FAR Summary Notes

REVIEW OF THE ACCOUNTING CYCLE

1. The accounting system generates a variety of reports for use by various decision-makers. Among the
most common are general-purpose financial statements, management reports, tax returns, and other
reports prepared for government agencies such as the SEC.

2. A manual and an automated accounting system are similar in that both are designed to serve the
same information-gathering and processing functions. Both systems also use the same underlying
accounting concepts and principles.

The differences between a manual and an automated accounting system involve some mechanical
aspects, time requirements, and the appearance of records and reports. Due to advanced technology
and reduced prices, today, almost all successful businesses of any size use computers to assist in the
various accounting functions.

3. The accounting process involves specific procedures used by businesses to produce financial
statement data.

The recording phase of the accounting process consists of those procedures used in the continuing
activity of analyzing, recording, and classifying business transactions in the various books of record
(journals and ledgers) during the fiscal period.

The reporting phase of the accounting process consists of those procedures used at the end of the
fiscal period to update and summarize data collected during the recording phase. Financial
statements are prepared from the updated and summarized data.

4. The accounting process includes the following steps:

(1) Business documents are analyzed. Business documents provide detailed information concerning
each transaction and establish support for the data recorded in the books of original entry.

(2) Transactions are recorded in chronological order in books of original entry -the journals.
Transactions are analyzed in terms of their effects on the various asset, liability, owners’ equity,
revenue, and expense accounts of the business unit.

(3) Transactions are posted to the appropriate accounts in the general and subsidiary ledgers. The
ledger accounts classify and summarize the full effect of all transactions recorded in the journals
and can be used in the preparation of financial statements.

(4) A trial balance may be prepared, showing the account balances in the general ledger and
reconciling subsidiary ledger balances with respective control account balances. The trial
balance provides a summary of the information as classified and summarized in the ledgers as
well as a verification of the accuracy of recording and posting.
 (5) Adjustments are made to bring the accounts up to date. Adjustments are necessary to record all
accounting information that has not yet been recorded and to recognize all revenues and
expenses on an accrual basis properly. If a worksheet is used (an optional step in the cycle),
adjustments may be journalized and posted any time before closing. If statements are prepared
directly from ledger balances, however, changes must be recorded at this point.

(6) Financial statements are prepared. Financial statements report the results of operations and cash
flows for a while and show the financial condition of the business unit as of a specific date.

(7) Closing entries are journalized and posted. Balances in nominal accounts are closed into
Retained Earnings. Operating results, as determined in the summary accounts, are finally
transferred to Retained Earnings.

(8) A post-closing trial balance may be prepared as an optional step in the

Cycle. A post-closing trial balance is prepared to check the equality of the debits and credits
after posting the adjusting and closing entries.

The steps in the accounting process are necessary to transform transaction data into useful
information, as summarized in the financial statements and other accounting reports. Some levels are
optional, such as preparing a trial balance and preparing a post-closing trial balance. These steps help
verify or facilitate the accounting process but are not essential.

5. Under double-entry accounting, assets, expenses, and dividends are increased by debits and
decreased by credits. Liabilities, owners’ equity accounts, and revenues are increased by credits and
decreased by debits.

6. a. Real accounts are balance sheet accounts not closed to a zero balance in the closing process.
Nominal accounts are income statements or temporary owners’ equity accounts closed out in the
process of arriving at the net increase or decrease in owners’ equity for a period.

b. A general journal is the most flexible book of original entry. It may be used to record all
business transactions or merely those that cannot be recorded in one of the individual journals.

Specialized journals are designed to facilitate the recording of some particular type of frequently
occurring transaction, such as sales, purchases, cash receipts, and cash disbursements.

c. The general ledger carries summaries of all accounts appearing on the financial statements.

Subsidiary ledgers afford additional detail in support of individual general ledger balances.
Thus, accounts payable appear in total in the public accounting, but own reports with each
creditor are provided in the accounts payable subsidiary ledger.

7. a. Adjusting entries are made at the end of an accounting period to update balance sheet accounts
and to record accrued expenses and accrued revenues.
 Frequently, adjusting entries are first made on a worksheet and then are recorded in the general
journal from which they are posted to the ledger accounts.

b. Closing entries are made after the adjusting entries have been posted. They transfer all nominal
account balances to Retained Earnings.

8. The company accountant is disregarding the periodic summary process and jeopardizing the
company’s audit trail by not entering the adjusting entries in the general journal. Adjusting entries
are made at the end of the period to bring accounts up to date. These entries must be entered first in
the general journal and then posted directly to the public ledger. If the adjusting entries are not
entered first in the general journal, the journals will be incomplete and will not provide the support
necessary for an adequate accounting system.

9. Examples of contra accounts include Allowance for Bad Debts, Accumulated Depreciation, Discount
on Notes Receivable, Discount on Notes Payable, and Discount on Bonds Payable.

Contra accounts are subtracted from related accounts. Hence, they are sometimes referred to as offset
accounts. Contra accounts are used to adjust accounts when the original balance needs to be
preserved.

For example, adequate disclosure in financial reports requires disclosure of both the original cost and
the depreciated cost of assets. A contra account, Accumulated Depreciation, is used for this purpose.

11. A worksheet is a multicolumn form designed to facilitate the summarization and organization of
accounting data needed to prepare the financial statements. The number of columns and the headings
used may vary, depending on the needs of a particular business. While the worksheet is an optional
step in the accounting process, it is a valuable aid in completing the trial balance and adjustment
procedures.

12. When a worksheet is used as a basis for statement preparation, the adjustments can be formally
recorded in the journals and posted to the ledger accounts at any time before closing the books.
However, if a worksheet is not used, financial statements must be prepared directly from the reports;
thus, the adjustments must be recorded and posted before statement preparation.

13. Only the following accounts would be closed, generally with the following debit/credit entries:
Rent Expense ................. Credit
Depreciation Expense ..... Credit
Sales .............................. Debit
Interest Revenue ............. Debit
Advertising Expense....... Credit
Dividends ....................... Credit

14. Accrual accounting recognizes revenues and expenses when they are earned and incurred, not
necessarily when cash is received or paid.
 Cash-basis accounting recognizes revenues and expenses as cash is received or disbursed, regardless
of the earnings process or the matching concept. Generally accepted accounting principles require
the use of accrual accounting.

15. The use of double-entry accrual accounting is more accurate than a cash-basis accounting system
primarily because

(a) The likelihood of errors and omissions is significantly increased in the absence
Of double-entry analysis and a trial balance to test the accuracy of the analysis and recording
process.

(b) Recording events under an accrual system as they occur more accurately reflects the effects and
timing of an event than does a system that records the events when cash is received or paid,
regardless of the earnings process and the matching concept.
BALANCE SHEET & NOTES TO FS

1. Three elements are contained in a balance sheet: assets, liabilities, and equity. These elements
measure the worth of an enterprise at a given point in time. The balance sheet thus reports what
resources an enterprise has and who has a claim against those resources. Two other elements,
investments by owners and distribution to owners, are related to the equity element. Information
concerning the change in equity is often contained in a separate statement that supplements the
balance sheet.

2. To meet the definition of an asset, an item need not be associated with certain future benefits. To
acknowledge the uncertainty inherent in the business, the definition of an asset stipulates that the
future benefit needs be only probable.

3. Some liabilities, such as accounts payable and long-term debt, are denominated in precise monetary
terms. However, the amounts of many liabilities must be estimated based on expectations about
future events.

4. The difference between current assets and current liabilities, referred to as working capital, is a
commonly used measure of the liquidity of an enterprise. It helps to determine whether the company
will be able to meet its current debt with available assets and continue normal operations.

5. a. Assets are classified as current if

(1) the asset will be realized in cash during the normal operating cycle of the business or one
year, whichever is longer, or

(2) the asset will be sold or consumed within a normal operating cycle or one year, whichever is
longer.

b. Liabilities are classified as current if liquidation of the liability is expected to require

(1) the use of current assets or

(2) the creation of other current

liabilities.

6. a. Cash is classified as noncurrent when it is a part of a fund that will be used to discharge
noncurrent obligations. Such funds include bond retirement funds, pension funds, and preferred
stock redemption funds. Cash to be used for the acquisition of land, buildings, and equipment or
cash received on long-term deposits from customers would also be reported as noncurrent.

b. Receivables not reportable as current assets include those arising from unusual transactions, such
as the sale of land, buildings, and equipment or advances to affiliates or employees that would
not be collectible within 12 months.
7. If a short-term loan is expected to be refinanced or paid back with the proceeds of a replacement
loan, the existing short-term loan is not classified as current. This is true as long as the intent of the
company is to refinance the loan on a long-term basis, and the company’s plan is evidenced by an
actual refinancing after the balance sheet date or by the existence of an explicit refinancing
agreement.

8. a. A subjective acceleration clause is a provision in a debt instrument that specifies some general
conditions permitting a lender to accelerate the due date unilaterally.

b. An objective acceleration clause is a provision in a debt instrument that specifies conditions that
can cause the debt to be immediately callable, for example, failure to earn a positive return on
the assets or to make an interest payment.

c. If a noncurrent debt instrument contains a subjective acceleration clause and the invoking of the
clause is deemed probable, the liability should be classified as current. If invoking of the clause
is considered to be reasonably possible but not likely, the obligation should continue to be
reported as a noncurrent liability with a note to describe the contingency. If a debt instrument
contains an objective acceleration clause and the conditions that trigger the call have occurred,
the debt should be classified as current.

Exceptions are that

(1) the creditor has waived the right to demand payment for a period that extends beyond the
debtor’s normal operating cycle or

(2) the debtor has cured the deficiency after the balance sheet date, but before the statements are
issued, and the debt is not callable for a period that extends beyond the debtor’s normal
operating cycle.

9. Contingent liabilities could or could not give rise to actual obligations; estimated liabilities are
known to exist, but the amount is not known. A company could, for example, win or lose a lawsuit,
but it is liable for income tax. The exact amount of the income tax is unknown until the final tax
return is completed. The tax liability could have to be estimated at the time financial statements are
prepared.

10. With a proprietorship, the owner’s equity is reported with a single capital account. In a partnership,
separate capital accounts are established for each partner. In a corporation, a distinction is made
between contributed capital and retained earnings.

11. The three major categories in a corporation's equity section are

(a) Contributed capital, including both capital stock at par and additional paid-in capital

(b) Retained earnings

 (c) Other equity, such as treasury stock, unrealized gains and losses on
Available-for-sale securities, foreign currency translation adjustments, and unrealized gains and
losses on derivatives.
12. Offset balances are used to adjust the gross amount of balance sheet items to arrive at proper
valuations. For example, allowance for bad debts is correctly offset against the gross amount of
accounts receivable to show the net amount estimated collectible. It is generally not proper to offset
an asset account against a liability or owners’ equity account because such an offset would not be to
value either account correctly but rather to condense financial data at the expense of adequate
disclosure.

13. Assets are usually presented in the order of their liquidity, with the most liquid items listed first.

14. Financial ratios are mathematical relationships between financial statement amounts. For example,
return on equity is net income divided by owners' equity.

15. The asset turnover ratio (total sales divided by total assets) is a measure of the number of dollars of
sales generated by each dollar of assets. The higher the asset turnover ratio, the more efficient the
company is in using its assets to generate sales.

16. Return on equity is an indicator of the overall performance of a company. Return on equity measures
the percentage return on the stockholders' investment and is computed as net income divided by total
equity.
17. There are at least four types of notes used by management to support the financial statements and
provide users with additional relevant information. They can be classified as follows:
(a) Summary of significant accounting
policies

(b) Additional information, both numerical and descriptive, to support summary

totals included in the financial statements

(c) Information about items that do not meet the recognition criteria but that is still useful to
decision-makers

18. Separate supplementary information or schedules may be included to disclose

segment information; details about property, plant, and equipment and short-term borrowing; and
trend data for periods beyond those included in the basic statements.
19. If a subsequent event provides additional information about items included in the financial
statements, especially those whose value has been estimated, the new information should be used to
make adjustments to the amounts in the statements. The event itself does not change the value but
merely provides additional information about conditions that existed at the balance sheet date. For
example, the filing of a bankruptcy petition by a significant customer provides other data concerning
the collectibility of accounts receivable. The conditions that led to the bankruptcy were probably
present at the balance sheet date but may not have been known to the preparer of the statements until
the bankruptcy filing took place. Under these circumstances, Allowance for Bad Debts may need
 adjustment to reflect the net realizable value of receivables accurately.

21. Many assets are reported at historical cost, which is usually less than market value, and other assets
(such as homegrown goodwill) are not included in the balance sheet at all. Accordingly, the balance
sheet numbers are often a feeble reflection of what a company is worth. Typically, a going concern is
worth significantly more than the reported book value of equity.
INCOME STATEMENT

1. The objective of financial reporting is to provide useful information for users of the financial
statements. The relevant information for decision making is future data, especially information
dealing with cash flows. The primary financial statements reflect economic transactions and events
that have taken place. The past is used to help project the future. Income, however, is only one of
many sources of cash flow. The balance sheet and statement of cash flows also furnish relevant
information upon which the investor may project other future cash flows. In summary, the income
statement contains only some of the information that is relevant for making economic decisions.

2. Two approaches can be used to measure income: the capital maintenance approach and the
transaction approach. The capital maintenance approach uses the balance sheet elements to
determine the change in total equity after eliminating any investments and withdrawals of resources
by owners. The transaction approach determines income by analyzing individual transactions and
events and their effect on related assets, liabilities, and owners’ equity. Although the method of
determining income differs, both approaches arrive at the same total income figure if the same
attributes and measurements are used. However, the transaction approach produces more detail as to
the composition of income than does the capital maintenance approach.

3. Measurement methods that could be applied to net assets in the capital maintenance approach to
income determination are as follows:
(a) The historical cost of net assets acquired in exchange transactions, reduced by an allowance for
their use.

(b) The historical cost of net assets acquired in exchange transactions, reduced by an allowance for
their use and adjusted for a change in price levels since original acquisition.

(c) The current value of net assets acquired in exchange transactions as determined by either their
replacement or market values.

(d) Some variation of the above (a through c) but including in assets all resources and claims to
support, not just those acquired in exchange transactions.

4. The objectives of reporting income for

income tax purposes and for financial reporting to users are not the same. Those formulating income
tax laws are usually concerned with fairness among taxpayers and with their ability to pay taxes.
Users, on the other hand, are concerned with a measure that distinguishes between a return on
investment and a return of investment. They want a measure that matches expenses against
recognized revenue. In most cases, the same accounting method can be used for both purposes. This
will reduce both the cost and the confusion of using more than one accounting method for the same
transaction. In some cases, however, the generally accepted accounting method is different from that
required by income tax regulations. This results in a temporary difference between the tax return and
the books and gives rise to interperiod income tax allocation.

5. Revenues and expenses are related to the ongoing major or central activities of a business and are
reported at gross amounts. Gains and losses are associated with peripheral and incidental
transactions and events and are reported as the difference between the selling price and the book
 value (often the depreciated cost). These classification and display distinctions will depend on the
specific circumstances and activities of an enterprise.

6. The following two factors must be considered when deciding at what point revenues and gains
should be recognized: (a) The resources from the transaction are either already realized in cash or
claims to cash or are readily realizable in cash, and (b) the revenues and gains have been earned
through substantial completion of clearly identified tasks and activities. Both factors are usually met
when merchandise is delivered, or services are rendered to customers. This is referred to as the point
of sale.

7. Three expense recognition principles are applied in matching costs with revenues:
(a) Direct matching -costs are associated directly with specific revenues and recognized as expenses
of the period in which the revenues are recognized.

(b) Systematic and rational allocation -when costs cannot be associated directly with specific
revenues, costs are associated systematically and rationally with the periods or products
benefited.

(c) Immediate recognition - those costs that cannot be related to revenues either by direct matching
or by systematic and rational allocation must be recognized as expenses of the current period.

10. The multiple-step income statement can contain too much information that might be confusing to the
reader and require excess time to evaluate. The detailed listing of purchases and inventory might best
be displayed in a supplementary schedule.

The single-step income statement can be too brief. Information required for investment decisions is
sometimes presented in supporting schedules or not reported. Because of these factors, the statement
could also be confusing, and valuable time could be lost by the statement reader in seeking
additional information.

11. The major sections that may be included in a multiple-step income statement may be divided into
two categories: (a) income from continuing operations, separated into six sections, and (b) irregular
or extraordinary items, separated into two sections. The sections of income from continuing
operations are
1. Revenue from net sales
2. Cost of goods sold
3. Operating expenses
4. Other revenues and gains
5. Other expenses and losses
6. Income taxes on continuing operations
The sections of irregular or extraordinary items are
7. Discontinued operations
8. Extraordinary items

12. A restructuring charge is a loss that arises when a company proposes a restructuring of its operations.
The charge is composed of the decline in value associated with assets that no longer fit in the
company’s strategic plans. The charge also includes the additional costs related to the termination or
relocation of employees. Restructuring charges are controversial because companies exercise
considerable discretion in determining the amount of a restructuring charge and thus can use
restructuring charges as a tool for manipulating the amount of reported net income.
13. Intraperiod income tax allocation involves the separation of income tax expense between income
from continuing operations and transitory, irregular, or extraordinary items. Under this concept, each
section of the transitory, irregular, or exceptional items category is reported net of its income tax
effect.

14. a. The effects of a change in accounting principle that is applied to prior periods are disclosed in
the financial statements as a direct adjustment to beginning retained earnings of the earliest year
reported. The financial statements are prepared using the new accounting principle for all years
being presented.

b. The effect of a change in accounting estimate is disclosed entirely in the current period or 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.

15. Under IAS 8, the cumulative effect of a change in accounting principle is reported as a direct
adjustment to beginning retained earnings of the earliest year reported.

16. Generally accepted accounting principles require entities to report earnings-per-share information for
income from continuing operations and each section of the transitory, irregular, or extraordinary
items category of an income statement. The computation is made by dividing the income or loss
from each of these sections by the weighted average number of common shares outstanding during
the reporting period. If a potential dilution of earnings exists due to the existence of convertible
securities, stock options, or stock warrants, additional earnings-per-share information must also be
presented.

17. “Comprehensive income is the change in equity of a business enterprise during a period from
transactions and other events and circumstances from nonowner sources. It includes all changes in
equity during a period except those resulting from investments by owners and distributions to
owners.” Net income is the reported income as required by GAAP. Currently, GAAP does not
require all components of comprehensive income to be disclosed in the income statement. For
example, it does not include the effect of error corrections, asset valuation changes, or some effects
of accounting changes.

18. The starting point for the preparation of forecasted financial statements is the forecast of sales.

19. In forecasting depreciation expense, one first must predict how much property, plant, and equipment
will be needed in the future. This amount is then used, along with an assumption about how rapidly
the plant and equipment will depreciate, to estimate future depreciation expense.
STATEMENT OF CASH FLOWS

1. Cash flow from operations can offer a clearer picture of a company's performance than does net
income when:
• A company reports large noncash
expenses, such as write-offs, depreciation, and provisions for future obligations. Earnings may
give an overly
pessimistic view of the firm.

• A company is multiplying. Reported earnings may be positive, but operations are consuming
rather than generating cash.

• A company badly needs to report favorable earnings, as is the case before a significant loan
application or before a stock offering. In these cases, cash flow from operations provides an
excellent reality check for reported earnings.

2. To qualify as a cash equivalent when preparing a statement of cash flows, an item must be
(a) readily convertible to cash, and

(b) so near its maturity that there is an insignificant risk of changes in value due to changes in
interest rates.

As a general rule, only investments with original maturities of 3 months or less qualify. The original
maturity is determined from the date of acquisition of the investment by the entity, not the date of the
original issuance of the security.

3. Operating activities include those transactions and events that enter into the determination of net
income. Cash receipts from selling goods or from providing services are the significant cash inflow
for most businesses. Major cash outflows include payments to purchase inventory and to pay wages,
taxes, interest, utilities, rent, and similar expenses.

Investing activities are the purchase and sale of land, buildings, and equipment, and the purchase and
sale of financial instruments not intended for trading purposes.

Financing activities include transactions and events whereby cash is obtained from or repaid to
owners (equity financing) and creditors (debt financing).

4. The normal pattern of cash flow is

• Operating - positive
• Investing - negative
• Financing - either positive or negative

5. The direct method reports all operating cash receipts and cash payments. The difference between
cash receipts and payments is the net cash flow from operations. The indirect method begins with net
income as reported on the income statement, adjusts for any noncash items (such as depreciation),
 and converts the accrual amounts to a cash basis. The result of this reconciliation process is net cash
flow from operations, which will be the same amount as derived using the direct method.

6. Many users favor the direct method because it is a straightforward approach that is easy to
understand. Most accountants prefer the indirect method because it is easy to apply and because it
helps explain or reconcile the differences between net cash flow from operations and net income.
Because accountants already have to report net income, it is easier for them to start with that number
and convert it to net cash flow from operations rather than use the direct method.

7. When the direct method is used, depreciation expense is omitted from the calculation of cash from
operating activities because it is a noncash expense. When the indirect method is used, depreciation
expense is added back to net income because depreciation was subtracted in the original computation
of net income.

8. The statement, “Cash flow is equal to net income plus depreciation,” is wrong because it ignores the
impact on cash from operating activities of all the changes in current operating assets and current
operating liabilities.

9. The “target number” is the net change in the cash balance, as shown in the balance sheet. The sum of
cash from operating,
investing, and financing activities should equal the net change in cash.

10. The cost of goods sold, combined with the change in the inventory balance, reveals how much
inventory was purchased during the year. Inventory purchases, coupled with the change in the
accounts payable balance for the year, are used to calculate the amount of cash paid for inventory
purchases.

11. A loss on the sale of a long-term asset is omitted from the calculation of cash from operating
activities when using the direct method. When the indirect method is used, the loss is added back to
net income
because the loss was subtracted in the original computation of net income. In both cases, any effects
of the sale of the long-term asset are removed from the computation of operating cash flow; cash
received from the sale of long-term assets is reported as an investing activity.

12. If the direct method is used, a separate schedule must be presented to reconcile net income to net
cash provided by (used in) operating activities. If a company elects to use the indirect method, the
amounts paid during the period for interest and income taxes should be disclosed. Regardless of the
method used for reporting operating cash flows, companies must disclose any significant noncash
investing and financing transactions.

13. Significant noncash investing and financing transactions (e.g., the purchase of land by issuing capital
stock) are to be reported in the notes to the financial statements or in a separate schedule
accompanying the cash flow statement. Because these transactions do not affect cash, they should
not be reported on the statement of cash flows itself.
14. Cash from operations is usually larger than net income. This is because of the large number of noncash
expenses included in the income statement, such as depreciation, write-downs, and restructuring
charges.

15. When the value of a company’s cash flow adequacy ratio is less than 1.0, that company is not
generating enough cash from operations to pay for all new plant and equipment purchases.
Accordingly, the company has no cash left over to repay loans or to distribute to investors.

16. The income statement details the transactions that occurred in temporary accounts that are
summarized in the Retained Earnings account. The statement of cash flows provides information
relating to transactions that occurred in the cash account for the period.

17. A forecasted statement of cash flows allows management to see the relationship between forecasted
operating cash flow and the cash needed for investing activities. If there is an expected shortfall in
available cash, a company can either use the forecasted information in obtaining additional
financing, or the company can scale back its expansion plans to reduce the drain on cash.

18. Lenders can use a forecasted statement of cash flows to see whether it seems likely that a company
can continue to meet its existing debt obligations. An investor can use the projected cash flow
statement to evaluate the likelihood that a company will be able to continue making dividend
payments.
CASH

1. Cash, because it is the standard medium of exchange, is required to complete almost all business
transactions. Therefore, a certain amount of cash must be kept immediately available for daily
transactions. It is management’s responsibility to see that sufficient cash, but not an excessive
amount, is available for current operating purposes. To be productive, any excess of “idle cash”
should be invested in temporary or long-term investments.
2. The compensating balance is
Legally restricted, the balance should be segregated and reported separately among the Cash Items in
the current or noncurrent asset section of the balance sheet, depending on the nature of the
restrictions. This will protect financial statement readers from assuming that the total cash balance is
available to pay current obligations.

3. (a) Differences between depositor and bank balances typically arise from the following:
(1) Deposits in transit
(2) Outstanding checks
(3) Bank service charges
(4) Not-sufficient-funds checks
(5) Direct collection by bank of amounts owed to depositor
(6) Recording errors by the depositor or the bank
(b) Items (3), (4), and (5) require entries on the depositor’s books, as well as item (6) if the error
was made by the depositor.
RECEIVABLES

1. (a) A receivable evidenced by a formal, written promise to pay is classified as a note receivable; an
informal, unsecured promise to pay is classified as an account receivable or other appropriate
titles (e.g., advances to officers).

(b) Receivables arising from the normal operating activities of a business are classified as trade
receivables; those from all other sources are nontrade
receivables.

(c) All trade receivables and those nontrade receivables expected to be collected within one year (or
the normal
Operating cycle, whichever is longer) are reported as Current Assets; all other receivables are
noncurrent and are reported under the Investments or Other Noncurrent Assets caption,
whichever is appropriate.

2. (a) Methods for establishing and maintaining an allowance for bad debts account are as follows:
(1) Allowance for Bad Debts is increased by a certain percentage of total sales or credit sales.

(2) Allowance for Bad Debts is adjusted to a certain percentage of receivables.

(3) Allowance for Bad Debts is adjusted to an amount determined by aging the accounts.

(b) The percentages to use in estimating uncollectible accounts should be based on the collection
experience of each
individual company. Analysis of the records can be made to determine the relationships between
write-offs and sales or receivables. If there has been no recognizable change in the economic
conditions or in the credit policy of the company, these historical percentages may be used as the
best estimate of future uncollectibles. To the extent that these conditions are
changing, the percentages will require appropriate adjustment.

3. GAAP requires the allowance method

because it provides for matching of current revenues with related expenses, and it reports the
receivables at their net realizable value. The direct write-off method is easy to apply and is objective
but does not provide for proper matching of revenues and expenses nor appropriate valuation of
receivables.

4. Product warranties are obligations that exist at a balance sheet date, but the amount to be paid
cannot be definitely
determined. The amount of the claim is therefore estimated. This estimated liability should usually
be recorded on an accrual basis because the obligation created upon the sale of a product should be
matched with the revenue received from the sale.

5. (a) Accounts receivable turnover is computed by dividing net sales by the average accounts
receivable outstanding for the year.
 (b) The average collection period is computed by dividing average daily sales (net sales ÷ 365) into
the average receivables for the year. This measurement can also be obtained by dividing the
number of days in a year by the accounts receivable turnover.

(c) The accounts receivable turnover represents the average number of sales or collection cycles
completed by a firm during a particular year. The average collection period shows the average
time required to collect receivables.

6. The practice of financing accounts receivable has become very popular. In the past, this form of
financing was viewed as a last resort for obtaining funds. Now it is often seen as a wise and
legitimate business tool that can be used to put the assets of a company to work. This change in
attitude results from the realization that an available, easy-to-obtain form of financing was not being
used.

7. (a) (1) When receivables are sold, they are removed from the books of the seller, and a gain or loss
is recognized for the difference between the net proceeds received and the carrying value of
the receivables.

(2) When receivables are used as collateral to secure loans, the receivables remain on the books,
and a loan is recorded. The amount of receivables assigned should be disclosed in the notes
to the financial statements.

(b) (1) The entry to record the sale of receivables without recourse involves a debit to Cash for the
sales price (less the amount, if any, withheld by the factor), a debit to Loss from Factoring
for the charge made by the factor, a debit to Allowance for Bad Debts, and a credit to
Accounts Receivable for the accounts sold. If the factor withholds a portion of the sales
price pending a final settlement, the amount withheld is recorded as a debit to Receivable
from Factor. If the receivables are sold with recourse, the value of the recourse obligation
must be estimated, and the loss on the sale is increased accordingly.

(2) Accounting for receivables involved in a secured borrowing involves making memorandum
entries for data concerning the pledge.
8. (a) A note receivable should be recorded at an amount different from its face amount when face
amount differs from present value. Such a difference arises when a note is non-interest-bearing
or when the face amount of interest-
bearing note is more or less than the fair market value of the consideration exchanged. However,
short-term trade notes may be recorded at face amount even when the face amount is not equal
to its present value.

(b) The difference between a note’s face amount and its present value is initially recorded as a
premium or discount and amortized over the life of the note. The amortization procedure is a
systematic allocation of the premium or discount to Interest Revenue on the books of the holder
of the note and to Interest Expense on the books of the issuer of the note.
9. An assignment is disclosed in a parenthetical comment or note to the balance sheet, stating the
nature and amount of the pledged receivables. The receivables continue to be reported as an asset in
the balance sheet, and the associated loan is reported as a liability.

10. Imputing a rate of interest is the process of selecting and applying an interest rate deemed
appropriate under the circumstances. An imputed rate must be determined when no interest rate is
stated or when the stated rate is unreasonable, and the present value of a note cannot be identified by
reference to the note itself, or the consideration exchanged for the note. The selection of an
appropriate rate is based on factors such as the credit standing of the issuer of the note, prevailing
interest rates for notes with similar terms, and the rate at which the debtor could obtain financing
from other sources at the time of the transaction.
INVENTORY & COST OF GOODS SOLD

1. Four questions associated with accounting for inventory are as follows:

• When is inventory considered to have been purchased?

• Similarly, when is inventory considered to have been sold?

• Which costs are considered to be part of the cost of inventory, and which are simply business
expenses for that period?

• How should total inventory cost be divided between the inventory that was sold (cost of goods
sold) and the inventory that remains (ending inventory)?

2. Vehicles are classified as inventory on the balance sheets of companies that sell vehicles in the
normal course of business. However, for a firm that uses vehicles but does not sell them, such as a
delivery service business, the vehicles would be shown as property, plant, and equipment instead of
as inventory.

3. Direct materials are applied directly to the manufacturing process and become part of the finished
product.

Indirect materials are auxiliary materials or materials that are not incorporated directly into the
finished product. They include such items as oil, fuels, and cleaning supplies. They may also include
materials of minor significance that are embodied in the final product but are too immaterial to
account for as direct materials.

4. (a) The three cost elements found in work in process and finished goods are direct materials, direct
labor, and manufacturing overhead.

(b) Manufacturing overhead is composed of all manufacturing costs other than direct materials and
direct labor. It includes indirect labor, indirect materials, depreciation, repairs, insurance, taxes,
and the portion of managerial costs identified with production efforts.

5. The general rule of thumb is that inventory-related costs incurred inside the factory wall are
allocated to the cost of inventory, and costs incurred outside the factory wall (e.g., in the finished
goods warehouse) are expensed as incurred.

6. Computers are characteristic of perpetual

inventory systems. The recordkeeping requirements of a perpetual system are greater than those for
a periodic system, so a computer can significantly aid in managing the data. Periodic systems can be
operated with just an old cash register. The decrease in computing costs over the past 20 years has
dramatically increased the use of perpetual systems.
7. The inventory system must be cost-effective. That is, cost vs. benefit must be considered. Also, it
should provide effective control over the use and management of the asset. The perpetual inventory
system, because it is more costly to maintain and implement, should be used for items of relatively
high unit value and for which management of the asset’s use is desired.

However, with information technology continually bringing down the cost of perpetual inventory
systems, a perpetual system may be used in all the cases.

8. When a perpetual inventory system is used, the company knows how much inventory should be on
hand at any point in time. Comparing the inventory records to the result of a physical count allows
the company to compute the amount of inventory shrinkage.

9. (a) Merchandise in transit is legally reported as inventory by the seller if it was shipped FOB
destination.

(b) Merchandise in transit is legally reported as inventory by the buyer if it was shipped FOB
shipping point or if it was shipped FOB destination and received before the year-end but not yet
unloaded or moved into the inventory storage area.

10. (a) Consigned goods should be included in the inventory of the shipper/consignor, not in the
inventory of the dealer holding the goods. The consigned inventory should be reported in the
shipper's inventory at the sum of its cost and the
Handling and shipping costs incurred in the transfer to the dealer.
(b) Inventory sold under an installment sale may continue to be shown in the inventory of the seller
because the seller retains title to the goods. If the seller reports the inventory, it should be
reduced by the buyer’s equity in the inventory as established by collections.

However, in the usual case, when the possibilities of returns and defaults are meager, the seller,
anticipating completion of the contract and the ultimate passing of title, recognizes the
transaction as a regular sale and removes the goods from reported inventory at the time of the
sale.
11. The substance of an inventory sale accompanied by a repurchase agreement is that the inventory is
being used as collateral for a loan. Accordingly, the inventory continues to be reported as part of the
seller’s inventory. The proceeds from the “sale” are reported as a loan. A note describes the
repurchase agreement.

12. An activity-based cost (ABC) system is one in which overhead costs are allocated to inventory based
on clearly identified cost drivers, which are characteristics of the production process known to create
overhead costs.
13. (a) Cash discounts may be accounted for under the gross method or the net method. Under the gross
method, purchases of merchandise are recorded at the gross amount of the invoice, and discounts
taken at the time of payment are recognized in a contra purchases account. Under the net
method, purchases of merchandise are recorded at the net amount of the invoice, and any
discounts not taken are recognized as an expense of the period.
 (b) The net method of accounting for purchases is strongly preferred. By separately reporting purchase
discounts lost, the failure of a company to take advantage of cash discounts is highlighted. It is
usually considered advantageous for a company to make a purchase discount. Failure to do so is
regarded as a lapse inefficient financial management of a company.

14. Although the specific identification method may be considered a highly satisfactory approach in
matching costs with revenues, it is often difficult or even impossible to apply. If there are many
items in the inventory with acquisition occurring at different times and different prices, cost
identification procedures may be prolonged, burdensome, and costly. When the units are in effect
identical, the specific identification method opens the door to possible profit manipulation through
the choice of particular units for sale.

15. The average cost method of inventory valuation has the advantage of evening out the fluctuations of
inventory pricing and generally is more comfortable to apply than the FIFO method. As prices vary,
the average price used to cost inventory sold is automatically adjusted. Because the cost of purchases
during a period is usually several times more than the value of the opening inventory, the price used
is heavily influenced by current costs.

16. For most businesses, a FIFO assumption better matches the physical flow of goods.

17. Computation of average cost under a perpetual system is complicated because the average cost of
units available for sale changes every time a purchase is made, and the identification of the “last in”
units also changes with every purchase.
20. In periods of increasing prices, FIFO's historical cost flow will reflect the highest peso value of
ending inventory because the historical unit cost assigned to the asset demonstrates the most recent
unit price.

21. The value assigned to inventory can be significant in determining how profits and losses are
allocated among different reporting units within the business. A manager wants any inventory he or
she receives from another department to be transferred at the lowest possible value. When
transferred inventory is reported at a low value, higher profits are recognized on the subsequent sale
of the item. Reported profits of a department may be used in the evaluation and bonus computation
for the manager of the department.

22. In developing a reliable gross profit percentage, reference is made to the historical rate, with
adjustments for changes in current circumstances. For example, the historical total profit percentage
would be adjusted if the pricing strategy has changed (e.g., because of increased competition), if the
sales mix has changed, or if a different inventory valuation method has been adopted.
27. (1) (2)
Effect on Statements of Effect on Statements of
Nature of Error Current Period Succeeding Period
(a) Ending inventory Net income is overstated by the Net income is understated by
over-stated because of amount of the error. the amount of the error.
a miscount. Current assets and owners’ No effect on the balance sheet.
equity are overstated by the
amount of the error.
(b) Failure to record the No effect on net income, No effect on net income
purchase of although both ending inventory because the understatement in
merchandise on the and purchases are understated the beginning inventory is
account and the by the amount of the omission. Counterbalanced by the
merchandise purchased Both current assets and current overstatement of purchases.
was not recognized in liabilities are understated by the No effect on the balance sheet.
recording the ending amount of omission.
inventory.
Net income is understated by Net income is overstated by the
(c) Ending inventory the amount of the error. amount of the error.
understated because of a Current assets and owners’ No effect on the balance sheet.
miscount. equity are understated by the
amount of the error.
PROPERTY, PLANT & EQUIPMENT: Initial Acquisition

1. a. The cost of land includes the original purchase price; brokers’ commissions; legal fees; title,
recording, and escrow fees; surveying costs; local government individual assessment taxes; the
cost of clearing or grading; and other costs that permanently improve the land or
Prepare it for use. Expenditures for land improvements that have a limited life, such as paving,
fencing, and landscaping, may be separately summarized as land improvements and depreciated
over their estimated useful lives.

b. The cost of buildings includes the

The original purchase price, brokers’ commissions, legal fees, title and escrow fees,
reconditioning costs, alteration and improvement costs, and any other costs that improve the
buildings and hence benefit future periods.

c. The cost of equipment includes the original purchase price, taxes, and duties on purchases,
freight charges, insurance while in transit, installation charges, and other costs in preparing the
asset for use, subsequent improvements or additions, and any other expenditures that will
improve the equipment and thus benefit more than one period.

2. Accountants frequently are required to allocate costs among two or more accounts. The principal
method of allocation is based on relative market values of the individual assets, if they can be
determined. A ratio of each asset’s market value to the sum of the market values for all assets
Involved in the purchase is used to determine the cost of each asset. If market values, or some
approximation of market values, cannot be obtained for all assets in the basket purchase, the
allocation can be made to those assets where market values are available, and any remaining balance
can be allocated, on some systematic basis, to remaining assets.

3. When equipment is purchased on a

Deferred payment contract, care must be taken to exclude the stated or implicit interest from the
purchase price. The asset should be recorded at its equivalent cash price. Interest on the unpaid
contract
balance should be recognized as interest expense over the life of the contract.

4. a. Sales practice for some products consistently inflates the list price that is
Initially assigned. Because most buyers are aware of this practice, considerable negotiations take
place between buyers and sellers before a market price is established. If accountants use the list
price without careful evaluation, values could be inflated.

b. The goal of accounting for the acquisition of property and equipment is to record the purchase at
the equivalent cash price or the closest approximation to cash that can be obtained. This is
especially important when trade-ins are involved.

5. a. If the donation of the property by the philanthropist is unconditional, the president’s position
cannot be defended. If the donation is not recognized, both assets and income will be
understated. Furthermore, subsequent income will be overstated through the failure to
acknowledge depreciation, and this misstatement will be accompanied by misrepresentations of
earnings-to-assets and earnings-to-owners’-equity relationships reflected on the financial
statements. Properties unconditionally transferred should be recognized by debits to asset
 accounts and a credit to a revenue account in terms of the fair market values of the properties
acquired, and depreciation should be recognized in using such features.

b. If the donation of the property is contingent upon certain conditions, the president’s position
relative to the nonrecognition of the asset is proper until the time the conditions are met. Until
the requirements are met, the fair value of the conditional gift, along with a description of the
terms, should be disclosed in the notes to the financial statements.

6. An asset retirement obligation is a legal obligation a company has to restore the site of a piece of
property or equipment when the asset is retired. The estimated fair value of the asset retirement
obligation is recognized as a liability and is added to the cost of the asset when it is acquired.

7. Many companies establish a minimum monetary amount for recording expenditures as assets, even
though the item purchased meets the definition of an asset. The principal reasons for this are
materiality and the cost involved in recording an asset and depreciating it over its estimated life. It is
more expedient to expense these smaller capital expenditures immediately, thus avoiding the
recordkeeping associated with assets.

9. a. The cost of a depreciable asset incorrectly recorded as an expense will understate assets and
owners’ equity for the current year and for succeeding years, but by successively decreasing
amounts until the asset no longer contributes to periodic revenue. Net income will be understated
in the first year by the excess of the expenditure over depreciation for the current period; net
income in succeeding years will be overstated by the amount of depreciation charges applicable
to the asset that should be charged off as an expense.

b. An expense expenditure incorrectly recorded as an addition to the cost of a depreciable asset will
overstate assets and owners’ equity for the first year and for succeeding years, but by
successively decreasing amounts until the charge has been entirely written off. Net income will
be overstated for the first year by the difference between the recognized depreciation for the
current period and the amount of the expenditure; net income for succeeding years will be
understated by the depreciation charges recognized in such periods.

8. Expenditure Classification
a. Cost of installing machinery ...................................... Asset
b. Cost of unsuccessful litigation to protect patent ......... Expense
c. Extensive repairs as a result of fire............................. Expense
d. Cost of grading land .................................................. Asset
e. Insurance on machinery in transit .............................. Asset
f. Interest incurred during construction period ............... Asset (if interest added to construction
cost)
Expense (if interest charged to expense)
g. Cost of replacing a major machinery component ........ Asset
h. New safety guards on machinery ............................... Asset
i. Commission on purchase of real estate ...................... Asset
j. Special tax assessment for street improvements ......... Asset
k. Cost of repainting offices........................................... Expense
10. The remaining net book value of a component that is replaced is added to depreciation expense for
the period.
11. a. Research activities are those used to discover new knowledge that will be useful in developing
new products, services, or processes, or significantly improve an existing product or process.
Development activities seek to apply research findings to develop a plan or design for new or
improved products and processes. Development activities include the formulation, design, and
testing of products, construction of prototypes, and operation of pilot plants.
b. Research and development costs are generally expensed in the period incurred. An exception is
when the expenditure is for equipment and facilities that have alternative future uses beyond the
specific current research project. This exception permits the deferral of costs incurred for
materials, equipment, facilities, and intangibles purchased, but only if the alternative future use
can be correctly identified. Also, software development costs are capitalized if they are incurred
after technological feasibility has been established.

12. The fixed asset turnover ratio is computed as sales divided by the average property, plant, and
equipment (fixed assets); it is interpreted as the number of pesos in sales generated by each peso of
fixed assets.

13. As with all ratios, the fixed asset turnover ratio must be used carefully to ensure that erroneous
conclusions are not made. For example, fixed asset turnover ratio values for two companies in
different industries cannot be meaningfully compared. Another difficulty in comparing costs for the
fixed asset turnover ratio among different companies is that the reported amount for property, plant,
and equipment can be a poor indicator of the actual fair value of the fixed assets being used by a
company. Another complication with the fixed asset turnover ratio is caused by leasing. Many
companies lease the bulk of their fixed assets in such a way that the assets are not included in the
Balance sheet. This practice biases the fixed asset turnover ratio for these companies upward because
the sales generated by the leased assets are included in the numerator of the ratio, but the leased assets
generating the sales are not included in the denominator.
PROPERTY, PLANT & EQUIPMENT: Depreciation

1. Depreciation refers to the cost allocation of tangible long-term assets; depletion refers to the cost
allocation of natural resources, and amortization refers to the cost allocation of intangible assets. All
three terms have similar underlying principles governing their use.

2. Four separate factors must be considered in determining the periodic depreciation charges that
should be made for a company’s assets. They are (1) asset cost, (2) residual or salvage value, (3)
useful life, and (4) pattern of use. These factors, when considered together, help determine which of
the conventional methods is most appropriate for the circumstances.

3. Residual or salvage value is included in the formulas for all time-factor depreciation methods except
for the declining-balance methods. In practice, the residual value is often ignored if it is the practice
of a company to retain assets for most of their useful lives. In the case of declining-balance methods,
although the residual value is not included in the formulas, it is considered when an asset is near the
end of its useful life. Generally, the book value should not be reduced below its expected residual
value.

4. Functional factors include inadequacy and obsolescence that reduce the usefulness of the asset.
Physical considerations include wear and tear, deterioration and decay, and damage or destruction,
reducing the value of the asset.

5. Time-factor methods of depreciation base cost allocation on time according to either straight-line or
accelerated depreciation. In theory, the pattern selected should be related to the pattern of benefits
expected from the asset. Because the pattern of benefits is very subjective, the selection of a specific
time-factor method is usually an arbitrary decision.

Use-factor methods of depreciation base cost allocation on some measure that relates more directly
to the use of the asset. Most commonly, the distribution is based on productive output or service
hours. In theory, the use-factor methods provide much better matching of costs against revenues than
do time-factor methods. However, because use-factor methods require more extensive accounting
records, they are not as common as the time-factor methods.

6. With group depreciation, periodic depreciation expense is computed on a whole group of assets as if
the group were one single asset. The weighted-average life of the group is used to determine how
much of the aggregate asset cost should be depreciated each year. No gains or losses are recognized
at the time of the retirement of individual assets; accumulated depreciation is reduced for the
difference between the asset cost and the cash retirement proceeds.

7. The amount of an asset retirement obligation is added to the cost of the associated asset.
Accordingly, the asset retirement obligation increases periodic depreciation. Also, the amount of the
asset retirement obligation itself increases each year as the time until the obligation must be satisfied
decreases. However, this increase, which conceptually is the same as interest expense, is not
accounted for as interest expense. Instead, it is called accretion expense.
 8. When a useful-life estimate is changed, the remaining book value of the asset is depreciated over the
revised remaining useful life. In other words, the forecast impacts only the current and future periods.
No attempt is made to go back and “fix” the depreciation amount recognized in prior periods.

9. Depreciation is an estimate, and the effort necessary to compute depreciation expense for the exact
number of days an asset is owned usually exceeds any benefit derived. For companies that acquire
and dispose of many assets during a year, detailed tracking of daily depreciation is almost
impossible. A variety of simplifying assumptions are used, including rounding to the nearest whole
month and the half-year convention in which one-half of a year’s depreciation is taken on any asset
acquired or disposed of during the year.
INTANGIBLE ASSETS

1. a. Copyright, when purchased, is recorded at its purchase price. When internally developed, all
costs of legally establishing the copyright are included as costs of the copyright.

b. The cost of purchasing a franchise and all other sums explicitly paid for a franchise including
legal fees are
Considered the franchise cost. Property improvements required under the franchise also are
recorded as part of the franchise cost.

c. The cost of a trademark includes all expenditures required to establish the trademark, such as
filing and registration fees, as well as legal expenses for the defense of the trademark.

Purchased trademarks are recorded at the purchase price.

2. In general, the cost of internally generated intangibles is expensed as incurred.

3. The five general categories of intangible assets are as follows:

1. Marketing related.
2. Customer-related.
3. Artistic related.
4. Contract-based.
5. Technology-based.

4. The two approaches used in estimating fair values using present value computations are the
traditional approach and the expected cash flow approach. In the traditional approach, which is
often used in situations in which the amount and timing of the future cash flows are determined by
contract, the present value is computed using a risk-adjusted interest rate that incorporates
expectations about the uncertainty of receipt of the future contractual cash flows.
In the expected cash flow approach, a range of possible outcomes is identified, the present value of
the cash flows in each possible outcome is computed (using the risk-free interest rate), and a
weighted-average current value is calculated by summing the current value of the cash flows in each
issue, multiplied by the estimated probability of that outcome.

5. a. Goodwill may be adequately reported as an asset only when it is purchased or otherwise

established by a transaction between independent parties.

b. Expenditures for advertising should not be capitalized as goodwill. Some advertising

expenditures may be deferred if the costs applicable to future benefits from such advertising can
be determined objectively. Usually, however, it is advisable to expense such expenditures
because of the fleeting nature of the benefits and because future benefits may be challenging to
estimate.
6. Contract-based and separately tradable intangibles are recognized in both a basket purchase and in a
business combination. Intangibles that are neither of these, but that are still relevant and reliably
measurable, are recognized in a basket purchase but are not separately recognized when acquired as
part of a business combination.
7. For accounting purposes, recorded intangible assets come in three varieties:

a. Intangible assets that are amortized. The impairment test for these intangibles is the same as the
two-step test used for tangible long-term operating assets.

b. Intangible assets that are not amortized. The impairment test for these intangibles involves a
simple one-step comparison of the book value to the fair value.
c. Goodwill, which is not amortized. The goodwill impairment test is a two-step process that first
involves estimating the fair value of the entire reporting unit to which the goodwill is allocated.

14. a. Compute the fair value of each reporting unit to which goodwill has been assigned.

b. If the fair value of the reporting unit exceeds the net book value of the assets and liabilities of the
reporting unit, the goodwill is assumed not to be impaired, and no impairment loss is recognized.

c. If the fair value of the reporting unit is less than the net book value of the assets and liabilities of
the reporting unit, a new fair value of goodwill is computed. The goodwill value is the amount of
fair value of a reporting unit that is left over after the benefits of all identifiable assets and
liabilities of the reporting unit has been considered.

d. If the implied amount of goodwill computed in (c) is less than the amount initially recorded, a
goodwill impairment loss is recognized for the difference.
BORROWING COSTS

1. a. In constructing a new building for its use, it will charge the building with all costs incurred in
connection with construction activities. These costs will include building costs in the form of
direct labor, direct materials, factory overhead, and any other expenditures that can be identified
with the construction of the asset.

b. When a company constructs its assets, two positions may be taken in assigning general overhead to
the cost of the asset: (1) Overhead may be assigned to special construction just as it is assigned to
normal activities because both activities benefit from the overhead; this would mean that
construction would be charged with the increase in overhead arising from construction activities as
well as a pro-rata share of the company’s fixed overhead. (2) Only the rise in rent may be charged
to construction because management decides to construct its assets after giving due consideration
to the differential or additional costs involved. An equitable allocation of the fixed overhead
between regular operations and construction affords no special favor to construction activities; on
the other hand, a charge to construction for only the increase in total overhead grants no special
concessions to regular events during the construction period.

2. Before interest charges are capitalized, a construction project should be a discrete project. Interest
should not be obtained for inventories manufactured or produced on a repetitive basis, for assets that
are currently being used, or for assets that are idle and not undergoing activities to prepare them for
use.
MINERAL RESOURCES

1. With the full cost method of accounting for oil and gas exploration costs, the cost of drilling dry
holes is capitalized and amortized. With the successful efforts method, only the exploratory costs
associated with successful wells are obtained; the cost of dry holes is expensed as incurred.

2. When new estimates of recoverable natural resources are obtained, a new depletion cost per basic
unit is computed from the beginning of the period in which the original assessment is made. No
adjustment is made to prior periods. It is a change in estimate and, therefore, prospective.

3. A company should recognize an impairment loss when the undiscounted sum of expected future cash
flows from the asset is less than the recorded book value of the asset. The impairment loss is
measured as the difference between the book value of the asset and the asset’s fair value. Fair value
can be estimated as the discounted sum of expected future cash flows.

4. A gain or loss is recognized whenever the exchange of assets takes place unless the exchange does
not affect the risk, timing, or amount of a company’s cash flows. In those instances where the
transaction lacks “commercial substance,” indicated gains are not recognized. Indicated losses are
always accepted.
DEBT FINANCING

1. The definition of liabilities are as follows:

(a) A commitment is a result of past transactions or events.

(b) A liability involves a probable future transfer of assets or services.

(c) Liability is the obligation of a particular entity.

All of these components should be present before the liability is recorded. Also, the amount of the
liability must be measurable to report it on the balance sheet.
2. a. An executory contract is one in which performance by both parties is still in the future. Only an
exchange of promises is made at the initiation of the contract. Common examples include labor
contracts and purchase orders.

b. The definition of liability states in part that liability should be the result of a past transaction or
event. Similar concepts in previous definitions used by accounting bodies have excluded
executory contracts from inclusion as liabilities. However, the accounting methods currently
accepted for leases, for example, essentially recognize liabilities before a performance by either
party to the lease contract.

3. Current liabilities are claims arising from operations that must be satisfied with current assets within
one operating cycle or within one year, whichever is longer. Non-operating cycle claims are
classified as current if they must be paid within one year from the balance sheet date.

Noncurrent liabilities are liabilities whose liquidation will not require the use of current assets to
satisfy the obligation within one year.
4. Generally, liabilities should be reported at their net present values rather than at the amounts that
eventually will be paid. The use of money involves a cost in the form of interest that should be
recognized whether or not such cost is expressly stated under the terms of the debt agreement.

5. Some companies include short-term borrowing as a permanent aspect of their overall financing mix.
In such a case, the company often intends to renew or rollover, its short-term loans as they become
due. As a result, a short-term loan can take on the nature of long-term debt because, with the
refinancing, the cash payment to satisfy the loan is deferred into the future. As of the date, the
financial statements are issued, if a company has either already done the refinancing or has a firm
agreement with a lender to refinance a short-term loan, the loan is classified in the balance sheet as a
long-term liability.

6. A line of credit is a negotiated arrangement with a lender in which the terms are agreed to before the
need for borrowing. When a company finds itself in need of money, an established line of credit
allows the company access to funds immediately without having to go through the credit approval
process.
7. In reporting long-term debt obligations, the emphasis is on reporting what the real economic value of
the obligation is today, not what the total debt payments will be in the future. The sum of the future
cash payments to be made on long-term debt is not a good measure of the actual economic
obligation. Because the cash outflows associated with a long-term liability extend far into the future,
present-value concepts must be used to value the liability properly.

8. For each payment, a portion is an interest, and the remainder is applied to reduce the principal. To
compute the amount attributable to the principal, the outstanding loan balance is multiplied by the
monthly interest rate. The result is the interest portion of the payment. Subtracting this amount from
the total payment gives the amount applied to reduce the principal.

9. a. Secured bonds have specific assets pledged as security for the issue. Unsecured bonds frequently
referred to as debenture bonds, are not protected by the pledge or mortgage of specific assets.

b. Collateral trust bonds are secured by stocks and bonds owned by the borrowing corporation.
There is no specific pledge of property in the case of debenture bonds, the issue being secured
only by the general credit of the company.

c. Convertible bonds may be exchanged at the option of the bondholder for other securities of the
corporation by the provisions of the bond contract. Callable bonds may be redeemed by the
issuing company before maturity at a specified price.

d. Coupon bonds are not recorded in the name of the owner, and title passes with the delivery of
the bond. Interest is paid by having the bondholder clip the coupons attached to the bonds and
present these for payment on the interest dates. Registered bonds call for the registry of the
bondholder’s name on the books of the corporation. Transfer of title to these bonds is
accomplished by the surrender of the old bond certificates to the transfer agent, who records the
change in ownership and issues new certificates to the buyer. Interest checks are periodically
prepared and mailed to the holders of record.

e. Municipal bonds are issued by governmental units, including state, county, and local entities.
The proceeds are used to finance expenditures such as school construction, utility lines, and road
construction. The bonds usually sell at lower interest rates than do other bonds because of the
favorable tax treatment given to the holders of the bonds for the interest received. Because the
interest revenue is not taxed by the federal government, these bonds are frequently referred to as
tax-exempt securities. Corporate bonds are issued by corporations as a means of financing their
long-term needs. Corporations usually have a choice of raising long-term capital through issuing
bonds or stock. Bonds have a fixed interest rate while stock pays its return through declared
dividends. The holders of corporate bonds must pay federal income taxes on interest revenue
received.
f. Term bonds mature as a lump sum on a single date. Serial bonds mature in installments on
various dates.
10. The market rate of interest is the rate prevailing in the market at the moment. The stated rate of
interest is the rate printed on the face of the bonds. This is also known as the contract rate. The
effective or yield rate of interest is the same as the market rate at the date of issuance (purchase) and
is the actual return on the purchase price received by the investor and incurred by the issuer.

The market rate fluctuates during the life of the bonds by economywide changes in expectations
about future inflation. With the changing financial condition of the company, the stated rate remains
the same. Although the effective rate stays the same for the individual bond investor or the
borrowing corporation over the life of the issue, this rate will vary from one bondholder to another
when the securities are acquired at different times and prices.

11. The use of the effective-interest method of amortization for bond premiums and discounts is
encouraged. Because the effective-interest method adjusts the stated interest rate to the effective rate,
it is theoretically more accurate than the straight-line method. The straight-line method may be used
if the interim results of using it do not differ materially from the resulting amortization using the
effective-interest method. The total amortization will, of course, be the same under either way over
the life of the bond.

12. Three ways bonds may be retired before maturity are as follows:
(a) Bonds may be redeemed by purchasing them on the open market or by exercising the call
provision is included in the bond indenture.

(b) Bonds may be converted or exchanged for other securities.

(c) Bonds may be refinanced (sometimes called refunded) with the use of proceeds from the sale of
a new issue.

Usually, with the early extinguishment of a debt, a gain or loss must be recognized for the difference
between the carrying value of the debt security and the amount paid.

13. Callable bonds serve the issuer’s interests because the callability feature enables the issuing
corporation to reduce its outstanding indebtedness at any time that it may be convenient or profitable
to do so.

14. Convertible debt securities generally have the following features:

(a) An interest rate lower than the issuer could establish for nonconvertible debt.

(b) An initial conversion price higher than the market value of the common stock at the time of
issuance.

(c) A call option retained by the issuer.

These securities raise many questions as to the nature of the securities. Examples of these questions
include whether they should be considered debt or equity securities, the valuation of the conversion
feature, and the treatment of any gain or loss on conversion.
15. Convertible bonds are securities that may be viewed either as primarily debt or primarily equity. If
they are considered as debt, the conversion from debt to equity could be considered to be a
significant economic event for which any difference between the current market price for the
securities and their carrying value should be recognized as a gain or loss. For the investor, this could
be viewed as the exchange of nonmonetary assets. For the issuer, this could be considered to be
creating a significant difference in the type of ownership being assumed.

On the other hand, if the convertible bonds are considered as primarily equity securities whose
market is responsive to the price of common stock, the exchange of one equity security for another
could be viewed as not a significant exchange. Under the historical cost concept, it should not give
rise to any gain or loss.

16. Bond refinancing or refunding means issuing new bonds and applying the proceeds to the retirement
of outstanding warrants. This may occur either at the maturity of the old bonds or whenever it may
be advantageous to retire old bonds by issuing new bonds with a lower interest rate, a more
favorable bond contract, or some other benefit.

17. Avoiding the inclusion of debt on the balance sheet through the use of off-balance-sheet financing
may allow a company to borrow more than otherwise possible due to debt-limit restrictions. Also,
the healthy appearance of a company’s financial position usually enables it to borrow at a lower cost.
Another possible reason is that companies wish to understate liabilities because inflation has, in
effect, understated its assets.

One of the main problems with off-balance-sheet financing is that many investors and lenders aren’t
able to see through the off-balance-sheet borrowing tactics and thereby make ill-informed decisions.
There is also concern that as these methods of financing gain popularity, the amount of total
corporate debt is reaching unhealthy proportions.
18. If a variable interest entity (VIE) is carefully designed, it can be accounted for as an independent
company, and any debt that it incurs will not be reported in the balance sheet of its sponsor.
19. Companies will, on occasion, join forces with other companies to share the costs and benefits
associated with specifically defined projects. These joint ventures are often developed to share the
risks associated with high-risk projects. Because the benefits of these joint ventures are uncertain,
companies have the possibility of incurring substantial liabilities with few, if any, assets were
resulting from their efforts. As a result, as is the case with unconsolidated subsidiaries, a joint
venture is carefully structured to ensure that the liabilities of the joint venture are not disclosed in the
balance sheets of the companies in the partnership. Often, both joint venture partners account for the
joint venture using the equity method; that is, the liabilities of the joint venture are not included in
the balance sheets of the partners.
20. Troubled debt restructuring occurs when the investor (the creditor) is willing to make significant
concessions as to the return from the investment to avoid making settlements under adverse
conditions, such as bankruptcy. This means that if the restructuring involves a significant
transaction, the investors (creditors) will almost always report a loss unless they have previously
anticipated the loss and have reduced the investment to a value lower than the amount finally
determined in the settlement. The issuer will report a gain if the restructuring involves a significant
transaction.
21. a. A bond restructuring involving an asset swap usually results in recognition of a loss on the
investor’s books and a gain on the issuer’s books. The market value of the assets swapped often
determines the amount of gain or loss be recognized. Only if the market value of the retired debt
is more determinable would such value be used.

b. A bond restructuring involving an equity swap similarly results in recognition of gains or losses
because the market value of the equity exchanged for the debt is used to record the transaction. If
the market value of the debt is more clearly determinable than the market value of the equity, the
value of the debt would be used.

c. A bond restructuring involving a modification of terms does not result in recognition of a gain
for the issuer unless the total amount of future cash to be paid, principal plus interest is less than
the carrying value of the debt. In that case, the difference between the future cash and the
carrying value is recognized as a gain. Under this condition, future cash payments are charged to
the liability account on the issuer’s books.
EQUITY FINANCING

1. The fundamental rights of common stockholders, unless otherwise restricted in the articles of
incorporation or bylaws, are as follows:
(a) The right to vote in the election of directors and the determination of certain corporate policies.

(b) The right to maintain one’s proportional interest in the corporation through the purchase of
additional stock issued by the company. (In recent years, some states have eliminated this
preemptive right.)

2. Historically, the par value was equal to the market value of the shares at issuance. Par value was also
sometimes viewed by the courts as the minimum contribution by
Investors. These days, par values for common stocks are usually set at very low
Values (less than P1), so the importance of par value has decreased substantially.

3. Preferred stock is stock that carries certain preferences over common stock, such as prior claims to
dividends and liquidation preferences. Often preferred stock has no voting rights or only limited
voting rights, and dividends are usually limited to a stated percentage or amount. The special rights
of a particular issue of preferred stock are outlined in the articles of incorporation and the preferred
stock certificates issued by the corporation.

4. When a stock is issued for noncash assets or services, the fair market value of the stock or the fair
market value of the property or services, whichever is more objectively determinable, is used to
record the transaction.

5. A company may repurchase its stock for any of the following reasons:
• To provide shares for incentive
compensation plans
• To obtain shares for convertible securities holders
• To reduce the amount of equity
outstanding
• To invest excess cash temporarily
• To protect against a hostile takeover
• To improve per-share earnings
• To display confidence that the stock is currently undervalued

6. a. The cost method of accounting for treasury stock records the treasury stock at cost, pending final
disposition of the stock; the par value method treats the acquisition of treasury stock as effective
or “constructive” retirement of outstanding stock.
b. Total stockholders’ equity will be the same regardless of whether the cost method or the par
value method is used to account for treasury stock. The respective amounts of retained earnings
and paid-in capital may differ, however.
7. The difference between the purchase price and the selling price of treasury stock
It is correctly excluded from the income statement because treasury stock transactions cannot be
considered to give rise to a gain or a loss. Gain or loss arises from the utilization of assets or
resources by the corporation in operating and investing activities. Because the recognition of
 treasury stock as an asset is discouraged, transactions in treasury stock are considered capital
transactions between the company and its stockholders and thus do not give rise to a gain or a loss.

8. If warrants are detachable, the issuance proceeds are allocated between the security and the warrant,
based on the relative fair market values of each. If warrants are nondetachable, no allocation is made
to recognize the value of the warrant. The
Entire proceeds are assigned to the security to which the warrant is attached.

9. The option value used in the computation of compensation expense associated with a basic stock-
based compensation plan is the estimated fair value of the option on the grant date.

10. The catch-up adjustment causes the cumulative expense recognized to equal the amount it would
have been had the revised number of options probable to vest been used all along in the yearly
computations of expense.

11. When a stock-based award calls for settlement in cash, the obligation is accounted for as a liability.

12. Mandatorily redeemable preferred shares should be reported in the balance sheet as a liability.

13. When a corporation writes a put option on its shares, the corporation typically receives cash. In
return, the corporation agrees to repurchase shares of its stock at a set price at some future date if
those shares are offered for sale by the option holder.

14. An obligation that requires a company to deliver a fixed number of its shares should be classified as
equity because the party to whom the shares must be given is at risk to the same extent as are the
existing shareholders. An obligation to provide shares with a fixed monetary amount is reported as a
liability rather than as equity.

15. If an error is discovered in the current year, it is corrected with a correcting entry. If a material error
is found in a year after the error, the error is corrected by a prior-period adjustment whereby the
beginning balance in Retained Earnings is adjusted. Some errors are counterbalancing (e.g.,
inventory errors) and may need no correction.

16. With a stock split, the par value of each share is reduced, and the number of shares outstanding is
increased. The total par value of shares is unchanged. With a stock dividend, the par value of each
share is Unchanged, and because the number of shares outstanding is increased, the total par value is
increased. This par value increase is effected through a transfer to par value from Retained Earnings
and Additional Paid-In Capital. With a small stock dividend, the market value of the newly issued
shares is transferred. With a large stock dividend, the par value of the new shares is transferred.
17. a. A liquidating dividend is a distribution of contributed capital to stockholders.
b. A liquidating dividend is paid when a corporation is undertaking a partial or complete
liquidation.

18. Each equity reserve account is associated with legal restrictions dictating whether it can be
distributed to shareholders. Therefore, the accounting for equity reserves directly influences a firm’s
ability to pay dividends. The most important distinction is whether the equity reserve is part of
distributable or nondistributable equity.
INVESTMENTS IN DEBT & EQUITY SECURITIES

1. Companies make investments in the securities of another company to provide a safety cushion of
available funds and to store a temporary excess of cash. Companies also invest in other companies to
earn a return, to secure influence, or to gain control.

2. A security is classified as held to maturity if the business has the intent and the ability to keep the
security to maturity.

4. To be classified as trading security, the security must have a readily determinable fair value. It must
be purchased and held to sell it to generate profits on short-term differences in price.

5. The effective-interest method computes interest revenue by multiplying the effective interest rate by
the carrying value of the investment.

6. When a company does not own more than 50% of a company, other factors may be considered to
determine if the control exists. Such factors include owning a large minority voting interest with no
other shareholder owning a significant block of stock or having a majority voting interest in
determining who is on the company’s board of directors. When these other factors exist, then control
may be assumed, and consolidation would be appropriate.

7. (a) Factors that may indicate the ability of a minority-interest investor to exercise significant
influence over an investee’s operating and financial policies are as follows:
1. Representation on the board of
directors of the investee.

2. Participation in the policy-making process.

3. Material intercompany transactions between investees and investors.

4. Interchange of managerial personnel between investees and investors.

5. The technological dependency of investee on an investor.

6. Substantial minority interest of the investor in an investee whose shares of stock are widely
distributed and not concentrated for
Control purposes.

(b) Factors that may indicate the inability of an investor with more than 20% of a company’s stock
to exercise significant influence over an investee’s operating and financial policies are as
follows:
1. Opposition by the investee, such as litigation or complaints to governmental regulatory
authorities.
 2. An agreement between the investor and the investee under which the investor surrenders
significant rights as a shareholder.

3. The majority ownership of the investee is concentrated among a small group of shareholders
who operate the investee without regard to the views of the investor.

4. The investor needs or wants more financial information to apply the equity method than is
available to the investee’s other shareholders, tries to obtain the information, and fails.

5. The investor tries and fails to obtain representation on the investee’s board of directors.

8. A joint venture is accounted for using the equity method for those partners that own 20% or more
and not more than 50% of the joint venture. For these joint venture partners, the liabilities of the
joint venture do not show up on the balance sheet. Instead, only the net investment in the joint
venture shows up on the balance sheet. Thus, the liabilities of the joint venture are “off” the balance
sheet of the partners that account for the joint venture using the equity method.
 EARNINGS PER SHARE

1. Earnings per share information are used by investors to evaluate the results of operations of a
business and estimate future earnings. Because earnings are an essential determinant of the market
price of a company’s common stock, the EPS measurement will aid the investor in determining the
attractiveness of an investment in a company’s stock. Earnings per share information are also used to
judge the dividend policy of a business, which is another critical determinant of the market price.
2. Earnings per share data have the same limitations that any income figure has under current generally
accepted accounting principles. The alternative methods available for computing net income
sometimes make comparisons among companies difficult, and the condensed EPS figure does not
remove this difficulty. In some cases, the existence of EPS data even increases the lack of
comparability because EPS information is frequently disclosed separately from any note disclosure
describing the accounting methods employed.
3. The investor uses EPS to help forecast the future profitability of an investment. If potential future
common stock transactions dilute the investor’s ownership interest in the company, future EPS will
decline relative to the past figures under the same conditions. By preparing predictive EPS, the
potential impact of conversion of convertible securities and exercise of stock options, warrants, or
rights can be captured in the EPS figure.
4. A simple capital structure consists only of common or common and preferred stock. It includes no
convertible securities, options, warrants, or rights that upon conversion or exercise would in the
aggregate dilute EPS. A complex capital structure includes securities and rights that would have a
dilutive effect on EPS if converted or exercised.
5. When a company issues a stock dividend, a stock split, or a reverse stock split, the number of shares
of stock is changed, but there is no other effect on the corporation’s resources. To meaningfully
compare EPS figures in the current period with earlier periods, the new capital structure should be
reflected retroactively in all prior periods. The unit in which EPS is measured should always be
uniform across accounting periods.
6. Dilution of EPS refers to the effect that certain types of securities - whose terms enable their holders
to acquire common shares - will have on EPS data if these securities are converted into common
stock. If in a complex capital structure, conversion of convertible securities or exercise of options,
warrants, or rights would reduce the EPS from what it would have been using only common shares
outstanding, dilution of EPS has occurred.
7. Anti-dilutive security is one whose terms permit it to be exercised or converted into common stock.
Still, if converted, the EPS would be increased, or the loss per share decreased from what it would
have been using only common shares outstanding. Because of changing economic conditions,
security may be dilutive in one accounting period but anti-dilutive in another. If stock options,
warrants, rights, or convertible securities are anti-dilutive, they are ignored in computing EPS.
Antidilutive securities are ignored for two reasons. First, by doing so, diluted EPS gives a worst-case
scenario for existing stockholders. Second, the economic terms of anti-dilutive securities suggest that
the probability that they will be converted soon is low.
8. The treasury stock method is a means of determining the extent of dilution in EPS arising from
options, warrants, and rights. Under the treasury stock method, EPS is computed as though the
options, warrants, and rights were exercised at the beginning of the period or at time of issuance,
whichever comes later, and as though the funds obtained thereby were applied to the reacquisition of
common stock at the market price for that period. The computation is necessary whenever the
 market price of the available stock exceeds the exercise price of the options, warrants, or rights
during the period.
9. The interest expense related to convertible debt, net of taxes, should be added back to income (in the
numerator) for the computation of EPS.
10. The if-converted method assumes the conversion of the security as of the beginning of the fiscal year
or as of the date of issue, whichever comes later. It is used to compute EPS “as if” the securities
were converted.
11. When stock options are exercised, the new shares issued are included in the computation of all EPS
amounts. The diluted EPS is computed as if the exercise took place as of the beginning of the year.
In computing diluted EPS, the stock price at the exercise date is used to calculate the incremental
number of shares assumed to be issued before the exercise date.
13. The inclusion of stock options and convertible securities in the computation of EPS decreases the
absolute value of the EPS. When a company experiences a net loss, the inclusion of these securities
decreases the loss per share just as it reduces the income per share. Thus, the inclusion of stock
options and convertible securities would always be anti-dilutive under loss conditions.
‡
14. To obtain the lowest possible EPS amount, a company with multiple potentially dilutive securities
first includes any dilutive stock options, warrants, or rights in the computations. If there are several
convertible securities, the impact of each on EPS must be considered on an individual basis. The
EPS amount can then be computed by including the convertible securities one at a time, beginning
with the security having the lowest incremental EPS. When the recomputed EPS is less than the
incremental EPS of the next security, no additional convertible securities are considered in
computing EPS.
DERIVATIVES

1. A derivative derives its value from the movements in prices, interest rates, or exchange rates
associated with other financial instruments, assets, or liabilities. Also, derivative contracts are often
entered into without any exchange of cash at the contract date. The derivative can have zero value on
the contract date. Still, its value changes subsequently (up or down), depending on the movement of
the relevant price or rate associated with the underlying item.
2. A derivative contract is often an executory contract because it doesn’t involve a transaction but is
merely an exchange of promises about future actions. Other examples of an executory contract are
operating leases and a salary agreement for the coming year between employer and employee: The
employer agrees to pay a certain amount if the employee works, and the employee agrees to work if
the employer pays that certain amount.

3. The four types of risk discussed in the chapter are as follows:

• Price risk—uncertainty about the future price of an asset.
• Credit risk—uncertainty over whether the party on the other side of a transaction will abide by
the terms of the agreement.
• Interest rate risk—possibility about
Future interest rates and their impact on cash flows and the fair value of financial instruments.
• Exchange rate risk—uncertainty about the future peso cash flows stemming from assets and
liabilities denominated in foreign currencies.

4. Interest payments come in two general varieties - fixed payments and variable payments. Sometimes
it is easier for a firm to negotiate a fixed-rate loan; sometimes, it is easier to negotiate a variable-rate
loan. If a firm is obligated to pay one type of interest payment but would prefer to be paying the
other, an interest rate swap can be used to transform the unwanted payment stream into the one that
is desired.

5. A forward contract is an agreement negotiated between two parties to exchange a specified amount
of a commodity, security, or foreign currency at a specified date in the future with the price or
exchange rate being set now. A futures contract is the same thing except that instead of being
negotiated between two parties, the contract is a standard one that is sponsored by an organized
exchange. With a futures contract, the exchange handles the cash settlements between the two parties
to the contract. Accordingly, with a futures contract, the two parties to the agreement rarely directly
contact one another. This is not true with forwarding contracts because they are directly negotiated
between the two parties.

6. Swaps, forwards, and futures provide two-sided protection. If these derivative instruments are used
in a hedging relationship, they hedge against both increases and decreases in prices or rates. An
option offers one-sided hedging: protection against unfavorable movements in prices or rates without
taking away the ability of the firm to profit from a favorable movement in prices or rates. Because of
the one-sided nature of an option, an option has a value at the agreed date, and the buyer of the
option must pay this amount at the beginning of the contract period.
 7. A cash flow hedge is a derivative that offsets, at least partially, the variability in cash flows from a
probable forecasted transaction. One example of a cash flow hedge is an interest rate swap that
hedges the fluctuation in variable-rate interest payments. Another example is a futures contract used
to lock in the price of purchases to be made in a future period.

8. Traditional historical cost accounting is inappropriate when accounting for derivative contracts
because the historical cost of a derivative is usually minimal, sometimes zero. With derivatives, the
subsequent changes in prices or rates are critical to determining the value of the derivative, yet these
changes are frequently ignored in traditional accounting.

9. Partial hedge ineffectiveness occurs when the terms of a derivative have not been constructed to
exactly match the amount and timing of the underlying hedged item. Partial hedge ineffectiveness
would arise if, for example, the derivative maturity date did not exactly match the date of a
forecasted purchase.

10. The appropriate financial statement treatment of unrealized gains and losses on derivatives depends
on whether the derivative serves as a hedge and, if so, the type of hedge.
• No hedge. All changes in fair value are recognized as gains or losses in the income statement in
the period in which the value changes.

• Fair value hedge. Changes in fair value are recognized as gains or losses and are offset (either in
whole or in part) by the recognition of gains or losses on the change in fair value of the item
being hedged.

• Cash flow hedge. Changes in fair value are recognized as part of comprehensive income. These
deferred derivative gains and losses are recognized in net income in the period in which the
hedged cash flow transaction was forecasted to occur.

11. The notional amount is the total face amount of the asset or liability that underlies the derivative
contract. The notional amount can be misleading because the value of a derivative is a function of
changes in prices or interest rates and usually is equal to just a small fraction of the notional amount
of the underlying asset.

For example, if a firm has a futures contract to purchase a certain amount of foreign currency for
P1,000,000, the notional amount of the futures contract is P1,000,000. However, the futures contract
has value only if exchange rates change. The futures contract is likely to have a value that is far less
than the notional amount.

12. Derivatives that serve as economic hedges of foreign currency assets and liabilities are accounted for
as speculations with all gains and losses recognized as part of income immediately.

13. The accounting for a speculative derivative investment is very straightforward; the derivative is
reported as an asset or liability in the balance sheet at its market value as of the balance sheet date,
and any unrealized gains or losses are always included in the computation of net income for the
period. Derivatives that serve as a hedge are also reported in the balance sheet at their market value,
but unrealized gains or losses might be deferred if the derivative serves as a cash flow hedge.
CONTINGENCIES

1. Contingent liabilities that are reasonably possible of becoming liabilities should be disclosed in the
notes to the financial statements. Only probable contingent liabilities should be recognized in the
balance sheet if they can be reasonably estimated.

2. Contingent gains should be recognized if it is probable that they will be realized. If a contingent gain
is only possible, often, no mention is made about it in the notes to avoid misleading financial
statement users about the likelihood of the gain being realized.

3. The key factors to consider in deciding whether a pending lawsuit should be reported as a liability on
the balance sheet are as follows:

• The nature of the lawsuit

• Progress of the case in court, including progress between the date of the financial statements
and their issuance date

• Views of legal counsel as to the probability of loss

• Prior experience with similar cases

• Management’s intended response to the lawsuit

SEGMENT REPORTING
1. Many companies today are large, complex organizations engaged in a variety of activities that bear
little relationship to one another. This means that one segment could be operating very profitably
while another could be experiencing a loss. To analyze a company's activities and status, it is helpful
to divide the company into segments so that individual segments can be compared with similar
companies or segments. Overall, company analysis is less useful because there are no standard
companies against which to measure the entire operation. If segment information is available,
analysis can be expanded to treat each segment as though it were a separate company.

2. A segment is reportable if it meets any one of the following three criteria:

• Revenue test. A segment should be reported if its total revenue (both to external customers and
other internal segments) is 10% or more of the total revenue (external and internal).

• Profit test. A segment should be reported if the absolute value of its operating profit (or loss) is
more than 10% of the total of the operating profit for all segments that reported profits (or the
sum of the losses for all segments that reported losses).

• Asset test. A segment should be reported if it contains 10% or more of the combined assets of all
operating segments.
3. Segment information often is not prepared according to GAAP. Accounting principles designed for
an entire entity are not always applicable to the individual pieces of a business. Firms are instructed
to prepare segment information using the same practices applied in making internal reports, whether
these internal practices conform with GAAP or not. This lowers the incremental cost of providing
segment information to external users and offers external users with the same type of data used
internally by management.
INTERIM REPORTING

1. Financial statements for each interim period should reflect all deferrals, accruals, adjustments, and
estimates that would be required for any accounting period. An interim period is not separate but is
an integral part of the total annual period. Revenues and costs are assigned to interim periods on a
reasonable basis, such as time, sales volume, or production.

2. Investors should use care in interpreting interim reports because of the potential danger of
misinterpreting these reports. Several factors may cause investors to misinterpret this information.
The seasonality of individual businesses may seriously distort reported earnings for particular
interim periods. "Below the line" items will have a greater impact on interim earnings than on yearly
earnings. Also, for preparers of interim reports to supply such information to investors, an increased
number of estimates must be made for the interim period. This increases the subjectivity of these
reports.
ACCOUNTING CHANGES & ERROR CORRECTIONS

1. Comparability enables users to relate accounting information to a benchmark or standard. The

benchmark may be in the form of another firm’s financial statements or financial data of the same
firm but for some other period. An accounting change could make it difficult to compare data from
one period to another or from one firm to another, thus detracting from comparability.

For example, if a company switched from straight-line depreciation to double-declining-balance

depreciation in 2021, depreciation expense for 2021 could not be compared with prior years’
depreciation expense without knowing the effects of the change in accounting for depreciation.

Consistency means that a company applies the same methods to similar transactions and events from
period to period. Therefore accounting changes, especially changes in methods used, would detract
from the informational characteristic of consistency.
2. a. Change in accounting estimate. As a result of experience or the availability of new information,
a company may revise estimates used in the measurement of income.

b. Change in accounting principle. A change in accounting principle or method may be required

due to changing economic conditions or as a result of a new pronouncement issued by an
authoritative standard-setting body.

3. Alternative procedures suggested for reporting accounting changes are as follows:

a. Restate the financial statements presented for prior periods to reflect the effect of the change.
Adjust the beginning retained earnings balance of the earliest period reported for the cumulative
impact of the change in all preceding years.

b. Not adjust statements presented for prior periods. Report the cumulative effect of the change in
the current year as a direct entry to Retained Earnings.

c. Same as (b) except report the cumulative effect of the change as a particular item in the income
statement instead of directly to Retained Earnings.

d. Report the cumulative effect in the current years as in (c) but also present limited pro forma
information for all prior periods included in the financial statements, reporting “what might have
been” if the change had been made in the previous years.

e. Make the change effective only for current and future periods with no catch-up adjustment.

4. a. Examples of areas for which changes in accounting estimates are often made include these:
(1) Uncollectible receivables
(2) Useful lives of depreciable or intangible assets
(3) Residual values for depreciable assets
(4) Warranty obligations
(5) Amounts of mineral reserves to be depleted
(6) Actuarial assumptions for pensions or other postemployment benefits
(7) Number of periods benefited by deferred costs
 b. A change in estimate should be reflected either in the current period or in current and future
periods. No retrospective adjustments are to be prepared for a change in the accounting estimate.

c. This procedure is considered proper because changes in estimates are deemed to be part of
the normal accounting process and not corrections or changes of prior periods.
5. A change in depreciation method is accounted for as “a change in accounting estimate effected by a
change in accounting principle.” The existing depreciable book value is depreciated over the
remaining useful life using the new depreciation method.

6. A change in accounting principle is implemented by recomputing all financial statement amounts for
the preceding years (at least those that will be included in the current year’s comparative financial
statements). These recomputed amounts are included in the comparative financial statements reported
this year. Any income effect in even earlier years is shown as an adjustment to the beginning balance
in Retained Earnings for the earliest year reported. Note disclosure gives a line-by-line comparison of
these retrospectively adjusted financial statements and the financial statements (using the former
accounting principles) that were initially reported.

8. a. The effects of a change in accounting principle should be reported as a direct adjustment to the
current year’s beginning retained earnings balance when it is impractical to determine the
precise periods when past differences arose.

b. The effects of a change in accounting principle should be reflected prospectively only when it is
impossible to determine the past impact of an accounting change.

9. Following a business combination, the combined company must provide pro forma revenue and net
income information for the year of the combination and the preceding year. Computations must be
made to adjust the reported numbers to what they would have been if the combination had occurred
at the beginning of the current year and to what they would have been if the combination had
happened at the beginning of the preceding year.

12. a. For bookkeeping purposes, accounting errors are to be treated as prior-period adjustments and
recorded as a direct adjustment to Retained Earnings. The reported comparative financial
statements are restated to correct for the errors.

b. Counterbalancing errors are those that, if not detected during the current period, is offset by an
equal misstatement in subsequent periods.
FS ANALYSIS

1. In addition to identifying a company’s weaknesses, financial statement analysis can be used to

predict a company’s future profitability and cash flows based on its past performance.
2. Comparative financial statements provide a better indication of the nature and trends of changes
affecting a business enterprise. Total amounts, in the absence of a benchmark, are not very good
indications of performance or efficiency. Comparative statements at least provide a basis for
judgment to other periods or industry data.
Comparative statements are more useful if there is uniformity of presentation and content,
consistency of application of accounting principles, and disclosure of significant changes in
circumstances and the resulting impact of those changes.

3. Analysis of financial ratios does not reveal the underlying causes of a firm’s problems. Financial
statement analysis only identifies the problem areas. The only way to find out why the financial
ratios look bad is to gather information from outside the financial statements: ask management, read
press releases, talk to financial analysts who follow the firm, and read industry newsletters. Financial
ratio analysis does not give the final answers, but it does point out areas about which more detailed
questions should be asked.

4. A common-size financial statement is a financial statement for which each number in a given year is
standardized by a measure of the size of the company in that year. A common standardization is to
divide all financial statement numbers by sales for the year. Common-size statements make possible
a ready comparison of financial data for companies of different size-either the same company in
different years or different companies at the same point in time.

5. The DuPont framework decomposes return on equity into three components: profitability, efficiency,
and leverage. For each of these components, a single ratio is used to give a summary measure of how
the company is performing in that area. The summary measures follow:
• Profitability: Return on sales
• Efficiency: Asset turnover
• Leverage: Assets-to-equity

Once the DuPont framework calculations have given a general picture of a company’s performance,
more detailed ratios can be computed to yield specific information about each of the three areas.

6. a. Inventory turnover is computed by dividing the cost of goods sold for the period by the average
inventory.

b. In arriving at a rate of inventory turnover, it is essential that the inventory figures used to compute
the average inventory be representative. If the beginning and ending balances are unusually high
or low, the turnover rate may be misleading.

c. A rising inventory turnover rate indicates that a smaller amount of capital is tied up in inventory
for a given volume of business. This may mean more efficient buying and merchandising
policies. However, if the turnover rate is higher than for other firms in the industry, it may
indicate dangerously low levels of inventory, exposing the firm to the risk of inventory shortages
 and running out of stock.

7. a. Times interest earned. Computed by dividing earnings before interest and taxes (operating
income) by interest expense for the period. This measures a company’s ability to meet interest
payments and suggests the security afforded to creditors.

b. Return on equity. Computed by dividing net income by stockholders’ equity. This measurement
indicates management’s effectiveness in employing the funds provided by the stockholders in
generating profits.

c. Earnings per share. Computed by dividing net income by the weighted average number of
common shares outstanding. EPS is a number useful in evaluating the level of cash dividends per
share relative to income and in assessing the market price per share relative to income.

d. Price-earnings ratio. Computed by dividing the market price per share by earnings per share.
The P/E ratio shows how much investors are willing to pay for each dollar of current earnings
and is an indication of what investors believe about a company’s future growth prospects.

e. Dividend payout ratio. Computed by dividing cash dividends by net income. This ratio reveals
what fraction of income a company distributes to shareholders in the form of cash dividends.

f. Book-to-market ratio. Computed by dividing the total book value of equity by the total market
value of shares outstanding. This ratio reveals how the market is currently valuing the net
investment in a company relative to the amount of investment provided initially by the
stockholders. Book-to-market ratios are usually less than 1.0, indicating that the market value of
the firm is greater than the total equity funds provided by the stockholders.

8. One of the factors affecting overall firm performance is the ability to invest in an asset and sell it at a
profit. The turnover of the assets affects the return on assets because a profit will be made each time
the operating cycle is completed (investment in an asset, selling the asset to a customer, collection of
cash). If within a given accounting period, an organization completes more than one operating cycle,
the resulting return on total assets will be a function of the profit percentage on each sale and the
number of completed operating cycles. Thus, the return on assets may be increased by either
increasing the turnover of assets or by increasing the profit made on each sale.

9. The return on assets equals the ROE when total assets equal total stockholders’ equity, meaning that
there are no liabilities. Overall, the ROE will always exceed the return on assets (unless a company’s
liabilities exceed its assets); however, on marginal or new investments, this will be true only if the
return on the new assets exceeds the cost of obtaining the additional funds.

10. Ratio comparisons can yield misleading implications if the ratios come from companies with
different accounting practices. Differences in accounting methods can make one company look
superior to another even though they are economically identical. For example, if one company uses a
10-year life for depreciating fixed assets and another depreciates similar assets over a 15-year life,
the decreased depreciation expense for the second company will make it look more profitable even
in the absence of real differences in operating performance.