7/24/2019 FAR CHAP 2 SOL http://slidepdf.com/reader/full/far-chap-2-sol 1/53 2-1 Financial Reporting and Analysis Chapter 2 Solutions Accrual Accounting and Income Determination Exercises Exercises E2-1. Determining accrual and cash basis revenue (AICPA adapted) Since the subscription begins with the first issue of 2002, no revenue can be recognized in 2001 on an accrual basis. No product or service has been exchanged between Gee Company and its customers. Therefore, no subscription revenue has been earned. On a cash basis, Gee would recognize the full amount of cash received of $36,000 as revenue in 2001. E2-2. Determining unearned subscription revenue (AICPA adapted) Since subscription revenue is not earned until the customer has received the video, unearned subscription revenue should be equal to the amount of subscriptions sold but not yet expired. Sold in 2001/Expiring in 2002 $200,000 Sold in 2001/Expiring in 2003 140,000 Sold in 2000*/Expiring in 2002 125,000 Unearned subscription revenue $465,000 *(The subscriptions sold in 2000 that did not expire in 2000 or in 2001 must be carried over to 2002 where they will be earned and recognized.) E2-3. Converting from accrual to cash basis revenue (AICPA adapted) Under the cash basis of income determination, the company would not regard its accounts receivable as revenue. To find cash basis revenue, we have to subtract the increase in accounts receivable from the revenue figure: Accrual basis revenue $1,750,000 + Beginning accounts receivable balance 375,000 - Ending accounts receivable balance (505,000) - Write-offs of accounts receivable (20,000) Cash basis revenue (cash collections on accounts receivable) $1,600,000
Chapter 2 SolutionsAccrual Accounting and Income Determination
Exercises
Exercises
E2-1. Determining accrual and cash basis revenue(AICPA adapted)
Since the subscription begins with the first issue of 2002, no revenue can berecognized in 2001 on an accrual basis. No product or service has beenexchanged between Gee Company and its customers. Therefore, nosubscription revenue has been earned.
On a cash basis, Gee would recognize the full amount of cash received of $36,000 as revenue in 2001.
Since subscription revenue is not earned until the customer has received thevideo, unearned subscription revenue should be equal to the amount of subscriptions sold but not yet expired.
Sold in 2001/Expiring in 2002 $200,000Sold in 2001/Expiring in 2003 140,000
Sold in 2000*/Expiring in 2002 125,000Unearned subscription revenue $465,000
*(The subscriptions sold in 2000 that did not expire in 2000 or in 2001 must be carried over to 2002
where they will be earned and recognized.)
E2-3. Converting from accrual to cash basis revenue(AICPA adapted)
Under the cash basis of income determination, the company would not regard
its accounts receivable as revenue. To find cash basis revenue, we have tosubtract the increase in accounts receivable from the revenue figure:
E2-4. Converting from accrual to cash basis revenue(AICPA adapted)
To convert Tara’s 2001 revenue from an accrual basis to a cash basis, we
need to subtract the change in accounts receivable from the accrual basisrevenue figure. Since no accounts were written off, we need not add back theallowance for doubtful accounts to the accounts receivable amounts.
$550,000 = $415,000 + $1,980,000 - XX = $1,845,000
E2-5. Converting from cash to accrual basis revenue(AICPA adapted)
To change Dr. Tracey’s revenue from cash basis to an accrual basis, wehave to add the earned but uncollected accounts receivable and subtractthe beginning accounts receivable collected in 2001 but earned in 2000. Wealso need to subtract fees collected in 2001 but not earned until 2002(unearned fees on 12/31/01):
E2-6. Converting from cash to accrual basis revenue
(AICPA adapted)
To transform Marr’s 2001 cash basis revenue to an accrual basis, we needto subtract beginning rents receivable collected in the current year (2001)but earned in the previous year (2000) and add ending rents receivable(adjusted for write-offs) representing revenue earned in the current year thatwill not be collected until the next year (2001).
a) Store lease was paid at the beginning of each month so there is nothing toaccrue for the 2001 lease.
b) Net sales for 2001 were $450,000. $450,000, less the $250,000 of salesexempt from additional rent, is $200,000: $200,000 ´ 6% = $12,000
c) The portion of the electric bill that should be accrued for the 2001 balancesheet is 12/16/01–12/31/01 or half of the 30-day period:$850/2 = $425
d) The portion of the telephone bill that should be part of the 2001 balancesheet is only the December service portion, $250.
Total accrued liabilities at December 31, 2001, are:Accrued rent payable $12,000Accrued electrical bill obligation +425Accrued telephone bill obligation +250Total accrued liabilities $12,675
E2-10. Determining cumulative effect of accounting change(AICPA adapted)
The net charge against income in the 2001 income statement would be the$500,000 of prepaid expense less the tax effect of the asset (40% of$500,000), $200,000. So the net charge against income due to the change inaccounting principle is $300,000.
E2-11. Determining cumulative effect of accounting change(AICPA adapted)
The cumulative effect of the accounting change on the 2001 incomestatement is the increase in inventory due to the change ($500,000) less thetax effect of this increase ($500,000 ´ 30% = $150,000). The cumulativeeffect is $350,000.
The answers to most items are straightforward. However, there are somesubjective calls. For instance, rent for inventory warehousing can be arguedto be product costs and included as part of inventory costs. However, manycompanies expense this cost as a period expense because of materialityconsiderations.
Some of the product costs are expensed as part of the inventory costs (e.g.,cost of raw materials, factory wages, and transportation and transit insurancefor inventory purchased), while others are expensed directly in the period inwhich the products are sold (e.g., bad debt expense and warranty expense).
To report Kelly Plumbing Supply's revenues on an accrual basis, we need tosubtract the accounts receivable collected in December but earned inNovember, and add the sales on account made during December, to thecash received from customers during December 2001.
To report Kelly Plumbing's expenses on an accrual basis, we have tosubtract the cash paid to suppliers in December for inventory purchased andused in November, and add inventory that was purchased in November andused in December, to the cash paid to suppliers for inventory duringDecember 2001.
Cash received from customers during December 2001 $387,000Cash received in December for November accounts receivable (139,000)December sales made on account 141,000Accrual basis revenues $389,000
Cash paid to suppliers for inventory during December 2001 $131,000Payments for inventory purchased and used in November (19,000)Inventory purchased in November but used in December 39,000Accrual basis expenses $151,000
Accrual basis revenues $389,000Less: Accrual basis expenses (151,000 )Gross profit for the month of December $238,000
To report the accrual-based revenue for the month of July, we must analyzethe change in the Accounts receivable and Unearned revenue accounts.
Unearned revenue June 30 $5,000Less: Balance at July 31 (3,000 )
Change in account $2,000
Since the balance in Unearned revenue decreased, we know that the changeof $2,000 represents unearned revenue that was earned during the month ofJuly.
Accounts receivable at June 30 $30,000Less: Balance at July 31 (29,000 )Change in account$ $ 1,000
Since the balance in Accounts receivable decreased, we know that thechange of $1,000 means that more cash was collected on account (cashbasis revenue) than was sold on account (accrual basis revenue).
Therefore, if we start with cash collections and add unearned revenue thatwould be recognized in July and subtract the decrease in Accountsreceivable we are able to determine the revenue that Runway should report inthe month of July.
Payments on account for July $73,000Add: Unearned revenue earned in July 2,000Less: Decrease in accounts receivable (1,000 )Revenue for July $74,000
Annual depreciation is $100,000/5 = $20,000. Since the equipment was usedfor only 6 months, the depreciation charge for this year is only $20,000/2 =$10,000.
DR Salaries expense $6,000CR Salaries payable $6,000
To accrue salaries expense for December 2001.
Requirement 3: Income statement
Frances CorporationIncome Statement
For Year Ended December 31, 1998
Revenue from services rendered $150,000Less: Expenses
To: Baron FlowersRe: Reconciliation from cash to accrual basis
When acquiring information about a potential debtor, a lending bank will oftenrequest financial statements prepared under the accrual basis. In
comparison with cash-basis financial statements, accrual-basis financialstatements provide a bank with more relevant information about a potentialdebtor’s ability to meet its obligations as they become due. The accrual basisof accounting attempts to match expenses with their related revenues. Thus,revenues and expenses are recognized when earned or incurred rather thanwhen cash is received or paid. Financial statements based on the accrualbasis of accounting provide a better indication of a company’s performance.In addition, the accrual basis of accounting provides information that allowsmore reliable comparisons to be made from period to period.
Accrual-basis financial statements also provide information that would not berecognized under the cash basis, such as noncash expenses or accruedliabilities. The contingent liability arising from the pending litigation againstBaron is relevant information that would not have been reflected in cash-basis financial statements. The accrual of this contingency alerts the bank toa future cash outflow that may affect Baron's ability to meet principal orinterest payments in the future.
P2-3. Adjusting entries and statement preparation
Requirement 1:
DR Advance to employee $10,000CR Salaries expense $10,000
DR Prepaid insurance $6,000CR Insurance expense $6,000
DR Bad debt expense $24,500CR Allowance for doubtful accounts $24,500
DR Dividends $10,000CR Dividends payable $10,000
Note : It is customary for companies to record dividends declared afterthe fiscal year end. This is typically the case with fourth quarter dividends, i.e.,the fourth quarter dividends are declared in the 1st quarter of the followingyear.
LiabilitiesAdvance from customers $25,000Accounts payable 18,000Salaries payable 4,000Dividends pa able _10,000
Total liabilities 57,000Shareholders’ e uit
Common stock 70,000Retained earnings _195,000Total liabilities and stockholders’ e uit $322,000
P2-4. Understanding the accounting equation
Requirement 1:Recasting the December 31, 2001 balance sheet. The following steps areneeded to calculate the unknowns. The correct balance sheet appearsabove. (Note that there are other possible ways of determining the correctanswer for these solutions.)
Item A: 2000 Current liabilities:Current liabilities plus non-current liabilities equals total liabilities.Therefore, total liabilities ($8,630) less non-current liabilities ($5,231)equals current liabilities ($3,399).
Item B: 2000 Total assets:Total assets are equal to total liabilities and stockholders' equity
($13,765).
Item C: 2000 Additional paid-in capital:Common stock plus additional paid-in capital is equal to contributedcapital. Therefore, contributed capital ($2,340) less common stock($138) equals additional paid-in capital ($2,202).
Item D: 2000 Current assets:Current assets plus non-current assets equals total assets. So totalassets ($13,765) less non-current assets ($8,667) equals current
assets ($5,098).Item E: 2000 Total stockholders' equity:
Contributed capital ($2,340) plus retained earnings ($2,795) equalstotal stockholders' equity ($5,135).
Item F: 2001 Total liabilities and stockholders' equity:Total liabilities ($8,683) plus total stockholders' equity ($5,168) equalstotal liabilities and stockholders' equity ($13,851).
Item G: 2001 Contributed capital:Common stock ($139) plus additional paid-in capital ($2,216) equalscontributed capital ($2,355).
Item H: 2001 Total assets:Total assets are equal to total liabilities and stockholders' equity($13,851) which was solved in (F).
Item I: 2001 Non-current liabilities:Current liabilities plus non-current liabilities is equal to total liabilities.Therefore, total liabilities ($8,683) less current liabilities ($3,420) is
equal to non-current liabilities ($5,263).
Item J: 2001 Current assets:Current assets plus non-current assets equals total assets.Accordingly, total assets ($13,851) less non-current assets ($8,721)equals current assets ($5,130).
Item K: 2002 Total liabilities and stockholders' equity:Total liabilities and stockholders' equity is equal to total assets($14,040).
Item L: 2002 Common stock:Common stock plus additional paid-in capital equals contributed capital.So contributed capital ($2,387) less additional paid-in capital ($2,247)
equals common stock ($140).
Item M: 2002 Non-current assets:Current assets plus non-current assets equals total assets. Therefore,total assets ($14,040) less current assets ($5,200) equals non-currentassets ($8,840).
Item N: 2002 Total liabilities:Current liabilities ($3,467) plus non-current liabilities ($5,335) equalstotal liabilities ($8,802).
Item O: 2002 Total stockholders' equity:Contributed capital ($2,387) plus retained earnings ($2,851) equalstotal stockholders' equity ($5,238).
Item P: 2003 Total liabilities and stockholders' equity:Total liabilities ($8,929) plus total stockholders' equity ($5,314) equalstotal liabilities and stockholders' equity ($14,243).
Item Q: 2003 Retained earnings:Contributed capital plus retained earnings equals total stockholders'equity. Accordingly, total stockholders' equity ($5,314) less contributedcapital ($2,422) equals retained earnings ($2,892).
Item R: 2003 Total assets:Total assets are equal to total liabilities and stockholders' equity($14,243) which was solved in (P).
Item S: 2003 Non-current liabilities:Current liabilities plus non-current liabilities is equal to total liabilities.Therefore, total liabilities ($8,929) less current liabilities ($3,517) is
equal to non-current liabilities ($5,412).
Item T: 2003 Additional paid-in capital:Common stock plus additional paid-in capital is equal to contributedcapital. Therefore, contributed capital ($2,422) less common stock($142) equals additional paid-in capital ($2,280).
Item U: 2004 Total liabilities and stockholders' equity:Total liabilities and stockholders' equity is equal to total assets($14,351).
Item V: 2004 Current liabilities:Take total liabilities and stockholders' equity ($14,351) which wascalculated in (U), less total stockholders' equity ($5,354). This equals
total liabilities ($8,997). Total liabilities ($8,997) less non-currentliabilities ($5,454) equals current liabilities ($3,543).
Item W: 2004 Contributed Capital:Common stock ($144) plus additional paid-in capital ($2,296) equalscontributed capital ($2,440).
Item X: 2004 Non-current assets:Current assets plus non-current assets equals total assets. Then totalassets ($14,351) less current assets ($5,315) equals non-current
assets ($9,036).Item Y: 2004 Retained earnings:
Contributed capital plus retained earnings equals total stockholders'equity. Accordingly, total stockholders' equity ($5,354) less contributedcapital ($2,440) equals retained earnings ($2,914).
Item Z: 2004 Total liabilities:Take total liabilities and stockholders' equity ($14,351) which wascalculated in (U), less total stockholders' equity ($5,354). This equalstotal liabilities ($8,997).
Requirement 1:Following are the steps needed to calculate the unknowns. The correctinformation appears above. Note that there are other possible ways ofdetermining the correct answer for these solutions.
Item A: 2000 Current assets:Current assets plus non-current assets equals total assets. Therefore,total assets ($5,821) less non-current assets ($3,665) equals currentassets ($2,156).
Item B: 2000 Non-current liabilities:First we must solve for (C) total stockholders' equity. We know thatTotal liabilities and stockholders' equity is equal to Total assets($5,821). Therefore, total liabilities and stockholders' equity ($5,821)less total stockholders equity ($2,172) is equal to total liabilities($3,649). Current liabilities plus non-current liabilities is equal to totalliabilities. Therefore, total liabilities ($3,649) less current liabilities
($1,437) is equal to non-current liabilities ($2,212).
Item C: 2000 Total stockholders' equity:Contributed capital ($990) plus retained earnings ($1,182) equals totalstockholders' equity ($2,172).
Item D: 2000 Total liabilities and stockholders' equity:Total liabilities and stockholders' equity is equal to total assets($5,821).
Item E: 2000 Working capital:Current assets ($2,156) less current liabilities ($1,437) equals workingcapital ($719).
Item F: 2001 Non-current assets:Solve for (G) total assets first. Current assets plus non-current assetsequals total assets. Then total assets ($6,170) less current assets($2,285) equals non-current assets ($3,885).
Item G: 2001 Total assets:First we need to solve for (H) current liabilities. We then can determinethat current liabilities ($1,523) plus non-current liabilities ($2,345) isequal to total liabilities ($3,868). Total liabilities ($3,868) plus totalstockholders' equity ($2,302) is equal to total liabilities andstockholders equity ($6,170). Total liabilities and stockholders' equityis equal to total assets ($6,170).
Item H: 2001 Current liabilities:Current assets less current liabilities equals working capital. Hence,current assets ($2,285) less working capital ($762) equals currentliabilities ($1,523).
Item I : 2001 Contributed capital:First we need to solve for (J) retained earnings. Contributed capitalplus retained earnings equals total stockholders' equity. Accordingly,total stockholders' equity ($2,302) less retained earnings ($1,253)equals contributed capital ($1,049).
Item J: 2001 Retained earnings:Beginning of the year retained earnings ($1,182) plus net income ($85)less dividends ($14) equals end of the year retained earnings ($1,253).
Item K: 2001 Total liabilities and stockholders' equity:Current liabilities ($1,523) plus non-current liabilities ($2,345) is equalto total liabilities ($3,868). Total liabilities ($3,868) plus total
stockholders' equity ($2,302) is equal to total liabilities andstockholders equity ($6,170).
Item L: 2002 Current assets:First solve for (M) total assets. Current assets plus non-currentassets equals total assets. Therefore, total assets ($5,724) less non-current assets ($3,604) equals current assets ($2,120).
Item M: 2002 Total assets:Total assets are equal to total liabilities and stockholders' equity
($5,724).Item N: 2002 Current liabilities:
Current assets less current liabilities equals working capital. Hence,current assets ($2,120) less working capital ($707) equals currentliabilities ($1,413).
Item O: 2002 Non-current liabilities:First solve for total liabilities. Total liabilities and stockholders' equity($5,724) less total stockholders' equity ($2,136) equals total liabilities($3,588). Current liabilities plus non-current liabilities equals totalliabilities. So total liabilities ($3,588) less current liabilities ($1,413)equals non-current liabilities ($2,175).
Item P: 2002 Contributed capital:Contributed capital plus retained earnings equals total stockholders'equity. Therefore, total stockholders' equity ($2,136) less retainedearnings ($1,087) equals contributed capital ($1,049).
Item Q: 2002 Net income (loss):Beginning of the year retained earnings plus net income less dividends
equals end of the year retained earnings. Therefore, end of the yearretained earnings ($1,087) plus dividends ($9) less beginning of theyear retained earnings ($1,253) equals net loss ($157).
Item R: 2003 Non-current assets:Current assets plus non-current assets equals total assets. Therefore,total assets ($5,805) less current assets ($2,150) equals non-currentassets ($3,655).
Item S: 2003 Current liabilities:First solve for (U) total stockholders equity. Total liabilities and
stockholders' equity ($5,805) less total stockholders' equity ($2,166)equals total liabilities ($3,639). Current liabilities plus non-currentliabilities equals total liabilities. Therefore, total liabilities ($3,639) lessnon-current liabilities ($2,206) equals current liabilities ($1,433).
Item T: 2003 Retained earnings:Beginning of the year retained earnings plus net income less dividendsequals end of the year retained earnings. Therefore, end of the yearretained earnings from 2004 ($1,204) plus dividends from 2004 ($12)less net income from 2004 ($99) equals beginning of the year retained
earnings ($1,117) which is also the end of the year retained earningsfor 2003.
Item U: 2003 Total stockholders' equity:Contributed capital ($1,049) plus retained earnings ($1,117) equalstotal stockholders' equity ($2,166).
Item V: 2003 Working capital:Current assets ($2,150) less current liabilities ($1,433) equals workingcapital ($717).
Item W: 2003 Dividends:Beginning of the year retained earnings plus net income, lessdividends, equals end of the year retained earnings. Accordingly, endof the year retained earnings ($1,117) less net income ($40) andbeginning of the year retained earnings ($1,087) equals dividends($10).
Item X: 2004 Current assets:Current assets less current liabilities equals working capital. Soworking capital ($732) plus current liabilities ($1,463) equals current
assets ($2,195).
Item Y: 2004 Total assets:Current assets ($2,195) plus non-current assets ($3,732) equals totalassets ($5,927).
Item Z: 2004 Contributed capital:First solve for (AA) total stockholders' equity. Contributed capital plusretained earnings equals total stockholders' equity. Therefore, totalstockholders' equity ($2,212) less retained earnings ($1,204) equalscontributed capital ($1,008).
Item AA: 2004 Total stockholders' equity:
First solve for (BB) total liabilities and stockholders equity. Next solvefor total liabilities. Current liabilities ($1,463) plus non-current liabilities($2,252) equals total liabilities ($3,715). Total liabilities andstockholders' equity ($5,927) less total liabilities ($3,715) equals totalstockholders' equity ($2,212).
Item BB: 2004 Total liabilities and stockholders' equity:Total liabilities and stockholders' equity is equal to total assets($5,927).
P2-6. Converting from cash to accrualRequirement 1:
To solve for cost of goods sold we must first determine what our purchases foAugust were by analyzing Accounts payable.
Accounts payable
$21,000 Beginning accounts payableCash paid to suppliers $130,000
$134,000 Solve for: purchases on account
$25,000 Ending accounts payable
$21,000 + X - $130,000 = $25,000X = $134,000
We can now solve for Cost of good sold by plugging the purchases into theInventory account.
InventoryBeginning inventory $33,000
purchases (solved above) $134,000
$142,000 Solve for: cost of goods sold
Ending inventory $25,000
$33,000 + $134,000 - X = $25,000X = $142,000
P2-7. Converting from cash to accrual basis
Requirement 1:
Rental income for October 2001on the accrual basis would not include therent receivable from the previous month that was collected in October. Rentalincome would also not include rental income that was collected in advancefor subsequent month's rent.
Rental receipts (cash) received $43,000Less: Receivable from September (2,000)Less: Prepayment of November rent (3,500 )Rental income for October 2001 $37,500
Insurance expense on the accrual basis would include any insurance thatwas owed at the end of October for the month of October.
Cash paid for insurance $ 5,000Add: Additional insurance owed for October 1,000
Insurance expense for October 2001 $ 6,000
Requirement 3:
Tax expense for October 2001 on the accrual basis would not include taxesthat were owed on October 1 and paid in October. Tax Expense would includeany taxes owed on October 31 but not yet paid.
Cash paid for taxes $ 6,000Less: Taxes owed on October 1 (1,000)
Add: Taxes owed on October 31 700Tax expense for October 2001 $ 5,700
Requirement 4:
DR Cash $11,000DR Accumulated depreciation 1,300DR Loss on disposal 1,200
Requirement 1:Recasting the Year 1 income statement. Following are the steps needed tocalculate the unknowns. The correct income statement appears above.
a) Net revenue:Gross profit and gross profit percentage are given as $241,171 and37.81%, respectively. Therefore, net revenue equals gross profit divided
by the gross profit percentage, or $241,171 / 37.81% = $637,850 .
b) Costs of goods sold:Net revenues less cost of goods sold equals gross profit ($241,171).Therefore, cost of goods sold equals’ net revenues ($637,850) less grossprofit ($241,171) or cost of goods sold equals $ 396,679 .
c) Amortization of intangible assets:Amortization of intangible assets can be determined by subtracting the
known operating expenses from total operating expenses of $232,452.Known operating expenses are: selling ($79,508), general andadministrative ($88,434), research and development ($48,615), andrestructuring costs and asset write-downs ($12,222). Or amortizationequals $3,673 ($232,452 – $228,779).
d) Operating income:Is simply gross profit ($241,171) less total operating expenses ($232,452)or $8,719 .
e) Interest expense:Income from continuing operations before income taxes ($34,664) equalsoperating income ($8,719) plus interest income ($11,972), plus otherincome ($20,830) less interest expense. Interest expense is $6,857($34,664 - $8,719 - $11,972 - $20,830).
f) Income from continuing operations:Income from continuing operations before income taxes ($34,664) less theprovision for income taxes ($10,047) equals income from continuing
operations before minority interest, or $34,664 - $10,047 = $24,617 .
g) Income before extraordinary item and cumulative effect of change inaccounting principle:Income before cumulative effect of change in accounting principle is givenas $74,642 less extraordinary gain on extinguishment of debt given as$1,121, or $73,521 .
h) Net income:Income before cumulative effect of change in accounting principle($74,642) less cumulative effect of change in accounting principle ($3,048)or $71,594 .
Requirement 2:While it may not be immediately obvious to students, this item had no direct
impact on IVAX's Year 1 cash flows. This item represents the accrual ofvarious expenses that IVAX expects to incur in the future. Examples includeseverance pay and health-care benefits for employees that left the firm aspart of the restructuring, plant closing costs, etc.
A copy of IVAX's Year 1 cash flow statement is included as part of thesolution so that students can see that the restructuring charge had noimpact on its cash flows.
Requirement 3:Agree: If you agree, you might suggest that R&D costs be carried on thebalance sheet as an asset and be charged (i.e., expensed or written off) infuture periods as the new products they produce are brought to market. Theidea behind this approach is the matching principle. Moreover, since theseexpenditures are made to benefit future operations and sales, they should becharged to the future periods that benefit.
Disagree: If you disagree, you might argue that many R&D projects fail, whileonly a small number succeed. If all R&D costs were carried on the balance
sheet as an asset, then assets would likely be overstated because some ofthe projects will fail, and the projected increase in future sales once expectedbecause of them may never materialize. The idea behind this approach isthat future benefits to current R&D expenditures are so uncertain, they lackthey cannot be reliably measured and reported on the balance sheet.
Requirement 4:To forecast next period’s earnings you need to examine what has transpiredduring the current period. Any unusual and non-recurring gains (revenues)
and or expenses (losses) should be disregarded, since they are notexpected to be repeated.
Utilizing IVAX’s Year 1 income statement we can make the followingobservations:· Assuming that Net revenues and normal operating expenses will remain
constant, then projected Year 2 operating income would be $20,491. (Year1 operating income of $8,719 plus restructuring costs (considered aspecial or unusual charge that would normally not be repeated) of$12,222.)
· Interest income and expense and other income would be analyzed andrevised if necessary and added to operating income. Projected tax rateswould be applied to estimate Year 2 net earnings.
· All items below IVAX’s Year 1 Income from continuing operations linewould be considered unusual and non-recurring and therefore notincluded in Year 2 projected net earnings.
IVAX Corporation’s Statement of Cash Flows for the year ending December31, Year 1 follows:
Borrowings on long-term debt and loans payable 3,895
Payments on long-term debt and loans payable (29,152)
Issuance of common stock 2,958
Repurchase of common stock (65,931)
Net financing activities of discontinued operations 10
Net cash used for financing activities ($88,220)
Effect of Exchange Rate changes on Cash (1,709)
Net Increase in Cash and Cash Equivalents 9,358
Cash and Cash Equivalents at Beginning of Year 199,235
Cash and Cash Equivalents at End of Year 208,593$
P2-11. Determining income from continuing operations and gain (loss) from
discontinued operations(AICPA adapted)
Requirement 1:The amounts to be reported for Income from continuing operations after taxescan be computed as follows.
2002 2001Loss from division ($640,000) ($500,000)Gain on sale of division 900,000Income from division before taxes 260,000 (500,000)Taxes (expense) benefit (130,000 ) 250,000Income (loss) from discontinued operations $ 130,000 ($250,000 )
Income from continuing operations (as reported) $1,250,000 $600,000Adjustments for (income) loss fromdiscontinued operations _(130,000 ) _250,000
1
Net income from continuing operations $1,120,000 $850,000
1 Since division contributed an after-tax loss in 2001, this loss must be added
to reported net income number of $600,000 to arrive at income fromcontinuing operation in 2001 which excludes divisional results.
Requirement 2: 2002 2001
Income (loss) from discontinued operations(net of tax) $130,000 ($250,000)
Income Statements for the Years Ended December 31 Year 2 Year 1
Operating income before taxes (as given) $161,136 $160,945Restructuring loss (23,000)Gain on sale (nonrecurring item) 33,694Write-off of investment (17,305 )Income from continuing operations before taxes 161,136 154,334Less: Income tax expense (40%) (64,454 ) (61,734 )Income from continuing operations 96,682 92,600Early extinguishment of debt (net of tax) (6,660)Cumulative effect of accounting change (net of tax) 9,756 – 0 – Net income $106,438 $ 85,940
Requirement 2:
Income Statements for the Years Ended December 31 Year 2 Year 1
Operating income before taxes (as given) $161,136 $160,945Less: Effect of new accounting method (890 )Sustainable income from continuing operations
before taxes 161,136 160,055Less: Income tax expense (40%) _64,454 _64,022Sustainable income from continuing operations $ 96,682 $96,033
Growth rate in sustainable income=($96,682/$96,033) - 1 = 0.676%Forecasted sustainable earnings for Year 3 = $96,682 ´ 1.00676 = $97,335
For Year Ended December 31, Year 1Sales $1,646,053Other operating revenues __45,189Total operating revenue 1,691,242
Crude oil, products, and related expenses 1,274,780Exploration expenses 65,755Selling and general expenses 67,461Depreciation, depletion, and amortization 225,924Impairment of long-lived assets 198,988
Provision for reduction in work force 6,610Interest expense ___5,722Total costs and expenses 1,845,240
Operating Income (153,998)Nonoperating revenue (interest income, etc.) __19,971Income (loss) before income taxes (134,027)Income tax benefit __15,415Net income (loss) ($118,612 )
Provision for reduction in work force and impairment of long-lived assets areconsidered as infrequent, but usual, items that require separate disclosure.
Requirement 2:First of all, let us reconstruct the income statement of Murphy Oil afterexcluding the revenues and expenses of the farm, timber, and realestate segment:
Operating income (153,998) 14,010 (168,008)Nonoperating revenue (interest income, etc.) ___19,971 ___691 __19,280Income (loss) before income taxes (134,027) 14,701 (148,728)Income tax benefit (expense) ___15,415 _(5,394) ___20,809Net income (loss) ($118,612 ) $9,307 ($127,919 )
The income statement of Murphy Oil can be re-constructed by addingthe net income of Deltic Farm & Timber as a single line item underdiscontinued operations to the income statement of the rest of the company.
Total operating revenue 1,612,500Less: Operating expensesCrude oil, products, and related expenses 1,218,083Exploration expenses 65,755Selling and general expenses 63,788Depreciation, depletion, and amortization 221,871Impairment of long-lived assets 198,988Provision for reduction in work force 6,610Interest expense __ 5,413Total costs and expenses (1,780,508)
Operating income (168,008)Nonoperating revenue (interest income, etc.) __19,280Income (loss) before income taxes (148,728)Income tax benefit __20,809Loss from continuing operations (127,919)Income from discontinued operations (Net of taxes) 9,307
Chapter 2 SolutionsAccrual Accounting and Income Determination
Cases
C2-1. Fuentes Corporation: Preparation of multiple-step income statement
2002 2001
Net sales $5,002 $4,350*Costs and expenses
Cost of goods sold (3,927) (3,288)Selling, general and administrative (350) ( 328)Special cost: Corporate restructuring ___(91 )
Income from continuing operations before taxes 634 734Income tax expense __(230 ) * * __(265 )Income from continuing operations 404 469Income from discontinued ops. (net of tax) 143 93Loss on disposal of disc. ops. (net of tax) (53)Cumulative effect of accounting principle
change (net of tax) _ $56Net income $550 $562
Pro-forma amounts:Income from continuing operations _ $404 _$477
*Note: $4,350 is computed as follows:Reported 2001 total sales $7,475Reported 2001 sales of discontinued operations (3,125 )
$4,350
Cost of goods sold and S,G & A are computed analogously
**Note: ($230) is computed as follows:Income tax expense from partial income statement for 2002 (part 4 of problem) ($261)Restructuring tax benefit (given in part 1 of problem) __31
C2-2. The Quaker Oats Company: Classification of gains vs. losses
This case shows students how the gray areas of GAAP can be used to alterreported year-to-year comparisons. Analysts who have a shallowunderstanding of financial reporting might be misled by the numbers whichresult from this latitude.
Requirements 1 and 2:The 1991 divestiture appears to have been reported in conformity with aliteral interpretation of GAAP. Fisher-Price represented a segment that wasfar removed from Quaker’s primary food-related businesses. It, therefore,seems appropriate to treat the severance of this activity as a discontinuedoperation.
The issue becomes more murky with the 1995 transactions. In fiscal 1995,Quaker’s profits were being eroded by the lackluster performance of theSnapple
® brand acquisition in 1994. The company was widely criticized for the
price it paid for Snapple
®
as well as for the drag on earnings it created.The large gain that resulted from disposition of the pet food businesses wasnot treated as a discontinued operation. Instead, this gain ($1,000.2 million)comprised the bulk of the “above the line” gains on divestitures andrestructuring of $1,094.3 reported on the 1995 income statement. (The othercomponents of the $1,094.3 “above the line” figure are appropriate “abovethe line items”.) If the $1,000.2 million pre-tax gains had been included “belowthe line” as a discontinued item, the 1994 versus 1995 pre-tax operatingincome comparison would have been dramatically altered:
1995 1994 % changePre-tax operating income as reported $1,359.9 $378.7 +359%Pre-tax operating income adjusted toexclude $1,000.2 from 1995 359.7 378.7 -5%
Obviously, the “as reported” numbers convey a much more positive changeand could–for the inattentive–offset some of the criticism Quaker wasreceiving.
Requirement 3:
As stated above, the reporting at the 1991 divestiture of Fisher-Price wasnon-controversial. The 1995 divestiture is another matter.
Quaker probably justified the “above the line” 1995 treatment by contendingthat it was in the food business in general. Some of its customers were two-legged and some four-legged. Thus, selling the pet food business simply
eliminated a (four-legged) product line. Eliminating a product line, in general,doesn’t qualify as a discontinued operation.
On the other hand, one could argue that the pet food division wasfundamentally different. All of Quaker’s other products were for humanconsumption. Targeting products for human consumption requires a differentset of production, marketing, and quality standards. (Can your dog really tell
you that she slightly prefers the taste of Brand X over Brand Y?)
The APB Opinion 30 rules do not use a materiality criterion. Even if they did,materiality cannot explain the 1991 versus 1995 differences.
Fisher-Price represented 10.9% (i.e., $601.0/$5,491.2) of Quaker’s 1991 salesand was treated as a discontinued operation. By contrast, proportionate 1995sales of the divested operations were much larger at 20.6% (i.e.,$1,315.0/$6,365.2). While no separate sales figure for the pet foods operationwas provided in the footnote, the bulk of the reported sales revenue is
presumably from the pet foods divisions since the gains on sale of the otherdivisions represent only 14.6% of the total gain on divested operations.1
C2-3. Baldwin Piano I (KR): Identifying “critical events” for revenue recognition
Requirement 1:
1. For the electronic contracting business, revenue is recognized at the time of shipment to its customers –Most Conservative.
2. For keyboard instruments and clocks shipped to its dealer network on aconsignment basis, revenue is recognized at the time the dealer sells the instrument to a third party .
3. For Wurlitzer, revenue is recognized at the time of shipment to its dealers–Least Conservative.
One important caveat is that this ranking does not suggest that Baldwin’sWurlitzer division is prematurely booking its revenue. What it suggests isthat, although Wurlitzer recognizes the revenue at the earliest time among allbusiness segments, Baldwin believes that the critical event and measurability
criteria have been met. However, it is imperative for a financial analyst toexamine the validity of management’s assumptions based on availableinformation and further inquiry with management.
1
Total gains on divested pet food operations are $513.0 + $487.2 = $1,000.2. Gains on other divestedoperations are $4.9 + $74.5 + $91.2 = $170.6. Thus, $170.6/($1,000.2 + $170.6) = 14.57%.
Since Baldwin does not wait until the sale to the ultimate customers, method(3) listed above appears to be the least conservative revenue recognitionpolicy. Although the legal title to the goods is transferred to the dealers at thetime of shipment, it appears that Baldwin is contingently liable to the dealers’bankers if the dealers default on their bank loan. While the dealers do notappear to have a direct right of return, they have a constructive right in casethey default on the loans. Before revenue is recognized, GAAP requires that
“the seller does not have significant obligations for future performance todirectly bring about the resale of the product by the buyer.” (See SFAS 48.) Inthe case of Wurlitzer, it appears that Baldwin may have some significantfuture obligations. Although we cannot categorically say that Baldwin has notmet the critical event and measurability criteria for its Wurlitzer business, atthe same time we also do not have enough information to conclude that it hasTo form a clear judgment on this, we must obtain information on the historicalloan default rates among its dealers as well as the ability of Wurlitzer toestimate the magnitude of cash outflows from such defaults. One possibility isthat, since Wurlitzer was acquired only recently, Baldwin might have decided
to continue its existing accounting practices for the moment. Epilogue:Beginning Sept. 1, 1995, Baldwin began shipping all Wurlitzer products underits consignment program. Under this program, sales are reported when thecompany receives payment from a dealer rather than, asWurlitzerdid, whenthe instruments were shipped to a dealer. The result was a reduction in thesales reported in the third quarter of 1995 compared to the same quarter inthe previous year.
The choice between whether method (1) or method (2) is the mostconservative policy is a judgment call. In terms of the critical event,thecompany recognizes revenue at the same time (sale to ultimate customers)for both the keyboard and electronic contracting segments. While thekeyboards are sent to the dealers on a consignment basis, the companyrecords revenue only after the dealers sell the keyboards to the end users.
The measurability criterion raises some interesting issues. The primarycustomers for the electronic contracting business appear to be originalequipment manufacturers. Moreover, unlike the installment contractreceivables, the receivables from the sale of printed circuit boards arelikely to be short-term. Taken together, this suggests that Baldwin probablyhas a good estimate on the expected bad debts in the electronic contracting
business.
However, the company probably faces greater uncertainties in estimating thebad debts on its installment contract receivables. The revenue from theinstallment contracts will be realized over a 3- to 5-year period. The importantissue is whether Baldwin can reasonably estimate the ability of its customersto fulfill their contractual obligations over this period. Given that the duration othe installment contracts ranges from 3 to 5 years, Baldwin might be liable for
substantial amounts of unanticipated bad debts long after the gross marginfrom the contracts are recognized. However, since Baldwin has beenengaged in financing the installment purchases over 80 years, it is quite likelythat it has built up a good statistical database for estimating expected baddebts. Overall, the revenue recognition on the installment contracttransactions appears to be less conservative than the revenue recognitionfor the electronic contracting business.
One might wonder, by “selling” its installment contracts to an independentfinancial institution, whether Baldwin has reduced any of the uncertainties.Although Baldwin has “sold” its receivables, it appears to retain most of thebad debt or credit risk. Note that Baldwin is required to repurchase from thefinancial institution those installment receivables that are more than 120 dayspast due or accounts that are deemed uncollectible. This explains whyBaldwin is retaining a substantial portion of the interest income. While thecustomers pay 12% to 16% on the installment contracts, Baldwin pays only5% interest to the independent financial institution. Thus, a substantial portion
of this “spread” (the difference between interest earned and interest paid) iscompensation to Baldwin for bearing the credit risk. Consequently, the “sale”of the installment receivables is purely a borrowing vehicle by which Baldwinis financing its investment in receivables. See Chapter 7 problems on thespecific accounting issues on sale or transfer of receivables.
Requirement 2:
Over the lives of the contracts, the difference between the original interestearned on the contracts and the interest paid to the independent financialinstitution is recognized as “Income on the sale of installmentreceivables.”This suggests that Baldwin is using “passage of time” as thecritical event for recording the net interest income. Note that the total incomefrom the sale of installment contracts consists of gross margin and interestincome. Baldwin recognizes the gross margin at the time of sale of inventory,whereas the interest income is recognized gradually over the life of thecontracts. The critical event for recognizing interest revenue or interestexpense is typically “passage of time” since interest represents the “time”value of money.
The measurability criterion appears to have been satisfied also. One may be
concerned whether Baldwin will be able to collect all of the promised cashflows on the installment contracts. If Baldwin is very uncertain about its abilityto estimate expected defaults, then it wouldn’t have recognized the grossmargin in the first place. In such a case, it would use the installment or costrecovery methods to record the gross margin and interest income.
C2-4. Baldwin Piano II (KR): Analysis and interpretation of income statement
To analyze the change in Baldwin’s profitability, we compute the year-to-yearchange in several of the income statement items.
1992 to 1993Net sales 9.61%
Gross profit 0.81%Income on the sale of installment 9.31%Interest income on installment 43.87%Other operating income, net -7.16%
Operating expenses:Selling, general, and administrative 4.26%Provision for doubtful accounts -17.09%Operating profit -0.94%
Interest expense -14.49%Income from before income taxes 2.59%Income taxes 0.73%Income before cumulative effects of 3.86%changes in accounting principles
Cumulative effect of changes in NApostretirement and postemploymentNet income -23.16%
Although Baldwin’s net sales increased by 9.6%, its net income decreased byabout 23%. One of the main reasons for this decline is due to the cumulativeeffect of adopting the new accounting standard for postretirement benefits.However, even earnings before income taxes and change in accountingprinciples increased by only about 2.6%.
Several factors have contributed to the less than proportionate increase inprofits.
1. It is straightforward to show that the gross margin rate has decreased from27.7% to 25.4%. Given the 1993 net sales of $120,657,455, this droptranslates into more than $2.6 million of lower operating profits. The decrease
in GM rate, if it is not transitory, is likely to severely impact the futureperformance of Baldwin.
2. Other operating income (net) has decreased by 7.2% from 1992 to 1993.However, the case identifies two nonrecurring items that are included in the1993 “other operating income, net.” We first eliminate these two nonrecurringitems as follows:
Other operating income, net $ 3,530,761- Eliminate gain on insurance settlement (1,412,000)+ Eliminate expenses relating to peridot 1,105,000Revised operating income, net 3,223,761
Additional decrease in other income $307 000
The elimination of the nonrecurring items further magnifies the drop in otheroperating income. To understand the reason for this decrease, let us focuson the main component of other operating income. From Baldwin Piano I, it
seems that the display fees paid by the dealers on the consigned inventorycomprise the majority of other operating income. Consequently, the decline inthis component of income is likely due to the decrease in the level ofconsigned inventory. Although we cannot be certain about this, the evidenceis consistent with this possibility. As provided in the case, the level of finishedgoods inventory has decreased by more than 8%. This decrease may be anindication of reduced demand for consigned inventory from the dealers, andconsequently, has resulted in lower display fees during 1993. This is, onceagain, likely to impact future profitability.
However, the following positive “factors” have had a mitigating effect on theincome statement.
1. SG&A expenses increased by only 4.3%. This could be due to scaleeconomies. In 1992, the SG&A expenses were 22.82% of sales revenue. Bycontrolling the level of the SG&A expenses, Baldwin has been able toimprove its pre-tax profits by about $1.3 million (see below).
Selling, general, and administrative ($26,187,629)Selling, general, and administrative at 22.82% of sales (27,532,842)
Additional profit due to lower SG&A $1,345,213
2. Provision for doubtful accounts decreased by 17% from 1992 to 1993; i.e.,it has decreased from 1.87% of net sales to about 1.41%. This decrease isconsistent with a change in management’s estimate. There is very littleinformation in the case to help us understand the reasons for the revision inthe management’s estimate. Has Baldwin changed its credit evaluation andextension policies? Have the past bad debt expenses been consistentlyhigher than the historical write-offs? There is some evidence to indicate that
the composition of Baldwin’s sales revenue has changed from 1992 to 1993.While musical products’ share of the total revenue has decreased from81.5% to 72.6%, that of electronic contracting has increased substantiallyfrom 13.3% to 22.2%. One possibility is that the electronic contractingbusiness has lower bad debt expense compared to the other businesssegments, thereby explaining the lower overall bad debt expense. Without aconvincing explanation, the decrease in the bad debt expense needs further
scrutiny. Note that if the management had maintained the same level of baddebt expense in 1993 as it had in 1992, then the operating income of Baldwinwould have decreased by about $555,000 [i.e., $120,657,455 ´ (0.0187 -0.0141)].
3. Interest expense decreased by 14.5%. The statement of cash flowsindicates that Baldwin has repaid more than $8.6 million of long-term debtduring 1993, which could explain the decrease in the interest expense.
4. As discussed earlier, there are significant differences in the inter-segment
growth rates in revenues. The musical products segment now accounts foronly 72.7% revenue as opposed to 81.5% in 1992. In addition, the operatingprofitability of this segment has decreased substantially from 7.6% to 5.0%.However, the electronic contracting segment, whose revenue has beengrowing at a greater rate, has a higher operating margin. Given that themusical products segment is slowing down and that the electroniccontracting business is likely to face severe competition (Baldwin may nothave any unique technical advantage here), Baldwin’s ability to maintaingrowth and operating margin in the electronic contracting segment may be akey factor for its future prospects.
Comment on inventory liquidation:In addition to the above items, Baldwin’s income statements were favorablyimpacted from realization of inventory holding gains (or inflationary profits).The following paragraph is excerpted from the company’s financialstatements:
During the past three years, certain inventories were reduced, resulting in theliquidation of LIFO inventory layers carried at lower costs prevailing in prioryears as compared with the current cost of inventories. The effect of theseinventory liquidations was to increase net earnings for 1993, 1992, and 1991
by approximately $694,000 ($ .20 per share), $519,000 ($ .15 per share), and$265,000 ($ .08 per share), respectively.
Chapter 9 discusses some of the implications of LIFO liquidations for financia
