Reporting and Analyzing Revenues and Receivables

©Cambridge Business Publishers, 2014

Solutions Manual, Chapter 6 6-1

Chapter 6 Reporting and Analyzing Revenues and Receivables

Learning Objectives – coverage by question Mini-

Exercises Exercises Problems Cases and Projects

LO1 – Describe and apply the criteria for determining when revenue is recognized.

14, 15, 17

26, 27, 32, 39

47 - 49

LO2 – Illustrate revenue and expense recognition when the transaction involves future deliverables.

17, 24, 25

30, 39, 40

46

47, 48

LO3 – Illustrate revenue and expense recognition for long-term projects.

13, 16

28 - 30

42

LO4 – Estimate and account for uncollectible accounts receivable.

18 - 21, 23

33 - 37

45

49

LO5 – Calculate return on capital employed, net operating profit after taxes, net operating profit margin, accounts receivable turnover, and average collection period.

22

31, 34, 38

44

49

LO6 –Discuss earnings management and explain how it affects analysis and interpretation of financial statements.

27, 32, 34

43, 44

48

LO7 Appendix 6A – Describe and illustrate the reporting for nonrecurring items.

41


6-2 Financial Accounting, 4th Edition

DISCUSSION QUESTIONS Q6-1. Revenue must be realized or realizable and earned before it can be reported in

the income statement. Realized or realizable means that the company’s net assets have increased, that is, the company has received an asset (for example, cash or accounts receivable) or satisfied a liability as a result of the transaction. Earned means that the company has done everything it must do under the terms of the sale.

For retailers, like Abercrombie & Fitch, revenue is generally earned when title to the merchandise passes to the buyer (e.g., when the buyer takes possession of the merchandise), because returns can be estimated. For companies operating under long-term contracts, the earning process is typically measured using the percentage-of-completion method, that is, by the percentage of costs incurred relative to total expected costs.

Q6-2. Financial statement analysis is usually conducted for purposes of forecasting future financial performance of the company. Discontinued operations are, by definition, not expected to continue to affect the profits and cash flows of the company. Accordingly, the financial statements separately report discontinued operations from continuing operations to provide more useful measures of financial performance and financial income. For example, yielding an income measure that is more likely to persist into the future, and a net assets measure absent discontinued items.

Q6-3. In order for an event to be classified as an extraordinary item, its occurrence must be both unusual and infrequent. Items that are considered to be both unusual and infrequent might be the destruction of property by natural disaster or the expropriation of assets by a foreign government in which the company operates. Gains and losses on early retirement of long-term bonds, once comprising the majority of extraordinary items, are no longer considered as such unless they meet the tests outlined above. Other events not likely to be included as extraordinary items include asset write-downs, gains and losses on the sales of assets, and costs related to an employee strike.

Q6-4. Restructuring costs typically consist of two general categories: asset write-downs and accruals of liabilities. Asset write-downs reduce assets and are recognized in the income statement as an expense that reduces income and, thus, equity. Liability accruals create a liability, such as for anticipated severance costs and exit costs, and yield a corresponding expense that reduces income and equity.

Big bath refers to an event in which a company records a nonrecurring loss in a period of already depressed income. By deliberately reducing current period earnings, the company removes future costs from the balance sheet or creates ‘reserves’ that can be used to increase future period earnings.



Q6-5. Earnings management may be motivated by a desire to reach or exceed previously stated earnings targets, to meet analysts’ expectations, or to maintain steady growth in earnings from year to year. This desire to achieve income goals may be motivated by the need to avoid violating covenants in loan indentures or to maximize incentive-based compensation.

The tactics used to manage income involve transaction timing (recognizing a gain or loss) and estimations that increase (or decrease) income to achieve a target.

Q6-6. Pro forma income adjusts GAAP income to eliminate (and sometimes add) various items that the company believes do not reflect its core operations. Such pro forma disclosures are only reported in earnings and press releases and are not part of the published 10-Ks or other annual reports provided for shareholders. The SEC requires that GAAP income be reported together with pro forma income. Yet, companies often report their GAAP income at the very end of the earnings or press release, thus obfuscating their comparison and focusing attention on the pro forma income.

It is because of this potential to confuse the reader about the true financial performance of the company that the SEC has become concerned. Also, pro forma numbers are not subject to accepted standards (and, thus, we observe differing definitions across companies), are not subject to usual audit tests, and are subject to considerable management latitude in what is and is not included and how items are measured.

Q6-7. Estimates are necessary in order to accurately measure and report income on a timely basis. For example, in order to record periodic depreciation of long-lived assets, one must estimate the useful life of the asset. Estimates allow accountants to match revenues and expenses incurred in different periods. For example, accountants estimate warranty costs so that the warranty expense is matched against the corresponding sales revenue. If the accounting process waited until no estimates were necessary, there would be a significant delay in the reporting of financial results.

Q6-8. When analysts publish earnings forecasts, these forecasts become a benchmark against which some investors evaluate the company’s performance. A company that fails to meet analysts’ forecasts may suffer a stock price decline, even though earnings are higher than previous years’ earnings and overall performance is good. Consequently, management may feel pressure to meet or slightly exceed analysts’ forecasts of earnings.



Q6-9. Bad debts expense is recorded in the income statement when the allowance for uncollectible accounts is increased. If a company overestimates the allowance account, net income will be understated on the income statement and accounts receivable (net of the allowance account) will be underestimated on the balance sheet. In future periods, such a company will not need to add as much to its allowance account since it is already overestimated from that prior period (or, it can reverse the existing excess allowance balance). As a result, future net income will be higher.

On the other hand, if a company underestimates its allowance account, then current net income will be overstated. In future periods, however, net income will be understated as the company must add to the allowance account and report higher bad debts expense.

Q6-10. There are several possible explanations for a decrease in the allowance account. First, after an aging of accounts receivable, Wallace Company may have determined that a smaller percentage of its receivables are past due. Wallace Company may have changed its credit policy such that it is attracting lower-risk customers than in the past. Second, experience may have indicated that the percentages used to estimate uncollectibles was too high in previous years. By correcting the estimated percentage of defaults, the estimated uncollectibles would end up lower than in past years. Third, Wallace Company may be managing earnings. By lowering estimated uncollectibles, the company can increase current earnings, but may end up reporting a loss in a future year when write-offs exceed the balance in the allowance account.

Q6-11. Minimizing uncollectible accounts is not necessarily the best objective for managing accounts receivable. That objective could be accomplished by not offering to sell to customers on credit. The purpose of offering credit to customers is to increase sales and profits. Losses from uncollectible accounts are a cost of doing business. As long as the benefit (greater contribution to profits due to increased sales) exceeds the cost (increased losses due to uncollectibles) then a higher-risk credit policy which increases the amount of uncollectible accounts would be a more profitable policy.

Q6-12. The number of defaults tends to rise and fall with the economy. For example, in a recession, customers are more likely to default and companies take longer, on average, to pay their bills than during a healthy economy. This would result in higher estimated uncollectibles if the estimates are based on an aging of accounts receivable.

For many companies, sales revenue also tends to decline during a recession. If estimated uncollectibles are estimated as a percentage of sales, then the estimate would tend to fall in a recession. This is contrary to the increase in the number of defaults that occurs during a recession. Therefore, the percentage of sales approach is not as sensitive to changing economic conditions as is accounts receivable aging.



MINI EXERCISES M6-13. (15 minutes) Note: The completed contract method is not required but is presented for the purpose of comparison.

Percentage-of-Completion Method Completed Contract

Year Costs

incurred

Percent of total

expected costs

(rounded)

Revenue recognized

(percentage of costs incurred

total contract amount)

Income (revenue – costs

incurred) Revenue

recognized Income 2013 $ 400,000 21%a $ 525,000 $125,000 0 0

2014 1,000,000 53%b 1,325,000 325,000 0 0

2015 500,000 26%c 650,000 150,000 $2,500,000 $600,000

Total $1,900,000 $2,500,000 $600,000 $2,500,000 $600,000 a $400,000 / $1,900,000 b $1,000,000/ $1,900,000 c $500,000 / $1,900,000 M6-14. (20 minutes) Company Revenue recognition GAP When merchandise is given to the customer and returns can be

estimated (or the right of return period has expired). Merck When merchandise is given to the customer and returns can be

estimated (or the right of return period has expired). The company will also establish a reserve and recognize expense relating to uncollectible accounts receivable at the time the sale is recorded.

Deere When merchandise is given to the customer and the right of return period, if any, has expired. The company will also establish a reserve and recognize expense for uncollectible accounts receivable and anticipated warranty costs at the time the sale is recorded.

Bank of America Interest is earned by the passage of time. Each period, Bank of America accrues income on each of its loans and establishes a receivable on its balance sheet.

Johnson Controls Revenue is recognized under long-term contracts under the percentage-of-completion method.



M6-15. (15 minutes) The Unlimited can only recognize revenues once they have been earned and the amount of returns can be estimated with sufficient accuracy. Assuming that happens at the time of sale, it must estimate the proportion of product that is likely to be returned and deduct that amount from gross sales for the period. In this case, it would report $4.9 million in net revenue (98% of $5 million) for the period. If The Unlimited does not have sufficient experience to estimate returns, then it should wait to recognize revenue until the right of return period has elapsed. M6-16. (20 minutes) a. Percentage-of-completion method:

Year 2013 2014 2015 Total Percent completed 30% 50% 20% Revenue $12,000,000 $20,000,000 $8,000,000 $40,000,000 Construction costs 9,000,000 15,000,000 6,000,000 30,000,000 Gross profit $3,000,000 $5,000,000 $2,000,000 $10,000,000

b. Completed contract method:

Year 2013 2014 2015 Total Revenue $40,000,000 $40,000,000 Construction costs 30,000,000 30,000,000 Gross profit $10,000,000 $10,000,000

M6-17. (20 minutes) a. A.J. Smith should recognize the warranty revenue as it is earned. Since the

warranties provide coverage for three years beginning in 2014, one-third of the revenue should be recognized in 2014, one-third in 2015, and the remaining third in 2016.

b.

Year 2014 2015 2016 Total Revenue $566,666 $566,667 $566,667 $1,700,000 Warranty expenses 166,666 166,667 166,667 500,000 Gross profit $400,000 $400,000 $400,000 $1,200,000

continued next page



M6-17. concluded c. Total revenue from sales of the camera packages is $79,800 ($399 x 200). The

revenue is allocated among the three elements of the sale (camera, printer and warranty) as follows:

Element Retail Price Proportion of Total Camera $300 60% ($300/$500) Printer 125 25% ($125/$500) Warranty 75 15% ($75/$500) Total $500 100%

Using these proportions, the revenue is allocated among the three elements and recognized for each element as it is earned. In this case, the portion of the revenue allocated to the camera and printer are recognized immediately, while the revenue allocated to the warranty is deferred and recognized over the three-year warranty coverage period.

Year Revenue 2014 $67,830 ($79,800 x .6 + $79,800 x .25) 2015 3,990 ($79,800 x .15 / 3) 2016 3,990 2017 3,990 Total $79,800

M6-18. (15 minutes) a. To bring the allowance to the desired balance of $2,100, the company will need to

increase the allowance account by $1,600, resulting in bad debt expense of that same amount.

b. The net amount of Accounts Receivable is calculated as follows: $98,000 $2,100 =

$95,900. c.

- Allowance for Doubtful Accounts (XA) + + Bad Debt Expense (E) - 500 Balance (a) 1,600 1,600 (a) 2,100 Balance Balance 1,600



M6-19. (15 minutes) a. Credit losses are incurred in the process of generating sales revenue. Specific

losses may not be known until many months after the sale. A company sets up an allowance for uncollectible accounts to place the expense of uncollectible accounts in the same accounting period as the sale and to report accounts receivable at its estimated realizable value at the end of the accounting period.

b. The balance sheet presentation shows the gross amount of accounts receivable, the

allowance amount, and the difference between the two, the estimated net realizable value. The balance sheet, thus, reports the net amount that we expect to collect. That is the amount that is the most relevant to financial statement users.

c. The matching concept requires that expenses (credit losses) related to a given

revenue be matched with, and deducted from, the revenue in the determination of net income. This dictates the use of the allowance method. Recognition of expense only upon the write-off of the account would delay the reporting of our knowledge that losses are likely and, thereby, reduce the informativeness of the income statement. Accountants believe that providing more timely information justifies the use of estimates that may not be as precise as we would like.

M6-20. (20 minutes) a.

($ millions) 2011 2010 Accounts receivable (net) ............................................. $6,361 $6,539 Allowance for uncollectible accounts ............................ 143 246 Gross accounts receivable ........................................... $6,504 $6,785 Percentage of uncollectible accounts to gross

accounts receivable ................................................... 2.2%

($143/$6,504) 3.6%

($246/$6,785) b. The decrease in the allowance for uncollectible accounts as a percentage of gross

accounts receivable may indicate that the quality of the accounts receivable has improved, perhaps because the economy has improved, the company is selling to a more creditworthy class of customers, or the company’s management of accounts receivable is more effective. It may also indicate, however, that the receivables were over-reserved (e.g., allowance account was too high in 2010). This would result in higher reported profits in 2011 because past profits were too low.

c. $54,365/[($6,361+$6,539)/2] = 8.43 times 365/8.43 = 43.3 days



M6-21. (10 minutes) Bad debt expense of $2,400 ($120,000 × 0.02) would cause the allowance for uncollectibles to increase by the same amount. If the allowance increased by only $2,100 for the period, Sloan Company must have written off accounts totaling $300. Under accounts receivable, sales revenue increased the account by $120,000, and the write offs would decrease it by $300. If there was a net increase of $15,000 for the period, Sloan Company must have collected $104,700 in cash. ($104,700 = $120,000 - $300 - $15,000.) M6-22. (20 minutes) a.

Accounts Receivable Turnover rates for 2011 Procter & Gamble $83,680 / [($6,068+$6,275)/2] = 13.6 times

365 / 13.6 = 26.8 days

Colgate-Palmolive $16,734 / [($1,675+$1,610)/2] = 10.2 times 365 / 10.2 = 35.8 days

b. P&G turns its accounts receivable faster than Colgate-Palmolive. Receivable turns

typically evolve to an equilibrium level for each industry that arises from the general business models used by industry competitors. Differences can arise due to variations in the product mix of competitors, the types of customers they sell to, their willingness to offer discounts for early payment, and their relative strength vis-à-vis the companies or individuals owing them money.

Also, the size of the firm may affect the ability of a company to exert bargaining

power over major suppliers or customers. For instance, both of these companies sell a significant amount of their product to Wal-Mart. P&G is a sizable company, and may have greater bargaining power over Wal-Mart than does the smaller Colgate-Palmolive.

One other possibility is that the difference is due to the companies’ differing fiscal

year-ends. If the receivable balance is not constant during the year due to some seasonality, then the receivable turnover ratio will depend on the choice of fiscal year.




i. Accounts receivable (+A) ……………………………………… 3,200,000 Sales revenue (+R, +SE) …………………………..…… 3,200,000 ii. Bad debts expense (+E, -SE) ………………………………… 42,000 Allowance for uncollectible accounts (+XA, -A)……. 42,000 iii. Allowance for uncollectible accounts (-XA, +A) ………. 39,000 Accounts receivable (-A) ………………………………….. 39,000 iv. Accounts receivable (+A) ……………………………………… 12,000 Allowance for uncollectible accounts (+XA, -A) 12,000 Cash (+A) …..……………………………………………………… 12,000 Accounts receivable (-A) ………………………………… 12,000

The recovered receivable is reinstated, so that its payment may be properly

recorded. b. Besides the $12,000 in recovery, the collections from customers can be summarized

in the following entry:

v. Cash (+A) 2,926,000 Accounts receivable (-A) 2,926,000

(This amount includes payment of the recovered receivable for $12,000. The allowance increases by $15,000 over the period, so the fact that net receivables increased by $220,000 means that gross receivables must have increased by $235,000. That fact allows us to “back out” the cash received.)

c.

+ Cash (A) - - Sales Revenue (R) + (iv) 12,000 3,200,000 (i) (v) 2,926,000 2,938,000

+ Accounts Receivable (A) - + Bad Debts Expense (E) - (i) 3,200,000 (ii) 42,000 (iv) 12,000 39,000 (iii) 12,000 (iv) 2,926,000 (v) 235,000

- Allowance for Uncollectibles (XA) + 42,000 (ii) (iii) 39,000 12,000 (iv) 15,000

continued next page



M6-23. concluded d.

Balance Sheet Income Statement Transaction Cash

Asset

+ Noncash Assets - Contra

Assets = Liabil-ities + Contrib.

Capital + Earned Capital Revenues - Expenses = Net Income

i. Sales on account.

+3,200,000 Accounts

Receivable -

=

+3,200,000 Retained Earnings

+3,200,000 Sales

Revenue -

=

+3,200,000

ii. Bad debt expense.

-

+42,000

Allowance for Uncollectible

Accounts

=

-42,000

Retained Earnings

-

+42,000 Bad Debt Expense

=

-42,000

iii. Write-off of uncollectible accounts.

-39,000 Accounts

Receivable -

-39,000


Accounts

=

-

=

iv. Reinstate account previously written off.

+12,000 Accounts

Receivable -

+12,000


Accounts

-

=

Collect reinstated account.

+12,000 Cash

-12,000 Accounts

Receivable - - =

v. Collect cash on sales.

+2,926,000

Cash

-2,926,000 Accounts

Receivable -

=

-

=


Fiscal Year Revenue Revenue Growth 2012 48,000 2013 55,000 14.6% 2014 62,000 12.7% 20150 62,000 0.0%

b.

Fiscal Year Revenue

Unearned Revenue Liability

(end of year)

Customer Purchases = Revenue + Change in Unearned

Revenue Liability

Growth in Customer Purchases

2012 48,000 20,000 2013 55,000 24,000 55,000 + 4,000 = 59,000 2014 62,000 26,000 62,000 + 2,000 = 64,000 8.5% 2015 62,000 25,000 62,000 - 1,000 = 61,000 -4.7%

continued next page



M6-24. concluded c. In both fiscal year 2014 and 2015, the growth in customer purchases is lower than

the growth in reported revenues. The practice of deferring revenue recognition implies that reported revenues in a given period are the result of customer purchases over many periods, resulting in a smoothing of revenues. In the case of Finn Publishing, revenues in any given year are the result of newsstand and bookstore purchases during that year, plus part of the subscriptions from that year, plus part of the subscriptions from the previous year. That means that growth in annual revenues is a composite of growth in customer purchases over an even longer period of time.

For 2014 and 2015, Finn’s growth in revenues exceeds the growth in customer purchases because the revenues are still reflecting growth from prior periods. Purchases are a “leading indicator” of revenues, and thus, calculating customer purchase behavior can be useful in forecasting future revenue and identifying changes in customers’ attitudes about a company’s current offerings.

M6-25. (15 minutes) This question is based on an actual situation, in which the accounting rules were influencing the product decisions. The rules for revenue deferral when there are multiple deliverables deterred the company from providing enhancements and upgrades that were available. If Commtech’s customers (the wireless companies) had been willing to pay for the upgrades to its customer’s phones, that would have been allowed. (It’s not clear what the wireless companies’ incentives would be, because they may want to encourage users to purchase new phones – with a new service contract – rather than improving their existing phones.) The question can generate a discussion about whether accounting should drive decisions. Whether it should or not, it does, so the question should evolve into what top management should do about this type of situation. Does the situation described in the problem require some managerial action, or not. Is the company foregoing sales because of its accounting? Within Commtech, the finance staff was skeptical of marketing’s predictions that the upgrades and enhancements would increase the sales of existing phone models. If the upgrades and enhancements are delivered, Commtech will have to change its accounting for revenue, with a resulting decrease in near-term profitability. How might the company communicate that change in a way that the investing public will understand as a net benefit to the company?



EXERCISES E6-26. (20 minutes) Company Revenue Recognition The Limited When merchandise is given to the customer and returns can be

estimated (or the right of return period has expired). Boeing Corporation

Revenue is recognized under long-term contracts under the percentage-of-completion method.

SUPERVALU When merchandise is given to the customer and cash is received. MTV When the content is aired by the TV stations. Real estate developer

When title to the houses is transferred to the buyers.

Wells Fargo Interest is earned by the passage of time. Each period, Wells Fargo accrues income on each of its loans and establishes an account receivable on its balance sheet.

Harley-Davidson When title to the motorcycles is transferred to the buyer. Harley will also set up a reserve for anticipated warranty costs and recognize the expected warranty cost expense when it recognizes the sales revenue.

Time-Warner When the magazines are sent to subscribers. E6-27. (20 minutes) Company Revenue Recognition Real Money Recognize revenue ratably over the period of time that customers

can access its Web site, not when the cash is received. The recognition of revenue is dependent upon Real Money providing updates.

Oracle The fee to purchase the right to use the software can be recorded as revenue when the software is installed, unless that fee includes future deliverables like upgrades and support. (If such post-sale services are included in the fee, some portion must be deferred and recognized over the appropriate period.) Service revenue can only be recognized ratably over the period of time covered by the service contract.

Intuit Recognize revenue when the software is sent to customers. The company must estimate potential warranty claims and establish a reserve for them when revenue is recorded.

Computer game developer

Record revenue after the 10-day right of return period has elapsed.



E6-28. (20 minutes)

($ millions) a. Percentage-of-Completion Method b. Completed Contract

Year

Costs incurred

Percent of total

expected costs

Revenue recognized (percentage of costs

incurred total contract amount)

Income (revenue –

costs incurred)

Revenue recognized

Income

2013 $100 25% $125 $ 25 $ 0 $ 0

2014 300 75% 375 75 500 100

$400 $500 $100 $500 $100 c. The percentage-of-completion method normally provides a reasonable estimate of

the revenues, expenses, and income earned for each period based on the amount of work completed. A key assumption underlying the use of this method is that the contract price is fixed and it is possible to obtain reliable estimates of expected costs and costs to date. When such estimates are not available, the completed contract method should be used.

The percentage-of-completion method is acceptable under GAAP for a variety of contracts spanning more than one accounting period, such as in the consulting and transportation industries.

E6-29. (20 minutes) a. ($ millions) Percentage-of-Completion Method Completed Contract

Year

Costs incurred

Percent of total

expected costs

(rounded)

Revenue recognized (percentage of costs

incurred total contract amount)

Income (revenue –

costs incurred)

Revenue recognized

Income 2014 $15 18%

($15/$85) $ 21.6 $ 6.6 $ 0 $ 0

2015 40 47% ($40/$85)

56.4 16.4 0 0

2016 30 35% ($30/$85)

42.0 12.0 120 35

$85 $120.0 $35.0 $120 $ 35 b. The percentage-of-completion method provides a good estimate of the revenue and

income earned in each period. This method is also acceptable under GAAP for contracts spanning more than one accounting period. Recognition of revenue and income is not affected by the cash received, but the percentage-of-completion method more closely approximates cash flows than the completed contract method.



E6-30. (15 minutes) a. Multiple element arrangements are sales transactions in which two or more

deliverables are “bundled” together and sold for one price. The revenue should be recognized on each deliverable element when it is earned. This involves first assigning a portion of the sales revenue to each element and then recognizing each portion of the revenue only when that element has been delivered to the customer.

b. The total revenue for the “bundle” is $190. However the Kindle, if sold alone sells for

$170 and the wireless and upgrades sell for $30, which brings the total “value” to $200. Thus, the Kindle device represents 85% of the total value of the bundle ($170/$200). Amazon should recognize $161.50 at the time of the sale (85% of the $190 sale price) and defer the remaining $28.50.

c.

Balance Sheet Income Statement

Transaction Cash Asset + Noncash

Assets = Liabil-ities + Contrib. Capital + Earned

Capital Revenues - Expenses = Net Income

To record bundled sale transaction

+190

=

+28.50 Unearned revenue

+161.50

Retained Earnings

+161.50 Sales

revenue -

=

+161.50

Cash (+A) 190.00 Sales revenue (+R, +SE) 161.50 Unearned revenue (+L) 28.50

E6-31. (15 minutes) a. 2010: €4,674 + €497 x (1-.35) = €4,997

2011: €6,029 + €514 x (1-.35) = €6,363

b. 2010: €4,997 / €97,761 = .0511 or 5.11% 2011: €6,363 / €106,540 = .0597 or 5.97%

c. €6,363 / [(€143,844 - €23,571 + €131,487 - €21,191) / 2] = .0552 or 5.52%



E6-32. (15 minutes) In none of these cases should Simpyl Technologies recognize revenue. Each of the four settings touches on one of the four conditions for revenue recognition listed by the SEC. In part a, “persuasive evidence of an exchange agreement” does not yet exist, because the company’s policies have defined a contract with authorized signatures to constitute persuasive evidence. In part b, delivery has not occurred. The product has been shipped, but not to the customer and not with the specified customizations that are required by the customer. In part c, the price is not yet fixed or determinable, because the negotiations over volume discounts have not been concluded. Finally, the distributor in part d does not have the means to pay for the items delivered, so collectibility cannot be reasonably assured (until the distributor sells the product to an end customer). The delivery should be viewed as a consignment arrangement, in which Simpyl recognizes revenue when the distributor sells the items to a third party. This problem is based on the restatements of Symbol Technologies, Inc.’s 10-K filing for fiscal year 2002, in which they detail the errors and irregularities in financial statements dating back to 1998. Symbol had made accounting entries that violated each of the SEC’s four criteria for revenue recognition. An article by Steve Lohr describing the incoming CEO’s experiences at Symbol Technologies can be found in the New York Times, June 21, 2004. The title of the article is “Day 2: I Learn the Books are Cooked.” (Motorola, Inc., acquired Symbol Technologies in January 2007 for a price of $3.9 billion.) E6-33. (20 minutes) a. Prior to the aging of accounts, the balance in the Allowance for Uncollectible

Accounts would be a credit of $520 (the opening balance of $4,350 less the amounts written off of $3,830).

2013 bad debt expense computation

$250,000 0.5% = $1,250 $ 90,000 1% = 900

20,000 2% = 400 11,000 5% = 550 6,000 10% = 600 4,000 25% = 1,000

4,700 Less: Unused balance before adjustment 520 Bad debt expense for 2013 $4,180

continued next page



E6-33. concluded b. Accounts receivable, net = $381,000 - $4,700 = $376,300

Reported in the balance sheet as follows: Accounts receivable, net of $4,700 in allowances ................................... $376,300

c. + Bad Debts Expense (E) - - Allowance for Uncollectible Accounts (XA) +

(a) 4,180 4,350 Balance Write-offs 3,830 4,180 (a) 4,700 Balance

E6-34. (25 minutes) a. Allowance for doubtful accounts (-XA) 70 Accounts receivable (-A) 70 Provision for doubtful accounts (+E,-SE) 9 Allowance for doubtful accounts (+XA) 9 The provision for doubtful accounts (bad debt expense) has a credit entry that has

the effect of decreasing Ethan Allen’s reported income by $9 thousand for the year. The write-off of $70 thousand of uncollectible accounts has no effect on income.

b.

2012 2011 Accounts receivable, net 14,919 15,036 Allowance for doubtful accounts 1,250 1,171 Gross receivables (net plus allowance) $16,169 $16,207 Allowance as a % of gross receivables 7.7% 7.2%

c. $729,373 / [($14,919 + $15,036) / 2] = 48.7 times. The very fast ART is probably

due to the custom furniture aspect of Ethan Allen’s business. Many of their products are not produced until a customer places an order and payment occurs upon delivery or very soon thereafter.

d. $729,373 + ($65,465 - $62,649) – ($14,919 - $15,036) – $9 = $723,297.



E6-35. (15 minutes) Accounts receivable $138,100 Less Allowance for uncollectible accounts 10,384 $127,716 Computations Accounts Allowance for Receivable Uncollectible Accounts Beginning balance $ 122,000 $ 7,900 Sales 1,173,000 Collections (1,150,000) Write-offs ($3,600 + $2,400 +$900) (6,900) (6,900) Provision for uncollectibles ($1,173,000 0.8%) _________ 9,384 $ 138,100 $ 10,384 E6-36. (20 minutes) a. Aging schedule at December 31, 2013 Current $304,000 1% = $ 3,040 0–60 days past due 44,000 5% = 2,200 61–180 days past due 18,000 15% = 2,700 Over 180 days past due 9,000 40% = 3,600 Amount required 11,540 Balance of allowance 4,200 Provision $ 7,340 = 2010 bad debt expense b. Current Assets Accounts receivable $375,000 Less: Allowance for uncollectible accounts 11,540 $363,460 c.

+ Bad Debts Expense (E) - - Allowance for Uncollectible Accounts (XA) + (a) 7,340 4,200 Balance 7,340 (a) 11,540 Balance



E6-37. (30 minutes) a.

Year Sales Collections Accounts Written Off 2012 $ 751,000 $ 733,000 $ 5,300 2013 876,000 864,000 5,800 2014 972,000 938,000 6,500 Total $2,599,000 $2,535,000 $17,600

Accounts Receivable at the end of 2014 is $46,400, computed as: ($2,599,000 - $2,535,000 - $17,600). Bad Debts Expense is: 2012 $ 7,510 computed as 1% $751,000 2013 8,760 computed as 1% $876,000 2014 9,720 computed as 1% $972,000 2012-2014 $25,990 computed as 1% $2,599,000 Allowance for Uncollectible Accounts is $8,390 computed as: $25,990 total bad debts expense less $17,600 in total write-offs.

b.

Accounts Receivable (A) Allowance for Uncollectibles (XA) Beg Bal 0 0 Beg Bal Sales 751,000 5,300 Write offs Write offs 5,300 7,510 Bad debts exp. 733,000 Collections 2012 Bal 12,700 2,210 2012 Bal Sales 876,000 5,800 Write offs Write offs 5,800 8,760 Bad debts exp. 864,000 Collections 2013 Bal 18,900 5,170 2013 Bal Sales 972,000 6,500 Write offs Write offs 6,500 9,720 Bad debts exp. 938,000 Collections 2014 Bal 46,400 8,390 2014 Bal

There isn’t any indication that the 1% rate is incorrect. If the rate is too high, we

would expect the allowance to grow at a faster rate than receivables. If the rate is too low, the opposite would occur. In this case, the allowance percentage of receivables is 17%, 27% and 18% at the end of 2012, 2013 and 2014, respectively. So, there is no clear direction that would indicate an inappropriate estimate.




Earnings

from Operations

End. Assets

Beg. Assets

Avg. Assets

Return on Capital

Employed

Personal Systems Group $ 2,350 $ 15,781 $ 16,548 $16,164.5 14.5%

Services 5,149 40,614 41,989 41,301.5 12.5%

Imaging and Printing Group 3,973 11,939 12,514 12,226.5 32.5%

Enterprise Servers, Storage and Network 3,026 17,539 18,262 17,900.5 16.9%

HP Software 698 21,028 9,979 15,503.5 4.5%

HP Financial Services 348 13,543 12,123 12,833.0 2.7%

b. The most profitable group seems to be the Imaging and Printing Group, which

represents HP’s traditional strength. However, it is not growing very quickly (based on sales percentage increases). The Enterprise Servers, Storage and Networking Group and the Personal Systems Group (commercial and personal PCs, workstations, etc.) also have good return on capital employed. The HP Software Group has a low return on capital employed but that group appears to have had a major investment in assets during the year, which can distort this measure, depending on the timing of the capital expenditures.

c. Restructuring charges are reported “above the line,” as part of income from

continuing operations before income taxes. They are listed as a charge against operating income in the income statement, and thus would reduce our calculation of return on capital employed. Restructuring charges are nonrecurring, however, and should be considered separately when evaluating profitability of a business segment.



E6-39. (20 minutes) a. Just like for-profit organizations, not-for-profit organizations cannot recognize

revenue until it has been earned. In the case of The Lyric Opera, it cannot recognize the ticket revenue until the performances occur. (The Lyric does not issue quarterly reports, so we cannot observe how much of the revenue has been earned by six months through its fiscal year.)

b. This entry is simplified by the fact the fiscal year-end is after the end of the current

season and by assuming that all of The Lyric’s deferred revenue relates to the following season (and none to any years after the following season).

To record revenue for the fiscal year 2012 season: Deferred ticket and other revenue (-L) 12,711 Cash or Accounts receivable (+A) 12,319 Ticket sales (+R, +NA) 25,030 (As a not-for-profit, The Lyric Opera does not have shareholders’ equity, but rather

“net assets.” Therefore, the recognition of revenue increases net assets (NA) on the balance sheet.)

To record advance purchases for the fiscal year 2012 season: Cash or Accounts receivable (+A) 12,638 Deferred ticket and other revenue (+L) 12,638 c. It’s likely that the downturn in the economy caused some subscribers not to renew

(or to wait until after April 30 to renew) in 2009 and it would appear that three years later, the advanced ticket sales have not recovered from the 2009 decline. It’s possible that the decline in advance purchases is a statement about the opera selections. However, the loyal subscriber base (and the desire to keep one’s assigned seating) makes the economy a more likely cause.

d. The Lyric Opera usually operates at close to seating capacity. And, in a typical year,

approximately more than one-half of its seats are sold by the April 30th preceding the season. So, the quantity of unsold seats will affect The Lyric’s marketing efforts for subscribers who have not yet renewed, outreach to new potential subscribers and promotions for individual tickets which go on sale shortly before the season. Those efforts can be scaled up or down depending on the experience with advance sales.



E6-40. (20 minutes) a. Membership fees are initially recorded as a liability (deferred membership fee

revenue) and recognized over a period of one year. Member rewards are similarly deferred, but the offsetting debit is recorded as a reduction to sales revenue.

b. Cash (+A) 2.203 Deferred membership fees (+L) 2,203 Deferred membership fees (-L) 2,075 Membership fee revenue (+R, +SE) 2,075

c.

Sales revenue (-R, -SE) 900 Accrued member rewards (+L) 900 Accrued member rewards (-L) 841 Merchandise inventory (-A)* 841

*The Costco note does not say how the membership rewards are redeemed. The entry above assumes that the rewards are redeemed for merchandise, as is the case in many such situations. If, instead, the rewards are redeemed for cash, the credit entry would be to cash and not merchandise inventory.



PROBLEMS P6-41.A (20 minutes) a. The following items might be considered to be operating:

1. Net Sales, cost of sales, R&D expenses, and SG&A expenses are typically designated as operating.

2. Amortization of intangible assets and restructuring charges would usually be considered to be operating under the assumptions that the acquisition that gave rise to the intangible assets is included as part of operations, and that the restructuring did not involve discontinuation of distinct parts of the business.

3. The asbestos-related credit, restructuring charges and goodwill impairment losses would be considered to be operating since they are related to Dow Chemical’s operating activities. (These items are both operating and nonrecurring – see b.)

4. Purchased in-process research and development charges and Acquisition-related expenses are caused by the company’s investing activities, and would be considered nonoperating.

5. Equity in earnings of nonconsolidated affiliates would be considered operating under the assumption that the affiliates are related to Dow’s core operations, which is typically the case.

6. Sundry income would generally be considered nonoperating in the absence of a footnote clearly indicating its connection to the operating activities of the company.

7. Interest income is considered nonoperating 8. Interest expense and amortization of debt discount is nonoperating.

continued next page



P6-41.A concluded b. The following items might be identified as nonrecurring items:

1. Purchased in-process research and development and Acquisition-related expenses – these are one-time (e.g., nonrecurring) costs incurred in connection with the acquisition of another company and can properly be expensed under GAAP.

2. Asbestos-related credit – this is a reversal of a previous accrual for litigation in connection with asbestos-related lawsuits. GAAP requires such an accrual if the loss is probable and can be reasonably estimated. Since it is a one-time occurrence, it can be considered to be a transitory item.

3. Goodwill impairment losses – this loss results from changes in expectations of the performance of past acquisitions. It would be considered operating, but transitory.

4. Restructuring charges – these relate to the company’s actions due to the economic decline in 2008 and the expectations that future performance will not meet prior expectations. Restructuring costs are considered “special items,” meaning that individually they are transitory, but as a category, they happen frequently.

5. The charge for discontinued operations would be considered nonrecurring. We would need to examine prior years’ income statements to discern if the other categories in Dow’s income statement are to be considered transitory.

c. 2010: $2,321 + ($1,473 + $143 - $125 - $37) x (1-.35) = $3,266.1

$3,266.1 / $53,674 = 6.1% 2009: $676 + ($1,571 + $7 + $166 - $891 - $39) x (1-.35) = $1,205.1 $1,205.1 / $44,875 = 2.7%



P6-42. (20 minutes) a. 1. Percentage-of-completion based on number of employees trained

Year 2013 2014 2015 Total Number of employees trained 125 200 75 400 Revenues (# trained x $1,200) $150,000.00 $240,000.00 $90,000.00 $480,000.00 Expenses (# trained x $437.50)* 54,687.50 87,500.00 32,812.50 175,000.00 Gross Profit $95,312.50 $152,500.00 $57,187.50 $305,000.00

* $437.50 = $175,000 / 400

2. Percentage-of-completion based on costs incurred Year 2013 2014 2015 Total Costs incurred $60,000 $75,000 $40,000 $175,000 Percentage completed 34.29% 42.86% 22.86% 100.00% Revenues (% x $480,000) $164,571.43 $205,714.29 $109,714.29 $480,000.00 Expenses 60,000.00 75,000.00 40,000.00 175,000.00 Gross Profit $104,571.43 $130,714.29 $69,714.29 $305,000.00

3. Completed contract method

Year 2013 2014 2015 Total Revenues $0 $0 $480,000 $480,000 Expenses 0 0 175,000 175,000 Gross Profit $0 $0 $305,000 $305,000

b. Assuming that (1) Philbrick has a noncancelable contract that specifies the price at

$1,200 per employee, (2) the number of employees and the costs of training can be estimated with a reasonable degree of accuracy, and (3) Elliot Company is a reasonable credit risk, the best method would be to recognize revenues using the percentage-of-completion method based on the number of employees trained. The completed contract method should only be used if either of the first two conditions is not met.



P6-43. (15 minutes) a. Management would have an incentive to shift $1 million of income from the current

period into next. This might be accomplished by delaying revenue recognition or accelerating expenses. This would increase their bonus by $100,000 next year without decreasing the current bonus.

b. Management would have an incentive to shift $3 million of income from next year

into income reported this year. This would increase the current year bonus by $300,000 without reducing next year’s bonus.

c. Management would have an incentive to shift income from the current year into next

year. Even though this would reduce earnings this year, earnings are already so low that management does not expect to receive a bonus. Shifting earnings into a future period increases the bonus in that period.

d. These incentives for earnings management would be mitigated if the “kinks” in the

bonus formula were removed. Alternatively, some companies pay bonuses based on a three-year moving average of earnings to minimize the impact of earnings management.

This problem can provide an opportunity to discuss the “slippery slope” of earnings management. For example, management’s optimism about next year in part b may not turn out to be warranted. Suppose next year’s “natural” earnings turns out to be $20 million instead of $24 million. Management’s action in the first year will have reduced next year’s $20 million to $17 million, and earnings management would again be required to meet the target. And, if meeting the target in one year causes the next year’s target to increase, things can get out of control very quickly.



P6-44. (40 minutes) (all in $ millions) a. Net receivables as of January 28, 2012 were $2,033.

Net receivables as of January 29, 2011 were $2,026. b.

Bad debts expense (+E, -SE) 101 Allowance for credit losses (+XA) 101 Allowance for credit losses (-XA) 153 Accounts receivable (-A) 153 Cash (+A) 22 Allowance for credit losses (+XA) 22

c. Estimated credit losses to gross credit card receivables are:

5.5% ($115/$2,074) in 2011 6.9% ($145/$2,103) in 2010

The decrease in the allowance for credit losses as a percent of credit card receivables is reflected in the aging of Nordstrom’s receivables. The percentage of receivables that are 30 or more days past due has decreased from 3.0% on January 29, 2011 to 2.6% at January 28, 2012. This could be caused by (1) a general improvement in economic conditions (fewer customers are late or defaulting on their obligations), (2) tighter credit policies (credit is denied to risky customers) and/or (3) more rigorous collection practices.

d. The receivables turnover rate is $10,497 / [($2,033 + $2,026)/2] = 5.17 Days sales in accounts receivable is $365/5.17 = 70.6 days



P6-45. (25 minutes) For the instructor: This problem covers the accounting for product returns, which is not covered in the chapter. The description of The Gap’s practices should allow students to answer parts a and b. Part c is a bit of a stretch, because it requires that the allowance for returns, which is in gross profit terms, be “grossed-up” to revenue terms.

a. Beginning balance + $634 million - $635 million = $21 million, so Beginning balance

= $22 million. b. Sale and expected returns:

(1) Record revenue. Cash (+A) 5,000 Revenue (+R,+SE) 5,000 (2) Record COGS. Cost of goods sold (+E,-SE) 3,000 Inventory (-A) 3,000 (3) Recognize

expected returns. Revenue contra, returns (+XR, -SE) 500

COGS contra, returns (+XE, +SE) 300 Sales returns allowance (+L) 200 The sales returns allowance is equal to Gross sales ($5,000) times the probability of return (10%) times the gross profit margin (40%), or $200. For these ten units, the cost of goods was $300.

Returns:

(4) Process return transactions.

Inventory (+A) 300 Sales returns allowance (-L) 200

Cash (-A) 500 At the conclusion of this transaction, the customers have their cash, the inventory

costs have been adjusted to include the returned items, and the sales returns allowance liability has a balance of zero because the actual returns coincided with the expected returns.

continued next page



P6-45. concluded c. The Gap’s reported gross profit is 36.2% of its net sales ($5,274million/$14,549

million). So, if The Gap expects returns of items with gross profit of $634 million, those items must have had sales prices of $1,751 million ($634 million/0.362) and cost of goods sold of $1,117 million ($1,751 million - $634 million). The entry that would have reflected The Gap’s accounting for these expected returns is the following:

Recognize expected returns.

Revenue contra, returns (+XR, -SE) 1,751 COGS contra, returns (+XE, +SE) 1,117

Sales returns allowance (+L) 634 The Gap’s gross sales revenue would have been $16,300 million ($14,549 million +

$1,751 million), and its expected returns as a percentage of sales would be 10.7% ($1,751 million/$16,300 million).

The size of the allowance for 2011 ($634 million) relative to the end-of-year return

liability ($21 million) means that the vast majority of these product returns occurred during the 2011 fiscal year, so it is more a reflection of actual experience than of management’s estimates of future events.

d. Under these circumstances, The Gap doesn’t have to worry about accounting for

expected returns, because it has not satisfied the requirements for revenue recognition. If the amount to be received (or in this case, the amount to be kept) is not yet “fixed or determinable,” the revenue should not be recognized until it is.

P6-46. (25 minutes) a.

Fiscal year ending March 31 Net revenue

Growth rate

2005 3,129 – 2006 2,951 -5.7% 2007 3,091 4.7% 2008 3,665 18.6% 2009 4,212 14.9% 2010 3,654 -13.2% 2011 3,589 -1.8% 2012 4,143 15.4%

continued next page



P6-46. concluded b.

Fiscal year ending

March 31 Net

revenue

Deferred net revenue (liability)

Purchases = Net revenue + Change in Deferred net revenue

Growth rate

2005 3,129 0 3,129 – 2006 2,951 9 2,960 -5.4% 2007 3,091 32 3,114 5.2% 2008 3,665 387 4,020 29.1% 2009 4,212 261 4,086 1.6% 2010 3,654 766 4,159 1.8% 2011 3,589 1,005 3,828 -8.0% 2012 4,143 1,048 4,186 9.4%

When companies defer revenue, there is a lag between customers’ purchases and

the recognition of revenue on the income statement. When purchases grow significantly (as they did in 2008) revenues grow in subsequent years. When purchases fall off, we would expect revenues to fall off in subsequent years (see 2009 and 2010). 2012 appears to be an anomaly. Purchases declined in 2011 but revenue grew significantly in 2012.

c. If customer purchases in 2012 are a leading indicator of revenue in 2013, we would

predict a substantial revenue growth for 2013.



CASES and PROJECTS C6-47. (40 minutes) a.

Cash (+A) 120,000 Sales revenue (+R, +SE) 60,000 Payable to merchant partners (+L) 60,000

b. Revenues were previously recorded at the full amount of the Groupon sale

($120,000 in a above) and the amount payable to the merchant partner was recorded as an expense. This was changed in 2011 to record the sale of the Groupon, net of the amount due to the merchant partner as revenue. The effect of this change was that revenues and expenses were reduced by the amount paid to the merchant partner. This did not alter the bottom line as net income does not change. The NOPM ratio would increase due to the decrease in revenue without a corresponding decrease in operating income.

c.

Sales revenue contra (-R, -SE) 6,000 Allowance for returns (+L) 6,000

Allowance for returns (-L) 6,000 Payable to merchant partners (-L) 6,000 Cash (-A) 12,000

d.

Cost of revenue (+E, -SE) 6,000 Allowance for returns (+L) 6,000

Allowance for returns (-L) 6,000 Cash (-A) 6,000

e. Groupon could wait to recognize revenue until the 60-day period to pay the

merchant partner has expired. By doing so, there would be no need to estimate refunds that would involve reducing the payable or recovering a refund from the merchant partner. Groupon would still need to estimate refunds for any cancelation that might occur after the end of the 60-day period when the merchant partner has been paid. This is when Groupon’s risk is greatest, since it cannot recover any part of the refund from the merchant. However, by waiting 60 days before recognizing the revenue (and estimating the refunds) Groupon would likely have a better idea about the amount of refunds that will likely occur.



C6-48. (30 minutes) a. When Dell sells other companies’ software products, it is often as part of a multiple-

element sales agreement. For example, the customer may purchase hardware, software, and customer support for one price. This is an example of a bundled sale. Dell must allocate the sales price based on the relative fair market value of each element. Revenue is recognized for each specific element when it is clear that the element has been delivered and the revenue is earned.

There are at least two possibilities for earnings management here. First, Dell could

misallocate the sales price. By allocating more of the price to hardware and less to software, Dell may be able to manage when earnings are reported. Second, Dell may be aggressive in applying the “earned and realizable” criteria to each element, thereby prematurely recognizing revenue.

From the information provided, it appears that Dell was recognizing revenue on

software “resales” at the time of sale. However, most software is not truly sold. Instead, the customer purchases a license to use the software. As a result, Dell should have deferred part of the revenue and recognized it ratably over the license period.

b. Extended warranties are typically sold separately from other products. Therefore,

the revenue should be deferred and recognized ratably over the warranty contract period. Dell employees were apparently recording revenue at the time of sale, or were recognizing the revenue over a shorter time period than the contract period. As a result, revenues and income were overstated.

c. It is common for managers to have performance targets based on revenues and

earnings. This provides an incentive for these employees to take actions to accelerate revenue recognition when it appears that targets may not be met. On the other hand, in periods when revenues and earnings exceed the targets, managers may delay revenue recognition until a future period. In this way, they can “store up” revenues and earnings to meet future targets.

The key to preventing this type of abuse is the periodic audit of divisional revenues

and earnings. In addition, businesses spend a large amount of resources trying to design incentive compensation plans that do not encourage this type of abuse.



C6-49. (45 minutes) a. 2011:

i. Bad debt expense (+E, -SE) 13,989 Allowance for doubtful accounts (+XA, -A) 13,989 ii. Allowance for doubtful accounts (-XA, +A) 1,206 Accounts receivable (-A) 1,206 2012: iii. Bad debt expense (+E, -SE) 2,111 Allowance for doubtful accounts (+XA, -A) 2,111 iv. Allowance for doubtful accounts (-XA, +A) 14,903 Accounts receivable (-A) 14,903

- Allowance for Doubtful Accounts (XA) ($000) +

Balance 6,859 2010 Balance Sales 13,989 (i) (ii) 1,206 Balance 19,642 2011 Balance 2,111 (iii) (iv) 14,903 6,850 2012 Balance

b. 2011: $19,642 / ($168,310 + $19,642 + $65,664) = 7.7%

2010: $6,850 / ($171,561 + $6,850 + $48,612) = 3.0% The extra provision for the Borders account significantly increased Wiley’s allowance account for 2011.

c. If sales returns are material in amount and can be estimated with a reasonable

degree of accuracy, they should be estimated just as bad debts are estimated. Sales revenue is debited for the estimated returns while an allowance for returns is credited. One important difference is that with sales returns (unlike bad debts) the customer returns the product to the company and it is often returned to inventory. Hence, the amount of allowance for returns is a net amount equal to the estimated gross profit on expected returns.

continued next page



C6-49. concluded d. To record estimated returns:

Sales revenue (est. sales returns) (-R, -SE) 112,948 Allowance for returns – A/R (+XA) 112,948

Allowance for returns – Inventory (+A) 17,761 Cost of sales (-E, +SE) 17,761

Allowance for returns – royalties payable (+XL) 12,286 Royalty expense (-E, +SE) 12,286

To record actual returns: Allowance for returns – A/R (-XA, +A) 130,000 Accounts receivable (-A) 130,000

Inventory (+A) 20,000 Allowance for returns – Inventory (-A) 20,000

Royalties payable (-L) 13,963 Allowance for returns – Royalties payable (-XL) 13,963

The net amount reported in the allowance for returns consists of three separate amounts – one offsetting accounts receivable (a contra asset) an amount added to inventory (an adjunct asset) and a third amount offsetting royalties payable (a contra liability): Allowance for returns – A/R: $65,664 + $112,948 - $130,000 = $48,612 Allowance for returns – Inventory: $9,485 + $17,761 - $20,000 = $7,246 Allowance for returns – Royalties: $7,270 + $12,286 - $13,963 = $5,593 Note that $130,000 - $20,000 - $13,963 = $96,037, and $112,948 - $17,761 - $12,286 = $82,901. When these three accounts are combined, we get the net amount reported in the allowance for returns each year.

e. Accounts receivable turnover: $1,782,742 / [($171,561 + $168,310)/2] = 10.5 times.

Average collection period: 365 / 10.5 = 34.8 days.



Chapter 7 Reporting and Analyzing Inventory



LO1 – Interpret disclosures of information concerning operating expenses, including manufacturing and retail inventory costs.

13 - 15, 17

LO2 – Account for inventory and cost of goods sold using different costing methods.

18 - 21, 23 26, 27,

29 - 31 33, 34, 36 37, 38

LO3 – Apply the lower of cost or market rule to value inventory.

24 28

LO4 – Evaluate how inventory costing affects management decisions and outsiders’ interpretations of financial statements.

18 26, 29 - 31 33, 34, 36 37, 38

LO5 – Define and interpret gross profit margin and inventory turnover ratios. Use inventory footnote information to make appropriate adjustments to ratios.

16, 22 25, 31, 32 33 - 35 37

LO6 – Appendix 7A: Analyze LIFO liquidations and the impact they have on the financial statements.

36 37



DISCUSSION QUESTIONS Q7-1. When company A purchases inventory from company B, the buyer and seller

must agree on which firm is responsible for the transportation costs. The terminology “freight on board shipping point” or FOB is used to indicate the buyer assumes responsibility for the transportation cost once notice of delivery to the shipper is received. In addition, the buyer assumes responsibility for any delay or damage during transit.

When goods are shipped FOB, the seller normally can recognize revenue unless the seller has not fulfilled all requirements of the purchase agreement. An example is when an equipment installation and/or up-and-running properly is part of that agreement.

Q7-2. If stable purchase prices prevail, the dollar amount of inventories (beginning or ending) tends to be approximately the same under different inventory costing methods and the choice of method does not materially affect net income. To see this, remember that FIFO profits include holding gains on inventories. If the inflation rate is low (or inventories turn quickly), there will be less holding (inflationary) profit in inventory.

Q7-3. FIFO holding gains occur when the costs of earlier inventory acquisitions are matched against current selling prices. Holding gains on inventories increase with an increase in the inflation rate and a decrease in the inventory turnover rate. Conversely, if the inflation rate is low or inventories turn quickly, there will be less holding (inflationary) profit in inventory.

Q7-4. (a) Last-in, first-out, (b) Last-in, first-out, (c) First-in, first-out, (d) First-in, first-out, (e) Last-in, first-out.

Q7-5. A significant tax benefit results from using LIFO when costs are consistently rising. LIFO results in lower pretax income and, therefore, lower taxes payable, than other inventory costing methods.

Q7-6. Kaiser Aluminum Corporation is using the lower of cost or market (LCM) rule. When the replacement cost for inventory falls below its (FIFO or LIFO) historical cost, the inventory must be written down to the lower replacement costs (market value).

Q7-7. The various inventory costing methods would produce the same results (inventory values and cost of goods sold) if prices were stable. The inventory costing methods produce differing results when prices are changing.

Q7-8. Inventory “shrink” refers to the loss of inventory due to theft, spoilage, damage, etc. Shrink costs are part of cost of goods sold but do not represent goods that were actually sold.



Q7-9. The “LIFO reserve” is the difference between the cost of inventory determined using the last-in, first-out (LIFO) method and the cost determined using another method (either FIFO or average cost). Companies that report inventory cost using the LIFO method must also report the LIFO reserve. This allows the financial statement reader to convert from LIFO to another method for comparison purposes.

The LIFO reserve represents the difference between the historical, LIFO cost of inventory and its current cost. This disparity between the book value and the current value represents a gain from holding the inventory that has not yet been recognized in income or in equity an unrealized holding gain.

Q7-10. Because LIFO assigns the last units purchased during the year to cost of goods sold (COGS), changing prices can make it difficult to forecast earnings. Companies have discretion as to when and how much inventory they purchase during an accounting period. LIFO is always applied on a periodic, annual basis, so a purchase made during the final days of the year will end up in COGS and affect current earnings. However, if that purchase is delayed until the first week of the next year, it could be several years before those units are transferred to COGS. Unlike other inventory methods, LIFO requires that the quantity and price of inventory purchases be predicted to make accurate earnings forecasts.

Q7-11A. LIFO liquidation is involuntary when it is caused by events that are beyond management’s control. Examples of such events include labor strikes, natural disasters, or wars which could interrupt the delivery of inventory by suppliers or shut down production facilities.

Q7-12A. In periods of rising prices, LIFO liquidation results in older, lower-cost goods being expensed as cost of goods sold, yielding higher profits. This may be the result of a management decision to reduce inventory levels for efficiency purposes. However, it may also be an earnings management tactic. Management may be trying to avoid violating bond covenants, or it may be trying to manipulate management compensation. In any case, this practice is costly, in that the additional profits lead to higher income taxes.



MINI EXERCISES M7-13. (15 minutes) The cost to be assigned to the inventory is $535 ($500 + $30 + $5).

+ Inventory (A) - - Accounts Payable (L) + (a) 500 50 (b) (b) (d)

50 5

10 5

(c) (d)

- Notes Payable (L) + + Interest Expense, Discounts Lost (E) -

500 (a) (c) 10

M7-14. (15 minutes) The only cost that should be included in inventory is the cost of merchandise to be sold. M7-15. (20 minutes) RAW MATERIALS INVENTORY Beginning inventory $ 0 Purchases + 84,000 Materials used - 63,000 Ending inventory $ 21,000 WORK IN PROCESS INVENTORY Beginning inventory $ 0 Materials used + 63,000 Labor costs + 58,000 Overhead costs + 28,000 Cost of goods produced - 130,000 Ending inventory $ 19,000 FINISHED GOODS INVENTORY Beginning inventory $ 0 Cost of goods produced + 130,000 Cost of goods sold - 95,000 Ending inventory $ 35,000



M7-16. (10 minutes)

2011: $65,030 -20,360 = 0.6869 $65,030

2010: $61,587 -18,792 = 0.6949 $61,587

2009: $61,897 -18,447 = 0.7020 $61,897 M7-17. (15 minutes) a. Purchases are understated. If ending inventory is correctly valued, cost of goods

sold will also be understated and current income will be overstated. There would be no effect in the following year.

If, however, ending inventory is understated (due to the mistakenly recorded

purchase) then there is no effect on income in either period. b. Purchases are overstated. The effect on income, assuming normal inventory levels,

depends on the inventory costing system being used by the company. Assuming rising prices, income would be reduced in the current year under LIFO or average costing but unaffected under FIFO costing. Income in the following year would not be affected. (The solution assumes the error is not discovered and corrected in the current year.)

c. Shrink (part of cost of goods sold) is overstated and ending inventory is understated.

Consequently, current period income is understated. If the inventory is counted correctly the following year, the error will reverse itself and income will be overstated. This is an example of a “self-correcting” inventory error.



M7-18. (20 minutes) a. Balance Sheet December 2013 Assets Cash $12,000 Inventory 50,000 Shareholders’ equity Contributed capital $62,000 b. All monetary amounts in $ thousands.

Year 2014 2015 2016 Income statement: Revenue 75 85 95 COGS-FIFO 50 60 70 Earnings before tax 25 25 25 Tax expense 10 10 10 Net income 15 15 15

Cash flows: Receipts 75 85 95 Inventory purchases -60 -70 -80 Tax payments -10 -10 -10

Cash from operations

5 5 5

Dividends -9 -9 -9 Cash from financing -9 -9 -9 Net change in cash -4 -4 -4

Balance sheet: Assets Cash 8 4 0 Inventory 60 70 80 Total 68 74 80

Shareholders’ equity Contributed capital 62 62 62 Retained earnings 6 12 18 Total 68 74 80

Clearly there is a problem with this business model. The company is showing profits, and assets and retained earnings are increasing. However, there is a cash flow problem. The net change in cash every year is -$4 thousand and, by the end of 2013, the company would have a cash balance of zero. In 2014, it would not be possible to replenish the inventory and to pay the dividend.

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M7-18. concluded c. All monetary amounts in $ thousands.

Year 2011 2012 2013 Income statement: Revenue 75 85 95 COGS-LIFO 60 70 80

Earnings before tax 15 15 15 Tax expense 6 6 6 Net income 9 9 9

Cash flows: Receipts 75 85 95

Inventory purchases -60 -70 -80 Tax payments -6 -6 -6

Cash from operations 9 9 9

Dividends -9 -9 -9 Cash from financing -9 -9 -9

Net change in cash 0 0 0

Balance sheet: Assets Cash 12 12 12 Inventory 50 50 50 Total 62 62 62

Shareholders’ equity Contributed capital 62 62 62 Retained earnings 0 0 0 Total 62 62 62

Interestingly, the use of LIFO reduces profits, and the company’s reported assets (and net assets) are not growing like the FIFO case above. However, the cash flow situation is improved. The company can pay the desired dividends and continue to replace its inventory at the end of every year. The difference between LIFO and FIFO is that FIFO profits include a gain from holding inventory while prices are rising. When the company is taxed on that gain, it has less cash available to maintain its physical assets (inventory). In essence, paying taxes based on FIFO (when inventory costs are increasing) can cause a firm’s ability to stay in business to be taxed away. LIFO profits exclude holding gains, so the company could continue to stay in business. (The tax authorities will “catch up” when the business decides to stop investing in inventory, and the LIFO liquidation profits get taxed.)



M7-19. (20 minutes) a. FIFO cost of goods sold = 1,000 @ $100 + 700 @ $150 = $205,000 FIFO ending inventories = $400,000 - $205,000 = $195,000 b. LIFO cost of goods sold = 1,700 @ $150 = $255,000 LIFO ending inventories = $400,000 - $255,000 = $145,000 c. AC cost of goods sold = 1,700 @ $400,000/3,000 = $226,667 AC ending inventories = $400,000 – $226,667 = $173,333 M7-20. (15 minutes) a. $1,320,000 + purchases - $6,980,000 = $1,460,000; purchases = $7,120,000. b.

1. Inventory (+A) 7,120,000 Cash or Accounts payable (-A or +L) 7,120,000

2. Cost of goods sold (+E, -SE) 6,980,000 Inventory (-A) 6,980,000

c.

+ Cash (A) - + Cost of Goods Sold (E) - 7,120,000 (1) (2) 6,980,000

+ Inventory (A) - Balance 1,320,000 (1) 7,120,000 6,980,000 (2) Balance 1,460,000

d.



Assets = Liabi-lities + Contrib.

Capital + Earned Capital Revenues - Expenses = Net

Income a. Purchase inventory. -7,120,000

Cash 7,120,000 Inventory = - =

c. Cost of inventory sold.

-6,980,000 Inventory =

-6,980,000 Retained Earnings

-

+6,980,000 Cost of

Goods Sold =

-6,980,000



M7-21. (10 minutes) a. FIFO cost of goods sold = 400 @ $10 + 200 @ $12 = $6,400 FIFO ending inventories = $12,400 - $6,400 = $6,000 b. LIFO cost of goods sold = 600 @ $12 = $7,200 LIFO ending inventories = $12,400 - $7,200 = $5,200 c. AC cost of goods sold = 600 @ $12,400/1,100 = $6,764 AC ending inventories = $12,400 – $6,764 = $5,636 M7-22. (20 minutes) a.

Inventory Turnover-2012 Inventory Turnover-2011 Wal-Mart 335/[(40.7+36.4)/2] = 8.69 315/[(36.4+32.7)/2] = 9.12 Target 47.9/[(7.92+7.60)/2] = 6.17 45.7/[(7.60+7.18)/2] = 6.18

b. Wal-Mart’s inventory turnover rate is higher than Target’s. There can be several

reasons for this. Wal-Mart’s product lines may be oriented toward lower-margin/higher-turnover goods (Wal-Mart does report a lower gross profit margin than Target). And, as the economy deteriorated in 2008, Wal-Mart’s product offerings and pricing strategies may have been more attractive to consumers. Wal-Mart’s inventory turnover improved more while Target’s remained level in 2011, and its gross profit margin increased, while Target’s was essentially unchanged. Both companies increased year-end 2012 inventories from the previous year, probably in anticipation of increased sales in 2013.

c. Inventory turns improve as the dollar volume of goods sold increases relative to the

dollar volume of goods on hand. Inventory reductions can be realized by reducing the depth and breadth of product lines carried (e.g., not every style, size and color), eliminating slow-moving product lines, working with suppliers to arrange for delivery when needed rather than inventorying for a longer holding period, and marking down goods for sale at the end of product seasons.

Retailers must balance the cost savings from inventory reductions against the

marketing implications of lower inventory levels on hand. It would be possible to stock only those items that turn over very quickly, but those items may have low margins. Or, there may be items that turn over slowly, but have sufficient margins to make offering them attractive, even though it reduces inventory turnover. Whenever ratios are used as incentive measures, it is important to recognize that they may cause “cherry-picking” of only those activities that provide the highest ratio outcome.



M7-23. (15 minutes) a. Cost of goods sold (+E, -SE) 142,790,000 Inventory (-A) 142,790,000 b.

+ Inventory - + Cost of Goods Sold - Balance 25,790,000 (a) 142,790,000 142,790,000 (a) (c) 140,560,000 Balance 23,560,000

c. Inventory (+A) 140,560,000 Cash or Accounts payable (-A or +L) 140,560,000 d. ($000)





Income c. Purchase

inventory -140,560

Cash +140,560 Inventory = - =

a. Cost of inventory sold

-142,790 Inventory =

-142,790 Retained Earnings

-

+142,790 Cost of

Goods Sold =

-142,790

M7-24. (10 minutes) a. (60 x $45) + (210 x $34) + (300 x $20) + (100 x $27) = $18,540 b. Cost: (60 x $45) + (210 x $38) + (300 x $22) + (100 x $27) = $19,980 Market: (60 x $48) + (210 x $34) + (300 x $20) + (100 x $32) = $19,220 Therefore, the ending inventory balance should be $19,220.



EXERCISES E7-25. (45 minutes) a. Fiscal year 2010: Gross profit margin = ($623 – $447) ÷ $623 = 28.3% Inventory turnover ratio = $447 ÷ [($197 + $202) ÷ 2] = 2.24 times Fiscal year 2011: Gross profit margin = ($643 – $458) ÷ $643 = 28.8% Inventory turnover ratio = $458 ÷ [($202 + $193) ÷ 2] = 2.32 times b.

Fiscal year Quarter Gross profit Gross profit margin

2010 1 $ 25 22.7% 2 82 35.2% 3 50 28.9% 4 18 16.8%

2011 1 25 21.9% 2 85 36.0% 3 54 30.0% 4 20 17.7%

The gross profit and gross profit margin numbers show that West Marine is significantly more profitable in the second and third quarters. While the revenues from these quarters are 80% higher than the other quarters, the gross profit from quarters two and three are three times that of quarters one and four. Unlike many retailers, who make most of their sales and profits in the fourth calendar quarter, West Marine must discount its prices and run promotions in order to generate sales in the first and fourth quarters.

c. Inventory is lowest at the end of the fiscal year. At the end of the first quarter (end of March), inventory has increased in anticipation of the busy second quarter, and inventory stays high through the second quarter (end of June). By the end of September (third quarter), inventory has declined, and it continues to decline through the fourth quarter. It is common for seasonal businesses to choose fiscal year-ends when inventories (and other balances like receivables) are lower. But it can mean that annual ratios (like those calculated in part a) do not reflect the inventory investment that was necessary to generate the sales reported for the year. Understanding these seasonal effects can be important for cash management over the year.

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E7-25. concluded d. One approach to calculating an inventory turnover ratio is to use an “average of

averages” approach. For the first quarter of 2010, the average inventory was ($197 + $243) ÷ 2 = $220. Follow the same process to determine the average inventory for quarters two, three and four. Then average the averages. The effect of this process is the following:

2010: Weighted average inventory = [197 + 2x(243+240+209+202) +202)]/10 = $219 2011: Weighted average inventory = [202 + 2x(248+242+212+194)+194)]/10 = $219

The weighted average inventory levels are greater than the simple annual averages for both years because the fiscal year-end is set when inventory is predictably low. When these inventory values are divided into annual cost of goods sold, the inventory turnover ratios are lower than those calculated in part Weighted average inventory turnover ratio:

2010: $447 ÷ $219 = 2.04 times 2011: $458 ÷ $219 = 2.10 times

The annual ratios showed a slight increase in turnover from 2010 to 2011, perhaps indicating an increase in the speed with which inventory translated into sales. The reduction in inventory at the end of 2011 is probably not due to West Marine being able to maintain sales with lower inventories, but rather an indication that the company expects the sales revenue declines of 2011 to continue in the future.

E7-26. (30 minutes)

Units Cost Beginning Inventory 1,000 $ 20,000 Purchases: #1 1,800 39,600 #2 800 20,800 #3 1,200 34,800 Goods available for sale 4,800 $115,200 Units in ending inventory = 4,800 – 2,800 = 2,000

continued next page



E7-26. concluded a. First-in, first-out

Units Cost Total 1,200 @ $29 = $34,800 800 @ $26 = 20,800

Ending Inventory 2,000 $55,600

Cost of goods available for sale $115,200 Less: Ending inventory 55,600 Cost of goods sold $ 59,600

b. Last-in, first-out

Units Cost Total 1,000 @ $20 = $20,000 1,000 @ $22 = 22,000

Ending inventory 2,000 $42,000

Cost of goods available for sale $115,200 Less: Ending inventory 42,000 Cost of goods sold $ 73,200

c. Average cost

$115,200/4,800 = $24 average unit cost 2,000 x $24 = $48,000 ending inventory $115,200 - $48,000 = $67,200 cost of goods sold (or 2,800x$24)

d. 1. The first-in, first-out method in most circumstances represents physical flow. This

inventory system applies to perishables or to situations in which the earliest items acquired are moved out first because of risk of deterioration or obsolescence.

2. Last-in, first-out results in the lowest inventory amount during periods of rising unit

costs, which in turn results in the lowest net income and the lowest income tax. 3. The first-in, first-out results in the lowest cost of goods sold in periods of rising

prices. This is the inventory method Chen should use to report the largest amount of income. Of course, this assumes that prices will continue to rise. Companies cannot change inventory costing methods without justification, and the change may be prohibited by tax laws as well.



E7-27. (25 minutes)

Units Cost Total Beginning inventory 100 @ $46 = $ 4,600 Purchases: Purchase #1 650 @ 42 = 27,300 Purchase #2 550 @ 38 = 20,900 Purchase #3 200 @ 36 = 7,200 Cost of goods available for sale 1,500 $60,000 a. First-in, first-out

Units Cost Total 200 @ $36 = $ 7,200 150 @ 38 = 5,700 Ending inventory ................................. 350 $12,900 Cost of goods available for sale .......... $60,000 Less: Ending inventory ....................... 12,900 Cost of goods sold .............................. $47,100

b. Average cost

Cost of Goods Available for Sale/Total Units Available for Sale = $60,000/1,500 = $40 Average Unit Cost

Ending Inventory = 350 units x $40 = $14,000

Cost of goods available for sale $60,000 Less: Ending inventory 14,000 Cost of goods sold $46,000 c. Last-in, first-out

Units Cost Total 100 @ $46 = $ 4,600 250 @ 42 = 10,500

Ending inventory 350 $15,100

Cost of goods available for sale $60,000 Less: Ending inventory 15,100 Cost of goods sold $44,900



E7-28. (20 minutes) a. 1. (70 x $190) + (45 x $268) + (20 x $350) + (120 x $60) + (80 x $88) + (50 x $126) = $52,900.

2. Desks: (70 x $190) + (45 x $280) + (20 x $350) = $32,900 (70 x $210) + (45 x $268) + (20 x $360) = $33,960

Chairs: (120 x $60) + (80 x $95) + (50 x $130) = $21,300 (120 x $64) + (80 x $88) + (50 x $126) = $21,020

Therefore, inventory would be reported at $32,900 + $21,020 = $53,920.

3. (70 x $190) + (45 x $280) + (20 x $350) + (120 x $60) + (80 x $95) + (50 x $130) = $54,200 (70 x $210) + (45 x $268) + (20 x $360) + (120 x $64) + (80 x $88) + (50 x $126) = $54,980

Therefore, inventory would be reported at $54,200. b. Applying the lower of cost or market rule to individual items in inventory results in the

lowest inventory amount, the highest cost of goods sold and the lowest net income. Under either of the other two methods, the inventory may be valued at the higher of cost or market for some items in inventory.

E7-29. (20 minutes) a. $13,042 million b. $14,275 million c. Pretax income has been reduced by $1,233 million cumulatively since GM adopted

LIFO inventory costing. This is because it has matched current inventory costs against current selling prices, thus avoiding the recognition of holding gains that would have resulted had FIFO inventory costing been used. If LIFO has put $1,233 million less into ending inventory than FIFO, it must have put $1,233 more into cost of goods sold than FIFO.

d. Pretax income has been reduced by $1,233 million (see part c). Assuming a 35% tax

rate, taxes have been reduced by $1,233 x 0.35 = $431.6 million. Cumulative taxes were decreased by the use of LIFO inventory costing.

e. During this period GM was experiencing declining earnings while inventory costs

were not keeping pace. Under these conditions, FIFO reporting mitigates the effect on income.



E7-30. (25 minutes) a. $3,063 million b. $4,461 million. the FIFO inventory carrying amount is greater than the LIFO carrying

amount, which is common. It implies Deere’s current inventory costs are rising. Although common, a lower FIFO carrying amount can occur We cannot blindly assume that inventory costs always rise. When costs decline as is true in the computer chip industry, losses can occur if LIFO layer- liquidation occurs, the opposite of what we would normally expect.

c. Pretax income has been decreased by $1,398 million cumulatively since Deere

adopted LIFO inventory costing. This result occurs because higher current inventory costs are matched against current selling prices, thus avoiding the recognition of holding gains that would have resulted had FIFO inventory costing been used.

d. Pretax income has been decreased by $1,398 million (see part c). Assuming a 35%

tax rate, taxes have been decreased by $1,398 x 0.35 = $489.3 million. Cumulative taxes have been decreased by use of LIFO inventory costing.

e. For 2010, the change in the LIFO reserve is an increase of $31 million [($4,461-

$2,777) – ($3,764-$2,437)]. Pretax income has been decreased by this amount, thus decreasing taxes by $31 million x 0.35 = $10.9 million.

Observation: If Deere’s inventory were at some future date to be more highly valued under LIFO than under FIFO, the company could reduce its tax expense by switching to FIFO costing. This is, however, unlikely for Deere or other industries facing continued price increases or even essentially constant prices.

E7-31. (20 minutes) a. ($ millions) $323 + Purchases - $6,571 = $337. Purchases = $16,356. b.

($ millions) As reported (LIFO) Pro forma (FIFO) Sales revenue $10,108 $10,108 Cost of goods sold 6,571 6,560.7 Gross profit $ 3,537 $ 3,547.3

$6,571 - ($29.7 - $19.4) = $6,560.7 c. As reported (LIFO): $3,537 / $10,108 = 35.0% Pro forma (FIFO): $3,547.3 / $10,108 = 35.1% The small differences between LIFO and FIFO reflect both the rate of price change

for Whole Foods’ inventories and the fact that its inventory moves through very quickly (about 27 times per year).




Tiffany Zale Blue Nile 2011 2010 2011 2010 2011 2010 Revenue $3643 $3085 $1743 $1616 $348 $333 COGS 1492 1262 862 802 276 261 Gross profit 2151 1823 881 814 72 72 Gross profit margin (GPM) 59.0% 59.1% 50.5% 50.4% 20.7% 21.6%

b. Usually, we would use average inventory to calculate the inventory turnover ratio. In

this case, the 2009 values are not supplied. So we use the 2010 final inventory value only to estimate the 2010 COGS.

Tiffany Zale Blue Nile 2011 2010 2011 2010 2011 2010 COGS 1492 1262 862 802 276 261 Ending inventory 2073 1625 721 703 29 20 Inventory turnover 0.81 0.78 1.21 1.14 11.27 13.05

c. The recent fiscal years have not been easy times for fine jewelry retailers. After

years of increasing revenues, all three of these companies experienced declining sales until 2011. Even the modest sales increases in the last two years have not led to a noticeable increase in GPM and Blue Nile’s GPM even declined. Inventory turnover ratios increased for Tiffany and Zale perhaps reflecting attention to improved inventory management. This improvement was not the case for Blue Nile. A turnover value of 0.81 means that Tiffany holds an item in inventory for 452 days (on average) before sale. Zale’s inventory turnover ratio is quicker and improved significantly. This improvement might reflect an inventory clearance program similar to one Zale engaged in during the period before 2009. Inventory turnover ratios are also affected by the cost flow assumption. Tiffany uses average cost, Zale’s uses LIFO and Blue Nile uses specific identification, probably close to average cost. Zale’s LIFO reserves were $35.9 million in 2011 and $18.9 million in 2010.)

As an Internet retailer, Blue Nile earns a significantly lower gross profit on every dollar of sales, but its volume of sales is very high relative to its inventory. Compared to Tiffany’s 452 days’ inventory, Blue Nile has less than 32 days’ inventory. One of the ways that Blue Nile keeps its turnover high can be seen in the following from their 2011 10-K. “The Company also lists loose diamonds on its websites that are typically not included in inventory until the Company receives a customer order for those diamonds. Upon receipt of a customer order, the Company

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E7-32. concluded

c. continued purchases a specific diamond and records it in inventory until it is delivered to the customer, at which time the revenue from the sale is recognized and inventory is relieved.” Blue Nile does not disclose the amount of such “consignment” or “agency” diamonds. Zale discloses consignment inventories of $53.5 million and $81.1 million at the end of 2011 and 2010, respectively. Tiffany’s financial reports make no mention of consignment inventories.

d. Zale has saved 0.35($619.8) = $216.93 million in taxes to date by using LIFO. Of

this amount, 0.35($619.8 - $606.4) = $4.69 million during 2010.



PROBLEMS P7-33. (25 Minutes) a. Caterpillar: $43,578/[($9,587 + $14,544)/2] = 3.61 Komatsu: ¥1,440,765/[(¥612,359 + ¥473,876)/2] = 2.65 As calculated, Caterpillar’s turnover is almost 1.0 times faster than Komatsu’s, and

there is a 37-day difference in the companies’ average inventory days outstanding. This difference could be attributed to differential production efficiencies or to differential component sourcing strategies. Perhaps Caterpillar purchased more components from outside suppliers.

b. When there are no LIFO liquidation effects, changes in the LIFO reserve can be

attributed to changes in the company’s costs. Caterpillar’s LIFO reserve increased in 2011, implying that its costs increased.

c. Pretax income has been reduced by $2,422 million cumulatively since CAT adopted

LIFO inventory costing. This is because it has matched current inventory costs against current selling prices, thus avoiding the recognition of holding gains that would have resulted had FIFO inventory costing been used. Each year, the difference between FIFO cost of goods sold and LIFO cost of goods sold is added to the LIFO reserve. Assuming a 35% tax rate, cumulative taxes have been reduced by $2,422 x 0.35 = $847.7 million by the use of LIFO inventory costing.

d. For 2011, the change in the LIFO reserve is a decrease of $153 million ($2,422 million - $2,575 million). Pretax income has been increased by this amount (relative to FIFO), thus increasing taxes by $153 million x 0.35 = $53.6 million.

e. Komatsu’s use of specific identification probably approximates a FIFO inventory costing method. As a result, the comparison in part a above is not valid because Caterpillar’s use of LIFO produces distortions. We should use the LIFO reserve information to construct Caterpillar’s inventory turnover based on FIFO.

FIFO 2011 cost of goods sold = $43,578 – ($2,422 – $2,575) = $43,731 FIFO 2011 average inventory = [($14,544+$2,422)+($9,587+$2,575)]÷2 = $14,564 FIFO 2011 inventory turnover = $43,731 ÷ $14,564 = 3.00 times So, Caterpillar’s inventory turnover is only 0.35 times faster than Komatsu’s once we

take into account the differences in their inventory cost flow assumptions.



P7-34. (20 minutes) a. $6,157 million - $1,043 million = $5,114 million b. $1,043 million c. $1,043 million x 0.35 = $365 million e. $602 million + [($1,043 million - $827 million) x (1 - 0.35)] = $531.7 million e. $71,494 / [($5,114 + $4,966) / 2] = 14.19 f. [$71,494 - ($1,043 - $827)] / [($6,157 + $5,793) / 2] = 11.97 P7-35. (30 minutes) a.

Dell Hewlett-Packard Apple 2012 2011 2010 2012 2011 2010 2012 2011 2010

Revenue $62,071 $61,494 $52,902 $127,245 $126,033 $114,552 $108,249 $65,225 $42,905

COGS 48,260 50,098 43,641 65,167 65,064 56,503 64,431 39,541 25,683

Gross profit 13,811 11,396 9,261 62,078 60,969 58,049 43,818 25,884 17,229

Gross profit margin (GPM)

22.3% 18.5% 17.5% 48.8% 48.4% 50.7% 40.5% 39.4% 40.1%

b.

Dell Hewlett-Packard Apple 2012 2011 2012 2011 2012 2011 COGS 48.260 50,098 65,167 65,064 64,431 39,341 Average ending inventory 1,352.5 1,176 6,978 6,297 912.5 753 Inventory turnover 35.7 42.6 9.3 10.3 70.5 52.5

continued next page



P7-35. concluded c. Gross profit margins reflect the companies’ cost control and their relative ability to

create differentiated products. Dell spends just over 1% of revenues currently on research and development (R&D), while Hewlett-Packard spends about 2.5%. Apple’s R&D is currently just over 2% of revenues, but its recent growth in sales and margins is due to the popularity of the iPhone® with sales up 87%,iPod sales up 113% and iMAC sales up 25% in 2011 alone. Apple does not expect these growth trends to continue however.

Inventory turnover differences may be tied to Dell’s founding strategy of only producing a computer after a customer has placed an order, and to Apple’s practice of outsourcing a great deal of its production to Asia. In fact, Apple reports “The Company’s inventories consist primarily of finished goods for all periods presented.” Over the past five years, Hewlett-Packard has increased its inventory turnover from around 4 to above 9 while Apple’s has mushroomed to 70.

P7-36.A (45 minutes) ($ thousands) a. Inventories as a percent of current assets follows: 80% ($432,433/$543,260) of current assets in 2012 82% ($455,236/$556,267) of current assets in 2011

As long as Seneca’s customers have sufficient product to meet demand, the reduction of inventories reflects a positive development as it likely represents more efficient manufacturing processes. The reduction of inventories might be of concern, however, if Seneca is facing price declines, crop yield decreases due to weather, a demand slowdown forcing the company to dispose of perishable product, or financial difficulty in securing sufficient harvesting labor or to purchase the raw materials necessary for production.

The decline in 2012, however, is due to the firm’s use of LIFO whereby the LIFO

reserve for finished goods increased. b. The inventory turnover rate follows:

2012: 2.632

$455,236 $432,433$1,169,102 2011: 2.44

2$446,460$455,236

$1,101,387

The inventory turnover rate has increased slightly from 2011 to 2012. This increase is positive because it represents increased manufacturing/retailing efficiency.

c. Seneca uses the LIFO inventory costing method.

continued next page



P7-36.A concluded d. The LIFO reserve – the difference between LIFO and FIFO inventories – increased

by $47,339 from 2011 to 2012 ($137,227 - $89,888). As a result, reported profits decreased in 2012 by $30,771. In 2011, the LIFO reserve decreased by $5,104. Note: a decrease in the LIFO reserve does not, by itself, indicate a drop in inventory costs, as the decrease in the reserve may also be due to LIFO liquidation.

During 2012, there was in fact a decrease in the LIFO reserve due to the liquidation

of certain LIFO layers. Had this liquidation not occurred, LIFO reported profits would have decreased earnings by an additional $2,899.

Seneca’s use of LIFO has led to a reduction of its taxes as indicated by the

$137,227 amount in the LIFO reserve. (See parts d and e.) Furthermore, the reduction in Seneca’s quantities of inventories is positive, as the holding costs of inventories (financing, insurance, handling costs, etc.) are substantial. As a general rule, companies should keep inventories at the lowest level possible without impairing their manufacturing efficiency or reducing the stock of finished goods to the point that sales are adversely impacted. We might also examine Seneca’s cash and quick ratios. (Using data from the 10k, not supplied in the problem statement, we report the following. Seneca’s cash increased by 98.7% in 2012 – from the cash-flow statement - thereby increasing cash as a percent of current assets from 28.8% to 38.2%. The company’s quick ratio increased from 28.0% to 87.3%.) All the data for 2012 support the importance Seneca places on cash. However, we only explore one year in any detail here and so definitive conclusions await a review of previous years and comparisons with competitors.

e. Senaca’s cash savings due to the use of LIFO over the past 5 years (when it

switched to LIFO from FIFO), and assuming a constant tax rate of 35% amount to $48,029 thousand = $137,227 X (0.35).

nstas



CASES and PROJECTS C7-37.A (30 minutes) a. Pretax earnings would be higher by the change in the LIFO reserve. In 2011 the

LIFO reserve increased from $21.3 billion to $25.6 billion, for an increase of $4.3 billion. The 2011 pretax income that would have been reported if FIFO had been used would thus be $73.257 billion - $4.3 billion = $68.957 billion.

b. The inventory turnover would be as follows:

$266,534 = 19.24 [($11,365+$3,359)+($9,852+$3,124)]/2

c. BP’s inventory turnover is calculated as follows:

$285,618 = 11.01 ($25,661+$26,218)÷2 d. Based on calculations from their financial statements, it appears that Exxon Mobil’s

inventory turns over much more quickly than BP’s. However, Exxon Mobil’s use of LIFO makes such a comparison invalid, because BP is not allowed to use LIFO under IFRS. To make a better comparison, we adjust Exxon Mobil’s inventory turnover ratio to FIFO. We need to increase the cost of goods sold by the decrease in the LIFO reserve and increase the value of the inventories by the balance in the LIFO reserve each year:

$266,534- $4,300 = 7.00 [(11,665+$3,359+$25,600)+ ($9,852+$3,124+$21,300)]/2

This ratio shows that Exxon Mobil’s inventory is turning over less than half as quickly as the original calculation implied. And, rather than turning over its inventory much more quickly than BP, it appears that Exxon Mobil’s inventory is turning over significantly less quickly than BP.

e. The statement refers to the impact of LIFO liquidation on Exxon-Mobil’s profits.



C7-38. (40 minutes) a. The effects of the change in accounting method are reported as of the beginning of

2005, which is the earliest balance sheet presented in Hormel’s 2006 10-K report. This is due to the GAAP requirement that LIFO abandonment decisions be presented using the retrospective method. That is, all of the financial statements that are presented must be restated using the new accounting method (FIFO). As a result, Hormel’s 2005 balance sheet and its 2004 and 2005 income statements were restated in its 2006 10-K to reflect the switch to FIFO.

However, note that the decision to abandon LIFO was made in the first quarter of

2006. In its 2005 10-K report, Hormel reported inventory and cost of goods sold using the LIFO method. Because 2005 earnings were originally reported using LIFO, the company had to restate its 2005 income statement, increasing 2005 net earnings by $1.1 million.

Hormel’s 2005 10-K reveals that the LIFO reserve at that time was $38.5 million,

indicating an increase of $1.8 million in 2005 ($38.5 - $36.7). Therefore, the tax effect of the LIFO-FIFO switch was $0.7 million ($1.8-$1.1) in 2005.

Hormel reports that total assets increased by $36.7 million at the beginning of

2005. This is the amount of the LIFO reserve that was added to inventories to restate the inventory to FIFO as of that date. However, since the decision to switch methods was made at the end of 2005 (beginning of 2006), the effect of the switch was that assets (inventories) increased by $38.5 million.

The balance in retained earnings was increased by $23.0 million as of the

beginning of 2005, reflecting the cumulative difference in earnings since the adoption of LIFO. Retained earnings increased by $24.1 million ($23.0 + $1.1) as of the end of 2005 (beginning of 2006).

The additional tax liability that results from the change is $13.7 million ($36.7 –

23.0) as of the beginning of 2005. By the end of 2005, tax liabilities were increased by $14.4 million ($13.7 + $0.7).

These changes are summarized in the table below:

($ millions) Effect as of the beginning of 2005 (as reported)

Effect as of the end of 2005/beginning of 2006

Total assets (inventory) +$36.7 +$38.5 Retained earnings +$23.0 +$24.1

Tax liabilities +13.7 +$14.4

continued next page



C7-38. concluded b. Hormel argues (correctly) that the FIFO method presents a better measure of

current inventory value in the balance sheet. It should be noted that in earlier 10-K reports, Hormel justified the use of LIFO by noting that it provided a better matching of current costs to current revenues in the income statement (also a correct statement).

The company also argued that FIFO more accurately reflects the physical flow of

inventory (oldest product is sold first). c. The effect on 2006 net income was not reported. However, assuming that inventory

costs continued to rise, the switch to FIFO would have increased net earnings. In the past two years, earnings were increased by $1.1 million (2005) and $1.9 million (2004).

d. There are several possible motivations other than those provided by the company.

Obviously, earnings management (the desire to report higher earnings) immediately comes to mind. In addition, one would want to know what effect the change had on Hormel’s proximity to debt covenants and on management compensation formulae.

Ultimately, the decision cost Hormel $14.4 million in back taxes and may cost the

company additional taxes moving forward, if prices continue to rise. However, there is substantial empirical evidence that companies that use LIFO carry greater quantities of inventory than those using FIFO. This is due to the desire to avoid the tax effects of LIFO liquidation profits. Ultimately, using FIFO allows companies to reduce inventory quantities (for efficiency reasons or in response to economic cycles) without paying a tax penalty for liquidating LIFO inventory layers.

Hormel management may feel that the costs of using LIFO (including bookkeeping

costs, contracting costs, and the costs of carrying excess inventory) are greater than the benefits of using LIFO (the tax savings). This would especially be true if management expects future inventory cost increases to be small.

Finally, it should be noted that, historically, many LIFO abandonment decisions have

been made by companies facing financial distress. However, in recent years, there has been an increase in healthy companies switching to FIFO due to low levels of inflation. When expected cost increases are small, the tax benefits of LIFO are small relative to the perceived costs of using LIFO.



Chapter 8

Reporting and Analyzing Long-Term Operating Assets



LO1 – Describe and distinguish between tangible and intangible assets.

17 31

LO2 – Determine which costs to capitalize and report as assets and which costs to expense.

11,17 22

LO3 – Apply different depreciation methods to allocate the cost of assets over time.

12, 13,

16, 18, 19 22 - 28, 32

LO4 – Determine the effects of asset sales and impairments on financial statements.

14, 15 22, 24,

26, 35 36, 38, 39 40, 42

LO5 – Describe the accounting and reporting for intangible assets.

17, 21 31, 34 37 42

LO6 – Analyze the effects of tangible and intangible assets on key performance measures.

20, 21 29, 30, 33 40 - 42



DISCUSSION QUESTIONS Q8-1. Routine maintenance costs that are necessary to realize the full benefits of

ownership of the asset should be expensed. However, betterment or improvement costs should be capitalized if the outlay enhances the usefulness of the asset or extends the asset’s useful life beyond original expectations. As would be the case with any cost, an immaterial amount should be expensed as incurred.

Q8-2. Capitalizing interest costs as part of the cost of constructing an asset reduces interest expense, and increases net income during the construction period. In subsequent periods, the interest costs that were capitalized as part of the cost of the asset will increase the periodic depreciation expense and reduce net income.

Q8-3. As any asset is used up, its cost is removed from the balance sheet and transferred into the income statement as an expense. Capitalization of costs onto the balance sheet and subsequent removal as expense is the essence of accrual accounting. If the cost of a depreciable asset is recognized in full upon purchase, profit would be inaccurately measured: it would be too low in the year of purchase when the asset is expensed and too high in later years as revenues earned by the asset are not matched with a corresponding cost. The proper matching of costs (expenses) and revenues is essential for the proper recognition of profit.

Q8-4. The primary benefit of accelerated depreciation for tax reporting is that the higher depreciation deductions in early periods reduce taxable income and income taxes. Cash flow is, therefore, increased, and this additional cash can be invested to yield additional cash inflows (e.g., an "interest-free loan" that can be used to generate additional income). We would generally prefer to receive cash inflows sooner rather than later in order to maximize this investment potential.

Q8-5. When a change occurs in the estimate of an asset's useful life or its salvage value, the revision of depreciation expense is handled by depreciating the current undepreciated cost of the asset (original cost – accumulated depreciation) using the revised assumptions of remaining useful life and salvage value.

Present and future periods are affected by such revisions. Depreciation expense calculated and reported in past periods is not revised.

Q8-6. The gain or loss on the sale of a PPE asset is determined by the difference between the asset's book value and the sale proceeds. Sales proceeds in excess of book values create gains; sales proceeds less than book values cause losses. The relevant factors, then, are the depreciation rate and salvage values used to compute depreciation expense, accumulated depreciation and the net book value of the asset, as well as the selling price of the asset.



Q8-7. A PPE asset is considered to be impaired when the sum of the undiscounted expected cash flows to be derived from the asset is less than its current book value.

An impairment loss is calculated as the difference between the asset's book value and its current fair market value.

Q8-8. Research and development costs must be expensed under GAAP unless they have alternative future uses. Equipment relating to a specific research project with no alternative use would, therefore, be expensed rather than capitalized and subsequently depreciated.

Accounting standard-setters have justified this ‘expense as incurred’ treatment for R&D costs since the outputs from research and development activities are uncertain and there are, therefore, no expected cash flows against which to match any future depreciation expense.

Q8-9. The difficulty with amortizing intangible assets is estimating the useful life. For some intangibles, the useful life is limited and can be easily estimated. However, some intangibles have an indefinite life. This means that the useful life of the intangible is long and cannot be determined with any reasonable degree of accuracy. Under these circumstances, it is not appropriate to amortize the asset until the useful life can be determined.

Q8-10. Goodwill arises whenever a company acquires another company and the purchase price is greater than the fair value of the identifiable assets acquired. The amount of goodwill is the difference between the purchase price and the value assigned to the net assets of the acquired company. It is recorded as a long-term asset in the balance sheet.

Since goodwill is assumed to have an indefinite life, it is not amortized. The only time that goodwill might affect the income statement is if it is determined that its value is impaired. In that case, an impairment loss is recorded in the income statement and the value of the goodwill asset on the balance sheet is reduced.



MINI EXERCISES M8-11. (10 minutes) a. Expense b. Capitalize c. Capitalize (the new equipment enhances the assembly line) d. Expense – this is routine maintenance of the building, unless it extends the

building’s useful life e. Capitalize – the useful life is extended f. Capitalize – this is a purchased intangible asset M8-12. (15 minutes) a. Straight-line: ($18,000 - $1,500)/ 5 years = $3,300 for both 2013 and 2014. b. Double-declining-balance: Twice straight-line rate = 2 x 1/5 = 40% 2013: $18,000 x 0.40 = $7,200 2014: ($18,000 - $7,200) x 0.40 = $4,320

Notice that, over the first two years, the company reports $6,600 of depreciation expense under the straight-line method and $11,520 of depreciation expense under the double-declining-balance method.

M8-13. (15 minutes) a. Straight-line: ($130,000 - $10,000)/ 6 years = $20,000 for both 2013 and 2014. b. Double-declining-balance: Twice straight-line rate = 2 x 1/6 = 1/3 2013: $130,000 x 1/3 = $43,333 2014: ($130,000 - $43,333) x 1/3 = $28,889 c. Units of production: ($130,000 - $10,000) / 1,000,000 = $0.12 per unit 2013: 180,000 units x $0.12 = $21,600 2014: 140,000 units x $0.12 = $16,800



M8-14. (15 minutes) Straight-line depreciation: $40,000/10 = $4,000; 8 years x $4,000 = $32,000. a. Cash (+A) .......................................................................................... 3,500 Accumulated depreciation (-XA, +A) ................................................. 32,000 Loss on sale of furniture and fixtures (+E, -SE) ................................. 4,500 Furniture and fixtures (-A) ................................................................ 40,000 b. Balance Sheet Income Statement

Transaction Cash Asset

+

Noncash Assets - Contra



Income Sold furniture and fixtures for cash.

+3,500 Cash

-40,000

Furniture and

Fixtures

-

-32,000 Accum. Deprec.

-4,500

Retained Earnings

-

+4,500 Loss on Sale of

Furniture and

Fixtures

=

-4,500

M8-15. (15 minutes) Twice the straight-line rate = 1/5 x 2 = 40%

Year 1: $75,000 x .4 = $30,000 Year 2: ($75,000 - $30,000) x .4 = 18,000 Year 3: ($75,000 - $30,000 - $18,000) x .4 = 10,800 Total accumulated depreciation $58,800 a. Cash (+A) ........................................................................................... 25,000 Accumulated depreciation (-XA, +A) .................................................. 58,800 Machinery (-A) .................................................................................. 75,000 Gain on sale of machinery (+R, +SE) ............................................... 8,800 b. Balance Sheet Income Statement


+




Income Sold machinery for cash.

+25,000

Cash

-75,000

Machinery

-

-58,800 Accum. Deprec.

+8,800

Retained Earnings

+8,800 Gain on Sale of

Machinery

-

=

+8,800



M8-16. (15 minutes) a. Straight-line depreciation 2013: ($145,800 - $5,400)/3 = $46,800; (8/12) x $46,800 = $31,200 2014: $46,800 b. Double-declining-balance depreciation Preliminary computation: Twice straight-line rate = 2 x 100%/3 = 66⅔% ($145,800 x 66⅔%) = $97,200 2013: (8/12) x $97,200 = $64,800 2014: ($145,800 - $64,800) x 66⅔% = $54,000 M8-17. (20 minutes) a. Under U.S. GAAP, capitalization of development costs is not allowed and all R&D

costs must be expensed. Under IFRS, development costs are capitalized if there is the intention, feasibility and resources to bring the asset to completion, there exists the ability to use or sell the asset to generate an economic benefit. Otherwise the costs must be expensed.

b. Yes, impairment should be tested for annually. M8-18. (20 minutes) a.

Year Book value Depreciation rate Depreciation expense 1 $50,000 2 x ¼ = 0.5 $25,000 2 25,000 2 x ¼ = 0.5 12,500 3 12,500 4,500 4 8,000 0*

*No depreciation is recorded in Year 4 because the asset is depreciated to its residual value of $8,000.

b.

Year Book value Depreciation rate Depreciation expense 1 $50,000 2 x 1/5 = 0.4 $20,000 2 30,000 2 x 1/5 = 0.4 12,000 3 18,000 2 x 1/5 = 0.4 7,200 4 10,800 2 x 1/5 = 0.4 4,320 5 6,480 3,480*

*$3,480 of depreciation is required in Year 5 to depreciate the asset to its residual value of $3,000.

continued next page



M8-18. concluded c.

Year Book value Depreciation rate Depreciation expense 1 $50,000 2 x 1/10 = 0.2 $10,000 2 40,000 2 x 1/10 = 0.2 8,000 3 32,000 2 x 1/10 = 0.2 6,400 4 25,600 2 x 1/10 = 0.2 5,120 5 20,480 2 x 1/10 = 0.2 4,096 6 16,384 2 x 1/10 = 0.2 3,277 7 13,107 2 x 1/10 = 0.2 2,621 8 10,486 2 x 1/10 = 0.2 2,097 9 8,389 2 x 1/10 = 0.2 1,678 10 6,711 5,711*

* $5,711 of depreciation is required in Year 10 to depreciate the remaining value of the asset. Alternatively, DeFond could switch to

straight-line depreciation in Year 7, recording $3,027 of depreciation in Years 7 through 10. M8-19. (15 minutes) a.

Year Barrels extracted Depletion per barrel Depletion 2013 300,000 $32,000,000 / 4,000,000 = $8 $2,400,000 2014 500,000 $32,000,000 / 4,000,000 = $8 $4,000,000 2015 600,000 $32,000,000 / 4,000,000 = $8 $4,800,000

b.

i. Oil reserve (+A) ......................................................... 32,000,000 Cash (-A) .............................................................. 32,000,000 ii. Oil inventory (+A) ...................................................... 2,400,000 Oil reserve (-A) ...................................................... 2,400,000

c.

+ Oil Reserve (A) - + Oil Inventory (A) - i. 32,000,000 ii. 2,400,000 2,400,000 ii. Balance 29,600,000 Balance 2,400,000




PPE turnover rates for 2007

Texas Instruments $13,735 / [($4,428 + $3,680) / 2] = 3.39

Intel Corp. $53,999 / [($23,627 + $17,899) / 2] = 2.60

Texas Instruments turns its PPE more quickly than does Intel.

b. PPE turnover rates increase with increases in sales volume relative to the dollar amount of PPE on the balance sheet. The PPE turnover rate is often a very difficult turnover rate to change, and typically requires creative thinking. Many companies are outsourcing the manufacturing process in whole or in part to others in the supply chain. This is beneficial so long as the savings realized by the reduction of manufacturing assets more than offset the higher cost of the goods as these are now purchased rather than manufactured. Another approach is to utilize long-term operating assets in partnership with another firm, say in a joint venture.

M8-21. (15 minutes) a. $4,801,914 / $38,851,259 = 12.4%. Abbott’s R&D expenditure level could be compared to the R&D expenditure level for its

competitors to gain a sense of the appropriateness of its R&D expenditures. The median value of R&D intensity for pharmaceutical companies is 19.6% in Exhibit 5.13 in Chapter 5. Abbott is one of the larger, more established firms in this industry and may have an R&D program that is more stable and less intensive than the median.

b. R&D costs must be expensed when incurred unless they are expenditures for

depreciable assets that have alternative future uses (in which case the depreciation is expensed as recognized). As a result, the balance sheet does not reflect the costs incurred for long-term R&D assets. In addition, operating expenses are increased, thus reducing retained earnings.

($000) Balance Sheet Income Statement




Income R&D expenditures

-4,801,914

Cash

=

-4,801,914 Retained Earnings

-

+4,801,914

R&D Expense

=

-4,801,914



EXERCISES E8-22. (15 minutes) a. Machine (+A) ..................................................................................... 89,500 Cash (-A) ($85,000 + $2,000 + $2,500) ............................................ 89,500 b. ($89,500 - $7,000) / 5 = $16,500 per year. Depreciation expense (+E, -SE) ........................................................ 16,500 Accumulated depreciation (+XA, -A) ................................................. 16,500 c. Cash (+A) ........................................................................................... 12,000 Accumulated depreciation (-XA, +A) ($16,500 x 4) ............................ 66,000 Loss on sale of machine (+E, -SE) .................................................... 11,500 Machine (-A) ..................................................................................... 89,500 E8-23. (20 minutes) a. Straight line: ($80,000 - $5,000)/5 years = $15,000 per year b. Double declining balance: Twice straight-line rate = 2 x 100%/5 = 40%

Year Book Value x Rate Depreciation Expense 1 $80,000 x 0.40 = $32,000 2 ($80,000 - $32,000) x 0.40 = 19,200 3 ($80,000 - $51,200) x 0.40 = 11,520 4 ($80,000 - $62,720) x 0.40 = 6,912 5 5,368 (plug) Total $75,000



E8-24. (25 minutes) a. 1. Cumulative depreciation expense to date of sale: [($800,000-$80,000)/10 years] x 6 years = $432,000

2. Net book value of the plane at date of sale: $800,000 - $432,000 = $368,000 b. 1. $ 0

Cash (+A) ......................................................................................... 368,000 Accumulated depreciation (-XA, +A) ................................................ 432,000 Plane (-A) ......................................................................................... 800,000 2. Loss on sale of: $195,000 - $368,000 = $173,000

Cash (+A) ......................................................................................... 195,000 Accumulated depreciation (-XA, +A) ................................................. 432,000 Loss on sale of plane (+E, -SE) ........................................................ 173,000 Plane (-A) ......................................................................................... 800,000 3. Gain on sale of: $600,000 - $368,000 = $232,000

Cash (+A) ......................................................................................... 600,000 Accumulated depreciation (-XA, +A) ................................................. 432,000 Gain on sale of plane (+R, +SE) ...................................................... 232,000 Plane (-A) ......................................................................................... 800,000

E8-25. (15 minutes) a. Straight-line: 2013 and 2014 ($218,700 - $23,400)/6 years = $32,550 b. Double-declining-balance: twice straight-line rate = 100% x 2/6 = 33⅓% 2013 $218,700 x 33⅓% = $72,900 2014 ($218,700 - $ 72,900) x 33⅓% = $48,600 E8-26. (15 minutes) a. Depreciation expense to date of sale is [($27,200 - $2,000)/6] x 3 = $12,600. The net book value of the van is, therefore, $27,200 - $12,600 = $14,600. b. 1. 0 2. $400 gain ($15,000 - $14,600) 3. $2,600 loss ($12,000 - $14,600)



E8-27. (20 minutes) a. Straight line: ($110,000 - $15,000) / 6 = $15,833 each year. b. Double-declining-balance: rate = 2 x 1/6 = 1/3. 2013: $110,000 x 1/3 = $36,667 2014: ($110,000 – $36,667) x 1/3 = $24,444 2015: ($110,000 – $36,667 – $24,444) x 1/3 = $16,296 c. Straight line: ($110,000 – $15,833x2 – $10,000) / 5 = $13,667 in 2015 and each

subsequent year. Double-declining balance: rate = 2 x 1/5 = 40%. ($110,000 – $36,667 – $24,444) x 40% = $19,556 in 2015 E8-28. (20 minutes) a. Straight-line: $6,000,000 / 30 = $200,000 per year each year. b. Double-declining balance: rate = 2 x 1/30 = 1/15. 2013: $6,000,000 x 1/15 = $400,000 2014: ($6,000,000 – $400,000) x 1/15 = $373,333 c. The revised depreciation rate = 2 x 1/23 = 8.7% 2015: ($6,000,000 – $400,000 – $373,333) x 8.7% = $454,493 E8-29. (10 minutes) Percent depreciated = Accumulated depreciation / Asset cost = $5,156 million / ($9,508 - $121 - $649) million = 59% Note: We eliminate land and construction in progress from the computation because these assets are not depreciated. Assuming that assets are replaced evenly as they are used up, we would expect assets to be 50% depreciated, on average. Deere’s 59% is higher than this level. Our concern is that it will require higher capital expenditures in the near future to replace aging assets.



E8-30. (25 minute) a. Receivable turnover rate Inventory turnover rate PPE turnover rate 2010

$26,662 = 7.77

$13,831 = 4.77

$26,662 = 3.73 $3,615+$3,250 $3,115+$2,639 $7,279+$7,000

2 2 2 2011

$29,611 = 7.92

$15,693 = 4.78

$29,611 = 3.96 $3,867+$3,615 $3,416+$3,155 $7,666+$7,279

2 2 2 b. 3M’s Receivable and PPE turnover ratios have improved significantly while its

inventory turnover rates improved marginally. 3M’s revenues increased significantly in 2011, and that increase is likely to account for the increase in PPET. However, PPE turns can also be improved by off-loading manufacturing to other companies in the supply chain and acquiring long-term operating assets in partnership with other companies, for example, in a joint venture. The Receivable turnover improvement could be due to monitoring more closely the quality of customers to which credit is granted, implementing better collection procedures, and offering discounts as an incentive for early payment. Inventory turnover rates can be improved by weeding out slowly moving product lines, by reducing the depth and breadth of products carried, and by implementing just-in-time deliveries.

E8-31. (10 minutes) a. Fair Value

(capitalized) Useful

life b Amortization

expense for 2013 Patent $200,000 3 years $66,667 Trademark $500,000 Indefinite Noncompetition agreement $300,000 5 years 60,000 $126,667



E8-32. (15 minutes) a. Cost of resource property: $7,200,000 + $420,000 + $50,000 + $800,000 = $8,470,000 Residual value: $1,200,000 Depletion base: $8,470,000 – $1,200,000 = $7,270,000 Depletion rate: $7,270,000 / 500,000 tons = $14.54 per ton 2013: 60,000 x $14.54 = $872,400 2014: 85,000 x $14.54 = $1,235,900 b. 2013: Inventory (+A) ................................................................................... 872,400 Resource property (-A) ..................................................................... 872,400 2014: Inventory (+A) ................................................................................... 1,235,900 Resource property (-A) ..................................................................... 1,235,900 E8-33. (15 minutes) a. Percent depreciated – 2011: $11,320 / $12,266 = 92.3% 2010: $10,925 / $11,804 = 92.6% b. PPET: $96,504 / [(946 + 879)/2] = 105.8 times c. Adams’ assets are almost completely depreciated. This results in an extremely high

percent depreciated ratio and also a very high PPE turnover ratio (PPET). Adding inventories and receivables to get all the firm’s net operating asset turnover (NOAT) is more reasonable devisor. Adams outsources most of its manufacturing and, recognizing concerns that these numbers might produce, reports in its 10K that its current facilities (PPE assets) are adequate for the foreseeable future. Thus, although the ratios might suggest otherwise, the company does not anticipate large capital expenditures in the near future. Indeed this has been the case for the last several years as well.

E8-34. (15 minutes) a. The list illustrates the wide range in expenditures for R&D (as a percent of sales)

across firms. Note the large amount spent by pharmaceutical companies Pfizer (13.51%) and Merck (17.62%), compared to the amount spent by Lenovo (1.53%). The companies in the list are paired by industry. It is interesting to see how similar some firms in the same industry are. For example, Callaway Golf and Adams Golf and Head N.V. spend almost the same percentage of sales on R&D despite the fact that Callaway is several times larger than Adams.

continued next page



E8-34. concluded b. Beside industry affiliation, the differences in R&D expenditures as a percent of sales

is due to differences in markets, product mix, and other strategic considerations. As suppliers of technology (hardware and software), Intel and Microsoft depend very heavily on their intellectual property. As a result, their expenditures on research and development are among the highest of established firms. Apple has established itself as an innovator in technology and design and has spent billions of dollars developing unique products such as the iPad®. Apple’s research intensity for 2011 has been reduced by the tremendous increase in the company’s sales revenue. From 2009 to 2011, Apple’s revenues increased by 152%, while R&D increased by 82%.

E8-35. (20 minutes) a. Yes, the equipment is impaired at July 1, 2013 because its book value is not

recoverable through future cash flows. Specifically, on July 1, 2013, its book value is $145,000 ($225,000 initial cost less $80,000 accumulated depreciation*) and the estimated future (undiscounted) cash flows are only $125,000.

*4 years of [($225,000-$25,000)/10 years]. b. The impairment loss in a is computed as the equipment's book value minus its current

fair value: $145,000 $90,000 = $55,000 Impairment loss (+E, -SE) .................................................................. 55,000 Equipment* (-A) ................................................................................ 55,000

*Accumulated depreciation is sometimes credited for the loss.

c. Assuming that the salvage value remains the same after the impairment (this is not

likely given the decline in market value of the asset), the annual depreciation expense would be ($90,000 - $25,000) / 6 = $10,833 per year.

Depreciation expense (+E, -SE) ....................................................... 10,833 Accumulated depreciation (+XA, -A) ................................................ 10,833

d.

($000) Balance Sheet Income Statement


+




Income b. Impairment

charge.

-55,000 Equip- ment

-

-55,000

Retained Earnings

-

+55,000

Impairment Loss

=

-55,000

c. Depreciation

expense.

-

+10,833 Accum. Deprec.

-10,833

Retained Earnings

-

+10,833 Deprec. Expense

=

-10,833



PROBLEMS P8-36. (20 minutes) In order to determine the entries for the sale of property, plant and equipment, we need to “fill in the blanks” for the PPE and accumulated depreciation accounts. Once we record the purchases and the depreciation expense, we can determine the cost and accumulated depreciation for the assets sold. (i) Property, plant and equipment (+A) ................................................. 5,559,183 Cash (-A) .......................................................................................... 5,559,183 (ii) Depreciation expense (+E, -SE) ...................................................... 3,174,956 Accumulated depreciation (+XA, -A) ................................................. 3,174,956 (iii) Cash (+A) ......................................................................................... 96,916 Accumulated depreciation (-XA, +A) ................................................ 906,373 Property, plant and equipment (-A) ……………………...... 923,806 Gain on sale of property and equipment (+R, +SE)……… 79,483

+ Property, Plant and Equipment (A) - - Accumulated Depreciation (XA) + Balance 80,132,394 57,852,770 Balance (i) 5,559,183 3,174,956 (ii) 923,805 (iii) (iii) 906,373 Balance 84,767,771 60,121,353 Balance

P8-37. (20 minutes) a. $649 million / $6,615 million = 9.8% b. R&D costs are expensed in the income statement except for the portion relating to

depreciable assets that have alternate uses. Expensing (rather than capitalizing and depreciating) reduces assets, and the additional expense reduces profit and equity (via the reduction in retained earnings). In addition, expensing R&D as incurred means that potentially valuable intangible assets are omitted from the balance sheet.

c. Agilent has reduced its R&D spending as a percent of revenues in recent years and,

as a result, increased its earnings. (Agilent had a loss from operations in 2003.) This has turned operating losses into an operating profit for the company. However, Agilent is dependent upon technology in order to maintain its market position, and R&D is critical to its very existence. Agilent has divested itself of some high-intensity R&D businesses over the eight years from 2003 to 2011, and its spending on R&D has remained pretty constant in absolute terms from 2005 to the present. The decrease in intensity is due to increased revenues, not decreases in R&D spending. In addition, a company can maintain its investment in intellectual capital and reduce expenses by outsourcing the activity to other countries where the intellectual resources are less expensive.



P8-38. (20 minutes) ($ millions) a.

i. Depreciation expense (+E, -SE) ...................................................... 2,060 Accumulated depreciation (+XA, -A) ................................................. 2,060 ii. Property and equipment (+A) ........................................................... 2,129 Cash (-A) .......................................................................................... 2,129

iii. Cash (+A) ......................................................................................... 69 Accumulated depreciation (-XA, +A) (see T-account) ...................... 990 Property and equipment (-A) (see T-account) ................................... 1,059

iv. Repair and maintenance expense (+E, -SE) .................................... 726 Cash (-A) .......................................................................................... 726 v. Impairment and writedown charges (+E, -SE) 34 Property and equipment (-A) 34

+ Property and Equipment (A) - - Accumulated Depreciation (XA) + Balance 35,765 10,485 Balance (ii) 2,129 2,060 (i) 1,059 (iii) (iii) 990 34 (v) (b) 247 Balance 37,048 11,555 Balance

b. The problem provides information directly to make entries (i), (ii), (iv) and (v) in part

a. For part (iii), we can infer the accumulated depreciation on disposed property and equipment as being the amount ($990) that makes that account balance. Since no gain or loss was reported on these disposals, the credit to property and equipment in part (iii) is the amount that balances the disposal transaction ($1,059).

However, this leaves the property and equipment T-account unbalanced. A likely

reason is that Target acquires some property and equipment without an expenditure of cash. (Chapter 10 will cover capital lease transactions, which play a role in Target’s operations.) Based on the information in the problem, we would estimate that $247 million of property and equipment was acquired through such transactions, because that amount balances the property and equipment T-account.



P8-39. (20 minutes) The process used in this question is to fill in the entries for property and equipment and for accumulated depreciation in parts a, b and c, and then to use the “plug” figures in the T-accounts to determine the values in part d. ($ thousands) a. Depreciation expense (+E, -SE) ....................................................... 144,630 Accumulated depreciation (+XA, -A) ................................................ 144,630

b. Property and equipment (+A) ............................................................ 61,906

Cash (-A) .......................................................................................... 61,906

c. Loss on impairment of property and equipment (+E) ........................ 5,453 Property and equipment (-A) ............................................................ 5,453

d. Cash (+A) ......................................................................................... 11,433 Accumulated depreciation (-XA, +A) (see T-account) ....................... 90,694 Property and equipment (-A) (see T-account) .................................. 100,988 Gain on sale of property and equipment (+R,+SE) 1,139

+ Property and Equipment (A) - - Accumulated Depreciation (XA) + Balance 1,902,584 1,073,557 Balance (b) 61,906 144,630 (a) 5,453 (c) 100,988 (d) (d) 90,694 Balance 1,858,049 1,127,493 Balance



CASES and PROJECTS C8-40. (90 min) a. PPE Turnover: $14,880.2/[($2,127.7 + $3,345.9)/2] = 4.6

The firm does not appear to be as capital intensive as others in the industry based on a higher than average PPE turnover ratio than its closest competitors.

b. Accumulated depreciation / Depreciable asset cost $4,146.2/ ($7,492.1 - $61.2*- $521.9*) =0.60 or 60% *Note: We eliminate land from the computation because land is never depreciated. We eliminate construction in progress because these represent assets that the company is building. These assets are not yet in service and are consequently not yet depreciable. This elimination is also used in part c.

If plant assets are replaced at a constant rate, we would expect those assets to be about 50% “used up,” on average. A substantially higher percentage “used up” indicates that the assets are closer to the end of their useful lives and will require replacement (and usually higher maintenance costs near the end of their useful lives). Such a situation would negatively impact future cash flows.

c. Average depreciation assets = [($7,492.1 – 61.2 – 521.9) + ($6,949.7 – 58.0 –

469.0)] / 2 = $6,665.85

Average depreciaiable assets/ Depreciation expense = $6,665.85 / $462 per year = 14.4 years.

d. Depreciation expense (+E, -SE) ....................................................... 462.0 PPE accumulated depreciation (+XA, -A) ......................................... 462.0

PPE (+A) ........................................................................................... 648.8 Cash (-A) .......................................................................................... 648.8

Impairment loss (+E, -SE) ................................................................. 1.7 PPE (-A) ........................................................................................... 1.7



C8-41. (40 minutes) Reducing operating assets is an important means of increasing performance measures including the return on net operating assets. Most companies focus first on reducing receivables and inventories. This is the so-called low-hanging fruit that can lead to quick results. Some possible actions include those listed. Students will think of additional possibilities. a. Reducing receivables through:

1. Better underwriting of credit quality 2. Better controls to identify delinquencies, automated over-due notices, and better

collection procedures 3. Increased attention to accuracy in invoicing 4. Offering early payment incentives

b. Reducing inventories and inventory costs through essentially eliminating

nonproductive activities including inspection, moving activities, waiting setup time: 1. Use of less costly components (of equal quality) and production with lower wage

rates 2. Elimination of product features not valued by customers 3. Outsourcing to reduce product cost 4. Just-in-time deliveries of raw materials 5. Elimination of manufacturing bottlenecks to reduce work-in-process inventories 6. Producing to order rather than to estimated demand to reduce finished goods

inventories 7. Eliminating defects

c. Reducing PPE assets is much more difficult. The benefits, however, can be

substantial. Some suggestions are the following: 1. Sale of unused and unnecessary assets 2. Acquisition of production and administrative assets in partnership with other

companies for greater throughput 3. Acquisition of finished or semi-finished goods (sub-components) from suppliers

to reduce manufacturing assets

d. Reducing unnecessary intangible assets that are reported on the balance sheet is the most difficult. 1. Sale of assets no longer relevant to company plans 2. License intangibles to other companies



C8-42. (30 minutes) a. Take-Two (TTWO) spent $159,859 in 2011 and in 2012 $196,683 on software

development. TTWO’s amortization and write-downs were $143,811 in 2011 and $150,700 in 2012. Using EA’s method, the money spent on additions would be expensed, and the amortization and write-downs would disappear. The result is that if TTWO’s used EA’s approach, 2011 expenses would increase by $16,048 ($159,859 – 143,811). Net income would decrease by $10,431 [$16,048 X (1-0.35)] in 2011. In 2012, TTWO’s expenses would increase by $45,983 ($196,683 - $150,700) if TTWO used the same method as EA. Net income would decrease by $29,889 [$45,983 X (1-0.35)].

b. A variety of answers are possible here. Amortization (including write- downs) as a

percentage of “amortizable cost” (average of beginning and ending balances) declined from 55% in 2011 to 51% in 2012. The decrease indicates a possible decrease in the rate of amortization. However, because write- downs are included in the denominator, the increase could be partly due to higher write-downs in 2011.



Chapter 9 Reporting and Analyzing Liabilities



LO1 – Identify and account for current operating liabilities.

18, 19, 21,

22, 25, 30 38 - 40, 49 59 61

LO2 – Describe and account for current nonoperating (financial) liabilities.

21 49 59

LO3 – Explain and illustrate the pricing of long-term nonoperating liabilities.

22, 31, 32,

34 - 37

42, 43,

45 - 48, 50 51 - 60 60, 61

LO4 – Analyze and account for financial statement effects of long-term nonoperating liabilities.

23, 24,

26 - 29, 31,

34 - 36

41, 42,

44 - 50 51 - 58 60, 61

LO5 – Explain how solvency ratios and debt ratings are determined and how they impact the cost of debt.

23, 30, 32 43 51 60, 61



DISCUSSION QUESTIONS Q9-1. Current liabilities are obligations that require payment within the coming year or

operating cycle, whichever is longer. Generally, current liabilities are normally settled with use of existing current

assets or operating cash flows. Q9-2. If a company fails to take a cash discount that is offered by a supplier, it is

effectively paying a penalty for taking additional time to pay the account payable. Depending on the size of the discount, this penalty (an implicit interest rate) can be quite high.

The net-of-discount method records the inventory at the purchase cost less the discount. If the discount is lost, the extra cost is treated as part of interest expense for the period. This has two benefits: (1) the lost discount is not capitalized as part of the cost of inventory, and (2) the lost discount is highlighted, which is useful information that may be helpful in managing accounts payable.

Q9-3. An accrual is the recognition of an event in the financial statements even though no actual transaction has occurred. Accruals can involve both liabilities (and expenses) and assets (and revenues).

Accruals are vital to the fair presentation of the financial condition of a company as they impact both the recognition of revenue and the matching of expense.

Q9-4. The coupon rate is the rate specified on the face of the bond. It is used to compute the amount of cash interest paid to the bond holder. The market rate is the rate of return expected by investors that purchase the bonds. The market rate determines the market price of the bond. It incorporates expectations about the relative riskiness of the borrower and the rate of inflation. In general, there is an inverse relation between the bond’s market rate and the bond’s market price.

Q9-5. Bonds sold at face (par) value earn an effective interest rate equal to the bonds’ coupon rate. Bonds are sold at a discount when the effective interest rate is higher than the coupon rate. Bonds are sold at a premium when the effective interest rate is lower than the coupon rate.

Q9-6. Bonds are reported at historical cost, that is, the face amount plus (minus) unamortized premium (discount). The market price of the bonds varies inversely with the level of interest rates and fluctuates continuously. Differences between the market price of a bond and its carrying amount represent unrealized gains and losses. These unrealized gains (losses) are not reflected in the financial statements (although they are disclosed in the footnotes). They must be recognized upon repurchase of the bonds, the point at which they become “realized.”

continued next page



continued

If the bonds are refunded (that is, replaced with new bonds reflecting current market values and interest rates), the gain (or loss) that is recognized in the current period will be offset by correspondingly higher (lower) interest payments in the future. The present value of the future interest payments, along with the present value of the difference between the face amount of the new bond and the former face amount, exactly offset the reported gain (loss).

Q9-7. Debt ratings reflect the relative riskiness of the borrowing company. This riskiness relates to the probability of default (e.g., not repaying the principal and interest when due). Higher (greater quality) debt ratings result in higher market prices for the bonds and a correspondingly lower effective interest rate for the issuer. Lower (lesser quality) debt ratings result in lower market prices for the bonds and a correspondingly higher effective interest rate for the issuer.

Q9-8. Reported gains or losses on bond redemption result from changes in the market price of the bonds and the use of historical cost accounting. Because bonds are typically reported at historical cost, fluctuations in bond prices are not recognized until they are realized when the bonds are redeemed or refunded. If the bonds are refunded (new bonds are issued), the gain or loss is offset by the present value of lower (higher) future interest payments on the new bond issue.

Q9-9. (a) Term loan – a loan that matures on a single, pre-specified date (b) Bonds payable – the liability account used to record the face value of

bonds issued by a company (c) Serial bonds – bonds that mature in installments rather than on one date (d) Call provision – the right for the bond issuer to repurchase the debt, before

it matures, at a predetermined price. (e) Convertible bonds – bonds that can be converted into some other asset

(typically common stock) at the option of the bondholder (f) Face value – the predetermined amount (typically $1,000) that must be

repaid when a bond matures (g) Nominal rate – the rate specified on the face of the bond that determines

the periodic interest (coupon) payment (h) Bond discount – the difference between the face value of the bond and the

market price when the price is lower than the face value; recorded as a contra-liability

(i) Bond premium – the difference between the market price of a bond and the face value when the market price is higher than the face value; recorded as an adjunct-liability

(j) Amortization of premium or discount – the periodic reduction of the balance in the premium or discount account recorded each time interest expense is accrued; equal to the difference between the accrued interest and the coupon payment (or payable)



Q9-10. The advantages of issuing bonds are (1) the interest payments are limited to the predetermined amount specified on the bond; (2) the interest is tax deductible; (3) bondholders do not have a vote when it comes to electing directors and managing the company; (4) the additional financial leverage created when bonds are issued increases profits in good years. The disadvantages of bonds include (1) bonds must be repaid while common stock is issued with an indefinite life; (2) bondholders can impose restrictive covenants in the loan indenture; (3) the additional financial leverage created when bonds are issued decreases profits in lean years.

Q9-11. $3,000,000 x [.98 + (.09 x 3/12)] = $3,007,500 Q9-12. The contract rate (or stated rate or coupon rate) determines the periodic

coupon payment. If this rate is not equal to the rate required by the market, the bond price is adjusted to the present value of the cash payments from the bond discounted at the applicable market rate of interest. If the market rate is higher than the coupon rate, then the periodic coupon payments are insufficient and the bond will be priced lower than the face value (a discount). If the market rate is lower than the coupon rate, then the periodic coupon payments will be higher than required by the market, and the bond will sell for a premium.

Q9-13. When the bonds mature, the book value of the bonds will be equal to the face value. Over the life of the bonds, the change in the book value of the bonds will be equal to face value less the market value at the time that the bonds are issued.

Q9-14. When the effective interest method is used to amortize a bond discount or premium, the effective rate is multiplied by the net balance in bonds payable (bonds payable plus/minus the premium or discount). If the bond is issued at a discount, the balance increases over the life of the bond; the interest expense will increase as the balance increases. If the bond is issued at a premium, the balance decreases over the life of the bond; the interest expense will decrease as the balance decreases.

Q9-15. Bonds payable is presented in the balance sheet net of any discount or plus any premium.

Q9-16. The loss is the difference between the retirement value and the book value of the bond: 101% x $200,000 – $197,600 = $4,400.

Q9-17. Each payment includes both interest on the outstanding balance and repayment of the principal. As each payment is made, the principal balance is reduced. As a consequence, the interest component of the payment is smaller each period.



MINI EXERCISES M9-18. (15 minutes) a.

11/15 Inventory (+A) 6,076 Accounts payable (+L) 6,076 11/23 Accounts payable (-L) 6,076 Cash (-A) 6,076 $6,076 = $6,200 x 0.98.

b.

+ Inventory (A) - - Accounts Payable (L) + 11/15 6,076 6,076 11/15 11/23 6,076

+ Cash (A) - 6,076 11/23

c. [($6,200 - $6,076)/$6,076] x [365/(30-10)] = 37.24%. (With interest

compounding, the annual rate of interest r can be solved from (1+r)(20/365)=1.02. The value that solves this relationship is r = 43.5%.)




1/20 Inventory (+A) 12,250 Accounts payable (+L) 12,250 2/15 Accounts payable (-L) 12,250 Interest expense, discounts lost (+E, -SE) 250 Cash (-A) 12,500 $12,250 = $12,500 x 0.98.

b.

+ Inventory (A) - - Accounts Payable (L) + 1/20 12,250 12,250 1/20 2/15 12,250

+ Cash (A) - + Interest Expense, Discounts Lost (E) - 12,500 2/15 2/15 250

c. [($12,500- $12,250)/$12,250] x [365/(60-15)] = 16.55%. (With interest

compounding, the annual rate of interest r can be solved from (1+r)(45/365)=1.02. The value that solves this relationship is r = 17.4%.)

M9-20. (10 minutes) a. Interest expense (+E,-SE)…………………… 24 Interest payable (+L)……………………. 24 b.

- Interest Payable (L) + + Interest Expense (E) - 24 a. a. 24

c.




Capital + Earned capital Revenues - Expenses = Net

Income Accrued $24 interest on note payable

=

+24 Interest Payable

-24

Retained Earnings

-

+24 Interest Expense

= -24



M9-21. (15 minutes) a. Accounts Payable, $110,000 (current liability). b. Not recorded as a liability; an accountable transaction has not yet occurred. c. Estimated liability for product warranty, $2,200 (current liability). d. Bonuses Payable, $30,000 (current liability)—computed as $600,000 5%. This

liability must be reported since its payment is “probable” and can be “estimated.” M9-22. (10 minutes) a. Boston Scientific is offering bonds with a coupon (stated) rate of 4.25% when the

market rate (yield) is higher (4.349%). In order to obtain this expected rate of return, the bonds sell at a discount price of 99.476 (99.476% of par).

b. The first bond matures in 2011 while the second matures in 2017. There is,

generally, a higher rate (yield) expected for a longer maturity. M9-23. (10 minutes) Amount paid to retire bonds ($200,000 x 101%).............................................. $202,000 Book value of retired bonds, net of $2,400 unamortized discount ................... 197,600 Loss on bond retirement .................................................................................. $ 4,400 M9-24. (10 minutes) a. The $597 million indicates that BMY has bonds maturing that will require payment in

the amount of $597 million in 2013. b. BMY will need to pay off the bonds when they mature. This will result in a cash

outflow that must come from operating activities if the bonds cannot be refinanced prior to maturity. However, most of BMY’s long-term debt matures more than 5 years after the financial statement date (December 31, 2011). Thus, BMY’s near-term cash needs for covering long-term debt should not place a significant burden on the company’s operations.



M9-25 (10 minutes) a. Gain on Bond Retirement: In the other (nonoperating) revenues and expenses section

unless it meets the tests for extraordinary treatment (e.g., unusual and infrequent) b. Discount on Bonds Payable: Deduction from Bonds Payable; thus, a (contra) long-term

liability in the balance sheet (e.g., it is netted in the presentation of long-term liabilities). c. Mortgage Notes Payable: Long-term liability in the balance sheet. d. Bonds Payable: Long-term liability in the balance sheet. e. Bond Interest Expense: In other (nonoperating) revenues and expenses section of

income statement. f. Bond Interest Payable: Current liability in the balance sheet. g. Premium on Bonds Payable: Addition to Bonds Payable; thus, part of a long-term

liability in the balance sheet (e.g., it is included in the presentation of long-term liabilities).

h. Loss on Bond Retirement: In the other (nonoperating) revenues and expenses section

unless it meets the tests for extraordinary treatment (e.g., unusual and infrequent) M9-26. (10 minutes) a. Restrictive loan covenants are typically designed to protect the bond holders against

actions by management that they feel would be detrimental to their interests. These covenants might include restrictions against the impairment of liquidity, restrictions on the amount of financial leverage the company can employ, and restrictions on the payment of dividends. In addition, bond holders usually impose various covenants prohibiting the acquisition of other companies or the divestiture of business segments without their consent. All of these covenants, by design, restrict management in its actions.

b. Management, facing imminent violation of one or more of its bond covenants, may

be pressured into taking actions in order to avoid default. These may include, for example, foregoing profitable investments, reduction of discretionary spending such as R&D or advertising in order to improve profitability, missing opportunities to take cash discounts and other methods of “leaning on the trade,” or reduction of receivables (via early payment incentives) and inventories (by marketing promotions or delaying restocking) in order to boost cash balances. Actions may also include questionable accounting measures, such as improper recognition of revenues or delayed recognition of expenses.

continued next page



M9-26. concluded c. When evaluation solvency, analysts should compare a company’s position relative to

its restrictive covenants. A company pay appear solvent, but in fact may be in close proximity to a restrictive covenant. Also, analysts should be aware of the potential effect that restrictive covenants can have management decisions (see the answer to requirement b). Restricted assets, such as cash or securities, should not be considered as general assets in an analysis of the firm’s liquidity or solvency because they are not available to management for general corporate uses.


1/1/2008 Cash (+A) ……………………………………..... 432,000 Bonds payable (+L) ………………..…… 400,000 Bond premium (+L) ………………..…… 32,000

1/1/2014 Bonds payable (-L) ………………………..….. 400,000 Bond premium (-L) ……………………..…….. 27,809 Cash (-A) ………………………………..... 412,000 Gain on retirement of bonds (+R, +SE) 15,809

b.

+ Cash (A) - - Bonds Payable (L) + 1/1/08 432,000 400,000 1/1/08

412,000 1/1/14 1/1/14 400,000

- Gain on Retirement of Bonds (R) + - Bond Premium (L) + 15,809 1/1/14 32,000 1/1/08 1/1/14 27,809

c.



Assets = Liabilities + Contrib. Capital + Earned


1/1/08 Issue bonds at a premium.

432,000 Cash

=

+400,000 Bonds

Payable

+32,000 Bonds

Payable, net

-

=

1/1/14 Retired bonds issued on 1/1/08.

-412,000 Cash

=

-400,000 Bonds

Payable

-27,809 Bonds

Payable, net

+15,809 Retained Earnings

+15,809 Gain on

Retirement of Bonds -

=

+15,809




7/1/2007 Cash (+A) ……………………………………. 240,000 Bond discount (+XL, -L) …………….….…. 10,000 Bonds payable (+L) ………………….. 250,000 7/1/2014 Bonds payable (-L) ………………………… 250,000 Loss on retirement of bonds (+E, -SE) … 9,314 Bond discount (-XL, +L) ……….…… 6,814 Cash (-A) ………………………………. 252,500

b.


252,500 7/1/14 7/1/14 250,000

+ Loss on Retirement of Bonds (E) - + Bond Discount (XL) - 7/1/14 9,314 7/1/07 10,000

6,814 7/1/14

c.





7/1/07 Issue bonds at a discount

+240,000 Cash

=

+250,000 Bonds

Payable

-10,000 Bonds

Payable, net

-

=

7/1/14 Retired bonds issued on 7/1/03

-252,500 Cash

=

-250,000 Bonds

Payable

+6,814 Bonds

Payable, net


-

+9,314 Loss on

retirement of Bonds =

-9,314

M9-29. (10 minutes) Nissim: $18,000 0.10 40/365 = $197.26

Klein: $14,000 0.09 18/365 = 62.14

Bildersee: $16,000 0.12 12/365 = 63.12 $322.52



M9-30. (10 minutes) a. The Debt-to-Equity ratio (D/E) will likely change, but the direction and amount is

difficult to determine from the information given. The increase in outstanding debt by $450 million (-$742.6+$1200.0-$7.4) along with the net share repurchases of $646.9 million ($1163.5-$516.6) and dividend payments of $739.7 million will increase D/E. (The effect of the share repurchases on reported equity is not provided – the $1163.5 million is the market value of the repurchased shares.)

Times interest earned will decrease as additional interest cost on new borrowing is added to the denominator. How much of an effect this will have depends on the size of the change in net income.

b. Generally, the higher (lower) the firm's solvency measures, the higher (lower) the

firm's debt rating. In financial leverage terms, the higher (lower) the firm's leverage the lower (higher) the firm's debt rating. Increasing the amount of debt while decreasing equity may harm General Mills’ debt ratings.

M9-31. (15 minutes) a. Selling price of 9% bonds discounted at 8% Present value of principal repayment ($500,000 0.45639) .................... $228,195 Present value of interest payments ($22,500 13.59033) .................... 305,782 Selling price of bonds ..................................................................................... $533,977 b. Selling price of 9% bonds discounted at 10% Present value of principal repayment ($500,000 0.37689) .................... $188,445 Present value of interest payments ($22,500 12.46221) .................... 280,400 Selling price of bonds ..................................................................................... $468,845 M9-32. (15 minutes) a. Selling price of zero-coupon bonds discounted at 8%: Present value of principal repayment ($500,000 0.45639) $228,195 b. Selling price of zero coupon bonds discounted at 10%: Present value of principal repayment ($500,000 0.37689) $188,445 c. Based on the debt-to-equity ratio, financial leverage would increase from 2.0 [=($3 -

$1)/$1] to 2.19 [=($3 - $1 + $0.188)/$1)




1. Inventory (+A) …………………………………. 300 Accounts payable (+L) ………………… 300 2. Accounts receivable (+A) …………………… 420 Sales revenue (+R, +SE) …..………….. 420 3. Cost of goods sold (+E, -SE) ………………. 300 Inventory (-A) …………………………… 300 4. Accounts payable (-L) ………………………. 300 Cash (-A) ………………………………… 300 5. Cash (+A) ……………………………………… 420 Accounts receivable (-A) ……………… 300

b.

+ Cash (A) - - Accounts Payable (L) + 300 4. 300 1.

5. 420 4. 300

+ Accounts Receivable (A) - - Sales Revenue (R) + 2. 420 420 2.

420 5.

+ Inventory (A) - + Cost of Goods Sold (E) - 1. 300 3. 300

300 3.

c.



Assets = Liabil- ities + Contrib.


Income 1. Purchase inventory

on account.

+300 Inventory =

+300 Accounts Payable

-

=

2. Sell inventory on credit.

+420 Accts Rec =

+420 Retained Earnings

+420 Sales -

=

+420

3. Cost of sales from 2.

-300 Inventory =

-300 Retained Earnings

-

+300 Cost of

Goods Sold =

-300

4. Paid cash for inventory purchased in 1.

-300 Cash

=

-300 Accounts Payable

-

=

d. Receive cash on receivable from 2.

420 Cash

-420 Accts Rec =

-

=



M9-34.(30 minutes)



M9-35. (15 minutes)

a. Gain on bond retirement Reported in the income statement under other

(nonoperating) income b. Discount on bonds payable Contra-liability netted against bonds payable

under long-term liabilities in the balance sheet c. Mortgage notes payable Long-term liability in the balance sheet; the

amount due within one year would be reported as a current liability

d. Bonds payable Long-term liability in the balance sheet; the amount due within one year would be reported as a current liability

e. Bond interest expense Nonoperating expense reported in the income statement

f. Bond interest payable A current liability in the balance sheet g. Premium on bonds payable Adjunct-liability added to bonds payable under

long-term liabilities in the balance sheet


12/31/13 Cash (+A) …………………………………….. 700,000 Mortgage note payable (+L) ………….. 700,000

6/30/14 Interest expense (+E, -SE) ………………….. 42,000 Mortgage note payable (-L) …………………. 8,854 Cash (-A) …………………………………. 50,854

12/31/14 Interest expense (+E, -SE) ………………….. 41,469 Mortgage note payable (-L) …………………. 9,385 Cash (-A) …………………………………. 50,854 * $41,469 = ($700,000 – $8,854) x 12%/2.

continued next page



M9-36. concluded b.

+ Cash (A) - - Mortgage Note Payable (L) + 12/31/13 700,000 700,000 12/31/13

50,854 6/30/14 6/30/14 8,854 50,854 12/31/14 12/31/14 9,385

+ Interest Expense (E) - 6/30/14 42,000

12/31/14 41,469

c.





Income 12/31/13 Borrow

$700,000 on a 15-year mortgage note payable.

+700,000 Cash

=

+700,000 Mortgage

Note Payable

-

=

6/30/14 Interest payment on note.

-50,854 Cash

=

-8,854 Mortgage

Note Payable


-

+42,000 Interest Expense =

-42,000


-50,854 Cash

=

-9,385 Mortgage

Note Payable


-


-41,469

M9-37. (5 minutes) $900,000 x 0.55839 + (900,000 x 10%/2) x 7.36009 = $833,755. $833,755 / $900,000 = 92.6% of par value.



EXERCISES E9-38. (15 minutes) a.

Total expected failures from units sold (69,000 0.02) ...................... 1,380

Average cost per failure ...................................................................... $50 Total expected future warranty costs .................................................. $69,000 Current warranty liability ..................................................................... $10,000 Additional warranty cost liability required ............................................ $ 59,000

The product warranty liability must be increased by $59,000 to cover the expected repair costs, (because the warranty is for a 60-day period, the $10,000 remaining in the liability account represents unused amounts left from prior years’ accruals). Warranty expense of $59,000 must be recorded in the income statement when the liability account is increased.

b. The warranty liability should be equal, at all times, to the expected dollar cost of

repairs. Analysis issues relate to whether the warranty liability exists and, if so, is it at the correct amount. Understating (overstating) the accrual overstates (understates) current period income at the expense (benefit) of future income.

c. The debt-to-equity ratio will increase and the operating cash flow to liabilities will

decrease. The times-interest earned ratio will not be affected. E9-39. (10 minutes) Item Accounting Treatment a. Neither record nor disclose (neither probable nor reasonably possible) b. Record a current liability for the note, no liability for interest until incurred c. Disclose in a footnote (at least reasonably possible) d. Record warranty liability on balance sheet and recognize expense in income

statement (costs are probable and reasonably estimable).



E9-40. (15 minutes) The company must accrue the $25,000 of wages that have been earned by employees even though these wages will not be paid until the first of next month. The required accounting accrual will:

increase wages payable by $25,000 on the balance sheet

increase wages expense by $25,000 in the income statement Failure to make this accounting accrual (called adjusting entry) would understate liabilities, understate expenses, overstate income, and overstate stockholders’ equity. M9-41. (15 minutes) a. Selling price of bonds: Present value of principal repayment ($300,000 0.30832) .................. $ 92,496

Present value of interest payments ($16,500 17.29203) ........... 285,318 Selling price of bonds $377,814 b.

1/1/14 Cash (+A) …………………………………….. 377,814 Bond premium (+L) …………………… 77,814 Bonds payable (+L) ……………...…… 300,000 6/30/14 Interest expense (+E, -SE) ………………… 15,113 Bond premium (-L) ……………...………….. 1,387 Cash (-A) ……………………………….. 16,500 12/31/14 Interest expense (+E, -SE) ………………… 15,057 Bond premium (-L) …………………………. 1,443 Cash (-A) ……………………………….. 16,500 * $15,057 = ($377,814 – $1,387) x 8%/2.

c. + Cash (A) - - Bonds Payable (L) +

1/1/14 377,814 300,000 1/1/10 16,500 6/30/10 16,500 12/31/10

+ Interest Expense (E) - - Bond Premium (L) + 77,814 1/1/10

6/30/14 15,113 6/30/14 1,387 12/31/14 15,057 12/31/14 1,443

continued next page



M9-41. concluded d.






+377,814 Cash

=

+300, Payable

+77,814 Bonds

Payable, net

-

=

6/30/14 Interest payment on bonds.

-16,500 Cash

=

-1,387 Bonds

Payable, net


-

+15,113 Interest Expense

= -15,113


-16,500 Cash

=

-1,443 Bonds

Payable, net


-


= -15,057

E9-42. (10 minutes) Selling price of bonds

Present value of principal repayment ($900,000 0.44230) .................... $398,070 Present value of interest payments ($49,500 9.29498) ......................... 460,102 Selling price of bonds ................................................................................ $858,172 E9-43. (15minutes) a.

Warranty expense (+E, -SE) ……………………. 123.0 Warranty liability (+L)…………………… 123.0

b.

- Accrued Warranty Liability (L) + + Warranty Expense (E) - 60.5 07 bal.

08 cost 125.1 123.0 08 exp. 123.0 55.2 08 bal.

c. 2008: $123.0 / $6,086.1 = 2.0% 2007: $118.8 / $6563.2 = 1.8%. Warranty expense appears to have increased in 2008 as a percentage of sales

revenue.




5/1/13 Cash (+A) ………………………………………... 500,000 Bonds payable (+L) ……………………… 500,000

10/31/13 Interest expense (+E, -SE) …………………… 22,5001 Cash (-A) ………………………………….. 22,500

11/1/14 Bonds payable (-L) ……………………………. 300,000 Loss on retirement of bonds (+E, -SE) ……. 3,000 Cash (-A) ………………………………….. 303,0002

1 $500,000 x 0.09 x 1/2 = $22,500 interest expense. Because the bonds were sold at par,

there is no discount or premium amortization. 2 Cash required to retire $300,000 of bonds at 101 = $300,000 x 1.01 = $303,000. The

difference between the cash paid and the carrying amount of the bonds is the gain or loss on the redemption. In this case, the loss is $3,000. This calculation assumes that the interest was paid on 10/31/14, so accrued interest is not recorded.

b.


22,500 10/31/10 303,000 11/1/11 11/1/14 300,000

+ Interest Expense (E) - + Loss on Retirement of Bonds (E) - 10/31/13 22,500 11/1/14 3,000

c.





Income 5/1/10 Issue bonds. +500,000

Cash

= +500,000

Bonds Payable

-

=

10/31/10Interest payment on bonds.

-22,500 Cash

=


-


= -22,500

11/1/11 Early retirement of bonds.

-303,000 Cash

=

-300,000 Bonds

Payable


-

+3,000 Loss on

Retirement of Bonds

=

-3,000



E9-45. (25 minutes)

a. Selling price of bonds

Present value of principal repayment ($250,000 0.41552) ............... $103,880 Present value of interest payments ($10,000 11.68959) .................. 116,896 Selling price of bonds .......................................................................... $220,776

b.

1/1/13 Cash (+A) ………………………………………. 220,776 Bond discount (+XL, -L) ……………………… 29,224 Bonds payable (+L) …………………….. 250,000

6/30/13 Interest expense (+E, -SE) …………………… 11,039 Bond Discount (-XL, +L) ………….……. 1,039 Cash (-A) ………………………………….. 10,000 $11,039 = $220,776 .05.

12/31/13 Interest expense (+E, -SE) …………………. 11,091 Bond Discount (-XL, +L) …………….…. 1,091 Cash (-A) ………………………………….. 10,000 $11,091 = [$220,776 + $1,039] .05.

c.


10,000 6/30/13 10,000 12/31/13

+ Interest Expense (E) - + Bond Discount (XL) - 1/1/13 29,224

6/30/13 11,039 1,039 6/30/13 12/31/13 11,091 1,091 12/31/13

d.





1/1/10 Issue bonds at a discount.

+220,776 Cash

=

+250,000 Bonds

Payable

-29,224 Bonds

Payable, net

-

=


-10,000 Cash

=

+1,039 Bonds

Payable, net


-


= -11,039


-10,000 Cash

=

+1,091 Bonds

Payable, net


-


= -11,091



E9-46. (25 minutes) a. Selling price of bonds:

Present value of principal repayment ($800,000 0.20829) ............... $166,632 Present value of interest payments ($36,000 19.79277) .................. 712,540 Selling price of bonds .......................................................................... $879,172

b.

1/1/14 Cash (+A) ………………………………………... 879,172 Bond premium (+L) ……………………… 79,172 Bonds payable (+L) ……………………… 800,000

6/30/14 Interest expense (+E,-SE) ……………………. 35,167 Bond premium (-L) …………….……………… 833 Cash (-A) ………………………………….. 36,000 $35,167 = $879,172 x .04.

12/31/14 Interest expense (+E,-SE) ……………………. 35,134 Bond premium (-L) …………….……………… 866 Cash (-A) ………………………………….. 36,000 $35,134 = ($879,171 - $833) x .04.

c.


36,000 6/30/14 36,000 12/31/14

+ Interest Expense (E) - - Bond Premium (L) + 79,172 1/1/14

6/30/14 35,167 6/30/14 833 12/31/14 35,134 12/31/14 866

d.






+879,172 Cash

=

+800,000 Bonds

Payable

+79,172 Bonds

Payable, net

-

=


-36,000 Cash

=

-833 Bonds

Payable, net


-


= -35,167


-36,000 Cash

=

-866 Bonds

Payable, net


-


= -35,134



E9-47. (20 minutes) a. There is an inverse relation between interest rates and bond prices (examine the

increasing discount rates as the yield increases in present value tables). Since the bonds now trade at a premium and assuming that Deere’s credit ratings have not changed, we can conclude that interest rates have fallen since the bonds were issued.

b. No, once the bond is initially recorded, neither the coupon rate nor the yield used to

compute interest expense is changed. Bonds are recorded at historical cost (like most other balance sheet assets and liabilities). As a result, changes in the general level of interest rates have no effect on interest expense (or the interest payment) that is reflected in the financial statements.

c. Because the bonds trade at a premium in the market, Deere would be paying more

to retire the bonds than the amount at which they are carried on its balance sheet. This would result in a loss on the repurchase that would lower current profitability.

d. The face amount of the bonds will be paid at maturity. As a result, the market price

of the bonds must also equal their face amount ($200 million) at that time. E9-48. (25 minutes) a. Selling price of bonds

Present value of principal repayment ($600,000 0.09722) ............... $ 58,332 Present value of interest payments ($33,000 15.04630) .................. 496,528 Selling price of bonds .......................................................................... $554,860

b.

1/1/13 Cash (+A) ………………………………………….. 554,860 Bond discount (+XL, -L) ………………..……… 45,140 Bonds payable (+L) ……………………….. 600,000

6/30/13 Interest expense (+E, -SE) ……………………… 33,292 Bond discount (-XL, +L) ……………….…. 292 Cash (-A) ……………………………………. 33,000 $33,292 = $554,860 .06.

12/31/13 Interest expense (+E, -SE) ……………………… 33,309 Bond discount (-XL, +L) …………….……. 309 Cash (-A) ………….…………………………. 33,000

$33,309 = ($554,860 + $292) .06.

continued next page



E9-48. concluded c.


33,000 6/30/13 33,000 12/31/13


6/30/13 33,292 292 6/30/13 12/31/13 33,309 309 12/31/13

d. At December 31, 2013 (after the coupon payment recorded in b) the book value of

the bonds would be $554,860 + $292 + $309 = $555,461. The market value would be $600,000 X 1.01 = $606,000. Thus, a fair value adjustment of $50,539 (=$606,000-$555,461) would be recorded as follows:

12/31/13 Loss due to adjustment of bonds to fair value (+E, -SE) 50,539 Fair value adjustment (+L) ……………….…. 50,539

e.

Coupon payments ($33,000 X 2) …………… $66,000 Discount amortization ($292 + $309) ……… 601 Total interest expense ……………………….. 66,601 Fair value adjustment ………………………... 50,539 Total effect on income (deduction) ……….. $117,140

E9-49. (10 minutes) Current liabilities: Bond interest payable $ 25,000 Current maturities of long-term debt:

10% bonds payable due 2014, including $15,000 premium 515,000 Total current liabilities $540,000 Long-term debt: 9% bonds payable due 2015, net of $19,000 discount $581,000 Zero coupon bonds payable due 2016 170,500 8% bonds payable due 2018 100,000 Total long-term debt $851,500




12/31/13 Cash (+A) …………………………………………… 500,000 Mortgage note payable (+L) ………………. 500,000

3/31/14 Interest expense (+E, -SE) ………………………. 10,000 Mortgage note payable (-L) ……………………... 8,278 Cash (-A) ……………………………………… 18,278

6/30/14 Interest expense (+E, -SE) ………………………. 9,834 Mortgage note payable (-L) ……………………... 8,444 Cash (-A) ……………………………………… 18,278 $9,834 = ($500,000 – $8,278) x 8%/4.

b.


18,278 3/31/14 3/31/14 8,278 18,278 6/30/14 6/30/14 8,444

+ Interest Expense (E) - 3/31/14 10,000 6/30/14 9,834

c.







+500,000 Cash

=

+500,000 Mortgage

Note Payable

-

=


-18,278 Cash

=

-8,278 Mortgage

Note Payable


-


-10,000


-18,278 Cash

=

-8,444 Mortgage

Note Payable


-


-9,834



PROBLEMS P9-51. (20 minutes) a.

Hewlett-Packard Dell Inc. - Accrued Warranty Liability (L) + - Accrued Warranty Liability (L) +

2,447 10 bal. 895 10 bal. 2,657 11 exp. 1,025 11 exp. 2,653 1,032 2,451 11 bal. 888 11 bal.

Hewlwtt-Packard incurred $2,653 million in warranty repair costs and settlements in

2011 while Dell, Inc. incurred costs of $1,032 million. b. HP’s ratio of warranty expense to sales was 3.1% in 2011 ($2,657/$84,757) down

slightly from 3.2% in 2010 ($2,689/$84,799). Dell’s ratio was 2.1% both years ($1,005/$49,906 in 2011 and $1,042/$50,002 in 2010). Dell’s warranty expense is lower relative to sales revenue than that of HP. Possible reasons for this include the following: (1) perhaps Dell products are higher- quality and require fewer repairs than HP products or (2) HP may have a more generous warranty policy than Dell, resulting in more warranty repairs, even if the quality is the same. The decrease in HP’s warranty expense as a percent of sales indicates that either (1) warranty costs have gone down, (2) the company overestimated warranty costs in the past and needed to record smaller than normal accruals in 2011 to correct the overestimation; or (3) HP was building up a “cookie-jar reserve” by increasing its warranty liability in past years.



P9-52. (20 minutes) a. Cash (+A) ………………………………………….. 518,750 Accrued interest payable (+L) …………… 18,750 Bonds payable (+L) ……………………….. 500,000

$18,750 = $500,000 x .09 x 5/12 b. Interest expense (+E, -SE)………………………. 3,750 Accrued interest payable (-L) ………………….. 18,750 Cash (-A) …………………………………….. 22,500

$22,500 = $500,000 x 9%/2 c. Interest expense (+E, -SE) ……………………… 7,500 Accrued interest payable (+L) …………… 7,500

$7,500 = $500,000 x 9% x 2/12 d. Fair value adjustment (+XL, -L) ……………….. 5,000 Gain from adjustment of bonds to fair value

(+R, +SE) …………………………….. 5,000

e. Interest expense (+E, -SE) ……………………… 15,000 Accrued interest payable (-L) ………………….. 7,500 Cash (-A) …………………………………….. 22,500 f. Bonds payable (-L) ………………………………. 300,000 Loss on retirement of bonds (+E, -SE) ………. 18,000 Cash (-A) …………………………………….. 303,000 Fair value adjustment (-XL, +L) … 15,000

continued next page



P9-52. concluded

+ Cash (A) - - Bonds payable (L) + a. 518,750 500,000 a.

22,500 b. 22,500 e. 303,000 f. f. 300,000

+ Interest expense (E) - - Accrued Interest Payable (L) + 18,750 a.

b. 3,750 b. 18,750 c. 7,500 7,500 c. e. 15,000 e. 7,500

+ Loss on Retirement of Bonds (E) - - Fair Value Adjustment (L) + f. 18,000

d. 5,000 15,000 f. - Gain from Fair Value Adjustment + 5,000 d.




capital Revenues - Expenses = Net Income

a. (10/1/13) Issue bonds.

+518,750 Cash

=

+500,000 Bonds

Payable

+18,750 Interest Payable

-

=

b. (11/1/13) Interest payment on bonds.

-22,500 Cash

=

-18,750 Interest Payable

-3,750

Retained Earnings

-


= -3,750

c. (12/31/13) Accrued interest on bonds.

=


-7,500

Retained Earnings

-


= -7,500

d. (12/31/13) Fair value adjustment

-5,000 Fair value adjustment

+5,000

Retained Earnings

+5,000 Gain on FV adjustment

+5,000

e. (5/1/14) Interest payment on bonds.

-22,500 Cash

=


-15,000

Retained Earnings

-


= -15,000

f. 5/1/18 Early retirement of bonds.

-303,000 Cash

=

-300,000 Bonds

Payable +15,000

Fair value adjustment


-

+18,000 Loss on

Retirement of Bonds =

-18,000



P9-53. (15 minutes) a. CVS reports interest expense of $588 million on average debt of $10,035.5 million

([$10,014 million + $10,057 million]/2) for an average rate of 5.9%. Using interest paid ($647 million) instead of interest expense yields 6.5%. See the answer to c below.

b. CVS reports coupon rates of 3.25% to 6.6%. In addition, no rates are reported for

capital leases, mortgage notes, commercial paper, or the floating rate notes. So, the average rate seems reasonable given the information disclosed in the long-term debt footnote.

c. Interest paid can differ from interest expense if bonds are sold at a premium or a

discount. It can also differ because of capitalized interest. CVS reported capitalized interest of $37 million in 2011. Thus, CVS apparently amortized $22 million in net bond discounts ($647m -$588m -$37m).

P9-54. (25 minutes) a. 6/1/13 Cash (+A) ……………………………………. 824,000 Accrued interest payable (+L) ……. 24,000 Bonds payable (+L) ………………… 800,000

$24,000 = $800,000 x .09 x 4/12 b. 9/1/13 Interest expense (+E, -SE) ……………..… 12,000 Accrued interest payable (-L) ……………. 24,000 Cash (-A) ……………………………… 36,000

$36,000 = $800,000 x 9%/2 c. 12/31/13 Interest expense (+E, -SE) ………………… 24,000 Accrued interest payable (+L) ……. 24,000 d. 3/1/14 Interest expense (+E) ……………………… 12,000 Accrued interest payable (-L) ……………. 24,000 Cash (-A) ……………………………… 36,000 e. 3/1/14 Bonds payable (-L) ………………………… 200,000 Loss on retirement of bonds (+E, -SE) … 2,000 Cash (-A) …………………………….. 202,000

continued next page



P9-54. concluded

+ Cash (A) - - Bonds Payable (L) + a. 824,000 36,000 b. 800,000 a.

36,000 d. 202,000 e. e. 200,000

+ Interest Expense (E) - - Accrued Interest Payable (L) + b. 12,000 b. 24,000 24,000 a. c. 24,000 d. 24,000 24,000 c. d. 12,000

+ Loss on Retirement of Bonds (E) - e. 2,000





Income a. (7/1/13) Issue

bonds. +824,000

Cash

=

+800,000 Bonds

Payable


-

=

b. (9/1/13) Interest payment on bonds.

-36,000 Cash

=


-12,000

Retained Earnings

-


= -12,000

c. (12/31/13) Accrued interest on bonds.

=



-


-24,000

d. (3/1/14) Interest payment on bonds.

-36,000 Cash

=


-12,000

Retained Earnings

-


= -12,000

e. 3/1/14 Early retirement of bonds.

-202,000 Cash

=

-200,000 Bonds

Payable


-

+2,000 Loss on

Retirement of bonds

=

-2,000




Period Interest Expense

Cash Interest

Paid Discount

Amortization Discount Balance

Bond Payable Net

0 $41,292 $678,708 1 $40,722 $39,600 $1,122 $40,170 $679,830 2 $40,790 $39,600 $1,190 $38,980 $681,020

$40,722 = $678,708 x 12%/2. $40,790 = $679,830 x 12%/2.

b. 12/31/13 Cash (+A) ………………………………….. 678,708 Bond discount (+XL) ……………………. 41,292 Bonds payable (+L) ……………….. 720,000

6/30/14 Interest expense (+E,-SE) ………………. 40,722 Bond discount (-XL) ……………….. 1,122 Cash (-A) …………………………….. 39,600

12/31/14 Interest expense (+E,-SE) ………………. 40,790 Bond discount (-XL) ……………….. 1,190 Cash (-A) …………………………….. 39,600

c.


39,600 6/30/14 39,600 12/31/14


6/30/14 40,722 1,122 6/30/14 12/31/14 40,790 1,190 12/31/14

d.



Assets = Liabilities + Contrib. Capital + Retained

Earnings Revenues - Expenses = Net Income


+678,708 Cash

=

+720,000 Bonds

Payable

-41,292 Bonds

Payable, net

-

=


-39,600 Cash

=

+1,122 Bonds

Payable, net


-


= -40,722


-39,600 Cash

=

+1,190 Bonds

Payable, net


-


= -40,790




Period Interest Expense

Cash Interest Paid

Discount Amortization

Discount Balance

Bond Payable Net

0 $43,230 $206,770 1 $8,271 $7,500 $771 $42,459 $207,541 2 $8,302 $7,500 $802 $41,657 $208,343

$8,271= $206,770 x 8%/2. $8,302 = $207,541 x 8%/2.

b. 4/30/13 Cash (+A) …………………….……….………..…… 206,770 Bond discount (+XL, -L) …………………………. 43,230 Bonds payable (+L) …….…………………… 250,000

10/31/13 Interest expense (+E, -SE) ………………..….….. 8,271 Bond discount (-XL, +L) ……………………. 771 Cash(-A) ……………………………………….. 7,500

12/31/13 Interest expense (+E, -SE) ………………..….….. 2,767 Bond discount (-XL, +L) ……………………. 267 Accrued interest payable (+L) …………….. 2,500

4/30/14 Interest expense (+E, -SE) …………………...….. 5,535 Accrued interest payable (-L) ………..….………. 2,500 Bond discount (-XL, +L) ……………………. 535 Cash(-A) ……………………………………….. 7,500

c.


7,500 10/31/13 7,500 4/30/14

+ Interest Expense (E) - + Bond Discount (XL) - 4/30/13 43,230 10/31/13 8,271 771 10/31/13 12/31/13 2,767 267 12/31/13 4/30/14 5,535 535 4/30/14

- Accrued Interest Payable (L) +

2,500 12/31/13 4/30/14 2,500

continued next page



P9-56. concluded d.






+206,770 Cash

=

+250,000 Bonds

Payable

-43,230 Bonds

Payable, net

-

=


-7,500 Cash

=

+771 Bonds

Payable, net


-


= -8,271

12/31/13 Accrued interest on bonds.

=

+267 Bonds

Payable, net +2,500

Accrued Interest Payable


-


=

-2,767


-7,500 Cash

=

+535 Bonds

Payable, net -2,500

Accrued Interest Payable


-


=

-5,535

P9-57. (20 minutes) a. Payment x 12.46221 = $500,000; Payment = $500,000/12.46221 = $40,121. b.

12/31/13 Cash (+A) ………………………………………..…… 500,000 Mortgage note payable (+L) ………………… 500,000

6/30/14 Interest expense (+E, -SE) ………………………… 25,000 Mortgage note payable (-L) ………………………. 15,121 Cash (-A) …………………………………..…… 40,121

* $25,000 = $500,000 x 10%/2

12/31/14 Interest expense (+E, -SE) ……………………….… 24,244 Mortgage note payable (-L) ……………………….. 15,877 Cash (-A) …………………………………..…… 40,121 $24,244 = ($500,000 – $15,121) x 10%/2.

continued next page



P9-57. concluded

c. + Cash (A) - - Mortgage Note Payable (L) +

12/31/13 500,000 500,000 12/31/13 40,121 6/30/11 6/30/14 15,121 40,121 12/31/11 12/31/14 15,877

+ Interest Expense (E) -

6/30/14 25,000 12/31/14 24,244

d.







+500,000 Cash

=

+500,000 Mortgage

Note Payable

-

=


-40,121 Cash

=

-15,121 Mortgage

Note Payable


-


-25,000


-40,121 Cash

=

-15,877 Mortgage

Note Payable


-


-24,244

P9-58. (20 minutes) a. Payment x 16.35143 = $950,000; Payment = $950,000/16.35143 = $58,099. b.

12/31/10 Cash (+A) ………………………………………..…… 950,000 Mortgage note payable (+L) ………………… 950,000

3/31/11 Interest expense (+E, -SE) ………………………… 19,000* Mortgage note payable (-L) ………………………. 39,099 Cash (-A) …………………………………..…… 58,099

* $19,000 = $950,000 x 8%/4

6/30/11 Interest expense (+E, -SE) ………………………… 18,218* Mortgage note payable (-L) ………………………. 39,881 Cash (-A) …………………………………..…… 58,099

* $18,218 = ($950,000 – $39,099) x 8%/4.

continued next page



P9-58. concluded c.


58,099 3/31/14 3/31/14 39,099 58,099 6/30/14 6/30/14 39,881

+ Interest Expense (E) -

3/31/14 19,000 6/30/14 18,218

d.







+950,000 Cash

=

+950,000 Mortgage

Note Payable

-

=

3/31/14 Payment on note.

-58,099 Cash

=

-39,099 Mortgage

Note Payable


-


-19,000

6/30/14 Payment on note.

-58,099 Cash

=

-39,881 Mortgage

Note Payable


-


-18,218

P9-59. (10 minutes) a. BP recorded the $9.2 billion estimate as an expense on its 2010 income

statements. This increased the company’s liabilities. b. If BP had prepared its financial statements in accordance with U.S. GAAP, the

accrual would most likely have been at the low end of the range -- $6 million, instead of the expected amount (best reliable estimate), or mid-point in the range.



CASES and PROJECTS C9-60. (30 minutes) a. The difference between interest expense and interest paid can be caused by three

factors: (1) interest capitalized as part of self constructed assets is paid but not part of interest expense; (2) coupon payments differ from interest expense charged on bonds due to amortization of discounts or premiums; (3) interest payments may not coincide with the fiscal period, thus requiring the company to record accrued interest payable.

b. In 2011, Comcast’s debt had a fair value of $45.1 billion while its historical cost was

$39.3 billion. Thus, Comcast would report a fair value adjustment as a credit in its balance sheet of $5.8 billion ($45.1 - $39.3). In 2010, the fair value was $34.3 billion and the historical cost was $31.4 billion yielding a credit balance in the fair value adjustment account of $2.9 billion ($34.3 - $31.4). The change in the fair value adjustment from 2010 to 2011 ($2.9 = $5.8 – $2.9) would be recorded as follows:

12/31/11 Loss due to adjustment of bonds to fair value (+E, -SE) 2.9 Fair value adjustment (+L) ……………….…. 2.9

c. It is likely that Comcast could get a lower interest rate by replacing its 7% debt with a

new debt issue. While this would translate into lower future interest costs, it would have an adverse impact on the 2012 income statement. If interest rates have fallen, the market value of Comcast’s 7% notes would have increased. Thus, Comcast would have to either pay a high price to repurchase the notes or pay a call premium, if the loan agreement allows them to call the notes. Either way, Comcast would record a loss on early retirement of the notes.

d. Debt-to-equity: $110,163 million/$47,655 million = 2.31 Times interest earned: ($8,207 million + $2,505 million)/$2,505 million = 4.28 Creditors are naturally concerned about the risk of default. The debt-to-equity ratio

measures the extent to which a company is relying on debt financing and the higher the ratio, the greater chance of default. In addition, the times interest earned ratio measures the company’s ability to pay the interest on the debt.

e. Management may bypass profitable investment projects or cut discretionary

expenditures such as R&D or advertising. It may also engage in questionable accounting practices in an attempt to manage the ratios.



C9-61. (20 minutes) a. The gain results from the difference between the book value of the debt

($3,000,000) and the current redemption (market) value ($1,900,000). The gain would be reported in the income statement under other (nonoperating) income. The source of the gain should be adequately disclosed in the notes.

b. Currently, Foster is paying 8% interest on the $3,000,000 of long-term debt, or

$240,000 per year. Under the proposed refinancing, Foster would pay 16%, or $480,000. The refinancing would generate an additional $1,100,000 in cash. However, because interest costs are increasing by $240,000 per year ($480,000 - $240,000), Foster is effectively borrowing the additional $1,100,000 at a rate of almost 22% ($240,000 / $1,100,000). As such, Foster would be paying in the future (in the form of higher interest costs) for a one-time boost in current earnings.

c. The potential ethical conflict exists because Foster’s president is concerned that his

job might be dependent on producing short-term earnings. Because of this, he might be tempted to accept this proposal and boost current earnings at the cost of lower earnings in future years. This thinking is misguided because, given adequate disclosure, analysts and investors would be able to identify and discount the source of the earnings boost. The most serious unethical act would be to try to hide (or obfuscate) the bond refinancing with inadequate disclosure.



Chapter 10

Reporting and Analyzing Leases, Pensions, and Income Taxes



LO1 – Define off-balance-sheet financing and explain its effects on financial analysis.

21 23 45

LO2 – Account for leases using the operating lease method or the capital lease method.

12 - 15 25, 26, 28 35, 36 45

LO3 – Convert off-balance-sheet operating leases to the capital lease method.

14, 16 27, 28 35 - 37 45

LO4 – Explain and interpret the reporting for pension plans.

17 - 20 24, 30 38, 39 44

LO5 – Analyze and interpret pension footnote disclosures.

18 - 20 24, 29, 30 38, 39 44

LO6 – Describe and interpret accounting for income taxes.

22 31 - 34 40 - 43 46, 47



DISCUSSION QUESTIONS Q10-1. Under an operating lease, the lessor retains the usual risks and rewards of

owning the property. In accounting for an operating lease, the lessee doesn’t record either the leased asset or the lease liability on the balance sheet, and normally charges each lease payment to rent expense. In contrast, a capital lease transfers to the lessee substantially all of the risks and rewards relating to the ownership of the property. Accordingly, the lessee accounts for a capital lease by recording the leased property as an asset and establishing a liability for the lease obligation. The leased asset is subsequently depreciated, and interest expense is accrued on the lease liability.

Q10-2. The leasing footnote is reasonably complete to allow for capitalization of operating leases for analysis purposes. Despite the quality of the leasing disclosures, on-balance-sheet treatment is, arguably, a more direct form of communication from the company and, as a result, is more easily interpreted by users of its financial statements.

Q10-3. Yes, over the term of the lease the rent expense on an operating lease will be equal to the sum of the interest and depreciation on a capital lease. Only the timing of the expense recognition changes. Expense is ultimately related to the cash flows required to discharge the obligation. Those cash flows are the same whether or not the lease is capitalized.

Q10-4. Under defined contribution plans, companies make contributions to the plans which, together with earnings on the amounts invested, provide the sole source of funding for payments to retirees. Under defined benefit plans, the obligations are defined with payment to be made in the future from general corporate funds. These plans may or may not be fully funded. Since the company’s obligation is extinguished upon payment for a defined contribution plan, the accounting is relatively simple: record an expense when paid or accrued. Defined benefit plans present a number of complications in that the liability is very difficult to estimate and involves a number of critical assumptions. In addition, companies lobbied for (and the FASB agreed to) various mechanisms to smooth the impact of pension costs on reported earnings. These smoothing mechanisms further complicate the accounting for defined benefit plans vis-à-vis defined contribution plans.

Q10-5. Although the accounting can get complicated, a net pension asset will be reported if the fair market value of the plan assets exceeds the plan obligation. Otherwise, a net liability will be reported on the balance sheet to represent the underfunding of the pension obligation.

Q10-6. Service cost, interest cost and the expected return on plan investments (a reduction of the pension cost) are the basic components of pension expense. Companies might also report amortization of deferred gains and losses.



Q10-7. The use of expected returns and the deferral of unexpected gains and losses act to smooth corporate earnings by removing the effects of swings in the market values of investments and variation in pension liabilities resulting from changes in actuarial assumptions or plan amendments.

Q10-8. For a capital lease, the initial value of the lease asset and the lease obligation are determined by calculating the present value of the minimum lease payments. The minimum lease payments include those payments that are not subject to options or contingencies, including any guaranteed residual value.

Q10-9. Retirement benefits are normally expensed in the period in which they are earned by the employee, not when they are paid. Some benefits are calculated for periods of employment prior to the inception of a pension plan or prior to a plan amendment. The cost of these benefits (called prior service costs) is expensed by amortizing the cost over the average expected future period of employee service.

Q10-10. The amount of the accumulated benefit obligation in excess of the fair value of the plan assets must be reported as a minimum pension liability. If the accrued pension liability that is reported in the balance sheet is smaller than the minimum liability, then an additional pension liability, equal to the difference, must be reported.

Q10-11. A tax payment would be recorded as deferred taxes under two situations. First, if the company is required to make a tax payment (based on the higher taxable income reported on the tax return) but not record that payment as tax expense, a deferred tax asset is recorded. Deferred tax assets result from those situations where an expense is recognized and recorded in the income statement, but is not deductible on the company’s tax return in the current period. This produces higher income on the tax return and tax payments that are higher than tax expense. The excess payment is recorded as an increase (debit) to a deferred tax asset.

The second situation arises when a deferred tax liability reverses. In this situation, tax expense has been recognized in excess of tax payments in prior years. When the tax return “catches up with” the income statement, the tax deferral reverses and the deferred tax liability is reduced (debited). In either situation, the deferred tax account (either asset or liability) is debited and cash is credited.



MINI EXERCISES M10-12. (15 minutes) a. i.

1/1 No entry

12/31 Rent expense (+E, -SE) …………………………. 12,000 Cash (-A) …………………………………… 12,000

ii.

1/1 Leased asset (+A) ……………………………….. 57,198 Lease liability (+L) ………………………… 57,198 $57,198 = $12,000 x 4.76654 12/31 Depreciation expense (+E, -SE) ……………...… 9,533 Accumulated depreciation (+XA) ………… 9,533 $9,533 = $57,198 / 6.

12/31 Lease liability (-L) ………………………………… 7,996 Interest expense (+E, -SE) ……………………… 4,004 Cash (-A) ………………………………… 12,000 $4,004 = $57,198 x .07; $7,996 = $12,000 - $4,004.

b.

+ Cash (A) - - Lease Liability (L) + 12,000 12/31 57,198 1/1 12/31 7,996

+ Leased Asset (A) - + Interest Expense (E) - 1/1 57,198 12/31 4,004

- Accumulated Depreciation (XA) + + Depreciation Expense (E) -

9,533 12/31 12/31 9,533

c.



+


Assets = Liabil -ities + Contrib.


Income Signed a capital lease.

+57,198 Leased Asset

-

= +57,198 Lease

Liability

- =

Depreciation on leased asset.

-

+9,533 Accumulated Depreciation =

-9,533

Retained Earnings

-

+9,533 Deprec. Expense = -9,533

Made annual lease payment. -12,000

Cash

-

=

-7,996 Lease

Liability

-4,004

Retained Earnings

-

+4,004 Interest Expense = -4,004



M10-13. (20 minutes)

a. 7/1 Leased asset (+A) ……………………………….. 123,100 Lease liability (+L) ………………………. 123,100 $123,100 = 4,500 x 27.35548

b.

9/30 Depreciation expense (+E, -SE) ……………….. 3,078 Accumulated depreciation (+XA, -A) …. 3,078 $3,078 = $123,100 / (10 x 4).

9/30 Lease liability (-L) ……………………………….. 2,038 Interest expense (+E, -SE) ……………………… 2,462 Cash (-A) …………………………………… 4,500 $2,462 = $123,100 x (.08/4); $2,038 = $4,500 - $2,462.

12/31 Depreciation expense (+E, -SE) ……………….. 3,078 Accumulated depreciation (+XA, -A) …. 3,078

12/31 Lease liability (-L) ……………………………….. 2,079 Interest expense (+E, -SE) ……………………… 2,421 Cash (-A) …………………………………… 4,500 $2,421 = ($123,100 - $2,038) x (.08/4); $2,079 = $4,500 - $2,421.

c.

+ Cash (A) - - Lease Liability (L) + 4,500 9/30 123,100 7/1 4,500 12/31 9/30 2,038 12/31 2,079

+ Leased Asset (A) - + Interest Expense (E) - 7/1 123,100 9/30 2,462

12/31 2,421

- Accumulated Depreciation (XA) + + Depreciation Expense (E) - 3,078 9/30 9/30 3,078 3,078 12/31 12/31 3,078

continued next page



M10-13. concluded d.



+




Signed a capital lease.

+123,100 Leased Asset

-

= +123,100

Lease Liability

- =


-

+3,078 Accum. Deprec. =

-3,078

Retained Earnings

-


Made quarterly lease payment. -4,500

Cash

-

=

-2,038 Lease

Liability

-2,462

Retained Earnings

-

+2,462 Interest

Expense = -2,462


-

+3,078 Accum. Deprec. =


-


Made quarterly lease payment. -4,500

Cash

-

= -2,079 Lease

Liability


-

+2,421 Interest

Expense = -2,421

e.

7/1 No entry

9/31 Rent expense (+E, -SE) ………………………… 4,500 Cash (-A) …………………………………… 4,500

12/31 Rent expense (+E, -SE) ………………………… 4,500 Cash (-A) …………………………………… 4,500

The amount of rent expense recognized if the lease is treated as an operating lease is $9,000 ($4,500 + $4,500). However, if the lease is treated as a capital lease, interest and depreciation are recognized. The total expense for 2014 is $11,039 ($2,462 + $2,421 + $3,078 + $3,078). The capital lease method tends to report higher expense in the early periods of the lease.

M10-14 (10 minutes) a. Leased asset (+A) ……………………………………… 74,520 Lease liability (+L) ………………………………. 74,520 b. Prepaid rent (+A) ……………………………………….. 1,000 Cash (-A) …………………………………………… 1,000



M10-15. (15 minutes) a. Capital leases record both the leased asset and the lease liability on the face of the

balance sheet. Operating leases, by contrast, do not record either the leased asset or the lease liability. They are, as a result, a common technique to achieve off-balance-sheet financing. Concerning the income statement, capital leases result in depreciation of the leased asset and interest expense on the lease liability. Operating leases record only rent expense.

b. Analysts frequently add the present value of the operating lease payments to both assets and liabilities, thus capitalizing the operating lease. This adjustment improves the interpretation of measures of financial leverage and operating performance. If Yum’s operating lease commitments in total are substantial, they could have a significant impact on the assessment of financial leverage. Yum indicates no individual lease is material. However, the total commitment could be substantial.

M10-16. (20 minutes) a. Present value of expected operating lease payments for Yum! Brands using a the

Table A2 in Appendix A, I/YR=7:

Year ($ millions)

Operating Lease Payment

Present Value Factor

Present Value

2012 ........................ $ 612 0.93458 $ 572.0 2013 ........................ 578 0.87344 504.8 2014 ........................ 538 0.81630 439.2 2015 ........................ 494 0.76290 376.9 2016 ........................ 462 0.71299 329.4 2017 ........................ 462 0.66634 307.8 2018 ........................ 462 0.62275 287.7 2019 ........................ 462 0.58201 268.9 2020 ........................ 462 0.54393 251.3 2021 ........................ 462 0.50835 234.9 2022 ........................ 343 0.47509 163.0 $3,735.9

b. The capitalization of these operating leases increases Yum’s total liabilities by

54% to $10,654 million ($6,918 million + $3,736 million).



M10-17 (10 minutes) a. Pension expense (+E, -SE) …………………………… 16,000 Cash (-A) …………………………………….…….. 16,000 16,000 = 400,000 x .04. b. Bartov would report a net liability of $450,000 ($625,000 - $175,000) in its 2013

balance sheet. Because Bartov is effectively self-insured, it must report the estimated death benefit obligation net of any assets set aside to meet that obligation.

M10-18. (10 minutes) a. American Express is reporting $51 million in pension expense for 2011. b. Expected returns are an offset to service and interest costs and serve to reduce

reported pension expense. c. “Expected” refers to the use of long-term average returns for the investment portfolio.

Expected returns are used in the computation of pension expense, rather than actual returns, in order to smooth reported income.

M10-19. (10 minutes) a. Yum Brands is reporting $49 million of pension expense for 2011.

b. Expected returns are an offset to service and interest costs and serve to reduce

reported pension expense.

c. “Expected” refers to the use of long-term average returns for the investment portfolio.

Expected returns are used in the computation of pension expense, rather than actual returns, in order to smooth reported income.



M10-20. (10 minutes) a. A&F maintains a defined contribution plan for the benefit of its employees.

b. Contributions are expensed when made. The entry to record expenses for 2011 was

($ millions): Pension expense (+E, -SE) …………………… 16.4 Cash (-A) ………………………………… 16.4

c. Only the unpaid contribution, if any, appears on the A&F balance sheet. M10-21. (15 minutes) a. The use of contract manufacturers removes the manufacturing assets and related

liabilities from Nike’s balance sheet.

Because sales are unaffected, PPE turnover is increased by the removal of assets. The effect on net operating profit after taxes (NOPAT) is uncertain; depreciation is removed (interest on the liabilities incurred to purchase the manufacturing assets is also removed, but this is a nonoperating expense and, therefore, does not affect NOPAT), but Nike will pay a higher price for its manufactured goods in order to provide the manufacturer with a return on its investment. If the contract manufacturer is more efficient than Nike, however, the price increase is mitigated. Profitability will increase if the turnover effect more than offsets the negative effect on NOPAT and profit margin, which is likely.

b. Executory contracts are not recognized under GAAP. As a result, the use of contract

manufacturers achieves off-balance-sheet financing. This is one motivating factor for their use.



M10-22. (20 minutes) a, b, c.

Year Book Value Tax Basis (after depreciation deduction) Temporary

Difference Tax Rate

Deferred Tax Liability

2014 $300,000 $173,000 $127,000 40% $50,800

2015 $200,000 $173,000 - ($100,000 - $31,000) = $104,000 $96,000 40% $38,400

2016 $100,000 $104,000 - ($100,000 - $31,000) = $35,000 $65,000 40% $26,000 d. Because the deferred tax liability is reversing in years 2015, 2016 and 2017, part of the

deferred tax liability should be classified as a current liability each year. The amounts are presented in the following table.

Year Deferred

Tax Liability Long-Term Amount –Reversing

Beyond One Year Current Portion – Reversing

Within One Year

2014 $50,800 $38,400 $12,400

2015 $38,400 $26,000 $12,400

2016 $26,000 $0 $26,000



EXERCISES E10-23. (30 minutes) a. Present value of operating leases = $1,988 million, computed using the NPV

function in Excel:

b.

($millions) Balance Sheet Income Statement




Income

To capitalize operating leases

+1,988 Leased Asset

= +1,988 Lease

Liability

-

=

c. Recognition of the operating leases would reduce the current ratio. Recording the

leased asset would increase noncurrent assets by $1,988 million, but recording the lease liability would increase current liabilities by $75 million ($194 million - $1,988 million x 0.06), and noncurrent liabilities by $1,913 million ($1,988 - $75).

d. (in $millions)

Leased asset (+A) ……………………………….. 1,988 Lease liability (+L) ………………………. 1,988

+ Leased Asset (A) - - Lease Liability (L) +

1,988 1,988

e. No. The fixed commitment for 2012 ($194 million) represents less than 4% of

Targets operating cash flow.



E10-24. (15 minutes) a. Target maintains only a defined contribution plan for the benefit of its employees.

b. Contributions are expensed when made.

c. Only the unpaid contribution, if any, appears on Target’s balance sheet.

d. First, employees who do not meet the unspecified eligibility requirement will not be covered. Second, matching contributions can be reduced or eliminated in bad times. Third, employees covered by defined contribution plans must choose how those funds are invested and, consequently, they bear all of the risks of price volatility.

E10-25. (20 minutes) a. The Home depot reports $449 million as capital lease obligations in its 2011 balance

sheet. This amount is reported as $420 million in non-current liabilities and $29 million as a current liability. At the inception of these leases, the leased assets and lease obligations were equal to the present value of the minimum lease payments. Since that point in time, however, the leased assets are depreciated on a straight-line basis and the lease obligations are amortized using the effective interest method. The result is that the net asset value declines faster than the liability. At the end of fiscal 2011, assets totaled $328 million and obligations totaled $449 million.

b. Present value = $4,989 million using the NPV function in Excel:

c. Home Depot’s D/E ratio was 1.26 ([$40,518 million - $17,898 million]/$17,898 million). Adding capitalized operating leases would increase the ratio to 1.54 ([$40,518 million + $4,989 million - $17,898 million]/$17,898 million).



E10-26. (25 minutes) a. According to Verizon’s lease footnote, it has both capital and operating leases. Only

the capital leases are reported on-balance sheet in the amount of $352 million ($66 million in current liabilities and $286 million as long-term liabilities). This is not the total obligation to its lessors. Verizon also has a significant amount of leases that it has classified as operating. In fact, the minimum lease payments under operating leases are over 26 times that for capital leases! These operating leases are not reported on-balance-sheet.

b. Although capital leases are reported as an asset and liability on the balance sheet, neither the leased asset nor the lease obligation is reported on the balance sheet for Verizon’s operating leases. As a result, total assets and total liabilities are lower than they otherwise would be if these leases were reported as capital leases. Over the life of the lease, total rent expense under operating leases will be equal to the interest and depreciation expense that would have been recorded under capital leases. Profit is unaffected by this classification. During any give year during the life of the lease, however, the two will not be equal. Even if depreciation is computed on a straight-line basis, interest is accrued based on the balance of the lease obligation which is higher in the earlier years of the lease. As a result, depreciation plus interest will exceed rent expense during the early years of the lease life and will be less toward the end of the lease.

c. Interest expense will be $26 million. The entry for 2012 is as follows: Lease obligation (-L) ……………………………. 66 Interest expense (+E, -SE) ……………………… 26 Cash (-A) …………………………………... 92

d. The present value of Verizon’s operating leases totals $9,658 million. This amount

would be added to Verizon’s noncurrent assets and to its lease obligations if these operating leases were reported as capital leases.



E

E10-27. (20 minutes) a. Our analysis might capitalize (add to both assets and liabilities) the present value of the

expected operating lease payments. The present value is $1,539 million, computed as follows:

b. In 2012, Dow would report interest expense of $77 million ($1,539 million x 0.05) and

depreciation expense of approximately $96 million ($1,539/16 years), instead of rent expense of $223 million.

E10-28. (30 minutes) a. The present value of Nike’s operating lease payments is computed as follows:

The present value of Nike’s operating leases is computed to be $1,435 million. We might consider adjusting its balance sheet by adding this amount to both assets and liabilities.

continued next page



E10-28. concluded b.





Income To capitalize operating leases.

+1,435 Leased Asset

= +1,435 Lease

Liability

-

=

c.

1. Leased asset (+A) ……………………………. 1,435 Lease Liability (+L) ……………………. 1,435 2. Depreciation expense (+E, -SE) ………….… 143.5 Accumulated depreciation (+XA, -A)... 143.5 3. Lease liability (-L) …………………………… 273.5 Interest expense (+E, -SE) ……………….… 100.5 Cash (-A) …………………..……………. 374

d.

+ Leased Asset (A) - - Lease Liability (L) + 1 1,435 1,435 1

3 273.5 - Accumulated Depreciation (XA) + + Depreciation Expense (E) - 143.5 2 2 143.5

+ Cash (A) - + Interest Expense (E) - 374 3 3 100.5

E10-29. (15 minutes) a. Service cost is the increase in the pension obligation resulting from employees working

another year for the company. Interest cost is the accrual of interest on the (discounted) pension obligation.

b. Payments to retirees are made from the pension investment account. There is a corresponding reduction in the pension obligation.

c. The funded status is the pension obligation less the fair value of the plan assets. In this

case $1,381 million (pension obligation) – $998 million (plan assets) = $383 million funded status (underfunded amount).

d. A $383 million net pension liability is reported in the balance sheet.



E10-30. (20 minutes)

a. Service cost is the increase in the pension obligation resulting from employees working another year for the company. Interest cost is the accrual of interest on the (discounted) pension obligation.

b. Payments to retirees are made form the pension investment account. There is a corresponding reduction in the pension obligation.

c. The funded status is the pension benefit obligation less the fair value of the plan

assets. In this case $30,582 million – $24,110 million = $6,472 million funded status (underfunded amount).

d. A $6,472 million net pension liability is reported on the balance sheet.

E10-31. (20 minutes) a. In 2013, the temporary difference is $8,000. $8,000 x 40% = $3,200. In 2014, the temporary difference reverses and no liability would be reported. b. Income tax expense (+E, -SE) ………………….. 91,200 Income taxes payable* (+L) ………………. 88,000 Deferred income tax liability (+L) ……….. 3,200

*($236,000 – $16,000) x 40% = $88,000. Income tax expense (+E, -SE) …………………. 94,800 Deferred income tax liability (-L) ……………… 3,200 Income taxes payable* (+L) ……………… 98,000

*($245,000 – $0) x 40% = $98,000.

c. Income tax expense (+E, -SE) …………………. 80,200 Income taxes payable (+L)* ……………… 77,000 Deferred income tax liability (+L) ………. 3,200

*($236,000 – $16,000) x 35% = $77,000.

Income tax expense (+E, -SE) …………………. 94,800 Deferred income tax liability (-L) ……………… 3,200 Income taxes payable (+L)* ……………….. 98,000

*($245,000 – $0) x 40% = $98,000.

continued next page



E10-31. concluded The solution to part c depends on what the company knew, in 2013, about the tax rate in 2014. In the journal entries above, the assumption is that the tax rate is 35% in 2013, but is supposed to change to 40% in 2014. However, if the change in the tax rate was not known, the following entries would be required:

c. Income tax expense (+E, -SE) …………………. 79,800 Income taxes payable (+L)* ……………… 77,000 Deferred income tax liability (+L) ** ……. 2,800

*($236,000 – $16,000) x 35% = $77,000. **$8,000 x 0.35 = $2,800

Income tax expense (+E, -SE) ............................................................................. 95,200 Deferred income tax liability (-L) ......................................................................... 2,800 Income taxes payable* (+L) ................................................................................... 98,000

*($245,000 – $0) x 40% = $98,000. Either way, the amount of income tax expense is determined as a plug amount.

E10-32. (15 minutes) a. $12,000 x 40% = $4,800. b. Because the source of the temporary difference is a noncurrent asset (PP&E), the

deferred tax liability would be classified as a noncurrent liability. c. $8,000 x 40% = $3,200.

E10-33. (15 minutes) a.





Income To record income

tax expense

=

+787 Taxes

Payable -76

Deferred Taxes

-711 Retained Earnings

-

+711 Income

Tax Expense

= -711

b. Deferred income taxes (-L) ……………….….….… 76 Income tax expense (+E, -SE) ……………..…..… 711 Income taxes payable (+L) …………………. 787

continued next page



E10-33. concluded

c. An expense of $711 million is recorded in the income statement, thereby reducing both net income and retained earnings. Liabilities are increased by $711 million, $787 million in income taxes payable less the decrease of $76 million in deferred income taxes.

d. 2009: 24.0% ($470/$1,957); 2010: 24.2% ($610/$2,517); 2011: 25.0% ($711/$2,844)

E10-34. (15 minutes) a.





Income a. To record income

tax expense.

+534 Taxes

Payable =

+1,916 Deferred

Taxes

-1,382

Retained Earnings

-

+1,382 Income

Tax Expense

= -1,382

b.

Income tax expense (+E, -SE) …..…….. 1,382 Tax refund receivable (+A) ……………. 534 Deferred income taxes (+L) ……. 1,916

c. An expense of $1,382 million is recorded in the income statement, thereby reducing

both net income and retained earnings. However, Boeing reports a negative current tax expense of $534 million. Thus, it expects a net refund of this amount and records a receivable of $534 million in its balance sheet. It also records an increase in deferred tax liabilities of $1,916 million.

The refund is most likely due to one of two sources: (1) an operating loss recorded in

2011 for tax reporting purposes or (2) a tax loss carryforward.



PROBLEMS P10-35. (25 minutes) a. The present value of Staples operating lease payments is computed as follows:

The present value of Staples’ operating leases is computed to be $3.574 billion. We might consider adjusting its balance sheet by adding this amount to both assets and liabilities. Staples’ liabilities are 56% higher following this adjustment (adjusted liabilities are $6.408 billion + $3.574 billion = $9.982 billion).

b.

($ 000s) Balance Sheet Income Statement




Income To capitalize operating leases.

+3,573,646 Leased Asset

= +3,573,646

Lease Liability

-

=

c.

2011 Leased asset (+A) ……………………………... 3,573,646 Lease liability (+L) ……………………… 3,573,646 2012 Depreciation expense (+E, -SE) ……….……. 397,072 Accumulated depreciation (XA, -A) ..… 397,072 Interest expense (+E, -SE) ……..………..…… 250,155 * Lease liability (-L) ……………………..………. 616,992 Cash (-A) ………………………………….. 867,147 * $250,155 = $3,573,646 x 0.07.

continued next page



P10-35. concluded d.

+ Leased Asset (A) - - Lease liability (L) + 2011 3,573,646 3,573,646 2011

2012 616,992

- Accumulated Depreciation (XA) + + Depreciation Expense (E) - 397,072 2012 2012 397,072

+ Cash (A) - + Interest Expense (E) - 867,147 2012 2012 250,155

P10-36. (60 minutes) a. Rent expense (+E, -SE) ………………………………. 209,000,000 Cash (-A) ……………………………………………. 209,000,000 b. Outback would report a lease liability of $939,621,000 at December 31, 2011 if the

operating leases were capitalized.

c. In 2012, Outback would report interest expense of $75,169,680 ($939,621,000 x .08)

and depreciation expense of $93,962,100 ($939,621,000/10) instead of rent expense of $179,814,000. In 2011, it would also report interest and depreciation instead of rent expense. The $209.0 million in rent expense reported for 2011 most likely includes some contingent rentals (rent based on some measure of usage, such as sales revenue). These contingent rentals are reported as rent expense even if the leases are capitalized. Therefore, it is impossible to say exactly how much of the 2011 rent expense would be replaced by the interest and depreciation.

In the early years of a lease the higher interest expense causes the capitalization of leases to increase expenses compared to the rent expense. This situation reverses in the later years of the lease.

continued next page



P10-36. concluded d. Capitalizing leases is reflected in the financial statement effects template below.

($000s) Balance Sheet Income Statement


+


Assets = Liabil- ities + Contrib.


Income Capitalize operating leases

+939,621 Leased Assets -

=

+939,621 Lease

Obligations

-

=

e. In the statement of cash flows, the rent expense on operating leases is classified as

an operating cash flow. Although the total cash flow is the same, if the lease is treated as a capital lease, then part of the lease payment (the interest) is classified as operating and the remainder (the principal) is classified as a financing cash flow. Depreciation on the lease is deducted in the computation of income but added back in the operating section of the cash flow statement because it is not a cash flow.

P10-37. (40 minutes) a. Best Buy reports $276 million of capital leases as assets and in its liabilities of which

$46 million due in 2013 is reported as a current liability. The $7,517 of operating leases are not reported in the balance sheet nor are the related leased assets.

b. Total assets and total liabilities are lower than the balance that would have been reported had the leases been capitalized. Over the life of the lease, total rent expense under operating leases will be equal to the interest and depreciation expense that would have been recorded under capital leases. In any given year of the lease, however, the two will not be equal. If depreciation is computed on a straight-line basis, interest is accrued based on the balance of the lease obligation, which is higher in the earlier years of the lease. As a result, depreciation plus interest will exceed rent expense during the early years of the lease life and will be less toward the end of the lease. Over the life of the lease, profit is unaffected by this classification.

c. Using a 10% discount rate, the present value of Best Buy’s operating leases payments

is $5,203 million, computed as follows:

continued next page



P10-37. continued d.





Income To capitalize operating leases at Mar. 3, 2012.

+5,203 Leased Asset

= +5,203 Lease

Liability +

-

=

To record depreciation expense in 2013

-520.3 Accumulated

Depreciation – Leased Asset

=

+ -520.3

Retained Earnings

-

+520.3 Depreciation

Expense = -520.3

To record lease payments in 2013

-1,216 Cash =

-695.7 Lease

Liability +

-520.3 Retained Earnings

-

+520.3 Interest Expense

-520.3

e. March 3, 2012

1. Leased asset (+A) ………………………………. 5,203 Lease liability (+L) ……………………….. 5,203

2013 2. Depreciation expense (+E, -SE) ………………. 520.3 Accumulated depreciation (+XA, -A) ….. 520.3 $520.3 = $5,203 / 10

3. Lease liability (-L) ……………………………….. 695.7 Interest expense (+E, -SE) …………………….. 520.3 Cash (-A) …………………………………… 1,216 $520.3 = $5,203 x 0.10

f.

+ Cash (A) - - Lease Liability (L) + 5,203 1. 1,216 3. 3. 695.7

+ Leased Asset (A) - + Interest Expense (E) - 1. 5,203 3. 520.3

- Accumulated Depreciation (XA) + + Depreciation Expense (E) - 520.3 2. 2. 520.3

Note: The interest expense is the same as the depreciation charge because interest is at 10% and depreciation is over 10 years. This is only true in 2013. Thereafter, interest will decline as the balance in the lease liability declines.

continued next page



P10-37. concluded g. The effect of a failure to report the leased assets and related lease obligation on-

balance-sheet understates assets and liabilities. Gross margin and net income are largely unaffected if we assume that the leases are approximately at the midpoint of their lives, on average. Capitalization of the leases would increase the asset base, which would, in turn, lower asset turnover. Hence turnover rates are overstated by the failure to capitalize the leases. The debt to equity ratio would be increased. Overall these two factors offset each other leaving ROE only marginally affected. Our conclusion of how Best Buy is achieving its ROE is likely to be altered because Best Buy would have lower turnover and higher financial leverage than was apparent based on the published (unadjusted) financial statements.

P10-38. (30 minutes) a. FedEx recognized $543 million as pension expense in 2011. b. The expected return is computed as the beginning fair market value of the pension

plan assets multiplied by the long-term expected return on these investments. For 2011, this is computed as $13,295 8% = $1063.6, slightly more than the reported amount of $1,062 million. The plan assets reported an actual return of $2,425 million. U.S. GAAP permits the use of the expected long-term rate of return in order to smooth earnings. If actual returns were to be used, corporate profits would fluctuate greatly with swings in investment returns. The logic behind using the long-term rate is that investment returns are expected to fluctuate around this average and its use more accurately captures the average cost of the pension plan. (It is similar to the logic of reporting held-to-maturity bond investments at historical cost rather than current market value.)

c. The pension liability is increased by the service and interest costs and decreased by

any payments made to plan participants. The actuarial loss (gain) relates to the effects on the pension obligation of changes in assumptions used to compute it, such as the discount rate or the rate of expected wage inflation. The pension plan assets are increased (decreased) by investment gains (losses), are increased by company contributions and are decreased by benefits paid to plan participants.

d. The “funded status” is the excess (deficiency) of the pension obligation over plan assets. If plan assets exceed pension obligation, the funded status is positive or overfunded. If pension obligations exceed the fair value of plan assets, the funded status is negative or underfunded. The funded status of the FedEx pension plan is $(1,531) million at the end of 2011. Pension obligations are $17,372 million and plan assets are $15,841 million. FedEx should report its net funded status as a net pension liability of $1,531 million on its balance sheet.

continued next page



P10-38. concluded e. Because the pension obligation is the present value of expected pension payments, an

decrease in the discount rate increases the present value reported on the balance sheet. The effect on the income statement is more difficult to predict. The interest cost component of pension expense is the product of the beginning of the year pension obligation and the discount rate. In 2011, the effect of a decrease in the discount rate is to apply a lower discount rate to a higher pension obligation. These two effects are offsetting, but usually result in lower interest cost.

f. The estimated wage inflation rate is used to project future benefit payments.

Decreasing the estimated inflation rate decreases the pension obligation because a lower amount of payments to plan participants is projected. Decreasing the expected wage inflation rate reduces service cost and decreases the pension obligation reported on the balance sheet and, consequently, the interest component of pension expense. It is an income-increasing action.

P10-39. (20 minutes) a. Service cost is the increase in the pension obligation resulting from employees working

another year for the company. Interest cost is the accrual of interest on the (discounted) pension obligation.

b. The “actual” return on plan assets is $89 million in 2011.

c. Actuarial losses (gains) generally arise as a result of decreases (increases) in the

discount rate used to compute the pension obligation (PBO). Because the PBO is the present value of expected future payouts to retirees, a decrease in the discount rate results in an increase in the PBO. This decrease is recorded as an actuarial loss.

d. Payments to retirees are made from the plan assets account. There is a corresponding reduction in the pension obligation.

e. American Express contributed $35 million to its pension plans in 2011. f. American Express paid $1287 million to its retirees in 2011. g. The funded status is the pension obligation less the fair value of the plan assets. In this

case $2,512 million – $2,069 million = $443 million underfunded amount. h. A $443 million net pension liability is reported on the balance sheet.



P10-40. (20 minutes) a. Tax expense – 2011: $5,732 million; 2010: 1,033 million; 2009: -1,142 million. Current taxes due – 2011: $5,935 mil.; 2010: $103 mil.; 2009: $1,636 mil. b. 2011: $5,732 / $20,098 = 28.5% 2010: $1,033 / $14,085 = 7.3% 2009: $(1,142) / $9,864 = -11.6% c. Deferred tax liabilities are created when a company reports greater revenues and/or

lower expenses in the income statement than are reported on the tax return. The most common cause is the use of accelerated depreciation for taxes and straight-line depreciation for financial reporting. When these deferred taxes reverse (late in the asset’s life) the deferred tax liability is reduced.

d. Deferred tax assets arise when income is recognized for tax purposes before it is

recognized in the financial statements, such as can be the case with advance payments from customers. Receipt of the cash creates a deferred tax asset as revenue is recognized on the tax return but deferred in the financial statements. Alternatively, deferred tax assets may arise when the tax return defers expenses that are recognized in the financial statements. Examples include bad debt expense and warranty expense. A restructuring charge is another example of the latter. Restructuring charges are not recognized in the tax return until they are realized (cash paid or assets sold at a loss).

P10-41. (15 minutes) a. Temporary differences – 2013: $32,000 - $24,000 = $8,000; 2014: ($32,000 + $37,000) – ($24,000 + $26,000) = $19,000. b. Deferred tax liability – 2013: $8,000 x 40% = $3,200; 2014: $19,000 x 40% = $7,600 c. $19,200 + ($7,600 – $3,200) = $23,600 d. Income tax expense (+E, -SE)…………………… 23,600 Income taxes payable (+L) ...……………… 19,200 Deferred tax liability (+L) …………..……… 4,400

+ Income Tax Expense (E) - - Income Taxes Payable (L) + - Deferred Tax Liability (L) + (d) 23,600 19,200 (d) 4,400 (d)



P9-42. (15 minutes) a. Temporary differences – 2013: $140,000 - $130,000 = $10,000; 2014: ($140,000 + $122,000) – ($130,000 + $128,000) = $4,000. b. Deferred tax liability – 2013: $10,000 x 35% = $3,500; 2014: $4,000 x 35% = $1,400 c. $45,150 + ($1,400 – $3,500) = $43,050 d. Income tax expense (+E, -SE)…………………… 43,050 Deferred tax liability (-L) ………………………… 2,100 Income taxes payable (+L) ……………….. 45,150 + Income Tax Expense (E) - - Income Taxes Payable (L) + - Deferred Tax Liability (L) + (d) 43,050 45,150 (d) (d) 2,100 P10-43. (20 minutes) a, b, c.

Assume that the tax rate increase in 2011 was not known until 2010. a. Book

Value b. Tax

Basis Temporary Difference

c. Deferred Tax Liability

2013 $12,000 $0 $12,000 $4,200 ($12,000 x 0.35) 2014 $6,000 $0 $6,000 $2,400 ($6,000 x 0.40) 2015 $0 $0 $0 $0

d. 12/31/09 Income tax expense (+E, -SE) ..………………… 112,000 Deferred income tax liability (+L)………… 4,200 Income taxes payable (+L)* ……………..… 107,800

*$308,000 x 0.35 = 107,800. 12/31/10 Income tax expense (+E, -SE) …….…………… 138,200 Deferred income tax liability (-L) ….…………… 1,800 Income taxes payable (+L)* ……..………. 140,000

*$400,000 x 0.35 = $140,000. 12/31/11 Income tax expense (+E, -SE) ………………….. 165,600 Deferred income tax liability (-L) ……………… 2,400 Income taxes payable (+L)* ……………… 168,000

*$420,000 x 0.40 = $168,000. The expense is determined as a plug amount.



CASES and PROJECTS C10-44. (30 minutes) a. Dow Chemical reported net pension expense of $561 million for 2011. b. The expected rate of return is computed as the beginning fair value of the pension plan

assets multiplied by the long-term expected return on these investments. For 2011, expected return was $$1,305 on assets of $15,851 million. This implies an expected rate of return of 8.23% ($1,305 / $15,851).

c. The pension liability is increased by the service and interest costs and decreased by

any payments made to plan participants. The actuarial loss (gain) relates to the effects of changes in assumptions used to compute the pension obligation, such as the discount rate or the rate of expected wage inflation. The pension plan assets are increased (decreased) by investment gains (losses), are increased by company contributions, and are decreased by benefits paid to plan participants.

d. The “funded status” is the excess (deficiency) of the pension obligation over plan

assets. If plan assets exceed pension obligation, the funded status is positive. If pension obligations exceed the fair value of plan assets, the funded status is negative. The funded status of the Dow Chemical pension plan is $(6,644) million at the end of 2011. Thus, the pension is underfunded and the balance sheet should show a net pension liability of $6,644 million.

e. Since the pension obligation is the present value of expected pension payments, a

decrease in the discount rate increases the present value reported on the balance sheet. The effect on the income statement is more difficult to predict. The interest cost component of pension expense is the product of the beginning-of-the-year pension obligation and the discount rate. The effect of a decrease in the discount rate is to apply a lower interest rate to a larger pension obligation. Interest expense on the pension liability will usually decrease in this circumstance. However, the actuarial “gain” resulting from the lower liability amount may offset the higher interest cost.

f. An increase in expected return unambiguously increases profitability as pension cost is

reduced. This result occurs because the long-term expected rate of return is used to compute the expected return that is subtracted in the computation of pension expense.

g. Inflation rates differ from country to country. For 2011, those rates are generally higher outside the U.S. where Dow operates. Inflation is expected to increase in the U.S. and could exceed the rates in other countries implying relatively higher compensation levels. Discount rates vary across countries as well, due in part to differences in inflation.



C10-45. (40 minutes) a.

2011 Rent expense (+E, -SE) …………………………. 847 Cash (-A) …………………………………... 847

2012 Rent expense (+E, -SE) …………………………. 640 Cash (-A) …………………………………... 640

Note: the rent expense in 2011 most likely includes contingent rentals, such as charges based on the number of hours a plane is flown. These contingent rentals are not included in the minimum rental obligation for 2012.

b. The total liability reported on the 2011 balance sheet is $42 million. Of this amount, $3

million would be classified as a current liability leaving a noncurrent liability of $39 million.

This amount only reflects those leases that Southwest classified as capital leases.

Operating leases represent many times that amount and are not recorded on its balance sheet.

c.

i. Leased assets (+A) ……………………………… 45 Lease liability (+L) ……………………….. 45

ii. Depreciation expense (+E, -SE) ………………. 7 Accumulated depreciation (+XA, -A) ….. 7

+ Leased Asset (A) - - Lease Liability (L) +

i. 45 45 i.

- Accumulated Depreciation (XA) + + Depreciation Expense (E) - 7 ii. ii. 7

d.

Lease liability (-L) ……………………………….. 3 Interest expense (+E, -SE) …………………….. 3 Cash (-A) …………………………………… 6

+ Cash (A) - - Lease Obligation (L) + + Interest expense (E) -

6 3 3

continued next page



C10-45. concluded e. Using a 6% discount rate, the present value of Southwest’s operating lease payments

is computed as follows:

If operating leases were capitalized, Southwest would report additional assets of

$4,182 million and additional liabilities of $4,182 million as well. The liabilities would be split between current liabilities of $389 million ($640 million - $4,182 million x 0.06) and noncurrent liabilities of $3,793 million ($4,182 - $389). Its long-term debt would increase by 122% from $3,107 million to $6,900 million ($3,107 + $3,793).

f. Not including the entry to record payments on existing capital leases, which are

recorded in d above, the entry to record lease payments would be:

Lease liability (-L) ……………………………….. 389 Interest expense (+E, -SE) …………………….. 251 Cash (-A) …………………………………… 640

+ Cash (A) - - Lease Obligation (L) + + Interest expense (E) -

640 389 251



C10-46. (30 minutes) a. $144,899

b. 2012: $144,899 / $381,830 = 37.95%. 2011: $122,833 / $323,060 = 38.02%

Current: $104,370 / $367,620 = 28.4% Deferred: $15,650 / $367,620 = 4.26%

c. $41,997 - $22,435 + $130,689 = $150,251 million d. Income tax expense (+E, -SE) …………………….……. 144,899 Deferred tax asset – current (+A) …..…………………. 6,132* Income taxes payable …………………………………... 19,652 Deferred tax asset – noncurrent (-A) ………….. 20,432** Cash (-A) …..………………………………………… 150,251 * $91,744 – $85,612 = $6,132; **Plug to balance. e. $734,672 – $9,008/0.35 = $708,935 million. f. Prepaid catalog expenses are capitalized and amortized for financial reporting

purposes. However, for tax reporting purposes, the costs are expensed when paid. Consequently, the tax deduction is recognized before the expense is recognized in the income statement. The prepaid catalog expense of $34,294 represents a temporary difference between financial and tax reporting. The resulting deferred tax liability of $12,869 offsets the current deferred tax assets in the balance sheet.

C10-47. (30 minutes) a. Domestic: 2011: ($1,724 + $274 + $452 - $109) / $4,693 = 49.9% 2010: ($1,657 + $458 - $25 + $47) / $4,948 = 43.2% 2009: ($1,531 + $450 - $273 + $13) / $3,579 = 48.1% Foreign: 2011: ($248 + $0) / $7,633 = 3.2% 2010: ($167 - $13) / $5,848 = 2.6% 2009: ($148 - $8) / $4,802 = 2.9% Total: 2011: $2,589 / ($4,693 + $7,633) = 21.0% 2010: $2,291 / ($4,948 + $5,848) = 21.2% 2009: $1,861 / ($3,579 + $4,802) = 22.2%

continued next page



C10-47. concluded b. Of its retained earnings of $37.6 billion, $24.8 billion, or 66%, have been earned and

retained in operations outside of the United States. Because retained earnings is a stockholders’ equity account, its location is meaningless. Of greater importance is the location of net assets that were obtained by reinvesting operating cash flows. Whenever resources are transferred into the United States, companies must typically pay U.S. taxes on those profits that were earned in a foreign country, but will receive a credit for any taxes paid to foreign entities.

c. Using 2011 tax rates, Google might owe $24.8 billion x (49.9% - 3.2%) = $11.6 billion.

This is a very rough guess, however. As long as Google doesn’t move its assets from foreign subsidiaries into the U.S., it may never have to pay these taxes. In the mean time however, there are plenty of ways that Google can get access to these resources without paying U.S. taxes. For example, a bank in the U.S. can lend money in the U.S. using foreign assets as collateral. As long as Google doesn’t default on the loan, the collateral remains in the foreign country and Google can use the borrowed funds within the U.S. without paying taxes on the collateral funds.



Chapter 11 Reporting and Analyzing Stockholders’ Equity



LO1 – Describe business financing through stock issuances.

37, 38 41 62, 63

LO2 – Explain and account for the issuance and repurchase of stock.

19 - 22,

25, 36 - 38

39 - 41,

45, 52, 54 55 - 59 62 - 64

LO3 – Describe how operations increase the equity of a business.

30 41 62 - 64

LO4 – Explain and account for dividends and stock splits.

23, 26 - 31,

36, 38

42, 44,

46 - 51, 54 58

LO5 – Define and illustrate comprehensive income.

59, 60

LO6 – Describe and illustrate basic and diluted earnings per share computations.

23 - 25,

32 - 34,

36, 37

41, 43, 44,

50, 54 55 - 57

LO7 – Appendix 11A: Analyze the accounting for convertible securities, stock rights, and stock options.

35 53 59, 60 61



DISCUSSION QUESTIONS Q11-1. Par value stock is stock that has a face value printed (identified) on the stock

certificate. From an accounting standpoint, the par value of the common stock is the

amount added to the common stock portion of paid-in-capital upon the issuance of stock. The remainder of the issue price is added to the additional paid-in-capital portion of paid-in-capital. There are no analysis implications of the par value of stock.

Q11-2. Preferred stock usually takes priority over common stock in the receipt of a specified amount of dividends and in the distribution of assets if the corporation is ever liquidated. Also, preferred stock does not usually have voting rights.

Typically, preferred stock has the following features: 1) Preferential claim to dividends and to assets in liquidation, 2) Cumulative dividend rights, and 3) No voting rights.

Q11-3. Preferred stock is similar to debt when 1. Dividends are cumulative. 2. Dividends are nonparticipating. 3. It has a preference to assets in liquidation.

Preferred stock is similar to common stock when 1. Dividends are not cumulative. 2. Dividends are fully participating. 3. It is convertible into common stock. 4. It does not have a preference to assets in liquidation. Q11-4. Dividend arrearage on preferred stock is the aggregate amount of dividends on

cumulative preferred stock that has not been declared to date. The amount of dividends in arrears and a current dividend must be paid to preferred stockholders before common stockholders can receive any dividends. In the example, preferred stockholders must receive $90,000 in dividends ($500,000 0.06 3 years = $90,000) before common stockholders receive any

dividends. Q11-5. A corporation's authorized stock is the maximum number of shares of stock it

may issue. The authorized amounts and classes of stock are enumerated in the company's charter when the corporation is formed. A corporation can later amend its charter to change the amount of authorized capital, but such action must have the approval of the company’s shareholders. Shares that have been sold and issued to stockholders are the company's issued stock. Shares that have been sold and issued can be subsequently reacquired by the corporation—called treasury stock. When treasury stock is held, the issued shares exceed the outstanding shares.



Q11-6. Contributed capital represents the total investment that has been paid in to the company by its shareholders as a result of the purchase of stock. Earned capital represents the cumulative net income that has been earned, less the portion of that income that has been paid out to shareholders in the form of dividends.

When profit is earned, shareholders have the option of paying out that profit as a dividend or reinvesting the earnings in order to grow the company. In fact, many companies title the Retained Earnings account as Reinvested Earnings. Earned capital, thus, represents an implicit investment by the shareholders in the form of forgone dividends.

Q11-7. Paid-in capital is divided into two accounts: the common or preferred stock account and additional paid-in capital. The common stock or preferred stock accounts are increased by the par value of the shares issued and the additional paid-in capital account is increased for the balance of the proceeds received from the sale of the shares. The balance of the paid-in capital account is affected by the par value of the stock; the higher (lower) the par value, the lower (higher) the additional paid-in capital. Although paid-in capital will, in general, be higher if the stock price is higher, the breakdown of paid-in capital between the common or preferred stock accounts and additional paid-in capital does not yield any inferences regarding the financial condition of the company.

Q11-8. A stock split refers to the issuance of additional shares of a class of stock to the current stockholders in proportion to their ownership interests, normally accompanied by a proportionate reduction in the par or stated value of the stock. For example, a 2-for-1 stock split doubles the number of shares outstanding and halves the par or stated value of the shares. Consequently, there is no change in the amount of contributed capital associated with that class of stock. The major reason for a stock split is to reduce the per-share market price of the stock. Another possible reason is to influence shareholders’ in believing there has been some distribution of value.

Q11-9. Treasury stock is a corporation's issued stock that has been reacquired by the issuing corporation through purchases of its stock from its shareholders. A corporation often purchases treasury stock for distribution to employees under stock option plans or to offset dilution resulting from such sales. It is also used by management to prop up stock price when management believes its stock is inappropriately underpriced.

On the balance sheet, treasury stock should be carried at its cost and is shown as a deduction in deriving the total stockholders' equity—known as a contra equity account.

Q11-10. The $2,400 increase should not be shown on the income statement as any form of income or gain. The $2,400 is properly treated as additional paid-in capital and is shown as such in the stockholders' equity section of the balance sheet. The latter treatment is justified because treasury stock transactions are considered capital rather than operating transactions.



Q11-11. The book value per share of common stock is the total stockholders' equity divided by the number of shares outstanding, or $4,628,000/260,000 = $17.80.

Q11-12. A stock dividend is the distribution of additional shares of a corporation's stock to its stockholders. A stock dividend does not change a stockholder's relative ownership interest, because each stockholder owns the same fractional share of the corporation before and after the stock dividend. There is empirical evidence, however, suggesting that the stock price does not decline fully for the additional shares issued—various hypotheses, such as signaling theory, have been asserted as explanations of this phenomenon.

Q11-13. The stock dividend transfers capital from retained earnings to contributed capital. For a small stock dividend, this transfer is recorded at the market price of the shares at the time of the dividend. For a large stock dividend, the transfer is made at the par value of the stock.

Q11-14. Many companies repurchase shares (as Treasury Stock) in order to offset the dilutive effects of exercised stock options which increase the number of outstanding shares. This repurchase results in a cash outflow, and has been used by those arguing for the expensing of employee stock options as evidence of the cash effect of these options and linkage to the payment of wages.

Q11-15. The statement of stockholders' equity analyzes and reconciles changes in all major components of stockholders' equity for an accounting period. The statement begins with the beginning balances of those key stockholders' equity components, reports the items causing changes in these components, and ends with the period-end balances.

Q11-16. Other Comprehensive Income (OCI) represents changes in stockholders’ equity that are caused by factors other than profit (loss) and the sale (repurchase) of equity securities. Some examples include unrealized gains (losses) on available-for-sale securities, foreign currency translation adjustments (current-rate method only), unrealized gains (losses) on derivatives, and minimum pension liability adjustments.

Q11-17. A stock option vesting period is a period of time after the grant date that an employee must wait before exercising stock options. For example, a company may grant five-year options that vest in three years. An employee would then be able to exercise the options in Years 4 or 5, but not before. Typically, the vesting period requires that the employee remains employed at the company until the options vest; otherwise he/she forfeits the options.

Q11-18. When a convertible bond is converted, both the face amount and any associated unamortized premium or discount is removed from the balance sheet. The stock is, then, issued considering the “purchase price” to be the book value (face amount ± an unamortized premium or discount) of the bond. This purchase price is, then, allocated to common stock and additional paid-in capital. No gain or loss is reported upon the conversion.



MINI EXERCISES M11-19. (10 minutes)





Income Issue 8,000

shares of $50 par value preferred stock at $68 cash per share.

+544,000 Cash

=

+400,00 Preferred

Stock

+144,000 Additional

Paid-in Capital

-

=

Issue 12,000 shares of $1 par value common stock at $10 cash per share.

+120,000 Cash

=

+12,000 Common Stock

+108,000 Additional

Paid-in Capital

-

=

M11-20. (15 minutes) a.

9/1 Cash (+A) ......................................................................................... 864,000 Preferred stock (+SE) ...................................................................... 180,000 Additional paid-in capital (+SE) ........................................................ 684,000

9/1 Cash (+A) ......................................................................................... 4,440,000 Common stock (+SE) ....................................................................... 240,000 Additional paid-in capital (+SE) ........................................................ 4,200,000

b.

+ Cash (A) - - Preferred Stock (SE) + 9/1 864,000 180,000 9/1 9/1 4,440,000

- Common Stock (SE) + - Additional Paid-in Capital (SE) + 240,000 9/1 684,000 9/1 4,200,000 9/1

continued next page



M11-20. concluded c.





Income Issue 18,000

shares of $10 par value preferred stock at $48 per share.

+864,000 Cash

=

+180,000 Preferred

Stock

+684,000 Additional

Paid-in Capital

-

=

Issue 120,000 shares of $2 par value common.

+4,440,000 Cash

=

+240,000 Common

Stock

+4,200,000 Additional

Paid-in Capital

-

=

M11-21. (10 minutes) Common stock ....................................... $ 5.298a Additional paid in capital ......................... 39,265.702 Total ....................................................... $39,271.000

a 5,298 million shares issued $0.001 par value, rounded. M11-22. (15 minutes) a.

1/1 Cash (+A) ................................................................................... 1,250,000 Preferred stock (+SE) .................................................................. 500,000 Additional paid-in capital (+SE) .................................................... 750,000

3/1 Treasury stock (+XSE, -SE) ......................................................... 415,000 Cash (-A) .................................................................................... 415,000

b.

+ Cash (A) - - Preferred Stock (SE) + 1/1 1,250,000 500,000 1/1

415,000 3/1

+ Treasury Stock (XSE) - - Additional Paid-in Capital (SE) + 3/1 415,000 750,000 1/1

continued next page






+

Noncash Assets = Liabil-

ities + Contributed Capital + Earned

Capital - Contra Equity Revenues - Expenses = Net

Income Issue 5,000

shares of $100 par value preferred stock at $250 per share.

+1,250,000 Cash

=

+500,000 Preferred

Stock

+750,000 Additional

Paid-in Capital

-

-

=

Repurchase

5,000 shares of $1 par value common stock at $83 per share.

-415,000 Cash

=

- +415,000 Treasury

Stock

-

=

M11-23. (10 minutes) A stock split does not result in an accounting transaction and, as a result, does not require an entry into the accounting records. The number of outstanding shares must be changed in the parenthetical note to the common and preferred stock accounts in the stockholders’ equity section of the balance sheet, and the par value of the stock must also be adjusted. In the three-for-one stock split affected by Cigna, each shareholder receives two additional shares for each share owned, thus tripling the outstanding shares, and the par value of the shares is reduced to one-third. The dollar amount of total paid-in capital, thus, remains unchanged, as does the total dollar amount of stockholders’ equity. Only the parenthetical note relating to the number of outstanding shares and their par value is adjusted for all periods presented. Earnings per share is also recomputed for all years presented in the income statement to reflect the additional shares outstanding.



M11-24. (15 minutes) a. Basic EPS: [$501,000 – (16,000 x $2)] / 134,000 = $3.50

Calculation of weighted average shares outstanding: 120,000 x 2/12 = 20,000 130,000 x 5/12 = 54,167 146,000 x 3/12 = 36,500 140,000 x 2/12 = 23,333

134,000 b. Diluted EPS: $501,000 / 150,000 = $3.34 c. Given a simple capital structure, only basic EPS need be reported. M11-25. (10 minutes) a. Treasury shares are deducted from issued shares to yield outstanding shares. The

outstanding shares are, therefore: Shares outstanding = 103,300,000 – 17,662,000 = 85,638,000

b. If the stock repurchase took place on March 31, 2011, two months after the end of

the previous fiscal year, the denominator of the basic EPS calculation would decrease by 17,662,000 x 10/12. That is, the weighted average shares outstanding would be 103,300,000 – [17,662,000 x (10/12)] = 88,581,667 shares.

M11-26. (15 minutes) a. Preferred dividend:

12/31 Retained earnings (-SE) ........................................................ 18,000 Cash (-A) ......................................................................................... 18,000

Common dividend:

12/31 Retained earnings (-SE) ................................................................... 88,000 Cash (-A) .......................................................................................... 88,000

b.

+ Cash (A) - - Retained earnings (SE) + 18,000 12/31 12/31 18,000 88,000 12/31 12/31 88,000

continued next page








Income Declared and paid

cash dividend on preferred stock.

-18,000 Cash

=

-18,000

Retained Earnings

-

=

Declared and paid cash dividend on common stock.

-88,000 Cash

=

-88,000

Retained Earnings

-

=

M11-27. (15 minutes) Because this is a small stock dividend (4%), retained earnings is debited for the market value of the stock (70,000 x 4% x $21). a.

1/1 Retained earnings (-SE) ............................................................... 58,800 Common stock (+SE) ................................................................... 14,000 Additional paid-in capital (+SE) ..................................................... 44,800

b. - Retained Earnings (SE) + - Common Stock (SE) +

12/31 58,800 14,000 12/31

- Additional Paid-in Capital (SE) + 44,800 12/31

c. Balance Sheet Income Statement




Income Declaration and

payment of stock dividend.

=

+14,000 Common

Stock

+44,800 Additional

Paid-in Capital

-58,800

Retained Earnings

-

=



M11-28. (10 minutes) a. Immediately after the 3-for-2 stock split, the company has 375,000 shares of $10 par

value common stock [250,000 shares (3/2) = 375,000 shares] issued and outstanding.

b. The dollar balance in the Common Stock account is unchanged by the stock split; the

balance remains at $3,750,000 (375,000 shares at the new $10 par value per share). c. The usual reason for a corporation to split its stock is to reduce the per share market

price of the stock and, therefore, improve the stock's marketability. The market price of the common stock prior to the split is $165 per share, which is somewhat high. Splitting the stock would reduce the per-share price (though not the total market value).


Distribution to Preferred Common

a. $1,000,000 6% ........................................................... $60,000 Balance to common ....................................................... $100,000 Per share $60,000/20,000 shares ....................................... $3.00 $100,000/80,000 shares ..................................... $1.25 b. $1,000,000 6% 2 years .......................................... $120,000 Balance to common ....................................................... $40,000 Per share $120,000/20,000 shares ..................................... $6.00

$40,000/80,000 shares ....................................... $0.50 M11-30. (10 minutes)

BAMBER COMPANY Statement of Retained Earnings

For the Year Ended December 31, 2014 Retained earnings, December 31, 2013 .................................................. $347,000 Add: Net income ...................................................................................... 94,000 441,000 Less: Cash dividends declared ................................................. $35,000 Stock dividends declared ................................................ 28,000 63,000 Retained earnings, December 31, 2014 .................................................. $378,000



M11-31. (10 minutes) a. No entry is made when the dividend is declared; an entry is required only when the

additional stock is issued. Because this is a large stock dividend, the dividend is recorded at par value:

Retained earnings (-SE) .............................................................. 400,000 Common stock (+SE) ................................................................... 400,000

b. The stock split would reduce the par value, but no journal entry would be recorded.

As a consequence, neither the common stock nor the retained earnings accounts are affected.

M11-32. (10 minutes) a. Basic EPS: [$440,000 – (10,000 x $50 x 8%)] / 50,000 = $8.00 per share b. Diluted EPS: $440,000 / (50,000 + 10,000x3) = $5.50 per share M11-33. (15 minutes) a. Basic EPS: $234,000 / 45,000 = $5.20

Calculation of weighted average shares outstanding: 38,000 x 4/12 = 12,667 48,000 x 4/12 = 16,000 49,000 x 4/12 = 16,333

45,000 b. Basic EPS: [$234,000 – (6,000 x $50 x 6%)] / 45,000 = $4.80



M11-34. (15 minutes) a. Basic earnings per share is computed as net income less any preferred dividends

divided by the weighted average number of common shares outstanding for the period. Diluted earnings per share adjusts for dilutive securities (such as convertible securities or employee stock options) by including the securities in the denominator and also adjusting for any effect on the numerator. Consequently, diluted earnings per share is always less than or equal to basic earnings per share.

b. In the case of 3M, it has 708.5 million weighted average common shares outstanding, and an additional 10.5 million weighted average common shares that could potentially be issued (dilutive). These dilutive shares relate to employee stock options and convertible securities, like convertible debt and convertible preferred stock, that potentially could be converted into common shares. (Note: with 708.5 million shares and a basic EPS of $6.05, the implied earnings number is $4,286.425 million, computed as 708.5 million $6.05. For diluted EPS, 719.0 million times $5.96 implies earnings of $4,285.24 million, a difference of $1.185 million. This difference is likely due to the interest/dividends on convertible securities.)

c. While diluted EPS are favored over basic EPS by analysts, the data reflect events that have not and may never occur. In addition, the dilution is assumed to be made at the year’s start.

M11-35. (15 minutes) a. No entry is required when the options are granted. The compensation expense is

recognized ratably over the vesting period. As the options vest, the following entry is required (assume one-third vested in 2011):

Compensation expense (+E, -SE) ................................................ 14,749 Additional paid in capital (+SE) .................................................... 14,749

b. Granted stock options (whether vested or not) are included in the denominator of

diluted EPS whenever the stock price is greater than the exercise price. These options would reduce diluted EPS but have no effect on basic EPS.

c. Cash (+A) ................................................................................... 321,000 Contributed capital (+SE) ............................................................. 321,000 d. When options are exercised, the number of outstanding shares increases. This

would reduce basic EPS. It might also lower diluted EPS, though most likely to a lesser degree. This is because the dilutive effect may already be reflected in diluted EPS prior to exercise.




Year Total

Assets Total

Liabilities

Total Stockholders’

Equity EPS Operating

Income 1 ….. Increase No effect Increase Decrease No effect 2 ….. Decrease No effect Decrease Increase No effect 3 ….. No effect Increase Decrease No effect No effect

M11-37. (15 minutes) a. $30 = $18,000,000 / 600,000 shares b. $10 = $6,000,000 / 600,000 shares c. $12,000,000 = $18,000,000 - $6,000,000 d. $4,000,000 = $5,000,000 – $1,000,000 e. 50,000 shares = 600,000 – 550,000 f. $8.70 = $5,000,000 ÷ (600,000 + 550,000)/2. 600,000 shares were outstanding for

the first half year but only 550,000 during the second half of the year. M11-38. (10 minutes) a. The diluted EPS calculation is made to reflect a worst-case scenario (conservative)

EPS figure. b. $86/278.689 = $0.309 or $0.31 per share c. $98/346.467 = $0.283 or $0.28 per share d. Options that are “under water” (the stock price is below the exercise price) are not

included in the calculation of diluted EPS. This is because diluted EPS is supposed to be the most conservative possible outcome. Including under water options would actually increase EPS. Thus these options are anti-dilutive.



EXERCISES E11-39. (15 minutes) a.

2/20 Cash (+A) ......................................................................................... 250,000 Common stock (+SE) ....................................................................... 10,000 Additional paid-in capital (+SE) ........................................................ 240,000

2/21 Cash (+A) ......................................................................................... 4,125,000 Preferred stock (+SE) ....................................................................... 1,500,000 Additional paid-in capital (+SE) ........................................................ 2,625,000

6/30 Treasury stock (+XSE, -SE) ............................................................. 30,000 Cash (-A) ........................................................................................... 30,000

9/25 Cash (+A) ......................................................................................... 21,000 Treasury stock (-XSE, +SE) ............................................................. 15,000 Additional paid-in capital (+SE) ........................................................ 6,000

b.

+ Cash (A) - - Preferred Stock (SE) + 2/20 250,000 1,500,000 2/21 2/21 4,125,000

30,000 6/30 - Common Stock (SE) + 9/25 21,000 10,000 2/20

+ Treasury Stock (XSE) - - Additional Paid-in Capital (SE) +

6/30 30,000 240,000 2/20 15,000 9/25 2,625,000 2/21 6,000 9/25

c.



+



Capital - Contra Equity Revenues - Expen-

ses = Net Income

Issue 10,000 shares of $1 par value common stock.

+250,000 Cash

=

+10,000 Common

Stock +240,000

Add’l Paid-in Capital

-

-

=

Issued 15,000 shares of $100 par preferred stock. +4,125,000

Cash

=

+1,500,000 Preferred

Stock +2,625,000

Add’l Paid-in Capital

-

-

=

Purchased treasury stock. -30,000

Cash

=

-

+30,000 Treasury

Stock

-

=

Sold 1,000 shares of treasury stock. +21,000

Cash

=

+6,000 Add’l Paid-in

Capital

-

-15,000 Treasury

Stock

-

=



E11-40. (20 minutes) a.

1/15 Cash (+A) ......................................................................................... 425,000 Common stock (+SE) ....................................................................... 125,000 Additional paid-in capital (+SE) ........................................................ 300,000

1/20 Cash (+A) ......................................................................................... 468,000 Preferred stock (+SE) ...................................................................... 300,000 Additional paid-in capital (+SE) ........................................................ 168,000

3/31 Treasury stock (+XSE, -SE) ............................................................. 60,000 Cash (-A) .......................................................................................... 60,000

6/25 Cash (+A) ......................................................................................... 52,000 Treasury stock (-XSE, +SE) ............................................................. 40,000 Additional paid-in capital (+SE) ........................................................ 12,000

7/15 Cash (+A) ......................................................................................... 19,000 Additional paid-in capital (+SE) ........................................................ 1,000 Treasury stock (-XSE, +SE) ............................................................. 20,000

b.

+ Cash (A) - - Preferred Stock (SE) + 1/15 425,000 300,000 1/20 1/20 468,000

60,000 3/31 - Common Stock (SE) + 6/25 52,000 125,000 1/15 7/15 19,000


3/31 60,000 300,000 1/15 40,000 6/25 168,000 1/20 20,000 7/15 12,000 6/25 7/15 1,000

continued next page



E11-40. concluded c.



+



Capital - Contra Equity Revenues - Expen-

ses = Net Income

Issue 25,000 shares of $5 par common stock.

+425,000 Cash

=

+125,000 Common

Stock +300,000

Add. Paid-in Capital

-

-

=

Issued 6,000 shares of $50 par preferred stock.

+468,000 Cash

=

+300,000 Preferred

Stock +168,000

Add. Paid-in Capital

-

-

=

Repurchased 3,000 shares of treasury stock.

-60,000 Cash

=

- +60,000 Treasury

Stock

-

=

Sold 2,000 shares of treasury stock.

+52,000 Cash

=

+12,000 Add. Paid-in

Capital

-

-40,000 Treasury Stock

-

=


+19,000 Cash

=

-1,000 Add. Paid-in

Capital

-

-20,000 Treasury Stock

-

=

E11-41. (20 minutes) a. 103.3 million - 17.662 million = 85.638 million shares outstanding. b. ($1.033 million + $369.171 million) / 103.3 million shares = $3.58 per share. c. $834.774 million / 17.662 million shares = $47.26 per share. d. EPS is computed based on the number of shares outstanding. The number of

shares in treasury stock is subtracted from shares issued to get the number of shares outstanding. Thus, the number of treasury shares is subtracted from the denominator in computing EPS.

e. $6.455 million – $(6.516) million = 12.971 million.



E11-42. (20 minutes)

a. Dividend Distribution

Preferred

Common Preferred per Share

Common per Share

2013 Preferred $0 $0.00 Common $0 $0.00

2014 Arrearage on preferred [7% (20,000 $60)] $84,000 Current year on preferred [7% (20,000 $60)] 84,000 Remainder to common $15,000 Total distribution $168,000 $15,000 Per share Preferred ($168,000/20,000) $8.40 Common ($15,000/100,000) $0.15

2015 Current year on preferred [7% (20,000 $60)] $84,000 Remainder to common $116,000 Per share Preferred ($84,000/ 20,000) $4.20 Common ($116,000/100,000) $1.16 b.


2014 Arrearage on preferred [7% (20,000 $60)] $84,000 Per share Preferred ($84,000/20,000) $4.20 Common $0.00

2015 Arrearage on preferred [7% (20,000 $60)] $ 84,000 Partial current year on preferred 66,000 Total distribution $150,000 Per share Preferred ($150,000/20,000) $7.50 Common $0.00



E 10-43. (15 minutes) a. Basic EPS: [$230,000 – (5,000 x $4)] / 30,000 = $7.00

Calculation of weighted average shares outstanding: 25,000 x 4/12 = 8,333 34,000 x 2/12 = 5,667 28,000 x 2/12 = 4,667 34,000 x 4/12 = 11,333

30,000 b. Diluted EPS: $230,000 / [(30,000 + (5,000 x 2)] = $5.75 c. If Nichols Corporation had a simple capital structure, only basic EPS ($7.00) would

be reported. E11-44. (25 minutes)

Distribution to Preferred Common

a. Year 1 $ 0 $ 0

Year 2: Arrearage from Year 1 ($750,000 8%) $ 60,000 Current year dividend ($750,000 8%) 60,000 Balance to common _______ $160,000

Total for Year 2 $120,000 $160,000

Year 3: Current year dividend ($750,000 8%) $ 60,000 $ 0

b. Year 1 $ 0 $ 0

Year 2: Current year dividend ($750,000 8%) $ 60,000

Balance to common $220,000

Year 3: Current year dividend ($750,000 8%) $ 60,000 $ 0

c. Because the preferred stock is not convertible, Potter Company has a simple capital

structure and would only report basic EPS. Basic EPS would be reduced in years 2 and 3 when the preferred dividends are subtracted from net income in the numerator.



E11-45. (20 minutes) a. 2,805,961,317 $0.331/3 = $935,320,439 rounded to $935 million

b. ($935 million + $5,674 million) / 2,806 million shares = $2.36 per share

c. 2,805,961,317 shares issued – 761,542,032 shares in treasury = 2,044,419,285 shares outstanding

d. $24,625 million / 761.542 million = $32.34 per share

e. Companies repurchase stock for a variety of reasons:

1. To offset the dilutive effects of shares issued to employees under stock option plans.

2. To mitigate a takeover threat by concentrating the remaining shares in “friendly hands.”

3. To send a signal to the market that the company feels its shares are undervalued.

E11-46. (30 minutes) a. Dividend Distribution

Preferred


Common per Share

2013 Current year on preferred [6% (18,000 $50)] $54,000 Remainder to common $9,000 Per share Preferred ($54,000/18,000) $3.00 Common ($9,000/90,000) $0.10


2015 Arrearage on preferred [6% (18,000 $50)] $54,000 Current year on preferred [6% (18,000 $50)] 54,000 Remainder to common $270,000 Total distribution $108,000 $270,000 Per share Preferred ($108,000/18,000) $6.00 Common ($270,000/90,000) $3.00

continued next page



E11-46. concluded b. Dividend Distribution

Preferred


Common per Share


2014 Arrearage on preferred [6% (18,000 $50)] $ 54,000 Current year on preferred [6% (18,000 $50)] 54,000 Common $0 Total distribution $108,000 $0 Per share Preferred ($108,000/18,000) $6.00 Common $0.00

2015 Current year on preferred [6% (18,000 $50)] $54,000 Remainder to common $135,000 Per share Preferred ($54,000/18,000) $3.00 Common ($135,000/90,000) $1.50

E11-47. (15 minutes) a.

1) Retained earnings (-SE) ................................................................... 47,500 Cash (-A) .......................................................................................... 47,500

2) Retained earnings (-SE) ................................................................... 35,000 Common stock (+SE) ....................................................................... 10,000 Additional paid-in capital (+SE) ........................................................ 25,000

b.

+ Cash (A) - - Common Stock (SE) + 47,500 1) 10,000 2)

- Retained Earnings (SE) + - Additional Paid-in Capital (SE) + 1) 47,500 25,000 2) 2) 35,000

continued next page








Income Declared and paid cash dividend.

-47,500 Cash

=

-47,5001

Retained Earnings

-

=

Declared and issued stock dividend.

=

+10,000 Common

Stock +25,000

Additional Paid-in Capital


-

=

1 $1.90 25,000 = $47,500. 2 Retained Earnings is reduced by the market price of the shares distributed (25,000 shares 4% $35

market value = $35,000). Common Stock is increased by the par value with the balance of the market price reflected in an increase in Additional Paid-in Capital.

E11-48. (20 minutes) a.

5/12 Retained earnings (-SE) ............................................................... 100,800 Common stock (+SE) .................................................................. 56,000 Additional paid-in capital (+SE) .................................................... 44,800

12/31 Retained earnings (-SE) .............................................................. 64,200 Cash (-A) ................................................................................... 64,200

b.

+ Cash (A) - - Common Stock (SE) + 64,200 12/31 56,000 5/12

- Retained Earnings (SE) + - Additional Paid-in Capital (SE) + 5/12 100,800 44,800 5/12

12/31 64,200

continued next page








Income Declared and paid stock dividend.

=

+56,000 Common

Stock +44,800

Additional Paid-in Cap

-100,8001

Retained Earnings

-

=

Declared and issued cash dividend.

-64,200 Cash

=

-64,2002

Retained Earnings

-

=

1 The 7% dividend is a small stock dividend and, accordingly, Retained Earnings is reduced by the market value of the shares distributed (7% 80,000 shares $18 = $100,800). Common Stock is increased by the par value of the shares ($56,000) and Additional Paid-in Capital in increased by the remainder ($44,800).

2 Retained Earnings is reduced by $0.75 per share on 85,600 shares outstanding and Cash is decreased by the payment.

d.

PALEPU COMPANY Statement of Retained Earnings

For the Year Ended December 31, 2014 Retained earnings, December 31, 2010 $305,000 Add: Net income 283,000

588,000 Less: Cash dividends declared $ 64,200

Stock dividends declared 100,800 165,000 Retained earnings, December 31, 2011 $423,000



E11-49. (20 minutes) a.

4/1 Retained earnings (-SE) ............................................................... 250,000 Common stock (+SE) ................................................................... 250,000

12/7 Retained earnings (-SE) .............................................................. 42,000 Common stock (+SE) .................................................................. 15,000 Additional paid-in capital (+SE) .................................................... 27,000

12/20 Retained earnings (-SE) .............................................................. 102,400 Cash (-A) .................................................................................... 102,400

b.

+ Cash (A) - - Common Stock (SE) + 102,400 12/20 250,000 4/1 15,000 12/7

- Retained Earnings (SE) + - Additional Paid-in Capital (SE) + 4/1 250,000 27,000 12/7

12/7 42,000 12/20 102,400

c.





Income Declared and paid 100% stock dividend.

=

+250,000 Common

Stock

-250,0001

Retained Earnings

-

=

Declared and paid 3% stock dividend.

+15,000 Common

Stock +27,000

Additional Paid-in Captal

-42,0002

Retained Earnings

Declared and issued cash dividend.

-102,400

Cash

=

-102,4003

Retained Earnings

-

=

1 The large stock dividend is reflected as a reduction of Retained Earnings at the par value of the shares distributed (50,000 shares 100% $5 par value per share = $250,000). Common Stock is increased by the same amount.

2 This is a small stock dividend. As a result, Retained Earnings is decreased by the market value of the shares to be distributed (3% 100,000 shares $14 per share = $42,000). Common Stock is increased by the par value of the shares distributed (3% 100,000 $5 = $15,000) and Additional Paid-in Capital is increased by the balance ($27,000).

3 Total dividends are 4,000 $5 = $20,000 for the preferred shares and 103,000 $0.80 = $82,400 for the common shares. Retained Earnings and Cash are reduced to reflect the payment.

continued next page



E11-49. concluded d.

KINNEY COMPANY Statement of Retained Earnings

For the Year Ended December 31, 2014

Retained earnings, December 31, 2010 $656,000 Add: Net income 253,000

909,000 Less: Cash dividends declared $102,400

Stock dividends declared 292,000 394,400 Retained earnings, December 31, 2011 $514,600

E11-50. (15 minutes) a. Immediately after the stock split, 800,000 shares (2 x 400,000 shares) of $10 par value

common stock are issued and outstanding. b. The stock split does not change the Common Stock account balance. The account

balance is $8,000,000 just before and immediately after the stock split. c. The stock split does not change the Paid-in Capital in Excess of Par Value account.

The account balance is $3,400,000 just before and immediately after the stock split. d. The 2-for-1 split will reduce EPS by half. The EPS numbers currently reported in

previous years’ income statements would also be reduced by half for comparison purposes.



E11-51. (20 minutes) a. 814,894,624 – 167,361,280 = 647,533,344 shares outstanding. b. “Paid-in amount” is the total paid-in capital, including the amount specified as the par

value and included in the Common Stock and the amount that would be included in the account as Additional Paid-in Capital.

c. $10,281 million / 167.361 million = $61.43 per share d. Generally, companies repurchase shares in order to

Offset the dilutive effects of shares issued to employees under stock option plans.

Mitigate a takeover threat if the remaining shares are concentrated in “friendly hands.”

Send a signal to the market that the company feels its shares are undervalued. e. Repurchasing common stock (buying stock for treasury stock) reduces the number

of shares outstanding. Because the number of shares outstanding is in the denominator of the EPS calculation, repurchasing common shares increases basic and diluted EPS.

E11-52. (20 minutes) a. Shares issued Par value = Common Stock amount

3,576.948 million shares $0.50 = $1,788.5 million b. (Common Stock + Other Paid-In Capital)/Shares issued = Average Issue price

($1,788 million + $40,633 million) / 3,576.948 million = $11.86 per share c. Treasury Stock / Treasury shares = Treasury cost per share $23,792 million / 536.11 million = $44.38 per treasury share d. Shares issued – Treasury shares = Shares outstanding 3,576,948,356 – 536,109,713 = 3,040,838,643 shares outstanding



E11-53. (20 minutes) a. No. If the firm had a gain (loss) from an extraordinary item, there would have been

an additional line in their report showing the EPS figures for extraordinary items separately.

b. $0.01 x 587.3 = $5.873 million loss based on basic EPS. $0.02 x 594.3 = $11.886

million loss based on diluted EPS. The actual amount (from Viacom’s 10-K) was $10.0 million. Because of rounding, the numbers based on basic EPS and diluted EPS reflect approximations and can be interpreted as high and low values of an estimated range. All such losses (and/or gains) are reported net of tax.

c. $2,136 million - $5.9 million = $2,130.1 million. d. The dilution would be due to potentially dilutive securities. In Viacom’s case these

dilutive securities were primarily in-the-money stock options. However the company also had some restricted stock units. The dilution of $0.05 per share is minimal.

E11-54. (20 minutes) a. No. The Euro amounts for ordinary shares (i.e. common stock) and preferred

shares (preferred stock) did not change either year. Neither did the capital reserve (additional paid-in capital).

b. Net income + other comprehensive income = total comprehensive income. €1,253 million + €(297) million = €956 million. c.

Cash (-A) .................................................................................... 12 Treasury stock (-XSE, +SE) ......................................................... 6 Retained earnings ………………………….. 6

+ Cash (A) - + Treasury Stock (XSE) -

12 6

- Retained Earnings (SE) + 6





Income Sold treasury shares +12

=

+6 Treasury

Stock

+6

Retained Earnings

-

=

d. (€1,253 million - €139 million)/[(€8,641+€7,859)/2 – €178] = 0.138 or 13.8%



PROBLEMS P11-55. (45 minutes) a.

1/10 Cash (+A) ................................................................................... 476,000 Common stock (+SE) .................................................................. 280,000 Additional paid-in capital (+SE) .................................................... 196,000


3/14 Cash (+A) ................................................................................... 84,000 Treasury stock (-XSE, +SE) ......................................................... 76,000 Additional paid-in capital (+SE) .................................................... 8,000

7/15 Cash (+A) ................................................................................... 128,000 Preferred stock (+SE) .................................................................. 80,000 Additional paid-in capital (+SE) ..................................................... 48,000


b.

+ Cash (A) - - Common Stock (SE) + 1/10 476,000 152,000 1/23 280,000 1/10 3/14 84,000 7/15 128,000 - Preferred Stock (SE) +

11/15 24,000 80,000 7/15

+ Treasury Stock (XSE) - - Additional Paid-in Capital (SE) + 1/23 152,000 76,000 3/14 196,000 1/10

19,000 11/15 8,000 3/14 48,000 7/15 5,000 11/15

continued next page



P11-55. continued c.



Assets = Liabil-ities + Contributed

Capital + Earned Capital - Contra

Equity Reve-nues - Expen

-ses = Net Income

1/10: Issued common stock.1

+476,000 Cash

=

+280,000 Common

Stock +196,000 Additonal

Paid-in Capital

-

-

=

1/23: Purchased treasury stock.2

-152,000 Cash

=

- +152,000 Treasury

Stock

-

=

3/14: Sold treasury stock.3

+84,000 Cash

=

+8,000


-

-76,000

Treasury Stock

-

=

7/15: Issued preferred stock.4

+128,000 Cash

=

+80,000 Preferred

Stock +48,000


-

-

=

11/15: Sold treasury stock.5

+24,000

=

+5,000

Additonal Paid-in Capital

-

-19,000

Treasury Stock

-

=

1 Total proceeds of 28,000 $17 = $476,000 are reflected as an increase in Cash. Common Stock is increased by the par value of the shares issued (28,000 $10 = $280,000) and Additional Paid-in Capital is increased for the balance (196,000).

2 Cash is decreased and Treasury Stock is increased by the purchase price of 8,000 shares $19 = $152,000. The increase in Treasury Stock reduces contributed capital.

3 Cash received is 4,000 shares $21 = $84,000. Treasury Stock is reduced by the original cost of $19 per share and the remainder of $8,000 is reflected as an increase in Additional Paid-in Capital.

4 Cash received is $128,000. The Preferred Stock account is increased by the par value of the preferred shares issued (3,200 $25 = $80,000) and Additional Paid-in Capital is increased for the balance.

5 Cash received is 1,000 shares $24 = $24,000. Treasury Stock is reduced by its original cost of 1,000 shares $19 = $19,000, thus increasing contributed capital, and Additional Paid-in Capital is increased for the balance ($5,000).

continued next page



P11-55. concluded d. 1/10: Decrease basic EPS 1/23: Increase basic EPS 3/14: Decrease basic EPS 7/15: Decrease basic EPS 11/15 Decrease basic EPS Note: These answers ignore the effect of cash balances on earnings. Each transaction

changed the cash balance. If cash is invested in operations or in securities to earn a return, net earnings would be affected by each transaction.

e.

Stockholders’ Equity Paid-in capital 8% Preferred stock, $25 par value, 50,000 shares authorized; 10,000 shares issued and outstanding $ 250,000 Common stock, $10 par value, 200,000 shares authorized; 78,000 shares issued, of which 3,000 shares are in treasury 780,000 $1,030,000 Additional paid-in capital Paid-in capital in excess of par value—Preferred stock 116,000 Paid-in capital in excess of par value—Common stock 396,000 Paid-in capital from Treasury stock 13,000 525,000 Total paid-in capital 1,555,000 Retained earnings 329,000 1,884,000 Less: Treasury stock (3,000 common shares) at cost 57,000 Total stockholders’ equity $1,827,000



P11-56. (30 minutes) a.

1/12 No entry is required for the 3-for-1 stock split.



11/21 Cash (+A) ................................................................................... 55,000 Common stock (+SE) ................................................................... 25,000 Additional paid-in capital (+SE) ..................................................... 30,000

12/28 Cash (+A) ................................................................................... 10,800 Additional paid-in capital (-SE) ..................................................... 1,200 Treasury stock (-XSE, +SE) ......................................................... 12,000

b.

+ Cash (A) - - Common Stock (SE) + 10/12 18,000 100,000 9/1 25,000 11/21 11/21 55,000 12/28 10,800

+ Treasury Stock (XSE) - - Additional Paid-in Capital (SE) + 9/1 100,000 15,000 10/12 12/28 1,200 3,000 10/12

12,000 12/28 30,000 11/21

c.



+




Income Purchased 10,000 shares of treasury stock for cash.

-100,000 Cash

=

- +100,0001 Treasury

Stock

-

=


+18,000 Cash

=

+3,000 Additional

Paid-in Capital

- -15,0002 Treasury

Stock

-

=

Issued 5,000 shares of common stock.

+55,000 Cash

=


+30,000 Additional

Paid-in Capital

-

-

=


+10,800 Cash

=

-1,200 Additional Paid-in Capital

-

-12,0004 Treasury

Stock

-

=

continued next page



P11-56. concluded c. continued

Notes: 1 The stock is acquired for 10,000 shares $10 = $100,000. This is reflected as a reduction in

Cash and a corresponding increase in the Treasury Stock account, a contra-equity account which reduces contributed capital.

2 Cash received is 1,500 shares $12 per shares = $18,000. Treasury Stock is reduced by its original cost of $10 per share and the balance ($3,000) is reflected as an increase in Additional Paid-in Capital.

3 Cash received is 5,000 shares $11 per share. Common Stock is increased by the par value of the shares issued (5,000 $5 = $25,000) and Additional Paid-in Capital is increased by the balance ($30,000).

4 Cash received is 1,200 shares $9 = $10,800. Treasury Stock is reduced by the original cost of the shares (1,200 shares $10 = $12,000) and Additional Paid-in Capital is reduced by the balance ($10,800 - $12,000 = -$1,200).

d. 1/12: stock split – decrease basic EPS 9/1: purchase treasury stock – increase basic EPS 10/12: sold treasury stock – decrease basic EPS 11/21: issued common stock – decrease basic EPS 12/28: sold treasury stock – decrease basic EPS e.

Stockholders’ Equity Paid-in capital 7% Preferred stock, $100 par value, 20,000 shares authorized; 5,000 shares issued and outstanding $500,000 Common stock, $5 par value, 300,000 shares authorized; 125,000 shares issued, of which 7,300 shares are in the treasury 625,000 $1,125,000 Additional paid-in capital Paid-in capital in excess of par value—Preferred stock 24,000 Paid-in capital in excess of par value—Common stock 390,000 Paid-in capital from treasury stock 1,800 415,800 Total paid-in capital 1,540,800

Retained earnings 408,000 1,948,800 Less: Treasury stock (7,300 common shares) at cost 73,000 Total stockholders' equity $1,875,800

f. Because Sougiannis did not pay the 7% dividend on its preferred stock, ROCE is

computed as follows:

$83,000 / [($1,875,800+$1,809,000)/2 -$500,000] = 0.062 or 6.2%



P11-57. (45 minutes) a.

1/51 Cash (+A) ................................................................................... 120,000 Common stock (+SE) ................................................................... 50,000 Additional paid-in capital (+SE) ..................................................... 70,000



7/174 Cash (+A) ................................................................................... 6,500 Additional paid-in capital (-SE) ..................................................... 500 Treasury stock (-XSE, +SE) ......................................................... 7,000

10/15 Cash (+A) ................................................................................... 175,000 Preferred stock (+SE) .................................................................. 125,000 Additional paid-in capital (+SE) .................................................... 50,000

1 Cash is increased by the proceeds from the stock sale (10,000 shares $12 = $120,000).

Common Stock is increased by the par value (10,000 shares $5) and Additional Paid-in Capital for the balance ($70,000).

2 Cash is reduced by the cost of the Treasury Stock (4,000 shares $14 = $56,000). The Treasury Stock account is increased accordingly. Since this account has a negative balance in stockholders’ equity, contributed capital is reduced.

3 Cash is increased by the proceeds from the sale of the Treasury Stock (1,000 shares $17 = $17,000). The Treasury Stock account is reduced by the original cost of the shares (1,000 $14 = $14,000) and Additional Paid-in Capital is increased for the balance.

4 Cash is increased by the proceeds from the sale of the Treasury Stock (500 shares $13 = $6,500). Treasury Stock is reduced by its original cost (500 shares $14 = $7,000) and Additional Paid-in Capital is reduced for the balance.

5 Cash is increased by the proceeds from the sale of the Preferred Stock (5,000 shares $35 per share = $175,000). Preferred Stock is increased by its par value (5,000 shares $25 = $125,000) and Additional Paid-in Capital is increased for the balance ($50,000).

b.

+ Cash (A) - - Common Stock (SE) + 1/5 120,000 56,000 1/18 50,000 1/5

3/12 17,000 7/17 6,500 - Preferred Stock (SE) + 10/1 175,000 125,000 10/1


1/18 56,000 14,000 3/12 70,000 1/5 7,000 7/17 7/17 500 3,000 3/12 50,000 10/1

continued next page



P11-57. concluded c.



+




Income Issued 10,000

shares of common stock.

+120,000 Cash

=


+70,000 Additional

Paid-in Capital

-

-

=

Purchased 4,000 shares of treasury stock.

-56,000 Cash

=

- +56,000 Treasury

Stock

-

=


+17,000 Cash

=

+3,000 Additional

Paid-in Capital

- -14,000

Treasury Stock

-

=

Sold 500 shares of treasury stock.

+6,500 Cash

=

-500


-

-7,000

Treasury Stock

-

=

Issued 5,000 shares of preferred stock.

+175,000 Cash

=

+125,000 Preferred Stock

+50,000 Additional

Paid-in Capital

-

-

=

d.

Stockholders’ Equity

Paid-in capital 8% Preferred stock, $25 par value, 50,000 shares authorized, 5,000 shares issued and outstanding $125,000 Common stock, $5 par value, 350,000 shares authorized; 160,000 shares issued; 2,500 shares in treasury 800,000 $ 925,000 Additional paid-in capital Paid-in capital in excess of par value—Preferred stock 50,000 Paid-in capital in excess of par value—Common stock 670,000 Paid-in capital from Treasury stock 2,500 722,500 Total paid-in capital 1,647,500 Retained earnings 418,500 2,066,000 Less: Treasury stock (2,500 shares) at cost 35,000 Total stockholders' equity $2,031,000

e. The transactions on January 5 (stock issue), March 12 and July 17 (both treasury

stock sales), and the transaction on October 1 (issued preferred stock) would decrease basic EPS. The transaction on January 18 (treasury stock purchase) would increase basic EPS.



P11-58. (30 minutes) a.

1/15 Cash (+A) ................................................................................... 62,000 Preferred stock (+SE) .................................................................. 50,000 Additional paid-in capital (+SE) ..................................................... 12,000 Cash is increased by the proceeds from the sale of the Preferred Stock (1,000 shares $62 per share = $62,000). The Preferred Stock account is increased for its par value (1,000 shares $50 par = $50,000) and Additional Paid-in Capital is increased for the balance ($12,000).

1/20 Cash (+A) ................................................................................... 144,000 Common stock (+SE) ................................................................... 80,000 Additional paid-in capital (+SE) ..................................................... 64,000 Cash is increased by the proceeds from the sale of the Common Stock (4,000 shares $36 = $144,000). Common Stock is increased by its par value (4,000 $20 = $80,000) and Additional Paid-in Capital is increased for the remainder ($64,000).

5/18 No entry is required for the 2-for-1 stock split

6/1 Cash (+A) ................................................................................... 60,000 Common stock (+SE) .................................................................. 20,000 Additional paid-in capital (+SE) ..................................................... 40,000 Common Stock is increased by its par value (2,000 $10 = $20,000) and Additional Paid-in Capital is increased for the balance ($40,000).

9/1 Treasury stock (+XSE, -SE) ......................................................... 45,000 Cash (-A) ................................................................................... 45,000 Cash is reduced by the cost of the Treasury Stock (2,500 shares $18 per share = $45,000). The Treasury Stock account is increased by its cost, thereby reducing contributed capital.

10/12 Cash (+A) ................................................................................... 18,900 Treasury stock (-XSE, +SE) ......................................................... 16,200 Additional paid-in capital (+SE) .................................................... 2,700 Cash is increased by the proceeds from the sale of the Treasury Stock (900 $21 = $18,900). The Treasury Stock account is reduced by its cost (900 $18 = $16,200), thereby increasing contributed capital, and Additional Paid-in Capital is increased by the balance ($2,700).

12/22 Cash (+A) ................................................................................... 29,500 Preferred stock (+SE) .................................................................. 25,000 Additional paid-in capital (+SE) ..................................................... 4,500 Cash is increased by the proceeds from the sale of the preferred shares (500 $59 = $29,500). The Preferred Stock account is increased for its par value (500 shares $50 = $25,000) and Additional Paid-in Capital is increased for the balance ($4,500).

continued next page



P11-58. concluded

b. + Cash (A) - - Common Stock (SE) +

1/15 62,000 80,000 1/20 1/20 144,000 20,000 6/1 6/1 60,000

45,000 9/1 - Preferred Stock (SE) + 10/12 18,900 50,000 1/15 12/22 29,500 25,000 12/22


9/1 45,000 12,000 1/15 16,200 10/12 64,000 1/20 40,000 6/1 2,700 10/12 4,500 12/22

c.



+




Income Issued 1,000 shares of preferred stock. +62,000

=


+12,000 Additional

Paid-in Capital

-

-

=

Issued 4,000 shares of common stock. +144,000

Cash

=


+64,000 Additional

Paid-in Capital

-

-

=

Issued 2,000 shares of common stock. +60,000

Cash

=


+40,000 Additional

Paid-in Capital

-

-

=

Purchased 2,500 shares of treasury stock.

-45,000 Cash

=

- +45,000 Treasury

Stock

-

=

Sold 900 shares of treasury stock. +18,900

Cash

=

+2,700


-

-16,200 Treasury

Stock

-

=

Issued 500 shares of preferred stock.

+29,500 Cash

=


+4,500 Additional

Paid-in Capital

-

-

=



P11-59. (50 minutes) a. 2012: 4,008 – 1,260.4 = 2,747.6 million 2011: 4,008 – 1,242.2 = 2,765.8 million Estimated average shares outstanding: (2,747.6 + 2,765.8)/2 = 2,756.7 million. Average shares outstanding is slightly greater than the number of shares

outstanding at year-end because P&G has more shares in treasury stock in 2012 that at the end of 2011.

b. 2012: $69,604/1,260.4 = $55.22; 2011: $67,278/1,242.2 = $54.16 c.

Preferred stock (-SE) ……………………………………… 39 Additional paid-in capital (-SE) ..................................................... 2,073 Treasury stock (-XSE, +SE) ......................................................... 2,112

The reported value for preferred stock includes additional paid-in capital. This fact

can be discerned by noting that 600 million of class A preferred shares are authorized and if all 600 million shares were issued, the stated value of $1 per share would yield $600 million of preferred stock. But if the $1,195 million is assumed to be the stated value, the number of issued shares exceeds the number authorized. Therefore, the $1,195 million figure must include additional paid-in capital of at least $595 million and the additional paid-in capital account refers only to common stock. The debit to preferred stock in this entry includes only the stated value. Technically, P&G should transfer a portion of the additional paid-in capital from the preferred stock amount to additional paid-in capital-common stock.

d. P&G’s diluted EPS reflects the effects of convertible preferred stock and, most likely,

outstanding stock options. e. 2012 ($millions): ($10,756 - $256) / [($64,035-$1,195+$68,001-$1,234)/2] = 0.162 or

16.2%



P11-60. (50 minutes) a. Class A and B common shares are identical except for voting rights. Class A shares

have 1 vote per share while class B shares have 10 votes per share. This means that class B shareholders have greater control in the governance of the corporation. Presumably, class B shares were retained by the original owners of the firm when the class A shares were offered.

b. 718,091 x $210.07 per share = $150,849,376. c. Options vest over 4 years; $150,849,376/4 = $37,712,344

Compensation expense (+E, -SE) ……………… 37,712,344 Additional paid-in capital (+SE) …………… 37,712,344

d. Intrinsic value refers to the difference between the current stock price and the

exercise price of the options. It is always less than or equal to the fair value of the options. The aggregate intrinsic value of the options granted in 2011 is:

($645.90 - $584.80) x 718,091 = $43,875,360

e. $6,520 / $20.62 = 316.2 million shares. Google had 321.3 million shares outstanding at the end of 2010 and 324.9 million

shares outstanding at the end of 2011. f. If all outstanding stock options were exercised, basic EPS would decrease. Google

had 9.8 million options outstanding at the end of 2011. If all of these options had been exercised and added to shares outstanding, basic EPS would have been $6,520 / (316.2 + 9.8) = $20.00 per share (compared to $20.62).

g. The diluted EPS figure includes an adjustment for outstanding options. Typically,

this adjustment is smaller than the effect of including all options in outstanding shares. This is due to two factors:

1. Some options may be under water (exercise price exceeds the stock price). If

this is true, the options are anti-dilutive and would not be exercised by the option holder.

2. When options are exercised, the shareholder pays the exercise price to the firm. The calculation in question f made no assumption about what happens to this cash (it would total about $3,508 million = 9.8 million x $357.92). Presumably, this cash could be invested to increase earnings and EPS. The calculation of diluted EPS adjusts for this cash by assuming that the cash is used to purchase treasury shares. Given the current stock price of $645.90 per share, Google could repurchase 5.4 million shares ($3,507 million/$645.90). Thus, the actual increase in shares outstanding if all options were exercised would be 9.8 million – 5.4 million = 4.4 million shares.



CASES and PROJECTS C11-61. (30 minutes) a. Mandatorily redeemable means that the issuing company can decide to repurchase

all of the remaining shares that have not been converted before the redemption date specified in the preferred issue contract. Prior to that date, holders of the preferred shares can convert their shares to common stock. Northrop Grumman preferred holders converted most of their shares and the rest were redeemed by the company. “Convertible” means that the preferred stock can be exchanged for common stock. Usually this option rests with the holder of the preferred stock. Sometimes, companies retain an option to force the conversion. Northrop Grumman did so. This option is spelled out in the preferred stock contract. The issue may also include a “liquidation preference”, which would indicate the amount that will be paid to the preferred shareholders in the event that the company fails. This amount must be paid in full before the common shareholders can be paid anything in the event of the liquidation of the company.

b. $350 million/$3.5 million = $100

c. The conversion option has increased substantially in value since issue. This increase is likely due to an expected new government contract most likely for aircraft.

d. The answer depends on whether the remaining preferred shares are redeemed for cash or converted into common shares. If Northrop Grumman pays for the conversion in cash, cash is reduced, as is preferred stock. If converted into common, the preferred stock is removed from the balance sheet and the common stock is “sold” for the book value of the preferred; that is, the par value and additional paid-in capital accounts increase as if the common were sold for the book value of the preferred.

e. Outstanding convertible preferred shares need to be considered in our analysis of the company, as the potential shares to be issued represent a contingent claim to the future cash flows of the company. Convertible preferred shares are considered in the computation of diluted EPS, which assumes conversion at the earliest possible opportunity. The forgone preferred dividends are removed from (added back to) the numerator, and the additional shares issued are added to the denominator. The net effect is a reduction in the diluted EPS over basic EPS.



C11-62. (15 minutes) King’s responsibility is to the shareholders of Image, Inc. Hatcher’s offer is beneficial to the shareholders, so, in theory, King should support Hatcher’s efforts. However, since it is likely that King and other managers will lose their jobs if Hatcher’s takeover attempt is successful, King’s inclination may be to resist Hatcher’s move. It would be unethical to pay Hatcher 50% above current market price to repurchase his stock. This would harm the remaining shareholders in two ways. First, blocking the takeover would deprive shareholders of the opportunity to sell their shares at a price that is substantially higher than current market price. Second, King would be using company funds to purchase Hatcher’s stock, so the other shareholders are essentially paying for King’s job security. A tactic that would be ethical and beneficial to shareholders is for King, along with other managers and directors, to make a competing offer to shareholders for the outstanding stock. In that way, shareholders benefit by receiving the higher stock price (whether from King or Hatcher) and if King acquires the company, he keeps his job. C11-63. (30 minutes) a. There are no cash proceeds from the stock dividend. b. 2013: $9,450,000 / 250,000 = $37.80 per share 2014: $10,285,000 / 275,000 = $37.40 per share c. Because of the stock dividend, the number of shares you own increased by 10% to

8,250 in 2014. Your percentage ownership in Pillar has remained the same. The market value of your shares at the end of 2014 is $214,500 (8,250 x $26). At December 14, just prior to the stock dividend, your shares were worth $210,000 (7,500 x $28).

d. Stock dividends, like stock splits, do not increase the book value of stockholders’

equity. Stock dividends are paid to indicate a continued expectation of earnings and earnings growth in periods when cash must be maintained for investment needs. Stock dividends also serve to keep the per share price of the stock at manageable levels during growth periods.

e. Retained earnings are restricted as to the amount of cash dividends that Pillar can

pay. Except for this restriction, paying a cash dividend then allowing shareholders to purchase additional shares would have accomplished the same thing as a stock dividend. However, some of the shareholders may have chosen not to purchase the additional shares. If this had happened, the company would have to make a public offering in order to raise the required cash. A public offer that is this small is not economical.

continued next page



C11-63. concluded f. The dividend cut is due to the restrictions on retained earnings and the amount of

cash needed to fund the plant addition. g. Retained earnings are not the same as cash. The company is borrowing $500,000

cash because that is how much additional cash will be needed to build the plant addition. The restriction on retained earnings simply prevents the company from using available cash to pay cash dividends.

C11-64. (20 minutes) The projected 5% decline in net income will reduce net income from $7,800,000 last year to $7,410,000 this year. The proposed stock buyback of 600,000 shares at midyear would reduce the weighted average shares outstanding from 4,000,000 to 3,700,000 (4,000,000 x 6/12 + 3,400,000 x 6/12). The resulting earnings per share would be $7,410,000 / 3,700,000 = $2.00 per share. Plummer is likely concerned about the proposal because the stock repurchase appears to manipulate EPS in order to achieve the goal of increasing EPS each year, earning management a nice bonus. This raises ethical concerns, since the cash might be better used to make profitable investments or pay a cash dividend to shareholders. A less obvious question is why Sunlight has so much “excess cash?” If the cash that would be used to repurchase stock (600,000 shares x market price per share) were invested in a profitable investment, management may be able to make up for the expected decline in earnings. It would be hard to believe that no profitable investment opportunities exist. Even a short-term investment in marketable securities might make up for the $390,000 decrease in earnings.

Documents

Reporting and Analyzing Revenues and Receivables