Instructors Manual for Financial Reporting and Analysis 8th Edition by Lawrenc

Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

Instructors Manual for Financial Reporting and Analysis 8th Edition by Lawrenc Chapter 1-20 CHAPTER 1 THE ECONOMIC AND INSTITUTIONAL SETTING FOR FINANCIAL REPORTING CHAPTER OVERVIEW Financial statements are an extremely important source of information about a company, its economic health, and its prospects. They help improve decision making and make it possible to monitor managers’ activities.  Equity investors use financial statements to form opinions about the value of a company and its stock.  Creditors use statement information to gauge a company’s ability to repay its debt and to check whether the company is complying with loan covenants.  Stock analysts, brokers, and portfolio managers use financial statements as the basis for their recommendations to investors and creditors.  Auditors use financial statements to help design more effective audits by spotting areas of potential reporting abuses.

Investors, creditors, and other interested parties demand financial statements because the information is useful. But what governs the supply of financial information? 



Mandatory reporting is a partial answer. Most companies in the United States and other developed countries are required to compile and distribute financial statements to shareholders and to file a copy with a government agency (in the United States, that agency is the SEC). This requirement allows all interested parties to view the statements.

The advantages of voluntary disclosure are the rest of the answer. Financial information that goes beyond the minimum requirements can benefit the company, its managers, and its owners. For example, voluntary financial disclosures can help the company obtain capital more cheaply or negotiate better terms from suppliers. Some companies routinely disclose nonfinancial metrics that can assist in the prediction of future performance. But benefits like these come with potential costs: information collection, processing, and dissemination

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

costs; competitive disadvantage costs; litigation costs; and political costs. This means that two companies with different financial reporting benefits and costs are likely to choose different accounting policies and reporting strategies.

Different companies choose different accounting policies and reporting strategies because financial reporting standards are often imprecise and open to interpretation. This imprecision gives managers an opportunity to shape financial statements in ways that allow them to achieve specific reporting goals.   

Most managers use their accounting flexibility to paint a truthful economic picture of the company.

Other managers mold the financial statements to mask weaknesses and to hide problems.

Analysts who understand financial reporting, managers’ incentives, and the accounting flexibility available to managers will maintain a healthy skepticism about the numbers and recognize that financial statements sometimes conceal more than they reveal.

The accountant’s and analyst’s job is made more difficult when financial reporting measurement and disclosure rules differ across national boundaries. Reporting rules in some countries such as Canada, the United Kingdom, and the United States evolved to reflect firms’ underlying economic performance. But reporting rules in many other countries—France, Germany, and Japan, for example—merely complied with taxation or other statutory requirements. 



Globalization forced many firms in countries using a commercial or tax law approach to seek foreign capital. In turn, this has led countries around the world to move to IFRS, making it easier for firms in their countries to raise capital in domestic and foreign financial markets.

The FASB and IASB have worked to converge the guidance for numerous accounting issues. However, in many cases, the boards have issued substantially different standards after having worked together originally.

CHAPTER OUTLINE I.

Why Financial Statements Are Important Teaching Tip: While financial statements are not as timely as press releases, they do provide an economic history and are indispensable in developing an accurate profile of ongoing performance and prospects.

Teaching Tip: This text does not focus on assisting readers of financial statements in detecting fraud, which is rare. Rather, the purpose of this text is to assist readers in understanding the financial flexibility and discretion inherent in financial accounting rules in order that they may make more informed decisions.

II.

Economics of Accounting Information

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Financial Reporting and Analysis 8e

III. IV.

The Economic and Institutional Setting for Financial Reporting

A. Demand for Financial Statements B. Disclosure Incentives and the Supply of Financial Information A Closer Look at Professional Analysts A. Analysts’ Decisions Fundamental Concepts of Financial Reporting A. Generally Accepted Accounting Principles B. Who Determines the Standards?

C. The Politics of Accounting Standards D. FASB Accounting Standards Codification™ Teaching Tip: It may be a good idea to access the FASB Codification and provide an overview of how to use the system and reinforce that everything in the Codification is a Generally Accepted Accounting Principle.

V.

Incentive Conflicts and Financial Reporting Teaching Tip: For example, the choice to capitalize, rather than expense amounts, will make firms appear to be larger, more profitable, and less risky.

Therefore, naive acceptance of financial statement data may be dangerous.

Much of the book is devoted to providing students with the skills necessary to become more informed readers of financial statements by making meaningful comparisons between companies and gaining insight into managers’ incentives.

VI. VII.

VIII.

Sustainability Accounting An International Perspective A. International Financial Reporting B. Globalization and the Rise of IFRS APPENDIX 1A: GAAP in the United States A. Early Developments B. Emergence of GAAP C. Current Institutional Structure in the United States

CHAPTER QUIZ 1. A company’s financial statements reflect information about a. product information and competitive positions. b. future projections of sales, expenses, and other future economic events. c. the general economy of the industry in which the company operates. d. economic events that affect a company that can be translated into accounting numbers.

2. Creditors assess credit risk by comparing a firm’s required principal and interest payments to estimates of the firm’s current and future a. cash flows. b. net assets. c. revenue. d. net income.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

3. Which is not correct regarding Regulation Fair Disclosure (Reg FD)? a. It limits what management can say in private conversations with analysts and investors. b. It does not limit what management can say in private conversations with analysts or investors. c. It was passed by the SEC. d. It helps level the playing field between individual and institutional investors.

4. Being verifiable and neutral is part of what makes financial information a. consistent. b. comparable. c. relevant. d. useful.

5. Financial information capable of making a difference in a decision is a. relevant. b. reliable. c. consistent. d. verifiable.

6. Factors that may influence a decision maker’s judgment as to what accounting information is useful include: a. The decision to be made. b. The information already possessed. c. The decision maker’s capacity to process the information. d. All of the above answers are correct.

7. Which one of the following types of disclosure costs is the cost of disclosing the company’s pricing strategies? a. Political cost b. Litigation cost c. Competitive disadvantage cost d. Information collection, processing, and dissemination cost 8. Employees demand financial statement information because the firm’s performance is often linked to a. Employee stock ownership plans. b. Social security benefits. c. Disability plan benefits. d. Workmen’s compensation benefits.

9. The primary current source of generally accepted accounting principles for publicly traded companies in the United States rests with the: a. Securities and Exchange Commission. b. New York Stock Exchange. c. Financial Accounting Standards Board. d. American Institute of Certified Public Accountants.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

10. International accounting standards are established by the a. Securities Exchange Commission b. London Stock Exchange c. International Accounting Standards Board d. Institute of Chartered Accountants Essay Questions 1. Define the expanded role of the PCAOB in the preparation of consistent and transparent financial statements.

2. Why would it be beneficial to narrow international differences in accounting rules for accounting and reporting?

3. Discuss nonfinancial metrics that companies use and how they can be used by investors and creditors.

4. Discuss sustainability accounting and the importance of uniform disclosures about climate change.

QUIZ ANSWERS: 1. D. The financial statements present historical information about what has happened to the company in the past.

2.

A. Creditors are concerned with a firm’s ability to repay principal and interest by projecting cash flows.

3.

B. Reg FD was passed to limit what management can say in private to analysts and investors.

4.

D. Useful information is verifiable and neutral.

5.

A. Relevant information is capable of making a difference in decision making.

6.

D. The judgment by a decision maker as to what accounting information can be useful includes the decision to be made, the information already possessed, and the decision maker’s capacity to process the information.

7.

C. Competitive disadvantage cost is the cost of disclosing the company’s pricing strategies.

8.

A. Managers and employees use financial information to monitor employee contracts such as bonus plans, profit–sharing plans, and pension plans.

9.

C. The FASB is charged with the responsibility of establishing financial accounting standards.

10.

C. The IASB is responsible for establishing IFRS.

RECOMMENDED FIGURES AND EXHIBITS 1.

Exhibit 1.1—Nonfinancial Metric Examples

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Financial Reporting and Analysis 8e

2.

The Economic and Institutional Setting for Financial Reporting

Figure 1.1—Desirable Characteristics of Accounting Information

CHAPTER 2 ACCRUAL ACCOUNTING AND INCOME DETERMINATION CHAPTER OVERVIEW  This chapter highlights the key differences between cash and accrual income measurement.  In most instances, accrual-basis revenues do not equal cash receipts and accrual expenses do not equal cash disbursements.  The principles that govern revenue and expense recognition under accrual accounting are designed to alleviate the mismatching of effort and accomplishment that occurs under cash-basis accounting.  The matching principle determines how and when the assets that are used up in generating the revenue or that expire with the passage of time are expensed.  Relative to current operating cash flows, accrual earnings generally provide a more useful measure of firm performance and serve as a more useful benchmark for predicting future cash flows.  Predicting future cash flows and earnings is critical to assessing the value of a firm’s shares and its creditworthiness.  Multiple-step income statements are designed to facilitate this forecasting process by isolating the more recurring or sustainable components of earnings from the nonrecurring or transitory earnings components.  This chapter outlines some common ways earnings are managed, some of which have come under SEC scrutiny. Auditors and financial statement users must be aware of the incentives to manage earnings and the ways in which this is accomplished.  Public companies must report EPS numbers on the face of their income statements. All firms report basic EPS based on the weighted average number of shares actually outstanding during the period, while firms with complex capital structures also disclose diluted EPS, which reflects the EPS that would result if all potentially dilutive securities were converted into common shares.  Certain changes in net assets resulting from incomplete or open transactions bypass the income statement and are reported as direct adjustments to stockholders’ equity. These direct adjustments are called other comprehensive income components. Under U.S. GAAP, firms are required to report the components of other comprehensive income in either a single-statement format or a two-statement format.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

CHAPTER OUTLINE I.

Cash Flow Versus Accrual Income Measurement A. Articulation of Income Statement and Balance Sheet B. Revenue Recognition—General Concepts Expense Recognition Teaching Tip: For-profit entities adopt accrual accounting because of its ability to provide investors and creditors with a more realistic picture of relevant economic events and their effects on firm activities. On the other hand, entities that do not have a profit motive may prefer a cash-basis accounting system because of its simplicity.

II.

Income Statement Format and Classification A. Income from Continuing Operations B. Discontinued Operations C. Frequency and Magnitude of Various Categories of Transitory Income Statement Items D. Net Income Attributable to Noncontrolling Interests and Parent Company Shareholders Teaching Tip: In forecasting future cash flows, a reader of the financial statements must determine whether the ―special or unusual items‖ are sustainable or transitory. The increased occurrence of these items heightens the speculative nature of these forecasts. It is important to remember that financial statements are designed to measure the economic conditions (micro and macro) and financial management of the company to assist users in determining future cash flows. Companies doing well in a great economic environment may be in trouble during the next economic turn while a company that exceeds the competition results during a recession may emerge as a market leader.

III. IV. V. VI. VII.

Earnings Management A. Popular Earnings Management Devices Earnings per Share Comprehensive Income and Other Comprehensive Income Global Vantage Point APPENDIX 2A: Review of Accounting Procedures and T-Account Analysis A. Understanding Debits and Credits B. Adjusting Entries C. Posting Journal Entries to Accounts and Preparing Financial Statements D. Closing Entries E. T-Accounts Analysis as an Analytical Technique

Teaching Tip: There are several mnemonic devices available to help students organize the effects of debits and credits on the different types of accounts.

CHAPTER QUIZ

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

1. High Tower, Inc. owns and operates resort campgrounds in the U.S. It sells annual memberships that allow a member’s family unlimited use of the company’s campgrounds for a one-year period for an annual membership fee. Assuming High Tower produces quarterly financial statements, how should it recognize membership revenue? a. Revenue should be recognized when the cash is received. b. Revenue should be recognized at the end of the membership period. c. Membership sales should be recognized equally over the course of the year. d. Membership sales should be recognized based on members’ actual use of the facilities.

2. The matching principle encourages: a. The recognition of expenses when cash is paid for supplies. b. The recognition of expenses in the same period as the revenue was recognized. c. The reconciliation of net income and comprehensive income in a separate financial statement. d. The recording of period costs on the balance sheet.

3. When a company has decided to dispose of a component of its business which of the following is true? a. The income or loss from that component should be reported as a component of operating income. b. The income or loss from that component should be separated as an unusual item. c. The income or loss from that component should not be included on the income statement. d. The income or loss from that component should be reported as a discontinued operation.

4. The use of accounting flexibility to meet earnings benchmarks is called a. impression management. b. earnings management. c. profit manipulation. d. accounting irregularities.

5.

The purpose of reporting nonrecurring items, net of related income taxes, below income from continuing operations is: a. These items help explain deviations in current year net income from past trends. b. These items assist in the task of predicting the timing and amount of future cash flows. c. Neither a. nor b. d. Both a. and b.

6. On November 1, 2016, Kris Co. paid $7,200 to for a one year insurance policy on its equipment. With respect to this policy, what amounts should Kris report for prepaid insurance and insurance expense in its December 31, 2016, financial statements?

Prepaid Insurance a. $6,000

Insurance Expense $1,200

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Financial Reporting and Analysis 8e

b. c. d.

$7,200 $0 $0

The Economic and Institutional Setting for Financial Reporting

$0 $7,200 $0

7. One of the most commonly reported measures of operating performance is: a. Other comprehensive income b. Net income attributable to parent company shareholders c. Earnings per share d. Discontinued operations 8. Other comprehensive income components a. are shown net of their related tax effects. b. include all changes in equity that do not affect the income statement. c. include realized gains and losses. d. eliminate the effects that unrealized gains and losses have on the financial statements.

9.

A debit a. increases Accounts Payable. b. increases Cost of Goods Sold. c. decreases Accounts Receivable. d. decreases Equipment.

10. Employees work during the month of December and earn $500. The paychecks will be issued to employees on January 3rd. What adjusting entry is required on December 31st? a. debit salary expense $500; credit salaries payable $500 b. debit salaries payable $500; credit salary expense $500 c. debit salaries receivable $500; credit salary expense $500 d. debit salary expense $500; credit salaries receivable $500 e. No adjusting entry is required because no cash has been paid.

QUIZ ANSWERS: 1.

C. Revenue should be recognized over the life of the contract.

2.

B. The matching principle matches the recognition of expenses to the same period as the revenue was recognized.

3. D. Income or loss from the disposal of a component of a business should be reported as a discontinued operation.

4. B. The use of accounting flexibility to meet earnings benchmarks is known as earnings management.

5. D. The purpose of reporting nonrecurring items, net of related income taxes, below income from continuing operations is to help explain deviations in current year net income from past trends, and to assist in the task of predicting the timing and amount of future cash flows.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

6. C. Insurance expense should be $600 per month. As of December 31, there are still 10 months of coverage remaining. Therefore, $6,000 is the balance in prepaid insurance. Insurance expense is $600 per month for 2 months, or $1,200.

7. C. Earnings per share is one of the most commonly reported measures of a company’s operating performance and all publicly traded companies must report EPS numbers on the face of their income statements.

8.

A. Comprehensive income components are shown net of their related tax effects.

9.

B. Debits increase assets, expenses and losses.

10. A. Adjusting entries such as this must be made for expenses that accrue over the reporting period. A liability exists for the money owed to the employees so the expense and liability must be recorded on December 31st.

RECOMMENDED FIGURES AND EXHIBITS 1.

Figure 2.1: Canterbury Publishing Comparison of Accrual-Based Earnings and Operating Cash Flow Figure 2.2: Proportion of firms reporting nonrecurring items (2002–2017) Exhibit 2.10: Posting to T-accounts Exhibit 2.11: Chicago Corporation (resulting financial statements from T-accounts in Exhibit 2.10)

2.

3.

4.

CHAPTER 3 REVENUE RECOGNITION CHAPTER OVERVIEW Revenue recognition rules have transitioned from a patchwork of guidance that addressed specific issues individually to a robust framework for addressing revenue reporting issues.

Previous guidance often addressed issues related to a specific industry or the quirks of a particular type of transaction. In contrast, ASC Topic 606 provides a single, five-step model that is to be applied by all firms in determining when revenue may be recognized: 1.

2.

3.

4.

5.

Identify the contract(s) with a customer Identify the performance obligations in the contract Determine the transaction price Allocate the transaction price to the performance obligations in the contract Recognize revenue when (or as) the entity satisfies a performance obligation

Contracts with customers give rise to performance obligations, representing the goods or services a firm has obligated itself to provide. Transaction prices are allocated to performance obligations and revenue is recognized when (or as) the performance obligations are satisfied.

CHAPTER OUTLINE I.

The Five-Step Revenue Recognition Model

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Financial Reporting and Analysis 8e

A. B. C. D. E. F. G.

The Economic and Institutional Setting for Financial Reporting

Step 1: Identify the Contract(s) with a Customer Step 2: Identify the Performance Obligations in the Contract Step 3: Determine the Transaction Price Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract Step 5: Recognize Revenue When (or as) the Entity Satisfies a Performance Obligation Practical Expedients in Applying the Model Applying the Model to Contract Modifications

Teaching Tip: Consulting firms use the percentage-of-completion method for fixed price, fixed period contracts. The Information Technology Professional Services sector, for example, uses this method to record approximately 30 % of its revenues.

II. III.

IV.

V. VI. VII.

Contract Acquisition and Fulfillment Costs A. Amortization and Impairment Disclosure Requirements A. Disaggregated Revenue B. Contract Balances C. Performance Obligations and Significant Judgments Teaching Tip: The notes to the financial statements provide important useful information for financial statement users. The new revenue recognition standard requires extensive disclosures. See Exhibit 3.4 for an example.

Effective Dates and Transition A. Retrospective Approach-Practical Expedients B. Additional Disclosure Requirement for Firms Using Cumulative Effect Approach Financial Statement Effects of ASC Topic 606 SEC Comment Letters on Revenue Recognition Global Vantage Point A. The Meaning of Collectibility B. Reversals of Impairments C. Disclosure Requirements

CHAPTER QUIZ 1. The new ASC Topic 606 provides a model for revenue recognition that includes a. five steps. b. four steps. c. three steps. d. two steps.

2. Under ASC Topic 606 for revenue recognition, which of the following statements is false regarding performance obligations? a. Firms must disclose warranties provided. b. Firms must disclose qualitative information about their performance obligations. c. Firms are not required to disclose qualitative information about performance obligations.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

d. Firms must disclose the aggregate amount of the transaction price allocated to unsatisfied performance obligations. e. Firms are not required to meet a minimum number of disaggregated revenue categories.

3. Microtex Corporation sells computers and accessories. The company’s newest computer has a wholesale price of $100. In addition, the company sells carrying cases ($25), hard drives ($15), and earbuds ($10) made especially for this computer. During the holiday season, Microtex offers the computer, carrying case, hard drive and earbuds as a package for $120. For each package sold, the transaction price allocated to the computer is a. $0. b. $80. c. $100. d. $120 4. Under ASC Topic 606 for revenue recognition, a performance obligation is considered satisfied when control over the goods and services is transferred to the customer. Which of the following is not an indicator that control has transferred? a. The customer has legal title of the goods. b. The customer is legally obligated to pay for the goods or services. c. The customer has accepted the goods and has physical possession of the goods. d. All of these are indicators that control has transferred.

5. Under ASC Topic 606 for revenue recognition, which of the following factors is not an indicator of the principal/agent determination? a. Credit risk. b. Inventory risk. c. Shipping terms. d. Control of prices of the goods or services.

6. Which of the following statements is not applicable to contract acquisition costs under ASC Topic 606 guidance for revenue recognition? a. Incremental costs of acquiring a contract must be capitalized and amortized over the life of the contract. b. Costs that would be incurred regardless of whether a contract is obtained are not capitalized. c. The capitalization requirement is subject to a practical expedient. d. Costs must be capitalized even if the amortization period is one year or less.

7. Spalding, Inc. sells, installs and maintains computer equipment. The contract with its customers to purchase equipment includes installation and includes a one-year maintenance contract, renewable for up to three years. Because the useful life of the equipment is expected to be three years, the company can reasonably expect its customers to renew the maintenance contracts for the full three years. Spalding records the cost of installation of the equipment as a capitalized contract and amortizes the cost over the three-year maintenance agreement period. A defect is discovered in one of Spalding’s models, and the company anticipates that many of its

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

customers will trade in the model and not renew the maintenance contracts. Spalding, Inc. should a. write down the full amount received for maintenance contracts for the full three years. b. write down the full amount of installation costs. c. write down the contract asset and recognize a loss equal to the difference between the amount of maintenance contracts expected and the carrying amount. d. do nothing until the customers fail to renew the maintenance contracts.

8. Which of the following statements is not true regarding ASC Topic 606? a. Long-term construction contracts is an area where the new standard clearly differs from existing guidance. b. Adoption for calendar reporting entities was first required for calendar year 2018. c. Current guidance on long-term contracts gives more flexibility to firms for determining when revenue is recognized. d. The new standard disallows the use of the percentage-of-completion method for long-term construction contracts.

9. Assuming the requirements for recognizing revenue over time are met, and using the percentage-of-completion method to recognize revenue, the measure of completion is computed by dividing a. profits earned to date by estimated total profits. b. costs incurred to date by estimated total costs. c. costs incurred to date by the contract price. d. profits earned to date by the contract price.

10. Billy’s Construction entered into the following contracts with Larry’s Landscaping, LLP: (1) construct a concrete patio, (2) plant shrubs, and (3) landscape area for a new home construction project. Larry’s Landscaping should treat the contracts a. as a single contract. b. as three separate contracts. c. as two contracts—one for hardscaping and one for landscaping. d. None of these.

Essay Question 1.

Technology companies sell software, hardware, and support in a bundled (multielement sales) transaction. Describe the various methods of revenue recognition that would be used by technology companies.

QUIZ ANSWERS: 1.

A. The new ASC topic 606 provides a 5-step model.

2.

C. Firms are required to disclose judgments used in applying the standard.

3.

B. 66.67% of the price of $120 is allocated to computer, or $80. $100 computer/$150 total = 66.67%

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The Economic and Institutional Setting for Financial Reporting

4.

D. All of these are indicators.

5.

C. Shipping terms are not an indicator of principal/agent determination.

6.

D. Costs may be immediately expensed if the amortization period is one year or less.

7.

C. A contract asset is written down if it is deemed to be impaired, in which case a loss is recognized. A contract asset is impaired if the carrying amount exceeds the recoverable amount.

8.

D. ASC Topic 606 allows the use of the percentage-of-completion method for longterm construction contracts.

9.

B. Percentage of completion is calculated as costs incurred to date divided by estimated total costs.

10.

A. Two or more contracts entered into around the same time with the same customer should be treated as a single contract if the contracts were negotiated together and have a single business purpose.

RECOMMENDED FIGURES AND EXHIBITS Exhibit 3.4: Revenue Note from General Dynamic’s 2017 Form 10-K (Example of the extensive supplemental disclosure requirements) CHAPTER 4 STRUCTURE OF THE BALANCE SHEET AND STATEMENT OF CASH FLOWS CHAPTER OVERVIEW         

The balance sheet and statement of cash flows are two of the primary financial statements required under GAAP. The balance sheet shows the assets owned by a company at a given point in time and how those assets are financed (debt versus equity). A variety of measurement bases are used to report the various asset, liability, and stockholders’ equity accounts.

When making intercompany comparisons, financial statement users must be careful to recognize how the different measurement bases affect key financial ratios and how account titles and statement formats vary across countries.

The statement of cash flows shows the change in cash for a given period broken down into operating, investing, and financing activities.

Successive balance sheets and the statement of cash flows articulate with one another, meaning changes in noncash balance sheet accounts can be used to explain changes in cash for a period.

Analysis of changes in selected balance sheet accounts also can be used to explain why operating cash flows differ from accrual income.

Conversely, the statement of cash flows provides information that enables users to understand changes in balance sheet accounts that have occurred over the reporting period.

Understanding the interrelationships between successive balance sheets and the statement of cash flows and being able to exploit these interrelationships to derive unknown account balances are important skills for analysts and lending officers.

Understanding the basic differences between the direct and indirect approach to presenting cash flows from operations, and differences between where certain items

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

are reported on a cash flow statement under IFRS versus U.S. GAAP, are also important skills.

CHAPTER OUTLINE I.

II.

III. IV.

Balance Sheet A. Current Assets B. Noncurrent Assets C. Current Liabilities D. Noncurrent Liabilities E. Stockholders’ Equity Contingencies A. Measuring, Recognizing, and Disclosing Loss Contingencies B. Recording Gain Contingencies C. Loan Guarantees Analytical Insights: Understanding the Nature of a Firm’s Business Global Vantage Point A. Balance Sheet Presentation B. Contingencies Teaching Tip: Account titles and formats of balance sheets prepared in other countries can differ from those prepared under U.S. GAAP. This can lead to a discussion of differences in recognition, measurement, and disclosure rules of financial reporting across countries.

V.

Statement of Cash Flows A. Structure of Cash Flow Statement B. Example of Indirect Method Cash Flow Statement C. Example of Direct Method Cash Flow Statement D. Cash Flow Statement and Financial Statement Articulation E. Deriving Cash Flow Information F. Comparison of Cash Flow from Operations under Direct and Indirect Methods G. Global Vantage Point Teaching Tip: Increases in noncash working capital are subtracted from net income in the process of calculating operating cash flow. While increases in working capital are generally viewed as a positive occurrence, this ―negative‖ effect can lead to nice classroom discussion of earnings versus cash flows with students.

VI.

APPENDIX 4A: Worksheet Approach to Indirect Method Cash Flow Statement

CHAPTER QUIZ 1. The residual interest in the resources of an entity that remains after deducting its debts to third parties from its assets defines a. additional paid-in capital. b. liabilities.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

c. equity. d. additional paid in capital.

2. In a common-size balance sheet, each balance sheet account is expressed as a percentage of total a. liabilities. b. assets. c. shareholders’ equity. d. assets plus shareholders’ equity.

3. Balance sheets developed under US GAAP a. may, but are not required to, list assets from most liquid to least liquid. b. must list assets from most liquid to least liquid. c. must list assets from least liquid to most liquid. d. must list assets in alphabetical order.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

4. Under which of the following scenarios must a loss contingency be accrued at the date of the financial statements? a. It is probable that an asset has been impaired or a liability has been incurred and the amount can be reasonably estimated. b. It is possible that an asset has been impaired or a liability has been incurred and the amount can be reasonably estimated. c. It is probable that an asset has been impaired or a liability has been incurred, but the amount cannot be reasonably estimated. d. It is possible that an asset has been impaired or a liability has been incurred, but the amount cannot be reasonably estimated.

5. Which of the following statements is not true? a. The operating section of the indirect method begins with net income. b. The amount of cash flows from operating activities will differ between the direct and indirect methods. c. The direct method presents cash inflows and outflows. d. Most US firms use the indirect method to prepare the statement of cash flows.

6. Sallie May, head accountant, is using the indirect method and the account balance from the balance sheet and income statement to prepare a statement of cash flows. An increase in the Computer Equipment account would a. decrease cash flow from operating activities. b. decrease cash flow from investing activities. c. increase cash flow from financing activities. d. decrease cash flow from investing activities.

7. Financing activities include the cash effects of a. producing and delivering goods and services. b. purchasing and disposing of productive assets used in production of revenue. c. purchasing and disposing of debt securities of other companies. d. selling stocks and bonds to raise capital used to produce revenue.

The following information relates to Problems 8 and 9: Selected data for Brave Corporation’s comparative balance sheets for Year 1 and Year 2 are as follows: Assets Cash Accounts receivable (net) Equipment (net) Total assets

Liabilities and Equity Accounts payable

Year 1 $200,000 50,000

Year 2 $200,000 100,000

300,000

350,000

$550,000

$650,000

$230,000

$130,000

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Financial Reporting and Analysis 8e

Bonds payable Common stock Retained earnings Total liabilities and Equity

The Economic and Institutional Setting for Financial Reporting

100,000 100,000

80,000 200,000

120,000

240,000

$550,000

$650,000

8. Using the indirect method to create the operating activities section of the statement of cash flows, the cash flow from accounts receivable would be recorded as a. an increase of $50,000 b. an increase of $150,000 c. a decrease of $50,000 d. a decrease of $150,000 9. The change in the balance of the common stock account would be recorded on the statement of cash flows as an increase of a. $100,000 under financing activities. b. $100,000 under investing activities. c. $100,000 under operating activities. d. $300,000 under financing activities.

10. Cash interest from investments is recorded as _______ in the statement of cash flows using U.S. GAAP, but can be recorded as ________ when using IFRS. a. cash flows from investing activities / cash flows from financing activities b. cash flows from financing activities / cash flows from operating activities c. cash flows from operating activities / cash flows from financing activities d. cash flows from operating activities / cash flows from investing activities Essay Question 1. The statement of cash flow reports three cash flow amounts including 1) operating cash flow, 2) investing cash flows, and 3) financing cash flows. Describe the corporate strategy of a company that has a positive operating cash flow, an investing cash flow that is negative, and a financing cash flow that is positive. (Note to instructors: You can change each of the three variables indicating different entity strategies) QUIZ ANSWERS: 1. C. Equity is the residual interest in an entity’s assets that remains after deducting its liabilities.

2. B. A common-size balance sheet presents each item as a percentage of total assets.

3. B. U.S. firms’ balance sheets list assets from most liquid to least liquid, where liquid refers to the ease of converting the asset into cash.

4. A. GAAP states that a loss contingency shall be accrued if there is a probable loss and the amount can be reasonably estimated.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

5. B. The amounts shown as cash flow from operations, investing, and financing are all the same under the indirect method and the direct method. The difference between the two methods lies in how cash flow from operations is presented, not in its amount.

6. B. Cash flow from investing activities comprises the decreases in cash resulting from investments made in productive assets or securities during the period, as well as the increases in cash when such investments are liquidated.

7. D. Cash flow from financing activities comprises changes in cash due to transactions related to the financing of the business, such as the issuance or repurchase of debt or equity securities and the payment of dividends. (Although interest payments actually are due to financing activities, U.S. GAAP includes interest payments in operating cash flows.)

8. C. Accounts receivable increased from 50,000 to 100,000 indicating the company earned more revenues on account than cash it collected, which is an operating cash flow that will be subtracted from net income.

9. A. Common Stock increased from $150.000 to $250,000, which indicates the company issued $100,000 of common stock, which is a financing activity.

10. D. U.S. GAAP requires entities to report cash interest from investments as part of operating cash flows. IAS 7 allows the option for entities to report these inflows in cash flows from investing activities.

RECOMMENDED EXHIBITS 1.

2.

3.

4.

Exhibit 4.1—Motorola Solutions, Inc. Consolidated Balance Sheets Exhibit 4.2—Common-Size Balance Sheet Comparison Exhibit 4.3—Burberry Group Balance Sheet at March 31, 2018 and March 31, 2017 Exhibit 4.5—Walmart, Inc. Consolidated Statements of Cash Flows CHAPTER 5

ACCOUNTING CHANGES AND RESTATEMENTS, FINANCIAL STATEMENT NOTES, AND NON-GAAP METRICS CHAPTER OVERVIEW 

The transition method for a change in accounting principles is most often retrospective, meaning prior financial statements are recast as if the company had always used the method to which it is changing. However, sometimes that approach is not practical or a new standard calls for a different transition method, such as a cumulative effect adjustment.



Retrospective treatment facilitates the analysis of a company’s performance over time.



Once discovered, accounting errors or irregularities must be corrected and disclosed through a restatement.



Particularly serious errors require immediate notification through an SEC

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

filing warning financial statement users not to continue relying on the previously issued financial statements. 

Financial statement notes are an integral part of companies’ financial reports and provide a wealth of information that helps financial statement users understand and interpret the numbers presented in the body of the financial statements.



Non-GAAP metrics are measures of performance or financial condition that are not amounts defined by GAAP, either because they exclude certain items from, say, a measure of income, or they define an amount differently than how it is defined under GAAP. Firms are permitted to provide non-GAAP metrics as long as they are not misleading, they are not presented any more prominently than GAAP measures in the financial reports, and for every nonGAAP metric presented, a reconciliation between it and the closest GAAP metric is also provided.

CHAPTER OUTLINE I.

Reporting Accounting Changes A. Change in Accounting Principle B. Change in Accounting Estimate C. Change in Reporting Entity Teaching Tip: Changes in accounting principles generally do not result in direct changes in cash flows. The only exception is a change from the LIFO method of accounting for inventory (because of the LIFO conformity rule). Since changes in accounting principles generally do not affect the tax return, a change in principles used for financial reporting purposes affects only income tax expense and deferred income taxes.

II. III.

IV.

D. Disclosure of the Expected Financial Statement Effects of Recently Issued Accounting Standards Accounting Errors, Restatements, and Prior Period Adjustments A. Reissuance Restatements B. Revision Restatements Notes to Financial Statements A. Summary of Significant Accounting Policies B. Subsequent Events C. Related-Party Transactions Non-GAAP Metrics

CHAPTER QUIZ 1. When reporting a change in an accounting principle, GAAP generally requires use of which approach? a. Prospective Approach b. Retrospective Approach c. Cumulative Effect Approach d. Companies can choose the approach they prefer.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

2. When reporting a change in an accounting estimate, GAAP generally requires use of which approach? a. Prospective Approach b. Retrospective Approach c. Cumulative Effect Approach d. Companies can choose the approach they prefer.

3. When a company changes the useful life of an asset, the change is reported a. as an error correction. b. as a change in an accounting estimate. c. using the retrospective approach and restating the prior year’s financial statements. d. by restating all financial statements impacted by the change.

4. Accounting errors or irregularities can occur for which reasons? a. Simple oversight. b. Misapplication of GAAP c. Management exploitation of the flexibility in GAAP. d. All of these answer choices are correct.

5. Which of the following parties are responsible for the detection of errors and accounting irregularities in a company’s financial statements? a. External auditors. b. The SEC staff during their review process. c. Internal audit staff. d. The company audit committee of the board of directors. e. All of these are correct.

6. Material errors discovered after the year in which the error is made are corrected through a(n) a. prospective approach. b. prior period adjustment. c. cumulative effect approach. d. approach chosen by the company.

7. Which of the following is incorrect regarding a Reissuance Restatement? a. It is the result of an error so significant that investors must be notified that they should no longer rely on the previously issued financial statements. b. It triggers the requirement that a Form 8-K be filed. c. It is less severe than a Revision Restatement. d. The financial statements are corrected in the next quarterly or annual report.

8. Notes to the financial statements typically contain all of the following except a. a summary of significant accounting policies.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

b. disclosure of subsequent events. c. non-GAAP financial metric disclosures. d. related-party transactions.

9. The summary of significant accounting policies helps explain a. events that occur after the close of the company’s fiscal year but before the financial statements are issued. b. transactions with other businesses that are connected in some way to company management. c. management’s assessment of financial performance. d. the cost flow assumptions used for valuing inventory.

10. Common non-GAAP metrics include all of the following except a. earnings before interest, taxes, depreciation, and amortization. b. earnings before income tax. c. earnings excluding share-based compensation expense. d. earnings before restructuring charges.

QUIZ ANSWERS 1.

B. GAAP requires firms to use the retrospective approach to account for changes in accounting principle unless it is impractical to do so or a new standard specifies a different method.

2.

A. Changes in accounting estimates are reflected using the prospective approach and are accounted for in the period of the change and/or future periods.

3.

B. When accounting estimates are changed, prior year income is never adjusted and the change is reflected in the period of the change and/or future periods.

4.

D. All of these options can lead to accounting errors or irregularities.

5.

E. All of these are responsible for discovering accounting errors and irregularities.

6.

B. Material errors discovered after the year in which the error is made are corrected through a prior period adjustment. The beginning retained earnings balance is adjusted and previous years’ financial statements that are presented are retroactively restated. Finally, the impact of the error on current and prior period net income is disclosed in the notes to the financial statements.

7.

C. A Reissuance Restatement is the result of a significant error that results in the financial statements being unreliable. A Reissuance is more severe than a Revision.

8.

C. Non-GAAP financial metric disclosures are included in the management discussion and analysis section of the report filed with the SEC, not the notes to the financial statements.

9.

D. Inventory cost flow assumptions are discussed in the summary of significant accounting policies. Subsequent events (a) and related-party transactions (b) have their own section in the notes to the financial statements and management’s assessment (c) is in the MD&A.

10. B. Earnings before income tax is a required GAAP amount that must be reported on the face of the income statement.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

RECOMMENDED FIGURES AND EXHIBITS 3. Exhibit 5.1 Types of Accounting Changes 4. Figure 5.2 Total Financial Restatements from 1997 to 2006 CHAPTER 6

ESSENTIALS OF FINANCIAL STATEMENT ANALYSIS CHAPTER OVERVIEW Financial ratios, along with common-size and trend statements, provide analysts powerful tools for tracking a company’s performance over time, for making comparisons among different companies, and for assessing compliance with contractual benchmarks.

Here are some things to remember about those tools: 

There is no single “correct” way to compute many financial ratios. In this chapter, we have shown you how to compute common financial ratios using widely accepted methods. But not every analyst calculates these ratios in exactly the same way. Why? Sometimes it’s a matter of personal taste or industry practice (for example, operating profit ratios for retail companies often exclude depreciation and rent). At other times, it’s because the analyst is attempting to make the numbers more comparable across companies or over time.



Financial ratios don’t always provide the answers, but they can help you ask the right questions. It’s useful to know that a company’s profitability or credit risk has improved (or declined), but it’s even more important to know why the change occurred. Did consumer demand increase, or was the company stealing market share from competitors? Were operating costs reduced and, if so, which ones? Use the financial ratios and the other tools in this chapter to guide your analysis. They can help you to ask the right questions and tell you where to look for answers.



Is it the economics of the business or is it the accounting? Watch out for accounting distortions that can complicate your interpretation of financial ratios and other comparisons. Remember that the analyst’s task is to ―get behind the numbers‖—that is, to develop a solid understanding of the company’s economic activities and how industry fundamentals have shaped where the company is today and where it will be tomorrow.

CHAPTER OUTLINE V.

Basic Approaches A. Financial Statement Analysis and Accounting Quality Teaching Tip: Benchmark comparison measures a firm’s performance or health against some predetermined standard. In time-series analysis, the benchmark may be the change in performance from year to year. In crosssectional analysis, the benchmark may be the performance of a particular competitor or industry averages.

VI.

A Case In Point: Getting Behind the Numbers at Kroger A. Examining Kroger’s Financial Statements

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

Teaching Tip: Cause-of-Change Analysis: Refer to the model in the text and demonstrate its usefulness by changing one component of the model (holding all other inputs constant) at a time using two periods of comparison. With each change, point out its effect on net income until every component of the model has been analyzed.

VII.

VIII. IX. X.

Profitability, Competition, and Business Strategy A. Financial Ratios and Profitability Analysis B. ROA and Competitive Advantage Return on Common Equity and Financial Leverage Global Vantage Point Liquidity, Solvency, and Credit Analysis A. Short-Term Liquidity B. Long-Term Solvency C. Cash Flow Analysis D. Financial Ratios and Default Risk Teaching Tip: It is interesting to discuss the different stakeholder groups and which ratios may be more meaningful to each. For example, shareholders may be more concerned about ROCE and profitability ratios, while creditors may be more concerned about liquidity and solvency.

CHAPTER QUIZ 1. All of the following may be used as tools for financial analysis except a. cause-of-change analysis. b. trend statements. c. common-size statements. d. financial ratios. e. All of the above are tools for financial analysis 2. Return on Assets (ROA) measures a firm’s a. ability to pay off debts quickly. b. profit performance. c. profitable use of debt. d. return on shareholders’ investment. e. None of these.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

Condensed financial data are presented below for the Tulsa Corporation: 2021 2020 Accounts receivable $277,500 $230,000 Inventory 310,000 250,000 Total current assets 675,000 565,000 Total assets 800,000 700,000 Current liabilities 250,000 200,000 Long-term liabilities 77,500 75,000 Sales 1,640,000 Cost of goods sold 985,000 Interest expense 10,000 Net income 130,000 Tax rate 25% 3. The profit margin used to calculate return on assets for 2021 is (rounded): a. 8.9% b. 16.3% c. 17.2% d. 18.3% 4. In a common size balance sheet for 2021, accounts receivable is expressed as: a. 16.9%. b. 41.4%. c. 34.7%. d. 120.6%.

5. The current ratio for 2021 is (rounded): a. 1.4 to 1 b. 2.0 to 1 c. 2.7 to 1 d. 3.4 to 1 6. The inventory turnover for 2021 is (rounded): a. 2.61 times. b. 3.94 times. c. 3.17 times. d. 3.51 times.

7. When assessing a company’s credit risk, analysts a. use only financial ratios. b. use only the statement of cash flows. c. review both liquidity and solvency. d. look only at the operating and cash conversion cycles.

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The Economic and Institutional Setting for Financial Reporting

8. Which of the following actions is not an option for the lender when a borrower is in default? a. Modify the debt payment schedule in exchange for an increased interest rate or additional collateral. b. Adjust the loan payment schedule to better suit the company’s anticipated operating cash flows. c. Petition a court to judge the borrower insolvent. d. Contact the borrower’s customers and begin collecting their receivables.

9.

Solvency refers to the: a. short-term ability to fund the company's operating needs. b. short-term ability to generate cash for immediate debt repayment needs. c. long-term ability to generate a positive return on assets. d. long-term ability to generate sufficient cash to satisfy plant capacity needs, fuel growth, and to repay debt when due. e. company's overall ability to generate a positive return on common equity for investors.

10. Trend statements help the user a. determine the reason(s) for changes over time in each financial statement line item. b. spot relationships among financial statement items. c. spot changes over time in each financial statement line item. d. identify variations in company financials against industry averages.

QUIZ ANSWERS 1.

E. The chapter provides an overview of four financial analysis tools—cause-ofchange analysis, common-size statements, trend statements, and financial ratios.

11. B. Most evaluations of profit performance begin with the return on assets (ROA) ratio.

12. D. Net income + Interest expense × (1 − Tax rate) ÷ Average assets (130,000 + 10,000 * 1 − .25) ÷ (800,000 +700,000 ÷ 2) 13. C. Accounts receivable ÷ Total assets (277,500 ÷ 800,000) 14. C. Current assets ÷ Current liabilities (675,000 ÷ 250,000) 15. D. Cost of goods sold ÷ Average inventory (985,000 ÷ (250,000 + 310,000 ÷ 2) 16. C. Although cash flow statements contain information enabling a user to assess a company’s credit risk, financial ratios are also useful for this purpose. Credit risk analysis using financial ratios typically involves an assessment of liquidity and solvency.

17. D. Lenders can respond to a default in several ways. Lenders may adjust the loan payment schedule to better suit the company’s anticipated operating cash flows.

Lenders may modify the payment schedule in exchange for an increased interest rate or additional collateral. Lenders may petition a court to judge the borrower insolvent.

18. C. Solvency refers to a company’s ability to generate a stream of cash inflows 1-26 Copyright © 2021 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill.

Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

sufficient to maintain its productive capacity and still meet the interest and principal payments on its long-term debt.

19.

C. Trend statements provide analysts a powerful tool for tracking a company’s performance over time.

RECOMMENDED FIGURES AND EXHIBITS 5. Figure 6.1—The Financial Reporting Filter and the Analyst’s Task 6. Exhibit 6.3—The Kroger Co. Cause-of-Change Analysis 2014 - 2017 7. Exhibit 6.4—The Kroger Co. Common-Size and Trend Analysis of Income 8. Exhibit 6.6—The Kroger Co. Comparative Balance Sheets 9. Exhibit 6.7—The Kroger Co. Common-Size and Trend Analysis of Assets 10. Exhibit 6.8—The Kroger Co. Common-Size and Trend Analysis of Liabilities and Shareholders’ Equity 11. Exhibit 6.12—The Kroger Co. Comparative Cash Flow Statements 12. Exhibit 6.13—The Kroger Co. Common-Size and Trend Analysis of Selected Cash Flow Items 13. Exhibit 6.16—Asset Turnover Decomposition 14. Exhibit 6.18—Profitability and Financial Leverage CHAPTER 7 THE ROLE OF FINANCIAL INFORMATION IN VALUATION AND CREDIT RISK ASSESSMENT CHAPTER OVERVIEW The objective of financial reporting is to provide information to existing and potential investors and creditors. This chapter provides a framework for understanding how financial reporting meets this important objective. Specifically, 

We show how accounting numbers are used in business valuation and credit risk assessment, and then illustrate in Appendix 7A what it means to assess the amounts, timing, and uncertainty of prospective net cash inflows of a business.



A critical part of understanding the decision-usefulness of accounting information—a major focus of this book—is understanding which accounting numbers are used, why they are used, and how they are used when making investment and credit decisions.



Knowing how earnings, book values, and cash flows are used in investment and credit decisions will help you to evaluate the alternative accounting measures discussed in subsequent chapters of this book—not only those recognized directly in the financial statements but also those disclosed in the financial statement notes.

CHAPTER OUTLINE I.

Business Valuation A. The Discounted Cash Flow Valuation Approach B. The Role of Earnings in Valuation C. The Abnormal Earnings Approach to Valuation

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

Teaching Tip: Cash flows are uneven, but accrual accounting earnings measurement takes a long-run perspective that smooths out the unevenness in year-to-year cash flows. The important implication is that investors are better able to predict a company’s future free cash flows using accrual earnings than by using realized cash flows.

II.

Fair Value Accounting Teaching Tip: There is significant debate in the accounting community about the role fair value played in the financial crisis of 2007–2008. Some argue it exacerbated the problem, while others suggest it prevented worse problems.

III. IV.

Global Vantage Point Research on Earnings and Equity Valuation A. Sources of Variation in P/E Multiples B. Earnings Surprises Teaching Tip: A number of empirical studies have compared analyst and mechanical model forecasts. The results generally indicate that analyst forecasts are superior, but not dramatically so. However, there are some caveats. The superiority of analyst forecasts is related to firm size. In addition, analyst forecasts provide less benefit as earnings uncertainty increases (Brown, Richardson, and Schwager, 1987). This result is troublesome since it is in the environment of high uncertainty that there is a need for analyst services, yet they may not outperform mechanical models. In direct contrast, another study of individual analysts notes that those analysts with the best forecasting record were those whose forecasting behavior was the most difficult to predict (Stickel, 1990). Furthermore, Brown, Foster, and Noreen (1985) find that analyst forecasts follow the market rather than lead it. Thus, if a firm’s stock is moving strongly in one direction, analyst forecasts will be revised in that same direction.

V.

Credit Risk Assessment A. Traditional Lending Products B. Credit Analysis C. Credit-Rating Agencies

VI.

APPENDIX 7A: Discounted Cash Flow and Abnormal Earnings Valuation Applications A. Valuing a Business Opportunity B. Valuing Kroger’s Shares APPENDIX 7B: Financial Statement Forecasts A. Illustration of Comprehensive Financial Statement Forecasts

VII.

CHAPTER QUIZ 1. The steps involved in business valuation are forecasting the future values of some financial attribute, determining the risk associated with that forecasted value, and then using a discount rate reflective of the risk to determine the

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Financial Reporting and Analysis 8e

a. b. c. d.

The Economic and Institutional Setting for Financial Reporting

present value of the firm’s dividends. certain future value of earnings. future value of a firm’s earnings. discounted present value of the expected future amounts.

2. To apply the discounted free cash flow model, the analyst needs to estimate a. net cash flows from operations for each future period, starting one period from now. b. free cash flows for each future period, starting one period from now. c. free cash flows for approximately ten years. d. net cash flows from operations for approximately ten years.

3. If a firm earns a return on net assets that exceeds its cost of equity capital, it will generate ________ abnormal earnings and its stock will sell at a ________ relative to book value. a. positive; premium b. positive; discount c. negative; premium d. negative; discount 4. Income from continuing operations, excluding special or nonrecurring items, is generally regarded as a. permanent earnings. b. value-relevant earnings. c. transitory earnings. d. abnormal earnings.

5. Under the abnormal earnings approach of equity valuation, investors willingly pay a premium for those firms that a. earn less than the cost of equity capital. b. produce negative abnormal earnings. c. produce positive abnormal earnings. d. earn an amount equal to the equity cost of capital.

The following information relates to Problem 6.

Firm A Actual earnings $5,000 r 8% BVt-1 $100,000 6. What are the abnormal earnings for Firm A? a. ($3,000) b. ($8,000) c. $5,000 d. $8,000

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

7. Carrying amounts in a GAAP balance sheet are measured using all the following except a. net realizable value. b. historical cost. c. discounted present value. d. projected ROI.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

8. In the process of determining fair value, the exit price refers to a. the amount the firm would receive if it sold a given asset. b. the amount the firm would pay if it bought an asset of the same type and condition as the one being valued. c. the sum of the future cash flows expected to be generated by use of the asset. d. the historical cost of the asset being valued.

9. Short-term notes sold directly to investors by large, highly rated companies are called a. bonds. b. leases. c. debentures. d. commercial paper.

10. The assessment of earnings quality is best accomplished using which of the following? a. Income statement and cash flow statement. b. Balance sheet and cash flow statement. c. Multi-step income statement, balance sheet, and cash flow statement. d. Single-step income statement, balance sheet, and cash flow statement.

QUIZ ANSWERS 1. D. Fundamental valuation uses basic accounting measures to assess the amount, timing, and uncertainty of a firm’s future operating cash flows or earnings, which are discounted at a risk-adjusted cost of capital to arrive at a valuation estimate.

2. B. The free cash flow valuation model says that today’s estimate of a company’s stock and debt equals the sum of the stream of expected future free cash flows discounted back to the present. The valuation model’s cash flow stream begins one period from now at t = 1, and it continues over an infinite horizon 3. A. When a firm is able to earn a return on net assets (common equity book value) that exceeds its cost of equity capital, it will generate positive abnormal earnings. Its stock will then sell at a premium relative to book value.

4. A. Income from continuing operations (with the possible exception of certain socalled special items) is generally regarded as a recurring, sustainable component of a company’s profit performance, and thus it would fall into the permanent earnings category.

5. C. Investors willingly pay a premium only for those firms that earn more than the cost of capital—meaning firms that produce positive abnormal earnings.

6. A. Abnormal earnings = Actual earnings – (Equity cost of capital * Book value) = $5,000 – (.08 * $100,000) = $(3,000) 7. D. Carrying amounts in a GAAP balance sheet are measured using historical cost, net realizable value, discounted present value, and fair value.

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The Economic and Institutional Setting for Financial Reporting

8. A. Exit price is the amount the firm would receive if it sold its investment.

9. D. Commercial paper is short-term notes sold directly to investors by large and financially sound companies.

10. C. Assessing earnings quality involves using information from a multiple-step income statement, a balance sheet, a cash flow statement, financial notes, and Management’s Discussion and Analysis (MD&A) to identify components of current earnings that are likely to be sustainable in contrast to those that are transitory or price irrelevant.

RECOMMENDED FIGURES AND EXHIBITS 1.

2.

3.

4.

5.

6.

7.

8.

Exhibit 7.1—Illustration of the Discounted Free Cash Flow Approach to Valuation Figure 7.1—Linkage Between Stock Price and Accrual Earnings Exhibit 7.2—Illustration of the Abnormal Earnings Approach to Valuation Figure 7.5—Stock Returns and Quarterly Earnings ―Surprises‖ Exhibit 7.5—Standard & Poor’s Key Financial Ratios and Ratings of Corporate Debt Exhibit 7.8—The Kroger Co. Forecasted Results Exhibit 7.9—Veto Equipment Supply Company Historical Financial Statements Exhibit 7.10—Veto Equipment Supply Company Historical and Forecasted Income Statements and Balance Sheets 9. Exhibit 7.11—Veto Equipment Supply Company Historical and Forecasted Cash Flow Statements CHAPTER 8 THE ROLE OF FINANCIAL INFORMATION IN CONTRACTING CHAPTER OVERVIEW   





Conflicts of interest among managers, shareholders, lenders, or regulators are natural features of business.

Contracts and regulations help address these conflicts of interest in ways that are mutually beneficial to the parties involved.

Accounting numbers often play an important role in contracts and regulations because they provide useful information about the company’s performance and financial condition as well as about the management team’s accomplishments.

Accounting-based lending agreements, compensation contracts, and regulations shape managers’ incentives; after all, that’s why accounting numbers are included in contracts and regulations. They also help to explain the accounting choices managers make.

Understanding why and how managers exercise their discretion in implementing GAAP can be extremely helpful to those who are analyzing and interpreting a company’s financial statements.

CHAPTER OUTLINE I. II.

Conflicts of Interest in Business Relationships Debt Covenants in Lending Agreements A. Affirmative Covenants, Negative Covenants, and Default Provisions

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Financial Reporting and Analysis 8e

B. C.

The Economic and Institutional Setting for Financial Reporting

Mandated Accounting Changes May Trigger Debt Covenant Violation Managers’ Responses to Potential Debt Covenant Violations

Teaching Tip: Debt covenants help mitigate the conflict of interest between managers/shareholders and creditors. Creditors benefit from debt covenants due to the reduced default risk, and shareholders benefit due to the lowered cost of debt financing.

III.

IV.

V.

VI.

Management Compensation A. How Executives Are Paid B. Proxy Statements and Executive Compensation C. Incentives Tied to Accounting Numbers D. Catering to Wall Street Regulation A. Capital Requirements for Financial Institutions B. Rate Regulation C. Taxation D. Other Disclosures Fair Value Accounting and the Financial Crisis A. The Meltdown B. The Controversy Analytical Insights: Incentives to “Manage” Earnings Teaching Tip: SEC Chairman Arthur Levitt gave a speech entitled ―The Numbers Game‖ at the NYU Center for Law and Business. In this speech, he warned of pressures on companies to meet earnings. This speech would is a quick and easy read which can generate lively discussion for all students.

CHAPTER QUIZ 1. Loan provisions that are specifically designed to restrict dividend payments to shareholders are called a. debt covenants. b. debt obligations. c. stock covenants. d. stock agreements.

2. When one party to a business relationship can make decisions that benefit him or her but harm another other party in the relationship a. a lawsuit is automatically filed. b. a contract arises. c. a conflict of interest arises. d. a contingent liability arises.

3. The Tax Cuts and Jobs Act did which of the following? a. Increased the restrictions on the deductibility of executive compensation. b. Decreased the restrictions on the deductibility of executive compensation. c. Reduced the likelihood that executives will be covered employees.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

d. Reduced the likelihood that lower level managers will be covered employees.

4. In the event of a default, lenders may do all of the following except a. seize the specified collateral. b. take immediate full control of the creditor. c. initiate bankruptcy proceedings. d. modify contract terms.

5. Discretionary accounting accruals are a. cash financial statement adjustments, which accrue revenue or expenses. b. noncash financial statement adjustments, which accrue revenue or expenses. c. cash financial statement adjustments, which accrue only revenue. d. noncash financial statement adjustments, which accrue only expenses. e. all of the above.

6. A covenant that specifies a required minimum level of net worth and working capital is a/an a. compliance covenant. b. financial covenant. c. implicit covenant. d. negative covenant. e. none of the above.

7. Which of the following gives outright ownership of company shares to the recipient? a. Stock options b. Stock grants c. Restricted stock d. All of these give outright ownership 8. Which of the following is an accounting strategy most likely used by management to meet EPS guidance? a. Postpone taking an accounting charge. b. Draw down accounting reserves. c. Delay R&D expense to the next quarter or year. d. Alter assumptions such as those relating to the allowance for doubtful accounts.

9. Which of the following is not a purpose served by debt covenants? a. Signals and triggers b. Protection against credit-damaging events c. Preservation of repayment capacity d. Eliminate default risk by the creditor 10. Potential conflicts of interest between shareholders and managers may be overcome if managers are given incentives which cause them to behave as if they were a. customers. b. owners.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

c. debtors. d. vendors.

QUIZ ANSWERS 1. A. Some covenants place strict limits on new borrowing, prohibit stock repurchases and dividends without prior lender approval, or ensure that cash generated both from ongoing operations and from asset sales will not be diverted away from servicing debt.

2. C. Conflicts of interest arise when one party to a business relationship can take actions for his or her own benefit that harm other parties in the relationship.

3. A. More executives are likely to be covered employees under The Tax Cuts and Jobs Act and there will be no way to avoid the limitation on deductibility of executive compensation.

4. B. Remedies for an event of default include renegotiating the debt contract terms such as an increase in the interest rate, seizing collateral, accelerating the maturity of the debt, or initiating bankruptcy proceedings.

5. B. Discretionary accounting accruals are noncash transactions that accrue revenues or expenses.

6. B. The financial covenants also define certain financial terms and ratios and provide restrictions on the values these ratios may have.

7. B. Stock grants give outright ownership where stock options give and option to purchase later and restricted stock has various restrictions.

8. C. Nearly 80% of financial executives surveyed said they would decrease discretionary spending on items such as research, advertising, and maintenance to meet an earnings target.

9. D. Debt covenants serve three broad purposes: 1) Preservation of repayment capacity; 2) Protection against credit-damaging events; and 3) Signals and triggers.

10. B. Potential conflicts of interest can be mitigated if managers are given incentives to behave as if they were owners.

RECOMMENDED FIGURES AND EXHIBITS 1.

2.

3.

4.

Figure 8.1—CEO Compensation Mix Exhibit 8.2—Tax Cuts and Jobs Act Figure 8.3—Long-Term Incentive Mix Figure 8.4 – Typical Structure of Annual Performance Bonuses CHAPTER 9 RECEIVABLES

CHAPTER OVERVIEW 

GAAP requires that accounts receivable generally be shown at their net realizable

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Financial Reporting and Analysis 8e



 

    

 





The Economic and Institutional Setting for Financial Reporting

value.

Companies often use one of two methods to estimate credit losses: (1) the sales revenue approach or (2) the gross accounts receivable approach. Under either approach, firms must periodically assess the reasonableness of the uncollectibles balance using a method consistent with the Current Expected Credit Loss (CECL) model, which utilizes both historical collection experience and expectations about the future.

Analysts should scrutinize the allowance for uncollectibles balance over time.

Significant increases in the allowance could indicate collection problems, while significant decreases in the allowance could be a sign of earnings management.

Receivables growth can exceed sales growth for several reasons, including a change in customer mix or credit terms. But a disparity in the growth rate of receivables and sales could also indicate that aggressive revenue recognition practices are being used.

In certain long-term credit sales transactions, interest must be imputed by determining the note receivable’s present value.

Firms may elect the fair value option for accounts and notes receivable. Changes in fair value are recognized in net income.

Firms sometimes transfer or dispose of receivables before their due date to accelerate cash collection. Sales of receivables—also called factoring—can be with or without recourse.

Receivables are also used as collateral for a loan.

In analyzing receivables transactions, it is sometimes not obvious whether the transaction to accelerate cash collection represents a sale or a borrowing; however, authoritative accounting literature provides guidelines in Topic 860 Transfers and Servicing of the FASB Accounting Standards Codification for distinguishing between sales (when the transferor surrenders control over the receivables) and borrowings (when control is not surrendered). Sales of receivables change ratios such as receivables turnover as well as potentially masking the underlying real growth in receivables.

Subprime loans and securitizations were at the heart of the 2008 economic crisis.

Accounting and regulatory reforms are under way to address some of the problems identified during the crisis.

Banks and other holders of receivables frequently restructure the terms of the receivable when a customer is unable to make required payments because of financial difficulties. These troubled debt restructurings can take one of two forms: (1) settlement or (2) continuation with modification of debt terms.

When terms are modified, the precise accounting treatment depends on whether the sum of future cash flows under the restructured note is more or less than the note’s carrying value at the restructuring date. The interest rate used in troubled debt restructurings may not reflect the real economic loss suffered by the lender.

Both the FASB and IASB have finalized most of their rules on financial instrument reporting. There are significant differences in the requirements related to estimating credit losses.

CHAPTER OUTLINE I.

Assessing the Net Realizable Value of Accounts Receivable

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Financial Reporting and Analysis 8e

A.

The Economic and Institutional Setting for Financial Reporting

Accounting for Credit Losses

Teaching Tip: Using the allowance method is an example of the matching principle. The cost of bad debts is matched to the period in which sales were made to those customers. Because companies do not know which customers will ultimately be ―bad debts,‖ considerable judgment still goes into evaluating the collectibility of the remaining accounts.

B. C. D. E.

Writing Off Credit Losses Assessing the Adequacy of the Allowance for Credit Losses Account Balance Estimating Sales Returns and Allowances Analytical Insight: Do Existing Receivables Represent Real Sales?

Teaching Tip: Point out that revenue recognition irregularities can be discovered by tracking the relationship between changes in sales and changes in receivables.

II. III. IV.

Notes Receivable A. Accounting for Credit Losses Imputing Interest on Notes Receivable The Fair Value Option Teaching Tip: An illustrative review of the examples provided in the text (Bristol Corporation and Quinones Corporation) may help to clarify the fair value option treatment.

V.

Accelerating Cash Collections: Sale of Receivables and Collateralized Borrowings A. Sale of Receivables (Factoring) B. Borrowing Using Receivables as Collateral C. Ambiguities Abound: Is It a Sale or a Borrowing?

D. A Closer Look at Securitizations E. Securitization and the 2008 Financial Crisis F. Some Cautions for Financial Statement Readers Teaching Tip: For currency, summarize the subprime lending issues that occurred from 2004 to 2009 relating to home prices.

VI.

VII.

Troubled Debt Restructuring A. Settlement B. Continuation with Modification of Debt Terms C. Sum of Restructured Flows Is Less Than Payable’s Carrying Value D. Evaluating Troubled Debt Restructuring Rules Global Vantage Point A. Credit Losses B. Fair Value Option

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Financial Reporting and Analysis 8e

C. D.

The Economic and Institutional Setting for Financial Reporting

Sales of Receivables Debt Restructurings

CHAPTER QUIZ 1. Net realizable value of receivables is gross receivables minus a. current bad debt expense and current sales returns. b. current bad debt expense and estimated returns and allowances. c. estimated credit losses and estimated returns and allowances. d. proven uncollectible accounts and estimated returns and allowances.

The following information relates to Problems 2 and 3, which are independent situations: Munster Inc. has the following unadjusted year-end trial balance information available for 2020. There were no write-offs during the year: Credit sales $600,000 Ending accounts receivable balance $180,000 Ending allowance for uncollectibles $1,500 2. If Munster Inc. uses the sales revenue approach for estimating the bad debt provision and estimates that 1% of sales will be uncollectible, the income statement should show an expense of a. $1,800 b. $6,000 c. $150 d. $4,200 3. If Munster Inc. uses the gross accounts receivable approach for estimating the bad debt provision and estimates that 4% of AR will be uncollectible, the income statement will show an expense of a. $2,100 b. $3,600 c. $5,100 d. $8,500 4. What effect does writing off a specific account receivable have on net income? a. increases net income. b. decreases net income. c. can either decrease or increase net income. d. has no effect on net income.

5. Accounting for long-term credit sales transactions utilizing notes receivable a. is problematic because it ignores interest unless an interest rate is specified in the note.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

b. makes it difficult to assess the degree to which a company’s overall earnings are due to profitable credit sales versus profitable customer financing. c. achieves a clear separation between income from credit sales and interest earned. d. is controversial because it necessitates use of an assumed interest rate.

6. The sale of receivables to a third party is called a. factoring. b. collateralizing. c. discounting. d. securitization.

7. Frankie Inc. enters into an arrangement with Fisker Enterprises whereby Fisker will assume $90,000 of Ritter’s receivables for a 5% fee. These receivables have a related allowance for doubtful accounts of $2,500. Assuming the transaction was a factoring arrangement without recourse, which one of the following entries will Ritter make? a. DR Cash $90,000 CR Accounts receivable $90,000 b. DR Cash $85,500 DR Loss on sale of receivables 4,500 CR Accounts receivable $90,000 c. DR Cash $85,500 DR Allowance for doubtful accounts 2,500 DR Loss on sale of receivables 2,000 CR Accounts receivable $90,000 d. DR Cash $87,500 DR Allowance for doubtful accounts 2,500 CR Accounts receivable $90,000 8. When receivables are bundled and transferred to another organization that issues securities collateralized by the transferred receivables, the arrangement is defined as a. factoring. b. collateralizing. c. discounting. d. securitization.

9. In a troubled debt restructuring, the restructured loan can differ from the original loan in any of the ways listed below except: a. Repayment schedule may be extended to a longer time period. b. Interest and principal payments may be reduced or eliminated. c. The repayment schedule is shortened and the interest rate is significantly increased. d. The customer and lender can settle the loan.

10. Under IFRS, the general accounting for accounts and notes receivable a. has yet to be determined by the IASB. b. presumes off-balance sheet treatment when these assets are sold.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

c. does not allow the fair value option. d. is similar to the accounting under U.S. GAAP. QUIZ ANSWERS: 1. C. When applied to trade receivables, net realizable value refers to the amount of money the business can reasonably expect to collect from its credit customers after deducting estimated credit losses and estimated returns and allowances.

2. B. Sales $600,000 × Expense rate 1% = $6,000 3. A. A/R $180,000 × Rate 4% = $7,200 (required allowance) − Allowance balance $1,500 = $5,700 4. D. Writing off an account has no effect on income. A specific account receivable is eliminated from the books and the allowance contra-account is reduced, but no bad debt provision is recorded.

5. C. Long-term credit sales transactions utilizing notes receivable achieves a clear separation between credit sales and interest earned. Income from the credit sale is recorded when the sale is made. Interest income from financing the customer’s purchase, on the other hand, is recorded over time as it is earned. This separation of income sources makes it possible to assess the degree to which a company’s overall earnings are due to profitable credit sales versus profitable customer financing.

6. A. Factoring is when a company sells its receivables outright to a bank or factoring company in exchange for cash.

7. C. In a factoring transaction without recourse, the purchaser (factor) has no recourse against the seller if the seller’s customers fail to pay and thus, bears the loss.

8. D. Securitization occurs when receivables (such as mortgages and automobile loans) are bundled together and sold or transferred to another organization (securitization entity) that issues securities collateralized by the transferred receivables.

9. C. The restructured loan can differ from the original loan in several ways: Scheduled interest and principal payments may be reduced or eliminated. The repayment schedule may be extended over a longer time period. The customer and lender can settle the loan for cash, other assets, or equity interests.

10. D. The general accounting for accounts and notes receivable under IFRS is similar to the accounting under U.S. GAAP. RECOMMENDED FIGURES AND EXHIBITS 1. Figure 9.2—Sale of Receivables and Collateralized Borrowings 2. Figure 9.3—Structure of a Securitization 3. Exhibit 9.10—Summary of Accounting Procedures for Troubled Debt Restructurings CHAPTER 10 INVENTORIES

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

CHAPTER OVERVIEW This chapter helps readers understand existing GAAP inventory methods and disclosures. It can also help readers compare and analyze profitability and net asset positions across firms that use different inventory methods. Here are the important messages from this chapter. 



   



 

Financial reporting rules allow firms latitude in selecting a cost flow assumption for determining the cost of goods sold reported on the income statement and the inventory values reported on the balance sheet. Firms use FIFO, LIFO, weighted average costing, or a combination of these methods.

This diversity in practice can severely hinder interfirm comparisons when inventory purchase costs are changing over time, which is usually the case. Before comparing a LIFO firm to a FIFO firm, numbers for the LIFO firms should be transformed to the FIFO basis.

Reported FIFO income merges sustainable operating profits and potentially unsustainable realized holding gains. Analysts must disentangle these elements when preparing earnings and cash flow forecasts.

Similarly, LIFO liquidations distort reported margins because ―old‖ costs are matched with current selling prices.

To address inventory impairments, GAAP requires that most inventory be carried at lower of cost or net realizable value. However, firms using LIFO or the retail inventory method must use a more complicated method to measure market.

IFRS accounting for inventory is similar to the accounting under GAAP. However, LIFO is not allowed. In addition, when applying lower of cost or net realizable value, write-downs may be reversed. Under IFRS, market is always defined as net realizable value.

The LIFO conformity rule requires firms to use LIFO for financial reporting if they use it for tax reporting. LIFO accounting gives firms significant tax deferrals.

These deferrals could go away because of deficit pressures or conversions to IFRS, which does not allow LIFO. Absorption costing is required by GAAP but may lead to potentially misleading period-to-period income changes when inventories increase or decrease sharply.

Most LIFO firms use some form of dollar-value LIFO. Dollar-value LIFO essentially converts FIFO inventory amounts to LIFO inventory amounts.

CHAPTER OUTLINE I.

An Overview of Inventory Accounting Issues Teaching Tip: A greater emphasis that inventory costing is a cost flow assumption and is NOT the actual physical flow of goods may be very important for student learning. Consider mentioning the Kroger illustration and why a LIFO physical flow would lead to spoiled goods since the most recent purchases would be the first sold.

II.

Determination of Inventory Quantities Teaching Tip: Most students are familiar with the perpetual inventory system.

For example, when goods at the grocery store are scanned, not only is the sale

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

recorded, but the inventory records are also updated. Similarly, it is not uncommon during a late-night visit to a grocery store to witness personnel carrying printouts that they are using to verify the accuracy of the inventory records.

Teaching Tip: A discussion of the managerial benefits of a perpetual inventory system is also appropriate. For example, a perpetual inventory system assists managers in avoiding excessive inventory levels, stock-outs through the generation of automatic purchase orders, inadequate staffing levels, etc. This system also assists in analyzing the effectiveness of end-of-aisle displays, etc.

III. IV.

V.

VI.

Items Included In Inventory Costs Included in Inventory A. Manufacturing Costs B. Vendor Allowances Cost Flow Assumptions: The Concepts A. First-In, First-Out (FIFO) Cost Flow B. Last-In, First-Out (LIFO) Cost Flow C. FIFO, LIFO, and Inventory Holding Gains Analyzing LIFO Companies A. The LIFO Reserve Disclosure Teaching Tip: Emphasize that the change in the LIFO reserve represents the difference between LIFO and FIFO gross margin for that period. The level of the LIFO reserve represents the cumulative, before-tax difference between LIFO and FIFO income since the firm adopted the LIFO inventory costing method.

VII. VIII.

IX. X. XI. XII. XIII. XIV.

Inflation and LIFO Reserves LIFO Liquidations A. Reconciliation of Changes in LIFO Reserve B. Improved Trend Analysis LIFO and Earnings Management Eliminating LIFO Ratio Distortions Tax Implications of LIFO Eliminating Realized Holding Gains for FIFO Firms Empirical Evidence on Inventory Policy Choice Inventory Impairment A. Lower of Cost and Net Realizable Value (LCNRV) B. Impact of Inventory Impairment C. LIFO-Lower of Cost and Market Method (LIFO-LCM)

Teaching Tip: The ceiling constraint simply requires that any expected loss be recorded in its entirety when the expected loss becomes known. In other words, writing down inventory to replacement cost that exceeds NRV results in a loss recognized in the current period, with additional loss recorded in the period of sale.

The floor constraint discourages managers from overstating losses in the current period, only to overstate profit in the period of sale. For example, if replacement cost is less than the floor, writing down inventory to replacement increases the loss

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

recognized in the current period, only to result in a sale of goods at greater than normal profit margins in the year of sale. This provides a signal to the market that contradicts the decline in replacement cost that led to the application of the lower of cost or market rule in the first place.

XV.

Global Vantage Point A. Comparison of IFRS and GAAP Inventory Accounting B. Future Directions Teaching Tip: One particular point of discussion is that IFRS does not allow the use of LIFO inventory. An interesting discussion can be had about the tax impact of moving away from LIFO for many US companies.

XVI. XVII. XVIII.

APPENDIX 10A: Variable Costing Versus Absorption Costing APPENDIX 10B: Dollar-Value LIFO APPENDIX 10C: Inventory Errors Teaching Tip: Of particular concern is the effect that inventory errors have on reported earnings. Overstating (understating) ending inventory overstates (understates) gross margin. In addition, ending inventory of one period becomes the beginning inventory of the next period. Therefore, an error this period carries over to the next period, having the opposite effect on gross margin. For this reason, inventory errors ―correct‖ themselves at the end of the second period.

CHAPTER QUIZ 1. Goods available for sale needs is allocated between a. beginning inventory and inventory purchases. b. beginning inventory and ending inventory. c. ending inventory and cost of goods sold. d. inventory purchases and cost of goods sold.

Use the following to answer Problems 2 and 3: The following information pertains to the San Company’s widget inventory: March 1 5 14 31

Inventory Balance Purchase Purchase Inventory Balance

400 units 1,200 units 250 units 550 units

@ $3.10 @ $3.20 @ $3.25

2. In a periodic inventory system, the LIFO cost of goods sold is a. $1,787. b. $4,120. c. $4,173. d. $5,006.

3. In a periodic inventory system, the FIFO cost of goods sold is

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Financial Reporting and Analysis 8e

a. b. c. d.

The Economic and Institutional Setting for Financial Reporting

$1,787. $4,120. $4,173. $5,006.

4. The Heat Company has used the LIFO method for inventory valuation since the start of business 15 years ago. The current year ending inventory is $175,000. If the FIFO method of inventory had been used, the inventory would be $250,000. If Heat Company had used the FIFO inventory method, pre-tax income would have been a. $75,000 higher over the 15-year period. b. $75,000 lower over the 15-year period. c. $75,000 higher in the current year. d. $75,000 lower in the current year. e. Cannot be determined from the information provided 5. The Stone Corporation reported a beginning LIFO reserve of $30,000 and an end of the year LIFO reserve of $35,000. The cost of goods sold was $192,000 under LIFO. The cost of goods sold under FIFO should be a. $157,000. b. $187,000. c. $197,000. d. $222,000.

6. The LIFO conformity rule states that a. if LIFO is used for tax purposes, the external financial statements must also use LIFO. b. if LIFO is used for tax purposes, the external financial statements must also use FIFO. c. if FIFO is used for tax purposes, the external financial statements must use FIFO. d. if FIFO is used for tax purposes, the external financial statements must use LIFO. 7. The Spider Company realized that on its financial statements for 2019, ending inventory was overstated by $7,000 and insurance expense was understated by $5,000. If all balances were correct at the end of 2018, how much will 2019 income before taxes be overstated or understated? a. $2,000 understated b. $2,000 overstated c. $12,000 understated d. $12,000 overstated 8. When applying the lower of cost or net realizable value (LCNRV) method, inventory value reported cannot exceed the a. replacement cost. b. selling price less the expected cost of completion and disposal. c. selling price less a normal profit margin. d. market floor.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

9. IFRS accounting for inventory (IAS 2) does not permit which of the following cost flow assumptions? a. LIFO. b. FIFO. c. Weighted average. d. Specific identification.

10. BAC Company has elected to adopt the dollar-value LIFO inventory method when the inventory is valued at $105,000. The adoption takes place as of January 1, 2018 when the entire inventory represents a single pool. ABC Company determined that the inventory at December 31, 2018 was $134,100 at current year cost and $121,000 at base year cost using a relevant price index of 1.10. The inventory at December 31, 2018 under dollar value LIFO is a. $121,000. b. $122,600. c. $134,100. d. $147,510.

QUIZ ANSWERS: 1.

C. Total cost of the goods available for sale must be allocated between ending inventory and cost of goods sold.

2.

C.

3.

4.

LIFO cost of goods sold:

250 @ $3.25 = 1,050 @ $3.20 =

$813 3,360 $4,173

FIFO cost of goods sold:

400 @ $3.10 = 900 @ $3.20 =

$1,240 2,880 $4,120

B.

A. FIFO inventory LIFO inventory

5.

$250,000 – 175,000 $75,000 higher with FIFO

B. LIFO cost of goods sold – Increase in LIFO reserve Estimated FIFO COGS

$192,000 (5,000) $187,000

6.

A. U.S. tax rules specify that if LIFO is used for tax purposes, the external financial statements must also use LIFO. This is called the LIFO conformity rule.

7.

D.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

2019: Cost of goods sold understated Insurance expense understated Income before taxes overstated

$7,000 income overstated 5,000 income overstated

$7,000 5,000 $12,000

8.

B. ―Market‖ is defined as net realizable value, the estimated selling price of the inventory in the ordinary course of business less the reasonably predictable costs of completing, disposing of, and transporting the inventory

9.

A. LIFO is not permitted under IAS 2.

10. B. Base year inventory Increase for 2018 (base year prices quantity increase of 16,000) Ending dollar value LIFO inventory

$105,000  1.00 = 16,000  1.10 =

$105,000 17,600 $122,600

RECOMMENDED FIGURES AND EXHIBITS 1.

2.

3.

4.

5.

Exhibit 10.1—Flow of Product Costs for Manufacturing Businesses Figure 10.1— FIFO Cost Flow Figure 10.2— LIFO Cost Flow Exhibit 10.3—Adjusting Cost of Goods Sold from LIFO to FIFO Figure 10.4—Magnitude of Inventory and LIFO Reserve Relative to PPI and Oil Prices 6. Exhibit 10.11—Application of Lower of Cost and Net Realizable Value 7. Exhibit 10.17—Summary of Cost Treatment by Category under Variable and Absorption Costing 8. Exhibit 10.19—Absorption versus Variable Costing Statements: Contrasting the Outcomes CHAPTER 11 LONG-LIVED ASSETS CHAPTER OVERVIEW 



 

U.S. GAAP for long-lived assets is far from perfect. The need for unbiased, accurate, cost-effective, and verifiable numbers causes these assets to be measured in terms of the economic sacrifice incurred to obtain them—their historical cost—rather than in terms of their current expected benefit—or economic worth—to the firm.

Changes in the amount of capitalized interest from one period to the next can distort earnings trends. A thorough understanding of how the GAAP measurement rules are applied allows statement readers to avoid pitfalls in trend analysis when investment in new assets is sporadic.

Incremental costs, such as sales commissions, associated with acquiring a contract may be deferred and amortized over the life of the contract.

Because it is uncertain whether future benefits result from research and brand

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Financial Reporting and Analysis 8e



 





The Economic and Institutional Setting for Financial Reporting

development costs, these costs are generally expensed in the period incurred.

Consequently, balance sheet carrying amounts for intangible assets often differ from their real value to the firm. Analysts must scrutinize disclosures of R&D expenses to undo the overly conservative accounting.

When comparing return on assets (ROA) ratios across firms, one must remember that historical cost leads to an upward drift in reported ROA as assets age. So, analysts must determine whether the average age of the long-lived assets for firms being analyzed is stable or rising. Inflation also injects an upward bias into reported ROA. Asset impairment write-downs depend on subjective forecasts and could be used to manage earnings.

An understanding of differences in depreciation choices across firms permits better interfirm comparisons. When making interfirm comparisons, analysts should use note disclosures to overcome differences in the long-lived asset useful lives chosen by each firm and, when possible, in their depreciation patterns.

International practices for long-lived assets are sometimes very different from those in the United States. Statement users who make cross-country comparisons must exercise caution. IFRS allows much greater use of fair value than does U.S. GAAP. Some of the key differences between IFRS and U.S. GAAP relate to the revaluation of tangible assets, investment property, capitalization of intangible development costs, and impairment losses.

CHAPTER OUTLINE I. Measurement of the Carrying Amount of Long-Lived Assets A. The Approach Used by GAAP Teaching Tip: While historical cost is reliable, it is often criticized as being irrelevant. Managers presumably make decisions based on market values. Since the economic sacrifice approach provides market values, it appears that managers would prefer the expected benefits approach. Of course, the trade-off with the expected benefits approach is that the numbers may not be reliable.

This is of particular concern when the transactions are between related parties and involve a swap that is not measured with a cash transfer. Property for property swaps may inflate earnings and balance sheet valuations.

II.

III. IV.

Long-Lived Asset Measurement Rules Illustrated A. Computing Avoidable Interest B. Tax versus Financial Reporting Incentives Deferred Costs Intangible Assets Teaching Tip: The value of many technology companies lies in their internally generated intangible assets. These assets have economic value, which is recognized by financial analysts and stock market participants. Class discussion could explore how this information is communicated to investors and when the value of these assets no longer exists.

V.

Asset Impairment A. Tangible and Amortizable Intangible Assets

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Financial Reporting and Analysis 8e

VI. VII. VIII.

IX. X.

The Economic and Institutional Setting for Financial Reporting

B. Indefinite-Lived Intangible Assets C. Case Study of Impairment Recognition and Disclosure—L Brands, Inc. D. Management Judgments and Impairments Obligations Arising from Retiring Long-Lived Assets Assets Held for Sale Depreciation A. Disposition of Long-Lived Assets B. Financial Analysis and Depreciation Differences Exchanges of Nonmonetary Assets A. Exchanges Recorded at Book Value Global Vantage Point A. Comparison of IFRS and GAAP Long-Lived Asset Accounting

CHAPTER QUIZ 1. Long-lived assets are a. non-operating assets expected to yield their economic benefits (or service potential) over a period longer than one year. b. operating assets expected to yield their economic benefits (or service potential) over a period longer than one year. c. non-operating assets expected to yield their economic benefits (or service potential) over a period longer than five years. d. operating assets expected to yield their economic benefits (or service potential) over a period longer than two years.

The following information relates to Problems 2 and 3: Reddy Co. acquired a piece of land for a new factory by paying $100,000. Reddy demolished the old building at a cost of $10,000, and sold scrapped material salvaged from the old building for $3,000. Reddy paid an architect $5,000, and the title insurance upon acquisition of the land was $1,000. The construction period interest was $8,000, and the contractor received $200,000 for the building.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

2. The cost of the land recorded by Reddy Co. is a. $97,000 b. $110,000 c. $111,000 d. $108,000 3. The cost of the building recorded by Reddy Co. is a. $200,000 b. $226,000 c. $213,000 d. $205,000 4. U.S. GAAP requires that virtually all costs incurred for research and development of an internally generated patent be a. amortized over 40 years. b. expensed. c. amortized over 20 years. d. capitalized.

5. Hank Co. manufactures toaster ovens. At the end of Year 1, Hank’s management believes that the demand for Hank’s toaster ovens will decrease. The ovens are manufactured using specialized equipment with a historic cost of $4,000,000 and accumulated depreciation of $2,520,000. The managers estimate the equipment has a remaining useful life of 4 years and will generate the following undiscounted cash flows: Year 2 Year 3 Year 4 Year 5 Salvage value

$640,000 420,000 190,000 25,000 50,000

If the equipment were sold today, the sales price would be $1,600,000. Is the equipment considered impaired? Why, or why not? a. Yes, because the undiscounted cash flows are lower than the carrying amount of the asset. b. Cannot determine impairment without discounted cash flows. c. No, because the fair value of the equipment is greater than the carrying value of the asset. d. Yes, because the undiscounted cash flows are less than the fair value of the equipment.

6. Which of the following is not an accurate statement regarding asset retirement obligations (AROs)? a. A liability is recorded at its present value and the liability increases over time. b. An annual expense is recorded as accretion expense. c. A liability is recorded with a credit entry in a contra-asset account. d. A liability is computed using a credit-adjusted risk-free rate.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

The following information relates to Problems 7 and 8: Bruce Company purchased a tractor for $50,000 on January 2, 2020. The asset has an expected salvage value of $10,000 at the end of its five-year useful life.

7. What depreciation method is used if depreciation expense is $8,000 in 2021? a. Straight-line. b. Sum of years’ digits. c. Double-declining balance. d. Composite.

8. What depreciation method is used if depreciation expense is $20,000 in 2020? a. Straight-line. b. Sum of years’ digits. c. Double-declining balance. d. Composite.

9. According to the 2012 AICPA survey of 2011 annual reports, the most favored method of depreciation for financial reporting purposes is a. units-of-production. b. declining-balance. c. straight-line. d. sum-of-the-years’ digits.

10. Daniel Company sold a machine for $8,000 that originally cost $36,000 and had accumulated depreciation of $27,000. Daniel had a a. gain of $1,000. b. gain of $8,000. c. loss of $28,000. d. loss of $1,000.

QUIZ ANSWERS: 1. B. Long lived assets are operating assets expected to yield their economic benefits (or service potential) over a period longer than one year.

2. D. Land $ Demolition Scrap value Title insurance Total land cost

100,000 10,000 (3,000) 1,000 $ 108,000

3. C. Architect fees Construction interest Building cost Total building cost

$

5,000 8,000 200,000 $ 213,000

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

4. B. The recoverability of research and development (R&D) expenditures is highly uncertain at the start of a project. Consequently, GAAP requires that virtually all R&D expenditures be charged to expense immediately.

5. A. Carrying value = $4,000,000 – $2,520,000 = $1,480,000. Undiscounted future cash flow = Sum of year 1 – 5 and salvage value = $1,325,000. Undiscounted future cash flow $1,325,000 is less than the carrying value of $1,480,000, therefore, and thus the asset is impaired.

6. C. Firms are required to estimate the expected present value of the outflows that will occur when assets are eventually retired. These outflows are discounted using a credit-adjusted risk-free rate. The liability’s discounted present value is recorded along with an increase in the carrying amount of the related long-lived asset.

Accretion expense reflects the current period’s increase, or accretion, of the liability.

Account titles other than Accretion expense can be used so long as the nature of the expense is clearly conveyed.

7. A. Straight line formula: (Cost-salvage value) ÷ life ($50,000 − 10,000) ÷ 5 = 8,000 per year Straight-line depreciation rate. See table below.

8. C. DDB formula: Book value × (2 ÷ life) ($50,000 × 2/5) = 20,000 year one DDB depreciation. See table below: Feedback for Problems 7 and 8: DDB 2020 $ 20,000 $ 2021 12,000 2022 7,200 2023 4,320

SL 8,000 8,000 8,000 8,000

9. C. The 2012 AICPA survey of 2011 annual reports shows that the straight-line method is by far the favored method for financial reporting; 94% of the firms use the straight-line method for at least some of their long-lived assets.

10. D. Book value = (36,000 − 27,000) 9,000 – cash proceeds of $8,000 = $1,000 loss on sale of assets.

RECOMMENDED FIGURES AND EXHIBITS 1.

2.

3.

4.

Exhibit 11.3—Hypothetical Long-Lived Asset Carrying Amounts Figure 11.1—Long-Lived Asset Impairment Guidelines Exhibit 11.10—Depreciation Example Figure 11.2—Alternative Depreciation Methods CHAPTER 12 FINANCIAL INSTRUMENTS AND LIABILITIES

CHAPTER OVERVIEW 

Companies now use a variety of financial instruments and nontraditional financing arrangements to fund corporate activities and to manage risk. Statement

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Financial Reporting and Analysis 8e





   

The Economic and Institutional Setting for Financial Reporting

readers face a daunting task when trying to grasp the economic implications of some financial innovations.

For many companies, the most important long-term obligation is still traditional debt financing. IFRS and U.S. GAAP guidance in this area is quite clear.

Noncurrent monetary liabilities are initially recorded at the discounted present value of the contractual cash outflows. The effective interest method is then used to compute interest expense and the net carrying value in each period. Interest rate changes occurring after the debt has been issued are ignored.

Long-term debt accounting makes it possible to ―manage‖ reported income statement and balance sheet numbers when debt is retired before maturity. The opportunity to ―manage‖ those numbers comes from the difference between debt book value and market value when interest rates have changed.

Firms may adopt the fair value option for long-term debt. Fair value changes caused by changes in credit quality are reflected in other comprehensive income.

When a firm issues noninterest-bearing debt, the debt must be recorded at the value of the asset exchanged for the note. A company must impute an interest rate and base subsequent interest expense on that rate.

Information contained in debt and fair value disclosures help investors determine whether companies have the financial resources to pay the debt interest and principal.

IFRS accounting for debt is very similar to U.S. GAAP. The main exception is that the use of the fair value option is more restrictive.

CHAPTER OUTLINE I. II.

Balance Sheet Presentation Bonds Payable A. Characteristics of Bond Cash Flows B. Bonds Issued at Par C. Bonds Issued at a Discount D. Bonds Issued at a Premium E. Graphic Look at Bonds F. Book Value versus Fair Value after Issuance Teaching Tip: Corporations issue bonds as a type of ―interest only‖ loans for longer-term projects. The idea is that the project will generate cash flows by the maturity date. Bonds are a contractual series of cash flows, but the prevailing interest rate will dictate what price investors are willing to pay for that series of cash flows.

III. IV.

V. VI. VII. VIII.

Extinguishment of Debt A. Managerial Incentives and Debt Extinguishments Fair Value Option A. How the Fair Value Accounting Option Mutes Earnings Volatility B. Opposing Views on the Fair Value Accounting Option Floating-Rate Debt Imputed Interest on Notes Payable Analytical Insights: How to Analyze Debt Disclosures Global Vantage Point

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

CHAPTER QUIZ 1. A probable future sacrifice of an economic benefit arising from a present obligation to transfer assets or provide services to other entities in the future as a result of a past transaction is a/an a. Expense. b. Liability. c. Equity. d. Asset.

2. Theta Company has prepared to sell bonds with a stated rate of 6% when the market rate is 8%. These bonds will sell in the market at a. a premium. b. a discount. c. par value. d. stated value. e. Solution cannot be determined with the given information.

3. Harvey Company issued $210,000 of ten-year bonds to yield 11% when the stated rate of the bonds was 9%. Present value interest factors (PVIF) are:

PVIF of $1, 10 years PVIF of Annuity of $1, 10 years

9% 0.42241 6.41766

11% 0.35218 5.88923

The entry to record the bond issuance would be a. DR Cash 88,221 DR Bond premium 11,779 CR Bonds payable b. DR Cash 88,221 DR Bond discount 11,779 CR Bonds payable c. DR Cash 111,779 CR Bond premium CR Bonds payable d. DR Cash 111,779 CR Bond discount CR Bonds payable

100,000

100,000 11,779 100,000 11,779 100,000

4. Floating-rate debt is the most common method for lenders to protect themselves from losses that may arise as a result of a. increases in the market interest rate. b. increases in the stated interest rate on bonds. c. decreases in the market interest rate. d. decreases in the stated rate on bonds.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

5. A bond with a $200,000 maturity value is immediately retired for $212,000 plus accrued interest. The premium on bonds payable (bond premium) at the retirement date is $15,500. Which of the following statements is correct? a. The loss on the debt extinguishment is $12,000. b. The gain on the debt extinguishment is $3,500. c. The gain on the debt extinguishment is $3,500. d. The gain or loss on the debt extinguishment can’t be determined without knowing the dollar amount of the accrued interest.

6.

Which of the following statements is correct with respect to the use of fair value accounting for liabilities under IFRS? a. Both IFRS and U.S. GAAP require changes in credit quality to be recorded in operating income. b. U.S. GAAP is more restrictive than IFRS regarding the use of fair value accounting for liabilities. c. The fair value option is permitted under IFRS only under two specific sets of circumstances. d. Fair value accounting under IFRS is only permitted if the liabilities are actively managed on a fair value basis as part of the company’s documented risk management or investment strategy.

7.

The fair value option is a(n) __________ election available to __________ financial assets and liabilities. a. revocable; all b. revocable; most c. irrevocable; all d. irrevocable; most

8.

Installment notes that have no stated interest rate are recorded at a. present value of cash flows using imputed interest. b. present value of cash flows using market interest. c. future value of cash flows using imputed interest. d. future value of cash flows using market interest. e. face value of the note payable.

9. When bonds are sold at a premium, interest expense will be __________ the cash interest payment and when bonds are sold at a discount, interest expense will be __________ the cash interest payment. a. less than; less than b. more than; more than c. less than; more than d. more than; less than e. equal to; equal to

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

10. Which of the following is/are shown at the discounted present value of the future cash outflows required to satisfy the obligation? a. current monetary liabilities b. noncurrent monetary liabilities c. current nonmonetary liabilities d. noncurrent nonmonetary liabilities

QUIZ ANSWERS: 1. B. Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or to provide services to other entities in the future as a result of past transactions or events.

2. B. When the market rate of interest is higher than the stated rate, a firm must sell the bonds at a discount relative to face value to provide investors the market return they demand.

3. B.

PVIF 0.35218  maturity value $100,000 $35,218 PVIFA5.88923  annual interest $ 9,000 53,003 Bond selling price $88,221 (Discount = 100,000-88,221 = 11,779)

4. A. Investors (lenders) benefit from floating-rate debt when market interest rates rise, and issuing corporations benefit when market rates fall.

5. B. The gain ($3,500) is the difference between the book value ($215,500) and the amount paid ($212,000) to retire the bonds; a gain results because the payment is less than book value.

6. C. The fair value option under IAS 39 is harder to elect than under U.S. standards. IAS 39 permits companies to opt for fair value accounting for liabilities only under two specific circumstances: (1) the liabilities are actively managed on a fair value basis as part of the company’s documented risk management or investment strategy; or (2) use of fair value accounting eliminates or significantly reduces the ―mismatch‖ that arises when different measurement bases are used for related financial instruments.

7. D. Once a company makes the fair value election, it must continue to use fair value measurement for that instrument until the asset is sold or liability extinguished. Fair value is available for most financial assets and liabilities; however, there are some exceptions including leasing, pensions, etc.

8. A. Noncurrent monetary liabilities must be recorded at their present value when incurred, even when no interest rate is stated. In such cases, the interest rate must be imputed.

9. C. When bonds are sold at a premium, interest expense will be less than the cash interest payment. The extra cash paid represents the amount of the premium being returned to bondholders. The opposite is true when bonds are sold at a discount.

10. B. Noncurrent monetary liabilities are recorded at the present value of future cash

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

flows when incurred. Current liabilities are rarely discounted because their short maturity makes the difference between present value and the amount due at maturity immaterial. Nonmonetary liabilities are not discounted.

RECOMMENDED FIGURES AND EXHIBITS 1. Exhibit 12.2—Demonstration that the Yield on Bonds Issued at Par Equals the Stated Interest Rate (here 10%) 2. Exhibit 12.3—Determining the Issue Price for 10% Stated Interest Rate Bonds When the Market Rate is 11% 3. Exhibit 12.4—Bond Discount Amortization Schedule 4. Exhibit 12.6—Determining the Issue Price for 10% Stated Interest Rate Bonds When the Market Rate is 9% 5. Figure 12.2(A)—Cash Interest Payment and Interest Expense 6. Figure 12.2(B)—Carrying Value for 10% Stated Interest Rate Bonds Sold at Discount 7. Figure 12.3—Shifty Corporation Debt-for-Debt Swap 8. Exhibit 12.9—How the Fair Value Accounting Option Reduces Earnings Volatility CHAPTER 13 FINANCIAL REPORTING FOR LEASES CHAPTER OVERVIEW    

 

   

Lease contracts allow lessees to use assets over short or long time periods.

U.S. GAAP views short-term lease contracts as executory contracts, but it views contracts longer than one year as conveying property rights.

Prior to 2019, most lessee leases were not recognized on the balance sheet.

Instead, they were treated as short-term executory contracts, even in cases where the lease terms are much longer than one year.

After 2018, for leases with lease terms in excess of one year, lessees record a lease liability and a corresponding right-of-use asset for the present value of the probable lease payments at the time of leas commencement. Shifting to the new standard may add $2 trillion of assets and liabilities to the balance sheet.

U.S. GAAP classifies long-term leases as finance or operating leases. The criteria attempt to identify situations where lessees control an asset and ―obtain substantially all of its remaining benefits.‖ Lessees account for operating lease and finance lease liabilities in the same way.

However, lessees amortize right-of-use finance lease assets consistent with how they depreciate other long-lived assets, whereas they amortize right-of-use operating lease assets to obtain an average lease expense.

U.S. GAAP requires substantial disclosures related to the lessee right-of-use assets, lease obligations, income statement effects, and cash flow effects.

Most leases are operating leases, and analysts can use the disclosures to recast them as finance leases in the financial statements.

Under IFRS 16, lessees will treat most long-term lease contracts as finance leases.

In addition to not having operating leases, IFRS lease accounting can differ for low-cost assets or investment property.

Lessors’ use of the sales-type lease approach accelerates income recognition in contract to the timing of income recognition under the operating lease approach.

Lessors’ financial statement ratios are also improved. It is perhaps not surprising,

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Financial Reporting and Analysis 8e



 

The Economic and Institutional Setting for Financial Reporting

therefore, that sales-type leases appear frequently on lessors’ financial statements.

Lessor accounting under both ASC Topic 842 and IFRS 16 are similar to the lessor accounting under ASC 840. Both standards are consistent with the revenue recognition accounting under ASC 606. One key difference between ASC Topic 842 and ASC Topic 840 relates to the accounting for uncertainty around the collectability of payments.

Unequal lease payments complicate the accounting for operating leases more than they do for finance leases.

Companies cannot recognize gains for a sale-leaseback if the lease is classified as a finance lease under ASC Topic 842. For operating leases, the seller-lessee can recognize any gain immediately if ASC Topic 606 criteria are met.

CHAPTER OUTLINE I.

Lease Contract Economics Teaching Tip: Much of the debate about lease accounting was to eliminate the opportunity to manage earnings. The early impact of adopting the new leasing standards may have a significant impact on many companies that have a large number of leases. This may impact financial statement ratios and even debt covenants. Shifting to the new lease standard is expected to add approximately $2 trillion of assets and liabilities to company balance sheets.

II.

III.

IV.

V.

VI.

Lessee Short-term and Finance Lease Accounting A. Overview of Lessee Accounting B. Criteria for Finance Lease Treatment C. Applying the Finance Lease Criteria D. Finance Lease Accounting E. Guaranteed Residual Values and Bargain Purchase Options F. Executory Costs G. Payments in Advance Lessee Operating Lease Accounting A. Operating Lease Liability Accounting B. Right-of-Use Asset—Operating Lease Accounting C. Beginning-of-Period Payments Interpreting Lessee Financial Statement Information Under ASC 842 A. Finance Lease Effects versus Operating and Short-Term Lease Effects B. Lessee Presentation and Disclosure Global Vantage Point A. Differences between ASC Topic 842 and IFRS 16 B. Evaluation of ASC Topic 842 Lessor Accounting A. Overview B. Sales-type Leases with Manufacturing Profit C. Sales-type Leases without Manufacturing Profit

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Financial Reporting and Analysis 8e

VII. VIII.

IX. X.

The Economic and Institutional Setting for Financial Reporting

D. Sales-type Leases without Manufacturing Profit Illustrated E. Financial Statement Effects of Sales-Type versus Operating Leases F. Sales-type Leases with Manufacturing Profit Illustrated G. Presentation and Disclosure—Lessor H. Collectability I. Differences between ASC Topic 842 and IFRS 16 Teaching Tip: Accounting for lessors under ASC Topic 842 is similar to the prior accounting under ASC Topic 840. The main difference is how collectability concerns affect the accounting.

Financial Versus Tax Accounting APPENDIX 13A: Evolution of Lease Accounting A. Securities and Exchange Commission’s Initiative B. FASB APPENDIX 13B: Unequal Lease Payment Amounts APPENDIX 13C: Sale and Leaseback

CHAPTER QUIZ 1. When accounting for an operating lease under ASC Topic 842, which one of the following accounts are charged with the expense on the lessee’s income statement? a. Rent Expense b. Amortization Expense c. Depreciation Expense d. Lease Expense e. Cost of goods sold 2. Which of the following is true for the lessee when comparing finance, operating, and short-term leases? a. The total lease expense over the life of the lease is the same under all three methods. b. The total lease expense over the life of the lease varies under all three methods. c. The finance lease approach has lower expense in the earlier years of the lease and higher expense in the later years compared to the other two methods. d. The annual lease expense is different for operating and short-term leases.

3. Executory costs of a lease are treated by the lessee as a. capitalized costs of the lease. b. additional interest expense. c. operating expenses. d. deferred expenses.

4. Decatur, Inc. agrees to lease equipment from the Bridgeport Corporation for 10 years at $20,000 at the end of each year. The equipment has a fair value of $175,000 and an estimated useful life of 10 years. The lease includes a guaranteed residual value of $5,000. In addition to the lease payments, Decatur will pay $5,000 per year for a maintenance agreement. Decatur can finance this lease with its bank at a 12% rate.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

The lessor’s implicit lease rate, known to the lessee, is 10%. The lessor and the lessee use ASC 842 guidelines for lease accounting.

Present value interest factors are: PV factor of $1 for 10 periods PV factor for ordinary annuity for 10 periods

10% 0.38554 6.14457

12% 0.32197 5.65022

The entry to record this lease on Decatur’s books is (Round all calculations to the nearest whole dollar amount.) a.

b.

c.

d.

DR Right-of-use asset—finance lease CR Finance lease liability

194,819

DR Right-of-use asset—finance lease CR Finance lease liability

124,819

DR Right-of-use asset—finance lease DR Discount on lease obligation CR Finance lease liability

124,819 75,181

DR Right-of-use asset—finance lease CR Finance lease liability

155,542

194,819

124,819

200,000

155,542

5. Which of the following does not describe a difference between ASC Topic 842 and IFRS 16? a. IFRS does not include separate accounting for operating leases. b. IFRS permits early adoption only if firms have adopted IFRS 15, the new revenue recognition standard. c. IFRS allows some right-of-use assets to be carried at fair value. d. IFRS allows executory contract accounting for short-term leases.

6. LesSea Corporation leases a tractor from LesSoar with a five-year non-cancelable lease on January 1, 2020 under the following terms:  Five payments of $26,379.74 (a 9% implicit rate, known to LesSea) due at the end each year.  The present value of the payments equals the fair value of the tractor.  The lease is nonrenewable and the tractor reverts to LesSoar at the end of the lease term.  The tractor has a six-year economic life.

Both LesSea and LesSoar use ASC 842 guidance for lease accounting. For LesSea and LesSoar, respectively, the lease will be treated as a: LesSea

LesSoar

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Financial Reporting and Analysis 8e

a. b. c. d.

Operating lease Finance lease Operating lease Finance lease

The Economic and Institutional Setting for Financial Reporting

Operating lease.

Finance lease Sales-type lease.

Sales-type lease.

7. Which of the following is true for the lessor when comparing sales-type and operating leases? a. The total rental revenue over the life of the lease varies depending on the depreciation method used. b. The total income over the life of the lease is the same under both methods. c. The sales-type lease approach has higher rental income over the life of the lease regardless of the depreciation method. d. The operating lease approach has higher rental income over the life of the lease regardless of the depreciation method.

8. When a lessor accounts for a lease as an operating lease, what journal entry is made each year to reflect the receipt of lease payments? a. DR Cash CR Net investment in leased asset CR Financing income-leases b. DR Cash CR Financing income-leases c. DR Cash CR Rental revenue d. DR Cash CR Net investment in leased asset 9. Under which type of lease is the lessee NOT required to record an asset or liability at the commencement of the lease? a. Finance leases b. Operating leases c. Short-term leases d. The lessee is required to record an asset or a liability in all cases.

10. The current ratio of the lessor is improved under which method of accounting for leases? a. The sales-type method b. The operating method c. The current ratio is the same under both the sales-type and operating methods. d. The current ratio is not impacted by the method of accounting for leases.

QUIZ ANSWERS: 1. D. Operating leases recognize ―lease expense‖ on the income statement. Finance leases recognize amortization and interest expense. Short-term leases recognize rent

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

expense.

2. A. The total lease expense over the life of the lease is the same under all three methods. The timing of the expense differs for finance and operating leases, while the annual lease expense is the same for operating and short-term leases.

3. C. Because executory costs represent a cost of using assets—rather than a cost of the assets themselves—these costs are omitted when determining minimum lease payments, and thus they are not a component of the capitalized amount shown in the Right-of-use asset—finance lease account.

4. B. PV lease payments = PVANNUITY* 6.14457  pmt $20,000 PV residual value = PV $1 factor* 0.38554  residual value $5,000 PV of lease

$122,891 $ 1,928 $124,819

5. D. Similar to ASC Topic 842, IFRS 16 allows executory contract accounting for short-term leases.

6. D. For LesSea, the present value of the lease payments equals the fair value of the asset so it meets one of the conditions for finance lease treatment. For the LesSoar, one of the five conditions is met so it is classified as a sales-type lease.

7. B. For the lessor, total income over the life of the lease is unaffected by which accounting method is used. The timing of income differs between the two methods, but the total amount of rental income is the same.

8. C. The leased asset remains on the lessor’s books and rental revenue is recognized each year.

9. C. Lessees treat short-term leases as executory contracts and do not record an asset or liability at commencement of the lease.

10. A. Current assets are higher under the sales-type method of accounting for leases than under the operating lease approach so the current ratio is accordingly improved.

RECOMMENDED FIGURES AND EXHIBITS 1. Figure 13.3—Lessee Company Pattern of Expense Recognition: Finance Versus Operating/Short-term Lease Method 2. Exhibit 13.7—Summary of Lessee Approaches Under ASC 842 3. Exhibit 13.10—Comparison of Undiscounted Dollar Magnitudes of Capital and Operating Lease Payments CHAPTER 14 INCOME TAX REPORTING CHAPTER OVERVIEW

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Financial Reporting and Analysis 8e

   







  

The Economic and Institutional Setting for Financial Reporting

The rules for determining income for financial reporting purposes—book income—differ from the rules for determining income for tax purposes.

The differences between book income and taxable income are caused by a combination of permanent and temporary differences in the revenue and expense items reported on a company’s books versus its tax return.

A temporary difference gives rise to either a deferred tax asset or a deferred tax liability.

Deferred tax accounting generally requires firms to report tax costs or benefits on the income statement in the period in which the related revenue and expense items are recognized for book purposes regardless of when these amounts are reported on the tax return.

Although income tax reporting rules have the effect of ―matching‖ income tax costs in the period the related pre-tax income amounts are recognized, tax reporting rules actually take a balance sheet approach. That is, the rules focus on the recognition and measurement of deferred tax assets and deferred tax liabilities.

The Tax Cuts and Jobs Act of 2017 altered corporation taxation, particularly with respect to the corporate income tax rate and the taxation of foreign income of U.S. companies. It also had a profound effect on reported financial results, especially in the 2017 financial statements.

The income tax note provides useful information for understanding how much of the current period’s tax provision (expense) is currently due and how much is deferred. Tax notes also allow users to understand why firms’ effective tax rates differ from the statutory rate.

GAAP disclosures are useful in assessing a firm’s uncertain tax positions and whether the firm is aggressive or conservative in recognizing the benefits associated with these positions.

Tax notes provide a wealth of information that can be exploited to improve interfirm comparability and evaluate firms’ earnings quality.

There are a number of differences between IFRS and U.S. GAAP rules for accounting for income taxes that you should be aware of as you analyze financial statements across countries.

CHAPTER OUTLINE I.

Understanding Income Tax Reporting A. A Note on Semantics B. Temporary and Permanent Differences between Book Income and Taxable Income C. Problems Caused by Temporary Differences D. Deferred Income Tax Accounting : Interperiod Tax Allocation Teaching Tip: At any point in time, the balance in the deferred tax liability (asset) equals the cumulative dollar amount of temporary difference(s) between book and tax income times the tax rate.

E. F. G. H.

Deferred Tax Liabilities Deferred Tax Assets Net Operating Losses Deferred Tax Asset Valuation Allowances

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Financial Reporting and Analysis 8e

II.

III. IV.

V.

VI.

VII.

The Economic and Institutional Setting for Financial Reporting

I. Classification of Deferred Tax Assets and Deferred Tax Liabilities J. Deferred Income Tax Accounting When Tax Rates Change K. Permanent Differences Measuring And Reporting Uncertain Tax Positions A. Assessing an Uncertain Tax Position Related to a Permanent Difference B. Assessing an Uncertain Tax Position Related to Timing of Deductibility C. Making Changes to or Resolving Uncertain Tax Positions D. Assessing Disclosures on Uncertain Tax Positions Deferred Taxes and Cash Flow The Tax Cuts and Jobs Act of 2017 and its Effect on Financial Statements A. Tax Rate Change B. Stranded Tax Effects C. Foreign Earnings D. Net Operating Losses E. Interest Deduction Limitation F. Immediate Expensing (Bonus Depreciation) G. Repeal of Domestic Production Activities Deduction H. Additional Book-Tax Conformity Requirement Understanding Income Tax Note Disclosures A. Current versus Deferred Portion of Current Period’s Tax Provision B. Reconciliation of Statutory and Effective Tax Rates C. Details on the Sources of Deferred Tax Assets and Liabilities D. Unrecognized Tax Benefits E. Other Tax Information Extracting Analytical Insights from Note Disclosures A. Using Deferred Tax Notes to Assess Earnings Quality B. Using Tax Notes to Improve Interfirm Comparability Global Vantage Point A. Enacted Tax Law Changes vs. Substantively Enacted Tax Law Changes B. Approach to Reporting Deferred Tax Assets When Realizability Is Uncertain C. Reconciliation of Statutory and Effective Tax Rates D. Classification and Offsetting of Deferred Tax Assets and Deferred Tax Liabilities E. Disclosure of Income Tax Amounts Recognized Directly in Equity (Other Comprehensive Income) F. Uncertain Tax Positions G. Other Current IASB Activities Teaching Tip: Tax reporting varies widely across firms and industries. Firms with foreign operations have an entirely different tax reporting regime than domestic firms. The note disclosures for tax positions are extremely important for interfirm comparability.

VIII.

APPENDIX 13A: Comprehensive Interperiod Tax Allocation Problem A. Computation of Taxable Income B. Calculation of Taxes Due

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Financial Reporting and Analysis 8e

C. D. E.

The Economic and Institutional Setting for Financial Reporting

Calculation of Change in Deferred Tax Asset and Liability Accounts Calculation of Income Tax Expense Hawkeye’s Tax Note

CHAPTER QUIZ 1. The allocation of income tax expense across periods when book and tax income differ is called a. interperiod tax allocation. b. intraperiod tax allocation. c. current income tax allocation. d. income tax matching allocation. e. constructive receipt allocation 2. Temporary differences that will cause future taxable income to be greater than future book income give rise to a. permanent differences. b. deferred tax assets. c. deferred tax liabilities. d. tax expense.

3. Which one of the following is a permanent difference between book and taxable income? a. Installment sales b. Interest received on municipal bonds c. Bad debts expense d. Warranty expense e. All of the above The following information relates to Problems 4–6: Ranger Company reported $300,000 in book income before income tax during 2020, its first year of operation. The tax depreciation exceeded its book depreciation by $20,000. The tax rate for 2020 and all future years was 30%.

4. What amount of deferred tax liability should Ranger report in its December 31, 2020, balance sheet? a. $6,000 b. $9,000 c. $10,000 d. $20,00 e. Cannot be determined 5. If Ranger paid no estimated taxes, what amount of income tax payable should Ranger report in its December 31, 2020, balance sheet? a. $84,000 b. $90,000 c. $96,000

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

d. $100,000 e. Cannot be determined.

6. Income tax expense reported in the income statement for the year ending December 31, 2020 would be a. $84,000. b. $90,000. c. $96,000. d. $100,000. e. Cannot be determined 7. At December 31, 2020, the Heather Corporation reported a $20,000 deferred tax liability pertaining to a $50,000 temporary difference that will reverse equally during the next four years. On December 31, 2020, after determining the deferred tax liability, Heather’s management was informed that the income tax rate for years subsequent to 2020 had been changed to 44%. As a result of the tax rate change, Heather’s 2020 income tax expense will a. not change. b. increase $800. c. increase $1,200. d. increase $2,000. e. Cannot be determined 8. If it is more likely than not that future benefits from a deferred tax asset will not be realized in its entirety, a/an a. loss is recorded b. valuation allowance is established. c. expense allowance is established. d. equity account is increased. e. liability is created 9. Which of the following was not a change enacted by the Tax Cuts and Jobs Act of 2017? a. The corporate tax rate was lowered from 35% to 21%. b. The option to carry back net operating losses was extended to five years. c. Bonus depreciation was expanded by eliminating the requirement that items be new to qualify. d. The domestic production activities deduction was repealed. e. All of these are changes enacted by the Tax Cuts and Jobs Act of 2017.

10. Which of the following statements does not correctly describe required income tax disclosures in the notes to the financial statements? a. The sources that created deferred tax assets and deferred tax liabilities is a required disclosure. b. The statutory tax rate and the effective tax rate are disclosed. c. The effective tax rate applicable to firms in the same industry is a required

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

disclosure. d. The current and deferred portions of the current period’s income tax provision must be disclosed separately. e. All of the above are required.

QUIZ ANSWERS: 1. A. Interperiod tax allocation deals with the differences between tax and book income and the reporting of income tax expense and tax obligations across time.

2. C. Temporary differences that result in deferred tax liabilities are called future taxable amounts because future taxable income will be greater that future book income.

3. B. Municipal bond interest income is never included in taxable income but it is part of pre-tax book income, so it represents a permanent difference.

4. A. Excess depreciation on tax return ($20,000) × Future rate (30%) = $6,000 5. A. Pre-tax book income ($300,000) – Excess depreciation ($20,000) = Taxable income ($280,000) × 30% = $84,000 6. B. Current tax ($84,000) + Deferred tax ($6,000) = $90,000 7. D. $50,000 × 4% [44% − 40%*] = $2,000 increase in the deferred tax liability which increases income tax expense. The full change in the amount of future liability is recognized as an increase in the year the tax rate change is enacted. *The current tax rate is 40% calculated as $20,000 deferred tax ÷ $50,000 temporary difference giving rise to the deferred tax.

8. B. Valuation allowances are used when it is uncertain the firm will be sufficiently profitable to realize tax benefits, but it is not appropriate when the firm’s tax positions may not be sustained.

9. B. The new law eliminated the option to carry back NOLs. NOLs are able to be carried forward indefinitely.

10. C. Income tax note disclosures provide financial statement users with a wealth of information about the firm; however, no industry information is required.

RECOMMENDED FIGURES AND EXHIBITS 1. Exhibit 14.1—Examples of Temporary Differences Between Book Income and Taxable Income 2. Exhibit 14.2—Examples of Permanent Differences Between Book Income and Taxable Income 3. Exhibit 14.6—Computation of Income Tax Expense with Interperiod Tax

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

Allocation 4. Figure 14.5— Relations Among Income Tax expense, Taxes Due, and Changes in Deferred Tax Assets and Liabilities 5. Figure 14.6—Overview of Interperiod Tax Allocation CHAPTER 15 PENSIONS AND POSTRETIREMENT BENEFITS CHAPTER OVERVIEW   

     

 

Pension plan contracts allow employees to exchange current service for payments to be received during retirement.

Defined contribution pension plans specify amounts to be invested for the employee during the employee’s career, and the employee’s pension will be based on the value of those investments at retirement.

In the United States, most new pension plans are defined contribution plans.

Consequently, defined contribution pension plans now hold 30% more assets than do defined benefit plans. Still, U.S. defined benefit pension plans hold in excess of $3.4 trillion in assets.

The accounting for defined contribution plans is straightforward. Defined benefit pension plans specify amounts to be received during retirement, thereby complicating the underlying economics of the exchange and the accounting.

Under ASC Topic 715, pension expense for defined benefit pension plans consists of service cost, interest cost, expected return on plan assets, and two other ―smoothing‖ components.

The two smoothing mechanisms avoid year-to-year volatility in pension expense but make pension accounting complex because many pension-related items are presented in AOCI. Employer funding of defined benefit pension plans is influenced by tax law, labor law, union membership, and the employer’s financial needs.

The reporting rules for other postretirement benefits (OPEB) closely parallel the pension accounting rules.

U.S. GAAP requires numerous disclosures regarding retirement expense, changes in plan assets, changes in obligations, amounts reported in AOCI, pension asset investment strategy, and assumptions so that investors can make cash flow projections, assess risk, evaluate assumptions, and evaluate asset management.

Academic research suggests that stock prices reflect pension and OPEB disclosures but their impact may not be fully valued.

Statement readers should view the following circumstances as potential warning signals or indicators of earnings management: o A significant disagreement between any of the various pension and OPEB rates selected by a firm (that is, the discount rate, the expected rate of return on plan assets, or the rate of increase in future compensation levels or health care costs) and the rates chosen by other firms in its industry.

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

The Economic and Institutional Setting for Financial Reporting

o A very large difference between the chosen expected rate of return on plan assets and the discount rate used. o An increase in the year-to-year expected rate of return on plan assets that seems unrelated to changes in market conditions. o A decrease in the assumed rate of increase in future compensation levels (or, for OPEB, future health cost trends) that cannot be explained by changing industry or labor market conditions. o Rate of return assumptions that are inconsistent with prior investment experience or mix of equity and debt investments.

IAS 19 (revised 2011) offers guidance that is markedly different from U.S. GAAP. Among other things, it requires that the discount rate be used to measure both the expected return on assets and the interest cost on PBO to obtain a net financing component. Additionally, actuarial losses (gains) recognized in OCI are not subsequently amortized into pension expense. It also requires new past service cost to be recognized immediately as a component of pension expense.

CHAPTER OUTLINE I. II. III.

IV.

V. VI.

VII.

VIII. IX.

Rights and Obligations in Pension Contracts Accounting Issues Related to Defined Benefit Pension Plans Pension Concepts and Pension Accounting A. A Simple Example: A World of Complete Certainty B. Component 1—Service Cost C. Component 2—Interest Cost D. Component 3—Expected Return on Plan Assets Accounting for Uncertainty and Plan Changes A. The Real World: Uncertainty Introduces Gains and Losses B. Component 4—Amortization of Experience Gains or Losses C. Component 5—Amortization of Prior Service Cost D. Income Statement Presentation Comprehensive Accounting Example U.S. Pension Regulation and Other Determinants of Funding A. Pension Plan Regulation in the United States B. Other Factors Influencing Funding Analyzing Pension Disclosures A. General Electric Company Case Study B. Accumulated Other Comprehensive Income Disclosure and Deferred Income Taxes C. Additional Issues in Computing Expected Return D. Extraction of Additional Analytic Insights from Note Disclosures Postretirement Benefits Other Than Pensions A. Analytical Insights: Assessing OPEB Liability Global Vantage Point A. Evaluation of Pension and Postretirement Benefit Financial Reporting B. Comparison of IFRS and GAAP Retirement Benefit Accounting

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

Teaching Tip: U.S. GAAP pension expense is usually more volatile than it would be under IFRS guidance.

CHAPTER QUIZ 1. A company instituted an IRS-approved plan to contribute monies to a plan that would pay each employee a percentage of his or her highest year of salary for each year of service upon termination of services. This plan is a a. postretirement benefit plan. b. defined contribution pension plan. c. government sponsored pension plan. d. defined benefit pension plan e. 401 (k) plan 2. The components of pension expense are a. service cost, plus interest cost, plus net amortization. b. service cost, plus interest cost, minus return on plan assets, minus net amortization. c. service cost, plus interest cost, plus (or minus) return on plan assets, plus (or minus) net amortization. d. service cost, plus interest cost, minus expected return on plan assets, plus (or minus) net amortization. e. None of the above 3. Which statement below is not correct regarding the Projected Benefit Obligation (PBO)? a. The PBO is based on service to date and future salary levels. b. The PBO represents the present value of the retirement benefits earned to date. c. The PBO is based on current salary level. d. Benefits paid to retirees do not affect the PBO. e. All of the above are correct.

The following information relates to Problems 4 and 5: Baha, Inc. has a defined benefit pension plan for its employees. The plan assets and projected benefit obligation at the beginning of the year were $508,000. The accumulated benefit obligation at the beginning of the year was $456,000. The expected return on plan assets was 7% while the actual return was 8%. The service cost for the year was $120,000. The actuarially assumed discount rate was 6% and amortization of prior service costs was $15,750.

4. The interest cost for the year is a. $27,360 b. $30,480. c. $35,560. d. $40,640.

5. The total pension expense for the year is

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Financial Reporting and Analysis 8e

a. b. c. d. e.

The Economic and Institutional Setting for Financial Reporting

$124,761. $131,451. $136,431. $142,511.

Cannot be determined.

6. Which of the following is not correct regarding prior service costs? a. They can result in either an increase or decrease in the pension benefit obligation. b. They result from retroactive changes to a pension plan. c. Unlike the minimum amortization method for actuarial gains or losses, there is no corridor concept for prior service cost amortization. d. A corridor concept similar to that for actuarial gains and losses is used for prior service cost.

7. Which of the following statements does not properly describe accounting for OPEB plans? a. Losses related to OPEB arise from a decrease in the discount rate assumptions. b. OPEB plans are deemed to be riskier than other debt instruments. c. OPEB plans are mandatorily funded under the same ERISA rules as pension plans. d. Losses related to OPEB arise from an increase in the life expectancy assumptions.

8. Which of the following is not a required disclosure pertaining to defined benefit pension plans? a. The amount of pension expense and its components. b. A reconciliation of the beginning and ending projected benefit obligation balances. c. The funded status of the PBO. d. The contributions to be made into the pension fund for each of the next ten years. e. All of the above are required.

9. The income statement reporting for other postretirement benefits (OPEB) is based on the a. accrual basis of accounting. b. cash basis of accounting. c. cash or accrual basis of accounting. d. OCBOA e. regulations established by the tax code.

10. Under IFRS, prior service cost is a. included in Other Comprehensive Income. b. expensed over the remaining work life. c. expensed immediately as a component of pension expense. d. expensed over the period covered by a collective bargaining agreement.

QUIZ ANSWERS:

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

1.

D. Defined benefit plans specify the formula that determines the annual benefit amount (lifetime annuity) to be paid out to the employee during retirement rather than the annual amount that will be contributed to the plan.

2. D. Pension expense comprises five separate components (+ indicates increase in expense, and − indicates decrease in expense): 1. Service cost (+).

2. Interest cost (+).

3. Expected return on the market-related value of pension plan assets (−).

4. Amortization of actuarial gains or losses (− or +).

5. Amortization of prior service cost (− or +).

3. C. The PBO calculation is based on service to date and future salaries.

4. B. Interest cost = Beginning PBO  Discount rate $30,480 = $508,000  6.0% 5. D. Service cost $120,000 + Interest cost 30,480 (Beginning PBO $508,000 × 6%) + Prior service cost amortization 15,750 – Expected return on plan assets (35,560) (Beg. plan assets $508,000 × 7%) = Pension expense $130,670 6. D. Unlike the minimum amortization method for actuarial gains or losses, there is no corridor concept for prior service cost amortization.

7. C. In contrast to pension plans, no ERISA rules required that the benefits be funded for OPEB. 8. D. Financial statement readers must be mindful that the future cash outflows associated with defined benefit plans could be much different than the current cash outflows.

9. A. OPEB uses accrual accounting for expense and liability recognition.

10. C. Under IAS 19, past service cost is recognized immediately as part of pension expense. In contrast, GAAP requires firms to recognize new prior service costs as part of OCI and recycles them to pension expense over the shorter of the average remaining work life or the period covered under a collective bargaining agreement.

RECOMMENDED FIGURES AND EXHIBITS 1. Figure 15.1—Pension Plan Entities and Relationships 2. Figure 15.2—Assets By Plan Type 3. Figure 15.3—Pension Discount Rate and Expected Long-Term Rate of Return on Plan Assets 4. Figure 15.5—Computing Component 4 – Amortization of Actuarial Gains or Losses 5. Figure 15.6—Analysis of Balance Sheet Liability and OCI Accounts 6. Figure 15.9—Short-term and Long-term Pension Risk CHAPTER 16 FINANCIAL REPORTING FOR OWNERS’ EQUITY CHAPTER OVERVIEW 

Many aspects of financial reporting for owners’ equity transactions are built on

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Financial Reporting and Analysis 8e



   

   

The Economic and Institutional Setting for Financial Reporting

technical rules and procedures that have evolved over time.

Other aspects of owners’ equity accounting have not changed despite changing economic and legal environments. Still other aspects of owners’ equity accounting involve complicated pronouncements that reflect political compromises.

Stock buybacks don’t produce accounting gains and losses, but they can be used to artificially inflate a company’s reported EPS. Buybacks have grown in popularity. S&P 500 firms bought back almost $806 billion of stock in 2018.

Preferred stock that has a mandatory redemption feature looks a lot like debt, so GAAP now requires it to be classified as debt in most cases.

Some companies can pay dividends in excess of their retained earnings balance, but their ability to do so depends on state law.

GAAP requires companies to record compensation expense based on the fair value of stock-based compensation at the date of grant. Fair value calculations require many assumptions, and the accounting is still controversial. The calculation methods and assumptions are disclosed in the notes to financial statements.

Tax accounting for stock compensation is different than GAAP accounting. These differences in accounting lead to both temporary and permanent differences.

GAAP ignores the option value in traditional convertible debt and can understate interest expense when companies issue traditional convertible debt. IFRS rules do not have this deficiency.

While some rules for owners’ equity accounting may seem arbitrary—and therefore insignificant—these financial statement items have a profound impact on lending agreements, regulation, and the cost of equity capital.

EPS numbers are adjusted for potential dilution from stock options, warrants, and convertible securities.

CHAPTER OUTLINE I.

II. III. IV. V. VI. VII.

VIII.

IX.

Accounting for Transactions With Shareholders A. What Constitutes the ―Firm‖?

B. Accounting for Share Issuances and Repurchases Why Companies Repurchase Their Common Shares Equity-Based Covenants and Preferred Stock Legality of Corporate Dividend Distributions Shareholders’ Equity: Financial Statement Presentation Global Vantage Point-Equity Presentation Accounting for Share-Based Compensation A. Prior Accounting B. Current GAAP Requirements C. Accounting at Date of Exercise D. Epilogue Taxation of Share-Based Compensation A. Incentive Stock Options (ISOs) B. Nonqualified Stock Option Plans C. How Does Tax Accounting Interact with Financial Reporting?

Share-Based Compensation Case Study—The Kroger Co.

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The Economic and Institutional Setting for Financial Reporting

X. XI.

Debt or Equity?

Convertible Debt A. Background B. Financial Reporting Issues C. Analytical Insights D. Convertible Debt That May Be Settled in Cash

XII. XIII.

Global Vantage Point-Convertible Debt Earnings per Share A. Simple Capital Structure B. Complex Capital Structure C. Treasury Stock Method and Stock Compensation D. Analytical Insights E. Is Earnings per Share a Meaningful Number?

Teaching Tip: Employee stock options and nonvested stock are not included in the calculation of basic EPS (even though nonvested shares are legally outstanding).

How employee stock options affect diluted EPS depends on the vesting provision. Awards that are subject to time-related vesting provisions are treated similar to options under the treasury stock method. In this case, nonvested stock options and partially paid subscriptions will be dilutive when the average price of the common stock during the period exceeds the exercise price of the options.

Plans that are subject to performance-based vesting provisions or any additional vesting criteria other than continued service or time-related vesting are treated as contingently issuable shares. Contingently issuable shares should be included in basic EPS as of the date that all necessary conditions have been satisfied.

However, to calculate diluted EPS, once all of the necessary conditions have been satisfied, those shares should be included in the denominator of the diluted EPS calculation as of the beginning of the interim period.

Prior to the end of the contingency period (i.e., before the necessary conditions have been satisfied), the number of contingently liable shares to be included in diluted EPS should be based on the number of shares, if any, that would be issuable under the terms of the arrangement if the end of the reporting period were the end of the contingency period, assuming that the result would be dilutive. These contingently issuable shares should then be included in the denominator of diluted EPS as of the beginning of the period, or as of the inception date of the contingent stock arrangement, if later.

XIV.

Appendix 16A: History of Accounting for Employee Stock Options A. Historical Perspective B. Opposition to the FASB C. The Initial Compromise—SFAS No. 123 D. Stock Options Debate Rekindled

CHAPTER QUIZ

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

1. Cash dividends paid by a corporation a. are an expense of the corporation that declared the dividend. b. reduce the revenues of the corporation that declared the dividend. c. reduce the retained earnings of the corporation that declared the dividend. d. are a loss for the corporation that declared the dividend.

The following information relates to Problems 2–4: The Georgia Corporation was formed on January 2, 2021. The company sold 10,000 shares of $8.00 par value stock for $20.00 per share. On July 1, 2021, Georgia bought back 1,000 shares of stock for $25.00 per share. All of the treasury stock was resold on September 1, 2021 for $32.00 per share.

2. Which one of the following is the entry to record the original sale of the stock? a. DR Cash 200,000 CR Common stock 80,000 CR Paid-in capital in excess of par 120,000 b. DR Cash 200,000 CR Common stock 200,000 c. DR Cash 200,000 CR Retained Earnings 120,000 CR Common stock 80,000 d. DR Common stock 80,000 DR Paid-in capital in excess of par 120,000 CR Cash 200,000 3. Which one of the following is the correct entry to record when Vernon acquires its shares to hold as treasury stock? a. DR Investment 25,000 CR Cash 25,000 b. DR Treasury stock 25,000 CR Cash 25,000 c. DR Common stock 25,000 CR Cash 25,000 d. DR Common stock 8,000 DR Retained earnings 17,000 CR Cash 25,000 4. Which one of the following is the correct entry to record the resale of treasury stock? a. DR Cash 32,000 CR Treasury stock 32,000 b. DR Cash 32,000 CR Treasury stock 25,000 CR Retained earnings 7,000 c. DR Cash 32,000 CR Treasury stock 25,000 CR Additional paid-in capital- treasury stock 7,000 1-75 Copyright © 2021 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill.

Financial Reporting and Analysis 8e

d. DR

The Economic and Institutional Setting for Financial Reporting

Cash 32,000 CR Common stock CR Paid-in capital in excess of par

8,000 24,000

5. Sendee Company’s retained earnings on December 31, 2020 was $2,150,000 and its shareholders’ equity was $9,275,000. During 2022, the company reported the following:     

Net income $250,000 A sale of treasury stock costing $65,000 for $69,750 A treasury stock purchase costing $137,500 A cash dividend declaration of $75,000 A ―small‖ common stock (5,000 shares of $1 par value) dividend was declared and distributed when the market value was $8.75 per share.

What is the retained earnings balance on December 31, 2022? a. $2,213,500 b.$2,281,250 c. $2,351,000 d.$2,400,000 6. Abner Industries has the following shareholders’ equity accounts at December 31, 2021: Preferred stock, $100 par value, 10% dividend, 40,000 shares issued $4,000,000 and outstanding Common stock, $5 par value, 1 million shares issued and outstanding 5,000,000 Paid-in capital in excess of par 120,000,000 Unrestricted retained earnings 8,500,000 Retained earnings restricted for plant expansion 1,500,000 Assuming that the preferred stock is cumulative, and that there are no dividends in arrears, what is the maximum dividend that may be distributed to common shareholders at December 31, 2021? a. $5,000,000 b. $8,100,000 c. $8,500,000 d. $120,000,000 The following information relates to Problems 7 and 8: The Hefty Corporation reported net income for 2021 of $175,000. Hefty began the year with 100,000 shares of $10 par value common shares outstanding and 2,500 shares of $100 par value 8% preferred shares outstanding. On June 1, Hefty sold 20,000 shares of common stock for $6 per share. Hefty paid dividends to the common shareholders in December.

7. The basic earnings per share for 2021 is (rounded) a. $1.29 per share.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

b. $1.41 per share. c. $1.45 per share. d. $1.75 per share.

8. If each share of preferred stock is convertible into 5 shares of common stock, the diluted earnings per share for 2021 is (rounded) a. $1.41 per share. b. $1.43 per share. c. $1.59 per share. d. $1.61 per share.

9. On January 1, 2021, Wobble Company adopted a compensatory stock option plan and granted its managers 10,000 options to buy shares of common stock; each option can be used to acquire a share of common stock at a price of $20 a share. The fair value of each option was $5.00 on January 1, 2021. The options can be converted into common stock after July 1, 2021. The required service period is four years. How much compensation expense will be recorded for the year ending December 31, 2023 using the fair value approach to accounting for stock options? a. $0 b. $12,500 c. $50,000 d. $200,000 10. A bond with a carrying value of $750,000 was converted into 100,000 shares of $5 per share par value common stock at a time when the market value per share was $9.00 per share. Which of the following statements does not accurately describe the financial accounting for the conversion? a. Total owners’ equity increases $900,000 if the market value method of recording the conversion is used. b. A loss of $150,000 will be recognized if the market value method of recording the conversion is used. c. Total owners’ equity increases $750,000 if the market value method of recording the conversion is used. d. Total owners’ equity increases $750,000 if the book value method of recording the conversion is used.

QUIZ ANSWERS: 1. C. Dividends are a distribution of earnings to owners, not an expense of the company.

2. A. For Georgia, the $8 par value per share bears no necessary relationship to the market value of each share at issuance ($20). The difference between the $20 issue price and the $8 par value of $12 is credited to the separate owners’ equity account Paid-in capital in excess of par (Additional Paid-in capital) account. Cash of 200,000 is received from the issuance and is thus debited.

3. B. When Georgia reacquires 1,000 of these shares at a cost of $25 each, the repurchased shares are called treasury stock. When treasury stock is acquired, it is

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The Economic and Institutional Setting for Financial Reporting

treated as a reduction in owners’ equity (debited at cost to acquire). Treasury stock is debited, and it appears on the balance sheet as a contra-equity account 4. C. The $32 per share selling price is $7 per share higher than the $25 paid to reacquire the shares. No gain is recognized because the transaction is between the firm and its owners. Instead, the difference of $7,000 (or 1,000 shares × [$32 − $25]) is added to a new account called Paid-in capital from treasury stock.

5. B. Net income increases retained earnings; treasury stock transactions do not affect retained earnings. Cash dividends and small stock dividends reduce retained earnings.

2,150,000+250,000 75,000 −43,750 (5,000*8.75) = $2,281,250 6. B. Unrestricted retained earnings $8,500,000 Less Preferred dividend 400,000 ($4,000,000×10%) Available to CS $8,100,000 7. C. Basic EPS = (Net income – Preferred dividends) ÷ Weighted average common shares outstanding Basic EPS = (175,000 – 20,000*) ÷ 110,000** *(.08  $100  2,500) ** Weighted average shares outstanding: 100,000  6/12 = 50,000 110,000  6/12 = 60,000 Total 110,000 8. B. Diluted EPS = (Net income – Preferred dividends after dilution) ÷ Weighted average common shares outstanding after dilution Diluted EPS = (175,000 – 0*) ÷ 122,500** * No preferred dividends assuming preferred stock has been converted **110,000 + 12,500 (2,500 preferred can be converted into 5 shares) 9. B. 10,000 * 5.00 * ¼ = 12,500 10. C. DR Bonds Payable DR Loss On Debt Conversion CR Common Stock CR Paid-in capital in excess of par

750,000 150,000 500,000 400,000

RECOMMENDED FIGURE 1. Figure 16.1—The Dollar Value of Stock Repurchased Each Quarter 2014 – 2018 by U.S. Companies in The Standard & Poor’s 500 Index

CHAPTER 17 INTERCORPORATE INVESTMENTS

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

CHAPTER OVERVIEW 



 

 

  



The accounting for investments in debt securities depends on the security’s classification. Held-to-maturity securities are reported at amortized cost. Trading securities are reported at fair value with gains and losses reported in the income statement. Available-for-sale securities are reported at fair value with gains and losses reported in other comprehensive income.

Financial reporting for intercorporate equity investments depends on the degree to which the investor is able to influence the investee’s operating decisions. Proportionate share size is a presumptive factor in assessing an investor’s influence over an investee.

Minority-passive equity investments are reported at fair value with unrealized gains and losses reported in the income statement.

For minority active investments, the equity method is used, whereby the investor records its proportionate share of the investee’s profits and losses, net of any excess cost amortization. However, using the fair value option, firms may instead elect to report these investments at fair value.

When one entity controls another, consolidation is required.

Currently, acquisitions are accounted for under the acquisition method, but two other methods—pooling of interests and the purchase method— were permitted previously. Acquisitions are not restated, so transactions previously recorded as poolings or purchases continue to be reported on that basis.

Goodwill is typically recorded in business combinations other than those that were treated as poolings of interest. Goodwill is subject to an annual impairment test.

Under current accounting for mergers and acquisitions, income of an acquired company is included in the parent’s income statement from date of acquisition, which greatly complicates trend analysis.

Certain entities must be a consolidated entity even if they are not majority owned. When a company is the primary beneficiary of an entity that does not have equity investors with voting rights or whose equity investors do not provide sufficient financial resources to the entity’s activities, it must consolidate the entity, which is called a variable interest entity, or VIE. There are a number of important differences between IFRS and U.S. GAAP: measurement and reporting of financial assets, how noncontrolling interests are measured in consolidated statements, and when VIEs (called SPEs under IFRS) must be consolidated.

CHAPTER OUTLINE I.

II. III.

Accounting for Investments in Debt Securities A. Held-to-Maturity Securities B. Available-for-Sale Securities C. Trading Securities D. Recording Credit Losses Types of Equity Investments Minority Passive Investments: Fair Value Accounting A. Income Tax Effects

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Financial Reporting and Analysis 8e

IV.

V.

VI. VII.

VIII. IX. X.

The Economic and Institutional Setting for Financial Reporting

B. Investment Losses and Earnings Volatility at Berkshire Hathaway Minority Active Investments: Equity Method A. When Cost and Book Value Differ B. Fair Value Option for Equity Method Investments Teaching Tip: A major consideration in the use of equity method or fair value is the amount of control that the investor has over the investee. However, many activist investors who hold less than 10% of a corporation’s stock, but may have the ability to significantly influence its operations. See recent examples of activist shareholders pushing for significant corporate changes at Apple and Target.

C. Impairment of Equity Method Investments Controlling (Majority) Interest: Acquisition Method and Consolidation A. Acquisition of 100% of Subsidiary B. Acquisition with Noncontrolling Interests (Less Than 100% Acquisition) C. Consolidation after the Date of Acquisition D. Return on Equity Calculations with Noncontrolling Interest E. Additional Consolidation Issues Joint Venture as Off-Balance Sheet Financing Vehicle Previous Approaches to Consolidated Statements A. Poolings of Interests and Purchases B. Goodwill C. Presentation of Noncontrolling Interests Financial Analysis Issues—Acquisition Method and Purchase Method Financial Analysis Issues—Acquisition Method vs. Pooling of Interests Global Vantage Point A. Accounting for Financial Assets (Marketable Securities and Investments) B. Consolidated Financial Statements and Accounting for Business Combinations C. Accounting for Special Purpose Entities (SPEs) or Variable Interest Entities (VIEs)

Teaching Tip: Enron, among other companies, exploited the rules of consolidation to form special purpose entities (SPEs), which allowed it to leave significant amounts of debt off its balance sheet. In response to concern about this practice, FASB issued Financial Interpretation No. 46 (FIN 46) in January 2003 and a revised version in December 2003 (FIN 46R) to help companies decide whether to consolidate VIEs into their financial statements, even if the companies do not own a majority of the stock. Such rules may have allowed investors and regulators to foresee problems at Enron sooner.

CHAPTER QUIZ 1. Investments in debt securities that the investor intends to hold for a short time and that are purchased in an attempt to profit from near-term price changes are classified as a. available-for-sale securities. b. trading securities. c. fair value securities. d. amortized cost securities.

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The Economic and Institutional Setting for Financial Reporting

2. Peter Investments bought 10% (2,000 shares) of Parker, Inc. common stock on January 1, for $20,000 and 10 % (2,000 shares) of Spider, Inc. common stock on July 1, for $24,000. At the end of the year, the fair value of the Parker stock was $18,000 and the fair value of the Spider stock was $28,000. The stocks were classified as trading securities. Peter should record the following year-end adjustment a. DR Fair value adjustment—Trading securities 2,000 CR Unrealized holding gain on Trading securities—Income 2,000 b. DR Unrealized holding gain on trading securities—Income CR Fair value adjustment —Trading securities

2,000 2,000

c. DR Fair value adjustment—Trading securities CR Unrealized holding loss on Trading securities—Income

2,000

d.

2,000

DR Fair value adjustment—Trading securities CR Realized gain on Trading securities

2,000

2,000

3. Of the following items, which would not be a circumstance that may trigger goodwill impairment? a. Loss of key personnel b. Unanticipated competition c. Adverse action imposed by a regulator d. Recognition of an inventory loss in the financial statements of the parent e. All of the above may trigger an impairment.

4. Beginning after December 31, 2019, investments in debt securities are subject to what treatment when the expectation is that not all principal and/or interest will be received? a. An other-than-temporary impairment is recorded for the difference between the present value of expected cash flows and amortized cost of the investment. b. A loss accrual is required for the difference between the present value of expected cash flows and the amortized cost of the investment. c. An unrealized holding loss is required for the difference between the present value of expected cash flows and the amortized cost of the investment. d. Any of the above treatments is acceptable after December 31, 2019.

5. When the investor has the ability to exert influence over an investee, generally when ownership percentage of stock exceeds 20 percent but is less than 50 percent, the investor should account for the investment by a. fair value method b. equity method. c. consolidation

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The Economic and Institutional Setting for Financial Reporting

d. lower of cost or market The following information relates to Problems 6 and 7: On January 1, Big Company purchased 30% of the outstanding common shares of the Little Company for $60,000 when the net assets were valued at $200,000. During the year, Little Company earned $80,000 and declared a dividend of $40,000. Big accounted for the investment using the equity method. The market value of Little’s stock at the end of the year was $500,000.

6. For 2018, with respect to this investment, Big would report income of a. $12,000 b. $24,000 c. $40,000 d. $80,000 7. What is the balance in the investment account as of the end of the year? a. $60,000 b. $72,000 c. $96,000 d. $150,000 8. If the parent company owns more than 50% of the subsidiary’s voting stock, and effectively has control of the subsidiary, the SEC requires a. Note disclosure. b. Consolidated financial statements. c. The investment to be recorded at fair value. d. The investment to be recognized as an equity investment.

9. On January 1, 2021, the Padre Corporation acquired 90% of Sol Company’s voting stock for $3,150,000. Sol’s net assets had a book value of $3,450,000; the fair value of Sols’s building was $5,000 greater than its book value. The book value of Padre’s net assets immediately after the acquisition of Spartan totaled $6,850,000.

What is the amount of goodwill to be reported on the January 1, 2021 consolidated balance sheet? a. $45,000 b.$5,000 c. $300,000 d.$245,000 10. Which of the following is not a legitimate use of a variable interest entity (VIE)? a. To set up take-or- pay contracts b. To increase EPS c. To securitize loans or mortgages d. To sell receivables QUIZ ANSWERS:

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

1. B. Any investments that the investor intends to hold for a short time and that are purchased in an attempt to profit from trading gains are classified as trading securities.

2. D. Fair value increases (decreases) of trading securities are debited (credited) to a Fair value adjustment account that is added to (subtracted from) the Trading securities asset account so that the amount reported in the balance sheet is the security’s fair value. The offsetting credit (debit) is made to the gain (loss) on trading securities account in the income statement.

3. E. The qualitative assessment for goodwill impairment must consider macroeconomic conditions such as a deterioration in general economic conditions, limitations on accessing capital, fluctuations in foreign exchange rates, or other developments in equity and credit markets; industry and market considerations such as a deterioration in the environment in which an entity operates, an increased competitive environment, a decline in market-dependent multiples or metrics (consider in both absolute terms and relative to peers); a change in the market for an entity’s products or services, or a regulatory or political development; cost factors such as increases in raw materials, labor, or other costs that have a negative effect on earnings and cash flows; overall financial performance such as negative or declining cash flows or a decline in actual or planned revenue or earnings compared with actual and projected results of relevant prior periods; other relevant entity-specific events such as changes in management, key personnel, strategy, or customers; contemplation of bankruptcy; or litigation ; events affecting a reporting unit such as a change in the composition or carrying amount of its net assets, a more-likely-than-not expectation of selling or disposing of all, or a portion, of a reporting unit; the testing for recoverability of a significant asset group within a reporting unit; or recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of a reporting unit. If applicable, a sustained decrease in share price (consider in both absolute terms and relative to peers).

4. B. Effective for fiscal years beginning after December 31, 2019, investments in debt securities are subject to the Current Expected Credit Loss (CECL) rules. These rules require firms to accrue a loss currently when there is the expectation that not all of the promised principal or interest payments will be received.

5. B. When an investor has the ability to exert significant influence over an investee’s decisions, the investor has an active investment. Under GAAP, there is a presumption that an investor holding 20% or more of an investee’s voting shares has an active investment. Such minority active investments are accounted for using the equity method.

6. B. $80,000 (net income) * 30% = $24,000 7. B. Beginning balance = 60,000 + 24,000 net income – 12,000 dividend = 72,000 8. B. Controlling financial interest is generally deemed to occur when one entity, directly or indirectly, owns more than 50 percent of the outstanding voting shares of another entity, called a subsidiary. The subsidiary’s financial statements are combined—line by line—with those of the parent using a process called consolidation.

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9. D. $45,000 = $3,500,000 ($3,150,000/0.90) − $3,450,000 − $5,000 10. B. VIEs are often formed to engage in what are called structured financing arrangements, which offer a company an opportunity to borrow money based on the value of a specific project or asset rather than on its own credit rating. Major uses of VIEs include synthetic leases, securitizing loans and mortgages, selling receivables, and setting up take-or-pay contracts or throughput arrangements.

RECOMMENDED FIGURES AND EXHIBITS 1. Exhibit 17.1—Financial Reporting Alternatives for Intercorporate Equity Investments 2. Exhibit 17.8—M&A Accounting Rules Over Time 3. Exhibit 17.11—U.S. GAAP vs IFRS CHAPTER 18 ACCOUNTING FOR FOREIGN OPERATIONS AND SEGMENT REPORTING CHAPTER OVERVIEW  The financial statements of foreign subsidiaries are converted into U.S. dollars using one of two methods before they are consolidated into the parent’s financial statements. o If the foreign subsidiary’s functional currency is the local currency, the financial statements are translated using the current rate method. o If the foreign subsidiary’s functional currency is the U.S. dollar, the financial statements are remeasured using the temporal method.  Under the current rate method, all assets and liabilities on the foreign subsidiary’s U.S. dollar balance sheet are constantly revalued to the current exchange rate. The resulting gains and losses are recognized in other comprehensive income.  Under the temporal method, all monetary assets and liabilities on the foreign subsidiary’s U.S. dollar balance sheet are constantly revalued to the current exchange rate. The resulting gains and losses are recognized in the income statement.  Under both methods, revenue growth rates in the U.S. dollar financial statements reflect both the growth in the local currency revenue amounts and the change in the exchange rate.  Under the current rate method, the operating margins in the local currency income statement are generally preserved in the U.S. dollar income statement.  Under the temporal method, the operating margins in the local currency income statement are generally not preserved in the U.S. dollar income statement. o When the exchange rate is rising (i.e., the foreign currency is increasing in value relative to the U.S. dollar), the U.S. dollar margin percentage will be greater than the margin based on the local currency financial statements. o When the exchange rate is falling (i.e., the foreign currency is decreasing in value relative to the U.S. dollar), the U.S. dollar margin percentage will

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  

The Economic and Institutional Setting for Financial Reporting

be less than the margin based on the local currency financial statements.

U.S. GAAP and IFRS require segment disclosures, which provide disaggregated data about an entity’s reportable segments.

The rules for determining reportable segments follow the management approach and are designed to aggregate only sufficiently similar operating units.

Segment disclosures allow analysts to obtain a more detailed picture of an entity’s operations, which often leads to a more thorough understanding of the firm and better forecasts of its future performance.

CHAPTER OUTLINE I.

II.

III.

IV.

Accounting for Foreign Subsidiaries A. Functional Currency B. General Concepts C. Current Rate Method D. Temporal Method E. Foreign Subsidiaries and Financial Statement Analysis F. Foreign Currency Transactions Global Vantage Point A. Determining the Functional Currency B. Hyperinflation Segment Reporting A. Definition of a Reportable Segment B. Required Disclosures C. Case Study: Harley-Davidson, Inc. Global Vantage Point

CHAPTER QUIZ 1. Which of the following accounting method applies to consolidation of foreign subsidiaries that are freestanding units with self-contained foreign operations? a. Remeasurement using the temporal method. b. Translation using the current rate method. c. Remeasurement using the fair value method. d. Translation using the fair value method.

2. Which of the following is true when exchange rates change under the current rate method? a. The foreign subsidiary’s assets and liabilities are revalued in U.S. dollars, and the gain or loss is recognized in net income. b. The foreign subsidiary’s assets and liabilities are revalued in U.S. dollars,

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The Economic and Institutional Setting for Financial Reporting

and the gain or loss is recognized in other comprehensive income. c. Only the foreign subsidiary’s monetary assets and liabilities are revalued in U.S. dollars, and the gain or loss is recognized in net income. d. Only the foreign subsidiary’s monetary assets and liabilities are revalued in U.S. dollars, and the gain or loss is recognized in other comprehensive income.

3. Under the temporal method, foreign currency nonmonetary assets and liabilities are reflected in the U.S. dollar balance sheet at the a. historical exchange rate from when they were first recognized. b. current rate of exchange on the balance sheet date. c. present value rate of exchange from when they were first recognized. d. temporal rate of exchange on the balance sheet date.

4. When accounting for a non-free-standing foreign subsidiary, translation exchange rates are accounted for using the temporal method which involves reporting cost of goods sold at the a. current rate. b. present value rate. c. rate at time of transaction. d. historical rate.

5. Which of the following is not a threshold for an operating segment to be deemed reportable? a. Revenue equals or exceeds 10% of total revenue from internal and external parties. b. Assets equal or exceed 10% of total segment assets. c. The absolute value of operating profit equals or exceeds 5% of the total segment operating profit for those segments with profits. d. The absolute value of operating profit equals or exceeds 10% of the greater of total segment operating profit (loss) for those segments with profits (losses).

6. Which of the following is not a similar characteristic required for aggregating operating segments under U.S. GAAP? a. Product and service b. Type or class of customer c. Regulatory environment d. Positive net income 7. On January 1, Styles Corporation, a U.S. Company, purchased 100,000 pounds

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

when the exchange rate was $1.25. On January 31, the exchange rate dropped to $1.20. What journal entry, if any, is required? a. DR Foreign exchange loss $5,000 CR Cash-British pound account $5,000 b. DR Unrealized exchange loss $5,000 CR Cash-British pound account $5,000 c. DR Foreign exchange loss $125,000 CR Cash-British pound account $125,000 d. DR Unrealized exchange loss $125,000 CR Cash-British pound account $125,000

8. When a subsidiary that had designated the local currency as the functional currency and later must change that designation due to hyperinflation, which of the following is true? a. Under U.S. GAAP and IFRS, prior period financial statements must be restated. b. Under IFRS prior period financial statements must be restated. c. Under U.S. GAAP, prior period financial statements must be restated. d. Under U.S. GAAP and IFRS, the temporal method is adopted prospectively. e. Under IFRS the temporal method is adopted prospectively.

9. If a subsidiary operates in a hyperinflationary economy, what is considered the functional currency? a. The currency where the subsidiary operates. b. The U.S. dollar. c. Either the currency where the subsidiary operates or the U.S. dollar. d. An average of the currency where the subsidiary operates and the U.S. dollar.

10. Under U.S. GAAP, which of the following is not a required disclosure of data for each reportable segment of a company? a. Revenue from customers outside the company. b. Interest revenue and expense. c. Cost of goods sold. d. Profit or loss.

QUIZ ANSWERS

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1. B. If a foreign subsidiary is essentially a freestanding unit with self-contained foreign operations, consolidation occurs with a translation using the current rate method. Foreign subsidiaries that are a mere extension of the parent company use the temporal method for remeasurement of currency.

2. B. When the functional currency is the local currency, the current rate method is used and ALL assets and liabilities are revalued in U.S. dollars with the resulting gain or loss recognized in other comprehensive income.

3. A. Nonmonetary assets and nonmonetary liabilities are not revalued under the temporal method. They continue to be reflected in the U.S. dollar balance sheet at the historical exchange rate from when they were first recognized, even as exchange rates change.

4. D. Nonmonetary assets are reflected at the historical exchange rate.

5. C. The absolute value of operating profit equals or exceeds 10% of the greater of the total segment operating profit for those segments with profits OR the total segment operating loss for those segments with losses.

6. D. An entity may combine operating segments that have similar economic characteristics and are similar with regard to all of the following: product and service, production process, type or class of customer, product and service distribution methods, and regulatory environment.

7. A. Monetary assets such as cash are continuously revalued to the current exchange rate. Gains and losses on the revaluations are recognized in net income.

8. B. Under U.S. GAAP, the temporal method is adopted prospectively and under IFRS, prior period financial statements must be restated.

9. B. If a subsidiary operates in a hyperinflationary economy, the U.S. dollar is considered the functional currency.

10. C. U.S. GAAP requires companies to explain how they determine their reportable segments and to describe the products or services generating revenue for each reportable segment. In addition, several income statement components are required; however, cost of goods sold is not.

RECOMMENDED FIGURES AND EXHIBITS 1. Exhibit 18.1—Indicators of the Appropriate Functional Currency 2. Exhibit 18.2—Comparison of Current Rate and Temporal Methods 3. Figure 18.2—Timing of Exchange Rates Under Current Rate Method and Temporal Method

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

CHAPTER 19 DERIVATIVES AND HEDGING CHAPTER OVERVIEW  

  









Derivatives are complex, and their fair values can change substantially in a short period of time. Firms may use them for hedging or speculation.

Derivatives, when used properly, allow companies to stabilize their operating cash flows by eliminating specific sources of volatility such as fluctuations in interest rates, exchange rates, and commodity prices.

Common types of derivatives are forwards and futures, swaps, and options.

FASB ASC Topic 815 provides the primary guidance for derivative accounting.

The GAAP rules for derivatives are detailed and complex, but the essential points are simple. Derivative contracts represent balance sheet assets and liabilities that must be marked-to-market at each balance sheet date.

The resulting mark-to-market adjustment-the change in fair value-then flows either to current earnings (for fair value hedges, certain foreign currency hedges, and derivatives held for trading and speculation) or to other comprehensive income (for cash flow hedges and most other foreign currency hedges).

Other aspects of hedge accounting then match gains (or losses) on the derivative with offsetting losses (or gains) on the hedged item. This allows the financial statements to reflect accurately the underlying economics of the hedge.

Before firms can use hedge accounting, they must demonstrate that changes in the derivative value effectively offset changes in the value of the underlying hedged item.

Derivative accounting under IFRS is governed by IFRS 9 and is similar to the accounting under U.S. GAAP.

CHAPTER OUTLINE I.

II.

III. IV.

Common Derivatives and Hedging A. Forward and Futures Contracts B. Swap Contracts C. Option Contracts Financial Reporting for Derivatives A. Stand-Alone Derivatives B. Hedge Accounting Fair Value Hedge Accounting Cash Flow Hedge Accounting A. Cash Flow Hedge for an Existing Asset or Liability

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Financial Reporting and Analysis 8e

V. VI.

VII.

The Economic and Institutional Setting for Financial Reporting

B. Cash Flow Hedge for an Anticipated Transaction Hedge Effectiveness Derivative Case Study—The Boeing Company A. Notional Amounts and Balance Sheet Effects B. OCI and AOCI Effects C. Net Income Effects Global Vantage Points

CHAPTER QUIZ 1. When two parties agree to the sale of some asset or commodity on some specified future date at a price specified today, it is a(n) A. forward contract.

B. options contract.

C. derivative contract.

D. performance contract.

E. swap contract.

2. On December 1, 2021 a company bought a call option costing $100,000 as a speculative investment. The call option gave the company the right to purchase 100,000 bushels of corn for $110 per bushel during April 2022. As of December 31, 2021 the call option had a value of $115,000. The company liquidated the call option on April 15, 2022 in exchange for $165,000. Which of the following accurately describes GAAP accounting for this call option?

A. The realized gain recognized on April 15, 2022 is $65,000.

B. The realized gain applicable to the year ending December 31, 2021 is $15,000.

C. The unrealized gain recognized on April 15, 2021 is $50,000.

D. The call option will be reported on the December 31, 2021 balance sheet at $115,000 and a $15,000 unrealized gain will be reported as a component of income from continuing operations for the year ending December 31, 2021.

3. A hedge of the exposure to changes in the fair value of an existing asset or liability or a firm commitment is a(n) A. fair value hedge.

B. mark-to-market hedge.

C. cash flow hedge.

D. foreign currency exposure hedge.

4. A contract that gives the holder the option to sell an asset at a specified price during a specified time period is a A. forward option.

B. call option.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

C. put option.

D. swap option.

5. A variation of a forward contract that is traded daily in a market with many buyers and sellers and does not have a predetermined settlement is a(n) A. swap contract.

B. futures contract.

C. performance contract.

D. options contract.

Use the following information for questions 6 & 7: On January 1, 2020, Iron Inc. purchases call options allowing the future purchase of 10 million board feet of May lumber. The strike price is $250 per 1,000 board feet, which is also the current spot price. Iron pays $60,000 for the option contract. By January 31, the spot price for lumber is $260 per 1,000 board feet and May call options for 10 million board feet trade for $80,000.

6. Which of the following is the correct journal entry Iron records on January 1?

A. DR Lumber $60,000 CR Cash $60,000 B. DR Derivatives-lumber options $60,000 CR Cash $60,000 C. DR Lumber $250,000 CR Cash $60,000 CR Gain on options $190,000 D. DR Derivatives-lumber options $250,000 CR Cash $60,000 CR Gain on options $190,000 7. Which of the following is the correct journal entry Iron records on January 31?

A. DR Derivatives-lumber options $20,000 CR Gain on options $20,000 B. DR Derivatives-lumber options $20,000 CR Loss on options $20,000 C. DR Lumber $20,000 CR Gain on options $20,000 D. DR Loss on options $20,000 CR Lumber $20,000 8. In order to use hedge accounting, management must do all of the following except A. designate the derivative as a hedging instrument.

B. describe the hedging strategy.

C. get external auditor approval to use hedge accounting.

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The Economic and Institutional Setting for Financial Reporting

D. document its effectiveness in eliminating a specific market risk for a specific hedged item.

9. Which of the following does not qualify for hedge accounting?

A. An existing asset or liability on the company’s books.

B. A firm commitment.

C. A forecasted future transaction.

D. An option to purchase real estate.

10. Which of the following statements does not accurately describe accounting for derivatives?

A. The holding gain resulting from a fair value hedge that qualifies for hedge accounting is recognized in net income along with the offsetting loss on the hedged item.

B. The holding loss resulting from a cash flow hedge that qualifies for hedge accounting is recognized in net income during the year of the loss.

C. Management must be able to describe its hedging strategy in order to meet the GAAP criteria to qualify for hedge accounting.

D. GAAP requires all derivative instruments to be marked-to-market.

QUIZ ANSWERS 11. A. In a forward contract, two parties agree to the sale of some asset on some future date—called the settlement date—at a price specified today.

12. D. Accounting entries for all types of derivatives (forwards, futures, swaps, and options), where the special hedge accounting rules do not apply have 3 main points: 1) Derivative contracts represent balance sheet assets and liabilities. 2) The carrying value of the derivative is adjusted to fair value at each balance sheet date. 3) The amount of the adjustment—the change in fair value—flows to the income statement as a holding gain (or loss).

13. A. A fair value hedge is a hedge of the exposure to changes in the fair value of an existing asset or liability, or a firm commitment.

14. C. A put option gives the holder the option to sell an asset at a specified price during a specified time period.

15. B. A variation of a forward contract is a futures contract. This type of contract is traded daily on a financial exchange with many buyers and sellers.

16. B. The call option derivative contract is recorded at the asset fair value-the purchase price paid on January 1st.

17. A. Changes in the fair value of derivatives must be recognized in income when they occur. The $20,000 increase in the call option value is a gain included as part of

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income from continuing operations.

18. C. Stringent GAAP criteria must be met to qualify for hedge accounting. To fulfill the criteria, management must do three things: designate the derivative as a hedging instrument, describe the hedging strategy, and document its effectiveness in eliminating a specific market risk for a specific hedged item.

19. D. A hedged item can be an existing asset or liability on the company’s books, a firm commitment, or an anticipated future transaction. Insurance contracts, options to purchase real estate, traditional equity and debt securities, and financial guarantee contracts do not qualify as hedging instruments.

20. C. Changes in cash flow hedges are reflected in other comprehensive income and shareholders’ equity.

RECOMMENDED FIGURES AND EXHIBITS 1. Figure 19.4 Financial Reporting for Derivative Instruments CHAPTER 20 STATEMENT OF CASH FLOWS CHAPTER OVERVIEW    







The statement of cash flows provides information for assessing a firm’s ability to generate sufficient cash to pay for operating expenses, capital improvements, and currently maturing obligations.

Firms able to generate consistently strong positive cash flows from operations are considered better credit risks and benefit from a lower cost of capital.

The two alternative methods for presenting the operating activities section of a cash flow statement are the direct and indirect methods.

Most firms use the indirect method. It begins with net income and adjusts for depreciation, amortization, noncash gains and losses, and changes in noncash working capital accounts other than short-term debt, which cause net income to differ from operating cash flows for the period.

You will frequently encounter situations in which the changes in noncash accounts shown on comparative balance sheets will not reconcile with the adjustments shown on the cash flow statement. These discrepancies are due to one or more of the following causes: (1) asset write-offs and impairments, (2) asset retirements and reclassifications to assets held for sale, (3) foreign currency translation adjustments, (4) acquisitions of other companies, and (5) simultaneous noncash financing and investing activities. Failure to understand how these events cause balance sheet account changes to differ from changes in account balances shown on the cash flow statement can lead to incorrect interpretation of both statements.

Operating cash flows can sometimes be distorted or legitimately managed. You should be aware of the ways this can occur and how to adjust reported operating cash flows to enhance the comparability of this important number across firms and over time.

IFRS rules allow firms greater flexibility relative to U.S. GAAP in how interest and dividends received and interest and dividends paid are reported on the

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

statement of cash flows.

CHAPTER OUTLINE I.

Review of Cash Flow Statement Formats and Content A. The Direct Method B. The Indirect Method Teaching Tip: Nearly all corporations prepare the statement of cash flows using the indirect method. One of the main reasons for this is that the indirect method is easier to prepare. For example, when using the direct method companies must also provide a reconciliation of net income to the cash provided by operating activities, which is done automatically under the indirect method.)

II. III.

IV.

V.

VI.

Preparing the Cash Flow Statement Reconciliation Between Statements: Some Complexities A. Asset Write-Offs and Impairments B. Asset Retirements and Reclassifications to Assets Held for Sale C. Foreign Currency Translation Adjustments D. Acquisitions of Other Companies E. Simultaneous Noncash Financing and Investing Activities Other Issues A. Treatment of Distributions from Equity Method Investees B. Debt Prepayments, Extinguishment Costs, and Settlements C. Restricted Cash Analytical Insights: Ways Operating Cash Flows Can Be Distorted or Manipulated A. Changes in Working Capital Accounts B. Accounts Receivable Sale (Securitization) versus Collateralized Borrowing C. Capitalizing versus Expensing D. Software Development Costs E. Finance versus Operating Leases F. Cash Flow Effect of Stock-Based Compensation Global Vantage Point Teaching Tip: IFRS allows for more flexibility in classification of certain cash flow items. What implications, if any, might this have on comparability of the statement of cash flows for international firms?

CHAPTER QUIZ 1. The primary purpose of the statement of cash flows is to provide relevant information about a. differences between net income and associated cash receipts and disbursements. b. an enterprise’s ability to generate future positive net cash flows. c. the cash receipts and cash disbursements of an enterprise during the period.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

d. an enterprise’s ability to meet cash operating needs.

2. Differences between a statement of cash flows prepared using the direct method versus the indirect method occur in which section? a. Operating b. Investing c. Financing d. All of the above 3. In a statement of cash flows, which of the following items is reported as a cash outflow from financing activities?

I. Payments to retire mortgage notes.

II. Interest payments on mortgage notes.

III. Dividend payments. a. b. c. d.

I, II, and III. II and III only.

I only.

I and III only.

4.

How should a gain from the sale of used equipment for cash be reported in the statement of cash flows using the indirect method? a. In investment activities as a reduction of the cash inflow from the sale. b. In investment activities as a cash outflow. c. In operating activities as a deduction from income. d. In operating activities as an addition to income.

5.

Investing activities of a corporation include all of the following except: a. Purchase of land for future plant expansion. b. Depreciation on plant assets during the fiscal period. c. Purchase of a wholly owned subsidiary. d. Sale of a machine used in production.

The following information relates to Problems 6–8: Revolution Tractors has the following activities during 2021: • Reported net income of $13,000.

• Paid cash to purchase land to use as a parking lot for $10,000 • Received dividends of $2,000 on stock investments.

• Paid dividends of $3,000 • Borrowed $7,000 from the bank. .

• Paid interest on the loan in the amount of $500 • Recorded an increase in current assets other than cash of $6,000.

• Recorded a decrease in current liabilities of $5,000.

• Depreciation and amortization expense is equal to $7,000.

6. In Revolution’s 2021 statement of cash flows, cash flow from operations is equal to: a. $8,500. b. $9,000. c. $11,500.

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

d. $21,000.

7. In Revolution’s 2021 statement of cash flows, cash flow from investing activities is an outflow of: a. $4,500. b. $7,500. c. $9,500. d. $10,000.

8. In Revolution’s 2021 statement of cash flows, cash flow from financing activities is an inflow of: a. $4,000. b. $7,000. c. $9,500. d. $14,500.

9. Using the indirect method for a statement of cash flows, cash flow from operations a. can be calculated by adding to or deducting from net income changes in current assets (other than cash) and current liabilities and noncash items on the income statement. b. can be calculated by adding to or deducting from net income changes in current assets (other than cash) and current liabilities and cash items on the income statement. c. is equal to accrual based income. d. is always positive.

10. The accounts receivable at December 31, 2020 for Craig Industries was listed in the financial statement as $250,000 (net). During the year Craig had sales, all on credit of $1,000,000. The net accounts receivable at the end of 2021 was $300,000. What was the amount of cash collected from customers? a. $250,000 b. $950,000 c. $1,000,000 d. $1,050,000 QUIZ ANSWERS: 1. C. The purpose of a cash flow statement is to explain the underlying causes of the change (receipts and disbursements) in the cash balance.

2. A. Cash flow from operating activities may be presented in two ways, called the direct method and the indirect method.

3. D. Financing cash flows result when a company sells its own stock or bonds, pays dividends, buys back its own shares (treasury stock), or issues or repays debt. Interest income and Interest expense are shown as components of cash flows from operating activities because cash flows from operating activities generally reflect the cash effects of transactions entering into the determination of net income.

4. C. Noncash revenues or gains (such as revenues earned but not received in cash and gains on the disposal of fixed assets) are included in accrual net income but did not affect operating cash flow and are therefore subtracted from accrual net income.

5. B. Investing cash flows result from the purchase or sale of productive assets such as

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Financial Reporting and Analysis 8e

The Economic and Institutional Setting for Financial Reporting

plant and equipment, from the purchase or sale of marketable securities (government bonds or stocks and bonds issued by other companies), and from the acquisition of other companies or divestitures. Depreciation is a noncash expense added back to net income in the operating activities section when using the indirect method.

6. B. Net income Deduct: increase in current assets other than cash Deduct decrease in current liabilities Add depreciation and amortization Cash flows from operations

$13,000 (6,000) (5,000) 7,000 $9,000

7. D. 10,000 cash paid for land.

8. A. 7,000 borrowed – 3,000 dividend = 4,000 9. A. The indirect method begins with accrual-basis net income and adjusts for noncash items on the income statement as well as changes in current assets and current liabilities.

10. B. 1,000,000 sales on credit – 50,000 increase in AR = 950,000 RECOMMENDED EXHIBITS 1. Exhibit 20.7—Consolidated Statements of Cash Flows 2. Exhibit 20.9—Amazon.com, Inc., Consolidated Statements of Cash Flows

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