Financial Accounting: Refresher Notes

TABLE OF CONTENTS self-study to a formal review course.

Selecting the right option is a matter of
Review of the Accounting Cycle 3 making an honest self-appraisal and
Balance sheet and Notes to FS 6 deciding which approach is most likely to
Income Statement 9 produce the desired result. You must
Statement of Cash Flows 12 consider how up-to-date your knowledge
Cash 14 is, how much new learning will be
Receivables 15 necessary, how much you know about the
Inventory & Cost of Goods Sold 17 CPA exam itself, how much time you
Property, Plant, and Equipment: Initial have to devote to review, how inclined
Acquisition 21 you are to procrastinate, and how well
Property, Plant, and Equipment: you can study on your own. The chief
Depreciation 24 concern at this stage is to decide on the
Intangible Assets 26 best possible game plan for you. Success
Borrowing Costs 28 will depend on the choice you make and
Mineral Resources 29 how well you stick to it.
Debt Financing 30
Equity Financing 34 3. Arrange your life to accommodate the
Investments in Debt & Equity Securities 36 necessities of review
Earnings per Share 38 You must plan on setting aside a
Derivatives 40 minimum of two or three hours per day
Contingencies 42 for either classroom attendance or self-
Segment Reporting 43 study. This represents a sizeable chunk of
Interim Reporting 44 your life. That, in turn, may adversely
Accounting Changes & Error Correction 45 affect friends and family. Since their
FS Analysis 47 cooperation and support can make your
task much more manageable, and since
STUDY TIPS FOR PROFESSIONALS your ties to them should endure long after
you become a CPA, you should seek their
understanding and share with them the
1. Self Appraisal
sense of purpose you feel. If they are
Take stock of yourself, your academic
made to feel a part of your hopes and
preparation, as well as your work habits
plans, they will forgive your irritability
and other strengths and weaknesses.
and unsociability during the review
period.
You can use the iCPA Study Plan to
determine how familiar you are with each
At the office, your supervisors and co-
topic listed, keeping in mind the
workers are not likely to be as
percentage indicator of relative emphasis
sympathetic. Your efforts to become a
given to each topic.
CPA are viewed as a worthy endeavor by
your employer, but not one that should
affect your availability for overtime,
2. Decide what kind of review program to
business travel, or other job requirements.
undertake
In other words, there will be little
Your options range from self-designed

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 opportunity for you to find much
flexibility in your job responsibilities to
accommodate your review program. You
are expected to show that you can become
a CPA even while you are giving your full
effort to job performance. The
arrangements necessary to allow for the
hours that must be set aside are usually
made by forging participation in all
nonessential personal and social activities
during the review period.
In many ways, your life off the job during
the review period may come to resemble
that of a recluse. If, however, you keep
your focus on the long-term benefits of
whatever temporary sacrifices you have to
endure, the inevitable tedium will seem
more bearable. The worst part of failing
the CPA exam has to gear up for and go
through the review process all over again.
It should be done right the first time.
4. Take the plunge
Procrastination is the thief of time, and
time is the reviewee’s scarcest resource.
Usually, the hardest part of any life
project is getting started. Some people
procrastinate by busying themselves with
preparatory details, telling themselves that
everything must be arranged and in place
before they can begin. Other people
simply postpone.
The point to remember is that things in
your life will never be exactly as you
would like them to be; once a decision is
made, action should follow. Natural
inertia must be overcome.
5. Maintain momentum
As you might expect, it is not easy to
sustain an intense and tedious effort over
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a long time. As one encounters setbacks
or obstacles, it is easy to become
discouraged. Self-doubt is a natural
human reaction. Expect it and deal with it.
But recognize it as nothing more than a
passing mood. If you have the self-
discipline and motivation that
characterizes successful candidates, you
will not lose the momentum of effort that
you have established.
There are certain things a candidate can
do during the review period that will help
maintain momentum:
a. Set daily goals
b. Maintain a progress record of
your study
c. Monitor the performance of
questions answered.
d. Keep fit.
You will need such exercise during the
review period as well since some physical
counterbalance will be necessary for the
periods during which you must remain
relatively immobile while in class or
studying at home. Beyond that, it is well
established that physical fitness and
mental alertness are connected.
To reduce mental fatigue, it helps to
“walk away from it” periodically when
you feel, during study sessions, that your
brain has become overloaded with
information. A brief rest will usually help
to clear the neurological circuitry.
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REVIEW OF THE ACCOUNTING
CYCLE
1. The accounting system generates a variety of
reports for use by various decision-makers.
Among the most common are general-
purpose financial statements, management
reports, tax returns, and other reports
prepared for government agencies such as
the SEC.
2. A manual and an automated accounting
system are similar in that both are designed
to serve the same information-gathering and
processing functions. Both systems also use
the same underlying accounting concepts and
principles.
The differences between a manual and an
automated accounting system involve some
mechanical aspects, time requirements, and
the appearance of records and reports. Due to
advanced technology and reduced prices,
today, almost all successful businesses of any
size use computers to assist in the various
accounting functions.
3. The accounting process involves specific
procedures used by businesses to produce
financial statement data.
The recording phase of the accounting
process consists of those procedures used in
the continuing activity of analyzing,
recording, and classifying business
transactions in the various books of record
(journals and ledgers) during the fiscal
period.
The reporting phase of the accounting
process consists of those procedures used at
the end of the fiscal period to update and
summarize data collected during the
recording phase. Financial statements are
prepared from the updated and summarized
data.
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4. The accounting process includes the
following steps:
(1) Business documents are analyzed.
Business documents provide detailed
information concerning each transaction
and establish support for the data
recorded in the books of original entry.
(2) Transactions are recorded in
chronological order in books of original
entry -the journals. Transactions are
analyzed in terms of their effects on the
various asset, liability, owners’ equity,
revenue, and expense accounts of the
business unit.
(3) Transactions are posted to the
appropriate accounts in the general and
subsidiary ledgers. The ledger accounts
classify and summarize the full effect of
all transactions recorded in the journals
and can be used in the preparation of
financial statements.
(4) A trial balance may be prepared,
showing the account balances in the
general ledger and reconciling
subsidiary ledger balances with
respective control account balances. The
trial balance provides a summary of the
information as classified and
summarized in the ledgers as well as a
verification of the accuracy of recording
and posting.
(5) Adjustments are made to bring the
accounts up to date. Adjustments are
necessary to record all accounting
information that has not yet been
recorded and to recognize all revenues
and expenses on an accrual basis
properly. If a worksheet is used (an
optional step in the cycle), adjustments
may be journalized and posted any time
before closing. If statements are prepared
directly from ledger balances, however,
changes must be recorded at this point.
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 (6) Financial statements are prepared.
Financial statements report the results of
operations and cash flows for a while
and show the financial condition of the
business unit as of a specific date.
(7) Closing entries are journalized and
posted. Balances in nominal accounts are
closed into Retained Earnings. Operating
results, as determined in the summary
accounts, are finally transferred to
Retained Earnings.
(8) A post-closing trial balance may be
prepared as an optional step in the
Cycle. A post-closing trial balance is
prepared to check the equality of the
debits and credits after posting the
adjusting and closing entries.
The steps in the accounting process are
necessary to transform transaction data into
useful information, as summarized in the
financial statements and other accounting
reports. Some levels are optional, such as
preparing a trial balance and preparing a
post-closing trial balance. These steps help
verify or facilitate the accounting process but
are not essential.
5. Under double-entry accounting, assets,
expenses, and dividends are increased by
debits and decreased by credits. Liabilities,
owners’ equity accounts, and revenues are
increased by credits and decreased by debits.
6. a. Real accounts are balance sheet accounts
not closed to a zero balance in the
closing process. Nominal accounts are
income statements or temporary owners’
equity accounts closed out in the process
of arriving at the net increase or decrease
in owners’ equity for a period.
b. A general journal is the most flexible
book of original entry. It may be used to
record all business transactions or merely
those that cannot be recorded in one of
the individual journals.
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Specialized journals are designed to
facilitate the recording of some particular
type of frequently occurring transaction,
such as sales, purchases, cash receipts,
and cash disbursements.
c. The general ledger carries summaries of
all accounts appearing on the financial
statements.
Subsidiary ledgers afford additional
detail in support of individual general
ledger balances. Thus, accounts payable
appear in total in the public accounting,
but own reports with each creditor are
provided in the accounts payable
subsidiary ledger.
7. a. Adjusting entries are made at the end of
an accounting period to update balance
sheet accounts and to record accrued
expenses and accrued revenues.
Frequently, adjusting entries are first
made on a worksheet and then are
recorded in the general journal from
which they are posted to the ledger
accounts.
b. Closing entries are made after the
adjusting entries have been posted. They
transfer all nominal account balances to
Retained Earnings.
8. The company accountant is disregarding the
periodic summary process and jeopardizing
the company’s audit trail by not entering the
adjusting entries in the general journal.
Adjusting entries are made at the end of the
period to bring accounts up to date. These
entries must be entered first in the general
journal and then posted directly to the public
ledger. If the adjusting entries are not entered
first in the general journal, the journals will
be incomplete and will not provide the
support necessary for an adequate accounting
system.
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 9. Examples of contra accounts include
Allowance for Bad Debts, Accumulated
Depreciation, Discount on Notes Receivable,
Discount on Notes Payable, and Discount on
Bonds Payable.
Contra accounts are subtracted from related
accounts. Hence, they are sometimes referred
to as offset accounts. Contra accounts are
used to adjust accounts when the original
balance needs to be preserved.
14. Accrual accounting recognizes revenues and
expenses when they are earned and incurred,
not necessarily when cash is received or
paid.
Cash-basis accounting recognizes revenues
and expenses as cash is received or
disbursed, regardless of the earnings process
or the matching concept. Generally accepted
accounting principles require the use of
accrual accounting.

For example, adequate disclosure in financial

15. The use of double-entry accrual accounting
reports requires disclosure of both the
is more accurate than a cash-basis accounting
original cost and the depreciated cost of
system primarily because
assets. A contra account, Accumulated
Depreciation, is used for this purpose.
(a) The likelihood of errors and omissions is
significantly increased in the absence
11. A worksheet is a multicolumn form designed Of double-entry analysis and a trial
to facilitate the summarization and balance to test the accuracy of the
organization of accounting data needed to analysis and recording process.
prepare the financial statements. The number
of columns and the headings used may vary, (b) Recording events under an accrual
depending on the needs of a particular system as they occur more accurately
business. While the worksheet is an optional reflects the effects and timing of an event
step in the accounting process, it is a than does a system that records the
valuable aid in completing the trial balance events when cash is received or paid,
and adjustment procedures. regardless of the earnings process and
the matching concept.
12. When a worksheet is used as a basis for
statement preparation, the adjustments can be
formally recorded in the journals and posted
to the ledger accounts at any time before
closing the books. However, if a worksheet is
not used, financial statements must be
prepared directly from the reports; thus, the
adjustments must be recorded and posted
before statement preparation.

13. Only the following accounts would be

closed, generally with the following
debit/credit entries:
Rent Expense ................. Credit
Depreciation Expense ..... Credit
Sales .............................. Debit
Interest Revenue ............. Debit
Advertising Expense....... Credit
Dividends ....................... Credit

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BALANCE SHEET & NOTES TO FS
1. Three elements are contained in a balance
sheet: assets, liabilities, and equity. These
elements measure the worth of an enterprise
at a given point in time. The balance sheet
thus reports what resources an enterprise has
and who has a claim against those resources.
Two other elements, investments by owners
and distribution to owners, are related to the
equity element. Information concerning the
change in equity is often contained in a
separate statement that supplements the
balance sheet.
2. To meet the definition of an asset, an item
need not be associated with certain future
benefits. To acknowledge the uncertainty
inherent in the business, the definition of an
asset stipulates that the future benefit needs
be only probable.
3. Some liabilities, such as accounts payable
and long-term debt, are denominated in
precise monetary terms. However, the
amounts of many liabilities must be
estimated based on expectations about future
events.
4. The difference between current assets and
current liabilities, referred to as working
capital, is a commonly used measure of the
liquidity of an enterprise. It helps to
determine whether the company will be able
to meet its current debt with available assets
and continue normal operations.
5. a. Assets are classified as current if
(1) the asset will be realized in cash
during the normal operating cycle of
the business or one year, whichever
is longer, or
(2) the asset will be sold or consumed
within a normal operating cycle or
one year, whichever is longer.
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b. Liabilities are classified as current if
liquidation of the liability is expected to
require
(1) the use of current assets or
(2) the creation of other current
liabilities.
6. a. Cash is classified as noncurrent when it
is a part of a fund that will be used to
discharge noncurrent obligations. Such
funds include bond retirement funds,
pension funds, and preferred stock
redemption funds. Cash to be used for
the acquisition of land, buildings, and
equipment or cash received on long-term
deposits from customers would also be
reported as noncurrent.
b. Receivables not reportable as current
assets include those arising from unusual
transactions, such as the sale of land,
buildings, and equipment or advances to
affiliates or employees that would not be
collectible within 12 months.
7. If a short-term loan is expected to be
refinanced or paid back with the proceeds of
a replacement loan, the existing short-term
loan is not classified as current. This is true
as long as the intent of the company is to
refinance the loan on a long-term basis, and
the company’s plan is evidenced by an actual
refinancing after the balance sheet date or by
the existence of an explicit refinancing
agreement.
8. a. A subjective acceleration clause is a
provision in a debt instrument that
specifies some general conditions
permitting a lender to accelerate the due
date unilaterally.
b. An objective acceleration clause is a
provision in a debt instrument that
specifies conditions that can cause the
debt to be immediately callable, for
example, failure to earn a positive return
on the assets or to make an interest
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 payment.
c. If a noncurrent debt instrument contains
a subjective acceleration clause and the
invoking of the clause is deemed
probable, the liability should be
classified as current. If invoking of the
clause is considered to be reasonably
possible but not likely, the obligation
should continue to be reported as a
noncurrent liability with a note to
describe the contingency. If a debt
instrument contains an objective
acceleration clause and the conditions
that trigger the call have occurred, the
debt should be classified as current.
Exceptions are that
(1) the creditor has waived the right to
demand payment for a period that
extends beyond the debtor’s normal
operating cycle or
(2) the debtor has cured the deficiency
after the balance sheet date, but before
the statements are issued, and the debt is
not callable for a period that extends
beyond the debtor’s normal operating
cycle.
9. Contingent liabilities could or could not give
rise to actual obligations; estimated liabilities
are known to exist, but the amount is not
known. A company could, for example, win
or lose a lawsuit, but it is liable for income
tax. The exact amount of the income tax is
unknown until the final tax return is
completed. The tax liability could have to be
estimated at the time financial statements are
prepared.
10. With a proprietorship, the owner’s equity is
reported with a single capital account. In a
partnership, separate capital accounts are
established for each partner. In a corporation,
a distinction is made between contributed
capital and retained earnings.
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11. The three major categories in a corporation's
equity section are
(a) Contributed capital, including both
capital stock at par and additional paid-in
capital
(b) Retained earnings
(c) Other equity, such as treasury stock,
unrealized gains and losses on
Available-for-sale securities, foreign
currency translation adjustments, and
unrealized gains and losses on
derivatives.
12. Offset balances are used to adjust the gross
amount of balance sheet items to arrive at
proper valuations. For example, allowance
for bad debts is correctly offset against the
gross amount of accounts receivable to show
the net amount estimated collectible. It is
generally not proper to offset an asset
account against a liability or owners’ equity
account because such an offset would not be
to value either account correctly but rather to
condense financial data at the expense of
adequate disclosure.
13. Assets are usually presented in the order of
their liquidity, with the most liquid items
listed first.
14. Financial ratios are mathematical
relationships between financial statement
amounts. For example, return on equity is net
income divided by owners' equity.
15. The asset turnover ratio (total sales divided
by total assets) is a measure of the number of
dollars of sales generated by each dollar of
assets. The higher the asset turnover ratio,
the more efficient the company is in using its
assets to generate sales.
16. Return on equity is an indicator of the overall
performance of a company. Return on equity
measures the percentage return on the
stockholders' investment and is computed as
net income divided by total equity.
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17. There are at least four types of notes used by
management to support the financial
statements and provide users with additional
relevant information. They can be classified
as follows:
(a) Summary of significant accounting
policies
Accordingly, the balance sheet numbers are
often a feeble reflection of what a company
is worth. Typically, a going concern is worth
significantly more than the reported book
value of equity.

(b) Additional information, both numerical

and descriptive, to support summary
totals included in the financial statements

(c) Information about items that do not meet

the recognition criteria but that is still
useful to decision-makers

18. Separate supplementary information or

schedules may be included to disclose
segment information; details about property,
plant, and equipment and short-term
borrowing; and trend data for periods beyond
those included in the basic statements.
19. If a subsequent event provides additional
information about items included in the
financial statements, especially those whose
value has been estimated, the new
information should be used to make
adjustments to the amounts in the statements.
The event itself does not change the value
but merely provides additional information
about conditions that existed at the balance
sheet date. For example, the filing of a
bankruptcy petition by a significant customer
provides other data concerning the
collectibility of accounts receivable. The
conditions that led to the bankruptcy were
probably present at the balance sheet date but
may not have been known to the preparer of
the statements until the bankruptcy filing
took place. Under these circumstances,
Allowance for Bad Debts may need
adjustment to reflect the net realizable value
of receivables accurately.

21. Many assets are reported at historical cost,

which is usually less than market value, and
other assets (such as homegrown goodwill)
are not included in the balance sheet at all.

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INCOME STATEMENT
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
the investor may project other future cash
flows. In summary, the income statement
contains only some of the information that is
relevant for making economic decisions.
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.
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 and adjusted for a
change in price levels since original
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acquisition.
(c) The current value of net assets acquired
in exchange transactions as determined
by either their replacement or market
values.
(d) Some variation of the above (a through
c) but including in assets all resources
and claims to support, 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.
5. 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 as the difference
between the selling price and the book value
(often the depreciated cost). These
classification and display distinctions will
depend on the specific circumstances and
activities of an enterprise.
6. 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
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 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.
7. Three expense recognition principles are
applied in matching costs with revenues:
(a) Direct matching -costs 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
systematically and rationally with the
periods or products benefited.
(c) Immediate recognition - those 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 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 two sections. The
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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
12. A restructuring charge is a loss that arises
when a company proposes a restructuring of
its operations. The charge is composed of the
decline in value associated with assets that
no longer fit in the company’s strategic
plans. The charge also includes the additional
costs related to 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 transitory, irregular, or extraordinary
items. Under this concept, each section of the
transitory, irregular, or exceptional items
category is reported net of its income tax
effect.
14. a. The effects of a change in accounting
principle that is applied to prior periods
are disclosed in the financial statements
as a direct adjustment to beginning
retained earnings of the earliest year
reported. The financial statements are
prepared using the new accounting
principle for all years being presented.
b. The effect of a change in accounting
estimate is disclosed entirely in the
current period or the current and future
periods. No adjustments are made to
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 prior periods’ statements as may be done assumption about how rapidly the plant and
for a change in principle. The change in equipment will depreciate, to estimate future
an estimate should be sufficiently depreciation expense.
disclosed in the financial statements so
that readers are alerted to those changes
that will materially affect future periods.

15. Under IAS 8, the cumulative effect of a

change in accounting principle is reported as
a direct adjustment to beginning retained
earnings of the earliest year reported.

16. Generally accepted accounting principles

require entities to report earnings-per-share
information for income from continuing
operations and each section of the transitory,
irregular, or extraordinary items category of
an income statement. The computation is
made by dividing the income or loss from
each of these 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.

17. “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.” 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.

18. The starting point for the preparation of

forecasted financial statements is the forecast
of sales.

19. In forecasting depreciation expense, one first

must predict how much property, plant, and
equipment will be needed in the future. This
amount is then used, along with an

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STATEMENT OF CASH FLOWS
1. Cash flow from operations can offer a clearer
picture of a company's performance than
does net income when:
• A company reports large noncash
expenses, such as write-offs,
depreciation, and provisions for future
obligations. Earnings may give an overly
pessimistic view of the firm.
• A company is multiplying. Reported
earnings may be positive, but operations
are consuming rather than generating
cash.
• A company badly needs to report
favorable earnings, as is the case before a
significant loan application or before a
stock offering. In these cases, cash flow
from operations provides an excellent
reality check for reported earnings.
2. To qualify as a cash equivalent when
preparing a statement of cash flows, an item
must be
(a) readily convertible to cash, and
(b) so near its maturity that there is an
insignificant risk of changes in value due
to changes in interest rates.
As a general rule, only investments with
original maturities of 3 months or less
qualify. The original maturity is determined
from the date of acquisition of the investment
by the entity, not the date of the original
issuance of the security.
3. Operating activities include those
transactions and events that enter into the
determination of net income. Cash receipts
from selling goods or from providing
services are the significant cash inflow for
most businesses. Major cash outflows
include payments to purchase inventory and
to pay wages, taxes, interest, utilities, rent,
and similar expenses.
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Investing activities are the purchase and sale
of land, buildings, and equipment, and the
purchase and sale of financial instruments
not intended for trading purposes.
Financing activities include transactions and
events whereby cash is obtained from or
repaid to owners (equity financing) and
creditors (debt financing).
4. The normal pattern of cash flow is
• Operating - positive
• Investing - negative
• Financing - either positive or negative
5. The direct method reports all operating cash
receipts and cash payments. The difference
between cash receipts and payments is the
net cash flow from operations. The indirect
method begins with net income as reported
on the income statement, adjusts for any
noncash items (such as depreciation), and
converts the accrual amounts to a cash basis.
The result of this reconciliation process is net
cash flow from operations, which will be the
same amount as derived using the direct
method.
6. Many users favor the direct method because
it is a straightforward approach that is easy to
understand. Most accountants prefer the
indirect method because it is easy to apply
and because it helps explain or reconcile the
differences between net cash flow from
operations and net income. Because
accountants already have to report net
income, it is easier for them to start with that
number and convert it to net cash flow from
operations rather than use the direct method.
7. When the direct method is used, depreciation
expense is omitted from the calculation of
cash from operating activities because it is a
noncash expense. When the indirect method
is used, depreciation expense is added back
to net income because depreciation was
subtracted in the original computation of net
income.
Page 12
 8. The statement, “Cash flow is equal to net
income plus depreciation,” is wrong because
it ignores the impact on cash from operating
activities of all the changes in current
operating assets and current operating
liabilities.
9. The “target number” is the net change in the
cash balance, as shown in the balance sheet.
The sum of cash from operating,
investing, and financing activities should
equal the net change in cash.
10. The cost of goods sold, combined with the
change in the inventory balance, reveals how
much inventory was purchased during the
year. Inventory purchases, coupled with the
change in the accounts payable balance for
the year, are used to calculate the amount of
cash paid for inventory purchases.
11. A loss on the sale of a long-term asset is
omitted from the calculation of cash from
operating activities when using the direct
method. When the indirect method is used,
the loss is added back to net income
because the loss was subtracted in the
original computation of net income. In both
cases, any effects of the sale of the long-term
asset are removed from the computation of
operating cash flow; cash received from the
sale of long-term assets is reported as an
investing activity.
12. If the direct method is used, a separate
schedule must be presented to reconcile net
income to net cash provided by (used in)
operating activities. If a company elects to
use the indirect method, the amounts paid
during the period for interest and income
taxes should be disclosed. Regardless of the
method used for reporting operating cash
flows, companies must disclose any
significant noncash investing and financing
transactions.
13. Significant noncash investing and financing
transactions (e.g., the purchase of land by
issuing capital stock) are to be reported in the
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notes to the financial statements or in a
separate schedule accompanying the cash
flow statement. Because these transactions
do not affect cash, they should not be
reported on the statement of cash flows itself.
14. Cash from operations is usually larger than net
income. This is because of the large number of
noncash expenses included in the income
statement, such as depreciation, write-downs,
and restructuring charges.
15. When the value of a company’s cash flow
adequacy ratio is less than 1.0, that company
is not generating enough cash from
operations to pay for all new plant and
equipment purchases. Accordingly, the
company has no cash left over to repay loans
or to distribute to investors.
16. The income statement details the transactions
that occurred in temporary accounts that are
summarized in the Retained Earnings
account. The statement of cash flows
provides information relating to transactions
that occurred in the cash account for the
period.
17. A forecasted statement of cash flows allows
management to see the relationship between
forecasted operating cash flow and the cash
needed for investing activities. If there is an
expected shortfall in available cash, a
company can either use the forecasted
information in obtaining additional
financing, or the company can scale back its
expansion plans to reduce the drain on cash.
18. Lenders can use a forecasted statement of
cash flows to see whether it seems likely that
a company can continue to meet its existing
debt obligations. An investor can use the
projected cash flow statement to evaluate the
likelihood that a company will be able to
continue making dividend payments.
Page 13
CASH

1. Cash, because it is the standard medium of

exchange, is required to complete almost all
business transactions. Therefore, a certain
amount of cash must be kept immediately
available for daily transactions. It is
management’s responsibility to see that
sufficient cash, but not an excessive amount,
is available for current operating purposes.
To be productive, any excess of “idle cash”
should be invested in temporary or long-term
investments.
2. The compensating balance is
Legally restricted, the balance should be
segregated and reported separately among
the Cash Items in the current or noncurrent
asset section of the balance sheet, depending
on the nature of the restrictions. This will
protect financial statement readers from
assuming that the total cash balance is
available to pay current obligations.

3. (a) Differences between depositor and bank

balances typically arise from the
following:
(1) Deposits in transit
(2) Outstanding checks
(3) Bank service charges
(4) Not-sufficient-funds checks
(5) Direct collection by bank of amounts
owed to depositor
(6) Recording errors by the depositor or
the bank
(b) Items (3), (4), and (5) require entries on
the depositor’s books, as well as item (6)
if the error was made by the depositor.

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RECEIVABLES
1. (a) A receivable evidenced by a formal,
written promise to pay is classified as a
note receivable; an informal, unsecured
promise to pay is classified as an account
receivable or other appropriate titles
(e.g., advances to officers).
(b) Receivables arising from the normal
operating activities of a business are
classified as trade receivables; those
from all other sources are nontrade
receivables.
(c) All trade receivables and those nontrade
receivables expected to be collected
within one year (or the normal
Operating cycle, whichever is longer) are
reported as Current Assets; all other
receivables are noncurrent and are
reported under the Investments or Other
Noncurrent Assets caption, whichever is
appropriate.
2. (a) Methods for establishing and
maintaining an allowance for bad debts
account are as follows:
(1) Allowance for Bad Debts is
increased by a certain percentage of
total sales or credit sales.
(2) Allowance for Bad Debts is adjusted
to a certain percentage of
receivables.
(3) Allowance for Bad Debts is adjusted
to an amount determined by aging
the accounts.
(b) The percentages to use in estimating
uncollectible accounts should be based
on the collection experience of each
individual company. Analysis of the
records can be made to determine the
relationships between write-offs and
sales or receivables. If there has been no
recognizable change in the economic
conditions or in the credit policy of the
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company, these historical percentages
may be used as the best estimate of
future uncollectibles. To the extent that
these conditions are
changing, the percentages will require
appropriate adjustment.
3. GAAP requires the allowance method
because it provides for matching of current
revenues with related expenses, and it reports
the receivables at their net realizable value.
The direct write-off method is easy to apply
and is objective but does not provide for
proper matching of revenues and expenses
nor appropriate valuation of receivables.
4. Product warranties are obligations that exist
at a balance sheet date, but the amount to be
paid cannot be definitely
determined. The amount of the claim is
therefore estimated. This estimated liability
should usually be recorded on an accrual
basis because the obligation created upon the
sale of a product should be matched with the
revenue received from the sale.
5. (a) Accounts receivable turnover is
computed by dividing net sales by the
average accounts receivable outstanding
for the year.
(b) The average collection period is
computed by dividing average daily sales
(net sales ÷ 365) into the average
receivables for the year. This
measurement can also be obtained by
dividing the number of days in a year by
the accounts receivable turnover.
(c) The accounts receivable turnover
represents the average number of sales or
collection cycles completed by a firm
during a particular year. The average
collection period shows the average time
required to collect receivables.
6. The practice of financing accounts receivable
has become very popular. In the past, this
form of financing was viewed as a last resort
Page 15
 for obtaining funds. Now it is often seen as a
wise and legitimate business tool that can be
used to put the assets of a company to work.
This change in attitude results from the
realization that an available, easy-to-obtain
form of financing was not being used.
7. (a) (1) When receivables are sold, they are
removed from the books of the
seller, and a gain or loss is
recognized for the difference
between the net proceeds received
and the carrying value of the
receivables.
(2) When receivables are used as
collateral to secure loans, the
receivables remain on the books, and
a loan is recorded. The amount of
receivables assigned should be
disclosed in the notes to the financial
statements.
(b) (1) The entry to record the sale of
receivables without recourse
involves a debit to Cash for the sales
price (less the amount, if any,
withheld by the factor), a debit to
Loss from Factoring for the charge
made by the factor, a debit to
Allowance for Bad Debts, and a
credit to Accounts Receivable for the
accounts sold. If the factor withholds
a portion of the sales price pending a
final settlement, the amount withheld
is recorded as a debit to Receivable
from Factor. If the receivables are
sold with recourse, the value of the
recourse obligation must be
estimated, and the loss on the sale is
increased accordingly.
(2) Accounting for receivables involved
in a secured borrowing involves
making memorandum entries for
data concerning the pledge.
8. (a) A note receivable should be recorded at
an amount different from its face amount
when face amount differs from present
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value. Such a difference arises when a
note is non-interest-bearing or when the
face amount of interest-
bearing note is more or less than the fair
market value of the consideration
exchanged. However, short-term trade
notes may be recorded at face amount
even when the face amount is not equal
to its present value.
(b) The difference between a note’s face
amount and its present value is initially
recorded as a premium or discount and
amortized over the life of the note. The
amortization procedure is a systematic
allocation of the premium or discount to
Interest Revenue on the books of the
holder of the note and to Interest
Expense on the books of the issuer of the
note.
9. An assignment is disclosed in a parenthetical
comment or note to the balance sheet, stating
the nature and amount of the pledged
receivables. The receivables continue to be
reported as an asset in the balance sheet, and
the associated loan is reported as a liability.
10. Imputing a rate of interest is the process of
selecting and applying an interest rate
deemed appropriate under the circumstances.
An imputed rate must be determined when
no interest rate is stated or when the stated
rate is unreasonable, and the present value of
a note cannot be identified by reference to
the note itself, or the consideration
exchanged for the note. The selection of an
appropriate rate is based on factors such as
the credit standing of the issuer of the note,
prevailing interest rates for notes with similar
terms, and the rate at which the debtor could
obtain financing from other sources at the
time of the transaction.
Page 16
INVENTORY & COST OF GOODS SOLD
1. Four questions associated with accounting
for inventory are as follows:
• When is inventory considered to have
been purchased?
• Similarly, when is inventory considered to
have been sold?
• Which costs are considered to be part of
the cost of inventory, and which are
simply business expenses for that period?
• How should total inventory cost be
divided between the inventory that was
sold (cost of goods sold) and the
inventory that remains (ending
inventory)?
2. Vehicles are classified as inventory on the
balance sheets of companies that sell
vehicles in the normal course of business.
However, for a firm that uses vehicles but
does not sell them, such as a delivery service
business, the vehicles would be shown as
property, plant, and equipment instead of as
inventory.
3. Direct materials are applied directly to the
manufacturing process and become part of
the finished product.
Indirect materials are auxiliary materials or
materials that are not incorporated directly
into the finished product. They include such
items as oil, fuels, and cleaning supplies.
They may also include materials of minor
significance that are embodied in the final
product but are too immaterial to account for
as direct materials.
4. (a) The three cost elements found in work in
process and finished goods are direct
materials, direct labor, and
manufacturing overhead.
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(b) Manufacturing overhead is composed of
all manufacturing costs other than direct
materials and direct labor. It includes
indirect labor, indirect materials,
depreciation, repairs, insurance, taxes,
and the portion of managerial costs
identified with production efforts.
5. The general rule of thumb is that inventory-
related costs incurred inside the factory wall
are allocated to the cost of inventory, and
costs incurred outside the factory wall (e.g.,
in the finished goods warehouse) are
expensed as incurred.
6. Computers are characteristic of perpetual
inventory systems. The recordkeeping
requirements of a perpetual system are
greater than those for a periodic system, so a
computer can significantly aid in managing
the data. Periodic systems can be operated
with just an old cash register. The decrease in
computing costs over the past 20 years has
dramatically increased the use of perpetual
systems.
7. The inventory system must be cost-effective.
That is, cost vs. benefit must be considered.
Also, it should provide effective control over
the use and management of the asset. The
perpetual inventory system, because it is
more costly to maintain and implement,
should be used for items of relatively high
unit value and for which management of the
asset’s use is desired.
However, with information technology
continually bringing down the cost of
perpetual inventory systems, a perpetual
system may be used in all the cases.
8. When a perpetual inventory system is used,
the company knows how much inventory
should be on hand at any point in time.
Comparing the inventory records to the result
of a physical count allows the company to
compute the amount of inventory shrinkage.
Page 17
 9. (a) Merchandise in transit is legally reported
as inventory by the seller if it was
shipped FOB destination.
(b) Merchandise in transit is legally reported
as inventory by the buyer if it was
shipped FOB shipping point or if it was
shipped FOB destination and received
before the year-end but not yet unloaded
or moved into the inventory storage area.
10. (a) Consigned goods should be included in
the inventory of the shipper/consignor,
not in the inventory of the dealer holding
the goods. The consigned inventory
should be reported in the shipper's
inventory at the sum of its cost and the
Handling and shipping costs incurred in
the transfer to the dealer.
(b) Inventory sold under an installment sale
may continue to be shown in the
inventory of the seller because the seller
retains title to the goods. If the seller
reports the inventory, it should be
reduced by the buyer’s equity in the
inventory as established by collections.
However, in the usual case, when the
possibilities of returns and defaults are
meager, the seller, anticipating
completion of the contract and the
ultimate passing of title, recognizes the
transaction as a regular sale and removes
the goods from reported inventory at the
time of the sale.
11. The substance of an inventory sale
accompanied by a repurchase agreement is
that the inventory is being used as collateral
for a loan. Accordingly, the inventory
continues to be reported as part of the seller’s
inventory. The proceeds from the “sale” are
reported as a loan. A note describes the
repurchase agreement.
12. An activity-based cost (ABC) system is one
in which overhead costs are allocated to
inventory based on clearly identified cost
drivers, which are characteristics of the
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production process known to create overhead
costs.
13. (a) Cash discounts may be accounted for
under the gross method or the net
method. Under the gross method,
purchases of merchandise are recorded at
the gross amount of the invoice, and
discounts taken at the time of payment
are recognized in a contra purchases
account. Under the net method,
purchases of merchandise are recorded at
the net amount of the invoice, and any
discounts not taken are recognized as an
expense of the period.
(b) The net method of accounting for
purchases is strongly preferred. By
separately reporting purchase discounts
lost, the failure of a company to take
advantage of cash discounts is
highlighted. It is usually considered
advantageous for a company to make a
purchase discount. Failure to do so is
regarded as a lapse inefficient financial
management of a company.
14. Although the specific identification method
may be considered a highly satisfactory
approach in matching costs with revenues, it
is often difficult or even impossible to apply.
If there are many items in the inventory with
acquisition occurring at different times and
different prices, cost identification
procedures may be prolonged, burdensome,
and costly. When the units are in effect
identical, the specific identification method
opens the door to possible profit
manipulation through the choice of particular
units for sale.
15. The average cost method of inventory
valuation has the advantage of evening out
the fluctuations of inventory pricing and
generally is more comfortable to apply than
the FIFO method. As prices vary, the average
price used to cost inventory sold is
automatically adjusted. Because the cost of
purchases during a period is usually several
times more than the value of the opening
inventory, the price used is heavily
Page 18
 influenced by current costs.

16. For most businesses, a FIFO assumption

better matches the physical flow of goods.

17. Computation of average cost under a

perpetual system is complicated because the
average cost of units available for sale
changes every time a purchase is made, and
the identification of the “last in” units also
changes with every purchase.
20. In periods of increasing prices, FIFO's
historical cost flow will reflect the highest
peso value of ending inventory because the
historical unit cost assigned to the asset
demonstrates the most recent unit price.

21. The value assigned to inventory can be

significant in determining how profits and
losses are allocated among different
reporting units within the business. A
manager wants any inventory he or she
receives from another department to be
transferred at the lowest possible value.
When transferred inventory is reported at a
low value, higher profits are recognized on
the subsequent sale of the item. Reported
profits of a department may be used in the
evaluation and bonus computation for the
manager of the department.

22. In developing a reliable gross profit

percentage, reference is made to the
historical rate, with adjustments for changes
in current circumstances. For example, the
historical total profit percentage would be
adjusted if the pricing strategy has changed
(e.g., because of increased competition), if
the sales mix has changed, or if a different
inventory valuation method has been
adopted.

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27. (1)
Effect on Statements of
Nature of Error Current Period
(a) Ending inventory Net income is overstated by the
over-stated because of amount of the error.
a miscount. Current assets and owners’
equity are overstated by the
amount of the error.
(b) Failure to record the No effect on net income,
purchase of although both ending inventory
merchandise on the and purchases are understated
account and the by the amount of the omission.
merchandise purchased Both current assets and current
was not recognized in liabilities are understated by the
recording the ending amount of omission.
inventory.
Net income is understated by
(c) Ending inventory the amount of the error.
understated because of a Current assets and owners’
miscount. equity are understated by the
amount of the error.
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(2)
Effect on Statements of
Succeeding Period
Net income is understated by
the amount of the error.
No effect on the balance sheet.
No effect on net income
because the understatement in
the beginning inventory is
Counterbalanced by the
overstatement of purchases.
No effect on the balance sheet.
Net income is overstated by the
amount of the error.
No effect on the balance sheet.
Page 20
PROPERTY, PLANT & EQUIPMENT:
Initial Acquisition
1. a. The cost of land includes the original
purchase price; brokers’ commissions;
legal fees; title, recording, and escrow
fees; surveying costs; local government
individual assessment taxes; the cost of
clearing or grading; and other costs that
permanently improve the land or
Prepare it for use. Expenditures for
land improvements that have a limited
life, such as paving, fencing, and
landscaping, may be separately
summarized as land improvements and
depreciated over their estimated useful
lives.
b. The cost of buildings includes the
The original purchase price, brokers’
commissions, legal fees, title and
escrow fees, reconditioning costs,
alteration and improvement costs, and
any other costs that improve the
buildings and hence benefit future
periods.
c. The cost of equipment includes the
original purchase price, taxes, and
duties on purchases, freight charges,
insurance while in transit, installation
charges, and other costs in preparing
the asset for use, subsequent
improvements or additions, and any
other expenditures that will improve
the equipment and thus benefit more
than one period.
2. Accountants frequently are required to
allocate costs among two or more accounts.
The principal method of allocation is based
on relative market values of the individual
assets, if they can be determined. A ratio of
each asset’s market value to the sum of the
market values for all assets
Involved in the purchase is used to
determine the cost of each asset. If market
values, or some approximation of market
values, cannot be obtained for all assets in
the basket purchase, the allocation can be
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made to those assets where market values
are available, and any remaining balance
can be allocated, on some systematic basis,
to remaining assets.
3. When equipment is purchased on a
Deferred payment contract, care must be
taken to exclude the stated or implicit
interest from the purchase price. The asset
should be recorded at its equivalent cash
price. Interest on the unpaid contract
balance should be recognized as interest
expense over the life of the contract.
4. a. Sales practice for some products
consistently inflates the list price that is
Initially assigned. Because most buyers
are aware of this practice, considerable
negotiations take place between buyers
and sellers before a market price is
established. If accountants use the list
price without careful evaluation, values
could be inflated.
b. The goal of accounting for the
acquisition of property and equipment
is to record the purchase at the
equivalent cash price or the closest
approximation to cash that can be
obtained. This is especially important
when trade-ins are involved.
5. a. If the donation of the property by the
philanthropist is unconditional, the
president’s position cannot be
defended. If the donation is not
recognized, both assets and income will
be understated. Furthermore,
subsequent income will be overstated
through the failure to acknowledge
depreciation, and this misstatement will
be accompanied by misrepresentations
of earnings-to-assets and earnings-to-
owners’-equity relationships reflected
on the financial statements. Properties
unconditionally transferred should be
recognized by debits to asset accounts
and a credit to a revenue account in
terms of the fair market values of the
properties acquired, and depreciation
Page 21
 should be recognized in using such recordkeeping associated with assets.
features.
9. a. The cost of a depreciable asset
b. If the donation of the property is incorrectly recorded as an expense will
contingent upon certain conditions, the understate assets and owners’ equity
president’s position relative to the for the current year and for succeeding
nonrecognition of the asset is proper years, but by successively decreasing
until the time the conditions are met. amounts until the asset no longer
Until the requirements are met, the fair contributes to periodic revenue. Net
value of the conditional gift, along with income will be understated in the first
a description of the terms, should be year by the excess of the expenditure
disclosed in the notes to the financial over depreciation for the current
statements. period; net income in succeeding years
will be overstated by the amount of
6. An asset retirement obligation is a legal depreciation charges applicable to the
obligation a company has to restore the site asset that should be charged off as an
of a piece of property or equipment when expense.
the asset is retired. The estimated fair value
of the asset retirement obligation is b. An expense expenditure incorrectly
recognized as a liability and is added to the recorded as an addition to the cost of a
cost of the asset when it is acquired. depreciable asset will overstate assets
and owners’ equity for the first year
and for succeeding years, but by
7. Many companies establish a minimum
successively decreasing amounts until
monetary amount for recording
the charge has been entirely written off.
expenditures as assets, even though the
Net income will be overstated for the
item purchased meets the definition of an
first year by the difference between the
asset. The principal reasons for this are
recognized depreciation for the current
materiality and the cost involved in
period and the amount of the
recording an asset and depreciating it over
expenditure; net income for succeeding
its estimated life. It is more expedient to
years will be understated by the
expense these smaller capital expenditures
depreciation charges recognized in
immediately, thus avoiding the
such periods.

8. Expenditure Classification
a. Cost of installing machinery ...................................... Asset
b. Cost of unsuccessful litigation to protect patent ......... Expense
c. Extensive repairs as a result of fire............................. Expense
d. Cost of grading land .................................................. Asset
e. Insurance on machinery in transit .............................. Asset
f. Interest incurred during construction period ............... Asset (if interest added to construction
cost)
Expense (if interest charged to expense)
g. Cost of replacing a major machinery component ........ Asset
h. New safety guards on machinery ............................... Asset
i. Commission on purchase of real estate ...................... Asset
j. Special tax assessment for street improvements ......... Asset
k. Cost of repainting offices........................................... Expense

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10. The remaining net book value of a indicator of the actual fair value of the fixed
component that is replaced is added to assets being used by a company. Another
depreciation expense for the period. complication with the fixed asset turnover
11. a. Research activities are those used to ratio is caused by leasing. Many companies
discover new knowledge that will be lease the bulk of their fixed assets in such a
useful in developing new products, way that the assets are not included in the
services, or processes, or significantly Balance sheet. This practice biases the fixed
improve an existing product or process.
Development activities seek to apply asset turnover ratio for these companies
research findings to develop a plan or upward because the sales generated by
design for new or improved products the leased assets are included in the
and processes. Development activities numerator of the ratio, but the leased assets
include the formulation, design, and generating the sales are not included in the
testing of products, construction of denominator.
prototypes, and operation of pilot
plants.
b. Research and development costs are
generally expensed in the period
incurred. An exception is when the
expenditure is for equipment and
facilities that have alternative future
uses beyond the specific current
research project. This exception
permits the deferral of costs incurred
for materials, equipment, facilities, and
intangibles purchased, but only if the
alternative future use can be correctly
identified. Also, software development
costs are capitalized if they are incurred
after technological feasibility has been
established.

12. The fixed asset turnover ratio is computed as

sales divided by the average property, plant,
and equipment (fixed assets); it is
interpreted as the number of pesos in sales
generated by each peso of fixed assets.
13. As with all ratios, the fixed asset turnover
ratio must be used carefully to ensure that
erroneous conclusions are not made. For
example, fixed asset turnover ratio values
for two companies in different industries
cannot be meaningfully compared. Another
difficulty in comparing costs for the fixed
asset turnover ratio among different
companies is that the reported amount for
property, plant, and equipment can be a poor

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PROPERTY, PLANT & EQUIPMENT:
Depreciation
1. Depreciation refers to the cost allocation of
tangible long-term assets; depletion refers
to the cost allocation of natural resources,
and amortization refers to the cost
allocation of intangible assets. All three
terms have similar underlying principles
governing their use.
2. Four separate factors must be considered in
determining the periodic depreciation
charges that should be made for a
company’s assets. They are (1) asset cost,
(2) residual or salvage value, (3) useful
life, and (4) pattern of use. These factors,
when considered together, help determine
which of the conventional methods is most
appropriate for the circumstances.
3. Residual or salvage value is included in the
formulas for all time-factor depreciation
methods except for the declining-balance
methods. In practice, the residual value is
often ignored if it is the practice of a
company to retain assets for most of their
useful lives. In the case of declining-
balance methods, although the residual
value is not included in the formulas, it is
considered when an asset is near the end of
its useful life. Generally, the book value
should not be reduced below its expected
residual value.
4. Functional factors include inadequacy and
obsolescence that reduce the usefulness of
the asset. Physical considerations include
wear and tear, deterioration and decay, and
damage or destruction, reducing the value
of the asset.
5. Time-factor methods of depreciation base
cost allocation on time according to either
straight-line or accelerated depreciation. In
theory, the pattern selected should be
related to the pattern of benefits expected
from the asset. Because the pattern of
benefits is very subjective, the selection of
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a specific time-factor method is usually an
arbitrary decision.
Use-factor methods of depreciation base
cost allocation on some measure that relates
more directly to the use of the asset. Most
commonly, the distribution is based on
productive output or service hours. In
theory, the use-factor methods provide
much better matching of costs against
revenues than do time-factor methods.
However, because use-factor methods
require more extensive accounting records,
they are not as common as the time-factor
methods.
6. With group depreciation, periodic
depreciation expense is computed on a
whole group of assets as if the group were
one single asset. The weighted-average life
of the group is used to determine how much
of the aggregate asset cost should be
depreciated each year. No gains or losses
are recognized at the time of the retirement
of individual assets; accumulated
depreciation is reduced for the difference
between the asset cost and the cash
retirement proceeds.
7. The amount of an asset retirement
obligation is added to the cost of the
associated asset. Accordingly, the asset
retirement obligation increases periodic
depreciation. Also, the amount of the asset
retirement obligation itself increases each
year as the time until the obligation must be
satisfied decreases. However, this increase,
which conceptually is the same as interest
expense, is not accounted for as interest
expense. Instead, it is called accretion
expense.
8. When a useful-life estimate is changed, the
remaining book value of the asset is
depreciated over the revised remaining
useful life. In other words, the forecast
impacts only the current and future periods.
No attempt is made to go back and “fix” the
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 depreciation amount recognized in prior
periods.

9. Depreciation is an estimate, and the effort

necessary to compute depreciation expense
for the exact number of days an asset is
owned usually exceeds any benefit derived.
For companies that acquire and dispose of
many assets during a year, detailed tracking
of daily depreciation is almost impossible.
A variety of simplifying assumptions are
used, including rounding to the nearest
whole month and the half-year convention
in which one-half of a year’s depreciation
is taken on any asset acquired or disposed
of during the year.

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INTANGIBLE ASSETS
1. a. Copyright, when purchased, is recorded
at its purchase price. When internally
developed, all costs of legally
establishing the copyright are included
as costs of the copyright.
b. The cost of purchasing a franchise and
all other sums explicitly paid for a
franchise including legal fees are
Considered the franchise cost. Property
improvements required under the
franchise also are recorded as part of
the franchise cost.
c. The cost of a trademark includes all
expenditures required to establish the
trademark, such as filing and
registration fees, as well as legal
expenses for the defense of the
trademark.
Purchased trademarks are recorded at
the purchase price.
2. In general, the cost of internally generated
intangibles is expensed as incurred.
3. The five general categories of intangible
assets are as follows:
1. Marketing related.
2. Customer-related.
3. Artistic related.
4. Contract-based.
5. Technology-based.
4. The two approaches used in estimating fair
values using present value computations
are the traditional approach and the
expected cash flow approach. In the
traditional approach, which is often used in
situations in which the amount and timing
of the future cash flows are determined by
contract, the present value is computed
using a risk-adjusted interest rate that
incorporates expectations about the
uncertainty of receipt of the future
contractual cash flows.
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In the expected cash flow approach, a range
of possible outcomes is identified, the
present value of the cash flows in each
possible outcome is computed (using the
risk-free interest rate), and a weighted-
average current value is calculated by
summing the current value of the cash
flows in each issue, multiplied by the
estimated probability of that outcome.
5. a. Goodwill may be adequately reported
as an asset only when it is purchased or
otherwise established by a transaction
between independent parties.
b. Expenditures for advertising should not
be capitalized as goodwill. Some
advertising expenditures may be
deferred if the costs applicable to future
benefits from such advertising can be
determined objectively. Usually,
however, it is advisable to expense
such expenditures because of the
fleeting nature of the benefits and
because future benefits may be
challenging to estimate.
6. Contract-based and separately tradable
intangibles are recognized in both a basket
purchase and in a business combination.
Intangibles that are neither of these, but that
are still relevant and reliably measurable, are
recognized in a basket purchase but are not
separately recognized when acquired as part
of a business combination.
7. For accounting purposes, recorded
intangible assets come in three varieties:
a. Intangible assets that are amortized.
The impairment test for these
intangibles is the same as the two-step
test used for tangible long-term
operating assets.
b. Intangible assets that are not
amortized. The impairment test for
these intangibles involves a simple one-
step comparison of the book value to
the fair value.
Page 26
 c. Goodwill, which is not amortized. The
goodwill impairment test is a two-step
process that first involves estimating
the fair value of the entire reporting
unit to which the goodwill is allocated.

14. a. Compute the fair value of each

reporting unit to which goodwill has
been assigned.

b. If the fair value of the reporting unit

exceeds the net book value of the assets
and liabilities of the reporting unit, the
goodwill is assumed not to be impaired,
and no impairment loss is recognized.

c. If the fair value of the reporting unit is

less than the net book value of the
assets and liabilities of the reporting
unit, a new fair value of goodwill is
computed. The goodwill value is the
amount of fair value of a reporting unit
that is left over after the benefits of all
identifiable assets and liabilities of the
reporting unit has been considered.

d. If the implied amount of goodwill

computed in (c) is less than the amount
initially recorded, a goodwill
impairment loss is recognized for the
difference.

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BORROWING COSTS

1. a. In constructing a new building for its

use, it will charge the building with all
costs incurred in connection with
construction activities. These costs will
include building costs in the form of
direct labor, direct materials, factory
overhead, and any other expenditures
that can be identified with the
construction of the asset.

b. When a company constructs its assets,

two positions may be taken in assigning
general overhead to the cost of the asset:
(1) Overhead may be assigned to special
construction just as it is assigned to
normal activities because both activities
benefit from the overhead; this would
mean that construction would be
charged with the increase in overhead
arising from construction activities as
well as a pro-rata share of the
company’s fixed overhead. (2) Only the
rise in rent may be charged to
construction because management
decides to construct its assets after
giving due consideration to the
differential or additional costs involved.
An equitable allocation of the fixed
overhead between regular operations
and construction affords no special
favor to construction activities; on the
other hand, a charge to construction for
only the increase in total overhead
grants no special concessions to regular
events during the construction period.

2. Before interest charges are capitalized, a

construction project should be a discrete
project. Interest should not be obtained for
inventories manufactured or produced on a
repetitive basis, for assets that are currently
being used, or for assets that are idle and
not undergoing activities to prepare them
for use.

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MINERAL RESOURCES

1. With the full cost method of accounting for

oil and gas exploration costs, the cost of
drilling dry holes is capitalized and
amortized. With the successful efforts
method, only the exploratory costs
associated with successful wells are
obtained; the cost of dry holes is expensed
as incurred.

2. When new estimates of recoverable natural

resources are obtained, a new depletion
cost per basic unit is computed from the
beginning of the period in which the
original assessment is made. No adjustment
is made to prior periods. It is a change in
estimate and, therefore, prospective.

3. A company should recognize an

impairment loss when the undiscounted
sum of expected future cash flows from the
asset is less than the recorded book value of
the asset. The impairment loss is measured
as the difference between the book value of
the asset and the asset’s fair value. Fair
value can be estimated as the discounted
sum of expected future cash flows.

4. A gain or loss is recognized whenever the

exchange of assets takes place unless the
exchange does not affect the risk, timing, or
amount of a company’s cash flows. In those
instances where the transaction lacks
“commercial substance,” indicated gains
are not recognized. Indicated losses are
always accepted.

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DEBT FINANCING
1. The definition of liabilities are as follows:
(a) A commitment is a result of past
transactions or events.
(b) A liability involves a probable future
transfer of assets or services.
(c) Liability is the obligation of a
particular entity.
All of these components should be present
before the liability is recorded. Also, the
amount of the liability must be measurable
to report it on the balance sheet.
2. a. An executory contract is one in which
performance by both parties is still in
the future. Only an exchange of
promises is made at the initiation of the
contract. Common examples include
labor contracts and purchase orders.
b. The definition of liability states in part
that liability should be the result of a
past transaction or event. Similar
concepts in previous definitions used
by accounting bodies have excluded
executory contracts from inclusion as
liabilities. However, the accounting
methods currently accepted for leases,
for example, essentially recognize
liabilities before a performance by
either party to the lease contract.
3. Current liabilities are claims arising from
operations that must be satisfied with
current assets within one operating cycle or
within one year, whichever is longer. Non-
operating cycle claims are classified as
current if they must be paid within one year
from the balance sheet date.
Noncurrent liabilities are liabilities whose
liquidation will not require the use of
current assets to satisfy the obligation
within one year.
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4. Generally, liabilities should be reported at
their net present values rather than at the
amounts that eventually will be paid. The
use of money involves a cost in the form of
interest that should be recognized whether
or not such cost is expressly stated under
the terms of the debt agreement.
5. Some companies include short-term
borrowing as a permanent aspect of their
overall financing mix. In such a case, the
company often intends to renew or rollover,
its short-term loans as they become due. As
a result, a short-term loan can take on the
nature of long-term debt because, with the
refinancing, the cash payment to satisfy the
loan is deferred into the future. As of the
date, the financial statements are issued, if
a company has either already done the
refinancing or has a firm agreement with a
lender to refinance a short-term loan, the
loan is classified in the balance sheet as a
long-term liability.
6. A line of credit is a negotiated arrangement
with a lender in which the terms are agreed
to before the need for borrowing. When a
company finds itself in need of money, an
established line of credit allows the
company access to funds immediately
without having to go through the credit
approval process.
7. In reporting long-term debt obligations, the
emphasis is on reporting what the real
economic value of the obligation is today,
not what the total debt payments will be in
the future. The sum of the future cash
payments to be made on long-term debt is
not a good measure of the actual economic
obligation. Because the cash outflows
associated with a long-term liability extend
far into the future, present-value concepts
must be used to value the liability properly.
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8. For each payment, a portion is an interest,
and the remainder is applied to reduce the
principal. To compute the amount
attributable to the principal, the outstanding
loan balance is multiplied by the monthly
interest rate. The result is the interest
portion of the payment. Subtracting this
amount from the total payment gives the
amount applied to reduce the principal.
9. a. Secured bonds have specific assets
pledged as security for the issue.
Unsecured bonds frequently referred to
as debenture bonds, are not protected
by the pledge or mortgage of specific
assets.
b. Collateral trust bonds are secured by
stocks and bonds owned by the
borrowing corporation. There is no
specific pledge of property in the case
of debenture bonds, the issue being
secured only by the general credit of
the company.
c. Convertible bonds may be exchanged
at the option of the bondholder for
other securities of the corporation by
the provisions of the bond contract.
Callable bonds may be redeemed by
the issuing company before maturity at
a specified price.
d. Coupon bonds are not recorded in the
name of the owner, and title passes
with the delivery of the bond. Interest
is paid by having the bondholder clip
the coupons attached to the bonds and
present these for payment on the
interest dates. Registered bonds call for
the registry of the bondholder’s name
on the books of the corporation.
Transfer of title to these bonds is
accomplished by the surrender of the
old bond certificates to the transfer
agent, who records the change in
ownership and issues new certificates
to the buyer. Interest checks are
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periodically prepared and mailed to the
holders of record.
e. Municipal bonds are issued by
governmental units, including state,
county, and local entities. The proceeds
are used to finance expenditures such
as school construction, utility lines, and
road construction. The bonds usually
sell at lower interest rates than do other
bonds because of the favorable tax
treatment given to the holders of the
bonds for the interest received. Because
the interest revenue is not taxed by the
federal government, these bonds are
frequently referred to as tax-exempt
securities. Corporate bonds are issued
by corporations as a means of financing
their long-term needs. Corporations
usually have a choice of raising long-
term capital through issuing bonds or
stock. Bonds have a fixed interest rate
while stock pays its return through
declared dividends. The holders of
corporate bonds must pay federal
income taxes on interest revenue
received.
f. Term bonds mature as a lump sum on a
single date. Serial bonds mature in
installments on various dates.
10. The market rate of interest is the rate
prevailing in the market at the moment. The
stated rate of interest is the rate printed on
the face of the bonds. This is also known as
the contract rate. The effective or yield rate
of interest is the same as the market rate at
the date of issuance (purchase) and is the
actual return on the purchase price received
by the investor and incurred by the issuer.
The market rate fluctuates during the life of
the bonds by economywide changes in
expectations about future inflation. With
the changing financial condition of the
company, the stated rate remains the same.
Although the effective rate stays the same
for the individual bond investor or the
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 borrowing corporation over the life of the
issue, this rate will vary from one
bondholder to another when the securities
are acquired at different times and prices.
11. The use of the effective-interest method of
amortization for bond premiums and
discounts is encouraged. Because the
effective-interest method adjusts the stated
interest rate to the effective rate, it is
theoretically more accurate than the
straight-line method. The straight-line
method may be used if the interim results
of using it do not differ materially from the
resulting amortization using the effective-
interest method. The total amortization
will, of course, be the same under either
way over the life of the bond.
12. Three ways bonds may be retired before
maturity are as follows:
(a) Bonds may be redeemed by purchasing
them on the open market or by
exercising the call provision is included
in the bond indenture.
(b) Bonds may be converted or exchanged
for other securities.
(c) Bonds may be refinanced (sometimes
called refunded) with the use of
proceeds from the sale of a new issue.
Usually, with the early extinguishment of a
debt, a gain or loss must be recognized for
the difference between the carrying value
of the debt security and the amount paid.
13. Callable bonds serve the issuer’s interests
because the callability feature enables the
issuing corporation to reduce its
outstanding indebtedness at any time that it
may be convenient or profitable to do so.
14. Convertible debt securities generally have
the following features:
(a) An interest rate lower than the issuer
could establish for nonconvertible debt.
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(b) An initial conversion price higher than
the market value of the common stock
at the time of issuance.
(c) A call option retained by the issuer.
These securities raise many questions as to
the nature of the securities. Examples of
these questions include whether they
should be considered debt or equity
securities, the valuation of the conversion
feature, and the treatment of any gain or
loss on conversion.
15. Convertible bonds are securities that may
be viewed either as primarily debt or
primarily equity. If they are considered as
debt, the conversion from debt to equity
could be considered to be a significant
economic event for which any difference
between the current market price for the
securities and their carrying value should
be recognized as a gain or loss. For the
investor, this could be viewed as the
exchange of nonmonetary assets. For the
issuer, this could be considered to be
creating a significant difference in the type
of ownership being assumed.
On the other hand, if the convertible bonds
are considered as primarily equity
securities whose market is responsive to the
price of common stock, the exchange of
one equity security for another could be
viewed as not a significant exchange.
Under the historical cost concept, it should
not give rise to any gain or loss.
16. Bond refinancing or refunding means
issuing new bonds and applying the
proceeds to the retirement of outstanding
warrants. This may occur either at the
maturity of the old bonds or whenever it
may be advantageous to retire old bonds by
issuing new bonds with a lower interest
rate, a more favorable bond contract, or
some other benefit.
Page 32
17. Avoiding the inclusion of debt on the
balance sheet through the use of off-
balance-sheet financing may allow a
company to borrow more than otherwise
possible due to debt-limit restrictions. Also,
the healthy appearance of a company’s
financial position usually enables it to
borrow at a lower cost. Another possible
reason is that companies wish to understate
liabilities because inflation has, in effect,
understated its assets.
One of the main problems with off-balance-
sheet financing is that many investors and
lenders aren’t able to see through the off-
balance-sheet borrowing tactics and thereby
21. a. A bond restructuring involving an asset
make ill-informed decisions. There is also
concern that as these methods of financing
gain popularity, the amount of total
corporate debt is reaching unhealthy
proportions.
18. If a variable interest entity (VIE) is
carefully designed, it can be accounted for
as an independent company, and any debt
that it incurs will not be reported in the
balance sheet of its sponsor.
19. Companies will, on occasion, join forces
with other companies to share the costs and
benefits associated with specifically
defined projects. These joint ventures are
often developed to share the risks
associated with high-risk projects. Because
the benefits of these joint ventures are
uncertain, companies have the possibility
of incurring substantial liabilities with few,
if any, assets were resulting from their
efforts. As a result, as is the case with
unconsolidated subsidiaries, a joint venture
is carefully structured to ensure that the
liabilities of the joint venture are not
disclosed in the balance sheets of the
companies in the partnership. Often, both
joint venture partners account for the joint
venture using the equity method; that is, the
liabilities of the joint venture are not
included in the balance sheets of the
partners.
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20. Troubled debt restructuring occurs when
the investor (the creditor) is willing to
make significant concessions as to the
return from the investment to avoid making
settlements under adverse conditions, such
as bankruptcy. This means that if the
restructuring involves a significant
transaction, the investors (creditors) will
almost always report a loss unless they
have previously anticipated the loss and
have reduced the investment to a value
lower than the amount finally determined in
the settlement. The issuer will report a gain
if the restructuring involves a significant
transaction.
swap usually results in recognition of a
loss on the investor’s books and a gain
on the issuer’s books. The market value
of the assets swapped often determines
the amount of gain or loss be
recognized. Only if the market value of
the retired debt is more determinable
would such value be used.
b. A bond restructuring involving an
equity swap similarly results in
recognition of gains or losses because
the market value of the equity
exchanged for the debt is used to record
the transaction. If the market value of
the debt is more clearly determinable
than the market value of the equity, the
value of the debt would be used.
c. A bond restructuring involving a
modification of terms does not result in
recognition of a gain for the issuer
unless the total amount of future cash
to be paid, principal plus interest is less
than the carrying value of the debt. In
that case, the difference between the
future cash and the carrying value is
recognized as a gain. Under this
condition, future cash payments are
charged to the liability account on the
issuer’s books.
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EQUITY FINANCING
1. The fundamental rights of common
stockholders, unless otherwise restricted in
the articles of incorporation or bylaws, are
as follows:
(a) The right to vote in the election of
directors and the determination of
certain corporate policies.
(b) The right to maintain one’s
proportional interest in the corporation
through the purchase of additional
stock issued by the company. (In recent
years, some states have eliminated this
preemptive right.)
2. Historically, the par value was equal to the
market value of the shares at issuance. Par
value was also sometimes viewed by the
courts as the minimum contribution by
Investors. These days, par values for
common stocks are usually set at very low
Values (less than P1), so the importance of
par value has decreased substantially.
3. Preferred stock is stock that carries certain
preferences over common stock, such as
prior claims to dividends and liquidation
preferences. Often preferred stock has no
voting rights or only limited voting rights,
and dividends are usually limited to a stated
percentage or amount. The special rights of
a particular issue of preferred stock are
outlined in the articles of incorporation and
the preferred stock certificates issued by the
corporation.
4. When a stock is issued for noncash assets
or services, the fair market value of the
stock or the fair market value of the
property or services, whichever is more
objectively determinable, is used to record
the transaction.
5. A company may repurchase its stock for
any of the following reasons:
• To provide shares for incentive
compensation plans
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• To obtain shares for convertible
securities holders
• To reduce the amount of equity
outstanding
• To invest excess cash temporarily
• To protect against a hostile takeover
• To improve per-share earnings
• To display confidence that the stock is
currently undervalued
6. a. The cost method of accounting for
treasury stock records the treasury
stock at cost, pending final disposition
of the stock; the par value method
treats the acquisition of treasury stock
as effective or “constructive”
retirement of outstanding stock.
b. Total stockholders’ equity will be the
same regardless of whether the cost
method or the par value method is used
to account for treasury stock. The
respective amounts of retained earnings
and paid-in capital may differ,
however.
7. The difference between the purchase price
and the selling price of treasury stock
It is correctly excluded from the income
statement because treasury stock
transactions cannot be considered to give
rise to a gain or a loss. Gain or loss arises
from the utilization of assets or resources
by the corporation in operating and
investing activities. Because the
recognition of treasury stock as an asset is
discouraged, transactions in treasury stock
are considered capital transactions between
the company and its stockholders and thus
do not give rise to a gain or a loss.
8. If warrants are detachable, the issuance
proceeds are allocated between the security
and the warrant, based on the relative fair
market values of each. If warrants are
nondetachable, no allocation is made to
recognize the value of the warrant. The
Entire proceeds are assigned to the security
Page 34
 to which the warrant is attached.
9. The option value used in the computation
of compensation expense associated with a
basic stock-based compensation plan is the
estimated fair value of the option on the
grant date.
10. The catch-up adjustment causes the
cumulative expense recognized to equal the
amount it would have been had the revised
number of options probable to vest been
used all along in the yearly computations of
expense.
11. When a stock-based award calls for
settlement in cash, the obligation is
accounted for as a liability.
12. Mandatorily redeemable preferred shares
should be reported in the balance sheet as a
liability.
inventory errors) and may need no
correction.
16. With a stock split, the par value of each
share is reduced, and the number of shares
outstanding is increased. The total par
value of shares is unchanged. With a stock
dividend, the par value of each share is
Unchanged, and because the number of
shares outstanding is increased, the total
par value is increased. This par value
increase is effected through a transfer to par
value from Retained Earnings and
Additional Paid-In Capital. With a small
stock dividend, the market value of the
newly issued shares is transferred. With a
large stock dividend, the par value of the
new shares is transferred.
17. a. A liquidating dividend is a distribution
of contributed capital to stockholders.
b. A liquidating dividend is paid when a
corporation is undertaking a partial or
complete liquidation.

18. Each equity reserve account is associated

13. When a corporation writes a put option on
with legal restrictions dictating whether it
its shares, the corporation typically receives
can be distributed to shareholders.
cash. In return, the corporation agrees to
Therefore, the accounting for equity
repurchase shares of its stock at a set price
reserves directly influences a firm’s ability
at some future date if those shares are
to pay dividends. The most important
offered for sale by the option holder.
distinction is whether the equity reserve is
part of distributable or nondistributable
14. An obligation that requires a company to equity.
deliver a fixed number of its shares should
be classified as equity because the party to
whom the shares must be given is at risk to
the same extent as are the existing
shareholders. An obligation to provide
shares with a fixed monetary amount is
reported as a liability rather than as equity.

15. If an error is discovered in the current year,

it is corrected with a correcting entry. If a
material error is found in a year after the
error, the error is corrected by a prior-
period adjustment whereby the beginning
balance in Retained Earnings is adjusted.
Some errors are counterbalancing (e.g.,

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INVESTMENTS IN DEBT & EQUITY
SECURITIES
1. Companies make investments in the
securities of another company to provide a
safety cushion of available funds and to
store a temporary excess of cash.
Companies also invest in other companies
to earn a return, to secure influence, or to
gain control.
2. A security is classified as held to maturity
if the business has the intent and the ability
to keep the security to maturity.
4. To be classified as trading security, the
security must have a readily determinable
fair value. It must be purchased and held to
sell it to generate profits on short-term
differences in price.
5. The effective-interest method computes
interest revenue by multiplying the
effective interest rate by the carrying value
of the investment.
6. When a company does not own more than
50% of a company, other factors may be
considered to determine if the control
exists. Such factors include owning a large
minority voting interest with no other
shareholder owning a significant block of
stock or having a majority voting interest in
determining who is on the company’s board
of directors. When these other factors exist,
then control may be assumed, and
consolidation would be appropriate.
7. (a) Factors that may indicate the ability of
a minority-interest investor to exercise
significant influence over an investee’s
operating and financial policies are as
follows:
1. Representation on the board of
directors of the investee.
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2. Participation in the policy-making
process.
3. Material intercompany transactions
between investees and investors.
4. Interchange of managerial
personnel between investees and
investors.
5. The technological dependency of
investee on an investor.
6. Substantial minority interest of the
investor in an investee whose
shares of stock are widely
distributed and not concentrated for
Control purposes.
(b) Factors that may indicate the inability
of an investor with more than 20% of a
company’s stock to exercise significant
influence over an investee’s operating
and financial policies are as follows:
1. Opposition by the investee, such as
litigation or complaints to
governmental regulatory
authorities.
2. An agreement between the investor
and the investee under which the
investor surrenders significant
rights as a shareholder.
3. The majority ownership of the
investee is concentrated among a
small group of shareholders who
operate the investee without regard
to the views of the investor.
4. The investor needs or wants more
financial information to apply the
equity method than is available to
the investee’s other shareholders,
tries to obtain the information, and
fails.
5. The investor tries and fails to
obtain representation on the
investee’s board of directors.
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 8. A joint venture is accounted for using
the equity method for those partners that
own 20% or more and not more than 50%
of the joint venture. For these joint venture
partners, the liabilities of the joint venture
do not show up on the balance sheet.
Instead, only the net investment in the joint
venture shows up on the balance sheet.
Thus, the liabilities of the joint venture are
“off” the balance sheet of the partners that
account for the joint venture using the
equity method.

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EARNINGS PER SHARE
1. Earnings per share information are used by
investors to evaluate the results of
operations of a business and estimate future
earnings. Because earnings are an essential
determinant of the market price of a
company’s common stock, the EPS
measurement will aid the investor in
determining the attractiveness of an
investment in a company’s stock. Earnings
per share information are also used to judge
the dividend policy of a business, which is
another critical determinant of the market
price.
2. Earnings per share data have the same
limitations that any income figure has
under current generally accepted
accounting principles. The alternative
methods available for computing net
income sometimes make comparisons
among companies difficult, and the
condensed EPS figure does not remove this
difficulty. In some cases, the existence of
EPS data even increases the lack of
comparability because EPS information is
frequently disclosed separately from any
note disclosure describing the accounting
methods employed.
3. The investor uses EPS to help forecast the
future profitability of an investment. If
potential future common stock transactions
dilute the investor’s ownership interest in
the company, future EPS will decline
relative to the past figures under the same
conditions. By preparing predictive EPS,
the potential impact of conversion of
convertible securities and exercise of stock
options, warrants, or rights can be captured
in the EPS figure.
4. A simple capital structure consists only of
common or common and preferred stock. It
includes no convertible securities, options,
warrants, or rights that upon conversion or
exercise would in the aggregate dilute EPS.
A complex capital structure includes
securities and rights that would have a
dilutive effect on EPS if converted or
exercised.
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5. When a company issues a stock dividend, a
stock split, or a reverse stock split, the
number of shares of stock is changed, but
there is no other effect on the corporation’s
resources. To meaningfully compare EPS
figures in the current period with earlier
periods, the new capital structure should be
reflected retroactively in all prior periods.
The unit in which EPS is measured should
always be uniform across accounting
periods.
6. Dilution of EPS refers to the effect that
certain types of securities - whose terms
enable their holders to acquire common
shares - will have on EPS data if these
securities are converted into common stock.
If in a complex capital structure,
conversion of convertible securities or
exercise of options, warrants, or rights
would reduce the EPS from what it would
have been using only common shares
outstanding, dilution of EPS has occurred.
7. Anti-dilutive security is one whose terms
permit it to be exercised or converted into
common stock. Still, if converted, the EPS
would be increased, or the loss per share
decreased from what it would have been
using only common shares outstanding.
Because of changing economic conditions,
security may be dilutive in one accounting
period but anti-dilutive in another. If stock
options, warrants, rights, or convertible
securities are anti-dilutive, they are ignored
in computing EPS. Antidilutive securities
are ignored for two reasons. First, by doing
so, diluted EPS gives a worst-case scenario
for existing stockholders. Second, the
economic terms of anti-dilutive securities
suggest that the probability that they will be
converted soon is low.
8. The treasury stock method is a means of
determining the extent of dilution in EPS
arising from options, warrants, and rights.
Under the treasury stock method, EPS is
computed as though the options, warrants,
and rights were exercised at the beginning
of the period or at time of issuance,
whichever comes later, and as though the
funds obtained thereby were applied to the
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 reacquisition of common stock at the
market price for that period. The
computation is necessary whenever the
market price of the available stock exceeds
the exercise price of the options, warrants,
or rights during the period.
9. The interest expense related to convertible
debt, net of taxes, should be added back to
income (in the numerator) for the
computation of EPS.
10. The if-converted method assumes the
conversion of the security as of the
beginning of the fiscal year or as of the date
of issue, whichever comes later. It is used
to compute EPS “as if” the securities were
converted.
11. When stock options are exercised, the new
shares issued are included in the
computation of all EPS amounts. The
diluted EPS is computed as if the exercise
took place as of the beginning of the year.
In computing diluted EPS, the stock price
at the exercise date is used to calculate the
incremental number of shares assumed to
be issued before the exercise date.
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13. The inclusion of stock options and
convertible securities in the computation of
EPS decreases the absolute value of the
EPS. When a company experiences a net
loss, the inclusion of these securities
decreases the loss per share just as it
reduces the income per share. Thus, the
inclusion of stock options and convertible
securities would always be anti-dilutive
under loss conditions.
‡
14. To obtain the lowest possible EPS amount,
a company with multiple potentially
dilutive securities first includes any dilutive
stock options, warrants, or rights in the
computations. If there are several
convertible securities, the impact of each
on EPS must be considered on an
individual basis. The EPS amount can then
be computed by including the convertible
securities one at a time, beginning with the
security having the lowest incremental
EPS. When the recomputed EPS is less
than the incremental EPS of the next
security, no additional convertible
securities are considered in computing EPS.
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DERIVATIVES
1. A derivative derives its value from the
movements in prices, interest rates, or
exchange rates associated with other
financial instruments, assets, or liabilities.
Also, derivative contracts are often entered
into without any exchange of cash at the
contract date. The derivative can have zero
value on the contract date. Still, its value
changes subsequently (up or down),
depending on the movement of the relevant
price or rate associated with the underlying
item.
2. A derivative contract is often an executory
contract because it doesn’t involve a
transaction but is merely an exchange of
promises about future actions. Other
examples of an executory contract are
operating leases and a salary agreement for
the coming year between employer and
employee: The employer agrees to pay a
certain amount if the employee works, and
the employee agrees to work if the
employer pays that certain amount.
3. The four types of risk discussed in the
chapter are as follows:
• Price risk—uncertainty about the
future price of an asset.
• Credit risk—uncertainty over whether
the party on the other side of a
transaction will abide by the terms of
the agreement.
• Interest rate risk—possibility about
Future interest rates and their impact on
cash flows and the fair value of
financial instruments.
• Exchange rate risk—uncertainty about
the future peso cash flows stemming
from assets and liabilities denominated
in foreign currencies.
4. Interest payments come in two general
varieties - fixed payments and variable
payments. Sometimes it is easier for a firm
to negotiate a fixed-rate loan; sometimes, it
is easier to negotiate a variable-rate loan. If
a firm is obligated to pay one type of
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interest payment but would prefer to be
paying the other, an interest rate swap can
be used to transform the unwanted payment
stream into the one that is desired.
5. A forward contract is an agreement
negotiated between two parties to exchange
a specified amount of a commodity,
security, or foreign currency at a specified
date in the future with the price or
exchange rate being set now. A futures
contract is the same thing except that
instead of being negotiated between two
parties, the contract is a standard one that is
sponsored by an organized exchange. With
a futures contract, the exchange handles the
cash settlements between the two parties to
the contract. Accordingly, with a futures
contract, the two parties to the agreement
rarely directly contact one another. This is
not true with forwarding contracts because
they are directly negotiated between the
two parties.
6. Swaps, forwards, and futures provide two-
sided protection. If these derivative
instruments are used in a hedging
relationship, they hedge against both
increases and decreases in prices or rates.
An option offers one-sided hedging:
protection against unfavorable movements
in prices or rates without taking away the
ability of the firm to profit from a favorable
movement in prices or rates. Because of the
one-sided nature of an option, an option has
a value at the agreed date, and the buyer of
the option must pay this amount at the
beginning of the contract period.
7. A cash flow hedge is a derivative that
offsets, at least partially, the variability in
cash flows from a probable forecasted
transaction. One example of a cash flow
hedge is an interest rate swap that hedges
the fluctuation in variable-rate interest
payments. Another example is a futures
contract used to lock in the price of
purchases to be made in a future period.
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8. Traditional historical cost accounting is
inappropriate when accounting for
derivative contracts because the historical
cost of a derivative is usually minimal,
sometimes zero. With derivatives, the
subsequent changes in prices or rates are
critical to determining the value of the
derivative, yet these changes are frequently
ignored in traditional accounting.
9. Partial hedge ineffectiveness occurs when
the terms of a derivative have not been
constructed to exactly match the amount
and timing of the underlying hedged item.
Partial hedge ineffectiveness would arise if,
for example, the derivative maturity date
did not exactly match the date of a
forecasted purchase.
10. The appropriate financial statement
treatment of unrealized gains and losses on
derivatives depends on whether the
derivative serves as a hedge and, if so, the
type of hedge.
• No hedge. All changes in fair value are
recognized as gains or losses in the
income statement in the period in
which the value changes.
• Fair value hedge. Changes in fair value
are recognized as gains or losses and
are offset (either in whole or in part) by
the recognition of gains or losses on the
change in fair value of the item being
hedged.
• Cash flow hedge. Changes in fair value
are recognized as part of
comprehensive income. These deferred
derivative gains and losses are
recognized in net income in the period
in which the hedged cash flow
transaction was forecasted to occur.
11. The notional amount is the total face
amount of the asset or liability that
underlies the derivative contract. The
notional amount can be misleading because
the value of a derivative is a function of
changes in prices or interest rates and
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usually is equal to just a small fraction of
the notional amount of the underlying asset.
For example, if a firm has a futures contract
to purchase a certain amount of foreign
currency for P1,000,000, the notional
amount of the futures contract is
P1,000,000. However, the futures contract
has value only if exchange rates change.
The futures contract is likely to have a
value that is far less than the notional
amount.
12. Derivatives that serve as economic hedges
of foreign currency assets and liabilities are
accounted for as speculations with all gains
and losses recognized as part of income
immediately.
13. The accounting for a speculative derivative
investment is very straightforward; the
derivative is reported as an asset or liability
in the balance sheet at its market value as
of the balance sheet date, and any
unrealized gains or losses are always
included in the computation of net income
for the period. Derivatives that serve as a
hedge are also reported in the balance sheet
at their market value, but unrealized gains
or losses might be deferred if the derivative
serves as a cash flow hedge.
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CONTINGENCIES

1. Contingent liabilities that are reasonably

possible of becoming liabilities should be
disclosed in the notes to the financial
statements. Only probable contingent
liabilities should be recognized in the
balance sheet if they can be reasonably
estimated.

2. Contingent gains should be recognized if it

is probable that they will be realized. If a
contingent gain is only possible, often, no
mention is made about it in the notes to
avoid misleading financial statement users
about the likelihood of the gain being
realized.

3. The key factors to consider in deciding

whether a pending lawsuit should be
reported as a liability on the balance sheet
are as follows:

• The nature of the lawsuit

• Progress of the case in court, including

progress between the date of the
financial statements and their issuance
date

• Views of legal counsel as to the

probability of loss

• Prior experience with similar cases

• Management’s intended response to

the lawsuit

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 information to external users and offers
SEGMENT REPORTING external users with the same type of data
1. Many companies today are large, complex used internally by management.
organizations engaged in a variety of
activities that bear little relationship to one
another. This means that one segment could
be operating very profitably while another
could be experiencing a loss. To analyze a
company's activities and status, it is helpful
to divide the company into segments so that
individual segments can be compared with
similar companies or segments. Overall,
company analysis is less useful because
there are no standard companies against
which to measure the entire operation. If
segment information is available, analysis
can be expanded to treat each segment as
though it were a separate company.

2. A segment is reportable if it meets any one

of the following three criteria:
• Revenue test. A segment should be
reported if its total revenue (both to
external customers and other internal
segments) is 10% or more of the total
revenue (external and internal).

• Profit test. A segment should be

reported if the absolute value of its
operating profit (or loss) is more than
10% of the total of the operating profit
for all segments that reported profits (or
the sum of the losses for all segments
that reported losses).

• Asset test. A segment should be reported

if it contains 10% or more of the
combined assets of all operating
segments.
3. Segment information often is not prepared
according to GAAP. Accounting principles
designed for an entire entity are not always
applicable to the individual pieces of a
business. Firms are instructed to prepare
segment information using the same
practices applied in making internal reports,
whether these internal practices conform
with GAAP or not. This lowers the
incremental cost of providing segment

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INTERIM REPORTING

1. Financial statements for each interim

period should reflect all deferrals, accruals,
adjustments, and estimates that would be
required for any accounting period. An
interim period is not separate but is an
integral part of the total annual period.
Revenues and costs are assigned to interim
periods on a reasonable basis, such as time,
sales volume, or production.

2. Investors should use care in interpreting

interim reports because of the potential
danger of misinterpreting these reports.
Several factors may cause investors to
misinterpret this information. The
seasonality of individual businesses may
seriously distort reported earnings for
particular interim periods. "Below the line"
items will have a greater impact on interim
earnings than on yearly earnings. Also, for
preparers of interim reports to supply such
information to investors, an increased
number of estimates must be made for the
interim period. This increases the
subjectivity of these reports.

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ACCOUNTING CHANGES & ERROR
CORRECTIONS
1. Comparability enables users to relate
accounting information to a benchmark or
standard. The benchmark may be in the
form of another firm’s financial statements
or financial data of the same firm but for
some other period. An accounting change
could make it difficult to compare data
from one period to another or from one
firm to another, thus detracting from
comparability.
For example, if a company switched from
straight-line depreciation to double-
declining-balance depreciation in 2021,
depreciation expense for 2021 could not be
compared with prior years’ depreciation
expense without knowing the effects of the
change in accounting for depreciation.
Consistency means that a company applies
the same methods to similar transactions
and events from period to period. Therefore
accounting changes, especially changes in
methods used, would detract from the
informational characteristic of consistency.
4. a. Examples of areas for which changes in
2. a. Change in accounting estimate. As a
result of experience or the availability
of new information, a company may
revise estimates used in the
measurement of income.
b. Change in accounting principle. A
change in accounting principle or
method may be required due to
changing economic conditions or as a
result of a new pronouncement issued
by an authoritative standard-setting
body.
3. Alternative procedures suggested for
reporting accounting changes are as
follows:
a. Restate the financial statements
presented for prior periods to reflect the
effect of the change. Adjust the
beginning retained earnings balance of
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the earliest period reported for the
cumulative impact of the change in all
preceding years.
b. Not adjust statements presented for
prior periods. Report the cumulative
effect of the change in the current year
as a direct entry to Retained Earnings.
c. Same as (b) except report the
cumulative effect of the change as a
particular item in the income statement
instead of directly to Retained
Earnings.
d. Report the cumulative effect in the
current years as in (c) but also present
limited pro forma information for all
prior periods included in the financial
statements, reporting “what might have
been” if the change had been made in
the previous years.
e. Make the change effective only for
current and future periods with no
catch-up adjustment.
accounting estimates are often made
include these:
(1) Uncollectible receivables
(2) Useful lives of depreciable or
intangible assets
(3) Residual values for depreciable
assets
(4) Warranty obligations
(5) Amounts of mineral reserves to be
depleted
(6) Actuarial assumptions for pensions
or other postemployment benefits
(7) Number of periods benefited by
deferred costs
b. A change in estimate should be
reflected either in the current period or
in current and future periods. No
retrospective adjustments are to be
prepared for a change in the accounting
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 estimate. year of the combination and the preceding
year. Computations must be made to adjust
c. This procedure is considered proper the reported numbers to what they would
because changes in estimates are have been if the combination had occurred
deemed to be part of the normal at the beginning of the current year and to
accounting process and not corrections what they would have been if the
or changes of prior periods. combination had happened at the beginning
of the preceding year.
5. A change in depreciation method is
accounted for as “a change in accounting
estimate effected by a change in accounting 12. a. For bookkeeping purposes, accounting
principle.” The existing depreciable book errors are to be treated as prior-period
value is depreciated over the remaining adjustments and recorded as a direct
useful life using the new depreciation adjustment to Retained Earnings. The
method. reported comparative financial
statements are restated to correct for
6. A change in accounting principle is the errors.
implemented by recomputing all financial
statement amounts for the preceding years b. Counterbalancing errors are those that,
(at least those that will be included in the if not detected during the current
current year’s comparative financial period, is offset by an equal
statements). These recomputed amounts are misstatement in subsequent periods.
included in the comparative financial
statements reported this year. Any income
effect in even earlier years is shown as an
adjustment to the beginning balance in
Retained Earnings for the earliest year
reported. Note disclosure gives a line-by-
line comparison of these retrospectively
adjusted financial statements and the
financial statements (using the former
accounting principles) that were initially
reported.

8. a. The effects of a change in accounting

principle should be reported as a direct
adjustment to the current year’s
beginning retained earnings balance
when it is impractical to determine the
precise periods when past differences
arose.

b. The effects of a change in accounting

principle should be reflected
prospectively only when it is
impossible to determine the past impact
of an accounting change.

9. Following a business combination, the

combined company must provide pro forma
revenue and net income information for the

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FS ANALYSIS
1. In addition to identifying a company’s
weaknesses, financial statement analysis
can be used to predict a company’s future
profitability and cash flows based on its
past performance.
2. Comparative financial statements provide a
better indication of the nature and trends of
changes affecting a business enterprise.
Total amounts, in the absence of a
benchmark, are not very good indications
of performance or efficiency. Comparative
statements at least provide a basis for
judgment to other periods or industry data.
Comparative statements are more useful if
there is uniformity of presentation and
content, consistency of application of
accounting principles, and disclosure of
significant changes in circumstances and
the resulting impact of those changes.
3. Analysis of financial ratios does not reveal
the underlying causes of a firm’s problems.
Financial statement analysis only identifies
the problem areas. The only way to find out
why the financial ratios look bad is to
gather information from outside the
financial statements: ask management, read
press releases, talk to financial analysts
who follow the firm, and read industry
newsletters. Financial ratio analysis does
not give the final answers, but it does point
out areas about which more detailed
questions should be asked.
4. A common-size financial statement is a
financial statement for which each number
in a given year is standardized by a
measure of the size of the company in that
year. A common standardization is to
divide all financial statement numbers by
sales for the year. Common-size statements
make possible a ready comparison of
financial data for companies of different
size-either the same company in different
years or different companies at the same
point in time.
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5. The DuPont framework decomposes return
on equity into three components:
profitability, efficiency, and leverage. For
each of these components, a single ratio is
used to give a summary measure of how the
company is performing in that area. The
summary measures follow:
• Profitability: Return on sales
• Efficiency: Asset turnover
• Leverage: Assets-to-equity
Once the DuPont framework calculations
have given a general picture of a
company’s performance, more detailed
ratios can be computed to yield specific
information about each of the three areas.
6. a. Inventory turnover is computed by
dividing the cost of goods sold for the
period by the average inventory.
b. In arriving at a rate of inventory
turnover, it is essential that the inventory
figures used to compute the average
inventory be representative. If the
beginning and ending balances are
unusually high or low, the turnover rate
may be misleading.
c. A rising inventory turnover rate
indicates that a smaller amount of
capital is tied up in inventory for a given
volume of business. This may mean
more efficient buying and
merchandising policies. However, if the
turnover rate is higher than for other
firms in the industry, it may indicate
dangerously low levels of inventory,
exposing the firm to the risk of
inventory shortages and running out of
stock.
7. a. Times interest earned. Computed by
dividing earnings before interest and
taxes (operating income) by interest
expense for the period. This measures a
company’s ability to meet interest
payments and suggests the security
afforded to creditors.
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 b. Return on equity. Computed by
dividing net income by stockholders’
equity. This measurement indicates
management’s effectiveness in
employing the funds provided by the
stockholders in generating profits.
c. Earnings per share. Computed by
dividing net income by the weighted
average number of common shares
outstanding. EPS is a number useful in
evaluating the level of cash dividends
per share relative to income and in
assessing the market price per share
relative to income.
d. Price-earnings ratio. Computed by
dividing the market price per share by
earnings per share. The P/E ratio shows
how much investors are willing to pay
for each dollar of current earnings and
is an indication of what investors
believe about a company’s future
growth prospects.
e. Dividend payout ratio. Computed by
dividing cash dividends by net income.
This ratio reveals what fraction of
income a company distributes to
shareholders in the form of cash
dividends.
f. Book-to-market ratio. Computed by
dividing the total book value of equity
by the total market value of shares
outstanding. This ratio reveals how the
market is currently valuing the net
investment in a company relative to the
amount of investment provided initially
by the stockholders. Book-to-market
ratios are usually less than 1.0,
indicating that the market value of the
firm is greater than the total equity
funds provided by the stockholders.
8. One of the factors affecting overall firm
performance is the ability to invest in an
asset and sell it at a profit. The turnover of
the assets affects the return on assets
because a profit will be made each time the
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operating cycle is completed (investment in
an asset, selling the asset to a customer,
collection of cash). If within a given
accounting period, an organization
completes more than one operating cycle,
the resulting return on total assets will be a
function of the profit percentage on each
sale and the number of completed operating
cycles. Thus, the return on assets may be
increased by either increasing the turnover
of assets or by increasing the profit made
on each sale.
9. The return on assets equals the ROE when
total assets equal total stockholders’
equity, meaning that there are no liabilities.
Overall, the ROE will always exceed the
return on assets (unless a company’s
liabilities exceed its assets); however, on
marginal or new investments, this will be
true only if the return on the new assets
exceeds the cost of obtaining the additional
funds.
10. Ratio comparisons can yield misleading
implications if the ratios come from
companies with different accounting
practices. Differences in accounting
methods can make one company look
superior to another even though they are
economically identical. For example, if one
company uses a 10-year life for
depreciating fixed assets and another
depreciates similar assets over a 15-year
life, the decreased depreciation expense for
the second company will make it look more
profitable even in the absence of real
differences in operating performance.
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