SM ch04

CHAPTER 4
QUESTIONS
1. The objective of financial reporting is to (c) The current value of net assets
provide useful information for users of the acquired in exchange transactions as
financial statements. The relevant determined by either their replacement
information for decision making is future or market values.
data, especially information dealing with (d) Some variation of the above (a through
cash flows. The primary financial c) but including in assets all resources
statements reflect economic transactions and claims to resources, not just those
and events that have taken place. The past acquired in exchange transactions.
is used to help project the future. Income,
4. The objectives of reporting income for
however, is only one of many sources of
income tax purposes and for financial
cash flow. The balance sheet and
reporting to users are not the same. Those
statement of cash flows also furnish
formulating income tax laws are usually
relevant information upon which the
concerned with fairness among taxpayers
investor may project other future cash
and with their ability to pay taxes. Users, on
flows. In summary, the income statement
the other hand, are concerned with a
contains only some of the information that
measure that distinguishes between a
is relevant for making economic decisions.
return on investment and a return of
2. Two approaches can be used to measure investment. They want a measure that
income: the capital maintenance approach matches expenses against recognized
and the transaction approach. The capital revenue. In most cases, the same
maintenance approach uses the balance accounting method can be used for both
sheet elements to determine the change in purposes. This will reduce both the cost
total equity after eliminating any and the confusion of using more than one
investments and withdrawals of resources accounting method for the same
by owners. The transaction approach transaction. In some cases, however, the
determines income by analyzing individual generally accepted accounting method is
transactions and events and their effect on different from that required by income tax
related assets, liabilities, and owners’ regulations. This results in a temporary
equity. Although the method of determining difference between the tax return and the
income differs, both approaches arrive at books and gives rise to interperiod income
the same total income figure if the same tax allocation.
attributes and measurements are used.
5. A code law country is one in which rules,
However, the transaction approach
laws, and accounting standards are set by
produces more detail as to the composition
legal processes—from the top down. A
of income than does the capital
common law country is one in which rules,
maintenance approach.
laws, and accounting standards evolve in
3. Measurement methods that could be response to societal and market forces—
applied to net assets in the capital from the bottom up.
maintenance approach to income 6. Revenues and expenses are related to the
determination are as follows: ongoing major or central activities of a
(a) The historical cost of net assets business and are reported at gross
acquired in exchange transactions, amounts. Gains and losses are associated
reduced by an allowance for their use. with peripheral and incidental transactions
(b) The historical cost of net assets and events and are reported as the
acquired in exchange transactions, difference between the selling price and the
reduced by an allowance for their use book value (often the depreciated cost).
and adjusted for a change in price These classification and display distinctions
levels since original acquisition.
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will depend on the specific circumstances investment decisions is sometimes
and activities of an enterprise. presented in supporting schedules or not
reported. Because of these factors, the
7. The following two factors must be
statement could also be confusing, and
considered when deciding at what point
valuable time could be lost by the
revenues and gains should be recognized:
statement reader in seeking additional
(a) The resources from the transaction are
information.
either already realized in cash or claims to
cash or are readily realizable in cash, and 11. The major sections that may be included in
(b) the revenues and gains have been a multiple-step income statement may be
earned through substantial completion of divided into two categories: (a) income
clearly identified tasks and activities. Both from continuing operations, separated into
factors are usually met when merchandise six sections, and (b) irregular or
is delivered or services are rendered to extraordinary items, separated into three
customers. This is referred to as the point sections. The sections of income from
of sale. continuing operations are
8. There are three specific exceptions to the 1. Revenue from net sales
general rule that were discussed in the 2. Cost of goods sold
chapter. They are recognizing revenue (a) 3. Operating expenses
at the point of completed production, (b) at 4. Other revenues and gains
the time of cash collection, and (c) at 5. Other expenses and losses
various points in time during the operat- 6. Income taxes on continuing operations
ing cycle (e.g., percentage-of-completion The sections of irregular or extraordinary
method). The justification for the use of items are
these exceptions is that, in each case, the 7. Discontinued operations
realization and earning criteria established 8. Extraordinary items
by the FASB are met. 9. Cumulative effects of changes in
9. Three expense recognition principles are accounting principles
applied in matching costs with revenues:
12. A restructuring charge is a loss that arises
(a) Direct matching—costs are associated
when a company proposes a restructuring
directly with specific revenues and
of its operations. The charge is composed
recognized as expenses of the period
of the loss in value associated with assets
in which the revenues are recognized.
that no longer fit in the company’s strategic
(b) Systematic and rational allocation—
plans. The charge also includes the
when costs cannot be associated
additional costs associated with the
directly with specific revenues, costs
termination or relocation of employees.
are associated in a systematic and
Restructuring charges are controversial
rational manner with the periods or
because companies exercise considerable
products benefited.
discretion in determining the amount of a
(c) Immediate recognition—those costs
restructuring charge and thus can use
that cannot be related to revenues
restructuring charges as a tool for
either by direct matching or by
manipulating the amount of reported net
systematic and rational allocation must
income.
be recognized as expenses of the
current 13. This flexibility in the timing of the
period. recognition of restructuring charges is
reduced by SFAS No. 146. Intraperiod
10. The multiple-step income statement can
income tax allocation involves the
contain too much information that might be
separation of income tax expense between
confusing to the reader and require excess
income from continuing operations and
time to evaluate. The detailed listing of
transitory, irregular, or extraordinary items.
purchases and inventory might best be
Under this concept, each section of the
displayed in a supplementary schedule.
transitory, irregular, or extraordinary items
The single-step income statement can be category is reported net of its income tax
too brief. Information required for effect.
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14. Pop-Up must separately disclose the 17. Under International Financial Reporting
current year’s income related to the Standard (IFRS) 8, the cumulative effect of
operations of the segment that will be
discontinued together with the $10,000 loss
resulting from the sale. This total would be
reported on the income statement, along
with any associated income tax impact,
immediately following income from
continuing operations.
15. The following items would not normally
qualify as extraordinary items:
(a) The write-down or write-off of
receivables.
(b) Major devaluation of foreign currency.
(c) Loss on sale of plant and equipment.
(d) Gain from early extinguishment of debt.
Before the issuance of SFAS No. 145
in April 2002, gains and losses from
early extinguishment of debt were
required to be classified as
extraordinary.
(f) Loss due to extensive earthquake
damage to furniture company in Los
Angeles, California. (Earthquakes are
not unusual in the Los Angeles area.)
(g) Farming loss due to heavy spring rains
in the Northwest. (Spring rains are not
unusual in the Northwest.)
Item (e) is classified as extraordinary
because flood damage is both unusual and
infrequent in Las Vegas.
16. a. The effects of a change in accounting
principle that is applied to past periods
are disclosed in the financial
statements of the period of change.
The effects of the change are
computed for past periods and
disclosed either as a cumulative effect
on current net income or as an
adjustment to the beginning retained
earnings. The FASB has specified
criteria to determine which approach is
appropriate.
b. The effect of a change in accounting
estimate is disclosed entirely in the
current period or in the current and
future periods. No adjustments are
made to prior periods’ statements as
may be done for a change in principle.
The change in an estimate should be
sufficiently disclosed in the financial
statements so that readers are alerted
to those changes that will materially
affect future periods.
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18. a change in accounting principle is and circumstances from nonowner
reported as a direct adjustment to sources. It includes all changes in equity
beginning retained earnings of the during a period except those resulting from
current year. investments by owners and distributions to
owners.”1 Net income is the reported
18. Generally accepted accounting principles
income as required by GAAP. Currently,
require entities to report earnings-per-share
GAAP does not require all components of
information for income from continuing
comprehensive income to be disclosed in
operations and for each section of the
the income statement. For example, it does
transitory, irregular, or extraordinary items
not include the effect of error corrections,
category of an income statement. The
asset valuation changes, or some effects of
computation is made by dividing the
accounting changes.
income or loss from each of these sections
by the weighted average number of 20. The starting point for the preparation of
common shares outstanding during the forecasted financial statements is the
reporting period. If a potential dilution of forecast of sales.
earnings exists due to the existence of
convertible securities, stock options, or 21. In forecasting depreciation expense, one
stock warrants, additional earnings-per- first must forecast how much property,
share information must also be presented. plant, and equipment will be needed in the
future. This amount is then used, along
19. “Comprehensive income is the change in with an assumption about how rapidly the
equity of a business enterprise during a plant and equipment will depreciate, to
period from transactions and other events estimate future depreciation expense.
1Statement of Financial Accounting Concepts No. 6, “Elements of Financial Statements” (Stamford, CT:
Financial Accounting Standards Board, December 1985), par. 70.
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PRACTICE EXERCISES
PRACTICE 41 FINANCIAL CAPITAL MAINTENANCE
Net assets, end of period $345,000

Net assets, beginning of period 170,000
Increase in net assets $175,000
Deduct investment by owners 100,000
Income $ 75,000
PRACTICE 42 PHYSICAL CAPITAL MAINTENANCE
Net assets, end of period $345,000

Net assets, beginning of period 170,000
Increase in net assets $175,000
Deduct investment by owners 100,000
Income, financial capital maintenance $ 75,000
Deduct increase necessary to maintain physical capital 65,000
Income, physical capital maintenance $ 10,000
PRACTICE 43 COMPUTATION OF INCOME USING MATCHING
Revenue ($150,000 + $91,000) $241,000

Cost of goods sold ($79,000 + $46,000) 125,000
Income $116,000
The $350,000 in costs incurred in the production of Machines B and D will not yet be recognized as an expense.
This expense is matched and reported in the income statement in the same year in which the revenue from the sale
of the machines is reported. In the meantime, this $350,000 cost is shown as an asset, Inventory, in the balance
sheet.
PRACTICE 44 REVENUE RECOGNITION
Cash Collected Amount of

or Collectibility Work Revenue to Be
Reasonably Assured? Completed? Recognized
a. No Yes $ 0
b. Yes No 0
c. Yes Yes 170,000
Total revenue to be recognized this year $170,000
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PRACTICE 45 EXPENSE RECOGNITION
Expense Expense
Amount of Recognition to Be Recognized
Cost Method This Year
a. $30,000 Direct matching $ 30,000
b. 70,000 Immediate recognition 70,000
c. 15,000 Rational allocation 5,000
d. 27,000 Immediate recognition 27,000
e. 45,000 Rational allocation 9,000
f. 50,000 Direct matching 0
Total expense recognized this year $141,000
PRACTICE 46 SINGLE-STEP INCOME STATEMENT
Sales $10,000
Less expenses:
Cost of goods sold 6,000
Selling and administrative expense 750
Interest expense 1,100
Income before income taxes $ 2,150
Income tax expense 1,200

Net income $ 950
PRACTICE 47 MULTIPLE-STEP INCOME STATEMENT
Sales $10,000
Gross profit $ 4,000
Operating expenses:
Selling and administrative expense 750
Operating income $ 3,250
Income tax expense 1,200
Net income $ 950
PRACTICE 48 COMPUTATION OF GROSS PROFIT
Revenues................................................. $9,488.8
Cost of sales............................................ 5,784.9
Gross profit...................................... $3,703.9
Gross profit/Sales = $3,703.9/$9,488.8 = 39.0%
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PRACTICE 49 COMPUTATION OF OPERATING INCOME
Revenues............................................................... $9,488.8
Operating expenses:
Cost of sales................................................... 5,784.9
Selling and administrative............................. 2,689.7
Restructuring charge, net (Note 13).............. (0.1)
Total operating expenses...................................... $8,474.5
Operating income................................................. $1,014.3
Operating income/Sales = $1,014.3/$9,488.8 = 10.7%
PRACTICE 410 COMPUTATION OF INCOME FROM CONTINUING OPERATIONS
Sales $10,000
Less: Selling and administrative expense 1,750
Income tax expense (40%) 1,260
Income from continuing operations $ 1,890
PRACTICE 411 COMPUTATION OF INCOME FROM DISCONTINUED OPERATIONS
2005 2004
Sales $ 5,000 $4,600
Expenses 4,400 4,100
Income before income taxes $ 600 $ 500
Income tax expense (30%) 180 150
Income from continuing operations $ 420 $ 350
Discontinued operations:
Income (loss) from operations
(including loss on disposal
in 2005 of $2,000) $(2,400) $600
Income tax expense (benefit)30% (720) 180
Income (loss) on discontinued operations (1,680) 420
Net income $(1,260) $ 770
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PRACTICE 412 COMPUTATION OF INCOME FROM DISCONTINUED OPERATIONS
2005 2004
Sales $ 3,500 $5,100
Expenses 3,900 4,500
Income before income taxes $ (400) $ 600
Income tax expense (benefit) 30% (120) 180
Income from continuing operations $ (280) $ 420
Income from operations
(including gain on disposal
in 2005 of $1,500) 2,100 500
Income tax expense30% 630 150
Income on discontinued operations 1,470 350
Net income $ 1,190 $ 770
PRACTICE 413 GAINS AND LOSSES ON EXTRAORDINARY ITEMS
Sales $20,000
Operating expenses and gains/losses:
Selling and administrative expense (1,750)
Other revenues and expenses:
Loss from an unusual but frequent event $(1,000)
Gain from a normal but infrequent event 1,250
Interest expense (2,100) (1,850)
Income tax expense (40%) 2,160
Extraordinary loss (net of tax benefit of $160) (240)
Net income $ 3,000
PRACTICE 414 CUMULATIVE EFFECT OF A CHANGE IN ACCOUNTING PRINCIPLE
2005 2004 2003

Sales $5,000 $3,000 $2,000
Oil and gas exploration expense 700 600 400
Income before income taxes $4,300 $2,400 $1,600
Income tax expense (30%) 1,290 720 480
Income from continuing operations $3,010 $1,680 $1,120
Cumulative effect of change
in accounting principle (net of income
tax benefit of $510) (1,190) 0 0
Net income $1,820 $1,680 $1,120
Cumulative effect = [($400 + $600) – ($1,500 + $1,200)] = ($1,700)
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PRACTICE 415 ACCOUNTING FOR CHANGES IN ESTIMATES
Original depreciation = $100,000/20 years = $5,000 per year

Accumulated depreciation as of January 1, 2005 = $5,000 per year  5 years = $25,000
Revised depreciation = Remaining depreciable book value/Remaining life

= ($100,000  $25,000)/(30 years  5 years elapsed already)
= $75,000/25 years
= $3,000 per year
PRACTICE 416 RETURN ON SALES
Return on sales = Net income/Sales = $200/$13,000 = 1.5%
PRACTICE 417 EARNINGS PER SHARE
2005 2004 2003

Net income $10,000 $6,000 $2,500
Average shares outstanding 2,500 2,000 1,000
Earnings per share $4.00 $3.00 $2.50
Percentage increase in 2004: ($3.00  $2.50)/$2.50 = 20%

Percentage increase in 2005: ($4.00  $3.00)/$3.00 = 33%
PRACTICE 418 PRICE-EARNINGS (P/E) RATIO
Price-earnings ratio = Market price per share/Earnings per share = $20.00/$1.67 = 12.0
PRACTICE 419 COMPREHENSIVE INCOME

Extraordinary loss (1,000)
Cumulative effect of a change in accounting principle (400)
Net income $ 9,600
Net income $ 9,600

Unrealized loss on available-for-sale securities (2,100)
Foreign currency translation adjustment (equity increase) 1,250
Comprehensive income $ 8,750
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PRACTICE 420 FORECASTED BALANCE SHEET
2005 2006
Actual Forecasted
Cash $ 100 $ 125 natural increase of 25%
Accounts receivable 500 625 natural increase of 25%
Inventory 1,000 1,250 natural increase of 25%
Land 2,500 2,500 no increase needed
Plant and equipment (net) 5,000 7,000 40% increase
Total assets $9,100 $11,500
PRACTICE 421 FORECASTED INCOME STATEMENT
2005 2006
Actual Forecasted
Sales $10,000 $13,000 30% increase (given)
Cost of goods sold 6,000 7,800 30% natural increase
Depreciation expense 1,000 1,200 same proportion with PPE
Interest expense 400 500 same apparent 10% interest rate
Income before income taxes $ 2,600 $ 3,500
Income tax expense 910 1,225 same tax rate ($910/$2,600) = 35%
Net income $ 1,690 $ 2,275
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EXERCISES
4–22.
Debit changes in accounts during 2005 other
than Retained Earnings:
Cash.......................................................................... $ 95,500
Accounts Receivable.............................................. 92,000
Buildings and Equipment (net)............................... 190,000
Accounts Payable................................................... 75,000 $452,500
Credit changes in accounts during 2005 other
than Retained Earnings:
Inventory.................................................................. $ 30,000
Patents..................................................................... 5,000
Bonds Payable......................................................... 150,000
Capital Stock............................................................ 100,000
Additional Paid-In Capital....................................... 50,000 335,000
Change in Retained Earnings for 2005....................... $117,500
Add: Dividends declared.............................................. 25,000
Net income..................................................................... $ 142,500
4–23.
(a) The receipt of an order from a customer does not constitute realization,
nor does it qualify as an earnings activity. Therefore no revenue is
recognized.
(b) There has been no sale of the asset to support the recognition of
revenue. Production remains to be performed, followed by sale of the
finished product. Accretion may give rise to revenue in certain
instances in which it can be objectively determined and the product has
a ready market at a definite price.
(c) The rendering of services is the earning activity, and it is assumed that
a valid claim exists against the client. The recognition criteria are met.
(d) The appreciation in value of the land is generally not recognized
because it is not yet realized.
(e) The receipt of cash meets the realization criteria; however, the revenue
is generally not reported as earned because the product has not yet
been delivered. Some argue that an estimate of the costs incurred to
honor the certificate can be made so that revenue could be recognized
at the time of certificate sale.
(f) Collection of cash on the subscriptions is realization. However, the
earning activity has yet to take place.
(g) The retirement of debt at less than the recorded liability results in the
recognition of a gain. The retirement of the debt meets the recognition
criterion for gains.
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4–24.
(a) The revenue is unearned in 2005. The credit is to the liability account
Unearned Rent Revenue.
(b) Revenue of $60,000 is to be recognized in 2005: $10,000 in cash plus a
note for $50,000. In addition, interest revenue of $3,000 is recognized in
2005 ($50,000  0.12  1/2 year). The $3,000 interest revenue to be
earned in 2006 will not be recorded until 2006.
(c) Transactions in a company’s own stock are not considered an income-
generating activity. The amount received above par is credited to
Additional Paid-In Capital.
(d) Because a claim against the customer (an asset) is created when the
merchandise is shipped and actions to prepare and ship the inventory
are felt to represent the earning activity, revenue is recognized at the
time of sale. In theory, the possibility of return should be evaluated and
recorded as a reduction of revenue if some return is probable and the
value of the return can be estimated. Similarly, the probability of a
customer’s taking a cash discount should be considered and a
reduction made to revenue for estimated cash discounts. In practice,
both sales returns and cash discounts are usually not recorded until
they actually occur.
(e) This is a difficult one. As discussed in Chapter 8, under the provisions
of SAB No. 101 the SEC generally does not allow the recognition of
revenue until title transfers. In such a case, the receipt of the 15% down
payment would be recorded as a debit to cash and a credit to a liability
such as Deposit Liability.
(f) The initial agreement does not represent a claim against the client until
the contract is at least partially complete. Because part of the work was
accomplished in 2005, a portion of the revenue could be recognized in
2005 on a percentage basis. However, because the bulk of the work will
be done in 2006, revenue could be deferred until the audit is completed
and billed.
4–25.
(a) Immediate recognition. The future benefits of the new drug are highly
uncertain.
(b) Direct matching. The warranty costs are anticipated expenses that are
directly related to revenues.
(c) Systematic and rational allocation. The lease agreement benefits
several accounting periods in a systematic and rational way.
(d) Direct matching. Labor associated with assembling a product is
matched with revenues and reported in the period the goods are sold.
(e) Systematic and rational allocation. The delivery trucks are expected to
benefit several accounting periods in a systematic and rational way.
(f) Immediate recognition. The advertising indirectly helps to generate
revenues and is not related to specific revenues.
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4–26.
Original cost of patent.................................................................... $450,000
Amortization for 5 years ($30,000 per year 2000–2004).............. 150,000
Remaining unamortized balance................................................... $ 300,000
New estimated life from January 1, 2005...................................... 4 years
Amortization expense for each year (2005–2008)........................ $75,000
Separate disclosure of the $45,000 increase due to the change in estimate
would be required in 2005 if it is considered a material amount.
4–27.
(a) Subtracted or included in determining net purchases in the Cost of
Goods Sold section
(b) Other revenues and gains
(c) Other revenues and gains
(d) Other expenses and losses
(e) Either extraordinary items or other expenses and losses depending on
whether unusual and infrequent
(f) Operating expenses—selling expenses
(g) Discontinued operations
(h) Deduction from income from continuing operations before income
taxes
(i) Other revenues and gains
(j) Subtraction from sales
(k) Other expenses and losses
(l) Cost of goods sold (an item entering into cost of goods manufactured)
(m) Cumulative effect of change in accounting principle
(n) Operating expenses—general and administrative
(o) Cost of goods sold
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4–28.
Caribou Inc.
Income Statement
For the Year Ended December 31, 2005
Sales..................................................................... $1,600,000 (a)
Cost of goods sold:
Beginning inventory......................................... $ 136,000
Net purchases................................................... 919,200 (b)
Cost of goods available for sale..................... $1,055,200
Less: Ending inventory.................................... 95,200
Cost of goods sold........................................... 960,000
Gross profit on sales.......................................... $ 640,000
Operating expenses:
Selling expenses.............................................. $ 208,000 (c)
General expenses (including bad debts)........ 272,000 (d) 480,000
Income before income taxes
and extraordinary items................................... $ 160,000
Income taxes....................................................... 48,000
Income before extraordinary items................... $ 112,000
Extraordinary gain (net of income taxes
of $9,000)........................................................... 21,000
Net income........................................................... $ 133,000
Earnings per share (e):
Income before extraordinary items................ $0.86
Extraordinary gain............................................ 0.16
Net income........................................................ $1.02
COMPUTATIONS:
(a) Sales
Income before income taxes as a percentage of sales:
Sales.............................................................. 100%
Cost of goods sold (see below).................. 60
Gross profit on sales................................... 40%
Selling expenses.......................................... 13%
General expenses, including bad debts.. . 17 30
Income before income taxes.......................... 10%
Sales: $160,000 (income before income taxes) ÷ 0.10 = $1,600,000
Cost of goods sold:
General expenses, excluding bad debts = 15% of sales and 25% of
cost of sales: therefore, 0.15  sales = 0.25  Cost of goods sold
Cost of goods sold = 0.15 ÷ 0.25 = 0.60 of sales
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4–28. (Concluded)
(b) Net purchases
Cost of goods sold = Beginning inventory  Net purchases less
ending inventory
Let X equal net purchases.
0.60  $1,600,000 = $136,000 + X  0.70 ($136,000)
$960,000 = $40,800 + X
X = $919,200
(c) 0.13  $1,600,000 = $208,000
(d) (0.15  $1,600,000) + (0.02  $1,600,000) = $272,000
(e) Earnings per share (130,000 shares of common stock outstanding):
Income before extraordinary gain: $112,000 ÷ 130,000 shares = $0.86
Extraordinary gain: $21,000 ÷ 130,000 shares = $0.16
Net income: $133,000 ÷ 130,000 shares = $1.02
4–29.
Brigham Corporation
Income Statement (Partial)
Income from continuing operations before income taxes............. $210,000
Income tax expense on continuing operations ($210,000  0.35).. 73,500
Income from continuing operations................................................. $136,500
Loss from operations of discontinued business
component (including gain on disposal of $20,000) $ (30,000)
Net income tax benefit............................................... 10,500 (19,500)
Extraordinary gain (net of income taxes of $49,000). 91,000
Net income.......................................................................................... $ 208,000
4–30.
(a) Discontinued operations:
Loss from operations of discontinued business
component (including gain on disposal of
$15,000).................................................................... $(115,000)
Income tax benefit................................................... 34,500 $
(80,500)
(b) If Garrison Manufacturing were reporting using the accounting

standards of the United Kingdom, it would also disclose information
about sales and operating profits for the continuing and discontinued
operations. This additional information allows financial statement users
to compare the relative size and operating profitability of the continuing
and discontinued operations. This practice is also similar to the
reporting requirements of IFRS 35.
4–31.
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2005 2004 2003
Sales $50,000 $43,000 $35,000
Cost of goods sold 20,000 18,000 15,000
Other expenses 13,000 12,000 11,000
Income before income taxes $17,000 $13,000 $ 9,000
Income tax expense (35%) 5,950 4,550 3,150
Income from continuing operations $11,050 $ 8,450 $ 5,850
Income (loss) from operations
(including gain on disposal
in 2005 of $10,000) $3,000 $(5,000) $20,000
Income tax expense (benefit)
—35% 1,050 (1,750) 7,000
Income (loss) on discontinued
operations 1,950 (3,250) 13,000
Net income $13,000 $ 5,200 $18,850
4–32.
(a)
(In millions
of dollars)
Income from continuing operations........................................... $1,032.3
Cumulative effect of change in accounting for income taxes
(net of applicable taxes)............................................................... 544.2
Net income.................................................................................... $ 1,576.5
Earnings per common share:
Income from continuing operations......................................... $ 2.06
Cumulative effect of accounting change................................. 1.09
Net income................................................................................. $ 3.15
(b) If Sears were a non-U.S. company reporting under the provisions of IFRS 8, the
$544.2 million “gain” from the cumulative effect of the change in accounting
principle would not be shown in the income statement at all. Instead, the $544.2
million amount would be shown as a direct adjustment (an increase) to the
beginning balance in retained earnings for the year.
4–33.
(a) Sales revenue.
(b) Loss on disposal of discontinued operations; a separate component of income
shown net of taxes before extraordinary items but after income from continuing
operations.
(c) Extraordinary item, net of taxes.
4–33. (Concluded)
(d) Prior-period adjustment (error correction); retained earnings adjustment.
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(e) Operating expense (or reduction in revenue)—it is a change in estimate.
(f) Asset.
(g) Results of discontinued operations: a separate component of income shown net
of taxes before extraordinary items but after income from continuing operations.
(h) Asset (possibly could be expensed).
(i) Prior-period adjustment (error correction); retained earnings adjustment.
(j) Other Revenues and Gains section of income statement.
(k) Other Expenses and Losses section of income statement unless the event is
considered unusual and infrequent, in which case it would be reported as an
extraordinary item.
(l) Cumulative effect of change in accounting principle; a separate component of
income shown net of taxes as last item before net income.
(m) Operating expense; it is a change in estimate.
(n) Other Revenues and Gains section of income statement.
(o) Operating Expense or Other Expenses and Losses section, depending on
nature of business unless the event is considered unusual and infrequent, in
which case, it would be reported as an extraordinary item.
(p) Operating expense or adjustment to cost of goods sold.
(q) Included with current-year tax expense.
(r) Other Expenses and Losses section because the sale is only a portion of
business segment.
(s) Operating expense because the move does not qualify as discontinued
operations.
(t) Operating expense.
137
4–34.
Income Statement
Revenue:
Sales
Less: Sales discounts
Sales returns and allowances
Cost of goods sold:
Inventory—beginning
Net purchases:
Purchases
Less: Purchase discounts
Purchase returns and allowances
Freight-in
Cost of goods available for sale
Less: Inventory—ending
Gross profit
Operating expenses:
Selling expenses:
Advertising expense
Sales salaries and commissions
Miscellaneous selling expense
General and administrative expenses:
Officers’ salaries expense
Office salaries expense
Office supplies expense
Depreciation expense—office building
Depreciation expense—office furniture and fixtures
Bad debt expense
Insurance expense
Property taxes expense
Miscellaneous general expense
Operating income
Other revenues and gains:
Dividend revenue
Interest revenue
Royalty revenue
Other expenses and losses:
Interest expense—bonds
Interest expense—other
Income from continuing operations before income taxes
Income tax expense
Income from continuing operations
Loss from discontinued operations (net of income taxes of _____ )
Extraordinary gain (net of income taxes of _____ )
Net income
Income from continuing operations
Loss from discontinued operations
Extraordinary gain
Net income
4–35.
The Pensacola Awning Company
138
Income Statement
Sales revenue............................................................ $1,380,000
Expenses:
Costs of goods sold............................................... $765,000
Selling expenses.................................................... 288,720
General and administrative expenses................. 236,400
Interest expense..................................................... 13,390
Income taxes.......................................................... 30,596 (a) 1,334,106
Net income................................................................ $ 45,894
Earnings per share ($45,894 ÷ 25,000 shares)....... $ 1.84
(a) 0.40  $76,490 (Income before taxes)
The Pensacola Awning Company

Statement of Retained Earnings
Retained earnings, January 1........................................................ $444,500
Add: Net income.............................................................................. 45,894
$490,394
Deduct: Dividends........................................................................... 45,000
Retained earnings, December 31................................................... $ 445,394
4–36.
1. Losser Corporation
Schedule of Corrected Net Income
Reported net income (profit and loss)........................ $13,680
Add: Change in amortization expense...................... $ 2,800
Gain on sale of land........................................... 18,350
Interest revenue................................................. 4,500 25,650
$39,330
Less: Increased depreciation—change in estimate.. $ 5,000
Loss on sale of equipment................................ 3,860
Extraordinary casualty loss.............................. 27,730 36,590
Corrected net income................................................... $ 2,740
139
4–36. (Concluded)
2.
Losser Corporation
Retained Earnings Statement
Retained earnings, January 1, 2005................................................ $85,949
Add: Net income............................................................................... 2,740
$88,689
Deduct: Dividends declared............................................................ 10,000
Retained earnings, December 31, 2005.......................................... $ 78,689
3. All items except dividends declared during the year would be reported on the
income statement and included in net income. Extraordinary items would be
reported separately after income from continuing operations.
4–37.
1. The unrealized losses on available-for-sale securities will decrease
comprehensive income because the value of the securities decreased during
the year. The foreign currency translation adjustment will decrease
comprehensive income because the value of the currencies of Svedin’s
foreign subsidiaries weakened relative to the U.S. dollar. The minimum
pension liability adjustment will decrease comprehensive income.
2. Svedin Incorporated
Statement of Comprehensive Income
Net income............................................................................ $17,650
Unrealized losses on available for sale securities............ (1,285)
Foreign currency translation adjustment.......................... (287)
Minimum pension liability adjustment............................... (315)
Comprehensive income...................................................... $15,763
140
4-38. Han Incorporated
Forecasted Income Statement
2006
2005 Forecasted
Sales................................................ $2,000 $2,200 given
Cost of goods sold......................... 700 770 35% of sales,
as last year
Gross profit..................................... $1,300 $1,430
Depreciation expense.................... 120 160 20% of PPE,
same as last year
Other operating expenses............. 1,010 1,111 50.5% of sales,
same as last year
Operating profit.............................. $ 170 $ 159
Interest expense............................. 90 75 15% of bank loan,
same as last year
Income before taxes...................... $ 80 $ 84
Income taxes.................................. 30 32 37.5% of pretax,
same as last year
Net income...................................... $ 50 $ 52
4-39.
Ryan Company
Forecasted Balance Sheet
December 31, 2006
2006
2005 Forecasted
Cash................................................ $ 10 $ 15 50% natural increase
Other current assets...................... 250 375 50% natural increase
Property, plant, and equipment,
net................................................. 800 800 more efficient, item (b)
Total assets.................................... $ 1,060 $ 1,190
Accounts payable.......................... $ 100 $ 150 50% natural increase

Bank loans payable........................ 700 900 new loan of $200,
item (c)
Total stockholders’ equity............. 260 140 to balance
Total liabilities and
stockholders’ equities................ $ 1,060 $ 1,190
141
4-39. (Concluded)
Ryan Company
2006
2005 Forecasted
Sales................................................ $1,000 $1,500 given, item (a)
Cost of goods sold......................... 750 1,125 75% of sales,
same as last year
Gross profit..................................... $ 250 $ 375
Depreciation expense.................... 40 40 5% of PPE,
same as last year
Other operating expenses............. 80 120 8% of sales,
same as last year
Operating profit.............................. $ 130 $ 215
Interest expense............................. 70 90 10% of bank loan,
same as last year
Income before taxes...................... $ 60 $ 125
Income taxes.................................. 20 42 33.3% of pretax,
same as last year
Net income...................................... $ 40 $ 83
Note: Total stockholders’ equity is forecasted to decrease by $120 ($260  $140). This
will happen even though net income will cause stockholders’ equity to increase by
$83. These forecasts imply that Ryan Company is either planning to pay out a large
cash dividend or to buy back a large amount of shares of its own stock.
142
PROBLEMS
4–40.
Payette Co.
Income Statement
For the Year Ended June 30, 2005
Revenue:
Sales ($2,380,000 less returns and
allowances, $30,000)............................................ $2,350,000
Interest revenue....................................................... 52,000
$2,402,000
Expenses:
Cost of goods sold (net purchases,
$1,473,000 less increase in inventory, $10,000) $1,463,000
Selling and general expenses................................ 238,000
Income taxes.............................................................. 262,800 1,963,800
Net income.................................................................. $ 438,200
Earnings per common share
($438,200 ÷ 325,000 shares)................................... $ 1.35
Payette Co.
For the Year Ended June 30, 2005
Retained earnings, July 1, 2004................................ $1,356,800
Add: Net income......................................................... 438,200
$1,795,000
Deduct: Dividends...................................................... 260,000
Retained earnings, June 30, 2005............................. $ 1,535,000
143
4–41.
1. Income statement–time of shipment:
Richmond Company
Income Statement
For the Years Ended December 31
2006 2005
Sales............................................................................... $150,000 $125,000
Cost of goods sold........................................................ 90,000 75,000
Gross profit.................................................................... $ 60,000 $ 50,000
Bad debt expense......................................................... (7,500) (6,250)
Selling expenses........................................................... (15,000) (25,000)
General and administrative expenses........................ (22,000) (22,000)
Net income (loss).......................................................... $ 15,500 $ (3,250)
Income statement—time of sale:

Richmond Company
Income Statement
For the Years Ended December 31
2006 2005
Sales............................................................................... $132,000 $ 84,000
Cost of goods sold........................................................ 66,000 42,000
Gross profit.................................................................... $ 66,000 $ 42,000
Bad debt expense......................................................... (660) (420)
Selling expenses........................................................... (15,000) (25,000)
General and administrative expenses........................ (22,000) (22,000)
Net income (loss).......................................................... $ 28,340 $ (5,420)
2. Under the first dealer agreement, revenue is recognized when goods are
shipped to the dealers. The dealer makes payment after receipt of the
goods. Possible bad debt losses are greater under this agreement
because the dealer may not have the cash to pay for the toys until they
are sold. The second type of dealer agreement is actually a
consignment of inventory. Because there is a right of return, the
revenue should not be recognized until the dealer makes a sale. The risk
is borne by Richmond. To cover this risk, the sales price is higher for
the toys.
In the problem, Richmond would have a larger loss in 2005 under the
consignment agreement than under the sale agreement; however, in
2006 the consignment agreement would produce a greater profit. In
addition, at the end of 2006 Richmond will still have 19,000 units out on
consignment, assuming that none of the units have been returned, with
a potential profit of $3 per unit less bad debt costs. Of course, if these
19,000 units are returned and cannot be resold, this profit will not be
realized. The uncertainty of the second type of dealer agreement
justifies the delay of revenue recognition until the dealer makes a sale.
144
4–42.
1. (a) Revenue must be both earned and realized in order to be reported on
the income statement. Until Hadley ships the inventory, the $18,000 of
orders paid for in advance should not be reported on the income
statement.
(b) Because customers are not returning the products, the earnings
process can be considered substantially complete when the sale is
made. The revenues and associated cost of goods sold should be
included on the income statement.
(c) The rent will benefit several accounting periods and should be allocated
in a systematic fashion.
(d) It is difficult to determine the period of time that is benefited by general
advertising. Because the advertising costs cannot be related to specific
revenues, the costs are typically recognized as expenses immediately.
(e) Current cost information is currently not disclosed on the face of the
income statement. Some companies elect to provide supplemental
information of this nature in the notes to the financial statements.
(f) If warranty costs can be reasonably estimated, the expenses are
matched directly to the period in which the revenue is generated. Using
the actual costs incurred to approximate warranty expense violates the
matching principle.
2. Sales............................................................................................. $183,000
Cost of goods sold...................................................................... 101,500
Gross profit.................................................................................. $ 81,500
Rent expense............................................................................... (12,000)
Advertising expense................................................................... (24,000)
Warranty expense....................................................................... (9,150)
Other expenses........................................................................... (15,000)
Net income................................................................................... $ 21,350
Sales: $185,000 – $18,000 + $16,000 = $183,000
Cost of goods sold: $94,000 + $7,500 = $101,500
Rent expense: $18,000 – $6,000 = $12,000
Advertising expense: $6,000 + $18,000 = $24,000
Warranty expense: $183,000  0.05 = $9,150
145
4–43.
Delaney Manufacturing Inc.
For the Fiscal Year Ended July 31, 2005
Income from continuing operations before income taxes...................... $1,014,000 (a)
Incomes taxes............................................................................................. 304,200 (b)
Income from continuing operations......................................................... $ 709,800
Extraordinary gain (net of income taxes of $30,300).............................. 70,700 (c)
Loss from disposal of a business component (net of income tax
savings of $42,000).................................................................................. (98,000) (d)
Net income.................................................................................................. $ 682,500
COMPUTATIONS:
(a) $975,000 – $101,000 + $140,000 = $1,014,000
(b) $1,014,000  0.30 = $304,200
(c) $101,000  0.30 = $30,300; $101,000 – $30,300 = $70,700
(d) $140,000  0.30 = $42,000; $140,000 – $42,000 = $98,000
Delaney Manufacturing Inc.

For the Fiscal Year Ended July 31, 2005
Retained earnings, August 1, 2004........................................................... $2,750,000
Less: Prior-period adjustment (net of income tax savings of $22,500). 52,500 (a)
Adjusted retained earnings, August 1, 2004............................................ $2,697,500
Add: Net income......................................................................................... 682,500
Retained earnings, July 31, 2005.............................................................. $ 3,380,000
(a) $75,000  0.30 = $22,500; $75,000 – $22,500 = $52,500
146
4–44.
Radiant Cosmetics Inc.
Income from continuing operations before income taxes............... $210,000
Income taxes ($82,000 + $20,000 – $8,000 – $10,000)...................... 84,000
Income from continuing operations.................................................. $126,000
Loss from operations of discontinued cosmetics
division (including loss on disposal of $50,000)......................... $(32,000)
Income tax benefit............................................................................ (12,000) (20,000)
Extraordinary gain (net of income taxes of $10,000)....................... 15,000
Net income........................................................................................... $ 121,000
Income from continuing operations ($126,000 ÷ 35,000 shares). $ 3.60
Loss from discontinued operations ($20,000 ÷ 35,000 shares).... (0.57)
Extraordinary gain ($15,000 ÷ 35,000 shares)................................ 0.43
Net income........................................................................................ $ 3.46
Radiant Cosmetics Inc.

Retained earnings, January 1, 2005.................................................................. $620,000
Add: Correction of sales understatement in 2004
(net of income taxes of $21,000)..................................................................... 39,000
$659,000
Deduct correction for omission of depreciation of prior periods
(net of income tax refund claim of $8,000)..................................................... 12,000
Adjusted retained earnings, January 1, 2005................................................... $647,000
Add: Net income................................................................................................. 121,000
$768,000
Deduct: Dividends.............................................................................................. 40,000
Retained earnings, December 31, 2005............................................................ $ 728,000
147
4–45.
Loss from operations of discontinued business component
(including loss on disposal of $5,000)..................................... $
(94,900)
Income tax benefit........................................................................ (33,215)
$
(61,685)
The expected operating loss and the expected disposal gain in 2006 are not reported
in the 2005 income statement. Before the release of SFAS No. 144 changed the
accounting for discontinued operations, these two expected items would have been
used to compute an “expected loss on disposal.”
4–46.
1. 2005 2004 2003
(a) Gross profit percentage......................... 48.0% 52.0% 54.0%
(b) Net profit percentage............................. 7.0% 9.3% 12.9%
(c) Price-earnings ratio................................ 13.7 18.1 20.9
2. While RoboCon’s sales are increasing every year, its gross margin is
declining, resulting in a decreasing profit margin. The market is
apparently aware of this information and is pricing the stock
accordingly. Even though sales are increasing, the firm’s earnings
multiple has declined each of the past 2 years.
148
4–47.
Connell Company
Multiple-Step Income Statement
Revenue:
Sales............................................................................. $8,125,000
Less: Sales discounts................................................ $ 55,000
Sales returns and allowances......................... 95,000 150,000 $
7,975,000
Cost of goods sold:
Inventory, January 1.................................................... $ 775,000
Net purchases:
Purchases.................................................................. $4,633,200
Less: Purchase discounts....................................... 47,700 4,585,500
Freight-in...................................................................... 145,000
Cost of goods available for sale................................. $5,505,500
Less: Inventory, December 31 (net of write-down)... 750,000 4,755,500
Gross profit.................................................................. $
3,219,500
Operating expenses:
Selling expenses:
Sales salaries............................................................ $ 521,000
Delivery expense...................................................... 425,000
Depreciation expense—delivery trucks.................. 29,000
Depreciation expense—store equipment............... 25,000
Miscellaneous selling expenses............................. 50,000 $1,050,000
Officers’ and office salaries..................................... $ 550,000
Employee pension expense..................................... 190,000
Property taxes expense........................................... 100,000
Bad debt expense..................................................... 32,000
Depreciation expense—office building................... 25,000
Depreciation expense—office equipment.............. 10,000
Miscellaneous general expenses............................ 45,000 952,000 2,002,000
Operating income........................................................... $
1,217,500
Dividend revenue......................................................... $ 35,000
Interest revenue........................................................... 10,000
Gain on sale of office equipment............................... 8,000 53,000
Loss on sale of investment securities....................... (20,000)
Income from continuing operations before
income taxes................................................................... $
1,250,500
Income taxes................................................................... 427,425
Net income...................................................................... $ 823,075
Earnings per share ($823,075 ÷ 60,000 shares)........... $ 13.72
149
4–47. (Concluded)
Connell Company
Retained earnings, January 1, 2005............................................................... $ 550,000
Add: Net income............................................................................................... 823,075
$1,373,075
Deduct: Dividends............................................................................................ 150,000
Retained earnings, December 31, 2005......................................................... $ 1,223,075
150
4–48.
Jericho Recreation, Inc.
Revenue:
Sales........................................................................ $797,500 (a)
Less: Sales returns and allowances.................... 9,500 $788,000
Cost of goods sold................................................... 302,800
(b)
Gross profit............................................................... $485,200
Operating expenses:
Selling expenses:
Sales salaries and commissions....................... $160,000
Depreciation—stores and store equipment...... 33,600 (c)
Advertising expense........................................... 13,400 $207,000
Officers’ and office salaries............................... $210,000
Depreciation—office building and equipment. . 22,400 (c)
Other general and administrative expenses..... 38,800 271,200 478,200
Operating income..................................................... $ 7,000
Interest revenue..................................................... $ 6,600
Gain on sale of land and building......................... 40,000 (d) 46,600
Interest expense..................................................... $ (10,600)
Loss on sale of short-term investment................ (3,000) (13,600)
Income before income taxes, extraordinary item,
and cumulative effect............................................ $ 40,000
Income taxes (30%).................................................. 12,000
Income before extraordinary item and
cumulative effect.................................................... $ 28,000
Extraordinary gain
(net of income taxes of $4,800)............................. 11,200
Cumulative effect of change in inventory costing
method (net of income tax savings of $5,400).... (12,600)
Net income................................................................ $ 26,600
Income before extraordinary item and cumulative effect........................... $ 2.80
Extraordinary gain.......................................................................................... 1.12
Cumulative effect of accounting change...................................................... (1.26)
Net income...................................................................................................... $ 2.66
4–48. (Concluded)
COMPUTATIONS:
(a) Sales: $797,000 + $9,500 – $6,600 + $10,600 + $3,000 – $16,000 = $797,500
(b) Cost of goods sold: $320,800 – $18,000 = $302,800. The $18,000 cumulative
effect of change in inventory method is reported separately, net of 30% tax
savings, as a nonoperating component of income.
(c) Depreciation: Stores and store equipment, $56,000  0.60 = $33,600
Office bldg. and equipment, $56,000  0.40 = $22,400
(d) The total pre-tax gain of $40,000 is included in income from continuing
operations. The sale of land and building does not constitute the disposal of a
business component.
4–49.
Rollins Sporting Goods
Sales.......................................................................... $103,200 (a)
Cost of goods sold:
Beginning inventory.............................................. $ 10,020
Purchases............................................................... 53,540 (b)
Goods available for sale........................................ $ 63,560
Less: Ending inventory......................................... 18,665 (d) 44,895
Gross profit............................................................... $ 58,305 (c)
Operating expenses:
Selling expenses.................................................... $ 11,661
General and administrative expenses................. 25,800 (e) 37,461
Income before taxes................................................. $ 20,844
Income taxes............................................................. 8,338 (f)
Net income................................................................ $ 12,506
Earnings per share ($12,506 ÷ 6,000 shares)......... $ 2.08
COMPUTATIONS:
(a) Cash collections................................................................ $107,770
Accounts receivable, December 31, 2004....................... (20,350)
Accounts receivable, December 31, 2005....................... 15,780
Sales................................................................................... $ 103,200
4–49. (Concluded)
(b) Cash payments.................................................................. $ 96,350

Accounts payable, December 31, 2004........................... (9,870)
Accounts payable, December 31, 2005........................... 5,175
Cash general and administrative expenses................... (22,704)*
Selling expenses............................................................... (11,661)
Wages and salaries payable, December 31, 2004.......... (3,750)
Purchases....................................................................... $ 53,540
*Total general and administrative expenses
(0.25  $103,200)............................................................. $ 25,800
Less depreciation on store equipment......................... 3,096 (g)
Cash general and administrative expenses................. $ 22,704
(c) Selling expense $11,661 ÷ 0.20 = $58,305 gross profit
(d) Sales (a)............................................................................. $103,200
Gross profit (c).................................................................. 58,305
Cost of goods sold........................................................ $ 44,895
Beginning inventory.......................................................... (10,020)
Purchases (b).................................................................... (53,540)
Ending inventory........................................................... $ (18,665)
(e) Sales $103,200  0.25 = $25,800 general and administrative expenses
(f) Income before income taxes $20,844  0.40 tax rate = $8,338 income taxes
(g) General and administrative expenses $25,800  0.12 = $3,096 depreciation
4–50.
Sunset Cosmetics Inc.
Revenue:
Sales.......................................................................... $499,400 (a)
Less: Sales returns and allowances...................... $ 11,200
Sales discounts............................................. 880 12,080 $487,320
Cost of goods sold:
Inventory, January 1................................................. $ 89,700
Net purchases:
Purchases............................................................... $173,000
Less: Purchase returns and allowances............. 10,380 (b) 162,620
Freight-in................................................................... 6,325 (c)
Cost of goods available for sale.............................. $258,645
Less: Inventory, December 31................................. 54,150 (d) 204,495
Gross profit............................................................... $282,825
Operating expenses:
Selling expenses:
Sales salaries and commissions.......................... $ 35,108 (e)
Advertising expense.............................................. 16,696 (f)
Depreciation expense—sales/delivery
equipment............................................................ 6,750 (g)
Freight expense..................................................... 4,200
Travel expense—sales representatives............... 4,560
Miscellaneous selling expenses.......................... 2,200 $ 69,514
Officers’ salaries expense................................... $ 36,600
Insurance and licenses........................................ 8,500
Bad debt expense................................................. 7,460 (i)
Utilities expense................................................... 6,400
Depreciation expense—office equipment.......... 4,800
Legal services...................................................... 2,225
Telephone and postage expense........................ 1,475
Supplies expense................................................. 580 (h) 68,040 137,554
Operating income........................................................ $145,271
Interest revenue........................................................ $ 1,390 (j)
Dividend revenue...................................................... 7,150
Gain on sale of assets.............................................. 18,500 $ 27,040
Interest expense....................................................... (4,520) 22,520
Income from continuing operations before
income taxes................................................................ $167,791
Income taxes................................................................ 58,727 (k)
Income from continuing operations........................... $109,064
Gain from discontinued operations (net of
income taxes of $14,000)...................................... 26,000
Extraordinary loss (net of income tax savings
of $25,410)................................................................. (47,190)
Net income................................................................... $ 87,874
4–50. (Concluded)

Income from continuing operations ($109,064 ÷ 39,000 shares)................. $ 2.80
Gain from discontinued operations ($26,000 ÷ 39,000 shares).................... 0.67
Extraordinary loss ($47,190 ÷ 39,000 shares)............................................... (1.21)
Net income ($87,874 ÷ 39,000 shares = $2.25*)............................................. $ 2.26*
*Difference due to rounding.
COMPUTATIONS:
(a) Sales: $495,200 + $4,200 = $499,400
(b) Purchase returns and allowances: $173,000  0.06 = $10,380
(c) Freight-in: $5,525 + $800 = $6,325
(d) Inventory: $20,550 + $33,600 = $54,150
(e) Sales salaries and commissions: $35,000 + ($3,600  0.03) = $35,108
(f) Advertising expense: $16,090 + ($1,818  2/6) = $16,696
(g) Depreciation expense: $6,100 + ($7,800  10/120) = $6,750
(h) Supplies expense: $2,180 – $1,600 = $580
(i) Bad debt expense: ($261,000  0.03) – $370 = $7,460
(j) Interest revenue: $700 + $690 = $1,390
(k) Income taxes: $167,791  0.35 = $58,727
Sunset Cosmetics Inc.

Retained earnings, January 1............................................................................ $440,670
Add: Net income................................................................................................. 87,874
$528,544
Deduct: Dividends.............................................................................................. 33,000
Retained earnings, December 31...................................................................... $ 495,544
4–51.
Before preparing the statement of comprehensive income, net income must be

computed, as follows:
Revenues and gains:

Sales............................................................................................. $450,000
Gain on sale of investment........................................................ 6,700
Total revenues and gains........................................................ $456,700
Expenses and losses:
Cost of goods sold...................................................................... $263,000
Selling expenses......................................................................... 63,900
General and administrative expenses...................................... 58,720
Income tax expense.................................................................... 21,500
Total expenses and losses...................................................... 407,120
Income from continuing operations............................................. $ 49,580
Extraordinary gain, net of income taxes...................................... 39,400
Cumulative effect of change in depreciation method,
net of income tax savings.......................................................... (18,380)
Net income...................................................................................... $ 70,600
Note: The sale of the land did not produce a gain or a loss; therefore, the proceeds
are not included in the statement. Dividends paid are part of the retained earnings
statement and are also excluded from the preceding statement. The correction of the
inventory error is a prior-period adjustment and is shown as a direct adjustment to
the beginning balance in retained earnings; it does not enter into the computation of
net income or of comprehensive income.
Blacksburg Company
Statement of Comprehensive Income
Net income........................................................................................................... $ 70,600
Other comprehensive income:
Foreign translation adjustment, net of income taxes................................... 33,000
Comprehensive income..................................................................................... $ 103,600
4-52.
1. Lorien Company
Forecasted Balance Sheet
December 31, 2006
2006
2005 Forecasted
Cash.......................................................... $ 40 $ 48 20% natural increase
Other current assets................................ 350 420 20% natural increase
Property, plant, and equipment, net....... 1,000 800 $1,000 – $200;
no replacements
Total assets.............................................. $ 1,390 $1,268
Accounts payable.................................... $ 100 $ 120 20% natural increase

Bank loans payable................................. 1,000 1,000 no new loans, item (c)
Paid-in capital........................................... 100 (147) to balance
Retained earnings.................................... 190 295 $190 + $120 – $15
Total liabilities and stockholders’
equity...................................................... $ 1,390 $1,268
Lorien Company
2006
2005 Forecasted
Sales.......................................................... $1,000 $1,200 given, item (a)

Cost of goods sold................................... 350 420 35% of sales,
same as last year
Gross profit.............................................. $ 650 $ 780
Depreciation expense.............................. 200 200 same as last year;
no replacements*
Other operating expenses....................... 250 300 25% of sales,
same as last year
Operating profit........................................ $ 200 $ 280
Interest expense....................................... 120 120 12% of bank loan,
same as last year
Income before taxes................................ $ 80 $ 160
Income taxes............................................ 20 40 25% of pretax,
same as last year
Net income................................................ $ 60 $ 120
*One could also argue that depreciation expense will be lower in 2006 because the
net amount of property, plant, and equipment will decline.
4-52. (Concluded)
2. Yes, it is possible for paid-in capital to be negative. This means that a company
has spent more to repurchase shares of its own stock than was initially invested
by shareholders. This is possible when share prices have increased significantly
since shares were first issued. As with this example, negative paid-in capital is
symptomatic of a company that has generated much excess cash and has used it
to buy back shares. Coca-Cola is an example of a real-world company with net
negative paid-in capital.
DISCUSSION CASES
Discussion Case 4–53

This case demonstrates how a change in an accounting principle may make an enterprise’s financial
statements more comparable with those of other enterprises but cause its current year’s statements to be
noncomparable with its prior years’ statements. Thus, the principle of consistency is violated. Accounting
standards do permit an enterprise to change its accounting principles. However, there must be full
disclosure of the change, including data revealing its impact on current financial statements.
Usually, information concerning an accounting change is contained in a note to the financial statements.
If a cumulative adjustment is necessary for past events, it should be reported as a separate income
statement item. In this case, the change affected depreciation. If prior years’ depreciation is adjusted to
the straight-line method, a cumulative adjustment would be necessary to restate the accumulated
depreciation for the equipment. If only current and future years’ depreciation is affected by the change, no
cumulative adjustment would be involved. In either case, a note describing the change and indicating the
impact on income, earnings per share, and asset valuation would be required. A more complete
discussion of accounting changes is provided in a later chapter.

Two different aspects of this case should be explored with students. First, there is no necessary
connection between income and cash. Cash payments may be made for purposes other than expenses,
such as equipment purchases. In addition, changes in the amounts of accounts receivable and accounts
payable affect cash but usually not income. Second, the increasing cost of inventory and supplies means
that if a company maintains the same quantity and quality of inventory and supplies, more cash will be
required. The replacement cost of goods sold in the past 2 years has been $90,000 more than what it
cost originally to buy those goods. This alone could account for the cash flow shortage.
This case can be used to emphasize the difference between financial capital maintenance income and
physical capital maintenance income. Because the company’s financial statements are prepared on the
basis of a financial capital maintenance concept, and Stevenson is withdrawing most of the reported net
income, it is not possible to maintain the company’s physical capital when prices are rising unless he
invests more money into the business.

This case presents some interesting points for class discussion. The final decision will probably be
prefaced by “It depends . . .” Students should use the revenue recognition criteria of the conceptual
framework as a basis for their decision. The first suggested revenue recognition point, completion of
production, probably fails the realized or realizable test. Until the product is actually sold, the asset is not
readily convertible to cash. If the artist’s reputation is established, sales could be made from design
drawings or small sample sculptures. If the sales contract is firm, the realizability test could be met prior
to actual delivery. It appears clear that the second criterion, substantial completion of the activity or task,
occurs upon completion of the sculpture as it is cast in bronze. Thus, revenue could be recognized at
completion of production. The revenue recognition decision thus depends on when the sale is actually
made.
The second suggested revenue recognition point, point of delivery of the product to the customer, implies
that both criteria are met. The sale has been made, and substantial completion must have occurred
because delivery is made. The remaining uncertainty revolves around the return privilege. If there is a
high likelihood of return, it could be argued that no sale has really occurred until the year is over. The
buyer may be considered to be a borrower of the sculpture—an agent who has a year to decide whether
to buy or not. The matching principle requires that an estimate of sales returns be made and recorded as
an offset to recognized revenue. If past experience provides a basis for this estimate, revenue recognition
at the point of delivery seems justified. If, however, an estimate of the extent of returns is not possible,
revenue recognition may have to wait until the end of the return period. The FASB has considered the
right of return as a separate issue. It is discussed in Chapter 8. The case as written does not contain
enough information to know whether an estimate of the expected returns is possible.

This case introduces the student to an arrangement that is similar to a consignment, even though the
term is not used. Factors indicating that no revenue should be recognized until the dealer completes a
sale to a third party are as follows:
 No payment is required until the final sale has been made.
 Skyways may request a return of the dishes at its discretion.
 No interest is charged on the receivable until a sale to a third party is completed.
 Purpose of the arrangement is to induce dealers to stock larger amounts of inventory.
There are also factors that suggest a sale has occurred: (1) There are no specific provisions for return of
the merchandise, and (2) prior returns have been nominal at 10%.
The revenue recognition criterion of realized or realizable does not appear to be met in this case until the
sale to a third party is consummated. This would be especially true if the dealers were in any way related
to Skyways. This case demonstrates how difficult it can be to apply revenue recognition principles in real-
world situations.

This case presents students an interesting problem when adjustments to the financial statements are
made based on estimates. Since the product line did not qualify as a business component, any losses
would be reported as part of ordinary income unless it was decided they met the criteria for an
extraordinary loss. If the expected loss is probable and if a reliable estimate of the amount can be made,
accounting standards would require accruing the loss in 2004. If either of these conditions is not met,
disclosure by note to the financial statements would be sufficient to meet the standards. When the line is
not discontinued in 2005, a reversal of the accrual would be necessary. The reversal should be reported
in the same way as the accrual. Due to the nature of the item, separate line disclosure of the accrual and
the reversal should probably be made. (Note: According to SFAS No. 146, estimates of losses associated
with asset write-downs should be included in a restructuring charge, but estimates of future liabilities
expected to be created by the restructuring may not be included in the initial recorded amount of the
restructuring charge.)

The question of how to record research costs for computer software has been a controversial one. It is
similar to the question of how to record research and development costs in general. The arguments to
support deferring the cost center on better matching of costs against revenues. Until the software is
developed and marketed, no revenue is generated. By deferring the costs associated with the software,
amortization of the costs against revenues can be made as sales are made. If a company has a history
that permits reasonable estimates of the probability of success, use of these statistics to defer software
development costs could lead to more useful financial statements.
Arguments to support expensing these costs center on the uncertainty of knowing whether a given piece
of software will be successful in the marketplace. Until the prospects of sales are probable, any costs
associated with development of software should be expensed. A company with past successes can give
no assurance that such success will continue.
Class discussion might address the issue of whether increased comparability occurs just because a
uniform method of accounting treatment is used. Companies differ in their ability to generate successful
software; any accounting method that ignores these differences by developing uniform criteria could
produce misleading financial statements. The FASB statement on software costs (Statement of Financial
Accounting Standards No. 86) requires the expensing of all costs incurred before technological feasibility
is established. Costs incurred after technological feasibility and before production are capitalized and
amortized.
This case provides an opportunity to discuss the nature of assets in general and deferred charges in
particular. The discussion should also stress the importance of properly matching the expiration of asset
costs with recognized revenues in order to report a proper income measure. Finally, students should be
made aware that FASB Statement No. 7 requires development stage enterprises to report on the same
basis as established operating enterprises. It is not considered proper accounting to capitalize operating
losses. If such losses are expected, that knowledge can be incorporated into the decision being made.
However, deferred charges should be limited to those costs that promise to provide future revenues. The
loss in the early months of a branch’s life does not guarantee future excess of revenues over expenses.
Misleading indications would be communicated if such items were deferred.

The adjustment of financial statements subsequent to their release has caused considerable discussion
within the profession. Although the students have not yet been exposed to many of the conditions that
cause changes to be made to previously issued financial statements, the issue is one that can be fruitfully
discussed at this point. Comparability is the accounting principle used to justify requiring an adjustment to
prior years’ income statements to reflect the discontinuance of a business component. If the current
year’s income statement deletes the revenues and expenses for the discontinued business component
from the operating section, the prior years’ statements reported with the current statement should be
adjusted in a similar manner. This will permit a reader to evaluate trend changes and separate the effect
of discontinuing the business component from the other operations of the enterprise.
The controller’s objection is valid. Careful readers of financial statements are often confused by the
changing numbers that appear in subsequent years in statements previously issued. Such changes are
required in many other areas. The instructor might indicate some of these in the discussion. They include
mergers, some changes in accounting principles, accounting errors, stock dividends and stock splits
when computing earnings-per-share data, and so on. Unless readers are aware that these subsequent
events or discoveries can cause prior statements to be adjusted, they may place less trust in the validity
of the issued statements.

1. Revenues can be booked in advance by a company’s recording the journal entry prior to meeting the
revenue recognition criteria. The typical journal entry would involve debiting a receivable account
and crediting a revenue account.
Expenses can be deferred using two methods. The first is simply not to make any journal entry. The
second is to record the expense as prepaid and to classify it as an asset on the balance sheet rather
than as an expense on the income statement. It would then be expensed at some future time.
2. In many cases, top executives encourage misleading accounting practices because their
compensation is based, in part, on accounting numbers. If the numbers can be manipulated to
portray favorable news, the executives receive raises, bonuses, and so forth.
3. Again, students should be made aware that the business world presents ethical dilemmas. While
textbooks provide the rules to be applied in a sterile environment, the dynamic environment of life
often presents individuals with quandaries for which there are no easy solutions. This question can
lead to an interesting difference in opinion among students.
4. Independent auditors have a responsibility to prepare an audit to detect material misstatements. The
objective of an audit is not to guarantee the accuracy of financial statements but to ensure that the
financial statements are prepared in accordance with GAAP.
Some frauds are so carefully constructed and concealed that auditors could not reasonably be
expected to uncover the fraud. The legal system is called on to evaluate the auditor’s liability.
Typically, the courts evaluate the auditor using three qualifying questions: (1) Were the auditor’s
actions in accordance with the duty expected of a professional? (2) Did individuals rely on the
information audited by the auditor? and (3) Were damages incurred as a result of this reliance? The
answers to these questions determine the extent of the auditor’s liability, especially under common
law. Under some statutory law, criteria (2) and (3) are not required.
1. To be recognized, revenue must, in most cases, meet two criteria: (1) Goods or services are
provided to the buyer and (2) payment or a valid promise of payment must be received by the seller.
In the RJR Nabisco example, cigarettes were shipped to wholesalers (criterion No. 1), but the
wholesalers had made no promise to pay for the cigarettes (criterion No. 2). In fact, rather than pay,
wholesalers returned the inventory. In the Regina example, by recording goods when they were
ordered rather than when they were shipped, Regina violated the first criterion. Goods were not
provided to buyers.
In both instances, revenue was booked before both revenue recognition criteria had been met.
2. The revenue recognition criteria are not a function of contracts. The criteria are based on business
events. If the business events occur, revenue is recognized. A legal contract may state any number
of things, but in most cases, until goods or services are provided and a promise of payment is
received, revenue should not be recognized. The arrangement is really a consignment of inventory.
3. For many businesses, inventory is shipped the same day a customer places the order. In these
cases, it does not matter if the journal entry is made when the order is placed or when the goods are
shipped.
In other cases, there may be a delay between the order and the shipment dates. Inventory may
have to be produced, materials ordered, or paperwork processed. In these cases, one must make
sure that the transaction giving rise to the revenue and the resulting journal entry are recorded in the
same accounting period.
The problem in the Regina example was that revenue was being booked in one year and actually
being earned in the next year. This resulted in erroneous annual financial statements.
4. Regina’s chief accountant elected to go along with the company president’s activities and, as a
result, spent six months in jail and was fined $25,000. The point of this question is not to provide
specific alternatives for dealing with fraud but rather to make students aware that fraudulent
activities exist and that students must be prepared to deal with them in their role as accountants.

The purpose of this case is to help students understand the relationships between net income, gross
profit percentage, and return on sales and the different ways in which profitability may be determined.
Drug store:
Net income $1,050,000  $950,000 – $39,500 = $60,500
Gross profit percentage $100,000/$1,050,000 = 9.5%
Return on sales $60,500/$1,050,000 = 5.8%
Department store
Net income $670,000 – $560,000 – $66,500 = $43,500
Gross profit percentage $110,000/$670,000 = 16.4%
Return on sales $43,500/$670,000 = 6.5%
The drug store has the higher net income, but the department store has a higher profit percentage. As to
which is more profitable, additional information would be required. However, this case illustrates that
using only one measure of profitability can often lead to an incomplete picture.
SOLUTIONS TO STOP & THINK
Stop & Think (p. 168): It would seem that the physical capital maintenance concept would provide the
best theoretical measure of "well-offness." What difficulties would be encountered by a firm as it tried to
turn theory into practice if the FASB had adopted the physical capital maintenance concept of measuring
income?
Measuring physical well-offness would require firms to obtain fair market value measures of each of their
assets and liabilities each period. The difficulties of obtaining these measures along with the associated
costs would, in most cases, cause the costs of the information to exceed its benefits.
Stop & Think (p. 170): Why is it important to separately disclose revenues and gains? expenses and
losses?
Revenues and expenses are associated with what a business does. That is, they relate to a company's
central activity. An investor or creditor would want to evaluate a business's performance in its central
activity. Additional information relating to gains and losses associated with the peripheral activities of a
business would be useful but should not be combined with revenues and expenses for disclosure
purposes.
Stop & Think (p. 172): Why do you think Kinross waits to recognize revenue from the sale of Kubaka
gold until the gold is actually sold?
Recall that revenue recognition at the time of production is acceptable when sale at an established price
is practically assured. For the gold produced by Kinross in eastern Russia, enough uncertainty surrounds
the shipment and sale of the gold that revenue is not recognized until the actual sale occurs.
Stop & Think (p. 177): Having just reviewed a single-step and a multiple-step income statement, which
type do you think provides better information for assessing a firm's performance?
Students' responses will vary in answering this question. Remind students that it is not their answer that
is important; it is the thinking about the question that is of value.
SOLUTIONS TO STOP & RESEARCH
Stop & Research (p. 171): Use the SEC’s EDGAR system (accessed through http://www.sec.gov) to
find the most recent 10-K filing of Service Corporation International (SCI).
1. What is SCI’s business?
2. What is SCI’s revenue recognition policy?
1. Service Corporation International is the largest funeral and cemetery company in the world. As of
December 31, 2001, SCI operated 3,099 funeral service locations, 475 cemeteries, and 177
crematoria located in 11 countries.
2. SCI sells price-guaranteed, prearranged funeral contracts through various programs providing for
future funeral services at prices prevailing when the agreements are signed. Revenues associated
with sales of prearranged funeral contracts are deferred until such time that the funeral services are
performed. Sales of at-need cemetery interment rights, merchandise, and services are recognized
when the service is performed or merchandise delivered. Preneed cemetery interment right sales of
constructed cemetery burial property are not recognized until a minimum percentage (10%) of the
sales price has been collected.
Stop & Research (p. 179): Each year, Fortune magazine compiles a list of the 500 largest companies in
the United States. The rankings in this “Fortune 500” are determined by reported revenues. Find the most
recent Fortune 500 listing and identify the ten largest companies in the United States (ranked by
revenue).
The Fortune 500 list can be viewed using Fortune’s Web site at http://www.fortune.com. According to the
2002 listing, the following ten companies had the highest reported revenues in the United States:
Rank Company Revenues
(in millions)
1 Wal-Mart Stores $219,812.0
2 ExxonMobil 191,581.0
3 General Motors 177,260.0
4 Ford Motor 162,412.0
5 Enron 138,718.0
6 General Electric 125,913.0
7 Citigroup 112,022.0
8 ChevronTexaco 99,699.0
9 International Business Machines 85,866.0
10 Philip Morris 72,944.0
SOLUTIONS TO NET WORK EXERCISES
Net Work Exercise (p. 166): In its 2001 annual report, AT&T reports 1998 revenue to be $47,817 million
and 1998 net income to be $5,052 million. As a company acquires new businesses and sheds old
businesses (as AT&T has done many times), it retroactively goes back and restates its past financial
statements to reflect its results as if the current company, and its subsidiaries, had been a functioning
unit all along.
Net Work Exercise (p. 194): On March 8, 2002, the P/E ratios were as follows:
Coca-Cola 36.1
PepsiCo 34.8
General Motors 25.5
Ford n/a Ford had negative earnings in the most recent year.
Kmart n/a Kmart also had negative earnings in the most recent year.
Wal-Mart 36.9
SOLUTIONS TO BOXED ITEMS
Polluted Accounting (p. 180)
1. One might say that capitalizing the costs of certain expenditures does not affect the income
statement at all. After all, when an expenditure that has been paid in cash, for example, is
capitalized, only two asset accounts are involved. The effect on the income statement is detrimental
when the expenditure should have been recorded as an expense rather than as an asset. If an
expenditure properly classified as an expense is incorrectly recorded as an asset, income will be
overstated. This is illustrated with the following journal entries:
What was done: Asset.................................... xxx
Cash.............................. xxx
What should have been done: Expense............................... xxx
Cash.............................. xxx
2. Obviously, there is no straightforward answer to this question. The students should recognize the
potential ethical dilemmas they may face as they enter the accounting profession and the business
world.
3. Many independent auditors leave their audit firms to take employment with a client. In the vast
majority of these cases, everyone benefits. By auditing the firm for several years, the audit partner
has gained valuable knowledge regarding the workings of that business that could be very useful to
the client. However, care must be taken to ensure that an adequate control environment is in place
to guard against any one person or group of people being able to manipulate the accounting
records.
Phar-Mor and the World Basketball League (p. 182)

1. Inventory can either be sold or is on hand. If it is sold, it is disclosed on the income statement as
cost of goods sold. If the inventory is on hand, it is disclosed on the balance sheet. If the balance
sheet account is overstated, cost of goods sold is understated, resulting in an increase in net
income. Overstating receivables causes an overstatement of sales, resulting in an increase in net
income. As you can easily see, when these two frauds are combined, the effect on net income can
be substantial.
A number of reasons exist to explain why anyone would inflate reported income. Higher than
expected income can have a positive effect on stock price. It can have a positive effect on the
likelihood of raising additional capital or of obtaining loans. Higher net income, if tied to an
executive's compensation, will obviously benefit the executive as well.
2. The independent auditor has the responsibility of examining the financial statements of a company
and determining whether the amounts included in the statements fairly present the company's
position as of a given date and the net income earned over a specified period. An auditor examines
many different kinds of evidence before an opinion can be rendered. The internal control structure of
the company, management's integrity, and the quality of the accounting system must be carefully
considered to determine the quantity and quality of evidence that must be gathered. Several of the
weaknesses mentioned in the description of Phar-Mor should probably have been discovered by the
auditor and the impact of the weaknesses on the financial statements considered. Vendor
confirmations, surprise inventory observations, analytical reviews, review of large cash
disbursements, and other such procedures should have raised sufficient questions for the auditor to
uncover the massive misstatements that were subsequently uncovered. Auditors are held
responsible for exercising due care in performing their duty to render audit opinions on financial
statements. If they fail to perform that duty carefully, they are, and should, be subject to the litigation
being brought against them. Many times fraudulent activities are very difficult to uncover by the
auditor if extensive management collusion exists.
3. Auditors are being encouraged to become very familiar with not only the company being audited but
also the key financial players in a company and any outside activities that might reflect on the
company being audited. Auditors should become familiar with the industry and the financial climate
in which the client is operating and be alert to any information that might suggest a conflict of
interest on the part of management. Such information may be found in financial magazines and
newspapers, discussions with other auditors and with company personnel, television and radio
broadcasts, and so on. The significant amount of litigation against CPA firms has created an
increased awareness of care on the part of all auditors. Auditors must keep their ears and eyes
open to anything that might suggest a problem in the financial reporting.
COMPETENCY ENHANCEMENT OPPORTUNITIES
Deciphering 4–1 (The Walt Disney Company)
1. In 2001, Disney had two below-the-line items. Both were cumulative effects of changes in accounting
principle. One change, resulting in a negative cumulative effect of $228 million, resulted from the
application of AICPA SOP 00-2 on the accounting for film revenues and costs. The other change,
resulting in a negative cumulative effect of $50 million, resulted from the adoption of SFAS No. 133
on derivative accounting.
2. There were three major reasons for the large decrease in net income from 2000 to 2001. The first
two reasons are the negative cumulative effects described in part (1). The third factor is the $1,454
million restructuring and impairment charge reported in 2001.
3. Disney reported a net loss of $158 million in 2001. If all of the income statement items reported in
2001 are viewed as permanent aspects of Disney’s operations, then a loss of $158 million is a good
first guess in terms of forecasting 2002 net income. However, the three items discussed in part (2)
causing the decline in Disney’s 2001 income are all one-time items that will probably not be repeated
in 2002. Thus, in forecasting 2002 net income we should add back the $228 million and the $50
million cumulative effects of changes in accounting principle. In addition, the $1,454 million
restructuring and impairment charge is (hopefully) an item that will not be repeated in 2002. This item
is reported before income taxes because it is an above-the-line item. In Note 6 to the financial
statements, we learn that Disney’s income tax rate if 42.5% (federal plus state), so the after-tax
amount of the restructuring charge is $836 million [$1,454 × (1  0.425)]. A first estimate of 2002 net
income is then computed as follows:
Net loss reported in 2001 (in millions) $(158)
Add: Film accounting cumulative effect 228
Derivative accounting cumulative effect 50
After-tax amount of restructuring charge 836
Initial estimate of 2002 net income $ 956
Interestingly, this forecast of 2002 net income is almost the same as was reported net income in
2000, suggesting that the reported results in 2001 differed from 2000 only because of the one-time
items.
4. During the Internet stock bubble, P/E ratios for Internet stocks were often over 100. To take
advantage of this, Disney separated its Internet Group and issued shares of stock having ownership
rights to the future income to be generated by the Internet Group. By doing this, Disney hoped to
make its Internet operations more visible to the market; if the results were merely lumped in with the
overall corporate results, the market might not value the Internet-related income with the high P/E
multiples given to other Internet stocks. Of course, after the collapse of the Internet stock bubble in
2000 and 2001, there was no longer any advantage to be gained by having a separately traded
Internet Group stock.
5. At the bottom of its statement of stockholders’ equity, Disney provides a brief statement of
comprehensive income. For 2001, comprehensive income was a negative $120 million, computed as
follows:
Net loss (in millions) $(158)

Cumulative effect of adopting SFAS No. 133 (accounting for derivatives) 60
Foreign currency translation, and other (22)
Comprehensive income $(120)
6. In Note 11 to the financial statements, we learn that the media networks segment had both the
highest reported revenue ($9,569 million) and the highest operating income ($1,758 million). The
parks and resorts segment had the highest operating profit margin; the operating profit margins for
the four segments are as follows:
Media networks 18.4%
Parks and resorts 22.6
Studio entertainment 4.3
Consumer products 15.5
7. In Note 11 relating to segments, Disney discloses that 83% ($20,970/$25,269) of its revenues
originate in the United States and Canada.
8. Note 1 details the company's revenue recognition policies. “Broadcast advertising revenues are
recognized when commercials are aired. … Revenues from advance theme park ticket sales are
recognized when the tickets are used.”
9. In Note 1, Disney reports that “Film and television production and participation costs are expensed
based on the ratio of the current period's gross revenues to estimated total gross revenues from all
sources on an individual production basis.” From this note, we can conclude that Disney uses a
method of systematic and rational allocation.
10. Parks, resorts, and other properties are expensed on a straight-line basis over a time period ranging
from 3 to 50 years.
Deciphering 4–2 (Pfizer)

1.
2001 2000 1999

a. Net income/Revenues 24.1% 12.7% 18.2%
b. Cost of sales/Revenues 15.6 17.1 20.5
c. Research and development expenses/Revenues 15.0 15.1 14.9
d. Advertising expense/Revenues 8.9 10.8 11.3
2. The most interesting trend in the numbers computed in part (1) is the steady research and
development expense as a percentage of revenues. Because research is the lifeblood of its business,
it appears that Pfizer has decided to plow 15% of revenues each year back into research. The
numbers also show the very high profit margins in the pharmaceutical industry; cost of sales as a
percentage of revenues is less than 20% in the two most recent years. Of course, this is balanced by
the high expenditure for research and development (which is good from the standpoint of society) and
for advertising (which does not necessarily add value to society as a whole).
3.
2001 2000 1999

Provision for taxes on income 2,561 2,049 1,968
Income from continuing operations before provision for
taxes on income and minority interests 10,329 5,781 6,945
24.8
Effective tax rate % 35.4% 28.3%
In the notes to the financial statements, Pfizer explains that more than one-half of its income from
continuing operations is earned outside the United States. This income is taxed at a lower rate than is
U.S. income.
4.
2001 2000 1999

Net income $7,788 $3,726 $4,952
Earnings per common share—basic $1.25 $0.60 $0.81
Average number of basic shares outstanding 6,230.4 6,210.0 6,113.6
Net income $7,788 $3,726 $4,952
Earnings per common share—diluted $1.22 $0.59 $0.78
Average number of diluted shares outstanding 6,383.6 6,315.3 6,348.7
5.
Net income $7,788 $3,726 $4,952
Currency translation adjustment (37) (458) (503)
Net unrealized gain (loss) on available-for-sale
securities (91) 37 111
Minimum pension liability (106) (49) (20)
Comprehensive income $7,554 $3,256 $4,540
Deciphering 4–3 (Wells Fargo & Company)

1. Financial statements for a financial institution are a lot different than those produced by a
manufacturing firm. Revenues and expenses are partitioned as to those relating to interest and
those not relating to interest.
2. Net interest income would probably be the term most closely related to the concept of gross profit. In
simple terms, a manufacturing business generates profits by selling a product at a price greater than
its cost—gross profit. A bank makes money by loaning money at a greater rate than it pays on
savings accounts—net interest income.
3.
2001 2000 1999
a. Total interest expense 6,741 7,860 5,818
Total interest income 19,201 18,725 15,934
Ratio 35.1% 42.0% 36.5%
b. Incentive compensation 1,195 846 643

Salaries 4,027 3,652 3,307
Ratio 29.7% 23.2% 19.4%
c. Employee benefits 960 989 901

Salaries 4,027 3,652 3,307
Ratio 23.8% 27.1% 27.2%
4. If you think of the relationship between total interest expense and total interest income as the
fundamental measure of operating profitability for a bank, then the performance of Wells Fargo
improved substantially in 2001 relative to 2000. In 2001, total interest expense was just 35.1% of
total interest income.
Because Wells Fargo’s income statement provides line-item detail about the different components of
employee compensation, we can see how big both incentive compensation and fringe benefits are
relative to base salaries. The year 2001 seems to have been a good one for Wells Fargo
employees; incentive compensation provided an extra 30% over and above salaries. In each year,
the cost of employee benefits was around one quarter of the amount of salaries that are paid.
5.
Interest expense on deposits 3,553
Average amount of deposits 178,413
Average interest rate 2.0%
Interest income on loans 14,461

Average loan balance 163,072
Average interest rate 8.9%
The cost of the money Wells Fargo gets from its depositors is only 2.0%, which is much less than
the 8.9% that Wells Fargo gets from lending this same money. This 6.9% interest rate spread must
be enough to cover all of the operating costs of the bank.
6. Price-earnings ratio: 2001—21.8 ($42.99/$1.97)

2000—23.1 ($53.90/$2.33)
1999—16.7 ($38.31/$2.29)
(Note: These P/E ratios are calculated using the diluted earnings per share numbers. Wells Fargo’s
P/E ratio increased substantially between 1999 and 2000. Fundamentally, a company’s P/E ratio
increases if investors have increased optimism about the chances of future earnings being high
relative to current earnings. The P/E ratio fell slightly in 2001.)
Deciphering 4–4 (The Reader's Digest Association, Inc.)

1. In 2001, Reader's Digest generated over 50% of its total operating profit and over 40% of its total
revenues from international businesses.
2. Operating profit/Revenues
2001 2000 1999
North America Books and Home 9.
Entertainment 9% 12.8% 6.7%
U.S. Magazines 11.8 15.4 17.3
International Businesses 10.6 10.3 2.3
New Business Development (30.9) (73.2) (14.6)
The U.S. Magazines segment has the highest profitability for each dollar of revenue in 2001 (and in
2000 and 1999 as well).
3. Revenues/Assets
2001 2000 1999
North America Books and Home
Entertainment 1.29 1.32 2.23
U.S. Magazines 3.43 3.96 2.02
New Business Development 0.80 2.50 1.55
The segment with the highest asset turnover, in 2001, is the U.S. Magazines segment.
4. Operating profit/Assets
2001 2000 1999
North America Books and Home
Entertainment 12.7% 16.8% 14.9%
U.S. Magazines 40.5 60.9 35.0
New Business Development (24.7) (182.8) (22.5)
Not surprisingly, the U.S. Magazines segment has the highest return on assets, a combination of
high profitability and high efficiency.
5. It would appear that Reader's Digest magazine is the most profitable of the four operating segments.
These computations understate the contribution of the magazine to overall company profits.
Remember that the primary method for selling books and home entertainment products is through
advertisements in Reader's Digest. Not only is the magazine very profitable itself, but it is also
because of the magazine that the other segments of the company are able to be successful.
Deciphering 4–5 (Ford Motor Company)

1. Ford partitions its revenues and expenses into those relating to the Automotive division and those
relating to the Financial Services division.
2.
2001 2000 1999
Cost of sales/Sales 98.2% 89.3% 88.1%
Clearly, it is almost mathematically impossible to report an overall profit when cost of sales is equal
to 98.2% of sales, as it was in Ford’s Automotive division in 2001.
3. In 2001, sales in Ford’s Automotive division decreased 6.9% compared to 2000. However, both cost
of sales and selling, administrative, and other expenses increased during 2001. When the volume of
sales activity goes down, but the level of operating expenses does not decline proportionately, one
can conclude that some of the operating costs are fixed costs. The 2001 results suggest that many
of Ford’s Automotive costs are fixed costs.
4. The Automotive division manufacturers and sells vehicles. In this division, depreciation is a product
cost, accounted for as part of manufacturing overhead. Accordingly, the amount of Automotive
division depreciation is included in cost of sales.
5. Negative income tax expense can mean one of three things:
a. The company receives a rebate of taxes paid in the past two years. This is called a net
operating loss carryback.
b. If the amount of negative income tax expense is larger than the amount of income taxes paid in
the preceding two years, the excess is carried forward to reduce the amount of income taxes
paid in future years. This is called a net operating loss carryforward.
c. Some financial accounting expenses are not currently deductible for income tax purposes. One
example is a restructuring charge; generally the taxing authorities do not allow a deduction until
the restructuring costs are actually spent. In this case, a deferred tax asset is recorded (along
with a subtraction from income tax expense) to represent the future benefit that will arise when
this expense becomes deductible for income tax purposes.
These three tax-related items are covered at length in Chapter 16.
6. Ford reports the income from the discontinued operation and the loss on the disposal (or spinoff) in
separate lines. In the chapter, it was explained that these two items should be added together and
shown in one line. Also, Ford reports these amounts net of income taxes. In the chapter, it was
explained that the amount of income taxes associated with discontinued operations should be
reported in a separate line item. The presentation by Ford conforms with the standard presentation
used before the issuance of SFAS No. 144 in August 2001.
7. The year 2001 was a bad year for both the Automotive division and the Financial Services division.
Over the 3-year period, cumulative profits in the Financial Services division were greater than
cumulative profits in the Automotive division. As discussed in part (3), with the level of fixed costs in
the Automotive division, a decline in sales volume can lead to large losses.
8. This question should cause you to realize that Ford makes a great deal of profit from nonautomotive
sources. In fact, for the years 19992001, Ford made significantly more profit from financial
services. It is also interesting to note that prior to the 1980s, the Financial Services division of Ford
was virtually nonexistent.
Deciphering 4–6 (Coca-Cola)
1. In 2001, Coca-Cola’s net income ($3,969 million) was greater than its comprehensive income
($3,858 million).
2. There is a subtraction for foreign currency translation adjustments in the computation of Coca-Cola’s
2001 comprehensive income. This subtraction indicates that the U.S. dollar value of the equity of
these foreign subsidiaries declined during the year. Accordingly, during the year, these foreign
currencies weakened relative to the U.S. dollar.
3. Coca-Cola’s available-for-sale securities portfolio decreased in value during 2001, as evidenced by
the subtraction of an unrealized loss of $29 million in the computation of comprehensive income.
(Note: As explained in Chapter 14, the liquidation of a portion of the available-for-sale securities
portfolio during the year can make the interpretation of the overall unrealized gain or loss for the
year somewhat difficult.)
SAMPLE CPA EXAM QUESTION
The correct answer is c. The operating loss for the discontinued operation was $600,000 in 2005. No
disposal gains or losses were recognized in 2005. Accordingly, the net amount reported for discontinued
operations in 2005, after income taxes, is ($360,000) [($600,000) + income tax benefit of $240,000].
Hart’s net gain on the discontinued operation in 2006 was $850,000 ($900,000 disposal gain  $50,000
operating loss). After income taxes, the reported amount is $510,000.
Writing Assignment: What are the benefits of a restructuring charge?

The following points might be made in outlining the benefits of recognizing a restructuring charge.
Economic benefits
A big-bath restructuring charge is sometimes evidence that a company has decided to cut its losses and
deal decisively with a bad situation, rather than continue to put band-aids on a hopeless case. Thus, the
recognition of a big restructuring charge might be part of a campaign to convince investors that a
company is committed to changing past unproductive operating practices.
Financial reporting benefits

The rationale behind an accounting big bath is that the results in the restructuring year are going to be
rotten anyway, so why not estimate as many future expenses as possible and recognize them this year?
In this way, the reported results in the following years will look great for two reasons: (1) they will be
compared to the terrible restructuring year and (2) remaining expenses will be small because they were
estimated and recognized in the restructuring year.
Research Project: Reviewing actual income statements and associated notes.
A sample solution for this research exercise is given below using the 2001 financial statements of
McDonald’s.
1. The format of McDonald’s income statement is something between the pure single-step and
multiple-step statements illustrated in the chapter. Operating revenues and operating expenses are
grouped together, like a single-step statement. However, the overall format—with operating income,
then interest expense, then income taxes—follows the general multiple-step format.
2.
Percentage Increase Percentage Increase
from 2000 to 2001 from 1999 to 2000
Total revenues.............................................. 4.4% 7.4%
Net income................................................... (17.2) 1.5
McDonald’s net income for 2001 actually declined from the 2000 level. Revenue growth slowed
substantially in 2001.
3. McDonald’s does not disclose any details about its revenue recognition practice at its company-
owned restaurants. This is because these transactions, which are almost exclusively cash sales of
food items, are very straightforward. McDonald’s does describe its franchise arrangements in a note
to the financial statements. Franchise revenues are composed of initial fees, minimum rentals, and
percentage fees based on franchisee sales.
4. During the years 1999, 2000, and 2001, McDonald’s had no below-the-line items.
The Debate: Net income or operating cash flow?
Cash Flow Is King!

 As any introductory accounting student can attest, the notion of “accrual” is a difficult one to grasp. It
is unlikely that most financial statement users understand exactly what accrual-based income is. On
the other hand, everyone understands the difference between cash generated and cash consumed
by operating activities.
 Bills are paid with cash, not with “accruals.” Financial statement users are most interested in a
company’s cash flow.
 Operating cash flow is less subject to manipulation by managers trying to massage reported results.
 Theoretically, a company is worth the discounted present value of the future cash flows to be
generated by the company. Accordingly, performance reporting should focus on cash flows.
Accountants Add Value!

 Accountants have worked for literally hundreds of years to refine their accrual adjustments in order to
make net income a useful measure of economic activity. Academic research supports the claim that
accrual-basis income appears to be the best measure of a company’s economic performance.
 Because accrual-basis income is not tied to the timing of cash receipts and cash disbursements, it
gives a better overall view of the economic activity of a company. As such, accrual-basis income
provides a better foundation with which to forecast future activity, including future cash flows.
Ethical Dilemma
1. If Dwight revises the income statement to achieve the 5% increase in net income and uses biased
information to do so, he will be presenting information that has little representational faithfulness.
That is, the information will not represent an honest and accurate reflection of the performance of
the company.
Another risk to Dwight is that if the company goes public and people invest in the company based on
the financial statements produced by Dwight, those investors may have recourse to the company
and Dwight if they should lose money.
If Dwight were to give in this time and revise the income statement to meet the requested “goals” of
management, Dwight may find himself being asked to revise the income statement each period.
This may not be a one-time issue.
2. If Dwight does not revise the financial statements and cannot convince the members of the board of
directors of the validity of his reasons for not doing so, he may find himself out of a job. What Dwight
needs to consider is how attractive it will be to continue to work in an organization where he is
expected to manage earnings.
Cumulative Spreadsheet Analysis

See Cumulative Spreadsheet Analysis solutions CD-ROM, provided with this manual.
Internet Search
Both the Fortune and Forbes lists for 2002 (using 2001 data) indicated that the company with the highest
profit was ExxonMobil. Fortune reported the amount of ExxonMobil profit for 2001 to be $15,320 million;
Forbes reported 2001 ExxonMobil profit to be $15,105 million. The 2001 income statement of ExxonMobil
indicates the following:
Income before extraordinary item $15,105

Extraordinary gain, net of tax 215
Net income $15,320
Apparently, Fortune uses bottom-line net income in doing its profit ranking, whereas Forbes excludes
below-the-line items in doing its ranking. The procedure used by Forbes is the better one because the
whole point of reporting items below the line is that they are not indicative of the company’s core
operating performance for the year.

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CHAPTER 4

PRACTICE 41 FINANCIAL CAPITAL MAINTENANCE

Net assets, end of period $345,000

PRACTICE 42 PHYSICAL CAPITAL MAINTENANCE

Net assets, end of period $345,000

PRACTICE 43 COMPUTATION OF INCOME USING MATCHING

Revenue ($150,000 + $91,000) $241,000

PRACTICE 44 REVENUE RECOGNITION

Cash Collected Amount of

Total revenue to be recognized this year $170,000

PRACTICE 46 SINGLE-STEP INCOME STATEMENT

Income tax expense 1,200

PRACTICE 47 MULTIPLE-STEP INCOME STATEMENT

PRACTICE 48 COMPUTATION OF GROSS PROFIT

Gross profit/Sales = $3,703.9/$9,488.8 = 39.0%

Operating income/Sales = $1,014.3/$9,488.8 = 10.7%

PRACTICE 410 COMPUTATION OF INCOME FROM CONTINUING OPERATIONS

PRACTICE 411 COMPUTATION OF INCOME FROM DISCONTINUED OPERATIONS

PRACTICE 413 GAINS AND LOSSES ON EXTRAORDINARY ITEMS

PRACTICE 414 CUMULATIVE EFFECT OF A CHANGE IN ACCOUNTING PRINCIPLE

2005 2004 2003

Cumulative effect = [($400 + $600) – ($1,500 + $1,200)] = ($1,700)

Original depreciation = $100,000/20 years = $5,000 per year

Revised depreciation = Remaining depreciable book value/Remaining life

PRACTICE 416 RETURN ON SALES

Return on sales = Net income/Sales = $200/$13,000 = 1.5%

PRACTICE 417 EARNINGS PER SHARE

2005 2004 2003

Earnings per share $4.00 $3.00 $2.50

Percentage increase in 2004: ($3.00  $2.50)/$2.50 = 20%

PRACTICE 418 PRICE-EARNINGS (P/E) RATIO

PRACTICE 419 COMPREHENSIVE INCOME

Income from continuing operations $ 11,000

Net income $ 9,600

PRACTICE 421 FORECASTED INCOME STATEMENT

(b) If Garrison Manufacturing were reporting using the accounting

(d) Prior-period adjustment (error correction); retained earnings adjustment.

The Pensacola Awning Company

Accounts payable.......................... $ 100 $ 150 50% natural increase

Income statement—time of sale:

Delaney Manufacturing Inc.

(a) $75,000  0.30 = $22,500; $75,000 – $22,500 = $52,500

Radiant Cosmetics Inc.

(b) Cash payments.................................................................. $ 96,350

Earnings per common share:

Sunset Cosmetics Inc.

Before preparing the statement of comprehensive income, net income must be

Revenues and gains:

Accounts payable.................................... $ 100 $ 120 20% natural increase

Sales.......................................................... $1,000 $1,200 given, item (a)

Discussion Case 4–53

Discussion Case 4–54

Discussion Case 4–55

Discussion Case 4–56

Discussion Case 4–57

Discussion Case 4–58

Discussion Case 4–60

Discussion Case 4–61

Discussion Case 4–63