1.The Audit Reportfaculty.chicagobooth.edu/philip.berger/teaching/B30116... · Web viewThomson...

Business 30116 (sections 01, 02, & 81) Course Pack

Accounting and Financial Analysis I

Philip G. Berger

Wallace W. Booth Professor of Accounting

Booth School of Business

University of Chicago

Chicago, IL

Autumn 2011

Class Notes

Professor Berger B30116 – Table of Contents Autumn 2011

Chapter Name of Item page number

A. First Class Assignment............................................ 3

B. Syllabus...................................................... 7

C. FASB and IFRS Standards Listing..................................... 15

1. The Audit Report1a. Audit Report Notes..................................... 191b. Blyth, Inc. (CASE #1).................................. 251c. “New SEC Rules Will Likely Draw More 8-K Filings”...... 411d. “Not Everyone Hates SarbOx”............................ 43

2. Income Taxes and Deferred Income Tax Accounting2a. Introduction to Deferred Taxes......................... 472b. Details on Deferred Taxes.............................. 492c. Example of Temporary and Permanent Differences......... 532d. MDC Manufacturing Problem.............................. 552e. Taxes – Lecture 1 Slides............................... 572f. Taxes – Lecture 2 Slides............................... 692g. Tax Disclosures – Cheat Sheet.......................... 732h. Monterey Pasta Company (CASE #2)....................... 772i. Self-Study Problem 1 – Anheuser-Busch.................. 892j. Solution to Self-Study Problem 1....................... 952k. Self-Study Problem 2 – Illustrative Example............ 972l. Solution to Self-Study Problem 2....................... 99

3. Revenue Recognition & Securitization3a. Revenue Recognition Notes.............................. 1073b. Self-Study Problem 3 – U.S. Air........................ 1113c. Solution to Self-Study Problem 3....................... 1213d. Installment Method Notes............................... 1233e. Factoring of Accounts Receivable - Notes............... 1273f. Patten Corporation (CASE #3)........................... 1313g-(i)Securitization Notes .................................. 1613g-(ii)More Details on SPEs and Securitization............... 1713h. Overview of FASB Statement No. 140..................... 1813i. Navistar Financial (CASE #4) .......................... 185

4. Statement of Cash Flows Analysis4a. SCF Classification Issues.............................. 203

5. Ratio and Profitability Analysis 5a. Profitability Analysis................................. 2135b. Ratio Analysis......................................... 215

6. Capitalization and Write-Offs6a. Interest Capitalization – An Illustration.............. 2216b. Long-Lived Assets Slides............................... 2236c. McCormick and Co. (CASE #5)............................ 2316d. Sunbeam Corporation (A) (CASE #6)...................... 237

Professor Berger B30116 - Table of Contents (continued) Autumn 2011


7. Intercorporate Investments7a. Investments, Significant Influence & Control, Notes.... 2657b. Purchase Accounting: A Simple Example ................. 2717c. Purchase Accounting: A Simple Example (Solution Notes) 2737d. The Equity Method: A Simple Example.................... 2757e. The Equity Method: A Simple Example (Solution Notes)... 2777f. “Mishmash Accounting” ................................. 2817g. “The Real Thing: Bottling Plan Taps Coke's Profits” ... 2837h. “Firms Facing Rule to Include Results From Minor Stakes” 2857i. New FASB Rule on Accounting for Minority Stakes........ 2877j. The Coca-Cola Company (CASE #7) ....................... 291

8. Long-Term Debt Overview8a. Long-Term Debt Obligations, Slides...................... 3058b. Bonds – Example Problem................................. 3078c. Convertible Debentures – Example Problem................ 3098d. Super-LYONs............................................. 311

9. Long-Term Debt Application9a. “Kirk Kerkorian’s Personal Money Machine”............... 3159b. Metro-Goldwyn-Mayer (CASE #8) .......................... 319

10. Lease Accounting Overview10a. Leases, Slides.......................................... 32510b. Transforming Capital to Operating Leases (& vice-versa). 32910c. Leases – Example Problem................................ 33110d. Giant Food Inc. – Lessee Accounting (CASE #9) .......... 33510e. Lessor Accounting....................................... 339

11. Capital Leases for the Lessor: Application11a. Crime Control – Notes on how to solve question 2........ 34311b. “You Better Believe”.................................... 34511c. Crime Control (CASE #10)................................ 347

12. Analysis of Earnings Quality12a. Prototype Company – Income Statement Format............ 37712b. The Seven Financial Statement Shenanigans.............. 37912c. Red Flags of Questionable Earnings Quality............. 38112d. The Role of Accounting Analysis........................ 38312e. Wired Wanda’s (CASE #11)............................... 385

13. Accounting and Organizational Form13a. “The Squawk Over Boston Chicken”....................... 39713b. Boston Chicken, Inc. (CASE #12)........................ 401

14. Employee Stock Options and Earnings Per Share Calculations14a. Notes on Employee Stock Options ....................... 41914b. Notes on EPS Calculations.............................. 42514c. Microsoft Corporation (CASE #13)....................... 42714d. Who Rules Accounting?.................................. 437

Professor Berger B30116 - Table of Contents (continued) Autumn 2011


15. Course Summary Notes.............................................. 445

16. Homework #1 Questions (Due Oct. 15th/16th).......................... 453

17. Homework #1 Financial Statements...................................... 463

18. Homework #2 Questions (Due Nov. 5th/6th)............................ 477


20. Homework #3 Questions (Due June 1st/2nd)............................ 509


22. Sample Exam Problems.............................................. 531

23. Solutions to Sample Exam Problems..................................... 605

24. Spring 2003 Midterm Exam Questions, Financial Statements, and Solutions........... 621

25. Spring 2003 Final Exam Questions, Financial Statements, and Solutions.............. 663

26. Fall 2010 Midterm Exam Questions, Financial Statements, and Solutions............. 715

27. Fall 2010 Final Exam Questions, Financial Statements, and Solutions................ 743

University of ChicagoGraduate School of Business

Accounting and Financial Analysis I – B30116

Sections 01, 02, and 81 – Spring 2011

First Day Assignment:

As indicated on the syllabus in this course packet, please read the chapter 1 packet notes on The Audit Report and then prepare a write-up for hand-in of CASE #1: BLYTH, INC . The write-up should be about three (3) to five (5) pages long (using double spacing) and should answer the four questions on the first page of the case. Please include your name and student ID number on your case write-up. The write-up will count for 5% of your course grade, but will be graded as much on effort as on correctness.

As described in the syllabus, the first day assignment write-up is to be done individually and I will be cold-calling people on their case write-ups in class. Cold-calls count for 10% of your course grade. You will be submitting your case via the Chalk Digital Drop Box, but you may also want to bring a printed copy of your case with you to help in answering if you are called on.

B30116 – Berger Chapter 1 - The Audit Report 1. The Audit Report

I. Role of the AuditorA. Auditors attest to the financial statements which are prepared by management.

1. Auditors do not attest to the quality of the firm as an investment.2. Audits are not designed solely to detect fraud.

B. Who Audits the Auditors?1. Auditors can be held liable for negligence.2. After the Sarbanes-Oxley Act of 2002 (SOX), audits of publicly traded companies in

the United States are overseen by the Public Company Accounting Oversight Board (PCAOB).

3. The value of an auditor to a client is based upon the auditor's reputation. Thus, auditors' desire to maintain the value of their reputation by avoiding signing off on statements that are subsequently revealed to be faulty.

II. The Audit ReportA. The Standard Report -- 4 items (the items are sometimes displayed as separate

paragraphs, but are sometimes grouped together in less than 4 paragraphs).1. Item 1 -- What statements have been audited? Who is ultimately responsible for the

statements? What responsibility is the auditor assuming?2. Item 2 -- What is the basis for the auditor’s opinion? What work was done?3. Item 3 -- The auditor’s opinion regarding the financial statements.

a. unqualified -- statements in conformity with GAAPb. qualified -- statements in conformity with GAAP except for some particular items

1. scope of the audit was limited -- statement of what balances were not audited2. inadequate disclosure regarding some balances or events -- audit report

usually supplements the disclosure3. GAAP violation regarding some balances -- audit report usually quantifies

magnitude of the violationc. disclaimer of opinion -- scope of audit too limited to warrant an opinion d. adverse -- deviations from GAAP are so extensive that a qualified opinion is not

even possible (extremely rare)4. Item 4 – This paragraph was introduced after enactment of SOX [it became effective for the first time for fiscal years ending after November 15, 2004]. In it, the auditor

Item 1a Audit Report Notes Page 1 of 6

B30116 – Berger Chapter 1 - The Audit Report

offered [as of the time of the Blyth case] an opinion on both internal control effectiveness and management’s assessment of internal control effectiveness [the external auditor no longer expresses an opinion about management’s assessment of the internal controls].

An example of the standard version of Item 4 as of the time of the Blyth case follows (taken from Microsoft’s annual report for the year ended June 30, 2005):

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of June 30, 2005, based on the criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated August 23, 2005 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

An example of the standard version of Item 4 as of today follows (taken from Microsoft’s annual report for the year ended June 30, 2008):

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of June 30, 2008, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated July 31, 2008 expressed an unqualified opinion on the Company’s internal control over financial reporting.

B. Additional Items (beyond the 4 standard items)1. uncertainties highlighted2. changes in accounting policy highlighted3. emphasis of matter -- auditor wants to highlight a particular issue for the reader4. going concern -- auditor wants to express doubt regarding the firm's ability to continue

for the next fiscal year. In other words, a going-concern opinion indicates that the auditor thinks the company may not avoid bankruptcy during the next 12 months.



The Audit ReportAuditor Changes -- Some Observations

Current SEC requirements [effective since August 23, 2004] require that upon a change in auditor, a registrant must notify the public by filing certain information on Form 8-K within four business days of the change [prior to August 23, 2004 the registrant had up to 15 calendar days to file the 8-K]. The 8-K filed for the auditor change must provide the following [per SEC Regulation S-K, item 304(a)]:

o Whether the auditors resigned, declined to stand for reelection, or were dismissed, as well as the date of the auditor change.

o The type of audit report issued for the last two years, and whether it contained anything other than an unqualified opinion (e.g., going concern, disclaimer, adverse opinion, or scope limitation).

o Whether the decision to change accountants was recommended or approved by the board of directors or the audit committee.

o Whether there were any disagreements with the auditors, and the nature of such disagreements.

o Whether any of the following reportable events occurred, and their nature: Internal controls necessary to develop reliable financial statements don’t exist; Management’s representation can’t be relied on, or the auditors are unwilling

to be associated with the financial statements prepared by management; Audit scope needs to be expanded; or Other information has arisen that materially impacts previous audit reports or

their underlying financial statements.o The name of the newly engaged auditors, and the effective date of engagement.o Any consultation with the new auditors regarding accounting principles, potential

opinions, or any matter that was subject to disagreements or reportable events with the predecessor auditors. If any of these have occurred, the nature of each must be described and possibly filed as an exhibit.

o The 8-K must be provided to the previous auditors. They must state their agreement or disagreement with the filing and this response should be included with the 8-K as an exhibit (previous auditors’ response letter is usually very brief to avoid controversy and reduce lawsuits).



Auditor changes result from either auditor resignations or client-initiated dismissals. Auditor resignations are more likely to occur when litigation risk (with regard to the audit report) increases or when the audited company’s financial health deteriorates. Client-initiated dismissals occur more frequently over disagreements about such issues as internal control weaknesses and the reliability of the audited company’s financial reporting.

A study by Turner, Williams and Weirich (2005) of all auditor changes filed on form 8-K during 2003 and 2004 reveals the following:

o Auditor changes are not infrequent, and have continued to increase in recent years. There were 905 companies registered with the SEC that changed auditors in 2003 and 1,609 in 2004.

o Although the filings reveal whether the auditor resigned or was fired, the underlying reason for the auditor change is not disclosed in about 2/3 of the filings. Thus, investors should always be cautious when a company announces an auditor change because it may be related to underlying but undisclosed problems in the company’s financial reporting and accounting practices. Companies often attempt to hide the real reason behind auditor changes, so investors often have to read the disclosure carefully to “dig out” the reason(s).

o About 1/3 of registrants reporting changes in auditors also had a going concern opinion included in the audit report of the departing auditor.

o About 2% of registrants reporting auditor changes in 2003 or 2004 also restated their financial statements around the time of the auditor change. About half of these companies also reported internal control weaknesses. All of these auditor changes occurred after the restatements and appeared to be related to the restatements (which may strain the auditor-client relationship).

o About 2% of registrants reporting auditor changes in 2003 or 2004 also reported accounting disagreements with the departing auditor. Companies and their auditors are required to report disagreements about accounting matters even if the disagreement is subsequently resolved to the auditor’s satisfaction [think about why the rule works in this manner]. Accounting disagreements are important because they may indicate that the company is attempting to apply improper, aggressive, or non-GAAP accounting that the auditor is unwilling to accept. A company will



sometimes fire an auditor that disagrees with it and subsequently hire a more conciliatory one (this is often referred to as “opinion shopping”).

On average, auditor changes, have not been consistently associated with significant negative abnormal returns. (See, for example, Johnson and Lys (1990)).

If switches are partitioned into those that occurred after a disagreement disclosed in an 8K filing and those that reported no such disagreement, then the following average results are attained. (See, for example, Dhaliwal, Schatzberg, and Trombley (1993))

o Negative abnormal returns are observed for the disagreement subsample around the 8K filing and positive abnormal returns are observed for the remaining subsample. The magnitude of the negative abnormal return is larger.

o The disagreement subsample exhibits poorer financial performance and increasing leverage before the disagreement, and deteriorating financial performance and increasing leverage after, relative to the remaining subsample.

o The disagreement subsample has positive abnormal returns in the 12 month's after the disclosure (greater than 15%) while the remaining subsample exhibits slightly positive abnormal returns over the same period.

The impact of having a going concern opinion included as an additional item in a firm’s audit report has also been examined by a number of academic studies. These studies fall into five categories – four types of stock market effect studies, and a fifth type of study that has directly investigated how useful a going concern opinion is in predicting bankruptcy.

o (1) With regard to stock price reactions, there is a short-run negative stock price reaction to the announcement of going concern opinions [Fleak and Wilson (1994); Carlson, Glezen and Benefield (1998)].

o (2) The short-run reaction around the announcement underestimates the total economic effect, however, as the studies above also find a negative price reaction in the period leading up to the going concern announcement. This suggests that information regarding the going concern status of the firm is leaking to the market in the period prior to the issuance of the audit report.

o (3) In addition, the combined reaction during the pre-announcement plus announcement periods may represent an under-reaction to the news content of the



going concern opinion, as the stock returns of firms receiving going concerns are abnormally low for anywhere from one quarter to one year following the going concern announcement [Elliott (1982); Taffler, Lu and Kausar (2004); Kausar, Taffler and Tan (2009)].

o (4) A going concern audit opinion if not a prediction by the auditor about bankruptcy and U.S. auditing standards are explicit in saying that users of financial statements should not interpret a going concern opinion as a prediction of bankruptcy [why do you think the auditor issues a going concern opinion if it is not an attempt to make a prediction about bankruptcy?]. Nevertheless, going concern opinions do indicate an increased likelihood of bankruptcy. This link has been studied indirectly by examining how the stock price reaction to a bankruptcy announcement is affected by having a preceding going concern audit opinion. Chen and Church (1996), Holder-Webb and Wilkins (2000) and Tan (2000) all find that the negative price reaction to a bankruptcy announcement is reduced when it is preceded by a going concern audit opinion. This suggests that the going concern opinion causes investors to increase the probability they assign to a bankruptcy for the firm.

o (5) Other papers directly examine how useful a going concern opinion is in predicting bankruptcy. Hopwood, McKeown and Mutchler (1989) find that going concern audit opinions provide useful information for predicting bankruptcy beyond what is obtainable from financial statement data alone. While going concern opinions are a useful addition to other variables in predicting bankruptcy, they do not have great predictive power by themselves. Thus, Raghunandan and Subramanyam (2003) find that traditional bankruptcy prediction models do a better job of forecasting bankruptcy than the existence of a going concern audit opinion does.

The Audit Report – Summary

1. Auditor reports are useful because they contain information regarding the following.

. What information was audited?

. Highlights of accounting issues the auditor deems important.

. Highlights of other information the auditor deems important.

. Identification of the auditor allows the reader to infer auditor changes.

2. Analyze auditor changes and attempt to assess the reasons for auditor changes.



CASE #1 Blyth, Inc.

1. The auditor's report for the fiscal 2003 (i.e., year ended January 31, 2004) financial statements of

Blyth, Inc. is on page 2 of the case. Items from the fiscal 2003 10-K filing that are related to the

auditor's report follow on pages 3 and 4.

a. What standard information relevant to users of Blyth's financial statements is contained in the

2003 auditor's report?

b. How does the 2003 audit report depart from the standard audit report? What is the purpose

served by the departure(s)?

c. What purposes are served by the additional items from the 10-K that follow the auditor’s report?

2. The auditor's report for the fiscal 2004 (i.e., year ended January 31, 2005) financial statements of

Blyth, Inc. is on page 5. An item from the fiscal 2004 10-K filing that is related to the auditor's report

is on pages 6 and 7, and a 10-K schedule mentioned in the fiscal 2004 audit report is on page 8. The

auditor's report for the fiscal 2005 (i.e., year ended January 31, 2006) financial statements of Blyth,

Inc. is on page 9 and a 10-K schedule mentioned in the fiscal 2005 audit report is on page 10. Repeat

questions a, b and c for the fiscal 2004 and 2005 audit reports and related items from the 10-K filings.

3. Three mandatory disclosures filed in Blyth’s 8-K reports are on pages 11 – 14 of the case. Why does

the SEC require each of the three disclosures? How are they useful? How might they be deficient?

4. Two newswire stories are on pages 15 and 16 of the case. Does the first article provide information

regarding the dismissal of PricewaterhouseCoopers (PwC) that is not in first of the 8-K mandatory

disclosures cited in question 3? Notice that the second newswire article is dated on April 14, 2004,

which is after the filing date of the first 8-K cited in question 3, but before the dates of the second and

third 8-Ks cited in question 3. Does the second newswire article provide information regarding the

dismissal of PwC that is not in the first of the three 8-K filings? Does it provide information

regarding PwC’s dismissal that is not in any of the three 8-K filings? Speculate as to why Blyth, Inc.

issued the press release on April 14, 2004 but did not file the closely related 8-K filing with the

Securities and Exchange Commission (SEC) until April 20.

Item 1b Blyth, Inc. (CASE #1) Page 1 of 16


BLYTH, INC. 10-K FOR YEAR ENDED JANUARY 31, 2004

BLYTH, INC. JANUARY 31, 2004REPORT OF INDEPENDENT AUDITORS

To the Board of Directors and Stockholders of Blyth, Inc:

In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of earnings, stockholders equity and cash flows present fairly, in all material respects, the financial position of Blyth, Inc. and Subsidiaries (the Company ) at January 31, 2004 and January 31, 2003, and the results of their operations and their cash flows for each of the three years in the period ended January 31, 2004 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for goodwill and intangible assets in fiscal 2003. As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for derivative instruments and hedging activities in fiscal 2002.

As discussed in Note 2 to the consolidated financial statements, the Company has restated its segment disclosures for the years ended January 31, 2003 and January 31, 2002 to reflect a revision in its reportable segments. Additionally, as also discussed in Note 2, the Company has restated its consolidated financial statements for the year ended January 31, 2003 to reflect an increase in the cumulative effect of the change in accounting relating to the adoption of SFAS 142 Goodwill and Other Intangible Assets. PRICEWATERHOUSECOOPERS LLP

Stamford, Connecticut April 26, 2004


B30116 – Berger Chapter 1 - The Audit Report BLYTH, INC. 10-K FOR YEAR ENDED JANUARY 31, 2004

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

(a) Previous independent accountants

On March 16, 2004, the Board of Directors of the Company, acting upon the recommendation of the Audit Committee, dismissed PricewaterhouseCoopers LLP ( PwC ) as the independent accountants of the Company, effective as of April 26, 2004, the date of its report on the financial statements of the Company as of January 31, 2004 and for the year then ended, which financial statements are included in this Annual Report on Form 10-K.

PwC’s reports on the financial statements of the Company for the fiscal years ended January 31, 2003 and 2004 did not contain any adverse opinion or disclaimer of opinion and were not qualified or modified as to uncertainty, audit scope or accounting principle.

In connection with its audits of the financial statements of the Company for the two most recent fiscal years ended January 31, 2004, and through April 30, 2004, there were no disagreements with PwC on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which disagreements, if not resolved to PwC’s satisfaction, would have caused PwC to make reference thereto in their reports on the Company’s financial statements for such fiscal years, except as follows: In connection with its audit of the financial statements of the Company as of January 31, 2004 and for the year then ended, PwC advised the Company in early April, 2004, that it believed that the Company’s then current designation of two reporting segments did not comply with the requirements of Statement of Financial Accounting Standards No. 131 (Disclosures about Segments of an Enterprise and Related Information), a position with which the Company did not agree. The Audit Committee has discussed the subject of the designation of operating segments with PwC. The Company has authorized PwC to respond fully to the inquiries of Deloitte & Touche LLP, the Company’s independent accountants for the fiscal year ending January 31, 2005, concerning this disagreement.

In response to PwC’s advice that it believed that the Company’s designation of two reporting segments did not comply with the requirements of SFAS 131, the Company reevaluated its reporting segments as at the end of each of its fiscal years ended January 31, 2004, 2003 and 2002. As a result of such reevaluation, the Company determined to report its financial results in five reporting segments in fiscal 2004, and four reporting segments in fiscal 2003 and fiscal 2002. This revision of segments had the related effect of requiring changes in the Company’s reporting units for purposes of goodwill impairment reviews under Statement of Financial Accounting Standards No. 142 (Goodwill and Other Intangible Assets), retroactive to the February 1, 2002 adoption date of SFAS 142. This resulted in the need to perform impairment reviews of several additional reporting units as of February 1, 2002, and each subsequent year-end balance sheet date thereafter. These impairment reviews have indicated the need to record additional impairment charges as of the February 1, 2002 adoption of SFAS 142, specifically to write off $20.9 million in goodwill associated with the 1999 acquisition of the Gies Group and $6.3 million in goodwill associated with the 1999 acquisition of the Colony Group. Both of these businesses are components of the Wholesale Home Fragrance reporting segment. The Company’s fiscal 2003 financial statements have been restated to reflect the recording of these $27.2 million in goodwill impairment charges as part of the cumulative effect of adopting SFAS 142 as of February 1, 2002.



During each of the two years in the period ended January 31, 2004, and through April 30, 2004, there were no reportable events (as defined in Regulation S-K Item 304(a)(1)(v)), except for the following event: On April 21, 2004, PwC advised the Company that it had identified an internal control issue which PwC considered to be a material weakness in that changes in circumstances, internal reporting and management structures appeared not to have been properly evaluated by management or considered in connection with ongoing compliance with SFAS 131 and SFAS 142 guidance. PwC recommended that the Company should (A) have a process in place to evaluate changes in management structure and reporting to the chief operating decision maker that would effect segment determination, (B) strengthen procedures to monitor all changes in operations that impact accounting and reporting matters and (C) ensure that it has sufficient staffing in its financial reporting function, with appropriate technical qualifications and tasked with ensuring ongoing compliance with relevant accounting and financial reporting requirements.

(b) New independent accountants

On March 16, 2004, the Board of Directors of the Company, acting upon the recommendation of the Audit Committee, appointed Deloitte & Touche LLP as the independent accountants of the Company for the fiscal year ending January 31, 2005.

ITEM 9A. CONTROLS AND PROCEDURES

(a) Evaluation of disclosure controls and procedures.

The Company’s management, with the participation of its principal executive officer and its principal financial officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Securities Exchange Act of 1934 (Exchange Act) Rules 13a-15(e) or 15d-15(e)) as of the end of the period covered by this report as required by paragraph (b) of Exchange Act Rules 13a-15 or 15d-15. Based upon this evaluation, the Company’s principal executive officer and its principal financial officer have concluded that our disclosure controls and procedures are effective as of the end of the period covered by this report. Nonetheless, in light of PwC’s advice to the Company that it has identified an internal control issue which PwC considers to be a material weakness, as described in Item 9(a) above, the Company, and its principal executive officer and its principal financial officer, recognize that the Company may need to make improvements in its internal controls, particularly insofar as they relate to ongoing compliance with SFAS 131 and SFAS 142 guidance, having in mind the recommendations that have been made by PwC, as described in Item 9(a) above. However, the Company and its principal executive officer and its principal financial officer have not yet determined what action, if any, the Company should take in response to PwC’s recommendations.

(b) Changes in internal control over financial reporting.

There was no change in the Company s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange Act Rules 13a-15 or 15d-15 that occurred during the fourth fiscal quarter of fiscal year 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.





We have audited the accompanying consolidated balance sheet of Blyth, Inc. and subsidiaries (the Company) as of January 31, 2005, and the related consolidated statements of earnings, stockholders equity, and cash flows for the fiscal year then ended. Our audit also included the financial statement schedule listed in the index in Item 15 in the Company’s Annual Report on Form 10-K for the year ended January 31, 2005. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audit. The financial statements of Blyth, Inc. for the years ended January 31, 2004 and 2003 were audited by other auditors whose report, dated April 26, 2004, except for Note 18, as to which the date is April 8, 2005, on those statements expressed an unqualified opinion and included an explanatory paragraph regarding the change in the Company’s method for accounting for goodwill and intangible assets in fiscal 2003 as discussed in Note 1 to the financial statements.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of January 31, 2005, and the results of its operations and its cash flows for the period ended January 31, 2005, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company s internal control over financial reporting as of January 31, 2005, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated April 15, 2005 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an adverse opinion on the effectiveness of the Company’s internal control over financial reporting.

DELOITTE & TOUCHE LLP

April 15, 2005 Chicago, Illinois



ITEM 9A. CONTROLS AND PROCEDURES

(d) Report of Independent Registered Public Accounting Firm

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of Blyth, Inc.:

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting ( Management s Report ), that Blyth, Inc. and subsidiaries (the Company) did not maintain effective internal control over financial reporting as of January 31, 2005, because of the effect of the material weakness identified in management’s assessment based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may


B30116 – Berger Chapter 1 - The Audit Report become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

A material weakness is a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weakness has been identified and included in management’s assessment. At January 31, 2005, the Company had not designed and implemented effective controls over: (1) the process to identify, quantify and account for income tax contingencies; and (2) the reconciliation of the recorded amounts in the prior year of its tax accounts and balances to its tax return. In addition, the Company’s controls over the reconciliation of its effective tax rate to its statutory rate did not operate effectively. Although there were no misstatements identified, the combination of the two design deficiencies and the operating deficiency results in more than a remote likelihood that a material misstatement to the current and deferred tax asset and liability accounts, the income tax provision and the related disclosures will not be prevented or detected in the annual or interim consolidated financial statements.

This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the consolidated financial statements and financial statement schedule as of and for the year ended January 31, 2005 of the Company and this report does not affect our report on such consolidated financial statements and financial statement schedule.

In our opinion, management’s assessment that the Company did not maintain effective internal control over financial reporting as of January 31, 2005, is fairly stated, in all material respects, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, the Company has not maintained effective internal control over financial reporting as of January 31, 2005, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and financial statement schedule.


April 15, 2005 Chicago, Illinois



ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

SCHEDULE II VALUATION AND QUALIFYING ACCOUNTSFor the years ended January 31, 2003, 2004 and 2005

(In thousands)

Description Balance Acquired Charged Deductions Balance at Balances to at Beginning Costs End of of Period and Period Expenses 2003 Allowance for $ 2,804 $ 255 $ 3,853 $ (2,819 ) $ 4,093 doubtful accounts Income tax valuation 1,841 - 500 (1,324 ) 1,017 allowance Inventory reserve 20,502 400 22,709 (16,466 ) 27,145

2004

Allowance for $ 4,093 $ 623 $ 1,809 $ (2,055 ) $ 4,470 doubtful accounts Income tax valuation 1,017 1,656 - - 2,673 allowance Inventory reserve 27,145 1,343 15,462 (20,970 ) 22,980

2005

Allowance for $ 4,470 $ 538 $ 1,371 $ (2,351 ) $ 4,028 doubtful accounts Income tax valuation 2,673 - 1,565 (200 ) 4,038 allowance Inventory reserve 22,980 1,730 14,130 (16,407 ) 22,433

Page S-2 -------------------------------------------------------------------------------





We have audited the accompanying consolidated balance sheets of Blyth, Inc. and subsidiaries (the Company) as of January 31, 2006 and 2005, and the related consolidated statements of earnings, stockholders equity, and cash flows for the fiscal years then ended. Our audits also included the financial statement schedule for the fiscal years ended January 31, 2006 and 2005 listed in the Index at Item 15. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of January 31, 2006 and 2005, and the results of its operations and its cash flows for the fiscal years ended January 31, 2006 and 2005, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of January 31, 2006, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated April 12, 2006 expressed an unqualified opinion on management s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.


Chicago, Illinois April 12, 2006



ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

SCHEDULE II VALUATION AND QUALIFYING ACCOUNTSFor the years ended January 31, 2004, 2005 and 2006

(In thousands)

Description Balance Acquired Charged Deductions Balance at Balances to at Beginning Costs End of of Period and Period Expenses 2004

Allowance for $ 4,093 $ 623 $ 1,809 $ (2,055 ) $ 4,470 doubtful accounts Income tax valuation 1,017 1,656 - - 2,673 allowance Inventory reserve 27,145 1,343 15,462 (20,970 ) 22,980

2005

Allowance for $ 4,470 $ 538 $ 1,371 $ (2,351 ) $ 4,028 doubtful accounts Income tax valuation 2,673 - 1,565 (200 ) 4,038 allowance Inventory reserve 22,980 1,730 14,130 (16,407 ) 22,433

2006 Allowance for $ 4,028 $ (78 ) $ 2,189 $ (2,247 ) $ 3,892 doubtful accounts Income tax valuation 4,038 - 767 ( 101 ) 4,704 allowance Inventory reserve 22,433 - 16,961 (17,075 ) 22,319

Page S-2 -------------------------------------------------------------------------------


B30116 – Berger Chapter 1 - The Audit Report BLYTH, INC. 8-K DATED MARCH 16, 2004 [FILED MARCH 25, 2004]

ITEM 4. CHANGES IN REGISTRANT’S CERTIFYING ACCOUNTANT

(a) Previous independent accountants

(i) On March 16, 2004, the Board of Directors of Blyth, Inc. (the Company ), acting upon the recommendation of its Audit Committee, dismissed PricewaterhouseCoopers LLP (PwC) as the independent accountants of the Company. The conclusion of PwC’s engagement as the Company’s independent accountants is effective as of the date of its report on the financial statements of the Company as of January 31, 2004 and for the year then ended, which financial statements will be included in the Annual Report on Form 10-K for the fiscal year ended January 31, 2004.

(ii) PwC’s reports on the financial statements of the Company for the fiscal years ended January 31, 2002 and 2003 did not contain any adverse opinion or disclaimer of opinion and were not qualified or modified as to uncertainty, audit scope or accounting principle.

(iii) In connection with its audits of the financial statements of the Company as of January 31, 2002 and 2003 and for the years then ended and through March 16, 2004, there were no disagreements with PwC on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which disagreements, if not resolved to PwC’s satisfaction, would have caused or will cause PwC to make reference thereto in their report on the Company s financial statements for such fiscal years.

(iv) During each of the two years in the period ended January 31, 2003 and through March 16, 2004, there have been no reportable events (as defined in Regulation S-K Item 304(a)(1)(v)).

(v) The Company provided PwC with a copy of the foregoing disclosures and requested that PwC provide a letter addressed to the SEC stating whether or not it agrees with the above statements. A copy of PwC’s letter in response to that report, dated March 24, 2004, is attached hereto as Exhibit 16.

(b) New independent accountants

On March 16, 2004, the Board of Directors of the Company, acting upon the recommendation of its Audit Committee, appointed Deloitte & Touche LLP as the independent accountants of the Company for the fiscal year ending January 31, 2005.

ITEM 7. FINANCIAL STATEMENTS, PRO FORMA FINANCIAL INFORMATION AND EXHIBITSExhibit 16 Letter of PwC LLP dated March 24, 2004 re Change in Certifying Accountant.

Commissioners:

We have read the statements made by Blyth, Inc. (the Company ) (copy attached), which we understand will be filed with the Commission, pursuant to Item 4 of Form 8-K, as part of the Company’s Form 8-K report dated March 16, 2004. We agree with the statements concerning our Firm in such Form 8-K.

Very truly yours, PRICEWATERHOUSECOOPERS LLP


B30116 – Berger Chapter 1 - The Audit Report BLYTH, INC. 8-K DATED APRIL 14, 2004 [FILED APRIL 20, 2004]

ITEM 12. RESULTS OF OPERATIONS AND FINANCIAL CONDITION

On April 14, 2004, Blyth, Inc. issued a press release stating that it would file a Form 12b-25 Notification of Late Filing with respect to its Form 10-K and reporting new Annual Meeting and record dates, which press release also contained information for completed annual fiscal periods. A copy of the press release is attached hereto as Exhibit 99.1 and is incorporated herein by reference.

BLYTH, INC. TO FILE FOR 15 DAY EXTENSION FOR 10-K New Annual Meeting and Record Date Established

Management to Hold Conference Call at 5:30 PM Eastern Today

GREENWICH, CT, USA, April 14, 2004: Blyth, Inc. (NYSE:BTH), a leader in home decor and home fragrance products, today announced that it will file Form 12b-25 with the Securities and Exchange Commission to extend the filing period for its Form 10-K until April 30, 2004. On March 15, 2004, the Company issued a press release in which it announced its financial results for the fiscal year ended January 31, 2004. Thereafter, the Company learned that the Company’s independent accountants, PricewaterhouseCoopers LLP, believed that the Company’s current designation of two operating segments does not comply with the requirements of Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information (SFAS 131). The Company has determined that it will change its designation of operating segments for fiscal 2004 and potentially for certain prior years, which will impact the number of reporting segments required in its SFAS 131 footnote and related disclosures. During the past several years, the Company has reported financial information with respect to two reporting segments, namely Candles & Home Fragrance and Creative Expressions. It is now anticipated that the Company will report information in a greater number of segments.

The designation of additional operating segments on a retrospective basis, pursuant to SFAS 131, is also anticipated to result, retrospectively, in a greater number of reporting units pursuant to Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (SFAS 142). Accordingly, the Company will need to reassess impairment reviews of goodwill required to be performed as of the adoption date of SFAS 142 (2/1/02) and for the fiscal year thereafter. It is anticipated that this will result in certain impairment charges not previously reported, and that prior year financial statements will need to be restated.

The Company has begun extensive analyses required to identify properly its operating segments, reporting segments and reporting units, and to assess potential impairments of goodwill for its re-defined reporting units. This work, however, is not yet complete. As a result, the Company has not been able to complete its financial statements or other portions of its annual report on Form 10-K in time for filing within the prescribed time period.

The Company presently expects that the financial statements which it will file as part of its annual report on Form 10-K will include SFAS 131 financial information with respect to an expanded number of reporting segments for its fiscal year ended January 31, 2004, and, comparatively, for all prior fiscal years presented. In addition, as a result of the change in its operating segments and reporting units, the Company also expects that it will need to restate its financial statements for the fiscal year ended January Item 1b Blyth, Inc. (CASE #1) Page 12 of 16

B30116 – Berger Chapter 1 - The Audit Report 31, 2003 so as to recognize an impairment loss pursuant to SFAS 142 with respect to the carrying value of goodwill, particularly that which relates to its wholesale candle businesses. As analyses and valuations are still in progress, the amount of such impairment charge is not yet finalized. However, based upon the work done to date, the Company believes such impairment charge will be approximately $30 million, or approximately $0.64 per share, which it expects will be recognized in fiscal 2003. The Company does not expect that the change in its reported segments will have any effect upon the Company’s cash flows in any reported period.

The Company expects that the change in the Company’s operating segments will not affect the Company’s previously reported results of operations for fiscal 2004.

The 10-K filing extension necessitates a change in the Company’s record date and date of its Annual Meeting of Shareholders, which were originally scheduled for March 19, 2004 and May 18, 2004, respectively. A new record date of May 13, 2004 has been established, and Blyth’s Annual Meeting of Shareholders will take place on June 24, 2004.

Management will conduct a conference call today at 5:30 p.m. Eastern time. The dial-in number is 1-877-226-4265, and the passcode 6810886 is required. The international dial-in number is 1- 706-679-0668 and requires the same passcode. This call will be broadcast live via the Internet at www.blyth.com.


B30116 – Berger Chapter 1 - The Audit Report BLYTH, INC. 8-K DATED APRIL 30, 2004 [FILED MAY 3, 2004]

ITEM 15. OTHER EVENTS

In connection with its audit of the financial statements of the Company as of January 31, 2004 and for the year then ended, PricewaterhouseCoopers LLP (PwC) as the then independent accountants of the Company, advised the Company in early April, 2004, that it believed that the Company’s then current designation of two reporting segments did not comply with the requirements of Statement of Financial Accounting Standards No. 131 (Disclosures about Segments of an Enterprise and Related Information), a position with which the Company did not agree.

In response to PwC’s advice that it believed that the Company’s designation of two reporting segments did not comply with the requirements of SFAS 131, the Company reevaluated its reporting segments as at the end of each of its fiscal years ended January 31, 2004, 2003 and 2002. As a result of such reevaluation, the Company determined to report its financial results in five reporting segments in fiscal 2004, and four reporting segments in fiscal 2003 and fiscal 2002. This revision of segments had the related effect of requiring changes in the Company’s reporting units for purposes of goodwill impairment reviews under Statement of Financial Accounting Standards No. 142 (Goodwill and Other Intangible Assets), retroactive to the February 1, 2002 adoption date of SFAS 142. This resulted in the need to perform impairment reviews of several additional reporting units as of February 1, 2002, and each subsequent year-end balance sheet date thereafter. These impairment reviews have indicated the need to record additional impairment charges as of the February 1, 2002 adoption of SFAS 142, specifically to write off $20.9 million in goodwill associated with the 1999 acquisition of the Gies Group and $6.3 million in goodwill associated with the 1999 acquisition of the Colony Group. Both of these businesses are components of the Wholesale Home Fragrance reporting segment. The Company’s fiscal 2003 financial statements have been restated to reflect the recording of these $27.2 million in goodwill impairment charges as part of the cumulative effect of adopting SFAS 142 as of February 1, 2002. The Company’s fiscal 2003 financial statements, as restated, appear in the Company s annual report on Form 10-K for the fiscal year ended January 31, 2004, which was filed with the Commission on April 30, 2004.

The Company intends to file as soon as practicable, but not later than June 30, 2004, amendments to its quarterly reports on Form 10-K for the fiscal quarters ended April 30, 2003, July 31, 2003 and October 31, 2003, in which it will restate its financial statements for the corresponding quarters of the Company’s fiscal 2003.


B30116 – Berger Chapter 1 - The Audit Report Blyth, Inc. Appoints Deloitte & Touche LLP Auditors 586 words23 March 2004PrimeZone Media NetworkEnglishCopyright (c) 2004 PrimeZone Media Network, Inc. All Rights Reserved.

GREENWICH, Conn., March 23, 2004 (PRIMEZONE) -- Blyth, Inc. (NYSE:BTH), a leader in home decor and home fragrance products, announced today that its Board of Directors has appointed Deloitte & Touche LLP as the Company's independent audit firm for the fiscal year ending January 31, 2005. Blyth expects to continue to use PricewaterhouseCoopers LLP for tax consultation and other projects.

Blyth, Inc. To File For 15 Day Extension For 10-K 1221 words14 April 2004PrimeZone Media NetworkEnglishCopyright (c) 2004 PrimeZone Media Network, Inc. All Rights Reserved.

GREENWICH, Conn., April 14, 2004 (PRIMEZONE) -- Blyth, Inc. (NYSE:BTH), a leader in home decor and home fragrance products, today announced that it will file Form 12b-25 with the Securities and Exchange Commission to extend the filing period for its Form 10-K until April 30, 2004. On March 15, 2004, the Company issued a press release in which it announced its financial results for the fiscal year ended January 31, 2004. Thereafter, the Company learned that the Company's independent accountants, PricewaterhouseCoopers LLP, believed that the Company's current designation of two operating segments does not comply with the requirements of Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS 131").

The Company has determined that it will change its designation of operating segments for fiscal 2004 and potentially for certain prior years, which will impact the number of reporting segments required in its SFAS 131 footnote and related disclosures. During the past several years, the Company has reported financial information with respect to two reporting segments, namely Candles & Home Fragrance and Creative Expressions. It is now anticipated that the Company will report information in a greater number of segments.

The designation of additional operating segments on a retrospective basis, pursuant to SFAS 131, is also anticipated to result, retrospectively, in a greater number of reporting units pursuant to Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"). Accordingly, the Company will need to reassess impairment reviews of goodwill required to be performed as of the adoption date of SFAS 142 (2/1/02) and for the fiscal year thereafter. It is anticipated that this will result in certain impairment charges not previously reported, and that prior year financial statements will need to be restated.

The Company has begun extensive analyses required to identify properly its operating segments, reporting segments and reporting units, and to assess potential impairments of goodwill for its re-defined reporting units. This work, however, is not yet complete. As a result, the Company has not been able to complete its financial statements or other portions of its annual report on Form 10-K in time for filing within the prescribed time period.

The Company presently expects that the financial statements which it will file as part of its annual report on Form 10-K will include SFAS 131 financial information with respect to an expanded number of reporting segments for its fiscal year ended January 31, 2004, and, comparatively, for all prior fiscal years presented. In addition, as a result of the change in its operating segments and reporting units, the Company also expects that it will need to restate its financial statements for the fiscal year ended January 31, 2003 so as to recognize an impairment loss pursuant to SFAS 142 with respect to the carrying value of goodwill, particularly that which relates to its wholesale candle businesses. As analyses and valuations are still in


B30116 – Berger Chapter 1 - The Audit Report progress, the amount of such impairment charge is not yet finalized. However, based upon the work done to date, the Company believes such impairment charge will be approximately $30 million, or approximately $0.64 per share, which it expects will be recognized in fiscal 2003. The Company does not expect that the change in its reported segments will have any effect upon the Company's cash flows in any reported period.

The Company expects that the change in the Company's operating segments will not affect the Company's previously reported results of operations for fiscal 2004.

The 10-K filing extension necessitates a change in the Company's record date and date of its Annual Meeting of Shareholders, which were originally scheduled for March 19, 2004 and May 18, 2004, respectively. A new record date of May 13, 2004 has been established, and Blyth's Annual Meeting of Shareholders will take place on June 24, 2004.

Management will conduct a conference call today at 5:30 p.m. Eastern time. The dial-in number is 1-877-226-4265, and the passcode 6810886 is required. The international dial-in number is 1-706-679-0668 and requires the same passcode. This call will be broadcast live via the Internet at www.blyth.com[http://www.blyth.com].



The Wall Street JournalAUGUST 23, 2004

Page C3

New SEC Rules Will Likely Draw More 8-K Filings

WASHINGTON – Get out your reading glasses.

Securities and Exchange Commission rules that take effect today could more than double the number of corporate regulatory filings known as Form 8-Ks, experts say. Publicly traded companies use these forms to report material developments between quarterly or annual reports.

The SEC already receives about 80,000 8-Ks each year, but as part of broader corporate-governance guidelines the agency approved, an additional 10 corporate events also should trigger companies to file an 8-K. Companies then must file faster, generating reports for most events within four business days rather than the five business days or 15 calendar days they had been allowed.

Form “8-K reporting volumes are going to go up dramatically,” said David Copenhafer of Bowne & Co., a financial printer that helps companies send reports to the SEC’s Edgar system. Edgar, which stands for Electronic Data Gathering, Analysis and Retrieval system, is the pipeline through which the SEC distributes corporate filings to the public.

Until now, 12 events triggered an 8-K, including a change in a company’s public accountant, a bankruptcy-protection filing, a director resignation and changes to a company’s fiscal year.

As of today, companies must report via 8-K on terminations of material agreements, notice of delisting from a stock exchange and financial restatements, as well as other events. The rules also mandate expanded disclosure involving director or officer resignations and appointments, and about amendments to company bylaws and changes to fiscal years.

Mr. Copenhafer, director of Edgar Services at Browne, of New York, and a former SEC manager, said the SEC expects an additional 60,000 8-K filings a year, but he anticipates volume will increase even more than that.

Chris Hodges, a principal at Ashton Partners, an investor-relations consulting firm, agreed that 8-Ks may double, at least in the short term, because companies “want to comply with the spirit of the law.” Mr. Hodges said he already has noted an increase in 8-K filings this year, as companies began early compliance.

However, Mr. Hodges and some other observers fear the new guidelines still are loose enough that they will leave companies in the dark about whether to draft a filing. And the faster filing times could exacerbate that confusion.

By Shira Ovide Dow Jones NewswiresItem 1c New Rules for 8-K Filings Page 1 of 1


Item 1c New Rules for 8-K Filings Page 2 of 1


JANUARY 29, 2007

NEWS & INSIGHTS

Not Everyone Hates SarbOxThe much maligned new rules are a big hit with investors

There has been no shortage of public outcry over Sarbanes-Oxley, the controversial 2002 accounting reform legislation that requires top corporate executives to fill out reams of new forms and personally certify their financial reports. SarbOx, say its critics, adds millions in compliance costs, makes life miserable for corporate directors, and encourages companies to bolt to foreign stock exchanges. The complaints have been so passionate that regulators are now planning to loosen the rules, probably before the year is out.

Not so fast, says a growing chorus of investors. Lost amid all the boos over SarbOx, they say, are some major benefits. The biggest: SarbOx and related reforms have produced much more reliable corporate financial statements, which investors rely on when deciding whether to buy or sell shares. For them, SarbOx has been a godsend.

What's more, says Duncan W. Richardson, chief equity investment officer at Eaton Vance (EV ) Management and overseer of $80 billion in stockholdings, even the act's much disparaged requirements for testing internal financial controls could drive gains in corporate productivity and profits. Says Donald J. Peters, a portfolio manager at T. Rowe Price Group (TROW ): "The accounting reforms have been a win."

Earnings will be on investors' minds over the next several weeks as most corporations announce yearend results. The numbers will include results tallied under generally accepted accounting principles and, thanks to a Securities & Exchange Commission regulation adopted during the reform years, they'll also come with reconciliations to any nonstandard or "pro forma" numbers that companies use to try to spin their results. The reconciliations, says Peters, are "extraordinarily" helpful. "It is [now] much easier for me to have a view of the true economics" of a company, he says.

Beefed-up disclosure requirements have also meant that companies now deliver numbers with fewer adjustments for unusual charges and write-offs, which in the past have been used to make earnings look better. Thomson Financial's (TOC ) Earnings Purity Index, which tracks earnings adjusted for such write-offs, shows improvements in each of the past four years. And now earnings reports reflect expenses for incentive stock options, information investors like that wasn't available before the big accounting scandals.

Item 1d Not Everyone Hates Sarbox Page 1 of 2

Close Window

http://www.businessweek.com/

B30116 – Berger Chapter 1 - The Audit Report Just as important, executives appear to have a firmer grasp of costs when they talk about operating margins, according to Richardson of Eaton Vance. He credits the improvement to the infamous Section 404 of SarbOx, which requires documented testing of internal controls. "Even not-so-good management teams have good controls now, and that leads to an ability to cut costs," he says.

This isn't to say SarbOx is flawless. Section 404 is often applied unreasonably, causing costly checks of minor book entries. It's bad, too, that small-scale businesses find fewer benefits relative to the costs.

TRUE TESTNor do the reforms mean that investors can trust the numbers implicitly. These days, financial reports increasingly include ad hoc performance measures other than closely regulated earnings, says Marc Siegel, research director at the Center for Financial Research & Analysis. "Companies are going to greater extents to hide" the true stories of their cash flows, order backlogs, bookings, and same-store sales, he says. Siegel notes that Duke University scholars found executives will go far to spin their numbers: Some three-fourths said that to meet earnings estimates, they will sacrifice corporate value, even if it means postponing profitable investments, deferring maintenance, or giving incentives to customers to buy before the end of a quarter.

Of course, the real test for how much earnings reporting has improved won't come until the next economic downturn, says UBS (UBS ) stock strategist David Bianco. In downturns, the lack of growth often exposes aggressive accounting estimates used to manipulate earnings. And that's when some capital investments are revealed to have been hiding operating costs.

Still, the next round of abuses to surface will probably not be as bad as it would have been without the reforms. Says Eaton Vance's Richardson: "You're always better going into any downturn with tighter rules." For regulators eager to start tinkering, that's food for thought.

By David Henry

Copyright 2000- 2007 by The McGraw-Hill Companies Inc. All rights reserved.

Item 1d Not Everyone Hates Sarbox Page 2 of 2

B30116 Chapter 2 – Deferred Income Taxes

2. Income Taxes and Deferred Income Tax Accounting

Item 2a Introduction to Deferred Taxes Page 1 of 2



Divergence complicates the way income taxes are reflected in financial reports

≠Taxable Income:

Income computed for tax compliance purposes

Pretax (or Book) Income:Income computed for

financial reporting purposes

Governed by the “constructive receipt/ability to pay” doctrine.

The timing of taxation usually (but not always) follows the inflow of cash or equivalents.

Deductions generally are allowed only when the expenditures are made or when a loss occurs.

Intended to reflect increases in the firm’s “well-offness”.

Includes all earned inflows of net assets, even when the inflow is not immediately convertible into cash.

Reflects expenses as they accrue, not just when they are paid.

Book income and taxable income



• Depreciation expense

• Bad debt expense

Permanentdifferences

Timingdifferences:

≠Taxable Income

Pretax (or Book)

A timing difference results when a revenue (gain) or expense (loss) enters book income in one period but affects taxable

Understanding income tax reporting:



• Statutory depletion in excess of

cost-based depletion• Dividend received deduction

Enter into taxable income but never affect book income.Because permanent differences do not reverse, they do

give rise to deferred tax assets or liabilities.

Permanentdifferences

Timingdifferences:

≠Taxable Income

Pretax (or Book) Income

• Interest on state and municipal bonds.

• Executive life insurance

Permanent differences are caused by income items that: Enter into book income but never affect taxable income.

Understanding income tax reporting:Permanent differences


Income Taxes -- Notes

Taxable income: Earnings subject to taxation as reported on the combined federal, state, and foreign tax return. Used to compute current income tax expense (below).

Pretax income: Earnings before income taxes for financial reporting (i.e., book) purposes. Reported on the income statement. Not used to compute provision for income taxes (below).

Permanent differences: Differences between taxable income and pretax income that will never reverse: tax-free income and non-deductible expenses (e.g., executive life insurance).

Temporary differences: Differences between taxable income and pretax income that will reverse in future periods: cash- vs. accrual-basis accounting, accelerated vs. straight-line depreciation of fixed assets.

Current income tax expense: Amount of income taxes that are due all taxing authorities for the period and reported on the combined federal, state, and foreign tax return. Based on taxable income (above)

Provision for income taxes: The income tax expense for financial reporting purposes and reported on the income statement. A negative expense is often called a benefit. A plug amount based on current income tax expense and the net change in the balance of deferred tax assets (net of any valuation allowance) and deferred tax liabilities:

EXP = CUR (DEF_ASSET ALLOW) + DEF_LIAB, where

EXP = provision for income taxes,CUR = current income tax expense,DEF_ASSET = deferred income tax assets (gross),ALLOW = valuation allowance,DEF_LIAB = deferred income tax liabilities, and = first-difference operator.

Deferred income tax asset: Arises if future taxable income (and hence future current income tax expense) is expected to be less than future pretax income (and hence the future provision for income taxes). Reflects temporary differences. The future journal entry (assuming positive future pretax income) is:

Provision for income taxes (plug) y+x Income StatementDeferred tax asset x Reversal (i.e., reduction) of assetTaxes payable / cash y = Tax Return taxes

Item 2b Details on Deferred Taxes Page 1 of 3


A deferred tax asset can also arise if taxable income is negative, in which case the company has an operating loss carryforward which can be used to offset future tax payments (i.e., future current income tax expense), provided it is not used to obtain a refund of tax payments for previous years.

Valuation allowance: Contra-asset to deferred income tax assets (credit balance). The company records a valuation allowance if it is more likely than not (i.e., probability greater than 50%) that the company will not be able to use all or a portion of its deferred tax assets. Increases (decreases) in the valuation allowance decrease (increase) deferred tax assets, which leads to an increase (decrease) in the provision for income taxes. A company’s ability to use a deferred tax asset depends on the source of the deferred tax asset. If the source is a temporary difference (e.g., restructuring charge), the company must have positive future pretax income or, if future pretax income is non-positive, deferred tax liabilities that can be used to offset the deferred tax asset. On the other hand, if the source of the deferred tax asset is an operating loss carryforward or a tax credit, then the company must have positive future taxable income which can be used to absorb the operating losses or tax credits.

Deferred income tax liability: Arises if future taxable income (and hence future current income tax expense) is expected to be greater than future pretax income(and hence the future provision for income taxes). Reflects temporary differences. The future journal entry is:

Provision for income taxes (plug) yx Income StatementDeferred tax liability x Reversal (i.e., reduction) of liability

Taxes payable / cash y = Tax Return taxes



Valuation Allowance

A valuation allowance is required when, based on available evidence, it is more likely than not that some portion (or all) of the deferred tax asset will not be realized. A firm must consider all available evidence, both positive and negative, to make the determination. Evidence includes: Information about a firm’s current financial position. Information about a firm’s results of operations for the current and preceding years. Information about a firm’s future operations.

A recent history of several years of losses is strong evidence that suggests a valuation allowance is needed. Other evidence suggesting the need for a valuation allowance includes, but is not limited to: A history of operating loss carryforwards that expire unused. Losses expected in future years. Circumstances that if unfavorably resolved would adversely affect future operations. A remaining carryback or carryforward period that is so short as to be of limited use in

realizing tax benefits if a large deductible temporary difference is expected to reverse in a single year or if the firm operates in a highly cyclical business.

Positive evidence that a valuation allowance is not needed includes the following: A history of profitability. Existing contracts or firm sales backlog that will produce more than enough taxable income

to realize the deferred tax asset. An excess of appreciated asset value over the tax basis of the assets sufficiently large to

realize the deferred tax asset.

Each of the above items provides information useful for estimating future taxable income. If the amount expected for future taxable income is large enough to realize the deferred tax asset, no valuation allowance is needed. Even if it is not, a valuation allowance might not be required. If the deductible temporary difference that is creating the deferred tax asset is to reverse soon enough that it can be carried to the current and prior years to realize the benefit, no valuation allowance is required. Also, if the future reversals of taxable temporary differences can offset deductible temporary differences by carryback and carryforward procedures, and the taxable temporary differences are large enough to cause the deferred tax assets to be realized, no valuation allowance is needed. Finally, if there are prudent and feasible tax-planning strategies that a firm could implement to prevent an operating loss or tax credit carryforward from expiring or that in general would result in the realization of the deferred tax asset, then again a valuation allowance is not needed.

Strong positive evidence from any one of the possible sources is sufficient to support a conclusion that a valuation allowance is not necessary. If such evidence is available from one source, other sources need not be considered.



Temporary and Permanent Tax Differences - Example

Income Statement1994 1995 1996

Revenue $ 200 $ 200 $ 200CGS (120) (120) (120)Gross Margin 80 80 80Restructuring charge - (20) -Interest income (tax-free) 10 - -Pretax income 90 60 80Income tax expense (40%) (32) a (24) b (32)cNet income $ 58 $ 36 $ 48

Effective income tax rate 35.6%d 40.0% e 40.0%f

Tax Return1994 1995 1996

Revenue $ 200 $ 200 $ 200CGS (120) (120) (120)Gross Margin 80 80 80Restructuring charge - - (20)Taxable income 80 80 60Current income tax exp (40%) (32) c (32) c (24)bAfter-tax income $ 48 $ 48 $ 36

a 32 = 0.4 x (90 - 10) = 0.4 x 80 d 35.6 = 32 / 90 = inc tax exp / pretax incb 24 = 0.4 x 60 e 40.0 = 24 / 60c 32 = 0.4 x 80 f 40.0 = 32 / 80

Item 2c Tax Example Page 1 of 2


Temporary and Permanent Tax Differences - Example (cont)

Journal entry - 1994

Income tax expense 32 Income statement Taxes payable / cash 32 Tax return

Journal entries - 1995

Restructuring charge (IS) 20 Expense taken in 1995 on the IS Severance liability (BS) 20 but in 1996 on the tax return

Income tax expense 24 Income statementDeferred tax asset 8 Temporary difference Taxes payable / cash 32 Tax return

Journal entries - 1996

Severance liability 20 Expense taken in 1995 on the IS Cash 20 but in 1996 on the tax return

Income tax expense 32 Income statement Deferred tax asset 8 Temporary difference reversed Taxes payable / cash 24 Tax return

Item 2c Tax Example Page 2 of 2


MDC Manufacturing

Katherine Allison, assistant to the new president of MDC Manufacturing, had just finished reviewing her notes from a recent meeting between herself, the controller of MDC, and the new president, Julia Lynch. Julia was formerly head of engineering and product development for the firm and has no background in accounting. After the meeting, she expressed concern to Katherine about discrepancies between what the firm is reporting in its financial statements and what the firm is reporting to the Internal Revenue Service.

A report presented by the controller at the meeting contained the following figures.

Income Tax ReturnFor the Year EndedDecember 31, 1995

Earnings Before Taxes $2,025,000Current Income Tax Liability 730,000

The December 31, 1995 income statements contained the following values for earnings before tax and earnings after tax.

December 31, 1995

Earnings Before Tax $2,500,000Provision for Taxes 900,000 Net Earnings $1,600,000

The balance sheet for the year ended December 31, 19x5 showed the following balances for income taxes.

December 31, 19x5 December 31, 19x4

Current Liabilities

Income Taxes Payable 180,000 175,000Long-Term Liabilities

Deferred Income Taxes 170,000 0

Item 2d MDC Manufacturing Problem Page 1 of 2


Katherine has summarized Julia's specific concerns in her notes from the meeting as follows:

i. Why is there such a large difference between the income before tax in the financial statements and the amounted reported for tax purposes?

ii. The tax rate reported for tax purposes and employed for financial reporting purposes differ from each other as well as the 40% statutory tax rate. How can this be the case?

iii. There exists a line for income taxes payable and a line for deferred income tax on the liabilities side of the end balance sheet. Neither corresponds the current income tax liability on the tax return.

Julia has asked Katherine to clear up these concerns for her. In investigating the discrepancies, Katherine received the following information from the controller.

> Revenues from investments in municipal tax free bonds totaled $100,000.> Accelerated depreciation is being used for tax purposes while straight line depreciation is

being used for financial reporting purposes. The depreciation deduction reported on the tax return exceed the depreciation expense on the financial statements by $900,000.

> MDC received an $80,000 investment tax credit for equipment purchased during 19x5. > MDC paid life insurance premiums of $50,000 for policies on the lives of its top executives

in which MDC is listed as the designated beneficiary. For book purposes the premiums paid are an expense. For tax purposes the premiums paid are not deductible.

> During 19x5 the company sold a plant for $500,000 more than its book value and then had leased it back for a 20 year period. The gain was deferred in accordance with GAAP and is being amortized over the life of the lease. The amount of the deferred gain amortized during the year totaled $25,000. In contrast to GAAP, the tax code required that the entire gain be immediately included as taxable income for 19x5.

Required

1. Prepare Katherine's report by filling in the appropriate blank areas in the document “Accounting for Income Taxes, Lecture 1” on pages 2 to 5.

2. Be prepared to discuss the merits of presenting values for taxes on the financial report that differ from the taxes due per the tax return.

Item 2d MDC Manufacturing Problem Page 2 of 2


Accounting for Income Taxes, Lecture 1 Slides

Accounting for Income TaxesWhy Should You Care?

Income statement

Tax expense numbers may deviate significantly from taxes owed to the taxing authorities.

Tax expense numbers may deviate significantly from the cash demands for taxes.

Balance Sheet

Deferred income tax assets/liabilities may not be economic assets/liabilities.

Deferred income tax assets/liabilities may never be realized.

Deferred income tax assets/liabilities do not reflect present values.

Deferred income tax assets/liabilities may not be properly classified as current/noncurrent.

All components of a deferred income tax asset/liability are not the same.

Why is there a discrepancy between financial statement earnings before tax and earnings before tax reported to the tax authority?

Earnings before tax reported to the tax authority (i.e., taxable income) is computed according to the accounting rules as specified by the tax code.

GAAP earnings before tax is computed according to GAAP.

Item 2e Taxes – Lecture 1 Slides Page 1 of 12


Reconciliation of MDC's earnings figures

GAAP earnings before tax 2500

Taxable income 2025

Reconciliation to 40% statutory tax ratefor Tax Return Numbers

Earnings before tax per tax return 2025times tax rateTaxes before creditsless tax creditsCurrent income tax liability 730

The Issues Arising from Differences in GAAP and Tax Accounting

What is the appropriate income tax expense for financial reporting (GAAP) purposes?

If income tax for GAAP income taxes due to the government, what happens to the difference?



Accounting for Taxes

GAAP mandates that tax expense should correspond to the income before tax reported on the financial statements.

Example journal entry

Provision of income tax (e) xIncome taxes payable (l) yDeferred income taxes (a or l) x-y

Differences between GAAP and taxable income

Permanent differences:

affect GAAP earnings before tax but never taxable income (or visa versa)

Temporary differences:

affect GAAP earnings before tax and taxable income in different periods. Only temporary differences give rise to deferred tax assets/liabilities on the balance sheet.

MDC example continuedPermanent differences

Temporary differences



Reconciliation to 40% statutory tax rate for GAAP Numbers GAAP earnings before tax

Adjustments for permanent differences

times tax rate 40%

Taxes before credits

less tax credits

Current provision for income tax 900

Recording MDC's Income Tax ProvisionTo record provision for income tax:

Provision for income tax (e)Income taxes payable (l)Deferred income tax (l)

Why does income taxes payable only have a balance of 180?

An entry to record MDC's payment in the 1st quarter of 1995 for 4th quarter of 19x4 taxes payable

Income taxes payable (l)Cash (a)

An entry in 1995 to summarize MDC's quarterly payments for taxes payable arising during 19x5 is:

Income taxes payable (l)Cash (a)



Reversals Illustrated

Assume that MDC has no temporary differences in subsequent years other than those that originated in 19x5.

Assume that in 19x6, 19x7, and 19x8, depreciation expense for GAAP will exceed depreciation expense for tax purposes by $300,000 in each period.

What will be the difference between the provision for taxes and the taxes payable recorded for subsequent years?

What will happen to the ending balance of the deferred tax liability account over subsequent years?

Reversals Illustrated continued

year provision end of year netafter less balance for DIT 19x5 payable A or L

12345. . .. . .. . .1718192021



Accounting Issue #1Changing Tax Rates

Liability Method Or Asset-Liability Approach is currently employed.

Push the effect of the change through income in the year that the change is known.

Accounting Issue #2Current vs. Noncurrent

Classify the deferred tax asset or liability in the same manner as the related asset or liability.

If there is no related asset/liability, classify based upon the expected reversal date.

Accounting Issue #3Deferred Tax Assets -- the Realization Issue.

Deferred tax assets are always allowed to be recorded if there are offsetting deferred tax liabilities. In addition, a deferred tax asset may be recorded even if there is not an offsetting liability. In this case, the gross deferred tax asset is reduced if it is "more likely than not" that the entire asset will not be recognized. This reduction is often called the valuation allowance.



Accounting Issue #4Tax Carryforwards

Tax carryforwards arise when a firm receives a tax benefit in a period that will be realized in future periods.

Tax carryforwards, if recognized, reduce (increase) the deferred tax liability (asset). Thus, these reduce the computation of income tax expense and can result in the income tax expense being negative (i.e., an increase to income).

Accounting Issue #4 continued

Tax Carryforwards


In early 2009, Norman determines that it is unlikely to earn enough taxable income in future years to DR Income tax expense ($315,000 - $200,000) $115,000

CR Allowance to reduce deferred tax asset

DR Income tax expense ($600,000 x .35) $210,000DR Deferred income tax asset ($900,000 x .35)

Deferred income tax assets:

Norman Corporation records a deferred tax asset in 2008 related to


Under current rules, carryforwards are treated exactly like other deferred tax assets.

Current or Noncurrent? Tax carryforwards are classified as current or noncurrent depending upon the expected utilization date.




Firms can elect one of two options: Both carryback and carryforward incurred losses. Only carryforward incurred losses.

Option 2

Option 1

Carry forward onlyLoss

Carry back Loss

Years20082007200620052004

Carry forward

Carry back Carry forwardLossincurred

Years20082007200620052004

Net operating losses:Carrybacks and carryforwards

The U.S. Income Tax code allows firms reporting operating losses to offset those losses against either past or future tax payments.



Or:

Unfortunato Corporation experienced a $1 million pre-tax operating loss in 2006. Under U.S. Income

Net operating losses:Carrybacks and carryforwards example


Accounting Issue #5Separation of DIT Assets and Liabilities

Firm's must net current (noncurrent) DIT assets and liabilities for balance sheet presentation for each tax jurisdiction and individual tax paying entity of the firm.

Implication

You might see 4 lines related to deferred taxes on the balance sheet: current DIT asset, current DIT liability, noncurrent DIT asset, and noncurrent DIT liability.


If future pre-tax operating profits are expected to exceed $250,000, then the DR Deferred income tax asset $87,500 CR Income tax expense (carryforward

DR Income tax refund receivable $262,500 CR Income tax expense (carryback

Suppose Unfortunato had the following operating profit history:

The following entry would be made to reflect the carryback:

Net operating losses:Carryback and carryforward


Accounting Issue #6Indefinite Reversals

Income from a subsidiary recognized for GAAP purposes may not be recognized for tax purposes. In such cases, the income is not recognized for tax purposes until received in the form of a dividend or consideration received in a taxable exchange.

If parent intends to "permanently reinvest" the subsidiary income or receive it in a tax free liquidation, GAAP allows the parent to forego recording the DIT liability.



Conceptual Issue #1Is it really an Asset or Liability?

Does the firm have a legal obligation (claim) associated with a deferred tax liability (asset)?

Conceptual Issue #2Will DIT Assets/Liabilities ever be Realized?

Illustrative Example:

Consider a firm that buys a new machine for 50 each year. For tax purposes, the machine is fully depreciated in the first year. For GAAP purposes, the machine is depreciated 25 each year. This depreciation difference is the only source of GAAP/tax accounting differences.

What happens to the balance of DIT as time passes? (Assume a 40% tax rate.)

Conceptual Issue #2 continuedWill DIT Assets/Liabilities ever be Realized?

Example

year provision end of year netof less balance for DIT operation payable A or L12345. . .. . .. . .



Conceptual Issue #3Is the DIT Asset or Liability Properly Valued?

Example

Consider our previous example with the added assumption that the firm will stop buying machines in year n.

What is the proper value of the DIT liability in year 1?

Conceptual Issue #4Are DIT Assets/Liabilities Properly Classified as Current or Noncurrent

Recall that classification as current/noncurrent generally has nothing to do with the expected date of reversals.

Therefore, the current/noncurrent designation cannot be blindly used to predict future tax payments.

Conceptual Issue #5Are all DIT Components Equivalent?

Other than being useful for projecting future cash flows for taxes, most DIT components do not have direct cash flow implications.

Exception:

Net operating loss carryforwards that cannot be utilized by firm A currently may have immediate cash flow implications for an acquirer of A.



Summary of What We Talked About

Why do accounting issues arise with respect to taxes?

Permanent vs. Temporary Differences

Accounting Issues

Conceptual Issues



Accounting for Income Taxes, Lecture 2 SlidesWe have addressed the following questions:

What is on the balance sheet and income statement for income taxes?

What are some of the accounting and conceptual problems with the reported numbers?

We still have to address the following questions:

What is disclosed in the notes to the financial statements regarding taxes?

Why might the disclosure be useful for analysis?

What Is Disclosed?Components of the deferred tax liabilities and assets

Amount of and change in the valuation allowance (i.e., DIT contra asset account for amounts that are not expected to be realized)

DIT liabilities not recognized1

Current year effects of temporary differences

Components of income tax expense (federal, state, foreign)

Reconciliation of income tax expense to amount based upon statutory rate (amounts or percentages)

Tax loss carryforwards and credits

1 In some cases firms forego recognizing DIT liabilities/assets. The most obvious case is when a firm has foreign subsidiaries that are not consolidated for tax purposes but are consolidated for book purposes. In these cases, the parent pays taxes related to subsidiary income only when the parent receives dividends or sells the subsidiary. If the parent intends to permanently hold the subsidiary and reinvest the income of the subsidiary (i.e., receive no dividends), then no DIT liability related to the subsidiary income are recorded. Firms must disclose the amount of the unrecorded DIT liability.

Item 2f Taxes – Lecture 2 Slides Page 1 of 3


MDC Example DisclosureComponents of deferred taxes

19x5 19x4AssetsGain on sale/lease-back 190Total Assets 190 0

LiabilitiesDepreciation 360Total Liabilities 360 0

Net Liability 170 0

MDC Example Disclosure Continued

Components of deferred tax provision19x5 19x4

Gain on sale/lease-back ( 190 )Depreciation 360Total 170 0

19x5 19x4

Current taxesFederal 730 ?State 0 ?Foreign 0 ?

730 ?Deferred taxes

Federal 170 ?State 0 ?Foreign 0 ?

170 ?Provision for income taxes 900 ?

MDC Example Disclosure Continued



Reconciliation of provision for income tax to the statutory rate of 40% is as follows:

19x5 19x4Tax based upon statutory rate of 40% 1000 ?Non-tax-deductible insurance premium 20 20Tax-free interest income ( 40 ) ?Investment tax credits ( 80 ) ?Provision for taxes 900 ?

or, alternatively, Statutory rate 40.0 % ?

%Non-tax-deductible insurance premium .8 ?Tax-free interest income ( 1.6 ) ?Investment tax credits ( 3.2 ) ?Effective tax rate 36.0 % ?

Why is Tax Information Useful?

Explain why tax disclosure can help you answer the following questions.

1. Are overly optimistic assumptions being used for financial reporting purposes?

2. What are manager/auditor beliefs about the firm's ability to generate income in the near term?

3. What real assets (on or off the balance sheet) generate immediate cash flow implications for an acquirer?

4. Is the current tax payable for the period indicative of what one might expect for the future?

5. Is the growth in firm income coming from domestic or foreign operations?

6. What is the firm's capital investment strategy?



Tax Note DisclosuresCheat Sheet

You will receive 3 or 4 tables in any income tax note. The key features of these tables are described below.

Table 1

One table essentially gives you the generic journal entry for recording taxes for the period. For example, a company called Winn Dixie had the following table for 1992.

Current Deferred Total Amounts in thousands1992 Federal $ 119,006 (16,602) 102,404 State 8,785 371 9,156 $ 127,791 (16,231) 111,560

Therefore, the 1992 journal entry is:Income tax expense 111,560Deferred income taxes (in this case it is a debit) 16,231

Current taxes payable (or Income taxes payable) 127,791

Tables 2 and 3

One table gives you the causes (e.g., differences in depreciation) that gave rise to the deferred tax asset/liability on the balance sheet. Another table (which is not always included) gives you the causes of the flow or entry to the deferred tax account during the year.

Remember the following for temporary differences.

A deferred tax debit entry (i.e., increase in asset or decrease in liability) arises when taxable income is greater than GAAP pretax income for the period (i.e., less revenue or more expense has been recorded for GAAP purposes). Therefore, a deferred tax liability associated with depreciation implies that the firm has recorded less depreciation expense for GAAP purposes than for tax purposes since the beginning of time. A decrease in that liability position over a single period implies that, for that period, the firm recorded more depreciation expense for GAAP purposes than for tax purposes (i.e., the liability position reversed during the period).

A deferred tax credit entry (i.e., decrease in asset or increase in liability) arises when taxable income is less than GAAP pretax income for the period (i.e., more revenue or less expense has been recorded for GAAP purposes). Therefore, a deferred tax asset associated with revenue recognition implies that the firm has recorded less revenue for GAAP purposes than for tax purposes since the beginning of time. A decrease in that asset position over a single period implies that, for that period, the firm recorded more

Item 2g Tax Disclosures – Cheat Sheet Page 1 of 2


revenue for GAAP purposes than for tax purposes (i.e., the asset position reversed during the period).

In addition, note that amounts for net operating loss carryforwards and the valuation allowance are included in these tables.

Table 4

The last table gives you a reconciliation from a tax expense number (or effective tax rate) using just the federal statutory rate to the actual tax expense number (or effective tax rate) on the GAAP income statement. The reconciling items include: adjustments for state and local taxes net of the federal benefit, differences between foreign tax rates and the federal statutory rate, permanent differences (e.g. nondeductible goodwill amortization), tax credits, and changes in the valuation allowance.

Item 2g Tax Disclosures – Cheat Sheet Page 2 of 2


Case #2 Monterey Pasta Company The 'Growth With Value Fund' of the Capstone Group of Funds is an active investment Fund with an investment philosophy of taking positions in stocks with excellent growth potential that are trading at favorable prices. The Growth With Value Fund has taken a beating for the first quarter of 1995 due in large part to a significant position in Monterey Pasta Company.

Monterey Pasta Co., based in California, processes a premium line of fresh gourmet pasta and pasta sauces served through a chain of company-owned quick-serve "Monterey Pasta Company" restaurants and distributed through retail grocery and club stores under the "Monterey Pasta Company" brand name. The company's product line, which emphasizes all-natural ingredients, includes such flavors as Snow Crab Ravioli, Sweet Red Pepper Fettuccini, and Sun Dried Tomato Pesto Sauce. Retail grocery and club store distribution of the company's product line is growing nationwide. The company's existing restaurants are located in upscale shopping and financial centers in California, Colorado, Texas and Washington.

Monterey Pasta announced particularly poor results for the final quarter of 1994, precipitating a 20% decline in its stock price. You have been asked by the overseers of the Capstone Group of Funds to apportion blame for the loss attributable to the position in Monterey Pasta between Joe Lightweight, the Group's analyst responsible for following Monterey Pasta and Mary Contrary, the manager of the Growth With Value Fund.

In addition to Monterey Pasta's financial results for the third quarter of 1994 and the full 1994 fiscal year (attached), you are provided with the following facts:

• Joe Lightweight sent a report on Monterey Pasta to Mary Contrary following the release of the company's results for the third quarter of 1994. He forecasted that Monterey Pasta would break even in the fourth quarter (i.e., report earnings of zero cents per share) on revenues of around $5 million. He expressed an optimistic longer-term outlook for Monterey Pasta and attributed the company's losses for the first three quarters of 1994 to investments in production and marketing infrastructure. His report recommended that The Growth With Value Fund Continue to hold its existing position in Monterey Pasta.

• After reading Joe's report, Mary Contrary was bullish on Monterey Pasta and thought the company had terrific growth potential. However, she firmly believed that good sales and earnings momentum were critical for Monterey Pasta's stock price to climb. Given Joe's predictions that Monterey Pasta would come out of the red in the fourth fiscal quarter on strong sales growth, she decided to double the Growth With Value Fund's existing position in Monterey Pasta.

• Joe blames Monterey Pasta's poor earnings for the fourth fiscal quarter on an "unusual and unpredictable accounting charge that is unrelated to Monterey Pasta's true financial performance". With the exception of this charge, he claims the analysis in his report was pretty much on target. Mary points out that the stock price decline in Monterey Pasta was directly attributable to the disappointing earnings results for the fourth fiscal quarter.

Item 2h MONTEREY PASTA (CASE #2) Page 1 of 13


She claims that the blame rests with Joe because she would never have doubled the Fund's position if she had known of the possibility of the accounting charge and that predicting such charges is Joe's job.

Required:

Prepare a report that analyses whether Joe Lightweight was guilty of providing bad forecasts of Monterey Pasta's fourth quarter earnings. Your report should include an analysis of Monterey Pasta's fourth quarter results, including the identification and analysis of any unusual accounting charges.



MONTEREY PASTA COMPANY10Q for Quarter Ended October 2, 1994

CONSOLIDATED BALANCE SHEETS

ASSETS December 31, 1993 October 2, 1994(unaudited)

Current Assets: Cash and cash equivalents…………………………... Held-to-maturity securities………………………….. Accounts receivable………………………………… Inventories…………………………………………... Prepaid expenses and other…………………………. Receivables from related parties……………………. Deferred income taxes………………………………. Total current assets………………………………

Property and equipment, net……………………………Intangible assets, net……………………………………Deposits and other……………………………………... Total assets………………………………………

LIABILITIES AND SHAREHOLDERS' EQUITYCurrent liabilities: Current portion of long-term debt………………….. Current portion of capital lease obligations……… Accounts payable………………………………… Accrued liabilities…………………………………... Income taxes payable………………………………. Amounts due to related parties……………………... Total current liabilities………………………...

Long-term debt…………………………………………Capital lease obligations………………………………..Deferred income taxes………………………………….Commitments and contingencies………………………Shareholders' equity: Series A. Preferred Stock, no par value, 5,000,000 shares authorized, 1,200,000 and 0 shares issued and outstanding at December 31, 1993 and October 2, 1994, respectively…… Common stock, no par value, 10,000,000 shares authorized, 3,657,500 and 5,607,500 issued and outstanding at December 31, 1993 and October 2, 1994, respectively…………….. Retained earnings (deficit)………………………… Total shareholders' equity…………………… Total liabilities and shareholders' equity………

$10,602,397---

487,458385,790109,46216,377

---11,601,484

2,600,054182,773 61,293

$14,445,604

$ 90,24563,883

478,972339,39528,000 37,930

1,038,425

113,347202,369

9,400---

---

13,042,807 39,256

13,082,063$14,445,604

$2,954,3502,690,5871,017,334

801,612340,71359,112

506,8138,370,521

10,374,7431,036,641

704,410$20,486,315

$ 46,802---

1,019,755578,044

--- ---

1,644,601

92,644

9,400---

---

19,460,904_(721,234)18,739,670

$20,486,315

The accompanying notes are an integral part of these statements.




CONSOLIDATED STATEMENTS OF OPERATIONS(unaudited)

Three Months Ended Nine Months EndedNet Revenues: 9/30/1993 10/2/1994 9/30/1993 10/2/94

Grocery and club stores Restaurants Total net revenues

Cost and expenses: Cost of sales Restaurant operating expenses Selling, general and administrative Depreciation and amortization

Income (loss) from operationsInterest (income) expense, netIncome (loss) before provision for income taxesBenefit for income taxesNet income (loss)Pro forma income tax provisionNet income after pro forma income tax provisionNet loss per sharePro forma net income per shareWeighted average common and common equivalent shares outstanding

$ 1,236,084 81,504

1,317,588

755,43552,156

241,962 35,267

1,084,820232,768

17,382

215,386 --

215,386 88,123

$ 127,263

$ .05

2,500,000

$ 2,528,9011,879,7434,408,644

2,472,8401,188,8621,181,653

329,4505,172,806(764,161)

(67,294)

(696,867)(278,747)

$ (418,120)

$ (,07)

5,606,951

$ 3,038,548 81,504

3,120,052

2,026,07352,156

717,882 99,331

2,895,442224,610

35,849

188,761 --

188,761 77,474

$ 111,287

$ .04

2,500,000

$ 6,462,8453,629,900

10,092,745

5,759,8402,374,9032,711,262

693,31811,539,323(1,446,578)

(179,275)

(1,267,303) (506,813)

$ (760,490)

$ (.15)

5,150,955





CONSOLIDATED STATEMENTS OF CASH FLOWS(unaudited)

Nine Months EndedSeptember 30, 1993 October 2, 1994

Cash flow from operating activities:Net Income (loss)……………………………Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization…………… Unrealized interest income from held-to-maturity securities…………….. Loss on sale of property…………………. Changes in assets and liabilities: (Increase) in accounts receivable…….. (Increase) in inventories (Increase) in prepaid expenses, intangible assets and other…………... Increase in accounts payable……………. Increase in accrued liabilities…………… (Increase) in deferred income-tax benefit. Net cash provided by (used in) operating activities…………………………….Cash flows from investing activities: Purchase of held-to-maturity securities…. Redemption of held-to-maturity securities... Purchase of property and equipment, net….. Net cash used in investing activities…..Cash flow from financing activities: Proceeds from long-term debt……………... Repayment of long-term debt and capital lease obligations…………………………… Proceeds from issuance of common stock… Issuance of note receivable (1)……………. Repurchase of common stock (1)…………. Net cash provided by financing activities………………...Net increase (decrease) in cash………………...Cash and cash equivalents at beginning of period...Cash and cash equivalents at end of period……….

$ 111,287

99,331

--3,301

(72,263)(43,698)

(178,020)27,81383,049

---

30,800

------

(480,703)(480,703)

648,144

(205,807)115,417

------

557,484107,581

3,381$ 110,962

$ (760,490)

693,318

(120,286)--

(529,876)(415,822)

(925,506)540,783200,719

(536,397)

(1,853,557)

(5,069,147)2,500,000

(7,563,472)(10,132,619)

---(330,396)

6,427,527(500,000)

(1,259,000)

4,338,129(7,648,047)10,602,397$ 2,954,350

(1) For supplemental disclosure of non cash financing activities see Note 7.





NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1: ACCOUNTING POLICIES AND PROCEDURES

Change in Accounting Period

Effective June 1, 1994, the Company changed from a monthly reporting period to a 4-week, 4-week and 5-week reporting period with the fiscal year ending on January 1, 1995. The Company reported its operating results in prior periods on a calendar year basis. The Company has determined that the change to this accounting period will not result in a material difference for comparable reporting periods.

Reclassification

Certain reclassifications have been made to prior period financial statements in order to be consistent with the current period presentation.

NOTE 2: INCOME TAXES

Effective July 1, 1990, the Company elected to be treated as an S corporation for federal and state income tax reporting purposes. As an S corporation, all taxable income and available tax credits were passed from the corporate entity to the individual shareholders. The S corporation election was automatically revoked upon the issuance of preferred stock (second class of stock) on August 31, 1993 and the Company was thereafter taxed as a C corporation.

The pro forma unaudited income tax adjustments presented in the accompanying consolidated statement of operations represent the estimated difference between the historical income tax expense and income tax expense that would have been reported had the Company been subject to federal and state income taxes based on tax laws in effect during those periods.

In the third quarter of 1994, the Company benefited $278,747 for income tax purposes from its net operating loss and accordingly, the deferred tax asset was increased by $278,747 with no valuation allowance provided.

NOTE 3: INVENTORIES

Inventories consist of the following:

Production-IngredientsProduction-Finished goodsPaper goods and packaging materialsRestaurant inventories

December 31, 1993

$ 127,616111,333136,32810,513

$ 385,790

October 2, 1994

$ 195,623$ 256,097

102,696247,196

$ 801,612



MONTEREY PASTA COMPANY10K for Year Ended January 1, 1995

CONSOLIDATED BALANCE SHEETSASSETSCurrent assets: Cash and cash equivalents…………………………….. Held-to-maturity securities……………………………. Accounts receivable…………………………………… Inventories…………………………………………….. Prepaid expenses and other……………………………. Receivables from related parties………………………. Total current assets………………………………..

Property and equipment, net……………………………...Intangible assets, net……………………………………...Deposits and other……………………………………….. Total assets

LIABILITIES AND STOCKHOLDERS' EQUITYCurrent liabilities: Accounts payable……………………………………... Accrued liabilities…………………………………….. Current portion of long-term debt…………………….. Current portion of capital lease obligations…………... Amounts due to related parties……………………….. Income taxes payable…………………………………. Total current liabilities

Capital lease obligations………………………………….Long-term debt……………………………………………

Commitments and contingencies…………………………

Stockholders' equity: Series A Convertible Preferred Stock, no par value, 5,000,000 shares authorized, 1,200,000 and 0 shares issued and outstanding at December 31, 1993 and January 1, 1995 respectively……………………….. Common stock, no par value, 10,000,000 shares authorized , 3,657,500 and 6,057,500 issued and outstanding at December 31, 1993 and January 1, 1995, respectively………………………………….. Retained earnings (deficit)……………………………. Total stockholders' equity………………………….. Total liabilities and stockholders' equity…………

December 31, 1993

$10,602,397---

487,458385,790109,462

16,37711,601,484

2,600,054182,773 61,293

$14,445,604

$478,972339,39590,24563.88337,930 37,400

1,047,825

202,369113,347

---

---

13,042,807 39,256

13,082,063$14,445,604

January 1, 1995

$3,117,5661,711,1331,109,9271,146,101

646,556 59,650

7,790,933

13,526,9591,040,230

644,300$23,002,422

$1,364,8681,113,624

45,870------

---2,524,362

---81,044

---

---

23,390,174(2,993,158)20,397,016

$23,002,422

The accompanying notes are an integral part of these consolidated financial statements.




CONSOLIDATED STATEMENTS OF OPERATIONS

Years EndedDecember 31,

1992December 31,

1993January 1,

1995Net revenues: Grocery and club stores………………………… Restaurants……………………………………… Total net revenues…………………………...

Costs and expenses: Cost of sales……………………………………. Restaurant and operating expenses…………….. Selling, general and administrative…………….. Depreciation and amortization………………….

Income (loss) from operations……………………...Interest (income) expense, net……………………Other income, net…………………………………...Income (loss) before provision for income taxes…..Provision for income taxes…………………………Net income (loss)…………………………………...Pro forma income tax provision (unaudited)Net income after pro forma income tax provision (unaudited)……………Net loss per share…………………………………...Proforma net income per share (unaudited)………...Weighed average common and common equivalent shares outstanding…………………………………..

3,353,329 ---

3,353,329

2,035,149 ---

1,009,303 74,171

3,118,623 234,706 69,287

(11,955)177,374

---177,37462,080

$115,294

$ .05

2,336,973

$4,737,711 380,264

5,117,975

3,186,253232,282

1,161,283 178,298

4,758,116359,85994,667

(21,991)287,183 37,400249,78377,474

$172,309

$ . ,07

2,636,111

$9,281,740 6,068,879

15,350,619

9,126,4754,044,5764,371,9931,124,581

18,667,626(3,317,007)

(284,593) ---

(3,032,414) ---

$(3,032,414)

$ (.57)

5,303,811





CONSOLIDATED STATEMENTS OF CASH FLOWS

Years EndedDecember 31,

1992December 31,

1993January 1,

1995Cash flows from operating activities:Net income (loss)Adjustments to reconcile net income to net cash from operating activities: Depreciation and amortization……………………………... Unrealized interest income from held-to-maturity securities. Loss on sale of property and equipment…………………… Change in assets and liabilities: Increase in accounts receivable………………………….. Increase in inventories…………………………………… (Increase) decrease in prepaid expenses, intangible assets and other…………………………….. Increase (decrease) in income taxes payable…………….. Increase in accounts payable…………………………….. Increase in accrued expenses……………………………... Net cash provided by (used in) operating activities……Cash flows from investing activities: Purchase of held-to-maturity securities…………………….. Redemption of held-to-maturity securities…………………. Purchase of property and equipment……………………….. Issuance of notes receivable………………………………... Proceeds from sale of property and equipment…………….. Net cash used in investing activities…………………Cash flow from financing activities: Proceeds from long-term debt……………………………... Repurchase of common stock…………………………… Repayment of long-term debt and capital lease obligations. Proceeds from issuance of common stock and stock subscription received…………………………………….. Net cash provided by (used in) financing activities….Net increase (decrease) in cash………………………………Cash and cash equivalents at beginning of period…………Cash and cash equivalents at end of period………………….

$ 177,374

74,171------

(30,436)(139,761)

16,026---

131,012 6,433

234,819

------

(190,295)---

---(190,295)

114,861---

(158,086)

---(43,225)

1,299 2,082

$ 3,381

$ 249,783

$ 178,298---

2,629

(130,071)(233,279)

(160,678)37,400

190,152 275,824410,058

------

(1,410,143)---

14,387(1,395,756)

733,071---

(1,413,462)

12,265,10511,584,71410,599,016

3,381$ 10,602,397

$(3,032,414)

1,124,582(141,986)

---

(622,469)(760,311)

(1,230,828)(37,400)885,896

736,299(3,078,631)

(5,069,147)3,500,000

(11,082,490)(500,000)

---(13,151,637)

---(1,259,000)

(342,930)

10,347,3678,745,437

(7,484,831)10,602,397$ 3,117,566

For supplemental disclosure of non cash financing activities see Note 12.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Presentation and Summary of Significant Accounting Policies

Basis of Presentation:

Monterey Pasta Company incorporated in the State of California on June 16, 1989 and is principally engaged in the business of the production and distribution of specialty food products.

Effective August 31, 1993, the Company acquired all of the outstanding stock of Upscale Food Outlets, Inc., a California corporation, which was incorporated on April 7, 1993 by stockholders of Monterey Pasta Company. Upscale Food Outlets, Inc.'s principal business is the operation of restaurant facilities. The acquisition was accounted for as a pooling of interests as the two entities were under common control since the inception of Upscale Food Outlets, Inc.

On May 16, 1994, the Company formed a wholly owned subsidiary, Monterey Pasta Development Company, for the purpose of franchising quick service pasta restaurants.

Collectively, Monterey Past Company, Upscale Food Outlets, Inc. and Monterey Pasta Development Company are referred to as the "Company."

On August 31, 1993, the Company declared a 175.38 to 1 split of its common stock and a .9231 to 1 preferred stock dividend (accounted for as a stock split) to all common stockholders. The accompanying consolidated financial statements have been retroactively restated to reflect the stock splits and preferred stock dividend for all periods presented.

Principles of Consolidation:

The consolidated financial statements include the accounts of Monterey Pasta Company, together with its wholly owned subsidiaries, Upscale Food Outlets, Inc. and Monterey Pasta Development Company. All significant intercompany accounts and transactions have been eliminated in consolidation.

Cash and Cash Equivalents:

The Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents.

The Company maintains cash balances at various financial institutions. The Company's cash balances at the financial institutions exceed the limits of $100,000 per account which is the account limit for full insurance by the Federal Deposit Insurance Corporation.

Held to Maturity Securities:

During 1994, $2,727,532 of held-to-maturity securities were sold prior to maturity for working capital and capital expenditure purposes. The sale of held-to-maturity securities resulted in an immaterial capital loss for the year ended January 1, 1995.

Accounts Receivable:

Accounts receivable at December 31, 1993 and January 1, 1995 are net of allowances for doubtful accounts



of $5,472 and $10,038, respectively. At January 1, 1995, the accounts receivable balance is also net of a reserve for returns of $49,621.

Inventories:

Inventories are stated at the lower of cost (using the first-in, first-out method) or market and consist principally of component ingredients to the Company's fresh pasta and sauces, finished goods, paper goods and packaging materials and restaurant inventories.

Advertising Costs:

The Company defers certain amortizable costs related to specific promotions. These costs are expensed upon commencement of the related campaign.

Property and Equipment:

Property and equipment are recorded at cost. Depreciation is provided for on the straight-line method over the estimated useful lives of the assets. Maintenance and repairs are charged to expense as incurred. Included in property and equipment are pre-opening costs associated with the opening of Company restaurants. Pre-opening costs consist of direct costs related to hiring and training of the initial workforce and other direct costs associated with restaurant openings. The Company amortizes pre-opening costs over the twelve month period following restaurant opening.

Intangible Assets:

Intangible assets consist of tradenames, covenants not to compete and goodwill recorded at cost, net of accumulated amortization of $19,720 in 1993 and $117,879 in 1994. The costs are being amortized ratably over periods of three or ten years.

Income Taxes:

Effective July 1, 1990, the Company elected to be treated as an S Corporation for federal and state tax reporting purposes. As such, all taxable income and available tax credits are passed from the corporate entity to the individual stockholders. It is the responsibility of the individual stockholders to report the taxable income and tax credits, and pay the resulting taxes. The S Corporation election was revoked upon the issuance of preferred stock on August 31, 1993 and the Company will be taxed as a C Corporation thereafter.

In conjunction with the termination of its S Corporation status, the Company adopted Statement of Financial Accounting Standard No. 109, "Accounting for Income Taxes." The impact of this adoption was not material to the Company. Under this method, deferred income taxes are provided based on the estimated future tax effects of differences between financial statement carrying amounts and the tax bases of existing assets and liabilities.

Cost of Sales:

Cost of sales includes food costs related to the retail and restaurant operations, packaging materials, production labor, factory overhead and distribution costs.



Conversion into Common Stock:

Effective on July 7, 1994, 1,200,000 shares, no par, non-voting preferred shares were automatically converted one for one to common stock as a result of the beneficial ownership of two principal stockholders being reduced to less than 20% of the common stock outstanding.

Retained Earnings:

Prior to September 1, 1993, the Company operated as an S Corporation for federal and state tax reporting purposes. Effective August 31, 1993, the Company terminated its S Corporation status and the undistributed earnings of the Company, in the amount of $609,227, have been reclassified as contributed capital.

Common Stock Offerings:

Effective December 7, 1993, the Company completed an Initial Public Offering of 2,357,500 shares of common stock at $6 per share.

Effective July 7, 1994, the Company issued 750,000 shares of its common stock to the public at a price of $10.00 per share.

On December 6, 1994, the Company completed the sale of 450,000 shares of its common stock to investors outside of the United States at a price of $9.20 per share.

11. Income Taxes

The following is a summary of the components of income taxes from operations:

Federal - current deferred

State

Total income taxes

1992$ 0 0

0

$ 0

1993$ 27,878

0

9,522

$ 37,400

1994$ 0

0

0

$ 0

A reconciliation between the Company's effective tax rate (shown as proforma for 1992 and 1993) and U.S. federal income tax rate on earnings (loss) from continuing operations is as follows:

Federal statutory rate

State income taxes

Losses not previously benefitted

Losses for which no tax benefit was recorded in the current period

Effective income tax rate for the year

199234.0%

6.0%

(5.0%)

0.0%

35.0%

199334.0%

6.0%

0.0%

0.0%

40.0%

1994(34.0%)

(6.0%)

0.0%

40.0%

0.0%



The pro forma unaudited income tax adjustments presented in the accompanying consolidated statements of operations represent the estimated difference between the historical income tax expense and income tax expense that would have been reported had the Company been a C corporation subject to federal and state income taxes based on tax laws in effect during those periods.

Deferred income taxes reflect the next tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's deferred tax liabilities and assets are as follows as of December 31, 1993 and January 1, 1995.

Deferred income tax liabilities

Deferred income tax assets: Net operating loss carryforwards Depreciation expense Amortization expense

Total deferred tax asset

Net deferred tax assetLess: Valuation allowance

Net deferred tax asset

1993

$ 0

000

0

00

$ 0

1994

$ 0

$1,357,366185,308(16,528)

1,526,146

1,526,146(1,526,146)

$ 0

As of January 1, 1995, the Company had a tax net operating loss carryforward (NOL) of approximately $3.4 million which expires in 2009. Should significant changes in the Company's ownership occur, the annual amount of NOL carryforwards available for future use would be limited. Statement of Financial Accounting Standard ("SFAS") No. 109 requires that the tax benefit of such NOL be recorded as an asset. However, SFAS No. 109 also requires that a valuation allowance be provided to the extent that management assesses that it is more likely than not that some portion or all of the deferred tax assets will not be realized.

12. Statement of Cash FlowsNon-Cash Investing and Financing Activities:

During the three years ended January 1, 1995, the Company engaged in investing and financingactivities that affected its assets and liabilities, but did not result in cash receipts or payments. These non-cash activities are as follows:

During the year ended January 1, 1995, the Company acquired certain assets of Lucca's Pasta Bar, Inc. in exchange for common stock of the Company and a promissory note. See Note 7 for further discussion. In addition, common stock was issued for the acquisition of a subsidiary, Monterey Pasta Development Company.

During the year ended December 31, 1993, vehicles, machinery and equipment in the amount of $374,356, were financed through notes payable and capital leases. In addition, stock subscriptions receivable in the amount of $37,047, were paid through the reduction of a loan payable to a stockholder; the Company issued 1,200,000 shares of Series A convertible preferred stock through a stock dividend (split); and common stock was issued for the acquisition of a subsidiary, Upscale Food Outlets, Inc.

During the year ended December 31, 1992, vehicles, machinery and equipment in the amount of $244,825, were financed through notes payable and capital leases, less trade-in amounts of $43,900.



Self-Study Problem #1

Refer to Anheuser-Busch Companies Inc.

1. What entry was recorded by Anheuser-Busch to record the deferred tax effects of the retroactively enacted increase in the federal statutory income tax rate?

2. What entry was recorded by Anheuser-Busch on 12/31/93 to record the income tax provision for 1993?

3. Why do fixed assets create a deferred tax liability? Why do accrued postretirement benefits create a deferred tax asset?

4. Assume the U.S. statutory tax rate (35%) was used to calculate deferred tax liability related to fixed assets. How much additional depreciation was reported on Anheuser-Busch's 1993 tax return (above that reported in the financial statements)? Assume that there were no acquisitions of companies accounted for by the purchase method (an advanced topic).

5. If the accelerated depreciation methods used for tax purposes were also used for financial accounting purposes for all years, what would be the 12/31/93 balance in accumulated depreciation? Assume that there were no acquisitions of companies accounted for by the purchase method (an advanced topic).

Item 2i Self Study Problem 1 – Anheuser Busch Page 1 of 5


CONSOLIDATED BALANCE SHEETASSETS (In millions)DECEMBER 31, 1993 1992

CURRENT ASSETS:

Cash and marketable securities $ 127.4 $ 215.0Accounts and notes receivable, less allowancefor doubtful accounts of $6.7 in 1993 and $4.9in 1992 751.1 649.8InventoriesRaw materials and supplies 385.5 417.7Work in process 99.4 88.7Finished goods 141.8 154.3Total inventories 626.7 660.7Other current assets 290.0 290.3 Total current assets 1,795.2 1,815.8 INVESTMENTS AND OTHER ASSETS:Investments in and advances to affiliatedcompanies 629.5 171.6Investment properties 151.9 164.8Deferred charges and other non-current assets 310.7 356.3Excess of cost over net assets of acquiredbusinesses, net 495.9 505.7 1,588.0 1,198.4 PLANT AND EQUIPMENT:Land 281.9 273.3Buildings 3,445.5 3,295.2Machinery and equipment 7,656.5 7,086.9Construction in progress 343.2 729.7 11,727.1 11,385.1Accumulated depreciation (4,230.0) (3,861.4) 7,497.1 7,523.7 $10,880.3 $10,537.9 The accompanying statements should be read in conjunction with the Notesto Consolidated Financial Statements.



CONSOLIDATED BALANCE SHEET (CONT'D) LIABILITIES AND SHAREHOLDERS EQUITY (In millions)DECEMBER 31, 1993 1992CURRENT LIABILITIES:Accounts payable $ 812.5 $ 737.4Accrued salaries, wages and benefits 243.9 257.3Accrued interest payable 54.9 52.4Due to customers for returnable containers 50.3 48.2Accrued taxes, other than income taxes 121.7 117.0Estimated income taxes 91.0 38.8Restructuring accrual 189.2 -Other current liabilities 252.1 208.7 Total current liabilities 1,815.6 1,459.8 POSTRETIREMENT BENEFITS 607.1 538.3 LONG-TERM DEBT 3,031.7 2,642.5 DEFERRED INCOME TAXES 1,170.4 1,276.9

COMMON STOCK AND OTHER SHAREHOLDERS EQUITY:Common stock, $1.00 par value, authorized800,000,000 shares 342.5 341.3Capital in excess of par value 808.7 762.9Retained earnings 6,023.4 5,794.9Foreign currency translation adjustment (33.0) (1.4) 7,141.6 6,897.7 Treasury stock, at cost (2,479.6) (1,842.9) ESOP debt guarantee offset (406.5) (434.4) 4,255.5 4,620.4 COMMITMENTS AND CONTINGENCIES - - $10,880.3 $10,537.9



CONSOLIDATED STATEMENT OF INCOME(In millions, except per share data)YEAR ENDED DECEMBER 31, 1993 1992 1991Sales $13,185.1 $13,062.3 $12,634.2Less federal and state excise taxes 1,679.8 1,668.6 1,637.9

Net sales 11,505.3 11,393.7 10,996.3Cost of products and services 7,419.7 7,309.1 7,148.7

Gross profit 4,085.6 4,084.6 3,847.6

Marketing, distribution andadministrative expenses 2,308.7 2,308.9 2,126.1Restructuring charge 565.0 - - Operating income 1,211.9 1,775.7 1,721.5 Other income and expenses:Interest expense (207.8) (199.6) (238.5)Interest capitalized 36.7 47.7 46.5Interest income 5.2 7.1 9.2Other income/(expense), net 4.4 (15.7) (18.1) Income before income taxes 1,050.4 1,615.2 1,520.6 Provision for income taxes:Current 562.4 561.9 479.1Deferred (139.5) 59.1 101.7Revaluation of deferred taxliability (FAS 109) 33.0 - - 455.9 621.0 580.8Net income, before cumulative effectof accounting changes 594.5 994.2 939.8Cumulative effect of changes in themethod of accounting forpostretirement benefits (FAS 106)and income taxes (FAS 109), net oftax benefit of $186.4 million - (76.7) - NET INCOME $ 594.5 $ 917.5 $ 939.8 PRIMARY EARNINGS PER SHARE:Net income, before cumulative effect $ 2.17 $ 3.48 $ 3.26Cumulative effect of accountingchanges - (.26) -

Net income $ 2.17 $ 3.22 $ 3.26



11-INCOME TAXES: The provision for income taxes consists of the following for the three years ended December 31 (in millions): 1993 1992 1991Current Tax Provision:Federal $459.5 $460.6 $386.7State and foreign 102.9 101.3 92.4

562.4 561.9 479.1Deferred Tax Provision:Federal (126.2) 50.3 93.3State and foreign (13.3) 8.8 8.4 (139.5) 59.1 101.7 $422.9 $621.0 $580.8 The deferred tax provision results from differences in the recognitionof income and expense for tax and financial reporting purposes. Theprimary differences are related to fixed assets (tax effect of $51.5million in 1993, $67.6 million in 1992 and $75.9 million in 1991) andthe restructuring charge benefit ($184 million) in 1993. Under the liability method, at December 31, 1993 the company haddeferred tax liabilities of $1,759 million and deferred tax assets of$588 million. The principal temporary differences included in deferredtax liabilities are related to fixed assets ($1,548 million). Theprincipal temporary differences included in deferred tax assets arerelated to accrued postretirement benefits ($232.2 million) and otheraccruals and temporary differences ($355.9 million) which are notdeductible for tax purposes until paid or utilized. On August 10, 1993, the Revenue Reconciliation Act of 1993 was signedinto law. As a result, the federal statutory income tax rate wasretroactively increased, effective January 1, 1993, by 1% to 35%. Thisresulted in a $33 million non-recurring, after-tax, non-cash chargerelated to revaluation of the deferred tax liability in accordance withFAS 109. The company's effective tax rate was 43.4% in 1993, 38.4% in 1992 and38.2% in 1991. A reconciliation between the statutory rate and theeffective rate is presented below: 1993 1992 1991 Statutory rate 35.0% 34.0% 34.0%State income taxes, net of federal benefit 4.7 3.9 3.8Revaluation of deferred tax liability 3.1 - -Other .6 .5 .4 Effective tax rate 43.4% 38.4% 38.2%



Self-Study Problem #1 Solution: Anheuser-Busch -- Taxes

1. Income tax expense 33Deferred income taxes 33

2. Income tax expense 422.9Deferred income taxes 139.5

Income taxes payable 562.4

3. A deferred tax liability is the result of the following type of journal entry:

Income tax expense XDeferred income taxes X-YIncome taxes payable Y

A deferred tax asset is the result of the following type of journal entry:

Income tax expense XDeferred income taxes Y-X

Income taxes payable Y

4. $51.5 / 0.35 = $147.1 million.

5. Accumulated depreciation was $4,230 million at December 31, 1993. If tax depreciation methods had been used, this balance would be higher by $4,422.9, or:

$4,230 + 4,422.9 = $8,652.9 million (205% of the original amount).

Item 2j Self Study Problem 1 – Solution Page 1 of 1



Accounting for Income TaxesAn Illustrative Example

Part I

Simple firm buys equipment for cash that it uses to produce a product that it sells for cash. It carries no inventory, payables, or receivables and operates in a tax jurisdiction in which the tax rate is 40%. It started with $1000 cash that was raised through the sale of no par common stock. It sells its product for $100 a piece. The materials used in the product cost $60 each. During its first year of operations, it had the following sales revenues, materials expenditures, and equipment purchases.

Year Revenues Materials Expenditures Equipment Purchases1 500 300 500

Simple firm uses cash basis accounting for tax purposes. For GAAP purposes, simple firm uses accrual accounting. More specifically, the equipment purchased in the first year is to be depreciated using the straight line method over a two year period with a full year’s depreciation taken in the first year.

1. Prepare the firm’s tax return for year 1.2. Prepare the firm’s GAAP income statement and tax note disclosure for year 1. Assume that

the firm is highly uncertain as to whether it will be able to use any tax benefits created in year 1.

3. Prepare the firm’s GAAP income statement and tax note disclosure for year 1. Assume that the firm is highly certain that it will be able to use any tax benefits created in year 1.

Part II

During its second year of operations, it had the following sales revenues, materials expenditures, and equipment purchases.

Year Revenues Materials Expenditures Equipment Purchases2 1000 600 0

1. Prepare the firm’s tax return for year 2.2. Assume the firm did its accounting in year 1 as in Part I question 2. Prepare the firm’s GAAP

income statement and tax note disclosure for year 2.3. Assume the firm did its accounting in year 1 as in Part I question 3. Prepare the firm’s GAAP income statement and tax note disclosure for year 2.

Item 2k Self Study Problem 2 – Illustrative E.g. Page 1 of 1

B30116 Chapter 2 – Deferred Income TaxesSelf-Study Problem #2 Solution: Illustrative Example -- Taxes

Part I question 1

Tax Return

Revenues 500Materials Expenditures 300Equipment Expenditures 500Taxable Income (300)Taxes Due 0 (40% of taxable income if taxable income is positive)

NOL carryforward is 300 (100% of taxable income if taxable income is negative.)

Item 2l Self Study Problem 2 – Solution Page 1 of 6

B30116 Chapter 2 – Deferred Income TaxesPart I question 2

Income Statement

Revenues 500Materials Expenditures 300Depreciation 250Earnings Before Tax (50)Tax Expense 0 Net Earnings (50)

Note Disclosure

Provision for taxes on income:

Current 0Deferred 0Provision for Tax 0

Components of deferred taxesYear 1

AssetsNOL 120

LiabilitiesDepreciation 100

Valuation Allowance 20

Net Deferred Tax Asset (Liability) 0


Year 1Statutory rate 40%Unrecognized NOL benefit (40%)Effective tax rate 0%

The firm currently has 300 in unused NOL carryforwards. These carryforwards expire in Year 21.


B30116 Chapter 2 – Deferred Income TaxesPart I question 3

Income Statement

Revenues 500Materials Expenditures 300Depreciation 250Earnings Before Tax (50)Tax Expense (20)Net Earnings (30)

Note Disclosure


Current 0Deferred (20)Provision for Tax (20)

Components of deferred taxesYear 1

AssetsNOL 120

LiabilitiesDepreciation 100

Valuation Allowance 0

Net Deferred Tax Asset 20


Year 1Statutory rate 40%Effective tax rate 40%

The firm currently has 300 in unused NOL carryforwards. These carryforwards expire in Year 21.


B30116 Chapter 2 – Deferred Income TaxesPart II question 1

Tax Return

Revenues 1000Materials Expenditures 600Equipment Expenditures 0 Taxable Income before carryforwards 400NOL carryforward (300)Taxable Income 100Taxes Due 40 (40% of taxable income if taxable income is positive)

NOL carryforward is 0. (100% of taxable income if taxable income is negative.)



Income Statement

Revenues 1000Materials Expenditures 600Depreciation 250Earnings Before Tax 150Tax Expense 40Net Earnings 110

Note Disclosure


Year 2 Year 1Current 40 0Deferred 0 0Provision for Tax 40 0

Components of deferred taxesYear 2 Year 1

AssetsNOL 0 120

LiabilitiesDepreciation 0 100

Valuation Allowance 0 20

Net Deferred Tax Asset (Liability) 0 0


Year 2 Year 1Statutory rate 40% 40%Unrecognized NOL benefit 0% (40%)Recognition of prior period NOL benefit (13%) 0%Effective tax rate 27% 0%

The firm currently has 0 in unused NOL carryforwards.



Income Statement

Revenues 1000Materials Expenditures 600Depreciation 250Earnings Before Tax 150Tax Expense 60Net Earnings 90

Note Disclosure



Year 2 Year 1Current 40 0Deferred 20 (20)Provision for Tax 60 (20)

Components of deferred taxesYear 2 Year 1

AssetsNOL 0 120

LiabilitiesDepreciation 0 100

Valuation Allowance 0 0

Net Deferred Tax Asset (Liability) 0 20


Year 2 Year 1Statutory rate 40% 40%Effective tax rate 40% 40%

The firm currently has 0 in unused NOL carryforwards.


B30116 – Berger Chapter 3 – Revenue & Securitization

3. Revenue Recognition & Securitization

Determining when a firm should recognize revenue is a difficult conceptual and practical issue. The purpose of our analysis of revenue recognition is to assist you by:> making you aware of the conceptual shortcomings of GAAP’s revenue recognition principles > helping you develop some skill at assessing the financial statement implications of a

particular revenue recognition policy

The fundamental issue of is timing: when should a firm recognize the increase in its net assets arising from the process of making or buying assets and then selling those assets.

The set of options which most individuals would not find unappealing can be summarized as follows: completion of production, time of sale, ir time cash is collected (i.e., any of the last 3 steps in the figure below of the Operating Cycle). You are well aware that GAAP generally mandates recognizing revenue at the time of sale. This does not imply that GAAP is conceptually better than the other two. In fact, none of the three options depicts reality exactly since the process which creates revenue (i.e., the Operating Cycle) contains many steps and the completion of no step constitutes a critical event after which revenue is earned and before which revenue has not been earned.

Item 3a Revenue Recognition Notes Page 1 of 4



Receive order

Negotiate production

contract

Order material

Manufacture product

Deliver product

Collect cash

Market the

product

Operating

Revenue recognition & operating cycle


I. When to Recognize Revenue -- General GuidelinesA. Revenue is recognized when it is:

1. Measurable – value to be received for the good or service is reasonably assured and can be measured with a high degree of reliability (i.e., it is either cash or is a claim to cash or other assets with future collection that is highly likely and with a current cash equivalent value that can be estimated well); and

2. Earned -- selling firm has accomplished what it must do to be entitled to the value to be received

B. Application of general guidelines1. recognize revenue from sale of goods at date of sale (usually date of delivery)2. recognize revenue from services provided when services have been performed and

are billable3. recognize revenue from asset use (i.e., rentals, loans) as time passes or the assets are

used4. recognize revenue from the disposal of assets (i.e., sales of fixed assets) at the date of

sale or trade-in

II. Exceptions to General Guidelines




Condition 1: The critical event in the process of earning the revenue has taken place.Condition 2: The amount of revenue that will be collected is

Exceptions to General Guidelines



IASB: Significant risks and

rewards of ownership have been transferred from the seller to the buyer.

Management involvement and control over the asset being transferred has passed

US: Revenues are

considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented

U.S. GAAP vs. IASB

Exceptions to General Guidelines



Revenue recognition prior to sale: Before construction begins, a formal contract

has been signed. The buyer is assured and the contract price is

specified.Consequently, both revenue recognition

conditions are satisfied prior to the time of sale.

Condition 1: The critical event is actual construction, thus revenue is earned over time as the project progresses toward completion.

Condition 2: Measurability is satisfied because there’s a firm contract with a known buyer at a



Sometimes revenue is not recognized at the point of sale even though a valid sale has taken place.

High risk of not receiving cash from the buyer (Conditions 1 and 2 are not met).

Or there is no reasonable basis for estimating uncollectible accounts (Condition 2 is not met).

Conditions 1 and 2 are both satisfied over time as cash collections take place.

So, revenue recognition occurs as cash is collected

Revenue recognition after the sale:



GAAP allows this approach when: Collections on installment sales occur over an

extended period. There is no reasonable basis for estimating

collectability.Under the cost recovery method: No profit is recognized until cash payments

from the buyer exceed the seller’s cost of goods sold.

Revenue recognition after the sale:



USAir: Revenue Recognition, Expense Recognition

USAir Group's primary business activity is conducted through its subsidiary USAir, Inc. ("USAir"). USAir is an air carrier engaged primarily in the business of transporting passengers, property and mail. USAir enplaned more than 57 million passengers in 1995 and is the fifth largest United States air carrier ranked by revenue passenger miles ("RPMs") flown.

Answer the following questions.

Revenue Recognition

1. Explain why USAir does not account for the sales of passenger tickets at the time the customer purchases the ticket.

2. Assume that USAir accounted for the sales of passenger tickets at the time of the customer purchased the tickets. Assume a 40% tax rate.

a. How would the 1995 ending balance sheet differ from the actual statement?

b. How would the 1995 income statement differ from the actual statement?

c. How would 1995 statement of cash flows differ from the actual statement?

Expense Recognition

Read the note and the discussion from the Management Discussion & Analysis (MD&A) regarding USAir's Frequent Traveler Program (FTP) before addressing the following questions.

3. Provide a simple accounting rationale for USAir's policy for the FTP.

4. Assume that the incremental cost per passenger for USAir is $40. What is the dollar amount on USAir's balance sheet at the end of 1995 for its FTP liability. (Note: any amount is included in the Accrued expenses line in the current liabilities section of the balance sheet.)

5. Assume again that the incremental cost per passenger is $40. Assume that USAir accounts for the FTP expenses as the costs are incurred. Assume a 40% tax rate.


b. How would the 1995 before tax income differ from the actual value?

Item 3b Self Study Problem 3 – U.S. Air Page 1 of 9


6. A reasonable accountant might disagree with the following part of USAir's FTP accounting policy.

Mileage for FTP participants who have accumulated less than the minimum number of mileage credits necessary to claim an award is excluded from the calculation of the accrual.

Explain why the accountant might be concerned and provide a suggested change in policy that would alleviate the accountant's concerns.

7. What impact would the January 1, 1995 and May 1, 1995 changes in the FTP awards program have on 1995 net income and the 1995 ending accrued liability. A numerical answer is not expected.

8. Any accounting for the FTP program is likely to forego recording amounts representing one opportunity cost to USAir for the program -- displaced paying passengers. USAir argues that little revenue is lost due to the programs displacement of passengers. Provide one critique of the argument presented by USAir.



USAir Group, Inc.Consolidated Statements of Operations

Years Ended December 31,(in thousands except per share amounts)

1995 1994 1993Operating RevenuesPassenger transportation $6,748,564 $6,357,547 $ 6,554,926Cargo and freight 157,262 163,598 173,824Other 568,522 476,049 354,458Total operating revenues 7,474,348 6,997,194 7,083,208 Operating ExpensesPersonnel costs 2,887,115 2,889,764 2,841,344Aviation fuel 634,320 671,926 710,109Commissions 563,037 583,158 596,779Other rent and landing fees 404,158 436,540 445,797Aircraft rent 437,649 563,572 472,622Aircraft maintenance 346,854 392,181 374,084Depreciation and amortization 352,447 408,587 352,467Other, net 1,527,081 1,542,822 1,385,798Total operating expenses 7,152,661 7,488,550 7,179,000

Operating income (loss) 321,687 (491,356) (95,792) Other Income (Expense)Interest income 51,624 27,088 12,632Interest expense (302,593) (284,034) (249,916)Interest capitalized 8,781 13,760 17,763Other, net 48,773 49,619 (34,054)

Other income (expense), net (193,415) (193,567) (253,575)

Income (loss) before taxes and cumulative effect of accounting change 128,272 (684,923) (349,367) Income tax provision (credit) 8,985 - -

Income (loss) before cumulative effect of accounting change 119,287 (684,923) (349,367)



USAir Group, Inc.Consolidated Statements of Operations (continued)

Years Ended December 31,(in thousands except per share amounts)

1995 1994 1993Cumulative effect of change in method of accounting for postemployment benefits in 1993 - - (43,749)

Net income (loss) 119,287 (684,923) (393,116) Preferred dividend requirement (84,904) (78,036) (73,651)

Net income (loss) applicable to common stockholders $ 34,383 $ (762,959) $ (466,767) Income (loss) per common share before accounting change $ 0.55 $ (12.73) $ (7.68)Effect of accounting change - - (0.80)Income (loss) per common share $ 0.55 $ (12.73) $ (8.48)Shares used for computation (000) 62,430 59,915 55,070



USAir Group, Inc.Partial Consolidated Balance Sheets

December 31,(dollars in thousands except per share amounts)

1995 1994ASSETS Current AssetsCash and cash equivalents $ 881,854 $ 429,538Short-term investments 19,831 22,133Receivables, net 322,122 324,539Materials and supplies, net 248,144 258,664Prepaid expenses and other 111,131 81,642

Total current assets 1,583,082 1,116,516 Property and EquipmentFlight equipment 5,251,742 5,162,599Ground property and equipment 1,073,720 1,059,027Less accumulated depreciation and amortization (2,301,059) (2,085,499) 4,024,403 4,136,127Purchase deposits 17,026 195,701Property and equipment, net 4,041,429 4,331,828 Other AssetsGoodwill, net 510,562 526,615Other intangibles, net 312,786 319,711Other assets, net 507,149 513,372

Total other assets 1,330,497 1,359,698

$6,955,008 $6,808,042 LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)Current LiabilitiesCurrent maturities of long-term debt $ 80,721 $ 85,538Accounts payable 325,330 275,847Traffic balances payable and unused tickets 607,170 568,215Accrued expenses 1,471,475 1,330,453

Total current liabilities 2,484,696 2,260,053 Long-Term Debt, Net of Current Maturities 2,717,085 2,895,378 Deferred Credits and Other LiabilitiesDeferred gains, net 386,947 413,961Postretirement benefits other than pensions, non-current 1,015,623 958,956Non-current employee benefit liabilities and other 427,726 417,878

Total deferred credits and other liabilities 1,830,296 1,790,795…



USAir Group, Inc.Consolidated Statements of Cash Flows

Years Ended December 31,(in thousands)

1995 1994 1993

Cash and cash equivalents beginning of year $ 429,538 $ 368,347 $ 296,038

Cash flows from operating activitiesNet income (loss) 119,287 (684,923) (393,116)Adjustments to reconcile net income (loss) to cash provided by (used for) operating activitiesDepreciation and amortization 352,447 408,587 352,467Loss (gain) on disposition of property (17,043) (24,099) 10,328Amortization of deferred gains and credits (27,817) (27,396) (27,309)Other 6,294 (11,605) 24,635Changes in certain assets and liabilitiesDecrease (increase) in receivables 2,417 41,101 (180,152)Decrease (increase) in materials, supplies, prepaid expenses and intangible pension assets (74,980) 74,663 24,234Increase (decrease) in traffic balances payable and unused tickets 38,955 (61,932) 35,517Increase (decrease) in accounts payable and accrued expenses 120,422 235,105 84,787Increase (decrease) in postretirement benefits other than pensions, non-current 56,667 51,613 65,967

Net cash provided by (used for) operations 576,649 1,114 (2,642) Cash flows from investing activitiesAircraft acquisitions and purchase deposits, net (61,689) (46,022) (202,085)Additions to other property (84,980) (134,086) (159,031)Proceeds from disposition of property 222,325 75,075 178,387Change in short-term investments 2,430 (21,994) -Change in restricted cash and investments 71,980 2,578 (14,221)Other (1,134) 1,110 (4,378)

Net cash provided by (used for) investing activities 148,932 (123,339) (201,328)



USAir Group, Inc.Consolidated Statements of Cash Flows (continued)

Years Ended December 31,(in thousands)

1995 1994 1993

Cash flows from financing activities

Issuance of debt 1,162 308,856 597,834Reduction of debt (283,160) (87,073) (889,872)Issuance of common stock 8,733 52 230,891Issuance of preferred stock - - 400,719Sale of treasury stock - 11,244 8,273Dividends paid - (49,663) (71,566)

Net cash provided by (used for) financing activities (273,265) 183,416 276,279

Net increase (decrease) in cash and cash equivalents 452,316 61,191 72,309

Cash and cash equivalents end of year $881,854 $ 429,538 $ 368,347



USAir Group, Inc. Selected Notes to Consolidated Financial Statements 1. Summary of Significant Accounting Policies...

(h) Passenger Revenue Recognition Passenger ticket sales are recognized as revenue when the transportation service is rendered or the ticket otherwise expires. At the time of sale, a liability is established (Traffic BalancesPayable and Unused Tickets) and subsequently eliminated either through carriage of the passenger, through billing from another carrier which renders the service or by refund to the passenger. (i) Frequent Traveler Awards USAir accrues the estimated incremental cost of providing outstanding travel awards earned by participants in its Frequent Traveler Program ("FTP") when participants accumulate sufficient miles to be entitled to claim award certificates for travel.

USAir Group, Inc. Selected Portion of MD&AFrequent Traveler Program

Under USAir's Frequent Traveler Program ("FTP"), participants generally receive mileage credits equal to the greater of actual miles flown or 500 miles, effective May 1, 1995 (750 miles before May 1, 1995), for each paid flight segment on USAir or USAir Express, or actual miles flown on one of USAir's FTP airline partners. Participants generally receive a minimum of 500 mileage credits, effective May 1, 1995, for each paid flight on USAir Shuttle (1,000 miles prior to May 1, 1995). Participants flying on first or business class tickets generally receive additional credits. Participants may also earn mileage credits by utilizing certain credit cards, staying at participating hotels or by renting cars from participating car rental companies. Mileage credits earned by FTP participants, which do not expire under current program guidelines, can be redeemed for various travel awards, including fare discounts, first class upgrades and tickets on USAir or other airlines participating in USAir's FTP. Certain awards also include hotel and car rental awards. Awards may not be brokered, bartered or sold, and have no cash value. USAir and its airline partners limit the number of seats allocated per flight for award recipients through inventory management techniques. The number of seats available for frequent travelers varies depending upon flight, day, season and destination. Award travel for all but USAir's most frequent travelers generally is not permitted on blackout dates, which correspond to certain holiday periods in the United States or peak travel dates to foreign destinations. USAir reserves the right to terminate the FTP or portions of the program at any time, and the FTP's rules, partners, special offers, blackout dates, awards and mileage levels are subject to change without prior notice.



USAir accounts for its FTP under the incremental cost method, whereby estimated future travel awards are valued at the estimated average incremental cost of carrying one additional passenger. Incremental costs include unit costs for passenger food, beverages and supplies, fuel, reservations, communications, liability insurance and denied boarding compensation expenses. No profit or overhead margin is included in the accrual for incremental costs. The Company periodically reviews the assumptions made to calculate its FTP liability for reasonableness and makes adjustments to these assumptions as necessary. No liability is recorded for airline, hotel or car rental award certificates that are to be honored by other parties because there is no cost to USAir for such awards. Effective January 1, 1995, USAir increased the minimum mileage level required for a free domestic flight from 20,000 to 25,000. FTP participants had accumulated mileage credits for approximately 3,350,000 awards and 3,697,000 awards at December 31, 1995 and 1994, respectively, at the 25,000 mile level required to earn an award. Because USAir expects that some potential awards will never be redeemed, the calculations of the accrued liability for incremental costs at December 31, 1995 and 1994 were based on approximately 87% and 86%, respectively, of the accumulated credits. Mileage for FTP participants who have accumulated less than the minimum number of mileage credits necessary to claim an award is excluded from the calculation of the accrual. Incremental changes in FTP liability resulting from redeemed or additional mileage credits are recorded as part of the regular review process. USAir's customers redeemed approximately 1,160,000, 927,000 and 841,000 awards for free travel on USAir in 1995, 1994 and 1993, respectively, representing approximately 9.0%, 7.0% and 8.0% of USAir's revenue passenger miles ("RPMs") in those years, respectively. USAir does not believe that usage of FTP awards results in any significant displacement of revenue passengers. USAir's exposure to the displacement of revenue passengers is not significant, as the number of USAir flights that depart 100% full is minimal. In the second quarter of 1995, the quarter when the highest number of free frequent traveler trips were flown for the year, for example, fewer than 6.5% of USAir's flights departed 100% full. During this same quarterly period, approximately 5.2% of USAir's flights departed 100% full and also had one or more passengers on board who were traveling on FTP award tickets. ....



Self Study Problem #3 Solution – USAir: Revenue Recognition, Expense Recognition1. Explain why USAir does not account for the sales of passenger tickets at the time the customer purchases the

ticket.

USAir has not provided the service.

2. Assume that USAir accounted for the sales of passenger tickets at the time of the customer purchased the tickets. Assume a 40% tax rate.


traffic balances payable and unused tickets liability down 607170deferred income tax liability (asset) up (down) 607170 x .40 = 242868retained earnings up by 607170 x (1-.40) = 364302

b. How would the 1995 income statement differ from the actual statement?

total operating revenues increases by the increase in the traffic balances payable and unused tickets liabilitythustotal operating revenues rises by 607170 - 568215 = 38955income before tax rises by 38955income tax expense rises by 38955 x .4 = 15582net income rises by 38955 x (1-.4) = 23373

Note that, if revenue is recognized earlier, there should be some expense accrued as well in order to satisfy the matching concept. Thus, one might also adjust total operating expenses up by some proportion of the additional revenues recognized.

c. How would 1995 statement of cash flows differ from the actual statement?

The key point is that cash flows aren’t changed because of a change in revenue recognition, so operating, investing, financing, and total cash flow remain the same. The first line item in the operating cash flow section under the indirect method is, however, net income and it would be larger by the amount identified in b (say 23373 for purposes of this part). Therefore, other items in the operating section must be smaller in total by the same amount. Specifically, there would be no addback for the 38955 increase in traffic balances payable and unused tickets. Finally, under “Changes in certain assets and liabilities” a line item would be inserted that adds 15,582 to reflect the effect of the increase in income tax expense on creating a deferred income tax liability. In sum, operating cash is unchanged, but net income rises by 23373, the “Increase (decrease) in traffic balances payable and unused tickets” line falls by 38955, and a new line item for the increase in deferred income tax liability rises by 15582.

3. Provide a simple accounting rationale for USAir's policy for the FTP.

The benefit derived from the FTP is more revenue today and the cost is not fully incurred until awards are exercised. Thus, to satisfy the matching concept, USAir accrues some expense.

4. Assume that the incremental cost per passenger for USAir is $40. What is the dollar amount on USAir's balance sheet at the end of 1995 for its FTP liability. (Note: any amount is included in the Accrued expenses line in the current liabilities section of the balance sheet.)

The FTP liability on USAir's balance sheet, in thousands, is 40 x 3350 x 87% = 116580

Item 3c Self Study Problem 3 – Solution Page 1 of 2


5. Assume again that the incremental cost per passenger is $40. Assume that USAir accounts for the FTP expenses as the costs are incurred. Assume a 40% tax rate.


FTP liability drops by 116580, so accrued expenses falls by 116580 (the amount calculated in 4)deferred income tax liability (asset) rises (falls) by 116580 x .40 = 46632retained earnings rises by 116580 x (1-.4) = 69948

b. How would the 1995 before tax income differ from the actual value?

change in income before tax = expense accrued less actual costs incurrednote:

expense accrued less actual costs incurred = end FTP liability - beg. FTP liabilitythus, the change in income before tax = 116580-(40x3697x86%) = -10597

6. A reasonable accountant might disagree with the following part of USAir's FTP accounting policy.

Mileage for FTP participants who have accumulated less than the minimum number of mileage credits necessary to claim an award is excluded from the calculation of the accrual.

Explain why the accountant might be concerned and provide a suggested change in policy that would alleviate the accountant's concerns.

Some of the FTP participants will ultimately accumulate an award. Therefore, an accountant might argue that expenses be accrued for some proportion of FTP participants who have not yet earned an award.

7. What impact would the January 1, 1995 and May 1, 1995 changes in the FTP awards program have on 1995 net income and the 1995 ending accrued liability. A numerical answer is not expected.

Because more miles must be accumulated for an award to be granted, and less minimum miles are awarded per trip, the changes reduced the liability and increased income.

8. Any accounting for the FTP program is likely to forego recording amounts representing one opportunity cost to USAir for the program -- displaced paying passengers. USAir argues that little revenue is lost due to the program’s displacement of passengers. Provide one critique of the argument presented by USAir.

USAir's argument does not consider the possibility that some passengers traveling on an award would have been paying passengers. Thus, the opportunity cost for these displaced paying passengers is not considered.

Item 3c Self Study Problem 3 – Solution Page 2 of 2


Installment MethodAn Illustrative Example

PC is formed at the beginning of year 1 with $750 cash and common equity. During year 1, PC acquires parcels of land for $750. On the last day of year 1, it sells the parcels of land for $1000. PC finances the purchases with mortgage notes which are repaid in 2 payments of $576 beginning on the last day of year 2. The effective interest rate on the notes is 10% (i.e., the present value of the 2 annual payments of $576 assuming a 10% interest rate is $1000 on the last day of year 1). There are no taxes on income.

Sales Basis Accounting

Year 1

Cash 750Common Stock 750

Land Inventory 750Cash 750

Notes Receivable 1000Sales Revenue 1000

Cost of Land Sold 750Land Inventory 750

Year 2

Cash 576Interest Revenue 100Notes Receivable 476

Year 3


Item 3d Installment Method Notes Page 1 of 4


Sales Basis Accounting

End of Year 1 End of Year 2 End of Year 3Balance Sheet

Cash 0 576 1152Notes Receivable 1000 524 0Total Assets 1000 1100 1152Common Stock 750 750 750Retained Earnings 250 350 402Total Liabilities and Equity 1000 1100 1152

Income Statement

Sales Revenue 1000 0 0Cost of Land Sold 750 0 0Gross Profit 250 0 0Interest Revenue 0 100 52Net Income 250 100 52



Accounting under the Installment Method

Year 1

Cash 750Common Stock 750

Land Inventory 750Cash 750

Notes Receivable 1000Land Inventory 750Deferred Gross Profit (xa or l) 250

Year 2


Deferred Gross Profit 119Gross Profit Realized On Installment Sales 119

Note: 119 = 476x[(1000-750)/1000]

Year 3


Deferred Gross Profit 131Gross Profit Realized On Installment Sales 131

Note: 131 = 524x[(1000-750)/1000]



Accounting under the Installment Method

End of Year 1 End of Year 2 End of Year 3Balance Sheet

Cash 0 576 1152Notes Receivable 1000 524 0Deferred Gross Profit (250) (131) 0Total Assets 750 969 1152Common Stock 750 750 750Retained Earnings 0 219 402Total Liabilities and Equity 750 969 1152

Income Statement

Gross Profit Realized On Installment Sales 0 119 131Interest Revenue 0 100 52Net Income 0 219 183


B30116 – Berger Chapter 3 – Revenue & Securitization Factoring of Accounts Receivable

A Brief Explanation

Accounts Receivable (and other receivables) have a payment schedule which dictates when credit customers must pay cash to the selling firm. What if the firm wants to accelerate cash collection? It can do so, with the help of a financial institution, through either securitization or factoring. Here we discuss factoring (securitization is discussed later in the chapter).

In factoring, the firm simply sells its receivables to a financial institution for cash. The customers then pay off their account to the financial institution rather than the firm they purchased from to originate the receivable.

Factoring without recourse means that the financial institution cannot seek payment from the firm that sold it the receivable in the event that the receivable proves uncollectible. For example,

Item 3e Factoring Notes Page 1 of 3

There are two ways to accelerate cash collections: Companies might want to accelerate cash collection: (1)

to avoid processing and collection costs; (2) because of a cash flow imbalance between supplier payments and receivable collections; or (3) to fund an immediate cash need.

Factoring of Accounts Receivable

B30116 – Berger Chapter 3 – Revenue & Securitization if Retailer sells $100,000 of accounts receivable without recourse to Bank, and Bank charges a 3% fee, Retailer's journal entry is:

Cash 97,000Interest Expense 3,000 Accounts Receivable 100,000

Why is the fee debited to interest expense? It represents the financing charge incurred to accelerate the collection of cash.

Factoring with recourse means the firm that sold the receivables is willing to buy back any uncollectible receivables from the financial institution. Suppose now that the sale of accounts receivable described above was instead a sale with recourse. The fee is reduced to 1% to reflect Bank's lower risk, but Bank withholds $2,000 of the cash payment to cover possible noncollections of the accounts receivable (for which Retailer will remain responsible). Retailer's journal entry is:

Cash 97,000Interest Expense 1,000Due from Bank 2,000 Accounts Receivable 100,000

Note that the asset account "Due from Bank" is unlikely to be entirely collected because it will be reduced by any uncollectibles among the receivables sold with recourse to the bank. This accounting is not misleading as long as Retailer has previously set up a normal "Allowance for Uncollectibles" contra-asset against the receivables.

Finally, assume that all but $1,500 of the receivables are ultimately collected. Thus, Bank settles the "Due from Bank" account at Retailer by paying only $500 to Retailer (i.e., 2,000 – 1,500).

As long as Retailer had previously set up a normal "Allowance for Uncollectibles" contra-asset against the receivables, its final entry is:

Cash 500Allowance for Uncollectibles 1,500 Due from Bank 2,000As you can see, this entry effectively writes off the $1,500 of uncollectible receivables for which Retailer was still responsible because its sale of receivables was with recourse.

What if Retailer had been using aggressive rather than conservative accounting and had not set up a sufficiently large "Allowance for Uncollectibles" to absorb any of the uncollectible accounts contained in the receivables it sold to Bank? Then the asset Due from Bank would have overstated the real value of Retailer's assets, because it would not have been offset by any contra-asset for anticipated uncollectibles. In this case, financial statement readers would only learn Item 3e Factoring Notes Page 2 of 3

B30116 – Berger Chapter 3 – Revenue & Securitization about the loss from uncollectibles after the fact, since Retailer's final journal entry would now be:

Cash 500Loss on Sale of Receivables 1,500

Due from Bank 2,000


B30116 – Berger Chapter 3 – Revenue & Securitization The main protection financial statement readers have against being totally surprised by this type of aggressive accounting is that a sale with recourse requires footnote disclosure of the contingent liability, if it is material. Unfortunately, materiality is basically defined as something large enough that, if disclosed, would change the financial statement reader's judgment about a decision (such as investing in, or lending to, the firm). This definition is sufficiently vague that companies sometimes fail to disclose anything about their factoring with recourse, arguing that the contingent liability amounts involved are immaterial.


Date post:	21-Mar-2018
Category:	Documents
Upload:	ngotram
View:	222 times
Download:	2 times

1.The Audit Reportfaculty.chicagobooth.edu/philip.berger/teaching/B30116... · Web viewThomson...

Documents