intermediate accounting 7e, chapter 4 solutions

© The McGraw-Hill Companies, Inc., 2013 Solutions Manual, Vol.1, Chapter 4 4–1

AACSB assurance of learning standards in accounting and business education require documentation of outcomes assessment. Although schools, departments, and faculty may approach assessment and its documentation differently, one approach is to provide specific questions on exams that become the basis for assessment. To aid faculty in this endeavor, we have labeled each question, exercise, and problem in Intermediate Accounting, 7e, with the following AACSB learning skills:

Questions AACSB Tags Brief Exercise AACSB Tags 4–1 Reflective thinking 4–14 Reflective thinking, Commun.

4–2 Reflective thinking Exercises 4–3 Reflective thinking 4–1 Analytic 4–4 Reflective thinking 4–2 Analytic 4–5 Reflective thinking 4–3 Analytic 4–6 Reflective thinking 4–4 Analytic 4–7 Reflective thinking 4–5 Analytic 4–8 Reflective thinking 4–6 Analytic 4–9 Reflective thinking 4–7 Analytic

4–10 Reflective thinking 4–8 Analytic 4–11 Reflective thinking, Commun. 4–9 Reflective thinking 4–12 Reflective thinking 4–10 Analytic 4–13 Reflective thinking 4–11 Reflective thinking 4–14 Reflective thinking 4–12 Analytic 4–15 Reflective thinking 4–13 Diversity, Analytic 4–16 Reflective thinking 4–14 Analytic 4–17 Reflective thinking 4–15 Analytic 4–18 Reflective thinking 4–16 Analytic 4–19 Reflective thinking 4–17 Analytic 4–20 Reflective thinking 4–18 Analytic 4–21 Reflective thinking 4–19 Analytic

Brief Exercises 4–20 Communications 4–1 Analytic 4–21 Communications 4–2 Analytic 4–22 Reflective thinking

4–3 Analytic CPA/CMA

4–4 Analytic 1 Reflective thinking 4–5 Analytic 2 Analytic 4–6 Analytic 3 Analytic 4–7 Analytic 4 Analytic 4–8 Analytic 5 Reflective thinking 4–9 Analytic 6 Reflective thinking

4–10 Analytic 7 Reflective thinking 4–11 Analytic 8 Reflective thinking 4–12 Analytic 1 Reflective thinking 4–13 Analytic

Chapter 4 The Income Statement, Comprehensive Income, and the Statement of Cash Flows

© The McGraw-Hill Companies, Inc., 2013 4–2 Intermediate Accounting, 7/e

CPA/CMA AACSB Tags

2 Reflective thinking 3 Reflective thinking

Problems 4–1 Analytic 4–2 Analytic, Reflective thinking 4–3 Analytic, Reflective thinking 4–5 Analytic 4–6 Analytic 4–7 Analytic 4–8 Analytic 4–9 Analytic

4–10 Analytic 4–11 Analytic


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

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

Question 4–2 Income from continuing operations includes the revenue, expense, gain, and loss transactions

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

Question 4–3 Operating income includes revenues and expenses and gains and losses that are directly related

to the principal revenue generating activities of the company. Nonoperating income includes items that are not directly related to these activities.

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

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

Question 4–5 The term earnings quality refers to the ability of reported earnings (income) to predict a

company’s future earnings. After all, an income statement simply reports on events that already have occurred. The relevance of any historical-based financial statement hinges on its predictive value.

Question 4–6 Restructuring costs include costs associated with shutdown or relocation of facilities or

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

Question 4–7 The process of intraperiod tax allocation matches tax expense or tax benefit with each major

component of income, specifically continuing operations and any item reported below continuing operations. The process is necessary to achieve the desired result of separating the total income effects of continuing operations from the two separately reported items—discontinued operations and extraordinary items—and also to show the after-tax effect of each of those two components.

QUESTIONS FOR REVIEW OF KEY TOPICS


Answers to Questions (continued)

Question 4–8 The net-of-tax income effects of a discontinued operation must be disclosed separately in the

income statement, below income from continuing operations. The income effects include income (loss) from operations and gain (loss) on disposal. The gain or loss on disposal must be disclosed either on the face of the statement or in a disclosure note. If the component is held for sale but not sold by the end of the reporting period, the income effects will include income (loss) from operations and an impairment loss if the fair value less costs to sell is less than the book value of the component’s assets. The income (loss) from operations of the component is reported separately in discontinued operations on prior income statements presented for comparative purposes.

Question 4–9 Extraordinary items are material gains and losses that are both unusual in nature and infrequent

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

Question 4–10 Extraordinary gains and losses are presented, net of tax, in the income statement below

discontinued operations, if any.



Question 4–11 GAAP permit alternative treatments for similar transactions. Common examples are the

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

In general, we report voluntary changes in accounting principles retrospectively. This means revising all previous periods’ financial statements as if the new method were used in those periods. In other words, for each year in the comparative statements reported, we revise the balance of each account affected. Specifically, we make those statements appear as if the newly adopted accounting method had been applied all along. Also, if retained earnings is one of the accounts whose balance requires adjustment (and it usually is), we revise the beginning balance of retained earnings for the earliest period reported in the comparative statements of shareholders’ equity (or statements of retained earnings if they’re presented instead). Then we create a journal entry to adjust all account balances affected as of the date of the change. In the first set of financial statements after the change, a disclosure note would describe the change and justify the new method as preferable. It also would describe the effects of the change on all items affected, including the fact that the retained earnings balance was revised in the statement of shareholders’ equity along with the cumulative effect of the change in retained earnings.

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

Question 4–12 A change in accounting estimate is accounted for in the year of the change and in subsequent

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

Question 4–13 Prior period adjustments are accounted for by restating prior years’ financial statements when

those statements are presented again for comparison purposes. The beginning of period retained earnings is increased or decreased on the statement of shareholders’ equity (or the statement of retained earnings) as of the beginning of the earliest period presented.



Question 4–14 Earnings per share (EPS) is the amount of income achieved during a period for each share of

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

Question 4–15 Comprehensive income is the total change in equity for a reporting period other than from

transactions with owners. Reporting comprehensive income can be accomplished with a continuous statement of comprehensive income that includes an income statement and other comprehensive income items or in two statements, an income statement and a separate statement of comprehensive income.

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

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

Question 4–17 The three categories of cash flows reported on the statement of cash flows are: 1. Operating activities—Inflows and outflows of cash related to the transactions entering into

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

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

and owners.

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

cash but are important investing and financing activities. An example would be the acquisition of property, plant, and equipment (an investing activity) by issuing either long-term debt or equity securities (a financing activity). These activities are reported either on the face of the statement of cash flows or in a disclosure note.

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

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


Answers to Questions (concluded)

Question 4–20 There are two possible separately reported items that could appear in income statements,

discontinued operations and extraordinary items. International Financial Reporting Standards (IFRS) prohibit reporting extraordinary items.

Question 4–21 U.S. GAAP designates cash outflows for interest payments and cash inflows from interest and

dividends received as operating cash flows. Dividends paid to shareholders are classified as financing cash flows. IFRS allows more flexibility. Companies can report interest and dividends paid as either operating or financing cash flows and interest and dividends received as either operating or investing cash flows. Interest and dividend payments usually are reported as financing activities. Interest and dividends received normally are classified as investing activities.


Brief Exercise 4–1

PACIFIC SCIENTIFIC CORPORATION Income Statement

For the Year Ended December 31, 2013 ($ in millions) Revenues and gains:

Sales .................................................................. $2,106 Gain on sale of investments .............................. 45

Total revenues and gains ............................... 2,151 Expenses and losses:

Cost of goods sold ............................................ $1,240 Selling ................................................................ 126 General and administrative ................................ 105 Interest ............................................................... 35

Total expenses and losses ............................. 1,506 Income before income taxes ................................ Income tax expense* ........................................... Net income ..........................................................

645 258

$ 387

* $645 x 40% = $258

Brief Exercise 4–2 (a) Sales revenue $2,106 Less: Cost of goods sold (1,240) Gross profit 866 Less: Selling expenses (126) General and administrative expenses (105) Operating income $ 635 (b) Gain on sale of investments 45 Interest expense (35) Nonoperating income $10

BRIEF EXERCISES



PACIFIC SCIENTIFIC CORPORATION Income Statement

For the Year Ended December 31, 2013 ($ in millions)

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

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

Total operating expenses .............................. 231Operating income ................................................ 635 Other income (expense):

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

Total other income, net ................................. 10Income before income taxes .............................. 645Income tax expense* .......................................... 258 Net income .......................................................... $ 387 *$645 x 40%


Brief Exercise 4–4 (a) Sales revenue $300,000 Less: Cost of goods sold (160,000) General and administrative expenses (40,000) Restructuring costs (50,000) Selling expenses (25,000) Operating income $ 25,000 (b) Operating income $25,000 Add: Interest revenue 4,000 Deduct: Loss on sale of investments (22,000) Income before income taxes and 7,000 Income tax expense (40%) (2,800) Income before extraordinary item $ 4,200 (c) Income before extraordinary item $ 4,200 Extraordinary item: Loss from flood damage, net of $20,000 tax benefit (30,000) Net loss (25,800)



MEMORAX COMPANYPartial Income Statement

For the Year Ended December 31, 2013 Income before income taxes and extraordinary item .......... $ 790,000 Income tax expense* .......................................................... 316,000 Income before extraordinary item ...................................... 474,000 Extraordinary item: Loss from earthquake, net of $208,000 tax benefit .......... (312,000)Net income ........................................................................... $ 162,000

*$790,000 x 40%



WHITE AND SONS, INC.

Partial Income Statement For the Year Ended December 31, 2013

Income before income taxes and extraordinary item .......... $ 850,000 Income tax expense* .......................................................... 340,000 Income before extraordinary item ...................................... 510,000 Extraordinary item: Loss from earthquake, net of $160,000 tax benefit ......... (240,000) Net income .......................................................................... $ 270,000 Earnings per share: Income before extraordinary item ....................................... $ 5.10 Loss from earthquake ......................................................... (2.40) Net income ......................................................................... $ 2.70

*$850,000 x 40% Note: Restructuring costs, interest revenue, and loss on sale of investments are

included in income before income taxes and extraordinary item.



CALIFORNIA MICROTECH CORPORATION


Income from continuing operations before income taxes ... $ 5,800,000Income tax expense* ........................................................... 1,740,000Income from continuing operations .................................... $ 4,060,000Discontinued operations:

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

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

* $5,800,000 x 30% ** Loss from operations of discontinued component: Gain on sale of assets $ 2,000,000 ($10 million less $8 million) Loss from operations (3,600,000) Total before-tax loss $(1,600,000)





Income from continuing operations before income taxes ... $ 5,800,000 Income tax expense* ........................................................... 1,740,000 Income from continuing operations ................................... $ 4,060,000 Discontinued operations:

Loss from operations of discontinued component** ...... (3,600,000) Income tax benefit ............................................................ 1,080,000 Loss on discontinued operations ...................................... (2,520,000)Net income .......................................................................... $ 1,540,000

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





Income from continuing operations before income taxes ... $ 5,800,000Income tax expense* ........................................................... 1,740,000Income from continuing operations .................................... $ 4,060,000Discontinued operations:

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

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

* $5,800,000 x 30% ** Loss from operations of discontinued component: Impairment loss ($8 million book value less $7 million net fair value) $(1,000,000) Loss from operations (3,600,000) Total before-tax loss $(4,600,000)



O’REILLY BEVERAGE COMPANYStatement of Comprehensive Income

For the Year Ended December 31, 2013 Net income .......................................................... $650,000 Other comprehensive income (loss): Deferred loss on derivatives, net of tax ........... $(36,000) Unrealized gains on investment securities, net of tax ........................................................ 24,000 Total other comprehensive loss ........................... (12,000) Comprehensive income ....................................... $638,000


Brief Exercise 4–11 Cash flows from operating activities:

Collections from customers $ 660,000 Interest on note receivable 12,000 Interest on note payable (18,000) Payment of operating expenses (440,000) Net cash flows from operating activities $214,000

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

Brief Exercise 4–12 Cash flows from investing activities:

Proceeds from note receivable collection $100,000 Sale of land 40,000 Purchase of equipment (120,000) Net cash flows from investing activities $20,000

Cash flows from financing activities:

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

Net cash flows from financing activities 170,000


Brief Exercise 4–13 Cash flows from operating activities:

Net income $45,000 Adjustments for noncash effects: Depreciation expense 80,000 Changes in operating assets and liabilities: Increase in prepaid rent (60,000) Increase in salaries payable 15,000 Increase in income taxes payable 12,000 Net cash inflows from operating activities $92,000

Brief Exercise 4–14 Under IFRS, interest received and interest paid usually are classified as investing

and financing cash flows, respectively, not operating cash flows as with U.S. GAAP. The revised cash flow categories usually would appear as follows: Cash flows from operating activities:

Collections from customers $ 660,000 Payment of operating expenses (440,000) Net cash flows from operating activities $220,000

Cash flows from investing activities:

Proceeds from note receivable collection $100,000 Sale of land 40,000 Interest on note receivable 12,000 Purchase of equipment (120,000) Net cash flows from investing activities $32,000

Cash flows from financing activities:

Issuance of common stock $200,000 Payment of dividends (30,000) Interest on note payable (18,000)

Net cash flows from financing activities 152,000


Exercise 4–1 Requirement 1

GREEN STAR CORPORATIONIncome Statement

For the Year Ended December 31, 2013 Revenues and gains:

Sales ................................................................. $1,300,000Interest .............................................................. 30,000Gain on sale of investments ............................. 50,000

Total revenues and gains .............................. 1,380,000 Expenses and losses:

Cost of goods sold ............................................ $720,000 Selling ............................................................... 160,000 General and administrative ............................... 75,000 Interest ............................................................... 40,000

Total expenses and losses ............................. 995,000Income before income taxes ............................... 385,000Income tax expense ............................................. 130,000Net income .......................................................... Earnings per share ..............................................

$ 255,000

$2.55

EXERCISES


Exercise 4–1 (concluded)

Requirement 2

GREEN STAR CORPORATIONIncome Statement

For the Year Ended December 31, 2013 Sales revenue ....................................................... $1,300,000 Cost of goods sold ............................................... 720,000 Gross profit .......................................................... 580,000 Operating expenses:

Selling ................................................................ $160,000 General and administrative ................................ 75,000

Total operating expenses ............................... 235,000 Operating income ................................................ 345,000 Other income (expense):

Interest revenue ................................................. 30,000 Gain on sale of investments .............................. 50,000 Interest expense ................................................ (40,000)

Total other income, net ................................. 40,000 Income before income taxes ............................... 385,000 Income tax expense ............................................. 130,000 Net income .......................................................... $ 255,000 Earnings per share ...............................................

$2.55



GENERAL LIGHTING CORPORATION Income Statement

For the Year Ended December 31, 2013 Revenues and gains:

Sales ................................................................. $2,350,000Rental revenue .................................................. 80,000

Total revenues and gains .............................. 2,430,000 Expenses and losses:

Cost of goods sold ............................................ $1,200,300 Selling .............................................................. 300,000 General and administrative ............................... 150,000 Interest ............................................................... 90,000 Loss on sale of investments ............................. 22,500 Loss from inventory write-down ..................... 200,000

Total expenses and losses ............................. 1,962,800Income before income taxes and extraordinary Item …………………………………………. Income tax expense * …………………………. Income before extraordinary item ...................... Extraordinary item: Loss from flood damage (net of $48,000 tax benefit) Net income ..........................................................

467,200

186,880280,320

(72,000)

$ 208,320 Earnings per share: Income before extraordinary item ...................... Extraordinary loss ............................................... Net income ..........................................................

$ .93 (.24) $ .69

* 40% x $467,200



Requirement 2

GENERAL LIGHTING CORPORATIONIncome Statement

For the Year Ended December 31, 2013

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

Operating expenses: Selling ............................................................... $300,000 General and administrative ............................... 150,000 Loss from inventory write-down ...................... 200,000

Total operating expenses ............................... 650,000 Operating income ................................................ 499,700

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

Total other income (expense), net ................. (32,500) Income before income taxes and extraordinary item ....................................................................

467,200

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

280,320

(72,000) $ 208,320

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

$ .93 (.24) $ .69

* 40% x $467,200


Exercise 4–3

LINDOR CORPORATIONStatement of Comprehensive Income


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

Selling and administrative ............................................. 420,000 Operating income ............................................................ 480,000 Other income (expense): Interest expense ............................................................... (40,000) Income before income taxes and extraordinary item ....... 440,000 Income tax expense * ....................................................... 132,000 Income before extraordinary item ................................... Extraordinary item: Gain on litigation settlement (net of $120,000 tax expense) .................................................................. Net income Other comprehensive income: Unrealized holding gains on investment securities, net of tax .................................................................... Comprehensive income ...................................................

308,000

280,000 588,000

56,000 $644,000

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

$ 0.31 0.28

$ 0.59

* 30% x $440,000


Exercise 4–4

AXEL CORPORATION Income Statement

For the Year Ended December 31, 2013 Sales revenue ................................................................... $ 592,000 Cost of goods sold ........................................................... 325,000 Gross profit ...................................................................... 267,000 Operating expenses:

Selling .......................................................................... $67,000 Administrative ............................................................. 87,000 Restructuring costs ....................................................... 55,000

Total operating expenses ........................................... 209,000 Operating income ............................................................ 58,000 Other income (expense):

Interest and dividends ...................................................

32,000

Interest expense ............................................................ Total other income, net .................................................

(26,000)

6,000

Income before income taxes and extraordinary item ....... 64,000 Income tax expense* ....................................................... 25,600 Income before extraordinary item ................................... Extraordinary item: Gain on litigation settlement (net of $34,400 tax expense) .................................................................. Net income .......................................................................

38,400

51,600 $ 90,000

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

$ .38 .52

$0.90

* 40% x $64,000


Exercise 4–5

CHANCE COMPANYPartial Income Statement

For the Year Ended December 31, 2013 Income from continuing operations .................................... $ 350,000 Discontinued operations:

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

Income tax benefit ............................................................ 212,000 Loss on discontinued operations ...................................... (318,000)Net income ........................................................................... $ 32,000 Earnings per share: Income from continuing operations .................................... $ 3.50 Loss from discontinued operations ..................................... (3.18)Net income .......................................................................... $ .32

* Loss on discontinued operations: Loss on sale of assets $(400,000) Loss from operations (130,000) Total before-tax loss (530,000) Less: Income tax benefit (40%) 212,000 Net-of-tax loss $(318,000)


Exercise 4–6

ESQUIRE COMIC BOOK COMPANY


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

Income from operations of discontinued component (including loss on disposal of $350,000) .................................. 150,000

Income tax expense ........................................................... 60,000 Income on discontinued operations .................................. 90,000 Net income ............................................................................ $642,000

* Income from continuing operations: Income before considering additional items $1,000,000 Decrease in income due to restructuring costs (80,000) Before-tax income from continuing operations 920,000 Income tax expense (40%) (368,000) Income from continuing operations $ 552,000



KANDON ENTERPRISES, INC. Partial Income Statement


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

Discontinued operations: Loss from operations of discontinued component (including impairment loss of $50,000) * ..............................

(190,000)

Income tax benefit ............................................................. 76,000 Loss on discontinued operations ...................................... (114,000)Net income .......................................................................... $ 286,000

* Loss on discontinued operations:

Loss from operations $(140,000) Impairment loss ($250,000 – 200,000) (50,000) Net before-tax loss (190,000) Income tax benefit (40%) 76,000 Net after-tax loss on discontinued operations $(114,000)

Requirement 2

KANDON ENTERPRISES, INC. Partial Income Statement


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

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

Loss on discontinued operations ...................................... (84,000) Net income .......................................................................... $ 316,000

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


Exercise 4–8 Pretax income from continuing operations $14,000,000 Income tax expense (5,600,000) Income from continuing operations 8,400,000 Less: Net income 7,200,000 Loss from discontinued operations $1,200,000 $1,200,000 60%* = $2,000,000 = Before-tax loss from discontinued operations. *1 – tax rate of 40% = 60% Pretax income of division $4,000,000 Add: Loss from discontinued operations 2,000,000 Impairment loss $6,000,000 Fair value of division’s assets $11,000,000 Add: Impairment loss 6,000,000 Book value of division’s assets $17,000,000

Exercise 4–9 Earnings per share: Income from continuing operations $5.00 Loss from discontinued operations (1.60) Extraordinary gain 2.20 Net income $5.60


Exercise 4–10

THE MASSOUD CONSULTING GROUP Statement of Comprehensive Income

For the Year Ended December 31, 2013 Net income .......................................................... $1,354,000Other comprehensive income (loss): Foreign currency translation gain, net of tax ... $168,000 Unrealized losses on investment securities, net of tax ....................................................... (56,000) Total other comprehensive income ..................... 112,000Comprehensive income ...................................... $1,466,000

Exercise 4–11 1. b Purchase of equipment for cash. 2. a Payment of employee salaries. 3. a Collection of cash from customers. 4. c Cash proceeds from a note payable. 5. b Purchase of common stock of another corporation for cash. 6. c Issuance of common stock for cash. 7. b Sale of machinery for cash. 8. a Payment of interest on note payable. 9. d Issuance of bonds payable in exchange for land and building. 10. c Payment of cash dividends to shareholders. 11. c Payment of principal on note payable.


Exercise 4–12 Bluebonnet Bakers

Statement of Cash Flows For the Year Ended December 31, 2013

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

Cash flows from investing activities: Collection of note receivable 50,000 Sale of investments 30,000 Purchase of equipment (85,000) Net cash flows from investing activities (5,000)

Cash flows from financing activities: Proceeds from note payable 100,000 Payment of note payable (25,000) Payment of dividends (20,000) Net cash flows from financing activities 55,000

Net increase in cash 181,000

Cash and cash equivalents, January 1 17,000

Cash and cash equivalents, December 31 $ 198,000


Exercise 4–13 Cash collected for interest, considered an operating cash flow by U.S. GAAP,

could be classified as either an operating cash flow or an investing cash flow according to International Accounting Standards.

Cash paid for interest, considered an operating cash flow by U.S. GAAP, could be classified as either an operating cash flow or a financing cash flow according to International Accounting Standards.

Cash paid for dividends, considered a financing cash flow by U.S. GAAP, could be classified as either an operating cash flow or a financing cash flow according to International Accounting Standards.

Accordingly, the statement of cash flows prepared according to IFRS could be the same as under U.S. GAAP (E4–12) or could be presented as follows:

BLUEBONNET BAKERS Statement of Cash Flows


Cash flows from operating activities: Collections from customers $ 380,000 Purchase of inventory (160,000) Payment of salaries (90,000) Payment of dividends (20,000) Net cash flows from operating activities $110,000

Cash flows from investing activities: Collection of note receivable 50,000 Interest on note receivable 6,000 Sale of investments 30,000 Purchase of equipment (85,000) Net cash flows from investing activities 1,000

Cash flows from financing activities: Proceeds from note payable 100,000 Payment of note payable (25,000) Interest on note payable (5,000) Net cash flows from financing activities 70,000


Cash and cash equivalents, January 1 17,000

Cash and cash equivalents, December 31 $ 198,000


Exercise 4–14 Cash flows from operating activities: Net income $17,300 Adjustments for noncash effects: Depreciation expense 7,800 Changes in operating assets and liabilities: Increase in accounts receivable (4,000) Decrease in inventory 5,500 Decrease in prepaid insurance 1,200 Decrease in salaries payable (2,700) Increase in interest payable 800 Net cash flows from operating activities $25,900


Financing Investing Operating 1. $300,000 2. $(10,000) 3. 4. 5. $ (5,000) 6. (6,000) 7. (70,000) 8. 55,000 9. __________ __________ __________

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



Requirement 2

WAINWRIGHT CORPORATION

Statement of Cash Flows For the Month Ended March 31, 2013

Cash flows from operating activities:

Collections from customers $ 55,000 Payment of rent (5,000) Payment of one-year insurance premium (6,000) Payment to suppliers of merchandise for sale (70,000) Net cash flows from operating activities $ (26,000) Cash flows from investing activities: Purchase of equipment (10,000) Net cash flows from investing activities (10,000) Cash flows from financing activities: Issuance of common stock 300,000 Net cash flows from financing activities 300,000 Net increase in cash 264,000 Cash and cash equivalents, March 1 40,000 Cash and cash equivalents, March 31 $ 304,000

Noncash investing and financing activities:

Acquired $40,000 of equipment by paying cash and issuing a note as follows: Cost of equipment $40,000

Cash paid 10,000 Note issued $30,000


Exercise 4–16 Cash flows from operating activities: Net income $624,000 Adjustments for noncash effects: Depreciation and amortization expense 87,000 Changes in operating assets and liabilities: Decrease in accounts receivable 22,000 Increase in inventories (9,200) Increase in prepaid expenses (8,500) Increase in salaries payable 10,000 Decrease in income taxes payable (14,000) Net cash flows from operating activities $711,300


Exercise 4–17 Consistent with U.S. GAAP, international standards also require a statement of

cash flows. Consistent with U.S. GAAP, cash flows are classified as operating, investing, or financing. However, the U.S. standard designates cash outflows for interest payments and cash inflows from interest and dividends received as operating cash flows. Dividends paid to shareholders are classified as financing cash flows.

IAS No. 7, on the other hand, allows more flexibility. Companies can report interest and dividends paid as either operating or financing cash flows and interest and dividends received as either operating or investing cash flows. Interest and dividend payments usually are reported as financing activities. Interest and dividends received normally are classified as investing activities.

Accordingly, the statement of cash flows prepared according to IFRS mostly likely would be presented as follows (differences from U.S. GAAP in italics):

BRONCO METALS


Cash flows from operating activities: Collections from customers $ 353,000 Purchase of inventory (186,000) Payment of operating expenses (67,000) Net cash flows from operating activities $100,000 Cash flows from investing activities: Interest on note receivable 4,000 Dividends received from investments 2,400 Collection of note receivable 100,000 Purchase of equipment (154,000) Net cash flows from investing activities (47,600) Cash flows from financing activities: Payment of interest on note payable (8,000) Proceeds from issuance of common stock 200,000 Dividends paid (40,000) Net cash flows from financing activities 152,000 Net increase in cash 204,400 Cash and cash equivalents, January 1 28,600 Cash and cash equivalents, December 31 $233,000


Exercise 4–18 TIGER ENTERPRISES Statement of Cash Flows

For the Year Ended December 31, 2013 ($ in thousands)

Cash flows from operating activities: Net income $ 900 Adjustments for noncash effects: Depreciation expense 240 Changes in operating assets and liabilities: Decrease in accounts receivable 80 Increase in inventory (40) Increase in prepaid insurance (30) Decrease in accounts payable (60) Decrease in administrative and other payables (100) Increase in income taxes payable 50 Net cash flows from operating activities $1,040

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

Cash flows from financing activities: Proceeds from issuance of common stock 100 Proceeds from note payable 200 Payment of dividends (1) (940) Net cash flows from financing activities(640)

Net increase in cash 100

Cash, January 1 200 Cash, December 31 $ 300

(1) Retained earnings, beginning $540 + Net income 900 – Dividends x x = $940 Retained earnings, ending $500


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

shown below. To derive the cash flows, the beginning and ending balances in the related assets and liabilities are inserted, together with the revenue and expense amounts from the income statements. In each balance sheet account, the remaining (plug) figure is the other half of the cash increases or decreases.

Cash Flows (Operating)(a.) 7,080 (b.) 130

(c.) 3,460(d.) 1,900

(e.) 550

Sales Revenue Accounts Receivable1/1 830 (a.) 7,080

7,000 <-----------> 7,00012/31 750

Prepaid Insurance Insurance Expense1/1 20

(b.) 130 100 <-----------> 10012/31 50

Accounts Payable Inventory Cost of Goods Sold(c.) 3,460 1/1 360 1/1 600 3,360 <-----------> 3,360

3,400 <-----------> 3,40012/31 300 12/31 640

Admin. & Other Payables Admin. & Other Expense(d.) 1,900 1/1 400

1,800 <-----------> 1,80012/31 300

Income Taxes Payable Income Tax Expense(e.) 550 1/1 150

600 <-----------> 60012/31 200

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

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



TIGER ENTERPRISES Statement of Cash Flows

For the Year Ended December 31, 2013 ($ in thousands)

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

Net cash flows from operating activities $ 1,040



FASB ASC 260: “Earnings per Share.”

Requirement 2 The specific citation that describes the additional information for earnings per

share that must be included in the notes to the financial statements is FASB ASC 260–10–50–1: “Earnings per Share–Overall–Disclosure.”

Requirement 3 For each period for which an income statement is presented, an entity discloses

all of the following:

a. A reconciliation of the numerators and the denominators of the basic and diluted per-share computations for income from continuing operations. The reconciliation includes the individual income and share amount effects of all securities that affect earnings per share (EPS). Example 2 (see paragraph 260–10–55–51) illustrates that disclosure. (See paragraph 260–10–45–3.) An entity is encouraged to refer to pertinent information about securities included in the EPS computations that is provided elsewhere in the financial statements as prescribed by Subtopic 505-10.

b. The effect that has been given to preferred dividends in arriving at income available to common stockholders in computing basic EPS.

c. Securities (including those issuable pursuant to contingent stock agreements) that could potentially dilute basic EPS in the future that were not included in the computation of diluted EPS because to do so would have been antidilutive for the period(s) presented. Full disclosure of the terms and conditions of these securities is required even if a security is not included in diluted EPS in the current period.

For the latest period for which an income statement is presented, an entity must provide a description of any transaction that occurs after the end of the most recent period but before issuance of the financial statements that would have changed materially the number of common shares or potential common shares outstanding at the end of the period if the transaction had occurred before the end of the period. Examples of those transactions include the issuance or acquisition of common shares; the issuance of warrants, options, or convertible securities; the resolution of a contingency pursuant to a contingent stock agreement; and the conversion or exercise of potential common shares outstanding at the end of the period into common shares.


Exercise 4–21

The FASB Accounting Standards Codification represents the single source of authoritative U.S. generally accepted accounting principles. The specific citation for each of the following items is:

1. The criteria for determining if a gain or loss should be reported as an

extraordinary item:

FASB ASC 225–20–45–2: “Income Statement–Extraordinary and Unusual Items–Other Presentation Matters–Criteria for Presentation as Extraordinary.” Extraordinary items are events and transactions that are distinguished by their unusual nature and by the infrequency of their occurrence. Thus, both of the following criteria shall be met to classify an event or transaction as an extraordinary item: a. Unusual nature. The underlying event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking into account the environment in which the entity operates.

b. Infrequency of occurrence. The underlying event or transaction should be of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates.

2. The calculation of the weighted average number of shares for basic

earnings per share purposes:

FASB ASC 260–10–55–2: “Earnings per Share–Overall–Implementation Guidance and Illustration–Computing a Weighted Average.”

The weighted-average number of shares is an arithmetical mean average of shares outstanding and assumed to be outstanding for EPS computations. The most precise average would be the sum of the shares determined on a daily basis divided by the number of days in the period. Less-precise averaging methods may be used, however, as long as they produce reasonable results. Methods that introduce artificial weighting, such as the Rule of 78 method, are not acceptable for computing a weighted-average number of shares for EPS computations.


Exercise 4–21 (continued) 3. The alternative formats permissible for reporting comprehensive income:

FASB ASC 220–10–45–1: “Comprehensive Income–Overall–Other Presentation Items–Reporting Comprehensive Income.”

1A. An entity reporting comprehensive income in a single continuous financial statement shall present its components in two sections, net income and other comprehensive income. If applicable, an entity shall present the following in that financial statement:

a. A total amount for net income together with the components that make up net income.

b. A total amount for other comprehensive income together with the components that make up other comprehensive income. As indicated in paragraph 220–10–15–3, an entity that has no items of other comprehensive income in any period presented is not required to report comprehensive income.

c. Total comprehensive income.

1B. An entity reporting comprehensive income in two separate but consecutive statements shall present the following:

a. Components of and the total for net income in the statement of net income b. Components of and the total for other comprehensive income as well as a

total for comprehensive income in the statement of other comprehensive income, which shall be presented immediately after the statement of net income. A reporting entity may begin the second statement with net income.

1C. An entity shall present, either in a single continuous statement of comprehensive income or in a statement of net income and statement of other comprehensive income, all items that meet the definition of comprehensive income for the period in which those items are recognized. Components included in other comprehensive income shall be classified based on their nature.


Exercise 4–21 (concluded) 4. The classifications of cash flows required in the statement of cash flows:

FASB ASC 230–10–45–1: “Statement of Cash Flows–Overall–Other Presentation Matters–Form and Content.”

A statement of cash flows shall report the cash effects during a period of an entity's operations, its investing transactions, and its financing transactions.


Exercise 4–22 List A List B

f 1. Intraperiod tax allocation a. Unusual, infrequent, and material gains and losses. g 2. Comprehensive income b. Starts with net income and works backwards to convert to cash. a 3. Extraordinary items c. Reports the cash effects of each operating activity directly on the statement. l 4. Operating income d. Correction of a material error of a prior period. k 5. A discontinued operation e. Related to the external financing of the company. j 6. Earnings per share f. Associates tax with income statement item. d 7. Prior period adjustment g. Total nonowner change in equity. e 8. Financing activities h. Related to the transactions entering into the determination of net income. h 9. Operating activities (SCF) i. Related to the acquisition and disposition of long-term assets. i 10. Investing activities j. Required disclosure for publicly traded corporation. c 11. Direct method k. A component of an entity. b 12. Indirect method l. Directly related to principal revenue- generating activities.


CPA / CMA REVIEW QUESTIONS

CPA Exam Questions

1. c. U.S. GAAP requires that discontinued operations be disclosed separately below income from continuing operations.

2. d. Other than sales, COGS, and administrative expenses, only the gain or loss from disposal of equipment is considered part of income from continuing operations. Income from continuing operations was ($5,000,000 – 3,000,000 – 1,000,000 + 200,000) = $1,200,000.

3. a. In a single-step income statement, revenues include sales as well as other revenues and gains.

Sales revenue $187,000 Interest revenue 10,200 Gain on sale of equipment 4,700 Total $201,900

The discontinued operations and the extraordinary gain are reported below income from continuing operations.

4. a. The $400,000 impairment loss and the $1,000,000 loss from operations should be combined for a total loss of $1,400,000.

5. a. Dividends paid to shareholders is considered a financing cash flow, not an

operating cash flow.

6. c. Issuing common stock for cash is considered a financing cash flow, not an investing cash flow.

7. b. IFRS prohibits reporting extraordinary items, and restructuring costs are not separately reported under both IFRS and U.S. GAAP. Both IFRS and U.S. GAAP report discontinued operations as a separate item, net of tax.

8. c. Interest paid can be classified as either an operating or financing cash flow.


CMA Exam Questions

1. d. Discontinued operations and extraordinary gains and losses are shown separately in the income statement, below income from continuing operations. The cumulative effect of most voluntary changes in accounting principle is accounted for by retrospectively revising prior years’ financial statements.

2. c. The operating section of a retailer’s income statement includes all revenues and costs necessary for the operation of the retail establishment, for example, sales, cost of goods sold, administrative expenses, and selling expenses.

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


Problem 4–1

REED COMPANY Comparative Income Statements

For the Years Ended December 31

2013 2012 Sales revenue ........................................................ [1] $4,000,000 [6] $3,000,000 Cost of goods sold ................................................ [2] 2,570,000 [7] 1,680,000 Gross profit ........................................................... 1,430,000 1,320,000

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

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

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

Total other expenses (net) .............................. (50,000) (60,000) Income from continuing operations before income taxes and extraordinary item ...............

205,000

343,000

Income tax expense .............................................. 82,000 137,200 Income from continuing operations before extraordinary item .............................................

123,000

205,800

Discontinued operations: Income (loss) from operations of discontinued component (including loss on disposal of $50,000 in 2013) ................................................

(10,000)

110,000 Income tax benefit (expense) ................................ 4,000 (44,000) Income (loss) on discontinued operations ......... [5] (6,000) 66,000 Income before extraordinary item ........................ 117,000 271,800 Extraordinary item: Loss from earthquake (net of $40,000 tax benefit)

(60,000)

- -

Net income ............................................................ $ 57,000 $ 271,800

Earnings per share: Income from continuing operations before extraordinary item .....................................................

$ .41

$ .69 Discontinued operations ............................................. (.02) .22 Extraordinary loss ....................................................... (.20) - -

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

PROBLEMS


Problem 4–1 (concluded) [1] $4,400,000 – 400,000 [2] $2,860,000 – 290,000 [3] $800,000 – 50,000 [4] $360,000 – 20,000 [5] Loss in 2011: Income from operations $ 40,000 Loss on sale of assets (50,000) Loss before tax benefit (10,000) Tax benefit (40% x $10,000) 4,000 Loss on discontinued operations, net of tax benefit $ (6,000) [6] $3,500,000 – 500,000 (sales from discontinued operation) [7] $2,000,000 – 320,000 (cost of goods sold from discontinued operation) [8] $675,000 – 40,000 (administrative expenses from discontinued operations) [9] $312,000 – 30,000 (selling expenses from discontinued operations)


Problem 4–2 Requirement 1

JACKSON HOLDING COMPANY

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

2013 2012 Income from continuing operations before income taxes [1] .......................................... $3,000,000 $1,300,000 Income tax expense ......................................... 1,200,000 520,000 Income from continuing operations ................ 1,800,000 780,000 Discontinued operations: Income (loss) from operations of discontinued component (including gain on disposal of $600,000 in 2011) [2] .......................................

200,000

(300,000) Income tax benefit (expense) ......................... (80,000) 120,000 Income (loss) on discontinued operations ..... 120,000 (180,000) Net Income ...................................................... $1,920,000 $ 600,000

[1] Income from continuing operations before income taxes: 2013 2012 Unadjusted $2,600,000 $1,000,000 Add: Loss from discontinued operations 400,000 300,000 Adjusted $3,000,000 $1,300,000

[2] Income from discontinued operations:

2013 2012 Loss from operations $(400,000) $(300,000) Gain on disposal 600,000 - Total $ 200,000 $(300,000)


Problem 4–2 (concluded)

Requirement 2 The 2013 income from discontinued operations would include only the loss from

operations of $400,000. Since no impairment loss is indicated ($5,000,000 – 4,400,000 = $600,000 anticipated gain), none is included. The anticipated gain on disposal is not recognized until it is realized, presumably in the following year.

Requirement 3 The 2013 income from discontinued operations would include the loss from

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



MICRON CORPORATION Partial Income Statement


Income from continuing operations before income taxes and extraordinary item .......

[1] $1,300,000

Income tax expense .................................... 390,000 Income from continuing operations before extraordinary item .......................................

910,000

Discontinued operations: Loss from operations of discontinued component (including loss on disposal of $300,000) .................................................

$(140,000)

Income tax benefit ................................... 42,000 Loss on discontinued operations .............. [2]

(98,000) Income before extraordinary item .............. 812,000 Extraordinary item: Loss from earthquake (net of $240,000 tax benefit) .....................

(560,000) Net Income ................................................. $ 252,000

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

[2] Loss on discontinued operations: Income from operations $ 160,000 Deduct: Loss on sale of assets (300,000) Loss before tax (140,000) Tax benefit (30% x $140,000) 42,000 Loss on discontinued operations $ (98,000)

Requirement 2 These events will not, or are unlikely to occur again in the near future. By

segregating them, users are better able to predict future cash flows.


Problem 4–4 1. Restructuring is an example of an event that is either unusual or infrequent, but not

both. Restructuring costs should be included in income from continuing operations but reported as a separate income statement component. The item is reported gross, not net of tax as with extraordinary gains and losses.

2. The extraordinary gain should be presented, net of tax, in the income statement below income from continuing operations. Also, earnings per share for income from continuing operations and for the extraordinary item should be disclosed.

3. The correction of the error should be treated as a prior period adjustment to beginning retained earnings, not as an adjustment to current year's cost of goods sold. In addition, the 2012 financial statements should be restated to reflect the correction, and a disclosure note is required that communicates the impact of the error on 2012 income.


Problem 4–5

ALEXIAN SYSTEMS, INC. Income Statement


($ in millions except per share date) Net sales revenue ................................................. $425 Cost of goods sold ............................................... [1] 265 Gross profit .......................................................... 160

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

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

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

Total other income ........................................ 9 Income before income taxes and extraordinary item ...................................................................

15

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

9 [4] 72

$ 81

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

$ 0.45 3.60 $ 4.05

[1] $270 – 5 (prior period adjustment) [2] $154 – 26 (restructuring costs) [3] 40% x $15 [4] $120 less taxes of $48 (40% x $120)

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


Problem 4–6

REMBRANDT PAINT COMPANY

Income Statement For the Year Ended December 31, 2013

($ in thousands, except per share amounts)

Sales revenue ................................................................... $18,000 Cost of goods sold ........................................................... 10,500 Gross profit ...................................................................... 7,500 Operating expenses: Selling and administrative ............................................ $2,500 Restructuring costs ....................................................... 800 3,300

Operating income ............................................................ 4,200 Interest income (expense), net ......................................... (150)Income from continuing operations before income taxes and extraordinary item ...................................................

4,050

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

2,835

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

400

Income tax expense ...................................................... 120 Income on discontinued operations ............................. 280 Income before extraordinary item ................................... 3,115 Extraordinary gain (net of $900 tax expense) ..................... 2,100 Net income ........................................................................ 5,215 Earnings per share: Income from continuing operations before extraordinary item ...............................................................................

$ 5.67

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


Problem 4–7

Requirement 1

SCHEMBRI MANUFACTURING CORPORATION Statement of Comprehensive Income

For the Year Ended December 31, 2013 ($ in 000s)

Sales revenue .................................................................. $15,300 Cost of goods sold ........................................................... 6,200 Gross profit ..................................................................... 9,100 Operating expenses: Selling .......................................................................... $1,300 General and administrative .......................................... 800 Restructuring costs ....................................................... 1,200 Total operating expenses ........................................ 3,300 Operating income ............................................................ 5,800

Other income (expense): Loss on sales of investments .......................................... $(220) Interest expense .............................................................. (180) Interest revenue .............................................................. 85 Other income (expense) .............................................. (315) Income from continuing operations before income taxes and extraordinary item ……………………………….

5,485

Income tax expense ......................................................... 2,194 Income from continuing operations before extraordinary item ..............................................................................

3,291

Discontinued operations: Income from operations of discontinued component (including gain on disposal of $1,400) ...................... 840 Income tax expense ...................................................... (336) Income from discontinued operations .......................... 504 Income before extraordinary item ................................... 3,795 Extraordinary item: Loss from earthquake (net of $800 tax benefit) ........... (1,200) Net income ....................................................................... 2,595 Other comprehensive income:

Unrealized gains from investments, net of tax 192 Loss from foreign currency translation, net of tax (144) 48 Comprehensive income $2,643



Earnings per share:* Income from continuing operations before extraordinary item $2.74 Discontinued operations .42 Extraordinary loss (1.00) Net income $2.16 *Weighted-average shares = 1,000,000 + (400,000/2) = 1,200,000

Note: The depreciation expense error is a prior period adjustment (to retained earnings) and is not reported in the income statement.

Requirement 2

SCHEMBRI MANUFACTURING CORPORATION

Statement of Comprehensive Income For the Year Ended December 31, 2013

($ in 000s)

Net income ....................................................................... $2,595Other comprehensive income (loss): Unrealized gains from investments, net of tax ............... $192 Loss from foreign currency translation, net of tax (144) Total other comprehensive income ................................. 48Comprehensive income ................................................... $2,643


Problem 4–8

DUKE COMPANY Statement of Comprehensive Income


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

Operating expenses: General and administrative .......................................... $1,000,000 Selling ......................................................................... 500,000 Restructuring costs ....................................................... 300,000 Loss from write-down of obsolete inventory 400,000

Total operating expenses .......................................... 2,200,000 Operating income ............................................................ 3,800,000

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

Income before income taxes and extraordinary item ....... 3,100,000 Income tax expense ......................................................... 1,240,000 Income before extraordinary item ................................... 1,860,000 Extraordinary item: Loss from expropriation of overseas plant (net of $1,200,000 tax benefit) ............................................

(1,800,000)

Net Income ....................................................................... 60,000 Other comprehensive income (loss): Foreign currency translation adjustment loss, net of tax (120,000) Unrealized gains on investment securities, net of tax 108,000 Total other comprehensive loss (12,000) Comprehensive income $ 48,000

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

statement.



DIVERSIFIED PORTFOLIO CORPORATION Statement of Cash Flows


Cash flows from operating activities: Collections from customers (1) $880,000 Payment of operating expenses (2) (660,000) Payment of income taxes (3) (85,000) Net cash flows from operating activities $135,000 Cash flows from investing activities: Sale of investments 50,000 Net cash flows from investing activities 50,000 Cash flows from financing activities: Proceeds from issue of common stock 100,000 Payment of dividends (80,000) Net cash flows from financing activities 20,000 Increase in cash 205,000 Cash and cash equivalents, January 1 70,000 Cash and cash equivalents, December 31 $275,000 (1) $900,000 in service revenue less $20,000 increase in accounts receivable. (2) $700,000 in operating expenses less $30,000 in depreciation less $10,000 increase in accounts payable. (3) $80,000 in income tax expense plus $5,000 decrease in income taxes payable.



Requirement 2 DIVERSIFIED PORTFOLIO CORPORATION


Cash flows from operating activities: Net income $120,000 Adjustments for noncash effects: Depreciation expense 30,000 Changes in operating assets and liabilities: Increase in accounts receivable (20,000) Increase in accounts payable 10,000 Decrease in income taxes payable (5,000) Net cash flows from operating activities $135,000



2012 Cash: 2012 Cash + Net increase in cash = 2013 Cash 2012 Cash + $86 = $145 2012 Cash = $59 2013 A/R: 2012 A/R + Cr. Sales – Cash collections = 2013 A/R $84 + 80 – 71 = $93

2012 Inventory: 2012 A/P + Purchases – Cash paid = 2013 A/P $30 + Purchases – 30 = $40 Therefore, Purchases = $40 2012 Inventory + Purchases – 2013 Inventory = Cost of goods sold 2012 Inventory + $40 – 60 = $32 2012 Inventory = $52 2012 Accumulated depreciation: 2013 accumulated depreciation less 2013 depreciation = 2012 accumulated depreciation $65 – 10 = $55


Problem 4–10 (continued)

2012 Total assets: $59 + 84 + 52 + 50 + 150 – 55 = $340 2013 Total assets: $145 + 93 + 60 + 150 – 65 = $383

2012 Income taxes payable: 2012 Inc. taxes payable + Inc. tax expense – Income taxes paid = 2013 Inc. taxes payable 2012 Inc. taxes payable =2013 Inc. taxes payable + Taxes paid – Inc. tax expense 2012 Inc. taxes payable = $22 + 9 – 7 = $24

2013 Retained earnings: 2012 R/E + Net income – Dividends = 2013 R/E $47 + 28 – 3 = $72

2012 Total liabilities and shareholders’ equity: $30 + 9 + 24 + 230 + 47 = $340 2013 Total liabilities and shareholders’ equity: $40 + 9 + 22 + 240 + 72 = $383



Requirement 2

GRANDVIEW CORPORATION


($ in millions) Cash flows from operating activities: Net income $ 28 Adjustments for noncash effects: Depreciation expense 10 Gain on sale of investments (15) Changes in operating assets and liabilities: Increase in accounts receivable1 (9) Increase in inventory2 (8) Increase in accounts payable3 10 Decrease in income taxes payable4 (2) Net cash flows from operating activities $14

1 $93 – 84 2 $60 – 52 3 $40 – 30 4 $22 – 24


Problem 4–11 SANTANA INDUSTRIES


($ in thousands)

Cash flows from operating activities: Net income $ 3,850 Adjustments for noncash effects: Depreciation expense 1,600 Changes in operating assets and liabilities: Increase in accounts receivable (300) Increase in inventory (1,000) Decrease in prepaid rent 150 Increase in accounts payable 300 Increase in interest payable 100 Increase in unearned service revenue 200 Decrease in income taxes payable (250) Net cash flows from operating activities $4,650

Cash flows from investing activities: Purchase of equipment (4,000) Sale of equipment 500 Net cash flows from investing activities (3,500)

Cash flows from financing activities: Proceeds from loan payable 5,000 Payment of dividends (1,000) Net cash flows from financing activities 4,000


Cash, January 1 2,200 Cash, December 31 $7,350


Judgment Case 4–1 Requirement 1

The term earnings quality refers to the ability of reported earnings (income) to predict a company’s future earnings. After all, an income statement simply reports on events that already have occurred. The relevance of any historical-based financial statement hinges on its predictive value.

Requirement 2 To enhance predictive value, analysts try to separate a company’s transitory

earnings effects from its permanent earnings. Transitory earnings effects result from transactions or events that are not likely to occur again in the foreseeable future, or that are likely to have a different impact on earnings in the future.

Requirement 3 An often-debated contention is that, within GAAP, managers have the power, to a

limited degree, to manipulate reported company income. And the manipulation is not always in the direction of higher income. Many believe that manipulating income reduces earnings quality because it can mask permanent earnings.

Requirement 4 You would consider the size of the gain in relation to net income, the size of the

company’s investment portfolio, and the frequency of gains and losses from the sale of investment securities in past years. The main objective is to determine the likelihood of this type of gain occurring again in the future.

CASES



Restructuring costs include costs associated with shutdown or relocation of facilities or downsizing of operations. Facility closings and related employee layoffs translate into costs incurred for severance pay and relocation costs as well as asset write-downs or write-offs.

Requirement 2 Prior to 2003, restructuring costs were recognized (expensed) in the period the

decision to restructure was made, not in the period or periods in which the actual activities took place. Now, restructuring costs are expensed in the period(s) incurred.

Requirement 3 Restructuring costs would be included as an operating expense in a multi-step

income statement.

Requirement 4 An analyst must interpret restructuring charges in light of a company’s past

history in this area. Information in disclosure notes describing the restructuring and management plans related to the business involved also can be helpful.

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

upward path. They try to avoid declines, but they also want to avoid increases that vary wildly from year to year. It is better to have two years of 15% earnings increases than a 30% gain one year and none the next. As a result, some companies “bank” earnings by understating them in particularly good years and use the banked profits to increase earnings in bad years.


Real World Case 4–4 Requirement 1

Companies often voluntarily provide a pro forma earnings number when they announce annual or quarterly earnings calculated according to GAAP. These pro forma earnings numbers are management’s view of permanent earnings. These pro forma earnings numbers are controversial as they represent management’s biased view of permanent earnings and should be interpreted in that light.

Requirement 2 The term earnings quality refers to the ability of reported earnings (income) to

predict a company’s future earnings. Management believes that pro forma earnings are of much higher quality than reported earnings because they are more indicative of future profitability.


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

on the sale of the timber tracts should be reported as an extraordinary item on the 2013 income statement. There is no right or wrong answer. The process of developing the proposed solutions will likely be more beneficial than the solutions themselves. Students should benefit from participating in the process, interacting first with other group members, then with the class as a whole.

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

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

gain should be reported net of tax below income from continuing operations. A disclosure note also is required and earnings per share disclosure should reflect the income statement presentation.

As a real world example of a similar situation, in 1974 Johns Manville

Corporation, manufacturer of asbestos products, reported a $21 million extraordinary gain from the sale of timber tracts. No disclosure note was provided to explain the event, so we can only speculate as to the circumstances leading to the company's presentation of the gain as extraordinary.

It is important that each student actively participate in the process. Domination by one or two individuals should be discouraged. Students should be encouraged to contribute to the group discussion by (a) offering information on relevant issues, and (b) clarifying or modifying ideas already expressed, or (c) suggesting alternative direction.


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

Content (70%) ______ 10 Is the loss material? ______ 25 Lists the alternative treatments. ____ Present before-tax amount as a separate line item. ____ Present the after-tax amount as an extraordinary item. ____ In either case, disclosure is required. ______ 25 Cites the appropriate authoritative pronouncement, FASB ASC 225–20–45 (previously APBO No. 30), and discuss the concepts of unusual and infrequent in the context of the company’s environment. ______ 10 A clear, well-supported recommendation is made. ____ ______ 70 points Writing (30%) ______ 6 Terminology and tone appropriate to the audience of a chief financial officer. ______ 12 Organization permits ease of understanding. ____ Introduction that states purpose. ____ Paragraphs that separate main points. ______ 12 English ____ Sentences grammatically clear and well organized, concise. ____ Word selection. ____ Spelling. ____ Grammar and punctuation. ____ ______ 30 points


Case 4–6 (continued) The following is provided as an example.

August 1990 TO: Chief Financial Officer, Carter Hawley Hale Stores (CHHS) FROM: John Doe, Controller (CHHS) RE: Income Statement treatment of October 17, 1989, earthquake damage costs.

A decision on the income statement treatment of the earthquake damage costs involves a number of considerations. First, the damage costs are clearly material. Inclusion of the costs in earnings results in an increase in the net loss for the fiscal year ended August 4, 1990, from $9.47 million to $25.97 million. This leaves us only two options for the income statement presentation of the loss:

1. Present the before-tax amount of the loss ($27.5 million) as a separate line item in the income statement.

2. Present the after-tax effect of the loss ($16.5 million) as an extraordinary item, below income from continuing operations.

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

The appropriate authoritative pronouncement pertaining to this case is FASB

ASC 225–20–45: “Income Statement–Extraordinary and Unusual Items–Other Presentation Matters” (previously Accounting Principles Board Opinion No. 30). It states that judgment is required in determining whether or not an event warrants separate reporting in the income statement as an extraordinary item. However, the following broad guideline is provided in paragraph 2:

“Extraordinary items are events and transactions that are distinguished by their unusual nature and by the infrequency of their occurrence.”

The characteristics of unusual nature and infrequency of occurrence must be considered in light of the environment in which the company operates.

These characteristics are only aids in answering the important question: What is the likelihood that this event will occur again in the foreseeable future? If it is not likely to occur again, then this should be communicated to financial statement users by segregating the income effect of the event as an extraordinary item. This will help them in using the income statement to predict future cash flows.


Case 4–6 (concluded) RECOMMENDATION I recommend that the earthquake damage costs be treated as an extraordinary

loss, net of tax, in the income statement for the fiscal year ended August 4, 1990. In addition, earnings per share for income both before and after the loss must be presented. While many earthquakes do occur in California, extremely large earthquakes causing significant amounts of damage are both unusual and infrequent. I do not believe that this type of loss will occur again in the foreseeable future.


Ethics Case 4–7 Discussion should include these elements.

Facts: The company incurred $10 million in expenses related to a product recall. The

company had experienced product recalls in the past and they do occur in the industry. To show a profit from continuing operations, Jim Dietz, the controller, wants to report the $10 million as an extraordinary loss, rather than as an expense included in operating income. He tells the CEO that the company has never had a product recall of this magnitude and that the company fixed the design flaw and upgraded quality control.

Extraordinary items are gains and losses that are material, and result from events that are both unusual and infrequent. These criteria must be considered in light of the environment in which the entity operates. There obviously is a considerable degree of subjectivity involved in the determination. The concepts of unusual and infrequent require judgment. In making these judgments, an accountant should keep in mind the overall objective of the income statement. The key question is how the event relates to a firm’s future profitability. If it is judged that the event, because of its unusual nature and infrequency of occurrence, is not likely to occur again, separate reporting as an extraordinary item is warranted.

Ethical Dilemma: It appears from the facts of the case that it would be difficult for the company to

come to the conclusion that a material product recall is not likely to occur again in the foreseeable future. This type of event has occurred before and is common in the industry. While a subjective judgment, extraordinary treatment of the $10 million does not appear warranted. Is the obligation of Jim and the CEO to maximize income from continuing operations, the company's position on the stock market, and management bonuses stronger than their obligation to fairly present accounting information to the users of financial statements?

Who is affected?

Jim Dietz CEO and other managers Other employees Shareholders Potential shareholders from the stock market Creditors Company auditors


Research Case 4–8 Requirement 1

The accounting standards topic number that addresses exit or disposal cost obligations is FASB ASC 420: “Exit or Disposal Cost Obligations.”

Requirement 2 The specific citation that addresses the initial measurement of these obligations is

FASB ASC 420–10–30–1: “Exit or Disposal Cost Obligations–Overall–Initial Measurement.”

Requirement 3 A liability for a cost associated with an exit or disposal activity is measured

initially at its fair value in the period in which the liability is incurred.

Requirement 4 The specific citation that describes the disclosure requirements for exit or disposal

obligations is FASB ASC 420–10–50–1: “Exit or Disposal Cost Obligations–Overall–Disclosure.”


Case 4–8 (concluded)

Requirement 5

All of the following information is disclosed in notes to financial statements that include the period in which an exit or disposal activity is initiated and any subsequent period until the activity is completed:

a. A description of the exit or disposal activity, including the facts and circumstances leading to the expected activity and the expected completion date.

b. For each major type of cost associated with the activity (for example, one-time employee termination benefits, contract termination costs, and other associated costs), both of the following are disclosed:

1. The total amount expected to be incurred in connection with the activity, the amount incurred in the period, and the cumulative amount incurred to date.

2. A reconciliation of the beginning and ending liability balances showing separately the changes during the period attributable to costs incurred and charged to expense, costs paid or otherwise settled, and any adjustments to the liability with an explanation of the reason(s) why.

c. The line item(s) in the income statement or the statement of activities in which the costs in (b) are aggregated.

d. For each reportable segment, as defined in Subtopic 280-10, the total amount of costs expected to be incurred in connection with the activity, the amount incurred in the period, and the cumulative amount incurred to date, net of any adjustments to the liability with an explanation of the reason(s) why.

e. If a liability for a cost associated with the activity is not recognized because fair value cannot be reasonably estimated, that fact and the reasons why.


Judgment Case 4–9 Financial Statement Presentation Situation Treatment (a–g) (CO, BC, or RE) 1. b. CO 2. c. RE 3. f. CO 4. g. CO 5. a. BC 6. b. CO 7. e. BC 8. d. RE

Judgment Case 4–10 1. The loss is not unusual or infrequent. It is included in income from continuing

operations along with other nonoperating items. 2. The sale of the financing component is treated as a discontinued operation. The

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

3. A change in depreciation method is treated as a change in accounting estimate achieved by a change in accounting principle. Changes in estimates are accounted for prospectively. The remaining book value is depreciated, using the new method, over the remaining useful life.

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

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

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


IFRS Case 4–11 1. GSK reported “interest received” and “dividends from associates and joint

ventures” as investing cash flows. U.S. GAAP requires these items to be included with operating cash flows.

2. “Interest paid” is reported as a financing cash flow. U.S. GAAP requires interest paid to be included with operating cash flows



1. a. As a component of operating income. 2. b. As a nonoperating income item. 3. d. As an other comprehensive income item. 4. b. As a nonoperating income item. 5. c. As a separately reported item. 6. a. As a component of operating income. 7. e. As an adjustment to retained earnings. 8. c. As a separately reported item.

Requirement 2 Situations 3, 5, and 8 would be reported in the statement of income and

comprehensive income net-of-tax. Also, the net-of-tax effect of the correction of the amortization error, situation 7, would increase or decrease retained earnings.


Judgment Case 4–13 It would be nice to think that management makes all accounting choices in the

best interest of fair and consistent financial reporting. Unfortunately, other motives influence the choices among accounting methods and whether to change methods. It has been suggested that the effect of choices on management compensation, on existing debt agreements, and on union negotiations each can affect management’s selection of accounting methods.1 For instance, research has suggested that managers of companies with bonus plans are more likely to choose accounting methods that maximize their bonuses (often those that increase net income).2 Other research has indicated that the existence and nature of debt agreements and other aspects of a firm’s capital structure can influence accounting choices.3 Whether a company is forbidden from paying dividends if retained earnings fall below a certain level, for example, can affect the choice of accounting methods.

Choices made are not always those that tend to increase income. As you will learn in Chapter 8, many companies use the LIFO inventory method because it reduces income and therefore reduces the amount of income taxes that must be paid currently. Also, some very large and visible companies might be reluctant to report high income that might render them vulnerable to union demands, government regulations, or higher taxes.4

1Watts, R.L., and J.L. Zimmerman, “Towards a Positive Theory of the Determination of Accounting Standards,” The

Accounting Review, January 1978, and “Positive Accounting Theory: A Ten Year Perspective,” The Accounting Review, January 1990.

2For example, see Healy, P.M., “The Effect of Bonus Schemes on Accounting Decisions,” Journal of Accounting and Economics, April 1985, and Dhaliwal, D., G. Salamon, and E. Smith, “The Effect of Owner Versus Management Control on the Choice of Accounting Methods,” Journal of Accounting and Economics, July 1982.

3Bowen, R.M., E.W. Noreen, and J.M. Lacy, “Determinants of the Corporate Decision to Capitalize Interest,” Journal of Accounting and Economics,” August 1981.

4This “political cost” motive is suggested by Watts, R.L.. and J.L. Zimmerman, “ “Positive Accounting Theory: A Ten-Year Perspective,” The Accounting Review, January 1990, and Zmijewski, M., and R. Hagerman, “An Income Strategy Approach to the Positive Theory of Accounting Standard Setting/Choice,” Journal of Accounting and Economics, August 1981.


Research Case 4–14 (Note: This case requires the student to reference a journal article.]

Requirement 2 The authors use the S&P 500 companies as their sample.

Requirement 3 77% in 2001 and only 54% in 2003.

Requirement 4 In 2001, 85% of firms have greater pro forma than GAAP earnings. This ratio

declined to 67% in 2003.

Requirement 5 In 2001, 136 firms reported “Restructuring Charges,” and the same number of

firms reported a “Divestiture/Sale of Business Units. In 2003, the most frequently reported adjustment was “Amortization/Impairment of Goodwill and Other Intangibles.”

Requirement 6 The authors’ main conclusions are that the introduction of pro forma regulation is

associated with a substantial change in firms’ pro forma reporting. Notably, far fewer firms are reporting pro forma earnings, while those that continue to report appear to do so in a manner consistent with the intention of the regulation, to provide useful information, not to mislead.


Integrating Case 4–15 DEFICIENCIES: Balance Sheet:

1. The asset section of the balance sheet should be classified. Cash, short-term investments, accounts receivable, and inventories should be included as current assets.

2. Accounts receivable should be shown net of the allowance for uncollectible accounts.

3. Inventories—the method used to cost inventory should be disclosed in a note. 4. Marketable securities—$21,000 of investments ($78,000 – 57,000) should be

classified in a noncurrent investments category. 5. Property and equipment—should be classified in a separate category.

Original cost should be disclosed along with the accumulated depreciation to arrive at the net amount. Also, the method used to compute depreciation should be disclosed in a note.

6. The liability and shareholders' equity section of the balance sheet should be classified into (1) current liabilities, (2) long-term liabilities, and (3) shareholders' equity.

7. Current liabilities should include accounts payable and accruals, notes payable (the $80,000 note due in 2014 and the $60,000 installment on note # 2 due in 2014). The latter should be classified as current maturities of long-term debt. Also, note disclosure is required for the notes providing information such as payment terms, interest rates, and collateral pledged as security for the debt.

8. Long-term liabilities should include the $60,000 second installment on note #2.

9. Common stock—the par value, if any, and the number of shares authorized, issued, and outstanding should be disclosed.

Income Statement:

1. The miscellaneous expense should be classified as an extraordinary item and shown net of tax below income from continuing operations. A note should describe the event.

2. Earnings per share disclosure is required. 3. The restructuring charges should be shown as a separate operating expense

item in the income statement and described in a note.


Financial Analysis Case 4–16 Requirement 1

2010 to 2011: ($2,635 – 1,433) ÷ $1,433 = 83.9% increase 2009 to 2010: ($1,433 – 2,478) ÷ $2,478 = 42.2% decrease

Requirement 2 Provision for income taxes ÷ Income before taxes $715 ÷ $3,350 = 21% = Approximate income tax rate

Requirement 3 $2,635 ÷ $61,494 = 4.3%

Real World Case 4–17 Answers to the questions will, of course, vary because students will research

financial statements of different companies. No specific standards dictate how income from continuing operations must be

displayed, so companies have considerable latitude in how they present the components of income from continuing operations. This flexibility has resulted in a considerable variety of income statement presentations. However, we can identify two general approaches, the single-step and the multiple-step formats that might be considered the two extremes, with the income statements of most companies falling somewhere in between.

The presentation of separately reported items, however, is mandated and students should be able to easily identify them.


Air France–KLM Case Requirement 1

AF classifies its expenses by both natural descriptions (e.g., salaries and related costs, taxes other than income taxes) and functions (e.g., external expenses). In the United States, expenses are classified by function.

Requirement 2 AF classifies interest paid and interest received as operating cash flows, and

dividends received as an investing cash flow. Under IFRS, companies can report interest paid as either an operating or financing cash flow and interest and dividends received as either operating or investing cash flows.

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