chapter the income statement and statement of cash...

Chapter 04 - The Income Statement and Statement of Cash FlowsChapter 04 - The Income Statement and Statement of Cash Flows

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

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

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

that will probably continue in futthat will probably continue in future periods. ure periods. It is important tIt is important to segregate the income effecto segregate the income effects of theses of theseitems because they are the most important transactions in terms of predicting future cash flows.items because they are the most important transactions in terms of predicting future cash flows.

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

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

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

operatoperations to arrive at total reveions to arrive at total revenues and gains. nues and gains. All expenAll expenses and lossses and losses are then grouped andes are then grouped andsubtotaled, subtracted frsubtotaled, subtracted from revenues and gains om revenues and gains to arrive at income to arrive at income from continuing operations. from continuing operations. TheThemultiple-stepmultiple-step format reports a series (multiple) of intermediate totals such as gross profit, operatingformat reports a series (multiple) of intermediate totals such as gross profit, operatingincome, and income before taxes. income, and income before taxes. Very often income statemVery often income statements adopt variations of theents adopt variations of these formats,se formats,falling somewhere in between the two extremes.falling somewhere in between the two extremes.

Question 4-5Question 4-5The termThe term earnings qualityearnings quality refers to the ability of reported earnings (income) to predict arefers to the ability of reported earnings (income) to predict a

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

Question 4-6Question 4-6 Restr Restructuriucturing ng costscosts incincludlude e coscosts ts asassocsociatiated ed witwith h shushutdotdown wn or or relrelocatocation ion of of facfaciliilitieties s or or

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

4-14-1

ChapterChapter 44 The Income Statement and Statement of CashThe Income Statement and Statement of Cash

FlowsFlows

QUESTIONS FOR REVIEW OF KEY TOPICSQUESTIONS FOR REVIEW OF KEY TOPICS


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

component of income, specifically continuing operations and any item reported below continuingcomponent of income, specifically continuing operations and any item reported below continuingoperatoperations. ions. The process is necesThe process is necessary to achieve the desiresary to achieve the desired result of separatid result of separating the ng the total incomtotal incomeeeffects of continuing operations from the two separately reported items - discontinued operationseffects of continuing operations from the two separately reported items - discontinued operationsand extraordinary items, and also to show theand extraordinary items, and also to show the after-taxafter-tax effect of each of those two components.effect of each of those two components.

Answers Answers to Questions (continued)to Questions (continued)

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

income statincome statementement, , below income from continbelow income from continuing operatiuing operations. ons. The income effects inclThe income effects include incomeude income(loss) from operations (loss) from operations and gain (loss) on diand gain (loss) on disposal. sposal. The gain or loss on diThe gain or loss on disposal must sposal must be disclosedbe disclosedeither on the face of the statement or in a diseither on the face of the statement or in a disclosure note. closure note. If the component is held for sale but notIf the component is held for sale but notsolsold d by by the end the end of of the the repreportorting ing perperiodiod, , the income effecthe income effects ts wilwill l incincludlude e incincome (lossome (loss) ) frofrommoperations and an impairment loss if the fair value less costs to sell is less than the book value of theoperations and an impairment loss if the fair value less costs to sell is less than the book value of thecomponent’s assets. component’s assets. The income (loss) fThe income (loss) from operations of the component irom operations of the component is reported separately s reported separately inindiscontinued operations on prior income statements presented for comparative purposes.discontinued operations on prior income statements presented for comparative purposes.

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

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

Question 4-10Question 4-10ExtExtraorraordinadinary ry gaigains ns and and loslosseses s are are prepresensentedted, , net net of of taxtax, , in in the the incincome ome stastatemtement ent belbelowow

discontinued operations, if any.discontinued operations, if any.

4-24-2


Answers Answers to Questions (continued)to Questions (continued)

Question 4-11Question 4-11GAAP permit altGAAP permit alternatiernative treatmenve treatments for similats for similar transactr transactions. ions. CommCommon examples are theon examples are the

choice among FIFO, LIFO, and average cost for the measurement of inventory and the choicechoice among FIFO, LIFO, and average cost for the measurement of inventory and the choiceamong alteramong alternative revennative revenue recognitiue recognition methods. on methods. A change in accountinA change in accounting principle occurg principle occurs when as when acompany changes from one generally accepted treatment to another.company changes from one generally accepted treatment to another.

In general, we report voluntIn general, we report voluntary changes in aary changes in accounting principles retrccounting principles retrospectively. ospectively. This meansThis meansrevising all previous periods’ financial statements as if the new method were used in those periods.revising all previous periods’ financial statements as if the new method were used in those periods.In other words, for each year in the comparative statements reported, we revise the balance of eachIn other words, for each year in the comparative statements reported, we revise the balance of eachaccount affected. account affected. Specifically, we make thosSpecifically, we make those statements ae statements appear as if the neppear as if the newly adopted accountingwly adopted accountingmethod had been applied all method had been applied all along. along. Also, if retained eAlso, if retained earnings is one of arnings is one of the accounts whose the accounts whose balancebalancerequires adjustment (and it usually is), we revise the beginning balance of retained earnings for therequires adjustment (and it usually is), we revise the beginning balance of retained earnings for theearliest period reported in the comparative statements of shareholders’ equity (or statements of earliest period reported in the comparative statements of shareholders’ equity (or statements of retained earnings if they’re presented instead).retained earnings if they’re presented instead). Then we create a journal entry to adjust all accountThen we create a journal entry to adjust all account balan balances affeces affected as of the date of the change. cted as of the date of the change. In the first seIn the first set of financiat of financial stateml statements afteents after ther thechange, a disclosure note would describe the change and justify the new method as preferable. Itchange, a disclosure note would describe the change and justify the new method as preferable. Italso would describe the effects of the change on all items affected, including the fact that thealso would describe the effects of the change on all items affected, including the fact that theretretainained ed earearninnings gs balbalancance e was was revreviseised d in in the the ststateatemenment t of of shasharehreholdoldersers’ ’ equequity ity aloalong ng witwith h thethecumulative effect of the change in retained earnings.cumulative effect of the change in retained earnings.

An exceptiAn exception is a on is a change in deprechange in depreciaticiation, amortizaon, amortization, or depletition, or depletion method. on method. These chanThese changesgesare accounted for as a change in esare accounted for as a change in estimate, rather than as a ctimate, rather than as a change in accounting principle. hange in accounting principle. ChangesChangesin estimates in estimates are accounted for prospectivelare accounted for prospectively. y. The remaining book value is The remaining book value is depreciated, amortized,depreciated, amortized,or depleted, using the new method, over the remaining useful life.or depleted, using the new method, over the remaining useful life.

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

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

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

those statthose statementements are s are presepresented again for comparisnted again for comparison purposes. on purposes. The beginning of period retainedThe beginning of period retainedearnings is increased or decreased on the statement of shareholders’ equity (or the statement of earnings is increased or decreased on the statement of shareholders’ equity (or the statement of retained earnings) as of the beginning of the earliest period presented.retained earnings) as of the beginning of the earliest period presented.

4-34-3


Answers to Answers to Questions (concludQuestions (concluded)ed)

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

common stock outstanding. common stock outstanding. If there are different components If there are different components of income reported below continuiof income reported below continuingngoperations, their effects on earnings per sharoperations, their effects on earnings per share must be disclosed. e must be disclosed. If a period contains discontinuedIf a period contains discontinuedoperoperatiations ons and and extextraoraordirdinarnary y iteitems, ms, EPS EPS datdata a musmust t be be repreportorted ed sepseparaarateltely y for for incincome ome frofrommcontcontinuinuing operaing operatiotions and ns and net inconet income. me. Per sharPer share e amoamountunts s for discfor discontontinuinued ed opeoperatrationions s andandextraordinary items would be disclosed on the face of the income statement.extraordinary items would be disclosed on the face of the income statement.

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

transactions with owners. Reporting comprehensive income can be accomplished with a separatetransactions with owners. Reporting comprehensive income can be accomplished with a separatestatement or by including the information in either the income statement or the statement of changesstatement or by including the information in either the income statement or the statement of changesin shareholders’ equity.in shareholders’ equity.

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

and cash disburand cash disbursementsements of an s of an enterenterprise duriprise during a ng a perioperiod. d. SimilSimilar to the ar to the incomincome statemee statement, it is ant, it is achangechange statstatement, summariement, summarizing zing the transactthe transactions that ions that causecaused d cash to cash to change during change during a a partiparticular cular period of time. period of time.

Question 4-17Question 4-17The three categories of cash flows reported on the statement of cash flows are:The three categories of cash flows reported on the statement of cash flows are:1.1. Operating activitiesOperating activities — Inflows and outflows of cash related to the transactions entering — Inflows and outflows of cash related to the transactions entering

into the determination of net income from operations.into the determination of net income from operations.2.2. Investing activities Investing activities — Involve the acquisition and sale of (1) long-term assets used in the— Involve the acquisition and sale of (1) long-term assets used in the

business and (2) nonoperating business and (2) nonoperating investment assets.investment assets.3.3. F F iinancing activitiesnancing activities — Involve cash inflows and — Involve cash inflows and outflows from transactions with creditorsoutflows from transactions with creditors

and owners.and owners.

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

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

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

each operating activityeach operating activity directlydirectly on the stateon the statement of cash flment of cash flows. ows. The indireThe indirect method of reportct method of reportingingcash flows from operating activities is derivedcash flows from operating activities is derived indirectlyindirectly, by starting with reported net income and, by starting with reported net income andadding and subtracting items to convert that amount to a cash basis.adding and subtracting items to convert that amount to a cash basis.

4-44-4

Chapter 04 - The Income Statement and Statement of Cash Flows

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

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

Question 4-21IFRS provides the option of presenting components of other comprehensive income either in

(a) a single statement of comprehensive income or (b) in a separate income statement followed by astatement of comprehensive income. U.S. GAAP also allows the reporting of other comprehensiveincome in the statement of shareholders’ equity

Question 4-22U.S. GAAP designates cash outflows for interest payments and cash inflows from interest and

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

4-5


BRIEF EXERCISES

PACIFIC SCIENTIFIC CORPORATIONIncome Statement

For the Year Ended December 31, 2011($ in millions)

Revenues and gains:Sales .................................................................. $2,106Gain on sale of investments .............................. 45

Total revenues and gains ............................... 2,151

Expenses and losses:Cost of goods sold ............................................ $1,240Selling................................................................ 126General and administrative................................ 105Interest............................................................... 35Income tax expense* ........................................ 258

Total expenses and losses ............................. 1,764Net income .......................................................... $ 387

*$2,151 – (1,240 + 126 + 105 + 35) = $645 x 40% = $258

(a) Sales revenue $2,106Less: Cost of goods sold (1,240)

Gross profit 866Less: Selling expenses (126)

General and administrative expenses (105)Operating income $ 635

(b) Gain on sale of investments 45Interest expense (35) Nonoperating income $10

4-6

Brief Exercise 4-1

Brief Exercise 4-2


Brief Exercise 4-3

PACIFIC SCIENTIFIC CORPORATIONIncome Statement


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

Operating expenses:Selling................................................................ $126General and administrative................................ 105

Total operating expenses ............................... 231Operating income ................................................ 635

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

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

*$645 x 40%

4-7


Brief Exercise 4-4(a) Sales revenue $300,000

Less: Cost of goods sold (160,000)General and administrative expenses (40,000)Restructuring costs (50,000)Selling expenses (25,000)

Operating income $ 25,000

(b) Operating income $25,000Add: Interest revenue 4,000Deduct: Loss on sale of investments (22,000)Income before income taxes and

Extraordinary item 7,000Income tax expense (40%) (2,800)Income before extraordinary item $ 4,200

(c) Income before extraordinary item $ 4,200Extraordinary item:Loss from flood damage, net of $20,000

tax benefit (30,000) Net loss (25,800)

4-8


O’REILLY BEVERAGE COMPANYStatement of Comprehensive Income

For the Year Ended December 31, 2011

Net income .......................................................... $650,000Other comprehensive income (loss):

Unrealized gains on investment securities,net of tax ........................................................ $ 24,000

Deferred loss on derivatives, net of tax ............ (36,000 )Total other comprehensive loss ........................... (12,000)Comprehensive income ....................................... $638,000

4-15

Brief Exercise 4-12


Brief Exercise 4-13

Cash Flows from Operating Activities:Collections from customers $ 660,000Interest on note receivable 12,000Interest on note payable (18,000)Payment of operating expenses (440,000 )

Net cash flows from operating activities $214,000

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

Cash Flows from Investing Activities:Proceeds from note receivable collection $100,000

Sale of land 40,000Purchase of equipment (120,000 )

Net cash flows from investing activities $20,000

Cash Flows from Financing Activities:Issuance of common stock $200,000Payment of dividends (30,000 )

Net cash flows from financing activities 170,000

4-16

Brief Exercise 4-14


Brief Exercise 4-15

Cash Flows from Operating Activities: Net income $45,000 Adjustments for noncash effects:

Depreciation expense 80,000Changes in operating assets and liabilities:

Increase in prepaid rent (60,000)Increase in salaries payable 15,000Increase in income taxes payable 12,000

Net cash inflows from operating activities $92,000

Under IFRS, interest received and interest paid usuallyare classified as investing and financing cash flows,respectively, not operating cash flows as with U.S. GAAP.

The revised cash flow categories usually would appear as follows:

Cash Flows from Operating Activities:Collections from customers $ 660,000Payment of operating expenses (440,000 )


Cash Flows from Investing Activities:Proceeds from note receivable collection $100,000Sale of land 40,000

Interest on note receivable 12,000Purchase of equipment (120,000)

Net cash flows from investing activities $32,000

Cash Flows from Financing Activities:Issuance of common stock $200,000Payment of dividends (30,000)

Interest on note payable (18,000 )Net cash flows from financing activities 152,000

4-17

Brief Exercise 4-16


EXERCISESRequirement 1

GREEN STAR CORPORATIONIncome Statement


Revenues and gains:Sales .................................................................. $1,300,000Interest .............................................................. 30,000Gain on sale of investments .............................. 50,000

Total revenues and gains ............................... 1,380,000

Expenses and losses:Cost of goods sold ............................................ $720,000Salaries............................................................... 160,000Depreciation....................................................... 50,000Interest............................................................... 40,000Rent.................................................................... 25,000Income tax ........................................................ 130,000

Total expenses and losses ............................. 1,125,000Net income .......................................................... $ 255,000

Earnings per share ............................................... $2.55

4-18

Exercise 4-1


Exercise 4-7Exercise 4-7

Requirement 1Requirement 1

KANDON ENTERPRISES, INC.KANDON ENTERPRISES, INC.Partial Income StatementPartial Income Statement

For the Year Ended December 31, 2011For the Year Ended December 31, 2011

IncIncome ome frofrom m contcontinuinuing ing operoperatiations ons ................................................................... ..... $ 400,00$ 400,0000

Discontinued operations:Discontinued operations:Loss from operations of discontinued componentLoss from operations of discontinued component

(including impairment loss of $50,000)(including impairment loss of $50,000) ** ............................................................ (190,000)(190,000)IncoIncome me tax tax benebenefitfit......................................................................................................................... . 76,076,00000LoLoss ss on on didiscsconontitinunued ed opopereratatioions ns ........................................................................... ... (1(11414,0,00000))

Net Net incoincome me ................................................................................................................................................... . $ 2$ 286,086,00000

** Loss on discontinued operations:Loss on discontinued operations:

OOppeerraattiinng g lloossss $$((114400,,000000))Impairment lossImpairment loss ($250,000 - 200,000)($250,000 - 200,000) (50,000)(50,000)

NNeet t bbeeffoorree--ttaax x lloossss ((119900,,000000))IInnccoomme e ttaax x bbeenneeffiit t ((4400%%) ) 7766,,000000

NNeet t aafftteerr--ttaax x lloosss s oon n ddiissccoonnttiinnuueed d ooppeerraattiioonnss $$((111144,,00000 0 ))


KANDON ENTERPRISES, INC.KANDON ENTERPRISES, INC.Partial Income StatementPartial Income Statement

For the Year Ended December 31, 2011For the Year Ended December 31, 2011

InIncocome fme frorom cm conontitinunuining opg opereratatioions .ns ....................................................................... $$ 400,000400,000

Discontinued operations:Discontinued operations:Loss from operations of discontinued componentLoss from operations of discontinued component **................. . ((114400,,000000))IncoIncome me tax tax benebenefit fit ....................................................................................................................... . 56,056,00000LoLoss ss on on didiscsconontitinunued ed opopereratatioions ns ........................................................................... ... (8(84,4,00000 0 ))

Ne Net t incincome ome .................................................................................................................................................... $$ 316,000316,000

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

4-264-26



PPrreettaax ix innccoomme fe frroom m ccoonnttiinnuuiinng og oppeerraattiioonnss $$1144,,000000,,000000IInnccoomme e ttaax x eexxppeennssee ((55,,660000,,000000))

IInnccoomme e ffrroom m ccoonnttiinnuuiinng g ooppeerraattiioonnss 88,,440000,,000000LLeessss: : NNeet t iinnccoommee 77,,220000,,000000LLoosss s ffrroom m ddiissccoonnttiinnuueed d ooppeerraattiioonnss $$11,,220000,,000000

$1,200,000$1,200,000 ÷÷ 60%* = $2,000,000 = before tax loss from discontinued60%* = $2,000,000 = before tax loss from discontinuedoperations.operations.

*1-tax rate of 40% = 60%*1-tax rate of 40% = 60%

PPrreettaax x iinnccoomme e oof f ddiivviissiioonn $$44,,000000,,000000AAdddd: : LLoosss s ffrroom m ddiissccoonnttiinnuueed d ooppeerraattiioonnss 22,,000000,,000000IImmppaaiirrmmeennt t lloossss $$66,,000000,,000000

FFaaiir r vvaalluue e oof f ddiivviissiioonn’’s s aasssseettss $$1111,,000000,,000000AAdddd: : IImmppaaiirrmmeennt t lloosss s 66,,000000,,000000Book value of division’s assetsBook value of division’s assets $17,000,000$17,000,000

4-274-27



Requirement 1Requirement 1In general, we report voluntary changes in accounting principles retrospectively.In general, we report voluntary changes in accounting principles retrospectively.

However, a change in depreciation method is considered a change in accountingHowever, a change in depreciation method is considered a change in accountingestimate resulting from a change in accounting principle. In other words, a change inestimate resulting from a change in accounting principle. In other words, a change inthe depreciation method reflects a change in the (a) estimated future benefits from thethe depreciation method reflects a change in the (a) estimated future benefits from theasset, (b) the pattern of receiving those benefits, or (c) the company’s knowledgeasset, (b) the pattern of receiving those benefits, or (c) the company’s knowledgeabout those benefits, and therefore the two events should be reported the same way.about those benefits, and therefore the two events should be reported the same way.Accordingly, Canliss reports the change prospectively; previous financial statementsAccordingly, Canliss reports the change prospectively; previous financial statementsare not revised. are not revised. Instead, the companInstead, the company simply employy simply employs the straight-line ms the straight-line method fromethod fromnow on. now on. The undThe undepreprecieciateated d coscost t remremainainining g at the time of the changat the time of the change e wouwould beld bedepreciated using the stradepreciated using the straight-line meight-line method over the remathod over the remaining useful life. ining useful life. A disclosureA disclosurenote should justify that the change is preferable and should describe the effect of thenote should justify that the change is preferable and should describe the effect of thechange on any financial statement line items and per share amounts affected for allchange on any financial statement line items and per share amounts affected for all

periods reported. periods reported.


AAsssseett’’s s ccoosstt $$880000,,000000

AccAccumumulaulated ted depdeprecreciatiatioion to n to datdate (e ($3$320,20,000 000 + 1+ 192,92,000000) ) (5(512,12,000 000 ))

TTo o bbe e ddeepprreecciiaatteed d oovveer r rreemmaaiinniinng g 3 3 yyeeaarrss $$228888,,000000

2011 2011 straight-line straight-line depreciationdepreciation: : $288,000$288,000 ÷÷ 3 3 years years = = $96,000$96,000

Adjusting entry:Adjusting entry:

DDepeprrececiiatatioion en exxpepensnse (e (cacalclcuulalateted ad aboboveve))............................................ 9696,0,00000AAccccuummuullaatteed d ddeepprreecciiaattiioon .n ............................................................................. 9966,,000000

4-284-28



Requirement 1Requirement 1This is a This is a change in accounting estimate.change in accounting estimate.

Requirement 2Requirement 2When an estimate is revised as new information comes to light, accounting for When an estimate is revised as new information comes to light, accounting for

the chanthe change ge in estimin estimate is ate is quiquite straite straightghtfoforwrwardard. . We do We do nonot t resrestattate e priprior yearor years's'financial statemfinancial statements to reflents to reflect the new estimaect the new estimate. te. Instead, we mereInstead, we merely incorpoly incorporate therate thenew estimate in any relatenew estimate in any related accounting deted accounting determinatiorminations from there on. ns from there on. If the afterIf the after-tax-taxincome effect of the change in estimate is material, the effect on net income andincome effect of the change in estimate is material, the effect on net income andearnings per share must be disclosed in a note, along with the justification for theearnings per share must be disclosed in a note, along with the justification for thechange.change.

Requirement 3Requirement 3$$880000,,000000 CCoosstt

$160,000 $160,000 Previous Previous annual annual depreciatidepreciationon ($800,000 ÷ 5 years)($800,000 ÷ 5 years)

x x 2 2 yeyearars s 32320,0,00000 0 DeDeprprececiaiatition on to to dadatete (2009-2010)(2009-2010)

448800,,000000 BBooook k vvaalluuee__ __ ÷ ÷ 6 6 yyrrss.. Estimated remaining lifeEstimated remaining life (8 years - 2 years)(8 years - 2 years)

$ $ 8800,,000000 NNeew w aannnnuuaal l ddeepprreecciiaattiioonn

4-294-29


Exercise 4-11

Requirement 1This is a change in accounting estimate.

Requirement 2$2,400,000 Cost

$240,000 Previous annual amortization ($2,400,000 ÷ 10 years)

x 21/2 yrs. 600,000 Amortization to date (2009-2011)

1,800,000 Book value__ ÷ 5 yrs. Estimated remaining life (given)

$ 360,000 New annual amortization

Earnings per share:Income from continuing

operations $5.00Loss from discontinued operations (1.60)Extraordinary gain 2 .20

Net income $5 .60

4-30

Exercise 4-12


Exercise 4-13

Requirement 1

THE MASSOUD CONSULTING GROUPStatement of Income and Comprehensive Income (in part)


Net income .......................................................... $1,354,000Other comprehensive income (loss):

Foreign currency translation gain, net of tax .... $168,000Unrealized losses on investment securities,

net of tax ........................................................ (56,000 )Total other comprehensive income ..................... 112,000Comprehensive income . ...................................... $1,466,000

Requirement 2

THE MASSOUD CONSULTING GROUPStatement of Comprehensive Income


Net income .......................................................... $1,354,000Other comprehensive income (loss):

Foreign currency translation gain, net of tax .... $168,000Unrealized losses on investment securities

net of tax ........................................................ (56,000 )Total other comprehensive income ..................... 112,000Comprehensive income . ...................................... $1,466,000

4-31


Requirement 1U.S. GAAP also permits the presentation of other

comprehensive income items in the statement of shareholders’ equity.

Requirement 2 IAS No. 1 also allows companies to report other comprehensive income items in either a combined statement of income and comprehensive income or in a separate statementof comprehensive income. Presentation in the statement of shareholders’ equity is not

permitted.

1.___ b Purchase of equipment for cash.

2.___ a Payment of employeesalaries.

3. a _ Collection of cash from customers.4. c _ Cash proceeds from a note payable.5. b _ Purchase of common stock of another corporation for cash.6. c _ Issuance of common stock for cash.7. b _ Sale of machinery for cash.8. a _ Payment of interest on note payable.9. d _ Issuance of bonds payable in exchange for land and building.

10. c _ Payment of cash dividends to shareholders.11. c _ Payment of principal on note payable.

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Exercise 4-14

Exercise 4-15


Problem 4-2 (concluded)

Requirement 2The 2011 income from discontinued operations would include only the operating

loss of $400,000. Since no impairment loss is indicated ($5,000,000 – 4,400,000 =$600,000 anticipated gain), none is included. The anticipated gain on disposal is notrecognized until it is realized, presumably in the following year.

Requirement 3The 2011 income from discontinued operations would include the operating loss

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

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Problem 4-3

Requirement 1

MICRON CORPORATIONPartial Income Statement


Income from continuing operations beforeincome taxes and extraordinary item........ [1] $1,300,000

Income tax expense .................................... 390,000

Income from continuing operations ............ 910,000

Discontinued operations:Loss from operations of discontinued

component (including loss on disposal of $300,000)

...................................................................$(140,000)

Income tax benefit...................................................................

42,000

Loss on discontinued operations ............... [2](98,000)

Income before extraordinary item ............... 812,000

Extraordinary item:Loss from earthquake

(net of $240,000 tax benefit) ..................... (560,000 )

Net Income ................................................. $ 252,000

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

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

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

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

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DUKE COMPANYStatement of Income and Comprehensive Income


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

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

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

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

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

of $1,200,000 tax benefit) ........................................... (1,800,000)Net Income....................................................................... 60,000Other comprehensive income (loss):

Foreign currency translation adjustment loss, net of tax (120,000)Unrealized gains on investment securities, net of tax 108,000

Total other comprehensive loss (12,000)Comprehensive income $ 48,000

Notes:1. The restructuring costs and the loss from write-down of inventory are not extraordinary items.

2. The depreciation expense error is a prior period adjustment and is not reported in theincome statement.

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Problem 4-8


Problem 4-9

Requirement 1Diversified Portfolio Corporation

Statement of Cash FlowsFor the Year Ended December 31, 2011

Cash flows from operating activities:Collections from customers (1) $880,000Payment of operating expenses (2) (660,000)Payment of income taxes (3) (85,000)


Cash flows from investing activities:Sale of investments 50,000

Net cash flows from investing activities 50,000

Cash flows from financing activities:Proceeds from issue of common stock 100,000Payment of dividends (80,000)

Net cash flows from financing activities 20,000Increase in cash 205,000Cash and cash equivalents, January 1 70,000Cash and cash equivalents, December 31 $275,000

(1) $900,000 in service revenue less $20,000 increase in accounts receivable.(2) $700,000 in operating expenses less $30,000 in depreciation less $10,000 increase

in accounts payable.(3) $80,000 in income tax expense plus $5,000 decrease in income taxes payable.

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Requirement 2Diversified Portfolio Corporation


Cash flows from operating activities:Net income $120,000 Adjustments for noncash effects:

Depreciation expense 30,000Changes in operating assets and liabilities:

Increase in accounts receivable (20,000)Increase in accounts payable 10,000Decrease in income taxes payable (5,000)


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Problem 4-10 (continued)

2010 Total assets:$59 + 84 + 52 + 50 + 150 – 55 = $340

2011 Total assets:$145 + 93 + 60 + 150 – 65 = $383

2010 Income taxes payable:2010 Inc. taxes payable + Inc. tax expense – Income taxes paid =2011 Inc. taxes payable2010 Inc. taxes payable =2011 Inc. taxes payable + Taxes paid – Inc. tax expense2010 Inc. taxes payable = 22 + 9 – 7 = $24

2011 Retained earnings:2010 R/E + Net income – Dividends = 2011 R/E

47 + 28 – 3 = 72

2010 Total liabilities and shareholders’ equity:$30 + 9 + 24 + 230 + 47 = $340

2011 Total liabilities and shareholders’ equity:$40 + 9 + 22 + 240 + 72 = $383

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Requirement 2

Grandview CorporationStatement of Cash Flows


Cash flows from operating activities:Net income $ 28

Adjustments for noncash effects:Depreciation expense 10Gain on sale of investments (15)

Changes in operating assets and liabilities:Increase in accounts receivable1 (9)Increase in inventory2 (8)Increase in accounts payable3 10Decrease in income taxes payable4 (2 )

Net cash flows from operating activities $14

1 $93 – 842 $60 – 523 $40 – 304 $22 – 24

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Problem 4-11Santana Industries


($ in thousands)

Cash flows from operating activities:Net income $ 3,850

Adjustments for noncash effects:Depreciation expense 1,600

Changes in operating assets and liabilities:Increase in accounts receivable (300)Increase in inventory (1,000)Decrease in prepaid rent 150Increase in accounts payable 300Increase in interest payable 100Increase in unearned service revenue 200Decrease in income taxes payable (250)


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

Net cash flows from investing activities (3,500)

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

Net cash flows from financing activities 4,000

Net increase in cash 5,150

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

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Case 4-8 (concluded)

Requirement 5

All of the following information is disclosed in notes to financial statements thatinclude the period in which an exit or disposal activity is initiated and any subsequent

period until the activity is completed:

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

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

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

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

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

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

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

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Judgment Case 4-9Financial Statement

PresentationSituation Treatment (a-g) (CO, BC, or RE)

1. b CO2. c RE3. f CO4. g CO5. a BC6. b CO7. e BC8. d. RE

1. The loss is not unusual or infrequent. It is included inincome from continuing operations along with other nonoperating items.

2. The sale of the financing component is treated as a discontinued operation. Thegain or loss from the sale of the assets along with income or loss generated by thecomponent is presented below income from continuing operations.

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

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

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

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

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Judgment Case 4-10


IFRS Case 4-11Requirement 1

1. GSK reported “interest received” and “dividends from associates and joint ventures” as investing cash flows. U.S. GAAP requires these itemsto be included with operating cash flows.

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

Requirement 2GSK could have combined its income statements and statements of comprehensive

income into a single statement.U.S. GAAP allows the presentation of other comprehensive income in one of three

ways: (a) included as an extension to the income statement, (b) reported (exactly thesame way) as a separate statement of comprehensive income, usually as part of adisclosure note, or (c) included in the statement of changes in shareholders’ equity.

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

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

Choices made are not always those that tend to increase income. As you willlearn in Chapter 8, many companies use the LIFO inventory method because itreduces income and therefore reduces the amount of income taxes that must be paidcurrently. Also, some very large and visible companies might be reluctant to reporthigh income that might render them vulnerable to union demands, governmentregulations, or higher taxes.4

1Watts, R.L. and J.L. Zimmerman, “ Towards a Positive Theory of the Determination of Accounting Standards,” The Accounting Review, January, 1978, and “Positive Accounting Theory: A Ten Year Perspective,” The Accounting Review, January, 1990.

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

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

4This “political cost’ motive is suggested by Watts, R.L. and J.L. Zimmerman, “ “Positive Accounting Theory: A TenYear Perspective,” The Accounting Review, January, 1990, and Zmijewski, M., and R. Hagerman, “An IncomeStrategy Approach To The Positive Theory of Accounting Standard Setting/Choice,” Journal of Accounting and

Economics, August, 1981.

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

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

Requirement 377 percent in 2001 and only 54% in 2003.

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

declined to 67% in 2003.

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

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

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

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

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Integrating Case 4-15DEFICIENCIES:Balance Sheet:

1. The asset section of the balance sheet should be classified. Cash, short-terminvestments, accounts receivable, and inventories should be included ascurrent assets.

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

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

classified in a noncurrent investments category.5. Property and Equipment - should be classified in a separate category. Original

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

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

7. Current liabilities should include accounts payable and accruals, notes payable(the $80,000 note due in 2012 and the $60,000 installment on note # 2 due in2012). The latter should be classified as current maturities of long-term debt.Also, note disclosure is required for the notes providing information such as

payment terms, interest rates, and collateral pledged as security for the debt.8. Long-term liabilities should include the $60,000 second installment on note

#2.9. Common stock - the par value, if any, and the number of shares authorized,

issued and outstanding should be disclosed.

Income Statement:1. The miscellaneous expense should be classified as an extraordinary item and

shown net of tax below income from continuing operations. A note shoulddescribe the event.

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

item in the income statement and described in a note.

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Financial Analysis Case 4-16

Requirement 12008 to 2009: ($2,478 – 2,947) ÷ $2,947 = 15.9% decrease

2007 to 2008: ($2,947 – 2,583) ÷ $2,583 = 14.1% increase

Requirement 2Provision for income taxes ÷ Income before taxes$846 ÷ $3,324 = 25% = approximate income tax rate

Requirement 3$2,478 ÷ $61,101 = 4%

Answers to the questions will, of course, vary because students will research financial statements of different companies.

No specific standards dictate how income from continuing operations must bedisplayed, so companies have considerable latitude in how they present thecomponents of income from continuing operations. This flexibility has resulted in aconsiderable variety of income statement presentations. However, we can identifytwo general approaches, the single-step and the multiple-step formats that might beconsidered the two extremes, with the income statements of most companies fallingsomewhere in between.

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

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Real World Case 4-17


British Airways Case

Requirement 1BA classifies its expenses by both natural descriptions (e.g. employee costs, fuel

and oil costs, and landing fees) and functions (e.g. restructuring costs and sellingcosts). In the U.S., expenses are classified by function.

Requirement 2BA classifies interest paid as an operating cash flow and interest received and

dividends received as investing cash flow. Under IFRS, companies can report interest

paid as either an operating or financing cash flow and interest and dividends received

as either operating or investing cash flows.

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chapter the income statement and statement of cash...

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