Financial Accounting Theory and Analysis Text and Cases, 13th Edition test bank

Accounting Theory and Analysis 13th Edition

Test Bank By Richard G. Schroeder University of North Carolina at Charlotte

Myrtle W. Clark University of Kentucky

Jack M. Cathey University of North Carolina at Charlotte

Chapter 1 Multiple Choice: 1. Which of the following bodies has the ultimate authority to issue accounting pronouncements in the United States? a. Securities and Exchange Commission b. Financial Accounting Standards Board c. International Accounting Standards Committee d. Internal Revenue Service Answer a 2. What historical evidence of the business operations of the private estate of Apollonius was discovered early in the 20th century? a. The Iliad b. Plato's Republic c. The Zenon papyri d. Pacioli’s work, Summa de Arithmetica Geometria Proportioni et Proportionalita, Answer c 3. Who has been given credit or developing the double-entry system of bookkeeping? a. Francis Wheat b. Fra Luca Pacioli c. A. C. Littleton d. William Paton Answer b 4. Which organization was responsible for a. The Committee on Accounting Procedure b. The Accounting Principles board c. The Financial Accounting Standards Board d. The Securities and Exchange Commission

issuing

Accounting

Research

Bulletins?

Answer a 5. Which of the following pronouncements were issued by the Accounting Principles Board? a. Accounting Research Bulletins b. APB Opinions c. Statements of Financial Accounting Concepts d. Accounting Standards Updates

Answer b 6. Which of the following was not a criticism of the development of accounting standards by the Accounting Principles Board? a. The independence of the members of the APB. The individuals serving on the board had fulltime responsibilities elsewhere that might influence their views of certain issues. b. The structure of the board. The largest eight public accounting firms (at that time) were automatically awarded one member, and there were usually five or six other public accountants on the APB. c. Harmonization. The accounting standards developed were dissimilar to those developed by the International Accounting Standards Committee. d. Response time. The emerging accounting problems were not being investigated and solved quickly enough by the part-time members.

Answer c 7. Which of the following is the professional organization of university accounting professors? a. American Accounting Association b. American Institute of Certified Public Accountants c. American Institute of Accountants d. Financial Executives Institute Answer a 8. What controversy originally highlighted the need for standard setting groups to have more authority? a. Accounting for stock options b. Accounting for derivatives c. Accounting for marketable securities d. Accounting for the investment tax credit Answer d 9. Which of the following committees recommended abolishing the Accounting Principles Board and replacing it with the Financial Accounting Board? a. Wheat b. Cohen c. Trueblood d. Anderson Answer a 10. Which of the following is a public sector accounting standard setter? a. FASB

b. SEC c. APB d. CAP Answer b 11. Which of the following types of pronouncements now establishes generally accepted accounting principles? a. Statements of Concepts b. Statements of Financial Accounting Standards c. APB Opinions d. Accounting Standards Updates Answer d 12. Which of the following types of pronouncements are intended to establish the objectives and concepts that the FASB will use in developing standards of financial accounting and reporting? a. Statements of Concepts b. Statements of Financial Accounting Standards c. APB Opinions d. Accounting Standards Updates Answer a 13. What is the purpose of Emerging Issues Task Force? a. Provide interpretation of existing standards. b. Provide timely guidance on select issues. c. Provide implementation guidance within the Codification framework to reduce diversity in practice on a timely basis. d. Provide interpretive guidance Answer c 14. Which of the following is not a consequence of the standards overload problem to small businesses? a. If a small business omits a GAAP requirement from audited financial statements, a qualified or adverse opinion may be rendered. b. Small businesses do not need to keep financial records c. The cost of complying with GAAP requirements may cause a small business to forgo the development of other, more relevant information. d. Small CPA firms that audit smaller companies must keep up to date on all the same requirements as large international firms, but they cannot afford the specialists that are available on a centralized basis in the large firms.

Answer b 15. Some accountants maintain that accounting standards are as much a product of political action as they are of careful logic or empirical findings. This belief is an example of the concept of a. Standard setting as a political process b. Standards overload c. Economic consequences d. The role of ethics in accounting Answer a 16. Financial accounting standard-setting in the United States can be described as: a. A democratic process in the sense that a majority of accountants must agree with a standard before it becomes enforceable. b. A research process based on empirical findings c. A political process which reflects actions of various interested user groups as well as a product of research and logic. d. A legalistic process based on rules promulgated by governmental agencies Answer c 17. The impact of accounting reports on various segments of our economic society is the definition of the concept of a. Standard setting as apolitical process b. Standards overload c. Economic consequences d. The role of ethics in accounting Answer c 18. Considering and understanding how business decisions affect the financial statements is a. The sole responsibility of the Securities and Exchange Commission. b. Provided in the auditor’s report. c. Referred to as an economic consequence perspective. d. Interpreted strictly by the company’s suppliers.

Answer c 19. Economic consequences of accounting standard-setting means: a. Standard-setters must give first priority to ensuring that companies do not suffer any adverse effect as a result of a new standard. b. Standard-setters must ensure that no new costs are incurred when a new standard is issued. c. The objective of financial reporting should be politically motivated to ensure acceptance by the general public.

d. Accounting standards can have detrimental impacts on the wealth levels of the providers of financial information.

Answer d 20. Which of the following companies was involved in an accounting failure that caused the public accounting firm Arthur Andersen to gout of business? a. Goldman Sachs b. Wachovia c. Enron d. AIG Answer c 21. The mission of the International Accounting Standards Board (IASB) is to a. Develop a uniform currency in which the financial transactions of companies throughout the world would be measured. b. Issue enforceable standards which regulate the financial accounting and reporting of multinational corporations. c. Develop a single set of high-quality and understandable IFRS for general-purpose financial statements. d. Arbitrate accounting disputes between auditors and international companies.

Answer c 22. The Financial Accounting Standards Board (FASB) was proposed by the a. American Institute of Certified Public Accountants. b. Study Group on establishment of Accounting Principles (Wheat Committee). c. Accounting Principles Board. d. Study Group on the Objectives of Financial Statements (Trueblood Committee) Answer c 23. The body that has the ultimate power to prescribe the accounting practices and standards to be employed by companies that fall under its jurisdiction is the a. SEC b. APB. c. FASB. d. AICPA. Answer a 24. Which of the following organizations was established by the federal government to help develop and standardize financial information presented to stockholders? a. AICPA (American Institute of Certified Public Accountants). b. SEC (Securities and Exchange Commission). c. FASB (Financial Accounting Standards Board).

d.

CAP (Committee on Accounting Procedure)

Answer b 25. All the following are true regarding the FASB Accounting Standards Codification except: a. The Codification changes the way GAAP is documented, presented, and updated. b. The goal of the Codification was to provide one place where all authoritative literature about a particular topic could be found. c. The purpose of the Codification is to create new GAAP. d. The Codification was created to simplify user access.

Answer c 26. International Financial Reporting Standards (IFRS) are issued by the: a. EU (European Union). b. SEC (Securities and Exchange Commission). c. FASB (Financial Accounting Standards Board). d. IASB (International Accounting Standards Board).

Answer d Essay 1. What is the difference between normative and positive theory?

Normative theories explain what should be, whereas positive theories explain what is. Ideally, there should be no such distinction, because a well-developed and complete theory encompasses both what should be and what is.

2. Why is the development of a general theory of accounting important?

The development of a general theory of accounting is important because of the role accounting plays in our economic society. We live in a capitalistic society, which is characterized by a selfregulated market that operates through the forces of supply and demand. Goods and services are available for purchase in markets, and individuals are free to enter or exit the market to pursue their economic goals. All societies are constrained by scarce resources that limit the attainment of all individual or group economic goals. In our society, the role of accounting is to report how organizations use scarce resources and to report on the status of resources and claims to resources.

3. Discuss the evolution of accounting during the 1930s.

One of the first attempts to improve accounting began shortly after the inception of the Great Depression with a series of meetings between representatives of the New York Stock Exchange (NYSE) and the American Institute of Accountants. The purpose of these meetings was to discuss problems pertaining to the interests of investors, the NYSE, and accountants in the preparation of external financial statements.

Similarly, in 1935 the American Association of University Instructors in Accounting changed its name to the American Accounting Association (AAA) and announced its intention to expand its activities in the research and development of accounting principles and standards. The first result of these expanded activities was the publication, in 1936, of a brief report cautiously titled “A Tentative Statement of Accounting Principles Underlying Corporate Financial Statements.” The four-and-one-half-page document summarized the significant concepts underlying financial statements at that time.

The cooperative efforts between the members of the NYSE and the AIA were well received.

However, the post-Depression atmosphere in the United States was characterized by regulation.

There was even legislation introduced that would have required auditors to be licensed by the federal government after passing a civil service examination.

Two of the most important pieces of legislation passed at this time were the Securities Act of 1933 and the Securities Exchange Act of 1934, which established the Securities and Exchange Commission (SEC). The SEC was created to administer various securities acts. Under powers provided by Congress, the SEC was given the authority to prescribe accounting principles and reporting practices. Nevertheless, because the SEC has acted as an overseer and allowed the private sector to develop accounting principles, this authority has seldom been used. However, the SEC has exerted pressure on the accounting profession and has been especially interested in narrowing areas of difference in accounting practice.

From 1936 to 1938 the SEC was engaged in an internal debate over whether it should develop accounting standards. Despite the fact that the then–SEC chairman, and later Supreme Court justice, William O. Douglas disagreed, in 1938 the SEC decided in Accounting Series Release (ASR) No. 4 to allow accounting principles to be set in the private sector. ASR No. 4 indicated that reports filed with the SEC must be prepared in accordance with accounting principles that have “substantial authoritative support.”

The profession was convinced that it did not have the time needed to develop a theoretical framework of accounting. As a result, the AIA agreed to publish a study by Sanders, Hatfield, and Moore titled A Statement of Accounting Principles. The publication of this work was quite controversial in that it was simply a survey of existing practice that was seen as telling practicing accountants “do what you think is best.” Some accountants also used the study as an authoritative source that justified current practice.

In 1936 the AIA merged with the American Society of Certified Public Accountants, forming a larger organization later named the American Institute of Certified Public Accountants (AICPA).

This organization has had increasing influence over the development of accounting theory. For example, over the years, the AICPA established several committees and boards to deal with the need to further develop accounting principles. The first was the Committee on Accounting Procedure. It was followed by the Accounting Principles Board, which was replaced by the Financial Accounting Standards Board. Each of these bodies has issued pronouncements on

accounting issues, which have become the primary source of generally accepted accounting principles that guide accounting practice today.

4. Discuss the evolution of the three private sector accenting standard setting organizations.

Professional accountants became more actively involved in the development of accounting principles following the meetings between members of the New York Stock Exchange and the AICPA and the controversy surrounding the publication of the Sanders, Hatfield, and Moore study.

In 1936 the AICPA’s Committee on Accounting Procedure (CAP) was formed. This committee had the authority to issue pronouncements on matters of accounting practice and procedure in order to establish generally accepted practices.

The CAP was relatively inactive during its first two years but became more active in response to the SEC’s release of ASR No. 4 and voiced concerns that the SEC would become more active if the committee did not respond more quickly. One of the first responses was to expand the CAP’s membership from seven to twenty-one members.

A major concern over the use of the historical cost model of accounting arose. The then-accepted definition of assets as unamortized cost was seen by some critics as allowing management too much flexibility in deciding when to charge costs to expense. This was seen as allowing earnings management to occur.

Another area of controversy was the impact of inflation on reported profits. During the 1940s several companies lobbied for the use of replacement cost depreciation. These efforts were rejected by both the CAP and the SEC, which maintained that income should be determined on the basis of historical cost. This debate continued over a decade, ending when Congress passed legislation in 1954 amending the IRS Tax Code to allow accelerated depreciation.

The works of the CAP were originally published in the form of Accounting Research Bulletins (ARBs); however, these pronouncements did not dictate mandatory practice and received authority only from their general acceptance. The ARBs were consolidated in 1953 into Accounting Terminology Bulletin No. 1, “Review and Resume,” and ARB No. 43. ARBs No. 44 through No. 51 were published from 1953 until 1959. The recommendations of these bulletins that have not been superseded are contained in the FASB Accounting Standards Codification (FASB ASC). Those not superseded can be accessed through the cross reference option on the FASB ASC website (asc.fasb.org).

By 1959 the methods of formulating accounting principles were being questioned as not arising from research or based on theory. The CAP was also criticized for acting in a piecemeal fashion and issuing standards that, in many cases, were inconsistent. Additionally, all of its members were part time and as a result their independence was questioned. Finally, the fact that all of the CAP members were required to be members of the AICPA prevented many financial executives, investors, and academics from serving on the committee. As a result, accountants and financial statement users were calling for wider representation in the development of accounting principles.

The AICPA responded to the alleged shortcomings of the CAP by forming the Accounting

Principles Board (APB). The objectives of this body were to advance the written expression of generally accepted accounting principles (GAAP), to narrow areas of difference in appropriate practice, and to discuss unsettled and controversial issues. However, the expectation of a change in the method of establishing accounting principles was quickly squelched when the first APB chairman, Weldon Powell, voiced his belief that accounting research was more applied and pure, with the usefulness of the end product being a major concern.

The APB was composed of from seventeen to twenty-one members, who were selected primarily from the accounting profession but also included individuals from industry, government, and academia.

The lack of support for some of the APB’s pronouncements and concern over the formulation and acceptance of GAAP caused the Council of the AICPA to adopt Rule 203 of the Code of Professional Ethics. This rule requires departures from accounting principles published in APB Opinions or Accounting Research Bulletins (or subsequently FASB Statements and now the FASB ASC) to be disclosed in footnotes to financial statements or in independent auditors’ reports when the effects of such departures are material. This action has had the effect of requiring companies and public accountants who deviate from authoritative pronouncements to justify such departures.

The members of the APB were, in effect, volunteers. These individuals had full-time responsibilities to their employers; therefore, the performance of their duties on the APB became secondary. By the late 1960s, criticism of the development of accounting principles again arose.

This criticism centered on the following factors: a. The independence of the members of the APB. The individuals serving on the board had fulltime responsibilities elsewhere that might influence their views of certain issues. b. The structure of the board. The largest eight public accounting firms (at that time) were automatically awarded one member, and there were usually five or six other public accountants on the APB. c. Response time. The emerging accounting problems were not being investigated and solved quickly enough by the part-time members.

As a result of the growing criticism of the APB, in 1971, the board of directors of the AICPA appointed two committees. The Wheat Committee, chaired by Francis Wheat, was to study how financial accounting principles should be established. The Trueblood Committee, chaired by Robert Trueblood, was asked to determine the objectives of financial statements.

The Wheat Committee issued its report in 1972 recommending that the APB be abolished and the Financial Accounting Standards Board (FASB) be created. This new board was to comprise representatives from various organizations, in contrast to the APB, whose members were all from the AICPA. The members of the FASB were also to be full-time paid employees, unlike the APB members, who served part time and were not paid.

The Trueblood Committee, formally known as the Study Group on Objectives of Financial Statements, issued its report in 1973 after substantial debate and with considerably more tentativeness in its recommendations about objectives than the Wheat Committee had with respect

to the establishment of principles. The study group requested that its report be regarded as an initial step in developing objectives and that significant efforts should be made to continue progress on the refinement and improvement of accounting standards and practices.

The AICPA quickly adopted the Wheat Committee recommendations, and the FASB became the official body charged with issuing accounting standards. The structure of the FASB is as follows.

A board of trustees nominated by organizations whose members have special knowledge and interest in financial reporting is selected. The organizations originally chosen to select the trustees were the American Accounting Association; the AICPA; the Financial Executives Institute; the National Association of Accountants (The NAA’s name was later changed to Institute of Management Accountants in 1991) and the Financial Analysts Federation. In 1997 the Board of Trustees added four members from public interest organizations. The board that governs the FASB is the Financial Accounting Foundation (FAF). The FAF appoints the Financial Accounting Standards Advisory Council (FASAC), which advises the FASB on major policy issues, the selection of task forces, and the agenda of topics. The number of members on the FASAC varies from year to year. The bylaws call for at least twenty members to be appointed. However, the actual number of members has grown to about thirty in recent years to obtain representation from a wider group of interested parties 5. What were the purposes of the Wheat and Trueblood committees?

The Wheat Committee, chaired by Francis Wheat, was to study how financial accounting principles should be established. The Trueblood Committee, chaired by Robert Trueblood, was asked to determine the objectives of financial statements.

6. What was the purpose of the GAAP Hierarchy?

The purpose of the GAAP Hierarchy was to categorize the sources of accounting principles1 that are generally accepted into descending order of authority.

7. What were the four types of pronouncements originally issued by the FASB prior to the adoption of the FASB ASC? 1. Statements of Financial Accounting Concepts (SFACs) and conveyed required accounting methods and procedures for specific accounting issues and officially created GAAP. 2. Interpretations were modifications or extensions of issues pronouncements. SFACs are intended to establish the objectives and concepts that the FASB will use in developing standards of financial accounting and reporting. To date, the FASB has issued seven 3. Statements of Financial Accounting Concepts which differed from Statements of Financial Accounting Standards in that they did not establish GAAP. Similarly, they were not intended to invoke Rule 203 of the Rules of Conduct of the Code of Professional Ethics. It is anticipated that the major beneficiary of these SFACs will be the FASB itself. However, knowledge of the objectives and concepts the board uses should enable financial statement users to better understand the content and limitations of financial accounting information.

4. Technical Bulletins were strictly interpretive in nature and did not establish new standards or amend existing standards. They were intended to provide guidance on financial accounting and reporting problems on a timely basis.

8. Discuss why standard setting may be viewed as a political process.

A highly influential academic accountant stated that accounting standards are as much a product of political action as they are of careful logic or empirical findings. This phenomenon exists because a variety of parties are interested in and affected by the development of accounting standards.

Various users of accounting information have found that the best way to influence the formulation of accounting standards is to attempt to influence the standard setters.

The CAP, APB, and FASB have all come under a great deal of pressure to develop or amend standards so as to benefit a particular user group. For example, the APB had originally intended to develop a comprehensive theory of accounting before attempting to solve any current problems; however, this approach was abandoned when it was determined that such an effort might take up to five years and that the SEC would not wait that long before taking action. The Business Roundtable engaged in what initially was a successful effort (later reversed) to increase the required consensus for passage of a SFAS from a simple majority to five of the seven members of the FASB. Congressional action was threatened over the FASB’s proposed elimination of the pooling of interest method of accounting for business combinations.

9. Define the following terms a. Economic consequences Economic consequences refers to the impact of accounting reports on various segments of our economic society. This concept holds that the accounting practices a company adopts affect its security price and value. Consequently, the choice of accounting methods influences decision making rather than just reflecting the results of these decisions. b. Standards overload Over the years, the FASB, the SEC, and the AICPA have been criticized for imposing too many accounting standards on the business community. This standards overload problem has been particularly burdensome for small businesses that do not have the economic resources to research and apply all the pronouncements issued by these authoritative bodies. Those who contend that there is a standards overload problem base their arguments on two allegations: (1) Not all GAAP requirements are relevant to small business financial reporting needs and (2) even when GAAP requirements are relevant, they frequently violate the pervasive cost–benefit constraint.

Critics of the standard-setting process for small businesses also assert that GAAP were developed primarily to serve the needs of the securities market. Many small businesses do not raise capital in

these markets; therefore, it is contended that GAAP were not developed with small business needs in mind.

10. Discuss the evolution of the phrase “generally accepted accounting principles”.

One result of the meetings between the AICPA and members of the NYSE following the onset of the Great Depression was a revision in the wording of the certificate issued by CPAs. The opinion paragraph formerly stated that the financial statements had been examined and were accurate. The terminology was changed to say that the statements are “fairly presented in accordance with generally accepted accounting principles.” This expression is now interpreted as encompassing the conventions, rules, and procedures that are necessary to explain accepted accounting practice at a given time. Therefore, financial statements are fair only to the extent that the principles are fair and the statements comply with the principles.

The expression generally accepted accounting principles (GAAP) has thus come to play a significant role in the accounting profession. The precise meaning of the term, however, evolved rather slowly. In 1938 the AICPA published a monograph titled Examinations of Financial Statements, which first introduced the term. Later, in 1939, an AICPA committee recommended including the wording, ‘present fairly…in conformity with generally accepted accounting principles’ in the standard form of the auditor’s report.

The meaning of the term was not specifically defined at that time, and no single source exists for all established accounting principles. However, later Rule 203 of the AICPA Code of Professional Ethics required compliance with accounting principles promulgated by the body designated by the Council of the Institute to establish such principles, except in unusual circumstances. Currently, that body is the FASB. The guidance for determining authoritative literature was originally outlined in Statement of Auditing Standards (SAS) No. 5. Later, SAS No. 5 was amended by SAS No. 43. This amendment classified the order of priority that an auditor should follow in determining whether an accounting principle is generally accepted. Also, it added certain types of pronouncements that did not exist when SAS No. 5 was issued to the sources of established accounting principles. SAS No. 43 was further amended by SAS No. 69; whose stated purpose was to explain the meaning of the phrase “present fairly … in conformance with generally accepted accounting principles” in the independent auditor’s report. SAS No. 69 noted that the determination of the general acceptance of a particular accounting principle is difficult because no single reference source exists for all such principles. In July 2003, the SEC issued the Study Pursuant to Section 108(d) of the SarbanesOxley Act of 2002 on the Adoption by the United States Financial Reporting System of a PrinciplesBased Accounting System (the Study). Consistent with the recommendations presented in the Study, the FASB undertook a number of initiatives aimed at improving the quality of standards and the standard-setting process, including improving the conceptual framework, codifying existing accounting literature, transitioning to a single standard-setter regime, and converging FASB and International Accounting Standards Board (IASB) standards.

In 2008, the FASB issued SFAS No 162 The Hierarchy of Generally Accepted Accounting Principles. SFAS No 162 categorized the sources of accounting principles1 that are generally accepted into descending order of authority. Previously, the GAAP hierarchy had drawn criticism because it was directed toward the auditor rather than the enterprise, it was too complex, and it ranked FASB Concepts Statements, which are subject to the same level of due process as FASB Statements, below industry practices that are widely recognized as generally accepted but are not subject to due process.

According to SFAS No 162, the sources of generally accepted accounting principles were: a.

AICPA Accounting Research Bulletins and Accounting Principles Board Opinions that are not superseded by action of the FASB, FASB Statements of Financial Accounting Standards and Interpretations, FASB Statement 133 Implementation Issues, and FASB Staff Positions. b. FASB Technical Bulletins and, if cleared by the FASB, AICPA Industry Audit and Accounting Guides and Statements of Position. c. AICPA Accounting Standards Executive Committee Practice Bulletins that have been cleared by the FASB and consensus positions of the FASB Emerging Issues Task Force (EITF). d. Implementation guides published by the FASB staff, AICPA accounting interpretations, and practices that are widely recognized and prevalent either generally or in the industry.

Finally, in 2009, the FASB issued SFAS No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles—a replacement of FASB Statement No. 162. SFAS No. 168 identified the FASB ASC as the official source of U. S. GAAP. Despite the continuing effort to narrow the scope of GAAP, critics maintain that management is allowed too much leeway in the selection of the accounting procedures used in corporate financial reports. These criticisms revolve around two issues that are elaborated on later in the text: (1) Executive compensation is frequently tied to reported earnings, so management is inclined to adopt accounting principles that increase current revenues and decrease current expenses and (2) the value of a firm in the marketplace is determined by its stock price. This value is highly influenced by financial analysts’ quarterly earnings estimates. Managers are fearful that failing to meet these earnings estimates will trigger a sell-off of the company’s stock and a resultant decline in the market value of the firm.

Previously, SEC Chairman Levitt noted these issues and indicated his belief that financial reports were descending “into the gray area between illegitimacy and outright fraud.” As a consequence, the SEC has set up an earnings management task force to uncover accounting distortions. Some companies have already voluntarily agreed to restructure their financial statements as a result of this new effort by the SEC. For example, SunTrust Bank, Inc., of Atlanta, though not accused of any wrongdoing, agreed to a three-year restructuring of earnings for the period ended December 31, 1996.

11. What controversy caused the AICPA to issue Rule 203 that requires companies to use GAAP when issuing financial statements?

Initially, the pronouncements of the APB, termed “opinions,” were not mandatory practice; however, the issuance of APB Opinion No. 2 (See FASB ASC 740-10- 25 and 45) and a subsequent partial retraction contained in APB Opinion No. 4 (See FASB ASC 740-10-50) highlighted the need for standard setting groups to have more authority.

This controversy was over the proper method to use in accounting for the investment tax credit. In the early 1960s the country was suffering from the effects of a recession. After President John F. Kennedy took office, his advisors suggested an innovative fiscal economic policy that involved a direct income tax credit (as opposed to a tax deduction) based on a percentage of the cost of a qualified investment. Congress passed legislation creating the investment tax credit in 1961.

The APB was then faced with deciding how companies should record and report the effects of the investment tax credit. It considered two alternative approaches: 1. The flow-through method, which treated the tax credit as a decrease in income tax expense in the year it occurred.

2. The deferred method, which treated the tax credit as a reduction in the cost of the asset and therefore was reflected over the life of the asset through reduced depreciation charges.

The APB decided that the tax credit should be accounted for by the deferred method and issued APB Opinion No. 2. This pronouncement stated that the tax reduction amounted to a cost reduction, the effects of which should be amortized over the useful life of the asset acquired. The reaction to this decision was quite negative on several fronts. Members of the Kennedy administration considered the flow-through method more consistent with the goals of the legislation, and three of the then–Big Eight accounting firms advised their clients not to follow the recommendations of APB Opinion No. 2, and in 1963, the SEC issued Accounting Series Release No. 96, allowing firms to use either the flow-through or deferred method in their SEC filings.

12. Discuss the FASB ASC including the reasons for its adoption and the FASB’s goals in developing it.

On July 1, 2009 the FASB ASC became the single source of generally accepted accounting principles. The FASB ASC became effective for interim and annual periods ending after September 15, 2009. On that date, all pronouncements issued by previous standard setters were superseded.

The major reason for embarking on the codification process was that researching multiple authoritative sources complicated the research process. For example, using the previously existing structure, an individual needed to review existing FASB, EITF, AICPA, and SEC literature to resolve even a relatively simple issue. As a result, it was easy to inadvertently overlook relevant guidance. Codifying all existing U.S. GAAP literature into one authoritative source eliminates the previous need to research multiple sources. In addition, creating one source will allow the FASB to more easily isolate differences in its ongoing effort to converge with international accounting standards. The codification represents the sole authoritative source of U.S. GAAP. Creating the codification is only the first step, but is only part of the overall solution. Going forward, the standard setting process will be changed to focus on the codification text. By implementing such an

approach, constituents immediately will know the revised codification language as soon as the standard setter issues the standard. This approach eliminates delays and ensures an integrated codification. The FASB has also developed a searchable retrieval system to provide greater functionality and timeliness to constituents.

The FASB had three primary goals in developing the Codification: 1. Simplify user access by codifying all authoritative US GAAP in one spot.

2. Ensure that the codified content accurately represented authoritative US GAAP as of July1, 2009.

3. Create a codification research system that is up to date for the released results of standardsetting activity.

The Codification is expected to: 1. Reduce the amount of time and effort required to solve an accounting research issue 2. Mitigate the risk of noncompliance through improved usability of the literature 3. Provide accurate information with real-time updates as Accounting Standards Updates are released 4. Assist the FASB with the research and convergence efforts.

13. Discuss the role of ethics in accounting.

Ethics are concerned with the types of behavior society considers right and wrong. Accounting ethics incorporate social standards of behavior as well as behavioral standards that relate specifically to the profession. The environment of public accounting has become ethically complex.

The accountants’ Code of Professional Ethics developed by the AICPA has evolved over time, and as business transactions have become more and more complex, ethical issues have also become more complex.

The public accountant has a Ralph Nader–type overseer role in our society. This role was described by former Chief Justice of the United States Warren Burger: Corporate financial statements are one of the primary sources of information available to guide the decisions of the investing public. In an effort to control the accuracy of their financial data available to investors in the securities markets, various provisions of the federal securities laws require publicly held corporations to file their financial statements with the Securities and Exchange Commission. Commission regulations stipulate that these financial reports must be audited by an independent certified public accountant.

By certifying the public reports that collectively depict a corporation’s financial status, the independent accountant assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation’s creditors and stockholders as well as the investing public. This

“public watchdog” function demands that the accountant maintains total independence from the client at all times and requires complete fidelity to the public trust.

The SEC requires the filing of audited financial statements in order to obviate the fear of loss from reliance on inaccurate information, thereby encouraging public investment in the nation’s industries. It is, therefore, not enough that financial statements be accurate; the public must perceive them as being accurate. Public faith in the reliability of a corporation’s financial statements depends upon the public perception of an outside auditor as an independent professional.

14. What is a special purpose entity and how do they work?

A special purpose entity (SPE) is used to access capital and hedge risk. By using SPEs such as limited partnerships with outside parties, a company may be permitted to increase its financial leverage and return on assets without reporting debt on its balance sheet. The arrangement works as follows: An entity contributes fixed assets and related debt to an SPE in exchange for an ownership interest. The SPE then borrows large sums of money from a financial institution to purchase assets or conduct other business without the debt or assets showing up on the originating company’s financial statements. The originating company can also sell leveraged assets to the SPE and record a profit. At the time these transactions took place, the FASB required that only 3 percent of a SPE be owned by an outside investor. If this guideline is met, the SPE didn’t need to be consolidated and the SPE’s debt was not disclosed on the originating company’s financial statements.

15. How did the Sarbanes-Oxley Act change the way the FASB is funded?

The Sarbanes-Oxley Act changed the way the FASB is funded. Previously, about a third of FASB’s annual budget came from voluntary contributions from public accounting firms, the AICPA, and about one thousand individual corporations. Under SOX, those voluntary contributions are replaced by mandatory fees from all publicly owned corporations based on their individual market capitalization. But the fees are to be collected by the PCAOB. The SEC oversees the PCAOB. As a result, some fear that SOX has inadvertently made FASB more vulnerable to political pressure 16. Discuss the objectives of the International Accounting Standards Board.

The International Accounting Standards Board is an independent private-sector body that was formed in 1973 to achieve this purpose. Its objectives are: 1. To formulate and publish in the public interest accounting standards to be observed in the presentation of financial statements and to promote their worldwide acceptance and observance; 2. To work generally for the improvement and harmonization of regulations, accounting standards, and procedures relating to the presentation of financial statements.

These objectives have resulted in attempts to coordinate and harmonize the activities of the many countries and agencies engaged in setting accounting standards. The IASB standards also provide a useful starting point for developing countries wishing to establish accounting standards.

Chapter 2 Multiple Choice 1. Which early accounting theorist was among the first to express the view that all changes in the value of assets and liabilities should be reflected in the financial statements? a. A. C. Littleton b. John Canning c. William Paton d. DR Scott Answer c 2. Which of the following economists most influenced the views of DR Scott? a. Thorstein Veblen b. John Hicks c. Karl Marx d. John Smith Answer a 3. Which of the following is not one of DR Scott’s hierarchy of accounting postulates and principles? a. Orientation postulate. b. The principles of truth and fairness. c. The materiality principle d. The principles of adaptability and consistency.

Answer c 4.

Which of the following organizations published the monograph titled A Tentative Statement of Accounting Principles Affecting Annual Corporate Reports? a. SEC b. AAA c. AIA d. NAA

Answer b 5. Which of the following organizations published the monograph titled A Statement of Accounting Principles? a.

SEC b.

AAA c.

AIA d.

NAA

Answer c 6. Who was the author of Accounting Research Study No. 1, The Basic Postulates of Accounting? a. Robert Sprouse b. Maurice Moonitz c. Alvin Jennings\ d. Thomas Hatfield Answer b 7. Which of the following is not an approach to accounting theory as categorized by Statement on Accounting Theory and Theory Acceptance? a. Classical, b. Neoclassical c. Decision usefulness d. Information economics.

Answer b 8. What is the objective of financial reporting? a. Provide information that is useful to management in making decisions. b. Provide information that clearly portrays nonfinancial transactions. c. Provide information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors. d. Provide information that excludes claims to the resources.

Answer c 9. Under Statement of Financial Accounting Concepts No. 8, confirmatory value is an ingredient of the primary quality of Relevance Faithful representation a.

No No b.

No Yes c.

Yes Yes d.

Yes No Answer d 10. Which of the following is considered a constraint by Statement of Financial Accounting Concepts No. 8? a. Cost b. Conservatism c. Timeliness

d. Verifiability Answer a 11. Under Statement of Financial Accounting Concepts No. 8, which of the following is an ingredient of the primary quality of relevance? a. Neutrality b. Materiality c. Understandability d. Verifiability Answer b 12. Under Statement of Financial Accounting Concepts No. 8, which of the following is an ingredient of the primary quality of faithful representation? a. Understandability b. Completeness c. Predictive value d. Materiality Answer b 13. Under Statement of Financial Accounting Concepts No. 8, the ability through consensus of measures to ensure that information represents what it purports to represent is an example of the concept of a. Relevance b. Verifiability c. Faithful representation d. Feedback value Answer c 14. Under Statement of Financial Accounting Concepts No. 8, which of the following relates to both relevance and faithful representation? a. Timeliness b. Materiality c. Predictive value d. Neutrality Answer a 15. Under Statement of Financial Accounting Concepts No. 8, which of the following is not a qualitative characteristic associated with faithful representation? a. Completeness

b. Free from error c. Neutrality d. Predictive value Answer d 16. What is meant by comparability when discussing financial accounting information? a. Information has predictive or confirmatory value. b. Information is reasonably free from error. c. Information that is measured and reported in a similar fashion across companies. d. Information is timely.

Answer c 17. What is meant by consistency when discussing financial accounting information? a. Information that is measured and reported in a similar fashion across points in time. b. Information is timely. c. Information is measured similarly across the industry. d. Information is verifiable Answer a 18. An item is considered material if a. It doesn’t cost a lot of money. b. It is of a tangible good. c. It is likely to influence the decision of an investor or creditor. d. The cost of reporting the item is greater than its benefits Answer c 19. If the FASB’s proposed definition of materiality as a legal concept is adopted the most likely outcome is a. It will have little impact on the number of items classified as material b. It will lower the threshold for recognizing event and transactions as material c. It will raise the threshold for recognizing event and transactions as material d. Its impact cannot be determined Answer c 20. Which of the following is not a topic being currently studied by the FASB as in conjunction with its effort on Chapter 8 of SFAC No. 8? a. Fair value measurement b. Defined benefit pension plans c. Leases

d. Income taxes Answer c 21. The purpose of Statements of Financial Accounting Concepts is to a. Form a conceptual framework for solving existing and emerging problems. b. Determine the need for FASB involvement in an emerging issue. c. Establish GAAP. d. Modify or extend an existing FASB Accounting Standards Update.

Answer a Essay 1. Discuss the contributions of Paton and Canning to the development of accounting theory.

The first attempts to develop accounting theory in the United States have been attributed to William A. Paton and John B. Canning. Paton’s work, based on his doctoral dissertation, was among the first to express the view that all changes in the value of assets and liabilities should be reflected in the financial statements, and that such changes should be measured on a current value basis.

He also maintained that all returns to investors (both dividends and interest) were distributions of income, and consequently he espoused the entity concept rather than the prevailing proprietary concept. An additional contribution of this work was an outline of what Paton believed to be the basic assumptions or postulates underlying the accounting process. Paton’s basic assumptions and postulates can be viewed as the first step in the development of the conceptual framework of accounting. Canning’s work suggested a framework for asset valuations and measurement based on future expectations as well as a model to match revenues and expenses. At this time, the balance sheet was viewed as the principal financial statement, and the concept of capital maintenance was just emerging.

2. Discuss the contribution DR Scott to the development of accounting theory.

During this early period, significant contributions to the development of a conceptual framework of accounting were also made by DR Scott. Scott was viewed as an outsider; however, his writings have proven to be quite insightful. Scott was originally trained as an economist and was heavily influenced by the views of his colleague, the economist and philosopher Thorstein Veblen. He adopted Veblen’s view that many academics were overly occupied with refining the details of existing theories when there was a need for the reexamination of fundamental assumptions. Both Scott and Veblen viewed the Industrial Revolution as changing the fundamental fabric of our society. Scott believed the Industrial Revolution caused managers to look for new methods of maintaining organizational control. As a result, scientific methods such as accounting and statistics became organizational control tools.

Scott contributed to the development of accounting theory by recognizing the need for a normative theory of accounting. This view, described in several publications from 1931 to 1941, evolved into a description of his conceptual framework in “The Basis for Accounting Principles.

In his first important work, The Cultural Significance of Accounts, Scott argued that accounting theory was not a progression toward a static ideal but rather a process of continually adapting to an evolving environment. The notion of adaptation later became one of Scott’s principles in his conceptual framework. He approached accounting from a sociological perspective. The basic premise presented in Cultural Significance was that the economic basis of any culture is shaped by the institutional superstructure of the society in question. This view later evolved into his orientation postulate.

Scott’s next important work was a response to the American Accounting Association’s “A Tentative Statement of Principles Underlying Corporate Financial Statements” (discussed later in the chapter). Scott criticized the AAA monograph as having a too narrow view of accounting in that it addressed only accounting’s transaction function. Rather, he saw accounting as encompassing other important functions, such as managerial control and the protection of the interests of equity holders. He also viewed accounting as having both an internal control function and an external function to act for the protection of various economic interests such as stockholders, bond holders, and the government.

Although Scott’s first two works contain what were to become elements of his conceptual framework, the first step in its articulation is contained in “Responsibilities of Accountants in a Changing Environment.” In this work he again alluded to the influence of the Industrial Revolution on a changing economy and saw it as requiring improved financial reporting to meet the needs of all investors. Scott supported Paton’s earlier acceptance of the entity theory and went on to emphasize that accounting must meet the needs of external users. This view is an example of why Scott was considered an outsider, because the prevailing view was that accounting should be designed to benefit the firm’s management or proprietor (the proprietary theory).

3. Discuss DR Scott’s hierarchy of postulates and principles.

In 1941 Scott unveiled his conceptual framework in “The Basis for Accounting Principles.” He maintained that it could serve as a vehicle for the development of internally consistent accounting principles. Scott’s framework includes the following hierarchy of postulates and principles to be used in the development of accounting rules and techniques. a. Orientation Postulate. —Accounting is based on a broad consideration of the current social, political, and economic environment. b. The Pervasive Principle of Justice. —The second level in Scott’s conceptual framework was justice, which was seen as developing accounting rules that offer equitable treatment to all users of financial statements.

c. The Principles of Truth and Fairness. —Scott’s third level contained the principles of truth and fairness. Truth was seen as an accurate portrayal of the information presented. Fairness was viewed as containing the attributes of objectivity, freedom from bias, and impartiality. d. The Principles of Adaptability and Consistency. —The fourth level of the hierarchy contained two subordinate principles, adaptability and consistency. Adaptability was viewed as necessary because society and economic conditions change; consequently, accounting must also change. However, Scott indicated a need to balance adaptability with consistency by stating that accounting rules should not be changed to serve the temporary purposes of management.

4. Discuss the contributions of the works by Sanders Hatfield and More, and Paton and Littleton to accounting theory.

In 1938, the American Institute of Accountants (AIA) also published a monograph, A Statement of Accounting Principles, written by Thomas H. Sanders, Henry Rand Hatfield, and Underhill Moore, that ostensibly described accounting theory. The goal of this publication was to provide guidance to the SEC on the best accounting practices. However, the study did not accomplish its objective because it was viewed as a defense of accepted practices rather than an attempt to develop a theory of accounting.

In 1940, the AAA published a benchmark study by Paton and A. C. Littleton, An Introduction to Corporate Accounting Standards. While this study continued to embrace the use of historical cost, its major contribution was the further articulation of the entity theory. It also described the matching concept, whereby management’s accomplishments (revenue) and efforts (expenses) could be evaluated by investors. This monograph was later cited as developing a theory that has been used in many subsequent authoritative pronouncements.

5. Discuss accounting Research Study No. 1.

Accounting Research Study No. 1, The Basic Postulates of Accounting, was published in 1961. It consisted of a hierarchy of postulates encompassing the environment, accounting, and the imperatives as follows: Group A Economic and Political Environmental Postulates This group is based on the economic and political environment in which accounting exists. They represent descriptions of those aspects of the environment that Sprouse and Moonitz presumed to be relevant for accounting.

A-1. Quantification Quantitative data are helpful in making rational economic decisions. Stated differently, quantitative data aid the decision maker in making choices among alternatives so that the actions are correctly related to consequences.

A-2. Exchange Most of the goods and services that are produced are distributed through exchange and are not directly consumed by the producers.

A-3. Entities Economic activity is carried on through specific units of entities. Any report on the activity must identify clearly the particular unit or entity involved.

A-4. Time period. (Including specification of the time period.)

Economic activity transpires during specifiable time periods. Any report on that activity must specify the period involved.

A-5. Unit of measure. (Including identification of the measuring unit.)

Money is the common denominator in terms of which goods and services, including labor, natural resources, and capital, are measured. Any report must clearly indicate which monetary unit is being used.

Group B Accounting Postulates The second group of postulates focuses on the field of accounting. They are designed to act as a foundation and assist in constructing accounting principles.

B-1. Financial statements. (Related to A-1.)

The results of the accounting process are expressed in a set of fundamentally related financial statements that articulate with each other and rest on the same underlying data.

B-2. Market prices. (Related to A-2.)

Accounting data are based on prices generated by past, present, or future exchanges that have actually taken place or are expected to.

B-3. Entities. (Related to A-3.)

The results of the accounting process are expressed in terms of specific units or entities.

B-4. Tentativeness. (Related to A-4.)

The results of operations for relatively short periods are tentative whenever allocations between past, present, and future periods are required.

Group C Imperative Postulates The third group differs fundamentally from the first two groups. They are not primarily descriptive statements but instead represent a set of normative statements of what should be, rather than statements of what is.

C-1 Continuity. (Including the correlative concept of limited life.)

In the absence of evidence to the contrary, the entity should be viewed as remaining in operation indefinitely. In the presence of evidence that the entity has a limited life, it should not be viewed as remaining in operation indefinitely.

C-2. Objectivity Changes in assets and liabilities and the related effect (if any) on revenues, expenses, retained earnings, and the like should not be given formal recognition in the accounts earlier than the point of time at which they can be measured objectively.

C-3. Consistency The procedures used in accounting for a given entity should be appropriate for the measurement of its position and its activities and should be followed consistently from period to period.

C-4. Stable unit Accounting reports should be based on a stable measuring unit.

C-5. Disclosure Accounting reports should disclose that which is necessary to make them not misleading.

6.

How did ASOBAT define accounting and what two new ideas arose from this monograph?

A Statement of Basic Accounting Theory (ASOBAT) in 1966 defined accounting as “the process of identifying, measuring and communicating economic information to permit informed judgments and decision by users of the information.”

Two new ideas arose out of ASOBAT’s definition of accounting. The members of the committee were mainly academics, so they looked upon accounting as an information system. Therefore, they saw communication as an integral part of the accounting process. Additionally, the inclusion of the term economic income broadened the scope of the type of information to be provided to assist in the allocation of scarce resources. The committee also embraced the entity concept by indicating that the purpose of accounting was to allow users to make decisions. In essence they were defining accounting as a behavioral science whose main function was to assist in decision making. As a consequence, the committee adopted a decision-usefulness approach and identified four standards to be used in evaluating accounting information: relevance, verifiability, freedom from bias, and quantifiability. ASOBAT maintained that if these four standards could not be attained, the information was not relevant and should not be communicated.

ASOBAT noted the inherent conflicts between relevance and verifiability in making one final recommendation. The monograph called for the reporting of both historical cost and current cost measures in financial statements. The current cost measures to be used included both replacement cost and price level adjustments.

7. Discuss the objectives of accounting as outlined by the Trueblood Committee.

The Trueblood Committee report specified the following four information needs of users:

1.

2.

3.

4.

Making decisions concerning the use of limited resources Effectively directing and controlling organizations Maintaining and reporting on the custodianship of resources Facilitating social functions and controls

Like its predecessors, the Trueblood Committee had difficulty agreeing on the answers to the questions proposed by the AICPA. As a result, it indicated that its final report be regarded as a first step in the process. The report listed the following objectives for financial reporting: 1. The basic objective of financial statements is to provide information useful for making economic decisions.

2. An objective of financial statements is to serve primarily those users who have limited authority, ability, or resources to obtain information and who rely on financial statements as their principal source of information about an enterprise’s economic activities.

3. An objective of financial statements is to provide information useful to investors and creditors for predicting, comparing, and evaluating potential cash flows in terms of amount, timing, and related uncertainty.

4. An objective of financial statements is to provide users with information for predicting, comparing, and evaluating enterprise earning power.

5. An objective of financial statements is to supply information useful in judging management’s ability to use enterprise resources effectively in achieving its primary enterprise goal.

6. An objective of financial statements is to provide factual and interpretative information about transactions and other events that is useful for predicting, comparing, and evaluating enterprise earning power. Basic underlying assumptions with respect to matters subject to interpretation, evaluation, prediction, or estimation should be disclosed.

7. An objective is to provide a statement of financial position useful for predicting, comparing, and evaluating enterprise earning power.

8. An objective is to provide a statement of periodic earnings useful for predicting, comparing, and evaluating enterprise earning power.

9. Another objective is to provide a statement of financial activities useful for predicting, comparing, and evaluating enterprise earning power. This statement should report mainly on factual aspects of enterprise transactions having or expecting to have significant cash consequences. This statement should report data that require minimal judgment and interpretation by the preparer.

10. An objective of financial statements is to provide information useful for the predicting process.

Financial forecasts should be provided when they will enhance the reliability of the users’ predictions.

11. An objective of financial statements for governmental and not-for-profit organizations is to provide information useful for evaluating the effectiveness of the management of resources in achieving the organization’s goals. Performance measures should be quantified in terms of identified goals.

12. An objective of financial statements is to report on the enterprise’s activities affecting society that can be determined and described or measured and that are important to the role of the enterprise in its social environment. This objective was an attempt to draw attention to those

enterprise activities that require sacrifices from members of society who do not benefit from those activities.

8. What were the approaches to accounting theory identified by SATTA? SATTA first embarked on a review of accounting theories and found that a number of theories explained narrow areas of accounting. The committee noted that while there was general agreement that the purpose of financial accounting is to provide economic data about accounting entities, divergent theories had emerged because of the way different theorists specified users of accounting data and the environment. For example, users might be defined either as the owners of the accounting entity or more broadly to include creditors, employees, regulatory agencies, and the general public. Similarly, the environment might be specified as a single source of information or as one of several sources of financial information. The various approaches to accounting theory were condensed into (1) classical, (2) decision usefulness, and (3) information economics.

9. According to Kuhn, how dies scientific progress occur?

SATTA noted that although the evolutionary view of accounting had considerable appeal, the evidence suggests that the existing accounting literature was inconsistent with that view. It suggested that the process of theorizing in accounting was more revolutionary than evolutionary and turned to a perspective developed by Kuhn. He suggests scientific progress proceeds in the following order: 1.

2.

3.

4.

5.

Acceptance of a paradigm.

Working with that paradigm by doing normal science.

Becoming dissatisfied with that paradigm.

Search for a new paradigm.

Accepting a new paradigm.

10. What is the purpose of the conceptual framework?

The CFP first attempted to develop principles or broad qualitative standards to permit the making of systematic rational choices among alternative methods of financial reporting. Subsequently, the project focused on how these overall objectives could be achieved. As a result, the CFP is a body of interrelated objectives and fundamentals. The objectives identify the goals and purposes of financial accounting, whereas the fundamentals are the underlying concepts that help achieve those objectives. These concepts are designed to provide guidance in: 1. Selecting the transactions, events, and circumstances to be accounted for 2. Determining how the selected transactions, events, and transactions should be measured 3. Determining how to summarize and report the results of events, transactions, and circumstances.

The FASB intends the CFP to be viewed not as a package of solutions to problems but rather as a common basis for identifying and discussing issues, for asking relevant questions, and for suggesting avenues for research.

11. Define the following terms: a. Comprehensive income Comprehensive income is the change in equity (net assets) of an entity during a period from transactions and events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. b. Relevance Relevant accounting information can make a difference in a decision by helping users to form predictions about the outcomes of past, present, and future events or to confirm or correct prior expectations. Relevant information has predictive value, feedback value, and timeliness. c. Faithful representation Faithful representation has three characteristics: completeness, neutrality, and free from error.

Although perfection is difficult or even impossible to achieve, the objective is to maximize those qualities to the extent possible. A complete depiction should include all information necessary for a user to understand the phenomenon being depicted. For some items, a complete depiction also might entail explanations of significant facts about the quality and nature of the items, factors, and circumstances that might affect their quality and nature and the process used to determine the numerical depiction. A neutral depiction is without bias in the selection or presentation of financial information. A neutral depiction is not slanted, weighted, emphasized, deemphasized, or otherwise manipulated to increase the probability that financial information will be received favorably or unfavorably by users. Neutral information does not mean information with no purpose or no influence on behavior. On the contrary, relevant financial information is, by definition, capable of making a difference in users’ decisions. Free from error means there are no errors or omissions in the description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process. Information that is free from error will result in a more faithful representation of financial results.

12. According to SFAC No. 5, what should a full set of financial statements for a period show?

According to SFAC No. 5, a full set of financial statements for a period should show: 1. Financial position at the end of the period.

2. Earnings for the period.

3. Comprehensive income for the period.

4. Cash flows during the period.

5. Investments by and distributions to owners during the period.

13. What is the purpose of SFAC No. 7: “Using Cash Flow Information and Present Value in Accounting Measurements?

The FASB indicated that the purpose of present-value measurements is to capture the economic difference between sets of future cash flows. For example, each of the following assets with a future cash flow of $25,000 has an economic difference: a. An asset with a certain, fixed contractual cash flow due in one day of $25,000. b. An asset with a certain, fixed contractual cash flow due in ten years of $25,000. c. An asset with a certain, fixed contractual cash flow due in one day of $25,000. The actual amount to be received may be less but not more than $25,000. d. An asset with a certain, fixed contractual cash flow due in ten years of $25,000. The actual amount to be received may be less but not more than $25,000. e. An asset with expected cash flow of $25,000 in ten years with a range of $20,000 to $30,000.

These assets are distinguished from one another by the timing and uncertainty of their future cash flows. Measurements based on undiscounted cash flows would have the result of recording each at the same amount. Since they are economically different, their expected present values are different.

A present value measurement that fully captures the economic differences between the five assets should include the following elements: a. An estimate of future cash flows b. Expectations about variations in the timing of those cash flows c. The time value of money represented by the risk-free rate of interest d. The price for bearing the uncertainty e. Other, sometimes unidentifiable, factors including illiquidity and market imperfections 14. What two approaches to present value were discussed in SFAS No. 7?

The two approaches to present value were discussed in SFAC No. 7: • Traditional. A single cash flow and a single interest rate as in a 12 percent bond due in ten years. Cases a and b above are examples of the use of the traditional approach.

• Expected cash flow. A range of possible cash flows with a range of likelihoods. Cases c, d, and e above are examples of the expected cash flow approach.

15. Discuss the qualitative characteristics of accounting information as outlined in SFAC No. 8 The qualitative characteristics are described in Chapter 3 of SFAC No. 8 and distinguish between better (more useful) information and inferior (less useful) information.

These qualitative characteristics are either fundamental or enhancing characteristics, depending on how they affect the decision usefulness of information.

The two fundamental qualities that make accounting information useful for decision making are relevance and faithful representation.

Relevant financial information is capable of making a difference in the decisions made by users.

Financial information is capable of making a difference in decisions if it has predictive value and confirmatory value and is material. Financial information has predictive value if it can be used as an input to processes employed by users to predict future outcomes. Financial information has confirmatory value if it provides feedback (confirms or changes) about previous evaluations.

Information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude or both of the items to which the information relates in the context of an individual entity’s financial report. Consequently, the FASB was not able to specify a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation.

Financial reports represent economic phenomena in words and numbers. To be useful, financial information not only must represent relevant phenomena but also must faithfully represent the phenomena that it purports to represent. A perfectly faithful representation has three characteristics: completeness, neutrality, and free from error . Although perfection is difficult or even impossible to achieve, the objective is to maximize those qualities to the extent possible.

A complete depiction should include all information necessary for a user to understand the phenomenon being depicted. For some items, a complete depiction also might entail explanations of significant facts about the quality and nature of the items, factors, and circumstances that might affect their quality and nature and the process used to determine the numerical depiction. A neutral depiction is without bias in the selection or presentation of financial information. A neutral depiction is not slanted, weighted, emphasized, deemphasized, or otherwise manipulated to increase the probability that financial information will be received favorably or unfavorably by users. Neutral information does not mean information with no purpose or no influence on behavior.

On the contrary, relevant financial information is, by definition, capable of making a difference in users’ decisions.

Free from error means there are no errors or omissions in the description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process. Information that is free from error will result in a more faithful representation of financial results.

Comparability, verifiability, timeliness, and understandability are the qualitative characteristics that enhance the usefulness of information that is relevant and faithfully represented. Comparability is the qualitative characteristic that enables users to identify and understand similarities in, and differences among, items.

Consistency refers to the use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities.

Comparability is the goal; consistency helps to achieve that goal.

Verifiability helps assure users that information faithfully represents the economic phenomena it purports to represent. Verifiability means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation.

Quantified information need not be a single point estimate to be verifiable.

A range of possible amounts and the related probabilities also can be verified.

Timeliness means having information available to decision makers in time to be capable of influencing their decisions. Generally, the older the information is, the less useful it is. However, some information can continue to be timely long after the end of a reporting period because, for example, some users might need to identify and assess trends. Understandability involves classifying, characterizing, and presenting information clearly and concisely.

16. Discuss the issue of principles based vs. rule-based accounting standards.

To illustrate the difference between rules-based and principles-based standards, the standardsetting process can be viewed as a continuum ranging from highly rigid standards on one end to general definitions of economics-based concepts on the other end. For example, consider accounting for the intangible asset of goodwill. An example of the extremely rigid end of the continuum is the previously acceptable practice: Goodwill is to be amortized over a period not to exceed 40 years.

This requirement leaves no room for judgment or disagreement about the amount of amortization expense to be recognized. Comparability and consistency across firms and through time is virtually assured under such a rule. However, the requirement lacks relevance because it does not reflect the underlying economics of the reporting entity, which differ across firms and through time.

At the opposite end of the continuum is the FASB ASC’s 350-20-35-1 rule: Goodwill shall not be amortized. Instead, goodwill shall be tested for impairment at a level of reporting referred to as a reporting unit.

This requirement necessitates the application of judgment and expertise by both managers and auditors. The goal is to record the economic deterioration of the asset, goodwill.

17. Discuss how the FASB and the IASC acted to improve comparability under the Norwalk Agreement.

In the Norwalk Agreement, the FASB and IASB committed to (1) undertake a short-term project aimed at removing a variety of individual differences between U.S. GAAP and International Financial Reporting Standards (IFRSs, discussed in Chapter 3); (2) remove other differences between IFRSs and U.S. GAAP that remained at January 1, 2005, through coordination of their

future work programs; that is, through the mutual undertaking of discrete, substantial projects that both Boards would address concurrently; (3) continue progress on the joint projects that they are currently undertaking; and (4) encourage their respective interpretative bodies to coordinate their activities.

18. Discuss the Statement of Financial Accounting Concepts No. 8—Conceptual Framework for Financial Reporting: Chapter 8: “Notes to Financial Statements.”

This pronouncement: a. Provides a decision-making framework for the FASB to follow when determining required disclosures in standards-level projects b. Summarizes the types of information and certain limitations on that information that should be considered by the Board for determining the information to be included in the notes to the financial statements c. Includes a list of decision questions to assist the Board and the FASB staff in developing potential disclosure requirements

Chapter 3 Multiple Choice 1. Which of the following is not an environmental factor that could impact on the development of a country’s accounting system? a. Level of education b. Political system c. Geographic location d. Legal system Answer c 2.

What is the current acronym for the body most responsible for issuing international accounting standards? a. IASB b. SEC c. FASB d. IASC

Answer a 3. How many trustees serve on the IFRS Foundation? a. 16 b. 18 c. 20 d. 22 Answer d 4. How many members serve on the IASB? a. 16 b. 18 c. 20 d. 22 Answer a 5. How many member serve on the Accounting Standards Advisory Forum? a. 12 b. 14 c. 20 d. 22

Answer a 6. Which of the following bodies has the responsibility to issue international financial reporting standards (IFRS)? a. The International Financial Reporting Interpretations Committee b. The International Standards Advisory Council c. The IASC Foundation d. The International Accounting Standards Board Answer d 7. Which of the following is not a use of international accounting standards? a. As national requirements. b. As standards to be violated to improve intercountry comparability. c. As an international benchmark for those countries that develop their own requirements. d. By regulatory authorities for domestic and foreign companies Answer b 8. How does the IASC enforce its standards? a. Through, the International Organization of Securities Commission b. Through the concept of best endeavors c. Through the Securities and Exchange Commission d. Through the Financial Accounting Standards Board Answer b 9. What is the name given to the agreement between the FASB and IASC to harmonize accounting standards? a. The Norwalk Agreement b. The London agreement c. The Washington D C agreement d. The Paris Accords Answer a 10. Which of the following is not an effect of the IFRS for SMEs? a. It omits topics in IFRS that are not relevant to SMEs b. It allows the easier option when IFRS permits accounting policy choices c. It simplifies many principles for recognizing and measuring assets, liabilities, income, and expenses d. It requires significantly greater disclosures Answer d 11. What is the title of the form that foreign companies have used to reconcile their financial statements to U. S. GAAP? a. Form 10-K b. Form 10-Q

c. Form SX d. Form 20-F Answer d 12. Which of the following is not one of the characteristics discussed in Chapter 2 - Qualitative Characteristics of Useful Financial Information of the IASB’s Framework for the Preparation of Financial Statements? a. Understandability b. Faithful representation c. Relevance d. Reliability Answer d 13. Which of the following is not an element of financial statements contained in the IASB’s Framework for the Preparation of Financial Statements? a. Gain b. Income c. Expense d. Asset Answer a 14. Which of the following is seen as a pervasive difference between IASB’s and FASB’s Conceptual Frameworks? a. Definition of elements b. Number of qualitative characteristics c. Scope of authority d. Level of detail Answer d 15. Which of the following concepts is contained in the FASB’s conceptual framework but not in the IASC’s a. Expense b. Gain c. Asset d. Liability Answer b 16. Which of the following is an element of financial statements under the IASB’s conceptual framework? a. Losses b. Comprehensive income c. Investment by owners d. Equity Answer d

17. Under the IASB’s conceptual framework, a decrease in economic benefit that results in a decrease in equity is termed as a(an): a. Distributions to owners b. Loss of economic benefit c. Comprehensive loss d. Expense Answer d 18. Which of the following statements is true regarding the conceptual frameworks developed by FASB and IASB? a. The economic entity assumption is not part of either framework b. The monetary unit assumption is part of each framework and the U.S. dollar is established as the common unit of currency. c. Both have similar measurement principles based on historical cost and fair value. d. The conceptual frameworks underlying U.S. GAAP and IFRS are dissimilar.

Answer c 19. Under IFRS a. The going concern assumption is used. b. The conceptual framework is similar to the conceptual framework under GAAP c. Companies may apply fair value to natural resources d. All of these answer choices are correct Answer d 20. Companies that use IFRS: a. Are allowed to report property, plant, and equipment and natural resources at fair value on their financial statements b. May only use historical cost as the measurement basis in financial reporting c. Are required to report all their assets on the statement of financial position at fair value d. May utilize the framework in a statement of concepts to estimate fair values when market data are not available.

Answer a 21. Which of the following is not a chapter of the IASB Framework? a. The objective of financial statements b. The elements of financial statements c. Concepts of capital and capital maintenance d. Concepts of income and expenditure Answer d 22. Which of the following statements regarding Chapter 4 - The Elements of Financial Statements of the IASB’s conceptual framework is false?

a. The focus of the definitions of assets and liabilities moved to the existence of a right (or an obligation) that has the potential to produce (or require an entity to transfer) economic benefits. b. It requires that a present obligation be as a result of past events. c. It changes how an entity distinguishes between a liability and an equity instrument. d. It removes of the reference to the expected flow of economic benefits in defining assets and liabilities.

Answer c 23. Which of the following is not a criterion for an element to be recognized according to Chapter 5 Recognition and Derecognition of the IASB’s conceptual framework? a. b. c. d.

It provides a reliability measurement threshold It provides relevant information It can be measured It faithfully represents the underlying transaction

Answer a 24. Chapter 6 – Measurement of the IASB’s conceptual framework includes a discussion of which of the following measurement bases? a. b. c. d.

Historical cost Fair value Value in use All the above

Answer d 25. Which of the following statements regarding Chapter 4 - The Elements of Financial Statements of the IASB’s conceptual framework is false? a. The focus of the definitions of assets and liabilities moved to the existence of a right (or an obligation) that has the potential to produce (or require an entity to transfer) economic benefits. b. It requires that a present obligation be as a result of past events. c. It changes how an entity distinguishes between a liability and an equity instrument. d. It removes of the reference to the expected flow of economic benefits in defining assets and liabilities.

Answer c 26. Chapter 7 - Presentation and Disclosure of the IASB’s conceptual framework indicates that the _____ is the primary source of information about an entity’s financial performance for the reporting period. a. Balance sheet b. Income statement

c. Statement of owners’ equity d. Statement of comprehensive income Answer b Essay 1. Discuss the environmental factors that impact on the development of a country’s accounting system.

Financial accounting is influenced by the environment in which it operates. Nations have different histories, values, cultures, and political and economic systems, and they are also in various stages of economic development. These national influences interact with each other and, in turn, influence the development and application of financial accounting practices and reporting procedures Level of Education There tends to be a direct correlation between the level of education obtained by a country’s citizens and the development of the financial accounting reporting practices in that country. The characteristics comprising these environmental factors include (1) the degree of literacy in a country; (2) the percentage of the population that has completed grade school, high school, and college; (3) the orientation of the educational system (vocational, professional, etc.); and (4) the appropriateness of the educational system to the country’s economic and social needs. Countries with better educated populations are associated with more advanced financial accounting systems.

Political System The type of political system (socialist, democratic, totalitarian, etc.) can influence the development of accounting standards and procedures. The accounting system in a country with a centrally controlled economy will be different from the accounting system in a market-oriented economy.

For example, companies in a socialist country may be required to provide information on social impact and cost–benefit analysis in addition to information on profitability and financial position.

Legal System The extent to which a country’s laws determine accounting practice influences the strengths of that country’s accounting profession. When governments prescribe accounting practices and procedures, the authority of the accounting profession is usually weak. Conversely, the nonlegalistic establishment of accounting policies by professional organizations is a characteristic of common-law countries.

Economic Development The level of a country’s economic development influences both the development and application of its financial reporting practices. Countries with low levels of economic development will have relatively less need for a sophisticated accounting system than countries with high levels of economic development

2. Discuss the approaches a company might take when issuing financial reports to users in foreign countries.

A company issuing financial reports to users in foreign countries may take one of several approaches in the preparation of its financial statements: 1. Send the same set of financial statements to all users (domestic or foreign).

2. Translate the financial statements sent to foreign users into the language of the foreign nation’s users.

3. Translate the financial statements sent to foreign users into the foreign nation’s language and currency.

4. Prepare two sets of financial statements, one using the home country language, currency, and accounting principles, the second using the language, currency, and accounting principles of the foreign country’s users.

5. Prepare one set of financial statements based on worldwide accepted accounting principles 3. What is the purpose of the International Accounting Standards Board?

The International Accounting Standards Committee (IASC) was formed in 1973 to develop worldwide accounting standards. It was an independent private-sector body; whose objective was to achieve uniformity in accounting principles that are used for worldwide financial reporting. In 2001 the IASC was replaced by the International Accounting Standards Board which retained the same objective.

4. Discuss the factors that have contributed to the need for new approaches to international standard setting.

The factors that have contributed to the need for new approaches to international standard setting include: 1. A rapid growth in international capital markets, combined with an increase in cross-border listings and cross-border investment. These issues have led to efforts by securities regulators to develop a common “passport” for cross-border securities listings and to achieve greater comparability in financial reporting.

2. The efforts of global organizations (such as the World Trade Organization) and regional bodies (such as the European Union, NAFTA, MERCOSUR [the southern common market countries of Argentina, Brazil, Paraguay, and Uruguay], and Asia-Pacific Economic Cooperation) to dismantle barriers to international trade.

3. A trend toward the internationalization of business regulation.

4. The increasing influence of international accounting standards on national accounting requirements and practice.

5. The acceleration of innovation in business transactions.

6. Users’ increasing demands for new types of financial and other performance information.

7. New developments in the electronic distribution of financial and other performance information.

8. A growing need for relevant and reliable financial and other performance information both in countries in transition from planned economies to market economies and in developing newly industrialized economies 5. Outline the steps in the IASB’s standard-setting process.

Stage 1: Setting the Agenda The IASB evaluates the merits of adding a potential item to its agenda mainly by reference to the needs of investors.

Stage 2: Project Planning The board decides whether to conduct the project alone or jointly with another standard setter, and a project team is selected.

Stage 3: Development and Publication of a Discussion Paper A discussion paper includes a comprehensive overview of the issue, possible approaches in addressing the issue, the preliminary views of its authors or the IASB, and an invitation to comment.

Stage 4: Development and Publication of an Exposure Draft An exposure draft is the IASB’s main vehicle for consulting the public. Unlike a discussion paper, an exposure draft sets out a specific proposal in the form of a proposed standard (or amendment to an existing standard).

Stage 5: Development and Publication of an International Financial Reporting Standard After resolving issues arising from the exposure draft, the IASB considers whether it should expose its revised proposals for public comment, for example, by publishing a second exposure draft.

Stage 6: Procedures after an IFRS Is Issued After an IFRS is issued, the staff and the IASB members hold regular meetings with interested parties, including other standard‐setting bodies, to help understand unanticipated issues related to the practical implementation and potential impact of its proposals. The IFRS Foundation also fosters educational activities to ensure consistency in the application of IFRSs. 6. Discuss the IASB’s annual improvements project.

In July, 2006 the IASB announced that it was beginning an annual improvements project. The Board stated: “Changes to standards, however small, are time-consuming for the Board and burdensome for others. The IASB has adopted an annual process to deal with non-urgent but necessary amendments to IFRSs. Issues dealt with in this process arise from matters raised by the IFRIC and suggestions from staff or practitioners, and focus on areas of inconsistency in IFRSs or where clarification of wording is required. As a result, the Board evaluates whether an amendment is appropriate to address the identified issue in this project the same way as it evaluates all other

technical agenda decisions which requires judgment. The adopted improvements are published in a single omnibus exposure draft in the third or fourth quarter of each year.

7. Discuss the composition and role of The International Accounting Standards Board.

The IASB currently consists of sixteen members appointed by the trustees. The key qualification for membership is technical expertise. The trustees also must ensure that the Board is not dominated by any particular constituency or regional interest; consequently, the following guidelines have been established: 1.

2.

3.

4.

5.

A minimum of five will have a background as practicing auditors.

A minimum of three will have a background in the preparation of financial statements.

A minimum of three will have a background as users of financial statements.

At least one member will have an academic background.

Seven of the full-time members will be expected to have formal liaison responsibilities with national standards setters in order to promote the convergence of national accounting standards with IASB standards.

8. Discuss the duties of the trustees of the International Accounting Standards Committee Foundation.

The trustees’ duties include: 1. Appointing the members of the Board, including those who will serve in liaison capacities with national standard setters, and establish their contracts of service and performance criteria.

2. Appointing the members of the Standing Interpretations Committee and the Standards Advisory Council.

3. Reviewing annually the strategy of the IASB and its effectiveness.

4. Approving annually the budget of the IASB and determine the basis for funding.

5. Reviewing broad strategic issues affecting accounting standards, promote IASB and its work, and promote the objective of rigorous application of International Accounting Standards, provided that the trustees shall be excluded from involvement in technical matters relating to accounting standards.

6. Establishing and amending operating procedures for the Board, the Standing Interpretations Committee, and the Standards Advisory Council (SAC).

7. Approving amendments to this constitution after following a due process, including consultation with the SAC and publication of an exposure draft for public comment.

9. Discuss the role of The International Financial Reporting Interpretations Committee The IASC originally did not issue interpretations of its standards, however, after noting criticism it began issuing interpretations of its standards, beginning in 1997.

Later the IASB established the International Financial Reporting Interpretations Committee (IFRIC).

The role of the IFRIC has evolved and was clarified by the publication of the IFRIC handbook in 2007. The IFRIC is comprised of fourteen members, appointed by the trustees of the IASB for renewable terms of three years. The trustees appoint a member of the IASB, the director of technical activities or another senior member of the IASB staff, or another appropriately qualified individual, to chair the committee. The chair has the right to speak about the technical issues being considered but not to vote. The trustees also may appoint as nonvoting observers, representatives of regulatory organizations, who have the right to attend and speak at meetings.

The committee (a) interprets the application of International Accounting Standards (IASs) and International Financial Reporting Standards (IFRSs) and provides timely guidance on financial reporting issues not specifically addressed in IASs and IFRSs, in the context of the IASB Framework, and undertakes other tasks at the request of the IASB; (b) in carrying out its work under (a) above, it must have regard to the IASB’s objective of working actively with national standard setters to bring about convergence of national accounting standards and IASs and IFRSs to high-quality solutions; (c) publish after clearance by the IASB the draft Interpretations for public comment and consider comments made within a reasonable period before finalizing an Interpretation; and (d) report to the IASB and obtain its approval for final Interpretations.

10. In 2013 a new organization, the Accounting Standards Advisory Forum (ASAF), was added to the IASB’s organizational structure. What is the purpose of the ASAF? The ASAF was established to: 1. Support the IFRS Foundation in its objectives, and contribute toward the development, in the public interest, of a single set of high‐quality understandable, enforceable, and globally accepted financial reporting standards to serve investors and other market participants in making informed resource allocations and other economic decisions.

2. Formalize and streamline the IASB’s collective engagement with the global community of national standard setters and regional bodies in its standard‐setting process to ensure that a broad range of national and regional input on major technical issues related to the IASB’s standard‐setting activities are discussed and considered.

3. Facilitate effective technical discussions on standard‐setting issues, primarily on the IASB’s work plan, but which may include other issues that have major implications for the IASB’s work, in sufficient depth, with representatives at a high level of professional capability and with a good knowledge of their jurisdictions/regions 11. How are IASB standards used by various countries?

International accounting standards are used in a variety of ways. The IASB noted that its standards are used: 1.

2.

3.

4.

As national requirements.

As the basis for some or all national requirements.

As an international benchmark for those countries that develop their own requirements.

By regulatory authorities for domestic and foreign companies.

5. By companies themselves.

In addition, the International Organization of Securities Commissions (IOSCO) looks to the IASB to provide International Accounting Standards that can be used in multinational securities offerings.

Currently, several stock exchanges in different countries require or allow issuers to prepare financial statements in accordance with International Accounting Standards 12. Discuss the Short-term International Convergence Project The goal of the FASB’s Short-term International Convergence Project is to remove a variety of individual differences between U.S. GAAP and International Financial Reporting Standards that are not within the scope of other major projects. The project’s scope is limited to those differences in which convergence around a high-quality solution would appear to be achievable in the short term, usually by selecting between existing IFRS and U.S. GAAP. The FASB intends to analyze each of the differences within the scope and either (1) amend applicable U.S. GAAP literature to reduce or eliminate the difference or (2) communicate to the IASB the Board’s rationale for electing not to change U.S. GAAP. Concurrently, the IASB will review IFRS and make similar determinations of whether to amend applicable IFRS or communicate its rationale to the FASB for electing not to change the IASB’s GAAP. The FASB originally set September 30, 2004, as the target date for issuing final for issuing final statements covering some, if not all, of the identified differences. Later the target completion date was reset for December 2011, but many projects are still to be completed at the time this text was published.

13. Discuss the IASB-FASB Norwalk agreement.

The FASB and the IASB held a joint meeting in Norwalk, Connecticut, on September 18, 2002.

Both standard-setting bodies acknowledged their commitment to the development of high-quality compatible accounting standards that can be used for both domestic and cross-border financial reporting. They also promised to use their best efforts to make their existing financial reporting standards compatible as soon as practicable and to coordinate their future work programs to maintain compatibility.

To this end, both Boards agreed to: 1.

Undertake a short-term project aimed at removing a variety of differences between U.S. GAAP and IFRSs. 2. Remove any other differences between IFRSs and U.S. GAAP that remained on January 1, 2005, by undertaking projects that both Boards would address concurrently.

3. Continue the progress on the joint projects currently underway.

4. Encourage their respective interpretative bodies to coordinate their activities.

The goal of this project is to achieve compatibility by identifying common high-quality solutions.

14. What is the objective of the joint FASB-IASB Convergence Project?

The objective of convergence of accounting standards is to have companies in different countries use the same accounting procedures to measure and report their financial position and results of operations.

15. Under rules enacted prior to 2007, how could a foreign company list its securities for sale in U. S. capital markets? How did this rule change?

Prior to 2007, foreign companies seeking to list on a U.S. stock exchange must have recast their financial statements to reflect then current GAAP. This reconciliation was made by filing Form 20F with the SEC within six months of the company’s fiscal year-end. In 2007, the SEC modified its position on the Form 20-F requirement when it issued; “Acceptance from Foreign Private Issuers of Financial Statements Prepared in Accordance with International Financial Reporting Standards without Reconciliation to GAAP.” This rule amends Form 20-F to accept from foreign private issuers in their filings with the SEC financial statements prepared in accordance with International Financial Reporting Standards as issued by the International Accounting Standards Board without reconciliation to generally accepted accounting principles as used in the United States. The SEC’s rationale for this action was to foster the adoption of a set of globally accepted accounting standards. However, the requirements regarding reconciliation to U.S. GAAP do not change for a foreign private issuer that files its financial statements using a basis of accounting other than IFRSs. 16. Discuss the objectives of accounting as defined by chapter 1 of the IASB’s Framework for the Preparation of Financial Statements.

Chapter 1 of the IASB’s Framework for the Preparation of Financial Statements. states that the objective of financial reporting is to provide financial information that is useful to users in making decisions relating to providing resources to the entity.

Users of financial reports are defined as an entity’s existing and potential investors, lenders and other creditors. Those users must rely on financial reports for much of the financial in-formation they need.

Users decisions include: • Buying, selling or holding equity or debt instruments • Providing or settling loans and other forms of credit • Voting, or otherwise influencing management’s actions In making these decisions, users assess: • The prospects for future net cash inflows to the entity • Management’s stewardship of the entity’s economic resources To make both these assessments, users need information about both

• •

The entity’s economic resources, claims against the entity and changes in those resources and claims How efficiently and effectively management has discharged its responsibilities to use the entity’s economic resources

17. Discuss the qualitative characteristics of accounting information as defined in chapter 2 of the IASB’s Framework for the Preparation of Financial Statements. The IASB also described how certain qualities enhance the usefulness of information and how the cost of information affects its usefulness. List those enhancing qualities.

The framework describes qualitative characteristics as the attributes that make the information provided in financial statements useful. The following two qualitative characteristics were defined.

Relevance • Information is relevant if it is capable of making a difference in the decisions made by users • Financial information is capable of making a difference in decisions if it has predictive value or confirmatory value or both Faithful representation • Information must faithfully represent the substance of what it purports to represent • A faithful representation is, to the maximum extent possible, complete, neutral and free from error • A neutral depiction is supported by the exercise of prudence. Prudence is the exercise of caution when making judgements under conditions of uncertainty.

• A faithful representation is affected by level of measurement uncertainty The chapter states that the following four qualitative characteristics enhance the usefulness of information; but cautions that they cannot make non-useful information useful: • Comparability - Information about a reporting entity is more useful if it can be compared with a similar in-formation about other entities and with similar information about the same entity for another period or an-other date.

• Verifiability - Verifiability helps to assure users that information represents faith-fully the economic phenomena it purports to represent.

• Timeliness - Information is available to decision-makers in time to be capable of influencing their decisions.

• Understandability - Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyze the information with diligence.

18. Discuss the elements of financial statements defined by Chapter 4 of the IASB’s Framework for the Preparation of Financial Statements.

The elements directly related to the measurement of financial position in the balance sheet are assets, liabilities, and equity. These elements were defined as follows:

Asset. A present economic resource controlled by the entity as a result of past events. (An economic resource is a right that has the potential to produce economic benefits.)

Liability. A present obligation of the entity to transfer an economic resource as a result of past events.

Equity. The residual interest in the assets of the enterprise after deducting all its liabilities.

The elements directly related to the measurement of performance in the income statement are income and expenses. These elements were defined as follows: Income. Increases in economic benefits during the accounting period in the form of inflows or enhancement of assets or the decreases in liabilities that result in increases in equity, other than those relating to contributions from equity participants.

Expenses. Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to contributions from equity participants.

19. Discuss the concepts of capital and capital maintenance discussed in the Framework for the Preparation of Financial Statements.

The final issues addressed in the revised conceptual framework were concepts of capital. The proposals in this chapter were carried forward from the 2010 Conceptual Framework that defined two concepts of capital – financial and physical.

The financial concept of capital, capital was defined as being synonymous with the net assets or equity of the enterprise. Under a physical concept of capital, capital is regarded as the productive capacity of the enterprise. The 2010 framework indicated that the selection of the appropriate concept of capital by an enterprise should be based on the needs of the user of its financial statements. As a consequence, a financial concept of capital should be adopted if users are concerned primarily with the maintenance of nominal invested capital or the purchasing power of invested capital. However, if the users’ main concern is with the operating capacity of an enterprise, a physical concept of capital should be used. As a result, the following concepts of capital maintenance may be used: •

•

Financial capital maintenance. Profit is earned only if the financial (or money) amount of net assets at the end of the period exceeds the net asset at the beginning of the period excluding any distributions to or contributions from owners.

Physical capital maintenance. Profit is earned only if the physical productive capacity (or operating capacity) of the enterprise exceeds the physical productive capacity at the beginning of the period.

Finally, the 2010 framework noted that the selection of the measurement bases and concept of capital maintenance will determine the accounting model used in preparing financial statements.

Also, since different accounting models differ with respect to relevance and reliability,

management must seek a balance between these qualitative characteristics. At the current time, the IASB does not intend to prescribe a particular model other than for exceptional circumstances, such as for reporting in the currency of a hyperinflationary economy.

20. Discuss IFRS No. 1, “First Time Adoption of International Reporting Standards.

IFRS No. 1, “First Time Adoption of International Reporting Standards,” requires an entity to comply with every IASB standard in force in the first year when the entity adopts IFRSs, with some targeted and specific exceptions after consideration of the cost of full compliance. Under IFRS No. 1, entities must explain how the transition to IASB standards affects their reported financial position, financial performance, and cash flows.

IFRS No. 1 requires an entity to comply with each IFRS that has become effective at the reporting date of its first financial statements issued under IASB standards. The following principles apply: 1. Recognize all assets and liabilities whose recognition is required under existing IFRSs; 2. Do not recognize items as assets or liabilities when existing IFRSs do not allow for such recognition; 3. Reclassify assets, liabilities, and equity as necessary to comply with existing IFRSs; and 4. Apply existing IFRSs in measuring all recognized assets and liabilities.

21. On December 18, 2014, as part of its Disclosure Initiative,28 the IASB issued amendments to IAS No. 1 to encourage companies to apply professional judgment in determining what information to disclose and how to structure it in their financial statements. What are the key aspects of this proposal?

The key provisions of the amendments include: 1. Materiality—Clarifies that entities should not obscure information by aggregating or providing immaterial information and that materiality considerations apply to all parts of the financial statements, even when a standard requires a specific disclosure.

2. Statement of financial position and statement of profit or loss and other comprehensive income—Explains that the list of line items to be presented in these statements can be disaggregated and aggregated as relevant and that an entity’s share of other comprehensive income of equity‐accounted associates and joint ventures should be presented in the aggregate as a single line item according to whether the share will subsequently be reclassified as profit or loss.

3. Notes—Add examples of possible ways to arrange the notes to clarify that entities should consider understandability and comparability when determining the order of the notes and to demonstrate that the notes need not be presented in the order listed in paragraph 114 of IAS No. 1. The IASB also removed guidance and examples related to the identification of significant accounting policies that were perceived as potentially unhelpful.

Chapter 4 Multiple Choice 1. Which of the following research approaches emphasizes going from the specific to the general? a. Deductive b. Behavioral c. Inductive d. Pragmatic Answer c 2. Which of the following research approaches is based on the concept of utility or usefulness? a. Deductive b. Behavioral c. Inductive d. Pragmatic Answer d 3. Which of the following research approaches is attributed to DR Scott? a. Deductive b. Ethical c. Inductive d. Pragmatic Answer b 4. Which of the following outcomes of providing accounting information is an attempt to identify individual securities that are mispriced by reviewing all available financial information? a. Agency theory b. Efficient markets c. Fundamental analysis d. Capital asset pricing model Answer c 5. Which of the following outcomes of providing accounting information is an attempt to deal with both risks and returns? a. b. c. d.

Agency theory Efficient markets Fundamental analysis Capital asset pricing model

Answer d 6. Which of the following outcomes of providing accounting information is based on the supply and demand model? a. Agency theory b. Efficient markets c. Fundamental analysis d. Capital asset pricing model Answer b 7. The efficient market hypothesis holds that that financial markets price assets at their intrinsic worth, given all available information. Which of the following forms of the efficient market hypothesis defines all available information as knowledge of past security prices? a. Weak b. Semi-weak c. Semi-strong d. Strong Answer a 8. The efficient market hypothesis holds that that financial markets price assets at their intrinsic worth, given all available information. Which of the following forms of the efficient market hypothesis defines all available information as all publicly available information including past stock prices? a. Weak b. Semi-weak c. Semi-strong d. Strong Answer c 9. The efficient market hypothesis holds that that financial markets price assets at their intrinsic worth, given all available information. Which of the following forms of the efficient market hypothesis defines all available information as information, including security price trends, publicly available information, and insider information? a. Weak b. Semi-weak c. Semi-strong d. Strong Answer d 10. Which of the following anomalies are related to particular time periods?

a. b. c. d.

Calendar anomalies Value anomalies Technical anomalies Other anomalies

Answer a 11. Which of the following anomalies are related to strategies designed to outperform the market? a. Calendar anomalies b. Value anomalies c. Technical anomalies d. Other anomalies Answer b 12. Which of the following anomalies are related to investing techniques that attempt to forecast security prices by studying past prices and other related statistics? a. Calendar anomalies b. Value anomalies c. Technical anomalies d. Other anomalies Answer c 13. Which of the following cognitive biases in finance suggests that the majority of people perceive a dividend dollar differently from a capital gains dollar? a.

Mental accounting b.

Biased expectations c.

Reference dependence d.

Representativeness heuristic: Answer a 14. Which of the following cognitive biases in finance suggests that people tend to be overconfident in their predictions of the future a.

Mental accounting b.

Biased expectations c.

Reference dependence d.

Representativeness heuristic: Answer b 15. Which of the following cognitive biases in finance suggests that people tend to judge Event A to be more probable than Event B when A appears more representative than B.

a. b. c. d.

Mental accounting Biased expectations Reference dependence Representativeness heuristic

Answer d 16. What theory on the outcomes of providing accounting information attempts to answer the question: What is an individual’s expected benefit from a particular course of action? a. Agency theory b. Efficient markets c. Fundamental analysis d. Capital asset pricing model Answer a 17. Which of the following is not viewed as a cost to the principal in an agency relationship? a. Monitoring expenditures by the principal b. Monitoring expenditures by the agent c. Bonding expenditures by the agent d. The residual loss Answer b 18. What theory on the outcomes of providing accounting information attempts to assess an individual’s ability to use information? a. Agency theory b. Efficient markets c. Human information processing d. Capital asset pricing model Answer c 19. Which of the following is not a conclusion that has been drawn from human information processing research? a. An individual’s perception of information is quite selective. That is, since individuals are capable of comprehending only a small part of their environment, their anticipation of what they expect to perceive about a particular situation will determine to a large extent what they do perceive. b. Since individuals make decisions on the basis of a small part of the total information available, they do not have the capacity to make optimal decisions c. Individuals are able to process and integrate large amounts of information simultaneously d. Since individuals are incapable of integrating a great deal of information, they process information in a sequential fashion.

Answer c 20. What theory on the outcomes of providing accounting information rejects the view that knowledge of accounting is grounded in objective principles a. Agency theory b. Critical perspective c. Fundamental analysis d. Capital asset pricing model Answer b Essay 1. Briefly describe the following research approaches: a.

Deductive

The deductive approach to the development of theory begins with the establishment of objectives.

Once the objectives have been identified, certain key definitions and assumptions must be stated.

The researcher must then develop a logical structure for accomplishing the objectives, based on the definitions and assumptions. This methodology is often described as “going from the general to the specific b.

Inductive

The inductive approach to research emphasizes making observations and drawing conclusions from those observations. Thus, this method is described as “going from the specific to the general” because the researcher generalizes about the universe on the basis of limited observations of specific situations. c.

Scientific method

The scientific method of inquiry, as the name suggests, was developed for the natural and physical sciences and not specifically for social sciences such as accounting. There are some clear limitations on the application of this research methodology to accounting; for example, the influence of people and the economic environment make it impossible to hold the variables constant. Nevertheless, an understanding of the scientific method can provide useful insights as to how research should be conducted.

Conducting research by the scientific method involves five major steps, which may also have several substeps: i. Identify and state the problem to be studied. ii. State the hypotheses to be tested.

iii. Collect the data that seem necessary for testing the hypotheses. iv. Analyze and evaluate the data in relation to the hypotheses. v. Draw a tentative conclusion.

2. What is fundamental analysis and what is its goal?

Fundamental analysis is an attempt to identify individual securities that are mispriced by reviewing all available financial information. These data are then used to estimate the amount and timing of future cash flows offered by investment opportunities and to incorporate the associated degree of risk to arrive at an expected share price for a security. This discounted share price is then compared to the current market price of the security, thereby allowing the investor to make buy–hold–sell decisions.

3. Describe the efficient market hypothesis and its three forms.

The efficient market hypothesis is an attempt to use the economic supply and demand model to determine (1) what information about a company is of value to investors and (2) does the form of the disclosure of various types of corporate information affect the understandability of that information?

This theory maintains that the price of a company’s stock accurately reflects the company’s value after incorporating the information available. As a result, knowledge of available information will not allow an investor to make excess returns. The three forms of the efficient market hypothesis (EMH) differ on the definition of available information.

According to the weak form of the EMH all available information is defined as knowledge of past stock prices.

Under the semistrong form of the EMH, all publicly available information including past stock prices is assumed to be important in determining security prices.

According to the strong form of the EMH, all information, including security price trends, publicly available information, and insider information, is impounded into security prices in such a way as to leave no opportunity for excess returns.

4. According to finance theory, a financial market anomaly occurs when the performance of a stock or a group of stocks deviates from the assumptions of the efficient market hypothesis. Katz has classified anomalies into four basic types.

Required: a. What are these four types of anomalies? b. Give examples of each.

a. The four types of anomalies identified by Katz are calendar anomalies, value (fundamental) anomalies, technical anomalies, and other anomalies.

Examples of Calendar Anomalies Weekend Effect Stock prices are likely to fall on Monday; consequently, the Monday closing price is less than the closing price of previous Friday.

Turn‐of‐the‐Month Effect The prices of stocks are likely to increase on the last trading day of the month and the first three days of the next month.

Turn‐of‐the‐Year Effect The prices of stocks are likely to increase during the last week of December and the first half month of January January Effect Small‐company stocks tend to generate greater returns than other asset classes and the overall market in the first two to three weeks of January.

Examples of Value Anomalies Low Price‐to‐Book Ratio Stocks with a low ratio of market price to book value generate greater returns than stocks having a high ratio of book value to market value.

High Dividend Yield Stocks with high dividend yields tend to outperform low dividend yield stocks.

Low Price‐to‐Earnings Ratio (P/E) Stocks with low price‐to‐earnings ratios are likely to generate higher returns and outperform the overall market, whereas the stocks with high market price‐to‐earnings ratios tend to underperform the overall market Examples of Technical Anomalies Moving Average Moving average is a trading strategy that involves buying stocks when short‐term averages are higher than long‐term averages and selling stocks when short‐term averages fall below their long‐term averages.

Trading Range Break Trading range break is a trading strategy based on resistance and support levels. A buy signal is created when the prices reaches a resistance level. A sell signal is created when prices reach the support level Neglected Stocks Prior neglected stocks tend to generate higher returns than th overall market in subsequent periods, and the prior best performers tend to underperform the overall market.

Trading Range Break Trading range break is a trading strategy based on resistance and support levels. A buy signal is created when the prices reaches a resistance level. A sell signal is created when prices reach the support level.

Examples of Other Anomalies The Size Effect Small firms tend to outperform larger firms.

Announcement‐Based Effects and Post‐Earnings Announcement Drift Price changes tend to persist after initial announcements. Stocks with positive surprises tend to drift upward, and those with negative surprises tend to drift downward.

IPOs, Seasoned Equity Offerings, and Stock Buybacks Stocks associated with initial public offerings (IPOs) tend to underperform the market, and there is evidence that secondary offerings also underperform, whereas stocks of firms announcing stock repurchases outperform the overall market in the following years.

Insider Transactions There is a relationship between transactions by executives and directors in their firm’s stock and the stock’s performance. These stocks tend to outperform the overall market.

The S&P Game Stocks rise immediately after being added to the S&P 500.

5. Kahneman and Tversky studied how people manage risk and uncertainty and developed a theory to describe it they termed prospect theory. Discuss the characteristics of prospect theory.

Prospect theory is characterized by the following: Certainty: People have a strong preference for certainty and are willing to sacrifice income to achieve more certainty. For example, if option A is a guaranteed win of $1,000, and option B is an 80 percent chance of winning $1400 but a 20 percent chance of winning nothing, people tend to prefer option A. Loss aversion: People tend to give losses more weight than gains: They’re loss‐averse. So, if you gain $100 and lose $80, it may be considered a net loss in terms of satisfaction, even though you came out $20 ahead, because you tend to focus on how much you lost, not on how much you gained.

Relative positioning: People tend to be most interested in their relative gains and losses as opposed to their final income and wealth. If your relative position doesn’t improve, you won’t feel any better off, even if your income increases dramatically. In other words, if you get a 10 percent raise and your neighbor gets a 10 percent raise, you won’t feel better off. But if you get a 10 percent raise and your neighbor doesn’t get a raise at all, you’ll feel rich.

Small probabilities: People tend to underreact to low‐probability events. For example, you might completely discount the probability of losing all your wealth if the probability is very small. This tendency can result in people making very risky choices.

6. Define the following cognitive biases: a. Mental accounting:

The majority of people perceive a dividend dollar differently from a capital gains dollar.

Dividends are perceived as an addition to disposable income; capital gains usually are not. b. Biased expectations: People tend to be overconfident in their predictions of the future. If security analysts believe with 80 percent confidence that a certain stock will go up, they are right about 40 percent of the time. Between 1973 and 1990, earnings forecast errors have been anywhere between 25 percent and 65 percent of actual earnings. c. Reference dependence: Investment decisions seem to be affected by an investor’s reference point. If a certain stock was once trading for $20, then dropped to $5 and finally recovered to $10, the investor’s propensity to increase holdings of this stock depends on whether the previous purchase was made at $20 or at $5. d. Representativeness heuristic: In cognitive psychology this term means simply that people tend to judge Event A to be more probable than Event B when A appears more representative than B. In finance, the most common instance of the representativeness heuristic is that investors mistake good companies for good stocks. Good companies are well-known and in most cases fairly valued.

Their stocks, therefore, might not have a significant upside potential.

7. Discuss the capital asset pricing model including the concepts of unsystematic risk, systematic risk and beta.

The capital asset pricing model (CAPM) is an attempt to deal with both risks and returns. The actual rate of return to an investor from buying a common stock and holding it for a period of time is calculated by adding the dividends to the increase (or decrease) in value of the security during the holding period and dividing this amount by the purchase price of the security or

Dividends + increase (or − decrease) in value Purchase price Since stock prices fluctuate in response to changes in investor expectations about the firm’s future cash flows, common stocks are considered risky investments. In contrast, U.S. Treasury bills are not considered risky investments because the expected and stated rates of return are equal (assuming the T-bill is held to maturity). Risk is defined as the possibility that actual returns will deviate from expected returns, and the amount of potential fluctuation determines the degree of risk.

A basic assumption of the CAPM is that risky stocks can be combined into a portfolio that is less risky than any of the individual common stocks that make up that portfolio. This diversification attempts to match the common stocks of companies in such a manner that environmental forces causing a poor performance by one company will simultaneously cause a good performance by another, for example, purchasing the common stock of an oil company and an airline company.

Although such negative relationships are rare in our society, diversification will reduce risk.

Some risk is peculiar to the common stock of a particular company. On the other hand, overall environmental forces cause fluctuations in the stock market that affect all stock prices.

These two types of risk are termed unsystematic risk and systematic risk. Unsystematic risk is that portion of risk peculiar to a company that can be diversified away. Systematic risk is the nondiversifiable portion that is related to overall movements in the stock market and is consequently unavoidable. Earlier in the chapter, we indicated that the EMH suggests that investors cannot discover undervalued or overvalued securities because the market consensus will quickly incorporate all available information into a firm’s stock price. However, financial information about a firm can help determine the amount of systematic risk associated with a particular stock.

Since investors can eliminate the risk associated with acquiring a particular company’s common stock by purchasing diversified portfolios, they are not compensated for bearing unsystematic risk.

And since well-diversified investors are exposed only to systematic risk, investors using the CAPM as the basis for acquiring their portfolios will be subject only to systematic risk. Consequently, systematic risk is the only relevant and investors will be rewarded with higher expected returns for bearing market-related risk that will not be affected by company-specific risk.

The measure of the parallel relationship of a particular common stock with the overall trend in the stock market is termed beta (β). β may be viewed as a gauge of a particular stock’s volatility to the total stock market.

A stock with a β of 1.00 has a perfect relationship to the performance of the overall market as measured by a market index such as the Dow-Jones Industrials or the Standard & Poor’s 500-stock index. Stocks with a β of greater than 1.00 tend to rise and fall by a greater percentage than the market, whereas stocks with a β of less than 1.00 are less likely to rise and fall than the general market index over the selected period of analysis. Therefore, β can be viewed as a stock’s sensitivity to market changes and as a measure of systematic risk 8. Discuss the difference between normative and positive accounting theory.

There are two basic types of theory: normative and positive. Normative theories are based on sets of goals that proponents maintain prescribe the way things should be. However, there is no set of goals that is universally accepted by accountants. As a consequence, normative accounting theories are usually acceptable only to those individuals who agree with the assumptions on which they are based. Nevertheless, most accounting theories are normative because they are based on certain objectives of financial reporting.

Positive theories attempt to explain observed phenomena. They describe what is without indicating how things should be. The extreme diversity of accounting practices and application has made development of a comprehensive description of accounting difficult. Concurrently, to become a theory, description must have explanatory value. For example, not only must the use of historical cost be observed, but under positive theory that use must also be explained. Positive accounting theory has arisen because existing theory does not fully explain accounting practice.

9. What is the basic assumption of agency theory? Why is the relationship between shareholders and management an agency relationship?

The basic assumption of agency theory is that individuals maximize their own expected utilities and are resourceful and innovative in doing so.

An agency is defined as a consensual relationship between two parties, whereby one party (agent) agrees to act on behalf of the other party (principal). For example, the relationship between shareholders and managers of a corporation is an agency relationship, as is the relationship between managers and auditors and, to a greater or lesser degree, that between auditors and shareholders.

An agency relationship exists between shareholders and managers because the owners don’t have the training or expertise to manage the firm themselves, have other occupations, and are scattered around the country and the world. Consequently, the stockholders must employ someone to represent them. These employees are agents who are entrusted with making decisions in the shareholders’ best interests. However, the shareholders cannot observe all of the actions and decisions made by the agents, so a threat exists that the agents will act to maximize their own wealth rather than that of the stockholders. This is the major agency theory issue—the challenge of ensuring that the manager/agent operates on behalf of the shareholders/principals and maximizes their wealth rather than his or her own.

10. Agency relationships involve costs to the principals. Discuss these costs. Give some examples of each of these costs.

Agency relationships involve costs to the principals. The costs of an agency relationship have been defined as the sum of monitoring expenditures by the principal, bonding expenditures by the agent, and the residual loss. Monitoring expenditures are defined as expenditures by the principal to control the agent’s behavior, for example, the costs of measuring and observing the agent’s behavior or the costs of establishing compensation policies. Bonding costs are defined as expenditures to guarantee that the agent will not take certain actions to harm the principal’s interest.

Finally, even with monitoring and bonding expenditures, the actions taken by the agent will differ from the actions the principal would take if the wealth effect of this divergence inactions is defined as residual loss.

Examples of monitoring costs are external and internal auditors, the SEC, capital markets including underwriters and lenders, boards of directors, and dividend payments. Examples of bonding costs include managerial compensation, including stock options and bonuses and the threat of a takeover

if mismanagement causes a reduction in stock prices. Residual losses are the extent to which returns to the owners fall below what they would be if the principals and the owners exercised direct control of the corporation.

11. What is the goal of human information processing studies? What are the general findings of these studies and what is the implication for accounting?

Studies attempting to assess an individual’s ability to use information have been broadly classified under the title human information processing (HIP) research. The issue addressed by these studies is, how do individuals use available information?

In general, HIP research has indicated that individuals have a very limited ability to process large amounts of information. This finding has three main consequences. a. An individual’s perception of information is quite selective. That is, since individuals are capable of comprehending only a small part of their environment, their anticipation of what they expect to perceive about a particular situation will determine to a large extent what they do perceive. b. Since individuals make decisions on the basis of a small part of the total information available, they do not have the capacity to make optimal decisions. c. Since individuals are incapable of integrating a great deal of information, they process information in a sequential fashion.

In summary, individuals use a selective, stepwise information processing system. This system has limited capacity, and uncertainty is frequently ignored.

These findings may have far-reaching disclosure implications for accountants. The current trend of the FASB and SEC is to require the disclosure of more and more information. But if the tentative conclusions of the HIP research are correct, these additional disclosures may have an effect opposite to what was intended. The goal of the FASB and SEC is to provide all relevant information so that individuals may make informed decisions about a company. However, the annual reports may already contain more information than can be adequately and efficiently processed by individuals.

12. Discuss the concept of critical perspectives research in accounting.

Critical perspective research rejects the view that knowledge of accounting is grounded in objective principles. Rather, researchers adopting this viewpoint share a belief in the indeterminacy of knowledge claims. Their indeterminacy view rejects the notion that knowledge is externally grounded and is revealed only through systems of rules that are superior to other ways of understanding phenomena. Critical perspective researchers attempt to interpret the history of accounting as a complex web of economic, political, and accidental co-occurrences.

They have also argued that accountants have been unduly influenced by one particular viewpoint in economics (utility-based, marginalist economics). The economic viewpoint holds that business organizations trade in markets that form part of a society’s economy. Profit is the result of these activities and is indicative of the organization’s efficiency in using society’s scarce resources. In addition, critical perspective researchers maintain that accountants have also taken as given the current institutional framework of government, markets, prices, and organizational forms, with the result that accounting serves to aid certain interest groups in society to the detriment of other interest groups.

13. In their book, “The End of Accounting and the Path Forward for Investors and Managers,” Baruch Lev and Feng Gu maintain that flaws in generally accepted accounting principles severely limit the usefulness of financial reporting. What are the three major reasons the authors indicate why accounting reports have lost relevance? What is their solution to this perceived problem?

The authors state that there are three major reasons why accounting reports have lost relevance: 1. The treatment of intangible assets. In the past few decades, the major corporate value drivers have shifted from property, plant, machinery, and inventories, to patents, brands, information technology, and human resources. That is, studies have shown that since the 1990s companies spend more on intangible assets and other strategic assets such as: brand development, advertising and marketing and unique personal talents; than on physical assets. However, GAAP has failed to adapt to this change and has continued to treat the cost of internally developed intangibles as ordinary expenses. L&G document that investment in physical assets declined by 35 percent; whereas, investment in intangible assets has increased by almost 60 percent since 1977.

2. Accounting has become less about facts and more and more about manager’s subjective judgments, estimates, and projections. That is, there has been a move away from strictly reporting items at their historical cost. Accounting regulations have increasingly required financial statement items to be revalued by using estimates such as fair value. L&G found a fivefold increase in the use of estimates during the 1995-2015 period.

3. The increase in unrecorded business events that affect corporate value (competitor moves, regulatory changes, restructurings, alliances, etc.). These events are reported to the SEC on form 8-K but are not formally entered in the accounting records. L&G found a threefold increase in these events during the 1994-2013 period.

Their solution is to report on an information system titled “The Strategic Resources and Consequences Report (SRCR)”. SRCR is mainly based on non-accounting information and focuses on a company’s business model and its execution. SRCR highlights what the authors term “fundamental indicators” such as internet and telecom companies’ new-customer additions and existing customer churn rates; car insurers’ accident severity and frequency and policy-renewal rates; biotech and pharmaceutical company clinical trial results; and energy companies’ proven oil and gas reserves. The SRCR contains the following five usefulness attributes.

1. Inform investors about the strategic resources available to the firm such as patents.

2. Inform investors about the expenditures made to acquire the strategic assets.

3. Inform investors about the major risks to the strategic assets such as patent infringement and the measures taken to mitigate those risks.

4. Inform investors how the company intends to extract value from the use of its strategic assets.

5. Inform investors of the quantifiable value achieved by using the strategic assets.

14. Discuss the relationship among research, education, and practice in accounting.

Research is necessary for effective theory development. In most professional disciplines, when research indicates that a preferable method has been found to handle a particular situation, the new method is taught to students, who then implement the method as they enter their profession. Simply stated, research results in education that influences practice.

The accounting profession has been criticized for not following this model. In fact, prior to the FASB’s development of the conceptual framework, research and normative theory had little impact on accounting education. During this previous period, students were taught current accounting practice as the desired state of affairs, and theoretically preferred methods were rarely discussed in accounting classrooms. As a result, the use of historical cost accounting received little criticism from accounting educators since it was the accepted method of practice, even though it has little relevance to current decision making.

Chapter 5 Multiple Choice 1. One concept of income suggests that income be measured by determining the net change over time in the discounted present value of net cash flow expected to be received by the firm. Under this concept of income, which of the following, ignoring income taxes would not affect the amount of income for a period? a. Providing services to outsiders and investments of the funds received b. Production of goods or services not yet sold not yet delivered to customers or clients. c. Windfall gains and losses due to external causes. d. The method used to depreciate property, plant and equipment.

Answer d 2. The term revenue recognition originally referred to a. The process of identifying transactions to be recorded as revenue in an accounting period. b. The process of measuring and relating revenue and expenses of an enterprise for an accounting period. c. The earning process that gives rise to revenue realization. d. The process of identifying those transactions that result in an inflow of assets from customers.

Answer d 3.

In the traditional transactions approach to income determination, income was measured by subtracting the expenses resulting from specific transactions during the period from revenues of the period also resulting from transactions. Under a strict transactions approach to income measurement, which of the following would not be considered a transaction? a. Sale of goods on account at 20 percent markup b. Exchange of inventory at a regular selling price for equipment c. Adjustment of inventory in lower of cost or market inventory valuations when market is below cost. d. Payment of salaries

Answer c 4. Conventionally accountants measure income a. By applying a value added concept b. By using a transactions approach c. As a change in the value of owners’ equity d. As a change in the purchasing power of owners’ equity Answer b

5. The principal disadvantage of using the percentage of completion method of recognizing revenue from long-term contracts is that it a. Is unacceptable for income tax purposes b. May require that intraperiod tax allocation procedures be used c. Gives results bases upon estimates that may be subject to considerable uncertainty d. Is likely to assign a small amount of revenue to a period during which much revenue was actually earned Answer c 6. One of the basic features of financial accounting is the a. Direct measurement of economic resources and obligations and changes in them in terms of money and sociological and psychological impact b. Direct measurement of economic resources and obligations and changes in them in terms of money c. Direct measurement of economic resources and obligations and changes in them in terms of money and sociological impact d. Direct measurement of economic resources and obligations and changes in them in terms of money and psychological impact Answer b 7 Which of the following is an argument for using historical cost in accounting? a. Fair values are more relevant. b. Historical costs are based on an exchange transaction. c. Historical costs are reliable. d. Fair values are subjective Answer d 8. The basic accounting concept that refers to the tendency of accountants to resolve uncertainty in favor of understating assets and revenues and overstating liabilities and expenses is known as a. the doctrine of conservatism. b. the materiality constraint. c. the substance over form principle. d. the industry practices constraint.

Answer a 9. Uncertainty and risks inherent in business situations should be adequately considered in financial reporting. This statement is an example of the concept of a. Conservatism b. Completeness c. Neutrality d. Representational faithfulness

Answer a 10. Determining periodic earnings and financial position depends on measuring economic resources and obligations and changes in them as these changes occur. This explanation pertains to a. Disclosure b. Accrual accounting c. Materiality d. The matching concept Answer b 11. Which of the following is not a concept of income identified by Bedford? a. Psychic b. Real c. Investment d. Money Answer c 12. The definition of the economic concept of income is usually attributed to which of the following economists? a. J. R. Hicks b. Paul Samuelson c. Ben Bernanke d. Adam Smith Answer a 13.

Which of the following is not an approach to determining current value? a. Replacement cost b. Thrift value c. Selling price d. Discounting present value

Answer b 14. Each asset—inventory, plant, equipment, and so on—would be valued based on the selling price that would be realized if the firm chose to dispose of it is the definition of which of the following current value concepts? a. Replacement cost b. Entry price c. Exit value d. Discounted present value

Answer c 15. The cost to replace assets with similar assets in a similar condition is the definition of which of the following current value concepts? a. Replacement cost b. Selling price c. Exit value d. Discounted present value Answer a 16. Income is equal to the difference between the present value of the net assets at the end of the period and their present value at the beginning of the period, excluding the effects of investments by owners and distributions to owners is the definition of which of the following current value concepts? a. Replacement cost b. Selling price c. Exit value d. Discounted present value Answer d 17. Which of the following is not a criterion outlined in SEC Staff Accounting Bulletin No. 101 for the recognition of revenue? a. Persuasive evidence of an arrangement exists. b. Delivery has not occurred. c. The vendor’s fee is fixed or determinable. d. Collectability is probable.

Answer b 18. Which of the following accounting theorists called of conservatism the most influential principle of valuation in accounting? a. Henry Sweeney b. Robert Sprouse c. Robert Sterling d. Edgar Edwards Answer c 19. The one-time overstatement of restructuring charges to reduce assets, which reduces future expenses, is the definition of which of the following earnings management techniques? a. Taking a bath

b. Creative acquisition accounting c. Creasing “cookie jar” reserves d. Abusing the materiality concept Answer a 20. Deliberately recording errors or ignoring mistakes in the financial statements under the assumption that their impact is not significant, is the definition of which of the following earnings management techniques? a. Taking a bath b. Creative acquisition accounting c. Creasing “cookie jar” reserves d. Abusing the materiality concept Answer d 21. Overstating sales returns or warranty costs in good times and using these overstatements in bad times to reduce similar charges, is the definition of which of the following earnings management techniques? a. Taking a bath b. Creative acquisition accounting c. Creasing “cookie jar” reserves d. Abusing the materiality concept Answer c 22. Under FASB ASC 606, the first step in the revenue recognition process is to a. Determine the transaction price b. Identify the contract with customers c. Allocate transaction price to the separate performance obligations d. Identify the separate performance obligations in the contract Answer b 23. Under FASB ASC 606, the second step in the revenue recognition process is to a. Allocate transaction price to the separate performance obligations b. Determine the transaction price c. Identify the contract with customers d. Identify the separate performance obligations in the contract Answer d 24. Under FASB ASC 606, the third step in the revenue recognition process is to a. Determine the transaction price b. Identify the separate performance obligations in the contract c. Allocate transaction price to the separate performance obligations d. Recognize revenue when each performance obligation is satisfied

Answer a 25. Under FASB ASC 606, the fourth step in the revenue recognition process is to a. Recognize revenue when each performance obligation is satisfied b. Identify the separate performance obligations in the contract c. Allocate transaction price to the separate performance obligations d. Determine the transaction price Answer c 26. Under FASB ASC 606, the last step in the revenue recognition process is to a. Allocate transaction price to the separate performance obligations b. Recognize revenue when each performance obligation is satisfied c. Determine the transaction price d. Identify the contract with customers Answer b 27. According to FASB ASC 606, a company must account for a contract modification as a new contract if the a. Goods or services are interdependent on each other b. Promised goods or services are distinct c. Company has the right to receive consideration equal to standalone price d. Goods or services are distinct and company has right to receive the standalone price Answer d 28. Under FASB ASC 606, when a contract modification does not result in a separate performance obligation, the additional products are priced at the a. Standalone price of the product b. Blended price of original contract and contract modification c. Average selling price of original selling price and standalone price d. Selling price specified in contract modification Answer b 29. According to FASB ASC 606, the transaction price a. Excludes discounts, volume rebates, coupons and free products, or services b. Is the amount of consideration that a company expects to receive from a customer c. Excludes time value of money if the contract involves a significant financing component d. Does not consider noncash consideration such as donations, gifts, equipment or labor Answer b 30. According to FASB ASC 606, a transaction price for multiple performance obligations should be allocated a. Based on selling price from the company’s competitors b. Based on what the company could sell the goods for on a standalone basis c. Based on forecasted cost of satisfying performance obligation d. Based on total transaction price less residual value

Answer b 31. According to FASB ASC 606, a performance obligation exists when a. A company receives the right to receive consideration b. A contract is approved and signed c. A company provides a distinct product or service d. A company provides interdependent product or service Answer c 32. Under FASB ASC 606, when multiple performance obligations exist in a contract, they should be accounted for as a single performance obligation when a. Each service is interdependent and interrelated b. Both performance obligations are distinct but interdependent c. The product is distinct within the contract d. Determination cannot be made Answer a 33. Under the provisions of FASB ASC 606, when a customer purchases a product but is not yet ready for delivery, this is referred to as a. A repurchase agreement b. A consignment c. A principal-agent relationship d. A bill-and-hold arrangement Answer d 34. Under the provisions of FASB ASC 606 A company has satisfied its performance obligation when the a. The company has transferred physical possession of the asset b. The company has received payment for goods or services c. The company has significant risks and rewards of ownership d. The company has legal title to the asset Answer a 35. Phoenix Music Company manufactures and sells stereo systems that include an assurance-type warranty for the first 120 days. Phoenix also offers an optional extended coverage plan under which it will repair or replace any defective part for 2 years beyond the expiration of the assurance-type warranty. The total transaction price for the sale of the stereo system and the extended warranty is $2,000. The standalone price of each is $1,600 and $400, respectively. The estimated cost of the assurance-warranty is $200. The amount assigned to the assurance warranty as unearned warranty revenue should be a. $2,000 b. $1,600 c. $400 d. $200

Answer c 36. Consignments are a specialized marketing method whereby the a. Consignee purchases goods for sale and sends payment when goods are sold b. Consignee (agent) holds title to the product c. Consignee pays for good up front and is paid when merchandise is sold d. Consignee takes possession of merchandise but title remains with manufacturer Answer d 37. Business organizations have long recognized that primarily using financial measures such as sales or profitability to measure performance often fails to provide information about the factors that result in success. One of these factors is sustainability. Which of the following is not a pillar of sustainability identified in chapter 5? a. Phycological b. Economic c. Social d. Environmental Answer a Essay 1. List three reasons why income reporting is important to our economic society.

Alexander lists six reasons why income reporting is important to our economic society: 1.

2.

3.

4.

5.

As the basis of one of the principal forms of taxation.

In public reports as a measure of the success of a corporation’s operations.

As a criterion for determining the availability of dividends.

By rate-regulating authorities for investigating whether those rates are fair and reasonable.

As a guide to trustees charged with distributing income to a life tenant while preserving the principal for a remainderman.

6. As a guide to management of an enterprise in the conduct of its affairs 2. Discuss the differences between the economic and accounting concepts of income.

Economists generally agree that the objective of measuring income is to determine how much better off an entity has become during some period of time. Consequently, economists have focused on the determination of real income. The definition of the economic concept of income is usually credited to the economist J. R. Hicks, who stated: The purpose of income calculation in practical affairs is to give people an indication of the amount which they can consume without impoverishing themselves. Following out this idea it would seem that we ought to define a man’s income as the maximum value which he can

consume during a week, and still expect to be as well off at the end of the week as he was at the beginning.

In an attempt to overcome the measurement problems associated with using the economic concept of income, accountants originally took the position that a transactions approach should be used to account for assets, liabilities, revenues, and expenses. This approach relies on the presumption that the elements of financial statements should be reported when there is evidence of an outside exchange (or an “arm’s-length transaction”).

Transactions-based accounting generally requires that reported income be the result of dealings with entities external to the reporting unit and gives rise to the realization principle. The realization principle holds that income should be recognized when the earnings process is complete or virtually complete and an exchange transaction has taken place.

3. Discuss the three basic concepts of income as defined by Bedford.

Bedford noted that the literature usually discusses three basic concepts of income: 1. Psychic income. Which refers to the satisfaction of human wants.

2. Real income. Which refers to increases in economic wealth.

3. Money income. Which refers to increases in the monetary valuation of resources.

These three concepts are all important, but each has one or more implementation issues.

The measurement of psychic income is difficult because the human wants are not quantifiable and are satisfied on various levels as an individual gains real income.

4. Explain the transaction approach to measuring income. Why is the transaction approach to income measurement preferable to other ways of measuring income?

The transaction approach focuses on the activities that have occurred during a given period and instead of presenting only a net change, a description of the components that comprise the change is included. In the capital maintenance approach, only the net change (income) is reflected whereas the transaction approach not only provides the net change (income) but the components of income (revenues and expenses). The final net income figure should be the same under either approach given the same valuation base.

5. Discuss the difference between financial capital maintenance and physical capital maintenance.

There are two primary concepts of capital maintenance: financial capital maintenance and physical capital maintenance. Financial capital maintenance occurs when the financial (money) amount of enterprise net assets at the end of the period exceeds the financial amount of net assets at the beginning of the period, excluding transactions with owners. This view is transactions based. It is the traditional view of capital maintenance employed by financial accountants.

Physical capital maintenance implies that a return on capital (income) occurs when the physical productive capacity of the enterprise at the end of the period exceeds its physical productive capacity at the beginning of the period, excluding transactions with owners. This concept implies that income is recognized only after providing for the physical replacement of operating assets.

Physical productive capacity at a point in time is equal to the current value of the net assets employed to generate earnings. Current value embodies expectations regarding the future earning power of the net assets.

The primary difference between physical capital maintenance and financial capital maintenance lies in the treatment of holding gains and losses. A holding gain or loss occurs when the value of a balance sheet item changes during an accounting period. For example, when land held by a company increases in value, a holding gain has occurred. Proponents of physical capital maintenance consider holding gains and losses as returns of capital and do not include them in income. Instead, holding gains and losses are treated as direct adjustments to equity. Conversely, under the financial capital maintenance concept, holding gains and losses are considered as returns on capital and are included in income.

6. Define the following terms: a. Entry price When productive capacity is measured using entry price, assets are stated at the cost to replace them with similar assets in similar condition. In order to maintain the entity’s physical productive capacity, it must generate enough cash flows to provide for the physical replacement of operating assets. To determine income under this approach, revenues are matched against the current cost of replacing these assets. Consequently, income can be distributed to the owners without impairing the physical capacity to continue operating into the future. As a result, the appropriateness of using the entry value approach relies on the accounting assumption of business continuity. b. Exit price Determining current value using exit value requires the assessment of each asset from a disposal point of view. Each asset—inventory, plant, equipment, and so on—would be valued based on the selling price that would be realized if the firm chose to dispose of it. In determining the cash equivalent exit price, it is presumed that the asset will be sold in an orderly manner, rather than be subject to forced liquidation’ Because holding gains and losses receive immediate recognition, the exit price approach to valuation completely abandons the realization principle for the recognition of revenues. The critical event for earnings recognition purposes becomes the point of purchase rather than the point of sale. c. Discounted present value When using the present value of the future cash flows expected to be received from an asset (or disbursed for a liability) to determine current value each asset’s discounted present value is the

relevant value of the asset (or liability) that should be disclosed in the balance sheet. Under this method, income is equal to the difference between the present value of the net assets at the end of the period and their present value at the beginning of the period, excluding the effects of investments by owners and distributions to owners. This measurement process is similar to the economic concept of income because discounted present value is perhaps the closest approximation of the actual value of the assets in use ––and hence may be viewed as an appropriate surrogate measure of welloffness.

7. Discuss the four types of income defined by Edwards and Bell.

The four types of income defined by Edwards and Bell are (1) current operating profit—the excess of sales revenues over the current cost of inputs used in production and sold, (2) realizable cost savings—the increases in the prices of assets held during the period, (3) realized cost savings—the difference between historical costs and the current purchase price of goods sold, and (4) realized capital gains—the excess of sales proceeds over historical costs on the disposal of long-term assets.

Edwards and Bell contended that these measures are better indications of well-offness and provide users more information to analyze enterprise results.

8. What conditions must be satisfied in order to recognize revenue according to Staff Accounting Bulletin (SAB) No. 101, “Revenue Recognition in Financial Statements?

The four conditions are: 1. Persuasive evidence of an arrangement exists.

2. Delivery has occurred.

3. The vendor’s fee is fixed or determinable.

4. Collectability is probable.

9. Discuss how revenue might be recognized at various points in a company’s production - sale cycle.

Companies usually recognize revenue when they sell their products or services because the sale fulfills the crucial event criterion. But recognition may be advanced or delayed due to circumstances associated with the sale. For example: 1. When production of the company’s product carries over into two or more periods, the allocation of revenue to the various accounting periods is considered essential for proper reporting. In such cases a method of revenue recognition termed percentage of completion may be used.

2. When the company’s product can be sold at a determinable price on an organized market, revenue may be realized when the goods are ready for sale.

3. In service contracts, realization should generally be connected with the performance of services, and revenue should be recognized in relation to the degree of services performed.

4. In certain circumstances, where the ultimate collectability of the revenue is in doubt, recognition is delayed until cash payment is received. The installment method and the cash recovery method are examples of delaying revenue recognition until the receipt of cash.

However, the APB stated that revenue recognition should not be delayed unless ultimate

collectability is so seriously doubted that an appropriate allowance for the uncollectible amount cannot be estimated.

5. In some cases, where binding contracts do not exist or rights to cancel are in evidence, the level of uncertainty may dictate that revenue recognition be delayed until the point of ratification or the passage of time. For example, some states have passed laws that allow door-to-door sales contracts to be voided within certain periods of time. In such cases, recognition should be delayed until that period has passed.

10. Discuss the matching concept.

Once a company has fulfilled its crucial event and recognized revenue, it must then identify all expenses associated with producing that revenue. This process of associating revenues with expenses is termed the matching concept. From a conceptual standpoint, matching revenues with the associated expenses relates efforts to accomplishments.

11. Define the following terms: a. Holding gains A holding gain or loss occurs when the value of a balance sheet item changes during an accounting period. For example, when land held by a company increases in value, a holding gain has occurred b. Materiality The concept of materiality has had a pervasive influence on all accounting activities despite the fact that no all-encompassing definition of the concept exists. Accounting Research Study No. 7 originally provided the following qualitative definition: A statement, fact or item is material, if giving full consideration to the surrounding circumstances, as they exist at the time, it is of such a nature that its disclosure, or the method of treating it, would be likely to influence or to “make a difference” in the judgment and conduct of a reasonable person.

Later in SFAC No. 8, the FASB made the following statement regarding materiality: Information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity. In other words, materiality is an entity specific aspect of relevance based on the nature or magnitude or both of the items to which the information relates in the context of an individual entity’s financial report. Consequently, the Board cannot specify a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation.

c. Conservatism Simply stated, conservatism holds that when you are in doubt; choose the accounting alternative that will be least likely to overstate assets or income.

12. Discuss the concepts of earnings quality and earnings management including: a. Taking a bath b. Cookie jar reserves c. Improper revenue recognition Earnings quality is defined as the degree of correlation between a company’s accounting income and its economic income. Earnings management is defined as the attempt by corporate officers to influence short-term reported income. a. Taking a bath The one-time overstatement of restructuring charges to reduce assets, which reduces future expenses. The expectation is that the one-time loss is discounted in the marketplace by analysts and investors who will focus on future earnings. b. Cookie jar reserves Overstating sales returns or warranty costs in good times and using these overstatements in bad times to reduce similar charges. c. Improper revenue recognition Recording revenue before it is earned. It was noted that over half of the SEC’s enforcement cases filed in 1999 and 2000 involved improper revenue recognition issues.

13. FASB ASC 606 introduces the concept of a performance obligation in recognizing revenue.

Discuss: a. How a performance obligation is defined under FASB ASC 606? b. How companies determine if a performance obligation exists? a. A performance obligation is a promise in a contract to provide a product or service to a customer. This promise may be explicit, implicit, or possibly based on customary business practice. b. To determine whether a performance obligation exists, a company must determine whether the customer can benefit from the good or service on its own or together with other readily available resources.

14. List the five steps in the revenue recognition process under FASB ASC 606.

The five steps in the revenue recognition under process FASB ASC 606 are: 1.

2.

3.

4.

5.

Identify the contract(s) with customers.

Identify the separate performance obligations in the contract.

Determine the transaction price.

Allocate the transaction price to the separate performance obligations.

Recognize revenue when each performance obligation is satisfied.

15. Norford Truck Company sells tractors to area farmers. The price of each tractor includes GPS service for 12 months The GPS service is regularly sold on a standalone basis by Norford for a monthly fee. After the 12-month period, the consumer can renew the service on a fee basis. How many performance obligations does Norford have?

It appears that Norford has two performance obligations: one related to providing the tractor and the other related to the GPS services. Both are distinct as they can be sold separately and are not interdependent.

16. FASB ASC 606 discusses the concept of transaction price. a. What is the transaction price according to FASB ASC 606? b. What are some additional factors related to the transaction price that must be considered in determining the transaction price? a. The transaction price is defined by FASB ASC 606 as the amount of consideration that a company expects to receive from a customer in exchange for transferring goods and services. b. Some additional factors companies must consider include: (1) Variable consideration, (2) The time value of money, (3) Noncash consideration, and (4) Consideration paid or payable to customer.

17. FASB ASC 606 discusses the concept of variable consideration. a. Under FASB ASC 606, what is variable consideration? b. What are some examples of variable consideration? c. What are the two approaches for estimating variable consideration? a. Variable consideration under FASB ASC 606 occurs when the price of a good or service is dependent on future events. b. Variable consideration includes items such as price or volume discounts, rebates, credits, performance bonuses, or royalties. A company estimates the amount of variable consideration it will receive from the contract to determine the amount of revenue to recognize. c. Companies use either (1) the expected value, which is a probability weighted amount, or (2) the most likely amount in a range of possible amounts to estimate variable consideration.

Companies select among these two methods based on which approach better predicts the

amount of consideration to which a company is entitled. The price of a good or service that is dependent on future events includes such elements as price or volume discounts, rebates, credits, performance bonuses, or royalties. A company estimates the amount of variable consideration it will receive from the contract to determine the amount of revenue to recognize.

18. Felix Corp. is evaluating a contract to determine proper revenue recognition. The contract is for construction of 10 yachts for a total price of $10,000,000. The customer needs the boats in its showrooms by March 1, 2018, for the yacht purchase season; the customer will provide a bonus payment of $100,000 if all yachts are delivered by the March 1 deadline. The bonus is reduced by $25,000 each week that the boats are delivered after the deadline until no bonus is paid if the boats are delivered after March 22, 2018. Felix frequently includes such bonus terms in it contracts and thus has good historical data for estimating the probabilities of completion at different dates. It estimates an equal probability (25%) for each full delivery outcome. How should Felix determine the transaction price under FASB ASC 606 for this contract?

The transaction price should be based upon the best estimate of the amount of consideration to which the entity will be entitled. Given that there are multiple outcomes and probabilities available based on prior experience, the probability-weighted method is the most predictive approach for estimating the variable consideration. Consequently, the following analysis should be performed: 25% chance of $1,100,000 if by March 1 (25% x 1,100,000) = 25% chance of $1,066667 if by March 8 (25% x $1066,667) = 25% chance of $1,033,333 if by March 15 (25% x $1,033,333) = 25% chance of $1,000,000 if after March 15 (25% x $1,000,000) =

$275,000 266,667 258,333 250,000 $1,050,000

Thus, the total transaction price is $1,050,000 based on the probability-weighted estimate. use to determine the transaction price for this contract?

19. Felix Corp. is evaluating a contract to determine proper revenue recognition. The contract is for construction of 10 yachts for a total price of $10,000,000. The customer needs the boats in its showrooms by March 1, 2018, for the yacht purchase season; the customer will provide a bonus payment of $100,000 if all yachts are delivered by the March 1 deadline. The bonus is reduced by $25,000 each week that the boats are delivered after the deadline until no bonus is paid if the boats are delivered after March 22, 2018. Felix frequently includes such bonus terms in it contracts and thus has good historical data for estimating the probabilities of completion at different dates. It estimates an equal probability (25%) for each full delivery outcome. Assume that Felix has limited experience with a construction project on the same scale as the 10 yachts. How should Felix determine the transaction price for this contract?

Felix should only allocate variable consideration to the performance obligation if it is reasonably assured that it will be entitled to that amount. In this case, it does not have experience with similar contracts and is not able to estimate the cumulative amount of revenue. Felix should not recognize revenue at this time. Felix is constrained in recognizing variable consideration as there might be a significant reversal of revenue previously recognized.

20. When measuring the transaction price under the provisions of FASB ASC 606, how does a company account for a. The existence of a significant financing component (i.e., time value of money), and b. Noncash considerations. a. The existence of a significant financing component—A company must account for the time value of money if the contract involves a significant financing component. When a sales transaction involves a significant financing component the fair value is determined either by measuring the consideration received or by discounting the payment using an imputed interest rate. To determine whether a financing component is significant, a company considers all relevant facts and circumstances, including: 1. The difference, if any, between the promised consideration and the cash price that would be paid if the customer had paid as the goods or services are delivered.

2. The combined effects of the promised consideration and the cash price that would be paid if the customer had paid as the goods or services are delivered.

3. The expected length of time between delivery of the goods or services and the receipt of payment.

4. The prevailing market interest rates.

When a financing component is in evidence, a company will report the effects of the financing either as interest expense or interest revenue.

b. Noncash consideration—If a company receives consideration in the form of goods, services, or other noncash consideration, the company should generally recognize revenue on the basis of the fair value of what is received. If a customer promises consideration in a form other than cash, a company should measure the noncash consideration (or promise of noncash consideration) at fair value. If a company cannot reasonably estimate the fair value of the noncash consideration, it should measure the consideration indirectly by reference to the stand‐ alone selling price of the goods or services promised in exchange for the consideration.

21. Under FASB ASC 606: a. How is the transaction price allocated when there are various performance obligations? b. What approaches may be used to allocate the transaction price. a. If an allocation of transaction price to various performance obligations is required, the allocation is based on the amount the company could sell the good or service on a standalone basis, which is referred to as the standalone selling price. If this information is not available, companies should use their best estimate of what the good or service might sell for as a standalone unit. b. The three approaches for estimating standalone selling price are (1) Adjusted market assessment approach; (2) Expected cost plus a margin approach, and (3) Residual approach.

22. Under the provisions of FASB ASC 606 a. When does a company satisfy a performance obligation? b. What are the indicators of the satisfaction of a performance obligation?

a. A company satisfies its performance obligation when the customer obtains control of the good or service. b. Indications that the customer has obtained control are: 1. The company has a right to payment for the asset.

2. The company transferred legal title to the asset.

3. The company transferred physical possession of the asset.

4. The customer has the significant risks and rewards of ownership.

5. The customer has accepted the asset.

23. Under the provisions of FASB ASC 606, companies satisfy performance obligations either at a point in time or over a period of time. Under what conditions does a company recognize revenue over a period of time?

Companies recognize revenue over a period of time if one of the following three criteria is met: 1. The customer receives and consumes the benefits as the seller performs.

2. The customer controls the asset as it is created or enhanced (e.g., a builder constructs a building on a customer’s property).

3. The company does not have an alternative use for the asset created or enhanced (e.g., a product built to customer specifications) and either (a) the customer receives benefits as the company performs and therefore the task would not need to be re-performed, or (b) the company has a right to payment and this right is enforceable.

24. According to the provisions of FASB ASC 606 How do companies recognize revenue from a performance obligation over time?

A company recognizes revenue from a performance obligation over time by measuring the progress toward completion. The method selected for measuring progress should depict the transfer of control from the company to the customer. Two methods may be used to measure a company’s progress toward completion of a performance obligation: output methods and input methods. Under an output method, an entity recognizes revenue by directly measuring the value of the goods and services transferred to date to the customer (e.g., milestones reached, time elapsed, or units produced). With an input method, an entity recognizes revenue based on the extent of its efforts or inputs toward satisfying a performance obligation compared to the expected total efforts or inputs needed to satisfy the performance obligation. (Examples of input measures include labor hours expended, machine hours used, and costs incurred.)

25. Explain the accounting for sales with right of return under the provisions of FASB ASC 606.

To account for sales with rights of return, revenue is only recognized for those goods that are not expected to be returned. This estimate should reflect the amount that the entity expects to repay to customers, using either the expected value method or the most likely amount method, whichever provides more reliable information

If the company is unable to reliably estimate the level of returns, it should defer reporting revenue until the returns are predictable 26. FASB ASC 606 discusses bill-and-hold sales. a. How does FASB ASC 606 define a bill-and-hold sale? b. When is revenue recognized in bill-and-hold sales situation? a. A bill-and-hold sale results when the buyer is not yet ready to take delivery but the buyer takes title and accepts billing. b. Revenue is recognized at the time title passes, if all of the following criteria are met and the control provisions related to revenue recognition are met: 1. The reason for the bill-and-hold arrangement must be substantive.

2. The product must be identified separately as belonging to the customer.

3. The product currently must be ready for physical transfer to the customer.

4. The seller cannot have the ability to use the product or to direct it to another customer 27. FASB ASC 606 identifies two types of warranties. a. What are the two types of warranties? b. Explain the accounting for each type. a. The two types of warranties are: 1. Assurance warranties. Warranties that the product meets agreed-upon specifications in the contract at the time the product is sold. This type of warranty is included in the sale price of the company’s product and is often referred to as an assurance-type warranty.

2. Service warranties. Warranties that provide an additional service beyond the assurancetype warranty. This warranty is not included in the sale price of the product and is referred to as a service-type warranty. b. Companies do not record a separate performance obligation for assurance-type warranties.

These types of warranties are nothing more than a quality guarantee that the good or service is free from defects at the point of sale. These types of obligations should be expensed in the period the goods are provided or services performed. In addition, the company should record a warranty liability. The estimated amount of the liability includes all the costs that the company will incur after sale and that are incident to the correction of defects or deficiencies required under the warranty provisions.

Warranties that provide the customer a service beyond fixing defects that existed at the time of sale represent a separate service and are an additional performance obligation. As a result, companies should allocate a portion of the transaction price to this performance obligation. The company recognizes revenue in the period that the service type warranty is in effect.

28. FASB ASC 606 outlines the accounting for contract modifications. Discuss accounting for contract modifications.

A contract modification occurs if a company changes the contract terms during the term of the contract. When a contract is modified, the company must determine whether a new performance obligation has occurred or whether it is a modification of the existing performance obligation. If it is a modification of an existing performance obligation, then the change is generally reported prospectively or as a cumulative effect adjustment to revenue, depending on the circumstances. If the modification results in a separate performance obligation, then this performance obligation should be accounted for separately.

29. Recently a new method of reporting on corporate value, termed sustainability reporting, has been developed. a. What are the reasons for this trend? b. Discuss the three pillars of sustainability. c. What are sustainability reports and how do they benefit business organizations? a. Business organizations have long recognized that primarily using financial measures such as sales or profitability to measure performance often fails to provide information about the factors that result in success. The drivers of performance and value extended beyond financial results to non-financial issues, such as customer, supplier, and employee relationships, as well as environmental and social matters. Additionally, most financial measures are historic in nature and companies need information that pertains to future treads. In contrast, nonfinancial measures generally are future oriented and provide better indicators of future financial performance. Therefore, it is necessary for companies to identify and attempt to measure all the factors, both financial and nonfinancial, that increase a company’s value.

Over the past few years, the issue of sustainability has gained added prominence because of several developments including major environmental incidents, product safety and supply chain issues, and child labor concerns. Many of these issues have had a significant impact on the companies that were linked to the events. The risks emanating from those events, plus a general societal shift by employees and consumers who expect companies to be more responsible about sustainability, has caught the attention of investors and other providers of capital. b. The three pillars of sustainability are environmental. social and economic. They are defined as follows:/ The Environmental Pillar. Environmental sustainability occurs when processes, systems and activities reduce the environmental impact of an organization’s facilities, products and operations.

The Social Pillar. The social aspect of sustainability focuses on balancing the needs of individuals with the needs of the group. A sustainable business must have the support and approval of its employees, stakeholders and the community in which it operates.

The Economic Pillar Economic sustainability is used to define strategies that promote the utilization of socioeconomic resources to their best advantage. A sustainable economic model proposes an equitable distribution and efficient allocation of resources.

c. Sustainability reports contain disclosures about business organizations’ economic, environmental and social impacts that are caused by their everyday activities. A sustainability report also presents the organization's values and governance model and demonstrates the link between its strategy and its commitment to a sustainable global economy. Sustainability reports can help organizations to measure, understand and communicate their economic, environmental, social and governance performance, and then set goals, and manage change more effectively.

Chapter 6 Multiple choice 1. The disposal of a significant component of a business is called a. A change in accounting principle b. A special item of income from continuing operations item c. An other expense d. Discontinued operation Answer d 2.

If year one sales equal $800,000, year two equal $840,000 and year three equals $896,000 the percentage to be assigned for year two in a sales trend analysis, assuming that year 1 is the base year, is a. 100% b. 89% c. 105% d. 112% Answer c

3. A measure of a company’s profitability is the a. Current ratio b. Current cash debt coverage ratio c. Return on assets ratio d. Debt to total assets ratio Answer c 4. Which of the following is not an economic consequence of financial reporting? a. Financial information can affect the distribution of wealth among investors. More informed investors, or investors employing security analysts, may be able to increase their wealth at the expense of less informed investors. b. Financial information can affect the level of risk accepted by a firm. Focusing on short-term, less risky projects may have long-term detrimental effects. c. Financial information can affect the rate of capital formation in the economy and result in a reallocation of wealth between consumption and investment within the economy. d. Financial information can affect the allocation of psychic income among investors.

Answer d 5. Which of the following is not an income statement element? a. Asset b. Gain

c. Revenue d. Expense Answer a 6. The statement, net income should reflect all items that affected the net increase or decrease in stockholders’ equity during the period is consistent with which of the following concepts of income? a. Economic b. All inclusive c. Current operating performance d. Money Answer b 7. Which of the following is not an accounting change? a. Change in accounting principle b. Change in accounting estimate c. Change in a reporting entity d. Change because of an error Answer d 8. Which of the following is not an example of an error? a. A change from an accounting practice that is not generally acceptable to a practice that is generally acceptable. b. Mathematical mistakes. c. A change from LIFO to FIFO inventory costing d. The incorrect classification of costs and expense Answer c 9. The formula, Operating profit/Sales, is used to calculate a. Gross profit percentage b. Net profit percentage c. Comprehensive income percentage d. Operating profit percentage Answer d 10. Which of the following is the definition of an expense? a. Outflows or other using-up of assets or incurrences of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.

b. Inflows or other enhancements of assets of an entity or settlements of its liabilities during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations. c. Decreases in equity (net assets) from peripheral or incidental transactions of an entity except those that result from expenses or distributions to owners. d. Increases in equity (net assets) from peripheral or incidental transactions of an entity except those that result from revenues or investments by owners.

Answer a 11. Which of the following occur from peripheral or incidental transactions? a. Sales revenue b. Cost of goods sold c. Gain on the sale of equipment d. Operating expenses Answer c 12. Which of the following items would be reported net of tax on the face of the income statement? a. Discontinued operations b. Unusual gain c. Change in collectability of receivables d. Prior period adjustment Answer a 13. An example of the correction of an error in previously issued financial statements is a change a. From the completed contract to the percentage-of-completion method of accounting for longterm construction-type contracts. b. In the depletion rate, based on new engineering studies of recoverable mineral resources. c. From the sum-of-years-digits to the straight-line method of depreciation for all plant assets. d. From the installment basis of recording sales to the accrual basis, when collection of the sales price has been and continues to be reasonably assured Answer d 14. Which of the following is characteristic of a change in an accounting estimate? a. It usually need not be disclosed b. It does not affect the financial statements of prior periods c. It should be reported through the restatement of the financial statements d. It makes necessary the reporting of pro forma amounts for prior periods Answer b

15. A change in the method of inventory pricing from FIFO to LIFO would be accounted for as a (an): a. Part of discontinued operations b. Part of gross profit c. Change in accounting principle d. Change in estimate.

Answer c 16. A company changed its method of inventory pricing from last-in, first-out to first-in, first-out during the current year. Generally accepting accounting principles require that this change in accounting method be reported by: a. Accounting for the effects of the change in the current and future periods. b. Showing the cumulative effect of the change in the current year’s financial statements and pro forma effects on prior year’s financial statements in an appropriate footnote c. Disclosing the reason for the change in the “significant accounting policies” footnote for the current year but not restating prior year financial statements d. Applying retroactively the new method in restatements of prior years and appropriate footnote disclosures Answer d 17. A transaction that is material in amount, unusual in nature, but not infrequent in occurrence should be presented separately as a (an) a. Component of income from continuing operations, but not net of applicable income taxes b. Component of income from continuing operations, net of applicable income taxes c. Extraordinary item, net of applicable income taxes d. Prior period adjustment, but not net of applicable income taxes Answer a (The extraordinary category no longer exists) 18. Which of the following is not reported as an accounting error (prior period adjustment)? a. Change in the method of inventory pricing form FIFO to average-cost. b. Mathematical mistakes. c. Mistakes in the application of accounting principles. d. Oversight or misuse of facts that existed at the time financial statements were prepared.

Answer a 19. The correction of an error in the financial statements of a prior period should be reflected, net of applicable income taxes, in the current a. Income statement after income from continuing operations b. Income statement before income from continuing operations c. Retained earnings statement as an adjustment of the opening balance d. Retained earnings statement after net income but before dividends

Answer c 20. A prior period adjustment is reported as: a. An unusual item in the income statement b. An addition to (or deduction from) net income in the income statement c. An addition to (or a deduction from) the beginning balance of retained earnings d. An addition to (or deduction from) the ending balance of retained earnings Answer c 21. A prior period adjustment should be reflected, net of applicable income taxes, in the financial statements of a business entity in the a. Retained earnings statement after net income but before dividends b. Retained earnings statement as an adjustment of the opening balance c. Income statement after income from continuing operations d. Income statement as part of income from continuing operations Answer b 22. Gains and losses that bypass net income but affect stockholders' equity are referred to as: a. Comprehensive income b. Other comprehensive income c. Prior period income d. Unusual gains and losses Answer b 23. What is the purpose of reporting comprehensive income? a. To provide information for each segment of the business. b. To provide a consolidation of the income of the firm's segments. c. To summarize all changes in equity from nonowner sources. d. To reconcile the difference between net income and cash flows provided from operating activities.

Answer c 24. Which of the following is not an acceptable way of displaying the components of other comprehensive income? a. Combined statement of retained earnings. b. One statement approach. c. Two statement approach. d. One or Two statement approach

Answer a 25. Earnings per share is computed as net income: a. Minus preferred dividends divided by the ending common shares outstanding b. Minus preferred dividends divided by the weighted average of common shares outstanding c. Divided by the weighted average of common shares outstanding d. Divided by the ending common shares outstanding Answer b 26. Bowler Company reports net income of $700,000. It declares and pays dividends of $100,000 for the year, one-half of which relate to the preferred shares. The weighted-average number of common shares outstanding during the year is 200,000 shares, and the weighted-average number of preferred shares outstanding during the year is 10,000 shares. Earnings per share for Bowler Company is (round your answer to the nearest cent): a. $3.18 b. $3.25 c. $3.30 d. $2.95.

Answer b 27. Antidilutive securities would generally be used in the calculation of Basic Diluted Earnings per share Earnings per share a.

Yes Yes b.

No Yes c.

No No d.

Yes No Answer c 28. A change in accounting principle requires that the cumulative effect of the change for prior periods be shown as an adjustment to: a. Beginning retained earnings of the earliest period presented b. Comprehensive income for the earliest period presented c. Stockholders’ equity of the period in which the change occurred d. Net income of the period in which the change occurred Answer a 29. Which of the following is true in accounting for changes in estimates? a. Changes in estimates are considered as errors.

b. A company recognizes a change in estimate by making a retrospective adjustment to the financial statements. c. A company accounts for changes in estimates only in the period of change, even though it affects the future periods. d. Changes in estimates are not carried back to adjust prior years.

Answer d 30. A change in the salvage value of an asset depreciated on a straight-line basis and arising because additional information has been obtained is a. An accounting change that should be reported in the period of change and future periods of change if the change affects both b. An accounting change that should be reported by restating the financial statements of all prior periods presented c. A correction of an error d. Not an accounting change Answer a 31. A loss should be reported separately as a net-of-tax component of net income when it is which of the following?

Unusual Infrequent In Nature in Occurrence a.

No Yes b.

No No c.

Yes No d.

Yes Yes Answer b 32. When a component of a business has been discontinued during the year, this component’s operating losses of the current period up to the measurement date should be included in the a. Income statement as part of the income (loss) from operations of the discontinued component b. Income statement as part of the loss on disposal of the discontinued component c. Income statement as part of the income (loss) from continuing operations d. Retained earnings statement as a direct decrease in retained earnings Answer a Essay 1. Discuss the economic consequences of financial reporting.

Income measurement and financial reporting involve economic consequences, including:

•

Financial information can affect the distribution of wealth among investors. More informed investors, or investors employing security analysts, may be able to increase their wealth at the expense of less informed investors.

•

Financial information can affect the level of risk accepted by a firm. As discussed in Chapter 4, focusing on short-term, less risky projects may have long-term detrimental effects.

•

Financial information can affect the rate of capital formation in the economy and result in a reallocation of wealth between consumption and investment within the economy.

•

Financial information can affect how investment is allocated among firms.

Since economic consequences may affect different users of information differently, the selection of financial reporting methods by the FASB and the SEC involves trade-offs. The deliberations of accounting standard setters should consider these economic consequences.

2. Discuss the four income statements elements defined by SFAC No. 6.

The income statement elements are defined in SFAC No. 6 as follows: •

Revenues. Inflows or other enhancements of assets of an entity or settlement of its liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.

•

Gains. Increases in net assets from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from revenues or investments by owners.

•

Expenses. Outflows or other using-up of assets or incurrences of liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.

•

Losses. Decreases in net assets from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except from expenses or distributions to owners.

3. Discuss the all-inclusive vs. current operating performance views of income.

An important distinction between revenues and gains and expenses and losses is whether or not they are associated with ongoing operations. Over the years, this distinction has generated questions concerning the nature of income reporting desired by various financial-statement users. Two viewpoints have dominated this dialogue and are termed the current operating performance concept and the all-inclusive concept of income reporting.

The proponents of the current operating performance concept of income base their arguments on the belief that only changes and events controllable by management that result from current-period decisions should be included in income. This concept implies that normal and recurring items should constitute the principal measure of enterprise performance. That is, net income should

reflect the day-to-day, profit-directed activities of the enterprise, and the inclusion of other items of profit or loss distorts the meaning of the term net income.

Alternatively, advocates of the all-inclusive concept of income hold that net income should reflect all items that affected the net increase or decrease in stockholders’ equity during the period, with the exception of capital transactions. They believe that the total net income for the life of an enterprise should be determinable by summing the periodic net income figures.

The underlying assumption behind the current operating performance versus all-inclusive concept controversy is that the manner in which financial information is presented is important. In essence, both viewpoints agree on the information to be presented but disagree on where to disclose certain revenues, expenses, gains, and losses. As discussed in Chapters 4 and 5, research indicates that investors are not influenced by where items are reported in financial statements so long as the statements disclose the same information. So, perhaps, the concern over the current operating performance versus the all-inclusive concept of income is unwarranted. In the following paragraphs we review the history of the issue.

4. Define and discuss the accounting treatment for discontinued operations.

In order to qualify for treatment as a discontinued operation, an item must meet several criteria.

First, the unit being discontinued must be considered a “component” of the business. The definition of component is based on the notion of distinguishable operations and cash flows. Specifically, FASB ASC 205-10-20 defines a component of an entity as comprising operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity.

Certain units—segments, operating divisions, lines of business, subsidiaries—are usually considered components. But depending on the business in which an entity operates, other units may be considered components as well.

Assuming the unit to be discontinued is a “component” of the business, it must meet two additional criteria before the transaction can be reported as a discontinued operation. First, the operations and cash flows of the component being disposed of must be eliminated from the operations and cash flows of the entity as a result of the transaction. The company is not allowed to retain an interest in the cash flows of the operation and still account for it as a discontinued operation. Second, and finally, the entity must retain no significant involvement in the operations of the component after the disposal takes place.

Once management decides to sell a component, its assets and liabilities are classified as “held-forsale” on its balance sheet. Then, if a business has a component classified as held-for-sale, or if it actually disposes of the component during the accounting period, it is to report the results of the operations of the component in that period, and in all periods presented on a comparative Income Statement, as a discontinued operation. It should report these results directly under the income subtotal “Income from Continuing Operations.” These results would be reported net of applicable

income taxes or benefit. In the period in which the component is actually sold (or otherwise disposed of), the results of operations and the gain or loss on the sale should be combined and reported on the Income Statement as the gain or loss from the operations of the discontinued unit.

The gain or loss on disposal may then be disclosed on the face of the Income Statement or in the notes to the financial statements.

5. Discuss the evolution of the accounting treatment of extraordinary items.

In APB Opinion No. 30, “Reporting the Results of Operations,” extraordinary items were defined as events and transactions that are distinguished by both their unusual nature and their infrequency of occurrence. These characteristics were originally defined as follows.

•

Unusual nature. —the event or transaction should possess a high degree of abnormality and be unrelated or only incidentally related to ordinary activities.

•

Infrequency of occurrence. —the event or transaction would not reasonably be expected to recur in the foreseeable future. Question: given the ASC, should we remove footnotes to original sources?

In APB Opinion No. 30, several types of transactions were defined as not meeting these criteria.

These included write-downs and write-offs of receivables, inventories, equipment leased to others, deferred research and development costs, or other intangible assets; gains or losses in foreign currency transactions or devaluations; gains or losses on disposals of segments of a business; other gains or losses on the sale or abandonment of property, plant, and equipment used in business; effects of strikes; and adjustments of accruals on long-term contracts. The position expressed in Opinion No. 30 was, therefore, somewhat of a reversal in philosophy; some items previously defined as extraordinary in APB Opinion No. 9 were now specifically excluded from that classification. The result was the retention of the extraordinary item classification on the income statement. However, the number of revenue and expense items allowed to be reported as extraordinary was significantly reduced.

On January 9, 2015, the FASB issued Accounting Standards Update 2015-01, Income Statement— Extraordinary and Unusual Items, as a part of the simplification initiative. This ASU eliminates the concept of extraordinary items from U.S. GAAP. It was issued after the FASB heard from stakeholders that the concept of extraordinary items causes uncertainty because it is unclear when an item should be considered both unusual and infrequent. According to the provisions of ASU 2015-01, the existing requirement to separately present items that are of an unusual nature or occur infrequently on a pre-tax basis within income from continuing operations has been retained. The new guidance also requires similar separate presentation of items that are both unusual and infrequent.

6. What are accounting changes and why is it an issue. List and define the three types of accounting changes.

The accounting standard of consistency indicates that similar transactions should be reported in the same manner each year. Stated differently, management should choose the set of accounting practices that most correctly presents the resources and performance of the reporting unit and continue to use those practices each year. However, companies may occasionally find that reporting is improved by changing the methods and procedures previously used or that changes in reporting may be dictated by the FASB or the SEC. The APB originally studied this problem and issued its findings in APB Opinion No. 20, “Accounting Changes.” This release identified three types of accounting changes, discussed the general question of errors in the preparation of financial statements, and defined these changes as follows.

1. Change in an accounting principle. This type of change occurs when an entity adopts a GAAP that differs from one previously used for reporting purposes. Examples of such changes are a change from LIFO to FIFO inventory pricing or a change in depreciation methods.

2. Change in an accounting estimate. These changes result from the necessary consequences of periodic presentation. That is, financial statement presentation requires estimation of future events, and such estimates are subject to periodic review. Examples of such changes are the life of depreciable assets and the estimated collectability of receivables.

3. Change in a reporting entity. Changes of this type are caused by changes in reporting units, which may be the result of consolidations, changes in specific subsidiaries, or a change in the number of companies consolidated.

7. Discuss the concept of simple vs. complex capital structures and how it relates to the reporting of earnings per share.

Under the provisions of APB Opinion No. 15, a company had either a simple or complex capital structure. A simple capital structure was comprised solely of common stock or other securities whose exercise or conversion would not in the aggregate dilute EPS by 3 percent or more.

Companies with complex capital structures have securities that potentially could be exchanged for common stock. Consequently, these companies were required to disclose dual EPS figures: (1) primary EPS and (2) fully diluted EPS. Primary EPS was intended to display the most likely dilutive effect of exercise or conversion on EPS. It included only the dilutive effects of common stock equivalents. APB Opinion No. 15 described common stock equivalents as securities that are not, in form, common stock, but rather contain provisions that enable the holders of such securities to become common stockholders and to participate in any value appreciation of the common stock.

Later, the FASB decided to replace primary EPS with basic EPS. The objective of basic EPS is to measure a company’s performance over the reporting period from the perspective of the common stockholder. Basic EPS is computed by dividing income available to common stockholders by the weighted average number of shares outstanding during the period. The objective of diluted EPS is to measure a company’s pro forma performance over the reporting period from the perspective of the common stockholder as if the exercise or conversion of potentially dilutive securities had actually occurred.

8. Define and discuss the accounting treatment for prior period adjustments.

Occasionally, companies make mistakes in their accounting records. Sometimes these “mistakes” occur because of intentional or fraudulent misapplication of accounting rules, principles, or estimates. Generally, mistakes are unintentional and arise because of errors in arithmetic, double entries, transposed numbers, or failure to record a transaction or adjustment. If the company discovers the mistake in the period in which it occurred, an adjustment is made to the accounts affected to correct it. If, however, the mistake does not get discovered until a later period, the company will need to make a prior period adjustment. Prior period adjustments involve adjusting the beginning retained earnings balance and reporting the adjustment in either the statement of stockholders’ equity or in a separate statement of retained earnings. Since the error occurred in a prior period, it does not affect the current income statement, so it is not reported in the income statement in the period of correction. Also, since the prior period’s net income was closed to retained earnings at the end of that period, retained earnings is misstated in the current period and must be adjusted to remove the effect of the error. FASB ASC 250 specifies that the only items of profit and loss that should be reported as prior period adjustments were a. Correction of an error in the financial statements of a prior period. b. Adjustments that result from the realization of income tax benefits of preacquisition operating loss carry-forwards of purchased subsidiaries.

9. What is the major distinction between revenues and gains and between expenses and losses?

The major distinction between revenues and gains (or expenses and losses) depends on the normal activities of the company. Revenues can occur from a variety of different sources, but these sources constitute the entity’s ongoing major or central operations. Gains also can arise from many different sources, but these sources occur from peripheral or incidental transactions of an entity. The same type of distinction is made between expenses and losses.

10. Define comprehensive income. What is the purpose of reporting comprehensive income?

Comprehensive income is defined as “the change in equity [net assets] of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.” The term comprehensive income is used to describe the total of all components of comprehensive income, including net income. FASB ASC 220-10-20 uses the term other comprehensive income to refer to revenues, expenses, gains, and losses included in comprehensive income but excluded from net income. The stated purpose of reporting comprehensive income is to report a measure of overall enterprise performance by disclosing all changes in equity of a business enterprise that result from recognized transactions and other economic events of the period other than transactions with owners in their capacity as owners.

FASB ASC 220 requires the disclosure of comprehensive income and discusses how to report and disclose comprehensive income and its components, including net income. However, it does not specify when to recognize or how to measure the items that make up comprehensive income. The FASB indicated that existing and future accounting standards will provide guidance on items that are to be included in comprehensive income and its components. When used with related disclosures and information in the other financial statements, the information provided by reporting comprehensive income should help investors, creditors, and others in assessing an enterprise’s financial performance and the timing and magnitude of its future cash flows.

11. What are the two ways that other comprehensive income may be reported on corporate financial statements?

Other comprehensive income must be displayed (reported) in one of two ways: (1) a single continuous income statement (one statement approach) or (2) two separate but consecutive statements of net income and other comprehensive income (two statement approach).

12. Obtain a company’s income statement and ask the students to compute the following: a. Gross profit percentage b. Net profit percentage c. Operating profit percentage d. Price earnings ratio These answers depend on the company chosen.

13. Discuss the sources of guidance for recording accounting transactions outlined by IAS No. 8, Accounting Policies, Changes in Accounting Estimates and Errors.

IAS No 8 indicated that the following sources should be considered in descending order: • the requirements and guidance in IASB standards and interpretations dealing with similar and related issues; and • the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework for the Presentation of Financial Statements.

• the most recent pronouncements of other standard-setting bodies that use a similar conceptual framework to develop accounting standards.

• other accounting literature and accepted industry practices, to the extent that these do not conflict with the sources in paragraph.

Chapter 7 Multiple Choice 1. On a balance sheet, what is the preferable presentation of notes or accounts receivable from officers, employees, or affiliated companies? a. As trade notes and accounts receivable if they otherwise qualify as current assets b. As assets but separately from other receivables c. As offsets to capital d. By means of notes or footnotes Answer b 2. The balance sheet can be used to analyze all of the following except a. Financial flexibility. b. Solvency. c. Liquidity. d. Profitability Answer d 3. The basis for classifying assets as current or noncurrent is the period of time normally elapsed from the time the accounting entity expends cash to the time it converts a. Inventory back to cash or 12 months, whichever is shorter b. Receivables back into cash or 12 months, whichever is longer c. Tangible fixed assets back into cash or 12 months, whichever is longer d. Inventory back to cash or 12 months, whichever is longer Answer d 4. Current assets are presented on the balance sheet in a. Descending order of their balances. b. Ascending order of their balances. c. Order of their liquidity. d. Reverse order of their liquidity.

Answer c 5. The valuation basis used in conventional financial statements is a. Replacement cost b. Market value c. Original cost d. A mixture of costs and values

Answer d 6. The financial statement which summarizes operating, investing, and financing activities of an entity for a period of time is the a. Statement of cash flows. b. Retained earnings statement. c. Statement of financial position. d. Income statement.

Answer a 7. A transaction that would appear as an application of funds on a conventional funds statement using the all-financial-resources concept, but not on a statement using the traditional working capital concept would be the a. Acquisition of property, plant, and equipment for cash b. Reacquisition of bonds issued by the reporting entity c. Acquisition of property, plant, and equipment with an issue of common stock d. Declaration and payment of dividends Answer c 8. There would probably be a major difference between a statement of source and application of working capital and a cash flow statement in the treatment of a. Dividends declared and paid b. Sales of noninventory assets for cash at a loss c. Payment of long-term debt d. A change during the period in the accounts payable balance Answer d 9. A basic objective of the statement of cash flows is to a. Supplant the income statement and balance sheet b. Disclose changes during the period in all asset and all liability accounts c. Disclose the change in working capital during the period d. Provide essential information for financial statements users in making economic decisions Answer d 10. A statement of cash flows should be issued by a profit-oriented business a. As an alternative to the statement of income and retained earnings b. Only if the business classifies its assets and liabilities as current and noncurrent c. Only when two-year comparative balance sheets are not issued d. Whenever a balance sheet and a statement of income and retained earnings are issued

Answer d 11. When preparing a statement of changes in financial position using the cash basis for defining funds, an increase in ending inventory over beginning inventory will result in an adjustment to reported net earnings because a. Funds were increased since inventory is a current asset b. The net increase in inventory reduced cost of goods sold but represents an assumed use of cash c. Inventory is an expense deducted in computing net earnings, but is not a use of funds d. All changes in noncash accounts must be disclosed under the all financial resources concept Answer b 12. Which of the following should theoretically be presented in a statement of changes in financial position only because of the all-financial-resources concept? a. Conversion of preferred stock to common stock b. Purchase of treasury stock c. Sale of common stock d. Declaration of cash dividend Answer a 13. Making and collecting loans and disposing of property, plant, and equipment are a. Liquidity activities. b. Financing activities. c. Investing activities. d. Operating activities Answer c 14. In preparing a statement of cash flows, which of the following transactions would be considered an investing activity? a. Sale of merchandise on credit b. Declaration of a cash dividend c. Issuance of bonds payable at a discount d. Sale of equipment at book value Answer d 15. When preparing a funds statement using the all financial resources concept, the retirement of longterm debt by the issuance of common stock should be presented in a statement of changes in financial position as a

a.

Source of Funds No

Use of Funds No

b. c. d.

No Yes Yes

Yes No Yes

Answer a 16. The working capital format is one possible format for presenting a statement of changes in financial position. Which of the following formats is (are) also theoretically acceptable?

Cash Quick Assets a.

Acceptable Not acceptable b.

Not acceptable Not acceptable c.

Not acceptable Acceptable d.

Acceptable Acceptable Answer d 17. A gain on the sale of plant assets in the ordinary course of business should be presented in a statement of cash flows as a (an) a. Source and use of cash b. Use of cash c. Addition to income from continuing operations d. Deduction from income from continuing operations Answer d 18. Which of the following should be presented in a statement of cash flows supplemental schedule?

Conversion of Conversion of Long-term debt preferred stock to common stock to common stock a.

No No b.

No Yes c.

Yes Yes d.

Yes No Answer c 19. A measure of a company’s financial flexibility is a. Return on assets ratio b. Return on sales ratio c. Free cash flow d. Accounts receivable turnover ratio Answer c

20. The balance sheet discloses a. Stocks b. Flows c. Both stocks and flows d. Neither stocks nor flows Answer a 21. Which of the following is not a balance sheet element? a. Assets b. Liabilities c. Gains d. Equities Answer c 22. Which of the following is not a component of equity? a. Common stock b. Treasury stock c. Retained earnings d. Unearned revenue Answer d 23. Which of the following is not an important aspect of SFAS No. 157 (FASB ASC 820)? a. A new definition of fair value. b. A requirement that all assets and liabilities are to be measured at their fair value. c. A fair value hierarchy used to classify the source of information used in fair value measurements (for example, market based or nonmarket based). d. New disclosures of assets and liabilities measured at fair value based on their level in the hierarchy.

Answer b 24. The definition of fair value in SFAS No 157 (FASB ASC 820) is a. Entry price based b. Exit price based c. Replacement cost based d. Historical cost based Answer b 25. The SFAS No 157 (FASB ASC 820) fair value hierarchy contains a. Two level

b. Three levels c. Four levels d. Five levels Answer b 26. Level 1 of fair value hierarchy measures originally outlined in SFAS No. 157 are based on: a. Historical cost of similar assets. b. Market prices for identical assets. c. Market prices for similar assets. d. Unobservable inputs.

Answer b 27. Which of the following is the lowest level of the SFAS 157 (FASB ASC 820) fair value hierarchy? a. Unobservable inputs (that are corroborated by observable market data) b. Unobservable inputs (that are not corroborated by observable market data) c. Observable market-based inputs (or unobservable inputs that are corroborated by market data) d. Quoted market prices for identical assets or liabilities in active markets Answer b 28. The calculation net income/sales is the formula for which of the following ratios a. Return on assets b. Profit margin c. Asset turnover d. Asset usage Answer b 29. The calculation sales/average total assets is the formula for which of the following ratios a. Return on assets b. Profit margin c. Asset turnover d. Asset usage Answer c 30. The calculation net income/average total assets is the formula for which of the following ratios a. Return on assets b. Profit margin c. Asset turnover d. Asset usage

Answer a 31. The firm’s ability to use its financial resources to adapt to change is the definition of a. Liquidity b. Solvency c. Financial flexibility d. Working capital Answer c 32. A firm’s ability to obtain cash for business operations change is the definition of a. Liquidity b. Solvency c. Financial flexibility d. Working capital Answer b 33. The firm’s ability to convert an asset to cash or to pay a current liability change is the definition of a. Liquidity b. Solvency c. Financial flexibility d. Working capital Answer a 34. Net cash provided (used) by operating activities − net cash used in acquiring property, plant is the calculation for a. Free cash flow b. Cash flow from investing activities c. Working capital d. Current ratio Answer a 35. Investments in equity securities are disclosed as current assets on a company’s balance sheet if a. Management intends to sell them within a year and they have a ready market exists. b. The fair market value cannot be determined. c. Management intends to convert them into common stock within one year. d. Management owns less than 50% of the outstanding stock.

Answer a 36. What is reported on the statement of cash flows?

a. Operating, investing, and financing activities of an entity for a period of time b. All revenues and expense listed by operating, financing, and operating actitivity c. Operating, investing, and financing activities of an entity at the balance sheet date d. A detail of all incoming and outgoing cash flows of a business Answer a Essay 1. Discuss the following balance sheet elements as defined by SFAC No. 6: a. Assets Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. An asset has three essential characteristics: (1) it embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net cash inflows; (2) a particular enterprise can obtain the benefit and control others’ access to it; and (3) the transaction or other event giving rise to the enterprise’s right to or control of the benefit has already occurred. b. Liabilities Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. A liability has three essential characteristics: (1) it embodies a present duty or responsibility to one or more other entities that entails settlement by probable future transfer or use of assets at a specified or determinable date, on occurrence of a specified event, or on demand; (2) the duty or responsibility obligates a particular enterprise, leaving it little or no discretion to avoid the future sacrifice; and (3) the transaction or other event obligating the enterprise has already happened. c. Equity Equity is the residual interest in the assets of an entity that remains after deducting its liabilities.

In a business enterprise, the equity is the ownership interest. Equity in a business enterprise stems from ownership rights (or the equivalent). It involves a relation between an enterprise and its owners as owners rather than as employees, suppliers, customers, lenders, or in some other nonowner role.

2. List three valuation techniques currently used on the balance sheet and discuss how each are used (What accounts?).

Asset Cash Accounts receivable

Measurement Basis Current value Expected future value

Marketable securities Inventory Investments Property, plant, and equipment

Fair value or amortized cost Current or past value Fair value, amortized cost, or the result of applying the equity method Past value adjusted for depreciation

3. Define the following terms: a. Current assets Current assets are those assets that may reasonably be expected to be realized in cash, sold or consumed during the normal operating cycle of the business or one year, whichever is longer b. Investments Investments may be divided into three categories: 1. Securities acquired for specific purposes, such as using idle funds for long periods or exercising influence on the operations of another company.

2. Assets not currently in use by the business organization, such as land held for a future building site.

3. Special funds to be used for special purposes in the future, such as sinking funds. c. Property, plant and equipment Property, plant and equipment consists of the tangible assets owned by a company and used in the production and or sale of a company’s product. d. Current liabilities Obligations whose liquidation is reasonably expected to require the use of existing resources properly classified as current assets or the creation of other current liabilities. e. Treasury stock Previously issued stock that has been reacquired by the company.

4. How is fair value defined in SFAS No. 157 (FASB ASC 820)?

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

5. Describe the fair value hierarchy as defined in SFAS No.157(FASB ASC 820).

Level 1:

Level 2: Observable market-based inputs, other than Level 1 quoted prices (or unobservable inputs corroborated by market data)

Level 3: Unobservable inputs (not corroborated by observable market data)

Quoted market prices for Company A common stock traded and quoted identical assets or liabilities in active markets on the New York Stock Exchange Company B common stock traded and quoted only on an inactive market in an emerging country A privately placed bond of Z whose value is derived from a similar Z bond that is publicly traded An over-the-counter interest rate swap, valued based on a model whose inputs are observable, such as LIBOR (London Interbank Offered Rate) forward interest rate curves.

A long-dated commodity swap whose forward price curve, used in a valuation model, is not directly observable or correlated with observable market data Shares of a privately held company whose value is based on projected cash flows

6. FSP FAS 157‐4 provided guidance on how to determine when the volume and level of activity for an asset or liability has significantly decreased and identified the circumstances in which a transaction is not orderly. What are these factors?

The factors identified that indicate a significant decrease in the volume and level of activity for an asset or liability in relation to normal market activity for the same or similar assets or liabilities include: a. There are few recent transactions. b. Price quotations are not based on current information. c. Price quotations vary substantially either over time or among market makers. d. Indexes that previously were highly correlated with the fair values of the asset or liability are demonstrably uncorrelated with recent indications of fair value for that asset or liability. e. There is a significant increase in implied liquidity of risk premiums, yields, or performance indicators for observed transactions or quoted prices when compared with the reporting entity’s estimate of expected cash flows, considering all available market data about credit and other nonperformance risks for the asset or liability. f. There is a wide bid–ask spread or a significant increase in the bid–ask spread. g. There is a significant decline or absence of a market for new issuances for the asset or liability or similar assets or liabilities. h. Little information is released publicly

7. After considering the significance and relevance of each of the factors that indicate the volume and level of activity for an asset or liability is not orderly, judgment must be used to determine whether the market is active and if a significant adjustment to the transactions or quoted prices may be necessary to estimate fair value. What are some circumstances identified in FSP FAS 157-4 that might indicate that a transaction is not orderly?

The circumstances identified in FSP FAS 157-4 that might indicate that a transaction is not orderly include: a. There was not adequate exposure to the market for a period before the measurement date to allow marketing activities that are usual and customary for transactions involving such assets or liabilities under current market conditions. b. There was a usual and customary marketing period, but the seller marketed the asset or liability to a single market participant. c. The seller is in or near bankruptcy or receivership (i.e., distressed), or the seller was required to sell to meet regulatory or legal requirements (i.e., forced). d. The transaction price is an outlier when compared with other recent transactions for the same or similar asset or liability.

8. In May 2011, FASB, issued Accounting Standards Update 2011‐04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS. What is the purpose of this ASU? The purpose of ASU 2011-04 is to provide greater transparency particularly for Level 3 fair value measurements. That is, for fair value measurements categorized within Level 3 of the fair value hierarchy, the ASU requires entities to provide quantitative information about significant unobservable inputs used in fair value measurements. The ASU also requires a description of the valuation processes used by an entity for Level 3 measurements. This description would include, for example, how an entity decides its valuation policies and procedures and analyzes changes in fair value measurements from period to period.

Finally, the ASU requires entities to provide a narrative description of the sensitivity of the Level 3 fair value measurements to changes, if a change in those inputs to a different amount might result in a significantly higher or lower fair value measurement.

9. Obtain a company’s financial statements and ask the students to compute the following: a. Return on investment b. Adjusted return on investment c. Profit margin ratio d. Asset turnover ratio e. Free cash flow These answers are dependent on the company selected.

10. What questions does the statement of cash flows enable financial statement users to answer?

The statement of changes in financial position was designed to enable financial statement users to answer such questions as: 1. Where did the profits go?

2. Why weren’t dividends larger?

3. How was it possible to distribute dividends in the presence of a loss?

4. Why are current assets down when there was a profit?

5. Why is extra financing required?

6. How was the expansion financed?

7. Where did the funds from the sale of securities go?

8. How was the debt retirement accomplished?

9. How was the increase in working capital financed?

11. Define the following terms: a. Liquidity Liquidity is the firm’s ability to convert an asset to cash or to pay a current liability. It is referred to as the “nearness to cash” of an entity’s economic resources and obligations. b.

Solvency

Solvency refers to a firm’s ability to obtain cash for business operations. Specifically, it refers to a firm’s ability to pay its debts as they become due. c. Financial flexibility Financial flexibility is the firm’s ability to use its financial resources to adapt to change. It is the firm’s ability to take advantage of new investment opportunities or to react quickly to a “crisis” situation. Financial flexibility comes in part from quick access to the company’s liquid assets.

However, liquidity is only one part of financial flexibility. Financial flexibility also stems from a firm’s ability to generate cash from its operations, contributed capital, or sale of economic resources without disrupting continuing operations.

12. Discuss the direct versus indirect methods of preparing the statement of cash flows.

The direct and indirect methods relate to the presentation of cash flows from operating activities.

Reporting gross cash receipts and payments is termed the direct method, and includes reporting the following classes of operating cash receipts and payments: 1. Cash collected from customers 2. Interest and dividends received 3. Other operating cash receipts 4. Cash paid to employees and other suppliers of goods and services 5. Interest paid 6. Income taxes paid

7. Other operating cash payments The FASB has stated a preference for the use of the direct method but a company that chooses not to use the direct method for reporting operating cash flow information must report the same amount of operating cash flow by adjusting net income to reconcile it with operating cash flow.

This method of reporting is termed the indirect method. The required adjustments include the effect of past deferrals of operating cash receipts and payments; accruals of expected operating cash receipts and payments; and the effect of items related to investing and financing activities such as depreciation, amortization of goodwill, and gains or losses on the sale of property, plant, and equipment.

13. Define and discuss the three major sections of the statement of cash flows.

The three sections of the statement of cash flows are 1. Cash flows from operating activities, 2.

Cash flows from investing activities and 3. Cash flows from financing activities. Cash flows from operating activities are generally the cash effect from transactions that enter into the determination of net income exclusive of financing and investing activities. Investing activities include making and collecting loans; acquiring and disposing of debt or equity securities of other companies; and acquiring and disposing of property, plant, and equipment, and other productive resources.

Financing activities result from obtaining resources from owners, providing owners with a return of and a return on their investment, borrowing money and repaying the amount borrowed, and obtaining and paying for other resources from long-term creditors.

Chapter 8 Multiple Choice 1. Of the following items, the one that should be classified as a current asset is a. Trade installment receivables normally collectible in 18 months b. Cash designated for the redemption of callable preferred stock c. Cash surrender value of a life insurance policy of which the company is beneficiary d. A deposit on machinery ordered, delivery of which will be made within six months Answer d 2. The advantage of relating a company’s bad debt experience to its accounts receivable is that this approach a. Gives a reasonable correct statement of receivables in the balance sheet b. Relates bad debts expense to the period of sale c. Is the only generally accepted method for valuing accounts receivable d. Makes estimates of uncollectible accounts unnecessary Answer a 3. Assuming that the ideal measure of short-term receivables in the balance sheet is the discounted value of the cash to be received in the future, failure to follow this practice usually does not make the balance sheet misleading because a. Most short-term receivables are not interest bearing b. The allowance for uncollectible accounts includes a discount element c. The amount of the discount is not material d. Most receivables can be sold to a bank or factor Answer c 4. An account that would be classified as a current liability is a. Dividends payable in stock b. Accounts payable - debit balance c. Reserve for possible losses on purchase commitments d. Excess of replacement cost over LIFO cost of basic inventory temporarily liquidated Answer d 5. Jamison Corporation’s inventory cost on its statement of financial position was lower using firstin, first-out than last-in, first-out. Assuming no beginning inventory, what direction did the cost of purchases move during the period? a. Up b. Down

c. Steady d. Cannot be determined Answer a 6.

If inventory levels are stable or increasing an argument that favors the FIFO method as compared to LIFO is a. Income taxes tend to be reduced in periods of rising prices b. Cost of goods sold tends to be stated at approximately current cost in the income statement c. Cost assignments typically parallel the physical flow of the goods d. Income tends to be smoothed as prices change over time Answer c 7. An inventory pricing procedure in which the oldest costs incurred rarely have an effect on the ending inventory valuation is a. FIFO b. LIFO c. Conventional retail d. Weighted average Answer b

8. When inventory declines in value below original (historical) cost, and this decline is considered other than temporary, what is the maximum amount that the inventory can be valued at? a. Sales price net of conversion costs b. Net realizable value c. Historical cost d. Net realizable value reduced by a normal profit margin Answer d 9. Which of the following inventory cost flow methods involves computations based on broad inventory pools of similar items? a. Regular quantity of goods LIFO b. Dollar-value LIFO c. Weighted average d. Moving average Answer b 10. When the allowance method of recognizing bad debt expense is used, the entries at the time of collection of an account previously written off would a. Increase net income

b. Have no effect on total current assets c. Increase working capital d. Decrease total current liabilities Answer b 11. Which inventory costing method most closely approximates current cost for each of the following: Ending Inventory Cost of Goods Sold a. FIFO LIFO b. LIFO FIFO c. LIFO LIFO d. FIFO FIFO Answer a 12. The original cost of an inventory item is above the replacement cost. The replacement cost is below the net realizable value less the normal profit margin. Under the lower of cost or market method the inventory item should be priced at its a. Original cost b. Replacement cost c. Net realizable value d. Net realizable value less the normal profit margin Answer d 13. Liquidity is the ability a. To increase net assets through regular operations b. To generate cash from sources other than regular operations c. To convert existing assets into cash d. Of financial statement users to predict a company’s cash flows Answer c 14. Liquidity ratios measures the a. Operating success of a company over a period of time b. The ability of a company to survive over a long period of time c. The short-term ability of a company to pay its maturing obligations and to meet unexpected needs for cash d. The number of times interest is earned Answer c 15. Working capital is a measure of

a. b. c. d.

Financial flexibility Liquidity.

Profitability.

Solvency.

Answer b 16. A common measure of liquidity is a. Return on assets. b. Accounts receivable turnover. c. Profit margin. d. Debt to equity.

Answer b 17. The net realizable value of receivables is calculated as the face value of the receivables less adjustments for a. Credit sales b. Actual uncollected amounts adjusted for purchase discounts. c. Bad debts already written off. d. Estimated uncollectible accounts Answer d 18. Under what circumstances should a company with high rate of return on sales consider the inventory sold? a. When the retailer gives a confirmation that the goods won’t be returned b. When the goods are sold on installment c. When it can reasonably estimate the amount of returns d. When the payment for goods is received Answer c 19. A successful discount retail store such as Wal-Mart would probably have a. A low inventory turnover b. A high inventory turnover c. Zero profit margin d. Low volume Answer b Use the following information to answer questions 20 & 21 Acme Auto Supplies Balance Sheet December 31, 2020

Cash $ 60,000 Prepaid Insurance 40,000 Accounts Receivable 50,000 Inventory 70,000 Land held for investment 80,000 Land 95,000 Building $100,000 Less Accumulated Depreciation (30,000) 70,000 Trademark 70,000 Total Assets $535,000

Accounts Payable Salaries Payable Mortgage Payable Total Liabilities

$ 65,000 10,000 90,000 $165,000

Common Stock Retained Earnings

$120,000 250,000

Total stockholders’ equity Total Liabilities and Stockholders’ Equity

$370,000 $535,000

20. The total amount of working capital is a. $155,000. b. $145,000. c. $60,000. d. $150,000.

Answer b 21. The current ratio is a. 1.86: 1. b. 2.00: 1. c. 3.38: 1. d. 2.93: 1.

Answer d 22. Why is the allowance method preferred over the direct write-off method of accounting for bad debts? a. Determining worthless accounts under direct write-off method is difficult to do. b. Improved matching of bad debt expense with revenue. c. Allowance method is used for tax purposes. d. Estimates are used.

Answer b 23. Which of the following methods of determining annual bad debt expense best achieves the matching concept? a. Percentage of average accounts receivable b. Direct write-off c. Percentage of sales d. Percentage of ending accounts receivable

Answer c 24. The Villas Corporation’s annual sales (all on credit) totaled $540,000 in 2020.

The company’s accounts receivable turnover ratio was 5. Villas’ average accounts receivable collection period and year end accounts receivable balance respectively were: a. 365 days and $108,000. b. 73 days and $120,000 c. 73 days and $108,000 d. 81 days and $108,000 Answer c 25. The accounts receivable turnover and inventory turnover ratios are used to analyze a. Long-term solvency b. Profitability c. Liquidity d. Leverage Answer c 26. During the year Snedicker reported net sales of $1,920,000. The company had accounts receivable of $150,000 at the beginning of the year and $240,000 at the end of the year Compute Snedicker’s average collection period (assume 365 days a year.) a. 28.5 days b. 45.7 days. c. 37.1 days. d. 74.2 days.

Answer c 27. What is a possible reason for accounts receivable turnover to increase from one year to the next year? a. Improved collection process. b. Granting credit to customers with lower credit quality. c. Decreased credit sales during a recession. d. Write-off uncollectible receivables.

Answer a 28. A high accounts receivable turnover ratio indicates a. Customers are making payments quickly b. A large portion of the company’s sales are on credit c. Many customers are not paying their receivables in a timely manner

d. The company’s sales have increased Answer a 29. Increasing a credit period from 30 to 60 days, in response to a similar action taken by company’s competitors, would likely result in: a. An increase in the average collection period. b. A decrease in bad debt losses. c. An increase in sales. d. Higher profits.

Answer a Essay 1. Define working capital.

Working capital is the net short-term investment needed to carry on day-to-day activities. It is calculated: current assets – current liabilities.

2. The ARB No. 43 definitions of current assets and current liabilities (see FASB ASC 210‐10‐45) include examples of each classification. List those examples.

Current Assets a. Cash available for current operations and items that are the equivalent of cash b. Inventories of merchandise, raw materials, goods in process, finished goods, operating supplies, and ordinary maintenance materials and parts c. Trade accounts, notes, and acceptances receivable d. Receivables from officers, employees, affiliates, and others if collectible in the ordinary course of business within a year e. Installment or deferred accounts and notes receivable if they conform generally to normal trade practices and terms within the business f. Marketable securities representing the investment of cash available for current operations g. Prepaid expenses, such as insurance, interest, rents, taxes, unused royalties, current paid advertising service not yet received, and operating supplies Current Liabilities a. Obligations for items that have entered into the operating cycle, such as payables incurred in the acquisition of materials and supplies to be used in producing goods or in providing services to be offered for sale b. Collections received in advance of the delivery of goods or performance of services Debts that arise from operations directly related to the operating cycle, such as accruals for wages, salaries and commission, rentals, royalties, and income and other taxes

c.

Other liabilities whose regular and ordinary liquidation is expected to occur within a relatively short time, usually 12 months, are also intended for inclusion, such as short‐term debts arising from the acquisition of capital assets, serial maturities of long‐term obligations, amounts required to be expended within one year under sinking fund provisions, and agency obligations arising from the collection or acceptance of cash or other assets for the account of third persons

3. Discuss the definitions of trading, available-for-sale and held-to-maturity securities as they related to investments in debt securities. a. Trading securities. Securities held for resale b. Securities available for sale. Securities not classified as trading securities or held‐to‐maturity securities c. Securities held to maturity. Debt securities for which the reporting entity has both the positive intent and the ability to hold until they mature Trading securities are reported at fair value, and all unrealized holding gains and losses are recognized in earnings. Available‐for‐sale securities are reported at fair value. However, unrealized holding gains and losses for these securities are not included in periodic net income; rather, they are reported as a component of other comprehensive income. Held‐to‐maturity securities are reported at amortized cost, whereby discounts and premiums are amortized over the remaining lives of the securities.

All trading securities are reported as current assets on the balance sheet. Individual held-to‐maturity and available‐for‐sale securities are reported as either current assets or investments, as appropriate.

The appropriate classification is to be based on the definition of current assets.

4. On January 5, 2016, the FASB issued Accounting Standards Update 2016‐01, “Financial Instruments—Overall (Subtopic 825‐10): Recognition and Measurement of Financial Assets and Financial Liabilities. Outline the provisions of this pronouncement.

According to the provisions of ASU2016-01, all equity investments in unconsolidated entities (other than those accounted for using the equity method of accounting) will be measured at fair value, and all changes in fair value will be reported on the income statement. There will no longer be a distinction between “trading” and “available‐for‐sale” securities, and changes in the fair value of equity investments previously classified as “available‐ for‐sale” will no longer be reported in other comprehensive income for equity securities with readily determinable fair values. This ASU did not change the FASB ASC 320 treatment for debt securities. ASU 2016‐01 applies to public and private companies, not‐for‐profit organizations, and employee benefit plans that hold financial assets or owe financial liabilities and is effective for public companies for fiscal years beginning after December 15, 2017.16 5. Define the following terms: a. Cash equivalents

Cash equivalents are short-term investments that satisfy the following two criteria: (1) readily convertible into a known amount of cash and (2) sufficiently close to its maturity date so that its market value is relatively insensitive to interest rate changes. b. Temporary investments Temporary investments classified as current assets should be readily marketable and intended to be converted into cash within the operating cycle or a year, whichever is longer. Short-term investments are generally distinguished from cash equivalents by relatively longer investment perspectives, at relatively higher rates of return. c. Receivables The term receivables encompasses a wide variety of claims held against others. Receivables are classified into two categories for financial statement presentation: (1) trade receivables and (2) nontrade receivables. The outstanding receivables balance often constitutes a major source of cash inflows to meet maturing obligations; therefore, the composition of this balance must be carefully evaluated so that financial statement users are not misled. In order for an item to be classified as a receivable, both the amount to be received and the expected due date must be subject to reasonable estimation. d. Inventories The term inventory designates the aggregate of those items of tangible personal property which: (1) are held for sale in the ordinary course of business, (2) are in process of production for such sale, or (3) are to be currently consumed in the production of goods or services to be available for sale. e. Payables Payables are obligations that are fixed by a transaction and involve a promise to pay at a subsequent date. In addition to notes and accounts payable, dividends and taxes represent payables requiring the use of current funds. f.

Deferrals Deferrals are liabilities whose settlement requires the performance of services rather than the payment of money. Examples of deferrals include magazine subscriptions collected in advance, advance-purchase airline tickets, and unearned rent.

g. Current maturities

Current maturities are that portion of long-term debt that is due to be repaid within the current year.

6. Define the following terms: a. LIFO liquidation LIFO liquidation occurs when normal inventory levels are depleted. That is, if inventory levels fall below the normal number of units in any year, the older, usually much lower, cost of these items is charged to cost of goods sold and matched against current sales revenue dollars, resulting in an inflated net income amount that is not sustainable. b. LIFO conformity The LIFO conformity rule stipulates that LIFO inventory costing must be used for reporting purposes when it is used for income tax purposes. c. Lower of cost or market inventory valuation When inventories have declined in value, current GAAP maintains that the future selling price will move in the same direction and that anticipated future losses should be reported in the same period as the inventory decline. In other words, companies must write-down their inventory value to reflect current prices.

7. Define and discuss the two methods of estimating bad debts on receivables.

The two methods are: 1. Bad debts are recorded as the loss is discovered (the direct write-off method).

2. Bad debts are estimated at the end of the accounting period (the estimation, or allowance method).

8. Discuss the two approaches that may be used to estimate expected losses from nonpayment of outstanding accounts receivable balances.

The two approaches that may be used are: (1) the estimated loss is based on annual sales, or (2) the estimated loss is based on the outstanding accounts receivable balance. When the estimated loss is based on annual sales, the matching process is enhanced because expenses are directly related to the revenues that caused the expenses. On the other hand, a more precise measure of anticipated losses can usually be made by reviewing the age and characteristics of the various accounts receivable. When the amount of loss is based on the outstanding accounts receivable, the net balance of the asset account closely resembles the expected amount to be collected in the future (net realizable value).

9. Why are cost flow assumptions used to determine inventory valuations? Define and explain the rationale for using each of the cost flow assumptions.

Cost flow assumptions are necessary to assign the cost of goods sold when it is impossible or impractical to maintain an actual physical count of inventory quantities The three cost flow assumptions are: 1. The first in, first out (FIFO) method under which the oldest goods acquired are assumed to be the first sold. This method is based on assumptions about the actual flow of merchandise throughout the enterprise; in effect, it is an approximation of specific identification.

2. The last in, first out (LIFO) method of inventory valuation under which the last goods acquired are assumed to be the first sold. This method is based on the assumption that current costs should be matched against current revenues. Most advocates of LIFO cite the matching principle as the basis for their stand and argue that decades of almost uninterrupted inflation require that LIFO be used to more closely approximate actual net income.

3. Averaging techniques: whereby, each purchase affects both inventory valuation and cost of goods sold. That is, the sum of all the periodic inventory costs is divided by the sum of all of the periodic inventory qualities. As a result, averaging does not result in either a good match of costs with revenues or a proper valuation of inventories in fluctuating market conditions. .

10. Discuss the perpetual vs. the periodic methods of accounting for inventories.

Businesses that issue audited financial statements are usually required to actually count all items of inventory at least once a year unless other methods provide reasonable assurance that the inventory figure is correct. When the inventory count is used to determine ending inventory, as in a periodic inventory system, the expectation is that all goods not on hand were sold. However, other factors, such as spoilage and pilferage, must be taken into consideration. When quantity is determined by the perpetual records method, all inventory items are tabulated as purchases and sales occur.

11. How is the accounts receivable turnover ratio computed, and what information does it provide?

The accounts receivable turnover ratio is computed by dividing net sales by the average accounts receivables outstanding during the year. This ratio is used to assess the liquidity of the receivables.

It measures the number of times, on average, receivables are collected during the period. It provides some indication of the quality of the receivables and how successful the company is in collecting its outstanding receivables.

12. What does the inventory turnover ratio measure and what is its significance?

Inventory turnover measures how quickly a company’s inventory is sold. Generally, the faster the inventory turnover, the better the enterprise is performing. The more times the inventory turns over, the smaller the net profit margin can be to earn an appropriate total profit and return on assets.

Consequently, a company can price its products lower if it has a high inventory turnover. A

company with a low profit margin, such as can earn as much as a company with a high net profit margin, such as if its inventory turnover often enough.

13. Discuss the concept of working capital management and the factors that impact it.

Working capital management is a strategy that focuses on maintaining efficient levels of the components of working capital, current assets, and current liabilities. The goal of working capital management is to ensure that a company has sufficient cash flow to meet its short‐term debt obligations and operating expenses. A company’s working capital needs are impacted by both internal and external factors: Internal factors: • Company size and growth rates • Organizational structure • Sophistication of working capital management • Borrowing and investing positions/activities/capacities External factors: • Banking services • Interest rates • New technologies and new products • The economy • Competitors 14. Inventory management is a key aspect of working capital management.

Discuss the objective of inventory management including why companies hold inventory and the approaches to managing inventory levels.

The objective of inventory management is to determine and maintain the level of inventory that is sufficient to meet demand but not more than necessary. There are several possible motives for holding inventory, including: • Transaction motive: To hold enough inventory for the ordinary production‐to‐sales cycle • Precautionary motive: To avoid stock‐out losses, which can result in foregone sales as a result of insufficient inventory • Speculative motive: To ensure the availability and pricing of inventory The approaches to managing levels of inventory include the following: • Economic order quantity and the reorder point. Computes the amount of inventory to acquire and the point in time when the company orders more inventory, thereby minimizing the sum of order costs and carrying costs • Just in time: Order inventory as it is needed, thereby reducing or eliminating carrying costs • Materials or manufacturing resource planning: A computer‐based, time‐phased system for planning and controlling the production and inventory function of a firm from the purchase of materials to the shipment of finished goods 15. Obtain a company’s financial statements and ask the students to compute the following:

a. b. c. d. e. f.

Working capital Current ratio Acid test ratio Cash flow from operations to current liabilities ratio Accounts receivable turnover Inventory turnover

The answer to this question is dependent on the companies selected.

Chapter 9 Multiple Choice 1. When a closely held corporation issues preferred stock for land, the land should be recorded at the a. Total par value of the stock issued b. Total book value of the stock issued c. Appraised value of the land d. Total liquidating value of the stock issued Answer c 2. A principal objection to the straight-line method of depreciation is that it a. Provides for the declining productivity of an aging asset b. Ignores variations in the rate of asset use c. Tends to result in a constant rate of return on a diminishing investment base d. Gives smaller periodic write-offs than decreasing charge methods Answer b 3. Property, plant, and equipment are conventionally presented n the balance sheet at a. Replacement cost less accumulated depreciation b. Historical cost less salvage value c. Original cost adjusted for general price level changes d. Acquisition cost less depreciated portion thereof Answer d 4. As generally used in accounting, depreciation a. Is a process of asset valuation for balance sheet purposes b. Applies only to long-lived intangible assets c. Is used to indicate a decline in market value of a long-lived asset d. Is an accounting process that allocates long-lived asset cost to accounting periods Answer d 5. Lyle, Inc., purchased certain plant assets under a deferred payment contract on December 31, 2020.

The agreement was to pay $20,000 at the time of purchase and $20,000 at the end of each of the next five years. The plant assets should be valued at a. The present value of a $20,000 ordinary annuity for five years b. $120,000 c. $120,000 less imputed interest d. $120,000 plus imputed interest

Answer c 6. For income statement purposes, depreciation is a variable expense if the depreciation method used for book purposes is a. Units of production b. Straight line c. Sum-of-the-year’s-digits d. Declining balance Answer a 7. A method that excludes salvage value from the base for the depreciation calculation is a. Straight line b. Sum-of-the-year’s digits c. Double-declining balance d. Productive output Answer c 8. When a company purchases land with a building on it and immediately tears down the building so that the land can be used for the construction of a plant, the cost incurred to tear down the building should be a. Expensed as incurred b. Added to the cost of the plant c. Added to the cost of the land d. Amortized over the estimated time period between the tearing down of the building and the completion of the plant Answer c 9. A machine with a four-year estimated useful life and an estimated 15 percent salvage value was acquired on January 1, 2019. On December 31, 2021, the accumulated depreciation using the sumof-year’s digits method would be a. (Original cost less salvage value) multiplied by 9/10 b. Original cost multiplied by 9/10 c. Original cost multiplied by 9/10 less total salvage value d. (Original cost less salvage value) multiplied by 1/10 Answer a 10. Assets that qualify for interest cost capitalization include a. Assets under construction for a company's own use b. Assets that are ready for their intended use in the earnings of the company c. Assets that are not currently being used because of excess capacity

d. All of these assets qualify for interest cost capitalization Answer a.

11. When computing the amount of interest cost to be capitalized, the concept of "avoidable interest" refers to a. A cost of capital charge for stockholders' equity b. That portion of weighted-average accumulated expenditures on which no interest cost was incurred c. The total interest cost actually incurred d. That portion of total interest cost which would not have been incurred if expenditures for asset construction had not been made Answer d 12. When boot is involved in an exchange having commercial substance a. Only losses should be recognized b. Only gains should be recognized c. Gains or losses are recognized in their entirely d. A gain or loss is computed by comparing the fair value of the asset received with the fair value of the asset given up Answer c 13. The cost of a nonmonetary asset acquired in exchange for another nonmonetary asset when the exchange has commercial substance is usually recorded at a. The fair value of the asset given up, and a gain but not a loss may be recognized b. The fair value of the asset given up, and a gain or loss is recognized c. The fair value of the asset received if it is equally reliable as the fair value of the asset given up d. Either the fair value of the asset given up or the asset received, whichever one results in the largest gain (smallest loss) to the company Answer b 14. A plant site donated by a city to a company that plans to open a new factory should be recorded on the company's books at a. The value assigned to it by the company's directors b. One dollar (since the site cost nothing but should be included in the balance sheet) c. The cost of taking title to it d. Its fair value Answer d

15. An impairment of property, plant, or equipment has occurred if a. The estimated salvage value is less than the actual proceeds received on disposal b. The revised estimated useful life is less than the original estimated useful life c. The expected future cash outflows exceed the asset’s carrying value d. The sum of the expected future net cash flows is less than the asset’s carrying value Answer d 16. When should a long-lived asset be tested for recoverability? a. When external financial statements are being prepared b. When the asset's fair value has decreased, and the decrease is judged to be permanent c. When events or changes in circumstances indicate that its carrying amount may not be recoverable d. When the asset's carrying amount is less than its fair value Answer c 17. The asset turnover ratio is computed by dividing a. Net sales by average total assets b. Net sales by ending total assets c. Net income by ending total assets d. Net income by average total assets Answer c 18. The rate of return on total assets is computed by dividing a. Net sales by ending total assets b. Net income by ending total assets c. Net income by average total assets d. Net sales by average total assets Answer c 19. The theoretical justification for reporting depreciation expense is a. Depreciation expense represents a decrease in the value of the asset that has occurred during the accounting period. b. Depreciation expense represents the impairment of the asset that has occurred during the accounting period. c. Depreciation expense represents the unrealized loss that has been incurred by using the asset during the accounting period. d. Depreciation expense represents the allocation of the historical cost of the asset that has been applied to the accounting period Answer d

20. Which of the following principles best describes the conceptual rationale for the methods of matching depreciation expense with revenues? a. Systematic and rational allocation b. Immediate recognition c.

The process of charging the decline in value of an economic resource to income in the period in which the benefit occurred. d. The process of allocating the cost of tangible assets to expense in a systematic and rational manner to those periods expected to benefit from the use of the asset.

Answer a 21. Which of the following is not one of the basic questions that must be answered before the amount of depreciation charge can be computed? a. What is the asset's useful life? b. What method of cost apportionment is best for this asset? c. What product or service is the asset related to? d. What is the depreciation base to use for the asset?

Answer c 22. A principal objection to the straight-line method of depreciation is that it a. Provides for the declining productivity of an aging asset b. Ignores variations in the rate of asset use c. Tends to result in a constant rate of return on a diminishing investment base d. Gives smaller periodic write-offs than decreasing charge methods Answer b 23. The most common method of recording depletion for accounting purposes is the a. Straight-line method b. Units-of-production method c. Percentage depletion method d. Decreasing charge method Answer b

Essay 1. List the objectives of accounting for property, plant and equipment.

The objectives of plant and equipment accounting are:

1. Reporting to investors on stewardship.

2. Accounting for the use and deterioration of plant and equipment.

3. Planning for new acquisitions, through budgeting.

4. Supplying information for taxing authorities.

5. Supplying rate-making information for regulated industries 2. Describe how cost is assigned to individual assets when they are acquired in a lump-sum group purchase.

When a group of assets is acquired for a lump-sum purchase price, such as the purchase of land, buildings, and equipment for a single purchase price, the total acquisition cost must be allocated to the individual assets so that an appropriate amount of cost can be charged to expense as the service potential of the individual assets expires. The most frequent, though arbitrary, solution to this allocation problem has been to assign the acquisition cost to the various assets on the basis of the weighted average of their respective appraisal values. Where appraisal values are not available, the cost assignment may be based on the relative carrying values on the seller’s books.

3. Discuss the three approaches to allocating fixed overhead to a self-construction project.

The three approaches are: a.

Allocate no fixed overhead to the self-construction project. Some accountants favor the first approach. They argue that the allocation of fixed overhead is arbitrary and therefore only direct costs should be considered.

b. Allocate only incremental fixed overhead to the project. When operations are at less than full capacity, this approach is the most logical. The decision to build the asset was probably connected with the availability of idle facilities. Increasing the profit margin on existing products by allocating a portion of the fixed overhead to the self-construction project will distort reported profits. c. Allocate fixed overhead to the project on the same basis as it is allocated to other products.

When the production of other products has been discontinued to produce a self-constructed asset, allocation of the entire amount of fixed overhead to the remaining products will cause reported profits on these products to decrease. (The same amount of overhead is allocated to fewer products.)

4. Discuss the issue of allocating interest to self-construction projects. That is, when should interest be allocated and how much interest should be allocated?

During the construction period, extra financing for materials and supplies will undoubtedly be required, and these funds will frequently be obtained from external sources. The central question is the advisability of capitalizing the cost associated with the use of these funds. Some accountants have argued that interest is a financing rather than an operating charge and should not be charged against the asset. Others have noted that if the asset were acquired from outsiders, interest charges would undoubtedly be part of the cost basis to the seller and would be included in the sales price.

In addition, public utilities normally capitalize both actual and implicit interest (when their own funds are used) on construction projects because future rates are based on the costs of services.

Charging existing products for the expenses associated with a separate decision results in an

improper matching of costs and revenues. Therefore, a more logical approach is to capitalize incremental interest charges during the construction period. Once the new asset is placed in service, interest is charged against operations. The FASB ASC 835-20-30 guidance indicates that the amount of interest to be capitalized is the amount that could have been avoided if the asset had not been constructed. Two interest rates may be used: the weighted average rate of interest charges during the period and the interest charge on a specific debt instrument issued to finance the project.

The amount of avoidable interest is determined by applying the appropriate interest rate to the average amount of accumulated expenditures for the asset during the construction period.

5. Explain the concept of commercial substance originally outlined in SFAS No. 158.

A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. For these exchanges, the book value of the asset exchanged is to be used to measure the asset acquired in the exchange. Thus, no gains are to be recognized; however, a loss should be recognized if the fair value of the asset exchanged is less than its book value (i.e., an impairment is evident).

6. How did SFAS No. 116, now FASB ASC 605-10-15-3, change the accounting for donated assets?

Previous practice required donated assets to be recorded at their fair market values, with a corresponding increase in an equity account termed donated capital. Recording donated assets at fair market values is defended on the grounds that if the donation had been in cash, the amount received would have been recorded as donated capital, and the cash could have been used to purchase the asset at its fair market value. SFAS No. 116 (See 605-10-15-3), requires that the inflow of assets from a donation be considered revenue (not donated capital).

7. Discuss the distinction between capital and revenue expenditures for long-term assets.

In most cases, the decision to expense or capitalize plant and equipment expenditures subsequent to acquisition is fairly simple and is based on whether the cost incurred is “ordinary and necessary” or “prolongs future life.” Expenditures in the first category are expensed while those in the second category are capitalized.

8. Discuss accounting for asset impairments originally outlined in SFAS No’s 121 and 144.

The FASB, noting divergent practices in the recognition of impairment of long-lived assets, originally issued SFAS No. 121, now superseded, which addressed the matter of when to recognize the impairment of long-lived assets and how to measure the loss. This release ignored current value as a determinant of impairment. Rather, it stated that impairment occurs when the carrying amount of the asset is not recoverable. The recoverable amount is defined as the sum of the future cash flows expected to result from use of the asset and its eventual disposal. Under this standard, companies were required to review long-lived assets (including intangibles) for impairment whenever events or changes in circumstances indicate that book value may not be recoverable. The FASB, noting divergent practices in the recognition of impairment of long-lived assets, originally

issued SFAS No. 121, now superseded, which addressed the matter of when to recognize the impairment of long-lived assets and how to measure the loss. This release ignored current value as a determinant of impairment. Rather, it stated that impairment occurs when the carrying amount of the asset is not recoverable. The recoverable amount is defined as the sum of the future cash flows expected to result from use of the asset and its eventual disposal. Under this standard, companies were required to review long-lived assets (including intangibles) for impairment whenever events or changes in circumstances indicate that book value may not be recoverable. The guidance from SFAS No. 144now contained at at FASB ASC 360-10-40 applies to all dispositions of long-term assets; however, it excludes current assets, intangibles, and financial instruments because they are covered in other releases. According to its provisions, assets are to be classified as: 1. Long-term assets held and used.

2. Long-lived assets to be disposed of other than by sale.

3. Long-lived assets to be disposed of by sale.

Long-term assets held and used are to be tested for impairment using the original SFAS No. 121 criteria if events suggest there may have been impairment. The impairment is to be measured at fair value by using the present value procedures outlined in SFAC No. 7 (see Chapter 2).

Long-lived assets to be disposed of other than by sale, such as those to be abandoned, exchanged for a similar productive asset, or distributed to owners in a spin-off, are to be considered held and used until disposed of. Additionally, in order to resolve implementation issues, the depreciable life of a long-lived asset to be abandoned was to be revised in accordance with the criteria originally established in APB Opinion No. 20, “Accounting Changes.”

The accounting treatment for long-lived assets to be disposed of by sale is used for all long-lived assets, whether previously held and used or newly acquired (FASB ASC 360-10-35). That treatment retains the requirement originally outlined in SFAS No. 121 to measure a long-lived asset classified as held for sale at the lower of its carrying amount or fair value less cost to sell and to cease depreciation (amortization). As a result, discontinued operations are no longer measured on a net realizable value basis, and future operating losses are no longer recognized before they occur.

In summary, SFAS No. 144 retained the requirements of SFAS No. 121 to recognize an impairment loss only if the carrying amount of a long-lived asset is not recoverable from its undiscounted cash flows. This loss is measured as the difference between the carrying amount and fair value of the asset (FASB ASC 360-10-35-17).

9. Define and discuss accounting for asset retirement obligations under SFAS No. 143 (FASB ASC 410-20) At the time SFAS No. 143 was issued, the FASB noted that existing practice regarding asset retirement obligations was inconsistent; consequently, the objective of this release was to provide accounting requirements for all obligations associated with the removal of long-lived assets. FASB ASC 410-20 applies to all entities that face existing legal obligations associated with the retirement of tangible long-lived assets.

FASB ASC 410-20 provides the following definitions associated with the issue:

1. Asset retirement obligation. —the liability associated with the ultimate disposal of a long-term asset.

2. Asset retirement cost. —the increase in the capitalized cost of a long-term asset that occurs when the liability for an asset retirement obligation is recognized.

3. Retirement. —an other than temporary removal of a long-term asset from service by sale, abandonment, or other disposal.

4. Promissory estoppel. —a legal concept that holds that a promise made without consideration may be enforced to prevent injustice.

For each asset retirement obligation, a company is required to initially record the fair value (present value) of the liability to dispose of the asset when a reasonable estimate of its fair value is available. Companies are required to use SFAC No. 7 criteria for recognition of the liability, which is the present value of the asset at the credit adjusted rate. This amount is defined as the amount a third party with a comparable credit standing would charge to assume the obligation.

Subsequently, the capitalized asset retirement cost is allocated in a systematic and rational manner as depreciation expense over the estimated useful life of the asset. Additionally, the initial carrying value of the liability is increased each year by use of the interest method using the credit adjusted rate and classified as accretion expense and not interest expense. In the event any of the original assumptions change, a recalculation of the obligation and the subsequent associated expenses is to be recorded as a change in accounting estimate.

10. What three questions must be answered before the amount of the depreciation charge can be computed?

Before the amount of the depreciation charge can be computed, three basic questions must be answered: 1. What is the depreciation base to be used for the asset?

2. What is the asset’s useful life?

3. What method of cost apportionment is best for this asset?

11. Discuss the guidelines for accounting for property, plant and equipment outlined in IAS No. 16.

IAS No. 16 indicates that items of property, plant, and equipment should be recognized as assets when it is probable that the future economic benefit associated with these assets will flow to the enterprise and that their cost can be reliably measured. Under these circumstances, the initial measurement of the value of the asset is defined as its cost. Subsequently, the stated preferred treatment is to depreciate the asset’s historical cost; however, an allowed alternative treatment is to periodically revalue the asset to its fair market value. When such revaluations occur, increases in value are to be recorded in stockholders’ equity, unless a previously existing reevaluation surplus exists, whereas decreases are recorded as current-period expenses. In the event a revaluation is undertaken, the statement requires that the entire group of assets to which the revalued asset belongs also be revalued. Examples of groups of property, plant, and equipment assets are land, buildings, and machinery. Finally, the required disclosures for items of property, plant, and equipment include

the measurement bases used for the assets, as well as a reconciliation of the beginning and ending balances to include disposals and acquisitions and any revaluation adjustments.

IAS No. 16 also requires companies to periodically review the carrying amounts of items of property, plant, and equipment to determine whether the recoverable amount of the asset has declined below its carrying amount. When such a decline has occurred, the carrying amount of the asset must be reduced to the recoverable amount, and this reduction is recognized as an expense in the current period. IAS No. 16 also requires write-ups when the circumstances or events that led to write-downs cease to exist. This treatment contrasts to the requirements of SFAS No. 144 (See FASB ASC 360-10), which prohibits recognition of subsequent recoveries.

12. How does IAS no. 23 define borrowing costs?

IAS No. 23 defines borrowing costs as interest on bank overdrafts and borrowings, amortization of discounts or premiums on borrowings, amortization of ancillary costs incurred in the arrangement of borrowings, finance charges on finance leases and exchange differences on foreign currency borrowings where they are regarded as an adjustment to interest costs.

13. Discuss accounting for the impairment of assets as outlined in IAS No. 36.

The purpose of IAS No. 36 is to make sure that assets are carried at no more than their recoverable amount, and to define how the recoverable amount is calculated. IAS No. 36 requires an impairment loss to be recognized whenever the recoverable amount of an asset is less than its carrying amount (its book value). The recoverable amount of an asset is the higher of its net selling price and its value in use. Both are based on present-value calculations.

Chapter 10 Multiple Choice 1. Under the equity method of accounting for investments, an investor recognizes its share of the earnings in the period in which the a. Investor sells the investment b. Investee declares a dividend c. Investee pays a dividend d. Earnings are reported by the investee in its financial statements Answer d 2. Lomax Corporation declares and distributes a cash dividend that is a result of current earnings.

How will the receipt of those dividends affect the investment account of the investor under each of the following accounting methods?

Fair Value Method a. No Effect b. Decrease c. No Effect d. Increase

Equity Method No Effect No Effect Decrease Decrease

Answer c 3. An investor has a long-term investment in stocks. Regular cash dividends received by the investor are recorded as Fair Value Method a. Income b. A reduction of the investment c. Income d. A reduction of the investment

Equity Method Income A reduction of the investment A reduction of the investment Income

Answer c 4. When a company holds between 20% and 50% of the outstanding stock of an investee, which of the following statements applies? a. The investor must use the fair value method unless it can clearly demonstrate the ability to exercise "significant influence" over the investee b. The investor should always use the equity method to account for its investment c. The investor should use the equity method to account for its investment unless circumstances indicate that it is unable to exercise "significant influence" over the investee d. The investor should always use the fair value method to account for its investment

Answer c 5. Under the equity method of accounting for investments, an investor recognizes its share of the earnings in the period in which the a. Earnings are reported by the investee in its financial statements b. Investee pays a dividend. c. Investor sells the investment d. Investee declares a dividend Answer a 6. Mayberrry Company owns 40% of Xnau Corporation’s outstanding common stock. During the calendar year 2018, Xnau had net earnings of $500,000 and paid dividends of $60,000. Mayberry mistakenly recorded these transactions using the fair value method rather than the equity method of accounting. What effect would this have on Mayberry’s investment account, net income, and retained earnings, respectively? a. Overstate, understate, understate b. Understate, understate, understate c. Understate, overstate, overstate d. Overstate, overstate, overstate Answer b 7. Pence Corporation, which accounts for its investments in the common stock of Walsh Company by the equity method, should ordinarily record a dividend received from Walsh as a. An addition to the carrying value of the investment b. Dividend revenue c. A reduction of the carrying value of the investment d. Revenue from affiliate Answer c 8. A requirement for a security to be classified as held-to-maturity is a. Positive intent b. The security must be a debt security c. Ability to hold the security to maturity d. All of these are required.

Answer d 9. When an investment in a held-to-maturity security is transferred to an available-for-sale debt security, the carrying value assigned to the available-for-sale debt security should be a. Its original cost

b. Its fair value at the date of the transfer c. The higher of its original cost or its fair value at the date of the transfer. d. The lower of its original cost or its fair value at the date of the transfer.

Answer b 10. “Gains trading” involves a. Reporting investment securities at fair value but liabilities at amortized cost b. Selling securities whose value has increased since acquisition (winners) while holding those whose value has decreased since acquisition (losers) c. Moving securities whose value has decreased since acquisition from available-for-sale to heldto-maturity in order to avoid reporting losses d. All of the above are considered methods of "gains trading" Answer b 11. Which characteristic is not possessed by intangible assets? a. Physical existence b. Long-lived c. Result in future benefits. d. Expensed over current and/or future years.

Answer a 12. Under current GAAP, intangible assets are classified as a. Amortizable or unamortizable. b. Limited-life or indefinite-life c. Specifically, identifiable or unidentifiable d. Legally restricted or unrestricted Answer b 13. Which types of intangible assets are amortized?

Limited-Life a. Yes b. No c. Yes d. No

Indefinite-Life Yes No No Yes

Answer c 14. The right granted to authors and other creative artists for their expressive works is termed a a. Copyright

b. Trademark c. Patent d. Franchise Answer a 15. On January 15, 2018, a corporation was granted a patent on a product. On January 2, 2020, to protect its patent, the corporation purchased a patent on a competing product that originally was issued on January 10, 2016. Because of its unique plant, the corporation does not feel the competing patent can be used in producing a product. The cost of the competing patent should be a. Amortized over a maximum period of 17 years b. Amortized over a maximum period of 13 years c. Amortized over a maximum period of 9 years d. Expensed in 2020 Answer d 16. Pacer Company purchased 300 of the 1,000 outstanding shares of Queen Company’s common stock for $80,000 on January 2, 2019. During 2020, Queen Company declared dividends of $8,000 and reported earnings for the year of $20,000.

If Pacer Company uses the equity method of accounting for its investment in Queen Company, its Investment in Queen Company account at December 31, 2020 should be a. $100, 000 b. $88,000 c. $83,600 d. $80,000 Answer c 17. Refer to the facts in the previous question. If Pacer Company uses the lower of cost or market method of accounting for its investment in Queen Company, and the value of its investment hasn’t changed, its Investment in Queen Company account on December 31, 2020, should be a. $100, 000 b. $88,000 c. $80,000 d. $73,600 Answer c 18. A large, publicly held company developed and registered a trademark during the current year. The cost of developing and registering the trademark should be accounted for by a. Charging it to an asset account that should not be amortized b. Expensing it as incurred c. Amortizing it over 25 years if in accordance with management’s evaluation

d.

Amortizing it over its useful life or 17 years, whichever is shorter

Answer b 19. Goodwill should be written off a. As soon as possible against retrained earnings b. When there is evidence that its carrying value has been impaired c. By systematic charges against retained earnings over the period benefited, but not more than 40 years d. By systematic charges to expense over the period benefited, but not more than 40 years Answer b 20. Cash dividends declared out of current earnings are distributed to an investor. How will the investor’s investment account be affected by those dividends under each of the following accounting methods?

Fair Value Method Equity Method a.

Decrease No effect b.

Decrease Decrease c.

No effect Decrease d.

No effect No effect Answer c 21. An activity that would be expensed currently as research and development costs is the a. Testing in search for or evaluation of product or process alternatives b. Adaptation of an existing capability to a particular requirement or customer’s need as a part of continuing commercial activity c. Legal work in connection with patent applications or litigation, and the sale or licensing of patents d. Engineering follow-through in an early phase of commercial production Answer a 22. Should the following fees associated with the registration of an internally developed patent be capitalized?

Registration Legal fees fees a.

Yes Yes b.

Yes No c.

No Yes d.

No No Answer a

23. Which of the following assets acquired in the current year are amortizable?

Goodwill Trademarks a.

No No b.

No Yes c.

Yes No d.

Yes No Answer b 24. A purchased patent has a remaining life of 15 years. It should be a. Expensed in the year of acquisition b. Amortized over 15 years regardless of its useful life c. Amortized over its useful life if less than 15 years d. Amortized over 40 years Answer c 25. Which of the following amounts incurred in connection with a trademark should be capitalized?

Cost of a Registration Successful defense fees a.

Yes No b.

Yes Yes c.

No Yes d.

No No Answer b 26. Zink Company owns 32% of Ace Company's outstanding voting stock. Zink Company normally should account for its investment in Ace Company using the a. Fair value method. b. Cost method. c. Consolidation procedure. d. Equity method.

Answer d 27. An investor purchased a bond as a long-term investment on January 1. Annual interest was received on December 31. The investor’s interest income for the year would be lowest if the bond was purchased at a. A discount b. A premium c. Par d. Face value

Answer b 28. A loss on impairment of an intangible asset is the difference between the asset’s a. Carrying amount and the expected future net cash flows b. Carrying amount and its fair value c. Fair value and the expected future net cash flows d. Book value and its fair value Answer b 29. The theoretical justification for expensing research and development (R&D) cost as it is incurred is based on which of the following arguments? a. R&D costs provide no future benefits, thus it does not meet the definition of an asset b. R&D costs are incurred to generate current period revenue; thus the matching concept requires that it be expensed as incurred. c. Whether R&D costs that have been incurred will provide future benefit is uncertain, thus it does not meet the definition of an asset. d. Since R&D costs have been incurred during the current period, they meet the definition of an expense.

Answer c 30. When a patent is successfully defended in court, the cost of the lawsuit a. Should be expensed as incurred because it is a period cost. b. Should be added to the cost of the patent and depreciated over the remaining useful life of the patent. c. Should be added to the cost of the patent which is then expensed as a period cost. d. Has already been expensed so there is no further action to take.

Answer b 31. Goodwill is an intangible asset a. That has a definite life and its cost should be amortized over its useful life. b. That is recorded when the company has projected earnings in excess of earnings expected for an investment in a similar company in the same industry. c. That is reviewed for impairment when circumstances indicate that impairment may have occurred. d. That is reviewed annually to determine whether impairment has occurred.

Answer d 32. The physical capital maintenance concept of income would require that an investment in the common stock of another entity be

a. Reported in the balance sheet at historical cost and that only realized gains and losses be reported in earnings. b. Reported in the balance sheet at historical cost and that unrealized gains and losses be reported in earnings. c. Reported in the balance sheet at fair value and that unrealized gains and losses be reported in earnings. d. Reported in the balance sheet at fair value and that unrealized gains and losses be reported in other comprehensive income.

Answer d 33. The economic concept of income would require that an investment in the common stock of another entity be a. Reported in the balance sheet at historical cost and that only realized gains and losses be reported in earnings. b. Reported in the balance sheet at historical cost and that unrealized gains and losses be reported in earnings. c. Reported in the balance sheet at fair value and that unrealized gains and losses be reported in earnings. d. Reported in the balance sheet at fair value and that unrealized gains and losses be reported in other comprehensive income.

Answer c 34. Under the fair value option, an investment in the common stock of another entity will be a. Reported as a current asset b. Reported as a noncurrent asset c. Reported as either a current or noncurrent asset depending on managerial intent. d. Reported as a current asset only if it was not previously reported as an equity method investment.

Answer a 35. When a company reports goodwill in its balance sheet, we know that a. It was internally generated because the company has earnings in excess of those of other companies in the industry. b. The company purchased it. c. The company will be reporting amortization expense for the goodwill. d. The company will not be reporting an impairment loss for the goodwill.

Answer b Essay

1. How are income and balance sheet values determined under the equity method?

Under the equity method, adjustments are made to the recorded cost of the investment to account for the profits and losses of the investee, and distributions of earnings. These adjustments are based on the investor’s percentage of ownership of the investee. For example, if the investee reports a profit, the investor will report as income its pro-rata ownership share of the investee profit and simultaneously increase the carrying value of the investment account by the same amount.

Conversely, dividends received decrease in the carrying value of the investment account for the amount of the dividend received or receivable. Dividends are not reported as income because the investor reports the income of the investee as the investee earns it. In other words, under the equity method, dividends are viewed as distributions of accumulated earnings. Because the accumulation of earnings increases the investment account, the distribution of earnings decreases the investment account. Consequently, the investment account represents the investee’s equity in the investment.

2. Discuss accounting for equity securities under the cost method.

Under the cost method an investment in equity securities is carried at its historical cost. Dividends received or receivable are reported as revenue. The cost method can be criticized because it does not measure current fair value. Historical cost provides information relevant for determining recovery when the securities are acquired. Current fair market value would provide a similar measure for the current accounting period. If the purpose of financial statements is to provide investors, creditors, and other users with information useful in assessing future cash flows, the current assessment of recoverable amounts (current market values) would be relevant. Even for those equity securities that are not actively traded, an estimate of current fair value may be more relevant than cost.

3. Summarize the accounting requirements for investments in equity securities. That is, what methods are available and when is each method appropriate?

The method of accounting for investments in equity securities is dependent on the percentage ownership. If an investor owns less than 20 percent of the outstanding shares of an investee the fair value method is to be used if fair value is readily available. If fair value is not determinable the cost method should be used. Additionally, the market value method may be used in certain circumstances as allowed by the industry practices exception. If an investor owns 20 to 50 percent of the outstanding shares the equity method is appropriate unless there is evidence the investor is not able to exercise significant influence over the investee. In such cases the fair value method is used. For investment in which the investor holds more than 50 percent of the outstanding shares of the investee, consolidate financial statements are prepared.

4. What is the definition of fair value?

Fair value is defined in the FASB ASC as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date." Fair value is therefore a market-based measure.

5. What is the fair value option as defined in FASB ASC 825‐10‐10?

The fair value option as defined in FASB ASC 825‐10‐10 gives companies the option to report most financial instruments at fair value with all gains and losses related to changes in fair value reported in the income statement. This option is applied on an instrument by instrument basis. The fair value option is generally available only at the time a company first purchases the financial asset or incurs a financial liability. If a company chooses to use the fair value option, it must measure this instrument at fair value until the company no longer has ownership.

6. Discuss the use of the fair value option originally described in SFAS No. 159 now contained at FASB ASC 825-10.

SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” FASB ASC 825-10) permits companies to measure most financial assets and liabilities that are recognized in financial statements at fair value. Companies may not opt for fair value reporting for the following financial items: investments that must be consolidated, assets and obligations representing postretirement benefits, leases, demand deposits reported by banks, and financial instruments classified as components of stockholder’s equity. The objective of the fair value option is “to improve financial reporting by providing entities with an opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting.” However, since the pronouncement is not limited to related assets and liabilities, it is apparent that the FASB is attempting to broaden the use of fair value accounting to areas where it was not previously allowed, most notably to liabilities.

The election to opt for fair value reporting may be applied by instrument. It may be elected for a single eligible debt or equity security without electing it for other identical items. Moreover, the option need not be applied to all instruments issued or acquired in a single transaction. An exception to being able to apply by instrument is that when electing fair value for an investment that would otherwise be accounted for under the equity method, the investor must apply fair value to all financial interests in the same entity, including its eligible debt and equity instruments.

After making the fair value election, all subject items are reported in the balance sheet at fair value.

Fair value is to be measured using exit prices on the balance sheet date. SFAS No. 159 defined fair value as the price that reporting entity would receive to sell an asset or pay to transfer a liability in an orderly transaction between market participants. All unrealized holding gains and losses are to be reported in earnings.

The reporting entity must separately disclose assets and liabilities pursuant to electing fair value in a manner that clearly separates them from the carrying values of other assets and liabilities, either parenthetically by a single line that includes both or on separate lines in the balance sheet.

Moreover, if the fair value option is elected for available-for-sale and/or held-to-maturity securities

when SFAS No. 159 (See FASB ASC 825-10) is adopted, they are to be reported as trading securities. The cumulative effect of the gains and losses for these securities is to be reported as an adjustment to retained earnings.

7. ASU 2016-01 attempted to simplify the impairment model for equity securities for which an entity has elected the practicability exception by eliminating the requirement to assess whether an impairment of such an investment is other than temporary. What are the factors to be considered in making this assessment and how is an impairment recorded?

The factors to be considered are: a. A significant deterioration in the earnings performance, credit rating, asset quality, or business prospects of the investee b. A significant adverse change in the regulatory, economic, or technological environment of the investee c. A significant adverse change in the general market condition of either the geographical area or the industry in which the investee operates d. A bona fide offer to purchase, an offer by the investee to sell, or a completed auction process for the same or similar investment for an amount less than the carrying amount of that investment e. Factors that raise significant concerns about the investee’s ability to continue as a going concern, such as negative cash flows from operations, working capital deficiencies, or noncompliance with statutory capital requirements or debt covenants.

If it is determined that an equity security is impaired on the basis of the qualitative assessment, the company will recognize an impairment loss equal to the amount by which the security’s carrying amount exceeds its fair value.

8. Discuss accounting for investments in debt securities.

Investments in debt securities, such as bonds or government securities, for which the fair value option is not elected, are initially recorded at cost, including upfront cost to acquire the securities.

Typically, the purchase price of a debt instrument differs from its face value. This difference reflects the fluctuations in market interest rates that have occurred since the time the debt instrument was initially offered for sale to the present. Thus, debt instruments are usually sold at a premium or discount.

SFAS No. 115 required that at acquisition, individual investments in debt securities be classified as trading, available-for-sale, or held-to-maturity (See FASB 320-10-25-1). Those debt securities that are classified as trading or available-for-sale are to be treated in the same manner as equity securities that are similarly classified. That is, the fair value method for trading and equity securities also applies to trading and available-for-sale debt securities. Thus, the discussion that follows will be limited to those debt securities that are classified as held-to-maturity.

Debt instruments must be classified as held-to-maturity “only if the reporting enterprise has the positive intent and ability to hold those securities to maturity.”

Debt securities that are classified as held-to-maturity must be measured at amortized cost. When these debt securities are sold at a premium or discount, the total interest income to the investing enterprise over the life of the debt instrument from acquisition to maturity is affected by the amount of the premium or discount. Measurement at amortized cost means that the premium or discount is amortized each period to calculate interest income.

9. What is an intangible asset? How is the cost of an intangible asset amortized?

Intangibles are capital assets having no physical existence whose value depends on the rights and benefits that possession confers to the owner.

Intangible assets derive their value from the special rights and privileges that they convey, and accounting for these assets involves the same problems as accounting for other long-term assets.

Specifically, an initial carrying amount must be determined and then systematically and rationally allocated to the periods that receive benefit.

Intangible assets other than goodwill are divided into two groups: those with indefinite lives and those with finite lives. An acquired intangible asset’s useful life is determined by reviewing various factors such as its expected use, related assets, legal regulatory or contractual provisions, the effects of obsolescence, and the level of required maintenance. If no legal, regulatory, contractual, or other factor limits an intangible asset’s useful life, it is considered to have an indefinite life. Intangible assets that are not amortized must be tested for impairment at least annually by comparing the fair values of those assets with their recorded amounts and/or amortized over their remaining useful lives. Intangible assets that have finite useful lives will continue to be amortized over their useful lives.

10. What factors should be considered in estimating the useful life of an intangible asset?

Factors to be considered in determining useful life are: a. Legal, regulatory, or contractual provisions may limit the maximum useful life. b. Provisions for renewal or extension may alter a specific limit on useful life. c. Effects of obsolescence, demand, competition, and other economic factors may reduce a useful life. d. A useful life may parallel the service life expectancies of individuals or groups of employees. e. Expected actions of competitors and others may restrict present competitive advantages. f. An apparently unlimited useful life may in fact be indefinite, and benefits cannot be reasonably projected. g. An intangible asset may be a composite of many individual factors with varying effective lives.

11. Discuss the accounting treatment for internally developed versus externally purchased intangible assets.

When intangibles are created internally, it is often difficult to determine the validity of any future service potential. To permit deferral of these types of costs would lead to a great deal of subjectivity because management could argue that almost any expense could be capitalized on the basis that it will increase future benefits. Therefore, intangibles created internally are expensed. The cost of purchased intangibles, however, is capitalized because its cost can be objectively verified and reflects its fair value at the date of acquisition.

12. What is goodwill? How is the recorded value of goodwill determined? How is goodwill written off under the provisions of SFAS No. 142 now FASB ASC 350?

As initially conceived, goodwill was viewed as good relations with customers. Such factors as a convenient location and habits of customers were viewed as adding to the value of the business. It has been described as everything that might contribute to the advantage an established business possessed over a business to be started anew. Over time, the concept of goodwill has evolved into an earning power concept in which its value is approximated by attributing to goodwill all future earnings that are expected to be in excess of those that a similar company would generate and then discounting the expected excess earnings stream to its present value.

Although goodwill may exist at any point in time, in practice goodwill is recognized for accounting purposes only when it is acquired through the purchase of an existing business. Only then is the value of goodwill readily determinable, because the purchase embodies an arm’s-length transaction wherein assets, often cash or marketable securities, are exchanged. The value of the assets exchanged indicates a total fair value for the business entity acquired. The excess of total fair value over the fair value of identifiable net assets is considered goodwill. This practice fulfills the stewardship function of accounting and facilitates the accountability of management to stockholders.

SFAS No. 142 changes the accounting treatment for goodwill from an amortization period not to exceed forty years, to an approach that requires, at a minimum, annual testing for impairment. The goodwill impairment test is to be performed at the reporting unit level which is defined as an operating segment or one level below an operating segment (also known as a component).

Under the provisions of SFAS No. 142, the test for goodwill impairment is a two-step process that involves: 1. A comparison of the fair value of the reporting unit to its carrying value. In the event fair value exceeds carrying value, no further testing is required. However, if the carrying value of the reporting unit exceeds its fair value, step two is required.

2. A calculation of the implied fair value of goodwill by measuring the fair value of the net assets other than goodwill and subtracting this amount from the fair value of the reporting unit.

13. Define research and development. How are research and development costs recorded?

Research is planned search or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service or new process or technique or in bringing about a significant improvement to an existing product or process.

Development is the translation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or use. It includes the conceptual formulation, design and testing of product alternatives, construction of prototypes, and operation of pilot plants. It does not include routine or periodic alterations to existing products, production lines, manufacturing processes, and other ongoing operations even though these alterations may represent improvements and it does not include market research or market testing activities.

FASB ASC 730 requires all research and development costs to be charged to expense as incurred.

14. What are the general requirements for the initial and subsequent measurement of financial instruments under IFRS No. 9?

All financial instruments are to be initially measured at fair value plus or minus, in the case of a financial asset not at fair value through profit or loss, transaction costs. The classification of a financial asset is made at the time it is initially recognized. Two criteria are used to determine how financial assets should be classified and measured: • The entity’s business model for managing the financial assets • The contractual cash flow characteristics of the financial asset

For subsequent measurement purposes, IFRS No. 9 divides all financial assets into two measurement classifications: 1. Those measured at amortized cost 2. Those measured at fair value Where assets are measured at fair value, gains and losses are either recognized entirely in profit or loss (fair value through profit or loss, FVTPL), or recognized in other comprehensive income (fair value through other comprehensive income, (FVTOCI). For debt instruments the FVTOCI classification is required for certain assets unless the fair value option is elected. For equity investments, the FVTOCI classification is an optional election. However, the requirements for reclassifying gains or losses recognized in other comprehensive income are different for debt instruments and equity investments.

A business model refers to how an entity manages its financial assets to generate cash flows—by collecting contractual cash flows, selling financial assets or both. Financial assets are measured at amortized cost in a business model whose objective is to hold assets to collect contractual cash flows. Financial assets are classified and measured at FVTOCI in a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets. Any financial assets that are not held in one of these two business models are measured at FVTPL. Financial

assets that are held for trading and those managed on a fair value basis are also included in this category.

Equity investments included under the scope of IFRS No. 9 are to be measured at fair value in the statement of financial position, with value changes recognized in profit or loss, except for those equity investments for which the entity has elected to present value changes in other comprehensive income. If a financial asset is a debt instrument and the objective of the entity’s business model is to collect its contractual cash flows, the financial asset is measured at amortized cost. All other debt instruments are measured at FVTPL.

Chapter 11 Multiple Choice 1. A loss from early extinguishment of debt, if material, should be reported as a component of income a. After cumulative effect of accounting changes and after discontinued operations of a segment of a business b. After cumulative effect of accounting changes and before discontinued operations of a segment of a business c. Income from continuing operations d. Before cumulative effect of accounting changes and before discontinued operation s of a segment of a business Answer c 2. Unamortized bond discount should be reported on the balance sheet of the issuer as a. A direct deduction from the face amount of the debt b. A direct deduction from the present value of the debt c. A deferred charge d. Part of the issue costs Answer a 3. An example of an item that is not a liability is a. Dividends payable in stock b. Advances from customers on contracts c. Accrued estimated warranty costs d. The portion of long-term debt due within one year Answer a 4. If bonds are issued initially at a discount and the straight-line method of amortization is used for the discount, interest expense in the earlier years will be a. Greater than if the compound interest method were used b. The same as if the compound interest method were used c. Less than if the compound interest method were used d. Less than the amount of the interest payments Answer a 5. Cole Manufacturing Corporation issued bonds with a maturity amount of $200,000 and a maturity 10 years from date of issue. If the bonds were issued at a premium, this indicates that a. The yield (effective or market) rate of interest exceeded the stated (coupon) rate b. The stated rate of interest exceeded the yield rate

c. d.

The yield and stated rates coincided No necessary relationship exists between the two rates

Answer b 6. Financial leverage refers to the a. Amount of working capital b. Amount of capital provided by owners c. Use of borrowed money to increase the return to owners d. Number of times interest is earned Answer c 7. Financial leverage is likely to be a good financial strategy for stockholders of companies having a. Cyclical high and low amounts of reported earnings b. Steady amounts of reported earnings c. Volatile fluctuation in reported earnings over short periods of time d. Steadily declining amounts of reported earnings Answer b 8. The covenants and other terms of the agreement between the issuer of bonds and the lender are set forth in the a. Registered bond b. Bond coupon c. Bond indenture d. Bond debenture Answer c 9. The term used for bonds that are secured only by the general credit of a company is a. Indebenture bonds b. Callable bonds c. Debenture bonds d. Mortgage bonds Answer c 10. The rate of interest actually earned by bondholders is called the a. Effective rate b. Stated rate c. Coupon rate d. Nominal rate

Answer a 11. Theoretically, a bond payable should be reported at the present value of the interest discounted at a. Stated interest rate for both principal and interest b. Effective interest rate for both principal and interest c. Stated interest rate for principal and effective interest rate for interest d. Effective interest rate for principal and stated interest rate for interest Answer b 12. If a bond was sold at 97, the market rate of interest was: a. Equal to the coupon rate b. Greater than the stated rate c. Equal to the stated rate d. Less than the stated rate Answer b 13. A threat of expropriation of assets that is reasonably possible, and for which the amount of loss can be reasonably estimated, is an example of a (an) a. Loss contingency that should be disclosed, but not accrued b. Loss contingency that should be accrued and disclosed c. Appropriation of retained earnings against which losses should be charged d. General business risk which should not be accrued and need not be disclosed Answer a 14. When it is necessary to impute an interest rate in connection with a note payable, the rate should be a. Two-thirds of the prime rate effective at the time the obligation is incurred b. The same as that used in the GNP Implicit Price Deflator c. At least equal to the rate at which the debtor can obtain financing of a similar nature from other sources at the date of the transaction d. As near zero as can be justified Answer c 15. Taft Company sells Lee Company a machine, the usual cash price of which is $10,000, in exchange for an $11,800 non-interest-bearing note due three years from date. If Taft initially records the note at $10,000, the overall effect will be a. A correct sales price and correct interest revenue b. A correct sales price and understated interest revenue c. An understated sales price and understated interest revenue d. An overstated interest price and understated interest revenue

Answer a 16. In the situation described in problem 15, if Lee records the asset and note at $11,800, the overall effect will be a. A correct acquisition cost and correct interest expense b. A correct acquisition cost and understated interest expense c. An understated acquisition cost and understated interest expense d. An overstated acquisition cost and understated interest expense Answer d 17. When a note payable is exchanged for property, goods, or services, the stated interest rate is presumed to be appropriate unless a. No interest rate is stated b. The stated interest rate is inappropriate. c. The stated face amount of the note is materially different from the current cash sales price for similar items or from current fair value of the note d. All of these answers are correct Answer d 18. If a debt instrument with no ready market is exchanged for property whose fair value is currently indeterminable. a. The board of directors of the entity receiving the property should estimate a value for the property that will serve as a basis for the transaction b. The present value of the debt instrument must be approximated using an imputed interest rate c. The directors of both entities involved in the transaction should negotiate a value to be assigned to the property d. It should not be recorded on the books of either party until the fair value of the property becomes evident Answer b 19. When bonds are issued at a discount, interest expense over the term of debt equals the cash interest paid a. Minus the discount b. Minus the discount minus the par value c. Plus the discount d. Plus the discount plus the par value Answer c 20. How would the amortization of premium on bonds payable affect each of the following?

a. b. c. d.

Carrying value of Bond Increase Increase Decrease Decrease

Net Income Decrease Increase Decrease Increase

Answer d 21. For a trouble debt restructuring involving only modification of terms, it is appropriate for a debtor to recognize a gain when the carrying amount of the debt a. Exceeds the total future cash payments specified by the new terms b. Is less than the total future cash payments specified by the new terms c. Exceeds the present value specified by the new terms d. Is less than the present value specified by the new terms Answer b 22. How should the value of warrants attached to a debt security be account for? a. No value assigned b. A separate portion of paid-in capital c. An appropriation of retained earnings d. A liability Answer b 23. For the issuer of a 10-year term bond, the amount of amortization using the interest method would increase each year if the bond was sold at a Discount Premium a.

No No b.

Yes Yes c.

No Yes d.

Yes No Answer d 24. Gain contingencies are usually recognized in the income statement when a. Realized b. Occurrence is reasonably possible, and the amount can be reasonably estimated c. Occurrence is probable and the amount can be reasonably estimated d. The amount can be reasonably estimated Answer a

25. An estimated loss from a loss contingency should be accrued when a. It is probable at the date of the financial statements that a loss has been incurred and the amount of the loss can be reasonably estimated b. The loss has been incurred by the date of the financial statements and the amount of the loss may be material c. It is probable at the date of the financial statements that a loss has been incurred and the amount of the loss may be material d. It is probable that a loss will be incurred in a future period and the amount of the loss can be reasonably estimated Answer a 26. A two-year note was issued in an arm’s-length transaction at face value solely for cash at the beginning of the year. There were no other rights or privileges exchanged. The interest rate is specified at 10 percent per year. Principal and interest are payable at maturity. The prevailing rate of interest for a loan of this type is 15 percent per year. What annual interest rate should be used to record interest expense for this year and next year?

This year Next Year a.

10 percent 15 percent b.

10 percent 10 percent c.

15 percent 10 percent d.

15 percent 15 percent Answer b 27. The interest rate used to calculate the cash interest payments by the issuer of bonds is a. The market rate of interest b. The effective interest rate c. The stated interest rate d. Equal to the actual interest expense rate Answer c 28. Ace Corporation has a debt to total assets ratio of 65%. This tells the user of Ace’s financial statements a. Ace is getting a 35% return on its assets b. There is a risk Ace cannot pay its debts as they come due c. 65% of the assets are financed by the stockholders d. Ace should issue more debt to reduce its risk Answer b

29. The current accounting treatment for convertible debt is to treat it as straight debt. This treatment can be defended on what basis? a. Convertible debt is a complex financial instrument. b. Convertible debt comprises two financial instruments – a debt instrument and the option to convert. c. The debt instrument and the option to convert are not separable. d. The option to convert is equity.

Answer c 30. A zero-coupon bond is different from a typical bond issue because a. The investor can clip the coupons and get paid for the periodic interest on the bond while a typical bond does not have coupons. b. It is reported in the balance sheet net of the discount on the bond. c. The zero-coupon bond’s deep discount is reported as an asset and a typical bond that is issued at a discount is reported net of the discount. d. It does not pay any periodic interest while the typical bond does.

Answer d 31. An unearned revenue is an example of a(an) a. Deferred credit. b. Accrued liability. c. Customer billing that takes place before a job is finished. d. Accounts receivable.

Answer a 32. A deferred credit meets the definition of a liability because a. It is a probable future sacrifice of assets as the result of a past transaction or event. b. It is a present obligation to transfer assets to another entity. c. It is an accrual representing an obligation to pay money in the future. d. It is a present obligation to provide services to another entity.

Answer d 33. ABC Company has a note payable that is due six months after its year end. Under which of the following conditions will ABC be able to classify the note as a long-term debt. a. ABC cannot classify the note as long term because it is due within the current operating cycle or one year, whichever is longer. b. ABC can classify the note as long term because it is due next year. c. ABC can classify the note as long term because management intends to refinance it with long term debt and has an agreement to do so with a qualified creditor.

d. ABC can classify the note as long term because it is a 10 year note and management intends to pay the maturity value at the end of the 10-year period.

Answer c 34. Current accounting treatment for gain contingencies is different from the accounting treatment for loss contingencies. Which accounting concept is this differential concept consistent with? a. Conservatism b. Materiality c. Full disclosure d. Revenue recognition Answer a 35. In general, derivative instruments are a. Not reported in a company’s balance sheet because their impact on the company is not yet known. b. Reported in the balance sheet at fair value and changes in their fair value are reported in earnings. c. Reported in the balance sheet at historical cost and changes in their fair value are reported in earnings. d. Reported in the balance sheet at fair value and changes in their fair value are reported in other comprehensive income.

Answer b 36. A debtor and a creditor have negotiated new terms on a note. How can you determine whether the restructuring is a troubled debt restructure? a. If the interest rate as stated in the restructuring agreement has been reduced relative to the original loan agreement b. If the present value of the restructured flows using the original interest rate is less than the market value of the original debt at the date of the restructure c. If the present value of the restructured flows using the original interest rate is less than the book value of the debt at the date of the restructure d. If the interest rate that equates (1) the book value of the debt at the date of the restructure and (2) the present value of restructured cash flows, exceeds the original interest rate Answer c 37. In a troubled debt restructuring in which the debt is continued with modified terms and the carrying amount of the debt is less than the total future cash flows, a. A gain should be recognized by the debtor b. No interest expense or revenue should be recognized in the future c. A loss should be recognized by the debtor

d. A new effective-interest rate must be computed Answer d 38. Under a troubled debt restructuring that results in a modification of terms the debtor will report interest expense when a. The debtor reports a gain on restructuring. b. The future cash flows under the restructuring agreement are less than the company’s obligation at the date the restructuring takes place. c. Always because the troubled debtor has a new agreement that obligates the company to make payments in the future. d. The debtor reports no gain on restructuring.

Answer d 39. The times interest earned ratio is computed by dividing a. Income before income taxes and interest expense by interest expense b. Income before taxes by interest expense c. Net income by interest expense. d. Net income and interest expense by interest expense Answer a 40. The following data pertain to Mahler Company’s operations for the year ended December 31, 2017: Operating income Interest expense Income before income tax Income tax expense Net income

$800,000 100,000 700,000 210,000 $490,000

The times interest earned ratio is a. 4.9 to 1 b. 5.6 to 1 c. 7.0 to 1 d. 8.0 to 1 Answer d 41. The long-term debt to assets ratio is computed by dividing a. Long-term debt by total assets b. Total assets by total liabilities c. Total liabilities by total assets d. Current liabilities by total assets

Answer a Essay 1. List and discuss five factors that may be employed to determine if a particular financial instrument is a debt or equity security.

There are 13 possible factors the students might select. These factors are: Maturity Date Debt instruments typically have a fixed maturity date, whereas equity instruments do not mature.

Because they do mature, debt instruments set forth the redemption requirements. One of the requirements may be the establishment of a sinking fund in order to ensure that funds will be available for the redemption.

Claim on Assets In the event the business is liquidated, creditors' claims take precedence over those of the owners.

There are two possible interpretations of this factor. The first is that all claims other than the first priority are equity claims. The second is that all claims other than the last are creditor claims. The problem area includes all claims between these two interpretations: those claims that are subordinated to the first claim but take precedence over the last claim.

Claim on Income A fixed dividend or interest rate has a preference over other dividend or interest payments. That it is cumulative in the event it is not paid for a particular period is said to indicate a debt security. On the other hand, a security that does not provide for a fixed rate, one that gives the holder the right to participate with common stockholders in any income distribution, or one whose claim is subordinate to other claims, may indicate an ownership interest.

Market Valuations As long as a company is solvent, market valuations of its liabilities are unaffected by company performance. Conversely, the market price of equity securities is affected by the earnings of the company as well as by investor expectations regarding future dividend payments.

Voice in Management A voting right is the most frequent evidence of a voice in the management of a corporation. This right is normally limited to common stockholders, but it may be extended to other investors if the company defaults on some predetermined conditions. For example, if interest is not paid when due or profits fall below a certain level, voting rights may be granted to other security holders, thus suggesting that the security in question has ownership characteristics.

Maturity Value

A liability has a fixed maturity value that does not change throughout its life. An ownership interest does not mature, except in the event of liquidation; consequently, it has no maturity value.

Intent of Parties The courts have determined that the intent of the parties is one factor to be evaluated in ruling on the debt or equity nature of a particular security. Investor attitude and investment character are two sub-factors that help in making this determination. Investors may be divided into those who want safety and those who want capital growth, and the investments may be divided into those that provide either safety or an opportunity for capital gains or losses. If the investor was motivated to make a particular investment on the basis of safety and if the corporation included in the issue those features normally equated with safety, then the security may be debt rather than equity. However, if the investor was motivated to acquire the security by the possibility of capital growth and if the security offered the opportunity of capital growth, the security would be viewed as equity rather than debt.

Preemptive Right By law, common stockholders have a preemptive right (the right to purchase common shares in a new stock offering by the corporation). If a security offers its holder a preemptive right, it may be considered to have an equity characteristic. Securities not carrying this right may be considered debt.

Conversion Features A security that may be converted into common stock has at least the potential to become equity if it is not currently considered equity. Thus, the security, or perhaps its conversion feature, may be considered equity. A historical study of eventual conversion or liquidation may be useful in evaluating this particular factor.

Potential Dilution of Earnings per Share This factor might be considered as a sub-factor of conversion because the conversion feature of a security is the most likely cause of dilution of earnings per share, other than a new issue of common stock. In any event, a security that has the potential to dilute earnings per share is assumed to have equity characteristics.

Right to Enforce Payments From a legal point of view, creditors have the right to receive periodic interest at the agreed-upon date and to have the maturity value paid at the maturity date. The enforcement of this right may result in the corporation being placed in receivership. Owners have no such legal right; therefore, the existence of the right to enforce payment is an indication of a debt instrument.

Good Business Reasons for Issuing Determining what constitutes good business reasons for issuing a security with certain features rather than one with different features presents a difficult problem. Two relevant sub=factors are the alternatives available and the amount of capitalization. Securities issued by a company in financial difficulty or with a low level of capitalization may be considered equity on the grounds

that only those with an ownership interest would be willing to accept the risk, whereas securities issued by a company with a high level of capitalization may be viewed as debt.

Identity of Interest between Creditors and Owners When the individuals who invest in debt securities are the same individuals, or family members, who hold the common stock, an ownership interest is implied.

2. Discuss the definition and the proper accounting for mandatorily redeemable preferred stock.

Mandatorily redeemable preferred stock is preferred stock which contains an unconditional obligation for the issuer to redeem it by transferring assets at a specified or determinable date or dates or upon an event that is certain to occur.

Mandatorily redeemable preferred stock is required to be classified as a liability.

3. Discuss the four basic reasons why a corporation may wish to issue debt rather than equity securities.

There are four basic reasons why a corporation may wish to issue debt rather than equity securities: •

Bonds may be the only available source of funds. Many small and medium-size companies may appear too risky for investors to make a permanent investment.

•

Debt financing has a lower cost. Since bonds have lower investment risk than stock, they traditionally have paid relatively low rates of interest. Investors acquiring equity securities generally expect a greater return to compensate for higher investment risk.

•

Debt financing offers a tax advantage. Interest payments to debt holders are deductible for income tax purposes, whereas dividends paid on equity securities are not.

•

The voting privilege is not shared. Stockholders wishing to maintain their present percentage of ownership in a corporation must purchase the current ownership proportion of each new common stock issue. Debt issues do not carry ownership or voting rights; consequently, they do not dilute voting power. Where the proportion of ownership is small and holdings are widespread, this consideration is probably not very important.

4. Define the following terms: a. Mortgage bonds Bonds that are secured by a lien against specific assets of the corporation are known as mortgage bonds. b. Debenture bonds Debenture bonds are not secured by any property or assets, and their marketability is based on the corporation's general credit.

5. Explain how the selling price of a bond is determined.

The issue price of the bond is equal to the sum of the present values of the principal and interest payments, discounted at the yield rate. If investors are willing to accept the interest rate stated on the bonds, they will be sold at their face value, or par, and the yield rate will equal the stated interest rate. When the market rate of interest exceeds the stated interest rate, the bonds will sell below face value (at a discount), thereby increasing the effective interest rate. Alternatively, when the market rate of interest is less than the stated interest rate, the bonds will sell above face value (at a premium), thereby lowering the effective interest rate.

6. Discuss the two methods of accounting for bond discounts or premiums. Include in you answer the preferable treatment under GAAP. Bond discounts and premiums may be amortized on a straight-line basis or on an effective-interest basis. GAAP generally requires the effective-interest method but permits the straight-line method when the results obtained are not materially different from the effective-interest method. The straight-line method results in an even or average allocation of the total interest over the life of the notes or bonds. The effective-interest method results in an increasing or decreasing amount of interest each period. This is because interest is based on the carrying amount of the bond issuance at the beginning of each period. The straight-line method results in a constant dollar amount of interest and an increasing or decreasing rate of interest over the life of the bonds. The effectiveinterest method results in an increasing or decreasing dollar amount of interest and a constant rate of interest over the life of the bonds.

7. How are bond issue costs recorded and reported on corporate financial statements?

Bond issuance costs should be recorded as a reduction to the issue amount and then amortized into expense over the life of the bond. A deferred charge account is set up for Unamortized Bond Issue Costs and amortized over the life of the issue, separately from but in a manner similar to that used for discount on bonds.

8. What is a zero-coupon bond? Discuss accounting for zero-coupon bonds.

A zero coupon or deep discount bond is a bond that does not carry a stated rate of interest and thus, the borrower makes no interest payments to the investor. As a result, zero coupon bonds are sold at considerably less than face value (i.e., at a deep discount). Because there are no interest payments, the interest cost to the issuer is equal to the difference between the maturity value and the issue price of the bond. The resulting periodic interest expense is equal to the amount of the discount amortized for the accounting period. For example, if a $100,000 zero coupon bond with a life of ten years is issued to yield 12 percent, the issue price will be $32,197 and the unamortized discount will be $67,803. Interest expense should be calculated using the effective interest method.

For the first-year interest expense will be $3,864 (12% × $32,197). The bond's carrying value will then increase by the amount of the discount amortized ($3,864), resulting in an increase in interest

expense incurred for year two. This pattern is repeated until the carrying value of the bond has increased to its face value.

9. Discuss the difference between the straight-line and the effective interest methods of bond premium or discount amortizations.

There are two methods of allocating interest expense and the associated premium or discount over the life of the bond issue: (1) the straight-line method and (2) the effective interest method. Under the straight-line method, the total discount or premium is divided by the total number of interest periods to arrive at the amount to be amortized each period. This method gives an equal allocation per period and results in a stable interest cost per period.

The assumption of a stable interest cost per interest period is not realistic, however, when a premium or discount is involved. The original selling price of the bonds was set to yield the market rate of interest. Therefore, the more valid assumption is that the yield rate should be reflected over the life of the bond issue. The effective interest method satisfies this objective by applying the yield rate to the beginning carrying value of the bonds in each successive period to determine the amount of interest expense to record. When using the effective interest method, the premium or discount amortization is determined by finding the difference between the stated interest payment and the amount of interest expense for the period.

10. List the three methods of accounting for bonds refunding. Under current GAAP, how are bond refundings recorded?

In ARB No. 43, three methods of accounting for the gain or loss from a refunding transaction were discussed.

• • •

Make a direct write-off of the gain or loss in the year of the transaction.

Amortize the gain or loss over the remaining life of the original issue.

Amortize the gain or loss over the life of the new issue.

After a subsequent reexamination of the topic, the APB issued Opinion No. 26, “Early Extinguishment of Debt” (See FASB ASC 470-50) In this release the Board maintained that all early extinguishments were fundamentally alike (whether retirements or refundings) and that they should be accounted for in the same manner. Since the accounting treatment of retirements was to reflect any gain or loss in the period of recall, it was concluded that any gains or losses from refunding should also be reflected currently in income. Thus, options two and three are no longer considered acceptable under GAAP. 11. Discuss the factors that might motivate corporate management to decide to issue convertible debt.

Senior securities (bonds or preferred stock) that are convertible into common stock at the election of the bondholder play a frequent role in corporate financing. There is rather widespread agreement that firms sell convertible securities for one of two primary reasons. Either the firm wants to increase equity capital and decides that convertible securities are the most advantageous way, or

the firm wants to increase its debt or preferred stock and discovers that the conversion feature is necessary to make the security sufficiently marketable at a reasonable interest or dividend rate. In addition, there are several other factors that, at one time or another, may motivate corporate management to decide to issue convertible debt. Among these are: 1. Avoid the downward price pressures on the firm's stock that placing a large new issue of common stock on the market would cause.

2. Avoid dilution of earnings and increased dividend requirements while an expansion program is getting under way.

3. Avoid the direct sale of common stock when the corporation believes that its stock is currently undervalued in the market.

4. Penetrate that segment of the capital market that is unwilling or unable to participate in a direct common stock issue.

5. Minimize the flotation cost (costs associated with selling securities).

12. Discuss accounting for long-term notes payable as originally described in APB Opinion No. 21.

The provisions of APB Opinion No. 21 are summarized as follows (See FASB ASC 835-30-25): 1. Notes exchanged solely for cash are assumed to have a present value equal to the cash exchanged.

2. Notes exchanged for property, goods, and services are presumed to have an appropriate rate of interest.

3. If no interest is stated or the amount of interest is clearly inappropriate on notes exchanged for property, goods, and services, the present value of the note should be determined by (whichever is more clearly determinable): a. Determining the fair market value of the property, goods, and services exchanged. b. Determining the market value of the note at the time of the transaction.

4. If neither 3a nor 3b is determinable, the present value of the note should be determined by discounting all future payments to the present at an imputed rate of interest. The imputed rate should approximate the rate of similar independent borrowers and lenders in arm's-length transactions. In this case, the imputed rate should approximate the rate that the borrower would have to pay to obtain additional funds. So, it is often referred to as the incremental borrowing rate.

13. What is off-balance sheet financing and why do companies engage in off-balance sheet financing?

Off-balance-sheet financing is an attempt to borrow monies in such a way that the obligations are not recorded in the financial statements. The proportion of debt in a firm’s capital structure is perceived as an indicator of the level of risk associated with investing in that company.

Consequently:

a. Removing debt enhances the quality of the balance sheet and permits credit to be obtained more readily and at less cost. b. Loan covenants are less likely to be violated. c. The asset side of the balance sheet is understated because fair value is not used for many assets. As a result, not reporting certain debt transactions offsets the nonrecognition of fair values on certain assets.

14. Discuss accounting for contingencies A contingency is a possible future event that will have some impact on the firm. Among the most frequently encountered contingencies are a. b. c. d.

pending lawsuits income tax disputes notes receivable discounted accommodation endorsements

The decision to report contingencies should be based on the principle of disclosure. That is, when the disclosure of an event adds to the information content of financial statements, it should be reported. Some authors have argued for basing this decision on expected value criteria. If a potential obligation has a high probability of occurrence, it should be recorded as a liability, whereas potential obligations with low probabilities are reported in the footnotes to the financial statements.

The FASB reviewed the nature of contingencies in SFAS No. 5, “Accounting for Contingencies.”

(See FASB ASC 450). This release defines two types of contingencies—gain contingencies (expected future gains) and loss contingencies (expected future losses).

With respect to gain contingencies, the Board held that they should not usually be reflected currently in the financial statement because to do so might result in revenue recognition before realization. Adequate disclosure should be made of all gain contingencies while exercising due care to avoid misleading implications as to the likelihood of realization.

The criteria established for reporting loss contingencies require that the likelihood of loss be determined as follows: a. Probable. The future event is likely to occur. b. Reasonably possible. The chance of occurrence is more than remote but less than likely. c. Remote. The chance of occurrence is slight.

Once the likelihood of a loss is determined, contingencies are charged against income and a liability is recorded if both of the following conditions are met:

a. Information available prior to the issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. b. The amount of the loss can be reasonably estimated.

If a loss is not accrued because one or both of these conditions has not been met, footnote disclosure of the contingency should be made when there is at least a reasonable possibility that a loss may have been incurred.

15. What is a derivative? Describe the accounting treatment for fair value and cash flow hedges required by SFAS No. 133.

A derivative is a transaction, or contract, whose value depends on the value of an underlying asset or index. (That is, its value is derived from an underlying asset or index.) In such a transaction, a party with exposure to unwanted risk can pass some or all of that risk onto a second party. When derivatives are employed, the first party can (1) assume a different risk from the second party, (2) pay the second party to assume the risk, or (3) use some combination of 1 and 2.

For a derivative designated as a hedge of the exposure to changes in the fair value of a recognized asset or liability or a firm commitment (referred to as a fair value hedge), the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item. The effect of this accounting treatment is to adjust the basis of the hedged item by the amount of the gain or loss on the hedging derivative to the extent that the gain or loss offsets the loss or gain experienced on the hedged item.

For a derivative designated as a hedge of the exposure to variable cash flows of a forecasted transaction (referred to as a cash flow hedge), the gain or loss is reported as a component of other comprehensive income (outside of earnings) and recognized in earnings on the projected date of the forecasted transaction.

16. Define the following terms: a. Forward A forward transaction obligates one party to buy and another to sell a specified item, such as 10,000 Euros, at a specified price on a specified future date. On the other hand, an option gives its holder the right, but not the obligation, to buy or sell the specific item, such as the 10,000 Euros, at a specified price on a specified date in the future. b. Future Obligates the holder to buy or sell specified amount of currency at a specified price on a specified date in the future.

c. Option Grants the purchaser the right, but not the obligation, to buy or sell a specific amount of currency at a specified price within a specified period. d. Swap Agreement between the parties to make periodic payments to each other during the swap period e. Hybrid Incorporates various provisions of any or all of the above types.

17. What is a troubled debt restructuring? How is a troubled debt restructuring accomplished?

According to, FASB ASC 470-60-20 a troubled debt restructuring occurs when “the creditor for economic or legal reasons related to the debtor's financial difficulties grants a concession to the debtor that it would not otherwise consider.” A troubled debt restructuring may include, but is not limited to, one or any combination of the following: 1. Modification of terms of a debt such as one or a combination of: a. Reduction of the stated interest rate for the remaining original life of the debt. b. Extension of the maturity date or dates at a stated interest rate lower than the current market rate for new debt with similar risk. c. Reduction of the face amount or maturity amount of the debt as stated in the instrument or other agreement. d. Reduction of accrued interest.

2. Issuance or other granting of an equity interest to the creditor by the debtor to satisfy fully or partially a debt unless the equity interest is granted pursuant to existing terms for converting the debt into an equity interest.

3. A transfer from the debtor to the creditor of receivables from third parties, real estate, or other assets to satisfy fully or partially a debt.

18. Obtain the financial statements of a company and ask the students to compute the: a. Long-term debt to assets ratio b. Interest coverage ratio c. Debt service coverage ratio The answer to this question is dependent on the company selected.

19. How are compound financial instruments accounted for under IAS No. 32?

IAS No. 32 indicates that some financial instruments have both a liability and an equity component.

In such case, IAS No. 32 requires that the component parts be accounted for and presented separately according to their substance based on the definitions of liability and equity. The split is

made at issuance and not revised for subsequent changes in market interest rates, share prices, or other event that changes the likelihood that the conversion option will be exercised.

20. What are the general rules for the initial and subsequent measurement of financial liabilities under IFRS No. 9?

Under the provision of IFRS No. 9, all financial liabilities are to be initially measured at fair value plus or minus, in the case of a financial liability not at fair value through profit or loss, transaction costs.

IFRS No. 9 doesn’t change the basic accounting model for the subsequent measurement of financial liabilities originally contained in IAS No.39. That is, two measurement categories continue to exist: 1. Fair value through profit or loss (FVTPL) and 2. Amortized cost.

Financial liabilities held for trading, derivatives, and financial liabilities designated are measured at FVTPL, and all other financial liabilities are measured at amortized cost unless the fair value option is applied. IFRS No. 9 provides an option to measure a financial liability at FVTPL if doing so eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as an accounting mismatch) or when doing so results in more relevant information.

Chapter 12 Multiple Choice 1. With respect to the difference between taxable income and pretax accounting income, the tax effect of the undistributed earnings of a subsidiary included in consolidated income should normally be a. Accounted for as a timing difference b. Accounted for as a permanent difference c. Ignored because it must be based on estimates and assumptions d. Ignored because it cannot be presumed that all undistributed earnings of a subsidiary will be transferred to the parent company Answer a 2. Which of the following would cause a deferred tax expense? a. Write-down of goodwill due to impairment b. Use of equity method where undistributed earnings of a 30 percent owned investee are related to probable future dividends c. Premiums paid on insurance carried by company (beneficiary) on its officers or employees d. Income is taxed at capital gains rates Answer b 3. Differences between taxable income and pretax accounting income arising from transactions that, under applicable tax laws and regulations, will not be offset by corresponding differences or “turn around” in future periods is a definition of a. Permanent differences b. Timing differences c. Intraperiod tax allocation d. Interperiod tax allocation Answer a 4. Taxable income of a corporation differs from pretax financial income because of Permanent Differences a.

No b.

Yes c.

No d.

Yes

Temporary Differences Yes Yes No No

Answer b 5. Which of the following is a permanent difference?

a. b. c. d.

Product warranty liabilities Installment sales accounted for on an accrual basis Deductible pension funding exceeding expense Interest received on state and municipal obligations

Answer d 6. A major distinction between temporary and permanent differences is a. Permanent differences are not representative of acceptable accounting practice b. Temporary differences occur frequently, whereas permanent differences occur only once c. Once an item is determined to be a temporary difference, it maintains that status; however, a permanent difference can change in status with the passage of time. d. Temporary differences reverse themselves in subsequent accounting periods, whereas permanent differences do not reverse Answer d 7. Under the comprehensive deferred interperiod method of tax allocation, deferred taxes are determined on the basis of a. Tax rates in effect when the timing differences originate without adjustment for subsequent changes in tax rates b. Tax rates expected to be in effect when the items giving rise to the timing differences reverse themselves c. Net valuations of assets or liabilities d. Averages determined on an industry-by-industry basis Answer b 8. The accounting recognition of the benefit from a tax loss carryforward in most situations should be reported as a. A reduction of the loss in the year of the loss with an appropriate valuation allowance b. A prior period adjustment in whichever year the benefit is realized c. As a component of income from continuing operations in the year in which the benefit is realized d. An item on the retained earnings statement, not the income statement Answer a 9. Intraperiod tax allocation arises because a. Items included in the determination of taxable income may be presented in different sections of the financial statements b. Income taxes must be allocated between current and future periods c. Certain revenues and expenses appear in the financial statements either before or after they are included in taxable income

d. Certain revenues and expenses appear in the financial statements but are excluded from taxable income Answer c 10.

Assuming no prior period adjustments, would the following affect net income?

Interperiod Intraperiod Income tax Income tax Allocation Allocation a.

Yes Yes b.

Yes No c.

No Yes d.

No No

Answer b 11. A machine with a 10-year useful life is being depreciated on a straight-line basis for financial statement purposes, and over 5 years for income tax purposes under the accelerated recovery cost system. Assuming that the company is profitable and that there are and have been no other timing differences, the related deferred income taxes would be reported in the balance sheet at the end of the first year of the estimated useful life as a a. Current liability b. Current asset c. Noncurrent liability d. Noncurrent asset Answer c 12. Smith Corporation owns only 25 percent of the voting stock of Jones Corporation, but exercises significant influence over its operating and financial policies. The tax effect of differences between taxable income and pretax accounting income attributable to undistributed earnings of Jones Corporation should be a. Accounted for as a timing difference b. Accounted for as a permanent difference c. Ignored because it must be based on estimates and assumptions d. Ignored because Smith holds less than 51 percent of the voting stock of Jones Answer a 13. Under the asset-liability method, deferred taxes should be presented on the balance sheet a. As one net non-current amount b. In two amounts: one for the net current amount and one for the net non-current amount c. In two amounts: one for the net debit amount and one for the net credit amount d. As reductions of the related asset or liability accounts

Answer b 14. A deferred tax asset represents a a. Future tax expense b. Future tax liability. c. Future tax benefit d. Future taxable amount Answer c 15. A company has four “deferred income tax” accounts arising from timing differences involving (1) current assets, (2) noncurrent assets, (3) current liabilities, and (4) noncurrent liabilities. The presentation of these four “deferred income tax” accounts in the statement of financial position should be shown as a. A single net non-current amount b. A net current and a net noncurrent amount c. Four accounts with no netting permitted d. Valuation adjustments of the related assets and liabilities that gave rise to the deferred tax Answer b 16. Which of the following are temporary differences that are normally classified as expenses or losses and are deductible for income tax purposes after they are recognized for financial accounting income? a. Product warranty liabilities b. Advance rental receipts c. Depreciable property d. Fines and expenses resulting from a violation of law Answer a 17. A company’s only temporary difference results from using double declining balance depreciation for tax purposes and straight-line depreciation for financial reporting. The company purchases new plant assets each year. If currently enacted tax law will result in a higher tax rate for all future tax years, which accounting approach for deferred taxes will result in the lowest net income for this current year? a. Nonallocation of deferred taxes. b. Partial allocation of deferred taxes under the asset/liability method. c. Comprehensive allocation of deferred taxes under the asset/liability method. d. Comprehensive allocation of deferred taxes under the deferred method.

Answer c

18. Which of the following is not an argument that an advocate of nonallocation of deferred taxes might use to support his/her position? a. Income taxes result only from taxable income. b. Income taxes are an expense of doing business and should be treated the same as other expenses of doing business under accrual accounting. c. Income taxes are not levied on individual items of income or expense. d. The current provision for income taxes is a better predictor of future cash flows than is income tax expense that includes deferred taxes.

Answer b 19. Which of the following is an argument that an advocate of interperiod income tax allocation might use to support his/her position? a. Income taxes result from taxable income. b. Income taxes are an expense of doing business and should be treated the same as other expenses of doing business under accrual accounting. c. Nonallocation of income taxes hides an economic difference between a company that employs tax strategies that reduce current tax payments than one that does not. d. Income taxes are not incurred in anticipation of future benefits, nor are they expirations of cost to provide facilities to generate revenues.

Answer b 20. A net operating loss carryoverforward that occurs in a company’s second year of operations a. May cause a company to report a tax benefit in the current period income statement. b. Has no effect on income tax expense of the current period because no taxes are paid. c. Causes a company to report a deferred income tax liability for taxes that are not paid currently. d. Results in future taxable amounts.

Answer a 21. A net operating loss: a. Must always be carried back 2 years b. Occurs when a company reports a net loss in their income statement c. May be carried forward indefinitely d. Must always be carried forward 20 years Answer c 22. Which of the following will result in a deferred tax asset? a. Using the installment sales method for tax purposes, while using point of sale for financial reporting. b. Reporting an unrealized gain for a trading security.

c. Using accelerated depreciation for tax purposes and straight-line depreciation for financial reporting. d. Reporting an expected loss on from a lawsuit in the income statement, when it cannot be reported on the tax return until it is actually incurred.

Answer d 23. Which of the following will result in a deferred tax liability? a. A net operating loss carryover. b. Reporting an unrealized gain for a trading security. c. Reporting an unrealized gain for an available-for-sale security. d. Reporting an expected loss on from a lawsuit in the income statement, when it cannot be reported on the tax return until it is actually incurred.

Answer b 24. A deferred tax liability represents the: a. Increase in taxes payable in future years as a result of taxable temporary differences b. Increase in taxes saved in future years as a result of deductible temporary differences c. Decrease in taxes saved in future years as a result of deductible temporary differences d. Decrease in taxes payable in future years as a result of taxable temporary differences Answer a 25. Which of the following causes a permanent difference between taxable income and financial accounting income? a. The useful life of an asset is 10 years. The asset is depreciated over 7 years for tax purposes. b. Rent received in advance is taxable upon receipt. c. A life insurance premium paid by the corporation on a policy that names the corporation as the beneficiary. d. A penalty paid to a bank when a CD is cashed before its maturity date.

Answer c 26. Which of the following approaches to interperiod tax allocation best represents an example of the matching principle? a. The deferred method of interperiod income tax allocation b. Discounting deferred income taxes c. Nonallocation of income taxes d. The asset/liability method of income tax allocation.

Answer d

27. A company that has both short-term deferred tax assets of $22,000, long-term deferred tax liabilities of $36,000, short-term deferred tax liabilities of $51,000 and short-term deferred tax assets of $60,000 should report a. A current asset for $22,000, a current liability for $36,000, a long-term asset for $60,000, and a long-term liability for $51,000. b. A current liability for $14,000 and a long-term asset for $9,000. c. A non-current liability for $5,000. d. A current liability for $14,000, a long-term asset for $60,000, and a long-term liability for $51,000.

Answer c 28. With regard to uncertain tax positions, the FASB requires that companies recognize a tax benefit when a. It is probable and can be reasonably estimated b. There is at least a 51% probability that the uncertain tax position will be approved by the taxing authorities c. It is more likely than not that the tax position will be sustained upon audit d. All of the above Answer c 29. An increase in the deferred income tax asset valuation allowance a. Occurs when there is an operating loss carryforward. b. Has no effect on income tax expense. c. Occurs when there is an expected increase in future taxable income. d. Increases income tax expense.

Answer d Essay 1. What are the objectives of accounting for income taxes?

The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and to recognize the future tax consequences of temporary differences as well as net operating losses (NOLs) and unused tax credits. To facilitate discussion of the issues raised by the concept of interperiod tax allocation, we first examine the nature of differences among pretax financial income, taxable income, and net operating losses (NOLs).

2. Define the following types of differences between financial accounting income and taxable income: a. Temporary

Most temporary differences between pretax financial accounting income and taxable income arise because the timing of revenues, gains, expenses, or losses in financial accounting income occurs in a different period from taxable income. These timing differences result in assets and liabilities having different bases for financial accounting purposes than for income tax purposes at the end of a given accounting period. Additional temporary differences occur because specific provisions of the IRC create different bases for depreciation or for gain or loss recognition for income tax purposes than are used for financial accounting purposes. b. Permanent Certain events and transactions cause differences between pretax accounting income and taxable income to be permanent. Most permanent differences between pretax financial accounting income and taxable income occur when specific provisions of the IRC exempt certain types of revenue from taxation or prohibit the deduction of certain types of expenses.

Others occur when the IRC allows tax deductions that are not expenses under GAAP. Permanent differences arise because of federal economic policy or because Congress may wish to alleviate a provision of the IRC that falls too heavily on one segment of the economy.

3. Describe the three types of permanent differences. ` There are three types of permanent differences: 1. Revenue recognized for financial accounting reporting purposes that is never taxable.

Examples include interest on municipal bonds and life insurance proceeds payable to a corporation upon the death of an insured employee.

2. Expenses recognized for financial accounting reporting purposes that are never deductible for income tax purposes. An example is life insurance premiums on employees where the corporation is the beneficiary.

3. Income tax deductions that do not qualify as expenses under GAAP. Examples include percentage depletion in excess of cost depletion and the special dividend exclusion.

4. List and give examples of the four types of differences that cause financial accounting income to be either greater than or less than taxable income.

These four types of differences are: Current Financial Accounting Income Exceeds Current Taxable Income 1. Revenues or gains are included in financial accounting income prior to the time they are included in taxable income. For example, gross profit on installment sales is included in financial accounting income at the point of sale but may be reported for tax purposes as the cash is collected.

2. Expenses or losses are deducted to compute taxable income prior to the time they are deducted to compute financial accounting income. For example, a fixed asset may be depreciated by MACRS depreciation for income tax purposes and by the straight-line method for financial accounting purposes.

Current Financial Accounting Income Is Less than Current Taxable Income 1. Revenues or gains are included in taxable income prior to the time they are included in financial accounting income. For example, rent received in advance is taxable when it is received, but it is reported in financial accounting income under as it is earned.

2. Expenses or losses are deducted to compute financial accounting income prior to the time they are deducted to determine taxable income. For example, product warranty costs are estimated and reported as expenses when the product is sold for financial accounting purposes, but they are deducted as actually incurred in later years to determine taxable income.

5. Distinguish between an originating temporary difference and a reversing temporary difference.

An originating temporary difference is the initial difference between the book basis and the tax basis of an asset or liability. A reversing difference occurs when a temporary difference that originated in prior periods is eliminated and the related tax effect is removed from the tax account.

6. What is the difference between a future taxable amount and a future deductible amount?

A future taxable amount will increase taxable income relative to pretax financial income in future periods due to temporary differences existing at the balance sheet date. A future deductible amount will decrease taxable income relative to pretax financial income in future periods due to existing temporary differences.

7. When is it appropriate to record a valuation account for a deferred tax asset?

A deferred tax asset is recognized for all deductible temporary differences. However, a deferred tax asset should be reduced by a valuation account if, based on all available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized. More likely than not means a level of likelihood that is slightly more than 50%.

8. Describe the accounting treatment for net operating losses.

A net operating loss (NOL) occurs when the amount of total tax deductions and tax-deductible losses is greater than the amount of total taxable revenues and gains during an accounting period.

The IRC allows corporations reporting NOLs to carry these losses forward indefinitely to offset other reported taxable income to a maximum of 80% of taxable income. In the year a NOL occurs a Tax Benefit (opposite of Tax Expense) and a Deferred Tax Asset is created.

9. Discuss the arguments for and against interperiod tax allocation.

The primary income tax allocation issue involves whether and how to account for the tax effects of temporary differences between taxable income, as determined by the IRC, and pretax financial accounting income as determined under GAAP. Some accountants believe that it is inappropriate

to give any accounting recognition to the tax effects of these differences. Others believe that recognition is appropriate but disagree on the method to use. There is also disagreement on the appropriate tax rate to use and whether reported future tax effects should be discounted to their present values. Finally, there is a lack of consensus over whether interperiod tax allocation should be applied comprehensively to all differences or only to those expected to reverse in the future.

Advocates of nonallocation argue as follows: 1. Income taxes result only from taxable income. Whether or not the company has accounting income is irrelevant. Hence, attempts to match income taxes with accounting income provide no relevant information for users of published financial statements.

2. Income taxes are different from other expenses; therefore, allocation in a manner similar to other expenses is irrelevant. Expenses are incurred to generate revenues; income taxes generate no revenues. They are not incurred in anticipation of future benefits, nor are they expirations of cost to provide facilities to generate revenues.

3. Income taxes are levied on total taxable income, not on individual items of revenue and expense. Therefore, there can be no temporary differences related to these items.

4. Interperiod tax allocation hides an economic difference between a company that employs tax strategies that reduce current tax payments (and is therefore economically better off) and one that does not.

5. Reporting a company’s income tax expense at the amount paid or currently payable is a better predictor of the company’s future cash outflows because many of the deferred taxes will never be paid or will be paid only in the distant future.

6. Income tax allocation entails an implicit forecasting of future profits. To incorporate such forecasting into the preparation of financial information is inconsistent with the long-standing principle of conservatism.

7. There is no present obligation for the potential or future tax consequences of present or prior transactions because there is no legal liability to pay taxes until an actual future tax return is prepared.

8. The accounting recordkeeping and procedures involving interperiod tax allocation are too costly for the purported benefits.

The advocates of interperiod tax allocation cite the following reasons to counter the preceding arguments or to criticize nonallocation: 1. Income taxes result from the incurrence of transactions and events. As a result, income tax expense should be based on the results of the transactions or events that are included in financial accounting income.

2. Income taxes are an expense of doing business and should involve the same accrual, deferral, and estimation concepts that are applied to other expenses.

3. Differences between the timing of revenues and expenses do result in temporary differences that will reverse in the future. Expanding, growing businesses experience increasing asset and

liability balances. Old assets are collected, old liabilities are paid, and new ones take their place.

Deferred tax balances grow in a similar manner.

4. Interperiod tax allocation makes a company’s net income a more useful measure of its longterm earning power and avoids periodic income distortions resulting from income tax regulations.

5. Nonallocation of a company’s income tax expense hinders the prediction of its future cash flows. For instance, a company’s future cash inflows from installment sales collection would usually be offset by related cash outflows for taxes.

6. A company is a going concern, and income taxes that are currently deferred will eventually be paid. The validity of other assets and liabilities reported in the balance sheet depends on the presumption of a viable company and hence the incurrence of future net income.

7. Temporary differences are associated with future tax consequences. For example, reversals of originating differences that provide present tax savings are associated with higher future taxable incomes and therefore higher future tax payments. In this sense, deferred tax liabilities are similar to other contingent liabilities that are currently reported under GAAP. However, one could argue that the recognition and measurement of other contingent liabilities hinges on the probability of their incurrence, whereas probability of future tax consequences is not a consideration.

10. Discuss the arguments for comprehensive vs. partial allocation of interperiod taxes.

Under comprehensive allocation, the income tax expense reported in an accounting period is affected by all transactions and events entering into the determination of pretax financial accounting income for that period. Comprehensive allocation results in including the tax consequences of all temporary differences as deferred tax assets and liabilities, regardless of how significant or recurrent they are. Proponents of comprehensive allocation view all transactions and events that create temporary differences as affecting cash flows in the accounting periods when the future tax consequences of temporary differences are realized. Under this view, the future tax consequence of a temporary difference is analogous to an unpaid accounts receivable or accounts payable invoice, which in the future is collected or paid.

In contrast, under partial allocation, the income tax expense reported in an accounting period would not be affected by those temporary differences that are not expected to reverse in the future. That is, proponents of partial allocation argue that, in certain cases, groups of similar transactions or events may continually create new temporary differences in the future that will offset the realization of any taxable or deductible amounts, resulting in an indefinite postponement of deferred tax consequences. In effect, partial allocationists argue that these types of temporary differences are more like permanent differences. Examples of these types of differences include depreciation for manufacturing companies with large amounts of depreciable assets and installment sales for merchandising companies.

Advocates of comprehensive allocation raise the following arguments:

1. Individual temporary differences do reverse. By definition, a temporary difference cannot be permanent; the offsetting effect of future events should not be assumed. It is inappropriate to look at the effect of a group of temporary differences on income taxes; the focus should be on the individual items comprising the group. Temporary differences should be viewed in the same manner as accounts payable. Although the total balance of accounts payable may not change, many individual credit and payment transactions affect the total.

2. Accounting is primarily historical. It is inappropriate to offset the income tax effects of possible future transactions against the tax effects of transactions that have already occurred.

3. The income tax effects of temporary differences should be reported in the same period as the related transactions and events are reported in pretax financial accounting income.

4. Accounting results should not be subject to manipulation by management. That is, a company’s management should not be able to alter the company’s results of operations and ending financial position by arbitrarily deciding what temporary differences will and will not reverse in the future.

Advocates of partial income tax allocation argue that: 1. All groups of temporary differences are not similar to certain other groups of accounting items; such as accounts payable. Accounts payable “roll over” as a result of actual individual credit and payment transactions. Income taxes, however, are based on total taxable income and not on the individual items constituting that income. Therefore, consideration of the impact of the group of temporary differences on income taxes is the appropriate viewpoint.

2. Comprehensive income tax allocation distorts economic reality. The income tax regulations that cause the temporary differences will continue to exist. For instance, Congress is not likely to reduce investment incentives with respect to depreciation. Consequently, future investments are virtually certain to result in originating depreciation differences of an amount to at least offset reversing differences. Thus, consideration should be given to the impact of future, as well as historical, transactions.

3. Assessment of a company’s future cash flows is enhanced by using the partial allocation approach. Since the deferred income taxes (if any) reported on a company’s balance sheet under partial allocation should actually reverse rather than continue to grow, partial allocation would better reflect future cash flows.

4. Accounting results should not be distorted by the use of a rigid, mechanical approach, such as comprehensive tax allocation. Furthermore, an objective of the audit function is to identify and deter any management manipulation.

11. Discuss the arguments for and against discounting deferred taxes.

Proponents of reporting deferred taxes at their discounted amounts argue that the company that reduces or postpones tax payments is economically better off. It is their belief that by discounting deferred taxes, a company best reflects the operational advantages of its tax strategies in its financial statements. Proponents also feel that discounting deferred taxes is consistent with the accounting

principles established for such items as notes receivable and notes payable, pension costs, and leases. They argue that discounted amounts are considered to be the most appropriate indicators of future cash flows.

Critics of discounting counter that discounting deferred taxes mismatches taxable transactions and the related tax effects. That is, the taxable transaction would be reported in one period and the related tax effects over several periods. They also argue that discounting would conceal a company’s actual tax burden by reporting as interest expense the discount factor that would otherwise be reported as part of income tax expense. Furthermore, deferred taxes may be considered as interest-free loans from the government that do not require discounting because the effective interest rate is zero. Although this argument has conceptual merit, a plausible counterargument would be that the time value of money is important to the well-being of companies, and because of this aspect, GAAP requires interest to be imputed for non-interestbearing financial instruments. It follows that the time value of money is enhanced by postponing tax payments, thus, consistency under GAAP would require imputing interest on deferred taxes.

12. Define the following: a. Deferred method of income tax allocation The deferred method of income tax allocation is an income statement approach. It is based on the concept that income tax expense is related to the period in which income is recognized. The deferred method measures income tax expense as though the current period pretax financial accounting income is reported on the current year’s income tax return. The tax effect of a temporary difference is the difference between income taxes computed with and without inclusion of the temporary difference. The resulting difference between income tax expense and income taxes currently payable is a debit or credit to the deferred income tax account.

The deferred tax account balance is reported in the balance sheet as deferred tax credit or deferred tax charge. Under the deferred method, the deferred tax amount reported on the balance sheets is the effect of temporary differences that will reverse in the future and that are measured using the income tax rates and laws in effect when the differences originated. No adjustments are made to deferred taxes for changes in the income tax rates or tax laws that occur after the period of origination. When the deferrals reverse, the tax effects are recorded at the rates that were in existence when the temporary differences originated. b. Asset-liability method of income tax allocation The asset/liability method of income tax allocation is balance sheet oriented. The intent is to accrue and report the total tax benefit or taxes payable that will actually be realized or assessed on temporary differences when their respective future taxable or deductible amounts are expected to occur. A temporary difference is viewed as giving rise to either a tax benefit that will result in a decrease in future tax payments or a tax liability that will be paid in the future at tax rates that are then current. Theoretically, the future tax rates used should be estimated,

based on expectations regarding future tax law changes. However, GAAP requires that the future tax rates used to determine current period deferred tax asset and liability balances be based on currently enacted tax law.

Under the asset/liability method, the deferred tax amount reported on the balance sheet measures the future tax consequences of existing temporary differences using the currently enacted tax rates and laws that will be in effect when those tax consequences are expected to occur. At the end of each accounting period, or when the temporary differences that caused the company to report a deferred tax asset or liability no longer exist, companies adjust their deferred tax asset and liability account balances to reflect any changes in the income tax rates.

Stated differently, at year-end companies report deferred tax asset and liability balances that measure the future tax consequences of anticipated deductible and taxable amounts that were caused by current and prior period temporary differences. The reported amounts are measured using tax rates that under currently enacted tax law will be in effect in those years when the deductible and taxable amounts are expected to occur. This practice results in reporting deferred tax assets and liabilities at their expected realizable values. c. Net-of-tax method The net-of-tax method is more a method of disclosure than a different method of calculating deferred taxes. Under this method, the income tax effects of temporary differences are computed by applying either the deferred method or the asset/liability method. The resulting deferred taxes, however, are not separately disclosed on the balance sheet. Instead, under the net-of-tax method the deferred charges (tax assets) or deferred credits (tax liabilities) are treated as adjustments of the accounts to which the temporary differences relate. Generally, the accounts are adjusted through the use of a valuation allowance rather than directly. For instance, if a temporary difference results from additional tax depreciation, the related tax effect would be subtracted (by means of a valuation account) from the cost of the asset (along with accumulated depreciation) to determine the carrying value of the depreciable asset. Similarly, the carrying value of installment accounts receivable would be reduced for the expected increase in income taxes that will occur when the receivable is collected (and taxed). Reversals of temporary differences would reduce the valuation allowance accounts.

13. Discuss how SFAS No. 109, now FASB ASC 740, changed the accounting for deferred tax assets.

The FASB was convinced by the critics of SFAS No. 96 that deferred tax assets should be treated similarly to deferred tax liabilities and that the scheduling requirements of SFAS No. 96 were often too complex and costly. However, the Board did not want to return to the deferred method and remained committed to the asset/liability approach. SFAS No. 109 (See FASB ASC 740) responded to these concerns by allowing the separate recognition and measurement of deferred tax assets and liabilities without regard to future income considerations, using the average enacted tax rates for future years. The deferred tax asset is to be reduced by a tax valuation allowance if available evidence indicates that it is more likely than not (a likelihood of more than 50 percent) that some portion or the entire deferred tax asset will not be realized.

14. Describe the use of the valuation allowance for deferred tax assets.

The deferred tax asset measures potential benefits to be received in future years arising from temporary differences, NOL carryovers, and unused tax credits. Because there may be insufficient future taxable income to actually derive a benefit from a recorded deferred tax asset, SFAS No. 109 requires a valuation allowance sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized.

15. Describe accounting for uncertain tax positions under FIN No. 48, now FASB ASC 740-10-25.

The validity of a tax position is a matter of tax law, and it is not controversial to recognize the benefit of a tax position in a firm’s financial statements when there is a high degree of confidence that a particular tax position will be sustained after examination by the IRS. However, in some cases, tax law is subject to varied interpretations, and whether a tax position will ultimately be sustained may be uncertain.

The evaluation of a tax position under FIN No. 48 (See FASB ASC 740-10-25) is a two-step process: 1. Recognition. A firm determines whether it is more likely than not that a tax position will be sustained upon examination by the IRS based on the technical merits of the position. In evaluating whether a tax position has merit, a firm is to use a more-likely-than-not recognition threshold. This evaluation should presume that the IRS would have full knowledge of all relevant information.

2. Measurement. A tax position that meets the more-likely-than-not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured at the largest cumulative amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement.

16. How is the earnings conservatism ratio calculated? Discuss the rationale behind the calculation of a company’s earnings conservatism ratio.

The earnings conservatism ratio is calculated pretax accounting income/taxable income. The rationale for the earnings conservatism ratio is that most companies will use the most conservative revenue and recognition criteria for income tax reporting purposes while attempting to maximize their deductible expenses in order to minimize income taxes. On the other hand, management is under constant pressure to report favorable financial accounting earnings. As a result, it may choose accounting methods and estimations that maximize financial accounting income. In interpreting the results of this calculation, amounts in excess of 1.0 will indicate that a company is being more aggressive in its use of accounting choices for financial reporting than it is in calculating its income taxes.

Chapter 13 1. Under the finance method of accounting for leases, under ASC 842, the excess of aggregate rentals over the cost of leased property should be recognized as revenue of the lessor a. In increasing amounts during the term of the lease b. In constant amounts during the term of the lease c. In decreasing amounts during the term of the lease d. After the cost of leased property has been fully recovered through rentals Answer c 2. Which of the following is one of the lease capitalization criteria under ASC 842? a. The minimum lease payments (excluding executory costs) equal or exceed 90% of the fair value of the leased property b. The lease transfers ownership of the property to the lessor c. The lease contains a purchase option d. The lease term is a major part of the asset’s economic life, not near the end of the asset’s life Answer d 3. When measuring the present value of future rentals to be capitalized as part of the purchase price in a lease that is be accounted for as a purchase, identifiable payments to cover taxes, insurance, and maintenance should be a. Included in the future rentals to be capitalized b. Excluded from future rentals to be capitalized c. Capitalized but at a different discount rate and recorded in a different account than future rental payments d. Capitalized but at a different discount rate and for a relevant period that tends to be different than that for future rental payments Answer b 4.

Under ASC 842, equal monthly rental payments for a particular lease should be charged to rental expense by the lessee for which of the following?

a. b. c. d.

Finance lease Yes Yes No No

Short-term lease No Yes No Yes

Answer d 5. In computing the present value of the minimum lease payments under ASC 842, the lessee should

a. Use its incremental borrowing rate in all cases b. Use either its incremental borrowing rate or the implicit rate of the lessor, whichever is higher, assuming that the implicit rate is known to the lessee c. Use either its incremental borrowing rate or the implicit rate of the lessor, whichever is lower, assuming that the implicit rate is known to the lessee d. Use the implicit rate in all cases.

Answer c 6. Under ASC 842, for a lease that is recorded as a sales-type lease by the lessor, the difference between the gross investment in the lease and sum of the present values of the components of the gross investment should be recognized as income a. In full at the lease’s expiration b. In full at the lease’s inception c. Over the period of the lease using the interest method of amortization d. Over the period of the lease using the straight-line method of amortization Answer b 7.

For a six-year finance lease, under ASC 842, the portion of the minimum lease payment in the third year applicable to the reduction of the obligation should be a. Less than in the second year b. More than in the second year c. The same as in the fourth year d. More than in the fourth year

Answer b 8. Generally accepted accounting principles require that certain lease agreements be accounted for as purchases. The theoretical basis for this treatment is that a lease of this type a. Effectively controls the right of use of identified property b. Is an example of form over substance c. Provides the use of the leased asset to the lessee for a limited period of time d. Must be recorded in accordance with the concept of cause and effect Answer a 9. The primary difference between a direct-financing lease and a sales-type lease under ASC 842 is the a. Whether the five lease recognition criteria are met b. Amount of the depreciation recorded each year by the lessor c. Allocation of initial direct costs by the lessor to periods benefited by the lease arrangements d. Manner in which rental receipts are recorded as rental income

Answer a 10. Lessees prefer to account for their leases as short-term leases because: a. This decreases the amount of liability reported b. This increases their debt to total equity ratio c. This decreases the income tax expense. d. This increases the amount of total assets.

Answer a 11. The appropriate valuation of an operating lease on the statement of financial position of a lessee is a. Zero b. The absolute sum of the lease payments c. The present value of the sum of the lease payments discounted at an appropriate rate d. The book value of the asset on the lessor’s books at the date of the inception of the lease Answer a 12. A six-year-finance lease entered into on December 31, 2020, specified equal minimum annual lease payments due on December 31, 2021. Minimum payment applicable to which of the following increased over the corresponding December 31, 2021, minimum payment? (The company is applying SFAS No. 13) Reduction of Interest Expense Liability a.

Yes Yes b.

Yes No c.

No Yes d.

No No Answer c 13. Office equipment recorded under a finance lease containing a bargain purchase option should be amortized under SFAS No. 13 a. Over the period of the lease using the interest method of amortization b. Over the period of the lease using the straight-line method of amortization c. In a manner consistent with the lessee’s normal depreciation policy for owned assets d. In a manner consistent with the lessee’s normal depreciation policy for owned assets except that the period of amortization should be the lease term Answer c 14. What was the primary accounting issue for lessees that lead to the issuance of ASU 2016-02? a. Recording interest expense on the lease obligation. b. Determining whether the lease meets the 90% of fair value test.

c. Off-balance sheet financing. d. The measurement of the leased asset under a finance lease.

Answer c 15. What is the primary accounting issue for lessors? a. Off-balance sheet financing. b. Revenue recognition and expense allocation over the lease term. c. Treating the lease in the same manner as the lessee does. d. Determining whether the lease is a sales-type lease or a direct financing lease.

Answer b 16. For the lessor to recognize a lease as a sales-type lease, under ASC 842, the following must occur. a. At least one of the finance lease criteria is met, at least one of the certainty criteria is met, and there is a manufacturer or dealer’s profit. b. At least one of the finance lease criteria is met. c. More than one of the finance lease criteria are met, both certainty criteria are met, and there is a manufacturer or dealer’s profit. d. Only one of the finance lease criteria is met, both certainty criteria are met, and there is a manufacturer or dealer’s profit.

Answer b 17. For a sales-type lease, under ASC 842, the net investment is equal to a. The present value of the minimum lease payments plus executor costs. b. The net investment minus unearned income. c. Sales minus the gross profit recognized on the sale. d. The present value of the gross lease payments.

Answer d 18. When a lease contract does not transfer title to the lessee, there is no purchase option reasonably certain to be exercised, and the lease term is not the major part of the asset’s remaining economic life a. The lessee must classify the lease as an operating lease. b. The amount of unguaranteed salvage value, if any, determines whether the lease is a finance lease or an operating lease. c. The interest rate used to determine the present value of the minimum lease payments also determines whether the lease is a finance lease or an operating lease. d. The lessee must use the greater of the lessor’s rate of return or the lessee’s incremental borrowing rate to determine whether the lease is a finance lease or an operating lease.

Answer a

19. When does the lessee report executory costs as an expense? a. When they are spelled out in the lease agreement. b. Only when they are incurred by the lessee and the lease is classified as a finance lease. c. When they are incurred by the lessee. d. Only when they are incurred by the lessee and the lease is classified as an operating lease.

Answer c 20. Which of the following would indicate that the lessee should not classify a lease as a finance lease under ASC 842? a. The fair value of the leased asset is $100,000 and the present value of the minimum lease payments is $95,000. b. The lease provides for no unguaranteed salvage value. c. The lessee has the option to purchase the leased asset in 4 years for $2 when the asset’s salvage value is expected to be $20,000. d. The asset’s useful life is 20 years; a 4-year lease occurs when the asset is 26 years old.

Answer d 21. Under the provisions of ASC 842 which of the following is not a criterion to use in determining whether a lessee should classify a lease as a finance lease? a. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term b. The lease grants the lessee an option to purchase the underlying asset the lessee is reasonably certain to exercise c. The lease term is for the major part of the remaining economic life of the underlying asset d. The present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds 50 percent of the fair value of the underlying asset.

Answer d 22. Under the provisions of ASC 842 a. Accounting by lessors for leases is virtually unchanged from what was required by SFAS No. 13 b. Accounting by lessees for leases is virtually unchanged from what was required by SFAS No. 13 c. Accounting by lessors for leases re is significantly changed from what was required by SFAS No. 13 d. Accounting by lessees and lessors for leases is virtually unchanged from what was required by SFAS No. 13.

Answer a 23. The major difference between ASU 2016-02 and IFRS No. 16 is

a. All leases must be recorded as finance leases by lessees under ASU 2016-02; whereas, some leases may be recorded as operating leases by lessees under IFRS No. 16. b. All leases must be recorded as finance leases by lessees under IFRS No. 16; whereas, some leases may be recorded as operating leases by lessees under ASU 2016-02 c. All leases must be recorded as finance leases by lessors under ASU 2016-02; whereas, some leases may be recorded as operating leases by lessors under IFRS No. 16 d. All leases must be recorded as finance leases by lessors under IFRS No. 16; whereas, some leases may be recorded as operating leases by lessors under ASU 2016-02.

Answer b 24. The key difference between ASC 842 and SFAS No. 13 in accounting for leases by lessees is a. The recognition of a right‐to‐use asset (ROU) and lease liability on the statement of financial position for those leases previously classified as operating leases under SFAS No. 13 b. Leases will be measured at their fair value by lessees c. The classification of a lease as a finance by a lessee is based on a completely new set of criteria than was used in SFAS No. 13. d. There are no major differences between the two standards in accounting for leases by lessees.

Answer a 25. Under the provisions of ASC 842 sale‐leaseback accounting is virtually eliminated as an off‐ balance sheet financing proposition, because both the seller‐lessee and a buyer‐lessor will apply the provisions of FASB ASC 602 Revenue Recognition to determine whether a sale has occurred.

Accordingly, which of the following is not a criterion that must be met to record a sale-leaseback a sale? a. The transaction meets the sale guidance in the new revenue recognition standard. b. The transaction is a leveraged lease c. The leaseback is not a finance or a sales‐type lease d. If there is a repurchase option, the exercise price is at the asset’s fair value at the time of exercise, and alternative assets that are substantially the same as the transferred asset are readily available in the marketplace.

Answer b 26. Under the provisions of ASC 842, which of the following is not required in a lease modification when the lease payments are required to be remeasured? a. Any variable lease payments that are based on a rate or index will need to be remeasured. b. The total lease liability is remeasured c. The remeasured lease must be subsequently recorded as an operating lease d. The lessee is generally required to use an updated discount rate.

Answer c

27. The amount to be recorded as the cost of an asset under finance lease is equal to the a. Present value of the lease payments plus the present value of any unguaranteed residual value. b. Carrying value of the asset on the lessor’s books. c. Present value of the lease payments. d. Present value of the lease payments or the fair value of the asset, whichever is lower.

Answer c 28. The classifications of a lease by the lessee are a. Operating and finance leases. b. Operating, sales, and finance leases. c. Operating and leveraged leases. d. None of these answers are correct.

Answer a 29. In computing the present value of the lease payments, the lessee should a. Use the implicit rate in all cases. b. Use the implicit rate of the lessor, assuming that the implicit rate is known to the lessee/ c. Use its incremental borrowing rate in all cases. d. Use both its incremental borrowing rate and the implicit rate of the lessor, assuming that the implicit rate is known to the lessee.

Answer b 30. Which of the following is not one of the lease classification tests? a. Transfer of ownership b. Collectibility c. Purchase option d. Lease term Answer b 31. From the lessee’s perspective, in the earlier years of a lease, a. Operating leases will cause debt to increase, compared to finance leases. b. Operating leases will cause income to increase, compared to finance leases. c. Finance leases will cause debt to increase, compared to operating leases. d. Finance leases will enable the lessee to report higher income, compared to operating leases.

Answer c 32. In a finance lease, the lessee records a. Interest expense only. b. Amortization expense only. c. Lease expense only. d. Amortization expense and interest expense.

Answer d 33. In an operating lease, the lessee records a. Amortization expense and lease expense. b. Interest expense.

c. Lease expense. d. Amortization expense.

Answer c Essay

1. List some advantages of leasing The advantages of leasing are: 1. It offers 100 percent financing at fixed rates. Leases often do not require down payments from the lessee. This helps companies conserve scarce cash which is an especially desirable feature for new and developing companies. Additionally, the lease payments usually remain fixed, thereby protecting the lessee from uncertainty.

2. It permits alternative uses. A leasing arrangement provides a firm with the use and control over the assets without incurring a huge up-front capital expenditure and requires making only periodic rental payments. Thus, leasing saves funds for alternative uses.

3. It offers protection against obsolescence. Leasing assets reduces the risk of obsolescence to the lessee and in many cases passes the risk of residual value to the lessor. That is, the lease agreement may allow an original lease to be cancelled and replaced by a new lease when improved technology becomes available. In these cases, the lessor protects itself by requiring the lessee to pay higher rental payments.

4. It allows flexibility. Lease agreements may contain more flexible provisions than other debt agreements by tailoring the lease agreement to the lessee's special needs. For example, the lease term may range from a short period of time to the entire expected economic life of the asset. The rental payments may be level from year to year, or they may increase or decrease in amount. The payment amount may be predetermined or may vary with sales, the prime interest rate, the Consumer Price Index, or some other factor.

5. It can result in less costly financing. Some companies find leasing cheaper than other forms of financing.

6. It offers tax advantages. For financial reporting purposes, companies do not report operating lease (discussed later in the chapter) assets or liabilities. However, for income tax purposes companies are allowed to capitalize and depreciate the leased asset. As a result, a company takes deductions earlier rather than later and thereby reduces its taxes.

7. It allows off-balance-sheet financing. Short-term operating leases can offer off-balance sheet financing and do not add debt on a balance sheet or affect financial ratios and therefore may add to borrowing capacity.

2. Define the following: a.

Finance lease A finance lease is based on the view that the lease constitutes an agreement through which the lessor finances the acquisition of assets by the lessee. Consequently, finance leases are insubstance installment purchases of assets.

b. Operating lease An operating lease is based on the view that the lease constitutes a rental agreement between the lessor and lessee.

3. List the five criteria for recording a lease transaction as a finance lease according to ASC 842.

If at its inception the lease meets any one of the following four criteria, the lessee will classify the lease as a finance lease; otherwise, it is classified as an operating lease: 1. The lease transfers ownership of the property to the lessee by the end of the lease term. This includes the fixed noncancelable term of the lease plus various specified renewal options and periods.

2. The lease contains a purchase option that the lessee is reasonably certain to exercise. This means that when the lessee has the option to purchase the leased asset, at the inception of the lease the stated purchase price is sufficiently lower than the fair market value of the property expected at the date the option will become exercisable such that it appears to be at a bargain price. In this case, exercise of the option appears to be reasonably assured.

3. The lease term is equal to 75 percent or more of the estimated remaining economic life of the leased property, unless the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property.

4. At the beginning of the lease term, the present value of the minimum lease payments (the amounts of the payments the lessee is required to make excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessee) equals or exceeds 90 percent of the fair value of the leased property less any related investment tax credit retained by the lessor. (This criterion is also ignored when the lease term falls within the last 25 percent of the total estimated economic life of the leased property).

5. The leased asset is not so specialized that it is expected to have no alternative use.

4. How is the recorded amount of a lessee finance lease determined under ASC 842?

The provisions of ASC 842 require a lessee entering into a finance lease agreement to record both an asset and a liability at the lower of the following: 1. The sum of the present value of the minimum lease payments at the inception of the lease (see the following discussion).

2. The fair value of the leased property at the inception of the lease.

5. What is the difference between a sales-type and a direct financing type of finance lease under ASC 842?

The lessor should report a lease as a sales-type lease when at least one of the finance lease criteria is met and both lessor certainty criteria are met. This implies that the leased asset is an item of

inventory. Sales-type leases arise when manufacturers or dealers use leasing as a means of marketing their products When none of the finance lease criteria and both lessor criteria are met, lessor’s account for the lease as a direct financing lease. Under the direct financing method, the lessor is essentially viewed as a lending institution for revenue recognition purposes.

6. What is a leveraged lease? How do lessees and lessors record leveraged leases under ASC 842?

A leveraged lease is a special leasing arrangement involving three different parties: (1) the equity holder—the lessor; (2) the asset user—the lessee; and (3) the debtholder—a long-term financer.

The lessee records the lease as a finance lease. The lessor records the lease as a direct financing lease.

7. What is the definition of a lease under the provisions of ASU 2016-02?

Under the provisions of ASU 2016-02, a lease is defined as a contract that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration. To be considered a lease, a contract would have to meet both of the following criteria: • Fulfillment of the contract depends on the use of an identified asset.

• The contract conveys the right to control the use of the identified asset.

Under ASU 2016‐02 an arrangement must have an explicitly or implicitly identified asset that is physically distinct and a contract that is or contains a lease—if it conveys the right to control the use of the identified asset for a period of time in exchange for consideration. A contract conveys the right to control the use of an identified asset if, throughout the period of use, the customer has the right to (1) obtain substantially all of the economic benefits from the use of the identified asset and (2) direct the use of the identified asset (i.e., direct how and for what purpose the asset is used). The requirement to determine whether the customer has the right to direct the use of the identified asset will require significant new judgments.

8. What are the two classifications of leases for lessees under ASU 2016-02 and how is that classification determined?

The lease classification distinction under current GAAP continues to exist under ASU 2016‐02, but it now affects how lessees measure and present lease expense and cash flows— not whether the lease is disclosed on or off the balance sheet. The key difference between the previous guidance and ASU 2016‐02 is the recognition of a right‐to‐use asset (ROU) and lease liability on the statement of financial position for those leases previously classified as operating leases under the old guidance.

ASU 2016‐02 identifies two classifications of leases:

1. Finance leases (which replaces capital leases) 2. Operating leases The classification of a lease as a finance lease will be based on criteria that are similar to those previously used to determine capital leases without explicit bright lines as follows: • • • • •

The lease transfers ownership of the underlying asset to the lessee by the end of the lease term The lease grants the lessee an option to purchase the underlying asset the lessee is reasonably certain to exercise The lease term is for the major part of the remaining economic life of the underlying asset The present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the underlying asset.

The underlying asset is of such specialized nature that there is no expected alternative use to the lessor at the end of the lease term.

9. How do lessees and lessors allocate the contract price to separate lease and nonlease components under the provisions of ASU 2016-02?

A lessee should allocate the contract price to the separate lease and nonlease components based on their relative, observable standalone prices. A price is observable if it is the price that either the lessor or similar suppliers charge for similar lease or nonlease components on a standalone basis. If observable standalone prices are not readily available, the lessee should estimate the standalone prices. If an estimate of the standalone price is highly variable or uncertain, then a residual approach can be used. A lessor should allocate the contract price to the separate lease and nonlease components in accordance with the transaction price allocation guidance in FASB ASC 606, Revenue from Contracts with Customers.

10. How do lessors determine whether to record a lease as: 1. Sales-type, 2. Direct financing or 3.

Operating, under the provisions of ASU 2016-02?

A lessor will classify a lease as a sales‐type lease if any one of the five criteria used to identify a finance lease are met if the collection of payments is probable. When none of the five finance lease criteria are met, a lessor will classify the lease as a direct financing lease or an operating lease. A lease is a direct financing lease if the following criteria are met: •

•

The present value of the sum of lease payments and any residual value guaranteed by the lessee that is not already reflected in lease payments and/or any other third party unrelated to the lessor equals or exceeds substantially all of the fair value of the underlying asset It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee.

If a lease is not classified as a sales‐type or direct financing lease, it is an operating lease.

11. What is a lease modification and what is the proper accounting treatment for lease modifications under ASU 2016-02?

A lease modification is a change to the contractual terms and conditions of a contract that results in a change in the scope of or the consideration for the lease. Initial direct costs, lease incentives, and any other payments made in connection with a modification are accounted for similar to the accounting fora new lease. In certain circumstances, the lessee may be required to remeasure the lease payments. Remeasurement of the lease payment may be triggered by a reassessment of the lease term. Remeasurement is also required when the contingency associated with a variable lease payment is subsequently resolved such that the variable lease payment now meets the definition of a lease payment or when there is a change in the amounts probable of being paid by the lessee under a residual value guarantee. When the lessee remeasures the lease payments, any variable lease payments that are based on a rate or index will need to be remeasured. Remeasurement of the lease payments also requires a remeasurement of the total lease liability, and the lessee is generally required to use an updated discount rate. The remeasurement to the lease liability results in an adjustment to the right‐of‐use asset until it is reduced to zero, after which any remaining adjustment is recorded in the income statement.

12. Lopez Company leases a new machine to Abbott Corporation. The machine has a cost of $70,000 and fair value of $95,000. Under the 3-year, non-cancelable contract, Abbott will receive title to the machine at the end of the lease. The machine has a 3-year useful life and no residual value.

The lease was signed on January 1, 2020. Lopez expects to earn an 8% return on its investment, and this implicit rate is known by Abbott. The annual rentals are payable on each December 31, beginning December 31, 2020. How should this lease be recorded by Lopez and Abbott?

Because title to the asset passes to the lessee, the lease term is for the major part of the remaining economic life of the underlying asset. That is, (3/3 = 100%), and the present value of the lease payments is more than 90% of the fair value of the asset ($95,000/$95,000 = 100%), it is a financing lease to the lessee. Assuming the collectibility of the rents is probable, the lease is accounted for as a sales-type lease by Lopez.

Abbott should account for the lease as a finance lease and record the right-of-use asset and lease liability at the present value of the lease payments using the incremental borrowing rate if it is impracticable to determine the interest rate implicit in the lease. Because both the economic life of the asset and the lease term are three years, the leased asset should be depreciated over this period.

Lopez should account for the lease as a sales-type lease. The lessor should record a lease receivable and sales revenue equal to the present value of the lease payments of $95,000. In addition, the lessor should remove the asset (inventory) from its books at $70,000, and the related cost of goods sold $70,000. Interest is recognized annually at a constant rate relative to the unrecovered lease receivable.

13. On January 1, 2020, Abreau Company contracts to lease equipment for 5 years, agreeing to make a payment of $120,987 at the beginning of each year, starting January 1, 2020. The leased equipment is to be capitalized at $550,000. The asset is to be amortized on a double-decliningbalance basis, and the obligation is to be reduced on an effective-interest basis. Abreau’s incremental borrowing rate is 6%, and the implicit rate in the lease is 5%, which is known by Abreau. Title to the equipment transfers to Abreau at the end of the lease. The asset has an estimated useful life of 5 years and no residual value.

What does $550,000 amount represent?

The $550,000 is the present value of the five annual lease payments of $120,987 to be made at the beginning of each year discounted at 5% since the lessee knows the implicit rate.

14. Under the provisions of SFAS No. 13, the difference between a sales-type and a direct financing lease for a lessor was the existence of manufacturer’s or dealer’s profit at (or loss) the inception of the lease. Under FASB ASC 842 this criterion no longer exists. What are the FASB ASC criteria for classifying a lease as either direct financing or sales-type?

Whether a lease is similar to a sale of a right of use asset depends on whether the lessee, in effect, obtains control of the leased asset. Since meeting any one of the five finance lease criteria implies that control of the leased asset passes from the lessor to the lessee, all leases that meet one or more of the finance lease criteria are classified as sales-type leases. In assessing the finance lease criteria, the lessor, unlike the lessee, the lessor shall always determine the present value the lease payments and any residual value guaranteed by the lessee using the rate implicit in the lease.

If none of the five finance lease criteria is met, the lessor is to classify the lease as either a direct financing lease or an operating lease. A lease is classified as a direct financing lease when both of the following conditions are met.

•

The present value of the sum of lease payments and any residual value guaranteed by the lessee that is not already reflected in lease payments and/or any other third party unrelated to the lessor equals or exceeds substantially all of the fair value of the underlying asset.

•

It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee.

All other leases are classified as operating leases 15. Burdi Leasing Company agrees to lease equipment to Hanson Corporation on January 1, 2020.

(Its fiscal year ends on December 31st each year) The following information relates to the lease agreement.

1. The term of the lease is 7 years with no renewal option, and the machinery has an estimated economic life of 9 years.

2. The cost of the machinery is $525,000, and the fair value of the asset on January 1, 2020, is $700,000.

3. At the end of the lease term, the asset reverts to the lessor and has a guaranteed residual value of $50,000. Hanson estimates that the expected residual value at the end of the lease term will be $50,000. Hanson amortizes all of its leased equipment on a straight-line basis.

4. The lease agreement requires equal annual rental payments, beginning on January 1, 2020.

5. The collectibility of the lease payments is probable.

6. Burdi requires a 5% rate of return on its investments. Hanson’s incremental borrowing rate is 6%, and the lessor’s implicit rate is unknown.

How should Burdi and Hanson record this lease?

This is a sales-type lease for Burdi because collectibility of the lease payments is probable, and one of the five criteria for classifying the lease as a financing lease has been met because the lease term is for the major part of the remaining economic life of the underlying asset. That is. the lease term is greater than 75% of the asset’s economic life. In addition, the present value of the lease payments is greater than 90% of the asset’s fair value.

This is a finance lease for Hanson because the lease term is a major part of the asset’s economic life. 75% is still used in FASB ASC 842 as minimum threshold for measuring the major part” of the asset’s economic life of the leased asset. (The lease term is 78% (7 ÷ 9) of the asset’s economic life).

16. Discuss the difference between a finance lease and an operating lease from a lessee’s perspective.

From the lessee’s perspective, a lessee should classify a lease based on whether the arrangement is effectively a purchase of the underlying asset. If the lessee transfers control (or ownership) of the underlying asset to a lessee, then the lease is classified as a finance lease. In this situation, the lessee takes ownership or consumes the substantial portion of the underlying asset over the lease term. All leases that do not meet any of the finance lease tests are classified as operating leases. In an operating lease, a lessee obtains the right to use the underlying asset but not ownership of the asset itself.

For a finance lease, the lessee recognizes interest expense on the lease liability over the life of the lease using the effective-interest method and records amortization expense on the right-of-use asset generally on a straight-line basis. A lessee therefore reports both interest expense and amortization of the right-of-use asset on the income statement. As a result, the total expense for the lease transaction is generally higher in the earlier years of the lease arrangement under a finance lease arrangement.

In an operating lease, the lessee also measures interest expense using the effective interest method. However, the lessee amortizes the right-of-use asset such that the total lease expense is the same from period to period. In other words, for operating leases, only a single lease expense (comprised of interest on the liability and amortization of the right-of-use asset) is recognized on the income statement, typically on a straight-line basis.

Chapter 14 Multiple Choice 1. The accumulated benefit obligation measures a. The pension obligation on the basis of the plan formula applied to years of service to date and based on future salary levels. b. The level cost that will be sufficient, together with interest to provide the total benefits at retirement. c. The shortest possible period for funding to maximize the tax deduction. d. The pension obligation on the basis of the plan formula applied to years of service to date and based on existing salary levels Answer d 2. In a defined-benefit plan, the process of funding refers to a. Determining the projected benefit obligation. b. Determining the amount that might be reported for pension expense. c. Determining the accumulated benefit obligation. d. Making the periodic contributions to a funding agency to ensure that funds are available to meet retirees' claims.

Answer d 3. In accounting for a defined-benefit pension plan a. The employer's responsibility is simply to make a contribution each year based on the formula established in the plan. b. The expense recognized each period is equal to the cash contribution. c. The liability is determined based upon known variables that reflect future salary levels promised to employees. d. An appropriate funding pattern must be established to ensure that enough monies will be available at retirement to meet the benefits promised Answer d 4. APB Opinion No. 8 set minimum and maximum limits on the annual provision for pension cost.

An amount that was always included in the calculation of both the minimum and the maximum limit is a. Normal cost b. Amortization of past service cost c. Interest on unfunded past and prior service costs d. Retirement benefits paid Answer a

5. In accounting for a pension plan, any difference between the pension cost charged to expense and the payments into the fund should be reported as a. An offset to the liability for prior service cost b. Accrued or prepaid pension cost c. An operating expense in this period d. An accrued actuarial liability Answer b 6. A corporation has a defined-benefit plan. A pension liability will result at the end of the year if a. The projected benefit obligation exceeds the fair value of the plan assets. b. The fair value of the plan assets exceeds the projected benefit obligation. c. The amount of employer contributions exceeds the pension expense. d. The amount of pension expense exceeds the amount of employer contributions Answer a 7. Benefits under a pension plan that are not contingent upon an employee’s continuing service are a. Granted under a plan of defined contribution b. Based upon terminal funding c. Actuarially unsound d. Vested Answer d 8. According to SFAS No. 87, “Employer’s Accounting for Pensions,” gains and losses should be a. Fully allocated to current and future periods b. Offset against pension expense in the year of occurrence c. Allocated if any unrecognized gain or loss at the beginning of the year is in excess of 10 percent of the greater of the projected benefit obligation or the market value of the plan assets d. Disclosed in a note to the financial statements using separate schedules for both gains and losses Answer c 9. In accounting for a pension plan, any difference between the pension cost charged to expense and the payments into the fund should be reported as a. An offset to the liability for prior service cost. b. Accumulated other comprehensive income c. A pension asset or liability. d. Other comprehensive income Answer c

10. The interest on the projected benefit obligation component of pension expense a. May be stated implicitly or explicitly when reported. b. Reflects the incremental borrowing rate of the employer. c. Reflects the rates at which pension benefits could be effectively settled. d. Is the same as the expected return on plan assets Answer c 11. Which of the following components of pension expense could result in a decrease to the annual pension expense amount? a. Service Cost. b. Actual return on plan assets. c. Interest on the liability. d. Amortization of prior service cost Answer b 12. The actual return on plan assets a. Is equal to interest expenses accrued each year on the projected benefit obligation, just as it does on any discounted debt. b. Is equal to the expected rate of return times the fair value of the plan assets at the beginning of the period. c. Is equal to the change in the fair value of the plan assets during the year. d. Includes interest, dividends, and changes in the fair value of the fund assets Answer d 13. According to SFAS No. 87, prior service costs should be a. Charged to retained earnings as a cost relating to the past b. Amortized over the service period of each employee expected to receive benefits c. Taken into consideration only by expensing interest on the unfunded amount d. Recorded in full as a liability at their discounted present value Answer b 14. In a defined benefit plan, the amount of annual funding depends on a. Compensation levels. b. Interest earnings. c. Turnover d. All of the above Answer d

15. According to SFAS No. 87, which of the following is never recorded as a component of annual pension cost? a. Amortization of the intangible asset recorded as the offset to the minimum pension liability b. Amortization of prior service cost c. Amortization of gains and losses d. Amortization of the transition amount Answer a 16. Gains and losses that relate to the computation of pension expense should be a. Recorded only if a loss is determined. b. Recorded currently as an adjustment to pension expense in the period incurred. c. Amortized over a 15-year period an amount in excess of the accumulated benefit obligation. d. Recorded currently and in the future by applying the corridor method which provides the amount to be amortized Answer d 17. A pension liability is reported when a. Accumulated other comprehensive income exceeds the fair value of pension plan assets. b. The projected benefit obligation exceeds the fair value of pension plan assets. c. The accumulated benefit obligation is less than the fair value of pension plan assets. d. The pension expense reported for the period is greater than the funding amount for the same period Answer b 18. The funded status of a defined benefit pension plan is equal to the a. Vested benefit obligation minus the fair value of the pension plan assets. b. Accumulated benefit obligation minus the fair value of the pension plan assets. c. Projected benefit obligation minus the fair value of the pension plan assets. d. Projected benefits plus the fair value of the pension plan assets minus employer contributions to the pension plan.

Answer c 19. If the projected benefit obligation of a defined benefit pension plan exceeds the fair value of the pension plan assets, the employer must report a. The difference as a liability in the balance sheet and a corresponding adjustment to the amount of pension expense reported in earnings. b. The difference as a liability in the balance sheet and a corresponding adjustment to other comprehensive income, net of deferred income taxes. c. The difference as an asset in the balance sheet and a corresponding adjustment to the amount of pension expense reported in earnings.

d. The difference as an asset in the balance sheet and a corresponding adjustment to other comprehensive income, net of deferred income taxes.

Answer b 20. Whenever a defined-benefit pension plan is amended, and credit is given to employees for their years of service provided before the date of amendment a. Both the pension expense and the projected benefit obligation are usually relatively more than the previous amount b. Both the pension expense and the projected benefit obligation are usually relatively smaller than the previous amount c. Both the pension expense and the projected benefit obligation are usually the same as previous amount d. The expected change cannot be determined Answer a 21. The funded status of a defined benefit pension plan is reported in the balance sheet. a. As an asset, if the pension plan is underfunded. b. As a liability, if the pension plan is underfunded. c. Because it measures the minimum pension plan liability. d. When it exceeds the projected benefit obligation.

Answer b 22. A company that maintains a defined-benefit pension plan for its employees should report a pension asset or liability on each balance sheet date equal to the a. Funded status relative to the projected benefit obligation. b. Projected benefit obligation. c. Accumulated benefit obligation. d. Plan’s vested benefits Answer a 23. Some theorists argue that the best measure of the employer’s defined benefit pension plan obligation is the accumulated benefit obligation. a. Since the accumulated benefit obligation is measured using current salaries, it represents the conservative floor for a company’s pension obligation to its employees. b. It is consistent with the measurement of pension expense. c. Since the accumulated benefit obligation is measured using future salaries, it represents the conservative floor for a company’s pension obligation to its employees. d. The accumulated benefit obligation measures the present value of the amounts that employees will receive from the pension plan once they retire.

Answer a 24. Benefits that are not contingent on the employee continuing in the service of the company are a. Accumulated benefits. b. Projected benefits. c. Benefits earned to date. d. Vested benefits.

Answer d 25. The corridor approach a. Is used to determine how much interest to add to the service cost and amortization of prior service in order to calculate pension expense for the period. b. Is used to determine the minimum amount of accumulated unamortized net gains or losses that must be amortized during the accounting period. c. Is used to determine the amount of prior service cost to expense each accounting period. d. Is use to determine the pension plan’s funded status.

Answer b 26. The main purpose of the Pension Benefit Guaranty Corporation is to a. Pay pension to participants of failed pension plans b. Require a voluntary termination of a pension plan whenever the risks related to nonpayment of the pension obligation seem high. c. Require plan administrators to publish a comprehensive description and summary of their plans. d. Require minimum funding of pensions Answer a 27. Which of the following is not a difference between defined benefit pension plans and other postretirement benefits (OPBs)? a. Unlike defined benefit pension plan payments, there is no cap on the amount of OPBs benefit to be paid to participants. b. Unlike defined benefit pension plans, management promises OPBs payments in exchange for current services. c. Unlike defined benefit pension plans, employees do not accumulate additional OPBs benefits with each year of service. d. Unlike defined benefit pension plans, OPBs do not vest.

Answer b 28. The expected postretirement benefit obligation (EPBO) is

a. Similar to the defined benefit pension plan’s projected benefit obligation because it is the obligation attributable to employee service rendered to date. b. Used to calculate the interest component of OPBs expense before full eligibility is achieved. c. Recognized over the life expectancy of the employees when most participants are fully eligible to receive benefits. d. The actuarial present value of the total benefits expected to be paid assuming full eligibility is achieved.

Answer d Essay 1. Discuss the difference between defined benefit and defined contribution pension plans.

A defined contribution plan sets forth a certain amount that the employer is to contribute to the plan each period. For example, the plan may require the employer to contribute 8 percent of the employee's salary each year. However, the plan makes no promises concerning the ultimate benefits to be paid. The retirement benefits actually received by the recipients are determined by the return earned on the invested pension funds during the investment period.

The terms of a defined benefit plan specify the amount of pension benefits to be paid out to plan recipients in the future. For example, the retirement plan of a company may promise that an employee retiring at age 65 will receive 2 percent of the average of the highest five years' salary for every year of service. An employee working for this company for thirty years will receive a pension for life equal to 60 percent of the average of his or her highest five salary years. Companies that provide defined benefit pension plans must make sufficient contributions to the funding agency in order to meet benefit requirements when they come due. Although no specific amount is required to be funded each period, the Employee Retirement Income Security Act (ERISA) does impose minimum funding requirements on these plans.

2. Discuss the cost approach and benefits approach actuarial funding methods.

The employer's actuarial funding method may be either a cost approach or a benefit approach. A cost approach estimates the total retirement benefits to be paid in the future and then determines the equal annual payment that will be necessary to fund those benefits. The annual payment necessary is adjusted for the amount of interest assumed to be earned by funds contributed to the plan.

A benefit approach determines the amount of pension benefits earned by employee service to date and then estimates the present value of those benefits. Two benefit approaches may be used: (1) the accumulated benefits approach and (2) the benefits/years of service approach. The major difference between these two methods is that under the accumulated benefits approach, the annual pension cost and liability are based on existing salary levels, whereas under the benefits/years of service approach (also called the projected unit credit method), the annual pension cost and liability

are based on the estimated final pay at retirement. The liability for pension benefits under the accumulated benefits approach is termed the accumulated benefits obligation. The liability computed under the benefits/years of service approach is termed the projected benefit obligation.

3. Define the following components of pension cost: under SFAS No. 87 (FASB ASC 715): a. Service cost The service cost component of pension cost is the actuarial present value of the benefits attributed by the pension formula to employee service for that period. b. Interest cost The interest cost component is the increase in the projected benefit obligation due to the passage of time. Recall that the pension liability is calculated on a discounted basis and accrues interest each year. The interest cost component is determined by accruing interest on the previous year's pension liability at the settlement-basis discount rate. c. Return on plan assets The return on plan assets component is the difference between the fair value of these assets from the beginning to the end of the period, adjusted for contributions, benefits, and payments.

That is, the interest and dividends earned on the funds actually contributed to the pension fund, combined with changes in the market value of invested assets, will reduce the amount of net pension cost for the period. SFAS No. 87 allows the use of either the actual return or the expected return on plan assets when calculating this component of pension expense. d. Prior service cost Prior service cost is the total cost of retroactive benefits at the date the pension plan is initiated or amended. Prior service cost is amortized over the expected remaining service period of each employee expected to receive benefits. e. Amortization of gains and losses Gains and losses include actuarial gains and losses or experience gains and losses. At a minimum, the amount of gain or loss to be amortized in a given period is the amount by which the cumulative unamortized gains and losses exceed what the pronouncement termed the corridor. The corridor is defined as 10 percent of the greater of the projected benefit obligation or market value of the plan assets. The excess, if any, is divided by the average remaining service period of employees expected to receive benefits.

4. What factors must be considered by actuaries in measuring the amount of pension benefits under a defined benefit plan?

In measuring the amount of pension benefits under a defined-benefit pension plan, an actuary must consider such factors as mortality rates, employee turnover, interest and earnings rates, early retirement frequency, and future salaries.

5. What is the minimum liability as it relates to reporting pensions on corporate financial statements?

FASB ASC 715 requires recognition of a liability, termed the minimum liability, when the accumulated benefit obligation exceeds the fair value of the plan assets. Thus, even though future salary levels are used to calculate pension expense, the liability reported on the balance sheet need take into consideration only present salary levels. The result is that the balance sheet and income statements are not articulated, a condition that is contrary to the conceptual framework.

The portion of the underfunded pension obligation that is not already recognized in the accounting records occurs because the company has unamortized prior service cost or unamortized gains and losses. Because the minimum liability is based on current salary levels and is therefore likely to be less than the underfunded projected benefit obligation, total unamortized prior service cost and unamortized gains and losses are likely to exceed the amount needed to increase the pension liability to the minimum required 6. What four categories of information are required to be disclosed under the provisions of SFAS No. 35 (FASB ASC 960)?

The FASB ASC 960 guidelines require that pension plan financial statements include four basic categories of information: 1. Net assets available for benefits 2. Changes in net assets during the reporting period 3. The actuarial present value of accumulated plan benefits 4. The significant effects of factors such as plan amendments and changes in actuarial assumptions on the year-to-year change in the actuarial present value of accumulated plan benefits 7. Discuss the characteristics that make accounting for other postretirement benefits more difficult than accounting for pensions.

These characteristics are: 1. Defined benefit pension payments are determined by formula, whereas the future cash outlays for OPBs depend on the amount of services, such as medical care, that the employees will eventually receive. Unlike pension plan payments, there is no “cap” on the amount of benefits to be paid to participants. Hence, the future cash flows associated with OPBs are much more difficult to predict.

2. Unlike defined pension benefits, employees do not accumulate additional OORB benefits with each year of service.

3. OPBs do not vest. That is, employees who leave have no further claim to future benefits.

Employees have no statutory right to vested health care benefits. Defined benefits are covered by stringent minimum vesting, participation, and funding standards, and are insured by the Pension Benefit Guaranty Corporation under ERISA. Health and other OPBs are explicitly excluded from ERISA. 8. What changes in accounting for pensions were required by SFAS No. 158 (FASB ASC 715)?

The FASB ASC 715 guidelines require recognition of the overfunded or underfunded status of a defined benefit pension plan (DBPP) or other postretirement benefit plan (OPBP) as an asset or liability in a company's statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. That is, a company is required to: 1. Recognize the funded status of a benefit plan in its statement of financial position. This amount is to be measured as the difference between plan assets at fair value and the projected benefit obligation.

2. Recognize as a component of other comprehensive income, net of tax, the gains or losses, and prior service costs or credits that arise during the period but were not recognized as components of net periodic benefit cost.

3. Measure DBPP and OPBP assets and obligations as of the date of the benefit provider's fiscal year-end.

4. Disclose in the notes to financial statements additional information about certain effects on net periodic benefit cost for the next fiscal year that arise from delayed recognition of the gains or losses, prior service costs or credits, and transition asset or obligation.

9. Discuss the differences between defined benefit pension plans (DBPP) and other postretirement benefit plans (OPBP) with respect to: a. b. c. d.

How they are funded The amount of benefits received How the benefit amount is paid Actuarial predictability of an individual plan

DBPPs and OPBPs differ in the following respects: a. DBPPs are usually funded as benefits are earned; whereas, OPBPs are generally not funded. b. The amount of a DBPP is generally well defined and consists of a level dollar amount each period; whereas, the amount of a OPBP can vary considerably depending on the benefits claimed. c. The DBPP is usually paid monthly’ whereas, a OPBP is paid as needed. d. The amount of a DBPP is fairly predictable; whereas, the utilization of a OPBP is difficult to predict.

10. Discuss the Employee Retirement Income Security Act. In 1974, the U. S. Congress passed the Employee Retirement Income Security Act (ERISA), also known as the Pension Reform Act of 1974. The basic goals of this legislation were to create standards for the operation of pension funds and to correct abuses in the handling of pension funds.

ERISA does not require employers to establish pension plans, and it generally does not require that pension plans provide a minimum level of benefits. Instead, it regulates the operation of a pension plan once it has been established by establishing guidelines for employee participation in pension plans, vesting provisions, minimum funding requirements, financial statement disclosure of pension plans, and the administration of the pension plan.

One of the major provisions of ERISA was the creation of the Pension Benefit Guarantee Corporation (PGBC). The PGBC is an independent agency of the U.S. government to encourage the continuation and maintenance of voluntary private DBPPs, provide timely and uninterrupted payment of pension benefits, and keep pension insurance premiums at the lowest level necessary to carry out its operations. The major goal of the PBGC is to pay pension to participants of failed pension plans. This is accomplished through an insurance program.

FASB Interpretation No. 3 stated that ERISA is concerned with pension funding requirements and that accounting for pension costs was not affected by ERISA. The provisions of FASB ASC 715 are also not affected by ERISA. Accounting standards for pension costs are concerned with periodic expense and liability recognition, whereas the provisions of ERISA are concerned mainly with the funding policies of pension plans.

Chapter 15 Multiple Choice 1. For a compensatory stock option plan for which the date of grant and measurement date are the same, compensation cost should be recognized in the income statement a. At the date of retirement b. Of each period in which services are rendered c. At the exercise date d. At the adoption date of the plan Answer d 2. In a corporate form of business organization, legal capital is best defined as a. The amount of capital the state of incorporation allows the company to accumulate over its existence. b. The amount of net assets that cannot be distributed to stockholder c. The amount of capital the federal government allows a corporation to generate. d. The total capital raised by a corporation within the limits set by the Securities and Exchange Commission.

Answer b 3. Payment of a dividend in stock a. Increases the current ratio b. Decreases the amount of working capital c. Increases total stockholders’ equity d. Decreases book value per share of stock outstanding Answer d 4. The pre-emptive right of a common stockholder is the right to a. Share proportionately in corporate assets upon liquidation. b. Share proportionately in any new issues of stock of the same class. c. Receive cash dividends before they are distributed to preferred stockholders. d. Exclude preferred stockholders from voting rights.

Answer b 5. The directors of Corel Corporation, whose $40 par value common stock is currently selling at $50 per share, have decided to issue a stock dividend. The corporation has an authorization for 200,000 shares of common, has issued 110,000 shares of which 10,000 shares are now held as treasury stock, and desires to capitalize $400,000 of the retained earnings balance. To accomplish this, the percentage of stock dividend that the directors should declare is

a. 10 b. 8 c. 5 d. 2 Answer b 6. When a stock dividend is small, for example a 10% stock dividend, a. Retained earnings is not reduced because the dividend is immaterial. b. Retained earnings is reduced by the fair value of the stock. c. Retained earnings is reduced to the par value of the stock. d. Paid-in capital in excess of par value is unaffected.

Answer b 7. The par value method of reporting a treasury stock transaction a. Will be reported in the balance sheet as a reduction of total stockholders’ equity. b. Results in no change to total stockholders’ equity. c. Results in a reduction in the number of shares that are available to be sold to prospective investors. d. Assumes constructive retirement of the treasury shares.

Answer d 8. On December 31, 2017, when the Conn Company’s stock was selling at $36 per share, its capital accounts were as follows: Capital stock (par value $20, 100,000 shares issued) $2,000,000 Premium on capital stock 800,000 Retained Earnings 4,550,000 If a 100 percent stock dividend were declared and the par value per share remained at $20 a. No entry would need to be made to record the dividend b. Capital stock would increase to $5,600,000 c. Capital stock would increase to $4,000,000 d. Total capital would decrease Answer c 9. A company has not paid dividends on its cumulative nonvoting preferred stock for 20 years.

Healthy earnings have been reported each year, but they have been retained to support the growth of the company. The board of directors appropriately authorized management to offer the preferred shareholders an exchange of bonds and common stock for all the preferred stock. The exchange is about to be consummated. Which of the following best describes the effect of the exchange on the company?

a. The statute of limitations applies; hence, cumulative dividends of only seven years need to be paid on the preferred stock exchanged. b. The company should record a gain for income determination purposes to the extent that dividends in arrears do not have to be paid in the exchange transaction. c. Gain or loss should be recognized on the exchange by the company, and the exchange would have to be approved by the Securities and Exchange Commission. d. Regardless of the market value of the bonds and common stock, no gain or loss should be recognized by the company on the exchange, and no dividends need to be paid on the preferred stock exchanged.

Answer d 10. A primary source of stockholders' equity is

a. Income retained by the corporation. b. Appropriated retained earnings. c. Contributions by stockholders. d. Both income retained by the corporation, and contributions by stockholders.

Answer d 11. Stockholders' equity is generally classified into two major categories: a. Contributed capital and appropriated capital. b. Appropriated capital and retained earnings. c. Retained earnings and unappropriated capital. d. Earned capital and contributed capital.

Answer d 12. Which of the following represents the total number of shares that a corporation may issue under the terms of its charter? a. Authorized shares b. Issued shares c. Unissued shares d. Outstanding shares Answer a 13. Stock that has a fixed per-share amount printed on each stock certificate is called a. Stated value stock. b. Fixed value stock. c. Uniform value stock. d. Par value stock.

Answer d

14. Treasury shares are a. Shares held as an investment by the treasurer of the corporation. b. Shares held as an investment of the corporation. c. Issued and outstanding shares. d. Issued but not outstanding shares.

Answer d 15. Which of the following features of preferred stock makes the security more like debt than an equity instrument? a. Participating b. Voting c. Redeemable d. Noncumulative Answer c 16. The cumulative feature of preferred stock a. Limits the amount of cumulative dividends to the par value of the preferred stock. b. Requires that dividends not paid in any year must be made up in a later year before dividends are distributed to common shareholders. c. Means that the shareholder can accumulate preferred stock until it is equal to the par value of common stock at which time it can be converted into common stock. d. Enables a preferred stockholder to accumulate dividends until they equal the par value of the stock and receive the stock in place of the cash dividends.

Answer b 17. A restriction of retained earnings is most likely to be required by the a. Exhaustion of potential benefits of the investment credit b. Purchase of treasury stock c. Payment of last maturing series of a serial bond issue d. Amortization of past service costs related to a pension plan Answer b 18. According to the FASB ASC, redeemable preferred stock should be a. Included in the common stock section. b. Included as a liability. c. Excluded from the stockholders' equity section. d. Included as a contra item in the stockholders' equity section.

Answer b

19. At the date of the financial statements, common stock shares issued would exceed common stock shares outstanding as a result of the a. Declaration of a stock split. b. Declaration of a stock dividend. c. Purchase of treasury stock. d. Payment in full of subscribed stock.

Answer c 20. A feature common to both stock splits and stock dividends is a. A transfer to earned capital of a corporation. b. No impact on total stockholders' equity. c. An increase in total liabilities of a corporation. d. A reduction in the contributed capital of a corporation.

Answer b 21. The rate of return on common stock equity is calculated by dividing a. Net income less preferred dividends by average common stockholders' equity. b. Net income by average common stockholders' equity. c. Net income less preferred dividends by ending common stockholders' equity. d. Net income by ending common stockholders' equity.

Answer a 22. A feature common to both stock splits and stock dividends is a. A reduction in total capital of a corporation b. A transfer from earned capital to paid-in capital c. A reduction in book value per share d. Inclusion in conventional statement of source and application of funds Answer c 23. Assuming the issuing company has only one class of stock, a transfer from retained earnings to capital stock equal to the market value of the shares issued is ordinarily a characteristic of a. Either a stock dividend or a stock split b. Neither a stock dividend nor a stock split c. A stock split but not a stock dividend d. A stock dividend but not a stock split Answer d 24. When a stock option plan for employees is compensatory, the measurement date for determining compensation cost is the

a. Date the option plan is adopted, provided it precedes the date on which the options may first be exercised by less than one operating cycle b. Date on which the options may first be exercised (if the first actual exercise is within the same operating period) or the date on which a recipient first exercises any of his options c. First date on which are known both the number of shares than an individual employee is entitled to receive and the option or purchase price, if any d. Date each option is granted Answer c 25. As a minimum, how large in relation to total outstanding shares may a stock distribution be before it should be accounted for as a stock split instead of a stock dividend? a. No less than 2 to 5 percent b. No less than 10 to 15 percent c. No less than 20 to 25 percent d. No less than 45 to 50 percent Answer c 26. The dollar amount of total stockholders’ equity remains the same when there is a (an) a. Issuance of preferred stock in exchange for convertible debentures b. Issuance of nonconvertible bonds with detachable stock purchase warrants c. Declaration of a stock dividend d. Declaration of a cash dividend Answer c 27. A company with a substantial deficit undertakes a quasi-reorganization. Certain assets will be written down to their present fair market value. Liabilities will remain the same. How would the entries to record the quasi-reorganization affect each of the following?

a. b. c. d.

Contributed Capital Increase Decrease Decrease No effect

Retained Earnings Decrease No effect Increase Increase

Answer c 28. What is the most likely effect of a stock split on the par value per share and the number of shares outstanding?

Par Value Number of shares Per share outstanding a.

Decrease Increase

b. c. d.

Decrease Increase No effect

No effect Increase No effect

Answer a 29. Gilbert Corporation issued a 40-percent stock dividend of its common stock that had a par value of $10 before and after the dividend. At what amount should retained earnings be capitalized for the additional shares issued? a. There should be no capitalization of retained earnings b. Par value c. Market value on the declaration date d. Market value on the payment date Answer b 30. How would the declaration and subsequent issuance of a 10 percent stock dividend by the issuer affect each of the following when the market value of the shares exceeds the par value of the stock?

Common Stock Additional Paid-in Capital a.

No effect No effect b.

No effect Increase c.

Increase No effect d.

Increase Increase Answer d 31. A company with a $2,000,000 deficit undertakes a quasi-reorganization on November 1, 2020.

Certain assets will be written down by $400, 000 to their present fair market value. Liabilities will remain the same. Capital stock was $3,000,000 and additional paid-in capital was $1,000,000 before the quasi-reorganization. How would the entries to accomplish these changes on November 1, 2020, affect each of the following?

Capital Stock Total Stockholders’ Equity a.

No effect No effect b.

No effect Decrease c.

Decrease Decrease d.

Decrease No effect Answer d 32. How would a stock split affect each of the following?

Total Stockholders’ Assets Equity a.

Increase Increase b.

No effect No effect

Additional Paid-in Capital No effect No effect

c. d.

No effect Decrease

No effect Decrease

Increase Decrease

Answer b 33. The purchase of treasury stock a. Decreases common stock authorized b. Decreases common stock issued c. Decreases common stock outstanding d. Has no effect on common stock outstanding Answer c 34. The equation, assets = equities, expresses which of the following theories of equity? a. Proprietary theory. b. Commander theory. c. Entity theory. d. Enterprise theory.

Answer c 35. Under the residual equity theory a. A business is viewed as a social institution. b. Management is responsible for maximizing the wealth of common stockholders. c. A manager’s goals are considered as important as those of the common stockholders. d. Equities are viewed as restrictions on assets.

Answer b 36. Under which of the theories of equity is a manager’s goals considered as important as those of the common stockholder. a. Proprietary theory. b. Commander theory. c. Entity theory. d. Enterprise theory.

Answer b 37. Which of the theories of equity is consistent with the definition of equity that is found in Statement of Financial Accounting Concepts No. 6? a. Proprietary theory. b. Commander theory. c. Entity theory. d. Enterprise theory.

Answer a 38. Which of the following securities must be reported as a liability because they have the characteristics of both liabilities and equity, but the liability characteristic is dominant? a. Redeemable preferred stock. b. Stock options issued with a debt security. c. Detachable stock options. d. Mandatorily redeemable preferred stock.

Answer d 39. When a dividend paid to stockholders who own mandatorily redeemable preferred stock, the company must report the dividend a. As an adjustment to retained earnings in its statement of owners’ equity. b. As interest expense in the income statement. c. As a reduction to other comprehensive income. d. In the financing activities section of the statement of cash flows.

Answer b 40. When preferred stock is converted to common stock a. The debt-to-equity ratio decreases. b. The debt-to-equity ratio increases. c. The debt-to-equity ratio is unchanged. d. A gain or loss is reported in earnings for the difference between the fair value of the common stock and the book value of the preferred stock that was converted.

Answer c 41. When employees are granted options as part of a compensatory stock option plan, a. Total compensation is measured using a fair value method. b. Total compensation is measured using the intrinsic method. c. Total compensation is measured when the options are in the money. d. Total compensation is measured using the difference between the strike price and the fair value of the options on the grant date.

Answer a Essay 1. Discuss the following theories of equity: a. Proprietary

According to the proprietary theory, the firm is owned by some specified person or group. The ownership interest may be represented by a sole proprietor, a partnership, or a number of stockholders. The assets of the firm belong to these owners, and any liabilities of the firm are also the owners’ liabilities. Revenues received by the firm immediately increase the owner’s net interest in the firm. Likewise, all expenses incurred by the firm immediately decrease the net proprietary interest in the firm. This theory holds that all profits or losses immediately become the property of the owners, and not the firm, whether or not they are distributed. Therefore, the firm exists simply to provide the means to carry on transactions for the owners, and the net worth or equity section of the balance sheet should be viewed as assets – liabilities = proprietorship Under the proprietary theory, financial reporting is based on the premise that the owner is the primary focus of a company’s financial statements. The proprietary theory is particularly applicable to sole proprietorships where the owner is the decision maker. When the form of the enterprise grows more complex, and the ownership and management separate, this theory becomes less acceptable. b. Entity The rise of the corporate form of organization, (1) was accompanied by the separation of ownership and management, (2) conveyed limited liability to the owners, and (3) resulted in the legal definition of a corporation as though it were a person, encouraged the evolution of new theories of ownership. Among the first of these theories was the entity theory. From an accounting standpoint, the entity theory can be expressed as assets = equities The entity theory, like the proprietary theory, is a point of view toward the firm and the people concerned with its operation. This viewpoint places the firm, and not the owners, at the center of interest for accounting and financial reporting purposes. The essence of the entity theory is that creditors as well as stockholders contribute resources to the firm, and the firm exists as a separate and distinct entity apart from these groups. The assets and liabilities belong to the firm, not to its owners. As revenue is received, it becomes the property of the entity, and as expenses are incurred, they become obligations of the entity. Any profits belong to the entity and accrue to the stockholders only when a dividend is declared. Under this theory, all the items on the right-hand side of the balance sheet, except retained earnings (it belongs to the firm), are viewed as claims against the assets of the firm, and individual items are distinguished by the nature of their claims. Some items are identified as creditor claims and others are identified as owner claims; nevertheless, they are all claims against the firm as a separate entity. c. Fund

The use of the fund theory would abandon the personal relationship advocated by the proprietary theory and the personalization of the firm advocated by the entity theory. Under the fund approach, the measurement of net income plays a role secondary to satisfying the special interests of management, social control agencies (e.g., government agencies), and the overall process of credit extension and investment. The fund theory is expressed by the following equation: assets = restrictions on assets This theory explains the financial reporting of an organization in terms of three features, as follows: 1. Fund. —an area of attention defined by the activities and operations surrounding any one set of accounting records and for which a self-balancing set of accounts is created.

2. Assets. —economic services and potentials.

3. Restrictions. —limitations on the use of assets.

These features are applied to each homogeneous set of activities and functions within the organization, thereby providing a separate accounting for each area of economic concern.

The fund theory has not gained general acceptance in financial accounting; it is more suitable to governmental accounting. d. Commander The commander approach is offered as a replacement for the proprietary and entity theories because it is argued that the goals of the manager (commander) are at least equally important to those of the proprietor or entity. The proprietary, entity, and fund approaches emphasize persons, personalization, and funds, respectively, but the commander theory emphasizes control. Everyone who has resources to deploy is viewed as a commander.

The commander theory, unlike the proprietary, entity, and fund approaches, has applicability to all organizational forms (sole proprietorships, partnerships, and corporations). The form of organization does not negate the applicability of the commander view because the commander can take on more than one identity in any organization. In sole proprietorships or partnerships, the proprietors or partners are both owners and commanders. Under the corporate form, both the managers and the stockholders are commanders in that each maintains some control over resources. (Managers control the enterprise resources, and stockholders control returns on investment emerging from the enterprise).

A commander theorist would argue that the notion of control is broad enough to encompass all relevant parties to the exclusion of none. The function of accounting, then, takes on an element of stewardship, and the question of where resource increments flow is not relevant. Rather, the relevant factor is how the commander allocates resources to the benefit of all parties.

Responsibility accounting is consistent with the commander theory. Responsibility accounting

identifies the revenues and costs that are under the control of various “commanders” within the organization, and the organization’s financial statements are constructed to highlight the contributions of each level of control to enterprise profits. The commander theory is not on the surface a radical move from current accounting practices, and it has generated little reaction in accounting circles. e. Enterprise Under the enterprise theory, business units, most notably those listed on national or regional stock exchanges, are viewed as social institutions, composed of capital contributors having “a common purpose or purposes and, to a certain extent, roles of common action.” Management within this framework essentially maintains an arm’s-length relationship with owners and has as its primary responsibilities (1) the distribution of adequate dividends and (2) the maintenance of friendly terms with employees, consumers, and government units. Because this theory applies only to large nationally or regionally traded issues, it is generally considered to have only a minor impact on accounting theory, or the development of accounting principles and practices. f.

Residual equity Residual equity is defined as “the equitable interest in organization’s assets which will absorb the effect upon those assets of any economic event that no interested party has specifically agreed to.” Here, the common shareholders hold the residual equity in the enterprise by virtue of having the final claim on income, yet they are the first to be charged for losses. The residual equity holders are vital to the firm’s existence in that they are the highest risk takers and provide a substantial volume of capital during the firm’s developmental stage.

The residual equity theory is formulated as assets –specific equities = residual equities Under this approach, the residual of assets, net of the claim of specific equity holders (creditors and preferred stockholders), accrue to residual owners. In this framework, the role of financial reporting is to provide prospective and current residual owners with information regarding enterprise resource flows so that they can assess the value of their residual claim. Management is in effect a trustee responsible for maximizing the wealth of residual equity holders. Income accrues to the residual owners after the claims of specific equity holders are met. Thus, the income to specific equity holders, including interest on debt and dividends to preferred stockholders, would be deducted in arriving at residual net income. This theory is consistent with models that are formulated in the finance literature, with current financial statement presentation of earnings per share, and with the Conceptual Framework’s emphasis on the relevance of projecting cash flows. Again, as with the fund, commander, and enterprise theories, the residual equity approach has gained little attention in financial accounting.

2. What is mandatorily redeemable preferred stock and how is it accounted for under the provisions of SFAS No. 150 (FASB ASC 480-10)?

Redemption provisions on preferred stock are common features of agreements entered into among the owners of closely held businesses. These agreements, which are often referred to as shareholders’ or buy–sell agreements, provide for the orderly disposition of the owners’ investment in the company upon their separation from the company, usually at retirement, disability, or death.

Because there is no market for the equity securities of a closely held company, departing owners or their heirs must rely on the company or the remaining owners to provide them with liquidity.

Redemption by the company is usually favored over requiring the remaining owners to fund a buyout because the remaining owners may not have the necessary financial resources. Prior to the guidance contained at FASB ASC 480 owners’ equity that was redeemable pursuant to a buy–sell agreement was accounted for as equity, not debt, and the existence and significant terms of the buy–sell agreement are required to be described in the notes to financial statements.

In 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity,” (See FASB ASC 480). This guidance requires companies to record and report mandatorily redeemable preferred stock (MRPS) as a liability on their balance sheets, and the dividends on these securities as interest expense. Most companies previously disclosed MRPS between the liability and stockholders’ equity sections (i.e., the mezzanine section) of the balance sheet.

3. List and discuss four advantages of the corporate form of organization.

Several advantages accrue to the corporate form and help explain its emergence. Among these are: 1. Limited liability. —A stockholder’s loss on his or her investment is limited to the amount of the amount invested (unless on the date of acquisition, the purchase price of the shares acquired was less than their par value). Creditors may not look to the assets of individual owners for debt repayments in the event of a liquidation, as is possible in the case of sole proprietorships and partnerships.

2. Continuity. —The corporation’s life is not affected by the death or resignation of owners.

3. Investment liquidity. —Corporate shares may be freely exchanged on the open market. Many shares are listed on national security exchanges, thereby improving their marketability.

4. Variety of ownership interest. —Shares of corporate stock usually contain four basic rights: the right to vote for members of the board of directors of the corporation and thereby participate in management, the right to receive dividends, the right to receive assets on the liquidation of the corporation, and the preemptive right to purchase additional shares in the same proportion to current ownership interest if new issues of stock are marketed. Shareholders may sacrifice any or all of these rights in return for special privileges. This results in an additional class of stock termed preferred stock, which may have either or both of the following features: a. Preference as to dividends. b. Preference as to assets in liquidation.

4. Discuss the components of a corporation’s balance sheet capital section.

The components of a corporation’s capital section are classified by source in the following manner: I.

Paid-in capital (contributed capital) a. Legal capital-par, stated value, or entire proceeds if no par or stated value accompanies the stock issue b. Additional paid-in capital—amounts received in excess of par or stated value

II.

Earned capital a. Appropriated b. Unappropriated

III.

Other comprehensive income

5. Discuss the following special features of preferred stock: a. Convertible A conversion feature allows preferred shareholders to exchange their shares for common shares. It is included on a preferred stock issue to make it more attractive to potential investors.

Usually, a conversion feature is attached to allow the corporation to sell its preferred shares at a relatively lower dividend rate than is found on other securities with the same degree of risk.

The conversion rate is normally set above the current relationship of the market value of the common share to the market value of the preferred convertible shares. b.

Call Call provisions allow the corporation to reacquire preferred stock at some predetermined amount. Corporations include call provisions on securities because of uncertain future conditions. Current conditions dictate the return on investment that will be attractive to potential investors, but conditions may change so that the corporation may offer a lower return on investment in the future. In addition, market conditions may make it necessary to promise a certain debt–equity relationship at the time of issue. Call provisions allow the corporation to take advantage of future favorable conditions and indicate how the securities may be retired. The existence of a call price tends to set an upper limit on the market price of nonconvertible securities, since investors will not normally be inclined to purchase shares that could be recalled momentarily at a lower price.

c. Cumulative Preferred shareholders normally have a preference as to dividends. That is, no common dividends may be paid in any one year until all required preferred dividends for that year are paid. Usually, corporations also include added protection for preferred shareholders in the form of a cumulative provision. This provision states that if all or any part of the stated preferred dividend is not paid in any one year, the unpaid portion accumulates and must be paid in subsequent years before any dividend can be paid on common stock. Any unpaid dividend on cumulative preferred stock constitutes a dividend in arrears and should be

disclosed in the notes to the financial statements, even though it is not a liability until the board of directors of the corporation actually declares it. Dividends in arrears are important in predicting future cash flows and as an indicator of financial flexibility and liquidity. d. Participating Participating provisions allow preferred stockholders to share dividends in excess of normal returns with common stockholders. For example, a participating provision might indicate that preferred shares are to participate in dividends on a 1:1 basis with common stock on all dividends in excess of $5 per share. This provision requires that any payments of more than $5 per share to the common stockholder also be made on a dollar-for-dollar basis to each share of preferred. e. Redemption A redemption provision indicates that the shareholder may exchange preferred stock for cash in the future. The redemption provision may include a mandatory maturity date or may specify a redemption price. If so, the financial instrument embodies an obligation to transfer assets, and would meet the definition of a liability, rather than equity. The SEC requires separate disclosure of mandatorily redeemable preferred shares because of their separate nature. FASB ASC 480-10-50-4 requires that a mandatorily redeemable financial instrument be classified as a liability unless redemption is required to occur only upon the liquidation or termination of the issuing company.

6. Distinguish between noncompensitory and compensatory stock option plans.

A noncompensatory stock option plan was defined as one not primarily designed as a method of compensation, but rather as a source of additional capital or of more widespread ownership among employees. Four essential characteristics of noncompensatory plans were identified: (1) the participation of all full-time employees, (2) the offering of stock on an equal basis or as a uniform percentage of salary to all employees, (3) a limited time for exercise of the option, and (4) a discount from market price that would not differ from a reasonable offer to stockholders. When these conditions were met, the plan did not discriminate in favor of company employees; thus, the corporation was not required record any compensation expense.

Compensatory stock option plans, on the other hand, give employees an option that is not offered to all employees or to stockholders. These plans involve the recording of an expense, and the timing of the measurement of this expense can greatly affect its impact on financial reports.

7. How did SFAS No. 123R change accounting for stock options?

SFAS 123R (FASB ASC 718), requires companies issuing stock options to estimate the compensation expense arising from the granting of stock options by using a fair value method and to disclose this estimated compensation expense on their income statements. This treatment differs from the previous requirement to estimate compensation expense on the date of the grant as the difference between the option price and the market price.

8. Define and discuss accounting for stock warrants.

Stock warrants are certificates that allow holders to acquire shares of stock at certain prices within stated periods. These certificates are generally issued under one of two conditions: 1. As evidence of the preemptive right of current shareholders to purchase additional shares of common stock from new stock issues in proportion to their current ownership percentage.

2. As an inducement originally attached to debt or preferred shares to increase the marketability of these securities.

Under current practice, the accounting for the preemptive right of existing shareholders creates no particular problem. These warrants are recorded only as memoranda in the formal accounting records. In the event warrants of this type are exercised, the value of the shares of stock issued is measured at the amount of cash exchanged.

Detachable warrants attached to other securities require a separate valuation because they may be traded on the open market. The amount to be attributed to these types of warrants depends on their value in the securities market. Their value is measured by determining the percentage relationship of the price of the warrant to the total market price of the security and warrant, and applying this percentage to the proceeds of the security issue. This procedure should be followed whether the warrants are associated with bonds or with preferred stock.

9. Discuss the difference between a stock dividend and a stock split. Include in your discussion, the reasons a company might issue either a stock dividend or a stock split.

Corporations may have accumulated earnings but not have the funds available to distribute these earnings as cash dividends to stockholders. In such cases, the company may elect to distribute some of its own shares of stock as dividends to current stockholders. Distributions of this type are termed stock dividends. When stock dividends are minor, relative to the total number of shares outstanding, retained earnings is reduced by the market value of the shares distributed. Capital stock and additional paid-in capital are increased by the par value of the shares and any excess, respectively.

In theory, a relatively small stock dividend will not adversely affect the previously established market value of the stock. The rationale behind stock dividend distributions is that the stockholders will receive additional shares with the same value per share as those previously held. Nevertheless, stock dividends are not income to the recipients. They represent no distribution of corporate assets to the owners and are simply a reclassification of ownership interests.

A procedure somewhat similar to stock dividends, but with a different purpose, is a stock split. The most economical method of purchasing and selling stock in the stock market is in blocks of 100 shares, and this practice affects the marketability of the stock. The higher the price of an individual share of stock, the fewer are the number of people able to purchase the stock in blocks of 100. For this reason, many corporations seek to maintain the price of their stock within certain ranges. When the price climbs above that range, the firm may decide to issue additional shares to all existing

stockholders (or split the stock). In a stock split, each stockholder receives a stated multiple of the number of shares currently held (usually two or three for one), which lowers the market price per share. In theory, this lower price should be equivalent to dividing the current price by the multiple of shares in the split, but intervening variables in the marketplace frequently affect prices simultaneously. A stock split does not cause any change in the stockholder’s equity section except to increase the number of actual shares outstanding and reduce the par or stated value per share. No additional values are assigned to the shares of stock issued in a stock split because no distribution of assets or reclassification of ownership interests occurs.

10. Define and discuss the two methods of accounting for treasury stock.

Two methods of accounting for treasury stock are found in current practice: the cost method and the par value method. Under the cost method, the presumption is that the shares acquired will be resold, and two events are assumed: (1) the purchase of the shares by the corporation and (2) the reissuance to a new stockholder. The reacquired shares are recorded at cost, and this amount is disclosed as negative stockholders’ equity by deducting it from total capital until the shares are resold. Because treasury stock transactions are transactions with owners, any difference between the acquisition price and the sales price is generally treated as an adjustment to paid-in capital (unless sufficient additional paid-in capital is not available to offset any “loss”; in such cases retained earnings is charged).

Under the par value method, it is assumed that the corporation’s relationship with the original stockholder is ended. The transaction is in substance a retirement; hence, the shares are considered constructively retired. Therefore, legal capital and additional paid-in capital are reduced for the original issue price of the reacquired shares. Any difference between the original issue price and the reacquisition price is treated as an adjustment to additional paid-in capital (unless a sufficient balance is not available to offset a “loss” and retained earnings is charged). The par value of the reacquired shares is disclosed as a deduction from capital stock until the treasury shares are reissued.

11.

Obtain the financial statements of a company and ask the students to compute the: a. Return on common stockholders’ equity. b. Financial structure ratio The answer to this question is dependent on the company selected.

Chapter 16 Multiple Choice 1. Which of the following is the best theoretical justification for consolidated financial statements? a. In form the companies are one entity; in substance they are separate b. In form the companies are separate; in substance they are one entity c. In form and substance, the companies are one entity d. In form and substance, the companies are separate Answer b 2. Consolidated financial statements are typically prepared when one company has a controlling interest in another unless: a. The subsidiary is a finance company b. The fiscal year-ends of the companies are more than three months apart. c. Circumstance prevent the exercise of control d. The two company are in unrelated industries, such as real estate and manufacturing.

Answer c 3.

Consolidated statements are proper for Neely, Inc., Randle, Inc., and Walker, Inc., if a. Neely owns 80 percent of the outstanding common stock of Randle and 40 percent of Walker; Randle owns 30 percent of Walker. b. Neely owns 100 percent of the outstanding common stock of Randle and 90 percent of Walker; Neely bought the stock of Walker one month before the balance sheet date and sold it seven weeks later. c. Neely owns 100 percent of the outstanding common stock of Randle and Walker; Walker is in legal reorganization. d. Neely owns 80 percent of the outstanding common stock of Randle and 40 percent of Walker; Reeves, Inc., owns 55 percent of Walker.

Answer a 4. On October 1, Company X acquired for cash all of the outstanding common stock of Company Y. Both companies have a December 31 year-end and have been in business for many years.

Consolidated net income for the year ended December 31 should include net income of a. Company X for3 months and Company Y for 3 months b. Company X for 12 months and Company Y for 3 months c. Company X for 12 months and Company Y for 12 months d. Company X for 12 months, but no income from Company Y until Company Y distributed a dividend Answer b

5. When a parent-subsidiary relation exists, consolidated financial statements are prepared in recognition of the accounting concept of: a. Reliability b. Materiality c. Legal entity d. Economic entity Answer d 6. Arkin, Inc., owns 90 percent of the outstanding stock of Baldwin Company. Curtis, Inc., owns 10 percent of the outstanding stock of Baldwin Company. On the consolidated financial statements of Arkin, Curtis should be considered as a. A holding company b. A subsidiary not to be consolidated c. An affiliate d. A noncontrolling interest Answer d 7. A sale of goods, denominated in a currency other than the entity’s functional currency, resulted in a receivable that was fixed in terms of the amount of foreign currency that would be received.

Exchange rates between the functional currency and the currency in which the transaction was denominated changed. The resulting gain should be included as a (an) a. Other comprehensive income b. Deferred credit c. Component of income from continuing operations d. Discontinued operations Answer a 8. Which of the following is not a consideration in segment reporting for diversified enterprises? a. Allocation of joint costs b. Transfer pricing c. Defining the segments d. Consolidation policy Answer d 9. Which of the following is the appropriate basis for valuing fixed assets acquired in a business combination carried out by exchanging cash for common stock? a. Historic cost b. Book value c. Cost plus any excess of purchase price over book value of asset acquired

d.

Fair value

Answer d 10. Goodwill represents the excess of the cost of an acquired company over the a. Sum of the fair values assigned to identifiable assets acquired less liabilities assumed b. Sum of the fair values assigned to tangible assets acquired less liabilities assumed c. Sum of the fair values assigned to intangible assets acquired less liabilities assumed d. Book value of an acquired company Answer a 11. The theoretically preferred method of presenting noncontrolling interest on a consolidated balance sheet is a. As a separate item with the deferred credits section b. As a reduction from (contra to) goodwill from consolidation, if any c. By means of notes or footnotes to the balance sheet d. As a separate item within the stockholders’ equity section Answer d 12. Meredith Company and Kyle Company were combined in an acquisition transaction. Meredith was able to acquire Kyle at a bargain price. The sum of the market or appraised values of identifiable assets acquired less the fair value of liabilities assumed exceeded the cost to Meredith. After revaluing noncurrent assets to zero there was still some of the bargain purchase amount remaining (formerly termed negative goodwill). Proper accounting treatment by Meredith is to report the amount as a. A discontinued operations item b. Part of current income in the year of combination c. A deferred credit and amortize it d. Paid-in capital Answer b 13. When translating foreign currency financial statements, which of the following accounts would be translated using current exchange rates?

a. b. c. d.

Property, Plant, and Equipment Yes No Yes No

Inventories carried at cost Yes No No Yes

Answer d 14. In financial reporting for segments of a business enterprise, the operating profit or loss of a segment should include Allocated Corporate Overhead Operating expenses a.

No No b.

No Yes c.

Yes No d.

Yes Yes Answer d

15. A foreign subsidiary’s function currency is its local currency that has not experienced significant inflation. The average exchange rate for the current year would be the appropriate exchange rate for translating Sales to Wages expense Customers a.

Yes Yes b.

Yes No c.

No No d.

No Yes Answer a 16. A subsidiary’s functional currency is the local currency that has not experienced significant inflation. The appropriate exchange rate for translating the depreciation on plant assets in the income statement of the foreign subsidiary is the a. Exit exchange rate b. Historical exchange rate c. Weighted average exchange rate over the economic life of each plant asset d. Weighted average exchange rate for the current year Answer b 17. In a business combination that is accounted for under the acquisition method, the entity that obtains control over one or more businesses and establishes the acquisition date that control was achieved is called the a. Controller. b. Acquirer. c. Proprietor. d. Controlling interest.

Answer b 18. Under the acquisition method for a business combination, the cost incurred to effect the business combination, such as finders and legal fees are a. Considered part of the historical cost of the business. b. Expensed as incurred. c. Allocated, along with the purchase price of the acquired company’s stock to the assets of the acquiree company. d. Deferred until a full accounting of all costs to acquire the acquire company are known.

Answer b 19. Under which of the theories of equity is a manager’s goals considered as important as those of the common stockholder. a. Proprietary theory. b. Commander theory. c. Entity theory. d. Enterprise theory.

Answer b 20. For a business combination, we measure all assets and liabilities of an acquired company at fair value. Fair value a. Is an exit value. b. Is an entry value. c. Is an appraisal value. d. Can be either an exit value or an entry value depending on the circumstances.

Answer a 21. Under the acquisition method of accounting for a business combination, restructuring costs are a. Capitalized and amortized over a period not exceeding ten years. b. Fees paid to lawyers and accountants to bring about the business combination. c. Costs incurred to effect the business combination. d. Treated as post acquisition expenses.

Answer d 22. Under the acquisition method of accounting for a business combination, goodwill is equal to a. The acquired company’s ability to generate excess profits. b. The excess of the cost of the acquisition plus the fair value of the noncontrolling interest over the fair value of the acquiree’s net assets. c. The excess of the cost of the acquisition over the fair value of the acquiree’s net assets.

d. The excess of the fair value of acquiree’s net assets over the cost of acquisition.

Answer b 23. Under the acquisition method of accounting for a business combination, a bargain purchase is a. Reported as goodwill in the balance sheet. b. Tested annually for impairment. c. Reported as a gain in the income statement. d. Reported as an adjustment to other comprehensive income.

Answer c 24. The acquisition method of accounting for a business combination is consistent with a. Entity theory. b. Proprietary theory. c. Parent company theory. a. Residual interest theory.

Answer a 25. Halcomb Company's balance sheet on December 31, 2020, was as follows: Assets Cash Trade accounts receivable (net) Inventories Plant assets (net) Total assets Liabilities & Stockholders' Equity Current liabilities Long-term debt Common stock, $1 par Additional paid-in capital Retained earnings Total liabilities & stockholders' equity

$

80,000 160,000 400,000 720,000 $1,360,000 $ 240,000 400,000 80,000 160,000 480,000 $1,360,000

On December 31, 2020, Ruth Corporation acquired all the outstanding common stock of Halcomb for $1,200,000. On that date, the current fair value of Halcomb's inventories was $360,000 and the current fair value of Halcomb's plant assets was $800,000. The current fair values of all other identifiable assets and liabilities of Halcomb were equal to their carrying amounts.

As a result of the acquisition of Halcomb by Ruth, the December 31, 2020, consolidated balance sheet of Ruth and subsidiary displays goodwill in the amount of: a. $400,000 b. $440,000 c. $480,000 d. $520,000 Answer b 26. Under the acquisition method of accounting for a business combination when the parent company has acquired only 90% of the voting stock of a subsidiary, a. 10% of the goodwill will be reported in a separate section of the balance sheet because it belongs to the noncontrolling interest. b. The consolidated balance sheet will report 100% of the value of goodwill. c. The consolidated balance sheet will report 90% of the value of goodwill. d. Goodwill will be amortized over its useful life or 40 years whichever comes first.

Answer b 27. The parent company concept of consolidated financial statements considers the noncontroling interest in net assets of a subsidiary to be: a. A liability b. A part of consolidated stockholders' equity c. An item between liabilities and stockholders' equity d. Some other classification Answer a 28. The noncontrolling interest in a subsidiary is reported in the consolidated balance sheet a. As an investment. b. As a liability. c. At fair value, as determined on the acquisition date. d. As an element of stockholders’ equity.

Answer d Essay 1. List and explain three reasons why businesses combine.

Several factors may cause a business organization to consider combining with another organization: •

Tax consequences. —The purchasing corporation may accrue the benefits of operating loss carryforwards from acquired corporations.

•

Growth and diversification. —The purchasing corporation may wish to acquire a new product or enter a new market.

•

Financial considerations. —A larger asset base may make it easier for the corporation to acquire additional funds from capital markets.

•

Competitive pressure. —Economies of scale may alleviate a highly competitive market situation.

•

Profit and retirement. —The seller may be motivated by a high profit or the desire to retire.

2. Discuss the issues that are to be addressed in an acquisition method business combination effected by an exchange of equity shares.

When a business combination is effected by an exchange of equity shares, the acquiring entity may not be so clearly evident. In this case, FASB ASC 805-10-55-12 requires that the following “pertinent facts and circumstances” be taken into consideration: 1. The relative voting rights of the combined entity. All else being equal, the acquiring entity would be the one whose owners retained or received the larger portion of the voting rights of the combined entity.

2. The existence of a large minority voting interest in the combined entity when no other owner or group of owners has a significant voting interest. All else being equal, the acquiring entity would be the one with the large minority voting interest.

3. The composition of the governing body of the combined entity. All else being equal, the acquiring entity’s owners or governing body would be the one that has the ability to elect or appoint a majority of the governing body of the combined entity.

4. The composition of senior management of the combined entity. All else being equal, the acquiring entity’s senior management would dominate that of the combined entity.

5. The terms of exchange of equity securities. All else being equal, the acquiring entity would be the one that pays a premium over the market value of the equity securities of the other combining entities.

3. How is the recorded cost determined in an acquisition business combination?

Under the revised standard for business combinations, the acquirer must recognize all assets acquired, liabilities assumed and any noncontrolling interest at fair value, measured as of the acquisition date (the date that control is attained). Fair value is defined by the FASB ASC (82010-20) as an exit value. It is the exchange price that would occur in an orderly transaction to sell an asset or transfer a liability in the most advantageous market. Thus, fair value is market based and is not entity specific. Fair value excludes transaction costs because they are the incremental direct costs incurred to sell an asset or settle a debt. As such, they are specific to the transaction, and have nothing to do with the value of the asset acquired itself or the liability assumed.

Fair value must be applied to assets and liabilities that meet the definition of assets and liabilities under SFAC No. 6. This means that the acquirer must recognize all assets and liabilities of the

acquiree – even those that are not on the acquiree’s books. Thus, the acquirer must identify and measure intangibles such as brand names and even in-process research and development as well as advertising jingles. In order to recognize such an intangible asset, it must meet either of the two following criteria: (1) separability or (2) contractual or legal. Separability means that the intangible can be sold, transferred, licensed, rented or exchanged. The contractual/legal criterion is that the asset arises from some contractual or legal right.

4. What are the two principles that are used to guide the preparation of consolidated financial statements?

In the preparation of consolidated financial statements, two overriding principles prevail. The first is balance sheet oriented and the second is income statement oriented.

1. The entity cannot own or owe itself.

2. The entity cannot make a profit by selling to itself.

5. Explain the concept of control as it applies to recording consolidated financial statement.

Control is defined as “the power of one entity to direct or cause the direction of the management and operating and financing policies of another entity.” Control is normally presumed when the parent owns, either directly or indirectly, a majority of the voting stock of the subsidiary. The following exceptions indicating an inability to control a majority-owned subsidiary are cited in FASB ASC 810-10-15-10: 1. The subsidiary is in a legal reorganization or bankruptcy.

2. There are severe governmentally imposed uncertainties.

In some cases, control may exit with less than a majority ownership, for example, by contract, by lease, as the result of an agreement with stockholders, or by court decree 6. Discuss the following two theories of consolidation: a. Entity According to entity theory, the consolidated group (parent company and subsidiaries) is an entity separate from its owners. Thus, the emphasis is on control of the group of legal entities operating as a single unit. Consolidated assets belong to the consolidated entity, and the income earned by investing in those assets is income to the consolidated entity rather than to the parent company stockholders. Consequently, the purpose of consolidated statements is to provide information to all shareholders—parent company stockholders and outside noncontrolling stockholders of the subsidiaries. b. Patent company

Parent company theory evolved from the proprietary theory of equity. Under parent company theory, parent company stockholders are viewed as having a proprietary interest in the net assets of the consolidated group. The purpose of consolidated statements is to provide information primarily for parent company stockholders. Thus, prior to the issuance of SFAS No. 160, consolidated financial statements reflected a parent company perspective. The assets reported on a consolidated balance sheet were those of the subsidiary adjusted by the parent company’s share of the difference between subsidiary historical cost and the asset’s fair value at the date of the acquisition. The net income reported in the consolidated income statement was equal to the net income of the parent company. Noncontrolling interest income was reported as a deduction to arrive at consolidated net income and noncontrolling interest was not considered an equity interest.

7. Define noncontrolling interest. Historically, how has noncontrolling interest been disclosed on corporate balance sheets?

When a portion of a subsidiary’s stock is owned by investors outside the parent company, this ownership interest is referred to as noncontrolling interest or previously termed minority interest in financial statements. In prior practice, noncontrolling interest has been variously (1) disclosed as a liability, (2) separately presented between liabilities and stockholders’ equity, and (3) disclosed as a part of stockholders’ equity.

8. Discuss the purpose of SFAS No. 167.

SFAS No. 167 amended FIN No. 46R by eliminating the qualifying special‐purpose entity concept originally outlined in FASB Statement No. 140, and also addressed concerns about the application of some of its provisions. SFAS No. 167 required entities to perform an analysis to determine whether its variable interest or interests gave it a controlling financial interest in a VIE. This analysis identifies the primary beneficiary of a VIE as the enterprise that has both of the following characteristics: 1. The power to direct the activities of a VIE that most significantly affect the entity’s economic performance.

2. The obligation to absorb losses of the entity that could potentially be significant to the VIE or the right to receive benefits from the entity that could potentially be significant to the VIE. 9. U.S. GAAP requires a reporting entity to consolidate an entity in which it has a controlling financial interest. There are two primary models for assessing whether there is a controlling financial interest.

Identify and discuss the accounting treatment required by each.

The two primary models for assessing whether there is a controlling financial interest in another entity are the voting interest model and the VIE model. Under the voting interest model, a controlling financial interest is obtained by ownership of a majority of an entity’s voting interests.

Under the VIE model, a reporting entity is deemed to have a controlling financial interest

when it has both (1) the power to direct the activities that most significantly affect the economic performance of the entity and (2) the obligation to absorb losses or the right to receive benefits of the entity that could potentially be significant to the entity. All entities are first evaluated as potential VIEs, where control is evaluated based on which party has the power and benefits. If the entity is not a VIE, it is evaluated for control under the voting interest model.

To determine which model applies, an entity must first determine whether it has a variable interest and whether the entity being evaluated is a VIE. This process involves the following steps: 1. Determine if the entity is a legal entity. The FASB defines a legal entity as any legal structure used to conduct activities or to hold assets. Examples of such structures are corporations, partnerships, and limited liability companies.

2. Determine if any scope exceptions apply. Topic 810 provides guideline for certain scope exceptions such as: not‐for profit entities, employee benefit plans, and investment companies.

3. Determine if the reporting entity has a variable interest in the legal entity. A variable interest is a contractual, ownership, or other financial interest that changes when the fair value of the net assets of legal entity changes. In essence the reporting entity that has a variable interest is acting as a fiduciary or agent rather than as a principal.

4. Determine if the legal entity is a VIE: An entity is considered to be a VIE if any of the following exist: a. It has insufficient equity to carry on its operations without additional subordinated financial support. b. As a group, the equity holders are unable to make decisions about the entity’s activities.

The entity has equity that does not absorb the entity’s expected losses or receive the entity’s expected residual return.

5. Determine if the reporting entity is the primary beneficiary. Once a reporting entity determines that it has a variable interest in a VIE, it must determine whether or not it is the primary beneficiary and should consolidate the legal entity based on the concept of control. The primary beneficiary is determined to have control based on: a. The power to direct the activities of the VIE that most significantly impact the performance of the VIE. Power might include voting rights, potential substantive voting rights (e.g., options or convertible instruments), rights to appoint key personnel, decision‐making rights within a management contract, removal or “kick‐out” rights. b. The obligation to absorb losses or the right to receive benefits of the VIE. c. In the event that an entity does not have both power and benefits, it should be determined if a related party or de facto agent individually has power and benefits to assess control or, if these parties collectively have power and benefits, the party most closely associated with the VIE would have control.

6. If the entity is not a VIE evaluate whether to consolidate using the voting interests model 10. According to SFAS No. 131(FASB ASC 280-10-50-20 to 25), what information should be disclosed for each operating segment?

Under the provisions of SFAS No. 131 (See FASB ASC 280-10-50-20 to 25), companies are required to report separately income statement and balance sheet information about each operating segment. In addition to a measure of a segment’s profit or loss and total assets, companies are to report specific information if it is included in the measure of segment profit or loss by the chief operating decision maker. The list of such segment disclosures is as follows: 1.

2.

3.

4.

5.

6.

7.

8.

9.

Revenues from external users Revenues from transactions with other operating segments of the same enterprise Interest revenue Interest expense Depreciation, depletion, and amortization expense Unusual items Equity in the net income of investees under the equity method Income tax expense or benefit Significant noncash items other than depreciation, depletion, and amortization expense

11. How are operating segments defined by SFAS No. 131 (FASB ASC 280-10-50-1)?

A goal of the guidance contained at FASB ASC 280 is to use the enterprise’s internal organization in such a way that reportable operating segments will be readily evident to the financial statement preparer. The resulting “management approach” to identifying operating segments is based on the manner in which management organizes the segments for making operating decisions and assessing performance.

FASB ASC 280-10-50-1 defines an operating segment as a component of the enterprise •

That engages in business activities from which it may earn revenues and incur expenses.

•

Whose operating results are regularly reviewed by the chief operating decision maker of the enterprise in making decisions about allocating resources to the segment and in assessing segment performance.

•

For which discrete financial information is available.

12. Discuss the criteria used to determine if an operating segment is a reportable segment.

Reportable segments include those operating segments that meet any of the following quantitative thresholds: 1. Reported revenue is at least 10 percent of combined revenue.

2. Reported profit (loss) is at least 10 percent of combined profit (loss).

3. Assets are 10 percent or more of combined assets.

13. Discuss how foreign currency translation occurs under each of the following methods\ a. Current – noncurrent

The current–noncurrent method is based on the distinction between current and noncurrent assets and liabilities. Under this method all current items (cash, receivables, inventory, and short-term liabilities) are translated at the foreign exchange rate existing at the balance sheet date. The noncurrent items (plant, equipment, property, and long-term liabilities) are translated using the rate in effect when the items were acquired or incurred (the historical rate). b. Monetary – nonmonetary The monetary–nonmonetary method requires that a distinction be made between monetary items (accounts representing cash or claims on cash, such as receivables, notes payable, and bonds payable) and nonmonetary items (accounts not representing claims on a specific amount of cash such as land, inventory, plant, equipment, and capital stock). Monetary items are translated at the exchange rate in effect at the balance sheet date, whereas nonmonetary items retain the historical exchange rate. c. Current The current rate method requires the translation of all assets and liabilities at the exchange rate in effect on the balance sheet date (current rate). It is, therefore, the only method that translates fixed assets at current rather than historical rates. d. Temporal Under this method monetary measurements depend on the temporal characteristics of assets and liabilities. That is, the time of measurement of the elements depends on certain characteristics. That is, money and receivables and payables measured at the amounts promised should be translated at the foreign exchange rate in effect at the balance sheet date. Assets and liabilities measured at money prices should be translated at the foreign exchange rate in effect at the dates to which the money prices pertain. This principle is simply an application of the fair value principle in the area of foreign translation.

14. How does SFAS No. 52 (FASB ASC 830) define functional currency?

FASB ASC 830 adopts the functional currency approach to translation. An entity’s functional currency is defined as the currency of the primary economic environment in which it operates, which will normally be the environment in which it expends cash (See FASB ASC 830-30).

15. What are the two situations in which the local currency would not be the functional currency?

The two situations in which the local currency would not be the functional currency are: 1. The foreign country’s economic environment is highly inflationary (over 100 percent cumulative inflation 2. The company’s investment is not considered long term.

16. Discuss the difference between translation and remeasurement.

Translation is the process of expressing in the reporting currency of the enterprise those amounts that are denominated or measured in a different currency. The translation process is performed in order to prepare financial statements and assumes that the foreign subsidiary is freestanding and that the foreign accounts will not be liquidated into U.S. dollars. Therefore, translation adjustments are disclosed as a part of other comprehensive income rather than as adjustments to net income.

Remeasurement is the process of measuring transactions originally denominated in a different unit of currency (e.g., purchases of an English subsidiary of a U.S. company payable in French euros).

Remeasurement is required when: 1. A foreign entity operates in a highly inflationary economy.

2. The accounts of an entity are maintained in a currency other than its functional currency.

3. A foreign entity is a party to a transaction that produces a monetary asset or liability denominated in a currency other than its functional currency.

17. Describe the four general procedures involved in the foreign currency translation process when the local currency is defined as the functional currency.

Most frequently the functional currency will be the local currency, and four general procedures are involved in the translation process when the local currency is defined as the functional currency: 1. The financial statements of each individual foreign entity are initially recorded in that entity’s functional currency. For example, a Japanese subsidiary would initially prepare its financial statements in terms of yen, for that would be the currency it generally uses to carry out cash transactions.

2. The foreign entity’s statements must be adjusted (if necessary) to comply with generally accepted accounting principles in the United States.

3. The financial statements of the foreign entity are translated into the reporting currency of the parent company (usually the U.S. dollar). Assets and liabilities are translated at the current exchange rate at the balance sheet date. Revenues, expenses, gains, and losses are translated at the rate in effect at the date they were first recognized, or alternatively, at the average rate for the period.

4. Translation gains and losses are accumulated and reported as a component of other comprehensive income.

18. IFRS No. 10 changes the method of reporting noncontrolling interests from what was previously required in IAS No.27. How are noncontrolling interest now defined and where are they to be disclosed?

Noncontrolling interests are now defined as “noncontrolling interests,” rather than as minority interests. They are to be disclosed in the consolidated balance sheet within equity but separate from the parent's shareholders' equity.

Chapter 17 Multiple choice 1. Footnotes to financial statements should not be used to a. Describe the nature and effect of a change in accounting principles b. Identify substantial differences between book and tax income c. Correct an improper financial statement presentation d. Indicate bases for valuing assets Answer c 2. Assuming that none of the following have been disclosed in the financial statements, the most appropriate item for footnote disclosure is the a. Collection of all receivables subsequent to year end b. Revision of employees’ pension plan c. Retirement of president of company and election of new president d. Material decrease in the advertising budget for the coming year and its anticipated effect upon income Answer b 3. The primary responsibility for the adequacy of disclosure in the financial statements and footnotes rests with the a. Partner assigned to the engagement b. Auditor in charge of fieldwork c. Staff who draft the statements and footnotes d. Client Answer d 4. Which of the following situations would require adjustment to or disclosure in the financial statements? a. A merger discussion b. The application for a patent on a new production process c. Discussions with a customer that could lead to a 40 percent increase in the client’s sales d. The bankruptcy of a customer who regularly purchased 30 percent of the company’s output Answer d 5. Which of the following should be disclosed in the Summary of Significant Accounting Policies? a. Composition of plant assets b. Pro forma effect of retroactive application of an accounting change c.

Method of depreciation

d.

Maturity dates of long-term debt

Answer c 6. An Accounting Principles Board Opinion was concerned with disclosure of accounting policies. A singular feature of this particular opinion is that it a. Calls for disclosure of every accounting policy followed by a reporting entity b. Applies to immaterial items whereas most opinions are concerned solely with material items c. Applies also to accounting policy disclosures by not-for-profit entities, whereas most opinions are concerned solely with accounting practices of profit-oriented entities d. Prescribes a rigid format for the disclosure of policies to be reported upon Answer c 7. Which of the following should be disclosed in a Summary of Significant Accounting Policies? a. Depreciation method followed b. Types of executory contracts c. Claims of equity holders d. Amount for cumulative effect of change in accounting principle Answer a 8. Significant accounting policies may not be a. Selected on the basis of judgment b. Selected from existing acceptable alternatives c. Unusual or innovative in application d. Omitted from financial statement disclosure on the basis of judgment Answer d 9. The stock of Gates, Inc., is widely held, and the company is under the jurisdiction of the Securities and Exchange Commission. In the annual report, information about the significant accounting policies adopted by Gates should be a. Omitted because it tends to confuse users of the report b. Included as an integral part of the financial statements c. Presented as supplementary information d. Omitted because all policies must comply with the regulations of the Securities and Exchange Commission Answer b 10. The basic purpose of the securities laws of the United States is to regulate the issue of investment securities by a. Providing a regulatory framework in those states which do not have their own securities laws

b. Requiring disclosure of all relevant facts so that investors can make informed decisions c. Prohibiting the issuance of securities which the Securities and Exchange Commission determines are not of investment grade d. Channeling investment funds into uses which are economically most important Answer b 11. The Securities and Exchange Commission (SEC) was established in1934 to help regulate the U.S. securities market. Which of the following statements is true concerning the SEC? a. The SEC prohibits the sale of speculative securities. b. The SEC regulates only securities offered for public sale. c. Registration with the SEC guarantees the accuracy of the registrant’s prospectus. d. The SEC’s initial influence and authority has diminished in recent years as the stock exchanges have become more organized and better able to police themselves.

Answer b 12. One of the major purposes of federal security regulation is to a. Establish the qualifications for accountants who are members of the profession b. Eliminate incompetent attorneys and accountants who participate in the registration of securities to be offered to the public c. Provide a set of uniform standards and test for accountants, attorneys, and others who practice before the Securities and Exchange Commission d. Provide sufficient information to the investing public who purchases securities in the marketplace Answer d 13. Under the Securities Act of 1933, subject to some exceptions and limitations, it is unlawful to use the mails or instruments of interstate commerce to sell or offer to sell a security to the public unless a. A surety bond sufficient to cover potential liability to investors is obtained and filed with the Securities and Exchange Commission b. The offer is made through underwriters qualified to offer the securities on a nationwide basis c. A registration statement has been properly filed with the Securities and Exchange Commission, has been found to be acceptable, and is in effect d. The Securities and Exchange Commission approves of the financial merit of the offering Answer c 14. Major, Major, and Sharpe, CPA’s, are the auditors of MacLain industries. In connection with the public offering of $10 million of MacLain securities, Major expressed an unqualified opinion as to the financial statements. Subsequent to the offering, certain misstatements and omissions are revealed. Major has been sued by the purchasers of the stock offered pursuant to the registration

statement, which include the financial statements audited by Major. In the ensuing lawsuit by the MacLain investors, Major will be able to avoid liability if a. The errors and omissions were caused primarily by MacLain b. It can be shown that at least some of the investors did not actually read the audited financial statements c. It can prove due diligence in the audit of the financial statements of MacLain d. MacLain had expressly assumed any liability in connection with the public offering Answer c 15. A major impact of the Foreign Corrupt Practices Act of 1977 is that registrants subject to the Securities Exchange Act of 1934 are now required to a. Keep records which reflect the transactions and dispositions of assets and maintain a system of internal accounting controls b. Provide access to records by authorized agencies of the federal government c. Records all correspondence with foreign nations d. Prepare financial statements in accordance with international accounting standards Answer a 16. The Securities and Exchange Commission’s fraud rule prohibits trading on the basis of inside information of a business corporation’s stock by a. Officers b. Officers and directors c. All officers, directors, and stockholders d. Officers, directors, and beneficial holders of 10 percent of the corporation’s stock Answer d 17. A CPA is subject to a criminal liability if the CPA a.

Refuses to turn over the working papers to the client b.

Performs an audit in a negligent manner c.

Willfully omits a material fact required to be stated in a registration statement d.

Willfully breaches the contract with the client Answer c 18. For interim financial reporting, an inventory loss from a temporary market decline in the first quarter which can reasonably be expected to be restored in the fourth quarter a. Should be recognized as a loss proportionately in each of the first, second, third, and fourth quarters b. Should be recognized as a loss proportionately in each of the first, second, and third quarters c. Need not be recognized as a loss in the first quarter d. Should be recognized as a loss in the first quarter

Answer c 19. An inventory loss from a market decline occurred in the first quarter that was not expected to be restored in the fiscal year. For interim financial reporting purposes, how would the dollar amount of inventory in the balance sheet be affected in the first and fourth quarters?

First Quarter Fourth Quarter a.

Decrease No effect b.

Decrease Increase c.

No effect Decrease d.

No effect No effect Answer a 20. A segment of a business enterprise is to be reported separately when the revenues of the segment exceed 10 percent of the a. Combined net income of all segments reporting profits b. Total combined revenues of all segments reporting profits. c. Total revenues of all the enterprise's industry segments. d. Total export and foreign sales. .

Answer c 21. Footnotes to a company’s financial statements are used to a. More fully explain certain items in the financial statements. b. Reflect financial notes personalized by the company’s executive team. c. Show the detail of salaries of every employee. d. Justify fraudulent business practices.

Answer a 22. The statement that “the financial statements were prepared in accordance with generally accepted accounting principles” is found in the a. Management letter b. Management discussion and analysis c. Footnotes to the balance sheet. d. Auditor’s report.

Answer d 23. According to the disclosure requirements outlined in Statement of Accounting Concepts No. 5, the following is an example supplementary information that should be disclosed because it affects an area that is directly affected by existing FASB Standards a. Management discussion and analysis. b. Segment information. c. Accounting policies.

d. A statement of cash flows.

Answer b 24. Which of the following post-balance-sheet events would require adjustment of the accounts before issuance of the financial statements? a. Loss on a lawsuit, the outcome of which was deemed uncertain at year end b. Loss of plant as a result of fire c. Changes in the quoted market prices of securities held as an investment d. Loss on an uncollectible account receivable resulting from a customer's major flood loss Answer a 25. Norris Company settled a lawsuit in February for an amount that was significantly different from the amount that was originally accrued as an estimate of potential loss. The company’s year-end is December 31 and its financial statements are issued in March. This is an example of a. A subsequent event that must be disclosed, but because it happened after the balance sheet date no adjustment is needed. b. A subsequent event that provided evidence of a condition that did not exist at the balance sheet date. c. A subsequent event that need not be disclosed because it did not occur before the company’s yearend. d. A subsequent event that provided further evidence of conditions that existed on the balance sheet.

Answer d 26. Footnote disclosure that summarizes information that does not meet the measurement and reporting requirements for presentation in a company’s financial statements, but is useful to informed readers, is required in order to meet the concept of a. Understandability. b. Reliability. c. Representational faithfulness. d. Cost/benefit.

Answer a 27. Conboy Corporation disclosed in the notes to its financial statements that a significant number of its unsecured trade account receivables are with companies that operate in the same industry. This disclosure is required to inform financial statement users of the existence of a. Concentration of market risk. b. Risk of measurement uncertainty. c. Off-balance sheet risk of accounting loss. d. Concentration of credit risk.

Answer d 28. The inclusion of MD&A (Management Discussion and Analysis) in annual reports is required by the a. FASB. b. AICPA. c. SEC. d. APB. Answer c 29. The Management Discussion and Analysis section of a company's annual report covers which of the following three items: a. Income statement, balance sheet, and statement of owners' equity. b. Income statement, balance sheet, and statement of cash flows. c. Changes in the stock price, mergers, and acquisitions. d. Liquidity, capital resources, and results of operations.

Answer d 30. Which SEC reporting form is the normal registration statement for securities to be sold to the public? a. Form 10. b. Form 10-K. c. Form 10-Q. a. Proxy Statement.

Answer a 31. Which of the following Federal Acts required the SEC to develop guidelines for all publicly traded companies to report on management’s responsibilities for, and assessment of, the internal control system? a. Securities Act of 1933, b. The Securities Exchange Act of 1934 c. The Foreign Corrupt Practices Act of 1977 d. The Sarbanes–Oxley Act of 2002 Answer d 32. The Sarbanes-Oxley (SOX) Act of 2002 created the PCAOB. The PCAOB a. Is primarily responsible for establishing generally accepted accounting principles. b. Provides legal and expert services to CPA firms when they are involved in class-action law suits.

c. Oversees the conduct of acts that are intended to influence, coerce, manipulate, or mislead a CPA when he/she is preparing a company’s financial statements. d. Oversees audits of companies whose securities are public traded.

Answer d 33. A disclaimer of opinion is issued when a. All informative disclosures have not been made in the financial statements. b. Circumstances prevent the auditor from performing all audit procedures necessary to comply with generally accepted auditing standards. c. The financial statements are not prepared in accordance with generally accepted accounting principles. d. There is a potential going concern issue.

Answer b 34. APB Opinion No. 28 (FASB ASC 270) indicates that a. The discrete view is the most appropriate approach to take in preparing interim financial reports. b. The same accounting principles used for the annual report should be employed for interim reports. c. All companies that issue an annual report should issue interim financial reports. d. The three basic financial statements should be presented each time an interim period is reported upon.

Answer b 35. Companies should disclose which of the following in interim reports a. Changes in accounting principles. b. Seasonal revenue, cost, or expenses. c. Basic and diluted earnings per share d. All of the above Answer d 36. The discrete view of interim reporting a. Holds that an interim period is a separate accounting period; thus, revenues and expenses should be treated as though they occurred only in one period. b. Holds that revenues and expenses should be allocated to the various interim periods. c. Holds that revenues and expenses should be reported as they occur. d. Holds that an interim period is an integral part of the annual reporting period.

Answer a

37. The Securities act of 1933 a. Regulates the trading of securities of publicly held companies. b. Regulates the initial public sale and distribution of a corporation’s securities. c. Addresses the personal duties of corporate officers. d. Specifies information that is to be contained in a company’s annual report.

Answer b 38. The Sarbanes-Oxley (SOX) Act of 2002 created the PCAOB. The PCAOB a. Is primarily responsible for establishing generally accepted accounting principles. b. Provides legal and expert services to CPA firms when they are involved in class-action law suits. c. Oversees the conduct of acts that are intended to influence, coerce, manipulate, or mislead a CPA when he/she is preparing a company’s financial statements. d. Oversees audits of companies whose securities are public traded.

Answer d Essay 1. List the building blocks to disclosure described in SFAC No. 5.

SFAC No. 5 summarizes the building blocks to disclosure as: 1.

2.

3.

4.

5.

The scope of recognition and measurement Basic financial statements Areas directly affected by existing FASB standards Financial reporting All information useful for investment, credit, and similar decisions.

2. List and discuss the types of information commonly disclosed in the footnotes to corporate financial statements.

The footnotes to a company’s financial statements provide a significant amount of additional information about the items on the company’s financial statements. In general, the footnotes disclose information that explains, clarifies, or develops items appearing on the financial statements, which cannot easily be incorporated into the financial statements themselves. The most common examples of footnotes are: a. Accounting policies. APB Opinion No. 22, “Disclosure of Accounting Policies” (See FASB ASC 235), required all companies to disclose both the accounting policies the firm follows and the methods it uses in applying those policies. Typically, companies disclose this information in a Summary of Significant Accounting Policies preceding the footnotes. Specifically, APB Opinion No. 22 required that the accounting methods and procedures involving the following be disclosed:

i.

A selection from existing acceptable alternatives.

ii.

Principles and methods peculiar to the industry in which the reporting entity operates.

iii. Unusual or innovative applications of GAAP. b. Schedules and exhibits. —Firms typically report schedules or exhibits concerning long-term debt and income tax, for example. The purpose of supplementary schedules is to improve the understandability of the financial statements. They may be used to highlight trends, such as five-year summaries; or they may be required by FASB pronouncements, such as information on current costs. c. Explanations of financial statement items. —Some items require additional explanation so that users can make sense of the reported information. Pensions and postretirement benefits are two examples. Parenthetical disclosures are contained on the face of the financial statements (usually on the balance sheet). They are generally used to describe the valuation basis of a particular financial statement element but also may provide other kinds of information, such as the par value and number of shares authorized and issued for various classes of a company’s stock d. General information about the company. —Occasionally, firms face events that may impact their financial performance or position but cannot yet be recognized on the financial statements.

In that case, investors have an interest in learning this information as soon as possible.

Information concerning subsequent events and contingencies are two examples.

3. List and discuss the recognition criteria for the two types of subsequent events.

These events are referred to as “subsequent events,” and may be either (1) events that provide further evidence of conditions that existed on the balance sheet date or (2) events that provide evidence of conditions that did not exist at the balance sheet date.

GAAP requires events in the first category to be reported on the company’s financial statements.

In other words, when a company experiences an event after the balance sheet date, but before it issues its financial statements, that provides further evidence of some condition existing at the balance sheet date, it is required to adjust its records to reflect the financial impact of that condition.

If, for example, a company settles litigation for an amount significantly different than the amount it had originally accrued, then it must adjust the amount it originally accrued and report the adjusted accrual on the financial statements. The adjusted disclosure is required because the event that gave rise to the adjustment occurred before the balance sheet date. If such an adjustment were not made, then the financial statements would not fully reflect the true financial condition at the balance sheet date or performance of the company that occurred during the fiscal year.

On the other hand, GAAP does not require adjustments to the financial statements for category 2 events. But we should note that companies frequently disclose these events in the footnotes to their financial statements. These footnote disclosures allow the company to discuss the impact of the new information. Companies often disclose this type of subsequent event when they issue debt or equity securities, incur casualty losses, sell significant assets, or settle litigation initiated as the result of events that occurred after the balance sheet date

4. The AICPA recently redrafted the majority of the auditing sections in the Codification of Statements on Auditing Standards, including the sections related to the audit report. The new standards identified the steps an auditor should take to form an opinion on a company’s financial statements. List these steps.

1. Form an opinion on whether the financial statements are presented fairly, in all material respects, in accordance with the applicable financial reporting framework.

2. In order to form that opinion, conclude whether he or she has obtained reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error.

3. Evaluate whether the financial statements are prepared, in all material respects, in accordance with the requirements of the applicable financial reporting framework. This evaluation should include consideration of the qualitative aspects of the entity’s accounting practices, including indicators of possible bias in management’s judgments.

4. Evaluate whether, in view of the requirements of the applicable financial reporting framework the financial statements adequately disclose the significant accounting policies selected and applied.

5. The evaluation about whether the financial statements achieve fair presentation should also include consideration of the following: a. The overall presentation, structure, and content of the financial statements b. Whether the financial statements, including the related notes, represent the underlying transactions and events in a manner that achieves fair presentation.

6. Evaluate whether the financial statements adequately refer to or describe the applicable financial reporting framework.

5. In most cases an audit will result in the issuance of an unmodified opinion List and discuss the paragraphs contained in a standard unmodified audit option and how they differ from previous requirements.

The paragraphs contained in an unmodified audit opinion are: 1. Introductory Paragraph—This paragraph identifies the company being audited and identifies each financial statement including the date or period covered. This paragraph has been changed to include a reference to the notes of the financial statements.

2. Management’s Responsibility Paragraph—Expanded from previous requirements to include language that management is responsible for the fair presentation of the financial statements and is also responsible for the design, implementation, and maintenance of the internal controls that are relevant to the financial reporting process. This section now includes the new heading Management’s Responsibility for the Financial Statements.

3. Auditor’s Responsibility Paragraph—Expanded to include language that the procedures performed depend on auditor’s judgment, including risk assessment. There is an additional requirement to state that the internal controls over financial reporting are considered to design appropriate audit procedures, but that the auditor does not express an opinion on the

effectiveness of the internal controls. This section includes the new heading Auditor’s Responsibility.

4. Auditor’s Opinion—This paragraph is unchanged from previous requirements to state that the financial statements are presented fairly in accordance with generally accepted accounting principles This section will include the new heading Opinion.

6. In the event the auditor cannot satisfy the criteria necessary to issue an unmodified audit opinion, he or she will issue a modified opinion. What are the types of modified opinions and what is that decision dependent upon?

The types of modified audit opinions are: qualified, adverse and disclaimer. The decision regarding which type of modified opinion is appropriate depends on: a. The nature of the matter giving rise to the modification (that is, whether the financial statements are materially misstated or, in the case of an inability to obtain sufficient appropriate audit evidence, may be materially misstated). b. The auditor’s professional judgment about the pervasiveness of the effects or possible effects of the matter on the financial statements.

Consequently, the determination of the type of modified opinion to issue is guided by the concept of pervasiveness. This term is used in the context of financial statement misstatements to describe the effects on the financial statements of misstatements or the possible effects on the financial statements of misstatements, if any, that are undetected due to an inability to obtain sufficient appropriate audit evidence. Pervasive effects on the financial statements are those that, in the auditor’s professional judgment: a. Are not confined to specific elements, accounts, or items of the financial statements; b. If they are so confined, represent or could represent a substantial proportion of the financial statements; or c. In regard to disclosures, are fundamental to users’ understanding of the financial statements.

A qualified opinion is issued when: a. The auditor, having obtained sufficient appropriate audit evidence, concludes that misstatements, individually or in the aggregate, are material but not pervasive to the financial statements, or b. The auditor is unable to obtain sufficient appropriate audit evidence on which to base the opinion, but the auditor concludes that the possible effects on the financial statements of undetected misstatements, if any, could be material but not pervasive.

An adverse opinion is issued when the auditor, having obtained sufficient appropriate audit evidence, concludes that misstatements, individually or in the aggregate, are both material and pervasive to the financial statements.

A disclaimer of opinion is issued when the auditor is unable to obtain sufficient appropriate audit evidence on which to base the opinion, and the auditor concludes that the possible effects on the financial statements of undetected misstatements, if any, could be both material and pervasive.

7. In April 2013, the FASB issued Accounting Standards Update 2013-07, Presentation of Financial Statements (Topic 205): Liquidation Basis of Accounting. a. Define the term liquidation as used in this pronouncement.

Liquidation is defined as “the process by which an entity converts its assets to cash or other assets and partially or fully settles its obligations with creditors in anticipation of the entity ceasing its operations.” 4 Liquidation is considered to be imminent when either of the following situations occurs: 1.

A plan for liquidation has been approved by the person or persons with the authority to make such a plan effective and the likelihood is remote that the execution of the plan will be blocked by other parties.

2. A plan for liquidation is being imposed by other forces (for example, involuntary bankruptcy) and the likelihood is remote that the entity will subsequently return from liquidation. b.

What information does the ASU require to be disclosed by entities subject to its provisions?

The ASU also requires financial statements prepared using the liquidation basis to reflect relevant information about an entity’s resources and obligations in liquidation by measuring and presenting assets and liabilities in the entity’s financial statements as the amount of cash or income that it expects to earn during the expected duration of the liquidation, including any costs associated with settlement of those assets and liabilities. These financial statements should include: 1. Statement of Changes in Net Assets in Liquidation: A statement that includes information about the changes during the period in net assets or other consideration that the entity expects to pay during the course of liquidation 2. Statement of Net Assets in Liquidation: A statement that includes information about the net assets available for distribution to investors and other claimants during liquidation as of the end of the reporting period’ The ASU also requires disclosures about the entity’s plan for liquidation, the methods and significant assumptions used to measure assets and liabilities, the type and amount of costs and income accrued, and the expected duration of liquidation.

Entities should apply the requirements prospectively from the day that liquidation becomes imminent 8. What information is required to be included in the Management Discussion and Analysis section of the 10-K annual report? (Do not include the information required by item 7a)

Basically, the MD&A section evaluates the causes and explains the reasons for a company’s performance during its preceding annual period. The required disclosures include information about liquidity, capital resources, and the results of operations. The SEC also requires management to highlight favorable or unfavorable trends and to identify significant events or uncertainties that affect those three factors. Since a company must disclose matters that could affect its financial statements in the future, the MD&A allows financial statement users to evaluate a company’s past performance and its likely impact on future performance 9. Define market risk and the types of market risk to be disclosed in item &a of a company’s MD&A. Market risk is defined as the risk of loss arising from adverse changes in market rates and prices from such items as: 1. Interest rates 2. Currency exchange rates 3. Commodity prices 4. Equity prices 10. How is the quantitative information about market risk–sensitive instruments to be disclosed according to the SEC? The quantitative information about market risk–sensitive instruments is to be disclosed by using one or more of the following alternatives: 1. Tabular presentation of fair value information and contract terms relevant to determining future cash flows, categorized by expected maturity dates.

2. Sensitivity analysis expressing the potential loss in future earnings, fair values, or cash flows from selected hypothetical changes in market rates and prices.

3. Value at risk disclosures expressing the potential loss in future earnings, fair values, or cash flows from market movements over a selected period and with a selected likelihood of occurrence.

11. What are the purposes of the letter to stockholders?

Management’s letter to the stockholders has four main purposes. It indicates that management: 1.

2.

3.

4.

Is responsible for preparation and integrity of statements.

Has prepared statements in accordance with GAAP. Has used their best estimates and judgment.

Maintains a system of internal controls.

12. List and explain the three types of financial analysts.

Professional security analysts make investment analyses. They frequently specialize in certain industries, using their training and experience to process and disseminate information more

accurately and economically than individual investors. There are three categories of financial analysts: Sell side. —Work for full-service broker dealers and make recommendations on securities they cover. Many work for the most prominent brokerage firms, which also provide investment banking services to companies, including those whose securities the analysts cover.

Buy side. —Work for institutional money managers, such as mutual funds, that purchase securities for their own accounts. Counsel their companies to buy, hold, and sell.

Independent. —Not associated with firms that underwrite the securities they cover. Often sell their recommendations on a subscription basis.

13. Discuss the general purposes of: a. The Securities Act of 1933 The Securities Act of 1933 regulates the initial public sale and distribution of a corporation’s securities (going public). The goal of this legislation is the protection of the public from fraud when a company is initially issuing securities to the general public. The provisions of the Securities Act of 1933 require a company initially offering securities to file a registration statement and a prospectus with the SEC. The registration statement becomes effective on the twentieth day after filing unless the SEC requires amendments. This twenty-day period is termed the waiting period, and it is unlawful for a company to offer to sell securities during this period. The registration of securities under the provisions of the 1933 Act is designed to provide adequate disclosures of material facts to allow investors to assess the degree of potential risk. Nevertheless, registration does not completely protect investors from the possibility of loss, and it is unlawful for any company officials to suggest that registration prevents possible losses. b. The Securities Exchange Act of 1934 The Securities Exchange Act of 1934 regulates the trading of securities of publicly held companies (being public). This legislation addresses the personal duties of corporate officers and owners (insiders) and corporate reporting requirements, and it specifies information that is to be contained in the corporate annual reports and interim reports issued to shareholders. The Act established extensive reporting requirements to provide continuous full and fair disclosure.

Each corporation that offers securities for sale to the general public must select the appropriate reporting forms. The most common reporting forms, all of which can be obtained from the SEC’s Web site, are: Form 10. —the normal registration statement for securities to be sold to the public.

Form 10-K. —the annual report.

Form 10-Q. —the quarterly report of operations.

Proxy statement. —used when a company makes a proxy solicitation for its stockholder meetings.

One of the major goals of the 1934 Act is to ensure that any corporate insider (broadly defined as any corporate officer, director, or 10 percent-or-more shareholder) does not achieve an advantage in the purchase or sale of securities because of a relationship with the corporation. It also established civil and criminal liabilities for insiders making false or misleading statements when trading corporate securities. The specific SEC reporting requirements for going public and being public are beyond the scope of this text; however, it should be noted that the SEC’s stipulation that much of the information provided in the 10-K, 10-Q, and proxy reports must be certified by an independent certified public accountant has been a significant factor in the growth and importance of the public accounting profession in the United States. c. The Foreign Corrupt Practices Act of 1977 The Foreign Corrupt Practices Act (FCPA) of 1977 contains two main elements. The first makes it a criminal offense to offer bribes to political or governmental officials outside the United States and imposes fines on offending firms. It also provides for fines and imprisonment of officers, directors, or stockholders of offending firms.

The second element of the FCPA is a requirement that all public companies must (1) keep reasonably detailed records that accurately and fairly reflect company financial activity and (2) devise and maintain a system of internal control that provides reasonable assurance that transactions were properly authorized, recorded, and accounted for. This element is an amendment to the Securities Exchange Act of 1934 and therefore applies to all corporations that are subject to the Act’s provisions. The major goals of this legislation are the prevention of the bribery of foreign officials and the maintenance of adequate corporate financial records.

14. Discuss three general provisions of the Sarbanes-Oxley Act. The students’ answers should be based on the following: Among the major provisions of this legislation are: 1.

The creation of the Public Company Accounting Oversight Board (PCAOB). —The PCAOB oversees audits of public companies that are subject to The Securities Act of 1933 and The Securities Exchange Act of 1934. The PCAOB contains five members appointed from among prominent individuals of integrity and reputation. These individuals must have a demonstrated commitment to the interests of investors and the public and an understanding of the responsibilities for the financial disclosures required in the preparation of financial statements and audit reports. The duties of the PCAOB include: a. Registering public accounting firms that prepare audit reports.

b. Establishing auditing, quality control, ethics, independence, and other standards relating to the preparation of audit reports. c. Conducting inspections of registered public accounting firms. d. Conducting investigations and disciplinary proceedings concerning and, where appropriate, imposing appropriate sanctions where justified upon registered public accounting firms and CPAs within those firms. e. Performing any other duties or functions necessary or appropriate to promote high professional standards among, and improve the quality of audit services offered by, CPA firms and CPAs within those firms. f. Enforcing compliance with the Securities Exchange Act of 1934.

Among the PCAOB’s powers are: a. To sue and be sued, complain and defend, in its corporate name and through its own counsel, with the approval of the SEC, in any federal, state, or other court. b. To conduct its operations and exercise all rights and powers authorized by the SEC, without regard to any qualification, licensing, or other provision of law in effect in any state or political subdivision.

2. The establishment of auditing, quality control, and independence standards. —The PCAOB is required to cooperate with various professional groups of CPAs related to the standard-setting process. The PCAOB may adopt standards proposed by the profession; however, it has the authority to amend, modify, repeal, and/or reject any standards suggested by the profession.

Additionally, CPA firms are required to prepare, and maintain for a period of not less than seven years, audit work papers and other information in sufficient detail to support the conclusions reached in each of its audit reports. CPA firms must also use a second-partner review and approval of its audit reports. The PCAOB developed an audit standard to implement internal control reviews. This standard requires auditors to evaluate whether internal controls include records that accurately and fairly reflect transactions of the reporting entity and provide reasonable assurance that the transactions are recorded in a manner that will permit the preparation of financial statements in accordance with the technical literature; auditors must also disclose any material weaknesses in internal controls they discover during audits.

3. The inspection of CPA firms. —The PCAOB will conduct annual quality reviews for CPA firms that audit financial statements of more than 100 publicly traded entities. Other firms must undergo this quality review/inspection process every three years. The SEC and/or the PCAOB may order a special inspection of any CPA firm at any time.

4. The establishment of accounting standards. —The SEC is authorized to recognize as generally accepted accounting principles those that are established by a standard-setting body that meet all of the criteria within the Sarbanes-Oxley Act, which include requirements that the standardsetting body: a. Be a private entity.

b. Be governed by a board of trustees or equivalent body, the majority of whom are not or have not been associated with a CPA firm within the two-year period preceding service on this board of trustees. c. Be funded in a manner similar to the PCAOB, through fees collected from CPA firms and other parties. d. Have adopted procedures to ensure prompt consideration of changes to accounting principles by a majority vote. Consider when adopting standards, the need to keep the standards current and the extent to which international convergence of standards is necessary/appropriate.

5. The delineation of prohibited services. —The legislation makes it unlawful for a CPA firm to provide any nonaudit service to the reporting entity contemporaneously with the financial statement audit. Prohibited services include the following: a. Bookkeeping or other services related to the accounting records or financial statements of the reporting entity. b. Financial information systems design/implementation. c. Appraisal or valuation services, fairness opinions, or contribution-in-kind reports. d. Actuarial services. e. Internal audit outsourcing services. f. Management functions or human resources. g. Broker/dealer, investor advisor, or investment banker services. h. Legal services and expert services unrelated to the audit, or any other service that the board rules is not permissible.

The legislations allow the board, on a case-by-case basis, to provide an exemption to these prohibitions, subject to review by the SEC, and does not make it unlawful to provide other nonaudit services (those not prohibited) if those services are approved in advance by the audit committee. The audit committee must disclose to investors in periodic reports the decision to preapprove those services. The preapproval requirement is waived if the aggregate amount of the fees for all of the services provided constitutes less than 5 percent of the total amount of revenues paid by the issuer to the auditing firm.

6. Prohibition of acts that influence the conduct of an audit. The Act makes it unlawful for any officer or director of an entity to fraudulently influence, coerce, manipulate, or mislead a CPA performing an audit.

7. Requiring specified disclosures. —Each financial report must reflect all material correcting adjustments a CPA determines are necessary. Each annual or quarterly financial report must disclose all material off–balance sheet transactions and other relationships with unconsolidated entities that may have a material current or future effect on the financial condition of the entity.

The SEC will issue rules providing that pro-forma financial information must be presented in a manner such that it does not contain an “untrue statement” or omit a material fact necessary in order for the information not to be misleading.

8. Requiring CEO and CFO certification. —CEOs and CFOs must certify in each annual and quarterly report that the officer has reviewed the report, that based on the officer’s knowledge

the report does not contain any untrue statement of a material fact or omit a material fact, and that based on the officer’s knowledge, the financial statements and other financial information included in the report fairly present the financial condition and results of operations of the issuer. They must also attest that they are responsible for establishing and maintaining internal controls, that they have designed such controls to ensure that material information is made known to the officers, that they have presented their conclusions about the effectiveness of those controls in the report, and that they have disclosed both to the outside auditors and to the company’s audit committee (1) all significant deficiencies in the design or operation of internal controls that could adversely affect the issuer’s ability to record, process, summarize, and report financial data and (2) any fraud, whether or not material, involving any employee who has a significant role in the issuer’s internal controls.

15. Discuss the general requirements of Sections 404(a) and 404(b) of the Sarbanes-Oxley Act. Section 404 contains two subsections—404(a) and 404(b). 404(a) outlines management’s responsibility under the act, and requires that the annual report include an internal control report by management that (1) acknowledges its responsibility for establishing and maintaining adequate internal control over financial reporting and (2) contains an assessment of the effectiveness of internal control over financial reporting as of the end of the most recent fiscal year. It also requires the principal executive and financial officers to make quarterly and annual certifications as to the effectiveness of the company’s internal control over financial reporting. Section 404(b) outlines the independent auditor’s responsibility. It requires the auditor to report on the internal control assessment made by management and also to make a separate independent assessment of the company’s internal controls over financial reporting.

16. Discuss the framework for analysis that may be used in the resolution of ethical dilemmas.

The resolution of ethical dilemmas can be assisted through a framework of analysis. The purpose of such frameworks is to help identify the ethical issues and to decide on an appropriate course of action. For example, the following six-step approach may be used: 1.

2.

3.

4.

5.

6.

Obtain the relevant facts.

Identify the ethical issues.

Determine the individuals or groups affected by the dilemma.

Identify the possible alternative solutions.

Determine how the individuals or groups are affected by the alternative solutions.

Decide on the appropriate action.

17. List the six criteria identified by the Anderson report and are indicative of effective auditor performance.

The Anderson Report, indicated that effective performance should meet six criteria: 1. Safeguard the public’s interest.

2.

3.

4.

5.

6.

Recognize the CPA’s paramount role in the financial reporting process.

Help ensure quality performance and eliminate substandard performance.

Help ensure objectivity and integrity in public service.

Enhance the CPA’s prestige and credibility.

Provide guidance as to proper conduct

18. List the four sections of the AICPA Code of Professional Conduct.

The Code of Professional Conduct in consists of the following four sections: Principles. —the standards of ethical conduct stated in philosophical terms.

Rules of conduct. —minimum standards of ethical conduct.

Interpretations. —interpretations of the rules by the AICPA Division of Professional Ethics.

Ethical rulings. —published explanations and answers to questions about the rules submitted to the AICPA by practicing accountants and others interested in ethical requirements

19. In January 2014, the AICPA’s Professional Ethics Executive Committee (PEEC) approved a revised AICPA Code of Professional Conduct that restructures the Code to improve its readability and converges the Code with international standards. The revised Code contains three sections. Part 1 contains the rules of conduct and interpretations that are applicable to members in public practice.

For AICPA members in public practice who provide attest services to clients, there is a conceptual framework for independence that focuses on the specific threats to independence and certain examples of threats associated with a specific relationship or circumstance are identified. What are these identified threats? How should a public practice member deal with other threats?

The identified threats are: • Adverse interest threat. The threat that an AICPA member will not act with objectivity because the member’s interests are in opposition to the interests of an attest client.

• Familiarity threat. The threat that, because of a long or close relationship with an attest client, an AICPA member will become too sympathetic to the attest client’s interests or too accepting of the attest client’s work or product.

• Management participation threat. The threat that an AICPA member will take on the role of attest client management or otherwise assume management responsibilities for an attest client.

• Undue influence threat. The threat that an AICPA member will subordinate his or her judgment to that of an individual associated with an attest client or any relevant third party due to that individual’s reputation or expertise, aggressive or dominant personality, or attempts to coerce or exercise excessive influence over the member.

In other cases, not covered by these specific examples, an AICPA member is to use a threat and safeguards approach.