Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Chapter The Income Statement and Statement of Cash Flows QUESTIONS FOR REVIEW OF KEY TOPICS Question 4-1 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 Question 4-2 Comprehensive income is the total change in equity for a reporting period other than from transactions with owners Reporting comprehensive income can be accomplished with a separate statement or by including the information in either the income statement or the statement of changes in shareholders’ equity Question 4-3 Income from continuing operations includes the revenue, expense, gain and loss transactions that will probably continue in future periods It is important to segregate the income effects of these items because they are the most important transactions in terms of predicting future cash flows Question 4-4 Operating income includes revenues and expenses that are directly related to the principal revenue generating activities of the company Nonoperating income includes items that are not directly related to these activities Question 4-5 The single-step format first lists all revenues and gains included in income from continuing operations to arrive at total revenues and gains All expenses and losses are then grouped and subtotaled, subtracted from revenues and gains to arrive at income from continuing operations The multiple-step format reports a series (multiple) of intermediate totals such as gross profit, operating income, and income before taxes Very often income statements adopt variations of these formats, falling somewhere in between the two extremes Question 4-6 The term earnings quality refers to the ability of reported earnings (income) to predict a company’s future earnings After all, an income statement simply reports on events that already have occurred The relevance of any historical-based financial statement hinges on its predictive value Question 4-7 Restructuring costs include costs associated with shutdown or relocation of facilities or downsizing of operations They are reported as an operating expense in the income statement Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 4-1 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (continued) Question 4-8 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 continuing operations The process is necessary to achieve the desired result of separating the total income effects of continuing operations from the two separately reported items - discontinued operations and extraordinary items, and also to show the after-tax effect of each of those two components Question 4-9 A component of an entity comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes The net-of-tax income effects of a discontinued operation must be disclosed separately in the income statement, below income from continuing operations The income effects include income (loss) from operations and gain (loss) on disposal The gain or loss on disposal must be disclosed either on the face of the statement or in a disclosure note If the component is held for sale but not sold by the end of the reporting period, the income effects will include income (loss) from operations and an impairment loss if the fair value less costs to sell is less than the book value of the component’s assets The income (loss) from operations of the component is reported separately in discontinued operations on prior income statements presented for comparative purposes Question 4-10 Extraordinary items are material gains and losses that are both unusual in nature and infrequent in occurrence, taking into account the environment in which the entity operates Question 4-11 Extraordinary gains and losses are presented, net of tax, in the income statement below discontinued operations, if any © The McGraw-Hill Companies, Inc., 2007 4-2 Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (continued) Question 4-12 GAAP permit alternative treatments for similar transactions Common examples are the choice among FIFO, LIFO, and average cost for the measurement of inventory and the choice among alternative revenue recognition methods A change in accounting principle occurs when a company changes from one generally accepted treatment to another In general, we report voluntary changes in accounting principles retrospectively This means 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 each account affected Specifically, we make those statements appear as if the newly adopted accounting method had been applied all along Also, if retained earnings is one of the accounts whose balance requires adjustment (and it usually is), we revise the beginning balance of retained earnings for the earliest period reported in the comparative statements of shareholders’ equity (or statements of retained earnings if they’re presented instead) Then we create a journal entry to adjust all account balances affected as of the date of the change In the first set of financial statements after the change, a disclosure note would describe the change and justify the new method as preferable It also would describe the effects of the change on all items affected, including the fact that the retained earnings balance was revised in the statement of shareholders’ equity An exception is a change in depreciation, amortization, or depletion method These changes are accounted for as a change in estimate, rather than as a change in accounting principle Changes in estimates are accounted for prospectively The remaining book value is depreciated, amortized, or depleted, using the new method, over the remaining useful life Question 4-13 Earnings per share (EPS) is the amount of income achieved during a period for each share of common stock outstanding If there are different components of income reported below continuing operations, their effects on earnings per share must be disclosed If a period contains discontinued operations and extraordinary items, EPS data must be reported separately for income from continuing operations and net income Per share amounts for discontinued operations and extraordinary items would be disclosed on the face of the income statement Question 4-14 A change in accounting estimate is accounted for in the year of the change and in subsequent periods; prior years’ financial statements are not restated A disclosure note should justify that the change is preferable and describe the effect of a change on any financial statement line items and per share amounts affected for all periods reported Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 4-3 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (concluded) Question 4-15 Prior period adjustments are accounted for by restating prior years’ financial statements when those statements are presented again for comparison purposes The beginning of period retained earnings is increased or decreased on the statement of shareholders’ equity (or the statement of retained earnings) in the year the error is discovered Question 4-16 The purpose of the statement of cash flows is to provide information about the cash receipts and cash disbursements of an enterprise during a period Similar to the income statement, it is a change statement, summarizing the transactions that caused cash to change during a particular period of time Question 4-17 The three categories of cash flows reported on the statement of cash flows are: Operating activities — Inflows and outflows of cash related to the transactions entering into the determination of net income from operations Investing activities — Involve the acquisition and sale of (1) long-term assets used in the business and (2) nonoperating investment assets Financing activities — Involve cash inflows and outflows from transactions with creditors and owners Question 4-18 Noncash investing and financing activities are transactions that not increase or decrease cash but are important investing and financing activities An example would be the acquisition of property, plant and equipment (an investing activity) by issuing either long-term debt or equity securities (a financing activity) These activities are reported either in a separate schedule or in a note Question 4-19 The direct method of reporting cash flows from operating activities presents the cash effect of each operating activity directly on the statement of cash flows The indirect method of reporting cash flows from operating activities is derived indirectly, by starting with reported net income and adding and subtracting items to convert that amount to a cash basis © The McGraw-Hill Companies, Inc., 2007 4-4 Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com BRIEF EXERCISES Brief Exercise 4-1 O’REILLY BEVERAGE COMPANY Statement of Comprehensive Income For the Year Ended December 31, 2006 Net income Other comprehensive income (loss): Unrealized gains on investment securities net of tax Deferred loss on derivatives, net of tax Total other comprehensive loss Comprehensive income Solutions Manual, Vol.1, Chapter $650,000 $ 24,000 (36,000) (12,000) $638,000 © The McGraw-Hill Companies, Inc., 2007 4-5 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Brief Exercise 4-2 PACIFIC SCIENTIFIC CORPORATION Income Statement For the Year Ended December 31, 2006 ($ in millions) Revenues and gains: Sales Gain on sale of investments Total revenues and gains $2,106 45 2,151 Expenses and losses: Cost of goods sold Selling General and administrative Interest Income tax expense* Total expenses and losses Net income $1,240 126 105 35 258 1,764 $ 387 *$2,151 – (1,240 + 126 + 105 + 35) = $645 x 40% = $258 Brief Exercise 4-3 (a) Sales revenue $2,106 Less: Cost of goods sold (1,240) Gross profit 866 Less: Selling expenses (126) General and administrative expenses (105) Operating income $ 635 (b) Gain on sale of investments Interest expense Nonoperating income © The McGraw-Hill Companies, Inc., 2007 4-6 45 (35) $10 Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Brief Exercise 4-4 PACIFIC SCIENTIFIC CORPORATION Income Statement For the Year Ended December 31, 2006 ($ in millions) Sales revenue Cost of goods sold Gross profit Operating expenses: Selling General and administrative Total operating expenses Operating income Other income (expense): Gain on sale of investments Interest expense Total other income, net Income before income taxes Income tax expense* Net income $2,106 1,240 866 $126 105 231 635 45 (35) 10 645 258 $ 387 *$645 x 40% Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 4-7 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Brief Exercise 4-5 (a) Sales revenue Less: Cost of goods sold General and administrative expenses Restructuring costs Selling expenses Operating income (b) Operating income Add: Interest revenue Deduct: Loss on sale of investments Income before income taxes and Extraordinary item Income tax expense (40%) Income before extraordinary item $25,000 4,000 (22,000) Income before extraordinary item Extraordinary item: Loss from flood damage, net of $20,000 tax benefit Net loss $ 4,200 (c) © The McGraw-Hill Companies, Inc., 2007 4-8 $300,000 (160,000) (40,000) (50,000) (25,000) $ 25,000 7,000 (2,800) $ 4,200 (30,000) (25,800) Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Brief Exercise 4-6 WHITE AND SONS, INC Partial Income Statement For the Year Ended December 31, 2006 Income before income taxes and extraordinary item Income tax expense* Income before extraordinary item Extraordinary item: Loss from earthquake, net of $160,000 tax benefit Net income Earnings per share: Income before extraordinary item Loss from earthquake Net income $ 850,000 340,000 510,000 (240,000) $ 270,000 $ 5.10 (2.40) $ 2.70 *$850,000 x 40% Note: Restructuring costs, interest revenue, and loss on sale of investments are included in income before income taxes and extraordinary item Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 4-9 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Brief Exercise 4-7 CALIFORNIA MICROTECH CORPORATION Partial Income Statement For the Year Ended December 31, 2006 Income from continuing operations before income taxes Income tax expense* Income from continuing operations Discontinued operations: Loss from operations of discontinued component (including gain on disposal of $2,000,000)** Income tax benefit Loss on discontinued operations Net income $ 5,800,000 1,740,000 $ 4,060,000 (1,600,000) 480,000 (1,120,000) $ 2,940,000 * $5,800,000 x 30% ** Loss from operations of discontinued component: Gain on sale of assets Operating loss Total before-tax loss © The McGraw-Hill Companies, Inc., 2007 4-10 $ 2,000,000 ($10 million less $8 million) (3,600,000) $(1,600,000) Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com CASES Judgment Case 4-1 Requirement The term earnings quality refers to the ability of reported earnings (income) to predict a company’s future earnings After all, an income statement simply reports on events that already have occurred The relevance of any historical-based financial statement hinges on its predictive value Requirement To enhance predictive value, analysts try to separate a company’s transitory earnings effects from its permanent earnings Transitory earnings effects result from transactions or events that are not likely to occur again in the foreseeable future, or that are likely to have a different impact on earnings in the future Requirement An often-debated contention is that, within GAAP, managers have the power, to a limited degree, to manipulate reported company income And the manipulation is not always in the direction of higher income Many believe that manipulating income reduces earnings quality because it can mask permanent earnings Requirement You would consider the size of the gain in relation to net income, the size of the company’s investment portfolio, and the frequency of gains and losses from the sale of investment securities in past years The main objective is to determine the likelihood of this type of gain occurring again in the future © The McGraw-Hill Companies, Inc., 2007 4-52 Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Judgment Case 4-2 Requirement Restructuring costs include costs associated with shutdown or relocation of facilities or downsizing of operations Facility closings and related employee layoffs translate into costs incurred for severance pay and relocation costs as well as asset write-downs or write-offs Requirement Prior to 2003, restructuring costs were recognized (expensed) in the period the decision to restructure was made, not in the period or periods in which the actual activities took place Now, restructuring costs are expensed in the period(s) incurred Requirement Restructuring costs would be included as an operating expense in a multi-step income statement Requirement An analyst must interpret restructuring charges in light of a company’s past history in this area Information in disclosure notes describing the restructuring and management plans related to the business involved also can be helpful Judgment Case 4-3 No Companies generally prefer to report earnings that follow a smooth, regular, upward path They try to avoid declines, but they also want to avoid increases that vary wildly from year to year It is better to have two years of 15% earnings increases than a 30% gain one year and none the next As a result, some companies “bank” earnings by understating them in particularly good years and use the banked profits to increase earnings in bad years Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 4-53 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Real World Case 4-4 Requirement Companies often voluntarily provide a pro forma earnings number when they announce annual or quarterly earnings calculated according to GAAP These pro forma earnings numbers are management’s view of permanent earnings These pro forma earnings numbers are controversial as they represent management’s biased view of permanent earnings and should be interpreted in that light Requirement The term earnings quality refers to the ability of reported earnings (income) to predict a company’s future earnings Management believes that pro forma earnings are of much higher quality than reported earnings because they are more indicative of future profitability Requirement There are some obvious reconciling items, to include restructuring costs and other special charges of $1,170 million, Inventory charges of $2,249 million and inprocess research and development of $109 million Cisco offered the following reconciliation ($ in millions): GAAP loss Add: Restructuring costs and other special charges In-process research and development Amortization of goodwill and other acquisition costs* Payroll tax on stock options exercised Inventory charges Total adjustments Tax effects (approximately 24.7% tax rate) Net of tax adjustments Pro forma net income $(2,693) $1,170 109 346 10 2,249 3,884 961 2,923 $ 230 *New accounting standards discussed in Chapters 10 and 11 require that goodwill no longer be amortized This standard became effective after August of 2001 © The McGraw-Hill Companies, Inc., 2007 4-54 Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Communication Case 4-5 The critical question that student groups should address is whether or not the gain on the sale of the timber tracts should be reported as an extraordinary item on the 2006 income statement There is no right or wrong answer The process of developing the proposed solutions will likely be more beneficial than the solutions themselves Students should benefit from participating in the process, interacting first with other group members, then with the class as a whole Solutions should address the following issues: Is the gain material? A consensus should be reached that the gain is material Is the event both unusual and infrequent? Debate should center on the critical issue of whether the event is likely to occur again in the foreseeable future If the event is deemed to require presentation as an extraordinary item, the gain should be reported net of tax below income from continuing operations A disclosure note also is required and earnings per share disclosure should reflect the income statement presentation As a real world example of a similar situation, in 1974 Johns Manville Corporation, manufacturer of asbestos products, reported a $21 million extraordinary gain from the sale of timber tracts No disclosure note was provided to explain the event, so we can only speculate as to the circumstances leading to the company's presentation of the gain as extraordinary It is important that each student actively participate in the process Domination by one or two individuals should be discouraged Students should be encouraged to contribute to the group discussion by (a) offering information on relevant issues, and (b) clarifying or modifying ideas already expressed, or (c) suggesting alternative direction Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 4-55 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Communication Case 4-6 Suggested Grading Concepts and Grading Scheme: Content (70%) 10 Is the loss material? 25 Lists the alternative treatments _ Present before-tax amount as a separate line item _ Present the after-tax amount as an extraordinary item _ In either case, disclosure is required 25 Cites the appropriate authoritative pronouncement, APBO 30, and discusses the concepts of unusual and infrequent in the context of the company’s environment 10 A clear, well supported recommendation is made 70 points Writing (30%) Terminology and tone appropriate to the audience of a chief financial officer 12 Organization permits ease of understanding _ Introduction that states purpose _ Paragraphs that separate main points 12 English _ Sentences grammatically clear and well organized, concise _ Word selection _ Spelling _ Grammar and punctuation 30 points © The McGraw-Hill Companies, Inc., 2007 4-56 Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Case 4-6 (continued) The following is provided as an example August, 1990 TO: Chief Financial Officer, Carter Hawley Hale Stores (CHHS) FROM: John Doe, Controller (CHHS) RE: Income Statement treatment of October 17, 1989, earthquake damage costs A decision on the income statement treatment of the earthquake damage costs involves a number of considerations First, the damage costs are clearly material Inclusion of the costs in earnings results in an increase in the net loss for the fiscal year ended August 4, 1990, from $9.47 million to $25.97 million This leaves us only two options for the income statement presentation of the loss: Present the before-tax amount of the loss ($27.5 million) as a separate line item in the income statement Present the after-tax effect of the loss ($16.5 million) as an extraordinary item, below income from continuing operations In both cases, a disclosure note would be required to explain the loss The appropriate authoritative pronouncement pertaining to this case is Accounting Principles Board Opinion No 30 The opinion states that judgment is required in determining whether or not an event warrants separate reporting in the income statement as an extraordinary item However, the following broad guideline is provided: “Extraordinary items are events and transactions that are distinguished by their unusual nature and by the infrequency of their occurrence.”(par 20) The opinion adds that the characteristics of unusual nature and infrequency of occurrence must be considered in light of the environment in which the company operates These characteristics are only aids in answering the important question: What is the likelihood that this event will occur again in the foreseeable future? If it is not likely to occur again, then this should be communicated to financial statement users by segregating the income effect of the event as an extraordinary item This will help them in using the income statement to predict future cash flows Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 4-57 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Case 4-6 (concluded) RECOMMENDATION I recommend that the earthquake damage costs be treated as an extraordinary loss, net of tax, in the income statement for the fiscal year ended August 4, 1990 In addition, earnings per share for income both before and after the loss must be presented While many earthquakes occur in California, extremely large earthquakes causing significant amounts of damage are both unusual and infrequent I not believe that this type of loss will occur again in the foreseeable future © The McGraw-Hill Companies, Inc., 2007 4-58 Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Ethics Case 4-7 Discussion should include these elements Facts: The company incurred $10 million in expenses related to a product recall The company had experienced product recalls in the past and they occur in the industry To show a profit from continuing operations, Jim Dietz, the controller, wants to report the $10 million as an extraordinary loss, rather than as an expense included in operating income He tells the CEO that the company has never had a product recall of this magnitude and that the company fixed the design flaw and upgraded quality control Extraordinary items are gains and losses that are material, and result from events that are both unusual and infrequent These criteria must be considered in light of the environment in which the entity operates There obviously is a considerable degree of subjectivity involved in the determination The concepts of unusual and infrequent require judgment In making these judgments, an accountant should keep in mind the overall objective of the income statement The key question is how the event relates to a firm’s future profitability If it is judged that the event, because of its unusual nature and infrequency of occurrence, is not likely to occur again, separate reporting as an extraordinary item is warranted Ethical Dilemma: It appears from the facts of the case that it would be difficult for the company to come to the conclusion that a material product recall is not likely to occur again in the foreseeable future This type of event has occurred before and is common in the industry While a subjective judgment, extraordinary treatment of the $10 million does not appear warranted Is the obligation of Jim and the CEO to maximize income from continuing operations, the company's position on the stock market and management bonuses stronger than their obligation to fairly present accounting information to the users of financial statements? Who is affected? Jim Dietz CEO and other managers Other employees Shareholders Potential shareholders from the stock market Creditors Company auditors Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 4-59 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Research Case 4-8 Requirement Most would agree that the events of September 11, 2001 were “extraordinary.” The terrorist attacks were unprecedented in terms of the magnitude of the losses incurred, the number of entities affected, the unprecedented federal ground stop order that closed the U.S air travel system for over 24 hours, and the unprecedented efforts undertaken by the U.S and other nations to prevent future terrorist attacks Requirement The EITF was initially reluctant to address the issue because of its importance However, timely accounting guidance was necessary to help companies in deciding how to measure and report the losses sustained as a result of the attacks The Task Force noted that without such guidance, financial statement preparers and auditors would be faced with individually resolving the difficult questions presented by this issue The FASB’s elaborate process would have not provided the necessary guidance in a timely manner Requirement The Task Force concluded that despite the incredible nature of the September 11 events, extraordinary item financial reporting treatment would not be an effective way to communicate the financial effects of those events and, therefore, should not be used in this case The Task Force noted that it would be impossible to isolate and therefore distinguish, in a consistent way, the effects of the September 11 events in any single line item on companies’ financial statements because of the inability to separate losses that are directly attributable to the events from those that were not © The McGraw-Hill Companies, Inc., 2007 4-60 Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Judgment Case 4-9 Situation Treatment (a-g) b c f g a b e d Financial Statement Presentation (CO, BC, or RE) CO RE CO CO BC CO BC RE Judgment Case 4-10 The loss is not unusual or infrequent It is included in income from continuing operations along with other gains and losses The sale of the financing component is treated as a discontinued operation The gain or loss from the sale of the assets along with income or loss generated by the component is presented below income from continuing operations A change in depreciation method is treated as a change in accounting estimate achieved by a change in accounting principle Changes in estimates are accounted for prospectively The remaining book value is depreciated, using the new method, over the remaining useful life This event is not unusual but may be infrequent It usually is presented as a separate line item included in income from continuing operations The correction of an error is treated as a prior period adjustment The effect of the correction is not included in income, but as an adjustment to retained earnings Prior years’ financial statements are restated to correct the error This event requires no unusual treatment The lipstick line does not qualify as a component of an entity requiring treatment as a discontinued operation The loss on sale of the assets of the product line is included in continuing operations along with other gains and losses Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 4-61 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com International Case 4-11 Differences in income statement presentation: The title of the statement is "Group Profit and Loss Account" as opposed to Income Statement The term "turnover" is used instead of sales or revenue The current years’ turnover and operating profit are presented for both continuing operations and for acquisitions In the U.S., the income effect of acquisitions is not disclosed separately in the income statement That information is contained in a disclosure note The Cadbury statement contains a column for exceptional items In the U.S., these exceptional items are either separately reported below continuing operations, or are reported as a separate line item in continuing operations Dividends on ordinary shares are deducted on the Cadbury Schweppes statement to arrive at "profit retained." In the U.S., dividends to shareholders not appear in the income statement They are shown as distributions to owners in either the statement of shareholders' equity or the statement of retained earnings There is no earnings per share presentation on the face of the statement as there commonly is in the U.S © The McGraw-Hill Companies, Inc., 2007 4-62 Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Judgment Case 4-12 It would be nice to think that management makes all accounting choices in the best interest of fair and consistent financial reporting Unfortunately, other motives influence the choices among accounting methods and whether to change methods It has been suggested that the effect of choices on management compensation, on existing debt agreements, and on union negotiations each can affect management’s selection of accounting methods.1 For instance, research has suggested that managers of companies with bonus plans are more likely to choose accounting methods that maximize their bonuses (often those that increase net income).2 Other research has indicated that the existence and nature of debt agreements and other aspects of a firm’s capital structure can influence accounting choices.3 Whether a company is forbidden 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 will learn in Chapter 8, many companies use the LIFO inventory method because it reduces income and therefore reduces the amount of income taxes that must be paid currently Also, some very large and visible companies might be reluctant to report high income that might render them vulnerable to union demands, government regulations, 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 Management Control 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 Ten Year Perspective,” The Accounting Review, January, 1990, and Zmijewski, M., and R Hagerman, “An Income Strategy Approach To The Positive Theory of Accounting Standard Setting/Choice,” Journal of Accounting and Economics, August, 1981 Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 4-63 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Research Case 4-13 (Note: This case requires the student to reference a journal article.] Requirement The most frequent type of voluntary accounting change involves inventory methods (38% of all voluntary accounting changes in the sample) More specifically, adoptions of LIFO are the most common accounting change and these adoptions increase with the rate of inflation Requirement The authors infer that the typical non-LIFO voluntary accounting change is income-increasing, and firms making income-increasing changes have significantly lower sales and earnings growth prior to making a change, and lower interest coverage ratios, higher debt-to-equity ratios, and tighter dividends constraints in the year of change compared to a random sample of firms They conclude that their results suggest that voluntary accounting changes are most likely to have been made for opportunistic or earnings management purposes © The McGraw-Hill Companies, Inc., 2007 4-64 Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Integrating Case 4-14 DEFICIENCIES: Balance Sheet: The asset section of the balance sheet should be classified Cash, short-term investments, accounts receivable, and inventories should be included as current assets Accounts receivable should be shown net of the allowance for uncollectible accounts Inventories - the method used to cost inventory should be disclosed in a note Marketable securities - $21,000 of investments ($78,000 - 57,000) should be classified in a noncurrent investments category Property and Equipment - should be classified in a separate category Original cost should be disclosed along with the accumulated depreciation to arrive at the net amount Also, the method used to compute depreciation should be disclosed in a note The liability and shareholders' equity section of the balance sheet should be classified into (1) current liabilities, (2) long-term liabilities, and (3) shareholders' equity Current liabilities should include accounts payable and accruals, notes payable (the $80,000 note due in 2007 and the $60,000 installment on note # due in 2007) 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 Long-term liabilities should include the $60,000 second installment on note #2 Common stock - the par value, if any, and the number of shares authorized, issued and outstanding should be disclosed Income Statement: The miscellaneous expense should be classified as an extraordinary item and shown net of tax below income from continuing operations A note should describe the event Earnings per share disclosure is required The restructuring charges should be shown as a separate operating expense item in the income statement and described in a note Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 4-65 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Financial Analysis Case 4-15 Requirement 2003 to 2004: ($838 – 830) ÷ $830 = 1% increase 2002 to 2003: ($830 – 710) ÷ $710 = 17% increase Requirement $481 ÷ $1,319 = 36% Requirement $838 ÷ $24,710 = 3% FedEx is able to generate three cents in net income for every sales revenue dollar This is a common financial ratio, known as the profit margin on sales Chapter discusses this and other ratios related to profitability Real World Case 4-16 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 be displayed, so companies have considerable latitude in how they present the components of income from continuing operations This flexibility has resulted in a considerable variety of income statement presentations However, we can identify two general approaches, the single-step and the multiple-step formats that might be considered the two extremes, with the income statements of most companies falling somewhere in between The presentation of separately reported items, however, is mandated and students should be able to easily identify them Trueblood Accounting Case 4-17 A solution and extensive discussion materials can be obtained from the Deloitte Foundation © The McGraw-Hill Companies, Inc., 2007 4-66 Intermediate Accounting, 4/e ... amounts affected for all periods reported Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 4-3 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com... Comprehensive income Solutions Manual, Vol.1, Chapter $650,000 $ 24,000 (36,000) (12,000) $638,000 © The McGraw-Hill Companies, Inc., 2007 4-5 Find more slides, ebooks, solution manual and testbank... 635 45 (35) 10 645 258 $ 387 *$645 x 40% Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 4-7 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com