Solution manual intermediate accounting 15e by stice ch04

CHAPTER QUESTIONS The objective of financial reporting is to provide useful information for users of the financial statements The relevant information for decision making is future data, especially information dealing with cash flows The primary financial statements reflect economic transactions and events that have taken place The past is used to help project the future Income, however, is only one of many sources of cash flow The balance sheet and statement of cash flows also furnish relevant information upon which the investor may project other future cash flows In summary, the income statement contains only some of the information that is relevant for making economic decisions (c) The current value of net assets acquired in exchange transactions as determined by either their replacement or market values (d) Some variation of the above (a through c) but including in assets all resources and claims to resources, not just those acquired in exchange transactions The objectives of reporting income for income tax purposes and for financial reporting to users are not the same Those formulating income tax laws are usually concerned with fairness among taxpayers and with their ability to pay taxes Users, on the other hand, are concerned with a measure that distinguishes between a return on investment and a return of investment They want a measure that matches expenses against recognized revenue In most cases, the same accounting method can be used for both purposes This will reduce both the cost and the confusion of using more than one accounting method for the same transaction In some cases, however, the generally accepted accounting method is different from that required by income tax regulations This results in a temporary difference between the tax return and the books and gives rise to interperiod income tax allocation Two approaches can be used to measure income: the capital maintenance approach and the transaction approach The capital maintenance approach uses the balance sheet elements to determine the change in total equity after eliminating any investments and withdrawals of resources by owners The transaction approach determines income by analyzing individual transactions and events and their effect on related assets, liabilities, and owners’ equity Although the method of determining income differs, both approaches arrive at the same total income figure if the same attributes and measurements are used However, the transaction approach produces more detail as to the composition of income than does the capital maintenance approach A code law country is one in which rules, laws, and accounting standards are set by legal processes—from the top down A common law country is one in which rules, laws, and accounting standards evolve in response to societal and market forces— from the bottom up Revenues and expenses are related to the ongoing major or central activities of a business and are reported at gross amounts Gains and losses are associated with peripheral and incidental transactions and events and are reported as the difference between the selling price and the book value (often the depreciated cost) These classification and display distinctions will depend on the specific Measurement methods that could be applied to net assets in the capital maintenance approach to income determination are as follows: (a) The historical cost of net assets acquired in exchange transactions, reduced by an allowance for their use (b) The historical cost of net assets acquired in exchange transactions, reduced by an allowance for their use and adjusted for a change in price levels since original acquisition 121 circumstances enterprise and activities of an The following two factors must be considered when deciding at what point revenues and gains should be recognized: (a) The resources from the transaction are either already realized in cash or claims to cash or are readily realizable in cash, and (b) the revenues and gains have been earned through substantial completion of clearly identified tasks and activities Both factors are usually met when merchandise is delivered or services are rendered to customers This is referred to as the point of sale There are three specific exceptions to the general rule that were discussed in the chapter They are recognizing revenue (a) at the point of completed production, (b) at the time of cash collection, and (c) at various points in time during the operating cycle (e.g., percentage-of-completion method) The justification for the use of these exceptions is that, in each case, the realization and earning criteria established by the FASB are met Three expense recognition principles are applied in matching costs with revenues: (a) Direct matching—costs are associated directly with specific revenues and recognized as expenses of the period in which the revenues are recognized (b) Systematic and rational allocation— when costs cannot be associated directly with specific revenues, costs are associated in a systematic and rational manner with the periods or products benefited (c) Immediate recognition—those costs that cannot be related to revenues either by direct matching or by systematic and rational allocation must be recognized as expenses of the current period 10 The multiple-step income statement can contain too much information that might be confusing to the reader and require excess time to evaluate The detailed listing of purchases and inventory might best be displayed in a supplementary schedule The single-step income statement can be too brief Information required for 122 investment decisions is sometimes presented in supporting schedules or not reported Because of these factors, the statement could also be confusing, and valuable time could be lost by the statement reader in seeking additional information 11 The major sections that may be included in a multiple-step income statement may be divided into two categories: (a) income from continuing operations, separated into six sections, and (b) irregular or extraordinary items, separated into three sections The sections of income from continuing operations are Revenue from net sales Cost of goods sold Operating expenses Other revenues and gains Other expenses and losses Income taxes on continuing operations The sections of irregular or extraordinary items are Discontinued operations Extraordinary items Cumulative effects of changes in accounting principles 12 A restructuring charge is a loss that arises when a company proposes a restructuring of its operations The charge is composed of the loss in value associated with assets that no longer fit in the company’s strategic plans The charge also includes the additional costs associated with the termination or relocation of employees Restructuring charges are controversial because companies exercise considerable discretion in determining the amount of a restructuring charge and thus can use restructuring charges as a tool for manipulating the amount of reported net income 13 This flexibility in the timing of the recognition of restructuring charges is reduced by SFAS No 146 Intraperiod income tax allocation involves the separation of income tax expense between income from continuing operations and transitory, irregular, or extraordinary items Under this concept, each section of the transitory, irregular, or extraordinary items category is reported net of its income tax effect 14 Pop-Up must separately disclose the current year’s income related to the operations of the segment that will be discontinued together with the $10,000 loss resulting from the sale This total would be reported on the income statement, along with any associated income tax impact, immediately following income from continuing operations 15 The following items would not normally qualify as extraordinary items: (a) The write-down or write-off of receivables (b) Major devaluation of foreign currency (c) Loss on sale of plant and equipment (d) Gain from early extinguishment of debt Before the issuance of SFAS No 145 in April 2002, gains and losses from early extinguishment of debt were required to be classified as extraordinary (f) Loss due to extensive earthquake damage to furniture company in Los Angeles, California (Earthquakes are not unusual in the Los Angeles area.) (g) Farming loss due to heavy spring rains in the Northwest (Spring rains are not unusual in the Northwest.) Item (e) is classified as extraordinary because flood damage is both unusual and infrequent in Las Vegas 16 a The effects of a change in accounting principle that is applied to past periods are disclosed in the financial statements of the period of change The effects of the change are computed for past periods and disclosed either as a cumulative effect on current net income or as an adjustment to the beginning retained earnings The FASB has specified criteria to determine which approach is appropriate b The effect of a change in accounting estimate is disclosed entirely in the current period or in the current and future periods No adjustments are made to prior periods’ statements as may be done for a change in principle The change in an estimate should be sufficiently disclosed in the financial statements so that readers are alerted to those changes that will materially affect future periods 17 Under International Financial Reporting Standard (IFRS) 8, the cumulative effect of 18 a change in accounting principle is reported as a direct adjustment to beginning retained earnings of the current year 18 Generally accepted accounting principles require entities to report earnings-pershare information for income from continuing operations and for each section of the transitory, irregular, or extraordinary items category of an income statement The computation is made by dividing the income or loss from each of these sections by the weighted average number of common shares outstanding during the reporting period If a potential dilution of earnings exists due to the existence of convertible securities, stock options, or stock warrants, additional earnings-pershare information must also be presented 19 “Comprehensive income is the change in equity of a business enterprise during a period from transactions and other events and circumstances from nonowner sources It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.” Net income is the reported income as required by GAAP Currently, GAAP does not require all components of comprehensive income to be disclosed in the income statement For example, it does not include the effect of error corrections, asset valuation changes, or some effects of accounting changes 20 The starting point for the preparation of forecasted financial statements is the forecast of sales 21 In forecasting depreciation expense, one first must forecast how much property, plant, and equipment will be needed in the future This amount is then used, along with an assumption about how rapidly the plant and equipment will depreciate, to estimate future depreciation expense 123 1Statement of Financial Accounting Concepts No 6, “Elements of Financial Statements” (Stamford, CT: Financial Accounting Standards Board, December 1985), par 70 124 PRACTICE EXERCISES PRACTICE 41 FINANCIAL CAPITAL MAINTENANCE Net assets, end of period Net assets, beginning of period Increase in net assets Deduct investment by owners Income PRACTICE 42 $345,000 170,000 $175,000 100,000 $75,000 PHYSICAL CAPITAL MAINTENANCE Net assets, end of period Net assets, beginning of period Increase in net assets Deduct investment by owners Income, financial capital maintenance Deduct increase necessary to maintain physical Income, physical capital maintenance PRACTICE 43 $345,000 170,000 $175,000 100,000 $ 75,000 capital $ 10,000 65,000 COMPUTATION OF INCOME USING MATCHING Revenue ($150,000 + $91,000) Cost of goods sold ($79,000 + $46,000) Income $241,000 125,000 $116,000 The $350,000 in costs incurred in the production of Machines B and D will not yet be recognized as an expense This expense is matched and reported in the income statement in the same year in which the revenue from the sale of the machines is reported In the meantime, this $350,000 cost is shown as an asset, Inventory, in the balance sheet PRACTICE 44 REVENUE RECOGNITION Cash Collected or Collectibility Reasonably Assured? a b c Work Completed? No Yes Yes Yes No Yes Total revenue to be recognized this year Amount of Revenue to Be Recognized $ 0 170,000 $170,000 125 PRACTICE 45 EXPENSE RECOGNITION Expense Amount of Recognition Cost Method a $30,000 Direct matching b 70,000 Immediate recognition c 15,000 Rational allocation d 27,000 Immediate recognition e 45,000 Rational allocation f 50,000 Direct matching Total expense recognized this year PRACTICE 46 Expense to Be Recognized This Year $ 30,000 70,000 5,000 27,000 9,000 $141,000 SINGLE-STEP INCOME STATEMENT Sales $10,000 Less expenses: Cost of goods sold 6,000 Selling and administrative expense 750 Interest expense 1,100 Income before income taxes $ 2,150 Income tax expense Net income PRACTICE 47 $ 1,200 950 MULTIPLE-STEP INCOME STATEMENT Sales Cost of goods sold Gross profit $10,000 6,000 $4,000 Operating expenses: Selling and administrative expense 750 Operating income $3,250 Interest expense 1,100 Income before income taxes $2,150 Income tax expense 1,200 Net income $ 950 PRACTICE 48 COMPUTATION OF GROSS PROFIT Revenues $9,488.8 Cost of sales 5,784.9 Gross profit $3,703.9 Gross profit/Sales = $3,703.9/$9,488.8 = 39.0% 126 PRACTICE 49 COMPUTATION OF OPERATING INCOME Revenues $9,488.8 Operating expenses: Cost of sales 5,784.9 Selling and administrative 2,689.7 Restructuring charge, net (Note 13) (0.1) Total operating expenses $8,474.5 Operating income $1,014.3 Operating income/Sales = $1,014.3/$9,488.8 = 10.7% PRACTICE 410 COMPUTATION OF INCOME FROM CONTINUING OPERATIONS Sales Cost of goods sold Gross profit Less: Selling and administrative expense Operating income Interest expense Income before income taxes Income tax expense (40%) Income from continuing operations PRACTICE 411 $10,000 4,000 $ 6,000 1,750 $ 4,250 1,100 $ 3,150 1,260 $ 1,890 COMPUTATION OF INCOME FROM DISCONTINUED OPERATIONS Sales Expenses Income before income taxes Income tax expense (30%) Income from continuing operations Discontinued operations: Income (loss) from operations (including loss on disposal in 2005 of $2,000) Income tax expense (benefit)30% Income (loss) on discontinued operations Net income 2005 $ 5,000 4,400 $ 600 180 $ 420 $(2,400) (720) $600 180 (1,680) $(1,260) 127 2004 $4,600 4,100 $ 500 150 $ 350 420 $ 770 PRACTICE 412 COMPUTATION OF INCOME FROM DISCONTINUED OPERATIONS 2005 $ 3,500 3,900 $ (400) (120) $ (280) Sales Expenses Income before income taxes Income tax expense (benefit) 30% Income from continuing operations Discontinued operations: Income from operations (including gain on disposal in 2005 of $1,500) Income tax expense30% Income on discontinued operations Net income PRACTICE 413 2,100 630 2004 $5,100 4,500 $ 600 180 $ 420 500 150 1,470 $ 1,190 350 $ 770 GAINS AND LOSSES ON EXTRAORDINARY ITEMS Sales $20,000 Cost of goods sold 11,000 Gross profit $ 9,000 Operating expenses and gains/losses: Selling and administrative expense (1,750) Operating income $ 7,250 Other revenues and expenses: Loss from an unusual but frequent event$(1,000) Gain from a normal but infrequent event 1,250 Interest expense (2,100) (1,850) Income before income taxes $ 5,400 Income tax expense (40%) 2,160 Income from continuing operations $ 3,240 Extraordinary loss (net of tax benefit of $160) (240) Net income $ 3,000 PRACTICE 414 CUMULATIVE EFFECT OF A CHANGE IN ACCOUNTING PRINCIPLE Sales Oil and gas exploration expense Income before income taxes Income tax expense (30%) Income from continuing operations Cumulative effect of change in accounting principle (net of income tax benefit of $510) Net income 2005 $5,000 700 $4,300 1,290 $3,010 2004 $3,000 600 $2,400 720 $1,680 2003 $2,000 400 $1,600 480 $1,120 (1,190) $1,820 $1,680 $1,120 Cumulative effect = [($400 + $600) – ($1,500 + $1,200)] = ($1,700) 128 PRACTICE 415 ACCOUNTING FOR CHANGES IN ESTIMATES Original depreciation = $100,000/20 years = $5,000 per year Accumulated depreciation as of January 1, 2005 = $5,000 per year  years = $25,000 Revised depreciation = Remaining depreciable book value/Remaining life = ($100,000  $25,000)/(30 years  years elapsed already) = $75,000/25 years = $3,000 per year PRACTICE 416 RETURN ON SALES Return on sales = Net income/Sales = $200/$13,000 = 1.5% PRACTICE 417 EARNINGS PER SHARE Net income Average shares outstanding Earnings per share 2005 $10,000 2,500 2004 $6,000 2,000 2003 $2,500 1,000 $4.00 $3.00 $2.50 Percentage increase in 2004: ($3.00  $2.50)/$2.50 = 20% Percentage increase in 2005: ($4.00  $3.00)/$3.00 = 33% PRACTICE 418 PRICE-EARNINGS (P/E) RATIO Price-earnings ratio = Market price per share/Earnings per share = $20.00/$1.67 = 12.0 PRACTICE 419 COMPREHENSIVE INCOME Income from continuing operations $ 11,000 Extraordinary loss (1,000) Cumulative effect of a change in accounting principle (400) Net income $ 9,600 Net income $ 9,600 Unrealized loss on available-for-sale securities (2,100) Foreign currency translation adjustment (equity increase) Comprehensive income $ 8,750 129 1,250 PRACTICE 420 FORECASTED BALANCE SHEET Cash Accounts receivable Inventory Land Plant and equipment (net) Total assets PRACTICE 421 2005 Actual $ 100 500 1,000 2,500 5,000 $9,100 natural increase of 25% natural increase of 25% natural increase of 25% no increase needed 40% increase FORECASTED INCOME STATEMENT 2005 Actual Sales $10,000 Cost of goods sold 6,000 Depreciation expense 1,000 Interest expense 400 Income before income taxes$ 2,600 Income tax expense 910 Net income $ 1,690 130 2006 Forecasted $ 125 625 1,250 2,500 7,000 $11,500 2006 Forecasted $13,000 7,800 1,200 500 $ 3,500 1,225 $ 2,275 30% increase (given) 30% natural increase same proportion with PPE same apparent 10% interest rate same tax rate ($910/$2,600) = 35% Discussion Case 4–59 This case provides an opportunity to discuss the nature of assets in general and deferred charges in particular The discussion should also stress the importance of properly matching the expiration of asset costs with recognized revenues in order to report a proper income measure Finally, students should be made aware that FASB Statement No requires development stage enterprises to report on the same basis as established operating enterprises It is not considered proper accounting to capitalize operating losses If such losses are expected, that knowledge can be incorporated into the decision being made However, deferred charges should be limited to those costs that promise to provide future revenues The loss in the early months of a branch’s life does not guarantee future excess of revenues over expenses Misleading indications would be communicated if such items were deferred Discussion Case 4–60 The adjustment of financial statements subsequent to their release has caused considerable discussion within the profession Although the students have not yet been exposed to many of the conditions that cause changes to be made to previously issued financial statements, the issue is one that can be fruitfully discussed at this point Comparability is the accounting principle used to justify requiring an adjustment to prior years’ income statements to reflect the discontinuance of a business component If the current year’s income statement deletes the revenues and expenses for the discontinued business component from the operating section, the prior years’ statements reported with the current statement should be adjusted in a similar manner This will permit a reader to evaluate trend changes and separate the effect of discontinuing the business component from the other operations of the enterprise The controller’s objection is valid Careful readers of financial statements are often confused by the changing numbers that appear in subsequent years in statements previously issued Such changes are required in many other areas The instructor might indicate some of these in the discussion They include mergers, some changes in accounting principles, accounting errors, stock dividends and stock splits when computing earnings-per-share data, and so on Unless readers are aware that these subsequent events or discoveries can cause prior statements to be adjusted, they may place less trust in the validity of the issued statements Discussion Case 4–61 Revenues can be booked in advance by a company’s recording the journal entry prior to meeting the revenue recognition criteria The typical journal entry would involve debiting a receivable account and crediting a revenue account Expenses can be deferred using two methods The first is simply not to make any journal entry The second is to record the expense as prepaid and to classify it as an asset on the balance sheet rather than as an expense on the income statement It would then be expensed at some future time In many cases, top executives encourage misleading accounting practices because their compensation is based, in part, on accounting numbers If the numbers can be manipulated to portray favorable news, the executives receive raises, bonuses, and so forth Again, students should be made aware that the business world presents ethical dilemmas While textbooks provide the rules to be applied in a sterile environment, the dynamic environment of life often presents individuals with quandaries for which there are no easy solutions This question can lead to an interesting difference in opinion among students Independent auditors have a responsibility to prepare an audit to detect material misstatements The objective of an audit is not to guarantee the accuracy of financial statements but to ensure that the financial statements are prepared in accordance with GAAP Some frauds are so carefully constructed and concealed that auditors could not reasonably be expected to uncover the fraud The legal system is called on to evaluate the auditor’s liability Typically, the courts evaluate the auditor using three qualifying questions: (1) Were the auditor’s actions in accordance with the duty expected of a professional? (2) Did individuals rely on the information audited by the auditor? and (3) Were damages incurred as a result of this reliance? The answers to these questions determine the extent of the auditor’s liability, especially under common law Under some statutory law, criteria (2) and (3) are not required Discussion Case 4–62 To be recognized, revenue must, in most cases, meet two criteria: (1) Goods or services are provided to the buyer and (2) payment or a valid promise of payment must be received by the seller In the RJR Nabisco example, cigarettes were shipped to wholesalers (criterion No 1), but the wholesalers had made no promise to pay for the cigarettes (criterion No 2) In fact, rather than pay, wholesalers returned the inventory In the Regina example, by recording goods when they were ordered rather than when they were shipped, Regina violated the first criterion Goods were not provided to buyers In both instances, revenue was booked before both revenue recognition criteria had been met The revenue recognition criteria are not a function of contracts The criteria are based on business events If the business events occur, revenue is recognized A legal contract may state any number of things, but in most cases, until goods or services are provided and a promise of payment is received, revenue should not be recognized The arrangement is really a consignment of inventory For many businesses, inventory is shipped the same day a customer places the order In these cases, it does not matter if the journal entry is made when the order is placed or when the goods are shipped In other cases, there may be a delay between the order and the shipment dates Inventory may have to be produced, materials ordered, or paperwork processed In these cases, one must make sure that the transaction giving rise to the revenue and the resulting journal entry are recorded in the same accounting period The problem in the Regina example was that revenue was being booked in one year and actually being earned in the next year This resulted in erroneous annual financial statements Regina’s chief accountant elected to go along with the company president’s activities and, as a result, spent six months in jail and was fined $25,000 The point of this question is not to provide specific alternatives for dealing with fraud but rather to make students aware that fraudulent activities exist and that students must be prepared to deal with them in their role as accountants Discussion Case 4–63 The purpose of this case is to help students understand the relationships between net income, gross profit percentage, and return on sales and the different ways in which profitability may be determined Drug store: Net income Gross profit percentage Return on sales $1,050,000  $950,000 – $39,500 = $60,500 $100,000/$1,050,000 = 9.5% $60,500/$1,050,000 = 5.8% Department store Net income Gross profit percentage Return on sales $670,000 – $560,000 – $66,500 = $43,500 $110,000/$670,000 = 16.4% $43,500/$670,000 = 6.5% The drug store has the higher net income, but the department store has a higher profit percentage As to which is more profitable, additional information would be required However, this case illustrates that using only one measure of profitability can often lead to an incomplete picture SOLUTIONS TO STOP & THINK Stop & Think (p 168): It would seem that the physical capital maintenance concept would provide the best theoretical measure of "well-offness." What difficulties would be encountered by a firm as it tried to turn theory into practice if the FASB had adopted the physical capital maintenance concept of measuring income? Measuring physical well-offness would require firms to obtain fair market value measures of each of their assets and liabilities each period The difficulties of obtaining these measures along with the associated costs would, in most cases, cause the costs of the information to exceed its benefits Stop & Think (p 170): Why is it important to separately disclose revenues and gains? expenses and losses? Revenues and expenses are associated with what a business does That is, they relate to a company's central activity An investor or creditor would want to evaluate a business's performance in its central activity Additional information relating to gains and losses associated with the peripheral activities of a business would be useful but should not be combined with revenues and expenses for disclosure purposes Stop & Think (p 172): Why you think Kinross waits to recognize revenue from the sale of Kubaka gold until the gold is actually sold? Recall that revenue recognition at the time of production is acceptable when sale at an established price is practically assured For the gold produced by Kinross in eastern Russia, enough uncertainty surrounds the shipment and sale of the gold that revenue is not recognized until the actual sale occurs Stop & Think (p 177): Having just reviewed a single-step and a multiple-step income statement, which type you think provides better information for assessing a firm's performance? Students' responses will vary in answering this question Remind students that it is not their answer that is important; it is the thinking about the question that is of value SOLUTIONS TO STOP & RESEARCH Stop & Research (p 171): Use the SEC’s EDGAR system (accessed through http://www.sec.gov) to find the most recent 10-K filing of Service Corporation International (SCI) What is SCI’s business? What is SCI’s revenue recognition policy? Service Corporation International is the largest funeral and cemetery company in the world As of December 31, 2001, SCI operated 3,099 funeral service locations, 475 cemeteries, and 177 crematoria located in 11 countries SCI sells price-guaranteed, prearranged funeral contracts through various programs providing for future funeral services at prices prevailing when the agreements are signed Revenues associated with sales of prearranged funeral contracts are deferred until such time that the funeral services are performed Sales of at-need cemetery interment rights, merchandise, and services are recognized when the service is performed or merchandise delivered Preneed cemetery interment right sales of constructed cemetery burial property are not recognized until a minimum percentage (10%) of the sales price has been collected Stop & Research (p 179): Each year, Fortune magazine compiles a list of the 500 largest companies in the United States The rankings in this “Fortune 500” are determined by reported revenues Find the most recent Fortune 500 listing and identify the ten largest companies in the United States (ranked by revenue) The Fortune 500 list can be viewed using Fortune’s Web site at http://www.fortune.com According to the 2002 listing, the following ten companies had the highest reported revenues in the United States: Rank Company Revenues (in millions) Wal-Mart Stores $219,812.0 ExxonMobil 191,581.0 General Motors 177,260.0 Ford Motor 162,412.0 Enron 138,718.0 General Electric 125,913.0 Citigroup 112,022.0 ChevronTexaco 99,699.0 International Business Machines 85,866.0 10 Philip Morris 72,944.0 SOLUTIONS TO NET WORK EXERCISES Net Work Exercise (p 166): In its 2001 annual report, AT&T reports 1998 revenue to be $47,817 million and 1998 net income to be $5,052 million As a company acquires new businesses and sheds old businesses (as AT&T has done many times), it retroactively goes back and restates its past financial statements to reflect its results as if the current company, and its subsidiaries, had been a functioning unit all along Net Work Exercise (p 194): On March 8, 2002, the P/E ratios were as follows: Coca-Cola 36.1 PepsiCo 34.8 General Motors 25.5 Ford n/a Ford had negative earnings in the most recent year Kmart n/a Kmart also had negative earnings in the most recent year Wal-Mart 36.9 SOLUTIONS TO BOXED ITEMS Polluted Accounting (p 180) One might say that capitalizing the costs of certain expenditures does not affect the income statement at all After all, when an expenditure that has been paid in cash, for example, is capitalized, only two asset accounts are involved The effect on the income statement is detrimental when the expenditure should have been recorded as an expense rather than as an asset If an expenditure properly classified as an expense is incorrectly recorded as an asset, income will be overstated This is illustrated with the following journal entries: What was done: Asset xxx Cash xxx What should have been done: Expense xxx Cash xxx Obviously, there is no straightforward answer to this question The students should recognize the potential ethical dilemmas they may face as they enter the accounting profession and the business world Many independent auditors leave their audit firms to take employment with a client In the vast majority of these cases, everyone benefits By auditing the firm for several years, the audit partner has gained valuable knowledge regarding the workings of that business that could be very useful to the client However, care must be taken to ensure that an adequate control environment is in place to guard against any one person or group of people being able to manipulate the accounting records Phar-Mor and the World Basketball League (p 182) Inventory can either be sold or is on hand If it is sold, it is disclosed on the income statement as cost of goods sold If the inventory is on hand, it is disclosed on the balance sheet If the balance sheet account is overstated, cost of goods sold is understated, resulting in an increase in net income Overstating receivables causes an overstatement of sales, resulting in an increase in net income As you can easily see, when these two frauds are combined, the effect on net income can be substantial A number of reasons exist to explain why anyone would inflate reported income Higher than expected income can have a positive effect on stock price It can have a positive effect on the likelihood of raising additional capital or of obtaining loans Higher net income, if tied to an executive's compensation, will obviously benefit the executive as well The independent auditor has the responsibility of examining the financial statements of a company and determining whether the amounts included in the statements fairly present the company's position as of a given date and the net income earned over a specified period An auditor examines many different kinds of evidence before an opinion can be rendered The internal control structure of the company, management's integrity, and the quality of the accounting system must be carefully considered to determine the quantity and quality of evidence that must be gathered Several of the weaknesses mentioned in the description of Phar-Mor should probably have been discovered by the auditor and the impact of the weaknesses on the financial statements considered Vendor confirmations, surprise inventory observations, analytical reviews, review of large cash disbursements, and other such procedures should have raised sufficient questions for the auditor to uncover the massive misstatements that were subsequently uncovered Auditors are held responsible for exercising due care in performing their duty to render audit opinions on financial statements If they fail to perform that duty carefully, they are, and should, be subject to the litigation being brought against them Many times fraudulent activities are very difficult to uncover by the auditor if extensive management collusion exists Auditors are being encouraged to become very familiar with not only the company being audited but also the key financial players in a company and any outside activities that might reflect on the company being audited Auditors should become familiar with the industry and the financial climate in which the client is operating and be alert to any information that might suggest a conflict of interest on the part of management Such information may be found in financial magazines and newspapers, discussions with other auditors and with company personnel, television and radio broadcasts, and so on The significant amount of litigation against CPA firms has created an increased awareness of care on the part of all auditors Auditors must keep their ears and eyes open to anything that might suggest a problem in the financial reporting COMPETENCY ENHANCEMENT OPPORTUNITIES Deciphering 4–1 (The Walt Disney Company) In 2001, Disney had two below-the-line items Both were cumulative effects of changes in accounting principle One change, resulting in a negative cumulative effect of $228 million, resulted from the application of AICPA SOP 00-2 on the accounting for film revenues and costs The other change, resulting in a negative cumulative effect of $50 million, resulted from the adoption of SFAS No 133 on derivative accounting There were three major reasons for the large decrease in net income from 2000 to 2001 The first two reasons are the negative cumulative effects described in part (1) The third factor is the $1,454 million restructuring and impairment charge reported in 2001 Disney reported a net loss of $158 million in 2001 If all of the income statement items reported in 2001 are viewed as permanent aspects of Disney’s operations, then a loss of $158 million is a good first guess in terms of forecasting 2002 net income However, the three items discussed in part (2) causing the decline in Disney’s 2001 income are all one-time items that will probably not be repeated in 2002 Thus, in forecasting 2002 net income we should add back the $228 million and the $50 million cumulative effects of changes in accounting principle In addition, the $1,454 million restructuring and impairment charge is (hopefully) an item that will not be repeated in 2002 This item is reported before income taxes because it is an above-the-line item In Note to the financial statements, we learn that Disney’s income tax rate if 42.5% (federal plus state), so the after-tax amount of the restructuring charge is $836 million [$1,454 × (1  0.425)] A first estimate of 2002 net income is then computed as follows: Net loss reported in 2001 (in millions) $(158) Add: Film accounting cumulative effect 228 Derivative accounting cumulative effect 50 After-tax amount of restructuring charge 836 Initial estimate of 2002 net income $ 956 Interestingly, this forecast of 2002 net income is almost the same as was reported net income in 2000, suggesting that the reported results in 2001 differed from 2000 only because of the one-time items During the Internet stock bubble, P/E ratios for Internet stocks were often over 100 To take advantage of this, Disney separated its Internet Group and issued shares of stock having ownership rights to the future income to be generated by the Internet Group By doing this, Disney hoped to make its Internet operations more visible to the market; if the results were merely lumped in with the overall corporate results, the market might not value the Internet-related income with the high P/E multiples given to other Internet stocks Of course, after the collapse of the Internet stock bubble in 2000 and 2001, there was no longer any advantage to be gained by having a separately traded Internet Group stock At the bottom of its statement of stockholders’ equity, Disney provides a brief statement of comprehensive income For 2001, comprehensive income was a negative $120 million, computed as follows: Net loss (in millions) Cumulative effect of adopting SFAS No 133 (accounting for derivatives) Foreign currency translation, and other Comprehensive income $(158) 60 (22) $(120) In Note 11 to the financial statements, we learn that the media networks segment had both the highest reported revenue ($9,569 million) and the highest operating income ($1,758 million) The parks and resorts segment had the highest operating profit margin; the operating profit margins for the four segments are as follows: Media networks Parks and resorts Studio entertainment Consumer products 18.4% 22.6 4.3 15.5 In Note 11 relating to segments, Disney discloses that 83% ($20,970/$25,269) of its revenues originate in the United States and Canada Note details the company's revenue recognition policies “Broadcast advertising revenues are recognized when commercials are aired … Revenues from advance theme park ticket sales are recognized when the tickets are used.” In Note 1, Disney reports that “Film and television production and participation costs are expensed based on the ratio of the current period's gross revenues to estimated total gross revenues from all sources on an individual production basis.” From this note, we can conclude that Disney uses a method of systematic and rational allocation 10 Parks, resorts, and other properties are expensed on a straight-line basis over a time period ranging from to 50 years Deciphering 4–2 (Pfizer) a b c d Net income/Revenues Cost of sales/Revenues Research and development expenses/Revenues Advertising expense/Revenues 2001 24.1% 15.6 15.0 8.9 2000 12.7% 17.1 15.1 10.8 1999 18.2% 20.5 14.9 11.3 The most interesting trend in the numbers computed in part (1) is the steady research and development expense as a percentage of revenues Because research is the lifeblood of its business, it appears that Pfizer has decided to plow 15% of revenues each year back into research The numbers also show the very high profit margins in the pharmaceutical industry; cost of sales as a percentage of revenues is less than 20% in the two most recent years Of course, this is balanced by the high expenditure for research and development (which is good from the standpoint of society) and for advertising (which does not necessarily add value to society as a whole) Provision for taxes on income Income from continuing operations before provision for taxes on income and minority interests Effective tax rate 2001 2,561 2000 2,049 1999 1,968 10,32 24.8 % 5,781 35.4 % 6,945 28.3 % In the notes to the financial statements, Pfizer explains that more than one-half of its income from continuing operations is earned outside the United States This income is taxed at a lower rate than is U.S income Net income Earnings per common share—basic Average number of basic shares outstanding 2001 $7,788 $1.25 6,230.4 2000 $3,726 $0.60 6,210.0 1999 $4,952 $0.81 6,113.6 Net income Earnings per common share—diluted Average number of diluted shares outstanding $7,788 $1.22 6,383.6 $3,726 $0.59 6,315.3 $4,952 $0.78 6,348.7 Net income Currency translation adjustment Net unrealized gain (loss) on available-for-sale securities Minimum pension liability Comprehensive income $7,788 (37) $3,726 (458) $4,952 (503) (91) (106) $7,554 37 (49) $3,256 111 (20) $4,540 Deciphering 4–3 (Wells Fargo & Company) Financial statements for a financial institution are a lot different than those produced by a manufacturing firm Revenues and expenses are partitioned as to those relating to interest and those not relating to interest Net interest income would probably be the term most closely related to the concept of gross profit In simple terms, a manufacturing business generates profits by selling a product at a price greater than its cost—gross profit A bank makes money by loaning money at a greater rate than it pays on savings accounts—net interest income a Total interest expense Total interest income Ratio 2001 6,741 19,201 35.1% 2000 7,860 18,725 42.0% 1999 5,818 15,934 36.5% b Incentive compensation Salaries Ratio 1,195 4,027 29.7% 846 3,652 23.2% 643 3,307 19.4% c Employee benefits Salaries Ratio 960 4,027 23.8% 989 3,652 27.1% 901 3,307 27.2% If you think of the relationship between total interest expense and total interest income as the fundamental measure of operating profitability for a bank, then the performance of Wells Fargo improved substantially in 2001 relative to 2000 In 2001, total interest expense was just 35.1% of total interest income Because Wells Fargo’s income statement provides line-item detail about the different components of employee compensation, we can see how big both incentive compensation and fringe benefits are relative to base salaries The year 2001 seems to have been a good one for Wells Fargo employees; incentive compensation provided an extra 30% over and above salaries In each year, the cost of employee benefits was around one quarter of the amount of salaries that are paid Interest expense on deposits Average amount of deposits Average interest rate 3,553 178,413 2.0% Interest income on loans Average loan balance Average interest rate 14,461 163,072 8.9% The cost of the money Wells Fargo gets from its depositors is only 2.0%, which is much less than the 8.9% that Wells Fargo gets from lending this same money This 6.9% interest rate spread must be enough to cover all of the operating costs of the bank Price-earnings ratio: 2001—21.8 ($42.99/$1.97) 2000—23.1 ($53.90/$2.33) 1999—16.7 ($38.31/$2.29) (Note: These P/E ratios are calculated using the diluted earnings per share numbers Wells Fargo’s P/E ratio increased substantially between 1999 and 2000 Fundamentally, a company’s P/E ratio increases if investors have increased optimism about the chances of future earnings being high relative to current earnings The P/E ratio fell slightly in 2001.) Deciphering 4–4 (The Reader's Digest Association, Inc.) In 2001, Reader's Digest generated over 50% of its total operating profit and over 40% of its total revenues from international businesses Operating profit/Revenues 2001 2000 1999 North America Books and Home Entertainment 9% 12.8% 6.7% U.S Magazines 11.8 15.4 17.3 International Businesses 10.6 10.3 2.3 New Business Development (30.9) (73.2) (14.6) The U.S Magazines segment has the highest profitability for each dollar of revenue in 2001 (and in 2000 and 1999 as well) Revenues/Assets 200 North America Books and Home Entertainment U.S Magazines International Businesses New Business Development 200 1.29 3.43 2.28 0.80 1999 1.32 3.96 2.13 2.50 2.23 2.02 2.22 1.55 The segment with the highest asset turnover, in 2001, is the U.S Magazines segment Operating profit/Assets North America Books and Home Entertainment U.S Magazines International Businesses New Business Development 2001 2000 1999 12.7% 40.5 24.3 (24.7) 16.8% 60.9 22.0 (182.8) 14.9% 35.0 5.0 (22.5) Not surprisingly, the U.S Magazines segment has the highest return on assets, a combination of high profitability and high efficiency It would appear that Reader's Digest magazine is the most profitable of the four operating segments These computations understate the contribution of the magazine to overall company profits Remember that the primary method for selling books and home entertainment products is through advertisements in Reader's Digest Not only is the magazine very profitable itself, but it is also because of the magazine that the other segments of the company are able to be successful Deciphering 4–5 (Ford Motor Company) Ford partitions its revenues and expenses into those relating to the Automotive division and those relating to the Financial Services division Cost of sales/Sales 2001 98.2% 2000 89.3% 1999 88.1% Clearly, it is almost mathematically impossible to report an overall profit when cost of sales is equal to 98.2% of sales, as it was in Ford’s Automotive division in 2001 In 2001, sales in Ford’s Automotive division decreased 6.9% compared to 2000 However, both cost of sales and selling, administrative, and other expenses increased during 2001 When the volume of sales activity goes down, but the level of operating expenses does not decline proportionately, one can conclude that some of the operating costs are fixed costs The 2001 results suggest that many of Ford’s Automotive costs are fixed costs The Automotive division manufacturers and sells vehicles In this division, depreciation is a product cost, accounted for as part of manufacturing overhead Accordingly, the amount of Automotive division depreciation is included in cost of sales Negative income tax expense can mean one of three things: a b c The company receives a rebate of taxes paid in the past two years This is called a net operating loss carryback If the amount of negative income tax expense is larger than the amount of income taxes paid in the preceding two years, the excess is carried forward to reduce the amount of income taxes paid in future years This is called a net operating loss carryforward Some financial accounting expenses are not currently deductible for income tax purposes One example is a restructuring charge; generally the taxing authorities not allow a deduction until the restructuring costs are actually spent In this case, a deferred tax asset is recorded (along with a subtraction from income tax expense) to represent the future benefit that will arise when this expense becomes deductible for income tax purposes These three tax-related items are covered at length in Chapter 16 Ford reports the income from the discontinued operation and the loss on the disposal (or spinoff) in separate lines In the chapter, it was explained that these two items should be added together and shown in one line Also, Ford reports these amounts net of income taxes In the chapter, it was explained that the amount of income taxes associated with discontinued operations should be reported in a separate line item The presentation by Ford conforms with the standard presentation used before the issuance of SFAS No 144 in August 2001 The year 2001 was a bad year for both the Automotive division and the Financial Services division Over the 3-year period, cumulative profits in the Financial Services division were greater than cumulative profits in the Automotive division As discussed in part (3), with the level of fixed costs in the Automotive division, a decline in sales volume can lead to large losses This question should cause you to realize that Ford makes a great deal of profit from nonautomotive sources In fact, for the years 19992001, Ford made significantly more profit from financial services It is also interesting to note that prior to the 1980s, the Financial Services division of Ford was virtually nonexistent Deciphering 4–6 (Coca-Cola) In 2001, Coca-Cola’s net income ($3,969 million) was greater than its comprehensive income ($3,858 million) There is a subtraction for foreign currency translation adjustments in the computation of CocaCola’s 2001 comprehensive income This subtraction indicates that the U.S dollar value of the equity of these foreign subsidiaries declined during the year Accordingly, during the year, these foreign currencies weakened relative to the U.S dollar Coca-Cola’s available-for-sale securities portfolio decreased in value during 2001, as evidenced by the subtraction of an unrealized loss of $29 million in the computation of comprehensive income (Note: As explained in Chapter 14, the liquidation of a portion of the available-for-sale securities portfolio during the year can make the interpretation of the overall unrealized gain or loss for the year somewhat difficult.) SAMPLE CPA EXAM QUESTION The correct answer is c The operating loss for the discontinued operation was $600,000 in 2005 No disposal gains or losses were recognized in 2005 Accordingly, the net amount reported for discontinued operations in 2005, after income taxes, is ($360,000) [($600,000) + income tax benefit of $240,000] Hart’s net gain on the discontinued operation in 2006 was $850,000 ($900,000 disposal gain  $50,000 operating loss) After income taxes, the reported amount is $510,000 Writing Assignment: What are the benefits of a restructuring charge? The following points might be made in outlining the benefits of recognizing a restructuring charge Economic benefits A big-bath restructuring charge is sometimes evidence that a company has decided to cut its losses and deal decisively with a bad situation, rather than continue to put band-aids on a hopeless case Thus, the recognition of a big restructuring charge might be part of a campaign to convince investors that a company is committed to changing past unproductive operating practices Financial reporting benefits The rationale behind an accounting big bath is that the results in the restructuring year are going to be rotten anyway, so why not estimate as many future expenses as possible and recognize them this year? In this way, the reported results in the following years will look great for two reasons: (1) they will be compared to the terrible restructuring year and (2) remaining expenses will be small because they were estimated and recognized in the restructuring year Research Project: Reviewing actual income statements and associated notes A sample solution for this research exercise is given below using the 2001 financial statements of McDonald’s The format of McDonald’s income statement is something between the pure single-step and multiple-step statements illustrated in the chapter Operating revenues and operating expenses are grouped together, like a single-step statement However, the overall format—with operating income, then interest expense, then income taxes—follows the general multiple-step format Percentage Increase Percentage Increase from 2000 to 2001 from 1999 to 2000 Total revenues 4.4% 7.4% Net income (17.2) 1.5 McDonald’s net income for 2001 actually declined from the 2000 level Revenue growth slowed substantially in 2001 McDonald’s does not disclose any details about its revenue recognition practice at its companyowned restaurants This is because these transactions, which are almost exclusively cash sales of food items, are very straightforward McDonald’s does describe its franchise arrangements in a note to the financial statements Franchise revenues are composed of initial fees, minimum rentals, and percentage fees based on franchisee sales During the years 1999, 2000, and 2001, McDonald’s had no below-the-line items The Debate: Net income or operating cash flow? Cash Flow Is King!  As any introductory accounting student can attest, the notion of “accrual” is a difficult one to grasp It is unlikely that most financial statement users understand exactly what accrual-based income is On the other hand, everyone understands the difference between cash generated and cash consumed by operating activities  Bills are paid with cash, not with “accruals.” Financial statement users are most interested in a company’s cash flow  Operating cash flow is less subject to manipulation by managers trying to massage reported results  Theoretically, a company is worth the discounted present value of the future cash flows to be generated by the company Accordingly, performance reporting should focus on cash flows Accountants Add Value!  Accountants have worked for literally hundreds of years to refine their accrual adjustments in order to make net income a useful measure of economic activity Academic research supports the claim that accrual-basis income appears to be the best measure of a company’s economic performance  Because accrual-basis income is not tied to the timing of cash receipts and cash disbursements, it gives a better overall view of the economic activity of a company As such, accrual-basis income provides a better foundation with which to forecast future activity, including future cash flows Ethical Dilemma If Dwight revises the income statement to achieve the 5% increase in net income and uses biased information to so, he will be presenting information that has little representational faithfulness That is, the information will not represent an honest and accurate reflection of the performance of the company Another risk to Dwight is that if the company goes public and people invest in the company based on the financial statements produced by Dwight, those investors may have recourse to the company and Dwight if they should lose money If Dwight were to give in this time and revise the income statement to meet the requested “goals” of management, Dwight may find himself being asked to revise the income statement each period This may not be a one-time issue If Dwight does not revise the financial statements and cannot convince the members of the board of directors of the validity of his reasons for not doing so, he may find himself out of a job What Dwight needs to consider is how attractive it will be to continue to work in an organization where he is expected to manage earnings Cumulative Spreadsheet Analysis See Cumulative Spreadsheet Analysis solutions CD-ROM, provided with this manual Internet Search Both the Fortune and Forbes lists for 2002 (using 2001 data) indicated that the company with the highest profit was ExxonMobil Fortune reported the amount of ExxonMobil profit for 2001 to be $15,320 million; Forbes reported 2001 ExxonMobil profit to be $15,105 million The 2001 income statement of ExxonMobil indicates the following: Income before extraordinary item Extraordinary gain, net of tax Net income $15,105 215 $15,320 Apparently, Fortune uses bottom-line net income in doing its profit ranking, whereas Forbes excludes below-the-line items in doing its ranking The procedure used by Forbes is the better one because the whole point of reporting items below the line is that they are not indicative of the company’s core operating performance for the year ... benefited (c) Immediate recognition—those costs that cannot be related to revenues either by direct matching or by systematic and rational allocation must be recognized as expenses of the current period... cumulative effect of 18 a change in accounting principle is reported as a direct adjustment to beginning retained earnings of the current year 18 Generally accepted accounting principles require entities... extraordinary items category of an income statement The computation is made by dividing the income or loss from each of these sections by the weighted average number of common shares outstanding during