Chapter 3 Measuring and Evaluating Financial …csproat/Homework/ACCTG 311...Instructor’s Solution Manual Chapter 3 Measuring and Evaluating Financial Performance Solution Outline

Instructor’s Solution Manual

Chapter 3 Measuring and Evaluating Financial Performance

Solution Outline for Problem 3.1As corporations began to take on lives of their own, the owners needed to know how the corporations were performing as time passed. It was not enough to wait for corporations to be wound up at the end of their lives, because that could be a long time. Dispersed ownership also led to a demand for performance measures because shareholders could not just stop in at the offices and ask how things were going. It was not feasible for a corporation with dispersed ownership to invite hundreds or thousands of shareholders into the offices to inspect the records. In any case, the majority of shareholders did not want or need to know the small details of the corporation’s operations, instead demanding financial statements that could be relied on as reliable summaries of the records and meaningful periodic measures of performance (results of operations and financial position). Solution Outline for Problem 3.2 The development of accounting concepts standards and principles began when management of companies became separate from their owners. The owners (shareholders) were no longer involved in the day-to-day operations and needed management to provide them with credible financial information. If every company made up its own measurements for financial performance, it would be confusing for the users of the financial statements. For each new investment, a shareholder would have to learn how the company’s accounting worked in order to understand if management was running the company well. Other users of financial information also need to evaluate many different companies. For example, taxation authorities would want to tax companies on the same basis so that all companies receive fair (or at least similar) treatment. Solution Outline for Problem 3.3 To answer this, think of the Hudson’s Bay Company and its far-flung fur trading empire, managed from across the ocean in London where most of its fur sales were made. A shareholder might be interested in knowing the following about HBC’s financial performance:

• Is the company performing well compared to prior years? • Is the company performing well compared to competitors (e.g. The North West Company)? • What are the details of its performance, e.g. the value of furs received compared to the value of

goods traded in return, any income from land rights sold, types and amounts of expenses incurred to earn revenue?

• Is the company able to pay dividends? • What has it cost to set up trading posts and other necessary facilities? • What is the basis of its performance, e.g. buying at good prices, efficient shipping of furs one way

and trading goods the other way, or the ability to anticipate the European markets for fur hats and other such items?

Solution Outline for Problem 3.4 1. Land is on the balance sheet because it is an asset, that is, a resource owned or controlled and

having economic value. Land carries the potential to produce revenues for the company in the future, as do other assets.

2. Assets = $5,222 + $2,410 = $7,632.

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Financial Accounting: An Integrated Approach, Sixth Edition

3. Share capital is one of the sources of funds used to acquire the assets on the left side of the balance sheet. Therefore, it is not an asset that can be used to purchase more land, but a co-creator of the assets that now exist. Assets can only be used to buy other assets. Therefore, you must use $3,000 cash or another asset to buy a new asset. The company did not have enough cash, since some had already been used to buy inventory and land, so more cash had to be borrowed.

4. Retained earnings is the accumulation of net income minus dividends for each year of the company’s history. It is the accumulated residual undistributed earnings of the company and is on the balance sheet because it is a source of present assets (because assets created in the process of earning income were not all distributed to owners).

5. Net income = $10,116 – $9,881 = $235. 6. Ending retained earnings were $1,222. Subtracting income that had been added ($235) and adding

back dividends that had been deducted ($120) gives beginning retained earnings of $1,107. Proof, going the other way: $1,107 + $235 – $120 = $1,222.

7. Ending retained earnings would be $1,107 + $10,116 – $11,600 = –$377. There would have been a net loss for the year of $1,484, and that would have turned the retained earnings at the beginning into a deficit at the end of $377.

8. If the debit for the deficit were shown among the assets, that would indicate that the company had something of value for the future, a resource that could be used to generate income in the future. This is not at all the case: instead, the company has incurred more expenses than revenue and has, therefore, diminished some of the equity (share capital) put into it by the owners. Its resources were decreased by this, not increased as would be indicated by showing it as an asset. That’s why a deficit is deducted from other equity (such as share capital) and shown as a negative item on the right-hand side of the balance sheet.

Solution Outline for Problem 3.5 a :8 f: 2 b: 3 g: 4 c: 9 h: 6 d: 7 i: 5 e: 1 j: 10 Solution Outline for Problem 3.6 1. Noranda Inc.: Cost of advertising for new employees. This would be an expense because it is a

decrease in wealth incurred to maintain or increase the number of employees working directly or indirectly to earn revenues for Noranda.

2. Royal Bank of Canada: Cost of renovating branch. This could be an expense or an asset, depending on

whether the renovations are expected to benefit the current revenue-producing activities (an expense) or if the benefits will also extend to future revenue-producing periods (an asset).

3. Zellers: Increased value of land. This is neither a revenue nor expense since no transaction has occurred

yet. A gain (i.e. revenue) can only be recorded if the land under the department stores is sold to an outside party. This would of course, also necessitate the sale of the Zellers department stores.

4. Wendy's Restaurants: Food sold on credit. This would be recorded as revenue of the current period.

There has been an increase in wealth arising from the production of hamburgers and so forth and the customers have paid cash.

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5. The Bay: Whether this is recorded as an expense of the current year depends on whether the customer's lawsuit is likely to be successful, and it is possible to estimate the amount that will be awarded to the customer in the event that his/her lawsuit is successful. If the lawsuit will likely be successful and the amount can be estimated, then it would be recorded as an expense because it is a cost of doing business.

6. Northern Gold Mines Ltd.: Cost of issuing new shares. This would not be treated as an expense of the

current year because it is related to transactions with owners and does not contribute to earning revenue in the current year.

7. ABC Travel Agency: Bribes paid to resorts to try to get favourable bookings for clients. These would

be an expense of the current period because they help to generate current revenue. To the extent that the payment of bribes may be illegal the Travel Agency may not wish to record this expense. (Accounting tries to reflect economic events, but it also reflects legal constraints: accounting for the Travel Agency could be quite a problem!)

8. Grand Centre Ltd.: Income Taxes paid in France. To be liable for French income taxes it must be the

case that the company derives some of its revenues from operations in France. The French income taxes are a cost of doing business in France. To the extent that the income taxes paid are related to current periods earnings in France, they would be an expense of the current period.

9. Advanced Management Ltd.: Special good-performance bonus promised this year but not paid until

next year. To the extent that the good-performance bonus relates to performance in the current period, this would be an expense of the current period regardless of when it is paid.

10. Advanced Management Ltd.: Special dividend to owners who are also employees. Dividends are

considered a distribution of income to owners, not an expense of producing income; therefore they are not recorded as either revenues or expenses. It makes no difference that employees are also owners of the company.

11. Sears Inc.: Decreased value of the land under some of its inner city locations. The decrease in value

will not be recorded as a revenue or expense, but depending on the circumstances it may be recorded as a loss in the current year's income statement. It would not be recorded as an expense because the decrease in value is incidental to the normal business operations of Sears.

12. Proctor & Gamble Inc.: Cost of scientific research aimed at developing new products. This would be

appear to be an expense of future periods since the new products are not yet producing revenue in the current period. However, there are special rules that result in research and development expenses being expensed in the current period (even though the research clearly does not directly benefit the current period): there is no identifiable product associated with the research, there is no guarantee that it will benefit future periods, nor is it possible to ascertain which future periods the research might benefit.

13. General Motors Inc.: Estimated amount of money needed to provide pensions to this year's employees

when they retire. Pension benefits are a cost of maintaining a work force in the same way that salary expense is. Some of this estimated money would relate to the current period (an expense) and some would relate to future periods (a liability). Actuaries assist in making these estimates.

14. Hattie's Handbags Ltd.: Goods lost to shoplifting. This is an expense of the current period and is

usually included in cost of goods sold expense. If Hattie's did not allow any customers in its stores no goods would be stolen, on the other hand no revenue would be generated!

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15. Hattie's Handbags Ltd.: Salary of floorwalker. This is an expense of the current period. Although the floorwalker does not generate revenue, he/she hopefully reduces the amount of goods lost to shoplifting, thus increasing net income.

16. PCL Construction Ltd.: Contract payments on five-year construction project. Accounting rules do not

allow one to recognize revenue until it is earned. To the extent that work on the project has been performed in the current year and it is possible to estimate the total contract price and total costs of the contract, some revenue may be recognized in the current year. The contract payments themselves would not be recognized as revenue, they would be recorded as a reduction of cost of contracts in progress that is an account much like inventory.

Solution Outline for Problem 3.7 Assumptions (all affect the balance sheet only): • Receivable amount due from Lucky Eddie appears to have been current because he paid it within a

year. • Loan to Amalgamated Loansharks also appears to have been current. • Wages are payable over a short term; a reasonable assumption is that employees would not allow

their wages to remain unpaid for long. • Noncurrent liabilities have no current portion payable within the next year.

Arctic Limo Services Ltd. Balance Sheet

as at September 30, 2006 (with 2005 figures for comparison) 2006 2005 Assets Current assets Cash $ 2,000 $ 4,000 Accounts receivable 0 1,000 $ 2,000 $ 5,000Noncurrent assets Equipment (limos) $90,000 $60,000 Less accumulated amortization (30,000) (20,000) $60,000 $40,000 Total assets $62,000 $45,000Liabilities and Equity Current liabilities Loan $ 0 $10,000 Wages payable 2,000 0 $ 2,000 $10,000Noncurrent liabilities Long-term limo financing $50,000 $30,000Shareholders’ equity Share capital $ 1,000 $ 1,000 Retained earnings 9,000 4,000 $10,000 $ 5,000 Total liabilities and equity $62,000 $45,000

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Arctic Limo Services Ltd. Income Statement

for the Year Ended September 30, 2006 Revenue $300,000 Less expenses: Wages $100,000 Other expenses 70,000 Amortization 10,000 $180,000Income before income tax $120,000 Income tax expense 35,000 Net income $ 85,000

Arctic Limo Services Ltd. Statement of Retained Earnings

for the Year Ended September 30, 2006 Beginning balance (September 30, 2005) $ 4,000 Net income for the year 85,000 Dividends declared (80,000) Ending balance (September 30, 2006) $ 9,000

Solution Outline for Problem 3.8 Revenue $6,300,750 COGS $3,518,350 Operating expenses 1,685,300 5,203,650 Operating income $1,097,100 Nonoperating items Interest expense $(207,750) Interest income 20,940 Gain on sale of building 40,000 (146,810) Continuing income before income tax $950,290 Income tax expense 321,300 Income from continuing operations $628,990 Loss on discontinued operations $(300,000) Extraordinary gain 60,000 (240,000) Net income for the year $388,990 Retained earnings, as reported at the end of the prior period $2,527,980 Error correction 4,400 Revised beginning retained earnings $2,532,380 Cost of redeeming shares (27,300) Net income 380,990 Dividends declared (125,000) Ending retained earnings $2,761,070

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Solution Outline for Problem 3.9 1. Apparent income statement accounts:

Salaries expense Office expenses Employee benefits expense Income tax expense Cash sales revenue Credit sales revenue Amortization expense Interest income Cost of goods sold expense Miscellaneous expenses Insurance expense Interest expense

2. Net income, based on part 1, and using the same account order as no income statement is asked for, just a

calculation is: – 78,000 – 13,200 + 33,400 – 37,200 – 184,100 – 13,800 – 46,200 – 8,100 + 402,200 + 2,100 – 9,700 – 20,500 = 26,900

3. Ending retained earnings = 96,600 + 26,900 – 14,000 = 109,500 4a. Geewhiz Productions Income Statement for the Year Ended November 30, 2006

Revenue $435,600 Operating expenses * 382,200 Operating income $53,400 Interest expense, net of interest income 18,400 Income before income tax $35,000 Income tax expense 8,100 Net income for the year $26,900 * All expenses are aggregated here. It would be quite acceptable to list them all, though most companies do not because such a list clutters the statement and gives information to competitors. The amount of amortization expense is normally disclosed in a note or by listing that account separately.

4b. Geewhiz Productions Statement of Retained Earnings for the Year Ended November 30, 2004

Retained earnings, beginning of year $96,600 Add net income for the year 26,900 $123,500 Deduct dividends declared (14,000) Retained earnings, end of year $109,500

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4c. Geewhiz Productions Balance Sheet as at November 30, 2004 Assets Liabilities and Equity Current assets: Current liabilities Cash $27,000 Bank Loan * $37,900 Accounts receivable 18,600 Accounts payable 53,000 Inventory 78,000 Other payables ** 22,000 Prepaid insurance 3,200 $112,900 $126,800 Noncurrent liabilities: Noncurrent assets: Mortgage payable * 169,800 Land $74,000 $282,700 Building 346,000 Shareholders’ equity: Trucks and equipment 253,400 Share capital $300,000 $673,400 Retained earnings 109,500 Less: accum. amort. 108,000 $409,500 $565,400 $692,200 $692,200 * Bank loan assumed all current; mortgage assumed all noncurrent. ** $3,200 + $6,100 + $5,200 + $7,500 = $22,000 5. Brief points:

• The company had a positive income, equalling 6.2% of revenue and 6.6% of year-end equity • Dividends declared equalled half of the net income, which the board of directors determined was

better in the shareholders’ hands than in the company’s. • The company had a positive year-end working capital ($126,800 - $112,900 = $13,900; ratio

1.123), so it was likely able to pay its bills on time (as long as it could sell its inventory). • The year-end debt-equity ratio was 0.690 ($282,700 / $409,500) so the company was mostly

financed by equity and was not particularly risky.

Solution Outline for Problem 3.10 Waltzing Matilda's Boutique Ltd. Income Statement for the Month of April 2006 Revenue $11,000 Cost of goods sold expense 5,500 Gross profit $5,500 Operating expenses: Wages $1,500 Insurance 150 Rent 250 Janitor and miscellaneous 670 Office supplies used 75 Amortization 60 2,705 Operating income $2,795 Nonoperating items: Interest 45 Continuing income before income tax $2,750 Income tax expense 550 Net income for April $2,200

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Waltzing Matilda's Boutique Ltd. Statement of Retained Earnings for April 2006 Retained earnings, March 31, 2006 $3,530 Net income for April 2,200 Retained earnings, April 30, 2006 $5,730

Waltzing Matilda's Boutique Ltd. Balance Sheet as at April 30, 2004

Assets Liabilities and Equity Current assets: Current liabilities: Cash $ 960 Bank loan $ 4,500 Accounts receivable 1,600 Accounts payable 3,200 Inventories* 12,600 Wages, taxes payable*** 2,350 Prepaid expenses** 1,700 $ 10,050 $16,860 Non-current liabilities: Nil Non-current assets: Owners' equity: Store fixtures(cost) $ 3,600 Share capital $ 3,000 Less accum. amort. 1,680 Retained earnings 5,730 $ 1,920 $ 8,730 Total $18,780 $18,780 * $12,000 unsold goods + $600 office supplies. ** $1,200 insurance + $500 rent. *** $750 wages + $1,600 taxes. (It is quite appropriate to list these items separately rather than group them as done here. It is also appropriate to not even mention non-current liabilities, as there are none.) Solution Outline for Problem 3.11

2004 2005 2006 2007 Revenue for the year 38,000 49,000 61,000 65,000 Expenses for the year (except income tax) 29,000 42,000 50,000 61,000Income before income tax for the year 9,000 7,000 11,000 4,000 Income tax expense for the year 2,000 1,500 3,000 1,000Net income for the year 7,000 5,500 8,000 3,000 Retained earnings, beg. of the year 21,000 25,000 29,500 33,000 Dividends declared during the year 3,000 1,000 4,500 0Retained earnings, end of the year 25,000 29,500 33,000 36,000 Other owners’ equity, end of the year 35,000 38,000 38,000 48,000 Liabilities, end of the year 80,000 85,000 111,000 105,000Assets, end of the year 140,000 152,500 182,000 189,000

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Solution Outline for Problem 3.12 Prentice Retail Ltd. Income Statement For Last Year Sales revenue $2,222,610 Operating expenses 1,778,170 Operating income 444,440 Investment revenue 24,810 Continuing income before income taxes 469,250 Income taxes 127,700 Income from continuing operations 341,550 Loss from discontinued operations, net of income tax recovery 40,475 Extraordinary loss on expropriation of land 14,950 Net income for the year $286,125 Prentice Retail Ltd. Statement of Retained Earnings For Last Year Retained earnings, beginning of year as previously reported $354,290 Add correction of error in previous years income 2,430 Retained earnings, beginning of year as restated $356,720 Add net income for the year 286,125 Less dividends declared (87,000) Retained earnings, end of the year $555,845

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Solution Outline for Problem 3.13 WideAway Manufacturing Ltd. Balance Sheet as at December 31, 2006 Assets Liabilities and Equity Current assets: Current liabilities: Cash $ 52,000 Bank loan $ 35,000 Accounts receivable 117,000 Accounts payable 98,000 Inventory 116,000 Income taxes payable 27,000 Prepaid expenses 21,000 Current portion of 306,000 mortgage 22,000 182,000 Noncurrent assets: Noncurrent liabilities: Land 100,000 Mortgage (minus current) 242,000 Factory 612,000 Other noncurrent liabilities 16,000 Accum. amort. (236,000) 258,000 476,000 Shareholders’ equity Share capital 150,000 Retained earnings (below) 192,000 342,000 Total $782,000 $782,000

WideAway Manufacturing Ltd. Statement of Income and Retained Earnings

For the Year Ended December 31, 2006 Revenue $949,000 Cost of goods sold 538,000 Gross profit 411,000 Expenses: Operating expenses 229,000 Amortization expense 74,000 303,000 Income before income tax 108,000 Income tax expense 41,000 Net income 67,000 Retained earnings, beginning of year 145,000 Dividend declared (20,000) Retained earnings, end of year $192,000

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Solution Outline for Problem 3.14 Reasonable assumptions here may lead to different entries than those below. Particular account names are not important. Location a. DR Supplies expense 5,000 Income statement CR Cash (bank) 2,000 Current assets CR Accounts payable 3,000 Current liabilities Purchase of supplies to be used immediately. (Because the supplies are being used immediately,

there is no need to record them as an asset.) b. DR Prepaid rent 400 Current assets CR Cash (bank) 400 Current assets Advance payment on vehicle rental contract. c. DR Maintenance expense 300 Income statement CR Cash (bank) 300 Current assets Painting of storage room. d. DR Automotive assets 8,000 Noncurrent assets CR Shareholder loan 8,000 Noncurrent liabilities Purchase of car from shareholder, valued at current market value. (Assumes payment to shareholder

is not expected within next year.) e. DR Retained earnings error correction 5,000 Retained earnings CR Accounts payable 5,000 Current liabilities Invoice for last year’s repairs received this year. (If, as is likely, this is considered a minor error, the

debit would just be made to this year’s Maintenance expense, income statement.) Solution Outline for Problem 3.15 Reasonable assumptions here may lead to different answers. Particular account names are not important. Location a. It is a transaction: an exchange of cash and a promise to repay. DR Cash (bank) Cur. ass. 500,000 CR Bank loan Non-cur. liab. 500,000 Bank loan, recorded as a noncurrent liability because payment is not due for 3 years (could also be considered a cash equivalent liability, because of call feature). b. The deposit is a transaction, but the order itself is not as there has been no exchange yet. DR Deposit on order Cur. ass. 10,000 CR Cash (bank Cur. ass. 10,000 Deposit sent with inventory order.

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c. No transaction because no exchange yet. Exchange comes with occupancy over time. d. No transaction. The legal charge is not an exchange until it is settled or settlement can be predicted. The decline in share price is not an exchange involving Southward as an entity, just its owners. Location e. The dividend is a transaction as the declaration creates a liability to owners. The share price change again does not involve Southward, just its owners. DR Retained earnings Ret. earn. 500,000 CR Dividend payable Cur. liab. 500,000 Declaration of a dividend of $.50 per share on the 1,000,000 shares outstanding, to be paid in one week. f. This is a transaction since the TV has been exchanged for a promise to pay. DR Accounts receivable Cur. ass. 800 CR Revenue Op. rev 800 To record sale of TV DR Cost of goods sold Cur. ass. 580 CR Inventory Op. exp. 580 To transfer cost of TV out of inventory and to COGS. g. Technically, this is not a transaction since the options haven’t been exercised yet. However, accounting standards are changing to require companies to recognize stock options as employee benefits. Some companies have already made this change and would therefore record the following journal entry:

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DR Salaries and benefits expense Op. exp. 120,000 CR Capital stock Equity 120,000 To record granting of stock options. Location h. This is a transaction since the plumbing services have been exchanged for a promise to pay. DR Repairs and maintenance Op. exp. 200 CR Accounts payable Cur. liab. 200 To record invoice for plumbing services received. i. This purchase of the display unit on credit is a transaction since the unit has been exchanged for a promise to pay. the option to buy two more is not a transaction because there has been no exchange. DR Furniture and equipment Non-cur. ass. 750 CR Accounts payable Cur. liab. 750 To record purchase of display unit. Solution Outline for Problem 3.16 This problem in “reconstructing” journal entries is meant to give students practice in understanding existing accounting data, as distinct from creating the data themselves. The specific wording of entry explanations is not important as long as the intent of each entry is recognized. a. DR Cash 30,000 CR Common shares 30,000 Issue of shares for cash. (Number of shares unknown.) b. DR Inventory 5,000 CR Accounts payable 5,000 Purchases of inventory, on credit. c. DR Equipment 3,600 CR Cash 1,200 CR Notes payable 2,400 Purchase of equipment, partly for cash. d. DR Supplies expense 700 CR Accounts payable 700 Supplies expense, not yet paid for. e. DR Accounts receivable 900 CR Sales revenue 900 Credit sales.

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DR Cost of goods sold expense 540 CR Inventory 540 Cost of the goods sold on credit. f. DR Cash 1,300 DR Accounts receivable 1,400 CR Sales revenue 2,700 Credit sales with down payment. DR Cost of goods sold expense 1,620 CR Inventory 1,620 Cost of the goods sold with down payment. g. DR Cash 650 CR Accounts receivable 650 Collections on customer accounts. h. DR Accounts payable 1,000 CR Cash 1,000 Payments to suppliers. i. DR Prepaid supplies 300 CR Supplies expense 300 Supplies on hand at end of the month. j. DR Interest expense 60 DR Notes payable 500 CR Cash 560 To record payment of interest and principal on notes. Solution Outline for Problem 3.17

CAUSE JOURNAL ENTRY 1. Repairs of $573 DR Repairs expense 573 obtained on credit CR Accounts payable 573 2. Revenue of $1,520 DR Cash 200 mostly on credit DR Accounts receivable 1,320 CR Revenue 1,520 3. New shares issued DR Cash 2,000 for $2,000 CR Share capital 2,000 4. Dividend of $500 DR Retained earnings 500 declared and paid CR Cash 500 5. Accounts receivable DR Cash 244 of $244 collected CR Accounts receivable 244 6. $1,000 payment DR Mortgage payable 1,000 made on mortgage CR Cash 1,000 7. Inventory purchased DR Inventory 2,320 on credit CR Accounts payable 2,320

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8. Inventory costing DR Cost of goods sold expense 400 $400 was sold CR Inventory 400 9. Building purchased for DR Building 25,000 $25,000, $5,000 down CR Cash 5,000 CR Mortgage payable 20,000 10. Revenue closed off to DR Revenue 249,320 retained earnings CR Retained earnings 249,320

Solution Outline for Problem 3.18 1. Paid $3,220 on accounts payable DR Accounts payable 3,220 CR Cash 3,220 2. Paid most of income tax expense DR Income tax expense 5,900 CR Cash 5,000 CR Income tax payable 900 3. $200 expense advance provided DR Travel advances rec. 200 CR Cash 200 4. Expense advances accounted for DR Travel expenses 189 DR Cash 11 CR Travel advances rec. 200 5. Customer made a $350 deposit DR Cash 350 CR Customer deposit liab. 350 6. Paid $600 of auditing expense, DR Audit expense 3,000

with the balance on credit CR Accounts payable 2,400 CR Cash 600 7. Shares issued in exchange for equip. DR Equipment 5,200 CR Share capital 5,200 8. Shares redeemed DR Share capital 1,000 CR Cash 1,000 9. Goods costing $2,750 sold DR Cash 1,200 for $4,500, some for cash and DR Accounts receivable 3,300 some on credit CR Revenue 4,500 DR COGS expense 2,750 CR Inventory 2,750 10. COGS closed off to retained DR Retained earnings 147,670 earnings CR COGS expense 147,670

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Solution Outline for Problem 3.19 1. An inventory shortage was DR Inventory shortage exp. 387 discovered CR Inventory 387 2. A dividend was declared and DR Retained earnings 5,000 partly paid CR Cash 2,000 CR Dividend payable 3,000 3. The investment was sold at a loss DR Cash 5,000 CR Investment 40,000 DR Loss on investment 35,000 4. Debt was converted into shares DR Long-term debt 10,000 CR Share capital 10,000 5. Inventory was bought, mostly DR Inventory 3,290 on credit CR Cash 748 CR Accounts payable 2,542 6. Bonuses were declared DR Bonuses expense 5,200 CR Bonuses payable 5,200 7. Company seems to have lost DR Lawsuit loss exp. 40,200 a lawsuit DR Legal fees expense 11,340 CR Cash 51,540 8. Money borrowed from the bank DR Cash 32,000 CR Demand loan 32,000 9. Company seems to have bought DR Accounts receivable 24,000 another business DR Inventory 36,000 DR Factory assets 100,000 DR Goodwill 40,000 CR Cash (assumed) 200,000 10. Accounts were closed (a loss) DR Revenues 730,670 CR Expenses 743,210 DR Retained earnings 12,540

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Solution Outline for Problem 3.20 1. Journal entries for the year ended December 31, 2004.

a. DR Cash 5,100 CR Loan from Cline Senior 5,000 CR Share capital 100 b. DR Prepaid expense 120 CR Cash 120 DR Storage expense 120 CR Prepaid expense 120 Done as two entries, one at the beginning of the year, one at the end. No entry for the $130 until

2005. c. DR Buns inventory 500 DR Wieners inventory 1,500 CR Cash 2,000 Purchase of inventory. d. DR Hot dog stands expense 600 CR Cash 100 CR Accounts payable 500 Since the stands were expected only to last this summer, their cost is expensed. DR Hot dog stands expense 60 CR Cash 60 The cost of fixing up the stands. DR Accounts payable 500 DR Interest expense 29 CR Cash 529 Payment on December 31, 2004, of the payable and the interest (which = $500 × 0.10 × 7/12 = $29). e. DR Cash 7,000 CR Revenue 7,000 This assumes that hot dog sales were for cash only, none on credit. f. DR Wages expense 2,400 CR Cash 2,400 Student employee’s wages. g. DR Cost of goods sold expense 1,960 DR Leftover products expense 40 CR Buns inventory 500 CR Wieners inventory 1,500 Ten dozen buns and wieners remain in inventory. Therefore, 490 dozen were sold during the summer.

This entry assumes that the remaining inventory will not last until next summer and sets the inventory on hand to 0.

h. DR Income tax expense 358 CR Cash 358 Income before tax = 7,000 – 120 – 29 – 600 – 60 – 2,400 – 1,960 – 40 = 1,791. Tax = 0.20 × $1,791 = $358. i. DR Loan from Cline Senior 5,000 CR Cash 5,000 Repayment to Graham’s father. It is assumed here that the father would be repaid before a

dividend would be paid to Graham, but the problem does not actually say that, so omitting this entry would not be wrong.

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j. DR Dividends declared (Retained earnings) 500 CR Cash 500 Dividend: $5 per share × 100 shares

2.

Graham Cline Inc. Balance Sheet

as at December 31, 2004 Assets Liabilities and Equity Cash $1,033 Common shares $ 100 Retained earnings 933Total Assets $1,033 $1,033

Graham Cline Inc. Statement of Income and Retained Earnings

for the Year Ended December 31, 2004 Sales revenue $7,000 Cost of goods sold 1,960Gross margin $5,040Operating expenses Leftover products $ 40 Storage 120 Wages 2,400 Interest 29 Hot dog stands 660 Total operating expenses $3,249Income before income tax $1,791 Income tax expense 358Net income for the year $1,433 Beginning retained earnings 0 Less dividend declared (500) Ending retained earnings $ 933

3. Graham did make some money. His company earned $1,791 ($1,433 after tax) over the summer and

repaid his father, but his employee earned more than that for doing less work (one of the two stands, no management). All that Graham actually received was the $500 dividend. Therefore, Graham should consider whether the venture could be made more viable next year. He may have enjoyed being his own boss, but so far the hot dog stand business seems to have been a marginal one.

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Solution Outline for Problem 3.21 1.

Fergama Productions Inc. Balance Sheet as at the End of Last Year

Assets Liabilities and Equity Current assets Current liabilities Cash $ 23,415 Accounts Accounts payable $37,778 receivable 89,455 Taxes payable 12,250 $ 50,028 Supplies inventory 10,240 $123,110 Long-term loan 15,000 Noncurrent assets Shareholders’ Office equip. equity cost $ 24,486 Share capital $20,000 Accum. amort. (11,134) 13,352 Retained earn. 51,434 71,434TOTAL $136,462 TOTAL $136,462

2. Entries to record the activities: a. DR Accounts receivable 216,459 CR Revenue 216,459 b. DR Production expenses 156,320 CR Cash 11,287 CR Accounts payable 145,033 c. DR Amortization expense 2,680 CR Accumulated amortization 2,680 d. DR Supplies inventory 8,657 CR Accounts payable 8,657 DR Cost of supplies used expense 12,984 CR Supplies inventory 12,984 e. DR Income tax expense 12,319 CR Income tax payable 12,319 f. DR Retained earnings 25,000 CR Dividend payable 25,000 g. DR Cash 235,260 CR Accounts receivable 235,260 h. DR Accounts payable 172,276 CR Cash 172,276 i. DR Income tax payable 18,400 CR Cash 18,400 j. DR Long-term loan 5,000 CR Cash 5,000 k. DR Dividend payable 25,000 CR Cash 25,000

3. Ending trial balance:

DR CR Cash 26,712 Accounts receivable 70,654 Supplies inventory 5,913 Office equipment 24,486 Accumulated amortization 13,814 Accounts payable 19,192 Income tax payable 6,169 Dividend payable 0 Long-term loan 10,000 Share capital 20,000 Retained earnings—beginning 51,434 Dividend 25,000 Revenue 216,459 Production expenses 156,320 Amortization expense 2,680 Cost of supplies used expense 12,984 Income tax expense 12,319 337,068 337,068

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Fergama Productions Inc.

Balance Sheet as at the End of This Year

Assets Liabilities and Equity Current assets Current liabilities Cash $26,712 Accounts Accounts payable $19,192 receivable 70,654 Taxes payable 6,169 $ 25,361 Supplies inventory 5,913 $103,279 Long-term loan 10,000 Noncurrent assets Shareholders’ Office equip. equity cost $24,486 Share capital $20,000 Accum. amort. (13,814) 10,672 Retained earn. 58,590 78,590TOTAL $113,951 TOTAL $113,951

4. Income statement has revenue of $216,459, income before income tax of $44,475, and net income

of $32,156. Retained earnings adds that to the beginning retained earnings of $51,434, subtract dividends and show ending retained earnings of $58,590. Balance sheet (end of this year) has current assets (cash, accounts receivable, and supplies) $103,279, noncurrent assets (office equipment minus accumulated amortization) net $10,672, total assets $113,951, current liabilities (accounts payable and taxes payable) $25,361, the long-term loan of $10,000, equity (share capital and retained earnings) $78,590, and total liabilities and shareholders’ equity $113,951.

5. Is the company better off than last year? Well, first, substantial net income was earned this year, around

15% of revenue. By the definition of net income, the company has increased its net resources (assets minus liabilities). While most of this income was paid as a dividend to the owners, not all of it was, so the retained earnings are higher than last year. Regarding current position, the working capital was $73,082 last year and is higher, $77,918, this year. The working capital ratio was 2.46 last year and is 4.07 this year. So it appears that the company is better off this year than last. (More ways of answering this question are developed in later chapters.)

Solution Outline for Problem 3.22 a. DR Inventory 283,500 CR Accounts payable 283,500 DR Accounts payable (283,500 - 37,400) 246,100 CR Cash 246,100 b. DR Wages expense 103,770 CR Cash 76,760 CR Cash 15,590 CR Wages payable 9,790 CR Emp. deductions due 1,630 c. DR Cash 255,760 CR Revenue 421,270 DR Accounts receivable 165,510 DR Cash (165,510 - 19,160) 146,350 CR Accounts receivable 146,350

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d. DR COGS expense 212,390 CR Inventory 212,390 DR Shoplifting expense 3,580 CR Inventory 3,580 e. DR Other expenses 58,500 CR Cash 56,540 CR Accounts payable 1,960 f. DR Income tax expense 10,750 CR Income tax payable 10,750 g. DR Retained earnings 10,000 CR Dividend payable 10,000 DR Investment 50,000 CR Cash 50,000

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Beginning Transactions Ending Cash 100,000 (246,100) (76,760) (15,590) 255,760 57,120 146,350 (56,540) (50,000) Accounts receivable 165,510 (146,350) 19,160 Inventory 283,500 (212,390) (3,580) 67,530 Investment 50,000 50,000 Accounts payable (283,500) 246,100 (1,960) (39,360) Wages payable (9,790) (9,790) Deductions due (1,630) (1,630) Income tax payable (10,750) (10,750) Dividend payable (10,000) (10,000) Shareholders loan (65,000) (65,000) Share capital (35,000) (35,000) Retained earnings 10,000 10,000 Revenue (421,270) (421,270) COGS expense 212,390 212,390 Shoplifting expense 3,580 3,580 Wages expense 103,770 103,770 Other expenses 58,500 58,500 Income tax expense 10,750 10,750 0 0 0

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Frothingsloth Beverages Inc. Statement of Income and Retained Earnings

For the Year Ended 20XX Revenue $421,270 COGS expense 212,390 Gross margin $208,880 Expenses Wages $103,770 Shoplifting 3,580 Other 58,500 165,850 Income before tax $ 43,030 Income tax expense 10,750 Net income $32,280 Beginning retained earnings 0 $32,280 Dividend declared 10,000 Ending retained earnings $22,280

Frothingsloth Beverages Inc. Balance Sheet As at 20XX

Current assets: Current liabilities: Cash $ 57,120 Accounts payable $ 39,360 Short-term investment 50,000 Wages payable 9,790 Accounts receivable 19,160 Emp. deductions due 1,630 Inventory 67,530 Income tax payable 10,750 $193,810 Dividend payable 10,000 $ 71,530 Noncurrent liabilities: Shareholder loan 65,000 $136,530 Shareholder’s equity: Share capital $ 35,000 Retained earnings 22,280 $ 57,280 TOTAL $193,810 TOTAL $193,810

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Solution Outline for Problem 3.23 DR Revenue 421,270 CR COGS expense 212,390 CR Shoplifting expense 3,580 CR Wages expense 103,770 CR Other expenses 58,500 CR Income tax expense 10,750 CR Retained earnings 32,280 Post-closing trial balance would be as “Ending” columns above (solution outline for Problem 3.22) for balance sheet accounts except retained earnings now = 22,280. All revenue and expense accounts will be zero. Solution Outline for Problem 3.24 a. Recording amortization DR Amortization expenseb. Recognizing interest cost that is building up DR Interest expense c. Capitalizing expense(s) CR Relevant expense(s) d. Recognizing unexpired insurance coverage CR Insurance expense e. Recognizing estimated warranty costs on DR Warranty expense this year’s revenue f. Recording dividends declared DR Retained earnings g. Estimating current income tax liability DR Income tax expense h. Removing customer deposits from revenue DR Revenue i. Unused supplies on hand CR Relevant expense (eg supplies) j. Recognizing year-end bonus DR Bonuses expense Solution Outline for Problem 3.25 Comments and necessary adjustments for SOS: a. DR Inventory 11,240 CR Accounts payable 11,240 b. DR Interest expense 330 CR Accrued interest liability 330 c. Not an event to be adjusted for—external to the company. d. DR Amortization expense 14,500 CR Accumulated amortization 14,500 e. DR Bad debts expense or loss 2,100 CR Accounts receivable or allowance for doubtful accounts 2,100 f. DR Warranty expense 780 CR Warranty liability 780 g. Not an event to be adjusted for—not effective until next year.

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h. DR Prepaid expenses 2,000 CR Insurance expense 2,000 (10/12 × $2,400) i. DR Sales revenue 400 CR Customer deposits liability 400 j. DR Accounts receivable 7,200 CR Sales revenue 7,200 DR COGS expense 3,300 CR Inventory 3,300 Solution Outline for Problem 3.26 a. DR Accounts receivable or cash 3,124 CR Sales revenue 3,124 b. DR Sales revenue 500 CR Deferred revenue liability 500 c. DR Interest expense 620 CR Accrued interest payable 620 0.08 x 123,000 x (23/365) = 620 d. DR Cost of goods sold or Inventory loss 1,278 CR Inventory 1,278 e. DR Travel expenses 1,823 CR Advances to employees 1,823 f. DR Bad debt expense 320 CR Accounts receivable 320 g. DR Pension expense 38,940 CR Current pension liability 38,940 h. DR Loss on patent write-off 32,400 DR Accumulated amortization 42,100 CR Patent asset 74,500 i. DR Expenses 5,430 CR Accounts payable 5,430 j. DR Retained earnings 150,000 CR Dividend payable 150,000

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Solution Outline for 3.27 Location

a. DR Office and cleaning expense Inc. stmnt. 114 CR Accounts payable Curr. liab. 114

DR Prepaid supplies Curr. ass. 382 CR Office and cleaning expense Inc. stmnt. 382

Unrecorded liability for cleaning and office supplies ($114) and supplies still on hand ($382) at the end of the year. (These items are very small and might be ignored.)

b. DR Accounts receivable Curr. ass. 11,621 CR Sales revenue Inc. stmnt. 11,621

Uncollected but earned revenue at the end of the year. (This follows from the company's apparent practice of recognizing revenue only upon collection.)

c. DR Raw materials inventory Curr. ass. 6,210 CR Raw materials expense Inc. stmnt. 6,210

Raw materials on hand at the end of the year.

d. DR Prepaid tools expense Curr. ass. 238 CR Tools and parts expense Inc. stmnt. 238

Small tools and parts on hand at the end of the year. (This amount is very small and might be ignored.) e. Probably no journal entry would be made because the advertising would be considered an expense

of the next year, to be matched against the revenue next year that the advertising would help to generate. (If it were desired to record the invoice, the $900 could be credited to accounts payable and debited to prepaid advertising.)

f. DR Equipment and fixtures Non-c. ass. 2,316 CR Repairs and maintenance expense Inc. stmnt. 2,316

Capitalizing expenditures originally charged to expense. (This would require some evidence of asset value beyond the president's suggestion.)

g. DR Mortgage interest expense Inc. stmnt. 187 CR Accrued interest liability Curr. liab. 187

Accrued mortgage interest at the end of the year. (This amount is small and might be ignored.)

h. DR Retained earnings Equity 14,000 CR Dividend payable Curr. liab. 14,000

Dividend declared before the year-end, to be paid two months hence.

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i. DR Bonuses expense Inc. stmnt. 3,058 CR Bonus payable Curr. liab. 3,058

General manager's bonus, 8% of $38,226 pre-tax and pre-bonus income, to be paid in three months. (The need to calculate this bonus may mean that even small adjustments, such as a, d and g above, will be made so that there is no argument about the bonus. It also would give the general manager a personal interest in adjustments such as f.)

Solution Outline for Problem 3.28 1. a. DR Bad debts expense 2,400 CR Accounts receivable 2,400 b. DR Amortization expense 13,000 CR Accum. amortization 13,000 c. DR Accounts receivable 11,200 CR Revenue 11,200 d. DR COGS expense 4,600 CR Inventory 4,600 e. DR Operating expense 900 CR Accrued interest liability 900 f. DR Operating expense 5,000 CR Bonus payable 5,000 g. DR Income tax expense 2,700 CR Income tax payable 2,700 2. and 3.

Unadjusted Adjustments Adjusted DR CR DR CR DR CR Cash 25,600 25,600 Accounts receivable 88,200 (c) 11,200 (a) 2,400 97,000 Inventory 116,900 (d) 4,600 112,300 Land 100,000 100,000 Buildings & equip. 236,100 236,100 Accum. amortization (b)13,000 13,000 Accounts payable 74,900 74,900 Employee deductions due 2,500 2,500 Sales taxes due 3,220 3,220 Accrued interest (e) 900 900 Bonus payable (f) 5,000 5,000 Income tax payable (g) 2,700 2,700 Mortgage 185,780 185,780 Share capital 275,000 275,000 Retained earnings 0 0 Revenue 349,600 (c) 11,200 360,800 COGS expense 142,500 (d) 4,600 147,100 Operating expenses 181,700 (a) 2,400 203,000 (b) 13,000 (e) 900 (f) 5,000 Income tax expense (g) 2,700 2,700 891,000 891,000 39,800 39,800 923,800 923,800

4. DR Revenue 360,800 CR COGS expense 147,100 CR Operating expenses 203,000 CR Income tax expense 2,700 CR Retained earnings 8,000

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5. Net income = $8,000 (see part 4) Current assets = $25,600 + $97,000 + $112,300 = $234,900 Current liabilities = $74,900 + $2,500 + $3,220 + $900 + $5,000 + $2,700 = $89,220 Working capital = $234,900 – $89,220 = $145,680 Shareholders’ equity = $275,000 + $8,000 = $283,000 Solution Outline for Problem 3.29 1. (a) DR Insurance expense 1,800 CR Prepaid insurance 1,800 (b) DR Supplies expense 600 CR Supplies on hand 600 (c) DR Amortization expense 4,000 CR Accumulated amortization 4,000 (d) DR Salaries expense 800 CR Salaries payable 800 (e) DR Unearned rest 2,400 CR Rent revenue 2,400 (f) DR Utilities expense 300 CR Miscellaneous payables 300 (g) DR Interest expense 100 CR Miscellaneous payables 100 (h) DR Advertising expense 300 CR Miscellaneous payables 300 2.& 4. Unadjusted Trial

Balance Adjusting

entries Adjusted Trial

Balance DR CR DR CR DR CR Cash $ 9,900 9,900 Short-term investment 15,000 15,000 Accounts receivable 12,000 12,000 Prepaid insurance 3,600 (a)1,800 1,800 Supplies on hand 1,500 (b)600 900 Truck 34,000 34,000 Accumulated amortization

Nil (c)4,000 4,000

Accounts payable 15,000 15,000Salaries payable (d)800 800Miscellaneous payables (f)300

(g)100 (h)300

700

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Current portion long-term bank loan

2,000 2000

Long-term bank loan 20,000 20,000Unearned rent 7,200 (e)2,400 4,800Common stock 20,000 20,000Revenue 40,100 40,100Rent revenue (e)2,400 2,400Advertising expense 2,600 (h)300 2,900 Commissions expense 3,000 3,000 Amortization expense (c)4,000 4,000 Insurance expense (a)1,800 1,800 Supplies expense (b)600 600 Interest expense 800 (g)100 900 Salaries expense 21,000 (d)800 21,800 Utilities expense 900 (f)300 1,200 TOTAL 104,300 104,300 10,300 10,300 109,800 109,800 3.

LEAKEY PENS INC. INCOME STATEMENT FOR THE YEAR ENDED

DECEMBER 31, 2006 Sales revenue $40,100 Rental revenue 2,400 Total revenue 42,500 Expenses: Advertising expense 2,900 Commissions expense 3,000 Amortization expense 4,000 Insurance expenses 1,800 Supplies expense 600 Interest expense 900 Salaries expense 21,800 Utilities expense 1,200 Total expenses 36,200 Income before income taxes 6,300 Income taxes 1,575 Net income 4,725 Solution Outline for Problem 3.30 (i) *all figures are in millions a. DR Accounts receivable 35.9

CR Freight revenue 35.9

b. DR Depreciation and amortization 12.4 CR Net properties 12.4

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c. DR Interest expense 15.3

CR Accounts payable and accrued liabilities 15.3 d. DR Dividends – common shares 5.2

CR Dividends payable on Common Shares 5.2 e. DR Fuel (expense) 42.3

CR Accounts payable and accrued liabilities 42.3 f. DR Income tax expense 8.7

CR Income and other taxes payable 8.7 ii) Unadjusted Adjustments Adjusted DR CR DR CR DR CR Cash and short-term inv’t 353.0 353.0 Accounts receivable 434.7 (a) 35.9 470.6 Materials and supplies 134.1 134.1 Future income taxes 70.2 70.2 Investments 96.0 96.0 Net properties 8,393.5 (b) 12.4 8,381.1 Other assets 1,018.3 1,018.3 Accts pay/accrued liab. 975.3 (c) 15.3 1,032.9 (e) 42.3 Inc. and other taxes pay. 16.2 (f) 8.7 24.9 Dividends payable 21.0 (d) 5.2 26.2 Long-term debt-current 275.7 275.7 Deferred liabilities 767.8 767.8 Long-term debt 3,075.3 3,075.3 Future income taxes 1,386.1 1,386.1 Share capital 1,120.6 1,120.6 Cont. surplus 300.4 300.4 Foreign currency adj. 77.0 77.0 Retained income-beg. 2,153.9 2,153.9 Dividends – common 82.5 (d) 5.2 87.7 Freight revenue 3,728.8 (a) 35.9 3,764.7 Other revenue 174.1 174.1 Comp. and benefits 1,259.6 1,259.6 Fuel 440.0 (e) 42.3 482.3 Materials 178.5 178.5 Equipment rents 218.5 218.5 Deprec/amortization 407.1 (b) 12.4 419.5 Purchased serv. and other 610.7 610.7 Special charges 71.9 71.9 Other charges 36.1 36.1 Foreign exchange gain on long-term debt 94.4 94.4 Interest expense 218.6 (c) 15.3 233.9 Income tax expense 143.3 (f) 8.7 152.0 14,166.6 14,166.6 119.8 119.8 14,274.0 14,274.0

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iii) The financial statements shown below are in summary form, in millions of dollars. Canadian Pacific Railway Limited Statement of Consolidated Income

Year-ended December 31, 2004 Revenue $3,938.8 Operating expenses 3,169.1 Operating income before the following 769.7 Spin-off charges 71.9 Operating income 697.8 Non-operating expenses 327.6 Net income $370.2

Canadian Pacific Railway Limited

Statement of Consolidated Retained Income Year-ended December 31, 2004

Balance, January 1, as restated $2,153.9 Net income for the year 370.2 Dividends (87.7) Balance, December 31 $2,436.4

Canadian Pacific Railway Limited

Consolidated Balance Sheet As at December 31, 2004

Current assets $957.7 Noncurrent assets 9,565.6 Total assets $10,523.3 Current liabilities $1,359.7 Noncurrent liabilities 5,229.2 Total liabilities $6,588.9 Shares and other equity $1,498.0 Retained income 2,436.4 Total shareholders’ equity $3,934.4 Total liabilities and shareholders’ equity $10,523.3

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Solution Outline for Problem 3.31 1. $5,400,000 would be the “smoothest” net income because it varies the least from the prior year. 2. Arguments for including all of the contract’s revenue and expenses in 2009:

• to increase net income and therefore improve performance in the eyes of investors; • to increase net income and possibly the managers’ bonuses. Arguments for including all of the contract’s revenue and expenses in 2010: • to delay payment of income taxes on the contract’s profit; • to reduce shareholders’ dividend expectations; • to take advantage of a “Big Bath” situation by worsening the current year’s results in order for

future results to look even better. Arguments for including a portion of the contract’s revenue and expenses in 2009: • to result in smoother income and an impression of good management from year to year; • this approach falls between the extremes of the other alternatives and so perhaps balances

conservatism and aggressiveness; • this approach is probably more common than the other two combined. Arguments could also be advanced for each possibility in terms of how the accounting reflects the economic reality of the transaction.

3. The company should choose the most appropriate accounting method that represents the essence of the transactions that have taken place. Methods should be applied consistently from one period to the next.

Solution Outline for Problem 3.32

1. DR Goodwill write-down 50,000,000 CR Goodwill 50,000,000

2. The write down of goodwill will have no effect on the company’s cash position since the transaction does not affect cash. The write-down of goodwill only affects the perceived value of the acquired companies. Additionally, it will reduce retained earnings thus decreasing the equity portion of the balance sheet.

3. Bill is not correct if he is referring to the company’s ability to pays its creditors or operate. The large loss does not affect cash or creditors thus there is no effect on the stability of the company. In the short run, the loss devastates the quarterly and annual earnings. Also, investors may lose confidence in the company and management for the takeover’s of overly priced companies. In the long run, the company may benefit when revenues begin to increase because they have gotten rid of a large item that would have had to been amortized in future years. Also, by clearing the balance sheet of items that have a lower market worth, it is easier for investors to gauge the true financial position of the company.

Solution Outline for Problem 3.33 Would it be better to spread out the loss?

• Probably not. Conservatism drives many accounting practices. If it is believed that goodwill or other such assets have declined in value then they should be written down immediately so as not to inflate the numbers on the balance sheet.

• From the investors’ point of view, a loss reported all at once will result in a better valuation of the company’s current financial position. The investors may not react much to a low-income figure in the current year if it was going to be low anyway.

• From management’s point of view, they can put all of the bad news into one quarter and take a massive loss when there would have been a smaller one anyway.

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Cleaning up the financial statements: • If new management is put in, they will want to blame any bad news on the former management

and incur expenses in the current quarter. This would make the current period look pretty bad, but cleaning up the financial statements would be consistent with a change in corporate goals and objectives for the future that would happen when new management takes over a company.

• From the investors’ point of view, they may feel that the clean-up is a sign that the new management is getting the company back on track.

“Big Bath” doesn’t affect cash flow: • This is true, since the cash was spent on the asset(s) in a prior period. • The large difference between cash income and accrual income would be noticeable. Investors

may see this as manipulation of earnings by management. Solution Outline for Problem 3.34 1. Given the way the question is asked, “manipulation” is usually seen as unethical for reasons such

as: a. The performance measures are biased and therefore less useful. b. Such manipulation is seen as self-serving. c. Manipulation of information by companies, governments, the media or anyone else is

usually felt to be repugnant, even immoral. d. Such behavior reduces the credibility of the whole measurement (accounting) system and

so hurts “honest” managers too. e. If manipulation costs money to do, that money is paid out of company funds that could

otherwise be used to pay dividends or otherwise benefit owners or others. 2. This is not an easy question! One way to getting a handle on it is to ask whether anyone else

would share in management's wish to have company performance “look good”. This thinking leads to such observations as:

a. If better performance figures make the company seem more attractive, then present owners

might be happy if it increased the value of their shares. (Accounting research is trying to answer the question of whether this works; so far the answer is “probably not, at least not most of the time, but there are cases where it does”.)

b. If such manipulation increases earnings, taxation authorities may be happy to collect more tax. (There are cases in which companies have apparently been willing to pay extra income tax, for example, resulting from accounting policy changes adopted to increase earnings.)

Solution Outline for Problem 3.35 Your explanations will have been in your own words, perhaps something like the following. 1. Net income is an increase in cash and other resources produced during a period of time by an

enterprise’s operating activities, that is, by selling goods and services to customers and incurring the costs of serving the customers.

2. Net income is part of owners’ equity because the increase in resources earned as mentioned above belongs to the owners, who may withdraw it as dividends. Until they do withdraw it, it is part of their ownership interest.

3. Net income could be reported on the balance sheet by just showing that owners’ equity has increased since the prior period. The income statement was developed to provide an explanation of the details of the change in owners’ equity and to separate that from any dividends withdrawn by the owners during the period.

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4. Including the dividends in the income calculation would confuse the enterprise’s relationships with customers and owners, and would make it less clear whether the enterprise was successful in increasing resources (making income) before making a distribution to owners.

Solution Outline for Problem 3.36 1. 2006: Revenue $300 * 10,000 = $3,000,000 Less: Estimated warrantee expense at 50% = $1,500,000 Net income = $1,500,000 2007: No revenue or expense 2008: No revenue or expense

2. Cash flow: 2006: Inflow $3,000,000 2007: NIL 2008: Outflow $1,500,000

3. With a 50% profit margin after returns plus the opportunity to earn a return by investing the

$1,500,000 that is returned to customers for at least two years the plan appears profitable. Solution Outline for Problem 3.37 It is hoped that the amount of jargon below is not large! 1. Profit, which accountants call “net income”, is measured as the difference between your revenues

and your expenses for a period of time. Revenues are sales and other increases in your wealth that customers pay you or promise to pay you in return for the goods and services you provide. Expenses are the opposite: the costs you incur in generating the revenue, such as the cost to you of the goods customers take away, wages, operating costs and taxes, whether or not you have yet paid all those costs in cash.

2. Accrual accounting tries to measure your economic performance, whether or not all the revenues

have yet been received, or the expenses paid, in cash. Accrual net income could be less than the increase in cash if you collect from customers faster than you pay your own bills, or greater than the increase in cash if your collections are slower than your payments.

3. The double entry system basically means that every accounting transaction is recorded twice which

results in a balance sheet that’s assets equal the liabilities plus owners’ interest. The balance sheet and the income statement fit together because they share the common component of net income. An increase in income also increases assets, decreases liabilities or decreases owners’ interest.

4. Because accrual accounting tries to approximate an unobservable economic performance beyond

cash flow, it requires judgment and choices about how to calculate that approximation. Choice is inevitable. Therefore accounting does not just report “the facts” but rather reports the results some human beings think are appropriate.

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Solution Outline for Problem 3.38 Some points for discussion: • Different users of financial statements usually desire information that is different than that

currently provided. • Users may desire greater detail e.g. financial and market analysts, competitors or accounting

researchers. • Management already has access to detailed financial information. • Have to consider the costs of providing different kinds of income statements to different users. • May give competitors an advantage you do not want them the have. • It costs more to provide different kinds of information to different users. For example: costs of

preparing the information, costs of auditing the information, costs of printing and disseminating the information.

• Are there any benefits from providing different information to different users? • Would different kinds of income statements supplied to different users cause those users to make

decisions which would be different from the decisions made based on a standard income statement?

Solution Outline for Problem 3.39 (a)

PastaPastaPasta Inc. Income Statement

For the First Six Months Revenue $86,410 Cost of goods sold 40,950Gross profit $45,460 Expenses: Salary $12,600 Rent 12,000 Amortization 5,265 Other 6,440 Interest 1,490 37,795Net income before tax $ 7,665 Income tax expense 1,500Net income $ 6,165

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(b) PastaPastaPasta Inc.

Balance Sheet at the End of the First Six Months

Assets Liabilities and Equity Current assets: Current liabilities: Cash $ 37,150 Bank loan $ 0 Accounts receivable 7,740 Accounts payable 15,150 Resale inventory 14,120 Salary payable 3,460 Supplies inventory 5,870 Income tax payable 1,500 Prepaid rent 0 Tax deduction liability 190 $ 64,880 Note payable—current 7,050 $ 27,350 Noncurrent assets: Noncurrent liabilities: Minivan 7,500 Shareholders’ loans 18,000 Food processing & storage Note payable—noncurrent 21,150 equipment 63,250 $ 66,500 Leasehold improvements 4,500 Owners’ equity: Recipes 500 Share capital 64,500 Accumulated amortization (5,175) Retained earnings 6,165 70,575 $ 70,665Incorporation costs 1,710 $ 72,285 Total assets $137,165 Total liabilities & equity $137,165

(1) DR Accounts receivable 87,340 CR Revenue 87,340 DR Cash 78,670 CR Accounts receivable 78,670 DR Revenue 420 CR Accounts receivable 420 DR Bad debt expense or revenue 510 CR Accounts receivable 510 (2) DR Supplies inventory 32,990 CR Accounts payable 32,990 DR Resale inventory 19,320 CR Accounts payable 19,320 DR Accounts payable 47,550 CR Cash 47,550 (3) DR Cost of goods sold 31,840 CR Supplies inventory 31,840 DR Cost of goods sold 9,110 CR Resale inventory 9,110 (4) DR Amortization expense 5,265 CR Accumulated amortization 5,175 CR Incorporation costs 90 (3,950 + 450 + 750 + 25 + 90)

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(5) DR Rent expense 2,000 CR Prepaid rent 2,000 DR Rent expense 8,000 CR Cash 8,000 DR Rent expense 2,000 CR Accounts payable 2,000 (6) DR Equipment loan 7,050 DR Interest expense 1,410 CR Cash 8,460 (7) DR Bank loan 2,500 DR Interest expense 80 CR Cash 2,580 (8) DR Salary expense 12,600 CR Tax deduction liability 190 CR Cash 8,000 CR Cash 950 CR Salary payable 3,460 (9) DR Other expense 6,440 CR Accounts payable 760 CR Cash 5,680 (10) DR Tax expense 1,500 CR Income tax payable 1,500 (11) No entry required

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(c) Balance from

Problem 2.28 Events recorded New balance

DR CR # DR CR DR CR39,700 1 78,670

2 47,550 5 8,000 6 8,460 7 2,580 8 8,950

Cash

9 5,680 37,150 1 87,340 1 78,670 1 420

Accounts receivable

1 510 7,740 3,910 2 19,320 Inventory

3 9,110 14,120 4,720 2 32,990 Supplies

3 31,840 5,870 Prepaid rent 2,000 5 2,000 Minivan 7,500 7,500 Recipes 500 500 Leasehold improvements 4,500 4,500 Equipment 63,250 63,250 Accumulated amortization 4 5,175 5,175Incorporation costs 1,800 4 90 1,710

7,630 2 47,550 2 53,310 5 2,000

Accounts payable

9 760 15,150Salary payable 8 3,460 3,460Equipment loan 32,250 6 7,050 28,200Income tax payable 10 1,500 1,500Tax deductions payable 8 190 190Bank loan 2,500 7 2,500 Shareholders loan 18,000 18,000Share capital 64,500 64,500Retained earnings (not

1 420 1 510

Revenue

1 87,340 86,4103 31,840 COGs 3 9,110 40,950

Other expenses 9 6,440 6,440 Salary expense 8 12,600 12,600

4 3,950 4 450 4 750 4 25

Amort. exp.

4 90 5,265 Inc. tax. exp. 10 1,500 1,500

5 2,000 5 8,000

Rent exp.

5 2,000 12,000 6 1,410 Interest exp. 7 80 1,490

127,880 127,880 356,595 356,595 222,585 222,585

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Solution Outline for Problem 3.40 1. e) DR Supplies inventory 11,250 CR Supplies purchased expense 11,250

f) DR Revenue 550 CR Credit note liability 550

DR Inventory of clothing 275 CR COGS expense 275 g) no entry h) DR Income tax receivable 950 CR Income tax expense 950 2. Gronsky's Great Things Ltd. Income Statement for the Year Ended August 31, 2007 Sales revenue (300,000 – 550) $299,450 Cost of goods sold (125,000 – 275) 124,725 Gross margin $174,725 Operating expenses: Wages and salaries $34,375 Supplies* 6,875 Rent 30,000 Amortization 3,750 Interest 625 General operating expenses 6,250 81,875 Operating income $ 92,850 Loss due to storage room fire** 50,000 Income before income tax $ 42,850 Income tax expense 7,800 Net income for the year*** $ 35,050 * Supplies expense = $18,125 purchases minus $11,250 on hand. ** Storage room fire loss could be shown after income tax expense as there are no income tax

consequences and it has characteristics of “extraordinary items”. *** Costs associated with incorporation are not deducted above, because they are assumed to be assets;

however, many companies would expense them rather than calling them assets, both for conservatism and to avoid “cluttering up” the balance sheet with doubtful assets.

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3. Gronsky’s Great Things Ltd.

Statement of Retained Earnings For the Year Ended August 31, 2007

Retained earnings, beginning $ 0 Net income 35,050 35,050 Dividend declared (5,000) Retained earnings, ending $30,050 4. Gronsky’s Great Things Ltd.

Balance Sheet As at August 31, 2007

Current assets: Current liabilities: Cash $ 3,250 Accounts payable $28,750 Accounts receivable 4,375 Credit note liability 550 Income tax receivable 950 Dividend payable 2,500 Inventory of clothing 37,775 Loan - current portion 2,500 Supplies inventory 11,250 $34,300 Prepaid rent 2,500 Non-current liabilities: $60,100 Loan less current portion 7,500 Non-current assets: $41,800 Furniture and fixtures 19,375 Shareholder’s equity: Accum. amortization (3,750) Share capital 18,750 Investment 12,500 Retained earnings 30,050 Incorporation costs 2,375 $48,800 $30,500 TOTAL $90,600 TOTAL $90,600 Solution Outline for Problem 3.41 This is a large, comprehensive problem. The following provides the basic data for the answers required. 1. Honest John's Used Cars Ltd. Balance Sheet as at January 31, 2006 Assets Liabilities and Equity Cash $ 6,800 Operating loan $27,500 Inventory 40,000 Share capital 50 $46,800 Retained earnings* 19,250 $46,800 *Retained earnings = $46,800 - $27,500 - $50= $19,250 by deduction, as specified in the question.

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2. February transactions (descriptions omitted): 1) DR Prepaid rent 1,500 DR Rent expense 1,500 CR Cash 3,000 2) DR Leasehold improvements 5,500 CR Cash 5,500 3) DR Inventory (Chrysler) 8,000 CR Cash 8,000 4) DR Salaries expense 4,000 CR Cash 4,000 5) DR Inventory (various) 19,000 CR Cash 19,000 6) DR Interest expense 275 CR Cash 275 7) DR Cash 12,500 CR Sales revenue 12,500 DR Cost of sales expense 9,000 CR Inventory (Camaro) 9,000 8) DR Cash 8,800 CR Sales revenue 8,800 DR Cost of sales expense 7,000 CR Inventory (Olds) 7,000 9) DR Cash 12,700 CR Sales revenue 12,700 DR Cost of sales expense 11,900 CR Inventory (Mazda, Ford) 11,900 10) DR Cash 5,000 CR Operating loan 5,000 3. Posting of transactions: Cash Begin DR 6,800 Add DR 12,500 + 8,800 + 12,700 + 5,000 = 39,000 Deduct CR 3,000 + 5,500 + 8,000 + 4,000 + 19,000 + 275 = 39,775 End DR 4,800 Inventory Begin DR 40,000 Add DR 8,000 + 19,000 = 27,000 Deduct CR 9,000 + 7,000 + 11,900 = 27,900 End DR 39,100

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Prepaid rent DR 1,500 (no beginning balance) Leasehold improvements DR 5,500 (no beginning balance) Operating loan Begin CR 27,500 Add CR 5,000 End CR 32,500 Sales revenue CR 12,500 + 8,800 + 12,700 = 34,000 End CR 34,000 Expenses DR 1,500 + 4,000 + 275 + 9,000 + 7,000 + 11,900 = 33,675 End DR 33,675 Retained earnings* Begin CR 19,250 Add revenue CR 34,000 Deduct expenses DR 33,675 End CR 19,575 *After closing revenues and expenses 4. Honest John's Used Cars Ltd. Income Statement for February 2006 Sales revenue $34,000 Cost of goods sold expense 27,900 Gross margin $ 6,100 Operating expenses: Interest on operating loan $ 275 Rent 1,500 Salary of employee 4,000 5,775 Income for February* $ 325 *Note no provision has been made for company income tax or salary of owner, or amortization of

leasehold improvements. Honest John's Used Cars Ltd. Statement of Retained Earnings for February 2006 Balance January 31, 2006 $19,250 Add income for February 325 Balance February 28, 2006 $19,575

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Honest John's Used Cars Ltd. Balance Sheet as at February 28, 2006 Assets Liabilities and Equity Current assets: Current liabilities: Cash $ 6,025 Operating loan $32,500 Inventory 39,100 Prepaid rent 1,500 Shareholder’s equity: $46,625 Share capital 50 Non-current assets: Retained earnings 19,575 Leasehold improvements 5,500 19,625 Total $52,125 Total $52,725 5. List of cars on hand, February 28, 2006: Cost 1997 Chrysler $ 8,000 1994 Lincoln 8,500 1998 Nissan 6,000 1996 Honda 4,500 1995 Volkswagen 4,500 1997 Toyota 7,600 $39,100 6. For illustration, this difference is calculated in the format of the Statement of Cash Flows: Income for February $ 325 Decrease in inventory ($39,100 – $40,000) (100) Increase in prepaid rent ($1,500 – $0) (1,500) Increase in operating loan ($27,500 – $32,500) 5,000 Cash from operating activities $ 3,925 Investing activities: Purchase of leasehold improvements (5,500) Decline in cash during the month ($3,925 – $5,500) $(1,575) 7. Some advantages (more can be imagined): • monitoring of cash flows • more frequent performance measurement so more timely adjustment may be made for

performance problems • smooths dealing with bank (unless performance is poor!) • helps in estimating eventual income tax liability • perhaps useful in judging whether products are priced properly (though John probably

already gets what he can on each car sold)

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Solution Outline for Problem 3.42 a. Retained earnings $ 13,000 Share capital 100,000 Equity 113,000 Liabilities 42,000 Assets $155,000b. Total assets $155,000 60% of 155,000—noncurrent (93,000) Current assets $ 62,000 Working capital = $62,000 – $42,000 = $20,000 c. Current assets: $62,000 + 40,000 – 18,000 =$ 84,000 Total assets: $84,000 + 93,000 = $177,000 or $155,000 + 40,000 – 18,000 = $177,000 Equity: $113,000 + (40,000 – 18,000) = $135,000 Total liabilities and equity: $135,000 + 42,000 = $177,000 d. Receivables have increased by $40,000 and inventory has decreased by $18,000, therefore total

assets increased by $22,000. Revenues increased $40,000 and expenses (cost of goods sold) increased $18,000 therefore net

income increased by $22,000. Net income is a component of equity on the balance sheet, therefore equity also increased $22,000. The double-entry system ensures that the balance sheet remains in balance, as shown by the fact that assets and equity have increased by the same amount.

Solution Outline for Problem 3.43

1. Debt-equity = 60,000/45,000 = 1.33

2. A = L + E Liabilities = 12,000 + 55,000 = $67,000

Equity = 45,000 + 8,000 = $53,000 Assets = 65,000 + 50,000 + (6,000) + Accounts Receivable Accounts Receivable = 67,000 + 53,000 – 109,000 = $11,000 The company has $11,000 in accounts receivable.

3. No, it could not pay off its liabilities of $12,000 and its bank loan of $55,000 with the $65,000 it currently has in cash. $2,000 in accounts receivable would need to be collected to have enough money.

4. Current D-E = $67,000/53,000 = 1.26 To have a D-E of 2.0, the company would have liabilities of $106,000 (2 x $53,000) therefore it can purchase $39,000 worth of equipment on credit ($106,000-67,000).

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Solution Outline for Problem 3.44 a. Assets 45,000 Liabilities (32,000) Equity 13,000 Deficit 7,000 Share capital 20,000 assumes no dividends declared b. Current liabilities need to be ½ of 234,000, or 117,000 Total liabilities = 459,000 - 100,000 = 359,000 Non-current liabilities 242,000 c. Dividend 75,000 Less bank balance (41,000) Less bank loan available (10,000) Cash required from customers 24,000 d. Revenue 783,000 Net income (21,000) Income tax expense (17,000) Other expenses 745,000 e. Beginning retained earnings 217,000 Net income 43,000 Dividend (11,000) Ending retained earnings 249,000 Share capital 181,000 Equity 430,000 Total assets 387,000 + 414,000 801,000 Total liabilities 371,000 Current liabilities (205,000) Non-current liabilities - present 166,000 f. Present working capital 387,000 - 205,000 = 182,000 Therefore need to borrow 250,000 - 182,000 = 68,000 New non-current liabilities = 166,000 + 68,000 = 234,000 g. Additional net income needed = 60,000 - 35,640 = 24,360 That is income before tax of 24,360 / (1-.40) = 40,600 And 40,600 is 11% of the additional revenue which is therefore 369,091 (check: New revenue = 540,000 + 369,091 = 909,091 New income before tax = 909,091 x 11% = 100,000 New net income = 100,000 - 40% tax = 60,000

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Solution Outline for Problem 3.45 An immediate question we might ask is whether accounting calculations would ever stop their arguing - perhaps they get pleasure from it and our attempts to settle issues may spoil their fun. Something accountants and other “experts” get used to is that many people don't seem to appreciate their carefully worked out, rational solutions! As before, the purpose of this question is not to try to reach “the” answer, for there are many answers, but rather to encourage discussion on assumptions, possibilities, the sheepherders' apparent priorities and decision making needs and other interesting things. The two sets of calculations below are therefore intended to prompt discussion, not end it. The general assumptions below are that income equals increase in wealth, and that “shepherding” income should be separated from personal consumption. Students should think about whether they like those assumptions! 1. Bob and Doug alone; valuation in sheep Sheep Bob Doug Net increase in sheep wealth 20 80 Increase in land wealth (sheep trade) 40 - Personal consumption (which has obscured income from shepherding by removing sheep for other than “business” reasons)* 18 7 Loss of ox (valued in the “sheep- equivalents” used in Problem 2-13) (5) Shepherding income 78 82 *No value assigned to Bob's making his own lunches. Reasonable? 2. Bob and his wife versus Doug; valuation in sheep Sheep Bob & Wife Doug Income from above 78 82 Coats completed (25 goats; 3 goats per sheep)* 8 1/3 - Family shepherding income 86 1/3 82 *As pointed out in the solution outline for Problem 2.8, it is “conservative” not to count as wealth

(or income) orders not yet completed, so the second order for five coats is not included in this year's income.

The results comparison shows Doug apparently having had high earnings in “sheep equivalents”

and, if Bob's wife is entitled to half the family earnings, he earned much more than Bob's half of 86 1/3.

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Solution Outline for Case 3A Here are some discussion points raised by the shareholder’s letter. The case was written to focus on the income statement but also to raise associated balance sheet issues, as the case preamble indicates. That preamble also suggests that the shareholder’s concerns might rest on some misunderstandings. The case discussion may raise other misunderstandings; also, the course’s coverage of the income statement may raise other points that can be revisited in addition to the points below. Concern 1

• Shareholder argues for manipulating accounting figures to “put the best light on its performance.” All the recent accounting scandals indicate this is a problem, not a solution. (See section 3.10.)

• Suggestion that such manipulation will increase share value also flies in the face of recent

events, though admittedly there may be some short-run improvement in share value until people catch on to the manipulation. At that point, share value may decline precipitously, much more than the apparent increase in value the manipulation may have provided – see the cases of WorldCom, Global Crossing, Tyco, etc.

• (Shareholder’s point 1.) Good point that the restructuring charge represents value for the future.

But presumably the charge comes from getting rid of poorly performing assets or past corporate structures, so calling the cost of fixing mistakes an asset for the future would be misleading.

• The restructuring charge may not hurt share value – if investors perceive that it represents a

good decision for the future, the share price may go up.

• (Shareholder’s point 2.) It’s a fundamental accounting convention that transactions with owners should not be part of the income calculation. But the shareholder’s contention that share issues are revenue could be discussed. Such discussion would raise the question of what revenue really is and what the accrual accounting definition of revenue is, as well (perhaps) as raising a discussion of cash versus accrual accounting.

• Shareholder is correct that counting the share issue as revenue would still end up increasing

equity – it would be part of retained earnings rather than share capital. In fact, if this were done for all share issues, there would be no share capital, just retained earnings.

• • (Shareholder’s point 3.) We have no way to evaluate the claim that warranty costs have been

overestimated. Shareholder is right that reducing that estimate would increase income, though there are two complications. One is that some of any overestimate may have existed in past years too, so “correcting” it would not necessarily result in the whole improvement going to this year’s earnings. The second is that the effect on net income would be less than the shareholder estimates because reducing the warranty expense would also increase income tax, leaving a smaller net after-tax effect.

• Paying off the whole warranty provision would have no effect on accrual income, as the cost of

that provision has already been deducted from income. Would reduce cash (and cash income) however. There is no “double whammy” as the warranty cost is deducted from income only one, when it is estimated, not again when it is paid.

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Concern 2

• Shareholder makes a good point re the quality of the revenue given lower gross profit. It may not be bad management, as there may have been competitive pressures etc., but the basic point is valid.

• The point about accounts receivable is not valid. Like the point about warranty provision above,

it shows a misunderstanding of accrual accounting. The revenue is recorded at the same time as the account receivable is created, and collecting the receivable faster would improve cash (and cash income) but would not affect accrual income.

• The shareholder doesn’t make the point, but there is a danger in larger receivables or lower-

quality customers – some of the receivables may end up being uncollectible and so the company may incur bad debt expenses, which would decrease earnings.

Concern 3

• The “EBITDA” idea was examined briefly in section 3.10 on earnings management. Some discussion of it would be useful – on the one hand, it smacks of earnings manipulation which investors may see through and so not reward the company’s share price, but on the other hand, numerous companies do claim that it is a better measure of “real” operating performance than net income is.

• The three specific points about components of income may also be discussed, because all three

might have some support, at least among non-accountants.

• Interest is indeed financing cost. The idea that such cost should not be part of calculating income implies that income is an operating measure, not an overall measure. Also, if interest is not an expense, where would the shareholder propose to put it in the financial statements? (See below re Concern 4 for more that might be relevant to how interest is accounted for.)

• Income tax (and other taxes) may well be considered a confiscation, or at least a cost that the

company has little ability to control. Calling it an expense leaves management responsible for it as part of the net income calculation, which may be unfair if management cannot affect it. (It may also lead to some incentive for decisions that are not good business but lead to reduced tax, such as companies using off-shore “head offices” in low-tax jurisdictions to save tax – for example, Tyco’s use of Bermuda.) Some people have suggested that income tax be viewed a bit like a dividend, as being paid out of income instead of being part of calculating income (see Concern 4 below).

• The shareholder is right that amortization and depreciation are allocations of past investment

cost. Many people feel their relevance to measuring income today is slight. Including such allocations as expense is part of the structure of accrual accounting, but is more problematic than including unpaid bills in expense or uncollected customer accounts in revenue. (Students could be told that the place of amortization and depreciation as expenses, and the resulting balance sheet valuations, will be examined more fully in Chapter 8 but that in the meantime, the shareholder is raising a reasonable concern.)

• The shareholder’s repeated wish that management manipulate income could also be re-

examined in this context. Section 3.10 will help here.

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Concern 4

• Others have raised the point that dividends must be paid to keep shareholders happy and the implication that dividends are therefore an expense. The shareholder may not be happy with the implication that net income should therefore be reported as a lower figure – there is an inconsistency here with the proposal that interest and income tax (to keep creditors and the government “happy”) should not be counted as expenses.

• Dividends however are not like interest or income taxes – those are paid according to laws or

legal contracts, whereas dividends are decided upon by the board of directors, and do not have to be paid. For high-growth companies, keeping the funds in the company rather than paying them out as dividends may be rewarded by investors with higher share prices. If the company can do better with the money than investors’ other prospects, it should keep it and the improved performance will be reflected in higher share prices. So dividends may not be necessary in keeping shareholders happy.

• It is true that the amount left for “growth” is the net of income minus dividends – that is what

retained earning and the retained earnings statement report. Dividends already are deducted from retained earnings, as the shareholder suggests – and doing so has no effect on any positive or negative effect of dividends.

• The shareholder seems to think that if dividends were related to EBITDA, they would seem to

have a smaller impact. That may be true, depending on people’s view of EBITDA. But there would be no effect on the company’s resources for growth. Dividends reduce such resources, no matter how they are accounted for or what they are compared to. The shareholder appears to think that changing the income measure would change the company’s real resources, which is not true. The left-out expenses (interest, income tax and amortization) would still have to be accounted for somehow.

Concern 5

• Shareholder is right on the mark here. A working capital decline greater than the income decline does indicate a problem. (The earlier-noted increase in accounts receivable would have increased working capital, so something else is wrong.)

• It is also right that accrual accounting separates the measure of income from that of working

capital – they are related, for example through accounts receivable and accounts payable, but they are distinct and do not have to move in the same direction.

• It is also right that working capital weakness can have real future costs and other consequences.

Chapter 4’s coverage of cash flow and Chapter 10’s coverage of ratio and leverage analysis will raise some of those.

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Solution Outline for Case 3B This case has been designed to prompt wide-ranging discussion. It can focus on the issues in the text (e.g. sections 3.5 and 3.10, as suggested) or can go well beyond that if the instructor wishes to incorporate more implications or issues that have arisen since the text was written. Asking students to read the various articles mentioned in the case or other similar ones would give the students more to get their teeth into. This would also allow the instructor to raise further issues to those in the case. This is an outline of issues raised in the case, intended to be used to prompt discussion. The outline can be expanded with reference to sections 3.5 and 3.10 plus the instructor’s own experiences and interests. The issues do not have clear “answers” but some features of answers are suggested below. Students could be told that much of the rest of the text will be devoted to improving their understanding of such issues and their ability to suggest answers.

• What is net income (earnings) actually supposed to represent? The text defines income as an increase in wealth or as revenue minus expenses, but that is rather bare. What do people in general, or investors in particular, expect earnings to mean?

• Does accrual accounting match people’s intuitions/expectations about income, or is cash

income closer, or something else?

• Does the rise in income alternatives (“pro forma,” EBITDA and the rest) indicate a serious problem with accrual accounting’s measure, or do such alternatives rather indicate that net income is a good measure just resented by managers who don’t measure up?

• Is accrual accounting too flexible or too soft, if earnings can be “widely inflated” as Business

Week claims or “easy to manipulate” as The Economist alleges? (Since the text was written, the quality of earnings may have changed, for better or for worse, and there may be a different consensus about such quality. There may have been a decline, or even an increase, in the use of income alternatives.)

• The Economist also implies some income smoothing, though its focus is on attempts to increase

earnings. Is income smoothing a less malign form of earnings manipulation?

• What impact on stock markets, investor confidence, management incentives, etc. might be predicted if people do begin to believe that accrual accounting allows “plenty of tricks” as The Economist claims? How important is confidence in accrual accounting?

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Solution Outline for Case 3B (Continued) • The Accounting Review’s research is based on averages over large numbers of companies in

various samples. Does such research get at the issues of concern to individual investors or managers who may be involved with only one or a few companies? Is it reassuring that most of the time things may be all right, but not necessarily for any given company?

• The research indicates that measuring income with error affects both the current year and any

future years in which errors are corrected. This is a consequence of accrual accounting’s double entry system. Does it provide enough protection against serious error? Or, looking at WorldCom and its like, are people too myopic about the current year and not thinking enough about the future for this self-correcting mechanism to be much help?

• The research also indicates that larger companies may have lower error and so higher earnings

quality than smaller companies (all of these companies big enough to be traded on stock markets, however). Does the suggestion that bigger companies are less a problem in measuring income square with the facts, as we understand them (Enron, WorldCom, Global Crossing, Xerox, etc.)? Or is it possible that the bigger you are, the harder you fall?

• The text emphasized that the balance sheet and income statement articulate through retained

earnings. They also articulate in that accounts receivable are uncollected revenue, accounts payable are unpaid expenses, amortization expense depends on the asset costs in the balance sheet, etc. Does this feature usefully constrain earnings manipulation, as the research suggests? Or do investors, creditors and managers understand it well enough to make it effective as a control on manipulation?

• Do the Big Bath and other write-offs “release” the balance sheet constraints and thus permit

more manipulation in the future, or do they reduce companies’ ability to manipulate by transferring potential expenses from the future to the present?

• Has earnings manipulation been largely successful, as Business Week worries, because people

do not really know enough accounting to know that they are being bamboozled? Perhaps a corollary to this is to ask if accrual accounting has become so complex that a sufficient understanding is beyond most people – more about this issue in the “second half” of the text (Chapters 6, 8 and 9 in particular) and in the very next chapter (Chapter 4 on cash flow).

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