Accounting 381 Intermediate Financial Accounting and

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Accounting 381Intermediate Financial Accounting and Reporting I Syllabus

Winter 2011 – REVISED (1/27/11)

Professor: Elizabeth Almer, PhD, CPA email: [email protected]: 503-725-3729 Fax: 503-725-5850Office: SBA534 Office hours: MW 1:00-2:00 and by appointmentCourse website: http://www.pdx.edu/sba/fp-elizabeth-d-almer

Class Times and Locations:MW 10:15-12:05 SBA140 Final: Wednesday, March 16, 2011, 10:15 – 12:05 in SBA140MW 2:15-4:05 in SBA160 Final: Wednesday, March 16, 2011, 12:30 – 2:20 in SBA160

Course Materials:1. Intermediate Accounting, 13th edition by Kieso, Weygandt, and Warfield, Wiley, 2009

2. Incorporating International Financial Reporting Standards (IFRS) into Intermediate Accounting,available on my faculty homepage http://www.pdx.edu/sba/fp-elizabeth-d-almer

3. Class notes, additional class materials and textbook homework solutions are available through myfaculty homepage http://www.pdx.edu/sba/fp-elizabeth-d-almer

4. Self-tests (multiple choice) available at http://bcs.wiley.com/he-bcs/Books?action=index&itemId=0470374942&bcsId=4881

Course Catalog Description:Comprehensive study of the principles, conventions and postulates of financial accounting. Appropriatepreparation of GAAP financial statements and financial disclosures, including exposure to the judgmentinherent in financial reporting. Considers information requirements and expectations of users of financialstatements. International financial accounting standards will be considered where appropriate. Specific focuson the responsibility of accountants for maintaining professional accountability to the public interest in the faceof institutional pressures. BA 213 is a prerequisite for this course.

Course Objectives:1. To understand how professional accountants have a responsibility to maintain the public interest.2. To understand how real events that take place as a firm conducts business are reflected in the balance sheet,

income statement, and the statement of cashflows.3. To understand how the balance sheet, income statement, and statement of cash flows are interrelated.4. To understand the economic substance of the real events that take place as a firm conducts business, the

generally accepted accounting principles (GAAP) that need to be applied, and the Conceptual Frameworkbehind GAAP.

5. To learn the criteria for the valuation, measurement, and disclosure of revenues and assets in accordancewith GAAP.

6. To acquire an understanding of not only “how” accounting procedures are applied but the underlyingreasons “why” these practices are adopted.

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Class structure:Class sessions will be a combination of lecture, discussions, and problem-solving. I will assign homework foreach chapter. Generally I will not collect it, but a word of caution is in order here. Successful accountingstudents will tell you that the only way to learn accounting at this level is to practice, practice, practice, and tounderstand what you are doing rather than going through the motions. I will expect that you have completed theassigned readings AND the assigned problems for that day prior to the class lecture. More complex assignedExercises and Problems are assigned to be completed after the topic is covered in class. I will approachhomework in class by asking if there are any questions on the assigned problems. Often I will ask you toexplain how you solved them so we all can learn from what you did.

Grading:Grades will be based on an accumulation of total points allocated as follows:

Introductory Quiz (Take-home) 20 6%Quizzes (20 points each, drop lowest) 60 16%Reading Discussion Questions 20 6%Projects 50 14%Midterm 100 29%Final Exam 100 29%Total 350 100%

Generally course grades are determined as follows:

A 93-100% B+ 88-89.9% C+ 78-79.9% D 60-69.9%A- 90-92.9% B 83-87.9% C 73-77.9% F 0-59.9%

B- 80-82.9% C- 70-72.9%

The overall trend of your course performance as well as participation in class discussions will be used to resolveborderline grades. There will not be any extra credit. If you drop the course or change your grading option,please review the PSU academic calendar for the relevant deadlines at:www.pdx.edu/registration/calendar.html.

Introductory Mechanics Quiz:The introductory take home quiz will cover the material from Fundamentals of Financial Accounting andAccounting Mechanics. Students should examine Chapter 3 as a review. The introductory quiz is to becompleted on an individual basis. Students receiving less than 70% on this quiz are STRONGLY encouraged todrop ACTG381 and instead take ACTG199 this term. ACTG 199 begins the third week of the term.

Chapter Quizzes:You will have 4 chapter quizzes throughout the quarter. Quizzes will be either take-home or in-class dependingupon time available and level of preparation of the class as a whole. Each quiz is worth 20 points. Your lowestquiz score will be dropped, so your final quiz score is the sum of your best 3 quiz scores and constitutes 16% ofyour final grade. If you miss a quiz you will receive a zero on that quiz. No make up quizzes will be given.

Reading Discussion Questions:Throughout the term there are reading assignments in addition to the textbook. Discussion questions for thereadings will be posted on the course web site. Answers to the discussion questions will be due at the beginningof the class on the date specified due. Answers will be graded as follows: + for complete answers, √ foranswers turned in but somewhat incomplete, - for no assignment turned in. At the end of the term, the total



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points received out of 10 is determined judgmentally based upon the number of +, √ and – received. Note thatIf you will not be in class the day a reading assignment is due, it is your responsibility to email your assignmentto me prior to the start of class. No make up assignments will be given.

Readings can be accessed from the URL link in the syllabus, or if none is given, from the library’s e-reserves.To access e-reserves:

1. Go to the library web site: http://library.pdx.edu/2. Click on Find Course Reserves .3. Search by course number (381) or by Almer. Then click SEARCH.4. Select the course you want; then view.5. Select a folder.6. Enter the password “almer” all in lowercase .7. Close the window.8. Select a reading folder I or II.9. Select the document you want.

FASB Codification Access:Homework problems designated with the “CE” prefix require accessing the FASB Codification. You mayaccess the FASB Codification database through the American Accounting Association by logging in athttp://aaahq.org/ascLogin.cfm using the following:

User ID: AAA51686Password: SLb736y

Projects:You will be assigned 2 class projects. The first project will involve the Starbucks 2010 10-K report and anapplication of relevant information covered in this course to the 10-K. Each student will turn in their own project.

The second project is designed to give you the opportunity to work in groups without guidance from the instructor,and to communicate your knowledge and beliefs about accounting issues in written form. Groups are self-selectedand may have no more than 4 members. This group will turn in one project, but each group member is responsiblefor having completed the project readings and understanding the answer their group is turning in. All projectsshould be typed, well reasoned, and grammatically correct. On the first page of project, include the names of allgroup members. Projects turned in after the scheduled date will receive a maximum of 60% credit, regardless ofthe reason.

Teamwork is an important aspect of professionalism. You will evaluate your team members based on your workexperience with them. For each case, you are to evaluate each member of your group (excluding yourself) byassigning each group member a score from 1 – 10, with 1 being the lowest score and 10 being the highest score.Your own peer evaluation score is the average of the scores given to you by your peers and is a maximum of 5points. Any students who for whatever reason turn in an assignment alone (i.e., no group members), will receive 0of 5 peer evaluation points.

Exams:There is one midterm and a final. Exams will be a combination of multiple choice, problems, and short essaysquestions. Problems will resemble the problems that were assigned for homework, and any essays will mirrordiscussions we had in class. All exams are closed-book. You may however bring one 4 x 6 index card withhandwritten notes on both sides that may be used during the exam. This index card must be turned in with yourexam. The final exam will not be cumulative. No alternate exam times or due dates will be available. Nomake up exams will be given. If the midterm exam is missed, more weight will be placed on the final exam.



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Class Participation:The attached course schedule shows the materials to be covered in each class meeting. Students are expected toprepare for class by reading assignments indicated and working the problems before coming to class. Sinceclasses will not be “straight lecture,” but will include your active participation in discussions and in-classactivities, your preparation is critical to success in this course.

Academic Honesty:The Student Conduct Code (SCC), which applies to all students, prohibits all forms of academic cheating,fraud, and dishonesty. These acts include, but are not limited to: plagiarism, buying and selling of courseassignments and research papers, performing academic assignments (including examinations) for other persons,unauthorized disclosure and receipt of academic information and other practices commonly understood to beacademically dishonorable. The code of conduct also describes standards of behavior for all student membersof the campus community. Violation of the SCC may lead to disciplinary action. Students may obtain copiesof the SCC by contacting the campus judicial officer at 503-725-4422, or by visiting the office in Room 433,Smith Memorial Student Union.

Re-grading Policy:On occasion you may disagree with the scoring of your work, and sometimes mistakes are made. Butremember that fairness is created above all by consistency; if the grader is equally mean to all, then there is noproblem. Should there be a specific grading issue that you wish to have re-examined, use the following process:

1. You must request the re-grade within one week of the day on which the work was returned.2. You must submit the re-grade request in writing; re-grading requests will not be processed “live.”

Office Hours:I encourage you to make full use of my office hours. Understand that office hours are not intended as make-uplectures for those who fail to attend lecture but rather are intended to help you with any questions you have afteryou have attended the lectures, reviewed the materials, and attempted the homework assignments. If myscheduled office hours are not convenient, please email me to set up an alternative time to meet.

SBA Undergraduate Programs Office Services:The SBA provides academic advisors as well as career and internship advisors to assist students in making themost of their collegiate experience. Academic advisors are trained to provide counsel in a wide range of issues.From selecting a business major to evaluating transferred transcripts, academic advisors are here to helpstudents with all of their degree related questions. The following is a brief summary of the type of issues withwhich academic advisors can offer assistance:

DARS reports SBA admissions requirements Major selection and requirements Transcript evaluation

Course overrides Transfer credit petitions Career planning Portland State rules and policies

All SBA advisors are available by appointment, which must be scheduled in advance. Drop-in hours areavailable as well. Drop-in hours are held regularly throughout the week and are designed to help answer routineor simple questions. For more information about SBA advising and drop-in hours please visit the School ofBusiness website at www.sba.pdx.edu and click on student resources. For more information and a schedule ofupcoming events, visit SBA 230 or go to the web at www.sba.pdx.edu and click on “Career Services.”Undergraduates may select “Undergrad Listserve” to sign up to receive emails on current internships and jobopportunities.



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Tentative Class Schedule – REVISED (2/21/11)Please note that adjustments to the schedule INCLUDING exam dates may need to occur.

KWW: Kieso, Weygandt and Warfield “Intermediate Accounting”IFRS: Incorporating International Financial Reporting Standards (available on course web site)

Week Date Topic Readings Homework/Deliverable1 M

1/3Introduction Course Introduction Accounting mechanics

KWW Chapter 3 BE3-2, BE3-3, BE3-4, BE3-8,BE3-10, BE3-11, BE3-13

W1/5

GAAP Structure Sources of U.S GAAP Principles vs. rules US/IFRS Convergence

KWW Chapter 1IFRS pp. 3-7

“Study Pursuant to Section 108(d) of theSarbanes-Oxley Act of 2002 on…Principles-Based Accounting System” available on thecourse web site

E3-6, E3-7, E3-9, E3-17,

CA1-3, CA1-15, CE1-2, CE1-3.Note: Use the FASBCodification Access instructionsin this syllabus, not your text.

Due: Introductory MechanicsQuiz

2 M1/10

GAAP Structure continued: The FASB’s conceptual

framework IFRS conceptual framework

The role of Accounting in thePublic Interest.

Introduce Project #1 - publiccompany annual report project


Kapnick, (1974). “In the Public Interest,”available on the course web site

Wyatt, (2004). “Accounting Professionalism –They Just don’t Get It!” Accounting Horizons

“Guide to Public Company Auditing,” Centerfor Audit Quality.http://www.iasplus.com/usa/aicpa/0905caqauditguide.pdf

BE2-2 thru BE2-11CE2-1 thru CE2-3E2-3, E2-5

Due: DQ Kapnick & Wyatt

W1/12

Quiz 1: Ch. 1-3 and readings

Ethical Frameworks

Read Framework for Ethical Decision Makinghttp://www.scu.edu/ethics/practicing/decision/framework.html

Ethics Case available on the course web site.

Due: DQ Ethics Case



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Week Date Topic Readings Homework/Deliverable

3 M1/17

MLK Holiday – No Class

W1/19

Comprehensive Income CI and the Accounting Equation I/S - usefulness, limitations and

format Investments in equity securities

without significant influence(AFS and Trading Securities)

Accounting Irregularities

KWW Chapter 4KWW Chapter 17 pages 866 -870KWW Chapter 22 pages 1195-97IFRS pp. 10-16

CE4-1, CE4-2, BE4-2 thruBE4-10, E4-3, E4-4, E4-5, E4-12

BE17-5, BE17-6, E17-6, E17-7,E4-13

BE 22-4, 22-5, BE22-7 thruBE22-10

4 M1/24

Comprehensive Income andEarnings Management Common Earnings Management

Strategies The Statement of

Comprehensive Income, formatand transparency

.

Arthur Levitt, “The Numbers Game,” NYUCenter for Law and Business, September 28,1998. Available athttp://www.sec.gov/news/speech/speecharchive/1998/spch220.txt

John J. Brennan (Chairman and CEO, TheVanguard Group), “The Market Value ofIntegrity, Dealing with Corporate Scandals.Available on the course web site.

P4-3, P4-4, P4-7

Due: DQ for Levitt andBrennan

W1/26

Quiz #2: Ch. 4, 17, 22

Balance Sheet & Intro to CashFlow Statement Format of BS & SCF Usefulness & limitations How to read a SCF


BE5-2 thru BE5-16, E5-12, E5-13, E5-14



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Week Date Topic Readings Homework/Deliverable

5 M1/31

SCF Constructing a SCF – indirect

method

Chapter 23 (pp. 1243-1270 only) Due: Project #1

BE23-1 thru BE23-9, E23-15,E23-14, E5-15 thru E5-17, P5-7

W2/2

SCF Constructing a SCF – indirect

method

Chapter 23 (pp. 1243-1270 only)

6 M2/7

SCF continued Constructing a SCF – direct

method

Catch up before Midterm

E23-4, 5, 13

W 2/9 Midterm: Ch 1-5, 17, 22, 23 andassigned readings

7 M2/14

Revenue, Receivables & Cash Basic revenue recognition

principles Sales discounts A/R bad debt reserve Right of return Presentation of receivables Selected topics about Cash,

including reconciliation

KWW Chapter 7, Appendix 7A and 18 (pp930-937 only)IFRS pp. 25-28

BE7-1 thru BE7-5, BE18-1, E7-12, E7-2, E7-6 thru 9, E7-24,E7-25, P7-6, P7-9

W2/16

Revenue and Receivables Impairment of receivables Analysis of receivables Notes receivable Securitizing receivables Factoring trade receivables

KWW Appendix 7B BE7-9 thru BE7-13, BE7-17,E7-13 thru E7-19, P7-3, P7-11,E7-26, E7-27, P7-15



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Tentative Class Schedule – REVISED (2/21/11)

Week Date Topic Readings Homework/Deliverable8 M

2/21Revenue and Receivables “New GAAP for Multiple Deliverables”

http://www.journalofaccountancy.com/Issues/2010/Jun/20102464.htm

KWW Chapter 6 (Note: review only for arefresher on present and future value)

KWW Chapter 18, Appendix 18A

DQ: New GAAP for MultipleDeliverables”

P7-2, P7-4BE 7-6 thru BE7-8, E7-20

W2/23

Revenue and Receivables Installment sales Franchise revenue Consignments

KWW Chapter 18, Appendix 18A BE18-7 thru BE18-12

9 M2/28

Quiz #3: Ch. 7, 7A, 18Inventory basics Inventoriable costs When goods become part of

inventory Basic cost flow assumptions

Error adjustments


BE8-3 thru BE8-7, E8-1 thruE8-3, E8-5, E8-20, P8-5, P8-6,E8-21

W3/2

Inventory valuation Lower of Cost or Market Retail Inventory Method

(ignore mark ups and markdowns)

Purchase CommitmentsAnalysis of inventories

Chapter 9 BE9-1 thru BE9-9, E9-1, E9-5,P9-1, P9-3, E9-7, E9-8, E9-9,E9-10, P9-4

10 M3/7

Quiz #4 (Ch. 8)Revenue and Receivables Long-term contracts

KWW Chapter 18 BE18-2 thru BE18-4

W 3/9 Revenue and Receivables Long-term contracts

KWW Chapter 18 Due: Project 2

W3/16

Final Exam: 10:15-12:05 for 10:15 section12:30-2:20 for 2:15 section



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Introduction QuestionnaireDue Date: Wednesday January 5, 2011

Name:

Email address:

Phone number:

1. Major: Undergraduate: ______________________

Post-Baccalaureates: ______________________(undergraduate major: ___________________________) from __________________________(undergraduate university)

2. Briefly describe any work experience that might be relevant to this course.

3. Please list any extra-curricular activities in which you participate (i.e. work, athletics, volunteer groups).

4. How many hours per week do you dedicate to the above activities? __________

5. What are your career goals?

6. Please tell me anything else that you think I should know that may affect your performance in this class.



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Copyright © 2010 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 13/e, Solutions Manual (For Instructor Use Only) 1-1

CHAPTER 1Financial Accounting and Accounting Standards

CE1-2(a) The Codification Overview module illustrates three items (1) the topic structure (2) different methods of

accessing and viewing content, and (3) a summary of the unique features of the CodificationResearch System.

(b) The Codification is intended to (1) become the single source of U.S. accounting standards and(2) supersede all of the non-SEC documents used to populate the Codification.

CE1-3The “What’s New” page provides links to Codification content that has been recently issued. During theverification phase, updates may result from either the issuance of Codification update instructions thataccompany new Standards or from changes to the Codification due to incorporation of constituentfeedback.

CA 1-3

Accounting numbers affect investing decisions. Investors, for example, use the financial statements ofdifferent companies to enhance their understanding of each company’s financial strength and operatingresults. Because these statements follow generally accepted accounting principles, investors can makemeaningful comparisons of different financial statements to assist their investment decisions.

Accounting numbers also influence creditors’ decisions. A commercial bank usually looks into acompany’s financial statements and past credit history before deciding whether to grant a loan and inwhat amount. The financial statements provide a fair picture of the company’s financial strength (forexample, short-term liquidity and long-term solvency) and operating performance for the current periodand over a period of time. The information is essential for the bank to ensure that the loan is safe andsound.

CA 1-15

(a) The ethical issue in this case relates to making questionable entries to meet expected earningsforecasts. As indicated in this chapter, businesses’ concentration on “maximizing the bottom line,”“facing the challenges of competition,” and “stressing short-term results” places accountants in anenvironment of conflict and pressure.

(b) Given that Normand has pleaded guilty, he certainly acted improperly. Doing the right thing, makingthe right decision, is not always easy. Right is not always obvious, and the pressures to “bend therules,” “to play the game,” “to just ignore it” can be considerable.

(c) No doubt, Normand was in a difficult position. I am sure that he was concerned that if he failed togo along, it would affect his job performance negatively or that he might be terminated. These jobpressures, time pressures, peer pressures often lead individuals astray. Can it happen to you?One individual noted that at a seminar on ethics sponsored by the CMA Society of Southern



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1-2 Copyright © 2010 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 13/e, Solutions Manual (For Instructor Use Only)

California, attendees were asked if they had ever been pressured to make questionable entries.This individual noted that to the best of his recollection, everybody raised a hand, and more thanone had eventually chosen to resign.

(d) Major stakeholders are: (1) Troy Normand, (2) present and potential stockholders and creditors ofWorldCom, (3) employees, and (4) family. Recognize that WorldCom is the largest bankruptcy inUnited States history, so many individuals are affected.



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CHAPTER 2Conceptual Framework

Underlying Financial Accounting

SOLUTION TO CODIFICATION EXERCISES

CE2-1

(a) The master glossary provides three definitions of fair value that are found in GAAP:

Fair Value—The amount at which an asset (or Liability) could be bought (or incurred) or settled ina current transaction between willing parties, that is, other than in a forced or liquidation sale.

Fair Value—The fair value of an investment is the amount that the plan could reasonably expect toreceive for it in a current sale between a willing buyer and a willing seller, that is, other than in aforced or liquidation sale. Fair value shall be measured by the market price if there is an activemarket for the investment. If there is no active market for the investment but there is a market forsimilar investments, selling prices in that market may be helpful in estimating fair value. If a marketprice is not available, a forecast of expected cash flows, discounted at a rate commensurate withthe risk involved, may be used to estimate fair value. The fair value of an investment shall bereported net of the brokerage commissions and other costs normally incurred in a sale.

Fair Value is the price that would be received to sell an asset or paid to transfer a liability in anorderly transaction between market participants at the measurement date.

(b) Revenue—Revenue earned by an entity from its direct distribution, exploitation, or licensing of afilm, before deduction for any of the entity’s direct costs of distribution. For markets and territoriesin which an entity’s fully or jointly-owned films are distributed by third parties, revenue is the netamounts payable to the entity by third party distributors. Revenue is reduced by appropriateallowances, estimated returns, price concessions, or similar adjustments, as applicable.

The glossary references a revenue definition for the SEC: (Revenue (SEC))—See paragraph942-235-S599-1, Regulation S-X Rule 9-05(c)(2), for the definition of revenue for purposes ofRegulation S-X Rule 9-05.

This definition relates to segment reporting requirements for public companies.

(c) Comprehensive Income is defined as the change in equity (net assets) of a business entity duringa period from transactions and other events and circumstances from nonowner sources. Itincludes all changes in equity during a period except those resulting from investments by ownersand distributions to owners.

CE2-2



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The FASB Codification’s organization is closely aligned with the elements of financial statements, asarticulated in the Conceptual Framework. This is apparent in the lay-out of the “Browse” section, whichhas primary links for Assets, Liabilities, Equity, Revenues, and Expenses.

CE2-3

The Importance of Industry Practices is reflected in the designation of several industries as top levellinks in the Codification organization. There are separate links to sections for the following industries(section numbers precede each name):

905 Agriculture908 Airlines910 Contractors—Construction912 Contractors—Federal Government915 Development Stage entities920 Entertainment—Broadcasters922 Entertainment—Cable Television924 Entertainment—Casinos926 Entertainment—Films928 Entertainment—Music930 Extractive Activities—Mining932 Extractive Activities—Oil and Gas940 Financial Services—Broker and Dealers942 Financial Services—Depository and Lending944 Financial Services—Insurance946 Financial Services—Investment Companies948 Financial Services—Mortgage Banking950 Financial Services—Title Plant952 Franchisors954 Health Care Entities956 Limited Liability Entities958 Not-for-Profit Entities960 Plan Accounting—Defined Benefit Pension Plans962 Plan Accounting—Defined Contribution Pension Plans965 Plan Accounting—Health and Welfare Benefit Plans970 Real Estate—General972 Real Estate—Common Interest Realty Associations974 Real Estate—Real Estate Investment Trusts976 Real Estate—Retail Land978 Real Estate—Time-Sharing Activities980 Regulated Operations985 Software995 U.S. Steamship Entities



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BRIEF EXERCISE 2-2

(a) Verifiability(b) Comparability(c) Consistency(d) Timeliness

BRIEF EXERCISE 2-3

(a) Equity(b) Revenues(c) Equity(d) Assets(e) Expenses(f) Losses(g) Liabilities(h) Distributions to owners(i) Gains(j) Investments by owners

BRIEF EXERCISE 2-4

(a) Periodicity(b) Monetary unit(c) Going concern(d) Economic entity

BRIEF EXERCISE 2-5

(a) Revenue recognition(b) Expense recognition(c) Full disclosure(d) Historical cost

BRIEF EXERCISE 2-6

Investment 1—Level 3Investment 2—Level 1



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Investment 3—Level 2

BRIEF EXERCISE 2-7

(a) Industry practices(b) Conservatism(c) Cost-benefit relationship(d) Materiality

BRIEF EXERCISE 2-8

Companies and their auditors for the most part have adopted the generalrule of thumb that anything under 5% of net income is considered not material.Recently, the SEC has indicated that it is okay to use this percentage forthe initial assessment of materiality, but other factors must be considered.For example, companies can no longer fail to record items in order to meetconsensus analyst’s earnings numbers; preserve a positive earnings trend;convert a loss to a profit or vice versa; increase management compensation,or hide an illegal transaction like a bribe. In other words, both quantitativeand qualitative factors must be considered in determining when an item ismaterial.

(a) Because the change was used to create a positive trend in earnings,the change is considered material.

(b) Each item must be considered separately and not netted. Thereforeeach transaction is considered material.

(c) In general, companies that follow an “expense all capital items belowa certain amount” policy are not in violation of the materiality concept.Because the same practice has been followed from year to year,Damon’s actions are acceptable.

BRIEF EXERCISE 2-9

(a) Net realizable value.

(b) Would not be disclosed. Liabilities would be disclosed in the order tobe paid.



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(c) Would not be disclosed. Depreciation would be inappropriate if thegoing concern assumption no longer applies.

(d) Net realizable value.

(e) Net realizable value (i.e., redeemable value).

BRIEF EXERCISE 2-10

(a) Conservatism(b) Full disclosure(c) Expense recognition principle(d) Historical cost

BRIEF EXERCISE 2-11

(a) Should be debited to the Land account, as it is a cost incurred in acquir-ing land.

(b) As an asset, preferably to a Land Improvements account. The drivewaywill last for many years, and therefore it should be capitalized anddepreciated.

(c) Probably an asset, as it will last for a number of years and thereforewill contribute to operations of those years.

(d) If the fiscal year ends December 31, this will all be an expense of thecurrent year that can be charged to an expense account. If statementsare to be prepared on some date before December 31, part of this costwould be expense and part asset. Depending upon the circumstances,the original entry as well as the adjusting entry for statement purposesshould take the statement date into account.

(e) Should be debited to the Building account, as it is a part of the cost ofthat plant asset which will contribute to operations for many years.

(f) As an expense, as the service has already been received; the contri-bution to operations occurred in this period.



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EXERCISE 2-3 (15–20 minutes)

(a) Gains, losses.(b) Liabilities.(c) Investments by owners, comprehensive income.

(also possible would be revenues and gains).(d) Distributions to owners.

(Note to instructor: net effect is to reduce equity and assets).(e) Comprehensive income.

(also possible would be revenues and gains).(f) Assets.(g) Comprehensive income.(h) Revenues, expenses.(i) Equity.(j) Revenues.(k) Distributions to owners.(l) Comprehensive income.


(a)(b)(c)(d)(e)(f)

(g)(h)(i)(j)

Historical cost principle.Conservatism.Full disclosure principle.Expense recognition principle.Materiality.Industry practices or fair valueprinciple.Economic entity assumption.Full disclosure principle.Revenue recognition principle.Full disclosure principle.

(k) Revenue and expense recogni-tion principles.

(l) Economic entity assumption.(m) Periodicity assumption.(n) Expense recognition principle.(o) Materiality.(p) Historical cost principle.(q) Conservatism.(r) Expense recognition principle.



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CHAPTER 3The Accounting Information System

BRIEF EXERCISE 3-2

Aug. 2 Cash....................................................................................................12,000Equipment ..........................................................................................2,500

Agazzi, Capital ............................................................................14,500

7 Supplies..............................................................................................500Accounts Payable.......................................................................500

12 Cash....................................................................................................1,300Accounts Receivable.........................................................................670

Service Revenue.........................................................................1,970

15 Rent Expense.....................................................................................600Cash ............................................................................................600

19 Supplies Expense ..............................................................................230Supplies ($500 – $270) ...............................................................230

BRIEF EXERCISE 3-3

July 1 Prepaid Insurance..............................................................................15,000Cash ............................................................................................15,000

Dec. 31 Insurance Expense ............................................................................2,500Prepaid Insurance

($15,000 X 1/2 X 1/3) ...............................................................2,500



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BRIEF EXERCISE 3-4

July 1 Cash....................................................................................................15,000Unearned Insurance Revenue ...................................................15,000

Dec. 31 Unearned Insurance Revenue.................................................. 3,0002,500Insurance Revenue

($15,000 X 1/2 X 1/3)................................................................2,500

BRIEF EXERCISE 3-8

Dec. 31 Interest Receivable ............................................................................300Interest Revenue.........................................................................300

Feb. 1 Cash....................................................................................................12,400Notes Receivable........................................................................12,000Interest Receivable .....................................................................300Interest Revenue.........................................................................100

BRIEF EXERCISE 3-10

Depreciation Expense .......................................................................2,000Accumulated Depreciation—Equipment .................................. 2,000

Equipment..........................................................................................$30,000Less: Accumulated depreciation—equipment ...............................2,000 $28,000



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BRIEF EXERCISE 3-11

Sales...................................................................................................808,900Interest Revenue ...............................................................................13,500

Income Summary ....................................................................... 822,400

Income Summary ..............................................................................780,300Cost of Goods Sold.................................................................... 556,200Operating Expenses .................................................................. 189,000Income Tax Expense.................................................................. 35,100

Income Summary ..............................................................................42,100Retained Earnings ..................................................................... 42,100

Retained Earnings.............................................................................18,900Dividends.................................................................................... 18,900

*BRIEF EXERCISE 3-13

(a) Salaries Payable................................................................................4,200Salaries Expense ....................................................................... 4,200

(b) Salaries Expense...............................................................................7,000Cash............................................................................................ 7,000

(c) Salaries Payable................................................................................4,200Salaries Expense...............................................................................2,800

Cash............................................................................................ 7,000



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1. Accounts Receivable ........................................................................750Service Revenue ........................................................................ 750

2. Utilities Expense................................................................................520Utilities Payable.......................................................................... 520

3. Depreciation Expense .......................................................................400Accumulated Depreciation—Dental Equipment....................... 400

Interest Expense................................................................................500Interest Payable.......................................................................... 500

4. Insurance Expense ($15,000 X 1/12) ................................................1,250Prepaid Insurance ...................................................................... 1,250

5. Supplies Expense ($1,600 – $400)....................................................1,200Supplies ...................................................................................... 1,200



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(a) Ending balance of supplies................................. $ 900Add: Adjusting entry........................................... 950Deduct: Purchases.............................................. 850Beginning balance of supplies............................ 1,000

(b) Total prepaid insurance....................................... $4,800 ($400 X 12)Amount used (6 X $400)....................................... 2,400Present balance ................................................... 2,400

The policy was purchased six months ago (August 1, 2009)

(c) The entry in January to record salary expense was

Salaries Expense.................................................... 1,800Salaries Payable..................................................... 900

Cash.................................................................. 2,700

The “T” account for salaries payable is

Salaries PayablePaid 900 Beg. Bal. ?January

End Bal. 800

The beginning balance is therefore

Ending balance of salaries payable................ $ 800Plus: Reduction of salaries payable .............. 900Beginning balance of salaries payable........... $1,700



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EXERCISE 3-7 (Continued)

(d) Service revenue........................................... $2,000Cash received.............................................. 1,600Unearned revenue reduced ........................ $ 400

Ending unearned revenue January 31, 2010 ................ $ 750Plus: Unearned revenue reduced.................................. 400Beginning unearned revenue December 31, 2009 ....... $1,150


(a) 10/15 Salaries Expense ...............................................................................800Cash ............................................................................................800

(To record payment of October 15payroll)

10/17 Accounts Receivable.........................................................................2,100Service Revenue.........................................................................2,100

(To record revenue for servicesperformed for which payment hasnot yet been received)

10/20 Cash....................................................................................................650Unearned Service Revenue .......................................................650

(To record receipt of cash forservices not yet performed)

(b) 10/31 Supplies Expense ..............................................................................470Supplies ......................................................................................470

(To record the use of supplies duringOctober)

10/31 Accounts Receivable.........................................................................1,650Service Revenue.........................................................................1,650

(To record revenue for services



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performed for which paymenthas not yet been received)

10/31 Salaries Expense ...............................................................................600Salaries Payable .........................................................................600

(To record liability for accrued payroll)

10/31 Unearned Service Revenue...............................................................400Service Revenue.........................................................................400

(To reduce the Unearned ServiceRevenue account for service thathas been performed)


Mar. 1 Cash ................................................................................ 60,000Common Stock..................................................... 60,000

(Investment of cash in business)

3 Land ................................................................................ 10,000Building .......................................................................... 22,000Equipment ...................................................................... 6,000

Cash ...................................................................... 38,000(Purchased Michelle Wie’s Golf Land)

5 Advertising Expense ..................................................... 1,600Cash ...................................................................... 1,600

(Paid for advertising)

6 Prepaid Insurance.......................................................... 1,480Cash ...................................................................... 1,480

(Paid for one-year insurance policy)

10 Equipment ...................................................................... 2,500Accounts Payable ................................................ 2,500

(Purchased equipment on account)

18 Cash ................................................................................ 1,200Service Revenue .................................................. 1,200

(Received cash for services performed)

25 Dividends........................................................................ 1,000Cash ...................................................................... 1,000

(Declared and paid a $1,000 cash dividend)



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30 Wages Expense ............................................................. 900Cash...................................................................... 900

(Paid wages expense)

30 Accounts Payable ......................................................... 2,500Cash...................................................................... 2,500

(Paid creditor on account)

31 Cash ............................................................................... 750Service Revenue.................................................. 750

(Received cash for services performed)



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CHAPTER 4Income Statement and Related Information

CE4-1

According to the Glossary:

(a) A change in accounting estimate is a change that has the effect of adjusting the carrying amountof an existing asset or liability or altering the subsequent accounting for existing or future assets orliabilities. Changes in accounting estimates result from new information. Examples of items forwhich estimates are necessary are uncollectible receivables, inventory obsolescence, service livesand salvage value of depreciable assets, and warranty obligations. A change in accounting estimateis a necessary consequence of the assessment, in conjunction with the periodic presentation offinancial statements, of the present status and expected future benefits and obligations associatedwith assets and liabilities.

(b) A change in accounting principle reflects a change from one generally accepted accountingprinciple to another generally accepted accounting principle when there are two or more generallyaccepted accounting principles that apply or when the accounting principle formerly used is nolonger generally accepted. A change in the method of applying an accounting principle also isconsidered a change in accounting principle. A “Change in Accounting Estimate Effected by aChange in Accounting Principle” is a change in accounting estimate that is inseparable from theeffect of a related change in accounting principle. An example of a change in estimate effected bya change in principle is a change in the method of depreciation, amortization, or depletion for long-lived, nonfinancial assets.

(c) Comprehensive Income is defined as the change in equity (net assets) of a business during aperiod from transactions and other events and circumstances from nonowner sources. It includesall changes in equity during a period except those resulting from investments by owners anddistributions to owners.

CE4-2

The master glossary provides the term “Unusual Nature”, a link from which yields the following:

Glossary Term Usage

The glossary term is used in the following locations.

Unusual Nature• 225 Income Statement > 20 Extraordinary and Unusual Items > 45 Other Presentation

– 225 Income Statement > 20 Extraordinary and Unusual Items > 45 Other Presentation >General, paragraph 45-2.

Following this link yields the following paragraph:

45-2 Extraordinary items are events and transactions that are distinguished by their unusual natureand by the infrequency of their occurrence. Thus, both of the following criteria shall be met toclassify an event or transaction as an extraordinary item:



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a. Unusual nature. The underlying event or transaction should possess a high degree ofabnormality and be of a type clearly unrelated to, or only incidentally related to, the ordinaryand typical activities of the entity, taking into account the environment in which the entityoperates (see paragraph 225-20-55-1).

b. Infrequency of occurrence. The underlying event or transaction should be of a type thatwould not reasonably be expected to recur in the foreseeable future, taking into account theenvironment in which the entity operates (see paragraph 225-20-55-2).

Thus, “unusual nature” is one of the criterion that determines whether an item meets thedefinition of an extraordinary item.



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BRIEF EXERCISE 4-2

BRISKY CORPORATIONIncome Statement

For the Year Ended December 31, 2010

RevenuesNet sales................................................................. $2,400,000Interest revenue ..................................................... 31,000

Total revenues................................................ 2,431,000

ExpensesCost of goods sold ................................................ $1,450,000Selling expenses.................................................... 280,000Administrative expenses....................................... 212,000Interest expense .................................................... 45,000Income tax expense* ............................................. 133,200

Total expenses.............................................. 2,120,200

Net income ....................................................................... $ 310,800

Earnings per share**........................................................ $4.44

*($2,431,000 – $1,450,000 – $280,000 – $212,000 – $45,000) X 30% = $133,200.

**$310,800 ÷ 70,000 shares.



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BRIEF EXERCISE 4-3

BRISKY CORPORATIONIncome Statement


Net sales ................................................................. $2,400,000Cost of goods sold ................................................. 1,450,000

Gross profit .................................................. 950,000Selling expenses .................................................... $280,000Administrative expenses ....................................... 212,000 492,000Income from operations......................................... 458,000Other revenue and gains

Interest revenue ........................................... 31,000Other expenses and losses

Interest expense........................................... 45,000 14,000Income before income tax ..................................... 444,000Income tax expense ............................................... 133,200Net income.............................................................. $ 310,800

Earnings per share ................................................. $4.44*

*$310,800 ÷ 70,000 shares.



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BRIEF EXERCISE 4-4

Income from continuing operations .......................... $10,600,000Discontinued operations

Loss from operation of discontinuedrestaurant division (net of tax) ...................... $315,000

Loss from disposal of restaurant division(net of tax)....................................................... 189,000 504,000

Net income................................................................... $10,096,000Earnings per share......................................................

Income from continuing operations ................. $1.06Discontinued operations, net of tax ................. (0.05)*Net income.......................................................... $1.01

*Rounded

BRIEF EXERCISE 4-5

Income before income tax and extraordinaryitem........................................................................... $6,300,000

Income tax expense .................................................... 1,890,000Income before extraordinary item.............................. 4,410,000Extraordinary item—loss from casualty .................... $770,000

Less: Applicable income tax ............................. 231,000 539,000Net income................................................................... $3,871,000Earnings per share......................................................

Income before extraordinary item..................... $0.88*Extraordinary loss, net of tax............................ (0.11)*Net income.......................................................... $0.77

*Rounded



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BRIEF EXERCISE 4-6

2010 2009 2008Income before income tax $180,000 $145,000 $170,000Income tax (30%) 54,000 43,500 51,000Net Income $126,000 $101,500 $119,000

BRIEF EXERCISE 4-7

Vandross would not report any cumulative effect because a change in estimateis not handled retrospectively. Vandross would report bad debt expense of$120,000 in 2010.

BRIEF EXERCISE 4-8

$1,000,000 – $250,000 = $3.95 per share190,000

BRIEF EXERCISE 4-9

PORTMAN CORPORATIONRetained Earnings Statement


Retained earnings, January 1 ........................................... $ 675,000Add: Net income.............................................................. 1,400,000

2,075,000Less: Cash dividends....................................................... 75,000Retained earnings, December 31 ..................................... $2,000,000



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BRIEF EXERCISE 4-10

PORTMAN CORPORATIONRetained Earnings Statement


Retained earnings, January 1, as reported ........................ $ 675,000Correction for overstatement of expenses in

prior period (net of tax) ............................................. 80,000Retained earnings, January 1, as adjusted ........................ 755,000Add: Net income................................................................. 1,400,000

2,155,000Less: Cash dividends ......................................................... 75,000Retained earnings, December 31 ........................................ $2,080,000


DUNBAR INC.Income Statement

For Year Ended December 31, 2010

RevenuesNet sales ($1,125,000(b) – $17,000) ........................ $1,108,000

ExpensesCost of goods sold ................................................$500,000Selling expenses....................................................360,000(c)

Administrative expenses....................................... 90,000(a)

Interest expense .................................................... 20,000Total expenses.............................................. 970,000

Income before income tax ............................................... 138,000Income tax.............................................................. 41,400

Net income $ 96,600Earnings per share (d) ..................................................... $3.22*



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*Rounded


Determination of amounts

(a) Administrative expenses = 18% of cost of good sold= 18% of $500,000= $90,000

(b) Gross sales X 8% = administrative expenses= $90,000 ÷ 8%= $1,125,000

(c) Selling expenses = four times administrative expenses.(operating expenses consist of sellingand administrative expenses; sinceselling expenses are 4/5 of operatingexpenses, selling expenses are4 times administrative expenses.)

= 4 X $90,000= $360,000

(d) Earnings per share $3.22 ($96,600 ÷ 30,000)

Note: An alternative income statement format is to show income tax as partof expenses, and not as a separate item. In this case, total expenses are$1,011,400.



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(a) Multiple-Step FormWEBSTER COMPANY

Income StatementFor the Year Ended December 31, 2010

(In thousands, except earnings per share)

Sales.................................................................... $96,500Cost of goods sold............................................. 63,570Gross profit......................................................... 32,930

Operating ExpensesSelling expenses

Sales commissions ................................ $7,980Depr. of sales equipment ....................... 6,480Transportation-out ................................. 2,690 $17,150

Administrative expensesOfficers’ salaries .................................... 4,900Depr. of office furn. and equip............... 3,960 8,860 26,010

Income from operations................... 6,920

Other Revenues and GainsRental revenue.............................................. 17,230

24,150Other Expenses and Losses

Interest expense ........................................... 1,860

Income before income tax ................................. 22,290Income tax .................................................... 7,580

Net income.......................................................... $14,710

Earnings per share ($14,710 ÷ 40,550) .............. $.36



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(b) Single-Step FormWEBSTER COMPANY

Income StatementFor the Year Ended December 31, 2010

(In thousands, except earnings per share)

RevenuesSales ................................................................................. $ 96,500Rental revenue ................................................................. 17,230

Total revenues............................................................ 113,730

ExpensesCost of goods sold........................................................... 63,570Selling expenses.............................................................. 17,150Administrative expenses................................................. 8,860Interest expense............................................................... 1,860

Total expenses ........................................................... 91,440

Income before income tax..................................................... 22,290Income tax.............................................................................. 7,580

Net income ....................................................................... $ 14,710

Earnings per share ................................................................ $0.36

Note: An alternative income statement format for the single-step formis to show income tax as part of expenses, and not as a separate item.

(c) Single-step:1. Simplicity and conciseness.2. Probably better understood by users.3. Emphasis on total costs and expenses and net income.4. Does not imply priority of one revenue or expense over another.



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

nonoperating items.2. Expenses are matched with related revenue.

Note to instructor: Students’ answers will vary due to the nature of thequestion; i.e., it asks for an opinion. However, the discussion supportingthe answer should include the above points.


PARNEVIK CORP.Income Statement


Sales RevenueSales.......................................................................... $1,280,000Less: Sales returns and allowances ...................... $150,000

Sales discounts............................................. 45,000 195,000Net sales revenue..................................................... 1,085,000Cost of goods sold................................................... 621,000

Gross profit..................................................................... 464,000

Operating ExpensesSelling expenses ................................................... 194,000Admin. and general expenses.............................. 97,000 291,000

Income from operations................................................. 173,000



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Other Revenues and GainsInterest revenue ....................................................... 86,000


Interest expense ...................................................... 60,000

Income before tax and extraordinary item..................... 199,000Income tax ($199,000 X .34) .................................... 67,660

Income before extraordinary item .................................. 131,340Extraordinary item—loss from earthquake damage ...... 120,000

Less: Applicable tax reduction ($120,000 X .34) .... 40,800 79,200Net income....................................................................... $ 52,140

Per share of common stock:Income before extraordinary item

($131,340 ÷ 100,000) ............................................... $1.31*Extraordinary item (net of tax) .................................. (0.79)Net income ($52,140 ÷ 100,000) ................................ $0.52

*Rounded



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Net income:Income from continuing operations

before income tax....................................................................$21,650,000Income tax (35% X $21,650,000) ................................................. 7,577,500Income from continuing operations...........................................14,072,500Discontinued operations

Loss before income tax.........................................................$3,225,000Less: Applicable income tax (35%) .....................................1,128,750 2,096,250

Net income...................................................................................$11,976,250

Preferred dividends declared: ..........................................................$ 860,000

Weighted average common shares outstanding....................................4,000,000

Earnings per shareIncome from continuing operations........................................... $3.30*Discontinued operations, net of tax........................................... (0.52)**Net income................................................................................... $2.78***

*($14,072,500 – $860,000) ÷ 4,000,000. (Rounded)**$2,096,250 ÷ 4,000,000. (Rounded)

***($11,976,250 – $860,000) ÷ 4,000,000.


(a) 2010Income before income tax ............................... $460,000Income tax (35%).............................................. 161,000Net Income........................................................ $299,000

(b) Cumulative effect for years prior to 2010:



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YearWeightedAverage FIFO Difference

Tax Rate(35%) Net Effect

2008 $370,000 $395,000 $25,0002009 390,000 420,000 30,000

Total $55,000 $19,250 $35,750

(c) 2010 2009 2008Income before income tax $460,000 $420,000 $395,000Income tax (35%) 161,000 147,000 138,250Net income $299,000 $273,000 $256,750



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PROBLEM 4-3

MAHER INC.Income Statement (Partial)


Income from continuing operationsbefore income tax ............................................... $838,500(a)

Income tax........................................................... 220,350(b)

Income from continuing operations ............................ 618,150Discontinued operations

Loss from disposal of recreational division ..... $115,000Less: Applicable income tax reduction............ 34,500 80,500

Income before extraordinary item................................ 537,650Extraordinary item:

Major casualty loss............................................. 90,000Less: Applicable income tax reduction............ 41,400 48,600

Net income..................................................................... $489,050

Per share of common stock:Income from continuing operations .................. $5.15*Discontinued operations, net of tax .................. (0.67)*Income before extraordinary items ................... 4.48Extraordinary item, net of tax ............................ (0.40)Net income ($489,050 ÷ 120,000)........................ $4.08

*Rounded



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PROBLEM 4-3 (Continued)

(a)Computation of income from cont. operations before taxes:As previously stated ............................ $790,000Loss on sale of securities.................... (57,000)Gain on proceeds of life insurance

policy ($150,000 – $46,000) .............. 104,000Error in computation of depreciationAs computed ($54,000 ÷ 6)........................ $9,000Corrected ($54,000 – $9,000) ÷ 6............... (7,500) 1,500As restated................................................. $838,500

(b)Computation of income tax:Income from continuing operations before taxes .......... $838,500Nontaxable income (gain on life insurance) ................... (104,000)Taxable income................................................................. 734,500Tax rate ............................................................................. X .30Income tax expense ......................................................... $220,350

Note: No adjustment is needed for the inventory method change, since thenew method is reported in 2010 income. The cumulative effect on prior yearsof retroactive application of the new inventory method will be recorded inretained earnings.



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PROBLEM 4-4

(a) TWAIN CORPORATIONIncome Statement

For the Year Ended June 30, 2010

Sales RevenueSales ............................................................................ $1,578,500Less: Sales discounts................................................$31,150

Sales returns....................................................62,300 93,450Net sales ...................................................................... 1,485,050

Cost of goods sold............................................................ 896,770Gross profit ....................................................................... 588,280

Operating ExpensesSelling expenses

Sales commissions.........................$97,600Sales salaries ..................................56,260Travel expense ................................28,930Freight-out .......................................21,400Entertainment expense...................14,820Telephone and internet

exp. .............................................9,030

Building expense ............................6,200Depr. of sales equipment................4,980Bad debt expense............................4,850Misc. selling expenses....................4,715 248,785



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Administrative ExpensesBuilding expense....................................9,130Real estate and other local taxes............7,320Depreciation of office

furniture and equipment ....................7,250Office supplies used ..............................3,450

Telephone and internet expense.............2,820Miscellaneous office expenses ...............6,000 35,970 284,755

Income from operations .............................. 303,525

Other Revenues and GainsDividend revenue ..................................... 38,000


Bond interest expense............................. 18,000

Income before income tax ........................... 323,525Income tax .............................................. 102,000

Net income.................................................... $ 221,525Earnings per common share

[($221,525 – $9,000) ÷ 80,000].................. $2.66*

*Rounded



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TWAIN CORPORATIONRetained Earnings Statement


Retained earnings, July 1, 2009, as reported.............. $337,000Correction of depreciation understatement,

net of tax.................................................................... (17,700)Retained earnings, July 1, 2009, as adjusted ............. 319,300Add: Net income .......................................................... 221,525

540,825Less:

Dividends declared on preferred stock ............. 9,000Dividends declared on common stock.............. 37,000 46,000

Retained earnings, June 30, 2010................................ $494,825



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(b) TWAIN CORPORATIONIncome Statement


RevenuesNet sales ...................................................................... $1,485,050Dividend revenue......................................................... 38,000

Total revenues .................................................... 1,523,050Expenses

Cost of goods sold ...................................................... 896,770Selling expenses ......................................................... 248,785Administrative expenses ............................................ 35,970Bond interest expense ................................................ 18,000

Total expenses.................................................... 1,199,525Income before income tax..................................................... 323,525

Income tax.................................................................... 102,000Net income ............................................................................. $ 221,525Earnings per common share................................................. $2.66



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TWAIN CORPORATIONRetained Earnings Statement


Retained earnings, July 1, 2009, as reported................ $337,000Correction of depreciation understatement,

net of tax...................................................................... (17,700)Retained earnings, July 1, 2009 as adjusted ................ $319,300Add: Net income ............................................................ 221,525

540,825Less:

Dividends declared on preferred stock ..............9,000Dividends declared on common stock ...............37,000 46,000

Retained earnings, June 30, 2010.................................. $494,825



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PROBLEM 4-7

WADE CORP.Income Statement (Partial)


Income from continuing operationsbefore income tax .................................... $1,200,000*

Income tax .......................................... 456,000**Income from continuing operations........... 744,000Discontinued operations

Loss from operations ofdiscontinued subsidiary ................$ 90,000

Less: Applicable income taxreduction.......................... 34,200 $ 55,800

Loss from disposal of subsidiary ........ 100,000Less: Applicable income tax

reduction .......................... 38,000 62,000 117,800Income before extraordinary item .............. 626,200Extraordinary item:

Gain on condemnation....................... 125,000Less: Applicable income tax ............ 50,000 75,000

Net income................................................... $ 701,200

Per share of common stock:Income from continuing operations.................................. $4.96Discontinued operations, net of tax.................................. (0.79)Income before extraordinary item..................................... 4.17Extraordinary item, net of tax ............................................ 0.50Net income ($701,200 ÷ 150,000) ....................................... $4.67



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*Computation of income from continuing operationsbefore income tax:As previously stated $1,210,000Loss on sale of equipment [$40,000 – ($80,000 – $30,000)] (10,000)Restated $1,200,000

**Computation of income tax expense:$1,200,000 X .38 = $456,000

Note: The error related to the intangible asset was correctly charged toretained earnings.



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CHAPTER 5Balance Sheet and Statement of Cash Flows

BRIEF EXERCISE 5-2

Current assetsCash..................................................................... $ 7,000Trading securities ............................................... 11,000Accounts receivable ........................................... $90,000

Less: Allowance for doubtful accounts....... (4,000) 86,000Inventory.............................................................. 30,000Prepaid insurance............................................... 5,200

Total current assets ................................ $139,200

BRIEF EXERCISE 5-3

Long-term investmentsHeld-to-maturity securities................................... $ 56,000Land held for investment ..................................... 39,000Long-term note receivables ................................. 42,000

Total investments............................................ $137,000



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BRIEF EXERCISE 5-4

Property, plant, and equipmentLand ..................................................................... $ 71,000Buildings.............................................................. $207,000

Less: Accumulated depreciation ................. (45,000) 162,000Equipment ........................................................... $190,000

Less: Accumulated depreciation ................ (19,000) 171,000Timberland........................................................... 70,000

Total property, plant, and equipment....... $474,000

BRIEF EXERCISE 5-5

Intangible assetsGoodwill............................................................... $150,000Patents ................................................................. 220,000Franchises ........................................................... 130,000

Total intangibles............................................ $500,000BRIEF EXERCISE 5-6

Intangible assetsGoodwill............................................................... $ 50,000Franchises ........................................................... 47,000Patents ................................................................. 33,000Trademarks.......................................................... 10,000

Total intangible assets.................................. $140,000



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BRIEF EXERCISE 5-7

Current liabilitiesNotes payable...................................................... $ 22,500Accounts payable ............................................... 72,000Accrued salaries ................................................. 4,000Income taxes payable ......................................... 7,000

Total current liabilities ............................ $105,500

BRIEF EXERCISE 5-8

Current liabilitiesAccounts payable ............................................... $220,000Advances from customers ................................. 41,000Wages payable .................................................... 27,000Interest payable................................................... 12,000Income taxes payable ......................................... 29,000

Total current liabilities ............................ $329,000

BRIEF EXERCISE 5-9

Long-term liabilitiesBonds payable .................................................... $400,000

Less: Discount on bonds payable ............... 29,000 $371,000Pension liability................................................... 375,000

Total long-term liabilities........................ $746,000



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BRIEF EXERCISE 5-10

Stockholders’ equityCommon stock .................................................... $750,000Additional paid-in capital.................................... 200,000Retained earnings ............................................... 120,000Accumulated other comprehensive loss........... (150,000)

Total stockholders’ equity ............................. $920,000

BRIEF EXERCISE 5-11

Stockholders’ equityPreferred stock.................................................... $152,000Common stock .................................................... 55,000Additional paid-in capital.................................... 174,000Retained earnings ............................................... 114,000

Total stockholders’ equity ............................. $495,000

BRIEF EXERCISE 5-12

Cash Flow Statement

Operating ActivitiesNet income .......................................................... $40,000Depreciation expense......................................... 4,000Increase in accounts receivable........................ (10,000)Increase in accounts payable ............................ 7,000

Net cash provided by operating activities ...... 41,000Investing Activities

Purchase of equipment ...................................... (8,000)



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Financing ActivitiesIssue notes payable ........................................... 20,000Dividends ............................................................ (5,000)

Net cash flow from financing activities....... 15,000Net change in cash ($41,000 – $8,000 + $15,000) ...... $48,000

Free Cash Flow = $41,000 (Net cash provided by operating activities) –$8,000 (Purchase of equipment) – $5,000 (Dividends) = $28,000.

BRIEF EXERCISE 5-13

Cash flows from operating activitiesNet income.......................................................... $151,000Adjustments to reconcile net income to

net cash provided by operating activitiesDepreciation expense .................................. $44,000Increase in accounts payable...................... 9,500Increase in accounts receivable.................. (13,000) 40,500

Net cash provided by operating activities ........ $191,500

BRIEF EXERCISE 5-14

Sale of land and building ......................................... $191,000Purchase of land ...................................................... (37,000)Purchase of equipment............................................ (53,000)

Net cash provided by investing activities ........ $ 101,000

BRIEF EXERCISE 5-15

Issuance of common stock ..................................... $147,000



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Purchase of treasury stock...................................... (40,000)Payment of cash dividend ....................................... (95,000)Retirement of bonds................................................. (100,000)

Net cash used by financing activities ............... $ (88,000)

BRIEF EXERCISE 5-16

Free Cash Flow Analysis

Net cash provided by operating activities .............. $400,000Less: Purchase of equipment................................ (53,000)

Purchase of land*......................................... (37,000)Dividends...................................................... (95,000)

Free cash flow .......................................................... $215,000

*If the land were purchased as an investment, it would be excluded in thecomputation of free cash flow.



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VIVALDI CORPORATIONBalance Sheet

December 31, 2010

AssetsCurrent assets

Cash ....................................................... $197,000Trading securities ................................. 153,000Accounts receivable ............................. $435,000

Less: Allowance for doubtfulaccounts .............................. (25,000) 410,000

Inventories ............................................. 597,000Total current assets ....................... 1,357,000

Long-term investmentsInvestments in bonds............................ 299,000Investments in stocks ........................... 277,000

Total long-term investments......... 576,000

Property, plant, and equipmentLand ....................................................... 260,000Buildings................................................1,040,000

Less: Accum. depreciation ............ (352,000) 688,000Equipment............................................. 600,000

Less: Accum. depreciation ............ (60,000) 540,000Total property, plant, and

equipment .................................... 1,488,000

Intangible assetsFranchise ............................................... 160,000Patent ..................................................... 195,000

Total intangible assets.................... 355,000Total assets..................................... $3,776,000



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Liabilities and Stockholders’ Equity

Current liabilitiesAccounts payable.............................. $ 455,000Short-term notes payable ................. 90,000Dividends payable ............................. 136,000Accrued liabilities.............................. 96,000

Total current liabilities .............. $ 777,000

Long-term debtBonds payable ................................... 1,000,000Long-term notes payable .................. 900,000

Total long-term liabilities ............. 1,900,000Total liabilities............................... 2,677,000

Stockholder’s equityPaid-in capital

Common stock ($5 par) ............... $1,000,000Paid-in capital in

excess of par............................. 80,000 1,080,000Retained earnings* ............................ 210,000

Total paid-in capital andretained earnings.................... 1,290,000

Less: Treasury stock........................ 191,000Total stockholders’ equity ........ 1,099,000Total liabilities and

stockholders’ equity............... $3,776,000



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*Computation of Retained Earnings:Sales.......................................................................... $7,900,000Investment revenue.................................................. 63,000Extraordinary gain.................................................... 80,000Cost of goods sold................................................... (4,800,000)Selling expenses ...................................................... (2,000,000)Administrative expenses ......................................... (900,000)Interest expense....................................................... (211,000)Net income................................................................ $ 132,000

Beginning retained earnings ................................... $ 78,000Net income................................................................ 132,000Ending retained earnings ........................................ $ 210,000

Or ending retained earnings can be computed as follows:

Total stockholders’ equity ....................................... $1,099,000Add: Treasury stock .............................................. 191,000Less: Paid-in capital................................................ 1,080,000Ending retained earnings ........................................ $ 210,000

Note to instructor: There is no dividends account. Thus, the 12/31/10 retainedearnings balance already reflects any dividends declared.


(a) 4. (f) 1. (k) 1.(b) 3. (g) 5. (l) 2.(c) 4. (h) 4. (m) 2.(d) 3. (i) 5.(e) 1. (j) 4.



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CONNECTICUT INC.Statement of Cash Flows


Cash flows from operating activitiesNet income ............................................................ $34,000Adjustments to reconcile net income

to net cash provided by operatingactivities:

Depreciation expense..................................... $ 6,000Increase in accounts receivable .................... (3,000)Increase in accounts payable ........................ 5,000 8,000

Net cash provided by operating activities .......... 42,000Cash flows from investing activities

Purchase of equipment ........................................ (17,000)Cash flows from financing activities

Issuance of common stock.................................. 20,000Payment of cash dividends ................................. (13,000)Net cash provided by financing activities........... 7,000

Net increase in cash................................................... 32,000Cash at beginning of year.......................................... 13,000Cash at end of year .................................................... $45,000



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(a) SONDERGAARD CORPORATIONStatement of Cash Flows


Cash flows from operating activitiesNet income.............................................................. $160,000Adjustments to reconcile net income


Depreciation expense ...................................... $17,000Loss on sale of investments............................ 7,000Decrease in accounts receivable .................... 5,000Decrease in current liabilities .......................... (17,000) 12,000

Net cash provided by operating activities ............ 172,000Cash flows from investing activities

Sale of investments[($74,000 – $52,000) – $7,000] ............................. 15,000

Purchase of equipment.......................................... (58,000)Net cash used by investing activities ................... (43,000)

Cash flows from financing activitiesPayment of cash dividends ................................... (50,000)

Net increase in cash..................................................... 79,000Cash at beginning of year............................................ 78,000Cash at end of year ...................................................... $157,000

(b) Free Cash Flow Analysis

Net cash provided by operating activities .................. $172,000Less: Purchase of equipment .................................... (58,000)

Dividends .......................................................... (50,000)Free cash flow .............................................................. $ 64,000



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(a) OROZCO CORPORATIONStatement of Cash Flows


Cash flows from operating activitiesNet income .............................................................. $105,000Adjustments to reconcile net income


Depreciation expense....................................... $27,000Increase in accounts receivable ...................... (16,000)Decrease in inventory ...................................... 9,000Decrease in accounts payable......................... (13,000) 7,000

Net cash provided by operating activities ............ 112,000Cash flows from investing activities

Sale of land ............................................................. 39,000Purchase of equipment .......................................... (70,000)Net cash used by investing activities ................... (31,000)

Cash flows from financing activitiesPayment of cash dividends ................................... (40,000)

Net increase in cash..................................................... 41,000Cash at beginning of year............................................ 22,000Cash at end of year ...................................................... $ 63,000Noncash investing and financing activities

Issued common stock to retire $50,000 of bonds outstanding



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(b) Current cash debt coverage ratio =

= Net cash provided by operating activitiesAverage current liabilities

= $112,000($34,000 + $47,000)/2

= 2.77 to 1

Cash debt coverage ratio =

= Net cash provided by operating activitiesAverage total liabilities

= $112,000 ÷ $184,000 + $247,0002

= 0.52 to 1


Net cash provided by operating activities.......................... $112,000Less: Purchase of equipment ............................................ (70,000)

Dividends................................................................... (40,000)Free cash flow ...................................................................... $ 2,000

Orozco has acceptable liquidity. Its financial flexibility is good. It might benoted that it substantially reduced its long-term debt in 2010 which willhelp its financial flexibility.



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(a) CHEKOV CORPORATIONStatement of Cash Flows


Cash flows from operating activitiesNet income ................................................................ $55,000Adjustments to reconcile net income


Depreciation expense......................................... $13,000Patent amortization ............................................ 2,500Loss on sale of equipment................................. 3,000*Increase in current liabilities ............................. 13,000Increase in current assets (other than cash) ....... (25,000) 6,500

Net cash provided by operating activities .............. 61,500

Cash flows from investing activitiesSale of equipment..................................................... 9,000Addition to building.................................................. (27,000)Investment in stock .................................................. (16,000)Net cash used by investing activities ..................... (34,000)

Cash flows from financing activitiesIssuance of bonds .................................................... 50,000Payment of dividends............................................... (25,000)Purchase of treasury stock...................................... (11,000)Net cash provided by financing activities............... 14,000

Net increase in cash....................................................... $41,500a

*[$9,000 – ($20,000 – $8,000)]aAn additional proof to arrive at the increase in cash is provided as follows:

Total current assets—end of period $301,500 [from part (b)]Total current assets—beginning of period 235,000Increase in current assets during the period 66,500Increase in current assets other than cash 25,000Increase in cash during year $ 41,500



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(b) CHEKOV CORPORATIONBalance Sheet

December 31, 2010

AssetsCurrent assets ................................................ $301,500b

Long-term investments.................................. 16,000Property, plant, and equipment

Land .......................................................... $ 30,000Building ($120,000 + $27,000).................. $147,000Less: Accum. depreciation

($30,000 + $4,000).......................... (34,000) 113,000Equipment ($90,000 – $20,000)................ 70,000Less: Accum. depreciation

($11,000 – $8,000 + $9,000) ........... (12,000) 58,000Total property, plant, and equipment..... 201,000

Intangible assets—patents($40,000 – $2,500) .................................. 37,500

Total assets........................................ $556,000

Liabilities and Stockholders’ EquityCurrent liabilities ($150,000 + $13,000) ........................ $163,000Long-term liabilities

Bonds payable ($100,000 + $50,000) ...................... 150,000Total liabilities ................................................... 313,000

Stockholders’ equityCommon stock ........................................................ $180,000Retained earnings ($44,000 + $55,000 – $25,000) ........ 74,000

Total paid-in capital and retained earnings........ 254,000Less: Cost of treasury stock ................................. (11,000)

Total stockholders’ equity ................................ 243,000Total liabilities and stockholders’ equity......... $556,000

b The amount determined for current assets could be computed last and then is a“plug” figure. That is, total liabilities and stockholders’ equity is computed becauseinformation is available to determine this amount. Because the total assets amount isthe same as total liabilities and stockholders’ equity amount, the amount of totalassets is determined. Information is available to compute all the asset amounts exceptcurrent assets and therefore current assets can be determined by deducting the totalof all the other asset balances from the total asset balance (i.e., $556,000 – $37,500 –$201,000 – $16,000). Another way to compute this amount, given the information, isthat beginning current assets plus the $25,000 increase in current assets other thancash plus the $41,500 increase in cash equals $301,500.



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PROBLEM 5-7

(a) AERO INC.Statement of Cash Flows


Cash flows from operating activitiesNet income ............................................................ $35,000Adjustments to reconcile net income to

net cash provided by operating activitiesDepreciation expense..................................... $12,000Loss on sale of investments.......................... 5,000Increase in accounts payable

($40,000 – $30,000) ................................... 10,000Increase in accounts receivable

($42,000 – $21,200) ................................... (20,800) 6,200Net cash provided by operating activities .......... 41,200

Cash flows from investing activitiesSale of investments.............................................. 27,000Purchase of land................................................... (38,000)Net cash used by investing activities ................. (11,000)

Cash flows from financing activitiesIssuance of common stock.................................. 30,000Payment of cash dividends ................................. (10,000)Net cash provided by financing activities........... 20,000

Net increase in cash................................................... 50,200Cash at beginning of year.......................................... 20,000Cash at end of year .................................................... $70,200Noncash investing and financing activities

Land purchased through issuance of $30,000 of bonds



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(b) AERO INC.Balance Sheet

December 31, 2010

Assets Liabilities and Stockholders’ EquityCash $ 70,200 Accounts payable $ 40,000Accounts

receivable 42,000Bonds payableCommon stock

71,000130,000

(3)(4)

Plant assets (net) 69,000 (1) Retained earnings 48,200 (5)Land 108,000 (2) $289,200

$289,200

(1) $81,000 – $12,000(2) $40,000 + $38,000 + $30,000(3) $41,000 + $30,000(4) $100,000 + $30,000(5) $23,200 + $35,000 – $10,000

(c) An analysis of Aero’s free cash flow indicates it is negative as shownbelow:


Net cash provided by operating activities.............................. $ 41,200Less: Purchase of land............................................................ (38,000)

Dividends ....................................................................... (10,000)Free cash flow .......................................................................... $( 6,800)



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Its current cash debt coverage is 1.18 to 1 $41,200$35,000*

. Overall, it appears

that its liquidity position is average and overall financial flexibility shouldbe improved.

*($30,000 + $40,000) ÷ 2

(d) This type of information is useful for assessing the amount, timing,and uncertainty of future cash flows. For example, by showing thespecific inflows and outflows from operating activities, investingactivities, and financing activities, the user has a better understandingof the liquidity and financial flexibility of the enterprise. Similarly, thesereports are useful in providing feedback about the flow of enterpriseresources. This information should help users make more accuratepredictions of future cash flow. In addition, some individuals haveexpressed concern about the quality of the earnings because themeasurement of the income depends on a number of accruals andestimates which may be somewhat subjective. As a result, the higherthe ratio of cash provided by operating activities to net income, themore comfort some users have in the reliability of the earnings.



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CHAPTER 7Cash and Receivables

BRIEF EXERCISE 7-1

Cash in bank—savings account................................ $68,000Cash on hand ............................................................. 9,300Checking account balance ........................................ 17,000Cash to be reported ................................................... $94,300

BRIEF EXERCISE 7-2

June 1 Accounts Receivable .......................... 50,000Sales............................................ 50,000

June 12 Cash ..................................................... 48,500*Sales Discounts................................... 1,500

Accounts Receivable ................. 50,000

*$50,000 – ($50,000 X .03) = $48,500

BRIEF EXERCISE 7-3

June 1 Accounts Receivable .......................... 48,500*Sales............................................ 48,500

June 12 Cash ..................................................... 48,500Accounts Receivable ................. 48,500



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*$50,000 – ($50,000 X .03) = $48,500

BRIEF EXERCISE 7-4

Bad Debt Expense........................................................... 28,000Allowance for Doubtful Accounts

($1,400,000 X 2%) ................................................ 28,000

BRIEF EXERCISE 7-5

(a) Bad Debt Expense...........................................................22,600Allowance for Doubtful Accounts

[(10% X $250,000) – $2,400] ................................ 22,600

(b) Bad Debt Expense...........................................................22,200Allowance for Doubtful Accounts

($24,600 – $2,400)................................................ 22,200

BRIEF EXERCISE 7-6

11/1/10 Notes Receivable ............................................................30,000Sales ....................................................................... 30,000

12/31/10 Interest Receivable .........................................................300Interest Revenue

($30,000 X 6% X 2/12) .......................................... 300



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5/1/11 Cash.................................................................................30,900Notes Receivable ................................................... 30,000Interest Receivable ................................................ 300Interest Revenue

($30,000 X 6% X 4/12)............................................. 600

BRIEF EXERCISE 7-7

Notes Receivable............................................................. 20,000Discount on Notes Receivable .............................. 3,471Cash ........................................................................ 16,529

Discount on Notes Receivable ....................................... 1,653Interest Revenue

$16,529 X 10%...................................................... 1,653

Discount on Notes Receivable ....................................... 1,818Interest Revenue

($16,529 + $1,653) X 10% .................................... 1,818

Cash ................................................................................. 20,000Notes Receivable ................................................... 20,000

BRIEF EXERCISE 7-8

Chung, Inc.

Cash .................................................................................730,000Finance Charge ($1,000,000 X 2%)................................. 20,000

Notes Payable......................................................... 750,000

Seneca National Bank



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Notes Receivable.............................................................750,000Cash ........................................................................ 730,000Financing Revenue ($1,000,000 X 2%) .................. 20,000

BRIEF EXERCISE 7-9

Wood

Cash .................................................................................138,000Due from Factor............................................................... 9,000*Loss on Sale of Receivables .......................................... 3,000**

Accounts Receivable ............................................. 150,000

*6% X $150,000 = $9,000**2% X $150,000 = $3,000

Engram

Accounts Receivable ......................................................150,000Due to Wood ........................................................... 9,000Financing Revenue ................................................ 3,000Cash ........................................................................ 138,000

BRIEF EXERCISE 7-10

Wood

Cash .................................................................................138,000Due from Factor............................................................... 9,000*Loss on Sale of Receivables ..........................................10,500**

Accounts Receivable ............................................. 150,000Recourse Obligation .............................................. 7,500

*6% X $150,000 = $9,000



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**2% X $150,000 = $3,000 + $7,500 = $10,500

BRIEF EXERCISE 7-11

Cash $250,000 – [$250,000 X (.05 + .04)] ........................227,500Due from Factor ($250,000 X .04) ................................... 10,000Loss on Sale of Receivables .......................................... 20,500*

Accounts Receivable ............................................. 250,000Recourse Obligation .............................................. 8,000

*($250,000 X .05) + $8,000

BRIEF EXERCISE 7-12

The entry for the sale now would be:

Cash $250,000 – [($250,000 X (.05 + .04)].......................227,500Due from Factor ($250,000 X .04) ................................... 10,000Loss on Sale of Receivables .......................................... 16,500*

Account Receivable ............................................... 250,000Recourse Obligation .............................................. 4,000

*($250,000 X .05) + $4,000

This lower estimate for the recourse obligation reduces the amount of theloss—this will result in higher income in the year of the sale. Arness’sliabilities will be lower by $4,000.

BRIEF EXERCISE 7-13

The accounts receivable turnover ratio is computed as follows:

Net Sales = $12,442,000,000 = 13.34 timesAverage Trade Receivables (net) $912,000,000 + $953,000,000

2



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The average collection period for accounts receivable in days is

365 days = 365 = 27.36 daysAccounts Receivable Turnover 13.34

As indicated from these ratios, General Mills’ accounts receivable turnoverratio appears quite strong.

**BRIEF EXERCISE 7-17

National American Bank (Creditor):Bad Debt Expense.................................................... 225,000

Allowance for Doubtful Accounts..................... 225,000


1. Cash balance of $925,000. Only the checking account balance shouldbe reported as cash. The certificates of deposit of $1,400,000 shouldbe reported as a temporary investment, the cash advance to subsidiaryof $980,000 should be reported as a receivable, and the utility depositof $180 should be identified as a receivable from the gas company.

2. Cash balance is $484,650 computed as follows:Checking account balance............................... $500,000Overdraft ........................................................... (17,000)Petty cash ......................................................... 300Coin and currency ............................................ 1,350

$484,650

Cash held in a bond sinking fund is restricted. Assuming that the bondsare noncurrent, the restricted cash is also reported as noncurrent.



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3. Cash balance is $599,800 computed as follows:Checking account balance ............................... $590,000Certified check from customer......................... 9,800

$599,800

The postdated check of $11,000 should be reported as a receivable.Cash restricted due to compensating balance should be described ina note indicating the type of arrangement and amount. Postage stampson hand are reported as part of office supplies inventory or prepaidexpenses.

4. Cash balance is $90,000 computed as follows:Checking account balance ............................... $42,000Money market mutual fund............................... 48,000

$90,000

The NSF check received from customer should be reported as areceivable.

5. Cash balance is $700,900 computed as follows:Checking account balance ............................... $700,000Cash advance received from customer........... 900

$700,900

Cash restricted for future plant expansion of $500,000 should bereported as a noncurrent asset. Short-term Treasury bills of $180,000should be reported as a temporary investment. Cash advance receivedfrom customer of $900 should also be reported as a liability; cashadvance of $7,000 to company executive should be reported as areceivable; refundable deposit of $26,000 paid to federal governmentshould be reported as a receivable.



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July 1 Accounts Receivable ......................................................30,000Sales ....................................................................... 30,000

July 10 Cash .................................................................................29,100*Sales Discounts...............................................................900

Accounts Receivable............................................. 30,000

*$30,000 – (.03 X $30,000) = $29,100

July 17 Accounts Receivable ......................................................250,000Sales ....................................................................... 250,000

July 30 Cash .................................................................................250,000Accounts Receivable............................................. 250,000



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(a) Bad Debt Expense...........................................................7,500Allowance for Doubtful Accounts......................... 7,500*

*.01 X ($800,000 – $50,000) = $7,500

(b) Bad Debt Expense...........................................................6,000Allowance for Doubtful Accounts......................... 6,000*

*Step 1: .05 X $160,000 = $8,000 (desired credit balance in Allow-ance account)

Step 2: $8,000 – $2,000 = $6,000 (required credit entry to bringallowance account to $8,000 credit balance)


(a) Allowance for Doubtful Accounts..................................8,000Accounts Receivable ............................................. 8,000

(b) Accounts Receivable ...................................................... $900,000Less: Allowance for Doubtful Accounts....................... 40,000

Net realizable value................................................ $860,000

(c) Accounts Receivable ...................................................... $892,000Less: Allowance for Doubtful Accounts....................... 32,000

Net realizable value................................................ $860,000


(a) Bad Debt Expense...........................................................4,950Allowance for Doubtful Accounts



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($80,000 X 4%) + $1,750 = $4,950....................... 4,950

(b) Bad Debt Expense...........................................................5,800Allowance for Doubtful Accounts

$580,000 X 1% = $5,800...................................... 5,800


7/1 Accounts Receivable—Legler Co. .................................9,800Sales ($10,000 X 98%) ............................................ 9,800

7/5 Cash [$12,000 X (1 – .09)]................................................10,920Loss on Sale of Receivables ..........................................1,080

Accounts Receivable ($12,000 X 98%).................. 11,760Sales Discounts Forfeited ..................................... 240

(Note: It is possible that the company already recorded the SalesDiscounts Forfeited. In this case, the credit to Accounts Receivablewould be for $12,000. The same point applies to the next entry as well.)


7/9 Accounts Receivable.......................................................180Sales Discounts Forfeited

($9,000 X 2%)....................................................... 180

Cash..................................................................................5,640Finance Charge ($6,000 X 6%) ........................................360

Notes Payable ......................................................... 6,000

7/11 Accounts Receivable—Legler Co. ..................................200Sales Discounts Forfeited



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($10,000 X 2%)...................................................... 200

This entry may be made at the next time financial statements areprepared. Also, it may occur on 12/29 when Legler Company’s receiv-able is adjusted.

12/29 Allowance for Doubtful Accounts ..................................9,000Accounts Receivable—Legler Co.

[$9,800 + $200 = $10,000;$10,000 – (10% X $10,000) = $9,000] ................... 9,000


(a) Cash.................................................................................290,000Finance Charge ...............................................................10,000*

Notes Payable ........................................................ 300,000

*2% X $500,000 = $10,000

(b) Cash.................................................................................350,000Accounts Receivable ............................................. 350,000


(c) Notes Payable .................................................................300,000Interest Expense .............................................................7,500*

Cash........................................................................ 307,500

*10% X $300,000 X 3/12 = $7,500




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1. Cash .................................................................................18,000Loss on Sale of Receivables

($20,000 X 10%) ............................................................2,000Accounts Receivable ............................................. 20,000

2. Cash .................................................................................50,600Finance Charge ($55,000 X 8%) ......................................4,400

Notes Payable......................................................... 55,000

3. Bad Debt Expense...........................................................5,850Allowance for Doubtful Accounts

[($82,000 X 5%) + $1,750] .................................... 5,850

4. Bad Debt Expense...........................................................6,450Allowance for Doubtful Accounts

($430,000 X 1.5%) ................................................ 6,450


Computation of net proceeds:Cash received.................................................................. $190,000Less: Recourse liability ................................................. 2,000Net proceeds ................................................................... $188,000

Computation of gain or loss:Carrying value .................................................. $200,000Net proceeds .................................................... 188,000Loss on sale of receivables............................. $ 12,000

The following journal entry would be made:Cash ........................................................................ $190,000Loss on Sale of Receivables ................................. 12,000

Recourse Liability........................................... 2,000Accounts Receivable ..................................... 200,000



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(a) To be recorded as a sale, all of the following conditions would be met:

1. The transferred asset has been isolated from the transferor (putbeyond reach of the transferor and its creditors).

2. The transferees have obtained the right to pledge or to exchangeeither the transferred assets or beneficial interests in the trans-ferred assets.

3. The transferor does not maintain effective control over the trans-ferred assets through an agreement to repurchase or redeem thembefore their maturity.

(b) Computation of net proceeds:Cash received ($250,000 X 94%)................. $235,000Due from factor ($250,000 X 4%) ................ 10,000 $245,000Less: Recourse obligation ......................... 3,000Net proceeds................................................ $242,000


Computation of gain or loss:Carrying value ........................................... $250,000Net proceeds ............................................. 242,000Loss on sale of receivables...................... $ 8,000

The following journal entry would be made:Cash ........................................................................$235,000Due from Factor......................................................10,000Loss on Sale of Receivables .................................8,000

Recourse Liability........................................... 3,000Accounts Receivable ..................................... 250,000



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(a) July 1 Cash.................................................................................378,000Due from Factor ..............................................................16,000*Loss on Sale of Receivables ..........................................6,000**

Accounts Receivable............................................. 400,000

**(4% X $400,000) = $16,000**(1 1/2% X $400,000) = $6,000

(b) July 1 Accounts Receivable ......................................................400,000Due to SEK Corp. ................................................... 16,000Financing Revenue ................................................ 6,000Cash........................................................................ 378,000


1. 7/1/10 Notes Receivable .............................................................1,416,163Discount on Notes Receivable................................ 516,163Land .......................................................................... 590,000Gain on Sale of Land

($900,000 – $590,000)................. 310,000

Computation of the discount$1,416,163 Face value of note

.63552 Present value of 1 for 4 periods at 12%$ 900,000 Present value of note

1,416,163 Face value of note$ 516,163 Discount on notes receivable



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Note: Problem does not require entries for future years. The amortizationtable and annual journal entries provided for your learning.

Note Amortization Schedule

Date

CashReceived

(0%)

InterestRevenue

(12%)

UnamortizedDiscount

Book Valueof Note*

7/31/10 516,163 900,0007/31/11 $0 108,000 408,163 1,008,0007/31/12 0 120,960 287,203 1,128,9607/31/13 0 135,475 151,728 1,264,4357/31/14 0 151,728** 0 1,416,163

* Note receivable – Unamortized discount ** Amount rounded



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7/1/11 Discount on Note Receivable 108,000Interest Revenue 108,000




Cash 1,416,163Note Receivable 1,416,163

2. 7/1/10 Notes Receivable .............................................................400,000.00Discount on Notes Receivable ................................178,836.32Service Revenue ......................................................221,163.68

Computation of the present value of the note:Maturity value............................................................ $400,000.00Present value of $400,000 due in

8 years at 12%—$400,000 X .40388......................$161,552.00Present value of $12,000

payable annually for 8 years at12% annually—$12,000 X 4.96764.........................59,611.68

Present value of the note ......................................... 221,163.68Discount on notes receivable .................................. $178,836.32



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(a) Notes Receivable ...........................................................300,000Discount on Notes Receivable .............................. 52,065Consulting Revenue ............................................. 247,935*

*Computation of present value of note:PV of $300,000 due in 2 years at 10%$300,000 X .82645 = $247,935

(b) Discount on Notes Receivable .......................................24,794Interest Revenue ................................................... 24,794*

*$247,935 X 10% = $24,794

(c) Discount on Notes Receivable .......................................27,271*Interest Revenue .................................................... 27,271

*$52,065 – $24,794

Cash .................................................................................300,000Notes Receivable .................................................. 300,000

(d) Notes Receivable ............................................................45,271Unrealized Holding Gain or

Loss—Income..................................................... 45,271*

*Note Receivable, net.......... $249,735Amortization, 12/31/10.... 24,794

Book Value, 12/31/10 ......... 274,529

Fair Value ........................... $320,000Carrying Value ................... (274,529)Unrealized Gain ................. $ 45,471



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(a) Accounts Receivable.......................................................100,000Sales........................................................................ 100,000

Cash..................................................................................80,000Accounts Receivable ............................................. 80,000

(b) Accounts Receivable Turnover = Net SalesAverage Trade Receivables (net)

Net Sales = $100,000 = 4.0 timesAverage Trade Receivables (net) ($15,000 + $35,000*)/2

*$15,000 + $100,000 – $80,000

Average number of days to collectreceivables = 365 = 91 days4.0

(c) Grant Company’s turnover ratio has declined significantly. That is, itis turning receivables 4.0 times a year and collections on receivablestook 91 days. In the prior year, the turnover ratio was almost double(7.0) and collections took only 52 days. This is a bad trend in liquidity.Grant should consider offering early payment discounts and/ortightened credit and collection policies.

*EXERCISE 7-24 (15–20 minutes)

(a) KIPLING COMPANY



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Bank ReconciliationJuly 31

Balance per bank statement, July 31............................. $ 8,650Add: Deposits in transit................................................. 2,850a

Deduct: Outstanding checks......................................... (1,100)b

Correct cash balance, July 31 ........................................ $10,400

Balance per books, July 31 ............................................ $ 9,250Add: Collection of note................................................. 1,500Less: Bank service charge ............................................$ 15

NSF check............................................................335 (350)Corrected cash balance, July 31.................................... $10,400

aComputation of deposits in transitDeposits per books $5,810Deposits per bank in July $ 4,500Less deposits in transit (June) (1,540)Deposits mailed and received

in July (2,960)Deposits in transit, July 31 $2,850

bComputation of outstanding checksChecks written per books $3,100Checks cleared by bank in July $ 4,000Less outstanding checks

(June)* (2,000)Checks written and cleared

in July (2,000)Outstanding checks, July 31 $1,100

*Assumed to clear bank in July



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*EXERCISE 7-24 (Continued)

(b) Cash.................................................................................. 1,150Office Expenses—Bank Charges ................................... 15Accounts Receivable....................................................... 335

Notes Receivable.................................................... 1,500


(a) ARAGON COMPANYBank Reconciliation, August 31, 2010

County National Bank

Balance per bank statement, August 31, 2010 ............... $ 8,089Add: Cash on hand..........................................................$ 310

Deposits in transit ..................................................3,800 4,11012,199

Deduct: Outstanding checks .......................................... 1,550Correct cash balance........................................................ $10,649

Balance per books, August 31, 2010($10,050 + $35,000 – $35,403)........................................ $ 9,647

Add: Note ($1,000) and interest ($40) collected............. 1,04010,687

Deduct: Bank service charges........................................$ 20Understated check for supplies ....................... 18 38

Correct cash balance $10,649

(b) Cash.................................................................................. 1,040Notes Receivable.................................................... 1,000Interest Revenue..................................................... 40

(To record collection of note and interest)



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*EXERCISE 7-25 (Continued)

Office Expense—Bank Charges ..................................... 20Cash ........................................................................ 20

(To record August bank charges)

Supplies Expense............................................................ 18Cash ........................................................................ 18

(To record error in recording check forsupplies)

(c) The corrected cash balance of $10,649 would be reported in the August31, 2010, balance sheet.

*EXERCISE 7-26 (15-25 minutes)

(a) Journal entry to record issuance of loan by Paris Bank:December 31, 2010

Notes Receivable..............................................................100,000Discount on Notes Receivable .............................. 37,908Cash ........................................................................ 62,092

$100,000 X Present value of 1 for 5 periods at 10%$100,000 X .62092 = $62,092

(b) Note Amortization Schedule(Before Impairment)

Date

CashReceived

(0%)

InterestRevenue

(10%)

Increase inCarryingAmount

CarryingAmount of

Note12/31/10 $62,09212/31/11 $0 $6,209 $6,209 68,30112/31/12 0 6,830 6,830 75,131



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Computation of the impairment loss:Carrying amount of investment (12/31/12)................. $75,131Less: Present value of $75,000 due in 3 years

at 10% ($75,000 X .75132) ................................ 56,349Loss due to impairment .............................................. $18,782

The entry to record the loss by Paris Bank is as follows:

Bad Debt Expense ...........................................................18,782Allowance for Doubtful Accounts ......................... 18,782

Note: Iva Majoli Company, the debtor, makes no entry because it stilllegally owes $100,000.

*EXERCISE 7-27 (15-25 minutes)

(a) Cash received by Conchita Martinez Company on December 31, 2010:

Present value of principal ($1,000,000 X .56743) ....... $567,430Present value of interest ($100,0000 X 3.60478) ........ 360,478Cash received .............................................................. $927,908

(b) Note Amortization Schedule(Before Impairment)

Date

CashReceived

(10%)

InterestRevenue

(12%)

Increase inCarryingAmount

CarryingAmount of

Note12/31/10 $927,90812/31/11 $100,000 $111,349 $11,349 939,25712/31/12 100,000 112,711 12,711 951,968

(c) Loss due to impairment:

Carrying amount of loan (12/31/12) ....................... $951,968Less: Present value of $600,000 due in

3 years ($600,000 X .71178) ........................427,068Present value of $100,000 payable annually



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for 3 years ($100,000 X 2.40183)........................240,183 667,251Loss due to impairment ......................................... $284,717

PROBLEM 7-2

1. Net sales ................................................................................ $1,200,000Percentage............................................................................. 1 1/2%Bad debt expense.................................................................. $ 18,000

2. Accounts receivable ............................................................. $1,750,000Amounts estimated to be uncollectible ............................... (180,000)Net realizable value ............................................................... $1,570,000

3. Allowance for doubtful accounts 1/1/10 .............................. $ 17,000Establishment of accounts written off in prior years ......... 8,000Customer accounts written off in 2010................................ (30,000)Bad debt expense for 2010 ($2,400,000 X 3%)..................... 72,000Allowance for doubtful accounts 12/31/10 .......................... $ 67,000

4. Bad debt expense for 2010 ................................................... $ 84,000Customer accounts written off as uncollectible

during 2010 ........................................................................ (24,000)Allowance for doubtful accounts balance 12/31/10 ............ $ 60,000

Accounts receivable, net of allowancefor doubtful Accounts ....................................................... $ 950,000

Allowance for doubtful accounts balance 12/31/10 ............ 60,000Accounts receivable, before deducting

allowance for doubtful accounts...................................... $1,010,000

5. Accounts receivable ............................................................. $ 310,000Percentage............................................................................. 3%Bad debt expense, before adjustment ................................. 9,300



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Allowance for doubtful accounts (debit balance) .............. 14,000Bad debt expense, as adjusted ........................................... $ 23,300

PROBLEM 7-3

(a) The Allowance for Doubtful Accounts should have a balance of $45,000at year-end. The supporting calculations are shown below:

Days AccountOutstanding Amount

ExpectedPercentage

UncollectibleEstimated

Uncollectible0–15 days $300,000 .02 $ 6,000

16–30 days 100,000 .10 10,00031–45 days 80,000 .15 12,00046–60 days 40,000 .20 8,00061–75 days 20,000 .45 9,000

Balance for Allowance for Doubtful Accounts $45,000

The accounts which have been outstanding over 75 days ($15,000)and have zero probability of collection would be written off immediatelyby a debit to Allowance for Doubtful Accounts for $15,000 and a creditto Accounts Receivable for $15,000. It is not considered when deter-mining the proper amount for the Allowance for Doubtful Accounts.

(b) Accounts receivable ($555,000 – $15,000) ........................ $540,000Less: Allowance for doubtful accounts ........................... 45,000Accounts receivable (net) .................................................. $495,000

(c) The year-end bad debt adjustment would decrease before-tax income$20,000 as computed below:

Estimated amount required in the Allowance



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for Doubtful Accounts ......................................................... $45,000Balance in the account after write-off of uncollectible

accounts but before adjustment ($40,000 – $15,000)........ 25,000Required charge to expense................................................... $20,000

PROBLEM 7-4

(a) FORTNER CORPORATIONAnalysis of Changes in the

Allowance for Doubtful AccountsFor the Year Ended December 31, 2010

Balance at January 1, 2010............................................... $130,000Provision for doubtful accounts ($9,000,000 X 2%) ........ 180,000Recovery in 2010 of bad debts written off previously .... 15,000

325,000Deduct write-offs for 2010 ($90,000 + $60,000) ............... 150,000Balance at December 31, 2010 before change

in accounting estimate.................................................. 175,000Increase due to change in accounting estimate

during 2010 ($263,600 – $175,000) ............................... 88,600Balance at December 31, 2010 adjusted (Schedule 1).... $263,600

Schedule 1Computation of Allowance for Doubtful Accounts

at December 31, 2010

AgingCategory Balance %

DoubtfulAccounts

Nov–Dec 2010 $1,080,000 2 $ 21,600July–Oct 650,000 10 65,000Jan–Jun 420,000 25 105,000Prior to 1/1/10 90,000(a) 80 72,000

$263,600



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(a) $150,000 – $60,000


(b) The journal entry to record this transaction is as follows:

Bad Debt Expense ......................................... $88,600Allowance for Doubtful Accounts.............

(To increase the allowance fordoubtful accounts at December 31,2010, resulting from a changein accounting estimate)

$88,600

PROBLEM 7-6

–1–Cash........................................................................... 136,800*Sales Discounts........................................................ 1,200

Accounts Receivable ...................................... 138,000

*[$138,000 – ($60,000 X 2%)]–2–

Accounts Receivable................................................ 5,300Allowance for Doubtful Accounts .................. 5,300

Cash........................................................................... 5,300Accounts Receivable ...................................... 5,300

–3–Allowance for Doubtful Accounts ........................... 17,500

Accounts Receivable ...................................... 17,500



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–4–Bad Debt Expense.................................................... 14,900

Allowance for Doubtful Accounts .................. 14,900**($17,300 + $5,300 – $17,500 = $5,100;

$20,000 – $5,100 = $14,900)

PROBLEM 7-9

(a) December 31, 2010Cash ........................................................................ 40,000Notes Receivable.................................................... 80,000

Discount on Notes Receivable ..................... 17,951Service Revenue............................................ 102,049

To record revenue at the present value of thenote plus the immediate cash payment:

PV of $20,000 annuity @ 11% for4 years ($20,000 X 3.10245)............ $ 62,049

Down payment................................... 40,000Capitalized value of services............ $102,049

(b) December 31, 2011Cash ........................................................................... 20,000

Notes Receivable.............................................. 20,000

Discount on Notes Receivable ................................. 6,825Interest Revenue .............................................. 6,825

Schedule of Note Discount Amortization

DateCash

ReceivedInterestRevenue

CarryingAmount of Note

12/31/10 — — $62,04912/31/11 $20,000.00 $6,825a 48,874b

12/31/12 20,000.00 5,376 34,25012/31/13 20,000.00 3,768 18,01812/31/14 20,000.00 1,982 —



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a$6,825 = $62,049 X 11%b$48,874 = $62,049 + $6,825 – $20,000.00

(c) December 31, 2012Cash............................................................ 20,000

Notes Receivable.............................. 20,000

Discount on Notes Receivable ................. 5,376Interest Revenue............................... 5,376

(d) December 31, 2013Cash............................................................ 20,000



(e) December 31, 2014Cash............................................................ 20,000



PROBLEM 7-11

SANDBURG COMPANYIncome Statement Effects



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Expenses resulting from accounts receivableassigned (Schedule 1) ................................................... $22,320

Loss resulting from accounts receivablesold ($300,000 – $270,000) ............................................ 30,000

Total expenses............................................................ $52,320

Schedule 1

Computation of Expensefor Accounts Receivable Assigned

Assignment expense:Accounts receivable assigned...................................$400,000

X 80%Advance by Keller Finance Company .......................320,000

X 3% $ 9,600Interest expense................................................................ 12,720

Total expenses ............................................................ $22,320

*PROBLEM 7-15

(a) The entries for the issuance of the note on January 1, 2010:

The present value of the note is: $1,200,000 X .68058 = $816,700(Rounded by $4).

Botosan Company (Debtor):Cash ........................................................................816,700Discount on Notes Payable ...................................383,300

Note Payable ..................................................... 1,200,000

National Organization Bank (Creditor):



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Notes Receivable....................................................1,200,000Discount on Notes Receivable......................... 383,300Cash................................................................... 816,700

(b) The amortization schedule for this note is:

SCHEDULE FOR INTEREST AND DISCOUNT AMORTIZATION—EFFECTIVE-INTEREST METHOD

$1,200,000 Note Issued to Yield 8%

DateCashPaid

InterestExpense

DiscountAmortized

CarryingAmount of

Note1/1/10 $ 816,70012/31/10 $0 $ 65,336* $ 65,336 882,036**12/31/11 0 70,563 70,563 952,59912/31/12 0 76,208 76,208 1,028,80712/31/13 0 82,305 82,305 1,111,11212/31/14 0 88,888 88,888 1,200,000Total $0 $383,300 $383,300

*$816,700 X 8% = $65,336.**$816,700 + $65,336 = $882,036.



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*PROBLEM 7-15 (Continued)

(c) The note can be considered to be impaired only when it is probablethat, based on current information and events, National OrganizationBank will be unable to collect all amounts due (both principal andinterest) according to the contractual terms of the loan.

(d) The loss is computed as follows:Carrying amount of loan (12/31/11) ................................ $952,599a

Less: Present value of $800,000 duein 3 years at 8%.................................................... (635,064)b

Loss due to impairment .................................................. $317,535

aSee amortization schedule from answer (b) on page 7-66.b$800,000 X .79383 = $635,064.

December 31, 2011National Organization Bank (Creditor):

Bad Debt Expense ........................................... 317,535Allowance for Doubtful Accounts ............ 317,535

Note: Botosan Company (Debtor) has no entry.



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CHAPTER 8Valuation of Inventories: A Cost-Basis Approach

BRIEF EXERCISE 8-3

December 31 inventory per physical count........................... $200,000Goods-in-transit purchased FOB shipping point.................. 25,000Goods-in-transit sold FOB destination.................................. 22,000

December 31 inventory.................................................. $247,000

BRIEF EXERCISE 8-4

Cost of goods sold as reported.............................................. $1,400,000Overstatement of 12/31/09 inventory ..................................... (110,000)Overstatement of 12/31/10 inventory ..................................... 35,000

Corrected cost of goods sold........................................ $1,325,000

12/31/10 retained earnings as reported ................................. $5,200,000Overstatement of 12/31/10 inventory ..................................... (35,000)

Corrected 12/31/10 retained earnings........................... $5,165,000

BRIEF EXERCISE 8-5

Weighted average cost per unit $11,850 = $11.851,000

Ending inventory 400 X $11.85 = $4,740

Cost of goods available for sale $11,850Deduct ending inventory 4,740Cost of goods sold (600 X $11.85) $ 7,110



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BRIEF EXERCISE 8-6

April 23 350 X $13 = $4,550April 15 50 X $12 = 600Ending inventory $5,150

Cost of goods available for sale $11,850Deduct ending inventory 5,150Cost of goods sold $ 6,700

BRIEF EXERCISE 8-7

April 1 250 X $10 = $2,500April 15 150 X $12 = 1,800Ending inventory $4,300

Cost of goods available for sale $11,850Deduct ending inventory 4,300Cost of goods sold $ 7,550

BRIEF EXERCISE 8-8

2009 $100,000

2010 $119,900 ÷ 1.10 = $109,000$100,000 X 1.00 ............................................................ $100,000$9,000* X 1.10 ............................................................... 9,900

$109,900*$109,000 – $100,000

2011 $134,560 ÷ 1.16 = $116,000$100,000 X 1.00 ............................................................ $100,000$9,000 X 1.10 ................................................................ 9,900$7,000** X 1.16.............................................................. 8,120

$118,020**$116,000 – $109,000



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BRIEF EXERCISE 8-9

2010 inventory at base amount ($22,140 ÷ 1.08) $20,5002009 inventory at base amount (19,750)Increase in base inventory $ 7502010 inventory under LIFO

Layer one $19,750 X 1.00 $19,750Layer two $ 750 X 1.08 810

$20,560

2011 inventory at base amount ($25,935 ÷ 1.14) $22,7502010 inventory at base amount 20,500Increase in base inventory $ 2,2502011 inventory under LIFO

Layer one $19,750 X 1.00 $19,750Layer two $ 750 X 1.08 810Layer three $ 2,250 X 1.14 2,565

$23,125


Items 2, 3, 5, 8, 10, 13, 14, 16, and 17 would be reported as inventory in thefinancial statements.

The following items would not be reported as inventory:1. Cost of goods sold in the income statement.4. Not reported in the financial statements.6. Cost of goods sold in the income statement.7. Cost of goods sold in the income statement.9. Interest expense in the income statement.

11. Advertising expense in the income statement.12. Office supplies in the current assets section of the balance sheet.15. Not reported in the financial statements.18. Short-term investments in the current asset section of the balance

sheet.



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Inventory per physical count.................................................. $441,000Goods in transit to customer, f.o.b. destination ................... + 33,000Goods in transit from vendor, f.o.b. shipping point.............. + 51,000Inventory to be reported on balance sheet............................ $525,000

The consigned goods of $61,000 are not owned by Garza and were properlyexcluded.

The goods in transit to a customer of $46,000, shipped f.o.b. shippingpoint, are properly excluded from the inventory because the title to thegoods passed when they left the seller (Oliva) and therefore a sale andrelated cost of goods sold should be recorded in 2010.

The goods in transit from a vendor of $73,000, shipped f.o.b. destination,are properly excluded from the inventory because the title to the goodsdoes not pass to Garza until the buyer (Garza) receives them.


1. Include. Merchandise passes to customer only when it is shipped.

2. Do not include. Title did not pass until January 3.

3. Include in inventory. Product belonged to Webber Inc. at December 31,2010.

4. Do not include. Goods received on consignment remain the propertyof the consignor.

5. Include in inventory. Under invoice terms, title passed when goodswere shipped.



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(a) Inventory December 31, 2010 (unadjusted).................. $234,890Transaction 2.................................................................. 10,420Transaction 3.................................................................. –0–Transaction 4.................................................................. –0–Transaction 5.................................................................. 8,540Transaction 6.................................................................. (10,438)Transaction 7.................................................................. (11,520)Transaction 8.................................................................. 1,500Inventory December 31, 2010 (adjusted) ...................... $233,392

(b) Transaction 3Sales .............................................................. 12,800

Accounts Receivable ................................................ 12,800(To reverse sale entry in 2010)

Transaction 4Purchases (Inventory) .................................. 15,630

Accounts Payable ..................................................... 15,630(To record purchase ofmerchandise in 2010)

Transaction 8Sales Returns and Allowances .................... 2,600

Accounts Receivable ........................... 2,600



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(a) FIFO Ending Inventory 12/31/0776 @ $10.89* = $ 827.6434 @ $11.88** = 403.92

$1,231.56

*[$11.00 – .01 ($11.00)]**[$12.00 – .01 ($12.00)]

(b) LIFO Cost of Goods Sold—200776 @ $10.89 = $ 827.6484 @ $11.88 = 997.9290 @ $14.85* = 1,336.50

5 @ $15.84** = 79.20$3,241.26

*[$15.00 – .01 ($15)]**[$16.00 – .01 ($16)]

(c) FIFO matches older costs with revenue. When prices are declining, asin this case, this results in a higher amount for cost of goods sold.Therefore, it is recommended that FIFO be used by Tom Brady Shop tominimize taxable income.


(a) The difference between the inventory used for internal reporting pur-poses and LIFO is referred to as the Allowance to Reduce Inventory toLIFO or the LIFO reserve. The change in the allowance balance fromone period to the next is called the LIFO effect (or as shown in thisexample, the LIFO adjustment).

(b) LIFO subtracts inflation from inventory costs by charging the items pur-chased recently to cost of goods sold. As a result, ending inventory(assuming increasing prices) will be lower than FIFO or average cost.



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(c) Cash flow was computed as follows:Revenue ................................. $3,200,000Cost of goods sold................ (2,800,000)Operating expenses.............. (150,000)Income taxes ......................... (75,600)Cash flow ............................... $ 174,400

If the company has any sales on account or payables, then the cash flownumber is incorrect. It is assumed here that the cash basis of accountingis used.

(d) The company has extra cash because its taxes are less. The reasontaxes are lower is because cost of goods sold (in a period of inflation)is higher under LIFO than FIFO. As a result, net income is lower whichleads to lower income taxes. If prices are decreasing, the oppositeeffect results.


$98,000 – $92,000 = $6,000 increase at base prices.$99,200 – $92,600 = $6,600 increase in dollar-value LIFO value.$6,000 X Index = $6,600.Index = $6,600 ÷ $6,000.Index = 110


(a) 12/31/10 inventory at 1/1/10 prices, $151,200 ÷ 1.12 ................. $135,000Inventory 1/1/10........................................................................... 160,000Inventory decrease at base prices............................................. $ 25,000

Inventory at 1/1/10 prices ........................................................... $160,000Less decrease at 1/1/10 prices................................................... 25,000



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Inventory 12/31/10 under dollar-value LIFO method................. $135,000

(b) 12/31/11 inventory at base prices, $195,500 ÷ 1.15 ................... $170,00012/31/10 inventory at base prices............................................... 135,000Inventory increment at base prices ........................................... $ 35,000

Inventory at 12/31/10 ................................................................... $135,000Increment added during 2011 at 12/31/11 prices,

$35,000 X 1.15........................................................................... 40,250Inventory 12/31/11 ....................................................................... $175,250


Current $ Price Index Base Year $Change from

Prior Year2007 $ 80,000 1.00 $ 80,000 —2008 111,300 1.05 106,000 +$26,0002009 108,000 1.20 90,000 (16,000)2010 122,200 1.30 94,000 +4,0002011 147,000 1.40 105,000 +11,0002012 176,900 1.45 122,000 +17,000

Ending Inventory—Dollar-value LIFO:

2007 $80,000 2011 $80,000 @ 1.00 = $ 80,00010,000 @ 1.05 = 10,500

2008 $80,000 @ 1.00 = $ 80,000 4,000 @ 1.30 = 5,20026,000 @ 1.05 = 27,300 11,000 @ 1.40 = 15,400

$107,300 $111,100

2009 $80,000 @ 1.00 = $ 80,000 2012 $80,000 @ 1.00 = $ 80,00010,000 @ 1.05 = 10,500 10,000 @ 1.05 = 10,500

$ 90,500 4,000 @ 1.30 = 5,20011,000 @ 1.40 = 15,400

2010 $80,000 @ 1.00 = $ 80,000 17,000 @ 1.45 = 24,650



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10,000 @ 1.05 = 10,500 $135,7504,000 @ 1.30 = 5,200

$ 95,700


Date Current $ Price Index Base-Year $Change from

Prior Year

Dec. 31, 2007 $ 70,000 1.00 $70,000 —Dec. 31, 2008 88,200 1.05 84,000 +$14,000Dec. 31, 2009 95,120 1.16 82,000 (2,000)Dec. 31, 2010 108,000 1.20 90,000 +8,000Dec. 31, 2011 100,000 1.25 80,000 (10,000)

Ending Inventory—Dollar-value LIFO:

Dec. 31, 2007 $70,000

Dec. 31, 2008 $70,000 @ 1.00 = $70,00014,000 @ 1.05 = 14,700

$84,700

Dec. 31, 2009 $70,000 @ 1.00 = $70,00012,000 @ 1.05 = 12,600

$82,600

Dec. 31, 2010 $70,000 @ 1.00 = $70,00012,000 @ 1.05 = 12,600

8,000 @ 1.20 = 9,600$92,200

Dec. 31, 2011 $70,000 @ 1.00 = $70,000



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10,000 @ 1.05 = 10,500$80,500

PROBLEM 8-5

(a) Assuming costs are not computed for each withdrawal (units received,5,700, minus units issued, 4,700, equals ending inventory at 1,000 units):

1. First-in, first-out.Date of Invoice No. Units Unit Cost Total Cost

Jan. 28 1,000 $3.50 $3,500

2. Last-in, first-out.Date of Invoice No. Units Unit Cost Total Cost

Jan. 2 1,000 $3.00 $3,000

3. Average cost.Cost of goods available:

Date of Invoice No. Units Unit Cost Total CostJan. 2 1,200 $3.00 $ 3,600Jan. 10 600 3.20 1,920Jan. 18 1,000 3.30 3,300Jan. 23 1,300 3.40 4,420Jan. 28 1,600 3.50 5,600

Total Available 5,700 $18,840

Average cost per unit = $18,840 ÷ 5,700 = $ 3.31Cost of inventory Jan. 31 = 1,000 X $3.31 = $3,310

(b) Assuming costs are computed at the time of each withdrawal:

Under FIFO—Yes. The amount shown as ending inventory would bethe same as in (a) above. In each case the units on hand would beassumed to be part of those purchased on Jan. 28.



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Under LIFO—No. During the month the available balance droppedbelow the ending inventory quantity so that the layers of oldest costswere partially liquidated during the month.

Under Average Cost—No. A new average cost would be computedeach time a withdrawal was made instead of only once for all itemspurchased during the year.

The calculations to determine the inventory on this basis are given below.

1. First-in, first-out.The inventory would be the same in amount as in part (a),$3,500.

2. Last-in, first-out.

Received Issued Balance

DateNo. ofunits

Unitcost

No. ofunits

Unitcost

No. ofunits

Unitcost* Amount

Jan. 2 1,200 $3.00 1,200 $3.00 $3,600Jan. 7 700 $3.00 500 3.00 1,500Jan. 10 600 3.20 500 3.00

3,420600 3.20

Jan. 13 500 3.20 500 3.001,820

100 3.20Jan. 18 1,000 3.30 300 3.30 500 3.00

100 3.20 4,130700 3.30

Jan. 20 700 3.30100 3.20300 3.00 200 3.00 600

Jan. 23 1,300 3.40 200 3.005,020

1,300 3.40Jan. 26 800 3.40 200 3.00

2,300500 3.40

Jan. 28 1,600 3.50 200 3.00500 3.40 7,900

1,600 3.50Jan. 31 1,300 3.50 200 3.00

500 3.40 3,350



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300 3.50

Inventory, January 31 is $3,350.

3. Average cost.

Received Issued Balance

DateNo. ofunits

Unitcost

No. ofunits

Unitcost

No. ofunits

Unitcost* Amount

Jan. 2 1,200 $3.00 1,200 $3.0000 $3,600Jan. 7 700 $3.0000 500 3.0000 1,500Jan. 10 600 3.20 1,100 3.1091 3,420Jan. 13 500 3.1091 600 3.1091 1,865Jan. 18 1,000 3.30 300 3.2281 1,300 3.2281 4,197Jan. 20 1,100 3.2281 200 3.2281 646Jan. 23 1,300 3.40 1,500 3.3773 5,066Jan. 26 800 3.3773 700 3.3773 2,364Jan. 28 1,600 3.50 2,300 3.4626 7,964Jan. 31 1,300 3.4626 1,000 3.4626 3,463

Inventory, January 31 is $3,463.

*Four decimal places are used to minimize rounding errors.



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PROBLEM 8-6

(a) Beginning inventory ..................... 1,000Purchases (2,000 + 3,000)............. 5,000Units available for sale ................. 6,000Sales (2,500 + 2,200) ..................... 4,700Goods on hand.............................. 1,300

Periodic FIFO1,000 X $12 = $12,0002,000 X $18 = 36,0001,700 X $23 = 39,1004,700 $87,100

(b) Perpetual FIFOSame as periodic: $87,100

(c) Periodic LIFO3,000 X $23 = $69,0001,700 X $18 = 30,6004,700 $99,600

(d) Perpetual LIFO

Date Purchased Sold Balance

1/1 1,000 X $12 = $12,0002/4 2,000 X $18 = $36,000 1,000 X $12

} $48,0002,000 X $18

2/20 2,000 X $18} $42,000

500 X $12 500 X $12 = $ 6,0004/2 3,000 X $23 = $69,000 500 X $12

} $75,0003,000 X $23

11/4 2,200 X $23 = $50,600 500 X $12} $24,400

______ 800 X $23$92,600



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(e) Periodic weighted-average1,000 X $12 = $ 12,0002,000 X $18 = 36,0003,000 X $23 = 69,000 4,700

$117,000 ÷ 6,000 = $19.50 X $19.50$91,650

(f) Perpetual moving average

Date Purchased Sold Balance

1/1 1,000 X $12 = $12,0002/4 2,000 X $18 = $36,000 3,000 X $16 = 48,0002/20 2,500 X $16 = $40,000 500 X $16 = 8,0004/2 3,000 X $23 = $69,000 3,500 X $22a = 77,00011/4 2,200 X $22 = 48,400 1,300 X $22 = 28,600

$88,400

a 500 X $16 = $ 8,0003,000 X $23 = 69,0003,500 $77,000

($77,000 ÷ 3,500 = $22)

PROBLEM 8-11

(a)

Schedule A

A B C D

Current $ Price Index Base-Year $Change from

Prior Year2006 $ 80,000 1.00 $ 80,000 —



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2007 111,300 1.05 106,000 +$26,0002008 108,000 1.20 90,000 (16,000)2009 128,700 1.30 99,000 +9,0002010 147,000 1.40 105,000 +6,0002011 174,000 1.45 120,000 +15,000

Schedule B

Ending Inventory-Dollar-Value LIFO:

2006 $ 80,000 2010 $80,000 @ $1.00 = $ 80,0002007 $80,000 @ $1.00 = $ 80,000 10,000 @ 1.05 = 10,500

26,000 @ 1.05 = 27,300 9,000 @ 1.30 = 11,700$107,300 6,000 @ 1.40 = 8,400

2008 $80,000 @ 1.00 = $ 80,000 $110,60010,000 @ 1.05 = 10,500 2011 $80,000 @ 1.00 = $ 80,000

$ 90,500 10,000 @ 1.05 = 10,5002009 $80,000 @ 1.00 = $ 80,000 9,000 @ 1.30 = 11,700

10,000 @ 1.05 = 10,500 6,000 @ 1.40 = 8,4009,000 @ 1.30 = 11,700 15,000 @ 1.45 = 21,750

$102,200 $132,350



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(b)

To: Richardson Company

From: Accounting Student

Subject: Dollar-Value LIFO Pool Accounting

Dollar-value LIFO is an inventory method which values groups or “pools”of inventory in layers of costs. It assumes that any goods sold during agiven period were taken from the most recently acquired group of goods instock and, consequently, any goods remaining in inventory are assumed tobe the oldest goods, valued at the oldest prices.

Because dollar-value LIFO combines various related costs in groups or“pools,” no attempt is made to keep track of each individual inventory item.Instead, each group of annual purchases forms a new cost layer of inventory.Further, the most recent layer will be the first one carried to cost of goodssold during this period.

However, inflation distorts any cost of purchases made in subsequent years.To counteract the effect of inflation, this method measures the incrementalchange in each year’s ending inventory in terms of the first year’s (baseyear’s) costs. This is done by adjusting subsequent cost layers, throughthe use of a price index, to the base year’s inventory costs. Only after thisadjustment can the new layer be valued at current-year prices.

To do this valuation, you need to know both the ending inventory at year-end prices and the price index used to adjust the current year’s new layer.The idea is to convert the current ending inventory into base-year costs.The difference between the current year’s and the previous year’s endinginventory expressed in base-year costs usually represents any inventorywhich has been purchased but not sold during the year, that is, the newestLIFO layer. This difference is then readjusted to express this most recentlayer in current-year costs.



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1. Refer to Schedule A. To express each year’s ending inventory (Column A)in terms of base-year costs, simply divide the ending inventory by theprice index (Column B). For 2006, this adjustment would be $80,000/100% or $80,000; for 2007, it would be $111,300/105%, etc. The quotient(Column C) is thus expressed in base-year costs.

2. Next, compute the difference between the previous and the currentyears’ ending inventory in base-year costs. Simply subtract the currentyear’s base-year inventory from the previous year’s. In 2007, thechange is +$26,000 (Column D).

3. Finally, express this increment in current-year terms. For the secondyear, this computation is straightforward: the base-year ending inven-tory value is added to the difference in #2 above multiplied by the priceindex. For 2007, the ending inventory for dollar-value LIFO wouldequal $80,000 of base-year inventory plus the increment ($26,000)times the price index (1.05) or $107,300. The product is the most recentlayer expressed in current-year prices. See Schedule B.

Be careful with this last step in subsequent years. Notice that, in 2008, thechange from the previous year is –$16,000, which causes the 2007 layer tobe eroded during the period. Thus, the 2008 ending inventory is valued atthe original base-year cost $80,000 plus the remainder valued at the 2007price index, $10,000 times 1.05. See 2008 computation on Schedule B.

When valuing ending inventory, remember to include each yearly layeradjusted by that year’s price index. Refer to Schedule B for 2009. Noticethat the +$9,000 change from the 2009 ending inventory indicates that the2007 layer was not further eroded. Thus, ending inventory for 2009 wouldvalue the first $80,000 worth of inventory at the base-year price index(1.00), the next $10,000 (the remainder of the 2007 layer) at the 2007 priceindex (1.05), and the last $9,000 at the 2009 price index (1.30).

These instructions should help you implement dollar-value LIFO in yourinventory valuation.



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CHAPTER 9Inventories: Additional Valuation Issues

BRIEF EXERCISE 9-1

(a) Ceiling $193.00 ($212 – $19)Floor $161.00 ($212 – $19 – $32)

(b) $106.00

(c) $51.00

BRIEF EXERCISE 9-2

Item CostDesignated

Market LCM

Jokers $2,000 $2,050 $2,000Penguins 5,000 4,950 4,950Riddlers 4,400 4,550 4,400Scarecrows 3,200 3,070 3,070

BRIEF EXERCISE 9-3

(a) Direct methodCost of Goods Sold.........................................................21,000

Inventory................................................................. 21,000

(b) Indirect methodLoss Due to Market Decline of Inventory ......................21,000

Allowance to Reduce Inventory to Market ........... 21,000



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BRIEF EXERCISE 9-4

GroupNumberof CDs

SalesPrice

per CD

TotalSalesPrice

RelativeSalesPrice

TotalCost

CostAllocated

to CDsCost

per CD1 100 $ 5 $ 500 5/100* X $8,000 = $ 400 $ 4**2 800 $10 8,000 80/100 X $8,000 = 6,400 $ 83 100 $15 1,500 15/100 X $8,000 = 1,200 $12

$10,000 $8,000

*$500/$10,000 = 5/100 **$400/100 = $4

BRIEF EXERCISE 9-5

Unrealized Holding Loss—Income (PurchaseCommitments) .............................................................. 50,000

Estimated Liability on PurchaseCommitments ...................................................... 50,000

BRIEF EXERCISE 9-6

Purchases (Inventory) ..................................................... 950,000Estimated Liability on Purchase Commitments ............ 50,000

Cash ........................................................................ 1,000,000

BRIEF EXERCISE 9-7

Beginning inventory................................................... $150,000Purchases ................................................................... 500,000Cost of goods available ............................................. 650,000Sales............................................................................ $700,000Less gross profit (35% X 700,000)............................. 245,000Estimated cost of goods sold.................................... 455,000Estimated ending inventory destroyed in fire .......... $195,000



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BRIEF EXERCISE 9-8

Cost Retail

Beginning inventory............................................. $ 12,000 $ 20,000Net purchases ...................................................... 120,000 170,000Net markups ......................................................... 10,000Totals .................................................................... $132,000 200,000Deduct:Net markdowns .................................................... 7,000Sales...................................................................... 147,000Ending inventory at retail .................................... $ 46,000

Cost-to-retail ratio: $132,000 ÷ $200,000 = 66%

Ending inventory at lower-of cost-or-market (66% X $46,000) = $30,360

BRIEF EXERCISE 9-9

Inventory turnover:

$264,152 = 8.05 times$33,685 + $31,910

2

Average days to sell inventory:

365 ÷ 8.05 = 45.3 days


Per Unit Lower-of-

Part No. Quantity Cost MarketTotalCost

TotalMarket

Cost-or-Market

110 600 $ 95 $100.00 $ 57,000 $ 60,000 $ 57,000111 1,000 60 52.00 60,000 52,000 52,000



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112 500 80 76.00 40,000 38,000 38,000113 200 170 180.00 34,000 36,000 34,000120 400 205 208.00 82,000 83,200 82,000121 1,600 16 0.50 25,600 800 800122 300 240 235.00 72,000 70,500 70,500

Totals $370,600 $340,500 $334,300

(a) $334,300.

(b) $340,500.


Per Unit Lower-of-

Part No. Quantity Cost MarketTotalCost

TotalMarket

Cost-or-Market

110 600 $ 95 $100.00 $ 57,000 $ 60,000 $ 57,000111 1,000 60 52.00 60,000 52,000 52,000112 500 80 76.00 40,000 38,000 38,000113 200 170 180.00 34,000 36,000 34,000120 400 205 208.00 82,000 83,200 82,000121 1,600 16 0.50 25,600 800 800122 300 240 235.00 72,000 70,500 70,500

Totals $370,600 $340,500 $334,300

(a) $334,300.

(b) $340,500.


(a) February March AprilSales $29,000 $35,000 $40,000Cost of goods sold

Inventory, beginning 15,000 15,100 17,000Purchases 17,000 24,000 26,500Cost of goods available 32,000 39,100 43,500Inventory, ending 15,100 17,000 14,000



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Cost of goods sold 16,900 22,100 29,500Gross profit 12,100 12,900 10,500Gain (loss) due to market

fluctuations of inventory* (2,000) 1,100 700$10,100 $14,000 $11,200

* Jan. 31 Feb. 28 Mar. 31 Apr. 30Inventory at cost $15,000 $15,100 $17,000 $14,000Inventory at the lower-of-cost-

or-market 14,500 12,600 15,600 13,300Allowance amount needed to

reduce inventory to market $ 500 $ 2,500 $ 1,400 $ 700Gain (loss) due to market

fluctuations of inventory** $ (2,000) $ 1,100 $ 700**$500 – $2,500 = $(2,000)

$2,500 – $1,400 = $1,100$1,400 – $700 = $700

(b) Jan. 31 Loss Due to Market Decline of Inventory .... 500Allowance to Reduce Inventory

to Market............................................ 500

Feb. 28 Loss Due to Market Decline of Inventory .... 2,000Allowance to Reduce Inventory

to Market............................................ 2,000

Mar. 31 Allowance to Reduce Inventory to Market..... 1,100Recovery of Loss Due to Market

Decline of Inventory.......................... 1,100

Apr. 30 Allowance to Reduce Inventory to Market..... 700Recovery of Loss Due to Market

Decline of Inventory.......................... 700



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EXERCISE 9-7 (15–20 minutes)C

ost P

er L

ot(C

ost A

lloca

ted/

No.

of L

ots)

$2,0

40

2,72

0

1,36

0

Cos

tA

lloca

ted

to L

ots

$18,

360

40,8

00

25,8

40

$85,

000

Tota

lC

ost

$85,

000

85,0

00

85,0

00

X X X

Rel

ativ

e Sa

les

Pric

e

$27,

000/

$125

,000

$60,

000/

$125

,000

$38,

000/

$125

,000

$78,

000

53,0

40

24,9

60

18,2

00

$6,

760

Gro

ssPr

ofit

$ 3

,840

10,2

40

10,8

80

$24,

960

Tota

lSa

les

Pric

e

$ 2

7,00

0

60,0

00

38,0

00

$125

,000

Sale

s (s

ee s

ched

ule)

Cos

t of g

oods

sol

d (s

ee s

ched

ule)

Gro

ss p

rofit

Ope

ratin

g ex

pens

es

Net

inco

me

Sale

s$1

2,00

0

32,0

00

34,0

00

$78,

000

Sale

sPr

ice

Per L

ot

$3,0

00

4,00

0

2,00

0

Cos

t

C

ost o

fPe

r

Lot

sLo

t

Sol

d$2

,040

$ 8

,160

2,72

0

2

1,76

0

1,36

023

,120

$53,

040

No.

of

Lots 9 15 19

Num

ber

of L

ots

Sold

*4 8 17 29

* 9

–5

= 4

15–

7 =

8

19–

2 =

17

Gro

up 1

Gro

up 2

Gro

up 3

Gro

up 1

Gro

up 2

Gro

up 3

Tota

l



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Cos

t per

Cha

ir

$54 48 30

Cos

tA

lloca

ted

to C

hairs

$21,

600

14,4

00

24,0

00

$60,

000

Tota

lC

ost

$60,

000

60,0

00

60,0

00

Gro

ssPr

ofit

$ 7

,200

3,20

0

2,40

0

$12,

800

X X X

Rel

ativ

e Sa

les

Pric

e

$36,

000/

$100

,000

$24,

000/

$100

,000

$40,

000/

$100

,000

Sale

s$1

8,00

0

8,00

0

6,00

0

$32,

000

Tota

lSa

les

Pric

e

$36,

000

24,0

00

40,0

00

$100

,000

Cos

t of

Cha

irsSo

ld$1

0,80

0

4,80

0

3,60

0

$19,

200

Sale

sPr

ice

per

Cha

in

$90 80 50

Cos

tpe

rC

hair

$54 48 30

Inve

ntor

y of

str

aigh

t cha

irs

(800

–12

0) X

$30

= $

20,4

00

No.

ofC

hairs

400

300

800

Num

ber

of C

hairs

Sold

200

100

120

Cha

irs

Loun

ge c

hairs

Arm

chai

rs

Stra

ight

cha

irs

Cha

irs

Loun

ge c

hairs

Arm

chai

rs

Stra

ight

cha

irs



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Unrealized Holding Gain or Loss—Income(Purchase Commitments).................................. 25,000

Estimated Liability on PurchaseCommitments ............................................ 25,000


(a) If the commitment is material in amount, there should be a footnote inthe balance sheet stating the nature and extent of the commitment.The footnote may also disclose the market price of the materials. Theexcess of market price over contracted price is a gain contingencywhich per FASB Statement No. 5 cannot be recognized in the accountsuntil it is realized.

(b) The drop in the market price of the commitment should be charged tooperations in the current year if it is material in amount. The followingentry would be made:

Unrealized Holding Gain or Loss—Income(Purchase Commitments) ............................................12,000

Estimated Liability on PurchaseCommitments ...................................................... 12,000

The entry is made because a loss in utility has occurred during theperiod in which the market decline took place. The account credited inthe above entry should be included among the current liabilities onthe balance sheet, with an appropriate footnote indicating the natureand extent of the commitment. This liability indicates the minimumobligation on the commitment contract at the present time—theamount that would have to be forfeited in case of breach of contract.

(c) Assuming the $12,000 market decline entry was made on December31, 2011, as indicated in (b), the entry when the materials are receivedin January 2012 would be:

Raw Materials ..................................................................108,000Estimated Liability on Purchase Commitments............12,000

Accounts Payable .................................................. 120,000



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This entry debits the raw materials at the actual cost, eliminates the$12,000 liability set up at December 31, 2011, and records the contrac-tual liability for the purchase. This permits operations to be chargedthis year with the $108,000, the other $12,000 of the cost having beencharged to operations in 2011.

PROBLEM 9-1

Item CostReplacement

Cost Ceiling* Floor**Designated

Market

Lower-of-Cost-or-Market

A $470 $ 460 $ 450 $350 $ 450 $450B 450 430 480 372 430 430C 830 610 820 640 640 640D 960 1,000 1,070 830 1,000 960

*Ceiling = 2011 catalog selling price less sales commissions and estimatedother costs of disposal. (2011 catalogue prices are in effect as of 12/01/10.)

**Floor = Ceiling less (20% X 2011 catalog selling price).

PROBLEM 9-3

(a) 12/31/10 (Direct Method)Cost of Goods Sold.........................................................68,000

Inventory................................................................. 68,000

12/31/11Cost of Goods Sold.........................................................75,000

Inventory................................................................. 75,000



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(b) 12/31/10 (Allowance Method)To write down inventory to market:Loss Due to Market Decline of Inventory ......................68,000

Allowance to Reduce Inventory to Market............ 68,000

12/31/11To write down inventory to market:Loss Due to Market Decline of Inventory ...................... 7,000

Allowance to Reduce Inventory to Market[($905,000 – $830,000) – $68,000] ....................... 7,000



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PROBLEM 9-4

Beginning inventory..................................................... $ 80,000Purchases..................................................................... 290,000

370,000Purchase returns.......................................................... (28,000)Total goods available................................................... 342,000Sales.............................................................................. $415,000Sales returns ................................................................ (21,000)

394,000Less: Gross profit (35% of $394,000) ......................... 137,900 (256,100)Ending inventory (unadjusted for damage)................ 85,900Less: Goods on hand—undamaged

($30,000 X [1 – 35%])......................................... 19,500Inventory damaged ...................................................... 66,400Less: Salvage value of damaged inventory............... 8,150Fire loss on inventory .................................................. $ 58,250



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CHAPTER 17Investments

BRIEF EXERCISE 17-5

(a) Available-for-Sale Securities ................................. 13,200Cash ................................................................. 13,200

(b) Cash......................................................................... 1,300Dividend Revenue (400 X $3.25)..................... 1,300

(c) Securities Fair Value Adjustment (AFS)................ 600Unrealized Holding Gain or Loss—Equity

[(400 X $34.50) – $13,200]............................ 600

BRIEF EXERCISE 17-6

(a) Trading Securities .................................................. 13,200Cash ................................................................. 13,200

(b) Cash......................................................................... 1,300Dividend Revenue (400 X $3.25)..................... 1,300

(c) Securities Fair Value Adjustment (Trading).......... 600Unrealized Holding Gain or Loss—

Income [(400 X $34.50) – $13,200] .............. 600


(a) Securities Fair Value Adjustment(Trading) ............................................................... 3,000

Unrealized Holding Gain or Loss—Income .......................................................... 3,000

(b) Securities Fair Value Adjustment(Available-for-Sale) .............................................. 3,000

Unrealized Holding Gain or Loss—Equity............................................................ 3,000

(c) The Unrealized Holding Gain or Loss—Income account is reported inthe income statement under Other Revenues and Gains. The UnrealizedHolding Gain or Loss—Equity account is reported as a part of other



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comprehensive income and as a component of stockholders’ equityuntil realized. The Securities Fair Value Adjustment account is added tothe cost of the Available-for-Sale or Trading Securities account to arriveat fair value.


(a) December 31, 2010Unrealized Holding Gain or Loss—Income............ 1,400

Securities Fair Value Adjustment (Trading) ... 1,400

(b) During 2011Cash.......................................................................... 9,500Loss on Sale of Securities ...................................... 500

Trading Securities ............................................ 10,000

(c) December 31, 2011

Securities Cost Fair ValueUnrealizedGain (Loss)

Stargate Corp. stock $20,000 $19,300 ($ (700)Vectorman Co. stock 20,000 20,500 ( 500)Total of portfolio $40,000 $39,800 ( (200)Previous securities fair value

adjustment balance—Cr.(

(1,400)Securities fair value

adjustment—Dr. ($1,200)

Securities Fair Value Adjustment (Trading)............... 1,200Unrealized Holding Gain or Loss—

Income.............................................................. 1,200



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CHAPTER 18Revenue Recognition

BRIEF EXERCISE 18-1

(a) Sales Returns and Allowances ........................ 78,000Accounts Receivable ................................ 78,000

(b) Sales Returns and Allowances ........................ 27,000Allowance for Estimated Sales

Returns and Allowances........................ 27,000[(15% X $700,000) – $78,000]

BRIEF EXERCISE 18-2

Construction in Process .......................................... 1,700,000Materials, Cash, Payables, etc. ........................ 1,700,000

Accounts Receivable ............................................... 1,200,000Billings on Construction in Process ............... 1,200,000

Cash .......................................................................... 960,000Accounts Receivable........................................ 960,000

Construction in Process.......................................... 680,000[($1,700,000 ÷ 5,000,000) X $2,000,000]

Construction Expenses ........................................... 1,700,000Revenue from Long-Term Contracts............... 2,380,000

($7,000,000,000 X 34%)

BRIEF EXERCISE 18-3

Current AssetsAccounts Receivable........................................ $ 240,000Inventories

Construction in process ........................... $2,450,000Less: Billings............................................ 1,400,000

Costs and recognized profit inexcess of billings ............................ 1,050,000



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BRIEF EXERCISE 18-4

Construction in Process .............................................. 1,700,000Materials, Cash, Payables, etc. ............................ 1,700,000

Accounts Receivable ................................................... 1,200,000Billings on Construction in Process ................... 1,200,000

Cash .............................................................................. 960,000Accounts Receivable............................................ 960,000

BRIEF EXERCISE 18-5

Current AssetsAccounts Receivable........................................... $240,000Inventories

Construction in process .............................. $1,715,000Less: Billings............................................... 1,000,000Costs and recognized profit in excess

of billings..................................................... 715,000

BRIEF EXERCISE 18-7

Installment Accounts Receivable, 2010 ..................... 150,000Installment Sales.................................................. 150,000

Cash ............................................................................. 54,000Installment Accounts Receivable, 2010 ............. 54,000

Cost of Installment Sales.............................................. 102,000Inventory ................................................................ 102,000



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BRIEF EXERCISE 18-7 (Continued)

Installment Sales.............................................................. 150,000Cost of Installment Sales ......................................... 102,000Deferred Gross Profit, 2010 ..................................... 48,000

Deferred Gross Profit, 2010 ............................................. 17,280Realized Gross Profit on Installment Sales

(32% X $54,000).................................................... 17,280

BRIEF EXERCISE 18-8

Repossessed Merchandise .............................................. 275Loss on Repossession ..................................................... 37*Deferred Gross Profit ($520 X 40%) ................................. 208

Installment Accounts Receivable ............................. 520

*[$275 – ($520 – $208)]

BRIEF EXERCISE 18-9

Current AssetsInstallment accounts receivable due in 2011........... $ 65,000Installment accounts receivable due in 2012........... 110,000

$175,000Current Liabilities

Deferred gross profit ($23,400 + $41,800) ................ $ 65,200

BRIEF EXERCISE 18-10

2010 $02011 $2,000 ($15,000 – $13,000)2012 $5,000



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Cash .................................................................................. 25,000Notes Receivable.............................................................. 50,000

Discount on Notes Receivable................................. 8,598Unearned Franchise Fees ($25,000 + $41,402) ....... 66,402


Cash .................................................................................. 18,850*Advertising Expense ........................................................ 500Commission Expense ...................................................... 2,150

Revenue from Consignment Sales .......................... 21,500

*[$21,500 – $500 – ($21,500 X 10%)]

Cost of Goods Sold .......................................................... 13,200Inventory on Consignment....................................... 13,200

[60% X ($20,000 + $2,000)]


(a) Gross profit recognized in:

2010 2011 2012Contract price $1,600,000 $1,600,000 $1,600,000Costs:

Costs to date $400,000 $825,000 $1,070,000Estimatedcosts tocomplete 600,000 1,000,000 275,000 1,100,000 0 1,070,000

Total estimatedprofit 600,000 500,000 530,000Percentagecompleted todate

40%* 75%** 100%

Total gross profitrecognized 240,000 375,000 530,000Less: Grossprofit recognizedin previous years 0 240,000 375,000Gross profitrecognized incurrent year $ 240,000 $ 135,000 $ 155,000



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**$400,000 ÷ $1,000,000**$825,000 ÷ $1,100,000

(b) Construction in Process ($825,000 – $400,000).... 425,000Materials, Cash, Payables, etc. .............................. 425,000Accounts Receivable ($900,000 – $300,000)......... 600,000

Billings on Construction in Process.............. 600,000

Cash ($810,000 – $270,000).................................... 540,000Accounts Receivable ...................................... 540,000

Construction Expenses.......................................... 425,000Construction in Process ........................................ 135,000

Revenue from Long-Term Contracts ............. 560,000*

*$1,600,000 X (75% – 40%)

(c) Gross profit recognized in:2010 2011 2012

Gross profit $–0– $–0– $530,000*

*$1,600,000 – $1,070,000


(a) Contract billings to date......................................... $61,500Less: Accounts receivable 12/31/10..................... 18,000Portion of contract billings collected .................... $43,500

(b) $19,500 = 30%$65,000

(The ratio of gross profit to revenue recognized in 2010.)

$1,000,000 X .30 = $300,000

(The initial estimated total gross profit before tax on the contract.)



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DOUGHERTY INC.Computation of Gross Profit to be

Recognized on Uncompleted ContractYear Ended December 31, 2010

Total contract priceEstimated contract cost at completion

($800,000 + $1,200,000)................................................ $2,000,000Fixed fee ............................................................................ 450,000

Total ........................................................................... 2,450,000

Total estimated cost ......................................................... 2,000,000Gross profit ....................................................................... 450,000Percentage of completion ($800,000 ÷ $2,000,000) ........ 40%Gross profit to be recognized ($450,000 X 40%)............. $ 180,000


(a) Realized gross profit recognized in 2011 under the installment-salesmethod of accounting is $83,000. When gross profit is expressed as apercentage of cost, it must be converted to percentage of sales to computethe realized gross profit under the installment-sales method of accounting.Thus, 2010 and 2011 gross profits as a percentage of sales are 20%and 21.875% respectively.



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Sale Year Gross Profit Percentage2011

Collections2011

Realized Profit2010 .25/(1.00 + .25) = 20% $240,000 $48,0002011 .28/(1.00 + .28) = 21.875% 160,000 35,000

TOTAL $83,000

(Note to instructor: The problem provides gross profit as a percent of cost.)

(b) The balance of “Deferred Gross Profit” could be reported on the balancesheet for 2011:

1. As a current liability on the theory that it is related to InstallmentAccounts Receivables that are normally treated as current assets;

2. As a deferred credit between liabilities and stockholders’ equity. Thistreatment is criticized because there is no obligation to outsiders; or

3. As an adjustment or offset to the related Installment AccountsReceivable. This is because the deferred gross profit is a part of reve-nue from installment sales not yet realized. The related receivablewill be overstated unless the deferred gross profit is deducted.On the other hand, the amount of deferred gross profit has nodirect relationship with the estimated collectibility of the accountsreceivable.

It is not a settled matter as to the proper classification of “deferredgross profit” on the balance sheet when the installment-sales methodof accounting is used to measure income. As indicated in the text, theFASB in Statement of Financial Accounting Concepts No. 6 indicatesthat it conceptually is an asset valuation. We support the FASB position.

(c) Gross profit as a percent of sales in 2010 is 20% (as computed in (a)above); gross profit therefore is $96,000 ($480,000 X .20) and the costof 2010 sales is $384,000 ($480,000 – $96,000). Because the amountscollected in 2010 ($130,000) and 2011 ($240,000) do not exceed thetotal cost of $384,000, no profit is recognized in 2010 or 2011 on 2010sales. Also, no profit is recognized on 2011 sales since the collections of$160,000 do not exceed the total cost of $484,375 [$620,000 X (1 – .21875)].



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(a) Computation of gross profit realized—cost-recovery method:

YearCash

Received

OriginalCost

Recovered

Balance ofUnrecovered

Cost

GrossProfit

RealizedBeginning balance — — $150,000 —

2010 $120,000 $120,000 30,000 $02011 90,000 30,000 0 60,0002012 40,000 0 0 40,000

(b) Computation of gross profit realized—installment-sales method:

Gross profit rate: ($250,000 – $150,000) ÷ $250,000 = 40%

2010 Gross profit realized: $120,000 X 40% = $48,0002011 Gross profit realized: $ 90,000 X 40% = $36,0002012 Gross profit realized: $ 40,000 X 40% = $16,000


(a) Cash............................................................................ 28,000Notes Receivable ....................................................... 42,000

Discount on Notes Receivable[$42,000 – (2.48685 X $14,000)]...................... 7,184

Revenue from Franchise Fees........................... 62,816

(b) Cash............................................................................ 28,000Unearned Franchise Fees.................................. 28,000

(c) Cash............................................................................ 28,000Notes Receivable ....................................................... 42,000

Discount on Notes Receivable .......................... 7,184Revenue from Franchise Fees........................... 28,000Unearned Franchise Fees

($14,000 X 2.48685)......................................... 34,816

(Calculations rounded)



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(a) Down payment made on 1/1/10.............................................. $10,000.00Present value of an ordinary annuity ($8,000 X 3.69590) ..... 29,567.20Total revenue recorded by Campbell and total

acquisition cost recorded by Lesley Benjamin ................ $39,567.20

(b) Cash................................................................ 10,000.00Notes Receivable ........................................... 40,000.00

Discount on Notes Receivable .............. 10,432.80Unearned Franchise Fees...................... $39,567.20

(c) 1. $10,000 cash received from down payment. ($29,567.20 is recordedas unearned revenue from franchise fees.)

2. $10,000 cash received from down payment.3. None. ($10,000 is recorded as unearned revenue from franchise

fees.)


(a) Inventoriable costs:80 units shipped at cost of $500 each ....................... $40,000Freight.......................................................................... 840

Total inventoriable cost ...................................... $40,840

40 units on hand (40/80 X $40,840) ............................ $20,420

(b) Computation of consignment profit:Consignment sales (40 X $750).................................. $30,000Cost of units sold (40/80 X $40,840) .......................... (20,420)Commission charged by consignee

(6% X $30,000) ......................................................... (1,800)Advertising cost .......................................................... (200)Installation costs......................................................... (320)

Profit on consignment sales............................... $ 7,260

(c) Remittance of consignee:Consignment sales.................................................. $30,000Less: Commissions................................................ $1,800

Advertising ................................................... 200Installation .................................................... 320 2,320

Remittance from consignee ..................... $27,680



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SOLUTIONS TO PROBLEMS

PROBLEM 18-1

(a) 1. The point of sale method recognizes revenue when the earningsprocess is complete and an exchange transaction has taken place.This can be the date goods are delivered, when title passes, whenservices are rendered and billable, or as time passes (e.g., rent orroyalty income). This method most closely follows the accrualaccounting method and is in accordance with generally acceptedaccounting principles (GAAP).

2. The completion-of-production method recognizes revenue only whenthe project is complete and the contract is completed. This is usedprimarily with short-term contracts, or with long-term contracts whenthere is considerable difficulty in estimating the costs remaining tocomplete a project. The advantage of this method is that income isrecognized on final results, not estimates. The disadvantage is thatwhen the contract extends over more than one accounting period,current performance on the project is not recognized and earningsare distorted. It is acceptable according to GAAP only in the extraor-dinary circumstances when forecasting the amount of work completedto date is not possible.

3. The percentage-of-completion method of revenue recognition isused on long-term projects, usually construction. To apply it, thefollowing conditions must exist:

(i) A firm contract price with a high probability of collection.

(ii) A reasonably accurate estimate of costs (and, therefore, ofgross profit).

(iii) A way to reasonably estimate the extent of progress tocompletion of the project.

Gross profit is recognized in proportion to the work completed. Theprogress toward contract completion is the revenue-generatingevent. Normally, progress is measured as the percentage of actualcosts to date to estimated total costs. This percentage is applied toestimated gross profit to indicate the total profit which should berecognized to that date. That total less the income that was recog-



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nized in previous periods is the amount recognized in the currentperiod. In the final period, the actual total profit is known and thedifference between this amount and profit previously recognizedis shown as profit of the period.This method is in accordance withgenerally accepted accounting principles for long-term projectswhen estimates are dependable.

4. The installment-sales method may be applicable when the salesprice is received over an extended period of time. The installment-sales method recognizes revenue as the cash is collected and is usedwhen the collection of the sales price is not reasonably assured.This method is commonly used for tax purposes, but it is not inaccordance with GAAP, except in certain situations, because itviolates accrual basis accounting. The installment-sales method canbe used in special circumstances when collectibility is very unsure.

(b) Depp ConstructionA change of cost estimates calls for a revision of revenue and profit to be

recognized in the period in which the change was made (in thiscase, the first period).Contract price ..................................... $30,000,000Costs: Actual costs to 11/30/10.... $ 7,200,000

Estimated costs to complete .................... 16,800,000Total cost ........................ 24,000,000

Estimated profit ......................................... $ 6,000,000Percentage of contract completed ($7,200,000 ÷ $24,000,000) 30%Revenue to be recognized in 2010 ($30,000,000 X 30%) $ 9,000,000

Dement Publishing DivisionSales—fiscal 2010 $7,000,000Less: Sales returns and allowances (20%) 1,400,000Net sales—revenue to be recognized in fiscal 2010 ..................... $5,600,000Although distributors can return up to 30 percent of sales, prior experience

indicates that 20 percent of sales is the expected average amountof returns. The collection of 2009 sales has no impact on fiscal2010 revenue. The 21 percent of returns on the initial $5,500,000 of2010 sales confirms that 20 percent of sales will provide areasonable estimate.

Ankiel Securities DivisionRevenue for fiscal 2010 = $5,200,000.



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The revenue is the amount of goods actually billed and shipped when revenueis recognized at point of sale (terms of F.O.B. factory). Orders forgoods do not constitute sales. Down payments are not sales. Theactual freight costs are expenses made by the seller that the buyerwill reimburse at the time s/he pays for the goods.

Commissions and warranty returns are also selling expenses. Both ofthese expenses will be accrued and will appear in theoperating expenses section of the income statement.



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PROBLEM 18-3

(a) Gross profit recognized in:

2010 2011 2012Contract price $3,000,000 $3,000,000 $3,000,000Costs:

Costs to date $ 600,000 $1,560,000 $2,100,000Estimated coststo complete 1,400,000 2,000,000 520,000 2,080,000 0 2,100,000

Total estimatedprofit 1,000,000 920,000 900,000Percentagecompleted to date 30%* 75%** 100%Total gross profitrecognized 300,000 690,000 900,000Less: Gross profitrecognized inprevious years 0 300,000 690,000Gross profitrecognized incurrent year $ 300,000 $ 390,000 $ 210,000

**$600,000 ÷ $2,000,000**$1,560,000 ÷ $2,080,000

(b) Construction in Process ($2,100,000 – $1,560,000) ... 540,000Materials, Cash, Payables, etc. ........................ 540,000

Accounts Receivable ($3,000,000 – $2,000,000) ..... 1,000,000Billings on Construction in Process................ 1,000,000

Cash ($2,850,000 – $1,950,000) ................................ 900,000Accounts Receivable ........................................ 900,000

Construction Expenses............................................ 540,000Construction in Process .......................................... 210,000

Revenue from Long-Term Contracts ............... 750,000*

*$3,000,000 X (100% – 75%)

Billings on Construction in Process ....................... 3,000,000Construction in Process................................... 3,000,000



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(c) CHANCE COMPANYBalance Sheet (Partial)

December 31, 2011

Current assets:Accounts receivable

($2,000,000 – $1,950,000) ........................... $ 50,000Inventories

Construction in process($1,560,000 + $690,000) ...................... $2,250,000

Less: Billings ......................................... 2,000,000Costs and recognized profit

in excess of billings..................... 250,000



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PROBLEM 18-4

(a) 2010 2011 2012Contract price $6,600,000 $6,600,000 $6,510,000Less estimated cost:

Costs to date 1,620,000 3,850,000 5,500,000Estimated cost to complete 3,780,000 1,650,000 —Estimated total cost 5,400,000 5,500,000 5,500,000

Estimated total gross profit $1,200,000 $1,100,000 $1,010,000

Gross profit recognized in—

2010: $1,620,000 X $1,200,000 = $360,000$5,400,000

2011: $3,850,000 X $1,100,000 = $770,000$5,500,000

Less 2010 recognized grossprofit 360,000

Gross profit in 2011 $410,000

2012: Less 2010–2011 recognizedgross profit 770,000

Gross profit in 2012 $240,000

(b) HEWITT CONSTRUCTION COMPANYBalance Sheet

December 31, 2011

Current assets:Accounts receivable

($3,300,000 – $2,800,000) ................ $ 500,000Inventories

Construction in process................ $4,620,000*Less: Billings ................................ 3,300,000

Costs and recognized profitin excess of billings............... 1,320,000

*$6,600,000 X ($3,850,000 ÷ $5,500,000)



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PROBLEM 18-8

(a)

Rate of gross profit ( Gross profitSales )

2010 2011 2012

38% 37% 35%

Gross profit realized:38% of $ 75,000 $28,50038% of $100,000 $38,00037% of $100,000 37,00038% of $ 50,000 $19,00037% of $120,000 44,40035% of $100,000 35,000

$28,500 $75,000 $98,400

(b) Installment Accounts Receivable—2012.................. 280,000Installment Sales ................................................ 280,000

Cash............................................................................ 270,000Installment Accounts Receivable—2010 .......... 50,000Installment Accounts Receivable—2011 .......... 120,000Installment Accounts Receivable—2012 .......... 100,000

Cost of Installment Sales .......................................... 182,000Inventory............................................................. 182,000

Installment Sales........................................................ 280,000Cost of Installment Sales................................... 182,000Deferred Gross Profit on Installment

Sales—2012 .................................................... 98,000

Deferred Gross Profit on Installment Sales—2010 .... 19,000Deferred Gross Profit on Installment Sales—2011 .... 44,400Deferred Gross Profit on Installment Sales—2012 .... 35,000

Realized Gross Profit on InstallmentSales................................................................ 98,400

Realized Gross Profit on Installment Sales ............. 98,400Income Summary ............................................... 98,400



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CHAPTER 22Accounting Changes and Error Analysis

BRIEF EXERCISE 22-4

This is a change in estimate effected by a change in accounting principle.

Cost of depreciable assets ......................................... $250,000Accumulated depreciation.......................................... (90,000)Carrying value at January 1, 2010.............................. 160,000Salvage value .............................................................. (40,000)Depreciable base......................................................... $120,000

Depreciation in 2010 = $120,000 ÷ 8 = $15,000.

Depreciation Expense................................................. 15,000Accumulated Depreciation.................................. 15,000

BRIEF EXERCISE 22-5

Depreciation Expense....................................................... 24,000Accumulated Depreciation........................................ 24,000

$58,000* – $10,0004 – 2

= $24,000

*Book value before changeCost .................................................... $74,000Accumulated depreciation ................ 16,000**

$58,000**[($74,000 – $18,000) ÷ 7] X 2



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BRIEF EXERCISE 22-7

BEIDLER COMPANYRetained Earnings Statement


Retained earnings, January 1, as previously reported....... $2,000,000Less: Correction of depreciation error, net of tax ......... 240,000*Retained earnings, January 1, as adjusted ..................... 1,760,000Add: Net income ............................................................. 900,000Less: Dividends................................................................ 250,000Retained earnings, December 31 ..................................... $2,410,000

*$400,000 X (1 – .4)

BRIEF EXERCISE 22-8

2010 2011a. Overstated Overstatedb. Overstated Understatedc. Understated Overstatedd. Overstated Understatede. No effect Overstated

BRIEF EXERCISE 22-9

1. The change to a three-year remaining life for the purpose of computingdepreciation on production equipment is a change in estimate due to achange in conditions.

2. This is an expense classification change arising from a change in theuse of the building for a different purpose. Thus, it is not a change inprinciple, a change in estimate, or an error.

3. The change to expensing preproduction costs (writing the costs off inone year as opposed to several years) is a change in estimate due to achange in conditions.



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BRIEF EXERCISE 22-10

1. Both FIFO and LIFO are generally accepted accounting principles;thus, this item is a change in accounting principle.

2. This oversight is a mistake that should be corrected. Such a correctionis considered a change due to error.

3. Both the completed-contract method and the percentage-of-completionmethod are generally accepted accounting principles; thus, such a changeis a change in accounting principle.



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ACTG 381Introductory Quiz

Winter 2011

Purpose of Quiz: This take home quiz has been designed to help you assess your level of accountingknowledge relative to our expectations of a student entering ACTG381. This quiz focuses onrecording basic accounting transactions and creating a set of financial statements. The accountingissues included in this quiz are assumed to have been covered in your prerequisite financial accountingcourse. If you need a reference, you could refer to the textbook from your pre-requisite accountingcourse or the text for this class. Students who are unable to successfully complete this quiz should at aminimum take ACTG199 concurrent with ACTG381.

Due Date: Wednesday January 5, 2011 at the beginning of class.

Possible Points: 20 points

Background: The Wyndam Wholesale Company began operations on August 1, 2010. The followingtransactions took place during the month of August:

a) On August 1, the owners invested $50,000 cash in the corporation in exchange for 5000 shares ofcommon stock ($10 par value).

b) On August 1, equipment is purchased for $20,000 cash. Depreciation is calculated to be $500 permonth.

c) On August 1, $6000 rent on the building is paid for the months of August and September.d) Merchandise inventory costing $38,000 is purchased on account. The company uses the perpetual

inventory system.e) On August 1, $30,000 is borrowed from a local bank, and a note payable is signed. Principal plus

interest at 10% is due on July 31, 2011.f) Credit sales for the month are $40,000. The cost of merchandise sold is $22,000.g) $15,000 is collected on account from customers.h) $20,000 is paid on account to suppliers for merchandise.i) Salaries of $7,000 are paid to employees for August. Note: Payroll taxes should be ignored.j) A bill for $2000 is received from the local utility company for the month of August.k) On August 15, $20,000 cash was loaned to another company. A note receivable was signed.

Principal plus interest at 12% per annum is to be repaid in 4 months.l) The corporation paid its shareholders a cash dividend of $1000.m) At the end of the month, the company anticipates that $2500 of the month end receivable balance

will not be collected.

Note: Income and Payroll taxes should be ignored.



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Required:(1) Using the Excel spreadsheet of T-accounts on the course web site, record the above August

transactions involving external parties AND the necessary month end adjusting journal entries inthe appropriate T-accounts. Please also place the letter of each transaction next to each journalentry (see transaction ‘a’ in the Excel T-Account sheet for an example). TIP: Set up yourspreadsheet to have debit and credit control totals so that you can check after each entry to see ifyou are in balance.

(2) In Excel, prepare a balance sheet as of 8/31/10 and a SINGLE STEP income statement for themonth ended 8/31/10. You do NOT need to prepare a Statement of Shareholders’ Equity.

(3) A hard copy of the T-accounts and financial statements should be turned in. You should also bringan additional copy of your assignment to class as we will be going over the correct answers onWednesday.



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Wyndam Wholesale Company

(a) 50,000

50,000

Equipment Accumulated Depreciation Interest Receivable

Accounts Payable Interest Payable Notes Payable

Cash Accounts Receivable Prepaid Rent

Allow for Doubtful Accts Inventory Notes Receivable

`

50,000 (a)

50,000

Utilities Expense Rent Expense Bad Debt Expense

Depreciation Expense Supplies Expense Interest Expense

Common Stock Retained Earnings Sales Revenue

Interest Revenue Cost of Goods Sold Salaries Expense

Accounts Payable Interest Payable Notes Payable



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Interest Receivable

Notes Payable

Prepaid Rent

Notes Receivable

Bad Debt Expense

Interest Expense

Sales Revenue

Salaries Expense

Notes Payable



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ACTG381Sample Midterm

Part 1: Multiple Choice (25 questions @ 3 pts ea. Suggested time 50 minutes)

Use a scantron to fill in the letter corresponding to the “best” answer.

1. Which of the following statements is NOT an objective of financial reporting?a. Provide information that is useful in investment and credit decisions.b. Provide information about enterprise resources, claims to those resources, and changes to them.c. Provide information on the liquidation value of an enterprise.d. Provide information that is useful in assessing cash flow prospects.

2. Accrual accounting is used becausea. cash flows are considered less important.b. it provides a better indication of ability to generate cash flows than the cash basis.c. it recognizes revenues when cash is received and expenses when cash is paid.d. it recognizes revenues when earned and expenses when cash is paid.

3. The body that has the power to prescribe the accounting practices and standards to be employed bypublicly traded companies is thea. FASB.b. AICPA.c. SEC.d. APB.

4. What would NOT be an advantage of having all countries adopt and follow the same accountingstandards?a. Consistency.b. Comparability.c. Lower financial statement preparation costs for multinational entities.d. Lower cost of raising debt or equity capital across national borders.

5. According to the conceptual framework, which of the following is a primary characteristic of usefulaccounting information?a. Comparability.b. Relevance.c. Consistency.d. Materiality.

6. In January 2010, ABC Inc. doubled the amount of its outstanding stock by selling on the market anadditional 10,000 shares to finance an expansion of the business. The president objected to showingthis information in a footnote to the December 31, 2009 financial statements because she claims thesale took place after December 31, 2009. Which, if any, of the following elements of GAAP is violatedby this action?a. GAAP was not violatedb. Materialityc. Conservatismd. Full disclosure

7. A decrease in net assets arising from peripheral or incidental transactions is called a(n)a. capital expenditure.b. cost.c. loss.d. expense.



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8. Why are certain costs of doing business capitalized when incurred and then depreciated or amortizedover subsequent accounting cycles?a. To reduce the federal income tax liabilityb. To aid management in cash-flow analysisc. To match the costs of with revenues as earnedd. To adhere to the accounting constraint of conservatism

9. Which of the following is an example of an accrued expense?a. Office supplies purchased at the beginning of the year and debited to an expense account.b. Property taxes incurred during the year, to be paid in the first quarter of the subsequent year.c. Depreciation expensed. Rent earned during the month, to be received on the 5th day of the following month.

10. An accrued expense can best be described as an amounta. paid and currently matched with earnings.b. paid and not currently matched with earnings.c. not paid and not currently matched with earnings.d. not paid and currently matched with earnings.

11. A deferred revenue can best be described as an amounta. collected and not yet earned.b. collected and earned.c. not collected and not yet earned.d. not collected and earned.

12. The failure to properly record an adjusting entry to accrue a revenue item will result in an:a. understatement of revenues and an understatement of liabilities.b. overstatement of revenues and an overstatement of liabilities.c. overstatement of revenues and an overstatement of assets.d. understatement of revenues and an understatement of assets.

13. In November and December 2010, Lane Co., a newly organized magazine publisher, received $90,000for 1,000 three-year subscriptions at $30 per year, starting with the January 2011 issue. Lane includedthe entire $90,000 in its 2010 income tax return. What amount should Lane report in its 2010 incomestatement for subscriptions revenue?a. $0.b. $5,000.c. $30,000.d. $90,000.

14. Which of the following is an example of managing earnings down?a. Revising the estimated life of equipment from 10 years to 8 years.b. Changing estimated bad debts from 3 percent to 2.5 percent of sales.c. Not writing off obsolete inventory.d. Reducing research and development expenditures.

15. Which of the following statements is correct?a. Changes in accounting principle are always handled in the current or prospective period.b. Prior statements should be restated for changes in accounting estimates.c. Both a correction of an error and a change in accounting principle require restatement of prior

period financial statements.d. Correction of an error related to a prior period should be considered as an adjustment to current

year net income.

16. Prophet Corporation has an extraordinary loss of $200,000, an unusual gain of $140,000, and a taxrate of 40%. At what amount should Prophet report each item?



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Extraordinary loss Unusual gaina. $(200,000) $140,000b. (200,000) 84,000c. (120,000) 140,000d. (120,000) 84,000

17. Under which of the following conditions would material flood damage be considered an extraordinaryitem for financial reporting purposes?a. Only if floods in the geographical area are unusual in nature and occur infrequently.b. Only if the flood damage is material in amount and could have been reduced by prudent

management.c. Under any circumstances as an extraordinary item.d. Flood damage should never be classified as an extraordinary item.

18. Palomo Corp has a tax rate of 30 percent and income before non-operating items of $357,000. It alsohas the following items (gross amounts).

Unusual gain $ 23,000Loss from discontinued operations 183,000Dividend revenue 6,000Extraordinary gain 74,000

What is the amount of income tax expense Palomo would report on its income statement on the lineitem titled “income tax expense”?a. $ 60,900b. $ 83,100c. $108,900d. $115,800

19. Garwood Company has disposed of its Sports Division at a total before tax loss of $370,000. TheSports Division is a distinct operating component of Garwood’s business. If Garwood’s tax rate is 30%,what is the Net of Tax loss from Discontinued Operations on the income statement?a. $111,000b. $259,000c. $370,000d. $0 as this does not qualify as a discontinued item

20. Which of the following is incorrect under U.S. GAAP?a. Cash is valued at fair market valueb. Marketable securities are valued at fair market value.c. Accounts receivable is valued at net realizable value.d. Inventory is valued at current cost

21. Instrument Corp. has the following investments which were held throughout 2010:Cost at 1/1/10 Market Value at 12/31/10

Trading $300,000 $400,000Available-for-sale 300,000 $280,000

What amount of unrealized holding gain (loss) would get recorded directly in equity (i.e., would not berecorded as part of net income) for the year ended December 31, 2010?a. $0b. $100,000 gain.c. $ 20,000 lossd. $ 80,000 gain.



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Use the following information for the next two problems. On 1/1/08, Nobel Corp. acquired machinery for$600,000. Nobel adopted straight-line depreciation for this machine and had been recording depreciationover an estimated life of ten years, with no residual value. At the beginning of 2011, a decision was madeto change the useful life of this machine to a total of 19 years.

22. Assuming a 30% tax rate, the cumulative effect of this accounting change on beginning retainedearnings, isa. $ 0b. $67,200.c. $78,960.d. $112,800.

23. The amount that Nobel should record as depreciation expense for 2011 isa. $26,250.b. $32,500.c. $52,000.d. $60,000.

24. Olmsted has the following items: common stock, $720,000; treasury stock, $85,000; deferred taxes,$100,000 and retained earnings, $363,000. What is the total amount reported in stockholders’ equity?a. $898,000.b. $998,000.c. $1,098,000.d. $1,198,000.

25. Lohmeyer Corporation reports:Cash provided by operating activities $250,000Cash used by investing activities 110,000Cash provided by financing activities 190,000Beginning cash balance 70,000

What is Lohmeyer’s ending cash balance?a. $330,000.b. $350,000.c. $400,000.d. $550,000.



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26. The chief accountant for Julius Co. provides you with the company's most recent income statement andcomparative balance sheets below. The accountant has asked for your help in preparing part of thecompany's 2009 statement of cash flows. (12 possible points, suggested time 15 minutes)

Required: Determine the amount of cash inflow or outflow for each of the following items reported on thestatement of cash flows using the DIRECT method. Do NOT prepare a complete operating section, justreport the correct amount for each of the following:

a) Cash collected from customers

b) Cash paid for selling and administrative expenses

c) Cash paid for income taxes

d) What is reported for net income on the direct method statement of cash flows? (circle correctanswer)

$5000 $700 Is not reported

2009 Income Statement ($ in thousands)

Sales revenue $5000Depreciation expense 280Selling & administrative expense 3720Income before taxes 1000Income tax expense 300Net income $700

Balance Sheet ($ in thousands) 12/31/2009 12/31/2008Cash $ 800 $ 750Accounts Receivable 450 365Plant and equipment 1900 1450

Less: Accumulated depreciation (800) (520)

Total Assets $2350 $2045

Payables for selling & admin expenses $ 300 325Income taxes payable 180 130Common stock 700 700Retained earnings 1170 890

Total liabilities & Stockholders' Equity $2350 $2045



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27. Presented below is the comparative balance sheets for Santana Industries. (13 possible points,suggested time 35 minutes)

Santana IndustriesBalance Sheet Information

Assets 12/31/2009 12/31/2008 ChangeCash $ 7,350 $ 2,200 5,150Accounts Receivable 2,500 2,200 300Inventory 4,000 3,000 1,000Prepaid rent 150 300 (150)Plant and equipment 14,500 12,000 2,500

Less: Accumulated depreciation (5,100) (4,500) (600)

Total Assets $ 23,400 $ 15,200

Liabilities and Stockholders' EquityAccounts payable $ 1,400 $ 1,100 300Interest payable 100 - 100Unearned service revenue 800 600 200Income taxes payable 550 800 (250)Long term note payable 5,000 - 5,000Common stock 10,000 10,000 -Retained earnings 5,550 2,700 2,850

Total liabilities & Stockholders' Equity $ 23,400 $ 15,200

Additional information for the 2009 year:1. Net income was $38502. Equipment costing $4000 was purchased with cash3. Equipment with a book value of $500 and cost of $1500 was sold for $500.4. Dividends of $1000 were declared and paid.

Required: Prepare a statement of cash flows on the following page using the indirect method.



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Stanana IndustriesStatement of Cash Flows

For the year ended 12/31/10



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ACTG381Sample Midterm - SOLUTION

Part 1: Multiple Choice (25 questions @ 3 pts ea. Suggested time 50 minutes)

Use a scantron to fill in the letter corresponding to the “best” answer.

1. Which of the following statements is NOT an objective of financial reporting?a. Provide information that is useful in investment and credit decisions.b. Provide information about enterprise resources, claims to those resources, and changes to them.c. Provide information on the liquidation value of an enterprise.d. Provide information that is useful in assessing cash flow prospects.

2. Accrual accounting is used becausea. cash flows are considered less important.b. it provides a better indication of ability to generate cash flows than the cash basis.c. it recognizes revenues when cash is received and expenses when cash is paid.d. it recognizes revenues when earned and expenses when cash is paid.

3. The body that has the power to prescribe the accounting practices and standards to be employed bypublicly traded companies is thea. FASB.b. AICPA.c. SEC.d. APB.

4. What would NOT be an advantage of having all countries adopt and follow the same accountingstandards?a. Consistency.b. Comparability.c. Lower financial statement preparation costs for multinational entities.d. Lower cost of raising debt or equity capital across national borders.

5. According to the conceptual framework, which of the following is a primary characteristic of usefulaccounting information?a. Comparability.b. Relevance.c. Consistency.d. Materiality.

6. In January 2010, ABC Inc. doubled the amount of its outstanding stock by selling on the market anadditional 10,000 shares to finance an expansion of the business. The president objected to showingthis information in a footnote to the December 31, 2009 financial statements because she claims thesale took place after December 31, 2009. Which, if any, of the following elements of GAAP is violatedby this action?a. GAAP was not violatedb. Materialityc. Conservatismd. Full disclosure

7. A decrease in net assets arising from peripheral or incidental transactions is called a(n)a. capital expenditure.b. cost.c. loss.d. expense.



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8. Why are certain costs of doing business capitalized when incurred and then depreciated or amortizedover subsequent accounting cycles?a. To reduce the federal income tax liabilityb. To aid management in cash-flow analysisc. To match the costs of with revenues as earnedd. To adhere to the accounting constraint of conservatism

9. Which of the following is an example of an accrued expense?a. Office supplies purchased at the beginning of the year and debited to an expense account.b. Property taxes incurred during the year, to be paid in the first quarter of the subsequent

year.c. Depreciation expensed. Rent earned during the month, to be received on the 5th day of the following month.

10. An accrued expense can best be described as an amounta. paid and currently matched with earnings.b. paid and not currently matched with earnings.c. not paid and not currently matched with earnings.d. not paid and currently matched with earnings.

11. A deferred revenue can best be described as an amounta. collected and not yet earned.b. collected and earned.c. not collected and not yet earned.d. not collected and earned.

12. The failure to properly record an adjusting entry to accrue a revenue item will result in an:a. understatement of revenues and an understatement of liabilities.b. overstatement of revenues and an overstatement of liabilities.c. overstatement of revenues and an overstatement of assets.d. understatement of revenues and an understatement of assets.

13. In November and December 2010, Lane Co., a newly organized magazine publisher, received $90,000for 1,000 three-year subscriptions at $30 per year, starting with the January 2011 issue. Lane includedthe entire $90,000 in its 2010 income tax return. What amount should Lane report in its 2010 incomestatement for subscriptions revenue?a. $0.b. $5,000.c. $30,000.d. $90,000.

14. Which of the following is an example of managing earnings down?a. Revising the estimated life of equipment from 10 years to 8 years.b. Changing estimated bad debts from 3 percent to 2.5 percent of sales.c. Not writing off obsolete inventory.d. Reducing research and development expenditures.

15. Which of the following statements is correct?a. Changes in accounting principle are always handled in the current or prospective period.b. Prior statements should be restated for changes in accounting estimates.c. Both a correction of an error and a change in accounting principle require restatement of

prior period financial statements.d. Correction of an error related to a prior period should be considered as an adjustment to current

year net income.



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16. Prophet Corporation has an extraordinary loss of $200,000, an unusual gain of $140,000, and a taxrate of 40%. At what amount should Prophet report each item?

Extraordinary loss Unusual gaina. $(200,000) $140,000b. (200,000) 84,000c. (120,000) 140,000d. (120,000) 84,000

17. Under which of the following conditions would material flood damage be considered an extraordinaryitem for financial reporting purposes?a. Only if floods in the geographical area are unusual in nature and occur infrequently.b. Only if the flood damage is material in amount and could have been reduced by prudent

management.c. Under any circumstances as an extraordinary item.d. Flood damage should never be classified as an extraordinary item.

18. Palomo Corp has a tax rate of 30 percent and income before non-operating items of $357,000. It alsohas the following items (gross amounts).

Unusual gain $ 23,000Loss from discontinued operations 183,000Dividend revenue 6,000Extraordinary gain 74,000

What is the amount of income tax expense Palomo would report on its income statement on the lineitem titled “income tax expense”?a. $ 60,900b. $ 83,100c. $108,900d. $115,800

19. Garwood Company has disposed of its Sports Division at a total before tax loss of $370,000. TheSports Division is a distinct operating component of Garwood’s business. If Garwood’s tax rate is 30%,what is the Net of Tax loss from Discontinued Operations on the income statement?a. $111,000b. $259,000c. $370,000d. $0 as this does not qualify as a discontinued item

20. Which of the following is incorrect under U.S. GAAP?a. Cash is valued at fair market valueb. Marketable securities are valued at fair market value.c. Accounts receivable is valued at net realizable value.d. Inventory is valued at current cost

21. Instrument Corp. has the following investments which were held throughout 2010:Cost at 1/1/10 Market Value at 12/31/10

Trading $300,000 $400,000Available-for-sale 300,000 $280,000

What amount of unrealized holding gain (loss) would get recorded directly in equity (i.e., would not berecorded as part of net income) for the year ended December 31, 2010?a. $0b. $100,000 gain.c. $ 20,000 lossd. $ 80,000 gain.



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Use the following information for the next two problems. On 1/1/08, Nobel Corp. acquired machineryfor $600,000. Nobel adopted straight-line depreciation for this machine and had been recordingdepreciation over an estimated life of ten years, with no residual value. At the beginning of 2011, a decisionwas made to change the useful life of this machine to a total of 19 years.

22. Assuming a 30% tax rate, the cumulative effect of this accounting change on beginning retainedearnings, isa. $ 0b. $67,200.c. $78,960.d. $112,800.

23. The amount that Nobel should record as depreciation expense for 2011 isa. $26,250.b. $32,500.c. $52,000.d. $60,000.

24. Olmsted has the following items: common stock, $720,000; treasury stock, $85,000; deferred taxes,$100,000 and retained earnings, $363,000. What is the total amount reported in stockholders’ equity?a. $898,000.b. $998,000.c. $1,098,000.d. $1,198,000.

25. Lohmeyer Corporation reports:Cash provided by operating activities $250,000Cash used by investing activities 110,000Cash provided by financing activities 190,000Beginning cash balance 70,000

What is Lohmeyer’s ending cash balance?a. $330,000.b. $350,000.c. $400,000.d. $550,000.



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26. The chief accountant for Julius Co. provides you with the company's most recent income statement andcomparative balance sheets below. The accountant has asked for your help in preparing part of thecompany's 2009 statement of cash flows. (12 possible points, suggested time 15 minutes)

Required: Determine the amount of cash inflow or outflow for each of the following items reported on thestatement of cash flows using the DIRECT method. Do NOT prepare a complete operating section, justreport the correct amount for each of the following:

a) Cash collected from customers

Sales Increase in Accounts receivable$5000 85 = $4,915

b) Cash paid for selling and administrative expenses

S & A. expense + decrease in S & A payable$3,720 + 25 = $3,745

c) Cash paid for income taxes

Income tax expense increase in Income taxes payable300 50 = $250

d) What is reported for net income on the direct method statement of cash flows? (circle correctanswer)

$5000 $700 Is not reported

2009 Income Statement ($ in thousands)

Sales revenue $5000Depreciation expense 280Selling & administrative expense 3720Income before taxes 1000Income tax expense 300Net income $700

Balance Sheet ($ in thousands) 12/31/2009 12/31/2008Cash $ 800 $ 750Accounts Receivable 450 365Plant and equipment 1900 1450

Less: Accumulated depreciation (800) (520)

Total Assets $2350 $2045

Payables for selling & admin expenses $ 300 325Income taxes payable 180 130Common stock 700 700Retained earnings 1170 890

Total liabilities & Stockholders' Equity $2350 $2045



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27. Presented below is the comparative balance sheets for Santana Industries. (13 possible points,suggested time 35 minutes)

Santana IndustriesBalance Sheet Information

Assets 12/31/2009 12/31/2008 ChangeCash $ 7,350 $ 2,200 5,150Accounts Receivable 2,500 2,200 300Inventory 4,000 3,000 1,000Prepaid rent 150 300 (150)Plant and equipment 14,500 12,000 2,500

Less: Accumulated depreciation (5,100) (4,500) (600)

Total Assets $ 23,400 $ 15,200

Liabilities and Stockholders' EquityAccounts payable $ 1,400 $ 1,100 300Interest payable 100 - 100Unearned service revenue 800 600 200Income taxes payable 550 800 (250)Long term note payable 5,000 - 5,000Common stock 10,000 10,000 -Retained earnings 5,550 2,700 2,850

Total liabilities & Stockholders' Equity $ 23,400 $ 15,200

Additional information for the 2009 year:1. Net income was $38502. Equipment costing $4000 was purchased with cash3. Equipment with a book value of $500 and cost of $1500 was sold for $500.4. Dividends of $1000 were declared and paid.

Required: Prepare a statement of cash flows on the following page using the indirect method.



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Stanana IndustriesStatement of Cash Flows




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Santana IndustriesStatement of Cash Flows

For the Year Ended December 31, 2009($ in thousands)

Cash flows from operating activities:Net income $ 3,850Adjustments for noncash effects:

Depreciation expense 1,600Changes in operating assets and liabilities:

Increase in accounts receivable (300)Increase in inventory (1,000)Decrease in prepaid rent 150Increase in accounts payable 300Increase in interest payable 100Increase in unearned service revenue 200Decrease in income taxes payable (250)

Net cash flows from operating activities $4,650

Cash flows from investing activities:Purchase of equipment (4,000)Sale of equipment 500

Net cash flows from investing activities (3,500)

Cash flows from financing activities:Proceeds from loan payable 5,000Payment of dividends (1,000)

Net cash flows from financing activities 4,000

Net increase in cash 5,150

Cash, January 1 2,200Cash, December 31 $7,350



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Agenda Monday 1/10

Announcements• BAP meetings Wednesday in Jan SBA160• OSCPA Educational Foundation Scholarship

http://www.orcpa.org/educational_foundation/scholarships• PSU Bookstore Board of Directors

http://www.portlandstatebookstore.com/site_elections.asp

Today• Finish Chapters 1-2, IFRS, Wyatt, Kapnick• Discuss project #1

Wed• Quiz on Wed Ch 1-3 and articles discussed today• Due: DQ for Kapnick, Wyatt• DQ Ethics case due date moved to Wed. Jan 19th

Announcements• BAP meetings Wednesday in Jan SBA160• OSCPA Educational Foundation Scholarship

http://www.orcpa.org/educational_foundation/scholarships• PSU Bookstore Board of Directors

http://www.portlandstatebookstore.com/site_elections.asp

Today• Finish Chapters 1-2, IFRS, Wyatt, Kapnick• Discuss project #1

Wed• Quiz on Wed Ch 1-3 and articles discussed today• Due: DQ for Kapnick, Wyatt• DQ Ethics case due date moved to Wed. Jan 19th



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• What do you think accounting is?

• Is accounting an art or a science? Consider…Is there only one correct Net Income amount?

• What are the accounting disciplines?

• What is common between all accounting’sdisciplines?

Chapter 1Chapter 1OverviewOverview

• What do you think accounting is?

• Is accounting an art or a science? Consider…Is there only one correct Net Income amount?

• What are the accounting disciplines?

• What is common between all accounting’sdisciplines?



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• Accounting identifies, measures andcommunicates financial information.

• This information is about economic entities.

• Information is communicated to interestedparties such as investors, creditors, unions andgovernmental agencies.– Users are assumed to have a reasonable understanding

of the business, and to use reasonable diligence

Characteristics of Financial AccountingCharacteristics of Financial Accounting

• Accounting identifies, measures andcommunicates financial information.

• This information is about economic entities.

• Information is communicated to interestedparties such as investors, creditors, unions andgovernmental agencies.– Users are assumed to have a reasonable understanding

of the business, and to use reasonable diligence



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To provide information that is1) Useful in investment and credit decisions

2) Useful in assessing cash flow prospects

3) About company resources, claims to thoseresources and changes in them

Objectives of Financial AccountingObjectives of Financial Accounting

To provide information that is1) Useful in investment and credit decisions

2) Useful in assessing cash flow prospects

3) About company resources, claims to thoseresources and changes in them



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• Demand: external parties demand financialaccounting information to facilitate theirresource allocation decisions

• Supply: Firms supply financial accountinginfo based on the expected economicconsequences of doing so

• Ultimately accounting informationfacilitates functioning capital markets

Supply and Demand of FinancialSupply and Demand of FinancialAccounting InformationAccounting Information

• Demand: external parties demand financialaccounting information to facilitate theirresource allocation decisions

• Supply: Firms supply financial accountinginfo based on the expected economicconsequences of doing so

• Ultimately accounting informationfacilitates functioning capital markets



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• Background – discussion of nature of business, markets, customers,and products/services.

• Management Discussion and Analysis (MD&A) – discussion ofresults of operations (including comparisons to prior years),liquidity, capital resources (including forward-looking information).

• Selected financial data – five or ten-year time series of selectedfinancial and non-financial data (allows analysis of trends).

• Financial statements – comparative B/S (2 years), I/S (3 years),SCF (3 years), and SE (3 years).

• Notes and supplemental disclosures – explanations, elaborations,and supplements to information reported in the financial statements

• Auditor report – independent auditor’s opinion on whether thefinancial statements and notes are fairly presented according togenerally accepted accounting principles (unqualified, qualified,adverse, or disclaimer).

Financial Reporting for Public Companies:Financial Reporting for Public Companies:The 10KThe 10K

• Background – discussion of nature of business, markets, customers,and products/services.

• Management Discussion and Analysis (MD&A) – discussion ofresults of operations (including comparisons to prior years),liquidity, capital resources (including forward-looking information).

• Selected financial data – five or ten-year time series of selectedfinancial and non-financial data (allows analysis of trends).

• Financial statements – comparative B/S (2 years), I/S (3 years),SCF (3 years), and SE (3 years).

• Notes and supplemental disclosures – explanations, elaborations,and supplements to information reported in the financial statements

• Auditor report – independent auditor’s opinion on whether thefinancial statements and notes are fairly presented according togenerally accepted accounting principles (unqualified, qualified,adverse, or disclaimer).



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• Why do we need accounting rules?

• Is GAAP rigid or flexible?

• Is there more than one type of GAAP?– U.S.

– IFRS

– Other

• Why do we care about “other GAAP”?– Comparability

– Roadmap for adoption of IFRS

Generally Accepted Accounting PrinciplesGenerally Accepted Accounting Principles(GAAP)(GAAP)

• Why do we need accounting rules?

• Is GAAP rigid or flexible?

• Is there more than one type of GAAP?– U.S.

– IFRS

– Other

• Why do we care about “other GAAP”?– Comparability

– Roadmap for adoption of IFRS



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In November 2008 the U.S. Securities and Exchange Commission issued aproposed "roadmap" for a potential transition by U.S. issuers from U.S. GAAP toInternational Financial Reporting Standards (IFRS.) Under the timelinecontemplated on this roadmap, the SEC would consider in 2011 whether torequire all public companies to adopt IFRS on a phased-in basis starting with largeaccelerated filers for years ending on or after December 15, 2014; acceleratedfilers for years ending on or after December 15, 2015; and non-accelerated filersand smaller companies for years ending on or after December 15, 2016.

In June 2009, President Obama announced his administration's proposals toreform the U.S. regulatory system, recommending that the FASB, the IASB andthe SEC make substantial progress toward a single set of high quality globalaccounting standards by the end of 2009.

In February 2010, the SEC issued a statement reiterating its commitment to asingle set of high quality global standards and for the convergence of IFRS andUS GAAP. The SEC directed the staff to develop a work plan to facilitate theSECs consideration in 2011 whether, and if so, how and when, to incorporateIFRS into the financial reporting system for U.S. issuers.

Status of IFRS in USStatus of IFRS in US

In November 2008 the U.S. Securities and Exchange Commission issued aproposed "roadmap" for a potential transition by U.S. issuers from U.S. GAAP toInternational Financial Reporting Standards (IFRS.) Under the timelinecontemplated on this roadmap, the SEC would consider in 2011 whether torequire all public companies to adopt IFRS on a phased-in basis starting with largeaccelerated filers for years ending on or after December 15, 2014; acceleratedfilers for years ending on or after December 15, 2015; and non-accelerated filersand smaller companies for years ending on or after December 15, 2016.

In June 2009, President Obama announced his administration's proposals toreform the U.S. regulatory system, recommending that the FASB, the IASB andthe SEC make substantial progress toward a single set of high quality globalaccounting standards by the end of 2009.

In February 2010, the SEC issued a statement reiterating its commitment to asingle set of high quality global standards and for the convergence of IFRS andUS GAAP. The SEC directed the staff to develop a work plan to facilitate theSECs consideration in 2011 whether, and if so, how and when, to incorporateIFRS into the financial reporting system for U.S. issuers.



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• Issued in 2008, SEC to decide by 2011 if mandatoryadoption will begin in 2014

• Milestones– Improving accounting standards– Improving funding and structure of IASB– Facilitating XBRL under IFRS– Updating education & licensing of US Accountants

• Concerns raised– Cost of conversion, time to convert– Consistency under principles based IFRS– Industry specific concerns (i.e., LIFO)– Private companies

SEC IFRS RoadmapSEC IFRS Roadmap

• Issued in 2008, SEC to decide by 2011 if mandatoryadoption will begin in 2014

• Milestones– Improving accounting standards– Improving funding and structure of IASB– Facilitating XBRL under IFRS– Updating education & licensing of US Accountants

• Concerns raised– Cost of conversion, time to convert– Consistency under principles based IFRS– Industry specific concerns (i.e., LIFO)– Private companies



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U.S.• FASB• AICPA “Codification”• SEC• The Sarbanes Oxley Act (SOX)• PCAOB

International (appx 100 countries)• IASB IFRS

IFRS for SMEs• Individual countries Jurisdictional IFRS

Who’s Who in the Regulatory Zoo?Who’s Who in the Regulatory Zoo?

U.S.• FASB• AICPA “Codification”• SEC• The Sarbanes Oxley Act (SOX)• PCAOB

International (appx 100 countries)• IASB IFRS

IFRS for SMEs• Individual countries Jurisdictional IFRS



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US Standard SettersUS Standard Setters

FAFFin’l Acctg FoundationOversees FASB, Appts

FASB & FASC members

FASBFin’l Acctg Stds Board

Establish & improveaccounting standards

FASACFin’l Acctg Stds Advisory

CommitteeAdvises FASB on policy

FASBFin’l Acctg Stds Board

Establish & improveaccounting standards

FASACFin’l Acctg Stds Advisory

CommitteeAdvises FASB on policy

SICStanding Interpretations

CommitteeSpecific application guidance

EITFEmerging Issues Task ForceHow to acct for new business

issues that arise



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Process operates in full view of the public, thus is open topolitical influences and can take considerable time.

1. FASB drafts and releases a discussion memorandums foridentified accounting issues:• Describes the possible accounting treatments• Describes FASB’s preliminary views on the issue

2. Receives public feedback on the discussion memorandum3. Prepares an exposure draft (proposed new accounting

standard) after analyzing and evaluating feedback4. Accepts public feedback on the exposure draft5. Decides whether to:

• Remove the exposure draft from further consideration• Revise and reissue the exposure draft• Vote upon the current version of the exposure draft

FASB Due ProcessFASB Due Processfor Standard Settingfor Standard Setting

Process operates in full view of the public, thus is open topolitical influences and can take considerable time.

1. FASB drafts and releases a discussion memorandums foridentified accounting issues:• Describes the possible accounting treatments• Describes FASB’s preliminary views on the issue

2. Receives public feedback on the discussion memorandum3. Prepares an exposure draft (proposed new accounting

standard) after analyzing and evaluating feedback4. Accepts public feedback on the exposure draft5. Decides whether to:

• Remove the exposure draft from further consideration• Revise and reissue the exposure draft• Vote upon the current version of the exposure draft



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SarbanesSarbanes--Oxley Act (SOX)Oxley Act (SOX)

– Created Public Company Accounting Oversight Board (PCAOB)• Creates auditing standards• Performs CPA firm inspections

– CEO and CFO certifications over F/S and internal controls– SOX Section 404 internal control audits– Audit committee members

• Independent• Financially literate• Must approve all services performed by audit firm• Responsible for retaining and terminating the auditor• Firm must disclose financial experts on the audit committee

– Certain non-audit services prohibited by audit firm– Audit partner rotation– Prohibition on loans to executive officers and directors– Certain employment prohibitions

– Created Public Company Accounting Oversight Board (PCAOB)• Creates auditing standards• Performs CPA firm inspections






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SarbanesSarbanes--Oxley Act (SOX)Oxley Act (SOX)

– Created Public Company Accounting Oversight Board (PCAOB)• Creates auditing standards• Performs CPA firm inspections• Required consideration of Principles Based Accounting System!




– Created Public Company Accounting Oversight Board (PCAOB)• Creates auditing standards• Performs CPA firm inspections• Required consideration of Principles Based Accounting System!






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International Standard SettersInternational Standard Setters

IASCFIntl Actg Stds Comm Fndn

Appts IASB members& fundraises

IASBInt’l Acctg Stds BoardIssue IFRS, Exposure Drafts

& approve IFRIC interpretations

SACStds Advisory Committee

Consults w/ FASB

IASBInt’l Acctg Stds BoardIssue IFRS, Exposure Drafts

& approve IFRIC interpretations

SACStds Advisory Committee

Consults w/ FASB

IFRICInt’l Fin Reporting Interpretations

CommitteeDevelops interpretations of stds that

To be approved by IASBwww.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in


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1. Potential agenda items discussed in meetings open to thepublic

2. Discussion papers and exposure drafts are published forpublic comment

3. The IASB solicits comments from various standardsetting and regulatory bodies, as well as other users of f/s

IASB Standard SettingIASB Standard Setting

1. Potential agenda items discussed in meetings open to thepublic

2. Discussion papers and exposure drafts are published forpublic comment

3. The IASB solicits comments from various standardsetting and regulatory bodies, as well as other users of f/s



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• Trust drives the accounting profession– SOX, PCAOB, and class action lawsuits are a

result of a breach of trust

– From a broad perspective, we pay a heavy pricefor low trust:

• Waits at airports, audit fees

• Implications for personal conduct?

TrustTrust

• Trust drives the accounting profession– SOX, PCAOB, and class action lawsuits are a

result of a breach of trust

– From a broad perspective, we pay a heavy pricefor low trust:

• Waits at airports, audit fees

• Implications for personal conduct?



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An expectations gap exists between what thepublic thinks accountants and auditors should doand what accountants and auditors think theycan do– Consider: what is earnings management? Is it

unethical?– Do accountants “manage” earnings by recording

accruals, adjustments, and depreciation?– Transparency

The Expectations GapThe Expectations Gap

An expectations gap exists between what thepublic thinks accountants and auditors should doand what accountants and auditors think theycan do– Consider: what is earnings management? Is it

unethical?– Do accountants “manage” earnings by recording

accruals, adjustments, and depreciation?– Transparency



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Recall: Revenue is recognized at the earliest momentthat both of the following conditions are met:

1.Earned: The critical event in the process of earningrevenue has taken place. (seller)

2. Realized: The amount of revenue that will be collected isreasonably assured and measurable with a reasonabledegree of reliability. (buyer)

Chapter 18 & 18AChapter 18 & 18AComplex Revenue RecognitionComplex Revenue Recognition

1



2. Realized: The amount of revenue that will be collected isreasonably assured and measurable with a reasonabledegree of reliability. (buyer)



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Basic Idea:• Various types of franchise arrangements, we will

focus on service sponsor-retailer• Franchisor sells

(1) right to operate business and(2) provides on-going support activities.

• Revenue streams(1) initial sale of franchise and related assets/services(2) fees based on the operation of the franchise

So how does franchisor record this revenue?

Franchise RevenueFranchise Revenue(Appendix 18A)(Appendix 18A)

2

Basic Idea:• Various types of franchise arrangements, we will

focus on service sponsor-retailer• Franchisor sells

(1) right to operate business and(2) provides on-going support activities.

• Revenue streams(1) initial sale of franchise and related assets/services(2) fees based on the operation of the franchise

So how does franchisor record this revenue?



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• Initial Franchise fee• Revenue recorded when there is:

• Substantial performance• No remaining obligation to refund any cash or excuse any

non-payment of note. Generally assumed to be whenfranchisee commences operations

• Collection of fee is reasonably assured

• If terms not met, then Unearned Franchise Fees• Often payment is in cash and a LT note receivable

• Continuing Fees• When earned and receivable.• Often amount must be verified

Franchise RevenueFranchise Revenue

3

• Initial Franchise fee• Revenue recorded when there is:

• Substantial performance• No remaining obligation to refund any cash or excuse any

non-payment of note. Generally assumed to be whenfranchisee commences operations

• Collection of fee is reasonably assured

• If terms not met, then Unearned Franchise Fees• Often payment is in cash and a LT note receivable

• Continuing Fees• When earned and receivable.• Often amount must be verified



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On 3/31/09 the Red Hot Chicken Wing Corp. entered into afranchise agreement with Thomas Keller. In exchange for an initialfranchise fee of $50,000, Red Hot will provide initial services toinclude the selection of location, construction of building,employee training and consulting services over several years.$10,000 is payable on 3/31/09, with the remaining $40,000 payablein annual installments. 10% interest on the note (at market rate) ispayable annually. In addition, the franchisee will pay continuingfranchise fees of $1000 per month for advertising and promotionprovided by Red Hot, beginning immediately after the franchisebegins operations. Thomas Keller opened his Red Hot franchise forbusiness on 9/30/09

Franchise Revenue ExampleFranchise Revenue Example

4

On 3/31/09 the Red Hot Chicken Wing Corp. entered into afranchise agreement with Thomas Keller. In exchange for an initialfranchise fee of $50,000, Red Hot will provide initial services toinclude the selection of location, construction of building,employee training and consulting services over several years.$10,000 is payable on 3/31/09, with the remaining $40,000 payablein annual installments. 10% interest on the note (at market rate) ispayable annually. In addition, the franchisee will pay continuingfranchise fees of $1000 per month for advertising and promotionprovided by Red Hot, beginning immediately after the franchisebegins operations. Thomas Keller opened his Red Hot franchise forbusiness on 9/30/09



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Initial Franchise fee3/31/09 Cash 10,000

Note Receivable 40,000Unearned franchise fee revenue 50,000

9/30/09 Unearned franchise fee revenue 50,000Franchise fee revenue 50,000

Continuing Fees10/31/09 Cash 1000(& monthly) Service Revenue 1000

Debt Service3/31/10 Cash 4000

Interest revenue 4000

Franchise Revenue ExampleFranchise Revenue Example

5

Initial Franchise fee3/31/09 Cash 10,000

Note Receivable 40,000Unearned franchise fee revenue 50,000

9/30/09 Unearned franchise fee revenue 50,000Franchise fee revenue 50,000

Continuing Fees10/31/09 Cash 1000(& monthly) Service Revenue 1000

Debt Service3/31/10 Cash 4000

Interest revenue 4000



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Basic idea:• Consignor “gives” merchandise to a a reseller to sell on your behalf

to an end user.• Can’t recognize revenue until sold to end user

Entries:Ships to consignee

Inventory on consignment xxxFinished good inventory xxx

Notified of sale to end userCash xxxCommission expense xxx

Revenue from consigned sales xxxCOGS xxx

Inventory on consignment xxx

Consignments (Appendix 18A)Consignments (Appendix 18A)

6

Basic idea:• Consignor “gives” merchandise to a a reseller to sell on your behalf

to an end user.• Can’t recognize revenue until sold to end user

Entries:Ships to consignee

Inventory on consignment xxxFinished good inventory xxx

Notified of sale to end userCash xxxCommission expense xxx

Revenue from consigned sales xxxCOGS xxx

Inventory on consignment xxx



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• What type of sales terms would resultin an “in substance” consignmentarrangement?

• Often take form of “side deal”

ConsignmentsConsignments

7

• What type of sales terms would resultin an “in substance” consignmentarrangement?

• Often take form of “side deal”



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Revenue may be recognized beforedelivery under certain circumstances.• Long-term construction contracts are a

notable example• US GAAP

• The percentage-of-completion method, and• The completed contract method

Revenue Recognition BeforeRevenue Recognition BeforeDeliveryDelivery

Revenue may be recognized beforedelivery under certain circumstances.• Long-term construction contracts are a

notable example• US GAAP

• The percentage-of-completion method, and• The completed contract method



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Long-Term ConstructionAccounting Methods

Percentage-of-CompletionMethod

Completed ContractMethod

Revenue Recognition BeforeRevenue Recognition BeforeDeliveryDelivery

1) Terms of contract mustbe certain, enforceable.

2) Certainty of performanceby both parties

3) Estimates of completioncan be made reliably

1) To be used only whenthe percentage method isinapplicable [uncertain]

2) For short-term contracts

Percentage-of-CompletionMethod

Completed ContractMethod



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1. Long-term construction contracts when outcomescannot be reasonably estimated:• US GAAP: must use Completed Contract Method (No revenue

or expense is recognized until the end of the contract)

• IFRS: must use the zero-profit method (revenues arerecognized only to the extent of costs)

2. Service Revenue• US GAAP: follow specific industry guidance for revenue

recognition

• IFRS: typically use the % Completion method (or straight-line if services are specified over a period of time)

Revenue Recognition:Revenue Recognition:US GAAP vs. IFRSUS GAAP vs. IFRS

1. Long-term construction contracts when outcomescannot be reasonably estimated:• US GAAP: must use Completed Contract Method (No revenue

or expense is recognized until the end of the contract)

• IFRS: must use the zero-profit method (revenues arerecognized only to the extent of costs)

2. Service Revenue• US GAAP: follow specific industry guidance for revenue

recognition

• IFRS: typically use the % Completion method (or straight-line if services are specified over a period of time)



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• Want to reflect economic substance of theactivities of the company

• I/S: Revenues earned and expenses incurred• B/S: Value of asset being constructed

• Requires the use of estimates• What information do we need?

• Contract revenue• Expenses incurred• Estimated remaining expenses• Billing and cash from customer

Percentage of Completion: Basic IdeaPercentage of Completion: Basic Idea

11

• Want to reflect economic substance of theactivities of the company

• I/S: Revenues earned and expenses incurred• B/S: Value of asset being constructed

• Requires the use of estimates• What information do we need?

• Contract revenue• Expenses incurred• Estimated remaining expenses• Billing and cash from customer



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Data: Contract price: $4,500,000 Estimated cost: $4,000,000Start date: July, 2003 Finish: October, 2005Balance sheet date: Dec. 31

Given: 2003 2004 2005

Costs to date $1,000,000 $2,916,000 $4,050,000Estimated costs to complete $3,000,000 $1,134,000 $ -0-Progress Billings during year $900,000 $2,400,000 $1,200,000Cash collected during year $750,000 $1,750,000 $2,000,000

PercentagePercentage--ofof--Completion:Completion:ExampleExample

12

Given: 2003 2004 2005

Costs to date $1,000,000 $2,916,000 $4,050,000Estimated costs to complete $3,000,000 $1,134,000 $ -0-Progress Billings during year $900,000 $2,400,000 $1,200,000Cash collected during year $750,000 $1,750,000 $2,000,000

What is the percent complete, revenue, and grossprofit recognized each year?



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2003To record cost of construction:

DR Construction in process (CIP) 1,000,000CR Accounts Payable 1,000,000

To record progress billings to customer:DR Accounts receivable 900,000

CR Billings on CIP 900,000

To record cash collections:DR Cash 750,000

CR Accounts receivable 750,000

PercentagePercentage--ofof--Completion: EntriesCompletion: EntriesInvolving Third PartiesInvolving Third Parties

13

2003To record cost of construction:

DR Construction in process (CIP) 1,000,000CR Accounts Payable 1,000,000

To record progress billings to customer:DR Accounts receivable 900,000

CR Billings on CIP 900,000

To record cash collections:DR Cash 750,000

CR Accounts receivable 750,000



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“Construction in Process” Similar to a Work-In-Process inventory account Accumulates all costs and profits

“Billings on Construction in Process” Similar to a deferred revenue account Gets offset to CIP (i.e., think of as a contra-account to

“Construction in Process”)

At the end of any accounting period, the difference between thebalance in “CIP” and “Billings on CIP” will appear on the balancesheet.

If “CIP” > “Billings on CIP”, the difference will be reported as anasset.

If “Billing on CIP” > “CIP”, the difference will appear as aliability.

PercentagePercentage--ofof--Completion:Completion:Balance Sheet AccountsBalance Sheet Accounts

14

“Construction in Process” Similar to a Work-In-Process inventory account Accumulates all costs and profits

“Billings on Construction in Process” Similar to a deferred revenue account Gets offset to CIP (i.e., think of as a contra-account to

“Construction in Process”)

At the end of any accounting period, the difference between thebalance in “CIP” and “Billings on CIP” will appear on the balancesheet.

If “CIP” > “Billings on CIP”, the difference will be reported as anasset.

If “Billing on CIP” > “CIP”, the difference will appear as aliability.



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Costs incurred to date = Percent completeMost recent estimated total costs

11

Estimated total revenue x Percent complete= Revenue to be recognized to date

22

PercentagePercentage--ofof--Completion: EntriesCompletion: Entriesto Record Revenue & Expenseto Record Revenue & Expense

15

Estimated total revenue x Percent complete= Revenue to be recognized to date

Total revenue to be recognized to date less Revenuerecognized in PRIOR periods = Current period revenue

33

Current Period Revenue less current costs = Gross profit44



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2003 2004 2005

% completeto-date

1,000,000 = 25% 2,916,000= 72% 100 %4,000,000 4,050,000

PercentagePercentage--ofof--Completion:Completion:ExampleExample

16

% completeto-date

Revenuerecognized

4,500,000 * 25% 4,500,000 * 72% 4,500,000= 1,125,000 less 1,125,000 less 3,240,000

= 2,115,000 = 1,260,000

1,125,000 less 2,115,000 less 1,260,0001,000,000 1,916,000 less 1,134,000= 125,000 = 199,000 = 126,000

Gross Profitrecognized



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2003To record revenue and expense

DR CIP (plug gross profit here) 125,000DR Construction Expenses 1,000,000

CR Revenue (1m/(1m+3m)x4.5m) 1,125,000

Note: Construction expenses = actual expenditures for theperiod

PercentagePercentage--ofof--Completion: EntriesCompletion: EntriesInvolving Third PartiesInvolving Third Parties

17

2003To record revenue and expense

DR CIP (plug gross profit here) 125,000DR Construction Expenses 1,000,000

CR Revenue (1m/(1m+3m)x4.5m) 1,125,000

Note: Construction expenses = actual expenditures for theperiod



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Balance Sheet 2003Construction In Progress

1,000,000

125,000

1,125,000

Billings

900,000

900,000

18

1,125,000

Balance Sheet

… in current assets:

CIP 1,125,000

Billings (900,000)

Costs and Recognized Gross Profit

in excess of Billings 225,000



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2004:Construction in Progress (2.916m – 1.0m) 1,916,000

A/P, etc. 1,916,000

A/R 2,400,000Billings 2,400,000

Cash 1,750,000A/R 1,750,000

CIP 199,000Construction Expenses 1,916,000

Revenue (2.916m/4.050m x 4.5m) – 1,125,000 2,115,000

PercentagePercentage--ofof--Completion:Completion:Journal EntriesJournal Entries

19

2004:Construction in Progress (2.916m – 1.0m) 1,916,000

A/P, etc. 1,916,000

A/R 2,400,000Billings 2,400,000

Cash 1,750,000A/R 1,750,000


Revenue (2.916m/4.050m x 4.5m) – 1,125,000 2,115,000



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% Completion Balance Sheet 2004

Construction In Progress

1,000,000

125,000

1,916,000

199,000

3,240,000

Billings

900,000

2,400,000

3,300,000

20

3,240,000

Balance Sheet

… in current liabilities:

Billings 3,300,000

Less: CIP (3,240,000)

Billings in excess of cost

and recognized gross profit 60,000



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2005:CIP (4,050 – 2,916) 1,134,000

A/P, etc. 1,134,000

A/R 1,200,000Billings 1,200,000

Cash 2,000,000A/R 2,000,000


Revenue (4,050/4,050 x 4,500) – 1,125 - 2,115 1,260,000

PercentagePercentage--ofof--Completion: Journal EntriesCompletion: Journal Entries

21

2005:CIP (4,050 – 2,916) 1,134,000

A/P, etc. 1,134,000

A/R 1,200,000Billings 1,200,000

Cash 2,000,000A/R 2,000,000


Revenue (4,050/4,050 x 4,500) – 1,125 - 2,115 1,260,000



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% Completion Balance Sheet 2005% Completion Balance Sheet 2005

CIP Billings

1,000,000 900,000

125,000 2,400,000

22

125,000 2,400,000

1,916,000 1,200,000

199,000 4,500,000

1,134,000 -

126,000

4,500,000

-



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At the end of the contract:

To record completion of project:DR Billings on CIP 4,500,000

CR Construction in process 4,500,000

Over the life of the contract, the total credits to “Billings on CIP”will equal the total amount billed to the customer, which is thetotal revenue received over the life of the contract.

PercentagePercentage--ofof--Completion: EntriesCompletion: Entries

23

At the end of the contract:

To record completion of project:DR Billings on CIP 4,500,000

CR Construction in process 4,500,000

Over the life of the contract, the total credits to “Billings on CIP”will equal the total amount billed to the customer, which is thetotal revenue received over the life of the contract.



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Note that Gross Profit is stored in the CIP Account – this is verydifferent from “ordinary” sales transactions, where gross profit isnot in any specific account

• A T-account analysis of the CIP account is very useful in answeringquestions

• For example, you could be told that Daniels Construction incurred$1 million in construction costs on a new contract this year. Theyexpect to incur another $7 million to complete the project. Thebalance in the CIP account at year end is $1.2 million. What isthe total revenue they expect to earn on the contract?

• Answer: 1.2 – 1 = 200,000 in GP recognized• Project is 1/(1+7) or 12.5% complete, so 200,000 / 0.125 = $1,600,000

in total profit• Since profit is revenues minus expenses, total revenues must be 1.6 +

8 = $9.6 million

PercentagePercentage--ofof--Completion: the ConstructionCompletion: the Constructionin Progress Accountin Progress Account

24

Note that Gross Profit is stored in the CIP Account – this is verydifferent from “ordinary” sales transactions, where gross profit isnot in any specific account

• A T-account analysis of the CIP account is very useful in answeringquestions

• For example, you could be told that Daniels Construction incurred$1 million in construction costs on a new contract this year. Theyexpect to incur another $7 million to complete the project. Thebalance in the CIP account at year end is $1.2 million. What isthe total revenue they expect to earn on the contract?

• Answer: 1.2 – 1 = 200,000 in GP recognized• Project is 1/(1+7) or 12.5% complete, so 200,000 / 0.125 = $1,600,000

in total profit• Since profit is revenues minus expenses, total revenues must be 1.6 +

8 = $9.6 million



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Use when is a lack of dependable estimates No revenue, no expense, no gross profit recognized until

the project is actually completed.

Journal entries prepared during the life of contract arethe same as those prepared under the percentage-of-completion method with the exception of the lastjournal entry that recognizes periodic revenue, expenseand gross profit.

Instead, the entire revenue, expense and gross profit arerecorded at the end of the project.

Completed Contract MethodCompleted Contract Method

25

Use when is a lack of dependable estimates No revenue, no expense, no gross profit recognized until

the project is actually completed.

Journal entries prepared during the life of contract arethe same as those prepared under the percentage-of-completion method with the exception of the lastjournal entry that recognizes periodic revenue, expenseand gross profit.

Instead, the entire revenue, expense and gross profit arerecorded at the end of the project.



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Completed Contract

• Assuming the same numbers as examplebefore, what are the journal entries underthe completed contract method?• All journal entries for 2003, 2004, and 2005

would appear exactly as before, except thatthere would be no revenue recognition journalentry in each year

• Therefore, the balance in CIP at the end of eachyear would represent only the inventoriedconstruction costs

26

• Assuming the same numbers as examplebefore, what are the journal entries underthe completed contract method?• All journal entries for 2003, 2004, and 2005

would appear exactly as before, except thatthere would be no revenue recognition journalentry in each year

• Therefore, the balance in CIP at the end of eachyear would represent only the inventoriedconstruction costs



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2003:Construction in Progress (CIP) 1,000,000

Cash, A/P, etc. 1,000,000

A/R 900,000Billings 900,000

Cash 750,000A/R 750,000

Entries above same as for % Completion. No entry to recordrevenues and expenses.

Completed Contract: Journal EntriesCompleted Contract: Journal Entries

27

2003:Construction in Progress (CIP) 1,000,000

Cash, A/P, etc. 1,000,000

A/R 900,000Billings 900,000

Cash 750,000A/R 750,000

Entries above same as for % Completion. No entry to recordrevenues and expenses.



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Balance Sheet 2003 – Completed Contract


1,000,000

1,000,000

Billings

900,000

900,000

28

1,000,000

Balance Sheet

… in current assets:

CIP 1,000,000

Billings (900,000)

Costs

in excess of Billings 100,000



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2004:Construction in Progress (2,916 – 1,000) 1,916,000

Cash, A/P, etc. 1,916,000

A/R 2,400,000Billings 2,400,000

Cash 1,750,000A/R 1,750,000

J/E above are same as for % Completion (no entry made forrevenue and expense)


29

2004:Construction in Progress (2,916 – 1,000) 1,916,000

Cash, A/P, etc. 1,916,000

A/R 2,400,000Billings 2,400,000

Cash 1,750,000A/R 1,750,000

J/E above are same as for % Completion (no entry made forrevenue and expense)



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Completed Contract Balance Sheet 2004


1,000,000

1,916,000

2,916,000

Billings

900,000

2,400,000

3,300,000

30

2,916,000

Balance Sheet

… in current liabilities:

Billings 3,300,000

Less: CIP (2,916,000)

Billings in excess of cost 384,000



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2005:CIP (4,050 – 2,916) 1,134,000

Cash, A/P, etc. 1,134,000

A/R 1,200,000Billings 1,200,000

Cash 2,000,000A/R 2,000,000

Now that the project is done, we can close out the Billings and CIP accounts andrecord Construction Revenue and Construction Expense:

Billings 4,500,000Revenue 4,500,000

Construction Expenses 4.050,000CIP 4,050,000


31

2005:CIP (4,050 – 2,916) 1,134,000

Cash, A/P, etc. 1,134,000

A/R 1,200,000Billings 1,200,000

Cash 2,000,000A/R 2,000,000

Now that the project is done, we can close out the Billings and CIP accounts andrecord Construction Revenue and Construction Expense:

Billings 4,500,000Revenue 4,500,000

Construction Expenses 4.050,000CIP 4,050,000



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Completed Contract Balance Sheet 2005Completed Contract Balance Sheet 2005

CIP Billings

1,000,000 900,000

2,400,000

32

2,400,000

1,916,000 1,200,000

4,500,000

1,134,000 -

4,050,000

-



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Losses on Contracts

Need to determine if the loss is for the currentperiod or if for the contract overall.

• If on overall profitable contract, recognize theloss in the period incurred via “negative grossprofit”

• Overall unprofitable contract• Percentage of completion: Recognize entire contract

loss now by “backing out” previous gross profit• Completed contract: Recognize the entire loss now.

What is the theoretical justification for this?33

Need to determine if the loss is for the currentperiod or if for the contract overall.

• If on overall profitable contract, recognize theloss in the period incurred via “negative grossprofit”

• Overall unprofitable contract• Percentage of completion: Recognize entire contract

loss now by “backing out” previous gross profit• Completed contract: Recognize the entire loss now.

What is the theoretical justification for this?



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Loss on anoverall unprofitablecontract

Percentage Method: Recognize entireloss now (this means “backing out” anypreviously recognized gross profit)

Recognizing Overall Losses onRecognizing Overall Losses onLongLong--Term ContractsTerm Contracts

34

Completed method:Recognize loss currently.



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Revenue recognition is deferred whencollection of sales price is not reasonablyassured and no reliable estimates can bemade. GAAP allows:• the installment sales method• the cost recovery method

Revenue Recognition AfterRevenue Recognition AfterDeliveryDelivery

35

Revenue recognition is deferred whencollection of sales price is not reasonablyassured and no reliable estimates can bemade. GAAP allows:• the installment sales method• the cost recovery method



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• Emphasizes income recognition in periods ofcollection rather than at point of sale.

• Title does not pass to the buyer until all cashpayments have been made to the seller.

• Gross profit is deferred to the periods ofcollection.

• Other expenses, selling and administrative,are not deferred.

The Installment Sales MethodThe Installment Sales Method

36

• Emphasizes income recognition in periods ofcollection rather than at point of sale.

• Title does not pass to the buyer until all cashpayments have been made to the seller.

• Gross profit is deferred to the periods ofcollection.

• Other expenses, selling and administrative,are not deferred.



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• Installment sales must be kept separate• Gross profit on installment sales must be

determinable• The amount of cash collected from

installment accounts must be known• The cash collected from current years’ and

prior years’ accounts must be known• Provision must be made for the carry forward

of each year’s deferred gross profit

The Installment Sales MethodThe Installment Sales Method

37

• Installment sales must be kept separate• Gross profit on installment sales must be

determinable• The amount of cash collected from

installment accounts must be known• The cash collected from current years’ and

prior years’ accounts must be known• Provision must be made for the carry forward

of each year’s deferred gross profit



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Installment Sales Issues - Interestand Repossessions

• Interest: recognize at time of receipt (donot defer)

• Repossessions:• Be sure to account for all payments and

recognition of gross profit until the repossessiondate

• Set up repossessed goods at their fair value atrepossession (not what they were worth whenoriginally sold)

• Write off any remaining A/R and deferred GP,plugging a gain/loss to make entry balance

38

• Interest: recognize at time of receipt (donot defer)

• Repossessions:• Be sure to account for all payments and

recognition of gross profit until the repossessiondate

• Set up repossessed goods at their fair value atrepossession (not what they were worth whenoriginally sold)

• Write off any remaining A/R and deferred GP,plugging a gain/loss to make entry balance



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• For installment sales inany year

• For installment salesmade in prior years(realized gross profit)

• Determine rate of grossprofit on installmentsales

• Apply this rate to cashcollections of currentyear’s installment salesto yield realized grossprofit

• The gross profit notrealized is deferred

• Apply the relevant rateto cash collections ofprior year’s installmentsales

The Installment Sales Method:The Installment Sales Method:StepsSteps

39

• For installment sales inany year

• For installment salesmade in prior years(realized gross profit)

• Determine rate of grossprofit on installmentsales

• Apply this rate to cashcollections of currentyear’s installment salesto yield realized grossprofit

• The gross profit notrealized is deferred

• Apply the relevant rateto cash collections ofprior year’s installmentsales



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Given: 2003 2004 2005

Installment sales $200,000 $250,000 $240,000Cost of sales $150,000 $190,000 $168,000Gross Profit $ 50,000 $ 60,000 $ 72,000

Cash received in:from 2003 sales $ 60,000 $ 100,000 $ 40,000from 2004 sales $ -0- $ 100,000 $125,000from 2005 sales $ -0- $ -0- $ 80,000

Determine the realized and deferred gross profit.

The Installment Sales Method:The Installment Sales Method:ExampleExample

40

Given: 2003 2004 2005






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2003 2004 2005

Gross profit rate 25% 24% 30%Realized Gross Profit:From 2003 sales (e.g., 60,000 x 25%)

Realized in $ 15,000 $ 25,000 $ 10,000From 2004 sales:Realized in: $ -0- $ 24,000 $ 30,000From 2005 sales:Realized in: $ -0- $ -0- $ 24,000

The Installment Sales Method:The Installment Sales Method:ExampleExample

41

2003 2004 2005

Gross profit rate 25% 24% 30%Realized Gross Profit:From 2003 sales (e.g., 60,000 x 25%)

Realized in $ 15,000 $ 25,000 $ 10,000From 2004 sales:Realized in: $ -0- $ 24,000 $ 30,000From 2005 sales:Realized in: $ -0- $ -0- $ 24,000



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When the 2003 installment sale is made:Installment A/R (2003) 200,000

Installment Sales 200,000

Installment Cost of Sales 150,000Inventory 150,000

Installment Sales 200,000Installment Cost of Sales 150,000Deferred Gross Profit, 2003 50,000

When cash is received, some deferred GP is recog’d as revenue:Cash 60,000

Installment A/R (2003) 60,000

Deferred Gross Profit, 2003 15,000Realized Gross Profit (I/S) 15,000(Realized: $60,000 x 25%)

The Installment Sales Method: 2003The Installment Sales Method: 2003Journal Entries for Gross ProfitJournal Entries for Gross Profit

42

When the 2003 installment sale is made:Installment A/R (2003) 200,000

Installment Sales 200,000




Installment A/R (2003) 60,000

Deferred Gross Profit, 2003 15,000Realized Gross Profit (I/S) 15,000(Realized: $60,000 x 25%)



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Installment A/R (2004) 250,000Installment Sales 250,000




Installment A/R (2003) 100,000Installment A/R (2004) 100,000

Deferred Gross Profit, 2003 25,000Deferred Gross Profit, 2004 24,000

Realized Gross Profit (I/S) 49,000(Realized: ’03: $100K x 25% + ’04 $100K X 24%)

The Installment Sales Method: 2004 JournalThe Installment Sales Method: 2004 JournalEntries for Gross ProfitEntries for Gross Profit

43





Installment A/R (2003) 100,000Installment A/R (2004) 100,000

Deferred Gross Profit, 2003 25,000Deferred Gross Profit, 2004 24,000

Realized Gross Profit (I/S) 49,000(Realized: ’03: $100K x 25% + ’04 $100K X 24%)



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When cash is received, some deferred GP is recognized as revenue:Cash 245,000

Installment A/R (2003) 40,000Installment A/R (2004) 125,000Installment A/R (2005) 80,000

Deferred Gross Profit, 2003 10,000Deferred Gross Profit, 2004 30,000Deferred Gross Profit, 2005 24,000

Realized Gross Profit (I/S) 64,000(Realized: ’03: $40K x 25% + ’04 $125K X 24% + ’05 80K X 30%)

Installment Sales Method: 2005 JournalInstallment Sales Method: 2005 JournalEntriesEntries

44




When cash is received, some deferred GP is recognized as revenue:Cash 245,000

Installment A/R (2003) 40,000Installment A/R (2004) 125,000Installment A/R (2005) 80,000

Deferred Gross Profit, 2003 10,000Deferred Gross Profit, 2004 30,000Deferred Gross Profit, 2005 24,000

Realized Gross Profit (I/S) 64,000(Realized: ’03: $40K x 25% + ’04 $125K X 24% + ’05 80K X 30%)



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• Used when no reasonable basis for estimatingcollectibility as in franchises and real estate.

• Seller recognizes no profit until cashpayments by buyer exceed seller’s cost ofmerchandise.

• After recovering all costs, seller includesadditional cash collections in income.

• The income statement reports the amount ofgross profit recognized and the amountdeferred.

The Cost Recovery MethodThe Cost Recovery Method

45

• Used when no reasonable basis for estimatingcollectibility as in franchises and real estate.

• Seller recognizes no profit until cashpayments by buyer exceed seller’s cost ofmerchandise.

• After recovering all costs, seller includesadditional cash collections in income.

• The income statement reports the amount ofgross profit recognized and the amountdeferred.



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Given: 2003 2004 2005




The Original ExampleThe Original Example –– CostCostRecovery MethodRecovery Method

46

Given: 2003 2004 2005






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2003:(J/E’s for sales and deferral of GP are same as in installment method)


Cost of Installment sales 150,000Inventory 150,000

Installment Sales 200,000Cost of Installment Sales 150,000Deferred Gross Profit 50,000

Cash collection J/E’s:Cash 60,000

Installment A/R (2003)60,000

• Note: costs remaining to recover = 150,000 – 60,000 = 90,000 beforeany recognition of profit


47

2003:(J/E’s for sales and deferral of GP are same as in installment method)


Cost of Installment sales 150,000Inventory 150,000

Installment Sales 200,000Cost of Installment Sales 150,000Deferred Gross Profit 50,000

Cash collection J/E’s:Cash 60,000

Installment A/R (2003)60,000

• Note: costs remaining to recover = 150,000 – 60,000 = 90,000 beforeany recognition of profit



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2004:J/E’s for sales and deferral of GP are same as in installment method

Cash 200,000Installment A/R (2003) 100,000Installment A/R (2004) 100,000

• 2003 GP can be recognized: 150,000 – 60,000 – 100,000 = 10,000 tobe recognized

• No 2004 GP to be recognized: 190,000 – 100,000 = 90,000

Deferred GP, 2003 sales 10,000Recognized GP 10,000


48


Cash 200,000Installment A/R (2003) 100,000Installment A/R (2004) 100,000

• 2003 GP can be recognized: 150,000 – 60,000 – 100,000 = 10,000 tobe recognized

• No 2004 GP to be recognized: 190,000 – 100,000 = 90,000

Deferred GP, 2003 sales 10,000Recognized GP 10,000



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Cash 245,000Installment A/R (2003) 40,000Installment A/R (2004) 125,000Installment A/R (2005) 80,000

• All cash collected in 2003 can be recognized as GP because costscovered in 2004

• 2004 GP to be recognized: 190,000 – 100,000 – 125,000 = 35,000• No GP for 2005: 168,000 – 80,000 = 88,000

Deferred GP, 2003 sales 40,000Deferred GP, 2004 sales 35,000

Recognized GP 75,000


49


Cash 245,000Installment A/R (2003) 40,000Installment A/R (2004) 125,000Installment A/R (2005) 80,000

• All cash collected in 2003 can be recognized as GP because costscovered in 2004

• 2004 GP to be recognized: 190,000 – 100,000 – 125,000 = 35,000• No GP for 2005: 168,000 – 80,000 = 88,000

Deferred GP, 2003 sales 40,000Deferred GP, 2004 sales 35,000

Recognized GP 75,000



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• Provide the structure for building a set of coherentaccounting standards.

• Levels:1. “Why” - Provides objectives of financial reporting2. “Bridges levels 1 and 3” - Defines qualitative

characteristics of accounting information and theelements of financial statements

3. “How/implementation” - Explains recognition andmeasurement criteria

• US and IFRS similar, but are not exactly the same• Convergence project underway, not yet approved

Chapter 2Chapter 2Conceptual FrameworksConceptual Frameworks

• Provide the structure for building a set of coherentaccounting standards.

• Levels:1. “Why” - Provides objectives of financial reporting2. “Bridges levels 1 and 3” - Defines qualitative

characteristics of accounting information and theelements of financial statements

3. “How/implementation” - Explains recognition andmeasurement criteria

• US and IFRS similar, but are not exactly the same• Convergence project underway, not yet approved



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General Conceptual FrameworkGeneral Conceptual Framework



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Per SFAC 1-2, 4-7• Provide information that is useful

to those making investment &credit decisions.

• Helpful to present and potentialinvestors, creditor and otherusers in assessing the amounts,timing and uncertainty of futurecash flows; and

• About economic resources, theclaims to those resources and thechanges in them.

Per IASB Framework (April 1989)• The objective of f/s’s is to provide

information about the financialposition, performance and changesin financial position of an entitythat is useful to a wide range ofusers in making economicdecisions.

• Users are present & potentialinvestors, employees, lenders,suppliers & other trade creditors,customers, gov’ts & their agencies& the general public.

IFRSUS GAAP

Level 1:Level 1:Objectives of Financial ReportingObjectives of Financial Reporting

Per SFAC 1-2, 4-7• Provide information that is useful

to those making investment &credit decisions.

• Helpful to present and potentialinvestors, creditor and otherusers in assessing the amounts,timing and uncertainty of futurecash flows; and

• About economic resources, theclaims to those resources and thechanges in them.

Per IASB Framework (April 1989)• The objective of f/s’s is to provide

information about the financialposition, performance and changesin financial position of an entitythat is useful to a wide range ofusers in making economicdecisions.

• Users are present & potentialinvestors, employees, lenders,suppliers & other trade creditors,customers, gov’ts & their agencies& the general public.



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U.S. Conceptual Framework Level 2:U.S. Conceptual Framework Level 2:Hierarchy of Qualitative CharacteristicsHierarchy of Qualitative Characteristics



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Primary characteristics• Relevance

– Predictive value– Feedback value– Timeliness

• Reliability– Verifiability– Representational

faithfulness– Neutrality

Secondary Characteristics• Comparability• Consistency

UnderstandabilityRelevance• Predictive value• Confirmatory value• Materiality

Reliability• Faithful representation• Substance over form• Neutrality• Prudence• Completeness

Comparability

IFRSUS GAAP

Level 2:Level 2:Qualitative CharacteristicsQualitative Characteristics

Primary characteristics• Relevance

– Predictive value– Feedback value– Timeliness

• Reliability– Verifiability– Representational

faithfulness– Neutrality

Secondary Characteristics• Comparability• Consistency

UnderstandabilityRelevance• Predictive value• Confirmatory value• Materiality

Reliability• Faithful representation• Substance over form• Neutrality• Prudence• Completeness

Comparabilitywww.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in


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Example: Suppose a biotech firm spends $1,000,000 onresearch and development expenditures. How could thefirm record the expenditures? CR Cash

DR Expense?

DR R&D Asset?

For each alternative consider: What is the relevance/reliability tradeoff?

How can the treatment be theoretically supported?

Does US or IFRS allow?

Relevance and ReliabilityRelevance and Reliability ––Tradeoff ExampleTradeoff Example

Example: Suppose a biotech firm spends $1,000,000 onresearch and development expenditures. How could thefirm record the expenditures? CR Cash

DR Expense?

DR R&D Asset?

For each alternative consider: What is the relevance/reliability tradeoff?

How can the treatment be theoretically supported?

Does US or IFRS allow?



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Constraints• Cost/Benefit• Materiality• Industry Practices• Conservatism

Constraints on relevant &reliable info

• Timeliness• Balance between benefit and cost• Balance between qualitative

characteristics

IFRSUS GAAP

Level 2:Level 2:Qualitative Characteristics con’tQualitative Characteristics con’t

Constraints• Cost/Benefit• Materiality• Industry Practices• Conservatism

Constraints on relevant &reliable info

• Timeliness• Balance between benefit and cost• Balance between qualitative

characteristics



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Scumbag Corp. pays a bonus to the CFO of $10,000 ifthe company earns net income over $1 million in anygiven year.– Draft f/s for 2004 show net income of $1.5 million dollars– However, the CFO argues that slowing sales indicate that

inventory may be overvalued, and advocates the followingjournal entry:

Dr. Cost of Goods Sold (overvalued goods) 400,000Cr. Inventory 400,000

– What would this entry do? Cause COGS to be 400K lowerin following year• Sometimes this practice is called the “cookie jar”

– What if projected net income in 2005 was $800,000 (beforethis journal entry was made)?

How to Cheat with Conservatism

Scumbag Corp. pays a bonus to the CFO of $10,000 ifthe company earns net income over $1 million in anygiven year.– Draft f/s for 2004 show net income of $1.5 million dollars– However, the CFO argues that slowing sales indicate that

inventory may be overvalued, and advocates the followingjournal entry:

Dr. Cost of Goods Sold (overvalued goods) 400,000Cr. Inventory 400,000

– What would this entry do? Cause COGS to be 400K lowerin following year• Sometimes this practice is called the “cookie jar”

– What if projected net income in 2005 was $800,000 (beforethis journal entry was made)?



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AssetsLiabilitiesEquityInvestment by OwnersDistributions to OwnersComprehensive IncomeRevenuesExpensesGainsLosses

AssetLiabilitiesEquity

IncomeExpensesCapital Maintenance• result from revaluation of assets

and liabilities

IFRSUS GAAP

Level 2:Level 2:Elements of Financial StatementsElements of Financial Statements

AssetsLiabilitiesEquityInvestment by OwnersDistributions to OwnersComprehensive IncomeRevenuesExpensesGainsLosses

AssetLiabilitiesEquity

IncomeExpensesCapital Maintenance• result from revaluation of assets

and liabilities



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(a) Arises from peripheral or incidentaltransactions.

(b) Obligation to transfer resourcesarising from a past transaction.

(c) Increases ownership interest.(d) Declares and pays cash dividends

to owners.(e) Increases in net assets in a period

from nonowner sources.(f) Items characterized by future

economic benefit.(g) Equals increase in net assets

during the year, after addingdistributions to owners andsubtracting investments byowners.

(h) Arises from income statementactivities that constitute theentity’s ongoing major orcentral operations.

(i) Residual interest in the netassets of the enterprise.

(j) Increases assets through saleof product.

(k) Decreases assets by purchasingthe company’s own stock.

(l) Changes in equity during theperiod, except those frominvestments by owners anddistributions to owners.

Element DefinitionsElement Definitions

(a) Arises from peripheral or incidentaltransactions.

(b) Obligation to transfer resourcesarising from a past transaction.

(c) Increases ownership interest.(d) Declares and pays cash dividends

to owners.(e) Increases in net assets in a period

from nonowner sources.(f) Items characterized by future

economic benefit.(g) Equals increase in net assets

during the year, after addingdistributions to owners andsubtracting investments byowners.

(h) Arises from income statementactivities that constitute theentity’s ongoing major orcentral operations.

(i) Residual interest in the netassets of the enterprise.

(j) Increases assets through saleof product.

(k) Decreases assets by purchasingthe company’s own stock.

(l) Changes in equity during theperiod, except those frominvestments by owners anddistributions to owners.



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Assumptions• Economic Entity• Going concern• Monetary Unit• PeriodicityPrinciples• Measurement

– Historical Cost– Fair value

• Revenue Recognition• Expense Recognition• Full disclosure

Underlying Assumptions• Accrual Basis• Going concern

Principles• Measurement

– Historical cost– Current cost– Realizable value– Fair value


IFRSUS GAAP

Level 3: Basic Assumptions,Level 3: Basic Assumptions,PrinciplesPrinciples

Assumptions• Economic Entity• Going concern• Monetary Unit• PeriodicityPrinciples• Measurement

– Historical Cost– Fair value


Underlying Assumptions• Accrual Basis• Going concern

Principles• Measurement

– Historical cost– Current cost– Realizable value– Fair value




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Measurement: Consider this example under USGAAP and IFRS.

If a firm bought land in 1950 for $10K and still ownedit in 2009, would it appear on the 2009 financialstatements at $10K even if it is now worth $1 million?

How is your answer justified by the conceptualframework?

Level 3:Level 3:PrinciplesPrinciples

Measurement: Consider this example under USGAAP and IFRS.

If a firm bought land in 1950 for $10K and still ownedit in 2009, would it appear on the 2009 financialstatements at $10K even if it is now worth $1 million?

How is your answer justified by the conceptualframework?



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Revenue Recognition – Criteria Earned – seller substantially completed what it must do to be

entitled to keep resources received from the transaction. Realized or realizable –buyer provided resources or resources

to be received are readily convertible to some other asset.

Revenue is generally at the point of sale. Exceptions:(1) During production – long term construction contracts (%

Completion Method)(2) End of production – when ready market at quoted price exists

(mining and agriculture)(3) Upon receipt of cash – when collections uncertain at time of sale

(Installment sales method)


Revenue Recognition – Criteria Earned – seller substantially completed what it must do to be

entitled to keep resources received from the transaction. Realized or realizable –buyer provided resources or resources

to be received are readily convertible to some other asset.

Revenue is generally at the point of sale. Exceptions:(1) During production – long term construction contracts (%

Completion Method)(2) End of production – when ready market at quoted price exists

(mining and agriculture)(3) Upon receipt of cash – when collections uncertain at time of sale

(Installment sales method)



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Matching Idea: Record expense in same period as the

revenue it helped generate.

To do: Determine revenue recognition

Choices to match expenses Direct (COGS)

Rational allocation (rent)

Immediate


Matching Idea: Record expense in same period as the

revenue it helped generate.

To do: Determine revenue recognition

Choices to match expenses Direct (COGS)

Rational allocation (rent)

Immediate



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Full Disclosure –Nature and amount ofinformation included in financial reportsreflects a series of judgmental trade-offs(between providing sufficient detail andkeeping information understandable).

Financial statements

Notes to financial statements

Supplementary information


Full Disclosure –Nature and amount ofinformation included in financial reportsreflects a series of judgmental trade-offs(between providing sufficient detail andkeeping information understandable).

Financial statements

Notes to financial statements

Supplementary information



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Level 3 PrinciplesLevel 3 Principles -- Full DisclosureFull Disclosure



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Readings: “Study Pursuant to Section 108(d) of the Sarbanes-Oxley

Act of 2002 on…Principles-Based Accounting System” Kapnick (1974) and Wyatt (2004)

Questions: What is meant by principles vs. rules based accounting?

Why did Congress want this examined?

What are the benefits and concerns with principles basedaccounting?

Are judgment and professional ethics more or lessimportant under principles based accounting?

Professional Ethics and PrinciplesProfessional Ethics and PrinciplesBased AccountingBased Accounting

Readings: “Study Pursuant to Section 108(d) of the Sarbanes-Oxley

Act of 2002 on…Principles-Based Accounting System” Kapnick (1974) and Wyatt (2004)

Questions: What is meant by principles vs. rules based accounting?

Why did Congress want this examined?

What are the benefits and concerns with principles basedaccounting?

Are judgment and professional ethics more or lessimportant under principles based accounting?



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Basic activities of businesses:• Financial activities – acquire capital (from investors and

creditors)

• Investing activities – invest in productive resources (i.e.equipment)

• Operating activities – generate wealth (i.e. manufacture andsell television sets)

Chapter 3Chapter 3Overview of Financial StatementsOverview of Financial Statements

Basic activities of businesses:• Financial activities – acquire capital (from investors and

creditors)

• Investing activities – invest in productive resources (i.e.equipment)

• Operating activities – generate wealth (i.e. manufacture andsell television sets)



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Balance Sheet

Asset

Liability

Owners’ Equity

Overview of Financial StatementsOverview of Financial Statements

Balance Sheet

Asset

Liability

Owners’ Equity



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Income Statement

Net income =

Revenue:

Expense:

Gain:

Loss


Income Statement

Net income =

Revenue:

Expense:

Gain:

Loss



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Statement of Cash flows

Net cash flows

Operating

Investing

Financing


Statement of Cash flows

Net cash flows

Operating

Investing

Financing



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How do the B/S and I/S fit together?• Called “Articulation”• Assets = Liabilities + Owners’ Equity


How do the B/S and I/S fit together?• Called “Articulation”• Assets = Liabilities + Owners’ Equity



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The Accounting Cycle:

During the period:

1. Analyze and record transactions

At the end of the period:

2. Adjusting entries and Adjusted Trial Balance

3. Closing entries

Review of the MechanicsReview of the Mechanics

The Accounting Cycle:

During the period:

1. Analyze and record transactions

At the end of the period:

2. Adjusting entries and Adjusted Trial Balance

3. Closing entries



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Asset

Debit

Liability Equity

Credit Credit

The Account and the DebitThe Account and the Debit--CreditCreditConventionConvention

Expense

Debit

Revenue

Credit

Normal balance in account



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TYPE OFACCOUNT

IMPACT OFDEBITINGACCOUNT

IMPACT OFCREDITINGACCOUNT

ASSET

LIABILITY

Review of the MechanicsReview of the Mechanics

LIABILITY

EQUITY

REVENUE

EXPENSE

DIVIDEND

GAIN

LOSS



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The T-Account

A T-Account can help you simplify and solveseemingly complex problems– Put in what you know

• If there only one unknown, you can solve for it• If there are multiple unknowns, you can recognize where you

need more information

– Example:• Given:

– 12/31/07 balance in supplies inventory: $700 DR.– Supplies expense for y/e 12/31/07: $950 DR– $850 of supplies were purchased during the year ended 12/31/07

• Question: What is the balance in supplies inventory on 1/1/07?

A T-Account can help you simplify and solveseemingly complex problems– Put in what you know

• If there only one unknown, you can solve for it• If there are multiple unknowns, you can recognize where you

need more information

– Example:• Given:

– 12/31/07 balance in supplies inventory: $700 DR.– Supplies expense for y/e 12/31/07: $950 DR– $850 of supplies were purchased during the year ended 12/31/07

• Question: What is the balance in supplies inventory on 1/1/07?



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Accrual Accounting

Accrual accounting provides a better basis for predicting futurecash flows than does cash flow accounting.

Cash flow accounting reports cash receipts and disbursements asthey occur.

Accrual accounting reports on effects of events that ultimatelyhave cash effects.– Focuses on economically meaningful event (revenue recognition)– Matches outflows with the inflows they help to generate (expense

recognition)

Accrual accounting provides a better basis for predicting futurecash flows than does cash flow accounting.

Cash flow accounting reports cash receipts and disbursements asthey occur.

Accrual accounting reports on effects of events that ultimatelyhave cash effects.– Focuses on economically meaningful event (revenue recognition)– Matches outflows with the inflows they help to generate (expense

recognition)



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Revenue and Expense Recognition

Revenues are recognized when they are both:– Earned – business has substantially accomplished what it must do to be

entitled to the benefits represented by the revenue.

– Realized – business has received cash or claim to cash (can estimatehow much the business will ultimately receive).

Expenses are recognized according to one of the followingpractices:– Direct - match expense to the specific revenue it helps generate

– Systematic and rational – match expense to periods in which it helps togenerate revenue

– Immediate – expense in period the cost is incurred

Revenues are recognized when they are both:– Earned – business has substantially accomplished what it must do to be

entitled to the benefits represented by the revenue.

– Realized – business has received cash or claim to cash (can estimatehow much the business will ultimately receive).

Expenses are recognized according to one of the followingpractices:– Direct - match expense to the specific revenue it helps generate

– Systematic and rational – match expense to periods in which it helps togenerate revenue

– Immediate – expense in period the cost is incurred



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Adjusting Entries are required for:Recognizing revenue for the period.

Matching expenses with revenues they helped generate.

Adjusting entries are required every time financial statements are prepared tocomply with GAAP

What to record:Events not journalized during period (e.g. consumption of supplies)

Costs that expire with passage of time (e.g. rent, insurance, buildingdeterioration)

Any unrecorded items (e.g. wages earned in current period but not paid untilnext period)

Adjusting EntriesAdjusting Entries

Adjusting Entries are required for:Recognizing revenue for the period.

Matching expenses with revenues they helped generate.

Adjusting entries are required every time financial statements are prepared tocomply with GAAP

What to record:Events not journalized during period (e.g. consumption of supplies)

Costs that expire with passage of time (e.g. rent, insurance, buildingdeterioration)

Any unrecorded items (e.g. wages earned in current period but not paid untilnext period)



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Prepayments (deferrals):– Prepaid expenses – the cash flow precedes the expense recognition (i.e.,

prepaid rent)– Unearned revenue – the cash flow precedes the revenue recognition (i.e.

unearned rent revenue)Accruals:

– Accrued expense – the expense recognition precedes the cash flow (i.e.interest payable)

– Accrued revenue – the revenue recognition precedes the cash flow (i.e.interest receivable)

Estimated items:– Accounts are updated based on subjective estimates as of the end of the

period (i.e., bad debt expense, depreciation expense).Periodic inventory:

– Inventory-related accounts (i.e. inventory, cost of goods sold) are adjustedbased on an end of period physical count).

Types of Adjusting EntriesTypes of Adjusting Entries

Prepayments (deferrals):– Prepaid expenses – the cash flow precedes the expense recognition (i.e.,

prepaid rent)– Unearned revenue – the cash flow precedes the revenue recognition (i.e.

unearned rent revenue)Accruals:

– Accrued expense – the expense recognition precedes the cash flow (i.e.interest payable)

– Accrued revenue – the revenue recognition precedes the cash flow (i.e.interest receivable)

Estimated items:– Accounts are updated based on subjective estimates as of the end of the

period (i.e., bad debt expense, depreciation expense).Periodic inventory:

– Inventory-related accounts (i.e. inventory, cost of goods sold) are adjustedbased on an end of period physical count).



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AdjustingPrepayments for

Expenses

RecordingAccrued Expense

Adjusting Entries: MatchingAdjusting Entries: MatchingExpensesExpenses

AdjustingPrepayments for

Expenses

RecordingAccrued Expense

Prepayments made incash and recorded

as assets(cash precedes

expense)

Expense incurredbut not yet

recordedin books

(expense precedes cash)



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Example:

On December 1, 2007, a firm paid its landlord $9,000 forrent for the following 12 months. The payment wasrecorded by debiting “Prepaid Rent” and crediting“Cash”. What adjusting entry will be necessary onDecember 31?

Adjusting EntriesAdjusting Entries –– Prepaid AssetPrepaid Asset

Example:

On December 1, 2007, a firm paid its landlord $9,000 forrent for the following 12 months. The payment wasrecorded by debiting “Prepaid Rent” and crediting“Cash”. What adjusting entry will be necessary onDecember 31?



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Adjusting Entry:

Debit Credit

Rent Expense $750Prepaid Rent $750

If no adjusting entry is made, will

•Assets be under or overstated on the Dec. 31 Balance Sheet?

•Rent Expense be under or overstated on the Income Statement?

•NI be under or overstated on the Income Statement?

•OE be under or overstated on the Balance Sheet?

Adjusting EntriesAdjusting Entries –– Prepaid AssetPrepaid Asset

Adjusting Entry:

Debit Credit

Rent Expense $750Prepaid Rent $750

If no adjusting entry is made, will

•Assets be under or overstated on the Dec. 31 Balance Sheet?

•Rent Expense be under or overstated on the Income Statement?

•NI be under or overstated on the Income Statement?

•OE be under or overstated on the Balance Sheet?



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Example of Prepaid Adjustment• You pay a property tax assessment of $6,000 on

December 1, 2005, to cover the period from December 1,2005 to May 31, 2006. What is the adjusting entryneeded for December 31? Two scenarios:(1) you recorded the December 1 payment as a prepaid asset, and

(2) you recorded the December 1 payment as an expense– Note that a time line can be very useful in organizing data on

these types of questions

• You pay a property tax assessment of $6,000 onDecember 1, 2005, to cover the period from December 1,2005 to May 31, 2006. What is the adjusting entryneeded for December 31? Two scenarios:(1) you recorded the December 1 payment as a prepaid asset, and

(2) you recorded the December 1 payment as an expense– Note that a time line can be very useful in organizing data on

these types of questions



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Example of Accrued Expense

• On January 15, 2006, you receive an invoice for$8,000 for copier maintenance for the last quarterof 2005. Is any entry needed on the books atDecember 31, 2005?

• On January 15, 2006, you receive an invoice for$8,000 for copier maintenance for the last quarterof 2005. Is any entry needed on the books atDecember 31, 2005?



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Example:

A firm purchases $1,000 of supplies on July 14 (therewere 0 supplies on hand at that time). On December 31,an end of the year count indicates that the firm has $328of these supplies remaining.

1. What is the required adjusting entry if the firm recorded theinitial acquisition of supplies by debiting “Supplies Inventory”?

2.What is the required adjusting entry is the firm recorded theinitial acquisition by debiting “Supplies Expense”?

Adjusting EntriesAdjusting Entries –– SuppliesSuppliesExpenseExpense

Example:

A firm purchases $1,000 of supplies on July 14 (therewere 0 supplies on hand at that time). On December 31,an end of the year count indicates that the firm has $328of these supplies remaining.

1. What is the required adjusting entry if the firm recorded theinitial acquisition of supplies by debiting “Supplies Inventory”?

2.What is the required adjusting entry is the firm recorded theinitial acquisition by debiting “Supplies Expense”?



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Adjusting Entry – Case 1:

Debit Credit

Supplies Expense $672Supplies $672

* If no adjusting entry is made, Assets will be overstatedon the Dec. 31 Balance Sheet and Supplies Expense willbe understated on the Income Statement (NI will beoverstated).



Debit Credit

Supplies Expense $672Supplies $672

* If no adjusting entry is made, Assets will be overstatedon the Dec. 31 Balance Sheet and Supplies Expense willbe understated on the Income Statement (NI will beoverstated).



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Debit Credit

Supplies $328Supplies Expense $328

* If no adjusting entry is made, Assets will beunderstated on the Dec. 31 Balance Sheet and SuppliesExpense will be overstated on the Income Statement (NIwill be understated).



Debit Credit

Supplies $328Supplies Expense $328

* If no adjusting entry is made, Assets will beunderstated on the Dec. 31 Balance Sheet and SuppliesExpense will be overstated on the Income Statement (NIwill be understated).



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AdjustingUnearned Revenue

RecordingAccrued Revenue

Adjusting Entries: RecognizingAdjusting Entries: RecognizingRevenueRevenue

“Revenues” receivedin cash

andrecorded as liabilities

(cash received beforerevenue earned)

Revenues earnedbut not yet

recordedin books

(revenue earned beforecash received)



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Example – Adjusting Entry - Unearned Revenue

On Oct 31, 2006, you receive a $12,000 payment forrent from November 1, 2006 to October 31,2007. Your fiscal y/e is December 31.

– Consider two possibilities:(1) Initial entry on Oct 31 debits cash, credits unearned

rent revenue(2) Initial entry debits cash, credits rent revenue

On Oct 31, 2006, you receive a $12,000 payment forrent from November 1, 2006 to October 31,2007. Your fiscal y/e is December 31.

– Consider two possibilities:(1) Initial entry on Oct 31 debits cash, credits unearned

rent revenue(2) Initial entry debits cash, credits rent revenue



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Example – Accrued Revenue

Rent is due to you on December 31, 2006 for the2006 year, but the deadline is missed by theclient. He pays you on $12,000 on January 15,2007. What is the appropriate adjusting entry onDecember 31?(Assume that you have not made any entries to

record accrued rental revenue for 2006)

Rent is due to you on December 31, 2006 for the2006 year, but the deadline is missed by theclient. He pays you on $12,000 on January 15,2007. What is the appropriate adjusting entry onDecember 31?(Assume that you have not made any entries to

record accrued rental revenue for 2006)



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After all adjusting entries have been made, a firm willgenerally prepare a report called an “Adjusted TrialBalance”.

A trial balance is list of all accounts of a firm and theirbalances, which will be used to prepare the financialstatements.

The sum of the debit balances must equal the sum ofthe credit balances.

Adjusted Trial BalanceAdjusted Trial Balance

After all adjusting entries have been made, a firm willgenerally prepare a report called an “Adjusted TrialBalance”.

A trial balance is list of all accounts of a firm and theirbalances, which will be used to prepare the financialstatements.

The sum of the debit balances must equal the sum ofthe credit balances.



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Closing Entries are used to:

Update the R/E account

To reset all temporary accounts (i.e. Revenue, Expense,Dividend, Gain, and Loss accounts) to zero to start thenext accounting period.

Closing EntriesClosing Entries

Closing Entries are used to:

Update the R/E account

To reset all temporary accounts (i.e. Revenue, Expense,Dividend, Gain, and Loss accounts) to zero to start thenext accounting period.



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1. Debit each Revenue and Gain account in the amountof the balance. Credit a temporary account called“Income Summary” or “R/E” for the same amount.

2. Credit each Expense and Loss account in the amountof the balance. Debit “Income Summary” or “R/E”for the same amount.

3. If “Income Summary” account is used, close it to“R/E”.

4. Credit “Dividends” account by the amount of itsbalance. Debit “R/E” for the same amount.

Closing EntriesClosing Entries

1. Debit each Revenue and Gain account in the amountof the balance. Credit a temporary account called“Income Summary” or “R/E” for the same amount.

2. Credit each Expense and Loss account in the amountof the balance. Debit “Income Summary” or “R/E”for the same amount.

3. If “Income Summary” account is used, close it to“R/E”.

4. Credit “Dividends” account by the amount of itsbalance. Debit “R/E” for the same amount.



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Closing Journal EntriesDr. All Revenue AccountsCr. All Expense Accounts

Dr/Cr. Income Summary (plug to balance)

[Assuming net income is positive]:Dr. Income SummaryCr. Retained Earnings

Dr. Retained EarningsCr. Dividends

Dr. All Revenue AccountsCr. All Expense Accounts

Dr/Cr. Income Summary (plug to balance)

[Assuming net income is positive]:Dr. Income SummaryCr. Retained Earnings

Dr. Retained EarningsCr. Dividends



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• Cash Basis accounting equates expenditures(when cash moves) with expenses (I/Srecognition of a decrease in resources)– So under cash basis:

• no cash moves, no recognition• Cash moves, recognition

– Violates matching, plus you get a lot ofsurprises because you have no record ofupcoming payables

Cash Basis vs. Accrual BasisCash Basis vs. Accrual Basis

• Cash Basis accounting equates expenditures(when cash moves) with expenses (I/Srecognition of a decrease in resources)– So under cash basis:

• no cash moves, no recognition• Cash moves, recognition

– Violates matching, plus you get a lot ofsurprises because you have no record ofupcoming payables



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• Cash to accrual basis conversion:– The A/R account has a balance on 12/31/2000

of $100, and on 12/31/2001 of $25. Cashreceipts for the year ending on 12/31/2001 are$500.

– What is the accrual basis revenue for the year?

Cash Basis vs. Accrual BasisCash Basis vs. Accrual Basis

• Cash to accrual basis conversion:– The A/R account has a balance on 12/31/2000

of $100, and on 12/31/2001 of $25. Cashreceipts for the year ending on 12/31/2001 are$500.

– What is the accrual basis revenue for the year?



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Today Monday 1/24 Finish Ch 4, 17, 21 DQ Levitt and Brennan

Wed 1/26 Quiz #2 on P&L (no scantron needed) Chapter 5 B/S and SCF

AgendaAgenda

Today Monday 1/24 Finish Ch 4, 17, 21 DQ Levitt and Brennan

Wed 1/26 Quiz #2 on P&L (no scantron needed) Chapter 5 B/S and SCF



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Lists the following for a firm over a period of time:Ongoing Activities

Revenues Expenses

Incidental or Peripheral Activities: Gains Losses

The excess of revenues and gains over expenses and losses isequal to net income for the period.US GAAP vs. IFRS:

IFRS requires at least one year of comparative data on incomestatement (IAS 7)US GAAP has no specific requirement (however, SEC rules requirefirms to report 3 years of income statement data)

Chapter 4Chapter 4The Income StatementThe Income Statement

Lists the following for a firm over a period of time:Ongoing Activities

Revenues Expenses

Incidental or Peripheral Activities: Gains Losses

The excess of revenues and gains over expenses and losses isequal to net income for the period.US GAAP vs. IFRS:

IFRS requires at least one year of comparative data on incomestatement (IAS 7)US GAAP has no specific requirement (however, SEC rules requirefirms to report 3 years of income statement data)



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Evaluate past performance of a company

Feedback value

Provide a basis for predicting future performance

Predictive value

Assist in assessing the risk or uncertainty of future cashflows

Predictive value

Usefulness of theUsefulness of theIncome StatementIncome Statement

Evaluate past performance of a company

Feedback value

Provide a basis for predicting future performance

Predictive value

Assist in assessing the risk or uncertainty of future cashflows

Predictive value



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Does not report items that cannot be measured reliablyExamples of excluded items?

Reported income is a function of the accounting choicesmade

Examples of accounting choices?

Managers exercise judgment in measuring income – canlead to earnings management:

Managers timing reporting of revenues, expenses, gains and losses tomeet their incentives

Generally increase current NI which decreases future NI

Can also be used to decrease current NI in order to increase future NI

Limitations of the Income StatementLimitations of the Income Statement

Does not report items that cannot be measured reliablyExamples of excluded items?

Reported income is a function of the accounting choicesmade

Examples of accounting choices?

Managers exercise judgment in measuring income – canlead to earnings management:

Managers timing reporting of revenues, expenses, gains and losses tomeet their incentives

Generally increase current NI which decreases future NI

Can also be used to decrease current NI in order to increase future NI



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Examples:

Dell

Enron

Worldcom

The Income StatementThe Income Statement ––Earnings ManagementEarnings Management

Examples:

Dell

Enron

Worldcom



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The single-step statementconsists of just twogroupings:

Income Statement (in thousands)Revenues:

Sales 285,000$Interest revenue 17,000

Total revenue 302,000Expenses:

Cost of goods sold 149,000Advertising expense 10,000Depreciation expense 43,000Interest expense 21,000Income tax expense 24,000

Total expenses 247,000Net income 55,000$

Earnings per share 0.75$

RevenuesExpenses

Net Income

SingleSingle--StepStep


SingleSingle--Step Income StatementStep Income Statement

Income Statement (in thousands)Revenues:

Sales 285,000$Interest revenue 17,000

Total revenue 302,000Expenses:

Cost of goods sold 149,000Advertising expense 10,000Depreciation expense 43,000Interest expense 21,000Income tax expense 24,000

Total expenses 247,000Net income 55,000$


RevenuesExpenses

Net Income



No distinction betweenOperating and Non-operatingcategories.



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The presentationdivides informationinto major sections.

The presentationdivides informationinto major sections.

Income Statement (in thousands)Sales 285,000$Cost of goods sold 149,000

Gross profit 136,000Operating expenses:

Advertising expense 10,000Depreciation expense 43,000

Total operating expense 53,000Income from operations 83,000Other revenue (expense):

Interest revenue 17,000Interest expense (21,000)

Total other (4,000)Income before taxes 79,000Income tax expense 24,000Net income 55,000$


1. Operating Section1. Operating Section

MultiMulti--Step Income StatementStep Income Statement


Gross profit 136,000Operating expenses:

Advertising expense 10,000Depreciation expense 43,000

Total operating expense 53,000Income from operations 83,000Other revenue (expense):

Interest revenue 17,000Interest expense (21,000)

Total other (4,000)Income before taxes 79,000Income tax expense 24,000Net income 55,000$


1. Operating Section1. Operating Section

2. NonoperatingSection

2. NonoperatingSection

3. Income tax3. Income tax



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Operating Section:• Contains information about the operating activity of a business• Used as basis for extrapolating into the future• May include unusual gains and losses

Non-operating Section:• Interest expense and revenue• Other gains and losses• May include unusual gains and losses

Income Tax Section:

Irregular Items Section: presented “Net of Tax”• Discontinued operations• Extraordinary items• Net of tax

MultiMulti--Step Income Statement PresentationStep Income Statement PresentationOperating Section:• Contains information about the operating activity of a business• Used as basis for extrapolating into the future• May include unusual gains and losses

Non-operating Section:• Interest expense and revenue• Other gains and losses• May include unusual gains and losses

Income Tax Section:

Irregular Items Section: presented “Net of Tax”• Discontinued operations• Extraordinary items• Net of tax



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Interest expense (21,000)Total other (4,000)

Income before taxes 79,000Income tax expense 24,000Income from continuing operations 55,000Discontinued operations:Loss from operations, net of tax 315Loss on disposal, net of tax 189

Total loss on discontinued operations 504Income before extraordinary item 54,496Extraordinary loss, net of tax 539Net income 53,957$


Reporting when bothDiscontinued Operations

andExtraordinary Items

are present.

Irregular ItemsIrregular Items

Interest expense (21,000)Total other (4,000)

Income before taxes 79,000Income tax expense 24,000Income from continuing operations 55,000Discontinued operations:Loss from operations, net of tax 315Loss on disposal, net of tax 189

Total loss on discontinued operations 504Income before extraordinary item 54,496Extraordinary loss, net of tax 539Net income 53,957$

Reporting when bothDiscontinued Operations

andExtraordinary Items

are present.

DiscontinuedOperations

(specify $ or % of tax)

DiscontinuedOperations

(specify $ or % of tax)

Extraordinary Item(specify $ or % of tax)

Extraordinary Item(specify $ or % of tax)



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Basic criteria (SFAS 144):

1. Results of operations and cash flows of a component of acompany have been (or will be) eliminated from ongoingoperations *

2. No significant continuing involvement in that component afterdisposal transaction *

Two important dates in reporting discontinued operations:•Measurement date (when management commits itself to a planof segment’s disposal)•Disposal date (the date of sale of the segment).

• The time between the measurement date and the disposaldate is often called the phase-out period

Reporting Irregular Items:Reporting Irregular Items:Discontinued OperationsDiscontinued Operations

Basic criteria (SFAS 144):

1. Results of operations and cash flows of a component of acompany have been (or will be) eliminated from ongoingoperations *

2. No significant continuing involvement in that component afterdisposal transaction *

Two important dates in reporting discontinued operations:•Measurement date (when management commits itself to a planof segment’s disposal)•Disposal date (the date of sale of the segment).

• The time between the measurement date and the disposaldate is often called the phase-out period



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Presentation:

1. Writedown of assets to “fair value less costs to sell” if lessthan carrying value. No “write-up” recorded if fair valuegreater than carrying value.

2. Results of operations for both current and prior periods arerequired to be reported as part of discontinued operations.

Both items are reported “net of tax” (i.e. “below the line”).Separate line item for tax expense (benefit)

Narrative – “less applicable tax expense (benefit) of $xxx” or xxx%

Refer to footnote on the face of the Income Statement

Reporting Irregular Items:Reporting Irregular Items:Discontinued OperationsDiscontinued Operations

Presentation:

1. Writedown of assets to “fair value less costs to sell” if lessthan carrying value. No “write-up” recorded if fair valuegreater than carrying value.

2. Results of operations for both current and prior periods arerequired to be reported as part of discontinued operations.

Both items are reported “net of tax” (i.e. “below the line”).Separate line item for tax expense (benefit)

Narrative – “less applicable tax expense (benefit) of $xxx” or xxx%

Refer to footnote on the face of the Income Statement



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Time Line for Discontinued OperationsTime Line for Discontinued Operations

MeasurementDate

Year-end Final DisposalYear-end

Loss fromOperations

(B)

Prior year:reclassifyinto lossfrom op.

(A)

Part of Loss onDisposition

(C)

Part of Loss onDisposition: estimate

future disposal costs andaccrue (D)

Combine actual portion (C) + estimatedportion (D) = Loss on Disposition on I/S



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Example: Albertson’s (2003)Example: Albertson’s (2003)

January 30, 2003 January 31, 2002Earnings from continuingoperations before taxes 1,405 863Income tax expense 540 367--------------------------------------- ----------------- -----------Earnings from continuing operations 865 496Discontinued operations:Operating (loss) income (50) 10Loss on disposition (379) -Tax (benefit) expense (143) 5

------------------------------------- ----------------- -----------Net (loss) earnings fromdiscontinued operations (286) 5

January 30, 2003 January 31, 2002Earnings from continuingoperations before taxes 1,405 863Income tax expense 540 367--------------------------------------- ----------------- -----------Earnings from continuing operations 865 496Discontinued operations:Operating (loss) income (50) 10Loss on disposition (379) -Tax (benefit) expense (143) 5

------------------------------------- ----------------- -----------Net (loss) earnings fromdiscontinued operations (286) 5



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1. Definition of component (IFRS 5)

US GAAP is less restrictive than IFRS definition (IFRS: areportable business or geographical segment or major componentthereof)

2. Continuing Involvement (IFRS 5)

IFRS does not address continuing involvement

3. Taxes (IFRS 5)

US GAAP requires both pre-tax and post-tax income /loss to bedisclosed on face of income statement

IFRS requires only post-tax income or loss to be disclosed

Discontinued Operations: US GAAP vs. IFRSDiscontinued Operations: US GAAP vs. IFRS

1. Definition of component (IFRS 5)

US GAAP is less restrictive than IFRS definition (IFRS: areportable business or geographical segment or major componentthereof)

2. Continuing Involvement (IFRS 5)

IFRS does not address continuing involvement

3. Taxes (IFRS 5)

US GAAP requires both pre-tax and post-tax income /loss to bedisclosed on face of income statement

IFRS requires only post-tax income or loss to be disclosed



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Extraordinary items must meet BOTH of the following criteria:1. Event/transaction must be unusual in nature.

2. Event/transaction must occur infrequently.

Items are reported “net of tax” (i.e. “below the line”).Items that are NOT Extraordinary Items under GAAP:• Losses from write-down or write-off of receivables, inventories, etc.

• Gains and losses from:

–Exchange or translation of foreign currency

–Disposal of a segment of a business

–Abandonment of property used in business

• Effects of strike

• Adjustments or accruals on long term contracts

Extraordinary Item classification not allowed under IFRS

Reporting Extraordinary ItemsReporting Extraordinary ItemsExtraordinary items must meet BOTH of the following criteria:1. Event/transaction must be unusual in nature.

2. Event/transaction must occur infrequently.

Items are reported “net of tax” (i.e. “below the line”).Items that are NOT Extraordinary Items under GAAP:• Losses from write-down or write-off of receivables, inventories, etc.

• Gains and losses from:

–Exchange or translation of foreign currency

–Disposal of a segment of a business

–Abandonment of property used in business

• Effects of strike

• Adjustments or accruals on long term contracts

Extraordinary Item classification not allowed under IFRS



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Verizon Communications:In January 2007, the Bolivarian Republic of Venezueladeclared its intent to nationalize certain companies, includingCANTV. On February 12, 2007, we entered into aMemorandum of Understanding (MOU) with the Republic.The MOU provides that the Republic will offer to purchase allof the equity securities of CANTV, including our 28.5%interest…at a price equivalent to $17.85….Based on the termsof the MOU and our current investment balance in CANTV,we recorded an extraordinary loss on our investment of $131million, net of tax, or $.05 per diluted shares, in the firstquarter of 2007.

Extraordinary Item ExampleExtraordinary Item Example

Verizon Communications:In January 2007, the Bolivarian Republic of Venezueladeclared its intent to nationalize certain companies, includingCANTV. On February 12, 2007, we entered into aMemorandum of Understanding (MOU) with the Republic.The MOU provides that the Republic will offer to purchase allof the equity securities of CANTV, including our 28.5%interest…at a price equivalent to $17.85….Based on the termsof the MOU and our current investment balance in CANTV,we recorded an extraordinary loss on our investment of $131million, net of tax, or $.05 per diluted shares, in the firstquarter of 2007.



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Unusual gains or losses:

Restructuring Charges

Gains or losses that are generally unusual or infrequent, but not both.

Do not qualify as “extraordinary” must be reported above the line in either operating or non-operating section

of the income statement.

This is an area where managers exercise discretion in presentation.

Example: AOL P&L and Note 9

http://www.sec.gov/Archives/edgar/data/1468516/000119312510045310/d10k.htm

ReportingReportingUnusual Gains or LossesUnusual Gains or Losses

Unusual gains or losses:

Restructuring Charges

Gains or losses that are generally unusual or infrequent, but not both.

Do not qualify as “extraordinary” must be reported above the line in either operating or non-operating section

of the income statement.

This is an area where managers exercise discretion in presentation.

Example: AOL P&L and Note 9

http://www.sec.gov/Archives/edgar/data/1468516/000119312510045310/d10k.htm



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Categories of Accounting Changes:

1. Change in Accounting Estimate

2. Accounting Errors in Financial Statements

3. Change in Accounting Principle

Accounting ChangesAccounting Changes

Categories of Accounting Changes:

1. Change in Accounting Estimate

2. Accounting Errors in Financial Statements

3. Change in Accounting Principle



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What possible ways can we handle these changes?

1.

2.

3.

Accounting ChangesAccounting Changes

What possible ways can we handle these changes?

1.

2.

3.



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Application of certain accounting concepts requires estimates: Matching concept requires an estimate of the life of long-lived assets

Examples: uncollectible accounts, warranty liabilities, depreciation.

Estimates updated as new information becomes available.

Reporting: Reported prospectively.

Change reported in current and future periods

No effect on prior periods

Reported in the affected accounts, NOT “below the line”

Change in Accounting EstimateChange in Accounting Estimate

Application of certain accounting concepts requires estimates: Matching concept requires an estimate of the life of long-lived assets

Examples: uncollectible accounts, warranty liabilities, depreciation.

Estimates updated as new information becomes available.

Reporting: Reported prospectively.

Change reported in current and future periods

No effect on prior periods

Reported in the affected accounts, NOT “below the line”



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Example of prospective treatment: Purchase machine on 1/1/05 for $110,000 with an estimated

useful life of 10 years and a salvage value of $10,000.

Due to technological changes in 2006, it is estimated that themachine will have zero salvage value and will only have a usefullife of 4 years beyond 2006. 2006 depreciation and beyond willbe:

Change in Accounting EstimateChange in Accounting Estimate

Example of prospective treatment: Purchase machine on 1/1/05 for $110,000 with an estimated

useful life of 10 years and a salvage value of $10,000.

Due to technological changes in 2006, it is estimated that themachine will have zero salvage value and will only have a usefullife of 4 years beyond 2006. 2006 depreciation and beyond willbe:



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Includes:

Change from an accounting principle that is not GAAP to GAAP.

Mathematical mistakes

Changes in estimate that occurs because estimates not prepared in goodfaith or facts used in error

Oversights (ex: failure to accrue or defer expenses and revenues at end ofperiod)

Reporting:

Reported retrospectively as a “restatement”

Correct error in year(s) originally made by a direct entry to the affectedline item(s). In following years the effect flows through beginning R/E. Iferror prior to years presented, just adjust beginning R/E.

Errors from previous periods do not flow through current period income.

Accounting Errors in F/SAccounting Errors in F/SIncludes:

Change from an accounting principle that is not GAAP to GAAP.

Mathematical mistakes

Changes in estimate that occurs because estimates not prepared in goodfaith or facts used in error

Oversights (ex: failure to accrue or defer expenses and revenues at end ofperiod)

Reporting:

Reported retrospectively as a “restatement”

Correct error in year(s) originally made by a direct entry to the affectedline item(s). In following years the effect flows through beginning R/E. Iferror prior to years presented, just adjust beginning R/E.

Errors from previous periods do not flow through current period income.



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Example: ABC company’s auditor found the following errors duringthe 12/31/10 audit. What is the impact of each error? AssumeABC is public.

(1) At the end of 2009, sales salaries of $45,000 were not accrued.

(2) In 2010, the company wrote off $87,000 of inventory considered to beobsolete; this loss was charged directly to Retained Earnings and credited toinventory.

(3) 2007 depreciation was understated by $100,000. Subsequent years’depreciation was correctly recorded

Accounting Errors in F/SAccounting Errors in F/SExample: ABC company’s auditor found the following errors during

the 12/31/10 audit. What is the impact of each error? AssumeABC is public.

(1) At the end of 2009, sales salaries of $45,000 were not accrued.

(2) In 2010, the company wrote off $87,000 of inventory considered to beobsolete; this loss was charged directly to Retained Earnings and credited toinventory.

(3) 2007 depreciation was understated by $100,000. Subsequent years’depreciation was correctly recorded



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Voluntary adoption of different acceptable accounting principle Common example is LIFO/FIFO/Weighted Average Inventory costing

Must demonstrate that newly adopted principle is preferable

Treat retrospectively. Need to restate prior years f/s for new method

Prior years’ statements presented in the financial statements are recast on abasis consistent with the newly adopted principle.

Adjust beginning retained earnings for the earliest year presented to reflect anycumulative effect on periods prior to those presented.

Mandated change in accounting principle Generally new standards require a retroactive approach unless it is impracticable

If impracticable or choice given to issuer, can report cumulative effect of change as aseparate net of tax line item on the Income Statement

Example stock options

Change in Accounting PrincipleChange in Accounting Principle

Voluntary adoption of different acceptable accounting principle Common example is LIFO/FIFO/Weighted Average Inventory costing

Must demonstrate that newly adopted principle is preferable

Treat retrospectively. Need to restate prior years f/s for new method

Prior years’ statements presented in the financial statements are recast on abasis consistent with the newly adopted principle.

Adjust beginning retained earnings for the earliest year presented to reflect anycumulative effect on periods prior to those presented.

Mandated change in accounting principle Generally new standards require a retroactive approach unless it is impracticable

If impracticable or choice given to issuer, can report cumulative effect of change as aseparate net of tax line item on the Income Statement

Example stock options



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Example: Mattke Co. (a non-public company) began operations in 2005 andadopted weighted average pricing for inventory. In 2008, Mattke changedto FIFO pricing. Net Income data is:

Net Income Net IncomeYear Wt’d Ave. FIFO2005 370,000 395,0002006 390,000 430,0002007 410,000 450,0002008 460,000 430,000

How is this reported? Retrospectively, prospectively, currently? Steps to report change.

1) Provide 3 years comparative P&L using restated amounts2) Provide 2 years comparative B/S using FIFO inventory value andrestated Retained Earnings3) Restate 2006 beginning Retained Earnings to reflect $25,000 higher netincome from 2005

What were the journal entries that made the above happen (ignoring taxes)?

Change in Accounting PrincipleChange in Accounting Principle

Example: Mattke Co. (a non-public company) began operations in 2005 andadopted weighted average pricing for inventory. In 2008, Mattke changedto FIFO pricing. Net Income data is:

Net Income Net IncomeYear Wt’d Ave. FIFO2005 370,000 395,0002006 390,000 430,0002007 410,000 450,0002008 460,000 430,000

How is this reported? Retrospectively, prospectively, currently? Steps to report change.

1) Provide 3 years comparative P&L using restated amounts2) Provide 2 years comparative B/S using FIFO inventory value andrestated Retained Earnings3) Restate 2006 beginning Retained Earnings to reflect $25,000 higher netincome from 2005

What were the journal entries that made the above happen (ignoring taxes)?



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• Basic EPS

• Diluted EPS

• Firms required to disclose both basic andDiluted EPS

Earnings Per ShareEarnings Per Share

• Basic EPS

• Diluted EPS

• Firms required to disclose both basic andDiluted EPS



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Computed as:

Net Income less Preferred DividendsWeighted Average of Common Shares Outstanding

Disclosed on the I/S for all the major sections:– Income from continuing operations– Discontinued operations loss, net of tax– Income before extraordinary item– Extraordinary item, net of tax– Net income


Computed as:

Net Income less Preferred DividendsWeighted Average of Common Shares Outstanding

Disclosed on the I/S for all the major sections:– Income from continuing operations– Discontinued operations loss, net of tax– Income before extraordinary item– Extraordinary item, net of tax– Net income



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Example:•Assume NI of $5K•Pfd Stk Dividends = $1K•12/31/06 year-end•Outstanding common shares as follows:

– 1/1/06: 100 shares– 4/1/06: 200 shares– 7/1/06: 250 shares

Weighted Average Calculation:


Example:•Assume NI of $5K•Pfd Stk Dividends = $1K•12/31/06 year-end•Outstanding common shares as follows:

– 1/1/06: 100 shares– 4/1/06: 200 shares– 7/1/06: 250 shares

Weighted Average Calculation:



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Example: At 12/31/06 Shi Corp. had the following stock outstanding:

10% cumulative preferred stock, $100 par, 107,500 shares $10,750,000

Common stock, $5 par, 4,000,000 shares 20,000,000

During 2007, Shi Corp. did not issue any additional common stock.The following also occurred during 2007:

Income from continuing operations before taxes $23,650,000

Discontinued operations (loss before taxes) $ 3,225,000Preferred dividends declared $ 1,075,000Common dividends declared $ 2,200,000Effective tax rate 35%

Compute EPS as it should appear on the 2007 f/s.


Example: At 12/31/06 Shi Corp. had the following stock outstanding:

10% cumulative preferred stock, $100 par, 107,500 shares $10,750,000

Common stock, $5 par, 4,000,000 shares 20,000,000

During 2007, Shi Corp. did not issue any additional common stock.The following also occurred during 2007:

Income from continuing operations before taxes $23,650,000

Discontinued operations (loss before taxes) $ 3,225,000Preferred dividends declared $ 1,075,000Common dividends declared $ 2,200,000Effective tax rate 35%

Compute EPS as it should appear on the 2007 f/s.



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• Increased by net income and decreased by net lossand dividends for the year.

• Prior period adjustments to beginning balance– Corrections of errors in prior period financial

statements

– cumulative impact of changes in accounting policy

• Any part of retained earnings appropriated for aspecific purpose is shown as restricted earnings.– So dividends can’t be paid out from restricted R/E (can

be part of a debt covenant)

Retained Earnings StatementRetained Earnings Statement

• Increased by net income and decreased by net lossand dividends for the year.

• Prior period adjustments to beginning balance– Corrections of errors in prior period financial

statements

– cumulative impact of changes in accounting policy

• Any part of retained earnings appropriated for aspecific purpose is shown as restricted earnings.– So dividends can’t be paid out from restricted R/E (can

be part of a debt covenant)



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What is comprehensive income?• All changes in equity during a period, except those

resulting from investments by or distributions to owners.

• Includes “regular” net income• PLUS “other comprehensive income”:

– unrealized holding gains or losses on securities (Ch17)

– unrealized gains or losses on foreign currency translation

– unrealized gains or losses on pension obligations

• Other items are presented “net of tax”

Comprehensive Income OverviewComprehensive Income Overview

What is comprehensive income?• All changes in equity during a period, except those

resulting from investments by or distributions to owners.

• Includes “regular” net income• PLUS “other comprehensive income”:

– unrealized holding gains or losses on securities (Ch17)

– unrealized gains or losses on foreign currency translation

– unrealized gains or losses on pension obligations

• Other items are presented “net of tax”



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• Why do companies invest in debt and equity securities?

• < 20% interest assume little or no influence over investee

• Report debt intending to hold at “held to maturity”– Record investment at amortized cost

– Record interest as income

• Report equity & other debt investment using fair value method– Mark investment to “market” on B/S.– Recognize unrealized gain or loss. Where depends upon classification

• Trading Income Statement

• Available-for-Sale Other comprehensive income

• Other issues– Can calculate gain or loss at the portfolio level

– Potential for earnings management here?

Unrealized Holding Gains/Losses onUnrealized Holding Gains/Losses onSecuritiesSecurities

• Why do companies invest in debt and equity securities?

• < 20% interest assume little or no influence over investee

• Report debt intending to hold at “held to maturity”– Record investment at amortized cost

– Record interest as income

• Report equity & other debt investment using fair value method– Mark investment to “market” on B/S.– Recognize unrealized gain or loss. Where depends upon classification

• Trading Income Statement

• Available-for-Sale Other comprehensive income

• Other issues– Can calculate gain or loss at the portfolio level

– Potential for earnings management here?



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Example: on 1/1/09 Big bought shares of Little for $100,000. Theshares were < 20% of the total outstanding stock of LittleCompany. On 12/31/09 the shares had a fair value of $125,000.Little paid dividends of $1000 to Big. How is this accounted for at1/1/09 and 12/31/09?

• If classified as Trading Securities?

• If classified as Available for Sale Securities?

Do E17-7

Unrealized Gains/LossesUnrealized Gains/LossesExample: on 1/1/09 Big bought shares of Little for $100,000. Theshares were < 20% of the total outstanding stock of LittleCompany. On 12/31/09 the shares had a fair value of $125,000.Little paid dividends of $1000 to Big. How is this accounted for at1/1/09 and 12/31/09?

• If classified as Trading Securities?

• If classified as Available for Sale Securities?

Do E17-7www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in


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Presentation of Comprehensive income• Must be displayed as:

– A separate statement of comprehensive income –OR-

– Combined income statement and comprehensive incomestatement –OR-

– Part of statement of stockholders’ equity (most companiesput it here)

– May present net of tax or before tax with a single linereporting taxes on comprehensive income

Do E4-14, E4-15

Presentation of ComprehensivePresentation of ComprehensiveIncomeIncome

Presentation of Comprehensive income• Must be displayed as:

– A separate statement of comprehensive income –OR-

– Combined income statement and comprehensive incomestatement –OR-

– Part of statement of stockholders’ equity (most companiesput it here)

– May present net of tax or before tax with a single linereporting taxes on comprehensive income

Do E4-14, E4-15



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• Announcements– TODAY is the SBA scholarship application

deadline!

• Class today– Finish Ch. 5 B/S– Ch. 5 SCF – Indirect method

• Wednesday 2/2– Finish Ch. 23 SCF – Indirect method

AgendaAgenda

• Announcements– TODAY is the SBA scholarship application

deadline!

• Class today– Finish Ch. 5 B/S– Ch. 5 SCF – Indirect method

• Wednesday 2/2– Finish Ch. 23 SCF – Indirect method



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• Addresses what is missing from the B/S and I/S• Users may want more detailed information on

cash flows– The income statement provides a measure of

operating performance over the year, but positive netincome does not necessarily mean positive cashflows

The Cash Flow StatementThe Cash Flow Statement(Chapters 5 & 23)(Chapters 5 & 23)

• Addresses what is missing from the B/S and I/S• Users may want more detailed information on

cash flows– The income statement provides a measure of

operating performance over the year, but positive netincome does not necessarily mean positive cashflows



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• What is included in “cash”?• The cash flow statement provides

information for a period of time about:– cash receipts (cash inflows)– uses of cash (cash outflows)

• Inflows and outflows are reported for:– operating– investing– financing activities– Summing to the net increase/decrease in cash over

the period

The Cash Flow StatementThe Cash Flow Statement

• What is included in “cash”?• The cash flow statement provides

information for a period of time about:– cash receipts (cash inflows)– uses of cash (cash outflows)

• Inflows and outflows are reported for:– operating– investing– financing activities– Summing to the net increase/decrease in cash over

the period



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Helps users assess:• The entity’s ability to generate future cash

flows• The entity’s ability to pay dividends and meet

obligations• The reasons as to why net income and net

cash flow from operating activities differ• Cash and non-cash investing and financing

activities during the year

Usefulness of the Statement ofUsefulness of the Statement ofCash FlowsCash Flows

Helps users assess:• The entity’s ability to generate future cash

flows• The entity’s ability to pay dividends and meet

obligations• The reasons as to why net income and net

cash flow from operating activities differ• Cash and non-cash investing and financing

activities during the year



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Cash Inflows and OutflowsCash Inflows and Outflows



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• Know where a company is in lifecycle• Focus on subtotals• Dig into “larger items”• Consider if is healthy/unhealthy given lifecycle• Examples:

– Yocream 2009 10Khttp://www.yocream.com/downloads/YoCream_10-1-09_annual_report.pdf

– Jones Soda 2008 10Khttp://www.sec.gov/Archives/edgar/data/1083522/000095013409005380/v51212e10vk.htm

How to Read a SCFsHow to Read a SCFs

• Know where a company is in lifecycle• Focus on subtotals• Dig into “larger items”• Consider if is healthy/unhealthy given lifecycle• Examples:

– Yocream 2009 10Khttp://www.yocream.com/downloads/YoCream_10-1-09_annual_report.pdf

– Jones Soda 2008 10Khttp://www.sec.gov/Archives/edgar/data/1083522/000095013409005380/v51212e10vk.htm



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Methods of preparing the statement of cashflows:

– Indirect method: derives cash flows from accrualbased statements• Used almost exclusively• Less preferred

– Direct method: derives cash flows directly for eachsource or use of cash

NOTE: Method used only affects preparation of“Cash Flows from Operations”. The other 2sections are prepared the same regardless of themethod used.

Preparing a Statement of Cash FlowsPreparing a Statement of Cash Flows

Methods of preparing the statement of cashflows:

– Indirect method: derives cash flows from accrualbased statements• Used almost exclusively• Less preferred

– Direct method: derives cash flows directly for eachsource or use of cash

NOTE: Method used only affects preparation of“Cash Flows from Operations”. The other 2sections are prepared the same regardless of themethod used.



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Accrual Based Statements Cash Flow Statement

Income Statementitems & Changes inCurrent Assets andCurrent Liabilities

Operating activities:Adjust net income for accrualsand non-cash charges to getcash flows

The Statement of Cash Flows:The Statement of Cash Flows:Indirect MethodIndirect Method

Income Statementitems & Changes inCurrent Assets andCurrent Liabilities

Operating activities:Adjust net income for accrualsand non-cash charges to getcash flows

Balance Sheet: Changes inNon-Current Assets

Investing activities:Inflows from sale of assets andOutflows from purchases ofassets

Balance Sheet: Changes inNon-Current Liabilities

andEquity

Financing activities:Inflows and outflowsfrom loan and equitytransactions



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For each event listed below, indicate whether the related cashfrom the transaction would be operating (op), investing (inv),financing (fin), or not a cash flow (not).

1. Payment on long-term debt2. Issuance of bonds at a premium3. Collection of accounts receivable4. Cash dividends declared5. Issuance of stock to acquire land6. Sale of available-for-sale securities (long-term)7. Payment of employees' wages8. Issuance of common stock for cash9. Payment of income taxes payable10. Purchase of equipment11. Purchase of treasury stock (common)12. Sale of real estate held as a long-term investment

Classification of Cash FlowsClassification of Cash FlowsFor each event listed below, indicate whether the related cashfrom the transaction would be operating (op), investing (inv),financing (fin), or not a cash flow (not).

1. Payment on long-term debt2. Issuance of bonds at a premium3. Collection of accounts receivable4. Cash dividends declared5. Issuance of stock to acquire land6. Sale of available-for-sale securities (long-term)7. Payment of employees' wages8. Issuance of common stock for cash9. Payment of income taxes payable10. Purchase of equipment11. Purchase of treasury stock (common)12. Sale of real estate held as a long-term investment



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Interest Paid:US GAAP: operating activity (cash from the associated debt is financing activity)IFRS: operating or financing activities

Interest Received:US GAAP: operating activity (cash from the related asset is investing activity)IFRS: operating or as investing activities

Dividends Paid:US GAAP: financing activity, consistent with the placement of proceeds from selling stock.IFRS: financing or operating

• Dividends Received:US GAAP: operating activities (cash from related outflows was investing activity)IFRS: financing or operating

• Tax payments/refunds:US GAAP: operating activity, regardless of whether underlying taxable income relates tooperations or not (e.g. if a firm has a taxable capital gain on the sale of equipment)

IFRS: operating unless specifically associated with financing or investing activities

SCF: Interest, Dividends and TaxesSCF: Interest, Dividends and TaxesClassificationClassification

Interest Paid:US GAAP: operating activity (cash from the associated debt is financing activity)IFRS: operating or financing activities

Interest Received:US GAAP: operating activity (cash from the related asset is investing activity)IFRS: operating or as investing activities

Dividends Paid:US GAAP: financing activity, consistent with the placement of proceeds from selling stock.IFRS: financing or operating

• Dividends Received:US GAAP: operating activities (cash from related outflows was investing activity)IFRS: financing or operating

• Tax payments/refunds:US GAAP: operating activity, regardless of whether underlying taxable income relates tooperations or not (e.g. if a firm has a taxable capital gain on the sale of equipment)

IFRS: operating unless specifically associated with financing or investing activities



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1. Label B/S line items by Operating, Investing, Financing2. Calculate changes in Operating balance sheet accounts, label

increase/decrease3. Analyze all Investing and Financing line items using T accounts and

journal entries.– Determine depreciation expense– Circle items that affect financing & investing cash flows

4. Start the operating section of Indirect statement with NI– Add back non-cash expenses (depreciation, amortization, losses)– Subtract non-cash revenues (gains)– Subtract increases in current assets– Add decreases in current assets– Add increases in current liabilities– Subtract decreases in current liabilities

5. Reconcile the net change in cash between beginning and endinginventory

SCF: Indirect Preparation GuideSCF: Indirect Preparation Guide1. Label B/S line items by Operating, Investing, Financing2. Calculate changes in Operating balance sheet accounts, label

increase/decrease3. Analyze all Investing and Financing line items using T accounts and

journal entries.– Determine depreciation expense– Circle items that affect financing & investing cash flows

4. Start the operating section of Indirect statement with NI– Add back non-cash expenses (depreciation, amortization, losses)– Subtract non-cash revenues (gains)– Subtract increases in current assets– Add decreases in current assets– Add increases in current liabilities– Subtract decreases in current liabilities

5. Reconcile the net change in cash between beginning and endinginventory



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Indirect Cash Flow Preparation:Indirect Cash Flow Preparation:Changes in Current Assets & LiabilitiesChanges in Current Assets & Liabilities

Change in Account BalanceDuring the Year

Increase DecreaseIncrease Decrease

Current Assets

CurrentLiabilities



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2005 2004N et S a les 345,000 320,000C ost o f S a les 225,000 215,000G ross M arg in 120,000 105,000

S G & A 106,000 92,000D eprec ia tion E xpense 2,000 2,000In te res t E xpense 1,800 1,080Incom e be fo re tax 10 ,200 9,920Incom e tax (30% ) 3 ,060 2,976N et incom e 7,140 6,944

O pen ing re ta ined earn ings 23,100 18,500D iv idends 2,740 2,344C los ing re ta ined earn ings 27,500 23,100

F o r th e year en d ed D ecem b er 31In co m e S tatem en t an d S tatem en t o f R eta in ed E arn in g s

Jim m y V o n J im m y S o cks In c .

2005 2004N et S a les 345,000 320,000C ost o f S a les 225,000 215,000G ross M arg in 120,000 105,000

S G & A 106,000 92,000D eprec ia tion E xpense 2,000 2,000In te res t E xpense 1,800 1,080Incom e be fo re tax 10 ,200 9,920Incom e tax (30% ) 3 ,060 2,976N et incom e 7,140 6,944

O pen ing re ta ined earn ings 23,100 18,500D iv idends 2,740 2,344C los ing re ta ined earn ings 27,500 23,100

F o r th e year en d ed D ecem b er 31In co m e S tatem en t an d S tatem en t o f R eta in ed E arn in g s

Jim m y V o n J im m y S o cks In c .



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Jimmy Von Socks SCFJimmy Von Socks SCF

Lets walk through preparing the SCF.



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SCF CommentsSCF Comments

• Non-cash transactions are not shown on the face of theSCF – but material non-cash transactions must bedisclosed (usually in the notes)– E.g. the firm trades $1M of common stock for a warehouse

• Dividends are shown under financing activities, but theseare dividends paid, not necessarily dividends declared– So if you see dividends on the R/E Statement, and dividends

payable on the B/S, you must determine what was actually paidduring the year

• Changes in ST Investments (Current Trading and AFSSecurities) are classified as Investing cash flows eventhough the underlying asset is current

• Non-cash transactions are not shown on the face of theSCF – but material non-cash transactions must bedisclosed (usually in the notes)– E.g. the firm trades $1M of common stock for a warehouse

• Dividends are shown under financing activities, but theseare dividends paid, not necessarily dividends declared– So if you see dividends on the R/E Statement, and dividends

payable on the B/S, you must determine what was actually paidduring the year

• Changes in ST Investments (Current Trading and AFSSecurities) are classified as Investing cash flows eventhough the underlying asset is current



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• Show cash inflows from revenue and cash outflows from operatingpayments

• To get from accrued revenue to cash revenue:(- increases in related current assets; + increases in related current

liabilities)

Sales+ (-) Decrease (Increase) in AR+ (-) Increase (Decrease) in Unearned revenue= Cash collected from customers

• Logic:– Net increase in AR happens when credit sales made, no cash received subtract from Sales

– Net decrease in Unearned Revenue when revenue earned but no cashreceived subtract from Sales

Direct Cash FlowDirect Cash Flow –– Operating SectionOperating Section

• Show cash inflows from revenue and cash outflows from operatingpayments

• To get from accrued revenue to cash revenue:(- increases in related current assets; + increases in related current

liabilities)

Sales+ (-) Decrease (Increase) in AR+ (-) Increase (Decrease) in Unearned revenue= Cash collected from customers

• Logic:– Net increase in AR happens when credit sales made, no cash received subtract from Sales

– Net decrease in Unearned Revenue when revenue earned but no cashreceived subtract from Sales



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To get from accrued expenses to cash expenses:(- increases in related current liabilities; + increases in related

current assets)

COGS+ (-) Decrease (Increase) in AP+ (-) Increase (Decrease) in Inventory= Cash paid to suppliers

Interest Expense+ (-) Decrease (Increase) in Interest payable= Cash paid for interest


To get from accrued expenses to cash expenses:(- increases in related current liabilities; + increases in related

current assets)

COGS+ (-) Decrease (Increase) in AP+ (-) Increase (Decrease) in Inventory= Cash paid to suppliers

Interest Expense+ (-) Decrease (Increase) in Interest payable= Cash paid for interest



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Wage Expense+ (-) Decrease (Increase) in Wage payable= Cash paid for wages

Other expense+ (-) Increase (decrease) in prepaid expenses+ (-) Decrease (increase) in Other payable= Cash paid for Other expenses

What do we do with Depreciation expense?


Wage Expense+ (-) Decrease (Increase) in Wage payable= Cash paid for wages

Other expense+ (-) Increase (decrease) in prepaid expenses+ (-) Decrease (increase) in Other payable= Cash paid for Other expenses

What do we do with Depreciation expense?



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Direct Cash Flow PreparationDirect Cash Flow Preparation –– Revenue:Revenue:Conversion of Accrual to Cash BasisConversion of Accrual to Cash Basis



Current Asset(A/R)

Subtract fromAccrual Rev

Add to AccrualRev

Current Liabilities(Unearned Rev)

Add toAccrual Rev

Subtract fromAccrual Rev



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Direct Cash Flow PreparationDirect Cash Flow Preparation –– Expense:Expense:Conversion of Accrual to Cash BasisConversion of Accrual to Cash Basis



Current Asset(ex: Prepaid Ins)

Add toAccrual Exp

Subtract fromAccrual Exp

Current Liabilities(ex: Taxes payable)

Subtract fromAccrual Exp

Add to AccrualExp



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Direct Cash FlowDirect Cash Flow ––Jimmy Von Jimmy SocksJimmy Von Jimmy Socks

Jimmy von Socks Inc.Statement of Cashflows - Direct methodFor the Year Ended 12/31/05

Cash Flows from Operations

Cash from sale of goods

Cash paid to suppliers for inventory

Cash paid for SG&A

Cash paid for interest

Cash paid for income tax

Cash paid for insurance

Net cash provided by operations $10,040

Jimmy von Socks Inc.Statement of Cashflows - Direct methodFor the Year Ended 12/31/05

Cash Flows from Operations

Cash from sale of goods

Cash paid to suppliers for inventory

Cash paid for SG&A

Cash paid for interest

Cash paid for income tax

Cash paid for insurance

Net cash provided by operations $10,040



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Direct Cash FlowDirect Cash Flow ––Peach Computer ExamplePeach Computer Example

Peach ComputersIncome Statement


Sales $305Cost of Goods Sold (185)

Gross Margin 120

Salaries Expense 41Insurance Expense 19Depreciation Expense 11Loss on sale of land 5 76Income before taxes 44Income tax expense (22)Net Income $ 22

Peach ComputersIncome Statement


Sales $305Cost of Goods Sold (185)

Gross Margin 120

Salaries Expense 41Insurance Expense 19Depreciation Expense 11Loss on sale of land 5 76Income before taxes 44Income tax expense (22)Net Income $ 22



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Direct Cash FlowDirect Cash Flow ––Peach ComputersPeach Computers

Adjustments to Non Cash EffectsDepreciation Expense $11Loss on sale of Land 5

Changes in operating assets and liabilitiesDecrease in accounts receivable 6Increase in inventory 13Decrease in Accounts Payable 8Increase in Salaries Payable 5Decrease in Prepaid Insurance 9Increase in income tax payable 20

Adjustments to Non Cash EffectsDepreciation Expense $11Loss on sale of Land 5

Changes in operating assets and liabilitiesDecrease in accounts receivable 6Increase in inventory 13Decrease in Accounts Payable 8Increase in Salaries Payable 5Decrease in Prepaid Insurance 9Increase in income tax payable 20



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• Class today– Quiz– Finish Ch. 4, Levitt, Brennan– Ch. 5 B/S

• Monday 1/31– Ch. 5 and Ch. 23 SCF

AgendaAgenda

1

• Class today– Quiz– Finish Ch. 4, Levitt, Brennan– Ch. 5 B/S

• Monday 1/31– Ch. 5 and Ch. 23 SCF



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Financial Position at a particular point in time

IFRS vs. US GAAPIFRS requires presentation of 2 years of balance sheet data

US GAAP Public companies, 2 years B/S (SEC)

Private companies, only 1 year B/S required

Generally listed in order of liquidity

Classified as “Current” or “Non-Current”.

Chapter 5, 17Chapter 5, 17Balance SheetBalance Sheet

2

Financial Position at a particular point in time

IFRS vs. US GAAPIFRS requires presentation of 2 years of balance sheet data

US GAAP Public companies, 2 years B/S (SEC)

Private companies, only 1 year B/S required

Generally listed in order of liquidity

Classified as “Current” or “Non-Current”.



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• Current Assets• Long-term

investments• Property, plant, and

equipment• Intangible assets• Other assets

Total Assets

• Current liabilities• Long-term debt• Owners’ equity

Capital stockAdditional paid-incapitalRetained earningsAccum OCILess: T-stock

Total Liab & Equity

Assets Liabilities and Equity

Balance Sheet: ClassificationBalance Sheet: Classification

3

• Current Assets• Long-term

investments• Property, plant, and

equipment• Intangible assets• Other assets

Total Assets

• Current liabilities• Long-term debt• Owners’ equity

Capital stockAdditional paid-incapitalRetained earningsAccum OCILess: T-stock

Total Liab & Equity



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The balance sheet provides information: Evaluating Capital structure – financing by creditors/investors Analyzing an enterprise’s: Profitability with rates of return (in combination with the I/S) ROE ROA

Liquidity (sufficient resources for day-to-day operations) Current Ratio/Working Capital

Solvency (ability to pay debts as they mature – more long-run) Lower solvency = higher debt

Financial flexibility (ability to respond to threats /take advantage ofopportunities)

Effectiveness in using assets employed Inventory and Receivables turnover

Balance Sheet: UsefulnessBalance Sheet: Usefulness

The balance sheet provides information: Evaluating Capital structure – financing by creditors/investors Analyzing an enterprise’s: Profitability with rates of return (in combination with the I/S) ROE ROA

Liquidity (sufficient resources for day-to-day operations) Current Ratio/Working Capital

Solvency (ability to pay debts as they mature – more long-run) Lower solvency = higher debt

Financial flexibility (ability to respond to threats /take advantage ofopportunities)

Effectiveness in using assets employed Inventory and Receivables turnover



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• Benchmarks:– Trends– Peers

• Scaling:– Ratios– Common size financial statements

• Limitations: Must compare apples to apples– Nature of accounting– Accounting choices– Economic conditions and business model differences

Financial Statement AnalysisFinancial Statement Analysis

• Benchmarks:– Trends– Peers

• Scaling:– Ratios– Common size financial statements

• Limitations: Must compare apples to apples– Nature of accounting– Accounting choices– Economic conditions and business model differences



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Type What is measured Examples

Liquidity ratiosShort-term ability topay maturingobligations

Current ratioQuick assets ratio

Types of RatiosTypes of Ratios

6

Coverage/Solvency ratios

Degree of protection forlong-term creditors andinvestors

Debt to total assetsTimes interest earned

Liquidity ratiosShort-term ability topay maturingobligations

Profitabilityratios

Degree of success orfailure for a givenperiod

Rate of return on assetsEarnings per share

Activity ratios Effectiveness in usingassets employed

Receivables turnoverInventory turnover



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Is the B/S appropriate for valuing a company?• Most assets and liabilities are stated at historical cost.

• Judgments and estimates are used in determining many ofthe items.

• The balance sheet does not report items that can not beobjectively determined.

• It does not report information regarding certain off-balancesheet financing.

Balance Sheet: LimitationsBalance Sheet: Limitations

7

Is the B/S appropriate for valuing a company?• Most assets and liabilities are stated at historical cost.

• Judgments and estimates are used in determining many ofthe items.

• The balance sheet does not report items that can not beobjectively determined.

• It does not report information regarding certain off-balancesheet financing.



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Balance SheetBalance Sheet –– Current AssetsCurrent Assets

Asset Category General Valuation Rule

Cash & CashEquivalents

Fair Market value

Accounts Receivable Net realizable value

8

Accounts Receivable Net realizable value

Inventory Lower of cost or market (cost measuredusing a variety of methods)

Prepaid Expenses Historical cost

MarketableSecurities/Investments

Fair Market value



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Investments of < 20%Investments of < 20%Held-to-maturity:

– Record debt securities at cost and don’t revalue“Fair value” or “Mark to Market”

– Trading:

• Debt & equities intended to sell.

• Revalue annually to Fair Value in B/S. Unrealizedholding gains and losses in income

– Available for Sale:• All others.

• Revalue annually to Fair Value in B/S. Unrealizedholding gains and losses in OCI and equity (AOCI)

9

Held-to-maturity:– Record debt securities at cost and don’t revalue

“Fair value” or “Mark to Market”– Trading:

• Debt & equities intended to sell.

• Revalue annually to Fair Value in B/S. Unrealizedholding gains and losses in income

– Available for Sale:• All others.

• Revalue annually to Fair Value in B/S. Unrealizedholding gains and losses in OCI and equity (AOCI)



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Investments of < 20%Investments of < 20%Issues with Fair Value Method• How is “fair value” determined?

– Level 1: active market

– Level 2: observable market data other than quoted marketprice

– Level 3: determined only through “unobservable inputs”and prices based on internal models or estimates

• Classification of Trading vs. AFS

• Dividends received:– DR Cash CR Dividend Income

10

Issues with Fair Value Method• How is “fair value” determined?

– Level 1: active market

– Level 2: observable market data other than quoted marketprice

– Level 3: determined only through “unobservable inputs”and prices based on internal models or estimates

• Classification of Trading vs. AFS

• Dividends received:– DR Cash CR Dividend Income



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Balance SheetBalance Sheet –– Non Current AssetsNon Current Assets

Asset Category General Valuation Rule

Property, Plant, &Equipment

Historical cost less accumulateddepreciation

Land Historical cost, no depreciation

11

Land Historical cost, no depreciation

Long-term Investments Historical cost, Market value, Equitymethod

Deferred Income TaxAsset

Undiscounted sum of expected future taxbenefits

Intangible Assets Acquisition cost less amortization ifacquired from external parties (usuallyzero if developed internally)



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LiabilitiesLiabilities

Balance Sheet (in thousands)Current liabilities

Notes payable 233,450$Accounts payable 131,800Accrued compensation 43,000Unearned revenue 17,000Income tax payable 23,400Current maturities LT debt 121,000

Total current liabilities 569,650Long-term liabilities

Long-term debt 979,500Obligations capital lease 345,800Deferred income taxes 77,909

Total long-term liabilities 2,093,859Stockholders' equity

Balance Sheet (in thousands)Current liabilities

Notes payable 233,450$Accounts payable 131,800Accrued compensation 43,000Unearned revenue 17,000Income tax payable 23,400Current maturities LT debt 121,000

Total current liabilities 569,650Long-term liabilities

Long-term debt 979,500Obligations capital lease 345,800Deferred income taxes 77,909

Total long-term liabilities 2,093,859Stockholders' equity



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• Short-term obligations:– Accounts payable, accrued liabilities (examples?)

– Current portion of long-term debt

• Long-term obligations:– obligations arising from specific financing situations

(issuance of bonds, bank debt)

– obligations arising from ordinary business operations(pension obligations)

– obligations that are contingent (product warranties forlong-term items)

LiabilitiesLiabilities

• Short-term obligations:– Accounts payable, accrued liabilities (examples?)

– Current portion of long-term debt

• Long-term obligations:– obligations arising from specific financing situations

(issuance of bonds, bank debt)

– obligations arising from ordinary business operations(pension obligations)

– obligations that are contingent (product warranties forlong-term items)



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• Book N/I ≠ Tax N/I• Deferred Tax Liability and Asset accounts

reconcile difference

• Example: Assume 34% effective tax rateBook Tax

Revenue $500,000 $500,000

Expense (300,000) (350,000)

NIBT 200,000 150,000

Tax exp ( 68,000) (51,000)

NI $132,000 $ 99,000

Deferred Tax Liabilities (and Assets)Deferred Tax Liabilities (and Assets)

14

• Book N/I ≠ Tax N/I• Deferred Tax Liability and Asset accounts

reconcile difference

• Example: Assume 34% effective tax rateBook Tax

Revenue $500,000 $500,000

Expense (300,000) (350,000)

NIBT 200,000 150,000

Tax exp ( 68,000) (51,000)

NI $132,000 $ 99,000



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• What is the journal entry to record this?

• Is a deferred tax liability “good” or “bad”?

Deferred Tax Liabilities (and Assets)Deferred Tax Liabilities (and Assets)

15

• What is the journal entry to record this?

• Is a deferred tax liability “good” or “bad”?



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Measurement of Liabilities uses a variety oftechniques: Amount equal to actual future payment

The present value of expected future payments Ex: Capital lease obligations

Some future obligations are not reported on thebalance sheet, but instead disclosed entirely in thenotes to the financial statements.

Ex: Operating lease obligations

Balance SheetBalance Sheet -- LiabilitiesLiabilities

16

Measurement of Liabilities uses a variety oftechniques: Amount equal to actual future payment

The present value of expected future payments Ex: Capital lease obligations

Some future obligations are not reported on thebalance sheet, but instead disclosed entirely in thenotes to the financial statements.

Ex: Operating lease obligations



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1. Capital Stock• Par or stated value of the shares issued

2. Additional paid-in capital• The excess of amounts paid in over par value

3. Retained earnings• Undistributed earnings

4. Accumulated Other Comprehensive Income• Analogous to RE as AOCI is the “bucket” where

OCI goes

Owners’ EquityOwners’ Equity

1. Capital Stock• Par or stated value of the shares issued

2. Additional paid-in capital• The excess of amounts paid in over par value

3. Retained earnings• Undistributed earnings

4. Accumulated Other Comprehensive Income• Analogous to RE as AOCI is the “bucket” where

OCI goes



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Owners’ EquityOwners’ Equity



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MeasurementAmounts reported in these accounts represent the aggregate oftransactions that occurred at various points in time

Common Stock & APIC will include proceeds from the sale ofstock from inception to present

Retained Earnings will include the sum of Net Income frominception through current year less dividends paid

Note that each year’s net income is expressed in that year’s dollars(i.e., monetary unit assumption)

Balance SheetBalance Sheet -- EquityEquity

19

MeasurementAmounts reported in these accounts represent the aggregate oftransactions that occurred at various points in time

Common Stock & APIC will include proceeds from the sale ofstock from inception to present

Retained Earnings will include the sum of Net Income frominception through current year less dividends paid

Note that each year’s net income is expressed in that year’s dollars(i.e., monetary unit assumption)



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Supplemental Information Reported Contingencies – material events that have an uncertain outcome Accounting Policies – Explanations of the valuation methods used or

the basic assumptions made concerning inventory valuations,depreciation, investment in subsidiaries, etc.

Contractual Situations – Explanations of certain restrictions orcovenants attached to specific assets or, more likely, liabilities.

Fair Values – Disclosures of fair values for certain items Subsequent Events – Disclosure of material events or transactions that

occur between the balance sheet date and its issuance date.Events that relate to conditions that existed as of the balance sheetdate are incorporated into the balance sheet as if the subsequentinformation was known as of the balance sheet date.

Events that relate to conditions that did not exist as of the balancesheet date are typically disclosed in the notes to the financialstatements.

Balance SheetBalance Sheet

20

Supplemental Information Reported Contingencies – material events that have an uncertain outcome Accounting Policies – Explanations of the valuation methods used or

the basic assumptions made concerning inventory valuations,depreciation, investment in subsidiaries, etc.

Contractual Situations – Explanations of certain restrictions orcovenants attached to specific assets or, more likely, liabilities.

Fair Values – Disclosures of fair values for certain items Subsequent Events – Disclosure of material events or transactions that

occur between the balance sheet date and its issuance date.Events that relate to conditions that existed as of the balance sheetdate are incorporated into the balance sheet as if the subsequentinformation was known as of the balance sheet date.

Events that relate to conditions that did not exist as of the balancesheet date are typically disclosed in the notes to the financialstatements.



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The lower of cost or market is an exception tothe historical cost principle.

• Future potential of the asset < original cost:

• Restate asset at market to replace cost.

• Loss charged against revenues of the period.

Ch. 9: InventoryCh. 9: InventoryLower of Cost or MarketLower of Cost or Market

The lower of cost or market is an exception tothe historical cost principle.

• Future potential of the asset < original cost:

• Restate asset at market to replace cost.

• Loss charged against revenues of the period.



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Market value is the replacement cost.

- The replacement cost must lie between a ceiling amount and a

floor amount.

- Ceiling is the net realizable value (NRV= selling price less disposal

cost).

- Floor is net realizable value less a normal profit margin.

– The “designated market value” is the “middle” value amongstthe replacement cost, ceiling, and floor

– Designated market value compared against the Cost value to

determine if an LCM write-down is needed.

Lower of Cost or Market Rules:Lower of Cost or Market Rules:Ceiling and FloorCeiling and Floor

Market value is the replacement cost.

- The replacement cost must lie between a ceiling amount and a

floor amount.

- Ceiling is the net realizable value (NRV= selling price less disposal

cost).

- Floor is net realizable value less a normal profit margin.

– The “designated market value” is the “middle” value amongstthe replacement cost, ceiling, and floor

– Designated market value compared against the Cost value to

determine if an LCM write-down is needed.



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Item Replacement Historical Ceiling Floor FinalCost Cost Inv $

A $88,000 $80,000 $120,000 $104,000 $

Lower of Cost or Market:Lower of Cost or Market:Ceiling and Floor ExampleCeiling and Floor Example

A $88,000 $80,000 $120,000 $104,000 $

B $88,000 $90,000 $100,000 $70,000 $

C $88,000 $90,000 $100,000 $90,000 $

D $88,000 $90,000 $87,000 $70,000 $



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Under the direct method:

DR. COGS

CR. Inventory

Under the indirect (allowance) method:

DR. Loss

CR. Allowance (contra- inventory acct.)

Recording the Decline in MarketRecording the Decline in MarketValueValue

Under the direct method:

DR. COGS

CR. Inventory

Under the indirect (allowance) method:

DR. Loss

CR. Allowance (contra- inventory acct.)



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The lower of cost or market may be applied:1. Either directly to each item

* most conservative approach* generally required for tax purposes

2. To each category, or3. To the total of the inventory

Whichever method is selected, it shouldbe consistently applied.

Lower of Cost or MarketLower of Cost or MarketApplicationApplication

The lower of cost or market may be applied:1. Either directly to each item

* most conservative approach* generally required for tax purposes

2. To each category, or3. To the total of the inventory

Whichever method is selected, it shouldbe consistently applied.



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LCM ExampleLCM Example

Assume in each case that the selling expenses are $8 per unit and that the normal profitis $5 per unit. Calculate the limits for each case (ceiling and floor). Then enter theamount that should be used for lower of cost or market.

Selling Ceiling Replacement FloorPrice Upper Limit Cost Lower Limit Cost LCM

(a) $54 $______ $38 $______ $43 $______

(b) 47 ______ 36 ______ 40 ______

(c) 56 ______ 39 ______ 40 ______

(d) 47 ______ 42 ______ 40 ______

Assume in each case that the selling expenses are $8 per unit and that the normal profitis $5 per unit. Calculate the limits for each case (ceiling and floor). Then enter theamount that should be used for lower of cost or market.

Selling Ceiling Replacement FloorPrice Upper Limit Cost Lower Limit Cost LCM

(a) $54 $______ $38 $______ $43 $______

(b) 47 ______ 36 ______ 40 ______

(c) 56 ______ 39 ______ 40 ______

(d) 47 ______ 42 ______ 40 ______



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Recording the Decline in MarketRecording the Decline in MarketValueValue

For subsequent increases in inventory value:

o US GAAP prohibits the reversal of writedowns

o IFRS requires the reversal of writedowns

What if the Market ValueWhat if the Market ValueRecovers?Recovers?

For subsequent increases in inventory value:

o US GAAP prohibits the reversal of writedowns

o IFRS requires the reversal of writedowns



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• Valuation at Net Realizable Value– Controlled market with a quoted price for all

quantities

– No significant costs of disposal

• Relative Sales Value – “Basket Purchase”• Purchase Commitments

Other Valuation IssuesOther Valuation Issues

• Valuation at Net Realizable Value– Controlled market with a quoted price for all

quantities

– No significant costs of disposal

• Relative Sales Value – “Basket Purchase”• Purchase Commitments



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• Appropriate basis when basket purchases are made.

• Basket purchases involve a group of varying units.

• The purchase price is paid as a lump sum amount.

• The lump sum price is allocated to units on the basis

of their relative sales values.

Valuation Basis:Valuation Basis:Relative Sales ValuesRelative Sales Values

• Appropriate basis when basket purchases are made.

• Basket purchases involve a group of varying units.

• The purchase price is paid as a lump sum amount.

• The lump sum price is allocated to units on the basis

of their relative sales values.



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Kirby Company buys three different lots (A, B and C)in a basket purchase, paying $300,000 for all three.

The lots were sold as follows:A ($75,000); B ($150,000) and C ($200,000) for atotal of $425,000.

What is the cost of A, B and C and the gross profit foreach lot?

Relative Sales Values: ExampleRelative Sales Values: Example

Kirby Company buys three different lots (A, B and C)in a basket purchase, paying $300,000 for all three.

The lots were sold as follows:A ($75,000); B ($150,000) and C ($200,000) for atotal of $425,000.

What is the cost of A, B and C and the gross profit foreach lot?



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Lot Sales Allocated GrossValue Cost Profit

A $75,000 ($75,000/$425,000)x $ 300,000

= $ 52,941 $ 22,059

Relative Sales Values: ExampleRelative Sales Values: Example

C $200,000 $ 141,176 $ 58,824

Totals $425,000 $300,000 $125,000

A $75,000 ($75,000/$425,000)x $ 300,000

= $ 52,941 $ 22,059

B $150,000 $105,882 $ 44,118



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Relative Sales Values: Example 2Relative Sales Values: Example 2

Adler Realty Company purchased a plot of ground for $800,000 and spent $2,100,000 indeveloping it for building lots. The lots were classified into Highland, Midland, andLowland grades, to sell at $100,000, $75,000, and $50,000 each, respectively.Complete the table below to allocate the cost of the lots using a relative sales valuemethod.

No. of Selling Total % of Apportioned CostGrade Lots Price Revenue Total Sales Total PerLotHighland 20 $ $ $ $Midland 40 $ $Lowland 100 $ $

160 $ $

Adler Realty Company purchased a plot of ground for $800,000 and spent $2,100,000 indeveloping it for building lots. The lots were classified into Highland, Midland, andLowland grades, to sell at $100,000, $75,000, and $50,000 each, respectively.Complete the table below to allocate the cost of the lots using a relative sales valuemethod.

No. of Selling Total % of Apportioned CostGrade Lots Price Revenue Total Sales Total PerLotHighland 20 $ $ $ $Midland 40 $ $Lowland 100 $ $

160 $ $



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• Cancellable contracts– No entry or disclosure required

• Formal, non-cancelable contracts– No entry, but disclosure required

– If execution of the contract expected to result ina loss, then must be recorded

DR Unrealized loss

CR Est liability on purchase commitment

Purchase CommitmentsPurchase Commitments

• Cancellable contracts– No entry or disclosure required

• Formal, non-cancelable contracts– No entry, but disclosure required

– If execution of the contract expected to result ina loss, then must be recorded

DR Unrealized loss

CR Est liability on purchase commitment



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• Inventory estimation used when:– a fire or other catastrophe destroys either

inventory or inventory records

– taking a physical inventory is impractical

– auditors only need an estimate of thecompany’s inventory

Inventory Estimation TechniquesInventory Estimation Techniques

• Inventory estimation used when:– a fire or other catastrophe destroys either

inventory or inventory records

– taking a physical inventory is impractical

– auditors only need an estimate of thecompany’s inventory



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• The Gross Profit Method uses estimated COGS (= actual salesX average gross profit on sales) to determine estimated endinginventory

• Example:On 10/16/07, Whitsunday Company’s warehouse burned andits inventory was completely destroyed. The accountingrecords were kept in the office building and escaped harm. Thefollowing information was available as of 10/16/07:

Net sales $426,000Beginning inventory 80,000Net purchases 300,000Average gross profit on sales 20%

Use the above information to estimate the ending inventory lostin the fire using the gross profit method.

Gross Profit Method to Determine EIGross Profit Method to Determine EI

• The Gross Profit Method uses estimated COGS (= actual salesX average gross profit on sales) to determine estimated endinginventory

• Example:On 10/16/07, Whitsunday Company’s warehouse burned andits inventory was completely destroyed. The accountingrecords were kept in the office building and escaped harm. Thefollowing information was available as of 10/16/07:

Net sales $426,000Beginning inventory 80,000Net purchases 300,000Average gross profit on sales 20%

Use the above information to estimate the ending inventory lostin the fire using the gross profit method.



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Beginning inventory $80,000

Net purchases 300,000

Cost of goods available for sale 380,000

Estimated cost of goods sold:

Net sales 426,000

Less: Est gross profit (85,200)(340,800)

Estimated ending inventory $39,200

Gross Profit Method to Determine EIGross Profit Method to Determine EI

Beginning inventory $80,000

Net purchases 300,000

Cost of goods available for sale 380,000

Estimated cost of goods sold:

Net sales 426,000

Less: Est gross profit (85,200)(340,800)

Estimated ending inventory $39,200



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On December 31, 2007 Carr Company's inventory burned.Sales and purchases for the year had been $1,400,000 and$980,000, respectively. The beginning inventory (Jan. 1,2007) was $170,000; in the past Carr's gross profit hasaveraged 40% of selling price. Compute the estimated costof inventory burned.

BI+ Net Purchases= COGA-Estimated COGS:

Net Salesless estimated gross profit

Estimated Ending inventory

Gross Profit Method Example 2Gross Profit Method Example 2On December 31, 2007 Carr Company's inventory burned.Sales and purchases for the year had been $1,400,000 and$980,000, respectively. The beginning inventory (Jan. 1,2007) was $170,000; in the past Carr's gross profit hasaveraged 40% of selling price. Compute the estimated costof inventory burned.

BI+ Net Purchases= COGA-Estimated COGS:

Net Salesless estimated gross profit

Estimated Ending inventory



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This inventory estimation technique is used when:• a fire or other catastrophe destroys either inventory or inventory

records• taking a physical inventory is impractical• auditors only need an estimate of the company’s inventory

• Appropriate for retail concerns with:• high volume sales and• different types of merchandise

• Assumes an observable pattern between cost andprices.

Retail Inventory MethodRetail Inventory Method

This inventory estimation technique is used when:• a fire or other catastrophe destroys either inventory or inventory

records• taking a physical inventory is impractical• auditors only need an estimate of the company’s inventory

• Appropriate for retail concerns with:• high volume sales and• different types of merchandise

• Assumes an observable pattern between cost andprices.



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Steps:1. Determine ending inventory at retail price

2. Convert this amount to a cost basis using a cost-to-retailratio

BI (at retail) + Net Purchases (at retail) – Net sales = EI (atretail)

EI (at retail) X Cost-to-Retail ratio = estimated “EI” (at cost)

Retail Inventory MethodRetail Inventory Method

Steps:1. Determine ending inventory at retail price

2. Convert this amount to a cost basis using a cost-to-retailratio

BI (at retail) + Net Purchases (at retail) – Net sales = EI (atretail)

EI (at retail) X Cost-to-Retail ratio = estimated “EI” (at cost)



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Given for the year 2002:at cost at retail

Beginning inventory $2,000 $3,000Purchases (Net) $10,000 $15,000Sales (Net) $12,000

What is ending inventory, at retail and at cost?

Retail Inventory Method: ExampleRetail Inventory Method: Example

Given for the year 2002:at cost at retail

Beginning inventory $2,000 $3,000Purchases (Net) $10,000 $15,000Sales (Net) $12,000

What is ending inventory, at retail and at cost?



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at cost at retail

Beginning inventory $ 2,000 $ 3,000Purchases (Net) $10,000 $15,000Goods available for sale $12,000 $18,000less: Sales (Net) ($12,000)Ending inventory (at retail) $6,000Times: cost to retail ratio xEnding inventory at costCOGS

Retail Inventory Method: ExampleRetail Inventory Method: Example

at cost at retail

Beginning inventory $ 2,000 $ 3,000Purchases (Net) $10,000 $15,000Goods available for sale $12,000 $18,000less: Sales (Net) ($12,000)Ending inventory (at retail) $6,000Times: cost to retail ratio xEnding inventory at costCOGS



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Administrative– Go over Midterm– DQ Multiple Deliverables due Monday Feb

21st (will be posted today)

In Class today and Wed- Cash and Receivables (Ch. 7, Appendix 7A,

Ch. 18 pp 930-937)

AgendaAgenda

Administrative– Go over Midterm– DQ Multiple Deliverables due Monday Feb

21st (will be posted today)

In Class today and Wed- Cash and Receivables (Ch. 7, Appendix 7A,

Ch. 18 pp 930-937)



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Chapter 7 & 18 (pp930Chapter 7 & 18 (pp930--937)937)Cash, Cash Equivalents, Basic RevenueCash, Cash Equivalents, Basic Revenue

Recognition & ReceivablesRecognition & Receivables

Cash & Cash Equivalents• Cash: Currency and coins held, checks & money

orders received, bank account balances• Cash Equivalents are short-term, highly liquid

investments that are:1. Readily convertible into known amounts of cash2. So near maturity that there is no risk of change in

valuation from fluctuating interest rates (originalmaturities of no longer than 3 months)

– Ex: T-bills, commercial paper, money market funds

Cash & Cash Equivalents• Cash: Currency and coins held, checks & money

orders received, bank account balances• Cash Equivalents are short-term, highly liquid

investments that are:1. Readily convertible into known amounts of cash2. So near maturity that there is no risk of change in

valuation from fluctuating interest rates (originalmaturities of no longer than 3 months)

– Ex: T-bills, commercial paper, money market funds



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• Cash Equivalents– Grouped together with cash– reported as the most liquid current asset on the balance sheet

• Restricted Cash– Disclosed separately– If relates terms of LT liability classify as LT

• Bank Overdrafts– US GAAP: Disclosed as a current liability unless there are other

positive-balance cash accounts at the same bank that it can benetted against

– IFRS: Included in cash and cash equivalents if repayable ondemand and form a part of an entity’s cash management

Reporting Issues with CashReporting Issues with Cash

• Cash Equivalents– Grouped together with cash– reported as the most liquid current asset on the balance sheet

• Restricted Cash– Disclosed separately– If relates terms of LT liability classify as LT

• Bank Overdrafts– US GAAP: Disclosed as a current liability unless there are other

positive-balance cash accounts at the same bank that it can benetted against

– IFRS: Included in cash and cash equivalents if repayable ondemand and form a part of an entity’s cash management



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Questions• Why are internal controls over cash so important?• What is the purpose of controls over cash?

Three Key Controls1) Management oversight and authorization

• Especially useful in small organizations where the ownercan monitor activities (and where there are limitedresources to have separation of duties)

2) Separation of duties:• Physical control, authorization and record keeping• E.g., one employee prepare the deposit slip and make the

entry, and another employee will actually make the deposit3) The bank reconciliation

Controls and CashControls and Cash

Questions• Why are internal controls over cash so important?• What is the purpose of controls over cash?

Three Key Controls1) Management oversight and authorization

• Especially useful in small organizations where the ownercan monitor activities (and where there are limitedresources to have separation of duties)

2) Separation of duties:• Physical control, authorization and record keeping• E.g., one employee prepare the deposit slip and make the

entry, and another employee will actually make the deposit3) The bank reconciliation



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Example: Hawthorne Co.’s May bank statement is as follows:Balance May 1, 2011 $33,240

Deposits 82,140

Checks processed (78,433)

Service Chg ( 80)

NSF checks ( 2,187)

Balance May 31, 2011 $34,680

Hawthorne’s GL cash account has a balance of $35,396 at 5/31/11.A review of the co’s records and the bank statement reveals:• Cash receipts not yet deposited totaled $2965

• A deposit of $1020 made on 5/31 was not credited to the company’s account untilJune.

• All checks written in April have been processed by the bank, but $5536 of checksfrom May have not.

Controls and Cash: BankControls and Cash: BankReconciliationReconciliation

Example: Hawthorne Co.’s May bank statement is as follows:Balance May 1, 2011 $33,240

Deposits 82,140

Checks processed (78,433)

Service Chg ( 80)

NSF checks ( 2,187)

Balance May 31, 2011 $34,680

Hawthorne’s GL cash account has a balance of $35,396 at 5/31/11.A review of the co’s records and the bank statement reveals:• Cash receipts not yet deposited totaled $2965

• A deposit of $1020 made on 5/31 was not credited to the company’s account untilJune.

• All checks written in April have been processed by the bank, but $5536 of checksfrom May have not.



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Bank Balance to Corrected Balance:Balance per bank statement $34,680Add: Outstanding deposits 3,985Less: Outstanding checks (5,536)Corrected cash balance $33,129

Balance per books $35,396Less: Service charge ( 80)Less: NSF checks ( 2,187)Corrected cash balance $33,129

Why is this an effective control?

Controls and Cash: BankControls and Cash: BankReconciliationReconciliation

Bank Balance to Corrected Balance:Balance per bank statement $34,680Add: Outstanding deposits 3,985Less: Outstanding checks (5,536)Corrected cash balance $33,129

Balance per books $35,396Less: Service charge ( 80)Less: NSF checks ( 2,187)Corrected cash balance $33,129

Why is this an effective control?



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2. Realized: The amount of revenue that will becollected is reasonably assured and measurable with areasonable degree of reliability. (buyer)

Basic Revenue RecognitionBasic Revenue Recognition



2. Realized: The amount of revenue that will becollected is reasonably assured and measurable with areasonable degree of reliability. (buyer)



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Example : On 1/1/07 a magazine publisher receives$300,000 for 1,000 3-year subscriptions. Magazine deliverybegins in January.

Can the revenue be recognized on 1/1/07?

• Is the revenue earned?

• Is the revenue realized?

When can the revenue be recognized?

Basic Revenue RecognitionBasic Revenue Recognition

Example : On 1/1/07 a magazine publisher receives$300,000 for 1,000 3-year subscriptions. Magazine deliverybegins in January.

Can the revenue be recognized on 1/1/07?

• Is the revenue earned?

• Is the revenue realized?

When can the revenue be recognized?



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Hierarchy of matching

• Direct – match expense to the revenue it helps generate

• Systematic and rational – match expense to periods in whichit helps to generate revenue (indirect cause and effectrelation between expense and revenue in periods expected tobe benefited)

• Immediate – expense in period the cost is incurred (i.e. nodiscernable or measurable future benefit.)

Expense Recognition (Matching)Expense Recognition (Matching)

Hierarchy of matching

• Direct – match expense to the revenue it helps generate

• Systematic and rational – match expense to periods in whichit helps to generate revenue (indirect cause and effectrelation between expense and revenue in periods expected tobe benefited)

• Immediate – expense in period the cost is incurred (i.e. nodiscernable or measurable future benefit.)



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1. Revenue Recognition at point of sale (delivery)

2. Revenue Recognition before delivery

3. Revenue Recognition after delivery

4. Revenue Recognition for specific salestransactions – franchises & consignment

Timing of Revenue RecognitionTiming of Revenue Recognition

1. Revenue Recognition at point of sale (delivery)

2. Revenue Recognition before delivery

3. Revenue Recognition after delivery

4. Revenue Recognition for specific salestransactions – franchises & consignment



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Revenues from manufacturing and selling arecommonly recognized at point of sale.

Exceptions:1. Sales with buyback agreements – No Sale2. Trade loading and channel stuffing – No Sale3. Sales when right of return exists (high rates that are not

reliably estimable) –Specific criteria to be met

Revenue Recognition at Point of SaleRevenue Recognition at Point of Sale

Revenues from manufacturing and selling arecommonly recognized at point of sale.

Exceptions:1. Sales with buyback agreements – No Sale2. Trade loading and channel stuffing – No Sale3. Sales when right of return exists (high rates that are not

reliably estimable) –Specific criteria to be met



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When right of return exists all of the following 6 criteria mustbe met to qualify as sale:

1. Price fixed or determinable at sale date

2. Buyer has paid seller, or is obligated to pay seller, and obligation isnot contingent on resale of product

3. Buyer’s obligation to seller would not be changed in event of theft ordamage to product

4. Buyer has economic substance apart from the seller

5. Seller does not have significant obligations for future performance todirectly bring about resale of product by buyer

6. Seller can reasonably estimate amount of future returns

Revenue Recognition at Point of SaleRevenue Recognition at Point of Sale

When right of return exists all of the following 6 criteria mustbe met to qualify as sale:

1. Price fixed or determinable at sale date

2. Buyer has paid seller, or is obligated to pay seller, and obligation isnot contingent on resale of product

3. Buyer’s obligation to seller would not be changed in event of theft ordamage to product

4. Buyer has economic substance apart from the seller

5. Seller does not have significant obligations for future performance todirectly bring about resale of product by buyer

6. Seller can reasonably estimate amount of future returns



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• Trade Discounts – reduction in list pricefor differential volume

• Cash discounts – reduction in amountowed if paid within a specified period.Possible accounting methods :

– Gross method records discounts when takenby customers (most commonly used)

– Net method records discounts not taken bycustomers.

Recognition of AccountsRecognition of AccountsReceivableReceivable

• Trade Discounts – reduction in list pricefor differential volume

• Cash discounts – reduction in amountowed if paid within a specified period.Possible accounting methods :

– Gross method records discounts when takenby customers (most commonly used)

– Net method records discounts not taken bycustomers.



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Cash Discounts - Net & Gross MethodsSale of $1,000 of inventory, 2/10, n/30 on 1/1/06, for two scenarios:a) Payment is made on 1/10/06 b) Payment is made on 1/15/06:

Net Method: Gross method:

January 1, 2006:Dr. A/R (1,000 x .98) 980Cr. Sales Revenue 980

January 1, 2006:Dr. A/R 1,000Cr. Sales Revenue 1,000

If paid within discount period January 10,2006:Dr. Cash 980Cr. A/R980

If paid inside discount period on January 10,2006:Dr. Cash 980Dr. Sales Discounts 20Cr. A/R 1,000

If paid outside discount period on 1/15/06:January 15, 2006:Dr. Cash 1,000Cr. A/R 980Cr. Sales Discounts Forfeited 20

If paid outside discount period on 1/15/06:January 15, 2006:Dr. Cash 1,000Cr. A/R 1,000

Net Method: Gross method:

January 1, 2006:Dr. A/R (1,000 x .98) 980Cr. Sales Revenue 980

January 1, 2006:Dr. A/R 1,000Cr. Sales Revenue 1,000

If paid within discount period January 10,2006:Dr. Cash 980Cr. A/R980

If paid inside discount period on January 10,2006:Dr. Cash 980Dr. Sales Discounts 20Cr. A/R 1,000

If paid outside discount period on 1/15/06:January 15, 2006:Dr. Cash 1,000Cr. A/R 980Cr. Sales Discounts Forfeited 20

If paid outside discount period on 1/15/06:January 15, 2006:Dr. Cash 1,000Cr. A/R 1,000



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• Short term receivables are reported at theirnet realizable value (NRV)

• What is NRV?– less estimated non-collectible accounts

– less allowance for returns.

Valuation of Accounts ReceivableValuation of Accounts Receivable

• Short term receivables are reported at theirnet realizable value (NRV)

• What is NRV?– less estimated non-collectible accounts

– less allowance for returns.



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Classification of Accounts Receivable

• US GAAP:– Must separately disclose material related party

receivables (i.e., trade receivables separate from non-trade)

• IFRS:– Classified on balance sheet as a financial asset

– May separately disclose material related partyreceivables

Accounts Receivable:Accounts Receivable:IFRS vs. US GAAPIFRS vs. US GAAP

Classification of Accounts Receivable

• US GAAP:– Must separately disclose material related party

receivables (i.e., trade receivables separate from non-trade)

• IFRS:– Classified on balance sheet as a financial asset

– May separately disclose material related partyreceivables



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Methods

Direct Write-Off Allowance

Not based on the matching Based on the matchingprinciple principle

Estimating UncollectibleEstimating UncollectibleReceivablesReceivables

Not based on the matching Based on the matchingprinciple principle

Appropriate only if Must be followed ifamounts are not material amounts are material

Accounts are written off Estimated; bad debts arewhen determined non-collectible matched against revenue



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Accounts Receivable

Direct write-off (used only if low & infrequent bad debts)Bad debt expense (I/S) XXX

AR (B/S - Asset) XXX

Indirect (allowance method)In year of the sale:Bad debt expense (I/S) XXX

Allowance for bad debts (B/S – Asset) XXX

When found to be uncollectible:Allowance for bad debts (B/S – Asset) XXX

AR (B/S – Asset) XXX

If payment received after account written off:AR (B/S – Asset) XXX

Allowance for bad debts (B/S – Asset) XXXCash (B/S – Asset) XXX


Direct write-off (used only if low & infrequent bad debts)Bad debt expense (I/S) XXX

AR (B/S - Asset) XXX

Indirect (allowance method)In year of the sale:Bad debt expense (I/S) XXX

Allowance for bad debts (B/S – Asset) XXX

When found to be uncollectible:Allowance for bad debts (B/S – Asset) XXX


If payment received after account written off:AR (B/S – Asset) XXX

Allowance for bad debts (B/S – Asset) XXXCash (B/S – Asset) XXX




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AR Allowance Methods: DeterminingAR Allowance Methods: Determiningthe Amount of the Adjustmentthe Amount of the Adjustment

Percent of Receivables Allowance method• Balance-sheet oriented• Uses one B/S account (AR) to estimate another B/S account

(Allowance)• Estimates the ENDING balance in the allowance account• Bad debt expense is the “plug”

Percent of Sales Allowance method• Income-statement oriented• Uses one I/S account (revenue) to estimate another I/S account (bad

debt expense)• Estimates the TOTAL bad debt expense• The allowance is the “running total”

Percent of Receivables Allowance method• Balance-sheet oriented• Uses one B/S account (AR) to estimate another B/S account

(Allowance)• Estimates the ENDING balance in the allowance account• Bad debt expense is the “plug”

Percent of Sales Allowance method• Income-statement oriented• Uses one I/S account (revenue) to estimate another I/S account (bad

debt expense)• Estimates the TOTAL bad debt expense• The allowance is the “running total”



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Allowance ExampleAllowance Example

1. “Percent of Receivables” method (B/S-oriented)Husky Co. has $60,000 in sales in 2005. AR at 12/31/05 is$24,000. Allowance for doubtful accounts at 12/31/05 is$200. What adjusting entry should be made at year end?

The company estimates allowance based on 1% of AR < 31 days, 2%31-60 days, 5% 61-90 days and 20% > 90 days:

Amount 0-30 31-60 61-90 91+$24,000 10,000 8,000 4,000 2,000Uncollectible % 1% 2% 5% 20%Allow. Est. $860 = 100 160 200 400

1. “Percent of Receivables” method (B/S-oriented)Husky Co. has $60,000 in sales in 2005. AR at 12/31/05 is$24,000. Allowance for doubtful accounts at 12/31/05 is$200. What adjusting entry should be made at year end?

The company estimates allowance based on 1% of AR < 31 days, 2%31-60 days, 5% 61-90 days and 20% > 90 days:

Amount 0-30 31-60 61-90 91+$24,000 10,000 8,000 4,000 2,000Uncollectible % 1% 2% 5% 20%Allow. Est. $860 = 100 160 200 400



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Allowance Example (cntd.)Allowance Example (cntd.)

2. “Percent of Sales” method (I/S-oriented)Assume instead that Husky estimates bad debt expense based on1.5% of sales.

Sales $60,000Uncollectible % 1.5%Bad debt expense $900

2. “Percent of Sales” method (I/S-oriented)Assume instead that Husky estimates bad debt expense based on1.5% of sales.

Sales $60,000Uncollectible % 1.5%Bad debt expense $900



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3. % of Sales Method is based on credit sales during the year

Example: Crawford Inc.Total sales, 2006: $20,000,000Credit sales, 2006: $15,000,000A/R Balance, Dec 31, 2006: $1,900,000Allow. for bad debt balance (before adjustment) 12/31/06: $62,000Prior history: 1% of credit sales are uncollectible

What is the journal entry to record bad debt expense for 2006

Allowance Examples (cntd.)Allowance Examples (cntd.)

3. % of Sales Method is based on credit sales during the year

Example: Crawford Inc.Total sales, 2006: $20,000,000Credit sales, 2006: $15,000,000A/R Balance, Dec 31, 2006: $1,900,000Allow. for bad debt balance (before adjustment) 12/31/06: $62,000Prior history: 1% of credit sales are uncollectible

What is the journal entry to record bad debt expense for 2006



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4. Percent of Receivables Now assume Crawford estimatestheir Allowance using an A/R aging. Prior collections history isused to estimate the percentage of each category that isuncollectible.

Age Balance % bad0-30 days 1,200,000 x 0.75% = 9,00031-60 days 500,000 x 8.00% = 40,00061+ days 200,000 x 20.00% = 40,000

89,000What is the adjusting journal entry at year end?


4. Percent of Receivables Now assume Crawford estimatestheir Allowance using an A/R aging. Prior collections history isused to estimate the percentage of each category that isuncollectible.

Age Balance % bad0-30 days 1,200,000 x 0.75% = 9,00031-60 days 500,000 x 8.00% = 40,00061+ days 200,000 x 20.00% = 40,000

89,000What is the adjusting journal entry at year end?



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5. Percent of Receivables – Write off’s and recovery. At the beginningof 2004, the balance in the Allowance account was $11,000 (CR).During the year, $8,000 of delinquent accounts were written off. Then,$2,000 of these delinquent accounts was ultimately determined to becollectible, and these accounts were collected. Additionally, the 2004ending balance in A/R was $150,000. If XYZ estimates that 5% of A/Ris uncollectible, what adjusting entry would be made to account for thebad debts?

What would be the ending balance in the Allowance for DoubtfulAccounts account?

5. Percent of Receivables – Write off’s and recovery. At the beginningof 2004, the balance in the Allowance account was $11,000 (CR).During the year, $8,000 of delinquent accounts were written off. Then,$2,000 of these delinquent accounts was ultimately determined to becollectible, and these accounts were collected. Additionally, the 2004ending balance in A/R was $150,000. If XYZ estimates that 5% of A/Ris uncollectible, what adjusting entry would be made to account for thebad debts?

What would be the ending balance in the Allowance for DoubtfulAccounts account?



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Short-term accounts receivable are shown at their netrealizable value as follows:

Accounts Receivable (gross): $ XXX

less: Allowance: ($ XX)

Net Realizable Value: $ XX

Or present in line item as:

“AR net of $xxx allowance for doubtful accounts”

Balance Sheet RepresentationBalance Sheet Representation

Short-term accounts receivable are shown at their netrealizable value as follows:

Accounts Receivable (gross): $ XXX

less: Allowance: ($ XX)

Net Realizable Value: $ XX

Or present in line item as:

“AR net of $xxx allowance for doubtful accounts”



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• The holder of accounts or notes receivable maytransfer them for cash.

• The transfer may be either:1. A secured borrowing (i.e., the “seller” is really

borrowing from the transferee)– Holder retains ownership of receivables in a

secured borrowing transaction.2. A sale of receivables

– Holder transfers ownership of receivables in asale (transfers risks of collection).

Disposition of Accounts andDisposition of Accounts andNotes ReceivableNotes Receivable

• The holder of accounts or notes receivable maytransfer them for cash.

• The transfer may be either:1. A secured borrowing (i.e., the “seller” is really

borrowing from the transferee)– Holder retains ownership of receivables in a

secured borrowing transaction.2. A sale of receivables

– Holder transfers ownership of receivables in asale (transfers risks of collection).



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Transfers

Secured Borrowing Sale

Accounting for Transfers ofAccounting for Transfers ofReceivablesReceivables

Secured Borrowing Sale

Without RecourseWith Recourse

-Seller guarantees payment if debtor does not pay

-Factored receivables are written off, but arecourse liability is recognized based on estimateof future payment firm will have to make

-Seller has no future obligation

-Write-off factored receivables(and recognize any gain / loss)



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• Overall - Receivables remain on the books of thecompany borrowing money (i.e. – no sale) (and continueto treat A/R as usual (collections, write-off, etc.)

• Also called “pledged” receivables• Transferor:

– Records liability– Records a finance charge.– Collects accounts receivable.– Records sales returns and sales discounts.– Absorbs bad debts expense.– Records interest expense on notes payable.– Pays on the note periodically from collections.

Secured BorrowingSecured Borrowing –– the Basicsthe Basics

• Overall - Receivables remain on the books of thecompany borrowing money (i.e. – no sale) (and continueto treat A/R as usual (collections, write-off, etc.)

• Also called “pledged” receivables• Transferor:

– Records liability– Records a finance charge.– Collects accounts receivable.– Records sales returns and sales discounts.– Absorbs bad debts expense.– Records interest expense on notes payable.– Pays on the note periodically from collections.



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Secured Borrowing ExampleTo help overcome a cash shortage, H Software took out a loan with T Bank. HSoftware used $1000 of A/R as collateral for the loan. T Bank withheld $30 as afinance charge, and forwarded $970 to H Software on July 1. H Softwarecollected the on the accounts on July 31 ($120 were written off), and repaid TBank on August 2nd with interest of $50.

July 1:Dr. Cash 970Dr. Finance charge 30Cr. Note Payable 1,000

July 31:Dr. Cash 880Dr. Allowance for doubtful accounts 120Cr. A/R 1,000

August 2:Dr. Interest Expense 50Dr. Note Payable 1,000Cr. Cash 1,050

To help overcome a cash shortage, H Software took out a loan with T Bank. HSoftware used $1000 of A/R as collateral for the loan. T Bank withheld $30 as afinance charge, and forwarded $970 to H Software on July 1. H Softwarecollected the on the accounts on July 31 ($120 were written off), and repaid TBank on August 2nd with interest of $50.

July 1:Dr. Cash 970Dr. Finance charge 30Cr. Note Payable 1,000

July 31:Dr. Cash 880Dr. Allowance for doubtful accounts 120Cr. A/R 1,000

August 2:Dr. Interest Expense 50Dr. Note Payable 1,000Cr. Cash 1,050



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• Factor records the (transferred) accounts as assets in itsbooks.

• Transferor:– Transfers ownership of receivables to factor.– Records any amount retained by transferee as “due from factor.”

• This is an amount held back to protect the transferee in case of non-payment by customer

– Records loss on sale of receivables.– Records any component liability IF with recourse

• i.e., any estimated future liability that the transferor will need to payif customers do not pay (and if the amount held back by the factor isinsufficient)

SaleSale of Receivablesof Receivables –– the Basicsthe Basics

• Factor records the (transferred) accounts as assets in itsbooks.

• Transferor:– Transfers ownership of receivables to factor.– Records any amount retained by transferee as “due from factor.”

• This is an amount held back to protect the transferee in case of non-payment by customer

– Records loss on sale of receivables.– Records any component liability IF with recourse

• i.e., any estimated future liability that the transferor will need to payif customers do not pay (and if the amount held back by the factor isinsufficient)



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Transfer of Receivables: Sale Without RecourseTo help overcome a cash shortage, H Software factored $1,000 of receivables to W Factor

on July 1, 2006. W Factor withheld $100 pending collectability, and charged HSoftware $40. The remaining $860 was forwarded to H Software on July 1. W Factorcollected on the A/R, without recourse. On August 2nd, W Factor informed HSoftware that $75 of the accounts were uncollectible, and W Factor returned to HSoftware the appropriate payment.

Dr. CashDr. Due from FactorDr. Loss on sale of A/RCr. A/R

Dr. CashDr. LossCr. Due from Factor

What if instead, W Factor informed H Software on Aug 2 that it was able to collect all ofthe AR? What would be the journal entry?

Dr. CashCr. Due from Factor

To help overcome a cash shortage, H Software factored $1,000 of receivables to W Factoron July 1, 2006. W Factor withheld $100 pending collectability, and charged HSoftware $40. The remaining $860 was forwarded to H Software on July 1. W Factorcollected on the A/R, without recourse. On August 2nd, W Factor informed HSoftware that $75 of the accounts were uncollectible, and W Factor returned to HSoftware the appropriate payment.

Dr. CashDr. Due from FactorDr. Loss on sale of A/RCr. A/R

Dr. CashDr. LossCr. Due from Factor

What if instead, W Factor informed H Software on Aug 2 that it was able to collect all ofthe AR? What would be the journal entry?

Dr. CashCr. Due from Factor



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Transfer of Receivables: Sale With RecourseTo help overcome a cash shortage, H Software factored $1,000 of receivables to W

Factor on July 1, 2006. W Factor withheld $100 pending collectability, and chargedH Software $40. The remaining $860 was forwarded to H Software on July 1. WFactor collected on the A/R, but had recourse in case of bad debts. H Softwareestimated that $150 of the receivables would ultimately be uncollectible. On August2nd, W Factor informed H Software that $120 of the accounts were uncollectible, andH Software sent W Factor the appropriate recourse payment.

Dr. CashDr. Due from FactorDr. Loss on Sale of A/R (plug)Cr. A/RCr. Recourse Liability

Dr. Recourse LiabilityCr. CashCr. Due from FactorCr. Recovery of loss sale

What if W Factor informed H Software that $220 of the accounts were uncollectible?

To help overcome a cash shortage, H Software factored $1,000 of receivables to WFactor on July 1, 2006. W Factor withheld $100 pending collectability, and chargedH Software $40. The remaining $860 was forwarded to H Software on July 1. WFactor collected on the A/R, but had recourse in case of bad debts. H Softwareestimated that $150 of the receivables would ultimately be uncollectible. On August2nd, W Factor informed H Software that $120 of the accounts were uncollectible, andH Software sent W Factor the appropriate recourse payment.

Dr. CashDr. Due from FactorDr. Loss on Sale of A/R (plug)Cr. A/RCr. Recourse Liability

Dr. Recourse LiabilityCr. CashCr. Due from FactorCr. Recovery of loss sale

What if W Factor informed H Software that $220 of the accounts were uncollectible?



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On January 1, 2006, Dawson Associates is considering outsourcing the collection of itsaccounts receivable. The following factoring options are available to Dawson.

Speedy Finance, Inc. Under the terms of the agreement, Speedy Finance would payDawson 98% of the gross amount of the transferred receivables and Dawson would beresponsible to pay Speedy Finance for any uncollectible accounts. Dawson estimates itsrecourse liability would be $60,000. Speedy Finance will collect the receivables and willhave the right to pledge or sell the receivables to another party.

Strapped Solutions, Inc. Under the terms of the agreement, Strapped Solutions wouldpay Dawson 96.5% of the gross amount of Dawson’s receivables without recourse.Strapped Solutions will collect the receivables and will have the right to pledge or sellthe receivables to another party.

The following information is available from Dawson’s Balance Sheet at Dec. 31, 2005:Accounts Receivable $5,000,000Allowance for doubtful accounts 80,000

Transfer of Receivables: Dawson Example

On January 1, 2006, Dawson Associates is considering outsourcing the collection of itsaccounts receivable. The following factoring options are available to Dawson.

Speedy Finance, Inc. Under the terms of the agreement, Speedy Finance would payDawson 98% of the gross amount of the transferred receivables and Dawson would beresponsible to pay Speedy Finance for any uncollectible accounts. Dawson estimates itsrecourse liability would be $60,000. Speedy Finance will collect the receivables and willhave the right to pledge or sell the receivables to another party.

Strapped Solutions, Inc. Under the terms of the agreement, Strapped Solutions wouldpay Dawson 96.5% of the gross amount of Dawson’s receivables without recourse.Strapped Solutions will collect the receivables and will have the right to pledge or sellthe receivables to another party.

The following information is available from Dawson’s Balance Sheet at Dec. 31, 2005:Accounts Receivable $5,000,000Allowance for doubtful accounts 80,000



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Prepare the journal entry that Dawson would record on January1, 2006 if it decides to enter into the agreement with SpeedyFinance.




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Prepare the journal entry that Dawson would record on January1, 2006 if it decides to enter into the agreement with StrappedSolutions.




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Which alternative should Dawson select if it wantsto maximize reported income in 2006?




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Notes Receivable

Short term N/R Long term N/R

Recognition of Notes ReceivableRecognition of Notes Receivable

Short term N/R Long term N/R

Record at face valueless allowance

Record at present valueof cash expected to

be collected



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• Why does a company issue a notes receivable?

• NR provides a stream of cash to the issuer– Principle

– interest

• What gets recorded?– Revenue: Present value cash inflow = fair value transaction

– Note Receivable: Amount of the note

– Maybe a discount or premium: contra account to the note

– Interest revenue: Market rate of interest on the net receivable

– Cash received (interest and principle)

LongLong--Term Notes Receivable: TheTerm Notes Receivable: TheBasicsBasics

• Why does a company issue a notes receivable?

• NR provides a stream of cash to the issuer– Principle

– interest

• What gets recorded?– Revenue: Present value cash inflow = fair value transaction

– Note Receivable: Amount of the note

– Maybe a discount or premium: contra account to the note

– Interest revenue: Market rate of interest on the net receivable

– Cash received (interest and principle)



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What are the true economics of a transaction involving a note?Consider this example.

Several years ago my husband and I purchased a Ford Explorer.The sticker price was $30,000. My husband negotiated it down to$27,000. When we went to pay, we were given two options:1) Receive a $2000 rebate off the negotiated price, OR2) Finance for 5 years at 0% interest.

Questions:1) What is the true value of the transaction (i.e, revenue)?2) Is the loan really at 0% interest?


What are the true economics of a transaction involving a note?Consider this example.

Several years ago my husband and I purchased a Ford Explorer.The sticker price was $30,000. My husband negotiated it down to$27,000. When we went to pay, we were given two options:1) Receive a $2000 rebate off the negotiated price, OR2) Finance for 5 years at 0% interest.

Questions:1) What is the true value of the transaction (i.e, revenue)?2) Is the loan really at 0% interest?



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• To ensure this happens, need to consider interest rates.

• Interest rates: Stated vs. market– Stated rate = effective (market rate) note issued at face value

– Stated rate < market rate note issued at a discount.

– Stated rate > market rate note issued at a premium.

– The discount or premium is amortized to interest revenue by the effectiveinterest method.

• Record interest revenue each period using the effective interestmethod.– Yields steady market rate of interest on net investment in note receivable

(i.e., note receivable + premium/discount)


• To ensure this happens, need to consider interest rates.

• Interest rates: Stated vs. market– Stated rate = effective (market rate) note issued at face value

– Stated rate < market rate note issued at a discount.

– Stated rate > market rate note issued at a premium.

– The discount or premium is amortized to interest revenue by the effectiveinterest method.

• Record interest revenue each period using the effective interestmethod.– Yields steady market rate of interest on net investment in note receivable

(i.e., note receivable + premium/discount)



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On December 31, 2007, Nemo, Inc. finished consultationservices and accepted in exchange a promissory note with a facevalue of $600,000, a due date of December 31, 2010, and a statedrate of 6%, with interest receivable at the end of each year. Thenote is considered to have a market rate of interest of 6%.

How much should the Note Receivable be recorded for?

What is the fair value of the transaction?– PV of cash interest payments

– PV of principle payment

Notes Receivable:Notes Receivable:Stated Rate = Market RateStated Rate = Market Rate



What is the fair value of the transaction?– PV of cash interest payments

– PV of principle payment



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Table 6-2 (PV of single sum)

Periods (n) 3% 6% 9%



3 0.91514 0.83962 0.77218

Table 6-4 (PV of an ordinary annuity)


3 2.82861 2.67301 2.53130



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Fair value of transaction:Interest:Principle:

Journal entries



Journal entries



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Is this a discount or a premium?


Notes Receivable:Notes Receivable:Stated Rate < Market RateStated Rate < Market Rate






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Journal entry at 12/31/07






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N/R: Stated Rate < Market RateN/R: Stated Rate < Market RateEffective Interest AmortizationEffective Interest Amortization

DateCash

InterestEffectiveInt Rev

DiscountAmortized

CarryingAmt N/R



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Journal Entries




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On December 31, 2007, Nemo, Inc. finished consultation servicesand accepted in exchange a promissory note with a face value of$600,000, a due date of December 31, 2010, and a stated rate of9%, with interest receivable at the end of each year. The note isconsidered to have a market rate of interest of 6%.



Notes Receivable:Notes Receivable:Stated Rate > Market RateStated Rate > Market Rate

On December 31, 2007, Nemo, Inc. finished consultation servicesand accepted in exchange a promissory note with a face value of$600,000, a due date of December 31, 2010, and a stated rate of9%, with interest receivable at the end of each year. The note isconsidered to have a market rate of interest of 6%.





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N/R: Stated Rate > Market RateN/R: Stated Rate > Market RateEffective Interest AmortizationEffective Interest Amortization

DateCash

InterestEffectiveInt Rev

PremiumAmortized

CarryingAmt N/R



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Journal Entries




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This is a special case of a discount.

Steps:

1. Determine issue price on notes receivableat implicit rate of interest

2. The discount is amortized to interestrevenue by the effective interest method

NonNon--interest Bearing Notesinterest Bearing Notes

This is a special case of a discount.

Steps:

1. Determine issue price on notes receivableat implicit rate of interest

2. The discount is amortized to interestrevenue by the effective interest method



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On 1/1/06 Mickey Co. purchases a machine from Mouse. Co. witha list price of $10,000. Mickey signs a non-interest bearing notepromising to pay Mouse Co. $10,000 on December 31, 2007. Thefair value of the machine on 1/1/06 is $7,972.

Implicitly, how much interest revenue will Mouse receive over the2 year period of the note?

What is the implicit interest rate on this note receivable?– It is the rate that equates $7972 at t=0 to $10,000 at t=2– 7,972F = 10,000; or F=10,000/7,972 = 1.2544– In table 6.1, Future Value of 1 (p. 303), the rate is 12% (F=1.2544, n =

2)-

Notes ReceivableNotes Receivable –– NonNon--Interest BearingInterest Bearing

On 1/1/06 Mickey Co. purchases a machine from Mouse. Co. witha list price of $10,000. Mickey signs a non-interest bearing notepromising to pay Mouse Co. $10,000 on December 31, 2007. Thefair value of the machine on 1/1/06 is $7,972.

Implicitly, how much interest revenue will Mouse receive over the2 year period of the note?

What is the implicit interest rate on this note receivable?– It is the rate that equates $7972 at t=0 to $10,000 at t=2– 7,972F = 10,000; or F=10,000/7,972 = 1.2544– In table 6.1, Future Value of 1 (p. 303), the rate is 12% (F=1.2544, n =

2)-



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CarryingDate Int Rev Disc. Amor. Amt NR

1/1/2006 7,97212/31/2006 957 957 8,92912/31/2007 1,071 1,071 10,000

2,028

CarryingDate Int Rev Disc. Amor. Amt NR

1/1/2006 7,97212/31/2006 957 957 8,92912/31/2007 1,071 1,071 10,000

2,028



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January 1, 2006:

December 31, 2006:

December 31, 2007:


January 1, 2006:

December 31, 2006:

December 31, 2007:



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General Host’s annual accounting period ends on December31. On July 1, 2004, General sold land having fair marketvalue of $700,000 in exchange for a four-year non-interestbearing promissory note in the face amount of $1,101,460.The land is carried on General’s books at a cost of $620,000.

Required: Prepare the journal entry to record the sale of landin exchange for the note.

Another NonAnother Non--Interest BearingInterest BearingExampleExample

General Host’s annual accounting period ends on December31. On July 1, 2004, General sold land having fair marketvalue of $700,000 in exchange for a four-year non-interestbearing promissory note in the face amount of $1,101,460.The land is carried on General’s books at a cost of $620,000.

Required: Prepare the journal entry to record the sale of landin exchange for the note.



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Another NonAnother Non--Interest BearingInterest BearingExampleExample



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• The “Crisis of Credit”• When does impairment occur?

• How is the impairment measured?– Book value less PV future cash flows

Impairment of LongImpairment of Long--TermTermReceivablesReceivables

• The “Crisis of Credit”• When does impairment occur?

• How is the impairment measured?– Book value less PV future cash flows



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Example: Brillard Properties owes First Prudent Bank $30millionunder a 10% note with two years remaining until maturity. Due tofinancial difficulties of the developer, the previous year’s interest of$3million was not paid. First Prudent agrees to1. Forgive the interest payment from last year2. Reduce the remaining two interest payments to $2 million each3. Reduce the principal to $25 million

How much impairment loss should be recorded? Assume 10% ismarket rate of interest.


Example: Brillard Properties owes First Prudent Bank $30millionunder a 10% note with two years remaining until maturity. Due tofinancial difficulties of the developer, the previous year’s interest of$3million was not paid. First Prudent agrees to1. Forgive the interest payment from last year2. Reduce the remaining two interest payments to $2 million each3. Reduce the principal to $25 million

How much impairment loss should be recorded? Assume 10% ismarket rate of interest.



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Book value of asset:Accrued interest (10% x $30million) $ 3,000,000Principal 30,000,000

Carrying amount of the receivable $33,000,000New Value:

PV of future interest ($2million x 1.73554) $3,471,080PV of principal ($25million x .82645) 20,661,250

PV of receivable (24,132,330)Loss $8,867,670

Journal EntryLoss on troubled debt restructuring 8,867,670

Accrued interest receivable 3,000,000Note receivable ($30,000,000-24,132,330) 5,867,670


Book value of asset:Accrued interest (10% x $30million) $ 3,000,000Principal 30,000,000

Carrying amount of the receivable $33,000,000New Value:

PV of future interest ($2million x 1.73554) $3,471,080PV of principal ($25million x .82645) 20,661,250

PV of receivable (24,132,330)Loss $8,867,670

Journal EntryLoss on troubled debt restructuring 8,867,670

Accrued interest receivable 3,000,000Note receivable ($30,000,000-24,132,330) 5,867,670



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Rules:• Segregate different types of receivables if material

• Offset valuation accounts against gross balance

• Ensure all receivables are really current

• Disclose any loss contingencies on the receivables

• Disclose amounts pledged as collateral

• Disclose significant concentrations of credit risk

Presentation & Disclosure ofPresentation & Disclosure ofReceivablesReceivables

Rules:• Segregate different types of receivables if material

• Offset valuation accounts against gross balance

• Ensure all receivables are really current

• Disclose any loss contingencies on the receivables

• Disclose amounts pledged as collateral

• Disclose significant concentrations of credit risk



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What is purpose of analysis?

Ratios usedAR Turnover = Net Sales/Average net Trade AR

Days AR or Average Collection Period = 365 days/AR turnover

Analysis of ReceivablesAnalysis of Receivables

What is purpose of analysis?

Ratios usedAR Turnover = Net Sales/Average net Trade AR

Days AR or Average Collection Period = 365 days/AR turnover



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Chapter 8Inventory Reporting

• Physical units to be accounted for:– What is there AND– Goods in transit (FOB Destination)– Goods on consignment with consignee– Goods sold under buy back agreements– Goods sold with high rates of return (if unable to estimate returns)– Installment sales (if unable to estimate bad debts)

• Report inventory units at the lower of cost ormarket (conservatism). What is included in costfor:- Retail- Manufacturing:

1

• Physical units to be accounted for:– What is there AND– Goods in transit (FOB Destination)– Goods on consignment with consignee– Goods sold under buy back agreements– Goods sold with high rates of return (if unable to estimate returns)– Installment sales (if unable to estimate bad debts)

• Report inventory units at the lower of cost ormarket (conservatism). What is included in costfor:- Retail- Manufacturing:



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• Purchases are debitedto Inventory account

• Freight-in, Purch.Returns & Allowancesand Purch. Disc. arerecorded in Inventoryaccount.

• Debit COGS and creditInventory account foreach sale.

• Purchases are debitedto Purchases account.

• Freight-in, Purch. R & Aand Purch. Disc. arerecorded in theirrespective accounts.

• COGS is computed onlyperiodically:

COGA – EI = COGS

Perpetual Method Periodic Method

Inventory Systems

• Purchases are debitedto Inventory account

• Freight-in, Purch.Returns & Allowancesand Purch. Disc. arerecorded in Inventoryaccount.

• Debit COGS and creditInventory account foreach sale.

• Purchases are debitedto Purchases account.

• Freight-in, Purch. R & Aand Purch. Disc. arerecorded in theirrespective accounts.

• COGS is computed onlyperiodically:

COGA – EI = COGS



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Purchase of Inventory:Dr. Inventory 1,000

Cr. A/P, Cash, etc. 1,000

Sale of Inventory:Dr. Cost of Goods Sold 1,000

Cr. Inventory 1,000

Dr. Cash, A/R, etc. 1,500Cr. Sales Revenue 1,500

At Year-End: no j/e required, unless errors are found ininventory count

Inventory System - Perpetual

3

Purchase of Inventory:Dr. Inventory 1,000

Cr. A/P, Cash, etc. 1,000

Sale of Inventory:Dr. Cost of Goods Sold 1,000

Cr. Inventory 1,000

Dr. Cash, A/R, etc. 1,500Cr. Sales Revenue 1,500

At Year-End: no j/e required, unless errors are found ininventory count



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• Purchases are debited to Purchases account.• Freight-in, Purchase Returns & Allowances and Purchase Discounts are

recorded in their respective accounts.• COGS is computed only periodically: COGA – EI = COGS

J/E, Periodic System:Purchase of Inventory:Dr. Purchases 1,000Cr. A/P, Cash, etc. 1,000

Sale of Inventory:Dr. Cash, A/R, etc. 1,500Cr. Sales Revenue 1,500

At Year-End:Dr. Ending Inventory (determined by count) 38,000Dr. Cost of Sales (plug) 283,000Cr. Purchases 286,000Cr. Opening Inventory (carried forward from prior year) 35,000

Inventory System - Periodic

4

• Purchases are debited to Purchases account.• Freight-in, Purchase Returns & Allowances and Purchase Discounts are

recorded in their respective accounts.• COGS is computed only periodically: COGA – EI = COGS

J/E, Periodic System:Purchase of Inventory:Dr. Purchases 1,000Cr. A/P, Cash, etc. 1,000

Sale of Inventory:Dr. Cash, A/R, etc. 1,500Cr. Sales Revenue 1,500

At Year-End:Dr. Ending Inventory (determined by count) 38,000Dr. Cost of Sales (plug) 283,000Cr. Purchases 286,000Cr. Opening Inventory (carried forward from prior year) 35,000



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Error in Effect on Effect onEnding Income Balance sheetInventory Items Items

Under- COGS (over) Inventory (under)stated Net income (under) Retained Earn (under)

Effect of Inventory Errors

Under- COGS (over) Inventory (under)stated Net income (under) Retained Earn (under)

Over- COGS (under) Inventory (over)stated Net income (over) Retained Earn (over)



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Effect of Inventory Errors (O/S Ending)

6



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Cost flow assumptions need not be consistent withphysical flow of goods. The objective is to mostclearly reflect periodic income.

The cost flow assumptions are:1 Specific identification2 Average cost3 First-in, first-out (FIFO) and4 Last-in, first-out (LIFO) (prohibited under IFRS)

Cost Flow Assumptions

Cost flow assumptions need not be consistent withphysical flow of goods. The objective is to mostclearly reflect periodic income.

The cost flow assumptions are:1 Specific identification2 Average cost3 First-in, first-out (FIFO) and4 Last-in, first-out (LIFO) (prohibited under IFRS)



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Spaworld reports the following transactions for 2004(assume no opening inventory):Date Purchases Purchase CostMay 12 100 units $1,000Aug 14 200 units 2,200Sep 18 120 units 1,800

420 units $5,000On December 31, the company had 20 units on handand uses the periodic inventory system.

What are the cost of goods sold and the cost ofending inventory?

Cost Flow Assumptions: Example

Spaworld reports the following transactions for 2004(assume no opening inventory):Date Purchases Purchase CostMay 12 100 units $1,000Aug 14 200 units 2,200Sep 18 120 units 1,800

420 units $5,000On December 31, the company had 20 units on handand uses the periodic inventory system.

What are the cost of goods sold and the cost ofending inventory?



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Date Purchases CostMay 12 100 units $1,000Aug 14 200 units $2,200Sep 18 120 units $1,800

420 units $5,000

Steps:

1. Calculate per unit average cost:

2. Apply this per unit average cost to units sold to get COGS:

3. Apply the per unit average cost to units remaining ininventory to determine Ending inventory:

Average Cost Method

Steps:

1. Calculate per unit average cost:

2. Apply this per unit average cost to units sold to get COGS:

3. Apply the per unit average cost to units remaining ininventory to determine Ending inventory:



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Journal Entries:

Year End Entry – Average Cost

10



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Given data:Date Purchases CostMay 12 100 units @ $10 $1,000Aug 14 200 units @ $11 $2,200Sep 18 120 units @ $15 $1,800

420 $5,000

Cost of goods sold (FIFO)

First-In, First-Out (FIFO) Method


420 $5,000

COGS

EI$5,000

GAFS

Note: FIFO = LISH (Last In Still Here)

“Count” from one direction and “plug” the other



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Cost of goods sold (LIFO)Given data:Date Purchases CostMay 12 100 units @ $10 $1,000Aug 14 200 units @ $11 $2,200Sep 18 120 units @ $15 $1,800

420 $5,000

Last-In, First-Out (LIFO) Method

COGS

EI$5,000

GAFS


420 $5,000

LIFO = FISH (First In Still Here)



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• The ending inventory in units is the same inall three methods: the cost is different

• The cost of goods available is the same forall methods

• The cost of goods sold and the cost ofending inventory are different

• In periods of rising prices, LIFO would resultin the smallest reported net income.

Cost Flow Assumptions: Notes

• The ending inventory in units is the same inall three methods: the cost is different

• The cost of goods available is the same forall methods

• The cost of goods sold and the cost ofending inventory are different

• In periods of rising prices, LIFO would resultin the smallest reported net income.



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• LIFO matches more recent costs withcurrent revenues.

• With increasing prices:– LIFO yields the lowest taxable income

(assuming inventory does not decrease).– Under LIFO, there is less need to write

down inventory down to market

Advantages of LIFO Method

• LIFO matches more recent costs withcurrent revenues.

• With increasing prices:– LIFO yields the lowest taxable income

(assuming inventory does not decrease).– Under LIFO, there is less need to write

down inventory down to market



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• LIFO yields the lowest net income and thereforereduced earnings (with increasing prices)

• Under LIFO, the ending inventory is understatedrelative to current costs

• LIFO liquidation (reduction of quantities ofinventory during a period – results in “costing”items at older prices):– May result in income that is detrimental from a tax view– May cause poor buying habits (because of the layer

liquidation problem)

• LIFO Conformity Rule: if you use LIFO for taxpurposes, you must use it for financial reportingalso.

Disadvantages of LIFO Method

• LIFO yields the lowest net income and thereforereduced earnings (with increasing prices)

• Under LIFO, the ending inventory is understatedrelative to current costs

• LIFO liquidation (reduction of quantities ofinventory during a period – results in “costing”items at older prices):– May result in income that is detrimental from a tax view– May cause poor buying habits (because of the layer

liquidation problem)

• LIFO Conformity Rule: if you use LIFO for taxpurposes, you must use it for financial reportingalso.



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Periodic vs. Perpetual

• FIFO: COGS and EI numbers are exactly thesame under either periodic or perpetual systems

• BUT – LIFO, Weighted Average will give youdifferent numbers– Under perpetual LIFO, with each sale, you cut into only

existing layers (so you must stop and calculate the costof goods sold at each sale)

– Under perpetual Weighted Average (more accurately,Moving Average), you stop and calculate a newaverage cost for every sale

16

• FIFO: COGS and EI numbers are exactly thesame under either periodic or perpetual systems

• BUT – LIFO, Weighted Average will give youdifferent numbers– Under perpetual LIFO, with each sale, you cut into only

existing layers (so you must stop and calculate the costof goods sold at each sale)

– Under perpetual Weighted Average (more accurately,Moving Average), you stop and calculate a newaverage cost for every sale



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Same Example - Perpetual Basis

Unit Total UnitsUnits Cost Cost Sold

12-May 100 10 10001-Jun 85

14-Aug 200 11 22001-Sep 100

18-Sep 120 15 180020-Sep 215

420 5000 400

Unit Extended Unit ExtendedFIFO: Units Cost Value LIFO: Units Cost Value

1-Jun 85 10 850 1-Jun 85 10 8501-Sep 15 10 150 1-Sep 100 11 1100

85 11 935 20-Sep 120 15 180020-Sep 115 11 1265 95 11 1045

100 15 1500COGS 400 4700 COGS 400 4795

EI 20 15 300 EI 15 10 150Same as Periodic 5 11 55

205Different from Periodic

Purchased

17

Unit Total UnitsUnits Cost Cost Sold

12-May 100 10 10001-Jun 85

14-Aug 200 11 22001-Sep 100

18-Sep 120 15 180020-Sep 215

420 5000 400

Unit Extended Unit ExtendedFIFO: Units Cost Value LIFO: Units Cost Value

1-Jun 85 10 850 1-Jun 85 10 8501-Sep 15 10 150 1-Sep 100 11 1100

85 11 935 20-Sep 120 15 180020-Sep 115 11 1265 95 11 1045

100 15 1500COGS 400 4700 COGS 400 4795

EI 20 15 300 EI 15 10 150Same as Periodic 5 11 55

205Different from Periodic

Purchased



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Same Example - Perpetual BasisSold

Unit ExtendedUnits Cost Cost Units

12-May 100 10 10001-Jun 85

14-Aug 200 11 22001-Sep 100

18-Sep 120 15 180020-Sep 215

420 5000 400

Calculate the average cost at time of each sale

Unit ExtendedWt. Av. Units Cost Value 1-Sep

1-Jun 85 10 850 costs to date 32001-Sep 100 10.9 1093.02 costs expensed 850

20-Sep 215 13 2796.81 0 23500 2150 Av Cost 10.9

COGS 400 4739.83Sept. 20

EI 20 13 260.168 Costs to date 5000Costs expensed 1943Remaining costs 3057Remaining units 235

Different from Periodic Av cost 13

Purchased

18

SoldUnit Extended

Units Cost Cost Units12-May 100 10 1000

1-Jun 8514-Aug 200 11 22001-Sep 100

18-Sep 120 15 180020-Sep 215

420 5000 400

Calculate the average cost at time of each sale

Unit ExtendedWt. Av. Units Cost Value 1-Sep

1-Jun 85 10 850 costs to date 32001-Sep 100 10.9 1093.02 costs expensed 850

20-Sep 215 13 2796.81 0 23500 2150 Av Cost 10.9

COGS 400 4739.83Sept. 20

EI 20 13 260.168 Costs to date 5000Costs expensed 1943Remaining costs 3057Remaining units 235

Different from Periodic Av cost 13

Purchased



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LIFO Reserve (Allowance) account is used,when:LIFO is used for external reporting and a non-LIFO basis is used for internal reporting.

SEC reporting requirements – disclose thedifference between LIFO and current cost ofinventory reported on the Balance Sheet

LIFO Reserve

LIFO Reserve (Allowance) account is used,when:LIFO is used for external reporting and a non-LIFO basis is used for internal reporting.

SEC reporting requirements – disclose thedifference between LIFO and current cost ofinventory reported on the Balance Sheet



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Jeppo Inc reports the following balances:Inventory (FIFO basis) on Dec 31, 2004: $50,000Inventory (LIFO basis) on Dec 31, 2004: $20,000

Adjust the cost of ending inventory to the LIFO basis

LIFO Reserve: Example

Dr. Cost of goods sold $30,000Cr. Allowance to Reduce Inventory

to LIFO $30,000

Balance Sheet (Assets):Inventory (FIFO) $50,000less: Allowance to Reduce Inventory ($30,000)Inventory (LIFO) basis $20,000



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• Under the LIFO approach, a business maybuild up layers of inventory from priorperiods. A layer liquidation occurs, when:– Earlier costs are matched against current sales

due to a reduction of quantities of inventoryduring a period (results in “costing” items atolder prices)

– Such matching results in distorted income.

LIFO Layers

• Under the LIFO approach, a business maybuild up layers of inventory from priorperiods. A layer liquidation occurs, when:– Earlier costs are matched against current sales

due to a reduction of quantities of inventoryduring a period (results in “costing” items atolder prices)

– Such matching results in distorted income.



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• Dollar value LIFO applies LIFO procedures to pools of similar goods basedon dollars rather than units

• Used for external purposes (i.e., financial statements and taxes)

• Advantages over regular LIFO:– Reduces record keeping (maximum of one layer per year).– Mitigates likelihood of eroding old layers (some decreases in goods in the pool

are offset by increases in other goods in the pool).

• Price index – a measure of the change in prices from a base year (the yeardollar value LIFO is adopted in this case) to the current year

– Internal = Ending inventory quantities X current year costsEnding inventory quantities X base year costs

– External – calculated by the Bureau of Labor Statistics

Dollar Value LIFO

22

• Dollar value LIFO applies LIFO procedures to pools of similar goods basedon dollars rather than units

• Used for external purposes (i.e., financial statements and taxes)

• Advantages over regular LIFO:– Reduces record keeping (maximum of one layer per year).– Mitigates likelihood of eroding old layers (some decreases in goods in the pool

are offset by increases in other goods in the pool).

• Price index – a measure of the change in prices from a base year (the yeardollar value LIFO is adopted in this case) to the current year

– Internal = Ending inventory quantities X current year costsEnding inventory quantities X base year costs

– External – calculated by the Bureau of Labor Statistics



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Compare ending inventory at base year prices to beginning of yearinventory, also at base year prices – if there is an increase –we add a new LIFO layer at CY prices:

1. Calculate EI at current year costs - FIFO2. Calculate current year price index.3. Calculate EI at base year costs - FIFO4. Calculate the change in inventory at base year costs – FIFO (this

represents the quantity change in base year prices)5. Calculate the EI at dollar value LIFO:

• If the change in inventory at base year FIFO is positive, add a layer to BI atcurrent year cost (i.e. price this real dollar quantity increase at current prices)

• If the change in inventory at base year FIFO is zero, BI equals EI• If the change in inventory at base year FIFO is negative, peel off layer(s)

from BI

Dollar Value LIFO Calculation Steps

23

Compare ending inventory at base year prices to beginning of yearinventory, also at base year prices – if there is an increase –we add a new LIFO layer at CY prices:

1. Calculate EI at current year costs - FIFO2. Calculate current year price index.3. Calculate EI at base year costs - FIFO4. Calculate the change in inventory at base year costs – FIFO (this

represents the quantity change in base year prices)5. Calculate the EI at dollar value LIFO:

• If the change in inventory at base year FIFO is positive, add a layer to BI atcurrent year cost (i.e. price this real dollar quantity increase at current prices)

• If the change in inventory at base year FIFO is zero, BI equals EI• If the change in inventory at base year FIFO is negative, peel off layer(s)

from BI



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Given:Base layer (Dec 31, 2003): $20,000Inventory (current prices)Dec 31, 2004: $26,400Prices increased 20% during 2004.

Determine dollar value LIFO at Dec 31,2004

Dollar Value LIFO: Example

24

Given:Base layer (Dec 31, 2003): $20,000Inventory (current prices)Dec 31, 2004: $26,400Prices increased 20% during 2004.

Determine dollar value LIFO at Dec 31,2004



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Dec 31, 2003 Dec 31, 2004

Price increase, 20%

At EOY prices:$26,400

$26,400 / 1.20At base $:$22,000

Dollar Value LIFO: Example

25

At EOY prices:$26,400

$26,400 / 1.20At base $:$22,000

Net increaseat base $:

$22,000 less$20,000

Restate atcurrent $:

$2,400(layer added)

$2,000 * 1.20

$20,000plus

$2,400 =$22,400

Dollar valueLIFO Inventory



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When the ending inventory (at base yearprices) is less than the beginning inventory(at base year prices) (i.e. in the exampleabove if EI at base year prices was <$20,000):– the decrease must be subtracted from the most

recently added layer.– Once a layer is eliminated (peeled off), it

cannot be rebuilt.

Dollar Value LIFO: Notes

26

When the ending inventory (at base yearprices) is less than the beginning inventory(at base year prices) (i.e. in the exampleabove if EI at base year prices was <$20,000):– the decrease must be subtracted from the most

recently added layer.– Once a layer is eliminated (peeled off), it

cannot be rebuilt.



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Incorporating International Financial

Reporting Standards (IFRS)

into Intermediate Accounting

Revised June 30, 2009

Rebecca G. FayJohn A. Brozovsky

Jennifer E. EdmondsPatricia G. Lobingier

Sam A. Hicks

We express our appreciation to the Deloitte Foundation and to Carl Cronin and Greg Aliff, bothDeloitte partners and Virginia Tech alums, for the encouragement and financial support that made thisproject possible. Any errors or omissions are solely the responsibility of the authors and not Deloitte.



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i

Preface

The purpose of these materials is to allow the intermediate accounting student and theirfaculty members to get started incorporating the International Financial Reporting Standardsin their course sooner rather than later. The materials are NOT exhaustive; rather thematerials cover the basic differences between US GAAP and IFRS for those topics normallydiscussed in the Intermediate Accounting Course.

The roadmap proposed by the Securities and Exchange Commission (SEC) would allowselect U.S. companies the option of adopting IFRS as early as 2009 with mandatory adoptionfollowing as early as 2014. While the current chairman of the SEC has expressed skepticismregarding the proposed timeline, she has also affirmed her commitment to work toward asingle, universal set of high quality accounting standards. Since most of the developed worldhas already adopted IFRS, it is important that today’s accounting students have a basicunderstanding of these standards even if they do not replace US GAAP. We hope thesematerials help with that process.

We do not plan to update these materials. They will be available on the AmericanAccounting Association’s web site, at http://aaahq.org/commons. If you have comments,have suggestions for improvements or corrections, please contact John Brozovsky [[email protected]] or Sam A. Hicks [at [email protected]]. If you prefer surface mail, contacteither at Department of Accounting and Information Systems, Virginia Tech Mail Code0101, Blacksburg, VA 24061. We will make corrections and add comments until December31, 2009.



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1

Incorporating IFRS into Intermediate Accounting

Table of Contents

Table of US GAAP, IFRS and Intermediate Textbook chapters by Topic .........................2

Unit 1 – Introduction ...........................................................................................................3

Unit 2 – Conceptual Framework .........................................................................................8

Unit 3 – Income Statement and Other Comprehensive Income .............................................10

Unit 3 Appendix A – Current IFRS................................................................................14

Unit 3 Appendix B – IFRS effective for years beginning after 1/1/2009 .....................15

Unit 4 – Balance Sheet ......................................................................................................17

Unit 5 – Statement of Cash Flows.....................................................................................21

Unit 6 – Cash and Receivables.......................................................................................... 25

Unit 7 – Inventories: Cost Basis........................................................................................29

Unit 8 – Inventories: Subsequent Valuation......................................................................32

Unit 9 – Property, Plant and Equipment............................ Error! Bookmark not defined.

Unit 10 – Depreciation and Impairment............................ Error! Bookmark not defined.

Unit 11 – Intangible Assets ............................................... Error! Bookmark not defined.

Unit 12 – Current Liabilities and Contingencies............... Error! Bookmark not defined.

Unit 13 – Long-term Liabilities......................................... Error! Bookmark not defined.

Unit 14 – Stockholders’ Equity ......................................... Error! Bookmark not defined.

Unit 15 – Earnings Per Share and Share-Based CompensationError! Bookmark not defined.

Unit 16 – Investments........................................................ Error! Bookmark not defined.

Unit 17 – Revenue Recognition ........................................ Error! Bookmark not defined.

Unit 18 – Income Taxes .................................................... Error! Bookmark not defined.

Unit 19 – Pensions............................................................. Error! Bookmark not defined.

Unit 20 – Leases ................................................................ Error! Bookmark not defined.

Unit 21 – Accounting Changes and Errors........................ Error! Bookmark not defined.

Unit 22 – Disclosures and Segment Reporting ................. Error! Bookmark not defined.

Conversion Case – Using Form 20-F Reconciliation for Ratio AnalysisError! Bookmark not

defined.

Additional Resources ........................................................................................................34



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2


Table of US GAAP, IFRS and Intermediate Textbook chapters by Topic

InternationalFinancialReportingStandards

(IFRS)

US GAAPAccountingStandards

Codification(ASC)

Intermediate TextbooksKieso

WeygandtWarfield

13th

SpicelandSepe

Tomassini5th

SticeStice

Skousen17th

1 Introduction 1 1 12 Conceptual Framework Framework 2 1 13 Income Statement &

Comprehensive IncomeIAS 1, 34, IFRS 5 220, 225 4 4 4

4 Balance Sheet IAS 1, 10, 34 210 5 3 35 Statement of Cash Flows IAS 1, 7 230 5, 23 4, 21 5, 216 Cash and Receivables IAS 7, 39 305, 310 7 7 77 Inventories – Cost Basis IAS 2 330 8 8 98 Inventories –Subsequent Valuation IAS 2 330 9 9 99 Property, Plant & Equipment IAS 16, 23 360 10 10 10

10 Depreciation & Impairment IAS 16, 36 360-10-35 11 11 11

11 Intangible Assets IAS 38 350 12 10 1012 Current Liabilities &

ContingenciesIAS 32, 37, 39 405, 450 13 13 12, 19

13 Long-term Liabilities IAS 32, 39 470, 480 14 14 1214 Stockholders' Equity IAS 1 215 15 18 1315 Earnings Per Share &

Share-Based PaymentIAS 33, IFRS 2 260 16 19 18

16 Investments IFRS 7, IAS 27,28, 32, 39

32X 17 12 14

17 Revenue Recognition IAS 11, 18, 20 605 18 5 8

18 Income Taxes IAS 12 740 19 16 1619 Pensions IAS 19 715 20 17 1720 Leases IAS 17, 40 840 21 15 1521 Accounting Changes & Errors IAS 8 250 22 20 20

22 Disclosures &Segment Reporting

IFRS 7, 8,IAS 24

280, 850 24 3 19

ResourcesUS GAAP Codificationhttp://asc.fasb.org/home

IFRShttp://www.iasb.org/IFRSs/IFRS.htm



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Unit 1 – Introduction 3


Unit 1 – Introduction

Why learn IFRS?International Financial Reporting Standards, commonly referred to as IFRS, are gaining

momentum as the global norm in financial reporting. Issued by the London-basedInternational Accounting Standards Board (IASB), IFRS is currently accepted in over 100countries, including the members of the European Union, Israel and Australia. Many othercountries, such as Canada, Mexico, and India have committed to adopt or converge withIFRS by 2011.

For years, the Financial Accounting Standards Board (FASB) has been working with theIASB as part of a long-term plan toward convergence of IFRS and U.S. generally acceptedaccounting principles (US GAAP). Recently the SEC has taken steps toward adopting IFRSin the US. In 2007, the U.S. Securities and Exchange Commission (SEC) began acceptingIFRS financial statements for foreign filers, eliminating the prior requirement forreconciliation to US GAAP. In 2008, the SEC proposed a roadmap for conversion to IFRSthat would allow select companies to report under IFRS as early as 2009, with mandatoryadoption beginning as early as 2014. While the current chairman of the SEC has expressedskepticism regarding this timeline, she has also affirmed her commitment to developing oneuniversal set of high quality accounting standards. This leaves accountants, managers,investors, financial analysts and other users of financial statements questioning when theSEC will allow, or require, U.S. companies to use IFRS for their annual filings.

While the answer to this question remains uncertain, there is no doubt that IFRS isalready relevant for U.S. accountants. The continuing globalization of business means manyU.S. companies operating or obtaining capital in foreign countries, including 40% of theGlobal Fortune 500, are already affected by IFRS. A survey conducted by the AICPA in2008 found 55% of CPAs nationwide are preparing for IFRS adoption. IFRS is especiallyrelevant for accounting students, since the AICPA has expressed its intent to incorporateIFRS into the CPA exam; it has also amended Rules 202 and 203 of the Code of ProfessionalConduct to recognize the IASB as an international accounting standard setter, allowingaccountants of private U.S. companies to prepare financial statements in accordance withIFRS.1

Introduction to IFRSHistorically, multinational and global companies were required to prepare separate

financial statements for each country in which they did business, in accordance with eachcountry’s generally accepted accounting principles. In 1973, the International AccountingStandards Committee (IASC) was formed in response to the growing need to develop a set ofcommon financial standards to address the global nature of corporate financing. In 2000, theIASC received support from the International Organization of Securities Commissioners(IOSCO), the primary forum for international cooperation among securities regulator. TheIOSCO recommended its members (currently 181 organizations including the U.S. Securities& Exchange Commission and the Committee of European Securities Regulators) permit

1 State rules may, in some cases, limit the use of IFRS by private companies.



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multinational companies to use IASC standards along with a reconciliation to nationalGAAP. In 2001, the IASC reorganized as the International Accounting Standards Board toincorporate representatives from national standard-setting organizations.

The term IFRS has both a narrow and broad definition. Narrowly, it refers to the specificset of numbered publications issued by the IASB. Broadly it refers to all publicationsapproved by the IASB, including standards and interpretations issued by its predecessor, theIASC. All standards and interpretations have equal levels of authoritativeness. The IASBcurrently provides free access for these standards, without accompanying documents, athttp://www.iasb.org/IFRSs/IFRS.htm. Users must purchase a subscription to access the fulldocuments that include illustrative examples, implementation guidance, and the IASB’s basisfor conclusion on each issue.

Issued by the IASB: International Financial Reporting Standards (IFRS) Interpretations originated from the International Financial Reporting

Interpretations Committee (IFRIC)

Issued by its predecessor, the IASC, prior to 2001: International Accounting Standards (IAS) Standing Interpretations Committee (SIC)

In practice, there is still much variance in how countries apply IFRS. While the followingdescriptions of standards used by companies may sound similar, the financial statementsprepared under the different methods may vary considerably:

IFRS as national standards, with explanatory material added IFRS used as national standards, plus national standards for topics not covered

by IFRS IFRS modified for national conditions National standards “similar to”, “based on”, or “converged with” IFRS

The IASB has no authority to enforce IFRS, and must rely on regulatory bodies of individualcountries or regions. One possible method of enforcement lies in the IOSCO.

Development of IFRSThe IASB currently consists of 14 Board members, expanding to 16 by 2012. Each

member has one vote. The Board members currently come from nine countries and have avariety of functional backgrounds. IASB board members are selected by the trustees of theInternational Accounting Standards Committee Foundation (IASCF), an independentorganization. There are 22 trustees of the IASCF. To ensure adequate geographicrepresentation, North America, Europe and the Asia/Oceanic region each have 6 trustees.The remaining 4 trustees are appointed from any geographic area, in such a way thatmaintains balance both geographically and by professional background. Each trustee servesfor a term of three years, renewable once. Vacancies are filled by vote of the existingtrustees.

The IASB board members develop accounting standards in the following processdesigned to be transparent and accessible to all interested parties:



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Potential agenda items are discussed in IASB meetings. IASB meetings are opento the public, as well as broadcast and archived on the IASB website.

Discussion papers and Exposure Drafts are published and posted on the IASBwebsite for public comment. Public comments are also available on the IASBwebsite.

The IASB solicits comments from numerous standard-setting organizations andregulatory bodies. It also holds numerous meetings to obtain feedback frompreparers, users, academics and other affected parties.

Convergence with U.S. GAAPIn response to the increasingly global nature of business, efforts have been under way to

converge IFRS and U.S. GAAP since 2002. The IASB and FASB have worked togetherclosely and developed a plan for convergence of the two sets of standards. The current phaseof the plan is expected to be completed by 2011. Main areas of differences with U.S. GAAPare summarized below:

Areas where IFRS and U.S. GAAP are not converged:Consolidation policy, impairment, liabilities, intangibles

Areas where there are differences in the “details”:Revenues, income taxes, leases, pensions, business combinations, share-basedpayments

Despite the progress toward convergence, the financial information reported by acompany may differ significantly under the two sets of standards. Historically, the SEC hasallowed foreign companies trading stock on U.S. exchanges to prepare Form 20-F, theirannual financial statements, in accordance with a foreign GAAP as long as reconciliation toU.S. GAAP was included. A review of 2006 reconciliations21 determined that approximately2/3 of companies had higher income under IFRS, with a median increase of 12.9%. For the1/3 of firms with lower income under IFRS, the median difference was 9.1%. As previouslymentioned, in November 2007, the SEC eliminated the reconciliation requirement for foreignprivate issuers using IFRS.

SEC RoadmapAs mentioned previously, the SEC proposed a Roadmap in 2008 that outlined the process

for adoption of IFRS in the U.S. The plan includes a test period, in which a limited numberof companies will be allowed to voluntarily adopt IFRS for fiscal years ending afterDecember 15, 2009. To be eligible for early adoption, companies must meet two criteria.First, it must be among the twenty largest public companies in its industry. Secondly, IFRSmust be the most commonly used set of accounting standards among the twenty largestcompanies in the industry. It is estimated that 110 companies will be eligible for earlyadoption.

The roadmap identifies several key activities that must be completed to facilitate theadoption. The SEC is scheduled to evaluate progress in each of these areas in 2011 anddetermine whether mandatory adoption will begin in 2014. Milestones for adoption of IFRSare as follows:

2 Ciesielski, J. (2007). It's Not A Small World, After All: The SEC Goes International.The Analyst’s Accounting Observer 16 (11).



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Improving specific accounting standards.The SEC identified revenue recognition as one of the areas to be improved. Iturged FASB and the IASB to complete the scheduled plan for convergence.

Improving the funding and structure of the IASB.The IASC is currently funded by voluntary contributions from accounting firms,public companies, central banks and governments. The organization is workingtoward more secure funding by establishing target contributions for eachparticipating jurisdiction. Many countries are instituting levies on publiccompanies in order to fund their portion of the IASCF budget. In addition tostable funding, the SEC will also evaluate the structure of the IASB. In 2009, theIASCF took steps to increase its accountability to the public by establishing a linkwith a Monitoring Board of public authorities that will be responsible for theappointment of IASCF Trustees. Members of the Monitoring Board includerepresentatives from the IOSCO, the European Commission, the Japan FinancialServices Agency, and the SEC.

Facilitating the use of interactive data under IFRS.Beginning in June 2009, the SEC required the largest public companies to beginfiling their financial information with XBRL tags. Over a two-year phase-inperiod, the remaining public companies will be required to implement XBRL.The IASCF has taken steps to meet this milestone, culminating in the release ofthe XBRL IFRS Taxonomy in April 2009.

Updating the education and licensing of U.S. accountants.A number of universities have begun incorporating IFRS into accountingcoursework in preparation for conversion. In March 2009, the AICPA announcedits intention to begin incorporating IFRS into the CPA exam. Additional steps arenecessary to educate investors, managers, and regulators.

Pros and ConsWhile many believe the adoption of IFRS in the U. S. is inevitable, including the Big

Four accounting firms and AICPA President Barry Melancon, not everyone agrees this is inthe best interest of the American public. Advocates for the U.S. adoption of IFRS believeone global set of standards will streamline costs for U.S. companies operating globally andincrease comparability of financial statements between companies, resulting in lower costs ofcapital.

On the other hand, many people are concerned that IFRS is not as robust as U.S. GAAP,that the cost of transition will be high, and that the U.S. market is not prepared for thetransition. The SEC estimated the cost of conversion as high as $32 million for each of thelarge companies allowed early adoption according to the roadmap; that results in anestimated impact of $3.5 billion dollars on the U.S. economy just for the 110 expected earlyadopters. Based on the similar transition in Europe, experts believe the implementation ofIFRS will take companies two to three years. This includes time to gather the necessaryinformation, modify accounting and control systems, and possibly renegotiate debt and otheragreements linked to financial performance. An additional concern is the lack of accountingprofessionals familiar with IFRS. Knowledge of IFRS will be a valuable asset as you enterthe workplace during this time of dynamic change in the accounting profession.



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ResourcesIFRS - http://www.iasb.org/About+Us/International+Accounting+Standards+Board+-+About+Us.htm

http://www.iasb.org/About+Us/About+the+IASC+Foundation/Constitution/Constitution.htm

http://www.iasb.org/NR/rdonlyres/7D97095E-96FD-4F1F-B7F2-366527CB4FA7/0/DueProcessHandbook.pdf

http://www.iasb.org/IFRSs/IFRS.htm

IOSCO - http://www.fsa.gov.uk/Pages/Library/Communication/PR/2003/110.shtml

Exercises1. International Financial Reporting Standards are comprised of which of the

following?a. International Financial Reporting Standardsb. International Accounting Standardsc. Interpretations from the International Financial Reporting Interpretations

Committeed. All of the abovee. a and b

2. How can national standard-setting bodies be involved in setting InternationalFinancial Reporting Standards?

a. Recommending topics for the International Accounting Standards Boardagenda

b. Participate in joint research projectsc. Provide feedback on discussion papers and exposure draftsd. All of the abovee. a and b

3. How are International Financial Reporting Standards enforced?a. Enforcement Committee of the International Accounting Standards Boardb. Regulatory bodies of individual countriesc. International Securities and Exchange Commissiond. All of the abovee. None of the above

4. Explain to a friend how accounting rules are established in the international arena.

5. Discuss the four milestones included in the SEC’s IFRS Roadmap and explain whyeach is important in the convergence process.

6. List the three important dates in the SEC’s IFRS Roadmap and explain what isscheduled to occur at each date.



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Unit 2 – Conceptual Framework 8


Unit 2 – Conceptual Framework

The conceptual framework for IFRS is documented in the IASB Framework for thePreparation and Presentation of Financial Statements (Framework). Originally issued bythe IASC in 1989, the Framework was adopted by the IASB in 2001 and serves as a guide foraccounting issues not specifically addressed in the standards or interpretations. This relianceon the Framework is established in IAS 8 Accounting Policies, Changes in AccountingEstimates and Errors, which states that management should use its judgment in developingaccounting policies for areas in which the standards do not provide guidance. IAS 8 furtherrequires that management consider the definitions, recognition criteria and measurementconcepts for assets, liabilities, income, and expenses presented in the Framework beforeexercising its judgment.

The framework specifically addresses: Objectives of financial statements Qualitative characteristics Concepts of capital and capital maintenance Elements of financial statements

While there are many similarities (e.g. objectives of financial statements) between theFramework and the conceptual framework established by FASB in the six Statements ofFinancial Accounting Concepts, there are differences as well. The greatest difference lies inthe concepts of capital and capital maintenance, which include measurement methods to beused in recognizing elements of the financial statements. While US GAAP relies primarilyon historical cost (with the exception of certain financial instruments which are carried at fairvalue), IFRS lists several options – historical cost, current cost, realizable value, and presentvalue – without providing guidance on which method to implement.

An additional difference is found in the elements of financial statements. While thedefinitions are similar for the two organizations, there are differences in the details – e.g. theline between liabilities and equity as applied to convertible debt. A minor difference is alsofound in the qualitative characteristics identified in each framework. The IASB Frameworkfocuses on understandability, relevance, reliability, and comparability. US GAAP alsoincludes these characteristics, but adds a focus on consistency – the ability to compare thefinancial statements of an entity at two different points in time.

As part of the long-term convergence project, IASB and FASB are jointly working ondeveloping a conceptual framework to be adopted by both organizations. Early stages of theproject include agreement on the objectives, qualitative characteristics, and elements offinancial statements. Later stages focus on measurement issues, reporting entities, andpresentation and disclosure.



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Unit 2 – Conceptual Framework 9


ResourcesIASB Framework for the Preparation and Presentation of Financial Statementshttp://eifrs.iasb.org/eifrs/bnstandards/en/framework.pdf

IAS 8 Accounting Policies, Changes in Accounting Estimates and Errorshttp://eifrs.iasb.org/eifrs/bnstandards/en/ias8.pdf

Exercises1. The conceptual framework for IFRS addresses:

a. Objectives of financial statementsb. Qualitative characteristicsc. Concepts of capital and capital maintenanced. All of the abovee. None of the above

2. What is the status of the IFRS/US GAAP convergence project related toconceptual frameworks?

a. No convergence is considered necessary, since the framework is not anaccounting standard

b. It is part of the short-term convergence projectc. It is part of the long-term convergence projectd. Convergence has been completede. None of the above

3. What are differences between the conceptual framework for IFRS and US GAAP?a. Measurement methodsb. Focus on reliabilityc. Focus on understandabilityd. a and be. b and c

4. Your company is considering switching from US GAAP to IFRS. Your CEO,Julie Jones, has asked you to identify the major differences in the conceptualframeworks of US GAAP and IFRS so that she can understand the differentfoundations of the accounting rules.



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Unit 3 – Income Statement and Other Comprehensive Income 10


Unit 3 – Income Statement and Other Comprehensive Income

Income statementFor IFRS, there is no set format for the income statement, but there are six required

elements: Revenue Finance costs Profit or loss from associates and joint ventures accounted for using the

equity method Tax expense Discontinued operations Profit or loss (bottom line)

The expenses may be presented by nature (e.g., depreciation, purchases, employeebenefits, advertising) or by function (expenses are allocated to cost of sales, administrativeexpenses, distribution expenses, etc). If expenses are presented by function, additionaldisclosure is required for the amount of depreciation, amortization and employee benefitexpense.

This differs from US GAAP, which uses a single-step (expenses are presented byfunction and total expenses are deducted from total income) or multi-step (calculates grossprofit before other income and expenses are presented) format. The SEC requires publiccompanies to present expenses by function.

An additional difference between the two accounting methods is that IFRS prohibitsitems from being presented as Extraordinary (defined for US GAAP as material transactionsboth unusual in nature and infrequent in occurrence) either on the face of the incomestatement or in the accompanying notes.

Other Comprehensive IncomeThrough 2008, IFRS did not use the term “other comprehensive income”, but reported

these items in a statement entitled “Statement of Recognised Income and Expenses” (SoRIE)which included all changes to owner’s equity that are not transactions with owners. IASBrevised IAS 1 Presentation of Financial Statements, effective in 2009. The revised standardintroduces the term comprehensive income, and requires a company to present either onecombined statement of comprehensive income (that includes current profit and loss followedby components of other comprehensive income), or two separate statements – an incomestatement and a statement of comprehensive income (that begins with net profit and loss andis followed by components of other comprehensive income). Similar to US GAAP,components of other comprehensive income may be reported net of tax, or before tax with asingle line reporting tax on other comprehensive income. The footnotes should disclose thetax impact for each component of comprehensive income.

The revision to IAS 1 was a result of Phase A of the IASB’s project on financialstatement presentation and brings the IFRS presentation of other comprehensive income very



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close to that of US GAAP. However, the revised IAS 1 prohibits the presentation of non-owner transactions (other comprehensive income) in the statement of changes inshareholders’ equity. US GAAP allows the firm to select from three alternative presentationsof other comprehensive income – a separate statement, inclusion in the income statement, orinclusion in the statement of changes in stockholders’ equity. Phase B, a joint project withFASB, will focus on more detailed aspects of the financial statements – e.g. requiredsubtotals and totals.

The appendices include sample presentations of other comprehensive income aspresented by IFRS through 2008, as well as under the revised IAS 1 effective for yearsbeginning on or after January 1, 2009.

Minority interestThrough 2008, net income differed between the two frameworks due to the presentation

of minority interest. Minority interest refers to the ownership of a subsidiary with less than50% interest. For US GAAP prior to 2009, a company acquiring over 50% interest in a firmreports 100% of the subsidiary’s income, but also recorded an expense equal to the portion ofincome attributed to minority shareholders of the subsidiary. Thus the parent company’s netincome only included the percentage of the subsidiary’s income attributed to the parentcompany. For IFRS, 100% of the subsidiary’s income is reported by the parent company andreflected in net income. A disclosure on the face of the financial statements indicates theamount of net income attributed to shareholders (of the parent company) and the amountattributed to minority interest (of the subsidiary). When foreign private issuers prepared thenet income reconciliation on Form 20-F, they either included minority interest as areconciling item or began the reconciliation with IFRS net income attributed to shareholders.

This difference was minimized when FAS 160 Noncontrolling Interests in ConsolidatedFinancial Statements—an amendment of ARB No. 51 was issued, effective for yearsbeginning on or after December 15, 2008. Under the new guidance, US GAAP includes100% of the subsidiary’s income in net income. Earnings attributed to the minority interestwill be subtracted on the face of the financial statements to present net income attributed tothe parent. The primary remaining difference relates to the measurement of non-controllinginterests at the point of business combination. IFRS permits measurement at fair value orbased on a proportionate share of identifiable net assets. US GAAP requires measurement atfair value.

Proposed ChangesIn October 2008, FASB and the IASB issued a joint discussion paper that proposes

changes to the presentation of financial statements. The suggested format includes severaldifferences from the current presentation under US GAAP:

Requires a single statement for comprehensive income that will include a subtotalfor net income.

Revenue and expenses will be classified according to the traditional categoriesfrom the cash flow statement – operating, investing, and financing – withsubtotals for each category.

Within each section, expenses will be presented by function (e.g. selling goods,



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advertising, administration) Within each function, expenses will be further detailed by nature (e.g. materials,

labor, etc.)A link to the FASB’s illustrative example using the proposed model can be found in the

Resources section below. FASB and the IASB are planning to respond to public commentsin July 2009 and issue an exposure draft in 2010.

ResourcesIAS 1 Presentation of Financial Statementshttp://eifrs.iasb.org/eifrs/bnstandards/en/ias1.pdf

FASB & IASB Proposed Improvements to Financial Statement Presentation

http://event.on24.com/eventRegistration/EventLobbyServlet?target=lobby.jsp&eventid=131045&sessionid=1&key=66111B437C923AA624D843106BAF7C51&eventuserid=21584390

Exercises1. What items are currently required elements of the IFRS income statement?

a. Revenueb. Cost of salesc. Comprehensive incomed. a and be. All of the above

2. Through 2008, other comprehensive income could be reported in which IFRS financialstatement?

a. Statement of comprehensive incomeb. Statement of changes in shareholders’ equityc. Statement of recognized income and expensesd. b or ce. All of the above

3. What change(s) is/are introduced in the revised IAS 1 Presentation of FinancialStatements effective 2009?

a. Allows statement of recognized income and expensesb. Allows statement of comprehensive incomec. Prohibits comprehensive income from being presented in statement of changes

in stockholders equityd. a and ce. b and c



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4. Through 2008, how is net income attributed to minority interest presented in the IFRSincome statement?

a. Included in net incomeb. As a reduction to net incomec. Disclosed on the face of the income statementd. a and ce. b and c

5. How does the proposed model in the Discussion Paper jointly issued by the FASB andthe IASB differ from the current US GAAP income statement?

6. How must the following IFRS financial statement be changed to be in compliance foryears beginning after January 1, 20X9? Assuming there are no differences in IFRS/USGAAP calculations, how must the IFRS statement be changed so the presentation is inaccordance with US GAAP?

Impressive CorpStatement of Recognised Income and ExpenseYear Ended December 31, 20X8(dollar amounts are in millions)

20X8 20X7Unrealized gain, investments (3)$ 10$Loss on cash flow hedge (5) (5)Tax on items taken directly to equity 3 (2)Net income recognised directly in equity (5) 3Profit for the year 130 100Total recognised income and expense for the year 125$ 103$



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Unit 3 Appendix A – IFRS effective through 2008

Example 1 - presented with changes in equity

Impressive CorpStatement of Changes in EquityYear Ended December 31, 20X8(dollar amounts are in millions)

Equity Attributable to ShareholdersShare

CapitalOther

ReservesRetainedEarnings Total

MinorityInterest Total

Balance at 12/31/20X6 50$ 15$ 25$ 90$ 5$ 95$Changes in equity for 20X7Unrealized gain, investments 10 10 - 10Loss on cash flow hedges (5) (5) - (5)Tax on items taken directly to equity (2) (2) - (2)Net income recognised directly in equity 3 3 - 3Profit for 20X7 80 80 20 100Total recognised income and expense for 20X7 3 80 83 20 103Dividends (20) (20) - (20)Balance at 12/31/20X7 50 18 85 153 25 178Changes in equity for 20X8Unrealized gain (loss), investments (2) (2) (1) (3)Loss on cash flow hedge (5) (5) (5)Tax on items taken directly to equity 3 3 3Net income recognised directly in equity (4) (4) (1) (5)Profit for 20X8 104 104 26 130Total recognised income and expense for 20X8 (4) 104 100 25 125Dividends (25) (25) - (25)Balance at 12/31/20X8 50$ 14$ 164$ 228$ 50$ 278$

Example 2 - presented in separate statement

Impressive CorpStatement of Recognised Income and ExpenseYear Ended December 31, 20X8(dollar amounts are in millions)

20X8 20X7Unrealized gain, investments (3)$ 10$Loss on cash flow hedge (5) (5)Tax on items taken directly to equity 3 (2)Net income recognised directly in equity (5) 3Profit for the year 130 100Total recognised income and expense for the year 125$ 103$

Attributable to:Owners of the parent 100$ 83$Minority interest 25$ 20$



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Unit 3 Appendix B – IFRS effective for yearsbeginning on or after 1/1/2009

Example 1 - Comprehensive income in one statement & expenses by function

Impressive CorpStatement of Comprehensive IncomeYear Ended December 31, 20X8(dollar amounts are in millions)

20X8 20X7Revenue 433$ 400$Cost of sales (245) (230)Gross Profit 188 170Other income 21 13Distribution costs (9) (9)Administrative expenses (20) (18)Other expenses (2) (5)Finance costs (8) (11)Profit before tax 170 140Income tax expense (40) (40)PROFIT FOR THE YEAR 130 100Other comprehensive incomeAvailable for sale investments (3) 10Cash flow hedge (5) (5)Income tax related to other comprehensive income 3 (2)Other comprehensive income for the year, net of tax (5) 3TOTAL COMPREHENSIVE INCOME FOR THE YEAR 125$ 103$

Profit attributable to:Owners of the parent 104$ 80$Minority interest 26$ 20$

Total comprehensive income attributable to:Owners of the parent 100$ 83$Minority interest 25$ 20$

Earnings per share, basic and diluted (in dollars) 0.46$ 0.30$



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Example 2 - Comprehensive income in two statements & expenses by natureImpressive CorpIncome StatementYear Ended December 31, 20X8(dollar amounts are in millions)

20X8 20X7Revenue 433$ 400$Other income 21 13Changes in inventories of finished goods & WIP (99) (95)Raw material and consumables used (79) (92)Employee benefits expense (45) (43)Depreciation and amortisation expense (19) (17)Administrative expenses (20)Other expenses (6) (8)Finance costs (16) (18)Profit before tax 170 140Income tax expense (40) (40)PROFIT FOR THE YEAR 130$ 100$

Profit attributable to:Owners of the parent 104$ 80$Minority interest 26$ 20$

Earnings per share, basic and diluted (in dollars) 0.46$ 0.30$

Impressive CorpStatement of Comprehensive IncomeYear Ended December 31, 20X8(dollar amounts are in millions)

20X8 20X7Profit for the year 130$ 100$Other comprehensive income (loss)Available for sale investments (3) 10Cash flow hedge (5) (5)Income tax related to other comprehensive income (loss) 3 (2)Other comprehensive income (loss) for the year, net of tax (5) 3TOTAL COMPREHENSIVE INCOME FOR THE YEAR 125$ 103$

Total comprehensive income attributable to:Owners of the parent 100$ 83$Minority interest 25$ 20$



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Unit 4 – Balance Sheet 17


Unit 4 – Balance Sheet

Presentation and ClassificationAccording to IAS 1 Presentation of Financial Statements, the balance sheet is a required

component of an entity’s financial statements. IFRS require the balance sheet to presentinformation on the entity’s assets, liabilities, and equities. IAS 1 does not require a specificformat for the balance sheet. It should classify each section as current and noncurrent unlessthe liquidity presentation is more appropriate. However, there is no requirement that currentitems precede noncurrent items or vice versa. IAS 1 allows entities to use the liquiditypresentation if it increases the reliability and relevance of the information. If the liquiditypresentation is used, assets and liabilities must be reported in order of liquidity. IFRSrequires one year of comparative financial information.

IFRS presentation differs from US GAAP, which allows entities to choose between aclassified or nonclassified balance sheet. US GAAP presents assets and liabilities in order ofliquidity within the balance sheet, typically in decreasing order. US GAAP does not detailrequirements for comparative information.

At a minimum, IAS 1 requires entities to present the following items on the balancesheet. Note the inclusion of biological assets, which are not separated from property, plantand equipment under US GAAP.

Cash and cash equivalents Trade and other receivables Financial assets Investments accounted for under the equity method Investment property Inventories Intangible assets Biological assets Property, plant, and equipment Trade and other payables Financial liabilities Provisions Liabilities and assets for current tax Deferred tax liabilities and assets Minority interests Issued capital and reserves



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In the equity section, IAS 1 requires entities to disclose: Number of shares authorized Number of shares issued and fully paid, and issued but not fully paid Par value per share Reconciliation of the shares outstanding at the beginning and end of period Description of rights, preferences, and restrictions Shares held by the entity, subsidiaries or associates Reserved shares Description of nature and purpose of reserves

OffsettingIFRS does not allow assets and liabilities to be offset unless specifically allowed under a

standard. U.S. GAAP permits offsetting when there is an intention to offset, the amount isdeterminable, and offsetting is enforceable by law.

Revaluation of AssetsA major area of difference between IFRS and US GAAP relates to reporting the value of

property, plant, and equipment. According to IAS 16 Property, Plant and Equipment, theseassets can be reported on the balance sheet at cost or fair value. See Unit 9 – Property, Plant& Equipment for additional information.

Minority interestUS GAAP and IFRS also differ on the presentation of minority interests on the balance

sheet. Through 2008, US GAAP prohibited minority interests from being included in equity.While some firms present minority interests as a liability, the common treatment was toinclude them in “mezzanine equity” – a section between liabilities and equity. Beginning in2009, US GAAP conforms to IFRS by requiring minority interests to be presented in theequity section.

Proposed ChangesThe joint discussion paper issued by FASB and the IASB in October 2008 included

several changes for the balance sheet from the US GAAP presentation: Assets and liabilities will be classified as operating, investing or financing,

according to how the item is used (the “management approach”) Within each section, management must use a classified approach (short-

term/long-term) unless unless the liquidity presentation is more informative. The classified balance sheet will be presented as short-term (due within one year)

versus long-term rather than current (due within one operating cycle) versusnoncurrent.

Cash equivalents will be reported separately from cash.

FASB believes these changes will improve the comparability of financial statements byprescribing one common format for all preparers under IFRS and US GAAP, enhancecohesiveness by increasing the linkages between the financial statements, and highlightinformation by disaggregating items on the face of the financial statements. Two primaryconcerns have been voiced by opponents – that users will be overwhelmed by the amount of



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information included on the face of the financial statements, and that similar items will beclassified differently by two companies due to the management approach. As mentionedpreviously, FASB and the IASB are planning to respond to public comments in July 2009and issue an exposure draft in 2010.

ResourcesIAS 1 Presentation of Financial Statementshttp://eifrs.iasb.org/eifrs/bnstandards/en/ias1.pdf

FASB & IASB Proposed Improvements to Financial Statement Presentationhttp://event.on24.com/eventRegistration/EventLobbyServlet?target=lobby.jsp&eventid=131045&sessionid=1&key=66111B437C923AA624D843106BAF7C51&eventuserid=21584390

Exercises1. According to IFRS, all entities must present a classified balance sheet.

True or False

2. Thompson Corporation’s general ledger trial balance is presented below.

a. Cash and cash equivalents $100,000b. Trade receivables 25,000c. Property, plant and equipment 75,000d. Goodwill 30,000e. Prepaid expenses 15,000f. Intangible assets 50,000g. Short term borrowings 35,000h. Current tax payable 80,000i. Accounts payable 60,000j. Current portion on long term debt 20,000k. Long term provisions 12,000

Assume Thompson Corporation classifies assets and liabilities as current andnoncurrent. Prepare the current assets and current liabilities sections of thebalance sheet under IAS 1.



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3. Venus Company’s general ledger trial balance includes the following accounts:a. Cash $60,000b. Property, plant and equipment 50,000c. Trading liabilities 110,000d. Minority interest 4,500e. Trading assets 35,000f. Goodwill 65,000g. Deferred tax liabilities 25,000h. Liabilities to customers 95,000i. Subscribed capital 1,500j. Additional paid in capital 4,000k. Deferred tax assets 15,000l. Retained earnings 2,500m. Translation reserve 7,500n. Other assets 25,000

Prepare the balance sheet for Venus Company assuming the assets and liabilitiesare presented in order of liquidity.

4. List four differences in balance sheet presentation between IFRS and US GAAP.

5. This text describes four changes to the US GAAP balance sheet presentationproposed by the joint FASB/IASB discussion paper.

a. List each of the four proposed changes.b. Discuss whether these changes will improve the balance sheet.



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Unit 5 – Statement of Cash Flows 21


Unit 5 – Statement of Cash Flows

Similar to US GAAP, entities must present a statement of cash flows. IAS 7 Cash FlowStatements does not provide exemptions to certain investment entities as does US GAAP.According to IAS 7, entities should provide information about historical changes in cash andcash equivalents and classify cash flows according to operating, investing, or financingactivities. Both US GAAP and IFRS identify the direct method as the preferred form ofpresentation, but allow companies to use the indirect method.

US GAAP and IFRS define cash and cash equivalents similarly. As discussed in Unit 6 –Cash and Receivables, one difference is that IFRS includes bank overdrafts in the cash andcash equivalents category and US GAAP does not. The primary difference between USGAAP and IFRS is the classification of cash flows. IAS 7 provides entities greater flexibilityconcerning classifying cash flows as operating, investing, or financing activities.

Major Classification Differences

Transaction US GAAP Classification IFRS ClassificationInterest Received Operating Operating or InvestingDividends Received Operating Operating or InvestingInterest Paid Operating Financing or OperatingDividends Paid Financing Financing or OperatingIncome Taxes Operating Operating unless

specifically associated withfinancing or investingactivity

IAS 7 requires entities to separately disclose interest and dividends received and paid.Entities also must separately disclose income taxes on the statement of cash flows. WhileIAS 7 is flexible concerning the classification of interest, dividends, and income taxes, itstates that entities must classify these items in a consistent manner from period to period.

Both IFRS and US GAAP allow entities to use the direct or indirect method to preparethe statement of cash flows. The indirect method is more common for entities following bothstandards. However, both frameworks encourage entities to follow the direct method.

Proposed ChangesThe financial statement model proposed jointly by FASB and the IASB includes several

changes to the cash flow statement. As noted previously, the discussion paper proposes cashequivalents be reported separately from cash. The cash flow statement would reconcile thebeginning and ending balances of cash (excluding cash equivalents). While the new modeluses the same three categories as current standards (operating, financing and investing), itdefines them differently. Classification is based on the underlying assets. The operatingcategory includes “assets and liabilities that management views as related to the centralpurpose”. In most cases, this will result in a change of classification for purchases ofproperty, plant and equipment from the traditional investing category to operating. Theproposed model adds a detailed reconciliation of cash flows to comprehensive income. The



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reconciliation will dissagregate components of comprehensive income into the followingcategories:

Cash received or paid. Accruals other than remeasurement (including depreciation allocations) Regularly recurring remeasurements (e.g. due to change in fair value) Remeasurements that are not recurring (e.g. impairment)

FASB and the IASB believe these changes will add value for financial statement users byproviding additional information on the persistence and subjectivity of income components.

ResourcesIAS 7 Cash Flow Statementshttp://eifrs.iasb.org/eifrs/bnstandards/en/ias7.pdf

FASB & IASB Proposed Improvements to Financial Statement Presentationhttp://event.on24.com/eventRegistration/EventLobbyServlet?target=lobby.jsp&eventid=131045&sessionid=1&key=66111B437C923AA624D843106BAF7C51&eventuserid=21584390

Exercises1. IAS 7 requires entities to present a statement of cash flows.

True or False

2. US GAAP provides entities greater flexibility than IFRS in the classification ofcash flows as operating, investing, or financing activities.True or False

3. IAS 7 requires entities to use the indirect method to prepare the statement of cashflows.True or False

4. According to U.S. GAAP and IFRS, cash flows are divided into all of thefollowing activities except

a. Operatingb. Investingc. Financingd. Directing

5. Unlike IFRS, which of the following would not be considered cash and cashequivalents according to US GAAP?

a. Bank overdraftsb. Marketable securitiesc. Treasury billsd. Money market holdings



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6. According to U.S. GAAP, which of the following cash flow transactions would beconsidered an operating activity?

a. Interest receivedb. Dividends receivedc. Interest paidd. All of the above

7. Which of the following items is currently classified as investing for US GAAP but willbe classified as operating under the model proposed by FASB and the IASB?

a. Interest receivedb. Interest paidc. Purchase of equipmentd. Dividends received

8. Below is a summary of cash transactions for Harris Furniture Store during the currentyear. For each cash flow transaction, indicate whether it is an investing, operating, orfinancing activity under US GAAP and IFRS.

Cash Flow Transaction Type of Activity- US GAAP Type of Activity- IFRSInterest ReceivedBorrowed Long Term DebtPaid DividendPaid Suppliers for goodsSold LandReceipt from sale of goodsPaid InterestReceived Dividend



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9. During fiscal year 2008, Mavor’s Metals completed several transactions. Net incomefor the year was $42,400 and the beginning cash balance was $25,000. Use thesummary of transactions to complete the following:

a. Prepare Mavor’s statement of cash flows in accordance with US GAAP usingthe indirect method.

b. Prepare the cash flow statement in accordance with IFRS, creating the mostdifferences from US GAAP.

c. Analyze the effect of those differences on the cash flow statement.

Summary of Transactions:1) Cash sales, $200,0002) Sales on account, $75,0003) Collections on account, $40,0004) Paid accounts payable, $20,0005) Purchased land for cash, $70,0006) Borrowed long term debt, $110,0007) Issued Common Stock, $40,0008) Sold investment (long term), $25,0009) Interest expensed and paid, $15,00010) Depreciation expense, $17,00011) Prepaid expenses, $9,00012) Sold Building $15,000



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Unit 6 – Cash and Receivables 25


Unit 6 – Cash and Receivables

Cash and Cash EquivalentsIFRS and US GAAP define cash and cash equivalents similarly. According to both

standards, cash includes cash on hand and demand deposits. IAS 7 Cash and CashEquivalents defines cash equivalents as short-term highly liquid investments that are readilyconvertible to known amounts of cash and are subject to insignificant risks. Cash equivalentsmature within 90 days. The definition under US GAAP is similar. There is one difference inclassification relating to bank overdrafts. In general, US GAAP does not offset bankoverdrafts against the cash account. There is one exception to this rule. When there is cashavailable in another account in the same bank on which the overdraft occurred offsettingagainst the cash account is required. IFRS includes bank overdrafts in the cash and cashequivalents category if they are repayable on demand and form an integral part of an entity’scash management. As noted previously, IASB and the FASB have jointly developed aproposed model for financial statement presentation that would require segregatingseparating cash equivalents from reported cash.

ReceivablesAccording to IFRS, loans and receivables is one of four financial assets categories. The

loans and receivables category does not exist under US GAAP. IAS 39 FinancialInstruments: Recognition and Measurement defines loans and receivables as financial assetsthat are created by the enterprise by providing money, goods or services directly to a debtor.The category of loans and receivables does not include the following:

loans and receivables that an entity has designated as held at fair value withgains or loss going through profit or loss

loans and receivables classified as held for trading because an entity intends tosell them in the near future

loans and receivables designated as available for sale loans and receivables that the holder may not recover substantially all of its

initial investment

Examples of items in the loans and receivables category include accounts receivable andloans to other entities. US GAAP does not include trade accounts receivable and loansreceivable in the same category as debt securities. IAS 39 requires loans and receivables tobe measured initially at fair value. Valuation changes subsequent to the initial purchase areaccounted for at amortized cost using the effective interest method. IFRS requires financialassets including loans and receivables to be reported on the face of the balance sheet. Loansand receivables are classified as current if they are expected to be realized within 12 monthsor the normal operating cycle. Otherwise, the loans and receivables are classified as non-current. Entities following IFRS may subclassify receivables as receivables from tradecustomers and receivables from related parties and other amounts. US GAAP reportsreceivables at net realizable value and must separately disclose material related partyreceivables.



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Uncollectible Accounts ReceivableAn entity may not be able to collect all of its accounts receivable balance. IFRS and US

GAAP have similar requirements for recording uncollectible accounts receivable. Bothstandards require entities to use the allowance method. Under the allowance method, entitiesestimate the amount of expected uncollectible accounts. The estimate is recorded as anexpense and reduces accounts receivable through an allowance account. Collection ofaccounts receivable previously written off is accounted for similarly under US GAAP andIFRS. The only difference between the two standards relates to terminology. IFRS refers tothe allowance accounts as a ‘provision.’

Example:Jones Company estimates that 3% of credit sales will be uncollectible. Assuming thecompany uses the allowance method and sales are $300,000, the company will recordthe following entry.

Bad Debt Expense 9,000Provision for Bad and Doubtful Debts 9,000

Impairment of Notes ReceivablesIAS 39 specifies that entities should assess whether its financial assets are impaired. If a

portion of accounts receivable is impaired, the loss is measured as the difference between theasset’s carrying value and the present value of expected future cash flows discounted at theasset’s original effective interest rate. Entities can choose to recognize the uncollectibleamount either directly or through an allowance account. IFRS refers to the allowance accountas a ‘provision.’ The amount of the loss is recognized in profit or loss. IFRS allows entities tosubsequently reverse impairment losses provided there is objective evidence to warrantreversing the original impairment. Reversal of impairment is recognized in profit and loss.

Similarly to IFRS, US GAAP requires entities to assess whether financial assets areimpaired and recognize the impairment. If a note receivable is impaired, the loss is measuredby the creditor as the difference between the investment in the loan (usually the principleplus accrued interest) and the expected future cash flows discounted at the loan’s historicaleffective interest rate. US GAAP recognizes the uncollectible amount through an allowanceaccount. Unlike IFRS, US GAAP prohibits the reversal of impairment losses.

Sale of ReceivablesUS GAAP and IFRS have similar conceptual requirements for the sale of receivables.

However, the derecognition model under IFRS is different from US GAAP. US GAAPderecognizes financial assets (removes them from the balance sheet) based on a control test.US GAAP considers a transaction a sale if control of the receivable is transferred from theseller to the buyer. Specifically, US GAAP outlines three key tests that must be satisfied toderecognize financial assets including:

1. Assets must be legally isolated from the transferor (out of reach from the transferorand its creditors)

2. The transferee has the right to pledge or sell the asset to another party; and3. The transferor does not maintain effective control through a right or obligation to

repurchase the transferred asset



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IFRS derecognizes financial assets based on a test of risk and rewards first and considersa test of control second. According to IFRS, an entity may derecognize a financial asset whenany of the following conditions are met:

The rights to the cash flows arising from the asset expire The rights to the asset’s cash flows and substantially all risks and rewards of

ownership are transferred An entity assumes an obligation to transfer the asset’s cash flows, transfers

substantially all risks and rewards and meets the following conditions: No obligation exists to pay cash flows unless equivalent cash flows have been

collected from the transferred asset Prohibited from selling or pledging the asset besides as security to future

recipients for the obligation to pass through cash flows; and Cash flows must be remitted without material delay

Control of the asset is transferred even though substantially all of the risks andrewards are neither transferred nor retained

ResourcesIAS 7 Cash Flow Statementshttp://eifrs.iasb.org/eifrs/bnstandards/en/ias7.pdf

IAS 39 Financial Instruments: Recognition and Measurementhttp://eifrs.iasb.org/eifrs/bnstandards/en/ias39.pdf

Exercises1. How do the standards differ related to classifying bank overdrafts? Which standard

would more frequently require bank overdrafts to be offset against the cashaccount?

2. Discuss the method used under IFRS and US GAAP to account for uncollectibleaccounts receivable.

3. US GAAP and IFRS have a similar loans and receivables category of financialassets.True or False

4. Subsequent measurement of loans and receivables is at amortized cost using theeffective interest method under IFRS.True or False

5. Is there a difference in terminology between US GAAP and IFRS regarding theallowance account? If yes, what is the difference?



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6. How should the following accounts be classified under IFRS? Is the classificationthe same under US GAAP?

a. Coins and currencyb. Petty cashc. Saving accountd. Checking accounte. Deposits in transitf. Post dated check expected to be collected in one monthg. Bank overdrafts repayable on demand and an integral part of the entity’s

cash management.h. Long term loan to another entityi. Trade receivables due in two months

7. Based on the scenarios below, indicate whether the entity can derecognize thefinancial asset according to the derecognition tests set forth in IAS 39.

a. Cole Company sold a financial asset, which included an option torepurchase the financial asset at its fair value at the time of repurchase.

b. Draper Company entered into a sale and repurchase transaction where therepurchase price of the financial asset was fixed.

c. Jones Inc. entered into a securities lending agreement.d. Thomas Corporation completed an unconditional sale of 20 percent of all

principal and interest cash flows.

8. Becker Company has accounts receivables of $500,000. At year end, the companydetermined that 5% of accounts receivables will be uncollectible and the companyintends to write off the balance. Record the journal entry according to IFRS andUS GAAP.

9. On December 31, 2006, Jones Company sold manufacturing equipment to SteelCorporation. Steel Corporation gave Jones Company a 5 year $200,000, zerointerest note. The market rate of interest for a note with similar risks is 10%. AtDecember 31, 2008 Jones Company reviews its financial assets for impairment.Jones Company concludes that the value of the note is impaired and it only expectsto collect $150,000 of the principal at maturity. By December 31, 2009 JonesCompany has determined that $10,000 of the impairment loss on themanufacturing equipment should be reversed. Prepare the appropriate journalentries for December 31, 2008 and December 31, 2009 according to a) IFRS b) USGAAP. Explain why the journal entries differ under the two sets of standards.



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Unit 7 – Inventories: Cost Basis 29


Unit 7 – Inventories: Cost Basis

US GAAP and IFRS define inventories similarly. According to both sets of standardsinventories are assets:

Held for sale in the ordinary course of business; Being produced for sale in the ordinary course of business; In the form of materials or supplies to be used in production or to provide

services

US GAAP and IFRS both measure inventories initially at cost. Inventories are classifiedas current assets on the face of the balance sheet, because they are expected to be realizedwithin the entity’s normal operating cycle. Both standards require entities to disclose thecomposition of inventory in the financial statements.

Included costsTo determine cost, both standards include the costs of purchase, costs of conversion, and

costs to bring the inventories to their current location and condition. According to IAS 2Inventories, costs to bring the inventories to their current condition could include specificdesign expenses. US GAAP does not consider design expenses when calculating the cost ofinventory. Both standards exclude selling costs, general administrative costs, and moststorage costs from the cost of inventory.

Cost flow assumptionsUS GAAP and IFRS differ related to cost flow assumptions. Under US GAAP and IFRS

specific identification should be used to assign costs for inventory items that are notinterchangeable. Specific identification assigns specific costs to identifiable inventory items.For inventory items that are interchangeable, IAS 2 allows entities to use the FIFO orweighted average methods. The FIFO method follows the assumption that items purchased orproduced first are sold first and the ending inventory is made up of items recently purchasedor produced. The weighted average method prices inventory based on the average cost ofsimilar items purchased or produced throughout the period. IAS 2 prohibits entities fromusing the last in, last out (LIFO) method of inventory valuation. The LIFO method assumesthat items purchased or produced last are sold first and the ending inventory is made up ofitems purchased or produced first. The prohibition of LIFO as a method of determining thecost of inventory is a major departure from US GAAP. US GAAP allows entities to use theLIFO method as well as FIFO or weighted average. Changing the cost flow assumption mayhave a significant impact on the carrying value of inventory. Note that companies must usethe same inventory costing method for tax purposes as they do for financial accounting, andthe Internal Revenue Service has estimated elimination of LIFO for tax purposes would raisean additional $106 billion in tax revenue.

Both standards also allow entities to use the standard cost and retail methods as long asthe results approximate actual cost. IFRS requires entities to apply the same cost formula toall inventories similar in nature or use. US GAAP does not have a similar specificrequirement. IFRS and US GAAP require entities to consistently apply the selected costformula.



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ResourcesIAS 2 Inventorieshttp://eifrs.iasb.org/eifrs/bnstandards/en/ias2.pdf

Exercises1. The following inventory information relates to Camden Corporation’s purchasing

activities.July 1 Balance 500 units @ $7August 1 Purchased 300 units @ $9September 1 Purchased 150 units @ $10

Assume there are 250 units on hand at the end of the year.a) Compute the ending inventory and costs of goods sold assuming Camden

Corporation follows IFRS and chose to use FIFO.b) Compute the ending inventory and costs of goods sold assuming Camden

Corporation follows US GAAP and chose to use LIFO.c) How will the differences between FIFO and LIFO affect the Camden

Corporation’s financial statements?

2. On January 1, 2007 Loren Company had 400 units of inventory on hand at a cost of$12 per unit. The company purchased inventory four times during the year. Thefollowing information relates to the inventory purchases.March 1 Purchased 300 units @ $15June 1 Purchased 200 units @ $16August 1 Purchased 250 units @ $17October 1 Purchased 300 units @ $18

Assume Loren company sold 1000 units of inventory during 2007.a) Compute the ending inventory and costs of goods sold assuming Camden

Corporation follows IFRS and chose to use the weighted average method.b) Compute the ending inventory and costs of goods sold assuming Camden

Corporation follows US GAAP and chose to use LIFO.c) What are the differences in ending inventory and costs of goods sold using

weighted average and LIFO?

3. Which method of assigning costs to inventory is not permitted under IFRS?

4. US GAAP and IFRS classify inventories on the balance sheet asa. Non-current assetsb. Current assetsc. Current liabilitiesd. None of the above



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5. IAS 2 requires entities to consistently apply their selected cost formula.True or False

6. IFRS permits the following methods of assigning costs to inventoriesa. FIFOb. Weighted Averagec. LIFOd. Both a and b

7. According to IFRS, the choice of using FIFO or weighted average is a matter ofmanagement judgment.True or False



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Unit 8 – Inventories: Subsequent Valuation 32


Unit 8 – Inventories: Subsequent Valuation

According to US GAAP and IFRS, inventory should be written down if it declines invalue below its original cost. However, the guidance differs between the two frameworks.IAS 2 Inventories requires inventories to be measured at the lower of cost and net realizablevalue. Net realizable value is defined by IAS 2 as “the estimated selling price in the ordinarycourse of business less the estimated costs of completion and the estimated costs necessary tomake the sale.” According to IFRS, the journal entry to write down inventory debitsInventory write down expense and credits inventory. IAS 2 requires entities to reverse thevalue of inventory previously written down when there is a subsequent increase in theinventory’s value. Reversals are limited to the amount of the original write down.

Unlike IFRS, US GAAP requires inventories to be measured at the lower of cost ormarket as opposed to the lower of cost or net realizable value. Market refers to the cost toreplace the item of inventory by purchase or reproduction. There is an upper and lower limitto the lower of cost or market rule. The upper limit is net realizable value and the lower limitis net realizable value less a normal profit margin. The value of inventory under US GAAPand IFRS will only be the same when replacement cost is greater than net realizable value.The measurement differences can produce different amounts of expense recognized by IFRSand US GAAP in a given accounting period.

To write down inventory, entities can use the direct or indirect method. The journal entryunder the direct method debits cost of goods sold and credits inventory. The journal entryunder the indirect method debits loss due to market decline of inventory and creditsallowance to reduce inventory to market. Unlike IFRS, US GAAP prohibits the reversal ofwrite downs to market if replacement costs subsequently increase.

ResourcesIAS 2 Inventorieshttp://eifrs.iasb.org/eifrs/bnstandards/en/ias2.pdf

Exercises1. The following information relates to Broom Company’s inventory:

Historical Cost $10,000Net Realizable Value 7,000Replacement Cost (Market Value) 5,000Net Realizable Value less normal profit 4,500

Which two amounts would Broom Company compare to determine whether itsinventory should be written down according to 1) IFRS 2) US GAAP? Howmuch would the inventory be written down according to 1) IFRS 2) US GAAP?



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Unit 8 – Inventories: Subsequent Valuation 33


2. The following information relates to an inventory item of Sanchez Company.Sanchez’s normal profit margin is 10%.

Historical cost $50,000Replacement cost (Market Value) 40,000

Estimated selling price 44,000Estimated cost to complete and sell 8,000Net Realizable Value 36,000

Assuming Sanchez Company follows IFRS, determine the amount at whichinventory should be reported on the Sanchez Company’s December 31, 2008balance sheet. At what amount would inventory be reported following USGAAP?

3. Loudon Company has inventory on hand with a historical cost of $6,000. Itestimates that it would cost $4,500 to replace the inventory. The inventory’sestimated selling price is $5,500 and its estimated cost to complete and sell is$500. Assuming the company’s normal profit margin is 15%, record thejournal entries to write down the inventory under a) IFRS and b) US GAAP.

4. Jeffers Company purchased inventory for $10,000. The current cost to replacethe inventory is $9,300. The company estimates it can sell the inventory for$9,700 but will have to spend $300 to complete the inventory. The company’snormal profit margin is 12%. How much would the company need to writedown the inventory assuming it follows a) IFRS b) US GAAP? Assume thatnext period the selling price increases to $9,900, the replacement costincreases to $9,500 and the estimated cost to complete remains $300. Howwould the company reverse the prior write down using a) IFRS b) US GAAP?

5. How do the requirements under IFRS differ from US GAAP related to thevalue of inventory reported on the balance sheet?

6. How do IFRS and US GAAP differ related to reversing inventory write-downs?

7. According to IAS 2, the reversal of previously written down inventory islimited to the original write down.True or False



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Additional Resources 34


Additional Resources

IASBThe IASB website includes information on the organization, background on IFRS andsummaries of the current standards. Full text of the standards and interpretations areavailable by subscription.http://www.iasb.org

FASBThe new codification of US GAAP (Accounting Standards Codification) is available online.http://asc.fasb.org/home

Convergence PlanBoth standard setting boards describes the status of the convergence plan.

FASBhttp://fasb.org/project/index.shtml

IASB Convergence Planhttp://www.iasb.org/Current+Projects/IASB+Projects/IASB+Work+Plan.htm

AICPAThe AICPA has created a new site to aid CPAs in the adoption of IFRS, including onlinevideos and a list of resources and CPE offerings.www.ifrs.com

Firm GuidanceEach of the Big Four accounting firms has provided resources to increase awareness of IFRS.

DeloitteDeloitte’s IASplus website includes a variety of IFRS resources including summaries ofeach standard, with history of amendments, and links to interpretations; as well as US(and other national) GAAP comparisons; and illustrative financial statements.http://www.iasplus.com/index.htm

On a separate website, Deloitte provides downloadable modules for IFRS training. Eachmodule includes real-life scenarios and worked examples to demonstrate application ofthe standards.http://www.deloitte.com/dtt/section_node/0,1042,sid%253D49563,00.html

Deloitte also produces webcasts on select IFRS topics.http://www.deloitte.com/dtt/article/0,1002,cid%253D184083,00.html



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Additional Resources 35


Ernst & YoungErnst & Young provides bi-monthly newsletters on IFRS changes as well as interpretiveguidance on select standards.http://www.ey.com/GL/en/Issues/Governance-and-reporting/IFRS/Publications

KPMGKPMG’s online library include briefing sheets providing monthly updates on IFRSchanges, and the option to order additional resources such as IFRS/national GAAPcomparisons and interpretive guidance for IFRS application.http://www.kpmgifrg.com/pubs/index.cfm

At a separate web address, KPMG has made news and insights related to IFRS, as well aswebcasts summarizing the impact of IFRS on US markets.http://www.kpmgifrsinstitute.com/Events.aspx?CallFrom=ONDEMAND

PriceWaterhouseCoopersPriceWaterhouseCoopers includes numerous resources including IFRS guidance by topic,comparisons to US (and other national) GAAP, and illustrative financial statements byindustry,http://www.pwc.com/Extweb/pwcpublications.nsf/docid/CE5F993CB77F8F9580256B35004F5576



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Incorporating International Financial

Reporting Standards (IFRS)

into Intermediate Accounting

SOLUTIONS MANUALRevised June 30, 2009

Rebecca G. FayJohn A. Brozovsky

Jennifer E. EdmondsPatricia G. Lobingier

Sam A. Hicks

We express our appreciation to the Deloitte Foundation and to Carl Cronin and Greg Aliff, bothDeloitte partners and Virginia Tech alums, for the encouragement and financial support that made thisproject possible. Any errors or omissions are solely the responsibility of the authors and not Deloitte.



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Unit 1 - Introduction1. d2. d3. b4. Students should include the following items:

Countries develop their own standards or adopt those developed by others(such as the U.S. or the International Accounting Standards Board).Approximately 100 countries have adopted International Financial ReportingStandards issued by the IASB.

The IASB consists of 14 board members, currently from nine countries. IASB board members are appointed by the International Accounting

Standards Committee Foundation, which has 22 members representing allgeographic regions.

The IASB process includes the following steps:- Potential agenda items discussed in meetings open to the public- Discussion papers and exposure drafts are published for public

comment- The IASB solicits comments from numerous standard-setting and

regulatory bodies, as well as other users of the financial statements5. Discussion should include the following items:

Improving specific accounting standards Improving the funding and structure of the IASB Facilitating the use of interactive data Updating the education and licensing of U.S. accountants

6. 2009 – Voluntary early adoption of IFRS by select set of large companies2011 – SEC evaluates progress toward milestones2014 – Proposed mandatory adoption by all public companies

Unit 2 – Conceptual Framework1. d2. c3. a4. Students should include the following items:

Greatest difference is in the concept of capital and capital maintenance. USGAAP relies on historical cost for recognizing most financial statementelements, while IFRS lists several acceptable options – historical cost, currentcost, realizable value, and present value.

Additional differences are found in the elements of the financial statements.While definitions may be similar, details of the guidance result in differingclassifications for items such as convertible debt.



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Minor difference found in qualitative characteristics. Both frameworksinclude understandability, relevance, reliability, and comparability. USGAAP also includes a focus on consistency – the ability to compare thefinancial statements of an entity at two different points in time.

Unit 3 – Income Statement and Other Comprehensive Income1. a2. d3. e4. d5. The proposed model requires use of a single statement of comprehensive income with a

subtotal for net income; it classifies items as operating, investing, or financing andpresents subtotals for each category.

6. IFRS effective after 1/1/20091 – The statement should be named “Statement of Comprehensive Income”.2 – The first line of the statement will be “Profit for the year”, followed by the line

“Other comprehensive income”.3 – The tax component will be labeled “Income tax related to other comprehensive

income”.4 – The subtotal will be labeled “Other comprehensive income, net of tax”.5 – The total will be labeled “Total comprehensive income”.

US GAAP - Same as above, except “Profit for the year” will use a term such as “Netincome”.

Unit 4 – Balance Sheet1. False; IFRS require entities to prepare a classified balance sheet unless the liquidity

presentation provides more relevant and reliable information.

2. Current AssetsCash and cash equivalents $100,000Trade receivable 25,000Prepaid expenses 15,000Total Current Assets $140,000

Current LiabilitiesAccounts payable 60,000Short term borrowings 35,000Current portion on long term debt 20,000Current tax payable 80,000Total Current Liabilities $195,000



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3.Venus Company

Balance Sheet as of 31 December 2008

AssetsCash $60,000Trading assets 35,000Property, plant and equipment 50,000Goodwill 65,000Other assets 25,000Deferred tax assets 15,000Total Assets $250,000

Liabilities and EquityLiabilitiesTrading liabilities $110,000Liabilities to customers 95,000Deferred tax liabilities 25,000Total Liabilities $230,000

Shareholder’s EquityMinority Interests $4,500Subscribed capital 1,500Additional paid in capital 4,000Retained earnings 2,500Translation reserve 7,500Total Equity $20,000Total liabilities and equity $250,000

4. – IFRS requires a classified presentation unless liquidity presentation is more informative.U.S. allows prepares to choose between the two formats.

– IFRS requires separate presentation of biological assets– IFRS does not allow offsetting of assets and liabilities, while US GAAP allows

offsetting under certain circumstances– IFRS allows revaluation of property, plant & equipment whereas US GAAP reports

these assets at historical cost less depreciation and impairment.

5. a. Proposed changes: Assets and liabilities will be classified as operating, investing or financing,

according to how the item is used (the “management approach”) Within each section, management must use a classified presentation (short-

term/long-term) unless the liquidity presentation is more informative. The classified balance sheet will be presented as short-term (due within one

year)/long-term rather than current (due within one operating cycle)/noncurrent. Cash equivalents will be reported separately from cash.

b. b. Responses will differ. FASB believes these changes will improve comparability,enhance cohesiveness (linkage between statements), and highlight information.Opponents have expressed concern about the overwhelming volume of information,and a decrease in comparability introduced by the management approach forclassification.



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Unit 5 – Statement of Cash Flows1. True2. False; IFRS is more flexible than U.S. GAAP concerning the classification of cash flow

transactions as operating, investing, or financing. Specifically, it provides more than oneoption for interest received and paid, dividends received and paid, and income taxes.

3. False; IAS 7 allows entities to choose between the indirect and direct method ofpresentation. The indirect method is most commonly used.

4. d5. a6. d7. c8.

Cash Flow Transaction Type of Activity- US GAAP Type of Activity- IFRSInterest Received Operating Operating or InvestingBorrowed Long Term Debt Financing FinancingPaid Dividend Financing Financing or OperatingPaid Suppliers for goods Operating OperatingSold Land Investing InvestingReceipt from sale of goods Operating OperatingPaid Interest Operating Financing or OperatingReceived Dividend Operating Operating or Investing



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9a. US GAAPMavor’s Metals

Statement of Cash FlowsFor the Year Ended December 31, 2008

Cash flows from operating activities:Net income $42,400Adjustments:

Subtract increase in accounts receivable (35,000)Add Depreciation expense 17,000Subtract Increase in prepaid expenses (9,000)Subtract Decrease in accounts payable (20,000)Net Cash used by Operating Activities (4,600)

Cash flows from investing activities:Sold investment 25,000Sold Building 15,000Purchased land (70,000)Net cash used by investing activities (30,000)

Cash flows from financing activities:Issued Common Stock 40,000Borrowed long term debt 110,000Net cash provided by financing activities 150,000

Net increase in cash 115,400Beginning Cash Balance 25,000Ending Cash Balance $140,400

Other disclosures:Interest paid $ 15,000



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b. IFRSMavor’s Metals

Statement of Cash FlowsFor the Year Ended December 31, 2008

Cash flows from operating activities:Net income $42,400Adjustments:

Subtract increase in accounts receivable (35,000)Add Depreciation expense 17,000Add Interest expense 15,000Subtract Increase in prepaid expenses (9,000)Subtract Decrease in accounts payable (20,000)Net Cash used by Operating Activities 10,400

Cash flows from investing activities:Sold investment 25,000Sold Building 15,000Purchased land (70,000)Net cash used by investing activities (30,000)

Cash flows from financing activities:Issued Common Stock 40,000Interest paid (15,000)Borrowed long term debt 110,000Net cash provided by financing activities 135,000

Net increase in cash 115,400Beginning Cash Balance 25,000Ending Cash Balance $140,400

c. While the two cash flow statements arrive at the same total increase in cash, they differon the net cash provided by/used in the different activities. The alternativeclassification of the $15,000 interest means the difference between $10,400 providedby operating activities (IFRS) and a $4,600 deficit from operating activities (USGAAP). This is important as users of the financial statement often look at the cashflow provided by operating activities to determine the ability of a company to meet itsobligations and sustain operations.

Unit 6 – Cash and Receivables1. US GAAP does not offset bank overdrafts against the cash account. There is one

exception to this rule. When there is cash available in another account in the same bankon which the overdraft occurred offsetting against the cash account is required. IFRSincludes bank overdrafts in the cash and cash equivalents category if they are repayableon demand and form an integral part of an entity’s cash management. Entities following



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IFRS would classify bank overdrafts as cash and cash equivalents more frequently,because US GAAP rarely classifies bank overdrafts in this manner.

2. Entities must follow the allowance method. Under the allowance method, entitiesestimate the amount of expected uncollectible accounts. The estimate is recorded as anexpense and reduction in accounts receivable through an allowance account.

3. False; The loans and receivables category does not exist under US GAAP.4. True5. Yes, IFRS uses the term provision to refer to the allowance account.6. a. Cash

b. Cashc. Cashd. Cashe. Cashf. Receivableg. Cash (offset)h. Loans and receivablesi. Loans and receivables

US GAAP would classify the bank overdraft as a current liability instead of offsetting itto the cash account. US GAAP does not have a loans and receivables category. The longterm loan would be classified as loan under noncurrent asset and the trade receivableswould be categorized as a receivable under current assets.

7.a. Cole Company has transferred substantially all the risks and rewards of ownership

and can derecognize the asset.b. Draper Company has retained substantially all the risks and rewards of ownership and

must continue to recognize the asset.c. Jones Inc. has retained substantially all the risks and rewards of ownership and must

continue to recognize the asset.d. Thomas Corporation has transferred substantially all the risks and rewards of

ownership and can derecognize the portion of the asset that has been transferred.

8. Journal entry under US GAAP:Bad debt expense 25,000

Allowance for doubtful accounts 25,000

Journal entry under IFRS:Bad debt expense 25,000

Provision for bad and doubtful debts 25,000



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9. Carrying amount of note on 12/31/06= $200,000 *.62092= $124, 184 (Present value of$200,000 due in five years at 10% with annual compounding).

Date Interest Revenue Discount Amortized Carrying Value12/31/06 124,18412/31/07 12,184 12,184 136,60212/31/08 13,660 13,660 150,262

Computation of Loss:Carrying amount of note receivable 12/31/08 $150,262Less: Present value of $150,000 due in 3 yearsat 10% interest compounded annually) 112, 698Impairment Loss $37,564

The journal entry for December 31, 2008 under US GAAP:Bad Debt Expense 37,564

Allowance for Doubtful Accounts 37,564

IFRS allows the direct write off method or the allowance method to recognizeimpairment. The journal entry for the allowance method under IFRS:

Bad Debt Expense 37,564Provision for Bad and Doubtful Debts 37,564

The journal entry for the direct write off method:Bad Debt Expense 37,564

Note Receivable 37,564

According to IFRS, Jones Company should reverse the previous impairment loss. Thejournal entry for February 20, 2008 under IFRS assuming the company used theallowance method:

Allowance for Doubtful Accounts 10,000Bad Debt Expense 10,000

The journal entry for February 20, 2008 under IFRS assuming the company used thedirect write off method:

Note Receivable 10,000Bad Debt Expense 10,000

According to US GAAP, impairment losses can not be subsequently reversed. There is nojournal entry to record the $10,000 reversal of impairment loss.



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Unit 7 – Inventories: Cost Basis1 a. Since Camden Corporation had inventory of 950 units and ending inventory of 250

units, the Corporation must have sold 700 units. Following FIFO the calculations ofending inventory

Costs of goods soldJuly 1 Balance 500 units @ $7 = $3,500August 1 Purchased 200 units @ $9 = $1,800

Ending InventoryAugust 1 Purchased 100 units @ $9 = $900September 1 Purchased 150 units @ $10 = $1,500

Costs of goods sold is $5,300 ($3,500+ $1,800). Ending inventory is $2,400($900 +$1,500).

b. Following LIFO, the calculations of ending inventory and costs of goods sold are:

Costs of goods soldJuly 1 Balance 250 units @ $7 = $1,750August 1 Purchased 300 units @ $9 = $2,700September 1 Purchased 150 units @ $10 = $1,500July 1 Balance 250 units @ $7 = $1,750

Costs of goods sold is $5,950 ($1,750 + $2,700 + $1,500) and ending inventory is$1,750.

c. Camden Corporation will have a higher profit using FIFO because it produces a lowercost of goods sold than LIFO. The ending inventory is higher using FIFO than LIFO andthis will appear on the balance sheet.

2 a. Weighted AverageJanuary 1 Balance 400 units @ $12= $4800March 1 Purchased 300 units @ $15= $4,500June 1 Purchased 200 units @ $16= $3,200August 1 Purchased 250 units @ $17= $4,250October 1 Purchased 300 units @ $18= $5,400

Total number of units= 1,450 (400+300+200+250+300)Total cost= $22,150 (4800+ 4500+ 3200+ 4250+ 5400)Weighted Average cost per unit= $22,150/ 1,450= $15.28Ending inventory in units= 450 units (1450-1000)Ending inventory cost= 450* $15.28=$6,876



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Cost of goods available for sale $22,150Less: Ending Inventory 6,876

Cost of goods sold $15,274

b. LIFOMarch 1 Purchased 250 units @ $15= $3,750June 1 Purchased 200 units @ $16= $3,200August 1 Purchased 250 units @ $17= $4,250October 1 Purchased 300 units @ $18= $5,400

Cost of goods available for sale $22,150Less Cost of goods sold $16,600 (3750+ 3200+ 4250+ 5400)Ending Inventory $5,550

c. Cost of goods sold is lower when the company follows IFRS and uses the weightedaverage method. Ending inventory is lower when the company follows US GAAP anduses LIFO.

3. IAS 2 does not permit entities to use the last in, last out (LIFO) method of costassignment. This is a departure from US GAAP, which does permit the use of LIFO.

4. b5. True6. d7. True

Unit 8 – Inventories: Subsequent Valuation1. Following IFRS, Broom Company would compare the historical cost of $10,000 to the

net realizable value of $7,000. Broom should write down the inventory by $3,000.Following US GAAP, Broom Company would compare the historical cost of $10,000 tothe replacement cost (market value) of $5,000. Broom should write down the inventoryby $5,000. The $5,000 falls within the upper and lower bounds ($7,000 net realizablevalue and $4,500 net realizable value less a normal profit).

2. Following IFRS, inventory should be reported on Sanchez Company’s balance sheet atthe lower of cost or net realizable value. Net realizable value is $36,000, which is lowerthan the historical cost of $50,000. Sanchez Company must write down its inventory by$14,000. Inventory will be reported on the balance sheet for the year ended December 31,2008 for its net realizable value of $36,000.

Following US GAAP, inventory should be reported on Sanchez Company’s balance sheetat the lower of cost or market value. The market value is its replacement cost of $40,000.The upper limit is net realizable value $36,000 and the lower limit is net realizable valueless a normal profit margin ($36,000-5,400= 30,600). Sanchez Company is subject to theupper limit and should report inventory on the balance sheet for its net realizable value of$36,000. The results are the same under IFRS and US GAAP because the replacementcost is greater than net realizable value.



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3. IFRSInventory is reported on the balance sheet at the lower of cost or net realizable value. Inthis case, net realizable value $ 5000 is below historical cost $6,000. Inventory should bewritten down by $1,000. The journal entry at December 31, 2008 is:

Inventory write down expense $1,000Inventory $1,000

To record the write down on inventory from a decline in net realizable value.

US GAAPInventory is reported on the balance sheet at the lower of cost or market value. Marketvalue is $4,500, which falls between the lower and upper limits of $5,000 and $4,250.Inventory must be written down by $1,500 ($6,000-4,500). The journal entry atDecember 31, 2008 assuming the company uses the direct method is:

Cost of Goods Sold $1,500Inventory $1,500

To record the write down of inventory from the decline in market value.

The journal entry at December 31, 2008 assuming the company uses the indirect methodis:

Loss due to Market Decline of Inventory $1,500Allowance to Reduce Inventory to Market $1,500

To record the write down of inventory from the decline in market value.

4. Part 1IFRSInventory is reported on the balance sheet at the lower of cost or net realizable value. Inthis case, net realizable value of $9,400 is lower than the cost of $10,000. Inventoryshould be written down by $600.

US GAAPInventory is reported on the balance sheet at the lower of cost or market value. In thiscase, market value is $9,300, which is lower than the cost of $10,000. The market value$9,300 falls within the upper of net realizable value and the lower limit of net realizablevalue less a normal profit margin(9,400 and 8,272). The inventory should be writtendown by $700.

Part 2IFRSThe net realizable value is $9,600 ($9,900-$300), which is an increase of $200 in thecarrying value. Under IFRS, the company would reverse the write down by debitinginventory for $200 and crediting inventory write down expense for $200.



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US GAAPUnder US GAAP, the company cannot reverse the prior write down, because reversals toprior write downs are not permitted when replacement costs subsequently increase.

5. Following IFRS, inventory should be reported on the balance sheet at the lower of cost ornet realizable value. Following US GAAP, inventory should be reported on the balancesheet at the lower of cost or market value with an upper limit (net realizable value) andlower limit (net realizable value less normal profit margin). The results under the twostandards are only the when the replacement cost is greater than net realizable value.

6. IAS 2 requires entities to reverse the value of inventory previously written down whenthere is a subsequent increase in the inventory’s value. Unlike IFRS, US GAAP prohibitsthe reversal of write downs to market if replacement costs subsequently increase.

7. True



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Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of2002 on the Adoption by the United States Financial Reporting

System of a Principles-Based Accounting System

Submitted to Committee on Banking, Housing, and Urban Affairs of theUnited States Senate and Committee on Financial Services of the United

States House of Representatives

Office of the Chief AccountantOffice of Economic Analysis

United States Securities and Exchange Commission

This is a report prepared by the staff of the U.S. Securities and ExchangeCommission. The Commission has expressed no view regarding the analysis,

findings, or conclusions contained herein.

TABLE OF CONTENTS

Glossary of Acronyms

Executive Summary

I. IntroductionA. The Mandate to Study Principles-Based Accounting StandardsB. Participants in the Financial Reporting Process and the Reforms of

Sarbanes-OxleyC. Defining Principles-Based Accounting StandardsD. The Role of Judgment in Applying Accounting StandardsE. Accounting Standards in the Context of the Sarbanes-Oxley ReformsF. Characterizing Current Accounting Standards RegimesG. An Example of a Rules-Based StandardH. An Outline of the Study

II. Historical BackgroundA. Development of Accounting Standards

i. Development of Promulgated Standardsii. Current Role of Conceptual Framework in Standard Settingiii. Current Role of AcSEC, the EITF, and the FASB Staffiv. Role of the SEC

B. Current Status of U.S. Standardsi. Examples of Rules-Based Standardsii. Examples of Principles-Based Standardsiii. Examples of Principles-Only Standards

III. Components of Objectives-Oriented Standard SettingA. Relevance, Reliability, and ComparabilityB. The Asset/Liability ViewC. Theory of Optimal ScopeD. Illustration of the Use of Optimal Scope TheoryE. Implementation GuidanceF. Legacy Scope ExceptionsG. No True and Fair OverrideH. Form of Objectives-Oriented Standard



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I. Behavioral Changesi. Exercise of Professional Judgmentii. More Transparent Disclosure

J. EnforcementIV. Implementation Issues

A. Changes to the Conceptual FrameworkB. Continued Efforts on ConvergenceC. Redefine GAAP HierarchyD. Establishing Implementation Guidance

i. Formal Guidanceii. Informal Guidance

E. Increasing Access to Authoritative LiteratureV. Economic and Policy Analysis

A. Improved Accessibility To and Meaningfulness of Financial Informationfor Investors

B. Better Alignment of Professional Incentives and Mindset with Investors'Interests

C. Increased Informativeness of Financial Statements Under CertainConditions

D. Enhanced Quality, Consistency, and Timeliness of Standard SettingE. Providing a Vehicle for Convergence with International Accounting

StandardsF. Cost of Accounting ServicesG. Litigation UncertaintyH. Comparability IssuesI. Transition Costs

VI. Conclusion

GLOSSARY OF ACRONYMS

AAA American Accounting Association

AAER Accounting and Auditing Enforcement Release

AcSEC Accounting Standards Executive Committee of the American Institute ofCertified Public Accountants

AIA American Institute of Accountants

AICPA American Institute of Certified Public Accountants

APB Accounting Principles Board

ARB Accounting Research Bulletin

ASR Accounting Series Release

AU Codification of Auditing Standards

Commission United States Securities and Exchange Commission

Committee Committee on Accounting Procedure



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DIG Derivatives Implementation Group

EC European Commission

EITF Emerging Issues Task Force

FAF Financial Accounting Foundation

FASB Financial Accounting Standards Board

FEI Financial Executives International

FSP FASB Staff Position

GAAP Generally Accepted Accounting Principles

IAS International Accounting Standard

IASB International Accounting Standards Board

IASC International Accounting Standards Committee

IFRS International Financial Reporting Standard

IMA Institute of Management Accountants

MD&A Management's Discussion and Analysis

PCAOB Public Company Accounting Oversight Board

SAB Staff Accounting Bulletin

SAS Statement on Auditing Standards

SEC United States Securities and Exchange Commission

SFAC Statement of Financial Accounting Concepts

SFAS Statement of Financial Accounting Standards

SOP Statement of Position



Executive Summary

The Sarbanes-Oxley Act of 2002 ("the Act") sought, among other things, to improveour system of financial reporting by reinforcing the checks and balances that arecritical to investor confidence. Additionally, Congress recognized that questionsremain regarding the approach by which accounting standards are established. Asdirected by the Act, we have conducted a study of the approach to standard settingand found that imperfections exist when standards are established on either a rules-based or a principles-only basis. Principles-only standards may present enforcementdifficulties because they provide little guidance or structure for exercisingprofessional judgment by preparers and auditors. Rules-based standards oftenprovide a vehicle for circumventing the intention of the standard. As a result of our



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study, the staff recommends that those involved in the standard-setting processmore consistently develop standards on a principles-based or objectives-orientedbasis. Such standards should have the following characteristics:

Be based on an improved and consistently applied conceptual framework;Clearly state the accounting objective of the standard;Provide sufficient detail and structure so that the standard can beoperationalized and applied on a consistent basis;1

Minimize exceptions from the standard;Avoid use of percentage tests ("bright-lines") that allow financial engineers toachieve technical compliance with the standard while evading the intent of thestandard.

The Act requires changes in many facets of the financial reporting by and analysis ofcompanies. Some of the important changes being implemented and studies beingundertaken under the direction of the Act are: (1) required certification ofinformation by company CEOs and CFOs, (2) empowerment of audit committees toengage and approve the services provided by independent auditors, (3) morestringent auditor independence standards, (4) greater oversight of auditors throughthe establishment of the Public Company Accounting Oversight Board, (5) a study ofwhether investment banks played a role in the manipulation of earnings by somepublic companies, and (6) greater independence for the accounting standard setter.Additionally, as noted above, the Act directed the Securities and ExchangeCommission ("SEC") to conduct a study on the adoption by the United Statesfinancial reporting system of a principles-based standard setting process and tosubmit a report thereon to Congress. This study is intended to fulfill that mandate.

In the staff's view, U.S. generally accepted accounting principles ("GAAP"), despitebeing the historical product of a mixture of standard setting approaches, constitutesthe most complete and well developed set of accounting standards in the world.These standards vary significantly in their level of detail, adherence to a conceptualframework, and reliance on objectives and rules. While it has become fashionablerecently to refer to principles-based and rules-based standards, these categories arenot well defined and, therefore, are subject to a wide variety of interpretations. Toconduct a study of the adoption of principles-based standard setting in the U.S., wefirst had to provide a clear definition of the optimal type of principles-basedaccounting standards and to distinguish it from other approaches.

We chose to base the study on what we considered to be the optimal type ofprinciples-based accounting standards because we believe that Congress' intent wasto have the staff consider whether a different standard-setting paradigm from theone that exists today would be beneficial to U.S. investors. We believe that neitherU.S. GAAP nor international accounting standards, as currently comprised, arerepresentative of the optimum type of principles-based standards. Defining what webelieve to be the optimal paradigm provides a necessary framework for this study.

In our minds, an optimal standard involves a concise statement of substantiveaccounting principle where the accounting objective has been included at anappropriate level of specificity as an integral part of the standard and where few, ifany, exceptions or conceptual inconsistencies are included in the standard. Further,such a standard should provide an appropriate amount of implementation guidancegiven the nature of the class of transactions or events and should be devoid of



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bright-line tests. Finally, such a standard should be consistent with, and derive from,a coherent conceptual framework of financial reporting.

To distinguish this study's vision of the optimal approach from less formally definedapproaches proposed by others, we refer to our approach as "objectives-oriented"standard setting. We do occasionally refer to principles-based standard setting in thestudy, by which we mean standard setting approaches that approximate theobjectives-oriented approach we have defined. This study concludes that objectives-oriented standard setting is desirable and that, to the extent U.S. standard settershave not already done so, the benefit of adopting this approach in the U.S. shouldjustify the costs.

In contrast to objectives-oriented standards (as we have defined the term), rules-based standards can provide a roadmap to avoidance of the accounting objectivesinherent in the standards. Internal inconsistencies, exceptions and bright-line testsreward those willing to engineer their way around the intent of standards.2 This canresult in financial reporting that is not representationally faithful to the underlyingeconomic substance of transactions and events. In a rules-based system, financialreporting may well come to be seen as an act of compliance rather than an act ofcommunication. Additionally, because the multiple exceptions lead to internalinconsistencies, significant judgment is needed in determining where within themyriad of possible exceptions an accounting transaction falls.

At the other extreme, a principles-only approach (which some have suggested as themeaning of the term principles-based accounting standards) typically providesinsufficient guidance to make the standards reliably operational. As a consequence,principles-only standards require preparers and auditors to exercise significantjudgment in applying overly-broad standards to more specific transactions andevents, and often do not provide a sufficient structure to frame the judgment thatmust be made.3 The result of principles-only standards can be a significant loss ofcomparability among reporting entities. Furthermore, under a principles-onlystandard setting regime, the increased reliance on the capabilities and judgment ofpreparers and auditors could increase the likelihood of retrospective disagreementson accounting treatments. In turn, this could result in an increase for bothcompanies and auditors in litigation with both regulators and the plaintiffs' bar.

In contrast to these extremes, objectives-oriented standards explicitly chargemanagement with the responsibility for capturing within the company's financialreports the economic substance of transactions and events-not abstractly, but asdefined specifically and framed by the substantive objectives built into each pertinentstandard. In turn, auditors would be held responsible for reporting whethermanagement has fulfilled that responsibility. Accordingly, objectives-orientedstandards place greater emphasis on the responsibility of both management andauditors to ensure that the financial reporting captures the objectives of the standardthan do either rules-based standards or principles-only standards. Further, ifproperly constructed, we believe objectives-oriented standards may require less useof judgment than either rules-based or principles-only standards, and thus, mayserve to better facilitate consistency and compliance with the intent of the standards.

Fundamental to this approach is that the objectives-oriented standards, as definedherein, would clearly establish the objectives and the accounting model for the classof transactions, providing management and auditors with a framework that is



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sufficiently detailed for the standards to be operational. At the same time, ifconstructed with the optimal level of detail, such standards would provide users, aswell as regulators and others who oversee or monitor the financial reporting process,with sufficient detail to better comprehend and properly gauge the results reportedby management and attested to by the auditors. Further, because objectives-oriented standards provide a better framework in which to exercise professionaljudgment than do either rules-based or principles-only standards, they may serve tobetter facilitate compliance with the intent of the standards.

In this manner, an objectives-oriented approach should provide the means by whichmanagement and auditors may be held accountable for reporting the substance oftransactions within the financial statements. We believe that this responsibility-toensure the fulfillment of specific, substantive accounting objectives-more effectivelyaligns the interests of management and auditors with those of investors, than doeither a rules-based approach or a principles-only approach. As a consequence, weconclude that an objectives-oriented approach should ultimately result in moremeaningful and informative financial statements.

In addition, and importantly, under an objectives-oriented system, the cost toinvestors and analysts of comprehending the standards themselves is expected to belower. Indeed, ideally, an investor or analyst would obtain a reasoned conceptualunderstanding of the meaning of reported numbers by studying the stated objectiveof the pertinent standards. That is, under an objectives-oriented regime, eachstandard's stated objective assists the user in comprehending how the standard isconstructed, how it is to be applied to a class of transactions or events, and howthose transactions or events should be reflected in the company's financialstatements.

Another benefit of objectives-oriented standards is that they may serve to enhancethe quality, consistency, and timeliness of the standard setting process itself. Withtoday's faster pace of change, timeliness in the development of accounting standardshas become increasingly important. Under an objectives-oriented regime, standardsetters should be able to move faster to address emerging practice issues while stillproviding sufficient guidance so that the standards are operational.

An additional benefit is the facilitation of greater convergence between U.S. GAAPand international standards. Standard setters can come to an agreement on aprinciple more rapidly than they can on a highly detailed rule. The benefits ofconvergence include greater comparability and improved capital formation globally.We believe that neither current U.S. GAAP nor the current array of internationalstandards strike an optimal balance in the various trade-offs inherent in standardsetting, and thus we see convergence as a process of continuing discovery andopportunity to learn by both U.S. and international standard setters.

Other issues relevant to an economic analysis of an objectives-oriented approach areexplored in the body of the study. These include: costs of accounting services,comparability issues, certain transition costs, and litigation uncertainty.

We believe, however, that the concern over litigation uncertainty is sometimesoverstated and may arise out of a confusion between principles-based and principles-only standards. If preparers and auditors maintain contemporaneous documentationthat demonstrates that they properly determined the substance of a covered



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transaction or event, applied the proper body of literature to it, had a sound basis fortheir conclusions-particularly those involving the exercise of judgment-and ensuredthrough disclosure that their method was transparent, their exposure to litigationmay be reduced.

While we conclude that the benefits of adopting objectives-oriented or principles-based standards in the U.S. justify the costs, the magnitude of these benefits andcosts are extremely difficult to assess. Indeed, a study of the relative merits ofadoption by the U.S. financial reporting system of principles-based accountingstandards, as mandated by the Act, does not lend itself to a direct empirical testprior to its adoption and implementation. Moreover, the work of balancing thevarious trade-offs inherent in standard setting is an on-going process of discoverywith many participants. Indeed, we would not expect these trade-offs to carry thesame weights from one accounting issue to the next. In light of these challenges, thefocus of our economic analysis has been to identify the most important trade-offs insetting accounting standards that relate to the application of principles versus rules.The study, while being directional and conceptual in nature, is informed through botheconomic analysis and accounting experience.

As such, this study is a policy study. In it, we will be characterizing certain existingU.S. GAAP standards and, at least implicitly, criticizing the manner in which somestandards are currently structured and formulated. We do this to fulfill a legislativemandate. Nonetheless, nothing in this study should be construed as indicating abelief by the staff that any current U.S. GAAP standard is lacking in terms ofproviding sufficient structure, guidance, and consistency to hold preparers andauditors accountable and to be enforceable, as we do not believe that to be the case.Recognition that there is room for improvement to the standards should not beconfused with a suggestion that current standards are inadequate. As noted above,we believe that the current U.S. standards are the most complete and well developedset of accounting standards in the world.

As we will demonstrate, U.S. standard setters have begun the shift to objectives-oriented standard setting and are doing so on a prospective, project-by-projectbasis. We expect that the U.S. standard setters will continue to move towardsobjectives-oriented standard setting on a transitional or evolutionary basis.Operationalizing an objectives-oriented approach to standard setting in the U.S.requires the standard setters to undertake the following key steps, which areexplored in more detail in this report:

Ensure that newly-developed standards articulate the accounting objectivesand are devoid of scope exceptions, bright-lines and excessive detail;When developing new standards, ensure that they are aligned with animproved conceptual framework;4

Address current standards that are more rules-based;Address deficiencies in the conceptual framework;Redefine the GAAP hierarchy;5 andContinue efforts on convergence.

The following table outlines the key steps required for the U.S. standard settingprocess to move to a more objectives-oriented approach.



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Action Items Current Status Time Horizon

Conceptualframeworkimprovements project

FASB currently evaluating most efficientapproacha

Medium Term

Move towardsobjectives-orientedform of standards

Recent standards (e.g., SFAS No. 141and following) have included elements ofobjectives-oriented form

Immediate

Comprehensivereview of currentstandards to identifyand address thosethat are rules-based

SFAS No. 141 superseded APB OpinionNo. 16 (rules-based); accounting forstock-based compensation added toFASB agenda on March 12, 2003; staffand Board are evaluating existingstandards for purposes of future agendadecisions

Underway

One standard setterb AcSEC will no longer be responsible forissuing "authoritative" standards,transition plan is in place; EITFconsensuses now are subject to FASBapproval

Underway

Redefine GAAPhierarchy

Conceptual framework improvementsproject to be completed first

Medium term

Convergence In October 2002, FASB and IASB jointlyannounced intention to work towardsconvergence of international anddomestic standards. Joint or cooperativeprojects underway include businesscombinations, measuring financialperformance, stock-basedcompensation, revenue recognition, andshort-term convergencec

Underway, somestandardsexpected to beissued within thenext year, buteffort will be longterm



I. Introduction

A. The Mandate to Study Principles-Based Accounting Standards

The recent spate of major corporate accounting scandals suggested to many that oursystem of corporate governance and financial reporting is in need of improvement.To many it appears that, at least in some cases, the checks-and-balances within thefinancial reporting system-ranging from management to auditors, audit committees,boards of directors, analysts, rating agencies, corporate counsel, standard setters,regulators and the investors themselves-failed to prevent or detect large-scale fraud



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in major corporations which were carried out over extended periods of time. Whilewe believe the financial reporting system remains fundamentally sound, and,generally, of the highest quality, these failures were a call for action.

Congress responded by passing the Sarbanes-Oxley Act of 2002 ("the Act"),1 themost significant piece of securities legislation since the 1930s. Much of the Act maybe viewed as a legislative attempt to better align the incentives of management,auditors and other professionals with those of investors. For example, with respect tocorporate management, the Act increased penalties2 for violations of securities lawsand required certification of financial results by key corporate officers. With respectto auditors, the Act directed the Commission to establish rules prohibiting auditorsfrom the provision of certain non-audit services to audit clients and rules tostrengthen oversight of the audit process by audit committees. Additionally, it calledfor increased resources for inspection, review and enforcement with respect toauditors through the creation of the Public Company Accounting Oversight Board("PCAOB").

In sum, the Act called for improvement in the checks-and-balances that govern theproduction of financial information provided to investors and, thereby, served noticeon bad actors that they would be discovered and dealt with for theirmisrepresentations. But the logical question loomed as to whether these actionsaddressed completely the causes of these financial scandals. Many asked whether,beyond the bad actors, the accounting standards themselves might have playedsome role in facilitating or even encouraging the bad behavior. More generally, manyasked whether technical compliance with U.S. accounting standards necessarilyresults in financial reporting that fairly reflects the underlying economic reality ofreporting entities.

Among these concerns, there was a growing sense that the standard setting processin the U.S. may have become overly rules-based. Three of the more significant andcommonly-accepted shortcomings of rules-based standards are that they:

Contain numerous bright-line tests, which ultimately can be misused byfinancial engineers as a roadmap to comply with the letter but not the spirit ofstandards;Contain numerous exceptions to the principles purportedly underlying thestandards, resulting in inconsistencies in accounting treatment of transactionsand events with similar economic substance, and;Further a need and demand for voluminously detailed implementationguidance on the application of the standard, creating complexity in anduncertainty about the application of the standard.

Accordingly, Section 108(d) of the Act calls upon the staff of the Securities andExchange Commission ("Commission" or "SEC") to conduct a study on the adoptionby the United States financial reporting system of a principles-based accountingsystem and for the Commission to submit a report thereon to Congress by July 30,2003.3 The Act mandates that the study shall include: (i) the extent to whichprinciples-based accounting and financial reporting exists in the United States;4 (ii)the length of time required for change from a rules-based to a principles-basedfinancial reporting system;5 (iii) the feasibility of and proposed methods by which aprinciples-based system may be implemented;6 and (iv) a thorough economic



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analysis of the implementation of a principles-based system.7 This study responds tothese mandated inquiries.

B. Participants in the Financial Reporting Process and the Reforms ofSarbanes-Oxley

The objectives of financial reporting are to provide information that is useful toinvestors and creditors8 in their decision-making process.9 In order for the financialreporting process to be successful-that is, for the objectives to be accomplished-many participants play important roles. Among the participants whose roles arecritical to the success of the financial reporting process are company management,audit committees, external auditors, analysts and investment advisors, investors,regulators and oversight bodies, and accounting standard setters. The Act requireschanges by many participants in the financial reporting. Some of the importantchanges being implemented and studies being undertaken under the direction of theAct are: (1) required certification of information by company CEOs and CFOs, (2)empowerment of audit committees to engage and approve the services provided byindependent auditors, (3) more stringent auditor independence standards, (4)greater oversight of auditors through the establishment of the PCAOB, (5) a study ofwhether investment banks played a role in the manipulation of earnings by somepublic companies, and (6) greater independence for the accounting standard setter.

To study the implications of principles-based standards, it is necessary to considerthe entire context of financial reporting in the time period subsequent to theenactment of the Act. Stated differently, the standard setting approach is but oneelement of the reforms put in motion by the Act. Thus, an evaluation of the potentialeffectiveness of a principles-based approach to standard setting must be madewithin the context of these other reforms.10

In particular, the reforms of the Act require management to accept responsibility forensuring that the financial information provided to investors fairly presents thecompany's financial position, results of operations, and cash flows. Additionally,management is required to ensure that it has proper disclosure controls in place sothat the company will be able to provide clear and transparent disclosure to investorsof all material information.

Furthermore, through the PCAOB, the audit process and auditors will be more closelyscrutinized. As the evaluation of auditors shifts from one of "peer review" to that ofPCAOB inspection, it will place an additional premium on the auditors' ability toevaluate both compliance with generally accepted accounting principles ("GAAP") andthe adequacy of a company's disclosures in light of the underlying economicsubstance of the company's transactions.

C. Defining Principles-Based Accounting Standards

To conduct a study of the adoption of principles-based standard setting in the U.S.,we must first define principles-based. There are a wide variety of views on themeaning of that term. Accordingly, we have defined principles-based standardsbelow in a manner consistent with what we would view as optimal adjustments toU.S. standards in this direction. This approach allows us to analyze such a shift witha reasonable degree of specificity.11



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In our view, the optimal principles-based accounting standard involves a concisestatement of substantive accounting principle where the accounting objective hasbeen incorporated as an integral part of the standard and where few, if any,exceptions or internal inconsistencies are included in the standard. Further, such astandard should provide an appropriate amount of implementation guidance giventhe nature of the class of transactions or events and should be devoid of bright-linetests. Finally, such a standard should be consistent with, and derive from, a coherentconceptual framework of financial reporting.

To distinguish our vision of a principles-based approach to standard setting fromthose proposed by others, we refer to it as objectives-oriented standard setting.Standards established in such a fashion are objectives-oriented in a number ofsenses.

First, in applying a particular standard in practice, preparers (and auditors) arerequired to focus the accounting (and attestation) decisions on fulfilling theaccounting objective of that standard. This minimizes the opportunities for financialengineering designed to evade the intent of the standard.

Second, each standard is drafted in accordance with objectives set by anoverarching, coherent conceptual framework meant to unify the accounting systemas a whole.

Third, this approach eschews exceptions, which by their very nature are contrary tofulfilling a principled objective, create internal inconsistencies within the standard,and, inherently, create a need for more detailed guidance.

Fourth, it also eschews bright-line tests, which often are a product of the exceptions.These are inherently contrary to any principled objective, because a slight shift in theform or structure of a transaction can cause it to move across the threshold resultingin profoundly different accounting for transactions that are economically similar.

Finally, objectives-oriented standards clearly articulate the class of transactions towhich they apply and contain sufficiently-detailed guidance so that preparers andauditors have a structure in which to determine the appropriate accounting for thecompany's transactions. In general, the possible degrees of specificity to whichaccounting standards may be drafted constitute a spectrum ranging from theabstract, at one end, to the very specific at the other. Objectives-oriented standards,when properly constructed, land solidly between the two ends of this spectrum.12

Objectives-oriented standards stand in contrast to rules-based accounting standards,which are characterized by bright-line tests, multiple exceptions, a high level ofdetail, and internal inconsistencies. The vision underlying a rules-based approach isto specify the appropriate accounting treatment for virtually every imaginablescenario, such that the determination of the appropriate accounting answer for anysituation is straight-forward and, at least in theory, the extent of professionaljudgment necessary is minimized. Ironically, however, significant application ofjudgment remains necessary in a rules-based environment. The focus of thatjudgment, however, is not on capturing the economic substance of the transactionsor events, but rather it is shifted to the determination of which of the accountingtreatments within a complex maze of scope exceptions and often conflicting guidanceis applicable.



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An argument in support of the use of bright-line tests that are endemic to rules-based accounting standards is that the tests result in greater comparability acrossissuers since all are applying the same bright-lines. However, contrary to thesebeliefs, rules-based standards often create only illusory comparability becausetransactions falling just barely on opposite sides of the bright-line are generally verysimilar, but receive very different accounting treatments.

Unfortunately, experience demonstrates that rules-based standards often provide aroadmap to avoidance of the accounting objectives inherent in the standards.Internal inconsistencies, exceptions and bright-lines tests reward those willing toengineer their way around the intent of standards. This can result in financialreporting that is not representationally faithful to the underlying economic substanceof transactions and events. In a rules-based system, financial reporting may wellcome to be seen as an act of compliance rather than an act of communication.Moreover, it can create a cycle of ever-increasing complexity, as financialengineering and implementation guidance vie to keep up with one another.

Objectives-oriented standards also stand in contrast to what we refer to asprinciples-only (as contrasted with principles-based) standard setting, which mightbe defined as high-level standards with little if any operational guidance.13 Aprinciples-only approach often provides insufficient guidance to make the standardsreliably operational. As a consequence, principles-only standards typically requirepreparers and auditors to exercise judgment in accounting for transactions andevents without providing a sufficient structure to frame that judgment.14 The resultof principles-only standards can be a significant loss of comparability amongreporting entities.

In contrast to these extremes, objectives-oriented or principles-based standardscharge management with the responsibility for capturing within the company'sfinancial reports the economic substance of transactions and events-not abstractly,but as defined specifically and framed by the substantive objectives built into eachpertinent standard. In turn, auditors would be held responsible for reporting whethermanagement fulfilled that responsibility. Accordingly, objectives-oriented standardsimpose a greater responsibility on both management and auditors than do eitherrules-based standards or principles-only standards. Further, if properly constructed,objectives-oriented standards may require less use of professional judgment thaneither rules-based or principles-only standards, and thus, may serve to betterfacilitate efforts to enforce compliance with the standards.

Fundamental to this approach is that the objectives-oriented standards would clearlyestablish the objectives and the accounting model for the class of transactions,providing management and auditors with a framework that is sufficiently detailed forthe standards to be operational. At the same time, such standards would provideusers, as well as regulators and others who oversee or monitor the financialreporting process, with sufficient detail to comprehend and properly gauge theresults reported by management and attested to by the auditors. In this manner, anobjectives-oriented approach should provide the means by which management andauditors may be held accountable for reporting the substance of transactions withinthe financial statements.

Thus, on the one hand, objectives-oriented standards are superior to rules-basedstandards, because they avoid the pitfalls that may result in financial engineering to



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achieve desired accounting results. On the other hand, objectives-oriented standardsare superior to principles-only standards, because they provide sufficient structurefor preparers and auditors to make a determination of the appropriate accounting. Asa consequence, we believe financial reporting based on objectives-oriented standardsstrikes an optimal balance and should increase both comparability and transparencyof information as compared to either a principles-only approach or a rules-basedapproach to standard setting.

Some of the concerns that have been expressed about principles-based standardsinclude: (1) a loss of comparability because of management and auditor discretion inthe application of the principles, (2) a greater difficulty in seeking remedies against"bad" actors either through enforcement or litigation, and (3) a concern by preparersand auditors that regulatory agencies might not accept "good faith" judgments.15

However, these concerns seem more founded as a critique of principles-onlystandards. Indeed, it is for these very reasons that we reject principles-onlystandards as an optimum standard setting paradigm.

In contrast to a principles-only approach, the framework for the application ofprofessional judgment in an objectives-oriented regime is much narrower andprovides a basis for more informative financial information to be provided toinvestors.16 Indeed, properly constructed objectives-oriented standards have thepotential to improve "actual" comparability as compared to either a rules-based or aprinciples-only approach,17 since the application of an objectives-oriented standard ismore likely to reflect the underlying economic substance of transactions or events,while the range within which professional judgment must be exercised is narrowedas compared to either a principles-only or a rules-based approach.18 Indeed, withmanagement and auditors held accountable for fulfilling the narrowly circumscribedsubstantive accounting objectives built into objectives-oriented standards, we believethat the degrees of freedom to achieve "desired" accounting results is minimized-relative to either a rules-based or a principles-only approach.19

D. The Role of Judgment in Applying Accounting Standards

Regardless of the approach that standard setters take to establishing accountingstandards, there are, inevitably, many interpretive actions taken by managementand the auditors in preparing and attesting to a company's financial statements.Indeed, the process of preparing the company's financial statements essentiallyconstitutes a translation of economic reality into an accounting framework as definedby a set of standards. Likewise, attesting to the appropriateness of those financialstatements requires the auditor to make an informed judgment as to whether thefinancial statements are representative of that economic reality, in accordance with aset of standards. This interpretive process necessarily involves judgment. Bychanging the focus of professional judgment to the objectives of the accountingstandard, objectives-oriented standards allow accounting professionals tooperationalize accounting treatments in a manner that best fulfills the objective ofeach standard and thereby best captures the underlying economic reality.

In contrast, inherent in a rules-based approach is an intent to minimize (and indeedin certain instances to trivialize) the judgmental component of accounting practicethrough the establishment of complicated, finely articulated rules that attempt toforesee all possible application challenges.20 Unfortunately, this belief that judgmentcan be minimized or eliminated is a mistake for at least three reasons.



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First and foremost, no standard setter can ever sufficiently identify the myriad ofbusiness situations to which accounting standards must be applied. As aconsequence, it is virtually impossible for standard setters to construct accountingcategories with sufficient refinement so as to be optimal for each and every situationencountered. Indeed, the more rigid and detailed accounting standards are, the lesswell they may fit the unforeseen specific facts associated with individual reportingcompanies' circumstances. In contrast, objectives-oriented accounting standardsshould provide a better balance of structure and flexibility that affords managementand accountants the opportunity, and gives them the responsibility, to interpretcompany-specific facts in the manner that best conveys the underlying economicreality to investors.

Second, excessively detailed accounting standards fail to take advantage of thecompany-specific knowledge of the front-line professionals-management,accountants, audit committee members, and auditors-who are making theaccounting judgments. Managements have access to much information that is crucialfor quality financial reporting. Excessive efforts by standard setters to eliminatejudgment sacrifice valuable information that might otherwise be offered by the mostinformed parties. Accounting standards must incorporate some flexibility within theirstructure-as do objectives-oriented standards-to best facilitate the capture of suchknowledge.

Finally, it is simply impossible to fully eliminate professional judgment in theapplication of accounting standards.21 To pretend that standards can be written insuch a manner results in both unnecessary cost and a misplaced regulatory focus. Noset of ever more complicated rules can substitute for the essential ingredients to thereporting process of professional integrity and accountability. Furthermore, as notedearlier, because of the exceptions and internal conflicts inherent in a rules-basedsystem of accounting standards, judgment is not eliminated at all. Rather, thejudgment shifts to a determination of which part of the contradictory rules should beapplied.22

E. Accounting Standards in the Context of the Sarbanes-Oxley Reforms

An evaluation of the potential effectiveness of an objectives-oriented standardsetting approach must be made within the context of the other reforms associatedwith the Act. In particular, the reforms of the Act require management to acceptresponsibility for ensuring that the financial information provided to investors fairlypresents the company's financial position, results of operations, and cash flows.Additionally, management is required to ensure that it has proper disclosure controlsin place so that the company will be able to provide clear and transparent disclosureto investors of all material information. Furthermore, through the PCAOB, the auditprocess and auditors will be more closely scrutinized. As the evaluation of auditorsshifts from one of "peer review" to that of PCAOB inspection, it will place anadditional premium on the auditors' ability to evaluate both compliance with GAAPand the adequacy of the company's disclosures in light of the underlying economicsubstance of the company's transactions. These changes coupled with greaterempowerment of audit committees to engage and approve the services provided byindependent auditors, more stringent auditor independence standards, andsubstantial penalties for violations23 provide the context for an evaluation ofobjectives-oriented standard setting. Thus, the other reforms from the Act serve to



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re-inforce the incentives of management and auditors to provide more informativefinancial reporting.

The reforms associated with the Act are highly complementary to objectives-orientedstandard setting. While objectives-oriented accounting standards hold preparers andauditors to a heightened degree of responsibility for the fulfillment of substantive,clearly-defined accounting objectives, the Act provides for the heightened monitoringand accountability that ensures most will be motivated to do so. For example,management certifications could be more meaningful when combined withobjectives-oriented accounting standards, as the goal of fair presentation of resultswould underly the objectives upon which standards are built. And while no regimecan preclude fraud, we believe that objectives-oriented accounting standards alsomay better align the incentives of those who produce financial information with theinterests of investors, which should result in more informative financial information.This, above all, is the underlying goal of the Act. Without the other reformsassociated with the Sarbanes-Oxley Act, the potential benefits of objectives-orientedstandards would be lower, while the associated costs would be higher.

F. Characterizing Current Accounting Standards Regimes

Many contend that U.S. GAAP provides an example of a rules-based approach tostandard setting. However, we do not fully agree. While we agree that certainstandards do suffer from the short-comings of a rules-based approach, many othersare closer to the kind of principles-based approach we prescribe herein. Moreover,U.S. GAAP already is based on an explicit conceptual framework, albeit one in needof improvement.

That being said, we do take certain standards currently extant in the U.S. accountingliterature as examples of rules-based standards. These include standards onderivatives, leases, and stock compensation. Many believe that these standards,which will be discussed in more detail later in this report, are far from the optimalpoint on the spectrum and would benefit from an objectives-oriented standardsetting approach.

Many have pointed to International Financial Reporting Standards ("IFRSs"),24 issuedby the International Accounting Standards Board ("IASB") and selected for adoptionin Europe by the European Commission ("EC"),25 as an example of a principles-basedregime. We do not believe the line of demarcation to be quite so simple. As theycurrently stand, the IFRSs do not embody the objectives-oriented approach toprinciples-based accounting standard setting. Indeed, a careful examination of theIFRSs shows that many of those standards are more properly described as rules-based. Other IFRSs could fairly be characterized as principles-only because they areoverly general.26 Accordingly, we reject the notion that IFRSs constitute a model forprinciples-based accounting standards.

G. An Example of a Rules-Based Standard

One conclusion of this study is that the existence of numerous exceptions andvoluminous detailed guidance, as characterizes a rules-based standard, often leadsto inconsistencies in the application of the standard Such standards may containconflicting guidance and, because preparers and auditors may have differentinterpretations about which application of the literature is appropriate, there can be



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inconsistent accounting among companies for similar transactions.27 Moreover, thebright-line tests that demarcate the exceptions provide a roadmap for financialengineers to achieve desired accounting results. A consequence of such financialengineering is that transactions that are substantively the same may receive verydifferent accounting. Some have argued that rules-based standards help achievegreater comparability in reporting. In reality, because of the inherent inconsistenciesand bright-lines, comparability in reporting can be illusory.

To illustrate, consider an example of accounting for a business combination.28

Accounting Principles Board ("APB") Opinion No. 16 concluded that both the poolingof interests method and the purchase method were appropriate methods inaccounting for business combinations. However, in reaching that conclusion, the APBspecified 12 criteria, all of which must be met, in order for a combination to beaccounted for as a pooling of interests.29 A combination that failed to meet one ormore of those criteria was accounted for as a purchase.30 These criteria were almostall bright-line tests. For example, if a company acquired 90% of another companythrough an exchange of stock, pooling of interests was possible, but if it acquiredonly 89%, pooling was not possible. Pursuant to another test, the issuance of oneshare of restricted stock to an employee during certain periods could turn atransaction from a pooling to a purchase.

The purchase method and the pooling of interests method yield dramatically differentfinancial reporting results. The purchase method reflects the business combination atfair value-that is, the amount paid by the acquiring company-while the pooling ofinterests method relies on book value. Because of this dramatic difference inreporting, financial engineers were sometimes eager to structure combinations in amanner that met the pooling of interests requirements. Inevitably, this led to ademand for increased guidance on the application of the pooling of interests criteria,which, in turn, led to increasingly complex and detailed guidance. Nonetheless,because of the significant difference in financial reporting under the two methods,companies often were willing to incur the cost and effort needed to navigate thedifficult path to achieve a desired accounting result (pooling of interests)-despite thefact that the basic transaction, the combination of two entities, was not altered bythe accounting method.

Consider a numerical illustration. Assume that Company A acquires Company Bthrough the exchange of voting stock. The value of the exchange to Company A is$1,000 and the book value of Company B's net assets is $400. Further, assume thatin the first year after the acquisition, Company B has net income of $300 (based onCompany B's underlying book value). Let us also assume that the $600 differencebetween Company B's book value and the fair value of the combination isattributable to identifiable assets that are depreciated or amortized over six years.Under the pooling of interests method, the income that would be reported fromCompany B's operations would be $300. If, however, the combination were reportedas a purchase, the income that would be reported from Company B's operationswould be $200 ($300 minus $100 of additional depreciation/amortization). In eithercase, however, the related cash flows and economic value of Company B's operationsto Company A would be the same.

Thus, the presence of the pooling of interests alternative, and the rules associatedwith it, rendered illusory the comparability in financial reporting for businesscombinations. Obviously, the underlying economic reality for a given transaction was



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the same regardless of whether the transaction was accounted for as a pooling ofinterests or a purchase. Nonetheless, there is evidence to suggest that investors'assessments of the company were affected by the difference in reporting.31



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ACTG381Project 2

Revenue Recognition – Gross vs. Net

Background: Your wealthy Uncle Al has recently hired you to help set up the accountingpolicies for his newly formed internet retail company, Excess Outdoor Equipment (EOE.com).EOE.com is modeled after Overstock.com, but is focused exclusively on selling discountedoutdoor apparel and equipment that is excess stock of other companies.

Uncle Al is very concerned that his newly formed company follows GAAP, and he is aware thatthere are specific accounting issues with the way on-line retailers account for revenue. Uncle Alexplained that some internet retailers act as intermediaries and do not take actual possession ofthe merchandise. There has been some controversy whether these retailers should record asrevenue the full selling price of the items sold along with the corresponding cost of goods sold(i.e., the gross method), or whether these retailers should just record as revenue the“commission” earned on selling the goods (i.e., the net method). At this point Uncle Al has notdetermined whether EOE.com will (1) take possession of the merchandise prior to the sale orwill (2) simply act as an intermediary.

Required: Uncle Al has asked you to write a memo documenting what you believe is theappropriate revenue recognition policy for EOE.com. You should consider both the scenariowhere EOE.com takes possession of the goods and where EOE.com acts as an intermediary.

To get you started, Uncle Al suggests that you do some research on the following:1) Identify the relevant authoritative literature on this issue by accessing the FASB

Codification database through as follows:http://aaahq.org/ascLogin.cfm

User ID: AAA51686Password: SLb736y

2) Determine the factors in the authoritative literature that influence the choice of whether acompany should use the gross or net method of recording revenue.

3) Learn what other on-line retailers are doing by using EDGAR (www.sec.gov) to locateOverstock.com’s 2003 and 2005 10-Ks and read the revenue recognition footnotes forthose years. Consider the rational discussed by Overstock in changing revenuerecognition methods.

Format: One memo should be turned in by each group. The memo should be typed, in standardbusiness memo format, well reasoned, and grammatically correct. Each group member’s nameshould be included in the “from” line of the memo. The memo should be 1-2 pages. The memoshould be structured as follows:

Introductory paragraph - purpose of the memo. Body – Background facts about the company situation, discussion of relevant authoritative

literature, summary of what other on-line retailers (i.e., Overstock.com) are doing. Conclusion – recommended accounting policy for revenue recognition.



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Group Member Evaluation: Teamwork is an important aspect of professionalism. Using theattached form, evaluate each team member of your group (excluding yourself). Your own groupmember evaluation score is the average of the scores given to you by your fellow group membersand is a maximum of 5 points. Each person should turn in their group member evaluation on aseparate piece of paper.

Possible Points: The memo is worth a maximum of 20 points. Group member evaluation is wortha maximum of 5 points.

Due Date: Monday March 7th at the beginning of class.



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ACTG381Group Member Evaluation Form

Please evaluate the contributions of each group member for your project

Your name:___________________________________________________________________

Team Member Name:StronglyDisagree

Disagree Agree StronglyAgree

1) This team member contributed his/her share of the researchand/or writing for the project.

1 2 3 4

2) This team member provided his/her work in a timely manner. 1 2 3 43) This team member provided high quality work. 1 2 3 44) This team member worked well with other members of the

group.1 2 3 4


Disagree

Agree StronglyAgree


1 2 3 4


group.1 2 3 4


Disagree

Agree StronglyAgree


1 2 3 4


group.1 2 3 4


Disagree

Agree StronglyAgree


1 2 3 4


group.1 2 3 4



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Accounting 381Winter 2011

Project 1: Starbucks 2010 10-K(25 points)

Due: Monday January 31, 2011 (at beginning of class). Also, please be prepared to discuss the questionsand your solution in class on this date.

Required: Answer the following questions based on your examination of the Starbucks 2010 10-K. Youcan find the 10-K at the SEC’s web site, www.sec.gov. Each student must turn in their own assignment(i.e., this is not a group project). The answer to each question can simply be typed underneath the question.

Possible Points: The memo is worth a maximum of 25 points.

General Questions1. What is an SEC Form 10-K?2. What is an SEC Form 10-Q?3. What is a proxy statement?4. How many total Starbucks stores are there? How many company operated stores are there in the

U.S. and Internationally?5. What accounting policies does Starbucks identify as being “critical” to the company?6. Who is Starbucks’ auditor?7. How do you know that Starbucks’ financial statements are fairly stated? What is the formal name

of the document that you are relying on to determine this?8. When is Starbucks’ fiscal year end? Why does this occur on a different day of the month each

year?9. What type of legal proceedings is Starbucks involved?10. What is the MD&A (Management’s Discussion and Analysis)?11. Does Starbucks have any incentive compensation plans for its employees?12. What is Starbucks’ policy on dividends?

Income Statement Questions: (Hint: some answers may be in the footnotes or on a different statementthan the income statement.)

1. Does Starbucks use the multi-step or single step method?2. Is Starbucks’ spending on Cost of Sales and Occupancy costs going up or down?3. Is Starbucks’ net income going up or down?4. Does Starbucks have any discontinued operations or extraordinary items? How can you tell?5. Does Starbucks have any unusual items (i.e., infrequent in occurrence or nature, but not both)? If

so, what is it and where is it classified on the Income Statement?6. Did Starbucks pay any dividends in 2010? If so, how much per share?7. What are the numerator and denominator for the calculation of the 2010 Basic EPS of $1.27?8. Where does Starbucks disclose comprehensive income?

Balance Sheet Questions1. Does Starbucks have a classified balance sheet?2. Does Starbucks have retained earnings or an accumulated deficit in 2010? How much does it

amount to?3. What business activity does Starbucks engage in that gives rise to Deferred Revenue?4. How much does Starbucks have in available-for-sale securities? What specific types of securities

are included in this line item?



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5. How much does Starbucks have in trading securities? What specific types of securities areincluded in this line item?

6. What types of items are included in Starbucks’ accumulated other comprehensive income?7. Cite one example of off-balance sheet financing from Starbucks’ 10-K?8. Where in the 10-K can information be found on the fair value measurement of securities (classified

by the fair value hierarchy) held by Starbucks?9. Identify which securities are classified as Level 3 and explain why these securities warrant a Level

3 classification?10. What was the amount (gross) of the unrealized holding gain / loss on Available for Sale securities

for 2010?

Statement of Cash Flows Questions1. Does Starbucks use the direct or indirect method?2. What is the largest since item that causes Starbucks’ cash flow from operations to differ net

income?3. From what category of activities does Starbucks generate the greatest amount of cash?4. In which category of activities does Starbucks use the greatest amount of cash?

Revenue Recognition, Receivables and Cash Questions1. What is Starbucks’ revenue recognition policy?2. Are product sales recorded as retail or specialty revenues typically on credit (i.e., recorded as an

accounts receivable)?3. What does “cash equivalent” mean?

Inventory Questions1. What cost method does Starbucks use for inventory?2. How much is recorded for inventory reserves at 10/3/10?

Financial Ratio Questions: Use the ratios on p. 209 of your textbook.1. What is Starbucks’ 2010 Current Ratio? Has it improved or deteriorated from 2009?2. What is Starbucks’ 2010 Quick (Acid-Test) Ratio? Has it improved or deteriorated from 2009?3. What is Starbucks’ 2010 Receivables Turnover? Has it improved or deteriorated from 2009? Note

only credit revenues (not cash sales) are relevant to calculating this ratio.4. What is Starbucks’ 2010 Inventory Turnover? Has it improved or deteriorated from 2009?5. What is Starbucks’ 2010 Profit Margin on Sales? Has it improved or deteriorated from 2009?



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ACTG381DQs for WorldCom Case

Case available at http://www.scu.edu/ethics/dialogue/candc/cases/worldcom.html#tt

The WorldCom case describes two questionable practices engaged in by Worldcom; (1) boardapproved loans to the CEO to ensure he did not sell large amount of company stock and (2)accepting below market loans from Citibank in exchange for using Citibank for merger andacquisition work.

Required: Analyze ONE of these two questionable practices using the questions below. Whenanswering the questions, put yourself in the position of a Board of Directors member who istrying to decide whether the practice should be continued. Note that these questions are basedupon your assigned reading “Framework for Ethical Decision Making”.

Get the Facts1. What are the relevant facts of the case? What facts are not known? Can I learn more

about the situation? Do I know enough to make a decision?

2. What individuals and groups have an important stake in the outcome? Are some concernsmore important? Why?

3. What are the options for acting? Have all the relevant persons and groups beenconsulted? Have I identified creative options?

Evaluate Alternative Actions4. Evaluate the options by asking the following questions:

a) Which option will produce the most good and do the least harm? (The UtilitarianApproach)

b) Which option best respects the rights of all who have a stake? (The Rights Approach)c) Which option treats people equally or proportionately? (The Justice Approach)d) Which option best serves the community as a whole, not just some members?

(The Common Good Approach)e) Which option leads me to act as the sort of person I want to be? (The Virtue

Approach)

Make a Decision and Test It5. Considering all these approaches, which option best addresses the situation?

6. If I told someone I respect-or told a television audience-which option I have chosen, whatwould they say?



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Accounting 381Discussion Questions 1:

Kapnick & Wyatt on Accounting and Professionalism

Due: Monday , October 5, 2009 (at beginning of class). Please be prepared todiscuss the questions and your solution in class on this date.

Required: Answer the following questions based on your readings listed below. Thisshould be completed on an individual basis. Your discussion should be nomore than 2 pages in length, single-spaced. You do not need to use aparticular format to prepare your discussion. However, your solutionsshould be clearly presented.

Applicable Readings and Questions:

Harvey Kapnick. 1974. “In the Public Interest.” Accounting and FinancialReporting. Arthur Andersen, Chicago: 1 – 11.

1. What does Kapnick believe should be the role of public accountants?2. Why does the author say that accountants have responsibility to more

stakeholders than just management and boards of directors?3. Where do you think the author would stand on today’s debate over fair

value vs. historical cost valuation?4. Do you think the author would today approve of adopting international

accounting standards?5. What are the two fundamental characteristics that distinguish individuals

who choose careers in a profession?6. What did you think is the main “take-away” of the article?

Arthur Wyatt. 2004. “Accounting professionalism – they just don’t get it!”Accounting Horizons 18 (1): 45-53.

1. Who is the “they” that Wyatt is referring to?2. What is “it” that Wyatt is referring to?3. Do you agree with Wyatt’s concerns about public accounting hiring

professionals without accounting degrees? Why or why not?4. Many of the broad issues raised by Kapnick in 1974 were also raised by

Wyatt in 2004. Why do you think these issues have persisted for 30years? Do you think they can ever be addressed?



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CHAPTER 23Statement of Cash Flows

BRIEF EXERCISE 23-1

Cash flow from investing activitiesSale of land..................................................................... $ 180,000Purchase of equipment.................................................. (415,000)Purchase of available-for-sale securities ..................... (59,000)Net cash used by investing activities ........................... $(294,000)

BRIEF EXERCISE 23-2

Cash flow from financing activitiesIssuance of common stock ........................................... $ 250,000Issuance of bonds payable............................................ 510,000Payment of dividends .................................................... (350,000)Purchase of treasury stock ........................................... (46,000)Net cash provided by financing activities .................... $ 364,000

BRIEF EXERCISE 23-3

(a) P-I (g) P-F (m) N(b) A (h) D (n) D(c) R-F (i) P-I (o) R-F(d) A (j) A (p) P-F(e) R-I (k) D (q) R-I, A(f) R-I, D (l) R-F (r) P-F



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BRIEF EXERCISE 23-4

Cash flows from operating activitiesCash received from customers

($200,000 – $12,000) ......................................... $188,000Cash payments

To suppliers($120,000 + $11,000 – $13,000) ................ $118,000

For operating expenses($50,000 – $21,000) ................................... 29,000 147,000

Net cash provided by operating activities ......... $ 41,000

BRIEF EXERCISE 23-5

Cash flows from operating activitiesNet income........................................................... $30,000Adjustments to reconcile net income


Depreciation expense ................................. $21,000Increase in accounts payable ..................... 13,000Increase in accounts receivable................. (12,000)Increase in inventory................................... (11,000) 11,000

Net cash provided by operating activities ......... $41,000

BRIEF EXERCISE 23-6

Sales.............................................................................. $420,000Add: Decrease in accounts receivable

($72,000 – $54,000) ............................................. 18,000Cash receipts from customers .................................... $438,000

BRIEF EXERCISE 23-7

Cost of goods sold ....................................................... $500,000Add: Increase in inventory ($113,000 – $95,000)....... 18,000Purchases ..................................................................... 518,000Deduct: Increase in accounts payable

($69,000 – $61,000)........................................ 8,000Cash payments to suppliers........................................ $510,000



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BRIEF EXERCISE 23-8

Net cash provided by operating activities........................ $531,000Net cash used by investing activities ............................... (963,000)Net cash provided by financing activities ........................ 585,000Net increase in cash........................................................... 153,000Cash, 1/1/10 ........................................................................ 333,000Cash, 12/31/10 .................................................................... $486,000

BRIEF EXERCISE 23-9

(a) Cash flows from operating activitiesCash received from customers ................................. $90,000Cash paid for expenses ($60,000 – $1,840) .............. 58,160

Net cash provided by operating activities....... $31,840

(b) Cash flows from operating activitiesNet income.................................................................. $40,000Increase in net accounts receivable

($26,960a – $18,800b) .............................................. (8,160)Net cash provided by operating activities....... $31,840

a($29,000 – $2,040) b($20,000 – $1,200)



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RODRIQUEZ COMPANYPartial Statement of Cash Flows


Cash flows from operating activitiesCash receipts from customers .............. $7,210,000 (a)Cash payments .......................................

To suppliers ..................................... $4,675,000 (b)For operating expenses .................. 1,380,000 (c) 6,055,000

Net cash provided by operatingactivities .............................................. $1,155,000

Computations:(a) Cash receipts from customers

Sales ........................................................ $6,900,000Add: Decrease in accounts

receivable...................................... 310,000Cash receipts from customers .............. $7,210,000

(b) Cash payments to suppliersCost of goods sold ................................. $4,700,000Deduct: Decrease in inventories ............ 300,000Purchases ............................................... 4,400,000Add: Decrease in accounts

payable .......................................... 275,000Cash payments to suppliers .................. $4,675,000

(c) Cash payments for operatingexpenses

Operating expenses, exclusiveof depreciation .................................... $1,090,000*

Add: Increase in prepaidexpenses .......................................$170,000

Add: Decrease in accruedAdd: expenses payable .....................120,000 290,000Cash payments for operating

expenses ............................................. $1,380,000

*$450,000 + ($700,000 – $60,000)



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NORMAN COMPANYPartial Statement of Cash Flows


Cash flows from operating activitiesCash receipts from customers ........ $862,000 (a)Cash payments .................................

For operating expenses............. $609,000 (b)For income taxes ....................... 44,500 (c) 653,500

Net cash provided by operatingactivities ......................................... $208,500

(a) Computation of cash receipts from customers:Revenue from fees ........................................... $840,000Add: Decrease in accounts receivableAd ($59,000 – $37,000) ................................. 22,000Cash receipts from customers ........................ $862,000

(b) Computation of cash payments:Operating expenses per income statement.... $624,000Deduct: Increase in accounts payableDeduct ($46,000 – $31,000) ............................ 15,000Cash payments for operating expenses ......... $609,000

(c) Income tax expense per income statement .... $ 40,000Add: Decrease in income taxes payableAdd ($8,500 – $4,000) ..................................... 4,500Cash payments for income taxes.................... $ 44,500


ANDREWS INC.Statement of Cash Flows


Cash flows from operating activitiesLess: Cash received from customers .............. $325,150a

Cash paid to suppliers ....................................... $151,000b

Cash paid for operating expenses..................... 82,000c

Cash paid for interest ......................................... 11,400c



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Cash paid for income taxes................................ 8,750d 253,150a

Net cash provided by operating activities......... $ 72,000a

Cash flows from investing activitiesSale of equipment

[$30,000 – ($30,000 X .7)] + $2,000................... 11,000Purchase of equipment

[$154,000 – ($130,000 – $30,000)]................... (54,000)Purchase of available-for-sale investments...... (17,000)Net cash used by investing activities................ (60,000)

Cash flows from financing activitiesPrincipal payment on short-term loan............... (2,000)Principal payment on long-term loan ................ (7,000)Dividend payments ............................................. (6,000)Net cash used by financing activities................ (15,000)

Net decrease in cash..................................................... (3,000)Cash, January 1, 2010 ................................................... 9,000Cash, December 31, 2010.............................................. $ 6,000

aSales ............................................................................. $338,150– Increase in accounts receivable................................ (13,000)Cash received from customers .................................... $325,150

bCost of goods sold....................................................... $175,000– Increase in accounts payable .................................... (4,000)– Decrease in inventories ............................................. (20,000)Cash paid to suppliers .................................................. $151,000



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cOperating expenses...................................................... $120,000+ Increase in prepaid rent .............................................. 1,000– Depreciation expense

$35,000 – [$25,000 – ($30,000 X .70)]..................... (31,000)– Amortization of copyright........................................... (4,000)– Increase in wages payable ......................................... (4,000)Cash paid for operating expenses ................................ $ 82,000dIncome tax expense...................................................... $ 6,750+ Decrease in income taxes payable ............................ 2,000Cash paid for income taxes........................................... $ 8,750


ANDREWS INC.Statement of Cash Flows


Cash flows from operating activitiesNet income ............................................................... $27,000Adjustments to reconcile net income to net

cash provided by operating activities:Depreciation expense ...................................... $31,000*Amortization of copyright ............................... 4,000Gain on sale of equipment .............................. (2,000)Decrease in inventories................................... 20,000Increase in wages payable .............................. 4,000Increase in accounts payable ......................... 4,000Increase in prepaid rent................................... (1,000)Increase in accounts receivable ..................... (13,000)Decrease in income taxes payable ................. (2,000) 45,000Net cash provided by operating activities...... 72,000

Cash flows from investing activitiesSale of equipment [($30,000 X 30%) + $2,000] ....... 11,000Purchase of equipment

[$154,000 – ($130,000 – $30,000)]........................ (54,000)



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Purchase of available-for-sale investments.......... (17,000)Net cash used by investing activities.................... (60,000)

*$35,000 – [$25,000 – ($30,000 X 70%)]



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Cash flows from financing activitiesPrincipal payment on short-term loan ................... (2,000)Principal payment on long-term loan .................... (7,000)Dividend payments ................................................. (6,000)Net cash used by financing activities.................... (15,000)

Net decrease in cash........................................................ (3,000)Cash, January 1, 2010...................................................... 9,000Cash, December 31, 2010 ................................................ $ 6,000

Supplemental disclosures of cash flow information:

Cash paid during the year for:Interest $11,400Income taxes $ 8,750


MORGANSTERN COMPANYStatement of Cash Flows


Cash flows from operating activitiesNet income .............................................................. $ 46,000*Adjustments to reconcile net income to net

cash provided by operating activities:Depreciation expense....................................... $ 28,000Loss on sale of investments ............................ 9,000Loss on sale of plant assets

[($60,000 X .20) – $8,000] .............................. 4,000Increase in current assets other than cash ...... (27,000)Increase in current liabilities............................ 18,000 32,000

Net cash provided by operating activities ............ 78,000

Cash flows from investing activitiesSale of plant assets ................................................ 8,000Sale of held-to-maturity investments .................... 34,000Purchase of plant assets........................................ (180,000)**Net cash used by investing activities.................... (138,000)



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Cash flows from financing activitiesIssuance of bonds payable..................................... 75,000Payment of dividends ............................................. (10,000)Net cash provided by financing activities ............. 65,000

Net increase in cash......................................................... 5,000Cash balance, January 1, 2011........................................ 10,000Cash balance, December 31, 2011 .................................. $15,000

*Net income $59,000 – $9,000 – $4,000 = $46,000**Supporting computation

(purchase of plant assets)Plant assets, December 31, 2009 ........................... $215,000Less: Plant assets sold.......................................... (60,000)

155,000Plant assets, December 31, 2010 ........................... 335,000Plant assets purchased during 2010...................... $180,000



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Accounting 381Discussion Questions 1: Levitt and Brennan on Earnings Management and Scandals

Due: Monday , October 19, 2009 (at beginning of class). Please be prepared todiscuss the questions and your solution in class on this date.

Required: Answer the following questions based on your readings listed below. Thisshould be completed on an individual basis. Your discussion should be nomore than 2 pages in length, single-spaced. You do not need to use aparticular format to prepare your discussion. However, your solutionsshould be clearly presented.

Applicable Readings and Questions:

Arthur Levitt, “The Numbers Game,” NYU Center for Law and Business, September 28,1998.

1. Why does Levitt say that earnings management is a problem to our economy?2. On page 2, Levitt says that “transparency and comparability” are the

touchstones of our financial reporting system. What does he mean by that?3. Levitt argues that companies are not alone in creating the problems of

earnings management. What role do the analysts and auditors play in earningsmanagement?

4. What are the five methods of earnings management that Levitt mentions in thearticle?

5. Levitt states several ways in which he has instructed the SEC to mitigate theearnings management techniques he mentioned. To what extent do you thinkthe SEC’s efforts will be effective?

John J. Brennan (Chairman and CEO, The Vanguard Group), “The Market Value ofIntegrity, Dealing with Corporate Scandals, 2002.

1. What are the two lessons that Brennan mentions in his speech?2. Brennan argues that the environmental conditions in the late 1990s were ideal

for corporate scandals to occur. What role did the stock market, corporateboards, the financial media and investors play in creating this environment?

3. Do you agree with Brennan’s statement that integrity has a market value?Can you think of an example of this that you have seen in our market oreconomy?



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Accounting 381Discussion Questions 4: New GAAP for Multiple Deliverables

Required: Answer the following questions based on your readings This should becompleted on an individual basis. Your discussion should be no more than2 pages in length, single-spaced.

1. What are “multiple deliverables”?2. What judgment is involved in recording revenue for multiple deliverables?3. If a company has multiple deliverables, where can you find information about

the significant factors that involve judgment which impact how much revenueis recorded each period?

4. Under the new guidance, how is the relative fair value of each separatedeliverable determined?



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Documents

Accounting 381 Intermediate Financial Accounting and