Ch04.soln

Kieso, Weygandt, Warfield, Young, Wiecek Intermediate Accounting, Eighth Canadian Edition

CHAPTER 4Posted with permission from John Wiley & Sons Canada, Ltd.

REPORTING FINANCIAL PERFORMANCE

ASSIGNMENT CLASSIFICATION TABLE

TopicsBrief

Exercises Exercises ProblemsWriting

Assignments

1. Income measurement concepts.

12, 14, 16 1

2. Calculation of net income.

1, 7 1, 2, 3 6, 7, 8, 9

3. Single-step income statements; earnings per share.

1, 2, 4, 5, 8, 9

4, 5, 6, 7, 10, 13, 14

2, 3, 4, 5, 8, 9, 11, 12, 16

4. Multiple-step income statements.

3 5, 6, 7, 8, 9, 10

1, 4, 6, 8, 15

5. Extraordinary items. 5 6, 8, 9, 10, 13

1, 3, 5, 6, 8, 11, 13, 15, 16

6. Disposal of a segment (discontinued operations).

4, 6 7, 11, 12, 14

1, 3, 6, 9, 10, 11

7. Retained earnings statement.

10, 11 10, 15 1, 2, 4, 5, 7, 8, 15

8. Accounting principle changes; changes in estimates; errors.

11 10, 15 5, 7, 8, 9

Solutions Manual 4-1 Chapter 4Copyright © 2007 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is strictly prohibited.


ASSIGNMENT CLASSIFICATION TABLE (CONTINUED)

TopicsBrief

Exercises Exercises ProblemsWriting

Assignments

9. Comprehensive income.

7, 12 16, 17 11

10. Cash basis* 13 18 17, 18 2

* This material is covered in an Appendix to the chapter.



ASSIGNMENT CHARACTERISTICS TABLE

Item DescriptionLevel of Difficulty

Time (minutes)

E4-1 Calculation of net income. Simple 18-20 E4-2 Calculation of net income – proprietorship Simple 18-20 E4-3 Income statement items. Simple 18-20 E4-4 Single-step income statement. Moderate 20-25 E4-5 Multiple-step and single-step. Simple 30-35 E4-6 Multiple-step and single-step. Moderate 30-40 E4-7 Combined single-step. Moderate 25-30 E4-8 Multiple-step and extraordinary items. Moderate 30-35 E4-9 Condensed income statement. Moderate 20-25 E4-10 Multiple-step statement, with retained

earnings.Simple 30-40

E4-11 Discontinued operations. Moderate 15-20 E4-12 Discontinued operations. Moderate 20-25 E4-13 Earnings per share. Simple 20-25 E4-14 Earnings per share. Moderate 15-20 E4-15 Retained earnings statement. Simple 20-25 E4-16 Comprehensive income Simple 15-20 E4-17 Comprehensive income Simple 15-20*E4-18 Cash and accrual basis Moderate 10-15

P4-1 Multiple-step income statement and retained earnings statement.

Moderate 40-45

P4-2 Single-step income statement and retained earnings statement.

Simple 25-30

P4-3 Irregular items. Moderate 35-45 P4-4 Multiple- and single-step income statement

and retained earningsModerate 45-55

P4-5 Irregular items. Moderate 30-35 P4-6 Comprehensive combined statement of

income and retained earningsModerate 45-50

P4-7 Retained earnings statement, correction of error and change in accounting principle.

Moderate 25-35

P4-8 Income statement and irregular items. Moderate 35-45 P4-9 Income statement and irregular items. Moderate 25-35 P4-10 Discontinued operations. Moderate 35-45 P4-11 Identification of income statement

deficiencies.Simple 35-45

P4-12 Identify income statement deficiencies. Simple 20-25 P4-13 Extraordinary items. Moderate 20-25



ASSIGNMENT CHARACTERISTICS TABLE (CONTINUED)

Item DescriptionLevel of Difficulty

Time (minutes)

P4-14 Earnings management. Moderate 20-25 P4-15 All-inclusive vs. current operating. Moderate 35-45 P4-16 Identification of income statement

weaknesses.Moderate 30-40

*P4-17 Cash and accrual basis. Moderate 35-40 P4-18 Cash and accrual basis. Complex 40-50



SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 4-1

Portables Inc.Income Statement

For the Year Ended December 31, 2008

RevenuesSales $890,000

ExpensesCost of goods sold $395,000Wages expense 120,000Other expenses 10,000Income tax expense 115,000

Total expenses 640,000

Net income $250,000

Earnings per share $2.50



BRIEF EXERCISE 4-2

Alley CorporationIncome Statement


RevenuesNet sales $2,780,000Investment revenue __103,000 Total revenues 2,883,000

ExpensesCost of goods sold 2,190,000Selling expenses 272,000Administrative expenses 211,000Interest expense 76,000Income tax expense 40,000

Total expenses 2,789,000

Net income $ 94,000




BRIEF EXERCISE 4-3

Alley CorporationIncome Statement


Net sales $2,780,000Cost of goods sold 2,190,000 Gross profit 590,000Operating expenses

Selling expenses $272,000Administrative expenses 211,000 483,000

Income from operations 107,000Other revenues and gains

Investment revenue 103,000 210,000

Other expenses and lossesInterest expense 76,000

Income before income tax 134,000Income tax expense 40,000 Net income $ 94,000


BRIEF EXERCISE 4-4

Income from continuing operations $12,600,000Discontinued operations

Loss from operation of discontinued restaurant division (net of tax) $315,000

Loss from disposal of restaurant division (net of tax) 89,000 404,000

Net income $12,196,000

Earnings per share:Income from continuing operations $1.26Discontinued operations (.04 )Net income $1.22



BRIEF EXERCISE 4-5

Income before income tax and extraordinary item $7,300,000Income tax 2,190,000 Income before extraordinary item 5,110,000Extraordinary loss from casualty, net of $381,000 in taxes 889,000Net income $4,221,000Earnings per share:

Income before extraordinary item $1.02Extraordinary loss (.18 )Net income $ .84

BRIEF EXERCISE 4-6

In order to qualify for separate presentation as discontinued operations on the income statement, the restaurants must be a component of the entity where the operations, cash flows, and financial elements are clearly distinguishable from the rest of the company. A key element is that the group of assets generates its own net cash flows and is operationally distinct. Selling the corporate owned stores to franchisees would qualify for discontinued operations treatment. The stores generate their own cash flows and are operationally distinct from the franchised restaurants.



BRIEF EXERCISE 4-7

DougieDoug LimitedStatement of Shareholders’ Equity


Total

Compre-hensive Income

Retained Earnings

Accumulated Other

Comprehensive Income

Common Shares

Beginning balance $520,000 $ 90,000 $80,000 $350,000Comprehensive income

Net income* 120,000 $120,000 120,000Other comprehensive

income Unrealized holding loss (60,000) (60,000 ) _______ (60,000) _______ Comprehensive income $ 60,000Ending balance $580,000 $210,000 $20,000 $350,000

*($700,000 – $500,000 – $80,000).



BRIEF EXERCISE 4-8

The number of common shares outstanding at December 31, 2008 is 44,000 (40,000 – 8,000 + 12,000)

Weighted average number of shares:

January 1 – April 1 40,000 X 3/12 = 10,000April 1 – August 31 32,000 X 5/12 = 13,333August 31 – Dec. 31 44,000 X 4/12 = 14,667

38,000

BRIEF EXERCISE 4-9

$1,200,000 – $250,000= $5.00 per share

190,000

BRIEF EXERCISE 4-10

Global CorporationRetained Earnings Statement


Balance, January 1 $ 529,000Add: Net income 1,646,000

2,175,000Deduct: Dividends declared 660,000 Balance, December 31 $1,515,000



BRIEF EXERCISE 4-11

Global CorporationRetained Earnings Statement


Balance, January 1, as reported $ 529,000Correction for amortization error (net of tax) 25,000 Balance, January 1, as adjusted 554,000Add: Net income 1,646,000

2,200,000Less: Dividends declared 660,000 Balance, December 31 $1,540,000

BRIEF EXERCISE 4-12

(a) Net Income = $8,000 (dividend revenue)(b) Comprehensive Income = Net income + Other

Comprehensive Income = $8,000 + $5,000 = $13,000(c) Other Comprehensive Income = $5,000 (d) Accumulated Other Comprehensive Income = Beginning

Balance + Other Comprehensive Income = $0 + $5,000 = $5,000



*BRIEF EXERCISE 4-13

(a)

Cash Receipts from Customers

- Beginning accounts receivable

+ Ending accounts receivable

= Revenue on accrual basis

$152,000 - 13,000 + 18,600 = $157,600

(b)

Cash payments for operating expenses

+ Beginning prepaid expenses

- Ending prepaid expenses

= Operating expenses on accrual basis

$97,000 + 17,500 - 23,200 = $91,300



SOLUTIONS TO EXERCISES

EXERCISE 4-1 (18-20 minutes)

Calculation of net income:Increase in assets: $74,000 + $45,000 +$137,000 – $47,000 = $209,000 Increase in liabilities: $82,000 – $56,000 = 26,000

Increase in shareholders’ equity: $183,000

Change in shareholders’ equity accounted for as follows:

Net increase $183,000Increase in common shares $125,000Increase in contributed surplus 13,000Decrease in retained earnings due to dividend declaration (19,000)

Net increase accounted for 119,000 Increase in retained earnings due to net income $ 64,000




Jan. 1, 2008

Dec. 31, 2008

Chang e

Cash $23,000 $ 20,000 $ 3,000Accounts receivable 19,000 36,000 17,000Other assets (derived) 33,000 45,000 12,000 Total assets 75,000 101,000 26,000Liabilities (1/1/08 derived) (37,000 ) (41,000 ) (4,000 )Capital (12/31/08 derived) $38,000 $ 60,000 $22,000

Calculation of net income:Capital account Dec. 31, 2008 $60,000Capital account Jan. 1, 2008 38,000 Increase 22,000Add: Withdrawals made $11,000Less: Cash investment made 5,000 6,000

Net income $28,000




(a) Total net revenue:Sales $390,000Less: Sales discounts $ 7,800 Sales returns 12,400 20,200 Net sales 369,800Dividends earned 71,000Rental revenue 6,500

Total net revenue $447,300

(b) Net income:Net revenues (from a) $447,300Expenses: Cost of goods sold 184,400 Selling expenses 99,400 Administrative expenses 82,500 Interest expense 12,700 Total expenses 379,000 Income before taxes 68,300Income taxes 31,000 Net income $ 37,300

(c) Dividends declared:Ending retained earnings $134,000Beginning retained earnings 114,400

Net increase 19,600Less net income (37,300 )Dividends declared $ 17,700



EXERCISE 4-3 (Continued)

ALTERNATE SOLUTION

Beginning retained earnings $114,400Add net income 37,300

151,700Deduct dividends declared (derive) ?___ Ending retained earnings $134,000

Dividends declared must be $17,700 ($151,700 – $134,000)




Geneva Inc.Income Statement

For Year Ended December 31, 2008

Sales $2,100,000Less sales discounts 15,000

Net sales 2,085,000 Expenses

Cost of goods sold 420,000Selling expenses 336,000Administrative expenses 84,000Interest expense 20,000

Total expenses 860,000 Income before taxes 1,225,000

Income taxes 428,750 Net income $ 796,250Earnings per share $53.08

Determination of amounts:

Administrative expenses

=

20% of cost of good sold

$84,000 = 20% of $420,000

Gross sales X 4% = administrative expensesGross sales = $2,100,000 ($84,000 / 4%)

Selling expenses = four times administrative expenses.(operating expenses consist of sellingand administrative expenses; since selling expenses are 4/5 of operating expenses, selling expenses are 4 times administrative expenses.)

= 4 X $84,000= $336,000

Per share $53.08 ($796,250 15,000)EXERCISE 4-5 (30-35 minutes)Solutions Manual 4-8 Chapter 4Copyright © 2007 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is strictly prohibited.


(a) Multiple-Step FormSingh Corp.

Income StatementFor the Year Ended December 31, 2008

(In thousands, except earnings per share)

Sales $106,500

Cost of goods sold 58,570

Gross profit 47,930

Operating Expenses Selling expenses Sales commissions $7,280 Amortization of sales

equipment 6,48

0 Transportation-out 2,290 $16,050

Administrative expenses Officers’ salaries 3,900 Amortization of office

furniture and equipment 3,560 7,460 23,510

Income from operations 24,420

Other Revenues and Gains Rental revenue 15,230

39,650Other Expenses and Losses Interest expense 1,860

Income before taxes 37,790 Income taxes 9,070 Net income $28,720

Earnings per share $.94*

*($28,720,000 30,550,000)




(b) Single-Step FormSingh Corp.


(In thousands, except earnings per share)

Revenues Net sales $ 106,500 Rental revenue 15,230 Total revenues 121,730

Expenses Cost of goods sold 58,570 Selling expenses 16,050 Administrative expenses 7,460 Interest expense 1,860 Total expenses 83,940

Income before taxes 37,790Income taxes 9,070 Net income $ 28,720

Earnings per share $.94

(c) Single-step:1. Simplicity and conciseness.2. Probably better understood by user.3. Emphasis on total costs and expenses and net

income.4. Does not imply priority of one expense over another.

Multiple-step:1. Provides more information through segregation of

operating and non-operating items.2. Expenses are matched with related revenue.




(a) Multiple-Step FormYing-Wai Corporation


Sales Revenue Sales $930,000 Less: Sales returns and allowances 15,000 Net sales 915,000

Cost of Goods Sold Merchandise inventory, January 1, 2008 $120,000 Purchases $600,000 Less purchase discounts 10,000 Net purchases 590,000 Add transportation-in 14,000 604,000 Total merchandise available for sale 724,000 Less merchandise inventory,

December 31, 2008 137,00

0 Cost of goods sold 587,000 Gross profit 328,000

Operating Expenses

Selling expenses

Sales salaries 71,000 Amortization expense—store

equipment 18,00

0 Store supplies expense 9,000 98,000 Administrative expenses Officers’ salaries 39,000 Amortization expense—building 28,500 Office supplies expense 9,500 77,000 175,000


Other Revenues and Gains Dividends revenue 20,000

173,000




Other Expenses and Losses Interest expense 9,000 Income before taxes and extraordinary item 164,000 Income taxes 55,760 Income before extraordinary item 108,240Extraordinary item Loss from flood damage 50,000 Less applicable income tax reduction 17,000 33,000 Net income $ 75,240

Earnings per share: Income before extraordinary item $5.41 Extraordinary item (1.65) Net income $3.76




(b) Single-Step FormYing-Wai Corporation


Revenues Net sales $915,000 Dividends revenue 20,000 Total revenues 935,000

Expenses Cost of goods sold 587,000 Selling expenses 98,000 Administrative expenses 77,000 Interest expense 9,000 Total expenses 771,000

Income before taxes and extraordinary item 164,000 Income taxes 55,760 Income before extraordinary item 108,240Extraordinary item Loss from flood damage $50,000 Less applicable income tax reduction 17,000 33,000 Net income $ 75,240Earnings per share: Income before extraordinary item $5.41 Extraordinary item (1.65) Net income $3.76




(c) Single-step:1. Simplicity and conciseness.2. Probably better understood by user.3. Emphasis on total costs and expenses and net

income.4. Does not imply priority of one expense over another.

Multiple-step:1. Provides more information through segregation of

operating and non-operating items.2. Expenses are matched with related revenue.




(a) Evelyn Roberts Inc.Income Statement

for the Year Ended December 31, 2008

RevenuesSales $1,900,000 Rent revenue 40,000

Total revenues 1,940,000

ExpensesCost of goods sold 850,000 Selling expenses 300,000 Administrative and general expenses 240,000


Income from continuing operations before taxes 550,000 Income taxes 187,000

Income from continuing operations 363,000

Discontinued operations:Loss from operation of Micron Division

(net of $25,000 in tax recovery) 50,000 Income before extraordinary items 313,000 Extraordinary items:

Gain from expropriation (net of $29,000 in taxes) 66,000Loss from flood (net of $18,000 in tax recovery) (42,000)

Net Income $ 337,000

Earnings per share:Income from continuing operations $14.52 Discontinued operations (2.00 ) Income before extraordinary items 12.52 Extraordinary items 0.96 Net income $13.48



EXERCISE 4-7 (Continued)(b) Evelyn Roberts Inc.

Statement of Income and Retained Earningsfor the Year Ended December 31, 2008

RevenuesSales $1,900,000 Rent revenue 40,000

Total revenues 1,940,000 Expenses

Cost of goods sold 850,000 Selling expenses 300,000 Administrative and general expenses 240,000

Total expenses 1,390,000 Income from continuing operations before taxes 550,000

Income taxes 187,000 Income from continuing operations 363,000 Discontinued operations:

Loss from operation of Micron Division(net of $25,000 in tax recovery) 50,000

Income before extraordinary items 313,000 Extraordinary items

Gain from expropriation (net of $29,000 in taxes) 66,000Loss from flood (net of $18,000 in tax recovery) (42,000)

Net Income $ 337,000 Retained earnings, January 1 600,000

937,000 Less: Dividends declared 70,000 Retained earnings, December 31 $ 867,000

Earnings per share:Income from continuing operations $14.52 Discontinued operations (2.00) Income before extraordinary items 12.52 Extraordinary items 0.96 Net income $13.48




Voisine Corp.Income Statement


Sales Revenue Sales $1,380,000 Less: Sales returns and allowances $150,000 Sales discounts 45,000 195,000 Net sales revenue 1,185,000

Cost of goods sold 621,000 Gross profit on sales 564,000

Operating ExpensesSelling expenses 194,000Administrative and general expenses 97,000 291,000


Other Revenue and GainsInterest revenue 86,000

359,000Other Expenses and Losses

Interest expense 60,000

Income before taxes and extraordinary item 299,000Income taxes 131,560

Income before extraordinary item 167,440Extraordinary item

Loss from earthquake damage 150,000Less applicable tax reduction 66,000 84,000

Net income $ 83,440

Earnings per share:Income before extraordinary item $0.84Extraordinary item (0.42 )Net income $0.42




Sooyoun CorporationIncome Statement


Net sales $4,162,000Cost of goods sold 2,665,000 Gross profit 1,497,000Selling expense $636,000Administrative expense 491,000 1,127,000 Income from operations 370,000Other revenue 240,000Other expense 176,000 64,000 Income before taxes 434,000 Income taxes* 147,560 Income before extraordinary item 286,440Extraordinary loss, net of $23,800 taxes 46,200 Net income $ 240,240

Earnings per share: Income before extraordinary item** $3.18 Extraordinary item (0.51 ) Net income $2.67

Supporting calculations: * Income taxes ($434,000 x 34%) = $147,560** $286,440 divided by 90,000 common shares.

Sales Revenue Sales $4,275,000 Less: Sales discounts $34,000 Sales returns 79,000 113,000 Net sales $4,162,000




Cost of Goods Sold: Merchandise inventory, Jan. 1, 2007 $535,000 Purchases $2,786,000

Less purchase returns (15,000) Less purchase discounts (27,000) Net purchases 2,744,000 Add transportation-in 72,000 2,816,000 Total merchandise available for sale 3,351,000

Less merchandise inventory Dec. 31, 2007 686,000 Cost of Goods Sold $2,665,000

Selling expenses:Sales salaries $284,000Sales commissions 83,000Travel and entertainment 69,000Advertising 54,000Transportation-out 93,000Amortization of sales equipment 36,000Telephone - sales 17,000 $636,000

Administrative Expenses:Office salaries $346,000

Accounting and legal services 33,000Insurance 24,000

Amortization of office 48,000 Utilities - office 32,000 Miscellaneous office expenses 8,000 $491,000




(a) Gottlieb Corp.Income Statement


Sales Revenue Net sales $1,300,000 Cost of goods sold 780,000 Gross profit 520,000

Operating ExpensesSelling expenses $65,000Administrative expenses 48,000 113,000


Other Revenue and GainsDividend revenue 20,000Interest revenue 7,000 27,000


Write-off of inventory due to obsolescence 80,000

Income before taxes and extraordinary item 354,000Income taxes 155,760


Casualty loss 50,000Less applicable tax reduction 22,000 28,000

Net income $ 170,240





(b) Gottlieb Corp.Retained Earnings Statement


Balance, January 1, as reported $ 980,000Correction for overstatement of net income in prior period (amortization error) (net of $24,200 tax) (30,800)Balance, January 1, as restated 949,200Add: Net income 170,240

1,119,440Less: Dividends declared 45,000 Balance, December 31 $1,074,440

(c)Dr) Retained Earnings 30,800Dr) Income taxes payable/receivable 24,200

Cr) Accumulated Amortization 55,000




(d) Gottlieb Corp.Statement of Income and Retained Earnings


Sales Revenue Net sales $1,300,000 Cost of goods sold 780,000 Gross profit 520,000Operating Expenses

Selling expenses $65,000Administrative expenses 48,000 113,000

Income from operations 407,000Other Revenue and Gains

Dividend revenue 20,000Interest revenue 7,000 27,000


Write-off of inventory due to obsolescence 80,000 Income before taxes and extraordinary item 354,000

Income taxes 155,760 Income before extraordinary item 198,240

Extraordinary item:Casualty loss (net of $22,000 in taxes) 28,000

Net income 170,240Retained earnings, January 1, as

previously reported 980,000Correction for overstatement of net

income in prior period (amortization error) (net of $24,200 tax) 30,800

Retained earnings, January 1, as restated 949,200 1,119,440

Less: Dividends declared 45,000 Retained earnings, December 31 $1,074,440





(e) Advantages: Since typically few transactions or adjustments are made to retained earnings, users have all of the changes to shareholders’ equity (except for share transactions) on one page. The combined statement also shows how net income flows to the balance sheet since the bottom number is the ending retained earnings balance that corresponds to the balance sheet. The format can also save on printing costs by eliminating an extra page.

Disadvantage: The presentation is not as comprehensible when the combined statements are too long or when adjustments are required to the opening balance of retained earnings. The presentation would also not be useful where the company reports comprehensive income since the other comprehensive income flows to accumulated other comprehensive income, whereas net income is closed to retained earnings.




(a)

2007:Loss from beginning of year to September 30 $(1,900,000)Loss from September 30 to December 31 (700,000)Estimated loss on impairment of net assets on

June 1, 2008, net of tax (150,000) Total loss $(2,750,000)

2008:No gain or loss on disposal reported in 2008. However, if applicable, any gains or losses from operating the subsidiary from January 1, 2008 to the disposal date would be reported in 2008.

(b)Discontinued operations (2007):

Loss from operations of CBTV subsidiary, net of tax $2,600,000

Loss on impairment of net assets of CBTV, net of tax 150,000

Loss from discontinued operations $2,750,000

(c)The correction of the gain or loss from disposal of a segment reported in 2007 should be reported in 2008 in the discontinued operations section of the income statement, net of tax and with separate EPS disclosure, supported by an explanation in a note to the financial statements. The correction receives the same treatment as a change in estimate.




(a) The income statement and related footnote are as follows:

Income from continuing operations before income taxes $144,000Income taxes 43,200 Income from continuing operations 100,800Discontinued operations (Note XX)

Income from operations of the discontinued Song and Elwood Division, less applicable income taxes $1,800 $4,200Loss on impairment of assets of

discontinued operations, less applicable income taxes of $6,000 (14,000) (9,800)

Net income $91,000

Note XX—Discontinued Operations. On October 5, 2008, the board of directors decided to dispose of the Song and Elwood Division by auction on May 10, 2009.

(b)The cleaning equipment would be shown separately on the balance sheet as part of noncurrent assets as “noncurrent asset related to discontinued operations. The asset would be valued at the lower of its carrying value and fair value less cost to sell. In this case this means the cleaning equipment would be remeasured at its estimated selling price of $5,000, which is net of selling costs.




Calculation of net income: 2009 net income after tax $43,000,000 2009 net income before tax [$43,000,000 (1 – .44)] 76,785,714 Add back major casualty loss 15,000,000 Income from operations 91,785,714 Income taxes (44% X $91,785,714) 40,385,714 Income before extraordinary item 51,400,000 Extraordinary item: Casualty loss 15,000,000 Less applicable income tax reduction 6,600,000

8,400,000 Net income $43,000,000

Net income $43,000,000 Less cumulative preferred dividends (8% of $4,500,000) 360,000 Income available for common 42,640,000 Common shares 10,000,000 Earnings per share $4.26

Income statement presentation Earnings per share: Income before extraordinary item $5.10a

Extraordinary item (0.84)b

Net income $4.26

a $51,400,000 – $360,000= $5.10

10,000,000

b $8,400,000= $0.84

10,000,000




Net income:Income from continuing operations

before taxes$23,650,000

Income taxes (35%) 8,277,500 Income from continuing operations 15,372,500 Discontinued operations Loss before taxes $3,225,000 Less applicable income tax 1,128,750 2,096,250 Net income $13,276,250

Preferred dividends declared: $ 1,075,000

Weighted average common shares outstanding: 12/31/07–3/31/08 (4,000,000 x 3/12) 1,000,000 4/1/08–12/31/08 (4,400,000 x 9/12) 3,300,000 Weighted average 4,300,000

Earnings per share: Income from continuing operations $3.33* Discontinued operations (.49 )** Net income $2.84***

*($15,372,500 – $1,075,000) 4,300,000. **$2,096,250 4,300,000.***($13,276,250 – $1,075,000) 4,300,000.




Holiday CorporationRetained Earnings Statement


Balance, January 1, as reported $270,000*Correction for amortization error (net of $22,230 tax)

(34,770)

Retroactive adjustment for change in inventory method (net of $14,430 tax) 22,570

Balance, January 1, as adjusted 257,800Add net income 207,400 **

465,200Deduct dividends declared 100,000 Balance, December 31 $365,200

*($55,000 + $135,000 + $160,000) – ($30,000 + $50,000)**[$340,000 – (39% X $340,000)]




Rosy Randall CorporationIncome Statement


Net sales $1,200,000Cost of goods sold 750,000 Gross profit 450,000Operating expenses

Selling and administrative expenses 320,000 Net income 130,000Other comprehensive income

Unrealized holding gains, net of tax 18,000 Comprehensive income $148,000




Kelly CorporationStatement of Shareholders' Equity

For the Year Ended December 31, 2008 (all amounts in thousands)

TotalComp. Income

Preferred Shares

Common Shares

Contr. Surplus

Retained Earnings

Acc. Other Comp.

Inc.

Beginning Balance $22,240 $1,526 $2,591 $2,425 $13,692 $2,006 Comprehensive Income:

Net income 4,352 $4,352 4,352 Other comprehensive income

Unrealized holding loss (348) (348) (348)

Comprehensive Income $4,004 Dividends to shareholders:

Preferred (23) (23)Common (7) (7)

Issue of Common shares 170 170

Ending Balance $26,384 $1,526 $2,761 $2,425 $18,014 $1,658




(b) Kelly CorporationBalance Sheet (Partial)

December 31, 2008

(‘000)

Share capital:Preferred shares $ 1,526Common shares 2,761 Total share capital 4,287

Contributed surplus 2,425 Total paid-in capital 6,712Retained earnings 18,014Accumulated other comprehensive income 1,658

Total shareholders’ equity $26,384



*EXERCISE 4-18 (10-15 minutes)

(a) Portmann Corp.Income Statement (Cash Basis)

For the Year Ended December 31,

2007 2008

Sales $320,000 $515,000Expenses 225,000 247,000 Net income $ 95,000 $268,000

(b) Portmann Corp.Income Statement (Accrual Basis)For the Year Ended December 31,

2007 2008

Sales* $510,000 $445,000Expenses** 277,000 230,000 Net income $233,000 $215,000

*2007: $320,000 + $160,000 + $30,000 = $510,000 2008: $355,000 + $90,000 = $445,000**2007: $185,000 + $67,000 + $25,000 = $277,000 2008: $40,000 + $135,000 + $55,000 = $230,000



TIME AND PURPOSE OF PROBLEMS

Problem 4-1 (Time 40-45 minutes)

Purpose—to provide the student with an opportunity to prepare an income statement and a retained earnings statement. A number of special items such as loss from discontinued operations, unusual items, and extraordinary losses are presented in the problem for analysis purposes. The problem also requires calculating the tax effect of special item from a net-of-tax amount.


Purpose—to provide the student with an opportunity to prepare an income statement and retained earnings statement using the single-step format.


Purpose—to provide the student with an opportunity to analyse a number of transactions and to prepare a partial income statement. The problem includes discontinued operations, extraordinary item, and earnings per share. The student must also prepare a statement of retained earnings and then discuss the impact of GAAP classification rules on the assessment of the quality of earnings.


Purpose—to provide the student with the opportunity to prepare a multiple-step and single-step income statement and a retained earnings statement from the same underlying information. The problem emphasizes the differences between the multiple-step and single-step income statement.


Purpose—to provide the student with a problem on the income statement treatment of (1) a usual but infrequently occurring charge, (2) an extraordinary item and its related tax effect, (3) a change in estimate, and (4) earnings per share. The student is required to identify the proper income statement treatment and to provide the rationale for such treatment. A revised income statement must be prepared.



TIME AND PURPOSE OF PROBLEMS (CONTINUED)


Purpose—to provide the student the opportunity to distinguish between different scenarios involving discontinued operations, extraordinary items and changes in accounting policy. Three different scenarios are proposed and a combined statement of income and retained earnings must be prepared. The problem involves intraperiod tax allocation. This problem is comprehensive.


Purpose—to provide the student with an opportunity to prepare a retained earnings statement. A number of special items must be reclassified and reported in the income statement. This problem illustrates the fact that ending retained earnings is unaffected by the choice of disclosing items in the income statement or the retained earnings statement, although the income reported would be different.


Purpose—to provide the student with the opportunity to correct a multi-step income statement. The student must determine which of the items presented should be presented in the income statement and must prepare a proper income statement. A combined statement of income and retained earnings is also required. This statement includes an adjustment to the beginning retained earnings balance for a change in policy. The student must also discuss the purpose of intraperiod tax allocation.


Purpose—to provide the student with a problem to determine the reporting of several items, which may get special treatment as irregular items. This is a good problem for a group assignment.


Purpose—to provide the student with a discontinued operations problem that requires discussion of balance sheet and income statement disclosure along with an illustration of the income statement presentation. The student is also required to discuss the factors applied to justify the use of the discontinued operations treatment and the impact on users of financial information.





Purpose—to provide the student with the opportunity to comment on deficiencies in an income statement format. The student is required to comment on such items as inappropriate heading, incorrect classification of special items, proper net of tax treatment, and presentation of per share data. The student is also required to prepare a correct income statement.


Purpose—to provide the student a real company context to identify factors that make income statement information useful. The focus is on overly aggregated information in a condensed income statement. Additional detail would seem to be warranted either on the face of the statement or with reference to the notes.


Purpose—to provide the student with an understanding of conditions where extraordinary item classification is appropriate. In this problem, it should be emphasized that in situations where extraordinary item classification is not permitted, a classification as an unusual item may still be employed.


Purpose—to provide the student an illustration of how earnings can be managed. The case allows students to see the effects of warranty expense timing on the trend of income and illustrates the potential use of accruals to smooth earnings.


Purpose—to provide the student with an understanding of the difference between the current operating and all-inclusive income statement. In addition, the student is to comment on the income statement presentation of a number of special items. Presentation of the proper earnings per share is also emphasized. A revised income statement presentation is required as well as a revised retained earnings statement.





Purpose—to provide the student with the opportunity to comment on deficiencies in a single-step income statement. This case includes discussion of extraordinary items, tax reassessments, and ordinary gains and losses. The problem provides a broad overview to a number of items discussed in the textbook.

*Problem 4-17 (Time 35-40 minutes)

Purpose—to provide an opportunity for the student to prepare and compare (a) cash basis and accrual basis income statements, (b) cash basis and accrual basis balance sheets, and (c) to discuss the weaknesses of cash basis accounting.

*Problem 4-18 (Time 40-50 minutes)

Purpose—to provide an opportunity for the student to determine income on an accrual basis. The student is asked to write a letter indicating what was done to arrive at an accrual basis net income.



SOLUTIONS TO PROBLEMS

PROBLEM 4-1

Barkley Corp.Income Statement


Sales $36,500,000Less cost of goods sold 28,500,000 Gross profit 8,000,000Less selling and administrative expenses 4,700,000

Income from operations 3,300,000Other revenues and gains

Interest revenue $170,000Gain on the sale of investments in trading

securities 110,000 280,000 3,580,000

Other expenses and lossesWrite-off of goodwill 520,000Assessment of additional income taxes 500,000 1,020,000

Income from continuing operations before income taxes 2,560,000

Income taxes**** 1,074,000 Income from continuing operations 1,486,000Discontinued operations

Loss from operations, net of taxes of $38,571* 90,000

Loss from disposition, net of taxes of $188,571** 440,000 530,000

Income before extraordinary item 956,000Extraordinary loss from flood damage, net of

taxes of $167,143*** 390,000 Net income $ 566,000

Earnings per share:Income from continuing operations $ 1.77a

Discontinued operations (0.66)b

Extraordinary loss (0.49) c

Net income $ 0.62d



PROBLEM 4-1 (Continued)

a $1,486,000 – $70,000= $1.77

800,000 shares

b ($530,000) = ($0.66)

800,000 shares

c ($390,000)= ($0.49)

800,000 shares

d $566,000 – $70,000= $0.62

800,000 shares

* $38,571 = [$90,000 / (100% - 30%)] - $90,000** $188,571 = [$440,000 / (100% - 30%)] - $440,000*** $167,143 = [$390,000 / (100% - 30%)] - $390,000**** Income tax expense = ($2,560,000 + $520,000 + $500,000) X

30% = $1,074,000. The goodwill and 2006 additional income taxes are not tax-deductible.

Barkley Corp.Retained Earnings Statement


Beginning balance of retained earnings $1,980,000Add net income 566,000

2,546,000Less dividends

Preferred shares $ 70,000Common shares 250,000 320,000

Ending balance of retained earnings $ 2,226,000



PROBLEM 4-2

McLean CorporationIncome Statement


RevenuesNet sales* $1,368,000Gain on sale of land 30,000Rent revenue 18,000


ExpensesCost of goods sold** 785,000Selling expenses 432,000Administrative expenses 99,000


Income before taxes 100,000Income taxes 38,500

Net income $ 61,500Earnings per share $2.05

* ($1,400,000 – $14,500 – $17,500)

**Cost of goods sold: Merchandise inventory, January 1 $ 89,000 Purchases $810,000 Less purchase discounts 10,000 Net purchases 800,000 Add freight-in 20,000 820,000 Merchandise available for sale 909,000 Less merchandise inventory, December 31 124,000 Cost of goods sold $785,000




McLean CorporationRetained Earnings Statement


Retained earnings at beginning of the year $ 260,000Plus net income 61,500

321,500Less cash dividends declared 45,000 Retained earnings at end of the year $ 276,500



PROBLEM 4-3

(a) Charyk Inc.Income Statement (Partial)


Income from continuing operations before taxes $1,738,500*Income taxes 673,800 **

Income from continuing operations: 1,064,700Discontinued operations:

Loss from disposal of recreational division $115,000Less applicable income tax reduction 46,000 69,000

Income before extraordinary item 995,700Extraordinary item:

Major casualty loss 80,000Less applicable income tax reduction 32,000 48,000

Net income $947,700

Earnings per share:Income from continuing operations $13.31Discontinued operations (0.86 )Income before extraordinary items 12.45Extraordinary item (0.60) Net income $11.85

*Calculation of income from continuing operations before taxes: As previously stated $1,790,000 Loss on sale of securities (107,000) Gain on proceeds of life insurance policy

($100,000 – $46,000) 54,000Error in calculation of amortization:

As calculated ($54,000 6) $9,000Corrected ($54,000 – $9,000) 6 7,500 1,500

As restated $1,738,500

**Calculation of income tax: Income from continuing operations before income tax $1,738,500 Nontaxable income (gain on life insurance) (54,000 ) Taxable income 1,684,500 Tax rate X .40 Tax expense $673,800




(b) Charyk Inc.Retained Earnings Statement


Retained earnings, January 1, 2008, as reported $2,540,000Correction of amortization overstatement

(net of tax of $1,200) * 1,800Retroactive adjustment for change in inventory

method (net of tax of $16,000) ** 24,000 Retained earnings, January 1, 2008, as adjusted $2,565,800Add: Net income 947,700

3,513,500Deduct Dividends declared 175,000 Retained earnings, December 31, 2008 $3,338,500

* Error in calculation of amortization:

As calculated ($54,000 6) $9,000

Corrected ($54,000 – $9,000) 6 7,500

Understatement of net income per year 1,500

X 2

Total understatement of beginning retained earnings 3,000

After-tax understatement ($3,000 X [1-40%]) $1,800

**Understatement of 2006 income $60,000

Overstatement of 2007 income (20,000)

Net understatement of beginning retained earnings 40,000

After-tax understatement ($40,000 X [1-40%]) $24,000




(c) The GAAP classification rules assist in assessing the quality of earnings by separating extraordinary items and discontinued operations from continuing and non-extraordinary results of operations. Extraordinary items involve non-recurring unusual transactions and separating them from regular operations helps users assess the results of transactions within management’s control. Discontinued operations are also presented separately to provide predictive value. By separating the results of operations that are being discontinued from ongoing operations, users can assess ongoing operations and more easily predict future performance. Results from continuing operations usually have greater significance for predicting future performance than do results from nonrecurring activities.

The GAAP classification rules also apply to financial statement elements and separate revenues and expenses from gains and losses. This separation helps users assess the past performance and profitability based on recurring, regular transactions and predict sustainability of earnings.

GAAP also requires various other items of the income statement to be disclosed. These also provide information to users to assess the quality, recurrence and sustainability of earnings and management’s performance. For example: government assistance, goodwill impairment, income taxes, etc.



PROBLEM 4-4

(a) Reid CorporationIncome Statement

For the Year Ended June 30, 2008

Sales Revenue Sales $1,928,500 Less: Sales discounts $31,150 Sales returns 62,300 93,450 Net sales 1,835,050Cost of Goods Sold 1,071,770 Gross profit 763,280Operating Expenses Selling expenses Sales commissions $97,600 Sales salaries 56,260 Travel expense 28,930 Entertainment expense 14,820 Freight-out 21,400 Telephone and Internet 9,030 Amortization of sales equipment 4,980 Building expense 6,200 Bad debt expense 4,850 Miscellaneous selling expense 4,715 248,785

Administrative Expenses Real estate and other local taxes 7,320Building expense 9,130

Amortization of office furniture and equipment 7,250

Office supplies used 3,450Telephone and Internet 2,820Miscellaneous office expenses 6,000 35,970 284,755

Income from operations 478,525Other Revenues and Gains Dividend revenue 38,000

516,525Other Expenses and Losses Bond interest expense 18,000 Income before taxes 498,525 Income taxes 133,000 Net income $ 365,525Earnings per share* $1.98

* ($365,525 – $9,000 of preferred dividends 180,000 shares)




Reid CorporationRetained Earnings Statement


Retained earnings, July 1, 2007, as reported $292,000Correction of amortization understatement

(net of tax) 17,700Balance July 1, 2004 adjusted $274,300Add: Net income 365,525

639,825Deduct: Dividends declared on preferred shares 9,000 Dividends declared on common shares 32,000 41,000 Retained earnings, June 30, 2008 $598,825

(b) Reid CorporationIncome Statement


RevenuesNet sales $1,835,050Dividends revenue 38,000


ExpensesCost of goods sold 1,071,770Selling expenses 248,785Administrative expenses 35,970Bond interest expense 18,000


Income before taxes 498,525Income taxes 133,000

Net income $ 365,525Earnings per share $1.98



PROBLEM 4-5(a)1. The usual but infrequently occurring charge of $10,500,000

should be disclosed separately, assuming it is material. This charge is shown above income before extraordinary items and would not be reported net of tax. This item should be separately disclosed to inform the user of the financial statements that this item is not frequently recurring and therefore may not impact next year's results. Furthermore, trend comparisons may be misleading if such an item is not highlighted and adjustments made. The item should not be considered extraordinary because it is usual in nature.

2. The extraordinary item of $9,000,000 should be reported net of tax in a separate section for extraordinary items. An adjustment should be made to income taxes to report this amount at $22,400,000. The $3,000,000 tax effect of this extraordinary item should be reported with the extraordinary item. The reason for the separate disclosure is much the same as that given above for the separate disclosure of the usual, but infrequently occurring item. Readers must be informed that certain revenue and expense items may be unusual and infrequent such that their likelihood for affecting operations again in the future is unlikely. Separate earnings per share information must also be presented for the extraordinary item.

3. The adjustment required for correction of an error is inappropriately labelled and also should not be reported in the retained earnings statement. Changes in estimate should be handled in current and prospective periods through the income statement. Catch-up adjustments are not permitted. To restate financial statements every time a change in estimate occurred would be extremely costly and confusing. In addition, adjusting the beginning balance of retained earnings is inappropriate, as the increased charge in this case would never be run through current or future income statements.




4. Earnings per share should be reported on the face of the income statement or in the notes to the financial statements according to the CICA Handbook Sec 3500.61. Because such importance is ascribed to this ratio, the profession believes it necessary to highlight the earnings per share figure. In this case it should report both income before extraordinary item, extraordinary item and net income on a per share basis.



PROBLEM 4-5 (Continued)(b)

Pereira Corp.Combined Statement of Income and Retained Earnings


($000 omitted)

Net sales $640,000

Cost and expenses:Cost of goods sold 500,000Selling, general and administrative

expenses (a) 55,500 Loss due to write-down of inventory 10,500Other, net (b) 8,000

574,000Income before taxes and extraordinary item 66,000 Income taxes 22,400Income before extraordinary item 43,600Extraordinary item: Extraordinary loss (net of taxes of $3,000) 6,000 Net income 37,600Retained earnings, at beginning of the year 141,000

178,600Less: Dividends on common shares 12,200 Retained earnings, at end of the year $166,400

(a) $66,000 - $10,500 = $55,500(b) $17,000 - $9,000 = $8,000



PROBLEM 4-6

SITUATION A:

Olive Miller Ltd.Combined Statement of Income and Retained Earnings


Sales ($5,700,000 - $1,200,000) $4,500,000Cost of goods sold ($2,900,000 - $600,000) 2,300,000Gross margin 2,200,000Selling, general and administrative expenses

($1,800,000 - $450,000 - $620,000) 730,000 Income before income taxes 1,470,000

Income taxes 441,000 Income from continuing operations 1,029,000Discontinued operations:

Income from apparel division (net of income taxes of $45,000)* $105,000

Loss on disposal of apparel division (net of income taxes of $186,000) 434,000 329,000

Income before extraordinary item 700,000Extraordinary item: Extraordinary loss (net of taxes of

$210,000) 490,000Net income 210,000Retained earnings, January 1 700,000 Retained earnings, December 31 $910,000

* ($1,200,000 - $600,000 - $450,000)




SITUATION B:



Sales $5,700,000Cost of goods sold 2,900,000Gross margin 2,800,000Selling, general and administrative expenses* 1,902,600Income from operations 897,400Other losses:Loss on disposal of equipment

($490,000 + $210,000) 700,000 Income before income taxes 197,400

Income taxes 59,220 Net income 138,180Retained earnings, January 1 700,000 Retained earnings, December 31 $838,180

* The amount recorded as bad debts expense represents the 1.2% rate ($68,400 / $5,700,000 = 1.2%)Revised bad debts expense = $5,700,000 X 3% = $171,000Bad debts expense previously recorded 68,400 Increase in bad debts expense $102,600




SITUATION C:



Sales $5,700,000Cost of goods sold 2,900,000Gross margin 2,800,000Selling, general and administrative expenses* 1,786,000Income from operations 1,014,000Other expenses:Loss due to labour disruption ($490,000 + $210,000) 700,000 Income before income taxes 314,000

Income taxes 94,200 Net income 219,800Retained earnings, January 1, as

previously reported $700,000Cumulative increase in prior years’

income from change in depreciation policy (net of income taxes of $24,000) 56,000

Retained earnings, January 1, restated 756,000 Retained earnings, December 31 $975,800

* Change in accounting policy:Double-

decliningStraight-

line2006: $500,000 X 2/10 $100,000 $50,0002007: ($500,000 - $100,000) X 2/10 80,000 50,000 Total for prior years $180,000 $100,000Net decrease in depreciation expense

= $180,000 - $100,000 = $80,000

2008: ($500,000 - $180,000) X 2/10 $64,000 $50,000Net decrease in depreciation expense in 2008= $64,000 - $50,000 = $14,000



PROBLEM 4-7

Byron Corp.Retained Earnings Statement


Retained Earnings, January 1, as reported $257,600Correction of error from prior period (net of tax) 25,400Retroactive adjustment for change in amortization

method (net of tax) (18,200) Adjusted balance of retained earnings at January 1 264,800Add net income 107,300 *

372,100Deduct cash dividends declared 32,000 Retained earnings, December 31 $340,100

*$107,300 = ($129,500 + $41,200 + $21,600 – $25,000 – $60,000)

(b) 1. Gain on sale of investment in trading securities—body of income statement, possibly unusual item

2. Refund of litigation—body of income statement, possibly unusual item.

3. Loss on discontinued operations—body of the income statement, following the caption, “Income from continuing operations, shown net of tax”

4. Write-off of goodwill—body of income statement, possibly unusual item.



PROBLEM 4-8

Hamad CorporationIncome Statement


Sales $9,500,000Cost of goods sold 5,900,000 Gross profit 3,600,000Selling and administrative expenses $1,280,000 *Loss due to write-down of inventory 112,000 **Total operating expenses 1,392,000 Income before taxes and extraordinary item 2,208,000 Income taxes 662,400 ***Income before extraordinary item 1,545,600Extraordinary item: Major casualty loss (net of taxes of

$69,429****) 162,000 Net income $1,383,600

Earnings per share: Income before extraordinary item $3.86 Extraordinary item (.40 ) Net income $3.46

* The 2007 sales commissions of $20,000 are deducted.** The $112,000 may be identified as an unusual item if

unusual or infrequent in nature. However, it cannot be considered extraordinary.

*** (30% of $2,208,000).**** The extraordinary loss before taxes = $162,000 / [100% -

30%] = $231,429. Income taxes = $231,429 - $162,000 = $69,429.




Hamad CorporationStatement of Income and Retained Earnings


Sales $9,500,000Cost of goods sold 5,900,000 Gross profit 3,600,000Selling and administrative expenses $1,280,000 Loss due to write-down of inventory 112,000 Total operating expenses 1,392,000 Income before taxes and extraordinary item 2,208,000 Income taxes 662,400 Income before extraordinary item 1,545,600Extraordinary item: Major casualty loss (net of taxes of

$69,429) 162,000 Net income 1,383,600Retained earnings, January 1,

as reported 2,800,000Cumulative effect on prior years of change in amortization method (net of taxes of $36,563) 85,312Correction of error in prior year’s income (net of taxes of $6,000) 14,000

Retained earnings, January 1, as restated 2,700,6884,084,288

Less: Cash dividends 700,000 Retained earnings, December 31 $3,384,288

Earnings per share: Income before extraordinary item $3.86 Extraordinary item (.40 ) Net income $3.46




(c) The income tax is allocated in the same manner as the underlying irregular item or adjustment to opening retained earnings. Since income taxes are a major expense for companies, it is important to reflect the individual impact of taxes for discontinued operations, extraordinary items, corrections of errors and changes in accounting policies. This helps users assess the quality of earnings and their related tax impact. Earnings per share information is also highlighted separately, net of taxes, for discontinued operations and extraordinary items. Intra period tax allocation also helps readers in trend analysis of income tax expense, and income from continuing operations by making the current year amount on a comparable basis with prior years.



PROBLEM 4-9

Fadime Corp.Income Statement (Partial)


Income from continuing operations before taxes $3,272,000*Income taxes 1,243,600 **

Income from continuing operations 2,028,640Discontinued operations

Loss from operations of discontinued subsidiary $ 90,000

Less applicable income tax reduction 34,200 $55,800

Loss from disposal of subsidiary 200,000 Less applicable income tax reduction 76,000 124,000 179,800

Net income $1,848,840

Earnings per share:Income from continuing operations $20.29Discontinued operations (1.80 )Net income $18.49

*Income from continuing operations before taxes:

As previously stated $2,710,000

Write-off of account receivable (54,000)

Gain on sale of equipment 96,000

Settlement of lawsuit 520,000

Restated $3,272,000

**Income tax expense: $3,272,000 X .38 = $1,243,360

Note: The prior year error related to the intangible asset was correctly charged to retained earnings.



PROBLEM 4-10

(a) The Rocketeer Division’s assets should be identified separately on Campbell Corporation’s balance sheet as of May 31, 2008 and carried at their net realizable value of $87 million, i.e., the amount of cash sale. This identification can be made in the body of the statement by showing the assets of the Rocketeer Division as a separate listing or by disclosure in a note to the financial statement.

(b) The operating loss must be reported as a separate component after income from continuing operations and before extraordinary items. The operating loss up to year end is presented as a loss from discontinued operations. The operating loss from a discontinued segment is presented net of tax. Separate earnings per share figures would also be required. The division assets would be measured at the lower of net book value and fair market value less costs to sell. The loss would be presented as a separate component of discontinued operations, on an after-tax basis.

All figures in thousands, except earnings per share:Income from continuing operations (Note–): $XXX

Loss from operations of the Rocketeer division less applicable income taxes of $4,000 $(6,000) Loss from impairment of Rocketeer division assets less applicable income taxes of $3,600* (5,400) $(11,400)

Net income $XXX

* Book value of assets $96,000,000Fair value 87,000,000Impairment loss $(9,000,000 )Applicable taxes (40%) 3,600,000After-tax loss $(5,400,000 )



(Note to instructor: We have presented the calculations in this format in order for the student to better understand how the loss on disposal was calculated. Other formats are acceptable.)


(c) The operating loss from June 1-30, 2008 is reported as a separate component after income from continuing operations and before extraordinary items. The operating loss is presented as a loss from discontinued operations on a net of tax basis. The loss on the disposal of the division assets would be presented as a separate component of discontinued operations, on an after-tax basis. The amounts would be disclosed on a comparative basis with the results of 2007. Separate earnings per share figures for the discontinued operations would also be required.

All figures in thousands, except earnings per share:Income from continuing operations (Note–): $XXX

Loss from operations of the Rocketeer division less applicable income taxes of $300 $(450) Loss from disposal of Rocketeer division assets less applicable income taxes of $1,200* (1,800) $(2,250)

Net income $XXX

(d) The Rocketeer Division financial results should be shown as a discontinued operation according to the following factors:

management has “formally” decided to dispose of the Rocketeer Division.

The division is a separate component of the entity and is operationally distinct as evidenced by the measurement of the division losses;

There is an active program to find a buyer (negotiations are in process).

Management could argue the following points against using discontinued operations treatment:

Changes to the plan are possible or likely; and



The assets are not available for immediate sale in their current state;


Management would usually prefer using the discontinued operations treatment. This separates the financial results of the division from continuing operations and allows users to concentrate on continuing financial results and to assess management performance on the more profitable parts of the business. This also allows users to see the unprofitable impact of the Rocketeer Division on prior years’ results since the treatment is applied retroactively. For a user, showing discontinued operations at the bottom of the income statement after income tax expense and with its own earnings per share information, provides more information about the quality and recurrence of earnings.



PROBLEM 4-11

The deficiencies of Amos Corporation income statement are as follows:

1. The heading is inappropriate. The heading should include the name of the company and the period of time for which the income statement is presented.

2. Gain on recovery of insurance proceeds should be classified as an extraordinary item in a separate section of the income statement.

3. The unrealized holding gain should be shown after net income as part of other comprehensive income, on a net of tax basis.

4. Cost of goods sold is usually listed as the first expense, followed by selling, administrative, and other expenses.

5. Advertising expense is a selling expense and should usually be classified as such, unless this expense is unusually different from previous periods.

6. Loss on obsolescence of inventories might be classified as an unusual item and separately disclosed if it is unusual or infrequent but not both.

7. Loss on discontinued operations requires a separate classification after income from continuing operations and before presentation of income before extraordinary items.

8. Intraperiod income tax allocation is required to relate income tax expense to income from continuing operations, loss on discontinued operations, and the extraordinary item.

9. Per share data is a required presentation for income from continuing operations, loss from discontinued operations, extraordinary gain, and net income.




Amos CorporationStatement of Income and Comprehensive Income


RevenuesSales $850,000Dividends 32,300

Total revenues 882,300 Expenses

Cost of goods sold 510,000Selling expenses ($100,100 + $13,700) 113,800Administrative expenses 73,400Loss on obsolescence of inventories 34,000

Total expenses 731,200 Income from continuing operations before

income taxes 151,100Income taxes* 60,440 Income from continuing operations 90,660Discontinued operations

Loss from operations, (net of taxes of $19,440)** 29,160


Gain from earthquake, (net of taxes of $10,920) 16,380 Net income 77,880Other comprehensive income

Unrealized holding gain, (net of taxes of $2,000) 3,000

Comprehensive income 80,880

Earnings per share:Income from continuing operations $0.91 a

Discontinued operations (0.29) b

Extraordinary gain 0.16 c

Net income $0.78 d

* The income tax rate is inferred as 40% by comparing the income tax expense to the income before income tax = $53,920 / $134,800.

** $19,440 = $48,600 X 40%.a $90,600/ 100,000 shares`b ($29,160) / 100,000 sharesc $16,380 / 100,000 sharesd $77,880/ 100,000 shares



PROBLEM 4-12

(a) The main deficiency in the Baring statement is that important information is being aggregated, particularly in the “Costs and Expenses” line item. More detail likely could be found in Baring’s published financial statements. However, the condensed income statement may be the one that investors and creditors rely upon. Also, the statement is missing the earnings per share information.

(b) Baring could provide additional details on the expenses included in Costs and Expenses on the face of the income statement. Alternatively, the company could provide the information in the notes to the financial statements, which could be referenced on the face of the income statement. Mandatory disclosure is required somewhere in the financial statements for the items such as amortization and interest expense. The company should also provide the earnings per share information.

(c) Companies may provide minimal disclosure in order to not reveal competitive or sensitive financial information. Management may also not be aware of the type of detailed information users would find useful since financial information is prepared by management based on their assessment of users’ needs. Company management may also mistakenly view GAAP requirements as the required disclosure rather than the minimum amount required. Management may also use minimal disclosure to avoid questions on its management practices and assessment or its stewardship abilities or to hide financial engineering transactions that could prove embarassing.



PROBLEM 4-13

1. Classify as an extraordinary item because all three conditions of an extraordinary item are met: unusual in nature and infrequent in occurrence does not depend primarily on decisions or determinations by management or owners.

2. Classify as a loss, but not extraordinary. Such losses would not be considered unusual for a business enterprise.

3. Classify as an extraordinary loss because the three conditions of an extraordinary item are met: unusual in nature and infrequent in occurrence, and event did not depend primarily on decisions or determinations by management or owners.

4. Classify as gain or loss, but not extraordinary. Because the company maintains a portfolio of such securities, the gain or loss would not be considered unusual in nature. The sale was also the result of a management decision.

5. Classify as an unusual gain or loss but not extraordinary because the third condition has not been met for extraordinary item treatment, since management decided to enter into the sale of the shares.

6. Classify as a gain or loss, but not extraordinary. Company practices indicate such sales are not unusual or infrequent in occurrence.

7. Classify as an expense with appropriate disclosure. Relocation costs are not considered an extraordinary item nor a cost associated with the disposal of a segment of the business. Relocation is a consequence of customary and continuing business activities and therefore is not considered unusual in nature.




8. Material losses on extinguishment of debt does not qualify

for extraordinary item treatment as the loss was incurred as a result of a management decision and are not an infrequent occurrence in this case.

9. Classify as a loss, but not extraordinary. The loss is not an infrequent occurrence taking into account the environment in which the entity operates.

10. Classify as a gain, but not extraordinary. Although the sale of the land is unusual and infrequent, it is also the result of a decision of management.



PROBLEM 4-14

(a) Earnings management is often defined as the planned timing of revenues, expenses, gains and losses to smooth out bumps in earnings. In most cases, earnings management is used to increase income in the current year at the expense of income in future years. For example, companies prematurely recognize revenue before it is earned in order to boost income. Earnings management can also be used to decrease current earnings in order to increase income in the future. This is done through the creation of reserves by using unrealistic assumptions to estimate liabilities for such items as sales returns, loan losses, and warranty returns.

(b) Proposed Accounting Income:2005 2006 2007 2008 2009

Income before warr. expense

$43,000

$43,000

Warr. expense 8,000 2,000 Income $20,000 $25,000 $30,000 $35,000 $41,000

Assuming the same income before warranty expense for both 2008 and 2009 and total warranty expense over the 2-year period of $10,000, this proposed accounting results in steadily increasing income over the two-year period.

(c) Appropriate Accounting Income:2005 2006 2007 2008 2009

Income before warr. expense

$43,000

$43,000

Warr. expense 5,000 5,000 Income $20,000 $25,000 $30,000 $38,000 $38,000

The appropriate accounting would be to record $5,000 in 2008, resulting in income of $38,000. However, with the same amount of warranty expense in 2009, Grace no longer shows an increasing trend in income. Thus, by taking more expense in 2008, Grace can maintain its growth trend in income.





PROBLEM 4-15

(a) The controller is using the current operating concept of income because non-operating items are charged directly to retained earnings. These non-operating items are: gain from casualty (net of tax) and loss from expropriation (net of tax). The gain on the sale of plant assets should be shown as a separate component of income from continuing operations. The correction of an error should be shown as an adjustment to the beginning balance of retained earnings.

(b) The answer to this question is dependent upon the reasons the student gives in support of his/her position. The current operating performance concept implies that (1) extraordinary gains and losses are not considered as either representative or reflective of earning power, and that (2) many users are not trained to differentiate between ordinary and extraordinary items. Therefore, extraordinary items are charged directly to retained earnings to avoid confusion. The all-inclusive concept implies that extraordinary items should be included along with regular operating income to reflect the long-range income-producing ability of the enterprise. Advocates of this approach state that any gain or loss experienced by the firm, whether directly or indirectly related to operations, contributes to long-run profitability and should be included in the calculation of net income. Also, it is contended that if judgement is permitted in the classification of extraordinary items, differences develop in the treatment of questionable items, which permit the manipulation of net income.

(c) The modified all-inclusive concept must be employed. The income statement and statement of retained earnings are as follows:



Problem 4-15 (Continued)

Tatooed Heart Inc.Income Statement


Sales Revenue Sales $377,852 Less sales returns and allowances 16,320 Net sales revenue 361,532Cost of Goods Sold

Merchandise inventory, January 1, 2008 $ 50,235 Purchases $192,143 Less purchase discounts 3,142 Net purchases 189,001 Total merchandise available for sale 239,236 Less merchandise inventory,

December 31, 2008 41,12

4 Cost of goods sold 198,112

Gross profit 163,420Operating Expenses Selling expenses 41,850 Administrative expenses 32,142 73,992


Other Revenues and Gains

Dividend revenue 40,000

Gain on sale of plant assets 21,400 61,400

Income before taxes and extraordinary item 150,828

Income tax 43,900

Income before extraordinary item 106,928

Extraordinary items:

Gain from casualty (net of tax) 10,000

Loss on expropriation (net of tax) (13,000 ) (3,000 )

Net income $103,928

Earnings per share:

Income before extraordinary items $2.14

Extraordinary items (.06 )

Net income $2.08



Problem 4-15 (Continued)

Tatooed Heart Inc.Retained Earnings Statement


Balance, January 1, as reported $216,000Correction of a mathematical error (net of tax) (17,186 )Balance, January 1, as adjusted 198,814Net income 103,928 Balance, December 31 $302,742



PROBLEM 4-16

The Income Statement of Klein Corporation contains the following weaknesses in classification and disclosure:

1. Sales taxes: sales taxes have been erroneously added to gross sales on the Income Statement of Klein Corporation. Failure to deduct these taxes directly from customer billings results in a deceptive inflation of the amount of sales. These taxes should be deducted from gross sales because the Corporation acts as an agent in collecting and remitting such taxes to the government.

2. Purchase discounts: purchase discounts should not be treated as revenue by being lumped with other revenue such as dividends and interest. A purchase discount is more logically a reduction of the cost of purchases because revenue is not created by purchasing goods and paying for them. In a cash transaction, cost is measured by the amount of the cash consideration. In a credit transaction, however, cost is measured by the amount of cash required to settle immediately the obligation incurred. The discount should reduce the cost of goods sold to the amount of cash that would be required to settle the obligation immediately.

3. Recoveries of amounts written off in prior years: these collections should be credited to the allowance for doubtful accounts unless the direct write-off method was used in accounting for bad debt expense, in which case the recovery would offset the current year’s bad debt expenses. Generally, the direct write-off method is not allowed, as it does not adhere to the matching principle.




4. Freight-in and freight-out: although freight-out is an expense of selling and is therefore reported properly in the statement, freight-in is a cost related to the acquisition of merchandise for resale should have been included in the calculation of cost of goods sold. The value assigned to inventory should represent the value of the economic resources given up in obtaining goods and readying them for sale.

5. Addition to reserve for possible inventory losses: additions to inventory reserves should not be treated as operating expenses. An appropriation is not an operating expense because it is only an anticipated loss from a future event, which is neither more nor less probable because of a past event. It does not represent a reduction in future benefits. It is a notification to shareholders that $3,800 of earnings retained for use in the business is designated for a stated purpose and is not available for dividends.

6. Loss on discontinued styles: this type of loss, though often substantial, should not be treated as an extraordinary item because it is apparently typical of the customary business activity of the corporation. It should be reported in "Costs and Expenses" as an operating expense.

7. Loss on sale of trading securities: this item should be reported as a separate component of income from operations and not as an extraordinary item. The conditions are not unusual in nature and management had influence over the outcome of this transaction.

8. Loss on sale of warehouse: this loss cannot be classified as an extraordinary item unless such a loss is the direct result of a major casualty, an expropriation, or a prohibition under a newly enacted law or regulation. This item should be separately disclosed as an unusual item, if either unusual in nature or infrequent in occurrence.




9. Tax reassessments for 2006 and 2005: a recurring settlement of income taxes should not be treated as an extraordinary item. The loss should be recognized as a charge to expense from operations before extraordinary items.

10. Income taxes: the income statement is missing income tax as an expense.



*PROBLEM 4-17

(a) Razorback Sales and ServiceIncome Statement

For the Month Ended January 31, 2008

Cash Basis

AccrualBasis

Revenues $75,000 $105,750*

ExpensesCost of computers & printers: Purchased and paid 89,250** Sold 63,750***Salaries 9,600 12,600Rent 6,000 2,000Other Expenses 8,400 10,400 Total expenses 113,250 88,750

Net income (loss) $(38,250) $ 17,000

* ($2,550 X 30) + ($4,500 X 4) + ($750 X 15) ** ($1,500 X 40) + ($3,000 X 6) + ($450 X 25)*** ($1,500 X30) + ($3,000 X 4) + ($450 X 15)



*PROBLEM 4-17 (Continued)

(b) Razorback Sales and ServiceBalance Sheet

As of January 31, 2008

Cash Basis

Accrual Basis

AssetsCash $51,750a $ 51,750a

Accounts Receivable 30,750Inventory 25,500b

Prepaid rent ______ 4,000 Total assets $51,750 $112,000

Liabilities and Owners’ EquityAccounts payable $ 2,000Salaries payable 3,000Owners’ equity $51,750c 107,000 d

Total liabilities and owners’ equity

$51,75 0

$112,00 0

aOriginal investment $90,000 Cash sales 75,000 Cash purchases (89,250) Rent paid (6,000) Salaries paid (9,600) Other expenses (8,400) Cash balance Jan. 31 $51,750

b(10 X $1,500) + (2 X $3,000) + (10 X $450).cInitial investment minus net loss: $90,000 – $38,250.dInitial investment plus net income: $90,000 + $17,000.




(c) 1. The $30,750 in receivables from customers is an asset and a future cash flow resulting from sales that is ignored. The cash basis understates the amount of revenues and inflow of assets in January from the sale of computers and printers by $30,750.

2. The cost of computers and printers sold in January is overstated by $25,500. The unsold computers and printers are an asset of $25,500 in the form of inventory.

3. The cash basis ignores $3,000 of the salaries that have been earned by the employees in January and will be paid in February.

4. Rent expense on the cash basis is overstated by $4,000 under the cash basis. This prepayment is an asset in the form of two months’ future right to the use of office, showroom, and repair space and should appear on the balance sheet.

5. Other operating expenses on a cash basis are understated by $2,000 as is the liability for the unpaid portion of these expenses incurred in January.



*PROBLEM 4-18

Dear Dr. Gleason:

Last week, you asked me to calculate net income on the accrual basis for Bones Clinic. For the year ending December 31, 2008, Bones Clinic earned $99,610. The following explanation as well as the attached schedule should help you to understand how I derived this amount.

First, I determined how much of your cash collections resulted from work which you actually performed during 2008. Obviously, the fees receivable existing on January 1, 2008 could not have been earned during 2008. Likewise, your ending receivables represent revenue, which you earned during 2008 but were not paid for. Because cash collections include payments made on beginning receivables but not on year-end receivables, beginning fees receivable must be subtracted from your cash collections while year-end fees receivable must be added.

The same logic applies to your unearned fees. As of January 1, 2008, these fees of $2,840 represent treatment that your patients had paid for but had not yet received. At year-end, a $1,620 balance in this account indicates revenue, which you collected but have not yet earned. Because the beginning unearned fees were eventually earned during 2008, they must be added to 2008 cash collections while the ending fees must be deducted.

Next, I calculated your 2008 expenses. Accrued expenses at the beginning of the year represent those incurred but not paid during 2007. Likewise, those at year-end were incurred during 2008 but not yet paid at year-end. Because cash disbursements include payments made on 2007 liabilities but not on 2008 liabilities existing at year-end, your 2008 disbursements must be adjusted for these items. To determine expenses resulting from operations during 2008, I subtracted the beginning accrued expenses balance and added the ending accrued expenses balance.




Finally, prepaid expenses represent money paid in advance for services, which you have not yet received. Your beginning prepaid expenses represent 2008 expenses paid in advance while ending prepaid expenses indicate 2009 expenses. Thus, I added beginning prepaid expenses and subtracted the ending ones to derive 2008 expenses.

As a result, your gross revenue for 2008 is $154,070, and your operating expenses are $54,460, amounting to net income of $99,610. The enclosed schedule provides supporting computations.

I hope that this information helps you. Thank you for giving me the opportunity to serve you.

Sincerely,

Your Name, C.A.




Bones ClinicConversion of Income Statement

From Cash Basis to Accrual BasisFor the Year 2008

Cash Adjustments Accrual Basis Add Ded. Basis

Receipts from fees: $146,000 –Fees receivable, Jan. 1 $9,250 +Fees receivable, Dec. 31 $16,100 +Unearned fees, Jan. 1 2,840 –Unearned fees, Dec. 31 1,620 Revenue from fees $154,070Disbursements: 55,470 –Accrued expenses, Jan. 1 3,435 +Accrued expenses, Dec. 31 2,200 +Prepaid expenses, Jan. 1 2,000 –Prepaid expenses, Dec. 31 1,775 Operating expenses ______ 54,460Receipts over disbursements -cash basis $90,530 ______Net income—accrual basis $ 99,610



TIME AND PURPOSE OF WRITING ASSIGNMENTS

WA 4-1 (Time 25-35 minutes)

Purpose—to provide the student with an understanding of the difference between the current operating and all-inclusive income statement. Although the current operating statement has lost favour with the profession, the continual expansion of special items below income from continuing operations suggests that the profession believes merit exists for a modified current operating concept.

*WA 4-2 (Time 15-20 minutes)

Purpose—to provide the student with the opportunity to discuss cash versus accrual financial statements. The student must discuss the need for accrual based financial information in an expanding business.

WA 4-3 (Time 30 minutes)Purpose – held for sale assets



SOLUTIONS TO WRITING ASSIGNMENTS

WA 4-1

(a) The “current operating performance” income statement is intended to provide a net income figure that is the best possible indication of the earning power of the business. Under this concept the importance of the amount of recurring net income, the indication of earning power, requires that all material extraordinary and nonrecurring items be reported as adjustments to retained earnings. Only items of revenue and expense applicable to the regular operations of the current period should be used in ascertaining net income for the period.

The “all-inclusive” income statement may be said to have been prepared on the "clean surplus" theory. All extraordinary and nonrecurring items, regardless of their materiality, are included in the determination of periodic net income. Thus, a series of income statements will reveal all income information for the periods covered by the statements.

(b) An income statement prepared strictly on the current operating performance basis would show operating expenses deducted from net revenues to arrive at income from the operations, which characterize the business. Recurring financial items are then added or deducted to produce net income. Material nonrecurring items are not included in the income statement but are charged or credited directly to retained earnings.

An income statement prepared strictly on the all-inclusive basis would show the same calculation of income from operations as does the current operating performance statement. Then the non-operating and nonrecurring items and corrections of prior periods' income would be added or deducted to produce net income.

There is substantial agreement that over the years all profits and losses should be accounted for in income, and a starting presumption is that all items of profit and loss recognized during an accounting period should be reported in the income of that period. However, it is recognized that readers of income statements draw inferences from a company's reported net income figure. For this reason extraordinary charges and credits should be segregated on the same income statement in a separate section appropriately labelled.



WA 4-1 (CONTINUED)

(c) Arguments advanced for the "all-inclusive" income statement are:1. Extraordinary items are related to income determination, and net income

for the period would be misstated if they were excluded.2. All items should be included so that the income statements over a period

of years will aggregate to the company's total income.3. Readers of the financial statements might be unaware that the retained

earnings statement should be read as well as the income statement to determine the results of the year's activities. Items handled through retained earnings might be overlooked.

4. Often there is no clear division between extraordinary items and operating items—frequently the distinction is a matter of opinion.

5. Charges and credits to retained earnings imply that the items are nonrecurring, but such items do recur.

6. There is a tendency for retained earnings charges to exceed credits so that, over a period of years, the income statements would exaggerate the company's earning power.

7. Retained earnings charges and credits create an opportunity for manipulation or normalization in the determination of net income.

8. Inconsistencies in determining extraordinary items affect the comparability of the company's earnings with prior years and with earnings of other companies.

9. The reader's attention is directed to the estimated and tentative nature of the income statement when corrections of prior years' net income are included.

Arguments offered for the "current operating performance" income statement are:

1. The earning power of the company is of interest to investors and others. Only normal operations produce the net income in which they are interested.

2. When nonrecurring items are included in the income statement, some readers are unable to determine the results of normal operations.

3. Inclusion of nonrecurring items causes difficulty in determining the trend of the company's operations and in comparing the results of operations with others.

4. There is a distortion of income for two years when a material correction of a prior year's net income is reported in the income statement.



WA 4-1 (CONTINUED)

Proponents of the combined "income and retained earnings statement" argue that:

1. The statement carries out the theory that the income statement is the connecting link between retained earnings at the beginning and the end of the period.

2. Including beginning and ending totals of retained earnings is desirable as a means of linking together the income statement and the balance sheet.

3. All factors affecting retained earnings during the period are combined in one statement so that none will be overlooked.

4. The statement distinguishes current charges and credits related to usual business operations from extraordinary charges and credits by placing them in different sections of a continuous statement.

5. The reader can readily determine the disposition of the current period's net income as to whether it has been distributed as dividends or retained in the company.

d. Other Comprehensive Income includes such items as: unrealized gains and losses on available-for-sale securities, certain translation gains and losses on foreign currency and unrealized gains and losses on certain hedging transactions. Other comprehensive income can be recorded on the Income Statement after Net Income. It is also acceptable to include it on the Statement of Equity or by adding another statement disclosing the Other Comprehensive Income. With respect to unrealized holding gains and losses on securities, this method of disclosure (i.e. segregation from net income): highlights the effect that fluctuations in fair value has on net income and it provides additional information to the user about the gain or loss that would result on a sale of an investment. The question is: why segregate this from net income? It is thought that it transitions GAAP over to an “all-inclusive” concept of net income.



*WA 4-2

This question deals with the ethical issues of honesty and integrity in financial reporting, job security for Banks, and the owners’ right to know the financial picture.

Banks could prepare financial statements on both bases and explain the differences to the owners. If the owners withdraw cash from the business without considering the need to replace inventory and capital assets, they may harm the business’ long term prospects. Users outside the business such as banks and other creditors would require financial statements prepared on the accrual basis.

WA 4-3

The financial reporting issue in this question is whether the Building should continue to be recorded as Property, Plant and Equipment (and depreciated) or whether it should be reclassified. As there is a formal plan to sell its head office tower which has been approved by the Board of Directors, this asset no longer meets the definition of Property, Plant and Equipment. Instead, it would likely be reclassified as an Inventory item and remeasured to the lower of its carrying value and its fair value. Therefore, the Building would be segregated on the balance sheet as an “asset held for sale” and remeasured to its fair value of $49 million. When an asset is reclassified, the company would stop depreciating the asset.

Further, the write down of the asset would result in a Loss from write-down of Property, Plant and Equipment. The CICA specifically states that such a loss would not be considered an Extraordinary Item as they are “usual in nature” and may be “expected to recur”. Therefore, this loss would be reported on the Income Statement as an Other Expense item.



RESEARCH AND FINANCIAL ANALYSIS

RA4-1

a. Stantec Inc. uses a condensed multi-step income statement.

B. Stantec Inc. is in the business of providing professional services in the area of infrastructure such as engineering, architecture, interior design, surveying and geometrics. This is indicated in the notes to the financial statements, specifically in note 1. On the income statement, the direct payroll cost represents the cost of sales figure which is typical of a professional services company. Also, given the nature of its earnings process, the company uses the percentage of completion method of revenue recognition which is reflected on the balance sheet with the use of the accounts: “costs and estimated earnings in excess of billings” and “billings in excess of costs and estimated earnings”.

c. The company describes the new set of standard on comprehensive income and financial instruments in the “recent accounting pronouncements” section in note 1. These new standards are not reflected in the 2005 financial statements, but the company intends to adopt the changes in 2007. It is expected that any “unrealized losses on the translation of self-sustaining foreign operations will be included in comprehensive income” and that the new standard on financial instruments (fair value valuation) would not impact the financial statements materially.



RA 4-2 ROYAL BANK OF CANADA

(a) The core business activities of the bank are to lend money to businesses, individuals and governments. Interest income is the main source of revenue for the Royal Bank. The direct expenses related to the earning of interest revenue are interest expense and provision for credit losses. Other expenses incurred to generate this revenue include labour, occupancy, equipment, communication, and professional fees.

(b) The presentation of the statement of income of Royal Bank highlights the sub-total between revenues from its core activities, less interest expense. The caption is “Net interest income”. This caption is highlighted in the income statement, to make comparisons easier between years and between banks. Other income items, which are of reduced significance in size, are itemized together, as are non-interest expenses.

(c) The primary sources of income for the last three fiscal years for the Royal Bank appear below (in millions of Canadian dollars).

2005 % of total 2004 % 2003 % Primary sources Interest income: Loans 10,790 36.70%9,535 37.73%9,900 40.32% Securitie 4,583 15.593,572 14.143,025 12.32 Reverse repurchase agreements 1,354 4.6 656 2.60 873 3.56 Deposits with banks 231 .79 103 .41 101 .41Primary sources Non-interest revenue : Insurance premiums 3,270 11.12 2,870 11.36 2,356 9.60 Trading revenue 1,594 5.42 1,563 6.19 1,908 7.77 Investment management and custodial fees 1,255 4.27 1,126 4.46 1,098 4.47 Securities brokerage commissions 1,163 3.96 1,166 4.61 1,031 4.20 Service charges 1,153 3.92 1,089 4.31 1,122 4.57 Underwriting and other advisory fees 1,026 3.49 918 3.63 813 3.31 Mutual fund revenue 962 3.27 850 3.36 673 2.74

Card service revenue 579 1.97 555 2.20 518 2.11

Foreign exchange 407 1.38 331 1.31 279 1.13

Securitization revenue 285 .97 200 .79 165 .67 Credit fees 187 .64 198 .78 227 .92Other 564 1.91 538 2.12 462 1.90

Total 29,403 100% 25,270 100% 24,551 100%



RA4-2 ROYAL BANK OF CANADA (continued)

The primary source of revenue by far continues to be interest income and specifically, interest from loans. The percentage of total coming from this source is declining. The primary sources of non-interest revenues are insurance premiums, trading revenues, management fees and securities commissions. The percentages of total income/revenues coming from these non-interest sources are consistent.



RA4-3 TRIZEC CANADA INC AND MAINSTREET EQUITY CORP

(a) Trizec Canada Inc. uses the condensed multi-step income statement format while Mainstreet Equity Corp. uses the single step format.

(b) Both companies are the real estate property rental business. Mainstreet’s strategy includes investing in capital assets through renovation and enhancement of operating efficiencies. This represents a source of revenue in addition to the primary source which is rental income. Trizec is primarily in the business of owning, renting and managing commercial property and does not explicitly identify selling properties part of its business strategy. It appears, however, that Trizec does turn over properties quite frequently.

(c) The main source of revenues for both companies is rental revenues. Rental revenues have increased for both companies from 2004 to 2005, but Mainstreet’s rental revenue increased by 21.33% while Trizec’s increased by 10.9%

(d) Yes, the nature of the business is reflected in the balance sheets of both companies. The primary asset for both companies is real estate properties and this asset represents 88.02% total assets for Mainstreet and 88.26% for Trizec. In 2005.

(e) Mainstreet has reported no irregular items in the income statements for the years presented, implying that all activities were normal. Trizec has reported many irregular items implying that such items are not part of normal operations. However, the fact that these items appear in both years presented implies that perhaps they are not really irregular. This brings to question whether the company has changed strategies to include buying and selling but has not updated their financial reporting accordingly by still defining items relating to sales of properties as irregular.



RA4-4 CANADIAN SECURITIES ADMINISTRATION

(a) The documents that can be found on the CSA website listed for the Bank of Montreal and the Royal Bank of Canada include:

1. Notices of annual filing2. Auditors’ comfort letters3. Consent letters of issuer’s legal counsel4. Prospectuses and related documents5. Decision Documents6. Press releases7. Interim financial statements8. Annual reports9. Annual information form10.Confirmations of mailing11.Proxy forms12.Meeting notices

(b) The annual information form provides reference to and some of the information required pursuant to the National Policy Statement No. 47 of the Canadian Securities Administrators and Schedule IX of the Quebec Securities Act Regulation for filing various regulatory authorities in Canada.

The majority of the financial information provided is referenced from an index provided to the Annual Report, providing page number references. Information not contained in the annual report follows the index and contains more historical information and information such as the name, principal occupation, and place of residence of the members of the Management Board.

Since the majority of the information provided is financial in nature, it would most certainly be of interest to a financial statement analyst. Although the information can be located through other means, it is less likely to have missing information. It can be relied upon for completeness and accuracy, since it is also being closely monitored and used by the regulatory authorities.

(c) The auditor of the Bank of Montreal is KPMG LLP. The auditor of Royal Bank of Canada is Deloitte & Touche LLP.

(d) The stock of Bank of Montreal is traded on the Toronto Stock Exchange, and the New York Stock Exchange. The stock of the Royal Bank of Canada is traded on the Toronto Stock Exchange and the New York Stock Exchange.



RA4-4 CANADIAN SECURITIES ADMINISTRATION (CONTINUED)

(e) The banks’ web sites with links for investor relations provide the most current announcements and notices of the banks, and provide information such as the Annual Reports, but in segments. For example the web user can select to read only the notes to the financial statements. While the information is and should be the same as what is filed with the securities authorities, it is being presented in a more user-friendly format, considering the many possible users that gain access to this information through the web site. The web presentation can also take advantage of some multi-media presentation techniques that is not necessarily appropriate for the formal annual filings. Information of a more promotional nature is being emphasized for marketing and other purposes. Additional links to live updates of stock transactions, for example, are also available through this site.



RA4-5

(a) Phase B of the financial statement presentation project “addresses the fundamental issues of presentation of information on the face of the financial statements; the Boards are currently deliberating issues in this Phase. The working principles of Phase B of the project are as follows. The FASB report titled Financial Statement Presentation (dated June 2006) states that “financial statements should present information in a manner that:

1. Portrays a cohesive financial picture of an entity.2. Allows for comparability over time.3. Allows for comparability across entities.4. Helps a user assess the liquidity of an entity’s assets and liabilities

(nearness to cash or time to conversion to cash).5. Separates an entity’s financing activities from its operating and

other activities and further separates financing activities into transactions with owners in their capacity as owner and all other financing activities.

6. Helps a user understand:a. The measurement attributes used to measure assets

and liabilitiesb. The relative dispersion of the measurements of

individual assets and liabilitiesc. What causes a change in reported amounts of

individual assets and liabilities (such as transactions of remeasurements).

7. Disaggregates items into groups that respond similarly to changes in the same economic condition, and presents subtotals and totals where appropriate.”

(b) There are a number of Income Statement categories that are being proposed. Firstly, it is being proposed that a financing category be added to the income statement and separated from its operating activities. Another proposal is that income statement items should be disaggregated into groups, either by function or by nature. If items are segregated based on nature, “like expenses such as depreciation, material costs, transportation costs etc… would not be allocated to the various functions of an entity (such as cost of sales).” Those who support this method of presentation say that there would be an increase to the statement’s predictive value. To illustrate this, investors could not predict future cost of goods sold when looking at the traditional reporting based on function. More specifically, since raw materials, labour charges and overhead are recorded in cost of goods sold, the readers would need to understand the specific items included in cost of good sold to make predictions about each item.



RA4-5 (CONTINUED)

c. In the proposal that financing activities be separated from other items on the statements, it appears that Other Comprehensive Income would not be shown separate after Net Income, instead it would be listed in the Operating section of the Income Statement. This could impact the usefulness of the Income Statement as its separate presentation highlights the fair value valuation of investments as well as the other items included in Other Comprehensive Income.



RA4-6 QUALITY OF EARNING RESEARCH

Student responses will vary depending on their sources. Some key points are as follows:

the more earnings reflect underlying economic reality, the higher the quality

earnings which are sustainable are higher quality than unsustainable earnings which can be converted to positive cash flow more quickly

are higher quality than those which have a longer time lag or more uncertainty with respect to the ultimate conversion to cash flow

the less risky the business environment and the better the risks are managed, the higher the quality of earnings

more objectively determined earnings are higher quality than earning which involve a high degree of estimation, accounting alternative choices and management bias

the more straightforward the presentation, the higher the quality of earnings



RA4-7 ALLIANCE ATLANTIS COMMUNICATIONS INC.

Management reporting of additional earnings numbers outside of the traditional audited financial statements provides additional information that would not otherwise be presented, or in some cases available, to investors and other users. The presentation of such information can assist users in assessing results of operations and financial position and in predicting future earnings potential. It allows users to focus specifically on what management sees as relevant information since it is tailored to that specific company and circumstances.

The problem with reporting additional earnings numbers is not so much with the practice, per se, as with how it is done. If the calculations and reasons for the items selected for adjustment are not clearly disclosed, and if a reconciliation with net income is not provided, the additional information may be confusing and/or misleading rather than aiding users in their decision making process. The other problem with these numbers is that no standards exist to ensure that they are calculated consistently, which means that it is risky to make comparisons between companies on the basis of these numbers.

In the case of this company, I do not think that this presentation provides good, useful information because the company does not provide a detailed reconciliation between EBITDA and GAAP based net income and does not sufficiently explain why this particular measure should be given special emphasis.



CASES

See the Case Primer on the Student Website as well as the summary case primer in the front of the text. Note that the first few chapters of the text lay the foundation for financial reporting decision-making. Therefore the cases in the first few chapters (1-5) are shorter with less depth. As such, they may not cover all aspects of a full-blown case analysis.

CA4-1 ALLEN CORP

Overview:

The Casino Royale Division is material since it contributes 30% of net income – therefore presentation and accounting is important. As auditor, you would want to provide the most useful information for transparency. The shareholders and investors of the company will want to assess the impact of the disposition on the future earnings capabilities of the company. Therefore, there may be some bias to show gains as income from continuing operations and expenses as one time or extraordinary items.

GAAP is a constraint since you are auditing the financial statements.

In conclusion, you would conservatively assess the financial reporting.

Analysis and recommendations:

The sale of the Casino Royale Division would qualify as a discontinued operation since the management of gambling facilities is a separate component for Allen Corp. It does not appear that the company will have any continued involvement in the division. As a division, the operational cash flows and books would be separate, allowing the company to capture the information for preparing the financial statements.

Therefore the accounting requirements related to discontinued operations should be followed. Although the financial vice-president might be correct regarding confusing users, professional pronouncements require that such segregation be made. A separate classification is required for disposals meeting the requirements of discontinued operations, net of applicable taxes, and with separate earnings per share disclosure.

The "walkout" or strike should not be reported as an extraordinary item. Events of this nature are a general risk that any business enterprise takes and should not warrant extraordinary item treatment. Not only would this type of event be typical it would not meet the third condition required for extraordinary item treatment Solutions Manual 4-94 Chapter 4Copyright © 2007 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is strictly prohibited.


either, because management had some influence over the outcome of the event described.

The financial vice-president is incorrect in his/her observations concerning the net materiality of the unusual and extraordinary items. The materiality of each item must be considered individually. It is not appropriate to consider only the materiality of the net effect of several financial statement items. Each extraordinary item, for example must be reported separately on the income statement.

Earnings per share for income from discontinued operations and extraordinary items must be reported on the face of the income statement or in the financial statement notes, in accordance with Section 3500.60/.61 of the CICA Handbook.



CA 4-2 ANDERSON CORP

Overview:

The brand name is important to the company, therefore, steps have been taken to protect the name after a major food recall where the food was tampered with.

The controller would want to ensure that the financial statements presented the full picture showing that the company had acted responsibly by recalling all products, designing the media campaign to alert consumers and producing new tamper proof packages. Since this would all be at a cost, the cost should be presented in such a way that this would be apparent. Investors and creditors will want to assess the impact of the problem on the company’s ability to continue operations.

Earnings of $225 million would result in materiality of approximately $11 million (5% of income from continuing operations – see AuG 41). The product tampering and recall is material because the credits and refunds alone are thirteen percent of earnings before income taxes.

It is unclear as to whether the company is public and therefore if GAAP is a legal constraint however, it is assumed that GAAP statements would provide the most useful statements.

As controller, you may want to be more conservative as well as transparent in this case. Any losses taken this year will result in fewer losses taken in future.

Analysis and Recommendations:

Issue: Should the product tampering and related costs be treated as an extraordinary item?

The product tampering and related costs in general are atypical because of the catastrophic nature. They are infrequent because it is the first occurrence in the more than fifty-year history of Anderson Corp.—with no indication that the event will recur. Lastly, had management or owners been able to take any action to avoid or influence this adverse result, they would certainly have done so. For all of these reasons, Anderson should treat this charge as an extraordinary item.

The extraordinary charge should be properly described as a "Loss from product tampering and recall" and placed in a separate section in the income statement between discontinued operations (if any) and net income. The charge must be presented net of its applicable income taxes and the taxes may be shown parenthetically or in columnar form. Reporting earnings per share amounts for



extraordinary items is also necessary either on the face of the income statement or in the notes to the financial statements. Details of the extraordinary charge should be disclosed in the notes to the financial statements.

Items 1, 3, 5, 6, 7, 8, 10, and 13 should be included in the extraordinary charge.Items not included in the extraordinary charge and the reason for each is as follows:

Item Number

Reason Not Included

2 Insurance to cover possible future events is not directly related to the 2008 event. Should be capitalized and expensed over future periods. This is an ordinary operating cost which will recur annually.

4 Future security measures are future costs and not directly related to the 2008 event. Should be deferred and expensed over future periods in order to match with future revenues.

9 These packaging costs are not directly related to the 2008 event and should be matched against revenues from the sale of the packaged products.

11 These costs resulted from a decision of the company in its reaction to the 2008 event. However, the costs are related to future operations as well. They may be charged to operating expense or spread over the estimated period that the redesigned package will be in use.

12 The cost of the packaging equipment should be charged to an asset account and expensed over its estimated useful life.

14 Lost sales revenue is an opportunity cost and is not recorded or disclosed anywhere on the financial statements. Ultimately, the lost sales revenue will already be incorporated in the financial statements through lower reported revenues.



CA 4-3 OSC

Overview:

As a member of the OSC, your role is to ensure that company financial statements provide good information to suppliers of capital so that they can make decisions about where to invest. GAAP is a constraint since all of these companies would be public companies if they were required to file financial statements with the OSC. It is not possible to identify reporting biases for all these companies.

Analysis and Recommendations

Description Discussion

1. Inventory overstated two years ago. Error has "washed out"; that is, subsequent income statement compensated for the error. However, prior year income statements should be restated if presented for comparative purposes and a discussion of the error reported in the notes, since the prior year’s information has been restated.

2. Unusual item. Cannot be classified as extraordinary as three conditions have not been met. May be treated as unusual due to its size

3. Amortization period extended. Changes in estimates are handled using the prospective treatment. The current and future years’ income will be increased from the reduced charge for amortization. Note disclosure is important since the amortization is materially lower. Care should be taken to watch for a possible bias to overstate net income.

4. Change in bad debt percentage (lower). Change in estimate, considered part of normal business activity and given a prospective treatment. Care should be taken to watch for a possible bias to overstate net income.

5. Potential discontinued operations. Gain or loss on discontinued operations reported on the income statement, net of taxes and with separate earnings per share disclosure, if the criteria for disposal of a segment are met per Handbook Section 3475. As a separate subsidiary, it is a separate component with separately distinguishable operations and financial information. It does not appear that the company has any continued involvement. Therefore it qualifies for separate presentation.



6. Change in accounting policy. A change in amortization methods is a change in accounting principle. Cumulative effect of a change in accounting principle for prior years is treated as a charge to the opening balance of retained earnings, net of applicable taxes. The change should only be made if it results in more relevant information per Section 1506.14.

7. Expense related to failed proposal. Loss on preparation of such proposals is not considered extraordinary in nature. The three conditions for extraordinary treatment are not met. Consideration may be given to treating as unusual.

8. Strike. Strikes are not considered extraordinary in nature for companies that are unionized. They may be if there is no union and no history of strikes. The losses may be reported in body of the income statement, possibly as an unusual item.

9. Correction of error. Corrections of errors relating to prior years must be adjustments to prior years’ income in the retained earnings statements. Adjust beginning retained earnings, net of any tax effect.

10. Costs associated with loss due to government decree.

Material, unusual in nature (atypical), and infrequent in occurrence. Does not depend primarily on decisions or determinations by management or owners since the government was responsible for the loss. Therefore treat as an extraordinary item and present in extraordinary item section, net of taxes, and with separate earnings per share information.

11. Disposition of business. As long as the business is a separate component (could argue this since major classes of customers) and is operationally distinct (financial records separate), may treat as discontinued per Handbook section 3475. Gain or loss on discontinued operations reported on the income statement, net of taxes and with separate earnings per share disclosure, assuming the criteria for disposal of segment is being met.



CA4-4 OCTOBER DIVISION

Overview:

The October Division is material since it contributes 20% of the sales to the company.

Management seems to have conflicting views re how to account for several large items including the disposition of the October Division, a strike, and the impact of government regulation. Investors and creditors will want to assess the impact of these events on the company’s future operations. There may be some bias therefore to treat the gains as income from continuing operations and the losses as extraordinary.

As the auditor, care would be taken to ensure that GAAP was complied with and that the financial statements presented the results in the most transparent and conservative manner.


Issue: Disposition of the October Division

Discontinued Operation Other - Separate component since the

division sells acoustic transmitters (a different product and customer base).

- Being a division, the business would be operationally distinct and the financial statements would be separate.

- Seems to be a formal plan since the sale was approved of at the last Board meeting. The sale is within one year (June 30) and a buyer is identified.

- If the asset is classified as held for sale, it is revalue to lower of carrying value and FV less costs to sell. Since the sale would result in a gain, the asset would remain at carrying value.

- The results of operations would be segregated in the income statement and shown net of taxes as discontinued

- Other arguments from treasurer and controller unfounded since the sale meet the definition of a discontinued operation.



operations.- Cannot be shown as

extraordinary item since sale results from management decision

Therefore, treat as discontinued operation as this provides the most meaningful presentation.

Issue: Strike, sale of old ovens, and government regulation.

The controller is correct that the strike and sale of ovens are not extraordinary items, since management has some influence over the outcome of these two events. If the loss is significant, they could be presented as unusual. With respect to the loss from the strike, the auditor might look at the history of the company – have strikes occurred in the past? If so how frequently? In any company with a union, there is a risk of strike action and so this might be seen as a typical risk.

The treasurer is correct that the loss due to the newly enacted law (inventory loss) may be an extraordinary item since it is unusual and infrequent and not dependent on the decisions or determinations of management or owners.

Unusual and extraordinary items must be considered individually and reported separately as appropriate in the financial statements. Earnings per share for income from continuing operations, for discontinued operations, and extraordinary items may be on the face of the statement or in the related notes, in accordance with Section 3500.60/61 of the CICA Handbook.



CA4-5 UNITED MANUFACTURING

Overview:

- The company is in bankruptcy proceedings and needs cash to effect a change in strategy. The bank is therefore the key user and will look to assess the ability of the company to repay loans.

- Management will therefore want to present the company in the best light as there is a concern that the loan will be turned down.

- GAAP is a constraint since the shares trade on the TSE.- The overall reporting objective, given the role, will be more aggressive.


Sale to LKT

Recognize revenue as sale No sale/financing- Profits of $4 million material

(material since 5% of $20 million loss = $1 million).

- Legal title and possession have passed to LKT.

- Transaction is measurable and cash is already collected - $10 million.

- Persuasive evidence of contract = agreement.

- Other

- Economic substance is that this is a loan – the company is short of cash and this is an alternate means of unlocking the cash that is tied up in the inventory.

- No profit should be recognized.- Since the company has agreed

to buy back the inventory in January, they have an obligation which cannot be avoided. Thus this represents a liability.

- The inventory appears to have little or no value since management is unsure as to how much they can resell it for and so the cost of $6 million should be written off.

- This is a material loss and will make the company look even worse.

- Other

Even though it is tempting to record the transaction as a sale and therefore make the company look better, the economic substance is that this is a financing transaction.



Sale of Snow Tubes

Recognize as a sale No sale/financing transaction- Since the goods are shipped

FOB shipping point in December, a sale has occurred.

- Legal title and possession has therefore passed.

- Persuasive evidence of contract – agreement exists.

- The $1 million is material (since it exceeds the $1 million threshold noted earlier).

- There is a bona fide reason for selling the inventory – i.e. need the space as well as the cash generated.

- It is not clear in the case what the buyback price is. If it is (future) market price, then this is a separate deal.

- Other

- Even though the goods were shipped FOB shipping point, the company still retains the risk of loss since they reimburse the customer if there is damage.

- Since UMC will take back any unsold merchandise – they still have the risk of loss on the goods.

- If this is estimable – may make a case to recognize the sale as well as an allowance for returns.

- The fact that the company will end up paying storage and insurance costs is further evidence that they have retained the risks of loss. This also supports the fact that the transaction is like a parking transaction only.

- Although it is not clear in the case, if the buyback price reflects the original transaction price, then this supports the fact that the transaction is a financing transaction.

- Other

In conclusion, this appears to be a bona fide sale transaction and should be recorded as such. The only issue is how, if at all, to record the potential obligation for buyback. If it is measurable, it could accrue any potential liability for items not sold by MMN. Detailed disclosures should be provided.



Disposition of ski business

Present as discontinued operations Loss/costs part of continuing operations

- Ski business separate and distinct from snow tubing.

- Cash flows and records separate – ($20 million loss)

- Will no longer be involved in selling skis.

- Want to show this as separate from new business since bank interested in ability to generate profits and cash flows in future.

- Retaining facilities and people (will be retrained) and therefore will have continuing involvement in the assets and related cash flows.

- This is not a separate division or subsidiary but really represents the whole income statement – it is therefore not really a component therefore.

In conclusion, this is not really a disposition of a division but rather the transitioning of the whole business. Therefore, it should not be shown as discontinued operations.

Minor issue —costs to refurbish the machinery. This may be capitalized since will have future benefit.



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