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CHAPTER 4

QUESTIONS
1. The objective of financial reporting is to
provide useful information for users of the
financial
statements.
The
relevant
information for decision making is future
data, especially information dealing with
cash flows. The primary financial
statements reflect economic transactions
and events that have taken place. The past
is used to help project the future. Income,
however, is only one of many sources of
cash flow. The balance sheet and
statement of cash flows also furnish
relevant information upon which other
future cash flows may be projected by the
investor. In summary, the income
statement contains only some of the
information that is relevant for making
economic decisions.

and adjusted for a change in price


levels since original acquisition.
(c) The current value of net assets
acquired in exchange transactions as
determined by either their replacement
or market values.
(d) Some variations of above (a through
c), but include in assets all resources
and claims to resources, not just those
acquired in exchange transactions.
4. The objectives of reporting income for
income tax purposes and for financial
reporting to users are not the same. Those
formulating income tax laws are usually
concerned with fairness among taxpayers
and with their ability to pay taxes. Users,
on the other hand, are concerned with a
measure that distinguishes between a
return on investment and a return of
investment. They want a measure that
matches expenses against recognized
revenue. In most cases, the same
accounting method can be used for both
purposes. This will reduce both the cost
and the confusion of using more than one
accounting
method
for
the
same
transaction. In some cases, however, the
generally accepted accounting method is
different from that required by income tax
regulations. This results in a temporary
difference between the tax return and the
books and gives rise to interperiod income
tax allocation.

2. Two approaches can be used to measure


income: the capital maintenance approach
and the transaction approach. The capital
maintenance approach uses the balance
sheet elements to determine the change in
total
equity, after
eliminating
any
investments and withdrawals of resources
by owners. The transaction approach
determines income by analyzing individual
transactions and events and their effect on
related assets, liabilities, and owners
equity. Although the method of determining
income differs, both approaches arrive at
the same total income figure if the same
attributes and measurements are used.
However,
the
transaction
approach
produces more detail as to the composition
of income than does the capital
maintenance
approach.

5. A code law country is one in which rules,


laws, and accounting standards are set by
legal processesfrom the top down. A
common law country is one in which rules,
laws, and accounting standards evolve in
response to societal and market forces
from the bottom up.

3. Measurement methods that could be


applied to net assets in the capital
maintenance
approach
to
income
determination are as follows:
(a) The historical cost of net assets
acquired in exchange transactions,
reduced by an allowance for their use.
(b) The historical cost of net assets
acquired in exchange transactions,
reduced by an allowance for their use

6. Revenues and expenses are related to the


ongoing major or central activities of a
business and are reported at gross
amounts. Gains and losses are associated
with peripheral and incidental transactions
and events and are reported net of selling
price minus cost. These classification and
display distinctions will depend on the

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specific circumstances and activities of an


enterprise.
7. The following two factors must be
considered when deciding at what point
revenues and gains should be recognized:
(a) The resources from the transaction are
either already realized in cash or claims to
cash or are readily realizable in cash, and
(b) the revenues and gains have been
earned through substantial completion of
clearly identified tasks and activities. Both
factors are usually met when merchandise
is delivered or services are rendered to
customers. This is referred to as the point
of sale.
8. There are three specific exceptions to the
general rule that were discussed in the
chapter. They are recognizing revenue (a)
at the point of completed production, (b) at
the time of cash collection, and (c) at
various points in time during the operating
cycle,
e.g.,
percentage-of-completion
method. The justification for the use of
these exceptions is that, in each case, the
realization and earning criteria established
by the FASB are met.
9. Three expense recognition principles are
applied in matching costs with revenues:
(a) Direct matchingcosts are associated
directly with specific revenues and
recognized as expenses of the period
in which the revenues are recognized.
(b) Systematic and rational allocation
when costs cannot be associated
directly with specific revenues, costs
are associated in a systematic and
rational manner with the periods or
products benefited.
(c) Immediate recognitionthose costs
that cannot be related to revenues
either by direct matching or by
systematic and rational allocation must
be recognized as expenses of the
current
period.
10. The multiple-step income statement can
contain too much information that might be
confusing to the reader and require excess
time to evaluate. The detailed listing of
purchases and inventory might best be
displayed in a supplementary schedule.
The single-step income statement can be
too brief. Information required for
investment
decisions
is
sometimes

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presented in supporting schedules or not


reported. Because of these factors, the
statement could also be confusing, and
valuable time could be lost by the
statement reader in seeking additional
information.
11. The major sections that may be included in
a multiple-step income statement may be
divided into two categories: (a) income
from continuing operations, separated into
six sections, and (b) irregular or
extraordinary items, separated into three
sections. The sections of income from
continuing operations are:
1. Revenue from net sales
2. Cost of goods sold
3. Operating expenses
4. Other revenues and gains
5. Other expenses and losses
6. Income taxes on continuing operations
The sections of irregular or extraordinary
items are:
7. Discontinued operations
8. Extraordinary items
9. Cumulative effects of changes in
accounting principles
12. A restructuring charge is a loss that arises
when a company proposes a restructuring
of its operations. The charge is composed
of the loss in value associated with assets
that no longer fit in the companys strategic
plans. The charge also includes the
additional costs associated with the
termination or relocation of employees.
Restructuring charges are controversial
because companies exercise considerable
discretion in determining the amount of a
restructuring charge and thus can use
restructuring charges as a tool for
manipulating the amount of reported net
income.
13. Intraperiod income tax allocation involves
the separation of income tax expense
between
income
from
continuing
operations and irregular or extraordinary
items. Under this concept, each section of
the irregular or extraordinary items
category is reported net of its income tax
effect.
14. Pop-Up must separately disclose the
current years income related to the
operations of the segment that will be
discontinued. In addition, the $10,000 loss

resulting from the sale must be separately


disclosed. These figures would be reported
on the income statement, net of any
related taxes, immediately following
income from continuing operations.

17. Under International Accounting Standard


(IAS) 8, the cumulative effect of a change
in accounting principle is reported as a
direct adjustment to beginning retained
earnings of the current year.

15. The following items would not normally


qualify as extraordinary items:
(a) The write-down or write-off of
receivables.
(b) Major devaluation of foreign currency.
(c) Loss on sale of plant and equipment.
(f) Loss due to extensive earthquake
damage to furniture company in Los
Angeles, California. (Earthquakes are
not unusual in the Los Angeles area.)
(g) Farming loss due to heavy spring rains
in the Northwest. (Spring rains are not
unusual in the Northwest.)
By definition, item (d) is considered an
extraordinary item. Item (e) could be
classified as extraordinary if flood damage
is both unusual and infrequent in Las
Vegas.

18. Generally accepted accounting principles


require entities to report earnings-per-share
information for income from continuing
operations and for each section of the
irregular or extraordinary items category of
an income statement. The computation is
made by dividing the income or loss from
each of the above sections by the weighted
average number of common shares
outstanding during the reporting period. If a
potential dilution of earnings exists due to
the existence of convertible securities,
stock options, or stock warrants, additional
earnings-per-share information must also
be presented.
19. Comprehensive income is the change in
equity of a business enterprise during a
period from transactions and other events
and circumstances from nonowner sources.
It includes all changes in equity during a
period except those resulting from
investments by owners and distributions to
owners.1 Net income is the reported
income as required by GAAP. Currently,
GAAP does not require all components of
comprehensive income to be disclosed in
the income statement. For example, it
does not include the effect of error
corrections, asset valuation changes, or
some effects of accounting changes.

16. a. The effects of a change in accounting


principle that is applied to past periods
are
disclosed
in
the
financial
statements of the period of change.
The effects of the change are
computed for past periods and
disclosed either as a cumulative effect
on current net income or as an
adjustment to the beginning retained
earnings. The FASB has specified
criteria to determine which approach is
appropriate.
b. The effect of a change in accounting
estimate is disclosed entirely in the
current period or in the current and
future periods. No adjustments are
made to prior periods statements as
may be done for a change in principle.
The change in an estimate should be
sufficiently disclosed in the financial
statements so that readers are alerted
to those changes that will materially
affect future periods.

20. The starting point for the preparation of


forecasted financial statements is the
forecast of sales.
21. In forecasting depreciation expense, one
first must forecast how much property,
plant, and equipment will be needed in the
future. This amount is then used, along
with an assumption about how rapidly the
plant and equipment will depreciate, to
estimate future depreciation expense.

1Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements, Stamford, CT:
Financial Accounting Standards Board, December 1985, par. 70.

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DISCUSSION CASES
Discussion Case 41
This case demonstrates how a change in an accounting principle may make an enterprises financial
statements more comparable with those of other enterprises but cause its current years statements to be
noncomparable with its prior years statements. Thus, the principle of consistency is violated. Accounting
standards do permit an enterprise to change its accounting principles. However, there must be full
disclosure of the change, including data revealing its impact on current financial statements.
Usually, information concerning an accounting change is contained in a note to the financial statements.
If a cumulative adjustment is necessary for past events, it should be reported as a separate income
statement item. In this case, the change affected depreciation. If prior years depreciation is adjusted to
the straight-line method, a cumulative adjustment would be necessary to restate the accumulated
depreciation for the equipment. If only current and future years depreciation is affected by the change,
no cumulative adjustment would be involved. In either case, a note describing the change and indicating
the impact on income, earnings per share, and asset valuation would be required. A more complete
discussion of accounting changes is provided in a later chapter.
Discussion Case 42
There are two different aspects of this case that should be explored with students. First, there is no
necessary connection between income and cash. Cash payments may be made for other purposes
besides expenses, such as equipment purchases. In addition, changes in the amounts of accounts
receivable and accounts payable affect cash but usually not income. Second, the increasing cost of
inventory and supplies means that if a company maintains the same quantity and quality of inventory
and supplies, more cash will be required. The replacement cost of goods sold in the past 2 years has
been $90,000 more than what it cost originally to buy those goods. This alone could account for the cash
flow shortage.
This case can be used to emphasize the difference between financial capital maintenance income and
physical capital maintenance income. Because the companys financial statements are prepared on the
basis of a financial capital maintenance concept, and Stevenson is withdrawing most of the reported net
income, it is not possible to maintain the companys physical capital when prices are rising unless he
invests more money into the business.
Discussion Case 43
This case presents some interesting points for class discussion. The final decision will probably be
prefaced by It depends . . . Students should use the revenue recognition criteria of the conceptual
framework as a basis for their decision. The first suggested revenue recognition point, completion of
production, probably fails the realized or realizable test. Until the product is actually sold, the asset is not
readily convertible to cash. If the artists reputation is established, sales could be made from design
drawings or small sample sculptures. If the sales contract is firm, the realizability test could be met prior
to actual delivery. It appears clear that the second criterion, substantial completion of the activity or task,
occurs upon completion of the sculpture as it is cast in bronze. Thus, revenue could be recognized at
completion of production. The revenue recognition decision thus depends on when the sale is actually
made.
The second suggested revenue recognition point, point of delivery of the product to the customer, implies
that both criteria are met. The sale has been made, and substantial completion must have occurred
because delivery is made. The remaining uncertainty revolves around the return privilege. If there is a
high likelihood of return, it could be argued that no sale has really occurred until the year is over. The
buyer may be considered to be a borrower of the sculpturean agent who has a year to decide whether
to buy or not. The matching principle requires that an estimate of sales returns be made and recorded as
an offset to recognized revenue. If past experience provides a basis for this estimate, revenue
recognition at the point of delivery seems justified. If, however, an estimate of the extent of returns is not
possible, revenue recognition may have to wait until the end of the return period. The FASB has

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considered the right of return as a separate issue. It is discussed in Chapter 6. The case as written does
not contain enough information to know if an estimate of the expected returns is possible.
Discussion Case 44
This case introduces the student to an arrangement that is similar to a consignment, even though the
term is not used. Factors indicating that no revenue should be recognized until the dealer completes a
sale to a third party are as follows:

No payment is required until the final sale has been made.

Skyways may request a return of the dishes at their discretion.

No interest is charged on the receivable until a sale to a third party is completed.

Purpose of the arrangement is to induce dealers to stock larger amounts of inventory.


There are also factors that suggest a sale has occurred: (1) There are no specific provisions for return of
the merchandise, and (2) prior returns have been nominal at 10%.
The revenue recognition criterion of realized or realizable does not appear to be met in this case until the
sale to a third party is consummated. This would be especially true if the dealers were in any way related
to Skyways. This case demonstrates how difficult it can be to apply revenue recognition principles in realworld situations.
Discussion Case 45
This case presents students with an interesting problem when adjustments to the financial statements are
made based on estimates. Since the product line did not qualify as a segment, any losses would be
reported as part of ordinary income unless it was decided they met the criteria for an extraordinary loss.
If the expected loss is probable and if a reliable estimate of the amount can be made, accounting
standards would require accruing the loss in 2001. If either of these conditions are not met, disclosure by
note to the financial statements would be sufficient to meet the standards. When the line is not
discontinued in 2002, a reversal of the accrual would be necessary. The reversal should be reported in
the same way as the accrual. Due to the nature of the item, separate line disclosure of the accrual and
the reversal should probably be made.
Discussion Case 46
The question of how to record development costs for computer software has been a controversial one. It
is similar to the question of how to record research and development costs in general. The arguments to
support deferring the cost center around better matching of costs against revenues. Until the software is
developed and marketed, no revenue is generated. By deferring the costs associated with the software,
amortization of the costs against revenues can be made as sales are made. If a company has a history
that permits reasonable estimates of the probability of success, use of these statistics to defer software
development costs could lead to more useful financial statements.
Arguments to support expensing these costs center around the uncertainty of knowing whether a given
piece of software will be successful in the marketplace. Until the prospects of sales are probable, any
costs associated with development of software should be expensed. A company with past successes can
give no assurance that such success will continue.
Class discussion might address the issue of whether increased comparability occurs just because a
uniform method of accounting treatment is used. Companies differ in their ability to generate successful
software; any accounting method that ignores these differences by developing uniform criteria could
produce misleading financial statements. The FASB statement on software costs (Statement of Financial
Accounting Standards No. 86) requires the expensing of all costs incurred before technological feasibility
is established. Costs incurred after technological feasibility and before production are capitalized and
amortized.

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Discussion Case 47
This case provides an opportunity to discuss the nature of assets in general and deferred charges in
particular. The discussion should also stress the importance of properly matching the expiration of asset
costs with recognized revenues in order to report a proper income measure. Finally, students should be
made aware that FASB Statement No. 7 requires development stage enterprises to report on the same
basis as established operating enterprises. It is not considered proper accounting to capitalize operating
losses. If such losses are expected, that knowledge can be incorporated into the decision being made.
However, deferred charges should be limited to those costs that promise to provide future revenues. The
loss in the early months of a branchs life does not guarantee future excess of revenues over expenses.
Misleading indications would be communicated if such items were deferred.
Discussion Case 48
The adjustment of financial statements subsequent to their release has caused considerable discussion
within the profession. Although the students have not yet been exposed to many of the conditions that
cause changes to be made to previously issued financial statements, the issue is one that can be
fruitfully discussed at this point. Comparability is the accounting principle used to justify requiring an
adjustment to prior years income statements to reflect the discontinuance of a segment. If the current
years income statement deletes the revenues and expenses for the discontinued segment from the
operating section, the prior years statements reported with the current statement should be adjusted in a
similar manner. This will permit a reader to evaluate trend changes and separate the effect of
discontinuing the segment from the other operations of the enterprise.
The controllers objection is valid. Careful readers of financial statements are often confused by the
changing numbers that appear in subsequent years in statements previously issued. There are many
other areas where such changes are required. The instructor might indicate some of these in the
discussion. They include mergers, some changes in accounting principles, accounting errors, stock
dividends and stock splits when computing earnings-per-share data, etc. Unless readers are aware that
these subsequent events or discoveries can cause prior statements to be adjusted, they may place less
trust in the validity of the issued statements.
Discussion Case 49
1.

2.

3.

4.

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Revenues can be booked in advance by a companys recording the journal entry prior to meeting
the revenue recognition criteria. The typical journal entry would involve debiting a receivable
account and crediting a revenue account.
Expenses can be deferred using two methods. The first is to simply not make any journal entry. The
second is to record the expense as prepaid and to classify it on the balance sheet rather than on the
income statement. It would then be expensed at some future time.
In many cases, top executives encourage misleading accounting practices because their
compensation is based, in part, on accounting numbers. If the numbers can be manipulated to
portray favorable news, the executives receive raises, bonuses, etc. Relating to the Boston
Company case, The Wall Street Journal specifically stated that Bostons executives cooked the
books to increase their bonuses. Their work also looks better, and thus, they may be able to retain
their company position for a longer period of time.
Again, students should be made aware that the business world presents ethical dilemmas. While
textbooks provide the rules to be applied in a sterile environment, the dynamic environment of life
often presents individuals with quandaries for which there are no easy solutions. This question can
lead to an interesting difference in opinion among students.
Independent auditors have a responsibility to prepare an audit to detect material misstatements.
The objective of an audit is not to guarantee the accuracy of financial statements but to ensure that
the financial statements are prepared in accordance with GAAP.
Some frauds are so carefully constructed and concealed that auditors could not reasonably be
expected to uncover the fraud. The legal system is called on to evaluate the auditors liability.
Typically, the courts evaluate the auditor using three qualifying questions: (1) Were the auditors
actions in accordance with the duty expected of a professional? (2) Did individuals rely on the
information audited by the auditor? and (3) Were damages incurred as a result of this reliance? The

answers to these questions determine the extent of the auditors liability, especially under common
law. Under some statutory law, criteria (2) and (3) are not required.
Discussion Case 410
1.

2.

3.

4.

To be recognized, revenue must, in most cases, meet two criteria: (1) Goods or services are
provided to the buyer, and (2) payment or a valid promise of payment must be received by the
seller.
In the RJR Nabisco example, cigarettes were shipped to wholesalers (criterion No. 1), but the
wholesalers had made no promise to pay for the cigarettes (criterion No. 2). In fact, rather than pay,
wholesalers returned the inventory. In the Regina example, by recording goods when they were
ordered rather than when they were shipped, Regina violated the first criterion. Goods were not
provided to buyers.
In both instances, revenue was booked before both revenue recognition criteria had been met.
The revenue recognition criteria are not a function of contracts. The criteria are based on business
events. If the business events occur, revenue is recognized. A legal contract may state any number
of things, but in most cases, until goods or services are provided and a promise of payment is
received, revenue should not be recognized. The arrangement is really a consignment of inventory.
For many businesses, inventory is shipped the same day a customer places the order. In these
cases, it does not matter if the journal entry is made when the order is placed or when the goods are
shipped.
In other cases, there may be a delay between the order and the shipment dates. Inventory may
have to be produced, materials ordered, or paperwork processed. In these cases, one must make
sure that the transaction giving rise to the revenue and the resulting journal entry are recorded in
the same accounting period.
The problem in the Regina example was that revenue was being booked in one year and actually
being earned in the next year. The result was erroneous annual financial statements.
Reginas chief accountant elected to go along with the company presidents activities and, as a
result, spent 6 months in jail and was fined $25,000. The point of this question is not to provide
specific alternatives for dealing with fraud but rather to make students aware that fraudulent
activities exist and that students must be prepared to deal with them in their role as accountants.

Discussion Case 411


The purpose of this case is to help students understand the relationships between net income, gross
profit percentage, and return on sales and the different ways in which profitability may be determined.
Drug Store:
Net income:
Gross profit percentage:
Return on sales:

$1,050,000 $950,000 $39,500 = $60,500


$100,000/$1,050,000 = 9.5%
$60,500/$1,050,000 = 5.8%

Department Store:
Net income:
Gross profit percentage:
Return on sales:

$670,000 $560,000 $66,500 = $43,500


$110,000/$670,000 = 16.4%
$43,500/$670,000 = 6.5%

While the drug store has the higher net income, the department store has a higher profit percentage. As
to which is more profitable, additional information would be required. However, this case illustrates that
using only one measure of profitability can often lead to an incomplete picture.

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EXERCISES
412.
Debit changes in accounts during 2002 other
than Retained Earnings:
Cash..........................................................................
Accounts Receivable..............................................
Buildings and Equipment (net)...............................
Accounts Payable....................................................
Credit changes in accounts during 2002 other
than Retained Earnings:
Inventory..................................................................
Patents.....................................................................
Bonds Payable.........................................................
Capital Stock............................................................
Additional Paid-In Capital.......................................
Change in Retained Earnings for 2002.......................
Add: Dividends declared..............................................
Net income.....................................................................

$ 95,500
92,000
190,000
75,000

$ 30,000
5,000
150,000
100,000
50,000

$452,500

335,000
$ 117,500
25,000
$ 142,500

413.
a. The receipt of an order from a customer does not constitute realization
nor qualify as an earnings activity. Therefore no revenue is recognized.
b. There has been no sale of the asset to support the recognition of
revenue. Production remains to be performed, followed by sale of the
finished product. Accretion may give rise to revenue in certain
instances where it can be objectively determined and the product has a
ready market at a definite price.
c. The rendering of services is the earning activity, and it is assumed that
a valid claim exists against the client. The recognition criteria are met.
d. The appreciation in value of the land is generally not recognized
because it is not yet realized.
e. The receipt of cash meets the realization criteria; however, the revenue
is generally not reported as earned because the product has not yet
been delivered. Some argue that an estimate of the costs incurred to
honor the certificate can be made so that revenue could be recognized
at the time of certificate sale.
f. Collection of cash on the subscriptions is realization. However, the
earning activity has yet to take place.
g. The retirement of debt at less than the recorded liability results in a
recognition gain. The retirement of the debt meets the recognition
criterion for gains.

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414.
a. The revenue is unearned in 2002. The credit is to the liability account
Unearned Rent Revenue.
b. Revenue of $60,000 is to be recognized in 2002; $10,000 in cash plus a
note for $50,000. In addition, interest revenue of $3,000 is recognized in
2002 ($50,000 12% 1/2 year). The $3,000 interest revenue to be
earned in 2003 will not be recorded until 2003.
c. Transactions in a companys own stock are not considered an incomegenerating activity. The amount received above par is credited to
Additional Paid-In Capital.
d. Because a claim against the customer (an asset) is created when the
merchandise is shipped, and actions to prepare and ship the inventory
are felt to represent the earning activity, revenue is recognized at the
time of sale. In theory, the possibility of return should be evaluated and
recorded as a reduction of revenue if some return is probable, and the
value of the return can be estimated. Similarly, the probability of a
customers taking a cash discount should be considered and a
reduction made to revenue for estimated cash discounts. In practice,
both sales returns and cash discounts are usually not recorded until
they actually occur.
e. The definition of an asset and recognition criteria for recording changes
in assets and revenue do not require ownership of the asset. Revenue
of $2,500 matched with cost of goods sold of $2,000 would be
recognized in 2002.
f. The initial agreement does not represent a claim against the client until
the contract is at least partially complete. Because part of the work was
accomplished in 2002, a portion of the revenue could be recognized in
2002 on a percentage basis. However, because the bulk of the work will
be done in 2003, revenue could be deferred until the audit is completed
and billed.
415.
a. Immediate recognition. The future benefits of the new drug are highly
uncertain.
b. Direct matching. The warranty costs are anticipated expenses that are
directly related to revenues.
c. Systematic and rational allocation. The lease agreement benefits
several accounting periods in a systematic and rational way.
d. Direct matching. Labor associated with assembling a product is
matched with revenues and reported in the period the goods are sold.
e. Systematic and rational allocation. The delivery trucks are expected to
benefit several accounting periods in a systematic and rational way.
f. Immediate recognition. The advertising indirectly helps to generate
revenues and is not related to specific revenues.

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416.
Original cost of patent....................................................................
Amortization for 5 years ($30,000 per year 19972001)...............
Remaining unamortized balance...................................................

$450,000
150,000
$ 300,000

New estimated life from January 1, 2002......................................


Amortization expense for each year (20022005)........................

4 years
$75,000

Separate disclosure of the $45,000 increase due to the change in estimate


would be required in 2002 if it is considered a material amount.
417.
a. Subtracted or included in determining net purchases in the cost of
goods sold section
b. Extraordinary items
c. Other revenues and gains
d. Other expenses and losses
e. Either extraordinary items or other expenses and losses depending on
whether unusual or not
f. Operating expensesselling expenses
g. Discontinued operations
h. Deduction from income from continuing operations before income taxes
i. Other revenues and gains
j. Subtraction from sales
k. Other expenses and losses
l. Cost of goods sold (an item entering into cost of goods manufactured)
m. Cumulative effect of changelast special item
n. Operating expensesgeneral and administrative
o. Cost of goods sold

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418.

Caribou Inc.
Income Statement
For the Year Ended December 31, 2002
Sales............................................................................
$1,600,000 1
Cost of goods sold:
Beginning inventory.............................................. $ 136,000
Net purchases........................................................
919,200 2
Cost of goods available for sale........................... $1,055,200
Less: Ending inventory.........................................
95,200
Cost of goods sold.................................................
960,000
Gross profit on sales.................................................
$ 640,000
Operating expenses:
Selling expenses.................................................... $ 208,000 3
General expenses (including doubtful accounts)
272,000 4
480,000
Income from operations before income taxes........
$ 160,000
Income taxes..............................................................
48,000
Income from operations............................................
$ 112,000
Extraordinary gain (net of income taxes of $9,000)
21,000
Net income..................................................................
$ 133,000
Earnings per share5:
Income before extraordinary items......................
Extraordinary gain.................................................
Net income..............................................................

$ 0.86
0.16
$ 1.02

COMPUTATIONS:
1
Sales
Income before income taxes as a percentage of sales:
Sales.........................................................................
................................................................................
100%
Cost of goods sold (see below).............................
60
Gross profit on sales...............................................
40%
Selling expenses.....................................................
13%
General expenses, including doubtful accounts..
17%
30%
Income before income taxes......................................
10%
Sales: $160,000 (income before income taxes) .10 = $1,600,000
Cost of goods sold:
General expenses, excluding doubtful accounts = 15% of sales and 25%
of cost of sales: therefore, .15 sales = .25 cost of goods sold
Cost of goods sold = .15 .25 = 60% of sales

115

418.

(Concluded)
2

Net purchases
Cost of goods sold = beginning inventory plus net purchases less
ending inventory.
Let X equal net purchases.
.60 $1,600,000 = $136,000 + X .70 ($136,000)
$960,000 = $40,800 + X
X = $919,200

.13 $1,600,000 = $208,000

(.15 $1,600,000) + (.02 $1,600,000) = $272,000

Earnings per share (130,000 shares of common stock outstanding):


Income before extraordinary gain: $112,000 130,000 shares = $0.86
Extraordinary gain: $21,000 130,000 shares = $0.16
Net income: $133,000 130,000 shares = $1.02

419.

Brigham Corporation
Income Statement (Partial)
For the Year Ended December 31, 2002
Income from continuing operations before income taxes............. $210,000
Income tax expense on continuing operations ($210,000 .35)....
73,500
Income from continuing operations................................................. $136,500
Discontinued operations:
Loss from operations of discontinued business
segment (net of income tax savings of $17,500). . .
$ (32,500)
Gain from disposal of a business segment (net
of income taxes of $7,000).......................................
13,000
(19,500)
Extraordinary gain on retirement of debt (net of
income taxes of $49,000)...................................................................
91,000
Net income.......................................................................................... $ 208,000

420.
a. The loss from operations of the discontinued segment is $77,000. Recall
that items following income from continuing operations are disclosed
net of applicable income tax. In this case, the income tax savings is
$33,000 ($110,000 30%).
b. The loss from disposal of the business segment is $3,500. The loss
incurred after the measurement date and the gain from the disposal of
plant assets are combined and disclosed net of applicable tax savings
of $1,500 [($20,000 loss + $15,000 gain) 30%].

116

420.

(Concluded)
c. Discontinued operations:
Loss from operations of discontinued business
segment (net of income tax savings of $33,000) $(77,000)
Loss from disposal of business segment (net of
income tax savings of $1,500)..............................
(3,500) $
(80,500)
d. If Garrison Manufacturing were reporting using the accounting
standards of the United Kingdom, it would also disclose information
about sales and operating profits for the continuing and discontinued
operations. This additional information allows financial statement users
to compare the relative size and operating profitability of the continuing
and discontinued operations. This practice is also similar to the
reporting requirements of IAS 35.

421.
Gain (loss) from operations
of discontinued segment...................
Gain (loss) from disposal
of discontinued segment...................
Gain (loss) from discontinued
segment...............................................

Case A

Case B

Case C

$ 1,000

$ (3,000)

$ (5,000)

(3,000)
$ (2,000)

3,500
$

500

Case D
$

6,000

5,000

(11,000)

$ (5,000)

EXPLANATIONS:
Case A. The expected loss on disposal is netted against the actual and expected
gain from operating the discontinued segment.
Case B. The segment was disposed of in the current year; therefore, all losses and
gains are recognized as realized events.
Case C. The expected gain in the subsequent year is not recognized; however, any
operating gain in the current year would be recognized.
Case D. All losses, actual and anticipated, are recognized in the current year.
422.
a.

(In millions of $)
Income from continuing operations...........................................
$1,032.3
Cumulative effect of change in accounting for income taxes
(net of applicable taxes)...............................................................
544.2
Net income....................................................................................
$ 1,576.5
Earnings per common share:
Income from continuing operations......................................
Cumulative effect of accounting change..............................
Net income...............................................................................

422.

(Concluded)

117

$ 2.06
1.09
$ 3.15

b.

If Sears were a non-U.S. company reporting under the provisions of IAS 8, the
$544.2 million gain from the cumulative effect of the change in accounting
principle would not be shown in the income statement at all. Instead, the $544.2
million amount would be shown as a direct adjustment (an increase) to the
beginning balance in retained earnings for the year.

423.
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.
l.
m.
n.
o.
p.
q.
r.
s.
t.

118

Sales revenue.
Loss on disposal of discontinued operations; a separate component of income
shown net of taxes before extraordinary items but after income from continuing
operations.
Extraordinary item, net of taxes.
Prior-period adjustment (error correction); retained earnings adjustment.
Operating expense; it is a change in estimate.
Asset.
Results of discontinued operations; a separate component of income shown net
of taxes before extraordinary items but after income from continuing operations.
Asset (possibly could be expensed).
Prior-period adjustment (error correction); retained earnings adjustment.
Other revenues and gains section of income statement.
Other expenses and losses section of income statement, unless the event is
considered unusual and infrequent, in which case, it would be reported as an
extraordinary item.
Cumulative effect of change in accounting principle; a separate component of
income shown net of taxes as last item before net income.
Operating expense; it is a change in estimate.
Other revenues and gains section of income statement.
Operating expense or other expenses and losses section, depending on nature
of business, unless the event is considered unusual and infrequent, in which
case, it would be reported as an extraordinary item.
Operating expense or adjustment to cost of goods sold.
Included with current-year tax expense.
Other expenses and losses section because the sale is only a portion of
business segment.
Operating expense because the move does not qualify as discontinued
operations.
Operating expense.

424.

Income Statement
Revenue:
Sales
Less: Sales discounts
Sales returns and allowances
Cost of goods sold:
Inventorybeginning
Net purchases:
Purchases
Less: Purchase discounts
Purchase returns and allowances
Freight-in
Cost of goods available for sale
Less: Inventoryending
Gross profit
Operating expenses:
Selling expenses:
Advertising expense
Sales salaries and commissions
Miscellaneous selling expense
General and administrative expenses:
Officers salaries expense
Office salaries expense
Office supplies expense
Depreciation expenseoffice building
Depreciation expenseoffice furniture and fixtures
Doubtful accounts expense
Insurance expense
Property taxes expense
Miscellaneous general expense
Operating income
Other revenues and gains:
Dividend revenue
Interest revenue
Royalty revenue
Other expenses and losses
Interest expensebonds
Interest expenseother
Income from continuing operations before income taxes
Income tax expense
Income from continuing operations
Loss from discontinued operations (net of income taxes of _____ )
Extraordinary gain (net of income taxes of _____ )
Net income
Earnings per common share:
Income from continuing operations
Loss from discontinued operations
Extraordinary gain
Net income

119

425.

The Pensacola Awning Company


Income Statement
For the Year Ended December 31, 2002
Sales revenue............................................................
Expenses:
Costs of goods sold............................................
$765,000
Selling expenses.................................................
288,720
General and administrative expenses...............
236,400
Interest expense..................................................
13,390
Income taxes.......................................................
30,596*
Net income................................................................
Earnings per share ($45,894 25,000 shares).......
*.40 $76,490 (Income before taxes)

$1,380,000

1,334,106
$ 45,894
$1.84

The Pensacola Awning Company


Statement of Retained Earnings
For the Year Ended December 31, 2002
Retained earnings, January 1........................................................
Add: Net income..............................................................................
Deduct: Dividends...........................................................................
Retained earnings, December 31...................................................

$444,500
45,894
$490,394
45,000
$ 445,394

426.
1.

Losser Corporation
Schedule of Corrected Net Income
For the Year Ended December 31, 2002

Reported net income (profit and loss)........................


Add: Change in amortization expense......................
Gain on sale of land...........................................
Interest revenue.................................................
Less: Increased depreciationchange in estimate..
Loss on sale of equipment................................
Extraordinary casualty loss..............................
Corrected net income...................................................

120

$13,680
$ 2,800
18,350
4,500
$ 5,000
3,860
27,730

25,650
$39,330
36,590
$ 2,740

426.

(Concluded)
2.

Losser Corporation
Retained Earnings Statement
For the Year Ended December 31, 2002

Retained earnings, January 1, 2002................................................


Add: Net income...............................................................................
Deduct: Dividends declared............................................................
Retained earnings, December 31, 2002..........................................
3.

$ 85,949
2,740
$ 88,689
10,000
$ 78,689

All items except dividends declared during the year would be reported on the
income statement and included in net income. Extraordinary items would be
reported separately after income from continuing operations.

427.
1.
The unrealized losses on available-for-sale securities will decrease
comprehensive income because the value of the securities decreased during
the year.
The foreign currency translation adjustment will decrease
comprehensive income because the value of the currencies of Svedins
foreign subsidiaries weakened relative to the U.S. dollar. The minimum
pension liability adjustment will decrease comprehensive income.
2.

Svedin Incorporated
Statement of Comprehensive Income
For the Year Ended December 31, 2002
Net income............................................................................
Unrealized losses on available for sale securities............
Foreign currency translation adjustment..........................
Minimum pension liability adjustment...............................
Comprehensive income......................................................

121

$17,650
(1,285)
(287)
(315)
$15,763

4-28.

Han Incorporated
Forecasted Income Statement
For the Year Ending December 31, 2003

Sales................................................
Cost of goods sold.........................

2002
$2,000
700

Gross profit.....................................
Depreciation expense....................

$1,300
120

Other operating expenses.............

1,010

Operating profit..............................
Interest expense.............................

$ 170
90

Income before taxes......................


Income taxes..................................

80
30

Net income......................................

50

2003
Forecasted
$2,200
770
given 35% of sales,
as last year
$1,430
160
20% of PPE,
same as last year
1,111
50.5% of sales,
same as last year
$ 159
75
15% of bank loan,
same as last year
$ 84
32
37.5% of pretax,
same as last year
$ 52

4-29.
Ryan Company
Forecasted Balance Sheet
December 31, 2003

122

2002
$ 10
250

2003
Forecasted
$ 15
50% natural increase
375
50% natural increase

Cash................................................
Other current assets......................
Property, plant, and equipment,
net....................................................
Total assets....................................

800
$ 1,060

800
$ 1,190

more efficient, item (b)

Accounts payable..........................
Bank loans payable........................

$ 100
700

$ 150
900

Total stockholders equity.............


Total liabilities and
stockholders equities...................

260

140

50% natural increase


new loan of $200,
item (c)
to balance

$ 1,060

$ 1,190

4-29. (Concluded)
Ryan Company
Forecasted Income Statement
For the Year Ending December 31, 2003

Sales................................................
Cost of goods sold.........................

2002
$1,000
750

Gross profit.....................................
Depreciation expense....................

$ 250
40

Other operating expenses.............

80

Operating profit..............................
Interest expense.............................

$ 130
70

Income before taxes......................


Income taxes..................................

60
20

Net income......................................

40

2003
Forecasted
$1,500
given, item (a)
1,125
75% of sales,
same as last year
$ 375
40
5% of PPE,
same as last year
120
8% of sales,
same as last year
$ 215
90
10% of bank loan,
same as last year
$ 125
42
33.3% of pretax,
same as last year
$ 83

Note: Total stockholders equity is forecasted to decrease by $120 ($260 $140). This
will happen even though net income will cause stockholders equity to increase by
$83. These forecasts imply that Ryan Company is either planning to pay out a large
cash dividend or to buy back a large amount of shares of its own stock.

123

PROBLEMS
430.
Payette Co.
Income Statement
For the Year Ended June 30, 2002
Revenue:
Sales ($2,380,000 less returns and
allowances, $30,000)..................................................
Interest revenue.........................................................
Expenses:
Cost of goods sold (net purchases,
$1,473,000 less increase in inventory, $10,000). $1,463,000
Selling and general expenses.............................
238,000
Income taxes..............................................................
262,800
Net income..................................................................
Earnings per common share
($438,200 325,000 shares)......................................

$2,350,000
52,000
$2,402,000

1,963,800
$ 438,200
$1.35

Payette Co.
Retained Earnings Statement
For the Year Ended June 30, 2002
Retained earnings, July 1, 2001................................
Add: Net income.........................................................
Deduct: Dividends......................................................
Retained earnings, June 30, 2002.............................

124

$1,356,800
438,200
$1,795,000
260,000
$ 1,535,000

431.

1. Income statementtime of shipment:


Richmond Company
Income Statement
For the Years Ended December 31
Sales...............................................................................
Cost of goods sold........................................................
Gross profit....................................................................
Doubtful accounts expense.........................................
Selling expenses...........................................................
General and administrative expenses........................
Net income (loss)..........................................................

2003
2002
$150,000 $125,000
90,000
75,000
$ 60,000 $ 50,000
(7,500)
(6,250)
(15,000)
(25,000)
(22,000)
(22,000)
$ 15,500 $ (3,250)

Income statementtime of sale:


Richmond Company
Income Statement
For the Years Ended December 31
Sales...............................................................................
Cost of goods sold........................................................
Gross profit....................................................................
Doubtful accounts expense.........................................
Selling expenses...........................................................
General and administrative expenses........................
Net income (loss)..........................................................

2003
2002
$132,000 $ 84,000
66,000
42,000
$ 66,000 $ 42,000
(660)
(420)
(15,000)
(25,000)
(22,000)
(22,000)
$ 28,340 $ (5,420)

2. Under the first dealer agreement, revenue is recognized when goods are
shipped to the dealers. Payment is made by the dealer after receipt of
the goods. Possible bad debt losses are greater under this agreement
because the dealer may not have the cash to pay for the toys until they
are sold. The second type of dealer agreement is actually a
consignment of inventory. Because there is a right of return, the
revenue should not be recognized until the dealer makes a sale. The
risk is borne by Richmond. To cover this risk, the sales price is higher
for the toys.
In the problem, Richmond would have a greater loss in 2002 under the
consignment agreement than under the sale agreement; however, in
2003 the consignment agreement would produce a greater profit. In
addition, at the end of 2003 Richmond will still have 19,000 units out on
consignment, assuming none of the units have been returned, with a
potential profit of $3 per unit less bad debt costs. Of course, if these
19,000 units are returned and cannot be resold, this profit will not be
realized. The uncertainty of the second type of dealer agreement
justifies the delay of revenue recognition until the dealer makes a sale.

125

432.
1.

a. Revenue must be both earned and realized in order to be reported on


the income statement. Until Hadley ships the inventory, the $18,000 of
orders paid for in advance should not be reported on the income
statement.
b. Because customers are not returning the products, the earnings
process can be considered substantially complete when the sale is
made. The revenues and associated cost of goods sold should be
included on the income statement.
c. The rent will benefit several accounting periods and should be allocated
in a systematic fashion.
d. It is difficult to determine the period of time that is benefited by general
advertising. Because the advertising costs cannot be related to specific
revenues, the costs are typically recognized as expenses immediately.
e. Current cost information is currently not disclosed on the face of the
income statement. Some companies elect to provide supplemental
information of this nature in the notes to the financial statements.
f. If warranty costs can be reasonably estimated, then the expenses are
matched directly to the period in which the revenue is generated. Using
the actual costs incurred to approximate warranty expense violates the
matching principle.

2.

Sales.............................................................................................
Cost of goods sold......................................................................
Gross profit..................................................................................
Rent expense...............................................................................
Advertising expense...................................................................
Warranty expense.......................................................................
Other expenses...........................................................................
Net income...................................................................................
Sales: $185,000 $18,000 + $16,000 = $183,000
Cost of goods sold: $94,000 + $7,500 = $101,500
Rent expense: $18,000 $6,000 = $12,000
Advertising expense: $6,000 + $18,000 = $24,000
Warranty expense: $183,000 .05 = $9,150

126

$183,000
101,500
$ 81,500
(12,000)
(24,000)
(9,150)
(15,000)
$ 21,350

433.

Delaney Manufacturing Inc.


Income Statement (Partial)
For the Fiscal Year Ended July 31, 2002

Income from continuing operations before income taxes......................


Incomes taxes.............................................................................................
Income from continuing operations.........................................................
Extraordinary gain (net of income taxes of $30,300)..............................
Loss from disposal of a business segment (net of income tax
savings of $42,000).....................................................................................
Net income..................................................................................................

$1,014,000 1
304,200 2
$ 709,800
70,700 3
(98,000)4
$ 682,500

COMPUTATIONS:
1
$975,000 $101,000 + ($140,000) = $1,014,000
2
$1,014,000 .30 = $304,200
3

$101,000 .30 = $30,300; $101,000 $30,300 = $70,700

$140,000 .30 = $42,000; $140,000 $42,000 = $98,000


Delaney Manufacturing Inc.
Retained Earnings Statement
For the Fiscal Year Ended July 31, 2002

Retained earnings, August 1, 2001...........................................................


Less: Prior-period adjustment (net of income tax savings of $22,500).
Adjusted retained earnings, August 1, 2001............................................
Add: Net income.........................................................................................
Retained earnings, July 31, 2002..............................................................
*$75,000 .30 = $22,500; $75,000 $22,500 = $52,500

127

$2,750,000
52,500*
$2,697,500
682,500
$ 3,380,000

434.

Radiant Cosmetics Inc.


Income Statement (Partial)
For the Year Ended December 31, 2002

Income from continuing operations before income taxes...............


$210,000
Income taxes ($82,000 + $20,000 $8,000 $10,000)......................
84,000
Income from continuing operations..................................................
$126,000
Discontinued operations:
Income from operations of discontinued cosmetics
division (net of income taxes of $8,000)...................................... $ 10,000
Loss on sale of cosmetics division
(net of income tax savings of $20,000)........................................ (30,000) (20,000)
Extraordinary gain on extinguishment of debt (net of income
taxes of $10,000)..................................................................................
15,000
Net income...........................................................................................
$ 121,000
Earnings per common share:
Income from continuing operations ($126,000 35,000 shares)
Loss from discontinued operations ($20,000 35,000 shares).
Extraordinary gain ($15,000 35,000 shares).............................
Net income......................................................................................

$3.60
(0.57)
0.43
$ 3.46

Radiant Cosmetics Inc.


Retained Earnings Statement
For the Year Ended December 31, 2002
Retained earnings, January 1, 2002..................................................................
Add: Correction of sales understatement in 2001
(net of income taxes of $21,000)........................................................................
Deduct correction for omission of depreciation of prior periods
(net of income tax refund claim of $8,000).......................................................
Adjusted retained earnings, January 1, 2002...................................................
Add: Net income..................................................................................................
Deduct: Dividends..............................................................................................
Retained earnings, December 31, 2002............................................................

128

$620,000
39,000
$659,000
12,000
$647,000
121,000
$768,000
40,000
$ 728,000

435.
1. The loss from operating the discontinued division is $25,090 [$38,600
($38,600 .35)].
2. The loss on disposal of the division is made up of two parts: (1) the loss
of $51,300 from the continued operation of the Laminating Division in
2002 after the measurement date and (2) the expected net loss of $5,000
from operating the division in 2003.
These two items are combined and disclosed as a loss, net of tax, of
$36,595 ($56,300 .65) on the income statement.
3. Discontinued operations:
Loss from operations of discontinued division (net of
income tax savings of $13,510)................................................... $
.......................................................................................... (25,090)
Loss from disposal of business segment including
operating losses during the phase-out period of $56,300
(net of income tax savings of $19,705).......................................
(36,595)
$
(61,685)
436.
1.
(a) Gross profit percentage.........................
(b) Net profit percentage.............................
(c) Price-earnings ratio................................

2002
48.0%
7.0%
13.7

2001
52.0%
9.3%
18.1

2000
54.0%
12.9%
20.9

2. While RoboCons sales are increasing every year, its gross margin is
declining, resulting in a decreasing profit margin. The market is
apparently aware of this information and is pricing the stock
accordingly. Even though sales are increasing, the firms earnings
multiple has declined each of the past 2 years.

129

437.

Connell Company
Income Statement
For the Year Ended December 31, 2002

Revenue:
Sales............................................................................
Less: Sales discounts...............................................
Sales returns and allowances........................
7,975,000
Cost of goods sold:
Inventory, January 1...................................................
Net purchases:
Purchases...............................................................
Less: Purchase discounts.....................................
Freight-in.....................................................................
Cost of goods available for sale................................
Less: Inventory, December 31 (net of write-down). .
Gross profit.................................................................
3,219,500
Operating expenses:
Selling expenses:
Sales salaries.........................................................
Delivery expense....................................................
Depreciation expensedelivery trucks...............
Depreciation expensestore equipment.............
Miscellaneous selling expenses...........................
General and administrative expenses:
Officers and office salaries...................................
Contribution to employee pension fund...............
Property taxes expense.........................................
Doubtful accounts expense..................................
Depreciation expenseoffice building................
Depreciation expenseoffice equipment............
Miscellaneous general expenses..........................
Operating income...........................................................
1,217,500
Other revenues and gains:
Dividend revenue........................................................
Interest revenue..........................................................
Gain on sale of office equipment..............................
Other expenses and losses:
Loss on sale of investment securities......................
Income from continuing operations before
income taxes...................................................................
1,250,500
Income taxes...................................................................
Net income......................................................................
Earnings per share ($823,075 60,000 shares)...........

130

$8,125,000
$

55,000
95,000

150,000 $
$ 775,000

$4,633,200
47,700

4,585,500
145,000
$5,505,500
750,000

4,755,500
$

$ 521,000
425,000
29,000
25,000
50,000 $1,050,000
$ 550,000
190,000
100,000
32,000
25,000
10,000
45,000

952,000

2,002,000
$

35,000
10,000
8,000

53,000
(20,000)
$
427,425
$ 823,075
$13.72

437.

(Concluded)

Connell Company
Retained Earnings Statement
For the Year Ended December 31, 2002

Retained earnings, January 1, 2002...............................................................


Add: Net income...............................................................................................
Deduct: Dividends............................................................................................
Retained earnings, December 31, 2002.........................................................
438.

$ 550,000
823,075
$1,373,075
150,000
$ 1,223,075

Jericho Recreation, Inc.


Income Statement
For the Year Ended December 31, 2002

Revenue:
Sales......................................................................
$797,500 (a)
Less: Sales returns and allowances...................
9,500
$788,000
Cost of goods sold...................................................
302,800 (b)
Gross profit...............................................................
$485,200
Operating expenses:
Selling expenses:
Sales salaries and commissions...................... $160,000
Depreciationstores and store equipment....
33,600 (c)
Advertising expense..........................................
13,400
$207,000
General and administrative expenses:
Officers and office salaries.............................. $210,000
Depreciationoffice building and equipment.
22,400 (c)
Other general and administrative expenses...
38,800
271,200
478,200
Operating income.....................................................
$ 7,000
Other revenues and gains:
Interest revenue....................................................
$ 6,600
Gain on sale of land and building........................
40,000 (d)
46,600
Other expenses and losses:
Interest expense...................................................
$ (10,600)
Loss on sale of short-term investment..............
(3,000)
(13,600)
Income from continuing operations before
income taxes.............................................................
$ 40,000
Income taxes (30%)..................................................
12,000
Income from continuing operations........................
$ 28,000
Extraordinary gain from early debt
extinguishment (net of income taxes of $4,800)....
11,200
Cumulative effect of change in inventory costing
method (net of income tax savings of $5,400).......
(12,600)
Net income................................................................
$ 26,600

131

438.

(Concluded)

Earnings per common share:


Income from continuing operations...............................................................
Extraordinary gain...........................................................................................
Cumulative effect of accounting change.......................................................
Net income........................................................................................................

$ 2.80
1.12
(1.26)
$ 2.66

COMPUTATIONS:
(a) Sales: $797,000 + $9,500 $6,600 + $10,600 + $3,000 $16,000 = $797,500
(b) Cost of goods sold: $320,800 $18,000 = $302,800. The $18,000 cumulative
effect of change in inventory method is reported separately, net of 30% tax
savings, as a nonoperating component of income.
(c) Depreciation: Stores and store equipment, $56,000 .60 = $33,600
Office bldg. and equipment, $56,000 .40 = $22,400
(d) The total pretax gain of $40,000 is included in income from continuing
operations. The sale of land and building does not constitute the disposal of a
business segment.
439.

Rollins Sporting Goods


Income Statement
For the Year Ended December 31, 2002

Sales..........................................................................
$103,200 (a)
Cost of goods sold:
Beginning inventory............................................. $ 10,020
Purchases.............................................................
53,540 (b)
Goods available for sale......................................
$ 63,560
Less: Ending inventory........................................
18,665 (d)
44,895
Gross profit...............................................................
$ 58,305 (c)
Operating expenses:
Selling expenses..................................................
$ 11,661
General and administrative expenses................
25,800 (e)
37,461
Income from operations before taxes.....................
$ 20,844
Income taxes.............................................................
8,338 (f)
Net income................................................................
$ 12,506
Earnings per share ($12,506 6,000 shares).........
$ 2.08
COMPUTATIONS:
(a) Cash collections................................................................
Accounts receivable, December 31, 2001.......................
Accounts receivable, December 31, 2002.......................
Sales...................................................................................

$107,770
(20,350)
15,780
$ 103,200

439.
(b)

(Concluded)

Cash payments..................................................................
Accounts payable, December 31, 2001...........................
Accounts payable, December 31, 2002...........................
Cash general and administrative expenses...................
Selling expenses...............................................................
Wages and salaries payable, December 31, 2001..........
Purchases......................................................................
*Total general and administrative expenses
(.25 $103,200)...............................................................
Less depreciation on store equipment.........................
Cash general and administrative expenses.................

$ 96,350
(9,870)
5,175
(22,704)*
(11,661)
(3,750)
$ 53,540
$ 25,800
3,096 (g)
$ 22,704

(c)

Selling expense $11,661 .20 = $58,305 gross profit

(d)

Sales (a).............................................................................
Gross profit (c)..................................................................
Cost of goods sold........................................................
Beginning inventory..........................................................
Purchases (b)....................................................................
Ending inventory...........................................................

(e)

Sales $103,200 .25 = $25,800 general and administrative expenses

(f)

Income before income taxes $20,844 .40 tax rate = $8,338 income taxes

(g)

General and administrative expenses $25,800 .12 = $3,096 depreciation

$103,200
58,305
$ 44,895
(10,020)
(53,540)
$ (18,665)

440.

Sunset Cosmetics Inc.


Income Statement
For the Year Ended December 31, 2002

Revenue:
Sales.........................................................................
Less: Sales returns and allowances.....................
Sales discounts............................................
Cost of goods sold:
Inventory, January 1................................................
Net purchases:
Purchases.............................................................
Less: Purchase returns and allowances............
Freight-in..................................................................
Cost of goods available for sale.............................
Less: Inventory, December 31................................
Gross profit..............................................................
Operating expenses:
Selling expenses:
Sales salaries and commissions.........................
Advertising expense.............................................
Depreciation expensesales/delivery
equipment.............................................................
Freight expense....................................................
Travel expensesales representatives..............
Miscellaneous selling expenses..........................
General and administrative expenses:
Officers salaries expense....................................
Insurance and licenses........................................
Doubtful accounts expense.................................
Utilities expense....................................................
Depreciation expenseoffice equipment...........
Legal services.......................................................
Telephone and postage expense........................
Supplies expense.................................................
Operating income........................................................
Other revenues and gains:
Interest revenue.......................................................
Dividend revenue.....................................................
Gain on sale of assets.............................................
Other expenses and losses:
Interest expense......................................................
Income from continuing operations before
income taxes................................................................
Income taxes................................................................
Income from continuing operations...........................
Discontinued operations:
Gain from discontinued operations (net of
income taxes of $14,000)........................................
Extraordinary loss (net of income tax savings
of $25,410)....................................................................
Net income....................................................................

$ 11,200
880

$499,400 (a)
12,080

$487,320

$ 89,700
$173,000
10,380 (b)

162,620
6,325 (c)
$258,645
54,150 (d)

204,495
$282,825

$ 35,108 (e)
16,696 (f)
6,750 (g)
4,200
4,560
2,200
$ 69,514
$ 36,600
8,500
7,460 (i)
6,400
4,800
2,225
1,475
580 (h)
$

68,040

137,554
$145,271

1,390 (j)
7,150
18,500
$ 27,040
(4,520)

22,520
$167,791
58,727 (k)
$109,064
26,000
(47,190)
$ 87,874

440.

(Concluded)

Earnings per common share:


Income from continuing operations ($109,064 39,000 shares).................
Gain from discontinued operations ($26,000 39,000 shares)....................
Extraordinary loss ($47,190 39,000 shares)...............................................
Net income ($87,874 39,000 shares = $2.25*).............................................

$ 2.80
0.67
(1.21)
$ 2.26*

*Difference due to rounding.


COMPUTATIONS:
(a) Sales: $495,200 + $4,200 = $499,400
(b) Purchase returns and allowances: $173,000 6% = $10,380
(c) Freight-in: $5,525 + $800 = $6,325
(d) Inventory: $20,550 + $33,600 = $54,150
(e) Sales salaries and commissions: $35,000 + ($3,600 3%) = $35,108
(f) Advertising expense: $16,090 + ($1,818 2/6) = $16,696
(g) Depreciation expense: $6,100 + ($7,800 10/120) = $6,750
(h) Supplies expense: $2,180 $1,600 = $580
(i) Doubtful accounts expense: ($261,000 3%) $370 = $7,460
(j) Interest revenue: $700 + $690 = $1,390
(k) Income taxes: $167,791 35% = $58,727
Sunset Cosmetics Inc.
Retained Earnings Statement
For the Year Ended December 31, 2002
Retained earnings, January 1............................................................................
Add: Net income..................................................................................................
Deduct: Dividends..............................................................................................
Retained earnings, December 31......................................................................

$440,670
87,874
$528,544
33,000
$ 495,544

441.
Before preparing the statement of comprehensive income, net income must be
computed, as follows:
Revenues and gains:
Sales...........................................................................................
Gain on sale of investment.......................................................
Total revenues and gains......................................................
Expenses and losses:
Cost of goods sold....................................................................
Selling expenses........................................................................
General and administrative expenses.....................................
Income tax expense..................................................................
Total expenses and losses...................................................
Income from continuing operations.............................................
Extraordinary gain, net of income taxes......................................
Cumulative effect of change in depreciation method,
net of income tax savings.........................................................
Net income......................................................................................

$450,000
6,700
$456,700
$263,000
63,900
58,720
21,500
407,120
$ 49,580
39,400
(18,380)
$ 70,600

Note: The sale of the land did not produce a gain or a loss; therefore, the proceeds
are not included in the statement. Dividends paid are part of the retained earnings
statement and are also excluded from the above statement. The correction of the
inventory error is a prior-period adjustment and is shown as a direct adjustment to
the beginning balance in retained earnings; it does not enter into the computation of
net income or of comprehensive income.
Blacksburg Company
Statement of Comprehensive Income
For the Year Ended December 31, 2002
Net income...........................................................................................................
Other comprehensive income:
Foreign translation adjustment, net of income taxes..................................
Comprehensive income.....................................................................................

$ 70,600
33,000
$ 103,600

4-42.
1.

Lorien Company
Forecasted Balance Sheet
December 31, 2003

2002
Cash.......................................................... $ 40
Other current assets................................
350
Property, plant, and equipment, net....... 1,000
Total assets.............................................. $ 1,390
Accounts payable.................................... $ 100
Bank loans payable................................. 1,000
Paid-in capital...........................................
100
Retained earnings....................................
190
Total liabilities and stockholders
equity........................................................ $ 1,390

2003
Forecasted
$ 48 20% natural increase
420 20% natural increase
800 $1,000 $200;
no replacements
$1,268
$ 120
1,000
(147)
295

20% natural increase


no new loans, item (c)
to balance
$190 + $120 $15

$1,268

Lorien Company
Forecasted Income Statement
For the Year Ending December 31, 2003
2002
Sales.......................................................... $1,000
Cost of goods sold...................................
350
Gross profit.............................................. $ 650
Depreciation expense..............................
200
Other operating expenses.......................

250

Operating profit........................................ $ 200


Interest expense.......................................
120
Income before taxes................................ $
Income taxes............................................

80
20

Net income................................................ $

60

2003
Forecasted
$1,200 given, item (a)
420 35% of sales,
same as last year
$ 780
200 same as last year;
no replacements*
300 25% of sales,
like last year
$ 280
120 12% of bank loan,
same as last year
$ 160
40 25% of pretax,
same as last year
$ 120

*One could also argue that depreciation expense will be lower in 2003 because the
net amount of property, plant, and equipment will decline.

4-42. (Continued)
2.

Yes, it is possible for paid-in capital to be negative. This means that a company
has spent more to repurchase shares of its own stock than was initially invested
by shareholders. This is possible when share prices have increased significantly
since shares were first issued. As with this example, negative paid-in capital is
symptomatic of a company that has generated a lot of excess cash and has used
it to buy back shares. Coca-Cola is an example of a real-world company with net
negative paid-in capital.

COMPETENCY ENHANCEMENT OPPORTUNITIES


Deciphering 41 (The Walt Disney Company)
1. In Note 11 to the financial statements, Disney reports that creative content accounted for 45% of the
company's revenues for 1998. Relating to profit margins, creative content reported a margin of 14%,
theme parks and resorts reported 23%, and broadcasting reported 19%.
2. The major reason for the decrease in income was increased costs and expenses relative to
revenues. This was particularly true for the creative content segment where the profit margin
decreased from 17% in 1997 to 14% in 1998.
3. In Note 11 relating to segments, Disney discloses that over 79% of its revenues originate in the
United States.
4. Note 1 details the company's revenue recognition policies: Revenues from motion pictures are
recognized when the movies are shown; revenues from video sales are recognized when the videos
are available for sale by retailers; and revenues from television licensing are recognized when the
shows are available for telecasting. Broadcast advertising revenues are recognized when
commercials are aired. Revenues from television subscription services related to the companys
primary
cable
programming services are recognized as services are provided. Revenues from participants and
sponsors at the theme parks are generally recorded over the period of the applicable agreements
commencing with the opening of the related attraction.
5. In Note 1, Disney reports that costs relating to film and television are expensed based on the ratio of
the current period's revenues to estimated total gross revenues. Television broadcast rights are
amortized on an accelerated basis over the estimated useful life of the programs. From this note we
can conclude that Disney uses a method of systematic and rational allocation.
6. Theme parks, resorts, and other properties are expensed on a straight-line basis over a time period
ranging from 3 to 50 years.
Deciphering 42 (Compaq Computer Corporation)
1998

1997

1996

Products revenue................................................

87.8%

98.1%

98.0%

Services revenue................................................

12.2

1.9

2.0

Total revenues...................................................

100.0%

100.0%

100.0%

Products: Cost of sales.......................................

68.6%

71.2%

72.8%

Services: Cost of sales........................................

8.3

1.3

1.4

Total cost of sales..............................................

76.9%

72.5%

74.2%

SG&A expenses..................................................

16.0

12.0

12.5

R&D costs...........................................................

4.3

3.3

3.5

Purchased in-process technology.......................

10.2

0.9

Restructuring and asset impairment charges......

1.3

0.3

Merger-related costs...........................................

0.2

Other income and expenses, net........................

(0.2)

(0.1)

0.1

Total expenses....................................................

108.5%

88.8%

90.6%

11.2%

9.4%

Income (loss) before taxes..................................


Provision for income taxes..................................
Net income (loss)................................................

(8.5)%
0.3
(8.8)%

3.7

2.8

7.5%

6.6%

1.

2.

3.
4.

Compaqs gross margin:

199823.1%
199727.5%
199625.8%
Compaqs gross margin by segment is as follows:
98
97
96
Products................................... 21.9%
27.5%
25.7%
Services.................................... 31.6
27.9
27.1%
The Services segment has been the more profitable, percentage wise, over the past three years.
Although sales increased by over $6.5 billion from 1997 to 1998 (a 27% increase), the company's
gross margin percentage decreased significantly. The largest item contributing to the net loss was
the expensing of purchased in-process technology. In addition, all other expenses except mergerrelated costs increased as a percentage of net revenues as well.
Research and development costs increased from 1997 to 1998 after dipping slightly (as a
percentage of sales) from 1996 to 1997.
When a company buys another company, a portion of the purchase price is allocated to the
research and development that has been done by the company being acquired. Purchased inprocess technology represents that amount. In-process technology is an asset and reflects a
probable future benefit.

Deciphering 43 (Wells Fargo & Company)


1.

2.

3.

Financial statements for a financial institution are a lot different than those produced by a
manufacturing firm. Revenues and expenses are partitioned as to those relating to interest and
those not relating to interest.
Net interest income would probably be the term most closely related to the concept of gross profit.
In simple terms, a manufacturing business generates profits by selling a product at a price greater
than its costgross profit. A bank makes money by loaning money at a greater rate than it pays on
savings accountsnet interest income.
Price-earnings ratio: 199726.6 ($339.44/$12.77)
199622.1 ($269.75/$12.21)
199510.6 ($216.00/$20.37)
Note: These P/E ratios are calculated using the basic earnings per share numbers. Wells Fargos
P/E ratio increased substantially between 1995 and 1997. Fundamentally, a companys P/E ratio
increases if investors have increased optimism about the chances of future earnings being high
relative to current earnings.

Deciphering 44 (The Reader's Digest Association, Inc.)


1.
2.

3.

Reader's Digest generates over 62% of its revenues and almost all of its profits from "Books and
Home Entertainment Products."
A measure of asset efficiency for each segment of Reader's Digest Association is as follows:
Reader's Digest Magazine
4.4%
Books and Home Entertainment Products
4.4 %
Special Interest Magazines
2.3%
Other Businesses
28.11 %
It would appear that the Reader's Digest magazine is not contributing a great deal to profits nor are
the assets associated with the magazine being used as efficiently as those being employed in the
"Other Businesses" segment. However, the primary method for selling books and home
entertainment products is through advertisements in the Reader's Digest magazine. The magazine
may not be as profitable as other segments of the company, but it is because of the magazine that
the other segments of the company are able to be successful.

Deciphering 45 (Ford Motor Company)


1.
2.

3.
4.
5.

Ford partitions its revenues and expenses into those relating to the Automotive division and those
relating to the Financial Services division.
Profit margin: Automotive
5.8%
Financial Services 72.8% (This includes a one time gainwithout the gain,
the profit margin is 9.8%.)
If one were to exclude the one-time gain, the Financial Services segment is actually experiencing
declining profits over the years 96 through 98.
Automotive profits have increased substantially since 1996 while the profits from Financial
Services, excluding the one-time gain, are actually declining.
This question should cause students to realize that Ford makes a great deal of profit from
nonautomotive sources. In fact, for 2 of the last 3 years disclosed in this set of financial statements,
Ford has made significantly more profit from financial services. It is also interesting to note that
prior to the 1980s, the Financial Services division of Ford was virtually nonexistent.

Writing Assignment: Recognizing holding gains


Students may make the following points as they address the issues raised in this assignment.
1. Holding gains do not result from an arm's-length transaction, and thus, verifiability and reliability are
less certain.
2. Securities that are traded on public markets have readily determinable fair market values. Those
fair market values can be realized with one phone call to a broker. The fair values are both
verifiable and reliable, thereby reducing many of the risks associated with disclosing holding gains
and losses.
3. As students will find in Chapter 14, when we discuss investments in securities, some of these
holding gains (those associated with trading securities) are reported on the income statement.
4. The difficulties associated with determining fair values of patents and other assets make reliability
an issue. Perhaps someday systems will be developed that allow these other assets to be easily and
reliably valued, as has happened with trading securities. Until that day, most long-term assets will be
disclosed at historical cost.
Research Project: Reviewing actual income statements and associated notes
A sample solution for this research exercise is given below using the 1997 financial statements of
McDonalds.
1. The format of McDonalds income statement is something between the pure single-step and
multiple-step statements illustrated in the chapter. Operating revenues and operating expenses are
grouped together, like a single-step statement. However, the overall formatwith operating income,
then interest expense, then income taxesfollows the general multiple-step format.
2.
Percentage Increase
Percentage Increase
from 1996 to 1997
from 1995 to 1996
Total revenues....................................................
6.8%
9.1%
Net income.........................................................
4.4%
10.2%
McDonalds net income for 1997 grew at a slower rate than did total revenues for the year. Part of the
reason for this is that income tax expense for the year increased by 12.7%.

3.

4.
5.

McDonalds does not disclose any details about its revenue recognition practice at its companyowned restaurants. This is because these transactions, which are almost exclusively cash sales of
food items, are very straightforward. McDonalds does describe its franchise arrangements in a note
to the financial statements. Franchise revenues are composed of initial fees, minimum rentals, and
percentage fees based on franchisee sales.
McDonalds discloses revenue, operating profit, and asset information by geographical segment.
McDonalds non-U.S. operations are growing faster than U.S. operations.
During the years 1995, 1996, and 1997, McDonalds had no below-the-line items.

The Debate: What is accrual-basis income?


Cash-Basis Income
As any introductory accounting student can attest, the notion of accrual is a difficult one to grasp. It
is unlikely that most financial statement users understand exactly what accrual-based income is. On
the other hand, everyone understands the difference between cash generated and cash consumed
by operating activities.
Bills are paid with cash, not with accruals. Financial statement users are most interested in a
companys cash flow.
Accrual-Basis Income
Accountants have worked for literally hundreds of years to refine their accrual adjustments in order to
make net income a useful measure of economic activity. Academic research supports the claim that
accrual-basis income appears to be the best measure of a companys economic performance.
Because accrual-basis income is not tied to the timing of cash receipts and cash disbursements, it
gives a better overall view of the economic activity of a company. As such, accrual-basis income
provides a better foundation with which to forecast future activity.
Ethical Dilemma
1.

2.

If Dwight revises the income statement to achieve the 5% increase in net income and uses biased
information to do so, he will be presenting information that has little representational faithfulness.
That is, the information will not represent an honest and accurate reflection of the performance of
the company.
Another risk to Dwight is that if the company goes public and people invest in the company based
on the financial statements produced by Dwight, those investors may have recourse to the company
and Dwight if they should lose money.
If Dwight were to give in this time and revise the income statement to meet the requested goals of
management, Dwight may find himself being asked to revise the income statement each period.
This may not be a one-time issue.
If Dwight does not revise the financial statements and cannot convince the members of the board of
directors of the validity of his reasons for not doing so, he may find himself out of a job.

Cumulative Spreadsheet Analysis


See Cumulative Spreadsheet Analysis solutions disk, provided with this manual.
Internet Search
An updated solution for the Internet Search exercise in this chapter can be found at the text Internet site
(http://skousen.swcollege.com).

SOLUTIONS TO STOP & THINK


Stop & Think (p. 162): It would seem that the physical capital maintenance concept would provide the
best theoretical measure of "well-offness." What difficulties would be encountered by a firm as it tried to
turn theory into practice if the FASB had adopted the physical capital maintenance concept of measuring
income?
Measuring physical well-offness would require firms to obtain fair market value measures of each of their
assets and liabilities each period. The difficulties of obtaining these measures along with the associated
costs would, in most cases, cause the costs of the information to exceed its benefits.
Stop & Think (p. 164): Why is it important to separately disclose revenues and gains? expenses and
losses?
Revenues and expenses are associated with what a business does. That is, they relate to a company's
central activity. An investor or creditor would want to evaluate a business's performance in its central
activity. Additional information relating to gains and losses associated with the peripheral activities of a
business would be useful but should not be combined with revenues and expenses for disclosure
purposes.
Stop & Think (p. 166): Why do you think Kinross waits to recognize revenue from the sale of Kubaka
gold until the gold is actually sold?
Recall that revenue recognition at the time of production is acceptable when sale at an established price
is practically assured. For the gold produced by Kinross in eastern Russia, enough uncertainty surrounds
the shipment and sale of the gold that revenue is not recognized until the actual sale occurs.
Stop & Think (p. 171): Having just reviewed a single-step and a multiple-step income statement, which
type do you think provides better information for assessing a firm's performance?
Students' responses will vary in answering this question. Remind students that it is not their answer that
is important, it is the thinking about the question that is of value.

SOLUTIONS TO BOXED ITEMS


Polluted Accounting (p. 174)
1.

2.

3.

One might say that capitalizing the costs of certain expenditures does not affect the income
statement at all. After all, when an expenditure that has been paid in cash, for example, is
capitalized, only two asset accounts are involved. The effect on the income statement is detrimental
when the expenditure should have been recorded as an expense rather than as an asset. If an
expenditure properly classified as an expense is incorrectly recorded as an asset, income will be
overstated. This is illustrated with the following journal entries:
What was done:
Asset....................................
xxx
Cash..............................
xxx
What should have been done:
Expense...............................
xxx
Cash..............................
xxx
Obviously, there is no straightforward answer to this question. The students should recognize the
potential ethical dilemmas they may face as they enter the accounting profession and the business
world.
Many independent auditors leave their audit firms to take employment with a client. In the vast
majority of these cases, everyone benefits. By auditing the firm for several years, the audit partner
has gained valuable knowledge regarding the workings of that business that could be very useful to
the client. However, care must be taken to ensure that an adequate control environment is in place
to guard against any one person or group of people being able to manipulate the accounting
records.

Phar-Mor and the World Basketball League (p. 176)


1.

2.

Inventory can either be sold or is on hand. If it is sold, it is disclosed on the income statement as
cost of goods sold. If the inventory is on hand, it is disclosed on the balance sheet. If the balance
sheet account is overstated, then cost of goods sold is understatedresulting in an increase in net
income. Overstating receivables causes an overstatement of salesresulting in an increase in net
income. As you can easily see, when these two frauds are combined, the effect on net income can
be
substantial.
A number of reasons exist to explain why anyone would inflate reported income. Higher than
expected income can have a positive effect on stock price. It can have a positive effect on the
likelihood of raising additional capital or of obtaining loans. Higher net income, if tied to an
executive's compensation, will obviously benefit the executive as well.
The independent auditor has the responsibility of examining the financial statements of a company
and determining if the amounts included in the statements fairly present the company's position as
of a given date and the net income earned over a specified period. An auditor examines many
different kinds of evidence before an opinion can be rendered. The internal control structure of the
company, management's integrity, and the quality of the accounting system must be carefully
considered to determine the quantity and quality of evidence that must be gathered. Several of the
weaknesses mentioned in the description of Phar-Mor should probably have been discovered by the
auditor and the impact of the weaknesses on the financial statements considered. Vendor
confirmations, surprise inventory observations, analytical reviews, review of large cash
disbursements, and other such procedures should have raised sufficient questions for the auditor to
uncover the massive misstatements now being disclosed. Auditors are held responsible to exercise
due care in performing their duty to render audit opinions on financial statements. If they fail to
perform that duty carefully, they are, and should, be subject to the litigation being brought against
them. Many times fraudulent activities are very difficult to uncover by the auditor. If extensive
management collusion exists, as could have been true in the Phar-Mor case, auditors may be able

3.

to file a countersuit against management. The article implies such suits and countersuits have
occurred.
Auditors are being encouraged to become very familiar with not only the company being audited but
also with the key financial players in a company and any outside activities that might reflect on the
company being audited. Auditors should become familiar with the industry, with the financial climate
that the client is operating in, and be alert to any information that might suggest a conflict of interest
on the part of management. Such information may be found in financial magazines and
newspapers, discussions with other auditors and with company personnel, television and radio
broadcasts, etc. The significant amount of litigation against CPA firms has created an increased
awareness of care on the part of all auditors. An auditor must keep ears and eyes open to anything
that might suggest a problem in the financial reporting.