Financial statement analysis 10th edition subramanyam test bank

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Chapter 06 - Analyzing Operating Activities

Chapter 06 Analyzing Operating Activities

Multiple Choice Questions 1. Which of the following is not a reason for economic income and accounting income to differ?

A. Transaction basis B. The monetary assumption C. Conservatism D. Earnings management

2. As a general rule, revenue is normally recognized when it is: A. measurable and earned.

B. measurable and received.

C. realizable and earned.

D. realizable.

3. Which of the following measures of accounting income is typically reported in an income statement?

A. Net income B. Comprehensive income C. Continuing income D. All of the above

4. According to FASB, initial franchise fees should be recognized as income when: A. the franchiser has substantially performed or satisfied all material services and conditions.

B. the franchiser has collected the majority of fee in cash.

C. the franchisee shows the ability to pay the fee.

D. the franchiser bills the franchisee.

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Chapter 06 - Analyzing Operating Activities

Brierton Company enters a contract at the beginning of year 1 to build a new federal courthouse for a price of $16 million. Brierton estimates that total cost of the project will be $12 million, and will take four years to complete.

5. If Brierton used percentage-of-completion method to account for this project, what would they have reported as profit in year 2?

A. $ 0 B. $ 1.333M C. $ 1.5M D. $ 0.667M

6. If Brierton used cash accounting to account for this project, what would they have reported as profit (loss) in year 2?

A. $ 0 B. $ 1.333M C. $ (2M) D. $ (4M)

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Chapter 06 - Analyzing Operating Activities

7. Hurik Company reports the following

Based upon this information which of the following is most correct: A. Cost of goods sold is a permanent cost.

B. Cost of goods sold is an economic cost.

C. Cost of goods sold is a totally variable cost.

D. Cost of goods sold is a period expense.

8. Which of the following combinations of accounting practices will lead to the highest reported earnings in an inflationary environment?

A. Choice A B. Choice B C. Choice C D. Choice D

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Chapter 06 - Analyzing Operating Activities

9. Which of the following are correct?

I. If a company uses straight-line depreciation for financial reporting purposes, it is very likely they have a deferred tax liability with respect to its depreciable assets.

II. Straight line depreciation yields an increasing rate of return on book value over the life of asset.

III. Straight line depreciation results in lower tax payments than accelerated depreciation methods over the life of an asset.

IV. If a company revises its estimate of the useful life of an asset upwards this will decrease annual depreciation expense.

A. I, II, III and IV B. I, II and IV C. I, II and III D. I and IV

10. Which of the following statements concerning deferred taxes is correct?

A. Deferred taxes will not be found in asset section of the balance sheet.

B. Deferred taxes arise from permanent differences in GAAP and tax accounting.

C. Deferred taxes will only decrease when a cash payment is made.

D. Deferred taxes arising from the depreciation of a specific asset will ultimately reduce to zero as the item is depreciated.

11. Differences in taxable income and pretax accounting income that will not be offset by corresponding differences or "turn around" in future periods are called: A. timing differences.

B. circular differences.

C. permanent differences.

D. reverse differences.

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Chapter 06 - Analyzing Operating Activities

The following information was extracted from Smurm Corporation's 2006 annual report:

12. Basic earnings per share for 2006 was: A. $3.50 B. $3.16 C. $3.08 D. $3.00

13. Using the treasury stock method, the options would result in how many extra shares being recognized in the diluted EPS calculation: A. 500,000 B. 358,975 C. 333,333 D. 285,714

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Chapter 06 - Analyzing Operating Activities

14. Diluted earnings per share for 2006 was: A. $3.52 B. $3.07 C. $2.00 D. $2.03

Tecktroniks Company reported in its annual report software refinement expenses of $12M, 15M and 18M for fiscal years 2005, 2006 and 2007, respectively. At the end of fiscal 2007, it had total assets of 140M. Net income was 20M for fiscal 2007, and it had a marginal tax rate of 35%.

15. If software refinement had been capitalized each year and amortized over a three-year period beginning in the year the cost was incurred, total assets at the end of fiscal 2007 would have been: A. $185M B. $172M C. $158M D. $157M

16. If software refinement had been capitalized each year and amortized over a three year period beginning in the year the cost was incurred, net income for fiscal 2007 would have been: A. $31.7M B. $29.75M C. $21.95M D. $14.95M

17. If the software refinement had been capitalized and amortized over a three year period beginning in the year the cost was incurred, but was expensed for tax purposes, the deferred tax position at the end of fiscal 2005 would have been: A. A deferred tax credit of $2.8M B. A deferred tax credit of $3.5M C. A deferred tax credit of $5.2M D. A deferred tax debit of $4M

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Chapter 06 - Analyzing Operating Activities

18. If a company that normally expenses advertising costs was to capitalize and amortize these costs over 3 years instead: A. after the third year net income would always be higher if it is capitalized.

B. after the third year net income would always be lower if it is capitalized.

C. after the third year net income would be higher (if it is capitalized) only if advertising costs were increasing.

D. after the third year net income would be lower (if it is capitalized) only if advertising costs were increasing.

19. Compared with companies that expense costs, firms that capitalize costs can be expected to report: A. higher asset levels and lower equity levels.

B. higher asset levels and higher equity levels.

C. lower asset levels and higher equity levels.

D. lower asset levels and lower equity levels.

20. Two growing firms are identical except that one firm capitalizes whereas the other firm expenses costs for long-lived resources over time. For these two firms, which of the following statements is generally true?

I. The expensing firm will show a more volatile pattern of reported income than capitalizing firm.

II. The expensing firm will show a less volatile pattern of return on assets than the capitalizing firm.

III. The expensing firm will show lower cash flows from operations than the capitalizing firm.

A. I only B. II only C. I and III only D. II and III only

21. The capitalization of interest cost during construction: A. increases future net income.

B. decreases future depreciation expense.

C. increases net income during construction phase.

D. decreases assets during construction phase.

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Chapter 06 - Analyzing Operating Activities

22. Windsor Company has net temporary differences between tax and book accounting of $80 million, resulting in a deferred tax liability of $28 million. An increase in the tax rate would have the following impact on deferred taxes and net income:

A. Choice A B. Choice B C. Choice C D. Choice D

23. Exoil recorded an expense and corresponding liability to recognize potential losses relating to an oil spill in 2006 of $10 million. Its net income for the year was $200 million. It was not able to take a deduction for tax purposes until later years when it actually paid cash out in relation to this event. In 2006, with respect to this, Exoil would have: A. recognized a deferred tax liability.

B. recognized a tax loss carryforward.

C. recognized a deferred tax asset.

D. recognized a deferred equity loss.

24. Which of the following statements are correct?

I. Tax loss carrybacks result in deferred tax assets.

II. Tax loss carryforwards result in deferred tax assets.

III. The tax valuation account is used to adjust deferred tax liabilities if it is "more likely than not" that they will not result in increased future taxes.

A. I only B. II only C. III only D. I and II

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Chapter 06 - Analyzing Operating Activities

25. Which of the following will cause the reported effective tax rate to differ from the federal statutory tax rate?

I. Foreign tax rates that are lower than federal statutory tax rate.

II. Tax-exempt income.

III. Different depreciation methods for tax and financial reporting purposes.

IV. Foreign tax rates that are higher than federal statutory tax rate.

A. I, II, and IV B. I, II and III C. I and II D. III only

26. If a company changes the useful life of its assets from 10 years to 12 years, this will be recorded as: A. a non-recurring gain.

B. an extraordinary item.

C. a change in accounting principle.

D. None of the above

27. If a company estimates that its expected return on pension plan assets will increase to 9.5% from 9.0%, this would be considered: A. an extraordinary gain.

B. a change in accounting principle.

C. a prior period adjustment.

D. a change in accounting estimate.

28. A company changes its depreciation method from an accelerated system to straight line.

Which of the following would normally be true?

I. The change would be discussed in the auditor's letter.

II. The cumulative effect of the change would appear net of tax on the income statement.

III. The change would appear in cash flow from operations as a cash inflow.

IV. The change would be mentioned in the footnotes.

A. I, II, III and IV B. I, II and III C. II and IV D. I, II and IV

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Chapter 06 - Analyzing Operating Activities

29. Which of the following is true with respect to extraordinary items?

I. Extraordinary items are recorded net of tax in income statement.

II. Extraordinary items, by definition, are probable and unusual in nature.

III. By definition, gains and losses from strikes are always extraordinary.

IV. By definition, gains and losses from sale of plant, property and equipment are never extraordinary.

A. I and IV B. I, III and IV C. II and IV D. I, II and III

30. Which of the following would be considered an extraordinary item?

I. Write-down of receivables II. Gains on disposal of a business segment III. Loss of inventory resulting from a fire IV. Loss resulting from a strike A. I and IV B. I, III and IV C. III only D. I, II and III

31. Which of the following items is not included in the calculation of net income but is included in the calculation of comprehensive income?

A. Unrealized holding gain on available-for-sale marketable securities.

B. Unrealized holding gain on trading marketable securities.

C. Gain from early extinguishments of bonds.

D. Gain arising from sale of available-for-sale marketable securities.

32. Which of the following statements is true? Under GAAP, comprehensive income: A. may be reported in addition to net income.

B. must be reported in addition to net income.

C. may be reported instead of net income.

D. must be reported instead of net income.

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Chapter 06 - Analyzing Operating Activities

33. Which of the following statements is incorrect? Employee stock options A. are not recorded as an expense when granted if they are at or out-of-the money under the intrinsic value method.

B. will not affect the share price of the company when exercised.

C. may reduce agency costs by more closely aligning interests of stockholders and managers.

D. may increase the risk propensity of managers.

A company's net income is $100,000, and its weighted-average shares outstanding are 20,000. During the year, the company issues 5,000 ESOs at an exercise price of $20.

34. What will be the basic EPS if average stock price during the year is $35 and treasury shares that can be purchased are 1000?

A. $3 B. $6 C. $5 D. $4.17

35. What will be the basic EPS if average stock price during the year is $15 and treasury shares that can be purchased are 6000?

A. $3 B. $6 C. $5 D. $4.17

36. What will be the diluted EPS if average stock price during the year is $15 and treasury shares that can be purchased are 6000?

A. $3 B. $5 C. $6 D. $4.17

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Chapter 06 - Analyzing Operating Activities

37. What will be the diluted EPS if average stock price during the year is $35 and treasury shares that can be purchased are 1000?

A. $3 B. $5 C. $6 D. $4.17

38. Which of the following is not an extraordinary item?

I. Loss on abandonment of property II. Gain on disposal of a business segment III. Effect of a strike against a key supplier IV. Write-down of deferred research and development costs A. I and III B. II and IV C. I, II and III D. I, II, III and IV

39. Which of the following overall accounting concepts has a number of exceptions under GAAP? A. Historical cost B. Transaction basis C. Conservatism D. Accrual accounting

40. When comparing expensing or capitalizing (with straight-line depreciation) software, return on assets A. will decrease over time using capitalization.

B. will increase over time using capitalization.

C. will be constant using expensing.

D. will initially be higher under expensing.

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Chapter 06 - Analyzing Operating Activities

41. The intrinsic value approach ignores two types of costs: A. Interest cost and opportunity cost B. Opportunity cost and exercise cost C. Interest cost and option cost D. Carrying cost and interest cost

True / False Questions 42. Economic income and accounting income are always the same.

FALSE

43. The matching principle in accounting prescribes that costs must be recognized in the same period when the related revenues are recognized.

TRUE

44. Revenue from sales where the buyer has the right of return can only be recognized after the return period has expired.

FALSE

45. If two firms are identical except that one firm uses percentage-of-completion accounting and the other uses completed contract accounting for revenue recognition, the cash flows of the firms will be identical.

TRUE

46. Generally revenue should be recorded when it is probable and reasonably estimable.

FALSE

47. Revenues are earned inflows that arise from the company's ongoing business activities.

TRUE

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Chapter 06 - Analyzing Operating Activities

48. Gains are earned inflows that arise from the company's ongoing business activities.

FALSE

49. Comprehensive income is computed by adjusting net income for dirty surplus items.

TRUE

50. For item to be considered extraordinary, it should be either unusual in nature or infrequent in occurrence.

FALSE

51. For item to be considered a special item, it should be either unusual in nature or infrequent in occurrence but not both.

TRUE

52. Accounting changes are usually cosmetic and do not yield cash flow consequences.

TRUE

53. A long term asset is said to be impaired when its fair value is below its book value.

TRUE

54. Under current accounting standards, gains and losses relating to the extinguishment of debt must be both unusual and infrequent to be classified as an extraordinary item, and debt refinancing does not typically meet these criteria.

TRUE

55. One difference between revenues and gains is that gains arise from transactions that are incidental to the operations of the business.

TRUE

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Chapter 06 - Analyzing Operating Activities

56. Smythe Corporation is in the real estate development business. If they sell a piece of land for $50,000 that they had previously purchased for $45,000, they should record a loss of $5,000.

FALSE

57. For companies in an expansion phase, capitalizing interest may result in higher earnings over an extended period of time as the amount of interest amortization will not catch up with the amount of interest capitalized in the current period.

TRUE

58. The capitalization of interest costs during construction increases future net income.

FALSE

59. Software costs may be capitalized once a company can show that the product is technologically feasible.

TRUE

60. A company that capitalizes costs, rather than expensing them will have a higher asset turnover.

FALSE

61. If revenue is recognized for financial reporting purposes but deferred for tax purposes this results in a deferred tax liability.

TRUE

62. If an expense is recognized for financial reporting purposes but not allowed as a bona-fide deduction for tax purposes, this results in a deferred tax asset.

FALSE

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Chapter 06 - Analyzing Operating Activities

63. Extraordinary items are defined as those that are both unusual in nature and infrequent in occurrence. These items are disclosed, net of tax in the income statement.

TRUE

64. Accounting errors are considered accounting changes and treated accordingly.

FALSE

65. When a company disposes of a segment of its business, it must restate all prior year financial statements as if it had never owned that segment of the business.

FALSE

66. A company that capitalizes rather than expenses software development costs, will have a less volatile net income, all other things equal.

TRUE

67. Comprehensive income differs from net income in that it reflects certain unrealized holding gains and losses foreign currency translation adjustments, and minimum pension liability adjustments.

TRUE

68. If a company, operating in an inflationary environment, uses FIFO for tax purposes and weighted-average for financial reporting purposes, this will result in a deferred tax asset.

TRUE

69. Deferred taxes arise due to temporary timing differences in recognizing items for tax and financial reporting purposes.

TRUE

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Chapter 06 - Analyzing Operating Activities

70. If a company depreciates an asset at a faster rate for tax purposes than for financial reporting purposes this will give rise to a deferred tax liability.

TRUE

71. A deferred tax liability imposes an obligation on the business to pay taxes.

FALSE

72. Some items appear on a company's income statement but never appear on its tax return.

TRUE

73. In order to determine permanent income for the year being analyzed, it is necessary to consider special charges from other years.

TRUE

74. Timing is one of the few revenue recognition issues that are seldom a concern in financial analysis.

FALSE

75. R&D expenses for tangible assets that have alternative future uses qualify as deferred charges.

TRUE

76. Employee stock options (ESOs) usually constitute a wealth transfer from current shareholders to prospective shareholders (employees) and have no effect on total liabilities and shareholders' equity.

TRUE

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Chapter 06 - Analyzing Operating Activities

77. Under long-term performance contracts—such as product warranty contracts and software maintenance contracts—revenues are often collected in advance and are recognized proportionally over the entire period of the contract.

TRUE

78. ESOs often are granted to managers in growth and innovative industries to induce more risk-taking.

TRUE

Essay Questions

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Chapter 06 - Analyzing Operating Activities

79. Problem One: Revenue Recognition from Long-Term Contract Housing Construction Company (HCC) has agreed to build a housing project for the city of New York. On January 1st, 2006 the company and the city agreed on the following terms, the construction should take no more than 3 years, HCC would be paid a total of $150 million for the project; the $150 million would be paid: 3 payments of $50 million each at the end of year 2006, 2007 and 2008. HCC expects contractions costs to be $50 million in year 2006, $50 million in year 2007, and $10 million in year 2008. a. If HCC uses the completed contract method, what revenues and expenses would HCC recognize in year 2006, 2007, and 2008? b. If HCC uses the percentage of completion method, what revenues and expenses would HCC recognize in year 2006, 2007, and 2008? c. Show the balance on the construction-in-process account at the end of 2006, 2007, and 2008 (prior to the completion of the project) using both the completed contract and the percentage of completion methods?

Problem One: Revenue Recognition from Long-Term Contract a. Year 1 and Year 2: no revenues and expenses for the observatory project.

Year 3: $150M – $110M = $40M. b. Year Revenue Expense Income 2006 (45.45%) x $150M =$68.18M $50M (45.45%) $ 18.18M 2007 (45.45%) x $150M =$68.18M $50M (45.45%) $ 18.18M 2008 ( 9.10%) x $150M =$13.64M $10M ( 9.10%) $ 3.64M $150M $110M $ 40M c. Year Completed Contract Method Percentage of Completion Method 1 $50M $68.18M 2 $50M + $50M = $100M $68.18M + 68.18M = $136.36M 3 100M + $50M = $150M $136.36M + $13.64M = $150M

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Chapter 06 - Analyzing Operating Activities

80. Problem Two: Earnings per Share The following information was obtained from Cyber Corporation's annual report.

a. Compute weighted-average number of common shares outstanding for the year. b. Compute basic EPS. c. Compute diluted EPS.

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Chapter 06 - Analyzing Operating Activities

Problem Two: Earnings per Share a. Compute weighted-average number of common shares outstanding for the year.

Weighted average: 8,400,000 ¸ 12 = 700,000 shares Compute basic EPS.

Basic Earnings per Share

Compute diluted EPS. Preferred Shares—if converted

Options: Assumed exercised

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Chapter 06 - Analyzing Operating Activities

Diluted Earnings per Share

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Chapter 06 - Analyzing Operating Activities

81. Problem Three: Goodwill/Cash flows The table below shows the differences in accounting treatments for goodwill in three selected countries.

*Goodwill is tax deductible in the United States under limited circumstances, for the purposes of this question, assume it is not.

Given a company that has recognized significant acquisition goodwill, identify the country whose accounting and tax rules for goodwill would likely result in the highest valuation of the company. Justify and explain your answer.

Problem Three: Goodwill/Cash flows The company should have the highest valuation in Canada as the resulting cash flows will be higher than the cash flows if the company was domiciled in Great Britain or the U.S. due to the tax deductibility of the goodwill. This is a real economic gain.

Net income will be higher in Great Britain and the U.S. as no amortization of goodwill will depress earnings on the Income Statement. However, the underlying cash flows will not be any higher as goodwill is not tax deductible. Therefore, the value should not be higher for a company domiciled in Great Britain or the U.S. (CFA Adapted)

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Chapter 06 - Analyzing Operating Activities

82. Problem Four: Taxes Below are selected portions from Quaker Oats' tax footnote in its X6 annual report.

Provisions for income taxes on income before cumulative effect of accounting change were as follows:

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Chapter 06 - Analyzing Operating Activities

Required: 1a. What was the effective tax rate on all income for fiscal X6?

1b. What was the effective tax rate on foreign income for fiscal X6?

2a. How much did Quaker Oats record in deferred taxes for fiscal X6? Was this an asset or liability?

2b. What was the major item contributing to the deferred tax for X6? Explain fully how this arose.

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Chapter 06 - Analyzing Operating Activities

Problem Four: Taxes 1a.

Provision for income taxes = $167.7 Total pretax income = $415.6 Effective tax rate = $167.7/$415.6 = 40.4% 1b.

Foreign Income = $52.8 (in footnote) Tax expense related to foreign income = $10.2 + $10.4 (current plus deferred) = 20.6 Effective tax rate = 20.6/52.8 = 39% 2a.

They recorded a $31.5 deferred tax liability. The taxes currently payable are lower than the income tax expense. Note that does not equal the change in the net liability balance given in the table - this is due in part to the fact that some deferred taxes are associated directly with associated assets and liabilities and due to changes in valuation account.

2b.

The major item contributing to the deferred tax liability is "accrued expenses including restructuring charge" of $40.6 - this is a deferred tax liability for X6. Further examination shows that this item is a deferred tax asset as of the end of X6, which has decreased from its prior year level. Therefore, we can infer that in prior years Quaker Oats recorded expenses on financial statements but did not take tax deduction that resulted in a deferred tax asset. This year, they paid cash out relating to these items, which allowed them to finally take a deduction on their tax returns. Thus for the year, they had a decrease in the deferred tax asset which shows up as a deferred tax liability in the reconciliation.

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Chapter 06 - Analyzing Operating Activities

83. Problem Five: Deferred taxes Many companies have significant deferred taxes. Deferred taxes are not always long-term liabilities. For the categories below, state whether deferred taxes can arise in this category and provide an example. i. Current Liabilities ii. Long-term liabilities iii. Stockholders' Equity iv. Current Assets v. Long-term assets Problem Five: Deferred taxes i. Current Liabilities Could arise from recognizing all income from installment sale for financial reporting purposes, and on cash basis for tax purposes. ii. Long-term liabilities Different depreciation methods for tax and financial reporting purposes give rise to deferred taxes. Typically assets are depreciated faster for tax purposes giving rise to a deferred tax liability. iii. Stockholders' Equity Deferred taxes are recorded to offset the valuation account for marketable securities. iv. Current Assets Warrantees, accrued compensation etc. where payment in cash is expected during next year will give rise to current deferred tax assets. v. Long-term assets Post-retirement health benefits and contingent liabilities not expected to be paid in cash within the next year will give rise to long-term deferred tax assets.

(CFA Adapted)

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Chapter 06 - Analyzing Operating Activities

84. Problem Six: Expensing versus Capitalizing Companies can capitalize software development costs when the product is "technologically feasible". Some companies never capitalize their software costs – for example, Microsoft.

Viderics, a software development company capitalizes those software costs allowed under GAAP. The following information is taken from its financial statements.

a. If Viderics had not capitalized its software costs but expensed them instead what would they have reported as software expense each year, assuming unamortized balance of software costs was $35 in year X0? b. What is the likely effect upon net income variability of expensing rather than capitalizing software development costs? c. How might income be manipulated under either of these two methods (expensing and capitalizing)?

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Chapter 06 - Analyzing Operating Activities

Problem Six: Expensing versus Capitalizing a. If Viderics had not capitalized its software costs but expensed them instead what would they have reported as software expense each year, assuming unamortized balance of software costs was $35 in year X0?

b. What is the likely effect upon net income variability of expensing rather than capitalizing software development costs?

Net income will normally have greater variability under the expensing method. Capitalizing and amortizing has a smoothing effect on net income (net income will only have the same variability under the two methods if the costs incurred are the same each period or they are increasing/decreasing at a constant rate). c. How might income be manipulated under either of these two methods?

When costs are expensed, net income is immediately affected by changes in software development expenditures. Hence if a company is desperate to increase net income it can cut software development costs (this of course will probably come back to haunt them in futures periods).

When costs are capitalized and subsequently amortized, a decrease in this year's expenditures will have a much smaller effect than if these costs were expensed immediately. However, management has plenty of latitude in determining when and which costs get capitalized and over how long they are amortized. Therefore, if a company wanted to increase its net income this period it could 1) increase amortization period, 2) capitalize more costs and/or 3) capitalize costs sooner.

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Chapter 06 - Analyzing Operating Activities

85. Problem Seven: Changes in accounting You are reading the 2006 annual report of Curpen Corporation and you find the following items in its footnotes. a. The useful life of machinery has been increased from 10 to 15 years. b. The expected rate of return on plan assets has been increased to 10% from 8%. c. The company has started to capitalize small tools purchased beginning in 2006.

For each of the above, determine the effect (higher, lower, unchanged) of the change on the ratios listed below for the year 2006: a. Debt-to-Equity b. Return on Assets c. Cash Flow from Operations Problem Seven: Changes in accounting

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Chapter 06 - Analyzing Operating Activities

86. Problem Eight: Employee Stock Options XYZ Company issued 10,000 options to its CEO on January 1, 2006, at the prevailing market price of $5 per share. The options were expected to vest over a 2-year period. The BlackScholes value of the option was valued at $2 per share. On December 31, 2007, the CEO exercised all options. Market price on that day was $9 per share. Assume a 35% tax rate.

What will be the cumulative effect on the balance sheet as of December 31, 2007 before the exercise of option?

What will be the cumulative effect on the balance sheet as of December 31, 2007 after the exercise of option?

Problem Eight: Employee Stock Options Balance Sheet Effect before exercise of option

The total pretax "cost" to the company is $2 X 10,000 = $20,000 which will be amortized over 2006 and 2007.

At a 35% tax rate, the tax saving is $7,000.

Balance Sheet Effect after exercise of option

$5 X 10,000 = $50,000 of cash is received from the CEO. In return, we issue 10,000 shares to the CEO. Because the options are no longer outstanding, we reverse the $20,000 that is in paid-in share capital—stock compensation. The sum total is charged to normal paid-in share capital

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Chapter 06 - Analyzing Operating Activities

87. Problem Nine: Impairment of Long-lived Assets Metals Corp. has four factories with the following data:

All cash flows are at year-end and terminate after December 31, 2010. The company's cost of capital is 10% and its tax rate is 35%. a. What is the value of each factory for balance sheet purposes at December 31, 2006? b. What impairment loss, if any, would be reported on Metals' 2006 income statement. How would it be reported and where would it be reported (i.e. what component of the income statement and other disclosures)?

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Chapter 06 - Analyzing Operating Activities

Problem Nine: Impairment of Long-lived Assets

Asset impairment losses are part of income from continuing operations, although they may be broken out as a special line item if material. They are reported gross and their impact is reflected in the overall income tax expense. In this problem, Metals' impairment loss is clearly material. Footnote disclosure would contain an explanation of the impairment loss and it would be discussed in MD&A.

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Chapter 06 - Analyzing Operating Activities

88. Problem Ten: Nonrecurring Items For each of these nonrecurring items give an example and indicate (match with) the appropriate accounting treatment.

Extraordinary item Prior period adjustment Change in accounting estimate Change in accounting principle Discontinued operation Special items Comprehensive income items Change in reporting entity SEC Enforcement Releases A. Shown net as a separate line item between net income and comprehensive income, no restatement.

B. Income statement line items adjusted as appropriate, gross or net, prior years restated.

C. Gross amount is part of its regular income or expense line item in income from continuing operations, prior years restated.

D. Gross amount is part of its regular income or expense line item in income from continuing operations, no restatement.

E. Shown gross as a separate line item in income from continuing operations, no restatement.

F. Shown net as a separate line item between income from continuing operations and net income, prior years restated.

G. Shown cumulative net as a separate line item between income from continuing operations and net income, no restatement.

H. Shown net as a separate line item between income from continuing operations and net income, no restatement.

I. Not in income statement, opening retained earnings is changed by net amount, no restatement.

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Chapter 06 - Analyzing Operating Activities

Problem Ten: Nonrecurring Items

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