CH-4 The Income Statement and Statement of Cash Flows – Intermediate Accounting : Book Guide

Chapter 4 The Income Statement and Statement of Cash Flows 1 Question 4-1 The income statement is a change statement that reports transactions — revenues, expenses, gains and losses — that cause owners’ equity to change during a specified reporting period. Question 4-2 Comprehensive income is the total change in equity for a reporting period other than from transactions with owners. Reporting comprehensive income can be accomplished with a separate statement or by including the information in either the income statement or the statement of changes in shareholders’ equity. Question 4-3 Income from continuing operations includes the revenue, expense, gain and loss transactions that will probably continue in future periods. It is important to segregate the income effects of these items because they are the most important transactions in terms of predicting future cash flows. Question 4-4 Operating income includes revenues and expenses that are directly related to the principal revenue generating activities of the company. Nonoperating income includes items that are not directly related to these activities. Question 4-5 The single-step format first lists all revenues and gains included in income from continuing operations to arrive at total revenues and gains. All expenses and losses are then grouped and subtotaled, subtracted from revenues and gains to arrive at income from continuing operations. The multiple-step format reports a series (multiple) of intermediate totals such as gross profit, operating income, and income before taxes. Very often income statements adopt variations of these formats, falling somewhere in between the two extremes. Question 4-6 The term earnings quality refers to the ability of reported earnings (income) to predict a company’s future earnings. After all, an income statement simply reports on events that already have occurred. The relevance of any historical-based financial statement hinges on its predictive value. Chapter 4 The Income Statement and Statement of Cash Flows QUESTIONS FOR REVIEW OF KEY TOPICS 2 Question 4-7 Restructuring costs include costs associated with shutdown or relocation of facilities or downsizing of operations. They are reported as an operating expense in the income statement. Answers to Questions (continued) Question 4-8 The process of intraperiod tax allocation matches tax expense or tax benefit with each major component of income, specifically continuing operations and any item reported below continuing operations. The process is necessary to achieve the desired result of separating the total income effects of continuing operations from the two separately reported items - discontinued operations and extraordinary items, and also to show the after-tax effect of each of those two components. Question 4-9 A component of an entity comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes. The net-of-tax income effects of a discontinued operation must be disclosed separately in the income statement, below income from continuing operations. The income effects include income (loss) from operations and gain (loss) on disposal. The gain or loss on disposal must be disclosed either on the face of the statement or in a disclosure note. If the component is held for sale but not sold by the end of the reporting period, the income effects will include income (loss) from operations and an impairment loss if the fair value less costs to sell is less than the book value of the component’s assets. The income (loss) from operations of the component is reported separately in discontinued operations on prior income statements presented for comparative purposes. Question 4-10 Extraordinary items are material gains and losses that are both unusual in nature and infrequent in occurrence, taking into account the environment in which the entity operates. Question 4-11 Extraordinary gains and losses are presented, net of tax, in the income statement below discontinued operations, if any. 3 Answers to Questions (continued) Question 4-12 GAAP permit alternative treatments for similar transactions. Common examples are the choice among FIFO, LIFO, and average cost for the measurement of inventory and the choice among alternative revenue recognition methods. A change in accounting principle occurs when a company changes from one generally accepted treatment to another. In general, we report voluntary changes in accounting principles retrospectively. This means revising all previous periods’ financial statements as if the new method were used in those periods. In other words, for each year in the comparative statements reported, we revise the balance of each account affected. Specifically, we make those statements appear as if the newly adopted accounting method had been applied all along. Also, if retained earnings is one of the accounts whose balance requires adjustment (and it usually is), we revise the beginning balance of retained earnings for the earliest period reported in the comparative statements of shareholders’ equity (or statements of retained earnings if they’re presented instead). Then we create a journal entry to adjust all account balances affected as of the date of the change. In the first set of financial statements after the change, a disclosure note would describe the change and justify the new method as preferable. It also would describe the effects of the change on all items affected, including the fact that the retained earnings balance was revised in the statement of shareholders’ equity. An exception is a change in depreciation, amortization, or depletion method. These changes are accounted for as a change in estimate, rather than as a change in accounting principle. Changes in estimates are accounted for prospectively. The remaining book value is depreciated, amortized, or depleted, using the new method, over the remaining useful life. Question 4-13 Earnings per share (EPS) is the amount of income achieved during a period for each share of common stock outstanding. If there are different components of income reported below continuing operations, their effects on earnings per share must be disclosed. If a period contains discontinued operations and extraordinary items, EPS data must be reported separately for income from continuing operations and net income. Per share amounts for discontinued operations and extraordinary items would be disclosed on the face of the income statement. Question 4-14 A change in accounting estimate is accounted for in the year of the change and in subsequent periods; prior years’ financial statements are not restated. A disclosure note should justify that the change is preferable and describe the effect of a change on any financial statement line items and per share amounts affected for all periods reported. 4 Answers to Questions (concluded) Question 4-15 Prior period adjustments are accounted for by restating prior years’ financial statements when those statements are presented again for comparison purposes. The beginning of period retained earnings is increased or decreased on the statement of shareholders’ equity (or the statement of retained earnings) in the year the error is discovered. Question 4-16 The purpose of the statement of cash flows is to provide information about the cash receipts and cash disbursements of an enterprise during a period. Similar to the income statement, it is a change statement, summarizing the transactions that caused cash to change during a particular period of time. Question 4-17 The three categories of cash flows reported on the statement of cash flows are: 1. Operating activities — Inflows and outflows of cash related to the transactions entering into the determination of net income from operations. 2. Investing activities — Involve the acquisition and sale of (1) long-term assets used in the business and (2) nonoperating investment assets. 3. Financing activities — Involve cash inflows and outflows from transactions with creditors and owners. Question 4-18 Noncash investing and financing activities are transactions that do not increase or decrease cash but are important investing and financing activities. An example would be the acquisition of property, plant and equipment (an investing activity) by issuing either long-term debt or equity securities (a financing activity). These activities are reported either in a separate schedule or in a note. Question 4-19 The direct method of reporting cash flows from operating activities presents the cash effect of each operating activity directly on the statement of cash flows. The indirect method of reporting cash flows from operating activities is derived indirectly, by starting with reported net income and adding and subtracting items to convert that amount to a cash basis. 5 Brief Exercise 4-1 O’REILLY BEVERAGE COMPANY Statement of Comprehensive Income For the Year Ended December 31, 2006 Net income .......................................................... $650,000 Other comprehensive income (loss): Unrealized gains on investment securities net of tax ....................................................... $ 24,000 Deferred loss on derivatives, net of tax ........... (36,000) Total other comprehensive loss .......................... (12,000) Comprehensive income ....................................... $638,000 BRIEF EXERCISES 6 Brief Exercise 4-2 PACIFIC SCIENTIFIC CORPORATION Income Statement For the Year Ended December 31, 2006 ($ in millions) Revenues and gains: Sales .................................................................. $2,106 Gain on sale of investments ............................. 45 Total revenues and gains .............................. 2,151 Expenses and losses: Cost of goods sold ............................................ $1,240 Selling ................................................................ 126 General and administrative ............................... 105 Interest ............................................................... 35 Income tax expense* ........................................ 258 Total expenses and losses ............................. 1,764 Net income .......................................................... $ 387 *$2,151 – (1,240 + 126 + 105 + 35) = $645 x 40% = $258 Brief Exercise 4-3 (a) Sales revenue $2,106 Less: Cost of goods sold (1,240) Gross profit 866 Less: Selling expenses (126) General and administrative expenses (105) Operating income $ 635 (b) Gain on sale of investments 45 Interest expense (35) Nonoperating income $10 7 Brief Exercise 4-4 PACIFIC SCIENTIFIC CORPORATION Income Statement For the Year Ended December 31, 2006 ($ in millions) Sales revenue ...................................................... $2,106 Cost of goods sold .............................................. 1,240 Gross profit ......................................................... 866 Operating expenses: Selling ................................................................ $126 General and administrative ............................... 105 Total operating expenses .............................. 231 Operating income ................................................ 635 Other income (expense): Gain on sale of investments ............................. 45 Interest expense ................................................ (35) Total other income, net ................................. 10 Income before income taxes .............................. 645 Income tax expense* ........................................... 258 Net income .......................................................... $ 387 *$645 x 40% 8 Brief Exercise 4-5 (a) Sales revenue $300,000 Less: Cost of goods sold (160,000) General and administrative expenses (40,000) Restructuring costs (50,000) Selling expenses (25,000) Operating income $ 25,000 (b) Operating income $25,000 Add: Interest revenue 4,000 Deduct: Loss on sale of investments (22,000) Income before income taxes and Extraordinary item 7,000 Income tax expense (40%) (2,800) Income before extraordinary item $ 4,200 (c) Income before extraordinary item $ 4,200 Extraordinary item: Loss from flood damage, net of $20,000 tax benefit (30,000) Net loss (25,800) 9 Brief Exercise 4-6 WHITE AND SONS, INC. Partial Income Statement For the Year Ended December 31, 2006 Income before income taxes and extraordinary item ........... $ 850,000 Income tax expense* ........................................................... 340,000 Income before extraordinary item ...................................... 510,000 Extraordinary item: Loss from earthquake, net of $160,000 tax benefit ......... (240,000) Net income .......................................................................... $ 270,000 Earnings per share: Income before extraordinary item ....................................... $ 5.10 Loss from earthquake .......................................................... (2.40) Net income .......................................................................... $ 2.70 *$850,000 x 40% Note: Restructuring costs, interest revenue, and loss on sale of investments are included in income before income taxes and extraordinary item. 10 Brief Exercise 4-7 CALIFORNIA MICROTECH CORPORATION Partial Income Statement For the Year Ended December 31, 2006 Income from continuing operations before income taxes ... $ 5,800,000 Income tax expense* ........................................................... 1,740,000 Income from continuing operations .................................... $ 4,060,000 Discontinued operations: Loss from operations of discontinued component (including gain on disposal of $2,000,000)** ......................... (1,600,000) Income tax benefit ........................................................... 480,000 Loss on discontinued operations ...................................... (1,120,000) Net income .......................................................................... $ 2,940,000 * $5,800,000 x 30% ** Loss from operations of discontinued component: Gain on sale of assets $ 2,000,000 ($10 million less $8 million) Operating loss (3,600,000) Total before-tax loss $(1,600,000) 11 Brief Exercise 4-8 CALIFORNIA MICROTECH CORPORATION Partial Income Statement For the Year Ended December 31, 2006 Income from continuing operations before income taxes ... $ 5,800,000 Income tax expense* ........................................................... 1,740,000 Income from continuing operations .................................... $ 4,060,000 Discontinued operations: Loss from operations of discontinued component** ....... (3,600,000) Income tax benefit ........................................................... 1,080,000 Loss on discontinued operations ...................................... (2,520,000) Net income .......................................................................... $ 1,540,000 * $5,800,000 x 30% ** Includes only the operating loss. There is no impairment loss. 12 Brief Exercise 4-9 CALIFORNIA MICROTECH CORPORATION Partial Income Statement For the Year Ended December 31, 2006 Income from continuing operations before income taxes ... $ 5,800,000 Income tax expense* ........................................................... 1,740,000 Income from continuing operations .................................... $ 4,060,000 Discontinued operations: Loss from operations of discontinued component (including impairment loss of $1,000,000)** .......................... (4,600,000) Income tax benefit ........................................................... 1,380,000 Loss on discontinued operations ...................................... (3,220,000) Net income .......................................................................... $ 840,000 * $5,800,000 x 30% ** Loss from operations of discontinued component: Impairment loss ($8 million book value less $7 million net fair value) $(1,000,000) Operating loss (3,600,000) Total before-tax loss $(4,600,000) 13 Brief Exercise 4-10 The change in inventory method is a change in accounting principle. The depreciation method change is considered to be a change in accounting estimate that is achieved by a change in accounting principle and is accounted for prospectively, exactly as we would account for any other change in estimate. The inventory method change, however, is accounted for by retrospectively recasting prior years’ financial statements presented with the current year for comparative purposes, applying the new inventory method (FIFO in this case) in those years. Brief Exercise 4-11 This is a change in accounting estimate. When an estimate is revised as new information comes to light, accounting for the change in estimate is quite straightforward. We do not restate prior years' financial statements to reflect the new estimate. Instead, we merely incorporate the new estimate in any related accounting determinations from there on. If the after- tax income effect of the change in estimate is material, the effect on net income and earnings per share must be disclosed in a note, along with the justification for the change. Depreciation for 2006 is $25,000: $300,000 Cost $ 50,000 Old annual depreciation ($300,000 ÷ 6 years) x 2 years 100,000 Depreciation to date (2004-2005) 200,000 Book value ÷ 8 yrs. Estimated remaining life (10 years - 2 years) $ 25,000 New annual depreciation 14 Brief Exercise 4-12 Cash Flows from Operating Activities: Collections from customers $ 660,000 Interest on note receivable 12,000 Interest on note payable (18,000) Payment of operating expenses (440,000) Net cash flows from operating activities $214,000 Only these four cash flow transactions relate to operating activities. The others are investing and financing activities. Brief Exercise 4-13 Cash Flows from Investing Activities: Sale of land $ 40,000 Purchase of equipment (120,000) Net cash flows from investing activities $(80,000) Cash Flows from Financing Activities: Proceeds from note payable collection $100,000 Issuance of common stock 200,000 Payment of dividends (30,000) Net cash flows from financing activities 270,000 15 Brief Exercise 4-14 Cash Flows from Operating Activities: Net income $45,000 Adjustments for noncash effects: Depreciation expense 80,000 Increase in prepaid rent (60,000) Increase in salaries payable 15,000 Increase in income taxes payable 12,000 Net cash inflows from operating activities $92,000 16 Exercise 4-1 Requirement 1 THE MASSOUD CONSULTING GROUP Statement of Income and Comprehensive Income (in part) For the Year Ended December 31, 2006 Net income .......................................................... $1,354,000 Other comprehensive income (loss): Foreign currency translation gain, net of tax ... $168,000 Unrealized losses on investment securities, net of tax ....................................................... (56,000) Total other comprehensive income ..................... 112,000 Comprehensive income ....................................... $1,466,000 Requirement 2 THE MASSOUD CONSULTING GROUP Statement of Comprehensive Income For the Year Ended December 31, 2006 Net income .......................................................... $1,354,000 Other comprehensive income (loss): Foreign currency translation gain, net of tax ... $168,000 Unrealized losses on investment securities net of tax ....................................................... (56,000) Total other comprehensive income ..................... 112,000 Comprehensive income ....................................... $1,466,000 EXERCISES 17 Exercise 4-2 Requirement 1 GREEN STAR CORPORATION Income Statement For the Year Ended December 31, 2006 Revenues and gains: Sales .................................................................. $1,300,000 Interest .............................................................. 30,000 Gain on sale of equipment ................................ 50,000 Total revenues and gains .............................. 1,380,000 Expenses and losses: Cost of goods sold ............................................ $720,000 Salaries .............................................................. 160,000 Depreciation ...................................................... 50,000 Interest ............................................................... 40,000 Rent ................................................................... 25,000 Income tax ........................................................ 130,000 Total expenses and losses ............................. 1,125,000 Net income .......................................................... $ 255,000 Earnings per share ............................................... $2.55 18 Exercise 4-2 (concluded) Requirement 2 GREEN STAR CORPORATION Income Statement For the Year Ended December 31, 2006 Sales revenue ...................................................... $1,300,000 Cost of goods sold .............................................. 720,000 Gross profit ......................................................... 580,000 Operating expenses: Salaries .............................................................. $160,000 Depreciation ...................................................... 50,000 Rent .................................................................. 25,000 Total operating expenses .............................. 235,000 Operating income ................................................ 345,000 Other income (expense): Interest revenue ................................................ 30,000 Gain on sale of equipment ................................ 50,000 Interest expense ................................................ (40,000) Total other income, net ................................. 40,000 Income before income taxes .............................. 385,000 Income tax expense ............................................. 130,000 Net income .......................................................... $ 255,000 Earnings per share ............................................... $2.55 19 Exercise 4-3 Requirement 1 GENERAL LIGHTING CORPORATION Income Statement For the Year Ended December 31, 2006 Revenues and gains: Sales .................................................................. $2,350,000 Rental revenue .................................................. 80,000 Total revenues and gains .............................. 2,430,000 Expenses and losses: Cost of goods sold ............................................ $1,200,300 Salaries ............................................................. 300,000 Depreciation ...................................................... 100,000 Interest ............................................................... 90,000 Rent .................................................................. 50,000 Loss on sale of equipment ................................ 22,500 Loss from inventory write-down ...................... 200,000 Income tax expense * ........................................ 186,880 Total expenses and losses ............................. 2,149,680 Income before extraordinary item ...................... Extraordinary item: Loss from flood damage (net of $48,000 tax benefit) Net income .......................................................... 280,320 (72,000) $ 208,320 Earnings per share: Income before extraordinary item ...................... Extraordinary loss ............................................... Net income .......................................................... $ .93 (.24) $ .69 * 40% x $467,200 20 Exercise 4-3 (concluded) Requirement 2 GENERAL LIGHTING CORPORATION Income Statement For the Year Ended December 31, 2006 Sales revenue ...................................................... $2,350,000 Cost of goods sold .............................................. 1,200,300 Gross profit ......................................................... 1,149,700 Operating expenses: Salaries ............................................................. $300,000 Depreciation ..................................................... 100,000 Rent .................................................................. 50,000 Loss from inventory write-down ...................... 200,000 Total operating expenses .............................. 650,000 Operating income ................................................ 499,700 Other income (expense): Rental revenue .................................................. 80,000 Loss on sale of equipment ................................ (22,500) Interest expense ................................................ (90,000) Total other income (expense), net ................ (32,500) Income before taxes and extraordinary item ...... 467,200 Income tax expense * ........................................... 186,880 Income before extraordinary item ...................... Extraordinary item: Loss from flood damage (net of $48,000 tax benefit) Net income .......................................................... 280,320 (72,000) $ 208,320 Earnings per share: Income before extraordinary item ...................... Extraordinary loss ............................................... Net income .......................................................... $ .93 (.24) $ .69 * 40% x $467,200 21 Exercise 4-4 LINDOR CORPORATION Statement of Income and Comprehensive Income For the Year Ended December 31, 2006 Sales revenue ................................................................... $2,300,000 Cost of goods sold ........................................................... 1,400,000 Gross profit ...................................................................... 900,000 Operating expenses: Selling and administrative ............................................. 420,000 Operating income ............................................................ 480,000 Other income (expense): Interest expense ............................................................... (40,000) Income before income taxes and extraordinary item ...... 440,000 Income tax expense * ....................................................... 132,000 Income before extraordinary item ................................... Extraordinary item: Gain on early debt extinguishment (net of $120,000 tax expense) .................................................................. Net income Other comprehensive income: Unrealized holding gains on investment securities, net of tax .................................................................... Comprehensive income ................................................... 308,000 280,000 588,000 56,000 $644,000 Earnings per share: Income before extraordinary item ................................... Extraordinary gain ........................................................... Net income ....................................................................... $ 0.31 0.28 $ 0.59 * 30% x $440,000 22 Exercise 4-5 AXEL CORPORATION Income Statement For the Year Ended December 31, 2006 Sales revenue ................................................................... $ 592,000 Cost of goods sold ........................................................... 325,000 Gross profit ...................................................................... 267,000 Operating expenses: Selling .......................................................................... $67,000 Administrative ............................................................. 87,000 Restructuring costs ....................................................... 55,000 Total operating expenses ........................................... 209,000 Operating income ............................................................ 58,000 Other income (expense): Interest and dividends ................................................... 32,000 Interest expense ............................................................ Total other income, net ................................................. (26,000) 6,000 Income before income taxes and extraordinary item ..... 64,000 Income tax expense* ....................................................... 25,600 Income before extraordinary item ................................... Extraordinary item: Gain on early debt extinguishment (net of $34,400 tax expense) .................................................................. Net income ....................................................................... 38,400 51,600 $ 90,000 Earnings per share: Income before extraordinary item ................................... Extraordinary gain ........................................................... Net income ....................................................................... $ .38 .52 $0.90 * 40% x $64,000 23 Exercise 4-6 CHANCE COMPANY Partial Income Statement For the Year Ended December 31, 2006 Income from continuing operations .................................... $ 350,000 Discontinued operations: Loss from operations of discontinued component (including loss on disposal of $400,000)* ............................... (530,000) Income tax benefit ........................................................... 212,000 Loss on discontinued operations ...................................... (318,000) Net income .......................................................................... $ 32,000 Earnings per share: Income from continuing operations .................................... $ 3.50 Loss from discontinued operations ..................................... (3.18) Net income .......................................................................... $ .32 * Loss on discontinued operations: Loss on sale of assets $(400,000) Operating loss (130,000) Total before-tax loss (530,000) Less: Income tax benefit (40%) 212,000 Net-of-tax loss $(318,000) 24 Exercise 4-7 ESQUIRE COMIC BOOK COMPANY Partial Income Statement For the Year Ended December 31, 2006 Income from continuing operations * .................................. $ 552,000 Discontinued operations: Income from operations of discontinued component (including loss on disposal of $350,000) ................................. 150,000 Income tax expense ........................................................... 60,000 Income on discontinued operations .................................. 90,000 Net income ............................................................................ 642,000 * Income from continuing operations: Income before considering additional items $1,000,000 Decrease in income due to restructuring costs (80,000) Before-tax income from continuing operations 920,000 Income tax expense (40%) (368,000) Income from continuing operations $ 552,000 25 Exercise 4-8 Requirement 1 KANDON ENTERPRISES, INC. Partial Income Statement For the Year Ended December 31, 2006 Income from continuing operations .................................... $ 400,000 Discontinued operations: Loss from operations of discontinued component (including impairment loss of $50,000) * .............................. (190,000) Income tax benefit ............................................................. 76,000 Loss on discontinued operations ....................................... (114,000) Net income .......................................................................... $ 286,000 * Loss on discontinued operations: Operating loss $(140,000) Impairment loss ($250,000 - 200,000) (50,000) Net before-tax loss (190,000) Income tax benefit (40%) 76,000 Net after-tax loss on discontinued operations $(114,000) Requirement 2 KANDON ENTERPRISES, INC. Partial Income Statement For the Year Ended December 31, 2006 Income from continuing operations .................................... $ 400,000 Discontinued operations: Loss from operations of discontinued component * ......... (140,000) Income tax benefit ............................................................ 56,000 Loss on discontinued operations ....................................... (84,000) Net income .......................................................................... $ 316,000 *Includes only the operating loss during the year. There is no impairment loss. 26 Exercise 4-9 Pretax income from continuing operations $14,000,000 Income tax expense (5,600,000) Income from continuing operations 8,400,000 Less: Net income 7,200,000 Loss from discontinued operations $1,200,000 $1,200,000 ÷ 60%* = $2,000,000 = before tax loss from discontinued operations. *1-tax rate of 40% = 60% Pretax income of division $4,000,000 Add: Net loss from discontinued operations 2,000,000 Impairment loss $6,000,000 Fair value of division’s assets $11,000,000 Plus impairment loss 6,000,000 Book value of division’s assets $17,000,000 27 Exercise 4-10 Requirement 1 This is a change in accounting estimate. Requirement 2 When an estimate is revised as new information comes to light, accounting for the change in estimate is quite straightforward. We do not restate prior years' financial statements to reflect the new estimate. Instead, we merely incorporate the new estimate in any related accounting determinations from there on. If the after- tax income effect of the change in estimate is material, the effect on net income and earnings per share must be disclosed in a note, along with the justification for the change. Requirement 3 $800,000 Cost $160,000 Old annual depreciation ($800,000 ÷ 5 years) x 2 years 320,000 Depreciation to date (2004-2005) 480,000 Book value ÷ 6 yrs. Estimated remaining life (8 years - 2 years) $ 80,000 New annual depreciation 28 Exercise 4-11 Requirement 1 In general, we report voluntary changes in accounting principles retrospectively. However, a change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. In other words, a change in the depreciation method reflects a change in the (a) estimated future benefits from the asset, (b) the pattern of receiving those benefits, or (c) the company’s knowledge about those benefits, and therefore the two events should be reported the same way. Accordingly, Canliss reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from now on. The undepreciated cost remaining at the time of the change would be depreciated using the straight-line method over the remaining useful life. A disclosure note should justify that the change is preferable and describe the effect of the change on any financial statement line items and per share amounts affected for all periods reported. Requirement 2 Asset’s cost $800,000 Accumulated depreciation to date ($320,000 + 192,000) (512,000) To be depreciated over remaining 3 years $288,000 2006 straight-line depreciation: $288,000 ÷ 3 years = $96,000 Adjusting entry: Depreciation expense (calculated above) ...................... 96,000 Accumulated depreciation ....................................... 96,000 Exercise 4-12 Earnings per share: Income from continuing operations $5.00 Loss from discontinued operations (1.60) Extraordinary gain 2.20 Net income $5.60 29 Exercise 4-13 1. d 2. d Exercise 4-14 1. b Purchase of equipment for cash. 2. a Payment of employee salaries. 3. a Collection of cash from customers. 4. c Cash proceeds from a note payable. 5. b Purchase of common stock of another corporation for cash. 6. c Issuance of common stock for cash. 7. b Sale of machinery for cash. 8. a Payment of interest on note payable. 9. d Issuance of bonds payable in exchange for land and building. 10. c Payment of cash dividends to shareholders. 11. c Payment of principal on note payable. 30 Exercise 4-15 Bluebonnet Bakers Statement of Cash Flows For the Year Ended December 31, 2006 Cash flows from operating activities: Collections from customers $ 380,000 Interest on note receivable 6,000 Purchase of inventory (160,000) Interest on note payable (5,000) Payment of salaries (90,000) Net cash flows from operating activities $131,000 Cash flows from investing activities: Collection of note receivable 50,000 Sale of investments 30,000 Purchase of equipment (85,000) Net cash flows from investing activities (5,000) Cash flows from financing activities: Proceeds from note payable 100,000 Payment of note payable (25,000) Payment of dividends (20,000) Net cash flows from financing activities 55,000 Net increase in cash 181,000 Cash and cash equivalents, January 1 17,000 Cash and cash equivalents, December 31 $ 198,000 31 Exercise 4-16 Requirement 1 Financing Investing Operating 1. $300,000 2. 4 $(10,000) 3. 4 4. 4 5. $ (5,000) 6. (6,000) 7. (70,000) 8. 55,000 9. 4 __________ __________ __________ $300,000 $(10,000) $(26,000) = $264,000 32 Exercise 4-16 (concluded) Requirement 2 Wainwright Corporation Statement of Cash Flows For the Month Ended March 31, 2006 Cash flows from operating activities: Collections from customers $ 55,000 Payment of rent (5,000) Payment of one-year insurance premium (6,000) Payment to suppliers of merchandise for sale (70,000) Net cash flows from operating activities $ (26,000) Cash flows from investing activities: Purchase of equipment (10,000) Net cash flows from investing activities (10,000) Cash flows from financing activities: Issuance of common stock 300,000 Net cash flows from financing activities 300,000 Net increase in cash 264,000 Cash and cash equivalents, March 1 40,000 Cash and cash equivalents, March 31 $ 304,000 Noncash investing and financing activities: Acquired $40,000 of equipment by paying cash and issuing a note as follows: Cost of equipment $40,000 Cash paid 10,000 Note issued $30,000 33 Exercise 4-17 1. c 2. d 3. b 34 Exercise 4-18 Tiger Enterprises Statement of Cash Flows For the Year Ended December 31, 2006 ($ in thousands) Cash flows from operating activities: Net income $ 900 Adjustments for noncash effects: Depreciation expense 240 Decrease in accounts receivable 80 Increase in inventory (40) Increase in prepaid insurance (30) Decrease in accounts payable (60) Decrease in administrative & other payables (100) Increase in income taxes payable 50 Net cash flows from operating activities $1,040 Cash flows from investing activities: Purchase of plant and equipment (300) Cash flows from financing activities: Proceeds from issuance of common stock 100 Proceeds from note payable 200 Payment of dividends (1) (940) Net cash flows from financing activities (640) Net increase in cash 100 Cash, January 1 200 Cash, December 31 $ 300 (1) Retained earnings, beginning $540 + Net income 900 - Dividends x x = $940 Retained earnings, ending $500 35 Exercise 4-19 The T-account analysis of the transactions related to operating cash flows is shown below. To derive the cash flows, the beginning and ending balances in the related assets and liabilities are inserted, together with the revenue and expense amounts from the income statements. In each balance sheet account, the remaining (plug) figure is the other half of the cash increases or decreases. Cash Flows (Operating) (a.) 7,080 (b.) 130 (c.) 3,460 (d.) 1,900 (e.) 550 Sales Revenue Accounts Receivable 1/1 830 (a.) 7,080 7,000 7,000 12/31 750 Prepaid Insurance Insurance Expense 1/1 20 (b.) 130 100 100 12/31 50 Accounts Payable Inventory Cost of Goods Sold (c.) 3,460 1/1 360 1/1 600 3,360 3,360 3,400 3,400 12/31 300 12/31 640 Admin. & Other Payables Admin. & Other Expense (d.) 1,900 1/1 400 1,800 1,800 12/31 300 Income Taxes Payable Income Tax Expense (e.) 550 1/1 150 600 600 12/31 200 Based on the information in the T-accounts above, the operating activities section of the SCF for Tiger Enterprises would be as shown below. 36 Exercise 4-19 (concluded) Tiger Enterprises Statement of Cash Flows For the Year Ended December 31, 2006 ($ in thousands) Cash flows from operating activities: Collections from customers $ 7,080 Prepayment of insurance (130) Payment to inventory suppliers (3,460) Payment for administrative & other exp. (1,900) Payment of income taxes (550) Net cash flows from operating activities $ 1,040 Exercise 4-20 List A List B f 1. Intraperiod tax allocation a. Unusual, infrequent, and material gains and losses. g 2. Comprehensive income b. Starts with net income and works backwards to convert to cash. a 3. Extraordinary items c. Reports the cash effects of each operating activity directly on the statement. l 4. Operating income d. Correction of a material error of a prior period. k 5. An operation (according to SFAS 144) e. Related to the external financing of the company. j 6. Earnings per share f. Associates tax with income statement item. d 7. Prior period adjustment g. Total nonowner change in equity. e 8. Financing activities h. Related to the transactions entering into the determination of net income. h 9. Operating activities (SCF) i. Related to the acquisition and disposition of long-term assets. i 10. Investing activities j. Required disclosure for publicly traded corporation. c 11. Direct method k. A component of an entity. b 12. Indirect method l. Directly related to principal revenue- generating activities. 37 Exercise 4-21 1. c. The operating section of a retailer’s income statement includes all revenues and costs necessary for the operation of the retail establishment, e.g., sales, cost of goods sold, administrative expenses, and selling expenses. 2. d. Discontinued operations and extraordinary gains and losses are shown separately in the income statement, below income from continuing operations. The cumulative effect of a change in accounting principle is accounted for by retrospectively revising prior years’ financial statements. 3. a. Extraordinary items should be presented net of tax after income from operations. 38 Problem 4-1 DUKE COMPANY Statement of Income and Comprehensive Income For the Year Ended December 31, 2006 Sales revenue .................................................................. $15,000,000 Cost of goods sold ........................................................... 9,000,000 Gross profit ..................................................................... 6,000,000 Operating expenses: General and administrative .......................................... $1,000,000 Selling ......................................................................... 500,000 Restructuring costs ....................................................... 300,000 Loss from write-down of obsolete inventory 400,000 Total operating expenses .......................................... 2,200,000 Operating income ............................................................ 3,800,000 Other income (expense): Interest expense ............................................................ (700,000) Income before income taxes and extraordinary item ...... 3,100,000 Income tax expense ......................................................... 1,240,000 Income before extraordinary item ................................... 1,860,000 Extraordinary item: Loss from expropriation of overseas plant (net of $1,200,000 tax benefit) ............................................ (1,800,000) Net Income ....................................................................... 60,000 Other comprehensive income (loss): Foreign currency translation adjustment loss, net of tax (120,000) Unrealized gains on investment securities, net of tax 108,000 Total other comprehensive loss (12,000) Comprehensive income $ 48,000 Notes: 1. The restructuring costs and the loss from write-down of inventory are not extraordinary items. 2. The depreciation expense error is a prior period adjustment and is not reported in the income statement. PROBLEMS 39 Problem 4-2 REED COMPANY Comparative Income Statements For the Years Ended December 31 2006 2005 Sales revenue ........................................................ [1] $4,000,000 [6] $3,000,000 Cost of goods sold ................................................ [2] 2,570,000 [7] 1,680,000 Gross profit ........................................................... 1,430,000 1,320,000 Operating expenses: Administrative .................................................... [3] 750,000 [8] 635,000 Selling ................................................................ [4] 340,000 [9] 282,000 Loss from fire damage ........................................ 50,000 - - Loss from write-down of obsolete inventory ...... 35,000 - - Total operating expenses ................................ 1,175,000 917,000 Operating income ................................................. 255,000 403,000 Other income (expense): Interest revenue ................................................... 150,000 140,000 Interest expense ................................................... (200,000) (200,000) Total other expenses (net) .............................. (50,000) (60,000) Income from continuing operations before income taxes and extraordinary item ............... 205,000 343,000 Income tax expense .............................................. 82,000 137,200 Income from continuing operations before extraordinary item ............................................. 123,000 205,800 Discontinued operations: Income (loss) from operations of discontinued component (including loss on disposal of $50,000 in 2006) ................................................ (10,000) 110,000 Income tax benefit (expense) ................................ 4,000 (44,000) Income (loss) on discontinued operations ......... [5] (6,000) 66,000 Income before extraordinary item ........................ 117,000 271,800 Extraordinary item: Loss from early extinguishment of debt (net of $40,000 tax benefit) .................................. (60,000) - - Net income ............................................................ $ 57,000 $ 271,800 Earnings per share: Income from continuing operations before extraordinary item ............................................. $ .41 $ .69 Discontinued operations ...................................... (.02) .22 Extraordinary item .............................................. (.20) - - Net income ............................................................ $ .19 $ .91 40 Problem 4-2 (concluded) [1] $4,400,000 - 400,000 [2] $2,860,000 - 290,000 [3] $800,000 - 50,000 [4] $360,000 - 20,000 [5] Loss in 2006: Operating income $ 40,000 Loss on sale of assets (50,000) Loss before tax benefit (10,000) Tax benefit (40% x $10,000) 4,000 Loss on discontinued operations, net of tax benefit $ (6,000) [6] $3,500,000 - 500,000 (sales from discontinued operation) [7] $2,000,000 - 320,000 (cost of goods sold from discontinued operation) [8] $675,000 - 40,000 (administrative expenses from discontinued operations) [9] $312,000 - 30,000 (selling expenses from discontinued operations) 41 Problem 4-3 Requirement 1 JACKSON HOLDING COMPANY Comparative Income Statements (in part) For the Years Ended December 31 2006 2005 Income from continuing operations before income taxes [1] ......................................... $3,000,000 $1,300,000 Income tax expense ......................................... 1,200,000 520,000 Income from continuing operations ................ 1,800,000 780,000 Discontinued operations: Income from operations of discontinued component (including gain on disposal of $600,000 in 2006) [2] ....................................... 200,000 (300,000) Income tax expense (benefit) ........................ 80,000 120,000 Income (loss) on discontinued operations .... 120,000 (180,000) Net Income ...................................................... $1,920,000 $ 600,000 [1] Income from continuing operations before income taxes: 2006 2005 Unadjusted $2,600,000 $1,000,000 Add: Loss from discontinued operation 400,000 300,000 Adjusted $3,000,000 $1,300,000 [2] Income from discontinued operations: 2006 2005 Operating loss $(400,000) $(300,000) Gain on disposal 600,000 - Total $ 200,000 $(300,000) Problem 4-3 (concluded) Requirement 2 The 2006 income from discontinued operations would include only the operating loss of $400,000. Since no impairment loss is indicated ($5,000,000 – 42 4,400,000 = $600,000 anticipated gain), none is included. The anticipated gain on disposal is not recognized until it is realized, presumably in the following year. Requirement 3 The 2006 income from discontinued operations would include the operating loss of $400,000 as well as an impairment loss of $500,000 ($4,400,000 book value of assets less $3,900,000 fair value). 43 Problem 4-4 Requirement 1 MICRON CORPORATION Partial Income Statement For the Year Ended December 31, 2006 Income from continuing operations before income taxes and extraordinary item ........ [1] $1,300,000 Income tax expense ..................................... 390,000 Income from continuing operations ............ 910,000 Discontinued operations: Loss from operations of discontinued component (including loss on disposal of $300,000) ................................................. $ (140,000) Income tax benefit .................................... (42,000) Loss on discontinued operations ............... [2] (98,000) Income before extraordinary item .............. 812,000 Extraordinary item: Gain from early extinguishment of debt (net of $120,000 tax expense) ..................... 280,000 Net Income .................................................. $1,092,000 [1] Income from continuing operations before taxes: Unadjusted $1,200,000 Add: Gain from sale of factory 100,000 Adjusted $1,300,000 [2] Loss on discontinued operations: Operating income $ 160,000 Deduct: Loss on sale of assets (300,000) Loss before tax (140,000) Tax benefit (30% x $140,000) 42,000 Loss on discontinued operations $ (98,000) Requirement 2 These events will not, or are unlikely to occur again in the near future. By segregating them, users are better able to predict future cash flows. 44 Problem 4-5 Requirement 1 Diversified Portfolio Corporation Statement of Cash Flows For the Year Ended December 31, 2006 Cash flows from operating activities: Collections from customers (1) $880,000 Payment of operating expenses (2) (660,000) Payment of income taxes (3) (85,000) Net cash flows from operating activities $135,000 Cash flows from investing activities: Sale of investments 50,000 Net cash flows from investing activities 50,000 Cash flows from financing activities: Proceeds from issue of common stock 100,000 Payment of dividends (80,000) Net cash flows from financing activities 20,000 Increase in cash 205,000 Cash and cash equivalents, January 1 70,000 Cash and cash equivalents, December 31 $275,000 (1) $900,000 in service revenue less $20,000 increase in accounts receivable. (2) $700,000 in operating expenses less $30,000 in depreciation less $10,000 increase in accounts payable. (3) $80,000 in income tax expense plus $5,000 decrease in income taxes payable. 45 Problem 4-5 (concluded) Requirement 2 Diversified Portfolio Corporation Statement of Cash Flows For the Year Ended December 31, 2006 Cash flows from operating activities: Net income $120,000 Adjustments for noncash effects: Depreciation expense 30,000 Increase in accounts receivable (20,000) Increase in accounts payable 10,000 Decrease in income taxes payable (5,000) Net cash flows from operating activities $135,000 46 Problem 4-6 1. Restructuring is an example of an event that is either unusual or infrequent, but not both. Restructuring costs should be included in income from continuing operations but reported as a separate income statement component. The item is reported gross, not net of tax as with extraordinary gains and losses. 2. The extraordinary gain should be presented, net of tax, in the income statement below income from continuing operations. Also, earnings per share for income from continuing operations and for the extraordinary item should be disclosed. 3. The correction of the error should be treated as a prior period adjustment to beginning retained earnings, not as an adjustment to current year's cost of goods sold. In addition, the 2005 financial statements should be restated to reflect the correction, and a disclosure note is required that communicates the impact of the error on 2005 income. 47 Problem 4-7 ALEXIAN SYSTEMS, INC. Income Statement For the Year Ended December 31, 2006 ($ in millions except per share date) Net sales revenue ................................................ $425 Cost of goods sold .............................................. [1] 265 Gross profit ......................................................... 160 Operating expenses: Selling and administrative ................................ [2] $128 Restructuring costs ........................................... 26 Total operating expenses .............................. 154 Operating income ................................................ 6 Other income: Interest revenue ................................................ 3 Gain on sale of assets ....................................... 6 Total other income ........................................ 9 Income before income taxes and extraordinary item ................................................................. 15 Income tax expense ............................................. [3] 6 Income before extraordinary item ...................... Extraordinary gain (net of $48 in taxes) ..................... Net income .......................................................... 9 [4] 72 $ 81 Earnings per share: Income before extraordinary item ...................... Extraordinary gain .............................................. Net income .......................................................... $ 0.45 3.60 $ 4.05 [1] $270 - 5 (prior period adjustment) [2] $154 - 26 (restructuring costs) [3] 40% x $15 [4] $120 less taxes of $48 (40% x $120) Note: The difference in net income of $3 million ($81 million compared to $78 million on the original income statement) is the effect of the inventory error of $5 million, less the 40% tax effect. 48 Problem 4-8 REMBRANDT PAINT COMPANY Income Statement For the Year Ended December 31, 2006 ($ in thousands, except per share amounts) Sales revenue ................................................................... $18,000 Cost of goods sold ........................................................... 10,500 Gross profit ...................................................................... 7,500 Operating expenses: Selling and administrative ............................................ $2,500 Restructuring costs ....................................................... 800 3,300 Operating income ............................................................ 4,200 Interest income (expense), net ......................................... (150) Income from continuing operations before income taxes and extraordinary item ................................................. 4,050 Income tax expense ......................................................... 1,215 Income from continuing operations before extraordinary item .............................................................................. 2,835 Discontinued operations: Income from operations of discontinued component (including gain on disposal of $2,000) .................................. 400 Income tax expense ...................................................... 120 Income on discontinued operations ............................. 280 Income before extraordinary item ................................... 3,115 Extraordinary gain (net of $900 tax expense) ..................... 2,100 Net income ........................................................................ 5,215 Earnings per share: Income from continuing operations before extraordinary item ............................................................................... $ 5.67 Income on discontinued operations ................................. .56 Extraordinary gain ........................................................... 4.20 Net income ....................................................................... $10.43 49 Problem 4-9 Requirement 1 2005 Cash: 2005 Cash + Net increase in cash = 2006 Cash 2005 Cash + 61 = 120 2005 Cash = 59 2006 A/R: 2005 A/R + Cr. Sales – Cash collections = 2006 A/R 84 + 80 – 71 = 93 2005 Inventory: 2005 A/P + Purchases – Cash Paid = 2006 A/P 30 + Purchases – 30 = 40 Therefore, Purchases = 40 2005 Inventory + Purchases – 2006 Inventory = Cost of goods sold 2005 Inventory + 40 – 60 = 32 2005 Inventory = 52 2005 Accumulated depreciation: Gain on sale of equipment was 15; Cash received was 40; therefore, book value of equipment was 25. Since the cost of equipment sold was 50 (200 - 150), accumulated depreciation on equipment sold must have been 25. 2005 Accumulated depreciation + Depreciation expense – Accumulated depreciation on equipment sold = 2006 Accumulated depreciation 2005 Accumulated depreciation + 10 – 25 = 40 2005 Accumulated depreciation = 30 + 25 = $55 50 Problem 4-9 (continued) 2005 Total assets: $59 + 84 + 52 + 200 – 55 = $340 2006 Total assets: $120 + 93 + 60 + 150 – 40 = $383 2005 Income taxes payable: 2005 Inc. taxes payable + Inc. tax expense – Income taxes paid = 2006 Inc. taxes payable 2005 Inc. taxes payable =2006 Inc. taxes payable + Taxes paid – Inc. tax expense 2005 Inc. taxes payable = 22 + 9 – 7 = $24 2006 Retained earnings: 2005 R/E + Net income – Dividends = 2006 R/E 47 + 28 – 3 = 72 2005 Total liabilities and shareholders’ equity: $30 + 9 + 24 + 230 + 47 = $340 2006 Total liabilities and shareholders’ equity: $40 + 9 + 22 + 240 + 72 = $383 51 Problem 4-9 (concluded) Requirement 2 Grandview Corporation Statement of Cash Flows For the Year Ended December 31, 2006 ($ in millions) Cash flows from operating activities: Net income $ 28 Adjustments for noncash effects: Depreciation expense 10 Gain on sale of equipment (15) Increase in accounts receivable1 (9) Increase in inventory2 (8) Increase in accounts payable3 10 Decrease in income taxes payable4 (2) Net cash flows from operating activities $14 1 $93 – 84 2 $60 – 52 3 $40 – 30 4 $22 – 24 52 Judgment Case 4-1 Requirement 1 The term earnings quality refers to the ability of reported earnings (income) to predict a company’s future earnings. After all, an income statement simply reports on events that already have occurred. The relevance of any historical-based financial statement hinges on its predictive value. Requirement 2 To enhance predictive value, analysts try to separate a company’s transitory earnings effects from its permanent earnings. Transitory earnings effects result from transactions or events that are not likely to occur again in the foreseeable future, or that are likely to have a different impact on earnings in the future. Requirement 3 An often-debated contention is that, within GAAP, managers have the power, to a limited degree, to manipulate reported company income. And the manipulation is not always in the direction of higher income. Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. Requirement 4 You would consider the size of the gain in relation to net income, the size of the company’s investment portfolio, and the frequency of gains and losses from the sale of investment securities in past years. The main objective is to determine the likelihood of this type of gain occurring again in the future. CASES 53 Judgment Case 4-2 Requirement 1 Restructuring costs include costs associated with shutdown or relocation of facilities or downsizing of operations. Facility closings and related employee layoffs translate into costs incurred for severance pay and relocation costs as well as asset write-downs or write-offs. Requirement 2 Prior to 2003, restructuring costs were recognized (expensed) in the period the decision to restructure was made, not in the period or periods in which the actual activities took place. Now, restructuring costs are expensed in the period(s) incurred. Requirement 3 Restructuring costs would be included as an operating expense in a multi-step income statement. Requirement 4 An analyst must interpret restructuring charges in light of a company’s past history in this area. Information in disclosure notes describing the restructuring and management plans related to the business involved also can be helpful. Judgment Case 4-3 No. Companies generally prefer to report earnings that follow a smooth, regular, upward path. They try to avoid declines, but they also want to avoid increases that vary wildly from year to year. It is better to have two years of 15% earnings increases than a 30% gain one year and none the next. As a result, some companies “bank” earnings by understating them in particularly good years and use the banked profits to increase earnings in bad years. 54 Real World Case 4-4 Requirement 1 Companies often voluntarily provide a pro forma earnings number when they announce annual or quarterly earnings calculated according to GAAP. These pro forma earnings numbers are management’s view of permanent earnings. These pro forma earnings numbers are controversial as they represent management’s biased view of permanent earnings and should be interpreted in that light. Requirement 2 The term earnings quality refers to the ability of reported earnings (income) to predict a company’s future earnings. Management believes that pro forma earnings are of much higher quality than reported earnings because they are more indicative of future profitability. Requirement 3 There are some obvious reconciling items, to include restructuring costs and other special charges of $1,170 million, Inventory charges of $2,249 million and in-process research and development of $109 million. Cisco offered the following reconciliation ($ in millions): GAAP loss $(2,693) Add: Restructuring costs and other special charges $1,170 In-process research and development 109 Amortization of goodwill and other acquisition costs* 346 Payroll tax on stock options exercised 10 Inventory charges 2,249 Total adjustments 3,884 Tax effects (approximately 24.7% tax rate) 961 Net of tax adjustments 2,923 Pro forma net income $ 230 *New accounting standards discussed in Chapters 10 and 11 require that goodwill no longer be amortized. This standard became effective after August of 2001. 55 Communication Case 4-5 The critical question that student groups should address is whether or not the gain on the sale of the timber tracts should be reported as an extraordinary item on the 2006 income statement. There is no right or wrong answer. The process of developing the proposed solutions will likely be more beneficial than the solutions themselves. Students should benefit from participating in the process, interacting first with other group members, then with the class as a whole. Solutions should address the following issues: 1. Is the gain material? A consensus should be reached that the gain is material. 2. Is the event both unusual and infrequent? Debate should center on the critical issue of whether the event is likely to occur again in the foreseeable future. 3. If the event is deemed to require presentation as an extraordinary item, the gain should be reported net of tax below income from continuing operations. A disclosure note also is required and earnings per share disclosure should reflect the income statement presentation. As a real world example of a similar situation, in 1974 Johns Manville Corporation, manufacturer of asbestos products, reported a $21 million extraordinary gain from the sale of timber tracts. No disclosure note was provided to explain the event, so we can only speculate as to the circumstances leading to the company's presentation of the gain as extraordinary. It is important that each student actively participate in the process. Domination by one or two individuals should be discouraged. Students should be encouraged to contribute to the group discussion by (a) offering information on relevant issues, and (b) clarifying or modifying ideas already expressed, or (c) suggesting alternative direction. 56 Communication Case 4-6 Suggested Grading Concepts and Grading Scheme: Content (70%) _____ 10 Is the loss material? _____ 25 Lists the alternative treatments. _____ Present before-tax amount as a separate line item. _____ Present the after-tax amount as an extraordinary item. _____ In either case, disclosure is required. _____ 25 Cites the appropriate authoritative pronouncement, APBO 30, and discusses the concepts of unusual and infrequent in the context of the company’s environment. _____ 10 A clear, well supported recommendation is made. ____ _____ 70 points Writing (30%) _____ 6 Terminology and tone appropriate to the audience of a chief financial officer. _____ 12 Organization permits ease of understanding. ____ Introduction that states purpose. ____ Paragraphs that separate main points. _____ 12 English ____ Sentences grammatically clear and well organized, concise. ____ Word selection. ____ Spelling. ____ Grammar and punctuation. ____ _____ 30 points 57 Case 4-6 (continued) The following is provided as an example. August, 1990 TO: Chief Financial Officer, Carter Hawley Hale Stores (CHHS) FROM: John Doe, Controller (CHHS) RE: Income Statement treatment of October 17, 1989, earthquake damage costs. A decision on the income statement treatment of the earthquake damage costs involves a number of considerations. First, the damage costs are clearly material. Inclusion of the costs in earnings results in an increase in the net loss for the fiscal year ended August 4, 1990, from $9.47 million to $25.97 million. This leaves us only two options for the income statement presentation of the loss: 1. Present the before-tax amount of the loss ($27.5 million) as a separate line item in the income statement. 2. Present the after-tax effect of the loss ($16.5 million) as an extraordinary item, below income from continuing operations. In both cases, a disclosure note would be required to explain the loss. The appropriate authoritative pronouncement pertaining to this case is Accounting Principles Board Opinion No. 30. The opinion states that judgment is required in determining whether or not an event warrants separate reporting in the income statement as an extraordinary item. However, the following broad guideline is provided: “Extraordinary items are events and transactions that are distinguished by their unusual nature and by the infrequency of their occurrence.”(par. 20) The opinion adds that the characteristics of unusual nature and infrequency of occurrence must be considered in light of the environment in which the company operates. These characteristics are only aids in answering the important question: What is the likelihood that this event will occur again in the foreseeable future? If it is not likely to occur again, then this should be communicated to financial statement users by segregating the income effect of the event as an extraordinary item. This will help them in using the income statement to predict future cash flows. 58 Case 4-6 (concluded) RECOMMENDATION I recommend that the earthquake damage costs be treated as an extraordinary loss, net of tax, in the income statement for the fiscal year ended August 4, 1990. In addition, earnings per share for income both before and after the loss must be presented. While many earthquakes do occur in California, extremely large earthquakes causing significant amounts of damage are both unusual and infrequent. I do not believe that this type of loss will occur again in the foreseeable future. 59 Ethics Case 4-7 Discussion should include these elements. Facts: The company incurred $10 million in expenses related to a product recall. The company had experienced product recalls in the past and they do occur in the industry. To show a profit from continuing operations, Jim Dietz, the controller, wants to report the $10 million as an extraordinary loss, rather than as an expense included in operating income. He tells the CEO that the company has never had a product recall of this magnitude and that the company fixed the design flaw and upgraded quality control. Extraordinary items are gains and losses that are material, and result from events that are both unusual and infrequent. These criteria must be considered in light of the environment in which the entity operates. There obviously is a considerable degree of subjectivity involved in the determination. The concepts of unusual and infrequent require judgment. In making these judgments, an accountant should keep in mind the overall objective of the income statement. The key question is how the event relates to a firm’s future profitability. If it is judged that the event, because of its unusual nature and infrequency of occurrence, is not likely to occur again, separate reporting as an extraordinary item is warranted. Ethical Dilemma: It appears from the facts of the case that it would be difficult for the company to come to the conclusion that a material product recall is not likely to occur again in the foreseeable future. This type of event has occurred before and is common in the industry. While a subjective judgment, extraordinary treatment of the $10 million does not appear warranted. Is the obligation of Jim and the CEO to maximize income from continuing operations, the company's position on the stock market and management bonuses stronger than their obligation to fairly present accounting information to the users of financial statements? Who is affected? Jim Dietz CEO and other managers Other employees Shareholders Potential shareholders from the stock market Creditors Company auditors 60 Research Case 4-8 Requirement 1 Most would agree that the events of September 11, 2001 were “extraordinary.” The terrorist attacks were unprecedented in terms of the magnitude of the losses incurred, the number of entities affected, the unprecedented federal ground stop order that closed the U.S. air travel system for over 24 hours, and the unprecedented efforts undertaken by the U.S. and other nations to prevent future terrorist attacks. Requirement 3 The EITF was initially reluctant to address the issue because of its importance. However, timely accounting guidance was necessary to help companies in deciding how to measure and report the losses sustained as a result of the attacks. The Task Force noted that without such guidance, financial statement preparers and auditors would be faced with individually resolving the difficult questions presented by this issue. The FASB’s elaborate process would have not provided the necessary guidance in a timely manner. Requirement 4 The Task Force concluded that despite the incredible nature of the September 11 events, extraordinary item financial reporting treatment would not be an effective way to communicate the financial effects of those events and, therefore, should not be used in this case. The Task Force noted that it would be impossible to isolate and therefore distinguish, in a consistent way, the effects of the September 11 events in any single line item on companies’ financial statements because of the inability to separate losses that are directly attributable to the events from those that were not. 61 Judgment Case 4-9 Financial Statement Presentation Situation Treatment (a-g) (CO, BC, or RE) 1. b CO 2. c RE 3. f CO 4. g CO 5. a BC 6. b CO 7. e BC 8. d. RE Judgment Case 4-10 1. The loss is not unusual or infrequent. It is included in income from continuing operations along with other gains and losses. 2. The sale of the financing component is treated as a discontinued operation. The gain or loss from the sale of the assets along with income or loss generated by the component is presented below income from continuing operations. 3. A change in depreciation method is treated as a change in accounting estimate achieved by a change in accounting principle. Changes in estimates are accounted for prospectively. The remaining book value is depreciated, using the new method, over the remaining useful life. 4. This event is not unusual but may be infrequent. It usually is presented as a separate line item included in income from continuing operations. 5. The correction of an error is treated as a prior period adjustment. The effect of the correction is not included in income, but as an adjustment to retained earnings. Prior years’ financial statements are restated to correct the error. 6. This event requires no unusual treatment. The lipstick line does not qualify as a component of an entity requiring treatment as a discontinued operation. The loss on sale of the assets of the product line is included in continuing operations along with other gains and losses. 62 International Case 4-11 Differences in income statement presentation: 1. The title of the statement is "Group Profit and Loss Account" as opposed to Income Statement. 2. The term "turnover" is used instead of sales or revenue. 3. The current years’ turnover and operating profit are presented for both continuing operations and for acquisitions. In the U.S., the income effect of acquisitions is not disclosed separately in the income statement. That information is contained in a disclosure note. 4. The Cadbury statement contains a column for exceptional items. In the U.S., these exceptional items are either separately reported below continuing operations, or are reported as a separate line item in continuing operations. 5. Dividends on ordinary shares are deducted on the Cadbury Schweppes statement to arrive at "profit retained." In the U.S., dividends to shareholders do not appear in the income statement. They are shown as distributions to owners in either the statement of shareholders' equity or the statement of retained earnings. 6. There is no earnings per share presentation on the face of the statement as there commonly is in the U.S. 63 Judgment Case 4-12 It would be nice to think that management makes all accounting choices in the best interest of fair and consistent financial reporting. Unfortunately, other motives influence the choices among accounting methods and whether to change methods. It has been suggested that the effect of choices on management compensation, on existing debt agreements, and on union negotiations each can affect management’s selection of accounting methods.1 For instance, research has suggested that managers of companies with bonus plans are more likely to choose accounting methods that maximize their bonuses (often those that increase net income).2 Other research has indicated that the existence and nature of debt agreements and other aspects of a firm’s capital structure can influence accounting choices.3 Whether a company is forbidden from paying dividends if retained earnings fall below a certain level, for example, can affect the choice of accounting methods. Choices made are not always those that tend to increase income. As you will learn in Chapter 8, many companies use the LIFO inventory method because it reduces income and therefore reduces the amount of income taxes that must be paid currently. Also, some very large and visible companies might be reluctant to report high income that might render them vulnerable to union demands, government regulations, or higher taxes.4 1Watts, R.L. and J.L. Zimmerman, “ Towards a Positive Theory of the Determination of Accounting Standards,” The Accounting Review, January, 1978, and “Positive Accounting Theory: A Ten Year Perspective,” The Accounting Review, January, 1990. 2For example, see Healy, P.M., “The Effect of Bonus Schemes On Accounting Decisions,” Journal of Accounting and Economics, April, 1985, and Dhaliwal, D.G. Salamon, and E. Smith, “The Effect of Owner Versus Management Control On The Choice Of Accounting Methods,” Journal of Accounting and Economics, July, 1982. 3Bowen, R.M., E.W. Noreen, and J.M. Lacy, “Determinants of the Corporate Decision To Capitalize Interest,” Journal of Accounting and Economics,” August, 1981. 4This “political cost’ motive is suggested by Watts, R.L. and J.L. Zimmerman, “ “Positive Accounting Theory: A Ten Year Perspective,” The Accounting Review, January, 1990, and Zmijewski, M., and R. Hagerman, “An Income Strategy Approach To The Positive Theory of Accounting Standard Setting/Choice,” Journal of Accounting and Economics, August, 1981. 64 Research Case 4-13 (Note: This case requires the student to reference a journal article.] Requirement 2 The most frequent type of voluntary accounting change involves inventory methods (38% of all voluntary accounting changes in the sample). More specifically, adoptions of LIFO are the most common accounting change and these adoptions increase with the rate of inflation. Requirement 3 The authors infer that the typical non-LIFO voluntary accounting change is income-increasing, and firms making income-increasing changes have significantly lower sales and earnings growth prior to making a change, and lower interest coverage ratios, higher debt-to-equity ratios, and tighter dividends constraints in the year of change compared to a random sample of firms. They conclude that their results suggest that voluntary accounting changes are most likely to have been made for opportunistic or earnings management purposes. 65 Integrating Case 4-14 DEFICIENCIES: Balance Sheet: 1. The asset section of the balance sheet should be classified. Cash, short- term investments, accounts receivable, and inventories should be included as current assets. 2. Accounts receivable should be shown net of the allowance for uncollectible accounts. 3. Inventories - the method used to cost inventory should be disclosed in a note. 4. Marketable securities - $21,000 of investments ($78,000 - 57,000) should be classified in a noncurrent investments category. 5. Property and Equipment - should be classified in a separate category. Original cost should be disclosed along with the accumulated depreciation to arrive at the net amount. Also, the method used to compute depreciation should be disclosed in a note. 6. The liability and shareholders' equity section of the balance sheet should be classified into (1) current liabilities, (2) long-term liabilities, and (3) shareholders' equity. 7. Current liabilities should include accounts payable and accruals, notes payable (the $80,000 note due in 2007 and the $60,000 installment on note # 2 due in 2007). The latter should be classified as current maturities of long-term debt. Also, note disclosure is required for the notes providing information such as payment terms, interest rates, and collateral pledged as security for the debt. 8. Long-term liabilities should include the $60,000 second installment on note #2. 9. Common stock - the par value, if any, and the number of shares authorized, issued and outstanding should be disclosed. Income Statement: 1. The miscellaneous expense should be classified as an extraordinary item and shown net of tax below income from continuing operations. A note should describe the event. 2. Earnings per share disclosure is required. 3. The restructuring charges should be shown as a separate operating expense item in the income statement and described in a note. 66 Financial Analysis Case 4-15 Requirement 1 2003 to 2004: ($838 – 830) ÷ $830 = 1% increase 2002 to 2003: ($830 – 710) ÷ $710 = 17% increase Requirement 2 $481 ÷ $1,319 = 36% Requirement 3 $838 ÷ $24,710 = 3%. FedEx is able to generate three cents in net income for every sales revenue dollar. This is a common financial ratio, known as the profit margin on sales. Chapter 5 discusses this and other ratios related to profitability. Real World Case 4-16 Answers to the questions will, of course, vary because students will research financial statements of different companies. No specific standards dictate how income from continuing operations must be displayed, so companies have considerable latitude in how they present the components of income from continuing operations. This flexibility has resulted in a considerable variety of income statement presentations. However, we can identify two general approaches, the single-step and the multiple-step formats that might be considered the two extremes, with the income statements of most companies falling somewhere in between. The presentation of separately reported items, however, is mandated and students should be able to easily identify them. Trueblood Accounting Case 4-17 A solution and extensive discussion materials can be obtained from the Deloitte Foundation. Solution Manual for Intermediate Accounting David J. Spiceland, James F. Sepe, Lawrence A. Tomassini 9780072994025, 9780072524482