6–1. Explain why an analyst attaches great importance to evaluation of the income statement.

The income statement portrays the net results of operations of an enterprise. Since
results are what enterprises are established to achieve and since their value is, in
large measure, determined by the size and quality of these results, it follows that the
analyst attaches great importance to the income statement.

6–2. Define income. Distinguish income from cash flow.

Income summarizes in financial terms the operating activities of a company. Income

is the amount of revenues and gains for the period in excess of expenses and losses,
all computed under accrual accounting. Income provides a measure of the change in
shareholder wealth for a period and an indication of a company’s future earning
power. Accounting income differs from cash flows because certain revenues and
gains are recognized in periods before or after cash is received and certain expenses
and losses are recognized in periods before or after cash is paid.

6–3. What are the two basic economic concepts of income? What implications do they have for
analysis?

Economic income is net cash flows plus the change in the present value of future
cash flows. Another similar concept, the Hicksian concept of income, considers
income for the period to be the amount that can be withdrawn from the company in a
period without changing the net wealth of the company. Hicksian income equals cash
flow plus the change in the fair value of net assets.

6–4. Explain how accountants measure income.

Accounting income is the excess of revenues and gains over expenses and losses
measured using accrual accounting. As such, revenues (and gains) are recognized
when earned and expenses (losses) are matched against the revenues (and gains).

6–5. Distinguish between net income, comprehensive income, and continuing income. Cite examples
of items that create differences between these three income measures.

Net income is the excess of the revenues and gains of the company over the
expenses and losses of the company. Net income often is called the “bottom line,”
although that is a misnomer because certain unrealized holding gains and losses are
charged directly to equity and bypass net income. Comprehensive income includes
all changes in equity that result from non-owner transactions (excluding items such
as dividends and stock issuances). Items creating differences between net income
and comprehensive income include unrealized gains and losses on available for sale
securities, foreign currency translation adjustments, minimum pension liability
adjustments, and unrealized holding gains or losses on derivative instruments.
Comprehensive income is the ultimate “bottom line” income number. Continuing
income is a measure of net income earned by ongoing segments of the company.
Continuing income differs from net income because continuing income excludes the
income or loss of segments of the company that are to be discontinued or sold (it
also excludes extraordinary items and effects from changes in accounting principles).

6–6. Although comprehensive income is the bottom line income number, it is rarely reported in the
income statement. Where will you typically find details regarding comprehensive income?
Details regarding comprehensive income are reported by the vast majority of
companies in the statement of stockholders’ equity rather than the income statement.

6–7. Analysts often refer to the core income of a company. What is meant by the term core income?

Core income is a measure of income that excludes all non-recurring items that are
reported as separate items on the income statement.

6–8. Distinguish between operating and nonoperating income. Cite examples of items that are
typically included in each category.

Operating income is a measure of firm performance from operating activities.

Examples of operating income include product sales, cost of product sales, and
selling, general, and administrative costs. Non-operating income includes all
components of income not included in operating income. Examples of non-operating
income include interest revenue and interest expense.

6–9. Operating vs. nonoperating and recurring vs. nonrecurring are two distinct dimensions of
classifying income. Explain this statement and discuss whether or not you agree with it.

Operating versus non-operating and recurring versus non-recurring are distinct

dimensions of classifying income. While there is overlap across selected items, these
dimensions reflect different characteristics of business activities. For example, the
interest income and interest expense of most companies recur in net income; hence,
they are included in recurring income. However, these items are non-operating in
nature. Similarly, non-recurring items such as restructuring charge are operating in
nature.

6–10. How does accounting define an extraordinary item? Cite three examples of such an item.
What are the analysis implications of such an item?

Accounting standards (APB 30) restricted the use of the "extraordinary" category by
requiring that an extraordinary item be both unusual in nature and infrequent in
occurrence. These attributes are defined as follows:
a. Unusual nature of the underlying event or transaction should possess a high
degree of abnormality and be of a type clearly unrelated to, or only incidentally
related to, the ordinary and typical activities of the entity, taking into account
the environment in which the entity operates.
b. Infrequency of occurrence of the underlying event or transaction should be of
a type that would not reasonably be expected to recur in the foreseeable
future, taking into account the environment in which the entity operates.

Three examples of extraordinary items are:

 Major casualty losses from an event such as an earthquake, flood, or fire.

 A gain or loss from expropriation of property.
 A gain or loss from condemnation of land by eminent domain.

6–11. Describe the accounting treatment for discontinued operations. How should an analyst treat
discontinued operations?
To qualify as discontinued operations, the assets and business activities of the
divested segment must be clearly distinguishable from the assets and business
activities of the remaining entity. Accounting and reporting for discontinued
operations is two-fold. First, the income statement for the current and prior two years
are restated after excluding the effects of the discontinued operations from the line
items that determine continuing income. Second, gains or losses pertaining to the
discontinued operations are reported separately, net of related tax effects. An analyst
should separate and ignore discontinued operations in predicting future performance
and financial condition.

E6-1

Many companies report discontinued operations in their income statements and balance sheets.
Required: a. What is your best estimate of the summary journal entry recording the disposal of
discontinued operations. b. What is included in the income (expense) items relating to discontinued
operations as reported in the income statement? c. Discuss the importance of discontinued
operations in analyzing a company’s financial statements. d. What is the rationale for separately
reporting the results of discontinued operations?

a. Cash xxx
Gain on disposition* xxx
Net assets of discontinued operations xxx
* (A loss on disposition would be recorded as a debit)

b. Income (expense) related to discontinued operations include the operating profit

(loss) recorded prior to sale and the gain (loss) on sale. These are reported net of
applicable tax.

c. When estimating future earning power, the results from discontinued operations
should not be treated as recurring. This is important for an assessment of the
permanent income of a company.

d. Separately reporting discontinued operations allows the analyst to view the

results of operations without the segment that will not be ongoing. As a result,
the analyst can better assess the permanent component of income, for which
results of discontinuing operations will be excluded.

E6-3

There are various types of accounting changes requiring different types of reporting treatments.
Understanding the different changes is important to analysis of financial statements. Required: a.
Under what category of accounting changes is the change from sum-of-the-years’-digits method of
depreciation to the straight-line method for previously recorded assets classified? Under what
circumstances does this type of accounting change occur? b. Under what category of accounting
changes is the change in expected service life of an asset (due to new information) classified? Under
what circumstances does this type of accounting change occur? c. Regarding changes in accounting
principle: (1) How does a company compute the effect of such changes? (2) How does a company
report the effect of these changes? Note: Do not discuss earnings per share requirements. d. Why
are accounting principles, once adopted, normally consistently applied over time? e. What is the
rationale for disclosure of a change from one accounting principle to another? f. Discuss how your
analysis of mandatory accounting changes might differ from that of voluntary accounting changes. g.
Discuss how companies might time the adoption of mandatory accounting changes for their own
benefit. h. Discuss how the adoption of mandatory accounting changes can create an opportunity to
establish a hidden reserve. Cite examples.

a. A change from the sum-of-the-years'-digits method of depreciation to the

straight-line method for previously recorded assets is a change in accounting
principle. Both the sum-of-the-years'-digits method and the straight-line
method are generally accepted. A change in accounting principle results from
adoption of a generally accepted accounting principle different from the
generally accepted accounting principle used previously for reporting
purposes.
b. A change in the expected service life of an asset arising because of more
experience with the asset is a change in accounting estimate. A change in
accounting estimate occurs because future events and their effects cannot be
perceived with certainty. Estimates are an inherent part of the accounting process.
Therefore, accounting and reporting for certain financial statement elements
requires the exercise of judgment, subject to revision based on experience.

c. 1. The cumulative effect of a change in accounting principle is the difference between: (1) the

amount of retained earnings at the beginning of the period of change and (2) the amount of

retained earnings that would have been reported at that date if the new accounting

principle had been used in prior periods.

2. FASB 2005 Statement “Accounting Changes and Error Corrections” requires

that effective in 2005, companies should apply the “retrospective approach” to changes in

accounting principle. Thus, all presented periods must be restated as if the change were in

effect during those periods, and any cumulative effect from periods before those presented

is an adjustment to beginning retained earnings of the earliest period presented.

d. Consistent use of accounting principles from one accounting period to another

enhances the usefulness of financial statements in comparative analysis of
accounting data across time.
e. If a change in accounting principle occurs, the nature and effect of a change in
accounting principle should be disclosed to avoid misleading financial statement
users. There is a presumption that an accounting principle, once adopted, should
not be changed in accounting for events and transactions of a similar type.

f. Mandatory accounting changes are largely non-discretionary. Thus, managerial

discretion is not present, or at least is to a lesser degree. One should examine the
motivations for voluntary accounting changes and assess any earnings quality
impact.

g. Mandatory accounting changes are largely non-discretionary. However, there is

often a window of time for a company to adopt a mandatory accounting change. If
a window exists, management has discretion as to the timing of the adoption.
Thus, the timing of adoption and any accounting ramifications should be
considered. For example, if a manager is going to adopt an accounting change
that includes a large charge, the manager might choose to adopt in a relatively
poor quarter to attempt to potentially conceal or downplay the poor operating
performance.

h. Mandatory accounting changes often include the recognition of retroactive

earnings affects. For example, the rules in accounting for other post-employment
benefits require that companies establish a liability for the accrued benefits to
date. This results in a large charge for many companies. Of course, the market
potentially views the charge as largely the fault of accounting rule makers. Thus,
managers have incentive to increase the amount of the charge and use the bloated
liability to increase future earnings.

E6-5

Revenue is usually recognized at the point of sale. Under special circumstances, dates other than the
point of sale are used for timing of revenue recognition. Required: a. Why is point of sale usually
used as the basis for the timing of revenue recognition? b. Disregarding special circumstances when
bases other than the point of sale are used, discuss the merits of both of the following objections to
the sale basis of revenue recognition: (1) It is too conservative because revenue is earned
throughout the entire process of production. (2) It is too liberal because accounts receivable do not
represent disposable funds, sales returns and allowances can occur, and collection and bad debt
expenses can be incurred in a later period. c. Revenue can be recognized (1) during production and
(2) when cash is received. For each of these two bases of timing revenue recognition, give an
example of the circumstances where it is properly used and discuss the accounting merits of its use
in lieu of the sales basis.

a. The point of sale is the most widely used basis for the timing of revenue recognition because in

most cases it provides the degree of objective evidence many consider necessary to measure

reliably periodic business income. That is, sales transactions with outsiders represent the point

in the revenue generating process when most of the uncertainty about the final outcome of

business activity has been alleviated. It is also at the point of sale in most cases that substantially
 all of the costs of generating revenues are known, and they can at this point be matched with

the revenues generated to produce a reliable statement of a firm's effort and accomplishment

for the period. Any attempt to measure business income prior to the point of sale would, in the

vast majority of cases, introduce considerably more subjectivity into financial reporting than

most accountants are willing to accept.

b. 1. Though it is recognized that revenue is earned throughout the entire production process,

generally it is not feasible to measure revenue on the basis of operating activity. It is not

feasible because of the absence of suitable criteria for consistently and objectively arriving

at a periodic determination of the amount of revenue to take up. Also, in most situations

the sale is the most important single step in the earning process. Prior to the sale the

amount of revenue anticipated from the processes of production is merely prospective

revenue; its realization remains to be validated by actual sales. The accumulation of costs

during production does not alone generate revenue; rather, revenues are earned by the

entire process including the actual sales. Thus, as a general rule the sale cannot be regarded

as being an unduly conservative basis for the timing of revenue recognition. Except in

unusual circumstances, revenue recognition prior to sale would be anticipatory in nature

and unverifiable in amount.

2. To criticize the sales basis as not being sufficiently conservative because

accounts receivable do not represent disposable funds, it is necessary to assume that

collection of receivables is the decisive step in the earning process and that periodic revenue

measurement and, therefore, net income should depend on the amount of cash generated

during the period. This assumption disregards the fact that the sale usually represents the

decisive factor in the earning process and substitutes for it the administrative function of

managing and collecting receivables. That is, the investment of funds in receivables should
 be regarded as a policy designed to increase total revenues, properly recognized at the point

of sale; and the cost of managing receivables (e.g., bad debts and collection costs) should be

matched with the sales in the proper period. The fact that some revenue adjustments (such

as sales returns) and some expenses (such as bad debts and collection costs) can occur in a

period subsequent to the sale does not detract from the overall usefulness of the sales basis

for the timing of revenue recognition. Both can be estimated with sufficient accuracy so as

not to detract from the reliability of reported net income. Thus, in the vast majority of cases

for which the sales basis is used, estimating errors, though unavoidable, will be too

immaterial in amount to warrant deferring revenue recognition to a later point in time.

c. 1. During production. This basis of recognizing revenue is frequently used by companies whose

major source of revenue are long-term construction projects. For these companies the point

of sale is far less significant to the earning process than is production activity because the

sale is assured under the contract, except of course where performance is not substantially

in accordance with the contract terms. To defer revenue recognition until the completion of

long-term construction projects could impair significantly the usefulness of the intervening

annual financial statements because the volume of completed contracts during a period is

likely to bear no relationship to production volume. During each year that a project is in

process a portion of the contract price is therefore appropriately recognized as that year's

revenue. The amount of the contract price to be recognized should be proportionate to the

year's production progress on the project. It should be noted that the use of the production

basis in lieu of the sales basis for the timing of revenue recognition is justifiable only when

total profit or loss on the contracts can be estimated with reasonable accuracy and its

ultimate realization is reasonably assured.

 2. When cash is received. The most common application of this basis for the

timing of revenue recognition is in connection with installment sales contracts. Its use is

justified on the grounds that, due to the length of the collection period, increased risks of

default, and higher collection costs, there is too much uncertainty to warrant revenue

recognition until cash is received. The mere fact that sales are made on an installment

contract basis does not justify using the cash receipts basis of revenue recognition. The

justification for this departure from the sales depends essentially upon an absence of a

reasonably objective basis for estimating the amount of collection costs and bad debts that

will be incurred in later periods. If these expenses can be estimated with reasonable

accuracy, the sales basis should be used.

E6-7

Crime Control Co. accounts for a substantial part of its alarm system sales under the sales-type
(capitalized) lease method. Under this method the company computes the present value of the total
receipts it expects to get (over periods as long as eight years) from a lease and records this present
value amount as sales in the first year of the lease. Justification for this accounting is that the 8-year
lease extends over more than 75% of the 10-year useful life of the equipment. While the sales-type
lease method is used for financial reporting, for tax purposes the company reports revenues only
when received. Because first-year expenses of a lease are particularly large, the company reports
substantial tax losses on these leases. Required: a. Critics maintain the sales-type lease method
“front loads” income and that reported earnings may not be received in cash for several years.
Comment on this criticism. b. Will financial reporting income be improved from the company’s tax
benefit? c. The company insists it can achieve earnings results similar to those achieved by the sales-
type lease method by selling the lease receivables to third-party lessors or financial institutions.
Comment on this assertion.

a. Crime Control's revenue recognition practices, while not the most conservative,
conform to GAAP. The important issue is whether lessees will, in fact, continue for
their eight-year terms. Should large cancellations occur, substantial portions of
the revenue recognized in earlier years might have to be reversed in subsequent
years. This would result in distortions of earning power and earning trends. Thus,
a critical issue of this accounting is whether the company provides adequately for
contingencies such as cancellations. Should the pace of newly written sales-type
leases slow, the company's earnings growth may stop or earnings may even
decline.
b. While the tax accounting does provide the company with significant funds from
tax postponement, it does not affect reported results because under GAAP the
company is required to provide for deferred taxes which it is assumed will be
payable in the future.

c. While it is true that the sale of the receivables without recourse would enable the
company to book profits in the year the lease originated, this practice would at the
same time substantially increase the company's tax bill.

E6-9

An analyst must be familiar with the concepts involved in determining income. The amount of icome
reported for a company depends on the recognition of revenues and expenses for a given time
period. In certain cases, costs are recognized as expenses at the time of product sale; in other
situations, guidelines are applied in capitalizing costs and recognizing them as expenses in future
periods. Required: a. Explain the rationale for recognizing costs as expenses at the time of product
sale. b. What is the rationale underlying the appropriateness of treating costs as expenses of a
period instead of assigning the costs to an asset? Explain. c. Under what circumstances is it
appropriate to treat a cost as an asset instead of as an expense? Explain. d. Certain expenses are
assigned to specific accounting periods on the basis of systematic and rational allocation of asset
cost. Explain the underlying rationale for recognizing expenses on this basis. e. Identify the
conditions necessary to treat a cost as a loss.

a. Some costs are recognized as expenses on the basis of a presumed direct

association with specific revenue. This has been identified both as "associating
cause and effect" and as the "matching concept." Direct cause-and-effect
relations can seldom be conclusively demonstrated, but many costs appear to be
related to particular revenue, and recognizing them as expenses accompanies
recognition of the revenue. Generally, the matching concept requires that the
revenue recognized and the expenses incurred to produce the revenue be given
concurrent periodic recognition in the accounting records. Only if effort is
properly related to accomplishment will the results, called earnings, have useful
significance concerning the efficient utilization of business resources. Thus,
applying the matching principle recognizes the cause-and-effect relationship that
exists between expense and revenue. Examples of expenses that are usually
recognized by associating cause and effect are sales commissions, freight-out on
merchandise sold, and cost of goods sold or services provided.

b. Some costs are assigned as expenses to the current accounting period because
(1) their incurrence during the period provides no discernible future benefits; (2)
they are measures of assets recorded in previous periods from which no future
benefits are expected or can be discerned; (3) they must be incurred each
accounting year, and no buildup of expected future benefits occurs; (4) by their
nature they relate to current revenues even though they cannot be directly
associated with any specific revenues; (5) the amount of cost to be deferred can
be measured only in an arbitrary manner or great uncertainty exists regarding the
 realization of future benefits, or both; and (6) uncertainty exists regarding whether
allocating them to current and future periods will serve any useful purpose. Thus,
many costs are called "period costs" and are treated as expenses in the period
incurred because neither do they have a direct relationship with revenue earned
nor can their occurrence be directly shown to give rise to an asset. The
application of this principle of expense recognition results in charging many costs
to expense in the period in which they are paid or accrued for payment. Examples
of costs treated as period expenses would include officers' salaries, advertising,
research and development, and auditors' fees. on hand at the end of an
accounting period, the costs of insurance coverage relating to future periods, and
the costs of self-constructed plant or equipment.

d. In the absence of a direct basis for associating asset cost with revenue, and if the
asset provides benefits for two or more accounting periods, its cost should be
allocated to these periods (as an expense) in a systematic and rational manner.
When it is impractical, or impossible, to find a close cause-and-effect relationship
between revenue and cost, this relationship is often assumed to exist. Therefore,
the asset cost is allocated to the accounting periods by some method. The
allocation method used should appear reasonable to an unbiased observer and
should be followed consistently from period to period. Examples of systematic
and rational allocation of asset cost would include depreciation of fixed assets,
amortization of intangibles, and allocation of rent and insurance.

e. A cost should be treated as a loss when an unfavorable event results from an

activity other than a normal business activity. The matching of losses to specific
revenue should not be attempted because, by definition, they are expired service
potentials not related to revenue produced. That is, losses resulting from
extraneous and exogenous events that are not recurring or anticipated as
necessary in the process of producing revenue. There is no simple way of
identifying a loss, because ascertaining whether a cost should be a loss is often a
matter of judgment. The accounting distinction between an asset, expense, loss,
and prior-period adjustment is not clear-cut. For example, an expense is usually
voluntary, planned, and expected as necessary in the generation of revenue. But a
loss is a measure of the service potential expired that is considered abnormal,
unnecessary, unanticipated, and possibly nonrecurring and is usually not taken
into direct consideration in planning the size of the revenue stream.

c. A cost should be capitalized, that is, treated as an asset, when it is expected

that the asset will produce benefits in future periods. The important concept here is
that the incurrence of the cost has resulted in the acquisition of an asset, a future
service potential. If a cost is incurred that resulted in the acquisition of an asset from
which benefits are not expected beyond the current period, the cost may be expensed
as a measure of the service potential that expired in producing the current period's
revenues. Not only should the incurrence of the cost result in the acquisition of an
asset from which future benefits are expected, but also the cost should be
measurable with a reasonable degree of objectivity, and there should be reasonable
grounds for associating it with the asset acquired. Examples of costs that should be
treated as measures of assets are the costs of merchandise

P6-1

The unaudited income statements of Disposo Corporation are reproduced below. Year 8 Year 7
Sales................................... $1,100 $900 Costs and expenses ............ 990 860 Loss on asset
disposal........ 10 — Income before taxes............ 100 40 Tax expense......................... 50 20 Net
income.......................... $ 50 $ 20

Note: On August 15, Year 8, the company decided to discontinue its Metals Division. The business
was sold on December 31, Year 8, at book value except for a factory building with a book value of
$25 that was sold for $15. Operations of the Metals Division were: Sales Income (Loss) Year
7...................................... $300 $8 Jan. 1 to Aug. 15, Year 8.......... 250 (3) Aug. 16 to Dec. 31, Year
8 ....... 75 (1) Required: Correct the Year 7 and Year 8 income statements to reflect the proper
reporting of discontinued operations.

The income statements of Disposo Corp. should be shown as follows

Year 8 Year 7

Sales................................................................................... $775 $600

Costs and expenses ......................................................... (657) (576)
Pretax income.................................................................... 118 24
Tax expense....................................................................... (59) (12)
Income from continuing operations ................................ $ 59 $ 12
Discontinued operations:
Operations (net of tax) [a]........................................... (3) 8
Disposal (net of $6 tax) [b].......................................... (6)

Net Income......................................................................... $ 50 $ 20

[a] Represents net income (loss) from operations for Year 7 and for Year 8 until

August 15.

[b] Represents:

Loss from operations August 15 to December 31....................... $ (1)

Loss on sale of assets (after $5 tax)............................................. (5)
Total................................................................................................ $ (6)
 The $10 loss and related tax benefit of $5 would still be recorded (anticipated)
at December 31, Year 8 (the asset would be reduced by $10 to market value).

P6-3

Cendant was formed on December 18, 1997, via the merger of CUC International and HFS, Inc. The
company owns the rights to franchises and brands including Avis, Century 21 Real Estate, Coldwell
Banker, Days Inn, Howard Johnson, and Ramada. The consolidated entity got off to a bad start when
it was revealed that CUC International executives had been committing “widespread and systemic”
accounting fraud with intent to deceive investors. When the company announced that it had
discovered “potential accounting irregularities” the stock dropped from $36 to $19 per share.
Eventually the stock would fall to as low as $6 per share as the company struggled to convince
investors about management’s integrity. According to the company’s own investigation, CUC
executives had inflated earnings by over $650 million over a three-year period using several tactics,
including: (1) failing to timely record returned credit card purchases and membership cancellations,
(2) improperly capitalizing and amortizing expenses related to attracting new members, and (3)
recording fictitious sales. Required: a. For each of three fraudulent tactics employed by CUC, identify
an analysis technique that could have identified the accounting improprieties. b. Both the investors
and the management of HFS had relied on audited financial statements in making decisions
regarding CUC International. What do you believe was the external auditor’s culpability in not
detecting these fraudulent practices?

a. (1) Failing to timely record returned credit card purchases and membership
cancellations: An accounts receivable analysis would be the focal point to
identifying this problem. We would examine for either continual growth in
accounts receivable or unusual (unexplained) write-offs of receivables. Ratios
or techniques that compare cash collections to accounts receivable also could
potentially identify a problem area or fraudulent behavior.

(2) Improperly capitalizing and amortizing expenses related to attracting new

members: This behavior would be difficult to uncover. The key is to
understand the growth in reported intangible assets and deferred charges, and
to assess its reasonableness. Unusual increases should be viewed as a
potential red flag.

(3) Recording fictitious sales: One key to uncovering fictitious sales is to monitor
the joint behavior of sales and accounts receivable, simultaneously. Increasing
sales should not necessarily lead to slower accounts receivable turnover.
Increases in the accounts receivable turnover ratio should be investigated
because this can be caused by, among other factors, the recognition of
fictitious or uncollectible sales.

b. The external auditor must conduct the audit according to generally accepted
auditing standards. The culpability of auditors in a fraud situation varies on a
 case by case basis. It is often difficult to detect a fraud if key client personnel are
colluding and conspiring to cover up. However, in this case the fraud was so
widespread that auditor negligence is part of the problem. From an economic
perspective, this question will ultimately be answered via litigation.

P6-5

Big-Deal Construction Company specializes in building dams. During Years 3, 4, and 5, three dams
were completed. The first dam was started in Year 1 and completed in Year 3 at a profit before
income taxes of $120,000. The second and third dams were started in Year 2. The second dam was
completed in Year 4 at a profit before income taxes of $126,000, and the third dam was completed
in Year 5 at a profit before income taxes of $150,000. The company uses percentageof-completion
accounting for financial reporting and the completed-contract method of accounting for income tax
purposes. The applicable income tax rate is 50% for each of the Years 1 through 5. Data relating to
progress toward completion of work on each dam as reported by the company’s engineers are given
here: Dam Year 1 Year 2 Year 3 Year 4 Year 5 1 20% 60% 20% 2 30 60 10% 3 10 30 50 10% Required:
For each of the five years, Year 1 through Year 5, compute: a. Financial reporting (book) income. b.
Taxable income. c. Change in deferred income taxes

BIG-DEAL CONSTRUCTION CO.

Dam Year 1 Year 2 Year 3 Year 4 Year 5 Total

Book income 1 $24,000 $ 72,000 $ 24,000

$120,000
Book income 2 37,800 75,600 $ 12,600 126,000
Book income 3 15,000 45,000 75,000 $ 15,000
150,000
a. Total book income $24,000 $124,800 $144,600 $ 87,600 $ 15,000
$396,000

Taxable income 1 $120,000

$120,000
Taxable income 2 $126,000 126,000
Taxable income 3 $150,000
150,000
b. Total taxable Inc. $120,000 $126,000 $150,000
$396,000

Line 4 less Line 8 $24,000 $124,800 $ 24,600 $(38,400) $(135,000)

c. Incr. in def. tax (cr.) $12,000 $ 62,400 $ 12,300

 Decr. in def. tax (dr.) $ 19,200 $
67,500

P6-7

Playgrounds, Inc., is granted a distribution franchise by Shady Products in Year 1. Operations are
profitable until Year 4 when some of the company’s inventories are confiscated and large legal
expenses are incurred. Playgrounds’ tax rate is 50% each year (all expenses and costs are tax
deductible). Relevant income statement data are (in thousands): Year 1 Year 2 Year 3 Year 4 Year 5
Year 6 Year 7 Year 8 Sales ............................ $50 $80 $120 $ 100 $200 $400 $500 $600 Cost of
sales ................ 20 30 50 300 50 120 200 250 General and administrative ......... 10 15 20 100 20 30
40 50 Pretax income............... $20 $35 $ 50 $(300) $130 $250 $260 $300 Required: Compute tax
expense for each of the Years 1 through 8, and present comparative income statements for these
years (assume a 3-year carryback period, a 20-year carryforward period for any losses, and a 100%
valuation allowance for the loss carryforward).

Income Statement

Years 1 2 3 4 5 6 7

Sales.................................................. $50 $80 $120 $100 $200 $400 $500

$600
Cost of sales..................................... 20 30 50 300 50 120 200
250
General and administrative............. 10 15 20 100 20 30 40
50
Net income before tax...................... $20 $35 $50 $(300) $130 $250 $260
$300

Tax expense (refund)*

Current provision........................... 10 17.5 25 92.5 130
150
Refund from carryback.................. (52.5)
Tax effect of loss carryforward..... 65 32.5
Total tax expense............................. $10 $17.5 $25 $(52.5) $65 $125 $130
$150
Income before extraordinary items. 10 17.5 25 (247.5) 65 125 130
150

Extraordinary gain (reduction)

 of taxes due to carryforward......... 65 32.5

Net income (**).................................. $10 $17.5 $25$(247.5) $130 $157.5 $130

$150

* Taxable income.................................... $20 $35 $50 $(300) $(65)b $185c $260

$300

Tax due at 50% rate............................. 10 17.5 25 (52.5)a 0 92.5 130

150
a
Operating loss of $300 carried back to eliminate all taxable income for Year 1, Year 2 and
Year 3 and secure refund of $52.5 for total taxes paid during those years.
b
Income for Year 5 of $130 less loss carryforward of $195.
c
Income for Year 6 of $250 less loss carryforward of $65.

** Disclosure: Tax loss carryforwards are $195 at end of Year 4 and $65 at end of Year 5.

Accounting effects [journal entries Dr. (Cr.)]:

Tax expense..................................... 10 17.5 25 (52.5) 65 125 130 150

FIT Receivable................................. 52.5

FIT Payable...................................... (10) (17.5) (25) (92.5) (130)

..................................................(150)

Extraordinary gains (65) (32.5)