthermore, cash discounts should not be recorded when the payments are made because in order to properly match a cash discount with the related purchase, the cash discount should be recorded when the related purchase is recorded. (c) Cash discounts should be accounted for as a direct reduction of purchase cost because they reduce the cost of acquiring the inventories. Purchases should be recorded net of cash discounts to reflect the net cash to be paid. The primary basis of accounting for inventories is cost, which represents the price paid or consideration given to acquire an asset.
CA 8-5 (a)
1. Inventories are unexpired costs and represent future benefits to the owner. A balance sheet includes a listing of unexpired costs and future benefits of the owner’s assets at a specific point in time. Because inventories are assets owned at the specific point in time for which a balance sheet is prepared, they must be included in order that the owner’s financial position will be presented fairly. 2. Beginning and ending inventories are included in the computation of net income only for the purpose of arriving at the cost of goods sold during the period of time covered by the statement. Goods included in the beginning inventory which are no longer on hand are expired costs to be matched against revenues earned during the period. Goods included in the ending inventory are unexpired costs to be carried forward to a future period, rather than expensed.
(b) Financial accounting has as its goal the proper reporting of financial transactions and events in accordance with generally accepted accounting principles. Income tax accounting has as its goal the reporting of taxable transactions and events in conformity with income tax laws and regulations. While the primary purpose of an income tax is the production of tax revenues to finance the operations of government, income tax laws and regulations are often produced by various forces. The income tax may be used as a tool of fiscal policy to stimulate all of the segments of the economy or to decelerate the economy. Some income tax laws may be passed because of political pressures brought to bear by individuals or industries. When the purposes of financial accounting and income tax accounting differ, it is often desirable to report transactions or events differently and to report the deferred tax consequences of any existing temporary differences as assets or liabilities. (c) FIFO and LIFO are inventory costing methods employed to measure the flow of costs. FIFO matches the first cost incurred with the first revenue produced while LIFO matches the last cost incurred with the first revenue produced after the cost is incurred. (This, of course, assumes a perpetual inventory system is in use and may not be precisely true if a periodic inventory system is employed.) If prices are changing, different costs would be matched with revenue for the same quantity sold depending upon whether the LIFO or FIFO system is in use. (In a period of rising or falling prices FIFO tends to value inventories at approximate market value in the balance sheet and LIFO tends to match approximately the current replacement cost of an item with the revenue produced.)
CA 8-6 (a) Inventory profits occur when the inventory costs matched against sales are less than the replacement cost of the inventory. The cost of goods sold therefore is understated and net income is considered overstated. By using LIFO (rather than some method such as FIFO), more recent costs are matched against revenues and inventory profits are thereby reduced.
CA 8-6 (Continued) (b) As long as the price level increases and inventory quantities do not decrease, a deferral of income taxes occurs under LIFO because the items most recently purchased at the higher price level are matched against revenues. It should be noted that where unit costs tend to decrease as production increases, the tax benefits that LIFO might provide are nullified. Also, where the inventory turnover is high, the difference between inventory methods is negligible.
CA 8-7 (a) The average-cost method assumes that inventories are sold or issued evenly from the stock on hand; the FIFO method assumes that goods are sold or used in the order in which they are purchased (i.e., the first goods purchased are the first sold or used); and the LIFO method matches the cost of the last goods purchased against revenue. (b) The weighted-average-cost method combines the cost of all the purchases in the period with the cost of beginning inventory and divides the total costs by the total number of units to determine the average cost per unit. The moving-average-cost method, on the other hand, calculates a new average unit cost when a purchase is made. The moving-average-cost method is used with perpetual inventory records. (c) When the purchase prices of inventoriable items are rising for a significant period of time, the use of the LIFO method (instead of FIFO) will result in a lower net income figure. The reason is that the LIFO method matches most recent purchases against revenue. Since the prices of goods are rising, the LIFO method will result in higher cost of goods sold, thus lower net income. On the balance sheet, the ending inventory tends to be understated (i.e., lower than the most recent replacement cost) because the oldest goods have lower costs during a period of rising prices. In addition, retained earnings under the LIFO method will be lower than that of the FIFO method when inflation exists.
CA 8-8 (a) 1. The LIFO method (periodic) allocates costs on the assumption that the last goods purchased are used first. If the amount of the inventory is computed at the end of the month under a periodic system, then it would be assumed that the total quantity sold or issued during the month would have come from the most recent purchases, and ordinarily no attempt would be made to compare the dates of purchases and sales. 2. The dollar-value method of LIFO inventory valuation is a procedure using dollars instead of units to measure increments or reductions in inventory. The method presumes that goods in the inventory can be classified into pools or homogenous groups. After the grouping into pools the ending inventory is priced at the end-of-year prices and a price index number is applied to convert the total pool to the base-year price level. Such a price index might be obtained from government sources, if available, or computed from the company’s records. The pools or groupings of inventory are required where a single index number is inappropriate for all elements of the inventory. After the closing inventory and the opening inventory have been placed on the same base-year price level, any difference between the two inventories is attributable to an increase or decrease in inventory quantity at the base-year price. An increase in quantity so determined is converted to the current-year price level and added to the amount of the opening inventory as a separate inventory layer. A decrease in quantity is deducted from the appropriate layer of opening inventory at the price level in existence when the layer was added.
CA 8-8 (Continued) (b) The advantages of the dollar-value method over the traditional LIFO method are as follows: 1. The application of the LIFO method is simplified because, under the pooling procedure, it is not necessary to assign costs to opening and closing quantities of individual items. As a result, companies with inventories comprised of thousands of items may adopt the dollar-value method and minimize their bookkeeping costs. 2. Base inventories are more easily maintained. The dollar-value method permits greater flexibility because each pool is made up of dollars rather than quantities. Thus, the problem of LIFO liquidation is less possible. The disadvantages of the dollar-value method as compared to the traditional LIFO method are as follows: 1. Due to technological innovations and improvements over time, material changes in the composition of inventory may occur. Items found in the ending inventory may not have existed during the base year. Thus, conversion of the ending inventory to base-year prices may be difficult to calculate or to justify conceptually. This may necessitate a periodic change in the choice of base year used. 2. Application of a year-end index, although widely used, implies use of the FIFO method. Other indexes used include beginning-of-year index and average indexes. 3. Determination of the degree of similarity between items for the purpose of grouping them into pools may be difficult and may be based upon arbitrary management decisions. (c) The basic advantages of LIFO are: 1. Matching—In LIFO, the more recent costs are matched against current revenues to provide a better measure of current earnings. 2. Tax benefits—As long as the price level increases and inventory quantities do not decrease, a deferral of income taxes occurs. 3. Improved cash flow—By receiving tax benefits from use of LIFO, the company may reduce its borrowings and related interest costs. 4. Future earnings hedge—With LIFO, a company’s future reported earnings will not be affected substantially by future price declines. LIFO eliminates or substantially minimizes write-downs to market as a result of price decreases because the inventory value ordinarily will be much lower than net realizable value, unlike FIFO. The major disadvantages of LIFO are: 1. Reduced earnings—Because current costs are matched against current revenues, net income is lower than it is under other inventory methods when price levels are increasing. 2. Inventory understated—The inventory valuation on the balance sheet is ordinarily outdated because the oldest costs remain in inventory. 3. Physical flow—LIFO does not approximate physical flow of the items except in peculiar situations. 4. Real income not measured—LIFO falls short of measuring real income because it is often not an adequate substitute for replacement cost. 5. Involuntary liquidation—If the base or layers of old costs are partially liquidated, irrelevant costs can be matched against current revenues. 6. Poor buying habits—LIFO may cause poor buying habits because a company may simply purchase more goods and match the cost of these goods against revenue to insure that old costs are not charged to expense.
CA 8-9 (a) A LIFO pool is a group of similar items which are combined and accounted for together under the LIFO inventory method. (b) It is possible to use a LIFO pool concept without using dollar-value LIFO. For example, the specific goods pooled approach utilizes the concept of a LIFO pool with quantities as its measurement basis. (c) A LIFO liquidation occurs when a significant drop in inventory level leads to the erosion of an earlier or base inventory layer. In a period of inflation (as usually is the case) LIFO liquidation will distort net income (make it higher) and incur substantial tax payments. (d) Price indexes are used in the dollar-value LIFO method to: (1) convert the ending inventory at current year-end cost to base-year cost, and (2) determine the current-year cost for each inventory layer other than the base-year layer. (e) The dollar-value LIFO method measures the increases and decreases in a pool in terms of total dollar value, not by the physical quantity of the goods in the inventory pool. As a result, the dollarvalue LIFO approach has the following advantages over specific goods LIFO pool. First, the pooled approach reduces record keeping and clerical costs. Second, replacement is permitted if it is a similar material, or similar in use, or interchangeable. Thus, it is more difficult to erode LIFO layers when using dollar-value LIFO techniques.
CA 8-10 (a) FIFO (Amounts in thousands, except earnings per share) 2014 $11,000
Sales revenue Cost of goods sold Beginning inventory 8,000 Purchases 8,000 Cost of goods available for sale 16,000 1. Ending inventory* (7,200) Cost of goods sold 8,800 Gross profit 2,200 Operating expense (15% of sales) 1,650 Depreciation expense 300 Income before taxes 250 Income tax expense (40%) 100 2. Net income $ 150
2015 $12,000
2016 $15,600
7,200 9,900 17,100 (9,000) 8,100 3,900 1,800 300 1,800 720 $ 1,080
9,000 12,000 21,000 (9,000) 12,000 3,600 2,340 300 960 384 $ 576
CA 8-10 (Continued) 2014 $ 0.15
2015 $ 1.08
2016 $ 0.58
4. Cash balance $ 400 Beginning balance Sales proceeds 11,000 Purchases (8,000) Operating expenses (1,650) Property, plant, and equipment (350) Income taxes (100) Dividends (150) Ending balance $ 1,150
$ 1,150 12,000 (9,900) (1,800) (350) (720) (150) $ 230
$
3. Earnings per share
230 15,600 (12,000) (2,340) (350) (384) (150) $ 606
*2014 = $ 8 X (1,000 + 1,000 – 1,100) = $7,200. 2015 = $ 9 X ( 900 + 1,100 – 1,000) = $9,000. 2016 = $10 X (1,000 + 1,200 – 1,300) = $9,000. LIFO (Amounts in thousands, except earnings per share)
Sales revenue Cost of goods sold Beginning inventory Purchases Cost of goods available for sale 1. Ending inventory** Cost of goods sold Gross profit Operating expense Depreciation expense Income before taxes Income tax expense
2014 $11,000
2015 $12,000
2016 $15,600
8,000 8,000 16,000 (7,200) 8,800 2,200 1,650 300 250 100
7,200 9,900 17,100 (8,100) 9,000 3,000 1,800 300 900 360
8,100 12,000 20,100 (7,200) 12,900 2,700 2,340 300 60 24
2. Net income
$
150
$
540
$
36
3. Earnings per share
$
0.15
$
0.54
$
0.04
CA 8-10 (Continued)
4. Cash balance Beginning balance Sales proceeds Purchases Operating expenses Property, plant, and equipment Income taxes Dividends Ending balance
2014
2015
2016
$
$ 1,150 12,000 (9,900) (1,800) (350) (360) (150) $ 590
$
400 11,000 (8,000) (1,650) (350) (100) (150) $ 1,150
590 15,600 (12,000) (2,340) (350) (24) (150) $ 1,326
**2014 = $8 X (1,000 + 1,000 – 1,100) = $7,200. 2015 = ($8 X 900) + ($9 X 100) = $8,100. 2014 = $8 X 900 = $7,200. (b)
According to the computation in (a), Harrisburg Company can achieve the goal of income tax savings by switching to the LIFO method. As shown in the schedules, under the LIFO method, Harrisburg will have lower net income and thus lower income taxes for 2015 and 2016 (tax savings of $360,000 in each year). As a result, Harrisburg will have a better cash position at the end of 2015 and especially 2016 (year-end cash balance will be higher by $360,000 for 2015 and $720,000 for 2016). However, since Harrisburg Company is in a period of rising purchase prices, the LIFO method will result in significantly lower net income and earnings per share for 2015 and 2016. The management may need to evaluate the potential impact that lower net income and earnings per share might have on the company before deciding on the change to the LIFO method.
CA 8-11 (a)
Major stakeholders are investors, creditors, Wilkens’ management (including the president and plant accountant), and other employees of Wilkens Company. The inventory purchase in this instance reduces net income substantially and lowers Wilkens Company’s tax liability. Current stockholders and company management benefit during the current year by this decision. However, the purchasing department may be concerned about inventory management and complications such as storage costs and possible inventory obsolescence. Assuming awareness of these benefits and possible complications, the plant accountant may follow the president’s recommendation without violating GAAP. The plant accountant also must consider whether this action is in the long-term best interests of the company and whether inventory amounts would provide a meaningful picture of Wilkens Company’s financial condition.
(b)
No, the president would not recommend a year-end inventory purchase because under FIFO there would be no effect on net income.
FINANCIAL STATEMENT ANALYSIS CASE 1
(a)
Sales ........................................................................ Cost of goods sold* ................................................ Gross profit ............................................................. Selling and administrative expense....................... Income from operations ......................................... Other expense ......................................................... Income before income tax ......................................
$618,876,000 474,206,000 144,670,000 102,112,000 42,558,000 24,712,000 $ 17,846,000
*Cost of goods sold (per annual report) ................. LIFO effect ($5,263,000 – $3,993,000) .................... Cost of goods sold (per FIFO)................................
$475,476,000 (1,270,000) $474,206,000
(b)
$17,846,000 income before taxes X 46.6% tax = $8,316,236 tax; $17,846,000 – $8,316,236 tax = $9,529,764 net income as compared to $8,848,000 net income under LIFO. This is $681,764 or about 8% different. The question as to materiality is to allow the students an opportunity to judge the significance of the difference between the two costing methods. Since it is less than 10% different, some students may feel that it is not material. An 8% change in net income, however, is probably material, but this would depend on the industry and perhaps on the company’s own past averages.
(c)
No, the use of different costing methods does not necessarily mean that there is a difference in the physical flow of goods. As explained in the text, the actual physical flow need have no relationship to the cost flow assumption. The management of T J International has determined that LIFO is appropriate only for a subset of its products, and these reasons have to do with economic characteristics, rather than the physical flow of the goods.
FINANCIAL STATEMENT ANALYSIS CASE 2
(a)
The most likely physical flow of goods for a pharmaceutical manufacturer would be FIFO; that is, the first goods manufactured would be the first goods sold. This is because pharmaceutical goods have an expiration date. The manufacturer would be careful to ship the goods made earliest first and thereby reduce the risk that outdated goods will remain in the warehouse.
(b)
Noven should consider first whether the inventory costing method will make a difference. If the prices in the economy, especially if the raw materials prices, are stable, then the inventory cost will be nearly the same under any of the measurement methods. If inventory levels are very small, then the method used will make little difference. Noven should also consider the cost of keeping records. A small company might not want to invest in complicated record keeping. The tax effects of any differences should be considered, as well as any international rules that might dictate Noven’s measurement of part of its inventory.
(c)
This amount is likely not shown in a separate inventory account because it is immaterial; that is, it is not large enough to make a difference with investors. Another possible reason is that no goods have yet been offered for sale. This amount might be in the Inventory of supplies account, but it is more likely to be included with Prepaid and other current assets, since it clearly is not just an article of supplies. This will definitely be shown separately as soon as Noven begins to sell its products to outside customers.
FINANCIAL STATEMENT ANALYSIS CASE 3
Revenues .................................. Cost of sales ............................. Ending inventories at FIFO ..... Ending inventories at LIFO ..... Difference......................... FIFO adjusted cost of sales.....
Feb. 25 2012 $36,100 28,010 $2,492 2,150 (342) $27,668
(a) (1) Inventory turnover @LIFO (2) Inventory turnover @FIFO
Feb. 26 2011 $37,534 29,124 $2,552 2,270 (282) $28,842
2012 12.67 10.97
Feb. 27 2010 $40,597 31,444 $2,606 2,342 (264) $31,180
2011 12.63 11.18
Recall that the formula for computing inventory turnover is Cost of Sales/Average Inventory (b)
2012 2011 (1) Inventory turnover using sales and LIFO 16.33 16.28 Recall that the formula for computing inventory turnover in part (b) is Sales/Average Inventory (2) Inventory turnover using sales and FIFO 14.31 14.55
(c) Using sales instead of cost of goods sold accounts for the mark-up in the inventory. By using cost of goods sold, there is a better matching of the costs associated to inventory, and should result in more useful information.
ACCOUNTING, ANALYSIS, AND PRINCIPLES Accounting (a)
FIFO
Residential pumps: Ending inventory cost = (300 X $500) + (200 X $475) = Beginning inventory cost = (200 X $400) = Purchases = $225,000 + $190,000 + $150,000 = Cost of goods sold = $80,000 + $565,000 – $245,000 =
$ 245,000 $ 80,000 $ 565,000 $ 400,000
Commercial pumps: Ending inventory at cost = (500 X $1,000) = Beginning inventory at cost = (600 X $800) = Purchases = $540,000 + $285,000 + $500,000 = Cost of goods sold = $480,000 + $1,325,000 – $500,000 =
$ 500,000 $ 480,000 $1,325,000 $1,305,000
Total ending inventory at cost = $245,000 + $500,000 =
$ 745,000
Total cost of goods sold = $1,305,000 + $400,000 =
$1,705,000
(b)
Dollar-value LIFO (one pool) Ending inventory at current cost = Ending inventory at base-year cost = (500 X $800) + (500 X $400) = Price index = $745,000 / $600,000 = 1.242 Current Inventory at base cost
Ending inventory Base inventory ($80,000 + $480,000) Layer ($600,000 – $560,000) Total
$560,000 40,000 $600,000
$ 745,000 $ 600,000
Conversion price index 1.000 1.242
Cost of goods sold = $560,000 + ($565,000 + $1,325,000) – $609,680 =
Inventory at LIFO cost $560,000 49,680 $609,680
$1,840,320
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) Analysis (a)
The purpose of a current ratio is to provide some indication of the resources the company has available to meet short term obligations, if those obligations come due. FIFO, which generally approximates the current cost of inventory, usually better suits this objective. LIFO inventory numbers on a balance sheet can sometimes be stated at lower values.
(b)
The U.S. Securities and Exchange Commission requires companies using LIFO to disclose the current cost of their inventories. Many companies disclose the FIFO cost of their inventories since that generally approximates current cost. This difference between LIFO cost and current cost is called the “LIFO reserve.” A financial statement reader can use the LIFO reserve to convert a LIFO company’s inventory and cost of goods sold to what they would have been if the company had used FIFO. This makes it possible to directly compare LIFO and FIFO companies, although the comparison must be done on a FIFO basis, not LIFO.
Principles Companies can change from one inventory accounting method to another, but not back and forth. Changes in accounting method (when not mandated by a regulatory body such as the FASB) should be to improve the financial statement reader’s ability to understand the companies’ financial results and position. The tradeoff is usually comparability for consistency. That is, if a company changes to a method that is used by most of its competitors, the change increases comparability. But, because the company now uses different methods across different years, consistency is sacrificed. Companies sometimes change accounting methods because they believe it improves the matching of expenses to revenues. Again, consistency across reporting periods is sacrificed, however.
PROFESSIONAL RESEARCH (a)
According to FASB ASC 605-15-15: 15-2 The guidance in this Subtopic applies to the following transactions: a. Sales in which a product may be returned, whether as a matter of contract or as a matter of existing practice, either by the ultimate customer or by a party who resells the product to others. The product may be returned for a refund of the purchase price, for a credit applied to amounts owed or to be owed for other purchases, or in exchange for other products. The purchase price or credit may include amounts related to incidental services, such as installation. However, exchanges by ultimate customers of one item for another of the same kind, quality, and price (for example, one color or size for another) are not considered returns for purposes of this Subtopic. b. Sales by a manufacturer who repurchases the product subject to an operating lease with the buyer.
(b)
The guidance in this subtopic (FASB ASC 605-15-15) does not apply to the following transactions: a. Revenue in service industries if part or all of the service revenue may be returned under cancellation privileges granted to the buyer. b. Transactions involving real estate or leases c. Sales transactions in which a customer may return defective goods, such as under warranty provisions. (See Topic 460 regarding warranty obligations incurred in connection with the sale of goods or services that may require further performance by the seller after the sale has taken place.)
PROFESSIONAL RESEARCH (Continued) > Right of Return (FASB ASC 605-15) 05-3 It is the practice in some industries for customers to be given the right to return a product to the seller under certain circumstances. In the case of sales to ultimate customer, the most usual circumstance is customer dissatisfaction with the product. For sales to customers engaged in the business of reselling the product, the most usual circumstance is that the customer has not been able to resell the product to another party. (Arrangements in which customers buy products for resale with the right to return products often are referred to as guaranteed sales.) (c)
Yes, different industries should be allowed to make different types of policies. (FASB ASC 605-15-05). 05-4 Sometimes, the returns occur very soon after a sale is made, as in the newspaper and perishable food industries. In other cases, returns occur over a longer period, such as with book publishing and equipment manufacturing. The rate of returns varies considerably from a low rate usually found in the food industry to a high rate often found in the publishing industry.
(d)
According to FASB ASC 605-15-25: 25-3 The ability to make a reasonable estimate of the amount of future returns depends on many factors and circumstances that will vary from one case to the next. However, any of the following factors may impair the ability to make a reasonable estimate: a. The susceptibility of the product to significant external factors, such as technological obsolescence or changes in demand b. Relatively long periods in which a particular product may be returned
PROFESSIONAL RESEARCH (Continued) c. Absence of historical experience with similar types of sales of similar products, or inability to apply such experience because of changing circumstances, for example, changes in the selling entity’s marketing policies or relationships with its customers d. Absence of a large volume of relatively homogeneous transactions. 25-4 The existence of one or more of the factors in the preceding paragraph, in light of the significance of other factors, may not be sufficient to prevent making a reasonable estimate; likewise, other factors may preclude a reasonable estimate.
PROFESSIONAL SIMULATION
Explanation To:
Norwel Management
From:
Student
Re:
Advantages of LIFO
The major advantages of the LIFO inventory method include better matching of costs with revenues, deferral of income taxes, improved cash flow, and minimization of the impact of future price declines on future earnings. Better matching arises in the use of LIFO because the most recent costs are matched with current revenues. In times of rising prices, this matching will result in lower taxable income, which in turn will reduce current taxes. The deferral of taxes under LIFO contributes to a higher cash flow. As illustrated in the analysis above the switch to FIFO resulted in a higher ending inventory, which leads to a lower cost of goods sold and higher income; thus, Norwel’s reported income will be higher but so will its taxes. Note that under LIFO, future taxes may be higher when lower cost items of inventory are sold in future periods and matched with higher sales prices.
CHAPTER 9 Inventories: Additional Valuation Issues ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics
Questions
Brief Exercises
Problems 1, 2, 3, 9, 10
1, 2, 3, 5
6
1. Lower-of-cost-or-market.
1, 2, 3, 4, 5, 6
1, 2, 3
1, 2, 3, 4, 5, 6
2.
Inventory accounting changes; relative sales value method; net realizable value.
7, 8
4
7, 8
3. Purchase commitments.
9
5, 6
9, 10
9
4. Gross profit method.
10, 11, 12, 13
7
11, 12, 13, 14, 15, 16, 17
4, 5
5. Retail inventory method.
14, 15, 16
8
18, 19, 20, 22, 23, 26
6, 7, 8, 10, 11
6.
Presentation and analysis.
17, 18
9
21
9
*7.
LIFO retail.
19
10
22, 23
12, 13, 14
*8.
Dollar-value LIFO retail.
11
24, 25, 26, 27
11, 13
*9.
Special LIFO problems.
28
13, 14
*This material is discussed in an Appendix to the chapter.
Concepts for Analysis
Exercises
4, 5
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives
Brief Exercises
Questions
Exercises
Problems
1.
Describe and apply the lowerof-cost-or-market rule.
1, 2, 3, 4
1, 2, 3
1, 2, 3, 4, 5, 6
1, 2, 3, 9, 10
2.
Explain when companies value inventories at net realizable value.
5, 6, 7
1, 2, 3
1, 2, 3, 4, 5, 6
1, 2, 3, 9, 10
3.
Explain when companies use the relative sales value method to value inventories.
8
4
7, 8
4.
Discuss accounting issues related to purchase commitments.
9
5, 6
9, 10
9
5.
Determine ending inventory by applying the gross profit method.
10, 11, 12, 13
7
11, 12, 13, 14, 15, 16, 17
4, 5
6.
Determine ending inventory by applying the retail inventory method.
14, 15, 16
8
18, 19, 20
6, 7, 8
7.
Explain how to report and analyze inventory.
17, 18
9
21
9
*8.
Determine ending inventory by applying the LIFO retail methods.
19
10, 11
22, 23, 24, 25, 26, 27, 28
11, 12, 13, 14
*This material is discussed in an Appendix to the chapter.
Concepts for Analysis CA9-1, CA9-2, CA9-3, CA9-5
CA9-6
CA9-4, CA9-5
ASSIGNMENT CHARACTERISTICS TABLE
Item
Description
Level of Difficulty
E9-1 E9-2 E9-3 E9-4 E9-5 E9-6 E9-7 E9-8 E9-9 E9-10 E9-11 E9-12 E9-13 E9-14 E9-15 E9-16 E9-17 E9-18 E9-19 E9-20 E9-21 *E9-22 *E9-23 *E9-24 *E9-25 *E9-26 *E9-27 *E9-28
Lower-of-cost-or-market. Lower-of-cost-or-market. Lower-of-cost-or-market. Lower-of-cost-or-market—journal entries. Lower-of-cost-or-market—valuation account. Lower-of-cost-or-market—error effect. Relative sales value method. Relative sales value method. Purchase commitments. Purchase commitments. Gross profit method. Gross profit method. Gross profit method. Gross profit method. Gross profit method. Gross profit method. Gross profit method. Retail inventory method. Retail inventory method. Retail inventory method. Analysis of inventories. Retail inventory method—conventional and LIFO. Retail inventory method—conventional and LIFO. Dollar-value LIFO retail. Dollar-value LIFO retail. Conventional retail and dollar-value LIFO retail. Dollar-value LIFO retail. Change to LIFO retail.
Simple Simple Simple Simple Moderate Simple Simple Simple Simple Simple Simple Simple Simple Moderate Simple Simple Moderate Moderate Simple Simple Simple Moderate Moderate Simple Simple Moderate Moderate Simple
15–20 10–15 15–20 10–15 20–25 10–15 15–20 12–17 05–10 15–20 8–13 10–15 15–20 15–20 10–15 15–20 20–25 20–25 12–17 20–25 10–15 25–35 15–20 10–15 5–10 20–25 20–25 10–15
P9-1 P9-2 P9-3
Lower-of-cost-or-market. Lower-of-cost-or-market. Entries for lower-of-cost-or-market—cost-of-goodsold and loss. Gross profit method. Gross profit method. Retail inventory method. Retail inventory method.
Simple Moderate Moderate
10–15 25–30 30–35
Moderate Complex Moderate Moderate
20–30 40–45 20–30 20–30
P9-4 P9-5 P9-6 P9-7
Time (minutes)
ASSIGNMENT CHARACTERISTICS TABLE (Continued) Level of Difficulty
Time (minutes)
Item
Description
P9-8 P9-9
Moderate Moderate
20–30 30–40
P9-10 *P9-11 *P9-12 *P9-13 *P9-14
Retail inventory method. Statement and note disclosure, LCM, and purchase commitment. Lower-of-cost-or-market. Conventional and dollar-value LIFO retail. Retail, LIFO retail, and inventory shortage. Change to LIFO retail. Change to LIFO retail; dollar-value LIFO retail.
Moderate Moderate Moderate Moderate Complex
30–40 30–35 30–40 30–40 40–50
CA9-1 CA9-2 CA9-3 CA9-4 CA9-5 CA9-6
Lower-of-cost-or-market. Lower-of-cost-or-market. Lower-of-cost-or-market. Retail inventory method. Cost determination, LCM, retail method. Purchase commitments.
Moderate Moderate Moderate Moderate Moderate Moderate
15–25 20–30 15–20 25–30 15–25 10–15
SOLUTIONS TO CODIFICATION EXERCISES CE9-1 (a)
According to the Master Glossary, Inventory is defined as the aggregate of those items of tangible personal property that have any of the following characteristics: 1. Held for sale in the ordinary course of business 2. In process of production for such sale 3. To be currently consumed in the production of goods or services to be available for sale. The term inventory embraces goods awaiting sale (the merchandise of a trading concern and the finished goods of a manufacturer), goods in the course of production (work in process), and goods to be consumed directly or indirectly in production (raw materials and supplies). This definition of inventories excludes long-term assets subject to depreciation accounting, or goods which, when put into use, will be so classified. The fact that a depreciable asset is retired from regular use and held for sale does not indicate that the item should be classified as part of the inventory. Raw materials and supplies purchased for production may be used or consumed for the construction of long-term assets or other purposes not related to production, but the fact that inventory items representing a small portion of the total may not be absorbed ultimately in the production process does not require separate classification. By trade practice, operating materials and supplies of certain types of entities such as oil producers are usually treated as inventory.
(b)
According to the Master Glossary, the phrase lower-of-cost-or-market, the term market means current replacement cost (by purchase or by reproduction, as the case may be) provided that it meets both of the following conditions. 1. Market shall not exceed the net realizable value 2. Market shall not be less than net realizable value reduced by an allowance for an approximately normal profit margin.
(c)
According to the Master Glossary, two definitions are provided for the phrase net realizable value 1. Estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal. 2. Valuation of inventories at estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation.
The second definition provides a link to guidance for lower-of-cost-or-market in the agricultural industry (FASB ASC 905-330-35) Growing Crops 35-1 Costs of growing crops shall be accumulated until the time of harvest. Growing crops shall be reported at the lower-of-cost-or-market. > Developing Animals 35-2 Developing animals to be held for sale shall be valued at the lower-of-cost-or-market.
CE9-1 (Continued) > Animals Available and Held for Sale 35-3 Animals held for sale shall be valued at either of the following: (a) The lower-of-cost-or-market (b) At sales price less estimated costs of disposal, if all the following conditions exist: 1. The product has a reliable, readily determinable, and realizable market price. 2. The product has relatively insignificant and predictable costs of disposal. 3. The product is available for immediate delivery. Inventories of harvested crops and livestock held for sale and commonly referred to as valued at market are actually valued at net realizable value. > Harvested Crops 35-4 Inventories of harvested crops shall be valued using the same criteria as animals held for sale in the preceding paragraph.
CE9-2 According to FASB ASC 330-10-35-1 through 5: Adjustments to Lower-of-Cost-or-Market A departure from the cost basis of pricing the inventory is required when the utility of the goods is no longer as great as their cost. Where there is evidence that the utility of goods, in their disposal in the ordinary course of business, will be less than cost, whether due to physical deterioration, obsolescence, changes in price levels, or other causes, the difference shall be recognized as a loss of the current period. This is generally accomplished by stating such goods at a lower level commonly designated as market. Thus, in accounting for inventories, a loss shall be recognized whenever the utility of goods is impaired by damage, deterioration, obsolescence, changes in price levels, or other causes. The measurement of such losses shall be accomplished by applying the rule of pricing inventories at the lower-of-cost-or-market. This provides a practical means of measuring utility and thereby determining the amount of the loss to be recognized and accounted for in the current period. However, utility is indicated primarily by the current cost of replacement of the goods as they would be obtained by purchase or reproduction. In applying the rule, however, judgment must always be exercised and no loss shall be recognized unless the evidence indicates clearly that a loss has been sustained. Replacement or reproduction prices would not be appropriate as a measure of utility when the estimated sales value, reduced by the costs of completion and disposal, is lower, in which case the realizable value so determined more appropriately measures utility. In addition, when the evidence indicates that cost will be recovered with an approximately normal profit upon sale in the ordinary course of business, no loss shall be recognized even though replacement or reproduction costs are lower. This might be true, for example, in the case of production under firm sales contracts at fixed prices, or when a reasonable volume of future orders is assured at stable selling prices. In summary, the determination of the amount of the write-off should be based on factors that relate to the net realizable value of the inventory, not the amount that will maximize the loss in the current period. Note that the sale manager’s proposed accounting is an example of “cookie jar” reserves, as discussed in Chapter 4. By writing the inventory down to an unsupported low value, the company can report higher gross profit and net income in subsequent periods when the inventory is sold.
CE9-3 According to FASB ASC 330-10-35-6, if inventory has been the hedged item in a fair value hedge, the inventory’s cost basis used in the lower-of-cost-or-market accounting shall reflect the effect of the adjustments of its carrying amount made pursuant to paragraph 815-25-35-1(b). And, according to 8152-35-1(b), gains and losses on a qualifying fair value hedge shall be accounted for as follows: The gain or loss (that is, the change in fair value) on the hedged item attributable to the hedged risk shall adjust the carrying amount of the hedged item and be recognized currently in earnings.
CE9-4 See FASB ASC 210-10-S99—Regulation S-X Rule 5-02, Balance Sheets S99-1 The following is the text of Regulation S-X Rule 5-02, Balance Sheets. The purpose of this rule is to indicate the various line items and certain additional disclosures which, if applicable, and except as otherwise permitted by the Commission, should appear on the face of the balance sheets or related notes filed for the persons to whom this article pertains (see § 210.4–01(a)). • ASSETS AND OTHER DEBITS • Current Assets, when appropriate • [See § 210.4–05] • 6. Inventories. – (a) State separately in the balance sheet or in a note thereto, if practicable, the amounts of major classes of inventory such as: • 1. Finished goods; • 2. inventoried cost relating to long-term contracts or programs (see (d) below and § 210.4–05); • 3. work in process (see § 210.4–05); • 4. raw materials; and • 5. supplies. – If the method of calculating a LIFO inventory does not allow for the practical determination of amounts assigned to major classes of inventory, the amounts of those classes may be stated under cost flow assumptions other that LIFO with the excess of such total amount over the aggregate LIFO amount shown as a deduction to arrive at the amount of the LIFO inventory. – (b) The basis of determining the amounts shall be stated. If cost is used to determine any portion of the inventory amounts, the description of this method shall include the nature of the cost elements included in inventory. Elements of cost include, among other items, retained costs representing the excess of manufacturing or production costs over the amounts charged to cost of sales or delivered or in-process units, initial tooling or other deferred startup costs, or general and administrative costs. – The method by which amounts are removed from inventory (e.g., average cost, first-in, firstout, last-in, first-out, estimated average cost per unit) shall be described. If the estimated average cost per unit is used as a basis to determine amounts removed from inventory under a total program or similar basis of accounting, the principal assumptions (including, where meaningful, the aggregate number of units expected to be delivered under the program, the number of units delivered to date and the number of units on order) shall be disclosed.
CE9-4 (Continued) – If any general and administrative costs are charged to inventory, state in a note to the financial statements the aggregate amount of the general and administrative costs incurred in each period and the actual or estimated amount remaining in inventory at the date of each balance sheet. – (c) If the LIFO inventory method is used, the excess of replacement or current cost over stated LIFO value shall, if material, be stated parenthetically or in a note to the financial statements. – (d) For purposes of §§ 210.5–02.3 and 210.5–02.6, long-term contracts or programs include • 1. all contracts or programs for which gross profits are recognized on a percentageof-completion method of accounting or any variant thereof (e.g., delivered unit, cost to cost, physical completion), and • 2. any contracts or programs accounted for on a completed contract basis of accounting where, in either case, the contracts or programs have associated with them material amounts of inventories or unbilled receivables and where such contracts or programs have been or are expected to be performed over a period of more than twelve months. Contracts or programs of shorter duration may also be included, if deemed appropriate. – For all long-term contracts or programs, the following information, if applicable, shall be stated in a note to the financial statements: (i) The aggregate amount of manufacturing or production costs and any related deferred costs (e.g., initial tooling costs) which exceeds the aggregate estimated cost of all inprocess and delivered units on the basis of the estimated average cost of all units expected to be produced under long-term contracts and programs not yet complete, as well as that portion of such amount which would not be absorbed in cost of sales on existing firm orders at the latest balance sheet date. In addition, if practicable, disclose the amount of deferred costs by type of cost (e.g., initial tooling, deferred production, etc.) (ii) The aggregate amount representing claims or other similar items subject to uncertainty concerning their determination or ultimate realization, and include a description of the nature and status of the principal items comprising such aggregate amount. (iii) The amount of progress payments netted against inventory at the date of the balance sheet.
ANSWERS TO QUESTIONS 1. 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. 2. The upper (ceiling) and lower (floor) limits for the value of the inventory are intended to prevent the inventory from being reported at an amount in excess of the net realizable value or at an amount less than the net realizable value less a normal profit margin. The maximum limitation, not to exceed the net realizable value (ceiling) covers obsolete, damaged, or shopworn material and prevents overstatement of inventories and understatement of the loss in the current period. The minimum limitation deters understatement of inventory and overstatement of the loss in the current period. 3. The usual basis for carrying forward the inventory to the next period is cost. Departure from cost is required 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.) 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 reflects 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. The arguments against the use of the lower-of-cost-or-market method of valuing inventories include the following: (a) 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 replacement cost below original cost is no more a sustained loss than a rise above cost is a realized gain. (b) 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-downs 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. (c) 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 the price increases. (d) 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 in one year and at market in the next year. (e) The lower-of-cost-or-market method values the inventory in 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.
Questions Chapter 9 (Continued) (f)
In the application of the lower-of-cost-or-market rule a prospective “normal profit” is used in determining inventory values in certain cases. Since “normal profit” is an estimated figure based upon past experiences (and might not be attained in the future), it is not objective in nature and presents an opportunity for manipulation of the results of operations.
4. The lower-of-cost-or-market rule may be applied directly to each item or to the total of the inventory (or in some cases, to the total of the components of each major category). The method should be the one that most clearly reflects income. The most common practice is to price the inventory on an item-by-item basis. Companies favor the individual item approach because tax requirements require that an individual-item basis be used unless it involves practical difficulties. In addition, the individual item approach gives the most conservative valuation for balance sheet purposes. 5. (1) (2) (3) (4) (5)
$14.50. $16.10. $13.75. $9.70. $15.90.
6. One approach is to record the inventory at cost and then reduce it to market, thereby reflecting a loss in the current period (often referred to as the loss method). The loss would then be shown as a separate item in the income statement and the cost of goods sold for the year would not be distorted by its inclusion. An objection to this method of valuation is that an inconsistency is created between the income statement and balance sheet. In attempting to meet this inconsistency some have advocated the use of a special account to receive the credit for such an inventory write-down, such as Allowance to Reduce Inventory to Market which is a contra account against inventory on the balance sheet. It should be noted that the disposition of this account presents problems to accountants. Another approach is merely to substitute market for cost when pricing the new inventory (often referred to as the cost-of-goods-sold method). Such a procedure increases cost of goods sold by the amount of the loss and fails to reflect this loss separately. For this reason, many theoretical objections can be raised against this procedure. 7. An exception to the normal recognition rule occurs where (1) there is a controlled market with a quoted price applicable to specific commodities and (2) no significant costs of disposal are involved. Certain agricultural products and precious metals which are immediately marketable at quoted prices are often valued at net realizable value (market price). 8. Relative sales value is an appropriate basis for pricing inventory when a group of varying units is purchased at a single lump-sum price (basket purchase). The purchase price must be allocated in some manner or on some basis among the various units. When the units vary in size, character, and attractiveness, the basis for allocation must reflect both quantitative and qualitative aspects. A suitable basis then is the relative sales value of the units that comprise the inventory. 9. The drop in the market price of the commitment should be charged to operations in the current year if it is material in amount. The following entry would be made [($6.20 – $5.90) X 150,000] = $45,000: Unrealized Holding Gain or Loss—Income (Purchase Commitments) ....... Estimated Liability on Purchase Commitments...............................
45,000 45,000
The entry is made because a loss in utility has occurred during the period in which the market decline took place. The account credited in the above entry should be included among the current liabilities on the balance sheet with an appropriate note indicating the nature and extent of the commitment. This liability indicates the minimum obligation on the commitment contract at the present time—the amount that would have to be forfeited in case of breach of contract.
Questions Chapter 9 (Continued) 10. The major uses of the gross profit method are: (1) it provides an approximation of the ending inventory which the auditor might use for testing validity of physical inventory count; (2) it means that a physical count need not be taken every month or quarter; and (3) it helps in determining damages caused by casualty when inventory cannot be counted. 11. Gross profit as a percentage of sales indicates that the markup is based on selling price rather than cost; for this reason the gross profit as a percentage of selling price will always be lower than if based on cost. Conversions are as follows: 25% on cost = 33 1/3% on cost = 33 1/3% on selling price = 60% on selling price =
20% on selling price 25% on selling price 50% on cost 150% on cost
12. A markup of 25% on cost equals a 20% markup on selling price; therefore, gross profit equals $1,000,000 ($5 million X 20%) and net income equals $250,000 [$1,000,000 – (15% X $5 million)]. The following formula was used to compute the 20% markup on selling price: Gross profit on selling price =
Percentage markup on cost .25 = = 20% 100% + Percentage markup on cost 1 + .25
13. Inventory, January 1, 2014 .................................................................... Purchases to February 10, 2014 ............................................................... $1,140,000 Freight-in to February 10, 2014.............................................................. 60,000 Merchandise available ................................................................... Sales revenue to February 10, 2014............................................................ 1,950,000 Less gross profit at 40% .................................................................... 780,000 Sales at cost .............................................................................. Inventory (approximately) at February 10, 2014 .........................
$ 400,000 1,200,000 1,600,000
1,170,000 $ 430,000
14. The validity of the retail inventory method is dependent upon (1) the composition of the inventory remaining approximately the same at the end of the period as it was during the period, and (2) there being approximately the same rate of markup at the end of the year as was used throughout the period. The retail method, though ordinarily applied on a departmental basis, may be appropriate for the business as a unit if the above conditions are met. 15. The conventional retail method is a statistical procedure based on averages whereby inventory figures at retail are reduced to an inventory valuation figure by multiplying the retail figures by a percentage which is the complement of the markup percent. To determine the markup percent, original markups and additional net markups are related to the original cost. The complement of the markup percent so determined is then applied to the inventory at retail after the latter has been reduced by net markdowns, thus in effect achieving a lower-ofcost-or-market valuation. An example of reduction to market follows: Assume purchase of 100 items at $1 each, marked to sell at $1.50 each, at which price 80 were sold. The remaining 20 are marked down to $1.15 each. The inventory at $15.33 is $4.67 below original cost and is valued at an amount which will produce the “normal” 33 1/3% gross profit if sold at the present retail price of $23.00.
Questions Chapter 9 (Continued) Computation of Inventory Purchases Sales revenue Markdowns (20 X $.35) Inventory at retail Inventory at lower-of-cost-or-market $23 X 66 2/3% = $15.33 16. (a)
Cost $100
Retail $150 (120) (7) $ 23
Ratio 66 2/3%
Ending inventory: Cost Beginning inventory .......................................................... Purchases......................................................................... Freight-in .......................................................................... Totals........................................................................ Add net markups...............................................................
$ 149,000 1,400,000 70,000 1,619,000 $1,619,000
Deduct net markdowns ..................................................... Deduct sales revenue ....................................................... Ending inventory, at retail.................................................. Ratio of cost to selling price
$1,619,000
Retail $
283,500 2,160,000
2,443,500 92,000 2,535,500 48,000 2,487,500 2,175,000 $ 312,500
= 63.85%.
$2,535,500 Ending inventory estimated at cost = 64% X $312,500 = $200,000. (b) The retail method, above, showed an ending inventory at retail of $312,500; therefore, merchandise not accounted for amounts to $17,500 ($312,500 – $295,000) at retail and $11,200 ($17,500 X .64) at cost. 17. Information relative to the composition of the inventory (i.e., raw material, work-in-process, and finished goods); the inventory financing where significant or unusual (transactions with related parties, product financing arrangements, firm purchase commitments, involuntary liquidations of LIFO inventories, pledging inventories as collateral); and the inventory costing methods employed (lower-of-cost-or-market, FIFO, LIFO, average cost) should be disclosed. If Deere Company uses LIFO, it should also report the LIFO reserve. 18. Inventory turnover measures how quickly inventory is sold. Generally, the higher the inventory turnover, the better the enterprise is performing. The more times the inventory turns over, the smaller the net margin can be to earn an appropriate total profit and return on assets. For example, a company can price its goods lower if it has a high inventory turnover. A company with a low profit margin, such as 2%, can earn as much as a company with a high net profit margin, such as 40%, if its inventory turnover is often enough. To illustrate, a grocery store with a 2% profit margin can earn as much as a jewelry store with a 40% profit margin and an inventory turnover of 1 if its turnover is more than 20 times. 19. Two major modifications are necessary. First, the beginning inventory should be excluded from the numerator and denominator of the cost-to-retail percentage and second, markdowns should be included in the denominator of the cost-to-retail percentage.
SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 9-1 (a)
Ceiling Floor
(b)
$106.00
(c)
$51.00
$193.00 ($212 – $19) $161.00 ($212 – $19 – $32)
BRIEF EXERCISE 9-2 Item Jokers Penguins Riddlers Scarecrows
Cost $2,000 5,000 4,400 3,200
Designated Market $2,050 4,950 4,550 3,070
LCM $2,000 4,950 4,400 3,070
BRIEF EXERCISE 9-3 (a)
Cost-of-goods-sold method Cost of Goods Sold.................................................. Allowance to Reduce Inventory to Market ....
21,000 21,000*
*($286,000 – $265,000) (b)
Loss method Loss Due to Market Decline of Inventory ............... Allowance to Reduce Inventory to Market ....
21,000 21,000
BRIEF EXERCISE 9-4
Group 1 2 3
Number of CDs 100 800 100
Sales Price per CD $ 5 $10 $15
*$500/$10,000 = 5/100
Total Sales Price $ 500 8,000 1,500 $10,000
Relative Cost Total Sales Allocated Cost Price to CDs 5/100* X $8,000 = $ 400 80/100 X $8,000 = 6,400 15/100 X $8,000 = 1,200 $8,000
Cost per CD $ 4** $ 8 $12
**$400/100 = $4
BRIEF EXERCISE 9-5 Unrealized Holding Loss—Income (Purchase Commitments) .......................................................... Estimated Liability on Purchase Commitments ($1,000,000 – $950,000)...........
50,000 50,000
BRIEF EXERCISE 9-6 Purchases (Inventory)................................................. Estimated Liability on Purchase Commitments ........ Cash ....................................................................
950,000 50,000 1,000,000
BRIEF EXERCISE 9-7 Beginning inventory................................................... Purchases ................................................................... Cost of goods available ............................................. Sales revenue ............................................................. Less gross profit (35% X 700,000)............................. Estimated cost of goods sold.................................... Estimated ending inventory destroyed in fire ..........
$150,000 500,000 650,000 $700,000 245,000 455,000 $195,000
BRIEF EXERCISE 9-8
Beginning inventory............................................. Net purchases ...................................................... Net markups ......................................................... Totals .................................................................... Deduct: Net markdowns .................................................... Sales revenue ....................................................... Ending inventory at retail ....................................
Cost $ 12,000 120,000 $132,000
Retail $ 20,000 170,000 10,000 200,000 7,000 147,000 $ 46,000
Cost-to-retail ratio: $132,000 ÷ $200,000 = 66% Ending inventory at lower-of cost-or-market (66% X $46,000) = $30,360
BRIEF EXERCISE 9-9 Inventory turnover: $9,275
= 5.73 times
$1,615 + $1,620 2 Average days to sell inventory: 365 ÷ 5.73 = 63.7 days
*BRIEF EXERCISE 9-10
Beginning inventory.............................................. Net purchases........................................................ Net markups........................................................... Net markdowns...................................................... Total (excluding beginning inventory) ................. Total (including beginning inventory).................. Deduct: Sales revenue ......................................... Ending inventory at retail......................................
Cost $ 12,000 120,000 120,000 $132,000
Retail $ 20,000 170,000 10,000 (7,000) 173,000 193,000 147,000 $ 46,000
Cost-to-retail ratio: $120,000 ÷ $173,000 = 69.4% Ending inventory at cost $20,000 X 60% ($12,000/$20,000) = $12,000 26,000 X 69.4% = 18,044 $46,000 $30,044
*BRIEF EXERCISE 9-11
Beginning inventory.............................................. Net purchases........................................................ Net markups........................................................... Net markdowns...................................................... Total (excluding beginning inventory) ................. Total (including beginning inventory).................. Deduct: Sales revenue ......................................... Ending inventory at retail......................................
Cost $ 12,000 120,000 120,000 $132,000
Retail $ 20,000 170,000 10,000 (7,000) 173,000 193,000 147,000 $ 46,000
*BRIEF EXERCISE 9-11 (Continued) Cost-to-retail ratio: $120,000 ÷ $173,000 = 69.4% Ending inventory at retail deflated to base year prices $46,000 ÷ 1.15 = $40,000 Ending inventory at cost $20,000 X 100% X 60% = $12,000 20,000 X 115% X 69.4% = 15,962 $27,962
SOLUTIONS TO EXERCISES EXERCISE 9-1 (15–20 minutes) Per Unit Part No. 110 111 112 113 120 121 122 Totals
Quantity 600 1,000 500 200 400 1,600 300
(a)
$330,820.
(b)
$340,020.
Cost $ 90 60 80 170 205 16 240
Market $100.00 52.00 76.00 180.00 208.00 0.20 235.00
Total Cost $ 54,000 60,000 40,000 34,000 82,000 25,600 72,000 $367,600
Total Market $ 60,000 52,000 38,000 36,000 83,200 320 70,500 $340,020
Lower-ofCost-orMarket $ 54,000 52,000 38,000 34,000 82,000 320 70,500 $330,820
EXERCISE 9-2 (10–15 minutes)
Item D E F G H I
Net Realizable Value (Ceiling) $90* 80 65 65 80 60
Net Realizable Value Less Normal Profit (Floor) $70** 60 45 45 60 40
Replacement Cost $120 72 70 30 70 30
Designated Market $90 72 65 45 70 40
Cost $75 80 80 80 50 36
LCM $75 72 65 45 50 36
*Estimated selling price – Estimated selling expense = $120 – $30 = $90. **Net realizable value – Normal profit margin = $90 – $20 = $70.
EXERCISE 9-3 (15–20 minutes)
Item No.
Cost per Unit
Replacement Cost
Net Realizable Value
1320 1333 1426 1437 1510 1522 1573 1626
$3.20 2.70 4.50 3.60 2.25 3.00 1.80 4.70
$3.00 2.30 3.70 3.10 2.00 2.70 1.60 5.20
$4.15* 3.00 4.60 2.95 2.45 3.40 1.75 5.50
Net Real. Value Less Normal Profit
Designated Market Value
Quantity
$2.90** 2.50 3.60 2.05 1.85 2.90 1.25 4.50
$3.00 2.50 3.70 2.95 2.00 2.90 1.60 5.20
1,200 900 800 1,000 700 500 3,000 1,000
Final Inventory Value $ 3,600 2,250 2,960 2,950 1,400 1,450 4,800 4,700*** $24,110
*$4.50 – $.35 = $4.15. **$4.15 – $1.25 = $2.90. ***Cost is used because it is lower than designated market value. EXERCISE 9-4 (10–15 minutes) (a)
12/31/13 12/31/13
(b)
12/31/14
12/31/14
Cost of Goods Sold............................... 19,000 Inventory.......................................
19,000
Cost of Goods Sold............................... 15,000 Inventory.......................................
15,000
Loss Due to Market Decline of Inventory............................................. Allowance to Reduce Inventory to Market....................................
19,000
Allowance to Reduce Inventory to Market............................................. Loss Due to Market Decline of Inventory ...............................
19,000
4,000* 4,000
EXERCISE 9-4 (Continued) *Cost of inventory at 12/31/13 Lower of cost or market at 12/31/13 Allowance amount needed to reduce inventory to market (a)
$346,000 (327,000)
Cost of inventory at 12/31/14 Lower of cost or market at 12/31/14 Allowance amount needed to reduce inventory to market (b)
$410,000 (395,000)
Recovery of previously recognized loss
(c)
$ 19,000
$ 15,000
= (a) – (b) = $19,000 – $15,000 = $4,000.
Both methods of recording lower-of-cost-or-market adjustments have the same effect on net income.
EXERCISE 9-5 (20–25 minutes) (a) Sales revenue Cost of goods sold Inventory, beginning Purchases Cost of goods available Inventory, ending Cost of goods sold Gross profit Gain (loss) due to market fluctuations of inventory*
February $29,000
March $35,000
April $40,000
15,000 20,000 35,000 15,100 19,900 9,100
15,100 24,000 39,100 17,000 22,100 12,900
17,000 26,500 43,500 13,000 30,500 9,500
(2,000) $ 7,100
1,100 $14,000
700 $10,200
EXERCISE 9-5 (Continued) *
Jan. 31
Feb. 28
Mar. 31
Apr. 30
Inventory at cost Inventory at the lower-of-costor-market Allowance amount needed to reduce inventory to market Gain (loss) due to market fluctuations of inventory**
$15,000
$15,100
$17,000
$13,000
14,500
12,600
15,600
12,300
$
$ 2,500
$ 1,400
$
700
$ (2,000)
$ 1,100
$
700
Loss Due to Market Decline of Inventory .... Allowance to Reduce Inventory to Market............................................
500
Loss Due to Market Decline of Inventory .... Allowance to Reduce Inventory to Market............................................
2,000
Allowance to Reduce Inventory to Market.... Recovery of Loss Due to Market Decline of Inventory..........................
1,100
Allowance to Reduce Inventory to Market.... Recovery of Loss Due to Market Decline of Inventory..........................
700
500
**$500 – $2,500 = $(2,000) $2,500 – $1,400 = $1,100 $1,400 – $700 = $700
(b)
Jan. 31
Feb. 28
Mar. 31
Apr. 30
500
2,000
1,100
700
EXERCISE 9-6 Net realizable value (ceiling) Net realizable value less normal profit (floor) Replacement cost Designated market Cost Lower-of-cost-or-market
$45 – $14 = $31 $31 – $ 9 = $22 $35 $31 Ceiling $40 $31
$35 figure used – $31 correct value per unit = $4 per unit. $4 X 1,000 units = $4,000. If ending inventory is overstated, net income will be overstated. If beginning inventory is overstated, net income will be understated. Therefore, net income for 2013 was overstated by $4,000 and net income for 2014 was understated by $4,000.
Total Cost
Cost Allocated to Lots
Cost Per Lot (Cost Allocated/ No. of Lots)
Sales Price Per Lot
Group 1
9
$3,000
$ 27,000
$27,000/$127,800 X $89,460
$18,900
$2,100
Group 2
15
4,000
60,000
$60,000/$127,800 X
89,460
42,000
2,800
Group 3
17
2,400
40,800
$40,800/$127,800 X
89,460
28,560
1,680
Relative Sales Price
$127,800
$89,460
Sales revenue (see schedule)
$80,000
Cost of goods sold (see schedule)
56,000
Gross profit
24,000
Operating expenses
18,200
Net income
$ 5,800
Number of Lots Sold*
Cost Per Lot
Cost of Lots Sold
Sales
Gross Profit
Group 1
4
$2,100
$ 8,400
$12,000
$ 3,600
Group 2
8
2,800
22,400
32,000
9,600
Group 3
15
1,680
25,200
36,000
10,800
Total
27
$56,000
$80,000
$24,000
* 9–5=4 15 – 7 = 8 17 – 2 = 15
EXERCISE 9-7 (15–20 minutes)
No. of Lots
Total Sales Price
Total Sales Price
Relative Sales Price
Total Cost
Cost Allocated to Chairs
No. of Chairs
Cost per Chair
Lounge chairs
400
$90
$36,000
$36,000/$95,000
X $59,850
$22,680
$56.70
Armchairs
300
80
24,000
$24,000/$95,000
X
59,850
15,120
50.40
Straight chairs
700
50
35,000
$35,000/$95,000
X
59,850
22,050
31.50
$95,000
$59,850
Chairs
Number of Chairs Sold
Cost per Chair
Cost of Chairs Sold
Sales
Gross Profit
Lounge chairs
200
$56.70
$11,340
$18,000
$ 6,660
Armchairs
100
50.40
5,040
8,000
2,960
Straight chairs
120
31.50
3,780
6,000
2,220
$20,160
$32,000
$11,840
Inventory of straight chairs (700 – 120) X $31.50 = $18,270
EXERCISE 9-8 (12–17 minutes)
Chairs
Sales Price per Lot
EXERCISE 9-9 (5–10 minutes) Unrealized Holding Gain or Loss—Income (Purchase Commitments) ................................. Estimated Liability on Purchase Commitments ($400,000 – $365,000) .......
35,000 35,000
EXERCISE 9-10 (15–20 minutes) (a)
If the commitment is material in amount, there should be a footnote in the balance sheet stating the nature and extent of the commitment. The footnote may also disclose the market price of the materials. The excess of market price over contracted price is a gain contingency which per FASB Statement No. 5 cannot be recognized in the accounts until it is realized.
(b)
The drop in the market price of the commitment should be charged to operations in the current year if it is material in amount. The following entry would be made: Unrealized Holding Gain or Loss—Income (Purchase Commitments) .......................................... 10,800 Estimated Liability on Purchase Commitments [$36,000 X ($3.00 – $2.70)] ...
10,800
The entry is made because a loss in utility has occurred during the period in which the market decline took place. The account credited in the above entry should be included among the current liabilities on the balance sheet, with an appropriate footnote indicating the nature and extent of the commitment. This liability indicates the minimum obligation on the commitment contract at the present time—the amount that would have to be forfeited in case of breach of contract. (c)
Assuming the $10,800 market decline entry was made on December 31, 2014, as indicated in (b), the entry when the materials are received in January 2015 would be: Raw Materials ............................................................ Estimated Liability on Purchase Commitments ..... Accounts Payable ............................................
97,200 10,800 108,000
EXERCISE 9-10 (Continued) This entry records the raw materials at the actual cost, eliminates the $10,800 liability set up at December 31, 2014, and records the contractual liability for the purchase. This permits operations to be charged this year with the $97,200, the other $10,800 of the cost having been charged to operations in 2014. EXERCISE 9-11 (8–13 minutes) 1.
20%
= 16.67% OR 16 2/3%.
100% + 20% 2.
25% 100% + 25%
3.
33 1/3% = 25%. 100% + 33 1/3%
4.
50%
= 20%.
= 33.33% OR 33 1/3%.
100% + 50% EXERCISE 9-12 (10–15 minutes) (a)
Inventory, May 1 (at cost) Purchases (at cost) Purchase discounts Freight-in Goods available (at cost) Sales revenue (at selling price) Sales returns (at selling price) Net sales (at selling price) Less: Gross profit (30% of $930,000) Net sales (at cost)
$160,000 640,000 (12,000) 30,000 818,000 $1,000,000 (70,000) 930,000 279,000
Approximate inventory, May 31 (at cost)
651,000 $167,000
EXERCISE 9-12 (Continued) (b) Gross profit as a percent of sales must be computed: 30% = 23.08% of sales. 100% + 30% Inventory, May 1 (at cost) Purchases (at cost) Purchase discounts Freight-in Goods available (at cost) Sales revenue (at selling price) $1,000,000 Sales returns (at selling price) (70,000) Net sales (at selling price) 930,000 Less: Gross profit (23.08% of $930,000) 214,644 Net sales (at cost) Approximate inventory, May 31 (at cost)
$160,000 640,000 (12,000) 30,000 818,000
715,356 $102,644
EXERCISE 9-13 (15–20 minutes) (a)
Merchandise on hand, January 1 Purchases Less: Purchase returns and allowances Freight-in Total merchandise available (at cost) Cost of goods sold* Ending inventory Less: Undamaged goods Estimated fire loss *Gross profit =
33 1/3%
= 25% of sales.
100% + 33 1/3% Cost of goods sold = 75% of sales of $100,000 = $75,000.
$ 38,000 72,000 (2,400) 3,400 111,000 75,000 36,000 10,900 $ 25,100
EXERCISE 9-13 (Continued) (b)
Cost of goods sold = 66 2/3% of sales of $100,000 = $66,667 Total merchandise available (at cost) [$111,000 (as computed above) – $66,667] Less: Undamaged goods Estimated fire loss
$44,333 10,900 $33,433
EXERCISE 9-14 Beginning inventory Purchases Purchase returns Goods available (at cost) Sales revenue Sales returns Net sales Less: Gross profit (40% X $626,000) Estimated ending inventory (unadjusted for damage) Less: Goods on hand—undamaged (at cost) $21,000 X (1 – 40%) Less: Goods on hand—damaged (at net realizable value) Fire loss on inventory
$170,000 390,000 560,000 (30,000) 530,000 $650,000 (24,000) 626,000 (250,400)
375,600 154,400 (12,600) (5,300) $136,500
EXERCISE 9-15 (10–15 minutes) Beginning inventory (at cost) Purchases (at cost) Goods available (at cost) Sales revenue (at selling price) Less sales returns Net sales Less: Gross profit* (2/7 of $112,000) Net sales (at cost) Estimated inventory (at cost) Less: Goods on hand ($30,500 – $6,000) Claim against insurance company 40%
*Computation of gross profit:
$ 38,000 85,000 123,000 $116,000 4,000 112,000 32,000 80,000 43,000 24,500 $ 18,500
= 2/7 of selling price
100% + 40% Note: Depending on details of the consignment agreement and Duncan’s insurance policy, the consigned goods might be considered owned for insurance purposes.
EXERCISE 9-16 (15–20 minutes)
Inventory 1/1/14 (cost) Purchases to 8/18/14 (cost) Cost of goods available Deduct cost of goods sold* Inventory 8/18/14
Lumber
Millwork
Hardware
$ 250,000 1,500,000 1,750,000 1,664,000 $ 86,000
$ 90,000 375,000 465,000 410,000 $ 55,000
$ 45,000 160,000 205,000 150,000 $ 55,000
*(See computations on next page)
EXERCISE 9-16 (Continued) Computation for cost of goods sold:* Lumber:
$2,080,000 = $1,664,000 1.25
Millwork:
$533,000 1.30
= $410,000
Hardware:
$210,000 1.40
= $150,000
*Alternative computation for cost of goods sold: Markup on selling price:
Cost of goods sold:
Lumber:
25% = 20% or 1/5 100% + 25%
$2,080,000 X 80% = $1,664,000
Millwork:
30% = 3/13 100% + 30%
$533,000 X 10/13 = $410,000
Hardware:
40% = 2/7 100% + 40%
$210,000 X 5/7 = $150,000
EXERCISE 9-17 (20–25 minutes) Ending inventory: (a)
Gross profit is 45% of sales Total goods available for sale (at cost) Sales (at selling price) Less: Gross profit (45% of sales) Sales (at cost) Ending inventory (at cost)
(b)
$2,100,000 $2,500,000 1,125,000 1,375,000 $ 725,000
Gross profit is 60% of cost 60% = 37.5% markup on selling price 100% + 60% Total goods available for sale (at cost) Sales (at selling price) Less: Gross profit (37.5% of sales) Sales (at cost) Ending inventory (at cost)
(c)
$2,100,000 $2,500,000 937,500 1,562,500 $ 537,500
Gross profit is 35% of sales Total goods available for sale (at cost) Sales (at selling price) Less: Gross profit (35% of sales) Sales (at cost) Ending inventory (at cost)
$2,100,000 $2,500,000 875,000 1,625,000 $ 475,000
EXERCISE 9-17 (Continued) (d)
Gross profit is 25% of cost 25% = 20% markup on selling price 100% + 25% Total goods available for sale (at cost) Sales (at selling price) Less: Gross profit (20% of sales) Sales (at cost) Ending inventory (at cost)
$2,100,000 $2,500,000 500,000 2,000,000 $ 100,000
EXERCISE 9-18 (20–25 minutes) (a) Beginning inventory Purchases Net markups Totals Net markdowns Sales price of goods available Deduct: Sales revenue Ending inventory at retail
(b)
1. 2. 3. 4.
$180,000 ÷ $300,000 = 60% $180,000 ÷ $273,865 = 65.73% $180,000 ÷ $310,345 = 58% $180,000 ÷ $284,210 = 63.33%
Cost $ 58,000 122,000 $180,000
Retail $100,000 200,000 10,345 310,345 (26,135) 284,210 186,000 $ 98,210
EXERCISE 9-18 (Continued) (c)
1. 2. 3.
Method 3. Method 3. Method 3.
(d)
58% X $98,210 = $56,962
(e)
$180,000 – $56,962 = $123,038
(f)
$186,000 – $123,038 = $62,962
EXERCISE 9-19 (12–17 minutes) Beginning inventory Purchases Totals Add: Net markups Markups Markup cancellations Totals
Cost $ 200,000 1,375,000 1,575,000 $95,000 (15,000) $1,575,000
Deduct: Net markdowns Markdowns Markdowns cancellations Sales price of goods available Deduct: Sales revenue Ending inventory at retail Cost-to-retail ratio =
$1,575,000
Retail $ 280,000 2,140,000 2,420,000
35,000 (5,000)
= 63%
$2,500,000 Ending inventory at cost = 63% X $270,000 = $170,100
80,000 2,500,000
30,000 2,470,000 2,200,000 $ 270,000
EXERCISE 9-20 (20–25 minutes) Cost $30,000 48,000 (2,000) 2,400 78,400
Beginning inventory Purchases Purchase returns Freight on purchases Totals Add: Net markups Markups Markup cancellations Net markups Totals
Retail $ 46,500 88,000 (3,000) 131,500 $10,000 (1,500) 8,500 140,000
$78,400
Deduct: Net markdowns Markdowns Markdowns cancellations Net markdowns Sales price of goods available Deduct: Net sales ($99,000 – $2,000) Ending inventory, at retail Cost-to-retail ratio =
$78,400
9,300 (2,800) 6,500 133,500 97,000 $ 36,500 = 56%
$140,000 Ending inventory at cost = 56% X $36,500 = $20,440
EXERCISE 9-21 (10–15 minutes) (a)
(b)
Inventory turnover: 2012 $10,436 = 5.7 times $1,870 + $1,803 2 Average days to sell inventory: 2012 365 ÷ 5.7 = 64 days
2011 $9,390
= 5.5 times
$1,803 + $1,598 2
2011 365 ÷ 5.5 = 66 days
*EXERCISE 9-22 (25–35 minutes) (a)
Conventional Retail Method Cost $ 38,100 130,900 169,000
Inventory, January 1, 2013 Purchases (net) Add: Net markups Totals Deduct: Net markdowns Sales price of goods available Deduct: Sales (net) Ending inventory at retail Cost-to-retail ratio =
$169,000
$169,000
Retail $ 60,000 178,000 238,000 22,000 260,000 13,000 247,000 167,000 $ 80,000
= 65%
$260,000 Ending inventory at cost = 65% X $80,000 = $52,000 (b)
LIFO Retail Method Inventory, January 1, 2013 Net purchases Net markups Net markdowns Total (excluding beginning inventory) Total (including beginning inventory) Deduct sales (net) Ending inventory at retail Cost-to-retail ratio =
$130,900 $187,000
= 70%
Cost $ 38,100 130,900 130,900 $169,000
Retail $ 60,000 178,000 22,000 (13,000) 187,000 247,000 167,000 $ 80,000
*EXERCISE 9-22 (Continued) Computation of ending inventory at LIFO cost, 2014: Ending Inventory at Retail Prices
Layers at Retail Prices
$80,000
2013 $60,000 2014 20,000
*$38,100 $60,000
Cost to Retail (Percentage)
Ending Inventory at LIFO Cost
63.5%* 70.0%
$38,100 14,000 $52,100
Cost $14,000 58,800 7,500
Retail $ 20,000 81,000
X X
(prior years cost to retail)
*EXERCISE 9-23 (15–20 minutes) (a) Inventory, January 1, 2014 Net purchases Freight-in Net markups Totals Sales revenue Net markdowns Estimated theft Ending inventory at retail Cost-to-retail ratio:
$80,300
$80,300
9,000 110,000 (80,000) (1,600) (2,000) $ 26,400
= 73%
$110,000 Ending inventory at lower-of-average-cost-or-market = $26,400 X 73% = $19,272
*EXERCISE 9-23 (Continued) (b)
Cost $58,800 7,500
Purchases Freight-in Net markups Net markdowns Totals Cost-to-retail ratio:
Retail $81,000 9,000 (1,600) $88,400
$66,300 $66,300
= 75%
$88,400 The increment at retail is $26,400 – $20,000 = $6,400. The increment is costed at 75% X $6,400 = $4,800. Ending inventory at LIFO retail: Beginning inventory, 2014 Increment Ending inventory, 2014
Cost $14,000 4,800 $18,800
Retail $20,000 6,400 $26,400
*EXERCISE 9-24 (10–15 minutes) (a)
Cost-to-retail ratio—beginning inventory:
$216,000
= 72%
$300,000 *($294,300 ÷ 1.09) X 72% = $194,400 *Since the above computation reveals that the inventory quantity has declined below the beginning level, it is necessary to convert the ending inventory to beginning-of-the-year prices (by dividing by 1.09) and then multiply it by the beginning cost-to-retail ratio (72%).
*EXERCISE 9-24 (Continued) (b)
Ending inventory at retail prices deflated $365,150 ÷ 1.09 $335,000 Beginning inventory at beginning-of-year prices 300,000 Inventory increase in terms of beginning-of-year dollars $ 35,000 Beginning inventory (at cost) Additional layer, $35,000 X 1.09 X 76%*
$216,000 28,994 $244,994
*($364,800 ÷ $480,000) *EXERCISE 9-25 (5–10 minutes) Ending inventory at retail (deflated) $100,100 ÷ 1.10 Beginning inventory at retail Increment at retail Ending inventory on LIFO basis First layer Second layer ($16,500 X 1.10 X 60%)
$91,000 74,500 $16,500 Cost $36,000 10,890 $46,890
*EXERCISE 9-26 (20–25 minutes) (a) Beginning inventory Net purchases Net markups Totals Net markdowns Sales revenue Ending inventory at retail
Cost $ 30,100 108,500 $138,600
Cost-retail ratio = 66% ($138,600/$210,000) Ending inventory at cost ($78,100 X 66%) (b)
Cost $ 30,100 108,500
Beginning inventory Net purchases Net markups Net markdowns Total (excluding beginning inventory) 108,500 Total (including beginning inventory) $138,600 Sales revenue Ending inventory at retail (current) Ending inventory at retail (base year) ($78,100 ÷ 1.10) Cost-to-retail ratio for new layer: $108,500/$155,000 = 70% Layers: Base layer $50,000 X 1.00 X 60.2%* = New layer ($71,000 – $50,000) X 1.10 X 70% =
Retail $ 50,000 150,000 10,000 210,000 (5,000) (126,900) $ 78,100
$ 51,546 Retail $ 50,000 150,000 10,000 (5,000) 155,000 205,000 (126,900) 78,100 $ 71,000
$ 30,100 16,170 $ 46,270
*($30,100/$50,000) (c)
Cost of goods available for sale Ending inventory at cost, from (b) Cost of goods sold
$138,600 46,270 $ 92,330
*EXERCISE 9-27 (20–25 minutes) 2013
Restate to base-year retail ($118,720 ÷ 1.06)
$112,000
Layers: 1. $100,000 X 1.00 X 54%* = 2. $ 12,000 X 1.06 X 57% = Ending inventory
$ 54,000 7,250 $ 61,250
*$54,000 ÷ $100,000 2014
2015
2016
Restate to base-year retail ($138,750 ÷ 1.11)
$125,000
Layers: 1. $100,000 X 1.00 X 54% = 2. $ 12,000 X 1.06 X 57% = 3. $ 13,000 X 1.11 X 60% = Ending inventory
$ 54,000 7,250 8,658 $ 69,908
Restate to base-year retail ($125,350 ÷ 1.15)
$109,000
Layers: 1. $100,000 X 1.00 X 54% = 2. $ 9,000 X 1.06 X 57% = Ending inventory
$ 54,000 5,438 $ 59,438
Restate to base-year retail ($162,500 ÷ 1.25)
$130,000
Layers: 1. $100,000 X 1.00 X 54% = 2. $ 9,000 X 1.06 X 57% = 3. $ 21,000 X 1.25 X 58% = Ending inventory
$ 54,000 5,438 15,225 $ 74,663
*EXERCISE 9-28 (5–10 minutes) Inventory (beginning)................................................ Adjustment to Record Inventory at Cost*....... ($212,600 – $205,000)
7,600 7,600
*Note: This account is an income statement account showing the effect of changing from a lower-of-cost-or-market approach to a straight cost basis.
TIME AND PURPOSE OF PROBLEMS Problem 9-1 (Time 10–15 minutes) Purpose—to provide the student with an understanding of the lower-of-cost-or-market approach to inventory valuation, similar to Problem 9-2. The major difference between these problems is that Problem 9-1 provides some ambiguity to the situation by changing the catalog prices near the end of the year. Problem 9-2 (Time 25–30 minutes) Purpose—to provide the student with an understanding of the lower-of-cost-or-market approach to inventory valuation. The student is required to examine a number of individual items and apply the lower-of-cost-or-market rule and to also explain the use and value of the lower-of-cost-or-market rule. Problem 9-3 (Time 30–35 minutes) Purpose—to provide a problem that requires entries for reducing inventory to lower-of-cost-or-market under the perpetual inventory system using both the cost-of-goods-sold and the loss methods. Problem 9-4 (Time 20–30 minutes) Purpose—to provide another problem where a fire loss must be computed using the gross profit method. Certain goods remained undamaged and therefore an adjustment is necessary. In addition, the inventory was subject to an obsolescence factor which must be considered. Problem 9-5 (Time 40–45 minutes) Purpose—to provide the student with a complex problem involving a fire loss where the gross profit method must be employed. The problem is complicated because a number of adjustments must be made to the purchases account related to merchandise returned, unrecorded purchases, and shipments in transit. In addition, some cash to accrual computations are necessary. Problem 9-6 (Time 20–30 minutes) Purpose—to provide the student with a problem on the retail inventory method. The problem is relatively straightforward although transfers-in from other departments as well as the proper treatment for normal spoilage complicate the problem. A good problem that summarizes the essentials of the retail inventory method. Problem 9-7 (Time 20–30 minutes) Purpose—to provide the student with a problem on the retail inventory method. This problem is similar to Problem 9-6, except that a few different items must be evaluated in finding ending inventory at retail and cost. Unusual items in this problem are employee discounts granted and loss from breakage. A good problem that summarizes the essentials of the retail inventory method. Problem 9-8 (Time 20–30 minutes) Purpose—to provide the student with a problem on the retail inventory method. This problem is similar to Problems 9-6 and 9-7, except that the student is asked to list the factors that may have caused the difference between the computed inventory and the physical count. Problem 9-9 (Time 30–40 minutes) Purpose—to provide the student with a problem requiring financial statement and note disclosure of inventories, the income statement disclosure of an inventory market decline, and the treatment of purchase commitments. Problem 9-10 (Time 30–40 minutes) Purpose—to provide the student with an opportunity to write a memo explaining what is designated market value and how it is computed. As part of this memo, the student is required to compute inventory on the lower-of-cost-or-market basis using the individual item approach.
Time and Purpose of Problems (Continued) *Problem 9-11 (Time 30–35 minutes) Purpose—to provide the student with a retail inventory problem where both the conventional retail and dollar-value LIFO method must be computed. An excellent problem for highlighting the difference between these two approaches to inventory valuation. It should be noted that the cost-to-retail percentage is given for LIFO so less computation is necessary. *Problem 9-12 (Time 30–40 minutes) Purpose—to provide the student with a comprehensive problem covering the retail and LIFO retail inventory methods, the computation of an inventory shortage, and the treatment of four special items relative to the retail inventory method. *Problem 9-13 (Time 30–40 minutes) Purpose—to provide the student with a basic problem illustrating the change from conventional retail to LIFO retail. This problem emphasizes many of the same issues as Problem 9-11, except that a dollarvalue LIFO computation is not needed. A good problem for providing the essential issues related to a change to LIFO retail. *Problem 9-14 (Time 40–50 minutes) Purpose—to provide the student with a retail inventory problem where both the conventional retail and dollar-value LIFO method must be computed. The problem is similar to Problem 9-10, except that the problem involves a three-year period which adds complexity to the problem. This problem provides an excellent summary of the essential elements related to the change of the retail inventory method from conventional retail to LIFO retail and dollar-value LIFO retail.
SOLUTIONS TO PROBLEMS PROBLEM 9-1
Item
Cost
Replacement Cost
Ceiling*
Floor**
A B C D
$470 450 830 960
$ 460 430 610 1,000
$ 450 480 820 1,070
$350 372 640 830
Designated Market $
450 430 640 1,000
Lower-ofCost-orMarket $450 430 640 960
*Ceiling = 2015 catalog selling price less sales commissions and estimated other costs of disposal. (2015 catalog prices are in effect as of 12/01/14.) **Floor = Ceiling less (20% X 2015 catalog selling price).
PROBLEM 9-2
(a)
1.
The balance in the Allowance to Reduce Inventory to Market at May 31, 2014, should be $34,600, as calculated in Exhibit 1 below. Exhibit 1 CALCULATIONS OF PROPER BALANCE in the Allowance to Reduce Inventory to Market At May 31, 2014
Cost
Replacement Cost
NRV (Ceiling)
NRV less normal profit (Floor)
Aluminum siding
$ 70,000
$ 62,500
$ 56,000
$ 50,900
$ 56,000
Cedar shake siding
86,000
79,400
84,800
77,400
79,400
Louvered glass doors
112,000
124,000
168,300
149,800
112,000
Thermal windows
140,000
126,000
140,000
124,600
126,000
Totals
$408,000
$391,900
$449,100
$402,700
$373,400
Inventory cost
$408,000
LCM valuation
373,400
Allowance at May 31, 2014
$ 34,600
LCM
2. For the fiscal year ended May 31, 2014, the loss that would be recorded due to the change in the Allowance to Reduce Inventory to Market would be $7,100, as calculated below. Balance prior to adjustment................................ Required balance ................................................. Loss to be recorded.............................................
$27,500 (34,600) $( 7,100)
PROBLEM 9-2 (Continued) (b)
The use of the lower-of-cost-or-market (LCM) rule is based on both the expense recognition principle and the concept of conservatism. The expense recognition principle applies because the application of the LCM rule allows for the recognition of a decline in the utility (value) of inventory as a loss in the period in which the decline takes place. The departure from the historical cost principle for inventory valuation is permitted on the basis of conservatism. The general rule is that the historical cost principle is abandoned when the future utility of an asset is no longer as great as its original cost.
PROBLEM 9-3
(a)
(b)
12/31/14 (Cost-of-Goods-Sold Method) Cost of Goods Sold .................................................. 68,000 Allowance to Reduce Inventory to Market ($780,000 – $712,000) ...................................
68,000
12/31/15 Cost of Goods Sold .................................................. Allowance to Reduce Inventory to Market ($905,000 – $830,000) ...................................
75,000
12/31/14 (Loss Method) To write down inventory to market: Loss Due to Market Decline of Inventory ............... Allowance to Reduce Inventory to Market..... 12/31/15 To write down inventory to market: Loss Due to Market Decline of Inventory ............... Allowance to Reduce Inventory to Market [($905,000 – $830,000) – $68,000] ................
75,000
68,000 68,000
7,000 7,000
PROBLEM 9-4
Beginning inventory..................................................... Purchases..................................................................... Purchase returns.......................................................... Total goods available................................................... Sales revenue ............................................................... Sales returns ................................................................ Net sales ....................................................................... Less: Gross profit (35% of $394,000) ......................... Ending inventory (unadjusted for damage)................ Less: Goods on hand—undamaged ($30,000 X [1 – 35%])......................................... Inventory damaged ...................................................... Less: Salvage value of damaged inventory............... Fire loss on inventory ..................................................
$ 80,000 290,000 370,000 (28,000) 342,000 $415,000 (21,000) 394,000 137,900
(256,100) 85,900 19,500 66,400 8,150 $ 58,250
PROBLEM 9-5
STANISLAW CORPORATION Computation of Inventory Fire Loss April 15, 2015 Inventory, 1/1/15 ........................................... Purchases, 1/1/ – 3/31/15.............................. April merchandise shipments paid ............. Unrecorded purchases on account............. Total .................................................... Less: Shipments in transit.......................... Merchandise returned ...................... Merchandise available for sale .................... Less estimated cost of sales: Sales revenue, 1/1/ – 3/31/15 ............. Sales revenue, 4/1/ – 4/15/15 Receivables acknowledged at 4/15/15.................................... Estimated receivables not acknowledged ........................... Total .............................................. Add collections, 4/1/ – 4/15/15 ($12,950 – $950)............................... Total .............................................. Less receivables, 3/31/15 .................. Total sales 1/1/ – 4/15/15.............. Less gross profit (45%* X $161,000) ........... Estimated merchandise inventory .............. Less: Sale of salvaged inventory ............... Inventory fire loss.........................................
$ 75,000 52,000 3,400 15,600 146,000 $
2,300 950
3,250 142,750
135,000 $46,000 8,000 54,000 12,000 66,000 40,000
26,000 161,000 72,450
88,550 54,200 3,500 $ 50,700
PROBLEM 9-5 (Continued) *Computation of Gross Profit Rate Net sales, 2013 ................................................ Net sales, 2014 ................................................ Total net sales....................................... Beginning inventory........................................ Net purchases, 2013........................................ Net purchases, 2014........................................ Total ....................................................... Less: Ending inventory.................................. Gross profit .......................................... Gross profit rate ($414,000 ÷ $920,000) .........
$390,000 530,000 920,000 $ 66,000 235,000 280,000 581,000 75,000
506,000 $414,000 45%
PROBLEM 9-6
(a) Beginning inventory........................... Purchases ........................................... Freight-in............................................. Purchase returns................................ Transfers in from suburban branch ............................. Totals ......................................... Net markups .......................................
Cost $ 17,000 82,500 7,000 (2,300)
Retail $ 25,000 137,000
9,200 $113,400
13,000 172,000 8,000 180,000 (4,000)
Net markdowns................................... Sales revenue ..................................... Sales returns ...................................... Inventory losses due to breakage..... Ending inventory at retail .................. Cost-to-retail ratio =
$113,400
(3,000)
$(95,000) 2,400
(92,600) (400) $ 83,000
= 63%
$180,000 (b)
Ending inventory at lower-of-average-cost-or-market (63% of $83,000) ..............................
$ 52,290
PROBLEM 9-7
Beginning inventory.......................... Purchases.......................................... Purchase returns............................... Purchase discounts .......................... Freight-in ........................................... Markups ............................................. Markup cancellations........................ Totals ........................................ Markdowns ........................................ Markdown cancellations................... Sales revenue .................................... Sales returns ..................................... Inventory losses due to breakage.... Employee discounts ......................... Ending inventory at retail ................. Cost-to-retail ratio =
$1,128,500
Cost $ 250,000 914,500 (60,000) (18,000) 42,000
Retail $ 390,000 1,460,000 (80,000) $
120,000 (40,000)
$1,128,500 (45,000) 20,000 (1,410,000) 97,500
80,000 1,850,000 (25,000) (1,312,500) (4,500) (8,000) $ 500,000
= 61%
$1,850,000 Ending inventory at cost (61% of $500,000) ...........................
$ 305,000
PROBLEM 9-8
(a) Inventory (beginning)...................... Purchases ........................................ Purchase returns............................. Freight-in.......................................... Totals ...................................... Markups ........................................... Markup cancellations ......................
Cost $ 52,000 272,000 (5,600) 16,600 $335,000
$335,000
493,000 9,000 (2,000)
Net markdowns................................ Normal spoilage and breakage....... Sales revenue .................................. Ending inventory at retail ............... Cost-to-retail ratio =
Retail $ 78,000 423,000 (8,000)
7,000 500,000 (3,600) (10,000) (390,000) $ 96,400
= 67%
$500,000 Ending inventory at lower-of-cost-or-market (67% of $96,400) ........................... (b)
$ 64,588
The difference between the inventory estimate per retail method and the amount per physical count may be due to: 1. Theft losses (shoplifting or pilferage). 2. Spoilage or breakage above normal. 3. Differences in cost/retail ratio for purchases during the month, beginning inventory, and ending inventory. 4. Markups on goods available for sale inconsistent between cost of goods sold and ending inventory. 5. A wide variety of merchandise with varying cost/retail ratios. 6. Incorrect reporting of markdowns, additional markups, or cancellations.
PROBLEM 9-9
(a)
The inventory section of Maddox’s balance sheet as of November 30, 2014, including required footnotes, is presented below. Also presented below are the inventory section supporting calculations. Current assets Inventory section (Note 1.) Finished goods (Note 2.) ........................ Work-in-process...................................... Raw materials.......................................... Factory supplies...................................... Total inventories ..................................... Note 1.
$643,000 108,700 237,400 64,800 $1,053,900
Lower-of-cost (first-in, first-out) or-market is applied on a major category basis for finished goods, and on a total inventory basis for work-in-process, raw materials, and factory supplies.
Note 2. Seventy-five percent of bar end shifters finished goods inventory in the amount of $136,500 ($182,000 X .75) is pledged as collateral for a bank loan, and one-half of the head tube shifters finished goods is held by catalog outlets on consignment.
PROBLEM 9-9 (Continued) Supporting Calculations
Down tube shifters at market........ Bar end shifters at cost ................. Head tube shifters at cost ............. Work-in-process at market............ Derailleurs at market ..................... Remaining items at market ........... Supplies at cost ............................. Totals....................................
Finished Goods $266,000 182,000 195,000
Work-inProcess
Raw Materials
Factory Supplies
$108,700 $110,0001 127,400 $643,000
$108,700
$237,400
$64,8002 $64,800
1$264,000 X 1/2 = $132,000; $132,000 ÷ 1.2 = $110,000. 2$69,000 – $4,200 = $64,800.
(b)
The decline in the market value of inventory below cost may be reported using one or two alternate methods, the direct write-down of inventory (cost-of-goods-sold method) or the (loss method). An allowance may be used under either method to report inventory on the balance sheet at LCM. The decline in the market value of inventory may be reflected in Maddox’s income statement as a separate loss item for the fiscal year ended November 30, 2014. The loss amount may also be written off directly, increasing the cost of goods sold on Maddox’s income statement. The loss must be reported in continuing operations rather than in extraordinary items. The loss must be included in the income statement since it is material to Maddox’s financial statements.
(c)
Purchase contracts for which a firm price has been established should be disclosed on the financial statements of the buyer. If the contract price is greater than the current market price and a loss is expected when the purchase takes place, an unrealized holding loss amounting to the difference between the contracted price and the current market price should be recognized on the income statement in the period during which the price decline takes place. Also, an estimated liability on purchase commitments should be recognized on the balance sheet. The recognition of the loss is unnecessary if a firm sales commitment exists which precludes the loss.
PROBLEM 9-10
(a)
Schedule A
Item
On Hand Quantity
Replacement Cost/Unit
NRV (Ceiling)
NRV— Normal Profit (Floor)
A B C D E
1,100 800 1,000 1,000 1,400
$8.40 7.90 5.40 4.20 6.30
$9.00 8.50 6.05 5.50 6.00
$7.20 7.30 5.45 4.00 5.00
Designated Market
Cost
Lower-ofCost-orMarket
$8.40 7.90 5.45 4.20 6.00
$7.50 8.20 5.60 3.80 6.40
$7.50 7.90 5.45 3.80 6.00
Schedule B Item A B C D E
(b)
Cost 1,100 X $7.50 = $8,250 800 X $8.20 = $6,560 1,000 X $5.60 = $5,600 1,000 X $3.80 = $3,800 1,400 X $6.40 = $8,960
Lower-of-Cost-or-Market 1,100 X $7.50 = $8,250 800 X $7.90 = $6,320 1,000 X $5.45 = $5,450 1,000 X $3.80 = $3,800 1,400 X $6.00 = $8,400
Cost of Goods Sold................................................... Allowance to Reduce Inventory to Market ......
Difference None $240 $150 None $560 $950 950 950
or Loss Due to Market Decline of Inventory ............... Allowance to Reduce Inventory to Market ......
950 950
PROBLEM 9-10 (Continued) (c) To:
Greg Forda, Clerk
From:
Accounting Manager
Date:
January 14, 2015
Subject:
Instructions on determining lower-of-cost-or-market for inventory valuation
This memo responds to your questions regarding our use of lower-of-costor-market for inventory valuation. Simply put, value inventory at whichever is the lower: the actual cost or the market value of the inventory at the time of valuation. The term cost is relatively simple. It refers to the amount our company paid for our inventory including costs associated with preparing the inventory for sale. The term market, on the other hand, is more complicated. As you have already noticed, this value could be the inventory’s replacement cost, its net realizable value (selling price minus any estimated costs to complete and sell), or its net realizable value less a normal profit margin. The profession requires that the middle value of the three above costs be chosen as the “designated market value.” This designated market value is then compared to the actual cost in determining the lower-of-cost-ormarket. Refer to Item A on the attached schedule. The values for the replacement cost, net realizable value, and net realizable value less a normal profit margin are $8.40, $9.00 ($10.50 – $1.50), and $7.20 ($9.00 – $1.80) respectively. The middle value is the replacement cost, $8.40, which becomes the designated market value for Item A. Compare it with the actual cost, $7.50, choosing the lower to value Item A in inventory. In this case, $7.50 is the value chosen to value inventory. Thus, inventory for Item A amounts to $8,250. (See Schedule B, Item A.)
PROBLEM 9-10 (Continued) Proceed in the same way, always choosing the middle value among replacement cost, net realizable value, and net realizable value less a normal profit, and compare that middle value to the actual cost. The lower of these will always be the amount at which you value the particular item. After you have aggregated the total lower-of-cost-or-market for all items, you will be likely to have a loss on inventory which must be accounted for. In our example, the loss is $950. You can journalize this loss in one of two ways: Cost of Goods Sold............................................................... Allowance to Reduce Inventory to Market.................. or Loss Due to Market Decline of Inventory ............................ Allowance to Reduce Inventory to Market..................
950 950 950 950
This memo should answer your questions about which value to choose when valuing inventory at lower-of-cost-or-market. Schedule A
Item A B C D E
On Hand Quantity 1,100 800 1,000 1,000 1,400
Replacement Cost/Unit $8.40 7.90 5.40 4.20 6.30
NRV Ceiling $9.00 8.50 6.05 5.50 6.00
NRV— Normal Profit (Floor) $7.20 7.30 5.45 4.00 5.00
Designated Market $8.40 7.90 5.45 4.20 6.00
Cost $7.50 8.20 5.60 3.80 6.40
Lower-ofCost-orMarket $7.50 7.90 5.45 3.80 6.00
Schedule B Item A B C D E
Cost 1,100 X $7.50 = $8,250 800 X $8.20 = $6,560 1,000 X $5.60 = $5,600 1,000 X $3.80 = $3,800 1,400 X $6.40 = $8,960
Lower-of-Cost-or-Market 1,100 X $7.50 = $8,250 800 X $7.90 = $6,320 1,000 X $5.45 = $5,450 1,000 X $3.80 = $3,800 1,400 X $6.00 = $8,400
Difference None $240 $150 None $560 $950
*PROBLEM 9-11
(a) Inventory, January 1 ....................... Purchases ........................................ Purchase returns............................. Totals ...................................... Add: Net markups Markups ................................. Markup cancellations............ Totals ...................................... Deduct: Net markdowns Markdowns ............................. Markdown cancellations........ Sales price of goods available ....... Sales revenue .................................. Sales returns and allowances ........ Ending inventory at retail ............... Cost-to-retail ratio =
$132,000
Cost $ 30,000 104,800 (2,800) 132,000
Retail $ 43,000 155,000 (4,000) 194,000 $
9,200 (3,200)
$132,000 $ 10,500 (6,500) $154,000 (8,000)
6,000 200,000
4,000 196,000 (146,000) $ 50,000
= 66%
$200,000 Inventory at lower-of-cost-ormarket (66% X $50,000)................ (b)
$ 33,000
Ending inventory at retail at January 1 price level ($59,400 ÷ 1.08) .................................................................. $ 55,000 Less beginning inventory at retail ...................................... 43,000 Inventory increment at retail, January 1 price level........... $ 12,000 Inventory increment at retail, June 30 price level ($12,000 X 1.08).................................................................. $ 12,960 Beginning inventory at cost ................................................ Inventory increment at cost at June 30 price level ($12,960 X 70%*) ................................................................ Ending inventory at dollar-value LIFO cost........................ *70% = $30,000/$43,000
$ 30,000 9,072 $ 39,072
*PROBLEM 9-12
(a)
The retail method is appropriate in businesses that sell many different items at relatively low unit costs and that have a large volume of transactions such as Sears or Wal-Mart. The advantages of the retail method in these circumstances include the following: 1. Interim physical inventories can be estimated. 2. The retail method acts as a control as deviations from the physical count will have to be explained.
(b)
Becker Department Stores’ ending inventory value, at cost, is $83,000, calculated as follows: Beginning inventory .................................... Purchases..................................................... Net markups ........................................ Net markdowns ................................... Net purchases ..................................... Goods available ........................................... Sales revenue............................................... Estimated ending inventory at retail...........
Cost $ 68,000 $255,000
$255,000
Retail $100,000 $400,000 50,000 (110,000) 340,000 440,000 (320,000) $120,000
Cost-to-retail percentage: $255,000 ÷ $340,000 = 75%. Beginning inventory layer ........................... Incremental increase At retail ($120,000 – $100,000)............ At cost ($20,000 X 75%) ...................... Estimated ending inventory at LIFO cost...
$ 68,000
$100,000 20,000
15,000 $ 83,000
$120,000
*PROBLEM 9-12 (Continued) (c)
The estimated shortage amount, at retail, for Becker Department Stores is $5,000 calculated as follows: Estimated ending inventory at retail............................... Actual ending inventory at retail ..................................... Estimated inventory shortage .........................................
(d)
$120,000 (115,000) $ 5,000
When using the retail inventory method, the four expenses and allowances noted are treated in the following manner: 1. Freight costs are added to the cost of purchases. 2. Purchase returns are considered as reductions to both the cost price and the retail price. Purchase allowances are considered a reduction in cost price. 3. Sales returns and allowances are subtracted as an adjustment to sales. 4. Employee discounts are deducted from the retail column in a manner similar to sales. They are not considered in the cost-toretail percentage because they do not reflect an overall change in the selling price.
*PROBLEM 9-13
(a) Inventory (beginning)...................... Purchases........................................ Markups ........................................... Totals ...................................... Markdowns ...................................... Sales revenue .................................. Ending inventory at retail ............... Cost-to-retail ratio =
$132,000
Cost
Retail
$ 15,800 116,200
$ 24,000 184,000 12,000 220,000 (5,500) (175,000) $ 39,500
$132,000
= 60%
$220,000 Ending inventory at cost (60% X $39,500) (b)
$ 23,700
Ending inventory for 2014 under the LIFO method: The cost-to-retail ratio for 2014 can be computed as follows:
Net purchases at cost $116,200 = = 61% Net purchases plus markups less markdowns at retail $184,000 + $12,000 – $5,500
December 31, 2014, inventory at LIFO cost:
Beginning inventory.............. Increment in 2014 .................. Ending inventory................... *$39,500 – $24,000 = $15,500
Retail $24,000 15,500* $39,500
Ratio 59% 61%
LIFO Cost $14,160 9,455 $23,615
*PROBLEM 9-14
(a)
DAVENPORT DEPARTMENT STORE COMPUTATION OF COST OF DECEMBER 31, 2013, INVENTORY BASED ON THE CONVENTIONAL RETAIL METHOD
Beginning inventory, January 1, 2013 .............. Add (deduct) transactions affecting cost ratio: Purchases................................................. Purchase returns ..................................... Purchase discounts ................................. Freight-in .................................................. Net markups ............................................. Totals .................................................. Add (deduct) other retail transactions not considered in computation of cost ratio: Gross sales .............................................. Sales returns ............................................ Net markdowns ........................................ Employee discounts ................................ Totals .................................................. Inventory, December 31, 2013: At retail ..................................................... At cost ($63,000 X 56%*).......................... *Ratio of cost-to-retail = $347,200 ÷ $620,000 = 56%
At Cost $ 29,800
At Retail $ 56,000
311,000 (5,200) (6,000) 17,600
554,000 (10,000)
$347,200
20,000 620,000
(551,000) 9,000 (12,000) (3,000) (557,000) $ 63,000 $ 35,280
*PROBLEM 9-14 (Continued) (b)
COMPUTATION OF COST OF DECEMBER 31, 2013 INVENTORY UNDER THE LIFO RETAIL METHOD
Totals used in computing cost ratio under conventional retail method (part a) ................ Exclude beginning inventory ............................ Net purchases .................................................... Deduct net markdowns ...................................... Totals used in computing cost ratio under LIFO retail method........................................... Cost ratio under LIFO retail method ($317,400 ÷ $552,000) ...................................... Inventory, December 31, 2013: At retail (Conventional) ........................... At cost under LIFO retail method ($60,000 X 57.5%) ..................................
Cost
Retail
$347,200 29,800 317,400
$620,000 56,000 564,000 12,000
$317,400
$552,000
57.5% $ 60,000 $ 34,500
*PROBLEM 9-14 (Continued) (c)
COMPUTATION OF 2014 AND 2015 YEAR-END INVENTORIES UNDER THE DOLLAR-VALUE LIFO METHOD
Computation of retail values on the basis of January 1, 2014, price levels Cost Retail 2014: Inventory at end of year (given) ................... Inventory at end of year stated in terms of January 1, 2014 prices ($75,600 ÷ 105%) ........................................ January 1, 2014 inventory base (given) cost ratio of 55.5% ($33,300 ÷ $60,000) .... Increment in inventory: In terms of January 1, 2014 prices............... In terms of 2014 prices—$12,000 X 105%.... At LIFO cost—61% (2014 cost ratio) X $12,600........................................................ December 1, 2014 inventory at LIFO cost..............
$75,600
72,000 $33,300
60,000 $12,000 $12,600
7,686 $40,986
2015: Inventory at end of year (given) .................. Inventory at end of year stated in terms of January 1, 2015 prices ($62,640 ÷ 108%) ....................................... December 31, 2015 inventory at LIFO cost—55.5%* (January 1, 2014 cost ratio) X $58,000 ...............................................$32,190 *Based on the beginning inventory for 2014 of
$62,640
$58,000
$33,300 Cost = 55.5%. $60,000 Retail
(Note to instructor: Because the retail inventory stated in terms of January 1, 2014 prices at December 31, 2015, $58,000, has fallen below the January 1, 2015 inventory base at retail, $60,000, under the LIFO theory the 2014 layer has been depleted and only a portion of the original inventory base remains. Hence the LIFO cost at December 31, 2015 is determined by applying the January 1, 2014 cost ratio of 55.5 percent to the retail inventory value of $58,000).
TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 9-1 (Time 15–25 minutes) Purpose—to provide the student with an opportunity to discuss the purpose, the application, and the potential disadvantages of the lower-of-cost-or-market method. In addition, the student is asked to discuss the ceiling and floor constraints for determining “market” value. CA 9-2 (Time 20–30 minutes) Purpose—to provide the student with an opportunity to examine ethical issues related to lower-of-costor-market on an individual-product basis. A relatively straightforward case. CA 9-3 (Time 15–20 minutes) Purpose—to provide the student with a case that requires an application and an explanation of the lower-of-cost-or-market rule and a differentiation of the LIFO and the average cost methods. CA 9-4 (Time 25–30 minutes) Purpose—to provide the student with an opportunity to discuss the main features of the retail inventory system. In this case, the following must be explained: (a) accounting features of the method, (b) conditions that may distort the results under the method, (c) advantages of using the retail method versus using a cost method, and (d) the accounting theory underlying net markdowns and net markups. A relatively straightforward case. CA 9-5 (Time 15–25 minutes) Purpose—the student discusses which costs are inventoriable, the theoretical arguments for the lowerof-cost-or-market rule, and the amount that should be used to value inventories when replacement cost is below the net realizable value less a normal profit margin. The treatment of beginning inventories and net markdowns when using the conventional retail inventory method must be explained. CA 9-6 (Time 10–15 minutes) Purpose—to provide the student with a case that allows examination of ethical issues related to the recording of purchase commitments.
SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 9-1 (a) The purpose of using the lower-of-cost-or-market method is to reflect the decline of inventory value below its original cost. A departure from cost is justified on the basis that a loss of utility should be reported as a charge against the revenues in the period in which it occurs. (b) The term “market” in the phrase “the lower-of-cost-or-market” generally means the cost to replace the item by purchase or reproduction. Market is limited, however, to an amount that should not exceed the net realizable value (the “ceiling”) (that is, the estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal) and should not be less than net realizable value reduced by an allowance for an approximately normal profit margin (the “floor”). The “ceiling” covers obsolete, damaged, or shopworn material and prevents serious overstatement of inventory. The “floor,” on the other hand, deters serious understatement of inventory. (c) The lower-of-cost-or-market method may be applied either directly to each inventory item, to a category, or to the total inventory. The application of the rule to the inventory total, or to the total components of each category, ordinarily results in an amount that more closely approaches cost than it would if the rule were applied to each individual item. Under the first two methods, increases in market prices offset, to some extent, the decreases in market prices. The most common practice is, however, to price the inventory on an item-by-item basis. Companies favor the individual item approach because tax rules require that an individual item basis be used unless it involves practical difficulties. In addition, the individual item approach gives the most conservative valuation for balance sheet purposes. (d) Conceptually, the lower-of-cost-or-market method has some deficiencies. First, decreases in the value of the asset and the charge to expense are recognized in the period in which loss in utility occurs—not in the period of sale. On the other hand, increases in the value of the asset are recognized only at the point of sale. This situation is inconsistent and can lead to distortions in the presentation of income data. Second, there is difficulty in defining “market” value. Basically, three different types of valuation can be used: replacement cost, net realizable value, and net realizable value less a normal markup. A reduction in the replacement cost of an item does not necessarily indicate a corresponding reduction in the utility (price) of the item. To recognize a loss in one period may misstate the period’s income and also that of future periods because when the merchandise is sold subsequently, the full price for the item is received. Net realizable value reflects the future service potential of the asset and, for that reason, it is conceptually sound. But net realizable value cannot often be measured with any certainty. Therefore, we revert to replacement cost because net realizable value less a normal markup is even more uncertain than net realizable value. From the standpoint of accounting theory there is little to justify the lower-of-cost-or-market rule. Although conservative from the balance sheet point of view, it permits the income statement to show a larger net income in future periods than would be justified if the inventory were carried forward at cost. The rule is applied only in those cases where strong evidence indicates that market declines in inventory prices have occurred that will result in losses when such inventories are disposed of.
CA 9-2 (a) The accountant’s ethical responsibility is to provide fair and complete financial information. In this case, the loss method distorts the cost of goods sold and hides the decline in market value. (b) If Wright’s cost-of-goods-sold method is used, management may have difficulty in calculations that involve the cost of goods sold. For example, these calculations are useful in establishing profit margins and determining selling prices; but from the investors’ and stockholders’ viewpoint, it is not good policy to hide declines in market value. (c) Conan should use the loss method to disclose the decline in market value and avoid distorting cost of goods sold. However, she faces an ethical dilemma if Wright will not accept the method Conan wants to use. She should consider various alternatives including the extremes of simply accepting her boss’s decision to quitting if Wright will not change his mind. Conan should assess the consequences of each possible alternative and weigh them carefully before she decides what to do.
CA 9-3 (a) 1. Ogala’s inventory should be reported at net realizable value. According to the lower-of-cost-ormarket rule, market is defined as replacement cost. However, market cannot exceed net realizable value. In this instance, net realizable value is below original cost. 2. The lower-of-cost-or-market rule is used to report the inventory in the balance sheet at its future utility value. It also recognizes a decline in the utility of inventory in the income statement in the period in which the decline occurs. (b) Generally, ending inventory would have been higher and cost of goods sold would have been lower had Ogala used the LIFO inventory method in a period of declining prices. Inventory quantities increased and LIFO associates the oldest purchase prices with inventory. However, in this instance, there would have been no effect on ending inventory or cost of goods sold had Ogala used the LIFO inventory method because Ogala’s inventory would have been reported at net realizable value according to the lower-of-cost-or-market rule. Net realizable value of the inventory is less than either its average cost or LIFO cost.
CA 9-4 (a) The retail inventory method can be employed to estimate retail, wholesale, and manufacturing finished goods inventories. The valuation of inventory under this method is arrived at by reducing the ending inventory at retail to an estimate of the lower-of-cost-or-market. The retail value of ending inventory can be computed by (1) taking a physical inventory, or by (2) subtracting net sales and net markdowns from the total retail value of merchandise available for sale (i.e., the sum of beginning inventory at retail, net purchases at retail, and net markups). The reduction of ending inventory at retail to an estimate of the lower-of-cost-or-market is accomplished by applying to it an estimated cost ratio arrived at by dividing the retail value of goods available for sale as computed in (2) above into the cost of goods available for sale (i.e., the sum of beginning inventory, net purchases, and other inventoriable costs).
CA 9-4 (Continued) (b) Since the retail method is based on an estimated cost ratio involving total merchandise available during the period, its validity depends on the underlying assumption that the merchandise in ending inventory is a representative mixture of all merchandise handled. If this condition does not exist, the cost ratio may not be appropriate for the merchandise in ending inventory and can result in significant error. Where there are a number of inventory subdivisions for which differing rates of markup are maintained, there is no assurance that the ending inventory mix will be representative of the total merchandise handled during the period. In such cases, accurate results can be obtained by subclassifications by rate of markup. Seasonal variations in the rate of markup will nullify the ending inventory “representative mix” assumption. Since the estimated cost ratio is based on total merchandise handled during the period, the same rate of markup should prevail throughout the period. Because of seasonal variations it may be necessary to use data for the last six months, quarter, or month to compute a cost ratio that is appropriate for ending inventory. Material quantities of special sale merchandise handled during the period may also bias the result of this method because merchandise data included in arriving at the estimated cost ratio may not be proportionately represented in ending inventory. This condition may be avoided by accumulating special sale merchandise data in separate accounts. Distortion of the ending inventory approximation under this method is often caused by an inadequate system of inventory control. Adequate accounting controls are necessary for the accurate accumulation of the data needed to arrive at a valid cost ratio. Physical controls are equally important because, for interim purposes, this method is usually applied without taking a physical inventory. (c) The advantages of using the retail method as compared to cost methods include the following: 1. Approximate inventory values can be determined without maintaining perpetual inventory records. 2. The preparation of interim financial statements is facilitated. 3. Losses due to fire or other casualty are readily determined. 4. Clerical work in pricing the physical inventory is reduced. 5. The cost of merchandise can be kept confidential in intracompany transfers. (d) The treatments to be accorded net markups and net markdowns must be considered in light of their effects on the estimated cost ratio. If both net markups and net markdowns are used in arriving at the cost ratio, ending inventory will be converted to an estimated average cost figure. Excluding net markdowns will result in the inventory being stated at an estimate of the lower-ofcost-or-market. The lower cost ratio arrived at by excluding net markdowns permits the pricing of inventory at an amount that reflects its current utility. The assumption is that net markdowns represent a loss of utility that should be recognized in the period of markdown. Ending inventory is therefore valued on the basis of its revenue-producing potential and may be expected to produce a normal gross profit if sold at prevailing retail prices in the next period.
CA 9-5 (a) 1. Olson’s inventoriable cost should include all costs incurred to get the lighting fixtures ready for sale to the customer. It includes not only the purchase price of the fixtures but also the other associated costs incurred on the fixtures up to the time they are ready for sale to the customer, for example, freight-in. 2. No, administrative costs are assumed to expire with the passage of time and not to attach to the product. Furthermore, administrative costs do not relate directly to inventories, but are incurred for the benefit of all functions of the business. (b) 1. The lower-of-cost-or-market rule is used for valuing inventories because of the concept of prudence or conservatism and because the decline in the utility of the inventories below their cost should be recognized as a loss in the current period. 2. The net realizable value less a normal profit margin should be used to value the inventories because market should not be less than net realizable value less a normal profit margin. To carry the inventories at net realizable value less a normal profit margin provides a means of measuring residual usefulness of an inventory expenditure. (c) Olson’s beginning inventories at cost and at retail would be included in the calculation of the cost ratio. Net markdowns would be excluded from the calculation of the cost ratio. This procedure reduces the cost ratio because there is a larger denominator for the cost ratio calculation. Thus, the concept of conservatism (prudence) is being followed and a lower-of-cost-or-market valuation is approximated.
CA 9-6 (a) Accounting standards require that when a contracted price is in excess of market, as it is in this case (market is $5,000,000 and the contract price is $6,000,000), and it is expected that losses will occur when the purchase is effected, losses should be recognized in the period during which such declines in market prices take place. It would be unethical to ignore recognition of the loss now if a loss is expected to occur when the purchase is effected. (b) If the loss is material, new and continuing shareholders are harmed by nonrecognition of the loss. Herman’s position as an accounting professional also is affected if he accepts a financial report he knows violates GAAP. (c) If the preponderance of the evidence points to a loss when the purchase is effected, the controller should recognize the amount of the loss in the period in which the price decline occurs. In this case the loss is measured at $1,000,000 and recorded as follows: Unrealized Holding Gain or Loss—Income (Purchase Commitments) .............................................................. Estimated Liability on Purchase Commitments .......................
1,000,000 1,000,000
Herman should insist on statement preparation in accordance with GAAP. If Hands will not accept Herman’s position, Herman will have to consider alternative courses of action such as contacting higher-ups at Prophet and assess the consequences of each course of action.
FINANCIAL REPORTING PROBLEM
(a) Inventories are valued at the lower-of-cost-or-market value. Productrelated inventories are primarily maintained on the first-in, first-out method. Minor amounts of product inventories, including certain cosmetics and commodities are maintained on the last-in, first-out method. The cost of spare part inventories is maintained using the average cost method. (b) Inventories are reported on the balance sheet simply as “inventories” with sub-totals reported for (1) Materials and supplies, (2) Work in process, and (3) Finished goods. (c)
In its note describing Cost of Products Sold, P&G indicates that cost of products sold is primarily comprised of direct materials and supplies consumed in the manufacture of product, as well as manufacturing labor, depreciation expense and direct overhead expense necessary to acquire and convert the purchased materials and supplies into finished product. Cost of products sold also includes the cost to distribute products to customers, inbound freight costs, internal transfer costs, warehousing costs and other shipping and handling activity.
(d)
Inventory turnover =
Cost of Goods Sold = $40,768 Average Inventory $7,379 + $6,384 2 = 5.9 or approximately 62 days to turn its inventory, which is a slightly lower than 2010 (5.7 or 64 days).
Its gross profit percentages for 2011 and 2010 are as follows: Net sales ........................... Cost of goods sold........... Gross profit.......................
2011 $82,559 40,768 $41,791
2010 $78,938 37,919 $41,019
Gross profit percentage...
50.62%
51.96%
P&G had an increase in its gross profit but a decrease gross profit percentage. Sales in 2011 showed a 4.6% increase. It appears that P&G has not been able to manage its costs to increase gross margin levels on these higher sales.
COMPARATIVE ANALYSIS CASE
(a) Coca-Cola reported inventories of $3,092 million, which represents 3.9% of total assets. PepsiCo reported inventories of $3,827 million, which represents 5.3% of its total assets. (b) Coca-Cola determines the cost of its inventories on the basis of average cost or first-in, first-out (FIFO) methods; its inventories are valued at the lower-of-cost-or-market. PepsiCo’s inventories are valued at the lower of cost (computed on the average, FIFO or LIFO method) or market. PepsiCo also reported that the cost of 13% of its 2011 inventories was computed using the LIFO method. (c) Coca-Cola classifies and describes its inventories as primarily raw materials and packaging and finished goods. PepsiCo classifies and describes its inventories as (1) raw materials, (2) work-in-process and (3) finished goods. (d) Inventory turnover ratios and days to sell inventory for 2011: Coca-Cola $18,216 = 6.3 times $3,092 + $2,650 2 365 ÷ 6.3 = 58 days
PepsiCo $31,593 = 8.8 times $3,827 + $3,372 2 365 ÷ 8.8 = 41 days
A substantial difference between Coca-Cola and PepsiCo exists regarding the inventory turnover and related days to sell inventory. The primary reason is that PepsiCo’s cost of goods sold and related inventories involves food operations as well as beverage cost. This situation is not true for Coca-Cola. Food will have a much higher turnover ratio because food must be turned over quickly or else spoilage will become a major problem.
FINANCIAL STATEMENT ANALYSIS CASE 1
(a) Although no absolute rules can be stated, preferability for LIFO can ordinarily be established if (1) selling prices and revenues have been increasing, whereas costs have lagged, to such a degree that an unrealistic earnings picture is presented, and (2) LIFO has been traditional, such as department stores and industries where a fairly constant “base stock” is present such as refining, chemicals, and glass. Conversely, LIFO would probably not be appropriate: (1) where prices tend to lag behind costs; (2) in situations where specific identification is traditional, such as in the sale of automobiles, farm equipment, art, and antique jewelry; and (3) where unit costs tend to decrease as production increases, thereby nullifying the tax benefit that LIFO might provide. Note that where inventory turnover is high, the difference between inventory methods is usually negligible. In this case, it is impossible to determine what conditions exist, but it seems probable that the characteristics of certain parts of the inventory make LIFO desirable, whereas other parts of the inventory provide higher benefits if FIFO is used. (b) It may provide this information (although it is not required to do so) because it believes that this information tells the reader that both its income and inventory would be higher if FIFO had been used. (c) The LIFO liquidation reduces operating costs because low price goods are matched against current revenue. As a result, operating costs are lower than normal because higher operating costs would have normally been deducted from revenues. (d) It would probably have reported more income if it had been on a FIFO basis. For example, its inventory as of December 31, 2014 was stated at $1,635,040. Its inventory under FIFO would have been $364,960 ($2,000,000–$1,635,040) higher in 2014 if FIFO had been used. On the other hand, the LIFO liquidation would not have occurred in 2014 or previous years because FIFO would have been used. Thus, the 2014 reduction in operating costs of $24,000 due to the LIFO liquidation would not have occurred.
FINANCIAL STATEMENT ANALYSIS CASE 2
(a)
There are probably no finished goods because gold is a highly liquid commodity, and so it can be sold as soon as processing is complete. Ore in stockpiles is probably a noncurrent asset because processing takes more than one year.
(b)
Sales are recorded as follows: Accounts Receivable or Cash .......................... Sales Revenue............................................
XXX XXX
AND Cost of Goods Sold........................................... Gold in Process Inventory ......................... (c)
Balance Sheet Inventory Overstated Retained earnings Overstated Accounts payable No effect Working capital Overstated Current ratio Overstated
XXX XXX
Income Statement Cost of goods sold Understated Net income Overstated
ACCOUNTING, ANALYSIS, AND PRINCIPLES Accounting (a)
Residential pumps: Ending inventory cost = (300 X $500) + (200 X $475) = Beginning inventory cost = (200 X $400) = Purchases = $225,000 + $190,000 + $150,000 = Cost of goods sold = $80,000 + $565,000 – $245,000 =
$ 245,000 $ 80,000 $ 565,000 $ 400,000
Commercial pumps: Ending inventory at cost = (500 X $1,000) = Beginning inventory at cost = (600 X $800) = Purchases = $540,000 + $285,000 + $500,000 = Cost of goods sold = $480,000 + $1,325,000 – $500,000 =
$ 500,000 $ 480,000 $1,325,000 $1,305,000
Total ending inventory at cost = $245,000 + $500,000 = Total cost of goods sold = $1,305,000 + $400,000 =
$ 745,000 $1,705,000
Lower-of-cost-or-market: NRV Replacement cost Normal profit margin NRV – normal profit margin Designated market value Number of units on hand, Mar. 31 Designated market value of ending inventory Required write-down
*($550 X 500)
Residential pumps $580 $550 0.1667 X $580.00 = $96.69 $580.00 – $96.69 = $483.31 $550 500
Commercial pumps $1,050 $ 900 0.1667 X $1,050.00 = $175.04 $1,050.00 – $175.04 = $874.96 $900 500
$275,000*
$450,000**
No
Yes, $450,000 < $500,000
**($900 X 500)
Total amount of inventory reported on March 31 balance sheet = $695,000 ($245,000 + $450,000).
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) (b)
Inventory at cost = $245,000 + $500,000 = $745,000 Designated market value = $275,000 + $450,000 = $725,000 $725,000 < $745,000, therefore write inventory down to $725,000 Total amount of inventory reported on March 31 balance sheet = $725,000
Analysis In this problem, one product’s market value is above cost and the other one is below. From a conservative perspective, the individual product approach results in a write-down for any product whose designated market value is below cost. So, potentially the individual product approach informs the financial statement reader about any products with weak markets, while the category approach does not. One could argue that the company’s balance sheet inventory amount, if aggregated into one category, is closer to its market value than with the individual product approach. This approach allows unrealized inventory gains to offset inventory losses. It is difficult to say which approach provides better information, but the individual product approach results in a larger write-down. Principles (a)
If the designated market value is $1,050, the designated market value of commercial pumps would be above cost. The written-down amount becomes the new cost for that inventory and Englehart would not be allowed to write that inventory back up.
(b)
The conceptual trade-off inherent in the accounting for inventory as it relates to lower-of-cost-or-market is between relevance and faithful representation. Market is generally thought to be more relevant than cost. Cost is considered less subjective (and a more faithful representation) than market. Under LCM, relevance takes precedence in a down market; however, faithful representation is more important in an up market.
PROFESSIONAL RESEARCH
(a)
The codification provides guidance at: FASB ASC 330-10-05 (Codification String: Assets > 330 Inventory > 10 Overall > 05 Background). The primary predecessor literature is: “Restatement and Revision of Accounting Research Bulletins.” Accounting Research Bulletin No. 43 (New York: AICPA, 1953), Ch. 4.
(b)
According to the FASB ASC 330-10-20, the Glossary indicates the following. Inventory is the aggregate of those items of tangible personal property that have any of the following characteristics: a. Held for sale in the ordinary course of business b. In process of production for such sale c. To be currently consumed in the production of goods or services to be available for sale. The term inventory embraces goods awaiting sale (the merchandise of a trading concern and the finished goods of a manufacturer), goods in the course of production (work in process), and goods to be consumed directly or indirectly in production (raw materials and supplies). This definition of inventories excludes long-term assets subject to depreciation accounting, or goods which, when put into use, will be so classified. The fact that a depreciable asset is retired from regular use and held for sale does not indicate that the item should be classified as part of the inventory. Raw materials and supplies purchased for production may be used or consumed for the construction of long-term assets or other purposes not related to production, but the fact that inventory items representing a small portion of the total may not be absorbed ultimately in the production process does not require separate classification. By trade practice, operating materials and supplies of certain types of entities such as oil producers are usually treated as inventory.
PROFESSIONAL RESEARCH (Continued) (c)
According to the FASB ASC 330-10-20, the Glossary indicates the following for the term Market: As used in the phrase lower-of-cost-or-market, the term market means current replacement cost (by purchase or by reproduction, as the case may be) provided that it meet both of the following conditions: a. Market shall not exceed the net realizable value b. Market shall not be less than net realizable value reduced by an allowance for an approximately normal profit margin.
(d)
According to FASB ASC 330-10-35: 35-15 Only in exceptional cases may inventories properly be stated above cost. For example, precious metals having a fixed monetary value with no substantial cost of marketing may be stated at such monetary value; any other exceptions must be justifiable by inability to determine appropriate approximate costs, immediate marketability at quoted market price, and the characteristic of unit interchangeability. For: Goods Stated Above Cost 50-3
Where goods are stated above cost this fact shall be fully disclosed.
35-16 It is generally recognized that income accrues only at the time of sale, and that gains may not be anticipated by reflecting assets at their current sales prices. However, exceptions for reflecting assets at selling prices are permissible for both of the following: a. Inventories of gold and silver, when there is an effective government-controlled market at a fixed monetary value b. Inventories representing agricultural, mineral, and other products, with any of the following criteria: (1) Units of which are interchangeable (2) Units of which have an immediate marketability at quoted prices (3) Units for which appropriate costs may be difficult to obtain. Where such inventories are stated at sales prices, they shall be reduced by expenditures to be incurred in disposal.
PROFESSIONAL SIMULATION
Resources
Journal Entry Cost of Goods Sold ........................................................... 4,000 Allowance to Reduce Inventory to Market .........
4,000
Note: This entry assumes use of the cost-of-goods-sold method. Explanation Expected selling prices are important in the application of the lower-ofcost-or-market rule because they are used in measuring losses of utility in inventory that otherwise would not be recognized until the period during which the inventory is sold. Declines in replacement cost generally are assumed to foreshadow declines in selling prices expected in the next period and hence in the revenue expected upon the sale of the inventory during the next period. However, the use of current replacement cost as “market” is limited to those situations in which it falls between (1) net realizable value (the “ceiling”) and (2) net realizable value less a “normal” profit (the “floor”), both of which depend upon the selling prices expected in the next period for their computation.
IFRS CONCEPTS AND APPLICATION
IFRS9-1 Key similarities are (1) the guidelines on who owns the goods—goods in transit, consigned goods, special sales agreements, and the costs to include in inventory are essentially accounted for the same under IFRS and U.S. GAAP; (2) use of specific identification cost flow assumption, where appropriate; (3) unlike property, plant and equipment, IFRS does not permit the option of valuing inventories at fair value. As indicated above, IFRS requires inventory to be written down, but inventory cannot be written up above its original cost; (4) certain agricultural products and minerals and mineral products can be reported at net realizable value using IFRS. Key differences are related to (1) the LIFO cost flow assumption—GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use. FIFO and average-cost are the only two acceptable cost flow assumptions permitted under IFRS; (2) lower-of-cost-or-market test for inventory valuation—IFRS defines market as net realizable value. GAAP on the other hand defines market as replacement cost subject to the constraints of net realizable value (the ceiling) and net realizable value less a normal markup (the floor). That is, IFRS does not use a ceiling or a floor to determine market; (3) inventory write-downs—under GAAP, if inventory is written down under the lower-of-cost-or-market valuation, the new basis is now considered its cost. As a result, the inventory may not be written back up to its original cost in a subsequent period. Under IFRS, the write-down may be reversed in a subsequent period up to the amount of the previous writedown. Both the write-down and any subsequent reversal should be reported on the income statement; (4) the requirements for accounting and reporting for inventories are more principles-based under IFRS. That is, GAAP provides more detailed guidelines in inventory accounting.
IFRS9-2 As shown in the analysis below, under IFRS, LaTour’s inventory turnover ratio is computed as follows: Cost of Goods Sold Average Inventory
=
$578 $154
= 3.75
Difficulties in comparison to a company using GAAP could arise if the U.S. company uses the LIFO cost flow assumption, which is prohibited under IFRS. Generally in times of rising prices, LIFO results in a lower inventory balance reported on the balance sheet (assumes more recently purchased items are sold first). Thus, the GAAP company will report higher inventory turnover ratios. The LIFO reserve can be used to adjust the reported LIFO numbers to FIFO and to permit an “apples to apples” comparison.
IFRS9-3 Reed must not be aware of the important convergence issue arising from the use of the LIFO cost flow assumption; IFRS specifically prohibits its use. Conversely, the LIFO cost flow assumption is widely used in the United States because of its favorable tax advantages. In addition, many argue that LIFO from a financial reporting point of view provides a better matching of current costs against revenue and therefore a more realistic income is computed. The problem is compounded in the United States because LIFO cannot be used for tax purposes unless it is used for financial reporting purposes. As a result, unless the tax law is changed, it is unlikely that GAAP will eliminate the use of the LIFO cost flow assumption because of its substantial tax advantages for many companies. Also, GAAP has more detailed rules related to accounting and reporting of inventories than IFRS. We expect that these more detailed rules will be used internationally because they provide practical guidance for some inventory accounting and reporting issues.
IFRS9-4 (a)
Biological assets are measured on initial recognition and at the end of each reporting period at fair value less costs to sell (net realizable value or NRV). Companies record a gain or loss due to changes in the NRV of biological assets in income when it arises.
(b)
Agricultural produce (which are harvested from biological assets) are measured at fair value less costs to sell (net realizable value or NRV) at the point of harvest. Once harvested, the NRV of the agricultural produce becomes its cost and this asset is accounted for similar to other inventories held for sale in the normal course of business.
IFRS9-5 (1) (2) (3) (4) (5)
$12.80 ($14.80 – $1.50 – $.50). $16.10. $13.00 ($15.20 – $1.65 – $.55). $ 9.20 ($10.40 – $ .80 – $.40). $15.90.
IFRS9-6
Item D E F G H I
Net Realizable Value $80* 62 60 35 70 40
Cost $75 80 80 80 50 36
LCNRV $75 62 60 35 50 36
*Estimated selling price – Estimated selling costs and cost to complete = $120 – $30 – $10 = $80.
IFRS9-7 (a)
12/31/14
12/31/15
(b)
12/31/14
12/31/15
Cost of Goods Sold .................................. 24,000 Allowance to Reduce Inventory to Net Realizable Value............
24,000
Allowance to Reduce Inventory to Net Realizable Value........................ Cost of Goods Sold.....................
4,000
Loss Due to Decline of Inventory to Net Realizable Value ......... 24,000 Allowance to Reduce Inventory to Net Realizable Value ............
24,000
Allowance to Reduce Inventory to NRV ................................................ Recovery of Loss Inventory .......
4,000
*Cost of inventory at 12/31/14 ............................... Lower-of-cost-or-NRV at 12/31/14 ....................... Allowance amount needed to reduce Inventory to NRV (a).......................................... Cost of inventory at 12/31/15............................... Lower-of-cost-or-NRV at 12/31/15 ....................... Allowance amount needed to reduce Inventory to NRV (b).......................................... Recovery of previously recognized loss
(c)
4,000*
4,000*
$346,000 (322,000) $ 24,000 $410,000 (390,000) $ 20,000
= (a) – (b) = $24,000 – $20,000 = $4,000.
Both methods of recording lower-of-cost-or-NRV adjustments have the same effect on net income.
IFRS9-8 Biological Assets – Shearing Sheep..................... Unrealized Holding Gain or Loss – Income ...........................................
4,125* 4,125
*$4,700 – $575 = $4,125. IFRS9-9 (a)
(b)
Wool Inventory ....................................................... Unrealized Holding Gain or Loss – Income ............................................
9,000
Cash ........................................................................ Cost of Goods Sold................................................ Wool Inventory .............................................. Sales Revenue...............................................
10,500 9,000
9,000
9,000 10,500
IFRS9-10 (a)
The IFRS requirements related to accounting and reporting for inventories is found in IAS 2 (Inventories), IAS 18 (Revenue) and IAS 41 (Agriculture). Inventories are assets: (a) held for sale in the ordinary course of business; (b) in the process of production for such sale; or (c) in the form of materials or supplies to be consumed in the production process or in the rendering of services. (IAS 2, paragraph 6) This Standard applies to all inventories, except: (a) work in progress arising under construction contracts, including directly related service contracts (see IAS 11 Construction Contracts); (b) financial instruments (see IAS 32 Financial Instruments: Presentation and IAS 39 Financial Instruments: Recognition and Measurement); and (c) biological assets related to agricultural activity and agricultural produce at the point of harvest (see IAS 41 Agriculture). (IAS 2, paragraph 2)
IFRS9-10 (Continued) (c)
Net realisable value refers to the net amount that an entity expects to realise from the sale of inventory in the ordinary course of business. Fair value reflects the amount for which the same inventory could be exchanged between knowledgeable and willing buyers and sellers in the marketplace. The former is an entity-specific value; the latter is not. Net realisable value for inventories may not equal fair value less costs to sell. (IAS 2, paragraph 7).
(d)
This Standard does not apply to the measurement of inventories held by: (a) producers of agricultural and forest products, agricultural produce after harvest, and minerals and mineral products, to the extent that they are measured at net realisable value in accordance with well established practices in those industries. When such inventories are measured at net realisable value, changes in that value are recognised in profit or loss in the period of the change. (b) commodity broker-traders who measure their inventories at fair value less costs to sell. When such inventories are measured at fair value less costs to sell, changes in fair value less costs to sell are recognised in profit or loss in the period of the change. (IAS 2, paragraph 3).
IFRS9-11 (a)
Inventories are valued at the lower-of-cost-or-net realisable value using the retail method, which is computed on the basis of selling price less the appropriate trading margin. All inventories are finished goods.
(b)
Inventories are reported on the statement of financial position simply as “Inventories.” The footnotes indicate that all inventories are finished goods.
(c)
No information is provided in the annual report regarding what costs are included in inventories or cost of sales.
IFRS9-11 (Continued) (d) Inventory turnover =
Cost of Sales
=
£6,179.1
Average Inventory
£681.9 + £685.3 2 = 9.04 or approximately 40 days to turn its inventory, which is slightly lower than in 2011 (9.3 or 39 days). Overall, turnover remains high. Its gross profit percentages for 2012 and 2011 are as follows: Net sales ............................ Cost of sales...................... Gross profit ....................... Gross profit percentage....
2012 £9,934.3 6,179.1 £3,755.2 37.8%
2011 £9,740.3 6,015.6 £3,724.7 38.2%
M&S had a small improvement in its gross profit and a slight decrease in gross profit percentage. Sales in 2012 showed a 2% increase. It appears that M&S has been able to maintain its gross profit percentage on these increased sales.
CHAPTER 10 Acquisition and Disposition of Property, Plant, and Equipment ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics
Questions
Brief Exercises
Problems
Concepts for Analysis
1, 2, 3, 4, 5, 13
1, 2, 3, 5
1, 5, 6
1. Valuation and classification of land, buildings, and equipment.
1, 2, 3, 4, 6, 7, 12, 13, 15, 21
2.
5, 8, 20, 21
4, 6, 12, 16
3. Capitalization of interest.
8, 9, 10, 11, 2, 3, 4 13, 21
4, 5, 7, 8, 9, 10, 16
1, 5, 6, 7
3
4. Exchanges of assets.
12, 16, 17
8, 9, 10, 11, 12
3, 11, 16, 17, 18, 19, 20
4, 8, 9, 10, 11
4
5. Lump-sum purchases, issuance of stock, deferredpayment contracts.
12, 14
5, 6, 7
3, 6, 11, 12, 2, 11 13, 14, 15, 16
6.
18, 19
13
21, 22, 23
Self-constructed assets, capitalization of overhead.
Costs subsequent to acquisition.
7. Alternative valuations.
22
8. Disposition of assets.
23
1
Exercises
2
1 3
14, 15
24, 25
4
1
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives Questions
Brief Exercises
Concepts for Analysis
Exercises
Problems
1, 2, 3, 4, 5, 11, 12, 13
1, 2, 3, 4, 5, 6, 11
CA10-1
4, 5, 6, 11, 12
3
CA10-2
1.
Describe property, plant, and equipment.
1
2.
Identify the costs to include in initial valuation of property, plant, and equipment.
2, 3, 4, 5, 6, 21
3.
Describe the accounting problems associated with self-constructed assets.
8
4.
Describe the accounting problems associated with interest capitalization.
8, 9, 10, 11
2, 3, 4
5, 6, 7, 8, 9, 10
5, 6, 7
CA10-3
5.
Understand accounting issues related to acquiring and valuing plant assets.
7, 12, 14, 16, 17, 19, 20, 22
5, 6, 7, 8, 9, 10, 11, 12
11, 12, 13, 14, 15, 16, 17, 18, 19, 20
3, 4, 8, 9, 10, 11
CA10-4, CA10-6
6.
Describe the accounting treatment for costs subsequent to acquisition.
6, 13, 15, 18
13
21, 22, 23
7.
Describe the accounting treatment for the disposal of property, plant, and equipment.
7, 23
14, 15
24, 25
1
CA10-5, CA10-6 2, 4
CA10-1
ASSIGNMENT CHARACTERISTICS TABLE Item
Description
Level of Difficulty
E10-1 E10-2 E10-3 E10-4 E10-5 E10-6 E10-7 E10-8 E10-9 E10-10 E10-11 E10-12 E10-13 E10-14 E10-15 E10-16 E10-17 E10-18 E10-19 E10-20 E10-21 E10-22 E10-23 E10-24 E10-25
Acquisition costs of realty. Acquisition costs of realty. Acquisition costs of trucks. Purchase and self-constructed cost of assets. Treatment of various costs. Correction of improper cost entries. Capitalization of interest. Capitalization of interest. Capitalization of interest. Capitalization of interest. Entries for equipment acquisitions. Entries for asset acquisition, including self-construction. Entries for acquisition of assets. Purchase of equipment with zero-interest-bearing debt. Purchase of computer with zero-interest-bearing debt. Asset acquisition. Nonmonetary exchange. Nonmonetary exchange. Nonmonetary exchange. Nonmonetary exchange. Analysis of subsequent expenditures. Analysis of subsequent expenditures. Analysis of subsequent expenditures. Entries for disposition of assets. Disposition of assets.
Moderate Simple Simple Moderate Moderate Moderate Moderate Moderate Moderate Moderate Simple Simple Simple Moderate Moderate Moderate Simple Moderate Moderate Moderate Moderate Simple Simple Moderate Simple
15–20 10–15 10–15 20–25 30–40 15–20 20–25 20–25 20–25 20–25 10–15 15–20 20–25 15–20 15–20 25–35 10–15 20–25 15–20 15–20 20–25 15–20 10–15 20–25 15–20
P10-1 P10-2 P10-3 P10-4
Classification of acquisition and other asset costs. Classification of acquisition costs. Classification of land and building costs. Dispositions, including condemnation, demolition, and trade-in. Classification of costs and interest capitalization. Interest during construction. Capitalization of interest. Nonmonetary exchanges. Nonmonetary exchanges. Nonmonetary exchanges. Purchases by deferred payment, lump-sum, and nonmonetary exchanges.
Moderate Moderate Moderate Moderate
35–40 40–55 35–45 35–40
Moderate Moderate Moderate Moderate Moderate Moderate Moderate
20–30 25–35 20–30 35–45 30–40 30–40 35–45
P10-5 P10-6 P10-7 P10-8 P10-9 P10-10 P10-11
Time (minutes)
ASSIGNMENT CHARACTERISTICS TABLE (Continued) Item
Description
Level of Difficulty
Time (minutes)
CA10-1 CA10-2 CA10-3 CA10-4 CA10-5 CA10-6
Acquisition, improvements, and sale of realty. Accounting for self-constructed assets. Capitalization of interest. Nonmonetary exchanges. Costs of acquisition. Cost of land vs. building—ethics.
Moderate Moderate Moderate Moderate Simple Moderate
20–25 20–25 30–40 30–40 20–25 20–25
SOLUTIONS TO CODIFICATION EXERCISES CE10-1 Master Glossary (a)
Capitalize is used to indicate that the cost would be recorded as the cost of an asset. That procedure is often referred to as deferring a cost, and the resulting asset is sometimes described as a deferred cost.
(b)
Nonmonetary assets are assets other than monetary ones. Examples are inventories; investments in common stocks; and property, plant, and equipment.
(c)
A nonreciprocal transfer is a transfer of assets or services in one direction, either from an entity to its owners (whether or not in exchange for their ownership interests) or to another entity, or from owners or another entity to the entity. An entity’s reacquisition of its outstanding stock is an example of a nonreciprocal transfer.
(d)
A contribution is an unconditional transfer of cash or other assets to an entity or a settlement or cancellation of its liabilities in a voluntary nonreciprocal transfer by another entity acting other than as an owner. Those characteristics distinguish contributions from exchange transactions, which are reciprocal transfers in which each party receives and sacrifices approximately equal value; from investments by owners and distributions to owners, which are nonreciprocal transfers between an entity and its owners; and from other nonreciprocal transfers, such as impositions of taxes or fines and thefts, which are not voluntary transfers. In a contribution transaction, the value, if any, returned to the resource provider is incidental to potential public benefits. In an exchange transaction, the potential public benefits are secondary to the potential proprietary benefits to the resource provider. The term contribution revenue is used to apply to transactions that are part of the entity’s ongoing major or central activities (revenues), or are peripheral or incidental to the entity (gains).
CE10-2 According to FASB ASC 835-20-15-8 (Capitalization of Land Expenditures), it depends: . . . Land that is not undergoing activities necessary to get it ready for its intended use is not a qualifying asset. If activities are undertaken for the purpose of developing land for a particular use, the expenditures to acquire the land qualify for interest capitalization while those activities are in progress. The interest cost capitalized on those expenditures is a cost of acquiring the asset that results from those activities. If the resulting asset is a structure, such as a plant or a shopping center, interest capitalized on the land expenditures is part of the acquisition cost of the structure. If the resulting asset is developed land, such as land that is to be sold as developed lots, interest capitalized on the land expenditures is part of the acquisition cost of the developed land.
CE10-3 According to FASB ASC 360-10-25-5, (Planned Major Maintenance Activities) . . . The use of the accrue-in-advance (accrual) method of accounting for planned major maintenance activities is prohibited in annual and interim financial reporting periods.
CE10-4 According to FASB ASC 845-10-15-5 (Purchases and Sales of Inventory with the Same Counterparty), the accounting for these exchanges is similar to other nonmonetary exchanges: The Purchases and Sales of Inventory with the Same Counterparty Subsections follow the same Scope and Scope Exceptions as outlined in the General Subsection of this Subtopic, see paragraph 845-10-15-1, with specific transaction exceptions noted below. With respect to recognition, FASB ASC 845-10-30 Initial Measurement 30-15
A nonmonetary exchange whereby an entity transfers finished goods inventory in exchange for the receipt of raw materials or work-in-process inventory within the same line of business is not an exchange transaction to facilitate sales to customers for the entity transferring the finished goods, as described in paragraph 845-10-30-3(b), and, therefore, shall be recognized by that entity at fair value if both of the following conditions are met: a. Fair value is determinable within reasonable limits. b. The transaction has commercial substance (see paragraph 845-10-30-4).
30-16
All other nonmonetary exchanges of inventory within the same line of business shall be recognized at the carrying amount of the inventory transferred. That is, a nonmonetary exchange within the same line of business involving either of the following shall not be recognized at fair value: a. The transfer of raw materials or work-in-process inventory in exchange for the receipt of raw materials, work-in-process, or finished goods inventory. b. The transfer of finished goods inventory for the receipt of finished goods inventory.
ANSWERS TO QUESTIONS 1. The major characteristics of plant assets are (1) that they are acquired for use in operations and not for resale, (2) that they are long-term in nature and usually subject to depreciation, and (3) that they have physical substance. 2. The company should report the asset at its historical cost of $450,000, not its current value. The main reasons for this position are (1) at the date of acquisition, cost reflects fair value; (2) historical cost involves actual, not hypothetical transactions, and as a result is extremely reliable; and (3) gains and losses should not be anticipated but should be recognized when the asset is sold. 3. (a) The acquisition costs of land may include the purchase or contract price, the broker’s commission, title search and recording fees, assumed taxes or other liabilities, and surveying, demolition (less salvage), and landscaping costs. (b) Machinery and equipment costs may properly include freight and handling, taxes on purchase, insurance in transit, installation, and expenses of testing and breaking-in. (c) If a building is purchased, all repair charges, alterations, and improvements necessary to ready the building for its intended use should be included as a part of the acquisition cost. Building costs in addition to the amount paid to a contractor may include excavation, permits and licenses, architect’s fees, interest accrued on funds obtained for construction purposes (during construction period only) called avoidable interest, insurance premiums applicable to the construction period, temporary buildings and structures, and property taxes levied on the building during the construction period. 4. (a) Land. (b) Land. (c) Land. (d) Machinery. The only controversy centers on whether fixed overhead should be allocated as a cost to the machinery. (e) Land Improvements, should be depreciated. (f) Buildings. (g) Buildings, provided the benefits in terms of information justify the additional cost involved in providing the information. (h) Land. (i) Land. 5. (a) The position that no fixed overhead should be capitalized assumes that the construction of plant (fixed) assets will be timed so as not to interfere with normal operations. If this were not the case, the savings anticipated by constructing instead of purchasing plant assets would be nullified by reduced profits on the product that could have been manufactured and sold. Thus, construction of plant assets during periods of low activity will have a minimal effect on the total amount of overhead costs. To capitalize a portion of fixed overhead as an element of the cost of constructed assets would, under these circumstances, reduce the amount assignable to operations and therefore overstate net income in the construction period and understate net income in subsequent periods because of increased depreciation charges. (b) Capitalizing overhead at the same rate as is charged to normal operations is defended by those who believe that all manufacturing overhead serves a dual purpose during plant asset construction periods. Any attempt to assign construction activities less overhead than the normal rate implies costing favors and results in the misstatement of the cost of both plant assets and finished goods.
Questions Chapter 10 (Continued) 6. (a) Disagree. Organization and promotion expenses should be expensed. (b) Agree. Architect’s fees for plans actually used in construction of the building should be charged to the building account as part of the cost. (c) Agree. GAAP recommends that avoidable interest or actual interest cost, whichever is lower, 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 are capitalized starting with the first expenditure related to the asset and capitalization would continue until the asset is substantially completed and ready for its intended use. Property taxes during construction should also be charged to the building account. (d) Disagree. Interest revenue is not considered part of the acquisition cost of the building and should be recorded as revenue. 7. Since the land for the plant site will be used in the operations of the firm, it is classified as property, plant, and equipment. The other tract is being held for speculation. It is classified as an investment. 8. A common accounting justification is that all costs associated with the construction of an asset, including interest, should be capitalized in order that the costs can be matched to the revenues which the new asset will help generate. 9. Assets that do not qualify for interest capitalization are (1) assets that are in use or ready for their intended use, and (2) assets that are not being used in the earnings activities of the firm. 10. The avoidable interest is determined by multiplying (an) interest rate(s) by the weighted-average amount of accumulated expenditures on qualifying assets. For the portion of weighted-average accumulated expenditures which is less than or equal to any amounts borrowed specifically to finance construction of the assets, the capitalization rate is the specific interest rate incurred. For the portion of weighted-average accumulated expenditures which is greater than specific debt incurred, the interest rate is a weighted average of all other interest rates incurred. The amount of interest to be capitalized is the avoidable interest, or the actual interest incurred, whichever is lower. As indicated in the chapter, an alternative to the specific rate is to use an average borrowing rate. 11. The total interest cost incurred during the period should be disclosed, indicating the portion capitalized and the portion charged to expense. Interest revenue from temporarily invested excess funds should not be offset against interest cost when determining the amount of interest to be capitalized. The interest revenue would be reported in the same manner customarily used to report any other interest revenue. 12. (a) Assets acquired by issuance of capital stock—when property is acquired by issuance of common stock, the cost of the property is not measured by par or stated value of such stock. If the stock is actively traded on the market, then the market value of the stock is a fair indication of the cost of the property because the market value of the stock is a good measure of the current cash equivalent price. If the market value of the common stock is not determinable, then the market value of the property should be established and used as the basis for recording the asset and issuance of common stock.
Questions Chapter 10 (Continued) (b) Assets acquired by gift or donation—when assets are acquired in this manner a strict cost concept would dictate that the valuation of the asset be zero. However, in this situation, accountants record the asset at its fair value. The credit should be made to Contribution Revenue. Contributions received should be credited to revenue unless the contribution is from a governmental unit. Even in that case, we believe that the credit should be to Contribution Revenue. (c) Cash discount—when assets are purchased subject to a cash discount, the question of how the discount should be handled occurs. If the discount is taken, it should be considered a reduction in the asset cost. Different viewpoints exist, however, if the discount is not taken. One approach is that the discount must be considered a reduction in the cost of the asset. The rationale for this approach is that the terms of these discounts are so attractive that failure to take the discount must be considered a loss because management is inefficient. The other view is that failure to take the discount should not be considered a loss, because the terms may be unfavorable or the company might not be prudent to take the discount. Presently both methods are employed in practice. The former approach is conceptually correct. (d) Deferred payments—assets should be recorded at the present value of the consideration exchanged between contracting parties at the date of the transaction. In a deferred payment situation, there is an implicit (or explicit) interest cost involved, and the accountant should be careful not to include this amount in the cost of the asset. (e) Lump sum or basket purchase—sometimes a group of assets are acquired for a single lump sum. When a situation such as this exists, the accountant must allocate the total cost among the various assets on the basis of their relative fair value. (f) Trade or exchange of assets—when one asset is exchanged for another asset, the accountant is faced with several issues in determining the value of the new asset. The basic principle involved is to record the new asset at the fair value of the new asset or the fair value of what is given up to acquire the new asset, whichever is more clearly evident. However, the accountant must also be concerned with whether the exchange has commercial substance and whether monetary consideration is involved in the transaction. The commercial substance issue rests on whether the expected cash flows on the assets involved are significantly different. In addition, monetary consideration may affect the amount of gain recognized on the exchange under consideration. 13. The cost of such assets includes the purchase price, freight and handling charges incurred, insurance on the equipment while in transit, cost of special foundations if required, assembly and installation costs, and costs of conducting trial runs. Costs thus include all expenditures incurred in acquiring the equipment and preparing it for use. When plant assets are purchased subject to cash discounts for prompt payment, the question of how the discount should be handled arises. The appropriate view is that the discount, whether taken or not, is considered a reduction in the cost of the asset. The rationale for this approach is that the real cost of the asset is the cash or cash equivalent price of the asset. Similarly, assets purchased on long-term payment plans should be accounted for at the present value of the consideration exchanged between the contracting parties at the date of the transaction. 14.
Fair value of land Fair value of building and land
X Cost = Cost allocated to land
$500,000 X $2,200,000 = $440,000 $2,500,000
(Cost allocated to land)
$2,000,000 $2,500,000
X $2,200,000 = $1,760,000 (Cost allocated to building)
Questions Chapter 10 (Continued) 15. $10,000 + $4,208 = $14,208 16. Ordinarily accounting for the exchange of nonmonetary assets should be based on the fair value of the asset given up or the fair value of the asset received, whichever is more clearly evident. Thus any gains and losses on the exchange should be recognized immediately. If the fair value of either asset is not reasonably determinable, the book value of the asset given up is usually used as the basis for recording the nonmonetary exchange. This approach is always employed when the exchange has commercial substance. The general rule is modified when exchanges lack commercial substance. In this case, the enterprise is not considered to have completed the earnings process and therefore a gain should not be recognized. However, a loss should be recognized immediately. In certain situations, gains on an exchange that lacks commercial substance may be recorded when monetary consideration is received. When monetary consideration is received, it is assumed that a portion of the earnings process is completed, and therefore, a partial gain is recognized. 17. In accordance with GAAP which requires losses to be recognized immediately, the entry should be: Trucks (new)....................................................................................... Accumulated Depreciation .................................................................. Loss on Disposal of Trucks................................................................. Trucks (old)................................................................................... Cash .............................................................................................
42,000 9,800* 4,200** 30,000 26,000
*[($30,000 – $6,000) X 49 months/120 months = $9,800] **(Book value $20,200 – $16,000 trade-in = $4,200 loss) 18. Ordinarily such expenditures include (1) the recurring costs of servicing necessary to keep property in good operating condition, (2) cost of renewing structural parts of major plant units, and (3) costs of major overhauling operations which may or may not extend the life beyond original expectation. The first class of expenditures represents the day-to-day service and in general is chargeable to operations as incurred. These expenditures should not be charged to the asset accounts. The second class of expenditures may or may not affect the recorded cost of property. If the asset is rigidly defined as a distinct unit, the renewal of parts does not usually disturb the asset accounts; however, these costs may be capitalized and apportioned over several fiscal periods on some equitable basis. If the property is conceived in terms of structural elements subject to separate replacement, such expenditures should be charged to the plant asset accounts. The third class of expenditures, major overhauls, is usually entered through the asset accounts because replacement of important structural elements is usually involved. Other than maintenance charges mentioned above are those expenditures which add some physical aspect not a part of the asset at the time of its original acquisition. These expenditures may be capitalized in the asset account. An expenditure which extends the life but not the usefulness of the asset is often charged to the Accumulated Depreciation account. A more appropriate treatment requires retiring from the asset and accumulated depreciation accounts the appropriate amounts (original cost from the asset account ) and to capitalize in the asset account the new cost. Often it is difficult to determine the original cost of the item being replaced. For this reason the replacement or renewal is charged to the Accumulated Depreciation account. 19. (a) Additions. Additions represent entirely new units or extensions and enlargements of old units. Expenditures for additions are capitalized by charging either old or new asset accounts depending on the nature of the addition.
Questions Chapter 10 (Continued) (b) Major Repairs. Expenditures to replace parts or otherwise to restore assets to their previously efficient operating condition are regarded as repairs. To be considered a major repair, several periods must benefit from the expenditure. The cost should be handled as an addition, improvement or replacement depending on the type of major repair made. (c) Improvements. An improvement does not add to existing plant assets. Expenditures for such betterments represent increases in the quality of existing plant assets by rearrangements in plant layout or the substitution of improved components for old components so that the facilities have increased productivity, greater capacity, or longer life. The cost of improvements is accounted for by charges to the appropriate property accounts and the elimination of the cost and accumulated depreciation associated with the replaced components, if any. Replacements. Replacements involve an “in kind” substitution of a new asset or part for an old asset or part. Accounting for major replacements requires entries to retire the old asset or part and to record the cost of the new asset or part. Minor replacements are treated as period costs. 20. The cost of installing the machinery should be capitalized, but the extra month’s wages paid to the dismissed employees should not, as this payment did not add any value to the machinery. The extra wages should be charged off immediately as an expense; the wages could be shown as a separate item in the income statement for disclosure purposes. 21. (a) Overhead of a business that builds its own equipment. Some accountants have maintained that the equipment account should be charged only with the additional overhead caused by such construction. However, a more realistic figure for cost of equipment results if the plant asset account is charged for overhead applied on the same basis and at the same rate as used for production. (b) Cash discounts on purchases of equipment. Some accountants treat all cash discounts as financial or other revenue, regardless of whether they arise from the payment of invoices for merchandise or plant assets. Others take the position that only the net amount paid for plant assets should be capitalized on the basis that the discount represents a reduction of price and is not income. The latter position seems more logical in light of the fact that plant assets are purchased for use and not for sale and that they are written off to expense over a long period of time. (c) Interest paid during construction of a building. GAAP requires that avoidable or actual interest cost, whichever is lower, 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 and location necessary for its intended use. (d) Cost of a safety device installed on a machine. This is an addition to the machine and should be capitalized in the machinery account if material. (e) Freight on equipment returned before installation, for replacement by other equipment of greater capacity. If ordering the first equipment was an error, whether due to judgment or otherwise, the freight should be regarded as a loss. However, if information became available after the order was placed which indicated purchase of the new equipment was more advantageous, the cost of the return freight may be viewed as a necessary cost of the new equipment.
Questions Chapter 10 (Continued) (f) Cost of moving machinery to a new location. Normally, only the cost of one installation should be capitalized for any piece of equipment. Thus the original installation and any accumulated depreciation relating thereto should be removed from the accounts and the new installation costs (i.e., cost of moving) should be capitalized. In cases where this is not possible and the cost of moving is substantial, it is capitalized and depreciated appropriately over the period during which it makes a contribution to operations. (g) Cost of plywood partitions erected in the remodeling of the office. This is a part of the remodeling cost and may be capitalized as part of the remodeling itself is of such a nature that it is an addition to the building and not merely a replacement or repair. (h) Replastering of a section of the building. This seems more in the nature of a repair than anything else and as such should be treated as an expense. (i) Cost of a new motor for one of the trucks. This probably extends the useful life of the truck. As such it may be viewed as an extraordinary repair and charged against the accumulated depreciation on the truck. The remaining service life of the truck should be estimated and the depreciation adjusted to write off the new book value, less salvage, over the remaining useful life. A more appropriate treatment is to remove the cost of the old motor and related depreciation and add the cost of the new motor if possible. 22. This approach is not correct since at the very minimum the investor should be aware that certain assets are used in the business, which are not reflected in the main body of the financial statements. Either the company should keep these assets on the balance sheet or they should be recorded at salvage value and the resulting gain recognized. In either case, there should be a clear indication that these assets are fully depreciated, but are still being used in the business. 23. Gains or losses on plant asset retirements should be shown in the income statement along with other items that arise from customary business activities-usually as other revenues and gains or other expenses and losses.
SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 10-1 $27,000 + $1,400 + $10,200 = $38,600
BRIEF EXERCISE 10-2 Expenditures Date 3/1 6/1 12/31
Capitalization Period 10/12 7/12 0
Amount $1,800,000 1,200,000 3,000,000 $6,000,000
Weighted-Average Accumulated Expenditures $1,500,000 700,000 0 $2,200,000
BRIEF EXERCISE 10-3
10%, 5-year note 11%, 4-year note
Principal $2,000,000 3,500,000 $5,500,000
Interest $200,000 385,000 $585,000 $585,000
Weighted-average interest rate =
= 10.64%
$5,500,000 BRIEF EXERCISE 10-4 Weighted-Average Accumulated Expenditures $1,000,000 1,200,000 $2,200,000
X
Interest Rate 12% 10.64%
=
Avoidable Interest $120,000 127,680 $247,680
BRIEF EXERCISE 10-5 Trucks ($80,000 X .68301) ..................................... Discount on Notes Payable .................................. Notes Payable...............................................
54,641 25,359 80,000
BRIEF EXERCISE 10-6
Land Building Equipment
Fair Value $ 60,000 220,000 80,000 $360,000
% of Total 60/360 220/360 80/360
X X X
Cost $315,000 $315,000 $315,000
Recorded Amount $ 52,500 192,500 70,000 $315,000
BRIEF EXERCISE 10-7 Land (2,000 X $40) ................................................. Common Stock (2,000 X $10)....................... Paid-in Capital in Excess of Par— Common Stock ........................................
80,000 20,000 60,000
BRIEF EXERCISE 10-8 Equipment.............................................................. Accumulated Depreciation—Trucks .................... Trucks ........................................................... Cash .............................................................. Gain on Disposal of Trucks .........................
3,300 18,000 20,000 500 800
BRIEF EXERCISE 10-9 Equipment ($3,300 – $800).................................... Accumulated Depreciation—Trucks .................... Trucks ........................................................... Cash ..............................................................
2,500 18,000 20,000 500
BRIEF EXERCISE 10-10 Equipment.............................................................. Accumulated Depreciation—Machinery .............. Loss on Disposal of Machinery............................ Machinery ..................................................... Cash ..............................................................
5,000 3,000 4,000 9,000 3,000
BRIEF EXERCISE 10-11 Trucks (new) .......................................................... Accumulated Depreciation—Trucks .................... Loss on Disposal of Trucks.................................. Trucks (used)................................................ Cash ..............................................................
37,000 27,000 2,000 30,000 36,000
BRIEF EXERCISE 10-12 Trucks (new) .......................................................... Accumulated Depreciation—Trucks .................... Loss on Disposal of Trucks.................................. Trucks (used)................................................ Cash ..............................................................
BRIEF EXERCISE 10-13 Only cost (c) is expensed when incurred.
35,000 17,000 1,000 20,000 33,000
BRIEF EXERCISE 10-14 (a) (b)
Depreciation Expense ($2,400 X 8/12) ..................... Accumulated Depreciation—Machinery.........
1,600
Cash ........................................................................... Accumulated Depreciation—Machinery ($8,400 + $1,600)................................................... Machinery ......................................................... Gain on Disposal of Machinery.......................
10,500
1,600
10,000 20,000 500
BRIEF EXERCISE 10-15 (a) (b)
Depreciation Expense ($2,400 X 8/12) ..................... Accumulated Depreciation—Machinery.........
1,600
Cash ........................................................................... Loss on Disposal of Machinery................................ Accumulated Depreciation—Machinery ($8,400 + $1,600)................................................... Machinery .........................................................
5,200 4,800 10,000
1,600
20,000
SOLUTIONS TO EXERCISES EXERCISE 10-1 (15–20 minutes) Item (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l) (m) (n) (o) (p)
Land
Land Improvements
Building
Other Accounts ($275,000) Notes Payable
$275,000 $
8,000 7,000 6,000 (1,000) 22,000 250,000 9,000 $ 4,000 11,000 (5,000) 13,000 19,000 14,000 3,000
EXERCISE 10-2 (10–15 minutes) The allocation of costs would be as follows: Land Razing costs Salvage Legal fees Survey Plans Title insurance Liability insurance Construction Interest
Land $400,000 42,000 (6,300) 1,850
Building
$
2,200 68,000
1,500
$439,050
900 2,740,000 170,000 $2,981,100
EXERCISE 10-3 (10–15 minutes) 1. 2.
3.
Trucks .................................................................. 13,900.00 Cash ............................................................ Trucks .................................................................. 14,727.26* Discount on Notes Payable .................................. 1,272.74 Cash ............................................................ Notes Payable ............................................ *PV of $14,000 @ 10% for 1 year = $14,000 X .90909 = $12,727.26 $12,727.26 + $2,000.00 = $14,727.26 Trucks .................................................................. 15,200.00 Cost of Goods Sold ............................................. 12,000.00 Inventory..................................................... Sales Revenue............................................
13,900.00
2,000.00 14,000.00
12,000.00 15,200.00
[Note to instructor: The selling (retail) price of the computer system appears to be a better gauge of the fair value of the consideration given than is the list price of the truck as a gauge of the fair value of the consideration received (truck). Vehicles are very often sold at a price below the list price.] 4.
Trucks ................................................................... 13,000.00 Common Stock........................................... Paid-in Capital in Excess of Par – Common Stock........................................ (1,000 shares X $13 = $13,000)
10,000.00 3,000.00
EXERCISE 10-4 (20–25 minutes) Purchase Cash paid for equipment, including sales tax of $5,000 Freight and insurance while in transit Cost of moving equipment into place at factory Wage cost for technicians to test equipment Special plumbing fixtures required for new equipment Total cost
$105,000 2,000 3,100 4,000 8,000 $122,100
The insurance premium paid during the first year of operation of this equipment should be reported as insurance expense, and not be capitalized. Repair cost incurred in the first year of operations related to this equipment should be reported as repair and maintenance expense, and not be capitalized. Both these costs relate to periods subsequent to purchase. Construction Material and purchased parts ($200,000 X .98) Labor costs Overhead costs Cost of installing equipment Total cost
$196,000 190,000 50,000 4,400 $440,400
Note that the cost of material and purchased parts is reduced by the amount of cash discount not taken because the equipment should be reported at its cash equivalent price. The imputed interest on funds used during construction related to stock financing should not be capitalized or expensed. This item is an opportunity cost that is not reported. Profit on self-construction should not be reported. Profit should only be reported when the asset is sold.
EXERCISE 10-5 (30–40 minutes) Land Abstract fees Architect’s fees Cash paid for land and old building Removal of old building ($20,000 – $5,500) Interest on loans during construction
$
Buildings
M&E
Other
520 $
3,170
87,000 14,500 7,400
Excavation before construction Machinery purchased Freight on machinery Storage charges caused by noncompletion of building
19,000
New building Assessment by city Hauling charges—machinery Installation—machinery Landscaping
485,000
$53,900 1,340
$1,100
—Misc. expense (Discount Lost)
2,180
—Misc. expense (Loss)
620
—Misc. expense (Loss)
1,600 2,000 5,400 $109,020
$514,570
$57,240
$3,900
EXERCISE 10-6 (15–25 minutes) 1.
Land ..................................................................... Buildings.............................................................. Equipment ........................................................... Cash ............................................................ $700,000 X
$150,000
131,250 306,250 262,500
= $131,250
Land
= $306,250
Buildings
= $262,500
Equipment
$800,000 $700,000 X
$350,000 $800,000
$700,000 X
$300,000 $800,000
700,000
EXERCISE 10-6 (Continued) 2.
3.
4.
5.
Equipment ........................................................... Cash............................................................ Note Payable ..............................................
25,000
Equipment ........................................................... Accounts Payable ($20,000 X .98).............
19,600
Land .................................................................... Contribution Revenue ...............................
27,000
Buildings ............................................................. Cash............................................................
600,000
2,000 23,000
19,600
27,000
600,000
EXERCISE 10-7 (20–25 minutes) (a)
Avoidable Interest Weighted-Average Accumulated Expenditures
X Interest Rate = Avoidable Interest
$2,000,000 1,600,000 $3,600,000
12% 10.42%
Weighted-average interest rate computation 10% short-term loan 11% long-term loan
Total Interest Total Principal
=
$240,000 166,720 $406,720 Principal
Interest
$1,400,000 1,000,000 $2,400,000
$140,000 110,000 $250,000
$250,000 = 10.42% $2,400,000
EXERCISE 10-7 (Continued) (b)
Actual Interest $2,000,000 X 12% = $1,400,000 X 10% = $1,000,000 X 11% = Total
Construction loan Short-term loan Long-term loan
$240,000 140,000 110,000 $490,000
Because avoidable interest is lower than actual interest, use avoidable interest. Cost $5,200,000 Interest capitalized 406,720 Total cost $5,606,720 Depreciation Expense = $5,606,720 – $300,000 = $176,891 30 years EXERCISE 10-8 (20–25 minutes) (a)
Computation of Weighted-Average Accumulated Expenditures Expenditures Date
Amount
March 1 June 1 July 1 December 1
$ 360,000 600,000 1,500,000 1,500,000 $3,960,000
X
Capitalization Period
=
Weighted-Average Accumulated Expenditures
10/12 7/12 6/12 1/12
$ 300,000 350,000 750,000 125,000 $1,525,000
Computation of Avoidable Interest Weighted-Average Accumulated Expenditures $1,525,000
X
Interest Rate .12 (Construction loan)
=
Avoidable Interest $183,000
Computation of Actual Interest Actual interest $3,000,000 X 12% $4,000,000 X 13% $1,600,000 X 10%
$ 360,000 520,000 160,000 $1,040,000
Note: Use avoidable interest for capitalization purposes because it is lower than actual.
EXERCISE 10-8 (Continued) (b)
Buildings ............................................................. Interest Expense*................................................ Cash ($360,000 + $520,000 + $160,000) .... *Actual interest for year Less: Amount capitalized Interest expense debit
183,000 857,000 1,040,000
$1,040,000 183,000 $ 857,000
EXERCISE 10-9 (20–25 minutes) (a)
Computation of Weighted-Average Accumulated Expenditures Expenditures Capitalization Date
Amount
July 31 November 1
$200,000 100,000
Interest revenue
X
Period
Weighted-Average =
Accumulated Expenditures
3/12 0
$50,000 0 $50,000
$100,000 X 10% X 3/12 = $2,500
Avoidable interest Weighted-Average Accumulated Expenditures
X
$50,000
Interest Rate 12%
Actual Interest $300,000 X 12% X 5/12 = $30,000 X 8% =
$15,000 2,400 $17,400
Interest capitalized
$ 6,000
=
Avoidable Interest $6,000
EXERCISE 10-9 (Continued) (b)
(1)
(2)
(3)
7/31 Cash ................................................. Note Payable ...........................
300,000
Machinery......................................... Trading Securities ........................... Cash.........................................
200,000 100,000
11/1 Cash ................................................. Interest Revenue ($100,000 X 10% X 3/12)....... Trading Securities ..................
102,500
Machinery......................................... Cash.........................................
100,000
Machinery......................................... Interest Expense ($17,400 – $6,000) ......................... Cash ($30,000 X 8%) ............... Interest Payable ($300,000 X 12% X 5/12).......
6,000
12/31
300,000
300,000
2,500 100,000
100,000
11,400 2,400 15,000
EXERCISE 10-10 (20–25 minutes) Situation I. $80,000—The requirement is the amount Oksana Baiul should report as capitalized interest at 12/31/14. The amount of interest eligible for capitalization is Weighted-Average Accumulated Expenditures X Interest Rate = Avoidable Interest
Since Oksana Baiul has outstanding debt incurred specifically for the construction project, in an amount greater than the weighted-average accumulated expenditures of $800,000, the interest rate of 10% is used for capitalization purposes. Therefore, the avoidable interest is $80,000, which is less than the actual interest. $800,000 X .10 = $80,000
EXERCISE 10-10 (Continued) Finally, per FASB ASC 835-20-30-1 the interest earned of $250,000 is irrelevant to the question addressed in this problem because such interest earned on the unexpended portion of the loan is not to be offset against the amount eligible for capitalization. Situation II. $39,000—The requirement is total interest costs to be capitalized. GAAP identifies assets which qualify for interest capitalization: assets constructed for an enterprise’s own use and assets intended for sale or lease that are produced as discrete projects. Inventories that are routinely produced in large quantities on a repetitive basis do not qualify for interest capitalization. Therefore, only $30,000 and $9,000 are capitalized. Situation III. $385,000—The requirement is to determine the amount of interest to be capitalized on the financial statements at April 30, 2008. The GAAP requirements are met: (1) expenditures for the asset have been made, (2) activities that are necessary to get the asset ready for its intended use are in progress, and (3) interest cost is being incurred. The amount to be capitalized is determined by applying an interest rate to the weighted-average amount of accumulated expenditures for the asset during the period. Because the $7,000,000 of expenditures incurred for the year ended April 30, 2008, were incurred evenly throughout the year, the weighted-average amount of expenditures for the year is $3,500,000, ($7,000,000 ÷ 2). Therefore, the amount of interest to be capitalized is $385,000 ($3,500,000 X 11%). In any period the total amount of interest cost to be capitalized shall not exceed the total amount of interest cost incurred by the enterprise. (Total interest is $1,100,000). Finally, the interest earned of $650,000 is irrelevant to the question addressed in this problem because such interest earned on the unexpended portion of the loan is not to be offset against the amount eligible for capitalization.
EXERCISE 10-11 (10–15 minutes) (a)
(b)
(c)
Equipment ........................................................... Accounts Payable ......................................
10,000
Accounts Payable ............................................... Equipment ($10,000 X .02) ......................... Cash ............................................................
10,000
Equipment (new) ................................................. Loss on Disposal of Equipment......................... Accumulated Depreciation—Equipment ........... Accounts Payable ...................................... Equipment (old)..........................................
9,900* 1,600** 6,000
*Cost ($9,500 + $400)
$9,900
**Cost Less: Accumulated depreciation Book value of equipment (old) Less: Fair value of equipment (old) Loss on disposal of equipment
$8,000 6,000 2,000 400 $1,600
10,000 200 9,800
9,500 8,000
Accounts Payable ............................................... Cash ............................................................
9,500
Equipment ($10,800 X .91743) ............................ Discount on Note Payable .................................. ($10,800 – $9,908) Note Payable ..............................................
9,908 892
Interest Expense ................................................. Note Payable ....................................................... Discount on Note Payable ......................... Cash ............................................................
892 10,800
9,500
10,800
892 10,800
EXERCISE 10-12 (15–20 minutes) (a) (b)
Land ..................................................................... Contribution Revenue ...............................
81,000
Land ..................................................................... Buildings ............................................................. Common Stock ($50 X 13,000) .................. Paid-in Capital in Excess of Par— Common Stock* .............................
180,000 630,000
81,000
650,000 160,000
*Since the market value of the stock is not determinable, the market value of the property is used as the basis for recording the asset and issuance of the stock. (c)
Machinery ............................................................ Materials ..................................................... Direct Labor................................................ Factory Overhead ...................................... *Fixed overhead applied Additional overhead Factory supplies used
(60% X $15,000)
40,100 12,500 15,000 12,600* $ 9,000 2,700 900 $12,600
EXERCISE 10-13 (20–25 minutes) 1.
Land .................................................................... 350,000 Building.................................................................... 1,050,000 Equipment ........................................................... 700,000 Common Stock (12,500 X $100) ................ Paid-in Capital in Excess of Par— Common Stock ($2,100,000 – $1,250,000)........................
1,250,000
850,000
The cost of the property, plant and equipment is $2,100,000 ($12,500 X $168). This cost is allocated based on appraisal values as follows: Land Building Equipment
$400,000 $2,400,000 $1,200,000 $2,400,000 $800,000 $2,400,000
X $2,100,000 = $350,000 X $2,100,000 = $1,050,000 X $2,100,000 = $700,000
EXERCISE 10-13 (Continued) 2.
3.
Buildings ($105,000 plus $161,000) ................... Equipment ........................................................... Land Improvements ............................................ Land ..................................................................... Cash ............................................................
266,000 135,000 122,000 18,000
Equipment ........................................................... Cash ............................................................ ($10,500 plus $254,800, which is 98% of $260,000.)
265,300
541,000
265,300
EXERCISE 10-14 (15–20 minutes) (a)
(b)
Equipment ........................................................... Discount on Notes Payable ................................ Notes Payable ............................................ *PV of $160,000 annuity @ 12% for 5 years ($160,000 X 3.60478) = $576,765
576,765* 223,235
Interest Expense ................................................. Notes Payable ..................................................... Discount on Notes Payable ....................... Cash ............................................................ *(12% X $576,765)
69,212* 160,000
Year 1/2/14 12/31/14 12/31/15
800,000
Note Payment
12% Interest
Reduction of Principal
$160,000 160,000
$69,212 58,317
$ 90,788 101,683
69,212 160,000
Balance $576,765 485,977 384,294
EXERCISE 10-14 (Continued) (c)
(d)
Interest Expense ................................................. Notes Payable ..................................................... Discount on Notes Payable....................... Cash............................................................
58,317 160,000
Depreciation Expense......................................... Accumulated Depreciation—Equipment .. *($576,765 ÷ 10)
57,677*
58,317 160,000
57,677
EXERCISE 10-15 (15–20 minutes) (a)
(b)
Equipment .............................................................. 86,861.85* Discount on Notes Payable ................................... 18,138.15 Cash............................................................ Notes Payable ............................................ *PV of $15,000 annuity @ 10% for 5 years ($15,000 X 3.79079) $56,861.85 Down payment 30,000.00 Capitalized value of equipment $86,861.85 Notes Payable ..................................................... Interest Expense (see schedule)........................ Cash............................................................ Discount on Notes Payable.......................
Year 12/31/13 12/31/14 12/31/15
Note Payment $15,000.00 15,000.00
10% Interest $5,686.19 4,754.80
30,000.00 75,000.00
15,000.00 5,686.19 15,000.00 5,686.19
Reduction of Principal
Balance
$ 9,313.81 10,245.20
$56,861.85 47,548.04 37,302.84
EXERCISE 10-15 (Continued) (c)
Notes Payable ..................................................... Interest Expense ................................................. Cash ............................................................ Discount on Notes Payable .......................
15,000.00 4,754.80 15,000.00 4,754.80
EXERCISE 10-16 (25–35 minutes) Hayes Industries Acquisition of Assets 1 and 2 Use Appraised Values to break-out the lump-sum purchase
Description Machinery Equipment
Appraisal
Percentage
Lump-Sum
Value on Books
90,000 30,000 120,000
90/120 30/120
100,000 100,000
75,000 25,000
Machinery .............................................................. Equipment ............................................................. Cash ..............................................................
75,000 25,000 100,000
Acquisition of Asset 3 Use the cash price as a basis for recording the asset with a discount recorded on the note. Machinery .............................................................. Discount on Notes Payable ($40,000 – $35,900)...... Cash .............................................................. Notes Payable ..............................................
35,900 4,100 10,000 30,000
EXERCISE 10-16 (Continued) Acquisition Asset 4 Since the exchange lacks commercial substance, a gain will be recognized in the proportion of cash received ($10,000/$80,000) times the $20,000 gain (FMV of $80,000 minus BV of $60,000). The gain recognized will then be $2,500 with $17,500 of it being unrecognized and used to reduce the basis of the asset acquired. Machinery ($70,000 – $17,500) ........................... Accumulated Depreciation—Machinery............ Cash..................................................................... Machinery ................................................... Gain on Disposal of Machinery.................
52,500 40,000 10,000 100,000 2,500
Acquisition of Asset 5 In this case the Office Equipment should be placed on Hayes’s books at the fair market value of the stock. The difference between the stock’s par value and its fair market value should be credited to Paid-in Capital in Excess of Par—Common Stock. Equipment ........................................................... Common Stock .......................................... Paid-in Capital in Excess of Par— Common Stock ........................................
1,100 800 300
EXERCISE 10-16 (Continued) Construction of Building Schedule of Weighted-Average Accumulated Expenditures
Date
Amount
February 1 February 1 June 1 September 1 November 1
$ 150,000 120,000 360,000 480,000 100,000 $1,210,000
Current Year Capitalization Period
Weighted-Average Accumulated Expenditures
9/12 9/12 5/12 2/12 0/12
$112,500 90,000 150,000 80,000 0 $432,500
Note that the capitalization is only 9 months in this problem. Avoidable Interest Weighted-Average Accumulated Expenditures $432,500
Interest Rate X
.12
Avoidable Interest =
$51,900
The weighted expenditures are less than the amount of specific borrowing; the specific borrowing rate is used. Land Cost Building Cost
150,000 1,111,900 (1,060,000 + 51,900)
Land ..................................................................... 150,000 Building................................................................ 1,111,900 Cash ............................................................ Interest Expense ........................................
1,210,000 51,900
EXERCISE 10-17 (10–15 minutes) Busytown Corporation Machinery ($340 + $85) ......................................... Accumulated Depreciation – Machinery.............. Loss on Disposal of Machinery............................ Machinery ..................................................... Cash .............................................................. *Computation of loss: Book value of old machine ($290 – $140) Less: Fair value of old machine Loss on disposal of machinery Dick Tracy Business Machine Company Cash ....................................................................... Inventory................................................................ Cost of Goods Sold............................................... Sales Revenue.............................................. Inventory.......................................................
425 140 65* 290 340
$150 85 $ 65
340 85 270 425 270
EXERCISE 10-18 (20–25 minutes) (a)
Exchange has commercial substance: Depreciation Expense............................................. Accumulated Depreciation—Equipment ...... ($11,200 – $700 = $10,500; $10,500 ÷ 5 = $2,100; $2,100 X 4/12 = $700) Equipment ............................................................... Accumulated Depreciation—Equipment ............... Gain on Disposal of Equipment .................... Equipment ...................................................... Cash ................................................................ *Cost of old asset Less: Accumulated depreciation ($6,300 + $700) Book value of equipment (old) Less: Fair value of old asset Gain on disposal of equipment
$11,200
**Cash paid Fair value of old asset Cost of new asset
$10,000 5,200 $15,200
7,000 4,200 (5,200) $ 1,000
700 700
15,200** 7,000 1,000* 11,200 10,000
EXERCISE 10-18 (Continued) (b)
Exchange lacks commercial substance: Depreciation Expense............................................... Accumulated Depreciation—Equipment ........
700
Equipment (melter)........................................................ 15,200** Accumulated Depreciation—Equipment ................. 7,000 Gain on Disposal of Equipment ...................... Equipment ........................................................ Cash.................................................................. **Cash paid Fair value of old asset Cost of new asset
700
1,000 11,200 10,000
$10,000 5,200 $15,200
Note that the entries are the same for both (a) and (b). Gain is not deferred because cash boot is greater than 25% of the total amount given up, which makes the transaction monetary in nature.
EXERCISE 10-19 (15–20 minutes) (a) Exchange lacks commercial substance. Carlos Arruza Company: Equipment........................................................ Accumulated Depreciation—Equipment........ Equipment............................................... Cash ........................................................ Valuation of equipment Book value of equipment given up Fair value of boot given up New equipment
12,000 19,000 28,000 3,000
$ 9,000 3,000 $12,000
OR Fair value received Less: Gain deferred New equipment
$15,500 3,500* $12,000
*Fair value of old equipment Less: Book value of old equipment Gain on disposal
$12,500 9,000 $ 3,500
Note: Cash paid is less than 25% of the total amount given up, the transaction is nonmonetary, so the gain is deferred. Tony Lo Bianco Company: Cash ...................................................................... Equipment............................................................. Accumulated Depreciation—Equipment............. Loss on Disposal of Equipment .......................... Equipment.................................................... *Computation of loss: Book value of old equipment Less: Fair value of old equipment Loss on disposal of equipment
3,000 12,500 10,000 2,500*
$18,000 15,500 $ 2,500
28,000
EXERCISE 10-19 (Continued) (b)
Exchange has commercial substance Carlos Arruza Company Equipment ........................................................... Accumulated Depreciation—Equipment ........... Equipment .................................................. Cash............................................................ Gain on Disposal of Equipment ................
15,500* 19,000 28,000 3,000 3,500**
*Cost of new equipment: Cash paid Fair value of old equipment Cost of new equipment
$ 3,000 12,500 $15,500
**Computation of gain on disposal of equipment: Fair value of old equipment Less: Book value of old equipment ($28,000 – $19,000) Gain on disposal of equipment
$12,500 9,000 $ 3,500
Tony LoBianco Company Cash..................................................................... Equipment ........................................................... Accumulated Depreciation—Equipment (Old) .... Loss on Disposal of Equipment......................... Equipment ..................................................
3,000 12,500* 10,000 2,500**
*Cost of new equipment: Fair value of equipment Less: Cash received Cost of new equipment
$15,500 3,000 $12,500
**Computation of loss on disposal of equipment: Book value of old equipment ($28,000 – $10,000) Less: Fair value of equipment (Old) Loss on disposal of equipment
$18,000 15,500 $ 2,500
28,000
EXERCISE 10-20 (15–20 minutes) (a)
Exchange has commercial substance Equipment ........................................................... Accumulated Depreciation—Equipment ........... Gain on Disposal of Equipment ................ Equipment .................................................. Cash ............................................................
56,900 20,000 5,800 62,000 9,100
Valuation of equipment Cash Installation cost Market value of used equipment Cost of new equipment
$ 8,000 1,100 47,800 $56,900
Computation of gain Fair value of old asset Cost of old asset Less: Accumulated depreciation Book value of old asset Gain on disposal of equipment (b)
$47,800 $62,000 20,000 (42,000) $ 5,800
Fair value information not determinable Automatic Equipment ......................................... Accumulated Depreciation—Equipment ........... Equipment .................................................. Cash ............................................................
51,100* 20,000
*Basis of new equipment Book value of old equipment Cash paid (including installation costs) Basis of new equipment
$42,000 9,100 $51,100
62,000 9,100
EXERCISE 10-21 (20–25 minutes) (a)
Any addition to plant assets is capitalized because a new asset has been created. This addition increases the service potential of the plant.
(b)
Expenditures that do not increase the service benefits of the asset are expensed. Painting costs are considered ordinary repairs because they maintain the existing condition of the asset or restore it to normal operating efficiency.
(c)
The approach to follow is to remove the old book value of the roof and substitute the cost of the new roof. It is assumed that the expenditure increases the future service potential of the asset.
(d)
Conceptually, the book value of the old electrical system should be removed. However, practically it is often difficult if not impossible to determine this amount. In this case, one of two approaches is followed. One approach is to capitalize the replacement on the theory that sufficient depreciation was taken on the old system to reduce the carrying amount to almost zero. A second approach is to debit accumulated depreciation on the theory that the replacement extends the useful life of the asset and thereby recaptures some or all of the past depreciation. In our present situation, the problem specifically states that the useful life is not extended and therefore debiting Accumulated Depreciation is inappropriate. Thus, this expenditure should be added to the cost of the plant facility.
(e)
See discussion in (d) above. In this case, because the useful life of the asset has increased, a debit to Accumulated Depreciation would appear to be the most appropriate.
EXERCISE 10-22 (15–20 minutes) 1/30
Accumulated Depreciation—Buildings ............ Loss on Disposal of Buildings.......................... Buildings ................................................... Cash...........................................................
112,200* 24,900** 132,000 5,100
*(5% X $132,000 = $6,600; $6,600 X 17 = $112,200) **($132,000 – $112,200) + $5,100 3/10
Cash ($2,900 – $300) .......................................... Accumulated Depreciation—Machinery........... Loss on Disposal of Machinery ........................ Machinery ..................................................
2,600 11,200* 2,200** 16,000
*(70% X $16,000 = $11,200) **($16,000 – $11,200) + $300 – $2,900 3/20
5/18
6/23
Machinery ........................................................... Cash...........................................................
2,000
Machinery ........................................................... Accumulated Depreciation—Machinery........... Loss on Disposal of Machinery ........................ Machinery .................................................. Cash........................................................... *(60% X $3,500 = $2,100) **($3,500 – $2,100)
5,500 2,100* 1,400**
Maintenance and Repairs Expense .................. Cash...........................................................
6,900
2,000
3,500 5,500
6,900
EXERCISE 10-23 (20–25 minutes) (a) C (b) E (immaterial) (c) C (d) C (e) C (f) C (g) C (h) E
EXERCISE 10-24 (20–25 minutes) (a)
(b)
Depreciation Expense (8/12 X $60,000) ................ Accumulated Depreciation—Machinery......
40,000
Loss on Disposal of Machinery ............................ ($1,300,000 – $400,000) – $430,000 Cash ....................................................................... Accumulated Depreciation—Machinery............... ($360,000 + $40,000) Machine .........................................................
470,000
Depreciation Expense (3/12 X $60,000) ................ Accumulated Depreciation—Machinery......
40,000
430,000 400,000 1,300,000 15,000 15,000
Cash ....................................................................... 1,040,000 Accumulated Depreciation—Machinery............... 375,000 ($360,000 + $15,000) Machine ......................................................... 1,300,000 Gain on Disposal of Machinery.................... 115,000* *$1,040,000 – ($1,300,000 – $375,000)
EXERCISE 10-24 (Continued) (c)
Depreciation Expense (7/12 X $60,000) ............... Accumulated Depreciation—Machinery.....
35,000 35,000
Contribution Expense........................................... 1,100,000 Accumulated Depreciation—Machinery.............. 395,000 ($360,000 + $35,000) Machine ........................................................ 1,300,000 Gain on Disposal of Machinery................... 195,000* *$1,100,000 – ($1,300,000 – $395,000)
EXERCISE 10-25 (15–20 minutes) April 1 Cash ................................................................... Accumulated Depreciation—Buildings............ Land........................................................... Building ..................................................... Gain on Disposal of Plant Assets............ *Computation of gain: Less: Cash received Book value of land $ 60,000 Book value of buildings ($280,000 – $160,000) 120,000 Book value of land and building Gain on disposal Aug. 1 Land.................................................................... Buildings ............................................................ Cash ..........................................................
430,000 160,000 60,000 280,000 250,000*
$430,000
(180,000) $250,000 90,000 400,000 490,000
TIME AND PURPOSE OF PROBLEMS Problem 10-1 (Time 35–40 minutes) Purpose—to provide a problem involving the proper classification of costs related to property, plant, and equipment. Property, plant, and equipment must be segregated into land, buildings, leasehold improvements, and machinery and equipment for purposes of the analysis. Such costs as demolition costs, real estate commissions, imputed interest, minor and major repair work, and royalty payments are presented. An excellent problem for reviewing the first part of this chapter. Problem 10-2 (Time 40–55 minutes) Purpose—to provide a problem involving the proper classification of costs related to property, plant, and equipment. Such costs as land, freight and unloading, installation, parking lots, sales and use taxes, and machinery costs must be identified and appropriately classified. An excellent problem for reviewing the first part of this chapter. Problem 10-3 (Time 35–45 minutes) Purpose—to provide a problem involving the proper classification of costs related to land and buildings. Typical transactions involve allocation of the cost of removal of a building, legal fees paid, general expenses, cost of organization, special tax assessments, etc. A good problem for providing a broad perspective as to the types of costs expensed and capitalized. Problem 10-4 (Time 35–40 minutes) Purpose—to provide a problem involving the method of handling the disposition of certain properties. The dispositions include a condemnation, demolition, trade-in, contribution and sale to a stockholder. The problem therefore involves a number of situations and provides a good overview of the accounting treatment accorded property dispositions. Problem 10-5 (Time 20–30 minutes) Purpose—to provide the student with a problem in which schedules must be prepared on the costs of acquiring land and the costs of constructing a building. Interest costs are included. Problem 10-6 (Time 25–35 minutes) Purpose—to provide the student with a problem to determine costs to include in the value of land and plant, including interest capitalization. Problem 10-7 (Time 20–30 minutes) Purpose—to provide the student with a problem to compute capitalized interest and to present disclosures related to capitalized interest. Problem 10-8 (Time 35–45 minutes) Purpose—to provide the student with a problem involving the exchange of machinery. Four different exchange transactions are possible, and journal entries are required for each possible transaction. The exchange transactions cover the receipt and disposition of cash as well as the purchase of a machine from a dealer of machinery. Problem 10-9 (Time 30–40 minutes) Purpose—to provide a problem on the accounting treatment for exchanges of assets that have and do not have commercial substance involving gain situations. Problem 10-10 (Time 30–40 minutes) Purpose—to provide the student with another problem involving the exchange of productive assets. This problem is unusual because the size of the boot is greater than 25%. As a result, the entire transaction is monetary in nature and all gains and losses are recognized. Problem 10-11 (Time 35–45 minutes) Purpose—to provide a property, plant, and equipment problem consisting of three transactions that have to be recorded—(1) an asset purchased on a deferred payment contract, (2) a lump-sum purchase, and (3) a nonmonetary exchange.
SOLUTIONS TO PROBLEMS PROBLEM 10-1
(a)
REAGAN COMPANY Analysis of Land Account for 2014 Balance at January 1, 2014...................
$ 230,000
Land site number 621 Acquisition cost .................................... $850,000 Commission to real estate agent ......... 51,000 Clearing costs........................................... $35,000 Less: Amounts recovered ....................... 13,000 22,000 Total land site number 621........ Land site number 622 Land value ............................................. Building value........................................ Demolition cost ..................................... Total land site number 622........ Balance at December 31, 2014 .............
923,000
300,000 120,000 41,000 461,000 $1,614,000
REAGAN COMPANY Analysis of Buildings Account for 2014 Balance at January 1, 2014................... $ 890,000 Cost of new building constructed on land site number 622 Construction costs....................... $330,000 Excavation fees ............................ 38,000 Architectural design fees............. 11,000 Building permit fee....................... 2,500 381,500 Balance at December 31, 2014 ............. $1,271,500
PROBLEM 10-1 (Continued) REAGAN COMPANY Analysis of Leasehold Improvements Account for 2014 Balance at January 1, 2014................................. Office space......................................................... Balance at December 31, 2014 ........................... REAGAN COMPANY Analysis of Equipment Account for 2014 Balance at January 1, 2014................................. Cost of the new equipment acquired Invoice price.............................................. $ 87,000 Freight costs ............................................. 3,300 Installation costs ...................................... 2,400 Balance at December 31, 2014 ........................... (b)
$660,000 89,000 $749,000
$875,000
92,700 $967,700
Items in the fact situation which were not used to determine the answer to (a) above are as follows: 1.
Interest imputed on common stock financing is not permitted by GAAP and thus does not appear in any financial statement.
2.
Land site number 623, which was acquired for $650,000, should be included in Reagan’s balance sheet as land held for resale (investment section).
3.
Royalty payments of $17,500 should be included as a normal operating expense in Reagan’s income statement.
PROBLEM 10-2
(a)
LOBO CORPORATION Analysis of Land Account 2014 Balance at January 1, 2014 ................................. Plant facility acquired from Mendota Company— portion of fair value allocated to land (Schedule 1) .............................................. Balance at December 31, 2014 ............................ LOBO CORPORATION Analysis of Land Improvements Account 2014 Balance at January 1, 2014 ................................. Parking lots, streets, and sidewalks................... Balance at December 31, 2014 ............................ LOBO CORPORATION Analysis of Buildings Account 2014 Balance at January 1, 2014 ................................. Plant facility acquired from Mendota Company—portion of fair value allocated to building (Schedule 1)........................................ Balance at December 31, 2014 ............................
$ 300,000
185,000 $ 485,000
$ 140,000 95,000 $ 235,000
$1,100,000
555,000 $1,655,000
LOBO CORPORATION Analysis of Equipment Account 2014 Balance at January 1, 2014 ................................. $ 960,000 Cost of new equipment acquired Invoice price................................................ $400,000 Freight and unloading costs ...................... 13,000 Sales taxes .................................................. 20,000 Installation costs......................................... 26,000 459,000 $1,419,000
PROBLEM 10-2 (Continued) Deduct cost of equipment disposed of Equipment scrapped June 30, 2014 ....... Equipment sold July 1, 2014 ................... Balance at December 31, 2014.........................
$ 80,000* 44,000*
124,000 $1,295,000
*The accumulated depreciation account can be ignored for this part of the problem. Schedule 1 Computation of Fair Value of Plant Facility Acquired from Mendota Company and Allocation to Land and Building 20,000 shares of Lobo common stock at $37 quoted market price on date of exchange (20,000 X $37)
$740,000
Allocation to land and building accounts in proportion to appraised values at the exchange date:
Land Building Total Land Building Total (b)
Amount $230,000 690,000 $920,000 ($740,000 X 25%) ($740,000 X 75%)
Percentage of total 25 75 100 $185,000 555,000 $740,000
Items in the fact situation that were not used to determine the answer to (a) above, are as follows: 1.
The tract of land, which was acquired for $150,000 as a potential future building site, should be included in Lobo’s balance sheet as an investment in land.
2.
The $110,000 and $320,000 book values respective to the land and building carried on Mendota’s books at the exchange date are not used by Lobo.
PROBLEM 10-2 (Continued) 3.
The $12,080 loss (Schedule 2) incurred on the scrapping of a machine on June 30, 2014, should be included in the other expenses and losses section in Lobo’s income statement. The $67,920 accumulated depreciation (Schedule 3) should be deducted from the Accumulated Depreciation—Equipment account in Lobo’s balance sheet.
4.
The $3,000 loss on sale of equipment on July 1, 2014 (Schedule 4) should be included in the other expenses and losses section of Lobo’s income statement. The $21,000 accumulated depreciation (Schedule 4) should be deducted from the Accumulated Depreciation—Equipment account in Lobo’s balance sheet.
Schedule 2 Loss on Scrapping of Machine June 30, 2014 Cost, January 1, 2006.................................................................... Less: Accumulated depreciation (double-declining-balance method, 10-year life) January 1, 2006, to June 30, 2014 (Schedule 3) ..................................................................... Asset book value June 30, 2014 Loss on scrapping of machine .....................................................
$80,000 67,920 $12,080 $12,080
PROBLEM 10-2 (Continued) Schedule 3 Accumulated Depreciation Using Double-Declining-Balance Method June 30, 2014 (Double-declining-balance rate is 20%)
Year 2006 2007 2008 2009 2010 2011 2012 2013 2014 (6 months)
Book Value at Beginning of Year $80,000 64,000 51,200 40,960 32,768 26,214 20,971 16,777 13,422
Depreciation Expense $16,000 12,800 10,240 8,192 6,554 5,243 4,194 3,355 1,342
Accumulated Depreciation $16,000 28,800 39,040 47,232 53,786 59,029 63,223 66,578 67,920
Schedule 4 Loss on Sale of Machine July 1, 2014 Cost, January 1, 2011................................................................ Depreciation (straight-line method, salvage value of $2,000, 7-year life) January 1, 2011, to July 1, 2014 [31/2 years ($44,000 – $2,000) ÷ 7] ..................... Asset book value July 1, 2014 ..................................................
$44,000
Asset book value....................................................................... Less: Proceeds from sale ......................................................... Loss on sale ..............................................................................
$23,000 20,000 $ 3,000
(21,000) $23,000
PROBLEM 10-3
(a)
1. Land (Schedule A) .................................................. 188,700 Buildings (Schedule B) ........................................... 136,250 Insurance Expense (6 months X $95)................ 570 Prepaid Insurance (16 months X $95) ............... 1,520 Organization Expense ........................................ 610 Retained Earnings .............................................. 53,800 Salaries and Wages Expense ............................ 32,100 Land and Buildings ................................... Paid-in Capital in Excess of Par— Common Stock (800 shares X $17)......
399,950 13,600
Schedule A Amount Consists of: Acquisition Cost ($80,000 + [800 X $117]).......................... Removal of Old Building ........................... Legal Fees (Examination of title) .............. Special Tax Assessment ........................... Total ......................................................
$173,600 9,800 1,300 4,000 $188,700
Schedule B Amount Consists of: Legal Fees (Construction contract).......... Construction Costs (First payment)......... Construction Costs (Second payment).... Insurance (2 months) ([2,280 ÷ 24] = $95 X 2 = $190)................ Plant Superintendent’s Salary .................. Construction Costs (Final payment) ........ Total ...................................................... 2. Land and Buildings ............................................ Depreciation Expense ............................... Accumulated Depreciation—Buildings ....
$
1,860 60,000 40,000
190 4,200 30,000 $136,250 4,000 2,637 1,363
PROBLEM 10-3 (Continued) Schedule C Depreciation taken ................................ Depreciation that should be taken (1% X $136,250) .................................. Depreciation adjustment ...................... (b)
Property, Plant, and Equipment: Land ....................................................... Buildings................................................ Less: Accumulated depreciation ........ Total.................................................
$ 4,000 (1,363) $ 2,637
$188,700 $136,250 1,363
134,887 $323,587
PROBLEM 10-4 The following accounting treatment appears appropriate for these items: Land—The loss on the condemnation of the land of $9,000 ($40,000 – $31,000) should be reported as an extraordinary item on the income statement. If condemnations are either usual or recurring, then an ordinary or unusual classification is more appropriate. The $35,000 land purchase has no income statement effect. Building—There is no recognized gain or loss on the demolition of the building. The entire purchase cost ($15,000), decreased by the demolition proceeds ($3,600), is allocated to land. Warehouse—The gain on the destruction of the warehouse should be reported as an extraordinary item, assuming that it is unusual and infrequent. The gain is computed as follows: Insurance proceeds ...................................... Deduct: Cost................................................. Less: Accumulated depreciation ............ Realized gain .................................................
$74,000 $70,000 16,000
54,000 $20,000
Some contend that a portion of this gain should be deferred because the proceeds are reinvested in similar assets. We do not believe such an approach should be permitted. Deferral of the gain in this situation is not permitted under GAAP. Machine—The recognized gain on the transaction would be computed as follows: Fair value of old machine............................... Deduct: Book value of old machine Cost ........................................................... Less: Accumulated depreciation............ Total gain ........................................................ Total gain recognized = $2,000 X
$900
$900 + $6,300 The gain deferred is $1,750 ($2,000 – $250)
$7,200 $8,000 2,800
= $250
5,200 $2,000
PROBLEM 10-4 (Continued) This gain would probably be reported in other revenues and gains. It might be reported as an unusual item if the company believes that such a situation occurs infrequently and if material. The cost of the new machine would be capitalized at $4,550. Fair value of new machine.............................................. Less: Gain deferred ($2,000 – $250) ............................. Cost of new machine ......................................................
$6,300 1,750 $4,550
Furniture—The contribution of the furniture would be reported as a contribution expense of $3,100 with a related gain on disposition of furniture of $950: $3,100 – ($10,000 – $7,850). The contribution expense and the related gain may be netted, if desired. Automobile—The loss on sale of the automobile of $2,580: [$2,960 – ($9,000 – $3,460)] should probably be reported in the other expenses or losses section. It might be reported as an unusual item if the company believes that such a situation occurs infrequently.
PROBLEM 10-5
(a)
(b)
BLAIR CORPORATION Cost of Land (Site #101) As of September 30, 2015 Cost of land and old building ...................................... Real estate broker’s commission................................ Legal fees...................................................................... Title insurance .............................................................. Removal of old building ............................................... Cost of land ..............................................................
$500,000 36,000 6,000 18,000 54,000 $614,000
BLAIR CORPORATION Cost of Building As of September 30, 2015 Fixed construction contract price ............................... Plans, specifications, and blueprints.......................... Architects’ fees............................................................. Interest capitalized during 2014 (Schedule 1) ............ Interest capitalized during 2015 (Schedule 2) ............ Cost of building........................................................
$3,000,000 21,000 82,000 130,000 190,000 $3,423,000
Schedule 1 Interest Capitalized During 2014 and 2015
2014:
Weighted-average accumulated construction expenditures $1,300,000
X X
Interest rate 10%
= =
Interest to be capitalized $130,000*
*Actual interest: $3,000,000 X 10% X 10/12 = $250,000. 2015:
$1,900,000
X
10%
=
$190,000**
**Actual interest: ($3,000,000 X 10% X 2/12) + ($2,700,000 X 10% X 10/12) = $275,000.
PROBLEM 10-6
INTEREST CAPITALIZATION Balance in the Land Account Purchase Price ....................................................................... Surveying Costs..................................................................... Title Insurance Policy ............................................................ Demolition Costs.................................................................... Salvage ................................................................................... Total Land Cost ................................................................
Expenditures (2014) Date
Amount
Fraction
1-Dec 1-Dec 1-Dec
$147,000 30,000 3,000 $180,000
1/12 1/12 1/12
Weighted—Average Accumulated Expenditures $12,250 2,500 250 $15,000
Interest Capitalized for 2014 Weighted—Average Accumulated Expenditures $15,000
Interest Rate 8%
Interest charged to Interest Expense [($600,000 X .08 X 1/12) – $1,200]
$139,000 2,000 4,000 3,000 (1,000) $147,000
Amount Capitalizable $1,200
$2,800
PROBLEM 10-6 (Continued) Expenditures (2015) Date Amount 1-Jan $180,000 1-Jan 1,200 1-Mar 240,000 1-May 330,000 1-Jul 60,000 $811,200
Fraction 6/12 6/12 4/12 2/12 0
Weighted Expenditure $ 90,000 600 80,000 55,000 0 $225,600
Interest Capitalized for 2015 WeightedAverage Expenditure $225,600
Interest Rate 8%
Amount Capitalizable $18,048
Interest charged to Interest Expense [($600,000 X .08) – $18,048] (a) (b) (c)
$29,952
Balance in Land Account—2014 and 2015 ........ Balance in Building—2014.................................. Balance in Building—2015.................................. Balance in Interest Expense—2014.................... Balance in Interest Expense—2015.................... *$30,000 + $3,000 + $1,200 **$34,200 + $240,000 + $330,000 + $60,000 + $18,048
147,000 34,200* 682,248** 2,800 29,952
PROBLEM 10-7
(a)
Computation of Weighted-Average Accumulated Expenditures Expenditures
(b)
Capitalization Weighted-Average X = Accumulated Expenditures Period
Date
Amount
July 30, 2014 January 30, 2015 May 30, 2015
$ 900,000 1,500,000 1,600,000 $4,000,000
10/12 4/12 0
Weighted-Average Weighted-Average Accumulated Expenditures X Interest Rate $1,250,000 11.2%*
$ 750,000 500,000 0 $1,250,000
=
Avoidable interest $140,000
Loans Outstanding During Construction Period
*10% five-year note 12% ten-year bond
Total interest Total principal (c)
=
Principal $2,000,000 3,000,000 $5,000,000 $560,000 $5,000,000
Actual Interest $200,000 360,000 $560,000
= 11.2% (weighted-average rate)
(1) and (2) Total actual interest cost
$560,000
Total interest capitalized
$140,000
Total interest expensed
$420,000
PROBLEM 10-8
1.
Holyfield Corporation Cash ...................................................................... Machinery ............................................................. Accumulated Depreciation—Machinery ............. Loss on Disposal of Machinery........................... Machinery ..................................................... *Computation of loss: Book value Less: Fair value Loss
2.
160,000
$100,000 92,000 $ 8,000
Dorsett Company Machinery ............................................................. Accumulated Depreciation—Machinery ............. Loss on Disposal of Machinery........................... Cash .............................................................. Machinery ..................................................... *Computation of loss: Book value Less: Fair value Loss
23,000 69,000 60,000 8,000*
92,000 45,000 6,000* 23,000 120,000
$ 75,000 69,000 $ 6,000
Holyfield Corporation Machinery ............................................................. Accumulated Depreciation—Machinery ............. Loss on Disposal of Machinery........................... Machinery ..................................................... Winston Company Machinery ($92,000 – $11,000) ............................ Accumulated Depreciation—Machinery ............. Machinery ..................................................... *Computation of gain $92,000 deferred: Fair value Less: Book value 81,000 Gain deferred $11,000
92,000 60,000 8,000 160,000
81,000* 71,000 152,000
PROBLEM 10-8 (Continued) 3.
Holyfield Corporation Machinery ............................................................ Accumulated Depreciation—Machinery............ Loss on Disposal of Machinery ......................... Machinery .................................................... Cash ............................................................. Liston Company Machinery ............................................................ Accumulated Depreciation—Machinery............ Cash ..................................................................... Machinery .................................................... Gain on Disposal of Machinery .................. *Fair value Less: Book value Gain
95,000 60,000 8,000 160,000 3,000 92,000 75,000 3,000 160,000 10,000*
$ 95,000 85,000 $ 10,000
Because the exchange has commercial substance, the should be recognized. 4.
entire gain
Holyfield Corporation Machinery ................................................................ 185,000 Accumulated Depreciation—Machinery............ 60,000 Loss on Disposal of Machinery ......................... 8,000 Machinery .................................................... Cash .............................................................
160,000 93,000
Greeley Company Cash ..................................................................... Inventory.............................................................. Sales Revenue.............................................
185,000
93,000 92,000
Cost of Goods Sold ................................................. 130,000 Inventory......................................................
130,000
PROBLEM 10-9
(a)
Exchange has commercial substance: Hyde, Inc.’s Books Machinery (B)........................................................ Accumulated Depreciation—Machinery (A) ....... Machinery (A) .............................................. Gain on Disposal of Machinery ($60,000 – [$96,000 – $40,000]) ................ Cash .............................................................
75,000 40,000 96,000 4,000 15,000
Wiggins, Inc.’s Books Cash ...................................................................... Machinery (A)........................................................ Accumulated Depreciation—Machinery (B) ....... Machinery (B) .............................................. Gain on Disposal of Machinery ($75,000 – [$110,000 – $47,000]) .............. (b)
15,000 60,000 47,000 110,000 12,000
Exchange lacks commercial substance: Hyde, Inc.’s Books Machinery (B) ($75,000 – $4,000)......................... Accumulated Depreciation—Machinery (A) ....... Machinery (A) .............................................. Cash ............................................................. *Computation of gain deferred: Fair value Less: Book value Gain deferred
$60,000 56,000 $ 4,000
71,000* 40,000 96,000 15,000
PROBLEM 10-9 (Continued) Wiggins, Inc.’s Books Cash....................................................................... Machienry (A) ........................................................ Accumulated Depreciation—Machinery (B)........ Machinery (B) ................................................ Gain on Disposal of Machinery .................... Computation of total gain: Fair value of Asset B Less: Book value of Asset B Gain on disposal of assets *Gain recognized =
$15,000
15,000 50,400** 47,000 110,000 2,400*
$75,000 63,000 $12,000 X $12,000 = $2,400
$15,000 + $60,000 **Fair value of asset acquired Less: Gain deferred ($12,000 – $2,400) Basis of Machinery A
$60,000 9,600 $50,400
OR Book value of Machinery B Less: Portion of book value sold
$63,000 12,600 $50,400
Note to instructor: This illustrates the exception to no gain or loss recognition for exchanges that lack commercial substance. Although it would be rare for an exchange to lack commercial substance when cash is received, a gain can be recognized based on the proportion of cash received to the overall fair value.
PROBLEM 10-10
(a)
Has Commercial Substance
1.
2.
(b)
Marshall Construction Equipment ($82,000 + $118,000) ........................ 200,000 Accumulated Depreciation—Equipment ....... 50,000 Loss on Disposal of Equipment ..................... 8,000* Equipment............................................... Cash ........................................................ *Computation of loss: Book value of old crane ($140,000 – $50,000) $90,000 Less: Fair value of old crane 82,000 Loss on disposal of equipment $ 8,000
140,000 118,000
Brigham Manufacturing Cash .................................................................... 118,000 Inventory .......................................................... 82,000 Sales Revenue ........................................
200,000
Cost of Goods Sold ............................................ 165,000 Inventory .................................................
165,000
Lacks Commercial Substance 1.
Marshall Construction should record the same entry as in part (a) above, since the exchange resulted in a loss.
2.
Brigham should record the same entry as in part (a) above. No gain is deferred because we are assuming that Marshall is a customer. In addition, because the cash involved is greater than 25% of the value of the exchange, the entire transaction is considered a monetary transaction and a gain is recognized.
PROBLEM 10-10 (Continued) (c)
Has Commercial Substance
1.
2.
(d) 1.
Marshall Construction Equipment ($98,000 + $102,000) ........................ 200,000 Accumulated Depreciation—Equipment ............. 50,000 Equipment................................................ Cash ......................................................... Gain on Disposal of Equipment ............. *Computation of gain: Fair value of old crane $98,000 Less: Book value of old crane ($140,000 – $50,000) 90,000 Gain on Disposal of Equipment $ 8,000
140,000 102,000 8,000*
Brigham Manufacturing Cash .................................................................... 102,000 Inventory.......................................................... 98,000 Sales Revenue........................................
200,000
Cost of Goods Sold ............................................ 165,000 Inventory.................................................
165,000
Marshall Construction Equipment ........................................................... 200,000 Accumulated Depreciation—Equipment ....... 50,000 Cash ........................................................ Equipment............................................... Gain on Disposal of Equipment ............
103,000 140,000 7,000*
*[Fair Value–Old ($97,000) – Book Value–Old ($90,000)] Note: Cash involved is greater than 25% of the value of the exchange, so the gain is not deferred.
PROBLEM 10-10 (Continued)
2.
Brigham Manufacturing Cash ............................................................... 103,000 Inventory ........................................................ 97,000 Sales Revenue ......................................
200,000
Cost of Goods Sold ....................................... Inventory ...............................................
165,000
165,000
Same reasons as cited in (b) (2) on the previous pages. Note: Even though the exchange lacks commercial substance, cash paid exceeds 25% of total fair value so the transaction is treated as a monetary exchange and recorded at fair value. Note that with this much cash involved, it is unlikely that the exchange would lack commercial substance.
PROBLEM 10-11
(a)
(b)
The major characteristics of plant assets, such as land, buildings, and equipment, that differentiate them from other types of assets are presented below. 1.
Plant assets are acquired for use in the regular operations of the enterprise and are not for resale.
2.
Property, plant, and equipment possess physical substance or existence and are thus differentiated from intangible assets such as patents and goodwill. Unlike other assets that possess physical substance (i.e., raw material), property, plant, and equipment do not physically become part of the product held for resale.
3.
These assets are durable and long-term in nature and are usually subject to depreciation.
Transaction 1. To properly reflect cost, assets purchased on deferred payment contracts should be accounted for at the present value of the consideration exchanged between the contracting parties at the date of the consideration. When no interest rate is stated, interest must be imputed at a rate that approximates the rate that would be negotiated in an arm’s-length transaction. In addition, all costs necessary to ready the asset for its intended use are considered to be costs of the asset. Asset cost = Present value of the note + Freight + Installation $28,000 X 3.17 + $425 + $500 = 4 = $22,190 + 925 = $23,115
PROBLEM 10-11 (Continued) Transaction 2. The lump-sum purchase of a group of assets should be accounted for by allocating the total cost among the various assets on the basis of their relative fair values. The $8,000 of interest expense incurred for financing the purchase is a period cost and is not a factor in determining asset cost. Inventory $220,000 X ($ 50,000/$250,000) = $ 44,000 Land $220,000 X ($ 80,000/$250,000) = $ 70,400 Building $220,000 X ($120,000/$250,000) = $105,600 Transaction 3. The cost of a nonmonetary asset acquired in an exchange that has commercial substance should be recorded at the fair value of the asset given up plus any cash paid. Furthermore, any gain on the exchange is also recognized. Fair value of trucks .................................................. Cash paid.................................................................. Cost of land .............................................................. (c)
$46,000 19,000 $65,000
1.
A building purchased for speculative purposes is not a plant asset as it is not being used in normal operations. The building is more appropriately classified as an investment.
2.
The two-year insurance policy covering plant equipment is not a plant asset because it has no physical substance and is not durable. This policy is more appropriately classified as a current asset (for the portion to be used up within the next 12 months), and as an other asset for the long-term portion.
3.
The rights for the exclusive use of a process used in the manufacture of ballet shoes are not plant assets as they have no physical substance. The rights should be classified as an intangible asset.
TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 10-1 (Time 20–25 minutes) Purpose—to provide the student with a problem to decide which expenditures related to purchasing land, constructing a building, and adding to the building should be capitalized and how each should be depreciated. When the land and building are sold, the student discusses how the book value is determined and how a gain would be reported. CA 10-2 (Time 20–25 minutes) Purpose—to provide the student with a situation involving the proper allocation of costs to selfconstructed machinery. As part of this case, the student is required to discuss the propriety of including overhead costs in the construction costs. Finally, the proper accounting treatment accorded the development costs associated with the construction of a new machine must be evaluated. CA 10-3 (Time 30–40 minutes) Purpose—to provide the student with a situation to determine capitalization of interest and to explain in a memorandum the conceptual basis for interest capitalization. CA 10-4 (Time 30–40 minutes) Purpose—to provide the student with a situation in which to examine differences in accounting for exchanges that have or lack commercial substance. CA 10-5 (Time 20–25 minutes) Purpose—to provide the student with an understanding of the proper accounting treatment involving incidental costs associated with the purchase of a machine. The student must be able to defend why certain costs might be capitalized even though this valuation has no relationship to net realizable value. In addition, the costs may be charged off immediately for tax purposes and the student is required to analyze why these costs may still be capitalized for book purposes. CA 10-6 (Time 20–25 minutes) Purpose—to provide the student with a case involving allocation of costs between land and buildings, including ethical issues.
SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 10-1 (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, these costs are 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 and the parking lot are land improvements, and these costs should be capitalized and classified separately as a land improvements. These costs should be depreciated over their estimated useful lives. 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 useful life of the addition. (b) A gain should be recognized on the sale of the land and building because income is realized whenever the earning process has been completed and a 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 sale would be accounted for as a gain in continuing operations in the income statement.
CA 10-2 (a) Materials and direct labor used in the construction of the equipment definitely should be charged to the equipment account. It should be emphasized that no gain on self-construction should be recorded because such an approach violates the historical cost principle. The controversy centers on the assignment of indirect costs, called overhead or burden, consisting of power, heat, light, insurance, property taxes on factory buildings, etc. The suggested approaches are discussed below. (b) 1. Many believe that only the variable overhead costs that increase as a result of the construction should be assigned to the cost of the asset. This approach assumes that the company will have the same fixed costs regardless of whether the company constructs the asset or not, so to charge a portion of the fixed overhead costs to the equipment will usually decrease current expenses and consequently overstate income of the current period. Therefore, only the incremental costs should be charged. 2. Proponents of alternative (2) argue that such assets should be given the same treatment as inventory items and that all costs should be allocated thereto just as if saleable goods were being produced. They state that no special favor should be granted in the allocation of any cost, as long as sufficient facts are available to enable the allocation to be made. They argue that allocation of overhead to fixed assets is similar to allocation to joint products and byproducts, and should be made at regular rates. Of course, no item should be capitalized at an amount greater than that prevailing in the market.
CA 10-2 (Continued) (c) It could be argued that because costs of development are usually higher on the first few units, the additional costs of $273,000 should be allocated to all four machines. If these costs are due to inefficiency and not development costs, the additional costs should be expensed.
CA 10-3 To:
Jane Esplanade, President
From:
Good Student, Manager of Accounting
Date:
January 15, 2014
Subject:
Capitalization of avoidable interest on the warehouse construction project
I am writing in response to your questions about the capitalized interest costs for the warehouse construction project. This brief explanation of my calculations should facilitate your understanding of these costs. Generally, the accounting profession does not allow accrued interest to be capitalized along with an asset’s cost. However, the FASB made an exception for interest costs incurred during construction. In order to qualify for this treatment, the constructed asset must require a period of time to become ready for its intended use. Because interest capitalization is allowed in special circumstances only, the company must be especially careful to capitalize only that interest which is associated with the construction itself. Thus, GAAP provides guidance indicating how much interest may be associated with the construction, i.e., the lower of actual or avoidable interest. On the surface, this standard seems simple. Actual interest incurred during the construction period equals all interest which accrued on any debt outstanding during that period. Avoidable interest equals the amount of interest which would not have been incurred if the construction project had not been undertaken. The amount of interest capitalized is the smaller of the two. To determine the amount capitalized, we must calculate both the actual and the avoidable interest during 2013. Actual interest is computed by applying the interest rates of 12%, 10%, and 11% to their related debt. Thus, total actual interest for this period is $490,000 (see Schedule #1).
CA 10-3 (Continued) Calculations for avoidable interest are more complex. First, interest can be capitalized only on the weighted-average amount of accumulated expenditures. Although total costs amounted to $5,200,000 for the project, an average of only $3,500,000 was outstanding during the period of construction. Second, of the total $4,400,000 debt outstanding during this period, only $2,000,000 of it can be associated with the actual construction project. Therefore, rather than arbitrarily choose the interest rate for one of the other loans, we must calculate the weighted-average interest rate. This rate is the ratio of accrued interest on the other loans to the total amount of their principal. For the $1,500,000 balance of weighted-average accumulated expenditures, this interest rate equals 10.42% (see Schedule #2). Third, we compute our avoidable interest as follows: calculate the interest on the loan directly associated with the construction. Apply the weightedaverage interest rate to the remainder of the weighted-average accumulated expenditures. Add these products. Avoidable interest for 2013 amounts to $396,300 (see Schedule #3). So as not to overstate the interest associated with the construction, we capitalize the smaller of the two—$396,300—along with the other construction costs. The remainder of the interest ($93,700) is expensed. I hope that this explanation has answered any questions you may have had about capitalized interest. If any further questions should arise, please contact me. Schedule #1 Actual Interest Construction loan Short-term loan Long-term loan
$2,000,000 X 12% = $1,400,000 X 10% = $1,000,000 X 11% = Total
$240,000 140,000 110,000 $490,000
CA 10-3 (Continued) Schedule #2 Weighted-Average Interest Rate Weighted-average interest rate computation 10% short-term loan 11% long-term loan Total Interest = Total Principal
Principal $1,400,000 1,000,000 $2,400,000
$250,000 $2,400,000
Interest $140,000 110,000 $250,000
= 10.42%
Schedule #3 Avoidable Interest Weighted-Average Accumulated Expenditures $2,000,000 1,500,000 $3,500,000
X Interest Rate 12% 10.42%
=
Avoidable Interest $240,000 156,300 $396,300
Schedule #4 Interest Capitalized Because avoidable interest is lower than actual interest, use avoidable interest. Cost ........................................................................................... Interest capitalized ................................................................... Total cost ..................................................................................
$5,200,000 396,300 $5,596,300
CA 10-4 (a) Client A Treatment if the exchange has commercial substance Client A would recognize a gain of $20,000 on the exchange. The basis of the asset acquired would be $100,000. The entry would be as follows: Machinery ($80,000 + $20,000).................................................................. 100,000 Accumulated Depreciation—Machinery ................................................ 40,000 Cash ............................................................................................. Gain on Disposal of Machinery...................................................... Machinery ..................................................................................... *Fair value of old machinery Less: Book value of old machinery ($100,000 – $40,000) Gain on disposal of machinery
20,000 20,000* 100,000
$80,000 60,000 $20,000
(b) Treatment if the exchange lacks commercial substance Client A would be prohibited from recognizing a $20,000 gain on the exchange. This is because the transaction lacks commercial substance. The new asset on their books would have a basis of $80,000 ($100,000 less the $20,000 unrecognized gain). The entry would be as follows: Machinery ($100,000 – $20,000) .......................................................... Accumulated Depreciation—Machinery ................................................ Cash ............................................................................................. Machinery .....................................................................................
80,000 40,000 20,000 100,000
(c) Memo to the Controller: TO:
The Controller
RE:
Exchanges of Assets—Commercial Substance Issues.
Financial statement effect of treating the exchange as having commercial substance versus not. 1. The income statement will reflect a before-tax gain of $20,000. This gain will increase the reported income on this year’s financial statements. Future income statements will show a higher depreciation deduction because of an increased book value of the new asset. Thus future income statements will reflect lower income. 2. The current balance sheet will show a $20,000 higher value for plant assets, a higher liability for taxes payable and higher retained earnings if the exchange has commercial substance. This difference will disappear gradually as the asset is depreciated.
CA 10-4 (Continued) (d) Client B Treatment if the exchange has commercial substance In this situation, the full $30,000 gain would be recognized on this year’s income statement. The new asset would go on the books at its fair value. The entry is as follows: Machinery ........................................................................................... Accumulated Depreciation—Machinery .............................................. Cash ................................................................................................... Machinery ................................................................................... Gain on Disposal of Machinery.................................................... *Fair value of old machinery Less: Book value of old machinery ($150,000 – $80,000) Gain on disposal of machinery
80,000 80,000 20,000 150,000 30,000*
$100,000 70,000 $ 30,000
(e) Treatment if the exchange lacks commercial substance Machinery ($80,000 – $24,000)......................................................... Accumulated Depreciation—Machinery............................................. Cash.................................................................................................. Machinery .................................................................................. Gain on Disposal of Machinery ..................................................
56,000 80,000 20,000 150,000 6,000*
* A partial gain will be recognized in the ratio of cash received to the fair value of all assets received. In this case, a gain of $6,000 will be recognized ($20,000/$100,000 times the gain of $30,000). The unrecognized portion of $24,000 will be used to reduce the basis of the new asset. The entry to record the exchange is as above. (f)
Memo to the Controller: TO:
The Controller
RE:
Asset Exchanges—Commercial Substance
1. The income statement will reflect a before-tax gain of $30,000 if the exchange has commercial substance. This gain will increase the reported income on this year’s financial statements. Future income statements will show a higher depreciation deduction because of an increased book value of the new asset. Thus future income statements will reflect lower income. The reported gain will only be $6,000 if the exchange lacks commercial substance. 2. The current balance sheet will show a $24,000 higher value for plant assets, a higher liability for taxes payable and higher retained earnings if the exchange has commercial substance. This difference will disappear gradually as the asset is depreciated.
CA 10-5 In general, the inclusion of the $7,500 as part of the cost of the machine is justified because the primary purpose in accounting for plant asset costs is to secure an equitable allocation of incurred costs over the period of time when the benefits are being received from the use of the assets. These costs—both the $50,000 and the $7,500—are much like prepaid expenses, to be matched against the revenue emerging through their use. The purpose of accounting for plant assets then is not primarily aimed at determining the fair valuation of the asset for balance sheet purposes, but proper matching of incurred costs with revenue resulting from use of the assets. (1) It may be true that these installation costs could not be recovered if the machine were to be sold. This is not important, however, because presumably the machine was acquired to be used, not to be sold. Assuming approximately equal utilization of the machine in each of the ten years, the owner properly could allocate $5,750 (10% of $57,500) against each year’s operations. If the owner’s suggestion was followed, the first year would be charged with $12,500 ($7,500 plus 10% of $50,000), and the following nine years with $5,000 per year, hence overstating expenses by $6,750 the first year and understating expenses by $750 per year for the succeeding nine years. This could hardly be defended as proper matching of costs and revenue. (2) Again, the purpose of accounting for plant assets is not to arrive at an approximation of fair value of the assets each year over the life of the assets. However, even if this were an objective, the question of which method would come closer to stating current market value at some later date would revolve around the general trend of the price level over the years involved. (3) Assuming that the $7,500 could properly be deducted, there would be some tax savings over the years unless the tax rates applicable to the business were reduced during the following years. There is some value to taking the $7,500 deduction right now because of the present value of money. If the rates increased, there would be an increase in total taxes, due to higher rates applicable during the period when depreciation deductions would be reduced. However, generally accepted accounting principles are not determined by income tax effects. In many instances, GAAP requires different accounting treatment of an item than the IRS Revenue Code does.
CA 10-6 (a) If the land is undervalued so that a higher depreciation expense is assigned to the building, management interests are served. The lower net income and reduced tax liability save cash to be used for management purposes. By contrast, stockholders and potential investors are misled by the inaccurate cost values. They will have been deprived of information concerning the significant impact of changing real estate values on this holding. (b) The ethical question centers on whether to allocate the cost of the purchase on the fair value of land and building or whether to determine the allocation in view of the potential effect on net income. Carter faces an ethical dilemma if Ankara will not accept Carter’s position. Carter should specify alternative courses of action and carefully assess the consequences of each before deciding what to do. (c) For basket (lump-sum) purchases of land and buildings, costs should be allocated on the ratio of fair values of the land and buildings.
FINANCIAL STATEMENT ANALYSIS CASE JOHNSON & JOHNSON ($ millions) (a)
The cost of building and building equipment at the end of 2009 was $9,389.
(b)
As indicated in footnote number 1 to the financial statements, the company utilizes the straight-line method for financial statement purposes for all additions to property, plant, and equipment. Given that straight-line depreciation provides a lower charge for depreciation as compared to an accelerated method in the early years of an asset’s life, the accounting appears to be less conservative.
(c)
The cash flow statement reports the amount of interest paid in cash ($576). A review of the income statement indicates that Johnson & Johnson incurred interest expense of $571 million (net of capitalized interest of $84—see note 4).
(d)
Free cash flow is defined as net cash flows provided by operating activities less capital expenditures and dividends. Free cash flow is the amount of discretionary cash flow a company has for purchasing additional investments, retiring its debt, purchasing treasury stock, or simply adding to its liquidity. In Johnson & Johnson’s situation, free cash flow is computed as follows: Net cash flows from operating activities ..................... Less: Additions to property, plant and equipment .... Dividends ........................................................... Free cash flow ...............................................................
$14,298 2,893 6,156 $ 5,249
As indicated from the above computation, Johnson & Johnson has considerable free cash flows. The company has excellent financial flexibility. For example, the company is able to pay its dividends without resorting to external financing. Secondly, even if operations decline, it appears that the company will be able to fund additions to property, plant, and equipment. Thirdly, the company is using its free cash flow to expand its operations by acquiring new businesses.
ACCOUNTING, ANALYSIS, AND PRINCIPLES Accounting Equipment** ............................................................... Accumluated Depreciation—Equipment ................. Equipment......................................................... Cash .................................................................. Gain on Disposal of Equipment * .................... *Fair value of old asset Less: Cost of old asset Less: Accumulated depreciation ( [$112,000 – $12,000] X 4/5) Gain on disposal of equipment **Cash paid Fair value of old equipment Cost of new equipment
62,000 80,000 112,000 12,000 18,000 $50,000
$112,000 80,000
(32,000) $18,000
$ 12,000 50,000 $ 62,000
Analysis The gain on the disposal increases income, leading to a one-time increase in the return on assets in the year of the exchange. In essence, the gain reflects the extent to which prior years’ depreciation was overstated related to the decline in the fair value of the asset traded in. As a result, in the year of the exchange, Durler’s ROA will appear higher than in prior years. Some analysts will adjust these nonrecurring gains out of income when conducting analysis using ROA. Principles The concept of commercial substance is a fundamental element in the accounting for exchanges. If the transaction above lacked commercial substance, the gain on the exchange would be deferred. That is, if the expected cash flows arising from the assets exchanged are not significantly different, Durler is in the same economic position after the exchange with respect to exchanged assets. As a result, no gain is reported, and the nonrecurring time gain will not affect analysts’ comparisons of a company’s ROA across years with and without exchanges.
PROFESSIONAL RESEARCH (a) Yes; according to FASB ASC 835-20-05, it is required to capitalize interest into the cost of assets that meet selected criteria (see (c) below). (b) According to FASB ASC 835-20-10-1, . . . the objectives of capitalizing interest are to obtain a measure of acquisition cost that more closely reflects an entity’s total investment in the asset and to charge a cost that relates to the acquisition of a resource that will benefit future periods against the revenues of the periods benefited. (c) According to FASB ASC 835-20-15-5, . . . interest shall be capitalized for the following types of assets (qualifying assets): a. Assets that are constructed or otherwise produced for an entity’s own use, including assets constructed or produced for the entity by others for which deposits or progress payments have been made. b. Assets intended for sale or lease that are constructed or otherwise produced as discrete projects (for example, ships or real estate developments). [FAS 034, paragraph 9, sequence 35] c. Investments (equity, loans, and advances) accounted for by the equity method while the investee has activities in progress necessary to commence its planned principal operations provided that the investee’s activities include the use of funds to acquire qualifying assets for its operations. (d) According to FASB ASC 835-20-30-6, . . . the total amount of interest cost capitalized in an accounting period shall not exceed the total amount of interest cost incurred by the entity in that period. In consolidated financial statements, that limitation shall be applied by reference to the total amount of interest cost incurred by the parent entity and consolidated subsidiaries on a consolidated basis. In any separately issued financial statements of a parent entity or consolidated subsidiaries and in the financial statements (whether separately issued or not) of unconsolidated subsidiaries and other investees accounted for by the equity method, the limitation shall be applied by reference to the total amount of interest cost (including interest on intra-entity borrowings) incurred by the separate entity.
PROFESSIONAL RESEARCH (Continued) (e) According to FASB ASC 835-20-50-1, An entity shall disclose the following information with respect to interest cost in the financial statements or related notes: a. For an accounting period in which no interest cost is capitalized, the amount of interest cost incurred and charged to expense during the period. b. For an accounting period in which some interest cost is capitalized, the total amount of interest cost incurred during the period and the amount thereof that has been capitalized.
PROFESSIONAL SIMULATION
Measurement Historical cost is measured by the cash or cash-equivalent price of obtaining the asset and bringing it to the location and condition for its intended use. For Norwel, this is: Price ................................................................... Tax ($12,000 X .05) ............................................ Platform ............................................................. Total............................................................
$12,000 600 1,400 $14,000
Journal Entry January 2, 2014 Machinery .......................................................... Cash ..........................................................
14,000 14,000
December 31, 2014 Depreciation Expense....................................... Accumulated Depreciation— Machinery ..............................................
1,500 1,500*
*Depreciable base: ($14,000 – $2,000) = $12,000 Depreciation expense: $12,000 ÷ 4 = $3,000 per year 2011: 1/2 year = $3,000 X .50 = $1,500 Financial Statements The amount reported on the balance sheet is the cost of the asset less accumulated depreciation: Machine.............................................................. Less: Accumulated depreciation ..................... Book value .........................................................
$14,000 1,500 $12,500
PROFESSIONAL SIMULATION (Continued) Analysis The income effect is a gain or loss, determined by comparing the book value of the asset to the disposal value: Cost .............................................................................. Less: Accumulated depreciation ($1,500 + $1,500)* . Book value ................................................................... Less: Cash received for machine and platform ........ Loss on disposal of machinery .................................. *$3,000 X 6/12
$14,000 3,000 11,000 7,000 $ 4,000
CHAPTER 11 Depreciation, Impairments, and Depletion ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics
Questions
1. Depreciation methods; meaning of depreciation; choice of depreciation methods.
1, 2, 3, 4, 5, 6, 10, 14, 20, 21, 22
2. Computation of depreciation.
7, 8, 9, 13
3. Depreciation base.
Brief Exercises
Exercises
Problems
Concepts for Analysis
1, 2, 3, 4, 5, 1, 2, 3 8, 14, 15
1, 2, 3, 4, 5
1, 2, 3, 4
1, 2, 3, 4, 5, 6, 7, 10, 15
1, 2, 3, 4, 8, 10, 11, 12
1, 2, 3
6, 7
5
8, 14
1, 2, 3, 8, 10
3
4. Errors; changes in estimate.
13
7
11, 12, 13, 14
3, 4
3
5. Depreciation of partial periods.
15
2, 3, 4
3, 4, 5, 6, 7, 15
1, 2, 3, 10, 11
6. Composite method.
11, 12
6
9
7. Impairment of value.
16, 17, 18, 19
8
16, 17, 18
9
8. Depletion.
22, 23, 24, 25, 26, 27
9
19, 20, 21, 22, 23
5, 6, 7
9. Ratio analysis.
28
10
24
*10. Tax depreciation (MACRS).
29
11
25, 26
*This material is covered in an Appendix to the chapter.
2
12
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives Questions
Brief Exercises
Exercises
Problems
Concepts for Analysis
1.
Explain the concept of depreciation.
1
CA11-1
2.
Identify the factors involved in the depreciation process.
2, 3, 4, 5, 6, 7
1, 2, 3, 4, 5
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15
1, 2, 3, 4, 8, 10, 11, 12
CA11-2, CA11-3
3.
Compare activity, straight-line and decreasing-charge methods of depreciation.
8, 9, 10
1, 2, 3, 4, 5
1, 2, 3, 4, 5, 6, 7, 8, 10, 11, 12, 13, 14, 15
1, 2, 3, 4, 5, 8, 10, 11, 12
CA11-4
4.
Explain special depreciation methods.
11, 12, 13, 14, 15, 16
6, 7
9, 11, 12, 13
5.
Explain the accounting issues related to asset impairment.
17, 18, 19, 20
8
16, 17, 18
9
6.
Explain the accounting procedures for depletion of natural resources.
21, 22, 23, 24, 25, 26, 27
9
19, 20, 21, 22, 23
5, 6, 7
7.
Explain how to report and analyze property, plant, equipment, and natural resources.
28
10
24
*8.
Describe income tax methods of depreciation.
29
11
25, 26
CA11-5
12
ASSIGNMENT CHARACTERISTICS TABLE Level of Difficulty
Time (minutes)
Simple Moderate Simple Simple Simple Moderate Simple Moderate
15–20 20–25 15–20 15–25 20–25 20–30 25–35 20–25
E11-9 E11-10 E11-11 E11-12 E11-13 E11-14 E11-15 E11-16 E11-17 E11-18 E11-19 E11-20 E11-21 E11-22 E11-23 E11-24 *E11-25 *E11-26
Depreciation computations—SL, SYD, DDB. Depreciation—conceptual understanding. Depreciation computations—SYD, DDB—partial periods. Depreciation computations—five methods. Depreciation computations—four methods. Depreciation computations—five methods, partial periods. Different methods of depreciation. Depreciation computation—replacement, nonmonetary exchange. Composite depreciation. Depreciation computations, SYD. Depreciation—change in estimate. Depreciation computation—addition, change in estimate. Depreciation—replacement, change in estimate. Error analysis and depreciation, SL and SYD. Depreciation for fractional periods. Impairment. Impairment. Impairment. Depletion computations—timber. Depletion computations—oil. Depletion computations—timber. Depletion computations—mining. Depletion computations—minerals. Ratio analysis. Book vs. tax (MACRS) depreciation. Book vs. tax (MACRS) depreciation.
Simple Simple Simple Simple Simple Moderate Moderate Simple Simple Simple Simple Simple Simple Simple Simple Moderate Moderate Moderate
15–20 10–15 10–15 20–25 15–20 20–25 25–35 10–15 15–20 15–20 15–20 10–15 15–20 15–20 15–20 15–20 20–25 15–20
P11-1 P11-2 P11-3 P11-4 P11-5 P11-6 P11-7 P11-8 P11-9 P11-10
Depreciation for partial period—SL, SYD, and DDB. Depreciation for partial periods—SL, Act., SYD, and DDB. Depreciation—SYD, Act., SL, and DDB. Depreciation and error analysis. Depletion and depreciation—mining. Depletion, timber, and extraordinary loss. Natural resources—timber. Comprehensive fixed asset problem. Impairment. Comprehensive depreciation computations.
Simple Simple Moderate Complex Moderate Moderate Moderate Moderate Moderate Complex
25–30 25–35 40–50 45–60 25–30 25–30 25–35 25–35 15–25 45–60
Item
Description
E11-1 E11-2 E11-3 E11-4 E11-5 E11-6 E11-7 E11-8
ASSIGNMENT CHARACTERISTICS TABLE (Continued) Level of Difficulty
Time (minutes)
Moderate
30–35
*P11-12
Depreciation for partial periods—SL, Act., SYD, and DDB. Depreciation—SL, DDB, SYD, Act., and MACRS.
Moderate
25–35
CA11-1 CA11-2 CA11-3 CA11-4 CA11-5
Depreciation basic concepts. Unit, group, and composite depreciation. Depreciation—strike, units-of-production, obsolescence. Depreciation concepts. Depreciation choice—ethics.
Moderate Simple Moderate Moderate Moderate
25–35 20–25 25–35 25–35 20–25
Item
Description
P11-11
SOLUTIONS TO CODIFICATION EXERCISES CE11-1 (a)
The master glossary provides two entries for amortization: Amortization The process of reducing a recognized liability systematically by recognizing revenues or reducing a recognized asset systematically by recognizing expenses or costs. In pension accounting, amortization is also used to refer to the systematic recognition in net pension cost over several periods of amounts previously recognized in other comprehensive income, that is, prior service costs or credits, gains or losses, and the transition asset or obligation existing at the date of initial application of Subtopic 715-30. Amortization The process of reducing a recognized liability systematically by recognizing revenues or by reducing a recognized asset systematically by recognizing expenses or costs. In accounting for postretirement benefits, amortization also means the systematic recognition in net periodic postretirement benefit cost over several periods of amounts previously recognized in other comprehensive income, that is, gains or losses, prior service cost or credits, and any transition obligation or asset.
(b)
Impairment is the condition that exists when the carrying amount of a long-lived asset (asset group) exceeds its fair value.
(c)
Recoverable amount is the current worth of the net amount of cash expected to be recoverable from the use or sale of an asset.
(d)
According to the glossary, the term activities is to be construed broadly. It encompasses physical construction of the asset. In addition, it includes all the steps required to prepare the asset for its intended use. For example, it includes administrative and technical activities during the preconstruction stage, such as the development of plans or the process of obtaining permits from governmental authorities. It also includes activities undertaken after construction has begun in order to overcome unforeseen obstacles, such as technical problems, labor disputes, or litigation.
CE11-2 According to FASB ASC 360-10-40-4 through 6 (Impairment or Disposal of Long-Lived Assets . . . Long-Lived Assets to Be Exchanged or to Be Distributed to Owners in a Spinoff): 40-4
For purposes of this Subtopic, a long-lived asset to be disposed of in an exchange measured based on the recorded amount of the nonmonetary asset relinquished or to be distributed to owners in a spinoff is disposed of when it is exchanged or distributed. If the asset (asset group) is tested for recoverability while it is classified as held and used, the estimated future cash flows used in that test shall be based on the use of the asset for its remaining useful life, assuming that the disposal transaction will not occur. In such a case, an undiscounted cash flows recoverability test shall apply prior to the disposal date. In addition to any impairment losses required to be recognized while the asset is classified as held and used, and impairment loss, if any, shall be recognized when the asset is disposed of if the carrying amount of the asset (disposal group) exceeds its fair value. The provisions of this Section apply to nonmonetary exchanges that are not recorded at fair value under the provisions of Topic 845.
CE11-2 (Continued) 40-5
A gain or loss not previously recognized that results from the sale of a long-lived asset (disposal group) shall be recognized at the date of sale.
40-6
See paragraphs 360-10-35-47 through 35-48 for guidance related to the disposition of an asset upon its abandonment.
CE11-3 According to FASB ASC 360-10-35-1 through 10 (Subsequent Measurement): 35-1
This Subsection addresses property, plant, and equipment, subsequent measurement issues related to depreciation and the acquisition of an interest in the residual value of a leased asset.
35-2
This guidance addresses the concept of depreciation accounting and the various factors to consider in selecting the related periods and methods to be used in such accounting.
35-3
Depreciation expense in financial statements for an asset shall be determined based on the asset’s useful life.
35-4
The cost of a productive facility is one of the costs of the services it renders during its useful economic life. Generally accepted accounting principles (GAAP) require that this cost be spread over the expected useful life of the facility in such a way as to allocate it as equitably as possible to the periods during which services are obtained from the use of the facility. This procedure is known as depreciation accounting, a system of accounting which 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.
35-5
See paragraph 360-10-35-20 for a discussion of depreciation of a new cost basis after recognition of an impairment loss.
35-6
See paragraph 360-10-35-43 for a discussion of cessation of deprecation on long-lived assets classified as held for sale.
35-7
The declining-balance method is an example of one of the methods that meet the requirements of being systematic and rational. If the expected productivity or revenue-earning power of the asset is relatively greater during the earlier years of its life, or maintenance charges tend to increase during later years, the declining-balance method may provide the most satisfactory allocation of cost. That conclusion also applies to other methods, including the sum-of-the-years’digits method, that produce substantially similar results.
55-8 In practice, experience regarding loss or damage to depreciable assets is in some cases one of the factors considered in estimating the depreciable lives of a group of depreciable assets, along with such other factors as wear and tear, obsolescence, and maintenance and replacement policies. 35-9
If the number of years specified by the Accelerated Cost Recovery System of the Internal Revenue Service (IRS) for recovery deductions for an asset does not fall within a reasonable range of the asset’s useful life, the recovery deductions shall not be used as depreciation expense for financial reporting.
35-10 Annuity methods of depreciation are not acceptable for entities in general.
CE11-4 According to FASB ASC 210-10-S99 (Balance Sheet-Overall-SEC Materials) SEC Rules, Regulations, and Interpretations >> Regulation S-X >>> Regulations, S-X Rule 5-02, Balance Sheets S99-1 The following is the text of Regulation S-X Rule 5-02, Balance Sheets. The purpose of this rule is to indicate the various line items and certain additional disclosures which, if applicable, and except as otherwise permitted by the Commission, should appear on the face of the balance sheets or related notes filed for the persons to whom this article pertains (see § 210.4–01(a)). Assets And Other Debits 13.
Property, plant and equipment. – (a) State the basis of determining the amount. – (b) Tangible and intangible utility plant of a public utility company shall be segregated so as to show separately the original cost, plant acquisition adjustments, and plant adjustments, as required by the system of accounts prescribed by the applicable regulatory authorities. This rule shall not be applicable in respect to companies which are not required to make much a classification.
14.
Accumulated depreciation, depletion, and amortization of property, plant and equipment. The amount is to be set forth separately in the balance sheet or in a note thereto.
ANSWERS TO QUESTIONS 1. The differences among the terms depreciation, depletion, and amortization are that they imply a cost allocation of different types of assets. Depreciation is employed to indicate that tangible plant assets have decreased in carrying value. Where natural resources (wasting assets) such as timber, oil, coal, and lead are involved, the term depletion is used. The expiration of intangible assets such as patents or copyrights is referred to as amortization. 2. 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. Assets are typically recorded at their acquisition cost, which is in most cases objectively determinable. But cost assignment in other cases—“basket purchases” and the selection of an implicit interest rate in asset acquisitions under deferred-payment plans—may be quite subjective, involving considerable judgment. The salvage value is an estimate of an amount potentially realizable when the asset is retired from service. The estimate is based on judgment and is affected by the length of the useful life of the asset. The useful life is also based on judgment. 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. 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. 3. Disagree. Accounting depreciation is defined as an accounting process of allocating the costs of tangible assets to expense in a systematic and rational manner to the periods expected to benefit from the use of the asset. Thus, depreciation is not a matter of valuation but a means of cost allocation. 4. The carrying value of a fixed asset is its cost less accumulated depreciation. If the company estimates that the asset will have an unrealistically long life, periodic depreciation charges, and hence accumulated depreciation, will be lower. As a result the carrying value of the asset will be higher. 5. A change in the amount of annual depreciation recorded does not change the facts about the decline in economic usefulness. It merely changes reported figures. Depreciation in accounting consists of allocating the cost of an asset over its useful life in a systematic and rational manner. Abnormal obsolescence, as suggested by the plant manager, would justify more rapid depreciation, but increasing the depreciation charge would not necessarily result in funds for replacement. It would not increase revenue but simply make reported income lower than it would have been, thus preventing overstatement of net income. Recording depreciation on the books does not set aside any assets for eventual replacement of the depreciated assets. Fund segregation can be accomplished but it requires additional managerial action. Unless an increase in depreciation is accompanied by an increase in sales price of the product, or unless it affects management’s decision on dividend policy, it does not affect funds.
Questions Chapter 11 (Continued) Ordinarily higher depreciation will not lead to higher sales prices and thus to more rapid “recovery” of the cost of the asset, and the economic factors present would have permitted this higher price regardless of the excuse given or the particular rationalization used. The price could have been increased without a higher depreciation charge. The funds of a firm operating profitably do increase, but these may be used as working capital policy may dictate. The measure of the increase in these funds from operations is not merely net income, but that figure plus charges to operations which did not require working capital, less credits to operations which did not create working capital. The fact that net income alone does not measure the increase in funds from profitable operations leads some non-accountants to the erroneous conclusion that a fund is being created and that the amount of depreciation recorded affects the fund accumulation. Acceleration of depreciation for purposes of income tax calculation stands in a slightly different category, since this is not merely a matter of recordkeeping. Increased depreciation will tend to postpone tax payments, and thus temporarily increase funds (although the liability for taxes may be the same or even greater in the long run than it would have been) and generate gain to the firm to the extent of the value of use of the extra funds. 6. Assets are retired for one of three reasons: physical factors or economic factors—or a combination of both. Physical factors are the wear and tear, decay, and casualty factors which hinder the asset from performing indefinitely. Economic factors can be interpreted to mean any other constraint that develops to hinder the service life of an asset. Some accountants attempt to classify the economic factors into three groups: inadequacy, supersession, and obsolescence. Inadequacy is defined as a situation where an asset is no longer useful to a given enterprise because the demands of the firm have increased. Supersession is defined as a situation where the replacement of an asset occurs because another asset is more efficient and economical. Obsolescence is the catchall term that encompasses all other situations and is sometimes referred to as the major concept when economic factors are considered. 7. Before the amount of the depreciation charge can be computed, three basic questions must be answered: (1) What is the depreciation base to be used for the asset? (2) What is the asset’s useful life? (3) What method of cost apportionment is best for this asset? 8. Cost
$800,000
Cost
$800,000
Depreciation rate
X
Depreciation for 2014
(240,000)
Depreciation for 2014
$240,000
Undepreciated cost in 2015
560,000
2014 Depreciation
$240,000
Depreciation rate Depreciation for 2015
X 30% $168,000
2015 Depreciation Accumulated depreciation at December 31, 2015
168,000
*(1 ÷ 5) X 150%
30%*
$408,000
Questions Chapter 11 (Continued) 9. Depreciation base: Cost Salvage
$162,000 (15,000) $147,000
Straight-line, $147,000 ÷ 20 = Units-of-output,
$147,000 X
$ 7,350 20,000
=
$35,000
84,000 14,300 Working hours,
= 42,000 Sum-of-the-years’-digits, $147,000 X 20/210* =
$50,050
Double-declining-balance, $162,000 X 10% =
$16,200
*20(20 + 1) 2
$147,000 X
$14,000
= 210
10. From a conceptual point of view, the method which best matches revenue and expenses should be used; in other words, the answer depends on the decline in the service potential of the asset. If the service potential decline is faster in the earlier years, an accelerated method would seem to be more desirable. On the other hand, if the decline is more uniform, perhaps a straight-line approach should be used. Many firms adopt depreciation methods for more pragmatic reasons. Some companies use accelerated methods for tax purposes but straight-line for book purposes because a higher net income figure is shown on the books in the earlier years, but a lower tax is paid to the government. Others attempt to use the same method for tax and accounting purposes because it eliminates some recordkeeping costs. Tax policy sometimes also plays a role. 11. The composite method is appropriate for a company which owns a large number of heterogeneous plant assets and which would find it impractical to keep detailed records for them. The principal advantage is that it is not necessary to keep detailed records for each plant asset in the group. The principal disadvantage is that after a period of time the book value of the plant assets may not reflect the proper carrying value of the assets. Inasmuch as the Accumulated Depreciation account is debited or credited for the difference between the cost of the asset and the cash received from the retirement of the asset (i.e., no gain or loss on disposal is recognized), the Accumulated Depreciation account is self-correcting over time. 12. Cash ................................................................................................... Accumulated Depreciation—Plant Assets ........................................... Plant Assets....................................................................... No gain or loss is recognized under the composite method.
14,000 36,000 50,000
13. Original estimate: $2,500,000 ÷ 50 = $50,000 per year Depreciation to January 1, 2015: $50,000 X 14 = $700,000 Depreciation in 2015 ($2,500,000 – $700,000) ÷ 15 years = $120,000 14. No, depreciation does not provide cash; revenues do. The funds for the replacement of the assets come from the revenues; without the revenues no income materializes and no cash inflow results. A separate decision must be made by management to set aside cash to accumulate asset replacement funds. Depreciation is added to net income on the statement of cash flows (indirect method) because it is a noncash expense, not because it is a cash inflow.
Questions Chapter 11 (Continued) 15. 25% straight-line rate X 2 = 50% double-declining rate $8,000 X 50% = $4,000 Depreciation for first full year. $4,000 X 6/12 = $2,000 Depreciation for half a year (first year), 2014. $6,000 X 50% = $3,000 Depreciation for 2015. 16. The accounting standards require that if events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable, then the carrying amount of the asset should be assessed. The assessment or review takes the form of a recoverability test that compares the sum of the expected future cash flows from the asset (undiscounted) to the carrying amount. If the cash flows are less than the carrying amount, the asset has been impaired. The impairment loss is measured as the amount by which the carrying amount exceeds the fair value of the asset. The fair value of assets is measured by their market value if an active market for them exists. If no market price is available, the present value of the expected future net cash flows from the asset may be used. 17. Under U.S. GAAP, impairment losses on assets held for use may not be restored. 18. An impairment is deemed to have occurred if, in applying the recoverability test, the carrying amount of the asset exceeds the expected future net cash flows from the asset. In this case, the expected future net cash flows of $705,000 exceed the carrying amount of the equipment of $700,000 so no impairment is assumed to have occurred; thus no measurement of the loss is made or recognized even though the fair value is $590,000. 19. Impairment losses are reported as part of income from continuing operations, generally in the “Other expenses and losses” section. Impairment losses (and recovery of losses for assets to be disposed of) are similar to other costs that would flow through operations. Thus, gains (recoveries of losses) on assets to be disposed of should be reported as part of income from continuing operations in the “Other revenues and gains” section. 20. In a decision to replace or not to replace an asset, the undepreciated cost of the old asset is not a factor to be considered. Therefore, the decision to replace plant assets should not be affected by the amount of depreciation that has been recorded. The relative efficiency of new equipment as compared with that presently in use, the cost of the new facilities, the availability of capital for the new asset, etc., are the factors entering into the decision. Normally, the fact that the asset had been fully depreciated through the use of some accelerated depreciation method, although the asset was still in use, should not cause management to decide to replace the asset. If the new asset under consideration for replacement was not any more efficient than the old, or if it cost a good deal more in relationship to its efficiency, it is illogical for management to replace it merely because all or the major portion of the cost had been charged off for tax and accounting purposes. If depreciation rates were higher it might be true that a business would be financially more able to replace assets, since during the earlier years of the asset’s use a larger portion of its cost would have been charged to expense, and hence during this period a smaller amount of income tax paid. By selling the old asset, which might result in a capital gain, and purchasing a new asset, the higher depreciation charge might be continued for tax purposes. However, if the asset were traded in, having taken higher depreciation would result in a lower basis for the new asset. It should be noted that expansion (not merely replacement) might be encouraged by increased depreciation rates. Management might be encouraged to expand, believing that in the first few years when they are reasonably sure that the expanded facilities will be profitable, they can charge off a substantial portion of the cost as depreciation for tax purposes. Similarly, since a replacement involves additional capital outlays, the tax treatment may have some influence. Also, because of the inducement to expand or to start new businesses, there may be a tendency in the economy as a whole for the accounting and tax treatment of the cost of plant assets to influence the retirement of old plant assets.
Questions Chapter 11 (Continued) It should be noted that to the extent that increased depreciation causes management to alter its decision about replacement, and to the extent it results in capital gains at the time of disposition, it is not matching costs and revenues in the closest possible manner. 21. In lieu of recording depreciation on replacement costs, management might elect to make annual appropriations of retained earnings in contemplation of replacing certain facilities at higher price levels. Such appropriations might help to eliminate misunderstandings as to amounts available for distribution as dividends, higher wages, bonuses, or lower sales prices. The need for these appropriations can be explained by supplementary financial schedules, explanations, and footnotes accompanying the financial statements. (However, neither depreciation charges nor appropriations of retained earnings result in the accumulation of funds for asset replacement. Fund accumulation is a result of profitable operations and appropriate funds management.) 22. (a) Depreciation and cost depletion are similar in the accounting sense in that: 1. The cost of the asset is the starting point from which computation of the amount of the periodic charge to operations is made. 2. The estimated life is based on economic or productive life. 3. The accumulated total of past charges to operations is deducted from the original cost of the asset on the balance sheet. 4. When output methods of computing depreciation charges are used, the formulas are essentially the same as those used in computing depletion charges. 5. Both represent an apportionment of cost under the process of matching costs with revenue. 6. Assets subject to either are reported in the same classification on the balance sheet. 7. Appraisal values are sometimes used for depreciation while discovery values are sometimes used for depletion. 8. Residual value is properly recognized in computing the charge to operations. 9. They may be included in inventory if the related asset contributed to the production of the inventory. 10. The rates may be changed upon revision of the estimated productive life used in the original rate computations. (b) Depreciation and cost depletion are dissimilar in the accounting sense in that: 1. Depletion is almost always based on output whereas depreciation is usually based on time. 2. Many formulas are used in computing depreciation but only one is used to any extent in computing depletion. 3. Depletion applies to natural resources while depreciation applies to plant and equipment. 4. Depletion refers to the physical exhaustion or consumption of the asset while depreciation refers to the wear, tear, and obsolescence of the asset. 5. Under statutes which base the legality of dividends on accumulated earnings, depreciation is usually a required deduction but depletion is usually not a required deduction. 6. The computation of the depletion rate is usually much less precise than the computation of depreciation rates because of the greater uncertainty in estimating the productive life. 7. A difference that is temporary in nature arises from the timing of the recognition of depreciation under conventional accounting and under the Internal Revenue Code, and it results in the recording of deferred income taxes. On the other hand, the difference between cost depletion under conventional accounting and its counterpart, percentage depletion, under the Internal Revenue Code is permanent and does not require the recording of deferred income taxes. 23. Cost depletion is the procedure by which the capitalized costs, less residual land values, of a natural resource are systematically charged to operations. The purpose of this procedure is to match the cost of the resource with the revenue it generates. The usual method is to divide the total cost less residual value by the estimated number of recoverable units to arrive at a depletion charge for each unit removed. A change in the estimate of recoverable units will necessitate a revision of the unit charge.
Questions Chapter 11 (Continued) Percentage depletion is the procedure, authorized by the Internal Revenue Code, by which a certain percentage of gross income is charged to operations in arriving at taxable income. Percentage depletion is not considered to be a generally accepted accounting principle because it is not related to the cost of the asset and is allowed even though the property is fully depleted under cost depletion accounting. Applicable rates, ranging from 5% to 22% of gross income, are specified for nearly all natural resources. The total amount deductible in a given year may not be less than the amount computed under cost depletion procedures, and it may not exceed 50% of taxable income from the property before the depletion deduction. Cost depletion differs from percentage depletion in that cost depletion is a function of production whereas percentage depletion is a function of income. Percentage depletion has arisen, in part, from the difficulty of valuing the natural resource or determining the discovery value of the asset and of determining the recoverable units. Although other arguments have been advanced for maintaining percentage depletion, a primary argument is its value in encouraging the search for additional resources. It is deemed to be in the national interest to provide an incentive to the continuing search for natural resources. As noted in the textbook, percentage depletion is no longer permitted for many enterprises. 24. Percentage depletion does not necessarily measure the proper share of the cost of land to be charged to expense for depletion and, in fact, may ultimately exceed the actual cost of the property. 25. The maximum dividend permissible is the amount of accumulated net income (after depletion) plus the amount of depletion charged. This practice can be justified for companies that expect to extract natural resources and not purchase additional properties. In effect, such companies are distributing gradually to stockholders their original investments. 26. Reserve recognition accounting (RRA) is the method that was proposed by the SEC to account for oil and gas resources. Proponents of this approach argue that oil and gas should be valued at the date of discovery. The value of the reserve still in the ground is estimated and this amount, appropriately discounted, is reported on the balance sheet as “oil deposits.” The costs of exploration incurred each year are deducted from the estimated reserves discovered during the same period with the difference probably being reported as income. The oil companies are concerned because the valuation issue is extremely tenuous. For example, to properly value the reserves, the following must be estimated: (1) amount of the reserves, (2) future production costs, (3) periods of expected disposal, (4) discount rate, and (5) the selling price. 27. Using full-cost accounting, the cost of unsuccessful ventures as well as those that are successful is capitalized, because a cost of drilling a dry hole is a cost that is needed to find the commercially profitable wells. Successful efforts accounting capitalizes only those costs related to successful projects. They contend that to measure cost and effort accurately for a single property unit, the only measure is in terms of the cost directly related to that unit. In addition, it is argued that full-cost is misleading because capitalizing all costs will make an unsuccessful company over a short period of time show no less income than does one that is successful. 28. Asset turnover: $69.8
= 1.54 times
$45.2 Return on assets: $2.9 = 6.4% $45.2
Questions Chapter 11 (Continued) *29. The modified accelerated cost recovery system (MACRS) has been adopted by the Internal Revenue Service. It applies to depreciable assets acquired in 1987 and later. MACRS eliminates the need to determine each asset’s useful life. The selection of a depreciation method and a salvage value is also unnecessary under MACRS. The taxpayer determines the recovery deduction for an asset by applying a statutory percentage to the historical cost of the property. MACRS was adopted to permit a faster write-off of tangible assets so as to provide additional tax incentives and to simplify the depreciation process. The simplification should end disputes related to estimated useful life, salvage value, and so on.
SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 11-1 2014:
($50,000 – $2,000) X 23,000 160,000
= $6,900
2015:
($50,000 – $2,000) X 31,000 160,000
= $9,300
BRIEF EXERCISE 11-2 (a)
$80,000 – $8,000 8
= $9,000
(b)
$80,000 – $8,000 8
X 4/12 = $3,000
BRIEF EXERCISE 11-3 (a)
($80,000 – $8,000) X 8/36* = $16,000
(b)
[($80,000 – $8,000) X 8/36] X 9/12 = $12,000 *[8(8 + 1)] ÷ 2
BRIEF EXERCISE 11-4 (a)
$80,000 X 25%* = $20,000
(b)
($80,000 X 25%) X 3/12 = $5,000 *(1/8 X 2)
BRIEF EXERCISE 11-5 Depreciable Base = ($28,000 + $200 + $125 + $500 + $475) – $3,000 = $26,300.
BRIEF EXERCISE 11-6 Asset A B C
Depreciation Expense ($70,000 – $7,000)/10 = $ 6,300 ($50,000 – $5,000)/5 = 9,000 ($82,000 – $4,000)/12 = 6,500 $21,800
Composite rate = $21,800/$202,000 = 10.8% Composite life = $186,000*/$21,800 = 8.5 years *($63,000 + $45,000 + $78,000) BRIEF EXERCISE 11-7 Annual depreciation expense: ($8,000 – $1,000)/5 = $1,400 Book value, 1/1/15: $8,000 – (2 x $1,400) = $5,200 Depreciation expense, 2015: ($5,200 – $500)/2 = $2,350 BRIEF EXERCISE 11-8 Recoverability test: Future net cash flows ($500,000) < Carrying amount ($520,000); therefore, the asset has been impaired. Journal entry: Loss on Impairment .............................................. Accumulated Depreciation— Equipment ($520,000 – $400,000)...........
120,000 120,000
BRIEF EXERCISE 11-9 Inventory ................................................................ Coal Mine ......................................................
73,500
$400,000 + $100,000 + $80,000 – $160,000 = $105 per ton 4,000 700 X $105 = $73,500
73,500
BRIEF EXERCISE 11-10 (a)
Asset turnover: $7,719
= 1.175 times
$6,862 + $6,276 2 (b)
Profit margin on sales: $805 = 10.43% $7,719
(c)
Return on assets: 1. 2.
1.175 X 10.43% = 12.25% $805 = 12.25% $6,862 + $6,276 2
*BRIEF EXERCISE 11-11 2014: 2015: 2016: 2017: 2018: 2019:
$50,000 X 20% $50,000 X 32% $50,000 X 19.2% $50,000 X 11.52% $50,000 X 11.52% $50,000 X 5.76%
= = = = = =
$10,000 16,000 9,600 5,760 5,760 2,880 $50,000
SOLUTIONS TO EXERCISES EXERCISE 11-1 (15–20 minutes) (a)
Straight-line method depreciation for each of Years 1 through 3 = $469,000 – $40,000 = $35,750 12
(b)
Sum-of-the-Years’-Digits =
12 X 13
= 78
2 12/78 X ($469,000 – $40,000) = $66,000 depreciation Year 1 11/78 X ($469,000 – $40,000) = $60,500 depreciation Year 2 10/78 X ($469,000 – $40,000) = $55,000
depreciation Year 3
100% (c)
Double-Declining Balance method depreciation rate.
X 2 = 16.67%
12
$469,000 X 16.67% =
$78,182 depreciation Year 1
($469,000 – $78,182) X 16.67% =
$65,149 depreciation Year 2
($469,000 – $78,182 – $65,149) X 16.67% =
$54,289 depreciation Year 3
EXERCISE 11-2 (20–25 minutes) (a)
If there is any salvage value and the amount is unknown (as is the case here), the cost would have to be determined by looking at the data for the double-declining balance method. 100%
= 20%; 20% X 2 = 40%
5 Cost X 40% = $20,000 $20,000 ÷ .40 = $50,000 Cost of asset
EXERCISE 11-2 (Continued) (b)
$50,000 cost [from (a)] – $45,000 total depreciation = $5,000 salvage value.
(c)
The highest charge to income for Year 1 will be yielded by the doubledeclining balance method.
(d)
The highest charge to income for Year 4 will be yielded by the straight-line method.
(e)
The method that produces the highest book value at the end of Year 3 would be the method that yields the lowest accumulated depreciation at the end of Year 3, which is the straight-line method. Computations: St.-line = $50,000 – ($9,000 + $9,000 + $9,000) = $23,000 book value, end of Year 3. S.Y.D. = $50,000 – ($15,000 + $12,000 + $9,000) = $14,000 book value, end of Year 3. D.D.B. = $50,000 – ($20,000 + $12,000 + $7,200) = $10,800 book value, end of Year 3.
(f)
The method that will yield the highest gain (or lowest loss) if the asset is sold at the end of Year 3 is the method which will yield the lowest book value at the end of Year 3, which is the double-declining balance method in this case.
EXERCISE 11-3 (15–20 minutes) (a)
20 (20 + 1) = 210 2 3/4 X 20/210 X ($711,000 – $60,000) = $46,500 for 2014
+
1/4 X 20/210 X ($711,000 – $60,000) = 3/4 X 19/210 X ($711,000 – $60,000) =
$15,500 44,175 $59,675 for 2015
EXERCISE 11-3 (Continued) (b)
100%
= 5%; 5% X 2 = 10%
20 3/4 X 10% X $711,000 = $53,325 for 2014 10% X ($711,000 – $53,325) = $65,768 for 2015
EXERCISE 11-4 (15–25 minutes) (a)
$315,000 – $15,000 = $300,000; $300,000 ÷ 10 yrs. = $30,000
(b)
$300,000 ÷ 240,000 units = $1.25; 25,500 units X $1.25 = $31,875
(c)
$300,000 ÷ 25,000 hours = $12.00 per hr.; 2,650 hrs. X $12.00 = $31,800
(d)
10 + 9 + 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1 = 55 OR
n(n + 1) 2
(e)
10 X $300,000 X 1/3 = 55
$18,182
9 X $300,000 X 2/3 = 55
32,727
Total for 2015
$50,909
$315,000 X 20% X 1/3 =
$21,000
[$315,000 – ($315,000 X 20%)] X 20% X 2/3 =
33,600
Total for 2015
$54,600
=
10(11) = 55 2
[May also be computed as 20% of ($315,000 – 2/3 of 20% of $315,000)]
EXERCISE 11-5 (20–25 minutes) (a)
($117,900 – $12,900) = $21,000/yr. = $21,000 X 5/12 = $8,750 5 2014 Depreciation—Straight line = $8,750
(b)
($117,900 – $12,900) = $5.00/hr. 21,000 2014 Depreciation—Machine Usage = 800 X $5.00 = $4,000
(c)
Machine Year Total 1 5/15 X $105,000 = $35,000 2 4/15 X $105,000 = $28,000
Allocated to 2014 2015 $14,583* $20,417** 11,667*** $14,583 $32,084
* $35,000 X 5/12 = $14,583 ** $35,000 X 7/12 = $20,417 *** $28,000 X 5/12 = $11,667 2015 Depreciation—Sum-of-the-Years’-Digits = $32,084 (d)
2014 40% X ($117,900) X 5/12 = $19,650 2015 40% X ($117,900 – $19,650) = $39,300 OR 1st full year (40% X $117,900) = $47,160 2nd full year [40% X ($117,900 – $47,160)] = $28,296 2014 Depreciation = 5/12 X $47,160 =
$19,650
2015 Depreciation = 7/12 X $47,160 = 5/12 X $28,296 =
$27,510 11,790 $39,300
EXERCISE 11-6 (20–30 minutes) (a)
2014
Straight-line
$212,000 – $12,000
= $25,000/year
8 3 months—Depreciation $6,250 = ($25,000 X 3/12) (b)
2014
Output
$212,000 – $12,000
= $5.00/output unit
40,000 1,000 units X $5.00 = $5,000 (c)
2014
Working hours
$212,000 – $12,000
= $10.00/hour
20,000 525 hours X $10.00 = $5,250
(d)
8 + 7 + 6 + 5 + 4 + 3 + 2 + 1 = 36 OR
n (n + 1)
=
8(9)
2
Sum-of-the-years’-digits Year 1 8/36 X $200,000 = 2 7/36 X $200,000 = 3 6/36 X $200,000 =
Total $44,444 $38,889 $33,333
2014 $11,111
= 36
2 Allocated to 2015 $33,333 9,722
$11,111
$43,055
2016 $29,167 8,333 $37,500
2016: $37,500 = (9/12 of 2nd year of machine’s life plus 3/12 of 3rd year of machine’s life) (e)
Double-declining balance 2015: 1/8 X 2 = 25%. 2014: 25% X $212,000 X 3/12 = $13,250 2015: 25% X ($212,000 – $13,250) = $49,688 OR 1st full year (25% X $212,000) = $53,000
EXERCISE 11-6 (Continued) 2nd full year [25% X ($212,000 – $53,000)] = $39,750 2014 Depreciation 3/12 X $53,000 = $13,250 2015 Depreciation 9/12 X $53,000 = $39,750 3/12 X $39,750 = 9,938 $49,688 EXERCISE 11-7 (25–35 minutes) Methods of Depreciation Description
Date Purchased
Cost
Salvage
Life
Method
Accum. Depr. to 2015
2016 Depr.
A B C D
2/12/14 8/15/13 7/21/12 (g) 10/12/14
$142,500 (c) 79,000 75,400 219,000
$16,000 21,000 23,500 69,000
10 5 8 5
(a) SYD SL DDB SYD
$33,350 29,000 (e) 47,567 70,000
(b) $19,550 (d) 11,600 (f) 4,333 (h) 35,000
Machine A—Testing the methods Straight-Line Method for 2014
$ 6,325 [($142,500 – $16,000) ÷ 10] X 1/2
Straight-Line Method for 2015 Total Straight Line
$12,650 $18,975
Double-Declining Balance for 2014 Double-Declining Balance for 2015 Total Double Declining Balance
$14,250 ($142,500 X .2 X .5) $25,650 [($142,500 – $14,250) X .2] $39,900
Sum-of-the-years-digits for 2014
$11,500 [($142,500 – $16,000) X
Sum-of-the-years-digits for 2015
10/55 X .5] $21,850 ($126,500 X 10/55 X 1/2) + ($126,500 X 9/55 X .5)
Total Sum-of-the-years-digits Method used must be Using SYD, 2016 Depreciation is
$33,350 SYD $19,550
($126,500 X 9/55 X 1/2) + ($126,500 X 8/55 X .5)
EXERCISE 11-7 (Continued) Machine B—Computation of the cost Asset has been depreciated for 2 1/2 years using the straight-line method. Annual depreciation is then equal to $29,000 divided by 2.5 or $11,600. 11,600 times 5 plus the salvage value is equal to the cost. Cost is $79,000 [($11,600 X 5) + $21,000]. Using SL, 2014 Depreciation is $11,600. Machine C—Using the double-declining balance method of depreciation 2012’s depreciation is $ 9,425 ($75,400 X .25 X .5) 2013’s depreciation is $16,494 ($75,400 – $9,425) X .25 2014’s depreciation is $12,370 ($75,400 – $25,919) X .25 2015’s depreciation is $ 9,278 ($75,400 – $38,289) X .25 $47,567 Using DDB, 2016 Depreciation is $4,333 ($75,400 – $47,567 – $23,500) Machine D—Computation of Year Purchased First Half Year using SYD = $25,000 [($219,000 – $69,000) X Second Year using SYD =
5/15 X .5] $45,000 ($150,000 X 5/15 X .5) + ($150,000 X 4/15 X .5)
$70,000 Thus the asset must have been purchased on October 12, 2006 Using SYD, 2016 Depreciation is
$35,000
($150,000 X 4/15 X .5) + ($150,000 X 3/15 X .5)
EXERCISE 11-8 (20–25 minutes) Old Machine June 1, 2012
Purchase Freight Installation Total cost
$31,000 200 500 $31,700
Annual depreciation charge: ($31,700 – $2,500) ÷ 10 = $2,920 On June 1, 2013, debit the old machine for $1,980; the revised total cost is $33,680 ($31,700 + $1,980); thus the revised annual depreciation charge is: ($33,680 – $2,500 – $2,920) ÷ 9 = $3,140. Book value, old machine, June 1, 2016: [$33,680 – $2,920 – ($3,140 X 3)] = Less: Fair value Loss on exchange Cost of removal Total loss
$21,340 20,000 1,340 75 $ 1,415
(Note to instructor: The above computation is done to determine whether there is a gain or loss from the exchange of the old machine with the new machine and to show how the cost of removal might be reported. Also, if a gain occurs, the gain is not deferred (1) because the exchange has commercial substance and (2) the cost paid exceeds 25% of the total value of the property received.) New Machine Basis of new machine Cash paid ($35,000 – $20,000) Fair value of old machine Installation cost Total cost of new machine
$15,000 20,000 1,500 $36,500
Depreciation for the year beginning June 1, 2016 = ($36,500 – $4,000) ÷ 10 = $3,250.
EXERCISE 11-9 (15–20 minutes) (a) Asset A B C D E
Cost $ 40,500 33,600 36,000 19,000 23,500 $152,600
Estimated Salvage $ 5,500 4,800 3,600 1,500 2,500 $17,900
Depreciable Cost $ 35,000 28,800 32,400 17,500 21,000 $134,700
Estimated Depreciation Life per Year 10 $ 3,500 9 3,200 9 3,600 7 2,500 6 3,500 $16,300
Composite life = $134,700 ÷ $16,300, or 8.26 years Composite rate = $16,300 ÷ $152,600, or approximately 10.7% (b)
(c)
Depreciation Expense......................................... Accumulated Depreciation—Plant Assets ......................................................
16,300
Cash ..................................................................... Accumulated Depreciation—Plant Assets ........ Plant Assets ...............................................
4,800 14,200
16,300
19,000
EXERCISE 11-10 (10–15 minutes) Sum-of-the-years’-digits =
8X9
= 36
2 Using Y to stand for the years of remaining life: Y/36 X ($430,000 – $70,000) = $60,000 Multiplying both sides by 36: $360,000 X Y = $2,160,000 Y = $2,160,000 ÷ $360,000 Y=6 The year in which there are six remaining years of life at the beginning of that given year is 2013.
EXERCISE 11-11 (10–15 minutes) (a)
No correcting entry is necessary because changes in estimate are handled in the current and prospective periods.
(b)
Revised annual charge Book value as of 1/1/2015 [$60,000 – ($7,000 X 5)] = $25,000 Remaining useful life, 5 years (10 years – 5 years) Revised salvage value, $4,500 ($25,000 – $4,500) ÷ 5 = $4,100 Depreciation Expense............................................ Accumulated Depreciation—Machinery......
4,100 4,100
EXERCISE 11-12 (20–25 minutes) (a)
1988–1997—($2,000,000 – $60,000) ÷ 40 = $48,500/yr.
(b)
1998–2015—Building ($2,000,000 – $60,000) ÷ 40 = Addition ($500,000 – $20,000) ÷ 30 =
(c)
No entry required.
(d)
Revised annual depreciation Building Book value: ($2,000,000 – $1,358,000*) Salvage value Remaining useful life Annual depreciation *$48,500 X 28 years = $1,358,000
$48,500/yr. 16,000/yr. $64,500/yr.
$642,000 60,000 582,000 32 years $ 18,188
EXERCISE 11-12 (Continued) Addition Book value: ($500,000 – $288,000**) Less: Salvage value
$ 212,000 20,000 192,000 ÷ 32 years $ 6,000
Remaining useful life Annual depreciation **$16,000 X 18 years = $288,000 Annual depreciation expense—building ($18,188 + $6,000)
$24,188
EXERCISE 11-13 (15–20 minutes) (a)
$2,200,000 ÷ 40 = $55,000
(b)
Loss on Disposal of Plant Assets...................... Accumulated Depreciation—Buildings ($160,000 X 20/40) ............................................ Buildings ....................................................
80,000
Buildings.............................................................. Cash ............................................................
300,000
80,000 160,000 300,000
Note: The most appropriate entry would be to remove the old roof and record a loss on disposal, because the cost of the old roof is given. Another alternative would be to debit Accumulated Depreciation— Buildings on the theory that the replacement extends the useful life of the building. The entry in this case would be as follows: Accumulated Depreciation—Buildings ............. Cash ............................................................
300,000 300,000
As indicated, this approach does not seem as appropriate as the first approach.
EXERCISE 11-13 (Continued) (c)
No entry necessary.
(d)
(Assume the cost of the old roof is removed) Buildings ($2,200,000 – $160,000 + $300,000) Less: Accumulated Depreciation ($55,000 X 20 – $80,000)
$2,340,000 1,020,000 1,320,000 ÷ 25 years $ 52,800
Remaining useful life Depreciation—2015 ($1,320,000 ÷ 25) OR (Assume the cost of the new roof is debited to Accumulated Depreciation—Equipment) Book value of the building prior to the replacement of roof $2,200,000 – ($55,000 X 20) = Cost of new roof
$1,100,000 300,000 $1,400,000 ÷ 25 years $ 56,000
Remaining useful life Depreciation—2015 ($1,400,000 ÷ 25)
EXERCISE 11-14 (20–25 minutes) (a)
(b)
Maintenance and Repairs Expense ................... Equipment ..................................................
500
The proper ending balance in the asset account is: January 1 balance Add: New equipment: Purchases $32,000 Freight 700 Installation 2,700 Less: Cost of equipment sold December 31 balance (1) Straight-line: $147,150 ÷ 10 = $14,715
500
$134,750
35,400 23,000 $147,150
EXERCISE 11-14 (Continued) (2) Sum-of-the-years’-digits: 10 + 9 + 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1 = 55 OR
n(n + 1) 2
=
10(11) = 55 2
For equipment purchased in 2013: $111,750 ($134,750 – $23,000) of the cost of equipment purchased in 2013, is still on hand. 8/55 X $111,750 = $16,255 For equipment purchased in 2015: 10/55 X $35,400 = 6,436 Total $22,691
EXERCISE 11-15 (25–35 minutes) (a) 2009 (1) $192,000 – $16,800 = $175,200 $175,200 ÷ 12 = $14,600 per yr. ($40 per day) 133*/365 of $14,600 = $ 5,320 2010–2015 Include. (6 X $14,600) 68/365 of $14,600 = (2) 0 (3) 14,600 (4) 7,300 (5) 4/12 of $14,600 4,867 2010–2015 Inc. 3/12 of $14,600 (6) 0
2010–2015 Incl.
2016
Total
$ 2,720 14,600 0 7,300
$ 95,640 102,200 102,200 102,200
3,650 0
96,117 87,600
$87,600 87,600 87,600 87,600 87,600 87,600
*(11 + 30 + 31 + 30 + 31)
(b)
The most accurate distribution of cost is given by methods 1 and 5 if it is assumed that straight-line is satisfactory. Reasonable accuracy is normally given by 2, 3, or 4. The simplest of the applications are 6, 2, 3, 4, 5, and 1, in about that order. Methods 2, 3, and 4 combine reasonable accuracy with simplicity of application.
EXERCISE 11-16 (10–15 minutes) (a)
December 31, 2014 Loss on Impairment ............................................... 3,200,000 Accumulated Depreciation—Equipment .. Cost Less: Accumulated depreciation Carrying amount Less: Fair value Loss on impairment
(b)
(c)
$9,000,000 1,000,000 8,000,000 4,800,000 $3,200,000
December 31, 2015 Depreciation Expense ............................................ 1,200,000 Accumulated Depreciation—Equipment .. New carrying amount Useful life Depreciation per year
3,200,000
1,200,000
$4,800,000 ÷ 4 years $1,200,000
No entry necessary. Restoration of any impairment loss is not permitted.
EXERCISE 11-17 (15–20 minutes) (a)
Loss on Impairment ............................................... 3,220,000 Accumulated Depreciation—Equipment .. Cost Accumulated depreciation Carrying amount Less: Fair value Plus: Cost of disposal Loss on impairment
$9,000,000 1,000,000 8,000,000 4,800,000 20,000 $3,220,000
3,220,000
EXERCISE 11-17 (Continued) (b)
No entry necessary. Depreciation is not taken on assets intended to be sold.
(c)
Accumulated Depreciation—Equipment .......... Recovery of Loss from Impairment ......... Fair value Less: Cost of disposal Less: Carrying amount Recovery of loss on impairment
500,000 500,000 $5,300,000 20,000 $5,280,000 4,780,000 $ 500,000
EXERCISE 11-18 (15–20 minutes) (a)
December 31, 2014 Loss on Impairment ............................................ Accumulated Depreciation—Equipment .. Cost Less: Accumulated depreciation Carrying amount Less: Fair value Loss on impairment
270,000 270,000
$900,000 400,000 500,000 230,000 $270,000
(b)
It may be reported in the other expenses and losses section or it may be highlighted as an unusual item in a separate section. It is not reported as an extraordinary item.
(c)
No entry necessary. Restoration of any impairment loss is not permitted.
(d)
Management first had to determine whether there was an impairment. To evaluate this step, management does a recoverability test. The recoverability test estimates the future cash flows expected from use of that asset and its eventual disposition. If the sum of the expected future net cash flows (undiscounted) is less than the carrying amount of the asset, an impairment results. If the recoverability test indicates that an impairment has occurred, a loss is computed. The impairment loss is the amount by which the carrying amount of the asset exceeds its fair value.
EXERCISE 11-19 (15–20 minutes) (a)
$84,000
Depreciation Expense:
= $2,800 per year
30 years Cost of Timber Sold: $1,400 – $400 = $1,000 $1,000 X 9,000 acres = $9,000,000 of value of timber ($9,000,000 ÷ 3,500,000 bd. ft.) X 700,000 bd. ft. = $1,800,000 (b)
Cost of Timber Sold: $9,000,000 – $1,800,000 = $7,200,000 $7,200,000 + $100,000 = $7,300,000 ($7,300,000 ÷ 5,000,000 bd. ft.) X 900,000 bd. ft. = $1,314,000
Note: The spraying costs as well as the costs to maintain the fire lanes and roads are expensed each period and are not part of the depletion base.
EXERCISE 11-20 (10–15 minutes) Cost per barrel of oil: Initial payment =
$500,000
=
$2.00
250,000 Rental =
$31,500
=
1.75
18,000 Premium = 5% of $55 =
Reconditioning of land =
2.75 $30,000
=......... 12
250,000 Total cost per barrel
$6.62
EXERCISE 11-21 (15–20 minutes) (a)
$1,300 – $300 = $1,000 per acre for timber $1,000 X 7,000 acres X 850,000 bd. ft. = 8,000 bd. ft. X 7,000 acres $7,000,000
X 850,000 bd. ft. = $106,250.
56,000,000 bd. ft. (b) (c)
$78,400 X 850,000 bd. ft. = $1,190. 56,000,000 bd. ft. Forda should capitalize the cost of $70,000 ($20 X 3,500 trees) and adjust the depletion the next time the timber is harvested.
EXERCISE 11-22 (15–20 minutes) Depletion base: $1,190,000 + $90,000 – $100,000 + $200,000 = $1,380,000 Depletion rate: $1,380,000 ÷ 60,000 = $23/ton (a) (b) (c)
Per unit material cost: $23/ton 12/31/14 inventory: $23 X 8,000 tons = $184,000 Cost of goods sold 2014: $23 X 22,000 tons = $506,000
EXERCISE 11-23 (15–20 minutes) (a)
$970,000 + $170,000 + $40,000* – $100,000 = .09 depletion per unit 12,000,000 *Note to instructor: The $40,000 should be depleted because it is a asset retirement obligation. 2,500,000 units extracted X $.09 = $225,000 depletion for 2014
(b)
2,100,000 units sold X $.09 = $189,000 charged to cost of goods sold for 2014
EXERCISE 11-24 (15–25 minutes) (a)
Asset turnover: $528.4 $858 + $857.9 2
(a)
= .6159 times
Return on assets: $43.9 $858 + $857.9 2
= 5.12%
(b)
Profit margin on sales: $43.9 = 8.31% $528.4
(c)
The asset turnover times the profit margin on sales provides the rate of return on assets computed for Tootsie Roll as follows: Profit margin on sales X Asset Turnover 8.31% X .6159
=
Return on Assets 5.12%
Note the answer 5.12% is the same as the rate of return on assets computed in (b) above.
*EXERCISE 11-25 (20–25 minutes)
(a)
(b)
Revenues Operating expenses (excluding depreciation) Depreciation [($27,000 – $6,000) ÷ 7] Income before income taxes
2014 $200,000 130,000 3,000 $ 67,000
2015 $200,000 130,000 3,000 $ 67,000
Revenues Operating expenses (excluding depreciation) Depreciation* Taxable income
2014 $200,000 130,000 5,400 $ 64,600
2015 $200,000 130,000 8,640 $ 61,360
*2014 2015
$27,000 X .20 = $5,400 $27,000 X .32 = $8,640
(c)
Book purposes ($27,000 – $6,000) Tax purposes (entire cost of asset)
(d)
Differences will occur for the following reasons: 1. different depreciation methods. 2. half-year convention used for tax purposes. 3. estimated useful life and tax life different. 4. tax system ignores salvage value.
$21,000 $27,000
*EXERCISE 11-26 (15–20 minutes) (a)
(1)
($31,000 – $1,000) X 1/10 X 10/12 = $2,500 depreciation expense for book purposes.
(2)
$31,000 X 1/5 X 1/2 = $3,100 depreciation for tax purposes.
*EXERCISE 11-26 (Continued) (b)
(c)
(1)
$31,000 X 20% X 10/12 = $5,167 depreciation expense for book purposes.
(2)
$31,000 X 40% X 1/2 = $6,200 depreciation expense for tax purposes.
Differences will occur for the following reasons: 1. half-year convention used for tax purposes. 2. estimated useful life and tax life different. 3. tax system ignores salvage value.
TIME AND PURPOSE OF PROBLEMS Problem 11-1 (Time 25–30 minutes) Purpose—to provide the student with an opportunity to compute depreciation expense using a number of different depreciation methods. The problem is complicated because the proper cost of the machine to be depreciated must be determined. For example, purchase discounts and freight charges must be considered. In addition, the student is asked to select a depreciation method that will allocate less depreciation in the early years of the machine’s life than in the later years. Problem 11-2 (Time 25–35 minutes) Purpose—to provide the student with an opportunity to compute depreciation expense using the following methods: straight-line, units-of-output, working hours, sum-of-the-years’-digits, and declining balance. The problem is straightforward and provides an excellent review of the basic computational issues involving depreciation methods. Problem 11-3 (Time 40–50 minutes) Purpose—to provide the student with an opportunity to compute depreciation expense using a number of different depreciation methods. Before the proper depreciation expense can be computed, the accounts must be corrected for a number of errors made by the company in its accounting for the assets. An excellent problem for reviewing the proper accounting for plant assets and related depreciation expense. Problem 11-4 (Time 45–60 minutes) Purpose—to provide the student with an opportunity to correct the improper accounting for Semitrucks and determine the proper depreciation expense. The student is required to compute separately the errors arising in determining or entering depreciation or in recording transactions affecting Semitrucks. Problem 11-5 (Time 25–30 minutes) Purpose—to provide the student with a problem involving the computation of estimated depletion and depreciation costs associated with a tract of mineral land. The student must compute depletion and depreciation on a units-of-production basis (tons mined). A portion of the cost of machinery associated with the product must be allocated over different periods. The student may experience some difficulty with this problem. Problem 11-6 (Time 25–30 minutes) Purpose—to provide the student with a problem involving the proper accounting for depletion cost. This problem involves timberland for which a depletion charge must be computed. In addition, a computation of a loss that occurs because of volcanic activity must be determined. Problem 11-7 (Time 25–35 minutes) Purpose—to provide the student with a problem involving depletion and depreciation computations. Problem 11-8 (Time 25–35 minutes) Purpose—to provide the student with a comprehensive problem related to property, plant, and equipment. The student must determine depreciable bases for assets, including capitalized interest, and prepare depreciation entries using various methods of depreciation. Problem 11-9 (Time 15–25 minutes) Purpose—to provide the student with an opportunity to analyze impairments for assets to be used and assets to be disposed of. Problem 11-10 (Time 45–60 minutes) Purpose—to provide the student with an opportunity to solve a complex problem involving a number of plant assets. A number of depreciation computations must be made, specifically straight-line, 150% declining balance, and sum-of-the-years’-digits. In addition, the cost of assets acquired is difficult to determine.
Time and Purpose of Problems (Continued) Problem 11-11 (Time 30–35 minutes) Purpose—to provide the student with the opportunity to solve a moderate problem involving a machinery purchase and the depreciation computations using straight-line, activity, sum-of-the-years’-digits, and the double-declining-balance methods, first for full periods and then for partial periods. *Problem 11-12 (Time 25–35 minutes) Purpose—to provide the student with an opportunity to compute depreciation expense using a number of different depreciation methods. The purpose of computing the depreciation expense is to determine which method will result in the maximization of net income and which will result in the minimization of net income over a three-year period. An excellent problem for reviewing the fundamentals of depreciation accounting.
SOLUTIONS TO PROBLEMS PROBLEM 11-1 (a)
1.
Depreciation Base Computation: Purchase price ................................... $85,000 Less: Purchase discount (2%)...... 1,700 Freight-in........................................ 800 Installation.......................................... 3,800 87,900 Less: Salvage value.......................... 1,500 Depreciation base .............................. $86,400 2014—Straight line: ($86,400 ÷ 8 years) X 2/3 year = $7,200
2.
Sum-of-the-years’-digits for 2015
1 2
Machine Year 8/36 X $86,400 = 7/36 X $86,400 =
Total Depreciation $19,200 $16,800
* $19,200 X 2/3 = $12,800 ** $19,200 X 1/3 = $ 6,400 *** $16,800 X 2/3 = $11,200 3. (b)
Double-declining-balance for 2014 ($87,900 X 25% X 2/3) = $14,650
An activity method.
2014 $12,800*
2015 $ 6,400** 11,200*** $17,600
PROBLEM 11-2
Depreciation Expense 2014 2015 (a)
(b)
(c)
(d)
Straight-line: ($89,000 – $5,000) ÷ 7 = $12,000/yr. 2014: $12,000 X 7/12 2015: $12,000
$12,000
Units-of-output: ($89,000 – $5,000) ÷ 525,000 units = $.16/unit 2014: $.16 X 55,000 2015: $.16 X 48,000
8,800 7,680
Working hours: ($89,000 – $5,000) ÷ 42,000 hrs. = $2.00/hr. 2014: $2.00 X 6,000 2015: $2.00 X 5,500
12,000 11,000
Sum-of-the-years’-digits: 1 + 2 + 3 + 4 + 5 + 6 + 7 = 28 or 2014: 7/28 X $84,000 X 7/12 2015: 7/28 X $84,000 X 5/12 = 6/28 X $84,000 X 7/12 =
(e)
$7,000
n(n + 1) = 2
7(8) 2
12,250 $ 8,750 10,500 $19,250
Declining-balance: Rate = 2/7 2014: 7/12 X 2/7 X $89,000 2015: 2/7 X ($89,000 – $14,833) = $21,191 OR 2015: 5/12 X $10,595 7/12 X 2/7 X ($89,000 – $25,428) = 10,595 $21,190*
*Difference due to rounding.
= 28
19,250
14,833
21,190
PROBLEM 11-3
(a)
(b)
(c)
(d)
Depreciation Expense............................................... Accumulated Depreciation—Machinery (A) (5/55 X [$46,000 – $3,100]) ............................
3,900
Accumulated Depreciation—Machinery (A) ............ Machinery (A) ($46,000 – $13,000) .................. Gain on Disposal of Machinery.......................
35,100
Depreciation Expense............................................... Accumulated Depreciation—Machinery (B) ([$51,000 – $3,000] ÷ 15,000 X 2,100)............
6,720
Depreciation Expense............................................... Accumulated Depreciation—Machinery (C) ([$80,000 – $15,000 – $5,000] ÷ 10)...............
6,000
Machinery (E) ............................................................ Retained Earnings............................................
28,000
Depreciation Expense............................................... Accumulated Depreciation—Machinery (E) ...
5,600*
*($28,000 X .20)
3,900 33,000 2,100
6,720
6,000 28,000
5,600
Per Company Books
(a)
1/1/12
Balance
7/1/12
Purchase Truck #5 Trade Truck #3
Trucks dr. (cr.)
Acc. Dep. Trucks dr. (cr.)
$ 94,000
$(30,200)
As Adjusted
Retained Earnings dr. (cr.)
Trucks dr. (cr.)
Acc. Dep., Trucks dr, (cr.)
$94,000
$(30,200)
40,000 (30,000)
9,000
$ 3,000 1
$ 3,000
(19,800)
(1,200) 1,800
22,000
Depreciation
(21,000)
12/31/12
Balances
116,000
1/1/13
Sale of Truck #1
(3,500)
12/31/13 12/31/13
Depreciation Balances
112,500
7/1/14
Purchase of Truck #6
42,000
7/1/14
Disposal of Truck #4
(2,500)
12/31/14
Depreciation
12/31/14
Balances
12/31/15
Depreciation
12/31/15
Balances
152,000
$152,000
(51,200)
(22,500) (73,700)
$21,000 21,000
22,500 43,500
104,000
(41,000)
(18,000)
14,400
100 3
100
86,000
(17,200) (43,800)
17,200 4 40,100
(5,300) (3,400)
14,400
6,400 5
7,100
(16,800)
16,800 6
(8,250)
(46,200)
63,300
(4,550)
(16,400)
16,400 7
(14,000)
$(62,600)
$79,700
$(18,550)
42,000 (700) (25,050)
25,050
(98,750)
67,850
(30,400)
30,400
$(129,150)
$98,250
Implied fair value of Truck #3 ($40,000 – $22,000) 1 Book value of Truck #3 [$30,000 – ($30,000/5 X 1 /2 yrs.)] = $30,000 – $9,000 = Loss on Trade
2
Truck #1: $18,000/5 Truck #2: $22,000/5 Truck #3: $30,000/5 X 1/2 Truck #4:$24,000/5 Truck #5: $40,000/5 X 1/2 Total
= = = = =
$3,600 4,400 3,000 4,800 4,000 $19,800
Income Overstated (Understated)
19,800 2 22,800
(24,000)
104,000
$104,000
Income effect 1
Retained Earnings dr, (cr.)
$18,000 (21,000) $ 3,000
PROBLEM 11-4
12/31/12
Net
PROBLEM 11-4 (Continued) 3
Book value of Truck #1 [$18,000 – ($18,000/5 X 4 yrs.)] = $18,000 – $14,400 ......................................................... Cash received on sale........................................................... Loss on sale ................................................................. 4
Truck #2: Truck #4: Truck #5: Total
$22,000/5 $24,000/5 $40,000/5
= = =
$ 4,400 4,800 8,000 $17,200
5
Book value of Truck #4 $24,000 – [($24,000/5 X 3 yrs.)] .... Cash received ($700 + $2,500) .............................................. Loss on disposal .......................................................... 6
7
Truck #2: Truck #4: Truck #5: Truck #6: Total
$22,000/5 X 1/2 $24,000/5 X 1/2 $40,000/5 $42,000/5 X 1/2
= =
Truck #2: Truck #5: Truck #6: Total
(fully dep.) $40,000/5 $42,000/5
$
(b)
= = =
= $3,600 = 3,500 $ 100
=
= $9,600 = 3,200 $6,400
$ 2,200 2,400 8,000 4,200 $16,800
0 8,000 8,400 $16,400
Compound journal entry December 31, 2015: Accumulated Depreciation—Trucks........................... 66,550 Trucks .................................................................. Retained Earnings............................................... Depreciation Expense ........................................
48,000 4,550 14,000
PROBLEM 11-4 (Continued) Summary of Adjustments:
Trucks Accumulated Depreciation Prior Years’ Income Retained Earnings, 2012 Retained Earnings, 2013 Retained Earnings, 2014 Totals Depreciation Expense, 2015
Per Books $152,000 $129,150
As Adjusted $104,000 $ 62,600
Adjustment Dr. or (Cr.) $(48,000) $ 66,550
$ 21,000 22,500 24,350 $ 67,850 $ 30,400
$ 22,800 17,300 23,200 $ 63,300 $ 16,400
$ 1,800 (5,200) (1,150) $ (4,550) $(14,000)
PROBLEM 11-5
(a)
Estimated depletion:
Depletion Base $870,000*
Estimated Yield 120,000 tons
Estimated Depletion 1ST & 11th Each of Yrs. Yrs. 2-10 Incl. $43,500** $87,000***
Per Ton $7.25
*($900,000 – $30,000) **($7.25 X 6,000) ***($7.25 X 12,000) Estimated depreciation:
Asset Building Machinery (1/2) Machinery (1/2)
Cost
Per ton Mined
$36,000 $.30* 30,000 .25** 30,000 .50***
1st Yr.
Yrs. 2–5
6th Yr.
Yrs. 7–10
11th Yr.
$1,800 1,500 3,000
$3,600 3,000 6,000
$3,600 3,000 3,000
$3,600 3,000 0
$1,800 1,500 0
* $36,000 ÷ 120,000 = $.30 ** $30,000 ÷ 120,000 = $.25 *** ($30,000 ÷ [120,000 ÷ 2]) = $.50 (b)
Depletion: $7.25 X 5,000 tons = $36,250 Depreciation:
Building $.30 X 5,000 = Machinery $.25 X 5,000 = Machinery $.50 X 5,000 = Total depreciation
$1,500 1,250 2,500 $5,250
PROBLEM 11-6
(a)
Original cost Deduct residual value of land
$550 X 3,000 = $200 X 3,000 =
Cost of logging road Depletion base
$1,650,000 600,000 1,050,000 150,000 $1,200,000
$1,200,000 = $2.40 depletion per board foot 500,000 ft. (b)
Inventory............................................................. Timber........................................................
240,000 240,000
Depletion, 2014: 20% X 500,000 bd. ft. = 100,000 bd. ft.; 100,000 bd. ft. X $2.40 = $240,000 (c)
Loss of timber [$1,050,000 – ($1,050,000 X 20%)] .................. $ 840,000 Cost of salvaging timber ................................... 700,000 Less: Recovery ($3 X 400,000 bd. ft.) ............... 1,200,000 $ 340,000 Loss of land value.............................................. 600,000 Loss of logging roads [($150,000 – (20% X $150,000)]...................... 120,000 Logging equipment............................................ 300,000 Extraordinary loss due to the eruption of Mt. Leno....................................................... $1,360,000
PROBLEM 11-7
Instructors should note the changing depletion base in this problem. 2014 Computation of depletion base for 2014 Timber Cost per acre $1,700 Land cost 800 Timber cost $ 900 X Road cost Total depletion base Estimated depletion for 2014
10,000 acres
$9,000,000 250,000 $9,250,000
Depletion expense for 2014
$9,250,000 X 0.08 (540,000/6,750,000) $ 740,000
Depreciation of removable equipment Cost Salvage value Depreciable base
$ 225,000 (9,000) $ 216,000
Annual depreciation using SL ($216,000/15) $
14,400
Depreciation expense for 2014
$
10,800 (9/12 X $14,400)
2015 Depletion base for 2015 Base for 2014 Less: Depletion for 2014 Plus: Seedling Planting Costs Depletion base for 2015
$9,250,000 740,000 120,000 $8,630,000
Depletion base for 2015 Times Depletion for 2015
$8,630,000 X 0.12 (774,000/6,450,000) $1,035,600
Depreciation expense for 2015
$
14,400
PROBLEM 11-7 (Continued) 2016 Depletion Base for 2016 Base for 2015 Less: Depletion for 2015 Plus: Seedling Planting Costs Depletion Base for 2016
$ 8,630,000 1,035,600 150,000 $ 7,744,400
Depletion Base for 2016 Times Depletion for 2016
$ 7,744,400 X .10 (650,000/6,500,000) $ 774,440
Depreciation Expense for 2016
$
14,400
PROBLEM 11-8
(a)
The amounts to be recorded on the books of Darby Sporting Goods Inc. as of December 31, 2014, for each of the properties acquired from Encino Athletic Equipment Company are calculated as follows: Cost Allocations to Acquired Properties
Appraisal Value (1) Land (2) Buildings (3) Machinery Totals
Remaining Purchase Price Allocations
Renovations
Capitalized Interest
$100,000
$21,0002
$100,000
$21,000
$290,000 $
77,0001 33,0001
$290,000
$110,000
Total $290,000 198,000 33,000 $521,000
Supporting Calculations 1
Balance of purchase price to be allocated. Total purchase price ........................................................... Less: Land appraisal........................................................... Balance to be allocated..............................................
Buildings Machinery Totals
Appraisal Values $105,000 45,000 $150,000
Ratios 105/150 = 45/150 =
.70 .30 1.00
X $110,000 X $110,000
$400,000 290,000 $110,000 Allocated Values $ 77,000 33,000 $110,000
PROBLEM 11-8 (Continued) 2
Capitalizable interest. Expenditures Date Amount 1/1 $ 50,000 4/1 120,000 10/1 140,000 12/31 190,000 $500,000
Capitalization Period 12/12 9/12 3/12 0/12
Weighted-Average Accumulated Expenditures $175,000
X
Interest Rate 12%
Weighted-Average Accumulated Expenditures $ 50,000 90,000 35,000 –0– $175,000
=
Avoidable Interest $21,000
Note to instructor: If the interest is allocated between the building and the machinery, $14,700 ($21,000 X 105/150) would be allocated to the building and $6,300 ($21,000 X 45/150) would be allocated to the machinery. (b)
Darby Sporting Goods Inc.’s 2015 depreciation expense, for book purposes, for each of the properties acquired from Encino Athletic Equipment Company is as follows: 1.
Land: No depreciation.
2.
Building: Depreciation rate 2015 depreciation expense
3.
Machinery: Depreciation rate = 2.00 X 1/5 = .40 2015 depreciation expense = Cost X Rate X 1/2 = $33,000 X .40 X 1/2 = $6,600
= 1.50 X 1/15 = .10 = Cost X Rate X 1/2 year = $198,000 X .10 X 1/2 = $9,900
PROBLEM 11-8 (Continued) (c)
Arguments for the capitalization of interest costs include the following. 1. Diversity of practices among companies and industries called for standardization in practices. 2. Total interest costs should be allocated to enterprise assets and operations, just as material, labor, and overhead costs are allocated. That is, under the concept of historical costs, all costs incurred to bring an asset to the condition and location necessary for its intended use should be reflected as a cost of that asset. Arguments against the capitalization of interest include the following: 1. Interest capitalized in a period would tend to be offset by amortization of interest capitalized in prior periods. 2. Interest cost is a cost of financing, not of construction.
PROBLEM 11-9
(a)
Carrying value of asset: $10,000,000 – $2,500,000* = $7,500,000. *($10,000,000 ÷ 8) X 2 Future cash flows ($6,300,000) < Carrying value ($7,500,000) Impairment entry: Loss on Impairment .................................................. 1,900,000* Accumulated Depreciation—Equipment ..... 1,900,000 *$7,500,000 – $5,600,000
(b)
Depreciation Expense ............................................... 1,400,000** Accumulated Depreciation—Equipment ..... 1,400,000 **($5,600,000 ÷ 4)
(c)
No depreciation is recorded on impaired assets to be disposed of. Recovery of impairment losses are recorded. 12/31/14
12/31/15
Loss on Impairment.............................. Accumulated Depreciation— Equipment .................................. Accumulated Depreciation— Equipment .......................................... Recovery of Loss from Impairment ($5,900,000 – $5,600,000) ...........
1,900,000 1,900,000
300,000 300,000
PROBLEM 11-10
(1)
$80,000
Allocated in proportion to appraised values (1/10 X $800,000).
(2)
$720,000
Allocated in proportion to appraised values (9/10 X $800,000).
(3)
Fifty years
Cost less salvage ($720,000 – $40,000) divided by annual depreciation ($13,600).
(4)
$13,600
Same as prior year since it is straight-line depreciation.
(5)
$91,000
[Number of shares (2,500) times fair value ($30)] plus demolition cost of existing building ($16,000).
(6)
None
No depreciation before use.
(7)
$40,000
Fair value.
(8)
$6,000
Cost ($40,000) times percentage (1/10 X 150%).
(9)
$5,100
Cost ($40,000) less prior year’s depreciation ($6,000) equals $34,000. Multiply $34,000 times 15%.
(10) $168,000
Total cost ($182,900) less repairs and maintenance ($14,900).
(11) $36,000
Cost less salvage ($168,000 – $6,000) times 8/36.
(12) $10,500
Cost less salvage ($168,000 – $6,000) times 7/36 times one-third of a year.
PROBLEM 11-10 (Continued) (13) $52,000
Annual payment ($6,000) times present value of annuity due at 8% for 11 years (7.710) plus down payment ($5,740). This can be found in an annuity due table since the payments are at the beginning of each year. Alternatively, to convert from an ordinary annuity to an annuity due factor, proceed as follows: For eleven payments use the present value of an ordinary annuity for 11 years (7.139) times 1.08. Multiply this factor (7.710) times $6,000 annual payment to obtain $46,260, and then add the $5,740 down payment.
(14) $2,600
Cost ($52,000) divided by estimated life (20 years).
PROBLEM 11-11
(a)
(1)
Straight-line Method:
(2)
Activity Method:
$90,000 – $6,000 = $16,800 a year 5 years
$90,000 – $6,000
= $.84 per hour
100,000 hours Year
(3)
(1)
$16,800 21,000 12,600 25,200 8,400
2012 2013 2014 2015 2016
5/15 X ($90,000 – $6,000) = 4/15 X $84,000 = 3/15 X $84,000 = 2/15 X $84,000 = 1/15 X $84,000 =
$28,000 22,400 16,800 11,200 5,600
Double-Declining-Balance Method: Each year is 20% of its total life. Double the rate to 40%. Year
(b)
20,000 hrs. X $.84 = 25,000 hrs. X $.84 = 15,000 hrs. X $.84 = 30,000 hrs. X $.84 = 10,000 hrs. X $.84 =
Sum-of-the-Years’-Digits: 5 + 4 + 3 + 2 + 1 = 15 Year
(4)
2012 2013 2014 2015 2016
2012 2013 2014 2015 2016
40% X $90,000 = 40% X ($90,000 – $36,000) = 40% X ($90,000 – $57,600) = 40% X ($90,000 – $70,560) = Enough to reduce to salvage =
$36,000 21,600 12,960 7,776 5,664
Straight-line Method: Year
2012 2013 2014 2015 2016 2017
$90,000 – $6,000
X 9/12 = 5 years Full year Full year Full year Full year Full year X 3/12 year =
$12,600 16,800 16,800 16,800 16,800 4,200
PROBLEM 11-11 (Continued) (2)
Sum-of-the-Years’-Digits Method: 2012
(5/15 X $84,000) X 9/12 =
2013
(5/15 X $84,000) X 3/12 = (4/15 X $84,000) X 9/12 =
$ 7,000 16,800
23,800
(4/15 X $84,000) X 3/12 = (3/15 X $84,000) X 9/12 =
5,600 12,600
18,200
(3/15 X $84,000) X 3/12 = (2/15 X $84,000) X 9/12 =
4,200 8,400
12,600
(2/15 X $84,000) X 3/12 = (1/15 X $84,000) X 9/12 =
2,800 4,200
7,000
2014 2015 2016 2017 (3)
(1/15 X $84,000) X 3/12 =
$21,000
1,400
Double-Declining Balance Method:
Year 2012 2013 2014 2015 2016 2017 (1) (2) (3) (4) (5) (6)
Cost $90,000 90,000 90,000 90,000 90,000 90,000
Accum. Depr. at beg. of year — $27,000 52,200 67,320 76,392 81,835
Book Value at beg. of year $90,000 63,000 37,800 22,680 13,608 8,165
$90,000 X 40% X 9/12 ($90,000 – $27,000) X 40% ($90,000 – $52,200) X 40% ($90,000 – $67,320) X 40% ($90,000 – $76,392) X 40% to reduce to $6,000 salvage value.
Depr. Expense $27,000 (1) 25,200 (2) 15,120 (3) 9,072 (4) 5,443 (5) 2,165 (6)
*PROBLEM 11-12
(a)
The straight-line method would provide the highest total net income for financial reporting over the three years, as it reports the lowest total depreciation expense. These computations are provided below.
Computations of depreciation expense and accumulated depreciation under various assumptions: (1)
Straight-line: $1,260,000 – $60,000 = $240,000 5 years
Year 2013 2014 2015
(2)
Accumulated Depreciation $ 240,000 $ 480,000 $ 720,000
Double-declining-balance: Year 2013 2014 2015
(3)
Depreciation Expense $240,000 240,000 240,000 $720,000
Depreciation Expense $504,000 (40% X $1,260,000) 302,400 (40% X $756,000) 181,440 (40% X $453,600) $987,840
Accumulated Depreciation $ 504,000 $ 806,400 $ 987,840
Sum-of-the-years’-digits: Year 2013 2014 2015
Depreciation Expense $400,000 320,000 240,000 $960,000
(5/15 X $1,200,000) (4/15 X $1,200,000) (3/15 X $1,200,000)
Accumulated Depreciation $ 400,000 $ 720,000 $ 960,000
*PROBLEM 11-12 (Continued) (4)
Units-of-output:
Year 2013 2014 2015
Depreciation Expense $288,000 ($24* X 12,000) 264,000 ($24 X 11,000) 240,000 ($24 X 10,000) $792,000
Accumulated Depreciation $288,000 $552,000 $792,000
*$1,200,000 ÷ 50,000 (total units) = $24 per unit (b)
2013 2014 2015
General MACRS method: Total Cost $1,260,000 X 1,260,000 X 1,260,000 X
MACRS Rates (%)* 14.29 = 24.49 = 17.49 =
Annual Depreciation $180,054 308,574 220,374 $709,002
Accumulated Depreciation $180,054 $488,628 $709,002
Annual Depreciation $ 90,000 180,000 180,000 $450,000
Accumulated Depreciation $ 90,000 $270,000 $450,000
*Taken from the MACRS rates schedule. Optional straight-line method:
2013 2014 2015
Depreciation Total Cost Rate $1,260,000 X (1/7 X 1/2) = 1,260,000 X 1/7 = 1,260,000 X 1/7 =
The general MACRS method would have higher depreciation expense ($709,002) than that of the optional straight-line method ($450,000) for the three-year period ending December 31, 2015. Therefore, the general MACRS method would minimize net income for income tax purposes for this period.
TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 11-1 (Time 25–35 minutes) Purpose—to provide the student with an understanding of the basic objective of depreciation accounting. In addition, the case involves a reverse sum-of-the-years’-digits situation and the student is to comment on the propriety of such an approach. Finally, the classic issue of whether depreciation provides funds must be considered. The tax effects of depreciation must be considered when this part of the case is examined. An excellent case for covering the traditional issues involving depreciation accounting. CA 11-2 (Time 20–25 minutes) Purpose—to provide the student with a basic understanding of the difference between the unit and group or composite depreciation methods. The student is required to indicate the arguments for and against these methods and to indicate how retirements are handled. CA 11-3 (Time 25–35 minutes) Purpose—to provide the student with an understanding of a number of unstructured situations involving depreciation accounting. The first situation considers whether depreciation should be recorded during a strike. The second situation involves the propriety of employing the units-of-production method in certain situations. The third situation involves the step-up of depreciation charges because properties are to be replaced due to obsolescence. The case is somewhat ambiguous, so cut-and-dried approaches should be discouraged. CA 11-4 (Time 25–35 minutes) Purpose—to provide the student with an understanding of the objectives of depreciation and the theoretical basis for accelerated depreciation methods. CA 11-5 (Time 20–25 minutes) Purpose—to provide the student with the opportunity to examine the ethical dimensions of the depreciation method choice.
SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 11-1 (a) The purpose of depreciation is to distribute the cost (or other book value) of tangible plant assets, less salvage, over their useful lives in a systematic and rational manner. Under generally accepted accounting principles, depreciation accounting is a process of allocation, not of valuation, through which the productive effort (cost) is to be matched with productive accomplishment (revenue) for the period. Depreciation accounting, therefore, is concerned with the timing of the expiration of the cost of tangible plant assets. (b) The proposed depreciation method is, of course, systematic. Whether it is rational in terms of cost allocation depends on the facts of the case. It produces an increasing depreciation charge, which is usually not justifiable in terms of the benefit from the use of the asset because manufacturers typically prefer to use their new equipment as much as possible and their old equipment only as needed to meet production quotas during periods of peak demand. As a general rule, then, the benefit declines with age. Assuming that the actual operations (including equipment usage) of each year are identical, maintenance and repair costs are likely to be higher in the later years of usage than in the earlier years. Hence the proposed method would couple light depreciation and repair charges in the early years. Reported net income in the early years would be much higher than reported net income in the later years of asset life, an unreasonable and undesirable variation during periods of identical operation. On the other hand, if the expected level of operations (including equipment usage) in the early years of asset life is expected to be low as compared to that of later years because of slack demand or production policies, the pattern of the depreciation charges of the proposed method approximately parallels expected benefits (and revenues) and hence is reasonable. Although the units-of-production depreciation method is the usual selection to fit this case, the proposed method also conforms to generally accepted accounting principles in this case provided that proper justification is given. (c) (1) Depreciation charges neither recover nor create funds. Revenue-producing activities are the sources of funds from operations: if revenues exceed out-of-pocket costs during a fiscal period, funds are available to cover other than out-of-pocket costs; if revenues do not exceed out-ofpocket costs, no funds are made available no matter how much, or little, depreciation is charged. (2) Depreciation may affect funds in two ways. First, depreciation charges affect reported income and hence may affect managerial decisions such as those regarding pricing, product selection, and dividends. For example, the proposed method would result initially in higher reported income than would the straight-line method, consequently stockholders might demand higher dividends in the earlier years than they would otherwise expect. The straight-line method, by causing a lower reported income during the early years of asset life and thereby reducing the amount of possible dividends in early years as compared with the proposed method, could encourage earlier reinvestments in other profit-earning assets in order to meet increasing demand. Second, depreciation charges affect reported taxable income and hence affect directly the amount of income taxes payable in the year of deduction. Using the proposed method for tax purposes would reduce the total tax bill over the life of the assets (1) if the tax rates were increased in future years or (2) if the business were doing poorly now but were to do significantly better in the future. The first condition is political and speculative but the second condition may be applicable to Burnitz Manufacturing Company in view of its recent origin and its rapid expansion program. Consequently, more funds might be available for reinvestment in plant assets in years of large deductions if one of the above assumptions were true.
CA 11-1 (Continued) If Burnitz is not profitable now, it would not benefit from higher deductions now and should consider an increasing charge method for tax purposes, such as the one proposed. If Burnitz is quite profitable now, the president should reconsider his proposal because it will delay the availability of the tax shield provided by depreciation. However, this decision should not affect the decision to use a depreciation method for stockholders’ reporting that is systematic and rational in terms of cost allocation under generally accepted accounting principles as presently understood.
CA 11-2 (a) (1) The unit method of recording depreciation involves the treatment of plant assets or substantial additions thereto as individual items. The method entails maintaining detailed records of the costs of specific assets and related accumulated depreciation. Computation of depreciation is based on the estimated useful life of the individual asset. The method is distinguished from group and composite-life methods under which the cost and estimated life of the assets are commingled. Depreciation may be recorded by straight-line, accelerated, or other accepted computation methods. (2) Under the group or composite-life methods, assets are aggregated into accounting units. Such grouping might be horizontal, vertical, or geographical. Horizontal grouping assembles together all assets of similar physical characteristics, such as trucks, presses, returnable containers, etc. A vertical or functional grouping comprises all assets contributing to a common economic function, such as a sugar refinery, a service station, etc. The geographical grouping includes all assets in a district or region, such as telephone poles. Depreciation under these methods requires development of a weighted-average rate from the assets’ depreciable costs and estimated lives. Separate accounts are established for the total cost of each asset grouping and its related accumulated depreciation. The asset grouping should be composed of a large number of units to obtain a reliable average life. (b) 1.
Arguments for the use of the unit method are: i. The method is simple in that it does not require involved mathematical computations. ii. The gain or loss on the retirement of a particular asset can be computed. iii. For cost purposes, depreciation on idle equipment can be isolated. iv. The method results in a more accurately computed depreciation provision in any given year, as the total depreciation charge represents the best estimate of the depreciation of each asset and is not the result of averaging the cost over a longer period of time. Arguments against the unit method are: i. Considerable additional bookkeeping is necessary to account for each asset and its related depreciation. (Computers reduce the work burden, however.) ii. There is a point of diminishing returns in the accumulation of accounting data under this method, that is, additional accuracy may not justify the additional cost of record-keeping. iii. Under a decentralized financial control system where a measure of the division’s efficiency is the rate of return on the gross book value of the investment a division manager might scrap fully or nearly fully depreciated equipment to improve the division’s rate of return even though the equipment is still serviceable. iv. There may be reluctance on the part of a division manager to replace equipment not fully depreciated with more efficient equipment because of the effect of the loss on the division’s profits in the year of replacement.
2.
Arguments for the use of the group and composite-life methods are: i. The methods require less detailed bookkeeping. ii. The application of depreciation to the whole group tends to average out or offset errors, economic or operating, caused by under-depreciation or over-depreciation. iii. Periodic income is not distorted by gains or losses on disposal of assets.
CA 11-2 (Continued) iv.
A more useful charge to expense is derived from these methods because of their recognition that depreciation estimates are based on averages and that gains and losses on individual assets are of little significance.
Arguments against the use of the group and composite-life methods would include: i. The methods would conceal faulty estimates for a long period of time. ii. When there is an early heavy retirement of assets a debit balance might appear in the Accumulated Depreciation account and present an accounting problem. iii. Information is not available regarding a particular machine for cost-calculation purposes. iv. Under a decentralized financial control system where a measure of the division’s efficiency is the rate of return on the gross book value of the investment, to improve the division’s financial reports a division manager might scrap idle but serviceable equipment or equipment that is not earning a satisfactory return on book value. The company would sustain an actual loss in the amount of the value of the equipment scrapped. v. Under the same situation as “iv” above, except that net book value is used, where the assets, although serviceable, are fully or almost fully depreciated, the division manager might hesitate to replace them because of the high rate of return on investment. (c) Under the unit method, retirements are recorded by removing from the accounts the cost of the asset and its related accumulated depreciation. The difference between the two accounts, adjusted for salvage and disposal costs, if any, is recognized as gain or loss. Under the group and composite-life methods the cost of the retired asset is removed from the asset account, and the Accumulated Depreciation—Plant assets account is reduced by the amount of the cost of the retired asset, adjusted for salvage, salvage costs, and removal costs. Accordingly, there is no periodic recognition of gain or loss; the Accumulated Depreciation—Plant assets account serves as a suspense account for the recognition of gain or loss until the final asset retirement.
CA 11-3 Situation I. This position relates to the omission of a provision for depreciation during a strike. The same question could be raised with respect to plant shut-downs for many reasons, such as for a lack of sales or for seasonal business. The method of depreciation used should be systematic and rational. The annual provision for depreciation should represent a fair estimate of the loss in value arising from wear and usage and also from obsolescence. Each company should analyze its own facts and establish the best method under the circumstances. If the company was employing a straight-line depreciation method, for example, it is inappropriate to stop depreciating the plant asset during the strike. If the company employs a units-of-production method, however, it would be appropriate not to depreciate the asset during this period. Even in this latter case, however, if the strike were prolonged, it might be desirable to record some depreciation because of the obsolescence factors related to the passage of time. Situation II. (a) Steady demand for the new blenders suggests use of the straight-line method or the units-of-production method, either of which will allocate cost evenly over the life of the machine. Decreasing demand indicates use of an accelerated method (declining-balance or sum-of-the-years’digits) or the units-of-production method in order to allocate more of the cost to the earlier years of the machine’s life. Increasing demand indicates the use of the units-of-production method to charge more of the cost to the later years of the machine’s life; an increasing-charge method (annuity or sinkingfund) could be employed, though these methods are seldom used except by utilities.
CA 11-3 (Continued) (b) In determining the depreciation method to be used for the machine, the objective should be to allocate the cost of the machine over its useful life in a systematic and rational manner, so that costs will be matched with the benefits expected to be obtained. In addition to demand, consideration should be given to the items discussed below, their interrelationships, the relative importance of each, and the degree of certainty with which each can be predicted: The expected pattern of costs of repairs and maintenance should be considered. Costs which vary with use of the machine may suggest the use of the units-of-production method. Costs which are expected to be equal from period to period suggest the use of the straight-line method. If costs are expected to increase with the age of the machine, an accelerated method may be considered reasonable because it will tend to equalize total expenses from period to period. The operating efficiency of the machine may change with its age. A decrease in operating efficiency may cause increases in such costs as labor and power; if so, an accelerated method is indicated. If operating efficiency is not expected to decline, the straight-line method is indicated. Another consideration is the expiration of the physical life of the machine. If the machine wears out in relation to the passage of time, the straight-line method is indicated. Within this maximum life, if the usage per period varies, the units-of-production method may be appropriate. The machine may become obsolete because of technological innovation; it may someday be more efficient to replace the machine even though it is far from worn out. If the probability is high that such obsolescence will occur in the near future, the shortened economic life should be recognized. Within this shortened life, the depreciation method used would be determined by evaluating such consideration as the anticipated periodic usage. An example of the interrelationship of the items discussed above is the effect of the repairs and maintenance policy on operating efficiency and physical life of the machine. For instance, if only minimal repairs and maintenance are undertaken, efficiency may decrease rapidly and life may be short. It is possible that different considerations may indicate different depreciation methods for the machine. If so, a choice must be made based on the relative importance of the considerations. For instance, physical life may be less important than the strong chance of technological obsolescence which would result in a shorter economic life. Situation III. Depreciation rates should be adjusted in order that the operating sawmills which are to be replaced will be depreciated to their residual value by the time the new facility becomes available. The step-up in the depreciation rates should be considered as a change in estimate and prior years’ financial statements should not be adjusted. The idle mill should be written off immediately as it appears to have no future service potential.
CA 11-4 To:
Phil Perriman, Supervisor of Canning Room
From:
Your name, Accountant
Date:
January 22, 2014
Subject: Annual depreciation charge to the canning department This memo addresses the questions you asked about the depreciation charge against your department. Admittedly this charge of $625,000 is very high; however, it is not intended to reflect the wear and tear which the machinery has undergone over the last year. Rather, it is a portion of the machines’ cost which has been allocated to this period. Depreciation is frequently thought to reflect an asset’s loss in value over time. For financial statement purposes, however, depreciation allocates part of an asset’s cost in a systematic way to each period during its useful life. Although there will always be a decline in an asset’s value over time, the depreciation charge is not supposed to measure that decline; instead, it is a periodic “charge” for using purchased equipment during any given period. When you consider the effect which the alternative would have on your departmental costs—expensing the total cost for all six machines this year—is more equitable. You also mentioned that using straight-line depreciation would result in a smaller charge than would the current double-declining-balance method. This is true during the first years of the equipment’s life. Straight-line depreciation expenses even amounts of depreciation for each canning machine’s twelveyear life. Thus the straight-line charge for this and all subsequent years would be $47,500 per machine for total annual depreciation of $285,000. During the earlier years of an asset’s life, the double-declining-balance method results in higher depreciation charges because it doubles the straight-line rate which would have been made under the straight-line method. However, the same percentage depreciation in the first year is applied annually to the asset’s declining book value. Therefore, the double-declining-balance charge becomes lower than the straight-line charge during the last several years of the asset’s life. For this year, as mentioned above, the charge is $625,000, but in subsequent years this expense will become lower. By the end of the twelfth year, the same amount of depreciation will have been taken regardless of the method used. The straight-line method would result in fewer charges against your department this year. However, consider this: when the asset is new, additional costs for service and repairs are minimal. Thus a greater part of the asset’s cost should be allocated to this optimal portion of the asset’s life. After a few years, your department will have to absorb the additional burden of repair and maintenance costs. During that time, wouldn’t you rather have a lower depreciation charge? I hope that this explanation helps clarify any questions which you may have had about depreciation charges to your department.
CA 11-5 (a)
The stakeholders are Beeler’s employees, including Prior, current and potential investors and creditors, and upper-level management.
(b)
The ethical issues are honesty and integrity in financial reporting, job security, and the external users’ right to know the financial picture.
CA 11-5 (Continued) (c)
Prior should review the estimated useful lives and salvage values of the depreciable assets. Since they are estimates, it is possible that some should be changed. Any changes should be based on sound, objective information without concern for the effect on the financial statements (or anyone’s job).
(Note: This case can be used with Chapter 22, Accounting Changes and Error Analysis.)
FINANCIAL REPORTING PROBLEM
(a)
P&G classifies its property, plant and equipment under three descriptions in its balance sheet: Buildings, Machinery and equipment, and Land.
(b)
P&G’s “depreciation expense is recognized over the assets’ estimated useful lives using the straight-line method.”
(c)
P&G depreciates its assets based on estimated useful lives of 15 years for machinery and equipment, 3 to 5 years for computer equipment and capitalized software, and 3 to 20 years for manufacturing equipment. Buildings are depreciated over an estimated useful life of 40 years.
(d)
P&G’s Statement of Cash Flows reports depreciation and amortization of $2,838 million in 2011, $3,108 million in 2010, and $3,082 million was charged to expense in 2009.
(e)
The statement of cash flows reports the following capital expenditures: 2011, $3,306 million; 2010, $3,067 million; and 2009, $3,238 million.
COMPARATIVE ANALYSIS CASE
(a)
Property, plant, and equipment, net of accumulated depreciation: Coca-Cola at 12/31/11 PepsiCo at 12/31/11
$14,939 million $19,698 million
Percent of total assets: Coca-Cola ($14,939 ÷ $79,974) PepsiCo ($19,698 ÷ $72,882) (b)
Coca-Cola and PepsiCo depreciate property, plant, and equipment principally by the straight-line method over the estimated useful lives of the assets. Depreciation expense was reported by Coca-Cola (includes amortization) and PepsiCo as follows:
2011 2010 2009 (c)
18.68% 27.03%
(1)
Coca-Cola $1,654 million 1,188 million 1,005 million
Asset turnover: Coca-Cola $46,542 = 0.6088 $79,974 + $72,921 2
(2)
PepsiCo $2,476 million 2,124 million 1,500 million
PepsiCo $66,504 = 0.9431 $72,882 + $68,153 2
Profit margin on sales: Coca-Cola $8,634 = 18.55% $46,542
PepsiCo $6,462 = 9.72% $66,504
COMPARATIVE ANALYSIS CASE (Continued) (3)
Return on assets: Coca-Cola $8,634 $79,974 + $72,921 2
PepsiCo = 11.29%
$6,462 = 9.16% $72,882 + $68,153 2
With the exception of the asset turnover, each of PepsiCo’s ratios are weaker compared to Coca-Cola’s. PepsiCo’s lower profit margin is primarily due to its large food business which experiences larger investments in property, plant, and equipment and lower margins compared to the beverage segment. Coca-Cola sales are derived almost entirely from higher margin beverages. (d)
Coca-Cola’s capital expenditures were $2,920 million in 2011 while PepsiCo’s capital expenditures were $3,339 million in 2011. For 2011, PepsiCo reported capitalized interest of $1,826 and Coca-Cola reported capitalized interest of $1,266.
FINANCIAL STATEMENT ANALYSIS CASE
(a)
McDonald’s used the straight-line method for depreciating its property and equipment.
(b)
Depreciation and amortization charges do not increase cash flow from operations. In a cash flow statement, these two items are often added back to net income to arrive at cash flow from operations and therefore some incorrectly conclude these expenses increase cash flow. What affects cash flow from operations are cash revenues and cash expenses. Noncash charges have no effect, except for positive tax savings generated by these charges.
(c)
The schedule of cash flow measures indicates that cash provided by operations is expected to cover capital expenditures over the next few years, even as expansion continues to accelerate. It is obvious that McDonald’s believes that cash flow measures are meaningful indicators of growth and financial strength, when evaluated in the context of absolute dollars or percentages.
ACCOUNTING, ANALYSIS, AND PRINCIPLES
Accounting (a)
Undiscounted future cash flows = (4 years X $4 million per year) = $16 million Book value = $36 million – $10 million = $26 million $16 million < $26 million; the impairment test suggests an impairment charge is necessary. Estimated fair value = ($4 million X PVF-OA4,5) = ($4 million X 3.54595) = $14,183,800 Impairment charge = $16,000,000 – $14,183,800 = $1,816,200 Post-impairment book value = $14,183,800
(b)
Undiscounted future cash flows = (10 years X $2.72 million per year) = $27.2 million Book value = $36 million – $10 million = $26 million $27.2 million > $26 million; the impairment test suggests no impairment charge is necessary. Book value at fiscal year end = $26 million.
Analysis If the stores are in the process of being sold, they would likely be considered ‘held for sale’ for financial reporting purposes. If they are held for sale, the impairment test is based on the discounted cash flows, instead of undiscounted. Essentially, it is a lower-of-cost-or-market approach. Estimated fair-value = ($2.72 million X PVF-OA10,6) = ($2.72 million X 7.36009) = $20,019,445 Therefore, Electroboy will need to write the stores down to $20,019,445 from $26 million. Fixed asset writedowns are a little more likely when management intends to sell the assets.
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) Principles Under GAAP, once an asset is written down to an impairment value, it can not be subsequently written back up. This provision is based in part on conservatism, as well as concerns about the reliability of measurements for the revaluations upward, following impairment. Note that if the assets are held-for-sale, the assets can be written back up (no higher than original historical cost).
PROFESSIONAL RESEARCH
(a) According to FASB ASC 360-10-05 (Property, Plant, and Equipment) 05-2
The guidance in the Overall Subtopic is presented in the following two Subsections: a. The General Subsections address the accounting and reporting for property, plant, and equipment, including guidance for accumulated depreciation. b. The Impairment or Disposal of Long-Lived Assets Subsections retain the pervasive guidance for recognizing and measuring the impairment of long-lived assets and for long-lived assets to be disposed of.
05-4
The Impairment of Disposal of Long-Lived Assets Subsections provide guidance for: a. Recognition and measurement of the impairment of longlived assets to be held and used b. Measurement of long-lived assets to be disposed of by sale.
(b) When to Test a Long-Lived Asset for Recoverability is addressed in FASB ASC 360-10-35-21: 35-21
A long-lived asset (asset group) shall be tested for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. The following are examples of such events or changes in circumstances: a. A significant decrease in the market price of a long-lived asset (asset group) [FAS 144, paragraph 8, sequence 115] b. A significant adverse change in the extent or manner in which a long-lived asset (asset group) is being used or in its physical condition c. A significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset (asset group), including an adverse action or assessment by a regulator d. An accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset (asset group)
PROFESSIONAL RESEARCH (Continued) e. A current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset (asset group) f. A current expectation that, more likely than not, a long-lived asset (asset group) will be sold or otherwise disposed of significantly before the end of its previously estimated useful life. The term more likely than not refers to a level of likelihood that is more than 50 percent. (c) According to FASB ASC 360-10-35-36, For long-lived assets (asset groups) that have uncertainties both in timing and amount, an expected present value technique will often be the appropriate technique with which to estimate fair value. According to FASB ASC 820-10-35-37 through 43 (Fair Value Hierarchy): 35-37
To increase consistency and comparability in fair value measurements and related disclosures, the fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). In some cases, the inputs used to measure fair value might fall in different levels of the fair value hierarchy. The level in the fair value hierarchy within which the fair value measurement in its entirety falls shall be determined based on the lowest level input that is significant to the fair value measurement in its entirety. Assessing the significance of a particular input to the fair value measurement in its entirety requires judgment, considering factors specific to the asset or liability.
PROFESSIONAL RESEARCH (Continued) 35-38
The availability of inputs relevant to the asset or liability and the relative reliability of the inputs might affect the selection of appropriate valuation techniques. However, the fair value hierarchy prioritizes the inputs to valuation techniques, not the valuation techniques. For example, a fair value measurement using a present value technique might fall within Level 2 or Level 3, depending on the inputs that are significant to the measurement in its entirety and the level in the fair value hierarchy within which those inputs fall.
35-39
The remainder of this guidance is organized as follows: a. Level 1 inputs b. Level 2 inputs c. Level 3 inputs d. Inputs based on bid and ask prices. e. Investments in certain entities that calculate net asset value per share (or its equivalent, for example, member units or an ownership interest in partners’ capital to which a proportionate share of net assets is attributed).
35-40
Level 1 inputs are defined in this Subtopic as quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.
35-41
A quoted price in an active market provides the most reliable evidence of fair value and shall be used to measure fair value whenever available, except as discussed in paragraphs 820-1035-16D, 820-10-35-42, and 820-10-35-43.
35-41 A A Level 1 fair value measurement for the liability is a quoted
price in an active market for the identical liability at the measurement date. In addition, the quoted price for the identical liability when traded as an asset in an active market also is a Level 1 fair value measurement for that liability when no adjustments to the quoted price of the asset are required. However, a reporting entity needs to determine whether the quoted price for the identical liability when traded as an asset in
PROFESSIONAL RESEARCH (Continued) an active market should be adjusted for factors specific to the liability and the asset (see paragraph 820-10-35-16D). Any adjustment to the quoted price of the asset shall render the fair value measurement of the liability a lower level measurement. 35-42
If the reporting entity holds a large number of similar assets or liabilities (for example, debt securities) that are required to be measured at fair value, a quoted price in an active market might be available but not readily accessible for each of those assets or liabilities individually. In that case, fair value may be measured using an alternative pricing method that does not rely exclusively on quoted prices (for example, matrix pricing) as a practical expedient. However, the use of an alternative pricing method renders the fair value measurement a lower-level measurement.
35-43
In some situations, a quoted price in an active market might not represent fair value at the measurement date. That might be the case if, for example, significant events (principal-toprincipal transactions, brokered trades, or announcements) occur after the close of a market but before the measurement date. The reporting entity should establish and consistently apply a policy for identifying those events that might affect fair value measurements. However, if the quoted price is adjusted for new information, the adjustment renders the fair value measurement a lower-level measurement.
Alternative methods for estimating fair value are addressed at FASB ASC 820-10-35-28 through 36: 35-28
Valuation techniques consistent with the market approach, income approach, and/or cost approach shall be used to measure fair value. The definitions and key aspects of those approaches follow.
35-29
The market approach is defined in this Subtopic as a valuation technique that uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities (including a business).
PROFESSIONAL RESEARCH (Continued) 35-30
For example, valuation techniques consistent with the market approach often use market multiples derived from a set of comparables. Multiples might lie in ranges with a different multiple for each comparable. The selection of where within the range the appropriate multiple falls requires judgment, considering factors specific to the measurement (qualitative and quantitative).
35-31
Valuation techniques consistent with the market approach include matrix pricing. Matrix pricing is a mathematical technique used principally to value debt securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the securities’ relationship to other benchmark quoted securities.
35-32
The income approach is defined in this Subtopic as an approach that uses valuation techniques to convert future amounts (for example, cash flows or earnings) to a single present amount (discounted). The measurement is based on the value indicated by current market expectations about those future amounts.
35-33
Those valuation techniques include the following: a. Present value techniques b. Option-pricing models (which incorporate present value techniques), such as the Black-Scholes-Merton formula (a closed-form model) and a binomial (a lattice model) c. The multiperiod excess earnings method, which is used to measure the fair value of certain intangible assets.
35-34
The cost approach is defined in this Subtopic as a valuation technique based on the amount that currently would be required to replace the service capacity of an asset (often referred to as current replacement cost).
35-35
From the perspective of a market participant (seller), the price that would be received for the asset is determined based on the cost to a market participant (buyer) to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence.
PROFESSIONAL RESEARCH (Continued) 35-36
Valuation techniques used to measure fair value shall maximize the use of observable inputs and minimize the use of unobservable inputs. Examples of markets in which inputs might be observable for some assets and liabilities (for example, financial instruments) include exchange markets, dealer markets, brokered markets, and principal-to-principal markets.
PROFESSIONAL SIMULATION
Note: This assignment is available on the Kieso website. Explanation (a)
The purpose of depreciation is to allocate the cost (or other book value) of tangible plant assets, less salvage, over their useful lives in a systematic and rational manner. Under generally accepted accounting principles, depreciation accounting is a process of allocation, not of valuation, through which the productive effort (cost) is to be matched with productive accomplishment (revenue) for the period. Depreciation accounting, therefore, is concerned with the timing of the expiration of the cost of tangible plant assets.
(b) 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. Assets are typically recorded at their acquisition cost, which is in most cases objectively determinable. Cost assignments in other cases— “basket purchases” and the selection of an implicit interest rate in an asset acquisitions or under deferred-payment plans—may be quite subjective, involving considerable judgment. The salvage value is an estimate of an amount potentially realizable when the asset is retired from service. The estimate is based on judgment and is affected by the length of the useful life of the asset. The useful life is also based on judgment. 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. Physical life involves wear and tear and casualties; economic life involves such things as technological obsolescence and inadequacy.
PROFESSIONAL SIMULATION (Continued) Measurement (a)
Compared to the use of an accelerated method, straight-line depreciation would result in the lowest depreciation expense and the highest income. For example, under straight-line, depreciation expense in each year would be: ($100,000 – $10,000)/4 = $22,500 Using the double-declining-balance method, depreciation expense in 2014 would be: $100,000 X (1/4 X 2) = $50,000 Depending on the level of use in the first year, use of the units-ofproduction method could yield an even lower expense in the first year compared to straight-line.
(b)
Over the entire four-year period, all methods will produce the same total depreciation expense. Use of alternative methods only results in differences in timing of the depreciation charges.
(c)
All methods used for financial reporting purposes results in the same cash flow in 2014—that is, a cash outflow of $100,000 for acquisition of the machine. However, use of an accelerated method for tax purposes, such as MACRS, results in the higher cash flow in 2014. This is because a larger tax deduction can be taken for depreciation expense, which reduces taxable income, resulting in less cash paid for taxes. Note that over the life of the asset, cash flows for taxes are the same regardless of the tax depreciation method used. Use of MACRS simply allows companies to defer tax payments.
Journal Entry Cash ............................................................... Accumulated Depreciation—Equipment...... Gain on Disposal of Equipment........... Equipment.............................................
84,000 45,000* 29,000 100,000
*($100,000 – $10,000)/4 = $22,500 per year X 2 years (2014, 2015)
IFRS CONCEPTS AND APPLICATION IFRS11-1 To determine whether an asset is impaired, on an annual basis, companies review the asset for indicators of impairment – that is, a decline in the asset’s cash-generating ability through use or sale. If the recoverable amount is less than the carrying amount, the asset has been impaired. The impairment loss is measured as the amount by which the carrying amount exceeds the recoverable amount of the asset. The recoverable amount of assets is defined as the higher of fair value less costs to sell or value-in-use. IFRS11-2 Under IFRS, impairment losses on plant assets may be restored as long as the write-up is never greater than the carrying amount before impairment. IFRS11-3 An impairment is deemed to have occurred if, in applying the impairment test, the carrying amount of the asset exceeds the recoverable amount of the asset. In this case, the value-in-use of $705,000 exceeds the carrying amount of the equipment of $700,000 so no impairment is assumed to have occurred; thus no measurement of the loss is made or recognized even though the fair value is only $590,000.
IFRS11-4 Impairment losses are reported as part of operating income generally in the “Other income and expense” section. Impairment losses (and recovery of impairment losses) are similar to other costs that would flow through operations. Thus, gains (recoveries of losses) on long-lived assets should also be reported as part of operating income in the “Other income and expense” section of the income statement.
IFRS11-5 The land should be reported on the statement of financial position at $20,000,000 and an unrealized gain of $5,000,000 is reported as other comprehensive income in the statement of comprehensive income.
IFRS11-6 A major reason most companies do not use revaluation accounting is the substantial and continuing costs associated with appraisals to determine fair value. In addition, losses associated with revaluation below historical cost decrease net income. However, revaluation increases result in higher depreciation expense and lower income.
IFRS11-7 Component A B C
Depreciation Expense ($70,000 – $7,000)/10 = $ 6,300 ($50,000 – $5,000)/ 5 = 9,000 ($82,000 – $4,000)/12 = 6,500 $21,800
IFRS11-8 Component Building 15-year property 5-year property
Depreciation Expense ($11,000,000 – 0) ÷ 40 = $275,000 ($ 150,000 – 0) ÷ 15 = 10,000 ($ 150,000 – 0) ÷ 5 = 30,000 $315,000
IFRS11-9 (a)
($50,000 – 0) ÷ 10 = $5,000
(b) Component Tires Transmission Trucks (c)
Depreciation Expense ($ 6,000 – 0) ÷ 2 = $3,000 ($10,000 – 0) ÷ 5 = 2,000 ($34,000 – 0) ÷ 10 = 3,400 $8,400
A company would want to use component depreciation if it believed this method produced more accurate results.
IFRS11-10 Impairment test: Present value of future net cash flows* ($500,000) < Carrying amount ($520,000)*; therefore, the asset has been impaired. The impairment equals $20,000 ($520,000 – $500,000). Journal entry: Loss on Impairment .................................................. Accumulated Depreciation—Machinery .........
20,000 20,000
*Recoverable amount is used because it is greater than fair value less costs to sell. IFRS11-11 (a)
December 31, 2014
Loss on Impairment .................................................. Accumulated Depreciation—Equipment ........
2,500,000
Cost ............................................................................ Less: Accumulated depreciation ............................. Carrying amount ....................................................... Less: Value-in-use..................................................... Loss on impairment ..................................................
$ 9,000,000 1,000,000 8,000,000 5,500,000 $ 2,500,000
2,500,000
IFRS11-11 (Continued) (b)
December 31, 2015
Depreciation Expense ............................................... Accumulated Depreciation—Equipment ........ New carrying amount ............................................... Useful life .................................................................. Depreciation per year............................................... (c)
687,500 687,500 $5,500,000 ÷ 8 years $ 687,500
December 31, 2015
Accumulated Depreciation—Equipment.................. Recovery of Impairment Loss .........................
1,237,500*
Recoverable amount Cost Less: accumulated depreciation Recovery of impairment loss
$6,050,000 $9,000,000 4,187,500
1,237,500
(4,812,500) $1,237,500
Note: The full amount is recovered because the revised carrying amount is still less than the carrying amount under the original cost ($9,000,000 – $2,000,000). IFRS11-12 (a)
December 31, 2014
Loss on Impairment .................................................. Accumulated Depreciation—Equipment ........
3,600,000
Cost ........................................................................... Less: Accumulated depreciation............................. Carrying amount....................................................... Less: Fair value less cost of disposal .................... Loss on impairment .................................................
$9,000,000 1,000,000 8,000,000 4,400,000 $3,600,000
(b)
3,600,000
No entry necessary. Depreciation is not taken on assets intended to be sold.
IFRS11-12 (Continued) (c)
December 31, 2015
Accumulated Depreciation—Equipment ................. Recovery of Impairment Loss .........................
680,000 680,000
Fair value ..................................................................... $ 5,100,000 Less: Costs of disposal ............................................... 20,000 5,080,000 Less: Carrying amount................................................ 4,400,000* Recovery of loss on impairment .............................. $ 680,000 *($9,000,000 – $1,000,000 – $3,600,000) IFRS11-13 (a)
January 1, 2013
Equipment.................................................................. Cash ..................................................................
12,000 12,000
December 31, 2013 Depreciation Expense............................................... Accumulated Depreciation—Equipment ........ (b)
2,000 2,000
December 31, 2014
Depreciation Expense............................................... Accumulated Depreciation—Equipment ........
2,000
Accumulated Depreciation—Equipment ................. Loss on Impairment .................................................. Equipment ($12,000 – $7,000)..........................
4,000 1,000
(c)
2,000
Depreciation expense—2015: ($12,000 – $5,000) ÷ 4 = $1,750
5,000
IFRS11-14 Liberty (a)
(1) Return on Assets (ROA)
£125 £5,577
= 2.2%
Kimco $297 $4,696
Liberty (2) Profit Margin on Sales
£125 £741
= 16.9%
Kimco $297 $517
Liberty (3) Asset Turnover
£741 £5,577
= .13
= 6.32%
= 57.4%
Kimco $517 $4,696
= .11
Based on return on assets (ROA), Kimco is performing better than Liberty. The main driver for this difference is strong profit margin, which is over three times that of Liberty. Even though Liberty has a higher asset turnover (.13 vs. .11), this results in only a 2.2% ROA when multiplied by the lower profit margin. (b)
(c)
Summary Entry Investment Properties ............................................ Unrealized Gain on Revaluation ...................
1,550 1,550
Relative to GAAP, an argument can be made that assets and equity are overstated. Note that in the entry in (b) above, the revaluation adjustment increases Liberty’s asset values and equity. To make Liberty’s reported numbers comparable to a U.S. company like Kimco, you would need to adjust Liberty’s assets and equity numbers downward by the amount of the revaluation surplus. For example, after adjusting Liberty’s assets downward by the amount of the revaluation reserve, Liberty’s ROA increases to: $125 = 3.45%. ($5,577 – $1,952) This is still lower than Kimco’s ROA but the gap is narrower after adjusting for differences in revaluation.
IFRS11-14 (Continued) Note to instructors: An alternative way to make Liberty and Kimco comparable is to adjust Kimco’s assets to fair values. This approach could be used to discuss the trade-off between relevance and faithful representation.
IFRS11-15 (a) The authoritative guidance for asset impairments is IAS 36: Impairment of Assets. This Standard shall be applied in accounting for the impairment of all assets, other than: a. inventories; b. assets arising from construction contracts; c. deferred tax assets; d. assets arising from employee benefits; e. financial assets that are within the scope of IAS 39 Financial Instruments: Recognition and Measurement; f. investment property that is measured at fair value; g. biological assets related to agricultural activity that are measured at fair value less costs to sell; h. deferred acquisition costs, and intangible assets, arising from an insurer’s contractual rights under insurance contracts within the scope of IFRS 4 Insurance Contracts; and i. non-current assets (or disposal groups) classified as held for sale in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations (para. 2). This Standard applies to financial assets classified as: a. subsidiaries, as defined in IAS 27 Consolidated and Separate Financial Statements; b. associates, as defined in IAS 28 Investments in Associates; and c. joint ventures, as defined in IAS 31 Interests in Joint Ventures. For impairment of other financial assets, refer to IAS 39 (para. 4).
IFRS11-15 (Continued) (b) In assessing whether there is any indication that an asset may be impaired, an entity shall consider, as a minimum, the following indications. (para. 12): External sources of information a. b.
c.
d.
during the period, an asset’s fair value has declined significantly more than would be expected as a result of the passage of time or normal use. significant changes with an adverse effect on the entity have taken place during the period, or will take place in the near future, in the technological, market, economic or legal environment in which the entity operates or in the market to which an asset is dedicated. market interest rates or other market rates of return on investments have increased during the period, and those increases are likely to affect the discount rate used in calculating an asset’s value in use and decrease the asset’s recoverable amount materially. the carrying amount of the net assets of the entity is more than its market capitalisation.
Internal sources of information e. f.
g.
evidence is available of obsolescence or physical damage of an asset. significant changes with an adverse effect on the entity have taken place during the period, or are expected to take place in the near future, in the extent to which, or manner in which, an asset is used or is expected to be used. These changes include the asset becoming idle, plans to discontinue or restructure the operation to which an asset belongs, plans to dispose of an asset before the previously expected date, and reassessing the useful life of an asset as finite rather than indefinite. evidence is available from internal reporting that indicates that the economic performance of an asset is, or will be, worse than expected.
IFRS11-15 (Continued) Dividend from a subsidiary, jointly controlled entity or associate h.
for an investment in a subsidiary, jointly controlled entity or associate, the investor recognizes a dividend from the investment and evidence is available that: (i) the carrying amount of the investment in the separate financial statements exceeds the carrying amounts in the consolidated financial statements of the investee’s net assets, including associated goodwill; or (ii) the dividend exceeds the total comprehensive income of the subsidiary, jointly controlled entity or associate in the period the dividend is declared.
The list in paragraph 12 is not exhaustive. An entity may identify other indications that an asset may be impaired and these would also require the entity to determine the asset’s recoverable amount or, in the case of goodwill, perform an impairment test in accordance with paragraphs 80–99 (para. 13). Evidence from internal reporting that indicates that an asset may be impaired includes the existence of: a.
b. c.
d.
cash flows for acquiring the asset, or subsequent cash needs for operating or maintaining it, that are significantly higher than those originally budgeted; actual net cash flows or operating profit or loss flowing from the asset that are significantly worse than those budgeted; a significant decline in budgeted net cash flows or operating profit, or a significant increase in budgeted loss, flowing from the asset; or operating losses or net cash outflows for the asset, when current period amounts are aggregated with budgeted amounts for the future. (para. 14)
Yes, it does appear that Klax should perform an impairment test because market value of assets are most likely lower than current carrying value.
IFRS11-15 (Continued) (c) Different situations may lead to the best evidence of fair value (i.e. could be market value, revalued asset, etc.). a.
if the asset’s fair value is its market value, the only difference between the asset’s fair value and its fair value less costs to sell is the direct incremental costs to dispose of the asset: (i) if the disposal costs are negligible, the recoverable amount of the revalued asset is necessarily close to, or greater than, its revalued amount (i.e., fair value). In this case, after the revaluation requirements have been applied, it is unlikely that the revalued asset is impaired and recoverable amount need not be estimated. (ii) if the disposal costs are not negligible, the fair value less costs to sell of the revalued asset is necessarily less than its fair value. Therefore, the revalued asset will be impaired if its value in use is less than its revalued amount (i.e., fair value). In this case, after the revaluation requirements have been applied, an entity applies this Standard to determine whether the asset may be impaired.
b.
if the asset’s fair value is determined on a basis other than its market value, its revalued amount (i.e., fair value) may be greater or lower than its recoverable amount. Hence, after the revaluation requirements have been applied, an entity applies this Standard to determine whether the asset may be impaired (para. 5).
IFRS11-16 (a) M&S classifies its property, plant, and equipment under three descriptions in its balance sheet: Property, Plant, and Equipment. (b) M&S’s depreciation is provided to write off the cost of tangible noncurrent assets by equal annual installments (straight-line method). (c) M&S depreciates freehold and leasehold buildings with a remaining lease term over 50 years over their estimated remaining economic lives; leasehold buildings with a remaining lease term of less than 50 years over the remaining period of the lease; and fixtures, fittings and equipment over 3 to 25 years.
IFRS11-16 (Continued) (d) M&S’s Note 3 reports depreciation expense of £404.8 million in 2012 and £416.5 million in 2011, and amortization expense of £65.3 million in 2012 and £51 in 2011. (e) The statement of cash flows reports the following capital expenditures: 2012, £564.3 million and 2011, £327.3 million.
CHAPTER 12 Intangible Assets ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics
Questions
1.
Intangible assets; concepts, definitions; items comprising intangible assets.
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14
2.
Patents; franchise; organization costs; trade name.
9, 10, 11, 25
3.
Goodwill.
4. 5.
Brief Exercises
Exercises
Concepts Problems for Analysis
1, 2, 3, 5, 6
1, 2, 3, 4
1, 2, 3
1, 2, 3, 4, 7, 12, 13
4, 5, 6, 7, 8, 9, 10, 11, 13
1, 2, 3, 4, 6
1, 2
12, 13, 14, 18
5, 7, 8
6, 12, 13, 15
5, 6
Impairment of intangibles.
15, 16, 17, 18
6, 7, 8
14, 15
6
Research and development costs and similar costs.
19, 20, 21, 22, 23, 24
9, 10, 11, 12
4, 16, 17
1, 2, 3
4, 5
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives Questions
Brief Exercises
Exercises Problems
Concepts for Analysis
1, 2, 3
1, 2, 3, 4
1. Describe the characteristics of intangible assets.
1
2. Identify the costs to include in the initial valuation of intangible assets.
2, 24
1, 2, 3, 4
5, 7, 9, 10, 11
1, 2, 3, 6
1, 2
3. Explain the procedure for amortizing intangible assets.
3, 7, 8, 10, 15, 25
1, 2, 3, 4, 12, 13
4, 5, 6, 7, 9, 10, 11, 13
1, 2, 3, 6
2
4. Describe the types of intangible assets.
4, 11, 15
5. Explain the accounting issues for recording goodwill.
5, 12, 13, 14, 18
5
12, 13, 15
5, 6
6. Explain the accounting issues related to intangible-asset impairments.
6, 7, 16, 17, 18
6, 7, 8
14, 15
5, 6
7. Identify the conceptual issues related to research and development costs.
10, 19, 24
8. Describe the accounting for research and development and similar costs.
9, 20, 21, 22, 23, 24
9. Indicate the presentation of intangible assets and related items.
1, 2, 3
1
5, 9
9, 10, 11, 12 13
4, 6, 8, 16, 17
3, 4
4
4, 6
3, 4
ASSIGNMENT CHARACTERISTICS TABLE Item
Description
Level of Difficulty
Time (minutes)
E12-1 E12-2 E12-3 E12-4 E12-5 E12-6 E12-7 E12-8 E12-9 E12-10 E12-11 E12-12 E12-13 E12-14 E12-15 E12-16 E12-17
Classification issues—intangibles. Classification issues—intangibles. Classification issues—intangible asset. Intangible amortization. Correct intangible asset account. Recording and amortization of intangibles. Accounting for trade name. Accounting for organization costs. Accounting for patents, franchises, and R&D. Accounting for patents. Accounting for patents. Accounting for goodwill. Accounting for goodwill. Copyright impairment. Goodwill impairment. Accounting for R&D costs. Accounting for R&D costs.
Moderate Simple Moderate Moderate Moderate Simple Simple Simple Moderate Moderate Moderate Moderate Simple Simple Simple Moderate Moderate
15–20 10–15 10–15 15–20 15–20 15–20 10–15 10–15 15–20 20–25 15–20 20–25 10–15 15–20 15–20 15–20 10–15
P12-1 P12-2 P12-3 P12-4 P12-5 P12-6
Correct intangible asset account. Accounting for patents. Accounting for franchise, patents, and trade name. Accounting for R&D costs. Goodwill, impairment. Comprehensive intangible assets.
Moderate Moderate Moderate Moderate Complex Moderate
15–20 20–30 20–30 15–20 25–30 30–35
CA12-1 CA12-2 CA12-3 CA12-4
Accounting for pre-opening costs. Accounting for patents. Accounting for research and development costs. Accounting for research and development costs.
Moderate Moderate Moderate Moderate
20–25 25–30 25–30 20–25
SOLUTIONS TO CODIFICATION EXERCISES CE12-1 According to the Master Glossary: (a) Intangible assets are assets (not including financial assets) that lack physical substance. (The term intangible assets is used to refer to intangible assets other than goodwill.) (b) An asset representing the future economic benefits arising from other assets acquired in a business combination or an acquisition by a not-for-profit entity that are not individually identified and separately recognized. For ease of reference, this term also includes the immediate charge recognized by not-for-profit entities in accordance with paragraph 958-805-25-29. (c) Research and Development: Research 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 (referred to as product) or a new process or technique (referred to as process) or in bringing about a significant improvement to an existing product or process. Development 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. It includes the conceptual formulation, design, and testing of product alternatives, construction of prototypes, and operation of pilot plants. (d) A development stage entity is an entity devoting substantially all of its efforts to establishing a new business and for which either of the following conditions exists: 1. Planned principal operations have not commenced. 2. Planned principal operations have commenced, but there has been no significant revenue therefrom.
CE12-2 See FASB ASC 350-30-35. In the discussions related to “Determining the Useful Life of an Intangible Asset” 35-1
The accounting for a recognized intangible asset is based on its useful life to the reporting entity. An intangible asset with a finite useful life shall be amortized; an intangible asset with an indefinite useful life shall not be amortized.
35-2
The useful life of an intangible asset to an entity is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of that entity. The useful life is not the period of time that it would take that entity to internally develop an intangible asset that would provide similar benefits. However, a reacquired right recognized as an intangible asset is amortized over the remaining contractual period of the contract in which the right was granted. If an entity subsequently reissues (sells) a reacquired right to a third party, the entity includes the related unamortized asset, if any, in determining the gain or loss on the reissuance.
CE12-2 (Continued) 35-3
The estimate of the useful life of an intangible asset to an entity shall be based on an analysis of all pertinent factors, in particular, all of the following factors with no one factor being more presumptive than the other: a. The expected use of the asset by the entity. b. The expected useful life of another asset or a group of assets to which the useful life of the intangible asset may relate. c. Any legal, regulatory, or contractual provisions that may limit the useful life. The cash flows and useful lives of intangible assets that are based on legal rights are constrained by the duration of those legal rights. Thus, the useful lives of such intangible assets cannot extend beyond the length of their legal rights and may be shorter. d. The entity’s own historical experience in renewing or extending similar arrangements, consistent with the intended use of the asset by the entity, regardless of whether those arrangements have explicit renewal or extension provisions. In the absence of that experience, the entity shall consider the assumptions that market participants would use about renewal or extension consistent with the highest and best use of the asset by market participants, adjusted for entity-specific factors in this paragraph. e. The effects of obsolescence, demand, competition, and other economic factors (such as the stability of the industry, known technological advances, legislative action that results in an uncertain or changing regulatory environment, and expected changes in distribution channels). f. The level of maintenance expenditures required to obtain the expected future cash flows from the asset (for example, a material level of required maintenance in relation to the carrying amount of the asset may suggest a very limited useful life). As in determining the useful life of depreciable tangible assets, regular maintenance may be assumed but enhancements may not. Further, if an income approach is used to measure the fair value of an intangible asset, in determining the useful life of the intangible asset for amortization purposes, an entity shall consider the period of expected cash flows used to measure the fair value of the intangible asset adjusted as appropriate for the entity-specific factors in this paragraph.
35-4
If no legal, regulatory, contractual, competitive, economic, or other factors limit the useful life of an intangible asset to the reporting entity, the useful life of the asset shall be considered to be indefinite. The term indefinite does not mean the same as infinite or indeterminate. The useful life of an intangible asset is indefinite if that life extends beyond the foreseeable horizon—that is, there is no foreseeable limit on the period of time over which it is expected to contribute to the cash flows of the reporting entity. Such intangible assets might be airport route authorities, certain trademarks, and taxicab medallions.
CE12-3 According the FASB ASC 730-10-50: 50-1
Disclosure shall be made in the financial statements of the total research and development costs charged to expense in each period for which an income statement is presented. Such disclosure shall include research and development costs incurred for a computer software product to be sold, leased, or otherwise marketed.
CE12-4 According the FASB ASC 926-720-25, General Overall Deals 25-1
An entity may enter into an overall deal arrangement. An entity shall charge the costs of overall deals that cannot be identified with specific projects to expenses as they are incurred over the related time period. > Exploitation Costs
25-2
An entity shall account for advertising costs in accordance with the provisions of Subtopic 720-35. That is, expense as incurred.
ANSWERS TO QUESTIONS > The two main characteristics of intangible assets are: (a) they lack physical substance. (b) they are not a financial instrument. > If intangibles are acquired for stock, the cost of the intangible is the fair value of the consideration given or the fair value of the consideration received, whichever is more clearly evident. > Limited-life intangibles should be amortized by systematic charges to expense over their useful life. An intangible asset with an indefinite life is not amortized. > When intangibles are created internally, it is often difficult to determine the validity of any future service potential. To permit deferral of these types of costs would lead to a great deal of subjecttivity because management could argue that almost any expense could be capitalized on the basis that it will increase future benefits. The cost of purchased intangibles, however, is capitalized because its cost can be objectively verified and reflects its fair value at the date of acquisition. > Companies cannot capitalize self-developed, self-maintained, or self-created goodwill. These expenditures would most likely be reported as selling expenses. > Factors to be considered in determining useful life are: (a) The expected use of the asset by the entity. (b) The expected useful life of another asset or a group of assets to which the useful life of the intangible asset may relate. (c) Any legal, regulatory, or contractual provisions that may limit useful life. (d) Any legal, regulatory or contractual provisions that enable renewal or extension of the asset’s legal or contractual life without substantial cost. (e) The effects of obsolescence, demand, competition, and other economic factors. (f) The level of maintenance expenditure required to obtain the expected future cash flows from the asset. > The amount of amortization expensed for a limited-life intangible asset should reflect the pattern in which the asset is consumed or used up, if that pattern can be reliably determined. If the pattern of production or consumption cannot be determined, the straight-line method of amortization should be used. > This trademark is an indefinite life intangible and, therefore, should not be amortized. > The $190,000 should be expensed as research and development expense in 2014. The $91,000 is expensed as selling and promotion expense in 2014. The $45,000 of costs to legally obtain the patent should be capitalized and amortized over the useful or legal life of the patent, whichever is shorter. >
Amortization Expense.................................................................... Patents (or Accumulated Patent Amortization) .........................
35,000 35,000
Straight-line amortization is used because the pattern of use cannot be reliably determined. >
Artistic-related intangible assets involve ownership rights to plays, pictures, photographs, and video and audiovisual material. These ownership rights are protected by copyrights. Contract-related intangible assets represent the value of rights that arise from contractual arrangements. Examples are franchise and licensing agreements, construction permits, broadcast rights, and service or supply contracts.
Questions Chapter 12 (Continued) >
Varying approaches are used to define goodwill. They are (a) Goodwill should be measured initially as the excess of the fair value of the acquisition cost over the fair value of the net assets acquired. This definition is a measurement definition but does not conceptually define goodwill. (b) Goodwill is sometimes defined as one or more unidentified intangible assets and identifiable intangible assets that are not reliably measurable. Examples of elements of goodwill include new channels of distribution, synergies of combining sales forces, and a superior management team. (c) Goodwill may also be defined as the intrinsic value that a business has acquired beyond the mere value of its net assets whether due to the personality of those conducting it, the nature of its location, its reputation, or any other circumstance incidental to the business and tending to make it permanent. Another definition is the capitalized value of the excess of estimated future profits of a business over the rate of return on capital considered normal in the industry. A bargain purchase (or negative goodwill) occurs when the fair value of the assets purchased is higher than the cost. This situation may develop from a market imperfection. In this case, the seller would have been better off to sell the assets individually than in total. However, situations do occur (e.g., a forced liquidation or distressed sale due to the death of the company founder), in which the purchase price is less than the value of the identifiable net assets.
>
Goodwill is recorded only when it is acquired by purchase. Goodwill acquired in a business combination is considered to have an indefinite life and therefore should not be amortized, but should be tested for impairment on at least an annual basis.
>
Many analysts believe that the value of goodwill is so subjective that it should not be given the same status as other types of assets such as cash, receivables, inventory, etc. The analysts are simply stating that they believe that presentation of goodwill on the balance sheet does not provide any useful information to the users of financial statements. Whether this is true or not is a difficult point to prove, but it should be noted that it appears contradictory to pay for the goodwill and then immediately write it off, denying that it has any value.
>
Accounting standards require that if events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable, then the carrying amount of the asset should be assessed. The assessment or review takes the form of a recoverability test that compares the sum of the expected future cash flows from the asset (undiscounted) to the carrying amount. If the cash flows are less than the carrying amount, the asset has been impaired. The impairment loss is measured as the amount by which the carrying amount exceeds the fair value of the asset. The fair value of assets is measured by their fair value if an active market for them exists. If no market price is available, the present value of the expected future net cash flows from the asset may be used.
>
Under U.S. GAAP, impairment losses on assets held for use may not be restored.
>
Impairment losses are reported as part of income from continuing operations, generally in the “Other expenses and losses” section. Impairment losses (and recovery of losses for assets to be disposed of) are similar to other costs that would flow through operations. Thus, gains (recoveries of losses) on assets to be disposed of should be reported as part of income from continuing operations.
>
The amount of goodwill impaired is $40,000, computed as follows: Recorded goodwill ................................................ $400,000 Implied goodwill .................................................... (360,000) Impaired goodwill.................................................. $ 40,000
Questions Chapter 12 (Continued) >
Research and development costs are incurred to develop new products or processes, to improve present products, or to discover new knowledge. R&D expenditures present problems of (1) identifying the costs associated with particular activities, projects, or achievements, and (2) determining the magnitude of the future benefits and the length of time over which such benefits may be realized. R&D activities may incur costs classified as follows: (a) materials, equipment, and facilities, (b) personnel, (c) purchased intangibles, (d) contract services, and (e) indirect costs.
>
(a) Personnel (labor) type costs incurred in R&D activities should be expensed as incurred. (b) Materials and equipment costs should be expensed immediately unless the items have alternative future uses. If the items have alternative future uses, the materials should be recorded as inventories and allocated as consumed and the equipment should be capitalized and depreciated as used. (c) Indirect costs of R&D activities should be reasonably allocated to R&D (except for general and administrative costs, which must be clearly related to be included) and expensed.
>
(a) Expense as R&D. (b) Expense as R&D. (c) Capitalize as patent and/or license and amortize. Also, see Illustration 12-14 (page 22).
>
Each of these items should be charged to current operations. Advertising costs have some minor exceptions to this general rule. However, the specific accounting is beyond the scope of this textbook.
>
$585,000 ($400,000 + $60,000 + $125,000).
>
These costs are referred to as start-up costs, or more specifically organizational costs in this case. The accounting for start-up costs is straightforward—expense these costs as incurred. The profession recognizes that these costs are incurred with the expectation that future revenues will occur or increased efficiencies will result. However, to determine the amount and timing of future benefits is so difficult that a conservative approach—expensing these costs as incurred—is required.
>
The total life, per revised facts, is 40 years (10 + 30). There are 30 (40 – 10) remaining years for $540,000 amortization purposes. Original amortization: = $18,000 per year; $18,000 X 10 years 30 expired = $180,000 accumulated amortization. $540,000 –180,000 $360,000
original cost accumulated amortization remaining cost to amortize
$360,000 ÷ 30 years = $12,000 amortization for 2014 and years thereafter.
SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 12-1 Patents .......................................................................... Cash .....................................................................
54,000
Amortization Expense.................................................. Patents ($54,000 X 1/10 = $5,400) .......................
5,400
54,000 5,400
BRIEF EXERCISE 12-2 Patents .......................................................................... Cash .....................................................................
24,000
Amortization Expense.................................................. Patents [($43,200 + $24,000) X 1/8 = $8,400].........
8,400
24,000 8,400
BRIEF EXERCISE 12-3 Trade Names................................................................. Cash .....................................................................
68,000
Amortization Expense.................................................. Trade Names ($68,000 X 1/8 = $8,500) ...............
8,500
68,000 8,500
BRIEF EXERCISE 12-4 Franchises .................................................................... Cash .....................................................................
120,000
Amortization Expense.................................................. Franchises ($120,000 X 1/8 X 9/12 = $11,250)....
11,250
120,000 11,250
BRIEF EXERCISE 12-5 Purchase price ............................................................. Fair value of assets ...................................................... Fair value of liabilities.................................................. Fair value of net assets................................................ Value assigned to goodwill .........................................
$700,000 $800,000 200,000 600,000 $100,000
BRIEF EXERCISE 12-6 Loss on Impairment ..................................................... Patents ($300,000 – $110,000) ............................
190,000 190,000
Note: An impairment has occurred because expected net future cash flows ($210,000) are less than the carrying amount ($300,000). The loss is measured as the difference between the carrying amount and fair value ($110,000). BRIEF EXERCISE 12-7 Because the fair value of the division exceeds the carrying amount of the assets, goodwill is not considered to be impaired. No entry is necessary.
BRIEF EXERCISE 12-8 Loss on Impairment ($400,000 – $350,000) ................ Goodwill...............................................................
50,000 50,000
The fair value of the reporting unit ($750,000) is less than the carrying value ($800,000)—an impairment has occurred. The loss is the difference between the recorded goodwill and the implied goodwill.
BRIEF EXERCISE 12-9 Organization Expense.................................................. Cash .....................................................................
60,000 60,000
BRIEF EXERCISE 12-10 Research and Development Expense ...................... Cash ..................................................................
430,000 430,000
BRIEF EXERCISE 12-11 (a) (b) (c) (d)
Capitalize Expense Expense Expense
BRIEF EXERCISE 12-12 Carrying Amount Patent (1/1/14) $288,000 Legal costs (12/1/14) 85,000 $373,000
Life in Months 96 85
Amortization Per Month $3,000 $1,000
Carrying amount....................................................... Less: Amortization of patent (12 X $3,000)............ Legal costs amortization (1 X $1,000).......... Carrying amount 12/31/14 ........................................
Months Amortization 12 1
$373,000 (36,000) (1,000) $336,000
BRIEF EXERCISE 12-13 Copyright No. 1 for $9,900 should be expensed and therefore not reported on the balance sheet. Copyright No. 2 for $24,000 should be capitalized. Because the useful life is indefinite, copyright No. 2 should be tested at least annually for impairment using a fair value test. It would be reflected on the December 31, 2014 balance sheet at its cost of $24,000.
SOLUTIONS TO EXERCISES EXERCISE 12-1 (15–20 minutes) (a)
10, 13, 15, 16, 17, 19, 23
(b)
1. 2. 3. 4. 5. 6. 7. 8. 9. 11. 12. 14. 18. 20. 21. 22.
Long-term investments in the balance sheet. Property, plant, and equipment in the balance sheet. Research and development expense in the income statement. Current asset (prepaid rent) in the balance sheet. Property, plant, and equipment in the balance sheet. Research and development expense in the income statement. Charge as expense in the income statement. Operating losses in the income statement. Charge as expense in the income statement. Not recorded; any costs related to creating goodwill incurred internally must be expensed. Research and development expense in the income statement. Research and development expense in the income statement. Research and development expense in the income statement. Research and development expense in the income statement. Long-term investments, or other assets, in the balance sheet. Expensed in the income statement.
EXERCISE 12-2 (10–15 minutes) The following items would be classified as an intangible asset: Cable television franchises Film contract rights Music copyrights Customer lists Goodwill Covenants not to compete Internet domain name Brand names Cash, accounts receivable, notes receivable, and prepaid expenses would be classified as current assets. Property, plant, and equipment, and land would be classified as noncurrent assets in the property, plant, and equipment section.
EXERCISE 12-2 (Continued) Investments in affiliated companies would be classified as part of the investments section of the balance sheet. Research and development costs would be classified as an operating expense. Discount on notes payable is shown as a deduction from the related notes payable on the balance sheet. Organization costs are start-up costs and should be expensed as incurred.
EXERCISE 12-3 (10–15 minutes) (a)
(b)
Trademarks Excess of cost over fair value of net identifiable assets of acquired subsidiary (goodwill) Total intangible assets
$15,000 75,000 $90,000
Organization costs, $24,000, should be expensed. Discount on bonds payable, $35,000, should be reported as a contra account to bonds payable in the long-term liabilities section. Deposits with advertising agency for ads to promote goodwill of company, $10,000, should be reported either as an expense or as prepaid advertising in the current assets section. Advertising costs in general are expensed when incurred or when first used. Cost of equipment acquired for research and development projects, $90,000, should be reported with property, plant, and equipment, because the equipment has an alternative use. Costs of developing a secret formula for a product that is expected to be marketed for at least 20 years, $80,000, should be classified as research and development expense on the income statement.
EXERCISE 12-4 (15–20 minutes) 1.
Alatorre should report the patent at $600,000 (net of $400,000 accumulated amortization) on the balance sheet. The computation of accumulated amortization is as follows. Amortization for 2012 and 2013 ($1,000,000/10) X 2 2014 amortization: ($1,000,000 – $200,000) ÷ (6 – 2) Accumulated amortization, 12/31/14
$200,000 200,000 $400,000
2.
Alatorre should amortize the franchise over its estimated useful life. Because it is uncertain that Alatorre will be able to retain the franchise at the end of 2022, it should be amortized over 10 years. The amount of amortization on the franchise for the year ended December 31, 2014, is $40,000: ($400,000/10).
3.
These costs should be expensed as incurred. Therefore $275,000 of organization expense is reported in income for 2014.
4.
Because the license can be easily renewed (at nominal cost), it has an indefinite life. Thus, no amortization will be recorded. The license will be tested for impairment in future periods.
EXERCISE 12-5 (15–20 minutes) Research and Development Expense ............................. 940,000 Patents .............................................................................. 75,000 Rent Expense [(5 ÷ 7) X $91,000]..................................... 65,000 Prepaid Rent [(2 ÷ 7) X $91,000] ...................................... 26,000 Advertising Expense........................................................ 207,000 Income Summary ............................................................. 241,000 Discount on Bonds Payable ............................................ 82,950* Interest Expense .............................................................. 1,050 Paid in Capital in Excess of Par on Common Stock ..... 250,000 Intangible Assets....................................................... 1,388,000 *84,000 ÷ 240 months = $350; $350 X 3 = $1,050; $84,000 – $1,050 = $82,950 Amortization Expense [($75,000 ÷ 10) X 1/2] .............. Patents (or Accumulated Amortization)
3,750 3,750
EXERCISE 12-6 (15–20 minutes) Patents ................................................................... Goodwill ................................................................. Franchise ............................................................... Copyright ............................................................... Research and Development Expense .................. Intangible Assets..........................................
350,000 360,000 450,000 156,000 215,000
Amortization Expense........................................... Patents ($350,000/8) ..................................... Franchise ($450,000/10 X 6/12) .................... Copyright ($156,000/5 X 5/12) ......................
79,250
1,531,000 43,750 22,500 13,000
Balance of Intangible Assets as of December 31, 2014 Patents = $350,000 – $43,750 = $306,250 Goodwill = $360,000 (no amortization) Franchise = $450,000 – $22,500 = $427,500 Copyright = $156,000 – $13,000 = $143,000 EXERCISE 12-7 (10–15 minutes) (a)
2013 amortization: $16,000 ÷ 10 = $1,600. 12/31/13 book value: $16,000 – $1,600 = $14,400. 2014 amortization: ($14,400 + $7,800) ÷ 9 = $2,467. 12/31/14 book value: ($14,400 + $7,800 – $2,467) = $19,733.
(b)
2014 amortization: ($14,400 + $7,800) ÷ 4 = $5,550. 12/31/14 book value: $14,400 + $7,800 – $5,550 = $16,650.
(c)
Carrying amount ($19,733) > future cash flows ($16,000); thus the trade name fails the recoverability test. The new carrying value is $15,000—the trade name’s fair value. 2015 amortization (after recording impairment loss): $15,000 ÷ 8 = $1,875. 12/31/15 book value: $15,000 – $1,875 = $13,125.
EXERCISE 12-8 (10–15 minutes) (a)
Attorney’s fees in connection with organization of the company Costs of meetings of incorporators to discuss organizational activities State filing fees to incorporate Total organization costs
$15,000 7,000 1,000 $23,000
Drafting and design equipment, $10,000, should be classified as part of fixed assets, rather than as organization costs. (b)
Organization Expense ........................................... Cash (Payables) ............................................
23,000 23,000
EXERCISE 12-9 (15–20 minutes) (a)
JIMMY CARTER COMPANY Intangibles Section of Balance Sheet December 31, 2014
Patent from Ford Company, net of accumulated amortization of $560,000 (Schedule 1) Franchise from Reagan Company, net of accumulated amortization of $48,000 (Schedule 2) Total intangibles Schedule 1 Computation of Patent from Ford Company Cost of patent at date of purchase Amortization of patent for 2013 ($2,000,000 ÷ 10 years) Amortization of patent for 2014 ($1,800,000 ÷ 5 years) Patent balance
$1,440,000 432,000 $1,872,000
$2,000,000 (200,000) 1,800,000 (360,000) $1,440,000
Schedule 2 Computation of Franchise from Reagan Company Cost of franchise at date of purchase $ 480,000 Amortization of franchise for 2014 ($480,000 ÷ 10) (48,000) Franchise balance $ 432,000
EXERCISE 12-9 (Continued) (b)
JIMMY CARTER COMPANY Income Statement Effect For the year ended December 31, 2014 Patent from Ford Company: Amortization of patent for 2014 ($1,800,000 ÷ 5 years) Franchise from Reagan Company: Amortization of franchise for 2014 $ 48,000 ($480,000 ÷ 10) Payment to Reagan Company ($2,500,000 X 5%) 125,000 Research and development costs Total charged against income
$360,000
173,000 433,000 $966,000
EXERCISE 12-10 (15–20 minutes) (a)
2010 Research and Development Expense ..... Cash..................................................
170,000
Patents....................................................... Cash..................................................
18,000
Amortization Expense .............................. Patents [($18,000 ÷ 10) X 3/12]........
450
Amortization Expense .............................. Patents ($18,000 ÷ 10) .....................
1,800
2011
170,000 18,000 450 1,800
EXERCISE 12-10 (Continued) (b)
2012
2013 (c)
Patents ......................................................... Cash ....................................................
9,480
Amortization Expense ................................. Patents ($750 + $1,190) ...................... [Jan. 1–June 1: ($18,000 ÷ 10) X 5/12 = $750 June 1–Dec. 31: ($18,000 – $450 – $1,800 – $750 + $9,480) = $24,480; ($24,480 ÷ 12) X 7/12 = $1,190]
1,940
Amortization Expense ................................. Patents ($24,480 ÷ 12) ........................
2,040
1,940
2014 and 2015 Amortization Expense ..................................... 10,625 Patents ($21,250 ÷ 2) .......................... ($24,480 – $1,190 – $2,040) = $21,250
EXERCISE 12-11 (a)
9,480
Patent A Life in years Life in months (12 X 17) Amortization per month ($30,600 ÷ 204) Number of months amortized to date Year Month 2010 10 2011 12 2012 12 2013 12 46
17 204 $150
Book value 12/31/13 $23,700: ($30,600 – [46 X $150])
2,040
10,625
EXERCISE 12-11 (Continued) Patent B Life in years Life in months (12 X 10) Amortization per month ($15,000 ÷ 120) Number of months amortized to date Year Month 2011 6 2012 12 2013 12 30
10 120 $125
Book value 12/31/13 $11,250: ($15,000 – [$125 X 30]) Patent C Life in years Life in months (12 X 4) Amortization per month ($14,400 ÷ 48) Number of months amortized to date Year Month 2012 4 2013 12 16
4 48 $300
Book value 12/31/13 $9,600: ($14,400 – [$300 X 16]) At December 31, 2013 Patent A Patent B Patent C Total
$23,700 11,250 9,600 $44,550
EXERCISE 12-11 (Continued) (b)
Analysis of 2014 transactions 1.
The $245,700 incurred for research and development should be expensed.
2.
The book value of Patent B is $11,250 and its estimated future cash flows are $6,000: (3 X $2,000); therefore Patent B is impaired. The impairment loss is imputed as follows: Book value Less: Present value of future cash flows ($2,000 X 2.57710) Loss recognized
$11,250 5,154 $ 6,096
Patent B carrying amount (12/31/14) $5,154 At December 31, 2014 Patent A $21,900 ($23,700 – [12 X $150]) Patent B 5,154 (Present value of future cash flows) Patent C 6,000 ($9,600 – [12 X $300]) Patent D 34,560 ($36,480 – $1,920*) Total $67,614 Patent D amortization Life in years Life in months Amortization per month ($36,480 ÷ 114) $320 X 6 = $1,920
9 1/2 114 $320
EXERCISE 12-12 Net assets of Zweifel as reported ($575,000 – $350,000) Adjustments to fair value Increase in land value Decrease in equipment value Net assets of Zweifel at fair value Selling price Amount of goodwill to be recorded
$225,000 30,000 (5,000)
25,000 250,000 350,000 $100,000
The journal entry to record this transaction is as follows: Cash .................................................................................. 100,000 Land................................................................................... 100,000 Building ............................................................................. 200,000 Equipment ......................................................................... 170,000 Copyright ...................................................................... 30,000 Goodwill ............................................................................ 100,000 Accounts Payable ............................................... Long-term Notes Payable ................................... Cash .....................................................................
50,000 300,000 350,000
EXERCISE 12-13 (10–15 minutes) (a)
Cash ..................................................................... Receivables ......................................................... Inventory.............................................................. Land ..................................................................... Buildings.............................................................. Equipment ........................................................... Trademark............................................................ Goodwill............................................................... Accounts Payable ...................................... Notes Payable ............................................ Cash ............................................................
50,000 90,000 125,000 60,000 75,000 70,000 15,000 65,000* 200,000 100,000 250,000
*$350,000 – [$235,000 + $20,000 + $25,000 + $5,000] Note that the building and equipment would be recorded at the 7/1/14 cost to Brigham; accumulated depreciation accounts would not be recorded.
EXERCISE 12-13 (Continued) (b)
Amortization Expense .................................................. 1,500 Trademarks ([$15,000 – $3,000] X 1/4 X 6/12).....
1,500
EXERCISE 12-14 (15–20 minutes) (a)
December 31, 2014 Loss on Impairment ......................................... Copyrights............................................... *Carrying amount Fair value Loss on impairment
1,100,000* 1,100,000
$4,300,000 3,200,000 $1,100,000
Note: Asset fails recoverability test. (b)
Amortization Expense ..................................... Copyrights............................................... *New carrying amount Useful life Amortization per year
(c)
320,000* 320,000
$3,200,000 ÷ 10 years $ 320,000
No entry is necessary. Restoration of any impairment loss is not permitted for assets held for use.
EXERCISE 12-15 (15–20 minutes) (a)
December 31, 2014 Loss on Impairment .............................. 15,000,000 Goodwill .......................................
15,000,000
The fair value of the reporting unit ($335 million) is below its carrying value ($350 million). Therefore, an impairment has occurred. To determine the impairment amount, we first find the implied goodwill. We then compare this implied fair value to the carrying value of the goodwill to determine the amount of the impairment to record.
EXERCISE 12-15 (Continued) Fair value of division Carrying amount of division, net of goodwill Implied value of goodwill Carrying value of goodwill Loss on impairment (b)
$335,000,000 150,000,000 185,000,000 (200,000,000) $ 15,000,000
No entry necessary. After a goodwill impairment loss is recognized, the adjusted carrying amount of the goodwill is its new accounting basis. Subsequent reversal of previously recognized impairment losses is not permitted under FASB ASC 350-30-35.
Note to instructor: It is important that before conducting the goodwill impairment test that all other long-lived assets are evaluated and adjusted for any impairments. EXERCISE 12-16 (15–20 minutes) (a)
In accordance with GAAP, the $325,000 is a research and development cost that should be charged to R & D Expense and, if not separately disclosed in the income statement, the total cost of R & D should be separately disclosed in the notes to the financial statements.
(b)
Research and Development Expense............ Cash, Accts. Payable, etc. ..................... (To record research and development costs)
110,000
Patents ............................................................. Cash, Accts. Payable, etc. ..................... (To record legal and administrative costs incurred to obtain patent #472-1001-84)
16,000
Amortization Expense..................................... Patents.................................................... [To record one year’s amortization expense ($16,000 ÷ 5 = $3,200)]
3,200
110,000
16,000
3,200
EXERCISE 12-16 (Continued) (c)
Patents................................................................ Cash, Accts. Payable, etc......................... (To record legal cost of successfully defending patent)
47,200 47,200
The cost of defending the patent is capitalized because the defense was successful and because it extended the useful life of the patent. Amortization Expense ....................................... Patents....................................................... (To record one year’s amortization Expense: $16,000 – $3,200 = $12,800; $12,800 ÷ 8 = $1,600 $47,200 ÷ 8 = 5,900 Amortization expense for 2015 $7,500 (d)
7,500 7,500
Additional engineering and consulting costs required to advance the design of a product to the manufacturing stage are R & D costs. As indicated in the chapter it is R &D because it translates knowledge into a plan or design for a new product.
EXERCISE 12-17 (10–12 minutes) Depreciation of equipment acquired that will have alternate uses in future research and development projects over the next 5 years ($280,000 ÷ 5) Materials consumed in research and development projects Consulting fees paid to outsiders for research and development projects Personnel costs of persons involved in research and development projects Indirect costs reasonably allocable to research and development projects Total to be expensed for research and development
$ 56,000 59,000 100,000 128,000 50,000 $393,000*
*Materials purchased for future R&D projects should be reported as an asset.
TIME AND PURPOSE OF PROBLEMS Problem 12-1 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to appropriately reclassify amounts charged to a single intangible asset account. Capitalized in the account are amounts representing franchise costs, prepaid rent, organization fees, prior net loss, patents, goodwill, and R&D costs. The student must also be alert to the fact that several transactions require that an adjustment of Retained Earnings be made. The problem provides a good summary of accounting for intangibles. Problem 12-2 (Time 20–30 minutes) Purpose—to provide the student with an opportunity to compute the carrying value of a patent at three balance sheet dates. The student must distinguish between expenditures that are properly included in the patent account and R&D costs which must be expensed as incurred. Computation of amortization is slightly complicated by additions to the account and a change in the estimated useful life of the patents. A good summary of accounting for patents and R&D costs. Problem 12-3 (Time 20–30 minutes) Purpose—the student determines the cost and amortization of a franchise, patent, and trademark and shows how they are disclosed on the balance sheet. The student prepares a schedule of expenses resulting from the intangibles transactions. Problem 12-4 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to determine income statement and balance sheet presentation for costs related to research and development of patents. The problem calls on the student to determine whether costs incurred are properly capitalized or expensed. The problem addresses the basic issues involved in accounting for R&D costs and patents. Problem 12-5 (Time 25–30 minutes) Purpose—to provide the student with an opportunity to determine the amount of goodwill in a business combination and to determine the goodwill impairment. Problem 12-6 (Time 30–35 minutes) Purpose—to provide the student with an opportunity to determine carrying value of intangible assets (limited life, indefinite life, and goodwill) at two balance sheet dates. The problem also requires students to determine impairments, if necessary on the intangible assets.
SOLUTIONS TO PROBLEMS PROBLEM 12-1
Franchises .................................................................... Prepaid Rent ................................................................. Retained Earnings (Net loss)....................................... Patents ($84,000 + $12,650) ......................................... Research and Development Expense ($75,000 + $160,000) .................................................. Goodwill........................................................................ Intangible Assets ................................................
48,000 24,000 16,000 96,650 235,000 278,400 698,050
Amortization Expense ($48,000 ÷ 8)............................ Retained Earnings ($48,000 ÷ 8 X 6/12)....................... Franchises ...........................................................
6,000 3,000
Rent Expense ($24,000 ÷ 2) ......................................... Retained Earnings ($24,000 ÷ 2 X 3/12)....................... Prepaid Rent ........................................................
12,000 3,000
Amortization Expense.................................................. Patents ($84,000 ÷ 10) + ($12,650 X 7/115) ...................
9,170
9,000
15,000
9,170
Balances at 12/31/15 Prepaid Rent ($24,000 – $15,000) ................................ Franchises ($48,000 – 9,000) ....................................... Patents ($96,650 – 9,170) ............................................. Goodwill........................................................................
$
9,000 39,000 87,480 278,400
Note: No amortization of goodwill; goodwill should be tested for impairment on at least an annual basis in future periods.
PROBLEM 12-2 (a)
Costs to obtain patent Jan. 2008 ................... 2008 amortization ($59,500 ÷ 17).................... Carrying value, 12/31/08 .................................
$59,500 (3,500) $56,000
All costs incurred prior to January 2008 are related to research and development activities and were expensed as incurred in accordance with GAAP. (b)
1/1/09 carrying value of patent ....................... 2009 amortization ($59,500 ÷ 17).................... 2010 amortization............................................ Legal fees to defend patent 12/10 .................. Carrying value, 12/31/10 ................................. 2011 amortization ($91,000 ÷ 14).................... 2012 amortization............................................ Carrying value, 12/31/12 .................................
$56,000 $3,500 3,500
6,500 6,500
(7,000) 49,000 42,000 91,000 (13,000) $78,000
The costs incurred in 2009 and 2011 are related to research and development activities and are expensed as incurred. (c)
1/1/13 carrying value ....................................... 2013 amortization ($78,000 ÷ 5)...................... 2014 amortization............................................ 2015 amortization............................................ Carrying value, 12/31/15 .................................
$78,000 $15,600 15,600 15,600
(46,800) $31,200
The legal costs in 2015 were expensed because the suit was unsuccessful.
PROBLEM 12-3
(a)
SANDRO CORPORATION Intangible Assets December 31, 2014 Franchise, net of accumulated amortization of $5,870 (Schedule 1) ............................................................................... Patent, net of accumulated amortization of $2,200 (Schedule 2) ............................................................................... Trademark, net of accumulated amortization of $6,600 (Schedule 3) ............................................................................... Total intangible assets ........................................................
$ 52,830 15,400 39,600 $107,830
Schedule 1 Franchise Cost of franchise on 1/1/14 ($15,000 + $43,700).......................... 2014 amortization ($58,700 X 1/10) .............................................. Cost of franchise, net of amortization................................
$ 58,700 (5,870) $ 52,830
Schedule 2 Patent Cost of securing patent on 1/2/14................................................ 2014 amortization ($17,600 X 1/8) ................................................ Cost of patent, net of amortization.....................................
$ 17,600 (2,200) $ 15,400
Schedule 3 Trademark Cost of trademark on 7/1/11 ......................................................... Amortization, 7/1/11 to 7/1/14 ($36,000 X 3/20)............................ Book value on 7/1/14 .................................................................... Cost of successful legal defense on 7/1/14................................. Book value after legal defense..................................................... Amortization, 7/1/14 to 12/31/14 ($40,800 X 1/17 X 6/12) ............ Cost of trademark, net of amortization ..............................
$ 36,000 (5,400) 30,600 10,200 40,800 (1,200) $ 39,600
PROBLEM 12-3 (Continued) (b)
SANDRO CORPORATION Expenses Resulting from Selected Intangible Assets Transactions For the Year Ended December 31, 2014
Interest expense ($43,700 X 14%) ............................................... Franchise amortization (Schedule 1) .......................................... Franchise fee ($900,000 X 5%) .................................................... Patent amortization (Schedule 2)................................................ Trademark amortization (Schedule 4)......................................... Total intangible assets .......................................................
$ 6,118 5,870 45,000 2,200 2,100 $61,288
Note: The $65,000 of research and development costs incurred in developing the patent would have been expensed prior to 2014. Schedule 4 Trademark Amortization Amortization, 1/1/14 to 6/30/14 ($36,000 X 1/20 X 6/12) ............... Amortization, 7/1/14 to 12/31/14 ($40,800 X 1/17 X 6/12) ............. Total trademark amortization ..............................................
$
900 1,200 $ 2,100
PROBLEM 12-4 (a)
Income statement items and amounts for the year ended December 31, 2014: Research and development expenses* .......................... Amortization of patent ($88,000 ÷ 10 years)...................
$288,000 8,800
*The research and development expenses could be listed by the components rather than in one total. The details of the research and development expenses are as follows: Depreciation—building ($320,000 ÷ 20 years) .................................................... Salaries and employee benefits...................................... Other expenses ................................................................ (b)
$ 16,000 195,000 77,000
Balance sheet items and amounts as of December 31, 2014: Land .................................................................................. Building (net of accumulated depreciation of $16,000) ..................................................................... Patent (net of amortization of $15,400)* .........................
$ 60,000 304,000 72,600
*([$88,000 ÷ 10] X 3/4) + ($88,000 ÷ 10) All research and development costs should be charged to expense when incurred. Therefore, all of Robin Wright Tool Company’s costs related to its research and development activities for 2014 would be expensed regardless of the long-term benefits. The patent was acquired for manufacturing rights rather than for use in research and development activities. Consequently, the cost of the patent can be capitalized as an intangible asset and amortized over its useful life.
PROBLEM 12-5
(a)
Goodwill = Excess of the cost of the division over the fair value of the identifiable assets: $3,000,000 – $2,750,000 = $250,000
(b)
No impairment loss is recorded, because the fair value of Conchita ($1,850,000) is greater than carrying value of the net assets ($1,650,000).
(c)
Computation of impairment: Implied fair value of goodwill = Fair value of division less the carrying value of the division (adjusted for fair value changes), net of goodwill: Fair value of Conchita division .................... Carrying value of division .................................$1,650,000 Increase in fair value of PP&E...................... 150,000 Less: Goodwill .................................................. 250,000
(1,550,000) 50,000 (250,000) ($ 200,000)
Implied fair value of goodwill ....................... Carrying value of goodwill ........................... Impairment loss ............................................ (d)
Loss on Impairment ...................................... Goodwill .................................................
$1,600,000
$ 200,000 200,000
This loss will be reported in income as a separate line item before the subtotal “income from continuing operations.”
PROBLEM 12-6 (a)
MONTANA MATT’S GOLF INC. Intangibles Section of Balance Sheet December 31, 2013
Trade name................................................................ Copyright (net accumulated amortization of $300) (Schedule 1) ........................................................... Goodwill (Schedule 2) .............................................. Total intangibles .......................................................
$ 10,000 23,700 170,000 $203,700
Schedule 1
Computation of Value of Old Master Copyright Cost of copyright at date of purchase..................... Amortization of Copyright for 2013 [($24,000 ÷ 40) X 1/2 year].......................................... Cost of copyright at December 31.................. Schedule 2 Goodwill Measurement Purchase price ......................................................... Fair value of assets.................................................. Fair value of liabilities ............................................. Fair value of net assets.................................. Value assigned to goodwill .....................................
$ 24,000 (300) $ 23,700 $770,000 $800,000 (200,000) (600,000) $170,000
Amortization expense for 2013 is $300 (see Schedule 1). There is no amortization for the goodwill or the trade name, both of which are considered indefinite life intangible assets. (b) Amortization Expense........................................ Copyrights ($24,000 ÷ 40) ...............................
600 600
There is a full year of amortization on the Copyright. There is no amortization for the goodwill or the trade name, which are considered an indefinite life intangibles.
PROBLEM 12-6 (Continued) MONTANA MATT’S GOLF INC. Intangibles Section of Balance Sheet December 31, 2014 Trade name......................................................................... Copyright (net accumulated amortization of $900) (Schedule 1)..................................................................... Goodwill.............................................................................. Total intangibles................................................................. Computation of Value of Old Master Copyright Cost of Copyright at date of purchase ............................. Amortization of Copyright for 2013, 2014 [($24,000 ÷ 40) X 1.5 years] ............................................. Cost of copyright at December 31 ...........................
$ 10,000 23,100 170,000 $203,100
Schedule 1
(c)
Loss on Impairment ....................................................... 87,000 Goodwill ($170,000 – $90,000*) ................................ Trade names ($10,000 – $3,000) ..............................
$ 24,000 (900) $ 23,100
80,000 7,000
*Fair value of Old Master reporting unit ............. $420,000 Net identifiable assets (excluding goodwill) ($500,000 – $170,000) ..................................... (330,000) Implied value of goodwill ................................ $ 90,000 The Goodwill is considered impaired because the fair value of the business unit ($420,000) is less than its carrying value ($500,000). The copyright is not considered impaired because the expected net future cash flows ($30,000) exceed the carrying amount ($24,000).
TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 12-1 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to determine the proper classification of certain expenditures related to organizing a business. The student is required to deal with such issues as costs incurred for interest expense during construction, the cost of promotional advertising, and expenditures related to obtaining tenants for a shopping center. Classification of these items is complicated due to a postponement in the starting of business operations. A challenging and interesting case which should provide good background for a discussion of the theoretical support for capitalizing organization costs. CA 12-2 (Time 25–30 minutes) Purpose—to present an opportunity for the student to discuss accounting for patents from a theoretical and a practical viewpoint. The student is required to explain the “discounted value of expected net receipts” method of accounting for patents and to provide support for using cost as the generally accepted valuation method. The student is also required to comment on the theoretical basis of patent amortization. Finally the student must determine proper disclosure in the financial statements for a patent infringement suit which is in progress at the balance sheet date. This case challenges the student to present theoretical support and practical application beyond that presented in the text. CA 12-3 (Time 25–30 minutes) Purpose—to provide the student with an opportunity to discuss the theoretical support for and practical applications of the FASB’s position on research and development costs. The student is required to define the terms “research” and “development” as used in the codification to provide theoretical support for the FASB’s position, and to apply the provisions to a situation presented in the case. A good case to thoroughly cover research and development costs. CA 12-4 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to examine the ethical issues related to expensing research and development costs.
SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 12-1 Interest on mortgage bonds. An amount equal to the interest cost incurred in 2013 ($720,000) is a cost which can be associated with the normal construction period and can be regarded as a normal element of the cost of the physical assets of the shopping center because the construction period would have ended at the end of the year if the tornado had not occurred. The decision to use debt capital to finance the shopping center was made with full knowledge that interest would accrue during the construction period and add to the total cost of building the center, bringing it to the point at which it would produce revenue. The future income to be generated by the shopping center must have been estimated to be more than sufficient to recover all of the expected costs of building the center and preparing it for occupancy, including interest during the construction period. In lieu of treating interest during construction as an element of the cost of the physical assets, it can be argued that it represents an element of the general cost of bringing the business to the point of revenue production and should therefore be treated as an organization expense. This view regards interest during construction as just another of the many expenditures that are necessary to acquire and organize the physical assets of a new business but do not attach to any specific assets. Note that interest must be capitalized in this situation (see chapter 10) because the building requires a period of time to get it ready for its intended use. The amount of interest cost for the first nine months of 2014 is the measure of the 2014 loss resulting from the tornado. The extension of the construction period to October 2014 because of the tornado does not warrant its capitalization as construction period interest. It is in effect an uninsured loss resulting from the tornado. Had it not been for the tornado, the entire amount would have been a normal operating expense chargeable against the rental revenue that would have been earned during the first nine months of 2014. Cost of obtaining tenants. Both the 2013 and 2014 costs of obtaining tenants should be expensed as incurred. The cost of obtaining tenants is a start-up cost. The accounting for start-up costs is straightforward—expense these costs as incurred. The profession recognizes that these costs are incurred with the expectation that future revenues will occur or increased efficiencies will result. However, to determine the amount and timing of future benefits is so difficult that a conservative approach—expense these costs as incurred—is required. Promotional advertising. The profession has concluded that, except in limited situations, future benefits from advertising are not sufficiently defined or measurable with a degree of reliability that is required to recognize these costs as an asset. As a result, the costs should be expensed as incurred or the first time the advertising takes place. The advertising costs incurred in 2014 might be reported as a loss to indicate that an unusual event caused this additional expense.
CA 12-2 (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. (b) 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
CA 12-2 (Continued) 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, $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. (d) 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 Ferry 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 Ferry Company’s production. Other valuation bases that have been suggested are current cash equivalent or fair market value. (e) 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. (f)
The litigation can and 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.
CA 12-2 (Continued) 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.
CA 12-3 (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.” (b) 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. (The authoritative guidance for R&D (FASB ASC 730-10-25) does not apply to activities that are unique to enterprises in the extractive industries. Accounting for the costs of research and development activities conducted for others under a contractual arrangement is a part of accounting for contracts in general and is addressed in other literature See FASB ASC 730-20-5.) 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 ($315,000). The remaining $585,000 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.
CA 12-4 (a) Investors and creditors are concerned with corporate profits, dividends, and cash flow. Employees in Czeslaw Corporation’s R&D department are concerned about job security if the company begins to hire outside firms rather than have work done internally. Reid must be concerned with his performance and reputation within the company as well. (b) Ethical issues include long-term versus short-term profits, concern for job security, loyalty to fellow employees, and an efficient operation. (c) Reid should do what is best for Czeslaw Corporation in the long run. He should choose to have the project done where the work will be done well and at the lowest cost. Whether expenses will appear in the income statement immediately or will be capitalized and allocated over a period of years should NOT be the driving factor in making the decision. He should be able to explain his decision to higherups and illustrate the different required accounting treatments. He also should give some thought to the impact on employee morale if he does not use the company’s own R&D department.
FINANCIAL REPORTING PROBLEM (a)
P&G reports Goodwill of $57,562 million for 2011. P&G also reports (net of amortization) Trademarks and other intangible assets of $32,620 million in 2011.
(b)
P&G spent $2,001 million on research and development in 2011 and $1,950 million in 2010. In 2011, P&G spent 2.42% ($2,001/$82,559) of its sales on research and development costs. As a percent of net income, it spent 16.96% ($2,001/$11,797) of its net income on research and development. For 2010, the figures were 2.47% ($1,950/$78,938) of sales and 15.31% ($1,950/$12,736) of net income.
COMPARATIVE ANALYSIS CASE (a)
(b)
(1) Coca-Cola reports: Trademarks, Goodwill and Other Intangible Assets . . . $27,669M. PepsiCo reports: Amortizable Intangible Assets (net) Goodwill and Other Non-Amortizable Intangible Assets of $33,245M. (2)
Coca-Cola: Intangible assets are 34.60% of total assets. PepsiCo: Intangible assets are 45.61% of total assets.
(3)
At Coca-Cola, intangible assets increased $2,024M from $25,645M to $27,669M. At PepsiCo, intangibles increased $4,776M from $28,469M to $33,245M.
(1) Coca-Cola amortizes intangible assets that are deemed to have definite lives over their useful life primarily on a straight-line basis. PepsiCo amortizes amortizable intangible assets on a straightline basis over their estimated useful lives. (2)
Coca-Cola had accumulated amortization of $445M and $316M on December 31, 2011 and 2010, respectively. PepsiCo had accumulated amortization of $1,332M and $1,244M at year-end 2011 and 2010, respectively.
(3)
Coca-Cola identified the composition of its intangible assets as follows: Trademarks with indefinite lives Goodwill Other intangible assets
$ 6,430M 12,219 9,020 $27,669M
PepsiCo identified its intangible assets as follows: Amortizable intangible assets Goodwill Other nonamortizable intangible assets
$ 11,742M 16,800 4,703 $ 33,245M
FINANCIAL STATEMENT ANALYSIS CASE 1
MERCK AND JOHNSON & JOHNSON (a)
The primary intangible assets of a healthcare products company would probably be patents, goodwill and trademarks. The nature of each of these is quite different; thus, an investor would normally want to know what the composition of intangible assets is if it is material.
(b)
Many corporate executives complain that investors are too concerned about the short-term and don’t reward good long-term planning. As a consequence, they feel that the requirement that research and development expenditures be expensed immediately penalizes those executives who do invest in the future. As a consequence, when net income does not look good, it is always tempting to cut research and development expenditures, since this will cause a direct increase in current year reported profits. Of course, it will also diminish the company’s longterm prospects.
(c)
If a company reports goodwill on its balance sheet, it can only have resulted from one thing—the company must have purchased another company. This is because companies are not allowed to record internally created goodwill. They can only report purchased goodwill. Ironically, if you want to report a large amount of goodwill, all you have to do is overpay when you purchase another company—the more you overpay, the more goodwill you will report. Obviously, reporting a lot of goodwill is not such a good thing.
FINANCIAL STATEMENT ANALYSIS CASE 2 (a)
The depressed market values (less than book value) suggest that market participants are not very optimistic about the future prospects for these companies. Accounting numbers are based in many cases on historical costs, while market prices will reflect new information about the company prospects. This situation does not look very promising.
(b)
Because the market (fair) value of each company is less than its book value of its net assets, it fails the first step in the goodwill impairment test; an impairment should be recorded. A
B
C
D
E
F
G
H
(Columns C–D) (Columns B–F) (Columns D–G)
Company
Carrying
Estimated Fair
Implied GW
Market Book Value Value of
Value of Net
(NA-Market
Goodwill
Assets
Value)
Impairment
Value
(Net Assets) Goodwill ROA
Sprint Nextel
$36,361
$51,271
$30,718
3.5%
$20,553
$15,808
$14,910
Washington Mutual
11,742
23,941
9,062
2.4%
14,879
0
9,062
E Trade Financial
1,639
4,104
2,035
5.6%
2,069
0
2,035
Total
$26,007
(c)
As indicated in the expanded spreadsheet above, unless their market values increases dramatically, each of these companies is likely to recognize a goodwill impairment. For Washington Mutual and E-Trade, the impairment will result in a complete write-off of the goodwill asset. Apparently, the prior acquisitions from which the goodwill was recorded did not pan out for these companies. Loss on Impairment .............................................. Goodwill .........................................................
(d)
26,007 26,007
Impairment losses are reported in operating income. Thus, the impairments will reduce the numerator in the return on asset ratio. Without recognition of the impairments, these companies’ operating performance is overstated relative to companies in their cohort.
ACCOUNTING, ANALYSIS, AND PRINCIPLES Accounting There is a full year of amortization on the copyright. There is no amortization for the trade name, which is considered an indefinite-life intangible. Amortization expense = $15,000/10 = $1,500 Amortization Expense............................................... Copyrights ........................................................
1,500 1,500
The recoverability test for the copyright indicates that the copyright is not impaired: The expected cash flows (undiscounted) of $20,000 are greater than the carrying value of $13,500 ($15,000 – $1,500). The trade name is tested for impairment using a fair value test. Thus, Raconteur writes it down to the fair value of $5,000, recording an impairment charge of $8,500 – $5,000 = $3,500. Lost on Impairment ................................................... Trade Names.....................................................
3,500 3,500
Analysis Impairment losses are recorded in operating income. Because impairments tend to be nonrecurring items, their recognition can make operating income more volatile from year to year. This volatility effect can be particularly severe for indefinite-life intangibles, such as a trade name or goodwill. The higher carrying values (due to no amortization), combined with the annual fair-value impairment test, can result in impairment losses having a significant impact on operating income. Principles The accounting for impairments provides relevant information about intangible assets by indicating in a timely fashion that intangible assets have declined in value. However, providing this timely information requires significant subjective judgments related to estimating (1) expected cash flows for the cash flow recovery test and (2) fair values in determining the amount of the impairment to be recognized. These estimates may raise concerns about the faithful representation of impairment-loss amounts.
PROFESSIONAL RESEARCH (a)
FASB ASC 350-10-05. Codification String: Assets > 350 Intangibles – Goodwill and other >10 Overall > 05 Overview and Background
(b)
Codification String: Assets > 350 Intangibles – Goodwill and other > 10 Overall > 20 Glossary Goodwill An asset representing the future economic benefits arising from other assets acquired in a business combination or an acquisition by a notfor-profit entity that are not individually identified and separately recognized. For ease of reference, this term also includes the immediate charge recognized by not-for-profit entities in accordance with paragraph 958-805-25-29.
(c)
Overall Accounting for Goodwill: Codification String; Assets > 350 Intangibles – Goodwill and other > 20 Goodwill > 35 Subsequent Measurement. 35-1 Goodwill shall not be amortized. Instead, goodwill shall be tested for impairment at a level of reporting referred to as a reporting unit. (Paragraphs 350-20-35-33 through 35-46 provide guidance on determining reporting units.)
(d)
Codification String: Assets > 350 Intangibles – Goodwill and other > 20 Goodwill > 35 Subsequent Measurement 35-48 All goodwill recognized by a public or nonpublic subsidiary (subsidiary goodwill) in its separate financial statements that are prepared in accordance with generally accepted accounting principles (GAAP) shall be accounted for in accordance with this Subtopic. Subsidiary goodwill shall be tested for impairment at the subsidiary level using the subsidiary’s reporting units. If a goodwill impairment loss is recognized at the subsidiary level, goodwill of the reporting unit or units (at the higher consolidated level) in which the subsidiary’s reporting unit
PROFESSIONAL RESEARCH (Continued) with impaired goodwill resides must be tested for impairment if the event that gave rise to the loss at the subsidiary level would more likely than not reduce the fair value of the reporting unit (at the higher consolidated level) below its carrying amount (see paragraph 350-20-35-30(g)). Only if goodwill of that higherlevel reporting unit is impaired would a goodwill impairment loss be recognized at the consolidated level.
PROFESSIONAL SIMULATION Journal Entries January 2, 2014 Patents .............................................................. Cash............................................................
80,000
July 1, 2014 Patents .............................................................. Cash............................................................
11,400
December 31, 2014 Amortization Expense...................................... Patents .......................................................
8,600
80,000
11,400
8,600
Computation of patent expense: $80,000 X 12/120 = $11,400 X 6/114 = Total
$8,000 600 $8,600
Measurement Computation of impairment loss: Cost ................................................................... Less: Accumulated amortization ................... Book value ........................................................
$42,000 7,875* $34,125
*$42,000 X 18/96 = $7,875 The book value of $34,125 is greater than net cash flows of $25,000. Therefore the franchise is impaired. The impairment loss is computed as follows: Book value ........................................................ Less: Fair value ............................................... Loss on impairment .........................................
$34,125 13,000 $21,125
PROFESSIONAL SIMULATION (Continued) Financial Statements Intangible assets as of December 31, 2013 Franchises ........................................................
$39,375*
*Cost.................................................................. Less: Accumulated amortization.................... Total...................................................................
$42,000 2,625** $39,375
**$42,000 X 6/96 = $2,625 Note that the net loss and all organization costs are expensed in 2013. Intangible assets as of December 31, 2014 Franchises ........................................................ Patents ($80,000 + $11,400 – $8,600)............... Goodwill ............................................................ Total intangible assets .....................................
$ 13,000 82,800 180,000 $275,800
Note that all the costs to develop the secret formula and the research and development costs are expensed as incurred.
IFRS CONCEPTS AND APPLICATION IFRS12-1 IFRS guidance related to intangible assets is presented in IAS 38, “Intangible Assets.” IFRS related to impairments is found in IAS 36, “Impairment of Assets.” IFRS12-2 Similarities include (1) in GAAP and IFRS, the costs associated with research and development are segregated into the two components; (2) IFRS and GAAP are similar for intangibles acquired in a business combination. That is, an intangible asset is recognized separately from goodwill if it represents contractual or legal rights or is capable of being separated or divided and sold, transferred, licensed, rented or exchanged; (3) Under both IFRS and GAAP, limited life intangibles are subject to amortization, but goodwill and indefinite life intangibles are not amortized; rather they are assessed for impairment on an annual basis; (4) IFRS and GAAP are similar in the accounting for impairments of assets held for disposal. Notable differences are: (1) while costs in the research phase are always expensed under both IFRS and GAAP, under IFRS costs in the development phase are capitalized once technological feasibility is achieved; (2) IFRS permits some capitalization of internally generated intangible assets (e.g., brand value), if it is probable there will be a future benefit and the amount can be reliably measured. GAAP requires expensing of all costs associated with internally generated intangibles; (3) IFRS requires an impairment test at each reporting date for long-lived assets and intangibles and records an impairment if the asset’s carrying amount exceeds its recoverable amount; the recoverable amount is the higher of the asset’s fair value less costs to sell and its value in use. Value in use is the future cash flows to be derived from the particular asset, discounted to present value. Under GAAP, impairment loss is measured as the excess of the carrying amount over the asset’s fair value; and (4) IFRS allows reversal of impairment losses for limited life intangibles when there has been a change in economic conditions or in the expected use of the asset. Under GAAP, impairment losses cannot be reversed for assets to be held and used; the impairment loss results in a new cost basis for the asset.
IFRS12-3 The IASB and FASB have identified a project, in a very preliminary stage, which would consider expanded recognition of internally generated intangible assets. As indicated, IFRS permits more recognition of internallygenerated intangibles compared to GAAP. Thus, it will be challenging to develop converged standards for intangible assets, given the long-standing prohibition on capitalizing internally-generated intangible assets and research and development in GAAP. Learn more about the timeline for the intangible asset project at the IASB website: http://www.iasb.org/current_ Projects/IASB_Projects/IASB_Work_Plan.htm.
IFRS12-4 Research and Development Expense ...................... Intangible Assets....................................................... Accounts Payable ............................................
430,000 75,000 505,000
IFRS12-5 (a) (b) (c) (d) (e)
Capitalize Expense Capitalize Expense Expense
IFRS12-6 Loss on Impairment .................................................. Patents ($300,000 – $110,000) .........................
190,000 190,000
IFRS12-7 Patents [$130,000 – ($110,000 – $11,000)] ............... Recovery of Loss from Impairment.................
31,000 31,000
IFRS12-8 Because the recoverable amount of the division exceeds the carrying amount of the assets, goodwill is not considered to be impaired. No entry is necessary. IFRS12-9 Loss on Impairment .................................................. Goodwill ($800,000 – $750,000) .......................
50,000 50,000
The recoverable amount of the reporting unit ($750,000) is less than the carrying value ($800,000)—an impairment has occurred. The loss is the difference between the recoverable amount and the carrying value. IFRS12-10 (a) In accordance with IFRS, the $325,000 is a research and development cost that should be charged to R&D Expense and, if not separately disclosed in the income statement, the total cost of R&D should be separately disclosed in the notes to the financial statements. (b) Patents ................................................................ Research and Development Expense............... Cash ........................................................... (to record research and development costs)
36,000 94,000
Patents ................................................................ Cash ........................................................... (To record legal and administrative costs incurred to obtain patent #472-1001-84)
24,000
Amortization Expense........................................ Patents ($60,000 / 5 years) ........................
12,000
130,000
24,000
12,000
IFRS12-10 (Continued) (c) Patents ....................................................................... Cash .................................................................. (To record legal costs of successfully defending patent)
47,200 47,200
Note: The cost of defending the patent is capitalized because the defense was successful and because it extended the useful life of the patent. Amortization Expense............................................... Patents..............................................................
11,900 11,900
(To record one year’s amortization expense: $60,000 – $12,000 = $48,000; $48,000 ÷ 8 = $6,000 $47,200 ÷ 8 = $5,900 Amortization expense for 2012; $6,000 + $5,900 = $11,900) Or Carrying value after 1 year $48,000 + Cost to defend $47,200 = $95,200 Expense: $95,200 ÷ 8 = $11,900 (d)
Additional engineering and consulting costs required to advance the design of a product to the manufacturing stage are R&D costs. As indicated in the chapter it is R&D because it translates knowledge into a plan or design for a new product. Given the uncertain market, economic viability is not met and these costs should be expensed as incurred.
IFRS12-11 (a)
IFRS 3 addresses goodwill, while IAS 38 addresses intangible assets.
(b)
IFRS 3 defines goodwill as “an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognised.” (Appendix A IFRS 3).
(c)
No, goodwill is not amortized. However, it is subject to impairment, as discussed in IAS 36.
IFRS12-11 (Continued) (d)
Goodwill recognised in a business combination is an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognised. Goodwill does not generate cash flows independently of other assets or groups of assets, and often contributes to the cash flows of multiple cash-generating units. Goodwill sometimes cannot be allocated on a non-arbitrary basis to individual cash-generating units, but only to groups of cashgenerating units. As a result, the lowest level within the entity at which the goodwill is monitored for internal management purposes sometimes comprises a number of cashgene rating units to which the goodwill relates, but to which it cannot be allocated. References in paragraphs 83–99 and Appendix C to a cash-generating unit to which goodwill is allocated should be read as references also to a group of cash-generating units to which goodwill is allocated (IAS 36, par. 81). Applying the requirements in paragraph 80 results in goodwill being tested for impairment at a level that reflects the way an entity manages its operations and with which the goodwill would naturally be associated. Therefore, the development of additional reporting systems is typically not necessary (par. 82). A cash-generating unit to which goodwill is allocated for the purpose of impairment testing may not coincide with the level at which goodwill is allocated in accordance with IAS 21 The Effects of Changes in Foreign Exchange Rates for the purpose of measuring foreign currency gains and losses. For example, if an entity is required by IAS 21 to allocate goodwill to relatively low levels for the purpose of measuring foreign currency gains and losses, it is not required to test the goodwill for impairment at that same level unless it also monitors the goodwill at that level for internal management purposes (par. 83). If the initial allocation of goodwill acquired in a business combination cannot be completed before the end of the annual period in which the business combination is effected, that initial allocation shall be completed before the end of the first annual period beginning after the acquisition date (par. 84).
IFRS12-11 (Continued) In accordance with IFRS 3 Business Combinations, if the initial accounting for a business combination can be determined only provisionally by the end of the period in which the combination is effected, the acquirer: a.
accounts for the combination using those provisional values; and
b.
recognises any adjustments to those provisional values as a result of completing the initial accounting within the measurement period, which will not exceed twelve months from the acquisition date.
In such circumstances it might also not be possible to complete the initial allocation of the goodwill recognised in the combination before the end of the annual period in which the combination is effected. When this is the case, the entity discloses the information required by paragraph 133 (par. 85).
IFRS12-12 (a)
M&S shows Intangible Assets on the statement of financial position. In its footnotes, M&S reposts Goodwill, Brands, and Computer Software. Goodwill of £584.3 million was reported at 31 March 2012.
(b)
M&S reported selling and administrative expenses of £3,021.9 million in 2012 and £2,959.7 million in 2011. These expenses were significant compared to M&S‘s revenue—80% of gross profit in 2012 and 79% in 2011.
CHAPTER 13 Current Liabilities and Contingencies ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics
Questions
Brief Exercises
Exercises
Problems
Concepts for Analysis
1, 16
1, 2
1, 2
1, 2
1, 2
1. Concept of liabilities; definition and classification of current liabilities.
1, 2, 3, 4, 6, 8
2.
Accounts and notes payable; dividends payable.
7, 11
1, 2, 3
2, 16
3.
Short-term obligations expected to be refinanced.
9, 10
4
3, 4
4.
Deposits and advance payments.
5, 12
5
5.
Compensated absences and bonuses.
13, 14, 15
8, 9
5, 6, 16
6. Collections for third parties.
16
6, 7
7, 8, 9, 16
3, 4
7. Contingent liabilities (General).
17, 18, 19, 20, 22
10, 11
13, 16
10, 11, 13
4, 5, 6
8. Guaranties and warranties.
21, 23
13, 14
10, 11, 16
5, 6, 7, 12, 14
6, 7
9.
Premiums and awards offered to customers.
24, 25
15
12, 15, 16
8, 9, 12, 14
10.
Self-insurance, litigation, claims, and assessments, asset retirement obligations.
26, 27, 28
10, 11, 12
14
2, 10, 11, 13
5, 6
11.
Presentation and analysis.
29, 30, 31
17, 18, 19
9
3
3 2
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)
Problems
Concepts for Analysis
1, 2
CA13-1
Learning Objectives Questions
Brief Exercises
Exercises
1.
Describe the nature, type, and valuation of current liabilities.
1,2,3,4,7,8
1, 2, 3, 4, 5, 6
1, 2, 7
2.
Explain the classification issues of shortterm debt expected to be refinanced.
5,6,9,10,11 ,12
4
3, 4
3.
Identify types of employeerelated liabilities.
13,14
7, 8, 9
5, 6, 8, 9
3, 4
4.
Identify the criteria used to account for and disclose gain and loss contingencies.
15,16
10, 11, 12, 13, 14, 15
13
7, 10, 11, 13
CA13-4, CA13-5
5.
Explain the accounting for different types of loss contingencies.
17, 18,19, 20,21, 22, 23, 24, 25, 26, 27, 28
10, 11, 12, 13, 14, 15
10, 11, 12, 13, 14, 15
2, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14
CA13-6, CA13-7
6.
Indicate how to present and analyze liabilities and contingencies.
29,30,31
16, 17, 18, 19
9
CA13-2, CA13-3
ASSIGNMENT CHARACTERISTICS TABLE Item
Description
Level of Difficulty
Time (minutes)
E13-1 E13-2 E13-3 E13-4 E13-5 E13-6 E13-7 E13-8 E13-9 E13-10 E13-11 E13-12 E13-13 E13-14 E13-15 E13-16 E13-17 E13-18 E13-19
Balance sheet classification of various liabilities. Accounts and notes payable. Refinancing of short-term debt. Refinancing of short-term debt. Compensated absences. Compensated absences. Adjusting entry for sales tax. Payroll tax entries. Payroll tax entries. Warranties. Warranties. Premium entries. Contingencies. Asset retirement obligation. Premiums. Financial statement impact of liability transactions. Ratio computations and discussion. Ratio computations and analysis. Ratio computations and effect of transactions.
Simple Moderate Simple Simple Moderate Moderate Simple Simple Simple Simple Moderate Simple Moderate Moderate Moderate Moderate Simple Simple Moderate
10–15 15–20 10–12 20–25 25–30 25–30 5–7 10–15 15–20 10–15 15–20 15–20 20–30 25–30 25–35 30–35 15–20 20–25 15–25
P13-1 P13-2 P13-3 P13-4 P13-5 P13-6 P13-7 P13-8 P13-9 P13-10 P13-11 P13-12 P13-13 P13-14
Current liability entries and adjustments. Liability entries and adjustments. Payroll tax entries. Payroll tax entries. Warranties, accrual, and cash basis. Extended warranties. Warranties, accrual, and cash basis. Premium entries. Premium entries and financial statement presentation. Loss contingencies: entries and essay. Loss contingencies: entries and essays. Warranties and premiums. Liability errors. Warranty and coupon computation.
Simple Simple Moderate Simple Simple Simple Moderate Moderate Moderate Simple Moderate Moderate Moderate Moderate
25–30 25–35 20–30 20–25 15–20 10–20 25–35 15–25 30–45 25–30 35–45 20–30 25–35 20–25
CA13-1 CA13-2 CA13-3 CA13-4 CA13-5 CA13-6 CA13-7
Nature of liabilities. Current versus noncurrent classification. Refinancing of short-term debt. Loss contingencies. Loss contingency. Warranties and loss contingencies. Warranties.
Moderate Moderate Moderate Simple Simple Simple Moderate
20–25 15–20 30–40 15–20 15–20 15–20 20–25
SOLUTIONS TO CODIFICATION EXERCISES CE13-1 Master Glossary (a)
An asset retirement is an obligation associated with the retirement of a tangible long-lived asset.
(b)
Current liabilities is used principally to designate obligations whose liquidation is reasonably expected to require the use of existing resources properly classifiable as current assets, or the creation of other current liabilities. See paragraphs 210-10-45-5 through 45-12.
(c)
Reasonably possible means the chance of the future event or events occurring is more than remote but less than likely.
(d)
A warranty is a guarantee for which the underlying is related to the performance (regarding function, not price) of nonfinancial assets that are owned by the guaranteed party. The obligation may be incurred in connection with the sale of goods or services; if so, it may require further performance by the seller after the sale has taken place.
CE13-2 According to FASB ASC 410-20-50 (Asset Retirement and Environmental Obligations): 50-1 An entity shall disclose all of the following information about its asset retirement obligations: (a)
A general description of the asset retirement obligations and the associated long-lived assets
(b)
The fair value of assets that are legally restricted for purposes of settling asset retirement obligations
(c)
A reconciliation of the beginning and ending aggregate carrying amount of asset retirement obligations showing separately the changes attributable to the following components, whenever there is a significant change in any of these components during the reporting period: 1. 2. 3. 4.
Liabilities incurred in the current period Liabilities settled in the current period Accretion expense Revisions in estimated cash flows.
50-2 If the fair value of an asset retirement obligation cannot be reasonably estimated, that
fact and the reasons therefor shall be disclosed.
CE13-3 According to FASB ASC 450-10-55 (Contingencies —Implementation Guidance and Illustrations): Depreciation 55-2
The fact that estimates are used to allocate the known cost of a depreciable asset over the period of use by an entity does not make depreciation a contingency; the eventual expiration of the utility of the asset is not uncertain. Thus, depreciation of assets is not a contingency, nor are such matters as recurring repairs, maintenance, and overhauls, which interrelate with depreciation. This Topic is not intended to alter depreciation practices as described in Section 360-10-35.
Estimates Used in Accruals 55-3
Amounts owed for services received, such as advertising and utilities, are not contingencies even though the accrued amounts may have been estimated; there is nothing uncertain about the fact that those obligations have been incurred.
Changes in Tax Law 55-4
The possibility of a change in the tax law in some future year is not an uncertainty.
CE13-4 According to FASB ASC 710-10-25-1 (Compensation Recognition—Compensated Absences), an employer must accrue a liability for employees’ compensation for future absences if all of the following conditions are met: (a)
The employer’s obligation relating to employees’ rights to receive compensation for future absences is attributable to employees’ services already rendered.
(b)
The obligation relates to rights that vest or accumulate. Vested rights are those for which the employer has an obligation to make payment even if an employee terminates; thus, they are not contingent on an employee’s future service. Accumulate means that earned but unused rights to compensated absences may be carried forward to one or more periods subsequent to that in which they are earned, even though there may be a limit to the amount that can be carried forward.
(c)
Payment of the compensation is probable.
(d)
The amount can be reasonably estimated.
ANSWERS TO QUESTIONS 1. Current liabilities are obligations whose liquidation is reasonably expected to require use of existing resources properly classified as current assets, or the creation of other current liabilities. Long-term debt consists of all liabilities not properly classified as current liabilities. 2. You might explain to your friend that the accounting profession at one time prepared financial statements somewhat in accordance with the broad or loose definition of a liability submitted by the AICPA in 1953: “Something represented by a credit balance that is or would be properly carried forward upon a closing of books of account according to the rules or principles of accounting, provided such credit balance is not in effect a negative balance applicable to an asset. Thus the word is used broadly to comprise not only items which constitute liabilities in the proper sense of debts or obligations (including provision for those that are unascertained), but also credit balances to be accounted for which do not involve the debtor and creditor relation.” Since your friend may not have completely understood the above definition (if it may be called that), you might indicate that more recent definitions of liabilities call for the disbursement of assets or services in the future and that the present value of all of a person’s or company’s future disbursements of assets constitutes the total liabilities of that person or company. But, accountants quantify or measure only those liabilities or future disbursements which are reasonably determinable at the present time. And, accountants have accepted the completed transaction as providing the objectivity or basis necessary for financial recognition. Therefore, a liability may be viewed as an obligation to convey assets or perform services at some time in the future and is based upon a past or present transaction or event. A formal definition of liabilities presented in Concepts Statement No. 6 is as follows: 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. 3. As a lender of money, the banker is interested in the priority his/her claim has on the company’s assets relative to other claims. Close examination of the liability section and the related footnotes discloses amounts, maturity dates, collateral, subordinations, and restrictions of existing contractual obligations, all of which are important to potential creditors. The assets and earning power are likewise important to a banker considering a loan. 4. Current liabilities are obligations whose liquidation is reasonably expected to require the use of existing resources properly classified as current assets, or the creation of other current liabilities. Because current liabilities are by definition tied to current assets and current assets by definition are tied to the operating cycle, liabilities are related to the operating cycle. 5. Unearned revenue is a liability that arises from current sales but for which some services or products are owed to customers in the future. At the time of a sale, customers pay not only for the delivered product, but they also pay for future products or services (e.g., another plane trip, hotel room, or software upgrade). In this case, the company recognizes revenue from the current product and part of the sale proceeds is recorded as a liability (unearned revenue) for the value of future products or services that are “owed” to customers. Market analysts indicate that an increase in the unearned revenue liability, rather than raising a red flag, often provides a positive signal about sales and profitability. When the sales are growing, its unearned revenue account should grow. Thus, an increase in a liability may be good news about company performance. In contrast, when unearned revenues decline, the company owes less future amounts but this also means that sales of new products may have slowed. 6. Payables and receivables generally involve an interest element. Recognition of the interest element (the cost of money as a factor of time and risk) results in valuing future payments at their current value. The present value of a liability represents the debt exclusive of the interest factor.
Questions Chapter 13 (Continued) 7. A discount on notes payable represents the difference between the present value and the face value of the note, the face value being greater in amount than the discounted amount. It should be treated as an offset (contra) to the face value of the note and amortized to interest expense over the life of the note. The discount represents interest expense chargeable to future periods. 8. Liabilities that are due on demand (callable by the creditor) should be classified as a current liability. Classification of the debt as current is required because it is a reasonable expectation that existing working capital will be used to satisfy the debt. Liabilities often become callable by the creditor when there is a violation of the debt agreement. Only if it can be shown that it is probable that the violation will be cured (satisfied) within the grace period usually given in these agreements can the debt be classified as noncurrent. 9. An enterprise should exclude a short-term obligation from current liabilities only if (1) it intends to refinance the obligation on a long-term basis, and (2) it demonstrates an ability to consummate the refinancing. 10. The ability to consummate the refinancing may be demonstrated (i) by actually refinancing the shortterm obligation by issuing a long-term obligation or equity securities after the date of the balance sheet but before it is issued, or (ii) by entering into a financing agreement that clearly permits the company to refinance the debt on a long-term basis on terms that are readily determinable. 11. A cash dividend formally authorized by the board of directors would be recorded by a debit to Retained Earnings and a credit to Dividends Payable. The Dividends Payable account should be classified as a current liability. An accumulated but undeclared dividend on cumulative preferred stock is not recorded in the accounts as a liability until declared by the board, but such arrearages should be disclosed either by a footnote to the balance sheet or parenthetically in the capital stock section. A stock dividend distributable, formally authorized and declared by the board, does not appear as a liability because a stock dividend does not require future outlays of assets or services and is revocable by the board prior to issuance. Even so, an undistributed stock dividend is generally reported in the stockholders’ equity section since it represents retained earnings in the process of transfer to paid-in capital. 12. Unearned revenue arises when a company receives cash or other assets as payment from a customer before conveying (or even producing) the goods or performing the services which it has committed to the customer. Unearned revenue is assumed to represent the obligation to the customer to refund the assets received in the case of nonperformance or to perform according to the agreement and thus earn the unrestricted right to the assets received. While there may be an element of unrealized profit included among the liabilities when unearned revenues are classified as such, it is ignored on the grounds that the amount of unrealized profit is uncertain and usually not material relative to the total obligation. Unearned revenues arise from the following activities: (1) The sale by a transportation company of tickets or tokens that may be exchanged or used to pay for future fares. (2) The sale by a restaurant of meal tickets that may be exchanged or used to pay for future meals. (3) The sale of gift certificates by a retail store. (4) The sale of season tickets to sports or entertainment events. (5) The sale of subscriptions to magazines.
Questions Chapter 13 (Continued) 13. Compensated absences are employee absences such as vacation, illness, and holidays for which it is expected that employees will be paid. 14. A liability should be accrued for the cost of compensated absences if all of the following conditions are met: (a) The employer’s obligation relating to employees’ rights to receive compensation for future absences is attributable to employees’ services already rendered. (b) The obligation relates to the rights that vest or accumulate. (c) Payment of the compensation is probable. (d) The amount can be reasonably estimated. If an employer meets conditions (a), (b), and (c), but does not accrue a liability because of failure to meet condition (d), that fact should be disclosed. 15. An employer is required to accrue a liability for “sick pay” that employees are allowed to accumulate and use as compensated time off even if their absence is not due to illness. An employer is permitted but not required to accrue to liability for sick pay that employees are allowed to claim only as a result of actual illness. 16. Employers generally withhold from each employee’s wages amounts to cover income taxes (withholding), the employee’s share of FICA taxes, and other items such as union dues or health insurance. In addition, the employer must set aside amounts to cover the employer’s share of FICA taxes and state and federal unemployment taxes. These latter amounts are recorded as payroll expenses and will lower Battle’s income. In addition, the amount set aside (both the employee and the employer share) will be reported as current liabilities until they are remitted to the appropriate third party. 17. (a) A contingency is defined as an existing condition, situation, or set of circumstances involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. (b) A contingent liability is a liability incurred as a result of a loss contingency. 18. A contingent liability should be recorded and a charge accrued to expense only if: (a) information available prior to the issuance of the financial statements indicates that it is probable that a liability has been incurred at the date of the financial statements, and (b) the amount of the loss can be reasonably estimated. 19. A determinable current liability is susceptible to precise measurement because the date of payment, the payee, and the amount of cash needed to discharge the obligation are reasonably certain. There is nothing uncertain about (1) the fact that the obligation has been incurred and (2) the amount of the obligation. A contingent liability is an obligation that is dependent upon the occurrence or nonoccurrence of one or more future events to confirm the amount payable, the payee, the date payable, or its existence. It is a liability dependent upon a “loss contingency.” Determinable current liabilities—accounts payable, notes payable, current maturities of longterm debt, dividends payable, returnable deposits, sales and use taxes, payroll taxes, and accrued expenses. Contingent liabilities—obligations related to product warranties and product defects, premiums offered to customers, certain pending or threatened litigation, certain actual and possible claims and assessments, and certain guarantees of indebtedness of others.
Questions Chapter 13 (Continued) 20. The terms probable, reasonably possible, and remote are used in GAAP to denote the chances of a future event occurring, the result of which is a gain or loss to the enterprise. If it is probable that a loss has been incurred at the date of the financial statements, then the liability (if reasonably estimable) should be recorded. If it is reasonably possible that a loss has been incurred at the date of the financial statements, then the liability should be disclosed via a footnote. The footnote should disclose (1) the nature of the contingency and (2) an estimate of the possible loss or range of loss or a statement that an estimate cannot be made. If the incurrence of a loss is remote, then no liability need be recorded or disclosed (except for guarantees of indebtedness of others, which are disclosed even when the loss is remote). 21. Under the cash-basis method, warranty costs are charged to expense in the period in which the seller or manufacturer performs in compliance with the warranty, no liability is recorded for future costs arising from warranties, and the period of sale is not necessarily charged with the costs of making good on outstanding warranties. Under the accrual method, a provision for warranty costs is made at the time of sale or as the productive activity takes place; the accrual method may be applied two different ways: expense warranty versus sales warranty method. But under either method, the attempt is to match warranty expense to the related revenues. 22. Under U.S. GAAP, companies may not record provisions for future operating losses. Such provisions do not meet the definition of a liability, since the amount is not the result of a past transaction (the losses have not yet occurred). Therefore the liability has not been incurred. Furthermore, operating losses reflect general business risks for which a reasonable estimate of the loss could not be determined. Note that use of provisions in this way is one of the examples of earnings management discussed in Chapter 4. By reducing income in good years through the use of loss contingencies, companies can smooth out their income from year-to-year. 23. The expense warranty approach and the sales warranty approach are both variations of the accrual method of accounting for warranty costs. The expense warranty approach charges the estimated future warranty costs to operating expense in the year of sale or manufacture. The sales warranty approach defers a certain percentage of the original sales price until some future time when actual costs are incurred or the warranty expires. 24. Southeast Airlines Inc.’s award plan is in essence a discounted ticket sale. Therefore, the full-fare ticket should be recorded as unearned transportation revenue (liability) when sold and recognized as revenue when the transportation is provided. The half-fare ticket should be treated accordingly; that is, record the discounted price as unearned transportation revenue (liability) when it is sold and recognize it as revenue when the transportation is provided. 25. Although the accounting for this transaction has been studied, no authoritative guideline has been developed to record this transaction. In the case of a free ticket award, AcSEC proposed that a portion of the ticket fares contributing to the accumulation of the 50,000 miles (the free ticket award level) be deferred as unearned transportation revenue and recognized as revenue when free transportation is provided. The total amount deferred for the free ticket should be based on the revenue value to the airline and the deferral should occur and accumulate as mileage is accumulated. 26. An asset retirement obligation must be recognized when a company has an existing legal obligation associated with the retirement of a long-lived asset and when the amount can be reasonably estimated. 27. The absence of insurance does not mean that a liability has been incurred at the date of the financial statements. Until the time that an event (loss contingency) occurs there can be no diminution in the value of property or incurrence of a liability. If an event has occurred which exposes an enterprise to risks of injury to others and/or damage to the property of others, then a contingency exists. Expected future injury, damage, or loss resulting from lack of insurance need not be recorded or disclosed if no contingency exists. And, a contingency exists only if an uninsurable event which causes probable loss has occurred. Lack of insurance is not in itself a basis for recording a liability or loss.
Questions Chapter 13 (Continued) 28. In determining whether or not to record a liability for pending litigation, the following factors must be considered: (a) The time period in which the underlying cause for action occurred. (b) The probability of an unfavorable outcome. (c) The ability to make a reasonable estimate of the amount of loss. Before recording a liability for threatened litigation, the company must determine: (a) The degree of probability that a suit may be filed, and (b) The probability of an unfavorable outcome. If both are probable, the loss reasonably estimable, and the cause for action dated on or before the date of the financial statements, the liability must be accrued. 29. There are several defensible recommendations for listing current liabilities: (1) in order of maturity, (2) according to amount, (3) in order of liquidation preference. The authors’ recent review of published financial statements disclosed that a significant majority of the published financial statements examined listed “notes payable” first, regardless of relative amount, followed most often by “accounts payable,” and ending the current liability section with “current portion of long-term debt.” 30. The acid-test ratio and the current ratio are both measures of the short-term debt-paying ability of the company. The acid-test ratio excludes inventories and prepaid expenses on the basis that these assets are difficult to liquidate in an emergency. The current ratio and the acid-test ratio are similar in that both numerators include cash, short-term investments, and net receivables, and both denominators include current liabilities. 31. (a) A liability for goods purchased on credit should be recorded when title passes to the purchaser. If the terms of purchase are f.o.b. destination, title passes when the goods purchased arrive; if f.o.b. shipping point, title passes when shipment is made by the vendor. (b) Officers’ salaries should be recorded when they become due at the end of a pay period. Accrual of unpaid amounts should be recorded in preparing financial statements dated other than at the end of a pay period. (c) A special bonus to employees should be recorded when approved by the board of directors or person having authority to approve, if the bonus is for a period of time and that period has ended at the date of approval. If the period for which the bonus is applicable has not ended but only a part of it has expired, it would be appropriate to accrue a pro rata portion of the bonus at the time of approval and make additional accruals of pro rata amounts at the end of each pay period. (d) Dividends should be recorded when they have been declared by the board of directors. (e) Usually it is neither necessary nor proper for the buyer to make any entries to reflect commitments for purchases of goods that have not been shipped by the seller. Ordinary orders, for which the prices are determined at the time of shipment and subject to cancellation by the buyer or seller, do not represent either an asset or a liability to the buyer and need not be reflected in the books or in the financial statements. However, an accrued loss on purchase commitments which results from formal purchase contracts for which a firm price is in excess of the market price at the date of the balance sheet would be shown in the liability section of the balance sheet. (See Chapter 9 on purchase commitments.)
SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 13-1 July 1 Purchases.......................................................... Accounts Payable ....................................
60,000
Freight-in ........................................................... Cash ..........................................................
1,200
Accounts Payable ............................................. Purchase Returns and Allowances.........
6,000
Accounts Payable ............................................. Cash ($54,000 X 98%)............................... Purchase Discounts.................................
54,000
July 3 July 10
60,000 1,200 6,000 52,920 1,080
BRIEF EXERCISE 13-2 11/1/14 12/31/14
2/1/15
Cash............................................................... Notes Payable ......................................
40,000
Interest Expense ........................................... Interest Payable ($40,000 X 9% X 2/12) .......................
600
Notes Payable ............................................... Interest Payable ............................................ Interest Expense ........................................... Cash [($40,000 X 9% X 3/12) + $40,000]....
40,000 600 300
40,000
600
40,900
BRIEF EXERCISE 13-3 11/1/14
12/31/14
Cash ................................................................. Discount on Notes Payable ............................ Notes Payable ........................................
60,000 1,350
Interest Expense ............................................. Discount on Notes Payable ($1,350 X 2/3) .......................................
900
61,350
900
BRIEF EXERCISE 13-3 (Continued) 2/1/15
Interest Expense.............................................. Discount on Notes Payable ...................
450
Notes Payable.................................................. Cash ........................................................
61,350
450 61,350
BRIEF EXERCISE 13-4 (a)
Since both criteria are met (intent and ability), none of the $500,000 would be reported as a current liability. The entire amount would be reported as a long-term liability.
(b)
Because repayment of the note payable required the use of existing 12/31/14 current assets, the entire $500,000 liability must be reported as current. (This assumes Burr had not entered into a long-term agreement prior to issuance.)
BRIEF EXERCISE 13-5 8/1/14
12/31/14
Cash ............................................................... Unearned Sales Revenue (12,000 X $18) ....................................
216,000
Unearned Sales Revenue ............................. Sales Revenue ($216,000 X 5/12 = $90,000)...............
90,000
216,000
90,000
BRIEF EXERCISE 13-6 (a)
(b)
Accounts Receivable ............................................. Sales Revenue............................................... Sales Taxes Payable ($30,000 X 6% = $1,800) .............................
31,800
Cash ........................................................................ Sales Revenue............................................... Sales Taxes Payable ($20,670 ÷ 1.06 = $19,500) ..........................
20,670
30,000 1,800 19,500 1,170
BRIEF EXERCISE 13-7 Salaries and Wages Expense ......................................... FICA Taxes Payable ............................................... Withholding Taxes Payable ................................... Insurance Premium Payable.................................. Cash ........................................................................
24,000 1,836 3,910 250 18,004
BRIEF EXERCISE 13-8 Salaries and Wages Expense ......................................... Salaries and Wages Payable (30 X 2 X $500) .....................................................
30,000 30,000
BRIEF EXERCISE 13-9 12/31/14 2/15/15
Salaries and Wages Expense........................ Salaries and Wages Payable................
350,000
Salaries and Wages Payable ......................... Cash.......................................................
350,000
350,000 350,000
BRIEF EXERCISE 13-10 (a) (b)
Lawsuit Loss ........................................................... Lawsuit Liability .............................................
900,000 900,000
No entry is necessary. The loss is not accrued because it is not probable that a liability has been incurred at 12/31/14.
BRIEF EXERCISE 13-11 Buchanan should record a litigation accrual on the patent case, since the amount is both estimable and probable. This entry will reduce income by $300,000 and Buchanan will report a litigation liability of $300,000. The $100,000 self-insurance allowance has no impact on income or liabilities.
BRIEF EXERCISE 13-12 Oil Platform .................................................................... Asset Retirement Obligation ...............................
450,000 450,000
BRIEF EXERCISE 13-13 2014 12/31/14
Warranty Expense........................................ Inventory .................................................
70,000
Warranty Expense........................................ Warranty Liability.......................................
400,000
70,000 400,000
BRIEF EXERCISE 13-14 (a)
(b) (c)
Cash .......................................................................... 1,980,000 Unearned Warranty Revenue (20,000 X $99) ............................................ Warranty Expense ................................................. Inventory.......................................................
180,000
Unearned Warranty Revenue ............................... Warranty Revenue ($1,980,000 X 180/1,080*) ..........................
330,000
1,980,000
180,000
330,000
*180,000 + 900,000 BRIEF EXERCISE 13-15 Premium Expense ............................................................. Premium Liability ..................................................... *UPC codes expected to be sent in (30% X 1,200,000) ... UPC codes already redeemed ......................................... Estimated future redemptions ......................................... Cost of estimated claims outstanding (240,000 ÷ 3) X ($1.10 + $0.60 – $0.50)..........................
96,000 96,000* 360,000 120,000 240,000 $ 96,000
SOLUTIONS TO EXERCISES EXERCISE 13-1 (10–15 minutes) (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l) (m) (n) (o) (p)
Current liability. Current liability. Current liability or long-term liability depending on term of warranty. Current liability. Current liability. Current liability. Current or noncurrent liability depending upon the time involved. Current liability. Current liability. Current liability. Current liabilities or long-term liabilities as a deduction from face value of note. Footnote disclosure (assume not probable and/or not reasonably estimable). Current liability. Current liability. Footnote disclosure. Separate presentation in either current or long-term liability section.
EXERCISE 13-2 (15–20 minutes) (a)
Sept. 1
Purchases.............................................. Accounts Payable ........................
50,000
Accounts Payable ................................. Notes Payable ..............................
50,000
Cash ....................................................... Discount on Notes Payable .................. Notes Payable ..............................
50,000 4,000
Dec. 31 Interest Expense ................................... Interest Payable ........................... ($50,000 X 8% X 3/12)
1,000
Dec. 31
1,000
Oct. 1 Oct. 1
(b)
Interest Expense ................................... Discount on Notes Payable ......... ($4,000 X 3/12)
50,000
50,000
54,000
1,000
1,000
EXERCISE 13-2 (Continued) (c)
(1)
Notes payable Interest payable
$50,000 1,000 $51,000
(2)
Notes payable Less discount ($4,000 – $1,000)
$54,000 3,000 $51,000
EXERCISE 13-3 (10–12 minutes) Hattie McDaniel Company Partial Balance Sheet December 31, 2014 Current liabilities: Notes payable (Note 1)
$250,000
Long-term debt: Notes payable refinanced in February 2015 (Note 1)
950,000
Note 1. Short-term debt refinanced. As of December 31, 2014, the company had notes payable totaling $1,200,000 due on February 2, 2015. These notes were refinanced on their due date to the extent of $950,000 received from the issuance of common stock on January 21, 2015. The balance of $250,000 was liquidated using current assets. OR Current liabilities: Notes payable (Note 1)
$250,000
Long-term debt: Short-term debt expected to be refinanced (Note 1)
950,000
(Same footnote as above.)
EXERCISE 13-4 (20–25 minutes) KATE HOLMES COMPANY Partial Balance Sheet December 31, 2014 Current liabilities: Notes payable (Note 1)
$3,400,000*
Long-term debt: Notes payable expected to be refinanced in 2015 (Note 1)
3,600,000
Note 1. Under a financing agreement with Gotham State Bank the Company may borrow up to 60% of the gross amount of its accounts receivable at an interest cost of 1% above the prime rate. The Company intends to issue notes maturing in 2019 to replace $3,600,000 of short-term, 15%, notes due periodically in 2015. Because the amount that can be borrowed is expected to range from $3,600,000 to $4,800,000, only $3,600,000 of the $7,000,000 of currently maturing debt has been reclassified as long-term debt. *[$7,000,000 – ($6,000,000 X 60%)]
EXERCISE 13-5 (25–30 minutes) (a)
2013 To accrue expense and liability for vacations Salaries and Wages Expense......................... Salaries and Wages Payable .................
7,200 7,200 (1)
To accrue the expense and liability for sick pay Salaries and Wages Expense......................... Salaries and Wages Expense................
4,320 (2) 4,320
To record payment for compensated time when used by employees Salaries and Wages Payable .......................... Cash ........................................................
2,880 (3) 2,880
2014 To accrue the expense and liability for vacations Salaries and Wages Expense......................... 7,920 Salaries and Wages Payable .................
7,920 (4)
To accrue the expense and liability for sick pay Salaries and Wages Expense......................... 4,752 Salaries and Wages Payable .................
4,752 (5)
To record vacation time paid Salaries and Wages Expense......................... Salaries and Wages Payable .......................... Cash ........................................................
648 6,480 (6) 7,128 (7)
To record sick leave paid Salaries and Wages Expense......................... Salaries and Wages Payable .......................... Cash ........................................................
144 3,816 (8) 3,960 (9)
EXERCISE 13-5 (Continued) (1) (2) (3) (4) (5) (6) (7) (8)
9 employees X $10.00/hr. X 8 hrs./day X 10 days = $7,200 9 employees X $10.00/hr. X 8 hrs./day X 6 days = $4,320 9 employees X $10.00/hr. X 8 hrs./day X 4 days = $2,880 9 employees X $11.00/hr. X 8 hrs./day X 10 days = $7,920 9 employees X $11.00/hr. X 8 hrs./day X 6 days = $4,752 9 employees X $10.00/hr. X 8 hrs./day X 9 days = $6,480 9 employees X $11.00/hr. X 8 hrs./day X 9 days = $7,128 9 employees X $10.00/hr. X 8 hrs./day X (6–4) days = $1,440 9 employees X $11.00/hr. X 8 hrs./day X (5–2) days = +2,376 = $3,816 (9) 9 employees X $11.00/hr. X 8 hrs./day X 5 days = $3,960 Note: Vacation days and sick days are paid at the employee’s current wage. Also, if employees earn vacation pay at different pay rates, a consistent pattern of recognition (e.g., first-in, first-out) could be employed which liabilities have been paid.
(b)
Accrued liability at year-end:
Jan. 1 balance + accrued – paid Dec. 31 balance
2013 Vacation Sick Pay Wages Wages Payable Payable $ 0 $ 0 7,200 4,320 ( 0) (2,880) $7,200(1) $1,440(2)
2014 Vacation Wages Payable $7,200 7,920 (6,480) $8,640(3)
Sick Pay Wages Payable $1,440 4,752 (3,816) $2,376(4)
(1)
9 employees X $10.00/hr. X 8 hrs./day X 10 days =
$7,200
(2)
9 employees X $10.00/hr. X 8 hrs./day X (6–4) days =
$1,440
(3)
9 employees X $10.00/hr. X 8 hrs./day X (10–9) days = 9 employees X $11.00/hr. X 8 hrs./day X 10 days =
$ 720 +7,920 $8,640
(4)
9 employees X $11.00/hr. X 8 hrs./day X (6 + 6 – 4 – 5) days
$2,376
EXERCISE 13-6 (25–30 minutes) (a)
2013 To accrue the expense and liability for vacations Salaries and Wages Expense................ Salaries and Wages Payable........ To record sick leave paid Salaries and Wages Expense................ Cash...............................................
7,740 (1) 7,740 2,880 (2) 2,880
To record vacation time paid No entry, since no vacation days were used. 2014 To accrue the expense and liability for vacations Salaries and Wages Expense................ Salaries and Wages Payable........
8,352 (3) 8,352
To record sick leave paid Salaries and Wages Expense................ Cash...............................................
3,960 (4)
To record vacation time paid Salaries and Wage Expense ................. Salaries and Wages Payable................. Cash...............................................
162 6,966 (5)
3,960
7,128 (6)
(1)
9 employees X $10.75/hr. X 8 hrs./day X 10 days = $7,740
(2)
9 employees X $10.00/hr. X 8 hrs./day X 4 days = $2,880
(3)
9 employees X $11.60/hr. X 8 hrs./day X 10 days = $8,352
(4)
9 employees X $11.00/hr. X 8 hrs./day X 5 days = $3,960
(5)
9 employees X $10.75/hr. X 8 hrs./day X 9 days = $6,966
(6)
9 employees X $11.00/hr. X 8 hrs./day X 9 days = $7,128
EXERCISE 13-6 (Continued) (b) Accrued liability at year-end: Jan. 1 balance + accrued – paid Dec. 31 balance
2013 $ 0 7,740 ( 0) $7,740(1)
2014 $7,740 8,352 (6,966) $9,126(2)
(1)
9 employees X $10.75/hr. X 8 hrs./day X 10 days =
$7,740
(2)
9 employees X $10.75/hr. X 8 hrs./day X 1 day = 9 employees X $11.60/hr. X 8 hrs./day X 10 days =
$ 774 8,352 $9,126
EXERCISE 13-7 (5–7 minutes) June 30 Sales Revenue................................................................. 21,900 Sales Tax Payable .................................................. Computation: Sales plus sales tax ($233,200 + $153,700) $386,900 Sales exclusive of tax ($386,900 ÷ 1.06) 365,000 Sales tax $ 21,900
21,900
EXERCISE 13-8 (10–15 minutes) Salaries and Wages Expense ......................................... 480,000 Withholding Taxes Payable ................................... FICA Taxes Payable*.............................................. Union Dues Payable............................................... Cash ........................................................................ *[($480,000 – $110,000) X 7.65% = $28,305 $110,000 X 1.45% = $1,595; $28,305 + $1,595 = $29,900
80,000 29,900 9,000 361,100
EXERCISE 13-8 (Continued) Payroll Tax Expense....................................................... FICA Taxes Payable .............................................. (See previous computation.) FUTA Taxes Payable ............................................. [($480,000 – $400,000) X .8%) SUTA Taxes Payable............................................. [$80,000 X (3.5% – 2.3%)]
31,500 29,900 640 960
EXERCISE 13-9 (15–20 minutes) (a)
Computation of taxes Wages Social security taxes (FICA) Federal unemployment taxes State unemployment taxes Total Cost
Factory $120,000 9,180 (7.65% X $120,000) 320 (.8% X $40,000) 1,000 (2.5% X $40,000) $130,500
Wages Social security taxes (FICA) Federal unemployment taxes State unemployment taxes Total Cost
Sales $32,000 1,208* 32 (.8% X $4,000) 100 (2.5% X $4,000) $33,340
*$12,000 X 7.65% = $918; $20,000 X 1.45% = $290; $918 + $290 = $1,208
Wages Social security taxes (FICA) Federal unemployment taxes State unemployment taxes Total Cost
Administrative $36,000 2,754 (7.65% X $36,000) –0– –0– $38,754
EXERCISE 13-9 (Continued) Schedule
Wages FICA Federal U.T. State U.T. Total Cost
Total $188,000 13,142 352 1,100 $202,594
Factory $120,000 9,180 320 1,000 $130,500
Sales $32,000 1,208 32 100 $33,340
(b) Factory Payroll: Salaries and Wages Expense ................................ Withholding Taxes Payable.......................... FICA Taxes Payable ...................................... Cash ............................................................... Payroll Tax Expense .............................................. FICA Taxes Payable ...................................... FUTA Taxes Payable..................................... SUTA Taxes Payable.....................................
Administrative $36,000 2,754 –0– –0– $38,754
120,000 16,000 9,180 94,820 10,500 9,180 320 1,000
EXERCISE 13-9 (Continued) Sales Payroll: Salaries and Wages Expense ............................... Withholding Taxes Payable ......................... FICA Taxes Payable ..................................... Cash .............................................................. Payroll Tax Expense ............................................. FICA Taxes Payable ..................................... FUTA Taxes Payable .................................... SUTA Taxes Payable.................................... Administrative Payroll: Salaries and Wages Expense ............................... Withholding Taxes Payable ......................... FICA Taxes Payable ..................................... Cash .............................................................. Payroll Tax Expense ............................................. FICA Taxes Payable .....................................
32,000 7,000 1,208 23,792 1,340 1,208 32 100
36,000 6,000 2,754 27,246 2,754 2,754
EXERCISE 13-10 (10–15 minutes) (a)
Cash (200 X $4,000)................................................ Sales Revenue...............................................
800,000
Warranty Expense .................................................. Cash ...............................................................
17,000
Warranty Expense ($66,000* – $17,000)................ Warranty Liability ..........................................
49,000
800,000 17,000 49,000
*(200 X $330) (b)
Cash ........................................................................ Sales Revenue...............................................
800,000
Warranty Expense .................................................. Cash ...............................................................
17,000
800,000 17,000
EXERCISE 13-11 (15–20 minutes) (a)
(b)
Cash ...................................................................... Sales Revenue............................................. (500 X $6,000)
3,000,000
Warranty Expense................................................ Cash .............................................................
20,000
Warranty Expense................................................ Warranty Liability........................................ ($120,000 – $20,000)
100,000
3,000,000
20,000 100,000
Cash ...................................................................... 3,000,000 Sales Revenue............................................. Unearned Warranty Revenue ..................... Warranty Expense................................................ Cash .............................................................
20,000
Unearned Warranty Revenue .............................. Warranty Revenue ...................................... [$150,000 X ($20,000/$120,000)]
25,000
2,850,000 150,000
20,000 25,000
EXERCISE 13-12 (15–20 minutes) Inventory of Premiums (8,800 X $.80) ......................... Cash .....................................................................
7,040
Cash (110,000 X $3.30)................................................. Sales Revenue.....................................................
363,000
Premium Expense ........................................................ Inventory of Premiums [(44,000 ÷ 10) X $.80]....
3,520
Premium Expense ........................................................ Premium Liability ................................................
1,760*
*[(110,000 X 60%) – 44,000] ÷ 10 X $.80 = 1,760
7,040 363,000 3,520 1,760
EXERCISE 13-13 (20–30 minutes) 1.
The FASB requires that, when some amount within the range of expected loss appears at the time to be a better estimate than any other amount within the range, that amount is accrued. When no amount within the range is a better estimate than any other amount, the dollar amount at the low end of the range is accrued and the dollar amount at the high end of the range is disclosed. In this case, therefore, Salt-n-Pepa Inc. would report a liability of $900,000 at December 31, 2014.
2.
The loss should be accrued for $5,000,000. The potential insurance recovery is a gain contingency—it is not recorded until received.
3.
This is a gain contingency because the amount to be received will be in excess of the book value of the plant. Gain contingencies are not recorded and are disclosed only when the probabilities are high that a gain contingency will become reality.
EXERCISE 13-14 (25–30 minutes) (a)
(b)
Plant Assets............................................................... Cash ..................................................................
600,000
Plant Assets............................................................... Asset Retirement Obligation ...........................
41,879
Depreciation Expense............................................... Accumulated Depreciation – Plant Assets.....
60,000
Depreciation Expense............................................... Accumulated Depreciation – Plant Assets.....
4,188
Interest Expense ....................................................... Asset Retirement Obligation ...........................
2,513
*$41,879/10. **$41,879 X .06.
600,000 41,879 60,000 4,188* 2,513**
EXERCISE 13-14 (Continued) (c)
Asset Retirement Obligation ............................... Loss on ARO Settlement ..................................... Cash .............................................................
75,000 5,000 80,000
EXERCISE 13-15 (25–35 minutes) 1. Liability for stamp redemptions, 12/31/13 Cost of redemptions redeemed in 2014 Cost of redemptions to be redeemed in 2015 (5,200,000 X 80%) Liability for stamp redemptions, 12/31/14
$13,000,000 (6,000,000) 7,000,000 4,160,000 $11,160,000
2. Total coupons issued Redemption rate To be redeemed Handling charges ($480,000 X 10%) Total cost
$800,000 60% 480,000 48,000 $528,000
Total cost Total payments to retailers Liability for unredeemed coupons
$528,000 330,000 $198,000
3. Boxes Redemption rate Total redeemable Coupons to be redeemed (490,000 – 250,000) Cost ($6.50 – $4.00) Liability for unredeemed coupons
700,000 70% 490,000 240,000 $2.50 $600,000
EXERCISE 13-16 (30–35 minutes) #
Assets
Liabilities
Owners’ Equity
Net Income
1
I
I
NE
NE
2
NE
NE
NE
NE
3
NE
I
D
D
4
I
I
NE
NE
5
NE
I
D
D
6
I
I
I
I
7
D
I
D
D
8
NE
I
D
D
9
NE
I
D
D
10
I
I
NE
NE
11
NE
I
D
D
12
NE
I
D
D
13
NE
I
D
D
14
D
D
NE
NE
15
I
I
I
I
16
D
NE
D
D
17
NE
D
I
I
18
NE
I
D
D
EXERCISE 13-17 (15–20 minutes) (a)
Current Ratio =
Current Assets Current Liabilities
$210,000 $80,000
=
= 2.63
Current ratio measures the short-term ability of the company to meet its currently maturing obligations. (b)
Acid-test ratio =
Cash + Short-term Investments + Net Receivables Current Liabilities
=
$115,000 = 1.44 $80,000
Acid-test ratio also measures the short-term ability of the company to meet its currently maturing obligations. However, it eliminates assets that might be slow moving, such as inventories and prepaid expenses. (c)
Debt to assets =
Total Liabilities Total Assets
=
$220,000 $430,000
= 51.16%
This ratio provides the creditors with some idea of the corporation’s ability to withstand losses without impairing the interests of creditors. (d)
Net Income
Return on assets =
=
Average Total Assets
$25,000
= 5.81%
$430,000
This ratio measures the return the company is earning on its average total assets and provides one indication related to the profitability of the enterprise.
EXERCISE 13-18 (20–25 minutes) (a)
(1) Current ratio =
$773,000
= 3.22 times
$240,000 (2) Acid-test ratio =
$52,000 + $198,000 + $80,000 $240,000
= 1.38 times
EXERCISE 13-18 (Continued) (3)
Accounts receivable turnover = $80,000 + $198,000 $1,640,000 ÷ = 11.8 times (or approximately 2 every 31 days)
(4)
Inventory turnover = $360,000 + $440,000 $800,000 ÷ = 2 times (or approximately 2 every 183 days)
(5)
Return on assets = $1,400,000 + $1,630,000 $360,000 ÷ 2
(6)
(b)
= 23.76%
Profit margin on sales = $360,000 ÷ $1,640,000 = 21.95%
Financial ratios should be evaluated in terms of industry peculiarities and prevailing business conditions. Although industry and general business conditions are unknown in this case, the company appears to have a relatively strong current position. The main concern from a short-term perspective is the apparently low inventory turnover. The rate of return on assets and profit margin on sales are extremely good and indicate that the company is employing its assets advantageously.
EXERCISE 13-19 (15–25 minutes) (a)
(1)
$318,000 ÷ $87,000 = 3.66 times
(2) $820,000 ÷
$200,000 + $170,000 = 4.43 times = 82 days 2
(3) $1,400,000 ÷ $95,000 = 14.74 times = 25 days
EXERCISE 13-19 (Continued)
(b)
(4)
$410,000 ÷ 52,000 = $7.88
(5)
$410,000 ÷ $1,400,000 = 29.3%
(6)
$410,000 ÷ $488,000 = 84.02%
(1)
No effect on current ratio, if already included in the allowance for doubtful accounts.
(2)
Weaken current ratio by reducing current assets.
(3)
Improve current ratio by reducing current assets and current liabilities by a like amount.
(4)
No effect on current ratio.
(5)
Weaken current ratio by increasing current liabilities.
(6)
No effect on current ratio.
TIME AND PURPOSE OF PROBLEMS Problem 13-1 (Time 25–30 minutes) Purpose—to present the student with an opportunity to prepare journal entries for a variety of situations related to liabilities. The situations presented are basic ones including purchases and payments on account, and borrowing funds by giving a zero-interest-bearing note. The student is also required to prepare year-end adjusting entries. Problem 13-2 (Time 25–35 minutes) Purpose—to present the student with the opportunity to prepare journal entries for several different situations related to liabilities. The situations presented include accruals and payments related to sales, use, and asset retirement obligations. Year-end adjusting entries are also required. Problem 13-3 (Time 20–30 minutes) Purpose—to present the student with an opportunity to prepare journal entries for four weekly payrolls. The student must compute income tax to be withheld, FICA tax, and state and federal unemployment compensation taxes. The student must realize the fact that in the fourth week only a portion of one employee’s payroll is subject to unemployment tax. Problem 13-4 (Time 20–25 minutes) Purpose—to provide the student with the opportunity to prepare journal entries for a monthly payroll. The student must compute income tax to be withheld, FICA tax, and state and federal unemployment compensation taxes. The student must be aware that the unemployment taxes do not apply to three employees as their earnings exceed the statutory maximum subject to the taxes. Problem 13-5 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to prepare journal entries and balance sheet presentations for warranty costs under the cash-basis and the expense warranty accrual methods. Entries in the sales year and one subsequent year are required. The problem highlights the differences between the two methods in the accounts and on the balance sheet. Problem 13-6 (Time 10–20 minutes) Purpose—to provide the student with a basic problem covering the sales-warranty method. The student is required to prepare journal entries in the year of sale and in subsequent years when warranty costs are incurred. Also required are balance sheet presentations for the year of sale and one subsequent year. While the problem is basic in nature it does test the student’s ability to understand and apply the sales warranty method. Problem 13-7 (Time 25–35 minutes) Purpose—to provide the student with an opportunity to prepare journal entries for warranty costs under the expense warranty method and the cash-basis method. The student is also required to indicate the proper balance sheet disclosures under each method for the year of sale. Finally, the student is required to comment on the effect on net income of applying each method. The problem highlights the differences between the two methods in the accounts and on the balance sheet. Problem 13-8 (Time 15–25 minutes) Purpose—to provide the student with a basic problem in accounting for premium offers. The student is required to prepare journal entries relating to sales, the purchase of the premium inventory, and the redemption of coupons. The student must also prepare the year-end adjusting entry reflecting the estimated liability for premium claims outstanding. A very basic problem.
Time and Purpose of Problems (Continued) Problem 13-9 (Time 30–45 minutes) Purpose—to present the student with a slightly complicated problem related to accounting for premium offers. The problem is more complicated in that coupons redeemed are accompanied by cash payments, and in addition to the cost of the premium item postage costs are also incurred. The student is required to prepare journal entries for various transactions including sales, purchase of the premium inventory, and redemption of coupons for two years. The second year’s entries are more complicated due to the existence of the liability for claims outstanding. Finally the student is required to indicate the amounts related to the premium offer that would be included in the financial statements for each of two years. This very realistic problem challenges the student’s ability to account for all transactions related to premium offers. Problem 13-10 (Time 25–30 minutes) Purpose—to present the student with the problem of determining the proper amount of and disclosure for a contingent loss due to lawsuits. The student is required to prepare a journal entry and a footnote. The student is also required to discuss any liability incurred by a company due to the risk of loss from lack of insurance coverage. A straightforward problem dealing with contingent losses. Problem 13-11 (Time 35–45 minutes) Purpose—to provide the student with a comprehensive problem dealing with contingent losses. The student is required to prepare journal entries for each of three independent situations. For each situation the student must also discuss the appropriate disclosure in the financial statements. The situations presented include a lawsuit, an expropriation, and a self-insurance situation. This problem challenges the student not only to apply the guidelines set forth in GAAP, but also to develop reasoning as to how the guidelines relate to each situation. Problem 13-12 (Time 20–30 minutes) Purpose—to provide the student with a problem to calculate warranty expense, estimated warranty liability, premium expense, inventory of premiums, and premium liability. Problem 13-13 (Time 25–35 minutes) Purpose—to present the student a comprehensive problem in determining various liabilities and present findings in writing. Issues addressed relate to contingencies, warranties, and litigation. Problem 13-14 (Time 20–25 minutes) Purpose—to present the student with a comprehensive problem in determining the amounts of various liabilities. The student must calculate (for independent situations) the estimated liability for warranties, and an estimated liability for premium claims outstanding. Journal entries are not required. This problem should challenge the better students.
SOLUTIONS TO PROBLEMS PROBLEM 13-1 (a)
February 2 Purchases ($70,000 X 98%) ................................... Accounts Payable.........................................
68,600
February 26 Accounts Payable .................................................. Purchase Discounts Lost ...................................... Cash ..............................................................
68,600 1,400
April 1 Trucks ..................................................................... Cash .............................................................. Notes Payable ............................................... May 1 Cash ........................................................................ Discount on Notes Payable ................................... Notes Payable ...............................................
68,600
70,000 50,000 4,000 46,000 83,000 9,000 92,000
August 1 Retained Earnings (Dividends) .................................. 300,000 Dividends Payable ........................................ September 10 Dividends Payable.................................................. Cash .............................................................. (b)
300,000
300,000 300,000
December 31 1. No adjustment necessary 2. Interest Expense ($46,000 X 12% X 9/12) ......... Interest Payable ............................................
4,140
3. Interest Expense ($9,000 X 8/12) ...................... Discount on Notes Payable .........................
6,000
4. No adjustment necessary
4,140 6,000
PROBLEM 13-2
1. 2.
3. 4.
Dec. 5 Dec. 1-31
Dec. 10 Dec. 31
Cash......................................................... Due to Customer............................
500 500
Cash......................................................... 798,000 Sales Revenue ($798,000 ÷ 1.05) ......................... Sales Taxes Payable ($760,000 X .05) ........................... Trucks ($120,000 X 1.05)......................... Cash................................................
126,000
Land Improvements................................ Asset Retirement Obligation.........
84,000
760,000 38,000 126,000 84,000
PROBLEM 13-3
Entries for Payroll 1 Salaries and Wages Expense ...................................... Withholding Taxes Payable (10% X $1,040)* ..... FICA Taxes Payable (7.65% X $1,040)................ Union Dues Payable (2% X $1,040) .................... Cash .....................................................................
1,040.00* 104.00 79.56 20.80 835.64
*$200 + $150 + $110 + $250 + $330 = $1,040 Payroll Tax Expense..................................................... FICA Taxes Payable (7.65% X $1,040)................ FUTA Taxes Payable [0.8% X ($200 + $150 + $110)] .......................... SUTA Taxes Payable (2.5% X $460) ................... Entries for Payroll 2 and 3 Salaries and Wages Payable (Vacation) ..................... Salaries and Wages Expense ...................................... Withholding Taxes Payable (10% X $1,040)....... FICA Taxes Payable (7.65% X $1,040)................ Union Dues Payable (2% X $1,040) .................... Cash .....................................................................
94.74 79.56 3.68 11.50
590.00* 450.00 104.00 79.56 20.80 835.64
*($300 + $220 + $660) ÷ 2 Payroll Tax Expense..................................................... FICA Taxes Payable (7.65% X $1,040)................ FUTA Taxes Payable (0.8% X $460).................... SUTA Taxes Payable (2.5% X $460) ................... Entries for Payroll 4 Salaries and Wages Expense ...................................... Withholding Taxes Payable (10% X $1,040)....... FICA Taxes Payable (7.65% X $1,040)................ Union Dues Payable (2% X $1,040) .................... Cash .....................................................................
94.74 79.56 3.68 11.50
1,040.00 104.00 79.56 20.80 835.64
PROBLEM 13-3 (Continued) Payroll Tax Expense .................................................... FICA Taxes Payable (7.65% X $1,040)................ FUTA Taxes Payable (0.8% X $460) ................... SUTA Taxes Payable (2.5% X $460) ...................
94.74
Monthly Payment of Payroll Liabilities Withholding Taxes Payable ($104.00 X 4)................... 416.00 FICA Taxes Payable ($79.56 X 8)................................. 636.48 Union Dues Payable ($20.80 X 4) ................................ 83.20 FUTA Taxes Payable ($3.68 X 4).................................. 14.72 SUTA Taxes Payable ($11.50 X 4) ............................... 46.00 Cash .....................................................................
79.56 3.68 11.50
1,196.40
PROBLEM 13-4
(a) Name B. D. Williams D. Raye K. Baker F. Lopez A. Daniels B. Kingston Total
Earnings to Aug. 31 $
6,800 6,500 7,600 13,600 107,000 112,000 $253,500
September Earnings $
800 700 1,100 1,900 13,000 16,000 $33,500
*($7,000 – $6,800) X 1% = $2.00 **($7,000 – $6,800) X .8% = $1.60 ***($7,000 – $6,500) X 1% = $5.00 ****($7,000 – $6,500) X .8% = $4.00
(b)
(c)
Income Tax Withholding $
80 70 110 190 1,300 1,600 $3,350
FICA
SUTA
FUTA
$ 61.20 53.55 84.15 145.35 506.75a 312.75b $1,163.75
$2.00* 5.00*** – – – – $7.00
$1.60** 4.00**** – – – – $5.60
a
($6,700 X 6.2%) + ($6,300 X 1.45%) = $506.75 ($1,700 X 6.2%) + ($14,300 X 1.45%) = $312.75
b
Salaries and Wages Expense .............................. 33,500.00 Withholding Taxes Payable ........................ FICA Taxes Payable .................................... Cash .............................................................
3,350.00 1,163.75 28,986.25
Payroll Tax Expense ............................................ FICA Taxes Payable .................................... FUTA Taxes Payable ................................... SUTA Taxes Payable...................................
1,176.35 1,163.75 5.60 7.00
Withholding Taxes Payable ................................. FICA Taxes Payable ............................................. FUTA Taxes Payable ............................................ SUTA Taxes Payable............................................ Cash .............................................................
3,350.00 2,327.50 5.60 7.00 5,690.10
PROBLEM 13-5
(a) (b)
Cash (400 X $2,500) ............................................ Sales Revenue ...........................................
1,000,000
Cash (400 X $2,500) ............................................ Sales Revenue ...........................................
1,000,000
Warranty Expense (400 X [$155 + $185]) ........... Warranty Liability.......................................
136,000
1,000,000 1,000,000 136,000
(c)
No liability would be disclosed under the cash-basis method relative to future costs due to warranties on past sales.
(d)
Current Liabilities: Warranty Liability........................................
$68,000
Long-term Liabilities: Warranty Liability........................................
$68,000
(e)
(f)
Warranty Expense................................................ Inventory...................................................... Salaries and Wages Payable ......................
61,300
Warranty Liability ................................................. Inventory...................................................... Salaries and Wages Payable ......................
61,300
21,400 39,900 21,400 39,900
PROBLEM 13-6
(a)
(b)
Cash ....................................................................... Sales Revenue (300 X $900) ........................ Unearned Warranty Revenue (270 X $90) .....
294,300 270,000 24,300
Current Liabilities: Unearned Warranty Revenue ($24,300/3) ... (Note: Warranty costs assumed to be incurred equally over the threeyear period)
$ 8,100
Long-term Liabilities: Unearned Warranty Revenue ($24,300 X 2/3) ........................................... (c)
(d)
$16,200
Unearned Warranty Revenue ............................... Warranty Revenue........................................
8,100
Warranty Expense ................................................. Inventory....................................................... Salaries and Wages Payable .......................
6,000
8,100 2,000 4,000
Current Liabilities: Unearned Warranty Revenue ......................
$ 8,100
Long-term Liabilities: Unearned Warranty Revenue ......................
$ 8,100
PROBLEM 13-7
(a)
(1) (2)
(3)
(4)
(b)
(1) (2)
(c)
Cash.............................................................. Sales Revenue (600 X $7,400) ..............
4,440,000
Warranty Expense ([600 X $390] / 2) ........... Inventory ($170 X 600 X 1/2)................. Salaries and Wages Payable ($220 X 600 X 1/2)................................
117,000
Warranty Expense........................................ Warranty Liability (600 machines X $390) – $117,000....
117,000
Warranty Liability......................................... Inventory ............................................... Salaries and Wages Payable................
117,000
Cash.............................................................. Sales Revenue ......................................
4,440,000
Warranty Expense........................................ Inventory ............................................... Salaries and Wages Payable................
117,000
4,440,000 51,000 66,000
117,000 51,000 66,000 4,440,000 51,000 66,000
(3)
Under the cash-basis method, the total warranty expense is recorded through entries 2 and 4 which recognize warranty costs as incurred. Warranty expense for 2015 is $117,000 under the cash basis.
(4)
Warranty Expense........................................ Inventory ............................................... Salaries and Wages Payable................
117,000 51,000 66,000
Cash-basis method: No liability for future costs to be incurred under outstanding warranties is recorded or normally disclosed under the cash basis method.
PROBLEM 13-7 (Continued) Expense warranty accrual method: As of 12/31/14 the balance sheet would disclose a current liability in the amount of $117,000 for Warranty Liability. (d)
In the case of Alvarado Company, the expense warranty accrual method reflects properly the income resulting from operations in 2014 and 2015 because the warranty costs are matched with the revenues resulting from the sale, which required such costs to be incurred. Under the cash-basis method, the warranty costs appearing on the 2015 income statement are charged against unrelated revenues; 2014 net income is overstated and 2015 net income is understated.
PROBLEM 13-8
Inventory of Premiums ................................................... Cash ........................................................................ (To record purchase of 40,000 puppets at $1.50 each)
60,000 60,000
Cash ................................................................................... 1,800,000 Sales Revenue........................................................ 1,800,000 (To record sales of 480,000 boxes at $3.75 each) Premium Expense ........................................................... Inventory of Premiums .......................................... [To record redemption of 115,000 coupons. Computation: (115,000 ÷ 5) X $1.50 = $34,500]
34,500
Premium Expense ........................................................... Premium Liability ................................................... [To record estimated liability for premium claims outstanding at December 31, 2015.]
23,100
34,500
23,100
Computation: Total coupons issued in 2015.................
480,000
Total estimated redemptions (40%) ............................... Coupons redeemed in 2015............................................ Estimated future redemptions........................................
192,000 115,000 77,000
Cost of estimated claims outstanding (77,000 ÷ 5) X $1.50 = $23,100
PROBLEM 13-9
(a) 2014 Inventory of Premiums................................................. Cash ..................................................................... (To record the purchase of 250,000 MP3 downloads at $2.25 each)
562,500 562,500
Cash .............................................................................. Sales Revenue ..................................................... (To record the sale of 2,895,400 candy bars at 30 cents each)
868,620
Cash [$600,000 – (240,000 X $.50)] .............................. Premium Expense ........................................................ Inventory of Premiums........................................ [To record the redemption of 1,200,000 wrappers, the receipt of $600,000 (1,200,000 ÷ 5) X $2.50, and the mailing of 240,000 MP3 downloads]
480,000 60,000
868,620
540,000
Computation of premium expense: 240,000 Codes @ $2.25 each = ........................... $540,000 Postage—240,000 X $.50 = .................................. 120,000 $660,000 Less: Cash received— 240,000 X $2.50........................................ 600,000 Premium expense for MP3 downloads issued............................................................ $ 60,000 Premium Expense ........................................................ Premium Liability ................................................ (To record the estimated liability for premium claims outstanding at 12/31/14) *(290,000 ÷ 5) X ($2.25 + $.50 – $2.50) = $14,500
14,500* 14,500
PROBLEM 13-9 (Continued) 2015 Inventory of Premiums ................................................ Cash ..................................................................... (To record the purchase of 330,000 MP3 downloads at $2.25 each)
742,500
Cash .............................................................................. Sales Revenue..................................................... (To record the sale of 2,743,600 candy bars at 30 cents each)
823,080
Cash ($750,000 – $150,000) ......................................... Premium Liability ......................................................... Premium Expense ........................................................ Inventory of Premiums ....................................... (To record the redemption of 1,500,000 wrappers, the receipt of $750,000 [(1,500,000 ÷ 5) X $2.50], and the mailing of 300,000 Codes.)
600,000 14,500 60,500
742,500
823,080
675,000
Computation of premium expense: 300,000 Codes @ $2.25 = .................................... $675,000 Postage—300,000 @ $.50 =................................ 150,000 825,000 Less: Cash received— (1,500,000 ÷ 5) X $2.50................................. 750,000 Premium expense for Codes issued.................. 75,000 Less: Outstanding claims at 12/31/14 charged to 2014 but redeemed in 2015 ...... 14,500 Premium expense chargeable to 2015............... $ 60,500 Premium Expense ........................................................ Premium Liability ................................................ *(350,000 ÷ 5) X ($2.25 + $.50 – $2.50) = $17,500
$ 17,500* 17,500
PROBLEM 13-9 (Continued) (b) Account Inventory of Premiums Premium Liability Premium Expense
Amount 2014 2015 Classification $22,500* $90,000** Current asset 14,500 17,500 Current liability 74,500*** 78,000**** Selling expense
* $2.25 (250,000 – 240,000) ** $2.25 (10,000 + 330,000 – 300,000) *** $60,000 + $14,500 **** $60,500 + $17,500
PROBLEM 13-10
(a)
Because the cause for litigation occurred before the date of the financial statements and because an unfavorable outcome is probable and reasonably estimable, Windsor Airlines should report a loss and a liability in the December 31, 2014, financial statements. The loss and liability might be recorded as follows: Lawsuit Loss ($9,000,000 X 60%)................................................ 5,400,000 Lawsuit Liability ..........................................
5,400,000
Note to the Financial Statements Due to an accident which occurred during 2014, the Company is a defendant in personal injury suits totaling $9,000,000. The Company is charging the year of the casualty with $5,400,000 in estimated losses, which represents the amount that the company legal counsel estimates will finally be awarded. (b)
Windsor Airlines need not establish a liability for risk of loss from lack of insurance coverage itself. GAAP does not require or allow the establishment of a liability for expected future injury to others or damage to the property of others even if the amount of the losses is reasonably estimable. The cause for a loss must occur on or before the balance sheet date for a loss contingency to be recorded. However, the fact that Windsor is self-insured should be disclosed in a note.
PROBLEM 13-11
(a)
1. 2.
(b)
Lawsuit Loss ................................................ Lawsuit Liability ..................................
250,000
Loss from Expropriation ................................. 1,925,000 Allowance for Expropriation [$5,725,000 – (40% X $9,500,000)] ....
250,000
1,925,000
3.
No entry required.
1.
A loss and a liability have been recorded in the first case because (i) information is available prior to the issuance of the financial statements that indicates it is probable that a liability had been incurred at the date of the financial statements and (ii) the amount is reasonably estimable. That is, the occurrence of the uninsured accidents during the year plus the outstanding injury suits and the attorney’s estimate of probable loss required recognition of a loss contingency.
2.
An entry to record a loss and establish an allowance due to threat of expropriation is necessary because the expropriation is imminent as evidenced by the foreign government’s communicated intent to expropriate and the prior settlements for properties already expropriated. That is, enough evidence exists to reasonably estimate the amount of the probable loss resulting from impairment of assets at the balance sheet date. The amount of the loss is measured by the amount that the carrying value (book value) of the assets exceeds the expected compensation. At the time the expropriation occurs, the related assets are written off against the allowance account. In this problem, we established a valuation account because certain specific assets were impaired. A valuation account was established rather than a liability account because the net realizability of the assets affected has decreased. A more appropriate presentation would, therefore, be provided for balance sheet purposes on the realizability of the assets. It does not seem appropriate at this point to write off the assets involved because it may be difficult to determine all the specific assets involved, and because the assets still have not been expropriated.
PROBLEM 13-11 (Continued) 3.
Even though Polska’s chemical product division is uninsurable due to high risk and has sustained repeated losses in the past, as of the balance sheet date no assets have been impaired or liabilities incurred nor is an amount reasonably estimable. Therefore, this situation does not satisfy the criteria for recognition of a loss contingency. Also, unless a casualty has occurred or there is some other evidence to indicate impairment of an asset prior to the issuance of the financial statements, there is no disclosure required relative to a loss contingency. The absence of insurance does not of itself result in the impairment of assets or the incurrence of liabilities. Expected future injuries to others or damage to the property of others, even if the amount is reasonably estimable, does not require recording a loss or a liability. The cause for loss or litigation or claim must have occurred on or prior to the balance sheet date and the amount of the loss must be reasonably estimable in order for a loss contingency to be recorded. Disclosure is required when one or both of the criteria for a loss contingency are not satisfied and there is a reasonable possibility that a liability may have been incurred or an asset impaired, or, it is probable that a claim will be asserted and there is a reasonable possibility of an unfavorable outcome.
PROBLEM 13-12
(a)
Sales of musical instruments and sound equipment ....... Estimated warranty cost ..................................................... Warranty expense for 2014........................................
$5,700,000 X .02 $ 114,000
(b)
Estimated liability for warranties—1/1/14 .......................... 2014 warranty expense (Requirement 1) ........................... Subtotal....................................................................... Actual warranty costs during 2014 .................................... Estimated liability from warranties—12/31/14 ...................
$ 136,000 114,000 250,000 (164,000) $ 86,000
(c)
Coupons issued (1 coupon/$1 sale) .................................. Estimated redemption rate ................................................. Estimated number of coupons to be redeemed................ Exchange rate (200 coupons for a player)......................... Estimated number of premium players to be issued ...................................................................... Net cost of players ($32 – $20) ........................................... Premium expense for 2014 ........................................
1,500,000 .60 900,000 ÷ 200
(d)
(e)
X $
4,500 12 54,000
Inventory of premium players—1/1/14 ............................... Premium players purchased during 2014 (6,500 X $32) ..................................................................... Premium players available ................................................. Premium players exchanged for coupons during 2014 (1,200,000/200 X $32)................................... Inventory of premium players—12/31/14 ...........................
$
37,600
Estimated liability for premiums—1/1/14........................... 2014 premium expense (Requirement 3) ........................... Subtotal....................................................................... Actual redemptions during 2014 [1,200,000/200 X ($32 – $20)] ........................................... Estimated liability for premiums—12/31/14.......................
$
208,000 245,600 192,000 $ 53,600
$
44,800 54,000 98,800 72,000 26,800
PROBLEM 13-13
1.
Memo prepared by: Date:
Millay Corporation December 31, 2014 Recognition of Warranty Expense During June of this year, the client began the manufacture and sale of a new line of dishwasher. Sales of 120,000 dishwashers during this period amounted to $60,000,000. These dishwashers were sold under a one-year warranty, and the client estimates warranty costs to be $25 per appliance. As of the balance sheet date, the client paid out $1,000,000 in warranty expenses which was also the amount expensed in its income statement. No recognition of any further liability associated with the warranty had been made. Because Millay accounts for warranties on the accrual basis, it must recognize the entire $3,000,000 as warranty expense in the year of sale. The client should have made the following journal entries: (a)
Cash ...................................................................... 60,000,000 Sales Revenue (120,000 X $500) .............. 60,000,000 (To record sale of 120,000 dishwashers)
(b)
Warranty Expense .................................................. 1,000,000 Inventory.................................................... (To record warranty costs incurred)
(c)
Warranty Expense [(120,000 X $25) – $1,000,000] ............................ 2,000,000 Warranty Liability ...................................... (To accrue estimated warranty costs)
1,000,000
2,000,000
PROBLEM 13-13 (Continued) 2.
Memo prepared by: Date:
Millay Corporation December 31, 2014 Loss Contingency from Violation Of EPA Regulations I contacted the client’s counsel via a routine attorney letter, asking for information about possible litigation in which the company might be involved. Morgan Sondgeroth, Millay’s attorney, informed me about court action taken against Millay for dumping toxic waste in the Kishwaukee River. Although the litigation is pending, Sondgeroth believes that the suit will probably be lost. A reasonable estimate of clean up costs and fines is $2,750,000. The client neither disclosed nor accrued this loss in the financial statements. Because this loss is both probable and reasonably estimable, it must be accrued as a contingent liability. I advised the client to record the following entry to accrue this liability. Lawsuit Loss ............................................................ 2,750,000 Lawsuit Liability ..........................................
2,750,000
PROBLEM 13-13 (Continued) 3.
Memo prepared by: Date:
Millay Corporation December 31, 2014 Loss Contingency on Patent Infringement Litigation In answer to my attorney letter requesting information about any possible litigation associated with the client, Morgan Sondgeroth informed me that the client is in the middle of a patent infringement suit with Megan Drabek over a hydraulic compressor used in several of Millay’s appliances. The possible loss of this suit is only reasonably possible. Millay did not in any way disclose this information. Because the loss is reasonably possible and can be estimated at $5,000,000, it must be disclosed in the notes to the financial statements. I advised the client to include as a footnote to the financial statements a discussion of this pending litigation along with the attorney’s assessment that the loss is reasonably possible. In addition, I advised the client to disclose the estimated amount of this loss contingency.
PROBLEM 13-14
1.
Estimated warranty costs: On 2013 sales $ 800,000 X .10 ................................ $ 80,000 On 2014 sales $1,100,000 X .10 .....................................110,000 On 2015 sales $1,200,000 X .10 ................................... 120,000 Total estimated costs.............................................310,000 Total warranty expenditures ................................ 85,700* Balance of liability, 12/31/15 .................................................$224,300 *2013—$6,500; 2014—$17,200, and 2015—$62,000. The liability account has a balance of $224,300 at 12/31/15 based on the difference between the estimated warranty costs (totaling $310,000) for the three years’ sales and the actual warranty expenditures (totaling $85,700) during that same period.
2.
Computation of liability for premium claims outstanding: Unredeemed coupons for 2014 ($9,000 – $8,000)..................................................... 2015 coupons estimated to be redeemed ($30,000 X .40) ........................................................ Total ...................................................................
$ 1,000 12,000 $13,000
TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 13-1 (Time 20–25 minutes) Purpose—to provide the student with the opportunity to define a liability, to distinguish between current and long-term liabilities, and to explain accrued liabilities. The student must also describe how liabilities are valued, explain why notes payable are usually reported first in the current liabilities section, and to indicate the items that may comprise “compensation to employees.” CA 13-2 (Time 15–20 minutes) Purpose—to provide three situations that require the application of judgment about the current or longterm nature of the items. The student must think about when typical short-term items might not be classified as current. CA 13-3 (Time 30–40 minutes) Purpose—to provide the student with a comprehensive case covering refinancing of short-term debt. Four situations are presented in which the student must determine the proper classification and disclosure of the debt in the financial statements. In order to thoroughly resolve the issues presented, the student is expected to research the FASB codification. CA 13-4 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to comment on the proper treatment in the financial statements of a contingent loss incurred after the balance sheet date but before issuance of the financial statements. In order to thoroughly answer the case the student will need to understand proper accounting for contingencies. CA 13-5 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to specify the conditions by which a loss contingency can be recorded in the accounts. The student is also required to indicate the proper disclosure in the financial statements of the situations where the amount of loss cannot be reasonably estimated. CA 13-6 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to discuss how product warranty costs and the fact that a company is being sued should be reported. CA 13-7 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to examine the ethical issues related to estimates for bad debts and warranty obligations.
SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 13-1 (a) A liability is 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.” In other words, it is an obligation to transfer some type of resource in the future as a result of a past transaction. (b) Current liabilities are “obligations whose liquidation is reasonably expected to require use of existing resources properly classified as current assets or the creation of other current liabilities.” In other words, they are liabilities generally payable within one year or the operating cycle, whichever is longer. (c) Accrued liabilities (sometimes called accrued expenses) arise through accounting recognition of unpaid expenses that come into existence as a result of past contractual commitments or past services received. Examples are salaries and wages payable, interest payable, property taxes payable, income taxes payable, payroll taxes payable, bonuses payable, postretirement benefits payable, and so on. (d) Theoretically, liabilities should be measured by the present value of the future outlay of cash required to liquidate them. But in practice, current liabilities are usually recorded in accounting records and reported in financial statements at their maturity value. Because of the short time periods involved—frequently less than one year—the difference between the present value of a current liability and the maturity value is not large. The slight overstatement of liabilities that results from carrying current liabilities at maturity value is accepted on the grounds it is immaterial. (e) Notes payable are listed first in the balance sheet because in liquidation they would probably be paid first. (f)
The item compensation to employees might include: 1. Wages, salaries, or bonuses payable. 2. Compensated absences payable. 3. Postretirement benefits payable.
CA 13-2 1.
Since the notes payable are due in less than one year from the balance sheet date, they would generally be reported as a current liability. The only situation in which this short-term obligation could possibly be excluded from current liabilities is if Rodriguez Corp. intends to refinance it. For those notes to qualify for exclusion from current liabilities, the company must meet the following criteria: (1) It must intend to refinance the obligation on a long-term basis, and (2) It must demonstrate an ability to consummate the refinancing. The second criteria, ability to refinance, can be demonstrated either by actually refinancing before the balance sheet is issued or by entering into a noncancelable financing agreement, which has not been violated, with a capable lender. Only that portion of the $25,000,000 which has been refinanced can be reclassified.
CA 13-2 (Continued) 2.
Generally, deposits from customers would be classified as a current liability. However, the classification of deposits as current or noncurrent depends on the time involved between the date of deposit and the termination of the relationship that required the deposit. In this case, the $6,250,000 would be excluded from current liabilities only if the equipment would not be delivered for more than one year (or one operating cycle, if longer).
3.
Salaries and wages payable is an accrued liability which in almost all circumstances would be reported as a current liability (could not be excluded).
CA 13-3 (This case requires some research of FASB Codification.) (a) No. GAAP indicates that refinancing a short-term obligation on a long-term basis means either replacing it with a long-term obligation or with equity securities, or renewing, extending, or replacing it with short-term obligations for an uninterrupted period extending beyond one year (or the operating cycle, if applicable) from the date of an enterprise’s balance sheet. Management’s intent to refinance the obligation on a long-term basis is not enough to warrant reclassification of the short-term obligation. The enterprise’s intent must be supported by an ability to consummate the refinancing. (b) Yes. The events described will have an impact on the financial statements. Since Dumars Corporation refinanced the long-term debt maturing in March 2015 in a manner that meets the conditions set forth in GAAP that obligation should be excluded from current liabilities. The $10,000,000 should be classified as long-term at December 31, 2014. A short-term obligation, other than one classified as a current liability, shall be excluded from current liabilities if the enterprise’s intent to refinance the short-term obligation on a long-term basis is supported by an ability to consummate the refinancing demonstrated in one of the ways stipulated in GAAP. One of the ways stipulated is the issuance of long-term debt or equity securities after the date of the balance sheet but before that balance sheet is issued. The issuance of the long-term debt or equity securities must be for the purpose of refinancing the short-term obligation on a longterm basis. (c) No. since Dumars Corporation refinanced the long-term debt maturing in March 2015 in a manner that meets the conditions set forth in GAAP that obligation should be excluded from current liabilities. (d) (1) No. The $10,000,000 should be shown under the caption of either “Long-Term Debt,” “Interim Debt,” “Short-Term Debt Expected to Be Refinanced,” or “Intermediate Debt.” (2) Yes. GAAP provides that total current liabilities shall be presented in classified balance sheets. If a short-term obligation is excluded from current liabilities pursuant to the provisions of this statement, the notes to the financial statements shall include a general description of the financing agreement and the terms of any new obligation incurred or expected to be incurred or equity securities issued or expected to be issued as a result of a refinancing.
CA 13-4 Because the casualty occurred subsequent to the balance sheet date, it does not meet the criteria of a loss contingency; that is, an asset had not been impaired or a liability incurred at the date of the balance sheet. Therefore, a loss contingency should not be accrued by a charge to expense due to the explosion. However, because it had become known before the financial statements were issued that assets were impaired and liabilities were incurred after the balance sheet date, disclosure is necessary to keep the financial statements from being misleading. The financial statements should indicate the nature of and an estimate of the loss to the company’s assets as a result of the explosion and the nature of and an estimate of the loss contingency anticipated from suits that will be filed and claims asserted for injuries and damages. If the loss to assets or the liability incurrence can be reasonably estimated, disclosure may best be made by supplementing the historical financial statements with pro forma financial data giving effect to the loss as if it had occurred at the date of the financial statements.
CA 13-5 (a) Two conditions must exist before a loss contingency is recorded: 1. Information available prior to the issuance of the financial statements indicates that it is probable that a liability has been incurred at the date of the financial statements. 2. The amount of the loss can be reasonably estimated. (b) When some amount within the range appears at the time to be a better estimate than any other amount within the range, that amount is accrued. When no amount within the range is a better estimate than any other amount, the dollar amount at the low end of the range is accrued and the dollar amount at the high end of the range is disclosed. (c) If the amount of the loss is uncertain, the following disclosure in the notes is required: 1. The nature of the contingency. 2. An estimate of the possible loss or range of loss or a statement that an estimate cannot be made.
CA 13-6 Part 1. For Product Grey, the estimated product warranty costs should be accrued by a charge to expense and a credit to a liability because both of the following conditions were met: 1. It is probable that a liability has been incurred based on past experience. 2. The amount of the loss can be reasonably estimated as 1% of sales. For Product Yellow, the estimated product warranty costs should not be accrued by a charge to income because the amount of loss cannot be reasonably estimated. Since only one condition is satisfied, a disclosure by means of a note should be made. Part 2. The probable judgment ($1,000,000) should be accrued by a charge to expense and a credit to a liability because both of the following conditions were met: 1. It is probable that a liability has been incurred because Constantine’s lawyer states that it is probable that Constantine will lose the suit. 2. The amount of loss can be reasonably estimated because Constantine’s lawyer states that the most probable judgment is $1,000,000.
CA 13-6 (Continued) Constantine should disclose in its financial statements or notes the following: The amount of the suit ($4,000,000). The nature of the accrual. The nature of the contingency. The range of possible loss ($400,000 to $2,000,000).
CA 13-7 (a) No, Hamilton should not follow his owner’s directive if his (Hamilton’s) original estimates are reasonable. (b) Rich Clothing Store benefits in lower rental expense. The Dotson Company is harmed because the misleading financial statement deprives it of its rightful rental fees. In addition, the current stockholders of Rich Clothing Store are harmed because the lower net income reduces the current value of their holdings. (c) Rich is acting unethically to avoid the terms of his rental agreement at the expense of his landlord and his own stockholders.
FINANCIAL REPORTING PROBLEM (a)
P&G’s short-term borrowings were $9,981 at June 30, 2011. (in $ millions) SHORT-TERM DEBT (In millions) Current portion of long-term debt Commercial paper Other Total short-term debt
2011 $ 2,994 6,950 37 $ 9,981
The weighted average interest rate is .9%. (b)
1.
Working capital = Current assets less current liabilities. ($5,323) = ($21,970 – $27,293)
2.
3.
Acid-test ratio = Cash + short-term investments + net receivables Current liabilities
0.33 times
=
Current ratio
=
$2,768 + $0 + $6,275 $27,293 Current assets Current liabilities
0.80 times
=
$ 21,970 $ 27,293
While P&G’s current and acid-test ratios are below one, this may not indicate a weak liquidity position. Many large companies carry relatively high levels of accounts payable, which charge no interest. For example, P&G has almost $8,022 of these short-term obligations, which can be viewed as very cheap forms of financing. Nonetheless, its short-term debt (see part (a)) has increased significantly (from $8,472 to $9,981) in 2011, which raises some liquidity/working capital concerns.
FINANCIAL REPORTING PROBLEM (Continued) (c)
P&G provided the following discussion related to commitments and contingencies: Note 10: Commitments and Contingencies Guarantees In conjunction with certain transactions, primarily divestitures, we may provide routine indemnifications (e.g., indemnification for representations and warranties and retention of previously existing environmental, tax and employee liabilities) which terms range in duration and in some circumstances are not explicitly defined. The maximum obligation under some indemnifications is also not explicitly stated and, as a result, the overall amount of these obligations cannot be reasonably estimated. Other than obligations recorded as liabilities at the time of divestiture, we have not made significant payments for these indemnifications. We believe that if we were to incur a loss on any of these matters, the loss would not have a material effect on our financial position, results of operations or cash flows. In certain situations, we guarantee loans for suppliers and customers. The total amount of guarantees issued under such arrangements is not material. Off-Balance Sheet Arrangements We do not have off-balance sheet financing arrangements, including variable interest entities, that have a material impact on our financial statements.
FINANCIAL REPORTING PROBLEM (Continued) Purchase Commitments and Operating Leases We have purchase commitments for materials, supplies, services and property, plant and equipment as part of the normal course of business. Commitments made under take-or-pay obligations are as follows: June 30 Purchase obiligations
2012 2013 2014 2015 2016 $1,351 $762 $368 $154 $104
Thereafter $273
Such amounts represent future purchases in line with expected usage to obtain favorable pricing. Approximately 26% of our purchase commitments relate to service contracts for information technology, human resources management and facilities management activities that have been outsourced to third-party suppliers. Due to the proprietary nature of many of our materials and processes, certain supply contracts contain penalty provisions for early termination. We do not expect to incur penalty payments under these provisions that would materially affect our financial position, results of operations or cash flows. We also lease certain property and equipment for varying periods. Future minimum rental commitments under non-cancelable operating leases, net of guaranteed sublease income, are as follows: June 30 Operating leases
2012 $264
2013 $224
2014 $192
2015 $173
2016 $141
Thereafter $505
Litigation We are subject to various legal proceedings and claims arising out of our business which cover a wide range of matters such as governmental regulations, antitrust and trade regulations, product liability, patent and trademark matters, income taxes and other actions. As previously disclosed, the Company is and has been subject to a variety of investigations into potential competition law violations in Europe by the European Commission and national authorities from a number of countries. These matters involve a number of other consumer products companies and/or retail customers. The Company's policy is to comply with all laws and regulations, including all antitrust and competition laws, and to cooperate with investigations by relevant regulatory authorities, which FINANCIAL REPORTING PROBLEM (Continued)
the Company is doing. Competition and antitrust law inquiries often continue for several years and, if violations are found, can result in substantial fines. In response to the actions of the European Commission and national authorities, the Company launched its own internal investigations into potential violations of competition laws. The Company has identified violations in certain European countries and appropriate actions were taken. Several regulatory authorities in Europe have issued separate complaints pursuant to their investigations alleging that the Company, along with several other companies, engaged in violations of competition laws in those countries. The remaining authorities' investigations are in various stages of the regulatory process. As a result of our initial and on-going analyses of the complaints, as well as final decisions issued by the European Commission and authorities in a number of other countries in fiscal 2011, the Company has reserves totaling $611 as of June 30, 2011, for fines for competition law violations. In accordance with U.S. GAAP, certain of the reserves included in this amount represent the low end of a range of potential outcomes. Accordingly, the ultimate resolution of these matters may result in fines or costs in excess of the amounts reserved that could materially impact our income statement and cash flows in the period in which they are accrued and paid, respectively. We will continue to monitor developments for all of these investigations and will record additional charges as appropriate. With respect to other litigation and claims, while considerable uncertainty exists, in the opinion of management and our counsel, the ultimate resolution of the various lawsuits and claims will not materially affect our financial position, results of operations or cash flows. We are also subject to contingencies pursuant to environmental laws and regulations that in the future may require us to take action to correct the effects on the environment of prior manufacturing and waste disposal practices. Based on currently available information, we do not believe the ultimate resolution of environmental remediation will have a material adverse effect on our financial position, results of operations or cash flows.
COMPARATIVE ANALYSIS CASE (a)
companies is as follows:
The working capital position of the two ($ millions) PepsiCo, Inc. Current assets ...................................... Current liabilities ................................. Working capital..................................... The Coca-Cola Company Current assets ...................................... Current liabilities .................................. Working capital.....................................
(b)
$ 17,441 (18,154) $ (713) $
25,497 (24,283) $ 1,214
The overall liquidity of both companies is good as indicated from the ratio analysis provided below:
(all computations in millions) PepsiCo, Inc. Coca-Cola $8,944 $9,474 Current cash debt = 0.53 = 0.44 coverage $18,154 + $15,892 $24,283 + $18,508 2 2 $8,944 = 0.18 $51,983 + $46,677 2
Cash debt coverage Current ratio
$17,441
= 0.96
$18,154 Acid-test ratio
$4,067 + $358 + $6,912 = 0.62 $18,154
$9,474 = 0.21 $48,053 + $41,604 2 $25,497
= 1.05
$24,283 $13,891 + $144 + $4,920 = 0.78 $24,283
Accounts receivable turnover
$66,504 = 10.05 $6,912 + $6,323 2
$46,542 = 9.96 $4,920 + $4,430 2
Inventory turnover
$31,593 = 8.78 $3,827 + $3,372 2
$18,216 = 6.3 $3,092 + $2,650 2
COMPARATIVE ANALYSIS CASE (Continued) (c)
As indicated in the chapter, a company can exclude a short-term obligation from current liabilities only if both of the following conditions are met: 1. It must intend to refinance the obligation on a long-term basis, and 2. It must demonstrate an ability to consummate the refinancing. At year-end 2011, neither PepsiCo or Coca-Cola have such debt.
(d)
Coca-Cola discusses its contingencies in the following note: NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Contingencies Our Company is involved in various legal proceedings and tax matters. Due to their nature, such legal proceedings and tax matters involve inherent uncertainties including, but not limited to, court rulings, negotiations between affected parties and governmental actions. Management assesses the probability of loss for such contingencies and accrues a liability and/or discloses the relevant circumstances, as appropriate. Refer to Note 11. NOTE 11: COMMITMENTS AND CONTINGENCIES Guarantees As of December 31, 2011, we were contingently liable for guarantees of indebtedness owed by third parties of $654 million, of which $321 million was related to VIEs. Refer to Note 1 for additional information related to the Company’s maximum exposure to loss due to our involvement with VIEs. Our guarantees are primarily related to thirdparty customers, bottlers, vendors and container manufacturing operations and have arisen through the normal course of business. These guarantees have various terms, and none of these guarantees was individually significant. The amount represents the maximum potential future payments that we could be required to make under the guarantees; however, we do not consider it probable that we will be required to satisfy these guarantees. We believe our exposure to concentrations of credit risk is limited due to the diverse geographic areas covered by our operations.
COMPARATIVE ANALYSIS CASE (Continued) Legal Contingencies The Company is involved in various legal proceedings. We establish reserves for specific legal proceedings when we determine that the likelihood of an unfavorable outcome is probable and the amount of loss can be reasonably estimated. Management has also identified certain other legal matters where we believe an unfavorable outcome is reasonably possible and/or for which no estimate of possible losses can be made. Management believes that the total liabilities to the Company that may arise as a result of currently pending legal proceedings will not have a material adverse effect on the Company taken as a whole. During the period from 1970 to 1981, our Company owned AquaChem, Inc., now known as Cleaver-Brooks, Inc. (“Aqua-Chem”). During that time, the Company purchased over $400 million of insurance coverage, which also insures Aqua-Chem for some of its prior and future costs for certain product liability and other claims. A division of Aqua-Chem manufactured certain boilers that contained gaskets that Aqua-Chem purchased from outside suppliers. Several years after our Company sold this entity, Aqua-Chem received its first lawsuit relating to asbestos, a component of some of the gaskets. Aqua-Chem was first named as a defendant in asbestos lawsuits in or around 1985 and currently has approximately 40,000 active claims pending against it. In September 2002, Aqua-Chem notified our Company that it believed we were obligated for certain costs and expenses associated with its asbestos litigations. AquaChem demanded that our Company reimburse it for approximately $10 million for out-of-pocket litigation-related expenses. Aqua-Chem also demanded that the Company acknowledge a continuing obligation to Aqua-Chem for any future liabilities and expenses that are excluded from coverage under the applicable insurance or for which there is no insurance. Our Company disputes Aqua-Chem’s claims, and we believe we have no obligation to Aqua-Chem for any of its past, present or future liabilities, costs or expenses. Furthermore, we believe we have substantial legal and factual defenses to Aqua-Chem’s claims. The parties entered into litigation in Georgia to resolve this dispute, which was stayed by agreement of the parties pending the outcome of litigation filed in Wisconsin by COMPARATIVE ANALYSIS CASE (Continued)
certain insurers of Aqua-Chem. In that case, five plaintiff insurance companies filed a declaratory judgment action against Aqua-Chem, the Company and 16 defendant insurance companies seeking a determination of the parties’ rights and liabilities under policies issued by the insurers and reimbursement for amounts paid by plaintiffs in excess of their obligations. During the course of the Wisconsin insurance coverage litigation, Aqua-Chem and the Company reached settlements with several of the insurers, including plaintiffs, who have or will pay funds into an escrow account for payment of costs arising from the asbestos claims against AquaChem. On July 24, 2007, the Wisconsin trial court entered a final declaratory judgment regarding the rights and obligations of the parties under the insurance policies issued by the remaining defendant insurers, which judgment was not appealed. The judgment directs, among other things, that each insurer whose policy is triggered is jointly and severally liable for 100 percent of AquaChem’s losses up to policy limits. The court’s judgment concluded the Wisconsin insurance coverage litigation. The Georgia litigation remains subject to the stay agreement. The Company and Aqua-Chem continued to negotiate with various insurers that were defendants in the Wisconsin insurance coverage litigation over those insurers’ obligations to defend and indemnify Aqua-Chem for the asbestosrelated claims. The Company anticipated that a final settlement with three of those insurers would be finalized in May 2011, but such insurers repudiated their settlement commitments and, as a result, Aqua-Chem and the Company filed suit against them in Wisconsin state court to enforce the coverage-in-place settlement or, in the alternative, to obtain a declaratory judgment validating Aqua-Chem and the Company’s interpretation of the court’s judgment in the Wisconsin insurance coverage litigation. Whether or not Aqua-Chem and the Company prevail in the coverage-in-place settlement litigation, these three insurance companies will remain subject to the court’s judgment in the Wisconsin insurance coverage litigation. The Company is unable to estimate at this time the amount or range of reasonably possible loss it may ultimately incur as a result of asbestos-related claims against Aqua-Chem. The Company believes that assuming (a) the defense and indemnity costs for the asbestosrelated claims against Aqua-Chem in the future are in the same range COMPARATIVE ANALYSIS CASE (Continued)
as during the past five years, and (b) the various insurers that cover the asbestos-related claims against Aqua-Chem remain solvent, regardless of the outcome of the coverage-in-place settlement litigation, there will likely be little defense or indemnity costs that are not covered by insurance over the next five to seven years and, therefore, it is unlikely that Aqua-Chem would seek indemnification from the Company within that period of time, In the event Aqua-Chem and the Company prevail in the coverage-in-place settlement litigation, and based on the same assumptions, the Company believes insurance coverage for substantially all defense and indemnity costs would be available for the next 10 to 12 years. Indemnifications At the time we acquire or divest our interest in an entity, we sometimes agree to indemnify the seller or buyer for specific contingent liabilities. Management believes that any liability to the Company that may arise as a result of any such indemnification agreements will not have a material adverse effect on the Company taken as a whole. Tax Audits The Company is involved in various tax matters, with respect to some of which the outcome is uncertain. These audits may result in the assessment of additional taxes that are subsequently resolved with authorities or potentially through the courts. Refer to Note 14. Risk Management Programs The Company has numerous global insurance programs in place to help protect the Company from the risk of loss. In general, we are selfinsured for large portions of many different types of claims; however, we do use commercial insurance above our self-insured retentions to reduce the Company’s risk of catastrophic loss. Our reserves for the Company’s self-insured losses are estimated through actuarial procedures of the insurance industry and by using industry assumptions, adjusted for our specific expectations based on our claim history. The Company’s self-insurance reserves totaled $527 million and $502 million as of December 31, 2011 and 2010, respectively. COMPARATIVE ANALYSIS CASE (Continued) Workforce (Unaudited)
We refer to our employees as “associates.” As of December 31, 2011, our Company had approximately 146,200 associates, of which approximately 67,400 associates were located in the United States. Our Company, through its divisions and subsidiaries, is a party to numerous collective bargaining agreements. As of December 31, 2011, approximately 19,000 associates in North America were covered by collective bargaining agreements. These agreements typically have terms of three to five years. We currently expect that we will be able to renegotiate such agreements on satisfactory terms when they expire. The Company believes that its relations with its associates are generally satisfactory. Operating Leases The following table summarizes our minimum lease payments under noncancelable operating leases with Initial or remaining lease terms in excess of one year as of December 31, 2011 (in millions):
Years Ending December 31, 2012 2013 2014 2015 2016 Thereafter Total minimum operating lease payments1
Operating Lease Payments $ 241 174 133 101 78 270 $ 997
1 Income associated with sublease arrangements is not significant.
We believe our exposure to concentrations of credit risk is limited due to the diverse geographic areas covered by our operations. The Company is involved in various legal proceedings. We establish reserves for specific legal proceedings when we determine that the likelihood of an unfavorable outcome is probable and the amount of loss can be reasonably estimated. Management has also identified certain other legal matters where we believe an unfavorable outcome COMPARATIVE ANALYSIS CASE (Continued) is reasonably possible and/or for which no estimate of possible losses can be made. Management believes that any liability to the Company that may arise as a result of currently pending legal
proceedings will not have a material adverse effect on the financial condition of the Company taken as a whole. PepsiCo discusses its contingencies in the following note: Note 9 Debt Obligations and Commitments
Short-term debt obligations Current maturities of long-term debt Commercial paper (0.1% and 0.2%) Other borrowings (7.6% and 5.3%) Long-term debt obligations Notes due 2011 (4.4%) Notes due 2012 (3.0% and 3.1%) Notes due 2013 (2.3% and 3.0%) Notes due 2014 (4.6% and 5.3%) Notes due 2015 (2.3% and 2.6%) Notes due 2016 (3.9% and 5.5%) Notes due 2017–2040 (4.8% and 4.9%) Other, due 2012–2020 (9.9% and 9.8%) Less: current maturities of long-term debt obligations Total
2011
2010
$ 2,549 2,973 643 $ 6,165
$ 1,626 2,632 640 $ 4,898
– 2,353 2,841 3,335 1,632 1,876 10,806 274 23,117 (2,549)
$ 1,513 2,437 2,110 2,888 1,617 875 9,953 232 21,625 (1,626)
$20,568
$19,999
$
The interest rates in the above table reflect weighted-average rates at year-end. In the second quarter of 2011, we issued:
$750 million of floating rate notes maturing in 2013, which bear interest at a rate equal to the three-month London Inter-Bank Offered Rate (LIBOR plums 8 basis points; and $1.0 billion of 2.500% senior notes maturing In 2016.
COMPARATIVE ANALYSIS CASE (Continued) In the third quarter of 2011, we issued: $500 million of 0.800% senior notes maturing in 2014; and $750 million of 3.000% senior notes maturing in 2021.
The net proceeds from the issuances of all the above notes were used for general corporate purposes. In the third quarter of 2011, we entered into a new four-year unsecured revolving credit agreement (Four-Year Credit Agreement) which expires in June 2015. Effective August 8, 2011, commitments under this agreement were increased to enable us to borrow up to $2.925 billion, subject to customary terms and conditions. We may request that commitment under this agreement be increased up to $3.5 billion. Additionally, we may, once a year, request renewal of the agreement for an additional one-year period. Also, In the third quarter of 2011, we entered into a new 364-day unsecured revolving credit agreement (364-Day Credit Agreement) which expires in June 2012. Effective August 8, 2011, commitments under this agreement were increased to enable us to borrow up to $2.925 billion, subject to customary terms and conditions. We may request that commitment under this agreement be increased up to $3.5 billion. We may request renewal of this facility for an additional 364-day period or convert any amounts outstanding into a term loan for a period of up to one year, which would matured no later than June 2013. The Four-Year Credit Agreement and the 364-Day Credit Agreement, together replaced our $2 billion unsecured revolving credit agreement, our $2.575 billion 364-day unsecure revolving credit agreement and our $1.080 billion amended PBG credit facility. Funds borrowed under the Four-Year Credit Agreement and the 364-Day Credit Agreement may be used for general corporate purposes, including but not limited to repayment of outstanding commercial paper issued by us and our subsidiaries working capital, capital investments and/or acquisitions. In the third quarter of 2011, we paid $784 million in a cash tender offer to repurchase $766 million (aggregate principal amount) of certain WBD debt obligations. As a result of this debt repurchase, we recorded a $16 million charge to interest expense (included in merger
COMPARATIVE ANALYSIS CASE (Continued) and integration charges) in the third quarter, primarily representing the premium paid in the tender offer. In addition, as of December 31, 2011, $848 million of our debt related to borrowings from various lines of credit that are primarily maintained for our international divisions. These lines of credit are subject to normal banking terms and conditions and are fully committed at least to the extent of our borrowings. Long-Term Contractual Commitments(a) Payments Due by Period Total
2012
2013– 2014
Long-term debt obligations(b) $19,738 $ – $6,084 Interest on debt obligations(c) 7,445 852 1,394 Operating leases 1,825 423 598 Purchasing commitments 2,434 1,113 957 Marketing commitments 2,519 240 589 $33,961 $2,628 $9,622 (a)
2015– 2016
2017 and beyond
$3,451 $10,203 1,091
4,108
337
467
302
62
535 1,155 $5,716 $15,995
Reflects non-cancelable commitments as of December 31, 2011, based on year-end foreign exchange rates and excludes any reserves for uncertain tax positions as we are unable to reasonably predict the ultimate amount or timing of settlement. (b) Excludes $2,549 million related to current maturities of long-term debt, $470 million related to the fair value step-up of debt acquired in connection with our acquisitions of PAG and PBS and $360 million related to the increase in carrying value of long-term debt representing the gains on our fair value interest rate swaps. (c) Interest payments on floating-rate debt are estimated using interest rates effective as of December 31, 2011.
COMPARATIVE ANALYSIS CASE (Continued) Most long-term contractual commitments, except for our long term debt obligations, are not recorded on our balance sheet. Non-cancelable operating leases primarily represent building leases. Non-cancelable purchasing commitments are primarily for sugar and other sweeteners, packaging materials, oranges and orange juice. Non-cancelable marketing commitments are primarily for sports marketing. Bottler funding to independent bottlers is not reflected in our long-term contractual commitments as it is negotiated on an annual basis. Accrued liabilities for pension and retiree medical plans are not reflected in our long- term contractual commitments because they do not represent expected future cash outflows. See Note 7 for additional information regarding our pension and retiree medical obligations. Off-Balance-Sheet Arrangements It is not our business practice to enter into off-balance-sheet arrangements, other than in the normal course of business. See Note 8 regarding contracts related to certain of our bottlers. See “Our Liquidity and Capital Resources” in Management’s Discussion and Analysis for further unaudited Information on our borrowings.
FINANCIAL STATEMENT ANALYSIS CASE 1 NORTHLAND CRANBERRIES (a)
Working capital is calculated as current assets – current liabilities, while the current ratio is calculated as current assets/current liabilities. For Northland Cranberries these ratios are calculated as follows: Current year
Working capital $6,745,759 – $10,168,685 = $–3,422,926 Current ratio ($6,745,759/$10,168,685) = .66
Prior year $5,598,054 – $4,484,687 = $1,113,367 ($5,598,054/$4,484,687) = 1.25
Historically, it was generally believed that a company should maintain a current ratio of at least 2.0. In recent years, because companies have been able to better maintain their inventory, receivables and cash, many healthy companies have ratios well below 2.0. However, Northland Cranberries has negative working capital in the current year, and current ratios in both years are extremely low. This would be cause for concern and additional investigation. As you will see in the next discussion point, there may well be a reasonable explanation. (b)
This illustrates a potential problem with ratios like the current ratio, that rely on balance sheet numbers that present a company’s financial position at a particular point in time. That point in time may not be representative of the average position of the company during the course of the year, and also, that point in time may not be the most relevant point for evaluating the financial position of the company. If the company does not like the representation that these commonly used measures give of the company’s position, it could change its year-end or suggest other measures that it considers to be more relevant for a company in this business. Also, it is possible that by using averages calculated across quarterly data some of this problem might be alleviated. As discussed in Chapter 5, there are also measures that employ cash flows, which addresses at least part of the point-in-time problem of balance sheet ratios.
FINANCIAL STATEMENT ANALYSIS CASE 2 MOHICAN COMPANY (a)
Under the cash basis, warranty costs are charged to expense as they are incurred; in other words, warranty costs are charged in the period in which the seller or manufacturer performs in compliance with the warranty. No liability is recorded for future costs arising from warranties, nor is the period in which the sale is recorded necessarily charged with the costs of making good on outstanding warranties. If it is probable that customers will make claims under warranties relating to goods or services that have been sold, and a reasonable estimate of the costs involved can be made, the accrual method must be used. Under the accrual method, a provision for warranty costs is made in the year of sale or in the year that the productive activity takes place.
(b)
When the warranty is sold separately from the product, the sales warranty approach is employed. Revenue on the sale of the extended warranty is deferred and is generally recognized on a straight-line basis over the life of the contract. Revenue is deferred because the seller of the warranty has an obligation to perform services over the life of the contract.
(c)
The general approach is to use the straight-line method to recognize deferred revenue on warranty contracts. If historical evidence indicates that costs incurred do not follow a straight-line approach, then revenue should be recognized over the contract period in proportion to the costs expected to be incurred in performing services under the contract. Only costs that vary with and are directly related to the acquisition of the contracts (mainly commissions) should be deferred and amortized. Costs such as employee’s salaries, advertising, and general and administrative expenses that would have been incurred even if no contract were acquired should be expensed as incurred.
FINANCIAL STATEMENT ANALYSIS CASE 3 (a)
BOP’s working capital and current ratio have declined in 2014 compared to 2013. While this would appear to be bad news, the acid-test ratio has improved. This is due to BOP carrying relatively more liquid receivables in 2014 (receivable days has increased.) And while working capital has declined, the amount of the operating cycle that must be financed with more costly borrowing has declined. That is, BOP is using relatively inexpensive accounts payable to finance its operating cycle. Note that the overall operating cycle has declined because inventory is being managed at a lower level (inventory days has declined by more than 60 days.
(b)
Answers will vary depending on the companies selected. This activity is a great spreadsheet exercise. The analysis for Best Buy and Circuit City for the years 2005 – 2007 is presented on the next page (just before Circuit City went out of business). Best Buy reports both a lower current ratio and acid-test ratio. However, much more of Best Buy’s operating cycle in financed with relatively inexpensive accounts payable as indicated by Best Buy’s longer payable days.
FINANCIAL STATEMENT ANALYSIS CASE 3 (Continued) Note to Instructor: Although the analysis below is for 2005 – 2007, this analysis is particularly useful as Circuit City subsequently filed for bankruptcy. Best Buy (in millions) 2005 2006 Cash $ 470 $748 Accounts Receivable 375 449 Inventory 2,851 3,338 Accounts Payable 2,824 3,234 Purchases 20,496 22,432 Cost of Goods Sold 20,983 23,122 Sales Revenue 30,848
2007 1,205 548 4,028 3,934 31,193 27,165 35,934
Circuit City (in thousands) 2005 2006 2007 879,660 315,970 141,141 230,605 222,869 382,555 1,455,170 1,698,026 1,636,507 635,674 850,359 922,205 7,618,508 8,765,202 11,137,945 7,861,364 8,703,683 9,501,438 10,413,524 11,514,151 12,429,754
Operating Cycle Receivable Days Inventory Days Operating Cycle
5.3 52.7 58.0
5.6 54.1 59.7
7.1 71.2 78.3
11.2 62.9 74.1
Less: Accounts Payable Days
52.62
46.03
35.41
30.22
Days to be Financed
5.38
13.67
42.89
43.88
$1,301 1.40 0.37
$1,847 1.47 0.45
$1,386,506 2.63 0.63
$1,237,998 2.34 0.57
Working Capital Current Ratio Acid-Test Ratio
ACCOUNTING, ANALYSIS, AND PRINCIPLES Accounting (1)
12/31/14 (2) 2/28/14
5/31/14 8/31/14 11/30/14 12/31/14 (3) 1/1/14 1/1/14
12/31/14
12/31/14
During 2014 Warranty Expense.................................. Cash...............................................
6,000 6,000
Warranty Expense.................................. Warranty Payable..........................
45,000
Interest Expense ($5,000 X 2/3)............. Interest Payable ($5,000 X 1/3) .............. Cash ($200,000 X 10% X 3/12) ......
3,333 1,667
Interest Expense .................................... Cash ($200,000 X 10% X 3/12) ......
5,000
Interest Expense .................................... Cash ($200,000 X 10% X 3/12) ......
5,000
Interest Expense .................................... Cash ($200,000 X 10% X 3/12) ......
5,000
Interest Expense .................................... Interest Payable ($5,000 X 1/3).....
1,667
Plant Assets ........................................... Cash...............................................
5,000,000
Plant Assets ........................................... Asset Retirement Obligation........ ($192,770 = $500,000 X 0.38554)
192,770
Depreciation Expense ........................... Acc. Depr.—Plant Assets ............. ($519,277 = [$5,000,000 + $192,770]/10)
519,277
Interest Expense .................................... Asset Retirement Obligation........ ($19,277 = $192,770 X 10%)
19,277
45,000
5,000 5,000 5,000 5,000 1,667
5,000,000 192,770
519,277
19,277
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) Analysis The warranty payable and the interest payable are current liabilities, so all else equal, these will decrease both the current and acid-test ratios. Because of the commitment letter from First Trust Corp., the $200,000 loan can be classified as a noncurrent liability. Without this letter, YellowCard would likely not be able to demonstrate the ability to refinance the obligation on a long-term basis. This would mean the $200,000 loan would have to be classified as a current liability, further depressing YellowCard’s current and acid-test ratios. The asset retirement obligation can be classified as a noncurrent liability, so it will not affect the current and acidtest ratios. Principles According to FASB Concepts Statement No. 6, liabilities are 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. With respect to the new warranty plan, YellowCard would be currently obligated to provide repair service to its customers, arising from the prior sales of its products. So even though customers are making an upfront payment, YellowCard still has an obligation to provide services in the future. Thus the company should record the payments as unearned revenue until it is no longer obligated to make repairs. That is, the current accounting reflects application of the expense warranty approach. The new plan would be accounted for under the sales warranty approach, which defers a certain percentage of the original sales price until some future time when the company incurs actual costs or the warranty expires.
PROFESSIONAL RESEARCH (a)
FASB ASC 605-20-25 addresses how revenue and costs from a separately priced extended warranty or product maintenance contract should be recognized.
(b)
An Extended Warranty is an agreement to provide warranty protection in addition to the scope of coverage of the manufacturer’s original warranty, if any, or to extend the period of coverage provided by the manufacturer’s original warranty. Product Maintenance Contracts are agreements to perform certain agreed-upon services to maintain a product for a specified period of time. The terms of the contract may take different forms, such as an agreement to periodically perform a particular service a specified number of times over a specified period of time, or an agreement to perform a particular service as the need arises over the term of the contract. Separately Priced Contracts are agreements under which the customer has the option to purchase an extended warranty or a product maintenance contract for an expressly stated amount separate from the price of the product. FASB ASC 605-20-20-20 (Glossary)
(c)
Costs that are directly related to the acquisition of a contract and that would have not been incurred but for the acquisition of that contract (incremental direct acquisition costs) shall be deferred and charged to expense in proportion to the revenue recognized. All other costs, such as costs of services performed under the contract, general and administrative expenses, advertising expenses, and costs associated with the negotiation of a contract that is not consummated, shall be charged to expense as incurred. FASB ASC 605-20-25-4
PROFESSIONAL SIMULATION Note: This assignment is available on the Kieso website. Journal Entries (a)
Unearned Sales Revenue......................................... 400,000 Sales Revenue ............................................ (To record subscriptions earned during 2014) Book balance of liability account at December 31, 2014................................... Adjusted balance ($600,000 + $500,000 + $800,000)............ Credit to revenue account..........................
400,000
$2,300,000 (1,900,000) $ 400,000
(b)
No entry should be made to accrue for an expense, because the absence of insurance coverage does not mean that an asset has been impaired or a liability has been incurred as of the balance sheet date. The company may, however, appropriate retained earnings for selfinsurance as long as actual costs or losses are not charged to the appropriation of retained earnings and no part of the appropriation is transferred to income. Appropriation of retained earnings and/or disclosure in the notes to the financial statements are not required, but are recommended.
(c)
Lawsuit Loss .......................................................... Lawsuit Liability ............................................ (To record estimated minimum damages on breach-of-contract litigation)
300,000 300,000
Explanation If a liability is scheduled to mature within one year after the date of an enterprise’s balance sheet or within an operating cycle that is longer than one year, then the liability is classified as current (unless the liability will be retired using a noncurrent asset or a long-term debt). Current liabilities will be liquidated (retired, discharged, paid) by the use of a resource properly classified as a current asset or by the creation of another current liability. Obligations are classified as noncurrent liabilities when they mature beyond one year or the operating cycle (whichever is longer) or if they are to be retired, discharged, or paid by using noncurrent assets.
PROFESSIONAL SIMULATION (Continued) Generally all three of these liabilities (accounts payable, notes payable, bonds payable) would be classified as current liabilities on the company’s balance sheet prepared as of December 31, 2014. However, the bonds payable, and possibly the notes payable, could be classified as noncurrent liabilities if the company intends to refinance the obligations on a long-term basis and the company’s intent to refinance the current obligations on a long-term basis can be demonstrated by: (1) issuance of long-term obligations or equity securities after the balance sheet date but before issuance of the financial statements and before the maturity date of the debt; or (2) by entering into a financing agreement before the balance sheet is issued and before the maturity date of the debt. The financing agreement should outline the terms of refinancing the current obligations on a long-term basis. Alternatively, the bonds and notes could be classified as noncurrent if they are to be retired, discharged, or paid using noncurrent assets.
IFRS CONCEPTS AND APPLICATION IFRS13-1 A company should exclude a short-term obligation from current liabilities only if (1) it intends to refinance the obligation on a long-term basis, and (2) it has an unconditional right to defer settlement of the liability for at least twelve months after the reporting date. IFRS13-2 The ability to defer settlement of short-term debt may be demonstrated by entering into a financing agreement that clearly permits the company to refinance the debt on a long-term basis on terms that are readily determinable before the next reporting date.
IFRS13-3 A provision is defined as a liability of uncertain timing or amount and is sometimes referred to as an estimated liability. Common types of provisions are obligations related to litigation, warranties, product guarantees, business restructurings, and environmental damage.
IFRS13-4 A provision should be recorded and a charge accrued to expense only if: (a) (b) (c)
the company has a present obligation (constructive or legal) as a result of a past event, it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation, and a reliable estimate can be made of the amount of the obligation.
IFRS13-5 A current liability such as accounts payable is susceptible to precise measurement because the date of payment, the payee, and the amount of cash needed to discharge the obligation are reasonably certain. There is nothing uncertain about (1) the fact that the obligation has been incurred and (2) the amount of the obligation. A provision is a liability of uncertain timing or amount and has greater uncertainty about the timing or amount of the future expenditure required to settle the obligation. IFRS13-6 Onerous contracts are ones in which the unavoidable costs of meeting the obligations exceed the economic benefits expected to be received. Examples include a loss to be recognized on an unfavorable noncancellable purchase commitment for inventory, and a lease cancellation fee for a facility that is no longer being used. IFRS13-7 ALEXANDER COMPANY Partial Statement of Financial Position December 31, 2014 Current liabilities: Notes payable (Note 1) .............................................................. $300,000 NOTE 1: Short-term debt refinanced. As of December 31, 2014, the company had notes payable totaling $1,200,000 due on February 2, 2015. These notes were refinanced on their due date to the extent of $900,000 received from the issuance of ordinary shares on January 21, 2015. The balance of $300,000 was liquidated using current assets.
IFRS13-8 (1)
Mckee should classify $100,000 of the obligation as a current maturity of long-term debt (current liability) and the $300,000 balance as a noncurrent liability.
(2)
While the maturity of the obligation was extended to February 15, 2017, the agreement was not reached with the lender until January 15, 2015. Since the agreement was not in place as of the reporting date (December 31, 2014), the obligation should be reported as a current liability.
IFRS13-9 1.
Warranty Expense ............................................... 5,000,000* Warranty Payable ....................................
5,000,000
* Expected warranty costs: No defects Minor defects Major defects
2.
% 60% 10% 30% 100%
Units 600,000 100,000 300,000 1,000,000
Costs per Unit $0 5 15
Income Tax Expense........................................ Income Taxes Payable............................
Total Costs $ 0 500,000 4,500,000 $5,000,000
400,000 400,000
IFRS13-10 (a)
No. IFRS indicate that refinancing a short-term obligation on a longterm basis also requires that a company have an unconditional right to defer settlement of the liability for at least 12 months after the reporting date.
IFRS13-10 (Continued) (b)
No. The events described will not have an impact on the financial statements. Since Kobayashi Corporation’s refinancing of the longterm debt maturing in March 2015 does not meet the conditions set forth in IFRS that obligation should be included in current liabilities. The $10,000,000 should continue to be classified as current at December 31, 2014. A short-term obligation, other than one classified as a current liability, shall be excluded from current liabilities if the entity’s intent to refinance the short-term obligation on a long-term basis is supported by an unconditional right to defer the settlement of the liability for at least 12 months after the reporting date.
(c)
Yes. The debt should be included in current liabilities. The issuance of ordinary shares in January does not meet the criteria to have an unconditional right to defer the settlement of the liability for at least 12 months after the reporting date.
IFRS13-11 (a)
IAS 37, Provisions, Contingent Liabilities and Contingent Assets.
(b)
Recognizing a liability from restructuring (IAS 37, 72 – 79). A constructive obligation to restructure arises only when an entity: (a) has a detailed formal plan for the restructuring identifying at least: (i) the business or part of a business concerned; (ii) the principal locations affected; (iii) the location, function, and approximate number of employees who will be compensated for terminating their services; (iv) the expenditures that will be undertaken; and (v) when the plan will be implemented; and (b) has raised a valid expectation in those affected that it will carry out the restructuring by starting to implement that plan or announcing its main features to those affected by it.
IFRS13-11 (Continued) Evidence that an entity has started to implement a restructuring plan would be provided, for example, by dismantling plant or selling assets or by the public announcement of the main features of the plan. A public announcement of a detailed plan to restructure constitutes a constructive obligation to restructure only if it is made in such a way and in sufficient detail (I.E. setting out the main features of the plan) that it gives rise to valid expectations in other parties such as customers, suppliers and employees (or their representatives) that the entity will carry out the restructuring. For a plan to be sufficient to give rise to a constructive obligation when communicated to those affected by it, its implementation needs to be planned to begin as soon as possible and to be completed in a timeframe that makes significant changes to the plan unlikely. If it is expected that there will be a long delay before the restructuring begins or that the restructuring will take an unreasonably long time, it is unlikely that the plan will raise a valid expectation on the part of others that the entity is at present committed to restructuring, because the timeframe allows opportunities for the entity to change its plans. A management or board decision to restructure taken before the end of the reporting period does not give rise to a constructive obligation at the end of the reporting period unless the entity has, before the end of the reporting period: (a) started to implement the restructuring plan; or (b) announced the main features of the restructuring plan to those affected by it in a sufficiently specific manner to raise a valid expectation in them that the entity will carry out the restructuring. If an entity starts to implement a restructuring plan, or announces its main features to those affected, only after the reporting period, disclosure is required under IAS 10 Events after the Reporting Period, if the restructuring is material and non-disclosure could influence the economic decisions that users make on the basis of the financial statements.
IFRS13-11 (Continued) Although a constructive obligation is not created solely by a management decision, an obligation may result from other earlier events together with such a decision. For example, negotiations with employee representatives for termination payments, or with purchasers for the sale of an operation, may have been concluded subject only to board approval. Once that approval has been obtained and communicated to the other parties, the entity has a constructive obligation to restructure, if the conditions of paragraph 72 are met. In some countries, the ultimate authority is vested in a board whose membership includes representatives of interests other than those of management (e.g. employees) or notification to such representatives may be necessary before the board decision is taken. Because a decision by such a board involves communication to these representatives, it may result in a constructive obligation to restructure. No obligation arises for the sale of an operation until the entity is committed to the sale, I.E. there is a binding sale agreement. Even when an entity has taken a decision to sell an operation and announced that decision publicly, it cannot be committed to the sale until a purchaser has been identified and there is a binding sale agreement. Until there is a binding sale agreement, the entity will be able to change its mind and indeed will have to take another course of action if a purchaser cannot be found on acceptable terms. When the sale of an operation is envisaged as part of a restructuring, the assets of the operation are reviewed for impairment, under IAS 36. When a sale is only part of a restructuring, a constructive obligation can arise for the other parts of the restructuring before a binding sale agreement exists. Costs to include (IAS 37, 80) A restructuring provision shall include only the direct expenditures arising from the restructuring, which are those that are both: (a) necessarily entailed by the restructuring; and (b) not associated with the ongoing activities of the entity.
IFRS13-11 (Continued) Costs to exclude (IAS 37, 81 – 82) A restructuring provision does not include such costs as: (a) retraining or relocating continuing staff; (b) marketing; or (c) investment in new systems and distribution networks. These expenditures relate to the future conduct of the business and are not liabilities for restructuring at the end of the reporting period. Such expenditures are recognised on the same basis as if they arose independently of a restructuring. Identifiable future operating losses up to the date of a restructuring are not included in a provision, unless they relate to an onerous contract as defined in paragraph 10. As required by paragraph 51, gains on the expected disposal of assets are not taken into account in measuring a restructuring provision, even if the sale of assets is envisaged as part of the restructuring. (c)
The current warranty contract is considered an onerous contract. The required accounting related to an onerous contract is in IAS 37, 81 – 82. If an entity has a contract that is onerous, the present obligation under the contract shall be recognised and measured as a provision. Many contracts (for example, some routine purchase orders) can be cancelled without paying compensation to the other party, and therefore there is no obligation. Other contracts establish both rights and obligations for each of the contracting parties. Where events make such a contract onerous, the contract falls within the scope of this Standard and a liability exists which is recognised. Executory contracts that are not onerous fall outside the scope of this Standard. This Standard defines an onerous contract as a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. The unavoidable costs under a contract reflect the least net cost of exiting from the contract, which is the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfil it.
IFRS13-11 (Continued) Before a separate provision for an onerous contract is established, an entity recognises any impairment loss that has occurred on assets dedicated to that contract (see IAS 36). Hincapie shoud therefore record a liability for the service contract at $75,000, the amount of the termination fee. IFRS13-12 (a)
M&S’s short-term borrowings were £327.7 million at 31 March, 2012. SHORT-TERM DEBT (In millions) Bank loans and overdrafts Medium term notes Finance lease liabilties Total short-term debt
2012 £ 38.4 280.6 8.7 £327.7
The interest rate is only provided for the notes (5.875%). (b)
1.
Working capital = Current assets less current liabilities. £11 = (£1,460.1 – £1,449.1)
2.
Acid-test ratio = Cash + short-term investments + net receivables Current liabilities
0.54 times
=
£196.1 + £67 + £254.6 + £260.5 £1,449.1
IFRS13-12 (Continued) 3.
Current ratio
Current assets
=
Current liabilities 1.01 times
=
£1,460.1 £1,449.1
M&S’s acid-test ratio is at 0.54, and working capital and the current ratio appear acceptable. The lower acid-test ratio may not be a problem. Many large companies carry relatively high levels of accounts payable, which charge no interest. For example, M&S has over £1.4 billion of these short-term obligations, which can be viewed as very cheap forms of financing. M&S has also substantially reduced its short-term borrowing during the year. Comparisons to industry are required to fully assess liquidity. (c)
M&S provided the following discussion related to commitments and contingencies: 25 Contingencies and commitments A. Capital commitments
Commitments in respect of properties in the course of construction
2012 £m
2011 £m
71.4
90.8
In respect of its interest in a joint venture, the Group is committed to in our capital expenditure of £nil (last year £0.5m). B. Other material contracts In the event of a material change in the trading arrangements with certain warehouse operators, the Group has a commitment to purchase property, plant and equipment, at values ranging from historical net book value to market value, which are currently owned and operated by the warehouse operators on the Group’s behalf. See note 12 for details on the partnership arrangement with the Marks & Spencer UK Pension Scheme.
IFRS13-12 (Continued) C. Commitments under operating leases The Group leases various stores, offices, warehouses and equipment under non-cancellable operating lease agreements. The leases have varying terms, escalation clauses and renewal rights 2012 £m
2011 £m
Total future minimum rentals payable under non-cancellable operating leases are as follows: Within one year 257.8 Later than one year and not later than five years 997.4 Later than five years and not later than ten years 1,029.5 Later than ten years and not later than 15 years 772.7 Later than 15 years and not later than 20 years 365.1 Later than 20 years and not later than 25 years 259.3 Later than 25 years 1,210.1 Total 4,891.9
242.6 923.0 990.8 767.4 402.9 243.1 1,210.3 4,780.1
The total future sublease payments to be received are £63.3m (last year £65.8m)
CHAPTER 14 Long-Term Liabilities ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics
Questions
Brief Exercises
Exercises
Problems
Concepts for Analysis
1, 2
10, 11
1, 2
1. Long-term liability; classification; definitions.
1, 10, 14, 22
2. Issuance of bonds; types of bonds.
2, 3, 4, 9, 10, 11
1, 2, 3, 4, 5, 6, 7
3, 4, 5, 6, 7, 8, 9, 10, 11
1, 2, 3, 4, 5, 6, 7, 10
1, 2, 5
3. Premium and discount; amortization schedules.
5, 6, 7, 8, 11
3, 4, 6, 7, 8, 10
4, 5, 6, 7, 8, 9, 10, 11, 13, 14, 15
1, 2, 3, 4, 5, 6, 7, 10, 11
1, 2
4. Retirement and refunding of debt.
12, 13
11
12, 13, 14, 15
2, 4, 5, 6, 7, 10
2, 3
5. Imputation of interest on notes.
14, 15, 16, 17, 18
12, 13, 14, 15
16, 17, 18
8, 9
6. Fair value option.
19, 20
16
19
7. Disclosures of long-term obligations.
21, 22, 23, 24
9
20
10
*8.
25, 26, 27, 28, 29, 30
21, 22, 23, 24, 25, 26, 27
12, 13, 14, 15
Troubled debt restructuring.
*This material is discussed in the Appendix to the Chapter.
1, 3, 4
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Brief Exercises
Learning Objectives Questions
Exercises
Problems
Concepts for Analysis
1.
Describe the formal 1 procedures associated with issuing long-term debt.
2.
Identify various types of bond issues.
2
3.
Describe the accounting valuation for bonds at date of issuance.
3,4,5,6
1, 2, 3, 4, 5, 6, 7, 8
3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15
1, 2, 3, 4, 5, 6, 7, 10
CA14-2
4.
Apply the methods of bond discount and premium amortization.
7,8,9,10,11,12
2, 3, 4, 5, 6, 7, 8, 10
3, 4, 5, 6, 7, 8, 9, 10, 12, 13, 14, 15
1, 2, 3, 4, 5, 6, 7, 10, 11
CA14-3
5.
Describe the accounting for the extinguishment of debt.
13
11
12, 13, 14, 15
2, 4, 5, 6, 7, 10
6.
Explain the accounting for longterm notes payable.
14, 15, 16, 17, 18
12, 13, 14, 15
16, 17, 18
3, 8, 9
7.
Describe the accounting for the fair value option.
19, 20
16
19
8.
Explain the reporting of off-balance-sheet financing arrangements.
22, 23, 24
9.
Indicate how to present and analyze long-term debt.
21
*10.
Describe the accounting for a debt restructuring.
25, 26, 27, 28, 29, 30
1, 2
CA14-1, CA14-5
CA14-4
9
20
4, 10
21, 22, 23, 24, 25, 26, 27
12, 13, 14
ASSIGNMENT CHARACTERISTICS TABLE Item
Description
Level of Difficulty
Time (minutes)
E14-1 E14-2 E14-3 E14-4 E14-5 E14-6 E14-7 E14-8 E14-9 E14-10 E14-11 E14-12 E14-13 E14-14 E14-15 E14-16 E14-17 E14-18 E14-19 E14-20 *E14-21 *E14-22 *E14-23 *E14-24 *E14-25 *E14-26 *E14-27
Classification of liabilities. Classification. Entries for bond transactions. Entries for bond transactions—straight-line. Entries for bond transactions—effective-interest. Amortization schedule—straight-line. Amortization schedule—effective-interest. Determine proper amounts in account balances. Entries and questions for bond transactions. Entries for bond transactions. Information related to various bond issues. Entry for redemption of bond; bond issue costs. Entries for redemption and issuance of bonds. Entries for redemption and issuance of bonds. Entries for redemption and issuance of bonds. Entries for zero-interest-bearing notes. Imputation of interest. Imputation of interest with right. Fair value option. Long-term debt disclosure. Settlement of debt. Term modification without gain—debtor’s entries. Term modification without gain—creditor’s entries. Term modification with gain—debtor’s entries. Term modification with gain—creditor’s entries. Debtor/creditor entries for settlement of troubled debt. Debtor/creditor entries for modification of troubled debt.
Simple Simple Simple Simple Simple Simple Simple Moderate Moderate Moderate Simple Simple Simple Simple Simple Simple Simple Moderate Simple Simple Moderate Moderate Moderate Moderate Moderate Simple Moderate
15–20 15–20 15–20 15–20 15–20 15–20 15–20 15–20 20–30 15–20 20–30 15–20 15–20 12–16 10–15 15–20 15–20 15–20 10–15 10–15 15–20 20–30 25–30 25–30 20–30 15–20 20–25
P14-1 P14-2 P14-3 P14-4
Analysis of amortization schedule and interest entries. Issuance and redemption of bonds. Negative amortization. Issuance and redemption of bonds; income statement presentation. Comprehensive bond problem. Issuance of bonds between interest dates, straight-line, retirement. Entries for life cycle of bonds. Entries for zero-interest-bearing note. Entries for zero-interest-bearing note; payable in installments. Comprehensive problem; issuance, classification, reporting. Effective-interest method.
Simple Moderate Moderate Simple
15–20 25–30 20–30 15–20
Moderate Moderate
50–65 20–25
Moderate Simple Moderate
20–25 15–25 20–25
Moderate
20–25
Moderate
40–50
P14-5 P14-6 P14-7 P14-8 P14-9 P14-10 P14-11
ASSIGNMENT CHARACTERISTICS TABLE (Continued) Level of Difficulty
Time (minutes)
Debtor/creditor entries for continuation of troubled debt. Restructure of note under different circumstances. Debtor/creditor entries for continuation of troubled debt with new effective interest.
Moderate Moderate Complex
15–25 30–45 40–50
Bond theory: balance sheet presentations, interest rate, premium. Bond theory: price, presentation, and redemption. Bond theory: amortization and gain or loss recognition. Off-balance-sheet financing. Bond issue, ethics.
Moderate
25–30
Moderate Simple Moderate Moderate
15–25 20–25 20–30 23–30
Item
Description
*P14-12 *P14-13 *P14-14
CA14-1 CA14-2 CA14-3 CA14-4 CA14-5
SOLUTIONS TO CODIFICATION EXERCISES CE14-1 Master Glossary (a)
An obligation is callable at a given date if the creditor has the right at that date to demand, or to give notice of its intention to demand, repayment of the obligation owed to it by the debtor.
(b)
The interest rate that results from a process of approximation (or imputation) required when the present value of a note must be estimated because an established exchange price is not determinable and the note has no ready market.
(c)
Long-term obligations are those scheduled to mature beyond one year (or the operating cycle, if applicable) from the date of an entity’s balance sheet.
(d)
The rate of return implicit in the loan, that is, the contractual interest rate adjusted for any deferred loan fees or costs, premium, or discount existing at the origination or acquisition of the loan.
CE14-2 According to FASB ASC 470-10-50-1 (Disclosure of Long-Term Obligations): The combined aggregate amount of maturities and sinking fund requirements for all long-term borrowings shall be disclosed for each of the five years following the date of the latest balance sheet presented. (See Section 505-10-50 for disclosure guidance that applies to securities, including debt securities.) See Example 3 (Paragraph 470-10-55-10) for an illustration of this disclosure requirement.
CE14-3 According of FASB ASC 470-10-45-1 (Classification of Debt that Includes Covenants): Some long-term loans contain certain covenants that must be met on a quarterly or semiannual basis. If a covenant violation occurs that would otherwise give the lender the right to call the debt, a lender may waive its call right arising from the current violation for a period greater than one year while retaining future covenant requirements. Unless facts and circumstances indicate otherwise, the borrower shall classify the obligation as noncurrent, unless both of the following conditions exist: (a)
A covenant violation that gives the lender the right to call the debt has occurred at the balance sheet date or would have occurred absent a loan modification.
(b)
It is probable that the borrower will not be able to cure the default (comply with the covenant) at measurement dates that are within the next 12 months.
See Example 1 (paragraph 470-10-55-2) for an illustration of this classification guidance.
CE14-4 According to FASB ASC 470-10-S99-2 (SAB Topic 4.A, Subordinated Debt): Subordinated debt may not be included in the stockholders’ equity section of the balance sheet. Any presentation describing such debt as a component of stockholders’ equity must be eliminated. Furthermore, any caption representing the combination of stockholders’ equity and only subordinated debts must be deleted.
ANSWERS TO QUESTIONS 1. (a)
Funds might be obtained through long-term debt from the issuance of bonds, and from the signing of long-term notes and mortgages.
(b)
A bond indenture is a contractual agreement (signed by the issuer of bonds) between the bond issuer and the bondholders. The bond indenture contains covenants or restrictions for the protection of the bondholders.
(c)
A mortgage is a document which describes the security for a loan, indicates the conditions under which the mortgage becomes effective (that is, conditions of default), and describes the rights of the mortgagee under default relative to the security. The mortgage accompanies a formal promissory note and becomes effective only upon default of the note.
2. If the entire bond matures on a single date, the bonds are referred to as term bonds. Mortgage bonds are secured by real estate. Debenture bonds are unsecured. The interest payments for income bonds depend on the existence of operating income in the issuing company. Callable bonds may be called and retired by the issuer prior to maturity. Registered bonds are issued in the name of the owner and require surrender of the certificate and issuance of a new certificate to complete the sale. A bearer or coupon bond is not recorded in the name of the owner and may be transferred from one investor to another by mere delivery. Convertible bonds can be converted into other securities of the issuing corporation for a specified time after issuance. Commodity-backed bonds (also called asset-linked bonds) are redeemable in measures of a commodity. Deepdiscount bonds (also called zero-interest bonds) are sold at a discount which provides the buyer’s total interest payoff at maturity. 3. (a)
Yield rate—the rate of interest actually earned by the bondholders; it is synonymous with the effective and market rates.
(b)
Nominal rate—the rate set by the party issuing the bonds and expressed as a percentage of the par value; it is synonymous with the stated rate.
(c)
Stated rate—synonymous with nominal rate.
(d)
Market rate—synonymous with yield rate and effective rate.
(e)
Effective rate—synonymous with market rate and yield rate.
4. (a)
Maturity value—the face value of the bonds; the amount which is payable upon maturity.
(b)
Face value—synonymous with par value and maturity value.
(c)
Market (fair) value—the amount realizable upon sale.
(d)
Par value—synonymous with maturity and face value.
5. A discount on bonds payable results when investors demand a rate of interest higher than the rate stated on the bonds. The investors are not satisfied with the nominal interest rate because they can earn a greater rate on alternative investments of equal risk. They refuse to pay par for the bonds and cannot change the nominal rate. However, by lowering the amount paid for the bonds, investors can alter the effective rate of interest. A premium on bonds payable results from the opposite conditions. That is, when investors are satisfied with a rate of interest lower than the rate stated on the bonds, they are willing to pay more than the face value of the bonds in order to acquire them, thus reducing their effective rate of interest below the stated rate.
Questions Chapter 14 (Continued) 6. Discount (premium) on bonds payable should be reported in the balance sheet as a direct deduction from (addition to) the face amount of the bond. Both are liability valuation accounts. 7. Bond discount and bond premium may be amortized on a straight-line basis or on an effectiveinterest basis. The profession recommends the effective-interest method but permits the straightline method when the results obtained are not materially different from the effective-interest method. The straight-line method results in an even or average allocation of the total interest over the life of the notes or bonds. The effective-interest method results in an increasing or decreasing amount of interest each period. This is because interest is based on the carrying amount of the bond issuance at the beginning of each period. The straight-line method results in a constant dollar amount of interest and an increasing or decreasing rate of interest over the life of the bonds. The effective-interest method results in an increasing or decreasing dollar amount of interest and a constant rate of interest over the life of the bonds. 8. The annual interest expense will decrease each period throughout the life of the bonds. Under the effective-interest method the interest expense each period is equal to the effective or yield interest rate times the book value of the bonds at the beginning of each interest period. When bonds are sold at a premium, their book value declines to face value over their life; therefore, the interest expense declines also. 9. Bond issuance costs should be debited to a deferred charge account for Unamortized Bond Issue Costs and amortized over the life of the issue, separately from but in a manner similar to that used for discount on bonds. 10. Amortization of Discount on Bonds Payable will increase interest expense. A discount on bonds payable results when investors demand a rate of interest higher than the rate stated on the bonds. The investors are not satisfied with the nominal interest rate because they can earn a greater rate on alternative investments of equal risk. They refuse to pay par for the bonds and cannot change the nominal rate. However, by lowering the amount paid for the bonds, investors can increase the effective rate of interest. 11. The call feature of a bond issue grants the issuer the privilege of purchasing, after a certain date at a stated price, outstanding bonds for the purpose of reducing indebtedness or taking advantage of lower interest rates. The call feature does not affect the amortization of bond discount or premium; because early redemption is not a certainty, the life of the bonds should be used for amortization purposes. 12. It is sometimes desirable to reduce bond indebtedness in order to take advantage of lower prevailing interest rates. Also the company may not want to make a very large cash outlay all at once when the bonds mature. Bond indebtedness may be reduced by either issuing bonds callable after a certain date and then calling some or all of them, or by purchasing bonds on the open market and then retiring them. When a portion of bonds outstanding is going to be retired, it is necessary for the accountant to make sure any corresponding discount or premium is properly amortized. When the bonds are extinguished, any gain or loss should be reported in income. 13. Gains or losses from extinguishment of debt should be aggregated and reported in income. For extinguishment of debt transactions disclosure is required of the following items: (1) A description of the transactions, including the sources of any funds used to extinguish debt if it is practicable to identify the sources. (2) The income tax effect in the period of extinguishment. (3) The per share amount of the aggregate gain or loss net of related tax effect.
Questions Chapter 14 (Continued) 14. The entire arrangement must be evaluated and an appropriate interest rate imputed. This is done by (1) determining the fair value of the property, goods, or services exchanged or (2) determining the fair value of the note, whichever is more clearly determinable. 15. If a note is issued for cash, the present value is assumed to be the cash proceeds. If a note is issued for noncash consideration, the present value of the note should be measured by the fair value of the property, goods, or services or by an amount that reasonably approximates the fair value of the note (whichever is more clearly determinable). 16. When a debt instrument is exchanged in a bargained transaction entered into at arm’s-length, the stated interest rate is presumed to be fair unless: (1) no interest rate is stated, or (2) the stated interest rate is unreasonable, or (3) the stated face amount of the debt instrument is materially different from the current sales price for the same or similar items or from the current market value of the debt instrument. 17. Imputed interest is the interest factor (a rate or amount) assumed or assigned which is different from the stated interest factor. It is necessary to impute an interest rate when the stated interest rate is presumed to be unreasonable. The imputed interest rate is used to establish the present value of the debt instrument by discounting, at that imputed rate, all future payments on the debt instrument. In imputing interest, the objective is to approximate the rate which 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 which bears the prevailing rate of interest to maturity. In order to accomplish that objective, consideration must be given to (1) the credit standing of the issuer, (2) restrictive covenants, (3) collateral, (4) payment and other items pertaining to the debt, (5) the existing prime interest rate, and (6) the prevailing rates for similar instruments of issuers with similar credit ratings. 18. A fixed-rate mortgage is a note that requires payment of interest by the mortgagor at a rate that does not change during the life of the note. A variable-rate mortgage is a note that features an interest rate that fluctuates with the market rate; the variable rate generally is adjusted periodically as specified in the terms of the note and is usually limited in the amount of each change in the rate up or down and in the total change that can be made in the rate. 19.
The fair value option is an accounting option where the company can elect to record fair values in their accounts for most financial assets and liabilities, including bonds and notes payable. With bonds at fair value, we assume that the decline in value of the bonds is due to an interest rate increase. In other situations, the decline may occur because the bonds become more likely to default. That is, if the creditworthiness of the issuer declines, the value of its debt also declines. If its creditworthiness declines, its bond investors are receiving a lower rate relative to investors with similar-risk investments. Thus, changes in the fair value of bonds payable for a decline in creditworthiness are included as part of income. Some question how a bond issuer can record a gain when its creditworthiness is becoming worse. However, the FASB notes that the debtholders’ loss is the shareholders’ gain. That is, the shareholders’ claims on the assets of the company increase when the value of the debtholders’ claims declines. In addition, the worsening credit position may indicate that the assets of the company are declining in value as well. Thus, the company may be reporting losses on the asset side, which will be offsetting gains on the liability side.
20.
Unrealized Holding Gain or Loss—Income ........................................ Notes Payable...........................................................................
2,600 2,600
Questions Chapter 14 (Continued) 21.
The required disclosures at the balance sheet date are future payments for sinking fund requirements and the maturity amounts of long-term debt during each of the next five years.
22. Off-balance-sheet financing is an attempt to borrow monies in such a way that the obligations are not recorded. Reasons for off-balance sheet financing are: (1) Many believe removing debt enhances the quality of the balance sheet and permits credit to be obtained more readily and at less cost. (2) Loan covenants are less likely to be violated. (3) The asset side of the balance sheet is understated because fair value is not used for many assets. As a result, not reporting certain debt transactions offsets the nonrecognition of fair values on certain assets. 23.
Forms of off-balance-sheet financing include (1) investments in non-consolidated subsidiaries for which the parent is liable for the subsidiary debt; (2) use of special purpose entities (SPEs), which are used to borrow money for special projects (resulting in take-or-pay contracts); (3) operating leases, which when structured carefully give the company the benefits of ownership without reporting the liability for the lease payments.
24. Under GAAP, a parent company does not have to consolidate a subsidiary company that is less than 50 percent owned. In such cases, the parent therefore does not report the assets and liabilities of the subsidiary. All the parent reports on its balance sheet is the investment in the subsidiary. As a result, users of the financial statements may not understand that the subsidiary has considerable debt for which the parent may ultimately be liable if the subsidiary runs into financial difficulty. *25. Two different types of situations result with troubled debt: (1) Impairments, and (2) Restructurings. Restructurings can be further classified into: (a) Settlements. (b) Modification of terms. When a debtor company runs into financial difficulty, creditors may recognize an impairment on a loan extended to that company. Subsequently, the creditor may modify the terms of the loan, or settles it on terms unfavorable to the creditor. In unusual cases, the creditor forces the debtor into bankruptcy in order to ensure the highest possible collection on the loan. *26. A transfer of noncash assets (real estate, receivables, or other assets) or the issuance of the debtor’s stock can be used to settle a debt obligation in a troubled debt restructuring. In these situations, the noncash assets or equity interest given should be accounted for at fair value. The debtor is required to determine the excess of the carrying amount of the payable over the fair value of the assets or equity transferred (gain). Likewise, the creditor is required to determine the excess of the receivable over the fair value of those same assets or equity interests transferred (loss). The debtor recognizes a gain equal to the amount of the excess and the creditor normally would charge the excess (loss) against Allowance for Doubtful Accounts. In addition, the debtor recognizes a gain or loss on disposition of assets to the extent that the fair value of those assets differs from their carrying amount (book value).
Questions Chapter 14 (Continued) *27. (a) (b)
The creditor will grant concessions in a troubled debt situation because it appears to be the more likely way to maximize recovery of the investment. The creditor might grant any one or a combination of the following concessions: 1. Reduce the face amount of the debt. 2. Accept noncash assets or equity interests in lieu of cash in settlement. 3. Reduce the stated interest rate. 4. Extend the maturity date of the face amount of the debt. 5. Reduce or defer any accrued interest.
*28. When a loan is restructured, the creditor should calculate the loss due to restructuring by subtracting the present value of the restructured cash flows (using the historical effective rate) from the carrying value of the loan. Interest revenue is calculated at the original effective rate applied towards the new carrying value. The debtor will record a gain only if the undiscounted restructured cash flows are less than the carrying value of the loan. If a gain is recognized, subsequent payments will be all principal. There is no interest component. If the undiscounted cash flows exceed the carrying amount, no gain is recognized, and a new imputed interest rate must be calculated in order to recognize interest expense in subsequent periods. *29. “Accounting symmetry” between the entries recorded by the debtor and the creditor in a troubled debt restructuring means that there is a correspondence or agreement between the entries recorded by each party. Impairments are nonsymmetrical because, while the creditor records a loss, the debtor makes no entry at all. Troubled debt restructurings are nonsymmetrical because creditors calculate their losses using the discounted present value of future cash flows, while debtors calculate their gains using the undiscounted cash flows. *30. A transaction would be recorded as a troubled debt restructuring by only the debtor if the amount for which the liability is settled is less than its carrying amount on the debtor’s books, but equal to or greater than the carrying amount on the creditor’s books. In addition to the situation created by the use of discounted versus undiscounted cash flows by creditors and debtors, this situation can occur when a debtor or creditor has been substituted for one of the parties to the original transaction.
SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 14-1 Present value of the principal $500,000 X .37689 .............................................................$188,445 Present value of the interest payments $22,500* X 12.46221 .......................................................... 280,400 Issue price ..................................................................$468,845 *($500,000 X 9% X 6/12) BRIEF EXERCISE 14-2 (a) (b)
(c)
Cash....................................................................... Bonds Payable .............................................
300,000
Interest Expense ................................................... Cash ($300,000 X 10% X 6/12) .....................
15,000
Interest Expense ................................................... Interest Payable ...........................................
15,000
300,000 15,000 15,000
BRIEF EXERCISE 14-3 (a)
(b)
(c)
Cash ($300,000 X 98%) ......................................... Discount on Bonds Payable................................. Bonds Payable .............................................
294,000 6,000
Interest Expense ................................................... Discount on Bonds Payable ($6,000 X 1/10 = $600) ............................... Cash ($300,000 X 10% X 6/12) .....................
15,600
Interest Expense ................................................... Discount on Bonds Payable ($6,000 X 1/10 = $600) ............................... Interest Payable ...........................................
15,600
300,000
600 15,000
600 15,000
BRIEF EXERCISE 14-4 (a)
(b)
(c)
Cash ($300,000 X 103%) ............................................ 309,000 Bonds Payable .................................................. Premium on Bonds Payable.............................
300,000 9,000
Interest Expense ........................................................ Premium on Bonds Payable ($9,000 X 1/10 = $900) ............................................. Cash ($300,000 X 10% X 6/12) ..........................
14,100 15,000
Interest Expense ........................................................ Premium on Bonds Payable ($9,000 X 1/10 = $900) ............................................. Interest Payable ................................................
14,100
900
900 15,000
BRIEF EXERCISE 14-5 (a)
(b) (c)
Cash ............................................................................ 408,000 Bonds Payable .................................................. Interest Expense ($400,000 X 6% X 4/12) ........ Interest Expense ........................................................ Cash ($400,000 X 6% X 6/12) ............................
12,000
Interest Expense ........................................................ Interest Payable ................................................
12,000
400,000 8,000
12,000 12,000
BRIEF EXERCISE 14-6 (a)
(b)
Cash ............................................................................ 559,224 Discount on Bonds Payable...................................... 40,776 Bonds Payable ..................................................
600,000
Interest Expense ($559,224 X 8% X 6/12).................. Cash ($600,000 X 7% X 6/12) ............................ Discount on Bonds Payable.............................
21,000 1,369
22,369
BRIEF EXERCISE 14-6 (Continued) (c)
Interest Expense ($560,593* X 8% X 6/12) ........... Interest Payable ........................................... Discount on Bonds Payable .......................
22,424 21,000 1,424
*($559,224 + $1,369) BRIEF EXERCISE 14-7 (a)
(b)
(c)
Cash....................................................................... Bonds Payable ............................................. Premium on Bonds Payable .......................
644,636
Interest Expense ($644,636 X 6% X 6/12) ............ Premium on Bonds Payable................................. Cash ($600,000 X 7% X 6/12).......................
19,339 1,661
Interest Expense ................................................... Premium on Bonds Payable................................. Interest Payable ($642,975* X 6% X 6/12 = $19,289) ...........
19,289 1,711
600,000 44,636
21,000
21,000
*($644,636 – $1,661) BRIEF EXERCISE 14-8 Interest Expense ($644,636 X 6% X 2/12)....................... Premium on Bonds Payable ........................................... Interest Payable ($600,000 X 7% X 2/12)...............
6,446 554 7,000
BRIEF EXERCISE 14-9 Current liabilities Bond Interest Payable............................................ Long-term liabilities Bonds Payable, due January 1, 2023.................... Less: Discount on Bonds Payable.......................
$
80,000
$2,000,000 88,000 $1,912,000
BRIEF EXERCISE 14-10 Bond Issue Expense .................................................................. 16,000 Unamortized Bond Issue Costs ($160,000 X 1/10)........................................................
16,000
BRIEF EXERCISE 14-11 Bonds Payable....................................................................... 500,000 Premium on Bonds Payable ................................................. 15,000 Unamortized Bond Issue Costs................................... 5,250 Gain on Redemption of Bonds .................................... 14,750 Cash .............................................................................. 495,000
BRIEF EXERCISE 14-12 (a) (b)
Cash ............................................................................. Notes Payable ....................................................
100,000
Interest Expense ......................................................... Cash ($100,000 X 10%) ......................................
10,000
100,000 10,000
BRIEF EXERCISE 14-13 (a)
(b)
Cash ............................................................................. Discount on Notes Payable ........................................ Notes Payable ....................................................
47,664 27,336
Interest Expense ......................................................... Discount on Notes Payable ($47,664 X 12%) ...
5,720
75,000 5,720
BRIEF EXERCISE 14-14 (a)
(b)
Equipment ............................................................. Discount on Notes Payable.................................. Notes Payable ..............................................
31,495 8,505
Interest Expense ($31,495 X 12%)........................ Cash ($40,000 X 5%) .................................... Discount on Notes Payable.........................
3,779
40,000 2,000 1,779
BRIEF EXERCISE 14-15 Cash ................................................................................. Discount on Notes Payable ............................................ Notes Payable......................................................... Unearned Sales Revenue [$60,000 – ($60,000 X .63552) = $21,869]............
60,000 21,869 60,000 21,869
BRIEF EXERCISE 14-16 (a) Fair Value – Book Value = $17,500 – $16,000 = $1,500 unrealized holding loss. (b) Unrealized Holding Gain or Loss—Income............. Notes Payable .................................................
1,500 1,500
SOLUTIONS TO EXERCISES EXERCISE 14-1 (15–20 minutes) (a)
(b) (c) (d) (e)
(f) (g)
(h) (i)
Valuation account relating to the long-term liability, bonds payable (sometimes referred to as an adjunct account). The $3,000 would continue to be reported as long-term. Current liability if current assets are used to satisfy the debt. Current liability, $200,000; long-term liability, $800,000. Current liability. Probably noncurrent, although if operating cycle is greater than one year and current assets are used, this item would be classified as current. Current liability. Current liability unless (a) a fund for liquidation has been accumulated which is not classified as a current asset or (b) arrangements have been made for refinancing. Current liability. Current liability.
EXERCISE 14-2 (15–20 minutes) (a)
Discount on bonds payable—Contra account to bonds payable on balance sheet.
(b)
Interest expense (credit balance)—Reclassify to interest payable on balance sheet.
(c)
Unamortized bond issue costs—Classified as “Other Assets” on balance sheet.
(d)
Gain on repurchase of debt—Classify as part of other gains and losses on the income statement.
(e)
Mortgage payable—Classify one-third as current liability and the remainder as long-term liability on balance sheet.
EXERCISE 14-2 (Continued) (f)
Debenture bonds—Classify as long-term liability on balance sheet.
(g)
Notes payable—Classify as long-term liability on balance sheet.
(h)
Premium on bonds payable—Classify as adjunct account to Bonds payable on balance sheet.
(i)
Treasury bonds—Classify as contra account to Bonds payable on balance sheet.
(j)
Bonds payable—Classify as long-term liability on balance sheet.
EXERCISE 14-3 (15–20 minutes) 1.
Simon Company: (a)
(b)
(c)
2.
1/1/14
7/1/14
12/31/14
Cash .................................................... Bonds Payable ..........................
200,000
Interest Expense ................................ ($200,000 X 9% X 3/12) Cash...........................................
4,500
Interest Expense ................................ Interest Payable ........................
4,500
200,000
4,500
4,500
Garfunkle Company: (a)
(b)
6/1/14
7/1/14
Cash .................................................... 105,000 Bonds Payable .......................... Interest Expense ....................... ($100,000 X 12% X 5/12) Interest Expense ................................ Cash........................................... ($100,000 X 12% X 6/12)
100,000 5,000
6,000 6,000
EXERCISE 14-3 (Continued) (c)
12/31/14
Interest Expense ................................ Interest Payable ........................
6,000 6,000
Note to instructor: Some students may credit Interest Payable on 6/1/14. If they do so, the entry on 7/1/14 will have a debit to Interest Payable for $5,000 and a debit to Interest Expense for $1,000.
EXERCISE 14-4 (15–20 minutes) (a)
(b)
(c)
1/1/14
7/1/14
12/31/14
Cash ($600,000 X 102%) ........................... Bonds Payable ................................. Premium on Bonds Payable ..........................................
612,000
Interest Expense ....................................... Premium on Bonds Payable..................... ($12,000 ÷ 40) Cash.................................................. ($600,000 X 10% X 6/12)
29,700 300
600,000 12,000
30,000
Interest Expense ........................................... 29,700 Premium on Bonds Payable..................... 300 Interest Payable ...............................
30,000
EXERCISE 14-5 (15–20 minutes) (a)
(b)
1/1/14
7/1/14
Cash ($600,000 X 102%)............................ 612,000 Bonds Payable ................................. Premium on Bonds Payable............ Interest Expense ....................................... ($612,000 X 9.7705% X 1/2) Premium on Bonds Payable ..................... Cash .................................................. ($600,000 X 10% X 6/12)
600,000 12,000
29,898 102 30,000
EXERCISE 14-5 (Continued) (c)
12/31/14
Interest Expense ........................................ 29,893 ($611,898 X 9.7705% X 1/2) Premium on Bonds Payable................... 107 Interest Payable ............................. Carrying amount of bonds at July 1, 2014: Carrying amount of bonds at January 1, 2014 Amortization of bond premium ($30,000 – $29,898) Carrying amount of bonds at July 1, 2014
30,000
$612,000 (102) $611,898
EXERCISE 14-6 (15–20 minutes) Schedule of Discount Amortization Straight-Line Method Cash Paid Year Jan. 1, 2014 Dec. 31, 2014 Dec. 31, 2015 Dec. 31, 2016 Dec. 31, 2017 Dec. 31, 2018
$200,000** 200,000 200,000 200,000 200,000
Interest Expense $228,836.80 228,836.80 228,836.80 228,836.80 228,836.80
Discount Amortized
Carrying Amount of Bonds
$28,836.80** 28,836.80 28,836.80 28,836.80 28,836.80
$1,855,816.00 1,884,652.80 1,913,489.60 1,942,326.40 1,971,163.20 2,000,000.00
**$2,000,000 X 10% **$28,836.80 = ($2,000,000 – $1,855,816) ÷ 5. EXERCISE 14-7 (15–20 minutes) The effective-interest or yield rate is 12%. It is determined through trial and error using Table 6-2 for the discounted value of the principal ($1,134,860) and Table 6-4 for the discounted value of the interest ($720,956); $1,134,860 plus $720,956 equals the proceeds of $1,855,816. (A financial calculator may be used to determine the rate of 12%.)
EXERCISE 14-7 (Continued) Schedule of Discount Amortization Effective-Interest Method (12%)
Year (1) Jan. 1, 2014 Dec. 31, 2014 Dec. 31, 2015 Dec. 31, 2016 Dec. 31, 2017 Dec. 31, 2018
Cash Paid
Interest Expense
Discount Amortized
(2)
(3)
(4)
$200,000 200,000 200,000 200,000 200,000
$222,697.92* 225,421.67 228,472.27 231,888.94 235,703.20**
$22,697.92 25,421.67 28,472.27 31,888.94 35,703.20
Carrying Amount of Bonds $1,855,816.00 1,878,513.92 1,903,935.59 1,932,407.86 1,964,296.80 2,000,000.00
*$222,697.92 = $1,855,816 X .12. **Rounded.
EXERCISE 14-8 (15–20 minutes) (a)
Printing and engraving costs of bonds Legal fees Commissions paid to underwriter Amount to be reported as Unamortized Bond Issue Costs
$12,000 49,000 60,000 $121,000
The Unamortized Bond Issue Costs, $121,000, should be reported as a deferred charge in the Other Assets section on the balance sheet. (b)
Interest paid for the period from January 1 (July 1) to June 30 (December 31), 2014; $2,000,000 X 10% X 6/12 Less: Premium amortization for the period from January 1 (July 1) to June 30 (December 31), 2014 [($2,000,000 X 1.04) – $2,000,000] ÷ 10 X 6/12 Interest expense to be recorded on July 1 (December 31), 2014
$100,000
4,000 $ 96,000
EXERCISE 14-8 (Continued) (c)
Carrying amount of bonds on June 30, 2014 Effective-interest rate for the period from June 30 to October 31, 2014 (.10 X 4/12) Interest expense to be recorded on October 31, 2014
$562,500 X.033333 $ 18,750
EXERCISE 14-9 (20–30 minutes)
(a)
1.
2.
3.
4.
June 30, 2014 Cash ....................................................... 4,300,920.00 Bonds Payable ......................... Premium on Bonds Payable.... December 31, 2014 Interest Expense ............................... 258,055.20 ($4,300,920.00 X 12% X 6/12) Premium on Bonds Payable............. 1,944.80 Cash .......................................... ($4,000,000 X 13% X 6/12)
4,000,000.00 300,920.00
260,000.00
June 30, 2015 Interest Expense ............................... 257,938.51 [($4,300,920.00 – $1,944.80) X 12% X 6/12] Premium on Bonds Payable............. 2,061.49 Cash ..........................................
260,000.00
December 31, 2015 Interest Expense ............................... 257,814.82 [($4,300,920.00 – $1,944.80 – $2,061.49) X 12% X 6/12] Premium on Bonds Payable............. 2,185.18 Cash ..........................................
260,000.00
EXERCISE 14-9 (Continued) (b)
Long-term Liabilities: Bonds payable, 13% (due on June 30, 2034) Premium on bonds payable* Book value of bonds payable
$4,000,000.00 294,728.53 $4,294,728.53
*($4,300,920.00 – $4,000,000) – ($1,944.80 + $2,061.49 + $2,185.18) = $294,728.53
(c)
1.
Interest expense for the period from January 1 to June 30, 2015 from (a) 3. Interest expense for the period from July 1 to December 31, 2015 from (a) 4. Amount of interest expense reported for 2015
$257,938.51 257,814.82 $515,753.33
2.
The amount of bond interest expense reported in 2015 will be greater than the amount that would be reported if the straightline method of amortization were used. Under the straight-line method, the amortization of bond premium is $15,046 ($300,920/20). Bond interest expense for 2015 is the difference between the amortized premium, $15,046, and the actual interest paid, $520,000 ($4,000,000 X 13%). Thus, the amount of bond interest expense is $504,954 ($520,000 – $15,046), which is smaller than the bond interest expense under the effectiveinterest method.
3.
Total interest to be paid for the bond ($4,000,000 X 13% X 20) Principal due in 2034 Total cash outlays for the bond Cash received at issuance of the bond Total cost of borrowing over the life of the bond
4.
They will be the same.
$10,400,000 4,000,000 14,400,000 (4,300,920) $10,099,080
EXERCISE 14-10 (15–20 minutes) (a)
(b)
January 1, 2014 Cash ........................................................... 537,907.37 Premium on Bonds Payable............ Bonds Payable .................................
37,907.37 500,000.00
Schedule of Interest Expense and Bond Premium Amortization Effective-Interest Method 12% Bonds Sold to Yield 10% Cash Paid
Interest Expense
Premium Amortized
Carrying Amount of Bonds
– $60,000.00* 60,000.00 60,000.00
– $53,790.74 53,169.81 52,486.79
– $6,209.26 6,830.19 7,513.21
$537,907.37 531,698.11 524,867.92 517,354.71
Date 1/1/14 12/31/14 12/31/15 12/31/16
*$500,000 X 12% (c)
(d)
December 31, 2014 Interest Expense ....................................... 53,790.74 Premium on Bonds Payable..................... 6,209.26 Cash ..................................................
60,000.00
December 31, 2015 Interest Expense ....................................... 52,486.79 Premium on Bonds Payable..................... 7,513.21 Cash ..................................................
60,000.00
EXERCISE 14-11 (20–30 minutes) Unsecured Bonds (1)
Maturity value
(2)
Number of interest periods
(3)
Stated rate per period
(4)
Effective rate per period
(5)
Payment amount per period
(6)
Present value
(a)
$10,000,000
$25,000,000
$20,000,000
40
10
10
0
10%
12%
12%
$375,000(a)
0
$2,000,000(b)
$11,733,639(c)
$8,049,250(d)
$17,739,840(e)
3.75% (
15% 4
)
3% (
12% 4
)
$20,000,000 X 10% = $2,000,000
Present value of an annuity of $375,000 discounted at 3% per period for 40 periods ($375,000 X 23.11477) = Present value of $10,000,000 discounted at 3% per period for 40 periods ($10,000,000 X .30656) =
(d)
(e)
Mortgage Bonds
$10,000,000 X 15% X 1/4 = $375,000
(b) (c)
Zero-Coupon Bonds
Present value of $25,000,000 discounted at 12% for 10 periods ($25,000,000 X .32197) =
Present value of an annuity of $2,000,000 discounted at 12% for 10 periods ($2,000,000 X 5.65022) = Present value of $20,000,000 discounted at 12% for 10 years ($20,000,000 X .32197)
$ 8,668,039 3,065,600 $11,733,639
$ 8,049,250
$11,300,440 6,439,400 $17,739,840
EXERCISE 14-12 (15–20 minutes) Reacquisition price ($900,000 X 101%) Less: Net carrying amount of bonds redeemed: Par value Unamortized discount Unamortized bond issue costs Loss on redemption Calculation of unamortized discount— Original amount of discount: $900,000 X 3% = $27,000 $27,000/10 = $2,700 amortization per year Amount of discount unamortized: $2,700 X 5 = $13,500 Calculation of unamortized bond issue costs— Original amount of costs: $24,000 X $900,000/$1,500,000 = $14,400 $14,400/10 = $1,440 amortization per year Amount of costs unamortized: $1,440 X 5 = $7,200 January 2, 2014 Bonds Payable ..................................................... Loss on Redemption of Bonds............................ Unamortized Bond Issue Costs ................. Discount on Bonds Payable ....................... Cash .............................................................
$909,000 $900,000 (13,500) (7,200)
879,300 $ 29,700
900,000 29,700 7,200 13,500 909,000
EXERCISE 14-13 (15–20 minutes) Cash ...........................................................................8,820,000 Discount on Bonds Payable (.02 X $9,000,000).. 180,000 Bonds Payable ............................................ (To record issuance of 10% bonds)
9,000,000
EXERCISE 14-13 (Continued) Bonds Payable...................................................... Loss on Redemption of Bonds............................ Cash ($6,000,000 X 1.02) ............................. Discount on Bonds Payable ....................... Unamortized Bond Issue Costs.................. (To record retirement of 11% bonds) Reacquisition price .............................................. Less: Net carrying amount of bonds redeemed: Par value ...................................................... Unamortized bond discount ....................... Unamortized bond issue costs................... Loss on redemption .............................................
6,000,000 270,000 6,120,000 120,000 30,000 $6,120,000 $6,000,000 (120,000) (30,000)
5,850,000 $ 270,000
EXERCISE 14-14 (12–16 minutes) (a)
June 30, 2015 Bonds Payable ............................................. Loss on Redemption of Bonds.................... Discount on Bonds Payable ............... Cash ..................................................... Reacquisition price ($800,000 X 104%)....... Less: Net carrying amount of bonds redeemed: Par value .............................................. Unamortized discount......................... (.02 X $800,000 X 11/20) Loss on redemption ..................................... Cash ($1,000,000 X 102%)............................ Premium on Bonds Payable ............... Bonds Payable ....................................
(b)
December 31, 2015 Interest Expense .......................................... Premium on Bonds Payable (1/40 X $20,000).......................................... Cash (.05 X $1,000,000).......................
800,000 40,800 8,800 832,000 $832,000 $800,000 (8,800)
791,200 $ 40,800
1,020,000 20,000 1,000,000 49,500 500 50,000
EXERCISE 14-15 (10–15 minutes) Reacquisition price ($300,000 X 104%)................ Less: Net carrying amount of bonds redeemed: Par value ..................................................... Unamortized discount ................................ Loss on redemption ..............................................
$312,000 $300,000 (10,000)
Bonds Payable ...................................................... Loss on Redemption of Bonds............................. Discount on Bonds Payable ........................ Cash .............................................................. (To record redemption of bonds payable)
300,000 22,000
Cash ($300,000 X 1.03).......................................... Unamortized Bond Issue Costs............................ Premium on Bonds Payable ........................ Bonds Payable ............................................. (To record issuance of new bonds)
306,000 3,000
290,000 $ 22,000
10,000 312,000
9,000 300,000
EXERCISE 14-16 (15–20 minutes) (a)
1.
2.
January 1, 2014 Land ........................................................ 200,000.00 Discount on Notes Payable ................... 137,012.00 Notes Payable................................ (The $200,000 capitalized land cost represents the present value of the note discounted for five years at 11%.) Equipment............................................... Discount on Notes Payable ................... Notes Payable................................
337,012.00
185,674.30 64,325.70* 250,000.00
EXERCISE 14-16 (Continued) *Computation of the discount on notes payable: Maturity value Present value of $250,000 due in 8 years at 11%—$250,000 X .43393 $108,482.50 Present value of $15,000 payable annually for 8 years at 11% annually—$15,000 X 5.14612 77,191.80 Present value of the note Discount (b)
1.
2.
Interest Expense................................... Discount on Notes Payable ........ ($200,000 X .11)
22,000.00
Interest Expense................................... ($185,674.30 X .11) Discount on Notes Payable ........ Cash ($250,000 X .06) ..................
20,424.17
$250,000.00
(185,674.30) $ 64,325.70
22,000.00
5,424.17 15,000.00
EXERCISE 14-17 (15–20 minutes) (a)
(b)
Face value of the zero-interest-bearing note Discount factor (12% for 3 periods) Amount to be recorded for the land at January 1, 2014
$550,000 X .71178 $391,479
Carrying value of the note at January 1, 2014 Applicable interest rate (12%) Interest expense to be reported in 2014
$391,479 X .12 $ 46,977
January 1, 2014 Cash ............................................................. Discount on Notes Payable ........................ Notes Payable..................................... Unearned Sales Revenue ..................
5,000,000 1,584,950
$5,000,000 – ($5,000,000 X .68301) = $1,584,950
5,000,000 1,584,950
EXERCISE 14-17 (Continued) Carrying value of the note at January 1, 2014 Applicable interest rate (10%) Interest expense to be reported for 2014
$3,415,050** X .10 $ 341,505
**$5,000,000 – $1,584,950 = $3,415,050
EXERCISE 14-18 (15–20 minutes) (a)
Cash ........................................................... Discount on Notes Payable ...................... Notes Payable .................................. Unearned Sales Revenue ................ ($400,000 – $317,532) Face value Present value of 1 at 8% for 3 years Present value
(b)
400,000 82,468 400,000 82,468
$400,000 X .79383 $317,532
Interest Expense ($317,532 X 8%)............ Discount on Notes Payable .............
25,403
Unearned Sales Revenue ($82,468 ÷ 3) Sales .................................................
27,489
25,403
27,489
EXERCISE 14-19 (10–15 minutes)
Year Ending 2014 2015 2016 (a)
Carrying Value $54,000 44,000 36,000
Fair Value $54,000 42,500 38,000
Unrealized Holding Gain or Loss $ 0 1,500 (2,000)
Change in Unrealized Holding Gain or Loss $ 0 1,500 (500)
2014 No Entry (Carrying value = Fair Value) 2015 Notes Payable..................................................... Unrealized Holding Gain or Loss— Income .................................................. 2016 Unrealized Holding Gain or Loss—Income ...... Notes Payable............................................
1,500 1,500 3,500 3,500
(b)
The fair value of $42,500.
(c)
Unrealized holding loss of $3,500.
(d)
Fallen’s creditworthiness has improved during 2016 because bond investors are receiving a higher rate relative to investors in similarrisk investments.
EXERCISE 14-20 (10–15 minutes) At December 31, 2014, disclosures would be as follows: Maturities and sinking fund requirements on long-term debt are as follows: 2015 2016 2017 2018 2019
$ 0 2,500,000 4,500,000 8,500,000 2,500,000
($2,000,000 + $2,500,000) ($6,000,000 + $2,500,000)
*EXERCISE 14-21 (15–20 minutes) (a)
Transfer of property on December 31, 2014: Strickland Company (Debtor): Notes Payable ............................................. Interest Payable .......................................... Accumulated Depreciation—Machinery.... Machinery ............................................ Gain on Disposal of Machinery .......... Gain on Restructuring of Debt ........... a
200,000 18,000 221,000 390,000 11,000a 38,000b
$180,000 – ($390,000 – $221,000) = $11,000. ($200,000 + $18,000) – $180,000 = $38,000.
b
Moran State Bank (Creditor): Machinery .................................................... Allowance for Doubtful Accounts.............. Notes Receivable ................................ Interest Receivable .............................
180,000 38,000 200,000 18,000
(b)
“Gain on Disposal of Machinery” and the “Gain on Restructuring of Debt” should be reported as an ordinary gain in the income statement.
(c)
Granting of equity interest on December 31, 2014: Strickland Company (Debtor): Notes Payable ............................................. Interest Payable .......................................... Common Stock.................................... Paid-in Capital in Excess of ParCommon Stock............................... Gain on Restructuring of Debt ........... Moran State Bank (Creditor): Equity Investments ..................................... Allowance for Doubtful Accounts.............. Notes Receivable ................................ Interest Receivable .............................
200,000 18,000 150,000 30,000 38,000
180,000 38,000 200,000 18,000
*EXERCISE 14-22 (20–30 minutes) (a)
No. The gain recorded by Barkley is not equal to the loss recorded by American Bank under the debt restructuring agreement. (You will see why this happens in the following four exercises.) In response to this “accounting asymmetry” treatment, GAAP did not address debtor accounting because the FASB was concerned that expansion of the scope of its pronouncement would delay issuance of GAAP for the creditor.
(b)
No. There is no gain under the modified terms because the total future cash flows after restructuring exceed the total pre-restructuring carrying amount of the note (principal): Total future cash flows after restructuring are: Principal.................................................................. Interest ($2,400,000 X 10% X 3) .............................
Total pre-restructuring carrying amount of note (principal): .................................................................... (c)
$2,400,000 720,000 $3,120,000
$3,000,000
The interest payment schedule is prepared as follows: BARKLEY COMPANY Interest Payment Schedule After Debt Restructuring Effective-Interest Rate 1.4276% Cash Interest Reduction Carrying Paid Expense of Carrying Amount of Date (10%) (1.4276%) Amount Note 12/31/14 $3,000,000 a b c 12/31/15 $240,000 $ 42,828 $197,172 2,802,828 12/31/16 240,000 40,013 199,987 2,602,841 d 12/31/17 240,000 37,159 202,841 2,400,000 Total $720,000 $120,000 $600,000 a
$2,400,000 X 10% = $240,000. $3,000,000 X 1.4276% = $42,828. c $240,000 – $42,828 = $197,172. d Adjusted $1 due to rounding. b
*EXERCISE 14-22 (Continued) (d)
Interest payment entry for Barkley Company is: December 31, 2016 Notes Payable ..................................................... Interest Expense ................................................. Cash ............................................................
(e)
199,987 40,013 240,000
The payment entry at maturity is: January 1, 2018 Notes Payable........................................................ 2,400,000 Cash ............................................................
2,400,000
*EXERCISE 14-23 (25–30 minutes) (a)
American Bank should use the historical interest rate of 12% to calculate the loss.
(b)
The loss is computed as follows: Pre-restructuring carrying amount of note Less: Present value of restructured future cash flows: Present value of principal $2,400,000 due in 3 years at 12% $1,708,272a Present value of interest $240,000 paid annually for 3 years at 12% 576,439b Loss on restructuring of debt a
$3,000,000
2,284,711 $ 715,289
$2,400,000 X .71178 = $1,708,272. $240,000 X 2.40183 = $576,439.
b
December 31, 2014 Bad Debt Expense ................................................... 715,289 Allowance for Doubtful Accounts.............
715,289
*EXERCISE 14-23 (Continued) (c)
The interest receipt schedule is prepared as follows: AMERICAN BANK Interest Receipt Schedule After Debt Restructuring Effective-Interest Rate 12% Cash Interest Increase Carrying Received Revenue in Carrying Amount of Date (10%) (12%) Amount Note 12/31/14 $2,284,711 a b c 12/31/15 $240,000 $274,165 $ 34,165 2,318,876 12/31/16 240,000 278,265 38,265 2,357,141 12/31/17 240,000 282,859* 42,859 2,400,000 Total $720,000 $835,289 $115,289 a
$2,400,000 X 10% = $240,000. $2,284,711 X 12% = $274,165. c $274,165 – $240,000 = $34,165. *Rounded $2 b
(d)
Interest receipt entry for American Bank is: December 31, 2016 Cash .................................................................... Allowance for Doubtful Accounts..................... Interest Revenue .......................................
(e)
240,000 38,265 278,265
The receipt entry at maturity is: January 1, 2018 Cash ....................................................................... 2,400,000 Allowance for Doubtful Accounts..................... 600,000 Notes Receivable ......................................
3,000,000
*EXERCISE 14-24 (25–30 minutes) (a)
Yes. Barkley Company can record a gain under this term modification. The gain is calculated as follows: Total future cash flows after restructuring are: Principal.......................................................... Interest ($1,900,000 X 10% X 3) .................... Total pre-restructuring carrying amount of note (principal): ..........................................................
$1,900,000 570,000 $2,470,000 $3,000,000
Therefore, the gain = $3,000,000 – $2,470,000 = $530,000. (b)
The entry to record the gain on December 31, 2014: Notes Payable................................................... 530,000 Gain on Restructuring of Debt ..............
530,000
(c)
Because the new carrying value of the note ($3,000,000 – $530,000 = $2,470,000) equals the sum of the undiscounted future cash flows ($1,900,000 principal + $570,000 interest = $2,470,000), the imputed interest rate is 0%. Consequently, all the future cash flows reduce the principal balance and no interest expense is recognized.
(d)
The interest payment schedule is prepared as follows: BARKLEY COMPANY Interest Payment Schedule After Debt Restructuring Effective-Interest Rate 0% Cash Interest Reduction Carrying Paid Expense of Carrying Amount of Date (10%) (0%) Amount Note 12/31/14 $2,470,000 a 12/31/15 $190,000 $0 $190,000 2,280,000b 12/31/16 190,000 0 190,000 2,090,000 12/31/17 190,000 0 190,000 1,900,000 Total $570,000 $0 $570,000 a
$1,900,000 X 10% = $190,000. $2,470,000 – $190,000 = $2,280,000.
b
*EXERCISE 14-24 (Continued) (e)
Cash interest payment entries for Barkley Company are: December 31, 2015, 2016, and 2017 Notes Payable............................................... 190,000 Cash .....................................................
(f)
190,000
The payment entry at maturity is: January 1, 2018 Notes Payable............................................... Cash .....................................................
1,900,000 1,900,000
*EXERCISE 14-25 (20–30 minutes) (a)
The loss can be calculated as follows: Pre-restructuring carrying amount of note ...... Less: Present value of restructured future cash flows: Present value of principal $1,900,000 due in 3 years at 12% ............................ $1,352,382a Present value of interest $190,000 paid annually for 3 years at 12%......... 456,348b Loss on restructuring of debt ........................... a
$3,000,000
1,808,730 $1,191,270
$1,900,000 X .71178 = $1,352,382 $190,000 X 2.40183 = $456,348
b
December 31, 2014 Bad Debt Expense ................................................. 1,191,270 Allowance for Doubtful Accounts.............
1,191,270
*EXERCISE 14-25 (Continued) (b)
The interest receipt schedule is prepared as follows: AMERICAN BANK Interest Receipt Schedule After Debt Restructuring Effective-Interest Rate 12% Cash Interest Increase Carrying Received Revenue in Carrying Amount of Date (10%) (12%) Amount Note 12/31/14 $1,808,730 a b c 12/31/15 $190,000 $217,048 $27,048 1,835,778 12/31/16 190,000 220,293 30,293 1,866,071 12/31/17 190,000 223,929 33,929 1,900,000 Total $570,000 $661,270 $91,270 a
$1,900,000 X 10% = $190,000. $1,808,730 X 12% = $217,048. c $217,048 – $190,000 = $27,048. b
(c)
(d)
Interest receipt entries for American Bank are: December 31, 2015 Cash ..................................................................... Allowance for Doubtful Accounts...................... Interest Revenue ........................................
190,000 27,048
December 31, 2016 Cash ..................................................................... Allowance for Doubtful Accounts...................... Interest Revenue ........................................
190,000 30,293
December 31, 2017 Cash ..................................................................... Allowance for Doubtful Accounts...................... Interest Revenue ........................................
190,000 33,929
217,048
220,293
223,929
The receipt entry at maturity is: January 1, 2018 Cash ........................................................................ 1,900,000 Allowance for Doubtful Accounts ......................... 1,100,000 Notes Receivable .......................................
3,000,000
*EXERCISE 14-26 (15–20 minutes) (a)
Gottlieb Co.’s entry: Notes Payable...................................................... Land ............................................................ Gain on Disposal of Plant Assets ($140,000 – $90,000) ............................... Gain on Restructuring of Debt ..................
199,800 90,000 50,000 59,800*
*$199,800 – $140,000 (b)
Ceballos Inc. entry: Land ..................................................................... Allowance for Doubtful Accounts ...................... Notes Receivable .......................................
140,000 59,800 199,800
*EXERCISE 14-27 (20–25 minutes) Because the carrying amount of the debt, $270,000 exceeds the total future cash flows $242,000 [$220,000 + ($11,000 X 2)], a gain and a loss are recognized and no interest is recorded by the debtor. (a)
Vargo Corp.’s entries: 2014 Notes Payable............................................. Gain on Restructuring of Debt ..........
28,000 28,000
2015 Notes Payable............................................. Cash (5% X $220,000).........................
11,000
2016 Notes Payable............................................. Cash [$220,000 + (5% X $220,000)] ..........
231,000
11,000
231,000
*EXERCISE 14-27 (Continued) (b)
First Trust’s entry on December 31, 2014: Bad Debt Expense................................................. Allowance for Doubtful Accounts...............
76,027 76,027
Pre-restructure carrying amount Present value of restructured cash flows: Present value of $220,000 due in 2 years at 12%, interest payable annually (Table 6-2); ($220,000 X .79719) ................... $175,382 Present value of $11,000 interest payable annually for 2 years at 12% (Table 6-4); ($11,000 X 1.69005) ................................... 18,591 Creditor’s loss on restructuring of debt..............
Date 12/31/14 12/31/15 12/31/16
Cash Interest
EffectiveInterest
Increase in Carrying Amount
$11,000a 11,000
$23,277b 24,750
$12,277c 13,750
$270,000
193,973 $ (76,027)
Carrying Amount of Note $193,973 206,250 220,000
a
$11,000 = $220,000 X .05 $23,227 = $193,973 X 12% c $12,277 = $23,277 – $11,000 b
December 31, 2015 Cash ..................................................................... Allowance for Doubtful Accounts...................... Interest Revenue ........................................
11,000 12,277
December 31, 2016 Cash ..................................................................... Allowance for Doubtful Accounts...................... Interest Revenue ........................................
11,000 13,750
Cash ..................................................................... Allowance for Doubtful Accounts...................... Notes Receivable .......................................
23,277
24,750 220,000 50,000 270,000
TIME AND PURPOSE OF PROBLEMS Problem 14-1 (Time 15–20 minutes) Purpose—to provide the student with the opportunity to interpret a bond amortization schedule. This problem requires both an understanding of the function of such a schedule and the relevance of each of the individual numbers. The student is to prepare journal entries to reflect the information given in the bond amortization schedule. Problem 14-2 (Time 25–30 minutes) Purpose—to provide the student with an understanding of how to make the journal entry to record the issuance of bonds. In addition, a portion of the bonds are retired and therefore a bond amortization schedule has to be prepared. Problem 14-3 (Time 20–30 minutes) Purpose—to provide the student with an understanding of how interest rates can be used to deceive a customer. The problem is challenging because for the first year of this transaction, negative amortization results. Problem 14-4 (Time 15–20 minutes) Purpose—to provide the student with an understanding of the relevant journal entries which are necessitated when there is a bond issuance and bond retirement. This problem also provides an opportunity for the student to learn the income statement treatment of the loss from retirement and the footnote disclosure required. Problem 14-5 (Time 50–65 minutes) Purpose—to provide the student with an understanding of the relevant journal entries which are necessitated for a bond issuance. This problem involves two independent bond issuances with the assumption that one is sold at a discount and the other at a premium, both utilizing the effective-interest method. This comprehensive problem requires preparing journal entries for the issuance of bonds, related interest payments and amortization (with the construction of amortization tables where applicable), and the retirement of part of the bonds. Problem 14-6 (Time 20–25 minutes) Purpose—to provide the student with an understanding of the relevant journal entries which are necessitated when there is a bond issuance and bond retirement. This problem requires preparing journal entries, assuming the straight-line method, for the issuance of bonds, related interest payments and amortization, and the retirement of part of the bonds. Problem 14-7 (Time 20–25 minutes) Purpose—to provide the student with a series of transactions from bond issuance, payment of bond interest, accrual of bond interest, amortization of bond discount, and bond retirement. Journal entries are required for each of these transactions. Problem 14-8 (Time 15–25 minutes) Purpose—to provide the student with an opportunity to become familiar with the application of GAAP, involving the exchange of notes for cash or property, goods, or services. This problem requires the preparation of the necessary journal entries concerning the exchange of a zero-interest-bearing longterm note for a computer, and the necessary adjusting entries relative to depreciation and amortization. The student should construct the relevant Schedule of Note Discount Amortization to support the respective entries.
Time and Purpose of Problems (Continued) Problem 14-9 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to become familiar with the application of GAAP, involving the exchange of a note, which is payable in equal installments, for machinery. This problem requires the preparation of the necessary journal entries concerning the exchange and the annual payments and interest. A Schedule of Note Discount Amortization should be constructed to support the respective entries. Problem 14-10 (Time 20–25 minutes) Purpose—to provide the student with an understanding of a number of areas related to bonds. Specifically, the classification of bonds, determination of cash received with bond issue costs and accrued interest, and disclosure requirements. Problem 14-11 (Time 40–50 minutes) Purpose—to provide the student with an opportunity to explain what the effective-interest method is, why it is preferable, and how it is computed. As one part of the problem, an amortization schedule must be prepared. *Problem 14-12 (Time 15–25 minutes) Purpose—to provide the student with a troubled debt situation that requires computation of the creditor’s loss on restructure, entries to recognize the loss, and discussion of GAAP relating to this situation. *Problem 14-13 (Time 30–45 minutes) Purpose—to provide the student with four independent and different restructured debt situations where losses or gains must be computed and journal entries recorded on the books of the creditor. *Problem 14-14 (Time 40–50 minutes) Purpose—to provide the student with a complex troubled debt situation that requires two amortization schedules, computation of loss on restructure, and entries at different times on both the creditor’s and debtor’s books.
SOLUTIONS TO PROBLEMS PROBLEM 14-1
(a)
The bonds were sold at a discount of $5,651. Evidence of the discount is the January 1, 2008 book value of $94,349, which is less than the maturity value of $100,000 in 2017.
(b)
The interest allocation and bond discount amortization are based upon the effective-interest method; this is evident from the increasing interest charge. Under the straight-line method the amount of interest would have been $11,565.10 [$11,000 + ($5,651 ÷ 10)] for each year of the life of the bonds.
(c)
The stated rate is 11% ($11,000 ÷ $100,000). The effective rate is 12% ($11,322 ÷ $94,349).
(d)
January 1, 2008 Cash ..................................................................... Discount on Bonds Payable ............................... Bonds Payable ...........................................
(e)
(f)
December 31, 2008 Interest Expense ................................................. Discount on Bonds Payable ...................... Interest Payable..........................................
94,349 5,651 100,000 11,322 322 11,000
January 1, 2015 (Interest Payment) Interest Payable................................................... 11,000 Cash ............................................................
11,000
December 31, 2015 Interest Expense ................................................. Discount on Bonds Payable ...................... Interest Payable..........................................
712 11,000
11,712
PROBLEM 14-2
(a)
Present value of the principal $2,000,000 X .38554 (PV10, 10%) .........................
$ 771,080
Present value of the interest payments $210,000* X 6.14457 (PVOA10, 10%)....................
1,290,360
Present value (selling price of the bonds) ........
$2,061,440
*$2,000,000 X 10.5% = $210,000 Cash ..................................................................... Unamortized Bond Issue Costs ......................... Bonds Payable ........................................... Premium Bonds Payable ...........................
2,011,440 50,000
(b) Date 1/1/13 1/1/14 1/1/15 1/1/16 1/1/17 (c)
Cash Paid
Interest Expense
Premium Amortization
$210,000 210,000 210,000 210,000
$206,144 205,758 205,334 204,868
$3,856 4,242 4,666 5,132
2,000,000 61,440 Carrying Amount of Bonds $2,061,440 2,057,584 2,053,342 2,048,676 2,043,544
Carrying amount as of 1/1/16 ............................... Less: Amortization of bond premium (5,132 ÷ 2) ................................................... Carrying amount as of 7/1/16 ...............................
$2,048,676
Reacquisition price ............................................... Carrying amount as of 7/1/16 ($2,046,110 ÷ 2)...................................................
$1,065,000
Unamortized bond issue costs ($32,500 ÷ 2) ...... Loss on redemption of bonds ..............................
2,566 $2,046,110
(1,023,055) 41,945 16,250 $ 58,195
PROBLEM 14-2 (Continued) Entry for accrued interest Interest Expense ................................................ Premium on Bonds Payable ($5,132 X 1/2 X 1/2) .......................................... Cash ($210,000 X 1/2 X 1/2) .............................
51,217 1,283 52,500
Entry for reacquisition Bonds Payable ................................................... 1,000,000 Premium on Bonds Payable .............................. 23,055* Loss on Redemption of Bonds ......................... 58,195 Unamortized Bond Issue Costs ............... 16,250** Cash ........................................................... 1,065,000 *Premium as of 7/1/14 to be written off ($2,046,110 – $2,000,000) X 1/2 = $23,055 **($50,000 X 1/2) ÷ 10 = $2,500 per year $2,500 X 3.5 = $8,750 Remaining Balance: $25,000 – $8,750 = $16,250 on 1/2 Bonds The loss is reported as an ordinary loss.
PROBLEM 14-3 (a)
Date 1/1/14 4/1/14 7/1/14 10/1/14 1/1/15
Cash Paid
Interest Expense
Discount Amortized
$400 400 400 400
$640* 645 650 655
$240 245 250 255
Carrying Amount of Note $32,000 32,240 32,485 32,735 32,990
*($32,000 X 8% X 1/4) (b)
At this point, we see that the customer owes $32,990, or $990 more than at the beginning of the year.
(c)
To earn 8% over the next two years the quarterly payments must be $4,503 computed as follows: $32,990 ÷ 7.32548 (PVOA8, 2%) = $4,503
(d)
Date 1/1/14 4/1/14 7/1/14 10/1/14 1/1/15 4/1/15 7/1/15 10/1/15 1/1/16
Cash Paid
Interest Expense
Discount Amortized
$4,503 4,503 4,503 4,503 4,503 4,503 4,503 4,503
$660 583 505 425 343 260 175 83*
$3,843 3,920 3,998 4,078 4,160 4,243 4,328 4,420
Carrying Amount of Note $32,990 29,147 25,227 21,229 17,151 12,991 8,748 4,420 0
*rounded up $5 (e) The new sales gimmick may bring people into the showroom the first time but will drive them away once they learn of the amount of their year 2 and year 3 payments. Many will not have budgeted for these increases, and will be in a bind because they owe more on their car than it’s worth. One should question the ethics of a dealer using this tactic.
PROBLEM 14-4
(a)
Entry to record the issuance of the 11% bonds on December 18, 2014: Cash ($4,000,000 X 1.02) ..................................... 4,080,000 Bonds Payable ........................................... Premium on Bonds Payable ......................
4,000,000 80,000
Entry to record the retirement of the 9% bonds on January 2, 2015: Bonds Payable ....................................................... 3,000,000 Loss on Redemption of Bonds........................... 180,000 Discount on Bonds Payable ...................... ($150,000 X 10/25) Cash ($3,000,000 X 104%).......................... [The loss represents the excess of the cash paid ($3,120,000) over the carrying amount of the bonds ($2,940,000).]
60,000 3,120,000
(b) The loss is reported as an ordinary loss. Note 1. Loss on Bond Redemption The loss represents a loss of $180,000 from the redemption and retirement of $3,000,000 of the Company’s outstanding bond issue due in 2025. The funds used to purchase the mortgage bonds represent a portion of the proceeds from the sale of $4,000,000 of 11% debenture bonds issued December 18, 2014 and due in 2034.
PROBLEM 14-5 1. Sanford Co. Schedule of Bond Discount Amortization Effective-Interest Method 10% Bonds Sold to Yield 12%
Date 3/1/14 9/1/14 3/1/15 9/1/15 3/1/16 9/1/16 3/1/17 9/1/17
Cash Paid
Interest Expense
Discount Amortized
$25,000* 25,000 25,000 25,000 25,000 25,000 25,000
$28,325 28,525 28,736 28,961 29,198 29,450 29,715**
$3,325 3,525 3,736 3,961 4,198 4,450 4,715
Carrying Amount of Bonds $472,090 475,415 478,940 482,676 486,637 490,835 495,285 500,000
*($500,000 X 10% X 1/2) **Rounded $2 3/1/14
Cash ............................................................... Discount on Bonds Payable ......................... Bonds Payable .....................................
472,090 27,910* 500,000
*Maturity value of bonds payable................................ Present value of $500,000 due in 7 periods at 6% ($500,000 X .66506) ....................................................... $332,530 Present value of interest payable semiannually ($25,000 X 5.58238)................................................... 139,560 Proceeds from sale of bonds ..................................... Discount on bonds payable........................................ 9/1/14
Interest Expense ........................................ Discount on Bonds Payable............. Cash...................................................
$500,000
(472,090) $ 27,910
28,325 3,325 25,000
PROBLEM 14-5 (Continued) 12/31/14
3/1/15
9/1/15
12/31/15
Interest Expense ........................................ Discount on Bonds Payable ($3,525 X 4/6) .................................. Interest Payable ($25,000 X 4/6) .......
19,017
Interest Expense ........................................ Interest Payable ......................................... Discount on Bonds Payable ($3,525 X 2/6) .................................. Cash...................................................
9,508 16,667
Interest Expense ........................................ Discount on Bonds Payable............. Cash...................................................
28,736
Interest Expense ........................................ Discount on Bonds Payable ($3,961 X 4/6) .................................. Interest Payable ................................
19,308
2,350 16,667
1,175 25,000 3,736 25,000
2,641 16,667
2. Titania Co.
Date 6/1/14 12/1/14 6/1/15 12/1/15 6/1/16 12/1/16 6/1/17 12/1/17 6/1/18
Cash Paid
Interest Expense
Premium Amortized
$24,000 24,000 24,000 24,000 24,000 24,000 24,000 24,000
$21,293 21,157 21,015 20,866 20,709 20,545 20,372 20,190**
$2,707 2,843 2,985 3,134 3,291 3,455 3,628 3,810
*($400,000 X 12% X 1/2) **$.50 adjustment due to rounding.
Carrying Amount of Bonds $425,853 423,146 420,303 417,318 414,184 410,893 407,438 403,810 400,000
PROBLEM 14-5 (Continued) 6/1/14
Cash ............................................................... Premium on Bonds Payable ................ Bonds Payable .....................................
425,853 25,853 400,000
Maturity value of bonds payable ................................. Present value of $400,000 due in 8 periods at 5% ($400,000 X .67684) ........................................................ $270,736 Present value of interest payable semiannually ($24,000 X 6.46321).................................................... 155,117 Proceeds from sale of bonds ...................................... Premium on bonds payable......................................... 12/1/14
12/31/14
6/1/15
10/1/15
Interest Expense ........................................ Premium on Bonds Payable...................... Cash ($400,000 X .12 X 6/12) ............
21,293* 2,707
Interest Expense ($21,157 X 1/6)............... Premium on Bonds Payable ($2,843 X 1/6) ........................................... Interest Payable ($24,000 X 1/6).......
3,526
Interest Expense ($21,157 X 5/6)............... Interest Payable ......................................... Premium on Bonds Payable ($2,843 X 5/6) ........................................... Cash...................................................
17,631 4,000
Interest Expense ($21,015 X .3* X 4/6) ................................ Premium on Bonds Payable ($2,985 X .3 X 4/6).................................... Cash................................................... *$120,000 ÷ $400,000 = .3
$400,000
(425,853) $ 25,853
24,000
474 4,000
2,369 24,000
4,203 597 4,800
PROBLEM 14-5 (Continued) 10/1/15
Bonds Payable ........................................... Premium on Bonds Payable...................... Gain on Redemption of Bonds......... Cash...................................................
*Reacquisition price $126,000 – ($120,000 X 12% X 4/12) Net carrying amount of bonds redeemed: Par value Unamortized premium [.3 X ($25,853 – $2,707 – $2,843)] – $597 Gain on redemption 12/1/15
12/31/15
6/1/16
12/1/16
120,000 5,494 4,294* 121,200
$121,200 $120,000 5,494
Interest Expense ($21,015 X .7*)................ Premium on Bonds Payable ($2,985 X .7) ............................................. Cash ($24,000 X .7) ........................... *($400,000 – $120,000) ÷ $400,000 = .7
14,711
Interest Expense ($20,866 X .7 X 1/6)........ Premium on Bonds Payable ($3,134 X .7 X 1/6) .................................... Interest Payable ($24,000 X .7 X 1/6) .........................
2,434
Interest Expense ($20,866 X .7 X 5/6)........ Interest Payable ......................................... Premium on Bonds Payable ($3,134 X .7 X 5/6) .................................... Cash ($24,000 X .7) ...........................
12,172 2,800
Interest Expense ($20,709 X .7) ................. Premium on Bonds Payable ($3,291 X .7) ............................................. Cash ($24,000 X .7) ...........................
14,496
(125,494) $ (4,294)
2,089 16,800
366 2,800
1,828 16,800
2,304 16,800
PROBLEM 14-6 May 1, 2014 Cash ($900,000 X 106%) + ($900,000 X 12% X 4/12) .......... 990,000.00 Bonds Payable .................................................. 900,000.00 Premium on Bonds Payable ............................. 54,000.00 Interest Expense ($900,000 X 12% X 4/12)....... 36,000.00 December 31, 2014 Interest Expense ($900,000 X 12%) ............................. 108,000.00 Interest Payable................................................. 108,000.00 Premium on Bonds Payable ...................................... Interest Expense ($54,000 X 8/116* = $3,724.14) .......................
3,724.14 3,724.14
*(12 X 10) – 4 = 116 January 1, 2015 Interest Payable ............................................................ 108,000.00 Cash ................................................................... 108,000.00 April 1, 2015 Bonds Payable .............................................................. 360,000.00 Premium on Bonds Payable .......................................... 19,551.72* Interest Expense ($360,000 X .12 X 3/12)....................... 10,800.00 Cash ($367,200 + $10,800) ................................ 378,000.00 Gain on Redemption of Bonds......................... 12,351.72** *[($360,000 ÷ $900,000) X $54,000 X 105/116 = $19,551.72] **[($360,000 + $19,551.72) – ($360,000 X 102%)] Reacquisition price (including accrued interest) ($360,000 X 102%) + ($360,000 X 12% X 3/12)..... $378,000.00 Net carrying value of bonds redeemed: Par value .................................................................. $360,000.00 Unamortized premium [$54,000 X ($360,000 ÷ $900,000) X 105/116]....... 19,551.72 (379,551.72) Accrued interest ($360,000 X 12% X 3/12) ............. (10,800.00) Gain on redemption of bonds................................. $ (12,351.72)
PROBLEM 14-6 (Continued) December 31, 2015 Interest Expense ($540,000 X .12) ............................. Interest Payable................................................. Premium on Bonds Payable ...................................... Interest Expense................................................ Amortization per year on $540,000 ($54,000 X 12/116 X .60*) ......................................... Amortization on $360,000 for 3 months ($54,000 X 3/116 X .40**).......................................... Total premium amortization....................................... *($900,000 – $360,000) ÷ $900,000 = .6 **$360,000 ÷ $900,000 = .4
64,800.00 64,800.00 3,910.34 3,910.34
$3,351.72 558.62 $3,910.34
PROBLEM 14-7
(a)
4/1/14
Cash (15,000 X $1,000 X 97%)............ 14,550,000 Discount on Bonds Payable .............. 450,000 Bonds Payable ......................... 15,000,000
(b)
10/1/14
Interest Expense................................. Cash.......................................... Discount on Bonds Payable.... *$15,000,000 X .11 X 6/12 = $825,000 **$450,000 ÷ 180 months = $2,500/mo.; $2,500/mo. X 6 months = $15,000
840,000
12/31/14 Interest Expense................................. Interest Payable ($825,000 X 3/6) ..................... Discount on Bonds Payable ($2,500 X 3 months) ..............
420,000
(c)
(d)
3/1/15
Interest Payable ($6,000,000 X 10% X 3/12) ............... Interest Expense................................. Cash.......................................... Discount on Bonds Payable.... *Cash paid to retiring bondholders: $6,000,000 X .11 X 5/12 = $275,000 **$2,500/mo. X 2 months X 6 /15 of the bonds = $2,000
825,000* 15,000**
412,500 7,500 165,000 112,000 275,000* 2,000**
At March 1, 2015 the carrying amount of the retired bonds is: Bonds payable ...........................................................................$6,000,000 Less: Unamortized discount .................................................... 169,000* $5,831,000 6 *$2,500/mo. X 169 months X /15 of the bonds = $169,000
PROBLEM 14-7 (Continued) The reacquisition price: 200,000 shares X $31 = $6,200,000. The loss on redemption of bonds is: Reacquisition price ................................... Less: Carrying amount ............................ Loss on redemption of bonds.................. The entry to record extinguishment of the bonds is: Bonds Payable .......................................... 6,000,000 Loss on Redemption of Bonds ................ 369,000 Discount on Bonds Payable ............. Common Stock .................................. Paid-in Capital in Excess of Par— Common Stock .............................
$6,200,000 5,831,000 $ 369,000
169,000 2,000,000 4,200,000
PROBLEM 14-8
(a)
(b)
December 31, 2014 Equipment ........................................................... 409,806.00 Discount on Notes Payable ................................ 190,194.00 Notes Payable ............................................ (Computer capitalized at the present value of the note—$600,000 X .68301) December 31, 2015 Depreciation Expense......................................... Accumulated Depreciation—Equipment [($409,806 – $70,000) ÷ 5]........................ Interest Expense ................................................. Discount on Notes Payable .......................
Date 12/31/14 12/31/15 12/31/16 12/31/17 12/31/18
600,000.00
67,961.20 67,961.20 40,980.60 40,980.60
Schedule of Note Discount Amortization Debit, Interest Expense Credit, Carrying Amount Discount on Notes Payable of Note $409,806.00 $40,980.60 450,786.60 45,078.66 495,865.26 49,586.53 545,451.79 54,548.21* 600,000.00
*3.03 adjustment due to rounding. (c)
December 31, 2016 Depreciation Expense......................................... Accumulated Depreciation—Equipment ..
67,961.20
Interest Expense ................................................. 45,078.66 Discount on Notes Payable .......................
67,961.20 45,078.66
PROBLEM 14-9
(a)
12/31/13 Machinery .......................................... 182,485.20 Discount on Notes Payable .............. 27,514.80 Cash .......................................... 50,000.00 Notes Payable .......................... 160,000.00 [To record machinery at the present value of the note plus the immediate cash payment: PV of $40,000 annuity @ 8% for 4 years ($40,000 X $132,485.20 3.31213)]................................. Down payment.......................... 50,000.00 Capitalized value of Machinery .............................. $182,485.20
(b)
12/31/14
Notes Payable.................................... Cash ..........................................
40,000.00
Interest Expense ............................... Discount on Notes Payable .....
10,598.82
40,000.00 10,598.82
Schedule of Note Discount Amortization Date 12/31/13 12/31/14 12/31/15 12/31/16 12/31/17
Cash Paid
Interest Expense
Amortization
$40,000.00 40,000.00 40,000.00 40,000.00
$10,598.82* 8,246.72 5,706.46 2,962.80***
$29,401.18 31,753.28 34,293.54 37,037.20
*$132,485.20 X 8% **$103,084.02 = $132,485.20 – $29,401.18. ***$0.18 adjustment due to rounding.
Carrying Amount of Note $132,485.20 103,084.02** 71,330.74 37,037.20 —
PROBLEM 14-9 (Continued) (c)
(d)
(e)
12/31/15
12/31/16
12/31/17
Notes Payable ................................... Cash..........................................
40,000.00
Interest Expense ............................... Discount on Notes Payable.....
8,246.72
Notes Payable ................................... Cash..........................................
40,000.00
Interest Expense ............................... Discount on Notes Payable.....
5,706.46
Notes Payable ................................... Cash..........................................
40,000.00
Interest Expense ............................... Discount on Notes Payable.....
2,962.80
40,000.00 8,246.72 40,000.00 5,706.46 40,000.00 2,962.80
PROBLEM 14-10
(a)
(b)
Wilke Co. Selling price of the bonds ($4,000,000 X 103%) ...... Accrued interest from January 1 to February 28, 2015 ($4,000,000 X 9% X 2/12) ......................... Total cash received from issuance of the bonds.... Less: Bond issuance costs ...................................... Net amount of cash received.................................... Langley Co. Carrying amount of the bonds on 1/1/14 ................. Effective-interest rate (10%) ..................................... Interest expense to be reported for 2014 ................
$4,120,000 60,000 4,180,000 27,000 $4,153,000
$656,992 X 0.10 $ 65,699
(c)
Tweedie Building Co. Maturities and sinking fund requirements on long-term debt for the next five year are as follows: 2015 $400,000 2018 $200,000 2016 350,000 2019 350,000 2017 200,000
(d)
Beckford Inc. Since the three bonds reported by Beckford Inc. are secured by either real estate, securities of other corporations, or plant equipment, none of the bonds are classified as debenture bonds.
PROBLEM 14-11
Dear Samantha, When a bond is issued at face value, the annual interest expense and the interest payout equals the face value of the bond times the interest rate stated on its face. However, if the bond is issued to yield a higher or lower interest rate than what is stated on its face, the interest expense and the actual interest payout will differ. Labeled as a discount or premium respectively, this difference in interest must be systematically associated with the interest periods which occur over the bond’s life through a process called amortization. One method of amortization is the straight-line method whereby the amount of the premium or discount is divided by the number of interest periods in the bond’s life. The result is an even amount of amortization for every period. However, a better way of recording interest expense in the period during which it is incurred is the effective-interest method. Assume a premium: the theory behind this method is that, as time passes, the difference between the face value of the bond and its carrying amount becomes smaller, resulting in a lower interest expense every period. (The carrying amount equals the face value of the bond plus any unamortized portion of the premium.) Because the carrying amount of the bond becomes smaller over time, the effective-interest expense also does. Since the stated interest rate remains constant, the resulting difference between the actual interest payout and the interest expense recognized must be reflected when interest expense is recorded for the period. To amortize the premium applying this method to the data provided, you must know the bond’s face amount, its stated rate of interest, its effective rate of interest, and its premium. 1.
Multiply the stated rate times the face amount. This is the interest payout.
2.
Calculate the carrying amount by adding the premium to the bond’s face amount. Now multiply this carrying amount by the effective rate which gives you the actual interest expense.
PROBLEM 14-11 (Continued) 3.
Subtract the amount calculated in #2 from that found in #1. This is the amount to be amortized for the period.
4.
Subtract the difference computed in #3 from the carrying amount. The process begins all over when you apply the effective rate to this new carrying amount for the following period.
The schedule below illustrates this calculation. The face value ($2,000,000) is multiplied by the stated rate of 11 percent, while the carrying amount ($2,171,600) is multiplied by the effective rate of 10 percent. Because this bond pays interest semiannually, you must also multiply these amounts by 6/12. The result is the stated interest of $110,000 and effective-interest of $108,580. The difference ($1,420) is amortized, lowering the carrying amount of the bond to $2,170,180. For the next period, this new carrying amount will be multiplied by the effective rate times 6/12 and subtracted from the constant $110,000. Obviously this time the effective-interest will be lower than it was last period, resulting in a greater amount of amortization in the next period. Follow these steps and you should have no trouble amortizing premiums and discounts over the life of a bond. Sincerely,
Attachment to letter
Date 6/30/14 12/31/14 6/30/15 12/31/15 6/30/16
HOBART COMPANY Interest and Discount Amortization Schedule 11% Bond Issued to Yield 10% Cash Interest Carrying Paid Expense Amount of Premium (11%) (10%) Amortized Bond $2,171,600 $110,000 $108,580 $1,420 2,170,180 110,000 108,509 1,491 2,168,689 110,000 108,434 1,566 2,167,123 110,000 108,356 1,644 2,165,479
*PROBLEM 14-12
(a)
It is a troubled debt restructuring.
(b)
1.
No entry.
2.
Bad Debt Expense ..................................... Allowance for Doubtful Accounts.....
237,311* 237,311
*Calculation of loss. Pre-restructure carrying amount Present value of restructured cash flows: Present value of $600,000 due in 10 years at 12%, interest payable annually ($600,000 X .32197) ........................................... Present value of $30,000 interest payable annually for 10 years at 12% ($30,000 X 5.65022) ........................................... Creditor’s loss on restructuring of debt............ (c)
$600,000
$193,182 169,507
(362,689) $237,311
Losses are calculated based upon the discounted present value of future cash flows. However, the debtor’s gain is calculated using the undiscounted cash flows. This does not fairly state the economic benefits derived by the debtor as a result of the restructuring.
*PROBLEM 14-13
(a)
On the books of Halvor Corporation: Notes Payable ........................................................ 5,000,000 Common Stock.......................................... Paid-in Capital in Excess of Par— Common Stock..................................... Gain on Restructuring of Debt .................
1,700,000 2,000,000 1,300,000
Fair value of equity ..............$3,700,000 Carrying amount of debt ... (5,000,000) Gain on restructuring of debt ............................. ($1,300,000) On the books of Frontenac National Bank: Equity Investments ............................................ Allowance for Doubtful Accounts..................... Notes Receivable ...................................... (b)
On the books of Halvor: Notes Payable .................................................... Land ........................................................... Gain on Disposal of Plant Assets ............ Gain on Restructuring of Debt ................. Fair value of land............. Book value of land .......... Gain on disposal of plant assets ..................
3,700,000 1,300,000 5,000,000
5,000,000 3,250,000 750,000 1,000,000
$4,000,000 (3,250,000) $ 750,000
Note payable (carrying amount) ............................... $5,000,000 Fair value of land ................... (4,000,000) Gain on restructuring of debt ................................. $1,000,000 On the books of Frontenac National Bank: Land .................................................................... Allowance for Doubtful Accounts..................... Notes Receivable ......................................
4,000,000 1,000,000 5,000,000
*PROBLEM 14-13 (Continued) (c)
On the books of Halvor: No entry is needed because aggregate cash flows equal the carrying amount. Aggregate cash flows—principal............. Carrying amount .......................................
$5,000,000 $5,000,000
On the books of Frontenac National Bank: Bad Debt Expense ................................................ 1,243,400* Allowance for Doubtful Accounts............
1,243,400
*Calculation of loss: Pre-restructure carrying amount Less: Present value of restructured cash flows: Present value of $5,000,000 due in 3 years at 10% (Table 6-2); ($5,000,000 X 0.75132) ................................ Creditor’s loss on restructuring of debt.................... (d)
On the books of Halvor: No entry is needed because aggregate cash flows equal the carrying amount. Principal .................................................... Interest ($4,166,667 X 10% X 2) ................ Aggregate cash flows Carrying amount On the books of Frontenac National Bank: Bad Debt Expense ............................................. 1,212,100* Allowance for Doubtful Accounts............
$5,000,000
3,756,600 $1,243,400
$4,166,667 833,333 $5,000,000 $5,000,000
1,212,100
*PROBLEM 14-13 (Continued) *Calculation of loss: Pre-restructure carrying amount ................... Present value of restructured cash flows: Present value of $4,166,667 due in 3 years at 10%, interest payable annually (Table 6-2); ($4,166,667 X .75132).................................................... $3,130,500 Present value of $416,667 interest payable annually for 3 years at 10%, (Table 6-4); ($416,667 X 2.48685).......... 1,036,188 Less first year payment: Present value of $416,667 interest due in 1 year at 10% (Table 6-2); ($416,667 X .90909) ............................... 378,788 Creditor’s loss on restructuring of debt ........
$5,000,000
3,787,900 $1,212,100
*PROBLEM 14-14
Carrying amount of the debt at date of restructure, $330,000 + $33,000 = $363,000. Total future cash flow, $300,000 + ($300,000 X .10 X 3) = $390,000. Because the future cash flow exceeds the carrying amount of the debt, no gain is recognized at the date of restructure. (a)
The effective-interest rate subsequent to restructure is computed by trial and error using the assumed partial present value tables based on the present value of $300,000 (new principal) plus $30,000 (interest per year) for three years to equal $363,000. Try 2 1/2% ($300,000)(.92859) = ($30,000)(2.85602) = PV =
$278,577 85,681 $364,258
Try 2 5/8% ($300,000)(.92521) = ($30,000)(2.84913) = PV =
$277,563 85,474 $363,037
Try 2 3/4% ($300,000)(.92184) = ($30,000)(2.84226) = PV =
$276,552 85,268 $361,820
Therefore, the approximate effective rate is 2 5/8%. (b)
SCHEDULE OF DEBT REDUCTION AND INTEREST EXPENSE AMORTIZATION
Date 12/31/14 12/31/15 12/31/16 12/31/17 12/31/18
Cash Paid
Interest Expense
Premium Amortized
$ 30,000 30,000 30,000 300,000
$9,529* 8,991 8,480**
$ 20,471 21,009 21,520 300,000
*$9,529 = $363,000 X 2.625% **Adjusted $40 due to rounding.
Carrying Amount of Note $363,000 342,529 321,520 300,000 –0–
*PROBLEM 14-14 (Continued) (c)
Calculation of loss: Pre-restructure carrying amount ......................... $363,000 Present value of restructured cash flows: Present value of $300,000 due in 3 years at 10% , interest payable annually (Table 6-2); ($300,000 X .75132) ....................$225,396 Present value of $30,000 interest payable annually for 3 years at 10% (Table 6-4); ($30,000 X 2.48685) ................................... 74,605 (300,000*) Creditor’s loss on restructuring of debt.............. $ 63,000 *Although the sum of the present value amounts is $300,001, the true present value of a 10% note discounted at 10% is face value, or $300,000. The $1 difference is due to rounding.
Date 12/31/14 12/31/15 12/31/16 12/31/17 12/31/18
Cash Received
Interest Revenue
$ 30,000a 30,000 30,000 300,000
$30,000b 30,000 30,000 0
Change in Carrying Amount $
0 0 0 300,000
Carrying Amount of Note $300,000 300,000c 300,000 300,000 0
a
$30,000 = $300,000 X 10%. $30,000 = $300,000 X 10%. c $300,000 = $300,000 – $0. b
(d)
Crocker Corp. entries: December 31, 2014 Interest Payable..................................................... Notes Payable ..............................................
33,000
December 31, 2015 Interest Expense ................................................... Notes Payable ....................................................... Cash ..............................................................
9,529 20,471
33,000
30,000
*PROBLEM 14-14 (Continued)
(e)
December 31, 2016 Interest Expense .................................................... Notes Payable ........................................................ Cash...............................................................
8,991 21,009
December 31, 2014 Bad Debt Expense ................................................. Allowance for Doubtful Accounts................
63,000
30,000
December 31, 2015, 2016 Cash ............................................................................ 30,000 Interest Revenue ...........................................
63,000
30,000
TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 14-1 (Time 25–30 minutes) Purpose—to provide the student with some familiarity with the economic theory which relates to the accounting for a bond issue. The student is required to discuss the conceptual merits for each of the three different balance sheet presentations for the same bond issue, and the merits for utilizing the nominal rate versus the effective rate at date of issue in the computation of the carrying value of the obligations arising from a bond issue. CA 14-2 (Time 15–25 minutes) Purpose—this case includes discussions of the determination of the selling price of bonds, presentation of items related to bonds on the balance sheet and the income statement, whether discount amortization increases or decreases, and how an early retirement of bonds should be reported on the income statement. CA 14-3 (Time 20–25 minutes) Part I—Purpose—to provide the student with an understanding of the significance of the difference between the effective-interest method of amortization and the straight-line method of amortization. Part II—Purpose—to provide the student with some familiarity with the various methods of accounting for gains and losses from the early extinguishment of debt, and the justifications for each of the different methods. CA 14-4 (Time 20–30 minutes) Purpose—the student is asked to explain project financing arrangements, take-or-pay contracts, offbalance-sheet financing, and the conditions for which a contractual obligation is to be disclosed as an unconditional purchase obligation. The case also requires the student to determine accounting treatment for a project financing arrangement. CA 14-5 (Time 20–30 minutes) Purpose—to provide the student with an opportunity to examine the ethical issues related to the issue of bonds.
SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 14-1 (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 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. (b) 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 Nichols 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. (c) 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.
CA 14-1 (Continued) 2. The effective-interest rate at January 1, 2014 is the market rate to Nichols 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. (d) 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 gains and losses under this method would equal the total interest expense using the yield rate at issue date.
CA 14-2 (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 a “noncurrent asset, deferred charge” under generally accepted accounting principles; however, there is theoretical justification for classifying the bond issue costs as either an expense or a reduction of the related debt liability. (b) The following items related to the bond issue would be included in Sealy’s 2014 income statement: 1. 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). 2. Interest expense (or bond issue expense) would be included for ten months of amortization of bond issue costs (March 1, 2014 to December 31, 2014). Bond issue costs should be amortized 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). However, there is theoretical justification for classifying the total bond issue costs as an expense. (c) 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.
CA 14-2 (Continued) (d) 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.
CA 14-3 Part I. (a) The effective-interest method of amortization of bond discount or premium applies a constant interest rate to the carrying value of the debt. The straight-line method applies a constant dollar amount over the life of the debt resulting in a changing effective-interest rate incurred based on the carrying value of the debt. Either method, however, computes the total premium or discount to be amortized as the difference between the par value of the debt and the proceeds from the issuance. (b) 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 effective 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. 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. (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.
CA 14-3 (Continued) 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 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. (b) 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.
CA 14-4 (a) Such financing arrangements arise when (1) two or more entities form another entity to construct an operating plant that will be used by both parties; (2) the new entity borrows funds to construct the project and repays the debt from the proceeds received from the project; and (3) payment of the debt is guaranteed by the companies that formed the new entity. (b) In some cases, project financing arrangements become more formalized through the use of takeor-pay contracts or similar types of contracts. In a simple take-or-pay contract, a purchaser of goods signs an agreement with the seller to pay specified amounts periodically in return for products or services. The purchaser must make specified minimum payments even if delivery of the contracted products or services is not taken. (c) Ryan should not record the plant as its asset. The plant is to be constructed and operated by ACC. Although Ryan agrees to purchase all of the cans produced by ACC, Ryan does not have the property right to the plant, nor the right to use the plant. (d) Accounting for purchase commitments is unsettled and controversial. Some argue that these contracts should be reported as assets and liabilities at the time the contract is signed; others believe that our present recognition at the delivery date is most appropriate. FASB Concepts Statement No. 6 states that “a purchase commitment involves both an item that might be recorded as an asset and an item that might be recorded as a liability. That is, it involves both a right to receive assets and an obligation to pay . . . If both the right to receive assets and the obligation to pay were recorded at the time of the purchase commitment, the nature of the loss and the valuation account that records it when the price falls would be clearly seen.” Although the discussion in Concepts Statement No. 6 does not exclude the possibility of recording assets and liabilities for purchase commitments, it contains no conclusions or implications about whether they should be recorded.
CA 14-4 (Continued) According to current practice, Ryan does not record an asset relating to the future purchase commitment. However, if the dollar amount involved is material, the details of the contract should be disclosed in a footnote to the balance sheet. In addition, if the contracted price is in excess of the purchase market price and it is expected that losses will occur when the purchase is effected, losses should be recognized in the accounts in the period during which such declines in prices take place. (e) Off-balance-sheet financing is an attempt to borrow monies in such a way that the obligations are not recorded in a company’s balance sheet. The reasons for off-balance-sheet financing are many. First, many believe that removing debt or otherwise keeping it from the balance sheet enhances the quality of the balance sheet and permits credit to be obtained more readily and at less cost. Second, loan covenants often impose a limitation on the amount of debt a company may have. As a result, off-balance-sheet financing is used because these types of commitments might not be considered in computing the debt limitation. Third, it is argued by some that the asset side of the balance sheet is severely understated because of the use of certain accounting methods (like LIFO and accelerated depreciation methods). As an offset to these lower values, some believe that part of the debt does not have to be reported. Note to instructor: Additional discussion of these type arrangements is presented in Appendix 17B related to variable interest entities.
CA 14-5 (a) The stakeholders in the Wichita case are: Donald Lennon, president, founder, and majority stockholder. Nina Friendly, minority stockholder. Other minority stockholders. Existing creditors (debt holders). Future bondholders. Employees, suppliers, and customers. (b) The ethical issues: The desires of the majority stockholder (Donald Lennon) versus the desires of the minority stockholders (Nina Friendly and others). Doing what is right for the company and others versus doing what is best for oneself. Questions: Is what Donald wants to do legal? Is it unethical? Is Donald’s action brash and irresponsible? Who may benefit/suffer if Donald arranges a high-risk bond issue? Who may benefit/suffer if Nina Friendly gains control of Wichita? (c) The rationale provided by the student will be more important than the specific position because this is a borderline case with no right answer.
FINANCIAL REPORTING PROBLEM (a)
According to the Short-Term and Long-Term Debt note (Note 4), Long-term debt maturities during the next five fiscal years are: 2012, $2,994 million; 2013, $3,839 million; 2014, $2,229 million; 2015, $3,021 million; and 2016, $2,300 million.
(b)
(Amounts in $millions) 1. Working capital = Current assets less current liabilities. ($5,323) = $21,970 – $27,293 2.
Cash + investments + net receivables Current liabilities
Acid-test ratio =
$2,768 + $6,275
0.33 times =
(.34 in 2010)
$27,293 3.
Current ratio = 0.80 times =
Current assets Current liabilities $21,970
(.77 in 2010)
$27,293 While it appears P&G has a fairly weak liquidity position. The current ratio is below 1. The acid-test ratio is significantly below 1, possibly due to a slowing economy. However, P&G’s high current liabilities could reflect a cheap form of financing. The other ratio analysis below provides P&G’s additional insight into financial position in 2011. Receivables turnover =
Net sales Average receivables
=
$82,559 $6,275 + $5,335 2
= 14.22 times (14.77 times in 2010)
FINANCIAL REPORTING PROBLEM (Continued) Inventory turnover = Cost of goods sold Average inventory $40,768 = $7,379 + $6,384 2 = Current cash debt coverage = =
= Cash debt coverage
5.92 times (5.72 in 2010)
Net cash provided by operating activities Average current liabilities $13,231 $27,293 + $24,282 2 0.51 times (.58 in 2010) = Net cash provided by operating activities Average total liabilities $13,231 = $70,353 + $66,733 2 = 0.19 times (.23 times in 2010)
Debt to assets =
$70,353
= 0.51 (.52 in 2010)
$138,354 Time interest earned = Income before income taxes and interest expense Interest expense = $15,189 + $831 $831 = 19.28 times (16.91 times in 2010) Similar to P&G’s liquidity position, the company’s solvency also appears weak. It has low coverage of its current and long-term liabilities. However, its interest coverage appears adequate. Industry and yearto-year comparisons should also be employed. In total, and with comparison to analysis in 2010, P&G has an improving liquidity and solvency position.
COMPARATIVE ANALYSIS CASE (a)
Debt to asset ratio: Coca-Cola PepsiCo
$48,053/$79,974 = 60% $51,983/$72,882 = 71%
Times interest earned ratio: Coca-Cola ($11,856 + $417)/$417 = 28.4 times PepsiCo ($9,690 + $856)/$856 = 12.3 times The debt to asset ratio around 60-70% for both Coca-Cola and PepsiCo show both companies to be highly leveraged, PepsiCo more so than Coca-Cola. The times interest earned ratios show that interest expense is quite adequately covered by the firms’ net income; PepsiCo’s coverage is more than good, especially considering the debt to total assets ratio of 70%. (b) Coca-Cola PepsiCo
Carrying Value $15,697 23,117
Fair Value $16,360 29,800
The fair value will vary from the historical cost carrying value due to changes in interest rates. (c)
1.
Lower interest rates may be available in foreign countries.
2.
Credit may be more readily available in foreign countries.
Using foreign debt to finance operations is subject to the risk of foreign currency exchange rate fluctuations. Both PepsiCo and Coca-Cola enter into interest rate and foreign currency swaps to effectively change the interest rate and currency of specific debt issuances. These swaps are generally entered into concurrently with the issuance of the debt they are intended to modify.
FINANCIAL STATEMENT ANALYSIS CASE COMMONWEALTH EDISON CO. (a)
Due to the markdown from 99.803 to 99.25, Commonwealth Edison would record a slightly larger discount and, of course, receive and record less cash. Amortization of the larger discount will result in a larger interest expense charge in each year the bonds are outstanding. As a result of the additional $5.50 markdown, the effective-interest rate increased from 9.3% to 9.45%.
(b)
In the same Wall Street Journal article, the following explanation was provided for Commonwealth Edison’s bond markdown and slow sale: “Commonwealth had the misfortune to begin its giant offering only hours before investor sentiment was soured by the report last Thursday of a record increase in the nation’s money supply. The monetary surge, plus a recent rebound in industrial productivity reported Friday, halted the market rally triggered in early May by signs of an economic slowdown and a peaking of interest rates.” Other economic events that can and do affect the price of securities issued are: 1.
A change in the Federal Reserve’s lending rate.
2.
A change in the bank prime rate.
3.
A flood of other similar securities issues.
4.
A good or poor earnings report for the issuer.
5.
A change in the issuer’s credit rating.
6.
The issuance of a favorable or unfavorable broker’s or other financial analysis.
FINANCIAL STATEMENT ANALYSIS CASE (Continued) Of course, noneconomic, political, or other world events can also affect the day-to-day sale of securities. The “recent rebound in industrial productivity” mentioned in the article would normally not be a depressant on a securities issue; but because the financial community was anticipating, even hoping for, a recession to “cool off the economy” and, thus, lower the then existing high interest rates, the rebound represented a delay in the recession and the lowering of interest rates.
ACCOUNTING, ANALYSIS, AND PRINCIPLES Accounting BUGANT, INC. Income Statement For the year Ended December 31, 2015 Sales revenue Expenses: Cost of goods sold (1) Salaries and wages expense Depreciation expense (2) Interest expense (3) Net income (1) (2) (3)
$3,500 $1,900 700 80 172
$1,800 + $2,000 – $1,900 = $1,900 $2,000 / 25 years = $80 1/1 – 6/30: $1,426 X 12% X 6/12 = $86 7/1 – 12/31: ($1,426 + [$86 – $75]) X 12% X 6/12 = $86 Interest expense = $86 + $86 = $172
2,852 $ 648
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) BUGANT, INC. Balance Sheet December 31, 2015 ASSETS Cash (1) .................................................................... Inventory .................................................................. Total current assets ................................................ Plant and equipment ............................................... Accumulated depreciation (2) ................................ Total assets..............................................................
$1,000 1,900 $2,900 2,000 (240)
LIABILITIES Bonds payable (3).................................................... STOCKHOLDERS’ EQUITY Common stock ........................................................ Retained earnings (4) .............................................. Total liabilities and stockholders’ equity............... (1) (2) (3) (4)
1,760 4,660 $1,448
$1,500 1,712
$450 + $3,500 – $2,000 – $700 – $100 – $150 = $1,000 $(160) + $(80) = $(240) $1,426 + ($86 – $75) + ($86 – $75) = $1,448 $1,164 + $648 – $100 = $1,712
3,212 $4,660
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) Analysis 2015 Debt to Assets Ratio
Times Interest Earned Ratio
$1,448 $4,660 = 0.31 $648 + $172 = 4.77 $172
2014 $1,426 $4,090 = 0.35 $550 + $169 = 4.25 $169
Less than one-third of Bugant’s financing comes from debt, which is good. Earnings before interest are also more than 4.5 times interest expense. Both ratios also improved during the year. Note that interest expense in this problem is larger than the company’s yearly cash interest payments. Cash payments for interest are $150 per year. Thus, one might argue the times interest earned ratio ‘understates’ a little the company’s ability to make interest payments. Essentially, the company is delaying the payment of some of the interest each year until the bond’s maturity date. With the company’s current cash balance and low income, one would have to question the company’s ability to meet its obligation on the maturity date when it arrives. Principles One could argue that this represents a classic trade-off between relevance and faithful representation. Many people think that the fair values of assets and liabilities are relevant to making investing and financing decisions. However, the determination of fair value is the responsibility of management. Management may have incentives to bias reported fair value numbers one direction or the other. For example, in this case, changes in the fair value of debt would be part of the period’s net income. Thus, management may have an incentive to bias their estimate of the fair values of their debt. On the other hand, one might argue that fair values of debt are not really relevant if the company will not pay off the debt early.
PROFESSIONAL RESEARCH (a) According to FASB ASC 835-30-05 05-2 Business transactions often involve the exchange of cash or property, goods, or service for a note or similar instrument. When a note is exchanged for property, goods, or service in a bargained transaction entered into at arm’s length, there should be a general presumption that the rate of interest stipulated by the parties to the transaction represents fair and adequate compensation to the supplier for the use of the related funds. That presumption, however, must not permit the form of the transaction to prevail over its economic substance and thus would not apply if interest is not stated, the stated interest rate is unreasonable, or the stated face amount of the note is materially different from the current cash sales price for the same or similar items or from the market value of the note at the date of the transaction. The use of an interest rate that varies from prevailing interest rates warrants evaluation of whether the face amount and the stated interest rate of a note or obligation provide reliable evidence for property recording the exchange and subsequent related interest. 05-3 This Subtopic provides guidance for the appropriate accounting when the face amount of a note does not reasonably represent the present value of the consideration given or received in the exchange. The circumstance may arise if the note is non-interestbearing or has a stated interest rate that is different from the rate of interest appropriate for the debt at the date of the transaction. Unless the note is recorded at its present value in this circumstance, the sales price and profit to a seller in the year of the transaction and the purchase price and cost to the buyer are misstated, and interest income and interest expense in subsequent periods are also misstated.
PROFESSIONAL RESEARCH (Continued) According to FASB ASC 835-30-15 15-2 The guidance in the Subtopic applies to receivables and payables that represent contractual rights to receive money or contractual obligations to pay money on fixed or determinable dates, whether or not there is any stated provision for interest, with certain exceptions noted below. Such receivables and payables are collectively referred to in this Subtopic as notes. Some examples are the following: a. Secured and unsecured notes b. Debentures c. Bonds d. Mortgage notes e. Equipment obligations f. Some accounts receivable and payable. (b) According to FASB ASC 835-30-25 25-3 If an established exchange price is not determinable and if the note has no ready market, the problem of determining present value is more difficult. To estimate the present value of a note under such circumstances, an applicable interest rate is approximated that may differ from the stated or coupon rate. This process of approximation is called imputation, and the resulting rate is called an imputed interest rate. Nonrecognition of an apparently small difference between the stated rate of interest and the applicable current rate may have a material effect on the financial statements if the face amount of the note is large and its term is relatively long. (c) According to FASB ASC 835-30-45 45-1 The guidance in this Section does not apply to the amortization of premium and discount and the debt issuance costs of liabilities that are reported at fair value.
PROFESSIONAL RESEARCH (Continued) 45-1 A The discount or premium resulting from the determination of
present value in cash or noncash transactions is not an asset or liability separable from the note that gives rise to it. Therefore, the discount or premium shall be reported in the balance sheet as a direct deduction from or addition to the face amount of the note. It shall not be classified as a deferred charge or deferred credit. 45-2
The description of the note shall include the effective interest rate. The face amount shall also be disclosed in the financial statements or in the notes to the statements.
45-3
Amortization of discount or premium shall be reported as interest expense. Issue costs shall be reported in the balance sheet as deferred charges.
PROFESSIONAL SIMULATION Note: This assignment is available on the Kieso website. Journal Entries April 1, 2013 Cash ................................................... Premium on Bonds Payable........ Bonds Payable .............................
5,307,228.36* 307,228.36 5,000,000.00
*Price using Tables: $5,000,000 X .38554 = $1,927,700 550,000 X 6.14457 = 3,379,514 $5,307,214 Difference due to rounding in tables. April 1, 2014 Interest Payable................................. Cash..............................................
550,000.00 550,000.00
Note: Entry made on March 31, 2012: Interest Expense ............................... Premium on Bonds Payable ............. Interest Payable ........................... Resources
530,722.84 19,277.16 550,000.00
PROFESSIONAL SIMULATION (Continued) Financial Statements BALZAC INC. Balance Sheet as of March 31, 2014 Long-term liabilities 11% bonds payable (Note A)............................... Premium on bonds payable ................................ Asset retirement obligation, warehouse site ..... Notes payable (Note B)........................................ Total long-term liabilities ..........................
$5,000,000 287,951 $5,287,951 35,000 1,100,000 $6,422,951
Note A—Bonds The 11% bonds call for annual interest payments on each April 1. The bonds mature on April 1, 2023. Note B—Notes Payable The current liabilities include current maturities of several notes payable. The long-term notes payable mature as follows. Due Date April 1, 2015 – March 31, 2016 April 1, 2016 – March 31, 2017
Amount Due $600,000 500,000
IFRS CONCEPTS AND APPLICATION IFRS14-1 Bond discount and bond premium are amortized on an effective-interest basis. The effective-interest method results in an increasing or decreasing amount of interest each period. This is because interest is based on the carrying amount of the bond issuance at the beginning of each period. The effective-interest method results in an increasing or decreasing dollar amount of interest and a constant rate of interest over the life of the bonds. The difference between the interest expense and the interest paid is the amount of discount or premium amortized each period. IFRS14-2 A transfer of noncash assets (real estate, receivables, or other assets) or the issuance of the debtor’s shares can be used to settle a debt obligation in an extinguishment. In these situations, the noncash assets or equity interest given should be accounted for at its fair value. The debtor is required to determine the excess of the carrying amount of the payable over the fair value of the assets or equity transferred (gain). The debtor recognizes a gain equal to the amount of the excess. In addition, the debtor recognizes a gain or loss on disposition of assets to the extent that the fair value of those assets differs from their carrying amount (book value). IFRS14-3 (a)
(b)
(c)
January 1 Cash .................................................................. Bonds Payable ........................................
559,224
July 1 Interest Expense ($559,224 X 8% X 6/12)........ Cash ($600,000 X 7% X 6/12) .................. Bonds Payable ........................................
22,369
December 31 Interest Expense ($560,593 X 8% X 6/12)........ Cash ($600,000 X 7% X 6/12) .................. Bonds Payable ........................................
22,424
559,224
21,000 1,369
21,000 1,424
IFRS14-4 (a)
January 1 Cash ................................................................................644,636 Bonds Payable ................................................. 644,636
(b)
July 1 Interest Expense ($644,636 X 6% X 6/12) ................. Bonds Payable........................................................... Cash ($600,000 X 7% X 6/12) ...........................
19,339 1,661
December 31 Interest Expense ($642,975 X 6% X 6/12) ................. Bonds Payable........................................................... Cash ($600,000 X 7% X 6/12) ...........................
19,289 1,711
(c)
21,000
21,000
IFRS14-5 (a) (b)
(c)
1/1/14 7/1/14
Cash ($800,000 X 1.19792) ........................ Bonds Payable .................................
958,336 958,336
Interest Expense ($958,336 X 8% X 6/12) ........................... Bonds Payable .......................................... Cash ($800,000 X 10% X 6/12) .........
38,333 1,667
12/31/14 Interest Expense [($958,336 – $1,667) X 8% X 6/12)]......... Bonds Payable .......................................... Interest Payable................................
38,267 1,733
40,000
40,000
IFRS14-6 (a) (b)
1/1/14 7/1/14
Cash ($800,000 X 0.8495).......................... Bonds Payable ................................. Interest Expense ($679,600 X 12% X 6/12) ........................ Bonds Payable ................................. Cash ($800,000 X 10% X 6/12) .........
679,600 679,600 40,776 776 40,000
IFRS14-6 (Continued) (c)
12/31/14 Interest Expense [ ($679,600 + $776) X 12% X 6/12) ]......... Bonds Payable ................................. Interest Payable ...............................
40,822 822 40,000
IFRS14-7 According to IAS 39: (a)
Initial measurement of financial assets and financial liabilities When a financial asset or financial liability is recognised initially, an entity shall measure it at its fair value plus, in the case of a financial asset or financial liability not at fair value through profit or loss, transaction costs that are directly attributable to the acquisition or issue of the financial asset or financial liability. (para. 43) In other words, Wie would deduct any transaction costs from the initial carrying value of the note. This would have the effect of increasing the effective interest rate, thereby increasing interest expense recognized over the term of the note.
(b)
Derecognition of a financial liability An entity shall remove a financial liability (or a part of a financial liability) from its statement of financial position when, and only when, it is extinguished—ie when the obligation specified in the contract is discharged or cancelled or expires. (para. 39) An exchange between an existing borrower and lender of debt instruments with substantially different terms shall be accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability. Similarly, a substantial modification of the terms of an existing financial liability or a part of it (whether or not attributable to the financial difficulty of the debtor) shall be accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability. (para. 40)
IFRS14-7 (Continued)
The difference between the carrying amount of a financial liability (or part of a financial liability) extinguished or transferred to another party and the consideration paid, including any non-cash assets transferred or liabilities assumed, shall be recognised in profit or loss. (para. 41) Therefore, it is possible that wie might recognize a gain or loss if the original debt is extinguished and a new note is issued. IFRS14-8 (a)
From Note 21 Within one year Between one and two years Between two and five years More than five years Total
(b)
£ 448.7 526.2 293.0 2,503.0 £3,770.9
Working capital = (£545.3 million) (£1,460.1 – £2,005.4) Current ratio = .73 (£1,460.1 ÷ £2,005.4) £196.1 + £68.6 + £253.0 + £260.5 Acid-test ratio = 0.39 = £2,005.4 The following ratios are also calculated.
Receivables turnover =
Net sales Average receivables
=
£9,934.3 (£253.0 + £250.3)/2
= 39.5 times
IFRS14-8 (Continued) Inventory turnover = Cost of goods sold Average inventory
=
£6,179.1 (£681.9 + £685.3)/2
Current cash debt coverage =
= 9.04 times
Net cash provided by operating activities Average current liabilities
=
£1,203.0 (£2,005.4 + £2,210.2)/2
=
0.57 times
Cash debt coverage = =
Net cash provided by operating activities Average total liabilities £1,203.0 (£4,494.5 + £4,666.7)/2
= 0.26 times Debt to assets = =
Total liabilities Total assets £4,494 £7,273
= 0.62
Time interest earned = Income before income taxes and interest expense Interest expense = £658.0 + £136.8 £163.8
= 5.81
IFRS14-8 (Continued) As discussed above, M&S’s acid-test and current ratios are below one and its working capital is negative. The lower acid-test ratio may not be a problem. Many large companies carry relatively high levels of accounts payable, which charge no interest. For example, M&S has over £1.4 billion of these short-term obligations, which can be viewed as very cheap forms of financing. M&S has also substantially reduced its short-term borrowing during the year. The company’s solvency also appears strong. It has adequate coverage of its current and longterm liabilities and its interest coverage appears good. Industry and year-to-year comparisons should also be employed.
CHAPTER 15 Stockholders’ Equity ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics
Questions
Brief Exercises
Exercises
Problems
Concepts for Analysis
1. Stockholders’ rights; corporate form.
1, 2, 3
2. Stockholders’ equity.
4, 5, 6, 16, 17, 18
3
7, 10, 16, 17
1, 2, 3, 9
3. Issuance of shares.
7, 10
1, 2, 6
1, 2, 4, 6, 9
1, 3, 4
4. Noncash stock transactions; lump sum sales.
8, 9
4, 5
3, 4, 5, 6
1, 4
2
5. Treasury stock transactions, cost method.
11, 12, 17
7, 8
3, 6, 7, 9, 10, 18
1, 2, 3, 5, 6, 7
7
6. Preferred stock.
3, 13, 14, 15
9
8
1, 3
10, 11, 17
9, 11, 12
1
7. Stockholders’ equity accounts; classifications; terminology. 8. Dividend policy.
19, 20, 21, 22, 25, 26
10
12, 15, 16
7, 10
9. Cash and stock dividends; stock splits; property dividends; liquidating dividends.
22, 23, 24
10, 11, 12, 13, 14
13, 14, 15, 18
6, 7, 8, 10, 11
10. Restrictions of retained earnings.
27, 28
9
11. Analysis. *12. Dividend preferences and book value.
17, 19, 20 29
15
*This material is covered in an Appendix to the chapter.
21, 22, 23, 24
3
4, 5, 6
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Brief Exercises
Learning Objectives Questions
Exercises
Problems
Concepts for Analysis
1. Discuss the characteristics of the corporate form of organization.
1, 2, 3
CA15-1
2. Identify the key components of stockholders’ equity.
4, 5
CA15-3
3. Explain the accounting procedures for issuing shares of stock.
6, 7, 8, 9, 10, 11
1, 2, 4, 5, 6
1, 2, 3, 4, 5, 6, 8, 9, 10
1, 3, 4, 9, 12
CA15-2
4. Describe the accounting for treasury stock.
12
3, 7, 8
6, 7, 9, 10, 18
1, 2, 3, 5, 6, 7, 9, 12
CA15-6, CA15-7
5. Explain the accounting for and reporting of preferred stock.
13, 14, 15, 16, 17, 18
9
5, 8
4
6. Describe the policies used in distributing dividends.
19, 20, 21, 22
10, 11, 12
16
7. Identify the various forms of dividend distributions.
23, 24
11, 12
11, 12, 15, 16, 18
3, 6, 7, 8, 9, 11, 12
8. Explain the accounting for small and large stock dividends, and for stock splits.
25, 26, 27, 28
13, 14
11, 13, 14, 15, 16, 18
3, 8, 10, 11, 12
9. Indicate how to present and analyze stockholders’ equity.
29
3
17, 19, 20
1, 2, 6, 9, 11, 12
15
8, 21, 22, 23, 24
*10.
Explain the different types of preferred stock dividends and their effect on book value per share.
CA15-4, CA15-5, CA15-6
ASSIGNMENT CHARACTERISTICS TABLE Item
Description
Level of Difficulty
Time (minutes)
E15-1 E15-2 E15-3 E15-4 E15-5 E15-6 E15-7 E15-8 E15-9 E15-10 E15-11 E15-12 E15-13 E15-14 E15-15 E15-16 E15-17 E15-18 E15-19 E15-20 *E15-21 *E15-22 *E15-23 *E15-24
Recording the issuances of common stock. Recording the issuance of common and preferred stock. Stock issued for land. Lump-sum sale of stock with bonds. Lump-sum sales of stock with preferred stock. Stock issuances and repurchase. Effect of treasury stock transactions on financials. Preferred stock entries and dividends. Correcting entries for equity transactions. Analysis of equity data and equity section preparation. Equity items on the balance sheet. Cash dividend and liquidating dividend. Stock split and stock dividend. Entries for stock dividends and stock splits. Dividend entries. Computation of retained earnings. Stockholders’ equity section. Dividends and stockholders’ equity section. Comparison of alternative forms of financing. Trading on the equity analysis. Preferred dividends. Preferred dividends. Preferred stock dividends. Computation of book value per share.
Simple Simple Simple Moderate Simple Moderate Moderate Moderate Moderate Moderate Simple Simple Simple Simple Simple Simple Moderate Moderate Moderate Moderate Simple Moderate Complex Moderate
15–20 15–20 10–15 20–25 10–15 25–30 15–20 15–20 15–20 20–25 15–20 10–15 10–15 10–12 10–15 05–10 20–25 30–35 20–25 15–20 10–15 15–20 15–20 10–15
P15-1 P15-2 P15-3 P15-4 P15-5 P15-6 P15-7 P15-8 P15-9 P15-10 P15-11 P15-12
Equity transactions and statement preparation. Treasury stock transactions and presentation. Equity transactions and statement preparation. Stock transactions—lump sum. Treasury stock—cost method. Treasury stock—cost method—equity section preparation. Cash dividend entries. Dividends and splits. Stockholders’ equity section of balance sheet. Stock dividends and stock split. Stock and cash dividends. Analysis and classification of equity transactions.
Moderate Simple Moderate Moderate Moderate Moderate Moderate Moderate Simple Moderate Simple Complex
50–60 25–35 25–30 20–30 30–40 30–40 15–20 20–25 20–25 35–45 25–35 35–45
Moderate Moderate Moderate Simple Simple Moderate Moderate
10–20 15–20 25–30 25–30 15–20 20–25 10–15
CA15-1 Preemptive rights and dilution of ownership. CA15-2 Issuance of stock for land. CA15-3 Conceptual issues—equity. CA15-4 Stock dividends and splits. CA15-5 Stock dividends. CA15-6 Stock dividend, cash dividend, and treasury stock. CA15-7 Treasury stock, ethics. *This material is presented in an appendix to the chapter.
SOLUTIONS TO CODIFICATION EXERCISES CE15-1 Master Glossary (a)
A security that is convertible into another security based on a conversion rate. For example, convertible preferred stock that is convertible into common stock on a two-for-one basis (two shares of common for each share of preferred).
(b)
An issuance by a corporation of its own common shares to its common shareholders without consideration and under conditions indicating that such action is prompted mainly by a desire to give the recipient shareholders some ostensibly separate evidence of a part of their respective interests in accumulated corporate earnings without distribution of cash or other property that the board of directors deems necessary or desirable to retain in the business. A stock dividend takes nothing from the property of the corporation and adds nothing to the interests of the stockholders; that is, the corporation’s property is not diminished and the interests of the stockholders are not increased. The proportional interest of each shareholder remains the same.
(c)
An issuance by a corporation of its own common shares to its common shareholders without consideration and under conditions indicating that such action is prompted mainly by a desire to increase the number of outstanding shares for the purpose of effecting a reduction in their unit market price and, thereby, of obtaining wider distribution and improved marketability of the shares. Sometimes called a stock split-up.
(d)
Contractual rights of security holders to receive dividends or returns from the security issuer’s profits, cash flows, or returns on investments.
CE15-2 According to FASB ASC 505-20-25-3 (Stock Dividends and Stock Splits): 25-3 The point at which the relative size of the additional shares issued becomes large enough to materially influence the unit market price of the stock will vary with individual entities and under differing market conditions and, therefore, no single percentage can be established as a standard for determining when capitalization of retained earnings in excess of legal requirements is called for and when it is not. Except for a few instances, the issuance of additional shares of less than 20 or 25 percent of the number of previously outstanding shares would call for treatment as a stock dividend as described in paragraph 505-20-30-3.
CE15-3 According to FASB ASC 340-10-S99-1 (Deferred Costs and Other Assets—SEC Materials): Specific incremental costs directly attributable to a proposed or actual offering of securities may properly be deferred and charged against the gross proceeds of the offering. However, management salaries or other general and administrative expenses may not be allocated as costs of the offering and deferred costs of an aborted offering may not be deferred and charged against proceeds of a subsequent offering. A short postponement (up to 90 days) does not represent an aborted offering.
CE15-4 According to FASB ASC 505-30-25-7 (Treasury Stock—Recognition): 25-7 After an entity’s repurchase of its own outstanding common stock, sometimes it may either retire the repurchased shares and issue additional common shares, or, as an alternative, resell the repurchased shares. In either case, the price received may differ from the amount paid to repurchase the shares. While the net asset value of the shares of common stock outstanding in the hands of the public may be increased or decreased by such repurchase and retirement, such transactions relate to the capital of the corporation and do not give rise to corporate profits or losses. There is no essential difference between the following: a.
The repurchase and retirement of a corporation’s own common stock and the subsequent issue of common shares.
b.
The repurchase and resale of its own common stock.
ANSWERS TO QUESTIONS 1.
The basic rights of each stockholder (unless otherwise restricted) are to share proportionately: (1) in profits, (2) in management (the right to vote for directors), (3) in corporate assets upon liquidation, and (4) in any new issues of stock of the same class (preemptive right).
2.
The preemptive right protects existing shareholders from dilution of their ownership share in the event the corporation issues new shares.
3.
Preferred stock commonly has preference to dividends in the form of a fixed dividend rate and a preference over common stock to remaining corporate assets in the event of liquidation. Preferred stock usually does not give the holder the right to share in the management of the company. Common stock is the residual security possessing the greater risk of loss and the greater potential for gain; it is guaranteed neither dividends nor assets upon dissolution but it generally controls the management.
4.
The distinction between paid-in capital and retained earnings is important for both legal and economic points of view. Legally, dividends can be declared out of retained earnings in all states, but in many states dividends cannot be declared out of paid-in capital. Economically, management, stockholders, and others look to earnings for the continued existence and growth of the corporation.
5.
Authorized capital stock—the total number of shares authorized by the state of incorporation for issuance. Unissued capital stock—the total number of shares authorized but not issued. Issued capital stock—the total number of shares issued (distributed to stockholders). Outstanding capital stock—the total number of shares issued and still in the hands of stockholders (issued less treasury stock). Treasury stock—shares of stock issued and repurchased by the issuing corporation but not retired.
6.
Par value is an arbitrary, fixed per share amount assigned to a stock by the incorporators. It is recognized by the state of incorporation as the amount that must be paid in for each share if the stock is to be fully paid when issued. If not fully paid, the shareholder has a contingent liability for the discount that results.
7.
The issuance for cash of no-par value common stock at a price in excess of the stated value of the common stock is accounted for as follows: (1) Cash is debited for the proceeds from the issuance of the common stock. (2) Common Stock is credited for the stated value of the common stock. (3) Paid-in Capital in Excess of Stated Value Common Stock is credited for the excess of the proceeds from the issuance of the common stock over its stated value.
8.
The proportional method is used to allocate the lump sum received on sales of two or more classes of securities when the fair value or other sound basis for determining relative value is available for each class of security. In instances where the fair value of all classes of securities is not determinable in a lump-sum sale, the incremental method must be used. The value of the securities is used for those classes that are known and the remainder is allocated to the class for which the value is not known.
9.
The general rule to be applied when stock is issued for services or property other than cash is that the property or services be recorded at either their fair value or the fair value of the stock issued, whichever is more clearly determinable. If neither is readily determinable, the value to be assigned is generally established by the board of directors.
Questions Chapter 15 (Continued) 10. The direct costs of issuing stock, such as underwriting costs, accounting and legal fees, printing costs, and taxes, should be reported as a reduction of the amounts paid in. Issue costs are therefore debited to Paid-in Capital in Excess of Par—Common Stock because they are unrelated to corporate operations. 11. The major reasons for purchasing its own shares are: (1) to provide tax-efficient distributions of excess cash to shareholders, (2) to increase earnings per share and return on equity, (3) to provide stock for employee stock compensation contracts or to meet potential merger needs, (4) to thwart takeover attempts or to reduce the number of stockholders, and (5) to make a market in the stock. 12. (a)
Treasury stock should not be classified as an asset since a corporation cannot own itself.
(b)
The “gain” or “loss” on sale of treasury stock should not be treated as additions to or deductions from income. If treasury stock is carried in the accounts at cost, these so-called gains or losses arise when the treasury stock is sold. These “gains” or “losses” should be considered as additions to or reductions of paid-in capital. In some instances, the “loss” should be charged to Retained Earnings. “Gains” or “losses” arising from treasury stock transactions are not included as a component of net income since dealings in treasury stock represent capital transactions.
(c)
Dividends on treasury stock should never be included as income, but should be credited directly to retained earnings, against which they were incorrectly charged. Since treasury stock cannot be considered an asset, dividends on treasury stock are not properly included in net income.
13. The character of preferred stock can be altered by being cumulative or noncumulative, participating or nonparticipating, convertible or nonconvertible, callable or noncallable, or redeemable. 14. Nonparticipating means the security holder is entitled to no more than the specified fixed dividend. If the security is partially participating, it means that in addition to the specified fixed dividend the security may participate with the common stock in dividends up to a certain stated rate or amount. A fully participating security shares pro rata with the common stock dividends declared without limitation. In this case, Dagwood Inc. has a fully participating preferred stock. Cumulative means dividends not paid in any year must be made up in a later year before any profits can be distributed to common stockholders. Any dividends not paid on cumulative preferred stock constitute a dividend in arrears. A dividend in arrears is not a liability until the board of directors declares a dividend. 15. Preferred stock is generally reported at par value as the first item in the stockholders’ equity section of a company’s balance sheet. Any excess over par value is reported as part of additional paid-in capital. 16. Additional paid-in capital results from: (1) issuance of common stock or preferred stock in excess of par premiums on stock issued, (2) sale of treasury stock above cost, (3) recapitalizations or revisions in the capital structure, (4) conversion of convertible bonds or preferred stock, and (5) declaration of a small stock dividend. 17. When treasury stock is purchased, the Treasury Stock account is debited and Cash is credited at cost ($290,000 in this case). Treasury Stock is a contra stockholders’ equity account and Cash is an asset. Thus, this transaction has: (a) no effect on net income, (b) decreases total assets, (c) has no effect on total paid-in capital, and (d) decreases total stockholders’ equity.
Questions Chapter 15 (Continued) 18. The answers are summarized in the table below: Account (a) Common Stock (b) Retained Earnings (c) Paid-in Capital in Excess of Par— Common Stock (d) Treasury Stock (e) (f) (g)
Paid-in Capital from Treasury Stock Paid-in Capital in Excess of Stated Value—Common Stock Preferred Stock
Classification Paid-in capital—capital stock Retained earnings Paid-in capital—additional paid-in capital Deducted from total paid-in capital and retained earnings Paid-in capital—additional paid-in capital Paid-in capital—additional paid-in capital Paid-in capital—capital stock
19. The dividend policy of a company is influenced by (1) the availability of cash, (2) the stability of earnings, (3) current earnings, (4) prospective earnings, (5) the existence or absence of contractual restrictions on working capital or retained earnings, and (6) a retained earnings balance. 20. In declaring a dividend, the board of directors must consider the condition of the corporation such that a dividend is (1) legally permissible and (2) economically sound. In general, directors should give consideration to the following factors in determining the legality of a dividend declaration: (1) Retained earnings, unless legally encumbered in some manner, is usually the correct basis for dividend distribution. (2) In some states, additional paid-in capital may be used for dividends, although such dividends may be limited to preferred stock. (3) Deficits in retained earnings and debits in paid-in capital accounts must be restored before payment of any dividends. (4) Dividends in some states may not reduce retained earnings below the cost of treasury stock held. In order that dividends be economically sound, the board of directors should consider: (1) the availability (liquidity) of assets for distribution; (2) agreements with creditors; (3) the effect of a dividend on investor perceptions (e.g. maintaining an expected “payout ratio”); and (4) the size of the dividend with respect to the possibility of paying dividends in future bad years. In addition, the ability to expand or replace existing facilities should be considered. 21. Cash dividends are paid out of cash. A balance must exist in retained earnings to permit a legal distribution of profits, but having a balance in retained earnings does not ensure the ability to pay a dividend if the cash situation does not permit it. 22. A cash dividend is a distribution in cash while a property dividend is a distribution in assets other than cash. Any dividend not based on retained earnings is a liquidating dividend. A stock dividend is the issuance of additional shares of the corporation’s stock in a nonreciprocal exchange involving existing stockholders with no change in the par or stated value. 23. A stock dividend results in the transfer from retained earnings to paid-in capital of an amount equal to the fair value of each share (if the dividend is less than 20–25%) or the par value of each share (if the dividend is greater than 20–25%). No formal journal entries are required for a stock split, but a notation in the ledger accounts would be appropriate to show that the par value of the shares has changed.
Questions Chapter 15 (Continued) 24. (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 price per share of the stock. GAAP 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 price. This is a characteristic of a stock split as opposed to a stock dividend, but, for legal reasons, the term “dividend” 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. (b) 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 fair value of the stock distributed. A stock split effected in the form of a dividend involves charging retained earnings 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. (c) A declared but unissued stock dividend should be classified as part of paid-in capital rather than as a liability in a balance sheet. A stock dividend affects only capital accounts; that is, retained earnings is decreased and paid-in 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 announce its intent to issue a specific number of additional shares, and these shares must be reserved for this purpose. 25. A partially liquidating dividend will be debited both to Retained Earnings and Paid-in Capital in Excess of Par. The portion of dividends that is a return of capital should be debited to Paid-in Capital in Excess of Par. 26. A property dividend is a nonreciprocal transfer of nonmonetary assets between company and its owners. A transfer of a nonmonetary asset to a stockholder or to another entity in a nonreciprocal transfer should be recorded at the fair value of the asset transferred, and a gain or loss should be recognized on the disposition of the asset. 27. Retained earnings are restricted because of legal or contractual restrictions, or the necessity to protect the working capital position. 28. Restrictions of retained earnings are best disclosed in a note to the financial statements. This allows a more complete explanation of the restriction.
Questions Chapter 15 (Continued)
*29. (a)
Current year’s dividend, 7% Participating dividend of 9% Totals
Preferred $ 7,000 9,000 $16,000
Common $21,000a 27,000 $48,000
Total $28,000 36,000 $64,000
a
(see schedule below for computation of amounts)
The participating dividend was determined as follows: Current year’s dividend: Preferred, 7% of $100,000 = $ 7,000 Common, 7% of $300,000 = 21,000
$ 28,000
Amount available for participation ($64,000 – $28,000)
$ 36,000
Par value of stock that is to participate ($100,000 + $300,000)
$400,000
Rate of participation ($36,000 ÷ $400,000)
9%
Participating dividend: Preferred, 9% of $100,000 Common, 9% of $300,000 Dividends (b) Dividends in arrears, 7% of $100,000 Current year’s dividend, 7% Participating dividend 7.25% ($29,000 ÷ $400,000)* Totals
$
9,000 27,000 $ 36,000
Preferred $ 7,000 7,000 7,250 $21,250
Common
Preferred $2,000 7,000
Common
$21,000 21,750 $42,750
Total $ 7,000 28,000 29,000 $64,000
*(The same type of schedule as shown in (a) could be used here) (c) Dividends in arrears ($100,000 X 7%) – $5,000 Current year’s dividend, 7% Remainder to common Totals
$9,000
$21,000 $21,000
Total $ 2,000 7,000 21,000 $30,000
SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 15-1 Cash ................................................................................... Common Stock (300 X $10)....................................... Paid-in Capital in Excess of Par— Common Stock .....................................................
4,500 3,000 1,500
BRIEF EXERCISE 15-2 (a) Cash............................................................................ Common Stock...................................................
8,200
(b) Cash............................................................................ Common Stock (600 X $2) ................................. Paid-in Capital in Excess of Stated Value— Common Stock..............................................
8,200
8,200 1,200 7,000
BRIEF EXERCISE 15-3 WILCO CORPORATION Stockholders’ Equity December 31, 2014 Common stock, $5 par value........................................... Paid-in capital in excess of par—common stock........... Total paid-in capital.......................................................... Retained earnings ............................................................ Less: Treasury stock ....................................................... Total stockholders’ equity .......................................
$ 510,000 1,320,000 1,830,000 2,340,000 4,170,000 90,000 $4,080,000
BRIEF EXERCISE 15-4 Cash .................................................................................. Preferred Stock (100 X $50)...................................... Paid-in Capital in Excess of Par— Preferred Stock ...................................................... Common Stock (300 X $10) ...................................... Paid-in Capital in Excess of Par— Common Stock.......................................................
13,500
FV of common (300 X $20) ............................................... FV of preferred (100 X $90) .............................................. Total FV .....................................................................
$ 6,000 9,000 $15,000
$6,000 Allocated to common
3,100 3,000 2,400
X $13,500 = $ 5,400
$15,000 $9,000
Allocated to preferred
5,000
X $13,500 =
8,100
$15,000 $13,500
BRIEF EXERCISE 15-5 Land................................................................................... Common Stock (3,000 X $5) ..................................... Paid-in Capital in Excess of Par— Common Stock.......................................................
31,000 15,000 16,000
BRIEF EXERCISE 15-6 Cash ($60,000 – $1,500) ................................................... Common Stock (2,000 X $10) ................................... Paid-in Capital in Excess of Par— Common Stock.......................................................
58,500 20,000 38,500
BRIEF EXERCISE 15-7 7/1/14 9/1/14
11/1/14
Treasury Stock (100 X $87) ......................... Cash ......................................................
8,700
Cash (60 X $90) ............................................ Treasury Stock (60 X $87).................... Paid-in Capital from Treasury Stock ..................................
5,400
Cash (40 X $83) ............................................ Paid-in Capital from Treasury Stock .......... Treasury Stock (40 X $87)....................
3,320 160
8,700 5,220 180
3,480
BRIEF EXERCISE 15-8 8/1/14 11/1/14
Treasury Stock (200 X $80) ......................... Cash ......................................................
16,000
Cash (200 X $70) .......................................... Retained Earnings ....................................... Treasury Stock .....................................
14,000 2,000
16,000
16,000
BRIEF EXERCISE 15-9 Cash .............................................................................. Preferred Stock (500 X $100) ............................... Paid-in Capital in Excess of Par— Preferred Stock..................................................
61,500 50,000 11,500
BRIEF EXERCISE 15-10 Aug. 1 Retained Earnings (2,000,000 X $1.00) .......... 2,000,000 Dividends Payable ..............................
2,000,000
Aug. 15 No entry. Sep.
9 Dividends Payable .......................................... 2,000,000 Cash .....................................................
2,000,000
BRIEF EXERCISE 15-11 Sep. 21
Equity Investments (available-for-sale)...... Unrealized Holding Gain or Loss— Income ($1,200,000 – $875,000) .........
325,000
Retained Earnings ....................................... Property Dividends Payable ...............
1,200,000
Oct. 8
No entry.
Oct. 23
Property Dividends Payable........................ Equity Investments .............................
325,000
1,200,000
1,200,000 1,200,000
BRIEF EXERCISE 15-12 Apr. 20
June 1
Retained Earnings ($500,000 – $125,000)................................ Paid-in Capital in Excess of Par— Common Stock.......................................... Dividends Payable............................... Dividends Payable ....................................... Cash .....................................................
375,000 125,000 500,000 500,000 500,000
BRIEF EXERCISE 15-13 Declaration Date. Retained Earnings ........................................................ Common Stock Dividend Distributable ............. Paid-in Capital in Excess of Par— Common Stock ................................................. (20,000 X $65 = $1,300,000; 20,000 X $10 = $200,000) Distribution Date. Common Stock Dividend Distributable....................... Common Stock ....................................................
1,300,000 200,000 1,100,000
200,000 200,000
BRIEF EXERCISE 15-14 Declaration Date. Retained Earnings....................................................... Common Stock Dividend Distributable (400,000 X $10) ................................................ Distribution Date. Common Stock Dividend Distributable ..................... Common Stock...................................................
4,000,000 4,000,000 4,000,000 4,000,000
*BRIEF EXERCISE 15-15 (a)
Preferred stockholders would receive $60,000 (6% X $1,000,000) and the remainder of $240,000 ($300,000 – $60,000) would be distributed to common stockholders.
(b)
Preferred stockholders would receive $180,000 (6% X $1,000,000 X 3) and the remainder of $120,000 would be distributed to the common stockholders.
SOLUTIONS TO EXERCISES EXERCISE 15-1 (15–20 minutes) (a) Jan. 10
Mar.
July
1
1
Sept. 1
(b) Jan. 10
Mar.
July
1
1
Cash (80,000 X $6) ............................... Common Stock (80,000 X $5) ........ Paid-in Capital in Excess of Par— Common Stock............................
480,000
Organization Expense ......................... Common Stock (5,000 X $5) .......... Paid-in Capital in Excess of Par— Common Stock............................
35,000
Cash (30,000 X $8) ............................... Common Stock (30,000 X $5) ........ Paid-in Capital in Excess of Par— Common Stock (30,000 X $3) .....
240,000
Cash (60,000 X $10) ............................. Common Stock (60,000 X $5) ........ Paid-in Capital in Excess of Par— Common Stock (60,000 X $5) .....
600,000
Cash (80,000 X $6) ............................... Common Stock (80,000 X $3) ........ Paid-in Capital in Excess of Stated Value—Common Stock (80,000 X $3) ...................................
480,000
Organization Expense ......................... Common Stock (5,000 X $3) .......... Paid-in Capital in Excess of Stated Value—Common Stock ($35,000 – $15,000 or 5,000 X $4) ...
35,000
Cash (30,000 X $8) ............................... Common Stock (30,000 X $3) ........ Paid-in Capital in Excess of Stated Value—Common Stock (30,000 X $5) ................................
240,000
400,000 80,000 25,000 10,000 150,000 90,000 300,000 300,000
240,000 240,000 15,000
20,000 90,000 150,000
EXERCISE 15-1 (Continued) Sept. 1
Cash (60,000 X $10) .............................. Common Stock (60,000 X $3) ......... Paid-in Capital in Excess of Stated Value —Common Stock (60,000 X $7).................................
600,000 180,000 420,000
EXERCISE 15-2 (15–20 minutes) Jan. 10
Mar.
1
April 1
May
1
Aug. 1
Cash (80,000 X $5) ........................................ Common Stock (80,000 X $1)................. Paid-in Capital in Excess of Stated Value—Common Stock ...................... (80,000 X $4)
400,000
Cash (5,000 X $108) ...................................... Preferred Stock (5,000 X $100) .............. Paid-in Capital in Excess of Par— Preferred Stock................................... (5,000 X $8)
540,000
Land............................................................... Common Stock (24,000 X $1)................. Paid-in Capital in Excess of Stated Value—Common Stock ...................... ($80,000 – $24,000)
80,000
Cash (80,000 X $7) ........................................ Common Stock (80,000 X $1)................. Paid-in Capital in Excess of Stated Value—Common Stock ...................... (80,000 X $6)
560,000
Organization Expense .................................. Common Stock (10,000 X $1)................. Paid-in Capital in Excess of Stated Value—Common Stock ...................... ($50,000 – $10,000)
50,000
80,000 320,000
500,000 40,000
24,000 56,000
80,000 480,000
10,000 40,000
EXERCISE 15-2 (Continued) Sept. 1
Nov.
1
Cash (10,000 X $9) ....................................... Common Stock (10,000 X $1) ................ Paid-in Capital in Excess of Stated Value—Common Stock ..................... (10,000 X $8)
90,000
Cash (1,000 X $112) ..................................... Preferred Stock (1,000 X $100).............. Paid-in Capital in Excess of Par— Preferred Stock .................................. (1,000 X $12)
112,000
10,000 80,000
100,000 12,000
EXERCISE 15-3 (10–15 minutes) (a) Land ($62 X 25,000) ................................................... 1,550,000 Treasury Stock ($53 X 25,000) ........................ Paid-in Capital from Treasury Stock ..............
1,325,000 225,000
(b) One might use the cost of treasury stock. However, this is not a relevant measure of this economic event. Rather, it is a measure of a prior, unrelated event. The appraised value of the land is a reasonable alternative (if based on appropriate fair value estimation techniques). However, it is an appraisal as opposed to a market-determined price. The trading price of the stock is probably the best measure of fair value in this transaction. EXERCISE 15-4 (20–25 minutes) (a) 1.
Unamortized Bond Issue Costs ($352,000 X $500/$880)................................. 200,000 Cash ($880 X 9,600) ............................................ 8,448,000 Bonds Payable.......................................... Common Stock (100,000 X $5)................. Paid-in Capital in Excess of Par— Common Stock ......................................
5,000,000 500,000 3,148,000
Assumes bonds properly priced and issued at par; residual attributed to common stock has a questionable measure of fair value.
EXERCISE 15-4 (Continued) Incremental method Lump sum receipt (9,600 X $880) Allocated to subordinated debenture (9,600 X $500) Balance allocated to common stock
$8,448,000 4,800,000 $3,648,000
Computation of common stock and paid-in capital Balance allocated to common stock Less: Common stock (10,000 X $5 X 10) Paid-in capital in excess of par.
$3,648,000 500,000 $3,148,000
Lump sum receipt (10,000 X $880) Allocated to debenture (10,000 X $500) Balance allocated to common stock
$8,800,000 5,000,000 $3,800,000
Bond issue costs allocation Total issue costs (400 X $880) Less: Amount allocated to bonds Amount allocated to common
$352,000 200,000 $152,000
Investment banking costs 400 @ $880 = $352,000 allocate 5/8.8 to debentures and 3.8/8.8 to common stock. Bond portion is bond issue costs; common stock portion is a reduction of paid-in capital, which means that total paid-in capital is $3,648,000 ($3,800,000 – $152,000). 2.
Cash.................................................................. Unamortized Bond Issue Costs ...................... Bond Discount ($5,000,000 – $4,888,889)....... Bonds Payable ......................................... Common Stock (100,000 X $5)................. Paid-in Capital in Excess of Par— Common Stock ......................................
8,448,000 195,556 111,111 5,000,000 500,000 3,254,667
Proportional method The allocation based on fair value for one unit is Subordinated debenture $500 Common stock (10 shares X $40) 400 Total fair value $900 Therefore 5/9 is allocated to the bonds and 4/9 to the common stock.
EXERCISE 15-4 (Continued) $8,800,000 X (5/9) = $4,888,889 To Debentures $8,800,000 X (4/9) = $3,911,111 To Common $352,000 X (5/9) = $195,556 $352,000 X (4/9) = $156,444 Paid-in capital in excess of par = $3,911,111 – $500,000 – $156,444 = $3,254,667 (b) One is not better than the other. The choice of method depends on the relative reliability of the valuations for the stocks and bonds. This question is presented to stimulate some thought and class discussion. EXERCISE 15-5 (10–15 minutes) (a) Fair Value of Common (500 X $165) Fair Value of Preferred (100 X $230)
$ 82,500 23,000 $105,500
Allocated to Common: $82,500/$105,500 X $100,000 Allocated to Preferred: $23,000/$105,500 X $100,000 Total allocation (rounded to nearest dollar) Cash........................................................................ Common Stock (500 X $10) ............................. Paid-in Capital in Excess of Par— Common Stock ($78,199 – $5,000).............. Preferred Stock (100 X $100)........................... Paid-in Capital in Excess of Par— Preferred Stock ($21,801 – $10,000)...........
100,000 5,000 73,199 10,000 11,801
(b) Lump-sum receipt Allocated to common (500 X $170) Balance allocated to preferred Cash........................................................................ Common Stock ................................................ Paid-in Capital in Excess of Par— Common Stock ($85,000 – $5,000).............. Preferred Stock ................................................ Paid-in Capital in Excess of Par— Preferred Stock ($15,000 – $10,000) ...........
$ 78,199 21,801 $100,000
$100,000 85,000 $ 15,000 100,000 5,000 80,000 10,000 5,000
EXERCISE 15-6 (25–30 minutes) (a) Cash [(5,000 X $45) – $7,000] .................................... Common Stock (5,000 X $5) .............................. Paid-in Capital in Excess of Par— Common Stock................................................
218,000
(b) Land (1,000 X $46) ..................................................... Common Stock (1,000 X $5) .............................. Paid-in Capital in Excess of Par— Common Stock ($46,000 – $5,000).................
46,000
25,000 193,000 5,000 41,000
Note: The market value of the stock ($46,000) is used to value the exchange because it is a more objective measure than the appraised value of the land ($50,000). (c) Treasury Stock (500 X $43) ....................................... Cash ....................................................................
21,500 21,500
EXERCISE 15-7 (15–20 minutes) Stockholders’ Paid-in Retained Net # Assets Liabilities Equity Capital Earnings Income 1 D NE D NE NE NE 2 I NE I I NE NE 3 I NE I D NE NE EXERCISE 15-8 (15–20 minutes) (a) $1,000,000 X 8% = $80,000; $80,000 X 3 = $240,000. The cumulative dividend is disclosed in a note to the stockholders’ equity section; it is not reported as a liability. (b) Preferred Stock (4,000 X $100)............................... Common Stock (4,000 X 7 X $10) ................... Paid-in Capital in Excess of Par— Common Stock............................................
400,000
(c) Paid-in capital Preferred stock, $100 par 8%, 10,000 shares issued Paid-in capital in excess of par (10,000 X $7)
280,000 120,000
$1,000,000 70,000
EXERCISE 15-9 (15–20 minutes) May 2
10
15 31
Cash............................................................... Common Stock (12,000 X $5) ............... Paid-in Capital in Excess of Par— Common Stock (12,000 X $11) .........
192,000
Cash............................................................... Preferred Stock (10,000 X $30) ............. Paid-in Capital in Excess of Par— Preferred Stock (10,000 X $30) .........
600,000
Treasury Stock.............................................. Cash .......................................................
15,000
Cash............................................................... Treasury Stock (500 X $15)................... Paid-in Capital from Treasury Stock (500 X $2).................................
8,500
60,000 132,000 300,000 300,000 15,000 7,500 1,000
EXERCISE 15-10 (20–25 minutes) (a) (1) The par value is $2.50. This amount is obtained from either of the following: 2014—$545 ÷ 218 or 2013—$540 ÷ 216. (2) The cost of treasury shares was higher in 2014. The cost at December 31, 2014 was $46 per share ($1,564 ÷ 34) compared to the cost at December 31, 2013 of $34 per share ($918 ÷ 27). (b) Stockholders’ equity (in millions of dollars) Paid-in capital Common stock, $2.50 par value, 500,000,000 shares authorized, 218,000,000 shares issued, and 184,000,000 shares outstanding Additional paid-in capital Total paid-in capital Retained earnings Total paid-in capital and retained earnings Less: Cost of treasury stock (34,000,000 shares) Total stockholders’ equity
$ 545 931 1,476 7,167 8,643 1,564 $7,079
EXERCISE 15-11 (15–20 minutes) Item
Assets Liabilities
1. 2. 3. 4. 5. 6. 7. 8. 9.
I NE NE NE D D NE NE NE
Stockholders’ Paid-in Equity Capital
NE I NE NE NE D I NE NE
I D NE NE D NE D NE NE
NE NE NE NE NE NE NE I NE
Retained Earnings
Net Income
I D NE NE D NE D D NE
I NE NE NE D NE D NE NE
EXERCISE 15-12 (10–15 minutes) (a)
(b)
6/1
Retained Earnings ................................ 8,000,000 Dividends Payable ....................
6/14
No entry on date of record.
6/30
Dividends Payable ................................ 8,000,000 Cash...........................................
8,000,000
8,000,000
If this were a liquidating dividend, the debit entry on the date of declaration would be to Additional Paid-in Capital rather than Retained Earnings.
EXERCISE 15-13 (10–15 minutes) (a)
No entry—simply a memorandum note indicating the number of shares has increased to 18 million and par value has been reduced from $10 to $5 per share.
(b)
Retained Earnings ($10 X 9,000,000)................. 90,000,000 Common Stock Dividend Distributable.....
90,000,000
Common Stock Dividend Distributable............. 90,000,000 Common Stock ...........................................
90,000,000
(c)
Stock dividends and splits serve the same function with regard to the securities markets. Both techniques allow the board of directors to increase the quantity of shares and reduce share prices into a desired “trading range.” For accounting purposes the 20%–25% rule reasonably views large stock dividends as substantive stock splits. In this case, it is necessary to capitalize par value with a stock dividend because the number of shares is increased and the par value remains the same. Earnings are capitalized for purely procedural reasons.
EXERCISE 15-14 (10–12 minutes) (a) Retained Earnings (15,000 X $37) .................. Common Stock Dividend Distributable..... Paid-in Capital in Excess of Par— Common Stock ........................................
555,000
Common Stock Dividend Distributable......... Common Stock ...........................................
150,000
Retained Earnings (300,000 X $10) ................ Common Stock Dividend Distributable.....
3,000,000
Common Stock Dividend Distributable......... Common Stock ...........................................
3,000,000
No entry, the par value becomes $5 and outstanding increases to 600,000.
the number of shares
(b)
(c)
150,000 405,000 150,000 3,000,000 3,000,000
EXERCISE 15-15 (10–15 minutes) (a)
Retained Earnings ............................................ Common Stock Dividend Distributable .. Paid-in Capital in Excess of Par— Common Stock...................................... (50,000 shares X 5% X $39 = $97,500)
97,500
Common Stock Dividend Distributable........... Common Stock ........................................
25,000
25,000 72,500
25,000
(b)
No entry, memorandum note to indicate that par value is reduced to $2 and shares outstanding are now 250,000 (50,000 X 5).
(c)
January 5, 2014 Debt Investments.............................................. Unrealized Holding Gain or Loss— Income ................................................... Retained Earnings ............................................ Property Dividends Payable.................... January 25, 2014 Property Dividends Payable ............................ Debt Investments.....................................
35,000 35,000 135,000 135,000
135,000 135,000
EXERCISE 15-16 (5–10 minutes) Total income since incorporation Less: Total cash dividends paid Total value of stock dividends Current balance of retained earnings
$317,000 $60,000 30,000
90,000 $227,000
The unamortized discount on bonds payable is shown as a contra liability; the gains on treasury stock are recorded as additional paid-in capital.
EXERCISE 15-17 (20–25 minutes) BRUNO CORPORATION Stockholders’ Equity December 31, 2014 Capital stock Preferred stock, $4 cumulative, par value $50 per share; authorized 60,000 shares, issued and outstanding 10,000 shares Common stock, par value $1 per share; authorized 600,000 shares, issued 200,000 shares, and outstanding 190,000 shares Total capital stock Additional paid-in capital— In excess of par—common From sale of treasury stock Total paid-in capital Retained earnings Total paid-in capital and retained earnings Less: Treasury stock, 10,000 shares at cost Total stockholders’ equity
$ 500,000
200,000 700,000 1,300,000 160,000 2,160,000 301,000 2,461,000 170,000 $2,291,000
EXERCISE 15-18 (30–35 minutes) (a)
1.
2.
3.
Dividends Payable—Preferred (2,000 X $10)...... Dividends Payable—Common (20,000 X $2) ...... Cash .........................................................
20,000 40,000
Treasury Stock ................................................. Cash (1,700 X $40)...................................
68,000
Land .................................................................. Treasury Stock (700 X $40) ..................... Paid-in Capital From Treasury Stock .....
30,000
60,000
68,000
28,000 2,000
EXERCISE 15-18 (Continued) 4.
5.
Cash (500 X $105) ............................................. Preferred Stock (500 X $100) ................... Paid-in Capital in Excess of Par— Preferred Stock .....................................
52,500
Retained Earnings (1,900* X $45)..................... Common Stock Dividend Distributable (1,900 X $5) ............................................ Paid-in Capital in Excess of Par— Common Stock......................................
85,500
50,000 2,500
9,500 76,000
*(20,000 – 1,700 + 700 = 19,000; 19,000 X 10%) 6. 7.
(b)
Common Stock Dividend Distributable ........... Common Stock.........................................
9,500
Retained Earnings ............................................ Dividends Payable—Preferred (2,500 X $10) .......................................... Dividends Payable—Common (20,900* X $2) ......................................... *(19,000 + 1,900)
66,800
9,500
25,000 41,800
ANNE CLEVES COMPANY Stockholders’ Equity December 31, 2014
Capital stock Preferred stock, 10%, $100 par, 10,000 shares authorized, 2,500 shares issued and outstanding Common stock, $5 par, 100,000 shares authorized, 21,900 shares issued, 20,900 shares outstanding Total capital stock Additional paid-in capital Total paid-in capital Retained earnings
$250,000 109,500 359,500 205,500 565,000 627,700
EXERCISE 15-18 (Continued) Total paid-in capital and retained earnings Less: Cost of treasury stock (1,000 shares common) Total stockholders’ equity
1,192,700 40,000 $1,152,700
Computations: Preferred stock $200,000 + $50,000 = $250,000 Common stock $100,000 + $ 9,500 = $109,500 Additional paid-in capital: $125,000 + $2,000 + $2,500 + $76,000 = $205,500 Retained earnings: $450,000 – $85,500 – $66,800 + $330,000 = $627,700 Treasury stock $68,000 – $28,000 = $40,000 EXERCISE 15-19 (20–25 minutes) (a)
Mary Ann Benson Company is the more profitable in terms of return on total assets. This may be shown as follows: Benson Company
$660,000
= 15.71%
$4,200,000 Kingston Company
$594,000
= 14.14%
$4,200,000 It should be noted that these returns are based on net income related to total assets, where the ending amount of total assets is considered representative. If the return on total assets uses net income before interest but after taxes in the numerator, the rates of return on total assets are the same as shown below: Benson Company
$660,000
= 15.71%
$4,200,000 Kingston Company
$594,000 + $120,000 – $54,000 $660,000 = $4,200,000 $4,200,000 = 15.71%
EXERCISE 15-19 (Continued) (b)
Kingston Company is the more profitable in terms of return on common stock equity. This may be shown as follows: $594,000
Kingston Company
= 22%
$2,700,000 $660,000
Benson Company
= 18.33%
$3,600,000 (Note to instructor: To explain why the difference in return on assets and return on common stock equity occurs, the following schedule might be provided to the student.)
Funds Supplied Current liabilities Long-term debt Common stock Retained earnings
Kingston Company Rate of Return Funds on Funds at Supplied 15.71%* $ 300,000 $ 47,130 1,200,000 188,520 2,000,000 314,200 700,000 109,970 $4,200,000 $659,820
Cost of Funds $ 0 66,000** 0 0 $66,000
Accruing to Common Stock $ 47,130 122,520 314,200 109,970 $593,820
*Determined in part (a), 15.71% **The cost of funds is the interest of $120,000 ($1,200,000 X 10%). This interest cost must be reduced by the tax savings (45%) related to the interest. The schedule indicates that the income earned on the total assets (before interest cost) was $659,820. The interest cost (net of tax) of this income was $66,000, which indicates a net return to the common equity of $593,820. (c)
The Kingston Company earned a net income per share of $5.94 ($594,000 ÷ 100,000) while Benson Company had an income per share of $4.55 ($660,000 ÷ 145,000). Kingston Company has borrowed a substantial portion of its assets at a cost of 10% and has used these assets to earn a return in excess of 10%. The excess earned on the borrowed assets represents additional income for the stockholders and has resulted in the higher income per share. Due to the debt financing, Kingston has fewer shares of stock outstanding.
EXERCISE 15-19 (Continued) (d)
Yes, from the point of view of income it is advantageous for the stockholders of the Kingston Company to have long-term debt outstanding. The assets obtained from incurrence of this debt are earning a higher return than their cost to the Kingston Company.
(e)
Book value per share. Kingston Company
$2,000,000 + $700,000
= $27.00
100,000 Benson Company
$2,900,000 + $700,000 = $24.83 145,000
EXERCISE 15-20 (15 minutes) (a)
Rate of return on common stock equity: $213,718 $875,000 + $375,000
=
$213,718 = 17.1% $1,250,000
Rate of interest paid on bonds payable:
$135,000
= 13.5%
$1,000,000 (b)
Emporia Plastics, Inc. is trading on the equity successfully, since its return on common stock equity is greater than interest paid on bonds.
Note: Some analysts use after-tax interest expense to compute the bond rate. *EXERCISE 15-21 (10–15 minutes) Preferred (a) Preferred stock is noncumulative, nonparticipating (2,000 X $100 X 8%) Remainder ($90,000 – $16,000)
$16,000
(b) Preferred stock is cumulative, nonparticipating ($16,000 X 3) Remainder ($90,000 – $42,000)
$48,000
Common
Total
$74,000
$90,000
$42,000
$90,000
EXERCISE 15-21 (Continued)
(c) Preferred stock is cumulative, participating
Preferred
Common
Total
$57,778
$32,222
$90,000
Common
Total $32,000 16,000
$20,000 12,222 $32,222
20,000 22,000* $90,000
The computation for these amounts is as follows:
Dividends in arrears (2 X $16,000) Current dividend Pro-rata share to common (5,000 X $50 X 8%) Balance dividend pro-rata
Preferred $32,000 16,000
9,778 $57,778
*Additional amount available for participation ($90,000 – $32,000 – $16,000 – $20,000) Par value of stock that is to participate Preferred (2,000 X $100) $200,000 Common (5,000 X $50) 250,000 Rate of participation $22,000 ÷ $450,000 Participating dividend Preferred, 4.8889% X $200,000 Common, 4.8889% X $250,000
22,000
450,000 4.8889% $ 9,778 12,222 $22,000
Note to instructor: Another way to compute the participating amount is as follows: Preferred Common
$200,000 $450,000 $250,000 $450,000
X $22,000
$ 9,778
X $22,000
12,222 $22,000
*EXERCISE 15-22 (10–15 minutes)
(a) Preferred stock is cumulative, fully participating
Preferred
Common
Total
$36,000
$330,000
$366,000
Common
Total
The computation for these amounts is as follows: Preferred Dividends in arrears (7% X $10 X 20,000) Current dividend Preferred Common (7% X $100 X 30,000) Balance dividend pro-rata
$14,000
$ 14,000
14,000 8,000 $36,000
*Additional amount available for participation ($366,000 – $14,000 – $210,000) Par value of stock that is to participate ($200,000 + $3,000,000) Rate of participation $128,000 ÷ $3,200,000 Participating dividend Preferred, 4% X $200,000 Common, 4% X $3,000,000
$210,000 120,000 $330,000
224,000 128,000* $366,000
$
128,000
$3,200,000 4% $
8,000 120,000 $128,000
Note to instructor: Another way to compute the participating amount is as follows: Preferred
$200,000
X $128,000
$
8,000
X $128,000
120,000 $128,000
$3,200,000 $3,000,000 Common
$3,200,000
*EXERCISE 15-22 (Continued)
(b) Preferred stock is cumulative and participating
Preferred
Common
Total
$14,000
$352,000
$366,000
Preferred
Common
Total
$17,250
$348,750
$366,000
Common
Total
$210,000
$ 14,000 210,000
90,000 48,750 $348,750
90,000 52,000* $366,000
The computation for these amounts is as follows: Current dividend (preferred) (7% X $10 X 20,000) Remainder to common ($366,000 – $14,000)
(c) Preferred stock is noncumulative and participating in distributions in excess of 10%
$ 14,000 352,000 $366,000
The computation for these amounts is as follows: Preferred Current year Preferred (7% X $10 X 20,000) Common (7% X $3,000,000) Additional 3% to common (3% X $3,000,000) Balance dividend pro-rata
$14,000
3,250 $17,250
*Additional amount available for participation ($366,000 – $14,000 – $210,000 – $90,000) Par value of stock that is to participate ($200,000 + $3,000,000) Rate of participation $52,000 ÷ $3,200,000 Participating dividend Preferred 1.625% X $200,000 Common 1.625% X $3,000,000
$
52,000
$3,200,000 1.625% $ 3,250 48,750 $52,000
*EXERCISE 15-23 (10–15 minutes) Assumptions
Year 2012 2013 2014 2015
Paidout $13,000 $26,000 $57,000 $76,000
(a) Preferred, noncumulative and nonparticipating Preferred Common $5.20 $6.00 $6.00 $6.00
-0$ .73a $2.80d $4.07f
(b) Preferred, cumulative and fully participating Preferred Common $ 5.20 $ 6.80b $14.25e $19.00g
-0$ .60c $1.43e $1.90g
The computations for part (a) are as follows: 2012 Dividends paid Amount due preferred (2,500 X $100 X 6%) Preferred per share ($13,000 ÷ 2,500) Common per share
$13,000 $15,000 $5.20 –0–
2013 Dividends paid Amount due preferred Amount due common Preferred per share ($15,000 ÷ 2,500) Common per share ($11,000 ÷ 15,000)
$26,000 15,000 $11,000 $6.00 $ .73
2014 Dividends paid Amount due preferred Amount due common Preferred per share ($15,000 ÷ 2,500) Common per share ($42,000 ÷ 15,000)
$57,000 15,000 $42,000 $6.00 $2.80
*EXERCISE 15-23 (Continued) 2015 Dividends paid Amount due preferred Amount due common Preferred per share ($15,000 ÷ 2,500) Common per share ($61,000 ÷ 15,000)
$76,000 15,000 $61,000 $6.00 $4.07
The computations for part (b) are as follows: 2012 Dividends paid Amount due preferred (2,500 X $100 X 6%) Preferred per share ($13,000 ÷ 2,500) Common per share
$13,000 $15,000 $5.20 –0–
2013 Dividends paid Amount due preferred In arrears ($15,000 – $13,000) Current Amount due common ($26,000 – $17,000) Preferred per share ($17,000 ÷ 2,500) Common per share ($9,000 ÷ 15,000)
$26,000 2,000 15,000 $17,000 $ 9,000 $6.80 $ .60
*EXERCISE 15-23 (Continued) 2014 Dividends paid Amount due preferred Current (2,500 X $100 X 6%) Amount due common Current (15,000 X $10 X 6%) Amount available for participation ($57,000 – $15,000 – $9,000) Par value of stock that is to participate ($250,000 + $150,000) Rate of participation $33,000 ÷ $400,000 Participating dividend Preferred (8.25% X $250,000) Common (8.25% X $150,000)
$57,000 $15,000 $ 9,000
$ 33,000 $400,000 8.25% $20,625 $12,375
Total amount per share—Preferred Current $15,000 Participation 20,625 $35,625 ÷ 2,500
$14.25
Total amount per share—Common Current $ 9,000 Participation 12,375 $21,375 ÷ 15,000
$1.43
*EXERCISE 15-23 (Continued) 2015 Dividends paid Amount due preferred Current (2,500 X $100 X 6%) Amount due common Current (15,000 X $10 X 6%) Amount available for participation ($76,000 – $15,000 – $9,000) Par value that is to participate ($250,000 + $150,000) Rate of participation $52,000 ÷ $400,000 Participating dividend Preferred (13% X $250,000) Common (13% X $150,000)
$76,000 $15,000 $ 9,000
$ 52,000 $400,000 13% $32,500 $19,500
Total amount per share—Preferred Current $15,000 Participation 32,500 $47,500 ÷ 2,500
$19.00
Total amount per share—Common Current $ 9,000 Participation 19,500 $28,500 ÷ 15,000
$1.90
*EXERCISE 15-24 (10–15 minutes) (a)
Common Stockholders’ equity Preferred stock Common stock Retained earnings Dividends in arrears (3 years at 8%) Remainder to common*
Shares outstanding Book value per share ($1,130,000 ÷ 750,000) *Balance in retained earnings ($800,000 – $40,000 – $260,000) Less: Dividends to preferred Available to common (b) Stockholders’ equity Preferred stock Liquidating premium Common stock Retained earnings Dividends in arrears (3 years at 8%) Remainder to common*
Shares outstanding Book value per share ($1,100,000 ÷ 750,000) *Balance in retained earnings ($800,000 – $40,000 – $260,000) Less: Liquidating premium to preferred Dividends to preferred Available to common
Preferred $500,000
$ 750,000 120,000 380,000 $1,130,000
$620,000
750,000 $1.51 $500,000 120,000 $380,000
$500,000 30,000 $ 750,000 $120,000 350,000 $1,100,000
$650,000
750,000 $1.47
$500,000 30,000 120,000 $350,000
TIME AND PURPOSE OF PROBLEMS Problem 15-1 (Time 50–60 minutes) Purpose—to provide the student with an understanding of the necessary entries to properly account for a corporation’s stock transactions. This problem involves such concepts as stock sold for cash, noncash stock transactions, and declaration and distribution of stock dividends. The student is required to prepare the respective journal entries and the stockholders’ equity section of the balance sheet to reflect these transactions. Problem 15-2 (Time 25–35 minutes) Purpose—to provide the student with an opportunity to record the acquisition of treasury stock and its sale at three different prices. In addition, a stockholders’ equity section of the balance sheet must be prepared. Problem 15-3 (Time 25–30 minutes) Purpose—to provide the student with an opportunity to record seven different transactions involving stock issuances, reacquisitions, and dividend payments. Throughout the problem the student needs to keep track of the shares outstanding. Problem 15-4 (Time 20–30 minutes) Purpose—to provide the student with an understanding of the necessary entries to properly account for a corporation’s stock transactions. This problem involves such concepts as a capital stock assessment, lump-sum sales of capital stock, and a noncash stock exchange. The student is required to prepare the journal entries to reflect these transactions. Problem 15-5 (Time 30–40 minutes) Purpose—to provide the student with an understanding of the proper entries to reflect the reacquisition, and reissuance of a corporation’s shares of stock. The student is required to record these treasury stock transactions under the cost method, assuming the FIFO method for purchase and sale purposes. Problem 15-6 (Time 30–40 minutes) Purpose—to provide the student with an understanding of the necessary entries to properly account for a corporation’s stock transactions. This problem involves such concepts as the reacquisition, and reissuance of shares of stock; plus a declaration and payment of a cash dividend. The student is required to prepare the respective journal entries and the stockholders’ equity section of the balance sheet to reflect these transactions. Problem 15-7 (Time 15–20 minutes) Purpose—to provide the student with an understanding of the proper accounting for the declaration and payment of cash dividends on both preferred and common stock. This problem also involves a dividend arrearage on preferred stock, which will be satisfied by the issuance of shares of treasury stock. The student is required to prepare the necessary journal entries for the dividend declaration and payment, assuming that they occur simultaneously. Problem 15-8 (Time 20–25 minutes) Purpose—to provide the student with an understanding of the accounting effects related to stock dividends and stock splits. The student is required to analyze their effect on total assets, common stock, paid-in capital, retained earnings, and total stockholders’ equity. Problem 15-9 (Time 20–25 minutes) Purpose—to provide the student with an understanding of the effect which a series of transactions involving such items as the issuance and reacquisition of common and preferred stock, and a stock dividend, have on the company’s equity accounts. The student is required to prepare the stockholders’ equity section of the balance sheet in proper form reflecting the above transactions.
Time and Purpose of Problems (Continued) Problem 15-10 (Time 35–45 minutes) Purpose—to provide the student with an understanding of the differences between a stock dividend and a stock split. Acting as a financial advisor to the Board of Directors, the student must report on each option and make a recommendation. Problem 15-11 (Time 25–35 minutes) Purpose—to provide the student with an understanding of the proper accounting for the declaration and payment of both a cash and stock dividend. The student is required to prepare both the necessary journal entries to record cash and stock dividends and the stockholders’ equity section of the balance sheet, including a note to the financial statements setting forth the basis of the accounting for the stock dividend. Problem 15-12 (Time 35–45 minutes) Purpose—to provide the student a comprehensive problem involving all facets of the stockholders’ equity section. The student must prepare the stockholders’ equity section of the balance sheet, analyzing and classifying a dozen different transactions to come up with proper accounts and amounts. A good review of Chapter 15.
SOLUTIONS TO PROBLEMS PROBLEM 15-1
(a) January 11 Cash (20,000 X $16)..................................................... 320,000 Common Stock (20,000 X $10) ....................... Paid-in Capital in Excess of Par—Common Stock .............................................................. February 1 Equipment ................................................................ Buildings .................................................................. Land.......................................................................... Preferred Stock (4,000 X $100) ........................ Paid-in Capital in Excess of Par—Preferred Stock ..............................................................
200,000 120,000
50,000 160,000 270,000 400,000 80,000
July 29 Treasury Stock (1,800 X $17) .................................. Cash ..................................................................
30,600
August 10 Cash (1,800 X $14) ................................................... Retained Earnings (1,800 X $3)............................... Treasury Stock .................................................
25,200 5,400*
30,600
30,600
*(The debit is made to Retained Earnings because no Paid-in Capital from Treasury Stock exists.)
PROBLEM 15-1 (Continued) December 31 Retained Earnings ................................................... Dividend Payable.............................................. *Common Stock Cash Dividend: Common shares outstanding Common cash dividend
37,000 37,000*
20,000 X $.25 $5,000
Preferred Stock Cash Dividend: 4,000 X 100 X 8% = $32,000 Total cash dividends: $5,000 + $32,000 = $ 37,000 December 31 Income Summary ......................................................... 175,700 Retained Earnings............................................
(b)
175,700
PHELPS CORPORATION Stockholders’ Equity December 31, 2014 Capital stock Preferred stock—par value $100 per share, 8% cumulative and nonparticipating, 5,000 shares authorized, 4,000 shares issued and outstanding ......... Common stock—par value $10 per share, 50,000 shares authorized, 20,000 shares issued and outstanding ....... Total capital stock................................... Additional paid-in capital In excess of par—preferred ............................ In excess of par—common............................. Total paid-in capital ................................ Retained earnings Total stockholders’ equity...................... *($175,700 – $5,400 – $37,000)
$400,000 200,000 600,000 $ 80,000 120,000
200,000 800,000 133,300* $933,300
PROBLEM 15-2 (a)
Feb. 1 Mar. 1
Mar. 18
Apr. 22
(b)
Treasury Stock ($19 X 2,000)................. Cash...............................................
38,000
Cash ($17 X 800) .................................... Retained Earnings ($2 X 800) ................ Treasury Stock ($19 X 800) ..........
13,600 1,600
Cash ($14 X 500) .................................... Retained Earnings ($5 X 500) ................ Treasury Stock ($19 X 500) ..........
7,000 2,500
Cash ($20 X 600) .................................... Treasury Stock ($19 X 600) .......... Paid-in Capital from Treasury Stock..........................................
12,000
38,000
15,200
9,500 11,400 600
CLEMSON COMPANY Stockholders’ Equity April 30, 2014 Common stock, $5 par value, 20,000 shares issued, 19,900 shares outstanding .................... Paid-in capital in excess of par— common stock..................................................... Paid-in capital from treasury stock........................ Total paid-in capital ..................................... Retained earnings*.................................................. Less: Treasury stock (100 shares)** ..................... Total stockholders’ equity........................... *Retained earnings (beginning balance) ............... March 1 reissuance ................................................ March 18 reissuance .............................................. Net income for period ............................................ Retained earnings (ending balance) ..................... **Treasury stock (beginning balance) ................... February 1 purchase (2,000 shares) ................... March 1 sale (800 shares) .................................... March 18 sale (500 shares) .................................. April 12 sale (600 shares) .................................... Treasury stock (ending balance).........................
$100,000 300,000 600 400,600 445,900 846,500 1,900 $844,600 $320,000 (1,600) (2,500) 130,000 $445,900 $ 0 38,000 (15,200) (9,500) (11,400) $ 1,900
PROBLEM 15-3 HATCH COMPANY Stockholders’ Equity December 31, 2014 Capital Stock Preferred stock, $20 par, 8%, 180,000 shares issued and outstanding ....................................... Common stock, $2.50 par, 4,100,000 shares issued, 4,080,000 shares outstanding ................. Total capital stock ............................... Additional paid-in capital In excess of par—preferred........................ In excess of par—common ........................ From treasury stock ................................... Total paid-in capital............................. Retained earnings .............................................. Total paid-in capital and retained earnings ...... Less: Treasury stock (20,000 shares common) ........................ Total stockholders’ equity ..................
$ 3,600,000 10,250,000 13,850,000 $
260,000 27,750,000 10,000
Supporting balances are indicated in the following T-Accounts. Preferred Stock Bal. 3,000,000 1. 600,000 3,600,000 Paid-in Capital in Excess of Par—Common Stock Bal. 27,000,000 4. 750,000 27,750,000
28,020,000 41,870,000 4,272,000 46,142,000 200,000 $45,942,000
PROBLEM 15-3 (Continued) Common Stock Bal. 10,000,000 3. 250,000 10,250,000 Retained Earnings Bal. 4,500,000 288,000 10. 2,100,000 2,040,000 4,272,000
8. 9.
Paid-in Capital in Excess of Par— Preferred Stock Bal. 200,000 2. 60,000 260,000
5.
Treasury Stock 300,000 6. 100,000 200,000
Paid-in Capital from Treasury Stock 7. 10,000 10,000 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.
Jan. 1 30,000 X $20 Jan. 1 30,000 X $2 Feb. 1 50,000 X $5 Feb. 1 50,000 X $15 July 1 30,000 X $10 Sept. 15 10,000 X $10 Sept. 15 10,000 X $1 Dec. 31 3,600,000 X 8% Dec. 31 4,080,000* X 50¢ *[(2,000,000 + 50,000) X 2] – 30,000 + 10,000 Dec. 31 Net income
PROBLEM 15-4 -1Cash .................................................................................. Discount on Bonds Payable ............................................ Bonds Payable .......................................................... Preferred Stock ......................................................... Paid-in Capital in Excess of Par—Preferred Stock ($106 – $50).................................................. -2Equipment (500 X $16) ..................................................... Common Stock ......................................................... Paid-in Capital in Excess of Par—Common Stock.......................................................................
10,000 106 10,000 50 56
8,000 5,000 3,000
(Assuming the stock is regularly traded, the value of the stock would be used.) If the stock is not regularly traded, the equipment would be recorded at its estimated fair value. -3Cash .................................................................................. Preferred Stock ......................................................... Paid-in Capital in Excess of Par—Preferred Stock ($5,974 – $5,000) .......................................... Common Stock ......................................................... Paid-in Capital in Excess of Par—Common Stock ($4,826 – $3,750) .......................................... Fair value of common (375 X $14) Fair value of preferred (100 X $65) Aggregate Allocated to common:
974 3,750 1,076 $ 5,250 6,500 $11,750
X $10,800 = $ 4,826
$6,500 $11,750
Total allocated
5,000
$5,250 $11,750
Allocated to preferred:
10,800
X $10,800 =
5,974 $10,800
PROBLEM 15-4 (Continued) -4Equipment.......................................................................... Preferred Stock .......................................................... Paid-in Capital in Excess of Par—Preferred Stock ($3,300 – $2,500)........................................... Common Stock .......................................................... Paid-in Capital in Excess of Par—Common Stock ($3,200 – $2,000)........................................... Fair value of equipment Less: Market value of common stock (200 X $16) Total value assigned to preferred stock
6,500 2,500 800 2,000 1,200 $6,500 3,200 $3,300
PROBLEM 15-5 (a) (b)
(c)
(d)
Treasury Stock (380 X $40) ................................. Cash .............................................................
15,200
Treasury Stock (300 X $45) ................................. Cash .............................................................
13,500
Cash (350 X $42).................................................. Treasury Stock (350 X $40) ......................... Paid-in Capital from Treasury Stock (350 X $2) ..................................................
14,700
Cash (110 X $38).................................................. Paid-in Capital from Treasury Stock .................. Treasury Stock ............................................
4,180 620
*30 shares purchased at $40 = 80 shares purchased at $45 = Cost of treasury shares sold using FIFO =
$1,200 3,600 $4,800
15,200
13,500
14,000 700
4,800*
PROBLEM 15-6
(a)
-1Treasury Stock (280 X $97) .............................................27,160 Cash ......................................................................
27,160
-2Retained Earnings ........................................................... 90,400 Dividends Payable [(4,800 – 280) X $20] .............
90,400
-3Dividends Payable ........................................................... 90,400 Cash ......................................................................
90,400
-4Cash (280 X $102) ........................................................ Treasury Stock ..................................................... Paid-in Capital from Treasury Stock (280 X $5)....
27,160 1,400
28,560
-5Treasury Stock (500 X $105) ....................................... Cash ......................................................................
52,500
-6Cash (350 X $96) .......................................................... Paid-in Capital from Treasury Stock .......................... Retained Earnings ....................................................... Treasury Stock (350 X $105)................................
33,600 1,400 1,750
52,500
36,750
PROBLEM 15-6 (Continued) (b)
WASHINGTON COMPANY Stockholders’ Equity December 31, 2015 Common stock, $100 par value, authorized 8,000 shares; issued 4,800 shares, 4,650 shares outstanding ............................... Retained earnings (restricted in the amount of $15,750* by the acquisition of treasury stock)................................................. Total paid-in capital and retained earnings..................................... Less: Treasury stock (150 shares).................... Total stockholders’ equity .......................... *($52,500 – $36,750) **($294,000 – $90,400 – $1,750 + $94,000)
$480,000 295,850** 775,850 15,750 $760,100
PROBLEM 15-7 (a)
For preferred dividends in arrears:
Retained Earnings........................................................ Treasury Stock ....................................................
18,000 18,000*
*1,500 shares of treasury stock issued as dividend; 1,500 X $12 = $18,000 For 6% preferred current year dividend: Retained Earnings........................................................ Cash .....................................................................
18,000 18,000*
*(6% X $300,000) For $.30 per share common dividend: Retained Earnings........................................................ Cash .....................................................................
89,610 89,610*
*Since all preferred dividends must be paid before the common dividend, outstanding common shares include— As of Dec. 31, 2014 (300,000 – 2,800) ................ Preferred distribution ......................................... Common dividend .............................................. Amount of common cash dividend ...................
297,200 shares 1,500 shares 298,700 shares X .30 /share $ 89,610
(b) The suggested cash dividend could be paid even if state law did restrict the retained earnings balance in the amount of the cost of treasury stock. Total dividends would be $125,160,* which is adequately covered by the cash balance. The retained earnings balance, after adding the 2015 net income (estimated at $77,000), is sufficient to cover the dividends.**
PROBLEM 15-7 (Continued) *Preferred dividends in arrears (6% X $300,000)..... $ 18,000 Current preferred dividend (6% X $300,000) .......... 18,000 Common dividend ($.30 X 297,200) ............................ 89,160 Total cash dividend ..................................................... $125,160 **Beginning balance ...................................................... $105,000 Estimated net income ................................................. 77,000 Total balance available............................................ 182,000 If restricted by cost of treasury shares...................... (33,600) Available to pay dividends ......................................... $148,400
PROBLEM 15-8 Transactions: (a) Assuming Myers Co. declares and pays a $.50 per share cash dividend. (1) Total assets—decrease $2,000 [($20,000 ÷ $5) X $.50] (2) Common stock—no effect (3) Paid-in capital in excess of par—no effect (4) Retained earnings—decrease $2,000 (5) Total stockholders’ equity—decrease $2,000 (b) Myers declares and issues a 10% stock dividend when the market price of the stock is $14. (1) Total assets—no effect (2) Common stock—increase $2,000 (4,000 X 10%) X $5 (3) Paid-in capital in excess of par—increase $3,600 (400 X $14) – $2,000 (4) Retained earnings—decrease $5,600 ($14 X 400) (5) Total stockholders’ equity—no effect (c) Myers declares and issues a 30% stock dividend when the market price of the stock is $15 per share. (1) Total assets—no effect (2) Common stock—increase $6,000 (4,000 X 30%) X $5 (3) Paid-in capital in excess of par—no effect (4) Retained earnings—decrease $6,000 (5) Total stockholders’ equity—no effect (d) Myers declares and distributes a property dividend. (1) Total assets—decrease $12,000 (2,000 X $6)—$8,000 gain less $20,000 dividend (2) Common stock—no effect (3) Paid-in capital in excess of par—no effect (4) Retained earnings—decrease $12,000—$8,000 gain less $20,000 dividend (5) Total stockholders’ equity—decrease $12,000
PROBLEM 15-8 (Continued) Note: The journal entries made for the previous transaction are: Equity Investments ($10 – $6) X 2,000.................... 8,000 Unrealized Holding Gain or Loss—Income..... (To record increase in value of securities to be issued) Retained Earnings ($10 X 2,000) ............................. Equity Investments........................................... (To record distribution of property dividend) (e) Myers declares a 2-for-1 stock split (1) Total assets—no effect (2) Common stock—no effect (3) Paid-in capital in excess of par—no effect (4) Retained earnings—no effect (5) Total stockholders’ equity—no effect
8,000
20,000 20,000
PROBLEM 15-9 VICARIO CORPORATION Stockholders’ Equity December 31, 2016 Capital stock: Preferred stock, $100 par value 10,000 shares authorized, 5,000 shares issued & outstanding ................................................
$ 500,000
Common stock, $50 par value 15,000 shares authorized, 8,000 shares issued 7,700 shares outstanding .......... Total capital stock ...............................................
400,000 900,000
Additional paid-in capital: In excess of par—preferred ......................................... $65,000 In excess of par—common.......................................... 59,000* From treasury stock—preferred.................................. 4,700 128,700 Total paid-in capital............................................. 1,028,700 Retained earnings 237,400** Total paid-in capital and retained earnings................ 1,266,100 Less: Cost of treasury stock (300 shares—common)..................................... 19,200 Total stockholders’ equity .................................. $1,246,900 *[($57 – $50) X 7,000 + ($60 – $50) X 1,000] **$610,000 – $312,600 – ($60 X 1,000 shares)
PROBLEM 15-10 To:
Oregon Inc. Board of Directors
From:
Good Student, Financial Advisor
Date:
Today
Subject:
Report on the effects of a stock dividend and a stock split INTRODUCTION
As financial advisor to the Board of Directors for Oregon Inc., I have been asked to report on the effects of the following options for creating interest in Oregon Inc. stock: a 20% stock dividend, a 100% stock dividend, and a 2for-1 stock split. The board wishes to maintain stockholders’ equity as it presently appears on the most recent balance sheet. The Board also wishes to generate interest in stock purchases, and the current market price of the stock ($110 per share) may be discouraging potential investors. Finally, the Board thinks that a cash dividend at this point would be unwise. RECOMMENDATION In order to meet the needs of Oregon Inc., the board should choose a 2-for-1 stock split. The stock split is the only option which would not change the dollar balances in the stockholders’ equity section of the company’s balance sheet. DISCUSSION OF OPTIONS The three above-mentioned options would all result in an increased number of common shares outstanding. Because the shares would be distributed on a pro rata basis to current stockholders, each stockholder of record would maintain his/her proportion of ownership after the declaration. All three options would probably generate significant interest in the stock.
PROBLEM 15-10 (Continued) A 20% STOCK DIVIDEND This option would increase the shares outstanding by 20 percent, which translates into 800,000 additional shares of $10 par value common stock. The problem with this type of stock dividend is that GAAP requires these shares to be accounted for at their current fair value if it significantly exceeds par. The following journal entry must be made to record this dividend. Retained Earnings ($110 X 800,000) ................... Common Stock Dividend Distributable....... Paid-in Capital in Excess of Par— Common Stock ..........................................
88,000,000 8,000,000 80,000,000
Although the Common Stock Dividend Distributable and the Paid-in Capital accounts increase, Retained Earnings decreases dramatically. This reduction in Retained Earnings may hinder Oregon’s success with the subsequent stock offer. A 100% STOCK DIVIDEND This option would double the number of $10 par value common stock currently issued and outstanding. Because this type of dividend is considered, in substance, a stock split, the shares do not have to be accounted for at fair value. Instead, Retained Earnings is reduced only by the par value of the additional shares, while Common Stock Dividend Distributable and, later, Common Stock are increased for that same amount. However, when 4,000,000 shares are already issued and outstanding, the reduction in Retained Earnings reflecting the stock dividend is still great: $40,000,000. In addition, no increase in any Paid-in Capital account occurs. The following journal entry would be made to record the declaration of this dividend: Retained Earnings ($10 X 4,000,000) .................. Common Stock Dividend Distributable.......
40,000,000 40,000,000
PROBLEM 15-10 (Continued) A 2-FOR-1 STOCK SPLIT This option doubles the number of shares issued and outstanding; however, it also cuts the par value per share in half. No accounting treatment beyond a memorandum entry is required for the split because the effect of splitting the par value cancels out the effect of doubling the number of shares. Therefore, Retained Earnings remains unchanged as does the Common Stock and Paid-in Capital Accounts. In addition, the decreased fair value will encourage investors who might otherwise consider the stock too expensive. CONCLUSION To generate the greatest interest in Oregon Inc. stock while maintaining the present balances in the stockholders’ equity section of the balance sheet, you should opt for the 2-for-1 stock split.
PROBLEM 15-11
(a) May 5, 2014 Retained Earnings .................................................. 1,800,000 Dividends Payable ($0.60 per share on 3,000,000) ..................
1,800,000
June 30, 2014 Dividends Payable .................................................. 1,800,000 Cash...............................................................
1,800,000
(b) November 30, 2014 Retained Earnings (6% X 3,000,000 X 34) ............. 6,120,000 Common Stock Dividend Distributable (6% X 3,000,000) .................. Paid-in Capital in Excess of Par—Common Stock................ December 31, 2014 Common Stock Dividend Distributable ................... 1,800,000 Common Stock..................................................
(c)
1,800,000 4,320,000
1,800,000
EARNHART CORPORATION Stockholders’ Equity December 31, 2014 Common stock—$10 par value, issued 3,180,000 shares............................................... Additional paid-in capital ................................... Retained earnings............................................... Total stockholders’ equity ...........................
$31,800,000 9,320,000 20,780,000 $61,900,000
PROBLEM 15-11 (Continued) Statement of Retained Earnings For the Year Ended December 31, 2014 Balance, January 1 .................................. Add: Net income .................................... Less: Dividends on common stock: Cash............................................... Stock (see note) ............................ Balance December 31..............................
$24,000,000 4,700,000 28,700,000 $1,800,000 6,120,000
7,920,000 $20,780,000
Schedule of Additional Paid-in Capital For the Year Ended December 31, 2014 Balance January 1 ................................... Excess of fair value over par value of 180,000 shares of common stock distributed as a dividend (see note)...... Balance December 31..............................
$5,000,000
4,320,000 $9,320,000
Note: The 6% stock dividend (180,000 shares) was declared on November 30, 2014. For the purposes of the dividend, the stock was assigned a price of $34 per share. The par value of $10 per share ($1,800,000) was credited to Common Stock and the excess of $24 ($34 – $10) per share ($4,320,000) to Paid-in Capital in Excess of Par—Common Stock.
PROBLEM 15-12 PENN COMPANY Stockholders’ Equity June 30, 2015 Capital stock 8% preferred stock, $25 par value, cumulative and nonparticipating, 100,000 shares authorized, 40,000 shares issued and outstanding—Note A................
$1,000,000
Common stock, $10 par value, 300,000 shares authorized, 115,400 shares issued with 1,500 shares held in the treasury........ Total capital stock ..............................................
1,154,000 2,154,000
Additional paid-in capital In excess of par-preferred........................................... $ 760,000 In excess of par-common ........................................... 2,821,800* From treasury stock.................................................... 1,500 Total paid-in capital............................................
3,583,300 5,737,300
Retained earnings Total paid-in capital and retained earnings...... Less: Treasury stock, 1,500 shares at cost..... Total stockholders’ equity .............................
409,200 6,146,500 58,500 $6,088,000
Note A: Penn Company is in arrears on the preferred stock in the amount of $40,000. * Paid-In Capital in Excess of Par—Common Stock: Issue of 85,000 shares X ($31 – $10) $1,785,000 Plot of land 170,000 Issue of 20,000 shares (3/1/13) 640,000 [20,000 X ($42 – $10)] 5,400 shares as dividend [5,400 X ($52 – $10)] 226,800 $2,821,800
PROBLEM 15-12 (Continued) Account Balances Common Stock 850,000 50,000 200,000 54,000 1,154,000
Paid-in Capital in Excess of Par—Common Stock 1,785,000 170,000 640,000 226,800 2,821,800
Preferred Stock 1,000,000
Paid-in Capital in Excess of Par—Preferred Stock 760,000
19,500
Paid-in Capital from Treasury Stock
Treasury Stock 78,000 58,500
1,500
Retained Earnings 690,000 280,800 40,000 40,000 409,200
Note that the Penn Company is authorized to issue 300,000 shares of $10 par value common and 100,000 shares of $25 per value, cumulative and nonparticipating preferred.
PROBLEM 15-12 (Continued) Entries supporting the balances. Common Stock 1.
2.
3.
Entries Cash ................................................................... 2,635,000 Common Stock ........................................ Paid-in Capital in Excess of Par— Common Stock ..................................... Land ................................................................. Common Stock ........................................ Paid-in Capital in Excess of Par— Common Stock .....................................
220,000
Cash................................................................. Common Stock ........................................ Paid-in Capital in Excess of Par— Common Stock .....................................
840,000
850,000 1,785,000 50,000 170,000 200,000 640,000
At the beginning of the year, Penn had 110,000 common shares outstanding, of which 85,000 shares were issued at $31 per share, resulting in $850,000 (85,000 shares at $10) of common stock and $1,785,000 of additional paid-in capital on common stock (85,000 shares at $21). The 5,000 shares exchanged for a plot of land would be recorded at $50,000 of common stock and $170,000 of paid-in capital (use the current fair value of the land on July 24 to value the stock issuance). The 20,000 shares issued in 2013 at $42 a share resulted in $200,000 of common stock and $640,000 of paid-in capital. Preferred Stock Cash ................................................................... 1,760,000 Preferred Stock ....................................... Paid-in Capital in Excess of Par— Preferred Stock.....................................
1,000,000 760,000
PROBLEM 15-12 (Continued) The issuance of 40,000 shares of preferred at $44 resulted in $1,000,000 (40,000 shares at $25) of preferred stock outstanding and $760,000 (40,000 shares at $19) of paid-in capital on preferred. Treasury Stock Nov. 30 Treasury Stock ........................................... Cash .......................................................
78,000
June 30 Cash ............................................................ Paid-in Capital from Treasury Stock.... Treasury Stock ...................................
21,000
78,000 1,500 19,500
The 2,000 shares of treasury stock purchased resulted in a debit balance of treasury stock of $78,000. Later, 500 shares were sold at $21,000, which brings the balance down to $58,500 (1,500 shares at $39 per share). The sale of the treasury shares above cost ($21,000 minus $19,500 cost) is recorded in a separate paid-in capital amount. Stock Dividend Dec. 15 Retained Earnings ..................................... 280,800** Common Stock................................... Paid-in Capital in Excess of Par— Common Stock................................ *Shares outstanding, beginning of year: 110,000 Treasury stock (2,000) 108,000 X 5% =
54,000* 226,800
5,400 X $10 Par $54,000
**5,400 Shares X $52 The 5% stock dividend resulted in an increase of 5,400 shares. Recall that there were 110,000 shares outstanding at the beginning of the year. The purchase of 2,000 treasury shares occurred before the stock dividend, bringing the number of shares outstanding at the time of the dividend (December 2014) to 108,000 shares. The resale of 500 treasury shares occurred after the stock dividend.
PROBLEM 15-12 (Continued) Retained Earnings The cash dividends only affect the retained earnings. Note that the preferred stock is in arrears for the dividends that should have been declared in June 2015. Ending retained earnings is the beginning balance of $690,000 plus net income of $40,000, less the preferred dividend of $40,000 and the common stock dividend of $280,800 (5,400 shares at $52), resulting in an ending balance of $409,200.
TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 15-1 (Time 10–20 minutes) Purpose—to provide the student with some familiarity with the applications of the capital stock share system. This case requires the student to analyze the concept dealing with the dilution of ownership interest and the establishment of any necessary corrective actions to compensate an existing stockholder for this dilution effect. CA 15-2 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to discuss the bases for recording the issuance of stock in exchange for nonmonetary assets. CA 15-3 (Time 25–30 minutes) Purpose—to provide a five-part theory case on equity based on Statement of Financial Accounting Concepts No. 6. It requires defining terms and analyzing the effects of equity transactions on financial statement elements. CA 15-4 (Time 25–30 minutes) Purpose—to provide the student with an understanding of the conceptual framework which underlies a stock dividend and a stock split. The student is required to explain what a stock dividend is, the amount of retained earnings to be capitalized in connection with a stock dividend, and how it differs from a stock split both from a legal standpoint and an accounting standpoint. This case also requires an explanation of the various reasons why a corporation declares a stock dividend or a stock split. CA 15-5 (Time 15–20 minutes) Purpose—to provide the student with an understanding of the theoretical concepts and implications that underlie the issuance of a stock dividend. The student is required to discuss the arguments against either considering the stock dividend as income to the recipient or issuing stock dividends on treasury shares. CA 15-6 (Time 20–25 minutes) Purpose—to provide the student with a situation containing a cash dividend declaration, a stock dividend, and a reacquisition and reissuance of shares requiring the student to explain the accounting treatment. CA 15-7 (Time 10–15 minutes) Purpose—to provide an opportunity for the student to consider and discuss the ethical issues involved when the control of a corporation is at stake. The student should recognize the potential conflict between the CEO’s personal will and the responsibility and accountability the CEO has to the stockholders.
SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 15-1 (a)
To share proportionately in any new issues of stock of the same class (the preemptive right).
(b)
Derek Wallace bought an additional $100,000 par value stock. His original ownership was $200,000 ($250,000 X 80%). Thus he increased his ownership by 100/200 (50%). This imbalance can be corrected by issuing to Ms. Baker, at par, shares equal to 50% of her present holdings of $25,000 or stock with a par value of $12,500. Other stockholders should also be offered the right to purchase shares equal to 50% of their holdings in order that all stockholders may retain the same proportionate interest as before the issuance of additional shares.
(c)
No information is given with respect to the fair value of the stock. In this situation, an estimate for fair value could be developed based on market transactions involving comparable assets. Otherwise, discounted expected cash flows could be used to approximate fair value. In this closely held company, and in the absence of reliable fair value data, the book value might be used for the computation of the amount of the cash settlement. Book value of Ms. Baker’s capital stock, June 30, 2014, before issuance of additional shares, 25/250 X $422,000 .................................... Less: Book value after issuance of additional shares to Derek Wallace, 25/350 X $522,000.................................................................................... Loss in book value and amount of cash settlement .......................................
$42,200 37,286 $ 4,914
CA 15-2 (a)
The general rule to be applied when stock is issued for services or property other than cash is that the property or services be recorded at either their fair value or the fair value of the stock issued, whichever is more clearly determinable.
(b)
If the fair value of the land is readily determinable, it is used as a basis for recording the exchange. The fair value could be determined by observing the cash sales price of similar pieces of property or through independent appraisals.
(c)
If the fair value of the land is not readily determinable, but the fair value of the stock issued is determinable, the fair value of the stock is used as a basis for recording the exchange. If the stock is traded on a stock exchange, the fair value can be determined from that day’s cash sales of the stock. If the stock is traded over the counter, recent sales or bid prices can be used to estimate fair value.
(d)
If Martin intentionally records this transaction at an amount greater than fair value, both assets and stockholders’ equity will be overstated. This overvaluation of stockholders’ equity from the inflated asset value is referred to as watered stock. This excess can be eliminated by writing down the overvalued assets with a corresponding charge to the appropriate paid-in capital accounts.
CA 15-3 (a)
Equity, or net assets, is the owners’ residual interest in the assets of an entity that remains after deducting liabilities; in other words, equity equals assets less liabilities. Assets are probable future economic benefits controlled by a particular entity as the result of past transactions or events, and liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity which result from past transactions or events; therefore equity can be defined as future economic benefits which will not be sacrificed to satisfy present obligations.
CA 15-3 (Continued) (b)
Transactions or events that change owners’ equity include revenues and expenses, gains and losses, investments by owners, distributions to owners, and changes within owners’ equity.
(c)
Investments by owners are increases in net assets resulting from transfers by other entities of something of value to obtain ownership. Examples of investments by owners are issuance of preferred or common stock, conversion of convertible bonds, reissuance of treasury stock, assessments on stock, and issuance of stock warrants. Generally, investments by owners cause an increase in assets in addition to the increase in equity.
(d)
Distribution to owners are decreases in net assets resulting from transferring assets to owners, rendering services for owners or incurring liabilities to owners. Examples of distributions to owners are cash or property dividends and the purchase of treasury stock. Dividends generally initially cause an increase in liabilities but eventually cause a decrease in assets in addition to the decrease in equity. The purchase of treasury stock causes a decrease in assets in addition to the decrease in equity.
(e)
Some examples of changes within owners’ equity that do not change the total amount of owners’ equity are retirement of treasury stock, quasi-reorganization (except revaluing of assets), conversion of preferred stock into common stock, stock dividends, and retained earnings appropriations.
CA 15-4 (a)
A stock dividend is the issuance by a corporation of its own stock to its stockholders on a prorata basis without receiving payment therefor. 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 is distinguished from a stock dividend in that a split results in an increase in the number of shares outstanding and a corresponding decrease in the par or stated value per share. A stock dividend, though it results in an increase in the number of shares outstanding, does not result in a decrease in the par or stated value of the shares. (2) The major distinction is that a stock dividend requires a journal entry to decrease retained earnings and increase paid-in capital, while there is no entry for a stock split. Also, from the accounting standpoint the distinction between a stock dividend and a stock split 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 prorata interests in accumulated corporate earnings, the action results in a stock dividend. If the intent is to issue enough shares to reduce the market price per share of the stock, the action results in a stock split, 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. Such reduction will seldom occur unless the number of shares issued is at least 20% to 25% of the number previously outstanding.
(b)
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.
CA 15-4 (Continued) 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, 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. A stock split is intended to obtain wider distribution and improved marketability of shares by means of a reduction in the fair 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 fair 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 distributions—and earnings—are greater than they actually are. If the per share fair value of the stock is materially reduced as a result of a distribution (usually 20%–25% of shares outstanding or more), no matter what form the distribution takes, the action is in substance a stock split and should be so designated and treated as such.
CA 15-5 (a)
The case against treating an ordinary stock dividend as income is supported by a majority of accounting authorities. It is based upon “entity” and “proprietary” interpretations. If the corporation is considered an entity separate from stockholders, the income of the corporation is corporate income and not income to stockholders, although the equity of the stockholders in the corporation increases as income to the corporation increases. This position is consistent with the interpretation that a dividend is not income to the recipient until it is realized as a result of a division, distribution, or severance of corporate assets. The stock dividend received merely redistributes each stockholder’s equity over a larger number of shares. Selling the stock dividend under this interpretation has the effect of reducing the recipient’s proportionate share of the corporation’s equity. A similar position is based upon a “proprietary” interpretation. Income of the corporation is considered income to the owners and, hence, stock dividends represent only a reclassification of equity since there is no increase in total proprietorship.
(b)
The case against issuing stock dividends on treasury stock rests principally upon the argument that stock reacquired by the corporation is a “reduction of capital” through the payment of cash to reduce the number of outstanding shares. According to this view, the corporation cannot obtain a proprietary interest in itself when it reacquires its own stock. The retained earnings are considered divisible only among the owners of outstanding shares and only the outstanding shares are entitled to a stock dividend. In those states that permit treasury shares to participate in the distribution accompanying a stock dividend or stock split, practice is influenced by the planned use of the treasury shares (such as, the issuance of treasury shares in connection with employee stock options). Unless there are specific uses for the treasury stock, no useful purpose is served by issuing additional shares to treasury.
CA 15-6 (a)
Mask Company should account for the purchase of the treasury stock on August 15, 2014, by debiting Treasury Stock and crediting Cash for the cost of the purchase (1,000 shares X $18 per share). Mask should account for the sale of the treasury stock on September 14, 2014, by debiting Cash for the selling price (500 shares X $20 per share), crediting Treasury Stock for cost (500 shares X $18 per share), and crediting Paid-in Capital from Treasury Stock for the excess of the selling price over the cost (500 shares X $2 per share). The remaining treasury stock (500 shares X $18 per share) should be presented separately in the stockholders’ equity section of Mask’s December 31, 2014, balance sheet as an unallocated reduction of stockholders’ equity. These shares are considered issued but not part of common stock outstanding.
(b)
Mask should account for the stock dividend by debiting Retained Earnings for $21 per share (the market price of the stock in October 2014, the date of the stock dividend) multiplied by the 1,950 shares distributed. Mask should then credit Common Stock for the par value of the common stock ($10 per share) multiplied by the 1,950 shares distributed, and credit Paid-In Capital in Excess of Par—Common Stock for the excess of the fair value ($21 per share) over the par value ($10 per share) multiplied by the 1,950 shares distributed. Total stockholders’ equity does not change, but, because this is considered a small stock dividend, recognition has been made of capitalization of retained earnings equivalent to the fair value of the additional shares resulting from the stock dividend.
(c)
Mask should account for the cash dividend on December 20, 2014, the declaration date, by debiting Retained Earnings and crediting Dividends Payable for $1 per share multiplied by the number of shares outstanding 21,450. A cash dividend is a distribution to the corporation’s stockholders. The liability for this distribution is incurred on the declaration date, and it is a current liability because it is payable within one year (January 10, 2015). The effect of the cash dividend on Mask’s balance sheet at December 31, 2014, is an increase in current liabilities and a decrease in retained earnings.
CA 15-7 (a)
The stakeholders are the dissident stockholders, the other stockholders, potential investors, creditors, and Kenseth.
(b)
The ethical issues are honesty, job security, and personal responsibility to others. That is, by using her inside information and her authority to do the buy-back, she can benefit herself at the potential expense of other stakeholders.
(c)
It is important for Kenseth to consider what is good for the corporation, not just for her (in finance terminology, an agency issue). Kenseth should consider the following questions: (1) Are there better uses for the cash? (2) Can she possibly win over the dissidents in some other way? (3) Would this buyout be in the long-term best interest of all parties?
FINANCIAL REPORTING PROBLEM
(a)
P&G’s preferred stock has a stated value of $1 per share.
(b)
P&G’s common stock has a stated value of $1 per share. Like many companies, the stated value of P&G’s common stock is small relative to its market value.
(c)
At June 30, 2011, P&G had 4,008 million shares of common stock issued. This represents 40.1 percent (10,000) of P&G’s authorized common stock.
(d)
At June 30, 2011 and June 30, 2010, P&G had 2,766 (4,008 – 1,242) million and 2,844 (4,008 – 1,164) million shares of common stock outstanding, respectively.
(e)
The cash dividends caused P&G’s Retained Earnings to decrease by $5,767,000 (including both common and preferred dividends).
(f)
Rate of return on common stock equity: 2011:
($11,797 – $233)/[$66,406 + $59,838)/2] = 18.3%
2010:
($12,736 – $219)/[$59,838 + $61,775)/2] = 20.6%
(g) Payout ratio: 2011:
$5,534/($11,797 – $233) = 47.9%
2010:
$5,239/($12,736 – $219) = 41.9%
(h) Price range for the quarter ended June 30, 2011: High—$67.72 Low—$61.47 Note to instructor: Stock price information can be found in P&G’s full 10-K at the KWW website.
COMPARATIVE ANALYSIS CASE
(a) Par value: Coca-Cola, $0.25 per share. PepsiCo, $0.012/3 per share. (b) Percentage of authorized shares issued: Coca-Cola, 3,520,000,000 ÷ 5,600,000,000 = 62.9%. PepsiCo, 1,865,000,000 ÷ 3,600,000,000 = 51.8%. (c) Treasury shares, year-end 2011: Coca-Cola, 1,257,000,000 shares. PepsiCo, 301,000,000 shares. (d) Common or capital stock shares outstanding, year-end 2011: Coca-Cola, 3,520,000,000 – 1,257,000,000 = 2,263,000,000. PepsiCo, 1,865,000,000 – 301,000,000 = 1,564,000,000. (e)
Coca-Cola declared cash dividends in 2011, reducing retained earnings by $4,300,000. PepsiCo declared cash dividend in 2011, reducing retained earnings by $3,217,000,000. ($3,192,000,000 common + $1,000,000 preferred + 24 million RSUs).
(f)
Rate of return on common stock equity. 2011: Coca-Cola,
$8,572
= 27.4%
$31,635 + $31,003 2 PepsiCo,
$6,443 – $1 $20,704 + $21,273 2
= 30.7%
COMPARATIVE ANALYSIS CASE (Continued) 2010: Coca-Cola,
$11,809
= 42.3%
$31,003 + $24,799 2 PepsiCo,
$6,320 – $1
= 33.1%
$21,273 + $16,908 2 During 2011, PepsiCo earned a higher return on its stockholders’ equity. (g) Payout ratios for 2011. Coca-Cola,
$4,300
= 50.2%
$8,572 PepsiCo,
$3,157 $6,443 – $1
= 49.0%
(h) Market price range of stock during the fourth quarter of 2011: Coca-Cola,
High Low
$70.29 $63.34
PepsiCo,
High Low
$66.78 $58.50
2011 stock price increase (decrease): Coca-Cola (from $65.22 to $69.97) 7.3% PepsiCo (from $65.64 to $66.35) 1.08%
FINANCIAL STATEMENT ANALYSIS CASES
CASE 1 (a) Management might purchase treasury stock to provide to stockholders a tax-efficient method for receiving cash from the corporation. In addition, it might have to repurchase shares to have them available to issue to people exercising options to purchase stock, or management might purchase treasury stock because it feels that its stock price is too low. It may believe that by purchasing shares it is signaling to the market that the price is too low. Management might also use excess cash to purchase stock to ward off a hostile takeover. Finally, management might purchase stock in an effort to change its capital structure. If it purchases stock and issues debt (or at least does not retire debt), it will increase the percentage of debt in its capital structure. (b) Earnings per share is calculated by dividing net income by the weightedaverage number of shares outstanding during the year. If shares are reduced by treasury stock purchases, the denominator (weighted-average number of shares outstanding) is reduced. As a result, earnings per share is often increased. However, because corporate assets are reduced by the purchase of the treasury stock, earnings potential may decrease. If this occurs, the effect on earnings per share may be mitigated. (c) One measure of solvency is the ratio of debt divided by total assets. This ratio shows how many dollars of assets are backing up each dollar of debt, should the company become financially troubled. For 2011 and 2010, this can be calculated as follows: 2011
2010
($10,139 ÷ $11,901) = 0.85
($9,693 ÷ $11,847) = 0.82
This represents a decrease in the ratio of debt to total assets. It may be determined that Kellogg’s solvency is weakening and should be watched. A debt to total assets ratio of .85% means that Kellogg is highly leveraged and that its financial flexibility may be weak.
FINANCIAL STATEMENT ANALYSIS CASES (Continued) CASE 2 (a)
The date of record marks the time when ownership of the outstanding shares is determined for dividend purposes. This in turn identifies which shareholders will receive the stock dividend. This date is also used when a stock split occurs. The date of distribution is when the additional shares are distributed (issued) to stockholders.
(b)
The purpose of a stock split is to increase the marketability of the stock by lowering its market price per share. This may make it easier for the corporation to issue additional shares of stock.
(c)
The effects are (1) no effect, (2) no effect, (3) increase, and (4) decrease.
ACCOUNTING, ANALYSIS, AND PRINCIPLES Accounting January 13, 2014 Retained Earnings ($1.05 X 60,000) ......................... Cash ..................................................................
63,000 63,000
April 15, 2014 Retained Earnings [(10% X 60,000) X $14] .............. Common Stock ................................................. Paid-in Capital in Excess of Par— Common Stock ............................................
84,000 60,000 24,000
May 15, 2014 Treasury Stock (2,000 X $15).................................... Cash ..................................................................
30,000 30,000
November 15, 2014 Cash ($18 X 1,000)..................................................... Paid-in Capital from Treasury Stock ............... Treasury Stock .................................................
18,000 3,000 15,000
December 31, 2014 Income Summary ...................................................... Retained Earnings............................................
370,000 370,000
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) The ending balances are indicated in the following partial balance sheet: AGASSI CORPORATION Balance Sheet December 31, 2014 Capital stock Common stock—par value $10 per share, 66,000 shares issued and outstanding (1) .............................................. $ 660,000 Additional paid-in capital In excess of par— common (2).................................................... $524,000 From treasury stock......................................... 3,000 527,000 Total paid-in capital................................. 1,187,000 Retained earnings (3) .............................................. 843,000 2,030,000 Less: Treasury stock (4).......................................... 15,000 Total stockholders’ equity ...................................... $2,015,000 (1) $600,000 + $60,000 (2) $500,000 + $24,000 (3) $620,000 – $63,000 – $ 84,000 + $370,000 (4) $ 30,000 – $15,000 Analysis Payout ratio: $63,000 ÷ $ 370,000 = 17% Rate of return on common stock equity: $370,000 ÷ [($1,720,000 + $2, 015,000) ÷ 2] = 19.8% Principles Treasury stock sold above or below cost does not result in gains or losses because treasury stock does not meet the definition of an asset. Rather, it is unissued equity. Furthermore, gains or losses should not be recorded, because share repurchases and reissues are transactions with its own stockholders; the effects of such transactions should not be recorded in income.
PROFESSIONAL RESEARCH (a)
See FASB ASC 505-10-50.
(b)
(FASB ASC 505-10-20.—Glossary) 1. Security—is defined as evidence of debt or ownership or a related right. It includes options and warrants as well as debt and stock. 2. Participation rights—are contractual rights of security holders to receive dividends or returns from the security issuer’s profits, cash flows, or returns on investments. 3. Preferred stock—is a security that has preferential rights compared to common stock.
(c)
FASB ASC 505-10-50-3. An entity shall explain, in summary form within its financial statements, the pertinent rights and privileges of the various securities outstanding. Examples of information that shall be disclosed are dividend and liquidation preferences, participation rights, call prices and dates, conversion or exercise prices or rates and pertinent dates, sinking-fund requirements, unusual voting rights, and significant terms of contracts to issue additional shares. An entity shall disclose within its financial statements the number of shares issued upon conversion, exercise, or satisfaction of required conditions during at least the most recent annual fiscal period and any subsequent interim period presented.
PROFESSIONAL SIMULATION Note: This assignment is available on the Kieso website. Explanation (a)
Common stock represents an owner’s claim against a portion of the total assets of the corporation. As a result, it is a residual interest. It therefore is part of stockholders’ equity.
(b)
Treasury stock is not an asset. When treasury stock is purchased, a reduction occurs in both assets (cash) and stockholders’ equity. It is inappropriate to imply that a corporation can own part of itself. Treasury stock may be sold to obtain funds, but that possibility does not make it an asset. When a corporation buys back some of its own outstanding stock, it has reduced its capitalization, but it has not acquired an asset.
(c)
“Accumulated other comprehensive loss” is the sum of all previous “other comprehensive income and loss” amounts. A number of items may be included in the accumulated other comprehensive loss. Among these items are foreign currency translation adjustments, unrealized holding gains and losses for available-for-sale securities and others.
(d)
The accumulated deficit is larger in the current year because AMR, like many other major airlines, reported a net loss of $761 million. AMR did not pay dividends in the current year, which would reduce retained earnings.
Analysis $(581) ÷ 161.156* = $(3.61) *(182,350,259 – 21,194,312 treasury stock) Thus, AMR’s net worth is negative due to Treasury Stock and Accumulated Losses.
IFRS CONCEPTS AND APPLICATION IFRS15-1 The primary IFRS reporting standards related to stockholders’ equity are IAS 1 (Presentation of Financial Statements), IAS 32 (Financial Instruments: Presentation), and IAS 39 (Financial Instruments: Recognition and Measurement).
IFRS15-2 Key similarities between IFRS and GAAP for transactions related to stockholders’ equity pertain to (1) issuance of shares, (2) purchase of treasury shares, (3) declaration and payment of dividends, (4) the costs associated with issuing shares reduce the proceeds from the issuance and reduce contributed (paid-in) capital, and (5) the accounting for par, no par and no par shares with a stated value. Major differences relate to terminology used, introduction of items such as revaluation surplus, and presentation of stockholders equity information. In addition, the accounting for treasury stock retirements differs between IFRS and GAAP. Under GAAP a company has the option of charging the excess of the cost of treasury stock over par value to (1) retained earnings, (2) allocate the difference between paid-in capital and retained earnings, or (3) charge the entire amount to paid-in capital. Under IFRS, the excess may have to be charged to paid-in capital, depending on the original transaction related to the issuance of the stock. An IFRS/GAAP difference relates to the account Revaluation Surplus. Revaluation surplus arises under IFRS because of increases or decreases in property, plant and equipment, mineral resources, and intangible assets. This account is part of general reserves under IFRS and is not considered contributed capital.
IFRS15-3 It is likely that the statement of stockholders’ equity and its presentation will be examined closely in the financial statement presentation project. In addition the options of how to present other comprehensive income under GAAP will change in any converged standard in this area.
IFRS15-4 No, Mary should not make that conclusion. While IFRS allows unrealized losses on non-trading equity investments to be reported under “Reserves”, U.S. GAAP requires these losses to be reported as other comprehensive income. Specifically, unrealized losses are reported in the Accumulated Other Comprehensive Income (Loss) account under U.S. GAAP. IFRS15-5 Authorized ordinary shares—the total number of shares authorized by the country of incorporation for issuance. Unissued ordinary shares—the total number of shares authorized but not issued. Issued ordinary shares—the total number of shares issued (distributed to shareholders). Outstanding ordinary shares—the total number of shares issued and still in the hands of shareholders (issued less treasury shares). Treasury shares—shares issued and repurchased by the issuing corporation but not retired.
IFRS15-6 The answers are summarized in the table below:
(a) (b) (c) (d) (e) (f) (g)
Account Share Capital—Ordinary Retained Earnings Share Premium—Ordinary Treasury Shares Share Premium—Treasury Share Capital—Preference Accumulated Other Comprehensive Income
Classification Share capital Retained earnings Share premium Deducted from total equity Share premium Share capital Added to total equity
IFRS15-7 Cash .................................................................................. Share Capital—Ordinary (300 X $10) ....................... Share Premium—Ordinary .......................................
4,500 3,000 1,500
IFRS15-8 WILCO CORPORATION Equity December 31, 2014 Share Capital—Ordinary, $5 par value............................ Share Premium—Ordinary............................................... Retained Earnings ............................................................ Treasury Shares ............................................................... Total Equity ...............................................................
$ 510,000 1,320,000 2,340,000 (90,000) $4,080,000
IFRS15-9 Cash .................................................................................. Share Capital—Preference (100 X $50).................... Share Premium—Preference.................................... Share Capital—Ordinary (300 X $10) ....................... Share Premium—Ordinary .......................................
13,500
FV of ordinary (300 X $20)................................................ FV of preference (100 X $90)............................................ Total FV .............................................................................
$ 6,000 9,000 $15,000
$6,000 Allocated to ordinary
Allocated to preference
X $13,500 = $ 5,400
$15,000 $9,000 $15,000
X $13,500 =
8,100 $13,500
5,000 3,100 3,000 2,400
IFRS15-10 (a)
$1,000,000 X 6% = $60,000; $60,000 X 3 = $180,000. The cumulative dividend is disclosed in a note to the equity section; it is not reported as a liability.
(b)
Share Capital—Preference (3,000 X $100)........ Share Capital—Ordinary (3,000 X 7 X $10) ..................................... Share Premium—Ordinary .......................
(c)
300,000
Preference shares, $100 par 6%, 10,000 shares issued ...................................... Share premium—preference (10,000 X $7) .......
210,000 90,000 $1,000,000 70,000
IFRS15-11
TELLER CORPORATION Partial Statement of Financial Position December 31, 2014 Equity Share capital—preference, cumulative, par value $50 per share; authorized 60,000 shares, issued and outstanding 10,000 shares........................................................... $ 500,000 Share capital—ordinary, par value $1 per share; authorized 600,000 shares, issued 200,000 200,000 $ 700,000 shares, and outstanding 190,000 shares............... Share premium—ordinary ........................................ 1,000,000 Share premium—treasury......................................... 160,000 1,160,000 Retained earnings ..................................................... 201,000 Treasury shares, 10,000 ordinary shares at cost.... (170,000) Total equity ........................................................ $1,891,000
IFRS15-12 (a)
IAS 1 addresses disclosure of information about capital structure.
(b)
An entity shall disclose the following, either in the statement of financial position or the statement of changes in equity, or in the notes: (a) for each class of share capital: (i) the number of shares authorised; (ii) the number of shares issued and fully paid, and issued but not fully paid; (iii) par value per share, or that the shares have no par value; (iv) a reconciliation of the number of shares outstanding at the beginning and at the end of the period; (v) the rights, preferences and restrictions attaching to that class including restrictions on the distribution of dividends and the repayment of capital; (vi) shares in the entity held by the entity or by its subsidiaries or associates; and (vii) shares reserved for issue under options and contracts for the sale of shares, including terms and amounts; and (b) a description of the nature and purpose of each reserve within equity (para. 79).
An entity shall present, either in the statement of changes in equity or in the notes, the amount of dividends recognised as distributions to owners during the period, and the related amount per share (para. 107). In paragraph 106, the components of equity include, for example, each class of contributed equity, the accumulated balance of each class of other comprehensive income and retained earnings (para. 108). Changes in an entity’s equity between the beginning and the end of the reporting period reflect the increase or decrease in its net assets during the period. Except for changes resulting from transactions with owners in their capacity as owners (such as equity contributions, reacquisitions of the entity’s own equity instruments and dividends) and transaction costs directly related to such transactions, the overall change in equity during a period represents the total amount of income and expense, including gains and losses, generated by the entity’s activities during that period (para. 109).
IFRS15-12 (Continued) IAS 8 requires retrospective adjustments to effect changes in accounting policies, to the extent practicable, except when the transition provisions in another IFRS require otherwise. IAS 8 also requires restatements to correct errors to be made retrospectively, to the extent practicable. Retrospective adjustments and retrospective restatements are not changes in equity but they are adjustments to the opening balance of retained earnings, except when an IFRS requires retrospective adjustment of another component of equity. Paragraph 106(b) requires disclosure in the statement of changes in equity of the total adjustment to each component of equity resulting from changes in accounting policies and, separately, from corrections of errors. These adjustments are disclosed for each prior period and the beginning of the period. IFRS15-13 (a)
M&S’s does not have any preference shares.
(b)
M&S’s ordinary shares have a par value of 25p per share. Like many companies, the par value of M&S’s ordinary shares is small relative to its market value.
(c)
At 31 March, 2012, M&S had 1,605.5 million ordinary shares issued. This represents 50.2 percent (3,200,000) of M&S’s authorized ordinary shares.
(d)
At 31 March, 2012 and 2 April, 2011, M&S had 1,605.5 million and 1,584.9 million ordinary shares outstanding, respectively.
(e)
The cash dividends caused M&S’s Retained Earnings to decrease by £267.9 million.
(f)
Return on ordinary share equity: 2012:
£489.6/[£2,790.2 + £2,673.5/2] = 17.9%
2011:
£598.6/[£2,673.5 + £2,168.6/2] = 24.7%
(g) Payout ratio: 2012:
£267.8/£489.6 = 54.7%
2011:
£247.5/£598.6 = 41.3%
CHAPTER 16 Dilutive Securities and Earnings Per Share ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics
Questions
Brief Exercises
Exercises
Problems
Concepts for Analysis
1.
Convertible debt and preferred stock.
1, 2, 3, 4, 5, 6, 7
1, 2, 3
1, 2, 3, 4, 5, 6, 7, 24, 25,
2
1
2.
Warrants and debt.
2, 3, 8, 9
4, 5
7, 8, 9
1
1, 3
3.
Stock options, restricted stock.
1, 10, 11, 12, 13, 14, 15
6, 7, 8
10, 11, 12, 13, 14
1, 3, 4
2, 4
4.
Earnings Per Share (EPS)—terminology.
18, 24
5.
EPS—Determining potentially dilutive securities.
19, 20, 21
12, 13, 14
22, 23, 27
6.
EPS—Treasury stock method.
22, 23
7.
EPS—Weightedaverage computation.
16, 17
10, 11
8.
EPS—General objectives.
24, 25
9, 15
9.
EPS—Comprehensive calculations.
26
10.
EPS—Contingent shares.
*11.
Stock appreciation rights.
28
5
15, 16, 17, 18, 21
5, 6, 7, 8, 9
27
*This material is dealt with in an Appendix to the chapter.
5, 6
5, 6 19, 20, 21, 22, 23, 24, 25, 26, 27, 28
16
5, 6
29, 30
5, 7, 8, 9
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Brief Exercises
Learning Objectives Questions 1. Describe the accounting for the issuance, conversion, and retirement of convertible securities.
1, 2, 4, 5
2. Explain the accounting for convertible preferred stock.
1, 2
Exercises
Problems
Concepts for Analysis
1, 2, 3, 4, 5, 6
1, 2
CA16-1
3
3. Contrast the accounting for stock warrants and for stock warrants issued with other securities.
3, 6, 7, 8, 9
4, 5
1, 7, 8, 9
1
CA16-3
4. Describe the accounting for stock compensation plans.
10, 11, 12, 13, 14, 15
6, 7, 8
10, 11, 12, 13, 14
1, 3, 4
CA16-2, CA16-4
6. Compute earnings per share in a simple capital structure.
16, 17, 19
9, 10, 11, 15
15, 16, 17, 18, 19, 20, 21
6, 9
CA16-5
7. Compute earnings per share in a complex capital structure.
18, 20, 21, 22, 23, 24, 25
12, 13, 14
22, 23, 24, 25, 26, 27, 28
5, 7, 8
CA16-6
16
29, 30
5. Discuss the controversy involving stock compensation plans.
*8. Explain the accounting for stock-appreciation rights plans. *9. Compute earnings per share in a complex situation.
26
ASSIGNMENT CHARACTERISTICS TABLE Item
Description
Level of Difficulty
Time (minutes)
E16-1 E16-2 E16-3 E16-4 E16-5 E16-6 E16-7 E16-8 E16-9 E16-10 E16-11 E16-12 E16-13 E16-14 E16-15 E16-16 E16-17 E16-18 E16-19 E16-20 E16-21 E16-22 E16-23 E16-24 E16-25 E16-26 E16-27 E16-28 *E16-29 *E16-30
Issuance and conversion of bonds. Conversion of bonds. Conversion of bonds. Conversion of bonds. Conversion of bonds. Conversion of bonds. Issuance of bonds with warrants. Issuance of bonds with detachable warrants. Issuance of bonds with stock warrants. Issuance and exercise of stock options. Issuance, exercise, and termination of stock options. Issuance, exercise, and termination of stock options. Accounting for restricted stock. Accounting for restricted stock. Weighted-average number of shares. EPS: Simple capital structure. EPS: Simple capital structure. EPS: Simple capital structure. EPS: Simple capital structure. EPS: Simple capital structure. EPS: Simple capital structure. EPS with convertible bonds, various situations. EPS with convertible bonds. EPS with convertible bonds and preferred stock. EPS with convertible bonds and preferred stock. EPS with options, various situations. EPS with contingent issuance agreement. EPS with warrants. Stock-appreciation rights. Stock-appreciation rights.
Simple Simple Simple Moderate Simple Moderate Simple Simple Moderate Moderate Moderate Moderate Simple Simple Moderate Simple Simple Simple Simple Simple Simple Complex Moderate Moderate Moderate Moderate Simple Moderate Moderate Moderate
15–20 15–20 10–15 15–20 10–20 25–35 10–15 10–15 15–20 15–25 15–25 15–25 10–15 10–15 15–25 10–15 10–15 10–15 20–25 10–15 10–15 20–25 15–20 20–25 10–15 20–25 10–15 15–20 15–25 15–25
P16-1 P16-2 P16-3 P16-4 P16-5 P16-6 P16-7 P16-8 P16-9
Entries for various dilutive securities. Entries for conversion, amortization, and interest of bonds. Stock option plan. Stock-based compensation. EPS with complex capital structure. Basic EPS: Two-year presentation. Computation of basic and diluted EPS. Computation of basic and diluted EPS. EPS with stock dividend and extraordinary items.
Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Complex
35–40 45–50 30–35 25–30 30–35 30–35 35–45 25–35 30–40
CA16-1 CA16-2 CA16-3 CA16-4 CA16-5 CA16-6
Warrants issued with bonds and convertible bonds. Ethical issues—compensation plan. Stock warrants—various types. Stock compensation plans. EPS: Preferred dividends, options, and convertible debt. EPS, antidilution.
Moderate Simple Moderate Moderate Moderate Moderate
20–25 15–20 15–20 25–35 25–35 25–35
SOLUTIONS TO CODIFICATION EXERCISES CE16-1 Master Glossary (a)
The amount of earnings for the period available to each share of common stock outstanding during the reporting period.
(b)
A reduction in EPS resulting from the assumption that convertible securities were converted, that options or warrants were exercised, or that other shares were issued upon the satisfaction of certain conditions.
(c)
A security that gives the holder the right to purchase shares of common stock in accordance with the terms of the instrument, usually upon payment of a specified amount.
(d)
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. Paragraph 718-10-25-5 provides guidance on determining the grant date. See Service Inception Date.
CE16-2 According to FASB ASC 260-10-45-7 (Earnings Per Share—Other Presentation Matters): EPS data shall be presented for all periods for which an income statement or summary of earnings is presented. If diluted EPS data are reported for at least one period, they shall be reported for all periods presented, even if they are the same amounts as basic EPS. If basic and diluted EPS are the same amount, dual presentation can be accomplished in one line on the income statement.
CE16-3 According to FASB ASC 260-10-50-1 (Earnings Per Share—Disclosure): For each period for which an income statement is presented, an entity shall disclose all of the following: (a)
A reconciliation of the numerators and the denominators of the basic and diluted per-share computations for income from continuing operations. The reconciliation shall include the individual income and share amount effects of all securities that affect earnings per share (EPS). Example 2 (see paragraph 260-10-55-51) illustrates that disclosure. (See paragraph 260-10-45-3.) An entity is encouraged to refer to pertinent information about securities included in the EPS computations that is provided elsewhere in the financial statements as prescribed by Subtopic 505-10.
CE16-3 (Continued) (b)
The effect that has been given to preferred dividends in arriving at income available to common stockholders in computing basic EPS.
(c)
Securities (including those issuable pursuant to contingent stock agreements) that could potentially dilute basic EPS in the future that were not included in the computation of diluted EPS because to do so would have been antidilutive for the period(s) presented. Full disclosure of the terms and conditions of these securities is required even if a security is not included in diluted EPS in the current period.
CE16-4 According to FASB ASC 260-10-55-12 (Earnings Per Share—Implementation—Restatement of EPS Data): If the number of common shares outstanding increases as a result of a stock dividend or stock split (see Subtopic 505-20) or decreases as a result of a reverse stock split, the computations of basic and diluted EPS shall be adjusted retroactively for all periods presented to reflect that change in capital structure.If changes in common stock resulting from stock dividends, stock splits, or reverse stock splits occur after the close of the period but before issuance of the financial statements, the per-share computations for those and any prior-period financial statements presented shall be based on the new number of shares. If per-share computations reflect such changes in the number of shares, that fact shall be disclosed.
ANSWERS TO QUESTIONS 1.
Securities such as convertible debt or stock options are dilutive because their features indicate that the holders of the securities can become common shareholders. When the common shares are issued, there will be a reduction—dilution—in earnings per share.
2.
Corporations issue convertible securities for two reasons. One is to raise equity capital without giving up more ownership control than necessary. A second reason is to obtain financing at cheaper rates. The conversion privilege attracts investors willing to accept a lower interest rate than on a straight debt issue.
3.
Convertible debt and debt issued with stock warrants are similar in that: (1) both allow the issuer to issue debt at a lower interest cost than would generally be available for straight debt; (2) both allow the holders to purchase the issuer’s stock at less than market value if the stock appreciates sufficiently in the future; (3) both provide the holder the protection of a debt security if the value of the stock does not appreciate; and (4) both are complex securities which contain elements of debt and equity at the time of issue. Convertible debt and debt with stock warrants are different in that: (1) if the market price of the stock increases sufficiently, the issuer can force conversion of convertible debt into common stock by calling the issue for redemption, but the issuer cannot force exercise of the warrants; (2) convertible debt may be essentially equity capital, whereas debt with stock warrants is debt with the additional right to acquire equity; and (3) the conversion option and the convertible debt are inseparable and, in the absence of separate transferability, do not have separate values established in the market; whereas debt with detachable stock warrants can be separated into debt and the right to purchase stock, each having separate values established by the transactions in the market.
4.
The accounting treatment of the $160,000 “sweetener” to induce conversion of the bonds into common shares represents a departure from GAAP because the FASB views the transaction as the retirement of debt. Therefore, the FASB requires that the “sweetener” of $160,000 be reported as an expense. It is not an extraordinary loss because it is simply a payment to induce conversion.
5.
(a) From the point of view of the issuer, the conversion feature of convertible debt results in a lower cash interest cost than in the case of nonconvertible debt. In addition, the issuer in planning its long-range financing may view the convertible debt as a means of raising equity capital over the long term. Thus, if the market value of the underlying common stock increases sufficiently after the issue of the debt, the issuer will usually be able to force conversion of the convertible debt into common stock by calling the issue for redemption. Under the market conditions, the issuer can effectively eliminate the debt. On the other hand, if the market value of the common stock does not increase sufficiently to result in the conversion of the debt, the issuer will have received the benefit of the cash proceeds to the scheduled maturity dates at a relatively low cash interest cost. (b) The purchaser obtains an option to receive either the face amount of the debt upon maturity or the specified number of common shares upon conversion. If the market value of the underlying common stock increases above the conversion price, the purchaser (either through conversion or through holding the convertible debt containing the conversion option) receives the benefits of appreciation. On the other hand, should the value of the underlying company stock not increase, the purchaser could nevertheless expect to receive the principal and (lower) interest.
Questions Chapter 16 (Continued) 6.
The view that separate accounting recognition should be accorded the conversion feature of convertible debt is based on the premise that there is an economic value inherent in the conversion feature or call on the common stock and that the value of this feature should be recognized for accounting purposes by the issuer. It may be argued that the call is not significantly different in nature from the call contained in an option or warrant and its issue is thus a type of capital transaction. The fact that the conversion feature coexists with certain senior security characteristics in a complex security and cannot be physically separated from these elements or from the instrument does not constitute a logical or compelling reason why the values of the various elements should not receive separate accounting recognition. The fact that the eventual outcome of the option granted the purchaser of the convertible debt cannot be determined at date of issuance is not relevant to the question of effectively reflecting in the accounting records the various elements of the complex document at the date of issuance. The conversion feature has a value at date of issuance and should be recognized. Moreover, the difficulties of implementation are not insurmountable and should not be relied upon to govern the conclusion.
7.
The method used by the company to record the exchange of convertible debentures for common stock can be supported on the grounds that when the company issued the convertible debentures, the proceeds could represent consideration received for the stock. Therefore, when conversion occurs, the book value of the obligation is simply transferred to the stock exchanged for it. Further justification is that conversion represents a transaction with stockholders which should not give rise to a gain or loss. On the other hand, recording the issue of the common stock at the book value of the debentures is open to question. It may be argued that the exchange of the stock for the debentures completes the transaction cycle for the debentures and begins a new cycle for the stock. The consideration or value used for this new transaction cycle should then be the amount which would be received if the debentures were sold rather than exchanged, or the amount which would be received if the related stock were sold, whichever is more clearly determinable at the time of the exchange. This method recognizes changes in values which have occurred and subordinates a consideration determined at the time the debentures were issued.
8.
Cash............................................................................................... Discount on Bonds Payable............................................................ Bonds Payable........................................................................ Paid-in Capital—Stock Warrants............................................. Value of bonds with warrants Value of warrants Value of bonds without warrants
3,000,000 100,000 3,000,000 100,000
$3,000,000 (100,000) $2,900,000
In this case, the incremental method is used since no separate value is given for the bonds without the warrants. 9.
If a corporation decides to issue new shares of stock, the old stockholders generally have the right, referred to as a stock right, to purchase newly issued shares in proportion to their holdings. No entry is required when rights are issued to existing stockholders. Only a memorandum entry is needed to indicate that the rights have been issued. If exercised, the corporation simply debits Cash for the proceeds received, credits Common Stock for the par value, and any difference is recorded with a credit to Paid-in Capital in Excess of Par.
10.
Companies are required to use the fair value method to recognize compensation cost. For most stock option plans compensation cost is measured at the grant date and allocated to expense over the service period, which typically ends on the vesting date. Questions Chapter 16 (Continued) 11.
This plan would not be considered compensatory since it meets the conditions of a noncompensatory plan; i.e., (1) substantially all full-time employees may participate on an equitable basis, (2) the discount from market price is small, and (3) the plan offers no substantive option feature.
12.
The profession recommends that the fair value of a stock option be determined on the date on which the option is granted to a specific individual. At the date the option is granted, the corporation foregoes the alternative of selling the shares at the then prevailing price. The market price on the date of grant may be presumed to be the value which the employer had in mind. It is the value of the option at the date of grant, rather than the grantor’s ultimate gain or loss on the transaction, which for accounting purposes constitutes whatever compensation the grantor intends to pay.
13.
GAAP requires that compensation expense be recognized over the service period. Unless otherwise specified, the service period is the vesting period—the time between the grant date and the vesting date.
14.
Using the fair value approach, total compensation expense is computed based on the fair value of the options on the date the options are granted to the employees. Fair value is estimated using an acceptable option pricing model (such as the Black-Scholes option-pricing model).
15.
The advantages of using restricted stock to compensate employees are: (1) The restricted stock never becomes completely worthless; (2) it generally results in less dilution than stock options; and (3) it better aligns the employee incentives with the companies’ incentives.
16.
Weighted-average number of shares outstanding Outstanding shares (all year) = .................................................. 400,000 October 1 to December 31 (200,000 X 1/4) = ................................ 50,000 Weighted-average number of shares outstanding ..................... Net income ........................................................................................... $2,000,000 Preferred dividends ............................................................................... (400,000) Income available to common stockholders ....................................... Earnings per share =
$1,600,000
450,000
$1,600,000
= $3.56
450,000 17.
The computation of the weighted-average number of shares outstanding requires restatement of the shares outstanding before the stock dividend or split. The additional shares outstanding as a result of a stock dividend or split are assumed to have been outstanding since the beginning of the year. Shares outstanding prior to the stock dividend or split are adjusted so that these shares are stated on the same basis as shares issued after the stock dividend/split.
18.
(a)
Basic earnings per share is the amount of earnings for the period available to each share of common stock outstanding during the reporting period.
(b) Potentially dilutive security is a security which can be exchanged for or converted into common stock and therefore upon conversion or exercise could dilute (or decrease) earnings per share. Included in this category are convertible securities, options, warrants, and other rights.
(c) Diluted earnings per share is the amount of earnings for the period available to each share of common stock outstanding and to each share that would have been outstanding assuming the issuance of common shares for all dilutive potential common shares outstanding during the reporting period.
Questions Chapter 16 (Continued) (d) Complex capital structure exists whenever a company’s capital structure includes dilutive securities. (e) Potential common stock is not common stock in form but does enable its holders to obtain common stock upon exercise or conversion. 19.
Convertible securities are potentially dilutive securities and part of diluted earnings per share if their conversion increases the EPS numerator less than it increases the EPS denominator; i.e., the EPS with conversion is less than the EPS before conversion.
20.
The concept that a security may be the equivalent of common stock has evolved to meet the reporting needs of investors in corporations that have issued certain types of convertible securities, options, and warrants. A potentially dilutive security is a security which is not, in form, common stock but which enables its holder to obtain common stock upon exercise or conversion. The holders of these securities can expect to participate in the appreciation of the value of the common stock resulting principally from the earnings and earnings potential of the issuing corporation. This participation is essentially the same as that of a common stockholder except that the security may carry a specified dividend yielding a return different from that received by a common stockholder. The attractiveness to investors of this type of security is often based principally upon this potential right to share in increases in the earnings potential of the issuing corporation rather than upon its fixed return or upon other senior security characteristics. In addition, the call characteristic of the stock options and warrants gives the investor potential control over a far greater number of shares per dollar of investment than if the investor owned the shares outright.
21.
Convertible securities are considered to be potentially dilutive securities whenever their conversion would decrease earnings per share. If this situation does not result, conversion is not assumed and only basic EPS is reported.
22.
Under the treasury-stock method, diluted earnings per share should be determined as if outstanding options and warrants were exercised at the beginning of year (or date of issue if later) and the funds obtained thereby were used to purchase common stock at the average market price for the period. For example, if a corporation has 10,000 warrants outstanding exercisable at $54, and the average market price of the common stock during the reported period is $60, the $540,000 which would be realized from exercise of warrants and issuance of 10,000 shares would be an amount sufficient to acquire 9,000 shares; thus, 1,000 shares would be added to the outstanding common shares in computing diluted earnings per share for the period. However, to avoid an incremental positive effect upon earnings per share, options and warrants should enter into the computation only when the average market price of the common stock exceeds the exercise price of the option or warrant.
23.
Yes, if warrants or options are present, an increase in the market price of the common stock can increase the number of potentially dilutive common shares by decreasing the number of shares repurchasable. In addition, an increase in the market price of common stock can increase the compensation expense reported in a stock-appreciation rights plan. This would decrease net income and, consequently, earnings per share.
24.
Antidilution is an increase in earnings per share resulting from the assumption that convertible securities have been converted or that options and warrants have been exercised, or other shares have been issued upon the fulfillment of certain conditions. For example, an antidilutive condition would exist when the dividend or interest requirement (net of tax) of a convertible security exceeds the current EPS multiplied by the number of common shares issuable upon conversion of the security. This may be illustrated by assuming a company in the following situation: Net income ........................................................................................................ Weighted-average number of shares outstanding.............................................. 6% Bonds payable (convertible into 5,000 shares of common stock)................. Tax rate .............................................................................................................
$ 10,000 20,000 $100,000 40%
Basic earnings per share = $10,000/20,000 shares = $.50 Questions Chapter 16 (Continued) Earnings per share assuming conversion of the bonds: Net income................................................................................................. Bond interest (net of tax) = (1 – .40) ($100,000 X .06) ............................... Adjusted net income .................................................................................. Earnings per share assuming conversion =
$13,600
$10,000 3,600 $13,600
= $.54
20,000 + 5,000 This antidilutive effect occurs because the bond interest (net of tax) of $3,600 is greater than the current EPS of $.50 multiplied by the number of shares issuable upon conversion of the bonds (5,000 shares). 25.
Both basic earnings per share and diluted earnings per share must be presented in a complex capital structure. When irregular items are reported, per share amounts should be shown for income from continuing operations, income before extraordinary items, and net income.
*26. Antidilution when multiple securities are involved is determined by ranking the securities for maximum possible dilution in terms of per share effect. Starting with the most dilutive, earnings per share is reduced until one of the securities maintains or increases earnings per share. When an increase in earnings per share occurs, the security that causes the increase in earnings per share is excluded. The previous computation therefore provided the maximum dilution.
SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 16-1 Cash ............................................................................. Discount on Bonds Payable ....................................... Bonds Payable ................................................. ...
3,960,000 40,000 4,000,000
BRIEF EXERCISE 16-2 Bonds Payable............................................................. Discount on Bonds Payable................................ Common Stock (2,000 X 50 X $10)...................... Paid-in Capital in Excess of Par— Common Stock..................................................
2,000,000 30,000 1,000,000 970,000
BRIEF EXERCISE 16-3 Preferred Stock (1,000 X $50) ..................................... Paid-in Capital in Excess of Par— Preferred Stock ($60 – $50) X 1,000 ....................... Common Stock (2,000 X $10) .............................. Paid-in Capital in Excess of Par—Common Stock ($60 X 1,000) – (2,000 X $10) ..................
50,000 10,000 20,000 40,000
BRIEF EXERCISE 16-4 Cash ............................................................................. Discount on Bonds Payable ($2,000,000 – $1,940,784) ........................................ Bonds Payable ..................................................... Paid-in Capital—Stock Warrants ........................
2,020,000 59,216 2,000,000 79,216
Fair value of bonds (2,000 X $1,000 X .98) ................. Fair value of warrants (2,000 X $40) ........................... Aggregate fair value ....................................................
$1,960,000 80,000 $2,040,000
Allocated to bonds [($1,960/$2,040) X $2,020,000].... Allocated to warrants [($80/$2,040) X $2,020,000].....
$1,940,784 79,216
$2,020,000 BRIEF EXERCISE 16-5 Cash ............................................................................... Discount on Bonds Payable [$2,000,000 X (1 – .98)] .............................................. Bonds Payable....................................................... Paid-in Capital—Stock Warrants ..........................
2,020,000 40,000 2,000,000 60,000*
*$2,000,000 X (1.01 – .98)
BRIEF EXERCISE 16-6 1/1/14
No entry
12/31/14
Compensation Expense ............................. Paid-in Capital—Stock Options ............................................
75,000
Compensation Expense ............................. Paid-in Capital—Stock Options ............................................
75,000
12/31/15
75,000
75,000
BRIEF EXERCISE 16-7 1/1/14
12/31/14 12/31/15
Unearned Compensation ........................... Common Stock (2,000 X $5) ............... Paid in Capital in Excess of Par— Common Stock [($65 – $5) X 2,000] ...........................
130,000
Compensation Expense ............................. Unearned Compensation....................
65,000
Compensation Expense ............................. Unearned Compensation....................
65,000
10,000 120,000 65,000 65,000
BRIEF EXERCISE 16-8 1/1/14
12/31/14
Unearned Compensation ............................. Common Stock.......................................... Paid-in Capital in Excess of Par— Common Stock......................................
75,000
Compensation Expense ............................... Unearned Compensation ($75,000 ÷ 3) ....
25,000
10,000 65,000 25,000
BRIEF EXERCISE 16-9 $1,000,000 – (100,000 X $2) = $3.20 per share 250,000 shares BRIEF EXERCISE 16-10 Dates Outstanding
Shares Outstanding
Fraction of Year
Weighted Shares
1/1–5/1 5/1–7/1 7/1–10/1 10/1–12/31
120,000 180,000 170,000 180,000
4/12 2/12 3/12 3/12
40,000 30,000 42,500 45,000 157,500
BRIEF EXERCISE 16-11 (a) (300,000 X 4/12) + (330,000 X 8/12) = 320,000 (b) 330,000 (The 30,000 shares issued in the stock dividend are assumed outstanding from the beginning of the year.) BRIEF EXERCISE 16-12 Net income ................................................................................ Adjustment for interest, net of tax [$80,000 X (1 – .40)]......... Adjusted net income ................................................................ Weighted-average number of shares outstanding adjusted for dilutive securities (100,000 + 16,000) ..................................
$300,000 48,000 $348,000 ÷116,000
Diluted EPS................................................................................
$3.00
BRIEF EXERCISE 16-13 Net income ................................................................................. Weighted-average number of shares adjusted for dilutive securities (50,000 + 10,000) ............................... Diluted EPS ................................................................................
$270,000 ÷ 60,000 $4.50
BRIEF EXERCISE 16-14 Proceeds from assumed exercise of 45,000 options (45,000 X $10) ........................................................... Shares issued upon exercise ................................................... Treasury shares purchasable ($450,000 ÷ $15) ....................... Incremental shares.................................................................... Diluted EPS =
$300,000 = 200,000 + 15,000
$450,000 45,000 (30,000) 15,000 $1.40
BRIEF EXERCISE 16-15 Earnings per share Income before extraordinary loss ($600,000/100,000)..... Extraordinary loss ($120,000/100,000) ............................. Net income ($480,000/100,000) .........................................
*BRIEF EXERCISE 16-16 2014:
(5,000 X $4) X 50% = $10,000
2015:
(5,000 X $9) – $10,000 = $35,000
$ 6.00 1.20 $ 4.80
SOLUTIONS TO EXERCISES EXERCISE 16-1 (15–20 minutes) 1.
2.
Cash ($20,000,000 X .99) ............................... Discount on Bonds Payable ......................... Bonds Payable ........................................
19,800,000 200,000
Unamortized Bond Issue Costs .................... Cash.........................................................
70,000
Cash................................................................ Discount on Bonds Payable ......................... Bonds Payable ........................................ Paid-in Capital—Stock Warrants ...........
19,600,000 1,200,000
Value of bonds plus warrants ($20,000,000 X .98) Less: Value of warrants (200,000 X $4) Value of bonds 3.
20,000,000 70,000
20,000,000 800,000
$19,600,000 800,000 $18,800,000
Debt Conversion Expense ............................ Bonds Payable............................................... Discount on Bonds Payable................... Common Stock ....................................... Paid-in Capital in Excess of Par............. Cash.........................................................
75,000 10,000,000 55,000 1,000,000 8,945,000* 75,000
*[($10,000,000 – $55,000) – $1,000,000] EXERCISE 16-2 (15–20 minutes) (a)
Interest Payable ($200,000 X 2/6).................. Interest Expense ($200,000 X 4/6) + $2,712.. Discount on Bonds Payable................... Cash ($4,000,000 X 10% ÷ 2) .................. Calculations: Par value Issuance price
$4,000,000 3,920,000
66,667 136,045 2,712 200,000
Total discount
$
80,000
EXERCISE 16-2 (Continued) Months remaining Discount per month ($80,000 ÷ 118) Discount amortized (4 X $678)
118 $678 $2,712
(b) Bonds Payable ........................................................ 1,500,000 Discount on Bonds Payable ......................... Common Stock (30,000 X $20)...................... Paid-in Capital in Excess of Par ...................
27,458 600,000 872,542*
*($1,500,000 – $27,458) – $600,000 Calculations: Discount related to 3/8 of the bonds ($80,000 X 3/8) Less: Discount amortized [($30,000 ÷ 118) X 10] Unamortized bond discount
$30,000 2,542 $27,458
EXERCISE 16-3 (10–20 minutes) Conversion recorded at book value of the bonds: Bonds Payable ............................................................ Premium on Bonds Payable ....................................... Preferred Stock (500 X 20 X $50) ........................ Paid-in Capital in Excess of Par (Preferred Stock)..............................................
500,000 7,500 500,000 7,500
EXERCISE 16-4 (15–20 minutes) (a) Cash ....................................................................... 10,800,000 Bonds Payable ............................................. 10,000,000 Premium on Bonds Payable........................ 800,000 (To record issuance of $10,000,000 of 8% convertible debentures for $10,800,000. The bonds mature in twenty years, and each $1,000 bond is convertible into five shares
of $30 par value common stock) EXERCISE 16-4 (Continued) (b) Bonds Payable .............................................. Premium on Bonds Payable (Schedule 1) ............................................. Common Stock, $15 par (Schedule 2) ...................................... Paid-in Capital in Excess of Par ........... (To record conversion of 30% of the outstanding 8% convertible debentures after giving effect to the 2-for-1 stock split)
3,000,000 216,000 450,000 2,766,000
Schedule 1 Computation of Unamortized Premium on Bonds Converted Premium on bonds payable on January 1, 2013 Amortization for 2013 ($800,000 ÷ 20) Amortization for 2014 ($800,000 ÷ 20) Premium on bonds payable on January 1, 2015 Bonds converted Unamortized premium on bonds converted
$800,000 $40,000 40,000
(80,000) 720,000 X 30% $216,000
Schedule 2 Computation of Common Stock Resulting from Conversion Number of shares convertible on January 1, 2013: Number of bonds ($10,000,000 ÷ $1,000) Number of shares for each bond Stock split on January 1, 2014 Number of shares convertible after the stock split % of bonds converted Number of shares issued Par value/per share Total par value
10,000 X 5
50,000 X 2 100,000 X 30% 30,000 X $15 $450,000
EXERCISE 16-5 (10–20 minutes) Interest Expense ............................................................ Discount on Bonds Payable .................................. [$10,240 ÷ 64 = $160; $160 X 4] Cash (10% X $500,000 X 1/2).................................. (Assumed that the interest accrual was reversed as of January 1, 2015; if the interest accrual was not reversed, interest expense would be $17,307 and interest payable would be debited for $8,333)
25,640
Bonds Payable ............................................................... Discount on Bonds Payable ($10,240 – $640)....... Common Stock ($25 X 6 X 500).............................. Paid-in Capital in Excess of Par ............................
500,000
640 25,000
9,600 75,000 415,400*
*($500,000 – $9,600) – $75,000 EXERCISE 16-6 (25–35 minutes) (a)
(b)
December 31, 2015 Bond Interest Expense ........................................... Premium on Bonds Payable .................................. ($80,000 X 1/20) Cash ($4,000,000 X 8% X 6/12) ....................... January 1, 2016 Bonds Payable........................................................ Premium on Bonds Payable .................................. Common Stock................................................ [8 X $100 X ($400,000/$1,000)] Paid-in Capital in Excess of Par..................... Total premium ($4,000,000 X .02) Less: Premium amortized ($80,000 X 2/10) Balance Bonds converted ($400,000 ÷ $4,000,000) Related premium
$80,000 16,000 $64,000 10%
156,000 4,000 160,000 400,000 6,400 320,000 86,400
($64,000 X 10%)
6,400
EXERCISE 16-6 (Continued) (c)
March 31, 2016 Bond Interest Expense ........................................... Premium on Bonds Payable .................................. ($6,400 ÷ 8 years) X 3/12 Bond Interest Payable..................................... ($400,000 X 8% X 3/12) March 31, 2016 Bonds Payable........................................................ Premium on Bonds Payable .................................. Common Stock................................................ Paid-in Capital in Excess of Par..................... Premium as of January 1, 2016 for $400,000 of bonds $6,400 ÷ 8 years remaining X 3/12 Premium as of March 31, 2016 for $400,000 of bonds
(d)
7,800 200 8,000
400,000 6,200 320,000 86,200
$6,400 (200) $6,200
June 30, 2016 Bond Interest Expense ........................................... Premium on Bonds Payable .................................. Bond Interest Payable ............................................ ($400,000 X 8% X 1/4)*** Cash .................................................................
124,800 3,200 8,000
[Premium to be amortized: ($80,000 X 80%) X 1/20 = $3,200, or $51,200** ÷ 16 (remaining interest and amortization periods) = $3,200] *Total to be paid: ($3,200,000 X 8% ÷ 2) + $8,000 = $136,000 **Original premium 2014 amortization 2015 amortization Jan. 1, 2016 write-off Mar. 31, 2016 amortization Mar. 31, 2016 write-off
$80,000 (8,000) (8,000) (6,400) (200) (6,200) $51,200
136,000*
***Assumes interest accrued on March 31. If not, debit Bond Interest Expense for $132,800.
EXERCISE 16-7 (10–15 minutes) (a) Basic formulas: Value of bonds without warrants X Issue price = Value assigned to bonds Value of bonds without warrants + Value of warrants Value of warrants X Issue price = Value assigned to warrants Value of bonds without warrants + Value of warrants $136,000
X $152,000 = $129,200
Value assigned to bonds
$136,000 + $24,000 $24,000 $136,000 + $24,000
X $152,000 =
22,800 $152,000
Value assigned to warrants Total
Cash......................................................................... Discount on Bonds Payable .................................. ($170,000 – $129,200) Bonds Payable ................................................ Paid-in Capital—Stock Warrants....................
152,000 40,800 170,000 22,800
(b) When the warrants are non-detachable, separate recognition is not given to the warrants. The accounting treatment parallels that given convertible debt because the debt and equity element cannot be separated. The entry if warrants were non-detachable is: Cash......................................................................... Discount on Bonds Payable .................................. Bonds Payable ................................................
152,000 18,000 170,000
EXERCISE 16-8 (10–15 minutes) SANDS COMPANY Journal Entry September 1, 2014 Cash ......................................................................... Unamortized Bond Issue Costs.............................. Bonds Payable (4,000 X $1,000)...................... Premium on Bonds Payable—Schedule 1 ..... Paid-in Capital—Stock Warrants— Schedule 1........................................................ Bond Interest Expense—Schedule 2 .............. (To record the issuance of the bonds)
4,220,000 30,000 4,000,000 136,000 24,000 90,000
Schedule 1 Premium on Bonds Payable and Value of Stock Warrants Sales price (4,000 X $1,040) Less: Face value of bonds
$4,160,000 4,000,000 160,000
Deduct value assigned to stock warrants (4,000 X 2 = 8,000; 8,000 X $3) Premium on bonds payable
24,000 $ 136,000
Schedule 2 Accrued Bond Interest to Date of Sale Face value of bonds Interest rate Annual interest
$4,000,000 X 9% $ 360,000
Accrued interest for 3 months – ($360,000 X 3/12)
$
90,000
EXERCISE 16-9 (10–15 minutes) (a) Cash ($2,000,000 X 1.02)........................... Discount on Bonds Payable..................... [(1 – .98) X $2,000,000] Bonds Payable ..................................... Paid-in Capital—Stock Warrants ........
2,040,000 40,000 2,000,000 80,000*
*$2,040,000 – ($2,000,000 X .98)
EXERCISE 16-9 (Continued) (b) Market value of bonds without warrants ($2,000,000 X .98) Market value of warrants (2,000 X $30) Total market value $1,960,000 $2,020,000 $60,000 $2,020,000
$1,960,000 60,000 $2,020,000
X $2,040,000 = $1,979,406
Value assigned to bonds
X $2,040,000 = $
Value assigned to warrants
60,594
$2,040,000
Total
Cash ........................................................................ Discount on Bonds Payable .................................. Bonds Payable ................................................... Paid-in Capital—Stock Warrants ......................
2,040,000 20,594 2,000,000 60,594
EXERCISE 16-10 (15–25 minutes) 1/2/15
No entry (total compensation cost is $450,000)
12/31/15
Compensation Expense.............................. Paid-in Capital—Stock Options .......... [To record compensation expense for 2015 (1/2 X $450,000)]
225,000
Compensation Expense ............................. Paid-in Capital—Stock Options ......... [To record compensation expense for 2016 (1/2 X $450,000)]
225,000
Cash (20,000 X $40) .................................... Paid-in Capital—Stock Options ................. ($450,000 X 20,000/30,000) Common Stock (20,000 X $10) ........... Paid-in Capital in Excess of Par......... (To record issuance of 20,000 shares of $10 par value stock upon exercise of options at
800,000 300,000
12/31/16
1/3/17
225,000
225,000
200,000 900,000
option price of $40)
EXERCISE 16-10 (Continued) (Note to instructor: The market price of the stock has no relevance in the prior entry and the following one.) 5/1/17
Cash (10,000 X $40)............................................... 400,000 Paid-in Capital—Stock Options............................ 150,000 ($450,000 X 10,000/30,000) Common Stock........................................... 100,000 Paid-in Capital in Excess of Par—Common Stock.............................. 450,000 (To record issuance of 10,000 shares of $10 par value stock upon exercise of options at option price of $40)
EXERCISE 16-11 (15–25 minutes) 1/1/15
No entry
12/31/15
Compensation Expense .................................... Paid-in Capital—Stock Options ............. ($350,000 X 1/2) (To recognize compensation expense for 2015)
175,000
Paid-in Capital—Stock Options ........................ Compensation Expense ......................... ($175,000 X 2,000/20,000) (To record termination of stock options held by resigned employees)
17,500
Compensation Expense .................................... Paid-in Capital—Stock Options ............. ($350,000 X 1/2 X 18/20) (To recognize compensation expense for 2016)
157,500
Cash (12,000 X $25) ........................................... Paid-in Capital—Stock Options ........................ ($350,000 X 12,000/20,000) Common Stock ....................................... Paid-in Capital in Excess of Par............. (To record exercise of stock options)
300,000 210,000
4/1/16
12/31/16
3/31/17
175,000
17,500
157,500
120,000 390,000
Note: There are 6,000 options unexercised as of 3/31/17 (20,000 – 2,000 – 12,000).
EXERCISE 16-12 (15–25 minutes) 1/1/13
No entry
12/31/13
Compensation Expense ............................. Paid-in Capital—Stock Options.......... ($400,000 X 1/2)
200,000
Compensation Expense ............................. Paid-in Capital—Stock Options..........
200,000
Cash (8,000 X $20) ...................................... Paid-in Capital—Stock Options ................. Common Stock (8,000 X $5) ............... Paid-in Capital in Excess of Par—Common Stock.......................
160,000 320,000*
12/31/14 5/1/15
200,000
200,000
40,000 440,000
*($400,000 X 8,000/10,000) 1/1/17
Paid-in Capital—Stock Options ................. Paid-in Capital—Expired Stock Options ($400,000 – $320,000)........
80,000 80,000
EXERCISE 16-13 (10–15 minutes) (a) 1/1/14
Unearned Compensation ................................... 120,000 Common Stock (4,000 X $5) .................... 20,000 Paid-in Capital Excess of Par— Common stock...................................... 100,000
12/31/15 Compensation Expense ................................. Unearned Compensation ($120,000 ÷ 4) ...
30,000
Common Stock ............................................... Paid-in Capital Excess of Par ........................ Unearned Compensation ........................ Compensation Expense (2 X $30,000)....
20,000 100,000
(b) 3/4/16
30,000
60,000 60,000
EXERCISE 16-14 (10–15 minutes) (a) 1/1/14
Unearned Compensation ............................... Common Stock ($10 X 10,000) ................ Paid-in Capital in Excess of Par— Common Stock .....................................
500,000
12/31/15 Compensation Expense ($500,000 ÷ 5) ......... Unearned Compensation..........................
100,000
(b) 7/25/18
100,000 400,000 100,000
Common Stock ............................................... 100,000 Paid-in Capital in Excess of Par— Common Stock ............................................... 400,000 Compensation Expense .......................... 400,000 Unearned Compensation ........................ 100,000
EXERCISE 16-15 (15–25 minutes) (a) 2,200,000 shares Jan. 1, 2013–Sept. 30, 2013 (2,000,000 X 9/12) Retroactive adjustment for stock dividend Jan. 1, 2013–Sept. 30, 2013, as adjusted Oct. 1, 2013–Dec. 31, 2013 (2,200,000 X 3/12)
1,500,000 X 1.10 1,650,000 550,000 2,200,000
Another way to view this transaction is that the 2,000,000 shares at the beginning of the year must be restated for the stock dividend regardless of where in the year the stock dividend occurs. (b) 3,700,000 shares Jan. 1, 2014–Mar. 31, 2014 (2,200,000 X 3/12) Apr. 1, 2014–Dec. 31, 2014 (4,200,000 X 9/12) (c) 7,400,000 shares 2014 weighted-average number of shares previously computed Retroactive adjustment for stock split (d) 8,400,000 shares Jan. 1, 2015–Mar. 31, 2015 (4,200,000 X 3/12) Retroactive adjustment for stock split Jan. 1, 2015–Mar. 31, 2015, as adjusted Apr. 1, 2015–Dec. 31, 2015 (8,400,000 X 9/12)
550,000 3,150,000 3,700,000 3,700,000 X 2 7,400,000 1,050,000 X 2 2,100,000 6,300,000 8,400,000
Another way to view this transaction is that the 4,200,000 shares at the beginning of the year must be restated for the stock split regardless of where in the year the stock split occurs.
EXERCISE 16-16 (10–15 minutes) (a) Dates Outstanding
Shares Outstanding
Jan. 1–Feb. 1 Feb. 1–Mar. 1 Mar. 1–May 1 May 1–June 1 June 1–Oct. 1 Oct. 1–Dec. 31
480,000 600,000 660,000 560,000 1,680,000 1,740,000
Event Beginning balance Issued shares Stock dividend Reacquired shares Stock split Reissued shares
Restatement 1.1 X 3.0 1.1 X 3.0 3.0 3.0
Fraction of Year
Weighted Shares
1/12 1/12 2/12 1/12 4/12 3/12
132,000 165,000 330,000 140,000 560,000 435,000 1,762,000
Weighted-average number of shares outstanding
(b)
Earnings Per Share =
(c)
Earnings Per Share =
$3,456,000 (Net Income) = $1.96 1,762,000 (Weighted-average Number Shares Outstanding) $3,456,000 – $900,000 1,762,000
= $1.45
(d) Income from continuing operationsa $1.72 b Loss from discontinued operations (.25) Income before extraordinary item 1.47 Extraordinary gainc................................................................................................49 Net income $1.96 a
Deduct extraordinary gain Add loss from discontinued operations Income from continuing operations a
$3,024,000 1,762,000 = $1.72
b
$(432,000) 1,762,000
= $(.25)
c
$864,000 1,762,000
= $.49
Net income$3,456,000 (864,000) 432,000 $3,024,000
EXERCISE 16-17 (12–15 minutes) Dates Shares Event Outstanding Outstanding Beginning balance Jan. 1–May 1 200,000 Issued shares May 1–Oct. 31 208,000 Reacquired shares Oct. 31–Dec. 31 194,000 Weighted-average number of shares outstanding
Fraction of Year 4/12 6/12 2/12
Weighted Shares 66,667 104,000 32,333 203,000
Income per share before extraordinary item ($249,690 + $40,600 = $290,290; $290,290 ÷ 203,000 shares) Extraordinary loss per share, net of tax ($40,600 ÷ 203,000) Net income per share ($249,690 ÷ 203,000)
$1.43 (.20) $1.23
EXERCISE 16-18 (10–15 minutes) Event
Dates Outstanding
Shares Outstanding
Beginning balance Jan. 1–May 1 750,000 Issued shares May 1–Aug. 1 1,050,000 Reacquired shares Aug. 1–Dec. 31 900,000 Weighted-average number of shares outstanding
Net income Preferred dividend (50,000 X $100 X 8%)
Restatement
Fraction of Year
Weighted Shares
2 2 2
4/12 3/12 5/12
500,000 525,000 750,000 1,775,000
$2,500,000 (400,000) $2,100,000
Net income applicable to common stock $2,100,000 = Weighted-average number of shares outstanding 1,775,000 = $1.18
EXERCISE 16-19 (20–25 minutes) Earnings per share of common stock: Income before extraordinary loss* Extraordinary loss, net of tax** Net income***
$1.78 (.16) $1.62
Income data: Income before extraordinary item Deduct 6% dividend on preferred stock Common stock income before extraordinary item Deduct extraordinary loss, net of tax Net income available for common stockholders Dates Outstanding
Shares Outstanding
$15,000,000 300,000 14,700,000 1,340,000 $13,360,000
Fraction of Year
Weighted Shares
January 1–April 1 7,500,000 3/12 April 1–December 31 8,500,000 9/12 Weighted-average number of shares outstanding
1,875,000 6,375,000 8,250,000
*$14,700,000 ÷ 8,250,000 shares = $1.78 per share (income before extraordinary loss) **$1,340,000 ÷ 8,250,000 shares = ($.16) per share (extraordinary loss net of tax) ***$13,360,000 ÷ 8,250,000 shares = $1.62 per share (net income) EXERCISE 16-20 (10–15 minutes) Income before income tax and extraordinary items Income taxes Income before extraordinary item Extraordinary gain, net of applicable income tax of $45,000 Net income Per share of common stock: Income before extraordinary item* Extraordinary gain, net of tax** Net income***
$300,000 150,000 150,000 45,000 $195,000 $.32 .16 $.48
EXERCISE 16-20 (Continued) Dates Outstanding
Shares Outstanding
Fraction of Year
Weighted Shares
January 1–April 1 200,000 3/12 April 1–July 1 250,000 3/12 July 1–Oct. 1 330,000 3/12 Oct. 1–Dec 31. 360,000 3/12 Weighted-average number of shares outstanding
50,000 62,500 82,500 90,000 285,000
$300,000 – income tax of $150,000 – preferred dividends of $60,000 (6% of $1,000,000) = $90,000 (income available to common stockholders) *$90,000 ÷ 285,000 shares = $.32 per share (income before extraordinary gain) **$45,000 ÷ 285,000 shares = $.16 per share (extraordinary gain, net of tax) ***$135,000 ÷ 285,000 shares = $.48 per share (net income)—(rounded up)
EXERCISE 16-21 (10–15 minutes)
Event Beginning balance Issued shares Reacquired shares
Dates Outstanding Jan. 1–April 1 April 1–Oct. 1 Oct. 1–Dec. 31
Shares Outstanding 900,000 1,350,000 1,240,000
Fraction of Year 3/12 6/12 3/12
Weighted Shares 225,000 675,000 310,000
Weighted-average number of shares outstanding— unadjusted Stock dividend, 2/15/2015 Weighted-average number of shares outstanding— adjusted Net income Preferred dividend (280,000 X $50 X 7%)
1,210,000 X 1.05 1,270,500
$2,530,000 (980,000) $1,550,000
Earnings per share for 2014: Net income applicable to common stock
=
$1,550,000
= $1.22
Weighted-average number of shares outstanding
1,270,500
EXERCISE 16-22 (20–25 minutes) (a) Revenues Expenses: Other than interest Bond interest (60 X $1,000 X .08) Income before income taxes Income taxes (40%) Net income
$17,500 $8,400 4,800
13,200 4,300 1,720 $ 2,580
Diluted earnings per share: $2,580 + (1–.40)($4,800) 2,000 + 6,000
= $5,460 = 8,000
$.68
(b) Revenues Expenses: Other than interest Bond interest (60 X $1,000 X .08 X 4/12) Income before income taxes Income taxes (40%) Net income
$17,500 $8,400 1,600
10,000 7,500 3,000 $ 4,500
Diluted earnings per share: $4,500 + (1–.40)($1,600) 2,000 + (6,000 X 1/3 yr.)
= $5,460 = 4,000
$1.37
(c) Revenues Expenses: Other than interest Bond interest (60 X $1,000 X .08 X 1/2) Bond interest (40 X $1,000 X .08 X 1/2) Income before income taxes Income taxes (40%) Net income
$17,500 $8,400 2,400 1,600
12,400 5,100 2,040 $ 3,060
Diluted earnings per share (see note): $3,060 + (1–.40)($4,000) 2,000 + (2,000 X 1/2 yr.) + 4,000 + (2,000 X 1/2)
=
$5,460 8,000
=
$.68
Note: The answer is the same as (a). In both (a) and (c), the bonds are assumed converted for the entire year.
EXERCISE 16-23 (15–20 minutes) (a) (1)
Number of shares for basic earnings per share. Dates Outstanding
Shares Outstanding
Fraction of Year
Jan. 1–April 1 800,000 3/12 April 1–Dec. 1 1,200,000 9/12 Weighted-average number of shares outstanding
Weighted Shares 200,000 900,000 1,100,000
OR Number of shares for basic earnings per share: Initial issue of stock April 1, 2014 issue (3/4 X 400,000) Total (2)
800,000 shares 300,000 shares 1,100,000 shares
Number of shares for diluted earnings per share: Dates Outstanding
Shares Outstanding
Fraction of Year
Jan. 1–April 1 800,000 3/12 April 1–July 1 1,200,000 3/12 July 1–Dec. 31 1,224,000* 6/12 Weighted-average number of shares outstanding
Weighted Shares 200,000 300,000 612,000 1,112,000
*1,200,000 + [($600,000 ÷ 1,000) X 40] (b) (1) (2)
Earnings for basic earnings per share: After-tax net income Earnings for diluted earnings per share: After-tax net income Add back interest on convertible bonds (net of tax): Interest ($600,000 X .08 X 1/2) Less income taxes (40%) Total
$1,540,000 $1,540,000
$24,000 9,600
14,400 $1,554,400
[Note to instructor: In this problem, the earnings per share computed for basic earnings per share is $1.40 ($1,540,000 ÷ 1,100,000) and the diluted
earnings per share is $1.40 (technically $1.39784). As a result, only one earnings per share number would be presented.]
EXERCISE 16-24 (20–25 minutes) (a) Net income for year Add: Adjustment for interest (net of tax) *Maturity value Stated rate Cash interest Discount amortization [(1.00 – .98) X $5,000,000 X 1/10] Interest expense 1 – tax rate (35%) After-tax interest
$9,500,000 234,000* $9,734,000 $5,000,000 X 7% 350,000 10,000 360,000 X .65 $ 234,000
$5,000,000/$1,000 = 5,000 debentures Increase in diluted earnings per share denominator: 5,000 X 18 90,000 Earnings per share: Basic EPS Diluted EPS
$9,500,000 ÷ 2,000,000 = $4.75 $9,734,000 ÷ 2,090,000 = $4.66
(b) If the convertible security were preferred stock, basic EPS would be the same assuming there were no preferred dividends declared or the preferred was noncumulative. For diluted EPS, the numerator would be the net income amount and the denominator would be 2,090,000. EXERCISE 16-25 (10–15 minutes) (a) Net income Add: Interest savings (net of tax) [$120,000 X (1 – .40)] Adjusted net income $2,000,000 ÷ $1,000 = 2,000 bonds X 15 30,000 shares
$300,000 72,000 $372,000
Diluted EPS: $372,000 ÷ (100,000 + 30,000) = $2.86
EXERCISE 16-25 (Continued) (b) Shares outstanding Add: Shares assumed to be issued (10,000* X 5) Shares outstanding adjusted for dilutive securities
100,000 50,000 150,000
*$1,000,000 ÷ $100 Diluted EPS: ($300,000 – $0) ÷ 150,000 = $2.00 Note: Preferred dividends are not deducted since preferred stock was assumed converted into common stock.
EXERCISE 16-26 (20–25 minutes) (a) Shares assumed issued on exercise Proceeds (1,000 X $6 = $6,000) Less: Treasury shares purchased ($6,000/$20) Incremental shares
Diluted EPS =
Diluted 1,000 300 700
$50,000 = $4.67 (rounded) 10,000 + 700
(b) Shares assumed issued on exercise Proceeds = $6,000 Less: Treasury shares purchased ($6,000/$20)
Diluted 1,000 300 700 X 3/12
Incremental shares Diluted EPS =
$50,000 = $4.91 (rounded) 10,000 + 175
175
EXERCISE 16-27 (10–15 minutes) (a) The contingent shares would have to be reflected in diluted earnings per share because the earnings level is currently being attained. (b) Because the earnings level is not being currently attained, contingent shares are not included in the computation of diluted earnings per share.
EXERCISE 16-28 (15–20 minutes) (a)
Diluted The warrants are dilutive because the option price ($10) is less than the average market price ($15). Incremental shares =
$15 – $10 X 15,000 = $15
5,000
OR Proceeds from assumed exercise: (15,000 warrants X $10 exercise price) Treasury shares purchasable with proceeds: ($150,000 ÷ $15 average market price) Incremental shares issued: (15,000 shares issued less 10,000 purchased) (b) Basic EPS = $3.60 ($360,000 ÷ 100,000 shares) (c) Diluted EPS = $3.43 ($360,000 ÷ 105,000 shares)
$150,000 10,000 5,000
*EXERCISE 16-29 (15–25 Minutes)
*EXERCISE 16-30 (15–25 Minutes)
TIME AND PURPOSE OF PROBLEMS
Problem 16-1 (Time 35–40 minutes) Purpose—to provide the student with an opportunity to prepare entries to properly account for a series of transactions involving the issuance and exercise of common stock rights and detachable stock warrants, plus the granting and exercise of stock options. The student is required to prepare the necessary journal entries to record these transactions and the stockholders’ equity section of the balance sheet as of the end of the year. Problem 16-2 (Time 45–50 minutes) Purpose—to provide the student with an understanding of the entries to properly account for convertible debt. The student is required to prepare the journal entries to record the conversion, amortization, and interest in connection with these bonds on specified dates. Problem 16-3 (Time 30–35 minutes) Purpose—to provide the student with an understanding of the entries to properly account for a stockoption plan over a period of years. The student is required to prepare the journal entries when the stock-option plan was adopted, when the options were granted, when the options were exercised, and when the options expired. Problem 16-4 (Time 25–30 minutes) Purpose—to provide the student with an understanding of the entries to properly account for a stock option and restricted stock plan. The student is asked to identify the important features of an employee stock-purchase plan. Problem 16-5 (Time 30–35 minutes) Purpose—to provide the student with an understanding of the effect options and convertible bonds have on the computation of the weighted-average number of shares outstanding with regard to basic EPS and diluted EPS. Preferred stock dividends must also be computed. Problem 16-6 (Time 30–35 minutes) Purpose—to provide the student with an understanding of the proper computation of the weightedaverage number of shares outstanding for two consecutive years. The student is also asked to determine whether the capital structure presented is simple or complex. A two-year comparative income statement with appropriate EPS presentation is also required. Problem 16-7 (Time 35–45 minutes) Purpose—to provide the student with an opportunity to calculate the number of shares used to compute basic and diluted earnings per share which is complicated by a stock dividend, a stock split, and several issues of common stock during the year. To be determined are the number of shares to compute basic EPS, the number of shares to compute diluted EPS, and the numerator for computing basic EPS. Problem 16-8 (Time 25–35 minutes) Purpose—to provide the student with a problem with multiple dilutive securities which must be analyzed to compute basic and diluted EPS. Problem 16-9 (Time 30–40 minutes) Purpose—to provide the student with an opportunity to calculate the weighted-average number of common shares for computing earnings per share and to prepare a comparative income statement including earnings per share data. In addition, the student explains a simple capital structure and the earnings per share presentation for a complex capital structure.
SOLUTIONS TO PROBLEMS PROBLEM 16-1
(a) 1.
Memo Entry (memo entry made to indicate the number of rights issued). 2.
Cash.................................................................. Discount on Bonds Payable* .......................... Bonds Payable ......................................... Paid-in Capital—Stock Warrants** ..........
208,000 8,000 200,000 16,000
*Allocated to Bonds: $96 X $208,000 = $192,000; $96 + $8 Discount = $200,000 – $192,000 = $8,000 **Allocated to Warrants: $8 X $208,000 = $16,000 $96 + $8 3.
Cash* ................................................................ Common Stock (9,500 X $10) .................. Paid-in Capital in Excess of Par— Common Stock .................................
304,000 95,000 209,000
*[(100,000 – 5,000) rights exercised] ÷ (10 rights/share) X $32 = $304,000 4.
Cash* ................................................................ Paid-in Capital—Stock Warrants ($16,000 X 80%) ........................................... Common Stock (1,600 X $10) .................. Paid-in Capital in Excess of Par— Common Stock ...................................... *.80 X $200,000/$100 per bond = 1,600 warrants exercised; 1,600 X $30 = $48,000
48,000 12,800 16,000 44,800
PROBLEM 16-1 (Continued) 5.
Compensation Expense* ................................ Paid-in Capital—Stock Options ..............
100,000 100,000
*$10 X 10,000 options = $100,000 6.
For options exercised: Cash (9,000 X $30)........................................... Paid-in Capital—Stock Options (90% X $100,000) .......................................... Common Stock (9,000 X $10).................. Paid-in Capital in Excess of Par— Common Stock ..................................... For options lapsed: Paid-in Capital—Stock Options...................... Compensation Expense ..........................
270,000 90,000 90,000 270,000 10,000 10,000
(Note to instructor: This entry provides an opportunity to indicate that a credit to Compensation Expense occurs when the employee fails to fulfill an obligation, such as remaining in the employ of the company. Conversely, if a stock option lapses because the stock price is lower than the exercise price, then a credit to Paid-in Capital—Expired Stock Options occurs.) (b) Stockholders’ Equity: Paid-in Capital: Common Stock, $10 par value, authorized 1,000,000 shares, 320,100 shares issued and outstanding ......................... Paid-in Capital in Excess of Par— Common Stock*...................................... Paid-in Capital—Stock Warrants* ............ Retained Earnings ............................................ Total Stockholders’ Equity .......................
$3,201,000 1,123,800 3,200 $4,328,000 750,000 $5,078,000
*These two accounts often are combined into one category called Additional Paid-in Capital, for financial reporting purposes.
PROBLEM 16-1 (Continued) Calculations: Paid-in Capital Common Stock in Excess of Par At beginning of year....................... From stock rights (entry #3) .......... From stock warrants (entry #4) ..... From stock options (entry #6) ....... Total .........................................
300,000 shares 9,500 shares 1,600 shares 9,000 shares 320,100 shares
$ 600,000 209,000 44,800 270,000 $1,123,800
PROBLEM 16-2
(a)
Entries at August 1, 2015 Bonds Payable ............................................................. 250,000 Discount on Bonds Payable (Schedule 1) ...... Common Stock (8 X 250 X $100) ..................... Paid-in Capital in Excess of Par— Common Stock .............................................. (To record the issuance of 2,000 shares of common stock in exchange for $250,000 of bonds and the write-off of the discount on bonds payable)
4,815* 200,000 45,185**
*($54,000 X 1/10) X (107/120) **($250,000 – $4,815) – $200,000 Interest Payable ....................................................... Cash ($250,000 X 12% X 1/12) ......................... (To record payment in cash of interest accrued on bonds converted as of August 1, 2015) (b)
Entries at August 31, 2015 Interest Expense...................................................... Discount on Bonds Payable (Schedule 1) ............. (To record amortization of one month’s discount on $2,250,000 of bonds)
2,500 2,500
405* 405
*($54,000 X 90%) X (1/120) Interest Expense...................................................... Interest Payable ($2,250,000 X 12% X 1/12) ........... (To record accrual of interest for August on $2,250,000 of bonds at 12%) (c)
22,500 22,500
Entries at December 31, 2015 (Same as August 31, 2015, and the following closing entry) Income Summary ......................................................... 292,675 Interest Expense (schedule 2) ................................ (To close expense account)
292,675
PROBLEM 16-2 (Continued) Schedule 1 Monthly Amortization Schedule Unamortized discount on bonds payable: Amount to be amortized over 120 months ..................................... $54,000 Amount of monthly amortization ($54,000 ÷ 120) .......................... $ 450 Amortization for 13 months to July 31, 2015 ($450 X 13) .............. $ 5,850 Balance unamortized 7/31/15 ($54,000 – $5,850)............................ $48,150 10% applicable to debentures converted ....................................... (4,815) Balance August 1, 2015 ................................................................... $43,335 Remaining monthly amortization over remaining 107 months ($43,335 ÷ 107) ............................................................................... $ 405 Schedule 2 Interest Expense Schedule Amortization of bond discount charged to bond interest expense in 2015 would be as follows: 7 months X $450 ............................... $3,150 5 months X $405 ............................... 2,025 Total ........................................... $5,175 Interest on Bonds: 12% on $2,500,000............................................................................ Amount per month ($300,000 ÷ 12) ................................................. 12% on $2,250,000............................................................................ Amount per month ($270,000 ÷ 12) ................................................. Interest for 2015 would be as follows: 7 months X $25,000 .................................................................. 5 months X $22,500 .................................................................. Total ................................................................................... Total interest Amortization of discount.................. Cash interest paid............................. Bond interest expense .....................
$ 5,175 287,500 $292,675
$300,000 $ 25,000 $270,000 $ 22,500 $175,000 112,500 $287,500
PROBLEM 16-3 2013
No journal entry would be recorded at the time the stock option plan was adopted. However, a memorandum entry in the journal might be made on November 30, 2013, indicating that a stock option plan had authorized the future granting to officers of options to buy 42,000 shares of $5 par value common stock at $9 a share.
2014
January 2 No entry December 31 Compensation Expense ................................... Paid-in Capital—Stock Options ............... (To record compensation expense attributable to 2014—22,000 options at $4)
2015
December 31 Compensation Expense ................................... Paid-in Capital—Stock Options ............... (To record compensation expense attributable to 2015—20,000 options at $4) Paid-in Capital—Stock Options ....................... Paid-in Capital—Expired Stock Options ................................................... (To record lapse of president’s and vice president’s options to buy 22,000 shares)
2016
December 31 Cash (20,000 X $9) ............................................ Paid-in Capital—Stock Options (20,000 X $4)................................................... Common Stock (20,000 X $5) ................... Paid-in Capital in Excess of Par— Common Stock....................................... (To record issuance of 20,000 shares of $5 par value stock upon exercise of options at option price of $9)
88,000 88,000
80,000 80,000
88,000 88,000
180,000 80,000 100,000 160,000
PROBLEM 16-4 (a)
(b)
(c)
1/1/14
No entry
12/31/14
Compensation Expense ($6 X 5,000 ÷ 5) ...... Paid-in Capital—Stock Options ............
6,000 6,000
1/1/14
Unearned Compensation ($40 X 700) ............... 28,000 Common Stock ($1 X 700)..................... 700 Paid-in Capital in Excess of Par— Common Stock ................................... 27,300
12/31/14
Compensation Expense ($28,000 ÷ 5)........... Unearned Compensation ......................
5,600 5,600
No change for part (a), unless the fair value of the options change. For part (b): 1/10/14
12/31/14 (d)
Unearned Compensation ($45 X 700) ........... Common Stock ($1 X 700)..................... Paid in Capital in Excess of Par— Common Stock ...................................
31,500
Compensation Expense ($31,500 ÷ 5)........... Unearned Compensation ......................
6,300
700 30,800 6,300
Numbers (1) substantially all employees may participate; (2) The discount from market is small (less than 5%); and (3) The plan offers no substantive option feature, are the three criteria that must be met for an employee stock-purchase plan to be non-compensatory. The fourth provision—there is no preferred stock outstanding—is irrelevant.
PROBLEM 16-5
The computation of Fitzgerald Pharmaceutical Industries’ basic earnings per share and the diluted earnings per share for the fiscal year ended June 30, 2014, are shown below. (a) Basic earnings per share
Net income – Preferred dividends = Weighted-average number of shares outstanding $1,500,000 – $75,0001 = 1,000,000 =
$1,425,000 1,000,000
= $1.425 or $1.43 per share 1
Preferred dividend = .06 X $1,250,000 = $75,000
(b) Diluted earnings per share =
Net income – Preferred dividends + Interest (net of tax) Weighted-average number of shares outstanding + Potentially dilutive common shares
$1,500,000 – $75,000 + $240,0002 = 1,000,000 + 250,0003 + 50,0004 =
$1,665,000 1,300,000
= $1.2808 or $1.28 per share 2
Use “if converted” method for 8% bonds Adjustment for interest expense (net of tax) ($5,000,000 X .08 X .6) .............................................
$240,000
PROBLEM 16-5 (Continued) 3
4
Shares assumed to be issued if converted $5,000,000 ÷ $1,000/bond X 50 shares........................
250,000
Use treasury stock method to determine incremental shares outstanding Proceeds from exercise of options (200,000 X $15) ..........................................................
$3,000,000
Shares issued upon exercise of options.................... Shares purchasable with proceeds (Proceeds ÷ Average market price) ($3,000,000 ÷ $20)..................................................... Incremental shares outstanding .........................
200,000
(150,000) 50,000
PROBLEM 16-6
(a) Melton Corporation has a simple capital structure since it does not have any potentially dilutive securities. (b) The weighted-average number of shares outstanding that Melton Corporation would use in calculating earnings per share for the fiscal years ended May 31, 2014, and May 31, 2015, is 1,600,000 and 2,200,000 respectively, calculated as follows: Event
Dates Outstanding
Shares Outstanding
Restatement
Fraction of Year
Weighted Shares
Beginning balance New Issue
June 1–Oct. 1 Oct. 1–May 31
1,000,000 1,500,000
1.20 1.20
4/12 8/12
400,000 1,200,000 1,600,000
Event
Dates Outstanding
Shares Outstanding
Restatement
Fraction of Year
Weighted Shares
Beginning balance New Issue
June 1–Dec. 1 Dec. 1–May 31
1,800,000 2,600,000
6/12 6/12
900,000 1,300,000 2,200,000
(c)
MELTON CORPORATION Comparative Income Statement For Fiscal Years Ended May 31, 2014 and 2015 2014
Income from operations ........................................... $1,800,000 Interest expense1..................................................................................... 240,000 Income before taxes ............................................. 1,560,000 Income taxes at 40% ................................................ 624,000 Income before extraordinary item........................ 936,000 Extraordinary loss, net of income taxes of $240,000 .................................................. — Net income............................................................. $ 936,000 Earnings per share: Income before extraordinary loss ................ Extraordinary loss ......................................... Net income .....................................................
$0.552 $0.55
2015 $2,500,000 240,000 2,260,000 904,000 1,356,000 (360,000) $ 996,000 $0.593 0.164 $0.435
PROBLEM 16-6 (Continued) 1
Interest expense
2
= $2,400,000 X .10 = $240,000
Earnings per share = =
(Net income – Preferred dividends) Weighted-Average Number of Common Shares ($936,000 – $60,000*) 1,600,000
= $0.55 per share *Preferred dividends = (No. of Shares X Par Value X Dividend %)
= (20,000 X $50 X .06) = $60,000 per year 3
Earnings per share =
($1,356,000 – $60,000) 2,200,000
= $0.59 per share
4
Earnings per share = =
Extraordinary Item Weighted-Average Number of Shares Outstanding $360,000 2,200,000
= $0.16 per share
5
Earnings per share = =
Net Income – Preferred Dividends Weighted-Average Number of Shares Outstanding $996,000 – $60,000 2,200,000
= $0.43
PROBLEM 16-7
(a) The number of shares used to compute basic earnings per share is 4,951,000, as calculated below. Dates Shares Fraction Event Outstanding Outstanding Restatement of Year Beginning Balance, including 5% stock dividend Jan. 1–Apr. 1 2,100,000 2.0 3/12 Conversion of Apr. 1–July 1 2,520,000 2.0 3/12 preferred stock Stock split July 1–Aug. 1 5,040,000 1/12 Issued shares for building Aug. 1–Nov. 1 5,340,000 3/12 Purchase of Treasury stock Nov. 1–Dec. 31 5,316,000 2/12 Total number of common shares to compute basic earnings per share
Weighted Shares
1,050,000 1,260,000 420,000 1,335,000 886,000 4,951,000
(b) The number of shares used to compute diluted earnings per share is 5,791,000, as shown below. Number of shares to compute basic earnings per share................................. Convertible preferred stock— still outstanding (300,000 X 2 X 1.05) ............. Convertible preferred stock— converted (400,000 X 2 X 1.05 X 3/12)............. Number of shares to compute diluted earnings per share...........................................
4,951,000 630,000 210,000 5,791,000
(c) The adjusted net income to be used as the numerator in the basic earnings per share calculation for the year ended December 31, 2015, is $10,350,000, as computed below. After-tax net income ........................................... Preferred stock dividends March 31 (700,000 X $.75) ........................... June 30, September 30, and December 31 (300,000 X $.75 X 3) .................................. Adjusted net income
$11,550,000 $525,000 675,000
(1,200,000) $10,350,000
PROBLEM 16-8
(a)
Basic EPS
=
$1,200,000 – ($4,000,000 X .06) 600,000*
= $1.60 per share *$6,000,000 ÷ $10
(b)
Diluted EPS
(Net income – Preferred dividends) + Interest savings (net of tax) = Weighted-average number of shares outstanding + Potentially dilutive common shares $1,200,000 – $240,000a + $84,000b = 600,000 + 15,000c + 60,000d =
$1,044,000 675,000
= $1.54 per share a
Preferred stock is not included since conversion would be antidilutive. That is, conversion of the preferred stock increases the numerator $240,000 ($4,000,000 X .06) and the denominator 120,000 shares [(4,000,000 ÷ 100) X 3] as shown in the following:
Diluted EPS with preferred.
=
$1,200,000 + $84,000 600,000 + 15,000 + 60,000 + 120,000
=
$1,284,000 795,000
= $1.61 per share > $1.54; therefore antidilutive. b
$2,000,000 X .07 X (1 – .40)
PROBLEM 16-8 (Continued) cMarket price – Option price
Market price $25 – $20
X Number of options = incremental shares
X 75,000 = 15,000
$25 d
($2,000,000 ÷ $1,000) X 30 shares/bond
Note to instructor: This problem can be used to apply the procedures in Appendix 17B for analysis of multiple dilutive securities. First, compute the dilutive effect for each security and rank from smallest to largest: Options: $0/15,000 = $0 Convertible bonds: $84,000/60,000 = $1.40 Preferred: $240,000/120,000 = $2 EPS with options: =
$1,200,000 – $240,000 600,000 + 15,000
=
$1.56
This is less than basic EPS; continue to bonds: $1.54 (see (b) above) which is less than diluted EPS with the options, so include. As indicated above, the preferred is anti-dilutive, so we stop.
PROBLEM 16-9
(a)
Weighted-Average Shares
Total as of June 1, 2013 Issue of September 1, 2013 Total as of May 31, 2015
(b)
Before Stock Dividend 1,000,000 400,000 1,400,000
After Stock Dividend 1,200,000 480,000 1,680,000
1. 1,200,000 X 3/12 = 1,680,000 X 9/12 = Total
300,000 1,260,000 1,560,000
2. 1,680,000 X 12/12
1,680,000
AGASSI CORPORATION Comparative Income Statement For the Years Ended May 31, 2015 and 2014 2015 $1,400,000 560,000 840,000
2014 $660,000 264,000 396,000
240,000 $ 600,000
$396,000
Per share of common stock Income before extraordinary item ..................... Extraordinary loss, net of tax ............................
$0.351 (0.14)4
$0.103 –
Net income.............................................................
$0.212
$0.10
Income from operations before income taxes .... Income taxes ......................................................... Income before extraordinary item........................ Extraordinary item—loss from earthquake, less applicable income taxes of $160,000........ Net income.............................................................
PROBLEM 16-9 (Continued) EPS calculations =
Net income – Preferred dividends Weighted-average common shares
Preferred dividends = 40,000 X $100 X .06 = $240,000 Extraordinary loss per share calculation
=
Loss Weighted-average common shares
1
($840,000 – $240,000) ÷ 1,680,000 = $0.35 ($600,000 – $240,000) ÷ 1,680,000 = $0.21 3 ($396,000 – $240,000) ÷ 1,560,000 = $0.10 4 $240,000 ÷ 1,680,000 = $0.14 2
(c) 1. A corporation’s capital structure is regarded as simple if it consists only of common stock or includes no potentially dilutive securities. Agassi Corporation has a simple capital structure because it has not issued any convertible securities, warrants, or stock options, and there are no existing rights or securities that are potentially dilutive of its earnings per common share. 2. A corporation having a complex capital structure would be required to make a dual presentation of earnings per share; i.e., both basic earnings per share and diluted earnings per share. This assumes that the potentially dilutive securities are not antidilutive. The basic earnings per share computation uses only the weightedaverage of the common stock outstanding. The diluted earnings per share computation assumes the conversion or exercise of all potentially dilutive securities that are not antidilutive.
TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 16-1 (Time 20–25 minutes) Purpose—to provide the student with an understanding of the underlying rationale behind the accounting treatments for the issuance of convertible bonds versus the situation when the debt instrument and the warrants are separable. The student is required to describe the differences that exist in accounting for the original proceeds of these two types of issuances, and the arguments which have been presented in support of these differences. This case also requires the interpretation of a situation involving an issuance of long-term notes and warrants, and the preparation of the necessary journal entry. CA 16-2 (Time 15–20 minutes) Purpose—to provide the student with an opportunity to discuss the ethical issues related to an earnings– based compensation plan. CA 16-3 (Time 15–20 minutes) Purpose—to provide the student with an understanding of the proper accounting and conceptual merits for the issuance of stock warrants to three different groups: existing stockholders, key employees, and purchasers of the company’s bonds. This problem requires the student to explain and discuss the reasons for using warrants, the significance of the price at which the warrants are issued (or granted) in relation to the current market price of the company’s stock, and the necessary information that should be disclosed in the financial statements when stock warrants are outstanding for each of the groups. CA 16-4 (Time 25–35 minutes) Purpose—to provide the student with an opportunity to respond to a contrary view of the FASB’s standard on “Accounting for Stock-Based Compensation,” and to defend the concept of neutrality in financial accounting and reporting. CA 16-5 (Time 25–35 minutes) Purpose—to provide the student with an understanding of how earnings per share is affected by preferred dividends and convertible debt. The student is required to explain how preferred dividends and convertible debt are handled for EPS computations. The student is also required to explain when the “treasury stock method” is applicable in EPS computations. CA 16-6 (Time 25–35 minutes) Purpose—to provide the student with an opportunity to articulate the concepts and procedures related to antidilution. Responses are provided in a written memorandum.
SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 16-1 (a)
(1) When the debt instrument and the option to acquire common stock are inseparable, as in the case of convertible bonds, the entire proceeds of the bond issue should be allocated to the debt and the related premium or discount accounts. When the debt and the warrants are separable, the proceeds of their sale should be allocated between them. The basis of allocation is their relative fair values. As a practical matter, these relative values are usually determined by reference to the price at which the respective instruments are traded in the open market. Thus, if the debt alone would bring six times as much as would the stock warrants if sold separately, one-seventh of the total proceeds should be apportioned to the warrants and six-sevenths to the debt securities. That portion of the proceeds assigned to the warrants should be accounted for as paid-in capital. The result may be that the debt is issued at a reduced premium or at a discount. (2)
In the case of convertible debt there are two principal reasons why all the proceeds should be ascribed to the debt. First, the option is inseparable from the debt. The investor in such securities has two mutually exclusive choices: be a creditor and later receive cash for the security; or give up all rights as a creditor and become a stockholder. There is no way to retain one right while selling the other. Second, the valuation of the conversion option or the debt security without the conversion option presents practical problems. For example, in the absence of separate transferability, no separate market values are established and the only values which could be assigned to each would be subjective. Separability of the debt and the warrants and the establishment of a market value for each results in an objective basis for allocating proceeds to the two different equities—creditors’ and stockholders’—involved.
(3)
(b)
Arguments have been advanced that accounting for convertible debt should be the same as for debt issued with detachable stock purchase warrants. Convertible debt has features of debt and stockholders’ equity, and separate recognition should be given to those characteristics at the time of issuance. Difficulties encountered in separating the relative values of the features are not insurmountable and, in any case, should not result in a solution which ignores the problem. In effect, the company is selling a debt instrument and a call on its stock. Coexistence of the two features in one instrument is no reason why each cannot receive its proper accounting recognition. The practical difficulties of estimation of the relative values may be overcome with reliable professional advice. Allocation is a wellrecognized accounting technique and could be applied in this case once reliable estimates of the relative values are known. If the convertible feature was added in order to sell the security at an acceptable price, the value of the convertible option is obviously material and recognition is essential. The question of whether or not the purchaser will exercise the option is not relevant to reflecting the separate elements at the time of issuance.
Incremental Cash.......................................................................... Discount on Bonds Payable ($18,000,000 X 22%)........................ Bonds Payable...................................................................... Paid-in Capital—Stock Warrants ...........................................
20,040,000 3,960,000 18,000,000 6,000,000
To record issuance of bonds at 22% discount with options to buy 1,200,000 shares of the company’s $10 par common stock at a price of $5 a share below the current market value. Debt matures in ten years in equal annual installments of $1,800,000 and warrants, if not exercised, lapse as bonds mature.
CA 16-2 (a)
Devers recognizes that altering the estimate will benefit Adkins and other executive officers of the company. Current stockholders and investors will be forced to pay out the bonuses, with the altered estimate as a critical factor.
(b)
The accountant’s decision should not be based on the existence of the compensation plan.
(c)
Adkins’s request should be denied.
CA 16-3 (a)
(b)
1.
The objective of issuing warrants to existing stockholders on a pro-rata basis is to raise new equity capital. This method of raising equity capital may be used because of preemptive rights on the part of a company’s stockholders and also because it is likely to be less expensive than a public offering.
2.
The purpose of issuing stock warrants to certain key employees, usually in the form of a non-qualified stock option plan, is to increase their interest in the long-term growth and income of the company and to attract new management talent. Also, this issuance of stock warrants to key employees under a stock-option plan frequently constitutes an important element in a company’s executive compensation program. Though such plans result in some dilution of the stockholders’ equity when shares are issued, the plans provide an additional incentive to the key employees to operate the company efficiently.
3.
Warrants to purchase shares of its common stock may be issued to purchasers of a company’s bonds in order to stimulate the sale of the bonds by increasing their speculative appeal and aiding in overcoming the objection that rising price levels cause money invested for long periods in bonds to lose purchasing power. The use of warrants in this connection may also permit the sale of the bonds at a lower interest cost.
1.
Because the purpose of issuing warrants to existing stockholders is to raise new equity capital, the price specified in the warrants must be sufficiently below the current market price to reasonably assure that they will be exercised. Because the success of the offering depends entirely on the current market price of the company’s stock in relation to the exercise price of the warrants, and because the objective is to raise capital, the length of time over which the warrants can be exercised is very short, frequently 60 days.
2.
Warrants may be offered to key employees below, at, or above the market price of the stock on the day the rights are granted except for incentive stock-option plans. If a stock-option plan is to provide a strong incentive, warrants that can be exercised shortly after they are granted and expire, say, within two or three years, usually must be exercisable at or near the market price at the date of the grant. Warrants that cannot be exercised for a number of years after they are granted or those that do not lapse for a number of years after they become exercisable may, however, be priced somewhat above the market price of the stock at the date of the grant without eliminating the incentive feature. This does not upset the principal objective of stock option plans, heightening the interest of key employees in the long-term success of the company.
3.
Income tax laws impose no restrictions on the exercise price of warrants issued to purchasers of a company’s bonds. The exercise price may be above, equal to, or below the current market price of the company’s stock. The longer the period of time during which the warrant can be exercised, however, the higher the exercise price can be and still stimulate the sale of the bonds because of the increased speculation appeal. Thus, the significance of the length of time over which the warrants can be exercised depends largely on the exercise price (or prices). A low exercise price in combination with a short exercise period can be just as successful as a high exercise price in combination with a long exercise period.
CA 16-3 (Continued) (c)
1. Financial statement information concerning outstanding stock warrants issued to a company’s stockholders should include a description of the stock being offered for sale, the option price, the time period during which the rights may be exercised, and the number of rights needed to purchase a new share. 2.
Financial statement information concerning stock warrants issued to key employees should include the following: status of these plans at the end of each period presented, including the number of shares under option, options exercised and forfeited, the weighted-average option prices for these categories, the weighted-average fair value of options granted during the year, and the average remaining contractual life of the options outstanding.
3.
Financial statement disclosure of outstanding stock warrants that have been issued to purchasers of a company’s bonds should include the prices at which they can be exercised, the length of time they can be exercised, and the total number of shares that can be purchased by the bondholders.
CA 16-4 (a)
In 2004, FASB issued an accounting standard related to stock compensation plans. Generally, the rule indicates that employee stock options be treated like all other types of compensation and that their value be included in financial statements as part of the costs of employee services. The rule requires that all types of stock options be recognized as compensation based on the fair value of the options. Fair value for public companies would be estimated using an option-pricing model. No adjustments after the grant date would be made for changes in the stock price—either up or down. For both public and nonpublic companies, the value of the award would be charged to expense over the period in which employees provide the related service, which is generally considered the vesting period. Expense is recognized over the service period with adjustment (reversal) of expense for options that do not vest, if employees do not meet the service requirement.
(b)
According to Ciesielski’s commentary, the bill in Congress would only record expense for the options granted to the top five executives. They also are recommending that the SEC conduct further study of the issue and therefore delay the implementation of the new standard. From a comparability standpoint, it is highly unlikely that recording expense on only some options would result in useful information. It will be difficult to compare compensation costs (and income) for companies—some that use stock options extensively and some that pay their employees with cash.
(c)
Here is an excerpt from a presentation given by Dennis Beresford on the concept of neutrality, which says it well. The FASB often hears that it should take a broader view, that it must consider the economic consequences of a new accounting standard. The FASB should not act, critics maintain, if a new accounting standard would have undesirable economic consequences. We have been told that the effects of accounting standards could cause lasting damage to American companies and their employees. Some have suggested, for example, that recording the liability for retiree health care or the costs for stock-based compensation will place U.S. companies at a competitive disadvantage. These critics suggest that because of accounting standards, companies may reduce benefits or move operations overseas to areas where workers do not demand the same benefits. These assertions are usually combined with statements about desirable goals, like providing retiree health care or creating employee incentives.
CA 16-4 (Continued) There is a common element in those assertions. The goals are desirable but the means require that the Board abandon neutrality and establish reporting standards that conceal the financial impact of certain transactions from those who use financial statements. Costs of transactions exist whether or not the FASB mandates their recognition in financial statements. For example, not requiring the recognition of the cost of stock options or ignoring the liabilities for retiree health care benefits does not alter the economics of the transactions. It only withholds information from investors, creditors, policy makers, and others who need to make informed decisions and, eventually, impairs the credibility of financial reports. One need only look to the collapse of the thrift industry to demonstrate the consequences of abandoning neutrality. During the 1970s and 1980s, regulatory accounting principles (RAP) were altered to obscure problems in troubled institutions. Preserving the industry was considered a greater good. Many observers believe that the effect was to delay action and hide the true dimensions of the problem. The public interest is best served by neutral accounting standards that inform policy rather than promote it. Stated simply, truth in accounting is always good policy. Neutrality does not mean that accounting should not influence human behavior. We expect that changes in financial reporting will have economic consequences, just as economic consequences are inherent in existing financial reporting practices. Changes in behavior naturally follow from more complete and representationally faithful financial statements. The fundamental question, however, is whether those who measure and report on economic events should somehow screen the information before reporting it to achieve some objective. In FASB Concepts Statement No. 2, Qualitative Characteristics of Accounting Information (paragraph 102), the Board observed: Indeed, most people are repelled by the notion that some “big brother,” whether government or private, would tamper with scales or speedometers surreptitiously to induce people to lose weight or obey speed limits or would slant the scoring of athletic events or examinations to enhance or decrease someone’s chances of winning or graduating. There is no more reason to abandon neutrality in accounting measurement. The Board continues to hold that view. The Board does not set out to achieve particular economic results through accounting pronouncements. We could not if we tried. Beyond that, it is seldom clear which result we should seek because our constituents often have opposing viewpoints. Governments, and the policy goals they adopt, frequently change.
CA 16-5 (a)
Dividends on outstanding preferred stock must be subtracted from net income or added to net loss for the period before computing EPS on the common shares. This generalization will be modified by the various features and different requirements preferred stock may have with respect to dividends. Thus, if preferred stock is cumulative, it is necessary to subtract its current dividend requirements from net income (or to add them to net loss) regardless of whether or not the preferred dividends were actually declared. Where the preferred shares are noncumulative, only preferred dividends actually declared during the current period need be subtracted from net income (or added to net loss) to arrive at the income to be used in EPS calculations. In case the preferred shares are convertible into common stock, when assuming conversion, dividend requirements on the preferred shares are not deducted from net income. This applies when testing for potential dilution to determine whether or not the diluted EPS figures for the period are lower than earnings per common share figures.
CA 16-5 (Continued) (b)
When options and warrants to buy common stock are outstanding and their exercise price (i.e., proceeds the corporation would derive from issuance of common stock pursuant to the warrants and options) is less than the average price at which the company could acquire its outstanding shares as treasury stock, the treasury stock method is generally applicable. In these circumstances, existence of the options and warrants would be dilutive. However, if the exercise price of options and warrants exceeded the average price of the common stock, the cash proceeds from their assumed exercise would provide for repurchasing more common shares than were issued when the warrants were exercised, thereby reducing the number of shares outstanding. In these circumstances assumed exercise of the warrants would be antidilutive, so exercise would not be presumed for purposes of computing diluted EPS.
(c)
In arriving at the calculation of diluted EPS where convertible debentures are assumed to be converted, their interest (net of tax) is added back to net income as the numerator element of the EPS calculation while the weighted-average number of shares of common stock into which they would be convertible is added to the shares outstanding to arrive at the denominator element of the calculation.
CA 16-6 Dear Mr. Dolan: I hope that the following brief explanation helps you understand why your warrants were not included in Rhode’s earnings per share calculations. Earnings per share (EPS) provides income statement users a quick assessment of the earnings that were generated for each common share outstanding over a given period. When a company issues only common and preferred stock, it has a simple capital structure; consequently, the only ratio needed to calculate EPS is the following: (Net Income – Preferred Dividends) ÷ Weighted-average Number of Shares Outstanding However, corporations that have outstanding a variety of other securities—convertible bonds, convertible preferred stock, stock options, and stock warrants—have a complex capital structure. Because these securities could be converted to common stock, they have a potentially “dilutive” effect on EPS. In order not to mislead users of financial information, the accounting profession insists that EPS calculations be transparent. Thus, a security which might dilute EPS must be figured into EPS calculations as though it had been converted into common stock. Basic EPS assumes a weightedaverage of common stock outstanding while diluted EPS assumes that any potentially dilutive security has been converted. Some securities, however, might actually inflate the EPS figure rather than dilute it. These securities are considered antidilutive and are excluded from the EPS computation. Take, for example, your warrants. The computations below provide a good example of how options and warrants are treated in diluted EPS. In these computations, we assume that Rhode will purchase treasury stock using the proceeds from the exercise of your warrants. If we assume that 30,000 warrants are exercised at $30, the company does not simply add 30,000 shares to common stock outstanding; rather, for diluted EPS, Rhode is assumed to purchase and retire
CA 16-6 (Continued) 36,000 [(30,000 X $30) ÷ $25] shares of treasury stock at $25 with the proceeds. Therefore, if you add the 30,000 exercised warrants to the common stock outstanding and then subtract the 36,000 shares presumably purchased, the number of shares outstanding would be reduced to 94,000 (100,000 + 30,000 – 36,000). Because the ratio’s denominator would be reduced by this inclusion, it would cause the ratio to increase, which defeats the purpose of the assumed exercise. These warrants are considered antidilutive and, therefore, are not included in EPS calculations. This explanation should address any concerns you may have had about the use of your warrants in EPS calculations. If you have any further questions, please call me. Sincerely, Ms. Smart Student Accountant
FINANCIAL REPORTING PROBLEM (a) (1) Under P&G’s stock-based compensation plan (Note 7), 29,141,000 options were granted during 2011. (2) At June 30, 2011, 271,096,000 options were exercisable by eligible managers. (3) In 2011, 29,065,000 options were exercised at an average price of $42.55. (4) The options granted since September 2002 will expire 10 years from the date of grant. (5) The accounts to which the proceeds from these option exercises are credited are Common Stock and Additional Paid-in Capital. (6) The number of outstanding options at June 30, 2009, is 363,174,000 at an average exercise price of $51.75. (b)
(In millions—except per share) Weighted-average common shares Diluted earnings per share
2011 3,001.9 $3.93
2010 3,099.3 $4.11
2009 3,154.1 $4.26
(c) P&G maintains the Procter & Gamble Profit Sharing Trust (Trust), Employee Stock Ownership Plan (ESOP), and restricted stock to provide a portion of the funding for its defined benefit pension plan.
COMPARATIVE ANALYSIS CASE (a)
Coca-Cola sponsors restricted stock award plans, and stock option plans. PepsiCo grants stock options to employees under three different incentive plans—the SharePower Stock Option Plan, the Long-Term Incentive Plan, and the Stock Option Incentive Plan.
(b) Options outstanding at year-end 2011
Coca-Cola 162,000,000
PepsiCo 91,075,000
Options granted during 2011
Coca-Cola 26,000,000
PepsiCo 7,150,000
Options exercised during 2011
Coca-Cola 32,000,000
PepsiCo 19,980,000
Average exercise price during 2011
Coca-Cola $47.96
PepsiCo $47.74
(c)
(d)
(e)
(f)
Weighted-Average Number of Shares (in millions) Coca-Cola PepsiCo 2011 2,323 1,597 2010 2,333 1,614 2009 2,329 1,577
(g)
Diluted Earnings Per Share (in millions) Coca-Cola PepsiCo 2011 $3.69 $4.03 2010 $5.06 $3.91 2009 $2.93 $3.77
FINANCIAL STATEMENT ANALYSIS CASE (a) Account 2014 (,000) Current Liabilities 554,114 Convertible Debt 648,020 Total Liabilities 1,228,313 Stockholders’ Equity 176,413 Net Income 58,333 (1) Rate of return on Assets (2) Rate of return on Common Stock Equity (3) Debt to Total Assets
4.15% = Net Income/Total Assets 33.07% = Net Income/Stockholders’ Equity 87.44% = Total Debt/Total Assets
(b) Ragatz is doing very well. Its ROA and ROE are above the industry average. However, its debt level is quite high, compared to the industry. This may suggest it is a riskier investment and may require a higher rate of return than the 5% coupon. Investors likely were attracted to the convertible bonds due to the possibility that Ragatz’s stock price will increase, and they can cash in on these gains when they convert to common stock. (c) Under GAAP, the debt and equity components of a convertible bond are not separately recorded as liabilities and stockholders’ equity. If Merck had non-convertible bonds with detachable warrants, Merck would allocate the bond amount between debt and equity. Therefore, the same should be done for Ragatz to make their ratios comparable Assuming an equity component of $150,000, for the Ragatz bonds, the following adjusted amounts would be used in the analysis. Reclassified: Account 2014 (,000) Current Liabilities 554,114 Convertible Debt 498,020 Total Liabilities 1,078,313 Stockholders’ Equity 326,413 Net Income 58,333 (1) Rate of return on Assets 4.15% = Net Income/Total Assets (2) Rate of return on Common Stock 17.9% = Net Income/Stockholders’ Equity Equity (3) Debt to Total Assets 76.8% = Total Debt/Total Assets
FINANCIAL STATEMENT ANALYSIS CASE (Continued) The adjustment results in Ragatz reporting a higher level of stockholders’ equity and less debt. Although Ragatz reports the same ROA, but lower ROE, the debt to assets ratio is in line with the industry level, suggesting Ragatz may not be as risky as the earlier analysis suggests. The 5% rate may be about right.
ACCOUNTING, ANALYSIS, AND PRINCIPLES Accounting (a)
Under U.S. GAAP, proceeds from the issuance of convertible debt are recorded entirely as debt.
Cash ..................................................................
200,000 200,000
Bonds Payable......................................... (b) 2014
2013
Basic EPS Net income (a)
$30,000 $27,000
Weighted-average number of shares outstanding (b)
10,000
10,000
Basic EPS (a ÷ b)
$3.00
$2.70
Diluted EPS Net income
$30,000 $27,000
Add: Interest savings ($200,000 X 6%)
12,000
Adjusted net income (a)
$42,000 $39,000
Outstanding shares
10,000
10,000
Shares upon conversion (200 X 30)
6,000
6,000
Total shares for diluted EPS (b)
16,000
16,000
Diluted EPS (a ÷ b)
$2.63
$2.44
12,000
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) (c) Bond Conversion Expense** ............................ Bonds Payable .................................................. Common Stock* ...................................... Paid-in-capital in Excess of Par— Common Stock* ................................. Cash.........................................................
7,500 150,000 9,000 141,000 7,500
*$200,000 X 75% = $150,000 of bonds converted $150,000 ÷ $1,000 per bond = 150 bonds 150 bonds X 30 shares per bond = 4,500 new shares issued 4,500 shares X $2 par value = $9,000 increase in common stock account $150,000 - $9,000 = $141,000 increase in paid-in capital account **150 bonds X $50 per bond = $7,500 bond conversion expense
Analysis EPS Presentation: Net income Basic EPS Diluted EPS
2014 $30,000 $3.00 $2.63
2013 $27,000 $2.70 $2.44
EPS standards are important to analysts who rely on reported earnings per share numbers in their analyses. A price-earnings (P-E) ratio is the price per share divided by earnings per share. Analysts use P-E ratios in a variety of analyses, including the evaluation of earnings quality and the assessment of a company's growth prospects. The more variation in how companies compute EPS, the less comparable are EPS numbers across companies and across time for the same company.
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) Principles IFRS for convertible debt primarily differs from U.S. GAAP on convertible debt in that IFRS requires that companies split the proceeds from issuance into a debt component and an equity component. For example, in part (a) we recorded the proceeds from Garner’s bond issue entirely as bonds payable – a liability. Under IFRS, Garner would be required to estimate the portion of the proceeds attributable to the equity component of the bonds. If, for example, Garner estimated the equity component of the convertible bonds to be worth $70,000 Garner would make an entry like this: Cash .................................................................. Discount on Bonds Payable ............................ Bonds Payable......................................... Share Premium-Conversion Equity........
200,000 70,000 200,000 70,000
Supporters of the IFRS treatment would argue that separating the bond issue into liability and equity components provides more representational faithful information into the financial statements. That is, the resulting financial statements do a better job of representing the underlying economics of the transaction. When bond investors buy bonds with a conversion feature, they are very likely paying something for the option to convert (i.e. investors value the option to become equity holders). Supporters of the U.S. treatment would argue that estimating the value of the conversion option is difficult and that the resulting number is not very reliable. Thus, IFRS potentially sacrifices reliability in favor of representational faithfulness while U.S. GAAP does the reverse.
PROFESSIONAL RESEARCH (a) The accounting for stock compensation is addressed in the FASB Codification at FASB ASC 718-10 (Compensation-Stock Compensation). (b) See FASB ASC 718-10-10 (Compensation—Stock Compensation, Overall, Objectives). 10-1 The objective of accounting for transactions under share-based payment arrangements with employees is to recognize in the financial statements the employee services received in exchange for equity instruments issued or liabilities incurred and the related cost to the entity as those services are consumed. This Topic uses the terms compensation and payment in their broadest senses to refer to the consideration paid for employee services. Currently Viewing: 718 Compensation—Stock Compensation 10 Overall 10 Objectives General 10-2 This Topic requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. This Topic establishes fair value as the measurement objective in accounting for share-based payment arrangements and requires all entities to apply a fair-value-based measurement method in accounting for share-based payment transactions with employees except for equity instruments held by employee stock ownership plans.
PROFESSIONAL RESEARCH (Continued) (c) See FASB ASC 718-50-25. 25-1 An employee share-purchase plan that satisfies all of the following criteria does not give rise to recognizable compensation cost (that is, the plan is noncompensatory): 1. The plan satisfies either of the following conditions: (a) The terms of the plan are no more favorable than those available to all holders of the same class of shares. Note that a transaction subject to an employee share-purchase plan that involves a class of equity shares designed exclusively for and held only by current or former employees or their beneficiaries may be compensatory depending on the terms of the arrangement. (b) Any purchase discount from the market price does not exceed the per-share amount of share issuance costs that would have been incurred to raise a significant amount of capital by a public offering. A purchase discount of 5 percent or less from the market price shall be considered to comply with this condition without further justification. A purchase discount greater than 5 percent that cannot be justified under this condition results in compensation cost for the entire amount of the discount. Note that an entity that justifies a purchase discount in excess of 5 percent shall reassess at least annually, and no later than the first share purchase offer during the fiscal year, whether it can continue to justify that discount pursuant to this paragraph. 2. Substantially all employees that meet limited employment qualifications may participate on an equitable basis. 3. The plan incorporates no option features, other than the following: (a) Employees are permitted a short period of time—not exceeding 31 days—after the purchase price has been fixed to enroll in the plan. (b) The purchase price is based solely on the market price of the shares at the date of purchase, and employees are permitted to cancel participation before the purchase date and obtain a refund of amounts previously paid (such as those paid by payroll withholdings).
PROFESSIONAL SIMULATION Note: This assignment is available on the Kieso website. Explanation (a) The controller’s computations were not correct in that the straight arithmetic average of the common shares outstanding at the beginning and end of the year was used. The weighted-average computed as follows: Dates Outstanding
number
of
outstanding
may be
Fraction of Year
Weighted Shares
Jan. 1–Oct. 1 1,285,000 9/12 Oct. 1–Dec. 1 1,035,000 2/12 Dec. 1–Dec. 31 1,200,000 1/12 Weighted-average number of shares outstanding
963,750 172,500 100,000 1,236,250
Net income for year
$3,374,960
Earnings per share =
Shares Outstanding
shares
$3,374,960 = $2.73 1,236,250
Financial Statements
(b)
Basic earnings per share = $3,374,960 = $2.73 1,236,250 Diluted earnings per share = $3,374,960 = $2.56 1,320,250*
PROFESSIONAL SIMULATION (Continued)
Schedule A *Computation of weighted-average number of shares adjusted for dilutive securities Average number of shares under options outstanding............. Option price per share ................................................................. Proceeds upon exercise of options ............................................ Market price of common stock: Average ................................................................................. Treasury shares that could be repurchased with proceeds ($1,400,000 ÷ $25) ..................................................... Excess of shares under option over treasury shares that could be repurchased (140,000 – 56,000) ......................... Incremental shares....................................................................... Average number of common shares outstanding ..................... Weighted-average number of shares adjusted for dilutive securities ......................................................................
140,000 X $10 $1,400,000 $25 56,000 84,000 84,000 1,236,250 1,320,250
IFRS CONCEPTS AND APPLICATION IFRS16-1 The primary IFRS reporting standards related to financial instruments, including dilutive securities is IAS 39 “Financial Instruments: Recognition and Measurement”. The accounting for various forms of stock-based compensation under IFRS is found in IFRS 2 “Share-Based Payment”. This standard was recently amended, resulting in significant convergence between IFRS and U.S. GAAP in this area. The IFRS standard addressing accounting and reporting for earnings per share computations in IAS 33 “Earnings per Share”. IFRS16-2 IFRS and U.S. GAAP are substantially the same in the accounting for dilutive securities, stock-based compensation, and earnings per share. For example, both IFRS and U.S. GAAP follow the same model for recognizing stock-based compensation. That is, the fair value of shares and options awarded to employees is recognized over the period to which the employees’ services relate. The main differences concern (1) the accounting for convertible debt. Under U.S. GAAP all of the proceeds of convertible debt are recorded as long term debt. Under IFRS, convertible bonds are “bifurcated”, or separated into the equity component—the value of the conversion option— of the bond issue and the debt component; (2) a minor differences in EPS reporting—the FASB allows companies to rebut the presumption that contracts that can be settled in either cash or shares will be settled in shares. IFRS requires that share settlement must be used in this situation; (3) other EPS differences relate to the treasury stock method and how the proceeds from extinguishment of a liability should be accounted for and how to make the computation for the weighted-average of contingently issuable shares. IFRS16-3 (a) Norman makes the following entry to record the issuance under U.S. GAAP. Cash .................................................................. Bonds Payable ........................................
400,000 400,000
IFRS16-3 (Continued) (b) Under IFRS, Norman must “bifurcate” (split out) the equity component— the value of the conversion option—of the bond issue. Under IFRS, the convertible bond issue is recorded as follows. Cash.................................................................... Bonds Payable ........................................ Share Premium-Conversion Equity .......
400,000 365,000 35,000
(c) IFRS provides a more faithful representation of the impact of the bond issue, by recording separately its debt and equity components. However, there are concerns about reliability of the models used to estimate the equity portion of the bond issue. IFRS16-4 The FASB has been working on a standard that will likely converge to IFRS in the accounting for convertible debt. Similar to the FASB, the IASB is examining the classification of hybrid securities; the IASB is seeking comment on a discussion document similar to the FASB Preliminary Views document: “Financial Instruments with Characteristics of Equity.” It is hoped that the boards will develop a converged standard in this area. While U.S. GAAP and IFRS are similar as to the presentation of EPS, the Boards have been working together to resolve remaining differences related to earnings per share computations. IFRS16-5 (a) From the point of view of the issuer, the conversion feature of convertible debt results in a lower cash interest cost than in the case of nonconvertible debt. In addition, the issuer in planning its longrange financing may view the convertible debt as a means of raising equity capital over the long term. Thus, if the market value of the underlying shares increases sufficiently after the issue of the debt, the issuer will usually be able to force conversion of the convertible debt into shares by calling the issue for redemption. Under the market conditions, the issuer can effectively eliminate the debt. On the other hand, if the market value of the shares does not increase sufficiently to result in the conversion of the debt, the issuer will have received the benefit of the cash proceeds to the scheduled maturity dates at a relatively low cash interest cost.
IFRS16-5 (Continued) (b) The purchaser obtains an option to receive either the face amount of the debt upon maturity or the specified number of shares upon conversion. If the market value of the underlying shares increases above the conversion price, the purchaser (either through conversion or through holding the convertible debt containing the conversion option) receives the benefits of appreciation. On the other hand, should the value of the underlying company shares not increase, the purchaser could nevertheless expect to receive the principal and (lower) interest. IFRS16-6 The view that separate accounting recognition should be accorded the conversion feature of convertible debt is based on the premise that there is an economic value inherent in the conversion feature or call on the ordinary shares and that the value of this feature should be recognized for accounting purposes by the issuer. It may be argued that the call is not significantly different in nature from the call contained in an option or warrant and its issue is thus a type of capital transaction. The fact that the conversion feature coexists with certain senior security characteristics in a complex security and cannot be physically separated from these elements or from the instrument does not constitute a logical or compelling reason why the values of the various elements should not receive separate accounting recognition. The fact that the eventual outcome of the option granted the purchaser of the convertible debt cannot be determined at date of issuance is not relevant to the question of effectively reflecting in the accounting records the various elements of the complex document at the date of issuance. The conversion feature has a value at date of issuance and should be recognized. Moreover, the difficulties of implementation are not insurmountable and should not be relied upon to govern the conclusion. IFRS16-7 The book value method used by the company to record the exchange of convertible debentures for ordinary shares can be supported on the grounds that when the company issued the convertible debentures, the proceeds could represent consideration received for the shares. Therefore, when conversion occurs, the book value of the obligation is simply transferred to the shares exchanged for it. Further justification is that conversion represents a transaction with shareholders which should not give rise to a gain or loss.
IFRS16-7 (Continued) On the other hand, recording the issue of the ordinary shares at the book value of the debentures is open to question. It may be argued that the exchange of the shares for the debentures completes the transaction cycle for the debentures and begins a new cycle for the shares. The consideration or value used for this new transaction cycle should then be the amount which would be received if the debentures were sold rather than exchanged, or the amount which would be received if the related shares were sold, whichever is more clearly determinable at the time of the exchange. This method recognizes changes in values which have occurred and subordinates a consideration determined at the time the debentures were issued.
IFRS16-8 Cordero would account for the discount as a reduction of the cash proceeds and an increase in compensation expense. The IASB concluded that this benefit represents employee compensation. IFRS16-9 Cash ($4,000,000 X .99) .............................................. Bonds Payable .................................................... Share Premium—Conversion Equity.................
3,960,000 3,800,000 160,000
IFRS16-10 Share Premium—Conversion Equity ........................ Bonds Payable............................................................ Share Capital—Ordinary (2,000 X 50 X $10)...... Share Premium—Ordinary .................................
20,000 1,950,000 1,000,000 970,000
IFRS16-11 (a) Present Value of Principal: ($2,000,000 X .79383) ...................................... Present Value of Interest Payments: ($120,000 X 2.57710) ....................................... Present Value of the Liability Component .......
$1,587,660 309,252 $1,896,912
Fair Value of Convertible Debt.......................... Less: Fair Value of Liability Component.......... Fair Value of Equity Component.......................
$2,000,000 1,896,912 $ 103,088
(b) Cash.................................................................... Bonds Payable ............................................ Share Premium—Conversion Equity.........
2,000,000
(c) Bonds Payable................................................... Cash.............................................................
2,000,000
1,896,912 103,088 2,000,000
IFRS16-12 (a) Carrying Value of Bonds, 1-1-13 (from Ex. 16–11(a)).......................................... Discount Amortized in 2013 [($1,896,912 X .08) – $120,000)]...................... Carrying Value of Bonds, 1-1-14....................... (b) Share Premium—Conversion Equity ............... Bonds Payable................................................... Share Capital—Ordinary............................. Share Premium—Ordinary ......................... *$103,088 + $1,928,665 – $500,000
$1,896,912 31,753 $1,928,665 103,088 1,928,665 500,000 1,531,753*
IFRS16-12 (Continued) (c) Share Premium—Conversion Equity................ Bonds Payable ................................................... Cash ............................................................. Gain on Repurchase ...................................
40,000* 1,928,665 1,940,000 28,665**
*$1,940,000 – $1,900,000 (Fair value of convertible bond issue (both liability and equity components less the fair value of the liability component). The remaining balance in this account could be transferred to Share Premium—Ordinary. **$1,928,665 – $1,900,000 (Angela has a gain because the repurchase amounts of the liability component is less than the carrying value of the liability component.) IFRS16-13 (a)
(b)
(c)
1/1/14
No entry
12/31/14
Compensation Expense ($6 X 5,000 ÷ 5) ...... Share Premium—Share Options...........
6,000 6,000
1/1/14
Unearned Compensation ($40 X 700)............ 28,000 Share Capital—Ordinary ($1 X 700)...... 700 Share Premium—Ordinary .................... 27,300
12/31/14
Compensation Expense ($28,000 ÷ 5)........... Unearned Compensation ......................
5,600 5,600
No change for part (a), unless the fair value of the options change. For part (b): 1/10/14
Unearned Compensation ($45 X 700)........... 31,500 Share Capital—Ordinary ($1 X 700)...... 700 Share Premium—Ordinary .................... 30,800
12/31/14
Compensation Expense ($31,500 ÷ 5).......... Unearned Compensation ......................
6,300 6,300
IFRS16-13 (Continued) (d)
Employee share-purchase plans generally permit all employees to purchase shares at a discounted price. When employees purchase the shares the entry is similar to the entry recording the sale of shares to shareholders. The one difference is the amount of the discount is recorded as compensation expense. The IASB concluded that since these plans are available only to employees the benefits provided represent employee compensation.
IFRS16-14 (a) IFRS 2 addresses compensation plans.
the
accounting
for
share-based
payment
(b) The objectives for accounting for stock compensation are (as stated by IFRS 2, paragraph 1): The objective of this IFRS is to specify the financial reporting by an entity when it undertakes a share-based payment transaction. In particular, it requires an entity to reflect in its profit or loss and financial position the effects of share-based payment transactions, including expenses associated with transactions in which share options are granted to employees. IFRS 2, IN5 states the role of fair value measurement: For equity-settled share-based payment transactions, the IFRS requires an entity to measure the goods or services received, unless that fair value cannot be estimated reliably. If the entity cannot estimate reliably the fair value of the goods or services received, the entity is required to measure their value, and the corresponding increase in equity, indirectly, by reference to the fair value of the equity instruments granted. (c) When the goods or services received or acquired in a share-based payment transaction do not qualify for recognition as assets, they shall be recognised as expenses (par.8). For equity-settled share-based payment transactions, the entity shall measure the goods or services received, and the corresponding increase in equity, directly, at the fair value of the goods or services received, unless that fair value cannot be estimated reliably. If the entity cannot estimate reliably the fair value of the goods or services received, the entity shall measure their value, and the corresponding increase in equity, indirectly, by reference to the fair value of the equity instruments granted (par. 10).
IFRS16-14 (Continued) To apply the requirements of paragraph 10 to transactions with employees and others providing similar services,† the entity shall measure the fair value of the services received by reference to the fair value of the equity instruments granted, because typically it is not possible to estimate reliably the fair value of the services received, as explained in paragraph 12. The fair value of those equity instruments shall be measured at grant date (par. 11). Typically, shares, share options or other equity instruments are granted to employees as part of their remuneration package, in addition to a cash salary and other employment benefits. Usually, it is not possible to measure directly the services received for particular components of the employee’s remuneration package. It might also not be possible to measure the fair value of the total remuneration package independently, without measuring directly the fair value of the equity instruments granted. Furthermore, shares or share options are sometimes granted as part of a bonus arrangement, rather than as a part of basic remuneration, eg as an incentive to the employees to remain in the entity’s employ or to reward them for their efforts in improving the entity’s performance. By granting shares or share options, in addition to other remuneration, the entity is paying additional remuneration to obtain additional benefits. Estimating the fair value of those additional benefits is likely to be difficult. Because of the difficulty of measuring directly the fair value of the services received, the entity shall measure the fair value of the employee services received by reference to the fair value of the equity instruments granted (par. 12).
IFRS16-15 (a) (1) Under M&S’s share-based compensation plan 18,367 options were granted during 2012. ($, 000) (2) At 31 March 2012, 2,803 options were exercisable by eligible managers. (3) In 2012, 19,345 options were exercised at an average price of 205.6p. (4) The options expire 10 years after the date of grant.
IFRS16-15 (Continued) (5) The accounts to which the proceeds from these option exercises are credited are Share Capital and Share Premium. (6) The number of outstanding options at 31 March 2012, is 47,245 at an average exercise price of 259.3p. (b) (In millions—except per share) Weighted-average ordinary shares Diluted earnings per share
2012 1,592.2 34.6p
2011 1,592.7 34.4p
(c) M&S also has a performance share plan, deferred share bonus plan, restricted share plan UK share incentive plan, share matching deal plan, and an M&S employee benefit trust.
CHAPTER 17 Investments ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics 1. Debt securities.
Questions
Brief Exercises Exercises
1, 2, 3, 13
1 2, 3, 5
Problems
Concepts for Analysis 6
(a) Held-to-maturity.
4, 5, 7, 8, 10, 13, 21
1, 3
1, 7
(b) Trading.
4, 6, 7, 8, 10, 21
4
(c) Available-for-sale.
4, 7, 8, 9, 10, 11, 21
2, 10
4
1, 2, 3, 4, 7
2. Bond amortization.
8, 9
1, 2, 3
3, 4, 5
1, 2, 3
3. Equity securities.
1, 12, 16
1
1
1
6
(a) Available-for-sale.
7, 10, 11, 15, 21
5, 8
6, 8, 9, 11, 12, 16, 19, 20
(b) Trading.
6, 7, 8, 10, 14, 15, 21
6
6, 7, 14, 15, 6, 8 19, 20
1, 3
(c)
16, 17, 18, 19, 20
7
12, 13, 16, 17
8
4, 5
4. Comprehensive income.
22
9
10
9, 10, 12
5. Disclosures of investments.
18
10
5, 8, 9, 10, 11, 12
6. Fair value option.
25, 26, 27
19, 20, 21
7. Impairments.
24
8. Transfers between categories.
23
* 9. Derivatives.
28, 29, 30, 31, 32, 33, 34, 35
* 10. Variable Interest Entities.
36, 37
Equity method.
10
*This material is dealt with in an Appendix to the chapter.
3, 5, 6, 8, 9, 1, 2, 3 10, 11, 12
18
3 8
22, 23, 24, 25, 26, 27
13, 14, 15, 16, 17, 18
1, 3, 6
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Brief Exercises
Learning Objectives Questions
Exercises
Problems
1
Concepts for Analysis
1.
Identify the three categories of debt securities and describe the accounting and reporting treatment for each category.
1, 2, 3, 4, 5, 6, 7
CA17-1
2.
Understand the procedures for discount and premium amortization on bond investments.
8, 9, 10, 11
1, 2, 3, 4
2, 3, 4, 5, 21
1, 2, 3, 4, 7
3.
Identify the categories of equity securities and describe the accounting and reporting treatment for each category.
12, 13, 14, 15
5, 6, 8
1, 6, 7, 8, 9, 11, 12, 14, 15, 16, 19, 20, 21
3, 5, 6, 8, 9, 10, 11, 12
CA17-1, CA17-3, CA17-5
4.
Explain the equity method of accounting and compare it to the fair value method for equity securities.
16, 17, 18, 19, 20, 25
7
12, 13, 16, 17
8
CA17-4
5.
Describe the accounting for the fair value option and the accounting for impairments of debt and equity investments.
21, 24, 26, 27
10
18, 19, 20, 21
8, 9, 10, 12
CA17-6
6.
Describe the reporting of reclassification adjustments and the accounting for transfers between categories.
22, 23
9
10
*7.
Describe the uses of, and accounting for derivatives.
28, 29
22, 26
13, 14, 15
*8.
Explain how to account for a fair
30, 31, 32
23, 25
16, 17, 18
value hedge. *9.
Explain how to account for a cash flow hedge.
33, 34
*10.
Identify special reporting issues for derivatives.
35, 36, 37
24, 27
ASSIGNMENT CHARACTERISTICS TABLE Item
Description
E17-1 E17-2 E17-3 E17-4 E17-5 E17-6 E17-7 E17-8 E17-9
Investment classifications. Entries for held-to-maturity securities. Entries for held-to-maturity securities. Entries for available-for-sale securities. Effective-interest versus straight-line bond amortization. Entries for available-for-sale and trading securities. Trading securities entries. Available-for-sale securities entries and reporting. Available-for-sale securities entries and financial statement presentation. Comprehensive income disclosure. Equity securities entries. Journal entries for fair value and equity methods. Equity method. Equity investment—trading. Equity investments—trading. Fair value and equity method compared. Equity method. Impairment of debt securities. Fair value measurement. Fair value measurement issues. Fair value option. Derivative transaction. Fair value hedge. Cash flow hedge. Fair value hedge. Call option. Cash flow hedge.
E17-10 E17-11 E17-12 E17-13 E17-14 E17-15 E17-16 E17-17 E17-18 E17-19 E17-20 E17-21 *E17-22 *E17-23 *E17-24 *E17-25 *E17-26 *E17-27 P17-1 P17-2 P17-3 P17-4 P17-5 P17-6 P17-7 P17-8 P17-9
Debt securities. Available-for-sale debt investments. Available-for-sale investments. Available-for-sale debt securities. Equity securities entries and disclosures. Trading and available-for-sale securities entries. Available-for-sale and held-to-maturity debt securities entries. Fair value and equity methods. Financial statement presentation of available-for-sale investments.
Level of Difficulty
Time (minutes)
Simple Simple Simple Simple Simple Simple Simple Simple Simple
5–10 10–15 15–20 10–15 20–30 10–15 10–15 5–10 10–15
Moderate Simple Simple Moderate Moderate Moderate Simple Simple Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate
20–25 20–25 15–20 10–15 10–15 15–20 15–20 10–15 15–20 15–20 15–20 15–20 15–20 20–25 20–25 15–20 20–25 25–30
Moderate Moderate Moderate Moderate Moderate Simple Moderate Moderate Moderate
20–30 30–40 25–30 25–35 25–35 25–35 25–35 20–30 20–30
ASSIGNMENT CHARACTERISTICS TABLE (Continued) Item P17-10 P17-11 P17-12 *P17-13 *P17-14 *P17-15 *P17-16 *P17-17 *P17-18
Description Gain on sale of securities and comprehensive income. Equity investments—available-for-sale. Available-for-sale securities—statement presentation. Derivative financial instrument. Derivative financial instrument. Free-standing derivative. Fair value hedge interest rate swap. Cash flow hedge. Fair value hedge.
Level of Difficulty Moderate Complex Moderate Moderate Moderate Moderate Moderate Moderate Moderate
Time (minutes) 20–30 30–40 20–30 20–25 20–25 20–25 30–40 25–35 25–35
CA17-1 CA17-2 CA17-3 CA17-4 CA17-5 CA17-6 CA17-7
Issues raised about investment securities. Equity securities. Financial statement effect of equity securities. Equity securities. Investment accounted for under the equity method. Equity investment. Fair value.
Moderate Moderate Simple Moderate Simple Moderate Moderate
25–30 25–30 20–30 15–25 15–25 25–35 25–35
SOLUTIONS TO CODIFICATION EXERCISES CE17-1 Master Glossary (a)
Trading securities are securities that are bought and held principally for the purpose of selling them in the near term and therefore held for only a short period of time. Trading generally reflects active and frequent buying and selling, and trading securities are generally used with the objective of generating profits on short-term differences in price.
(b)
A holding gain or loss is the net change in fair value of a security. The holding gain or loss does not include dividend or interest income recognized but not yet received or write-downs for otherthan-temporary impairment.
(c)
A cash flow hedge is a hedge of the exposure to variability in the cash flows of a recognized asset or liability, or of a forecasted transaction, that is attributable to a particular risk.
(d)
A fair value hedge is a hedge of the exposure to changes in the fair value of a recognized asset or liability, or of an unrecognized firm commitment, that are attributable to a particular risk.
CE17-2 According to FASB ASC 235-10-S99-1 (Notes to Financial Statements—SEC Materials): (n)
Accounting policies for certain derivative instruments. Disclosures regarding accounting policies shall include descriptions of the accounting policies used for derivative financial instruments and derivative commodity instruments and the methods of applying those policies that materially affect the determination of financial position, cash flows, or results of operation. This description shall include, to the extent material, each of the following items: (1) A discussion of each method used to account for derivative financial instruments and derivative commodity instruments; (2) The types of derivative financial instruments and derivative commodity instruments accounted for under each method; (3) The criteria required to be met for each accounting method used, including a discussion of the criteria required to be met for hedge or deferral accounting and accrual or settlement accounting (e. g., whether and how risk reduction, correlation, designation, and effectiveness tests are applied); (4) The accounting method used if the criteria specified in paragraph (n)(3) of this section are not met; (5) The method used to account for terminations of derivatives designated as hedges or derivatives used to affect directly or indirectly the terms, fair values, or cash flows of a designated item;
CE17-2 (Continued) (6) The method used to account for derivatives when the designated item matures, is sold, is extinguished, or is terminated. In addition, the method used to account for derivatives designated to an anticipated transaction, when the anticipated transaction is no longer likely to occur; and (7) Where and when derivative financial instruments and derivative commodity instruments, and their related gains and losses, are reported in the statements of financial position, cash flows, and results of operations. Instructions to paragraph 4-08(n). 1. For purposes of this paragraph (n), derivative financial instruments and derivative commodity instruments (collectively referred to as “derivatives”) are defined as follows: (i) Derivative financial instruments have the same meaning as defined by generally accepted accounting principles (see Financial Accounting Standards Board (“FASB”), Statement of Financial Accounting Standards No. 119, “Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments,” (“FAS 119”) paragraphs 5–7, (October 1994)), and include futures, forwards, swaps, options, and other financial instruments with similar characteristics. (ii) Derivative commodity instruments include, to the extent such instruments are not derivative financial instruments, commodity futures, commodity forwards, commodity swaps, commodity options, and other commodity instruments with similar characteristics that are permitted by contract or business custom to be settled in cash or with another financial instrument. For purposes of this paragraph, settlement in cash includes settlement in cash of the net change in value of the derivative commodity instrument (e. g., net cash settlement based on changes in the price of the underlying commodity). 2. For purposes of paragraphs (n)(2), (n)(3), (n)(4), and (n)(7), the required disclosures should address separately derivatives entered into for trading purposes and derivatives entered into for purposes other than trading. For purposes of this paragraph, trading purposes has the same meaning as defined by generally accepted accounting principles (see, e. g., FAS 119, paragraph 9a (October 1994)). 3. For purposes of paragraph (n)(6), anticipated transactions means transactions (other than transactions involving existing assets or liabilities or transactions necessitated by existing firm commitments) an enterprise expects, but is not obligated, to carry out in the normal course of business (see, e. g., FASB, Statement of Financial Accounting Standards No. 80, “Accounting for Futures Contracts,” paragraph 9, (August 1984)). 4. Registrants should provide disclosures required under paragraph (n) in filings with the Commission that include financial statements of fiscal periods ending after June 15, 1997. [45 FR 63669, Sept. 25, 1980, as amended at 46 FR 56179, Nov. 16, 1981; 50 FR 25215, June 18, 1985; 50 FR 49532, Dec. 3, 1985; 51 FR 3770, Jan. 30, 1986; 57 FR 45293, Oct. 1, 1992; 59 FR 65636, Dec. 20, 1994; 62 FR 6063, Feb. 10, 1997]
CE17-3 According to FASB ASC 323-10-35-20 (Investments—Equity Method and Joint Ventures—Subsequent Measurement): The investor ordinarily shall discontinue applying the equity method if the investment (and net advances) is reduced to zero and shall not provide for additional losses unless the investor has guaranteed obligations of the investee or is otherwise committed to provide further financial support for the investee.
CE17-4 According to FASB ASC 815-10-45-4 (Derivatives and Hedging—Other Presentation Matters—Balance Sheet Netting); Unless the conditions in paragraph 210-20-45-1 are met, the fair value of derivative instruments in a loss position shall not be offset against the fair value of derivative instruments in a gain position. Similarly, amounts recognized as accrued receivables shall not be offset against amounts recognized as accrued payables unless a right of setoff exists.
ANSWERS TO QUESTIONS 1.
A debt security is an instrument representing a creditor relationship with an entity. Debt securities include U.S. government securities, municipal securities, corporate bonds, convertible debt, and commercial paper. Trade accounts receivable and loans receivable are not debt securities because they do not meet the definition of a security. An equity security is described as a security representing an ownership interest such as common, preferred, or other capital stock. It also includes rights to acquire or dispose of an ownership interest at an agreed-upon or determinable price, such as warrants, rights, and call options or put options. Convertible debt securities and redeemable preferred stocks are not treated as equity securities.
2.
The variety in bond features along with the variability in interest rates permits investors to shop for exactly the investment that satisfies their risk, yield, and marketability desires, and permits issuers to create a debt instrument best suited to their needs.
3.
Cost includes the total consideration to acquire the investment, including brokerage fees and other costs incidental to the purchase.
4.
The three types of classifications are: Held-to-maturity: Debt investments that the company has the positive intent and ability to hold to maturity. Trading: Debt investments bought and held primarily for sale in the near term to generate income on short-term price differences. Available-for-sale: Debt investments not classified as held-to-maturity or trading securities.
5.
A debt investment should be classified as held-to-maturity only if the company has both: (1) the positive intent and (2) the ability to hold those securities to maturity.
6.
Trading securities are reported at fair value, with unrealized holding gains and losses reported as part of net income. Any discount or premium is amortized.
7.
Trading and available-for-sale securities should be reported at fair value, whereas held-tomaturity securities should be reported at amortized cost.
8.
$3,500,000 X 10% = $350,000; $350,000 ÷ 2 = $175,000. Wheeler would make the following entry: Cash ($4,000,000 X 8% X 1/2) ................................................................. 160,000 Debt Investments ............................................................................... 15,000 Interest Revenue ($3,500,000 X 10% X 1/2)................................
9.
Fair Value Adjustment (available-for-sale) ................................................. Unrealized Holding Gain or Loss—Equity [$3,604,000 – ($3,500,000 + $15,000)*].........................................
175,000
89,000 89,000
*See number 8. 10.
Unrealized holding gains and losses for trading securities should be included in net income for the current period. Unrealized holding gains and losses for available-for-sale securities should be reported as other comprehensive income and as a separate component of stockholders’ equity. Unrealized holding gains and losses are not recognized for held-to-maturity securities.
Questions Chapter 17 (Continued) 11. (a)
Unrealized Holding Gain or Loss—Equity ..................................... Fair Value Adjustment (available-for-sale) .............................
60,000
(b) Unrealized Holding Gain or Loss—Equity ..................................... Fair Value Adjustment (available-for-sale) .............................
70,000
60,000 70,000
12. Investments in equity securities can be classified as follows: (a) Holdings of less than 20% (fair value method)—investor has passive interest. (b) Holdings between 20% and 50% (equity method)—investor has significant influence. (c) Holdings of more than 50% (consolidated statements)—investor has controlling interest. Holdings of less than 20% are then classified into trading and available-for-sale, assuming determinable fair values. 13. Investments in stock do not have a maturity date and therefore cannot be classified as held-tomaturity securities. 14. Selling price of 10,000 shares at $27.50 ............................................... Less: Brokerage commissions ............................................................. Proceeds from sale............................................................................... Cost of 10,000 shares........................................................................... Gain on sale of investments.................................................................. Cash ..................................................................................................... Equity Investments........................................................................ Gain on Sale of Investments .........................................................
$275,000 (1,770) 273,230 (260,000) $ 13,230 273,230 260,000 13,230
15. Both trading and available-for-sale equity securities are reported at fair value. However, any unrealized holding gain or loss is reported in net income for trading securities but as other comprehensive income and as a separate component of stockholders’ equity for available-forsale securities. 16. Significant influence over an investee may result from representation on the board of directors, participation in policy-making processes, material intercompany transactions, interchange of managerial personnel, or technological dependency. An investment (direct or indirect) of 20% or more of the voting stock of an investee constitutes significant influence unless there exists evidence to the contrary. 17. Under the equity method, the investment is originally recorded at cost, but is adjusted for changes in the investee’s net assets. The investment account is increased (decreased) by the investor’s proportionate share of the earnings (losses) of the investee and decreased by all dividends received by the investor from the investee. 18. The 20% rule is that an investment (direct or indirect) of 20 percent or more of the voting stock of an investee leads to the presumption that an investor has the ability to exercise significant influence over an investee and the equity method should be used. However, there are other factors, when considered, may indicate that ownership of 20 percent or more may not enable an investor to exercise significant influence. An investor with ownership just below 20% may be able to exercise significant influence based on representation on the board of directors, participation in policy-making processes, material intercompany transactions, interchange of managerial personnel, or technological dependency. Another important consideration is the extent of ownership by an investor in relation to the concentration of other shareholdings
Questions Chapter 17 (Continued) Factors that could lead to a conclusion of no significant ownership, when ownership in above 20percent include: (1) The investee opposes the investor’s acquisition of its stock; (2) The investor and investee sign an agreement under which the investor surrenders significant shareholder rights; (3) The investor’s ownership share does not result in “significant influence” because majority ownership of the investee is concentrated among a small group of shareholders who operate the investee without regard to the views of the investor; (4) The investor tries and fails to obtain representation on the investee’s board of directors. 19. Dividends subsequent to acquisition should be accounted for as a reduction in the Equity Investment received account. 20. Ordinarily, Raleigh Corp. should discontinue applying the equity method and not provide for additional losses beyond the carrying value of $170,000. However, if Raleigh Corp.’s loss is not limited to its investment (due to a guarantee of Borg’s obligations or other commitment to provide further financial support or if imminent return to profitable operations by Borg appears to be assured), it is appropriate for Raleigh Corp. to provide for its entire $186,000 share of the $620,000 loss. 21. Trading securities should be reported at aggregate fair value as current assets. Individual held-tomaturity and available-for-sale securities are classified as current or noncurrent depending upon the circumstances. Held-to-maturity securities generally should be classified as current or noncurrent, based on the maturity date of the individual securities. Debt securities identified as available-for-sale should be classified as current or noncurrent, based on maturities and expectations as to sales and redemptions in the following year. Equity securities identified as available-for-sale should be classified as current if these securities are available for use in current operations. 22. Reclassification adjustments are necessary to insure that double counting does not result when realized gains or losses are reported as part of net income but also are shown as part of other comprehensive income in the current period or in previous periods. 23. When a security is transferred from one category to another, the transfer should be recorded at fair value, which in this case becomes the new basis for the security. Any unrealized gain or loss at the date of the transfer increases or decreases stockholders’ equity. The unrealized gain or loss at the date of the transfer to the trading category is recognized in income. 24. A debt security is impaired when “it is probable that the investor will be unable to collect all amounts due according to the contractual terms.” When an impairment has occurred, the security is written down to its fair value, which is also the security’s new cost basis. The amount of the writedown is accounted for as a realized loss. 25. Fair value is defined 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.” Fair value is therefore a market-based measure. 26. The fair value option gives companies the option to report most financial instruments at fair value with all gains and losses related to changes in fair value reported in the income statement. This option is applied on an instrument by instrument basis. The fair value option is generally available only at the time a company first purchases the financial asset or incurs a financial liability. If a company chooses to use the fair value option, it must measure this instrument at fair value until the company no longer has ownership. 27. No. The fair value option is generally available only at the time a company first purchases the financial asset or incurs a financial liability. If a company chooses to use the fair value option, it must measure this instrument at fair value until the company no longer has ownership.
Questions Chapter 17 (Continued) *28. An underlying is a special interest rate, security price, commodity price, index of prices or rates, or other market-related variable. Changes in the underlying determine changes in the value of the derivative. Payment is determined by the interaction of the underlying with the face amount and the number of shares, or other units specified in the derivative contract (these elements are referred to as notional amounts). *29.
See illustration below: Feature Payment Provision
Traditional Financial Instrument (e.g., Trading Security) Stock price times the number of shares.
Initial Investment Settlement
Investor pays full cost. Deliver stock to receive cash.
Derivative Financial Instrument (e.g., Call Option) Change in stock price (underlying) times number of shares (notional amount). Initial investment is less than full cost. Receive cash equivalent, based on changes in stock price times the number of shares.
For a traditional financial instrument, an investor generally must pay the full cost, while derivatives require little initial investment. In addition, the holder of a traditional security is exposed to all risks of ownership, while most derivatives are not exposed to all risks associated with ownership in the underlying. For example, the intrinsic value of a call option only can increase in value. Finally, unlike a traditional financial instrument, the holder of a derivative could realize a profit without ever having to take possession of the underlying. This feature is referred to as net settlement and serves to reduce the transaction costs associated with derivatives. *30. The purpose of a fair value hedge is to offset the exposure to changes in the fair value of a recognized asset or liability or of an unrecognized firm commitment. *31. The unrealized holding gain or loss on available-for-sale securities should be reported as income when this security is designated as a hedged item in a qualifying fair value hedge. If the hedge meets the special hedge accounting criteria (designation, documentation, and effectiveness), the unrealized holding gain or loss is reported as income. *32. This is likely a setting where the company is hedging the fair value of a fixed-rate debt obligation. The fixed payments received on the swap will offset fixed payments on the debt obligation. As a result, if interest rates decline, the value of the swap contract increases (a gain), while at the same time the fixed-rate debt obligation increases (a loss). The swap is an effective risk management tool in this setting because its value is related to the same underlying (interest rates) that will affect the value of the fixed-rate bond payable. Thus, if the value of the swap goes up, it offsets the loss in the value of the debt obligation. *33. A cash flow hedge is used to hedge exposures to cash flow risk, which is exposure to the variability in cash flows. The cash flows received on the hedging instrument (derivative) will offset the cash flows received on the hedged item. Generally, the hedged item is a transaction that is planned some time in the future (an anticipated transaction). *34. Derivatives used in cash flow hedges are accounted for at fair value on the balance sheet but gains or losses are recorded in equity as part of other comprehensive income. *35. A hybrid security is a security that has characteristics of both debt and equity and often is a combination of traditional and derivative financial instruments. A convertible bond is a hybrid security because it is comprised of a debt security, referred to as the host security, combined with an option to convert the bond to shares of common stock, the embedded derivative.
Questions Chapter 17 (Continued) *36. The voting-interest model is when a company owns more than 50% of another company. The risk-and-reward model is when a company is involved substantially in the economics of another company. If one of these two conditions exist, the consolidation should occur. *37.
A variable-interest entity (VIE) is an entity that has one of the following characteristics: (a) Insufficient equity investment at risk. Stockholders are assumed to have sufficient capital investment to support the entity’s operations. If thinly capitalized, the entity is considered a VIE and is subject to the risk-and-reward model. (b) Stockholders lack decision-making rights. In some cases, stockholders do not have the influence to control the company’s destiny. (c) Stockholders do not absorb the losses or receive the benefits of a normal stockholder. In some entities, stockholders are shielded from losses related to their primary risks, or their returns are capped or must be shared by other parties.
SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 17-1 (a) Debt Investments ...................................................... Cash ...................................................................
74,086
(b) Cash ($80,000 X .09) ................................................. Debt Investments ...................................................... Interest Revenue ($74,086 X .11) ......................
7,200 949
74,086
8,149
BRIEF EXERCISE 17-2 (a) Debt Investments (available-for-sale)...................... Cash ...................................................................
74,086
(b) Cash ($80,000 X .09) ................................................. Debt Investments (available-for-sale)...................... Interest Revenue ($74,086 X .11) ......................
7,200 949
(c) Fair Value Adjustment (available-for-sale).............. Unrealized Holding Gain or Loss—Equity [($74,086 + $949) – $75,500] ..........................
465
74,086
8,149
465
BRIEF EXERCISE 17-3 (a) Debt Investments ...................................................... Cash ...................................................................
65,118
(b) Cash ($60,000 X .08 X 6/12) ........................................ Debt Investments (held-to-maturity) ................ Interest Revenue ($65,118 X .06 X 6/12) .............
2,400
65,118 446 1,954
BRIEF EXERCISE 17-4 (a) Debt Investments (trading) .................................... Cash .................................................................
50,000
(b) Cash......................................................................... Interest Revenue .............................................
2,000
(c) Unrealized Holding Gain or Loss—Income........... Fair Value Adjustment (trading) ($50,000 – $47,400) ......................................
2,600
50,000 2,000
2,600
BRIEF EXERCISE 17-5 (a) Equity Investments (available-for-sale)................. Cash .................................................................
13,200
(b) Cash......................................................................... Dividend Revenue (400 X $3.25).....................
1,300
(c) Fair Value Adjustment (available-for-sale)............ Unrealized Holding Gain or Loss—Equity [(400 X $34.50) – $13,200]............................
600
13,200 1,300
600
BRIEF EXERCISE 17-6 (a) Equity Investments (trading) ................................. Cash .................................................................
13,200
(b) Cash......................................................................... Dividend Revenue (400 X $3.25).....................
1,300
(c) Fair Value Adjustment (trading)............................. Unrealized Holding Gain or Loss—Income [(400 X $34.50) – $13,200]............................
600
13,200 1,300
600
BRIEF EXERCISE 17-7 Equity Investments......................................................... Cash.........................................................................
300,000
Equity Investments......................................................... Investment Income (30% X $180,000)....................
54,000
Cash ................................................................................ Equity Investments (30% X $60,000) .....................
18,000
300,000 54,000 18,000
BRIEF EXERCISE 17-8 Fair Value Adjustment (available-for-sale) Bal. 200 500 700 Bal. Fair Value Adjustment (available-for-sale)............ Unrealized Holding Gain or Loss—Equity.....
500 500
BRIEF EXERCISE 17-9 (a)
Other comprehensive income (loss) for 2011: ($10.9) million
(b) Comprehensive income for 2011: $1,234.8 million or ($1,245.7 – $10.9) (c)
Accumulated other comprehensive income: $46.3 million or ($57.2 – $10.9)
Note to instructor: In 2011, Starbucks also reported foreign currency translation adjustments, which affected accumulated other comprehensive income. BRIEF EXERCISE 17-10 Loss on Impairment .............................................................. 10,000 Debt Investments (available-for-sale) ...................... 10,000 In this case, an impairment has occurred and the individual security should be written down. If Hillsborough has already recognized an unrealized holding loss—equity, an additional entry is needed to reverse this amount as well as eliminate the fair value adjustment (available-for-sale) account.
SOLUTIONS TO EXERCISES EXERCISE 17-1 (5–10 minutes) (a) 1.
(b) 2.
(c) 1.
(d) 2.
(e) 2.
(f) 3.
EXERCISE 17-2 (10–15 minutes) (a)
January 1, 2013 Debt Investments.............................................. Cash ...........................................................
(b)
300,000
December 31, 2013 Cash................................................................... Interest Revenue .......................................
(c)
300,000
December 31, 2014 Cash................................................................... Interest Revenue .......................................
36,000 36,000
36,000 36,000
EXERCISE 17-3 (15–20 minutes) (a)
January 1, 2013 Debt Investments .................................................. 322,744.44 Cash ...........................................................
(b)
322,744.44
Schedule of Interest Revenue and Bond Premium Amortization Effective-Interest Method 12% Bonds Sold to Yield 10% Date 1/1/13 12/31/13 12/31/14 12/31/15 12/31/16 12/31/17
Cash Received — $36,000 36,000 36,000 36,000 36,000
*Rounded by 45¢.
Interest Revenue — $32,274.44 31,901.89 31,492.08 31,041.29 30,545.86*
Premium Amortized — $3,725.56 4,098.11 4,507.92 4,958.71 5,454.14
Carrying Amount of Bonds $322,744.44 319,018.88 314,920.77 310,412.85 305,454.14 300,000.00
EXERCISE 17-3 (Continued) (c)
December 31, 2013 Cash..................................................................... Debt Investments ........................................ Interest Revenue .........................................
(d)
36,000 3,725.56 32,274.44
December 31, 2014 Cash..................................................................... Debt Investments ........................................ Interest Revenue .........................................
36,000 4,098.11 31,901.89
EXERCISE 17-4 (10–15 minutes) (a)
January 1, 2013 Debt Investments (available-for-sale) ................... 322,744.44 Cash ............................................................. 322,744.44
(b)
December 31, 2013 Cash..................................................................... Debt Investments (available-for-sale) ........ Interest Revenue ($322,744.44 X .10) ......... Fair Value Adjustment (available-for-sale) .......................................... Unrealized Holding Gain or Loss—Equity ($320,500.00 – $319,018.88) ....................
(c)
36,000 3,725.56 32,274.44 1,481.12 1,481.12
December 31, 2014 Unrealized Holding Gain or Loss—Equity ........ Fair Value Adjustment (available-for-sale)...................................
7,401.89 7,401.89
EXERCISE 17-4 (Continued) Amortized Cost Available-for-sale bonds Previous fair value adjustment—Dr. Fair value adjustment—Cr.
Fair Value
Unrealized Gain (Loss)
$314,920.77 $309,000.00
$(5,920.77) 1,481.12 $(7,401.89)
EXERCISE 17-5 (20–30 minutes) (a)
Schedule of Interest Revenue and Bond Discount Amortization Straight-line Method 9% Bond Purchased to Yield 12% Date 1/1/13 12/31/13 12/31/14 12/31/15
Cash Received — $18,000 18,000 18,000
Interest Bond Discount Carrying Amount Revenue Amortization of Bonds — — $185,589 $22,804 $4,804* 190,393 22,804 4,804 195,197 22,803** 4,803 200,000
*($200,000 – $185,589) ÷ 3 = $4,804 **Rounded by $1. (b)
Schedule of Interest Revenue and Bond Discount Amortization Effective-Interest Method 9% Bond Purchased to Yield 12% Date 1/1/13 12/31/13 12/31/14 12/31/15
Cash Received — $18,000 18,000 18,000
Interest Bond Discount Carrying Amount Revenue Amortization of Bonds — — $185,589.00 $22,270.68* $4,270.68 189,859.68 22,783.16 4,783.16 194,642.84 23,357.16** 5,357.16 200,000.00
*$185,589 X .12 = $22,270.68 **Rounded by $.02.
EXERCISE 17-5 (Continued) (c)
December 31, 2014 Cash.......................................................................... 18,000.00 Debt Investments ..................................................... 4,804.00 Interest Revenue .............................................. 22,804.00
(d)
December 31, 2014 Cash.......................................................................... 18,000.00 Debt Investments ..................................................... 4,783.16 Interest Revenue .............................................. 22,783.16
EXERCISE 17-6 (10–15 minutes) (a) Fair Value Adjustment (trading) ................................................................ Unrealized Holding Gain or Loss—Income ....
5,000
(b) Fair Value Adjustment (available-for-sale) ............................................... Unrealized Holding Gain or Loss—Equity......
5,000
5,000
5,000
(c) The Unrealized Holding Gain or Loss—Income account is reported in the income statement under Other Revenues and Gains. The Unrealized Holding Gain or Loss—Equity account is reported as a part of other comprehensive income and as a component of stockholders’ equity until realized. The Securities Fair Value Adjustment account is added to the cost of the Debt Investment account to arrive at fair value. EXERCISE 17-7 (10–15 minutes) (a) December 31, 2013 Unrealized Holding Gain or Loss—Income............ Fair Value Adjustment (trading) ......................
1,400
(b) During 2014 Cash.......................................................................... Loss on Sale of Investments................................... Equity Investments (trading) ...........................
9,400 600
1,400
10,000
EXERCISE 17-7 (Continued) (c) December 31, 2014 Securities Clemson Corp. stock Buffaloes Co. stock Total of portfolio Previous fair value adjustment balance—Cr. Fair value adjustment—Dr.
Cost $20,000 20,000 $40,000
Fair Value $19,100 20,500 $39,600
Fair Value Adjustment (trading)................................. Unrealized Holding Gain or Loss—Income .......
Unrealized Gain (Loss) $ (900) 500 (400) (1,400) $1,000
1,000 1,000
EXERCISE 17-8 (5–10 minutes) The unrealized gains and losses resulting from changes in the fair value of available-for-sale securities are recorded in an unrealized holding gain or loss account that is reported as other comprehensive income and as a separate component of stockholders’ equity until realized. Therefore, the following adjusting entry should be made at the year-end: Unrealized Holding Gain or Loss—Equity........................... Fair Value Adjustment (available-for-sale)...................
8,000 8,000
Unrealized Holding Gain or Loss—Equity is reported as other comprehensive income and as a separate component in stockholders’ equity and not included in net income. The Fair Value Adjustment (available-for-sale) account is a valuation account to the related investment account.
EXERCISE 17-9 (10–15 minutes) (a) The portfolio should be reported at the fair value of $54,500. Since the cost of the portfolio is $53,000, the unrealized holding gain is $1,500, of which $400 is already recognized. Therefore, the December 31, 2013 adjusting entry should be: Fair Value Adjustment (available-for-sale) ..................................................... Unrealized Holding Gain or Loss—Equity............
1,100 1,100
(b) The unrealized holding gain of $1,500 (including the previous balance of $400) should be reported as an addition to stockholders’ equity and the Fair Value Adjustment (available-for-sale) account balance of $1,500 should be added to the cost of the investment account. STEFFI GRAF, INC. Balance Sheet As of December 31, 2013 Current assets: Equity investments
$54,500
Stockholders’ equity: Common stock Additional paid-in capital Retained earnings
xxx,xxx xxx,xxx xxx,xxx xxx,xxx
Add: Accumulated other comprehensive income Total stockholders’ equity
1,500* $xxx,xxx
*Note: The unrealized holding gain could also be disclosed. (c) Computation of realized gain or loss on sale of stock: Net proceeds from sale of security A Cost of security A Loss on sale of stock January 20, 2014 Cash........................................................................... Loss on Sale of Investments.................................... Equity Investments (available-for-sale) ...........
$15,100 17,500 ($ 2,400) 15,100 2,400 17,500
EXERCISE 17-10 (20–25 minutes) (a)
STEFFI GRAF, INC. Statement of Comprehensive Income For the Year Ended December 31, 2013 Net income Other comprehensive income Unrealized holding gain Comprehensive income
(b)
$120,000 1,100 $121,100
STEFFI GRAF, INC. Statement of Comprehensive Income For the Year Ended December 31, 2014 Net income Other comprehensive income Holding gains Add: Reclassification adjustment for loss included in net income Comprehensive income Accumulated other comprehensive income: Beginning balance, January 1, 2014 Current period other comprehensive income Amount reclassified from accumulated other comprehensive income Unrealized holding gain Ending balance, December 31, 2014
$140,000 $40,000 2,400
42,400 $182,400 $1,100
$40,000 2,400 42,400 $43,400
EXERCISE 17-11 (20–25 minutes) (a) The total purchase price of these investments is: Sanchez: (10,000 X $33.50) + $1,980 = $336,980 Vicario: (5,000 X $52.00) + $3,370 = $263,370 WTA: (7,000 X $26.50) + $4,910 = $190,410 The purchase entries will be: January 15, 2014 Equity Investments (available-for-sale)............... Cash ...............................................................
336,980 336,980
EXERCISE 17-11 (Continued) April 1, 2014 Equity Investments (available-for-sale)............... Cash ...............................................................
263,370 263,370
September 10, 2014 Equity Investments (available-for-sale)............... Cash ...............................................................
190,410 190,410
(b) Gross selling price of 4,000 shares at $35 Less: Commissions, taxes, and fees Net proceeds from sale Cost of 4,000 shares ($336,980 X 0.4) Gain on sale of stock
$140,000 (3,850) 136,150 (134,792) $ 1,358
May 20, 2014 Cash........................................................................ Equity Investments (available-for-sale) ........ Gain on Sale of Investments .........................
136,150 134,792 1,358
(c) Securities Sanchez Co. Vicario Co. WTA Co. Total portfolio value Previous fair value adjustment balance Fair value adjustment—Cr.
Cost Fair Value $202,188* $180,000(1) 263,370 275,000(2) 190,410 196,000(3) $655,968 $651,000
*$336,980 X 0.6 = $202,188. (1) (2) (6,000 X $30) (5,000 X $55)
Unrealized Gain (Loss) $(22,188) 11,630 5,590 (4,968) 0 $ (4,968)
(3)
(7,000 X $28)
December 31, 2014 Unrealized Holding Gain or Loss—Equity ............ Fair Value Adjustment (available-for-sale).......................................
4,968 4,968
EXERCISE 17-12 (15–20 minutes) Situation 1: Journal entries by Conchita Cosmetics: To record purchase of 20,000 shares of Martinez Fashion at a cost of $13 per share: March 18, 2014 Equity Investments (available-for-sale) ........................ Cash.........................................................................
260,000 260,000
To record the dividend revenue from Martinez Fashion: June 30, 2014 Cash .................................................................................. Dividend Revenue ($75,000 X 10%) .........................
7,500 7,500
To record the investment at fair value: December 31, 2014 Fair Value Adjustment (available-for-sale)......................................................... Unrealized Holding Gain or Loss—Equity ...............
40,000 40,000*
*($15 – $13) X 20,000 shares = $40,000 Situation 2: Journal entries by Monica, Inc.: To record the purchase of 30% of Seles Corporation’s common stock: January 1, 2014 Equity Investments (Seles Corp.)..................................... Cash [(30,000 X 30%) X $9] .......................................
81,000 81,000
Since Monica, Inc. obtained significant influence over Seles Corp., Monica, Inc. now employs the equity method of accounting. To record the receipt of cash dividends from Seles Corporation: June 15, 2014 Cash ($36,000 X 30%)........................................................ Equity Investments (Seles Corp.) .............................
10,800 10,800
EXERCISE 17-12 (Continued) To record Monica’s share (30%) of Seles Corporation’s net income of $85,000: December 31, 2014 Equity Investments (Seles Corp.).................................... (30% X $85,000) Investment Income .................................................
25,500 25,500
EXERCISE 17-13 (10–15 minutes) (a) (b) (c) (d)
$110,000, the increase to the Investment account. If the dividend payout ratio is 40%, then 40% of the net income is their share of dividends = $44,000. Their share is 25%, so, Total Net Income X 25% = $110,000 Total Net Income = $110,000 ÷ 25% = $440,000 $44,000 ÷ 25% = $176,000 or $440,000 X 40% = $176,000
EXERCISE 17-14 (10–15 minutes) 1.
2.
3.
Equity Investments (trading) (200 shares X $40) .............................................. Cash.............................................................
8,000 8,000
Cash (100 shares X $45) ......................................... Gain on Sale of Investments ...................... Equity Investments (trading) (100 X $40) ..............................................
4,500
Unrealized Holding Gain or Loss—Income ........... Fair Value Adjustment (trading) ($40–$35) X 100.......................
500
500 4,000
500
EXERCISE 17-15 (15–20 minutes) (a) Unrealized Holding Gain or Loss—Income.............. Fair Value Adjustment (trading) ........................
7,900
(b) Cash [(1,500 X $45) – $1,200] .................................... Loss on Sale of Investments .................................... Equity Investments (trading) .............................
66,300 7,200
(c) Equity Investments (trading) [(700 X $75) + $1,300]............................................ Cash ....................................................................
53,800
7,900
73,500
53,800
(d) Securities
Cost
Fair Value
Wallace Corp., Common Earnhart Corp., Common Martin Inc., Preferred Total portfolio Previous fair value adjustment—Cr. Fair value adjustment—Cr.
$180,000 53,800 60,000 $293,800
$175,000 50,400 58,000 $283,400
Unrealized Holding Gain or Loss—Income..... Fair Value Adjustment (trading) ...............
2,500
Unrealized Gain (Loss) $ (5,000) (3,400) (2,000) (10,400) (7,900) $ (2,500)
2,500
EXERCISE 17-16 (15–20 minutes) (a)
December 31, 2013 Equity Investments (available-for-sale)........... Cash ...........................................................
1,200,000 1,200,000
June 30, 2014 Cash................................................................... Dividend Revenue .....................................
42,500 42,500
December 31, 2014 Cash................................................................... Dividend Revenue .....................................
42,500 42,500
EXERCISE 17-16 (Continued) Fair Value Adjustment (available-for-sale)..... Unrealized Holding Gain or Loss— Equity .................................................... $27 X 50,000 = $1,350,000 $1,350,000 – $1,200,000 = $150,000 (b)
150,000 150,000
December 31, 2013 Equity Investments (Kulikowski) ............................. 1,200,000 Cash .................................................................
1,200,000
June 30, 2014 Cash......................................................................... Equity Investments (Kulikowski Inc.).............
42,500 42,500
December 31, 2014 Cash......................................................................... Equity Investments (Kulikowski Inc.).............
42,500
Equity Investment (Kulikowski Inc.) ...................... Investment Income.......................................... (20% X $730,000)
146,000
(c) Investment amount (balance sheet) Dividend revenue (income statement) Investment income (income statement) *$1,200,000 + $146,000 – $42,500 – $42,500
42,500
Fair Value Method $1,350,000 85,000
146,000
Equity Method $1,261,000* 0 146,000
EXERCISE 17-17 (10–15 minutes) Equity Investments (Edwards Co.) ........................ Cash .................................................................
180,000
Cash ($20,000 X .30) ............................................... Equity Investments (Edwards Co.) ................
6,000
Equity Investments (Edwards Co.) ........................ Investment Income.......................................... (.30 X $80,000)
24,000
180,000 6,000 24,000
EXERCISE 17-18 (15–20 minutes) (a) Loss on Impairment ($800,000 – $720,000)........... Debt Investments (available-for-sale) ............
80,000 80,000
(b) The new cost basis is $720,000. GAAP indicates that the difference between the carrying amount and the maturity value should not be recorded. If the bonds are impaired, it is inappropriate to increase the asset back up to its original maturity value. (c) Fair Value Adjustment (available-for-sale) .............................................. Unrealized Holding Gain or Loss—Equity ($760,000 – $720,000) .................................
40,000 40,000
EXERCISE 17-19 (15-20 Minutes) (a) Unrealized Holding Gain or Loss—Income ($100,000 – $80,000) ............................................ Equity Investments (Arroyo Company) .........
20,000 20,000
(b) Fair Value Adjustment (available-for-sale)............ Unrealized Holding Gain or Loss—Equity ($300,000 – $250,000)...................................
50,000
(c) Fair Value Adjustment (trading)............................. Unrealized Holding Gain or Loss—Income ($190,0000 – $180,000) .................................
10,000
50,000
10,000
EXERCISE 17-20 (15-20 minutes) (a) Net income before security gains or losses ............ Sale of Investment in Woods Inc. stock ($195,000 – $180,000).............................................. Investment in Arroyo Company stock ($140,000 – $80,000)................................................ Net income .................................................................
$905,000 15,000 60,000 $980,000
(b) Equity Investments (Arroyo Company) ($140,000 – $80,000) .................................................... 60,000 Unrealized Holding Gain or Loss—Income ......
60,000
EXERCISE 17-21 (15-20 minutes) (a) Net income before security gains and losses.......... Investment in debt securities ($41,000 – $40,000)... Investment in Chen Company stock ($910,000 – $800,000).............................................. Bonds payable ($220,000 – $195,000) ...................... Net income .................................................................
$100,000 1,000 110,000 25,000 $236,000
(b) Bonds Payable ............................................................... 25,000 Unrealized Holding Gain or Loss—Income ($220,000 – $195,000) ......................................
25,000
*EXERCISE 17-22 (15–20 minutes) (a) Call Option............................................................... Cash .................................................................
300
(b) Unrealized Holding Gain or Loss—Income........... Call Option ($300 – $200) ................................
100
Call Option............................................................... Unrealized Holding Gain or Loss—Income (1,000 X $3) ..................................................
3,000
(c) Unrealized Holding Gain: $2,900 ($3,000 – $100)
300
100
3,000
*EXERCISE 17-23 (20–25 minutes) (a)
6/30/14 $100,000 3% 3,000 3,000 $ 0
Fixed-rate debt Fixed rate (6% ÷ 2) Semiannual debt payment Swap fixed receipt Net income effect Swap variable rate 5.7% X 1/2 X $100,000 6.7% X 1/2 X $100,000 Net interest expense
$ $
(b)
2,850 0 2,850
12/31/14 $100,000 3% 3,000 3,000 $ 0
$ $
3,350 3,350
Note to instructor: An interest rate swap in which a company changes its interest payments from fixed to variable is a fair value hedge because the changes in fair value of both the derivative and the hedged liability offset one another. *EXERCISE 17-24 (20–25 minutes) (a)
Variable-rate debt Variable rate Debt payment Debt payment Swap variable received Net income effect Swap payable—fixed ($10,000 X 6%) Net interest expense
12/31/14 (b) 12/31/13 $10,000,000 $10,000,000 X5.8% X6.6% $ 580,000 $ 660,000
$ $
580,000 (580,000) 0 600,000 600,000
$ $
660,000 (660,000) 0 600,000 600,000
Note to instructor: An interest swap in which a company changes its interest payments from variable to fixed is a cash flow hedge because interest costs are always the same.
*EXERCISE 17-25 (15–20 minutes) (a) Interest Expense ....................................................... Cash (7.5% X $1,000,000)..................................
75,000
(b) Cash........................................................................... Interest Expense................................................
13,000
(c) Swap Contract........................................................... Unrealized Holding Gain or Loss—Income .....
48,000
(d) Unrealized Holding Gain or Loss—Income............. Notes Payable....................................................
48,000
75,000 13,000 48,000 48,000
*EXERCISE 17-26 (20–25 minutes) (a)
(b)
August 15, 2013 Call Option...................................................................... Cash ........................................................................ September 30, 2013 Call Option...................................................................... Unrealized Holding Gain or Loss—Income .......... ($8 X 400) Unrealized Holding Gain or Loss—Income.................. Call Option ($360 – $180) .......................................
(c)
December 31, 2013 Unrealized Holding Gain or Loss—Income.................. Call Option ($2 X 400) ............................................ Unrealized Holding Gain or Loss—Income.................. Call Option ($180 – $65) .........................................
360 360
3,200 3,200 180 180
800 800 115 115
*EXERCISE 17-26 (Continued) (d)
January 15, 2014 Unrealized Holding Gain or Loss—Income.................. Call Option ($65 – $30)........................................... Cash (400 X $7) .............................................................. Gain on Settlement of Call Option* ....................... Call Option** ...........................................................
35 35 2,800 370 2,430
*Computation of Gain: $370 (400 shares X $1) – $30 **Value of Call Option at settlement: Call Option 360 3,200
180 800 115 35
2,430
*EXERCISE 17-27 (25–30 minutes) (a)
May 1, 2014 Memorandum entry to indicate entering into the futures contract.
(b)
June 30, 2014 Futures Contract..................................................... Unrealized Holding Gain or Loss—Equity [($520 – $500) X 200 ounces]......................
(c)
4,000 4,000
September 30, 2014 Futures Contract..................................................... Unrealized Holding Gain or Loss—Equity [($525 – $520) X 200 ounces]......................
1,000 1,000
*EXERCISE 17-27 (Continued) (d)
October 5, 2014 Inventory ................................................................ Cash ($525 X 200 ounces) .............................
105,000
Cash........................................................................ Futures Contract ............................................ [($525 – $500) X 200 ounces]
5,000
105,000 5,000
Note to instructor: In practice, futures contracts are settled on a daily basis; for our purposes, we show only one settlement for the entire amount. (e)
(f)
December 15, 2014 Cash........................................................................ Sales Revenue................................................
250,000
Cost of Goods Sold ............................................... Inventory (Finished goods) ...........................
140,000
Unrealized Holding Gain or Loss—Equity ........... Cost of Goods Sold ($4,000 + $1,000)...........
5,000
250,000 140,000 5,000
HART GOLF CO. Partial Income Statement For the Quarter Ended December 31, 2014 Sales revenue Cost of goods sold Gross profit
$250,000 135,000* $115,000
*Cost of inventory Less: Futures contract adjustment Cost of goods sold
$140,000 (5,000) $135,000
TIME AND PURPOSE OF PROBLEMS Problem 17-1 (Time 20–30 minutes) Purpose—the student is required to prepare journal entries and adjusting entries covering a three-year period for debt investments first classified as held-to-maturity and then classified as available-for-sale. Bond premium amortization is also involved. Problem 17-2 (Time 30–40 minutes) Purpose—The student is required to prepare journal entries and adjusting entries for available-for-sale debt investments, along with an amortization schedule and a discussion of financial statement presentation. Problem 17-3 (Time 25–30 minutes) Purpose—to provide the student with an understanding of the differentiation in accounting treatments for debt and equity security investments. The student is required to prepare the necessary journal entries to properly reflect transactions relating to available-for-sale debt and equity investments. Problem 17-4 (Time 25–35 minutes) Purpose—the student is required to distinguish between the existence of a bond premium or discount. The student is also required to prepare the adjusting entries at two year-ends for available-for-sale debt investments. Problem 17-5 (Time 25–35 minutes) Purpose—the student is required to prepare journal entries for the sale and purchase of available-forsale equity investments along with the year-end adjusting entry for unrealized holding gains or losses and to discuss the financial statement presentation. Problem 17-6 (Time 25–35 minutes) Purpose—the student is required to prepare during-the-year and year-end entries for trading equity investments and to explain how the entries would differ if the securities were classified as available-forsale. Problem 17-7 (Time 25–35 minutes) Purpose—the student is required to prepare during-the-year and year-end entries for available-for-sale debt investments and to explain how the entries would differ if the securities were classified as held-tomaturity. Problem 17-8 (Time 20–30 minutes) Purpose—to provide the student with an understanding of the accounting for trading and available-forsale equity investments. The student is required to apply the fair value method to both classes of securities and describe how they would be reflected in the body and notes to the financial statements. There is also a requirement involving the equity method. Problem 17-9 (Time 20–30 minutes) Purpose—to provide the student with an understanding of the proper accounting treatment with respect to available-for-sale equity investments and the resulting effect of a reclassification from available-forsale to trading status. The student is required to discuss the descriptions and amounts which would be reported on the face of the balance sheet with regard to these investments, plus prepare any necessary note disclosures. Problem 17-10 (Time 20–30 minutes) Purpose—to provide the student with an opportunity to prepare entries for available-for-sale transactions and to report the results in a comprehensive income statement and a balance sheet.
Time and Purpose of Problems (Continued) Problem 17-11 (Time 30–40 minutes) Purpose—to provide the student with an understanding of the reporting problems associated with available-for-sale equity investments. Description and amounts that should be reported on a company’s comparative financial statements are then required. Problem 17-12 (Time 20–30 minutes) Purpose—to provide the student with an understanding of the reporting problems associated with available-for-sale equity investments. Description and amounts that should be reported on a company’s comparative financial statements are then required. *Problem 17-13 (Time 20–25 minutes) Purpose—the student is required to prepare the entries at purchase, throughout the life, and at expiration for a stand-alone derivative (call option). *Problem 17-14 (Time 20–25 minutes) Purpose—the student is required to prepare the entries at purchase, throughout the life, and at expiration for a stand-alone derivative (put option). *Problem 17-15 (Time 20–25 minutes) Purpose—the student is required to prepare the entries at purchase, throughout the life, and at expiration for a stand-alone derivative (put option). *Problem 17-16 (Time 30–40 minutes) Purpose—the student is provided with an opportunity to prepare the entries for a fair value hedge in the context of an interest rate swap, including how the effects of the swap will be reported in the financial statements. *Problem 17-17 (Time 25–35 minutes) Purpose—the student is provided with an opportunity to prepare the entries for a cash flow hedge in the context of an option contract on the purchase of inventory, including how the effects of the hedge will be reported in the financial statements. *Problem 17-18 (Time 25–35 minutes) Purpose—the student is provided with an opportunity to prepare the entries for a fair value hedge in the context of the use of a put option to hedge an available-for-sale security, including how the effects for the hedging instrument and hedged item will be reported in the financial statements.
SOLUTIONS TO PROBLEMS PROBLEM 17-1
(a)
(b)
(c)
(d)
(e)
December 31, 2012 Debt Investments .......................................... Cash ...................................................... December 31, 2013 Cash ............................................................... Debt Investments ................................. Interest Revenue .................................. December 31, 2015 Cash ............................................................... Debt Investments ................................. Interest Revenue .................................. December 31, 2012 Debt Investments (available-for-sale) .......... Cash ...................................................... December 31, 2013 Cash ............................................................... Debt Investments (available-for-sale) .. Interest Revenue .................................. Unrealized Holding Gain or Loss—Equity ($107,093 – $106,500) ................................. Fair Value Adjustment (available-for-sale).............................
108,660 108,660 7,000 1,567 5,433 7,000 1,728 5,272 108,660 108,660 7,000 1,567 5,433 593 593
PROBLEM 17-1 (Continued) (f)
December 31, 2015 Cash ................................................................. Debt Investments (available-for-sale) ... Interest Revenue ....................................
7,000 1,728 5,272
Debt Investments (available-for-sale)
Spangler Company, 7% bonds Previous fair value adjustment—Dr. Fair value adjustment—Cr.
Amortized Cost $103,719
Fair Value $105,650
Unrealized Gain (Loss) $1,931 2,053* $ (122)
*($107,500 – $105,447) Unrealized Holding Gain or Loss—Equity................. Fair Value Adjustment (available-for-sale)..........
122 122
PROBLEM 17-2 (a) January 1, 2014 purchase entry: Debt Investments (available-for-sale).................... Cash .................................................................
369,114 369,114
(b) The amortization schedule is as follows: Schedule of Interest Revenue and Bond Discount Amortization—Effective-Interest Method 8% Bonds Purchased to Yield 10%
Date 1/1/14 7/1/14 12/31/14 7/1/15 12/31/15 7/1/16 12/31/16 7/1/17 12/31/17 7/1/18 12/31/18 Total
Interest Receivable Or Cash Received
Interest Revenue
Bond Discount Amortization
16,000 16,000 16,000 16,000 16,000 16,000 16,000 16,000 16,000 16,000 $160,000
$ 18,456 18,579 18,707 18,843 18,985 19,134 19,291 19,455 19,628 19,808* $190,886
$ 2,456 2,579 2,707 2,843 2,985 3,134 3,291 3,455 3,628 3,808 $30,886
Carrying Amount of Bonds $369,114 371,570 374,149 376,856 379,699 382,684 385,818 389,109 392,564 396,192 400,000
*$2 difference due to rounding. (c) Interest entries: July 1, 2014 Cash......................................................................... Debt Investments (available-for-sale).................... Interest Revenue .............................................
16,000 2,456
December 31, 2014 Interest Receivable ................................................. Debt Investments (available-for-sale).................... Interest Revenue .............................................
16,000 2,579
18,456
18,579
PROBLEM 17-2 (Continued) (d) December 31, 2015 adjusting entry: Securities Aguirre (total portfolio value) Previous fair value adjustment—Dr. Fair value adjustment— Cr.
Available-for-Sale Portfolio Cost
Fair Value
Unrealized Gain (Loss)
$379,699*
$372,726
$ (6,973) 3,375 $(10,348)
*This is the amortized cost of the bonds on December 31, 2015. See (b) schedule. December 31, 2015 Unrealized Holding Gain or Loss—Equity ........... Fair Value Adjustment (available-for-sale).......................................
10,348 10,348
(e) January 1, 2016 sale entry: Selling price of bonds ........................................... Less: Amortized cost (see schedule from (b)).... Realized loss on sale of investment (available-for-sale) ..............................................
$370,726 (379,699) $ (8,973)
January 1, 2016 Cash........................................................................ Loss on Sale of Investments................................. Debt Investments (available-for-sale) ...........
370,726 8,973 379,699
PROBLEM 17-3
(a) Debt Investments (available-for-sale).................... Equity Investments (available-for-sale)................. Interest Revenue ($50,000 X .12 X 4/12) ................ Investments .....................................................
162,000* 37,400 2,000 201,400
*[$110,000 + ($50,000 X 1.04)] (Note to instructor: Some students may debit Interest Receivable at date of purchase instead of Interest Revenue. This procedure is correct, assuming that when the cash is received for the interest, an appropriate credit to Interest Receivable is recorded.) (b)
December 31, 2014 Interest Receivable ................................................. Debt Investments (available-for-sale) ............ Interest Revenue ............................................. [Accrued interest $50,000 X .12 X 10/12 = $5,000 Premium amortization 6/236 X $2,000 = (51) Accrued interest $110,000 X .11 X 3/12 = 3,025 $7,974]
(c)
8,025 51 7,974
December 31, 2014 Available-for-Sale Portfolio Securities Sharapova Company stock U.S. government bonds McGrath Company bonds Total Previous fair value adjustment balance Fair value adjustment—Dr. *($50,000 X 1.04) – $51
Cost $ 37,400 110,000 51,949* $199,349
Fair Value $ 31,800 124,700 58,600 $215,100
Unrealized Gain (Loss) $ (5,600) 14,700 6,651 15,751 0 $15,751
PROBLEM 17-3 (Continued) Fair Value Adjustment (available-for-sale).......... Unrealized Holding Gain or Loss—Equity... (d)
15,751 15,751
July 1, 2015 Cash ($119,200 + $3,025)...................................... Debt Investments (available-for-sale) .......... Interest Revenue ($110,000 X .11 X 3/12)..... Gain on Sale of Investments ........................
122,225 110,000 3,025 9,200
PROBLEM 17-4
(a) The bonds were purchased at a discount. That is, they were purchased at less than their face value because the bonds’ amortized cost increased from $491,150 to $550,000. (b)
December 31, 2014 Fair Value Adjustment (available-for-sale)............... Unrealized Holding Gain or Loss—Equity........
4,850 4,850
Available-for-Sale Portfolio
Debt Investment Previous fair value adjustment—Dr. Fair value adjustment—Dr. (c)
Amortized Cost
Fair Value
Unrealized Gain (Loss)
$491,150
$497,000
$5,850 1,000 $4,850
December 31, 2015 Unrealized Holding Gain or Loss—Equity ............... Fair Value Adjustment (available-for-sale) .......
16,292 16,292
Available-for-Sale Portfolio
Debt Investment Previous fair value adjustment—Dr. Fair value adjustment—Cr. needed to bring balance to $10,442 Cr.
Amortized Cost
Fair Value
Unrealized Gain (Loss)
$519,442
$509,000
$(10,442) 5,850 ($16,292)
PROBLEM 17-5 (a) Gross selling price of 3,000 shares at $22 ............. Less: Commissions, taxes, and fees..................... Net proceeds from sale ........................................... Cost of 3,000 shares ................................................ Gain on sale of investments ...................................
$66,000 (2,150) 63,850 (58,500) $ 5,350
January 15, 2015 Cash.......................................................................... Equity Investments (available-for-sale) .......... Gain on Sale of Investments ...........................
63,850 58,500 5,350
(b) The total purchase price is: (1,000 X $33.50) + $1,980 = $35,480. The purchase entry will be: April 17, 2015 Equity Investments (available-for-sale).................. Cash .................................................................. (c)
35,480 35,480
Available-for-Sale Portfolio—December 31, 2015
Securities Munter Ltd. King Co. Castle Co. Total of portfolio Previous fair value adjustment balance—Cr. Fair value adjustment—Dr.
Cost
Fair Value
Unrealized Gain (Loss)
$580,000 255,000 35,480 $870,480
$610,000 240,000 29,000 $879,000
$30,000 (15,000) (6,480) 8,520 (10,100) $18,620
December 31, 2015 Fair Value Adjustment (available-for-sale)............. Unrealized Holding Gain or Loss—Equity......
18,620 18,620
(d) The unrealized holding gains or losses should be reported on the balance sheet under the title “accumulated other comprehensive income” as a separate component of stockholders’ equity.
PROBLEM 17-6
(a)
(1)
October 10, 2014 Cash (5,000 X $54)........................................... Gain on Sale of Investments................... Equity Investments (trading) ..................
(2)
270,000 55,000 215,000
November 2, 2014 Equity Investments (trading) ......................... Cash (3,000 X $54.50) ..............................
163,500 163,500
(3) At September 30, 2014, McElroy had the following fair value adjustment: Trading Securities Portfolio—September 30, 2014 Securities Horton, Inc. common Monty, Inc. preferred Oakwood Corp. common Total of portfolio Previous fair value adjustment balance Fair value adjustment—Cr.
Cost
Fair Value
Unrealized Gain (Loss)
$215,000 133,000 180,000 $528,000
$200,000 140,000 179,000 $519,000
$(15,000) 7,000 (1,000) (9,000) 0 $ (9,000)
PROBLEM 17-6 (Continued) At December 31, 2014, McElroy had the following fair value adjustment: Trading Securities Portfolio—December 31, 2014 Securities Monty, Inc. preferred Oakwood Corp. common Patriot common Total of portfolio Previous fair value adjustment balance—Cr. Fair value adjustment—Cr.
Cost
Fair Value
Unrealized Gain (Loss)
$133,000 $106,000 180,000 193,000 163,500 132,000 $476,500 $431,000
$(27,000) 13,000 (31,500) (45,500) (9,000) $(36,500)
The entry on December 31, 2014 is therefore as follows: Unrealized Holding Gain or Loss—Income ..... Fair Value Adjustment (trading)................ (b)
36,500 36,500
The entries would be the same except that instead of debiting and crediting accounts associated with trading securities, the accounts used would be associated with available-for-sale securities. In addition, the Unrealized Holding Gain or Loss—Equity account is used instead of Unrealized Holding Gain or Loss—Income. The Unrealized Holding Loss—Equity is included in other comprehensive income and then would be reported on the balance sheet in Accumulated comprehensive income.
PROBLEM 17-7
(a)
February 1 Debt Investments (available-for-sale)..................... Interest Revenue (4/12 X .10 X $300,000) ............... Cash ..................................................................
300,000 10,000 310,000
April 1 Cash.......................................................................... Interest Revenue ($300,000 X .10 X 6/12)........
15,000 15,000
July 1 Debt Investments (available-for-sale)..................... Interest Revenue (1/12 X .09 X $200,000) ............... Cash ..................................................................
200,000 1,500 201,500
September 1 Cash [($60,000 X 99%) + ($60,000 X .10 X 5/12)] .... Loss on Sale of Investments ................................. Debt Investments (available-for-sale) ............. Interest Revenue (5/12 X .10 X $60,000 = $2,500) ....................
61,900 600 60,000 2,500
October 1 Cash [($300,000 – $60,000) X .10 X 6/12] ................ Interest Revenue ..............................................
12,000 12,000
December 1 Cash ($200,000 X 9% X 6/12)................................... Interest Revenue ..............................................
9,000 9,000
PROBLEM 17-7 (Continued) December 31 Interest Receivable ................................................. Interest Revenue ............................................. (3/12 X $240,000 X .10 = $6,000) (1/12 X $200,000 X .09 = $1,500) ($6,000 + $1,500 = $7,500)
7,500 7,500
December 31 Unrealized Holding Gain or Loss—Equity ............ Fair Value Adjustment (available-for-sale) ....
26,000 26,000
Available-for-Sale Portfolio Security Gibbons Co. Sampson, Inc. Total
Cost
Fair Value
Unrealized Gain (Loss)
$240,000 200,000 $440,000
$228,000* 186,000** $414,000
$(12,000) (14,000) $(26,000)
*$240,000 X 95% **$200,000 X 93% (Note to instructor: Some students may debit Interest Receivable at date of purchase instead of Interest Revenue. This procedure is correct, assuming that when the cash is received for the interest, an appropriate credit to Interest Receivable is recorded.) (b) All the entries would be the same except the account title Debt Investments (held-to-maturity) would be used instead of Debt Investments (available-for-sale). In addition, held-to-maturity securities would be carried at amortized cost and not valued at fair value at yearend, so the last entry would not be made.
PROBLEM 17-8
(a) 1.
Investment in trading securities: Unrealized Holding Gain or Loss—Income.......... Fair Value Adjustment (trading) ....................
2.
80,000 80,000
Investment in available-for-sale securities: Fair Value Adjustment (available-for-sale) .............. 725,000 Unrealized Holding Gain or Loss—Equity.... 725,000
Computations: Cost
Fair Value
Unrealized Gain (Loss)
$1,400,000 1,000,000 $2,400,000
$1,600,000 720,000 $2,320,000
$ 200,000 (280,000) $ (80,000)
1. Security Delaney Motors Patrick Electric Total of portfolio 2.
Computation of Unrealized Gain or Loss in 2013 Fair Unrealized Value Gain (Loss) Security Cost Norton Ind.
Security
$22,500,000
$21,500,000
($1,000,000)
Computation of Unrealized Gain or Loss in 2014 Fair Unrealized Cost Value Gain (Loss)
Norton Ind. Previous Fair Value Adjustment (Cr) Fair Value Adjustment (Dr)
$22,500,000
$22,225,000
$ (275,000) (1,000,000) $
725,000
PROBLEM 17-8 (Continued) (b) The unrealized holding loss on the valuation of Brooks’ trading securities is reported on the income statement. The loss would appear in the “Other expenses and losses” section of the income statement. The Fair Value Adjustment is a valuation account and it will be used to show the reduction in the fair value of the trading securities. The trading securities portfolio is disclosed in the balance sheet as a current asset and reported at its fair value. The unrealized holding gain on the valuation of Brooks’ available-forsale securities is reported as other comprehensive income and as a separate component of stockholders’ equity. The Fair Value Adjustment account is used to report the increase in fair value of the available-forsale securities. The fair value of the securities is reported in the Investments section of the balance sheet. It should be noted that a combined statement of income and comprehensive income, a statement of comprehensive income, or a statement of stockholders’ equity would report the components of comprehensive income. The note disclosures for the available-for-sale securities include the aggregate fair value, gross unrealized holding gains, and gross unrealized holding losses. Any change in the net unrealized holding gain or loss account should also be disclosed. The disclosure for trading securities includes the change in net unrealized holding gains or losses which was included in earnings. (c)
Equity Investments (Norton Industries)..................... Investment Income ($500,000 X 25%).................
125,000
Cash ($100,000 X 25%) .............................................. Equity Investments (Norton Industries) ..............
25,000
125,000 25,000
With 25% ownership, Brooks has significant influence and should apply the equity method. No fair value adjustments are recorded under the equity method.
PROBLEM 17-9 (a) Available-for-Sale Portfolio Securities Frank, Inc. Ellis Corp. Mendota Company Total of portfolio
Cost
Fair Value
Unrealized Gain (Loss)
$ 22,000 115,000 124,000 $261,000
$ 32,000 95,000 96,000 $223,000
$ 10,000 (20,000) (28,000) $(38,000)
Balance Sheet—December 31, 2014 Long-term investments: Equity Investments (available-for-sale) ............. $261,000 Less: Fair value adjustment .............................. 38,000 Equity Investments (available-for-sale), at fair value .................................................... $223,000 Stockholders’ equity: Common stock ................................................. Paid-in capital in excess of par— common stock............................................... Retained earnings ............................................ Accumulated other comprehensive loss........ Total stockholders’ equity .......................
$
xx
xx xx (38,000) $ xx
(b) Available-for-Sale Portfolio Securities Ellis Corp. Mendota Company Total of portfolio Previous fair value adjustment balance—Cr. Fair Value Adjustment—Dr. *(4,000 X $31) + (2,000 X $25) **[(4,000 + 2,000) X $23]
Cost
Fair Value
Unrealized Gain (Loss)
$115,000 174,000* $289,000
$140,000 138,000** $278,000
$ 25,000 (36,000) $(11,000) (38,000) $27,000
PROBLEM 17-9 (Continued) Balance Sheet—December 31, 2015 Long-term investments: Equity investments (available-for-sale), at cost ....................................................... Less: Fair value adjustment ...................... Equity investments (available-for-sale), at fair value ............................................... Stockholders’ equity: Common stock ............................................ Paid-in capital in excess of par— common stock .......................................... Retained earnings ....................................... Accumulated other comprehensive loss... Total stockholders’ equity ..................
$289,000 11,000 $278,000 $
xx
xx xx (11,000) $ xx
The Frank security is transferred to the trading security category at fair value, which is the new cost basis of the security. The unrealized holding loss of $6,000 [($11 – $8) X 2,000] is recognized in earnings at the date of the transfer.
PROBLEM 17-10
(a)
January 1, 2014 Fair value of available-for-sale securities ............... Accumulated other comprehensive income ........... Cost basis .................................................................
$240,000 (30,000) $210,000
December 31, 2014 Fair value of available-for-sale securities ............... Cost basis ................................................................. Accumulated other comprehensive income ...........
$190,000 (140,000) $ 50,000
Cash ($70,000 + $30,000).......................................... 100,000 Gain on Sale of Investments ............................ Equity Investments (available-for-sale) ...........
30,000 70,000*
*($210,000 – $140,000)
(b)
ACKER INC. Statement of Comprehensive Income For the Year Ended December 31, 2014 Net income.................................................................... Other comprehensive income Unrealized holding gain ....................................... Comprehensive income ............................................... Acker will provide the following disclosure for Accumulated other comprehensive income: Beginning balance, January 1, 2014 Current period other comprehensive income Amount reclassified from accumulated other comprehensive income Unrealized holding gain Ending balance, December 31, 2014
$35,000 20,000 $55,000
$30,000 $50,000** 30,000 20,000 $50,000
PROBLEM 17-10 (Continued) **Accumulated other comprehensive income 12/31/14 ....................................................... Accumulated other comprehensive income 1/1/14 ........................................................... Increase in unrealized holding gain.......................... Realized holding gain ................................................ Total holding gains arising during period................ (c)
$50,000 30,000 20,000 30,000 $50,000
ACKER INC. Balance Sheet As of December 31, 2014
Assets Cash Equity investments (available-for-sale) Total assets
$155,000* 190,000 $345,000
Stockholders’ Equity Common stock $260,000 35,000 Retained earnings Accumulated other comprehensive income 50,000 Total equity $345,000
*Beginning balance ................................................................. Dividend revenue ................................................................... Cash proceeds on sale ..........................................................
$ 50,000 5,000 100,000 $155,000
PROBLEM 17-11 (a) 1. 3/1/14 2. 4/30/14
Cash ...................................................... Dividend Revenue (900 X $2) .....
1,800
Cash ...................................................... Gain on Sale of Investments......... Equity Investments (available-for-sale) ......................
3,300
1,800 600* 2,700
*(300 X ($11 – $9)) 3. 5/15/14
4. 12/31/14
Equity Investments (availablefor-sale).............................................. Cash (100 X $16)............................ Fair Value Adjustment (availablefor-sale).............................................. Unrealized Holding Gain or Loss—Equity..........................
1,600 1,600 8,500 8,500
Security
Cost
Unrealized Fair Value Gain (Loss)
Evers Comp. ($15,000 + $1,600) Rogers Comp. Chance Comp. ($4,500 – $2,700) Total of portfolio Previous fair value adjustment bal.—Cr. Fair value adjustment—Dr.
$16,600 18,000 1,800 $36,400
$18,700(1) 17,100(2) 1,600(3) $37,400
(1)
[(1,000 + 100) X $17]
5. 2/1/15
6. 3/1/15
(2)
(900 X $19)
$ 2,100 (900) (200) $ 1,000 (7,500) $ 8,500
(3)
[(500 – 300) X $8]
Cash ...................................................... Loss on Sale of Investments [200 X ($8 – $9)].................................... Equity Investments (available-for-sale)......................
1,600
Cash ...................................................... Dividend Revenue .........................
1,800
200 1,800 1,800
PROBLEM 17-11 (Continued) 7. 8.
12/21/15 12/31/15
Dividend Receivable ............................... 3,300 Dividend Revenue (1,100 X $3) ....
3,300
Fair Value Adjustment (available-for-sale) ............................... 4,200 Unrealized Holding Gain or Loss—Equity.............................
4,200
Security
Cost
Evers Comp. Rogers Comp. Total of portfolio Previous fair value adjustment bal.—Dr. Fair value adjustment—Dr. (1)
(b)
(1,100 X $19)
Unrealized Fair Value Gain (Loss)
(2)
$16,600 18,000 $34,600
$20,900(1) 18,900(2) $39,800
$4,300 900 $5,200 1,000 $4,200
(900 X $21)
Partial Balance Sheet as of
December 31, 2014
December 31, 2015
Current Assets Dividend receivable
$
0
$ 3,300
Investments Equity investments (availablefor-sale), at fair value
37,400
39,800
Stockholders’ equity Accumulated other comprehensive income
1,000
5,200
PROBLEM 17-12
(a)
Balance Sheet Equity Investments (available-for-sale), at fair value ......... (Reported as current or noncurrent based on intent) Unrealized Holding Loss (available-for-sale) ...................... ($127,000 – $123,000) (reported as a separate component of stockholders’ equity as a deduction and identified as accumulated other comprehensive loss)
$123,000 $
4,000
Income Statement No effect (b)
Balance Sheet Equity Investments (available-for-sale), at fair value ......... (Reported as current or noncurrent based on intent) Unrealized Holding Loss (available-for-sale) ...................... ($136,000 – $94,000) (reported as a separate component of stockholders’ equity as a deduction and identified as accumulated other comprehensive loss)
$94,000 $42,000
Income Statement Other Expenses and Losses Loss on Sale of Investments..................
$1,800*
*The entry made to recognize the loss on sale is as follows: Cash ..................................................................... Loss on Sale of Investments .............................. Equity Investments (available-for-sale)....
38,200 1,800 40,000
PROBLEM 17-12 (Continued) (c)
Balance Sheet Equity investments (available-for-sale), at fair value.......... (Reported as current or noncurrent based on intent) Unrealized holding gain (available-for-sale)........................ ($88,000 – $80,000) (reported as a separate component of stockholders’ equity as an addition and identified as accumulated other comprehensive gain)
$88,000 $ 8,000
Income Statement Other expenses and losses Loss on Sale of Investments ($8,100 + $2,700) ..........
$10,800
The entry made to record the sale of Lindsay Jones’ stock was: Cash ........................................................................ Loss on Sale of Investments ................................. Equity Investments (available-for-sale) ($15,000 + $33,000) ..................................... (d)
(1)
39,900 8,100 48,000
Statement of Comprehensive Income Reports unrealized holding loss of $4,000 as part of comprehensive income.
(2)
Statement of Comprehensive Income Unrealized holding loss ................................ *($42,000 – $4,000)
$38,000*
*PROBLEM 17-13
(a)
(b)
July 7, 2014 Call Option .............................................................. Cash.................................................................. September 30, 2014 Call Option .............................................................. Unrealized Holding Gain or Loss—Income ($7 X 200) ....................................................... Unrealized Holding Gain or Loss—Income........... Call Option ($240–$180)...................................
(c)
December 31, 2014 Unrealized Holding Gain or Loss—Income........... Call Option ($2 X 200) ...................................... Unrealized Holding Gain or Loss—Income........... Call Option ($180 – $65)...................................
(d)
January 4, 2015 Call Option ($1 X $200)........................................... Unrealized Holding Gain or Loss—Income....
240 240 1,400 1,400 60 60 400 400 115 115 200 200
Unrealized Holding Gain or Loss—Income........... Call Option ($65 – $30).....................................
35
Cash (200 X $6) ....................................................... Loss on Settlement of Call Option ........................ Call Option* ......................................................
1,200 30
*Value of Call Option at Settlement: Call Option 240 1,400 60 200 400 115 35 1,230
35
1,230
*PROBLEM 17-14
(a)
(b)
(c)
(d)
July 7, 2014 Put Option ................................................................ Cash ...................................................................
240
September 30, 2014 Unrealized Holding Gain or Loss—Income............ Put Option ($240 – $125)...................................
115
December 31, 2014 Unrealized Holding Gain or Loss—Income............ Put Option ($125 – $50).....................................
75
January 31, 2015 Loss on Settlement of Put Option .......................... Put Option ($50 – $0) ........................................
50
240
115
75
50
*PROBLEM 17-15
(a)
(b)
January 7, 2014 Put Option ............................................................... Cash.................................................................. March 31, 2014 Put Option ............................................................... Unrealized Holding Gain or Loss—Income ($5 X 400) ....................................................... Unrealized Holding Gain or Loss—Income........... Put Option ($360 – $200) .................................
(c)
June 30, 2014 Unrealized Holding Gain or Loss—Income........... Put Option ($2 X 400) ....................................... Unrealized Holding Gain or Loss—Income........... Put Option ($200 – $90) ...................................
(d)
July 6, 2014 Put Option ($5 X $400)............................................ Unrealized Holding Gain or Loss—Income....
360 360 2,000 2,000 160 160 800 800 110 110 2,000 2,000
Unrealized Holding Gain or Loss—Income........... Put Option ($90 – $25) .....................................
65
Cash (400 X $8) ....................................................... Loss on Settlement of Put Option ......................... Put Option* .......................................................
3,200 25
*Value of Put Option at settlement: Put Option 360 2,000 160 2,000 800 110 65 3,225
65
3,225
*PROBLEM 17-16
(a)
(1) No entry necessary at the date of the swap because the fair value of the swap at inception is zero. (2)
June 30, 2015 Interest Expense...................................................... 400,000 Cash (8% X $10,000,000 X 1/2) ...................... 400,000
(3)
June 30, 2015 Cash ..................................................................... Interest Expense ............................................
Swap receivable (8% X $10,000,000 X 1/2) ........ Payable at LIBOR (7% X 10,000,000 X 1/2) ........ Cash settlement ..................................................
(b)
50,000 50,000 Interest Received (Paid) $ 400,000 (350,000) 50,000
(4)
June 30, 2015 Notes Payable .......................................................... 200,000 Unrealized Holding Gain or Loss—Income.. 200,000
(5)
June 30, 2015 Unrealized Holding Gain or Loss—Income .......... 200,000 Swap Contract................................................
Financial statement presentation as of December 31, 2014 Balance Sheet Liabilities Notes Payable $10,000,000 Income Statement No effect
200,000
*PROBLEM 17-16 (Continued) (c)
Financial statement presentation as of June 30, 2015 Balance Sheet Liabilities Notes payable $ 9,800,000 Swap contract 200,000 Income Statement Interest expense Unrealized holding gain— notes payable Unrealized holding loss— swap contract Total
(d)
$
350,000 ($400,000 – $50,000)
$
200,000
$
(200,000) 0
Financial statement presentation as of December 31, 2015 Balance Sheet Assets Swap contract $ 60,000 Liabilities Notes payable 10,060,000 Income Statement Interest expense First six months Next six months Total Unrealized holding gain— swap contract Unrealized holding loss— notes payable Total *Swap receivable (8% X 10,000,000 X 1/2) Payable at LIBOR (7.5% X 10,000,000 X 1/2) Cash settlement Interest expense unadjusted June 30–December 31, 2015 Cash settlement
$ $
350,000 [as shown in (c)] 375,000* (see below) 725,000
$
60,000
$
(60,000) 0
$
400,000
$
375,000 25,000
$ $
400,000 (25,000) 375,000
*PROBLEM 17-17
(a)
April 1, 2014 Memo entry to indicate entering into the futures contract.
(b)
June 30, 2014 Futures Contract..................................................... Unrealized Holding Gain or Loss— Equity [($310 – $300) X 500 ounces] ............
(c)
(d)
September 30, 2014 Futures Contract..................................................... Unrealized Holding Gain or Loss— Equity [($315 – $310) X 500 ounces] ............ October 10, 2014 Inventory ................................................................. Cash ($315 X 500 ounces) ............................... Cash......................................................................... Futures Contract [($315 – $300) X 500 ounces]........................
(e)
December 20, 2014 Cash......................................................................... Sales Revenue..................................................
5,000 5,000 2,500 2,500 157,500 157,500 7,500 7,500
350,000 350,000
Cost of Goods Sold ................................................ Inventory...........................................................
200,000
Unrealized Holding Gain or Loss—Equity ............ Cost of Goods Sold ($5,000 + $2,500).............
7,500
200,000 7,500
*PROBLEM 17-17 (Continued) (f)
LEW JEWELRY COMPANY Partial Balance Sheet At June 30, 2014 Current Assets Futures contract.................................................................
$5,000
Stockholders’ Equity Accumulated other comprehensive income ....................
$5,000
There are no income effects associated with this anticipated transaction in the quarter ended June 30, 2014. (g)
LEW JEWELRY COMPANY Income Statement For the Quarter Ended December 30, 2014 Sales revenue..................................................................... Cost of goods sold............................................................. Gross profit ................................................................
$350,000 192,500* $157,500
*Cost of inventory .............................................................. Less: Futures contract adjustment................................... Cost of goods sold.............................................................
$200,000 (7,500) $192,500
*PROBLEM 17-18
(a)
(1)
November 3, 2014 Equity Investments (available-for-sale) .......... Cash (4,000 X $50) ...................................... Put Option......................................................... Cash.............................................................
(2)
(3)
(4)
December 31, 2014 Unrealized Holding Gain or Loss—Income .... Put Option ($600 – $375) ............................ March 31, 2015 Unrealized Holding Gain or Loss—Income .... Fair Value Adjustment (available-for-sale) [($50 – $45) X 4,000].................................
200,000 200,000 600 600 225 225
20,000 20,000
Put Option......................................................... Unrealized Holding Gain or Loss—Income [($50 – $45) X 4,000].................................
20,000
Unrealized Holding Gain or Loss—Income .... Put Option ($375 – $175) ............................
200
June 30, 2015 Unrealized Holding Gain or Loss—Income .... Fair Value Adjustment (available-for-sale) [($45 – $43) X 4,000].................................
20,000 200 8,000 8,000
Put Option......................................................... Unrealized Holding Gain or Loss— Income [($45 – $43) X 4,000] ...................
8,000
Unrealized Holding Gain or Loss—Income .... Put Option ($175 – $40) ..............................
135
8,000 135
*PROBLEM 17-18 (Continued) (5)
(b)
July 1, 2015 Cash ($7 X 4,000) ............................................. Loss on Settlement of Put Option .................. Put Option...................................................
28,000 40 28,040
Cash ($43 X 4,000) ........................................... Loss on Sale of Investments........................... Equity Investments (available-for-sale) ....
172,000 28,000
Fair Value Adjustment (available-for-sale)..... Unrealized Holding Gain or Loss— Income......................................................
28,000
200,000
28,000
SPRINKLE COMPANY Partial Balance Sheet At December 31, 2014 Assets Equity Investments (available-for-sale).................. Put option .................................................................
$200,000 375
SPRINKLE COMPANY Income Statement For the Year Ended December 31, 2014 Other Income (Loss) Unrealized holding loss—put option ..............
$ $
(225) (225)
*PROBLEM 17-18 (Continued) (c)
SPRINKLE COMPANY Partial Balance Sheet At June 30, 2015 Assets Equity Investments (available-for-sale) ...................... Put Option.....................................................................
$172,000 28,040*
SPRINKLE COMPANY Partial Income Statement For Six Months Ended June 30, 2015 Other Income (Loss) Unrealized holding loss (available-for-sale investment)........................ Unrealized holding gain (put option) .................. *Put Option 600 225 20,000 200 8,000 135 28,040
$(28,000) $ 27,665 $ (335)
TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 17-1 (Time 25–30 minutes) Purpose—To provide the student with an opportunity to discuss the issues raised by FASB in determining the accounting for investments in certain debt and equity securities. For example, the proper accounting for the reclassification of securities from trading to available-for-sale must be discussed. Four other situations involving debt and equity securities investments must be addressed. CA 17-2 (Time 25–30 minutes) Purpose—To provide the student with an opportunity to discuss the justification for using fair value as a basis for reporting equity securities. In addition, a number of computations are necessary to determine whether the company properly applied the reporting provisions for investments in certain debt and equity securities. CA 17-3 (Time 20–30 minutes) Purpose—To provide the student with an understanding of the accounting applications dealing with investments in equity securities. This case involves three independent situations for which the student is required to discuss the effects upon classification, carrying value, and earnings. CA 17-4 (Time 15–25 minutes) Purpose—To allow the student to discuss the equity method of accounting for investments and to provide rationale for this method of accounting. CA 17-5 (Time 25–35 minutes) Purpose—To provide the student with an opportunity to discuss the equity method of accounting and provide rationale in a memorandum. CA 17-6 (Time 25–35 minutes) Purpose—To provide the student an opportunity to examine the ethical issues related to fair value accounting.
SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 17-1 Situation 1
GAAP requires that securities which are classified as trading securities be reported on the balance sheet at their fair value amount. Any changes in the fair value of trading securities from one period to another are included in earnings. Therefore, the $4,200 decrease will be reported on the income statement as an unrealized holding loss.
Situation 2
The security should be reported in the available-for-sale category at the current fair value. The transfer of the security affects earnings because the unrealized loss at the date of transfer is recognized in the income statement.
Situation 3
The reclassification does not affect earnings and the available-for-sale security will continue to be reported at its fair value.
Situation 4
When a reduction in the fair value of a security is considered to be an impairment, the new cost basis of the security is its fair value. The security is written down to the fair value amount and the loss is included in earnings. In this case, the fair value of the security at the end of the prior year is the new cost basis. However, since the security is classified as available-for-sale, the fair value at the end of the current year is reported on the balance sheet. Therefore, the increase in fair value will not affect earnings but instead is reported as other comprehensive income and as a separate component of stockholders’ equity.
Situation 5
The securities would be classified as available-for-sale securities since management’s intention is neither to hold the securities for the entire term nor to sell the securities in the near future (less than 3 months). Available-for-sale securities are reported on the balance sheet at the fair value. The unrealized holding loss of $7,700 is excluded from earnings and instead is reported as other comprehensive income and as a separate component of stockholders’ equity.
CA 17-2 (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 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.
CA 17-2 (Continued) (b)
Lexington Company should record the following journal entry and then report the following amounts on its balance sheet. December 31, 2014 Unrealized Holding Gain or Loss—Equity ..................................... Fair Value Adjustment (available-for-sale)...........................
1,100 1,100
Balance Sheet—December 31, 2014 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, Lexington 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, Lexington should have recorded a $300 ($9,200 – $9,500) loss on investments as follows: Cash............................................................................................. Loss on Sale of Investments......................................................... Equity Investments (available-for-sale) ...............................
(d)
9,200 300 9,500
December 31, 2015 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 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 Greenspan Corp. stock Tinkers Company stock Total of portfolio Previous fair value adjustment balance—Cr. Fair value adjustment—Dr.
Cost $20,000 20,000 $40,000
Fair Value $19,900 20,500 $40,400
Unrealized Gain (Loss) $ (100) 500 $ 400 (1,100) $1,500
CA 17-3 Situation 1
The carrying value of the trading investment will be the fair value on the date of the transfer. The unrealized holding loss, the difference between the current fair value and the cost, will be recognized immediately.
Situation 2
When a decrease in the fair value of a security is considered to be other than temporary, an impairment in the value of the security has occurred. As a result, the security is written down to the fair value and this becomes the new cost basis of the security. The security is reported on the balance sheet at its current fair value. The amount of the write-down is included in earnings as a realized loss.
Situation 3
Both the portfolio of trading securities and the portfolio of available-for-sale securities are reported at their fair value. The $13,500 decrease in fair value of the trading portfolio is recorded in the unrealized holding loss account and is included in earnings for the period. The $28,600 increase in fair value of the available-for-sale portfolio is recorded in the unrealized holding gain account and is not included in earnings for the period. Instead, the unrealized holding gain is shown as other comprehensive income and as a separate component of stockholders’ equity.
CA 17-4 Since Fontaine Company purchased 40% of Knoblett Company’s outstanding stock, Fontaine is considered to have significant influence over Knoblett Company. Therefore, Fontaine will account for this investment using the equity method. The investment is reported on the December 31 balance sheet as a long-term investment. The account balance includes the initial purchase price plus 40% of Knoblett’s net income since the acquisition date of July 1, 2015. The investment account balance will be reduced by 40% of the cash dividends paid by Knoblett’s. The cash dividends represent a return of Fontaine’s investment and, therefore, the investment account is reduced. The income statement will report the 40% of Knoblett’s net income received by Fontaine as investment income. Equity Investments (Knoblett Co.) 40% of cash dividends Cost of investment received from Knoblett 40% of Knoblett’s income since 7/1/15
CA 17-5 Memo on accounting treatment to be accorded Investment in Spoor Corporation: Selig Company should follow the equity method of accounting for its investment in Spoor Corporation because Selig Company is presumed to be able to exercise significant influence over the operating and financial policies of Spoor Corporation due to the size of its investment (40%). In 2014, Selig Company should report its interest in Spoor Corporation’s outstanding capital stock as a long-term investment. Following the equity method of accounting, Selig Company should record the cash purchase of 40 percent of Spoor Corporation at acquisition cost. Forty percent of Spoor Corporation’s total net income from July 1, 2014, to December 31, 2014, should be added to the carrying amount of the investment in Selig Company’s balance sheet and shown as revenue in its income statement to recognize Selig Company’s share of the net income of Spoor Corporation 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.
CA 17-5 (Continued) The cash dividends paid by Spoor Corporation to Selig Company should reduce the carrying amount of the investment in Selig Company’s balance sheet and have no effect on Selig Company’s income statement.
CA 17-6 (a)
Classifying the securities as they propose will indeed have the effect on net income that they say it will. Classifying all the gains as trading securities will cause all the gains to flow through the income statement this year and classifying the losses as available-for-sale and held-to-maturity will defer the losses from this year’s income statement. Classifying the gains and losses just the opposite will have the opposite effect.
(b)
What each proposes is unethical since it is knowingly not in accordance with GAAP. The financial statements are fraudulently, not fairly, stated. The affected stakeholders are other members of the company’s officers and directors, company employees, the independent auditors (who may detect these misstatements), the stockholders, and prospective investors.
(c)
The act of selling certain securities (those with gains or those with losses) is management’s choice and is not per se unethical. Generally accepted accounting principles allow the sale of selected securities so long as the inventory method of assigning cost adopted by the company is consistently applied. If the officers act in the best interest of the company and its stakeholders, and in accordance with GAAP, and not in their self-interest, their behavior is probably ethical. Knowingly engaging in unsound and poor business and accounting practices that waste assets or that misstate financial statements is unethical behavior.
FINANCIAL REPORTING PROBLEM (a)
P&G does not separately report investment balances in 2011. Investment securities consist of readily marketable debt and equity securities. Unrealized gains or losses are charged to earnings for investments classified as trading. Unrealized gains or losses on securities classified as available-for-sale are generally recorded in shareholders’ equity. If an available-for-sale security is other than temporarily impaired, the loss is charged to either earnings or shareholders’ equity depending on our intent and ability to retain the security until we recover the full cost basis and the extent of the loss attributable to the creditworthiness of the issuer. Investments in certain companies over which we exert significant influence, but do not control the financial and operating decisions, are accounted for as equity method investments and are classified as other noncurrent assets. Other investments that are not controlled, and over which we do not have the ability to exercise significant influence, are accounted for under the cost method. Both equity and cost method investments are included as noncurrent assets in the balance sheet.
(b)
Certain financial instruments are required to be recorded at fair value. Changes in assumptions or estimation methods could affect the fair value estimates; however, we do not believe any such changes would have a material impact on our financial condition, results of operations or cash flows. Other financial instruments, including cash equivalents, other investments and short-term debt, are recorded at cost, which approximates fair value. The fair values of long-term debt and derivative instruments are disclosed in Note 4 and Note 5, respectively.
FINANCIAL REPORTING PROBLEM (Continued) (c)
According to Note 5, As a multinational company with diverse product offerings, we are exposed to market risks, such as changes in interest rates, currency exchange rates and commodity prices. We evaluate exposures on a centralized basis to take advantage of natural exposure netting and correlation. To the extent we choose to manage volatility associated with the net exposures, we enter into various financial transactions which we account for using the applicable accounting guidance for derivative instruments and hedging activities. These financial transactions are governed by our policies covering acceptable counterparty exposure, instrument types and other hedging practices. At inception, we formally designate and document qualifying instruments as hedges of underlying exposures. We formally assess, both at inception and at least quarterly, whether the financial instruments used in hedging transactions are effective at offsetting changes in either the fair value or cash flows of the related underlying exposure. Fluctuations in the value of these instruments generally are offset by changes in the fair value or cash flows of the underlying exposures being hedged. This offset is driven by the high degree of effectiveness between the exposure being hedged and the hedging instrument. The ineffective portion of a change in the fair value of a qualifying instrument is immediately recognized in earnings. The amount of ineffectiveness recognized is immaterial for all periods presented. Credit Risk Management We have counterparty credit guidelines and generally enter into transactions with investment grade financial institutions. Counterparty exposures are monitored daily and downgrades in credit rating are reviewed on a timely basis. Credit risk arising from the inability of a counterparty to meet the terms of our financial instrument contracts generally is limited to the amounts, if any, by which the counterparty’s obligations to us exceed our obligations to the counterparty.
FINANCIAL REPORTING PROBLEM (Continued) We have not incurred and do not expect to incur material credit losses on our risk management or other financial instruments. Certain of the Company’s financial instruments used in hedging transactions are governed by industry standard netting agreements with counterparties. If the Company’s credit rating were to fall below the levels stipulated in the agreements, the counterparties could demand either collateralization or termination of the arrangement. The aggregate fair value of the instruments covered by these contractual features that are in a net liability position as of June 30, 2011 was $143 million. The Company has never been required to post any collateral as a result of these contractual features. Interest Rate Risk Management Our policy is to manage interest cost using a mixture of fixed-rate and variable-rate debt. To manage this risk in a cost-efficient manner, we enter into interest rate swaps in which we agree to exchange with the counterparty, at specified intervals, the difference between fixed and variable interest amounts calculated by reference to an agreed upon notional amount. Interest rate swaps that meet specific accounting criteria are accounted for as fair value and cash flow hedges. There were no fair value hedging instruments at June 30, 2011 or June 30, 2010. For cash flow hedges, the effective portion of the changes in fair value of the hedging instrument is reported in other comprehensive income (OCI) and reclassified into interest expense over the life of the underlying debt. The ineffective portion, which is not material for any year presented, is immediately recognized in earnings. Foreign Currency Risk Management We manufacture and sell our products in a number of countries throughout the world and, as a result, are exposed to movements in foreign currency exchange rates. The purpose of our foreign currency hedging program is to manage the volatility associated with short term changes in exchange rates.
FINANCIAL REPORTING PROBLEM (Continued) To manage this exchange rate risk, we have historically utilized a combination of forward contracts, options and currency swaps. As of June 30, 2011, we had currency swaps with maturities up to five years, which are intended to offset the effect of exchange rate fluctuations on intercompany loans denominated in foreign currencies and are therefore accounted for as cash flow hedges. The Company has also utilized forward contracts and options to offset the effect of exchange rate fluctuations on forecasted sales, inventory purchases and intercompany royalties denominated in foreign currencies. The effective portion of the changes in fair value of these instruments is reported in OCI and reclassified into earnings in the same financial statement line item and in the same period or periods during which the related hedged transactions affect earnings. The ineffective portion, which is not material for any year presented, is immediately recognized in earnings. The change in value of certain non-qualifying instruments used to manage foreign exchange exposure of intercompany financing transactions, income from international operations and other balance sheet items subject to revaluation is immediately recognized in earnings, substantially offsetting the foreign currency mark-to-market impact of the related exposure. Net Investment Hedging We hedge certain net investment positions in major foreign subsidiaries. To accomplish this, we either borrow directly in foreign currencies and designate all or a portion of foreign currency debt as a hedge of the applicable net investment position or enter into foreign currency swaps that are designated as hedges of our related foreign net investments. Changes in the fair value of these instruments are immediately recognized in OCI to offset the change in the value of the net investment being hedged. Currency effects of these hedges reflected in OCI were an after-tax loss of $1,176 in 2011 and $789 gain in 2010. Accumulated net balances were after-tax losses of $4,446 and a $3,270 as of June 30, 2011 and 2010, respectively.
FINANCIAL REPORTING PROBLEM (Continued) Commodity Risk Management Certain raw materials used in our products or production processes are subject to price volatility caused by weather, supply conditions, political and economic variables and other unpredictable factors. To manage the volatility related to anticipated purchases of certain of these materials, we use futures and options with maturities generally less than one year and swap contracts with maturities up to five years. These market instruments generally are designated as cash flow hedges. The effective portion of the changes in fair value for these instruments is reported in OCI and reclassified into earnings in the same financial statement line item and in the same period or periods during which the hedged transactions affect earnings. The ineffective and non-qualifying portions, which are not material for any year presented, are immediately recognized in earnings.
COMPARATIVE ANALYSIS CASE THE COCA-COLA COMPANY and PEPSICO, INC. (a) (1) (2) (3)
Cash used in investing activities Cash used for acquisitions and investments Total investment in unconsolidated affiliates at 12/31/11
Coca-Cola $(2,524)
PepsiCo $(5,618)
$ (977)
$(3,193)
$ 1,141
$ 1,477
(b) (1) Coca-Cola reported the $7,233 million of equity investments on its December 31, 2011 balance sheet. (2) Coca-Cola reported “other method investments, principally bottling companies” in the amount of $1,141 million in its December 31, 2011 balance sheet. (c)
At December 31, 2011, Coca-Cola reported in its Note 3 on Investments the following: December 31, 2011 (in millions)
Cost
Gross Unrealized Gains
Gross Unrealized Estimated Fair Value Losses
Trading securities Available-for-sale securities
$211 $1,166
$238
$(3)
$1,401
Held-to-maturity securities
$111
—
—
$111
FINANCIAL STATEMENT ANALYSIS CASE UNION PLANTERS (a) While banks are primarily in the business of lending money, they also need to balance their asset portfolio by investing in other assets. For example, a bank may have excess cash that it has not yet loaned, which it wants to invest in very short-term liquid assets. Or it may believe that it can earn a higher rate of interest by buying long-term bonds than it can currently earn by making new loans. Or it may purchase investments for short-term speculation because it believes these investments will appreciate in value. (b) Trading securities are shown on the balance sheet at current fair value, and any unrealized gains and losses resulting from reporting them at fair value are reported as part of income. Available-for-sale securities are reported on the balance sheet at their fair value, and any unrealized gains and losses resulting from reporting them at fair value are reported as other comprehensive income and as a separate component of stockholders’ equity until realized. Held-to-maturity securities are reported at their amortized cost; that is, they are not reported at fair value. Note that Union Planters has no held-to-maturity securities. (c) Securities are reported in three different categories because these three different categories reflect the likelihood that any unrealized gains and losses will eventually be realized by the company. That is, trading securities are held for a short period; thus, if the bank has an unrealized gain on its trading security portfolio, it is likely that these securities will be sold soon and the gain will be realized. On the other hand, available-for-sale securities are not going to be sold for a longer period of time; thus, unrealized gains on these securities may not be realized for several years. If securities were all grouped into a single category, the investor would not be aware of these differences in the probability of realization.
FINANCIAL STATEMENT ANALYSIS CASE (Continued) (d) The answer to this involves selling your “winner” stocks in your availablefor-sale portfolio at year-end. Union Planters could have increased reported net income by $108 million (clearly, a material amount when total reported income was $224 million). Management chose not to sell these securities because at the time it must have felt that either the securities had additional room for price appreciation, or it didn’t want to pay the additional taxes that would be associated with a sale at a gain, or it wanted to hold the securities because they were needed to provide the proper asset balance in its management of its total asset portfolio, or it would prefer to report the gain in the following year.
ACCOUNTING, ANALYSIS, AND PRINCIPLES Accounting (a)
Instar’s investment in Dorsel Corp. bonds should be classified as held-to-maturity because they have a specific maturity date and Instar has the intent and ability to hold them until the maturity date. Instar’s investment of idle cash in equity securities should be classified as trading. Instar’s investment in its supplier should be classified as an availablefor-sale security. Instar does not intend to sell it in the short term and thus the investment does not qualify for classification as trading. Instar’s ownership stake is far less than 20%, and there is no evidence that Instar can exert significant influence over the supplier, so the investment does not qualify for classification as an equity method investment. For similar reasons, Instar’s investment in Forter Corp. stock should be classified as available-for-sale. Instar’s investment in Slobbaer Co. common stock should be classified as an equity method investment because its holdings are greater than 20% and Instar exerts significant influence over Slobbaer.
(b)
Fair Value Adjustment (trading) ................................ Unrealized Holding Gain or Loss—Income ..... (To record the increase in value of the trading securities, $920,000 – $800,000)
120,000
Fair Value Adjustment (available-for-sale) ............... Unrealized Holding Gain or Loss—Equity....... (To record the increase in the value of the investment in the supplier, $1,550,000 – $1,200,000)
350,000
Loss on Impairment ................................................... Equity Investments (available-for-sale) ........... (To record the other-than-temporary decline In value of the investment in Forter Co. $50,000 – $200,000)
150,000
120,000
350,000
150,000
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) Equity Investments (Slobbaer) .................................. Investment Income............................................ (To record income on the equity method, $300,000 X 25% = $75,000)
75,000
Cash ............................................................................ Equity Investments (Slobbaer)......................... (To record dividends received from equity-method investee, $100,000 X 25% = $25,000
25,000
75,000
25,000
Analysis The total effect on net income is $120,000 – $150,000 + $75,000 = $45,000. Note that the gain on the available-for-sale securities is a component of other comprehensive income, not net income reported on Instar’s income statement. Note also that the equity method dividends received reduce the balance sheet value of the investment and are not recorded as revenue or income. Principles The rationale for reporting held-to-maturity securities at amortized cost is that if management intends to hold the securities to maturity, fair values are not relevant for evaluating the cash flows associated with these securities. On the other hand, if the securities are trading or available-for-sale, they may be sold before maturity or have such short maturities that information on their fair value is relevant for determining future cash flows. When a company exercises significant influence over the operations of another company, it is argued that the investor company should use the equity method of accounting. The rationale for this measurement basis is that the investor company should report the net income at the time the investee company earns it. Under the fair value method for available-forsale securities, the company does not report income until it receives a dividend or sells the security (although it can increase or decrease other comprehensive income).
PROFESSIONAL RESEARCH (a)
According to FASB ASC 320-10: 15-5 The guidance in the Investments—Debt and Equity Securities Topic establishes standards of financial accounting and reporting for both of the following: a.
Investments in equity determinable fair values
securities
that
have
readily
b.
All investments in debt securities, including debt instruments that have been securitized.
Readily Determinable Fair Value (FASB ASC 320-10-20 Glossary) An equity security has a readily determinable fair value if it meets any of the following conditions: a. The fair value of an equity security is readily determinable if sales prices or bid-and-asked quotations are currently available on a securities exchange registered with the U.S. Securities and Exchange Commission (SEC) or in the over-the-counter market, provided that those prices or quotations for the over-the-counter market are publicly reported by the National Association of Securities Dealers Automated Quotations systems or by Pink Sheets LLC. Restricted stock meets that definition if the restriction terminates within one year. b. The fair value of an equity security traded only in a foreign market is readily determinable if that foreign market is of a breadth and scope comparable to one of the U.S. markets referred to above. c. The fair value of an investment in a mutual fund is readily determinable if the fair value per share (unit) is determined and published and is the basis for current transactions.
PROFESSIONAL RESEARCH (Continued) (b)
See FASB ASC 320-10-35 35-18 For individual securities classified as either available for sale or held to maturity, an entity shall determine whether a decline in fair value below the amortized cost basis is other than temporary. Providing a general allowance for unidentified impairment in a portfolio of securities is not appropriate. 35-30 If the fair value of an investment is less than its amortized cost basis at the balance sheet date of the reporting period for which impairment is assessed, the impairment is either temporary or other than temporary. In addition to the guidance in this Section, an entity shall apply other guidance that is pertinent to the determination of whether an impairment is other than temporary, such as the guidance in Section 325-4035, as applicable. Other than temporary does not mean permanent.
(c)
See FASB ASC 320-10-25 25-14 Sales of debt securities that meet either of the following conditions may be considered as maturities for purposes of the classification of securities and the disclosure requirements under this Subtopic: 1. The sale of a security occurs near enough to its maturity date (or call date if exercise of the call is probable) that interest rate risk is substantially eliminated as a pricing factor. That is, the date of sale is so near the maturity or call date (for example, within three months) that changes in market interest rates would not have a significant effect on the security’s fair value. 2. The sale of a security occurs after the entity has already collected a substantial portion (at least 85 percent) of the principal outstanding at acquisition due either to prepayments on the debt security or to scheduled payments on a debt security payable in equal installments (both principal and interest) over its term. For variable-rate securities, the scheduled payments need not be equal.
PROFESSIONAL RESEARCH (Continued) (d)
See FASB ASC 320-10-50 50-10 For any sales of or transfers from securities classified as heldto-maturity, an entity shall disclose all of the following in the notes to the financial statements for each period for which the results of operations are presented: 1. The net carrying amount of the sold or transferred security 2. The net gain or loss in accumulated other comprehensive income for any derivative that hedged the forecasted acquisition of the held-to-maturity security 3. The related realized or unrealized gain or loss 4. The circumstances leading to the decision to sell or transfer the security. (Such sales or transfers should be rare, except for sales and transfers due to the changes in circumstances identified in paragraph 320-10-25-6(a) through (f).)
PROFESSIONAL SIMULATION Note: This assignment is available on the Kieso website. Journal Entries (a)
Debt Investments (available-for-sale) .................. Interest Revenue ($50,000 X .12 X 4/12) ............... Investments.......................................................
187,400* 2,000 189,400
*($37,400 + $100,000 + $50,000) (b)
December 31, 2014 Interest Receivable................................................ Interest Revenue............................................... **Accrued interest: $50,000 X .12 X 10/12 = Accrued interest: $100,000 X .11 X 3/12 =
Measurement
7,750 7,750** $5,000 2,750 $7,750
PROFESSIONAL SIMULATION (Continued) Explanation If Powerpuff owns 30%, it will use the equity method to account for the investment. As a result, this investment would not be reported at fair value and there would be no unrealized holding gains or losses. Under the equity method, the investment carrying amount is periodically increased (decreased) by the investor’s proportionate share of the earnings (losses) of the investor and decreased by all dividends received by the investor from the investee.
IFRS CONCEPTS AND APPLICATION IFRS17-1 The accounting for investment securities is discussed in IAS 27 (“Consolidated and Separate Financial Statements”), IAS 28 (“Accounting for Investments in Associates”), IAS 39 (“Financial Instruments: Recognition and Measurement”), and IFRS 9 (“Financial Instruments”). IFRS17-2 GAAP classifies investments as trading, available-for-sale (both debt and equity investments), and held-to-maturity (debt investments). IFRS uses heldfor-collection (debt investments), trading (both debt and equity investments), and non-trading equity investment classifications. The accounting for trading investments is the same between GAAP and IFRS. Held-to-maturity (GAAP) and held-for-collection (IFRS) investments are accounted for at amortized cost. Gains and losses related to available-for-sale (GAAP) and non-trading equity investments (IFRS) are reported in other comprehensive income. Both GAAP and IFRS use the same test to determine whether the equity method of accounting should be used—that is, significant influence with a general guide of over 20 percent ownership. The basis for consolidation under IFRS is control. Under GAAP, a bipolar approach is used, which is a risk-and-reward model (often referred to as a variable-entity approach) and a voting interest approach. However, under both systems, for consolidation to occur, the investor company must generally own 50 percent of another company. GAAP and IFRS are similar in the accounting for the fair value option. That is, the option to use the fair value method must be made at initial recognition, the selection is irrevocable, and gains and losses are reported as part of income. One difference is that GAAP permits the fair value option for equity method investments. While measurement of impairments is similar, GAAP does not permit the reversal of an impairment charge related to available-for-sale debt and equity investments. IFRS allows reversals of impairments for held-for-collection investments.
IFRS17-3 The two criteria for determining the valuation of financial assets are the (1) company’s business model for managing their financial assets and (2) contractual cash flow characteristics of the financial asset. IFRS17-4 Only debt investments such as loans and bond investments are valued at amortized cost. A company should use amortized cost if it has a business model whose objective is to hold assets in order to collect contractual cash flows and the contractual terms of the financial asset gives specified dates to cash flows. IFRS17-5 Lady Gaga should classify this investment as a trading investment because companies frequently buy and sell this type of investment to generate profits in short term differences in price. IFRS17-6 If Lady Gaga plans to hold the investment to collect interest and receive the principal at maturity, it should account for this investment at amortized cost. IFRS17-7 Unrealized holding gains and losses for trading investments should be included in net income for the current period. Unrealized holding gains and losses are not recognized for held-for-collection investments. IFRS17-8 (a)
Under U.S. GAAP, Ramirez makes no entry, because impaired investments may not be written up if they recover in value.
(b)
Under IFRS, Ramirez makes the following entry: Debt Investments ............................................. Recovery of Impairment Loss ................
300,000 300,000
IFRS17-9 (a) Debt Investments.................................................... Cash .................................................................
65,118
(b) Cash ($60,000 X .08 X 6/12) .................................... Debt Investments ............................................ Interest Revenue ($65,118 X .06 X 6/12).........
2,400
65,118 446 1,954
IFRS17-10 (a) Equity Investments................................................. Cash .................................................................
13,200
(b) Cash......................................................................... Dividend Revenue (400 X $3.25).....................
1,300
(c) Fair Value Adjustment............................................ Unrealized Holding Gain or Loss—Income [(400 X $34.50) – $13,200]............................
600
13,200 1,300
600
IFRS17-11 (a) Equity Investments................................................. Cash .................................................................
13,200
(b) Cash......................................................................... Dividend Revenue (400 X $3.25).....................
1,300
(c) Fair Value Adjustment............................................ Unrealized Holding Gain or Loss— Equity [(400 X $34.50) – $13,200]................
600
13,200
1,300
600
IFRS17-12 (a)
January 1, 2014 Debt Investments .................................................. 537,907.40 Cash ...........................................................
(b)
537,907.40
Schedule of Interest Revenue and Bond Premium Amortization 12% Bonds Sold to Yield 10% Date 1/1/14 12/31/14 12/31/15 12/31/16 12/31/17 12/31/18
Cash Received — $60,000 60,000 60,000 60,000 60,000
Interest Revenue — $53,790.74 53,169.81 52,486.80 51,735.48 50,909.77*
Premium Amortized — $6,209.26 6,830.19 7,513.20 8,264.52 9,090.23
Carrying Amount of Bonds $537,907.40 531,698.14 524,867.95 517,354.75 509,090.23 500,000.00
*Rounded by 75¢. (c)
December 31, 2014 Cash................................................................... Debt Investments ...................................... Interest Revenue .......................................
(d)
60,000.00 6,209.26 53,790.74
December 31, 2015 Cash................................................................... Debt Investments ...................................... Interest Revenue .......................................
60,000.00 6,830.19 53,169.81
IFRS17-13 (a)
January 1, 2014 Debt Investments .................................................. 537,907.40 Cash ...........................................................
537,907.40
IFRS17-13 (Continued) (b)
December 31, 2014 Cash...................................................................... Debt Investments ......................................... Interest Revenue ($537,907.40 X .10) ..........
60,000.00
Fair Value Adjustment......................................... Unrealized Holding Gain or Loss— Income ($534,200.00 – $531,698.14)........
2,501.86
(c)
6,209.26 53,790.74
2,501.86
December 31, 2015 Unrealized Holding Gain or Loss—Income ............ 12,369.81 Fair Value Adjustment ................................. Amortized Cost Debt investments Previous fair value adjustment—Dr. Fair value adjustment—Cr.
Fair Value
12,369.81 Unrealized Gain (Loss)
$524,867.95 $515,000.00 $ (9,867.95) 2,501.86 $(12,369.81)
IFRS17-14 (a) December 31, 2014 Unrealized Holding Gain or Loss—Income........ Fair Value Adjustment .................................
1,400
(b) During 2015 Cash...................................................................... Loss on Sale of Investments .............................. Equity Investments ......................................
9,500 500
1,400
10,000
IFRS17-14 (Continued) (c) December 31, 2015 Investments Stargate Corp. shares Vectorman Co. shares Total of portfolio Previous fair value adjustment balance—Cr. Fair value adjustment—Dr.
Cost $20,000 20,000 $40,000
Fair Value $19,300 20,500 $39,800
Fair Value Adjustment ........................................... Unrealized Holding Gain or Loss— Income .........................................................
Unrealized Gain (Loss) $ (700) 500 (200) (1,400) $ 1,200
1,200 1,200
IFRS17-15 (a) Contractual cash flow [($400,000 X .10 X 3) + $400,000]........................ Expected cash flow................................................ Cash flow loss........................................................
$520,000 (455,000) $ 65,000
Recorded investment ............................................ $400,000 Less: Present value of $350,000 due in 3 years at 10% ($350,000 X .75131) ........................ $262,959 Present value of $35,000 annual interest for 3 years at 10% ($35,000 X 2.48685) .............. 87,040 349,999 Impairment loss ..................................................... $ 50,001 (b)
Loss on Impairment............................................... Debt Investments ...........................................
50,001 50,001
(c) Since Komissarov will now receive the contractual cash flow ($520,000) there is no cash flow loss. Therefore Komissarov must reverse the impairment loss by debiting Debt Investments and crediting Recovery of Impairment Loss.
IFRS17-16 (a)
According to IAS 39, paragraph AG71, “A financial instrument is regarded as quoted in an active market if quoted prices are readily and regularly available from an exchange, dealer, broker, industry group, pricing service or regulatory agency, and those prices represent actual and regularly occurring market transactions on an arm’s length basis.”
(b)
According to IAS 39, paragraph IN22, “The Standard requires that impairment losses on available-for-sale equity instruments cannot be reversed through profit or loss, i.e. any subsequent increase in fair value is recognised in other comprehensive income.” Also, according to paragraph 58, “An entity shall assess at the end of each reporting period whether there is any objective evidence that a financial asset or group of financial assets is impaired. If any such evidence exists, the entity shall apply paragraph 63 (for financial assets carried at amortised cost), paragraph 66 (for financial assets carried at cost) or paragraph 67 (for available-for-sale financial assets) to determine the amount of any impairment loss.”
(c)
According to IFRS 9, paragraph B4.3, Although the objective of an entity’s business model may be to hold financial assets in order to collect contractual cash flows, the entity need not hold all of those instruments until maturity. Thus an entity’s business model can be to hold financial assets to collect contractual cash flows even when sales of financial assets occur. For example, the entity may sell a financial asset if: 1. the financial asset no longer meets the entity’s investment policy (e.g., the credit rating of the asset declines below that required by the entity’s investment policy); 2. an insurer adjusts its investments portfolio to reflect a change in expected duration (i.e., the expected timing of payouts); or 3. an entity needs to fund capital expenditures. However, if more than an infrequent number of sales are made out of a portfolio, the entity needs to assess whether and how such sales are consistent with an objective of collecting contractual cash flows.
IFRS17-17 (a) M&S reports both current and non-current “other financial assets,” along with both current and non-current derivative financial instruments. These investments are reported on the statement of financial position and in the notes to the financial statements. (b) M&S’s investments are valued at fair value for trading and non-trading, while held-for-collection investments are valued at amortized cost. If there is no quoted price in an active market for a security, and the fair value can’t be reliably measured, then the security is held at cost. Derivatives are reported at fair value. (c) M&S uses derivatives to manage its exposure to fluctuations in interest rates and exchange rates.
CHAPTER 18 Revenue Recognition – 2014 Update ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics
Questions
Brief Exercises
1. Current Environment; 5-Step Model.
1, 2, 3, 4, 5, 6
2. Contracts; Contract modifications.
7, 9
1, 3
3. Performance Obligations
10, 11, 12
3, 4, 19, 20
4. Transaction Price
8, 13
Problems
Concepts for Analysis
8
1, 2, 3
1, 2, 3, 4, 17, 18
1, 2
1
5, 8, 9
4, 5
1 5
Exercises
5. Variable Consideration; 8, 14, 15, Time value; Non-Cash 16, 17, 18, consideration, consideration paid to customer
5, 6, 7, 8, 9, 10
6, 7
3, 4, 6, 7, 8, 9
6. Allocate transaction price to 11, 12, performance obligations. 19, 20
2, 8, 11, 12
5, 8, 9, 10
1, 2, 3, 4, 5
7. Satisfying Performance Obligations – transfer control: Returns; repurchases; Bill and Hold; Principal-agent; consignments; Warranties; Upfront fees.
5, 21, 22, 23, 24, 25, 26, 27, 28, 29, 30
13, 14, 15, 16, 17, 18, 20
10, 11, 12, 13, 14, 15, 16
1, 2, 3, 5, 6, 7, 8, 9
8. Presentation, Contract Costs, Collectability.
30, 31, 32, 33
19
17, 18, 19, 20
*9. Long-Term Contracts
34, 35, 36, 37
21, 22, 23
21, 22, 23, 24, 25
10, 11, 12
*10. Franchising.
38
24
26, 27
13
*Material is in the Appendices.
2, 3, 4, 6, 7
1, 2, 6 8
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives
Brief Exercises
1. Understand revenue recognition issues.
Exercises
Problems
1, 2
8
2. Identify the five steps in the revenue recognition model. 3. Identify the contracts with customers.
1, 2, 3
1, 2, 3, 4
2
4. Identify the separate performance obligations in the contract.
2
5, 8, 9, 10
1, 2, 3, 4, 5
5. Determine the transaction price.
4, 5, 6, 7, 8, 9, 10, 11, 12,
1, 2, 5, 6, 7
1, 2, 3, 4, 5, 8, 9, 10
6. Allocate the transaction price to the separate performance obligations.
11, 12
8, 9, 10, 11, 12, 13
1, 2, 3, 4, 5
7. Recognize revenue when the company satisfies its performance obligations.
1, 2, 3, 4, 5
8. Identify other revenue recognition issues.
13, 14, 15, 16, 17, 18
14, 15, 16, 17, 18, 19, 20, 21,
9. Describe presentation and disclosure regarding revenue.
19, 20
22, 23, 24, 25
*10. Apply the percentage-of-completion method for long-term contracts.
21
26, 27, 29, 30
10, 11, 12
*11. Apply the completed-contract method for long-term contracts.
22
26, 28, 29, 30
10, 11, 12
*12. Identify the proper accounting for losses on long-term contracts.
23
*13. Explain revenue recognition for franchises.
24
*Material is in the Appendices.
5, 6, 7, 8, 9, 10
11, 12 31, 32
11, 13
ASSIGNMENT CHARACTERISTICS TABLE Level of Time Difficulty (minutes)
Item
Description
E18-1 E18-2 E18-3 E18-4 E18-5 E18-6 E18-7 E18-8 E18-9 E18-10 E18-11 E18-12 E18-13 E18-14 E18-15 E18-16 E18-17 E18-18 E18-19 E18-20 E18-21 E18-22 E18-23 E18-24 E18-25 *E18-26 *E18-27 *E18-28 *E18-29 *E18-30
Simple Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate Simple Moderate Moderate Simple Simple Moderate Moderate Moderate Simple Simple Moderate Moderate Simple Simple Simple Moderate Moderate Simple Simple Simple Simple
5–10 20–25 20–25 20–25 15–20 15–20 15–20 15–20 25–30 5–10 25–30 25–30 10–15 5–10 15–20 20–25 10–15 10–15 5–10 10–15 15–20 10–15 10–15 10–15 20–25 20–25 10–15 10–15 15–20 15–25
*E18-31 *E18-32
Sales with Discounts. Transaction Price. Contract Modification. Contract Modification Variable Consideration Trailing Commission. Sales with Discounts. Sales with Discounts. Allocate Transaction Price Allocate Transaction Price Allocate Transaction Price. Allocate Transaction Price. Allocate Transaction Price. Sales with Returns. Sales with Returns. Sales with Repurchase. Repurchase Agreement Bill and Hold. Consignment Sales. Warranty Arrangement. Warranty Arrangement. Existence of a Contract. Existence of a Contract. Contract Costs. Contract Costs, Collectability. Recognition of Profit on Long-Term Contracts. Analysis of Percentage-of-Completion Financial Statements. Gross Profit on Uncompleted Contract. Recognition of Revenue on Long-Term Contract and Entries. Recognition of Profit and Balance Sheet Amounts for LongTerm Contracts. Franchise Entries. Franchise fee, initial down payment.
Simple Simple
20–25 15–20
P18-1 P18-2 P18-3 P18-4 P18-5 P18-6 P18-7 P18-8
Allocate Transaction Price, Upfront Fees. Allocate Transaction Price, Modification of Contract. Allocate Transaction Price, Discounts, Time Value. Allocate Transaction Price, Discounts, Time Value. Allocate Transaction Price, Returns, and Consignments Warranty, Customer Loyalty Program. Recognition of Revenue—Bonus Dollars. Comprehensive Three-Part Revenue Recognition.
Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate
30–35 20–25 25–35 35–40 35–40 25–30 30–35 30–45
ASSIGNMENT CHARACTERISTICS TABLE (Continued) Item
Description
Level of Difficulty
Time (minutes)
P18-9 *P18-10 *P18-11 *P18-12 *P18-13
Time Value, Gift cards, Discounts. Recognition of Profit on Long-Term Contract. Long-Term Contract with Interim Loss. Long-Term Contract with an Overall Loss. Franchise Revenue.
Moderate Complex Simple Complex Moderate
30–35 30–40 20–25 40–50 35–45
CA18-1 CA18-2 CA18-3 CA18-4 CA18-5 CA18-6 *CA18-7 *CA18-8 *CA18-9
Five-Step Revenue Model. Satisfying Performance Obligations. Recognition of Revenue—Theory. Recognition of Revenue—Theory. Discounts Recognition of Revenue from Subscriptions. Revenue Recognition—Membership Fees. Revenue Recognition—Membership Fees, Ethics. Long-term Contract—Percentage-of-Completion.
Moderate Moderate Moderate Moderate Moderate Complex Moderate Moderate Moderate
20–30 20–30 25–30 25–30 20–25 35–45 20–25 20–25 20–25
SOLUTIONS TO CODIFICATION EXERCISES CE18-1 (a)
Customer - A user or reseller. A party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration.
(b)
Performance Obligation - A promise in a contract with a customer to transfer to the customer either: a. A good or service (or a bundle of goods or services) that is distinct b. A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.
(c)
Standalone Selling Price - The price at which an entity would sell a promised good or service separately to a customer.
(d)
Transaction Price - The amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties.
CE18-2 According to FASB ASC 606-10-25-15: An entity shall account for a contract modification as a separate contract if both of the following conditions are present: a.
The scope of the contract increases because of the addition of promised goods or services that are distinct (in accordance with paragraphs 606-10-25-18 through 25-22).
b.
The price of the contract increases by an amount of consideration that reflects the entity’s standalone selling prices of the additional promised goods or services and any appropriate adjustments to that price to reflect the circumstances of the particular contract. For example, an entity may adjust the standalone selling price of an additional good or service for a discount that the customer receives, because it is not necessary for the entity to incur the selling-related costs that it would incur when selling a similar good or service to a new customer.
CE18-3 According to FASB ASC 606-10-32-10: Refund Liabilities An entity shall recognize a refund liability if the entity receives consideration from a customer and expects to refund some or all of that consideration to the customer. A refund liability is measured at the amount of consideration received (or receivable) for which the entity does not expect to be entitled (that is, amounts not included in the transaction price). The refund liability (and corresponding change in the transaction price and, therefore, the contract liability) shall be updated at the end of each reporting period for changes in circumstances. To account for a refund liability relating to a sale with a right of return, an entity shall apply the guidance in paragraphs 606-10-55-22 through 55-29.
CE18-4 According to FASB ASC 606-10-32-36 to 38 Allocation of a Discount 36 - A customer receives a discount for purchasing a bundle of goods or services if the sum of the standalone selling prices of those promised goods or services in the contract exceeds the promised consideration in a contract. Except when an entity has observable evidence in accordance with paragraph 606-10-32-37 that the entire discount relates to only one or more, but not all, performance obligations in a contract, the entity shall allocate a discount proportionately to all performance obligations in the contract. The proportionate allocation of the discount in those circumstances is a consequence of the entity allocating the transaction price to each performance obligation on the basis of the relative standalone selling prices of the underlying distinct goods or services. 37 - An entity shall allocate a discount entirely to one or more, but not all, performance obligations in the contract if all of the following criteria are met: a. The entity regularly sells each distinct good or service (or each bundle of distinct goods or services) in the contract on a standalone basis. b. The entity also regularly sells on a standalone basis a bundle (or bundles) of some of those distinct goods or services at a discount to the standalone selling prices of the goods or services in each bundle. c. The discount attributable to each bundle of goods or services described in (b) is substantially the same as the discount in the contract, and an analysis of the goods or services in each bundle provides observable evidence of the performance obligation (or performance obligations) to which the entire discount in the contract belongs. 38 - If a discount is allocated entirely to one or more performance obligations in the contract in accordance with paragraph 606-10-32-37, an entity shall allocate the discount before using the residual approach to estimate the standalone selling price of a good or service in accordance with paragraph 606-10-32-34(c).
ANSWERS TO QUESTIONS 1.
Most revenue transactions pose few problems for revenue recognition. This is because, in many cases, the transaction is initiated and completed at the same time. However, due to the complexity of some transactions, many believe the revenue recognition process is increasingly complex to manage, more prone to error, and more material to financial statements compared to any other area of financial reporting. As a result, the FASB and IASB have indicated that the present state of reporting for revenue is unsatisfactory and the Boards issued a standard, “Revenue from Contracts with Customers,” in 2014. This new standard provides a new approach for how and when companies should report revenue. The standard is comprehensive and applies to all companies. As a result, comparability and consistency in reporting revenue should be enhanced.
2.
GAAP had numerous standards related to revenue recognition, but many believed the standards were often inconsistent with one another.
3.
The revenue recognition principle indicates that revenue is recognized in the accounting period when a performance obligation is satisfied. That is, a company recognizes revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration that it receives, or expects to receive, in exchange for those goods or services.
4.
The five steps in the revenue recognition process are: 1. 2. 3. 4. 5.
Identify the contract(s) with customers. Identify the separate performance obligations in the contract. Determine the transaction price. Allocate the transaction price to the separate performance obligations. Recognize revenue when each performance obligation is satisfied.
5.
Change in control is the deciding factor in determining when a performance obligation is satisfied. Control is transferred when the customer has the ability to direct the use of and obtain substantially all the remaining benefits from the asset or service. Control is also indicated if the customer has the ability to prevent other companies from directing the use of, or receiving the benefit, from the asset or service.
6.
Revenues are recognized generally as follows: (a) Revenue from selling products—date of delivery to customers. (b) Revenue from services performed—when the services have been performed (performance obligation satisfied) and are billable. (c) Revenue from permitting others to use company assets—as time passes or as the assets are used. (d) Revenue from disposing of assets other than products—at the date of sale.
7.
The first step in the revenue recognition process is the identification of a contract or contracts with the customer. A contract is an agreement between two or more parties that creates enforceable rights or obligations. That is, the contract identifies the performance obligations in a revenue arrangement. Contracts can be written, oral, or implied from customary business practice. In some cases, there may be multiple contracts related to the transaction, and accounting for each contract may or may not occur, depending on the circumstances. These situations often develop when not only a product is provided but some type of service is performed as well.
Questions Chapter 18 (Continued) 8.
No entry is required on October 10, 2014, because neither party has performed on the contract. That is, neither party has an unconditional right as of October 10, 2014. On December 15, 2014, Executor delivers the product and therefore should recognize revenue on that date as it satisfied its performance obligation on that date. The journal entry to record the sales revenue and related cost of goods sold is as follows. December 15, 2014 Notes Receivable ............................................... Cash .................................................................. Sales Revenue ........................................
5,000 5,000
Cost of Goods Sold ............................................ Inventory..................................................
6,500
10,000 6,500
9.
A contract modification occurs if a company changes the contract terms during the term of the contract. When a contract is modified, the company must determine whether a new performance obligation has occurred or whether it is a modification of the existing performance obligation. If it is a modification of an existing performance obligation, then the change is generally reported prospectively or as a cumulative effect adjustment to revenue, depending on the circumstances. If the modification results in a separate performance obligation, then this performance obligation should be accounted for separately.
10.
A performance obligation is a promise in a contract to provide a product or service to a customer. This promise may be explicit, implicit, or possibly based on customary business practice. To determine whether a performance obligation exists, the company must determine whether the customer can benefit from the good or service on its own or together with other readily available resources.
11.
To determine whether the company has to account for multiple performance obligations, a company must first provide a distinct good or service on its own or together with other available resources. Once this condition is met, the company next evaluates whether the product or service is distinct within the contract. In other words, if the performance obligation is not highly dependent on, or interrelated with, other promises in the contract, then each performance obligation should be accounted for separately. Conversely if each of these services is interdependent and interrelated, these services are combined and reported as one performance obligation.
12.
In this situation, it appears that Engelhart has two performance obligations: (1) one related to providing the tractor and (2) the other related to the GPS services. Both are distinct (they can be sold separately) and are not interdependent.
13.
The transaction price is the amount of consideration that a company expects to receive from a customer in exchange for transferring goods and services. The transaction price in a contract is often easily obtained because the customer agrees to pay a fixed amount to the company over a short period of time. In other contracts, companies must consider the following factors (1) Variable consideration, (2) Time value of money, (3) Noncash consideration, and (4) Consideration paid or payable to customer.
Questions Chapter 18 (Continued) 14.
Variable consideration (when the price of a good or service is dependent on future events), includes such elements as discounts, rebates, credits, performance bonuses, or royalties. A company estimates the amount of variable consideration it will receive from the contract to determine the amount of revenue to recognize. Companies use either (1) the expected value, which is a probability weighted amount, or (2) the most likely amount in a range of possible amounts to estimate variable consideration. Companies select among these two methods based on which approach better predicts the amount of consideration to which a company is entitled.
15.
The transaction price should include management’s estimate of the amount of consideration to which the entity will be entitled. Given the multiple outcomes and probabilities available based on prior experience, the probability-weighted method is the most predictive approach for estimating the variable consideration. In this situation: 25% chance of $421,000 if by February 1 (25% X $421,000) = $ 105,250 25% chance of $414,000 if by February 8 (25% X $414,000) = 103,500 25% chance of $407,000 if by February 15 (25% X $407,000) = 101,750 25% chance of $400,000 if after February 15 (25% X $400,000) = 100,000 $ 410,500 Thus, the total transaction price is $410,500 based on the probability-weighted estimate.
16.
Allee should not allocate variable consideration to the performance obligation, unless it is entitled to that amount. In this case, it does not have experience with similar contracts and therefore is not able to estimate the cumulative amount of revenue. Allee is constrained in recognizing variable consideration if there might be a significant reversal of revenue previously recognized.
17.
In measuring the transaction price, companies make the following adjustment for: (a) Time value of money - When a sales transaction involves a significant financing component (that is, interest is accrued on consideration to be paid over time), the fair value (transaction price) is determined either by measuring the consideration received or by discounting the payment using an imputed interest rate. The imputed interest rate is the more clearly determinable of either (1) the prevailing rate for a similar instrument of an issuer with a similar credit rating, or (2) a rate of interest that discounts the nominal amount of the instrument to the current sales price of the goods or services. The company will report the effects of the financing either as interest expense or interest revenue. (b) When noncash consideration is involved, revenue is generally recognized on the basis of the fair value of what is received. If the fair value cannot be determined, then the company should estimate the selling price of the goods delivered or services performed and recognize this amount as revenue. In addition, companies sometimes receive contributions (donations, gifts). A contribution is often some type of asset (such as securities, land, buildings or use of facilities) but it could be the forgiveness of debt. Similarly, this consideration should be recognized as revenue based on the fair value of the consideration received.
18.
Any discounts or volume rebates should reduce consideration received and reduce revenue recognized.
19.
If an allocation of transaction price to various performance obligations is needed, the allocation is based on their relative fair value. The best measure of fair value is what the company could sell the good or service on a standalone basis (referred to as the standalone selling price). If this information is not available, companies should use their best estimate of what the good or service might sell for as a standalone unit. The three approaches for estimating stand-alone selling price are (1) Adjusted market assessment approach; (2) Expected cost plus a margin approach, and (3) Residual approach.
Questions Chapter 18 (Continued) 20.
Since each element sells separately and has a separate stand-alone value, the equipment, installation, and training are three separate performance obligations. The total revenue of $80,000 should be allocated to the three performance obligations based on their relative fair values. Thus, the total estimated fair value is $100,000) ($90,000 + $7,000 + $3,000). The allocation is as follows. Equipment ($90,000 ÷ $100,000) X $80,000 = $72,000. Installation ($7,000 ÷ $100,000) X $80,000 = $5,600. Training ($3,000 ÷ $100,000) X $80,000 = $2,400.
21.
A company satisfies its performance obligation when the customer obtains control of the good or service. Indications that the customer has obtained control are: 1. 2. 3. 4. 5.
22.
The company has a right to payment for the asset. The company transferred legal title to the asset. The company transferred physical possession of the asset. The customer has the significant risks and rewards of ownership. The customer has accepted the asset.
Companies recognize revenue over a period of time if one of the following two criteria is met. 1. 2.
The customer controls the asset as it is created or enhanced. The company does not have an alternative use for the asset created or enhanced and either (1) the customer receives benefits as the company performs and therefore, the task would not need to be re-performed, or (2) The company has a right to payment and this right should be enforceable.
23.
A company recognizes revenue from a performance obligation over time by measuring the progress toward completion. The method selected for measuring progress should depict the transfer of control from the company to the customer. The most common are the cost-to-cost and units-of-delivery methods. The objective of all these methods is to measure the extent of progress in terms of costs, units, or value added. Companies identify the various measures (costs incurred, labor hours worked, tons produced, floors completed, etc.) and classify them as input or output measures. Input measures (costs incurred, labor hours worked) are efforts devoted to a contract. Output measures (with units of delivery measured as tons produced, floors of a building completed, miles of a highway completed) track results. Neither is universally applicable to all long-term projects. Their use requires the exercise of judgment and careful tailoring to the circumstances. The most popular input measure used to determine the progress toward completion is the cost-to-cost basis. Under this basis, a company measures the percentage of completion by comparing costs incurred to date with the most recent estimate of the total costs required to complete the contract.
24.
To account for sales with rights of return, (and for some services that are provided subject to a refund), companies generally recognize all of the following. a. b. c.
Revenue for the transferred products in the amount of consideration to which seller is reasonably assured to be entitled (considering the products expected to be returned). A refund liability. An asset (and corresponding adjustment to cost of sales) for its right to recover inventory from the customer. Thus, at the point of sale, only the revenue not subject to estimated refund is recognized. The remaining revenue is recognized when the refund provision expires.
Questions Chapter 18 (Continued) 25.
If a company sells a product in one period and agrees to buy it back in the next period, legal title has transferred, but the economic substance of the transaction is that the seller retains the risks of ownership. When this occurs, the transaction is often a financing arrangement and does not give rise to revenue.
26.
Bill-and-hold sales result when the buyer is not yet ready to take delivery but the buyer takes title and accepts billing. Revenue is recognized at the time title passes, if all of the following criteria are met: (a) (b) (c) (d)
The reason for the bill-and-hold arrangement must be substantive. The product must be identified separately as belonging to the customer. The product currently must be ready for physical transfer to the customer. The seller cannot have the ability to use the product or to direct it to another customer.
27.
In a principal-agency relationship, amounts collected on behalf of the principal are not revenue of the agent. The revenue for the agent is the amount of the commission it receives (usually a percentage of the selling price).
28.
A sale on consignment is the shipment of merchandise from a manufacturer (or wholesaler) to a dealer (or retailer) with title to the goods and the risk of sale being retained by the manufacturer who becomes the consignor. The consignee (dealer) is expected to exercise due diligence in caring for the merchandise and the dealer has full right to return the merchandise. The consignee receives a commission upon the sale and remits the balance of the cash collected to the consignor. The consignor recognizes a sale and the related revenue upon notification of sale from the consignee and receipt of the cash. The consigned goods are carried in the consignor’s inventory, not the consignee’s, until sold.
29.
The two types of warranties are: a.
Warranties that the product meets agreed-upon specifications in the contract at the time the product is sold. This type of warranty is included in the sale price of company’s product and is often referred to as an assurance-type warranty.
b.
Warranties that provide an additional service beyond the assurance-type warranty. This warranty is not included in the sale price of the product and is referred to as a service-type warranty.
Companies do not record a separate performance obligation for assurance type warranties. These types of warranties are nothing more than a quality guarantee that the good or service is free from defects at the point of sale. These type of obligations should be expensed in the period the goods are provided or services performed (in other words, at the point of sale). In addition, the company should record a warranty liability. The estimated amount of the liability includes all the costs that the company will incur after sale and that are incident to the correction of defects or deficiencies required under the warranty provisions. Warranties that provide the customer a service beyond fixing defects that existed at the time of sale represent a separate service and are an additional performance obligation. As a result, companies should allocate a portion of the transaction price to this performance obligation. The company recognizes revenue in the period that the service type warranty is in effect. 30.
The total transaction price is $420 [$300 + ($5 X 24)]. That is, Campus Cellular is providing a service in the second year without receiving an upfront fee. Thus the upfront fee should be recognized as revenue over two periods. As a result, Campus Cellular recognizes revenue of $210 ($420 ÷ 2) in both year 1 and year 2.
Questions Chapter 18 (Continued) 31.
Under the asset-liability model for recognizing revenue, companies recognize assets and liabilities according to the definitions of assets and liabilities in a revenue arrangement. For example, when a company has a right to consideration for meeting a performance obligation, it has a right to consideration from the customer and therefore has a contract asset. A contract liability is a company’s obligation to transfer goods or services to a customer for which the company has received consideration from the customer. Thus, if the customer performs first, by prepaying for the product, then the seller has a contract liability. Companies must present these contract assets and contract liabilities on their balance sheet. Contract assets are of two types: (a) Unconditional rights to receive consideration because the company has satisfied its performance obligation with customer, and (b) Conditional rights to receive consideration because the company has satisfied one performance obligation, but must satisfy another performance obligation in the contract before it can bill the customer. Companies should report unconditional rights to receive consideration as a receivable on the balance sheet. Conditional rights on the balance sheet should be reported separately as contract assets.
32.
(a) Companies divide fulfillment costs (contract acquisition costs) into two categories: (1) those that give rise to an asset, and (2) those that are expensed as incurred. Companies recognize an asset for the incremental costs, if these costs are incurred to obtain a contract with a customer. In other words, incremental costs are costs that a company would not incur if the contract had not been obtained (for example, selling commissions). Other examples are: (a) Direct labor, direct materials, and allocation of costs that relate directly to the contract (such as costs of contract management and supervision, insurance, and depreciation of tools and equipment), and (b) Costs that generate or enhance resources of the company that will be used in satisfying performance obligations in the future. Costs include intangible design or engineering costs that will continue to benefit in the future. Companies capitalize costs that are direct, incremental, and recoverable (assuming that the contract period is more than one year). (b) Collectability – whether a company will get paid for satisfying a performance obligation is not a consideration in determining revenue recognition. That is, the amount recognized is not adjusted for customer credit risk. Rather, companies report the revenue gross and then present an allowance for any impairment due to bad debts (recognized initially and subsequently in accordance with the respective bad debt guidance) prominently as an expense in the income statement. If significant doubt exists at contract inception about collectability, it often indicates that the parties are not committed to their obligations. As a result, conditions for the existence of a contract are not met and therefore revenue is not recognized.
33.
Quantitative Disclosures include: (a) Contracts with customers – These disclosures include the disaggregation of revenue, presentation of opening and closing balances in contract assets and contract liabilities, and significant information related to its performance obligations; (b) Qualitative disclosures include information on significant judgments. These disclosures include judgments and changes in these judgments that affect the determination of the transaction price, the allocation of the transaction price and the determination of the timing of revenue; (c) Assets recognized from costs incurred to fulfill contract—these disclosures include the closing balances of assets recognized to obtain or fulfill a contract, the amount of amortization recognized and the method used for amortization.
Questions Chapter 18 (Continued) *34. Companies satisfy performance obligations either at (1) a point in time or (2) over a period of time. Companies recognize revenue over a period of time if the customer receives and consumes the benefits as the seller performs and one of the following two criteria is met. 1.
The customer controls the asset as it is created or enhanced (e.g., a builder constructs a building on a customer’s property).
2.
The company does not have an alternative use for the asset created or enhanced (e.g., an aircraft manufacturer builds specialty jets to a customer’s specifications) and either (a) the customer receives benefits as the company performs and therefore the task would not need to be re-performed, or (b) the company has a right to payment and this right is enforceable.
If criterion 1. or 2. is met then a company recognizes revenue over time, if it can reasonably estimate its progress toward satisfaction of the performance obligations. That is, it recognizes revenues and gross profits each period based upon the progress of the construction— referred to as the percentage of completion method. The company accumulates construction costs plus gross profit earned to date in an inventory account (Construction in Process), and it accumulates progress billings in a contra inventory account (Billings on Construction in Process). The rationale for using percentage-of-completion accounting is that under most of these contracts the buyer and seller have enforceable rights. The buyer has the legal right to require specific performance on the contract. The seller has the right to require progress payments that provide evidence of the buyer’s ownership interest. As a result, a continuous sale occurs as the work progresses. Companies should recognize revenue according to that progression. Alternatively, if the criteria for recognition over time are not met, the company recognizes revenues and gross profit at a point in time – that is, when the contract is completed. Once all costs are recognized, profit is recognized. This approach is referred to as the completed contract method. The company accumulates construction costs in an inventory account (Construction in Process), and it accumulates progress billings in a contra inventory account (Billings on Construction in Process). *35. Under the percentage-of-completion method, income is reported to reflect more accurately the production effort. Income is recognized periodically on the basis of the percentage of the job completed rather than only when the entire job is completed. The principal disadvantage of the completed-contract method is that it may lead to distortion of earnings because no attempt is made to reflect current performance when the period of the contract extends into more than one accounting period. *36. The methods used to determine the extent of progress toward completion are the cost-to-cost method and units-of-delivery method. Costs incurred and labor hours worked are examples of input measures, while tons produced, stories of a building completed, and miles of highway completed are examples of output measures. *37.
The two types of losses that can become evident in accounting for long-term contracts are: (1) A current period loss involved in a contract that, upon completion, is expected to produce a profit. (2) A loss related to an unprofitable contract.
Questions Chapter 18 (Continued) The first type of loss is actually an adjustment in the current period of gross profit recognized on the contract in prior periods. It arises when, during construction, there is a significant increase in the estimated total contract costs but the increase does not eliminate all profit on the contract. Under the percentage-of-completion method, the estimated cost increase necessitates a current period adjustment of previously recognized gross profit; the adjustment results in recording a current period loss. No adjustment is necessary under the completed-contract method because gross profit is only recognized upon completion of the contract. Cost estimates at the end of the current period may indicate that a loss will result upon completion of the entire contract. Under both methods, the entire loss must be recognized in the current period. *38. It is improper to recognize the entire franchise fee as revenue at the date of sale when many of the services of the franchisor are yet to be performed. *39. Continuing franchise fees should be reported as revenue when the performance obligations related to those fees have been satisfied by the franchisor. These revenues are generally recognized over time as the related product and services are provided. Continuing product sales would be accounted for in the same manner as would any other product sales.
SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 18-1 No entry is required on May 10, 2014, because neither party has performed on the contract. That is, neither party has an unconditional right as of May 10, 2014. On June 15, 2014, Cosmo delivers the product and therefore should recognize revenue as it received an unconditional right to consideration on that date. In addition, Cosmo satisfies its performance obligation by delivering the product to Greig. The journal entry to record the sale and related cost of goods sold is as follows. June 15, 2014 Accounts Receivable ........................................................ Sales Revenue ...........................................................
2,000
Cost of Goods Sold........................................................... Inventory ....................................................................
1,300
2,000
1,300
After receiving the cash payment on July 15, 2014, Cosmo makes the following entry. July 15, 2014 Cash ................................................................................... Accounts Receivable.................................................
2,000 2,000
BRIEF EXERCISE 18-2 In evaluating how to account for the modification, Stengel Co. concludes that the remaining services to be provided are distinct from the services transferred on or before the date of the contract modification. In addition, Stengel has the right to receive an amount of consideration that reflects the standalone selling price of the reduced menu of maintenance services. Therefore, Stengel allocates the new transaction price of $80,000 to the third year of service. In effect, Stengel should account for this modification as a termination of the original contract and the creation of a new contract.
BRIEF EXERCISE 18-3 Ismail accounts for the bundle of goods and services as a single performance obligation because the goods or services in the bundle are highly interrelated. Ismail also provides a significant service by integrating the goods or services into the combined item (that is, the hospital) for which the customer has contracted. In addition, the goods or services are significantly modified and customized to fulfill the contract. Revenue for the performance obligation would be recognized over time by selecting an appropriate measure of progress toward satisfaction of the performance obligation. BRIEF EXERCISE 18-4 The performance obligations relate to the license and the consulting services. They are distinct. (a) If interdependent, the contract is accounted for as a single revenue amount of $33,333 [$200,000 X 6/36]. (b) If not interdependent, service revenue is $75,000 and the license revenue is $137,500 ($125,000 + [$75,000 X 6/36]), based on estimated standalone values. BRIEF EXERCISE 18-5 The transaction price should include management’s estimate of the amount of consideration to which the entity will be entitled. Given the multiple outcomes and probabilities available based on prior experience, the probability-weighted method is the most predictive approach for estimating the variable consideration in this situation: Completion Date August 1 August 8 August 15 After August 15
Probability
Expected Value
70% chance of $1,150,000 = $ 805,000 20% chance of $1,100,000 = 220,000 5% chance of $1,050,000 = 52,500 5% chance of $1,000,000 = 50,000 $1,127,500
Thus, the total transaction price is $ 1,127,500 based on the probabilityweighted estimate.
BRIEF EXERECISE 18-6 (a) In this situation, Nair uses the most likely amount as the estimate $1,150,000. (b) When there is limited information with which to develop a reliable estimate of completion, then no revenue related to the incentive should be recognized until the uncertainty is resolved. Therefore, no revenue is recognized until the completion of the contract.
BRIEF EXERCISE 18-7 January 2, 2014 Notes Receivable...................................................... Discount on Notes Receivable......................... Sales Revenue ..................................................
11,000
Cost of Goods Sold ................................................. Inventory ..........................................................
6,000
1,000 10,000 6,000
Revenue Recognized in 2014 Sales revenue ........................................................... Interest revenue ($11,000 – $10,000)....................... Total revenue ....................................................
$ 10,000 1,000 $ 11,000
BRIEF EXERCISE 18-8 Parnevik should record revenue of $660,000 on March 1, 2014, which is the fair value of the inventory in this case. Parnevik is also financing this purchase and records interest revenue on the note over the 5-year period. In this case, the interest rate is imputed to be 10% ([$660,000/$1,062,937] = .6209, which is the PV of $1 factor for n = 5, I = 10%). Parnevik records interest revenue of $55,000 (10% X $660,000 X 10/12) at December 31, 2014.
BRIEF EXERCISE 18-8 (continued) (a) The journal entries to record Parnevik’s sale to Goosen Company and related cost of goods sold is as follows. March 1, 2014 Notes Receivable ............................................. Sales Revenue.......................................... Discount on Notes Receivable ................
1,062,937
Cost of Goods Sold .................................... ….. Inventory ...................................................
400,000
660,000 402,937 400,000
(b) Parnevik makes the following entry to record interest revenue for 2014. December 31, 2014 Discount on Notes Receivable........................ Interest Revenue (10% X $660,000 X 10/12) ......................
55,000 55,000
As a practical expedient, companies are not required to reflect the time value of money to determine the transaction price if the time period for payment is less than a year. BRIEF EXERCISE 18-9 January income ........................................................ February income ($4,000 – $3,000) X 50% .............. March income ($4,000 – $3,000) X 30%).................. April income ($4,000 – $3,000) X 20%) ....................
$ 0 $500 $300 $200
BRIEF EXERCISE 18-10 Accounts Receivable .............................................. Sales Revenue ($110,000 X 94%) ....................
103,400 103,400
Manual reduces revenue by $6,600 ($110,000 – $103,400) because it is probable that it will provide rebates amounting to 6%. As a result, Manual recognized revenue of $103,400.
BRIEF EXERCISE 18-11 July 1, 2014 No entry – neither party has performed under the contract. On September 1, 2014, Geraths has two performance obligations: (1) the delivery of the windows and (2) the installation of the windows. Windows Installation Total
$2,000 600 $2,600
Allocation Windows ($2,000 ÷ $2,600) X $2,400 = $1,846 Installation ($600 ÷ $2,600) X $2,400 = 554 $2,400 Revenue recognized (rounded to nearest dollar) Geraths makes the following entries for delivery and installation. September 1, 2014 Cash .......................................................................... Accounts Receivable ............................................... Unearned Service Revenue ............................. Sales Revenue .................................................
2,000 400
Cost of Goods Sold.................................................. Inventory ...........................................................
1,100
554 1,846 1,100
(Windows delivered, performance obligation for installation recorded) October 15, 2014 Cash .......................................................................... Unearned Service Revenue ..................................... Service Revenue (Installation) ......................... Accounts Receivable........................................
400 554 554 400
The sale of the windows is recognized once delivered. The installation fee is recognized when the windows are installed.
BRIEF EXERCISE 18-12 (a)
July 1, 2014 No entry – neither party has performed under the contract.
On September 1, 2014, Geraths has two performance obligations: (1) the delivery of the windows and (2) the installation of the windows. Windows Installation ($400 + (20% X $400)] Total
$2,000 480 $2,480
Allocation Windows ($2,000 ÷ $2,480) X $2,400 = $1,935 Installation ($480 ÷ $2,480) X $2,400 = 465 Revenue recognized $2,400 (rounded to nearest dollar) Geraths makes the following entries for delivery and installation. September 1, 2014 Cash ......................................................................... Accounts Receivable .............................................. Unearned Service Revenue ............................ Sales Revenue ................................................
2,000 400
Cost of Goods Sold ................................................. Inventory ..........................................................
1,100
465 1,935 1,100
(Windows delivered, performance obligation for installation recorded) October 15, 2014 Cash ......................................................................... Unearned Service Revenue .................................... Service Revenue (Installation) ........................ Accounts Receivable.......................................
400 465 465 400
The sale of the windows is recognized once delivered. The installation is fee is recognized when the windows are installed.
BRIEF EXERCISE 18-12 (continued) (b) If Garaths cannot estimate the costs for installation, then the residual approach is used. In this approach, the total fair value of the contract is $2,400. Given that the windows have a standalone fair value of $2,000, then $400 ($2,400 – $2,000) is allocated to the installation. Geraths makes the following entries for delivery and installation. September 1, 2014 Cash .......................................................................... Accounts Receivable ............................................... Unearned Service Revenue ............................. Sales Revenue .................................................
2,000 400
Cost of Goods Sold.................................................. Inventory ...........................................................
1,100
400 2,000 1,100
(Windows delivered, performance obligation for installation recorded) October 15, 2014 Cash .......................................................................... Unearned Service Revenue ..................................... Service Revenue (Installation) ......................... Accounts Receivable........................................
400 400 400 400
BRIEF EXERCISE 18-13 (a)
July 10, 2014 Accounts Receivable ....................................... Refund Liability (15% X $700,000)............ Sales Revenue ..........................................
700,000
Cost of Goods Sold ......................................... Estimated Inventory Returns ........................... Inventory ...................................................
476,000 84,000*
*($560,000 ÷ $700,000) X $105,000
105,000 595,000
560,000
BRIEF EXERCISE 18-13 (continued) (b)
October 11, 2014 Refund Liability .............................................. Accounts Receivable .............................. Returned Inventory ......................................... Estimated Inventory Returns ..................
78,000 78,000 62,400* 62,400
*($560,000 ÷ $700,000) X $78,000 BRIEF EXERCISE 18-14 Upon transfer of control of the products, Kristin would recognize: (a) Revenue of $5,800 ($20 X 290 [300-10]) products expected not to be returned) (b) A refund liability for $200 ($20 refund X 10 products expected to be returned) (c) An asset of $120 ($12 X 10 products) for its right to recover products from customers on settling the refund liability. Hence, the amount recognized in cost of goods sold for 290 products is $3,480 ($12 X 290). The journal entries to record the sale and related cost of goods sold are as follows:
Cash ......................................................................... Sales Revenue ................................................. Refund Liability ................................................
6,000
Cost of Goods Sold ................................................. Estimated Inventory Returns.................................. Inventory (300 X $12) .......................................
3,480 120
5,800 200
3,600
If the company is unable to estimate the level of returns with any reliability, it should not report any revenue until the returns are predictable.
BRIEF EXERCISE 18-15 When to recognize revenue in a bill-and-hold arrangement depends on the circumstances. Mills determines when it has satisfied its performance obligation to transfer a product by evaluating when ShopBarb obtains control of that product. For ShopBarb to have obtained control of a product in a bill-and-hold arrangement, all of the following criteria should be met: (a) The reason for the bill-and-hold arrangement must be substantive. (b) The product must be identified separately as belonging to ShopBarb. (c) The product currently must be ready for physical transfer to ShopBarb. (d) Mills cannot have the ability to use the product or to direct it to another customer. In this case, the criteria are assumed to be met. As a result, revenue recognition should be permitted at the time the contract is signed. Mills makes the following entry to record the bill and hold sale. June 1, 2014 Accounts Receivable ............................................... Sales Revenue ..................................................
200,000
Cost of Goods Sold.................................................. Inventory ...........................................................
110,000
200,000 110,000
Mills makes the following entry to record the cash received. September 1, 2014 Cash .......................................................................... Accounts Receivable........................................
200,000 200,000
If a significant period of time elapses before payment, the accounts receivable is discounted. In addition, if one of the four conditions is violated, revenue recognition should be deferred until the goods are delivered to ShopBarb.
BRIEF EXERCISE 18-16 Accounts Payable (ShipAway Cruise Lines) .................. Sales Revenue ($70,000 X 6%) ................................. Cash ..........................................................................
70,000 4,200 65,800
BRIEF EXERCISE 18-17 Cash .................................................................................. Advertising Expense ........................................................ Commission Expense ...................................................... Revenue from Consignment Sales ..........................
18,850* 500 2,150 21,500
*[$21,500 – $500 – ($21,500 X 10%)] Cost of Goods Sold .......................................................... Inventory on Consignment [60% X ($20,000 + $2,000)].....................................
13,200 13,200
BRIEF EXERCISE 18-18 Talarczyk makes the following entry to record the sales of products with warranties. July 1, 2014 Cash ......................................................................... Warranty Expense ................................................... Warranty Liability............................................. Unearned Warranty Revenue .......................... Sales Revenue .................................................
1,012,000 40,000 40,000 12,000 1,000,000
To reduce inventory and recognize cost of goods sold: Cost of Goods Sold ................................................. Inventory ..........................................................
550,000 550,000
BRIEF EXERCISE 18-18 (continued) Talarczyk reduces the Warranty Liability account over the first two years as the actual warranty costs are incurred The company also recognizes revenue related to the service type warranty over the two-year period that extends beyond the assurance warranty period (two years). In most cases, the unearned warranty revenue is recognized on a straight line basis and the costs associated with the service type warranty are expensed as incurred. BRIEF EXERCISE 18-19 No entry is required on May 1, 2014 because neither party has performed on the contract. On June 15, 2014, Eric agreed to pay the full price and therefore Mount has an unconditional right to those funds on that date. On receiving the cash on June 15, 2014, Mount records the following entry. June 15, 2014 Cash .......................................................................... Unearned Sales revenue ..................................
25,000 25,000
On satisfying the performance obligation on September 30, 2014, Mount records the following entry September 30, 2014 Unearned Sales Revenue......................................... Sales Revenue ..................................................
25,000 25,000
BRIEF EXERCISE 18-20 The initiation fee may be viewed as separate performance obligation because it provides a renewal option at a lower price than normally charged. As a result, BlueBox is providing a discounted price in the subsequent years. This should be reflected in the revenue recognized in all four periods. In this situation, in the total transaction price is $280 ([($5 X 12) X 3] + $100). In the first year (2014), BlueBox would report revenue of $70 ($280 ÷ 4). The initiation fee is allocated over the entire four year period.
BRIEF EXERCISE 18-20 (continued) Another approach is to assume that the initiation fee is a separate performance obligation because it provides a renewal option at a lower price than normally charged. As a result the initiation fee would be allocated to years two through four, unless forfeited earlier. * BRIEF EXERCISE 18-21 Construction in Process ......................................... Materials, Cash, Payables. ..............................
1,700,000
Accounts Receivable .............................................. Billings on Construction in Process ..............
1,200,000
Cash ......................................................................... Accounts Receivable.......................................
960,000
Construction in Process [$1,700,000 ÷ ($1,700,000 + $3,300,000)] X $2,000,000 ............................................................. Construction Expenses .......................................... Revenue from Long-Term Contracts ($7,000,000 X 34%*)....................................... *$1,700,000 ÷ ($1,700,000 + $3,300,000)
1,700,000 1,200,000 960,000
680,000 1,700,000 2,380,000
* BRIEF EXERCISE 18-22 Current Assets Accounts receivable ........................................ Inventories Construction in process .......................... Less: Billings........................................... Costs in excess of billings..........................
$240,000 $1,715,000 1,000,000 715,000
* BRIEF EXERCISE 18-23 (a) Construction Expenses ................................... Construction in Process .......................... Revenue from Long-Term Contracts ......
278,000
(b) Loss from Long-Term Contracts .................... Construction in Process .......................... *[$420,000 – ($278,000 + $162,000)]
20,000*
20,000* 258,000 20,000
* BRIEF EXERCISE 18-24 April 1, 2014 Cash ......................................................................... Notes Receivable ($75,000 – $25,000).................... Discount on Notes Receivable........................ Unearned Service Revenue (Training) ........... Unearned Franchise Revenue ($25,000 + $41,402 - $2,000) .........................
25,000 50,000 8,598 2,000 64,402
July 1, 2014 Unearned Service Revenue (Training) ................... Unearned Franchise Revenue ................................ Franchise Revenue.......................................... Service Revenue (Training).............................
2,000 64,402 64,402 2,000
SOLUTIONS TO EXERCISES EXERCISE 18-1 (5–10 minutes) (a) The journal entry to record the sale and related cost of goods sold are as follows. Accounts Receivable..................................... Sales Revenue ($610,000 – $10,000) .....
600,000
Cost of Goods Sold ....................................... Inventory ................................................
500,000
(b) Cash................................................................ Sales Revenue........................................ Accounts Receivable .............................
610,000
600,000
500,000 10,000 600,000
If payment is received after 5 days, Jupiter recognizes $600,000 sales revenue and $10,000 of additional revenue, using an account such as Sales Discounts Forfeited. EXERCISE 18-2 (5–10 minutes) (a) Grupo would recognize revenue of $1,000,000 at delivery. (b) Grupo would recognize revenue of $800,000 at the point of sale. (c) Grupo would recognize revenue of $464,000 at the point of sale. EXERCISE 18-3 (20–25 minutes) (a) Cash................................................................ Sales Revenue (90 X $100) ....................
9,000
Cost of Goods Sold ....................................... Inventory (90 X $54) ...............................
4,860
(b) Cash................................................................ Sales Revenue (10 X $100) ....................
1,000
9,000 4,860 1,000
EXERCISE 18-3 (continued) Cost of Goods Sold ........................................ Inventory (10 X $54) ................................
540 540
In this situation, the contract modification for the additional 45 products is, in effect, a new and separate contract for future products that does not affect the accounting for the previously existing contract. (c) In this case, because the new price does not reflect a stand-alone selling price, Gaertner allocates a modified transaction price (less the amounts allocated to products transferred at or before the date of the modification) to all remaining products to be transferred. Under the prospective approach, Gaertner determines the transaction price for subsequent sales ($97.86) as follows. Consideration for products not yet delivered under original contract ($100 X 60) Consideration for products to be delivered under the contract modification ($95 X 45) Total remaining revenue Revenue per remaining unit ($10,275 105) = $97.86.
$ 6,000 4,275 $10,275
As indicated, the numerator includes products not yet transferred under original contract ($100 X 60) plus products to be transferred under the contract modification ($95 X 45), which is divided by the remaining 105 products. The journal entries to record subsequent sales and related cost of goods sold for 10 units is as follows. Cash (10 X $97.86) .......................................... Sales Revenue.........................................
978.60
Cost of Goods Sold ........................................ Inventory..................................................
540.00
978.60 540.00
EXERCISE 18-4 (20–25 minutes) (a)
January 1, 2014 Cash................................................................ Unearned Service Revenue ...................
10,000 10,000
December 31, 2014 Unearned Service Revenue........................... Service Revenue.....................................
10,000 10,000
January 1, 2015 Cash................................................................ Unearned Service Revenue ...................
10,000 10,000
December 31, 2015 Unearned Service Revenue........................... Service Revenue..................................... (b)
10,000 10,000
January 1, 2016 Cash ($8,000 + $20,000)................................. Unearned Service Revenue ...................
28,000 28,000
December 31, 2016 Unearned Service Revenue ($28,000 ÷ 4)..... Service Revenue.....................................
7,000 7,000
In this case, the modification of the contract does not result in new performance obligation. As a result, the remaining service revenue is recognized evenly over the remaining four years.
EXERCISE 18-4 (continued) (c) Given the change in services in the extended contract period, the services are distinct; the modification should not be considered as part of the original contract – Tyler recognizes revenue on the remaining services at different rates. Tyler will recognize $6,667 ($20,000 ÷ 3) per year in the extended period (2017–2019). For 2016, Tyler makes the following entry. January 1, 2016 Cash ($8,000 + $20,000).................................. Unearned Service Revenue ....................
28,000 28,000
December 31, 2016 Unearned Service Revenue............................ Service Revenue .....................................
8,000 8,000
EXERCISE 18-5 (15–20 minutes) (a) Because the arrangement only has two possible outcomes (regulatory approval is achieved or not), Blair determines the transaction price based on the most likely approach. Thus, the best measure for the transaction price is $10,000,000. (b)
December 20, 2014 Accounts Receivable...................................... License Revenue.....................................
10,000,000 10,000,000
January 15, 2015 Cash................................................................. Accounts Receivable ..............................
10,000,000 10,000,000
EXERCISE 18-6 (15–20 minutes) (a) Aaron determines that the transaction price for the 100 policies is $14,500 [($100 X 100) + ($10 X 4.5 X 100)]. (b)
January, 2014 Cash (100 X $100) ........................................... Accounts Receivable…………………………. . Service Revenue (Commissions) ..........
10,000 4,500 14,500
Because on average, customers renew for 4.5 years, Aaron includes that amount in its estimate for the transaction price. When Aaron satisfies its performance obligation by selling the insurance policy to the customer, it recognizes revenue of $145 on each policy because it determines that it is reasonably assured to be entitled to that amount. Aaron concludes that its past experience is predictive, even though the total amount of commission received depends on the actions of a third party (that is, policyholder behavior). As circumstances change, Aaron updates its estimate of the transaction price and recognizes revenue (or a reduction of revenue) for those changes in circumstances. EXERCISE 18-7 (15–20 minutes) (a) The journal entries to record sales and related cost of goods sold are as follows. June 3, 2014 Accounts Receivable................................ Refund Liability .............................. Sales Revenue................................
8,000
Estimated Inventory Returns................. Cost of Goods Sold................................ Inventory........................................
560* 5,040
800 7,200
* (5,600 ÷ 8,000) X $800 The journal entries to record the return is as follows.
5,600
EXERCISE 18-7 (continued) June 5, 2014 Refund Liability ......................................... Accounts Receivable .......................
300
Returned Inventory * ................................. Estimated Inventory Returns ...........
120
300 120
* Because these goods were damaged and might not be sold at a profit, they likely will be separated from other inventory. A loss may be subsequently recognized if this inventory is sold or disposed of at an amount lower than cost. The journal entry to record delivery cost is as follows. June 7, 2014 Delivery Expense....................................... Cash ...................................................
24 24
The journal entry to record payment within the discount period is as follows. June 12, 2014 Cash........................................................... Sales Discounts (2% X $7,700*) ............... Accounts Receivable (Ann Mount) .. *$8,000 – $300 (b)
7,546 154 7,700
August 5, 2014 Cash........................................................... Accounts Receivable (Ann Mount)..
7,700 7,700
EXERCISE 18-8 (15–20 minutes) (a)
December 31, 2014 Cash................................................................. Unearned Rent Revenue (2015 slips – 300 X $800) ........................
240,000 240,000
December 31, 2015 Cash................................................................. Unearned Rent Revenue [2016 slips – 200 X $800 X (1.00 – .05)]..
152,000
Cash................................................................. Unearned Rent Revenue [2017 slips – 60 X $800 X (1.00 – .20)]....
38,400
152,000
38,400
(b) The marina operator should recognize that advance rentals generated $190,400 ($152,000 + $38,400) of cash in exchange for the marina’s promise to deliver future services. In effect, this has reduced future cash flow by accelerating payments from boat owners. Also, the price of rental services has effectively been reduced. The current cash bonanza does not reflect current revenue. The future costs of operation must be covered, in part, from this accelerated cash inflow. On a present value basis, the granting of these discounts seems illadvised unless interest rates were to skyrocket so that interest revenue would offset the discounts provided or because costs for dock repairs is expected to increase significantly.
EXERCISE 18-9 (25–30 minutes) (a)
January 2, 2014 Cash................................................................. Unearned Sales Revenue .........................
150,000
(To record upfront payment for sales of products A and B)
150,000
EXERCISE 18-9 (continued) December 31, 2014 Interest Expense ($150,000 X 6%) ................. Interest Payable ........................................
9,000 9,000
(To record interest on the contract liability) (b)
December 31, 2015 Interest Expense ([$150,000 + $9,000] X 6%)........................... Interest Payable ........................................
9,540 9,540
(To record interest on the contract liability) (c)
January 2, 2016 Unearned Sales Revenue ............................... Interest Payable ([$9,000 + $9,540] X 25%) ... Sales Revenue...........................................
37,500 4,635 42,135
(To record revenue on transfer of product A) Note: Interest will continue to accrue on product B over the next 3 years. EXERCISE 18-10 (5–10 minutes) (a) The entry to record the sale and related cost of goods sold is as follows. Accounts Receivable...................................... Sales Revenue........................................... Unearned Service Revenue ...................... (b)
410,000 370,000 40,000
First Quarter Sales revenue .................................................
$370,000
The revenue for installation will be recognized in the second quarter.
EXERCISE 18-11 (25–30 minutes) (a) The total revenue of $1,000,000 should be allocated to the two performance obligations based on their relative fair values. In this case, the fair value of the equipment should be considered $1,000,000 and the fair value of the installation fee is $50,000. The total fair value to consider is $1,050,000 ($1,000,000 + $50,000). The allocation is as follows. Equipment ($1,000,000 / $1,050,000) X $1,000,000 = $952,381 Installation ($50,000 / $1,050,000) X $1,000,000 = $ 47,619 (b) Crankshaft makes the following entries. September 30, 2014 Cash................................................................ Service Revenue (Installation)............... Sales Revenue (Equipment) ..................
1,000,000
Cost of Goods Sold ....................................... Inventory .................................................
600,000
47,619 952,381 600,000
The sale of the equipment should be recognized once the installation is completed on September 30, 2014 and the installation fee also should be recognized because these services have been provided. As a practical expedient, if a company has two or more distinct performance obligations, it may bundle these performance obligations if they have the same revenue recognition pattern. That is they are recognized immediately or they are recognized over time using the same revenue recognition pattern.
EXERCISE 18-12 (25–30 minutes) (a) The total revenue of $1,000,000 should be allocated to the two performance obligations based on their relative fair values. In this case, the fair value of the equipment should be considered $1,000,000 and the fair value of the installation fee, assuming a cost plus approach is $45,000 ($36,000 + [25% X $36,000]). The total fair value to consider is $1,045,000 ($1,000,000 + $45,000). The allocation is as follows. Equipment ($1,000,000 / $1,045,000) X $1,000,000 = $ 956,938 Installation ($45,000 / $1,045,000) X $1,000,000 = $ 43,062 (b) Crankshaft makes the following entries. September 30, 2014 Cash................................................................. Service Revenue (Installation) ............... Sales Revenue (Equipment) ...................
1,000,000
Cost of Goods Sold ........................................ Inventory..................................................
600,000
43,062 956,938 600,000
EXERCISE 18-13 (10–15 minutes) (a) The separate performance obligations are the oven, installation, and maintenance service, since each item has standalone value to the customer. (b) Oven Installation Maintenance Total *$50 = $850 – $800 **$175 = $975 – $800
$ 800/$1,025 X $1,000 = $ 780 $ 50*/$1,025 X $1,000 = $ 49 $ 175**/$1,025 X $1,000 = $ 171 $1,025
EXERCISE 18-14 (5–10 minutes) (a)
January 2, 2014 Accounts Receivable..................................... Refund Liability ($1,500,000 X 20%) ...... Sales Revenue........................................
1,500,000
Estimated Inventory Returns ........................ Cost of Goods Sold ....................................... Inventory .................................................
160,000* 640,000
300,000 1,200,000
800,000
* (20% X 800,000) (b)
March 1, 2014 Refund Liability .............................................. Accounts Receivable .............................
100,000
Inventory ........................................................ Estimated Inventory Returns.................
53,333*
100,000 53,333
* ($800,000 ÷ $1,500,000) X $100,000 (c) If Organic Growth is unable to estimate returns, it defers recognition of revenue until the return period expires on May 2, 2014. EXERCISE 18-15 (15–20 minutes) (a) Uddin could recognize revenue at the point of sale based upon the time of shipment because the books are sold f.o.b. shipping point. That is, control has transferred and its performance obligation is met. Because the returns can be estimated, recognition is at point of sale (shipping point) with a returned liability established. (b) Based on the available information, the correct treatment is to recognize revenue when the performance obligation is satisfied – in this case at the time of shipment (transfer of title). The transaction price amount is adjusted for the estimated returns for which a refund liability is recorded.
EXERCISE 18-15 (continued) (b)
July 1, 2014
Accounts Receivable...................................... Refund Liability ($15,000,000 X 12%)..... Sales Revenue (Texts) ............................ Estimated Inventory Returns ($12,000,000 X 12%) ..................................... Cost of Goods Sold ........................................ Inventory.................................................. (c)
15,000,000 1,800,000 13,200,000 1,440,000 10,560,000 12,000,000
October 3, 2014
Refund Liability .............................................. Accounts Receivable ..............................
1,500,000
Cash................................................................. Accounts Receivable ..............................
13,500,000
Inventory ......................................................... Estimated Inventory Returns .................
1,200,000*
1,500,000 13,500,000 1,200,000
* ($12,000,000 ÷ $15,000,000) X $1,500,000 EXERCISE 18-16 (20–25 minutes) (a) In this case, due to the agreement to repurchase the equipment, Cramer continues to have the control of the asset and therefore this agreement is a financing transaction and not a sale. Thus the asset is not removed from the books of Cramer. The entries to record to financing are as follows. July 1, 2014 Cash................................................................. Liability to Enyart Company...................
40,000 40,000
(b)
December 31, 2014 Interest Expense ............................................ Liability to Enyart Company ($40,000 X 6%* X 1/2)...........................
1,200 1,200
(*) An interest rate of 6% is imputed from the agreement. EXERCISE 18-16 (continued) (c)
June 30, 2015 Interest Expense ............................................ Liability to Enyart Company ($40,000 X 6% X 1/2) ............................ Liability to Enyart Company.......................... Cash ($40,000 + $1,200 + $1,200) ..........
1,200 1,200 42,400 42,400
EXERCISE 18-17 (10–15 minutes) (a)
March 1, 2014 If the selling price of the ingots was $200,000, Zagat would record the following entry when it receives the consideration from the customer: Cash................................................................ Liability to Werner Metal Company.......
200,000 200,000
(To record repurchase agreement with Werner Metal Company) (b)
May 1, 2014 Interest Expense ($200,000 X 2%).................. Liability to Werner Metal Company ............... Cash .........................................................
4,000 200,000 204,000
(To record payment plus interest on financing) EXERCISE 18-18 (10–15 minutes) (a) This transaction is a bill-and-hold situation. Delivery of the counters is delayed at the buyer’s request, but the buyer takes title and accepts billing. Thus, the agreement must be evaluated to determine if revenue can be recognized before delivery.
EXERCISE 18-18 (continued) (b) Revenue is reported at the time title passes if the following conditions are met: (1) The reason for the bill-and-hold arrangement must be substantive. (2) The product must be identified separately as belonging to the customer. (3) The product currently must be ready for physical transfer to the customer, and (4) The seller cannot have the ability to use the product or to direct it to another customer. (c) Cash................................................................. Accounts Receivable...................................... Sales Revenue.........................................
300,000 1,700,000 2,000,000
EXERCISE 18-19 (15–20 minutes) (a) Inventoriable costs: 80 units shipped at cost of $500 each ............ Freight............................................................... Total inventoriable cost ...........................
$40,000 840 $40,840
40 units on hand (40/80 X $40,840) .................
$20,420
(b) Computation of consignment profit: Consignment sales (40 X $750)....................... Cost of units sold (40/80 X $40,840) ............... Commission charged by consignee (6% X $30,000) .............................................. Advertising cost ............................................... Installation costs.............................................. Profit on consignment sales ................................... (c) Remittance of consignee: Consignment sales.................................................. Less: Commissions................................................ Advertising ................................................... Installation .................................................... Remittance from consignee ....................................
$30,000 (20,420) (1,800) (200) (320) $ 7,260 $30,000 $1,800 200 320
2,320 $27,680
EXERCISE 18-20 (5–10 minutes) (a)
Cash ($48,800 + $1,200)............................................ Warranty Expense..................................................... Warranty Liability .............................................. Sales Revenue...................................................
50,000 1,200 1,200 50,000
(b) Grando should recognize $400 of warranty revenue in 2016 and 2017. Cash ($48,800 + $1,200 + $800) ................................ Warranty Expense..................................................... Warranty Liability .............................................. Sales Revenue................................................... Unearned Service Revenue (Warranty)............
50,800 1,200 1,200 50,000 800
EXERCISE 18-21 (15–20 minutes) (a)
October 31, 2014 Cash (or Accounts Receivable) ............................... Warranty Expense..................................................... Unearned Service Revenue (assurance-type warranty) ............................ Unearned Service Revenue (service-type warranty) ................................. Sales Revenue...................................................
3,600 200 200 400 3,200
(To record sales revenue and contract liabilities related to warranties.) Cost of Goods Sold .................................................. Inventory ............................................................
1,440 1,440
(To record inventory sold and recognize cost of sales). (b) Celic reduces the warranty liability (Unearned Service Revenue) associated with the assurance-type warranty as actual warranty costs are incurred during the first 90 days after the customer receives the computer. Celic recognizes the Unearned Service Revenue associated with the service-type warranty as revenue during the contract warranty period and recognizes the costs associated with providing the servicetype warranty as they are incurred.
EXERCISE 18-22 (10–15 minutes) (a) No entry – neither party has performed on the contract on January 1, 2014. (b) The entries to record the sale and related cost of goods sold of the wiring base is as follows. February 5, 2014 Contract Asset ........................................................... Sales Revenue....................................................
1,200
Cost of Goods Sold ................................................... Inventory.............................................................
700
1,200
700
(c) The entries to record the sale and related cost of goods sold of the shelving unit is as follows. February 25, 2014 Cash............................................................................ Contract Asset ................................................... Sales Revenue....................................................
3,000
Cost of Goods Sold ................................................... Inventory.............................................................
320
1,200 800
320
EXERCISE 18-23 (10–15 minutes) (a)
May 1, 2014 No entry – neither party has performed on May 1, 2014.
(b)
May 15, 2014 Cash............................................................................ Unearned Sales Revenue ..................................
900 900
EXERCISE 18-23 (continued) (c)
May 31, 2014 Unearned Sales Revenue ......................................... Sales Revenue...................................................
900
Cost of Goods Sold .................................................. Inventory ............................................................
575
900
575
EXERCISE 18-24 (15–20 minutes) (a) The $2,000 commission costs related to obtaining the contract are recognized as an asset. The design services ($3,000), controllers ($6,000), testing and inspection fees ($2,000) should be capitalized as well, as they are specific to the contract. The $27,000 cost for the receptacles and loading equipment appear to be independent of the contract, as Rex will retain these and likely use them in other projects. (b) Companies only capitalize costs that are direct, incremental, and recoverable (assuming that the contract period is more than one year. General and administrative costs (unless those costs are explicitly chargeable to the customer under the contract) and wasted materials and labor are not eligible for capitalization and should be expensed as incurred.
EXERCISE 18-25 (10–15 minutes) (a) If the contract is for less than 1 year, Rex can use the practical expedient and recognize the incremental costs of obtaining a contract as an expense when incurred. (b) The collectability of the contract payments will not affect the amount of revenue recognized. That is, the amount recognized is not adjusted for customer credit risk. Rather, Rex should report the revenue gross and then present an allowance for any impairment due to bad debts (recognized initially and subsequently in accordance with the respective bad debt guidance) prominently as an expense in the income statement. If there is significant doubt at contract inception about collectability, this may indicate that the parties to the contract are not committed to perform their respective obligations to the contract (i.e., existence of a contract may not be met). No revenue is recognized until the issue of significant doubt is resolved.
* EXERCISE 18-26 (20–25 minutes) (a) Gross profit recognized in: 2014 Contract price Costs: Costs to date Estimated costs to complete Total estimated profit Percentage completed to date Total gross profit recognized Less: Gross profit recognized in previous years Gross profit recognized in current year
2015
$1,600,000 $400,000 600,000
*$400,000 ÷ $1,000,000
2016
$1,600,000 $825,000
1,000,000 600,000 X
40%*
275,000
$1,600,000 $1,070,000
1,100,000 500,000 X
75%**
0
1,070,000 530,000 X
100%
240,000
375,000
530,000
0
240,000
375,000
$ 240,000
$ 135,000
$ 155,000
**$825,000 ÷ $1,100,000
EXERCISE 18-26 (continued) (b) 2015 Construction in Process ($825,000 – $400,000).... Materials, Cash, Payables...............................
425,000
Accounts Receivable ($900,000 – $300,000) ......... Billings on Construction in Process ..............
600,000
Cash ($810,000 – $270,000) .................................... Accounts Receivable ......................................
540,000
Construction Expenses .......................................... Construction in Process......................................... Revenue from Long-Term Contracts .............
425,000 135,000
425,000 600,000 540,000
560,000*
*$1,600,000 X (75% – 40%) (c) Gross profit recognized in: Gross profit
2014 $–0–
2015 $–0–
2016 $530,000*
*$1,600,000 – $1,070,000 * EXERCISE 18-27 (10–15 minutes) (a) Contract billings to date ......................................... Less: Accounts receivable 12/31/14 ..................... Portion of contract billings collected .................... (b)
$61,500 18,000 $43,500
$19,500 = 30% $65,000 (The ratio of gross profit to revenue recognized in 2014.) $1,000,000 X .30 = $300,000 (The initial estimated total gross profit before tax on the contract.)
* EXERCISE 18-28 (10–15 minutes) DOUGHERTY INC. Computation of Gross Profit to be Recognized on Uncompleted Contract Year Ended December 31, 2014 Total contract price Estimated contract cost at completion ($800,000 + $1,200,000) ............................................... Fixed fee ............................................................................ Total ........................................................................... Total estimated cost ......................................................... Gross profit............................................................................... Percentage of completion ($800,000 ÷ $2,000,000) ........ Gross profit to be recognized .................................................
$2,000,000 450,000 2,450,000 (2,000,000) 450,000 X 40% $ 180,000
* EXERCISE 18-29 (15–20 minutes) (a)
2014:
$640,000
X $2,200,000 = $880,000
$1,600,000 2015: $2,200,000 (contract price) minus $880,000 (revenue recognized in 2014) = $1,320,000 (revenue recognized in 2015). (b) All $2,200,000 of the contract price is recognized as revenue in 2015. (c) Using the percentage-of-completion method, the following entries would be made: Construction in Process ........................................ Materials, Cash, Payables ..............................
640,000
Accounts Receivable.............................................. Billings on Construction in Process..............
420,000
Cash......................................................................... Accounts Receivable ......................................
350,000
Construction in Process ........................................ Construction Expenses.......................................... Revenue from Long-Term Contracts [from (a)] ......................................................
240,000* 640,000
640,000 420,000 350,000
880,000
EXERCISE 18-29 (continued) *[$2,200,000 – ($640,000 + $960,000)] X [($640,000 ÷ $1,600,000)] (Using the completed-contract method, all the same entries are made except for the last entry. No income is recognized until the contract is completed.) * EXERCISE 18-30 (15–25 minutes) (a) Computation of Gross Profit to Be Recognized under CompletedContract Method. No computation necessary. No gross profit to be recognized prior to completion of contract. Computation of Billings on Uncompleted Contract in Excess of Related Costs under Completed-Contract Method. Construction costs incurred during the year.................. Partial billings on contract (25% X $6,000,000)...............
$ 1,185,800 (1,500,000) $ (314,200)
(b) Contract price ..............................................
$6,000,000
Costs to date ................................................ Est costs to complete .................................. Total ......................................................
$1,185,800 4,204,200
Est profit ($6,000,000 – $5,390,000) ............ % of completion ........................................... Gross profit...........................................
610,000 X 22% *
* ($1,185,800 ÷ $5,390,000)
5,390,000
$ 134,200
* EXERCISE 18-31 (20–25 minutes) (a)
May 1, 2014 Cash............................................................................ Notes Receivable ($70,000 – $28,000) ...................... Discount on Notes Receivable [$42,000 – (2.48685* X $14,000)] ..................... Unearned Franchise Revenue ($25,000 + $42,000 – $7,184) ...........................
28,000 42,000 7,184 62,816
July 1, 2014 Unearned Franchise Revenue .................................. Franchise Revenue ........................................... (b)
62,816 62,816
May 1, 2014 Cash............................................................................ Notes Receivable ....................................................... Discount on Notes Receivable [$42,000 – (2.48685* X $14,000)] ..................... Contract Liability (franchise) ($28,000 + $34,816)..........................................
28,000 42,000 7,184 62,816
December 31, 2014 Unearned Franchise Revenue ...................................... 13,959** Franchise Revenue ...........................................
13,959
** ($62,816 ÷ 3) X 8/12 (c)
May 1, 2014 Cash............................................................................ Notes Receivable ....................................................... Discount on Notes Receivable [$42,000 – (2.48685* X $14,000)] ..................... Unearned Service Revenue (Training).............. Unearned Franchise Revenue ($25,600 + $42,000 – $7,184) .............................................
28,000 42,000 7,184 2,400 60,416
EXERCISE 18-31 (continued) July 1, 2014 Unearned Service Revenue (Training)..................... Unearned Franchise Revenue.................................. Franchise Revenue ........................................... Service Revenue (Training) ..............................
1,200*** 60,416 60,416 1,200
*** $2,400 ÷ 2 September 1, 2014 Unearned Service Revenue (Training)..................... Service Revenue ...............................................
1,200* 1,200
(Calculations rounded) *Present value of ordinary annuity 3 years at 10%. * EXERCISE 18-32 (15–20 minutes) (a)
January 1, 2014 Cash........................................................................... Notes Receivable ...................................................... Discount on Notes Receivable ......................... Unearned Franchise Revenue ($10,000 + $29,567) .........................................
*Down payment made on 4/1/14............................... Present value of an ordinary annuity ($8,000 X 3.69590)........................................... Total revenue recorded by Campbell and total acquisition cost recorded by Lesley Benjamin .............................................
10,000 40,000 10,433 39,567*
$10,000.00 29,567.20 $39,567.20
April 1, 2014 Unearned Franchise Revenue.................................. Franchise Revenue ...........................................
39,567 39,567
EXERCISE 18-32 (continued) (b)
January 1, 2014 Cash............................................................................ Notes Receivable ....................................................... Discount on Notes Receivable .......................... Unearned Service Revenue (Training).............. Unearned Franchise Revenue ...........................
10,000 40,000 10,433 3,600 35,967
April 1, 2014 Unearned Service Revenue (Training) ..................... Unearned Franchise Revenue .................................. Franchise Revenue ............................................ Service Revenue (Training) ...............................
900 35,967 35,967 900
December 31, 2014 Unearned Service Revenue (Training) ..................... Service Revenue ................................................ Discount on Notes Receivable.................................. Interest Revenue [($40,000 – $10,433) X 11%] ............................ (c)
2,700 2,700 3,252 3,252
January 1, 2014 Cash............................................................................ Notes Receivable ....................................................... Discount on Notes Receivable .......................... Contract Liability (franchise) ($10,000 + $29,567).......................................... *Down payment made on 4/1/14 ............................... Present value of an ordinary annuity ($8,000 X 3.69590) ........................................... Total revenue recorded by Campbell and total acquisition cost recorded by Lesley Benjamin..............................................
10,000 40,000 10,433 39,567* $10,000.00 29,567.20 $39,567.20
December 31, 2014 Unearned Franchise Revenue .................................. Franchise Revenue ............................................ ** ($39,567 ÷ 5)
7,913** 7,913
TIME AND PURPOSE OF PROBLEMS Problem 18-1 (Time 30–35 minutes) Purpose—to provide the student with an opportunity to determine transaction price, allocate the transaction price to performance obligations, and account for upfront fees. Problem 18-2 (Time 20–25 minutes) Purpose—to provide the student with an opportunity to determine transaction price, allocate the transaction price to performance obligations, and account for a contract modification. Problem 18-3 (Time 30–35 minutes) Purpose—to provide the student with an opportunity to determine transaction price, allocate the transaction price to performance obligations, and account for discounts and time value. Problem 18-4 (Time 35–40 minutes) Purpose—to provide the student with an opportunity to determine transaction price, allocate the transaction price to performance obligations, and account for discounts and time value. Problem 18-5 (Time 35–40 minutes) Purpose—to provide the student with an opportunity to determine transaction price, allocate the transaction price to performance obligations, and account for returns and consignment sales. Problem 18-6 (Time 25–30 minutes) Purpose—to provide the student with an opportunity to account for warranty and customer loyalty programs. Problem 18-7 (Time 30–35 minutes) Purpose—to provide the student with an understanding of the criteria and applications utilized in the determination revenue recognition for a bonus point program. The student is required to allocate the transaction price to the bonus points and sales revenue for the products and then prepare entries for bonus point redemptions. Problem 18-8 (Time 30–45 minutes) Purpose—the student defines and describes the point of sale and over-time recognition of revenue. Then the student computes revenue to be recognized in situations using a point of sale and over time recognition, when the right of return exists, consignments, and a service contracts. Problem 18-9 (Time 30–35 minutes) Purpose—to provide the student with an understanding of and an opportunity to determine transaction price, allocate the transaction price to performance obligations, and account for time value, gift cards, and discounts. *Problem 18-10 (Time 30–40 minutes) Purpose—to provide the student with an understanding of both the percentage-of-completion and completed-contract methods of accounting for long-term construction contracts. The student is required to compute the estimated gross profit that would be recognized during each year of the construction period under each of the two methods. *Problem 18-11 (Time 20–25 minutes) Purpose—to provide the student with a long-term construction contract problem that requires the recognition of a loss during an interim year on a contract that is profitable overall. This problem requires application of both the percentage-of-completion method and the completed-contract method to an interim loss situation.
*Problem 18-12 (Time 40–50 minutes) Purpose—to provide the student with a long-term construction contract problem that requires the recognition of a loss during an interim year on an unprofitable contract overall. This problem requires application of both the percentage-of-completion method and the completed-contract method to this unprofitable contract. *Problem 18-13 (Time 35–45 minutes) Purpose—to provide the student with an understanding of the accounting treatment accorded franchising operations. The student is required to discuss the alternatives types of franchise fees – initial franchise fee and continuing franchise fees – and determine when fees should be recognized, at a point in time or over time.
SOLUTIONS TO PROBLEMS PROBLEM 18-1
(a) The total revenue of $50,000 (100 contracts X $500) should be allocated to the two performance obligations based on their relative fair values. In this case, the fair value of each tablet is $250 and the fair value of the internet service is $286. The total fair value to consider is $536 ($250 + $286) for each contract. The allocation for each contract is as follows. Tablet ($250 / $536) X $500 = $233 Internet Service ($286 / $536) X $500 = $267 The present value of the future payments on the internet service ($7,200 ($72 X 100) X 2.5771 [PVOA n=3, i=8%]) = $18,555 January 2, 2014 Cash ($10,000 + $ 21,445*) ....................................... Notes Receivable ($72 X 3 X 100) ............................ Discount on Notes Receivable ($21,600 – $18,555) ......................................... Unearned Service Revenue (100 X $267)......... Sales Revenue (100 X $233) .............................
31,445 21,600
Cost of Goods Sold ($175 X 100) ............................. Inventory ............................................................
17,500
3,045 26,700 23,300 17,500
*Cash received on 100 contracts: Total contract price Less upfront payment on the internet service Less the PV of the note receivable
$50,000 10,000 18,555 $21,445
The sale of the tablets (and gross profit) should be recognized once the tablets are delivered on January 2, 2014.
PROBLEM 18-1 (Continued) Amortization Schedule for the Notes Receivable Date Cash January 2, 2014 January 2, 2015 $7,200 January 2, 2016 $7,200 January 2, 2017 $7,200
(b)
Interest Revenue Amortization $1,484 $5,716 1,027 6,173 534 6,666
Balance $18,555 12,839 6,666 -0-
December 31, 2015 Interest Receivable ($12,839 X 8%) .......................... Interest Revenue ................................................
1,027 1,027
(To accrue interest on the note receivable) Unearned Service Revenue ($26,700 ÷ 4)................. Service Revenue ................................................
6,675 6,675
(To record revenue for internet service provided in 2015) (c)
December 31, 2016 Interest Receivable ($6,666 X 8%) ............................ Interest Revenue ................................................
534 534
(To accrue interest on the note receivable) Unearned Service Revenue ($26,700 ÷ 4)................. Service Revenue ................................................
6,675 6,675
(To record revenue for internet service provided in 2016) (d) Without reliable data with which to estimate the standalone selling price of the internet service Tablet Tailors allocates $250 for each contract to revenue on the tablets, with the residual amount allocated to the Internet service.
PROBLEM 18-1 (Continued) Tablet Tailors makes the following entries. January 2, 2014 Cash ($10,000 + $ 21,445*) ....................................... Notes Receivable ($7,200 X 3).................................. Discount on Notes Receivable ......................... Unearned Service Revenue (Internet Service) ($250 X 100)....................... Sales Revenue (Equipment) .............................
31,445 21,600
Cost of Goods Sold .................................................. Inventory ............................................................
17,500
3,045 25,000 25,000 17,500
The sale of the tablets (and gross profit) should be recognized once the tablets are delivered on January 2, 2014. Tablet Tailors will recognize service revenue of $6,250 ($25,000 ÷ 4) in each year of the 4-year contract.
PROBLEM 18-2 (a) Since the services in the extended period are the same as those provided in the original contract period, the services are not distinct; the modification should be considered as part of the original contract. Tablet Tailors makes the following entries in 2016 related to the 40 extended contracts. January 2, 2016 Cash (40 X $120) ........................................................ Unearned Service Revenue ...............................
4,800 4,800
(To record cash received for 40 extended internet service contracts) December 31, 2016 Unearned Service Revenue....................................... Service Revenue ($15,480* ÷ 4) ......................... *Consideration for service not yet delivered under original contract ($267 X 40) Consideration for products to be delivered under the contract modification ($40 X $120) Total remaining revenue Revenue per remaining unit ($15,480 4) = $3,870.
3,870 3,870 $ 10,680 4,800 $15,480
(b) Bundle B contains three different performance obligations: (1) the tablet, (2) internet service, and (3) tablet service plan. The total revenue of $120,000 (200 contracts X $600) should be allocated to the three performance obligations based on their relative fair values: Tablet $250 Internet service 286 Tablet service plan 160 Total estimated fair value $696
PROBLEM 18-2 (Continued) The allocation for a single contract is as follows. Tablet Internet Service Tablet service Total Revenue
$215 ($250 / $696) X $600 247 ($286 / $696) X $600 138 ($160 / $696) X $600 $600
Tablet Tailors makes the following entries for 200 Tablet Bundle B. The present value of the future payments on the internet service ($14,400 [$72 X 200] X 2.5771) 37,110 January 2, 2014 Cash ($20,000 + $62,890*) ........................................ Notes Receivable ([100 X 2 X $72] X 3).................... Discount on Notes Receivable ......................... Unearned Service Revenue (Internet Service) (200 X $247)....................... Unearned Service Revenue (Tablet Service) (200 X $138) ......................... Sales Revenue (Equipment) (200 X $215)........
82,890 43,200
Cost of Goods Sold .................................................. Inventory (200 X $175) ......................................
35,000
6,090 49,400 27,600 43,000 35,000
* Cash received on 200 contracts: Total contract price (200 X $600) Less upfront payment on the internet service Less PV of the note receivable
$120,000 20,000 37,110 $ 62,890
The sale of the tablets (and gross profit) should be recognized once the tablets are delivered on January 2, 2014. The unearned service revenue for Internet and tablet services will be recognized evenly over the 4-year contract.
PROBLEM 18-3 (a) The total revenue of $8,000 ($800 X 10) should be allocated to the two performance obligations based on their relative fair values. In this case, the fair value of the grills is considered $7,000 ($700 X 10) and the fair value of the installation fee is $1,500 ($150 X 10). The total fair value to consider is therefore $8,500 ($7,000 + $1,500). The allocation is as follows. Equipment ($7,000 / $8,500) X $8,000 = $6,588 Installation ($1,500 / $8,500) X $8,000 = $1,412 Grill Masters makes the following entries. April 20, 2014 Cash............................................................................ Unearned Service Revenue (Installation) ......... Unearned Sales Revenue (Equipment).............
8,000 1,412 6,588
May 15, 2014 Unearned Service Revenue (Installation)................. Unearned Sales Revenue (Equipment) .................... Service Revenue (Installation) .......................... Sales Revenue (Equipment) ..............................
1,412 6,588
Cost of Goods Sold ................................................... Inventory ($425 X 10) .........................................
4,250
1,412 6,588 4,250
Both the sale of the equipment and the service revenue are recognized once the installation is completed on May 15, 2014. (b)
April 17, 2014 Cash............................................................................ Sales Revenue ([$200 X 280] X 94%) ................
52,640
Cost of Goods Sold .................................................. Inventory (280 X $160) .......................................
44,800
52,640 44,800
PROBLEM 18-3 (Continued) In this case, Grill Masters should reduce revenue recognized by $3,360 [($56,000 ($280 X 200) – $52,640)] because it is probable (almost certain) that it will provide the discounted price amounting to 6%. (c) 1.
September 1, 2014 Accounts Receivable [$20,000 – (3% X $20,000)] ............................. Sales Revenue ........................................... Cost of Goods Sold ........................................... Inventory ($550 X 20) .................................
19,400 19,400 11,000 11,000
September 25, 2014 Cash ................................................................... Accounts Receivable................................. 2.
19,400 19,400
September 1, 2014 Accounts Receivable [$20,000 – (3% X $20,000)] ............................. Sales Revenue ........................................... Cost of Goods Sold ........................................... Inventory ($550 X 20) .................................
19,400 19,400 11,000 11,000
October 15, 2014 Cash ($1,000 X 20)............................................. Accounts Receivable................................. Sales Discounts Forfeited (3% X $20,000).........................................
20,000 19,400 600
PROBLEM 18-3 (Continued) (d)
October 1, 2014 Notes Receivable ....................................................... Sales Revenue ($5,324 X .75132 [ PV i=10%, n=3]).... Discount on Notes Receivable ..........................
5,324
Cost of Goods Sold ................................................... Inventory.............................................................
2,700
4,000 1,324 2,700
December 31, 2014 Discount on Notes Receivable.................................. Interest Revenue (10% X ¼ X $4,000) ...............
100 100
Grill Masters records revenue of $4,000 on October 1, 2014, which is the value of consideration received, based on the present value of the note. As a practical expedient, companies are not required to reflect the time value of money to determine the transaction price if the time period for payment is less than a year.
PROBLEM 18-4 (a) The journal entry to record the sale and related cost of goods sold is as follows June 1, 2014 Accounts Receivable ....................................... Refund Liability (4% X $70,000)............... Sales Revenue..........................................
70,000
Cost of Goods Sold ....................................... Estimated Inventory Returns (4% X $40,000) ............................................. Inventory ($400 X 100) ...........................
38,400
(b) 1.
1,600 40,000
May 1, 2014 Cash (20% X [300 X $1,800]) ..................... Unearned Sales Revenue..................
2.
2,800 67,200
108,000 108,000
August 1, 2014 Unearned Sales Revenue.......................... Cash............................................................ Sales Revenue ($1,800 X 300) ..........
108,000 432,000
Cost of Goods Sold .................................. Inventory (300 X [$260 + $275 + $400])
280,500
540,000 280,500
Note: Economy could account for the installation and product sales as separate performance obligations. However, as a practical expedient, if a company has two or more distinct performance obligations, it may bundle these performance obligations if they have the same revenue recognition pattern. That is, they are recognized immediately or they are recognized over time using the same revenue recognition pattern.
PROBLEM 18-4 (Continued) (c) The introduction of bonus payment gives rise to a change in the transaction price for the revenue arrangement, to include an adjustment for management’s estimate of the amount of consideration to which Economy will be entitled. Given the information available, a probability-weighted method could be used: 60% chance of $594,000 ($540,000 X 1.10) = $356,400 40% chance of $540,000 = 216,000 $572,400 Thus, the total transaction price is $572,400 based on the probabilityweighted estimate. Note: With just two possible outcomes, Economy uses the “mostlikely-amount” approach, resulting in a transaction price of $594,000. May 1, 2014 Cash (20% X $540,000) ................................... Unearned Sales Revenue ........................
108,000 108,000
July 1, 2014 Unearned Sales Revenue................................ Cash ($594,000 – $108,000) ........................... Sales Revenue .........................................
108,000 486,000
Cost of Goods Sold......................................... Inventory (300 X [$400 + $275 + $260]) ...
280,500
594,000 280,500
(d) This is a bill and hold arrangement. It appears that the criteria for Epic to have obtained control of the appliance bundles have been met: (a) The reason for the bill-and-hold arrangement must be substantive. (b) The product must be identified separately as belonging to Epic Rentals. (c) The product currently must be ready for physical transfer to Epic. (d) Economy cannot have the ability to use the product or to direct it to another customer.
PROBLEM 18-4 (Continued) Economy makes the following entries. February 1, 2014 Cash (10% X 400 X $1,800) ............................. Unearned Sales Revenue ........................
72,000 72,000
April 1, 2014 Unearned Sales Revenue.................................... Accounts Receivable ($720,000 – $72,000) ... Sales Revenue..........................................
72,000 648,000
Cost of Goods Sold........................................ Inventory (400 X $935) ............................
374,000
720,000
374,000
Thus, Economy has transferred control to Epic; Economy has a right to payment for the appliances and legal title has transferred.
PROBLEM 18-5 (a)
(b)
January 1, 2014 Notes Receivable (Mills)................................... Refund Liability (5% X $48,000) .............. Sales Revenue .........................................
48,000
Cost of Goods Sold......................................... Estimated Inventory Returns (40 X $800 X 5%) .......................................... Inventory (40 X $800) ...............................
30,400
2,400 45,600
1,600 32,000
August 10, 2014 Cash (16 X $3,600*) .......................................... Sales Revenue .........................................
57,600
Cost of Goods Sold......................................... Inventory (16 X $2,000) ............................
32,000
57,600
32,000
* Note: There is no adjustment for the volume discount, because it is not probable that the customer will reach the benchmark. (c) This revenue arrangement has 3 different performance obligations: (1) the sale of the dryers, (2) installation, and (3) the maintenance plan. The total revenue of $45,200 should be allocated to the three performance obligations based on their relative fair values: Dryers (3 X $14,000) Installation (3 X $1,000) Maintenance plan Total estimated fair value
$42,000 3,000 1,200 $46,200
PROBLEM 18-5 (Continued) The allocation for a single contract is as follows. Dryers Installation Maintenance plan Total Revenue
$41,091 ($42,000 / $46,200) X $45,200 2,935 ($3,000 / $46,200) X $45,200 1,174 ($1,200 / $46,200) X $45,200 $45,200
Ritt makes the following entries. June 20, 2014 Cash (20% X $45,200) .......................................... Accounts Receivable ($45,200 – $9,040) ....... Unearned Service Revenue (Installation).......................................... Unearned Service Revenue (Maintenance Plan) .............................. Unearned Sales Revenue (Dryers).........
9,040 36,160 2,935 1,174 41,091
(To record agreement to sell and install dryers and maintenance plan) Note: Rather than Unearned Sales Revenue, a Contract Liability Account could be used.
October 1, 2014 Cash (80% X $45,200)...................................... Accounts Receivable ..............................
36,160
Unearned Service Revenue (Installation) ......... Unearned Sales Revenue (Dryers)................. Service Revenue (Installation) ............... Sales Revenue (Dryers) ..........................
2,935 41,091
Cost of Goods Sold ........................................ Inventory (3 X $11,000) .........................
33,000
36,160
2,935 41,091 33,000
PROBLEM 18-5 (Continued) December 31, 2014 Unearned Service Revenue (Maintenance Plans) .................................................................. Service Revenue (Maintenance Plans) ($1,174 X 3/36) .......................................
97.83 97.83
(d) Entries for Ritt April 25, 2014 No entry – Inventory continues to be controlled by Ritt. June 30, 2014 Cash [(60 X $1,200) – (10% X 60 X $1,200)] ... Consignment Expense ................................... Sales Revenue .........................................
64,800 7,200
Cost of Goods Sold (60 X $800) ..................... Inventory .................................................
48,000
72,000 48,000
Entries for Farm Depot April 25, 2014 No entry – Inventory continues to be controlled by Ritt. Summary Entry for Consignment Sales Cash ....................................................................... Due to Ritt (Consignment)....................... Service Revenue (Consignments) ..........
72,000 64,800 7,200
June 30, 2014 Due to Ritt ............................................................. Cash..........................................................
64,800 64,800
PROBLEM 18-6 (a) Warranty Performance Obligations 1. 2.
To transfer 70 specialty winches to customers with a total transaction price of $21,000. To provide extended warranty services for 20 winches after the assurance warranty period with a value of $8,000 (20 X $400) for 2 years.
With respect to the bonus points program, obligation for: 1. 2.
Delivery of the products and, Future delivery of products that can be with bonus point earned.
Hale has a performance
purchased by customers
(b) Cash ....................................................................... Warranty Expense ........................................... Warranty Liability .................................... Unearned Warranty Revenue (20 X $400) ............................................ Sales Revenue.........................................
29,000 2,100 2,100 8,000 21,000
To reduce inventory and recognize cost of goods sold: Cost of Goods Sold ........................................ Inventory..................................................
16,000 16,000
Hale reduces the Warranty Liability account over the first two years as the actual warranty costs are incurred. The company also recognizes revenue related to the service type warranty over the three year period that extends beyond the assurance warranty period (two years). In most cases, the unearned warranty revenue is recognized on a straight line basis and the costs associated with the service type warranty are expensed as incurred. (c) Because the points provide a material right to a customer that it would not receive without entering into a contract, the points are a separate performance obligation. Hale allocates the transaction price to the product and the points on a relative standalone selling price basis as follows.
PROBLEM 18-6 (Continued) The standalone selling price: Purchased products: Estimated points to be redeemed Total Fair Value
$100,000 9,500 $109,500
The allocation is as follows. Products ($100,000 / $109,500) X $100,000 = $91,324 Installation ($9,500 / $109,500) X $100,000 = $ 8,676
To record sales of products subject to bonus points: Cash................................................................. Liability to Bonus Point Customers ....... Sales Revenue .........................................
100,000
Cost of Goods Sold (1–45%) X 100,000......... Inventory ..................................................
55,000
8,676 91,324
55,000
(d) Additional Sales Revenue from bonus point redemptions, if 4,500 points have been redeemed: (4,500 points ÷ 9,500 points X $8,676) = $4,110
PROBLEM 18-7
(a) The transaction price is allocated to the products and loyalty points, as follows: Standalone Percent Transaction Allocated Selling Prices Allocated Price Amounts Product Purchases Loyalty Points (b)
$300,000 75,000 $375,000
80% 20%
$300,000 $300,000
$240,000 60,000 $300,000
July 2, 2014 Cash................................................................. Unearned Sales Revenue………............. Sales Revenue ………………………........
300,000
Cost of Goods Sold ........................................ Inventory……………………………...........
171,000
60,000 240,000 171,000
(c) At July 31, 2014, the revenue recognized as a result of the loyalty points redeemed is $24,000 ($60,000 X [30,000 ÷ 75,000]). Note: Assuming the points were applied to cash purchases with a sales value of $75,000 (cost of $39,000), Martz makes the following entries during July. Cash................................................................. Unearned Sales Revenue ............................... Sales Revenue.........................................
51,000 24,000
Cost of Goods Sold ........................................ Inventory..................................................
39,000
75,000 39,000
PROBLEM 18-8 (a) DeMent recognizes revenue when it delivers books to distributors, which is when it satisfies the performance obligation. The transaction price for the arrangement is adjusted for the expected returns, unless no reliable estimate of returns can be developed. In that case the amount of revenue recognized may be constrained to amounts not subject to returns – until the returns are known. Ankiel recognizes revenue when alarm systems are delivered to customers, which is when it satisfies the performance obligation related to product sales. Commissions are recorded as expenses and a warranty liability and expense are recorded for the assurance warranty. Depp recognizes revenue over time as the asset management services are provided. The transaction price may adjusted for the expected bonus payment. (b) DeMent Publishing Division Sales—fiscal 2014.................................................................. Less: Refund liability (20%) ................................................. Net sales—revenue to be recognized in fiscal 2014............
$7,000,000 1,400,000 $5,600,000
Although 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 2013 sales has no impact on fiscal 2014 revenue. The 21 percent of returns on the initial $5,500,000 of 2014 sales confirms that 20 percent of sales will provide a reasonable estimate.
PROBLEM 18-8 (Continued) Ankiel Securities Division Revenue for fiscal 2014 = $5,200,000. The revenue is the amount of goods actually billed and shipped when revenue is recognized at point of sale (terms of F.O.B. factory). Orders for goods do not constitute sales. Down payments are not sales. The actual freight costs are expenses made by the seller that the buyer will reimburse at the time s/he pays for the goods. Commissions and warranty returns are also selling expenses. Both of these expenses will be accrued and will appear in the operating expenses section of the income statement. Depp Advisory Division Revenue for 1st Quarter of fiscal 2014 = $6,000 ($2,400,000 X .25%) Depp is not reasonably assured to be entitled to the incentive fee until the end of the year. Although Depp has experience with similar contracts, that experience is not predictive of the outcome of the current contract because the amount of consideration is highly susceptible to volatility in the market. In addition, the incentive fee has a large number and high variability of possible consideration amounts. The bonus payment should be deferred until the end of the year, as it is subject to substantial volatility.
PROBLEM 18-9 (a) Sales with financing January 1, 2014 Notes Receivable ............................................ Discount on Notes Receivable................ Sales Revenue ($5,000 X .8900 [PV n=2; i=6%]) ....................
5,000
Cost of Goods Sold ........................................ Inventory ..................................................
4,000
550 4,450 4,000
Total revenue for Colbert Sales revenue Interest revenue ($4,450 X 6%)
$4,450 (Gross profit = $1,000) 267 $4,717
(b) Gift Cards March 1, 2014 Cash................................................................. Unearned Sales Revenue (20 X $100).....
2,000 2,000
March 31, 2014 Unearned Sales Revenue ............................... Sales Revenue (10 X $100) ......................
1,000
Cost of Goods Sold ........................................ Inventory (10 X $80) .................................
800
1,000 800
April 30, 2014 Unearned Sales Revenue ............................... Sales Revenue (6 X $100) ........................
600
Cost of Goods Sold ........................................ Inventory (6 X $80) ...................................
480
600 480
PROBLEM 18-9 (Continued) June 30, 2014 Unearned Sales Revenue ............................... Sales Revenue (1 [20 X .05] X $100).......
100
Cost of Goods Sold ........................................ Inventory (1 [20 X .05] X $80)..................
80
100 80
In addition, an additional entry is made on June 30, 2014 to recognize that 15% of the gift cards (3 cards) will not be redeemed. June 30, 2014 Unearned Sales Revenue ............................... Sales Revenue (3 X $100) .......................
300 300
There is no cost of goods sold related to the last 3 gift cards as they were not redeemed. (c) Bundle Sales Since the paper is delivered later, Colbert has two performance obligations, the printer and the stand and the paper. As indicated, the standalone price for the printer, stand, and paper is $5,625, but the bundled price for all three is $5,125. In this case, the performance obligation related to the printer and stand is where the discount applies. As a result, the allocation of the discount of $500 should be allocated to these two items, as follows. Allocated Amounts Paper Printer and Stand ($5,125 – $175) Total
$ 175 4,950 $5,125
PROBLEM 18-9 (Continued) The journal entries are as follows: March 1, 2014 Cash................................................................. Sales Revenue (10 X $4,950) ................... Unearned Sales Revenue (paper) ...........
51,250
Cost of Goods Sold [10 X ($4,000 + $200]..... Inventory ..................................................
42,000
49,500 1,750 42,000
(To record sale of printer and stand) September 1, 2014 Unearned Sales Revenue (Paper).................. Sales Revenue (10 X $175) ......................
1,750
Cost of Goods Sold ........................................ Inventory (10 X $135) ...............................
1,350
(To record sale of paper)
1,750 1,350
*PROBLEM 18-10
(a) Contract price Less estimated cost: Costs to date Estimated cost to complete Estimated total cost Estimated total gross profit
2014 $900,000
2015 $900,000
2016 $900,000
270,000 330,000 600,000 $300,000
450,000 150,000 600,000 $300,000
610,000 — 610,000 $290,000
Gross profit recognized in— 2014: $270,000 X $300,000 = $600,000
$135,000
2015: $450,000 X $300,000 = $600,000 Less 2014 recognized gross profit Gross profit in 2015
$225,000
135,000 $ 90,000
2016: Less 2014–2015 recognized gross profit Gross profit in 2016
225,000 $ 65,000
(b) In 2014 and 2015, no gross profit would be recognized. Total billings...................................... Total cost........................................... Gross profit recognized in 2016.......
$900,000 (610,000) $290,000
* PROBLEM 18-11
(a)
Computation of Recognizable Profit/Loss Percentage-of-Completion Method 2014 Costs to date (12/31/14)........................................... Estimated costs to complete .................................. Estimated total costs .......................................
$2,880,000 3,520,000 $6,400,000
Percent complete ($2,880,000 ÷ $6,400,000) ..........
45%
Revenue recognized ($8,400,000 X 45%) ............... Costs incurred ......................................................... Profit recognized in 2014 ........................................
$3,780,000 (2,880,000) $ 900,000
2015 Costs to date (12/31/15) ($2,880,000 + $2,230,000)..................................... Estimated costs to complete .................................. Estimated total costs ....................................... Percent complete ($5,110,000 ÷ $7,300,000) .......... Revenue recognized in 2015 ($8,400,000 X 70%) – $3,780,000 ......................... Costs incurred in 2015 ............................................ Loss recognized in 2015 .........................................
$5,110,000 2,190,000 $7,300,000 70% $2,100,000 (2,230,000) $ (130,000)
2016 Total revenue recognized........................................ Total costs incurred ................................................ Total profit on contract............................................ Deduct profit previously recognized ($900,000 – $130,000) .......................................... Profit recognized in 2016 ........................................
$8,400,000 (7,300,000) 1,100,000 770,000 $ 330,000
PROBLEM 18-11 (Continued) (b) No profit or loss recognized in 2014 and 2015 2016 Contract price .......................................................... Costs incurred ......................................................... Profit recognized......................................................
$8,400,000 7,300,000 $1,100,000
* PROBLEM 18-12 (a)
Computation of Recognizable Profit/Loss Percentage-of-Completion Method 2014 Costs to date (12/31/14)................................................. Estimated costs to complete ........................................ Estimated total costs .............................................
$ 300,000 1,200,000 $1,500,000
Percent complete ($300,000 ÷ $1,500,000) ...................
20%
Revenue recognized ($1,900,000 X 20%) ..................... Costs incurred ............................................................... Profit recognized in 2014 ..............................................
$ 380,000 (300,000) $ 80,000
2015 Costs to date (12/31/15)................................................. Estimated costs to complete ........................................ Estimated total costs ............................................. Contract price ................................................................ Total loss........................................................................
$1,200,000 800,000 2,000,000 (1,900,000) $ 100,000
Total loss........................................................................ Plus gross profit recognized in 2014 ........................... Loss recognized in 2015 ...............................................
$ 100,000 80,000 $ 180,000
*2016 revenue ($1,900,000 – $380,000 – $760,000) .................. Less: 2016 estimated costs................................. 2016 loss ...............................................................
$ 760,000 800,000 $ (40,000)
PROBLEM 18-12 (Continued) 2016 Costs to date (12/31/16) ........................................ Estimated costs to complete ...............................
$2,100,000 0 2,100,000 1,900,000 $ (200,000)
Contract price ....................................................... Total loss ............................................................... Total loss ............................................................... Less: Loss recognized in 2015 ........................... Gross profit recognized in 2014........................... Loss recognized in 2016.......................................
$ (200,000) $180,000 (80,000)
(100,000) $ (100,000)
(b) No profit or loss in 2014 2015 Contract price ....................................................... Estimated costs .................................................... Loss recognized ...................................................
$1,900,000 2,000,000 $ 100,000
2016 Contract price ....................................................... Costs incurred ...................................................... Total loss ............................................................... Less: Loss recognized in 2015 ............................ Loss recognized.................................................
$1,900,000 2,100,000 200,000 100,000 $ 100,000
* PROBLEM 18-13
(a) A company recognizes revenue in the accounting period when a performance obligation is satisfied—the revenue recognition principle. A key element of the revenue recognition principle is that a company recognizes revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration that it receives, or expects to receive, in exchange for those goods or services. Companies satisfy performance obligations either at a point in time or over a period of time. Companies recognize revenue over a period of time if one of the following two criteria is met. 1.
The customer controls the asset as it is created or enhanced.
2.
The company does not have an alternative use for the asset created or enhanced and either (1) the customer receives benefits as the company performs and therefore the task would not need to be re-performed, or (2) the company has a right to payment and this right is enforceable.
In the case of a franchise, fees related to rights to use the intellectual property generally are recognized at a point in time, usually when the franchise begins operation. That is because at that time, the customer controls the product or service when it has the ability to direct the use of and obtain substantially all the remaining benefits from the franchise rights. Control also includes the customer’s ability to prevent other companies from directing the use of, or receiving the benefit, from the asset or service. The continuing franchise fees are recognized over time, because they are in exchange for products and services transferred to the franchisee during the franchise period.
PROBLEM 18-13 (Continued) (b) 1.
January 5, 2014 Cash.................................................. Notes Receivable ............................. Discount on Notes Receivable ($100,000 – $75,816*) ............... Unearned Franchise Revenue ....
20,000 100,000 24,184 95,816
* Present value of future payments ($20,000 X 3.79079) July 1, 2014 2. Unearned Franchise Revenue......... Revenue (Franchise) ...................
20,000 20,000
To record revenue from delivery of franchise rights. December 31, 2014 Cash (260,000 X 2%) ........................ Revenue (Franchise)..............
5,200 5,200
(to recognize continuing franchise fees) Unearned Franchise Revenue ($75,816 ÷ 60 X 6) ......................................... Revenue (Franchise)...............................
7,582 7,582
(To recognize ongoing fees for brand maintenance) Cash………………………………………………. Discount on Notes Receivable....................... Interest Revenue ($75,816 X 10%) ............ Notes Receivable……………………………
20,000 3,791 3,791 20,000
(c) In this situation Amigos would recognize the entire franchise fee of $95,816 when the franchise opens. That is, franchise revenue is recognized at a point in time.
TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 18-1 (Time 20–30 minutes) Purpose—to provide the student an opportunity to describe the 5-step revenue recognition model and explain the importance of fair value measurement and the definitions of asset and liabilities to application of the 5-step model. CA 18-2 (Time 20–30 minutes) Purpose—to provide the student an opportunity to describe the revenue recognition principle and the importance of control and the definitions of assets and liabilities to application of the revenue recognition principle. CA 18-3 (Time 25–30 minutes) Purpose—to provide the student with an understanding of the conceptual merits of recognizing revenue at the point of sale. The student is required to explain and defend the reasons why the point of sale is usually used as the basis for the timing of revenue recognition, plus describe the situations where revenue would be recognized over time. CA 18-4 (Time 25–30 minutes) Purpose—to provide the student with an understanding of the conceptual factors underlying the recognition of revenue. The student is required to explain and justify why revenue is often recognized as earned at the time of sale, the situations when it would be appropriate to recognize revenue over time. CA 18-5 (Time 20–25 minutes) Purpose— to provide the student with an understanding of the conceptual factors underlying the recognition of revenue. The student is required to explain the factors that result in the constraint of or deferral or revenue recognition. CA 18-6 (Time 35–45 minutes) Purpose—to provide the student an opportunity to explain how a magazine publisher should recognize subscription revenue. The case is complicated by a 25% return rate and a premium offered to subscribers. The effect on the current ratio must be discussed. CA 18-7 (Time 25–30 minutes) Purpose—to provide the student with an understanding of the criteria and applications utilized in the determination revenue recognition for a bonus point program. The student is required to discuss the factors to be considered in determining when revenue should be recognized, plus apply these factors in discussing the accounting alternatives that should be considered for the recognition of revenues and related expenses with regard to the information presented in the case. CA 18-8 (Time 20–25 minutes) Purpose—to provide the student an ethical situation related to the recognition of revenue from membership fees. *CA 18-9 (Time 20–25 minutes) Purpose—to provide the student an opportunity to discuss the theoretical justification for use of the percentage-of-completion method. The student explains how progress billings are accounted for and how to determine the income recognized in the second year of a contract by the percentageof-completion method. The student indicates the effect on earnings per share in the second year of a four-year contract from using the percentage-of-completion method instead of the completed-contract method.
SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 18-1 (a)
The 5-step model is as follows. 1.
Identify the contract with customers. A contract is an agreement that creates enforceable rights or obligations and (1) has commercial substance, (2) has been approved and both parties are committed to performing their obligations, (3) the company can identify each party’s rights regarding the goods or services to be transferred, and (4) the payment terms. A company applies the revenue guidance to contracts with customers and must determine if new performance obligations are created by a contract modification.
2.
Identify the separate performance obligations in the contract. A performance obligation is a promise in a contract to provide a product or service to a customer. A performance obligation exists if the customer can benefit from the good or service on its own or together with other readily available resources. A contract may be comprised of multiple performance obligations. The accounting for multiple performance obligations is based on evaluation of whether the product or service is distinct within the contract. If each of the goods or services is distinct, but is interdependent and interrelated, these goods and services are combined and reported as one performance obligation.
3.
Determine the transaction price. The transaction price is the amount of consideration that a company expects to receive from a customer in exchange for transferring goods and services. In determining the transaction price, companies must consider the following factors: (1) variable consideration, (2) time value of money, (3) noncash consideration, (4) consideration paid to a customer, and (5) upfront fee payments.
4.
Allocate the transaction price to separate performance obligations. If there is more than one performance obligation, allocate the transaction price based on relative fair values. The best measure of fair value is what the good or service could be sold for on a standalone basis (standalone selling price). Estimates of standalone selling price can be based on (1) adjusted market assessment, (2) expected cost plus a margin approach, or (3) a residual approach.
CA 18-1 (Continued) 5.
Recognize revenue when each performance obligation is satisfied. A company satisfies its performance obligation when the customer obtains control of the good or service. Companies satisfy performance obligations either at a point in time or over a period of time. Companies recognize revenue over a period of time if (1) the customer controls the asset as it is created or the company does not have an alternative use for the asset, and (2) the company has a right to payment.
(b)
A contract is an agreement between two or more parties that creates enforceable rights or obligations. Contracts can be written, oral, or implied from customary business practice. By definition, revenue from a contract with a customer cannot be recognized until a contract exists. On entering into a contract with a customer, a company obtains rights to receive consideration from the customer and assumes obligations to transfer goods or services to the customer (performance obligations). In some cases, there are multiple contracts related to the transaction, and accounting for each contract may or may not occur, depending on the circumstances. These situations often develop when not only a product is provided but some type of service is performed as well.
(c)
Companies often have to allocate the transaction price to more than one performance obligation in a contract. If an allocation is needed, the transaction price allocated to the various performance obligations is based on their relative fair value. The best measure of fair value is what the company could sell the good or service on a standalone basis, referred to as the standalone selling price. If this information is not available, companies should use their best estimate of what the good or service might sell for as a standalone unit. Depending on the circumstances, companies use the following approaches to determine standalone fair value: (1) Adjusted market assessment approach-Evaluate the market in which it sells goods or services and estimate the price that customers in that market are willing to pay for those goods or services. That approach also might include referring to prices from the company’s competitors for similar goods or services and adjusting those prices as necessary to reflect the company’s costs and margins; (2) Expected cost plus a margin approach-Forecast expected costs of satisfying a performance obligation and then add an appropriate margin for that good or service; or (3) Residual approach - If the standalone selling price of a good or service is highly variable or uncertain, then a company may estimate the standalone selling price by reference to the total transaction price less the sum of the observable standalone selling prices of other goods or services promised in the contract. A selling price is highly variable when a company sells the same good or service to different customers (at or near the same time) for a broad range of amounts. A selling price is uncertain when a company has not yet established a price for a good or service and the good or service has not previously been sold.
CA 18-67 (Continued) (d)
Companies use an asset-liability model to recognize revenue. For example, when a company delivers a product (satisfying its performance obligation), it has a right to consideration and therefore has a contract asset. If, on the other hand, the customer performs first, by prepaying, the seller has a contract liability. Companies must present these contract assets and contract liabilities on their balance sheets. Contract assets are of two types: (1) unconditional rights to receive consideration because the company has satisfied its performance obligation with a customer, and (2) conditional rights to receive consideration because the company has satisfied one performance obligation but must satisfy another performance obligation in the contract before it can bill the customer. Companies should report unconditional rights to receive consideration as a receivable on the balance sheet. Conditional rights on the balance sheet should be reported separately as contract assets. A contract liability is a company’s obligation to transfer goods or services to a customer for which the company has received consideration from the customer.
CA 18-2 (a)
A company recognizes revenue in the accounting period when a performance obligation is satisfied—the revenue recognition principle. A key element of the revenue recognition principle is that a company recognizes revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration that it receives, or expects to receive, in exchange for those goods or services. Companies satisfy performance obligations either at a point in time or over a period of time. Companies recognize revenue over a period of time if one of the following two criteria is met. 1.
The customer controls the asset as it is created or enhanced.
2.
The company does not have an alternative use for the asset created or enhanced and either (1) the customer receives benefits as the company performs and therefore the task would not need to be re-performed, or (2) the company has a right to payment and this right is enforceable.
The concept of change in control is the deciding factor in determining when a performance obligation is satisfied. The customer controls the product or service when it has the ability to direct the use of and obtain substantially all the remaining benefits from the asset or service. Control also includes the customer’s ability to prevent other companies from directing the use of, or receiving the benefit, from the asset or service. Indicators that the customer has obtained control are as follows: 1. 2.
The company has a right to payment for the asset. The company transferred legal title to the asset.
CA 18-2 (Continued) 3. 4. 5.
The company transferred physical possession of the asset. The customer has significant risks and rewards of ownership. The customer has accepted the asset.
(b)
Companies use an asset-liability model to recognize revenue. For example, when a company delivers a product (satisfying its performance obligation), it has a right to consideration and therefore has a contract asset. If, on the other hand, if the customer performs first, by prepaying, the seller has a contract liability. Companies must present these contract assets and contract liabilities on their balance sheets. Contract assets are of two types: (1) unconditional rights to receive consideration because the company has satisfied its performance obligation with a customer, and (2) conditional rights to receive consideration because the company has satisfied one performance obligation but must satisfy another performance obligation in the contract before it can bill the customer. Companies should report unconditional rights to receive consideration as a receivable on the balance sheet. Conditional rights on the balance sheet should be reported separately as contract assets. A contract liability is a company’s obligation to transfer goods or services to a customer for which the company has received consideration from the customer.
(c)
Collectability refers to a customer’s credit risk—that is, the risk that a customer will be unable to pay the amount of consideration in accordance with the contract. Any time a company sells a product or performs a service on account, a collectability issue occurs. Will the customer pay the promised consideration? Whether a company will get paid for satisfying a performance obligation is not a consideration in determining revenue recognition. The amount recognized is not adjusted for customer credit risk. Rather, companies report the revenue gross and then present an allowance for any impairment due to bad debts (recognized initially and subsequently in accordance with the respective bad debt guidance) prominently as an operating expense in the income statement. If significant doubt exists at contract inception about collectability, it often indicates that the parties are not committed to their obligations. As a result, it may mean that the existence of a contract is not met.
CA 18-3 (a)
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 that control has transferred to the customer. In other words, sales transactions with outsiders represent the point in the revenuegenerating process when most of the uncertainty about satisfying a performance obligation is resolved.
CA 18-3 (Continued) (b)
1. 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 recognize. Also, in most situations the sale represents the most important single step in satisfying a performance obligation. 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 recognized by the completion of 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. 2.
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 satisfying a performance obligation and that periodic revenue 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 satisfying a performance obligation 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 sales 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)
Over-time. 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 is far less significant to satisfying a performance obligation 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 impair significantly the usefulness of the intervening annual financial statements because the volume of contracts completed 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. Income might be recognized on a production basis for some products whose salability at a known price can be reasonably determined as might be the case with some precious metals and agricultural products.
CA 18-3 (Continued) 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.
CA 18-4 (a)
Recognizing revenue at point of sale is appropriate for many revenue arrangements, because this is the time at which control of the asset transfers to the customer. That is, the concept of change in control is the deciding factor in determining when a performance obligation is satisfied. The customer controls the product or service when it has the ability to direct the use of and obtain substantially all the remaining benefits from the asset or service. Control also includes the customer’s ability to prevent other companies from directing the use of, or receiving the benefit, from the asset or service. Change in control indicators are as follows: 1. 2. 3. 4. 5.
The company has a right to payment for the asset. The company transferred legal title to the asset. The company transferred physical possession of the asset. The customer has significant risks and rewards of ownership. The customer has accepted the asset.
Thus, for many revenue arrangements (for delivery of goods and/or services), these indicators are present at point-of-sale. (b)
Companies recognize revenue over a period of time if one of the following two criteria is met. 1.
The customer controls the asset as it is created or enhanced.
2.
The company does not have an alternative use for the asset created or enhanced and either (1) the customer receives benefits as the company performs and therefore the task would not need to be re-performed, or (2) the company has a right to payment and this right is enforceable.
A company recognizes revenue from a performance obligation over time by measuring the progress toward completion. The method selected for measuring progress should depict the transfer of control from the company to the customer. Companies use various methods to determine the extent of progress toward completion. The most common are the cost-to-cost and units-of-delivery methods. The objective of all these methods is to measure the extent of progress in terms of costs, units, or value added. Companies identify the various measures (costs incurred, labor hours worked, tons produced, floors completed, etc.) and classify them as input or output measures.
CA 18-4 (Continued) Input measures (e.g., costs incurred and labor hours worked) are efforts devoted to a contract. Output measures (with units of delivery measured as tons produced, floors of a building completed, miles of a highway completed, etc.) track results. Neither is universally applicable to all long-term projects. Their use requires the exercise of judgment and careful tailoring to the circumstances. Both input and output measures have certain disadvantages. The input measure is based on an established relationship between a unit of input and productivity. If inefficiencies cause the productivity relationship to change, inaccurate measurements result. Another potential problem is front-end loading, in which significant upfront costs result in higher estimates of completion. To avoid this problem, companies should disregard some early-stage construction costs—for example, costs of uninstalled materials or costs of subcontracts not yet performed—if they do not relate to contract performance. Similarly, output measures can produce inaccurate results if the units used are not comparable in time, effort, or cost to complete. For example, using floors (stories) completed can be deceiving. Completing the first floor of an eight-story building may require more than one-eighth the total cost because of the substructure and foundation construction. The most popular input measure used to determine the progress toward completion is the costto-cost basis. Under this basis, a company measures the percentage of completion by comparing costs incurred to date with the most recent estimate of the total costs required to complete the contract. The percentage-of- completion method is discussed more fully in Appendix 18A, which examines the accounting for long-term contracts.
CA 18-5 (a)
Fahey records $1,700,000 on the date of sale. Only $1,700,000 is recognized at point of sale because this amount is not subject to a discount.
(b)
In situations where there may be returns or variable consideration, revenue on sales subject to reversal may not be recognized (constrained). Companies therefore may only recognize if (1) they have experience with similar contracts and are able to estimate the returns, and (2) based on experience, they do not expect a significant reversal of revenue previously recognized. To account for the sale of products with a right of return (and for some services that are provided subject to a refund), the seller should recognize all of the following. 1.
Revenue for the transferred products in the amount of consideration to which the seller is reasonably assured to be entitled (considering the products expected to be returned).
CA 18-5 (Continued)
(c)
2.
A refund liability.
3.
An asset (and corresponding adjustment to cost of sales) for its right to recover products from the customer on settling the refund liability.
GAAP in the past has required that revenue be recognized only when collectability is reasonably assured. However, the new guidance permits companies to recognize revenue earlier even if collectability is a problem. Collectability refers to a customer’s credit risk—that is, the risk that a customer will be unable to pay the amount of consideration in accordance with the contract. Any time a company sells a product or performs a service on account, a collectability issue occurs. The amount recognized is not adjusted for customer credit risk. Rather, companies report the revenue gross and then present an allowance for any impairment due to bad debts (recognized initially and subsequently in accordance with the respective bad debt guidance) prominently as an operating expense in the income statement. If significant doubt exists at contract inception about collectability, it often indicates that the parties are not committed to their obligations. As a result, it may mean that the existence of a contract is not met.
CA 18-6 (a)
Receipts based on subscriptions should be credited to Unearned Sales Revenue. As each monthly issue is distributed, Unearned Sales Revenue is reduced (Dr.) and Sales Revenue is recognized (Cr.). A problem results because of the unqualified guarantee for a full refund. Certain companies experience such a high rate of returns to sales that they find it necessary to postpone revenue recognition (revenue recognized is constrained) until the return privilege has substantially expired. Cutting Edge is expecting a 25% return rate and it will not expire until the new subscriptions expire. Companies therefore may only recognize revenue on sales with return privileges if (1) they have experience with similar contracts and are able to estimate the returns, and (2) based on experience, they do not expect a significant reversal of revenue previously recognized.
(b)
To account for the sale of products with a right of return (and for some services that are provided subject to a refund), the seller should recognize all of the following. 1.
Revenue for the transferred products in the amount of consideration to which the seller is reasonably assured to be entitled (considering the products expected to be returned).
2.
A refund liability.
3.
An asset (and corresponding adjustment to cost of sales) for its right to recover inventory from the customer on settling the refund liability.
CA 18-6 (Continued) (c)
Since the atlas premium may be accepted whenever requested, it is necessary for Cutting Edge to record a liability (a performance obligation) for estimated premium claims outstanding. According to GAAP, the estimated premium claims outstanding is a contingent liability which should be reported since it can be readily estimated [60% of the new subscribers X (cost of atlas = $2)] and its occurrence is probable. As the new subscription is obtained, Cutting Edge should record the estimated liability as follows: Premium Expense ..................................................................................... Premium Liability................................................................................
XXX XXX
Upon request for the atlas and payment of $2 by the new subscriber, Cutting Edge should record: Cash .......................................................................................................... Premium Liability ....................................................................................... Inventory of Premiums ....................................................................... (d)
XXX XXX XXX
The current ratio (Current Assets Current Liabilities) will change, but not in the direction Embry thinks. As subscriptions are obtained, current assets (cash or accounts receivable) will increase and current liabilities (unearned revenue) will increase by the same amount. In addition, the liabilities for estimated premium claims outstanding and the refund liability will increase with no change in current assets. Consequently, the current ratio will decrease rather than increase as proposed. Naturally as the revenue is recognized, these ratios will become more favorable. Similarly, the debt to equity ratio will not be decreased due to the increase in liabilities.
CA 18-7 (a)
A company recognizes revenue in the accounting period when a performance obligation is satisfied—the revenue recognition principle. A key element of the revenue recognition principle is that a company recognizes revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration that it receives, or expects to receive, in exchange for those goods or services. The concept of change in control is the deciding factor in determining when a performance obligation is satisfied. The customer controls the product or service when it has the ability to direct the use of and obtain substantially all the remaining benefits from the asset or service. Control also includes the customer’s ability to prevent other companies from directing the use of, or receiving the benefit, from the asset or service. Indicators of change in control include: 1. 2. 3. 4. 5.
The company has a right to payment for the asset. The company transferred legal title to the asset. The company transferred physical possession of the asset. The customer has significant risks and rewards of ownership. The customer has accepted the asset.
Companies satisfy performance obligations either at a point in time or over a period of time. Companies recognize revenue over a period of time if one of the following two criteria is met. 1.
The customer controls the asset as it is created or enhanced.
2.
The company does not have an alternative use for the asset created or enhanced and either (1) the customer receives benefits as the company performs and therefore the task would not need to be re-performed, or (2) the company has a right to payment and this right is enforceable.
CA 18-7 (Continued) (b)
Griseta & Dubel Inc., in effect, collects cash for merchandise credits far in advance of when merchants furnish the goods. Thus, this is an example of upfront payments. In addition, since the data indicate that about 5 percent of the credits sold will never be redeemed, it also has revenue from this source unless these credits are redeemed. Griseta & Dubel’s revenues are recognized when the performance obligation is met when credits are redeemed. The performance obligation is to deliver premiums (tickets and other items) in the future. This revenue is recognized when the bonus points sales occur. Reasonable estimation is crucial to revenue recognition. Griseta and Dubel uses historical bonus points data to estimate the amount of consideration to allocate to the future bonus point revenue.
(c)
Griseta & Dubel’s major asset (in terms of data given in the question) would be its inventory of premiums. The major account with a credit balance would be performance obligation to deliver premiums to merchants in the future.
CA 18-8 (a)
Honesty and integrity of financial reporting versus higher corporate profits are the ethical issues. Nies’s position represents GAAP. The financial statements should be presented fairly and that will not be the case if Avery’s approach is followed. External users of the statements such as investors and creditors, both current and future, will be misled.
(b)
Nies should insist on statement presentation in accordance with GAAP. If Avery will not accept Nies’s position, Nies will have to consider alternative courses of action, such as contacting higherups at Midwest, and assess the consequences of each.
* CA 18-9 (a)
Widjaja Company should recognize revenue as it performs the work on the contract (the percentage-of-completion method) because it meets the criteria for revenue recognition over time.
(b)
Progress billings would be accounted for by increasing accounts receivable and increasing progress billings on contract, a contra-asset that is offset against the Construction in Process account. If the Construction in Process account exceeds the Billings on Construction in Process account, the two accounts would be shown net in the current assets section of the balance sheet. If the Billings on Construction in Process account exceeds the Construction in Process account, the two accounts would be shown net, in most cases, in the current liabilities section of the balance sheet.
(c)
The income recognized in the second year of the four-year contract would be determined using the cost-to-cost method of determining percentage of completion as follows: 1. The estimated total income from the contract would be determined by deducting the estimated total costs of the contract (the actual costs to date plus the estimated costs to complete) from the contract price.
CA 18-9 (Continued) 2. The actual costs to date would be divided by the estimated total costs of the contract to arrive at the percentage completed. This would be multiplied by the estimated total income from the contract to arrive at the total income recognizable to date. 3. The income recognized in the second year of the contract would be determined by deducting the income recognized in the first year of the contract from the total income recognizable to date. (d)
Earnings per share in the second year of the four-year contract would be higher using the percentage-of-completion method instead of the completed-contract method because income would be recognized in the second year of the contract using the percentage-of-completion method, whereas no income would be recognized in the second year of the contract using the completed-contract method.
FINANCIAL REPORTING PROBLEM (a) 2011 Net sales: $82,559 million. (b) P&G’s Net sales increased from $78,938 million to $82,559 million from 2010 to 2011, or 4.59%. net sales increased from $76,694 million to $78,938 million from 2009 to 2010, or 2.93%. Revenues increased from $76,694 million in 2009 to $82,559 million in 2011—a 7.65% increase. (c) Sales are recognized when revenue is realized or realizable and has been earned. Revenue transactions represent sales of inventory. The revenue recorded is presented net of sales and other taxes we collect on behalf of governmental authorities. The revenue includes shipping and handling costs, which generally are included in the list price to the customer. Our policy is to recognize revenue when title to the product, ownership and risk of loss transfer to the customer, which can be on the date of shipment or the date of receipt by the customer. A provision for payment discounts and product return allowances is recorded as a reduction of sales in the same period that the revenue is recognized. (d) Trade promotions, consisting primarily of customer pricing allowances, merchandising funds and consumer coupons, are offered through various programs to customers and consumers. Sales are recorded net of trade promotion spending, which is recognized as incurred, generally at the time of the sale. Most of these arrangements have terms of approximately one year. Accruals for expected payouts under these programs are included as accrued marketing and promotion in the accrued and other liabilities line item in the Consolidated Balance Sheets. The policies for trade promotions are consistent with revenue recognition criteria and with accrual accounting concepts. Trade promotion expenses are recorded in the period of the sales, and as a result are matched with the revenue they help generate. Any amounts that benefit future periods are accrued and reported as liabilities to be matched with revenues in future periods when paid out.
COMPARATIVE ANALYSIS CASE (a) For the year 2011, Coca-Cola reported net operating revenues of $46,542 million and PepsiCo reported net revenue of $66,504 million. Coca-Cola’s revenues increased by $11,423 million or 32.5% from 2010 to 2011 while PepsiCo’s revenues increased by $8,666 million or 15% from 2010 to 2011. (b) Revenue Recognition Policies Coca-Cola provided the following revenue recognition note: Our Company recognizes revenue when persuasive evidence of an arrangement exists, delivery of products has occurred, the sales price charged is fixed or determinable, and collectability is reasonably assured. For our Company, this generally means that we recognize revenue when title to our products is transferred to our bottling partners, resellers or other customers. In particular, title usually transfers upon shipment to or receipt at our customers’ locations, as determined by the specific sales terms of the transactions. Our sales terms do not allow for a right of return except for matters related to any manufacturing defects on our part. PepsiCo’s Revenue Recognition note is as follows: We recognize revenue upon shipment or delivery to our customers in accordance with written sales terms that do not allow for a right of return. However, our policy for DSD and certain chilled products is to remove and replace damaged and out-of-date products from store shelves to ensure that our consumers receive the product quality and freshness that they expect. Similarly, our policy for certain warehouse distributed products is to replace damaged and out-of-date products. Based on our historical experience with this practice, we have reserved for anticipated damaged and out-of-date products. Based on our experience with this practice, we have reserved for anticipated damaged and out-of-date products. The policies are similar.
COMPARATIVE ANALYSIS CASE (Continued) (c) In 2011, Coca Cola experienced significant amounts of revenue in Eurasia and Africa, $2,841 million; Europe, $5,474 million; Latin America, $4,690 million; and Pacific $5,838 million. In 2011, PepsiCo reported net revenues in Mexico, $4,782 million; Canada, $3,364 million; United Kingdom, $2,075; all other countries, $18,276. In 2011, Coca-Cola’s U.S. revenues were $18,699 million compared with $27,843 million of foreign revenues, while PepsiCo’s U.S. revenues were $33,053 million compared with $33,451 ($66,504 – $33,053) million of foreign revenues.
FINANCIAL STATEMENT ANALYSIS CASE WESTINGHOUSE ELECTRIC CORPORATION (a) For product sales, Westinghouse Electric Corporation uses the date of delivery, point of sale, basis for revenue recognition. For services rendered, Westinghouse uses the “when services are complete and billable method” of recognizing revenues. For nuclear steam supply system orders (approximately 5 years in duration) and other long-term construction projects, Westinghouse uses the percentage-of-completion method for recognizing revenue. And, WFSI revenues are recognized on the accrual basis, except when accounts become delinquent for two or more periods; then income is recognized only as payments are received; that is, on the cash basis. (b) Point of sale or date of delivery is acceptable in ordinary product sale transactions where the seller’s earning process is virtually complete, no further obligations or costs remain, and the exchange transaction has taken place (title passes). For service transactions revenue is recognized as earned and realizable, which is when services are rendered to the satisfaction of the customer and become billable. The percentage-of-completion method of revenue recognition is acceptable on long-term projects, usually construction contracts exceeding one year in length. Its application is required if the following conditions exist: 1. 2. 3.
A firm contract price with a high probability of collection exists. A reasonably accurate estimate of costs and therefore gross profit, can be made. A reasonable estimate of the extent of progress toward completion can be made intermittently.
(c) WFSI is probably a wholly owned finance subsidiary of Westinghouse that provides financing for customers of Westinghouse. The character of the revenue being recognized by WFSI is interest revenue on notes receivable. So long as accounts are current, payments are being received, interest and principal are recognized in each payment. When two payments are missed, the account is declared delinquent and interest is no longer accrued. On delinquent accounts it is probable that if and as cash is collected, the cost-recovery method is applied; that is, interest is recognized only after all principal is recovered.
ACCOUNTING, ANALYSIS, AND PRINCIPLES Accounting Sales revenue ............................................................................. Expenses .................................................................................... Gross profit from pump bundle* ............................................... Gross profit on consignment sales**........................................ Net income..................................................................................
$9,500,000 7,750,000 1,750,000 24,000 120,000 $1,894,000
* Since the sump-pump and installation bundle are delivered at the same time, there are two performance obligations. Any discount is applied to the pump/installation bundle. The total transaction price of $54,600 is allocated between the equipment and installation ($43,800) and the service contract ($10,800 [$10 X 36 X 30]). Sales revenue ..................................................... Cost of goods sold (30 X [$540 + $150]) ........... Gross profit....................................................
$43,800 20,700
Service revenue [($10,800 ÷ 36 X 10)] ............... Expense ($7,560 [$7 X 36 X 30] ÷ 36 X 10) ........ Income on service contract .......................... Net income on this arrangement..................
$3,000 2,100
$23,100
900 $24,000
* Sales revenue (200 X $1,200)................................$240,000 Cost of goods sold (200 X $540) ............................. 108,000 Gross profit....................................................
$132,000
Consignment expense ($240,000 X 5%) ........... Net Income on this arrangement..................
12,000 $120,000
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) Analysis Net income .................................................................................. Depreciation expense ................................................................ Increase in working capital........................................................ Net cash flow from operating activities .................................... Less: Capital expenditures ....................................................... Dividends ......................................................................... Free cash flow ............................................................................
$1,894,000 175,000 (250,000) 1,819,000 500,000 120,000 $1,199,000
Principles Under the 5-step model, a company first identifies the contract with customer(s); identifies the separate performance obligations in the contract; determines the transaction price; allocates the transaction price to separate performance obligations, and recognizes revenue when each performance obligation is satisfied. As indicated, a company satisfies its performance obligation when the customer obtains control of the good or service. Companies satisfy performance obligations either at a point in time or over a period of time. Companies recognize revenue over a period of time if (1) the customer controls the asset as it is created or the company does not have an alternative use for the asset, and (2) the company has a right to payment. In the case of the sump-pump sales, the customer has control of the pumps when the pumps are delivered and installed. The service contract revenue is recognized over time as Diversified provides the services. With respect to the consignment sales, Menards is acting as an agent; revenue on those sales is recognized when the customers purchase (have control of) the pumps. Using control as a key element contributes to relevance because it indicates the cash flows that the seller is entitled to as a result of the revenue arrangement, which enhances the predictive value of the revenue information.
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) Faithful representation may be sacrificed in situations companies must allocate the transaction price to more than one performance obligation in a contract. If an allocation is needed, the transaction price allocated to the various performance obligations is based on their relative fair value. In addition, faithful representation could be affected when companies must estimate returns, warranty obligations, and other elements that affect the transaction price. These estimates could be subject to error or bias.
PROFESSIONAL RESEARCH (a)
Sale with a Right of Return is addressed at FASB ASC 606-10-55.
(b) According to FASB ASC 606-10-55-22 related to right of return: In some contracts, an entity transfers control of a product to a customer and also grants the customer the right to return the product for various reasons (such as dissatisfaction with the product) and receive any combination of the following: a.
A full or partial refund of any consideration paid
b.
A credit that can be applied against amounts owed, or that will be owed, to the entity
c.
Another product in exchange.
Bill and Hold: According to FASB ASC 606-10-55-81: A bill-and-hold arrangement is a contract under which an entity bills a customer for a product but the entity retains physical possession of the product until it is transferred to the customer at a point in time in the future. For example, a customer may request an entity to enter into such a contract because of the customer’s lack of available space for the product or because of delays in the customer’s production schedules. (c)
According to FASB ASC 606-10-55-23: To account for the transfer of products with a right of return (and for some services that are provided subject to a refund), an entity should recognize all of the following: a.
Revenue for the transferred products in the amount of consideration to which the entity expects to be entitled (therefore, revenue would not be recognized for the products expected to be returned)
b.
A refund liability
PROFESSIONAL RESEARCH (Continued) c.
An asset (and corresponding adjustment to cost of sales) for its right to recover products from customers on settling the refund liability.
(d) According to FASB ASC 606-10-55-82 to 84: 82 - An entity should determine when it has satisfied its performance obligation to transfer a product by evaluating when a customer obtains control of that product (see paragraph 606-10-25-30). For some contracts, control is transferred either when the product is delivered to the customer’s site or when the product is shipped, depending on the terms of the contract (including delivery and shipping terms). However, for some contracts, a customer may obtain control of a product even though that product remains in an entity’s physical possession. In that case, the customer has the ability to direct the use of, and obtain substantially all of the remaining benefits from, the product even though it has decided not to exercise its right to take physical possession of that product. Consequently, the entity does not control the product. Instead, the entity provides custodial services to the customer over the customer’s asset. 83 - In addition to applying the guidance in paragraph 606-10-25-30, for a customer to have obtained control of a product in a bill-andhold arrangement, all of the following criteria must be met: a.
The reason for the bill-and-hold arrangement must be substantive (for example, the customer has requested the arrangement).
b.
The product must be identified separately as belonging to the customer.
c.
The product currently must be ready for physical transfer to the customer.
d.
The entity cannot have the ability to use the product or to direct it to another customer.
PROFESSIONAL RESEARCH (Continued) 84 - If an entity recognizes revenue for the sale of a product on a billand-hold basis, the entity should consider whether it has remaining performance obligations (for example, for custodial services) in accordance with paragraphs 606-10-25-14 through 25-22 to which the entity should allocate a portion of the transaction price in accordance with paragraphs 606-10-32-28 through 32-41.When goods are sold on a bill-and-hold basis, what conditions must be met to recognize revenue upon receipt of the order?
PROFESSIONAL SIMULATION Measurement Computation of net income for 2015: Revenues.................................................................... Expenses.................................................................... Gross profit on long-term contract .......................... Realized gross profit on installment sales .............. Net income ................................................................. *
$5,500,000 4,200,000 1,300,000 25,000* 39,600** $1,364,600
$100,000 + $100,000
= 50%; 50% X ($500,000 – $400,000) = $50,000 $100,000 + $100,000 + $200,000 Less gross profit recognized in 2014 25,000 $25,000
**$220,000 X 18% = $39,600
Journal Entries Construction in Process .................................. Materials, Cash, Payables ........................
100,000
Construction in Process (Gross Profit)* ......... Construction Expenses.................................... Revenue from Long-Term Contracts .......
25,000 100,000
*See above. ***(50% X $500,000) – $125,000
100,000
125,000***
PROFESSIONAL SIMULATION (Continued) Financial Statements NOMAR INDUSTRIES, INC. Balance Sheet December 31, 2015 Current Assets Accounts receivable ($230,000 – $202,500)...................... $27,500 Inventories Construction in process ($100,000 + $100,000 + $50,000) ................................. $250,000 Less: Billings ................................................................. 230,000 Costs and recognized profits in excess of billings ... 20,000 Explanation Given these facts, a more appropriate revenue recognition policy would be the cost-recovery method. Using the cost-recovery method, given the uncertainty of getting paid, gross profit is not recognized until cash collected on the sale exceeds the cost. This represents a more conservative policy in light of the uncertainty of realizability of the real estate sales.
CHAPTER 19 Accounting for Income Taxes ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics
Brief Questions Exercises
Exercises
Concepts Problems for Analysis
1. Reconcile pretax financial income with taxable income.
1, 13
1, 2, 3, 4, 5, 12, 18, 20, 21
1, 2, 3, 4, 8
2. Identify temporary and permanent differences.
3, 4, 5
4, 5, 6, 7
2, 3, 4
3. Determine deferred income taxes and related items— single tax rate.
6, 7, 13
1, 2, 3, 4, 5, 6, 7, 9
1, 3, 4, 5, 7, 8, 3, 4, 8, 9 12, 14, 15, 19, 21
2
4. Classification of deferred taxes.
10, 11, 12
15
7, 11, 16, 18, 19, 20, 21, 22
3, 6
2, 3, 5
5. Determine deferred income taxes and related items— multiple tax rates, expected future income.
10
2, 13, 16, 17, 18, 20, 22
1, 2, 6, 7
1, 6, 7
6. Determine deferred taxes, multiple rates, expected future losses.
10
7. Carryback and carryforward of NOL.
16, 17, 18, 12, 13, 14
9, 10, 23, 24, 25
5
8. Change in enacted future tax rate.
14
16
2, 7
8, 17
2, 7
11
9. Tracking temporary differences through reversal. 10. Income statement presentation. 9
11. Conceptual issues—tax allocation.
1, 2, 8, 19
12. Valuation allowance—deferred 8, 19 tax asset. 13. Disclosure and other issues.
8
15
5, 6
1, 2, 3, 4, 5, 7, 1, 2, 3, 5, 10, 12, 16, 19, 7, 8, 9 23, 24, 25 7
7
3, 4, 5
7, 14, 15, 23, 24, 25
1, 2, 7
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives Questions
Brief Exercises
Exercises
Problems
Concepts for Analysis
1.
Identify differences between pretax financial income and taxable income.
1, 2
1, 2, 5
CA19-1
2.
Describe a temporary difference that results in future taxable amounts.
3, 4
1, 2, 4, 9, 10
1, 2, 3, 4, 5, 7, 8, 11, 12, 13, 16, 17, 18, 19, 20, 21, 22
1, 3, 4, 6, 7, 8, 9
3.
Describe a temporary difference that results in future deductible amounts.
5
5, 6, 9
4, 5, 7, 8, 11, 12, 14, 15, 17, 18, 19, 20, 21, 22
1, 2, 4, 6, 8, 9
4.
Explain the purpose of a deferred tax asset valuation allowance.
6, 7, 8, 9
7, 14
7, 14, 15, 23, 24, 25
5.
Describe the presentation of income tax expense in the income statement.
10
4, 6, 8
1, 3, 4, 5, 8, 12, 15, 16
1, 2, 3, 4, 5, 7, 8, 9
6.
Describe various temporary and permanent differences.
11, 12, 13, 14
4, 6, 7
2, 3, 9
CA19-2, CA19-3
7.
Explain the effect of various tax rates and tax rate changes on deferred income taxes.
14, 15
11
13, 16, 17, 18, 21, 23, 24, 25
5, 7
CA19-4, CA19-5
8.
Apply accounting procedures for a loss carryback and a loss carryforward.
16, 17, 18
12, 13, 14
9, 10, 23, 24, 25
5
CA19-6
9.
Describe the presentation of deferred income taxes in financial statements.
19
3, 15
8, 11, 16, 19, 20, 21, 22
3, 5, 6, 8, 9
C19-7
ASSIGNMENT CHARACTERISTICS TABLE Level of Difficulty
Time (minutes)
Item
Description
E19-1
One temporary difference, future taxable amounts, one rate, no beginning deferred taxes.
Simple
15–20
E19-2
Two differences, no beginning deferred taxes, tracked through 2 years.
Simple
15–20
E19-3
One temporary difference, future taxable amounts, one rate, beginning deferred taxes.
Simple
15–20
E19-4
Three differences, compute taxable income, entry for taxes.
Simple
15–20
E19-5
Two temporary differences, one rate, beginning deferred taxes.
Simple
15–20
E19-6
Identify temporary or permanent differences.
Simple
10–15
E19-7
Terminology, relationships, computations, entries.
Simple
10–15
E19-8
Two temporary differences, one rate, 3 years.
Simple
10–15
E19-9
Carryback and carryforward of NOL, no valuation account, no temporary differences.
Simple
15–20
E19-10
Two NOLs, no temporary differences, no valuation account, entries and income statement.
Moderate
20–25
E19-11
Three differences, classify deferred taxes.
Simple
10–15
E19-12
Two temporary differences, one rate, beginning deferred taxes, compute pretax financial income.
Complex
20–25
E19-13
One difference, multiple rates, effect of beginning balance versus no beginning deferred taxes.
Simple
20–25
E19-14
Deferred tax asset with and without valuation account.
Moderate
20–25
E19-15
Deferred tax asset with previous valuation account.
Complex
20–25
E19-16
Deferred tax liability, change in tax rate, prepare section of income statement.
Complex
15–20
E19-17
Two temporary differences, tracked through 3 years, multiple rates.
Moderate
30–35
E19-18
Three differences, multiple rates, future taxable income.
Moderate
20–25
E19-19
Two differences, one rate, beginning deferred balance, compute pretax financial income.
Complex
25–30
E19-20
Two differences, no beginning deferred taxes, multiple rates.
Moderate
15–20
E19-21
Two temporary differences, multiple rates, future taxable income.
Moderate
20–25
E19-22
Two differences, one rate, first year.
Simple
15–20
E19-23
NOL carryback and carryforward, valuation account versus no valuation account.
Complex
30–35
E19-24
NOL carryback and carryforward, valuation account needed.
Complex
30–35
E19-25
NOL carryback and carryforward, valuation account needed.
Moderate
15–20
ASSIGNMENT CHARACTERISTICS TABLE (Continued) Item
Description
Level of Difficulty
P19-1
Three differences, no beginning deferred taxes, multiple rates.
Complex
40–45
P19-2
One temporary difference, tracked for 4 years, one permanent difference, change in rate.
Complex
50–60
P19-3
Second year of depreciation difference, two differences, single rate, extraordinary item.
Complex
40–45
P19-4 P19-5
Permanent and temporary differences, one rate.
Moderate Simple
20–25 20–25
Moderate
20–25
P19-6
NOL without valuation account. Two differences, two rates, future income expected.
Time (minutes)
P19-7
One temporary difference, tracked 3 years, change in rates, income statement presentation.
Complex
45–50
P19-8
Two differences, 2 years, compute taxable income and pretax financial income.
Complex
40–50
P19-9
Five differences, compute taxable income and deferred taxes, draft income statement.
Complex
40–50
CA19-1
Objectives and principles for accounting for income taxes.
Simple
15–20
CA19-2
Basic accounting for temporary differences.
Moderate
20–25
CA19-3
Identify temporary differences and classification criteria.
Complex
20–25
CA19-4
Accounting and classification of deferred income taxes.
Moderate
20–25
CA19-5
Explain computation of deferred tax liability for multiple tax rates.
Complex
20–25
CA19-6
Explain future taxable and deductible amounts, how carryback and carryforward affects deferred taxes.
Complex
20–25
CA19-7
Deferred taxes, income effects.
Moderate
20–25
SOLUTIONS TO CODIFICATION EXERCISES CE19-1 Master Glossary (a)
The deferred tax consequences attributable to deductible temporary differences and carryforwards. A deferred tax asset is measured using the applicable enacted tax rate and provisions of the enacted tax law. A deferred tax asset is reduced by a valuation allowance if, based on the weight of evidence available, it is more likely than not that some portion or all of a deferred tax asset will not be realized.
(b)
The excess of taxable revenues over tax deductible expenses and exemptions for the year as defined by the governmental taxing authority.
(c)
The portion of a deferred tax asset for which it is more likely than not that a tax benefit will not be realized.
(d)
The deferred tax consequences attributable to taxable temporary differences. A deferred tax liability is measured using the applicable enacted tax rate and provisions of the enacted tax law.
CE19-2 According to FASB ASC 740-10-30-2 (Income Taxes—Initial Measurement): The following basic requirements are applied to the measurement of current and deferred income taxes at the date of the financial statements: (a)
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.
(b)
The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be realized.
CE19-3 According to FASB ASC 740-10-S99-2 (Income Taxes—SEC Materials): Yes. In such an event, a note must (1) disclose the aggregate dollar and per share effects of the tax holiday and (2) briefly describe the factual circumstances including the date on which the special tax status will terminate.
CE19-4 According to FASB ASC 740-10-25-6 (Income Taxes—Recognition): An entity shall initially recognize the financial statement effects of a tax position when it is more likely than not, based on the technical merits, that the position will be sustained upon examination. The term more likely than not means a likelihood of more than 50 percent; the terms examined and upon examination also include resolution of the related appeals or litigation processes, if any. For example, if an entity determines that it is certain that the entire cost of an acquired asset is fully deductible, the more-likely-than-not recognition threshold has been met. The more-likely-than-not recognition threshold is a positive assertion that an entity believes it is entitled to the economic benefits associated with a tax position. The determination of whether or not a tax position has met the more-likely-than-not recognition threshold shall consider the facts, circumstances, and information available at the reporting date. The level of evidence that is necessary and appropriate to support an entity’s assessment of the technical merits of a tax position is a matter of judgment that depends on all available information.
ANSWERS TO QUESTIONS 1.
Pretax financial income is reported on the income statement and is often referred to as income before income taxes. Taxable income is reported on the tax return and is the amount upon which a company’s income taxes payable are computed.
2.
One objective of accounting for income taxes is to recognize the amount of taxes payable or refundable for the current year. A second objective is to recognize deferred tax liabilities and assets for the future tax consequences of events already recognized in the financial statements or tax returns.
3.
A permanent difference is a difference between taxable income and pretax financial income that, under existing applicable tax laws and regulations, will not be offset by corresponding differences or “turn around” in other periods. Therefore, a permanent difference is caused by an item that: (1) is included in pretax financial income but never in taxable income, or (2) is included in taxable income but never in pretax financial income. Examples of permanent differences are: (1) interest received on municipal obligations (such interest is included in pretax financial income but is not included in taxable income), (2) premiums paid on officers’ life insurance policies in which the company is the beneficiary (such premiums are not allowable expenses for determining taxable income but are expenses for determining pretax financial income), and (3) fines and expenses resulting from a violation of law. Item (3), like item (2), is an expense which is not deductible for tax purposes.
4.
A temporary difference is a difference between the tax basis of an asset or liability and its reported (carrying or book) amount in the financial statements that will result in taxable amounts or deductible amounts in future years when the reported amount of the asset is recovered or when the reported amount of the liability is settled. The temporary differences discussed in this chapter all result from differences between taxable income and pretax financial income which will reverse and result in taxable or deductible amounts in future periods. Examples of temporary differences are: (1) Gross profit or gain on installment sales reported for financial reporting purposes at the date of sale and reported in tax returns when later collected. (2) Depreciation for financial reporting purposes is less than that deducted in tax returns in early years of assets’ lives because of using an accelerated depreciation method for tax purposes. (3) Rent and royalties taxed when collected, but deferred for financial reporting purposes and recognized as when the performance obligation is satisfied in later periods. (4) Unrealized gains or losses recognized in income for financial reporting purposes but deferred for tax purposes.
5.
An originating temporary difference is the initial difference between the book basis and the tax basis of an asset or liability. A reversing difference occurs when a temporary difference that originated in prior periods is eliminated and the related tax effect is removed from the tax account.
6.
Book basis of assets................................................................................... Tax basis of assets ..................................................................................... Future taxable amounts .............................................................................. Tax rate ...................................................................................................... Deferred tax liability (end of 2015) ..............................................................
$900,000 700,000 200,000 34% $ 68,000
Questions Chapter 19 (Continued) 7.
Book basis of asset Tax basis of asset Future taxable amounts Tax rate Deferred tax liability (end of 2015)
8.
A future taxable amount will increase taxable income relative to pretax financial income in future periods due to temporary differences existing at the balance sheet date. A future deductible amount will decrease taxable income relative to pretax financial income in future periods due to existing temporary differences.
$90,000 –0– 90,000 X 34% $30,600
Deferred tax liability (end of 2015) Deferred tax liability (beginning of 2015) Deferred tax benefit for 2015 Income taxes payable for 2015 Income tax expense for 2015
$ 30,600 68,000 (37,400) 230,000 $192,600
A deferred tax asset is recognized for all deductible temporary differences. However, a deferred tax asset should be reduced by a valuation account if, based on all available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized. More likely than not means a level of likelihood that is slightly more than 50%. 9.
Taxable income Tax rate
$100,000
Income taxes payable
Future taxable amounts Tax rate
$70,000 X 40%
$ 40,000
Deferred tax liability (end of 2015)
$28,000
Deferred tax liability (end of 2015)
$ 28,000
Current tax expense
$40,000
Deferred tax liability (beginning of 2015)
(
–0–
Deferred tax expense
(28,000)
Deferred tax expense for 2015
$ 28,000
Income tax expense for 2015
$68,000
X
40%
)
10.
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 purposes. 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 purposes, including deferred tax assets related to loss carryforwards, shall be classified according to the expected reversal date of the temporary difference.
11.
The balances in the deferred tax accounts should be analyzed and classified on the balance sheet in two categories: one for the net current amount, and one for the net noncurrent amount. This procedure is summarized as indicated below. (1) Classify the amounts as current or noncurrent. If an amount is related to a specific asset or liability, it should be classified in the same manner as the related asset or liability. If not so related, it should be classified on the basis of the expected reversal date. (2) Determine the net current amount by summing the various deferred tax assets and liabilities classified as current. If the net result is an asset, report on the balance sheet as a current asset; if it is a liability, report as a current liability. (3) Determine the net noncurrent amount by summing the various deferred tax assets and liabilities classified as noncurrent. If the net result is an asset, report on the balance sheet as a noncurrent asset (“other assets” section); if it is a liability, report as a long-term liability.
12.
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.
Questions Chapter 19 (Continued) 13.
Pretax financial income........................................................................................ Interest income on municipal bonds.................................................................... Hazardous waste fine ......................................................................................... Depreciation ($60,000 – $45,000)....................................................................... Taxable income .................................................................................................. Tax rate .............................................................................................................. Income taxes payable.........................................................................................
14.
$200,000 (2017 taxable amount) 10% (30% – 20%) $ 20,000 Decrease in deferred tax liability at the end of 2014 Deferred Tax Liability............................................................................... Income Tax Expense .......................................................................
$550,000 (70,000) 25,000 15,000 520,000 X 30% $156,000
20,000 20,000
15.
Some of the reasons for requiring income tax component disclosures are: (a) Assessment of the quality of earnings. Many investors seeking to assess the quality of a company’s earnings are interested in the reconciliation of pretax financial income to taxable income. Earnings that are enhanced by a favorable tax effect should be examined carefully, particularly if the tax effect is nonrecurring. (b) Better prediction of future cash flows. Examination of the deferred portion of income tax expense provides information as to whether taxes payable are likely to be higher or lower in the future.
16.
The loss carryback provision permits a company to carry a net operating loss back two years and receive refunds for income taxes paid in those years. The loss must be applied to the second preceding year first and then to the preceding year. The loss carryforward provision permits a company to carry forward a net operating loss twenty years, offsetting future taxable income. The loss carryback can be accounted for with more certainty because the company knows whether it had taxable income in the past; such is not the case with income in the future.
17.
The company may choose to carry the net operating loss forward, or carry it back and then forward for tax purposes. To forego the two-year carryback might be advantageous where a taxpayer had tax credit carryovers that might be wiped out and lost because of the carryback of the net operating loss. In addition, tax rates in the future might be higher, and therefore on a present value basis, it is advantageous to carry forward rather than carry back. For financial reporting purposes, the benefits of a net operating loss carryback are recognized in the loss year. The benefits of an operating loss carryforward are recognized as a deferred tax asset in the loss year. If it is more likely than not that the asset will be realized, the tax benefit of the loss is also recognized by a credit to Income Tax Expense on the income statement. Conversely, if it is more likely than not that the loss carryforward will not be realized in future years, then an allowance account is established in the loss year and no tax benefit is recognized on the income statement of the loss year.
18.
Many believe that future deductible amounts arising from net operating loss carryforwards are different from future deductible amounts arising from normal operations. One rationale provided is that a deferred tax asset arising from normal operations results in a tax prepayment—a prepaid tax asset. In the case of loss carryforwards, no tax prepayment has been made. Others argue that realization of a loss carryforward is less likely—and thus should require a more severe test—than for a net deductible amount arising from normal operations. Some have suggested that the test be changed from “more likely than not” to “probable” realization. Others have indicated that because of the nature of net operating losses, deferred tax assets should never be established for these items.
Questions Chapter 19 (Continued) 19.
Uncertain tax positions are tax positions for which the tax authorities may disallow a deduction in whole or in part. Uncertain tax positions often arise when a company takes an aggressive approach in its tax planning, such as instances in which the tax law is unclear or the company may believe that the risk of audit is low. Such positions give rise to tax benefits by either reducing income tax expense or related payables or by increasing an income tax refund receivable or deferred tax asset. In assessing whether an uncertain tax position should be recognized, companies must determine whether a tax position will be sustained upon audit. If the probability is more than 50 percent, the company may reduce its liability or increase its assets. If the probability is less that 50 percent, companies may not record the tax benefit. In determining “more likely than not,” companies must assume that they will be audited by the tax authorities. If the recognition threshold is passed, companies must then estimate the amount to record as an adjustment to its tax assets and liabilities.
SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 19-1 2014 taxable income ............................................................... Tax rate .................................................................................... 12/31/14 income taxes payable...............................................
$120,000 X 40% $ 48,000
BRIEF EXERCISE 19-2 Excess depreciation on tax return ......................................... Tax rate .................................................................................... Deferred tax liability ................................................................
$ 40,000 X 30% $ 12,000
BRIEF EXERCISE 19-3 Income Tax Expense................................................. Deferred Tax Liability ......................................... Income Taxes Payable .......................................
$67,500*** 12,000** 55,500*
*$185,000 X 30% = $55,500 **$40,000 X 30% = $12,000 ***$55,500 + $12,000 = $67,500 The $12,000 deferred tax liability should be classified as a noncurrent liability. The balances in the deferred tax accounts should be classified in the same manner as the related asset. Since property, plant, and equipment is a noncurrent asset, noncurrent liability is the proper classification for the deferred tax liability.
BRIEF EXERCISE 19-4 Deferred tax liability, 12/31/15 ................................................ Deferred tax liability, 12/31/14 ................................................ Deferred tax expense for 2015 ............................................... Current tax expense for 2015 ................................................. Total income tax expense for 2015 ........................................
$42,000 25,000 17,000 48,000 $65,000
BRIEF EXERCISE 19-5 Book value of warranty liability .................................................... Tax basis of warranty liability....................................................... Cumulative temporary difference at 12/31/14 .............................. Tax rate .......................................................................................... 12/31/14 deferred tax asset ...........................................................
$105,000 –0– 105,000 X 40% $ 42,000
BRIEF EXERCISE 19-6 Deferred tax asset, 12/31/15.......................................................... Deferred tax asset, 12/31/14.......................................................... Deferred tax benefit for 2015 ........................................................ Current tax expense for 2015 ....................................................... Total income tax expense for 2015 ..............................................
$59,000 30,000 (29,000) 61,000 $32,000
BRIEF EXERCISE 19-7 Income Tax Expense ....................................................... Allowance to Reduce Deferred Tax Asset to Expected Realizable Value..............................
60,000 60,000
BRIEF EXERCISE 19-8 Income before income taxes .......................................... Income tax expense Current...................................................................... Deferred.................................................................... Net income .......................................................................
$195,000 $48,000 30,000
78,000 $117,000
BRIEF EXERCISE 19-9 Income Tax Expense ....................................................... Income Taxes Payable ($148,000* X 45%).............. Deferred Tax Liability ($10,000 X 45%) ................... *$154,000 + $4,000 – $10,000 = $148,000
71,100 66,600 4,500
BRIEF EXERCISE 19-10 Year 2015 2016 2017
Future taxable amount $ 42,000 244,000 294,000
X
Tax Rate 34% 34% 40%
=
Deferred tax liability $ 14,280 82,960 117,600 $214,840
BRIEF EXERCISE 19-11 Income Tax Expense...................................................... Deferred Tax Liability ($2,000,000 X 6%)...............
120,000 120,000
BRIEF EXERCISE 19-12 Income Tax Refund Receivable..................................... Benefit Due to Loss Carryback $97,500 + [($480,000 – $325,000) X 30%]...........
144,000 144,000
BRIEF EXERCISE 19-13 Income Tax Refund Receivable ($350,000 X .40) ......... Benefit Due to Loss Carryback..............................
140,000
Deferred Tax Asset ($500,000 – $350,000) X .40........... Benefit Due to Loss Carryforward.........................
60,000
140,000 60,000
BRIEF EXERCISE 19-14 Income Tax Refund Receivable ($350,000 X. 40) ......... Benefit Due to Loss Carryback..............................
140,000
Deferred Tax Asset ($500,000 – $350,000) X .40........... Benefit Due to Loss Carryforward.........................
60,000
Benefit Due to Loss Carryforward ................................ Allowance to Reduce Deferred Tax Asset to Expected Realizable Value.............................
60,000
140,000 60,000
60,000
BRIEF EXERCISE 19-15 Current assets Deferred tax asset ($62,000 – $38,000).................
$24,000
Long-term liabilities Deferred tax liability ($96,000 – $27,000)..............
$69,000
SOLUTIONS TO EXERCISES EXERCISE 19-1 (15–20 minutes) (a) Pretax financial income for 2014 Temporary difference resulting in future taxable amounts in 2015 in 2016 in 2017 Taxable income for 2014
$300,000 (55,000) (60,000) (65,000) $120,000
Taxable income for 2014 Enacted tax rate Income taxes payable for 2014 (b) Future taxable (deductible) amounts Tax rate Deferred tax liability (asset)
$120,000 30% $ 36,000 Future Years 2015 2016 $55,000 $60,000 30% 30% $16,500 $18,000
2017 $65,000 30% $19,500
Deferred tax liability at the end of 2014 Deferred tax liability at the beginning of 2014 Deferred tax expense for 2014 (increase in deferred tax liability) Current tax expense for 2014 (Income taxes payable) Income tax expense for 2014 Income Tax Expense ............................................... Income Taxes Payable ..................................... Deferred Tax Liability....................................... (c) Income before income taxes Income tax expense Current Deferred Net income
Total $180,000 $ 54,000
$54,000 –0– 54,000 36,000 $90,000 90,000 36,000 54,000 $300,000
$36,000 54,000
90,000 $210,000
Note: The current/deferred tax expense detail can be presented in the notes to the financial statements.
EXERCISE 19-2 (15–20 minutes) (a) Pretax financial income for 2013 Excess of tax depreciation over book depreciation Rent received in advance Taxable income (b) Income Tax Expense ............................................. Deferred Tax Asset ................................................ Income Taxes Payable ($280,000 X .40)........ Deferred Tax Liability..................................... Temporary Difference **Depreciation *Unearned rent
Future Taxable (Deductible) Amounts $40,000 (20,000)
Tax Rate 40% 40%
(c) Income Tax Expense ............................................. Deferred Tax Liability ($10,000 X .40) ................... Income Taxes Payable ($325,000 X .40)........ Deferred Tax Asset ($20,000 X .40) ...............
$300,000 (40,000) 20,000 $280,000 120,000 8,000* 112,000 16,000** Deferred Tax (Asset) $(8,000) $(8,000)
Liability $16,000 $16,000
134,000* 4,000 130,000 8,000
*($130,000 – $4,000 + $8,000) EXERCISE 19-3 (15–20 minutes) (a) Taxable income for 2014 Enacted tax rate Income taxes payable for 2014 (b) Future taxable (deductible) amounts Tax rate Deferred tax liability (asset)
$405,000 40% $162,000 Future Years 2015 2016 Total $175,000 $175,000 $350,000 40% 40% $ 70,000 $ 70,000 $140,000
EXERCISE 19-3 (Continued) Deferred tax liability at the end of 2014 Deferred tax liability at the beginning of 2014 Deferred tax expense for 2014 (increase required in deferred tax liability) Current tax expense for 2014 Income tax expense for 2014 Income Tax Expense ........................................ Income Taxes Payable........................... Deferred Tax Liability............................. (c) Income before income taxes Income tax expense Current Deferred Net income
$140,000 92,000 48,000 162,000 $210,000 210,000 162,000 48,000 $525,000 $162,000 48,000
210,000 $315,000
Note to instructor: Because of the flat tax rate for all years, the amount of cumulative temporary difference existing at the beginning of the year can be calculated by dividing $92,000 by 40%, which equals $230,000. The difference between the $230,000 cumulative temporary difference at the beginning of 2014 and the $350,000 cumulative temporary difference at the end of 2014 represents the net amount of temporary difference originating during 2014 (which is $120,000). With this information, we can reconcile pretax financial income with taxable income as follows: Pretax financial income Temporary difference originating giving rise to net future taxable amounts Taxable income
$525,000 (120,000) $405,000
EXERCISE 19-4 (15–20 minutes) (a) Pretax financial income for 2014 Excess depreciation per tax return Excess rent collected over rent earned Nondeductible fines Taxable income Taxable income Enacted tax rate Income taxes payable
$70,000 (16,000) 22,000 11,000 $87,000 $87,000 30% $26,100
EXERCISE 19-4 (Continued) (b)
Income Tax Expense ............................................... Deferred Tax Asset .................................................. Income Taxes Payable ..................................... Deferred Tax Liability....................................... Temporary Difference Depreciation Unearned rent Totals
Future Taxable (Deductible) Amounts $16,000 (22,000) $ (6,000)
Tax Rate 30% 30%
24,300 6,600 26,100 4,800 Deferred Tax (Asset) Liability $4,800 $(6,600) $(6,600) $4,800*
*Because of a flat tax rate, these totals can be reconciled: $(6,000) X 30% = $(6,600) + $4,800. Deferred tax liability at the end of 2014 Deferred tax liability at the beginning of 2014 Deferred tax expense for 2014 (increase required in deferred tax liability)
$4,800 0
Deferred tax asset at the end of 2014 Deferred tax asset at the beginning of 2014 Deferred tax benefit for 2014 (increase required in deferred tax asset)
$ 6,600 0 $(6,600)
Deferred tax expense for 2014 Deferred tax benefit for 2014 Net deferred tax benefit for 2014 Current tax expense for 2014 (Income taxes payable) Income tax expense for 2014
$ 4,800 (6,600) (1,800) 26,100 $24,300
(c) Income before income taxes Income tax expense Current Deferred Net income
$4,800
$70,000 $26,100 (1,800)
24,300 $45,700
Note: The details on the current/deferred tax expense may be presented in a note to the financial statements. (d) $24,300 = 34.7% effective tax rate for 2014. $70,000
EXERCISE 19-5 (15–20 minutes) (a) Taxable income Enacted tax rate Income taxes payable
$95,000 40% $38,000
(b) Income Tax Expense ............................................... Deferred Tax Asset .................................................. Income Taxes Payable ..................................... Deferred Tax Liability....................................... Temporary Difference First one Second one Totals
Future Taxable (Deductible) Amounts $240,000 (35,000) $205,000
Tax Rate 40% 40%
80,000 14,000 38,000 56,000 Deferred Tax (Asset) Liability $96,000 $(14,000) $(14,000) $96,000
*Because of a flat tax rate, these totals can be reconciled: $205,000 X 40% = $(14,000) + $96,000. Deferred tax liability at the end of 2014 Deferred tax liability at the beginning of 2014 Deferred tax expense for 2014 (increase required in deferred tax liability)
$96,000 40,000
Deferred tax asset at the end of 2014 Deferred tax asset at the beginning of 2014 Deferred tax benefit for 2014 (increase required in deferred tax asset)
$ 14,000 –0– $(14,000)
Deferred tax expense for 2014 Deferred tax benefit for 2014 Net deferred tax benefit for 2014 Current tax expense for 2014 (Income taxes payable) Income tax expense for 2014
$56,000 (14,000) 42,000 38,000 $80,000
(c) Income before income taxes Income tax expense Current Deferred Net income
$56,000
$200,000 $38,000 42,000
80,000 $120,000
Note: The details on the current/deferred tax expense can be disclosed in the notes to the financial statements.
EXERCISE 19-5 (Continued) Note to instructor: Because of the flat tax rate for all years, the amount of cumulative temporary difference existing at the beginning of the year can be calculated by dividing the $40,000 balance in Deferred Tax Liability by 40%, which equals $100,000. This information may now be combined with the other facts given in the exercise to reconcile pretax financial income with taxable income as follows: Pretax financial income Net originating temporary difference giving rise to future taxable amounts ($240,000 – $100,000) Originating temporary differences giving rise to future deductible amounts Taxable income
$200,000 (140,000) 35,000 $ 95,000
EXERCISE 19-6 (10–15 minutes) (a) (b) (c) (d)
(2) (1) (3) (1)
(e) (f) (g) (h)
(2) (2) (3) (3)
(i) (j) (k)
(3)* (1) (1)
*When the cost method is used for financial reporting purposes, the dividends are recognized in the income statement in the period they are received, which is the same period they be must be reported on the tax return. However, depending on the level of ownership by the investor, 70% or 80% of the dividends received from other U.S. corporations may be excluded from taxation because of a “dividends received deduction.” These tax-exempt dividends create a permanent difference. EXERCISE 19-7 (10–15 minutes) (a) (b) (c) (d) (e) (f) (g) (h) (i) (j)
greater than $190,000 = ($76,000 divided by 40%) are not less than benefit; $15,000 $3,500 = [($100,000 X 40%) – $36,500] debit $59,000 = ($82,000 – $23,000) more likely than not; will not be benefit
EXERCISE 19-8 (10–15 minutes) (a)
2014
Income Tax Expense.............................................. Deferred Tax Asset ($20,000 X 40%) ..................... Deferred Tax Liability ($30,000 X 40%) ......... Income Taxes Payable ($830,000 X 40%)......
336,000 8,000 12,000 332,000
2015 Income Tax Expense.............................................. Deferred Tax Asset ($10,000 X 40%) ..................... Deferred Tax Liability ($40,000 X 40%) ......... Income Taxes Payable ($880,000 X 40%)......
364,000 4,000 16,000 352,000
2016 Income Tax Expense.............................................. Deferred Tax Asset ($8,000 X 40%) ....................... Deferred Tax Liability ($10,000 X 40%) ......... Income Taxes Payable ($943,000 X 40%)......
378,000 3,200 4,000 377,200
(b) Current assets Deferred tax asset ($8,000 + $4,000 + $3,200)
$15,200
Long-term liabilities Deferred tax liability ($12,000 + $16,000 + $4,000)
$32,000
The warranty is classified as current because settlement is expected within one year. The deferred tax liability is noncurrent because the related asset is noncurrent. (c) Pretax financial income Income tax expense Current Deferred ($4,000 – $3,200) Net Income
$945,000 $377,200 800
378,000 $567,000
Note: The details on the current/deferred tax expense can be disclosed in the notes to the financial statements.
EXERCISE 19-9 (15–20 minutes) 2011 Income Tax Expense ........................................................ Income Taxes Payable ($80,000 X 40%) .................. 2012 Income Tax Refund Receivable ....................................... ($160,000 X 45%) Benefit Due to Loss Carryback (Income Tax Expense) .......................................... 2013 Income Tax Refund Receivable ....................................... Benefit Due to Loss Carryback (Income Tax Expense) .......................................... ($80,000 X 40%)
32,000 32,000
72,000 72,000
32,000 32,000
Deferred Tax Asset ............................................................... 120,000 Benefit Due to Loss Carryforward (Income Tax Expense) .......................................... [40% X ($380,000 – $80,000)] 2014 Income Tax Expense ........................................................ Deferred Tax Asset (40% X $120,000)......................
48,000
2015 Income Tax Expense ........................................................ Deferred Tax Asset ($100,000 X 40%)......................
40,000
120,000
48,000
40,000
Note: Benefit Due to Loss Carryback and Benefit Due to Loss Carryforward amounts are negative components of income tax expense.
EXERCISE 19-10 (20–25 minutes) (a) Income Tax Refund Receivable ................................ [($17,000 X 35%) + ($48,000 X 50%)] Benefit Due to Loss Carryback .........................
29,950
Deferred Tax Asset .................................................... Benefit Due to Loss Carryforward .................... ($150,000 – $17,000 – $48,000 = $85,000) ($85,000 X 40% = $34,000)
34,000
(b) Operating loss before income taxes Income tax benefit Benefit due to loss carryback Benefit due to loss carryforward Net loss (c) Income Tax Expense ................................................. Deferred Tax Asset ............................................ Income Taxes Payable ....................................... [40% X ($90,000 – $85,000)] (d) Income before income taxes Income tax expense Current Deferred Net income (e) Income Tax Refund Receivable ................................ [($30,000 X 40%) + ($30,000 X 40%)] Benefit Due to Loss Carryback ......................... (f)
Operating loss before income taxes Income tax benefit Benefit due to loss carryback Net loss
29,950
34,000
$(150,000) $29,950 34,000
63,950 $ (86,050)
36,000 34,000 2,000 $90,000 $ 2,000 34,000
36,000 $54,000
24,000 24,000 $(60,000) 24,000 $(36,000)
EXERCISE 19-11 (10–15 minutes)
Temporary Difference Depreciation Lawsuit obligation Installment sale Installment sale Totals
Resulting Deferred Tax (Asset) Liability $200,000 $(50,000) 48,000* $(50,000)
*$120,000 X 40% = $48,000
Related Balance Sheet Account Plant Assets Lawsuit Obligation Installment Receivable
177,000** Installment Receivable $425,000
Classification Noncurrent Current Current Noncurrent
**$225,000 – $48,000 = $177,000
Current assets Deferred tax asset ($50,000 – $48,000) Long-term liabilities Deferred tax liability ($200,000 + $177,000)
$
2,000 377,000
EXERCISE 19-12 (20–25 minutes) (a) To complete a reconciliation of pretax financial income and taxable income, solving for the amount of pretax financial income, we must first determine the amount of temporary differences arising or reversing during the year. To accomplish that, we must determine the amount of cumulative temporary differences underlying the beginning balances of the deferred tax liability of $60,000 and the deferred tax asset of $20,000. $60,000 ÷ 40% = $150,000 beginning cumulative temporary difference. $20,000 ÷ 40% = $ 50,000 beginning cumulative temporary difference. Cumulative temporary difference at 12/31/14 which will result in future taxable amounts Cumulative temporary difference at 1/1/14 which will result in future taxable amounts Originating difference in 2014 which will result in future taxable amounts
$230,000 150,000 $ 80,000
EXERCISE 19-12 (Continued) Cumulative temporary difference at 12/31/14 which will result in future deductible amounts Cumulative temporary difference at 1/1/14 which will result in future deductible amounts Originating difference in 2014 which will result in future deductible amounts
$95,000 50,000 $45,000
Pretax financial income Originating difference which will result in future taxable amounts Originating difference which will result in future deductible amounts Taxable income for 2014
$
X
(80,000) 45,000 $105,000
Solving for pretax financial income: X – $80,000 + $45,000 = $105,000 X = $140,000 = Pretax financial income (b) Income Tax Expense ................................................. Deferred Tax Asset .................................................... Income Taxes Payable ....................................... ($105,000 X 40%) Deferred Tax Liability......................................... Temporary Difference First one Second one Totals
Future Taxable (Deductible) Amounts $230,000 (95,000) $135,000
Tax Rate 40% 40%
56,000 18,000 42,000 32,000 Deferred Tax (Asset) Liability $92,000 $(38,000) $(38,000) $92,000*
*Because of a flat tax rate, these totals can now be reconciled: $135,000 X 40% = $(38,000) + $92,000. Deferred tax liability at the end of 2014 Deferred tax liability at the beginning of 2014 Deferred tax expense for 2014 (net increase required in deferred tax liability)
$92,000 60,000 $32,000
EXERCISE 19-12 (Continued) Deferred tax asset at the end of 2014 Deferred tax asset at the beginning of 2014 Deferred tax benefit for 2014 (net increase required in deferred tax asset)
$ 38,000 20,000
Deferred tax expense for 2014 Deferred tax benefit for 2014 Net deferred tax expense (benefit) for 2014 Current tax expense for 2014 (Income taxes payable) Income tax expense for 2014
$32,000 (18,000) 14,000 42,000 $56,000
$(18,000)
(c) Income before income taxes Income tax expense Current Deferred Net income
$140,000 $42,000 14,000
56,000 $ 84,000
(d) Because of the same tax rate for all years involved and no permanent differences, the effective rate should equal the statutory rate. The following calculation proves that it does: $56,000 ÷ $140,000 = 40% effective tax rate for 2014.
EXERCISE 19-13 (20–25 minutes) (a) Income Tax Expense ............................................. Income Taxes Payable ................................... Deferred Tax Liability.....................................
178,500 128,000 50,500
Taxable income for 2013 Enacted tax rate Income taxes payable for 2013
Future taxable (deductible) amounts Enacted tax rate Deferred tax liability (asset)
$320,000 40% $128,000
2014
Future Years 2015 2016
2017
Total
$60,000 30% $18,000
$50,000 30% $15,000
$30,000 25% $ 7,500
$180,000
$40,000 25% $10,000
$ 50,500
EXERCISE 19-13 (Continued) Deferred tax liability at the end of 2013 Deferred tax liability at the beginning of 2013 Deferred tax expense for 2013 (net increase required in deferred tax liability) Current tax expense for 2013 Income tax expense for 2013 (b) Income Tax Expense .............................................. Income Taxes Payable .................................... Deferred Tax Liability......................................
$ 50,500 0 50,500 128,000 $178,500 156,500 128,000 28,500
The income taxes payable for 2013 of $128,000 and the $50,500 balance for Deferred Tax Liability at December 31, 2013, would be computed the same as they were for part (a) of this exercise. The resulting change in the deferred tax liability and total income tax expense would be computed as follows: Deferred tax liability at the end of 2013 Deferred tax liability at the beginning of 2013 Deferred tax expense for 2013 (net increase required in deferred tax liability) Current tax expense for 2013 (Income taxes payable) Income tax expense for 2013
$ 50,500 22,000 28,500 128,000 $156,500
EXERCISE 19-14 (20–25 minutes) (a) Income Tax Expense .............................................. Deferred Tax Asset ................................................. Income Taxes Payable ....................................
298,000 30,000 328,000
Taxable income Enacted tax rate Income taxes payable Cumulative Future Taxable Date Tax Rate (Deductible) Amounts 12/31/14 $(450,000) 40%
$820,000 40% $328,000 Deferred Tax (Asset) $(180,000)
Liability
EXERCISE 19-14 (Continued) Deferred tax asset at the end of 2014 Deferred tax asset at the beginning of 2014 Deferred tax benefit for 2014 (increase in deferred tax asset account) Current tax expense for 2014 (Income taxes payable) Income tax expense for 2014
$180,000 150,000 (30,000) 328,000 $298,000
(b) The journal entry at the end of 2014 to establish a valuation account: Income Tax Expense .............................................. Allowance to Reduce Deferred Tax Asset to Expected Realizable Value .....................
30,000 30,000
Note to instructor: Although not requested by the instructions, the pretax financial income can be computed by completing the following reconciliation: Pretax financial income for 2014 Originating difference which will result in future deductible amounts Taxable income for 2014
$
X
75,000a $820,000
Solving for pretax financial income: X + $75,000 = $820,000 X = $745,000 = Pretax financial income a
$450,000 – $375,000 = $75,000
EXERCISE 19-15 (20–25 minutes) (a)
Income Tax Expense ............................................. Deferred Tax Asset ................................................ Income Taxes Payable ................................... Allowance to Reduce Deferred Tax Asset to Expected Realizable Value............................ Income Tax Expense...................................... Taxable income Enacted tax rate Income taxes payable
298,000 30,000 328,000 45,000 45,000 $820,000 40% $328,000
EXERCISE 19-15 (Continued) Cumulative Future Taxable Date Tax Rate (Deductible) Amounts 12/31/14 $(450,000) 40%
Deferred Tax (Asset) Liability $(180,000)
Deferred tax asset at the end of 2014 Deferred tax asset at the beginning of 2014 Deferred tax benefit for 2014 (increase in deferred tax asset account) Current tax expense for 2014 (Income taxes payable) Income tax expense for 2014
$180,000 150,000
Valuation account needed at the end of 2014 Valuation account balance at the beginning of 2014 Reduction in valuation account during 2014
$ –0– 45,000 $45,000
(30,000) 328,000 $298,000
(b) Income Tax Expense................................................... 298,000 Deferred Tax Asset ................................................. 30,000 Income Taxes Payable ....................................
328,000
Income Tax Expense................................................... 135,000 Allowance to Reduce Deferred Tax Asset to Expected Realizable Value .....................
135,000
Taxable income Enacted tax rate Income taxes payable
$820,000 40% $328,000
Cumulative Future Taxable Date Tax Rate (Deductible) Amounts 12/31/14 $(450,000) 40%
Deferred Tax (Asset) Liability $(180,000)
Deferred tax asset at the end of 2014 Deferred tax asset at the beginning of 2014 Deferred tax benefit for 2014 (increase in deferred tax asset account) Current tax expense for 2014 (Income taxes payable) Income tax expense for 2014
$180,000 150,000 (30,000) 328,000 $298,000
EXERCISE 19-15 (Continued) Valuation account needed at the end of 2014 Valuation account balance at the beginning of 2014 Increase in valuation account during 2014
$180,000 45,000 $135,000
Note to instructor: Although not requested by the instructions, the pretax financial income can be computed by completing the following reconciliation: Pretax financial income for 2014 Originating difference which will result in future deductible amounts Taxable income for 2014
$
X
75,000a $820,000
Solving for pretax financial income: X + $75,000 = $820,000 X = $745,000 = Pretax financial income a
$450,000 – $375,000 = $75,000.
EXERCISE 19-16 (15–20 minutes) Future Years 2014 2015
(a) Future taxable (deductible) amounts Tax rate Deferred tax liability (asset)
$1,500,000 40%* $ 600,000
Total
$1,500,000 34% $ 510,000
$3,000,000 $1,110,000
*The prior tax rate of 40% is computed by dividing the $1,200,000 balance of the deferred tax liability account at January 1, 2013, by the $3,000,000 cumulative temporary difference at that same date. Resulting Deferred Tax (Asset)
Liability $600,000 $510,000
Related Balance Sheet Account Installment Receivable Installment Receivable
Classification Current Noncurrent*
EXERCISE 19-16 (Continued) *One-half of the installment receivable is classified as a current asset and one-half is noncurrent. Therefore, the deferred tax liability related to the portion of the receivable coming due in 2014 is current and the deferred tax liability balance related to the portion of the receivable coming due in 2015 is noncurrent. (b) Deferred Tax Liability ................................................ Income Tax Expense..........................................
90,000 90,000
There are no changes during 2013 in the cumulative temporary difference. The entire change in the deferred tax liability account is due to the change in the enacted tax rate. That change is computed as follows: Deferred tax liability at the end of 2013 (computed in (a)) Deferred tax liability at the beginning of 2013 Deferred tax benefit for 2013 due to change in enacted tax rate (decrease in deferred tax liability required) (c) Income before income taxes Income tax expense Current Adjustment due to change in tax rate Net income
$1,110,000 1,200,000 $
(90,000)
$5,000,000* $2,000,000** (90,000) 1,910,000 $3,090,000
*Pretax financial income is equal to the taxable income for 2013 because there were no changes in the cumulative temporary difference and no permanent differences. **Taxable income for 2013 Tax rate for 2013 (computed in (a)) Current tax expense
$5,000,000 40% $2,000,000
Current tax expense for 2013 would also need to be recorded. The entry would be a debit to Income Tax Expense and a credit to Income Taxes Payable for $2,000,000.
EXERCISE 19-17 (30–35 minutes) Journal entry at December 31, 2013: Income Tax Expense ................................................ Deferred Tax Asset ................................................... Income Taxes Payable ...................................... Deferred Tax Liability........................................
67,900 4,500 65,200 7,200
Taxable income for 2013 Enacted tax rate Income taxes payable for 2013
$163,000 40% $ 65,200
The deferred tax account balances at December 31, 2013, are determined as follows: Temporary Difference Installment sales Warranty costs Totals
Future Taxable (Deductible) Amounts $16,000 (10,000) $ 6,000
Rate 45% 45%
Deferred Tax (Asset) Liability $7,200 $(4,500) $(4,500) $7,200*
*Because all deferred taxes were computed at the same rate, these totals can be reconciled as follows: $6,000 X 45% = $(4,500) + $7,200. Deferred tax liability at the end of 2013 Deferred tax liability at the beginning of 2013 Deferred tax expense for 2013 (net increase required in deferred tax liability)
$7,200 –0–
Deferred tax asset at the end of 2013 Deferred tax asset at the beginning of 2013 Deferred tax expense (benefit) for 2013 (net increase required in deferred tax asset)
$ 4,500 –0– $(4,500)
Deferred tax expense for 2013 Deferred tax benefit for 2013 Net deferred tax expense for 2013 Current tax expense for 2013 (Income taxes payable) Income tax expense for 2013
$ 7,200 (4,500) 2,700 65,200 $67,900
$7,200
EXERCISE 19-17 (Continued) Journal entry at December 31, 2014: Income Tax Expense ................................................ Deferred Tax Liability ............................................... Income Taxes Payable ...................................... Deferred Tax Asset ........................................... Taxable income Enacted tax rate Income taxes payable for 2014
94,500 3,600 95,850 2,250 $213,000 45% $ 95,850
The deferred tax account balances at December 31, 2014, are determined as follows: Temporary Difference Installment sales Warranty costs Totals
Future Taxable (Deductible) Amounts $8,000 (5,000) $3,000
Rate 45% 45%
Deferred Tax (Asset) Liability $3,600 $(2,250) $(2,250) $3,600*
*Because all deferred taxes were computed at the same rate, these totals can be reconciled as follows: $3,000 X 45% = $(2,250) + $3,600. Deferred tax liability at the end of 2014 Deferred tax liability at the beginning of 2014 Deferred tax benefit for 2014 (decrease required in deferred tax liability)
$ 3,600 7,200
Deferred tax asset at the end of 2014 Deferred tax asset at the beginning of 2014 Deferred tax expense for 2014 (decrease required in deferred tax asset)
$2,250 4,500
Deferred tax benefit for 2014 Deferred tax expense for 2014 Net deferred tax benefit for 2014 Current tax expense for 2014 Income tax expense for 2014
$ (3,600) 2,250 (1,350) 95,850 $94,500
$(3,600)
$2,250
EXERCISE 19-17 (Continued) Journal entry at December 31, 2015: Income Tax Expense ................................................ Deferred Tax Liability ............................................... Income Taxes Payable ...................................... Deferred Tax Asset............................................
40,500 3,600 41,850 2,250
Taxable income for 2015 Enacted tax rate Income taxes payable for 2015
$93,000 45% $41,850
Deferred tax liability at the end of 2015 Deferred tax liability at the beginning of 2015 Deferred tax benefit for 2015 (decrease required in deferred tax liability)
$
0 3,600
$(3,600)
Deferred tax asset at the end of 2015 Deferred tax asset at the beginning of 2015 Deferred tax expense for 2015 (decrease required in deferred tax asset)
$
0 2,250
Deferred tax benefit for 2015 Deferred tax expense for 2015 Net deferred tax benefit for 2015 Current tax expense for 2015 Income tax expense for 2015
$ (3,600) 2,250 (1,350) 41,850 $40,500
$2,250
EXERCISE 19-18 (20–25 minutes) (a)
December 31, 2014 Deferred Tax Temporary Difference Installment sales Depreciation Unearned rent Totals
Future Taxable (Deductible) Amounts $ 96,000 30,000 (100,000) $ 26,000
Tax Rate 40% 40% 40%
(Asset)
Liability $38,400 12,000
$(40,000) $(40,000)* $50,400*
*Because of a flat tax rate, these totals can be reconciled: $26,000 X 40% = $(40,000) + $50,400.
EXERCISE 19-18 (Continued) (b) Pretax financial income for 2014 Excess gross profit per books Excess depreciation per tax return Excess rental income per tax return Taxable income (c) Income Tax Expense .............................................. Deferred Tax Asset ................................................. Income Taxes Payable .................................... Deferred Tax Liability......................................
$250,000 (96,000) (30,000) 100,000 $224,000 111,200 40,000 100,800 50,400
Taxable income Tax rate Income taxes payable
$224,000 45% $100,800
Deferred tax liability at the end of 2014 Deferred tax liability at the beginning of 2014 Deferred tax expense for 2014 (net increase required in deferred tax liability)
$50,400 –0–
Deferred tax asset at the end of 2014 Deferred tax asset at the beginning of 2014 Deferred tax benefit for 2014 (net increase required in deferred tax asset)
$ 40,000 –0–
Deferred tax expense for 2014 Deferred tax benefit for 2014 Net deferred tax expense for 2014 Current tax expense for 2014 (Income taxes payable) Income tax expense for 2014
$ 50,400 (40,000) 10,400 100,800 $111,200
$50,400
$(40,000)
EXERCISE 19-19 (25–30 minutes) (a) (All figures are in millions.) Temporary Difference $100 million estimated costs per books $50 million excess depreciation per tax Totals
Resulting Deferred Tax Rate
(Asset)
40%
$(40)
40% $(40)
Related Balance Sheet Account
Liability
Classification
Estimated Payable Current $20 $20
Plant Assets
(b) Current assets Deferred tax asset
$40,000,000
Long-term liabilities Deferred tax liability (c) Income before income taxes Income tax expense Current Deferred Net income
Noncurrent
$20,000,000 $85,000,0002 $64,000,0001 (30,000,000)3
1
Taxable income for 2014 Enacted tax rate Income taxes payable for 2014
34,000,0004 $51,000,000 $160,000,000 40% $ 64,000,000
2
$10,000,000 ÷ 40% = $25,000,000 cumulative taxable temporary difference at the beginning of 2014.
Cumulative taxable temporary difference at the end of 2014 Cumulative taxable temporary difference at the beginning of 2014 Taxable temporary difference originating during 2014 Cumulative deductible temporary difference at the end of 2014 Cumulative deductible temporary difference at the beginning of 2014 Deductible temporary difference originating during 2014
$50,000,000 25,000,000 $25,000,000 $100,000,000 –0– $100,000,000
EXERCISE 19-19 (Continued) Pretax financial income for 2014 Taxable temporary difference originating Deductible temporary difference originating Taxable income for 2014
$
X (25,000,000) 100,000,000 $160,000,000
Solving for X: X – $25,000,000 + $100,000,000 = $160,000,000 X = $85,000,000 = Pretax financial income 3
Deferred tax liability at the end of 2014 Deferred tax liability at the beginning of 2014 Deferred tax expense for 2014 (increase in deferred tax liability)
$20,000,000 10,000,000
Deferred tax asset at the end of 2014 Deferred tax asset at the beginning of 2014 Deferred tax benefit for 2014 (increase in deferred tax asset) Deferred tax expense for 2014 Net deferred tax benefit for 2014
$ 40,000,000 –0–
4
$(30,000,000) 64,000,000 $ 34,000,000
$10,000,000
(40,000,000) 10,000,000 $(30,000,000)
Net deferred tax benefit for 2014 Current tax expense for 2014 (Income taxes payable) Income tax expense for 2014
EXERCISE 19-20 (15–20 minutes) (a) Income Tax Expense .............................................. Deferred Tax Asset ................................................. Income Taxes Payable .................................... Deferred Tax Liability...................................... 2014 Future taxable (deductible) amounts Depreciation Warranty costs Enacted tax rate Deferred tax liability Deferred tax (asset)
$ 20,000 (200,000) 34% $ 6,800 $ (68,000)
Future Years 2015 $30,000 34% $10,200
128,800 68,000 176,800 20,000 2016
Total
$10,000 $ 60,000 $(200,000) 30% $ 3,000 $ 20,000 $ (68,000)
EXERCISE 19-20 (Continued) Taxable income for 2013 Tax rate Income taxes payable for 2013
$520,000 34% $176,800
Deferred tax liability at the end of 2013 Deferred tax liability at the beginning of 2013 Deferred tax expense for 2013 (increase required in deferred tax liability account)
$ 20,000 –0–
Deferred tax asset at the end of 2013 Deferred tax asset at the beginning of 2013 Deferred tax benefit for 2013 (increase in deferred tax asset)
$ 68,000 –0– $(68,000)
Deferred tax benefit for 2013 Deferred tax expense for 2013 Net deferred tax benefit for 2013 Current tax expense for 2013 Income tax expense for 2013
$ (68,000) 20,000 (48,000) 176,800 $128,800
(b) Current assets Deferred tax asset Long-term liabilities Deferred tax liability
$ 20,000
$68,000 $20,000
The deferred tax asset is classified as current because the related warranty obligation is a current liability. The warranty obligation is classified as current because it is expected to be settled in the year that immediately follows the balance sheet date. The deferred tax liability is classified as noncurrent because the related plant assets are in a noncurrent classification.
EXERCISE 19-21 (20–25 minutes) (a)
Income Tax Expense .............................................. Deferred Tax Asset ................................................. Income Taxes Payable .................................... Deferred Tax Liability......................................
242,880 12,920 170,000 85,800
Taxable income Enacted tax rate Income taxes payable
$500,000 34% $170,000
Temporary Difference
Future Taxable (Deductible) Amounts
Tax Rate
Installment sale
$ 40,000
34%
Installment sale
190,000*
Loss accrual Totals
(34,000)** $196,000
38% 38%
Deferred Tax Liability
Classification
1
$13,600
Current
2
72,200
Current
(Asset)
$(12,920) $(12,920)
Noncurrent $85,800
*$50,000 + $60,000 + $80,000 = $190,000. **$15,000 + $19,000 = $34,000. 1 Tax rate for 2014. 2 Tax rate for 2015–2018.
Deferred tax liability at the end of 2013 Deferred tax liability at the beginning of 2013 Deferred tax expense for 2013 (increase required in deferred tax liability)
$85,800 –0–
Deferred tax asset at the end of 2013 Deferred tax asset at the beginning of 2013 Deferred tax benefit for 2013 (increase required in deferred tax asset)
$ 12,920 –0– $(12,920)
Deferred tax expense for 2013 Deferred tax benefit for 2013 Net deferred tax expense for 2013 Current tax expense for 2013 (Income taxes payable) Income tax expense for 2013
$ 85,800 (12,920) 72,880 170,000 $242,880
$85,800
(b) Other assets (noncurrent) Deferred tax asset
$12,920
Current liabilities Deferred tax liability
$85,800
EXERCISE 19-21 (Continued) The deferred tax asset is noncurrent because the related liability is noncurrent. The liability from the accrual of the loss contingency is noncurrent because it is expected to be settled in years later than the year immediately following the balance sheet date. An alternative is to argue that the loss contingency should be classified as current because the operating cycle is 4 years. In that case, the deferred tax asset related to the loss contingency would be reported as current. The deferred tax liability is current because it is assumed that the related installment receivable is classified as a current asset. The installment receivable is classified as current when it is a trade practice for the entity to sell on an installment basis. If you assume the installment receivable is related to an installment sale of an investment and, therefore, is classified as part current and part noncurrent, then $13,600 ($40,000 X 34%) of the deferred tax liability should be classified as current and $72,200 ($190,000 X 38%) of it should be classified as noncurrent.
EXERCISE 19-22 (15–20 minutes) (a)
Income Tax Expense ............................................. Deferred Tax Asset ................................................ Income Taxes Payable ................................... Deferred Tax Liability.....................................
125,800 10,200 119,000 17,000
Taxable income Enacted tax rate Income taxes payable Temporary Difference Accounts receivable Litigation liability Totals
Future Taxable (Deductible) Amounts $50,000 (30,000) $20,000
$350,000 34% $119,000 Tax Rate 34% 34%
Deferred Tax (Asset) Liability $17,000 $(10,200) $(10,200)
$17,000
*Because of a flat tax rate for all periods, these totals can be reconciled as follows: $20,000 X 34% = $(10,200) + $17,000.
EXERCISE 19-22 (Continued)
(b)
Deferred tax liability at the end of 2013 Deferred tax liability at the beginning of 2013 Deferred tax expense for 2013 (increase required in deferred tax liability)
$17,000 –0–
Deferred tax asset at the end of 2013 Deferred tax asset at the beginning of 2013 Deferred tax benefit for 2013 (increase required in deferred tax asset)
$ 10,200 –0– $(10,200)
Deferred tax expense for 2013 Deferred tax benefit for 2013 Net deferred tax expense for 2013 Current tax expense for 2013 (Income taxes payable) Income tax expense for 2013
$ 17,000 (10,200) 6,800 119,000 $125,800
Temporary Difference Accounts receivable Litigation liability Totals
Resulting Deferred Tax (Asset) Liability $17,000 $(10,200) $(10,200)
$17,000
Related Balance Sheet Account Accounts Receivable Lawsuit Obligation
Classification Current Current
$17,000
The deferred tax asset is current because the related liability is current. The liability from the accrual of the litigation loss is current because it is expected to be settled in the year that immediately follows the balance sheet date. The deferred tax liability is current because the related accounts receivable is classified as a current asset. The entire accounts receivable balance is classified as current because the operating cycle of the business is two years.
EXERCISE 19-23 (30–35 minutes) (a)
2012 Income Tax Expense ................................................. Income Taxes Payable ($120,000 X 34%) .........
40,800 40,800
EXERCISE 19-23 (Continued) 2013 Income Tax Expense .............................................. Income Taxes Payable ($90,000 X 34%).........
30,600 30,600
2014 Income Tax Refund Receivable ............................ Deferred Tax Asset ................................................ Benefit Due to Loss Carryback ..................... Benefit Due to Loss Carryforward ................
71,400 26,600 71,400* 26,600**
*[34% X $(120,000)] + [34% X $(90,000)] = $71,400 **38% X ($280,000 – $120,000 – $90,000) = $26,600 2015 Income Tax Expense ............................................. Income Taxes Payable ................................... Deferred Tax Asset.........................................
83,600 57,000* 26,600
*[($220,000 – $70,000) X 38%] (b) Operating loss before income taxes Income tax benefit Benefit due to loss carryback Benefit due to loss carryforward Net loss (c)
$(280,000) $71,400 26,600
98,000 $(182,000)
2014 Income Tax Refund Receivable ............................ Deferred Tax Asset ................................................ Benefit Due to Loss Carryback ..................... Benefit Due to Loss Carryforward ................
71,400 26,600 71,400* 26,600**
*[34% X $(120,000)] + [34% X $(90,000)] = $71,400 **38% X ($280,000 – $120,000 – $90,000) = $26,600 Benefit Due to Loss Carryforward ........................ Allowance to Reduce Deferred Tax Asset to Expected Realizable Value .................... (25% X $26,600)
6,650 6,650
EXERCISE 19-23 (Continued) 2015 Income Tax Expense ................................................. Deferred Tax Asset ............................................ Income Taxes Payable ....................................... [($220,000 – $70,000) X 38%] Allowance to Reduce Deferred Tax Asset to Expected Realizable Value................................ Benefit Due to Loss Carryforward ....................
83,600 26,600 57,000
6,650 6,650
(d) Operating loss before income taxes $(280,000) Income tax benefit Benefit due to loss carryback $71,400 Benefit due to loss carryforward ($26,600 – $6,650) 19,950 91,350 Net loss $(188,650) Note: Using the assumption in part (a), the income tax section of the 2015 income statement would appear as follows: Income before income taxes Income tax expense Current Deferred Net income
$220,000 $57,000 26,600
83,600 $136,400
Note: Using the assumption in part (c), the income tax section of the 2015 income statement would appear as follows: Income before income taxes Income tax expense Current Deferred Benefit due to loss carryforward Net income
$220,000 $57,000 26,600 (6,650)
76,950 $143,050
EXERCISE 19-24 (30–35 minutes) (a)
2012 Income Tax Expense ............................................. Income Taxes Payable ($120,000 X 40%) .......
48,000 48,000
2013 Income Tax Expense ............................................. Income Taxes Payable ($90,000 X 40%) .........
36,000 36,000
2014 Income Tax Refund Receivable ............................ Deferred Tax Asset ................................................ Benefit Due to Loss Carryback....................... Benefit Due to Loss Carryforward ..................
84,000 31,500 84,000* 31,500**
*[40% X $(120,000)] + [40% X $(90,000)] = $84,000 **45% X ($280,000 – $120,000 – $90,000) = $31,500 Benefit Due to Loss Carryforward ........................ Allowance to Reduce Deferred Tax Asset to Expected Realizable Value...................... (50% X $31,500)
15,750 15,750
2015 Income Tax Expense ............................................. Deferred Tax Asset .......................................... Income Taxes Payable..................................... [($120,000 – $70,000) X 45%] Allowance to Reduce Deferred Tax Asset to Expected Realizable Value ............................ Benefit Due to Loss Carryforward .................. (b)
54,000 31,500 22,500
15,750 15,750
Operating loss before income taxes $(280,000) Income tax benefit Benefit due to loss carryback $84,000 Benefit due to loss carryforward ($31,500 – $15,750) 15,750 99,750 Net loss $(180,250)
EXERCISE 19-24 (Continued) (c) Income before income taxes Income tax expense Current Deferred Benefit due to loss carryforward Net income
$120,000 $22,500 31,500 (15,750)
38,250 $ 81,750
EXERCISE 19-25 (15–20 minutes) (a)
2014 Income Tax Expense ($120,000 X .40) ................. Income Taxes Payable ..................................
48,000 48,000
2015 Income Tax Refund Receivable ........................... Deferred Tax Asset ............................................... Benefit Due to Loss Carryback .................... Benefit Due to Loss Carryforward ...............
167,000 40,000 167,000* 40,000**
*($350,000 X .34) + ($120,000 X .40) **[($570,000 – $350,000 – $120,000) X .40] Benefit Due to Loss Carryforward....................... Allowance to Reduce Deferred Tax Asset to Expected Realizable Value ................... (1/5 X $40,000)
8,000 8,000
2016 Income Tax Expense ............................................ Income Taxes Payable .................................. [($180,000 – $100,000) X .40] Deferred Tax Asset ....................................... Allowance to Reduce Deferred Tax Asset to Expected Realizable Value........................... Benefit Due to Loss Carryforward ...............
72,000 32,000 40,000 8,000 8,000
EXERCISE 19-25 (Continued) (b) Loss before income taxes $(570,000) Income tax benefit Benefit due to loss carryback $167,000 Benefit due to loss carryforward ($40,000 – $8,000) 32,000 199,000 Net loss $(371,000)
TIME AND PURPOSE OF PROBLEMS Problem 19-1 (Time 40–45 minutes) Purpose—to provide the student with an understanding of how to compute and properly classify deferred income taxes when there are three types of temporary differences. A single tax rate applies. The student is required to compute and classify deferred income taxes. Also, the student must use data given to solve for both taxable income and pretax financial income. The latter computation is complicated by the fact there are deferred taxes at the beginning of the year. Problem 19-2 (Time 50–60 minutes) Purpose—to provide the student with a situation where: (1) a temporary difference originates over a three-year period and begins to reverse in the fourth period, (2) a change in an enacted tax rate occurs in a year in which there is a change in the amount of cumulative temporary difference, (3) the amount of originating or reversing temporary difference must be calculated each year in order to determine the cumulative temporary difference at the end of each year, and (4) there is a permanent difference along with a temporary difference each year. Journal entries are required for each of four years, including the entry for the adjustment of deferred taxes due to the change in the enacted tax rate. Problem 19-3 (Time 40–45 minutes) Purpose—to provide the student with an understanding of how future temporary differences for existing depreciable assets are considered in determining the future years in which existing temporary differences result in taxable or deductible amounts. The student is given information about pretax financial income, one temporary difference, and one permanent difference. The student must compute all amounts related to income taxes for the current year and prepare the journal entry to record them. In order to determine the beginning balance in a deferred tax account, the student must calculate deferred taxes for the prior year’s balance sheet. An income statement presentation is also required and an extraordinary gain is recognized in the current period. Problem 19-4 (Time 20–25 minutes) Purpose—to provide the student with an understanding of permanent and temporary differences when there are multiple differences and a single rate. Problem 19-5 (Time 20–25 minutes) Purpose—to provide the student with a situation involving a net operating loss which can be partially offset by prior taxes paid using the carryback provision. Journal entries for the loss year and two subsequent years are required. The benefits of the loss carryforward are realized in the year following the loss year. Income statement presentations are required for the loss year where the benefits of the carryback and the carryforward are recognized and the year following the loss year where the benefits of the carryforward are realized. Problem 19-6 (Time 20–25 minutes) Purpose—to provide the student with an understanding of how the computation and classification of deferred income taxes are affected by the individual future year(s) in which future taxable and deductible amounts are scheduled to occur because of existing temporary differences. Two situations are given and the student is required to compute and classify the deferred income taxes for each. A net deferred tax asset results in both cases. Problem 19-7 (Time 45–50 minutes) Purpose—to provide the student with a situation where: (1) a temporary difference originates in one period and reverses over the following two periods, (2) a change in an enacted tax rate occurs in a year in which there is a change in the amount of cumulative temporary difference, and (3) the amount of originating or reversing temporary difference must be calculated each year in order to determine the cumulative temporary difference at the end of each year. Journal entries are required for each of three years, including the entry for the adjustment of deferred taxes due to the change in the enacted tax rate.
Time and Purpose of Problems (Continued) Problem 19-8 (Time 40–50 minutes) Purpose—to test a student’s understanding of the relationships that exist in the subject area of accounting for income taxes. The student is required to compute and classify deferred income taxes for two successive years. The journal entry to record income taxes is also required for each year. A draft of the income tax expense section of the income statement is also required for each year. An interesting twist to this problem is that the student must compute taxable income for two individual periods based on facts about the tax rate and amount of taxes paid for each period and then combine that information with data on temporary differences to compute pretax financial income. Problem 19-9 (Time 40–50 minutes) Purpose—to test a student’s ability to compute and classify deferred taxes for three temporary differences and to draft the income tax expense section of the income statement for the year.
SOLUTIONS TO PROBLEMS PROBLEM 19-1
(a) X(.40) = $320,000 taxes due for 2014 X = $320,000 ÷ .40 X = $800,000 taxable income for 2014 (b) Taxable income [from part (a)]................................ Excess depreciation ................................................ Municipal interest .................................................... Unearned rent .......................................................... Pretax financial income for 2014..................... (c)
$800,000 120,000 10,000 (40,000) $890,000
2014 Income Tax Expense ($320,000 + $42,000 – $14,000)............................ Deferred Tax Asset ($40,000 X .35)......................... Income Taxes Payable ($800,000 X .40).......... Deferred Tax Liability ($120,000 X .35) ...........
348,000 14,000 320,000 42,000
2015 Income Tax Expense ($343,000 + $7,000 – $10,500).............................. Deferred Tax Liability [($120,000 ÷ 4) X .35]........... Income Taxes Payable ($980,000 X .35).......... Deferred Tax Asset [($40,000 ÷ 2) X .35]......... (d) Income before income taxes................................... Income tax expense Current.............................................................. Deferred ($42,000 – $14,000) ........................... Net income ...............................................................
339,500 10,500 343,000 7,000 $890,000 $320,000 28,000
348,000 $542,000
PROBLEM 19-2
(a) Before deferred taxes can be computed, the amount of temporary difference originating (reversing) each period and the resulting cumulative temporary difference at each year-end must be computed: Pretax financial income Nondeductible expense Subtotal Taxable income Temporary difference originating (reversing)
2014 2015 2016 2017
2014 $290,000 30,000 320,000 180,000
2015 $320,000 30,000 350,000 225,000
2016 $350,000 30,000 380,000 260,000
2017 $ 420,000 30,000 450,000 560,000
$140,000
$125,000
$120,000
$(110,000)
Cumulative Temporary Difference At End of Year $140,000 $265,000 ($140,000 + $125,000) $385,000 ($265,000 + $120,000) $275,000 ($385,000 – $110,000)
Because the temporary difference causes pretax financial income to exceed taxable income in the period it originates, the temporary difference will cause future taxable amounts. Taxable income for 2014 .................................................... Enacted tax rate for 2014.................................................... Current tax expense for 2014 (Income taxes payable) .....
$180,000 35% $ 63,000
2014 Income Tax Expense ............................................... Income Taxes Payable ..................................... Deferred Tax Liability.......................................
112,000 63,000 49,000
PROBLEM 19-2 (Continued) The deferred taxes at the end of 2014 would be computed as follows: Temporary Difference
Future Taxable (Deductible) Amounts
Tax Rate
Deferred Tax (Asset) Liability
Depreciation
$140,000
35%
$49,000
Deferred tax liability at the end of 2014............................... Deferred tax liability at the beginning of 2014 .................... Deferred tax expense for 2014 (increase in deferred tax liability).........................................................
$ 49,000 –0–
Deferred tax expense for 2014 ............................................. Current tax expense for 2014 (Income taxes payable)....... Income tax expense for 2014 ...............................................
$ 49,000 63,000 $112,000
$ 49,000
2015 Income Tax Expense ............................................... Deferred Tax Liability....................................... (To record the adjustment for the increase in the enacted tax rate)
7,000*
Income Tax Expense ............................................... Income Taxes Payable ..................................... Deferred Tax Liability....................................... (To record income taxes for 2015)
140,000
7,000
90,000 50,000
*The adjustment due to the change in the tax rate is computed as follows: Cumulative temporary difference at the end of 2014 ............................................................................... Newly enacted tax rate for future years .............................. Adjusted balance of deferred tax liability at the end of 2014 ............................................................. Current balance of deferred tax liability.............................. Adjustment due to increase in enacted tax rate.................
$140,000 40% 56,000 49,000 $ 7,000
PROBLEM 19-2 (Continued) Taxable income for 2015 ....................................................... Enacted tax rate ..................................................................... Current tax expense for 2015 (Income taxes payable) ........
$225,000 40% $ 90,000
The deferred taxes at December 31, 2015, are computed as follows: Temporary Difference
Future Taxable (Deductible) Amounts
Tax Rate
Deferred Tax (Asset) Liability
Depreciation
$265,000
40%
$106,000
Deferred tax liability at the end of 2015................................ Deferred tax liability at the beginning of 2015 after adjustment ................................................................. Deferred tax expense for 2015 exclusive of adjustment due to change in tax rate (increase in deferred tax liability)......................................................
$106,000
Deferred tax expense for 2015 .............................................. Current tax expense for 2015 (Income taxes payable) ........ Income tax expense (total) for 2015, exclusive of adjustment due to change in tax rate...........................
$ 50,000 90,000
56,000 $ 50,000
$140,000
2016 Income Tax Expense ............................................. Income Taxes Payable ................................... Deferred Tax Liability..................................... Taxable income for 2016 ....................................... Enacted tax rate ..................................................... Current tax expense for 2016 (Income taxes payable).......................................
152,000 104,000 48,000 $260,000 40% $104,000
The deferred taxes at December 31, 2016, are computed as follows: Temporary Difference
Future Taxable (Deductible) Amounts
Tax Rate
Deferred Tax (Asset) Liability
Depreciation
$385,000
40%
$154,000
PROBLEM 19-2 (Continued) Deferred tax liability at the end of 2016................................ Deferred tax liability at the beginning of 2016 ..................... Deferred tax expense for 2016 (increase in deferred tax liability)..........................................................
$154,000 106,000 $ 48,000
Deferred tax expense for 2016 .............................................. Current tax expense for 2016 (Income taxes payable)........ Income tax expense for 2016 ................................................
$ 48,000 104,000 $152,000
2017 Income Tax Expense ............................................ Deferred Tax Liability ........................................... Income Taxes Payable ..................................
180,000 44,000 224,000
Taxable income for 2017 ....................................................... Enacted tax rate ..................................................................... Current tax expense for 2017 (Income taxes payable)........
$560,000 40% $224,000
The deferred taxes at December 31, 2017, are computed as follows: Temporary Difference
Future Taxable (Deductible) Amounts
Tax Rate
Deferred Tax (Asset) Liability
Depreciation
$275,000
40%
$110,000
Deferred tax liability at the end of 2017................................ $110,000 Deferred tax liability at the beginning of 2017 ..................... 154,000 Deferred tax benefit for 2017 (decrease in deferred tax liability) ........................................................... $ (44,000) Deferred tax benefit for 2017 ................................................ Current tax expense for 2017 (Income taxes payable)........ Income tax expense for 2017 ................................................ (b)
$ (44,000) 224,000 $180,000
2015 Income before income taxes ............................... Income tax expense Current ............................................................ Deferred........................................................... Adjustment due to change in tax rate ........... Net income............................................................
$320,000 $90,000 50,000 7,000
147,000 $173,000
PROBLEM 19-3
2014 2015 2016 2017 2018 2019 2020 2021 Totals
Book Depreciation $ 150,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 $1,200,000
Tax Depreciation $ 120,000* 240,000 240,000 240,000 240,000 120,000* 0 0 $1,200,000
Difference $ 30,000 (90,000) (90,000) (90,000) (90,000) 30,000 150,000 150,000 $ 0
*($1,200,000 ÷ 5) X .5 (a) Pretax financial income for 2015 ......................... Nontaxable interest............................................... Excess depreciation ($240,000 – $150,000) ........ Taxable income for 2015 ...................................... Tax rate.................................................................. Income taxes payable for 2015 ............................ (b) Income Tax Expense ............................................ Income Taxes Payable .................................. Deferred Tax Liability.................................... Deferred Tax Asset........................................
$1,400,000 (60,000) (90,000) $1,250,000 35% $ 437,500 469,000 437,500 21,000 10,500
PROBLEM 19-3 (Continued) Scheduling—End of 2015
Future taxable (deductible) amounts Enacted tax rate Deferred tax (asset) liability
Future taxable (deductible) amounts Enacted tax rate Deferred tax (asset) liability
2016
Future Years 2017
2018
$(90,000)
$(90,000)
$(90,000)
35% $(31,500)
35% $(31,500)
35% $(31,500)
2019
Future Years 2020
2021
Total
$30,000 X 35% $10,500
$150,000 X 35% $ 52,500
$150,000 X 35% $ 52,500
$60,000 $21,000
The net deferred tax liability at December 31, 2015, is $21,000. Scheduling—End of 2014
Future taxable (deductible) amounts Enacted tax rate Deferred tax (asset) liability
Future taxable (deductible) amounts Enacted tax rate Deferred tax (asset) liability
2015
Future Years 2016
2017
2018
$(90,000) X 35% $(31,500)
$(90,000) X 35% $(31,500)
$(90,000) X 35% $(31,500)
$(90,000) X 35% $(31,500)
2019
Future Years 2020
2021
Total
$30,000 X 35% $10,500
$150,000 X 35% $ 52,500
$150,000 X 35% $ 52,500
$(30,000) $(10,500)
PROBLEM 19-3 (Continued) The net deferred tax asset at December 31, 2014, is $10,500. Deferred tax liability at the end of 2015................................. Deferred tax liability at the beginning of 2015 ...................... Deferred tax expense for 2015 (increase in deferred tax liability) ........................................................... Deferred tax asset at the end of 2015 .................................... Deferred tax asset at the beginning of 2015 ......................... Deferred tax expense for 2015 (decrease in deferred tax asset) .............................................................. Deferred tax expense for 2015 (from deferred tax liability) ................................................. Deferred tax expense for 2015 (from deferred tax asset) .................................................... Net deferred tax expense for 2015......................................... Current tax expense for 2015 (Income taxes payable) ......... Deferred tax expense for 2015 ............................................... Income tax expense for 2015 ................................................. (c) Income before income taxes and extraordinary item........................................... Income tax expense Current ($437,500 – $70,000b)..................... Deferred ....................................................... Income before extraordinary item ..................... Extraordinary gain....................................... Less applicable income tax ........................ Net income ..........................................................
$ 21,000 –0– $ 21,000 $ –0– 10,500 $ 10,500
$ 21,000 10,500 $ 31,500 $437,500 31,500 $469,000 $1,200,000a
$367,500 31,500 200,000 70,000b
a
399,000 801,000 130,000 $ 931,000
$1,400,000 pretax financial income – $200,000 extraordinary item = $1,200,000.
b
($200,000 X 35%)
(d) Long-term liabilities Deferred tax liability............................................
$21,000
PROBLEM 19-4
(a)
Schedule of Pretax Financial Income and Taxable Income for 2014 Pretax financial income ....................................................... Permanent differences Insurance expense......................................................... Bond interest revenue ................................................... Pollution fines ................................................................ Temporary differences Depreciation expense .................................................... Installment sales ($100,000 – $75,000) ......................... Warranty expense ($50,000 – $10,000) ......................... Taxable income ............................................................. * Depreciation for books ($300,000/5) Depreciation tax return ($300,000 X 30%) Difference
$750,000 9,000 (4,000) 4,200 759,200 (30,000)* (25,000) 40,000 $744,200
= $60,000 = 90,000 $30,000
The income taxes payable for 2014 is as follows: Taxable income ....................................... $744,200 Tax rate .................................................... 30% Income taxes payable ............................. $223,260 The computation of the deferred income taxes for 2014 is as follows: Temporary differences Depreciation expense Installment sales ($100,000 – $75,000) Warranty expense ($50,000 – $10,000)
$(30,000) X 30% = $(9,000) DTL (25,000) X 30% = (7,500) DTL 40,000 X 30% = 12,000 DTA
PROBLEM 19-4 (Continued) (b)
The journal entry to record income taxes payable, income tax expense and deferred income taxes is as follows: Income Tax Expense ............................................. Deferred Tax Asset................................................ Deferred Tax Liability ($9,000 + $7,500) ......... Income Taxes Payable ....................................
227,760* 12,000
*Deferred tax expense for 2014 (from deferred tax liability) ($9,000 + $7,500) .... $ 16,500 Deferred tax benefit for 2014 (from deferred tax asset)................................. (12,000) Net deferred tax expense for 2014 ....................... 4,500 Current tax expense for 2014 (income taxes payable) ................................... 223,260 Income tax expense for 2014................................ $227,760
16,500 223,260
PROBLEM 19-5 (a)
2014 Income Tax Refund Receivable [($50,000 X 30%) + ($80,000 X 40%)] ..................... Benefit Due to Loss Carryback ......................... Deferred Tax Asset .................................................... Benefit Due to Loss Carryforward ($180,000 – $50,000 – $80,000 = $50,000) ($50,000 X 40% = $20,000) .............................
47,000 47,000 20,000 20,000
2015 Income Tax Expense ................................................. Deferred Tax Asset ............................................ Income Taxes Payable [($70,000 – $50,000) X 40%] ...........................
28,000 20,000 8,000
2016 Income Tax Expense ................................................. Income Taxes Payable ($100,000 X 35%) ......... (b)
35,000 35,000
The income tax refund receivable account totaling $47,000 will be reported under current assets on the balance sheet at December 31, 2014. This type of receivable is usually listed immediately above inventory in the current assets section. This receivable is normally collectible within two months of filing the amended tax returns reflecting the carryback. A deferred tax asset of $20,000 should also be classified as a current asset because the benefits of the loss carryforward are expected to be realized in the year that immediately follows the loss year which means the benefits are expected to be realized in 2015. A current deferred tax asset is usually listed at or near the end of the list of current assets on the balance sheet. Also, retained earnings is increased by $67,000 ($47,000 + $20,000) as a result of the entries to record the benefits of the loss carryback and the loss carryforward.
PROBLEM 19-5 (Continued) (c)
2014 Income Statement Operating loss before income taxes ............... Income tax benefit Benefit due to loss carryback .................. Benefit due to loss carryforward.............. Net loss..............................................................
(d)
$(180,000) $47,000 20,000
67,000 $(113,000)
2015 Income Statement Income before income taxes............................ Income tax expense Current ....................................................... Deferred ..................................................... Net income ........................................................ a
Loss (2014)....................................................... Loss carryback (2012)..................................... Loss carryback (2013) .................................... Loss carryforward (2015) ............................... Taxable income 2015 before carryforward .... Taxable income 2015 ...................................... Enacted tax rate for 2015 ................................ Income taxes payable for 2015 .................
$70,000 $ 8,000a 20,000
28,000 $42,000 ($180,000) 50,000 80,000 (50,000) 70,000 20,000 40% $ 8,000
PROBLEM 19-6 1. Temporary Difference
Future Taxable (Deductible) Amounts
2015 2016 2017 2018 2018 2019 Totals a
Tax rate for 2015. b Tax rate for 2016. c Tax rate for 2017.
$
300 300 300 300 (1,600) 300 $ (100)
Tax Rate
30%a 30%b 30%c 35%d 35%d 35%e
Deferred Tax (Asset) Liability
$ 90 90 90 105 $(560) $(560)
105 $480
d e
Tax rate for 2018. Tax rate for 2019. MOONEY CO. Balance Sheet December 31, 2014
Other assets (noncurrent) Deferred tax asset ($560 – $480) .......................................
$80
2. Temporary Difference
Future Taxable (Deductible) Amounts
2015 2016 2017 2017 2018 Totals a
Tax rate for 2015. b Tax rate for 2016.
$
300 300 300 (2,300) 300 $ (1,100) c
Tax rate for 2017. Tax rate for 2018.
d
Tax Rate 30%a 30%b 30%c 30%c 35%d
Deferred Tax (Asset)
Liability
$ 90 90 90 $(690) $(690)
105 $375
PROBLEM 19-6 (Continued) ROESCH CO. Balance Sheet December 31, 2014 Other assets (noncurrent) Deferred tax asset ($690 – $375) ......................................
$315
PROBLEM 19-7
(a) Before deferred taxes can be computed, the amount of cumulative temporary difference existing at the end of each year must be computed:
Pretax financial income Taxable income Temporary difference originating (reversing) Cumulative temporary difference at the beginning of the year Cumulative temporary difference at the end of the year
2014 $130,000 90,000
2015 $70,000 90,000
2016 $70,000 90,000
40,000
(20,000)
(20,000)
0
40,000
20,000
$ 40,000
$20,000
$ –0–
2014 Income Tax Expense ............................................... Income Taxes Payable ..................................... Deferred Tax Liability.......................................
52,000 36,000 16,000
Taxable income for 2014 ......................................... Enacted tax rate for 2014 ........................................ Current tax expense for 2014 (Income taxes payable) .......................................
$90,000 X 40% $36,000
Temporary Difference
Future Taxable (Deductible) Amounts
Tax Rate
December 31, 2015 Deferred Tax (Asset) Liability
Installment Accounts Receivable
$ 40,000
40%a
$16,000
a
Tax rate enacted for 2014.
Deferred tax liability at the end of 2014................................. Deferred tax liability at the beginning of 2014 ...................... Deferred tax expense for 2014 (increase in deferred tax liability)...........................................................
$16,000 –0– $16,000
PROBLEM 19-7 (Continued) Deferred tax expense for 2014 ............................................... Current tax expense for 2014 (Income taxes payable) ......... Income tax expense for 2014 .................................................
$16,000 36,000 $52,000
2015 Deferred Tax Liability .............................................. Income Tax Expense........................................ (To record the adjustment for the decrease in the enacted tax rate)
2,000
Income Tax Expense ............................................... Deferred Tax Liability .............................................. Income Taxes Payable .....................................
24,500 7,000
2,000*
31,500
*Cumulative temporary difference at the end of 2014............ Newly enacted tax rate for future year .................................. Adjusted balance of deferred tax liability at the end of 2014 ................................................................................. Current balance of deferred tax liability................................ Adjustment due to decrease in enacted tax rate ..................
$40,000 X 35% 14,000 16,000 $ (2,000)
Taxable income for 2015 ........................................................ Enacted tax rate for 2015........................................................ Current tax expense for 2015 (Income taxes payable) .........
$90,000 X 35% $31,500
Temporary Difference
Future Taxable (Deductible) Amounts
Tax Rate
December 31, 2015 Deferred Tax (Asset) Liability
Installment Accounts Receivable
$20,000
35%b
$ 7,000
b
Tax rate enacted for 2015.
Deferred tax liability at the end of 2015................................. Deferred tax liability at the beginning of 2015 after adjustment ($16,000 – $2,000) ................................... Deferred tax benefit for 2015 (decrease in deferred tax liability) ...........................................................
$ 7,000 14,000 $ (7,000)
PROBLEM 19-7 (Continued) Deferred tax benefit for 2015 ................................................. Current tax expense for 2015 (Income taxes payable)......... Income tax expense for 2015 .................................................
$ (7,000) 31,500 $24,500
2016 Income Tax Expense ............................................... Deferred Tax Liability .............................................. Income Taxes Payable .....................................
24,500 7,000 31,500
Taxable income for 2016 ........................................................ Enacted tax rate for 2016 ....................................................... Current tax expense for 2016 (Income taxes payable).........
$90,000 X 35% $31,500
Temporary Difference
Future Taxable (Deductible) Amounts
Tax Rate
December 31, 2016 Deferred Tax (Asset) Liability
Installment Accounts Receivable
$–0–
30%
$–0–
Deferred tax liability at the end of 2016................................. $ –0– Deferred tax liability at the beginning of 2016 ...................... 7,000 Deferred tax benefit for 2016 (decrease in deferred tax liability)............................................................. $ (7,000) Deferred tax benefit for 2016 ................................................. Current tax expense for 2016 (Income taxes payable)......... Income tax expense for 2016 ................................................. (b)
$ (7,000) 31,500 $24,500
December 31, 2014 Current liabilities Deferred tax liability ........................................................
$16,000
December 31, 2015 Current liabilities Deferred tax liability ........................................................ December 31, 2016 There is no deferred tax liability to be reported at this date.
$ 7,000
PROBLEM 19-7 (Continued) (c)
2014 Income before income taxes....................................... Income tax expense Current .................................................................. Deferred ................................................................ Net income ...................................................................
$130,000 $36,000 16,000
52,000 $ 78,000
2015 Income before income taxes....................................... $70,000 Income tax expense Current .................................................................. $31,500 Deferred ................................................................ (7,000) Adjustment due to decrease in tax rate .......................................................... (2,000) 22,500 Net income ................................................................... $47,500 2016 Income before income taxes....................................... $70,000 Income tax expense Current .................................................................. $31,500 Deferred ................................................................ (7,000) 24,500 Net income ................................................................... $45,500
PROBLEM 19-8 (a) Temporary Difference
Future Taxable (Deductible) Amounts
Depreciation
$(60,000)*
Tax Rate
Deferred Tax (Asset) Liability
40% $(24,000)
*(Computation shown on next page.) Other assets (noncurrent) Deferred tax asset ...........................................................
$24,000
This answer may differ from what is expected. Usually, depreciation is faster for tax purposes; in this situation, there is excess depreciation for book purposes in the first year of depreciation (2014). (b) Income Tax Expense ............................................ Deferred Tax Asset ............................................... Income Taxes Payable ..................................
106,000 24,000 130,000
$130,000 taxes due for 2014 ÷ 40% 2014 tax rate = $325,000 taxable income for 2014. Taxable income for 2014 ........................................................ Tax rate.................................................................................... Income taxes payable for 2014 (also given data) .................
$325,000 X 40% $130,000
Deferred tax asset at the end of 2014.................................... Deferred tax asset at the beginning of 2014 ......................... Deferred tax benefit for 2014 (increase in deferred tax asset).............................................................. Current tax expense for 2014 (Income taxes payable)......... Income tax expense for 2014 .................................................
$ 24,000 –0–
(c) Income before income taxes................................ Income tax expense Current ...............................................................$130,000 Deferred ............................................................. (24,000) Net income ............................................................
$265,000a
a
Pretax financial income ......................................................... Excess depreciation per books............................................. Taxable income [from (b) above] ..........................................
(24,000) 130,000 $106,000
106,000 $159,000 $
X 60,000b $325,000
Solving for X; X + $60,000 = $325,000; X = $265,000 pretax financial income.
PROBLEM 19-8 (Continued)
2014 2015 2016 2017 2018 2019 Totals
Book Depreciation $120,000 120,000 120,000 120,000 120,000 0 $600,000
b
Tax Depreciation $ 60,000* 120,000 120,000 120,000 120,000 60,000 $600,000
Difference $ 60,000 0 0 0 0 (60,000) $ 0
*($600,000 ÷ 5) X .5 (d) Temporary Difference
Future Taxable (Deductible) Amounts
Depreciation Unearned rent Unearned rent Totals
$ (60,000) (75,000) (75,000) $(210,000)
Temporary Difference Depreciation Unearned rent Unearned rent Totals
Tax Rate
Deferred Tax (Asset) Liability
40% $(24,000) 40% (30,000) 40% (30,000) $(84,000)
Resulting Deferred Tax (Asset) Liability
Related Balance Sheet Account
Classification
$(24,000) (30,000) (30,000) $(84,000)
Plant Assets Unearned Rent Unearned Rent
Noncurrent Current Noncurrent
Current assets Deferred tax asset ...........................................................
$30,000
Other assets (noncurrent) Deferred tax asset ...........................................................
$54,000c
c
$30,000 + $24,000 = $54,000
PROBLEM 19-8 (Continued) (e) Income Tax Expense .............................................. Deferred Tax Asset ................................................. Income Taxes Payable ....................................
44,000 60,000 104,000
$104,000 taxes due for 2015 ÷ 40% 2015 tax rate = $260,000 taxable income for 2015.
(f)
Taxable income for 2015 ........................................................ Tax rate for 2015 ..................................................................... Income taxes payable for 2015 (also given data) .................
$260,000 X 40% $104,000
Deferred tax asset at the end of 2015.................................... Deferred tax asset at the beginning of 2015 ......................... Deferred tax benefit for 2015 (increase in deferred tax asset)..............................................................
$ 84,000 24,000 $ (60,000)
Deferred tax benefit for 2015 ................................................. Current tax expense for 2015 (Income taxes payable)......... Income tax expense for 2015 .................................................
$ (60,000) 104,000 $ 44,000
Income before income taxes.................................. Income tax expense Current .............................................................. $104,000 Deferred ............................................................ (60,000) Net income ..............................................................
$110,000d
d
Pretax financial income ......................................................... Excess rent collected over rent recognized......................... Taxable income [from (e) above] ..........................................
Solving for X: X + $150,000 = $260,000 X = $110,000 pretax financial income.
44,000 $ 66,000 $
X 150,000 $260,000
PROBLEM 19-9
(a) Pretax financial income .......................................................... Permanent differences: Fine for pollution ............................................................. Tax-exempt interest ........................................................ Originating temporary differences: Excess warranty expense per books ($7,000 – $2,000) .......................................................... Excess construction profits per books ($92,000 – $67,000) ...................................................... Excess depreciation per tax return ($80,000 – $60,000) ...................................................... Taxable income .......................................................................
$100,000 3,500 (1,500) 5,000 (25,000) (20,000) $ 62,000
(b) Temporary Difference
Future Taxable (Deductible) Amounts
Tax Rate
Deferred Tax (Asset) Liability
Warranty costs Construction profits Depreciation Totals
$ (5,000) 25,000 20,000 $40,000
40% 40% 40%
$(2,000)
$(2,000)
$10,000 8,000 $18,000*
*Because of a flat tax rate, these totals can be reconciled: $40,000 X 40% = $(2,000) + $18,000. (c)
Income Tax Expense ............................................... Deferred Tax Asset .................................................. Deferred Tax Liability....................................... Income Taxes Payable .....................................
40,800 2,000 18,000 24,800
Taxable income for 2015 [answer part (a)]............................ Tax rate.................................................................................... Income taxes payable for 2015 ..............................................
$62,000 40% $24,800
Deferred tax liability at the end of 2015 [part (b)] ................. Deferred tax liability at the beginning of 2015 ...................... Deferred tax expense for 2015 ...............................................
$18,000 0 $18,000
PROBLEM 19-9 (Continued) Deferred tax asset at the end of 2015.................................... Deferred tax asset at the beginning of 2015 ......................... Deferred tax benefit for 2015 .................................................
$
2,000 –0– $ (2,000)
Deferred tax expense for 2015 ............................................... Deferred tax benefit for 2015 ................................................. Net deferred tax expense for 2015.........................................
$ 18,000 (2,000) $ 16,000
Current tax expense for 2015 (Income taxes payable)......... Deferred tax expense for 2015 ............................................... Income tax expense for 2015 .................................................
$ 24,800 16,000 $ 40,800
(d) Income before income taxes.................................. Income tax expense Current ................................................................ $24,800 Deferred............................................................... 16,000 Net income ..............................................................
$100,000
40,800 $ 59,200
TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 19-1 (Time 15–20 minutes) Purpose—to provide the student an opportunity to explain the objectives in accounting for income taxes in the financial statements and the basic principles that are applied in meeting the objectives. The student is also required to list the steps involved in the annual computation of deferred income taxes. CA 19-2 (Time 20–25 minutes) Purpose—to provide the student an opportunity to discuss the principles of the asset-liability method, how the deferred tax effects of temporary differences are computed, and how the deferred tax consequences of temporary differences are classified on a balance sheet. CA 19-3 (Time 20–25 minutes) Purpose—to develop an understanding of temporary and permanent differences. The student is required to explain the nature of four differences and to explain why each is a permanent or temporary difference. Two of the four situations are challenging. Also, the nature of and the classification of deferred tax accounts are examined. CA 19-4 (Time 20–25 minutes) Purpose—to develop an understanding of deferred taxes and balance sheet disclosure. This case has two parts. In the first part, the student is required to indicate whether deferred income taxes should be recognized for each of four items. In the second part, the student must discuss the conditions under which deferred taxes will be classified as a noncurrent item in the balance sheet. CA 19-5 (Time 20–25 minutes) Purpose—to develop an understanding of how to determine the appropriate tax rate to use in computing deferred taxes when different tax rates are enacted for various years affected by existing temporary differences. CA 19-6 (Time 20–25 minutes) Purpose—to develop an understanding of the concept of future taxable amounts and future deductible amounts. Also, to develop an understanding of how the carryback and carryforward provisions affect the computation of deferred tax assets and liabilities when there are multiple tax rates enacted for the various periods affected by existing temporary differences. CA 19-7 (Time 20–25 minutes) Purpose—to provide the student an opportunity to examine the income effects of deferred taxes, including ethical issues.
SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 19-1 (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.
(b)
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. 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: (1) the types and amounts of existing temporary differences and (2) 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.
CA 19-2 (a)
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. 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.
(b)
Dexter should do the following in accounting for the temporary differences. 1. Identify the types and amounts of existing temporary differences. The depreciation policies give rise to a temporary difference that will result in net future taxable amounts (because depreciation for tax purposes exceeds the depreciation for financial statements). Rents are taxed in the year they are received but reported on the income statement in the year earned. The collection of rent revenue in advance will cause future deductible amounts.
CA 19-2 (Continued) 2.
Measure the total deferred tax liability for the taxable temporary difference using the enacted marginal tax rate. Measure the total deferred tax asset for the deductible temporary difference using the enacted marginal tax rate. Reduce the deferred tax asset 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 asset will not be realized.
3. 4.
(c)
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. Dexter’s deferred tax liability resulting from the depreciation difference should be reported as a longterm liability because a related asset (the asset being depreciated) is in a noncurrent classification. Dexter’s deferred tax asset resulting from the advance collection of rents should be reported as a current asset because the related obligation (Unearned Rent Revenue) is classified as a current liability.
CA 19-3 (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.
CA 19-3 (Continued) 4.
(b)
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 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.
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 “Longterm liabilities” section.
CA 19-4 Part A. (a)
Deferred income taxes are reported in the financial statements when temporary differences exist at the balance sheet date. Deferred taxes are never reported for permanent differences. The tax consequences of most events recognized in the financial statements for a year are included in determining income taxes currently payable. However, tax laws often differ from the recognition and measurement requirements of financial accounting standards, and differences can arise between: (1) the amount of taxable income and pretax financial income for a year and (b) the tax bases of assets or liabilities and their reported amounts in financial statements. An assumption inherent in an company’s balance sheet prepared in accordance with generally accepted accounting principles is that the reported amounts of assets and liabilities will be recovered and settled, respectively. Based on that assumption, a difference between the tax basis of an asset or a liability and its reported amount in the balance sheet will result in taxable or deductible amounts in some future year(s) when the reported amounts of assets are recovered and the reported amounts of liabilities are settled. A deferred tax liability is reported for the increase in taxes payable in future years as a result of taxable temporary differences existing at the balance sheet date. A deferred tax asset is reported for the increase in taxes refundable in future years as a result of deductible temporary differences existing at the balance sheet date. The most common temporary differences arise from including revenues or expenses in taxable income in a period later or earlier than the period in which they are included in pretax financial income.
(b)
1. Gross profit on installment sales—Deferred income taxes would be recognized when gross profit on installment sales is included in pretax financial income in the year of sale and included in taxable income when later collected. 2. Revenues on long-term construction contracts—Deferred income taxes would be recognized whenever revenues on long-term construction contracts are recognized for financial reporting purposes on the percentage-of-completion basis but deferred for tax purposes.
CA 19-4 (Continued) 3. 4.
Estimated costs of product warranty contracts—Deferred income taxes should usually be recognized because estimated costs of product warranty contracts should be recognized for financial reporting purposes in the year of sale and reported for tax purposes when paid. Premiums on officers’ life insurance policies with Gumowski as beneficiary—This is a permanent difference and deferred income taxes should not be recognized. Premiums on officers’ life insurance policies with Gumowski as beneficiary should be recognized in Gumowski Company’s income statement but are not a deductible expense for tax purposes.
Part B. Deferred income taxes related to a noncurrent asset or liability would be classified as a noncurrent item in the balance sheet. Deferred income taxes are related to an asset or liability if reduction of the asset or liability causes the underlying temporary difference to reverse. Deferred income taxes that are not related to an asset or liability because: (1) there is no associated asset or liability or (2) reduction of an associated asset or liability will not cause the temporary difference to reverse, would be classified based on the expected reversal date of the specific temporary difference. An expected reversal date beyond one year (or the normal operating cycle) would require noncurrent classification of the deferred income taxes. Deferred income taxes are to be reported in the balance sheet in the net current and net noncurrent portions. Therefore, deferred income taxes would be classified in the balance sheet as a noncurrent liability when the noncurrent deferred tax liabilities relating to temporary differences exceed the noncurrent deferred tax assets relating to temporary differences. Conversely, they would be classified in the balance sheet as a noncurrent asset when the noncurrent deferred tax assets relating to temporary differences exceed the noncurrent deferred tax liabilities relating to temporary differences.
CA 19-5 (a)
The 45% tax rate would be used in computing the deferred tax liability at December 31, 2014, if a net operating loss (an NOL) is expected in 2015 that is to be carried back to 2014 (the enacted tax rate is 45% in 2014). (See discussion below.)
(b)
The 40% tax rate would be used in computing the deferred tax liability at December 31, 2014, if taxable income is expected in 2015 (the tax rate enacted for 2015 is 40% and 2015 is the year in which the future taxable amount is expected to occur). (See discussion below.)
(c)
The 34% tax rate would be used in computing the deferred tax liability at December 31, 2014, if a net operating loss (an NOL) is expected in 2015 that is to be carried forward to 2016 (the tax rate enacted for 2016 is 34%). (See discussion below.)
Discussion: In determining the future tax consequences of temporary differences, it is helpful to prepare a schedule which shows in which future years existing temporary differences will result in taxable or deductible amounts. The appropriate enacted tax rate is applied to these future taxable and deductible amounts. In determining the appropriate tax rate, you must make assumptions about whether the entity will report taxable income or losses in the various future years expected to be affected by the reversal of existing temporary differences. Thus, you calculate the taxes payable or refundable in the future due to existing temporary differences. In making these calculations, you apply the provisions of the tax laws and enacted tax rates for the relevant periods.
CA 19-5 (Continued) For future taxable amounts: 1. If taxable income is expected in the year that a future taxable amount is scheduled, use the enacted rate for that future year to calculate the related deferred tax liability. 2. If an NOL is expected in the year that a future taxable amount is scheduled, use the enacted rate of what would be the prior year the NOL would be carried back to or the enacted rate of the future year to which the carryforward would apply, whichever is appropriate, to calculate the related deferred tax liability. For future deductible amounts: 1. If taxable income is expected in the year that a future deductible amount is scheduled, use the enacted rate for that future year to calculate the related deferred tax asset. 2. If an NOL is expected in the year that a future deductible amount is scheduled, use the enacted rate of what would be the prior year the NOL would be carried back to or the enacted rate of the future year to which the carryforward would apply, whichever is appropriate, to calculate the related deferred tax asset.
CA 19-6 (a)
Future taxable amounts increase taxable income relative to pretax financial income in the future due to temporary differences existing at the balance sheet date. Future deductible amounts decrease taxable income relative to pretax financial income in the future due to existing temporary differences. A deferred tax liability should be recorded for the deferred tax consequences attributable to the future taxable amounts scheduled and a deferred tax asset should be recorded for the deferred tax consequences attributable to the future deductible amounts scheduled.
(b)
The carryback and carryforward provisions will affect the amounts to be reported for the resulting deferred tax asset and deferred tax liability. In computing deferred tax account balances to be reported at a balance sheet date, the appropriate enacted tax rate is applied to future taxable and deductible amounts related to temporary differences existing at the balance sheet date. In determining the appropriate tax rate, you must make assumptions about whether the entity will report taxable income or losses in the various future years expected to be affected by the existing temporary differences. Thus, you calculate the taxes payable or refundable in the future due to existing temporary differences. In making these calculations, you apply the provisions of the tax laws and enacted tax rates for the relevant periods. For future taxable amounts: 1. If taxable income is expected in the year that a future taxable amount is scheduled, use the enacted rate for that future year to calculate the related deferred tax liability. 2. If an NOL is expected in the year that a future taxable amount is scheduled, use the enacted rate of what would be the prior year the NOL would be carried back to or the enacted rate of the future year to which the carryforward would apply, whichever is appropriate, to calculate the related deferred tax liability. For future deductible amounts: 1. If taxable income is expected in the year that a future deductible amount is scheduled, use the enacted rate for that future year to calculate the related deferred tax asset. 2. If an NOL is expected in the year that a future deductible amount is scheduled, use the enacted rate of what would be the prior year the NOL would be carried back to or the enacted rate of the future year to which the carryforward would apply, whichever is appropriate, to calculate the related deferred tax asset.
CA 19-7 (a)
To realize a sizable deferred tax liability, Acme must have used an accelerated depreciation method for tax purposes while using straight-line depreciation for its financial statements. Once the temporary difference reversed, taxable income would exceed financial accounting income. Acme would be required to pay the taxes it “deferred” from the years when tax depreciation exceeded book depreciation. To stop this from happening, Acme would have to sell these plant assets. It probably would have to report a gain on sale, but it likely would be taxed at the favorable capital gains rates. If Acme buys new plant assets and again uses accelerated depreciation for tax purposes and straight-line for financial reporting purposes, it will perpetuate a “deferral” of income taxes.
(b)
The deferral of income taxes means that due to temporary differences caused by the difference in financial accounting principles and tax laws, a company will be able to defer paying its income taxes (or reaping an income tax benefit) until future periods. The practice of selling-off assets before the temporary difference reverses means that the company may pay a lesser amount of taxes to the government. Although some might be concerned that Acme is not paying its “fair share,” Acme appears to be minimizing its taxes through a tax strategy plan which is perfectly legal. The federal government has chosen to provide these incentives and there is nothing wrong with Acme deferring the payable.
(c)
The primary stakeholders who could be harmed by Acme’s income tax practice are the federal government, which receives fewer taxes as a result of this practice. Ultimately, other taxpayers have to pay more. In addition, if replacement plant assets are very costly to acquire, positive cash flow is reduced. Though the impact should not be great, investors and creditors are affected negatively.
(d)
As a CPA, Stephanie is obligated to uphold objectivity and integrity in the practice of financial reporting. If she thinks that this practice is unethical, then she needs to communicate her concerns to the highest levels of management within Acme, including members of the Board of Directors and/or the Audit Committee. However, it would appear here that Acme is simply trying to minimize its income taxes which should not be considered unethical.
FINANCIAL REPORTING PROBLEM (a) 1.
2.
3.
Per P&G’s 2011 income statement: Income taxes ................................................... Per P&G’s June 30, 2011 balance sheet: In current assets: Deferred income taxes.............................. In noncurrent liabilities: Deferred income taxes.............................. Per P&G’s 2011 statement of cash flows: In cash flows provided by operating activities: Deferred income taxes.............................. In supplemental disclosure: Cash payments for income taxes ............
$ 3,392 million
$ 1,140 million $11,070 million
$
128 million
$ 2,992 million
(b) P&G’s effective tax rates: 2009: (25.9%), 2010: (27.3%), 2011: (22.3%) (c) Income taxes: Current .................................................................... Deferred................................................................... Total...................................................................
$3,263 129 $3,392
(d) Significant components of P&G’s deferred tax assets and liabilities at June 30, 2011 were as follows:
FINANCIAL REPORTING PROBLEM (Continued) Deferred tax assets Pension and postretirement benefits .................................... Stock-based compensation ................................................... Loss and other carryforwards................................................ Goodwill and other intangible assets.................................... Accrued marketing and promotion........................................ Fixed assets ............................................................................ Unrealized loss on financial and foreign exchange transactions ........................................................ Accrued interest and taxes .................................................... Inventory ................................................................................. Other ........................................................................................ Valuation allowances.............................................................. Total ......................................................................................... Deferred tax liabilities Goodwill and other intangible assets.................................... Fixed assets ............................................................................ Other ........................................................................................ Total .........................................................................................
$ 1,406 1,284 874 298 217 111 770 28 52 834 (293) $ 5,581
$12,206 1,742 211 $14,159
COMPARATIVE ANALYSIS CASE (a) 2011 provision for income taxes (In Millions): Coca-Cola:
Current portion ......................................... Deferred portion........................................ Total expense ....................................
$1,777 1,028 $2,805
PepsiCo:
Current portion ......................................... Deferred portion........................................ Total expense ....................................
$1,617 755 $2,372
(b) 2011 income tax payments (In Millions): Coca-Cola............................................................................... PepsiCo (Note 14) ..................................................................
$1,612 $2,218
(c) The 2011 U.S. Federal statutory tax rate was 35.0%. Coca-Cola’s effective tax rate in 2011 was 24.5%. PepsiCo’s effective tax rate in 2011 was 26.8%. Their effective tax rates differ due to the items listed in the reconciliation of U.S. Federal statutory tax rate and effective tax rates. Coca-Cola’s rate is lower because of earnings in jurisdictions taxed at rates different from the statutory U.S. federal rate. (d)
(In Millions) 1. Gross deferred tax assets Gross deferred tax liabilities
Coca-Cola $5,128 8,512
PepsiCo $4,930 7,816
(e) Net operating loss carryforwards at year-end 2011: Coca-Cola had $6,297 million of operating loss carryforwards available to reduce future taxable income. Loss carryforwards of $391 million must be utilized within the next five years and the remainder can be utilized over a period greater than 10 years. PepsiCo had $10 billion of net operating loss carryforwards available to reduce future taxes of certain subsidiaries. $0.1 billion expire in 2012, $8.2 billion expire between 2013 and 2031, and $1.7 billion may be carried forward indefinitely.
FINANCIAL STATEMENT ANALYSIS CASE (a) Of the total provision for income taxes (reported in the income statement) the “current taxes” portion represents the taxes payable in cash while the “deferred taxes” represent the taxes payable in future years (although in this case, because the deferred taxes are a credit, they represent tax benefits receivable in future years). (b) Future taxable amounts increase taxable income relative to pretax financial income in the future due to temporary differences existing at the balance sheet date. Future deductible amounts decrease taxable income relative to pretax financial income in the future due to existing temporary differences. A deferred tax liability should be recorded for the deferred tax consequences attributable to the future taxable amounts scheduled and a deferred tax asset should be recorded for the deferred tax consequences attributable to the future deductible amounts scheduled. (c) The carryback and carryforward provisions will affect the amounts to be reported for the resulting deferred tax asset and deferred tax liability. In computing deferred tax account balances to be reported at a balance sheet date, the appropriate enacted tax rate is applied to future taxable and deductible amounts related to temporary differences existing at the balance sheet date. In determining the appropriate tax rate, you must make assumptions about whether the entity will report taxable income or losses in the various future years expected to be affected by the existing temporary differences. Thus, you calculate the taxes payable or refundable in the future due to existing temporary differences. In making these calculations, you apply the provisions of the tax laws and enacted tax rates for the relevant periods. For future taxable amounts: 1.
If taxable income is expected in the year that a future taxable amount is scheduled, use the enacted rate for that future year to calculate the related deferred tax liability.
FINANCIAL STATEMENT ANALYSIS CASE (Continued) 2.
If an NOL is expected in the year that a future taxable amount is scheduled, use the enacted rate of what would be the prior year the NOL would be carried back to or the enacted rate of the future year to which the carryforward would apply, whichever is appropriate, to calculate the related deferred tax liability.
For future deductible amounts: 1.
If taxable income is expected in the year that a future deductible amount is scheduled, use the enacted rate for that future year to calculate the related deferred tax asset.
2.
If an NOL is expected in the year that a future deductible amount is scheduled, use the enacted rate of what would be the prior year the NOL would be carried back to or the enacted rate of the future year to which the carryforward would apply, whichever is appropriate, to calculate the related deferred tax asset.
ACCOUNTING, ANALYSIS, AND PRINCIPLES Accounting Taxable income for 2014: Pretax financial income .......................................................... Permanent differences: Fines and penalties ......................................................... Tax-exempt interest ........................................................ Originating temporary differences: Excess installment gross profit per books ($560,000 – $112,000) .................................................. Taxable income .......................................................................
$500,000 26,000 (28,000)
(448,000) $ 50,000
Income taxes payable for 2014: Taxable income ....................................................................... 2014 Income tax rate............................................................... Income taxes payable.............................................................
$ 50,000 X 50% $ 25,000
De John has future taxable amounts arising from temporary differences as follows: 2015 Future taxable (deductible) amounts Enacted tax rate Deferred tax liability (asset)
$112,000 X 40% $ 44,800
Future Years 2016 2017 $112,000 X 40% $ 44,800
$112,000 X 40% $ 44,800
2018
Total
$112,000 X 40% $ 44,800
$448,000 $179,200
The $179,200 is a deferred tax liability because the temporary difference is from future taxable amounts. The deferred tax liability needed is $179,200. Journal entry: Income Tax Expense ....................................................... Income Taxes Payable ........................................... Deferred Tax Liability .............................................
204,200 25,000 179,200
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) Analysis The temporary difference in this case is due to the installment receivable. Because the installment receivable would likely be classified as current (despite collection over four subsequent years; see Chapter 18), the $179,200 deferred tax liability would also be classified as current. Income taxes payable would also be classified as current. The income tax expense portion of the income statement would look as follows: Income before income taxes ........................................ Income tax expense: Current .................................................................. Deferred ................................................................ Net income.....................................................................
$500,000 $ 25,000 179,200
204,200 $295,800
De John’s 2014 effective tax rate is 40.84% ($204,200 ÷ $500,000). Principles We can use the conceptual framework to determine that deferred taxes should be reported as assets and liabilities. The conceptual framework provides specific guidance as to how to define assets and liabilities.
PROFESSIONAL RESEARCH (a) According to FASB ASC 740-10-30-18 (Income Taxes, Overall, Initial Measurement), future realization of the tax benefit of an existing deductible temporary difference or carryforward ultimately depends on the existence of sufficient taxable income of the appropriate character (for example, ordinary income or capital gain) within the carryback, carryforward period available under the tax law. (b) According to FASB ASC 740-10-30-18 (Income Taxes, Overall, Initial Measurement): The following four possible sources of taxable income may be available under the tax law to realize a tax benefit for deductible temporary differences and carryforwards: a. Future reversals of existing taxable temporary differences b. Future taxable income exclusive of reversing temporary differences and carryforwards c. Taxable income in prior carryback year(s) if carryback is permitted under the tax law d. Tax-planning strategies (see paragraph 740-10-30-19) that would, if necessary, be implemented to, for example: (1) Accelerate taxable amounts to utilize expiring carryforwards (2) Change the character of taxable or deductible amounts from ordinary income or loss to capital gain or loss (3) Switch from tax-exempt to taxable investments. Evidence available about each of those possible sources of taxable income will vary for different tax jurisdictions and, possibly, from year to year. To the extent evidence about one or more sources of taxable income is sufficient to support a conclusion that a valuation allowance is not necessary, other sources need not be considered. Consideration of each source is required, however, to determine the amount of the valuation allowance that is recognized for deferred tax assets.
PROFESSIONAL RESEARCH (Continued) (c) According to FASB ASC 740-10-30 (Income Taxes, Overall, Initial Measurement): 30-19 In some circumstances, there are actions (including elections for tax purposes) that: a. Are prudent and feasible. b. An entity ordinarily might not take, but would take to prevent an operating loss or tax credit carryforward from expiring unused. c. Would result in realization of deferred tax assets. This Subtopic refers to those actions as tax-planning strategies. An entity shall consider tax-planning strategies in determining the amount of valuation allowance required. Significant expenses to implement a tax-planning strategy or any significant losses that would be recognized if that strategy were implemented (net of any recognizable tax benefits associated with those expenses or losses) shall be included in the valuation allowance. See paragraphs 740-10-55-39 through 55-48 for additional guidance. Implementation of the tax-planning strategy shall be primarily within the control of management but need not be within the unilateral control of management. 30-22 Examples (not prerequisites) of positive evidence that might support a conclusion that a valuation allowance is not needed when there is negative evidence include, but are not limited to, the following: a. Existing contracts or firm sales backlog that will produce more than enough taxable income to realize the deferred tax asset based on existing sales prices and cost structures. b. An excess of appreciated asset value over the tax basis of the entity’s net assets in an amount sufficient to realize the deferred tax asset.
PROFESSIONAL RESEARCH (Continued) c. A strong earnings history exclusive of the loss that created the future deductible amount (tax loss carryforward or deductible temporary difference) coupled with evidence indicating that the loss (for example, an unusual, infrequent, or extraordinary item) is an aberration rather than a continuing condition. 30-23 An entity shall use judgment in considering the relative impact of negative and positive evidence. The weight given to the potential effect of negative and positive evidence shall be commensurate with the extent to which it can be objectively verified. The more negative evidence that exists, the more positive evidence is necessary and the more difficult it is to support a conclusion that a valuation allowance is not needed for some portion or all of the deferred tax asset. A cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome. 30-24 Future realization of a tax benefit sometimes will be expected for a portion but not all of a deferred tax asset, and the dividing line between the two portions may be unclear. In those circumstances, application of judgment based on a careful assessment of all available evidence is required to determine the portion of a deferred tax asset for which it is more likely than not a tax benefit will not be realized. From the information given, it is not obvious whether a tax planning strategy could be employed. More information is needed from the client.
PROFESSIONAL SIMULATION Note: This assignment is available on the Kieso website. Journal Entries Income Tax Expense ................................................... Deferred Tax Asset ...................................................... Deferred Tax Liability........................................... Income Taxes Payable .........................................
40,840 1,200 20,000 22,040
Calculation of Deferred Taxes Temporary Difference
Future Taxable (Deductible) Amounts
Tax Rate
Deferred Tax (Asset) Liability $12,000
20,000
40% $(1,200) 40% 40%
$47,000
$(1,200)
$20,000*
Warranty costs
$ (3,000)
Construction profits
30,000
Depreciation Totals
8,000
*Because of a flat tax rate, these totals can be reconciled: $47,000 X 40% = $(1,200) + $20,000. Calculation of Taxable Income Pretax financial income.......................................................... Permanent differences Fine for pollution............................................................. Tax-exempt interest ........................................................ Originating temporary differences Excess warranty expense per books ($5,000 – $2,000) ....................................................... Excess construction profits per books ($92,000 – $62,000) ................................................... Excess depreciation per tax return ($80,000 – $60,000) ................................................... Taxable income.......................................................................
$100,000
Taxable income for 2014 ........................................................ Tax rate.................................................................................... Income taxes payable for 2014 ..............................................
$ 55,100 40% $ 22,040
3,500 (1,400)
3,000 (30,000) (20,000) $ 55,100
PROFESSIONAL SIMULATION (Continued) Deferred tax liability at the end of 2014................................. Deferred tax liability at the beginning of 2014 ...................... Deferred tax expense for 2014 ...............................................
$ 20,000 –0– $ 20,000
Deferred tax asset at the end of 2014 .................................... Deferred tax asset at the beginning of 2014 ......................... Deferred tax benefit for 2014..................................................
$
1,200 –0– $ (1,200)
Financial Statements Income before income taxes................................... Income tax expense Current .............................................................. Deferred ............................................................ Net income ...............................................................
$100,000 $22,040 18,800
40,840 $ 59,160
IFRS CONCEPTS AND APPLICATION IFRS19-1 The accounting for income taxes in IFRS is covered in IAS 12 “Income Taxes”. IFRS19-2 Both IFRS and GAAP use the asset and liability approach for recording deferred tax assets. In general, the differences between IFRS and GAAP involve limited differences in the exceptions to the asset-liability approach, some minor differences in the recognition, measurement and disclosure criteria, and differences in implementation guidance. Following are some key elements for comparison. Under IFRS, an affirmative judgment approach is used by which a deferred tax asset is recognized up to the amount that is probable to be realized. GAAP uses an impairment approach. In this situation, the deferred tax asset is recognized in full. It is then reduced by a valuation account if it is more likely than not that all or a portion of the deferred tax asset will not be realized. IFRS uses the enacted tax rate or substantially enacted tax rate (Substantially enacted means virtually certain). For GAAP the enacted tax rate must be used. The tax effects related to certain items are reported in equity under IFRS. That is not the case under GAAP, which charges or credits the tax effects to income. GAAP requires companies to assess the likelihood of uncertain tax positions being sustainable upon audit. Potential liabilities must be accrued and disclosed if the position is “more likely than not” to be disallowed. Under IFRS, all potential liabilities must be recognized. With respect to measurement, IFRS uses an expected value approach to measure the tax liability which differs from GAAP. The classification of deferred taxes under IFRS is always non-current. GAAP classifies deferred taxes based on the classification of the asset or liability to which it relates.
IFRS19-3 The IASB and the FASB have been working to address some of the differences in the accounting for income taxes. Some of the issues under discussion are the term “probable” under IFRS for recognition of a deferred tax asset, which might be interpreted to mean “more likely than not”. If changed, the reporting for impairments of deferred tax assets will be essentially the same between GAAP and IFRS. In addition, the IASB is considering adoption of the classification approach used in GAAP for deferred tax assets and liabilities. Also, GAAP will likely continue to use the enacted tax rate in computing deferred taxes, except in situations where the U.S. taxing jurisdiction is not involved. In that case, companies should use IFRS which is based on enacted rates or substantially enacted tax rates. Finally, the issue of allocation of deferred income taxes to equity for certain transactions under IFRS must be addressed in order to achieve convergence. At the time of this printing, deliberations on the Income Tax project have been suspended indefinitely.
IFRS19-4 Deferred tax accounts are reported on the statement of financial position as assets and liabilities. They should be classified in a net non-current amount. IFRS19-5 Deferred tax assets and deferred tax liabilities are separately recognized and measured but are offset in the statement of financial position. The net deferred tax asset or net deferred tax liability is reported in the non-current section of the statement of financial position.
IFRS19-6 Income Tax Expense ....................................................... Deferred Tax Asset ..................................................
60,000 60,000
IFRS19-7 Income Tax Refund Receivable ($350,000 X .40) .. Benefit Due to Loss Carryback.......................
140,000
Deferred Tax Asset ($500,000 – $350,000) X .40.... Benefit Due to Loss Carryforward..................
60,000
140,000 60,000
IFRS19-8 Income Tax Refund Receivable ($350,000 X .40) .. Benefit Due to Loss Carryback.......................
140,000 140,000
IFRS19-9 Non-current liabilities Deferred tax liability ($69,000 – $24,000)........
$45,000
IFRS19-10 Non-current liabilities Deferred tax liability ........................................
$450,000
IFRS19-11 (a) Income Tax Expense ....................................... Deferred Tax Asset .......................................... Income Taxes Payable ............................. Taxable income................................................ Enacted tax rate ............................................... Income taxes payable......................................
Date 12/31/15
Cumulative Future Taxable (Deductible) Amounts $(500,000)
Tax Rate 40%
290,000 50,000 340,000 $850,000 X 40% $340,000 Deferred Tax (Asset) Liability $(200,000)
IFRS19-11 (Continued) Deferred tax asset at the end of 2015 ................................... Deferred tax asset at the beginning of 2015 ........................ Deferred tax benefit for 2015 (increase in deferred tax asset) ............................................................. Current tax expense for 2015 (Income taxes payable) ........ Income tax expense for 2015 ................................................
$200,000 150,000 (50,000) 340,000 $290,000
(b) The journal entry at the end of 2015: Income Tax Expense .............................................. Deferred Tax Asset..........................................
30,000 30,000
Note to instructor: Although not requested by the instructions, the pretax financial income can be computed by completing the following reconciliation: Pretax financial income for 2015 .......................................... Originating difference which will result in future deductible amounts ............................................ Taxable income for 2015 .......................................................
$
X
125,000a $850,000
Solving for pretax financial income: X + $125,000 = $850,000 X = $725,000 = Pretax financial income a
$500,000 – $375,000 = $125,000
IFRS19-12 (a)
According to IAS 12, paragraph 34, “A deferred tax asset shall be recognised for the carryforward of unused tax losses and unused tax credits to the extent that it is probable that future taxable profit will be available against which the unused tax losses and unused tax credits can be utilised.” Thus, future taxable income is important because it will help increase the amount recognized in the deferred-tax asset balance.
IFRS19-12 (Continued) (b)
This question relates to the information found in paragraph 36, which states, “An entity considers the following criteria in assessing the probability that taxable profit will be available against which the unused tax losses or unused tax credits can be utilised: (1) whether the entity has sufficient taxable temporary differences relating to the same taxation authority and the same taxable entity, which will result in taxable amounts against which the unused tax losses or unused tax credits can be utilised before they expire; (2) whether it is probable that the entity will have taxable profits before the unused tax losses or unused tax credits expire; (3) whether the unused tax losses result from identifiable causes which are unlikely to recur; and (4) whether tax planning opportunities (see paragraph 30) are available to the entity that will create taxable profit in the period in which the unused tax losses or unused tax credits can be utilised.” To the extent that it is not probable that taxable profit will be available against which the unused tax losses or unused tax credits can be utilised, the deferred tax asset is not recognised.
(c)
Paragraph 30 discusses tax planning opportunities: “Tax planning opportunities are actions that the entity would take in order to create or increase taxable income in a particular period before the expiry of a tax loss or tax credit carryforward. For example, in some jurisdictions, taxable profit may be created or increased by: (1) electing to have interest income taxed on either a received or receivable basis; (2) deferring the claim for certain deductions from taxable profit; (3) selling, and perhaps leasing back, assets that have appreciated but for which the tax base has not been adjusted to reflect such appreciation; and (4) selling an asset that generates non-taxable income (such as, in some jurisdictions, a government bond) in order to purchase another investment that generates taxable income.” Where tax planning opportunities advance taxable profit from a later period to an earlier period, the utilisation of a tax loss or tax credit carryforward still depends on the existence of future taxable profit from sources other than future originating temporary differences.
IFRS19-13 (a) 1.
Per M&S’s 2012 consolidated income statement: Total income tax expense...............................
£168.4 million
2.
Per M&S’s 31 March, 2012 statement of financial position: In current assets: Current tax receivable............................... £ 1.6 million In current liabilities: Current tax liabilities................................. £ 87.8 million In non-current liabilities: Deferred tax liabilities ............................... £195.7 million
3.
Per M&S’s 2012 statement of cash flows: In cash flows provided by operating activities: Tax paid .....................................................
£149.1 million
(b) M&S’s effective tax rates: 2012: (25.6%), 2011: (23.3%) (c) Income tax expense: Current..................................................................... Deferred................................................................... Total...................................................................
£178.2 (9.8) £168.4
(d) Significant components of M&S’s deferred tax assets and liabilities at 31 March, 2012 were as follows: Deferred Tax Assets Other short-term temporary differences ..................... Deferred Tax Liabilities Non-current assets temporary differences ................. Pension temporary differences.................................... Accelerated capital allowances ................................... Overseas deferred tax ..................................................
£
6.5
£ 58.2 28.5 100.6 14.9 £202.2
CHAPTER 20 Accounting for Pensions and Postretirement Benefits ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics 1. Basic definitions and concepts related to pension plans.
Brief Questions Exercises Exercises 1, 2, 3, 4, 5, 6, 7, 8, 9, 12, 24, 30
2. Worksheet preparation.
Problems
16
Concepts for Analysis 1, 2, 3, 4, 5, 7
3
3, 4, 7, 10, 14, 15, 18
1, 2, 4, 7, 8, 9, 10, 11, 12
9, 10, 11, 13, 16, 17
1, 2, 4
1, 2, 3, 6, 11, 13, 14, 15, 16, 17, 18
1, 2, 3, 4, 5, 6, 9, 11, 12
4. Balance sheet recognition, 15, 19, 20, computation of pension 22, 23 expense.
6, 10
3, 9, 11, 12, 1, 2, 3, 4, 13, 14 5, 6, 7, 8, 9, 11, 12
2, 5, 7
5. Corridor calculation.
18
7
8, 13, 14, 16, 17, 18
2, 3, 5, 6, 7, 8, 11, 12
3, 4, 5, 6
6. Prior service cost.
12, 13, 20
5, 6, 8
1, 2, 3, 5, 9, 11, 12, 13, 14
1, 2, 3, 4, 6, 7, 8, 9, 11, 12
1, 4
7. Gains and losses.
14, 17, 21, 22
7, 9
8, 9, 13, 14, 1, 2, 3, 4, 5, 6, 16, 17 7, 8, 9, 11, 12
4, 5, 6
8. Disclosure issues.
23
10
9, 11, 12
11, 12
3, 4
9. Special Issues.
25 11, 12
19, 20, 21, 22, 23, 24
13, 14
3. Income statement recognition, computation of pension expense.
*10. Postretirement benefits.
26, 27, 28, 29
*This material is dealt with in an Appendix to the chapter.
4, 5
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives Questions
Brief Exercises
Exercises
Problems
Concepts for Analysis
1.
Distinguish between accounting for the employer’s pension plan and accounting for the pension fund.
1
CA20-1
2.
Identify types of pension plans and their characteristics.
2, 3, 4
CA20-1, CA202
3.
Explain alternative measures for valuing the pension obligation.
5, 6, 7, 8
4.
List the components of pension expense.
9, 10, 11, 12, 13, 14, 15
1, 2, 4
1, 2, 6, 11, 12, 13, 15
5.
Use a worksheet for employer’s pension plan entries.
16
3
3, 4, 7, 10, 14, 18
1, 2, 4, 7, 8, 9, 10, 11, 12
6.
Describe the amortization of prior service costs.
20
5
1, 2, 5, 7, 12, 13
1, 2, 3, 4, 6, 7, 8, 9, 10, 11, 12
7.
Explain the accounting for unexpected gains and losses.
17, 19, 21, 22
12, 13
1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12
CA20-7
8.
Explain the corridor approach to amortizing gains and losses.
18
7
8, 12, 13, 16, 17, 18
3, 4, 5, 6, 8, 11, 12
CA20-6
9.
Describe the requirements for reporting pension plans in financial statements.
23, 24, 25
6, 8, 9, 10
9, 11,12, 13
1, 2, 3, 8, 11, 12
CA20-5
*10.
Identify the differences between pensions and postretirement healthcare benefits.
27, 28
11, 12
19, 20, 21, 22, 23, 24
13, 14
*11.
Contrast accounting for pensions to accounting for other postretirement benefits.
26, 29
11, 12
19, 20, 21, 22, 23, 24
13, 14
CA20-3, CA204
ASSIGNMENT CHARACTERISTICS TABLE Item E20-1 E20-2 E20-3 E20-4 E20-5 E20-6 E20-7 E20-8 E20-9 E20-10 E20-11 E20-12 E20-13 E20-14 E20-15 E20-16 E20-17 E20-18 *E20-19 *E20-20 *E20-21 *E20-22 *E20-23 *E20-24 P20-1 P20-2 P20-3 P20-4 P20-5 P20-6 P20-7 P20-8 P20-9 P20-10 P20-11 P20-12 *P20-13 *P20-14
Description Pension expense, journal entries. Computation of pension expense. Preparation of pension worksheet. Basic pension worksheet. Application of years-of-service method. Computation of actual return. Basic pension worksheet. Application of the corridor approach. Disclosures: pension expense and other comprehensive income. Pension worksheet. Pension expense, journal entries, statement presentation. Pension expense, journal entries, statement presentation. Computation of actual return, gains and losses, corridor test, and pension expense. Worksheet for E20-13. Pension expense, journal entries. Amortization of accumulated OCI (G/L), corridor approach, pension expense computation. Amortization of accumulated OCI balances. Pension worksheet—missing amounts. Postretirement benefit expense computation. Postretirement benefit worksheet. Postretirement benefit expense computation. Postretirement benefit expense computation. Postretirement benefit worksheet. Postretirement benefit worksheet—missing amounts. 2-year worksheet. 3-year worksheet, journal entries, and reporting. Pension expense, journal entries, amortization of loss. Pension expense, journal entries for 2 years. Computation of pension expense, amortization of net gain or loss-corridor approach, journal entries for 3 years. Computation of prior service cost amortization, pension expense, journal entries, and net gain or loss. Pension worksheet. Comprehensive 2-year worksheet. Comprehensive 2-year worksheet. Pension worksheet—missing amounts. Pension worksheet. Pension worksheet. Postretirement benefit worksheet. Postretirement benefit worksheet—2 years.
Level of Time Difficulty (minutes) Simple 15–20 Simple 10–15 Moderate 15–25 Simple 10–15 Moderate 15–25 Simple 10–15 Moderate 15–25 Moderate 20–25 Moderate 25–35 Moderate 20–25 Moderate 20–30 Moderate 20–30 Complex 35–45 Complex Moderate Moderate
40–50 15–20 25–35
Moderate Moderate Moderate Moderate Simple Simple Moderate Moderate
30–40 20–25 5–10 25–30 10–12 10–12 15–20 25–30
Moderate Complex Complex Moderate Complex
40–50 45–55 40–50 30–40 45–55
Complex
45–60
Moderate Complex Moderate Moderate Moderate Moderate Moderate Moderate
35–45 45–60 40–45 25–30 35–45 35–45 30–35 40–45
ASSIGNMENT CHARACTERISTICS TABLE (Continued) Item CA20-1 CA20-2 CA20-3 CA20-4 CA20-5 CA20-6 CA20-7
Description Pension terminology and theory. Pension terminology. Basic terminology. Major pension concepts. Implications of GAAP rules on pensions. Gains and losses, corridor amortization. Nonvested employees—an ethical dilemma.
Level of Difficulty Moderate Moderate Simple Moderate Complex Moderate Moderate
Time (minutes) 30–35 25–30 20–25 30–35 50–60 30–40 20–30
SOLUTIONS TO CODIFICATION EXERCISES CE20-1 Master Glossary (a)
The actuarial present value of benefits (whether vested or nonvested) attributed, generally by the pension benefit formula, to employee service rendered before a specified date and based on employee service and compensation (if applicable) before that date. The accumulated benefit obligation differs from the projected benefit obligation in that it includes no assumption about future compensation levels. For plans with flat-benefit or non-pay-related pension benefit formulas, the accumulated benefit obligation and the projected benefit obligation are the same.
(b)
A plan that defines postretirement benefits in terms of monetary amounts (for example, $100,000 of life insurance) or benefit coverage to be provided (for example, up to $200 per day for hospitalization, or 80 percent of the cost of specified surgical procedures). Any postretirement benefit plan that is not a defined contribution postretirement plan is, for purposes of Subtopic 715–60, a defined benefit postretirement plan. (Specified monetary amounts and benefit coverage are collectively referred to as benefits).
(c)
The value, as of a specified date, of an amount or series of amounts payable or receivable thereafter, with each amount adjusted to reflect the time value of money (through discounts for interest) and the probability of payment (for example, by means of decrements for events such as death, disability, or withdrawal) between the specified date and the expected date of payment.
(d)
The cost of retroactive benefits granted in a plan amendment. Retroactive benefits are benefits granted in a plan amendment (or initiation) that are attributed by the pension benefit formula to employee services rendered in periods before the amendment.
CE20-2 According to FASB ASC 715-30-35-43 (Defined-Benefit Plans – Pension – Discount Rates): Assumed discount rates shall reflect the rates at which the pension benefits could be effectively settled. It is appropriate in estimating those rates to look to available information about rates implicit in current prices of annuity contracts that could be used to effect settlement of the obligation (including information about available annuity rates published by the Pension Benefit Guaranty Corporation). In making those estimates, employers may also look to rates of return on high-quality fixed-income investments currently available and expected to be available during the period to maturity of the pension benefits. Assumed discount rates are used in measurements of the projected, accumulated, and vested benefit obligations and the service and interest cost components of net periodic pension cost.
CE20-3 According to FASB ASC 715-30-35-4 (Defined-Benefit Plans – Pension – Components of Net Periodic Cost): All of the following components shall be included in the net pension cost recognized for a period by an employer sponsoring a defined-benefit pension plan: (a)
Service cost
(b)
Interest cost
(c)
Actual return on plan assets, if any
(d)
Amortization of any prior service cost or credit included in accumulated other comprehensive income
(e)
Gain or loss (including the effects of changes in assumptions), which includes, to the extent recognized (see paragraph 715-30-35-26), amortization of the net gain or loss included in accumulated other comprehensive income
(f)
Amortization of any net transition asset or obligation existing at the date of initial application of this Subtopic and remaining in accumulated other comprehensive income.
CE20-4 According to FASB ASC 715-20-50-6 (Defined-Benefit Plans – General – Interim Disclosure Requirements for Publicly Traded Entities): A publicly traded entity shall disclose the following information for its interim financial statements that include a statement of income: (a)
The amount of net benefit cost recognized, for each period for which a statement of income is presented, showing separately each of the following: 1. 2. 3. 4. 5. 6. 7.
(b)
The service cost component The interest cost component The expected return on plan assets for the period The gain or loss component The prior service cost or credit component The transition asset or obligation component The gain or loss recognized due to a settlement or curtailment.
The total amount of the employer’s contributions paid, and expected to be paid, during the current fiscal year, if significantly different from amounts previously disclosed pursuant to paragraph 71520-50-1(g). Estimated contributions may be presented in the aggregate combining all of the following: 1. 2. 3.
Contributions required by funding regulations or laws Discretionary contributions Noncash contributions.
ANSWERS TO QUESTIONS 1. 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. 2. A defined-contribution plan specifies the employer’s contribution to the plan usually based on a formula, which may consider such factors as age, length of service, employer’s profit, or compensation levels. A defined-benefit plan specifies a determinable pension benefit that the employee will receive at a time in the future. The employer must determine the amount that should be contributed now to provide for the future promised benefits. In a defined-contribution plan, the employer’s obligation is simply to make a contribution to the plan each year based on the plan formula. The benefit of gain or risk of loss from assets contributed to the plan is borne by the employee. In a defined-benefit plan, the employer’s obligation is to make sufficient contributions each year to provide for the promised future benefits. Therefore, the employer is at risk to the extent that contributions will not be adequate to meet the promised benefits. 3. 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, income from fund investments, and computing the amounts due to individual pension recipients. Accounting for the pension costs and obligations of the employer is the topic of this chapter; accounting for the pension fund is not. 4. When the term “fund” is used as a noun, it refers to assets accumulated in the hands of a funding agency for the purpose of meeting pension benefits when they become due. When the term “fund” is used as a verb, it means to pay over to a funding agency (as to fund future pension benefits or to fund pension cost). 5. An actuary’s role is to ensure that the company has established an appropriate funding pattern to meet its pension obligations, to make predictions and assumptions about future events and conditions that affect pension costs, and to assist the accountant in measuring facets of the pension plan that must be reported (costs, liabilities and assets). In order to determine the company’s pension obligation, the actuary must first determine the expected benefits that will be paid in the future. To accomplish this requires the actuary to make actuarial assumptions, which are estimates of the occurrence of future events affecting pension costs, such as mortality, withdrawals, disablement and retirement, changes in compensation, and changes in discount rates to reflect the time value of money. 6. In measuring the amount of pension benefits under a defined-benefit pension plan, an actuary must consider such factors as mortality rates, employee turnover, interest and earnings rates, early retirement frequency, and future salaries.
Questions Chapter 20 (Continued) 7. One measure of the pension obligation is the vested benefit obligation. This measure uses only current salary levels and includes only vested benefits; that is, benefits the employee is already entitled to receive even if the employee renders no additional services under the plan. A company’s accumulated benefit obligation is the actuarial present value of benefits attributed by the pension benefit formula to service before a specified date and is based on employee service and compensation prior to that date. The accumulated benefit obligation differs from the projected benefit obligation in that it includes no assumption about future compensation levels. The projected benefit obligation is based on vested and nonvested services using future salaries. 8. Cash-basis accounting recognizes pension cost as being equal to the amount of cash paid by the employer to the pension fund in any period; pension funding serves as the basis for expense recognition under the cash basis. Accrual-basis accounting recognizes pension cost as it is incurred and attempts to recognize pension cost in the same period in which the company receives benefits from the services of its employees. Frequently, the amount which an employer must fund for pension purposes during a particular period is unrelated to the economic benefits derived from the pension plan in that period. Cashbasis accounting recognizes the amount funded as periodic pension cost and the amount funded may be discretionary and vary widely from year to year. Funding is a matter of financial management, based on working capital availability, tax considerations, and other matters unrelated to accounting considerations. 9. The five components of pension expense are: (1) Service cost—the actuarial present value of benefits attributed by the pension benefit formula to employee service during the period. (2) Interest cost—the increase in the projected benefit obligation as a result of the passage of time. (3) Actual return on plan assets—the reduction in pension cost for actual investment income from plan assets and the change in the market value of plan assets. (4) Amortization of prior service cost—the cost of retroactive benefits granted in a plan amendment (including initiation of a plan). (5) Gains and losses—a change in the value of either the projected benefit obligation or the plan assets resulting from experience different from that assumed or expected or from a change in an actuarial assumption. Note to instructor: Regarding return on plan assets, the final component is expected rate of return. We are assuming above that an adjustment is made to the actual return to determine expected return. 10. The service cost component of net periodic pension expense is determined as the actuarial present value of benefits attributed by the pension benefit formula to employee service during the period. The plan’s benefit formula provides a measure of how much benefit is earned and, therefore, how much cost is incurred in each individual period. The FASB concluded that future compensation levels had to be considered in measuring the present obligation and periodic pension expense if the plan benefit formula incorporated them. 11. The interest component is the interest for the period on the projected benefit obligation outstanding during the period. The assumed discount rate should reflect the rates at which pension benefits could be effectively settled (settlement rates). Companies should look to rates of return on highquality fixed-income investments currently available whose cash flows match the timing and amount of the expected benefit payments.
Questions Chapter 20 (Continued) 12. Service cost is the actuarial present value of benefits attributed by the pension benefit formula to employee service during the period. Actuaries compute service cost at the present value of the new benefits earned by employees during the year. Prior service cost is the cost of retroactive benefits granted in a plan amendment or initiation of a pension plan. The cost of the retroactive benefits is the increase in the projected benefit obligation at the date of the amendment. 13. When a defined-benefit plan is either initiated or amended, credit is often given to employees for years of service provided before the date of initiation or amendment. The cost of these retroactive benefits are referred to as prior service cost. Employers grant retroactive benefits because they expect to receive benefits in the future. As a result, prior service cost should not be recognized as pension expense entirely in the year of amendment or initiation. It is recognized as an adjustment to other comprehensive income. It should be recognized during the service periods of those employees who are expected to receive benefits under the plan. Consequently, prior service cost is amortized over the service life of employees who will receive benefits and is a component of net periodic pension expense each period. 14. Liability gains and losses are unexpected gains or losses from changes in the projected benefit obligation. Liability gains (resulting from unexpected decreases) and liability losses (resulting from unexpected increases) are recognized in other comprehensive income. The accumulated gains and losses are then amortized, subject to complex amortization guidelines in other comprehensive income. 15. If pension expense recognized in a period exceeds the current amount funded, a liability account referred to as Pension Asset/Liability arises; the account would be reported either as a current or long-term liability, depending on the ultimate date of payment. If the current amount funded exceeds the amount recognized as pension expense, an asset account referred to as Pension Asset/Liability arises; the account would be reported as a non-current asset. Because these assets are used to fund the pension obligation, noncurrent classification is appropriate. 16. Computation of actual return on plan assets Fair value of plan assets at end of period .................................. Deduct: Fair value of plan assets at beginning of period ........... Increase in fair value of assets .................................................. Deduct: Contributions to plan during the period............................... $1,000,000 Add: Benefits paid during the period .................................... 1,400,000 Actual return on plan assets ......................................................
$10,150,000 9,500,000 650,000 400,000 $ 1,050,000
*17. An asset gain occurs when the actual return on the plan assets is greater than the expected return on plan assets while an asset loss occurs when the actual return is less than the expected return on the plan assets. A liability gain results from unexpected decreases in the pension obligation and a liability loss results from unexpected increases in the pension obligation. 18. Corridor amortization occurs when the accumulated OCI (G/L) balance gets too large. The gain or loss is too large when it exceeds the arbitrarily selected FASB criterion of 10% of the larger of the beginning balances of the projected benefit obligation or the market-related value of the plan assets. The excess gain or loss balance may be amortized using any systematic method but the amortization cannot be less than the amount computed using the straight-line method over the average remaining service-life of active employees expected to receive benefits.
Questions Chapter 20 (Continued) 19. The amount of the pension asset/liability to be reported on the company’s balance sheet is as follows: Projected benefit obligation.......................................................... Pension plan assets..................................................................... Pension liability ............................................................................
$(400,000) 350,000 $ (50,000)
In the financial statements, the company will report a pension liability of $50,000. This amount is also referred to as the funded status of the plan. 20. The prior service cost arising in the year of the amendment (which increases the projected benefit obligation) is recognized by an offsetting debit to Other Comprehensive Income (PSC). In subsequent periods, the $9,150,000 will be amortized into periodic pension expense over the remaining service lives of the employees. This approach is consistent with the treatment for actuarial gains and losses. 21. Actuarial gains or losses arise from (1) asset gains or losses (when the expected return is different than the actual return on plan assets) and (2) a liability gain or loss (when actuarial assumptions do not coincide with actual experiences related to computation of the projected benefit obligation.) In the period that they arise, these gains and losses are not recognized as part of pension expense, but are recognized as increases or decreases in other comprehensive income. In subsequent periods, these amounts are amortized into periodic pension expense over the remaining service lives of the employees, using corridor amortization. 22. (a) Other Comprehensive Income for 2015 is as follows: Actuarial liability gain ...................................................................... Asset loss ....................................................................................... Other comprehensive loss ..............................................................
$10,000 14,000 $ 4,000
(b) The computation of comprehensive income for 2015 is as follows: Net income ..................................................................................... Other comprehensive loss .............................................................. Comprehensive income ..................................................................
$25,000 4,000 $21,000
23. Multiple plans may be combined and shown as one amount on the balance sheet, only if they are in the same under or overfunded position. For example, if the company has two or more underfunded (overfunded) plans, the underfunded (overfunded) plans are combined and shown as one amount as a liability (asset) on the balance sheet. The FASB rejected the alternative of combining all plans and representing the net amount as a single net asset or net liability. The rationale: A company does not have the ability to offset the excess of one plan against underfunded obligations of another plan. Furthermore, netting all plans is inappropriate because offsetting assets and liabilities is not permitted under GAAP unless a right of offset exists. 24. (a) (b) (c) (d)
A contributory plan is a pension plan under which employees contribute part of the cost. In some contributory plans, employees wishing to be covered must contribute; in other contributory plans, employee contributions result in increased benefits. Vested benefits are benefits for which the employee’s right to receive a present or future pension benefit is no longer contingent on remaining in the service of the employer. Retroactive benefits are benefits granted in a plan amendment (or initiation) that are attributed by the pension benefit formula to employee services rendered in periods prior to the amendment. The years-of-service method is used to allocate prior service cost to the remaining years of service of the affected employees. Each year receives a fraction of the original cost with the fraction depicting the number of service-years received out of the total service-years to be worked by the affected employees.
Questions Chapter 20 (Continued) 25. The accounting issue that arises from these terminations is whether a gain should be recognized by the corporation when these assets revert (often called asset reversion transactions) to the company. The profession requires that these gains or losses be reported immediately in most situations. *26. Postretirement benefits other than pensions include healthcare and other welfare benefits provided to retirees, their spouses, dependents, and beneficiaries. The other welfare benefits include life insurance offered outside a pension plan, dental care as well as medical care, eye care, legal and tax services, tuition assistance, day care, and housing activities. *27. The FASB did not cover both pensions and healthcare benefits in the earlier pension accounting rules because of the significant differences between the two types of postretirement benefits. These differences are listed in the following schedule: Differences between Postretirement Healthcare Benefits and Pensions Item Funding Benefit
Pensions Generally funded. Well-defined and level dollar amount.
Beneficiary
Retiree (maybe some benefit to surviving spouse). Monthly. Variables are reasonably predictable.
Benefit Payable Predictability
*28.
Healthcare Benefits Generally NOT funded. Generally uncapped and great variability. Retiree, spouse, and other dependents. As needed and used. Utilization difficult to predict. Level of cost varies geographically and fluctuates over time.
The major differences between pension benefits and postretirement benefits are listed below: Differences between Postretirement Healthcare Benefits and Pensions Item
Pensions
Healthcare Benefits
Funding Benefit
Generally funded. Well-defined and level dollar amount.
Beneficiary
Retiree (maybe some benefit to surviving spouse). Monthly. Variables are reasonably predictable.
Generally NOT funded. Generally uncapped and great variability. Retiree, spouse, and other dependents. As needed and used. Utilization difficult to predict. Level of cost varies geographically and fluctuates over time.
Benefit Payable Predictability
Additionally, although healthcare benefits are generally covered by the fiduciary and reporting standards for employee benefit funds under ERISA, the stringent minimum vesting, participation, and funding standards that apply to pensions do not apply to healthcare benefits. *29. EPBO (expected postretirement benefit obligation) is the actuary’s present value of all benefits expected to be paid after retirement, while APBO (accumulated postretirement benefit obligation) is the actuarial present value of future benefits attributed to employees’ services rendered to a particular date. The components of postretirement expense are service cost, interest cost, expected return on plan assets, amortization of prior service cost, and gains and losses.
SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 20-1 Service cost ........................................................... Interest on PBO ..................................................... Return on plan assets ........................................... Amortization of prior service cost........................ Amortization of net loss........................................ Pension expense ...................................................
$ 366,000,000 737,000,000 (593,000,000) 13,000,000 154,000,000 $ 677,000,000
BRIEF EXERCISE 20-2 Ending plan assets................................................ Beginning plan assets .......................................... Increase in plan assets ......................................... Deduct: Contributions.......................................... Less: Benefits paid................................ Actual return on plan assets ................................
$ $120,000 200,000 $
2,000,000 (1,780,000) 220,000 (80,000) 300,000
BRIEF EXERCISE 20-3 HENNEIN COMPANY General Journal Entries
Items
Pension Expense
Cash
1/1/14 Service cost 27,500 Dr. Interest cost 28,000 Dr. Actual return* 25,000 Cr. Contributions 20,000 Cr. Benefits Journal entry 12/31/14 30,500 Dr. 20,000 Cr.
Pension Asset/Liability
Memo Record Projected Benefit Plan Obligation Assets 280,000 Cr. 280,000 Dr. 27,500 Cr. 28,000 Cr. 25,000 Dr. 20,000 Dr. 17,500 Dr. 17,500 Cr.
10,500 Cr.
318,000 Cr. 307,500 Dr.
*Note: We show actual return on the worksheet to ensure that plan assets are properly reported. If expected and actual returns differ, then an additional adjustment is made to compute the proper amount of pension expense.
BRIEF EXERCISE 20-4 Pension Expense.................................................... Pension Asset/Liability .......................................... Cash.................................................................
73,000,000 2,000,000 71,000,000
BRIEF EXERCISE 20-5 Cost per service year: $160,000/2,000 = $80 2014 amortization: 350 X $80 = $28,000 BRIEF EXERCISE 20-6 Project benefit obligation ....................................................... Plan assets at fair value.......................................................... Pension liability .......................................................................
$(560,000) 322,000 $(238,000)
BRIEF EXERCISE 20-7 Net loss in accumulated OCI .................................................. Corridor (10% X $3,300,000) ................................................... Excess...................................................................................... Average remaining service life............................................... Minimum amortization ............................................................
$465,000 (330,000) 135,000 ÷ 7.5 $ 18,000
BRIEF EXERCISE 20-8 Projected benefit obligation ................................................... Fair value of plan assets......................................................... Pension liability (classified short-term or long-term depending on when due) ...................................
$2,600,000 (2,000,000) $ 600,000
Prior service cost is reported as a component of accumulated other comprehensive income in stockholders’ equity.
BRIEF EXERCISE 20-9 (a) Other Comprehensive Loss for 2014 is as follows: Actuarial liability loss .............................................. Unexpected asset gain ............................................ Other comprehensive loss ......................................
($ 28,000) 18,000 ($ 10,000)
(b) The computation of comprehensive income for 2014 is as follows: Net income ............................................................... Other comprehensive loss ...................................... Comprehensive income...........................................
$ 26,000 (10,000) $ 16,000
BRIEF EXERCISE 20-10 Pension Assets Projected Benefit Pension Asset/ (at fair value) Obligation Liability Plan X $600,000 $500,000 $100,000 asset Plan Y $900,000 $720,000 $180,000 asset Plan Z $550,000 $700,000 $150,000 liability Lahey reports a pension asset of $280,000 ($100,000 + $180,000) and a pension liability of $150,000. *BRIEF EXERCISE 20-11 Service cost ............................................................................... Interest cost ............................................................................... Expected return on plan assets................................................ Postretirement expense............................................................
$40,000 47,400 (26,900) $60,500
*BRIEF EXERCISE 20-12 Postretirement Expense .............................................. Cash....................................................................... Postretirement Asset /Liability .............................
240,900 180,000 60,900
SOLUTIONS TO EXERCISES EXERCISE 20-1 (15–20 minutes) (a) Computation of pension expense: Service cost..................................................... Interest cost ($500,000 X .10) ......................... Expected return on plan assets ..................... Prior service cost amortization ...................... Pension expense for 2014 .............................. (b) Pension Expense .................................................... Cash ................................................................. Pension Asset/Liability................................... Other Comprehensive Income (PSC).............
$ 60,000 50,000 (15,000) 8,000 $103,000 103,000 90,000 5,000 8,000
EXERCISE 20-2 (10–15 minutes) Computation of pension expense: Service cost ............................................................ Interest cost ($700,000 X 10%)............................... Expected return on plan assets............................. Prior service cost amortization.............................. Pension expense for 2014......................................
$ 90,000 70,000 (64,000) 10,000 $106,000
EXERCISE 20-3 (15–20 minutes)
EXERCISE 20-4 (10–15 minutes)
EXERCISE 20-5 (15–25 minutes) Computation of Service-Years Year 2014 2015 2016 2017 2018 2019
Jim 1 1 1
Paul 1 1 1 1
Nancy 1 1 1 1 1
3
4
5
Dave 1 1 1 1 1 1 6
Kathy 1 1 1 1 1 1 6
Total 5 5 5 4 3 2 24
Cost per service-year: $72,000 ÷ 24 = $3,000 Computation of Annual Prior Service Cost Amortization Year
Total Service-Years
Cost Per Service-Year
Annual Amortization
2014 2015 2016 2017 2018 2019
5 5 5 4 3 2
$3,000 3,000 3,000 3,000 3,000 3,000
$15,000 15,000 15,000 12,000 9,000 6,000 $72,000
EXERCISE 20-6 (10–15 minutes) Computation of Actual Return on Plan Assets Fair value of plan assets at 12/31/14 ....................... Fair value of plan assets at 1/1/14 ........................... Increase in fair value of plan assets ....................... Deduct: Contributions to plan during 2014 ........... Less benefits paid during 2014 ................ Actual return on plan assets for 2014 .....................
$2,725,000 (2,400,000) 325,000 $280,000 350,000
(70,000) $ 395,000
EXERCISE 20-7 (15–25 minutes)
EXERCISE 20-8 (20–25 minutes) Corridor and Minimum Loss Amortization
Year
Projected Benefit Obligation (a)
Plan Assets
10% Corridor
Accumulated OCI (G/L) (a)
2013 2014 2015 2016
$2,000,000 2,400,000 2,950,000 3,600,000
$1,900,000 2,500,000 2,600,000 3,000,000
$200,000 250,000 295,000 360,000
$ 0 280,000 367,000(c) 372,000(e)
(a) (b) (c) (d) (e) (f)
Minimum Amortization of Loss $
0 3,000(b) 6,000(d) 1,000(f)
As of the beginning of the year. ($280,000 – $250,000) ÷ 10 years = $3,000 $280,000 – $3,000 + $90,000 = $367,000 ($367,000 – $295,000) ÷ 12 years = $6,000 $367,000 – $6,000 + $11,000 = $372,000 ($372,000 – $360,000) ÷ 12 years = $1,000
EXERCISE 20-9 (25–35 minutes) (a) Note to financial statements disclosing components of 2014 pension expense: Note X: Net pension expense for 2014 is composed of the following components of pension cost: Service cost .............................................................. Interest cost.............................................................. Expected return on plan assets .............................. Prior service cost amortization ............................... Pension expense ..............................................
$ 94,000 253,000 (175,680) 42,000 $213,320
(b) Comprehensive income, 2014 Amortization of prior service cost .......................... Actuarial loss............................................................ Other comprehensive loss ......................................
$ (42,000) 45,680 $ 3,680
Comprehensive income, 2014 Net income................................................................ Other comprehensive loss ...................................... Comprehensive income...........................................
$ 35,000 3,680 $ 31,320
EXERCISE 20-9 (Continued) (c)
Accumulated OCI at December 31, 2014 is $255,680; this amount is comprised of the following:
Balance Jan. 1, 2014* Amortization of PSC Actuarial loss Balance Dec. 31, 2014 *$210,000 + $42,000
PSC $252,000 Dr. 42,000 Cr. $210,000 Dr.
Gain/Loss $ 0 — 45,680 Dr. $45,680 Dr.
EXERCISE 20-9 (Continued)
EXERCISE 20-10 (20–25 minutes)
EXERCISE 20-11 (20–30 minutes) (a) Pension expense for 2014 composed of the following: Service cost ....................................................... Interest on projected benefit obligation (9% X $900,000) ............................................. Expected return on plan assets ....................... Amortization of prior service cost ................... Pension expense ....................................... (b)
Pension Expense ...................................................... Pension Asset/Liability ............................................ Cash ................................................................... Other Comprehensive Income (PSC) ...............
$ 56,000 81,000 (54,000) 50,000 $133,000
133,000 62,000 145,000 50,000
(c) Income Statement Pension expense ............................................... Comprehensive Income Statement Net income ................................................................ Other comprehensive income Amortization of PSC .............................................. Comprehensive income............................................ Balance Sheet Liabilities Pension liability ................................................. *Projected benefit obligation Plan assets Pension liability Partial worksheet Bal. January 1, 2014 Service cost Interest on PBO Actual return Contribution Bal. December 31,2014
$133,000 $ XXXX 50,000 $ XXXX
$238,000*
$1,037,000 (799,000) $ 238,000 Projected Benefit Obligation $ 900,000 56,000 81,000
Plan Assets $600,000 54,000 145,000 $799,000
Stockholders’ equity Accumulated OCI (PSC) Jan. 1, 2014 Amortization of prior service cost Accumulated OCI (PSC) Dec. 31, 2014
$1,037,000 400,000 (50,000) 350,000
EXERCISE 20-12 (20–30 minutes) (a) Pension expense for 2014 composed of the following: Service cost................................................... Interest on projected benefit obligation (10% X $1,500,000) .................................... Expected return on plan assets (10% X $800,000) ....................................... Amortization of prior service cost ............... Pension expense ................................... (b)
Pension Expense .................................................. Pension Asset /Liability ........................................ Cash ............................................................... Other Comprehensive Income (PSC)........... Other Comprehensive Income (G/L) ............ (To record pension expense and employer’s contribution)
150,000 (80,000) 120,000 $267,000
267,000 303,000 250,000 120,000 200,000
(c) Income Statement: Pension expense........................................... Comprehensive Income Statement Net income..................................................... Other comprehensive income (loss) Amortization of PSC ............................... Liability gain............................................ Comprehensive income .......................................
$ 77,000
$ 267,000 $ $120,000 200,000
XXXX
320,000 $ XXXX
Balance Sheet: Liabilities Pension liability .....................................
$ 397,000*
Stockholders’ Equity Accumulated OCI (PSC)................................ Accumulated OCI (G/L) .................................
$1,080,000** 200,000
*Projected benefit obligation, Dec. 31, 2014 Plan assets, Dec. 31, 2014 Pension liability **$1,200,000 – $120,000
$1,527,000 (1,130,000) $ 397,000
EXERCISE 20-12 (Continued)
EXERCISE 20-13 (35–45 minutes) (a) Actual Return = (Ending – Beginning fair value of assets) – (Contributions – Benefits) Fair value of plan assets, December 31, 2014 ........................................ Deduct: Fair value of plan assets, January 1, 2014 ............................................. Increase in fair value of plan assets ................ Deduct: Contributions ...................................... $700 Less benefits paid .............................. 200 Actual return on plan assets in 2014 ...............
$2,620 1,700 920 500 $ 420
(b) Computation of pension liability gains and losses and pension asset gains and losses. 1.
Difference between 12/31/14 actuarially computed PBO and 12/31/14 recorded projected benefit obligation (PBO): PBO at end of year............................. $3,300 PBO per memo records: 1/1/14 PBO ...................................... $2,500 Add interest (10%) ......................... 250 Add service cost ............................ 400 Less benefits paid.......................... 200 2,950 Liability loss ................................... $350
2.
Difference between actual fair value of plan assets and expected fair value: 12/31/14 actual fair value of plan assets ............................. Expected fair value 1/1/14 fair value of plan assets...... 1,700 Add expected return ($1,700 X 10%) ............................ 170 Add contributions .......................... 700 Less benefits paid.......................... 200 Asset gain....................................... Net (gain) or loss................................
2,620
(2,370) 250 ($100)
(c) Because no net gain or loss existed at the beginning of the period, no amortization occurs. Therefore, the corridor calculation is not needed. An example of how the corridor would have been computed is illustrated on the next page, assuming a net loss of $240 at the beginning of the year.
EXERCISE 20-13 (Continued) Beginning-of-the-Year Accumulated OCI (G/L) $240
Loss Amortization –0–
(d) Pension expense for 2014: Service cost ................................................................. Interest cost ($2,500 X 10%) ....................................... Actual return on plan assets [from (a)]...................... Unexpected gain [from (b) 2.] ..................................... Pension expense .........................................................
$ 400 250 (420) 250 $ 480
Year 2014
Plan PBO Assets (FV) $2,500 $1,700
10% Corridor $250
EXERCISE 20-14 (40–50 minutes)
EXERCISE 20-14 (Continued) Journal entries 12/31/14 1.
Other Comprehensive Income (G/L)..................... Pension Expense................................................... Pension Asset /Liability ......................................... Cash ................................................................
100 480 120 700
Balance Sheet at December 31, 2014 Liabilities Pension liability..............................................
$680
Stockholders’ equity Accumulated other comprehensive loss (G/L) ....................................................
$100
EXERCISE 20-15 (15–20 minutes) (a) Computation of pension expense: Service cost ................................................... Interest cost ($700,000 X .10) ....................... Expected return on plan assets ................... Pension expense for 2012 ............................ Pension Expense .................................................. Pension Asset /Liability ........................................ Cash ...............................................................
$ 80,000 70,000 (10,000) $140,000 140,000 10,000 150,000
(b) Income Statement: Pension expense ...........................................
$140,000
Balance Sheet: Liabilities Pension liability ....................................
$ 15,000*
*$25,000 – $10,000
20-30
Copyright © 2013 John Wiley & Sons, Inc.
Kieso, Intermediate Accounting, 15/e, Solutions Manual
(For Instructor Use Only)
EXERCISE 20-15 (Continued)
EXERCISE 20-16 (25–35 minutes) The excess of the cumulative net gain or loss over the corridor amount is amortized by dividing the excess by the average remaining service period of employees. The average remaining service period is computed as follows: Expected future years of service = Average remaining service life per employee Number of employees 5, 600 Average remaining service life per employee = = 14. 400
Amortization of Net (Gain) or Loss (Gain) or Loss For the Year Ended December 31, 2014 2015 2016 2017
Amount 300,000 480,000 (210,000) (290,000)
Year
Projected Benefit Obligation (a)
Plan Assets (a)
Corridor (b)
Accumulated OCI (G/L) (a)
2014 2015 2016 2017
$4,000,000 4,520,000 5,000,000 4,240,000
$2,400,000 2,200,000 2,600,000 3,040,000
$400,000 452,000 500,000 424,000
$ 0 300,000 780,000 550,000(d)
Minimum Amortization of (Gain) Loss $
0 0 20,000(c) 9,000(e)
(a) As of the beginning of the year. (b) The corridor is 10 percent of the greater of the projected benefit obligation or plan assets. (c) $780,000 – $500,000 = $280,000; $280,000/14 = $20,000. (d) $780,000 – $ 20,000 – $210,000 = $550,000. (e) $550,000 – $424,000 = $126,000; $126,000/14 = $9,000.
EXERCISE 20-17 (30–40 minutes) (a) Year 2014 2015
Prior Service Cost Amortized $120,000 120,000
($1,260,000 ÷ 10.5 years) ($1,260,000 ÷ 10.5 years)
(b) The excess of the accumulated OCI (G/L) over the corridor amount is amortized by dividing the excess by the average remaining service life per employee. The average service life is 10.5 years. Amortization of Net (Gain) or Loss (Gain) or Loss For the Year Ended December 31,
Amount
2014 2015
$198,000 (24,000)
Year
Projected Benefit Obligation (a)
Plan Assets(a)
10% Corridor(b)
Accumulated OCI (G/L)(a)
2014 2015
$2,800,000 3,650,000
$1,700,000 2,900,000
$280,000 365,000
$
0 198,000
Minimum Amortization of (Gain) Loss $ –0– –0–(c)
(a) As of the beginning of the year. (b) The corridor is 10 percent of the greater of the projected benefit obligation or plan assets. (c) $365,000 is greater than $198,000; therefore, no amortization.
(c) Pension expense for 2014 is composed of the following: Service cost................................................................. Interest on projected benefit obligation ($2,800,000 X 9%) .................................................... Expected return on plan assets ($1,700,000 X 10%) .................................................. Amortization of prior service cost ............................. Pension expense .................................................
$ 400,000 252,000 (170,000) 120,000 $ 602,000
EXERCISE 20-17 (Continued) Pension expense for 2015 is composed of the following: Service cost ..................................................................... Interest on projected benefit obligation ($3,650,000 X 8%) ........................................................ Expected return on plan assets ($2,900,000 X 10%) ...................................................... Amortization of prior service cost ................................. Pension expense .....................................................
$475,000 292,000 (290,000) 120,000 $597,000
EXERCISE 20-17 (Continued)
EXERCISE 20-18 (20–25 minutes) (a) Below is the completed worksheet, indicating debit and credit entries. Annual Pension Expense Balance, Jan. 1, 2014 Service cost Interest cost Actual return Unexpected gain Amortization of PSC Contributions Benefits Liability increase Journal entry Accumulated OCI, Dec. 31, 2013 Balance, Dec. 31, 2014
General Journal Entries OCI—Prior OCI—Gain/ Service Loss Cash Cost
Pension Asset/Liability 1,100 Cr.
500 Dr. 280 Dr. 220 Cr. 150 Dr. 55 Dr.
Memo Record Projected Plan Benefit Assets Obligation 2,800 Cr. 500 Cr. 280 Cr.
220 Dr. 150 Cr. 55 Cr. 800 Cr.
765 Dr.
1,700 Dr.
800 Cr.
55 Cr. 1,100 Dr. 1,045 Dr.
365 Dr. 215 Dr. 0 215 Dr.
(b) Pension Expense......................................... Other Comprehensive Income (G/L) .......... Pension Asset/Liability ........................... Cash ......................................................... Other Comprehensive Income (PSC).....
200 Dr. 365 Cr.
800 Dr. 200 Cr.
125 Cr. 1,225 Cr.
3,745 Cr.
2,520 Dr.
765 215 125 800 55
(c) Usher records no amortization of gain or loss in 2014, because there were no gains or losses at the beginning of the year. For 2015, the corridor is $374.50 (10% of the PBO). Since the balance of the Other Comprehensive Income (G/L) at the beginning of 2015 ($215) is less than the corridor, there will be no gain or loss amortization in 2015 either. *EXERCISE 20-19 (5–10 minutes) Postretirement benefit expense is comprised of the following: Service cost ............................................................. Interest on the liability (8% X $330,000) ................. Actual and expected return on plan assets ........... Postretirement expense ..........................................
$45,000 26,400 (11,000) $60,400
EXERCISE 20-20 (25–30 minutes) General Journal Entries Annual Postretirement Expense Balance, Jan. 1, 2014 Service cost Interest cost Actual return Contributions Benefits Journal entry for 2014 Balance, Dec. 31, 2014
Cash
Postretirement Asset/Liability 220,000 Cr.
45,000 Dr. 26,400 Dr. 11,000 Cr. 10,000 Cr. 60,400 Dr.
10,000 Cr.
50,400 Cr. 270,400 Cr.
Postretirement Expense........................................ Postretirement Asset/Liability....................... Cash ................................................................
Memo Record
APBO
Plan Assets
330,000 Cr. 110,000 Dr. 45,000 Cr. 26,400 Cr. 11,000 Dr. 10,000 Dr. 20,000 Dr. 20,000 Cr. 381,400 Cr. 111,000 Dr.
60,400 50,400 10,000
*EXERCISE 20-21 (10–12 minutes) Service cost ................................................................... Interest on accumulated postretirement benefit obligation (10% X $710,000) .......................... Expected return on plan assets ................................... Amortization of prior service cost ............................... Postretirement expense................................................
$ 83,000 71,000 (34,000) 21,000 $141,000
*EXERCISE 20-22 (10–12 minutes) Service cost ................................................................... Interest on accumulated postretirement benefit obligation (9% X $760,000) ............................ Expected return on plan assets ................................... Amortization of prior service cost ............................... Postretirement expense................................................ *EXERCISE 20-23 (15–20 minutes) See worksheet on next page.
$ 90,000 68,400 (62,000) 3,000 $ 99,400
*EXERCISE 20-23 (15–20 minutes)
*EXERCISE 20-24 (25–30 minutes) (a) Below is the completed worksheet, indicating debit and credit entries.
General Journal Entries Other Comprehensive Cash Income—PSC
Annual Expense Balance, Jan. 1, 2014 Service cost Interest cost Actual/Expected return Contributions Benefits Amortization of PSC Journal entry for 2014 Accumulated OCI, Dec. 31, 2013 Balance, Dec. 31, 2014
Memo Record Entries Postretirement Asset/Liability 290,000 Cr.
56,000 Dr. 36,900 Dr. 2,000 Cr.
APBO 410,000 Cr. 56,000 Cr. 36,900 Cr.
66,000 Cr.
3,000 Cr. 3,000 Cr. 30,000 Dr. 27,000 Dr.
120,000 Dr.
5,000 Dr.
2,000 Dr. 66,000 Dr. 5,000 Cr.
497,900 Cr.
183,000 Dr.
66,000 Cr. 3,000 Dr. 93,900 Dr.
Plan Assets
24,900 Cr. 314,900 Cr.
(b) Pension Expense ..................................................93,900 Cash ........................................................... 66,000 Other Comprehensive Income (PSC) ....... 3,000 Postretirement Asset/Liability .................. 24,900 (c) The discount (settlement) rate can be determined by dividing the interest cost by the beginning APBO: $36,900 ÷ $410,000 = 9%
TIME AND PURPOSE OF PROBLEMS Problem 20-1 (Time 40–50 minutes) Purpose—to provide a problem that requires preparation of a pension worksheet for two separate years’ pension transactions. Included in the problem are an unexpected loss and prior service cost amortization. Problem 20-2 (Time 45–55 minutes) Purpose—to provide a problem that requires preparation of a pension worksheet for three separate years’ pension transactions, three years of general journal entries for the pension plan, and reporting in financial statements for the third year. Problem 20-3 (Time 40–50 minutes) Purpose—to provide a problem that requires computation of the annual pension expense, preparation of the pension journal entries, measurement of gains and losses and their amortization, and presentation in financial statements. Problem 20-4 (Time 30–40 minutes) Purpose—to provide a problem that requires computation of pension expense and preparation of the pension journal entries. Problem 20-5 (Time 45–55 minutes) Purpose—to provide a problem that requires computation of the pension expense for three separate years and the preparation of the pension journal entries for three years. Problem 20-6 (Time 45–60 minutes) Purpose—to provide a problem that requires computation and amortization of prior service cost, computation of pension expense, and preparation of pension journal entries. Problem 20-7 (Time 35–45 minutes) Purpose—to provide a problem that requires preparation of a worksheet. Problem 20-8 (Time 45–60 minutes) Purpose—to provide a problem that requires preparation of a comprehensive worksheet for two years, covering all facets of pension accounting. Problem 20-9 (Time 40–45 minutes) Purpose—to provide a problem that requires preparation of a worksheet for two years, journal entries, and indicates financial statement presentation. Problem 20-10 (Time 25–30 minutes) Purpose—to provide a problem to understand elements of a pension worksheet. Problem 20-11 (Time 35–45 minutes) Purpose—to provide a problem that requires preparation of a worksheet, journal entries, and indicates financial statement presentation (year 2 of P20-10).
Time and Purpose of Problems (Continued) Problem 20-12 (Time 35–45 minutes) Purpose—to provide a problem that requires preparation of a worksheet, journal entries, and indicates financial statement presentation. *Problem 20-13 (Time 30–35 minutes) Purpose—to provide a problem that requires preparation of a worksheet and entries for postretirement benefit expense. *Problem 20-14 (Time 40–45 minutes) Purpose—to provide a problem that requires a worksheet for two years, journal entries, and indicates financial statement presentation.
SOLUTIONS TO PROBLEMS PROBLEM 20-1
PROBLEM 20-2
PROBLEM 20-2 (Continued) Worksheet computations: (a)
$25,000 = $250,000 X 10% $2,000 = ($200,000 X 10%) – $18,000; expected return exceeds actual return. (c) $43,700 = $437,000 X 10% (d) Expected return and actual return are the same. (e) $48,330 = $483,300 X 10% (f) $2,560 = ($265,600 X 10%) – $24,000; expected return exceeds actual return. (g) $16,630 = ($483,300 + $26,000 + $48,330 – $21,000 – $520,000) (b)
(Note to instructor: Because the amount of net gain or loss does not exceed 10% of the larger of the projected benefit obligation or the fair value of the plan assets at the beginning of any of the years, no amortization is recorded. (b) Journal entries: 2013 Other Comprehensive Income (G/L) ....................... Pension Expense ..................................................... Cash .................................................................. Pension Asset /Liability....................................
2,000 21,000
2014 Other Comprehensive Income (PSC) ..................... Pension Expense ..................................................... Cash .................................................................. Pension Asset /Liability....................................
105,600 95,100
2015 Pension Expense ..................................................... Pension Asset /Liability ........................................... Other Comprehensive Income (G/L) ............... Other Comprehensive Income (PSC) .............. Cash ..................................................................
16,000 7,000
40,000 160,700 89,370 14,300 14,070 41,600 48,000
PROBLEM 20-2 (Continued) (c) Financial Statements—2015 Income Statement Pension expense.............................................. Comprehensive Income Statement Net Income........................................................ Other comprehensive income (loss)
$ 89,370
$
XXXX
Asset gain (loss) .............................................. $ (2,560) Liability gain (loss)........................................... 16,630 Prior service cost amortization ....................... 41,600 (55,670) Comprehensive income .......................................... $ XXXX Balance Sheet Liabilities Pension liability ............................................ Stockholders’ equity Accumulated other comprehensive loss (PSC) ...................................................... Accumulated other comprehensive income (G/L) ..................................................
$203,400
$ 64,000 12,070
PROBLEM 20-3
(a) Pension expense for 2014 comprises the following: Service cost............................................................ Interest on projected benefit obligation (10% X $380,000) ................................................ Actual return on plan assets................................. Unexpected loss .................................................... Amortization of gain or loss in 2014..................... Amortization of prior service cost ........................ ($150,000 ÷ 10 years) ......................................... Pension expense ............................................
$52,000 38,000 (11,000) (9,000)* 0 15,000 $85,000
*([10% X $200,000] – $11,000) (b)
Journal Entries—2014 Other Comprehensive Income (G/L) ..................... Pension Expense ................................................... Cash ................................................................ Pension Asset /Liability.................................. Other Comprehensive Income (PSC) ............
29,000 85,000 65,000 34,000 15,000
*Computed in part (c) (c) 2014 Increase/Decrease in Gains/Losses (1) 12/31/14 new actuarially computed PBO Less: Projected benefit obligation per memo record: 1/1/14 PBO $380,000 Add interest (10% X $380,000) 38,000 Add service cost (given) 52,000 Less benefit payments 0
$490,000
470,000 Liability loss
$20,000
PROBLEM 20-3 (Continued) (2) 12/31/14 fair value of plan assets Less: Expected fair value 1/1/14 fair value of plan assets Add expected return (10% X $200,000) Add pension plan contribution Less benefit payments
$276,000 $200,000 20,000 65,000 0 285,000
Asset loss Net loss at 12/31/14 ($20,000 liability loss + $9,000)
9,000 $29,000
The $29,000 net loss in the accumulated OCI (G/L) account becomes the beginning balance in 2015. The corridor at 1/1/15 is 10% of the greater of $490,000 (PBO) or $276,000 (market-related asset value). Since the corridor of $49,000 is greater than the balance in the accumulated OCI (G/L) account of $29,000, there will be no gain/loss amortization in 2015. It follows that no amortization occurs in 2014 because no balance existed in the accumulated OCI (G/L) account at the beginning of 2014. (d) Financial Statements—2014 Income Statement Pension expense.............................................
$ 85,000
Comprehensive Income Statement Net Income .............................................................. $ XXXX Other comprehensive income (loss) Asset gain (loss) ............................................. $ (9,000) Liability gain (loss).......................................... (20,000) Prior service cost amortization ...................... 15,000 (14,000) Comprehensive income ......................................... $ XXXX Balance Sheet Liabilities Pension asset /liability ......................... Stockholders’ equity Accumulated other comprehensive loss (PSC) ......................................... Accumulated other comprehensive loss.......................... *($380,000 – $200,000) + $34,000 **($150,000 – $15,000)
$214,000*
$135,000** $ 29,000
PROBLEM 20-3 (Continued)
PROBLEM 20-4
(a) Computation of pension expense:
Service cost ...................................................... Interest cost ($700,000 X .09) and ($800,000 X .09)..................................... Expected return on plan assets ...................... Amortization of prior service cost .................. Pension expense .............................................. (b) Pension Asset/Liability .................................... Pension Expense.............................................. Other Comprehensive Income (PSC) ........ Other Comprehensive Income (G/L).......... Cash ............................................................ Pension Expense.............................................. Cash............................................................. Pension Asset/Liability.............................. Other Comprehensive Income (PSC) ........
2014 $ 60,000
2015 $ 90,000
63,000 (24,000) 10,000 $109,000
72,000 (30,000) 12,000 $144,000
2014 39,000 109,000 10,000 23,000 115,000 2015 144,000 120,000 12,000 12,000
Note to instructors: Although not required, students could be encouraged to prepare a 2-year pension worksheet, as shown on the following page.
PROBLEM 20-4 (Continued)
PROBLEM 20-5
(a) Pension expense for 2014 consisted only of the service cost component amounting to $60,000. There were no prior service cost, net gain or loss, plan assets, or projected benefit obligation as of January 1, 2014. Pension expense for 2015 comprised the following: Service cost .................................................................... Interest on projected benefit obligation ($60,000 X 11%)........................................................... Expected return on plan assets ($50,000 X 10%)........................................................... Amortization of net gain or loss .................................... Amortization of prior service cost................................. Pension expense.....................................................
$ 85,000 6,600 (5,000) 0 0 $ 86,600
Pension expense for 2016 comprised the following: Service cost .................................................................... Interest on projected benefit obligation ($200,000 X 8%)........................................................... Expected return on plan assets ($85,000 X 10%)........................................................... Amortization of net gain or loss (1) ............................... Amortization of prior service cost................................. Pension expense.....................................................
$119,000 16,000 (8,500) 4,867 0 $131,367
PROBLEM 20-5 (Continued) (1) Year 2014 2015 2016
Projected Benefit Plan Assets Obligation (a) (a)
Corridor (b)
$
$
0 60,000 200,000
$ 0 50,000 85,000
0 6,000 20,000
Accumulated OCI (G/L) (a) $
Minimum Amortization of (Gain) Loss
0 0 78,400
$
0 0 4,867 (c)
(a) As of the beginning of the year. (b) The corridor is 10 percent of the greater of the projected benefit obligation or plan assets. (c) $78,400 – $20,000 = $58,400; $58,400/12 = $4,867
(b)
Journal Entries—2014 Pension Expense ..................................................... Cash .................................................................. Pension Asset/Liability....................................
60,000
Journal Entries—2015 Pension Expense ..................................................... Other Comprehensive Income (G/L) ....................... Cash .................................................................. Pension Asset/Liability....................................
86,600 78,400
Journal Entries—2016 Pension Expense ...................................................... Other Comprehensive Income (G/L) ........................ Cash ................................................................... Pension Asset/Liability.....................................
131,367 2,633*
50,000 10,000
60,000 105,000
105,000 29,000
*Note: The debit to Other Comprehensive Income (G/L) is a plug figure. It equals the corridor amortization credit ($4,867) netted against an additional loss in 2016 of $7,500. Note to instructors: Although not required, students could be encouraged to prepare a 3-year worksheet, as presented on the following page.
PROBLEM 20-5 (Continued)
PROBLEM 20-6
(a) Prior Service Cost Amortization 2014 2015 2016
$166,667 166,667 166,667
($2,000,000 ÷ 12 years) ($2,000,000 ÷ 12 years) ($2,000,000 ÷ 12 years)
(b) Pension expense for 2014 comprised the following: Service cost........................................................................ Interest on projected benefit obligation*.......................... Actual return on plan assets** .......................................... Unexpected gain*** ............................................................ Amortization of prior service cost .................................... Pension expense ........................................................
$200,000 500,000 (325,000) 25,000 166,667 $566,667
*($5,000,000 X 10% = $500,000) **[$4,100,000 – $3,000,000 – ($775,000 – $0)] ***(Expected return of $300,000 – actual return of $325,000 = $25,000 unexpected gain) (c) Pension liability, beginning of year ................................. Less: Pension liability, end of year ................................. Decrease in liability...................................................
$2,000,000 750,000* $1,250,000
*$4,850,000 – $4,100,000 Journal Entries—2014 Pension Expense .................................................. 566,667 Pension Asset/Liability ........................................ 1,250,000 Other Comprehensive Income (G/L) ............ Other Comprehensive Income (PSC) ........... Cash ...............................................................
875,000 166,667 775,000
PROBLEM 20-6 (Continued) (d) 12/31/14 Fair value of plan assets Less: Expected fair value of assets 1/1/14 fair value of plan assets Add expected return (10% X $3,000,000) Add contributions to the plan Less benefits Asset gain (increase) 12/31/14 Actuarially computed PBO Less: 1/1/14 PBO $5,000,000 Add interest (10% X $5,000,000) 500,000 Add service cost 200,000 Less benefits 0 Liability gain (decrease)
$4,100,000 $3,000,000 300,000 775,000 0
4,075,000 25,000 Dr
4,850,000
5,700,000 850,000 Dr
Net gain 12/31/14
$ 875,000
Amortization in 2014: None because there was no beginning balance. Amortization in 2015 (corridor approach): $32,500, as shown below. Year 2014 2015
Projected Benefit Fair Value Obligation of Plan Assets Corridor $5,000,000 4,850,000
$3,000,000 4,100,000
$500,000 485,000
Accumulated OCI (G/L) Amortization $ 0 (875,000)
*$875,000 – $485,000 = $390,000; $390,000 ÷ 12 = $32,500
$ 0 32,500*
PROBLEM 20-6 (Continued)
PROBLEM 20-7
PROBLEM 20-8
PROBLEM 20-8 (Continued) Worksheet computations: $60,000 = $600,000 X 10%.
(a)
$5,000 = ($410,000 X 10%) – $36,000; expected return exceeds actual return.
(b)
(c)
$75,550 = $755,500 X 10%.
(d)
$9,850 = ($511,500 X 10%) – $61,000; actual return exceeds expected return.
(e)
2015 Corridor Test: Accumulated net (gain) or loss at beginning of year................. 10% of larger of PBO or fair value of plan assets ...................... Amortizable amount .....................................................................
$92,000 (75,550) $16,450
2015 amortization ($16,450 ÷ 20 years) .......................................
$
(b)
823
2014 Pension Expense ........................................................... 129,000 Other Comprehensive Income (G/L)......................... 92,000 Cash .................................................................... Pension Asset/Liability...................................... Other Comprehensive Income (PSC)................
97,000 54,000 70,000
2015 Pension Asset/Liability ............................................ Pension Expense ...................................................... Cash ................................................................... Other Comprehensive Income (PSC)............... Other Comprehensive Income (G/L) ................
81,000 50,000 10,673
7,450 134,223
PROBLEM 20-8 (Continued) (c) Financial Statements—2015 Income Statement Pension expense ............................................
$134,223
Comprehensive Income Statement Net Income ............................................................. Other comprehensive income (loss) Asset gain (loss)............................................. Amortization of loss ....................................... Prior Service cost amortization..................... Comprehensive income Balance Sheet Liabilities Pension liability ....................................... Stockholders’ equity Accumulated other comprehensive loss (PSC) ............................................ Accumulated other comprehensive loss (G/L)..............................................
$ XXXX $ 9,850 823 50,000
60,673 $ XXXX
$236,550
$ 40,000 81,327
PROBLEM 20-9
(a) See worksheet on next page. (b)
December 31, 2014 Other Comprehensive Income (G/L)...................... Pension Expense .................................................... Cash ................................................................. Pension Asset/Liability...................................
24,000 334,000 200,000 158,000
(c) See worksheet on next page. The entry is below. December 31, 2015 Other Comprehensive Income (PSC) .................... Other Comprehensive Income (G/L)...................... Pension Expense .................................................... Cash ................................................................. Pension Asset/Liability ................................... (d)
510,000 36,560 432,440 184,658 794,342
Financial Statements—2015 Income Statement Pension expense.............................................
$432,440
Balance Sheet Liabilities Pension liability ........................................
$952,342
Stockholders’ equity Accumulated other comprehensive loss (PSC)............................................... Accumulated other comprehensive loss (G/L) ................................................
$510,000 60,560
PROBLEM 20-9 (Continued)
PROBLEM 20-10
PROBLEM 20-11
PROBLEM 20-11 (Continued) Worksheet computations: Interest cost: $39,950 = $399,500 X 10% Unexpected gain: $7,100 = ($249,000 X 10%) – $32,000; exceeds expected return.
actual return
2015 Corridor Test: Accumulated net (gain) or loss at beginning of year ... Less: 10% of larger of PBO or fair value of plan assets .............................................................. Amortizable amount....................................................
$46,000 39,950 $ 6,050
2015 amortization ($6,050 ÷ 25 years) ....................... (b)
$
2015 Pension Expense ........................................................ 102,292 Pension Asset/Liability........................................ Other Comprehensive Income (PSC) ................. Other Comprehensive Income (G/L)................... Cash......................................................................
(c) Financial Statements—2015 Income Statement Pension expense ................................................. Comprehensive Income Statement Net Income .................................................................. Other comprehensive income (loss) Asset gain (loss) .................................................. Amortization of loss ............................................ Prior service cost amortization........................... Comprehensive income..............................................
242
15,950 28,000 7,342 51,000
$102,292 $ XXXX 7,100 242 28,000
Balance Sheet Liabilities Pension liability ....................................................... Stockholders’ equity Accumulated other comprehensive loss (PSC) .... Accumulated other comprehensive loss (G/L)......
35,342 $ XXXX
$166,450 $ 17,000 38,658
PROBLEM 20-12
PROBLEM 20-12 (Continued) (b)
2015 Pension Expense ..................................................... Pension Asset/Liability............................................ Other Comprehensive Income (PSC) .............. Other Comprehensive Income (G/L)................ Cash...................................................................
59,700 23,200 12,000 5,900 65,000
(c) Financial Statements—2015 Income Statement Pension expense .............................................. Comprehensive Income Statement Net Income ............................................................... Other comprehensive income (loss) Asset gain (loss) ............................................... Amortization of loss ......................................... Prior service cost amortization........................ Comprehensive income...........................................
$59,700 $ XXXX 5,400 500 12,000
Balance Sheet Liabilities Pension liability ...................................................... Stockholders’ equity Accumulated other comprehensive loss (PSC) ... Accumulated other comprehensive loss (G/L).....
17,900 $ XXXX
$46,800 $78,000 33,100
*PROBLEM 20-13
*PROBLEM 20-14
(a) See worksheet on next page. (b)
December 31, 2014 Postretirement Expense ...................................... Other Comprehensive Income (G/L) ................... Cash............................................................... Postretirement Asset/Liability .....................
120,000 40,000 45,000 115,000
(c) See worksheet on next page. The entry is below. December 31, 2015 Other Comprehensive Income (PSC).................. Other Comprehensive Income (G/L) ................... Postretirement Expense ...................................... Cash............................................................... Postretirement Asset/Liability .....................
163,000 23,700 221,800 35,000 373,500
(d) Financial Statements—2015 Income Statement Postretirement expense ............................... Comprehensive Income Statement Net Income .......................................................... Other comprehensive income (loss) Asset gain (loss) .......................................... Plan amendment (PSC) ............................... Prior service cost amortization................... Comprehensive income......................................
$221,800 $ $ (23,700) (175,000) 12,000
Balance Sheet Liabilities Postretirement liability........................................... Stockholders’ equity Accumulated other comprehensive loss (PSC) ... Accumulated other comprehensive loss (G/L).....
XXXX
(186,700) $ XXXX
$488,500 $163,000 63,700
*PROBLEM 20-14 (Continued)
TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 20-1 (Time 30–35 minutes) Purpose—to provide the student with the opportunity to discuss some of the more traditional issues related to pension reporting. Specifically, the student is asked to define a pension plan, distinguish between a funded and unfunded plan, differentiate between accounting for the employer and the pension fund. In addition, justification for accrual accounting must be developed, as well as a determination of the relative objectivity of the accrual versus the cash basis. CA 20-2 (Time 25–30 minutes) Purpose—to provide the student with the opportunity to discuss the terminology employed in GAAP related to pension accounting. CA 20-3 (Time 20–25 minutes) Purpose—to provide the student with the opportunity to discuss the reasons why accrual accounting is followed for pension reporting. In addition, certain terms are required to be explained and the proper footnote disclosures identified. CA 20-4 (Time 30–35 minutes) Purpose—to provide the student with the opportunity to study some of the implications of GAAP as it related to pensions. The student is required to identify the five components of pension expense, the major differences between the accumulated benefit obligation and the projected benefit obligation, and how to report actuarial gains and losses. CA 20-5 (Time 50–60 minutes) Purpose—to provide the student with the opportunity to discuss the implications of GAAP given a number of different factual situations related to pensions. This case is quite thought-provoking and should stimulate a great deal of class discussion. CA 20-6 (Time 30–40 minutes) Purpose—to provide the student with the opportunity to explain gains and losses, including the use of corridor amortization. CA 20-7 (Time 20–30 minutes) Purpose—to provide the student with the opportunity to consider the ethical implications of the impact of pension benefits and their impact on financial statements.
SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 20-1 (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.
(b)
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.
(c)
(d)
(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 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. (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 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.
CA 20-1 (Continued) (e)
Terms and their definitions as they apply to accounting for pension plans follow: (1)
Service cost is the actuarial present value of benefits attributed by the pension benefit formula to employee service during that period. The service cost component is a portion of the projected benefit obligation and is unaffected by the funded status of the plan.
(2)
Prior service costs are the retroactive benefits granted in a plan amendment (or initiation). Retroactive benefits are benefits granted in a plan amendment (or initiation) that are attributed by the pension benefit formula to employee services rendered in periods prior to the amendment.
(3)
Vested benefits are benefits that are not contingent on the employee continuing in the service of the employer. In some plans the payment of the benefits will begin only when the employee reaches the normal retirement date; in other plans the payment of the benefits will begin when the employee retires (which may be before or after the normal retirement date). The actuarially computed value of vested benefits represents the present value: (a) the benefits expected to become payable to former employees who have retired, or who have terminated service with vested rights, at the date of determination; and (b) the benefits (based on service rendered prior to the date of determination) expected to become payable at future dates to present employees, taking into account the probable time that employees will retire.
CA 20-2 1.
Pension asset/liability in the asset section is the excess of the fair value of pension plan assets over the projected benefit obligation.
2.
Pension asset/liability in the liability section is the excess of the projected benefit obligation over the fair value of the pension plan assets.
3.
Accumulated OCI—PSC arises when an additional liability is recognized in the PBO due to prior service cost. This account should be reported in the stockholders’ equity section as a component of accumulated other comprehensive income. In addition, it should be shown as part of other comprehensive income.
4.
Pension expense is the amount recognized in an employer’s financial statements as the expense for a pension plan for the period. Components of pension expense are service cost, interest cost, expected return on plan assets, amortization of gain or loss, and amortization of prior service cost. It should be noted that GAAP uses the term net periodic pension cost instead of pension expense because part of the cost recognized in a period may be capitalized along with other costs as part of an asset such as inventory.
CA 20-3 (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. (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.
(b)
(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.
The following disclosures about a company’s pension plans should be made in financial statements or their notes: 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 OCI and the impact of amortization of these items on pension expense in the current and next year.
5.
A table is required indicating the allocation of 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.
CA 20-4 (a)
(b)
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 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.
CA 20-5 1.
This situation can exist because companies vary as to whether they are using an implicit or explicit set of assumptions when interest rates are disclosed. In the implicit approach, two or more assumptions do not individually represent the best estimate of the plan’s future experience with respect to these assumptions, but the aggregate effect of their combined use is presumed to be approximately the same as that of an explicit approach. In the explicit approach, each significant assumption reflecting the best estimate of the plan’s future experience solely with respect to that assumption must be stated. As a result, some companies are presently using an implicit approach, others an explicit approach. GAAP requires yet more consistency in discount rates. It requires companies to use rates on high quality fixed income investments currently available whose cash flows match the timing and amount of the expected benefit payments. As a result, this large variance in interest rates will probably disappear to some extent. However, it should be noted that companies will have some leeway in establishing settlement rates. In addition, the expected return on assets will also be different among companies.
2.
This situation will occur because the net funded position of the plan is required to be reported. That is, companies are required to report as a liability the excess of their projected benefit obligation over the fair value of plan assets. In the past, the basic liability companies reported was the excess of the amount expensed over the amount funded.
3.
This statement is questionable. If a financial measure purports to represent a phenomenon that is volatile, the measure must show that volatility or it will not be representationally faithful. Neverthe-less, many argue that volatility is inappropriate when dealing with such long-term measures as pensions. A good example of where dampening might be useful is the recognition of gains and losses. If assumptions prove to be accurate estimates of experience over a number of years, gains or losses in one year will be offset by losses or gains in subsequent periods, and amortization of gains and losses would be unnecessary. The main point is that volatility per se should not be considered undesirable when establishing accounting principles. Although some managements may consider volatility bad, this belief should not influence standard-setting. However, it is clear from some of the compromises made in GAAP that certain procedures were provided to dampen the volatility effect.
4.
(a) In a defined-contribution plan, the amount contributed is the amount expensed. No significant reporting problems exist here. On the other hand, defined benefit plans involve many difficult reporting issues which may lead to additional expense and liability recognition. Significant amendments will generally increase prior service cost which may lead to significant adjustments to pension expense in the future.
5.
(b)
Plan participants are of importance, because the expected future years of service computation can have an impact on the amortization of the prior service cost and gains and losses.
(c)
If the plan is underfunded, pension expense will generally increase (all other factors constant). If the plan is overfunded, pension expense will generally decrease (all other factors constant). The reason is that the expected return on plan assets will be less if the plan is underfunded and vice versa.
(d)
If the company is using an actuarial funding method different than the one prescribed in GAAP (benefits/years-of-service approach), some changes in the computation of pension expense will occur for the company.
The corridor method is an approach which requires that only gains and losses in excess of 10% of the greater of the projected benefit obligation or market related plan asset value be allocated. This excess is then amortized over the average remaining service period of current employees expected to participate in the plan. The corridor’s purpose is to only recognize gains and losses above a certain amount, on the theory that gains and losses within the corridor will offset one another over time.
CA 20-6 To:
Vickie Plato, Accounting Clerk
From:
Good Student, Manager of Accounting
Date:
January 3, 2016
Subject:
Amortization of gains and losses in pension expense
Pension expense includes several components; one occasionally included is the amortization of cumulative gains/losses. These gains/losses occur for two reasons. First, the plan assets may provide a return that is either greater or less than what was expected. Second, changes in actuarial assumptions may create increases or decreases in the pension liability. If these gains/losses are small in relation to the projected benefit obligation (PBO) or the market related value of the Plan Assets (PA), then do not include them in annual pension expense. If, in any given year, the gains or losses become too great, then at least a portion must be included in pension expense so as not to understate or overstate the annual obligation. This is done through a process called amortization. To decide whether or not you should include gains/losses in annual pension expense, calculate 10 percent of either the PBO or the PA (whichever is greater) as a “corridor.” Amortize the amount of any gain or loss falling outside the corridor over the average remaining service life of the active employees. Note: these gains/losses must exist at the beginning of the year for which amortization takes place [see (a) on the schedule below]. Thus, in the attached schedule, no amortization of the $280,000 loss in 2013 was required because the balance in the gain/loss account at the beginning of that year was zero. However, at the beginning of 2014, the balance in that account was $280,000. The 10 percent corridor is $250,000, so the loss exceeds this corridor by $30,000. Since the remaining service life of employees is 10 years, you derive the amortized portion by dividing $30,000 by 10: $3,000 [see (b) on the schedule below]. Note that the unamortized portion of the gain/loss from the previous year is combined with the current gain/loss. Check this new sum against a newly calculated 10 percent corridor. If the sum exceeds this corridor, then amortize the excess. In the attached schedule, the unamortized loss from 2014 ($277,000) was added to the 2014 loss of $85,000, resulting in a cumulative loss of $362,000 (see (c) below). This amount exceeds the new corridor ($290,000) by $72,000. However, the remaining service life has been changed to 12 years, resulting in annual amortization of only $6,000 [see (d) below]. Finally, if the losses from 2015 are added to the unamortized portion of the loss from prior years, the sum ($368,000) falls within the 2016 corridor ($390,000) and does not need to be amortized at all. Corridor and Minimum Loss Amortization Schedule
Year 2013 2014 2015 2016
Projected Benefit Obligation (a) $2,200,000 2,400,000 2,900,000 3,900,000
Plan Assets Value (a) $1,900,000 2,500,000 2,600,000 3,000,000
10% Corridor $220,000 250,000 290,000 390,000
Accumulated OCI (G/L) (a) $ 0 280,000 362,000 (c) 368,000 (e)
Minimum Amortization of Loss $ 0 3,000 (b) 6,000 (d) 0
CA 20-6 (Continued) (a) (b) (c) (d) (e)
As of the beginning of the year. ($280,000 – $250,000) ÷ 10 years = $3,000 $280,000 – $3,000 + $85,000 = $362,000 ($362,000 – $290,000) ÷ 12 years = $6,000 $362,000 – $6,000 + $12,000 = $368,000
CA 20-7 While Habbe may be correct in assuming that the termination of nonvested employees would decrease its pension-related liabilities and associated expenses, she is callous to suggest that firing employees is a reasonable approach to correcting the underfunding of College Electronix’s pension plan. Arbitrarily dismissing productive employees on the basis of being vested or not vested in the pension plan in order to avoid capitalizing a liability and recognizing expenses is a capricious and unsound business decision. Gerald Ott should discuss the ethical, legal, and financial implications of the alternatives available as well as the accounting requirements relating to this situation. This obligation and its effect on the financial statements should have been known to Thinken Technology when it performed its due diligence audit of CE at the time of merger negotiations. Thinken Technology should capitalize the pension obligations of CE as required by GAAP.
FINANCIAL REPORTING PROBLEM (a)
P&G offers various postretirement benefits to its employees. The most prevalent employee benefit plans offered are defined contribution plans, which cover substantially all employees in the U.S. Under the defined contribution plans, the company generally makes contributions to participants based on individual base salaries and years of service. The company maintains the Procter & Gamble Profit Sharing Trust and Employee Stock Ownership Plan (ESOP) to provide a portion of the funding for the U.S. defined contribution plan, as well as other retiree benefits. Certain other employees, primarily outside the U.S., are covered by local defined benefit plans.
(b)
2011 2010 2009
Pension expense Pension expense Pension expense
$538,000,000 $469,000,000 $341,000,000
(c)
In 2011, P&G reports a $4,388,000,000 Accrued Pension Cost on its balance sheet. It reports $538,000,000 as pension expense on its income statement. It also reports a postretirement liability of $1,516,000,000 classified as non-current.
(d)
P&G provides the following disclosure of its asset allocations for the pension fund and the fund for Other Retiree Benefits. Plan Assets. The Company’s target asset allocation for the year ending June 30, 2011 and actual asset allocation by asset category as of June 30, 2011, are as follows:
Asset Category Cash Equity securities Debt securities Total
Target Asset Allocation Pension Benefits Other Retiree Benefits 2011 2011 2% 2% 47% 90% 51% 8% 100% 100%
FINANCIAL REPORTING PROBLEM (Continued)
Asset Category Equity securities Debt securities Cash Total
Asset Allocation at June 30 Pension Benefits Other Retiree Benefits 2011 2011 2% 91% 52% 8% 46% 1% 100% 100%
These allocations appear in-line with the expected return assumptions for these two funds: 2011 Assumptions used to determine net periodic cost Expected return on plan assets
Pensions
Other Retiree
7.0%
9.2%
As indicated, almost all of the assets in the Other Retiree Benefit fund are equity investments, which should earn higher (if not also riskier) returns than debt investments. The differences are consistent with the higher expected return assumption for Other Retiree Benefit funds. Thus, this information is useful to users of the financial statements in evaluating the pension plan’s exposure to market risk and possible cash flow demands on the company. In addition, it will help users to better understand and assess the reasonableness of the company’s expected rate of return assumption.
COMPARATIVE ANALYSIS CASE (a) Coca-Cola sponsors and/or contributes to pension plans covering substantially all U.S. employees and certain employees in international locations. Coca-Cola also sponsors nonqualified, unfunded defined benefit plans for certain officers and other employees. In addition, Coca-Cola and its subsidiaries have various pension plans and other forms of postretirement arrangements outside the United States. PepsiCo sponsors noncontributory defined benefit pension plans covering substantially all full-time U.S. employees and certain international employees. (b) Coca-Cola reported “net periodic benefit cost” of $249 million in 2011. PepsiCo reported “pension expense” of $415 million in 2011 for U.S. plans. (c)
2011 Funded Status ($millions) Coca-Cola PepsiCo U.S. plans
Pensions ($2,084) ($2,829)
OPEB ($ 768) ($1,373)
(d) Relevant rates used to compute pension information:
Discount rate (expense) Rate of increase in compensation levels Expected long-term rate of return on plan assets
Coca-Cola
PepsiCo
4.75% 4.0%
5.7% 3.7%
8.25%
7.8%
(e) Coca-Cola and PepsiCo provide the following disclosures on expected contributions and benefit payments (amounts in millions):
COMPARATIVE ANALYSIS CASE (Continued) Coca-Cola Cash Flows Information about the expected cash flow for our pension and other postretirement benefit plans is as follows: Pension Benefits
Other Benefits
$ 486 501 521 537 553 3,042
$ 53 56 59 62 65 342
Expected benefit payments: 2012 2013 2014 2015 2016 2017–2021
Coca-Cola anticipate making contributions in 2012 of approximately $953 million, primarily to our non-U.S. pension plans. PepsiCo Future Benefit Payments Our estimated future benefit payments to beneficiaries are as follows: Pension Retiree medical
2012 $560 $135
2013 $560 $135
2014 $560 $140
2015 $600 $145
2016 $645 $145
2017–2021 $4,050 $ 730
In 2012, PepsiCo will make pension contributions of approximately $1,300 million, with up to approximately $1,000 million expected to be discretionary. The net cash payments for retiree medical are estimated to be approximately $124 million in 2012. PepsiCo appears to have a much higher cash claim related to its postretirement benefit plans with expected benefit payments than CocaCola’s. Thus, these disclosures provide information related to the cash outflows of the company. With this information, financial statement users can better understand the potential cash outflows related to the pension plan. As a result, users can better assess the liquidity and solvency of the company, which helps in assessing the company’s overall financial flexibility.
FINANCIAL STATEMENT ANALYSIS CASE (a)
The components of postretirement expense are service cost, interest cost, return on plan assets, amortization of prior service cost, and gains and losses. The expense for these plans is reporting in income from operations. Similar to pensions, the net pension asset for the postemployment benefit plan will be reported in Peake’s balance sheet, depending on whether there is a net debit or credit balance in the memorandum accounts related to the plan.
(b)
The accounting for defined-benefit plans and OPEBs is very similar. For example, the measures of the obligation are similar and the components of expense and their calculation are the same (with similar smoothing mechanisms employed for both types of plans with respect to gains and losses.) There are, however, a number of differences between Postretirement Healthcare Benefits and Pensions: Item Funding Benefit
Pensions Generally funded. Well-defined and level dollar amount. Beneficiary Retiree (maybe some benefit to surviving spouse). Benefit Payable Monthly. Predictability Variables are reasonably predictable.
Healthcare Benefits Generally NOT funded. Generally uncapped and great variability. Retiree, spouse, and other dependents. As needed and used. Utilization difficult to predict. Level of cost varies geographically and fluctuates over time.
Additionally, although healthcare benefits are generally covered by the fiduciary and reporting standards for employee benefit funds under ERISA, the stringent minimum vesting, participation, and funding standards that apply to pensions do not apply to healthcare benefits. The lack of required funding is particularly relevant for OPEB plans compared to pensions. Generally, this results in a much higher unfunded OPEB obligation reported in the balance sheet. In addition, with fewer assets in OPEB plan, there is a lower credit associated with the return-on-asset component of OPEB expense.
ACCOUNTING, ANALYSIS, AND PRINCIPLES Accounting Balance in PBO at 12/31/2015 Balance at 1/1/2015 Interest cost: ($820.5 X 0.10) = Service cost Increase from actuarial assumptions Benefits paid Amount of plan assets at 12/31/2015 Balance at 1/1/2015 Actual dollar return in 2015 Contributions in 2015 Benefits paid in 2015 Corridor test and amortization of net gain/loss Corridor limit: 10% times greater of $820.5 and $476.5 = Excess of net G/L over corridor limit = $92.0 – $82.1 = Amortization = $9.9 ÷ 15 = Pension expense: Interest cost = ($820.5 X 0.10) = Service cost Amortization of unamortized prior service cost = Amortization of unamortized net loss Expected return on plan assets: ($476.5 X 0.12) = Balance in pension liability Projected benefit obligation Plan assets Pension liability Balance in Unamortized Prior Service Cost at 12/31/2015 Balance at 1/1/2015 Amortization in 2015
$820.5 82.1 42.0 0.0 (40.0) $904.6 $476.5 10.4 70.0 (40.0) $516.9 $ 82.1 9.9 0.7 $ 82.1 42.0 15.0 0.7 (57.2) $ 82.6 $904.6 (516.9) $387.7
($150.0) 15.0 ($135.0)
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) Balance in Unamortized Net Gain or Loss at 12/31/2015 Balance at 1/1/2015 Gain (loss) due to actual return on plan assets below expected return Amortization
($ 92.0) (46.8) 0.7 ($138.1)
Journal entry: Pension Expense...................................................... Other Comprehensive Income (G/L) ....................... Pension Asset/Liability ................................... Other Comprehensive Income (PSC) ............ Cash..................................................................
82.6 46.1 43.7 15.0 70.0
PENCOMP, INC. Income Statement for the year ended Dec. 31, 2015 Revenues: Sales .......................................................................... Expenses: Cost of goods sold ................................................... Salary expense.......................................................... Pension expense ...................................................... Depreciation expense............................................... Interest expense ....................................................... Total expenses and losses............................. Net income ................................................................
$3,000.0 $2,000.0 700.0 82.6 80.0 100.0 2,962.6 $ 37.4
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) PENCOMP, INC. Statement of Financial Position at Dec. 31, 2013 Assets: Cash ............................................................................... Inventory ........................................................................
$ 368.0 1,800.0 2,168.0
Plant and equipment..................................................... $2,000.0 Accumulated depreciation .............................................. (320.0) Total Assets.....................................................
1,680.0 $3,848.0
Liabilities: Note payable.................................................................. Pension liability............................................................. Total Liabilities ................................................
$1,000.0 387.7 1,387.7
Equity: Common stock .............................................................. Retained earnings ......................................................... Accumulated other comprehensive income............... Total Equity...................................................... Total Liabilities and Stockholders’ Equity....
$2,000.0 733.4 (273.1) 2,460.3 $3,848.0
Plant and equip. = no change from previous statement of financial position. Accumulated depreciation = [$240 + ($2,000 ÷ 25)] = $320 Inventory = $1,800 given Cash = $438 – $700 + $3,000 – $2,000 –$100 – $200 – $70 = $368 Note payable = no change from previous statement of financial position. Pension liability = $387.7 per above analysis Capital stock = no change from previous statement of financial position. Retained earnings = $896.0 + $37.4 –$200 = $733.4 Accumulated other comprehensive income = $135.0 + $138.1 = $273.1
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) Analysis ROE = $37.4 ÷ $2,460.3 = 0.0152 or 1.52%. In this example, the unexpected return on plan assets ‘skipped’ the income statement and went to other comprehensive income. Had this item been included in income, ROE would have been = ($37.4 –$46.8) ÷ $2,460.3 = – 0.0038 or –0.38 percent. Whether this ‘should’ be included in a return on equity calculation is debatable. The rationale for excluding this from current period income (and therefore from ROE) is that a defined benefit pension plan is a long-term contract and so it is the long term expected return on the plan’s assets that is relevant to measuring the cost of sponsoring the plan. Some people believe that a particularly high or low return in a given year is not indicative of the long-term return. Others argue that all returns, high or low, accrue to the plan sponsor and so pension expense should reflect all returns.
Principles The effects of plan amendments and actuarial gains and losses in a given year can be thought of as fairly transitory items with respect to income. In other words, these are items that are not likely to repeat at the same dollar amount year in and year out. Including these items in income arguably makes identifying the company’s ‘permanent’ income more difficult. Therefore, the FASB (and the IASB) have (so far!) decided to keep those items out of the income statement.
PROFESSIONAL RESEARCH (a)
According to FASB ASC 715-30-35: 35-22 Asset gains and losses are differences between the actual return on plan assets during a period and the expected return on plan assets for that period. Asset gains and losses include both changes reflected in the market-related value of plan assets and changes not yet reflected in the market-related value (that is, the difference between the fair value of assets and the market-related value). Gains or losses on transferable securities issued by the employer and included in plan assets are also included in asset gains and losses. Asset gains and losses not yet reflected in market-related value are not required to be amortized under paragraphs 715-30-35-24 through 35-25. 35-24 As a minimum, amortization of a net gain or loss included in accumulated other comprehensive income (excluding asset gains and losses not yet reflected in market-related value) shall be included as a component of net pension cost for a year if, as of the beginning of the year, that net gain or loss exceeds 10 percent of the greater of the projected benefit obligation or the market-related value of plan assets. If amortization is required, the minimum amortization shall be that excess divided by the average remaining service period of active employees expected to receive benefits under the plan. The amortization must always reduce the beginning-of-the-year balance. Amortization of a net gain results in a decrease in net periodic pension cost; amortization of a net loss results in an increase in net periodic pension cost. If all or almost all of a plan’s participants are inactive, the average remaining life expectancy of the inactive participants shall be used instead of the average remaining service period.
PROFESSIONAL RESEARCH (Continued) (b)
According to FASB ASC 715-30-35: Gains and Losses 35-18 As established in the definition of the term, a gain or loss results from a change in the value of either the projected benefit obligation or the plan assets resulting from experience different from that assumed or from a change in an actuarial assumption. This Subtopic generally does not distinguish between gains and losses that result from experience different from that assumed or from changes in assumptions. Gains and losses include amounts that have been realized, for example by sale of a security, as well as amounts that are unrealized. 35-19 Because gains and losses may reflect refinements in estimates as well as real changes in economic values and because some gains in one period may be offset by losses in another or vice versa, this Subtopic does not require recognition of gains and losses as components of net pension cost of the period in which they arise.
(c)
According to FASB ASC 715-30-25: 25-1 If the projected benefit obligation exceeds the fair value of plan assets, the employer shall recognize in its statement of financial position a liability that equals the unfunded projected benefit obligation. If the fair value of plan assets exceeds the projected benefit obligation, the employer shall recognize in its statement of financial position an asset that equals the overfunded projected benefit obligation.
PROFESSIONAL SIMULATION Note: This assignment is available on the Kieso website.
PROFESSIONAL SIMULATION (Continued) (b) Simply change the formula in cell B11 to multiply by .07; change the formula in cell B12 to multiply .10 times (N9* – 1). Journal Entry Other Comprehensive Income (G/L) .............................. Pension Expense............................................................. Pension Asset/Liability ........................................... Cash.......................................................................... Other Comprehensive Income (PSC) .....................
71,000 113,250 66,250 99,000 19,000
Disclosure Financial Statements Income Statement Pension expense .....................................................
$113,250
Balance Sheet Liabilities Pension liability .......................................................
$211,250
Stockholders’ equity Accumulated other comprehensive loss ...............
$152,000*
*($81,000 + $71,000)
IFRS CONCEPTS AND APPLICATION IFRS20-1 Net interest is defined as the amount that accrues by multiplying the net benefit obligation by the discount rate (using defined benefit obligation and the pension asset balances as of the beginning of the year. The discount rate is based on the yields of high-quality bonds with terms consistent with the companies’ pension obligation. Net interest is then computed as indicated in the following equation. Net Interest = [Defined Benefit Obligation X Discount Rate] – [Plan Assets X Discount Rate] Because payment of the pension obligation is deferred, companies record the pension liability on a discounted basis. As a result, the liability accrues interest over the life of the employee (passage of time), which is essentially interest expense. Similarly, companies earn a return on its plan assets. That is, a company assumes that it earns interest based on multiplying the discount rate by the plan assets. Net interest is a component of pension expense, which is reported in net income. Note that the actual return on plan assets may differ from the assumed interest revenue computed, resulting in an unrealized gain or loss on plan assets. These gains or losses are recorded in other comprehensive income. IFRS20-2 The service cost component of pension expense is determined as the actuarial present value of benefits attributed by the pension benefit formula to employee service during the period. The plan’s benefit formula provides a measure of how much benefit is earned and, therefore, how much cost is incurred in each individual period. The IASB concluded that future compensation levels had to be considered in measuring the present obligation and periodic pension expense if the plan benefit formula incorporated them.
IFRS20-3 Past service cost is the cost of retroactive benefits (either positive or negative) granted in a plan amendment or initiation of a pension plan. Also included in past service costs are the reduction in benefits, arising from curtailments – a significant reduction in the number of employees covered by the plan. The cost of the retroactive benefits is the increase in the defined benefit obligation at the date of the amendment and is recognized in pension expense in the period of the change. IFRS20-4 Bill is not correct. Liability gains and losses, although not included in pension expense, are recorded in other comprehensive income in the period that they arise. Total comprehensive income is comprised of net income (including pension expense) and other comprehensive income. Thus, total comprehensive income will include the gains and losses. A similar analysis applies to asset gains and losses. IFRS20-5 Joshua Co. would report a pension asset of $10,000 ($345,000 – $335,000) and in equity, accumulated other comprehensive gain of $8,300. IFRS20-6 Current Service cost ........................................................ Past Service cost.............................................................. Interest expense............................................................... Interest revenue ............................................................... Pension expense ..............................................................
$26,000 (125,000) 9,000 (2,500) ($92,500)
IFRS20-7 Statement of Comprehensive Income Revenues Expenses Pension expense Net income Other comprehensive income Actuarial loss on defined benefit plan Total comprehensive income
$125,000 85,000 14,000 26,000 750 $ 25,250
IFRS20-8
IFRS20-9
IFRS20-10
(a)
(b)
Actual Return = (Ending – Beginning) – (Contributions – Benefits) Fair value of plan assets, December 31, 2014 ..................................................... Deduct: Fair value of plan assets, January 1, 2014........................................................... Increase in fair value of plan assets ............................. Deduct: Contributions.................................................... $700 Less benefits paid ......................................... 200 Actual return on plan assets in 2014 ............................
$2,620 1,700 920 500 $ 420
Computation of pension liability gains and losses and pension asset gains and losses. Difference between 12/31/14 actuarially computed DBO and 12/31/14 recorded projected benefit obligation (DBO): DBO at end of year ........................................ $3,300 DBO per memo records: 1/1/14 DBO...................................................... $2,500 Add interest (10%)..................................... 250 Add service cost........................................ 400 Less benefits paid ..................................... (200) (2,950) Liability loss............................................... $350 Difference between actual fair value of plan assets and 12/31/14 actual fair value of plan assets ........................................ Expected fair value 1/1/14 fair value of plan assets................. 1,700 Interest revenue ($1,700 X 10%) ....................................... 170 Add contributions ..................................... 700 Less benefits paid ..................................... (200) Asset gain .................................................. Net (gain) or loss ...........................................
2,620
(2,370) 250 ($100)
The amount recorded in other comprehensive income is The asset gain and liability loss: Asset gain .................................................................................... $ 250 Liability loss................................................................................. 350 Net loss ........................................................................................ 100 Accumulated OCI (G/L) 12/31/14 ........................................................................................ 0 Accumulated OCI (G/L) ........................................................................ $ 100 Dr
IFRS20-11 Accounting Research (a) According to IAS 19, (pars 127–130) 127 Remeasurements of the net defined benefit liability (asset) comprise: (a) actuarial gains and losses (see paragraphs 128 and 129);(b) the return on plan assets (see paragraph 130), excluding amounts included in net interest on the net defined benefit liability (asset) (see paragraph 125); and (c) any change in the effect of the asset ceiling, excluding amounts included in net interest on the net defined benefit liability (asset) (see paragraph 126). 128 Actuarial gains and losses result from increases or decreases in the present value of the defined benefit obligation because of changes in actuarial assumptions and experience adjustments. Causes of actuarial gains and losses include, for example: (a) unexpectedly high or low rates of employee turnover, early retirement or mortality or of increases in salaries, benefits (if the formal or constructive terms of a plan provide for inflationary benefit increases) or medical costs; 129 Actuarial gains and losses do not include changes in the present value of the defined benefit obligation because of the introduction, amendment, curtailment or settlement of the defined benefit plan, or changes to the benefits payable under the defined benefit plan. Such changes result in past service cost or gains or losses on settlement. 130 In determining the return on plan assets, an entity deducts the costs of managing the plan assets and any tax payable by the plan itself, other than tax included in the actuarial assumptions used to measure the defined benefit obligation (paragraph 76). Other administration costs are not deducted from the return on plan assets. According to par. 122: Remeasurements of the net defined benefit liability (asset) recognized in other comprehensive income shall not be reclassified to profit or loss in a subsequent period. However, the entity may transfer those amounts recognised in other comprehensive income within equity. (b) The IASB made the following points in it basis for conclusion for amendments to IAS 19 (pars BC99– BC99):
IFRS20-11 (Continued) BC90 The Board confirmed the proposal made in the 2010 ED that an entity should recognize remeasurements in other comprehensive income. The Board acknowledged that the Conceptual Framework and IAS 1 do not describe a principle that would identify the items an entity should recognise in other comprehensive income rather than in profit or loss. However, the Board concluded that the most informative way to disaggregate the components of defined benefit cost with different predictive values is to recognise the remeasurements component in other comprehensive income. BC95 However, most respondents to the 2010 ED expressed the view that it would be inappropriate to recognise in profit or loss short-term fluctuations in an item that is long-term in nature. The Board concluded that in the light of the improved presentation of items of other comprehensive income in its amendment to IAS 1 issued in June 2011, the most informative way to disaggregate the components of defined benefit cost with different predictive values is to recognise the remeasurement component in other comprehensive income. With respect to recycling these amounts into net income in subsequent periods: BC99 Both before and after the amendments made in 2011, IAS 19 prohibits subsequent reclassification of remeasurements from other comprehensive income to profit or loss. The Board prohibited such reclassification because: (a) there is no consistent policy on reclassification to profit or loss in IFRSs, and it would have been premature to address this matter in the context of the amendments made to IAS 19 in 2011. (b) it is difficult to identify a suitable basis to determine the timing and amount of such reclassifications. (c) According to IAS 19 (pars. 63-65), 63 An entity shall recognise the net defined benefit liability (asset) in the statement of financial position. IFRS20-11 (Continued)
64 When an entity has a surplus in a defined benefit plan, it shall measure the net defined benefit asset at the lower of: (a) the surplus in the defined benefit plan; and (b) the asset ceiling, determined using the discount rate specified in paragraph 83. 65 A net defined benefit asset may arise where a defined benefit plan has been overfunded or where actuarial gains have arisen. An entity recognises a net defined benefit asset in such cases because: (a) the entity controls a resource, which is the ability to use the surplus to generate future benefits; (b) that control is a result of past events (contributions paid by the entity and service rendered by the employee); and (c) future economic benefits are available to the entity in the form of a reduction in future contributions or a cash refund, either directly to the entity or indirectly to another plan in deficit. The asset ceiling is the present value of those future benefits. IFRS20-12 (a)
M&S provides pension arrangements for the benefit of its UK employees through the Marks & Spencer UK Pension Scheme. This has a defined benefit section, which was closed to new entrants with effect from 1 April 2002, and a defined contribution section which has been open to new members with effect from 1 April 2003. M&S also operates a small funded defined benefit pension scheme in the Republic of Ireland. Retirement benefits also include a UK postretirement healthcare scheme and unfunded retirement benefits.
(b)
2012 2011
(c)
Impact on 2012 financial statements: pension expense decreased net income by £32.1; actuarial loss of £1,412.8 on consolidated statement of recognized income and expense; net retirement benefit asset of £78.
Pension expense Pension expense
£32.1 million (£11.7 million)
IFRS20-12 (Continued) (d)
M&S’s Analysis of assets and expected rates of return portion of its pension footnote details the major categories of assets, which are property partnership interest; UK equities; overseas equities; government bonds; corporate bonds; and cash and other. In general, the expected long-term rate of return on these assets increases with an increase in risk for the asset. M&S’s overall expected rate of return is 4.9%.
CHAPTER 21 Accounting for Leases ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Brief Exercises
Topics
Questions
1.
Rationale for leasing.
1, 2, 4
2.
Lessees; classification of leases; accounting by lessees.
3, 5, 7, 8, 14
3.
Disclosure of leases.
19
4.
Lessors; classification of leases; accounting by lessors.
5, 6, 9, 10, 11, 12, 13
6, 7, 8, 11
5.
Residual values; bargainpurchase options; initial direct costs.
15, 16, 17, 18
*6.
Sale-leaseback.
20
Exercises
Problems
Concepts for Analysis 1, 2
1, 2, 3, 4, 5
1, 2, 3, 4, 6, 7, 8, 9, 11, 12, 14, 15, 16
1, 2, 3, 4, 5, 6
2, 4, 5, 7, 8
2, 3, 5
4, 5, 6, 7, 9, 10, 12, 13, 14
1, 2, 3, 5, 10, 16
2, 4
9, 10
4, 8, 9, 10
6, 7, 10, 11, 13, 14, 15
5, 6
12
15, 16
*This material is dealt with in an Appendix to the chapter.
1, 2, 3, 5, 7, 8, 11, 12, 13, 14
7
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Questions Learning Objectives
Brief Exercises
Exercises
Problems
Concepts for Analysis
1. Explain the nature, economic substance, and advantages of lease transactions.
1, 2
2. Describe the accounting criteria and procedures for capitalizing leases by the lessee.
3, 4, 5, 6
1, 2, 3, 4
1, 2, 3, 5, 11
1, 3, 4, 6, 7, 8, 9, 11, 12, 14, 15, 16
CA21-1, CA21-2
3. Contrast the operating and capitalization methods of recording leases.
7, 8
5
5, 12, 13, 14
2, 15
CA21-3
4. Explain the advantages and economics of leasing to lessors and identify the classifications of leases for the lessor.
9
6, 7, 8
12, 13, 14
2, 10, 13, 16
CA21-4
5. Describe the lessor’s accounting for directfinancing leases.
10
6, 7
4, 10
5
6. Identify special features of lease arrangements that cause unique accounting problems.
11, 12, 13
9, 10
8, 9
4, 9, 11, 12
7. Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting.
14, 15, 16
9, 10
3, 8
6, 10, 11, 13, 14, 15, 16
8. Describe the lessor’s accounting for sales-type leases.
17, 18
11
6, 7, 8, 9
1, 3, 10, 13
CA21-5, CA21-6
9. List the disclosure requirements for leases.
19
3, 4, 5, 7, 8
CA2-12
*10. Describe the lessee’s accounting for saleleaseback transactions.
20
12
15, 16
CA21-7
ASSIGNMENT CHARACTERISTICS TABLE Item E21-1 E21-2 E21-3 E21-4 E21-5 E21-6 E21-7 E21-8 E21-9 E21-10 E21-11 E21-12 E21-13 E21-14 *E21-15 *E21-16 P21-1 P21-2 P21-3 P21-4 P21-5 P21-6 P21-7 P21-8 P21-9 P21-10 P21-11 P21-12 P21-13 P21-14 P21-15 P21-16
Description Lessee entries; capital lease with unguaranteed residual value. Lessee computations and entries; capital lease with guaranteed residual value. Lessee entries; capital lease with executory costs and unguaranteed residual value. Lessor entries; direct-financing lease with option to purchase. Type of lease; amortization schedule. Lessor entries; sales-type lease. Lessee-lessor entries; sales-type lease. Lessee entries with bargain-purchase option. Lessor entries with bargain-purchase option. Computation of rental; journal entries for lessor. Amortization schedule and journal entries for lessee. Accounting for an operating lease. Accounting for an operating lease. Operating lease for lessee and lessor. Sale-leaseback. Lessee-lessor, sale-leaseback. Lessee-lessor entries-sales-type lease. Lessee-lessor entries; operating lease. Lessee-lessor entries; balance sheet presentation; sales-type lease. Balance sheet and income statement disclosure—lessee. Balance sheet and income statement disclosure—lessor. Lessee entries with residual value. Lessee entries and balance sheet presentation, capital lease. Lessee entries and balance sheet presentation, capital lease. Lessee entries, capital lease with monthly payments. Lessor computations and entries, sales-type lease with unguaranteed residual value. Lessee computations and entries, capital lease with unguaranteed residual value. Basic lessee accounting with difficult PV calculation. Lessor computations and entries; sales-type lease with guaranteed residual value. Lessee computations and entries; capital lease with guaranteed residual value. Operating lease vs. capital lease. Lessee-lessor accounting for residual values.
Level of Difficulty Moderate
Time (minutes) 15–20
Moderate
20–25
Moderate
20–30
Moderate Simple Moderate Moderate Moderate Moderate Moderate Moderate Simple Simple Simple Moderate Moderate
20–25 15–20 15–20 20–25 20–30 20–30 15–25 20–30 10–20 15–20 15–20 20–30 20–30
Simple Simple Moderate
20–25 20–30 35–45
Moderate Moderate Moderate Moderate Moderate Moderate Complex
30–40 30–40 25–35 25–30 20–30 20–30 30–40
Complex
30–40
Moderate Complex
40–50 30–40
Complex
30–40
Moderate Complex
30–40 30–40
ASSIGNMENT CHARACTERISTICS TABLE (Continued) Item CA21-1 CA21-2 CA21-3 CA21-4 CA21-5 CA21-6 *CA21-7
Description Lessee accounting and reporting. Lessor and lessee accounting and disclosure. Lessee capitalization criteria. Comparison of different types of accounting by lessee and lessor. Lessee capitalization of bargain-purchase option. Lease capitalization, bargain-purchase option. Sale-leaseback.
Level of Difficulty Moderate Moderate Moderate Moderate
Time (minutes) 15–25 25–35 20–30 15–25
Moderate Moderate Moderate
30–35 20–25 15–25
SOLUTIONS TO CODIFICATION EXERCISES CE21-1 Master Glossary (a)
A bargain-purchase option is a provision allowing the lessee, at his option, to purchase the leased property for a price that is sufficiently lower than the expected fair value of the property at the date the option becomes exercisable that exercise of the option appears, at lease inception, to be reasonably assured.
(b)
The incremental borrowing rate is the rate that, at lease inception, the lessee would have incurred to borrow over a similar term the funds necessary to purchase the leased asset. This definition does not proscribe the lessee’s use of a secured borrowing rate as its incremental borrowing rate if that rate is determinable, reasonable, and consistent with the financing that would have been used in the particular circumstances.
(c)
Estimated residual value is the estimated fair value of the leased property at the end of the lease term.
(d)
Unguaranteed residual value is the estimated residual value of the leased property exclusive of any portion guaranteed by the lessee or by a third party unrelated to the lessor. A guarantee by a third party related to the lessee shall be considered a lessee guarantee. If the guarantor is related to the lessor, the residual value shall be considered as unguaranteed.
CE21-2 According to FASB ASC 840-10-25-5 (Leases—Recognition): For a lessee, minimum lease payments comprise the payments that the lessee is obligated to make or can be required to make in connection with the leased property, excluding both of the following: (a)
Contingent rentals
(b)
Any guarantee by the lessee of the lessor’s debt and the lessee’s obligation to pay (apart from the rental payments) executory costs such as insurance, maintenance, and taxes in connection with the leased property.
CE21-3 According to FASB ASC 840-30-50-1 (Capital Leases—Disclosure): All of the following information with respect to capital leases shall be disclosed in the lessee’s financial statements or the footnotes thereto: (a)
The gross amount of assets recorded under capital leases as of the date of each balance sheet presented by major classes according to nature or function. This information may be combined with the comparable information for owned assets.
CE21-3 (Continued) (b)
Future minimum lease payments as of the date of the latest balance sheet presented, in the aggregate and for each of the five succeeding fiscal years, with separate deductions from the total for the amount representing executory costs, including any profit thereon, included in the minimum lease payments and for the amount of the imputed interest necessary to reduce the net minimum lease payments to present value (see paragraphs 840-30-30-1 through 30-4).
(c)
The total of minimum sublease rentals to be received in the future under noncancelable subleases as of the date of the latest balance sheet presented.
(d)
Total contingent rentals actually incurred for each period for which an income statement is presented.
CE21-4 According to FASB ASC 840-30-30-6 (Capital Leases—Initial Measurement): The lessor shall measure the gross investment in either a sales-type lease or direct financing lease initially as the sum of the following amounts: (a)
The minimum lease payments net of amounts, if any, included therein with respect to executory costs (such as maintenance, taxes, and insurance to be paid by the lessor) including any profit thereon.
(b)
The unguaranteed residual value accruing to the benefit of the lessor. The estimated residual value used to compute this amount shall not exceed the amount estimated at lease inception except as provided in paragraph 840-30-30-7.
ANSWERS TO QUESTIONS 1.
The major lessor groups in the United States are banks, captives, and independents. Captives have the point of sale advantage in finding leasing customers; that is, as soon as a parent receives a possible order, a lease financing arrangement can be developed by its leasing subsidiary. Furthermore, the captive (lessor) has the product knowledge which gives it an advantage when financing the parents’ product. The current trend is for captives to focus on the company’s products rather than to do general lease financings.
2.
(a) Possible advantages of leasing: 1. Leasing permits the write-off of the full cost of the assets (including any land and residual value), thus providing a possible tax advantage. 2. Leasing may be more flexible in that the lease agreement may contain less restrictive provisions than the bond indenture. 3. Leasing permits 100% financing of assets. 4. Leasing may permit more rapid changes in equipment, reduce the risk of obsolescence, and pass the risk in residual value to the lessor or a third party. 5. Leasing may have favorable tax advantages. 6. Potential of off-balance-sheet financing with certain types of leases. Assuming that funds are readily available through debt financing, there may not be great advantages (in addition to the above-mentioned) to signing a noncancelable, long-term lease. One of the usual advantages of leasing is its availability when other debt financing is unavailable. (b) Possible disadvantages of leasing: 1. In an ever-increasing inflationary economy, retaining title to assets may be desirable as a hedge against inflation. 2. Interest rates for leasing often are higher and a profit factor may be included in addition. 3. In some cases, owning the asset provides unique tax advantages, such as when bonus depreciation is permitted. (c) Since a long-term noncancelable lease which is used as a financing device generally results in the capitalization of the leased assets and recognition of the lease commitment in the balance sheet, the comparative effect is not very different from purchase and ownership. Assets leased under such terms would be capitalized at the present value of the future lease payments; this value is probably somewhat equivalent to the purchase price of the assets. Bonds sold at par would be nearly equivalent to the present value of the future lease payments; in neither case would interest be capitalized. The amounts presented in the balance sheet would be quite comparable as would the general classifications; the specific labels (leased assets and lease liability) would be different.
3.
Lessees have available two lease accounting methods: (a) the operating method and (b) the capital-lease method. Under the operating method, the leased asset remains the property of the lessor with the payment of a lease rental recognized as rental expense. Generally the lessor pays the insurance, taxes, and maintenance costs related to the leased asset. Under the capital-lease method, the lessee treats the lease transaction as if an asset were being purchased on credit; therefore, the lessee: (1) sets up an asset and a related liability and (2) recognizes depreciation of the asset, reduction of the liability, and interest expense.
Questions Chapter 21 (Continued) 4.
Ballard Company’s rental of warehousing space on a short-term and sporadic basis is seldom construed as the acquisition of an asset or even a financing arrangement. The contract consists mainly of services which are to be performed proportionately by the lessor and the lessee—the rent to be paid by the lessee is offset by the service to be performed by the lessor. While a case can be made for the existence of an acquisition of some property rights, the accounting treatment would be to record only the periodic rental payments as they are made and to allocate rent expense to the periods in which the benefits are received. No asset would be capitalized in this case, and a liability for lease payments would be recorded only to the extent that services received from the lessor exceeded the rentals paid; that is, the rent payment is overdue. This lease should be reported as an operating lease.
5.
Minimum rental payments are the periodic payments made by the lessee and received by the lessor. These payments may include executory costs such as maintenance, taxes, and insurance. Minimum lease payments are payments required or expected to be made by the lessee. They include minimum rental payments less executory costs, a bargain purchase option, a guaranteed residual value, and a penalty for failure to renew the lease. The present value of the minimum lease payments is capitalized by the lessee.
6.
The distinction between a direct-financing lease and a sales-type lease is the presence or absence of a manufacturer’s or dealer’s profit. A sales-type lease involves a manufacturer’s or dealer’s profit, and a direct-financing lease does not. The profit is the difference between the fair value of the leased property at the inception of the lease and the lessor’s cost or carrying value.
7.
Under the operating method, rent expense (and a compensating liability) accrues day by day to the lessee as the property is used. The lessee assigns rent to the periods benefiting from the use of the asset and ignores in the accounting any commitments to make future payments. Appropriate accruals are made if the accounting period ends between cash payment dates.
8.
Under the capital-lease method, the lessee treats the lease transactions as if the asset were being purchased on an installment basis: a financial transaction in which an asset is acquired and an liability is created. The asset and the liability are stated in the lessee’s balance sheet at the lower of: (1) the present value of the minimum lease payments (excluding executory costs) during the lease term or (2) the fair value of the leased asset at the inception of the lease. The present value of the lease payments is computed using the lessee’s incremental borrowing rate unless the implicit rate used by the lessor is lower and the lessee has knowledge of it. The effectiveinterest method is used to allocate each lease payment between a reduction of the lease obligation and interest expense. If the lease transfers ownership or contains a bargain-purchase option, the asset is depreciated in a manner consistent with the lessee’s normal depreciation policy on assets owned, using the economic life of the asset and allowing for salvage value. If the lease does not transfer ownership or contain a bargain-purchase option, the leased asset is amortized over the lease term.
9.
From the standpoint of the lessor, leases may be classified for accounting purposes as: (a) operating leases, (b) direct-financing leases, and (c) sales-type leases. From the standpoint of lessors, a capital lease meets one or more of the following four criteria: 1. The lease transfers ownership, 2. The lease contains a bargain-purchase option, 3. The lease term is equal to 75% or more of the estimated economic life of the property, 4. The present value of the minimum lease payments (excluding executory costs) equals or exceeds 90% of the fair value of the property. And meet both of the following criteria: 1. Collectibility of the payments required from the lessee is reasonably predictable, and
Questions Chapter 21 (Continued) 2.
No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor,
Capital leases are classified as direct-financing leases or sales-type leases. All other leases are classified as operating leases. The distinction for the lessor between a direct-financing lease and a sales-type lease is the presence or absence of a manufacturer’s or dealer’s profit or loss. 10. If the lease transaction satisfies the necessary criteria to be classified as a direct-financing lease, the lessor records a “lease receivable” for the leased asset. The lease receivable is the present value of the minimum lease payments. Minimum lease payments include the rental payments (excluding executory costs), bargain-purchase option (if any), guaranteed residual value (if any) and penalty for failure to renew (if any). In addition, the present value of the unguaranteed residual value (if any) must also be included. 11. Under the operating method, each rental receipt of the lessor is recorded as rent revenue on the use of an item carried as a fixed asset. The fixed asset is depreciated in the normal manner, with the depreciation expense of the period being matched against the rent revenue. The amount of revenue recognized in each accounting period is equivalent to the amount of rent receivable according to the provisions of the lease. In addition to the depreciation charge, maintenance costs and the cost of any other services rendered under the provisions of the lease that pertain to the current accounting period are charged against the recognized revenue. 12. Walker Company can use the sales-type lease method if at the inception of the lease a manufacturer’s or dealer’s profit (or loss) exists and the lease meets one or more of the following four criteria: (1) The lease transfers ownership of the property to the lessee, (2) The lease contains a bargain-purchase option, (3) The lease term is equal to 75% or more of the estimated economic life of the property leased, (4) The present value of the minimum lease payments (excluding executory costs) equals or exceeds 90% of the fair value of the leased property. Both of the following criteria must also be met: (1) Collectibility of the payments required from the lessee is reasonably predictable, and (2) No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor. 13. Metheny Corporation should recognize the difference between the fair value (normal sales price) of the leased property at the inception of the lease and its cost or carrying amount (book value) as gross profit in the period the sales-type lease begins and the assets are transferred to the lessee. The balance of the transaction is treated as a direct-financing lease (i.e., interest revenue is earned over the lease term). 14. The lease agreement between Alice Foyle, M.D. and Brownback Realty, Inc. appears to be in substance a purchase of property. Because the lease has a bargain-purchase option which transfers ownership of the property to the lessee, the lease is a capital lease. Additional evidence of the capital lease character is that the lessor recovers all costs plus a reasonable rate of return on investment. As a capital lease, the property and the related liability should be recorded at the discounted amount of the future lease payments with that amount being allocated between the land and the building in proportion to their fair values at the inception of the lease. The building should be depreciated over its estimated useful life. 15. (a) (1) The lessee’s accounting for a lease with an unguaranteed residual value is the same as the accounting for a lease with no residual value in terms of the computation of the minimum lease payments and the capitalized value of the leased asset and the lease liability. That is, unguaranteed residual values are not included in the lessee’s minimum lease payments.
Questions Chapter 21 (Continued) (2) A guaranteed residual value affects the lessee’s computation of the minimum lease payments and the capitalized amount of the leased asset and the lease liability. The capitalized value is affected initially by the presence of a guaranteed residual value since the present value of the lease liability is now made up of two components—the periodic lease payments and the guaranteed residual value. The amortization of the lease obligation will result in a lease liability balance at the end of the lease period which is equal to the guaranteed residual value. Upon termination of the lease, the lessee may recognize a gain or loss depending on the relationship between the actual residual value and the amount guaranteed. (b) (1) & (2)
The amount to be recovered by the lessor is the same whether the residual value is guaranteed or unguaranteed. Therefore, the amount of the periodic lease payments as set by the lessor is the same whether the residual value is guaranteed or unguaranteed.
16. If the estimate of the residual value declines, the lessor must recognize a loss to the extent of the decline in the period of the decline. Taken literally, the accounting for the entire transaction must be revised by the lessor using the changed estimate. The lease receivable is reduced by the amount of the decline in the estimated residual value. Upward adjustments of the estimated residual value are not made. 17. If a bargain-purchase option exists, the lessee must increase the present value of the minimum lease payments by the present value of the option price. A bargain purchase option also affects the depreciable life of the leased asset since the lessee must depreciate the asset over its economic life rather than the term of the lease. If the lessee fails to exercise the option, the lessee will recognize a loss to the extent of the net book value of the leased asset in the period that the option expired. 18. Initial direct costs are the incremental costs incurred by the lessor that are directly associated with negotiating, consummating and initially processing leasing transactions. For operating leases, the lessor should defer initial direct costs and allocate them over the lease term in proportion to the recognition of rent revenue. In a sales-type lease transaction, the lessor expenses the initial direct costs in the year of incurrence (i.e., the year in which profit on the sale is recognized). In a directfinancing lease, initial direct costs should be added to the net investment in the lease and amortized over the life of the lease as a yield adjustment. 19.
Lessees and lessors should disclose the future minimum rental payments required as of the date of the latest balance sheet presented, in the aggregate, and for each of the five succeeding fiscal years.
*20. The term “sale-leaseback” describes a transaction in which the owner of property sells such property to another and immediately leases it back from the new owner. The property is sold generally at a price equal to or less than current fair value and leased back for a term approximating the property’s useful life for lease payments sufficient to repay the buyer for the cash invested plus a reasonable return on the buyer’s investment. The purpose of the transaction is to raise money with certain property given as security. For accounting purposes the saleleaseback should be accounted for by the lessee as a capital lease if the criteria are satisfied and by the lessor as a purchase and a direct-financing lease if the criteria are satisfied. Any income or loss experienced by the seller-lessee from the sale of the assets that are leased back should be deferred and amortized over the lease term (or the economic life if either criteria (1) a bargainpurchase option or (2) a transfer of ownership occurs at the end of the lease is satisfied) in proportion to the amortization of the leased assets. Losses should be recognized immediately. Furthermore, minor leasebacks (present value of rentals less than 10% of fair value) should be reported as a sale with related gain recognition.
SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 21-1 The lease does not meet the transfer of ownership test, the bargain purchase test, or the economic life test [(5 years ÷ 8 years) < 75%]. However, it does pass the recovery of investment test. The present value of the minimum lease payments ($31,000 X 4.16986 = $129,266) is greater than 90% of the FV of the asset (90% X $138,000 = $124,200). Therefore, Callaway should classify the lease as a capital lease. BRIEF EXERCISE 21-2 Leased Equipment ......................................................... Lease Liability.........................................................
150,000
Lease Liability ................................................................ Cash.........................................................................
43,019
150,000 43,019
BRIEF EXERCISE 21-3 Interest Expense ............................................................ Interest Payable [($300,000 – $53,920) X 12%]......
29,530
Depreciation Expense.................................................... Accumulated Depreciation—Capital Leases ($300,000 X 1/8) .................................................
37,500
29,530
37,500
BRIEF EXERCISE 21-4 Interest Payable [($300,000 – $53,920) X 12%] ............. Lease Liability ................................................................ Cash.........................................................................
29,530 24,390 53,920
BRIEF EXERCISE 21-5 Rent Expense ................................................................. Cash.........................................................................
35,000 35,000
BRIEF EXERCISE 21-6 Lease Receivable (4.99271 X $30,044) ......................... Equipment ..............................................................
150,000
Cash ............................................................................... Lease Receivable ...................................................
30,044
150,000 30,044
BRIEF EXERCISE 21-7 Interest Receivable........................................................ Interest Revenue [($150,000 – $30,044) X 8%] .....
9,596 9,596
BRIEF EXERCISE 21-8 Cash ............................................................................... Rent Revenue.........................................................
15,000
Depreciation Expense ................................................... Accumulated Depreciation—Capital Leases ($80,000 X 1/8) ....................................................
10,000
15,000
10,000
BRIEF EXERCISE 21-9 Leased Equipment......................................................... Lease Liability ........................................................ *PV of rentals PV of guar. RV
$40,000 X 4.79079 $20,000 X 0.56447
202,921* 202,921
$191,632 11,289 $202,921
Lease Liability................................................................ Cash........................................................................
40,000 40,000
BRIEF EXERCISE 21-10 Lease Receivable ........................................................... Equipment ...............................................................
202,921
Cash ................................................................................ Lease Receivable....................................................
40,000
202,921 40,000
BRIEF EXERCISE 21-11 Lease Receivable ($40,800 X 4.03735) .......................... Sales Revenue ........................................................
164,724
Cost of Goods Sold........................................................ Inventory .................................................................
110,000
Cash ................................................................................ Lease Receivable....................................................
40,800
164,724 110,000 40,800
*BRIEF EXERCISE 21-12 Cash ................................................................................ Trucks...................................................................... Unearned Profit on Sale—Leaseback....................
33,000
Leased Equipment ......................................................... Lease Liability.........................................................
33,000*
28,000 5,000 33,000
*($8,705 X 3.79079; $1 difference due to rounding.) Depreciation Expense.................................................... Accumulated Depreciation—Capital Leases ($33,000 X 1/5) ....................................................
6,600
Unearned Profit on Sale—Leaseback ........................... Depreciation Expense ($5,000 X 1/5) .....................
1,000
Interest Expense ($33,000 X 10%) ................................. Lease Liability ................................................................ Cash.........................................................................
3,300 5,405
6,600 1,000
8,705
SOLUTIONS TO EXERCISES EXERCISE 21-1 (15–20 minutes) (a) This is a capital lease to Burke since the lease term (5 years) is greater than 75% of the economic life (6 years) of the leased asset. The lease term is 831/3% (5 ÷ 6) of the asset’s economic life. (b) Computation of present value of minimum lease payments: $8,668 X 4.16986* = $36,144 *Present value of an annuity due of 1 for 5 periods at 10%. (c) 1/1/14
12/31/14
1/1/15
Leased Equipment ................................. Lease Liability.................................
36,144
Lease Liability ........................................ Cash ................................................
8,668
Depreciation Expense............................ Accumulated Depreciation— Capital Leases ............................ ($36,144 ÷ 5 = $7,229)
7,229
Interest Expense .................................... Interest Payable.............................. [($36,144 – $8,668) X .10]
2,748
Lease Liability ........................................ Interest Payable ..................................... Cash ................................................
5,920 2,748
36,144 8,668
7,229
2,748
8,668
EXERCISE 21-2 (20–25 minutes) (a) To Delaney, the lessee, this lease is a capital lease because the terms satisfy the following criteria: 1. 2.
The lease term is greater than 75% of the economic life of the leased asset; that is, the lease term is 831/3 % (50/60) of the economic life. The present value of the minimum lease payments is greater than 90% of the fair value of the leased asset; that is, the present value of $8,555 (see below) is 98% of the fair value of the leased asset:
(b) The minimum lease payments in the case of a guaranteed residual value by the lessee include the guaranteed residual value. The present value therefore is: Monthly payment of $200 for 50 months........... $7,840 Residual value of $1,180..................................... 715 Present value of minimum lease payments ...... $8,555 (c) Leased Equipment..................................................... Lease Liability .....................................................
8,555
(d) Depreciation Expense ............................................... Accumulated Depreciation—Capital Leases ............................................................. [($8,555 – $1,180) ÷ 50 months = $148]
148
(e) Lease Liability............................................................ Interest Expense (1% X $8,555) ................................ Cash.....................................................................
114 86
8,555
148
200
EXERCISE 21-3 (20–30 minutes) Capitalized amount of the lease: Yearly payment Executory costs Minimum annual lease payment
$72,000 2,471 $69,529
EXERCISE 21-3 (Continued) Present value of minimum lease payments $69,529 X 6.32825 = $440,000* *rounded by $3. 1/1/14 1/1/14
12/31/14
12/31/14
1/1/15
12/31/15
12/31/15
Leased Buildings .............................. Lease Liability ...........................
440,000
Executory Costs................................. Lease Liability ................................... Cash ...........................................
2,471 69,529
Depreciation Expense ...................... Accumulated Depreciation— Capital Leases ....................... ($440,000 ÷ 10)
44,000
Interest Expense (See Schedule 1) ........................... Interest Payable.........................
440,000
72,000
44,000
44,457 44,457
Executory Costs ..................................... Interest Payable ................................ Lease Liability ................................... Cash ...........................................
2,471 44,457 25,072
Depreciation Expense ...................... Accumulated Depreciation— Capital Leases .......................
44,000
Interest Expense ............................... Interest Payable.........................
41,448
72,000
44,000 41,448
EXERCISE 21-3 (Continued) Schedule 1
Date 1/1/15 1/1/15 1/1/16 1/1/17
KIMBERLY-CLARK CORP. Lease Amortization Schedule (Lessee)
Annual Payment Less Executory Costs
Interest (12%) on Liability
$69,529 69,529 69,529
$
0 44,457 41,448
Reduction of Lease Liability
Lease Liability
$69,529 25,072 28,081
$440,000 370,471 345,399 317,318
EXERCISE 21-4 (20–25 minutes) Computation of annual payments Cost (fair value) of leased asset to lessor Less: Present value of salvage value (residual value in this case) $16,000 X .82645 (Present value of 1 at 10% for 2 periods) Amount to be recovered through lease payments
$160,000
13,223 $146,777
Two periodic lease payments $146,777 ÷ 1.73554*
$84,571
*Present value of an ordinary annuity of 1 for 2 periods at 10% CASTLE LEASING COMPANY (Lessor) Lease Amortization Schedule
Date 1/1/14 12/31/14 12/31/15
Annual Payment Less Executory Costs $84,571 84,571
Interest on Lease Receivable $16,000 9,142* $25,142
*Difference of $.1 due to rounding.
Recovery of Lease Receivable
Lease Receivable
$68,571 75,429
$160,000 91,429 16,000
EXERCISE 21-4 (Continued) (a) 1/1/14 12/31/14
12/31/15
(b) 12/31/15
Lease Receivable ...................... Equipment..........................
160,000
Cash ($84,571 + $5,000) ............ Executory Costs Payable........................... Lease Receivable............... Interest Revenue................
89,571
Cash ........................................... Executory Costs Payable........................... Lease Receivable............... Interest Revenue................
89,571
Cash ........................................... Lease Receivable...............
16,000
160,000
5,000 68,571 16,000
5,000 75,429 9,142 16,000
EXERCISE 21-5 (15–20 minutes) (a) Because the lease term is longer than 75% of the economic life of the asset and the present value of the minimum lease payments is more than 90% of the fair value of the asset, it is a capital lease to the lessee. Assuming collectibility of the rents is reasonably assured and no important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor, the lease is a direct financing lease to the lessor. The lessee should adopt the capital lease method and record the leased asset and lease liability at the present value of the minimum lease payments using the lessee’s incremental borrowing rate or the interest rate implicit in the lease if it is lower than the incremental rate and is known to the lessee. The lessee’s depreciation depends on whether ownership transfers to the lessee or if there is a bargain purchase option. If one of these conditions is fulfilled, amortization would be over the economic life of the asset. Otherwise, it would be depreciated over the lease term. Because both the economic life of the asset and the lease term are three years, the leased asset should be depreciated over this period.
EXERCISE 21-5 (Continued) The lessor should adopt the direct-financing lease method and replace the asset cost of $95,000 with Lease Receivable of $95,000. (See schedule below.) Interest would be recognized annually at a constant rate relative to the unrecovered net investment. Cost (fair value of leased asset) .............................................
$95,000
Amount to be recovered by lessor through lease payments..............................................................................
$95,000
Three annual lease payments: $95,000 ÷ 2.53130* ...............
$37,530
*Present value of an ordinary annuity of 1 for 3 periods at 9%. (b) Schedule of Interest and Amortization
1/1/14 12/31/14 12/31/15 12/31/16
Rent Receipt/ Payment
Interest Revenue/ Expense
Reduction of Principal
Receivable/ Liability
— $37,530 37,530 37,530
— $8,550* 5,942 3,098**
— $28,980 31,588 34,432
$95,000 66,020 34,432 0
*$95,000 X .09 = $8,550 **rounding difference EXERCISE 21-6 (15–20 minutes) (a) $35,013 X 5.7122* = $200,001 *Present value of an annuity due of 1 for 8 periods at 11%. (b) 1/1/14
1/1/14
Lease Receivable ............................... Cost of Goods Sold............................ Sales Revenue ............................ Inventory .....................................
200,001 160,000
Cash .................................................... Lease Receivable .......................
35,013
200,001 160,000 35,013
EXERCISE 21-6 (Continued) 12/31/14
Interest Receivable ............................ Interest Revenue......................... [($200,001 – $35,013) X .11]
18,149 18,149
EXERCISE 21-7 (20–25 minutes) (a) This is a capital lease to Flynn since the lease term is 75% (6 ÷ 8) of the asset’s economic life. In addition, the present value of the minimum lease payments is more than 90% of the fair value of the asset. This is a capital lease to Bensen since collectibility of the lease payments is reasonably predictable, there are no important uncertainties surrounding the costs yet to be incurred by the lessor, and the lease term is 75% of the asset’s economic life. Because the fair value of the equipment ($150,000) exceeds the lessor’s cost ($120,000), the lease is a salestype lease. (b) Computation of annual rental payment: $150,000 – ($10,000 .53464)* = $30,804 4.69590** *Present value of $1 at 11% for 6 periods. **Present value of an annuity due at 11% for 6 periods. (c) 1/1/14
Leased Equipment .............................. Lease Liability.............................. ($30,804 X 4.60478)***
141,846
Lease Liability ..................................... Cash .............................................
30,804
141,846
30,804
***Present value of an annuity due at 12% for 6 periods. 12/31/14
Depreciation Expense......................... Accumulated Depreciation— Capital Leases ......................... ($141,846 ÷ 6 years)
23,641
Interest Expense ................................. Interest Payable ........................... ($141,846 – $30,804) X .12
13,325
23,641
13,325
EXERCISE 21-7 (Continued) (d) 1/1/14
Lease Receivable ............................ Cost of Goods Sold......................... Sales Revenue ......................... Inventory ..................................
150,000* 114,654** 144,654*** 120,000
*($30,804 X 4.6959) + ($10,000 X .53464), rounded **$120,000 – ($10,000 X .53464) ***$30,804 X 4.6959, rounded
12/31/14
Cash ................................................. Lease Receivable ....................
30,804
Interest Receivable ......................... Interest Revenue ..................... [($150,000 – $30,804) X .11]
13,112
30,804 13,112
EXERCISE 21-8 (20–30 minutes) (a) The lease agreement has a bargain-purchase option and thus meets the criteria to be classified as a capital lease from the viewpoint of the lessee. Also, the present value of the minimum lease payments exceeds 90% of the fair value of the assets. (b) The lease agreement has a bargain-purchase option. The collectibility of the lease payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. The lease, therefore, qualifies as a capital-type lease from the viewpoint of the lessor. Due to the fact that the initial amount of lease receivable (net investment) (which in this case equals the present value of the minimum lease payments, $91,000) exceeds the lessor’s cost ($65,000), the lease is a sales-type lease. (c) Computation of lease liability: $21,227.65 Annual rental payment X 4.16986 PV of annuity due of 1 for n = 5, i = 10% $88,516.32 PV of periodic rental payments
EXERCISE 21-8 (Continued) $ 4,000.00 X .62092 $ 2,483.68
Bargain purchase option PV of 1 for n = 5, i = 10% PV of bargain-purchase option
$88,516.32 + 2,483.68 $91,000.00
PV of periodic rental payments PV of bargain-purchase option Lease liability RODE COMPANY (Lessee) Lease Amortization Schedule
Date 5/1/14 5/1/14 5/1/15 5/1/16 5/1/17 5/1/18 4/30/19
Annual Lease Payment Plus BPO $ 21,227.65 21,227.65 21,227.65 21,227.65 21,227.65 4,000.00 $110,138.25
Interest (10%) on Liability
Reduction of Lease Liability
$ 6,977.24 5,552.19 3,984.65 2,260.35 363.82* $19,138.25
$21,227.65 14,250.41 15,675.46 17,243.00 18,967.30 3,636.18 $91,000.00
Lease Liability $91,000.00 69,772.35 55,521.94 39,846.48 22,603.48 3,636.18 0
*Rounding error is 20 cents. (d) 5/1/14
12/31/14
Leased Equipment ..................... Lease Liability.....................
91,000.00
Lease Liability ............................ Cash ....................................
21,227.65
Interest Expense ........................ Interest Payable .................. ($6,977.24 X 8/12 = $4,651.49)
4,651.49
91,000.00 21,227.65 4,651.49
EXERCISE 21-8 (Continued)
1/1/15 5/1/15
12/31/15
12/31/15
Depreciation Expense................. Accumulated Depreciation— Capital Leases ................. ($91,000.00 ÷ 10 = $9,100.00; $9,100.00 X 8/12 = $6,066.67)
6,066.67
Interest Payable .......................... Interest Expense..................
4,651.49
Interest Expense ......................... Lease Liability ............................. Cash .....................................
6,977.24 14,250.41
Interest Expense ......................... Interest Payable................... ($5,552.19 X 8/12 = $3,701.46)
3,701.46
Depreciation Expense................. Accumulated Depreciation— Capital Leases ................. ($91,000.00 ÷ 10 years = $9,100.00)
9,100.00
6,066.67
4,651.49
21,227.65 3,701.46
9,100.00
(Note to instructor: Because a bargain-purchase option was involved, the leased asset is depreciated over its economic life rather than over the lease term.) EXERCISE 21-9 (20–30 minutes) Note: The lease agreement has a bargain-purchase option. The collectibility of the lease payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. The lease, therefore, qualifies as a capital lease from the viewpoint of the lessor. Due to the fact that the amount of the sale (which in this case equals the present value of the minimum lease payments, $91,000) exceeds the lessor’s cost ($65,000), the lease is a sales-type lease.
EXERCISE 21-9 (Continued) The minimum lease payments associated with this lease are the periodic annual rents plus the bargain purchase option. There is no residual value relevant to the lessor’s accounting in this lease. (a) The lease receivable is computed as follows: $21,227.65 X 4.16986 $88,516.32
Annual rental payment PV of an annuity due of 1 for n = 5, i = 10% PV of periodic rental payments
$ 4,000.00 X .62092 $ 2,483.68
Bargain purchase option PV of 1 for n = 5, i = 10% PV of bargain-purchase option
$88,516.32 + 2,483.68 $91,000.00
PV of periodic rental payments PV of bargain-purchase option Lease receivable at inception
(b)
MOONEY LEASING COMPANY (Lessor) Lease Amortization Schedule
Date 5/1/14 5/1/14 5/1/15 5/1/16 5/1/17 5/1/18 4/30/19
Annual Lease Payment Plus BPO $ 21,227.65 21,227.65 21,227.65 21,227.65 21,227.65 4,000.00 $110,138.25
Interest (10%) on Lease Receivable
$ 6,977.24 5,552.19 3,984.65 2,260.35 363.82* $19,138.25
*Rounding error is 20 cents.
Recovery of Lease Receivable $21,227.65 14,250.41 15,675.46 17,243.00 18,967.30 3,636.18 $91,000.00
Lease Receivable $91,000.00 69,772.35 55,521.94 39,846.48 22,603.48 3,636.18 0
EXERCISE 21-9 (Continued) (c) 5/1/14
12/31/14
5/1/15
12/31/15
5/1/16
12/31/16
Lease Receivable ...................... Cost of Goods Sold................... Sales Revenue ................... Inventory ............................
91,000.00 65,000.00
Cash ........................................... Lease Receivable ..............
21,227.65
Interest Receivable ................... Interest Revenue ............... ($6,977.24 X 8/12 = $4,651.49)
4,651.49
Cash ........................................... Lease Receivable .............. Interest Receivable............ Interest Revenue ............... ($6,977.24 – $4,651.49)
21,227.65
Interest Receivable ................... Interest Revenue ............... ($5,552.19 X 8/12 = $3,701.46)
3,701.46
Cash ........................................... Lease Receivable .............. Interest Receivable............ Interest Revenue ............... ($5,552.19 – $3,701.46)
21,227.65
Interest Receivable ................... Interest Revenue ............... ($3,984.65 X 8/12 = $2,656.43)
2,656.43
91,000.00 65,000.00 21,227.65 4,651.49
14,250.41 4,651.49 2,325.75
3,701.46
15,675.46 3,701.46 1,850.73
2,656.43
EXERCISE 21-10 (15–25 minutes) (a) Fair value of leased asset to lessor Less: Present value of unguaranteed residual value $43,622 X .56447 (present value of 1 at 10% for 6 periods) Amount to be recovered through lease payments
$245,000.00
24,623.31 $220,376.69
Six periodic lease payments $220,376.69 ÷ 4.79079*
$46,000.00**
*Present value of an annuity due of 1 for 6 periods at 10%. **Rounded to the nearest dollar. (b)
MORGAN LEASING COMPANY (Lessor) Lease Amortization Schedule
Date 1/1/14 1/1/14 1/1/15 1/1/16 1/1/17 1/1/18 1/1/19 12/31/19 (c) 1/1/14 1/1/114 12/31/14 1/1/15
12/31/15
Annual Lease Payment Plus URV $ 46,000 46,000 46,000 46,000 46,000 46,000 43,622 $319,622
Interest (10%) on Lease Receivable $ –0– 19,900 17,290 14,419 11,261 7,787 3,965 $74,622
Recovery of Lease Receivable
Lease Receivable $245,000 199,000 172,900 144,190 112,609 77,870 39,657 0
$ 46,000 26,100 28,710 31,581 34,739 38,213 39,657 $245,000
Lease Receivable ................................ Equipment....................................
245,000
Cash ..................................................... Lease Receivable.........................
46,000
Interest Receivable ............................. Interest Revenue..........................
19,900
Cash ..................................................... Lease Receivable......................... Interest Receivable......................
46,000
Interest Receivable ............................. Interest Revenue..........................
17,290
245,000 46,000 19,900 26,100 19,900 17,290
EXERCISE 21-11 (20–30 minutes) Note: This lease is a capital lease to the lessee because the lease term (five years) exceeds 75% of the remaining economic life of the asset (five years). Also, the present value of the minimum lease payments exceeds 90% of the fair value of the asset. $18,142.95 Annual rental payment X 4.16986 PV of an annuity due of 1 for n = 5, i = 10% $75,653.56 PV of minimum lease payments (a)
PLOTE COMPANY (Lessee) Lease Amortization Schedule
Date 1/1/14 1/1/14 1/1/15 1/1/16 1/1/17 1/1/18
Annual Lease Payment $18,142.95 18,142.95 18,142.95 18,142.95 18,142.95 $90,714.75
Interest (10%) on Liability
Reduction of Lease Liability
–0– 5,751.06 4,511.87 3,148.76 1,649.50* $15,061.19 $
$18,142.95 12,391.89 13,631.08 14,994.19 16,493.45 $75,653.56
Lease Liability $75,653.56 57,510.61 45,118.72 31,487.64 16,493.45 0
*Rounding error is 15 cents. (b) 1/1/14 1/1/14
Leased Equipment ...................... Lease Liability......................
75,653.56
Lease Liability ............................. Cash .....................................
18,142.95
75,653.56 18,142.95
During 2014 Insurance Expense ..................... Cash .....................................
900.00
Property Tax Expense ................ Cash .....................................
1,600.00
900.00 1,600.00
EXERCISE 21-11 (Continued) 12/31/14
1/1/15
Interest Expense ............................. Interest Payable .......................
5,751.06
Depreciation Expense..................... Accumulated Depreciation— Capital Leases ..................... ($75,653.56 ÷ 5 = $15,130.71)
15,130.71
Interest Payable............................... Interest Expense......................
5,751.06
Interest Expense ............................. Lease Liability ................................. Cash .........................................
5,751.06 12,391.89
5,751.06
15,130.71
5,751.06
18,142.95
During 2015
12/31/15
Insurance Expense ......................... Cash .........................................
900.00
Property Tax Expense..................... Cash .........................................
1,600.00
Interest Expense ............................. Interest Payable .......................
4,511.87
Depreciation Expense..................... Accumulated Depreciation— Capital Leases .....................
15,130.71
900.00 1,600.00 4,511.87
15,130.71
Note to instructor: 1. The lessor sets the annual rental payment as follows: Fair value of leased asset to lessor Less: Present value of unguaranteed residual value $7,000 X .62092 (present value of 1 at 10% for 5 periods) Amount to be recovered through lease payments Five periodic lease payments $75,653.56 ÷ 4.16986* *Present value of annuity due of 1 for 5 periods at 10%.
$80,000.00 4,346.44 $75,653.56 $18,142.95
EXERCISE 21-11 (Continued) 2.
The unguaranteed residual value is not subtracted when depreciating the leased asset.
EXERCISE 21-12 (10–20 minutes) (a) Entries for Doug Nelson are as follows: 1/1/14 12/31/14
Buildings ........................................ Cash ............................................
4,500,000
Cash ................................................ Rent Revenue .........................
275,000
Depreciation Expense.................... Accumulated Depreciation— Buildings............................. ($4,500,000 ÷ 50)
90,000
Property Tax Expense ................... Insurance Expense ........................ Cash ........................................
85,000 10,000
4,500,000 275,000
90,000
95,000
(b) Entries for Patrick Wise are as follows: 12/31/14
Rent Expense ................................. Cash ........................................
275,000 275,000
(c) The real estate broker’s fee should be capitalized and amortized equally over the 10-year period. As a result, real estate fee expense of $3,000 ($30,000 ÷ 10) should be reported in each period. EXERCISE 21-13 (15–20 minutes) (a) Annual rental revenue Less: maintenance and other executory costs Depreciation ($900,000 ÷ 8) Income before income tax
$210,000 25,000 112,500 $ 72,500
EXERCISE 21-13 (Continued) (b) Rent expense
$210,000
Note: Both the rent security deposit and the last month’s rent prepayment should be reported as a noncurrent asset. EXERCISE 21-14 (15–20 minutes) (a)
RUDY COMPANY Rent Expense For the Year Ended December 31, 2014 Monthly rental Lease period in 2014 (March–December)
(b)
$ 19,500 X 10 months $ 195,000
BARBARA BRENT INC. Income or Loss from Lease before Taxes For the Year Ended December 31, 2014 Rental revenue ($19,500 X 10 months) Less expense Depreciation Commission Income from lease before taxes
$195,000 $125,000* 6,250**
131,250 $ 63,750
*$1,500,000 cost ÷ 10 years = $150,000/year $150,000 X 10/12 = $125,000 **(Note to instructor: Under principles of accrual accounting, the commission should be amortized over the life of the lease: $30,000 ÷ 4 years = $7,500 X 10/12 = $6,250.)
*EXERCISE 21-15 (20–30 minutes) Elmer’s Restaurants (Lessee)* 1/1/14
Cash .................................................... Equipment ................................... Unearned Profit on Sale— Leaseback................................
680,000
Leased Equipment.............................. Lease Liability ............................. ($110,666.81 X 6.14457)
680,000
600,000 80,000 680,000
Throughout 2014 Executory Costs ................................. Accounts Payable (Cash) ........... 12/31/14
12/31/14
Unearned Profit on Sale— Leaseback ....................................... Depreciation Expense**.............. ($80,000 ÷ 10)
9,000 9,000 8,000 8,000
Depreciation Expense ........................ Accumulated Depreciation— Capital Leases......................... ($680,000 ÷ 10)
68,000
Interest Expense................................. Lease Liability..................................... Cash .............................................
68,000 42,667
68,000
110,667
*Lease should be treated as a capital lease because present value of minimum lease payments equals the fair value of the computer. Also, the lease term is greater than 75% of the economic life of the asset, and title transfers at the end of the lease. **The credit could also be to a revenue account.
*EXERCISE 21-15 (Continued) Note to instructor: 1.
The present value of an ordinary annuity at 10% for 10 periods should be used to capitalize the asset. In this case, Elmer’s Restaurants would use the implicit rate of the lessor because it is lower than its own incremental borrowing rate and known to Elmer’s Restaurants.
2.
The unearned profit on the sale-leaseback should be amortized on the same basis that the asset is being depreciated. Partial Lease Amortization Schedule
Date 1/1/14 12/31/14
Annual Lease Payment $110,667
Interest (10%) $68,000
Liquidity Finance Co. (Lessor)* 1/1/14 Equipment ................................ Cash ..................................
12/31/14
Amortization
Balance
$42,667
$680,000 637,333
680,000 680,000
Lease Receivable ..................... Equipment.........................
680,000
Cash.......................................... Lease Receivable ............. Interest Revenue ..............
110,667
680,000 42,667 68,000
*Lease should be treated as a direct financing lease because the present value of the minimum lease payments equals the fair value of the computer, and (1) collectibility of the payments is reasonably assured, (2) no important uncertainties surround the costs yet to be incurred by the lessor, and (3) the cost to the lessor equals the fair value of the asset at the inception of the lease.
*EXERCISE 21-16 (20–30 minutes) (a)
Sale-leaseback arrangements are treated as though two transactions were a single financing transaction if the lease qualifies as a capital lease. Any gain or loss on the sale is deferred and amortized over the lease term (if possession reverts to the lessor) or the economic life (if ownership transfers to the lessee). In this case, the lease qualifies as a capital lease because the lease term (10 years) is 83% of the remaining economic life of the leased property (12 years). Therefore, at 12/31/14, all of the gain of $120,000 ($520,000 – $400,000) would be deferred and amortized over 10 years. Since the sale took place on 12/31/14, there is no amortization for 2014.
(b)
A sale-leaseback is usually treated as a single financing transaction in which any profit on the sale is deferred and amortized by the seller. However, FASB 28 amends this general rule when either only a minor part of the remaining use of the property is retained, or more than a minor part but less than substantially all of the remaining use of property is retained. The first situation occurs when the present value of the lease payments is 10% or less of the fair value of the sale-leaseback property. The second situation occurs when the lease-back is more than minor but does not meet the criteria of a capital lease for all the property sold. (The second situation was not discussed in the text.) This problem is an example of the first situation because the present value of the lease payments ($35,000) is less than 10% of the fair value of the asset ($480,000). Under these circumstances the sale and the leaseback are accounted for as separate transactions. Therefore, the full gain ($480,000 – $420,000, or $60,000) is recognized.
(c)
The profit on the sale of $121,000 should be deferred and amortized over the lease term. Since the leased asset is being depreciated using the sum-of-the-years’ depreciation method, the deferred gain should also be reported in the same manner. Therefore, in the first year, $22,000 (10/55 X $121,000) of the gain would be recognized.
(d)
In this case, Sondgeroth would report a loss of $87,300 ($300,000 – $212,700) for the difference between the book value and lower fair value. The profession requires that when the fair value of the asset is less than the book value (carrying amount), a loss must be recognized immediately. In addition, rent expense of $72,000 should be reported.
TIME AND PURPOSE OF PROBLEMS Problem 21-1 (Time 20–25 minutes) Purpose—to develop an understanding of the accounting principles used in a sales-type lease for both the lessee and the lessor. The student is required to discuss the nature of the lease and make journal entries for both the lessee and the lessor. Problem 21-2 (Time 20–30 minutes) Purpose—to develop an understanding of the accounting treatment for operating leases. The student is required to identify the type of lease involved, explain the respective reasons for their classification, and discuss the accounting treatment that should be applied for both the lessee and lessor. The student is also asked to prepare the journal entries to reflect the first year of this lease contract for both the lessee and lessor and to discuss the disclosures required of the lessee and lessor. Problem 21-3 (Time 35–45 minutes) Purpose—to develop an understanding of the accounting procedures involved in a sales-type leasing arrangement. The student is required to discuss the nature of this lease transaction from the viewpoint of both the lessee and lessor. The student is also requested to prepare the journal entries to record the lease for both the lessee and lessor plus illustrate the items and amounts that would be reported on the balance sheet at the end of the first year for the lessee and the lessor. Problem 21-4 (Time 30–40 minutes) Purpose—to provide an understanding of how lease information is reported on the balance sheet and income statement for three different years in regard to the lessee. In addition, the year-end month is changed in order to help provide an understanding of the complications involved with partial periods. Problem 21-5 (Time 30–40 minutes) Purpose—to provide an understanding of how lease information is reported on the balance sheet and income statement for three different years in regard to the lessor. In addition, the year-end month is changed in order to help provide an understanding of the complications involved with partial periods. Problem 21-6 (Time 25–35 minutes) Purpose—to provide an understanding of the journal entries to be recorded by the lessee given a guaranteed residual value. Journal entries for two periods are required. Problem 21-7 (Time 25–30 minutes) Purpose—to develop an understanding of the accounting for a capital lease by the lessee in an annuity due arrangement. The student is required to prepare the lease amortization schedule for the entire term of the lease and all the necessary journal entries for the lease through the first two lease payments. The student is also asked to indicate the amounts that would be reported on the lessee’s balance sheet. Problem 21-8 (Time 20–30 minutes) Purpose—to develop an understanding of the accounting by the lessee for a capital lease. The student is required to explain the relationship between the capitalized amount of leased equipment and the leasing arrangement. The student is asked to prepare the lessee’s journal entries at the date of inception, for depreciation of the leased asset, and for the first lease payment, as well as to indicate the amounts that should be reported on the lessee’s balance sheet.
Time and Purpose of Problems (Continued) Problem 21-9 (Time 20–30 minutes) Purpose—to develop an understanding of the accounting for a capital lease by a lessee in an annuitydue arrangement. The student is required to prepare all the journal entries, with supportive computations, which the lessee would have made to record the lease for the first period of the lease. Problem 21-10 (Time 30–40 minutes) Purpose—to develop an understanding of the accounting treatment accorded a sales-type lease involving an unguaranteed residual value. The student is required to discuss the nature of the lease with regard to the lessor and to compute the lease receivable, the sales price, and the cost of sales. The student is also required to construct a 10-year lease amortization schedule for the leasing arrangement, and to prepare the lessor’s journal entries for the first year of the lease contract. Problem 21-11 (Time 30–40 minutes) Purpose—to develop an understanding of a capital lease with an unguaranteed residual value. The student explains why it is a capital lease and computes the amount of the initial liability. The student prepares a 10-year amortization schedule and all of the lessee’s journal entries for the first year. Problem 21-12 (Time 40–50 minutes) Purpose—to develop an understanding of the accounting for capital leases where the lease payments for the first half of the lease term differ from those for the latter half. The student is required to compute for the lessee the discounted present value of the leased property and the related liability at the lease’s inception date. The student is also asked to prepare journal entries for the lessee. Problem 21-13 (Time 30–40 minutes) Purpose—to develop an understanding of a sales-type lease with a guaranteed residual value. The student discusses the classification of the lease and computes the lease receivable at inception of lease, sales price, and cost of sales. The student prepares a 10-year amortization schedule and all of the lessor’s journal entries for the first year. Problem 21-14 (Time 30–40 minutes) Purpose—to develop an understanding of a capital lease with a guaranteed residual value. The student explains why it is a capital lease and computes the amount of the initial liability. The student prepares a 10-year amortization schedule and all of the lessee’s journal entries for the first year. Problem 21-15 (Time 30–40 minutes) Purpose—to develop a memo to your audit supervisor to discuss: (a) why you inspected the lease agreement, (b) what you determined about the lease, and (c) how you advised your client to account for the lease. As part of the discussion you are required to make the journal entry necessary to record the lease property. Problem 21-16 (Time 30–40 minutes) Purpose—to develop an understanding of how residual values affect the accounting for the lessee and the lessor. The student must understand both the accounting for a guaranteed and unguaranteed residual value and determine how large the residual value must be to have operating lease treatment.
SOLUTIONS TO PROBLEMS PROBLEM 21-1
(a) This is a capital lease to Jensen since the lease term is greater than 75% of the economic life of the leased asset. The lease term is 78% (7 ÷ 9) of the asset’s economic life. This is a capital lease to Glaus because collectibility of the lease payments is reasonably predictable, there are no important uncertainties surrounding the costs yet to be incurred by the lessor, and the lease term is greater than 75% of the asset’s economic life. Since the fair value ($700,000) of the equipment exceeds the lessor’s cost ($525,000), the lease is a sales-type lease. (b) Calculation of annual rental payment: $700,000 – ($100,000 X .51316)* = $121,130 5.35526**
*Present value of $1 at 10% for 7 periods. **Present value of an annuity due at 10% for 7 periods. (c) Computation of present value of minimum lease payments: PV of annual payments: $121,130 X 5.23054* = $633,575 PV of guaranteed residual value: $100,000 X .48166** = 48,166 $681,741 *Present value of an annuity due at 11% for 7 periods. **Present value of $1 at 11% for 7 periods. (d) 1/1/14
Leased Equipment .............................. Lease Liability..............................
681,741
Lease Liability ..................................... Cash .............................................
121,130
681,741
121,130
PROBLEM 21-1 (Continued) 12/31/14
1/1/15
12/31/15
(e) 1/1/14
12/31/14
1/1/15
12/31/15
Depreciation Expense.......................... Accumulated Depreciation— Capital Leases ($681,741 – $100,000) ÷ 7 .........
83,106
Interest Expense .................................. Interest Payable ($681,741 – $121,130) X .11 ......
61,667
Lease Liability ...................................... Interest Payable ................................... Cash ..............................................
59,463 61,667
Depreciation Expense.......................... Accumulated Depreciation— Capital Leases .........................
83,106
Interest Expense .................................. Interest Payable............................ [($681,741 – $121,130 – $59,463) X .11]
55,126
Lease Receivable ................................. Cost of Goods Sold.............................. Sales Revenue .............................. Inventory .......................................
700,000 525,000
Cash ...................................................... Lease Receivable .........................
121,130
Interest Receivable .............................. Interest Revenue [($700,000 – $121,130) X .10]....
57,887
Cash ...................................................... Lease Receivable ......................... Interest Receivable.......................
121,130
Interest Receivable .............................. Interest Revenue ($700,000 – $121,130 – $63,243) X .10 ................................
51,563
83,106
61,667
121,130
83,106 55,126
700,000 525,000 121,130
57,887 63,243 57,887
51,563
PROBLEM 21-2
(a) The lease is an operating lease to the lessee and lessor because: 1.
it does not transfer ownership,
2.
it does not contain a bargain-purchase option,
3.
it does not cover at least 75% of the estimated economic life of the crane, and
4.
the present value of the lease payments is not at least 90% of the fair value of the leased crane.
$33,000 Annual Lease Payments X PV of an annuity-due at 9% for 5 years $33,000 X 4.23972 = $139,910.76, which is less than $216,000.00 (90% X $240,000.00). At least one of the four criteria would have had to be satisfied for the lease to be classified as other than an operating lease. (b) Lessee’s Entries Rent Expense ............................................................ Cash ....................................................................
33,000
Lessor’s Entries Insurance Expense ................................................... Property Tax Expense .............................................. Maintenance and Repairs Expense ......................... Accounts Payable ..............................................
500 2,000 650
33,000
3,150
Depreciation Expense .............................................. Accumulated Depreciation—Capital Leases [($240,000 – $15,000) ÷ 12]............................
18,750
Cash........................................................................... Rent Revenue .....................................................
33,000
18,750 33,000
PROBLEM 21-2 (Continued) (c) Abriendo as lessee must disclose in the income statement the $33,000 of rent expense and in the notes the future minimum rental payments required as of January 1 (in total, $132,000) and for each of the succeeding four years: 2015—$33,000; 2016—$33,000; 2017—$33,000; 2018— $33,000. Nothing relative to this lease would appear on the lessee’s balance sheet. Cleveland as lessor must disclose in the balance sheet or in the notes the cost of the leased crane ($240,000) and the accumulated depreciation of $18,750 separately from assets not leased. Additionally, Cleveland must disclose in the notes the minimum future rentals as a total of $132,000, and for each of the succeeding four years: 2015—$33,000; 2016—$33,000; 2017—$33,000; 2018—$33,000. The income statement for the lessor reports rent revenue and expenses for insurance, taxes, maintenance, and depreciation expense.
PROBLEM 21-3
(a) The lease should be treated as a capital lease by Winston Industries requiring the lessee to capitalize the leased asset. The lease qualifies for capital lease accounting by the lessee because: (1) title to the engines transfers to the lessee, (2) the lease term is equal to the estimated life of the asset, and (3) the present value of the minimum lease payments exceeds 90% of the fair value of the leased engines. The transaction represents a purchase financed by installment payments over a 10-year period. For Ewing Inc. the transaction is a sales-type lease because a manufacturer’s profit accrues to Ewing. This lease arrangement also represents the manufacturer’s financing the transaction over a period of 10 years. Present Value of Lease Payments $413,971 X 7.24689* .................................................
$3,000,000
*Present value of an annuity due at 8% for 10 years, rounded by $2. Dealer Profit Sales (present value of lease payments).................... Less cost of engines.................................................... Profit on sale ................................................................ (b) Leased Equipment ........................................... Lease Liability ...........................................
3,000,000
(c) Lease Receivable ............................................. Cost of Goods Sold ......................................... Sales Revenue........................................... Inventory....................................................
3,000,000 2,600,000
$3,000,000 2,600,000 $ 400,000 3,000,000
3,000,000 2,600,000
(d) Lessee (January 1, 2014) Lease Liability .................................................. Cash ...........................................................
413,971
Lessor (January 1, 2014) Cash.................................................................. Lease Receivable ......................................
413,971
413,971
413,971
PROBLEM 21-3 (Continued) (e)
WINSTON INDUSTRIES Lease Amortization Schedule
Date 1/1/14 1/1/14 1/1/15 1/1/16
Annual Lease Receipt/ Payment
Interest on Receivable/ Liability at 8%
Reduction in Receivable/ Liability
$413,971 413,971 413,971
$ –0– 206,882 190,315
$413,971 207,089 223,656
Lease Receivable/ Liability $3,000,000 2,586,029 2,378,940 2,155,284
Lessee (December 31, 2014) Interest Expense ............................................... Interest Payable .........................................
206,882
Lessor (December 31, 2014) Interest Receivable ........................................... Interest Revenue ........................................
206,882
(f)
206,882
206,882
WINSTON INDUSTRIES Balance Sheet (Partial) December 31, 2014 Property, plant, and equipment: Leased property $3,000,000 Less accumulated depreciation— capital leases
300,000* $2,700,000
Current liabilities: Interest payable Lease liability Long-term liabilities: Lease liability (See schedule)
$ 206,882 207,089**
2,378,940***
*$3,000,000 ÷ 10 = $300,000 **($413,971 – $206,882) ***No portion of this amount paid within the next year. Note: The title Obligations under Capital Leases is often used instead of Lease liability.
PROBLEM 21-3 (Continued) EWING INC. Balance Sheet (Partial) December 31, 2014 Assets Current assets: Interest receivable...................................................... Lease receivable ........................................................
$ 206,882 207,089
Noncurrent assets: Lease receivable ........................................................
$2,378,940*
Note: The title Net Investment in leases is often shown instead of Lease receivable. *See balance on amortization schedule at 1/1/15.
PROBLEM 21-4
(a) 1.
$ 23,768 $ 5,500 $ 50,064
Interest expense (See amortization schedule) Lease executory expense Depreciation expense ($300,383 ÷ 6 = $50,064)
$ 38,932 $ 23,768
Current liabilities: Lease liability Interest payable
$198,751
Long-term liabilities: Lease liability
$300,383 ($50,064)
Property, plant, and equipment: Leased equipment Accumulated depreciation—capital leases
$ 19,875 $ 5,500 $ 50,064
Interest expense (See amortization schedule) Lease executory expense Depreciation expense ($300,383 ÷ 6 = $50,064)
$ 42,825 $ 19,875
Current liabilities: Lease liability Interest payable
$155,926
Long-term liabilities: Lease liability
$300,383 ($100,128)
Property, plant, and equipment: Leased Equipment Accumulated depreciation—capital leases
2.
3.
4.
(b) 1.
$ 5,942 $ 1,375 $ 12,516
Interest expense ($23,768 X 3/12 = $5,942) Lease executory expense ($5,500 X 3/12 = $1,375) Depreciation expense ($300,383 ÷ 6 = $50,064; $50,064 X 3/12 = $12,516)
PROBLEM 21-4 (Continued) 2. $ 38,932 $ 5,942
Current liabilities: Lease liability Interest payable
$198,751
Long-term liabilities: Lease liability
$300,383 ($12,516)
Property, plant, and equipment: Leased equipment Accumulated depreciation—capital leases
$ 3.
4,125
$ 22,795
Current assets: Prepaid lease executory costs ($5,500 X 9/12 = $4,125)
$ 5,500 $ 50,064
Interest expense [($23,768 – $5,942) + ($19,875 X 3/12) = $17,826 + $4,969 = $22,795] Lease executory expense Depreciation expense ($300,383 ÷ 6 = $50,064)
$ 42,825 $ 4,969
Current liabilities: Lease liability Interest payable ($19,875 X 3/12 = $4,969)
$155,926
Long-term liabilities: Lease liability
4.
$300,383 ($62,580)
Property, plant, and equipment: Leased equipment Accumulated depreciation—capital leases ($12,516 + $50,064 = $62,580)
$
Current assets: Prepaid lease executory costs ($5,500 X 9/12 = $4,125)
4,125
PROBLEM 21-5
(a) 1.
$ 23,768
2.
3.
Current assets: Lease receivable $38,932 Interest receivable $23,768
$198,751
Noncurrent assets: Lease receivable (net investment)
$ 19,875
Interest revenue
4.
(b) 1.
Current assets: Lease receivable $42,825 Interest receivable $19,875 $155,926
Noncurrent assets: Lease receivable (net investment)
$
Interest revenue ($23,768 X 3/12 = $5,942)
5,942
2.
Current assets: Lease receivable $38,932 Interest receivable $5,942 $198,751
3.
Interest revenue
$ 22,795
4.
Noncurrent assets: Lease receivable Interest revenue [($23,768 – $5,942) + ($19,875 X 3/12) = $17,826 + $4,969 = $22,795] Current assets: Lease receivable Interest receivable
$155,926
Noncurrent assets: Lease receivable
$42,825 $4,969
PROBLEM 21-6 Note: This lease is a capital lease to the lessee because the lease term (six years) exceeds 75% of the remaining economic life of the asset (six years). Also, the present value of the minimum lease payments exceeds 90% of the fair value of the asset. $ 124,798 X 4.60478 $ 574,668*
Annual rental payment PV of an annuity-due of 1 for n = 6, i = 12% PV of periodic rental payments
$ X $
50,000 .50663 25,332
Guaranteed residual value PV of 1 for n = 6, i = 12% PV of guaranteed residual value
$ 574,668* + 25,332 $ 600,000
PV of periodic rental payments PV of guaranteed residual value PV of minimum lease payments
(a)
VANCE COMPANY (Lessee) Lease Amortization Schedule
Date
Annual Lease Payment Plus GRV
Interest (12%) on Liability
Reduction of Lease Liability
1/1/14
Lease Liability $600,000
–0–
$124,798
475,202
124,798
57,024
67,774
407,428
1/1/16
124,798
48,891
75,907
331,521
1/1/17
124,798
39,783
85,015
246,506
1/1/18
124,798
29,581
95,217
151,289
1/1/19
124,798
18,155
106,643
44,646
12/31/19
50,000 $798,788
5,354* $198,788
44,646 $600,000
0
1/1/14
$124,798
1/1/15
*Rounding error is $1. **Rounding error is $3.
$
PROBLEM 21-6 (Continued) (b)
January 1, 2014 Leased Equipment.................................................. Lease Liability .................................................. Lease Liability......................................................... Cash..................................................................
600,000 600,000 124,798 124,798
During 2014 Executory Costs ..................................................... Cash..................................................................
5,000
December 31, 2014 Interest Expense ..................................................... Interest Payable ...............................................
57,024
Depreciation Expense ............................................ Accumulated Depreciation—Capital Leases ([$600,000 – $50,000] ÷ 6) ............... January 1, 2015 Interest Payable ...................................................... Interest Expense .............................................. Interest Expense ..................................................... Lease Liability......................................................... Cash..................................................................
5,000
57,024 91,667 91,667 57,024 57,024 57,024 67,774 124,798
During 2015 Executory Costs ..................................................... Cash..................................................................
5,000
December 31, 2015 Interest Expense ..................................................... Interest Payable ...............................................
48,891
Depreciation Expense ............................................ Accumulated Depreciation—Capital Leases ..........................................................
5,000
48,891 91,667 91,667
PROBLEM 21-6 (Continued) (Note to instructor: The guaranteed residual value was subtracted for purposes of determining the depreciable base. The reason is that at the end of the lease term, hopefully, this balance can offset the remaining lease obligation balance. To depreciate the leased asset to zero might lead to a large gain in the final years if the asset has a value at least equal to its guaranteed amount.)
PROBLEM 21-7
(a)
December 31, 2014 Leased Equipment.................................................. Lease Liability .................................................. (To record leased asset and related liability at the present value of 5 future annual payments of $40,000 discounted at 10%, $40,000 X 4.16986) December 31, 2014 Lease Liability......................................................... Cash.................................................................. (To record the first rental payment)
(b)
December 31, 2015 Depreciation Expense ............................................ Accumulated Depreciation—Capital Leases .......................................................... (To record depreciation of the leased asset based upon a cost to Ludwick of $166,794 and a life of 7 years) December 31, 2015 Interest Expense ..................................................... Lease Liability......................................................... Cash.................................................................. (To record annual payment on lease liability of which $12,679 represents interest at 10% on the unpaid principal of $126,794)
166,794 166,794
40,000 40,000
23,828 23,828
12,679 27,321 40,000
PROBLEM 21-7 (Continued) LUDWICK STEEL COMPANY (Lessee) Lease Amortization Schedule (Annuity Due Basis)
Date
Annual Lease Payment
Interest (10%) on Liability
Reduction of Lease Liability
Lease Liability
12/31/14
—
—
—
$166,794
12/31/14
$40,000
$
0
$40,000
126,794
12/31/15
40,000
12,679
27,321
99,473
12/31/16
40,000
9,947
30,053
69,420
12/31/17
40,000
6,942
33,058
36,362
12/31/18
40,000
3,638*
36,362
0
*Rounding error of $2 (c)
December 31, 2016 Depreciation Expense .............................................. Accumulated Depreciation—Capital Leases............................................................. (To record annual depreciation on assets leased) Interest Expense ....................................................... Lease Liability ........................................................... Cash .................................................................... (To record annual payment on lease liability of which $9,947 represents interest at 10% on the unpaid principal of $99,473)
23,828 23,828
9,947 30,053 40,000
PROBLEM 21-7 (Continued) (d)
LUDWICK STEEL COMPANY Balance Sheet (Partial) December 31, 2016 Property, plant, and equipment: Current liabilities: Leased equipment $166,794 Lease liability $33,058 Less: Accumulated Long-term liabilities: depreciation— Lease liability 36,362 capital leases 47,656 $119,138
PROBLEM 21-8
(a) The $550,000 is the present value of the five annual lease payments of $137,899 less the $6,000 attributable to the payment for taxes, insurance, and maintenance. In other words, it is the present value of five $131,899 payments to be made at the beginning of each year discounted at 10%, the lower of the implicit or incremental rates (since the lessee knows the implicit rate). The cost of taxes, insurance, and maintenance represents periodic services to be performed in the future by the lessor and should not be capitalized. The amount capitalized represents the completed service element by the lessor company in that it has made the property available; the taxes, insurance, and maintenance represent the uncompleted, unrendered services of the lessor. (b) Leased Equipment ................................................. Lease Liability ................................................. ($131,899 X Annuity Due Factor for 5 years at 10% = $131,899 X 4.16986 = $550,000)
550,000
Executory Costs .................................................... Lease Liability ........................................................ Cash .................................................................
6,000 131,899
(c) Depreciation Expense ........................................... Accumulated Depreciation—Capital Leases.......................................................... ($550,000 X 40% = $220,000)
220,000
(d) Interest Expense .................................................... Interest Payable .............................................. (See amortization schedule)
41,810
(e) Executory Costs .................................................... Interest Payable ..................................................... Lease Liability ........................................................ Cash .................................................................
6,000 41,810 90,089
550,000
137,899
220,000
41,810
137,899
PROBLEM 21-8 (Continued) CAGE COMPANY (Lessee) Lease Amortization Schedule
Date
Annual Lease Payment
Interest (10%) on Liability
Reduction of Lease Liability
1/1/14
Lease Liability $550,000
1/1/14
$131,899
$
–0–
$131,899
418,101
1/1/15
131,899
41,810
90,089
328,012
1/1/16
131,899
32,801
99,098
228,914
(f)
CAGE COMPANY Balance Sheet (Partial) December 31, 2014 Assets Property, plant, and equipment: Leased Equipment $550,000 Less: Accumulated depreciation— capital leases 220,000 $330,000
Liabilities Current: Interest payable Lease liability Noncurrent: Lease liability
*See Lease Amortization Schedule in part (e) above.
$ 41,810 90,089* 328,012
PROBLEM 21-9
Entries on August 1, 2014: (1) Leased Equipment ............................................. Lease Liability .............................................
2,845,263 2,845,263
Explanation and computation: This is a capital lease because the lease term exceeds 75% of the asset’s useful life. The leased computer and the related liability are recorded at the present value of the minimum lease payments, excluding the maintenance charge, as follows: ($40,000 – $3,000) X 76.899 = $2,845,263. (2) Maintenance and Repairs Expense ................ Lease Liability .................................................. Cash ...........................................................
3,000 37,000 40,000
Explanation: This entry is to record the August 1, 2014, first payment under the lease agreement. No interest is recognized on August 1 because the agreement began on that date. Cash payment includes $3,000 of maintenance cost. Entries on August 31, 2014: (1) Interest Expense .............................................. Interest Payable ........................................
28,083 28,083
Explanation and computation: Interest accrued on the unpaid balance of the lease liability from August 1 to August 31, 2014, is computed as follows: ($2,845,263 – $37,000) X .01 = $28,083. (2) Depreciation Expense ..................................... Accumulated Depreciation—Capital Leases....................................................
19,759 19,759
Explanation and computation: Depreciation is recorded for one month of the use of computer using the lease term: ($2,845,263 X 1/12 X 1/12 = $19,759).
PROBLEM 21-10
(a) The lease is a sales-type lease because: (1) the lease term exceeds 75% of the asset’s estimated economic life, (2) collectibility of payments is reasonably assured and there are no further costs to be incurred, and (3) George Company realized an element of profit aside from the financing charge. 1.
Present value of an annuity due of $1 for 10 periods discounted at 10%.................................... Annual lease payment .................................................... Present value of the 10 rental payments....................... Add present value of estimated residual value of $20,000 in 10 years at 10% ($20,000 X .38554) ...................................................... Lease receivable at inception ........................................
6.75902 X $ 40,000 270,361 7,711 $278,072
2.
Sales price is $270,361 (the present value of the 10 annual lease payments); or, the initial PV of $278,072 minus the PV of the unguaranteed residual value of $7,711.
3.
Cost of sales is $172,289 (the $180,000 cost of the asset less the present value of the unguaranteed residual value).
PROBLEM 21-10 (Continued) (b)
GEORGE COMPANY (Lessor) Lease Amortization Schedule Annuity Due Basis, Unguaranteed Residual Value Beginning of Year Initial PV 1 2 3 4 5 6 7 8 9 10 End of 10
Annual Lease Payment Plus Residual Value (a) $ 0 40,000 40,000 40,000 40,000 40,000 40,000 40,000 40,000 40,000 40,000 20,000 $420,000
Interest (10%) on Lease Receivable (b) $ 0 0 23,807 22,188 20,407 18,447 16,292 13,921 11,313 8,445 5,289 1,819* $141,928
Lease Receivable Recovery (c) $ 0 40,000 16,193 17,812 19,593 21,553 23,708 26,079 28,687 31,555 34,711 18,181 $278,072
Lease Receivable (d) $278,072 238,072 221,879 204,067 184,474 162,921 139,213 113,134 84,447 52,892 18,181 0
*Rounding error is $1.00. (a) (b) (c) (d)
Annual lease payment required by lease contract. Preceding balance of (d) X 10%, except beginning of first year of lease term. (a) minus (b). Preceding balance minus (c).
(c) Beginning of the Year Lease Receivable ................................................... Cost of Goods Sold ............................................... Sales Revenue................................................. Inventory.......................................................... (To record the sale and the cost of goods sold in the lease transaction) Selling Expenses ................................................... Cash ................................................................. (To record payment of the initial direct costs relating to the lease)
278,072 172,289 270,361 180,000
4,000 4,000
PROBLEM 21-10 (Continued) Cash............................................................................ Lease Receivable ................................................ (To record receipt of the first lease payment) End of the Year Interest Receivable .................................................... Interest Revenue ................................................. (To record interest earned during the first year of the lease)
40,000 40,000
23,807 23,807
PROBLEM 21-11
(a) The lease is a capital lease because: (1) the lease term exceeds 75% of the asset’s economic life and (2) the present value of the minimum lease payments exceeds 90% of the fair value of the leased asset. Initial Lease Liability: Minimum lease payments ($40,000) X PV of an annuity due for 10 periods at 10% (6.75902) ............... (b)
$270,361
NATIONAL AIRLINES (Lessee) Lease Amortization Schedule (Annuity-due basis and URV) Beginning of Year Initial PV 1 2 3 4 5 6 7 8 9 10
Annual Lease Payment (a) — $ 40,000 40,000 40,000 40,000 40,000 40,000 40,000 40,000 40,000 40,000 $400,000
Interest (10%) on Lease Liability (b) — — $ 23,036 21,340 19,474 17,421 15,163 12,680 9,948 6,942 3,635* $129,639
Reduction of Lease Liability (c) — $ 40,000 16,964 18,660 20,526 22,579 24,837 27,320 30,052 33,058 36,365 $270,361
Lease Liability (d) $270,361 230,361 213,397 194,737 174,211 151,632 126,795 99,475 69,423 36,365 0
*Rounding error is $1. (a) Annual lease payment required by lease contract. (b) Preceding balance of (d) X 10%, except beginning of first year of lease term. (c) (a) minus (b). (d) Preceding balance minus (c).
PROBLEM 21-11 (Continued) (c) Lessee’s journal entries: Beginning of the Year Leased Equipment.................................................. Lease Liability .................................................. (To record the lease of computer equipment using capital lease method) Lease Liability......................................................... Cash.................................................................. (To record the first rental payment) End of the Year Interest Expense ..................................................... Interest Payable ............................................... (To record accrual of annual interest on lease liability) Depreciation Expense ............................................ Accumulated Depreciation—Capital Leases .......................................................... (To record depreciation expense for first year [$270,361 ÷ 10])
270,361 270,361
40,000 40,000
23,036 23,036
27,036 27,036
PROBLEM 21-12 (a)
GRISHELL TRUCKING COMPANY Schedule to Compute the Discounted Present Value of Terminal Facilities and the Related Obligation January 1, 2014 Present value of first 10 payments: Immediate payment ...................................... Present value of an ordinary annuity for 9 years at 6% ($800,000 X 6.801692)........
$ 800,000 5,441,354
$6,241,354
Present value of last 10 payments: First payment of $320,000 ............................ 320,000 Present value of an ordinary annuity for 9 years at 6% ($320,000 X 6.801692) ........... 2,176,541 Present value of last 10 payments at January 1, 2022 ............................................ 2,496,541 Discount to January 1, 2014 ($2,496,541 X .558395) ..............................
1,394,056
Discounted present value of terminal facilities and related obligation................
$7,635,410
(Note to instructor: The student can compute the $6,241,354 by using the present value of an annuity due for 10 periods at 6% (7.80169 X $800,000 = $6,241,352; $2 rounding difference). For the last ten periods, the present value of an annuity due for 20 periods less the present value of an annuity due for 10 periods can be used as follows: ([12.15812 – 7.80169] X $320,000 = $1,394,058; $2 difference due to rounding.) (b)
GRISHELL TRUCKING COMPANY Journal Entries 2016 (1/1/16) Interest Payable ................................................. Lease Liability .................................................... Property Tax Expense ....................................... Insurance Expense ............................................ Cash .............................................................
384,480 415,520 125,000 23,000 948,000
PROBLEM 21-12 (Continued) Partial Amortization Schedule (Annuity-Due Basis)
Date 1/1/14 1/1/14 1/1/15 1/1/16 1/1/17
Lease Payment
Executory Costs
$
$ 0 148,000 148,000 148,000 148,000
0 948,000 948,000 948,000 948,000
Interest (6%) on Lease Liability $
0 0 408,000 384,480 359,549
(2) (12/31/16) Depreciation Expense ............................................ Accumulated Depreciation—Capital Leases .......................................................... (To record annual depreciation expense on leased assets) ($7,600,000 ÷ 40)
Reduction of Lease Liability
Lease Liability
$ 0 800,000 392,000 415,520 440,451
$7,600,000 6,800,000 6,408,000 5,992,480 5,552,029
190,000 190,000
Note: The leased asset is depreciated over its economic life because a bargain-purchase option is available at the end of the lease term. (3) (12/31/16) Interest Expense ..................................................... Interest Payable ............................................... (To record interest accrual at 6% on outstanding debt of $5,992,480)
359,549 359,549
PROBLEM 21-13
(a) The noncancelable lease is a sales-type capital lease because: (1) the lease term is for 83% (10 ÷ 12) of the economic life of the leased asset, (2) the present value of the minimum lease payments exceeds 90% of the fair value of the leased property, (3) the collectibility of the lease payments is reasonably predictable and no uncertainties exist as to unreimbursable costs yet to be incurred by the lessor, and (4) the lease provides the lessor with manufacturer’s profit in addition to interest revenue. 1.
2. 3.
Lease Receivable: Present value of annual payments of $60,000 made at the beginning of each period for 10 years, $60,000 X 6.75902 (PV of an annuity due @ 10%) ........
$405,541
Present value of guaranteed residual value, $15,000 X .38554............................................................. Present value of minimum lease payments..............
5,783 $411,324
Sales price is the same as the present value of minimum lease payments..............................................
$411,324
Cost of sales is the cost of manufacturing the x-ray machine.................................................................
$250,000
PROBLEM 21-13 (Continued) (b)
AMIRANTE INC. (Lessor) Lease Amortization Schedule (Annuity due basis, guaranteed residual value) Beginning of Year Initial PV 1 2 3 4 5 6 7 8 9 10 End of 10
Annual Lease Payment Plus Residual Value (a) — $ 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 15,000 $615,000
Interest (10%) on Lease Receivable (b) — — $ 35,132 32,646 29,910 26,901 23,591 19,950 15,945 11,540 6,694 1,367* $203,676
Recovery of Lease Receivable (c) — $ 60,000 24,868 27,354 30,090 33,099 36,409 40,050 44,055 48,460 53,306 13,633 $411,324
Lease Receivable (d) $411,324 351,324 326,456 299,102 269,012 235,913 199,504 159,454 115,399 66,939 13,633 0
*Rounding error is $4.00. (a) (b) (c) (d)
Annual lease payment required by lease contract. Preceding balance of (d) X 10%, except beginning of first year of lease term. (a) minus (b). Preceding balance minus (c).
(c) Lessor’s journal entries: Beginning of the Year Lease Receivable.................................................... Cost of Goods Sold ................................................ Sales Revenue ................................................. Inventory .......................................................... Selling Expenses .................................................... Accounts Payable ............................................ (To record the incurrence of initial direct costs relating to the lease)
411,324 250,000 411,324 250,000 14,000 14,000
PROBLEM 21-13 (Continued) Cash........................................................................... Lease Receivable ............................................... (To record receipt of the first lease payment) End of the Year Interest Receivable ................................................... Interest Revenue ................................................ (To record interest earned during the first year of the lease)
60,000 60,000
35,132 35,132
PROBLEM 21-14
(a) The noncancelable lease is a capital lease because: (1) the lease term is for 83% (10 ÷ 12) of the economic life of the leased asset and (2) the present value of the minimum lease payments exceeds 90% of the fair market value of the leased asset. Initial Lease Liability: PV of lease payments, $60,000 X 6.75902 ....................... PV of guaranteed residual value, $15,000 X .38554 ........ Initial lease liability ........................................................... (b)
$405,541 5,783 $411,324
CHAMBERS MEDICAL (Lessee) Lease Amortization Schedule (Annuity-Due Basis, GRV) Beginning of Year Initial PV 1 2 3 4 5 6 7 8 9 10 End of 10
Annual Lease Payment Plus GRV (a) $ 0 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 15,000 $615,000
Interest (10%) on Unpaid Liability (b) $ 0 0 35,132 32,646 29,910 26,901 23,591 19,950 15,945 11,540 6,694 1,367* $203,676
Reduction of Lease Liability (c) $ 0 60,000 24,868 27,354 30,090 33,099 36,409 40,050 44,055 48,460 53,306 13,633 $411,324
Lease Liability (d) $411,324 351,324 326,456 299,102 269,012 235,913 199,504 159,454 115,399 66,939 13,633 0
*Rounding error is $4. (a) Annual lease payment required by lease contract. (b) Preceding balance of (d) X 10%, except beginning of first year of lease term. (c) (a) minus (b). (d) Preceding balance minus (c).
PROBLEM 21-14 (Continued) (c) Lessee’s journal entries: Beginning of the Year Leased Equipment ................................................. Lease Liability ................................................. (To record the lease of x-ray equipment using capital lease method) Lease Liability ........................................................ Cash ................................................................. (To record payment of annual lease obligation) End of the Year Interest Expense .................................................... Interest Payable .............................................. (To record accrual of annual interest on lease obligation) Depreciation Expense ........................................... Accumulated Depreciation—Capital Leases.......................................................... (To record depreciation expense for year 1 using straight-line method [($411,324 – $15,000) ÷ 10 years])
411,324 411,324
60,000 60,000
35,132 35,132
39,632 39,632
PROBLEM 21-15
Memorandum Prepared by: Date:
(Your Initials)
HOCKNEY, INC. December 31, 2014 Reclassification of Leased Auto As a Capital Lease While performing a routine inspection of the client’s garage, I found a used automobile which was not listed among the company’s assets in the equipment subsidiary ledger. I asked Stacy Reeder, plant manager, about the vehicle, and she indicated that because it was only being leased, it was not listed along with other company assets. Having accounted for this agreement as an operating lease, Hockney, Inc. had charged $3,240 to 2014 rent expense. Examining the noncancelable lease agreement entered into with Crown New and Used Cars on January 1, 2014, I determined that the automobile should be capitalized because its lease term (4 years) is greater than 75% of its useful life (5 years). I advised the client to capitalize this lease at the present value of its minimum lease payments: $10,731 (the present value of the monthly payments), plus $809 (the present value of the guaranteed residual). The following journal entry was suggested: Leased Equipment ............................................................. 11,540 Lease Liability ($10,731 + $809) .............................
11,540
To account for the first year’s payments as well as to reverse the original entries, I advised the client to make the following entry: Lease Liability................................................................ Interest Expense (8% X $11,540) .................................. Rent Expense ..........................................................
2,317 923 3,240
PROBLEM 21-15 (Continued) Finally, this vehicle must be depreciated over its lease term. Using straightline, I computed annual depreciation of $2,610 (the capitalized amount, $11,540, minus the guaranteed residual, $1,100, divided by the 4 year lease term). The client was advised to make the following entry to record 2014 depreciation: Depreciation Expense ................................................... Accumulated Depreciation—Capital Leases.........
2,610 2,610
PROBLEM 21-16
(a) The lease agreement satisfies both the 75% of useful life and 90% of fair value requirements, collectibility is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. For the lessee, it is a capital lease, and for the lessor, it is a direct-financing lease (since cost equals fair value). (b)
January 1, 2014 Lessee: Leased Equipment.................................................. Lease Liability .................................................. ($30,300 X 6.99525= $211,956 $20,000 X .42241= 8,448 = $220,404) Lease Liability......................................................... Cash..................................................................
220,404 220,404
30,300 30,300
January 1, 2014 Lessor: Lease Receivable.................................................... Equipment ........................................................
220,404
Cash......................................................................... Lease Receivable .............................................
30,300
220,404 30,300
December 31, 2014 Lessee: Interest Expense ..................................................... Interest Payable [($220,404 – $30,300) X .09] ......................... Depreciation Expense ............................................ Accumulated Depreciation—Capital Leases [($220,404 – $20,000) ÷ 10] ..........................
17,109 17,109 20,040 20,040
PROBLEM 21-16 (Continued) December 31, 2014 Lessor: Interest Receivable ................................................... Interest Revenue ................................................
17,109 17,109
(c) (1) and (2) are both $211,956, as the lessee has no obligation to pay the residual value. (d) (1) and (2) are both $220,404, as residual value exists whether or not it is guaranteed. (e) Since 90% of $220,404 is $198,364, the difference of $22,040 is the present value of the residual value. The future value of $22,040 for n = 10, i = .09 is $52,177 ($22,040 X 2.36736). Therefore, the residual value would have had to be greater than $52,177.
TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 21-1 (Time 15–25 minutes) Purpose—to provide the student with an understanding of the theoretical reasons for requiring certain leases to be capitalized by the lessee and how a capital lease is recorded at its inception and how the amount to be recorded is determined. The student explains how to determine the lessee’s expenses during the first year and how the lessee will report the lease on the balance sheet at the end of the first year. CA 21-2 (Time 25–35 minutes) Purpose—to provide an understanding of the factors underlying the accounting for a leasing arrangement from the point of view of both the lessee and lessor. The student is required to determine the classification of this leasing arrangement, the appropriate accounting treatment which should be accorded this lease, and the financial statement disclosure requirements for both the lessee and lessor. CA 21-3 (Time 20–30 minutes) Purpose—to provide the student with an understanding of the classification of three leases. The student determines how the lessee should classify each lease, what amount should be recorded as a liability at the inception of each lease, and how the lessee should record each minimum lease payment for each lease. CA 21-4 (Time 15–25 minutes) Purpose—to provide the student with an assignment to describe: (a) the accounting for a capital lease both at inception and during the first year and (b) the accounting for an operating lease. The student is also required to compare and contrast a sales-type lease with a direct-financing lease. CA 21-5 (Time 30–35 minutes) Purpose—to provide the student with a lease situation containing a bargain-purchase option and both an implicit rate and a stated interest rate between which the student must choose. The student is required to compute the appropriate amount at which to capitalize the lease and, in a second requirement, given different interest rates, to prepare the balance sheet and income statement presentation of this lease by the lessee. CA 21-6 (Time 20–25 minutes) Purpose—to provide the student with a lease arrangement with a bargain-purchase option in order to examine the ethical issues of lease accounting. *CA 21-7 (Time 15–25 minutes) Purpose—to provide the student with an assignment to discuss the theoretical justification for lease capitalization. In addition, the student is required to discuss the accounting issues related to a saleleaseback.
SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 21-1 (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.
(b)
Evans 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.
(c)
Evans 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 at the beginning of the period. In addition, Evans will incur an expense relating to depreciation of the capitalized cost of the leased asset. This depreciation should be based on the estimated useful life of the leased asset and depreciated in a manner consistent with Evans’ normal depreciation policy for owned assets.
(d)
The asset recorded under the capital lease and the accumulated depreciation should be classified on Evans’ December 31, 2014, balance sheet as noncurrent and should be separately identified by Evans in its balance sheet or footnotes thereto. The related obligation recorded under the capital lease should be reported on Evans’ December 31, 2014, balance sheet appropriately classified into current and noncurrent liabilities categories and should be separately identified by Evans in its balance sheet.
CA 21-2 (a)
(1) 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, Sylvan should record this as a capital lease. (2)
Since the given facts state that Sylvan (lessee) does not have access to information that would enable determination of Breton Leasing Corporation’s (lessor) implicit rate for this lease, Sylvan should determine the present value of the minimum lease payments using the incremental borrowing rate (10 percent). This is the rate that Sylvan would have to pay for a like amount of debt obtained through normal third party sources (bank or other direct financing).
(3)
The amount recorded as an asset on Sylvan’s books should be shown in the fixed assets section of the balance sheet as “Leased Equipment” or another similar title. Of course, at the same time as the asset is recorded, a corresponding liability (“Lease Liability” or similar titles) 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 cost of the lease is matched with revenue through depreciation taken on the machine over the life of the lease. Since ownership of the machine is not expressly conveyed to Sylvan in the terms of the lease at its inception, the term of the lease is the appropriate depreciable life. 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
CA 21-2 (Continued) represents a fixed interest rate applied to the declining balance of the debt. Executory costs (such as insurance, maintenance, or taxes) paid by Sylvan are charged to an appropriate expense, accrual, or deferral account as incurred or paid. (4)
(b)
For this lease, Sylvan must disclose the future minimum lease payments in the aggregate and for each of the succeeding fiscal years (not to exceed five), with a separate deduction for the total amount for imputed interest necessary to reduce the net minimum lease payments to the present value of the liability (as shown on the balance sheet).
(1) Based on the given facts, Breton 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 arrangement, collectibility of minimum lease payments is reasonably assured, and there are no important uncertainties surrounding unreimbursable costs to be paid by the lessor. (2)
Breton should record a Lease Receivable for the present value of the minimum lease payments and the present value of the residual value. It should also remove the machine from the books by a credit to the applicable asset account.
(3)
During the life of the lease, Breton will record payments received as a reduction in the receivable. Interest is recognized as interest revenue by applying the implicit interest rate to the declining balance of the lease receivable. The implicit rate is the rate of interest that 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 income recognition is termed the effective interest method of amortization. In this case, Breton will use the 9% implicit rate.
(4)
Breton must make the following disclosures with respect to this lease: (a) The components of the lease receivable 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, and (3) the amounts of unearned interest 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 balance sheet presented.
CA 21-3 (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 GAAP for classifying a lease as a capital lease. Lease L 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 M should be classified as a capital lease because the lease contains a bargain-purchase option. Lease N 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.
CA 21-3 (Continued) (b)
For Lease L, Santiago 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 the minimum lease payments during the lease term. This amount excludes 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 M, Santiago Company should record as a liability at the inception of the lease an amount determined in the same manner as for Lease L, and the payment called for in the bargain-purchase option should be included in the minimum lease payments at its present value. For Lease N, Santiago Company should not record a liability at the inception of the lease.
(c)
For Lease L, Santiago 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 M, Santiago Company should allocate each minimum lease payment in the same manner as for Lease L. For Lease N, Santiago Company should charge minimum lease (rental) payments to rental expense as they become payable.
CA 21-4 Part 1 (a)
A lessee would account for a capital lease as an asset and a liability at the inception of the lease. Rental payments during the year would be allocated between a reduction in the liability and interest expense. The asset would be amortized in a manner consistent with the lessee’s normal depreciation policy for owned assets, except that in some circumstances, the period of amortization would be the lease term.
(b)
No asset or liability would be recorded at the inception of the lease. Normally, rent on an operating lease would be charged to expense over the lease term as it becomes payable. If rent payments are not made on a straight-line basis, rent 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 lease receivable in the lease is the same for both a sales-type and a direct-financing lease. The lease receivable is the present value of 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 present value of the unguaranteed residual value accruing to the benefit of the lessor.
(b)
For both a sales-type lease and a direct-financing lease, the interest revenue is recognized over the lease term by use of the interest method to produce a constant periodic rate of return on the lease receivable. However, other methods of income recognition may be used if the results obtained are not materially different from the interest method.
CA 21-4 (Continued) (c)
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.
CA 21-5 (a)
The appropriate amount for the leased aircraft on Albertsen Corporation’s balance sheet after the lease is signed is $1,000,000, the fair value of the plane. In this case, fair value is less than the present value of the net rental payments plus purchase option ($1,022,226). When this occurs, the asset is recorded at the fair value.
(b)
The leased aircraft will be reflected on Albertsen Corporation’s balance sheet as follows: Noncurrent assets Leased equipment ................................................................................ Less: Accumulated depreciation—capital leases................................... Current liabilities Interest payable .................................................................................... Lease liability (Note A) .......................................................................... Noncurrent liabilities Lease liability (Note A) ..........................................................................
$1,000,000 61,667 $ 938,333 $
77,600 60,180 $ 137,780 $ 802,040
The following items relating to the leased aircraft will be reflected on Albertsen Corporation’s income statement: Depreciation expense (Note A) ............................................................. $61,667 Interest expense ................................................................................... 77,600 Maintenance and repairs expense ........................................................ 6,900 Insurance and property tax expense ..................................................... 4,000 Note A The company leases a Viking turboprop aircraft under a capital lease. The lease runs until December 31, 2023. The annual lease payment is paid in advance on January 1 and amounts to $141,780, of which $4,000 is for insurance and property taxes. The aircraft is being depreciated on the straight-line basis over the economic life of the asset. The depreciation on the aircraft included in the current year’s depreciation expense and the accumulated depreciation on the aircraft amount to $61,667.
CA 21-5 (Continued) Computations Depreciation expense: Capitalized amount .................................................................... Less: Salvage value ..................................................................
$1,000,000 75,000 $ 925,000
Economic life..............................................................................
15 years
Annual depreciation ...................................................................
$61,667
Liability amounts: Lease liability 1/1/14.................................................................... Less: Payment 1/1/14 ................................................................ Lease liability 12/31/14................................................................ Less: Lease payment due 1/1/15 ............................................... Interest on lease ($862,220 X .09)............................................... Reduction of principal .................................................................. Noncurrent liability 12/31/14 ........................................................
$1,000,000 137,780 862,220 $137,780 (77,600) (60,180) $ 802,040
CA 21-6 (a)
The ethical issues are fairness and integrity of financial reporting versus profits and possibly misleading financial statements. On one hand, if Buchanan can substantiate her position, it is possible that the agreement should be considered an operating lease. On the other hand, if Buchanan cannot or will not provide substantiation, she would appear to be trying to manipulate the financial statements for some reason, possibly debt covenants or minimum levels of certain ratios.
(b)
If Buchanan has no particular expertise in copier technology, she has no rational case for her suggestion. If she has expertise, then her suggestion may be rational and would not be merely a means to manipulate the balance sheet to avoid recording a liability.
(c)
Suffolk must decide whether the situation presents a legitimate difference of opinion where professional judgment could take the answer either way or an attempt by Buchanan to mislead. Suffolk must decide whether he wishes to argue with Buchanan or simply accept Buchanan’s position. Suffolk should assess the consequences of both alternatives. Suffolk might conduct further research regarding copier technology before reaching a decision.
*CA 21-7 (a)
The economic effect of a long-term capital lease on the lessee is similar to that of an installment purchase. Such a lease transfers substantially all of the benefits and risks incident to the ownership of property to the lessee. Therefore, the lease should be capitalized.
(b)
(1) Perriman should account for the sale portion of the sale-leaseback transaction at January 1, 2014, by recording cash for the sale price, decreasing equipment at the undepreciated cost (net carrying amount) of the equipment, and establishing a deferred gain on sale-leaseback for the excess of the sale price of the equipment over its undepreciated cost (net carrying amount).
*CA 21-7 (Continued) (2) Perriman should account for the leaseback portion of the sale-leaseback transaction at January 1, 2014, by recording both an asset and a liability 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 the payments representing executory costs, together with any profit. However, if the present value exceeds the fair value of the leased equipment at January 1, 2014, the amount recorded for the asset and liability should be the equipment’s fair value. (c)
The deferred gain should be amortized over the lease term or life of the asset, whichever is appropriate. During the first year of the lease, the amortization will be an amount proportionate to the amortization of the asset. This deferral and amortization method for a sale-leaseback transaction is required because the sale and the leaseback are two components of a single transaction rather than two independent transactions. Because of this interdependence of the sale and leaseback portions of the transaction, the gain (unearned profit) should be deferred and amortized over the lease term.
FINANCIAL REPORTING PROBLEM (a) In P&G’s Management’s Discussion and Analysis (under Contractual Commitments), both capital leases and operating leases are disclosed. (b) P&G reported (note 4) capital leases of $407 million in total, and $46 million for less than 1 year (see Contractual Commitments under Management’s Discussion and Analysis). (c) P&G disclosed future minimum rental commitments under noncancelable operating leases in excess of one year as of June 30, 2011, of: 2012—$264 million 2013—$224 million 2014—$192 million 2015—$173 million 2016—$141 million 2017 and beyond—$505 million Note to instructor: The notes to the financial statements and MD&A are not included in Appendix 5B. It can be accessed at the KWW website or at P&G’s corporate site.
COMPARATIVE ANALYSIS CASE (a) Southwest uses both capital leases and long-term operating leases. Southwest primarily leases aircraft and terminal space. (b) Southwest has some long-term leases that don’t expire until after 2016. In many cases the leases can be renewed and most aircraft leases have purchase options. (c) Future minimum commitments under noncancelable leases are set forth below (in millions):
2012 .................................................... 2013 .................................................... 2014 .................................................... 2015 .................................................... 2016 .................................................... Later years .........................................
Capital
Operating
$6 6 6 6 6 26 $56
$ 640 717 642 579 489 2,516 $5,583
(d) At year-end 2011, the present value of minimum lease payments under capital leases was $42 million. Imputed interest deducted from the future minimum annual rental commitments was $14 million. (e) The details of rental expense are set forth below:
(f)
2011
2010
2009
$847
$631
$596
The main difference between Southwest and UAL is that UAL is leasing more types of assets compared to Southwest. In addition to aircraft and terminal space, UAL is leasing aircraft hangars, maintenance facilities, real estate, office and computer equipment, and vehicles.
FINANCIAL STATEMENT ANALYSIS CASE ($ millions) (a) The total obligations under capital leases at 1/31/2012 for Walmart Company is $3,335 (the present value of the future lease payments). (b) The total rental expense for Walmart in fiscal 2011 (ending 1/31/2012) was $2.4 billion. (c) To estimate the present value of the operating leases, the same portion of interest to net minimum lease payments under capital leases must be determined. For example, the following proportion for capital leases as of January 31, 2012, is 43.3% or ($2,550/$5,885). The total payments under operating leases are $16,415 and, therefore, the amount representing interest might be estimated to be $7,108 ($16,415 X 43.3%). Thus, the present value of the net operating payments might be $9,307.
FINANCIAL STATEMENT ANALYSIS CASE (Continued) Total operating lease payments due ................................ Less estimated interest ..................................................... Estimated present value of net operating lease payments ..............................................................
$16,415 7,108 $9,307
This answer is an approximation. This answer is somewhat incorrect because the proportion of payments after five years may be different between an operating and capital lease arrangement. Another approach would be to discount the future operating lease payments. However, from the information provided, it is difficult to determine exactly what the payment schedules are beyond five years, although it is likely that the operating leases have shorter payment schedules and therefore higher present values. In addition, selecting the appropriate discount rate requires judgment. Some companies provide the present value of the operating leases in order to curb speculation as to what this amount should be.
ACCOUNTING, ANALYSIS, AND PRINCIPLES Accounting There are four lease capitalization criteria. They are (1) transfer of title, (2) bargain-purchase option, (3) the lease term is 75% or more of the economic life of the leased asset, and (4) the present value of the minimum lease payments is 90% or more of the leased asset’s fair value. This lease does not transfer title. The option to purchase at the end of the lease is clearly not a bargain. The lease term is (3 ÷ 5) = 0.6 or 60% of the economic life, so the economic life test is not met. The recovery of investment test is as follows: Minimum lease payments = rental payments – executory costs = $3,557.25 – $500 = $3,057.25. Present value of min. lease payments = $3,057.25 X (PVF-AD3,12) = ($3,057.25 X 2.69005) = $8,224.16. Present value of min. lease payments as % of fair value = $8,224.16 ÷ $10,000 = 0.8224 or 82.24 percent. Therefore, the recovery of investment test is not met either. Consequently, this lease is accounted for as an operating lease. Therefore the journal entry that Salaur makes on January 1, 2014 is: Rent Expense ............................................................... 3,557.25 Cash ................................................................... 3,557.25
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) Analysis When companies structure leases to avoid capitalization, both the leased assets and the obligation for the noncancelable lease payments are “offbalance-sheet.” As a result, the denominator of the return on assets ratio (ROA = Net income ÷ Average assets) will be understated, and a company will look more profitable than it really is. The debt to total assets ratio (Total debt ÷ Total assets) will be understated, thereby giving the impression that the company is more solvent than is really the case. If companies capitalize differing percentages of their leases, it will be difficult to compare the companies based on ROAs and debt to total asset ratios.
Principles The element of the fundamental quality is faithful representation. The lease criteria are designed to report leases according to their economic substance. Thus, if through a lease arrangement a company controls the risks and rewards of the leased asset, it meets the definition of an asset and should be recognized on the balance sheet. Similarly, the associated liability should be recognized if it represents an unavoidable obligation and thereby meets the definition of a liability. That is, the financial statements faithfully represent (completeness) if they report all assets and liabilities of the company. Of course, structuring a lease to avoid capitalization detracts from representational faithful reporting of the lease arrangement, which may not be neutral.
PROFESSIONAL RESEARCH (a) According to FASB ASC 840-10-10-1 the objective of the lease classification criteria in this Subtopic derives from the concept that a lease that transfers substantially all of the benefits and risks incident to the ownership of property 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 and that, therefore, all other leases should be accounted for as operating leases. (b) According to the Glossary at FASB ASC 840-10-20, “substantially all” relates to the concepts underlying the lease classification criteria. A 90 percent recovery test in the minimum-lease-payments criterion in paragraph 840–10–25–1(d) could be used as a guideline. That is, if the present value of a reasonable amount of rental for the leaseback represents 10 percent or less of the fair value of the asset sold, the seller-lessee would be presumed to have transferred to the purchaserlessor the right to substantially all of the remaining use of the property sold. In contrast, if a leaseback of the entire property sold meets the criteria of Topic 840 for classification as a capital lease, the seller-lessee would be presumed to have retained substantially all of the remaining use of the property sold. (c) Lease Term (Codification String: Broad Transactions > 840 Leases > 10 Overall > 20 Glossary) The lease term is the fixed noncancelable lease term plus all of the following, except as noted in the following paragraph: a. All periods, if any, covered by bargain renewal options. b. All periods, if any, for which failure to renew the lease imposes a penalty on the lessee in such amount that a renewal appears, at lease inception, to be reasonably assured. c. All periods, if any, covered by ordinary renewal options during which any of the following conditions exist: (1) A guarantee by the lessee of the lessor’s debt directly or indirectly related to the leased property is expected to be in effect.
PROFESSIONAL RESEARCH (Continued) (2) A loan from the lessee to the lessor directly or indirectly related to the leased property is expected to be outstanding. d. All periods, if any, covered by ordinary renewal options preceding the date as of which a bargain purchase option is exercisable. e. All periods, if any, representing renewals or extensions of the lease at the lessor’s option. The lease term shall not be assumed to extend beyond the date a bargain purchase option becomes exercisable. (d) According to FASB ASC 840-10-25-9, a lease provision requiring the lessee to make up a residual value deficiency that is attributable to damage, extraordinary wear and tear, or excessive usage does not constitute a lessee guarantee of the residual value for purposes of paragraph 840-10-25-6(b).
PROFESSIONAL SIMULATION 1 Note: This assignment is available on the Kieso website. Resources Note: This lease is a capital lease to the lessee because the lease term (six years) exceeds 75% of the economic life of the asset (six years). Also, the present value of the minimum lease payments exceeds 90% of the fair value of the asset. $ 81,365 X 4.60478 $ 374,668
Annual rental payment PV of an annuity-due of 1 for n = 6, i = 12% PV of periodic rental payments
$ X $
50,000 .50663 25,332
Guaranteed residual value PV of 1 for n = 6, i = 12% PV of guaranteed residual value
$ 374,668 + 25,332 $ 400,000
PV of periodic rental payments PV of guaranteed residual value PV of minimum lease payments
PROFESSIONAL SIMULATION 1 (Continued) Journal Entries January 1, 2014 Leased Equipment ......................................................... Lease Liability......................................................... Lease Liability ................................................................ Cash.........................................................................
400,000 400,000 81,365 81,365
During 2014 Executory Costs............................................................. Cash.........................................................................
4,000
December 31, 2014 Interest Expense ............................................................ Interest Payable ......................................................
38,236
Depreciation Expense.................................................... Accumulated Depreciation—Capital Leases ([$400,000 – $50,000] ÷ 6) ...................... January 1, 2015 Interest Payable.............................................................. Interest Expense ..................................................... Interest Expense ............................................................ Lease Liability ................................................................ Cash.........................................................................
4,000
38,236 58,333 58,333
38,236 38,236 38,236 43,129 81,365
During 2015 Executory Costs............................................................. Cash.........................................................................
4,000
December 31, 2015 Interest Expense ............................................................ Interest Payable ......................................................
33,061
Depreciation Expense.................................................... Accumulated Depreciation—Capital Leases .................................................................
4,000
33,061 58,333 58,333
PROFESSIONAL SIMULATION 1 (Continued) (Note to instructor: The guaranteed residual value was subtracted for purposes of determining the depreciable base. The reason is that at the end of the lease term, hopefully, this balance can offset the remaining lease obligation balance. To depreciate the leased asset to zero might lead to a large gain in the final years if the asset’s residual value has a value at least equal to its guaranteed amount.)
PROFESSIONAL SIMULATION 2 Explanation This is a capital lease to Dexter Labs since the lease term (5 years) is greater than 75% of the economic life (6 years) of the leased asset. The lease term is 831/3% (5 ÷ 6) of the asset’s economic life. Measurement Computation of present value of minimum lease payments: $8,668 X 4.16986* = $36,144 *Present value of an annuity due of 1 for 5 periods at 10%. Journal Entries 1/1/14
12/31/14
1/1/15
Leased Equipment ......................................... Lease Liability .........................................
36,144
Lease Liability ................................................ Cash.........................................................
8,668
Depreciation Expense.................................... Accumulated Depreciation— Capital Leases..................................... ($36,144 ÷ 5 = $7,229)
7,229
Interest Expense ............................................ Interest Payable [($36,144 – $8,668) X .10] ....................
2,748
Lease Liability ................................................ Interest Payable ............................................. Cash.........................................................
5,920 2,748
36,144 8,668
7,229
2,748
8,668
IFRS CONCEPTS AND APPLICATION IFRS21-1 The IFRS leasing standard is IAS 17, first issued in 1982. This standard is the subject of only three interpretations. IFRS21-2 Both U.S. GAAP and IFRS share the same objective of recording leases by lessees and lessors according to their economic substance—that is, according to the definitions of assets and liabilities. U.S. GAAP for leases is much more “rule-based” with specific bright-line criteria to determine if a lease arrangement transfers the risks and rewards of ownership; IFRS is more general in its provisions. IFRS21-3 Lease accounting is one of the areas identified in the IASB/FASB Memorandum of Understanding and also a topic recommended by the SEC in its off-balance-sheet study for standard-setting attention. The joint project will initially primarily focus on lessee accounting. One of the first areas to be studied is, “What are the assets and liabilities to be recognized related to a lease contract?” The current exposure draft calls for all leases to be recorded as finance leases based on a right of use model. Thus, the operating lease classification will be eliminated. IFRS21-4 Under the operating method, rent expense (and a compensating liability) accrues day by day to the lessee as the property is used. The lessee assigns rent to the periods benefiting from the use of the asset and ignores in the accounting any commitments to make future payments. Appropriate accruals are made if the accounting period ends between cash payment dates.
IFRS21-5 Under the finance lease method, the lessee treats the lease transactions as if the asset were being purchased on an installment basis: a financial transaction in which an asset is acquired and an obligation is created. The asset and the obligation are stated in the lessee’s balance sheet at the lower of: (1) the present value of the minimum lease payments (excluding executory costs) during the lease term or (2) the fair value of the leased asset at the inception of the lease. The present vaiue of the lease payments is computed using the lessee’s implicit rate unless the implicit rate cannot be determined (then use the incremental borrowing rate). The effectiveinterest method is used to allocate each lease payment between a reduction of the lease obligation and interest expense. If the lease transfers ownership or contains a bargain purchase option, the asset is depreciated in a manner consistent with the lessee’s normal depreciation policy on assets owned, using the economic life of the asset and allowing for residual value. If the lease does not transfer ownership or contain a bargain-purchase option, the leased asset is amortized over the lease term.
IFRS21-6 From the standpoint of the lessor, leases may be classified for accounting purposes as: (a) operating leases, (b) direct-financing leases, and (c) salestype leases. Leases are classified as finance leases if they meet one or more of the following four criteria: 1. The lease transfers ownership of the property to the lessee, 2. The lease contains a bargain-purchase option, 3. The lease term is for the major part of the economic life of the asset, 4. The present value of the minimum lease payments amounts to substantially all of the fair value of the leased asset. Finance leases are further classified as direct-financing leases or salestype leases. All other leases are classified as operating leases. The distinction for the lessor between a direct-financing lease and a sales-type lease is the presence or absence of a manufacturer’s or dealer’s profit or loss.
IFRS21-7 Interest Expense............................................................ Interest Payable [($300,000 – $53,920) X 12%].....
29,530
Depreciation Expense ................................................... Accumulated Depreciation—Capital Leases ($300,000 X 1/8) ....................................
37,500
29,530
37,500
IFRS21-8 Interest Payable [($300,000 – $53,920) X 12%] ............ Lease Liability................................................................ Cash........................................................................
29,530 24,390 53,920
IFRS21-9 (a) To Brecker, the lessee, this lease is a finance lease because the terms satisfy the following criteria: 1. 2.
The lease term is for the major portion (greater than 75%) of the economic life of the leased asset; that is, the lease term is 831/3 % (50/60) of the economic life. The present value of the minimum lease payments amounts to substantially all (greater than 90%) of the fair value of the leased asset; that is, the present value of $10,515 (see below) amounts to substantially all (96%) of the fair value of the leased asset:
(b) The minimum lease payments in the case of a guaranteed residual value by the lessee include the guaranteed residual value. The present value therefore is: Monthly payment of $250 for 50 months ........... $ 9,800 Residual value of $1,180..................................... 715 Present value of minimum lease payments ...... $10,515 (c) Leased Equipment ..................................................... Lease Liability .....................................................
10,515 10,515
IFRS21-9 (Continued) (d) Depreciation Expense ............................................... Accumulated Depreciation—Capital Leases [($10,515 – $1,180) ÷ 50 months = $187]........
187
(e) Lease Liability............................................................ Interest Expense (1% X $10,515) .............................. Cash.....................................................................
145 105
187
250
IFRS21-10 (a) The lease agreement has a bargain-purchase option and thus meets the criteria to be classified as a finance lease from the viewpoint of the lessee. Also, the present value of the minimum lease payments is substantially all (exceeds 90%) of the fair value of the asset. (b) The lease agreement has a bargain-purchase option. The lease, therefore, qualifies as a finance-type lease from the viewpoint of the lessor. Due to the fact that the initial amount of the lease receivable (net investment) (which in this case equals the present value of the minimum lease payments, $81,000) exceeds the lessor’s cost ($65,000), the lease is a sales-type lease. (c) Computation of lease liability: $18,829.49 X 4.16986 $78,516.34
Annual rental payment PV of an annuity-due of 1 for n = 5, i = 10% PV of periodic rental payments
$ 4,000.00 X .62092 $ 2,483.68
Bargain-purchase option PV of 1 for n = 5, i = 10% PV of bargain-purchase option
$78,516.34 + 2,483.68 $81,000.00*
PV of periodic rental payments PV of bargain-purchase option Lease liability
*rounded
IFRS21-10 (Continued) GILL COMPANY (Lessee) Lease Amortization Schedule
Date 5/1/14 5/1/14 5/1/15 5/1/16 5/1/17 5/1/18 4/30/19
Annual Lease Payment Plus BPO $18,829.49 18,829.49 18,829.49 18,829.49 18,829.49 4,000.00 $98,147.45
Interest (10%) on Liability –0– 6,217.05 4,955.81 3,568.44 2,042.33 363.82* $17,147.45 $
Reduction of Lease Liability
Lease Liability
$18,829.49 12,612.44 13,873.68 15,261.05 16,787.16 3,636.18 $81,000.00
$81,000.00 62,170.51 49,558.07 35,684.39 20,423.34 3,636.18 0
*Rounding error is 20 cents. (d) 5/1/14
12/31/14
1/1/15 5/1/15
Leased Equipment ............................. 81,000.00 Lease Liability.............................
81,000.00
Lease Liability .................................... 18,829.49 Cash ............................................
18,829.49
Interest Expense ................................ Interest Payable ($6,217.05 X 8/12 = $4,144.70) ...
4,144.70 4,144.70
Depreciation Expense........................ Accumulated Depreciation— Capital Leases ........................ ($81,000.00 ÷ 10 = $8,100.00; $8,100.00 X 8/12 = $5,400)
5,400
Interest Payable.................................. Interest Expense.........................
4,144.70
5,400
Interest Expense ................................ 6,217.05 Lease Liability .................................... 12,612.44 Cash ............................................
4,144.70
18,829.49
IFRS21-10 (Continued) 12/31/15
12/31/15
Interest Expense ............................. Interest Payable....................... ($4,955.81 X 8/12 = $3,303.87)
3,303.87
Depreciation Expense..................... Accumulated Depreciation— Capital Leases ..................... ($81,000.00 ÷ 10 years = $8,100.00)
8,100.00
3,303.87
8,100.00
(Note to instructor: Because a bargain-purchase option was involved, the leased asset is depreciated over its economic life rather than over the lease term.)
IFRS21-11 Note: The lease agreement has a bargain-purchase option. The lease, therefore, qualifies as a finance lease from the viewpoint of the lessor. Due to the fact that the amount of the sale (which in this case equals the present value of the minimum lease payments, $81,000) exceeds the lessor’s cost ($65,000), the lease is a sales-type lease. The minimum lease payments associated with this lease are the periodic annual rents plus the bargain-purchase option. There is no residual value relevant to the lessor’s accounting in this lease. (a) The lease receivable is computed as follows: $18,829.49 X 4.16986 $78,516.34
Annual rental payment PV of an annuity-due of 1 for n = 5, i = 10% PV of periodic rental payments
$ 4,000.00 X .62092 $ 2,483.68
Bargain-purchase option PV of 1 for n = 5, i = 10% PV of bargain-purchase option
IFRS21-11 (Continued) $78,516.34 + 2,483.68 $81,000.00*
PV of periodic rental payments PV of bargain-purchase option Lease receivable at inception
*Rounded (b)
LENNOX LEASING COMPANY (Lessor) Lease Amortization Schedule
Date 5/1/14 5/1/14 5/1/15 5/1/16 5/1/17 5/1/18 4/30/19
Annual Lease Payment Plus BPO $18,829.49 18,829.49 18,829.49 18,829.49 18,829.49 4,000.00 $98,147.45
Interest (10%) on Lease Receivable
$ 6,217.05 4,955.81 3,568.44 2,042.33 363.82* $17,147.45
Recovery of Lease Receivable $18,829.49 12,612.44 13,873.68 15,261.05 16,787.16 3,636.18 $81,000.00
Lease Receivable $81,000.00 62,170.51 49,558.07 35,684.39 20,423.34 3,636.18 0
*Rounding error is 20 cents. (c) 5/1/14
12/31/14
Lease Receivable ...................... Cost of Goods Sold................... Sales Revenue ................... Inventory ............................
81,000.00 65,000.00
Cash ........................................... Lease Receivable...............
18,829.49
Interest Receivable ................... Interest Revenue................ ($6,217.05 X 8/12 = $4,144.70)
4,144.70
81,000.00 65,000.00 18,829.49 4,144.70
IFRS21-11 (Continued) 5/1/15
12/31/15
5/1/16
12/31/16
Cash ........................................... Lease Receivable .............. Interest Receivable............ Interest Revenue ............... ($6,217.05 – $4,144.70)
18,829.49
Interest Receivable ................... Interest Revenue ............... ($4,955.81 X 8/12 = $3,303.87)
3,303.87
Cash ........................................... Lease Receivable .............. Interest Receivable............ Interest Revenue ............... ($4,955.81 – $3,303.87)
18,829.49
Interest Receivable ................... Interest Revenue ............... ($3,568.44 X 8/12 = $2,378.96)
2,378.96
12,612.44 4,144.70 2,072.35
3,303.87
13,873.68 3,303.87 1,651.94
2,378.96
IFRS21-12 (a) According to IAS 17, paragraph 7, “The classification of leases adopted in this Standard is based on the extent to which risks and rewards incidental to ownership of a leased asset lie with the lessor or the lessee. Risks include the possibilities of losses from idle capacity or technological obsolescence and of variations in return because of changing economic conditions. Rewards may be represented by the expectation of profitable operation over the asset’s economic life and of gain from appreciation in value or realisation of a residual value.” Also, paragraph 8 states “A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership.”
IFRS21-12 (Continued) (b) IAS 17 does not define “substantially all.” (c) IAS 17 does not name other considerations in determining “lease term,” but paragraph 4 defines “lease term” as “the non-cancellable period for which the lessee has contracted to lease the asset together with any further terms for which the lessee has the option to continue to lease the asset, with or without further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise the option.”
IFRS21-13 (a) M&S uses both finance leases and operating leases. (b) M&S reported finance leases of £65.5 million (net of interest of £156.4 million) in total, and £8.7 million for less than 1 year, £8.7 million for more than 1 year and less than 5 years, and £48.1 million for more than 5 years. (c) M&S disclosed future minimum rentals (in millions) under non-cancelable operating lease agreements as of 31 March 2012, of: Not later than one year .................................... Later than one year and not later than five years ................................ Later than five years and not later than 25 years .................................. Later than 25 years .......................................... Total ..................................................................
£ 257.8 997.4 2,446.6 1,210.1 £4,911.9
CHAPTER 22 Accounting Changes and Error Analysis ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics
Questions
1.
Differences between change in principle, change in estimate, change in entity, errors.
2, 4, 6, 7, 8, 9, 12, 13, 15, 21
2.
Accounting changes:
3.
*4.
Brief Exercises Exercises 8
Concepts Problems for Analysis 3
1, 2, 3, 4
3, 6, 7
1, 2, 4, 5
a.
Comprehensive.
b.
Changes in estimate, changes in depreciation methods.
8, 9
4, 5, 9
3, 4, 6, 7, 8, 9, 10, 11, 12, 16, 17
1, 2, 4, 6, 7
1, 2, 3, 4, 5, 6
c.
Changes in accounting for long-term construction contracts.
2, 10
1, 2, 10
1, 8, 13
3
1, 2
d.
Change from FIFO to average cost.
e.
Change from FIFO to LIFO.
2, 11
10
f.
Change from LIFO.
8
3
g.
Miscellaneous.
1, 3, 4, 5, 8
8, 9, 10
2, 8, 14
3 1, 2
2, 3, 5, 8, 14
2, 5 1, 5
Correction of an error. a.
Comprehensive.
8, 14, 15, 17, 19
8, 9, 10
8, 15, 16, 18, 19, 20, 21
3, 6, 7, 8, 9, 10
b.
Depreciation.
2, 18, 21
6, 7
9, 15, 17, 18
1, 6, 8
c.
Inventory.
9, 16, 20
10
7, 17, 18
2, 10
11, 12
22, 23
11, 12
Changes between fair value and equity methods.
*This material is dealt with in an Appendix to the chapter.
2, 3, 4
1, 2
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives Questions
Brief Exercises
Exercises
Problems
Concepts for Analysis
1
CA22-5
2, 3, 5
CA22-1, CA22-2, CA 22-3, CA22-4
CA22-5, CA22-6
1. Identify the types of accounting changes. 2. Describe the accounting for changes in accounting principles.
1, 2, 3, 4
3. Understand how to account for retrospective accounting changes.
5, 6, 7, 8, 9, 10
4. Understand how to account for impracticable changes.
11
5. Describe the accounting for changes in estimates.
12
6. Identify changes in a reporting entity.
13
7. Describe the accounting for correction of errors.
15, 16, 17, 18, 19, 20, 21
1, 2, 3, 9, 10
1, 2, 3, 4, 5, 8, 13, 14 2
4, 5, 9
6, 7, 8, 9, 10, 11, 12
1, 2, 3, 4, 6
6, 7, 8, 10
7, 8, 9, 15, 16, 17, 18, 19, 20, 21
1, 2, 3, 6, 7, 8, 9, 10
18, 19, 20, 21
6, 7, 8, 9, 10
22, 23
11, 12
8. Identify economic motives for changing accounting methods. 9. Analyze the effect of errors. *10. Make the computations and prepare the entries necessary to record a change from or to the equity method of accounting.
14 11, 12
ASSIGNMENT CHARACTERISTICS TABLE Item
Description
Level of Difficulty
Time (minutes)
E22-1 E22-2 E22-3 E22-4 E22-5 E22-6 E22-7 E22-8 E22-9 E22-10 E22-11 E22-12 E22-13 E22-14 E22-15 E22-16 E22-17 E22-18 E22-19 E22-20 E22-21 *E22-22 *E22-23
Change in principle—long-term contracts. Change in principle—inventory methods. Accounting change. Accounting change. Accounting change. Accounting changes—depreciation. Change in estimate and error; financial statements. Accounting for accounting changes and errors. Error and change in estimate—depreciation. Depreciation changes. Change in estimate—depreciation. Change in estimate—depreciation. Change in principle—long-term contracts. Various changes in principle—inventory methods. Error correction entries. Error analysis and correcting entry. Error analysis and correcting entry. Error analysis. Error analysis and correcting entries. Error analysis. Error analysis. Change from fair value to equity. Change from equity to fair value.
Moderate Moderate Difficult Difficult Difficult Difficult Moderate Simple Simple Moderate Simple Simple Simple Moderate Simple Simple Simple Moderate Simple Moderate Moderate Complex Moderate
10–15 10–15 25–30 25–30 30–35 30–35 25–30 5–10 15–20 20–25 10–15 20–25 10–15 20–25 15–20 10–15 10–15 25–30 20–25 20–25 10–15 25–30 15–20
P22-1 P22-2 P22-3 P22-4 P22-5 P22-6 P22-7 P22-8 P22-9 P22-10 *P22-11 *P22-12
Change in estimate and error correction. Comprehensive accounting change and error analysis problem. Error corrections and accounting changes. Accounting changes. Change in principle—inventory—periodic. Accounting change and error analysis. Error corrections. Comprehensive error analysis. Error analysis. Error analysis and correcting entries. Fair value to equity method with goodwill. Change from fair value to equity method.
Moderate Complex Complex Moderate Moderate Moderate Moderate Difficult Moderate Complex Moderate Moderate
30–35 30–40 30–40 40–50 30–35 25–30 25–30 30–35 20–25 50–60 20–25 20–25
CA22-1 CA22-2 CA22-3 CA22-4 CA22-5 CA22-6
Analysis of various accounting changes and errors. Analysis of various accounting changes and errors. Analysis of three accounting changes and errors. Analysis of various accounting changes and errors. Change in principle, estimate. Change in estimate, ethics.
Moderate Moderate Moderate Moderate Moderate Moderate
25–35 20–30 30–35 20–30 20–30 20–30
SOLUTIONS TO CODIFICATION EXERCISES CE22-1 Master Glossary (a)
A change that has the effect of adjusting the carrying amount of an existing asset or liability or altering the subsequent accounting for existing or future assets or liabilities. A change in accounting estimate is a necessary consequence of the assessment, in conjunction with the periodic presentation of financial statements, of the present status and expected future benefits and obligations associated with assets and liabilities. Changes in accounting estimates result from new information. Examples of items for which estimates are necessary are uncollectible receivables, inventory obsolescence, service lives and salvage values of depreciable assets, and warranty obligations.
(b)
A change from one generally accepted accounting principle to another generally accepted accounting principle when there are two or more generally accepted accounting principles that apply or when the accounting principle formerly used is no longer generally accepted. A change in the method of applying an accounting principle also is considered a change in accounting principle.
(c)
The process of revising previously issued financial statements to reflect the correction of an error in those financial statements.
(d)
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.
CE22-2 According to FASB ASC 250-10-50-7 (Accounting Changes and Error Corrections—Disclosure): When financial statements are restated to correct an error, the entity shall disclose that its previously issued financial statements have been restated, along with a description of the nature of the error. The entity also shall disclose both of the following: (a)
The effect of the correction on each financial statement line item and any per-share amounts affected for each prior period presented.
(b)
The cumulative effect of the change on retained earnings or other appropriate components of equity or net assets in the statement of financial position, as of the beginning of the earliest period presented.
CE22-3 According to FASB ASC 250-10-45-5 (Accounting Changes and Error Corrections—Other Presentation Matters): An entity shall report a change in accounting principle through retrospective application of the new accounting principle to all prior periods, unless it is impracticable to do so. Retrospective application requires all of the following: (a)
The cumulative effect of the change to the new accounting principle on periods prior to those presented shall be reflected in the carrying amounts of assets and liabilities as of the beginning of the first period presented.
(b)
An offsetting adjustment, if any, shall be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period.
(c)
Financial statements for each individual prior period presented shall be adjusted to reflect the period-specific effects of applying the new accounting principle.
CE22-4 According to FASB ASC 250-10-S99-4 (Accounting Changes and Error Corrections—SEC Materials): Question 5: If a registrant justified a change in accounting method as preferable under the circumstances, and the circumstances change, may the registrant revert to the method of accounting used before the change? Any time a registrant makes a change in accounting method, the change must be justified as preferable under the circumstances. Thus, a registrant may not change back to a principle previously used unless it can justify that the previously used principle is preferable in the circumstances as they currently exist.
ANSWERS TO QUESTIONS 1.
The major reasons why companies change accounting methods are: (a) Desire to show better profit picture. (b) Desire to increase cash flows through reduction in income taxes. (c) Requirement by Financial Accounting Standards Board to change accounting methods. (d) Desire to follow industry practices. (e) Desire to show a better measure of the company’s income.
2.
(a) Change in accounting principle; retrospective application is generally not made because it is impracticable to determine the effect of the change on prior years. The FIFO inventory amount is therefore generally the beginning inventory in the current period. (b) Correction of an error and therefore prior period adjustment; adjust the beginning balance of retained earnings. (c) Increase income for litigation settlement, assuming it was not accrued. (d) Change in accounting estimate; currently and prospectively. Part of operating section of income statement. (e) Reduction of accounts receivable and the allowance for doubtful accounts. (f) Change in accounting principle; retrospective application to prior period financial statements.
3.
The three approaches suggested for reporting changes in accounting principles are: (a) Currently—the cumulative effect of the change is reported in the current year’s income as a special item. (b) Retrospectively—the cumulative effect of the change is reported as an adjustment to retained earnings. The prior year’s statements are changed on a basis consistent with the newly adopted principle. (c) Prospectively—no adjustment is made for the cumulative effect of the change. Previously reported results remain unchanged. The change shall be accounted for in the period of the change and in subsequent periods if the change affects future periods.
4.
The FASB believes that the retrospective approach provides financial statement users the most useful information. Under this approach, the prior statements are changed on a basis consistent with the newly adopted standard; any cumulative effect of the change for prior periods is recorded as an adjustment to the beginning balance of retained earnings of the earliest period reported.
5.
The indirect effect of a change in accounting principle reflects any changes in current or future cash flows resulting from a change in accounting principle that is applied retrospectively. An example is the change in payments to a profit-sharing plan that is based on reported net income. Indirect effects are not included in the retrospective application, but instead are reported in the period in which the accounting change occurs (current period).
6.
A change in an estimate is simply a change in the way an individual perceives the realizability of an asset or liability. Examples of changes in estimate are: (1) change in the realizability of trade receivables, (2) revisions of estimated lives, (3) changes in estimates of warranty costs, and (4) change in estimate of deferred charges or credits. A change in accounting estimate effected by a change in accounting principle occurs when a change in accounting estimate is inseparable from the effect of a related change in accounting principle. An example would be switching from capitalizing advertising expenditures to expensing them if the future benefit of the expenditures can no longer be estimated with reasonable certainty.
Questions Chapter 22 (Continued) 7.
This is an example of a situation in which it is difficult to differentiate between a change in accounting principle and a change in estimate. In such a situation, the change should be considered a change in estimate, and accordingly, should be handled currently and prospectively. Thus, all costs presently capitalized and viewed as providing doubtful future values should be expensed immediately, and costs currently incurred should also be expensed immediately.
8.
(a) Charge to expense—possibly separately disclosed. (b) Change in estimate that is effected by a change in accounting principle—currently and prospectively. (c) Charge to expense—possibly separately disclosed. (d) Correction of an error and reported as a prior period adjustment—adjust the beginning balance of retained earnings. (e) Change in accounting principle—retrospective application to all affected prior-period financial statements. (f) Change in accounting estimate—currently and prospectively.
9.
This change is to be handled as a correction of an error. As such, the portion of the change attributable to prior periods ($23,000) should be reported as an adjustment to the beginning balance of retained earnings in the 2014 financial statements. If statements for previous years are presented for comparative purposes, these statements should be restated to correct for the error. The remainder of the inventory value ($29,000) should be reported in the 2014 income statement as a reduction of materials cost.
10.
Preferability is a difficult concept to apply. The problem is that there are no basic objectives to indicate which is the most preferable method, assuming a selection between two generally accepted accounting practices is possible, such as completed-contract and percentage-of-completion. If a FASB standard creates a new principle or expresses preference for or rejects a specific accounting principle, a change is considered clearly acceptable. A more appropriate matching of revenues and expenses is often given as the justification for a change in accounting principle.
11.
When a company changes to the LIFO method, the base-year inventory for all subsequent LIFO calculations is the beginning inventory in the year the method is adopted. This assumes that prior years’ income is not changed because it would be too impractical to do so. The only adjustment necessary may be to adjust the beginning inventory from a lower-of-cost-or-market approach to a cost basis. This establishes the beginning LIFO layer.
12.
Where individual company statements were reported in prior years and consolidated financial statements are to be prepared this year, the following reporting and disclosure practices should be implemented: (1) The financial statements of all prior periods presented should be restated to show the financial information for the new reporting entity for all periods. (2) The financial statements of the year in which the change in reporting entity is made should describe the nature of the change and the reason for it. (3) The effect of the change on income before extraordinary items, net income, and earnings per share amounts should be disclosed for all periods presented.
13.
This change represents a change in reporting entity. This type of change should be reported by restating the financial statements of all prior periods presented to show the financial information for the new reporting entity for all periods. The financial statements of the year in which the change in reporting entity is made should describe the nature of the change and the reason for it. The effect of the change on income before extraordinary items, net income, and earnings per share amounts should be disclosed for all periods presented.
Questions Chapter 22 (Continued) 14.
Counterbalancing errors are errors that will be offset or corrected over two periods. Noncounterbalancing errors are errors that are not offset in the next accounting period. An example of a counterbalancing error is the failure to record accrued wages or prepaid expenses. Failure to capitalize equipment and record depreciation is an example of a noncounterbalancing error.
15.
A correction of an error in previously issued financial statements should be handled as a priorperiod adjustment. Thus, such an error should be reported in the year that it is discovered as an adjustment to the beginning balance of retained earnings. And, if comparative statements are presented, the prior periods affected by the error should be restated. The disclosures need not be repeated in the financial statements of subsequent periods. As an illustration, assume that credit sales of $40,000 were inadvertently overlooked at the end of 2014. When the error was discovered in a subsequent period, the appropriate entry to record the correction of the error would have been (ignoring income tax effects): Accounts Receivable ................................................................................. Retained Earnings .............................................................................
40,000 40,000
16.
This change represents a change from an accounting principle that is not generally accepted to an accounting principle that is acceptable. As such, this change should be handled as a correction of an error. Thus, in the 2014 statements, the cumulative effect of the change should be reported as an adjustment to the beginning balance of retained earnings. If 2013 statements are presented for comparative purposes, these statements should be restated to correct for the accounting error.
17.
Retained earnings is correctly stated at December 31, 2016. Failure to accrue salaries in earlier years is a counterbalancing error that has no effect on 2016 ending retained earnings.
18.
December 31, 2015 Machinery .................................................................................................. Accumulated Depreciation—Equipment ............................................. Retained Earnings ............................................................................. (To correct for the error of expensing installation costs on machinery acquired in January, 2014) Depreciation Expense [($36,000 – $3,600) ÷ 20] ....................................... Accumulated Depreciation—Equipment ............................................. (To record depreciation on machinery for 2015 based on a 20-year useful life)
19.
6,000 600 5,400
1,620 1,620
The amortization error decreases net income by $2,700 in 2014. Interest expense related to the discount should have been charged for $300, but was charged for $3,000. The entry to correct for this error is as follows: Discount on Bonds Payable....................................................................... Interest Expense ................................................................................
2,700 2,700
The entry to record accrued interest on the $100,000 of principal at 11% for 6 months is: Interest Expense........................................................................................ Interest Payable .................................................................................
5,500 5,500
Questions Chapter 22 (Continued) 20.
This error has no effect on net income because both purchases and inventory were understated. The entry to correct for this error, assuming a periodic inventory system, is: Purchases ................................................................................................. Accounts Payable ..............................................................................
21.
13,000 13,000
This error increases net income by $2,400 in 2014. Depreciation should have been charged to net income. The entry to correct for this error is as follows: Depreciation Expense................................................................................ Accumulated Depreciation—Equipment.............................................
2,400 2,400
SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 22-1 Construction in Process ($120,000 – $80,000) ......... Deferred Tax Liability [($120,000 – $80,000) X 35%] .......................... Retained Earnings ..............................................
40,000 14,000 26,000
BRIEF EXERCISE 22-2 Difference in profit-sharing expense—prior years Pre-tax income—percentage-of-completion............. Pre-tax income—completed-contract .......................
$120,000 80,000 $ 40,000 X 1% $ 400
Indirect effect..............................................................
The indirect effect from prior years will be reported as a profit-sharing expense for year 2014. BRIEF EXERCISE 22-3 Inventory ..................................................................... Deferred Tax Liability ($1,200,000 X 40%) ......... Retained Earnings ..............................................
1,200,000 480,000 720,000
BRIEF EXERCISE 22-4 This is a change in estimate effected by a change in accounting principle. Cost of depreciable assets ........................................ Accumulated depreciation......................................... Carrying value at January 1, 2014 ............................. Salvage value.............................................................. Depreciable base ........................................................
$250,000 (90,000) 160,000 (40,000) $120,000
Depreciation in 2014 = $120,000 ÷ 8 = $15,000. Depreciation Expense ................................................. Accumulated Depreciation..................................
15,000 15,000
BRIEF EXERCISE 22-5 Depreciation Expense ........................................................... 24,000 Accumulated Depreciation—Equipment.................. $58,000* – $10,000 = $24,000 4– 2
24,000
*Book value before change Cost .................................................... Less: Accumulated depreciation......
$74,000 16,000** $58,000
**[($74,000 – $18,000) ÷ 7] X 2
BRIEF EXERCISE 22-6 Equipment.......................................................................... Accumulated Depreciation—Equipment.................. Deferred Tax Liability ................................................ Retained Earnings ..................................................... ($20,000 = $50,000 X 2/5; $9,000 = $30,000 X 30%)
50,000 20,000 9,000 21,000
BRIEF EXERCISE 22-7 BEIDLER COMPANY Retained Earnings Statement For the Year Ended December 31, 2014 Retained earnings, January 1, as previously reported....... Less: Correction of depreciation error, net of tax ......... Retained earnings, January 1, as adjusted ..................... Add: Net income ............................................................. Less: Dividends................................................................ Retained earnings, December 31 ..................................... *$400,000 X (1 – .4)
$2,000,000 240,000* 1,760,000 900,000 250,000 $2,410,000
BRIEF EXERCISE 22-8 a. b. c. d. e.
2014 Overstated Overstated Understated Overstated No effect
2015 Overstated Understated Overstated Understated Overstated
BRIEF EXERCISE 22-9 1.
The change to a three-year remaining life for the purpose of computing depreciation on production equipment is a change in estimate due to a change in conditions.
2.
This is an expense classification change arising from a change in the use of the building for a different purpose. Thus, it is not a change in principle, a change in estimate, or an error.
3.
The change to expensing preproduction costs (writing the costs off in one year as opposed to several years) is a change in estimate due to a change in conditions.
BRIEF EXERCISE 22-10 1.
Both FIFO and LIFO are generally accepted accounting principles; thus, this item is a change in accounting principle.
2.
This oversight is a mistake that should be corrected. Such a correction is considered a change due to error.
3.
Both the completed-contract method and the percentage-of-completion method are generally accepted accounting principles; thus, such a change is a change in accounting principle.
*BRIEF EXERCISE 22-11 Cash ($95,000 X 10%)..................................................... Equity Investments (Available-for-sale) ................ Dividend Revenue ($80,000 X 10%) .......................
9,500 1,500 8,000
*BRIEF EXERCISE 22-12 Equity Investments (Equity Method) ($475,000 + $33,000) .................................................. Cash......................................................................... Retained Earnings ..................................................
508,000 475,000 33,000
Equity Investments (Equity Method)............................. Equity Investments (Available-for-sale) ................
185,000
Unrealized Holding Gain or Loss—Equity.................... Fair Value Adjustment (Available-for-Sale)...........
34,000
185,000 34,000
SOLUTIONS TO EXERCISES EXERCISE 22-1 (10–15 minutes) (a) The net income to be reported in 2015, using the retrospective approach, would be computed as follows: Income before income tax $700,000 Income tax (35% X $700,000) 245,000 Net income $455,000 (b) Construction in Process....................................... Deferred Tax Liability ($190,000 X 35%) ........ Retained Earnings.........................................
190,000 66,500 123,500*
*($190,000 X 65% = $123,500)
EXERCISE 22-2 (10–15 minutes) (a) Inventory ........................................................................ 14,000* Retained Earnings.............................................
14,000
*($19,000 + $23,000 + $25,000) – ($15,000 + $18,000 + $20,000) (b) Net Income (FIFO)
2012 2013 2014
$19,000 23,000 25,000
(c) Inventory ................................................................... Retained Earnings.............................................
24,000*
*($19,000 + $23,000 + $25,000) – ($12,000 + $14,000 + $17,000)
24,000
EXERCISE 22-3 (25–30 minutes) (a)
TAVERAS CO. Income Statement For the Year Ended December 31 LIFO 2012 Sales ...................................................... $3,000 Cost of goods sold................................ 800 Operating expenses .............................. 1,000 Net income...................................... $1,200
2013 $3,000 1,000 1,000 $1,000
2014 $3,000 1,130 1,000 $ 870
2013 $3,000 940 1,000 $1,060
2014 $3,000 1,100 1,000 $ 900
Income Statement For the Year Ended December 31 FIFO 2012 Sales ...................................................... $3,000 Cost of goods sold................................ 820 Operating expenses .............................. 1,000 Net income...................................... $1,180 (b)
TAVERAS CO. Income Statement For the Year Ended December 31 2014 Sales ...................................................... $3,000 Cost of goods sold................................ 1,100 Operating expenses.............................. 1,000 Net income...................................... $ 900
2013 As adjusted (Note A) $3,000 940 1,000 $1,060
EXERCISE 22-3 (Continued) (c) Note A: Change in Method of Accounting for Inventory Valuation On January 1, 2014, Taveras elected to change its method of valuing its inventory to the FIFO method, whereas in all prior years inventory was valued using the LIFO method. The new method of accounting for inventory was adopted because it better reflects the current cost of the inventory on the balance sheet and comparative financial statements of prior years have been adjusted to apply the new method retrospectively. The following financial statement line items for fiscal years 2014 and 2013 were affected by the change in accounting principle.
Balance Sheet Inventory Retained Earnings
2014 2013 LIFO FIFO Difference LIFO FIFO Difference $ 320 $ 390 $70 $ 200 $ 240 $40 3,070 3,140 70 2,200 2,240 40
Income Statement Cost of Goods Sold Net Income
$1,130 $1,100 870 900
$30 30
$1,000 1,000
$940 1,060
$60 60
Statement of Cash Flows (no effect)
(d) Retained earnings statements after retrospective application. 2014 Retained earnings, January 1, as reported Less: Adjustment for cumulative effect of applying new accounting method (FIFO) Retained earnings, January 1, as adjusted Net Income Retained earnings, December 31
$2,240 900 $3,140
2013 $1,200 20 1,180 1,060 $2,240
EXERCISE 22-4 (25–30 minutes) (a) Retained earnings, January 1, as reported ................. Cumulative effect of change in accounting principle to average cost .......................................... Retained earnings, January 1, as adjusted.................
2011 $160,000 (15,000)* $145,000
*[$10,000 (2009) + $5,000 (2010)] (b) Retained earnings, January 1, as reported ................. Cumulative effect of change in accounting principle to average cost .......................................... Retained earnings, January 1, as adjusted.................
2014 $590,000 (25,000)* $565,000
*[$10,000 (2009) + $5,000 (2010) + $10,000 (2011) – $10,000 (2012) + $10,000 (2013)] (c) Retained earnings, January 1, as reported ................. Cumulative effect of change in accounting principle to average cost .......................................... Retained earnings, January 1, as adjusted.................
2015 $780,000 (20,000)* $760,000
*($25,000 at 12/31/2013 – $5,000) (d) Net Income .............................
2012 $130,000
2013 $290,000
2014 $310,000
EXERCISE 22-5 (30–35 minutes) (a)
KENSETH COMPANY Income Statement For the Year Ended Sales................................................................ Cost of goods sold ......................................... Operating expenses Income before profit sharing .................. Profit sharing expense................................... Net income ...............................................
2014 $3,000 1,100 1,000 $ 900 96 $ 804
2013 $3,000 940 1,000 $1,060 100 $ 960
Under GAAP, Kenseth Company should report $100 as the profit sharing expense in 2013, even though the profit sharing expense would be $106 if FIFO had been used in 2013. (b) The profit sharing expense reflects an indirect effect of the change in accounting principle. Under GAAP, indirect effects from periods before the change are recorded in the year of the change. In this case, profit sharing expense recorded in 2014 is composed of: $900 X 10% =$90 (2014 under FIFO) $ 60 X 10% = 6 (difference in profit sharing for 2013) $96 (profit sharing expense for FIFO in 2014) (c)
Retained Earnings Statement Retained earnings, January 1, as reported ................. Cumulative effect of change to FIFO ($960 – $900) ...... Retained earnings, January 1, as adjusted ................. Add: Net Income ........................................................... Deduct: Dividends ........................................................ Retained earnings, December 31.................................
2014 $8,000 60 8,060 804 2,000 $6,864
EXERCISE 22-6 (25–30 minutes) (a) Depreciation to date on equipment Sum-of-the-years’-digits depreciation 2012 (5/15 X $510,000) 2013 (4/15 X $510,000) 2014 (3/15 X $510,000)
$170,000 136,000 102,000 $408,000
Cost of equipment Less: Depreciation to date Book value (December 31, 2014)
$525,000 408,000 $117,000
Book value – Salvage value = Depreciable cost $117,000 – $15,000 = $102,000 Depreciation for 2015: $102,000/2 = $51,000 Depreciation Expense ............................................ Accumulated Depreciation—Equipment .......
51,000 51,000
(b) Depreciation to date on building $693,000/30 years = $23,100 per year $23,100 X 3 = $69,300 depreciation to date Cost of building Less: Depreciation to date Book value (December 31, 2014)
$693,000 69,300 $623,700
Depreciation for 2015: $623,700/(40 – 3) = $16,856.76 Depreciation Expense .............................................. 16,856.76 Accumulated Depreciation—Buildings ......... 16,856.76
EXERCISE 22-7 (25–30 minutes) Change from sum-of-the-years digit to straight-line Cost of depreciable assets................................. Less: Depreciation in 2014 ($100,000 X 4/10).... Book value at December 31, 2014......................
$100,000 40,000 $ 60,000
Depreciation for 2015 using straight-line depreciation Book value at December 31, 2014...................... Estimated useful life ........................................... Depreciation for 2015 ($60,000 ÷ 3) ...................
$60,000 3 years $20,000
DENISE HABBE INC. Retained Earnings Statement For the Year Ended Retained earnings, January 1, unadjusted ........ Less: Correction of error for inventory overstatement............................................... Retained earnings, January 1, adjusted ............ Add: Net income Less: Dividends................................................... Retained earnings, December 31 .......................
2015 $125,000 (24,000) 101,000 86,000 30,000 $157,000
2014
$ 72,000 54,000 25,000 $101,000
Note to instructor: 1.
2014 Cost of sales increased $24,000; 2015 cost of sales decreased $24,000. As a result, net income for 2014 is overstated $24,000 and net income for 2015 is understated $24,000 as a result of the inventory error.
2.
2014 expenses remained unchanged.
3.
2015 expenses decreased $10,000 ($30,000 – $20,000). Net income in 2015 is therefore $86,000 ($52,000 + $24,000 + $10,000).
4.
Additional disclosures would be a necessitated as indicated in the chapter.
EXERCISE 22-8 (5–10 minutes) 1. 2. 3. 4. 5.
a. b. a. b. b.
6. 7. 8. 9. 10.
a. b. a. b. b.
EXERCISE 22-9 (15–20 minutes) December 31, 2015 Retained Earnings ($550,000 X 9/55) ............................ Accumulated Depreciation—Equipment............... (To correct for the omission of depreciation expense in 2013) Cost of Machine Less: Depreciation prior to 2015 2012 ($550,000 X 10/55) 2013 ($550,000 X 9/55) 2014 ($550,000 X 8/55) Book Value at January 1, 2015
90,000 90,000
$550,000 $100,000 90,000 80,000
270,000 $280,000
Depreciation for 2015: $280,000 ÷ 7 = $40,000 Depreciation Expense.................................................... Accumulated Depreciation—Equipment............... (To record depreciation expense for 2015)
40,000 40,000
EXERCISE 22-10 (20–25 minutes) (a) Computation of depreciation for 2015: Cost of building $800,000 Less: Depreciation prior to 2015 2011 ($800,000 – $0) X .05* $40,000 2012 ($800,000 – $40,000) X .05 38,000 2013 ($800,000 – $78,000) X .05 36,100 2014 ($800,000 – $114,100) X .05 34,295 148,395 Book value, January 1, 2015 $651,605 *(1 ÷ 40) X 2 Depreciation expense for 2015: $16,711 [($651,605 – $50,000) ÷ 36] Depreciation Expense ........................................... Accumulated Depreciation—Buildings.........
16,711 16,711
(b) Computation of 2015 depreciation expense on the equipment: Cost of equipment Less: Accumulated depreciation [($100,000 – $10,000) ÷ 12] X 4 years Book value, 1/1/15 2015 Depreciation expense:
$100,000 30,000 $ 70,000
$70,000 – $5,000
$65,000
(9 – 4)
= $13,000
5
EXERCISE 22-11 (10–15 minutes) (a) No entry necessary. Changes in estimates are treated prospectively. (b) Depreciation Expense .............................................. Accumulated Depreciation—Equipment ......... *Original cost Accumulated depreciation [($510,000 – $10,000) ÷ 10] X 7 Book value (1/1/15) Estimated salvage value Remaining depreciable basis Remaining useful life (15 years – 7 years) Depreciation expense—2015
$510,000 (350,000) 160,000 (5,000) 155,000 ÷ 8 $ 19,375
19,375* 19,375
EXERCISE 22-12 (20–25 minutes) (a) Cost of plant assets $1,600,000 Less: Depreciation prior to 2015 2012 ($1,600,000 X .25) $400,000 2013 ($1,200,000 X .25) 300,000 2014 ($ 900,000 X .25) 225,000 925,000 Book value at January 1, 2015 $675,000 2015 Depreciation: ($675,000 – $100,000) ÷ 5 = $115,000 Depreciation Expense ............................................ Accumulated Depreciation—Equipment ....... (b) Income before depreciation expense Depreciation expense Net income
115,000 115,000 2015 $300,000 115,000 $185,000
2014 $270,000 225,000 $ 45,000
EXERCISE 22-13 (10–15 minutes) (a) The net income to be reported in 2015, using the retrospective approach, would be computed as follows: Income before income tax $900,000 Income tax (40% X $900,000) 360,000 Net income $540,000 (b) Construction in Process ...................................... Deferred Tax Liability (40% X $290,000) ...... Retained Earnings......................................... *($290,000 X 60% = $174,000)
290,000 116,000 174,000*
EXERCISE 22-14 (20–35 minutes) (a) Retained Earnings .................................................... Inventory ............................................................ *2012 2013 2014
$2,000 5,000 1,000 $8,000
8,000 8,000*
($26,000 – $24,000) ($30,000 – $25,000) ($28,000 – $27,000)
2015
2014
2013
2012
$30,000
$27,000
$25,000
$24,000
(b) Inventory ................................................................... Retained Earnings.............................................
19,000
Net income
*2012 2013 2014
$ 6,000 9,000 4,000 $19,000
19,000*
($26,000 – $20,000) ($30,000 – $21,000) ($28,000 – $24,000)
2015
2014
2013
2012
$34,000
$28,000
$30,000
$26,000
Accumulated Depreciation—Equipment ................. Depreciation Expense....................................... Retained Earnings.............................................
25,500
Net income EXERCISE 22-15 (15–20 minutes) 1.
Depreciation taken Less: Depreciation (correct)
8,500 17,000
2013–2014
2015
$170,000* 153,000 $ 17,000
$85,000 76,500 $ 8,500
*$510,000 X 1/6 X 2 2. 3.
Retained Earnings .................................................... Salaries and Wages Expense ........................... No entry necessary.
45,000 45,000
EXERCISE 22-15 (Continued) 4.
5.
Amortization Expense ............................................ Retained Earnings .................................................. Copyrights ....................................................... ($45,000 ÷ 20 = $2,250; $2,250 X 2 = $4,500)
2,250 4,500
Write off of Inventories........................................... Retained Earnings...........................................
87,000
6,750
87,000
EXERCISE 22-16 (10–15 minutes) 1. 2. 3. 4.
Salaries and Wages Expense ................................ Salaries and Wages Payable ..........................
3,400
Salaries and Wages Expense ................................ Salaries and Wages Payable ..........................
31,100
Prepaid Insurance ($2,640 X 10/12) ....................... Insurance Expense .........................................
2,200
Sales Revenue ........................................................ [$2,120,000 ÷ (1.00 + .06)] X 6% Sales Taxes Payable .......................................
120,000
Sales Taxes Payable............................................... Sales Tax Expense..........................................
103,400
3,400 31,100 2,200
120,000 103,400
EXERCISE 22-17 (10–15 minutes) Retained Earnings.......................................................... Inventory ................................................................. Accumulated Depreciation—Equipment............... ($38,500 – $17,000)
37,700 16,200 21,500
Computations:
Overstatement of 2015 ending inventory Overstatement of 2014 depreciation Understatement of 2015 depreciation Total effect of errors on retained earnings
Effect on retained earnings over (under) statement $16,200 (17,000) 38,500 $37,700
Note: The understatement of inventory in 2014 was a self-correcting error at the end of 2015.
EXERCISE 22-18 (25–30 minutes) (a) Effect of errors on 2015 net income: $24,700 overstatement Computations: Effect on 2015 net income over (under) statement Understatement of 2014 ending inventory Overstatement of 2015 ending inventory Expensing of insurance premium in 2014 ($66,000 ÷ 3) Failure to record sale of fully depreciated machine in 2015 Total effect of errors on net income (overstated)
$ 9,600 8,100 22,000 (15,000) $24,700
(b) Effect of errors on working capital: $28,900 understatement Computations: Effect on working capital over (under) statement Overstatement of 2015 ending inventory Expensing of insurance premium in 2014 (prepaid insurance) Sale of fully depreciated machine unrecorded Total effect on working capital (understated)
$ 8,100 (22,000) (15,000) $(28,900)
(c) Effect of errors on retained earnings: $26,600 understatement Computations: Effect on retained earnings over (under) statement Overstatement of 2015 ending inventory Understatement of depreciation expense in 2014 Expensing of insurance premium in 2014 Failure to record sale of fully depreciated machine in 2015 Total effect on retained earnings (understated)
$ 8,100 2,300 (22,000) (15,000) $(26,600)
EXERCISE 22-19 (20–25 minutes) (a) 1. 2.
3. 4.
5. 6.
7. (b) 1. 2. 3. 4. 5. 6. 7.
Supplies Expense ($2,700 – $1,100) .................. Supplies .......................................................
1,600
Salary and Wages Expense................................ ($4,400 – $1,500) Salaries and Wages Payable ......................
2,900
Interest Revenue ($5,100 – $4,350) .................... Interest Receivable on Investments...........
750
Insurance Expense ............................................. ($90,000 – $65,000) Prepaid Insurance .......................................
25,000
Rent Revenue ($28,000 ÷ 2)................................ Unearned Rent Revenue .............................
14,000
Depreciation Expense ........................................ ($50,000 – $5,000) Accumulated Depreciation .........................
45,000
Retained Earnings .............................................. Accumulated Depreciation .........................
7,200
Retained Earnings .............................................. Supplies .......................................................
1,600
Retained Earnings .............................................. Salaries and Wages Payable ......................
2,900
Retained Earnings .............................................. Interest Receivable......................................
750
Retained Earnings .............................................. Prepaid Insurance .......................................
25,000
Retained Earnings .............................................. Unearned Rent Revenue .............................
14,000
Retained Earnings .............................................. Accumulated Depreciation .........................
45,000
Same as in (a).
1,600
2,900 750
25,000 14,000
45,000 7,200 1,600 2,900 750 25,000 14,000 45,000
EXERCISE 22-19 (Continued) (c) 6.
7.
Retained Earnings.............................................. Income Taxes Receivable.................................. Accumulated Depreciation ........................ *($45,000 40%) – less tax expense.
27,000 18,000*
Retained Earnings.............................................. Income Taxes Receivable.................................. Accumulated Depreciation ........................ **($7,200 40%) – less tax expense.
4,320 2,880**
45,000
7,200
EXERCISE 22-20 (20–25 minutes)
Income before tax Corrections: Sales erroneously included in 2014 income Understatement of 2014 ending inventory Adjustment to bond interest expense* Repairs erroneously charged to the Equipment account Depreciation recorded on improperly capitalized repairs (10%)*** Corrected income before tax
2014
2015
$101,000
$77,400
(38,200) 8,640 (1,450) (8,500)
38,200 (8,640) (1,552) (9,400)
850 $ 62,340
1,790 $97,798
*Bond interest expense for 2014 and 2015 was computed as follows:
2014 2015
Book Value of Bonds
Stated Interest
Effective Interest
$235,000 236,450
$15,000 15,000
$16,450** 16,552
**$235,000 X 7% Difference between effective interest at 7% and stated interest (6%): 2014: $1,450 2015: 1,552
EXERCISE 22-20 (Continued) ***Erroneous depreciation taken in 2015: on 2014 addition ($8,500 ÷ 10) on 2015 addition ($9,400 ÷ 10) Total excess depreciation 2015
$ 850 940 $1,790
EXERCISE 22-21 (10–15 minutes) Item (1) (2) (3) (4) (5)
2014 OverUnderstatement statement
No Effect X
X
2015 OverUnderstatement statement X X
X
No Effect
X
X
X X
X
*EXERCISE 22-22 (25–30 minutes) Because Beyonce Co. now has a 30% interest in Elton John Corp. as of 7/1/15, it is necessary to first adjust the investment in Elton John to the equity method in prior periods. The following schedule provides this information:
Beyonce’s equity in earnings of Elton John Corp. (10%) Dividends received Adjustment
12/31/14
6/30/15
$70,000 0 $70,000
$50,000 0 $50,000
Note to instructor: Under GAAP, goodwill is not amortized. A computation of the ending balance in the investment account of Elton John Corp. can now be made as follows: Investment in Elton John Corp. 1/1/14 Additional purchase 7/1/15 Adjustment for 2014 income (prior period) Adjustment for 2015 income to 6/30 (prior period) Income (7/1/15–12/31/15) $815,000 X 30% Dividends (7/1/15–12/31/15) $1.55 X 75,000 shares Investment in Elton John Corp. 12/31/15
$1,400,000 3,040,000 70,000 50,000 244,500 (116,250) $4,688,250
*EXERCISE 22-23 (15–20 minutes) (a)
Prior to January 2, 2014, Dan Aykroyd Corp. carried the investment in Martin Company under the equity method of accounting as evidenced from the entries in the investment account. Use of the equity method was appropriate because Dan Aykroyd’s interest in Martin exceeded 20%. With the sale of 126,000 shares, Dan Aykroyd’s interest dropped to 12% and it could no longer use the equity method of accounting for the investment. Aykroyd must change to the fair value method. Cessation of the equity method (increasing the investment for the proportionate share of earnings and decreasing it for dividends received) occurs immediately. The carrying value of the remaining 12% interest becomes the carrying amount for the fair value method with adjustments for cumulative excess dividends received after the change from the equity method over its share of Steve Martin Company’s earnings. That carrying amount is transferred from the investment in Steve Martin account to the Available-for-Sale Securities account.
(b)
The carrying amount of the investment in Martin as of December 31, 2014, would be computed as follows: Carrying amount, 12/31/13 (from the given account information) Less portion attributable to 126,000 shares sold 1/2/14 Balance, 1/2/14 Less cumulative excess dividends received over share of Martin earnings Carrying amount, 12/31/14 a
(2,214,000)a 1,476,000 (14,400)b $1,461,600
$3,690,000 X 126/210
b
Computation of Excess Dividends Received over Share of Earnings:
2014 c
$3,690,000
Dividends Received
Share of Martin Co. Income
Excess Dividends Received Over Share of Earnings
$50,400
$36,000c
$(14,400)
$300,000 X 12% = $36,000
*EXERCISE 22-23 (Continued) Note to instructor: The entry in 2014 to record the receipt of the dividend would be: Cash........................................................................ Equity Investments (Available-for-Sale) ....... Dividend Revenue ..........................................
50,400 14,400 36,000
(c) The entry to recognize the excess of fair value over the carrying amount of the securities is as follows: December 31, 2014 Fair Value Adjustment (Available-for-Sale)........... Unrealized Holding Gain or Loss— Equity ($1,570,000 – $1,461,600) ................
108,400 108,400
TIME AND PURPOSE OF PROBLEMS Problem 22-1 (Time 30–35 minutes) Purpose—to provide a problem that requires the student to: (1) account for a change in estimate, (2) record a correction of an error, and (3) account for a change in accounting principle. The student is also required to compute corrected/adjusted net income amounts. Problem 22-2 (Time 30–40 minutes) Purpose—to develop an understanding of the way in which accounting changes and error corrections are handled in accounting records. The problem presents descriptions of various situations for which the student is required to indicate the correct accounting treatment and to prepare comparative income statements for a four-year period. Problem 22-3 (Time 30–40 minutes) Purpose—to provide a problem that requires the student to: (1) prepare correcting entries for two years’ unrecorded sales commissions, (2) three years’ inventory errors, and (3) prepare entries for two different accounting changes. Problem 22-4 (Time 40–50 minutes) Purpose—to allow the student to see the impact of accounting changes on income and to examine an ethical situation related to the motivation for change. Problem 22-5 (Time 30–35 minutes) Purpose—to develop an understanding of the impact which a change in the method of inventory pricing (from LIFO to average cost) has on the financial statements during a five-year period. The student is required to prepare a comparative statement of income and retained earnings for the five years assuming the change in inventory pricing with an indication of the effects on net income and earnings per share for the years involved. Problem 22-6 (Time 25–30 minutes) Purpose—to develop an understanding of the journal entries and the reporting which are necessitated by an accounting change or correction of an error. The student is required to prepare the entries to reflect such changes or errors and the comparative income statements and retained earnings statements for a two-year period. Problem 22-7 (Time 25–30 minutes) Purpose—to provide a problem that requires the student to analyze ten transactions and to prepare adjusting or correcting entries for these transactions. Problem 22-8 (Time 30–35 minutes) Purpose—to help a student understand the effect of errors on income and retained earnings. The student must analyze the effects of errors on the current year’s net income and on the next year’s ending retained earnings balance. Problem 22-9 (Time 20–25 minutes) Purpose—to develop an understanding of the effect that errors have on the financial statements. The student is required to prepare a schedule portraying the corrected net income for the years involved with this error analysis.
Time and Purpose of Problems (Continued) Problem 22-10 (Time 50–60 minutes) Purpose—to develop an understanding of the correcting entries and income statement adjustments that are required for changes in accounting policies and accounting errors. This comprehensive problem involves many different concepts such as consignment sales, bonus computations, warranty costs, and bank funding reserves. The student is required to prepare the necessary journal entries to correct the accounting records and a schedule showing the revised income before taxes for each of the three years involved. *Problem 22-11 (Time 20–25 minutes) Purpose—to provide the student with a problem involving an investment that grows from 10% to 40% (from lack of significant influence to significant influence). The student is required to account for the effect of this change on income. *Problem 22-12 (Time 20–25 minutes) Purpose—to provide the student with an understanding of the proper entries to reflect a change from the cost method to the equity method with excess attributable to depreciable assets in accounting for an investment. The student is required to prepare the necessary journal entries for a three-year period with respect to this stock investment and the change in reporting methods.
SOLUTIONS TO PROBLEMS PROBLEM 22-1
(a) 1.
Cost of equipment........................................................... Less: Salvage value ........................................................ Depreciable cost ............................................................. Depreciation to 2014 2011 ($80,000/10) ......................... 2012 ($80,000/10) ......................... 2013 ($80,000/10) .........................
Depreciation in 2014 Cost of equipment ....................... Less: Depreciation to 2014 ........ Book value (January 1, 2014) ..... Less: Salvage value ................... Depreciable cost..........................
$85,000 5,000 $80,000
$ 8,000 8,000 8,000 $24,000 $85,000 24,000 61,000 3,000 $58,000
Depreciation in 2014 $58,000/4 = $14,500 Depreciation Expense ................................................ 14,500 Accumulated Depreciation—Equipment........ 2.
Cost of Building ................................... Less: Depreciation to 2014 2012............................................ 2013............................................ Book value (January 1, 2014)... Less: Salvage value................. Depreciable cost .......................
14,500
$300,000 60,000 48,000 $192,000 30,000 $162,000
Depreciation in 2014 ($162,000/8) = $20,250 Depreciation Expense ................................................ 20,250 Accumulated Depreciation—Buildings.........
20,250
PROBLEM 22-1 (Continued) 3.
Depreciation Expense ($120,000 – $16,000) ÷ 8..... Accumulated Depreciation—Machinery .........
13,000
Accumulated Depreciation—Machinery................. Retained Earnings............................................
3,000
13,000 3,000
Depreciation recorded in 2012: 1 ($120,000 ÷ 8) X = 7,500 2 Depreciation that should be recorded in 2012: 1 ([$120,000 – $16,000] ÷ 8) X = 6,500 2 Depreciation recorded in 2013: (120,000 ÷ 8) = $15,000 Depreciation that should be recorded in 2013: (120,000 – $16,000) ÷ 8 = 13,000 Depreciation Depreciation that taken should be taken Differences
(b)
2012
$7,500
$6,500
$1,000
2013
15,000
13,000
2,000
22,500
19,500
$3,000
HOLTZMAN COMPANY Comparative Income Statements For the Years 2014 and 2013 2014
2013
Income before depreciation expense................. $300,000 $310,000 Depreciation expense* ........................................ 47,750 69,000 Net income........................................................... $252,250 $241,000 *Depreciation Expense Equipment..................................................... Buildings ....................................................... Machinery......................................................
2014 $ 14,500 20,250 13,000 $ 47,750
2013 $
8,000 48,000 13,000 $ 69,000
PROBLEM 22-2
(a) 1.
Bad debt expense for 2012 should not have been reduced by $10,000. A change in the experience rate is considered a change in estimate, which should be handled prospectively.
2.
A change from LIFO to FIFO is considered a change in accounting principle, which must be handled retrospectively.
3.
(a) The inventory error in 2014 is a prior period adjustment and the 2014 and 2015 financial statements should be restated. (b) The lawsuit settlement is correctly treated.
(b)
BOTTICELLI INC. Comparative Income Statements For the Years 2012 through 2015 Income before extraordinary item Extraordinary gain Net income (see below)
Net income (unadjusted) 1. Bad debt expense adjustment 2. Inventory adjustment (FIFO) 3. Inventory overstatement Net income (adjusted)
2012
2013
$145,000 $145,000
$135,000* 30,000 $165,000
2012
2013
$140,000
$160,000
2014
2015
$201,000 $274,000 $201,000 $274,000 2014
2015
$205,000 $276,000
(10,000) 15,000 $145,000
5,000
10,000
(16,000)
(14,000) 14,000 $165,000* $201,000 $274,000
*The income before extraordinary item in 2013 is $135,000 ($165,000 – $30,000).
PROBLEM 22-3
1.
2.
Retained Earnings ..................................................... Sales Commissions Payable ............................. Sales Commission Expense..............................
3,500
Cost of Goods Sold ($19,000 + $6,700) .................... Retained Earnings.............................................. Inventory.............................................................
25,700
2,500 1,000 19,000 6,700
Income Overstated (Understated) Beginning inventory Ending inventory
3.
4.
2012
2013
2014
$(16,000) $(16,000)
$ 16,000 (19,000) $ (3,000)
$19,000 6,700 $25,700
Accumulated Depreciation—Equipment.................. Depreciation Expense........................................ *Equipment cost ........................................ Depreciation before 2014 ......................... Book value ................................................
$100,000 (36,000) $ 64,000
Depreciation recorded ............................. Depreciation to be taken ($64,000/8)....... Difference..................................................
$ 12,800 (8,000) $ 4,800
Construction in Process ........................................... Deferred Tax Liability......................................... Retained Earnings.............................................. *($150,000 – $105,000) X 40%
4,800 4,800*
45,000 18,000* 27,000
PROBLEM 22-4 (a)
ASTON CORPORATION Projected Income Statement For the Year Ended December 31, 2014 Sales ..................................................... Cost of goods sold ................................. $14,000,000 Depreciation expense.......................... 1,600,000a Operating expenses............................. 6,400,000 Income before income taxes............... Unrealized holding gain....................... Income before taxes and bonus ......... President’s bonus................................ Income before income taxes............... Income taxes Current .......................................... $ 3,000,000 Deferred ........................................ 500,000c Net income ...........................................
$29,000,000 22,000,000 $ 7,000,000 1,000,000b $ 8,000,000 1,000,000 $ 7,000,000 3,500,000 $ 3,500,000
Conditions met: 1. 2.
Net income before taxes and bonus > $7,000,000. Payable for income taxes does not exceed $3,000,000.
a
Depreciation for the current year includes $600,000 for the old equipment and $2,000,000 for the robotic equipment. If the robotic equipment is changed to straight-line, its depreciation is only $1,000,000 and the total is $1,600,000.
b
By urging the Board of Directors to change the classification of Securities A and D to Trading securities, income is increased by a $1,000,000 recognition of a holding gain.
c
The unrealized holding gain is not currently taxable until the securities are sold.
PROBLEM 22-4 (Continued) (b) Students’ answers will vary. There is nothing unethical about changing the first-year election of depreciation back to the straight-line method provided that it meets with the approval of appropriate corporate decision makers. Considering the immediate needs for cash of $1,000,000 for the president’s bonus and $3,000,000 for income taxes, there may be a need to sell some of the marketable securities. Therefore, the transfer of $3,000,000 of availablefor-sale securities to trading securities may also be appropriate. It is naive to believe that corporate officers do no planning for year-end (or interim) financial statements. The slippery slope arises with manipulation of financial statements. The security reclassification for the selected securities clearly manipulates the income to the benefit of the president. While legal and within GAAP guidelines, the ethics of this situation are borderline. Any auditor would automatically bring this transaction to the attention of the board of directors. Some stakeholders and their interests are: Stakeholder
Interests
President
Personal gain of $1,000,000 bonus.
CFO
Placed in ethical dilemma between the interests of the president and the corporation.
Board of Directors
May be subject to the manipulations of the CEO for his personal gain.
Stockholders
Increased income from higher (paper) income may increase demand for dividends. Also, paying a bonus may decrease cash available for dividends.
Employees
President takes over 25% of net income for himself. This could have been used to start a pension plan for all of the employees.
Creditors
The increased income represents a 17% inflation of the true net income of the corporation. This may lead to a miss-representation of creditworthiness.
PROBLEM 22-5
UTRILLO INSTRUMENT COMPANY Statement of Income and Retained Earnings For the Years Ended May 31 2010
2011
2012
2013
2014
Sales—net Cost of goods sold Beginning inventory Purchases Ending inventory Total Gross profit Administrative expenses Income before taxes Income taxes (50%) Net income Retained earnings—beginning: As originally reported Adjustment (See note* and schedule) As restated Retained earnings—ending
$13,964
$15,506
$16,673
$18,221
$18,898
1,010 13,000 (1,124) 12,886 1,078 700 378 189 189
1,124 13,900 (1,101) 13,923 1,583 763 820 410 410
1,101 15,000 (1,270) 14,831 1,842 832 1,010 505 505
1,270 15,900 (1,500) 15,670 2,551 907 1,644 822 822
1,500 17,100 (1,720) 16,880 2,018 989 1,029 515 514
1,206
1,388
1,759
2,237
3,005
5 1,211 $ 1,400
12 1,400 $ 1,810
51 1,810 $ 2,315
78 2,315 $ 3,137
132 3,137 $ 3,651
Earnings per share (100 shares)
$
$
$
$
$
1.89
4.10
5.05
8.22
5.14
*Note to instructor: The retained earnings balances are usually reported in the above manner. If desired, only the restated balances might be reported. The adjustments are simply the cumulative difference in income between the two inventory methods, net of tax. For example, the $5 in 2010 reflects the difference in ending inventories in 2009 ($1,000 – $1,010) times the tax rate 50%. In 2011, the difference in income of $7 between the two methods in 2010 is added to the $5 to arrive at a $12 adjustment to the beginning balance of retained earnings in 2011.
PROBLEM 22-5 (Continued) In 2014, the Company changed its method of pricing inventory from the last-in, first out (LIFO) to the average cost method in order to more fairly present the financial operations of the company. The financial statements for prior years have been restated to retrospectively reflect this change, resulting in the following effects on net income and related per share amounts: Increase in Net income Earnings per share
2010
2011
2012
2013
2014
$ 7 $0.07
$ 39 $0.39
$ 27 $0.27
$ 54 $0.54
$ 44 $0.44
2013
2014
Schedule of Income Reconciliation and Retained Earnings Adjustments 2010–2014 2009
2010
Beginning Inventory LIFO Average Cost Difference Tax Effect (50%) Effect on Income*
2011
2012
$1,000 1,010 (10) 5 $ (5)
$1,100.00 $1,000.00 $1,115.00 $1,237.00 1,124.00 1,101.00 1,270.00 1,500.00 (24.00) (101.00) (155.00) (263.00) † † 12.00 50.50 77.50 131.50† † † $ (12.00) $ (50.50) $ (77.50) $ (131.50)
Ending Inventory LIFO Average Cost Difference Tax Effect (50%) Effect on Income**
$1,000 1,010 (10) 5 $ 5
$1,100 1,124 (24) 12 $ 12
$1,000.00 $1,115.00 $1,237.00 $1,369.00 1,101.00 1,270.00 1,500.00 1,720.00 (101.00) (155.00) (263.00) (351.00) † † † 50.50 77.50 131.50 175.50 † † † $ 50.50 $ 77.50 $ 131.50 $ 175.50
Net Effect on Income
$
$
7
$
38.50† $
27.00
$
12
$
50.50† $
77.50† $ 131.50 $ 175.50
Cumulative Effect on Beginning Retained Earnings
5
$
54.00
$ 44.00†
*Larger (smaller) beginning inventory has negative (positive) effect on net income. **Larger (smaller) ending inventory has positive (negative) effect on net income. †
The tax effects are rounded up to the next whole dollar in the problem. Therefore, the net effects on income and retained earnings are effectively rounded down to the next whole dollar.
PROBLEM 22-6
(a) 1.
Depreciation Expense....................................... Accumulated Depreciation—Equipment..
94,500 94,500
Computations: Cost of Equipment ........................................ Less: Depreciation prior to 2014 .................. Book value, January 1, 2014.........................
$540,000 162,000* $378,000
*($540,000 ÷ 10) X 3 Depreciation for 2014: $378,000 X 7/28** = $94,500 **[7(7 + 1)] ÷ 2 = 28 2.
Depreciation Expense....................................... Accumulated Depreciation— Equipment..............................................
25,800 25,800
Computations: Original cost .............................................. Accumulated depreciation (1/1/14) $12,000 X 4 ............................................. Book value (1/1/14) .................................... Estimated salvage value ........................... Remaining depreciable base .................... Remaining useful life (9 years—4 years taken)........................ Depreciation expense—2014 .................... 3.
$180,000 (48,000) 132,000 (3,000) 129,000 ÷ 5 $ 25,800
Equipment (Asset C)......................................... Accumulated Depreciation—Equipment (4 X $16,000)........................................... Retained Earnings .....................................
160,000
Depreciation Expense....................................... Accumulated Depreciation— Equipment..............................................
16,000
64,000 96,000
16,000
PROBLEM 22-6 (Continued) (b)
MADRASA INC. Comparative Retained Earnings Statements For the Years Ended
Retained earnings, January 1, as previously reported Add: Error in recording equipment (Asset C) Retained earnings, January 1, as adjusted Add: Net income Retained earnings, December 31
2014
2013
$666,000 208,700** $874,700
$200,000 112,000* 312,000 354,000*** $666,000
*Amount expensed incorrectly in 2010 .................... Depreciation to be taken to January 1, 2013 ($16,000 X 3).......................................................... Prior period adjustment for income........................
$160,000
**Income before depreciation expense (2014) Depreciation for 2014 Equipment (Asset A) $94,500 Equipment (Asset B) 25,800 Equipment (Asset C) 16,000 Other 55,000 Income after depreciation expense
$400,000
***Net income as reported ........................................... Depreciation (Asset C) ............................................ Net income as adjusted...........................................
$370,000 (16,000) $354,000
(48,000) $112,000
(191,300) $208,700
PROBLEM 22-7
(1) Depreciation Expense ................................................... Accumulated Depreciation—Equipment ..............
3,200
(2) Cost of Goods Sold ....................................................... Retained Earnings .................................................
19,000
(3) Cash ............................................................................... Accounts Receivable.............................................
5,600
(4) Accumulated Depreciation—Equipment...................... Equipment .............................................................. Gain on Disposal of Plant Assets .........................
3,200
19,000
5,600 25,000 21,300 3,700
(5) Lawsuit Loss.................................................................. Lawsuit Liability .....................................................
125,000
(6) Unrealized Holding Gain or Loss—Income ................. Fair Value Adjustment (Trading)...........................
2,000
(7) Salaries and Wages Payable ($16,000 – $12,200)........ Salaries and Wages Expense................................
3,800
(8) Depreciation Expense ................................................... Equipment...................................................................... Maintenance and Repairs Expense ...................... Accumulated Depreciation—Equipment ..............
125,000
2,000
3,800 5,000 40,000 40,000 5,000
PROBLEM 22-7 (Continued) (9) Insurance Expense ($12,000 ÷ 3)....................................... Prepaid Insurance .............................................................. Retained Earnings ......................................................
4,000 6,000
(10) Amortization Expense ($50,000 ÷ 10)................................ Retained Earnings.............................................................. Trademarks .................................................................
5,000 5,000
10,000
10,000
PROBLEM 22-8
Net Income for 2013
Retained Earnings 12/31/14
Item
Understated
Overstated
Understated
Overstated
1. 2. 3. 4. 5. 6.
$14,100 $ 3,500 0 $28,000 0 $18,200
0 0 $22,000 0 $24,000 0
0 $ 2,500 0 $28,000 0 0
0 0 $11,000 0 $12,000 0
Although explanations were not required in answering the question, they are included below for your interest. Explanations: 1.
The net income would be understated in 2013 because interest income is understated. The net income would be overstated in 2014 because interest income is overstated. The errors, however, would counterbalance (wash) so that the Balance Sheet (Retained Earnings) would be correct at the end of 2014.
2.
The depreciation expense in 2013 should be $500 for this machine. Since the machine was bought on July 1, 2013, only one-half of a year’s depreciation should be taken in 2013 ($4,000/4 X 1/2 = $500). The company expensed $4,000 instead of $500 so net income is understated by $3,500 in 2013. An additional $1,000 of depreciation expense should have been taken in 2014. At the end of 2014, retained earnings would be understated by $2,500 ($3,500 – $1,000).
3.
GAAP requires that all research and development costs should be expensed when incurred. Net income in 2013 is overstated $22,000 ($33,000 research and development costs capitalized less $11,000 amortized). By the end of 2014, only $11,000 of the research and development costs would remain as an asset. Therefore, retained earnings would be overstated by $11,000 ($33,000 research and development costs – $22,000 amortized).
PROBLEM 22-8 (Continued) 4.
The security deposit should be a long-term asset, called refundable deposits. The $8,000 of the last month’s rent is also an asset, called prepaid rent. The net income of 2013 is understated by $28,000 ($20,000 + $8,000) because these amounts were expensed. Retained earnings will continue to be understated by $28,000 until the last year of the lease. The security deposit will then be refunded, and the last month’s rent should be expensed.
5.
$12,000 or one-third of $36,000 should be reported as income each year. In 2013, $36,000 was reported as income when only $12,000 should have been reported. Because $24,000 too much was reported, the net income of 2013 is overstated. By the end of 2014, $24,000 should have been reported as income, so retained earnings is still overstated by $12,000 ($36,000 – $24,000).
6.
The ending inventory would be understated since the merchandise was omitted. Because ending inventory and net income have a direct relationship, net income in 2013 would be understated. The ending inventory of 2013 becomes the beginning inventory of 2014. If beginning inventory of 2014 is understated, then net income of 2014 is overstated (inverse relationship). The omission in inventory over the two-year period will counterbalance, and retained earnings at the end of 2014 will be correct.
PROBLEM 22-9
Net income, as reported Rent received in 2013, earned in 2014 Salaries and Wages not accrued, 12/31/12 Salaries and Wages not accrued, 12/31/13 Salaries and Wages not accrued, 12/31/14 Inventory of supplies, 12/31/12 Inventory of supplies, 12/31/13 Inventory of supplies, 12/31/14 Corrected net income
2013 $29,000 (1,000) 1,100 (1,200) (1,300) 940 $27,540
2014 $37,000 1,000 1,200 (940) (940) 1,420 $38,740
PROBLEM 22-10
PROBLEM 22-10 (Continued) (b)
Sales Revenue .......................................................... Inventory on Consignment....................................... Cost of Goods Sold........................................... Accounts Receivable ........................................ (To adjust for consignments treated as sales, 3/31/13)
5,590 4,472
Sales Revenue .......................................................... Retained Earnings............................................. (To adjust for C.O.D. sales not recorded, 3/31/12)
6,100
Warranty Expense..................................................... Retained Earnings ($3,908 + $3,443) ....................... Warranty Liability .............................................. (To record accrued warranty expense)
5,067 7,351
Retained Earnings ($1,584 + $1,237) ....................... Bad Debt Expense .................................................... Allowance for Doubtful Accounts .................... (To set up allowance for uncollectible accounts)
2,821 608
Due to Customer ....................................................... Finance Expense ............................................... Retained Earnings ($3,000 + $3,900)................ (To record finance charge reserve held by bank)
12,000
Salaries and Wages Expense................................... Retained Earnings ($1,400 – $500) .......................... Salaries and Wages Payable ............................ (To adjust for accrued commissions)
220 900
Retained Earnings ($664 + $1,185) .......................... Salaries and Wages Expense................................... Salaries and Wages Payable ............................ (To set up accrued bonus payable to manager)
1,849 956
4,472 5,590
6,100
12,418
3,429
5,100 6,900
1,120
2,805
*PROBLEM 22-11
(a)
MILLAY INC. Schedule of Income or Loss from Investment For Year Ending December 31, 2014 Dividend revenue....................................................................... (10,000 shares X $1.50 dividend/share)
(b)
$15,000
MILLAY INC. Schedule of Income or Loss from Investment For Years Ending December 31, 2015 and 2014
Income from investment in Genso (Schedule 1) Schedule 1
2015
2014
$170,000
$55,000
Millay’s Share of Investee’s Income 2015
Income for 2014 ($550,000 X 10%) Income for 2015 First half ($300,000* X 10%) Second half ($350,000 X 40%) *($650,000 – $350,000)
2014 $55,000
$ 30,000 140,000 $170,000
$55,000
*PROBLEM 22-12
January 3, 2013 Equity Investments (Available-for-sale)....................... Cash........................................................................ (To record the purchase of a 10% interest in Renner Corp.)
500,000 500,000
December 31, 2013 Cash ............................................................................... Dividend Revenue.................................................. (To record the receipt of cash dividends from Renner Corp.)
15,000 15,000
December 31, 2013 Fair Value Adjustment (Available-for-Sale) ................. Unrealized Holding Gain or Loss—Equity ........... (To recognize as part of stockholders’ equity the increase in fair value of available-for-sale securities)
60,000 60,000
December 31, 2014 Cash ............................................................................... Dividend Revenue.................................................. (To record the receipt of cash dividends from Renner Corp.)
20,000 20,000
December 31, 2014 Unrealized Holding Gain or Loss—Equity ................... Fair Value Adjustment (Available-for-Sale).......... (To recognize as part of stockholders’ equity the decrease in fair value of available-for-sale securities)
45,000 45,000
*PROBLEM 22-12 (Continued) January 2, 2015 Equity Investments (Renner Corp.)......................... Cash................................................................... Retained Earnings ............................................ (To record purchase of additional interest in Renner and to reflect retroactively a change from the fair value to the equity method)
1,564,000 1,545,000 19,000
Computation of Prior Period Adjustment Martin equity in earnings of Renner (10%) Amortization of excess of purchase price over underlying equity [$500,000 – ($3,700,000 X 10%) ÷ 10] Dividend received Prior period adjustment
2013
2014
Total
$35,000*
$45,000
$80,000
(13,000) (15,000) $ 7,000
(13,000) (20,000) $12,000
(26,000) (35,000) $19,000
*$350,000 X 10% January 2, 2015 Equity Investments (Renner Corp.)......................... Equity Investments (Available-for-sale).......... (To reclassify investment carried under fair value method to investment carried under equity method)
500,000
Unrealized Holding Gain or Loss—Equity.............. Fair Value Adjustment (Available-for-Sale)..... (To eliminate accounts and balances used under fair value method accounting)
15,000
500,000
15,000
*PROBLEM 22-12 (Continued) December 31, 2015 Equity Investments (Renner Corp.). ............................. Investment Revenue ............................................. (To record equity in net income of Renner—40% of $550,000 less $50,500 amortization of excess cost over underlying equity) Computation of amortization: 2013 purchase ($130,000 ÷ 10 years) 2015 purchase [$1,545,000 – ($4,150,000 X 30%) ÷ 8 years] Total
169,500 169,500
$13,000 37,500 $50,500
Cash ............................................................................... Equity Investments (Renner Corp.). ..................... (To record the receipt of cash dividends from Renner Corp.)
70,000 70,000
TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 22-1 (Time 25–35 minutes) Purpose—to provide the student with some familiarity with the applications of GAAP related to accounting changes. This case describes several proposed accounting changes with which the student is required to identify whether the change involves an accounting principle, accounting estimate, or correction of an error, plus the necessary reporting requirements for each proposal. CA 22-2 (Time 20–30 minutes) Purpose—to provide the student with an understanding of the application and reporting requirements of GAAP. This case describes many different accounting changes with which the student is required to identify the type of change involved and to indicate which changes necessitate the restatement of prior years’ financial statements when presented in comparative form with the current year’s statement. CA 22-3 (Time 30–35 minutes) Purpose—to provide the student with an understanding of GAAP and its respective applications. This case describes three independent situations with which the student is required to identify the type of accounting change involved, the reporting which is necessitated under current generally accepted accounting principles, and the effects of each change on the financial statements. CA 22-4 (Time 20–30 minutes) Purpose—to provide the student with an understanding of how changes in accounting can be reflected in the accounting records to facilitate analysis and understanding of financial statements. This case involves several situations with which the student is required to indicate the appropriate accounting treatment that each should be given. CA 22-5 (Time 20–30 minutes) Purpose—to provide the student with an opportunity to explain how to account for various accounting change situations. Explanations for a change in estimate, change in principle, and change in entity are communicated in a written letter. CA 22-6 (Time 20–30 minutes) Purpose—to provide the student with an opportunity to explain the ethical issues related to changes in estimates.
SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 22-1 (a)
1.
Uncollectible Accounts Receivable. This is a change in accounting estimate. Restatement of prior periods is not appropriate.
2.
Depreciation. a. This is a change in accounting estimate. Restatement of opening retained earnings is not appropriate. b. This is a new method for a new class of assets. No change is involved.
(b)
3.
Mathematical Error. This is a correction of an error and prior period treatment would be in order.
4.
Preproduction Costs—Furniture Division. This should probably be construed as an inseparability situation in that the change in accounting estimate (period benefited by deferred costs) has been affected by a change in accounting principle (amortization on a per-unit basis). Consequently, it is treated as a change in accounting estimate. Restatement of opening retained earnings is not appropriate.
5.
FIFO to LIFO Change. This is a change in accounting principle. Restatement of December 31, 2013 retained earnings is not appropriate, given that the effect on net income in prior periods cannot be determined. Note that a LIFO to FIFO change does qualify for restatement of opening retained earnings, but FIFO to LIFO does not qualify in most cases because it is impracticable to determine prior year’s income under LIFO.
6.
Percentage of Completion. This is a change in accounting principle. Retained earnings should be adjusted.
The adjustment to the December 31, 2013 retained earnings balance would be computed as follows: Item 3.................................................................................................. Item 6.................................................................................................. Increase in 12/31/13—Retained Earnings ...........................................
$ (235,000) 1,075,000 $ 840,000
CA 22-2
Item Change
Type of Change
Should Prior Years’ Statements Be Retrospectively Applied or Restated?
1.
A change in accounting principle.
Yes
2.
A change in an accounting estimate.
No
3.
An accounting change involving both a change in accounting principle and a change in accounting estimate. Referred to as an change in accounting estimate effected by a change in principle. Handle as a change in estimate.
No
4.
Not an accounting change but rather a change in classification.
Yes
5.
An error correction not involving a change in accounting principle.
Yes
6.
An accounting change involving a change in the reporting entity which is a special type of change in accounting principle.
Yes
7.
Not a change in accounting principle. Simply, a change in tax accounting.
No
8.
An accounting change from one generally accepted accounting principle to another generally accepted accounting principle.
No*
*Generally impracticable to determine what LIFO inventory would be in prior periods.
CA 22-3 Situation 1. (a)
A change from an accounting principle not generally accepted to one generally accepted is a correction of an error.
(b)
When comparative statements are presented, net income, components of net income, retained earnings, and any other affected balances for all periods presented should be restated to correct for the error. When single period statements are presented, the required adjustments should be reported in the opening balance of retained earnings. A description of the change and its effect on income before extraordinary items, net income, and the related per share amounts should be disclosed in the period of the change. Financial statements of subsequent periods need not repeat the disclosures.
(c)
The beginning balance of retained earnings in the balance sheet is restated. The income statement for the current year should report the correct approach for revenue recognition. If prior years’ financial statements are presented, they should be restated directly.
CA 22-3 (Continued) Situation 2. (a)
The change in method of inventory pricing represents a change in accounting principle, as defined by GAAP.
(b)
Changes in accounting principle are accounted for through retrospective application. Under this approach, the cumulative effect of the new method on the financial statements at the beginning of the period is computed (and recorded in retained earnings at the beginning of the period). Prior statements are changed to be reported on a basis consistent with the new standard.
(c)
As a result of the change to weighted-average costing, the current year balance sheet will reflect weighted-average costing (at relatively higher prices in times of rising prices). Cost of goods sold will also be different (higher), resulting in lower income.
Situation 3. (a)
A change in the depreciable lives of fixed assets is a change in accounting estimate.
(b)
In accordance with GAAP, the change in estimate should be reported in the current period and in future periods. Unlike a change in accounting principle, the change in accounting estimate should not be accounted for by presenting prior earnings data giving effect to the change as if it had been applied retrospectively.
(c)
This change in accounting estimate will affect the balance sheet 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 income statement in the current and future years.
CA 22-4 1.
This situation is a change in estimate. Whenever it is impossible to determine whether a change in principle or a change in estimate has occurred, the change should be considered a change in estimate. This is often referred to as a change in accounting estimate effected by a change in accounting principle. A change in estimate employs the current and prospective approach by: (a)
Reporting current and future financial statements on the new basis.
(b)
Presenting prior periods’ financial statements as previously reported.
(c)
Making no adjustments to current opening balances for purposes of catch-up.
2.
This situation is considered a change in estimate because new events have occurred which call for a change in estimate. The accounting should be the same as discussed in 1.
3.
This situation is considered a correction of an error. The general rule is that careful estimates which later prove to be incorrect should be considered changes in estimates. Where the estimate was obviously computed incorrectly because of lack of expertise or in bad faith, the adjustment should be considered an error. Changes due to error should employ the retroactive approach by: (a)
Restating, via a prior period adjustment, the beginning balance of retained earnings for the current period.
CA 22-4 (Continued) (b)
Correcting all prior period statements presented in comparative financial statements. The amount of the error related to periods prior to the earliest year’s statement presented for comparative purposes should be included as an adjustment to the beginning balance of retained earnings of that earliest year’s statement.
4.
No adjustment is necessary—a change in accounting principle is not considered to have happened if a new principle is adopted in recognition of events that have occurred for the first time.
5.
This situation is considered a change in estimate because new events have occurred which call for a change in estimate. The accounting should be the same as discussed in 1.
6.
This situation is considered a change in accounting principle. A change in accounting principle should employ the retrospective approach by: (a)
Reporting current results on the new basis.
(b)
Presenting prior period financial statements on a basis consistent with the newly adopted method.
(c)
Computing the cumulative effect of the new method in beginning retained earnings on the earliest year presented.
CA 22-5 Mr. Joe Davison, CEO Sports-Pro Athletics, Inc. Dear Mr. Davison: You recently contacted me about several accounting changes made at Sports-Pro Athletics, Inc. in 2014. This letter details how you should account for each change. Your change from one method of depreciation to another constitutes a change in accounting estimate effected by a change in accounting principle. A change in estimate employs the prospective approach by reporting current and future financial statements on the new basis. Prior periods financial statements are presented as previously reported. Your change in salvage values for your office equipment is considered a change in estimate. This type of change does not really affect previous financial statements and is thus accounted for prospectively. The change is included in the most current period being reported. There is no need to restate prior periods’ financial statements. Finally, your change in specific subsidiaries results in a change in reporting entity which must be reported by restating the financial statements for all periods presented. The effect of this change should be shown on income before extraordinary items, net income, and earnings per share amounts. In addition, you must disclose in a footnote the nature of the change as well as the reasons for it. I hope that this information helps you account for the various changes which have taken place at Sports-Pro Athletics. If you need further information, please contact me. Sincerely,
CA 22-6 (a)
The ethical issues are the honesty and integrity of Frost’s financial reporting practices versus the Corporation’s and the accounting manager’s profit motives. Shortening the life of fixed assets from 10 to 6 years may be evidence that depreciation expense during the first five years were understated. Such a practice distorts Frost’s operating results and misleads users of Frost’s financial statements. If this practice is intentional, it is unethical.
(b)
The primary stakeholders in the above situation include Frost’s stockholders and creditors. Crane and his auditing firm are stakeholders because they know of the depreciation practices at Frost.
(c)
Crane should report his finding to the partner-in-charge of the Frost engagement. If this practice is deemed to be intentional and fraudulent, then Crane’s firm has a professional responsibility to report this incident to the highest levels of management within Frost (the Audit Committee of the Board of Directors).
FINANCIAL REPORTING PROBLEM (a)
New Accounting Pronouncements and Policies
Derivative Instruments and Hedging Activites On January 1, 2009 we adopted new accounting guidance on disclosures about derivative instruments and hedging activities. The new guidance impacted disclosures only and requires additional qualitative and quantitative information on the use of derivatives and their impact on an entity’s financial position, results of operations and cash flows. Business Combinations On July 1, 2009, we adopted new accounting guidance on business combinations. The new guidance revised the method of accounting for a number of aspects of business combinations including acquisition costs, contingencies (including contingent assets, contingent liabilities and contingent purchase price) and postacquisition exit activities of acquired businesses. Noncontrolling Interests in Cosolidated Financial Statements On July 1, 2009, we adopted new accounting guidance on noncontrolling interests in consolidated financial statements. The new accounting guidance requires that a noncontrolling interest in the equity of a subsidiary be accounted for and reported as equity, provides revised guidance on the treatment of net income and losses attributable to the noncontrolling interest and changes in ownership interests in a subsidiary and requires additional disclosures that identify and distinguish between the interests of the controlling and noncontrolling owners.
FINANCIAL REPORTING PROBLEM (Continued) (b)
Use of Estimates Preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (U.S. GAAP) requires management to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying disclosures. These estimates are based on management’s best knowledge of current events and actions the Company may undertake in the future. Estimates are used in accounting for, among other items, consumer and trade promotion accruals, pensions, post-employment benefits, stock options, valuation of acquired intangible assets, useful lives for depreciation and amortization of long-lived assets, future cash flows associated with impairment testing for goodwill, indefinite-lived intangible assets and other long-lived assets, deferred tax assets, uncertain income tax positions and contingencies. Actual results may ultimately differ from estimates, although management does not generally believe such differences would materially affect the financial statements in any individual year. However, in regard to ongoing impairment testing of goodwill and indefinite-lived intangible assets, significant deterioration in future cash flow projections or other assumptions used in valuation models, versus those anticipated at the time of the valuations, could result in impairment charges that may materially affect the financial statements in a given year.
COMPARATIVE ANALYSIS CASE THE COCA-COLA COMPANY VS. PEPSICO, INC. (a) and (c) for Coca-Cola Company: NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Recently Issued Accounting Guidance In June 2011, the FASB issued an amendment to an existing accounting standard which requires companies to present net income and other comprehensive income in one continuous statement or in two separate, but consecutive, statements. In addition, in December 2011, the FASB issued an amendment to an existing accounting standard which defers the requirement to present components of reclassifications of other comprehensive income on the face of the income statement. This new accounting pronouncement is effective for our first quarter of 2012 and we do not expect any material impact on our financial statements from its adoption. As previously discussed, in June 2009, the FASB amended its guidance on accounting for VIEs. Please refer to the heading “Principles of Consolidation” above. (b) and (c) for Pepsi: Recent Accounting Pronouncements In June 2009, the Financial Accounting Standards Board (FASB) amended its accounting guidance on the consolidation of variable interest entities (VIE). Among other things, the new guidance requires a qualitative rather than a quantitative assessment to determine the primary beneficiary of a VIE based on whether the entity (1) has the power to direct matters that most significantly impact the activities of the VIE and (2) has the obligation to absorb losses or the right to receive benefits of the VIE that could potentially be significant to the VIE. In addition, the amended guidance requires an ongoing reconsideration of the primary beneficiary. The provisions of this guidance were effective as of the beginning of our 2010 fiscal year, and the adoption did not have a material impact on our financial statements.
COMPARATIVE ANALYSIS CASE (Continued) In the second quarter of 2010, the Patient Protection and Affordable Care Act (PPACA) was signed into law. The provisions of the PPACA required us to record the effect of this tax law change beginning in our second quarter of 2010, and consequently we recorded a onetime related tax charge of $41 million in the second quarter of 2010. In June 2011, the FASB amended its accounting guidance on the presentation of comprehensive income in financial statements to improve the comparability, consistency and transparency of financial reporting and to increase the prominence of items that are recorded in other comprehensive income. We do not expect the adoption of this guidance to have a material impact on our financial statements. In September 2011, the FASB issued new accounting guidance that permits an entity to first assess qualitative factors of whether it is more likely than not that a reporting unit’s fair value is less than its carrying amount before applying the two- step goodwill impairment test. We are currently evaluating the impact of the new guidance on our financial statements. In September 2011, the FASB amended its guidance regarding the disclosure requirements for employers participating in multiemployer pension and other postretirement benefit plans (multiemployer plans) to improve transparency and increase awareness of the commitments and risks involved with participation in multiemployer plans. We have reviewed our level of participation in multiemployer plans and determined that the impact of adopting this new guidance did not have a material impact on our financial statements. In December 2011, the FASB issued new disclosure requirements that are intended to enhance current disclosures on offsetting financial assets and liabilities. We are currently evaluating the impact of the new guidance on our financial statements. In the first quarter of 2011, Quaker Foods North America (QFNA) changed its method of accounting for certain U.S. inventories from the last- in, firstout (LIFO) method to the average cost method. This change is considered preferable by management as we believe that the average cost method of accounting for all U.S. foods inventories will improve our financial reporting by better matching revenues and expenses and better reflecting the current value of inventory.
COMPARATIVE ANALYSIS CASE (Continued) In addition, the change from the LIFO method to the average cost method will enhance the comparability of QFNA’s financial results with our other food businesses, as well as with peer companies where the average cost method is widely used. The impact of this change on consolidated net income in the first quarter of 2011 was approximately $9 million (or less than a penny per share). Prior periods were not restated as the impact of the change on previously issued financial statements was not considered material.
ACCOUNTING, ANALYSIS, AND PRINCIPLES Accounting ABC CO. Statement of Financial Position at December 31 Cash Inventory PPE Accumulated depreciation Total assets
2014 2013 $ 548 $ 365 Share capital 580 560 Retained earnings 400 400 (120) (80) 1,408 1,245 Total equity
2014 2013 $ 500 $ 500 908 745
$1,408 $1,245
ABC CO. Income Statement for the Year Ended December 31, Sales................................................................................. Cost of goods sold .......................................................... Depreciation expense ..................................................... Compensation expense .................................................. Net income .......................................................................
2014 $550 330 40 17 $163
2013 purchases: $480 + P – $300 = $500; P = $320 2013 Beginning inventory using FIFO = $480 + $50 = $530 2013 Ending inventory using FIFO = $500 + $60 = $560 2013 Cost of goods sold using FIFO = $530 + $320 – $560 = $290 2013 Retained Earnings = $685 + $60 = $745 2014 Retained Earnings = $745 + $163 = $908 2014 Cost of goods sold = $560 + $350 – $580 = $330 2014 Depreciation Expense = $400/10 = $40 2014 Accumulated Depreciation = $80 + $40 = $120 2014 Cash = $365 + $550 – $350 – $17 = $548
2013 $500 290 40 15 $155
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) Analysis Inventory turnover:
LIFO FIFO
2014 N/A LIFO information not available $330 ÷ $570 = 0.58
2013 $300 ÷ $490 = 0.61 $290 ÷ $545 = 0.53
Inventory turnover is lower under FIFO, which leads to ROA being slightly higher. Under FIFO (in this example) COGS is lower because older costs that had been deferred in the inventory balance under average cost were brought to COGS. The inventory balance is higher because FIFO leaves the most recent inventory costs in the inventory account. Principles The issue is consistency across time. When a company changes accounting policies, financial statements from one period are not really comparable to the financial statements of the next period because they are based on different accounting policies. GAAP requires restating past results presented for comparison to the new accounting policy so that financial statement readers can see how the company’s financial position and performance have changed without the effects of an accounting change.
PROFESSIONAL RESEARCH (a) According to FASB ASC 250-10-20 (Glossary), a change in accounting estimate that is inseparable from the effect of a related change in accounting principle is a change in estimate effected by a change in principle. An example of a change in estimate effected by a change in principle is a change in the method of depreciation, amortization, or depletion for long-lived, nonfinancial assets. Under FASB ASC 250-10-45 45-17, A change in accounting estimate shall be accounted for in the period of change if the change affects that period only or in the period of change and future periods if the change affects both. A change in accounting estimate shall not be accounted for by restating or retrospectively adjusting amounts reported in financial statements of prior periods or by reporting pro forma amounts for prior periods. 45-19 Like other changes in accounting principle, a change in accounting estimate that is effected by a change in accounting principle may be made only if the new accounting principle is justifiable on the basis that it is preferable. For example, an entity that concludes that the pattern of consumption of the expected benefits of an asset has changed, and determines that a new depreciation method better reflects that pattern, may be justified in making a change in accounting estimate effected by a change in accounting principle. (See paragraph 250-10-45-12.) (b) According to FASB ASC 250-10-45-18, distinguishing between a change in an accounting principle and a change in an accounting estimate is sometimes difficult. In some cases, a change in accounting estimate is effected by a change in accounting principle. One example of this type of change is a change in method of depreciation, amortization, or depletion for long-lived, nonfinancial assets (hereinafter referred to as depreciation method). The new depreciation method is adopted in partial or complete recognition of a change in the estimated future benefits inherent in the asset, the pattern of consumption of those benefits, or the information available to the entity about those benefits. The effect of the change in accounting principle, or the method of
PROFESSIONAL RESEARCH (Continued) applying it, may be inseparable from the effect of the change in accounting estimate. Changes of that type often are related to the continuing process of obtaining additional information and revising estimates and, therefore, shall be considered changes in estimates for purposes of applying this Subtopic. (c) According to FASB ASC 250-10-S50—Disclosure of the Impact that Recently Issued Accounting Standards Will Have on the Financial Statements of the Registrant when Adopted in a Future Period S50-1 See paragraph 250-10-S99-5, SAB Topic 11.M, for SEC Staff views regarding disclosure of the impact of recently issued accounting standards. SAB Topic 11.M, Disclosure of the Impact that Recently Issued Accounting Standards Will Have on the Financial Statements of the Registrant when Adopted in a Future Period S99-5 The following is the text of SAB Topic 11.M, Disclosure of the Impact that Recently Issued Accounting Standards Will Have on the Financial Statements of the Registrant when Adopted in a Future Period. Facts: An accounting standard has been issued that does not require adoption until some future date. A registrant is required to include financial statements in fillings with the Commission after the Issuance of the standard but before it is adopted by the registrant.5 – 5Some registrants may want to disclose the potential effects of proposed accounting standards not yet issued, (e.g., exposure drafts). Such disclosures, which generally are not required because the final standard may differ from the exposure draft, are not addressed by this SAB. See also FRR 26. Question 1: Does the staff believe that these filings should include disclosure of the impact that the recently issued accounting standard will have on the financial position and results of operations of the registrant when such standard is adopted in a future period?
PROFESSIONAL RESEARCH (Continued) Interpretive Response: Yes. The commission addressed a similar issue with respect to Statement 52 and concluded that “The Commission also believes that registrants that have not yet adopted Statement 52 should discuss the potential effects of adoption in registration statements and reports filed with the Commission.”6 The staff believes that this disclosure guidance applies to all accounting standards which have been issued but not yet adopted by the registrant unless the impact on its financial position and results of operations is not expected to be material.7 MD&A8 requires registrants to provide information with respect to liquidity, capital resources and results of operations and such other information that the registrant believes to be necessary to understand its financial condition and results of operations. In addition, MD&A requires disclosure of presently known material changes, trends and uncertainties that have had or that the registrant reasonably expects will have a material impact on future sales, revenues or income from continuing operations. The staff believes that disclosure of impending accounting changes is necessary to inform the reader about expected impacts on financial information to be reported in the future and, therefore, should be disclosed in accordance with the existing MD&A requirements. With respect to financial statement disclosure, GAAS9 specifically address the need for the auditor to consider the adequacy of the disclosure of impending changes in accounting principles if (a) the financial statements have been prepared on the basis of accounting principles that were acceptable at the financial statement date but that will not be acceptable in the future and (b) the financial statements will be restated in the future as a result of the change. The staff believes that recently issued accounting standards may constitute material matters and, therefore, disclosure in the financial statements should also be considered in situations where the change to the new accounting standard will be accounted for in financial statements of future periods, prospectively or with a cumulative catch-up adjustment.
PROFESSIONAL RESEARCH (Continued) – 6FRR 6, Section 2. – 7In those instances where a recently issued standard will impact the preparation of, but not materially affect, the financial statements, the registrant is encouraged to disclose that a standard has been issued and that its adoption will not have a material effect on its financial position or results of operations. 8 – Item 303 of Regulation S-K. – 9See AU 9410.13-18. Question 2: Does the staff have a view on the types of disclosure that would be meaningful and appropriate when a new accounting standard has been issued but not yet adopted by the registrant? Interpretive Response: The staff believes that the registrant should evaluate each new accounting standard to determine the appropriate disclosure and recognizes that the level of information available to the registrant will differ with respect to various standards and from one registrant to another. The objectives of the disclosure should be to (1) notify the reader of the disclosure documents that a standard has been issued which the registrant will be required to adopt in the future and (2) assist the reader in assessing the significance of the impact that the standard will have on the financial statements of the registrant when adopted. The staff understands that the registrant will only be able to disclose information that is known. The following disclosures should generally be considered by the registrant: – A brief description of the new standard, the date that adoption is required and the date that the registrant plans to adopt, if earlier. – A discussion of the methods of adoption allowed by the standard and the method expected to be utilized by the registrant, if determined.
PROFESSIONAL RESEARCH (Continued) – A discussion of the impact that adoption of the standard is expected to have on the financial statements of the registrant, unless not known or reasonably estimable. In that case, a statement to that effect may be made. – Disclosure of the potential impact of other significant matters that the registrant believes might result from the adoption of the standard (such as technical violations of debt covenant agreements, planned or intended changes in business practices, etc.) is encouraged.
PROFESSIONAL SIMULATION Note: This assignment is available on the Kieso website. Journal Entries (a)
Inventory ......................................................... Retained Earnings...................................
18,000* 18,000
*($20,000 + $24,000 + $27,000) – ($15,000 + $18,000 + $20,000) (b) Inventory ......................................................... Retained Earnings...................................
28,000* 28,000
*($20,000 + $24,000 + $27,000) – ($12,000 + $14,000 + $17,000) Financial Statements Computation of EPS for 2015 Basic EPS Net income................................................... Outstanding shares..................................... Basic EPS ....................................................
$30,000 10,000 $3.00 ($30,000 ÷ 10,000)
Diluted EPS Net income................................................... Add: Interest savings ($200,000 X 6%) ..... Adjusted net income ...................................
$30,000 12,000 $42,000
Adjusted net income ................................... Outstanding shares..................................... Shares upon conversion............................. Diluted EPS..................................................
$42,000 10,000 6,000* $2.63 ($42,000 ÷ 16,000)
*$200,000 ÷ $1,000 = 200 bonds; 200 bonds X 30 = 6,000 shares
PROFESSIONAL SIMULATION (Continued) Computation of EPS for 2014 Basic EPS Net income ................................................ Outstanding shares.................................. Basic EPS ................................................. Diluted EPS Net income ................................................ Add: Interest savings ($200,000 X 6%)..................................... Adjusted net income ................................ Adjusted net income ............................... Outstanding shares................................. Shares upon conversion......................... Diluted EPS ...............................................
EPS Presentation Net income Basic EPS Diluted EPS
2015
2014
$30,000 $ 3.00 $ 2.63
$27,000 $ 2.70 $ 2.44
$27,000 10,000 $2.70 ($27,000 ÷ 10,000) $27,000 12,000 $39,000 $39,000 10,000 6,000 $2.44 ($39,000 ÷ 16,000)
IFRS CONCEPTS AND APPLICATION IFRS22-1 The IFRS standard addressing accounting and reporting for changes in accounting principles, changes in estimates, and errors is IAS 8 (“Accounting Policies, Changes in Accounting Estimates and Errors”). Various presentation issues related to restatements are addressed in IAS 1. IFRS22-2 FASB has issued guidance on changes in accounting principles, changes in estimates, and corrections of errors, which essentially converges U.S. GAAP to IAS 8. Key remaining differences are as follows. One area in which IFRS and U.S. GAAP differ is the reporting of error corrections in previously issued financial statements. While both GAAPs require restatement, U.S. GAAP is an absolute standard—that is, there is no exception to this rule. Under U.S. GAAP and IFRS, if determining the effect of a change in accounting principle is considered impracticable, then a company should report the effect of the change in the period in which it believes it practicable to do so, which may be the current period. Under IFRS, the impracticality exception applies to both changes in accounting principles and to the correction of errors. Under U.S. GAAP, this exception only applies to changes in accounting principle. IAS 8 does not specifically address the accounting and reporting for indirect effects of changes in accounting principles. As indicated in the chapter, U.S. GAAP has detailed guidance on the accounting and reporting of indirect effects.
IFRS22-3 Currently, under U.S. GAAP, when a company prepares financial statements on a new basis, comparative information must be provided for a three-year period. Under IFRS, up to two years of comparative data must be provided. Use of the shorter comparative data period must be addressed before U.S. companies can adopt IFRS.
IFRS22-4 The indirect effect of a change in accounting policy reflects any changes in current or future cash flows resulting from a change in accounting policy that is applied retrospectively. An example is the change in payments to a profit-sharing plan that is based on reported net income. While IFRS does not address indirect effects, under U.S. GAAP, indirect effects are not included in the retrospective application, but instead are reported in the period in which the accounting change occurs (current period).
IFRS22-5 The company prospectively applies the new accounting policy as of the earliest date it is practicable to do so.
IFRS22-6 (a)
1.
Uncollectible Accounts Receivable. This is a change in accounting estimate. Restatement of prior periods is not appropriate.
2.
Depreciation. a.
This is a change in accounting estimate. Restatement of opening retained earnings is not appropriate.
b.
This is a new method for a new class of assets. No change is involved.
3.
Mathematical Error. This is a correction of an error and prior period adjustment treatment would be in order.
4.
Preproduction Costs—Furniture Division. This should probably be construed as an inseparability situation in that the change in accounting estimate (period benefited by deferred costs) has been affected by a change in accounting policy (amortization on a per-unit basis). Consequently, it is treated as a change in accounting estimate. Restatement of opening retained earnings is not appropriate.
IFRS22-6 (Continued)
(b)
5.
FIFO to Average-Cost Change. This is a change in accounting policy. Restatement of December 31, 2013 retained earnings is not appropriate, given that the effect on net income in prior periods cannot be determined. Note that a FIFO to Average Cost change does qualify for restatement of opening retained earnings in most cases.
6.
Percentage-of-Completion. This is a change in accounting policy. Retained earnings should be adjusted.
The adjustment to the December 31, 2013 retained earnings balance would be computed as follows: Item 3 Item 6 Increase in 12/31/13 Retained Earnings
$ (235,000) 1,075,000 $ 840,000
IFRS22-7 (a) The guidelines for reporting a change in accounting principle related to depreciation methods can be found in IAS 8, paragraphs 32-38, under the heading “Changes in accounting estimates.” (b) According to paragraph 14, “An entity shall change an accounting policy only if the change: (1) is required by an IFRS; or (2) results in the financial statements providing reliable and more relevant information about the effects of transactions, other events or conditions on the entity’s financial position, financial performance or cash flows.”
IFRS22-8 (a)
There are no IFRS or IFRS IC interpretations that are effective for the first time in this financial period that have had a material impact on the Group. The following IFRS, IFRS IC interpretations and amendments have been issued but are not yet effective and have not been early adopted by the Group: IAS 19, ‘Employee benefits’ was amended in June 2011 and is effective for periods beginning on or after 1 January 2013. The impact will be to replace interest cost and expected return on plan assets with a net interest amount that is calculated by applying the discount rate to the net defined benefit liability/asset. The Group is yet to assess the full impact of this amendment.
(b)
Critical accounting estimates and judgements The preparation of consolidated financial statements requires the Group to make estimates and assumptions that affect the application of policies and reported amounts. Estimates and judgements are continually evaluated and are based on historical experience and other factors, including expectations of future events that are believed to be reasonable under the circumstances. Actual results may differ from these estimates. The estimates and assumptions which have a significant risk of causing a material adjustment to the carrying amount of assets and liabilities are: A.
Impairment of goodwill and brands – The Group is required to test, at least annually, whether the goodwill or brands have suffered any impairment. The recoverable amount is determined based on value in use calculations. The use of this method requires the estimation of future cash flows and the choice of a suitable discount rate in order to calculate the present value of these cash flows. Where there is a noncontrolling interest, goodwill is tested for the business as a whole. This involves a notional increase to goodwill, to reflect the non-controlling shareholders’ interest. Actual outcomes could vary from those calculated. See note 14 for further details.
IFRS22-8 (Continued) B.
Impairment of property, plant and equipment and computer software – Property, plant and equipment and computer software are reviewed for impairment if events or changes in circumstances indicate that the carrying amount may not be recoverable. When a review for impairment isconducted, the recoverable amount is determined based on value in use calculations prepared on the basis of management’s assumptions and estimates. See notes 14 and 15 for further details.
C.
Depreciation of property, plant and equipment and amortisation of computer software – Depreciation and amortisation is provided so as to write down the assets to their residual values over their estimated useful lives as set out above. The selection of these residual values and estimated lives requires the exercise of management judgement. See notes 14 and 15 for further details.
D.
Post-retirement benefits – The determination of the pension cost and defined benefit obligation of the Group’s defined benefit pension schemes depends on the selection of certain assumptions which include the discount rate, inflation rate, salary growth, mortality and expected return on scheme assets. Differences arising from actual experiences or future changes in assumptions will be reflected in subsequent periods. See note 11 for further details of assumptions and note 12 for critical judgements associated with the Marks & Spencer UK Pension Scheme interest in the Marks and Spencer Scottish Limited Partnership.
E.
Refunds and loyalty scheme accruals – Accruals for sales returns and loyalty scheme redemptions are estimated on the basis of historical returns and redemptions and these are recorded so as to allocate them to the same period as the original revenue is recorded. These accruals are reviewed regularly and updated to reflect management’s latest best estimates, however, actual returns and redemptions could vary from these estimates.
CHAPTER 23 Statement of Cash Flows ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics
Questions
Brief Exercises
Exercises
Concepts Problems for Analysis
1. Format, objectives purpose, and source of statement.
1, 2, 7, 8, 12
1, 2, 5, 6
2. Classifying investing, financing, and operating activities.
3, 4, 5, 6, 16, 17, 19
1, 2, 3, 6, 7, 8, 12
1, 2, 10, 16
1, 3, 4, 5
3. Direct vs. indirect methods of preparing operating activities.
9, 20
4, 5, 9, 10, 11
3, 4
5
4. Statement of cash flows— 11, 13, 14 direct method.
8
4, 5, 7, 9, 12, 13
3, 4, 6, 7, 8
5. Statement of cash flows— 10, 13, indirect method. 15, 16
8
3, 6, 8, 11, 14, 15, 16, 17, 18
1, 2, 5, 6, 7, 8, 9
2
6.
5, 7, 8, 9
5
Preparing schedule of noncash investing and financing activities.
18
12
7. Worksheet adjustments.
21
13
19, 20, 21
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Brief Exercises
Learning Objectives Questions
Exercises
Problems
Concepts for Analysis
1.
Describe the purpose of the statement of cash flows.
1, 2
CA23-5
2.
Identify the major classifications of cash flows.
3, 4
3
1, 2, 10, 16
3.
Prepare a statement of cash flows.
5, 6, 7
8
9, 11, 12, 13, 14, 15, 17, 18
1, 2, 3, 4, 5, 6, 7, 8, 9
CA23-1, CA232
4.
Differentiate between net income and net cash flow from operating activities.
8, 9, 10, 11, 12
4, 5, 9, 10, 11
2, 4, 5, 6, 7, 8, 11, 16
1
CA23-3
5.
Determine net cash flows from investing and financing activities.
13, 14
1, 2
16
6.
Identify sources of information for a statement of cash flows.
7.
Contrast the direct and indirect methods of calculating net cash flow from operating activities.
15, 16, 20
4, 5, 6, 7, 9
3, 4, 5, 6, 7, 8, 9
6, 7
8.
Discuss special problems in preparing a statement of cash flows.
17, 18, 19
12
10, 18
1, 2, 4, 5, 6, 7, 8, 9
9.
Explain the use of a worksheet in preparing a statement of cash flows.
21
13
19, 20, 21
CA23-5
CA23-4
2, 4, 5, 6, 7, 8, 9
CA23-6
ASSIGNMENT CHARACTERISTICS TABLE Level of Difficulty
Time (minutes)
Classification of transactions. Statement presentation of transactions—indirect method. Preparation of operating activities section—indirect method, periodic inventory. Preparation of operating activities section—direct method. Preparation of operating activities section—direct method. Preparation of operating activities section—indirect method. Computation of operating activities—direct method. Schedule of net cash flow from operating activities— indirect method. SCF—direct method. Classification of transactions. SCF—indirect method. SCF—direct method. SCF—direct method. SCF—indirect method. SCF—indirect method. Cash provided by operating, investing, and financing activities. SCF—indirect method and balance sheet. Partial SCF—indirect method. Worksheet analysis of selected accounts. Worksheet analysis of selected transactions. Worksheet preparation.
Simple Moderate Simple
10–15 20–30 15–25
Simple Simple Simple Simple Moderate
20–30 20–30 15–20 15–20 20–30
Moderate Moderate Moderate Moderate Moderate Moderate Moderate Moderate
20–30 25–35 30–35 20–30 30–40 30–40 25–35 30–40
Moderate Moderate Moderate Moderate Moderate
30–40 25–30 20–25 20–25 45–55
Moderate Moderate Complex Moderate Complex Moderate
40–45 50–60 50–60 45–60 50–65 40–50
Moderate
30–40
P23-8 P23-9
SCF—indirect method. SCF—indirect method. SCF—direct method. SCF—direct method. SCF—indirect method. SCF—indirect method, and net cash flow from operating activities, direct method. SCF—direct and indirect methods from comparative financial statements. SCF—direct and indirect methods. Indirect SCF.
Moderate Moderate
30–40 30–40
CA23-1 CA23-2 CA23-3 CA23-4 CA23-5 CA23-6
Analysis of improper SCF. SCF theory and analysis of improper SCF. SCF theory and analysis of transactions. Analysis of transactions’ effect on SCF. Purpose and elements of SCF. Cash flow reporting.
Moderate Moderate Moderate Moderate Complex Moderate
30–35 30–35 30–35 20–30 30–40 20–30
Item
Description
E23-1 E23-2 E23-3 E23-4 E23-5 E23-6 E23-7 E23-8 E23-9 E23-10 E23-11 E23-12 E23-13 E23-14 E23-15 E23-16 E23-17 E23-18 E23-19 E23-20 E23-21 P23-1 P23-2 P23-3 P23-4 P23-5 P23-6 P23-7
SOLUTIONS TO CODIFICATION EXERCISES CE23-1 Master Glossary (a)
Cash equivalents are short-term, highly liquid investments that have both of the following characteristics: 1. 2.
Readily convertible to known amounts of cash So near their maturity that they present insignificant risk of changes in value because of changes in interest rates.
Generally, only investments with original maturities of three months or less qualify under that definition. Original maturity means original maturity to the entity holding the investment. For example, both a three-month U.S. Treasury bill and a three-year Treasury note purchased three months from maturity qualify as cash equivalents. However, a Treasury note purchased three years ago does not become a cash equivalent when its remaining maturity is three months. Examples of items commonly considered to be cash equivalents are Treasury bills, commercial paper, money market funds, and federal funds sold (for an entity with banking operations). (b)
Financing activities include obtaining resources from owners and providing them with a return on, and a return of, their investment; receiving restricted resources that by donor stipulation must be used for long-term purposes; borrowing money and repaying amounts borrowed, or otherwise settling the obligation; and obtaining and paying for other resources obtained from creditors on long-term credit.
(c)
Investing activities include making and collecting loans and acquiring and disposing of debt or equity instruments and property, plant, and equipment and other productive assets, that is, assets held for or used in the production of goods or services by the entity (other than materials that are part of the entity’s inventory). Investing activities exclude acquiring and disposing of certain loans or other debt or equity instruments that are acquired specifically for resale, as discussed in paragraphs 230-10-45-12 and 230-10-45-21.
(d)
Operating activities include all transactions and other events that are not defined as investing or financing activities (see paragraphs 230-10-45-12 through 45-15). Operating activities generally involve producing and delivering goods and providing services. Cash flows from operating activities are generally the cash effects of transactions and other events that enter into the determination of net income.
CE23-2 According to FASB ASC 230-10-45-14 (Statement of Cash Flow—Other Presentation Matters—Cash Flows from Financing Activities): All of the following are cash inflows from financing activities: (a)
Proceeds from issuing equity instruments.
(b)
Proceeds from issuing bonds, mortgages, notes, and from other short- or long-term borrowing.
CE23-2 (Continued) (c)
Receipts from contributions and investment income that by donor stipulation are restricted for the purposes of acquiring, constructing, or improving property, plant, equipment, or other long-lived assets or establishing or increasing a permanent endowment or term endowment.
(d)
Proceeds received from derivative instruments that include financing elements at inception, whether the proceeds were received at inception or over the term of the derivative instrument, other than a financing element inherently included in an at-the-market derivative instrument with no prepayments.
(e)
Cash retained as a result of the tax deductibility of increases in the value of equity instruments issued under share-based payment arrangements that are not included in the cost of goods or services that is recognizable for financial reporting purposes. For this purpose, excess tax benefits shall be determined on an individual award (or portion thereof) basis.
CE23-3 According to FASB ASC 230-10-45-11 (Statement of Cash Flows—Other Presentation Matters—Cash Flows from Investing Activities): Cash flows from purchases, sales, and maturities of available-for-sale securities shall be classified as cash flows from investing activities and reported gross in the statement of cash flows.
CE23-4 According to FASB ASC 230-10-50-3 (Statement of Cash Flows—Disclosure—Noncash Investing and Financing Activities): Information about all investing and financing activities of an entity during a period that affect recognized assets or liabilities but that do not result in cash receipts or cash payments in the period shall be disclosed. Those disclosures may be either narrative or summarized in a schedule, and they shall clearly relate the cash and noncash aspects of transactions involving similar items.
ANSWERS TO QUESTIONS 1. The main purpose of the statement of cash flows is to provide information about a company’s cash receipts and cash payments in a period. The statement of cash flows provides information about a company’s operating, financing, and investing activities. It reports cash receipts, cash payments, and net change in cash from operating, investing, and financing activities. 2. Some uses of this statement are: Assessing future cash flows: Income data when augmented with current cash flow data provide a better basis for assessing future cash flows. Assessing reasons for differences between income and net cash flow from operation: Some believe that cash flow information is more reliable than income information because income involves a number of assumptions, estimates and valuations. Assessing operating capability: Whether a company is able to maintain its operating capability, provide for future growth, and distribute dividends to the owners depends on whether adequate cash is being or will be generated. Assessing financial flexibility and liquidity: Cash flow data indicate whether a company should be able to survive adverse operating problems and whether a company might have difficulty in meeting obligations as they become due, paying dividends, or meeting other recurring costs. Providing information on cash and non-cash investing and financing activities: Cash flows are classified by their effect on balance sheet items; investing activities affect assets while financing activities affect liabilities and stockholders’ equity. 3. Investing activities generally involve long-term assets and include (1) lending money and collecting on those loans and (2) acquiring and disposing of investments and productive long-lived assets. Financing activities, on the other hand, involve liability and stockholders’ equity items and include (1) obtaining cash from creditors and repaying the amounts borrowed and (2) obtaining capital from owners and providing them with a return on their investment. Operating activities include all transactions and events that are not investing and financing activities. Operating activities involve the cash effects of transactions that enter into the determination of net income. 4. Examples of sources of cash in a statement of cash flows include cash from operating activities, issuance of debt, issuance of capital stock, sale of investments, and the sale of property, plant, and equipment. Examples of uses of cash include cash used in operating activities, payment of cash dividends, redemption of debt, purchase of investments, redemption of capital stock, and the purchase of property, plant, and equipment. 5. Preparing the statement of cash flows involves three major steps: (1) Determine the change in cash. This is simply the difference between the beginning and ending cash balances. (2) Determine the net cash flow from operating activities. This involves analyzing the current year’s income statement, comparative balance sheets and selected transaction data. (3) Determine cash flows from investing and financing activities. All other changes in balance sheet accounts are analyzed to determine their effect on cash. 6. Purchase of land—investing; Payment of dividends—financing; Cash sales—operating; Purchase of treasury stock—financing. 7. Comparative balance sheets, a current income statement, and certain transaction data all provide information necessary for preparation of the statement of cash flows. Comparative balance sheets indicate how assets, liabilities, and equities have changed during the period. A current income statement provides information about the amount of cash provided from operating activities. Certain transactions provide additional detailed information needed to determine whether cash was provided or used during the period.
Questions Chapter 23 (Continued) 8. It is necessary to convert accrual-based net income to a cash basis because net income includes items that do not provide or use cash. An example would be an increase in accounts receivable. If accounts receivable increased during the period, revenues reported on the accrual basis would be higher than the actual cash revenues received. Thus, accrual basis net income must be adjusted to reflect the net cash flow from operating activities. 9. Net cash flow from operating activities under the direct method is the difference between cash revenues and cash expenses. The direct method adjusts the revenues and expenses directly to reflect the cash basis. This results in cash net income, which is equal to “net cash flow from operating activities.” The indirect method involves adjusting accrual-based net income. This is done by starting with accrual net income and adding or subtracting noncash items included in net income. Examples of adjust-ments include depreciation and other noncash expenses and changes in the balances of current asset and current liability accounts from one period to the next. 10. Net cash flow from operating activities is $3,820,000. Using the indirect method, the solution is: Net income ................................................................................ $3,500,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense .......................................................... $ 520,000 Increase in accounts receivable ........................................... (500,000) Increase in accounts payable............................................... 300,000 320,000 Net cash provided by operating activities................................... $3,820,000 11. Accrual basis sales.................................................................. $100,000 Less: Increase in accounts receivable .................................... 30,000 70,000 Less: Write-off of accounts receivable .................................... 2,000 Cash sales.......................................................................... $ 68,000 12. A number of factors could have caused an increase in cash despite the net loss. These are: (1) high cash revenues relative to low cash expenses, (2) sales of property, plant, and equipment, (3) sales of investments, and (4) issuance of debt or capital stock. 13. Declared dividends .................................................................. $260,000 Add: Dividends payable (beginning of year) ........................... 85,000 345,000 Deduct: Dividends payable (end of year)................................ 90,000 Cash paid in dividends during the year .................................... $255,000 14. To determine cash payments to suppliers, it is first necessary to find purchases for the year. To find purchases, cost of goods sold is adjusted for the change in inventory (increased when inventory increases or decreased when inventory decreases). After purchases are computed, cash payments to suppliers are determined by adjusting purchases for the change in accounts payable. An increase (decrease) in accounts payable is deducted from (added to) purchases to determine cash payments to suppliers. 15. Cash flows from operating activities Net income ........................................................................ Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ................................................ Amortization of patent ................................................ Loss on sale of plant assets ....................................... Net cash provided by operating activities ...........................
$320,000 $124,000 40,000 21,000
185,000 $505,000
Questions Chapter 23 (Continued) 16. (a)
Cash flows from operating activities Net income.............................................................................. Adjustments to reconcile net income to net cash provided by operating activities: Loss on sale of plant assets [($18,000 ÷ 10) x 31/2 ] – $4,000.................................... Cash flows from investing activities Sale of plant assets .................................................................
XXXX
(b) Cash flows from financing activities Issuance of common stock ...................................................... (c)
$
2,300
$
4,000
$410,000
No effect on cash; not shown in the statement of cash flows or in any related schedules or notes. Note to instructor: The change in net accounts receivable is an adjustment to net income under the indirect method.
(d) Cash flows from operating activities Net loss ................................................................................... Adjustments to reconcile net loss to net cash provided by operating activities: Depreciation expense.............................................................. Gain on sale of available-for-sale securities ............................ Cash flows from investing activities Sale of available-for-sale securities ......................................... 17. (a) (b) (c) (d) (e) (f)
Operating activity. Financing activity. Investing activity. Operating activity. Significant noncash investing and financing activities. Financing activity.
$(50,000) $22,000 (9,000) $ 38,000
(g) Operating activity. (h) Financing activity. (i) Significant noncash investing and financing activities. (j) Financing activity. (k) Investing activity. (l) Operating activity.
18. Examples of noncash transactions are: (1) issuance of stock for noncash assets, (2) issuance of stock to liquidate debt, (3) issuance of bonds or notes for noncash assets, and (4) noncash exchanges of property, plant, and equipment. 19. Cash flows from operating activities Net income...................................................................................... Adjustments to reconcile net income to net cash provided by operating activities: Gain on redemption of bonds payable ..................................... Cash flows from financing activities Redemption of bonds payable.........................................................
XXXX $ (120,000) $(1,880,000)
20. Arguments for the indirect or reconciliation method are: (a) By providing a reconciliation between net income and net cash provided by operating activities, the differences are highlighted. (b) The direct method is nothing more than a cash basis income statement which will confuse and create uncertainty for financial statement users who are familiar with the accrual-based income statements.
Questions Chapter 23 (Continued) (c) There is some question as to whether the direct method is cost/benefit-justified as this method would probably lead to additional preparation cost because the financial records are not maintained on a cash basis. 21. A worksheet is desirable because it allows the orderly accumulation and classification of data that will appear on the statement of cash flows. It is an optional but efficient device that aids in the preparation of the statement of cash flows.
SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 23-1 Cash flows from investing activities Sale of land ..................................................................... Purchase of equipment.................................................. Purchase of available-for-sale securities ..................... Net cash used by investing activities ...........................
$ 180,000 (415,000) (59,000) $(294,000)
BRIEF EXERCISE 23-2 Cash flows from financing activities Issuance of common stock ........................................... Issuance of bonds payable............................................ Payment of dividends .................................................... Purchase of treasury stock ........................................... Net cash provided by financing activities ....................
$ 250,000 510,000 (350,000) (46,000) $ 364,000
BRIEF EXERCISE 23-3 (a) (b) (c) (d) (e) (f)
P-I A R-F A R-I R-I, D
(g) (h) (i) (j) (k) (l)
P-F D P-I A D R-F
(m) (n) (o) (p) (q) (r)
N D R-F P-F R-I, A P-F
BRIEF EXERCISE 23-4 Cash flows from operating activities Cash received from customers ($200,000 – $12,000) ........................................ Cash payments: To suppliers ($120,000 + $11,000 – $13,000) ............... For operating expenses ($50,000 – $21,000) .................................. Net cash provided by operating activities ........
$188,000 $118,000 29,000
147,000 $ 41,000
BRIEF EXERCISE 23-5 Cash flows from operating activities Net income........................................................... Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ................................. Increase in accounts payable..................... Increase in accounts receivable................. Increase in inventory .................................. Net cash provided by operating activities.........
$30,000
$21,000 13,000 (12,000) (11,000)
11,000 $41,000
BRIEF EXERCISE 23-6 Sales revenue ............................................................... Add: Decrease in accounts receivable ($72,000 – $54,000)............................................. Cash receipts from customers ....................................
$420,000 18,000 $438,000
BRIEF EXERCISE 23-7 Cost of goods sold....................................................... Add: Increase in inventory ($113,000 – $95,000)....... Purchases..................................................................... Deduct: Increase in accounts payable ($69,000 – $61,000)........................................ Cash payments to suppliers........................................
$500,000 18,000 518,000 8,000 $510,000
BRIEF EXERCISE 23-8 Net cash provided by operating activities.................. Net cash used by investing activities ......................... Net cash provided by financing activities .................. Net increase in cash..................................................... Cash, 1/1/14 .................................................................. Cash, 12/31/14 ..............................................................
$531,000 (963,000) 585,000 153,000 333,000 $486,000
BRIEF EXERCISE 23-9 (a)
(b)
a
Cash flows from operating activities Cash received from customers ....................... Cash payments for expenses ($60,000 – $1,840) ......................................... Net cash provided by operating activities............................................... Cash flows from operating activities Net income........................................................ Increase in net accounts receivable ($26,960a – $18,800b) .................................... Net cash provided by operating activities...............................................
($29,000 – $2,040)
b
$90,000 58,160 $31,840 $40,000 (8,160) $31,840
($20,000 – $1,200)
BRIEF EXERCISE 23-10 Cash flows from operating activities Net income................................................................ Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ...................................... 17,000 Increase in accounts payable .......................... 12,300 Increase in accounts receivable...................... (11,000) Increase in inventory........................................ (7,400) Net cash provided by operating activities ..............
$50,000
10,900 $60,900
BRIEF EXERCISE 23-11 Cash flows from operating activities: Net loss ..................................................................... ($70,000) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation expense .......................................... 81,000 Increase in accounts receivable...................... (8,100) 72,900 Net cash provided by operating activities .............. $ 2,900
BRIEF EXERCISE 23-12 (a)
Land ........................................................................ Common Stock.............................................. Paid-in Capital in Excess of Par— Common Stock.........................................
(b)
No effect
(c)
Noncash investing and financing activities: Purchase of land through issuance of common stock............................................
40,000 10,000 30,000
$40,000
BRIEF EXERCISE 23-13 (a) (b) (c) (d)
Operating—Net Income ......................................... 317,000 Retained Earnings.........................................
317,000
Retained Earnings.................................................. 120,000 Financing—Cash Dividends.........................
120,000
Equipment .............................................................. 114,000 Investing—Purchase of Equipment .............
114,000
Investing—Sale of Equipment............................... Accumulated Depreciation—Equipment .............. Equipment ..................................................... Operating—Gain on Sale of Equipment ...... *$10,000 – ($40,000 – $32,000)
10,000 32,000 40,000 2,000*
SOLUTIONS TO EXERCISES EXERCISE 23-1 (10–15 minutes) (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l)
Investing activity. Financing activity. Investing activity. Operating—add to net income. Significant noncash investing and financing activity. Financing activity. Operating—add to net income. Financing activity. Significant noncash investing and financing activity. Financing activity. Operating—deduct from net income. Operating—add to net income.
EXERCISE 23-2 (20–30 minutes) (a)
Plant assets (cost) Accumulated depreciation ([$20,000 10] X 6) Book value at date of sale Sale proceeds Loss on sale
$20,000 12,000 8,000 (5,300) $ 2,700
The loss on sale of plant assets is reported in the operating activities section of the statement of cash flows. It is added to net income to arrive at net cash provided by operating activities. The sale proceeds of $5,300 are reported in the investing activities section of the statement of cash flows as follows: Sale of plant assets (b)
$5,300
Shown in the financing activities section of a statement of cash flows as follows: Sale of common stock
$430,000
EXERCISE 23-2 (Continued) (c)
The writeoff of the uncollectible accounts receivable of $27,000 is not reported on the statement of cash flows. The writeoff reduces the Allowance for Doubtful Accounts balance and the Accounts Receivable balance. It does not affect cash flows. Note to instructor: The change in net accounts receivable is sometimes used to compute an adjustment to net income under the indirect method.
(d)
The net loss of $50,000 should be reported in the operating activities section of the statement of cash flows. Depreciation of $22,000 is reported in the operating activities section of the statement of cash flows. The gain on sale of land also appears in the operating activities section of the statement of cash flows. The proceeds from the sale of land of $39,000 are reported in the investing activities section of the statement of cash flows. These four items might be reported as follows: Cash flows from operating activities Net loss Adjustments to reconcile net income to net cash used in operating activities*: Depreciation expense Gain on sale of land
$(50,000)
22,000 (9,000)
*Either net cash used or provided depending upon other adjustments. Given only the adjustments in (d), the “net cash used” should be employed. Cash flows from investing activities Sale of land
$39,000
(e)
The purchase of the U.S. Treasury bill is not reported in the statement of cash flows. This instrument is considered a cash equivalent and therefore cash and cash equivalents have not changed as a result of this transaction.
(f)
Patent amortization of $20,000 is reported in the operating activities section of the statement of cash flows. It is added to net income in arriving at net cash provided by operating activities.
EXERCISE 23-2 (Continued) (g)
The exchange of common stock for an investment in Tabasco is reported as a “noncash investing and financing activity.” It is shown as follows: Noncash investing and financing activities Purchase of investment by issuance of common stock
(h)
$900,000
The purchase of treasury stock is reported as a cash payment in the financing activities section of the statement of cash flows.
EXERCISE 23-3 (15–25 minutes) VINCE GILL COMPANY Partial Statement of Cash Flows For the Year Ended December 31, 2014 Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Decrease in accounts receivable Decrease in inventory Increase in prepaid expenses Decrease in accounts payable Decrease in accrued expenses payable Net cash provided by operating activities
$1,050,000 $ 60,000 360,000 300,000 (170,000) (275,000) (100,000)
175,000 $1,225,000
EXERCISE 23-4 (20–30 minutes) VINCE GILL COMPANY Partial Statement of Cash Flows For the Year Ended December 31, 2014 Cash flows from operating activities Cash receipts from customers Cash payments: To suppliers For operating expenses Net cash provided by operating activities
$7,260,000 (a) $4,675,000 (b) 1,360,000 (c)
$1,225,000
Computations: (a) Cash receipts from customers Sales revenue Add: Decrease in accounts receivable Cash receipts from customers (b)
(c)
$6,900,000 360,000 $7,260,000
Cash payments to suppliers Cost of goods sold Deduct: Decrease in inventories Purchases Add: Decrease in accounts payable Cash payments to suppliers Cash payments for operating expenses Operating expenses, exclusive of depreciation Add: Increase in prepaid expenses Decrease in accrued expenses payable Cash payments for operating expenses
*$450,000 + ($700,000 – $60,000)
6,035,000
$4,700,000 300,000 4,400,000 275,000 $4,675,000
$1,090,000* $170,000 100,000
270,000 $1,360,000
EXERCISE 23-5 (20–30 minutes) KRAUSS COMPANY Partial Statement of Cash Flows For the Year Ended December 31, 2014 Cash flows from operating activities Cash receipts from customers Cash payments: For operating expenses For income taxes Net cash provided by operating activities (a)
(b)
(c)
$857,000 (a) $614,000 (b) 44,500 (c)
Computation of cash receipts from customers: Service revenue Add: Decrease in accounts receivable ($54,000 – $37,000) Cash receipts from customers Computation of cash payments: Operating expenses per income statement Deduct: Increase in accounts payable ($41,000 – $31,000) Cash payments for operating expenses Income tax expense per income statement Add: Decrease in income taxes payable ($8,500 – $4,000) Cash payments for income taxes
658,500 $198,500
$840,000 17,000 $857,000
$624,000 10,000 $614,000 $ 40,000 4,500 $ 44,500
EXERCISE 23-6 (15–20 minutes) KRAUSS COMPANY Partial Statement of Cash Flows For the Year Ended December 31, 2014 Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Loss on sale of equipment Decrease in accounts receivable Increase in accounts payable Decrease in income taxes payable Net cash provided by operating activities
$90,000 $60,000 26,000 17,000 10,000 (4,500)
108,500 $198,500
EXERCISE 23-7 (15–20 minutes) Situation A: Cash flows from operating activities Cash receipts from customers ($200,000 – $71,000) Cash payments for operating expenses ($110,000 – $29,000) Net cash provided by operating activities Situation B: (a) Computation of cash payments to suppliers Cost of goods sold Plus: Increase in inventory Decrease in accounts payable Cash payments to suppliers (b) Computation of cash payments for operating expenses Operating expenses Deduct: Decrease in prepaid expenses Increase in accrued expenses payable Cash payments for operating expenses
$129,000 81,000 $ 48,000
$310,000 26,000 17,000 $353,000
$230,000 8,000 11,000 $211,000
EXERCISE 23-8 (25–35 minutes) Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Gain on sale of investment [($200 – $145) X 100] Decrease in accounts receivable Income from equity method investment ($27,000 X 0.40) Dividends from equity method investment ($2,000 X 0.40) Net cash provided by operating activities
$145,000
$39,000 (5,500) 12,000 (10,800) 800
35,500 $180,500
Other comments: No. 1 is shown as a cash inflow from the issuance of treasury stock and cash outflow for the purchase of treasury stock, both financing activities. No. 2 is shown as a cash inflow from investing activities of $20,000 and the gain of $5,500 is deducted from net income in the operating activities section. No. 3 is a noncash expense (Bad Debt Expense) in the income statement. Bad debt expense is not handled separately when using the indirect method. It is part of the change in net accounts receivable. No. 4 is a significant noncash investing and financing activity. No. 7 (dividends received) is added to net income. Another alternative is to net the Company’s pro-rata share of the dividend against the income from equity method investment amount reported in the cash flows from operating activities. No. 8 is not shown on a statement of cash flows.
EXERCISE 23-9 (20–30 minutes) 1.
2.
3.
4.
5.
Sales revenue Deduct: Increase in accounts receivable, net of write-offs [$33,000 – ($30,000 – $4,800)] Cash collected from customers
$538,800
Cost of goods sold Deduct: Decrease in inventory ($47,000 – $31,000) Purchases Deduct: Increase in accounts payable ($25,000 – $15,500) Cash payments to suppliers
$250,000 16,000 234,000 9,500
Interest expense Deduct: Decrease in unamortized bond discount ($5,000 – $4,500) Cash paid for interest
$4,300 500
Income tax expense Add: Decrease in income taxes payable ($29,100 – $21,000) Deduct: Increase in deferred tax liability ($5,300 – $4,600) Cash paid for income taxes
$20,400 8,100
Selling expenses Deduct: Depreciation ($1,500* X 1/3) Bad debt expense Cash paid for selling expenses
$141,500
*($16,500 – $15,000)
7,800 $531,000
$224,500
$3,800
700 $27,800
500 5,000
5,500 $136,000
EXERCISE 23-10 (25–35 minutes) 1.
The solution can be determined through use of a T-account for Property, Plant, and Equipment. Property, Plant & Equipment 12/31/13 Equipment from exchange of B/P Payments for purchase of PP&E
247,000 20,000 ?
12/31/14
277,000
45,000 Equipment sold
Payments = $277,000 + $45,000 – $247,000 – $20,000 = $55,000 SFAS 95 states that investing activities include the acquisition and disposition of long-term productive assets. Accordingly, the purchase of property, plant, and equipment is an investing activity. Note that the acquisition of property, plant, and equipment in exchange for bonds payable would be disclosed as a noncash investing and financing activity. 2.
The solution can be determined through use of a T-account for Accumulated Depreciation. Accumulated Depreciation
Equipment sold
167,000 33,000
12/31/13 Depreciation expense
178,000
12/31/14
?
Accumulated depreciation on equipment sold = $167,000 + $33,000 – $178,000 = $22,000 The entry to reflect the sale of equipment is: Cash (proceeds from sale of equipment) ($45,000 + $14,500 – $22,000) Accumulated Depreciation Property, Plant, and Equipment Gain on Sale of Equipment
37,500 22,000 45,000 14,500
(given)
EXERCISE 23-10 (Continued) The proceeds from the sale of equipment of $37,500 are considered an investing activity. Investing activities include the acquisition and disposition of long-term productive assets. 3.
The cash dividends paid can be determined by analyzing T-accounts for Retained Earnings and Dividends Payable. Retained Earnings Dividends declared
?
91,000 31,000
12/31/13 Net income
104,000
12/31/14
Dividends declared = $91,000 + $31,000 – $104,000 = $18,000 Dividends Payable
Cash dividends paid
5,000 18,000
12/31/13 Dividends declared
8,000
12/31/14
?
Cash dividends paid = $5,000 + $18,000 – $8,000 = $15,000 Financing activities include all cash flows involving liabilities and stockholders’ equity other than operating items. Payment of cash dividends is thus a financing activity. 4.
The redemption of bonds payable amount is determined by setting up a T-account. Bonds Payable
Redemption of B/P
46,000 20,000
12/31/13 Issuance of B/P for PP&E
49,000
12/31/14
?
The problem states that there was no amortization of bond premium or discount; thus, the redemption of bonds payable is the only change not accounted for.
EXERCISE 23-10 (Continued) Redemption of bonds payable = $46,000 + $20,000 – $49,000 = $17,000 Financing activities include all cash flows involving liabilities and stockholders’ equity other than operating items. Therefore, redemption of bonds payable is considered a financing activity.
EXERCISE 23-11 (30–35 minutes) PAT METHENY COMPANY STATEMENT OF CASH FLOWS For the Year Ended December 31, 2014 (Indirect Method) Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ($1,200 – $1,170) Gain on sale of investments Decrease in inventory Increase in accounts payable Increase in accounts receivable Decrease in accrued liabilities Net cash provided by operating activities Cash flows from investing activities Sale of held-to-maturity investments [($1,420 – $1,300) + $80] Purchase of plant assets [($1,900 – $1,700) – $70] Net cash provided by investing activities Cash flows from financing activities Issuance of capital stock [($1,900 – $1,700) – $70] Redemption of bonds payable Payment of cash dividends Net cash used by financing activities
$ 810 $ 30 (80) 300 300 (450) (50)
50 860
200 (130) 70 130 (150) (260) (280)
Net increase in cash Cash, January 1, 2014 Cash, December 31, 2014
650 1,150 $1,800
Noncash investing and financing activities Issuance of common stock for plant assets
$
70
EXERCISE 23-12 (20–30 minutes) PAT METHENY COMPANY STATEMENT OF CASH FLOWS For the Year Ended December 31, 2014 (Direct Method) Cash flows from operating activities Cash receipts from customers Less: Cash paid for merchandise Cash paid for selling/administrative expenses Cash paid for income taxes Net cash provided by operating activities Cash flows from investing activities Sale of held-to-maturity investments [($1,420 – $1,300) + $80] Purchase of plant assets [($1,900 – $1,700) – $70] Net cash provided by investing activities Cash flows from financing activities Issuance of capital stock [($1,900 – $1,700) – $70] Redemption of bonds payable Payment of cash dividends Net cash used by financing activities
$6,450* $4,100** 950*** 540 5,590 860
200 (130) 70 130 (150) (260) (280)
Net increase in cash Cash, January 1, 2014 Cash, December 31, 2014
650 1,150 $1,800
Noncash investing and financing activities Issuance of common stock for plant assets
$
*$1,300 + $6,900 – $1,750 **$1,600 + $4,700 – $1,900 + $900 – $1,200 ***$250 + ($930 – $30) – $200
70
EXERCISE 23-13 (30–40 minutes) BRECKER INC. STATEMENT OF CASH FLOWS For the Year Ended December 31, 2014 Cash flows from operating activities Less: Cash received from customers $149,000b Cash payments to suppliers Cash payments for operating expenses 89,000c Cash payments for interest 11,400 Cash payments for income taxes 8,750d Net cash provided by operating activities Cash flows from investing activities Sale of equipment [($20,000 X 30%) + $2,000] Purchase of equipment Purchase of available-for-sale investments Net cash used by investing activities
8,000 (44,000) (17,000)
Cash flows from financing activities Principal payment on short-term loan Principal payment on long-term loan Dividend payments Net cash used by financing activities
(2,000) (9,000) (6,000)
258,150 69,000
(53,000)
(17,000)
Net decrease in cash Cash, January 1, 2014 Cash, December 31, 2014
(1,000) 7,000 $ 6,000
a
Sales revenue – Increase in accounts receivable Cash received from customers
$338,150 (11,000) $327,150
b
$175,000 (6,000) (20,000) $149,000
Cost of goods sold – Increase in accounts payable – Decrease in inventories Cash payments to suppliers
$327,150a
EXERCISE 23-13 (Continued) c
Operating expenses + Increase in prepaid rent – Depreciation expense $35,000 – [$25,000 – ($20,000 X .70)] – Amortization of copyrights – Increase in salaries and wages payable Cash paid for operating expenses
$120,000 1,000 (24,000) (4,000) (4,000) $ 89,000
d
Income tax expense + Decrease in income taxes payable Cash payments for income taxes
$6,750 2,000 $8,750
EXERCISE 23-14 (30–40 minutes) BRECKER INC. STATEMENT OF CASH FLOWS For the Year Ended December 31, 2014 Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Amortization of copyright Gain on sale of equipment Decrease in inventories Increase in salaries and wages payable Increase in accounts payable Increase in prepaid rent Increase in accounts receivable Decrease in income taxes payable Net cash provided by operating activities Cash flows from investing activities Sale of equipment [($20,000 X 30%) + $2,000] Purchase of equipment Purchase of available-for-sale investments Net cash used by investing activities
$27,000 $24,000* 4,000 (2,000) 20,000 4,000 6,000 (1,000) (11,000) (2,000)
42,000 69,000
8,000 (44,000) (17,000) (53,000)
EXERCISE 23-14 (Continued) Cash flows from financing activities Principal payment on short-term loan Principal payment on long-term loan Dividend payments Net cash used by financing activities
(2,000) (9,000) (6,000) (17,000)
Net decrease in cash Cash, January 1, 2014 Cash, December 31, 2014
(1,000) 7,000 $ 6,000
Supplemental disclosures of cash flow information: Cash paid during the year for: Interest Income taxes
$11,400 $ 8,750
*$35,000 – [$25,000 – ($20,000 X 70%)] EXERCISE 23-15 (25–35 minutes) ALEE COMPANY STATEMENT OF CASH FLOWS For the Year Ended December 31, 2014 Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Loss on sale of investments Loss on sale of plant assets Increase in current assets other than cash Increase in current liabilities Net cash provided by operating activities Cash flows from investing activities Sale of plant assets Sale of held-to-maturity investments Purchase of plant assets Net cash used by investing activities
$ 46,000* $ 20,000 9,000 2,000 (25,000) 18,000
24,000 70,000
8,000 34,000 (170,000)** (128,000)
EXERCISE 23-15 (Continued) Cash flows from financing activities Issuance of bonds payable Payment of dividends Net cash provided by financing activities Net increase in cash Cash balance, January 1, 2014 Cash balance, December 31, 2014 *Net income $57,000 – $9,000 – $2,000 = $46,000 **Supporting computation (purchase of plant assets) Plant assets, December 31, 2013 Less: Plant assets sold Plant assets, December 31, 2014 Plant assets purchased during 2014
75,000 (10,000) 65,000 7,000 8,000 $15,000
$215,000 50,000 165,000 335,000 $170,000
EXERCISE 23-16 (30–40 minutes) (a)
Computation of net cash provided by operating activities: Net income ($8,000 + $10,000) – $5,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Loss on sale of equipment ($6,000 – $3,000) Increase in accounts receivable ($45,000 – $55,000) Increase in inventory ($45,000 – $65,000) Decrease in prepaid expenses ($25,000 – $15,000) Increase in accounts payable ($65,000 – $52,000) Decrease in accrued expenses ($15,000 – $18,000) Net cash provided by operating activities
*[$18,000 + ($10,000 – $6,000)] – $8,000
$13,000
$14,000* 3,000 (10,000) (20,000) 10,000 13,000 (3,000) 7,000 $20,000
EXERCISE 23-16 (Continued) (b)
Computation of net cash provided (used) by investing activities: Sale of equipment Purchase of equipment [$90,000 – ($75,000 – $10,000)] Net cash used by investing activities
$ 3,000 (25,000) $(22,000)
(c) Computation of net cash provided (used) by financing activities: Cash dividends paid Payment of notes payable Issuance of bonds payable Net cash used by financing activities
$(10,000) (23,000) 30,000 $ (3,000)
EXERCISE 23-17 (30–40 minutes) (a)
JOBIM INC. STATEMENT OF CASH FLOWS For the Year Ended December 31, 2014
Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Gain on sale of investments Net cash provided by operating activities
$35,250
$13,500 (2,000)
Cash flows from investing activities Purchase of land Sale of available-for-sale investments Net cash provided by investing activities
(9,000) 12,875
Cash flows from financing activities Payment of dividends Redemption of bonds payable Issuance of capital stock Net cash used by financing activities
(9,375) (15,000) 10,000
11,500 46,750
3,875
(14,375)
EXERCISE 23-17 (Continued) Net increase in cash Cash, January 1, 2014 Cash, December 31, 2014
36,250 8,500 $44,750
Noncash investing and financing activities Issuance of bonds for land
$22,500
(b)
JOBIM INC. BALANCE SHEET December 31, 2014 Assets
Cash Current assets other than cash Investments Plant assets (net) Land
$ 44,750 29,000 9,125a 54,000 71,500* $208,375
Equities Current liabilities $ 15,000 Long-term notes payable 25,500 Bonds payable 32,500** Capital stock 85,000 Retained earnings 50,375*** $208,375
a
$20,000 – ($12,875 – $2,000) *$40,000 + $9,000 + $22,500 **$25,000 – $15,000 + $22,500 ***$24,500 + $35,250 – $9,375 EXERCISE 23-18 (25–30 minutes) ANITA BAKER COMPANY Statement of Cash Flows (partial) For the Year Ended December 31, 2014 Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Loss on sale of equipment Net cash provided by operating activities
$ 40,000 $16,800 5,800
22,600 62,600
EXERCISE 23-18 (Continued) Cash flows from investing activities Purchase of equipment Sale of equipment [($56,000 – $25,200) – $5,800] Extraordinary repairs on equipment Cost of equipment constructed Net cash used by investing activities
(62,000) 25,000 (21,000) (48,000) (106,000)
Cash flows from financing activities Payment of cash dividends
(15,000)
Decrease in cash Cash, January 1, 2014 Cash, December 31, 2014
(58,400) xxx $ xxx
EXERCISE 23-19 (20–25 minutes) Retained Earnings........................................................... Financing—Cash Dividends ..................................
15,000
Operating—Net Income .................................................. Retained Earnings..................................................
40,000
Operating—Depreciation Expense................................. Accumulated Depreciation—Equipment ..............
16,800
Equipment........................................................................ Investing—Purchase of Equipment ...................... Investing—Construction of Equipment ................
110,000
Accumulated Depreciation—Equipment ....................... Investing—Extraordinary Repairs to Equipment .
21,000
Operating—Loss on Sale of Equipment ........................ Accumulated Depreciation—Equipment ....................... Investing—Sale of Equipment........................................ Equipment ..............................................................
5,800 25,200 25,000
15,000
40,000
16,800
62,000 48,000
21,000
56,000
EXERCISE 23-20 (20–25 minutes) 1.
2.
3.
4.
5.
Bonds Payable....................................................... Common Stock............................................. (Noncash financing activity)
300,000
Operating—Net Income......................................... Retained Earnings........................................
410,000
Operating—Depreciation Expense....................... Accumulated Depreciation—Building.........
90,000
Accumulated Depreciation—Equipment ............. Equipment.............................................................. Operating—Gain on Disposal of Plant Assets .............................................. Investing—Purchase of Equipment ............
30,000 10,000
Retained Earnings................................................. Dividend Payable..........................................
123,000
300,000
410,000
90,000
6,000 34,000
123,000
EXERCISE 23-21 (45–55 minutes) STEVIE WONDER CORPORATION WORKSHEET FOR PREPARATION OF STATEMENT OF CASH FLOWS For the Year Ended December 31, 2014
Debits Cash Short-term investments Accounts receivable Prepaid expenses Inventory Land Buildings Equipment Equipment (Delivery) Patents Total debits Credits Accounts payable Notes payable Accrued liabilities Allowance for doubtful accounts Accum. depr.—bldg. Accum. depr.—equip. Accum. depr.—equip. Mortgage payable Bonds payable Capital stock Paid-in capital in excess of par Retained earnings Total credits
Balance at 12/31/13 $ 21,000 19,000 45,000 2,500 65,000 50,000 73,500 46,000 39,000
2014 Balance at Reconciling Items Debit Credit 12/31/14 (17) $ 4,500 $ 16,500 (2)
$ 6,000
(4) (5)
1,700 16,500
(10) (11)
51,500 7,000
(12)
15,000
(3)
2,000
(6)
$10,000
$361,000
$ 16,000
25,000 43,000 4,200 81,500 50,000 125,000 53,000 39,000 15,000 $452,200
$ 26,000
6,000 (7) 4,600 (8)
$ 2,000 1,600
4,000 3,000
2,000 (3) 23,000 15,500 20,500 53,400 62,500 (16) 102,000
200
1,800 30,000 19,000 22,000 73,000 50,000 140,000
4,000 51,500 (9) $361,000
(13) (13) (13) (14)
7,000 3,500 1,500 19,600
(15)
38,000
(15) 15,000 (1)
6,000 36,900
12,500
10,000 73,400 $452,200
EXERCISE 23-21 (Continued) Statement of Cash Flows Effects Operating activities Net income Depreciation expense Dec. in accounts receivable (net) Inc. in prepaid expenses Inc. in inventory Inc. in accounts payable Dec. in notes payable Dec. in accrued payables
(1) (13)
36,900 12,000
(3)
1,800
(6)
(14) (15) (17)
1,700 16,500
(7) (8)
2,000 1,600
(2) (10) (11) (12)
6,000 51,500 7,000 15,000
(9)
15,000
(16)
12,500 257,800
10,000
Investing activities Purchase of available-for-sale investments Purchase of building Purchase of equipment Purchase of patents Financing activities Payment of cash dividends Issuance of mortgage payable Sale of stock Redemption of bonds Totals Decrease in cash Totals
(4) (5)
19,600 44,000 253,300 4,500 $257,800
$257,800
TIME AND PURPOSE OF PROBLEMS Problem 23-1 (Time 40–45 minutes) Purpose—to develop an understanding of the procedures involved in the preparation of a statement of cash flows. The student is required to prepare the statement using the indirect method. Problem 23-2 (Time 50–60 minutes) Purpose—to develop an understanding of the procedures involved in the preparation of a statement of cash flows, including a schedule of noncash investing and financing activities. The student is required to prepare the statement using the indirect method, and consider the proper treatment of an extraordinary item. Problem 23-3 (Time 50–60 minutes) Purpose—to develop an understanding of the procedures involved in the preparation of a statement of cash flows. The student is required to prepare the statement using the direct method. Problem 23-4 (Time 45–60 minutes) Purpose—to develop an understanding of the procedures involved in the preparation of a statement of cash flows. The student is required to prepare the statement using the direct method, including a reconciliation schedule. Problem 23-5 (Time 50–65 minutes) Purpose—to develop an understanding of the procedures involved in the preparation of a statement of cash flows, including the treatment accorded unusual and extraordinary items. The student is required to prepare the statement using the indirect method, and include any supporting schedules or computations. Problem 23-6 (Time 40–50 minutes) Purpose—to develop an understanding of the procedures involved in the preparation of a statement of cash flows. The student is required to prepare the statement using the indirect method. The student also must calculate the net cash flow from operating activities using the direct method. Problem 23-7 (Time 30–40 minutes) Purpose—Using comparative financial statement data, the student is required to prepare the statement of cash flows, using the direct method. The student must also prepare the operating activities section of the statement of cash flows using the indirect method. Problem 23-8 (Time 30–40 minutes) Purpose—to develop an understanding of both the direct and indirect method. The student is first asked to compute net cash provided by operating activities under the direct method. In addition a statement of cash flows using the indirect method must be computed. Problem 23-9 (Time 30–40 minutes) Purpose—to develop an understanding of the indirect method. In the second part, the student is asked to determine how operating, investing and financing sections of the statement of cash flows will change under various situations.
SOLUTIONS TO PROBLEMS PROBLEM 23-1 SULLIVAN CORP. Statement of Cash Flows For the Year Ended December 31, 2014 Cash flows from operating activities Net income .................................................... Adjustments to reconcile net income to net cash provided by operating activities: Depreciation .......................................... Gain on sale of equipment ................... Equity in earnings of Myers Co............ Decrease in accounts receivable......... Increase in inventory ............................ Increase in accounts payable .............. Decrease in income taxes payable ...... Net cash provided by operating activities ....................................................
$370,000
$147,000 (a) (2,000) (b) (35,000) (c) 40,000 (135,000) 60,000 (20,000)
425,000
Cash flows from investing activities: Proceeds from sale of equipment................ Loan to TLC Co. ............................................ Principal payment of loan receivable .......... Net cash used by investing activities..........
40,000 (300,000) 50,000
Cash flows from financing activities: Dividends paid .............................................. Net cash used by financing activities .........
(100,000)
Net increase in cash.............................................. Cash, January 1, 2014 ........................................... Cash, December 31, 2014......................................
55,000
(210,000)
(100,000) 115,000 700,000 $815,000
PROBLEM 23-1 (Continued) Schedule at bottom of statement of cash flows: Noncash investing and financing activities: Issuance of capital lease liability for office building................................................
$400,000
Explanation of Amounts (a) Depreciation Net increase in accumulated depreciation for the year ended December 31, 2014................................... Accumulated depreciation on equipment sold: Cost ................................................................... $60,000 Carrying value ............................................... (38,000) Depreciation for 2014............................................
$125,000 22,000 $147,000
(b) Gain on sale of equipment Proceeds........................................................ Carrying value ............................................... Gain...........................................................
$ 40,000 (38,000) $ 2,000
(c) Equity in earnings of Myers Co. Myers’s net income for 2014 ........................ Sullivan’s ownership..................................... Undistributed earnings of Myers Co....
$140,000 X 25% $ 35,000
PROBLEM 23-2
HINCKLEY CORPORATION Statement of Cash Flows For the Year Ended December 31, 2014 Cash flows from operating activities Net income ..................................................... Adjustments to reconcile net income to net cash provided by operating activities: Loss on sale of equipment.................... Gain from flood damage ....................... Depreciation expense............................ Patent amortization ............................... Gain on sale of investments ................. Increase in accounts receivable (net) .. Increase in inventory............................. Increase in accounts payable ............... Net cash provided by operating activities ...
$14,750 (a)
$ 4,100 (b) (8,250)* 1,900 (c) 1,250 (1,700) (3,750)** (3,000) 2,000
Cash flows from investing activities Sale of investments....................................... Sale of equipment.......................................... Purchase of equipment ................................. Proceeds from flood damage to building .... Net cash provided by investing activities....
4,700 2,500 (20,000)(d) 32,000
Cash flows from financing activities Payment of dividends ................................... Payment of short-term note payable............ Net cash used by financing activities ..........
(5,000) (1,000)
Increase in cash .................................................... Cash, January 1, 2014 ........................................... Cash, December 31, 2014...................................... *($30,000 + $2,000) – ($29,750 – $6,000) **($12,250 – $3,000) – ($10,000 – $4,500)
(7,450) 7,300
19,200
(6,000) 20,500 13,000 $33,500
PROBLEM 23-2 (Continued) Supplemental disclosures of cash flow information: Cash paid during the year for: Interest Income taxes:
$2,000 $6,500
Noncash investing and financing activities Retired notes payable by issuing common stock Purchased equipment by issuing notes payable
$10,000 16,000 $26,000
Supporting Computations: (a) Ending retained earnings ...................................... Beginning retained earnings................................. Net income .............................................................
$20,750 (6,000) $14,750
(b) Cost......................................................................... Accumulated depreciation (40% X $11,000)......... Book value.............................................................. Proceeds from sale ................................................ Loss on sale ...........................................................
$11,000 (4,400) $ 6,600 (2,500) $ 4,100
(c) Accumulated depreciation on equipment sold .... Decrease in accumulated depreciation ................ Depreciation expense ............................................
$ 4,400 (2,500) $ 1,900
(d) Beginning equipment balance .............................. Cost of equipment sold ......................................... Remaining balance ................................................ Purchase of equipment with note ......................... Adjusted balance ................................................... Ending equipment balance.................................... Purchased with cash .............................................
$20,000 (11,000) 9,000 16,000 25,000 (45,000) $20,000
PROBLEM 23-3
MORTONSON COMPANY Statement of Cash Flows For the Year Ended December 31, 2014 ($000 Omitted) Cash flows from operating activities Cash receipts from customers ...................... Cash payments for: Payments for merchandise ....................... $1,270 (b) Salaries and benefits ................................. 725 Heat, light, and power ................................ 75 Property taxes ............................................ 19 Interest ........................................................ 30 Miscellaneous ............................................ 10 Income taxes .............................................. 808 (c) Net cash provided by operating activities .... Cash flows from investing activities Sale of available-for-sale investments .......... Purchase of buildings and equipment .......... Purchase of land ............................................. Net cash used by investing activities............
Sales ................................................................ Deduct ending accounts receivable .............. Add beginning accounts receivable.............. Cash receipts (collections) from Customers ...........................................
2,937 583
40 (310) (80) (350)
Increase in cash ...................................................... Cash, January 1, 2014 ............................................. Cash, December 31, 2014........................................ (a)
$3,520 (a)
233 100 $ 333 $3,800 780 3,020 500 $3,520
PROBLEM 23-3 (Continued) (b) Cost of goods sold....................................... Add ending inventory .................................. Goods available for sale ...................... Deduct beginning inventory........................ Purchases............................................. Deduct ending accounts payable ............... Add beginning accounts payable ............... Cash purchases (payments for merchandise).................................... (c) Income taxes ................................................ Deduct ending income taxes payable ........ Add beginning income taxes payable ........ Income taxes paid...............................
$1,200 720 1,920 560 1,360 420 940 330 $1,270 $818 40 778 30 $ 808
PROBLEM 23-4 MICHAELS COMPANY Statement of Cash Flows For the Year Ended December 31, 2014 (Direct Method) Cash flows from operating activities Cash receipts: Cash received from customers ......................... $1,152,450a Dividends received ........................................... 2,400 $1,154,850 Cash payments: To suppliers ...................................................... 765,000b For operating expenses ................................... 226,350c For taxes............................................................ 38,400d For interest ........................................................ 57,300e 1,087,050 Net cash provided by operating activities ............... $ 67,800 Cash flows from investing activities Sale of short-term investments ($8,000 + $4,000) ............................................ Sale of land ($175,000 – $125,000) + $8,000 .... Purchase of equipment .................................... Net cash used by investing activities.............. Cash flows from financing activities Proceeds from issuance of common stock .... Principal payment on long-term debt.............. Dividends paid .................................................. Net cash used by financing activities .............
12,000 58,000 (125,000) (55,000) 27,500 (10,000) (24,300) (6,800)
Net increase in cash.................................................. Cash, January 1, 2014 ............................................... Cash, December 31, 2014..........................................
$
a
Sales revenue ........................................................... – Increase in Accounts receivable ........................... Cash received from customers ................................
$1,160,000 (7,550) $1,152,450
b
$ 748,000 7,000 10,000 $ 765,000
Cost of Goods Sold.................................................. + Increase in Inventory.............................................. + Decrease in Accounts Payable.............................. Cash paid to suppliers ..............................................
6,000 4,000 10,000
PROBLEM 23-4 (Continued) c
Operating Expenses ............................................. – Depreciation/Amortization expense................... – Decrease in prepaid rent..................................... + Increase in prepaid insurance............................ + Increase in office supplies.................................. – Increase in salaries and wages payable ............ Cash payments for operating expenses .......
$276,400 (40,500) (9,000) 1,200 250 (2,000) $226,350
d
Income tax expense.............................................. – Increase in income taxes payable...................... Taxes paid .......................................................
$ 39,400 (1,000) $ 38,400
e
$ 51,750 5,550 $ 57,300
Interest Expense ................................................... + Decrease in bond premium ................................ Interest paid .................................................... Reconciliation of Net Income to Net Cash Provided by Operating Activities: Net income.............................................................. Adjustments to reconcile net income to net cash provided by operating activities: Depreciation/amortization expense ............... Decrease in prepaid rent ................................ Increase in income taxes payable ................. Increase in salaries and wages payable........ Increase in accounts receivable .................... Increase in inventory ...................................... Increase in prepaid insurance........................ Increase in supplies........................................ Decrease in accounts payable ....................... Gain on sale of land ........................................ Gain on sale of short-term investments........ Amortization of bond premium ...................... Total adjustments ................................... Net cash provided by operating activities............
$58,850 $40,500 9,000 1,000 2,000 (7,550) (7,000) (1,200) (250) (10,000) (8,000) (4,000) (5,550) 8,950 $67,800
PROBLEM 23-5
ALEXANDER CORPORATION Statement of Cash Flows For the Year Ended December 31, 2014 (Indirect Method) Cash flows from operating activities Net income ....................................................... Adjustments to reconcile net income to net cash used by operating activities: Loss on sale of machinery ...................... Gain on redemption of bonds ................. Depreciation of machinery ...................... Depreciation of building .......................... Amortization of patents ........................... Amortization of copyrights ..................... Amortization of bond discount ............... Amortization of bond premium ............... Equity in earnings of subsidiary............. Increase in accounts receivable (net) ........................................................ Increase in inventory ............................... Increase in prepaid expenses ................. Increase in income taxes payable .......... Increase in accounts payable ................. Net cash used by operating activities ............ Cash flows from investing activities Sale of machinery ............................................ Investment in subsidiary ................................. Addition to buildings ....................................... Extraordinary repairs to building.................... Purchase of machinery ................................... Purchase of patent........................................... Increase in cash surrender value of life insurance....................................................... Net cash used by investing activities.............
$115,000*
$
2,200 (4) (1,425) (5) 48,200 (4) 31,200 (8) 10,000 (3) 10,000 87 (6) (75) (5) (10,500) (7)
(121,124) (131,700) (4,000) 10,650 19,280
(137,207) (22,207)
9,000 (4) (100,000) (7) (127,300) (7,200) (8) (33,400) (4) (15,000) (3) (504) (274,404)
PROBLEM 23-5 (Continued) Cash flows from financing activities Redemption of bonds ...................................... Sale of bonds less expense of sale ................ Sale of stock..................................................... Net cash provided by financing activities ......
(100,900) (5) 120,411 (6) 257,000 276,511
Decrease in cash ..................................................... Cash, January 1, 2014............................................. Cash, December 31, 2014 ....................................... *Net income per retained earnings statement ($25,000 + $90,000) ..............................................
(20,100) 298,000 $277,900
$115,000
Supplemental disclosures of cash flow information: Cash paid during the year for: Interest.............................................................. Income taxes .................................................... Noncash investing and financing activities Reduction in stated value of stock to eliminate deficit.............................................
$10,500 $34,000
$425,000
Comments on Numbered Items (1) Write-off of deficit has no effect on cash. Analysis of the capital stock account shows the following: Balance 12/31/13 .............................................. $1,453,200 Restatement of stated value of stock ............. (425,000) Balance 4/1/14 .................................................. 1,028,200 (2) Sale of 29,600 shares 11/1/14 for $257,000 with stated value of $5 per share .................... Balance 12/31/14 ..............................................
148,000 $1,176,200
PROBLEM 23-5 (Continued) (3) A patent was purchased for $15,000 cash. The account activity is analyzed as follows: Balance 12/31/13 ................................................... $64,000 Purchase................................................................ 15,000 Total ....................................................................... 79,000 Balance 12/31/14 ................................................... (69,000) Amortization charged against income which did not use cash................................................. $10,000 (4) Analysis of the Machinery account shows the following: Balance 12/31/13 .................................................... Disposition of machinery ...................................... Total ............................................................... Balance 12/31/14 .................................................... Additions requiring cash ..............................
$190,000 (16,400) 173,600 (207,000) $ (33,400)
Loss on sale: ($16,400 – $5,200) – $9,000 .......................... $2,200 Cash received from disposition ..................... $9,000 Analysis of accumulated depreciation— machinery: Balance 12/31/13 of Accumulated Depreciation ....................................... Amount on asset sold........................... Balance .................................................. Balance 12/31/14 ................................... Depreciation charged against income which did not use cash .....................
$130,000 (5,200) 124,800 (173,000) $ (48,200)
PROBLEM 23-5 (Continued) (5) Funds to redeem bonds ($100,000 X 1.009) ......... Face value of bonds............................................... Unamortized premium 12/31/13 ............................ $2,400 Amortization to 3/31/14 not requiring cash ($6,000 ÷ 20) X 1/4 ............................................... 75 Balance at date of redemption ...................... Book value of bonds ...................................... Gain on redemption ($102,325 – $100,900) ................................. (6) Face amount of bonds issued............................... Discount on $125,000 of bonds sold ($125,000 X .03) .................................................. $3,750 Expense of issuance.............................................. 839 Total ............................................................... Proceeds of issue .................................................. Amortization for nine months, which did not require cash................................... (87)* Change in discount account ........................ $4,502
$100,900 $100,000
2,325 $102,325 $ (1,425) $125,000
(4,589) $120,411
*($4,589/477 months (a)) X 9 months = $87 (a) (40 years X 12 months) – 3 (7) Purchase of stock requiring cash......................... 70% of subsidiary’s income for year ($15,000), which did not provide cash but was credited to income ....................... Balance 12/31/14 ........................................... (8) Analysis of accumulated depreciation— building Balance of accumulated depreciation 12/31/13 ... Charge for major repairs which used cash .......... Balance 12/31/14 .................................................... Depreciation charged against income which did not require cash............................................
$100,000 10,500 $110,500
$400,000 (7,200) 392,800 (424,000) ($ 31,200)
PROBLEM 23-5 (Continued) Comments on Other Items (not required) Increase in cash surrender value of insurance required cash...... Increase in Buildings required cash ............................................... Decrease in Copyrights was a noncash charge against income .. Dividends declared did not require cash........................................ Accrued interest on retired bonds and issuance does not affect the statement of cash flows. These items are already recorded in income.
$
504 127,300 10,000 70,000
PROBLEM 23-6
(a)
Net Cash Flow from Operating Activities Cash received from customers ............................. Cash payments: Cash payments to suppliers ............................... $375,7502 Cash payments for operating expenses.......... 105,6753 Net cash provided by operating activities ............ 1
$540,000 – $10,500 – $4,650* = $524,850
2
$380,000 + $6,000 – $10,250 = $375,750
3
$120,450 – $8,625 – $750** – $5,400 = $105,675
*Writeoff of accounts receivable. ($1,500 + $5,400 – $2,250) **Increase in accrued payables
$524,8501 481,425 $ 43,425
PROBLEM 23-6 (Continued) (b)
MARCUS INC. Statement of Cash Flows For the Year Ended December 31, 2014 Cash flows from operating activities Net income ....................................................... Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense............................... Gain on sale of investments .................... Loss on sale of machinery....................... Increase in accounts receivable (net) ..... Increase in inventory ................................ Increase in accounts payable .................. Increase in accrued payables .................. Net cash provided by operating activities ..... Cash flows from investing activities Purchase of investments $22,250 – ($38,500 – $25,000)...................... Purchase of machinery $30,000 – ($18,750 – $3,750)........................ Addition to buildings ....................................... Sale of investments ......................................... Sale of machinery ............................................ Net cash used by investing activities............. Cash flows from financing activities Reduction in long-term note payable ............ Cash dividends paid ....................................... Net cash used by financing activities............ Net increase in cash .............................................. Cash, January 1, 2014 ........................................... Cash, December 31, 2014...................................... *($70,500 – $2,250) – ($60,000 – $1,500)
$42,500
$ 8,625 (3,750) 800 (9,750)* (6,000) 10,250 750
925 43,425
(8,750) (15,000) (11,250) 28,750 2,200 (4,050) (10,000) (21,125) (31,125) 8,250 33,750 $42,000
PROBLEM 23-7 (a) Both the direct method and the indirect method for reporting cash flows from operating activities are acceptable in preparing a statement of cash flows according to GAAP; however, the FASB encourages the use of the direct method. Under the direct method, the statement of cash flows reports the major classes of cash receipts and cash disbursements, and discloses more information; this may be the statement’s principal advantage. Under the indirect method, net income on the accrual basis is adjusted to the cash basis by adding or deducting noncash items included in net income, thereby providing a useful link between the statement of cash flows and the income statement and balance sheet. (b) The Statement of Cash Flows for Chapman Company, for the year ended May 31, 2014, using the direct method, is presented below. CHAPMAN COMPANY Statement of Cash Flows For the Year Ended May 31, 2014 Cash flows from operating activities Cash received from customers ...................... Cash payments: To suppliers ............................................ To employees ......................................... For other expenses ................................ For interest.............................................. For income taxes .................................... Net cash provided by operating activities .....
$1,238,250 $684,000 276,850 10,150 73,000 43,000
1,087,000 151,250
Cash flows from investing activities Purchase of plant assets................................. Cash flows from financing activities Cash received from common stock issue ..... Cash paid: For dividends.......................................... To retire bonds payable ......................... Net cash used by financing activities ............ Net increase in cash................................................. Cash, June 1, 2013 ................................................... Cash, May 31, 2014...................................................
(28,000) $ 20,000 (105,000) (30,000) (115,000)
$
8,250 20,000 28,250
PROBLEM 23-7 (Continued) Note 1:
Noncash investing and financing activities: Issuance of common stock for plant assets $70,000.
Supporting Calculations: Cash collected from customers Sales revenue ......................................................$1,255,250 Less: Increase in accounts receivable .............. 17,000 Cash collected from customers ..............$1,238,250 Cash paid to suppliers Cost of merchandise sold .............................. Less: Decrease in inventory.......................... Increase in accounts payable ............. Cash paid to suppliers.........................
$ 722,000 30,000 8,000 $ 684,000
Cash paid to employees Salaries and wages expense .......................... $ 252,100 Add: Decrease in salaries and wages payable ........................................... 24,750 Cash paid to employees ....................... $ 276,850 Cash paid for other expenses Other expenses ............................................... $ Add: Increase in prepaid expenses ................... Cash paid for other expenses .............. $
8,150 2,000 10,150
Cash paid for interest Interest expense.............................................. $ Less: Increase in interest payable..................... Cash paid for interest .......................... $
75,000 2,000 73,000
Cash paid for income taxes: Income tax expense (given)............................
43,000
$
PROBLEM 23-7 (Continued) (c) The calculation of the cash flow from operating activities for Chapman Company, for the year ended May 31, 2014, using the indirect method, is presented below. CHAPMAN COMPANY Statement of Cash Flows For the Year Ended May 31, 2014 Cash flows from operating activities Net income ........................................................ Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ............................. $25,000 Decrease in inventory ............................. 30,000 Increase in accounts payable ................. 8,000 Increase in interest payable.................... 2,000 Increase in accounts receivable............. (17,000) Increase in prepaid expenses................. (2,000) Decrease in salaries and wages payable ..................................... (24,750) Net cash provided by operating activities...............
$130,000
21,250 $151,250
PROBLEM 23-8
(a)
Net Cash Provided by Operating Activities Cash receipts from customers Cash payments: To suppliers For operating expenses For income taxes Net cash provided by operating activities
$925,000 (1) $608,000(2) 226,000(3) 43,000(4) 877,000 $ 48,000
(1) (Sales Revenue) less (Increase in Accounts Receivable) $950,000 – $25,000 = $925,000 (2) (Cost of Goods Sold) plus (Increase in Inventory) less (Increase in Accounts Payable) $600,000 + $14,000 – $6,000 = $608,000 (3) (Operating Expenses) less (Depreciation Expense) less (Bad Debt Expense) $250,000 – $22,000* – $2,000 = $226,000 (4) (Income Taxes) less (Increase in Income Taxes Payable) $45,000 – $2,000 = $43,000 *$21,000 – [$14,000 – ($10,000 X .60)] = $13,000 Equipment depreciation $37,000 – $28,000 = 9,000 Building depreciation $22,000
PROBLEM 23-8 (Continued) (b)
SHARPE COMPANY Statement of Cash Flows For the Year Ended December 31, 2014
Cash flows from operating activities Net income .......................................................... Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense................................. Gain on sale of investments ...................... Loss on sale of equipment......................... Increase in accounts receivable (net) ....... Increase in inventory .................................. Increase in accounts payable .................... Increase in income taxes payable ............. Net cash provided by operating activities ........ Cash flows from investing activities Purchase of investments [$55,000 – ($85,000 – $35,000)]....................... Purchase of equipment [$70,000 – ($48,000 – $10,000)]....................... Sale of investments ($35,000 + $15,000) ........... Sale of equipment [$10,000 – ($10,000 X 60%)] – $3,000 ............. Net cash provided by investing activities......... Cash flows from financing activities Payment of long-term notes payable ................ Cash dividends paid [($95,000 + $67,000) – $92,000]....................... Issuance of common stock................................ Net cash used by financing activities ...............
$67,000
$22,000 (15,000) 3,000 (23,000) (14,000) 6,000 2,000
(19,000) 48,000
(5,000) (32,000) 50,000 1,000 14,000 (8,000) (70,000) 35,000* (43,000)
Net increase in cash.................................................... Cash, January 1, 2014................................................. Cash, December 31, 2014 ...........................................
19,000 51,000 $70,000
Noncash investing and financing activities Issuance of common stock for land..................
$15,000
*$310,000 – $260,000 = $50,000; $50,000 – ($40,000 – $25,000) = $35,000
PROBLEM 23-9 (a)
DINGEL CORPORATION Statement of Cash Flows For the Year Ended December 31, 2014 Cash flows from operating activities Net income.......................................................... Adjustments to reconcile net income to net cash provided by operating activities: Loss on sale of equipment......................... Gain from flood damage ............................ Depreciation expense................................. Copyright amortization .............................. Gain on sale of investment ........................ Increase in accounts receivable (net) ....... Increase in inventory.................................. Increase in accounts payable .................... Net cash flow provided by operating activities ...
$15,750(a) $ 5,200(b) (13,250)* 800(c) 250 (1,500) (3,750) (2,000) 1,000
Cash flows from investing activities Sale of investments............................................ Sale of equipment .............................................. Purchase of equipment (cash) .......................... Proceeds from flood damage to building ......... Net cash provided by investing activities ........
4,500 2,500 (15,000) 37,000
Cash flows from financing activities Payment of dividends ........................................ Payment of short-term notes payable .............. Net cash used by financing activities ...............
(5,000) (1,000)
Increase in cash ...................................................... Cash, January 1, 2014 ............................................ Cash, December 31, 2014 ....................................... Supplemental disclosures of cash flow information: Cash paid during the year for: Interest .......................................... $2,000 Income taxes................................. $5,000 *[($33,000 + $4,000) – ($29,750 – $6,000)]
(13,250) 2,500
29,000
(6,000) 25,500 13,000 $38,500
PROBLEM 23-9 (Continued) Noncash investing and financing activities: Retired note payable by issuing common stock ........ Purchased equipment by issuing notes payable........
$ 5,000 16,000 $21,000
Supporting Computations: (a) Ending retained earnings ............................................. Beginning retained earnings ........................................ Net income .............................................................
$20,750 (5,000) $15,750
(b) Cost................................................................................ Accumulated depreciation (30% X $11,000) ................ Book value..................................................................... Proceeds from sale ....................................................... Loss on sale...........................................................
$11,000 (3,300) $ 7,700 (2,500) $ 5,200
(c) Accumulated depreciation on equipment sold ........... Decrease in accumulated depreciation ....................... Depreciation expense............................................
$ 3,300 (2,500) $ 800
(b) (1) For a severely financially troubled firm: Operating: Investing: Financing:
Probably a small cash inflow or a cash outflow. Probably a cash inflow as assets are sold to provide needed cash. Probably a cash inflow from debt financing (borrowing funds) as a source of cash at high interest cost.
(2) For a recently formed firm which is experiencing rapid growth: Operating: Investing: Financing:
Probably a cash inflow. Probably a large cash outflow as the firm expands. Probably a large cash inflow to finance expansion.
TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 23-1 (Time 30–35 minutes) Purpose—to develop an understanding of the proper composition and presentation of the statement of cash flows. The student is required to analyze a statement of sources and application of cash and indicate the proper treatment of various transactions. CA 23-2 (Time 30–35 minutes) Purpose—to illustrate the proper form of the statement of cash flows. The student is required to prepare the statement using the indirect method, and to discuss the rationale behind the statement. CA 23-3 (Time 30–35 minutes) Purpose—to help a student identify whether a transaction creates a cash inflow or a cash outflow. The student is required to indicate whether a cash inflow or a cash outflow results from the transaction. The student must also discuss the proper disclosure of the transaction. CA 23-4 (Time 20–30 minutes) Purpose—to help the student identify the sections of the statement of cash flows. The student is required to indicate whether a transaction belongs in the investing, financing, or operating section of the statement. CA 23-5 (Time 30–40 minutes) Purpose—to identify and explain reasons and purposes for preparing a statement of cash flows, to identify the categories of activities reported in the statement of cash flows, to identify and describe the two methods of reporting cash flows from operations, and to describe the presentation of noncash transactions. CA 23-6 (Time 20–30 minutes) Purpose—provides the student the opportunity to examine the effects of a securitization on the statement of cash flows, including ethical dimensions.
SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 23-1 (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 and investing activities of the entity, including the extent to which the company 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 company. (b) The following are weaknesses in form and format of Maloney 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. (c) 1. (i) The $25,000 option plan salaries and wages 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. (ii) Since the statement balances and no reference is made to the $25,000 salaries and wages 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.
CA 23-1 (Continued) 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.
CA 23-2 (a) From the information given, it appears that from an operating standpoint Pacific Clothing Store did not have a superb first year, having suffered an $11,000 net loss. Lenny is correct; the statement of cash flows is not prepared in correct form. The sources and uses format is not an acceptable form. The correct form classifies cash flows from three activities—operating, investing, and financing; and it also presents significant noncash investing and financing activities in a separate schedule. Lenny is wrong, however, about the actual increase in cash—$109,000 is the correct increase in cash.
(b)
PACIFIC CLOTHING STORE Statement of Cash Flows For the Year Ended January 31, 2014
Cash flows from operating activities Net loss................................................................ Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ................................. $ 80,000 Gain from sale of investment ..................... (25,000) Net cash provided by operating activities ........ Cash flows from investing activities Sale of investment .............................................. Purchase of fixtures and equipment ................. Purchase of investment ..................................... Net cash used by investing activities................ Cash flows from financing activities Sale of capital stock ........................................... Purchase of treasury stock ................................ Net cash provided by financing activities......... Net increase in cash.................................................... Supplemental disclosure of cash flow information: Cash paid for interest .........................................
$ (11,000)*
55,000 44,000
120,000 (330,000) (95,000) (305,000) 380,000 (10,000) 370,000 $109,000
$3,000
Note to Instructor: The data provided do not allow reconciliation of other working capital accounts.
CA 23-2 (Continued) Noncash investing and financing activities Issuance of note for truck ...................................... *Computation of net income (loss) Sales of merchandise............................................. Interest revenue...................................................... Gain on sale of investment ($120,000 – $95,000) ... Total revenues................................................. Merchandise purchases......................................... $253,000 Operating expenses ($170,000 – $80,000) ............ 90,000 Depreciation............................................................ 80,000 Interest expense ..................................................... 3,000 Total expenses ................................................ Net loss ...................................................................
$ 30,000 $382,000 8,000 25,000 415,000
(426,000) $ (11,000)
CA 23-3 1.
The earnings are treated as an inflow of cash and should be reported as part of the net cash provided by operating activities in the statement of cash flows. There should be $810,000 of income before extraordinary items because extraordinary items should be separated from operating activities.
2.
The $315,000 depreciation expense is neither an inflow nor an outflow of cash. Because depreciation is an expense, it was deducted in the computation of net income. Accordingly, the $315,000 must be added back to income before extraordinary items in the operating activities section because it was deducted in determining earnings, but it was not a use of cash.
3.
The write-off of uncollectible accounts receivable against the allowance account has no effect on cash because the net accounts receivable remain unchanged. An adjustment to income is only necessary if the net receivable amount increases or decreases. Because the net receivable amount is the same before and after the write-off, an adjustment to income would not be made. The $51,000 of bad debt expense does not affect cash but would be added back to income because it affects the amount of net accounts receivable. The recording of bad debt expense reduces the net receivable because the allowance account increases. Although bad debt expense is not usually treated as a separate item to be added back to income from operations, it is accounted for by analyzing the accounts receivable at the net amount and then making the necessary adjustment to income based on the change in the net amount of receivables.
4.
The $6,000 gain realized on the sale of the machine is an ordinary gain, not an extraordinary gain, for accounting purposes. This $6,000 gain must be deducted from net income to arrive at net cash provided by operating activities. The proceeds of $36,000 ($30,000 + $6,000) are shown as a cash inflow from investing activities.
5.
Generally, extraordinary items are investing or financing activities and the cash inflow or outflow resulting from such events should be reported in the investing or financing activities section of the statement of cash flows. In this case, no cash flow resulted from the lightning damage. The net loss (a noncash event) must be added back to net income (under the indirect method) as one of the adjustments to reconcile net income to net cash provided by operating activities.
CA 23-3 (Continued) 6.
The $75,000 use of cash should be reported as a cash outflow from investing activities. The $200,000 issuance of common stock and the $425,000 issuance of the mortgage note, neither of which affects cash, should be reported as noncash financing and investing activities.
7.
This conversion is not an inflow or an outflow of cash, but it is a significant noncash financing activity and should be reported in a separate schedule or note.
CA 23-4 Where to Present
How to Present
1.
Investing and operating
Cash provided by sale of fixed assets, $4,750 as an investing activity. In addition, the loss of $2,250 ([($20,000 x 31/2) ÷ 10] – $4,750) on the sale would be added back to net income.
2.
Operating
The impairment reduced earnings from operations but did not use cash. The amount of $15,000 is added back to net income.
3.
Financing
Cash provided by the issuance of capital stock of $16,000.
4.
Operating
The net loss of $2,100 is presented as loss from operations, and depreciation of $2,000 and amortization of $400 are added back to the loss from operations. Net cash provided by operating activities is $300.
5.
Not reported in statement.
6.
Investing and operating
Cash provided by the sale of the investment, $10,600 as an investing activity. The loss of $1,400 is added back to net income.
7.
Financing and operating
The redemption is reported as cash used by financing activities of $24,240. Additionally, the gain (of $1,760 = $26,000 – $24,240) is deducted from net income in the operating activities section.
CA 23-5 (a) The primary purpose of the statement of cash flows is to provide information concerning the cash receipts and cash payments of a company during a period. The information contained in the statement of cash flows, together with related disclosures in other financial statements, may help investors and creditors 1. assess the company’s ability to generate future net cash inflows. 2. assess the company’s ability to meet its obligations, e.g., pay dividends and meet needs for external financing. 3. assess the reasons for differences between net income and net cash flow from operating activities. (b) The statement of cash flows classifies cash inflows and outflows as those resulting from operating activities, investing activities, and financing activities. Cash inflows from operating activities include receipts from the sale of goods and services, receipts from returns on loans and equity securities (interest and dividends), and all other receipts that do not arise from transactions defined as financing and investing activities. Cash outflows for operating activities include payments to buy goods for manufacture and resale, payments to employees for services, tax payments, payments to creditors for interest, and all other payments that do not arise from transactions defined as financing and investing activities.
CA 23-5 (Continued) Cash inflows from investing activities include receipts from collections or sales of debt instruments of other companies, from the sale of the investments in those stocks, and from sales of various productive fixed assets. Cash outflows for investing activities include payments for stocks of other companies, purchase of productive fixed assets, and debt instruments of other companies. Cash inflows from financing activities include proceeds from the company issuing its own stock or its own debt. Cash outflows for financing activities include payments to shareholders and debtholders for dividends or retirement of its own stocks and bonds (i.e., treasury stock). (c) Cash flows from operating activities may be presented using the direct method or the indirect method. Under the direct method, the major classes of operating cash receipts and cash payments are shown separately. The indirect method involves adjusting net income to net cash flow from operating activities by removing the effects of deferrals of past cash receipts and payments, accruals of future cash receipts and payments, and noncash items from net income. (d) Noncash investing and financing transactions are to be reported in the related disclosures, either in a narrative form or summarized within a schedule. Examples of noncash transactions are the conversion of debt to equity, acquiring assets by assuming directly related liabilities, and exchanging noncash assets or liabilities for other noncash assets or liabilities. For transactions that are part cash and part noncash, only the cash portion should be reported in the statement of cash flows.
CA 23-6 (a) It is true that selling current assets, such as receivables and notes to factors, will generate cash flows for the company, but this practice does not cure the systemic cash problems for the organization. In short, it may be a bad business practice to liquidate assets, incurring expenses and losses, in order to “window dress” the cash flow statement. The ethical implications are that Brockman creates a short-term cash flow at the longer-term expense of the company’s operations and financial position. Barbara’s idea creates the deceiving illusion that the company is successfully generating positive cash flows. (b) Barbara Brockman should be told that if she executes her plan, the company may not survive. While the factoring of receivables and the liquidation of inventory will indeed generate cash, the actual amount of cash the company receives will be less than the carrying value of the receivables and the raw materials. In addition, the company would still have the future expenditure of replenishing its raw materials inventories, at a cost higher than the sales price. As chief accountant for Brockman Guitar, it is your responsibility to work with the company’s chief financial officer to devise a coherent strategy for improving the company’s cash flow problems. One strategy may be to downsize the organization by selling excess property, plant, and equipment to repay long-term debt. In addition, Brockman Guitar may be a good candidate for a quasi-reorganization discussed on KWW website.
FINANCIAL REPORTING PROBLEM (a)
P&G uses the indirect method to compute and report net cash provided by operating activities. The amounts of net cash provided by operating activities for 2009, 2010, and 2011 are $14,919 million, $16,072 million, and $13,231 million, respectively. The two items most responsible for the decrease in cash provided by operating activities in 2011 are the net earnings decrease ($939) and change in accounts payable and other liabilities ($2,090).
(b)
The most significant item in the investing activities section is the $3,306 million that P&G spent on “capital expenditures.” The most significant item in the financing activities section is the $7,039 million that P&G paid to purchase treasury stock.
(c)
Deferred taxes are reported in the operating activities section of P&G’s statement of cash flows. The $128 million is reported as an add back to net income because it is a noncash charge in the income statement.
(d)
Depreciation and amortization is reported in the operating activities section of P&G’s statement of cash flows as an add back (of $2,838) to net income because it is a noncash charge in the income statement.
COMPARATIVE ANALYSIS CASE (a)
Both Coca-Cola and PepsiCo use the indirect method of computing and reporting net cash provided by operating activities in 2009–2011. (In millions) Net cash provided by operating activities
Coca-Cola $9,474
PepsiCo $8,944
(b) The most significant investing activities items in 2011: Coca-Cola Proceeds from disposal of short term investments
$5,647 million
PepsiCo Capital spending
$3,339 million
The most significant financing activities items in 2011:
(c)
Coca-Cola Issuances of debt
$27,495 million
PepsiCo Cash dividends paid
$3,157 million
The Coca-Cola Company has increased net cash provided by operating activities from 2009 to 2011 by $1,288 million or 15.7%. PepsiCo, Inc. has increased net cash provided by operating activities by $2,148 million or 31.6%. Only PepsiCo has a favorable trend in the generation of internal funds from operations. Coco-Cola’s operating activity cash flow increased from 2009 to 2010 but declined slightly from 2010 to 2011.
(d) Both Coca-Cola and PepsiCo report depreciation and amortization in the operating activities section: Coca-Cola, $1,954 million PepsiCo, $2,737 million Depreciation and amortization is reported in the operating activities section because it is a noncash charge in the income statement.
COMPARATIVE ANALYSIS CASE (Continued) (e)
(f)
Coca-Cola
PepsiCo
1.
Current cash debt coverage
$9,474 ($24,283 + $18,508) = 0.44:1 2
$8,944 $18,154 + $15,892) = 0.53:1 2
2.
Cash debt coverage
$9,474 ($48,053 + $41,604) = 0.21:1 2
$8,944 ($51,983 + $46,667) = 0.18:1 2
The current cash debt coverage ratio uses cash generated from operations during the period and provides a better representation of liquidity on an average day. PepsiCo’s ratio of $0.53 of cash flow from operations for every dollar of current debt was approximately 20% higher (0.53 vs. 0.44) than Coca-Cola’s $0.44 of cash flow from operations per dollar of current debt and indicates PepsiCo was more liquid in 2011 than Coca-Cola. The cash debt coverage ratio shows a company’s ability to repay its liabilities from cash generated from operating activities without having to liquidate the assets employed in its operations. Since Coca-Cola’s cash debt coverage ratio was approximately 17% larger (0.21 vs. 0.18) than PepsiCo’s, its ability to repay liabilities with cash flow from operations was greater than PepsioCo’s in 2011.
FINANCIAL STATEMENT ANALYSIS CASE VERMONT TEDDY BEAR CO. (a)
Even though prior year income exceeded the current year income by $821,432 ($838,955 – $17,523), the current year cash flow from operations exceeded prior year’s cash flow from operations by $937,437 [$236,480 – ($700,957).]. This apparent paradox can be explained by evaluating the components of net cash flow from operating activities. Significant contributors to the positive cash flow figure in the current year were (1) the depreciation and amortization add-back of $316,416 versus $181,348 in the prior year, and (2) accounts payable increase of $2,017,059 in the current year versus a decline of $284,567 in the prior year. An increase in accounts payable causes an increase in net cash from operating activities; thus, the majority of the increase in cash is explained by the company’s dramatic increase in accounts payable. An investor or creditor would want to investigate this increase to ensure that the company is not delinquent on its payments. However, it should be noted that inventories did increase by $1,599,014.
(b)
Liquidity: current cash debt coverage ratio (net cash provided by operating activities ÷ average current liabilities) $236,480 ÷ (($4,055,465 + $1,995,600) ÷ 2) = .078:1 Solvency: cash debt coverage (net cash provided by operating activities ÷ average total liabilities) $236,480 ÷ (($4,620,085 + $2,184,386) ÷ 2) = .070:1 Profitability: cash return on sales ratio (net cash provided by operating activities ÷ net sales) $236,480 ÷ $20,560,566 = 1.15% All of these ratios are very low. This is not surprising, however, for a company like the Vermont Teddy Bear Company that is in the early stages of its life. When a company is in the introductory phase of its main product, it will not typically generate significant net cash flow from operating activities. However, because of the precarious nature of companies in this stage of their lives, the company’s cash position should be monitored closely to ensure that it does not slide into a distress financial state due to cash shortages.
ACCOUNTING, ANALYSIS, AND PRINCIPLES Accounting LASKOWSKI COMPANY Statement of Cash Flows For the Year Ended December 31, 2014 Cash flows from operating activities Net income ............................................................ Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense ...................................... Loss on sale of machinery .............................. Increase in accounts receivable...................... Decrease in inventory ...................................... Increase in accounts payable.......................... Net cash provided by operating activities .......... Cash flows from investing activities Sale of machinery ................................................. Purchase of machinery......................................... Net cash used by investing activities..................
$ 430,000 $ 880,000 24,000 (165,000) 33,000 20,000
792,000 1,222,000
270,000 (750,000) (480,000)
Cash flows from financing activities Payment of cash dividends..................................
(200,000)
Net increase in cash.................................................. Cash at beginning of period ..................................... Cash at end of period................................................
542,000 130,000 $ 672,000
Analysis Laskowski’s free cash flow is: Net cash provided by operating activities ...... $1,222,000 Less: Purchase of machinery......................... 750,000 Dividends............................................... 200,000 Free cash flow .................................................. $ 272,000
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) Laskowski’s free cash flow for the current year ($272,000) is less than the amount needed for expansion next year ($500,000). Thus, assuming operations at roughly the same level in future periods, Laskowski’s free cash flow will not be sufficient to fund the expansion plan. The company might explore reducing the dividend or securing additional funds for the expansion through a borrowing.
Principles According to Statement of Financial Accounting Concepts No. 1, paragraph 37, “Financial reporting should provide information to help present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption, or maturity of securities or loans. The prospects for those cash receipts are affected by an enterprise’s ability to generate enough cash to meet its obligations when due and its other cash operating needs, to reinvest in operations, and to pay cash dividends and may also be affected by perceptions of investors and creditors generally about that ability, which affect market prices of the enterprise’s securities. Thus, financial reporting should provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows to the related enterprise.” By reporting cash provided by operations, and the inflows and outflows of cash from investing and financing decisions, the statement of cash flows provides information relevant to assessing a company’s future cash flows.
PROFESSIONAL RESEARCH (a) According to FASB ASC 230-10-10 (Statement of Cash Flows/Overall/ Objectives): 10-1 The primary objective of a statement of cash flows is to provide relevant information about the cash receipts and cash payments of an entity during a period. As indicated in the glossary at this same section (230-10-20), cash includes not only currency on hand but demand deposits with banks or other financial institutions. Cash also includes other kinds of accounts that have the general characteristics of demand deposits in that the customer may deposit additional funds at any time and also effectively may withdraw funds at any time without prior notice or penalty. All charges and credits to those accounts are cash receipts or payments to both the entity owning the account and the bank holding it. For example, a bank’s granting of a loan by crediting the proceeds to a customer’s demand deposit account is a cash payment by the bank and a cash receipt of the customer when the entry is made. Thus, the basis for the statement of cash flows is cash, not broader measures of liquidity, like working capital. (b) See FASB ASC 230-10-10 (Statement of Cash Flows—Objectives) 10-2 The information provided in a statement of cash flows, if used with related disclosures and information in the other financial statements, should help investors, creditors, and others (including donors) to do all of the following: a. Assess the entity’s ability to generate positive future net cash flows b. Assess the entity’s ability to meet its obligations, its ability to pay dividends, and its needs for external financing c. Assess the reasons for differences between net income and associated cash receipts and payments
PROFESSIONAL RESEARCH (Continued) d. Assess the effects on an entity’s financial position of both its cash and noncash investing and financing transactions during the period. (c) According to FASB ASC 230-10-45-16 to 17: 45-16 All of the following are cash inflows for operating activities: a. Cash receipts from sales of goods or services, including receipts from collection or sale of accounts and both shortand long-term notes receivable from customers arising from those sales. The term goods includes certain loans and other debt and equity instruments of other entities that are acquired specifically for resale, as discussed in paragraph 230-10-45-21. b. Cash receipts from returns on loans, other debt instruments of other entities, and equity securities—interest and dividends. c. All other cash receipts that do not stem from transactions defined as investing or financing activities, such as amounts received to settle lawsuits; proceeds of insurance settlements excepts for those that are directly related to investing or financing activities, such as from destruction of a building; and refunds from suppliers. 45-17 All of the following are cash outflows for operating activities: a. Cash payments to acquire materials for manufacture or goods for resale, including principal payments on accounts and both short- and long-term notes payable to suppliers for those materials or goods. [FAS 095, paragraph 23, sequence 101] [The term goods includes certain loans and other debt and equity instruments of other entities that are acquired specifically for resale, as discussed in paragraph 230-10-4521, and securities that are classified as trading securities, as discussed in Topic 320.] b. Cash payments to other suppliers and employees for other goods or services.
PROFESSIONAL RESEARCH (Continued) c. Cash payments to governments for taxes, duties, fines, and other fees or penalties and the cash that would have been paid for income taxes if increases in the value of equity instruments issued under share-based payment arrangements that are not included in the cost of goods or services recognizable for financial reporting purposes also had not been deductible in determining taxable income. (This is the same amount reported as a financing cash inflow pursuant to paragraph 230-10-45-14(e).) d. Cash payments to lenders and other creditors for interest. e. Cash payment made to settle an asset retirement obligation. f. All other cash payments that do not stem from transactions defined as investing or financing activities, such as payments to settle lawsuits, cash contributions to charities, and cash refunds to customers.
PROFESSIONAL SIMULATION Note: This assignment is available on the Kieso website. Financial Statements ELLWOOD HOUSE, INC. Statement of Cash Flows For the Year Ended December 31, 2015 Cash flows from operating activities Net income ............................................................ Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense (a) .................................. $13,550 Gain on sale of investments (b) ................... (500) Net cash provided by operating activities .......... Cash flows from investing activities Purchase of land (c) ............................................. Sale of investments (d)......................................... Net cash provided by investing activities...........
(5,500) 15,500
Cash flows from financing activities Payment of dividends (e) ..................................... Redemption of bonds payable (f) ........................ Issuance of common stock (g) ............................ Net cash used by financing activities .................
(19,000) (10,000) 20,000
$42,000
13,050 55,050
10,000
(9,000)
Net increase (decrease) in cash .................................. Cash, January 1, 2015.................................................. Cash, December 31, 2015 ............................................
56,050 10,000 $66,050
Noncash investing and financing activities Issuance of bonds for equipment........................
$32,000
PROFESSIONAL SIMULATION (Continued) Explanation Dear Mr. Brauer: Enclosed is your statement of cash flows for the year ending December 31, 2015. I would like to take this opportunity to explain the changes which occurred in your business as a result of cash activities during 2015. (Please refer to the attached statement of cash flows.) The first category shows the net cash flow which resulted from all of your operating activities. Operating activities are those engaged in for the routine conduct of business, involving most of the transactions used to determine net income. The cash inflow from operations which affects this category is net income. However, this figure must be adjusted, first for depreciation (item a)—because this expense did not involve a cash outlay in 2015—and second for the $500 gain on the sale of your investment portfolio (item b). The gain must be subtracted from this section because it was included in net income, but it is not the result of an operating activity—it is an investing activity. The second category, cash flows from investing activities, results from the acquisition/disposal of long-term assets including the purchase of another entity’s debt or equity securities. Your purchase of land (item c) as well as the sale of your investment portfolio (item d) represent your investing activities during 2015, the purchase being a $5,500 outflow and the sale being a $15,500 inflow. Cash flows arising from the issuance and retirement of debt and equity securities are properly classified as “Cash flows from financing activities.” These inflows and outflows generally include the long-term liability and stockholders’ equity items on the balance sheet. Examples of your financing activities resulting in cash flows are the payment of dividends (item e), the retirement of your bonds payable (item f), and your issuance of common stock (item g). Note that, although $32,000 worth of bonds were issued for the purchase of heavy equipment, the transaction has no effect on the change in cash from January 1, 2015 to December 31, 2015. I hope this information helps you to better understand the enclosed statement of cash flows. If I can further assist you, please let me know. Sincerely,
IFRS CONCEPTS AND APPLICATION IFRS23-1 IAS 7, “Cash Flow Statements,” provides the overall IFRS requirements for cash flow information. IFRS23-2 As in U.S. GAAP, the statement of cash flows is a required statement for IFRS. In addition, the content and presentation of an IFRS statement of cash flows is similar to one used for U.S. GAAP. However, the disclosure requirements related to the statement of cash flows are more extensive under U.S. GAAP. Other similarities include: (1) Companies preparing financial statements under IFRS must prepare a statement of cash flows as an integral part; (2) Both IFRS and U.S. GAAP require that the statement of cash flows should have three major sections—operating, investing and financing—along with changes in cash and cash equivalents; (3) Similar to U.S. GAAP, the cash flow statement can be prepared using either the indirect or direct method under IFRS. In both U.S. and international settings, companies choose for the most part to use the indirect method for reporting net cash flow provided by operating activities. Notable differences are (1) IFRS encourages companies to disclose the aggregate amount of cash flows that are attributable to the increase in operating capacity separately from those cash flows that are required to maintain operating capacity; (2) The definition of cash equivalents used in IFRS is not the same as that used in U.S. GAAP. A major difference is that in certain situations bank overdrafts are considered part of cash and cash equivalents under IFRS (which is not the case in U.S. GAAP). Under U.S. GAAP, bank overdrafts are classified as financing activities; (3) IFRS requires that non-cash investing and financing activities be excluded from the statement of cash flows. Instead, these non-cash activities should be reported elsewhere. This requirement is interpreted to mean that non-cash investing and financing activities should be disclosed in the notes to the financial statements instead of in the financial statements. Under U.S. GAAP, companies may present this information in the cash flow statement. IFRS allows interest paid and received to be classified as either operating or investing activities. U.S. GAAP classifies interest paid and received as an operating activity.
IFRS23-3 Presently, the FASB and the IASB are involved in a joint project on the presentation and organization of information in the financial statements. The FASB favors presentation of operating cash flows using the direct method only. However, the majority of IASB members express a preference for not requiring use of the direct method of reporting operating cash flows. So the two Boards will have to resolve their differences in this area in order to issue a converged standard for the statement of cash flows. U.S. GAAP rules related to cash flow reporting are less flexible than IFRS, but this is not a major concern.
IFRS23-4 Examples of non-cash transactions are: (1) issuance of shares for non-cash assets, (2) issuance of shares to redeem debt, (3) issuance of bonds or notes for non-cash assets, (4) non-cash exchanges of property, plant, and equipment, and (5) refinancing of long-term debt.
IFRS23-5 (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l)
Operating—add to net income. Financing activity. Investing activity. Operating—add to net income. Non-cash investing and financing activity (presented in the notes). Financing activity. Operating—add to net income. Financing activity. Non-cash investing and financing activity (presented in the notes). Financing activity. Operating—deduct from net income. Investing activity.
IFRS23-6 (a)
The solution can be determined through use of a T-account for Property, Plant, and Equipment. Property, Plant & Equipment 12/31/13 Equipment from exchange of B/P Payments for purchase of PP&E
247,000 25,000 ?
12/31/14
277,000
45,000 Equipment sold
Payments = $277,000 + $45,000 – $247,000 – $25,000 = $50,000 IFRS states that investing activities include the acquisition and disposition of long-term productive assets. Accordingly, the purchase of property, plant, and equipment is an investing activity. Note that the acquisition of property, plant, and equipment in exchange for bonds payable would be disclosed in the notes as a non-cash investing and financing activity. (b)
The solution can be determined through use of a T-account for Accumulated Depreciation. Accumulated Depreciation
Equipment sold
167,000 38,000
12/31/13 Depreciation expense
178,000
12/31/14
?
Accumulated depreciation on equipment sold = $167,000 + $38,000 – $178,000 = $27,000 The entry to reflect the sale of equipment is: Cash (proceeds from sale of equipment) ($45,000 + $14,500 – $27,000) .................... 32,500 Accumulated Depreciation ........................... 27,000 Property, Plant, and Equipment........ Gain on Sale of Equipment ...............
45,000 14,500
(given) (given)
IFRS23-6 (Continued) The proceeds from the sale of equipment of $32,500 are considered an investing activity. Investing activities include the acquisition and disposition of long-term productive assets. (c)
The cash dividends paid can be determined by analyzing T-accounts for Retained Earnings and Dividends Payable. Retained Earnings Dividends declared
?
91,000 31,000
12/31/13 Net income
104,000
12/31/14
Dividends declared = $91,000 + $31,000 – $104,000 = $18,000 Dividends Payable
Cash dividends paid
5,000 18,000
12/31/13 Dividends declared
8,000
12/31/14
?
Cash dividends paid = $5,000 + $18,000 – $8,000 = $15,000 Financing activities include all cash flows involving liabilities and equity other than operating items. Payment of cash dividends is thus a financing activity. (d)
The redemption of bonds payable amount is determined by setting up a T-account for Bonds Payable. Bonds Payable
Redemption of B/P
46,000 25,000
12/31/13 Issuance of B/P for PP&E
49,000
12/31/14
?
The problem states that there was no amortization of bond premium or discount; thus, the redemption of bonds payable is the only change not accounted for.
IFRS23-6 (Continued) Redemption of bonds payable = $46,000 + $25,000 – $49,000 = $22,000 Financing activities include all cash flows involving liabilities and equity other than operating items. Therefore, redemption of bonds payable is considered a financing activity. IFRS23-7 DINGEL CORPORATION Statement of Cash Flows For the Year Ended December 31, 2014 Cash flows from operating activities Net income........................................................... Adjustments to reconcile net income to net cash provided by operating activities: Loss on sale of equipment ......................... Gain from flood damage ............................. Depreciation expense ................................. Patent amortization .................................... Gain on sale of equity investment.............. Increase in accounts receivable (net) ........ Increase in inventory................................... Increase in accounts payable..................... Net cash flow provided by operating activities ....
$14,750(a) $ 4,100(b) (8,250) (c) 1,900(d) 1,250 (1,700) (3,750) (3,000) 2,000
Cash flows from investing activities Sale of equity investments ................................. Sale of equipment ............................................... Purchase of equipment (cash) ........................... Proceeds from flood damage to building.......... Net cash provided by investing activities .........
4,700 2,500 (20,000) 32,000
Cash flows from financing activities Payment of dividends ......................................... Payment of short-term note payable ................. Net cash used by financing activities................
(5,000) (1,000)
Increase in cash....................................................... Cash, January 1, 2014 ............................................. Cash, December 31, 2014........................................
(7,450) 7,300
19,200
(6,000) 20,500 13,000 $33,500
IFRS23-7 (Continued) Supplemental disclosures of cash flow information: Cash paid during the year for: Interest ........................................................................ Income taxes............................................................... Non-cash investing and financing activities:* Retired note payable by issuing ordinary shares .... Purchased equipment by issuing note payable .......
$ 2,000 $ 6,500 $10,000 16,000 $21,000
*Presented in the notes to the financial statements. Supporting Computations: (a) Ending retained earnings........................................... Beginning retained earnings ..................................... Net income .............................................................
$20,750 (6,000) $14,750
(b) Cost .............................................................................. Accumulated depreciation (40% X $11,000) .............. Book value ................................................................... Proceeds from sale...................................................... Loss on sale...........................................................
$11,000 (4,400) 6,600 (2,500) $ 4,100
(c) Cost .............................................................................. Accumulated depreciation .......................................... Book value ................................................................... Proceeds from insurance............................................ Gain from flood damage........................................
$29,750 (6,000) 23,750 (32,000) ($ 8,250)
(d) Accumulated depreciation on equipment sold.......... Decrease in accumulated depreciation...................... Depreciation expense............................................
$ 4,400 (2,500) $ 1,900
IFRS23-8 (a)
According to IAS 7, “Information about the cash flows of an entity is useful in providing users of financial statements with a basis to assess the ability of the entity to generate cash and cash equivalents and the needs of the entity to utilise those cash flows. The economic decisions that are taken by users require an evaluation of the ability of an entity to generate cash and cash equivalents and the timing and certainty of their generation. The objective of this Standard is to require the provision of information about the historical changes in cash and cash equivalents of an entity by means of a statement of cash flows which classifies cash flows during the period from operating, investing and financing activities.” IAS 7 does not mention anything about working capital.
(b)
According to paragraph 10, “The statement of cash flows shall report cash flows during the period classified by operating, investing and financing activities.” Further, paragraph 11 states “An entity presents its cash flows from operating, investing and financing activities in a manner which is most appropriate to its business. Classification by activity provides information that allows users to assess the impact of those activities on the financial position of the entity and the amount of its cash and cash equivalents. This information may also be used to evaluate the relationships among those activities.”
(c)
According to paragraph 14, “Cash flows from operating activities are primarily derived from the principal revenue-producing activities of the entity. Therefore, they generally result from the transactions and other events that enter into the determination of profit or loss. Examples of cash flows from operating activities are: (a) (b) (c) (d) (e)
cash receipts from the sale of goods and the rendering of services; cash receipts from royalties, fees, commissions and other revenue; cash payments to suppliers for goods and services; cash payments to and on behalf of employees; cash receipts and cash payments of an insurance entity for premiums and claims, annuities and other policy benefits; (f) cash payments or refunds of income taxes unless they can be specifically identified with financing and investing activities; and (g) cash receipts and payments from contracts held for dealing or trading purposes.”
IFRS23-9 (a)
M&S uses the indirect method to compute and report net cash generated from operating activities. The amounts of net cash generated from operating activities for 2012 and 2011 are £1,203 million and £1,200 million, respectively. The two items most responsible for the decrease in cash generated from operating activities in 2012 compared to 2011 are the lower operating profit and the smaller increase in payables.
(b)
The most significant item in the investing activities section is the £564.3 million that M&S spent on “property, plant and equipment.” The most significant item in the financing activities section is redemption of medium-term notes (£307.6 million).
(c)
M&S does not report deferred income taxes on its statement of cash flows. It does report income tax expense as an add back to net income in the operating activities section.
(d)
Depreciation and amortization is reported in the operating activities section of M&S’s statement of cash flows as an add back to net income because it is a non-cash charge in the income statement.
CHAPTER 24 Full Disclosure in Financial Reporting ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics
Questions
Brief Exercises
Exercises
Concepts Problems for Analysis
1.
The disclosure principle; type of disclosure.
2, 3
1, 2, 3
2.
Role of notes that accompany financial statements.
1, 4, 5
1, 2
3.
Subsequent events.
6
3
1, 2
1
4, 12
4.
Segment reporting; diversified firms.
7, 8, 9, 10, 11
4, 5, 6, 7
3
2
5, 6, 7
5.
Discussion and analysis.
12, 13
6.
Interim reporting.
16, 17, 18, 19
8, 9
7.
Audit opinions and fraudulent reporting.
20, 21
11
8.
Earnings forecasts.
14, 15
10
*9.
Interpretation of ratios.
22, 23, 24
*10.
Impact of transactions on ratios.
*11.
Liquidity ratios.
*12.
Profitability ratios.
*13.
Coverage ratios.
*14.
Activity ratios.
*15.
Comprehensive ratio problems.
*16.
Percentage analysis.
1, 2, 3, 4
4, 5, 6
5
8
4, 5, 6
3
8
4, 5, 6
3, 5
4, 5, 6
3, 5
28
4, 5, 6 25, 26
8, 9
24, 27
*This material is dealt with in an Appendix to the chapter.
4, 5, 6
3
4, 5, 6
3, 5 3, 4
13
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives Questions
Brief Exercises
Exercises
Problems
Concepts for Analysis
1.
Review the full disclosure principle and describe implementation problems.
CA24-5, CA24-6, CA24-7
2.
Explain the use of notes in financial statement preparation.
1
1, 2
3.
Discuss the disclosure requirements for related party transactions, post-balancesheet events, and major business segments.
2, 3, 4, 5, 6, 7, 8, 9, 10
3, 4, 5, 6, 7
4.
Describe the accounting problems associated with interim reporting.
16, 17, 18, 19
5.
Identify the major disclosures in the auditor’s report.
11, 20
6.
Understand management’s responsibilities for financials.
12, 13
7.
Identify issues related to financial forecasts and projections.
14, 15
CA24-10, CA24-11
8.
Describe the profession’s response to fraudulent financial reporting.
21
CA24-11
*9.
Understand the approach to financial statement analysis.
22, 23
*10.
Identify major analytic ratios and describe their calculation.
24, 25, 26, 27
*11.
Explain the limitations of ratio analysis.
28
*12.
Describe techniques of comparative analysis.
3
*13.
Describe techniques of percentage analysis.
4
1, 2, 3
1, 2
CA24-1, CA24-2, CA24-3, CA24-4, CA24-12 CA24-8, CA24-9
8, 9
4, 5, 6
3, 5
CA24-13
ASSIGNMENT CHARACTERISTICS TABLE Item
Description
Level of Difficulty
Time (minutes)
E24-1 E24-2 E24-3 *E24-4 *E24-5 *E24-6
Post-balance-sheet events. Post-balance-sheet events. Segmented reporting. Ratio computation and analysis; liquidity. Analysis of given ratios. Ratio analysis.
Moderate Moderate Moderate Simple Moderate Moderate
10–15 10–15 5–10 20–30 20–30 30–40
P24-1 P24-2 *P24-3 *P24-4 *P24-5
Subsequent events. Segmented reporting. Ratio computations and additional analysis. Horizontal and vertical analysis. Dividend policy analysis.
Difficult Moderate Moderate Simple Difficult
40–50 24–30 35–45 40–60 40–50
CA24-1
General disclosures, inventories, property, plant, and equipment. Disclosures required in various situations. Disclosures, conditional and contingent liabilities. Post-balance-sheet events. Segment reporting. Segment reporting—theory. Segment reporting—theory. Interim reporting. Treatment of various interim reporting situations. Financial forecasts. Disclosure of estimates. Reporting of subsequent events. Effect of transactions on financial statements and ratios.
Simple
10–20
Moderate Simple Moderate Moderate Simple Moderate Simple Moderate Moderate Moderate Simple Moderate
20–25 24–30 20–25 30–35 20–25 24–30 20–25 30–35 24–30 15–20 10–15 24–35
CA24-2 CA24-3 CA24-4 CA24-5 CA24-6 CA24-7 CA24-8 CA24-9 CA24-10 CA24-11 CA24-12 *CA24-13
SOLUTIONS TO CODIFICATION EXERCISES CE24-1 Master Glossary (a)
Ordinary income (or loss) refers to income (or loss) from continuing operations before income taxes (or benefits) excluding significant unusual or infrequently occurring items. Extraordinary items, discontinued operations, and cumulative effects of changes in accounting principles are also excluded from this term. The term is not used in the income tax context of ordinary income vs. capital gain. The meaning of unusual or infrequently occurring items is consistent with their use in the definition of the term extraordinary item.
(b)
An error in recognition, measurement, presentation, or disclosure in financial statements resulting from mathematical mistakes, mistakes in the application of generally accepted accounting principles (GAAP), or oversight or misuse of facts that existed at the time the financial statements were prepared. A change from an accounting principle that is not generally accepted to one that is generally accepted is a correction of an error.
(c)
The amount of earnings attributable to each share of common stock. For convenience, the term is used to refer to either earnings or loss per share.
(d)
A business entity that has any of the following characteristics: a. Whose securities are traded in a public market on a domestic stock exchange or in the domestic over-the-counter market (including securities quoted only locally or regionally) b. That is a conduit bond obligor for conduit debt securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets) c. Whose financial statements are filed with a regulatory agency in preparation for the sale of any class of securities in a domestic market.
CE24-2 According to FASB ASC Glossary: Related parties include: a. Affiliates of the entity b. Entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of Section 825-10-15, to be accounted for by the equity method by the investing entity c. Trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of management d. Principal owners of the entity and members of their immediate families e. Management of the entity and members of their immediate families f. Other parties with which the entity may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests g. Other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.
CE24-3 According to FASB ASC 280-10-50-12 (Segment Reporting—Overall—Disclosure): A public entity shall report separately information about an operating segment that meets any of the following quantitative thresholds (see Example 2, Cases C, D, and E [paragraphs 280-10-55-39 through 55-45]): (a)
Its reported revenue, including both sales to external customers and intersegment sales or transfers, is 10 percent or more of the combined revenue, internal and external, of all operating segments.
(b)
The absolute amount of its reported profit or loss is 10 percent or more of the greater, in absolute amount, of either: 1. The combined reported profit of all operating segments that did not report a loss. 2. The combined reported loss of all operating segments that did report a loss.
(c)
Its assets are 10 percent or more of the combined assets of all operating segments.
Operating segments that do not meet any of the quantitative thresholds may be considered reportable, and separately disclosed, if management believes that information about the segment would be useful to readers of the financial statements.
CE24-4 No. According to FASB ASC 270-10-S99-2 (Interim Reporting— Overall—SEC Materials): Question 2: The staff believes disclosure of inventory components is important to investors. In reaching this decision the staff recognizes that registrants may not take inventories during interim periods and that managements, therefore, will have to estimate the inventory components. However, the staff believes that management will be able to make reasonable estimates of inventory components based upon their knowledge of the company’s production cycle, the costs (labor and overhead) associated with this cycle as well as the relative sales and purchasing volume of the company.
ANSWERS TO QUESTIONS 1.
As indicated in the text, the major advantages are: (1) additional information pertinent to specific financial statements can be explained in qualitative terms, or supplementary data of a quantitative nature can be provided to expand on the information in the financial statements, and (2) restrictions on basic contractual agreements can be explained. The types of items normally found in footnotes are: (1) disclosure of accounting methods used, (2) disclosure of contingent assets and liabilities, (3) examination of creditor claims, (4) claims of equity holders, and (5) executory commitments.
2.
The full disclosure principle in accounting calls for reporting in financial statements any financial facts significant enough to influence the judgment of an informed reader. Disclosure has increased because of the complexity of the business environment, the necessity for timely information, and the desire for more information on the enterprise for control and monitoring purposes.
3.
The benefit of reconciling the effective tax rate and the federal statutory rate is that an investor can determine the actual taxes paid by the enterprise. Such a determination is particularly important if the enterprise has substantial fluctuations in its effective tax rate caused by unusual or infrequent transactions. In some cases, companies only have income in a given period because of a favorable tax treatment that is not sustainable. Such information should be extremely useful to a financial statement reader.
4.
(a) The increased likelihood that the company will suffer a costly strike requires no disclosure in the financial statements. The possibility of a strike is an inherent risk of many businesses. It, along with the risks of war, recession, etc., is in the category of general news. (b) A note should provide a description of the extraordinary item in order that the financial statement user has some understanding of the nature of this item. (c) Contingent assets which may materially affect a company’s financial position must be disclosed when the surrounding circumstances indicate that, in all likelihood, a valid asset will materialize. In most situations, an asset would not be recognized until the court settlement had occurred.
5.
Transactions between related parties are disclosed to ensure that the users of the financial statements understand the basic nature of some of the transactions. Because it is often difficult to separate the economic substance from the legal form in related party transactions, disclosure is used extensively in this area. Purchase of a substantial block of the company’s common stock by Holland, coupled with the use of a Holland affiliate to act as food broker, suggests that disclosure is needed.
6.
“Subsequent events” are of two types: (1) Those which affect the financial statements directly and should be recognized therein through appropriate adjustments. (2) Those which do not affect the financial statements directly and require no adjustment of the account balances but whose effects may be significant enough to be disclosed with appropriate figures or estimates shown. (a) (b) (c) (d) (e) (f) (g) (h)
Probably adjust the financial statements directly. Disclosure. Disclosure. Disclosure. Neither adjustment nor disclosure necessary. Neither adjustment nor disclosure necessary. Probably adjust the financial statements directly. Neither adjustment nor disclosure necessary.
Questions Chapter 24 (Continued) 7.
Diversified companies are enterprises whose activities are segmented into unrelated industries. The accounting problems related to diversified companies are: (1) the problem of defining a segment for financial reporting purposes, (2) the difficulty of allocating common or joint costs to various segments, and (3) the problem of evaluating segment results when a great deal of transfer pricing is involved.
8.
After the company decides on the segments for possible disclosure, a quantitative test is made to determine whether the segment is significant enough to warrant actual disclosure. A segment is identified as a reportable segment if it satisfies one or more of the following tests. (a) Its revenue (including both sales to unaffiliated customers and intersegment sales or transfers) is 10% or more of the combined revenue (sales to unaffiliated customers and intersegment sales or transfers) of all the enterprise’s industry segments. (b) The absolute amount of its operating profit or operating loss is 10% or more of the greater, in absolute amount, of 1. the combined operating profit of all industry segments that did not incur an operating loss, or 2. the combined operating loss of all industry segments that did incur an operating loss. (c) Its identifiable assets are 10% or more of the combined identifiable assets of all segments. In applying these tests, two additional factors must be considered. First, segment data must explain a significant portion of the company’s business. Specifically, the segmented results must equal or exceed 75% of the combined sales to unaffiliated customers for the entire enterprise. This test prevents a company from providing limited information on only a few segments and lumping all the rest into one category. Second, the profession recognized that reporting too many segments may overwhelm users with detailed information. Although the FASB did not issue any specific guidelines regarding how many segments are too many, this point is generally considered reached when a company has 10 or more reportable segments.
9.
GAAP requires that a company report: (a) (b) (c) (d) (e) (f)
10.
General information about its operating segments. Segment profit and loss and related information. Segment assets. Reconciliations (reconciliations of total revenues, income before income taxes, and total assets). Information about products and services and geographic areas. Major customers.
An operating segment is a component of an enterprise: (a) That engages in business activities from which it earns revenues and incurs expenses. (b) Whose operating results are regularly reviewed by the company’s chief operating decision maker to assess segment performance and allocate resources to the segment. (c) For which discrete financial information is available that is generated by or based on the internal financial reporting system. Information about two operating segments can be aggregated only if the segments have the same basic characteristics related to the: (1) nature of the products and services provided, (2) nature of the production process, (3) type or class of customer, (4) methods of product or service distribution, and (5) nature of the regulatory environment.
Questions Chapter 24 (Continued) 11.
One of the major reasons for not providing segment information is that competitors will then be able to determine the profitable segments and enter that product line themselves. If this occurs and the other company is successful, then the present stockholders of Lafayette Inc. may suffer. This question should illustrate to the student that the answers are not always black and white. Disclosure of segments undoubtedly provides some needed information, but some disclosures are confidential.
12.
The management discussion and analysis section covers three financial aspects of an enterprise’s business—liquidity, capital resources, and results of operations. It requires management to highlight favorable or unfavorable trends and to identify significant events and uncertainties that affect these three factors.
13.
Management has the primary responsibility for the preparation, integrity, and objectivity of the company’s financial statements. If management wishes to present information in a certain way, it may do so. If the auditor objects because GAAP is violated, some type of audit exception is called for.
14.
Arguments against providing earnings projections: (a) No one can foretell the future. Therefore forecasts, while conveying an impression of precision about the future, will nevertheless inevitably be wrong. (b) Organizations will not strive to produce results which are in the stockholders’ best interest, but merely to meet their published forecasts. (c) When forecasts are not met, there will be recriminations and probably legal actions. (d) Disclosure of forecasts will be detrimental to organizations because it will fully inform not only investors but competitors (foreign and domestic).
15.
Arguments for providing earnings forecasts are: (a) Investment decisions are based on future expectations; therefore, information about the future facilitates better decisions. (b) Forecasts are already circulated informally. This situation should be regulated to ensure that forecasts are available to all investors. (c) Circumstances now change so rapidly that historical information is no longer adequate for prediction.
16.
Interim reports are unaudited financial statements normally prepared four times a year. Interim balance sheets are often not provided because this information is not deemed crucial over a short period of time; the income figure has much more relevance to interim reporting.
17.
The accounting problems related to the presentation of interim data are as follows: (a) (b) (c) (d) (e)
18.
The proper handling of extraordinary items. The difficulty of allocating costs, such as income taxes, pensions, etc., to the proper quarter. The problem of LIFO inventory valuation. Presentation of EPS figures. Problems of fixed cost allocation.
The problem when a LIFO base is used for quarterly reporting is that the LIFO base might be reduced in a given quarter, but for the year, this base is not reduced. If the inventory base will be replaced before the year ends, then a purchase reserve (equalization account) should be set up to reflect a higher cost of sales and to achieve a more realistic interim statement for net income.
Questions Chapter 24 (Continued) 19.
One suggestion has been to normalize the fixed nonmanufacturing costs on the basis of predicted sales. The problem with this method is that future sales are unknown and hence a great deal of subjectivity is involved. Another approach is to charge as a period charge those costs that are impossible to allocate to any one period. Under this approach, reported results for a quarter would only indicate the contribution toward fixed costs and profits, which is essentially a contribution margin approach. To alleviate the problem of seasonality, the profession recommends companies subject to material seasonal variations disclose the seasonal nature of their business and consider supplementing their annual reports with information for 12-month periods ended at the interim dates for the current and preceding years.
20.
The CPA expresses a “clean” or unqualified opinion when the client’s financial statements present fairly the client’s financial position and results of operations on the basis of an examination made in accordance with generally accepted auditing standards, and the statements are in conformity with generally accepted accounting principles and include all informative disclosures necessary to make the statements not misleading. The CPA expresses a qualified opinion when he/she must take exception to the presentation of one or more components of the financial statements but the exception or exceptions are not serious enough to negate his/her expression of an opinion or to express an “adverse” opinion.
21.
Fraudulent financial reporting is intentional or reckless conduct, whether by act or omission, that results in materially misleading financial statements. Fraudulent financial reporting can involve many factors and take many forms. It may entail gross and deliberate distortion of corporate records, such as inventory count tags, or falsified transactions, such as fictitious sales or orders. It may entail the misapplication of accounting principles. Company employees at any level may be involved, from top to middle management to lower-level personnel. If the conduct is intentional, or so reckless that it is the legal equivalent of intentional conduct, and results in fraudulent financial statements, it comes within the operating definition of the term fraudulent financial reporting. Fraudulent financial reporting differs from other causes of materially misleading financial statements, such as unintentional errors. Fraudulent financial reporting is distinguished from other corporate improprieties, such as employee embezzlements, violations of environmental or product safety regulations, and tax fraud, which do not necessarily cause financial statements to be materially inaccurate. Fraudulent financial reporting usually occurs as the result of certain environmental, institutional, or individual forces and opportunities. These forces and opportunities add pressures and incentives that encourage individuals and companies to engage in fraudulent financial reporting and are present to some degree in all companies. If the right combustible mixture of forces and opportunities is present, fraudulent financial reporting may occur. A frequent incentive for fraudulent financial reporting that improves the company’s financial appearance is the desire to obtain a higher price from a stock or debt offering or to meet the expectations of investors. Another incentive may be the desire to postpone dealing with financial difficulties and thus avoid, for example, violating a restrictive debt covenant. Other times the incentive is personal gain: additional compensation, promotion, or escape from penalty for poor performance.
Questions Chapter 24 (Continued) Situational pressures on the company or an individual manager also may lead to fraudulent financial reporting. Examples of these situational pressures include: Sudden decreases in revenue or market share. A single company or an entire industry can experience these decreases. Unrealistic budget pressures, particularly for short-term results. These pressures may occur when a company arbitrarily determines profit objectives and budgets without taking actual conditions into account. Financial pressure resulting from bonus plans that depend on short-term economic performance. This pressure is particularly acute when the bonus is a significant component of the individual’s total compensation. Opportunities for fraudulent financial reporting are present when the fraud is easier to commit and when detection is less likely. Frequently these opportunities arise from: The absence of a board of directors or audit committee that vigilantly oversees the financial reporting process. Weak or nonexistent internal accounting controls. This situation can occur, for example, when a company’s revenue system is overloaded from a rapid expansion of sales, an acquisition of a new division, or the entry into a new, unfamiliar line of business. Unusual or complex transactions. Examples include the consolidation of two companies, the divestiture or closing of a specific operation, and agreements to buy or sell government securities under a repurchase agreement. Accounting estimates requiring significant subjective judgment by company management. Examples include allowance for loan losses and the yearly provision for warranty expense. *22. It has been said that “everything is relative,” and this is certainly true of financial statement data. The chief significance of financial statement data is not so much in the absolute amounts presented but in their relative significance; that is, in the conclusions reached after comparing each item with similar items and after association with related data. Financial statements present measures of quantity (this is not to exclude the qualitative aspects of things that dollar quantities reflect), but whether any amount is adequate or not in view of the company’s needs, or whether it represents an amount out of proportion to the company’s other amounts, or whether it represents an improvement over previous years cannot be determined from the absolute amount alone. *23.
Your friend should be advised that in order to interpret adequately and to evaluate financial statement data, an individual must: (a) (b) (c) (d)
Understand the nature and limitations of accounting. Understand the terminology of accounting and business. Have some knowledge of business. Be acquainted with the nature and tools of financial statement analysis.
*24. Percentage analysis consists of reducing a series of related amounts to a series of percentages of a given base while ratio analysis is the computation of any specific ratio of one figure to another within the reported data. Percentage analysis facilitates comparison and is helpful in evaluating the relative size of a series of items. Ratio analysis points out the existence of a specific relationship and then proceeds to measure the relationship in terms of either a percentage figure or a single proportion.
Questions Chapter 24 (Continued) *25. Cost of goods sold is used for two reasons: first, cost must be used rather than retail value because the average inventory figures are on a cost basis. Second, since measurement of the turnover involves determination of the number of times inventory was sold this period in comparison to the total cost incurred, cost of goods sold must be used as representative of total cost incurred. An increasing inventory turnover may be an indication of stockouts or inventory shortages. *26.
The relationship of asset turnover to the rate of return on assets is as follows: Sales Average Total Assets
X
Net Income Sales
=
Net Income Average Total Assets
An increase in the asset turnover, holding profit margin constant, results in an increase in rate of return on assets and vice versa. *27.
(a) Common-size analysis is reduction of all dollar amounts in the financial statements to a percentage of a base amount. (b) Vertical analysis is the expression percentage-wise of each item on a financial statement in a given period to a base figure. (c)
Horizontal analysis is the computation of the percentage change over time.
(d) Percentage analysis consists of reducing a series of related amounts to a series of percentages of a given base. This type of analysis facilitates comparisons and is helpful in evaluating the relative size of items such as expenses, current assets, or net income. *28. Some believe that the FASB should not be involved in developing standards related to the presentation of ratios. A basic concern expressed by this group is: how far should the FASB go? That is, where does financial reporting end and financial analysis begin? Furthermore, we know so little concerning which ratios are used and in what combinations that attempting to require disclosure of certain ratios in this area would not be helpful. One reason for the profession’s reluctance to mandate disclosures of ratios on the financial statements is that research regarding the use and usefulness of summary indicators is still limited.
SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 24-1 The reader should recognize that the firm has an annual obligation for lease payments of approximately $5,711,000 for the next three years. In certain situations, this information is very important in determining: (1) the ability of the firm to use additional lease financing, and (2) the nature of maturing commitments and the amount of cash expenditures involved. Off-balancesheet financing is common and the investor should be cognizant that the company has a commitment even though it is not reflected in the liability section of the balance sheet. The rental income from the subleases also provides useful information concerning the company’s ability to generate revenues in the near future. BRIEF EXERCISE 24-2 The reader should recognize that there are dilutive securities outstanding which may have an effect on earnings per share. In addition, the purchase of treasury stock enabled the company to increase its earnings per share. The important point concerning this note is that information is provided about potential dilution related to some dilutive securities outstanding. BRIEF EXERCISE 24-3 Net income will decrease by $10,000 ($160,000 – $170,000) as a result of the adjustment of the liability. The settlement of the liability is the type of subsequent event which provides additional evidence about conditions that existed at the balance sheet date. The flood loss ($80,000) is an event that provides evidence about conditions that did not exist at the balance sheet date but are subsequent to that date and does not require adjustment of the financial statements. BRIEF EXERCISE 24-4 It should be emphasized that because a company discloses its segmental results, this does not diminish the necessity for providing consolidated results as well. Sometimes individuals become confused because they believe that employment of segmental reporting means that consolidated statements should not be presented. There appears to be a need to provide both types of information. The consolidated results provide information on overall financial position and profitability, while the segmental results provide information on the specific details which comprise the overall results.
BRIEF EXERCISE 24-5 $600 + $650 + $250 + $275 + $225 + $200 + $700 = $2,900 = total revenue. $2,900 X 10% = $290. Penley, Konami, and Molina meet this test, since their revenues equaled or exceeded $290. BRIEF EXERCISE 24-6 $90 + $25 + $50 + $34 + $150 = $349 = total profits of profitable segments. $349 X 10% = $34.90. Penley, Konami, Red Moon, and Molina meet this test, since their absolute profit or loss is equal to or greater than $34.90.
BRIEF EXERCISE 24-7 $500 + $550 + $250 + $400 + $200 + $150 + $475 = $2,525 = total assets. $2,525 X 10% = $252.50. Penley, Konami, Red Moon, and Molina meet this test, since their identifiable assets equal or exceed $252.50. *BRIEF EXERCISE 24-8 (a) X + $500,000 = 5X $500,000 = 4X $125,000 = Current liabilities (b) Cost of goods sold last year = $200,000 X 5 = $1,000,000 $1,000,000 ÷ 8 = $125,000 = Average inventory in current year (c) $ 90,000 ÷ $40,000 = Current ratio of 2.25:1 $ 50,000 ÷ $40,000 = Acid-test ratio of 1.25:1 $105,000 ÷ $55,000 = Current ratio of 1.91:1 $ 65,000 ÷ $55,000 = Acid-test ratio of 1.18:1 (d) $600,000 ÷ $420,000 = 1.43:1 after declaration, but before payment After payment, $420,000 ÷ $240,000 = 1.75:1
*BRIEF EXERCISE 24-9 Cost of Goods Sold = Inventory Turnover Average Inventory $99,000,000 Average Inventory
=9
Average inventory (current) therefore equals $11,000,000 ($99,000,000 ÷ 9). $99,000,000 Average Inventory
= 12
Average inventory (new) equals $8,250,000 ($99,000,000 ÷ 12). $2,750,000 X 10% = $275,000 cost savings.
SOLUTIONS TO EXERCISES EXERCISE 24-1 (10–15 minutes) (a) The issuance of common stock is an example of a subsequent event which provides evidence about conditions that did not exist at the balance sheet date but arose subsequent to that date. Therefore, no adjustment to the financial statements is recorded. However, this event should be disclosed either in a note, a supplemental schedule, or even pro forma financial data. (b) The changed estimate of income taxes payable is an example of a subsequent event which provides additional evidence about conditions that existed at the balance sheet date. The income tax liability existed at December 31, 2014, but the amount was not certain. This event affects the estimate previously made and should result in an adjustment of the financial statements. The correct amount ($1,270,000) would have been recorded at December 31 if it had been available. Therefore, Madrasah should increase income tax expense in the 2014 income statement by $170,000 ($1,270,000 – $1,100,000). In the balance sheet, income taxes payable should be increased and retained earnings decreased by $170,000. EXERCISE 24-2 (10–15 minutes) 1. 2. 3.
(a) (c) (b)
4. 5. 6.
(b) (c) (c)
7. 8. 9.
(c) (b) (a)
10. 11. 12.
(c) (a) (b)
EXERCISE 24-3 (5–10 minutes) (a) Revenue test: 10% X $102,000 = $10,200. Segments W ($60,000) and Y ($23,000) both meet this test. (b) Operating profit test: 10% X ($15,000 + $3,000 + $1,000) = $1,900. Segments W ($15,000), X ($3,000), and Y ($2,000 absolute amount) all meet this test. (c) Identifiable assets test: 10% X $290,000 = $29,000. Segments W ($167,000) and X ($83,000) both meet this test.
*EXERCISE 24-4 (20–30 minutes) Computations are given below which furnish some basis of comparison of the two companies:
Composition of current assets Cash Receivables Inventories
Computation of various ratios Current ratio ($910 ÷ $305) Acid-test ratio ($120 + $220) ÷ $305 Accounts receivable turnover ($930 ÷ $220) Inventory turnover Cash to current liabilities ($120 ÷ $305) a($930 X .70) ÷ $570
Toulouse Co.
Lautrec Co.
13% 24% 63% 100%
28% 27% 45% 100%
2.98 to 1 1.11 to 1 4.23 times 1.14a times .39 to 1
($1,140 ÷ $350) ($320 + $302) ÷ $350 $1,500 ÷ $302 ($320 ÷ $350)
3.26 to 1 1.78 to 1 4.97 times 1.74b times .91 to 1
b($1,500 X .60) ÷ $518
Lautrec Co. appears to be a better short-term credit risk than Toulouse Co. Analysis of various liquidity ratios demonstrates that Lautrec Co. is stronger financially, all other factors being equal, in the short-term. Comparative risk could be judged better if additional information were available relating to such items as net income, purpose of the loan, due date of current and long-term liabilities, future prospects, etc.
*EXERCISE 24-5 (20–30 minutes) (a) The acid-test ratio is the current ratio with the subtraction of inventory and prepaid expenses (generally insignificant relative to inventory) from current assets. Any divergence in trend between these two ratios would therefore be dependent upon the inventory account. Inventory turnover has declined sharply in the three-year period, from 4.91 to 3.42. During the same period, sales to fixed assets have increased and total sales have increased 7 percent. The decline in the inventory turnover is therefore not due to a decline in sales. The apparent cause is that investment in inventory has increased at a faster rate than sales, and this has accounted for the divergence between the acid-test and current ratios.
*EXERCISE 24-5 (Continued) (b) Financial leverage has definitely declined during the three-year period. This is shown by the steady drop in the long-term debt to assets ratio, and the debt to assets ratio. Apparently the decline of debt as a percentage of this firm’s capital structure is accounted for by a reduction in the long-term portion of the firm’s indebtedness. This reduction of leverage accounts for the decrease in the return on common stock equity ratio. This conclusion is reinforced by the fact that net income to sales and return on total assets have both increased. (c) The company’s net investment in plant and equipment has decreased during the three-year period 2012–2014. This conclusion is reached by using the sales-to-fixed-assets (fixed asset turnover) and sales-as-apercent-of-2012-sales ratios. Because sales have grown each year, the sales-to-fixed-assets could be expected to increase unless fixed assets grew at a faster rate. The sales-to-fixed-assets ratio increased at a faster rate than the 3 percent annual growth in sales; therefore, net investment in plant and equipment must have declined. *EXERCISE 24-6 (30–40 minutes) (a) The current ratio measures overall short-term liquidity and is an indicator of the short-term debt-paying ability of the firm. The quick ratio also is a measure of short-term liquidity. However, it is a measure of more immediate liquidity than the current ratio and is an indicator of a firm’s ability to pay all of its immediate debts from cash or near-cash assets. The quick ratio is also an indicator of the degree of inventories in its current assets when compared to the current ratio. Inventory turnover is an indicator of the number of times a firm sells its average inventory level during the year. A low inventory turnover may indicate excessive inventory accumulation or obsolete inventory. Net sales to stockholders’ equity is an activity ratio that measures the number of times the stockholders’ equity was turned over in sales volume. This ratio could also be referred to as a net asset turnover ratio that measures net asset management. Thus, it is a measure of operational efficiency. This ratio is similar to asset turnover.
*EXERCISE 24-6 (Continued) Return on common stock equity is a profitability ratio. It measures the return on stockholders’ investment and is used to evaluate the company’s success in generating income for the benefit of its stockholders (i.e., management effectiveness). Total liabilities to stockholders’ equity compares the amount of resources provided by creditors to the resources provided by stockholders. Thus, it measures the extent of leverage in the company’s financial structure and is used to evaluate or judge the degree of financial risk. This ratio is similar to the debt to assets ratio. (b) The two ratios that each of the four entities would specifically use to examine Edna Millay Inc. are as follows: Archibald MacLeish Bank might employ the current or quick ratio and the total liabilities to equity ratio. Robert Lowell Company might employ either the current or quick ratios in conjunction with either the inventory turnover or total liabilities to equity ratio. Robert Penn Warren might employ net sales to stockholders’ equity and return on common stock equity. The Working Capital Management Committee might review the current or quick ratio and the inventory turnover. (c) Edna Millay Inc. appears to have a strong liquidity position as evidenced by the current and quick ratios that have been improving over the three-year period. In addition, the current ratio is greater than the industry average and the quick ratio is just slightly below. However, the increase in the current ratio could be due to an increase in inventory levels. This fact is confirmed by the deteriorating inventory turnover ratio that is also below the industry average. Overstock or obsolete inventory conditions may exist. Edna Millay’s profitability is good as indicated by the profitability ratios that have been increasing. Both profitability ratios are greater than the industry average. The profit margin on sales (net income to net sales) can be derived from these two ratios (net income to common stock equity and net sales to common stock equity), and Millay’s margin has increased each year (2012: 5.17%; 2013: 5.36%; 2014: 5.69%) and
*EXERCISE 24-6 (Continued) exceeds the industry average (3.86%). The total liabilities to equity ratio has increased over the three-year period and exceeds the industry average, indicating a heavy reliance on debt. This high leverage position could be dangerous if sales volume, sales margin, or income falls because interest expense is a fixed cash outlay.
TIME AND PURPOSE OF PROBLEMS Problem 24-1 (Time 40–50 minutes) Purpose—to provide the student with various post-balance-sheet or subsequent events to evaluate and to prepare the proper disclosures for each item, if necessary. Problem 24-2 (Time 24–30 minutes) Purpose—to provide the student with an understanding of the rules for segment reporting. The student must determine which of five segments are subject to segment reporting rules and describe the required disclosures. *Problem 24-3 (Time 35–45 minutes) Purpose—to provide the student with an understanding of certain key ratios. In addition, the student is asked to identify and explain what other financial reports or financial analysis might be employed. Also, the student is to determine whether the company can finance the plant expansion internally and whether an extension on the note should be made. *Problem 24-4 (Time 40–60 minutes) Purpose—to provide the student with an understanding of the conceptual merits in the presentation of financial statements by both horizontal analysis and vertical analysis. The student is required to prepare a comparative balance sheet for the given financial information under each of the two approaches. The student is then asked to discuss the merits of each of the presentations. *Problem 24-5 (Time 40–50 minutes) Purpose—to provide the student with a situation in which ratio analysis is used in a decision concerning payment of dividends.
SOLUTIONS TO PROBLEMS PROBLEM 24-1
ALMADEN CORPORATION Balance Sheet December 31, 2014 Assets Current assets Cash ($571,000 – $300,000) .... Accounts receivable ($480,000 + $30,000)............. Less allowance for doubtful accounts ......... Notes receivable...................... Inventories (LIFO) ................... Prepaid expenses.................... Total current assets ....
$ 271,000 $510,000 30,000
$1,620,800
Long-term investments Investments in land................. Cash surrender value of life insurance policy............. Cash restricted for plant expansion ............................. Property, plant, and equipment Plant and equipment (pledged as collateral for bonds) ($4,130,000 + $1,430,000) ..... Less accumulated depreciation................... Land ......................................... Intangible assets Goodwill, at cost ..................... Total assets .................
480,000 162,300 645,100 62,400
185,000 84,000 300,000
569,000
4,130,000 446,200
4,576,200
5,560,000 1,430,000
252,000 $7,018,000
PROBLEM 24-1 (Continued) Liabilities and Stockholders’ Equity Current liabilities Accounts payable....................... Unearned revenue ...................... Dividends payable...................... Salaries and wages payable ...... Income taxes payable ................ Interest payable ($750,000 X 8% X 8/12) ............ Total current liabilities ..... Long-term liabilities Notes payable (due 2017) .......... 8% bonds payable (secured by plant and equipment) ......... $ 750,000 Less unamortized bond discount*............................ 29,900 Total liabilities ................ Stockholders’ equity Common stock, par value $10 per share; authorized 200,000 shares; 184,000 shares issued and outstanding.............................. 1,840,000 Paid-in capital in excess of par.... 150,000 Retained earnings ...................... Total stockholders’ equity ........................... Total liabilities and stockholders’ equity ...
$ 510,000 489,500 200,000 225,000 145,000 40,000 $1,609,500
157,400
720,100
877,500 2,487,000
1,990,000 2,541,000** 4,531,000 $7,018,000
*($34,500 ÷ 5 = $6,900; $6,900 X 8/12 = $4,600; $34,500 – $4,600 = $29,900) **Retained earnings $2,810,600 Accrued wages omitted (225,000) Accrued interest (40,000) Bond amortization (4,600) $2,541,000
PROBLEM 24-1 (Continued) Additional comments: 1.
The information related to the competitor should be disclosed because this innovation may have a significant effect on the company. The value of the inventory is overstated because of the need to reduce selling prices. This factor along with the net realizable value of the inventory should be disclosed.
2.
The pledged assets should be described in the balance sheet as indicated or in a footnote.
3.
The error in calculating inventory will have been offset, so no adjustment is needed.
4.
Salaries and wages payable is included as a liability and retained earnings is reduced.
5.
The fact that the gain on sale of certain plant assets was credited directly to retained earnings has no effect on the balance sheet presentation.
6.
Technically, the plant and equipment account should be separately disclosed and depreciation computed on each item individually. However, the information to divide the accounts was not given in this problem.
7.
Interest payable on the bonds ($750,000 X 8% X 8/12 = $40,000) was never recorded. This amount will also reduce retained earnings. The related discount amortization [($34,500 ÷ 60) X 8 months = $4,600] will reduce both the discount account and retained earnings.
8.
Since the loss from heavy damage was caused by a fire after the balance sheet date, this event does not reflect conditions existing at that date. Thus, adjustment of the financial statements is not necessary. However, the loss should be disclosed in a note, especially since users of the financial statements who may have read about the fire in the newspaper, would likely be looking for disclosure of the financial implications.
PROBLEM 24-2
(a) Determination of reportable segments: 1.
Revenue test: 10% X $785,000* = $78,500. Only Segment C ($580,000) meets this test. *$40,000 + $75,000 + $580,000 + $35,000 + $55,000
2.
Operating profit test: 10% X ($11,000 + $75,000 + $4,000 + $7,000) = $9,700. Segments A ($11,000), B ($15,000 absolute value), and C ($75,000) all meet this test.
3.
Identifiable assets test: 10% X $730,000** = $73,000. Segments B ($80,000) and C ($500,000) meet this test. **$35,000 + $80,000 + $500,000 + $65,000 + $50,000
(b) Disclosures required by GAAP:
External Revenues Intersegment Revenues Total Revenues Cost of Goods Sold Operating Expenses Total Expenses Operating Profit (Loss) Identifiable Assets
A
B
C
Other
Totals
$40,000
$ 55,000 20,000 75,000 50,000 40,000 90,000 $(15,000) $ 80,000
$480,000 100,000 580,000 270,000 235,000 505,000 $ 75,000 $500,000
$ 90,000
$665,000 120,000 $785,000
40,000 19,000 10,000 29,000 $11,000 $35,000
90,000 49,000 30,000 79,000 $ 11,000 $115,000
Reconciliation of revenues Total segment revenues ........................................................ Revenues of immaterial segments ....................................... Elimination of intersegment revenues ................................. Revenues from reportable segments ...................................
$ 82,000 $730,000
$785,000 (90,000) (120,000) $575,000
PROBLEM 24-2 (Continued) Reconciliation of profit or loss Total segment operating profit ............................................. Profits of immaterial segments............................................. Profits from reportable segments ........................................
$ 82,000 (11,000) $ 71,000
Reconciliation of assets Total segment assets ............................................................ Assets of immaterial segments ............................................ Assets from reportable segments ........................................
$730,000 (115,000) $615,000
*PROBLEM 24-3
(a)
BRADBURN CORPORATION Ratio Analysis 1.
Current ratio =
Current assets Current liabilities
2014:
2.
2015:
$403,000 = 2.46 to 1 $164,000
Acid test (Quick) ratio = Current assets – Inventories Current liabilities 2014:
3.
$320,000 = 2.02 to 1 $158,500
$270,000 = 1.70 to 1 $158,500
Inventory turnover =
2015:
$298,000 = 1.82 to 1 $164,000
Cost of goods sold Average inventory
$1,530,000 2015: $50,000 + $105,000 = 19.7 times (every 18.5 days) 2 4.
Return on assets =
Net income Average total assets
2014:
$297,000 $1,688,500 + $1,740,500 = 17.3% 2
2015:
$366,000 $1,740,500 + $1,852,000 = 20.4% 2
*PROBLEM 24-3 (Continued) 5. Percent Changes
Amounts (000s omitted) 2015 2014
Sales revenue
$3,000
$2,700
Cost of goods sold
1,530
1,425
Gross margin
1,470
1,275
366
297
Net income after taxes
Percent Increase $300
= 11.11%
$2,700 $105 = 7.37% $1,425 $195 = 15.29% $1,275 $69 = 23.23% $297
(b) Other financial reports and financial analyses which might be helpful to the commercial loan officer of Topeka National Bank include: 1. The Statement of Cash Flows would highlight the amount of cash provided by operating activities, the other sources of cash, and the uses of cash for the acquisition of long-term assets and long-term debt requirement. 2. Projected financial statements for 2016 including a projected Statement of Cash Flows. In addition, a review of Bradburn’s comprehensive budgets might be useful. These items would present management’s estimates of operations for the coming year. 3. A closer examination of Bradburn’s liquidity by calculating some additional ratios, such as day’s sales in receivables, accounts receivable turnover, and day’s sales in inventory. 4. An examination as to the extent that leverage is being used by Bradburn. (c) Bradburn Corporation should be able to finance the plant expansion from internally generated funds as shown in the calculations presented on the next page.
*PROBLEM 24-3 (Continued)
Sales revenue Cost of goods sold Gross margin Operating expenses Income before income taxes Income taxes (40%) Net income Add: Depreciation Deduct: Dividends Note repayment Funds available for plant expansion Plant expansion Excess funds
2015
(000 omitted) 2016
2017
$3,000.0 1,530.0 1,470.0 860.0 610.0 244.0 $ 366.0
$3,333.3 1,642.8 1,690.5 948.2 742.3 296.9 $ 445.4
$3,703.6 1,763.8 1,939.8 1,045.5 894.3 357.7 $ 536.6
102.5 (260.0) (6.0) 281.9 (150.0) $ 131.9
102.5 (260.0) 379.1 (150.0) $ 229.1
Assumptions: Sales revenue increases at a rate of 11.11%. Cost of goods sold increases at rate of 7.37%, despite depreciation remaining constant. Other operating expenses increase at the same rate experienced from 2014 to 2015; i.e., at 10.26% ($80,000 ÷ $780,000).
Depreciation remains constant at $102,500. Dividends remain at $2 per share. Plant expansion is financed equally over the two years ($150,000 each year). Loan extension is granted.
(d) Topeka National Bank should probably grant the extension of the loan, if it is really required, because the projected cash flows for 2016 and 2017 indicate that an adequate amount of cash will be generated from operations to finance the plant expansion and repay the loan. In actuality, there is some question whether Bradburn needs the extension because the excess funds generated from 2016 operations might cover the $70,000 loan repayment. However, Bradburn may want the loan extension to provide a cushion because its cash balance is low. The financial ratios indicate that Bradburn has a solid financial structure. If the bank wanted some extra protection, it could require Bradburn to appropriate retained earnings for the amount of the loan and/or restrict cash dividends for the next two years to the 2015 amount of $2.00 per share.
*PROBLEM 24-4
(a)
GILMOUR COMPANY Comparative Balance Sheet December 31, 2015 and 2014 December 31 Assets Cash Accounts receivable (net) Short-term Investments Inventories Prepaid expenses Plant and equipment Accumulated depreciation Total Liabilities and Stockholders’ Equity Accounts payable Accrued expenses Bonds payable Capital stock Retained earnings Total
2015
2014
$ 180,000 220,000 270,000 1,060,000 25,000 2,585,000 (1,000,000) $3,340,000
5.39% 6.59 8.08 31.74 .75 77.39 (29.94) 100.00%
$ 275,000 155,000 150,000 980,000 25,000 1,950,000 (750,000) $2,785,000
9.87% 5.57 5.39 35.18 .90 70.02 (26.93) 100.00%
$
1.50% 5.09 13.47 62.87 17.07 100.00%
$
2.69% 7.18 6.82 63.56 19.75 100.00%
50,000 170,000 450,000 2,100,000 570,000 $3,340,000
75,000 200,000 190,000 1,770,000 550,000 $2,785,000
*PROBLEM 24-4 (Continued) (b)
GILMOUR COMPANY Comparative Balance Sheet December 31, 2015 and 2014 Assets Cash Accounts receivable (net) Investments Inventories Prepaid expenses Plant and equipment Accumulated depreciation Total Liabilities and Stockholders’ Equity Accounts payable Accrued expenses Bonds payable Capital stock Retained earnings Total
December 31 Increase or (Decrease) 2015 2014 $ Change % Change $ 180,000 $ 275,000 $ (95,000) (34.55) 220,000 155,000 65,000 41.94 270,000 150,000 120,000 80.00 1,060,000 980,000 80,000 8.16 25,000 25,000 0 0 2,585,000 1,950,000 635,000 32.56 (1,000,000) (750,000) (250,000) 33.33 $ 3,340,000 $2,785,000 $ 555,000 19.93%
$
50,000 170,000 450,000 2,100,000 570,000 $3,340,000
$
75,000 200,000 190,000 1,770,000 550,000 $2,785,000
$ (25,000) (33.33) (30,000) (15.00) 260,000 136.84 330,000 18.64 20,000 3.64 $555,000 19.93%
(c) The component percentage (common-size) balance sheet makes easier analysis possible. It actually reduces total assets and total liabilities and stockholders’ equity to a common base. Thus, the statement is simplified into figures that can be more readily grasped. It can also show relationships that might be out of line. For example, management might believe that accounts receivable of 6.59% is rather low. Perhaps the company is not granting enough credit. The increased percentage of bonds payable from 6.82% to 13.47% indicates increased leverage which may reflect negatively on the company’s debt-paying ability and long-run solvency. These percentages can be compared with those of other successful firms to see how the firm stands and to see where possible improvements could be made. (d) A statement such as that in part (b) is a good analysis and breakdown of the total change in assets and liabilities and stockholders’ equity. The statement breaks down the 19.93% increase and makes it easier for analysts to spot any unusual items. The increase is explained on the asset side by an increase in accounts receivable, short-term investments, and fixed assets and on the liability side by an increase in bonds payable and capital stock. This statement makes analysis of the year’s operations generally easier.
*PROBLEM 24-5
(a) In establishing a dividend policy, the following are factors that should be taken into consideration: 1.
The expansion plans or goals of the organization and the need for monies to finance new activities.
2.
The investment opportunities available to the company versus the return available to stockholders on earnings distributed by way of a cash dividend.
3.
The possible effect on the market value of the company’s shares of instituting a dividend, and the possible effect on financing alternatives.
4.
The earnings ability and stability of the company—past and future.
5.
The ability of the organization to maintain a given dividend in future years. To offer a dividend this year that cannot be maintained may be harmful. It could also be harmful to establish a policy seeming to call for increasing dividends over the years in the event the increase could not be kept up.
6.
The current position of the company. Is cash available to pay the dividend? Will working capital be decreased to a dangerous level?
7.
The possibility of offering a stock dividend in addition to or rather than a cash dividend.
8.
The dividend policies of other similar organizations.
9.
The general condition of the economy in the area where the company operates, as well as in the United States in general.
10.
The tax situation of the company.
11.
Legal restrictions, such as a restrictive covenant in a bond indenture.
*PROBLEM 24-5 (Continued) 12.
Personal tax situations of stockholders if known—whether preference for dividends or capital gains.
13.
Degree of dispersion of stockholdings and stockholders’ needs or preference for dividends.
(b) Return on assets
Profit margin on sales
Earnings per share
Price-earnings ratio
Current ratio
2015 $2,400 $22,000 10.9%
2014 $1,400 $19,000 7.4%
2013 $800 $11,500 7.0%
2012 $700 $4,200 16.7%
2011 $250 $3,000 8.3%
$2,400 $20,000 12.0%
$1,400 $16,000 8.8%
$800 $14,000 5.7%
$700 $6,000 11.7%
$250 $4,000 6.3%
$2,400 2,000 $1.20
$1,400 2,000 $.70
$800 2,000 $.40
$700 20 $35.00
$250 20 $12.50
$9 $1.20 7.5 times
$6 $.70 8.6 times
$4 $.40 10 times
$8,000 $6,000 $3,000 $1,200 $1,000 $4,400* $2,800 $1,800 $700 $600 1.82 times 2.14 times 1.67 times 1.71 times 1.67 times
*$8,000 – $3,600
(c)
While the return on assets, profit margin on sales, and earnings per share have been increasing, the market price of the shares has not given full recognition to these increases. This suggests that market factors (and perhaps industry factors) are having a depressing effect on the market price of the shares. It may be suggested that the relatively low market price of the shares may be due, in part, to the fact that dividends have not been paid in the past. It may be concluded that the enterprise is in an improving operating position and appears to be able to pay a dividend (though the amount of cash is not given). It would, however, be wise to examine as many as possible of the other internal and external factors outlined in part (a) to this case.
*PROBLEM 24-5 (Continued) A dividend in the range of 12¢ to 36¢ being 10% to 30% of earnings per share for 2015, would appear to be reasonable. Cash required would be $240,000 ($0.12 X 2,000,000) to $720,000 ($0.36 X 2,000,000). Payments considerably in excess of $720,000 would appear to have a serious impact on working capital. This would provide a yield of between 1.3% and 4% on the average 2015 market value.
TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS CA 24-1 (Time 10–20 minutes) Purpose—to provide the student with an understanding of the necessary information which must be disclosed in the financial statements with regard to certain asset classifications. The student is required to discuss each of these respective disclosures for Inventories and Property, Plant, and Equipment in the audited financial statements issued to the stockholders. CA 24-2 (Time 20–25 minutes) Purpose—to provide the student with an understanding of the necessary information which should be disclosed in the financial statements and notes. The student is required to evaluate the facts of four items concerning the company’s operations and to discuss any additional disclosures in the financial statements and notes that the auditor should recommend with respect to these items. CA 24-3 (Time 24–30 minutes) Purpose—to provide the student with an understanding of the types of disclosures which are necessitated under certain circumstances. This case involves three independent situations dealing with such concepts as warranty claims, a self-insurance contingency, and the discovery of a probable loss subsequent to the date of the financial statements. The student is required to discuss the accrual treatment and type of disclosure necessary and the reasons why such disclosure is appropriate for each of the three situations. CA 24-4 (Time 20–25 minutes) Purpose—to provide the student with an understanding of the proper accounting for subsequent event transactions. Bankruptcy, issue of debt, strikes, and other typical subsequent event transactions are presented. CA 24-5 (Time 30–35 minutes) Purpose—to provide the student with an understanding of segment reporting requirements, including providing explanations as to which segments are reportable. CA 24-6 (Time 20–25 minutes) Purpose—to provide the student with an understanding of segment reporting. The case explores why a company did not have to prepare certain segment information. In addition, examination of when export sales should be disclosed is discussed. Finally, the student is asked to determine why international segments should be reported if significant international operations exist. CA 24-7 (Time 24–30 minutes) Purpose—to provide the student with an understanding of the concepts underlying the applications of segment reporting. The student is required to identify the reasons for requiring financial data to be reported by segments, the possible disadvantages of this requirement, and the accounting difficulties inherent in segment reporting. CA 24-8 (Time 20–25 minutes) Purpose—to provide the student with an understanding of the applications and requirements of interim financial reporting. The student is required to explain how a company’s operating results would be reflected in a quarterly report and describe what financial information must be disclosed to a company’s stockholders in the quarterly reports.
Time and Purpose of Concepts for Analysis (Continued) CA 24-9 (Time 30–35 minutes) Purpose—to provide the student with an understanding of the concepts of interim reporting and its respective applications to specific financial information. This case involves six independent examples on how accounting facts might be reported on a company’s quarterly reports. The student is required to evaluate each example and state whether the method proposed to be used for interim reporting would be acceptable under generally accepted accounting principles applicable to interim financial data. CA 24-10 (Time 24–30 minutes) Purpose—to provide the student with an understanding of the conceptual merits underlying the preparation of financial forecasts. The student is required to discuss the arguments for preparing profit forecasts, the purpose of the “safe harbor” rule, and the reasons why corporations are concerned about presenting financial forecasts. CA 24-11 (Time 15–20 minutes) Purpose—to provide the student with an understanding of an ethical dilemma that may arise in the future. In this case, the reason for the profit margin increasing is not properly described by the financial vicepresident and the controller realizes the misstatement. The question is what should the controller do? CA 24-12 (Time 10–15 minutes) Purpose—to provide the student with an understanding of an ethical dilemma that may arise in the future. In this case, the company decides to delay the issuance of a debt offering to make their ratios look more impressive. *CA 24-13 (Time 24–35 minutes) Purpose—to provide the student with an understanding of the effects which various transactions have on a company’s financial status. The student is required to decide for each of these transactions the respective effect on the company’s net income, retained earnings, current ratio, stockholders’ equity, and stockholders’ equity per share of stock.
SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 24-1 Koch Corporation must disclose the following information regarding inventories: 1. The dollar amount assigned to inventory. 2. The method of inventory pricing; e.g., FIFO, LIFO, weighted average. 3. The basis of valuation; i.e., cost or lower-of-cost-or-market; if an amount other than cost is presented, then cost should still be presented by stating the amount of cost or by stating the amount of the valuation allowance. 4. The composition of the inventory into raw materials, work-in-process, and finished goods. The following information must be disclosed for property, plant, and equipment: 1. The balance of major classes of depreciable assets (assets classified by nature or function). 2. Accumulated depreciation, either by major classes of depreciable assets or in total. 3. A general description of the methods used in computing depreciation on major classes of depreciable assets. 4. The amount of depreciation expense for the period. The information regarding inventories and property, plant, and equipment will be disclosed in the body of the financial statements and in the notes which are an integral part of the statements.
CA 24-2 Item 1 The staff auditor reviewing the loan agreement misinterpreted its requirements. Retained earnings are restricted in the amount of $420,000, 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 a note to the financial statements. Item 2 Unless cumulative preferred dividends are involved, no recommendation by the CPA is 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 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 be disclosed in the financial statements or a note. Note that the SEC encourages companies to disclose their dividend policy in their annual report. Those that: (1) have earnings but fail to pay dividends or (2) do not expect to pay dividends in the foreseeable future are encouraged to report this information. In addition, companies that show a consistent pattern of paying dividends are encouraged to indicate whether they intend to continue this practice in the future. Item 3 A competitive development of this nature normally is considered to be the type of subsequent event that provides evidence with respect to a condition that did not exist at the date of the balance sheet. In some circumstances the auditor might conclude that Ace’s poor competitive situation was evident at yearend. In any event, the development should be disclosed to users of the financial statements because the economic recoverability of the new plant and inventory are in doubt and Ace may incur substantial expenditures to modify its facilities. Because the economic effects probably cannot be determined, the usual disclosure will be in a note to the financial statements. If the present recoverable value of the plant can be determined, Ace 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 condition did exist at year-end should the financial statements for the year ended December 31, 2015, be adjusted for the ascertainable economic effects of this development.)
CA 24-2 (Continued) Item 4 The lease agreement with Wichita National Bank meets the criteria for a capital lease because it contains a bargain purchase option (a 25-year-life building can be purchased at the end of 10 years for $1). Additionally, unless the fair value of the building is considerably greater than its $2,400,000 cost, the present value of the lease payments probably exceeds 90% of the fair value of the building. The lessee, therefore, must capitalize the leased asset and the related obligation in the balance sheet at the appropriate discounted amount of the future rental payments under the lease agreement. Via note, the lessee must disclose: (1) the gross amount of the leased asset and the accumulated depreciation thereon, (2) the future minimum lease payments as of the latest balance sheet date, in the aggregate and for each five succeeding fiscal years and for the amount of imputed interest necessary to reduce the lease payments to present value, (3) a general description of the lease arrangement, and (4) the existence of the terms of the purchase option. The income statement should contain a charge for depreciation of the leased asset plus an interest charge.
CA 24-3 Situation 1 When a company sells a product subject to a 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 note, 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 note 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 enough of a basis 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 the company is self-insuring this risk should be disclosed by means of a note to alert the financial statement reader to the exposure created by the lack of insurance.
CA 24-4 1.
The financial statements should be adjusted for the expected loss pertaining to the remaining receivable of $240,000. Such adjustment should reduce accounts receivable to their realizable value as of December 31, 2014.
2.
Report the fire loss in a footnote to the balance sheet and refer to it in connection with the income statement, since earnings power is presumably affected.
3.
Strikes are considered general knowledge and therefore disclosure is not required. Many auditors, however, would encourage disclosure in all cases.
4.
This case is a difficult problem. If this event is of the second type which provides evidence with respect to conditions that did not exist at December 31, 2014, then appropriate disclosures should indicate that: (a) (b) (c)
Recovery of costs invested in plant and inventory is in doubt. The company may incur additional costs to modify the existing facility. Due to this situation, future economic events cannot be determined. (If we could determine them, pro-forma information might be appropriate.)
If it is the type of subsequent event for which the condition existed at December 31, 2014, then the financial statements must be adjusted. The provisions of GAAP accounting related to contingencies would govern if amounts could not be estimated. It should be emphasized in class that no right answer exists for this problem. Judgment must play a major role in determining the adjustment or disclosure necessary for this transaction. 5.
Adjust the inventory figure as of December 31, 2014, as required by a market price of $2.00 instead of $1.40, applying the lower-of-cost-or-market principle. The actual quotation was a transitory error and no purchases had been made at this quotation.
6.
Report the action of the new stock issue in a footnote to the balance sheet.
CA 24-5 To:
Anthony Reese, Accountant
From:
Student
Date:
Current date
Subject:
Determination of reportable segments for Winsor Corp.
I have analyzed the segment information which you gave me and determined that the funeral, the cemetery, and the real estate segments must be reported separately. The remaining three—the limousine, floral, and dried whey segments—can be combined under the category of other. To make this determination, I applied three criteria put forth by the FASB to the information provided for 2015. First, a segment must be reported separately if its revenue is greater than or equal to 10 percent of the enterprise’s combined revenue. This is the case with both the funeral and the cemetery segments as revenue for both is greater than $40,600 (10 percent of combined revenue). Second, a segment is considered significant enough to be reported separately if its absolute operating profit or operating loss is 10% or more of the greater, in absolute amount of: (a) the combined operating profit of all segments without an operating loss or (b) the combined operating loss of all segments that incurred a loss. Combined operating profit for all profitable segments totals $96,000. Both the funeral and the cemetery segments have operating profits exceeding 10% of total profits whereas the real estate segment’s operating loss in absolute amount is greater than 10 percent of total profits. Thus, all three must be separately reported.
CA 24-5 (Continued) Third, a segment must be reported separately if its identifiable assets are greater than or equal to 10 percent of the combined identifiable assets for all segments. Again, the funeral, the cemetery, and the real estate segments meet this test. Note that the limousine, floral, and dried whey segments meet none of the above criteria, so they are not reported separately. When reporting segment information, you must include the following items: revenues, operating profit (loss), identifiable assets, depreciation expense, and amount of capital expenditures. Furthermore, all segment information must be prepared on the same accounting basis as the consolidated entity’s. I hope that this information helps you in determining future reportable segments. If you have any other questions, please contact me.
CA 24-6 (a)
Some companies such as H. J. Heinz have only one dominant product or service and therefore it is impossible to provide segmented data in a meaningful fashion. Dominant means that a given segment has 90% of all the sales, profit and identifiable assets of the company. In this case, segmented data are not provided, but the industry in which the dominant segment operates must be identified.
(b)
Export sales are sales to customers in foreign countries by a domestic operation. Export sales must be reported when a company derives 10% or more of its revenue (consolidated revenue) from this source.
(c)
Reporting sales by geographical area is extremely important. Many countries are both unstable politically and economically, and, as a result, sales to these areas should be evaluated carefully. Conversely, sales to countries that appear politically and economically stable suggest a high rate of continuance of sales to these areas.
CA 24-7 (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.
(b)
The reasons for requiring financial data to be reported by segments include the following: 1. 2. 3. 4. 5. 6. 7.
They would provide more detailed disclosure of information needed by investors, creditors, and other users of financial statements. Appraisers can evaluate major segments of a business enterprise before considering the business in its entirety. In addition to being useful and desirable, such information is practical to compute. The growth potential of an enterprise can be evaluated by reviewing the growth potential of its major segments. Users can better assess management decisions to drop or add a segment. 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. Managerial ability is better assessed with segment data because managerial responsibility within the enterprise is frequently decentralized.
CA 24-7 (Continued) (c)
The possible disadvantages of requiring financial data to be reported by segments include the following: 1. 2. 3. 4.
5. 6.
(d)
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. They may disguise the interdependence of all the segments. They might result in misleading comparisons of segments of different enterprises. 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. Information thus made available might cause customers to challenge prices to the disadvantage of the company. 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.
The accounting difficulties inherent in segment reporting include the following: 1. 2.
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. 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: (a) (b) (c) (d) (e) (f)
3. 4. 5. 6.
Determining whether common costs should be allocated to segments. Selecting allocation bases if common costs are to be allocated. Determining which costs of capital (interest, preferred dividends, etc.) should be attributed to segments. Determining whether extraordinary items and the cumulative effect of a change in accounting principle should be attributed to segments. Determining how income tax should be allocated to segments. Determining how a minority interest’s share of income, and income from investee companies, should be attributed to segments.
The treatment of segment information in interim financial reports must be established. The method of presenting segment information in financial statements must be established. Such presentation may be by notes or by separate financial statements. The additional disclosures required, such as accounting policies used, must be established. The effect of annual comparisons must be considered. This would entail retroactive restatement of previously reported segment information presented currently for comparative purposes.
CA 24-8 (a)
1.
The company should report its quarterly results as if each interim period is an integral part of the annual period.
CA 24-8 (Continued) 2.
The company’s revenue and expenses would be reported as follows on its quarterly report prepared for the first quarter of the 2014–2015 fiscal year: Sales revenue........................................................................................... Cost of goods sold .................................................................................... Variable selling expenses ......................................................................... Fixed selling expenses Advertising ($2,000,000 ÷ 4) ............................................................ Other ($3,000,000 – $2,000,000) .....................................................
$60,000,000 36,000,000 1,000,000 500,000 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. (b)
The financial information to be disclosed to its stockholders in its quarterly reports as a minimum include: 1. 2. 3. 4. 5. 6. 7. 8.
Sales revenue or gross revenues, provision for income taxes, extraordinary items 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.
CA 24-9 (a)
Acceptable. The use of estimated gross profit rates to determine the cost of goods sold is acceptable for interim reporting purposes as long as the method and rates utilized are reasonable. The company should disclose the method employed and any significant adjustments which result from reconciliations with annual physical inventory.
(b)
Acceptable. Pension costs are more identifiable with a time period rather than with the sale of a product or service. Companies are encouraged to make quarterly estimates of those items that usually result in year-end adjustments. Consequently, it is acceptable to allocate this expense to each of the four interim periods.
(c)
Acceptable. Any loss in inventory value should be reported when the decline occurs. Any recoveries of the losses on the same inventory in later periods should be recognized as gains in the later interim periods of the same fiscal year. However, the gains should not exceed the previously recorded losses.
(d)
Not acceptable. Gains on the sale of investments would not be deferred if they occurred at yearend. Consequently, they should not be deferred to future interim periods but should be reported in the quarter the gain was realized.
CA 24-9 (Continued) (e)
Acceptable. The annual audit fee is an expense which benefits the company’s entire year. Companies are encouraged to make quarterly estimates of these items that usually result in year-end adjustments. Therefore, this expense can be prorated over the four quarters.
(f)
Not acceptable. Revenue from products sold should be recognized as earned during the interim period on the same basis as followed for the full year. Because the company normally recognizes a sale when shipment occurs, it should recognize the revenue in the second quarter and not defer the revenue recognition. To do otherwise would be an inconsistent application of company accounting policy and violate general accounting rules for revenue recognition.
CA 24-10 (a)
Arguments for requiring published forecasts: 1. 2. 3.
Investment decisions are based on future expectations; therefore, information about the future would facilitate better decisions. Forecasts are already circulated informally, but are uncontrolled, frequently misleading, and not available equally to all investors. This confused situation should be brought under control. Circumstances now change so rapidly that historical information is no longer adequate as a base of prediction.
(b)
The purpose of a safe harbor rule is to provide protection to an enterprise that presents an erroneous projection as long as the projections were prepared on a reasonable basis and were disclosed in good faith. An enterprise’s concern with the safe harbor rule is that a jury’s definition of reasonable might be at some variance from a company’s or, for that matter, the SEC’s.
(c)
An enterprise’s concerns about preparing a forecast are as follows: 1. 2. 3. 4.
No one can foretell the future. Therefore forecasts, while conveying an impression of precision about the future, will inevitably be wrong. Organizations will strive only to meet their published forecasts, not to produce results that are in the stockholders’ best interest. When forecasts are not proved to be accurate, there will be recriminations and probably legal actions. Even with a safe harbor rule, enterprises are concerned because the definition of reasonable is subjective. Disclosure of forecasts will be detrimental to enterprises because it will fully inform not only investors, but also competitors (foreign and domestic).
CA 24-11 (a)
The controller notes that the financial vice president is misrepresenting the financial condition of the company by suggesting that the company has become more efficient when, in fact, the improved ratio is gained through manipulation of estimates. The controller, however, hesitates because estimating does not follow precise, clear-cut rules. The dilemma exists because Lilly is asked to weigh the benefits that may accrue to the company if its profit margin on sales appears much improved against the accountant’s normal requirement to present financial information fairly (that is, in a manner that is consistent with previous reporting).
(b)
No, the controller should oppose the release of the publicity. The company has not improved its financial condition, and the claim of increased efficiency is not supported by the financial information.
(c)
The favorable media release enhances the current stockholders’ position, as well as boosting the image of management. Such publicity may well contribute to an increased stock price. Future investors and stockholders are harmed because the media release depicts a misleading perspective on the financial condition of the company.
CA 24-11 (Continued) (d)
The controller is responsible for both the accuracy and the clarity of financial reporting. If the media release obscures how an accounting decision has influenced the apparent improvement of the company’s financial condition, the controller cannot let this matter slide. Lilly must protest and not let her name be connected to the misinformation.
CA 24-12 (a)
The ethical issues involved are profitability, long-term versus short-term performance, and integrity of financial reporting.
(b)
Form should not dictate substance. The bonds should be issued when the company needs the cash to help improve its performance. Though ratios may be lower than desired if the bonds are issued immediately, the investors and creditors are served best when the company is performing at the highest possible level. If immediate cash inflow will assist enhanced performance, McElroy should not delay issuance.
*CA 24-13 1. 2. 3.
b, j a, e, i e, h, i
4. 5. 6.
b, j j e
7. 8. 9.
a, e, i b, e, j d, j
FINANCIAL REPORTING PROBLEM (a) Proctor & Gamble (P&G) commented on the following items in its note on accounting policies: Nature of operations Basis of presentation Use of estimates Revenue recognition Cost of products sold Selling, general and administrative expense Other non-operating income, net Currency translation
Cash flow presentation Cash equivalents Investments Inventory valuation Property, plant and equipment Goodwill and other intangible assets Fair values of financial instruments New accounting pronouncements and policies
(b) P&G reported information for the following segments: 1. 2. 3. 4. 5. 6.
Beauty Grooming Health care Snacks and pet care Fabric care and home care Baby care and family care
The fabric care and home care segment is the largest in net sales and net earnings. The grooming segment is largest in total assets. Wal-Mart Stores, Inc. is P&G’s largest customer, accounting for 15% of 2011 net sales (Note 11).
(c) In Note 13, P&G reported quarterly information for net sales, operating income, gross margin, net earnings, and diluted net earnings per common share.
COMPARATIVE ANALYSIS CASE THE COCA-COLA COMPANY VERSUS PEPSICO, INC. (a) 1.
Coca-Cola commented on the following list of items in its note on accounting policies: The Coca-Cola Company and Subsidiaries (Note 1)
2.
Description of Business Basis of Presentation Principles of Consolidation Risks and Uncertainties Revenue Recognition Deductions from Revenue Advertising Costs Shipping and Handling Costs Net Income Per Share Cash Equivalents Short-term Investments Investments in Equity and Debt Securities Trade Accounts Receivable Inventories Derivative Instruments Property, Plant and Equipment Goodwill, Trademarks and Other Intangible Assets Contingencies Stock-Based Compensation Pensions and Other Postretirement Benefit Plans Income Taxes Translation and Remeasurement Hyperinflationary Economies Recently Issued Accounting Guidance
PepsiCo commented on the following list of items in its note on accounting policies: PepsiCo, Inc. and Subsidiaries Note 2—Our Significant Accounting Policies Revenue Recognition Sales Incentives and Other Marketplace Spending Distribution Costs
COMPARATIVE ANALYSIS CASE (Continued) Cash Equivalents Software Costs Commitments and Contingencies Research and Development Other Significant Accounting Policies Recent Accounting Pronouncements (b) Coca-Cola divided its operations into seven operating segments: (1) Eurasia and Africa, (2) Europe, (3) Latin America, (4) North America, (5) Pacific, (6) Bottling Investments, and (7) Corporate. PepsiCo divided its operations into six segments, with geographic subsegments: (1) Frito-Lay North America, (2) Quaker Foods North America, (3) Latin America Foods, (4) PepsiCo America Beverages, (5) Europe, and (6) Asia, Middle East, and Africa. (c) Coca-Cola’s independent auditors are Ernst & Young LLP, while PepsiCo’s independent auditors are KPMG LLP. Coca-Cola’s audit report expresses an unqualified opinion on the financial statements and a separate report the expressed an opinion on the internal controls. PepsiCo’s audit report is a combined report that expresses an unqualified opinion on both the financial statements and the internal controls. Their report therefore has additional detail on the audit of internal controls.
*FINANCIAL STATEMENT ANALYSIS CASE RNA INC. (a) The calculation of selected financial ratios for RNA for the fiscal year 2015 is as follows: Current ratio
=
Current assets Current liabilities
= $9,900 $6,300 =
Acid-test ratio
1.57
Short-term Net = Cash + Investments + receivables Current liabilities = $3,900 $6,300 = .62
Times interest earned
Profit margin on sales
=
Income before income taxes and interest expense Interest expense
=
$7,060 + $900 $900
=
8.84
= Net income Net sales =
$4,260 $30,500
= 13.97%
*FINANCIAL STATEMENT ANALYSIS CASE (Continued) Asset turnover
Inventory turnover
=
Net sales Average total assets
=
$30,500 ($17,000 + $16,000) ÷ 2
=
1.85 times
=
Cost of goods sold Average inventory
=
$17,600 ($6,000 + $5,400) ÷ 2
=
3.09 times
(b) The analytical use of each of the six ratios presented above and what investors can learn about RNA’s financial stability and operating efficiency are presented below. Current ratio Measures the ability to meet short-term obligations using shortterm assets.
RNA’s current ratio has declined over the last three years from 1.62 to 1.57. This declining trend, coupled with the fact that it is below the industry average, is not yet a major concern; however, the company should be watched in the future as the ratio assumes that noncash current assets (particularly inventory) can be quickly converted to cash at or close to book value.
Acid-test ratio Measures the ability to meet short-term debt using the most liquid assets.
RNA’s acid-test ratio has remained stable over the last three years; however, it is still below the industry average. Furthermore, a quick ratio below 1 indicates that RNA may have difficulty meeting its shortterm obligations if inventory does not turn over fast enough.
*FINANCIAL STATEMENT ANALYSIS CASE (Continued) Times interest earned Measures the ability to meet interest commitments from current earnings. The higher the ratio, the more safety for long-term creditors. RNA’s ratio has been improving over the last three years and is above the industry average. This provides an indication that RNA has been paying down or refinancing debt and/or increasing sales and profits, which indicates long-term stability. Profit margin on sales Measures the net income generated by each dollar of sales. It provides some indication of the ability to absorb cost increases or sales declines. RNA’s profit margin has been improving and is currently above the industry average, indicating a trend towards marginal operating efficiency. Furthermore, it improves the ability to absorb soft economic periods, pay down debt, or take on additional debt for expansion. Asset turnover Measures the efficiency of resource use; i.e., the ability to generate sales through the use of assets. RNA’s ratio has been steadily improving and is above the industry average, indicating good use of assets and ability to generate sales. Inventory turnover Measures how quickly inventory is sold, as well as how effectively investment in inventory is used. It also provides a basis for determining if obsolete inventory is present or pricing problems exist. RNA’s ratio has been steadily declining and is below the industry average. This slower-than-average situation may indicate a decline in operating efficiency, hidden obsolete inventory, or overpriced stock items.
*FINANCIAL STATEMENT ANALYSIS CASE (Continued) (c) Limitations of ratio analysis include: Difficulty making comparisons among firms in the same industry due to accounting differences. Different accounting methods may cause different results in straight-line depreciation versus accelerated methods, LIFO versus FIFO, etc. The fact that no one ratio is conclusive.
ACCOUNTING, ANALYSIS, AND PRINCIPLES Accounting Integral Approach
Sales Less: Variable manufacturing costs Fixed manufacturing costs Variable non manufacturing costs Fixed non manufacturing costs Net income
1st Quarter $320,000
2nd Quarter $600,000
3rd Quarter $2,200,000
4th Quarter $480,000
32,000 64,000
60,000 120,000
220,000 440,000
48,000 96,000
28,000
52,500
192,500
42,000
96,000 $100,000
180,000 $187,500
660,000 $ 687,500
144,000 $150,000
Sales = (Number of units X $4.00) Variable manufacturing costs = (Number of units X $0.40) Variable non manufacturing costs = (Number of units X $0.35) Fixed manufacturing costs = Number of units X ($720,000 ÷ 900,000) Fixed non manufacturing costs = Number of units X ($1,080,000 ÷ 900,000) Discrete Approach
Sales Less: Variable manufacturing costs Fixed manufacturing costs Variable non manufacturing costs *Fixed non manufacturing costs Net income (Loss)
*$1,080,000 ÷ 4
1st Quarter $320,000
2nd Quarter $600,000
3rd Quarter $2,200,000
4th Quarter $480,000
32,000 64,000
60,000 120,000
220,000 440,000
48,000 96,000
28,000 270,000 ($ 74,000)
52,500 270,000 $ 97,500
192,500 270,000 $1,077,500
42,000 270,000 $ 24,000
ACCOUNTING, ANALYSIS, AND PRINCIPLES (Continued) Analysis Profit margin on sales = Net income ÷ Net sales Integral approach:
Net income (Loss) Net sales Profit margin on sales
1st Quarter
2nd Quarter
3rd Quarter
4th Quarter
$100,000 320,000 31.3%
$187,500 600,000 31.3%
$687,500 2,200,000 31.3%
$150,000 480,000 31.3%
1st Quarter $(74,000) 320,000 (23.1%)
2nd Quarter $97,500 600,000 16.3%
3rd Quarter $1,077,500 2,200,000 49.0%
4th Quarter $24,000 480,000 5.0%
Discrete approach:
Net income (Loss) Net sales Profit margin on sales
The integral approach smoothes variation in profit margin on sales across quarters relative to the discrete approach. This smoothing happens because the integral approach allocates fixed costs across quarters according to the sales occurring in the quarter. The discrete approach, however, allocates fixed costs across quarters evenly (an equal amount each quarter). Because the sales vary from quarter-to-quarter, an even allocation of fixed costs to the quarter’s results in more variation in net income. Principles The concept underlying the integral approach is that an individual quarter is part of a larger time interval about which we have more information. In this problem, for example, we know that sales are seasonal. So, we know that a greater proportion of the revenue generating process occurs in the third quarter than in the other quarters. Arguably, then, a greater proportion of the fixed costs for the year should be allocated to the third quarter than to the other quarters. Part of the reason we incur fixed costs at the level we do is so that we can handle the volume of the third quarter. Allocating the same amount of fixed costs to each quarter paints a picture of the firm’s profitability across quarters that is arguably inaccurate.
PROFESSIONAL RESEARCH (a) According to FASB ASC 235-10-50: 50-3 Disclosure of accounting policies shall identify and describe the accounting principles followed by the entity and the methods of applying those principles that materially affect the determination of financial position, cash flows, or results of operations. In general, the disclosure shall encompass important judgments as to appropriateness of principles relating to recognition of revenue and allocation of asset costs to current and future periods; in particular, it shall encompass those accounting principles and methods that involve any of the following: a. A selection from existing acceptable alternatives b. Principles and methods peculiar to the industry in which the entity operates, even if such principles and methods are predominantly followed in that industry c. Unusual or innovative applications of GAAP. (b) According to FASB ASC 235-10-50. Examples of Disclosures 50-4 Examples of disclosures by an entity commonly required with respect to accounting policies would include, among others, those relating to the following: a. Basis of consolidation b. Depreciation methods c. Amortization of intangibles d. Inventory pricing e. Accounting for recognition of profit on long-term constructiontype contracts f. Recognition of revenue from franchising and leasing operations.
PROFESSIONAL SIMULATION Note: This assignment is available on the Kieso website. Analysis The current-ratio increase is a favorable indication as to solvency, but alone tells little about the going-concern prospects of the client. From this ratio change alone, it is impossible to know the amount and direction of the changes in individual accounts, total current assets, and total current liabilities. Also unknown are the reasons for the changes. The acid-test ratio is an unfavorable indication as to solvency, especially when the current ratio increase is also considered. This decline is also unfavorable to the going-concern prospects of the client because it reflects a declining cash position and raises questions as to reasons for the increases in other current assets, such as inventories. The increase in the ratio of property, plant, and equipment to stockholders’ equity cannot alone tell anything about either solvency or going-concern prospects. There is no way to know the amount and direction of the changes in the two items. If assets increased, one must know whether the new assets are immediately productive or need further development. A reduction in stockholders’ equity at this point would cause much concern for the creditors of this client. The decrease in the ratio of sales to stockholders’ equity is in itself an unfavorable indicator because the most likely reason is a sales decline. However, this decline, which is more relevant to going-concern prospects than to solvency, is largely offset by the fact that net income has significantly increased. The increase in net income is a favorable indicator for both solvency and going-concern prospects although much depends on the quality of receivables generated from sales and how quickly they can be converted into cash. A significant factor here may be that despite a decline in sales, the client’s management has been able to reduce costs to produce this increase. Indirectly, the improved income picture may have a favorable impact on solvency and going-concern potential by enabling the client to borrow currently to meet cash requirements.
PROFESSIONAL SIMULATION (Continued) The 32-percent increase in earnings per common share, which is identical to the percentage increase in net income, is an indication that there has probably been no change in the number of shares of common stock outstanding. This in turn indicates that financing was not obtained through the issuance of common stock. It is not possible to reach conclusions about solvency and going-concern prospects without additional information about the nature and extent of financing. The percentage increases in book value per common share demonstrate nothing so far as solvency and going-concern potential are concerned. It is probable that the smaller percentage increase in the current year only reflects the larger base value created in the preceding year. It is not possible to tell from these figures what the dividend policy of the client is or whether there is an increase in net assets which is capable of generating future earnings, thus making it possible to raise capital for current needs by the issue of additional common stock. The collective implications of these data alone are that the client entity is about as solvent and as viable as a going concern at the end of the current year as it was at the beginning although there may be a need for short-term operating cash. Explanation The creditors will probably ask for the information listed below to overcome the limitations inherent in the ratios discussed above and to obtain more evidence to support the conclusions drawn from them. 1.
Additional ratios and other comparative data may be requested. They are likely to include such items as the following: (a) Changes in current assets other than quick assets. (b) Accounts receivables turnover, inventory turnover, and the number of days it takes to complete the cycle from cash to inventories to receivables to cash. (c) Liabilities to stockholders’ equity.
2.
The creditors will probably want explanations for the changes in ratios during the current year. The client should be prepared to respond to questions about the age and collectibility of the receivables, the condition and salability of the inventories, the cause of the quickasset position in the current year, the nature of increases in property,
PROFESSIONAL SIMULATION (Continued) plant, and equipment and their potential for providing greater sales or cost reductions in the future, the presence of long-term debt and the dates when it must be repaid, and the manner of controlling costs so that a larger net income was shown in the current year. (The comparative financial statements themselves will answer many of these questions and will provide insight into the client’s capability of meeting current obligations as well as continuing profitable operations.) The client may also be expected to provide information about future plans and projections. 3.
The creditors may also ask for ratios and related information for several recent years. These data may demonstrate trends and can be compared to data for other companies and for the industry.
Although a quick evaluation of a reporting entity can be made using only a few ratios and comparing these with past ratios and industry statistics, the creditors should realize the limitations of such analysis even from the best prepared statements carrying a CPA’s unqualified opinion. A limitation on comparisons with industry statistics or other companies within the industry exists because material differences can be created through the use of alternative (but acceptable) accounting methods. Further, when evaluating changes in ratios or percentages, the evaluation should be directed to the nature of the item being evaluated because very small differences in ratios or percentages can represent significant changes in dollar amounts or trends. The creditors should evaluate conclusions drawn from ratio analysis in the light of the current status of, and expected changes in, such things as general economic conditions, the client’s competitive position, the public’s demand (for the product itself, increased quality of the product, control of noise and pollution, etc.), and the client’s specific plans.
IFRS CONCEPTS AND APPLICATION IFRS24-1 The IFRS standards addressing related party disclosures are: IAS 1 (“First Time Adoption of IFRS”); IAS 24 (“Related Party Disclosures”); disclosure and recognition of post-balance sheet events in IAS 10 (“Events after the Balance Sheet Date”); segment reporting provisions in IFRS 8 (“Operating Segments”); and interim reporting requirements are presented in IAS 34 (“Interim Financial Reporting”).
IFRS24-2 There are two types of subsequent events:
(a) (b) (c) (d) (e) (f) (g) (h)
(1)
Those which affect the financial statements directly and should be recognized therein through appropriate adjustments.
(2)
Those which do not affect the financial statements directly and require no adjustment of the account balances but whose effects may be significant enough to be disclosed with appropriate figures or estimates shown.
Probably adjust the financial statements directly. Disclosure. Disclosure. Disclosure. Neither adjustment nor disclosure necessary. Neither adjustment nor disclosure necessary. Probably adjust the financial statements directly. Neither adjustment nor disclosure necessary.
IFRS24-3 (1)
Net income will decrease by $10,000 ($160,000 –$170,000) as a result of the adjustment of the liability. The settlement of the liability is the type of subsequent event which provides additional evidence about conditions that existed at the statement of financial position date.
(2)
The flood loss ($80,000) is an event that provides evidence about conditions that did not exist at the statement of financial position date but are subsequent to that date and does not require adjustment of the financial statements.
IFRS24-4 (a) The issuance of ordinary shares is an example of a subsequent event which provides evidence about conditions that did not exist at the statement of financial position date but arose subsequent to that date. Therefore, no adjustment to the financial statements is recorded. However, this event should be disclosed either in a note, a supplemental schedule, or even proforma financial data. (b) The changed estimate of income taxes payable is an example of a subsequent event which provides additional evidence about conditions that existed at the statement of financial position date. The income tax liability existed at December 31, 2014, but the amount was not certain. This event affects the estimate previously made and should result in an adjustment of the financial statements. The correct amount ($1,320,000) would have been recorded at December 31 if it had been available. Therefore, Keystone should increase income tax expense in the 2014 income statement by $220,000 ($1,320,000 – $1,100,000). In the statement of financial position, income taxes payable should be increased and retained earnings decreased by $220,000.
IFRS24-5 1. 2. 3.
(a) (c) (b)
4. 5. 6.
(b) (c) (b)
7. 8. 9.
(c) (c) (a)
10. 11. 12.
(c) (a) (b)
IFRS24-6 Interim reports are unaudited financial statements normally prepared four times a year. A complete set of interim financial statements is often not provided because this information is not deemed crucial over a short period of time; the income figure has much more relevance to interim reporting. The accounting problems related to the presentation of interim data are as follows: (a) The difficulty of allocating costs, such as income taxes, pensions, etc., to the proper quarter. (b) Problems of fixed cost allocation. IFRS24-7 A company records losses from inventory write-downs in an interim period similar to how it would record them in annual financial statements. However, if an estimate from a prior interim period changes in a subsequent interim period of that year, the write-down is adjusted in the subsequent interim period. IFRS24-8 While U.S. GAAP has a preference for the integral approach, IFRS leans toward the discrete approach to interim reports. Thus, if an IFRS company expenses interim amounts, like advertising expenditures that could benefit later interim periods, it may be difficult to compare to a U.S. company that would spread the cost across interim periods. IFRS24-9 (a)
1.
The company should report its quarterly results as if each interim period is discrete.
2.
Under the discrete approach the amounts should be reported as the company’s revenue and expenses would be reported as follows on its quarterly report prepared for the first quarter of the 2014–2015 fiscal year:
IFRS24-9 (Continued) Sales revenue Cost of goods sold Variable selling expenses Fixed selling expenses Advertising Other
$60,000,000 36,000,000 1,000,000 2,000,000 1,000,000
Sales revenue and cost of goods sold and other expenses 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. (b)
The financial information to be disclosed to its shareholders in its quarterly reports as a minimum include: 1.
2. 3.
4. 5. 6. 7. 8. 9.
Statement that the same accounting policies and methods of computation are followed in the interim financial statements as compared with the most recent annual financial statements or, if those policies or methods have been changed, a description of the nature and effect of the change. Explanatory comments about the seasonality or cyclicality of interim operations. The nature and amount of items affecting assets, liabilities, equity, net income, or cash flows that are unusual because of their nature, size, or incidence. The nature and amount of changes in accounting policies and estimates of amounts previously reported. Issuances, repurchases, and repayments of debt and equity securities. Dividends paid (aggregate or per share) separately for ordinary shares and other shares. Segment information, as required by IFRS 8, “Operating Segments.” Changes in contingent liabilities or contingent assets since the end of the last annual reporting period. Effect of changes in the composition of the company during the interim period, such as business combinations, obtaining or losing control of subsidiaries and long-term investments, restructurings, and discontinued operations.
IFRS24-9 (Continued) 10.
Other material events subsequent to the end of the interim period that have not been reflected in the financial statements for the interim period.
IFRS24-10 (a) According to IAS 1, paragraph 117, “An entity shall disclose in the summary of significant accounting policies:
(b)
(1)
the measurement basis (or bases) used in preparing the financial statements, and
(2)
the other accounting policies used that are relevant to an understanding of the financial statements.” A few examples taken from IAS 1: Paragraph 118: It is important for an entity to inform users of the measurement basis or bases used in the financial statements. Paragraph 120: Each entity considers the nature of its operations and the policies that the users of its financial statements would expect to be disclosed for that type of entity. Paragraph 122: An entity shall disclose, in the summary of significant accounting policies or other notes, the judgements, apart from those involving estimations (see paragraph 125), that management has made in the process of applying the entity’s accounting policies and that have the most significant effect on the amounts recognised in the financial statements. Paragraph 124: Some of the disclosures made in accordance with paragraph 122 are required by other IFRSs. For example, IAS 27 requires an entity to disclose the reasons why the entity’s ownership interest does not constitute control, in respect of an investee that is not a subsidiary even though more than half of its voting or potential voting power is owned directly or indirectly through subsidiaries. IAS 40 Investment Property requires disclosure of the criteria developed by the entity to distinguish investment property from owner-occupied property and from property held for sale in the ordinary course of business, when classification of the property is difficult.
IFRS24-11 (a) The specific items M&S discusses in Note 1 are basis of preparation; accounting convention; basis of consolidation; subsidiaries; revenue; dividends; pensions; intangible assets; property, plant and equipment; leasing; leasehold prepayments; cash and cash equivalents inventories; provisions; share-based payments; foreign currencies; taxation; financial instruments; derivative financial instruments and hedging activities; embedded derivatives critical accounting estimates and judgments and non-GAAP performance measures. (b) M&S reported segments for its UK and International Operations. UK was further segmented into general merchandise and food. International was segmented into franchised and owned. The UK segment is the largest segment in terms of revenue and assets. M&S does not report its largest customer. (c) No interim information is reported.