Chapter 15: Short-Term Liabilities Questions

CHAPTER 15: SHORT-TERM LIABILITIES
QUESTIONS
2. Conceptually, how should a liability be measured?
Answer: Conceptually, a liability should be measured as the present value of all related
future cash flows discounted at a rate of interest consistent with the risk involved.
6. In evaluating a balance sheet, some bankers say the liability section is one of the most
important parts. What are the reasons ustifying this position?
Answer: The primary reason is to assess the liquidity, and in the extreme, the solvency of the
company. For this assessment, one would need to know (a) the current versus lon!term
liabilities and (b) their maturity dates, interest rates, and other terms. "lso, liabilities are often
the most difficult of all the items listed on the balance sheet to ascertain with respect to their
existence. "n individual, so inclined, can intentionally fail to report selected liabilities. "uditors
routinely conduct tests to detect unrecorded liabilities.
!. "ome liabilities are reported at their maturity amount. In general, when should
liabilities, prior to maturity date, be reported at less than their maturity amount?
Answer: " liability will be reported at less than its maturity amount prior to the maturity date if
(a) it is a non!interest!bearin note, or (b) the stated rate of interest on the liability is lower
than the market rate of interest.
#. $efine a current liability.
Answer: " current liability is an obliation that will be settled by usin current assets or the
creation of other current liabilities. That is, it will be paid with current assets durin the comin
year or next operatin cycle, whichever is loner. #hort!term obliations that will be paid with
noncurrent assets should not be classified with current liabilities.
%%. $istinguish between the stated rate of interest and the effective rate of interest &yield'
on a debt.
Answer: #tated rate of interest$the rate specified in the debt areement% it determines the
cash interest to be paid. &ffective or yield rate$the true rate of interest based on the cash
equivalents received and the total cash equivalents paid back.
%(. )re all declared dividends a liability between declaration and payment dates?
*+plain.
Answer: " cash or property dividend is a liability between declaration and payment dates
because there is a contract to distribute assets. " stock dividend is not a liability because no
assets will be distributed.
%6. Why is unearned revenue classified as a liability?
Answer: 'nearned revenue, which is revenue collected in advance of bein earned, is a
liability because oods or services must be expended in the future to earn the deferred
revenue.
Chapter () !(*+,! #hort!Term -iabilities
%!. What is compensated absence? When should the e+pense related to compensated
absences be recogni,ed?
Answer: " compensated absence is time away from work (represented by vacation, holiday,
and sick leave) iven to employees without reducin their salaries or waes. The related
expense should be reconi.ed when earned and not when the time is taken off, if the two are
different.
%-. What is the accounting definition of a contingency? What are the three characteristics
of a contingency? Why is the concept important?
Answer: " continency, as defined in SFAS No. 5, is an existin condition, situation or set of
circumstances involvin uncertainty as to possible ain (a ain continency) or loss (a loss
continency) to an enterprise that will ultimately be resolved when one or more future events
occur or fail to occur. /esolution of the uncertainty may confirm (() the acquisition of an asset
or the reduction of a liability, or (+) impairment of an asset or the incurrin of a liability.
The three characteristics of a continency are (() an existin condition, (+) uncertainty as to
the ultimate effect, and (0) its resolution dependin on one or more future events.
The concept is important because it represents a potential future asset or liability that has
arisen as a result of an event or transaction that has already occurred. The hih deree of
uncertainty results in extra caution in accountin for continencies.
2.. /riefly e+plain the accounting and reporting for loss contingencies.
Answer: -oss continencies are either accrued or reported in a footnote, dependin upon the
deree of uncertainty and whether they can be reasonably estimated. 1f probable and
measurable, they are accrued% if probable but not sub2ect to reasonable estimation or if only
reasonably possible, they should be disclosed by footnote. 1f the possibility of their arisin is
remote, no disclosure is required.
EXERCISES
E 15-1 Multiple Choice
%. 0n 1anuary %!, %##-, an e+plosion occurred at a Cord Company plant causing
e+tensive property damage to area buildings. )lthough no claims have yet been
asserted against Cord by 2arch %., %##-, Cord3s management and counsel concluded
that it was reasonably possible that Cord would be responsible for damages, and that
42,(..,... would be a reasonable estimate of its liability. Cord3s 4%.,...,...
comprehensive public liability policy has a 4(..,... deductible clause. In Cord3s
$ecember 5%, %##! financial statements, which were issued on 2arch 2(, %##-, how
should this item be reported?
a. 6o footnote disclosure or accrual is necessary.
b. )s a footnote disclosure indicating the possible loss of 4(..,....
c. )s an accrued liability of 4(..,....
d. )s a footnote disclosure indicating the possible loss of 42,(..,....
Chapter () !+*+,! #hort!Term -iabilities
Answer: B. 3er #F"# ), a loss continency should be accrued if it is probable that a liability
has been incurred at the balance sheet date and the amount of the loss is reasonably
estimable. "lthouh the continency is reasonably estimable, it is not probable. Therefore, no
loss is accrued. 4owever, since the continency is reasonably possible, it will be disclosed in
the footnotes to the (+*0(*5, financial statements. The possible loss will be disclosed as
6)77,777. The additional potential liability above the deductible would be covered by the
insurance policy and would not be a loss for Cord.
2. 7one Company is the defendant in a lawsuit filed by Witt in %##! disputing the
validity of a copyright held by 7one. )t $ecember 5%, %##!, 7one determined that
Witt would probably be successful against 7one for an estimated amount of 4-..,....
)ppropriately, an 4-..,... loss was accrued by a charge to income for the year
ended $ecember 5%, %##!. 0n $ecember %(, %##-, 7one and Witt agreed to a
settlement providing for cash payment of 4(..,... by 7one to Witt and transfer of
7one3s copyright to Witt. 7he carrying amount of the copyright on 7one3s accounting
records was 4%2.,... at $ecember %(, %##-. What would be the effect of the
settlement of this liability on 7one3s income before income ta+ in %##-?
a. 6o effect.
b. 4%2.,... decrease.
c. 4%-.,... increase.
d. 45..,... increase.
Answer: C. "t (+*0(*5,, the continent liability from the lawsuit met #F"# )8s criteria for
accrual (probable and reasonably estimable), so a loss and liability of 6977,777 was
reconi.ed. 1n (559, the lawsuit was settled and the actual loss was 6:+7,777 (6(+7,777
copyriht transfer and 6)77,777 cash payment). This is a chane in estimate which should be
accounted for in the period of chane per "3; <pinion +7, para. 0(. Therefore the 6(97,777
difference will be reflected in (559 income as a ain. The 2ournal entry on (+*()*59 to record
the settlement would be=
-awsuit liability........................................................................ 977,777
>ain from settlement of lawsuit........................................ (97,777
Cash................................................................................. )77,777
Copyriht.......................................................................... (+7,777
5. ) manufacturer of household appliances has potential losses due to the discovery of a
possible defect in one of its products. 7he occurrence of the loss is reasonably
possible and the costs can be reasonably estimated. 7he possible loss should be
Disclosed
Accrued in Footnotes
a. 6o 6o
b. 6o 8es
c. 8es 8es
d. 8es 6o
Answer: B. 3er #F"# ), a loss continency will be accrued only if its occurrence is probable
and the amount can be reasonably estimated. 1n this case the loss is not considered probable
and, therefore, should not be accrued. "lthouh a continent loss is not accrued if it is only
reasonably possible (not probable) it will be disclosed in the footnotes to the financial
statements. Therefore, the correct answer is ;, the reasonably possible loss will not be
Chapter () !0*+,! #hort!Term -iabilities
accrued but it will be disclosed. #uch disclosure should include the nature of the continency
and should ive an estimate of the possible loss or rane of loss or state that such an
estimate cannot be made.
9. )n e+propriation of assets which is imminent and for which the amount of loss can be
reasonably estimated should be
Disclosed
Accrued in Footnotes
a. 6o 6o
b. 6o 8es
c. 8es 8es
d. 8es 6o
Answer: C. The requirement is to determine the proper treatment of an expected loss that is
imminent (probable) and the amount of which can be reasonably estimated. "nswer (C) is
correct because, per #F"# ?o. ), para. 9, an estimated loss from continencies shall be
accrued and chared to income when it is probable that an asset has been impaired or a
liability incurred and when the amount of the loss can be reasonably estimated. ;oth of these
requirements are met by the expropriation of assets described in this question. Therefore, this
loss continency should be accrued. "dditionally, per para. 5, the nature of the continency
should be disclosed in a note to the financial statements. Therefore, answers (a), (b) and (c)
are incorrect.
%. 0n $ecember 5%, %##-, /eal Company was involved in a ta+ dispute with the I:".
/eal3s ta+ counsel believed that an unfavorable outcome was probable and a
reasonable estimate of additional ta+es was 42!(,..., with a chance that the
additional ta+es could be as much as 492(,... )fter the %##- financial statements
were issued, /eal accepted the I:" settlement offer of 452(,.... What amount of
additional ta+es should have been accrued in %##-?
a. 492(,....
b. 452(,....
c. 42!(,....
d. 4.
Answer: C. The additional taxes must be accrued as a loss continency in accordance with
#F"# ?o. ) because an unfavorable outcome is probable and the amount of the loss is
reasonably estimable. 3er F"#; 1nterpretation (@, when a rane of possible losses exists,
the best estimate in the rane (in this case 6+,),777) is accrued. #ince the 60+),777
settlement occurred after the statements were issued, this information was not available
when the estimates were made. 1f, however, it had become available after the end of the
fiscal year but before the financial statements were issued, it would have been a Type (
#ubsequent &vent and 60+),777 would be accrued in (559.
Chapter () !@*+,! #hort!Term -iabilities
2. 0n 6ovember (, %##!, a $unn Corporation truck was in an accident with an
automobile driven by :. /ell. $unn received notice on 1anuary %2, %##- of a lawsuit
for 45(.,... in damages for personal inuries suffered by /ell. $un Corporation3s
counsel believes it is probable that /ell will be awarded an estimated amount in the
range between 4%..,... and 422(,..., and that 4%(.,... is a better estimate of
potential liability than any other amount. $unn3s accounting year ends on $ecember
5%, and the %##! financial statements were issued on 2arch 2, %##-. What liability
should $unn accrue at $ecember 5%, %##!?
a. 4..
b. 4%..,....
c. 4%(.,....
d. 422(,....
Answer: C. 3er #F"# ), a loss continency should be accrued if it is probable that a liability
estimable. This loss must be accrued because it meets both criteria. &ven thouh the lawsuit
was not initiated until (*(+*59, the liability was incurred on ((*)*5, when the accident
occurred. F"#; 1nterpretation (@ requires that when some amount within an estimated rane
is a better estimate than any other amount in the rane, that amount is accrued. Therefore, a
loss of 6()7,777 should be accrued. 1f no amount within the rane is a better estimate than
any other amount, the amount at the low end of the rane is accrued and the amount at the
hih end is disclosed.
5. 7he following information pertains to a fire insurance policy in effect during the
calendar year %##-, covering ;ail Company3s inventory<
=ace amount of policy.................................... 49..,...
$eductible...................................................... 2(,...
)mount of premium....................................... 2,...
Coinsurance clause......................................... -.>
;ail3s inventory averages 4(..,... uniformly throughout the year. ;ail3s income ta+
rate is 9.>. ?ow much of a contingent liability should ;ail accrue at $ecember 5%,
%##- to cover possible future fire losses?
a. 4..
b. 4%(,....
c. 425,....
d. 46.,....
Answer: A. The requirement is to determine the amount Aail should accrue as a continent
liability at (+*0(*59 to cover possible future fire losses. "nswer (a) is correct because, per
#F"# ), para. 9, a continent liability shall only be accrued if the likelihood of its occurrence
is probable and the amount of the loss can be reasonably estimated. "n event such as a
future fire loss is not considered probable at +*0(*59 based on the information iven, nor can
an amount of the loss from such an event be reasonably estimated. Thus, no accrual is
required at (+(*0(*59.
Chapter () !)*+,! #hort!Term -iabilities
9. When the occurrence of a gain contingency is reasonably possible and the amount can
be reasonably estimated, the gain contingency should be
a. Included in net income and disclosed.
b. Included in an appropriation of retained earnings.
c. $isclosed, but not included in net income.
d. 6either included in net income nor disclosed.
Answer: C. 3er #F"# ), para. (,, continencies that miht result in ains usually are not
reflected in the accounts since to do so miht result in revenue bein reconi.ed prior to its
reali.ation. "lthouh adequate disclosure shall be made of continencies that miht result in
ains, care should be exercised to avoid misleadin implications as to the likelihood of
reali.ation. Therefore, answer (c) is correct. "nswer (a) is incorrect because the ain
continency should not be reconi.ed in the income statement. "nswer (b) is incorrect
because the ain continency would not be reflected in any of the accounts. "nswer (d) is
incorrect because the continency should be disclosed in the notes to the financial
statements.
%. :obb Company re@uires advance payments with special orders from customers for
machinery constructed to their specification. Information for %##- is<
Customer advancesAbalance %2B5%B#!........................4(#.,...
)dvances received with orders in %##-..........................#2.,...
)dvances applied to orders shipped in %##-..................-2.,...
)dvances applicable to orders canceled in %##-............2(.,...
)t $ecember 5%, %##-, what amount should :obb report as a current liability for
customer deposits?
a. 4..
b. 499.,....
c. 46#.,....
d. 4!9.,...
Answer: B. To determine the (+*0(*59 balance of the liability for customer advances the
followin ad2ustments are made to the beinnin (+*0(*5, credit balance=
(+*0(*5, ;alance.....................................................6)57,777
(559 "dvances /eceived........................................ 5+7,777
#ubtotal.................................................................6(,)(7,777
-ess=
(559 "dvances "pplied (9+7,777)
(559 "dvances Cancelled (+)7,777
(+*0(*59 ;alance.....................................................6@@7,777
Bhen advances are received C65+7,777D, cash is debited and the liability account is credited.
Bhen advances are applied to orders shipped C69+7,777D, the liability account is debited and
sales is credited. Bhen an order is cancelled C6+)7,777D, the liability account is debited and
Chapter () !:*+,! #hort!Term -iabilities
either cash or a revenue account is credited, dependin upon whether or not the deposit is
returned to the customer.
2. Cobb Company sells appliance service contracts to repair appliances for a twoCyear
period. Cobb3s past e+perience is that, of the total amount spent for repairs on service
contracts, 9.> is incurred evenly during the first contract year and 6.> evenly
during the second contract year. :eceipts from service contract sales for the two years
ended $ecember 5%, %##- are 42(.,... in %##! and 45..,... in %##-. :eceipts from
contracts are credited to unearned service contract revenue. )ssume that all contract
sales are made evenly during the year. What amount should Cobb report as unearned
service contract revenue at $ecember 5%, %##-?
a. 4%-.,....
b. 425(,....
c. 429.,....
d. 45%(,....
Answer: D. "ll contract sales are made evenly durin the year. Therefore, the (55, contracts
rane from one year expired (if sold on (+*0(*5,) to two years expired (if sold on (*(*5,), for
an averae of (E years expired. #imilarly, the (559 contracts rane from 7 years expired to (
year expired, for and averae of E year expired. The averae unearned portion of the (55,
contracts is E year. The amount of unearned revenue related to the (55, contracts is
calculated as follows=
6+)7,777 x :7F x E G 6,),777
The averae unearned portion of the (559 contracts is (E years. The amount of unearned
revenue related to the (559 contracts is calculated as follows=
6077,777 x @7F x E G 6 :7,777
6077,777 x :7F G (97,777
6+@7,777
Therefore, the total unearned revenue is 6,),777 H 6+@7,777 G 60(),777.
5. In packages of its products, Curran Co. includes coupons that may be presented at
retail stores to obtain discounts on other Curran products. :etailers are reimbursed for
the face amount of coupons redeemed plus %.> of that amount for handling costs.
Curran honors re@uests for coupon redemption by retailers up to three months after
the consumer e+piration date. Curran estimates that !.> of all coupons issued will
ultimately be redeemed. Information relating to coupons issued by Curran during
%##- is as follows< consumer e+piration date, $ecember 5%, %##-D total face amount
of coupons issued, 45..,...D and total payments to retailers as of $ecember 5%,
%##-, 4%%.,.... What amount should Curran report as a liability for unredeemed
coupons at $ecember %, %##-?
a. 4..
b. 4%..,....
c. 4%2%,....
d. 4%(9,....
Answer: C. "t (+*0(*59, Curran should report a liability even thouh the coupons expired
(+*0(*59 because retailers may submit coupons to Curran for three months after the
Chapter () !,*+,! #hort!Term -iabilities
expiration date. Thus, Curran will still have to redeem coupons until 0*0(*55. Total expected
redemptions are 6+(7,777 (.,7 x 6077,777), and on those redemptions Curran expects to pay
out 6+0(,777 (6+(7,777 plus .(7 x 6+(7,777 for handlin) "s of (+*0(*59, total payments to
retailers have been 6((7,777, which means a liability of 6(+(,777 should be reported
(6+0(,777 ! 6((7,777).
9. )n employer3s obligation relating to employees3 rights to receive compensation for
future absences is attributable to employees3 services already rendered. 7he payment
of compensation is probable and the amount of compensation can be reasonably
estimated. *mployees3 compensation should be
a. )ccrued if the obligation relates to rights that vest or accumulate.
b. )ccrued if the obligation relates to rights that do not vest or accumulate.
c. *+pensed when paid.
d. $isclosed but not accrued if the obligation relates to rights that vest or
accumulate.
Answer: A. #F"# @0, para. : requires employers to accrue a liability for future absences
when all of the followin conditions are met=
() The employees8 services have already been rendered.
+) The obliation relates to rihts that vest or accumulate.
0) 3ayment is probable% and
@) The amount can be easily estimated.
%. /loy Company pays all salaried employees on a biweekly basis. 0vertime pay,
however, is paid in the ne+t biweekly period. /loy accrues salary e+pense only at its
$ecember 5% yearCend. $ata relating to salaries earned in $ecember %##- are<
East payroll was paid on $ecember 26, %##-, for the twoCweek period ended on
that day.
0vertime pay earned in the twoCweek period ended $ecember 26, %##- was
4-,9...
:emaining work days in %##- were $ecember 2#,5., and 5%, on which days there
was no overtime.
7he recurring biweekly salaries total 4%(.,....
)ssuming a fiveCday workweek, /loy should record a liability at $ecember 5%, %##-,
for accrued salaries of
a. 49(,....
b. 4(5,9...
c. 4#.,....
d. 4#-,9...
Answer: B. the liability for accrued salaries at (+*0(*59 should include all salaries expense
that has been accrued but not yet paid. This would include the overtime pay earned by
employees for the two!week period ended (+*+:*59 (69,@77), which will not be paid until the
next pay period. "ccrued salaries would also include the reular pay for the workdays
(Iecember +5, 07, and 0(). #ince each biweekly pay period results in 6()7,777 reular pay
for (7 workdays (+ five!day weeks), the accrued salaries for three workdays would be 0*(7 of
6()7,777, 6@),777. Therefore, the total liability for accrued salaries at (+*0(*59 is 6)0,@77
(6@),777 H 69,@77).
2. 0n "eptember %, %##!, the Fine Company issued a note payable to 6ational /ank in
the amount of 4#..,..., bearing interest at %2>, and payable in three e@ual annual
principal payments of 45..,.... 0n this date the bank3s prime rate was %%>. 7he first
interest and principal payment was made on "eptember %, %##-. )t $ecember 5%,
%##-, Fine should record interest payable of
a. 422,....
b. 429,....
c. 455,....
d. 456,....
Answer: B. "ccrued interest payable at (+*0(*59 is interest expense that has been incurred
by (+*0(*59 but not yet paid. 1n this case, interest was last paid on #eptember (, (559, so the
accrued interest payable includes interest expense incurred for 5*( throuh (+*0( (@ months).
The oriinal balance of the note was 6577,777, but the 5*(*59 principal payment of 6077,777
reduced the balance to 6:77,777. Therefore, the interest payable at (+*0(*59 is 6+@,777.
6:77,777 x .(+ x @*(+ G 6+@,777
The stated rate of (+F is used rather than the bank8s prime rate of ((F because (+F is the
rate neotiated for this particular note.
5. Fam, Inc. has 4(..,... of notes payable due 1une %(, %###. )t the financial statement
date of $ecember 5%, %##-, Fam signed an agreement to borrow up to 4(..,... to
refinance the notes payable on a longCterm basis. 7he financing agreement called for
borrowings not to e+ceed -.> of the face value of the collateral that Fam was
providing. )t the date of issue of $ecember 5%, %##- financial statements, the value
of the collateral was 46..,... and was not e+pected to fall below this amount during
%###. In its $ecember 5%, %##- balance, Fam should classify notes payable as
Short-term Long-term
Obligations Obligations
a. 4 . 4(..,...
b. 4 2.,... 49-.,...
c. 4%..,... 49..,...
d. 4(..,... 4 .
Answer: B. "ll the notes are due :*()*55 and normally the entire amount would be classified
as current. 4owever, #F"# ?o. : states that a short!term obliation can be reclassified as
lon!term if the enterprise intends to refinance the obliation on a lon!term basis and the
intent is supported by the ability to refinance. 3am demonstrated its ability by enterin into a
financin areement before the statements are issued. #F"# ?o. : further states that the
amount to be excluded from current liabilities cannot exceed the amount available for
refinancin under the areement. 3am expects to be able to refinance at least 6@97,777 (.97
x 6:77,777) of the notes. Therefore, that amount can be classified as lon!term while the
remainin 6+7,777 must be classified as short!term.
9. Which of the following is classified as an accrued liability?
Liability for Liability for
Federal Employers
nemployment Share of
!a"es F#$A !a"es
a. 8es 8es
b. 8es 6o
c. 6o 6o
d. 6o 8es
Answer: A. "ccrued liabilities include expenses that have been incurred but not yet paid.
;oth federal unemployment taxes and the employer8s share of F1C" taxes represent tax
expense that is incurred as employees earn waes, but which is only paid periodically.
Therefore, both types of expenses represent accrued liabilities.
E 15-7 Identi!in" Cu##ent $i%&ilitie'( Consider the following five items<
a. /ank overdraft.
b. :etained earnings.
c. EongCterm debt.
d. Cash dividends declared but not paid.
e. Customer payments for maga,ine subscriptions not yet delivered.
Required: Identify the current liabilities among these five items.
Answer: 1tems a, d and e are current liabilities. 1tem b belons with stockholders8 equity.
E 15-) Identi!in" % Cu##ent $i%&ilit!( "uppose a firm has an obligation that re@uires it
to pay another organi,ation 4(..,... two years from today.
Required: 6ormally such an obligation would be considered longCterm. Is there any
situation in which this obligation could be considered a current liability.
*+plain.
Answer: Jes. 1f the business of the firm is such that a period loner than a year is necessary
for reportin purposes, such an obliation could be considered a current liability.
&xamples often iven of such cases are ma2or construction activities includin
shipbuildin, dams and the buildin of ma2or plant or office buildins. -on!term
ventures miht also qualify, such as the search for oil or for treasure. 1n these cases
the normal production or operatin cycle exceeds a year and this loner period
dictates the reportin cycle.
Chapter () !(7*+,! #hort!Term -iabilities
E15-12 *n%l!'i' %nd Co+p%#i'on o Inte#e't-,e%#in" %nd Noninte#e't-,e%#in" Note' 0n
"eptember %, %##-, $yer Company borrowed cash on a 4%..,... note payable, principal and
interest due in one year. )ssume the going rate of interest was %2 percent per year for this
particular level of risk. 7he accounting period ends $ecember 5%.
Required: Complete the following tabulationD round to the nearest dollar.
*''u+in" the Note -%'
Inte#e't-
Noninte#e't-
,e%#in" ,e%#in"
%. Cash received 4 GGGGGGGG 4 GGGGGGGG
2. Cash paid at maturity date 4 GGGGGGGG 4 GGGGGGGG
5. 7otal interest paid &cash' 4 GGGGGGGG 4 GGGGGGGG
9. Interest e+pense in %##- 4 GGGGGGGG 4 GGGGGGGG
(. Interest e+pense in %### 4 GGGGGGGG 4 GGGGGGGG
6. )mount of liabilities reported on %##- balance sheet<
6ote payable &net' 4 GGGGGGGG 4 GGGGGGGG
Interest payable 4 GGGGGGGG 4 GGGGGGGG
!. Frincipal amount 4 GGGGGGGG 4 GGGGGGGG
-. =ace amount 4 GGGGGGGG 4 GGGGGGGG
#. 2aturity value 4 GGGGGGGG 4 GGGGGGGG
%.. "tated interest rate 4 GGGGGGGG 4 GGGGGGGG
%%. 8ield or effective interest rate 4 GGGGGGGG 4 GGGGGGGG
Answer:
Assuming the Nte !"s
Interest-
Nninterest-
Be"ring Be"ring
(. Cash received .......................................................... 6 (77,777 6 95,+9:
+. Cash paid at maturity date ....................................... ((+,777 (77,777
0. Total interest paid (cash) .......................................... (+,777
@. 1nterest expense in (559 ......................................... @,777
). 1nterest expense in (555 ......................................... 9,777
:. "mount of liabilities reported on (559 balance sheet=
?ote payable (net) ................................................ (77,777
interest payable .................................................... @,777
,. 3rincipal amount ...................................................... (77,777
9. Face amount ............................................................ (77,777 (77,777
5. Katurity value........................................................... (77,777 (77,777
(7. #tated interest rate .................................................. (+F
((. Jield or effective interest rate .................................. (+F
Chapter () !((*+,! #hort!Term -iabilities
Cm#ut"tins:
(. 6(77,777 L (.(+ G 695,+9:
+. 6(77,777 H (6(77,777 x .(+) G 6((+,777
0. 6((+,777 ! 6(77,777 G 6(+,777
6(77,777 ! 695,+9: G 6(7,,(@
@. 6(+,777 x @*(+ G 6@,777
6(7,,(@ x @*(+ G 60,),(
). 6(+,777 x 9*(+ G 69,777
6(7,,(@ x 9*(+ G 6,,(@0
:. 695,+9: H 60,),( G 65+,9),
,. Cash received when the note was sined.
9. >iven% same for both notes.
5. Katurity value is the amount due at maturity, excludin any separate interest
payments.
(7. >iven for interest!bearin% not applicable to noninterest! bearin note,
((. #ame as stated rare on interest!bearin note% implicit (iven as the oin rate) on
noninterest!bearin note, (+F. 'sed to compute cash received,
E15-14 Cu##ent $i%&ilitie'. O#i"in%l %nd *d/u'tin" Ent#ie' ;intage "ales Company, a large
retail outlet, completed the following selected transactions during %##- and %###<
a. )t the end of %##-, accrued wages that have not yet been recorded amounted to 49.,....
7hese accrued wages were paid in the 1anuary %(, %###, payroll, which amounted to
4%#.,... &disregard payroll ta+es'.
b. 0n 6ovember %, %##-, rent revenue for the following si+ months was collected, 4#,6...
c. 0n 0ctober %, %##-, ;intage received 49.. as a deposit from a customer for some special
containers that are to be returned on or about 2arch 5%, %###. ;intage agreed to Hgive the
customer credit at an annual rate of 6 percent interest on the deposit.H 7he containers were
returned on )pril %, %###.
Required: Iive all of the re@uired entries &omit closing and reversing entries' during %##- and
%### for each of the above transactions. 7he accounting period of ;intage ends on $ecember 5%.
Answers:
Tr"ns"$tin %"&:
Iecember 0(, (559$"d2ustin entry=
Bae expense........................................................................ @7,777
Baes payable................................................................. @7,777
Manuary (), (555$3ayroll=
Baes payable (above).................................................... @7,777
Bae expense(6(57,777 ! 6@7,777)................................ ()7,777
Cash (iven)............................................................... (57,777
Tr"ns"$tin %'&:
?ovember (, (559$Collected rent in advance=
Cash ................................................................................ 5,:77
/ent revenue collected in advance............................ 5,:77
Chapter () !(+*+,! #hort!Term -iabilities
/ent revenue collected in advance................................... 0,+77
/ent revenue (65,:77 x +*:)....................................... 0,+77
"pril 07, (555$ /econi.e revenue earned=
/ent revenue collected in advance .................................. :,@77
/ent revenue (65,:77 x @*:)....................................... :,@77
Tr"ns"$tin %$&:
<ctober (, (559$Ieposit received=
Cash................................................................................. @77
-iability, container deposit.......................................... @77
Iecember ((, (559$"ccrued interest=N
1nterest expense (6@77 x .7: x 0*(+) ............................... :
-iability, container deposit.......................................... :
"pril (, (555$Ieposit returned=
-iability, container deposit (6@77 H 6:)............................ @7:
1nterest expense (6@77 x .7: x 0*(+)N............................... :
Cash (6@77 H 6: H 6:)............................................... @(+
N&ntry would probably not be made for 6: because the amount is not material.
E 15-15 Repo#tin" $i%&ilitie'. 0i1idend' %nd Secu#ed Note' 7he records of the =isk
Corporation provided the following information at $ecember 5%, %##-.
a. 6otes payable &trade', short term &includes a 49,... note given on
purchase of e@uipment that cost 42.,...D assets were mortgaged
in connection with purchase'.......................................................................
5.,...
b. /onds payable &45.,... due each )pril %'..................................................
.............................................................................................................. %2.,...
c. )ccounts payable &including 45,... owed to president of the company'....
............................................................................................................... (.,...
d. )ccrued property ta+es &estimated'..............................................................
................................................................................................................ %,...
e. "tock dividends issuable on 5B%B%### &at par value'....................................
............................................................................................................... 26,...
f. Cash dividends declared, payable 5B%B%###.................................................
............................................................................................................... 2.,...
g. EongCterm note payable, maturity amount &4%9,(.. carrying value'...........
............................................................................................................... %6,...
h. )ccrued interest on all bonds and notes.......................................................
............................................................................................................... %5,(..
Required: )ssuming that the fiscal year ends $ecember 5%, show how each of the above items
should be reported on the balance sheet at $ecember 5%, %##-.
Answer:
Current Liabilities:
"ccounts payable (trade)............................................................................
............................................................................................................. 6@,,777
?otes payable (trade).................................................................................
3ayable to company officer........................................................................
&quipment notes payable (secured by equipment)....................................
Current payment on bonds payable...........................................................
&stimated property taxes payable..............................................................
Iividends payable (cash)...........................................................................
1nterest payable (on notes and bonds).......................................................
Long-Term Liabilities:
;onds payable (less current portion)..........................................................
?ote payable (maturity amount, 6(:,777)..................................................
Operational Assets:
&quipment (pleded on )@,777 note) ...................................................+7,777
Stoc!olders" #$uity:
#tock dividends issuable (at par) ........................................................+:,777N
N"ssumin an entry was made on issue date as follows=
/etained earnins .................................................................. +:,777
#tock dividends issuable .................................................
+:,777
<therwise, simply disclose in a note to the financial statements stock dividends usually are not
recorded until issued.
E15-12 Ent#ie' to Reco#d 3%!#oll %nd Rel%ted 0eduction' :yan company paid salaries for the
month amounting to 4%2.,.... 0f this amount, 45.,... was received by employees who had
already been paid the 4(5,9.. ma+imum amount of annual earnings ta+able in one year under
=IC) laws &=IC) rate< !.6( percent'.
0f the 4%2.,..., 4%9,... was paid to employees who had already reached the 4!,...
ma+imum wages subect to unemployment ta+es &rates< (.9 percent state and ..- percent federal'.
Withholding ta+es amounted to 456,..., and 4%,9(. was withheld from the 4%2.,... for
investment in company stock per an agreement with certain employees.
Required: Iive entries to record &a' salary payment and the liabilities for the deductions, &b'
employer payroll e+penses, and &c' remittance of the ta+es.
Answer:
(a) To record salaries and related deductions=
#alary expense....................................................................... (+7,777
Bithholdin tax payable....................................................
0:,777
&mployee stock investment payable.................................
(,@)7
F1C" tax payable$!employees........................................
:,99)................................................................................ N
Chapter () !(@*+,! #hort!Term -iabilities
Cash.................................................................................
,),::)
N (6(+7,777 ! 607,777) x .7,:) G 6:,99)
(b) To record employer payroll taxes=
&xpense!payroll taxes............................................................. (0,@),
F1C" tax payable$employer............................................
:,99)...............................................................................
(()
F'T" tax payable$federal...............................................
(+)
#'T" tax !state.................................................................
),,+@...............................................................................
(0)
(()
(6(+7,777 ! 607,777) x .7,:) G 6:,99)
(+)
(6(+7,777 ! 6 (@,777) x .779 G 69@9
(0)
(6(+7,777 ! 6 (@,777) x .7)@ G 6),,+@
(c) To record remittance of taxes=
Bithholdin tax payable.......................................................... 0:,777
F1C" tax payable$employees................................................ :,99)
F1C" tax payable$employer.................................................. :,99)
F'T" tax payable$federalN.................................................... 9@9
#'T" tax payable$state........................................................ ),,+@
Cash.................................................................................
):,0@+
N3aid annually.
E 15-17 Reco#din" 3%!#oll %nd Rel%ted 0eduction' "miley Corporation paid salaries and
wages of 4%95,-... 0f this amount, 45,-6. was paid to employees who had already e+ceeded the
=IC) ma+imum. )lso, 495,-.. was paid to employees who had already been paid the "J7)
ma+imum. Jse the =IC) and =J7) rates given in the chapter. Income ta+ withholding was
45(,.... $eductions< union dues &in conformity with the union agreement', 45,..., and
insurance premiums, 4%2,....
Required: Iive the entries to record liabilities for payroll deductions, payroll e+penses, and
remittance of the deductions.
Answers:
(a) To record salaries and the related employee deductions=
#alary expense ............................................................................. (@0,977
Bithholdin tax payable .........................................................
0),777
'nion dues payable ...............................................................
0,777
1nsurance premiums payable .................................................
(+,777
F1C" tax payable (6(@0,977 ! 60,977) x .7,:) .......................
(7,,(7
Cash .......................................................................................
90,757
Chapter () !()*+,! #hort!Term -iabilities
(b) To record employer payroll taxes=
&xpense!payroll taxes .................................................................. (:,5(7
F1C" tax payable, employer (6(@0,977 ! 60,977) x .7,:).......
(7,,(7
F'T" tax payable, federal (6(@0,977 ! 6@0,977) x .779..........
#'T" tax payable, state (6(@0,977 ! 6@0,977) x .7)@ ............
),@77
(c) For remittance of taxes and other deductions=
Bithholdin tax payable (a) above ......................................... 0),777
'nion dues payable ............................................................... 0,777
1nsurance premiums payable ................................................. (+,777
F1C" tax payable, employees ................................................. (7,,(7
F1C" tax payable, employer ................................................... (7,,(7
F'T" tax payable, federal ...................................................... 977
#'T" tax payable, state ......................................................... ),@77
Cash........................................................................................
,,,:+7
E15-1) Co+pen'%ted *&'ence'. Ent#ie' %nd Repo#tin" 7unacliff 2owers allows each
employee to earn %( paid vacation days each year with full pay while on vacation. Jnused
vacation time can be carried over to the ne+t yearD if not taken during the ne+t year it is lost. /y
the end of %##-, all but 5 of the 5. employees had taken their earned vacation timeD these three
carried over to %### a total of 2. vacation days, which represented %##- salary of 46,.... $uring
%###, each of these three used their %##- vacation carryoverD none of them had received a pay
rate change from %##- to the time they used their carryover. 7otal cash wages paid< %##-,
4!..,...D %###, 4!9.,.... 7here was no carryover of vacation time earned in %###.
Required:
%. Iive all of the entries for 7unacliff related to vacations during %##- and %###. $isregard
payroll ta+es.
2. Compute the total amount of wage e+pense for %##- and %###. ?ow would the vacation time
carried over from %##- affect the %##- balance sheet?
Answers:
Re(uirement 1:
Iecember 0(, (559$"d2ustin entry to accrue vacation salaries not yet taken or
paid=
#alary expense................................................................. :,777
-iability for compensated absences .......................... :,777
Iurin (555$Aacation time carryover taken and paid=
-iability for compensated absences ................................. :,777
Cash (included in payroll entry) ................................. :,777
Re(uirement )
Chapter () !(:*+,! #hort!Term -iabilities
Total wae expense=
(559= 6,77,777 H 6:,777
(555= 6,@7,777 ! 6:,777 G 6,0@,777
(559 ;alance sheet position=
Current liabilities=
-iability for compensated absences .................... 6:,777
E15-14 E'ti+%ted -%##%nt! E5pen'e. Reco#din" %nd Repo#tin" 2acy =urniture sells a line
of products that carry a threeCyear warranty against defects. /ased on industry e+perience, the
estimated warranty costs related to dollar sales are the following< first year after sale, I percent of
sales< second year after sale, 5 percent of salesD and third year after sale, ( percent. "ales and
actual warranty e+penditures for the first threeCyear period were as follows<
C%'h S%le' *ctu%l -%##%nt! E5penditu#e'
%##-. 4 -.,... 4%,...
%###. %%.,... 9,%..
2... %2.,... #,-..
Required:
%. Iive entries for the three years for &a' the sales, &b' the estimated warranty e+pense, and &c'
the actual e+penditures.
2. What amount should be reported its a liability on the balance sheet at the end of each year?
Answers:
Re(uirement 1
(a) O (b) To record sales and estimated warranty costs=
1**+ 1*** ),,,

Cash 97,777 ((7,777 (+7,777
Barranty expense ,,+77
a
5,577
b
(7,977
c
#ales 97,777 ((7,777
(+7,777
&stimated warranty liability ,,+77 5,577
(7,977
a
697,777 x (.7( H .70 H.7)) G 6,,+77
b
6((7,777 x (.7( H .70 H .7)) G 65,577
c
6(+7,777 x (.7( H .70 H .7)) G 6(7,977
(c) To record actual expenditures=
&stimated warranty liability (,777 @,(77 5,977
Cash (,777 @,(77
5,977
Chapter () !(,*+,! #hort!Term -iabilities
Re(uirement )
;alance in the liability account=
(559 (6,,+77 ! 6(,777) ................................................ 6:,+77
(555 (6:,+77 H 65,577 ! 6@,(77) ................................. (+,777
+777 (6(+,777 H 6(7,977 ! 65,977).............................. (0,777
E15-21 $o'' Contin"enc!6Th#ee C%'e'. Ent#ie' %nd E5pl%n%tion Canseco Company is
preparing the annual financial statements at $ecember 5%, %###. $uring %###, a customer fell
while riding on the escalator and has filed a lawsuit for 49.,... because of a claimed back inury.
7he lawyer employed by the company has carefully assessed all of the implications. If the suit is
lost, the lawyerKs reasonable estimate is that the 49.,... will be assessed by the court.
Required: ?ow should the contingency be handled during %### in each of the following cases?
Iive all necessary entries and any notes<
%. )ssume that the lawyer and the management concluded that it is reasonably possible that the
company will be liable, and it is reasonably estimated that the amount will be 49.,....
2. )ssume, instead, that the lawyer, the independent accountant, and management have
reluctantly concluded that it is probable that the suit will be successful.
5. )ssume that the conclusion of the legal counsel and management is that the chance of a
contingency loss is remote. 7hey believe the suit is without merit.
Answers:
Re(uirement 1
This Preasonably possibleP and Preasonably estimatedP loss continency would be reflected only
in a footnote% accrual is not permitted. " suitable footnote is as follows=
?ote= " customer was in2ured on company premises. "lthouh the litiation has
not been ad2udicated, leal counsel and manaement have concluded
that it is reasonably possible that the court will assess damaes of
approximately 6@7,777.
Re(uirement )
This PprobableP and Preasonably estimatedP continent loss must be accrued because (() a loss
is probable and (+) it can be reasonably estimated=
-oss due to accident.................................................. @7,777
&stimated liability for damaes (lawsuit)........ @7,777
?ote= " customer was in2ured on company premises. "lthouh the litiation has
not been finally ad2udicated, leal counsel and manaement believe it is
probable that damaes of approximately 6@7,777 will be assessed by the
court.
Re(uirement -
This PremoteP and Preasonably estimatedP continent loss does not require accrual or note
disclosure. 4owever, conservatism, coupled with the full!disclosure principle, suests the
propriety of disclosin the situation in a note to the financial statements.
Comment= The situation in /equirement (, as a practical matter, probably
would seldom occur$they would settle out of court. The situation in
/equirement + probably would never occur for the same reason.
E 15-23 R%tio *n%l!'i' "uppose a firm issues shortCterm interestCbearing notes and uses the
proceeds to purchase inventories. )ssume, further, that the decision turns out to be a good one for
the firm. )ssume the firmKs profits for the year remain unchanged.
Required: Indicate how the use of the notes would affect the indicated ratios immediately
following the decision unless otherwise indicated by the symbol L, which means indicate the
effect over the year but before any of the liability is repaid. Jse the following symbols< J for up,
$ for down, and 6C for no change.
Eect on
R%tio Nu+e#%to# 0eno+in%to# R%tio
a. Current ratio............................................. GGGGGGG GGGGGGG GGGGGGG
b. Working capital to total assets.................. GGGGGGG GGGGGGG GGGGGGG
c. 6et cash to current liabilities.................... GGGGGGG GGGGGGG GGGGGGG
d. $ebt to e@uity........................................... GGGGGGG GGGGGGG GGGGGGG
e. $ebt to total assets.................................... GGGGGGG GGGGGGG GGGGGGG
f. 7imes interest earnedL.............................. GGGGGGG GGGGGGG GGGGGGG
g. Cash flow per shareL................................ GGGGGGG GGGGGGG GGGGGGG
h. :eturn on total assetsL.............................. GGGGGGG GGGGGGG GGGGGGG
Answer:
E..e$t n
R"ti Numer"tr Denmin"tr R"ti
a. Current ratio.................................................... ' ' I
(
b. Borkin capital to total assets........................ ?C ' I
c. ?et cash to current liabilities........................... ?C ' I
+
d. Iebt to equity.................................................. ' ?C '
e. Iebt to total assets......................................... ' ' '
0
f. Times interest earnedN.................................... I ' I
. Cash flow per shareN....................................... Q ?C Q
h. /eturn on total assetsN.................................... ?C ' I
(
1f current assets exceed current liabilities, the ratio will immediately fall and vice versa. The
former condition is the more likely. 1f we take a lon!term view, assets, includin current assets
would rise and the liability decline increasin the ratio. 4ere we assume the Pood resultP occurs
as we will elsewhere and examine only the short term.
+
The decision is a ood one (iven), but it is not clear whether the increased inflow will be in the
form of cash or some other asset in the short run such as accounts receivable. 4ence cash flow
could even o down due the interest on the debt. The answer here assumes all the cash is
invested in inventories,
0
This result holds because debt is less than total assets.
3 15-1 Multiple Choice
%. =arr Company sells its products in e+pensive, reusable containers. 7he customer is charged a
deposit for each container delivered and receives a refund for each container returned within
two years after the year of delivery. =arr accounts for the containers not returned within the
time limit as a sale at the deposit amount. Information for %##- is &dollar amounts represent
deposits received from customers'<
Containers held by customers at $ecember 5%, %##! from deliveries in
%##6................. 4%(.,...
%##!................. 95.,... 4(-.,...
Containers delivered in %##-............... !-.,...
Containers returned in%##-, from deliveries in
%##6................. 4#.,...
%##!................. 2(.,...
%##-................. 2-6,... 4626,...
What amount should =arr report as a liability for returnable containers at $ecember 5%, %##-?
a. 49#9,....
b. 4699,....
c. 46!9,....
d. 4!59,....
Answer: %$& The requirement is the amount to reported as a liability for returnable containers
at (+*0(*59. The solutions approach sets up a T!account for the liability.
-iability
R )97,777 (+*0(*5, balance
(559 returns :+:,777 R ,97,777 (559 deliveries
(559 sales :7,777 R
R :,@,777 (+*0(*59 balance
Bhen customers pay the deposit for a container, cash is debited and the liability is credited.
Therefore, at (+*0(*5,, the liability consists of deposits for containers still held by customers
from the last two years (6)97,777). Iurin (559, the liability is increased for deposits on
containers delivered (6,97,777). Bhen containers are returned, the deposits are returned to
the customers% in (559, the liability was debited and cash credited for 6:+:,777. "lso, at
(+(0(*59, some customers still held containers from (55@ (6()7,777 ! 657,777 G 6:7,777).
The two!year time limit has expired on these, so the company no loner is obliated to return
the deposit. The containers are considered sold to the customers, so the liability account is
debited and sales credited for 6:7,777. These transactions result in a (+*0(*59 liability
balance of 6:,@,777.
2. $unn 7rading "tamp Company records stamp service revenue and provides for the cost of
redemptions in the year stamps are sold to licensees. $unnKs past e+perience indicates that
Chapter () !+7*+,! #hort!Term -iabilities
only -. percent of the stamps sold to licensees will be redeemed. $unnKs liability for stamp
redemptions was 429,...,... at $ecember 5%, %##!. )dditional information for %##- is<
"tamp service revenue from stamps sold to licensees..........
...................................................................................4%6,...,...
Cost of redemptions &stamps sold prior to %B%B#-'...............
....................................................................................%%,...,...
If all the stamps sold in %##- were presented for redemption in %###, the redemption cost
would be 4#,...,.... What amount should $unn report as a liability for stamp redemptions
at $ecember 5%, %##-?
a. 4%5,...,....
b. 42.,2..,....
c. 422,...,....
d. 42#,...,....
Answer: %'& The requirement is the amount to reported as a liability for stamp redemptions at
(+*0(*59. The solutions approach sets up a T!account for the liability.
Li"'i/it0
R +@,777,777 (+*0(*5) balance
/edemptions ((,777,777 R ,,+77,777 1ncrease
R +7,+77,777 (+*0(*59 balance
Bhen stamps are sold cash is debited and revenue is credited for the face amount
(6(:,777,777). "dditionally, cost of redemptions is debited and the liability credited for the
estimated cost of redemption. This increase in the liability is computed by takin the total
possible redemption cost and multiplyin by the expected redemption rate (65,777,777 x .97
G 6,,+77,777) "s redemptions actually occur, the liability is decreased. The cost of (559
redemptions (6((,777,777) is debited to the liability account and credited to inventory.
5. Irey operates atD a retail furrier. "ome customers pick out furs and place deposits with Irey
to set the furs aside for future delivery. Irey records the cash receipts on these transactions as
layaway plan sales. ?owever, title to the fur passes to the customer only when the full sales
price is received by Irey. 7he average gross margin on the furs is !( percent of sales. 7he
following pertinent data were taken from IreyKs $ecember 5%, %##- unadusted trial balance<
:egular sales........................................................................
....................................................................................4(,...,...
Eayaway plan sales..............................................................
....................................................................................42,...,...
$eposits from customers.....................................................
)n analysis of the layaway plan sales revealed that 4%,2..,... was received in full payment
for furs delivered to customers during %##-. In IreyKs $ecember 5%, %##- balance sheet,
deposits from customers would be
a. 42,...,....
b. 4%,(..,....
c. 4%,2..,....
d. 4-..,....
Answer: %1& 3rior to ad2ustin entries, >rey has balances of 6+,777,777 in laya%ay plan
sales and 67 in deposits &rom customers. 4owever, of the 6+,777,777 balance in the sales
account, only 6(,+77,777 represents sales where payment has been made in full and title has
Chapter () !+(*+,! #hort!Term -iabilities
passed to the customers. The remainin 6977,777 represents collections from customers.
who have not yet paid in full. "t (+*0(*59, an ad2ustin entry must be prepared to remove
6977,777 from the sales account and record it in the liability account, deposits from
customers.
9. $uring %##!, Ward Company introduced a new product carrying a twoCyear warranty against
defects. 7he estimated warranty costs related to dollar sales are 2 percent within %2 months
following sale and 9 percent in the second %2 months following sale. "ales and actual
warranty e+penditures for the years ended $ecember 5%, %##! and %##- are<
*ctu%l -%##%nt7
S%le' E5penditu#e'
%##!........................................... 4 6..,... 4 #,...
%##-........................................... %,...,... 5.,...
4%,6..,... 45#,...
)t $ecember 5%, %##-. Ward would report an estimated warranty liability of
a. 4(!,....
b. 49(,....
c. 4%!,....
d. 4%.,....
Answer: %"& &ach year, warranty expense is estimated at :F of sales and recorded by
debitin the expense account and creditin the liability. "s warranty expenditures are made,
the liability is debited and cash is credited. ?ote that the total estimated warranty cost for
bot! years C(.7+ H .7@) G .7:D is recorded in the year of sale in compliance with the matchin
principle.
3#o&le+ 15-2 Multiple Choice
%. ) state re@uires @uarterly sales ta+ returns to be filed with the sales ta+ bureau by the 2.th
day following the end of the calendar @uarter. ?owever, the state further re@uires that sales
ta+es collected be remitted to the sales ta+ bureau by the 2.th day of the month following any
month such collections e+ceed 4%,.... 7hese payments can be taken as credits on the
@uarterly sales ta+ return.
7aft Corporation operates a retail hardware store. )ll items are sold subect to a 6 percent
state sales ta+, which 7aft collects and records as sales revenue. 7he sales ta+es paid by 7art
are charged against sales revenue. 7aft pays the sales ta+es when they are due.
=ollowing is a monthly summary appearing in 7aftKs firstC@uarter %##- sales revenue
account<
0e&it C#edit
1anuary............................................. C.C 42%,2..
=ebruary........................................... 4%,2.. %9,-9.
2arch............................................... C.C %#,.-.
4%,2.. 4((,%2.
In its financial statements for the @uarter ended 2arch 5%, %##-, 7aftKs sales revenue and sales
ta+es payable would be
Chapter () !++*+,! #hort!Term -iabilities
S%le' S%le' T%5e'
Re1enue 3%!%&le
a. 4((,%2. 45,%2.
b. 4(5,#2. 4%,2..
c. 4(2,... 45,%2.
d. 4(2,... 4%,#2.
Answer: %1& The amount reported for sales revenue should include amounts chared customers
when inventory is sold, but it should exclude amounts collected for sales taxes. To determine the
correct amount for sales revenue, Taft must divide the total of sales and sales taxes by (77F plus
the sales tax percentae (:F), as indicated below=
Mnth Tt"/ Per$ent"ge S"/es Re2enue
Manuary 6 +(,+77 (.7: 6 +7,777
February 6 (@,9@7 (.7: (@,777
Karch 6 (5,797 (.7: (9,777
Total 6 )+,777
#ales taxes payable would include all sales taxes collected, less any sales taxes already
remitted.
Manuary sales taxes (6+(,+77 ! 6+7,777)................................
(,+77
February sales taxes (6(@,9@7 ! 6(@,777)..............................
Karch sales taxes (6(5,797 ! 6(9,777)...................................
........................................................................................... (,797
Total .......................................................................................
........................................................................................... 0,(+7
-ess taxes remitted for Manuary sales.....................................
.......................................................................................... ((,+77)
#ales taxes payable................................................................
.......................................................................................... 6(,5+7
2. In 2arch %##-, an e+plosion occurred at 6ilo CompanyKs plant, causing damage to area
properties. /y 2ay %##-, no claims had yet been asserted against 6ilo. ?owever, 6iloKs
management and legal counsel concluded that it was reasonably possible that 6ilo would be
held responsible for negligence and that 4%,(..,... was a reasonable estimate of the
damages. 6iloKs 42,(..,... comprehensive public liability policy contains a 4%(.,...
deductible clause. In 6iloKs $ecember 5%, %##! financial statements, for which the auditorKs
field work was completed in )pril %##-, how should this casualty be reported?
a. )s a footnote disclosing a possible liability of 4%,(..,....
b. )s in accrued liability of 4%(.,....
c. )s a footnote disclosing a possible liability of 4%(.,....
d. 6o footnote disclosure or accrual is re@uired for %##! because the event occurred in %##-.
Answer: %$& 3er #F"# ), a loss continency should he accrued if it is probable that a liability
estimable. "lthouh this continency is reasonably estimable, it is not probable. Therefore, no
loss is accrued. 4owever, since the continency is reasonably possible, it will be disclosed in
the footnotes to the (+*0(*5, financial statements. The possible loss will be disclosed as
6()7,777. The additional potential liability above the deductible would be covered by the
insurance policy, and would not be a loss for ?ilo.
5. 7he following information relating to compensated absences was available from Iraf
CompanyKs accounting records at $ecember 5%, %##-.
*mployeesK rights to vacation pay vest and are attributable to services already rendered.
Fayment is probable, and IrafKs obligation was reasonably estimated at 422.,....
*mployeesK rights to sick pay benefits do not vest but accumulate for possible future use.
7he rights are attributable to services already rendered, and the total accumulated sick
pay was reasonably estimated at 4%..,....
What amount is Iraf re@uired to report as the liability for compensated absences in its
$ecember 5%, %##-, balance sheet?
a. 452.,....
b. 422.,....
c. 4%..,....
d. 4..
Answer: %'& S3AS ?o. @0 states that accrual of a liability for future vacation pay is required if
all of the conditions below are met=
(. <bliation arises from employee services already performed.
+. <bliation arises from vestin or accumulation of rihts.
0. 3ayment is probable.
@. "mount can be reasonably estimated
These criteria are met for the vacation pay (6++7,777). "ccrual for sick pay is not required in
this case, however, because the third condition (probable payment) is not specified in the
problem. Therefore, the proper amount of the liability to be reported is 6++7,777.
9. :uhl Company grants all employees two weeksK paid vacation for each full year of
employment, up to si+ weeks. Jnused vacation time can be accumulated and carried forward
to succeeding years and will be paid at the salaries in effect when vacations are taken or when
employment is terminated. 7here was no employee turnover in %##-. )dditional information
relating to the year ended $ecember 5%, %##- is<
Eiability for accumulated vacations at %2B5%B#!..................................
FreC%##- accrued vacations taken from %B%B%#- to #B5.B#- &the
authori,ed period for vacations'....................................................
;acations earned for work in %##- &adusted to current rates'.............
:uhl granted a %. percent salary increase to all employees on 0ctober %, %###, its annual
salaryCincrease date. =or the year ended $ecember 5%, %##-, :uhl should report vacation pay
e+pense of
a. 492,....
b. 49(,....
c. 46.,....
d. 4!.,....
Answer: %"& 3er #F"# ?o. @0, an employer is required to accrue a liability for employeesS
rihts to receive compensation for future absences, such as vacations, when certain
conditions are met. The #tatement does not, however, specify how such liabilities are to be
measured. #ince vacation time is paid by /uhl Co. at the salaries in effect when vacations
are taken or when employment is terminated, /uhl ad2usts its vacation liability and expense
to current salary levels. /uhlSs (559 vacation pay expense consists of vacations earned for
work in (559 (ad2usted to current rates) of 6+7,777 plus the amount necessary to ad2ust its
pre!(559 vacation liability for the (7F salary increase. The amount of this ad2ustment is equal
Chapter () !+@*+,! #hort!Term -iabilities
to ten percent of the pre!existin liability balance at Iecember 0(, (559 C(6)7,777 ! 607,777)
x .(7 G 6+,777D. Therefore, total vacation pay expense for the period is equal to 6@+,777
(6@7,777 H +,777).
3 15-) Co+pen'%ted *&'ence'. Ent#ie' %nd Repo#tin" )loha Company has a personnel
policy that allows each employee with at least one yearKs employment 2. days vacation time and
two holidays with regular pay. Jnused days are carried over to the ne+t year. If not taken during
the ne+t year, the vacation and holiday times are lost. )lohaKs accounting period ends $ecember
5%.
)t the end of %###, the personnel records showed the following<
8%c%tion' C%##ied o1e# to 2999 :olid%!' C%##ied o1e# to 2999
Tot%l 0%!' Tot%l S%l%#ie' Tot%l 0%!' Tot%l S%l%#ie'
!. 4%6,-.. %. 42,(-.
$uring 2..., all of the %### vacation time and eight days of the holiday time, which were carried
over, were taken. "alary increases in 2... for these employees relating to the days carried over
amounted to 4%,6... 7otal cash wages paid< %###, 4%,!-.,...D 2..., 4%,-6.,....
Required:
%. Iive all of the entries for )loha Company related to vacations and holidays during %### and
2.... $isregard payroll ta+es.
2. "how how the effects of the above transactions should be reported on the %### and 2...
financial statements of )loha.
Answers:
Re(uirement 1
Iurin (555!/ecord payroll in usual manner=
#alary expense.......................................................... (,,97
Cash.................................................................... (,,97
Iecember 0(, (555$"d2ustin entry to accrue vacation and holiday time
carried over=
#alary expense (6(:,977 H 6+,)97)........................... (5,097
-iability for compensated absences..................... (5,097
Iurin +777$To record payment of (555 vacation and holiday time
carried over to +777=
-iability for compensated absences........................... (5,057
#alary expense (6(,9:7,777 ! 6(5,097)..................... (,9@7,:+7
Cash.................................................................... (,9:7,777 N
N These amounts already include the 6(,:77 salary increase. #ee instructional note.
Re(uirement )
1*** ),,,
1ncome statement=
#alary expense.......................................... 6(,,55,097 NN 6(,9@7,:+7 NNN
Chapter () !+)*+,! #hort!Term -iabilities
;alance sheet=
-iability for compensated absences .......... (5,097 $
NN 6(,,97,777 H 6(5,097 G 6(,,55,097
NNN 6(,9:7,777 ! 6(5,097 G 6(,9@7,:+7
1nstructional note$;ecause some employees did not take two vacation days it had the effect of
reducin salary expense in +777% the implicit entry is= debit liability for compensated absences
and credit salary expense.
* 15-1 *n%l!'i' o Cu##ent $i%&ilitie' $i'ted &elo; %#e the cu##ent li%&ilit! 'ection %nd note
7 o the 1445 &%l%nce 'heet o *+oco Co#po#%tion< % +%/o# oil i#+(
1445 1444
Cu##ent li%&ilitie' (millions of dollars)
Current portion of longCterm obligations.......... 4 %#6
"hortCterm obligations...................................... 226
)ccounts payable............................................. 2,9#6
)ccrued liabilities............................................. #9-
7a+es payable &including income ta+es'........... 6!2
49,(5-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
!. Short-Term Obligations
)mocoKs shortCterm obligations consist of notes payable and commercial paper.
6otes payable as of $ecember 5%, %##(, totaled 456 million at an average annual
interest rate of (.! percent, compared with 4! million at an average annual
interest rate of (.! percent at yearCend %##9. Commercial paper borrowings at
$ecember 5%, %##(, were 46## million at an average annual interest rate of (.!
percent compared with 42%! million at an average annual interest rate of (.#
percent as of $ecember 5%, %##9.
/ank lines of credit available to support e+isting commercial paper
borrowings of the corporation amounted to 49#. million at both $ecember 5%
%##( and %##9. )ll of these were supported by commitment fees.
7he corporation also maintains compensating balances with a number of
banks for various purposes. "uch arrangements do not legally restrict withdrawal
or usage of available cash funds. In the aggregate, they are not material in
relation to total li@uid assets.
Required:
%. What amount of )mocoKs longCterm debt reflected in its current liabilities did )moco pay off
in %##(?
2. *+plain the origin of the 4%#6 million figure.
5. $uring %##(, did )moco reduce its average yearly interest re@uirements on its shortCterm
obligations described in note !? $o you observe any interesting issues you might want to
learn more about? If so, what are they?
Chapter () !+:*+,! #hort!Term -iabilities
9. $o the lines of credit that )moco holds at the end of %##( appear as liabilities on its balance
sheet? *+plain.
Answers:
Re(uirement 1
The company paid 65@ million in (55). They may also have elected to pay off additional lon!
term debt, but this is not disclosed.
Re(uirement )
The 6(5: million is the portion of "mocoSs lon!term debt comin due in (55: and which the
company expects to pay of off in (55:. This portion of the debt is shown as a current liability.
Re(uirement -
The company increased its averae interest obliations because short!term borrowins increased
even thouh the interest rates on the commercial paper declined. <ne miht ask why commercial
paper was used in (55@ iven that the interest rate was ).5 versus )., on notes.
Re(uirement 4
-ines of credit are not obliations of "moco. The commitment fees to hold open these fines of
credit, which permit borrowin on demand, are expensed in the year they are due to the bank. 1t
would be useful to know the amounts required as compensatin balances, as this is cash that
cannot be used in operations. For lare firms, such as "moco, these amounts are likely to be
immaterial.
* 15-3 *n Un=no;n Co+p%n!>' Cu##ent $i%&ilitie' 7he following is the liability section of a
corporationKs %##( annual financial statement<
Chapter () !+,*+,! #hort!Term -iabilities
0ece+&e# 31
1445 1444
Eiabilities &millions'
6oninterestCbearing deposits in J" offices..................................... 4%5,5--
4%5,69-
InterestCbearing deposits in J" offices............................................ 56,!..
5(,6##
6oninterestCbearing deposits in offices outside the Jnited "tates... -,%69
!,2%2
Interest Cbearing deposits in offices outside the Jnited "tates........ %.-,-!#
##,%6!
7otal deposits............................................................................ 4%6!,%5%
4%((,!26
7rading account liabilities &6ote %'L............................................... %-,2!9
22,5-2
Furchased funds and other borrowings &6ote %'L........................... %6,559
2.,#.!
)cceptances outstanding................................................................. %,((#
%,99.
)ccrued ta+es and other e+penses &6ote -'L................................... (,!%#
(,9#5
0ther liabilities............................................................................... #,!6!
-,-!-
EongCterm debt &6ote %'L............................................................... %!,%(%
%6,9#!
"ubordinated capital notes &6ote %'L.............................................. %,55!
%,5#!
L 7he notes are not reproduced here.
Required:
%. What is unusual about the items included in the disclosure?
2. What do you believe would be included in Hpurchased funds and other borrowingsH?
5. What type of corporation is this? ?ow do you know?
Answers:
Re(uirement 1
First, there is no separate section for lon!term liabilities. This should be a clue that the issuin
firm is a bank. "lso, the liabilities include preferred stock.
Re(uirement )
The content is shown in ?ote ( of the companySs report (not reproduced here). 3erhaps the
reader could uess that this account includes=
a. Federal funds 3urchased and securities is ties sold under repurchase areements
b. Commercial paper issued by the parent companySs and the #tudent -oan Corp.
c. <ther borrowed funds
Re(uirement -
This liability section is from CiticorpSs, a ma2or financial institution, (55) balance sheet. This
corporation is a bank, which can be seen by the nature of the ma2ority of its liabilities, that is,
deposits. "lso, since the liabilities are not classified as to current or noncurrent, the reportin is
consistent with the format for financial institutions.
CHAPTER 15: LON6-TERM LIABILITIES
2. What are the primary distinctions between a debt security and an e@uity security?
Answer: The primary distinctions between debt and equity securities are=
a. 'ebt security$fixed principal and interest% no votin privilees% fixed maturity date% cash flow
dates and amounts are fixed.
b. #$uity security$no fixed principal and interest% votin privilees (common stock)% fixed cash flow
amounts and dates.
5. *+plain the difference between the stated rate of interest and the effective rate on a longCterm debt
security.
Answer: Stated rate o& interest$contractual rate specified on the debt instrument% it determines the
amount of cash interest each interest period.
The e&&ective rate o& interest is the true interest rate on a debt security. 1t is determined by the market
and it is based on the resources received currently and the future resource flows. The effective rate is
often called the market rate of interest.
(. /riefly e+plain the effects on interest recogni,ed when the stated and effective rates of interest are
different.
Answer: "n effective interest rate above the stated rate causes a discount and the opposite cause, a
premium on the debt. " discount increases interest reported on the income statement and a premium
decreases interest reported on the income statement (compared with the effects of the stated rate).
-. What are the principal advantages and disadvantages of bonds versus common stock for &a' the issuer
and &b' the investor?
Answers:
a. From the issuerSs point of view, a primary advantae of bonds versus common stock is that
interest payments are deductible as an expense for income tax purposes, whereas dividends paid
are not. The disadvantaes are that interest payments on bonds constitute a leal and fixed
obliation that must be paid in cash, whereas dividends on common stock are paid only when
sufficient funds and retained earnins are available, and that bonds have a specific maturity date
but capital stock does not. 1ssuers expect to earn a hiher rate of return on their investment (than
the return paid on bonds) to satisfy stockholders.
b. From the investorSs point of view, bond investments usually have not been considered as ood a
hede aainst inflation as capital stock investments. &ach investor weihs whether the
uaranteed fixed interest rate and maturity amount, or the potential for dividends and increase in
stock prices would be more advantaeous. #tock investments usually are considered to be more
risky.
#. $istinguish between the par amount and the price of a bond. When are they the same? When
different? *+plain.
Answers:
The face (i.e., par) amount of a bond is the maturity amount specified on the bond certificate.
The bond price represents the present value of the future cash flows (principal plus all interest
payments) at the effective rate of interest.
The face amount of bond and its price are the same if the bond has the same stated and effective
rates of interest when issued% otherwise, they will be different.
Chapter (: !(*(,! -on!Term -iabilities
%9. Jnder I))F, when is it appropriate to use the &a' straightCline and &b' interest method ofK
amorti,ation for bond discount or premium?
Answer: 'nder enerally accepted accountin principles (>""3), it is acceptable to use the straiht!
line method only if its results are not materially different in amount from the results produced by the
interest method. <therwise, the interest method must be used.
%-. Why is the accounting different for nonconvertible bonds with detachable stock purchase warrants
and nonconvertible bonds with nondetachable stock purchase warrants?
Answer: " detachable stock purchase warrant is separable from the nonconvertible bond to which it
relates% therefore, the warrants can be sold separately in the market. "n ob2ective valuation of the
bonds and the warrants separately can be made, makin possible separate recordin and reportin
of the debt and equity components.
1n accountin for nonconvertible bonds with nondetachable stock purchase warrants, separate
accountin for debt and equity is not feasible due to the inseparability of the two different securities
(there will be no separate market for either the bond or the warrants). 1t is difficult to ob2ectively assin
the amounts that should be allocated between the debt and equity components.
29. Interest rates have increased since a company issued its bonds. Why would the firm want to refund
the bonds with another issue ofK bonds paying a higher rate?
Answer: Bhen interest rates rise, the market value of bonds decreases, allowin the refundin of the
older bond issue at a ain, thus increasin earnins.
2(. ) firm retired a bond issue early at a loss. Is the firm in an economically worse position after the
retirement?
Answer: This question does not have a definite answer. 4owever, the firm would not have retired the
bonds if it were not in its best interest. "lso, the firm paid the market value of the bonds. Therefore,
one could arue that they are in an equivalent position before and after the retirement. 1n addition, the
loss occurred because interest rates have fallen. The firm may take this opportunity to issue lower
rate debt, reduce its future interest costs, and extend the maturity of its debt. This arument suests
the firm is in a better economic position after the retirement.
2!. *+plain the classification of gains and losses from troubled debt restructuring.
Answer: 1n a settlement the debtor records a ain and the creditor a loss. The debtorSs ain is
reported as extraordinary while the creditorSs losses are reported as ordinary, unusual or infrequent,
or extraordinary in conformity with >""3 (as specified in "3; 07). The debtor also has a ain in a
modification of terms if the sum of restructured flows is less than the debt book value.
2-. $ifferentiate between a debt restructure in which debt is settled and one in which it continues after the
restructure.
Answer: 1n a debt restructure the areement relaxes the payment requirements on the debtor. There
are two cases, as follows= (a) the debt is settled in &ull by the transfer of assets or equity interests of
the debtor that have a value below the carryin value of the debt (i.e., a concession)% (b) the debt
provisions are relaxed for timin, interest, or principal (or any combination). 1n this case the debt
continues under the terms of the debt restructure.
Chapter (: !+*(,! -on!Term -iabilities
E12-1 ,ond'. I''ue %&o1e< %t %nd &elo; 3%# :owe Corporation authori,ed 46..,... of - percent
&interest payable semiannually', %.Cyear bonds. 7he bonds were dated 1anuary %. %##-D interest dates are
1une 5. and $ecember 5%.
)ssume four different cases with respect to the sale ofK the bonds< Case AC"old on 1anuary %, %##- at
parD Case A"old on 1anuary %, %##- at %.2D Case CAC"old on 1anuary %, %##- at #-D Case DA"old on
2arch %, %##- at par.
Required:
%. =or each case, what amount of cash interest will be paid on the first interest date. 1une 5., %##-?
2. In what cases will the effective rate of interest be &a' the same, (b) higher, or &c' lower than the stated
rate?
5. )fter sale of the bonds, and prior to maturity date, in what cases will the carrying or book value of the
bonds &as reported on the balance sheet' be &a' the same, (b) higher, or &c' lower than the maturity or
face amount?
9. )fter the sale of the bonds, in Cases ), / and C, which case will report interest e+pense &a' the same,
&b' higher, or &c' lower than the amount of cash interest paid each period?
Answers:
Re(uirement 1
For all cases. cash interest paid each interest date will be= 6:77,777 x @F G 6+@,777.
Re(uirement )
The effective rate is the same as the stated rate in Cases " and I because the bonds sold at par. The
effective rate is hiher than the stated rate in Case C because the bonds sold at a discount. The effective
rate is lower than the stated rate in Case ; because the bonds sold at a premium
Re(uirement -
"fter the sale of the bonds and prior to maturity date, the carryin or book value of the bonds will be the
same as the maturity or face amount in Cases " and I (sold at par)% in Case ; (sold at a premium). the
carryin or book value will be hiher than the maturity or face amount, and in Case C (sold at a discount).
the carryin or book value will be lower than the maturity or face amount.
Re(uirement 4
Case " will report the same amount for interest expense and cash interest paid (sold at par)% in Case ;,
the amount of interest expense will be lower than the cash interest paid (sold at a premium)% and in Case
C,. the amount of interest expense will be hiher than the cash interest paid (sold at a discount).
E 12-5 ,ond' %t % 3#e+iu+< *cc#ued Inte#e't. St#%i"ht $ine 0n "eptember %, %##-, Iolf Company
issued to 8oungblood Company 45.,..., fiveCyear, # percent &payable semiannually' bonds for 452,52.
plus accrued interest. 7he bonds were dated 1uly %, %##-, and interest is payable each 1une 5. and
$ecember 5%. 7he accounting period for each company ends on $ecember 5%.
Required: In parallel columns, give entries for the issuer and the investor for the following dates<
"eptember %, %##-D $ecember 5%, %##-D and 1une 5., %###. )ssume that the difference between the
Chapter (: !0*(,! -on!Term -iabilities
interest method and straightCline method amorti,ation amounts is not materialD therefore, use straightCline
amorti,ation. 8oungblood intends to hold the bonds to maturity.
Answer:
Issuer-6/. Cm#"n0 in2estr-7ung'/1 Cm#"n0
September () (**+:
Cash .............................0+,,,7 1nvestment in bonds......... 0+,0+7
;onds payable..................... 07,777 1nterest receivable............ @)7
1nterest payable................... @)7 N Cash....................... 0+,,,7
3remium on bonds
payable............................. +,0+7
N"ccrued interest
(607,777 x @E x +*:) 6 @)7
3rice of bonds 0+,0+7
Total cash 60+,,,7
'ecember ,() (**+:
1nterest payable................... @)7 Cash ................................ (,0)7
1nterest expense.................. ,@7 1nvestment in bonds (:7
3remium on bonds 1nterest revenue...... ,)7
payable............................. (:7 1nterest receivable. . @)7
Cash........................... (,0)7
6+,0+7 x @*)9 G 6(:7 ("morti.ation period=
) years minus + months G )9 months).
607,777 x @EF G 6(,0)7.
-une ,.) (***:
1nterest expense.................. (,((7 Cash ................................ (,0)7
3remium on bonds 1nvestment in bonds +@7
payable............................. +@7 1nterest revenue...... (,((7
Cash........................... (,0)7
E 12-2 ,ond'< *cc#ued Inte#e't< I''ue# Ent#ie'. St#%i"ht $ine :yan Corporation sold and issued
4!(,... of threeCyear, - percent &payable semiannually' bonds payable for 4!-,2.. plus accrued interest.
Interest is payable each =ebruary 2- and )ugust 5%. 7he bonds were dated 2arch %, %##-, and were sold
on 1uly %, %##-. 7he accounting period ends on $ecember 5%.
Required:
%. ?ow much accrued interest should be recogni,ed at date of sale?
2. ?ow long is the amorti,ation period?
5. Iive entries for :yan Corporation through =ebruary %###. Jse straightCline amorti,ation.
9. Would the above amounts also be recorded by the investor if the intent was to hold the bonds to
maturity? *+plain.
Chapter (: !@*(,! -on!Term -iabilities
Answers:
Re(uirement 1
"ccrued interest for Karch!Mune= 6,),777 x @F x @*: G 6+,777.
Re(uirement )
"morti.ation period= 0 years ! @ months G 0+ months.
Re(uirement -
>ross method and straiht!line amorti.ation=
Muly (, (559=
Cash .......................................................................................... 97,+77 N
;onds payable..................................................................... ,),777
3remium on bonds payable................................................. 0,+77
1nterest payable (per /equirement ().................................. +,777
N3rice of bond......................................... 6,9,+77
"ccrued interest per (().......................... +,777
Cash....................................................... 697,+77
"uust 0(, (559=
1nterest payable............................................................................. +,777
1nterest expense............................................................................ 977
3remium on bonds payable........................................................... +77
Cash.................................................................................... 0,777
6,),777 x @F G 60,777.
60,+77 x +*0+ G 6+77 (amorti.ation for Muly and "uust).
Iecember 0(, (559 (ad2ustin entry)=
1nterest expense............................................................................ (,:77
3remium on bonds payable........................................................... @77
1nterest payable................................................................... +,777
6,),777 x @F x @*: G 6+,777.
60,+77 x @*0+ G 6@77 (amorti.ation for #eptember
throuh Iecember).
February +9, (555=
1nterest expense............................................................................ 977
3remium on bonds payable (60,+77 x +*0+).................................. +77
1nterest payable............................................................................. +,777
Cash .......................................................................................... 0,777
Re(uirement 4
Jes, the above amounts would be recorded by the investor in the accounts that parallel those for the
issuer, /yan Corporation. "sset and revenue accounts would be used instead of liability and expense
accounts.
Chapter (: !)*(,! -on!Term -iabilities
E12-4 Multiple Choice *ccountin" o# ,ond' Choose the correct answer for each @uestion.
%. ) 6 percent bond issue has nine semiannual interest periods remaining in its term. *ach 4%,... bond
in the issue was sold to yield %. percent. 7he bonds were sold at !# between interest dates. What is
the current book value under the interest and straightCline methods of amorti,ation, as measured in
percentage of face value?
Inte#e't Method St#%i"ht-$ine Method
a. #%.2 #!.5
b. -(.- Cannot be determined
c. %.%.( -(.-
d. -! Cannot be determined
Answer: '8 1nterest method book value G 6(,777(3A(, .7), 5) H 607 (3A", .7), 5)
G 6(,777 (.:@@:() H 607 (,.(7,9+)
G 69)9
The #- Kethod book value cannot be determined because the bond term is not iven.
nor is the amount of the bond term expired as of the current date. Therefore, the amount
of unamorti.ed discount remainin, or the amount of discount amorti.ed to the current
date, cannot be determined.
2. 0n 1uly %, %##-, Center Company paid 4(##,... for %. percent, 2.Cyear bonds with a face value of
4(..,.... Interest is paid on $ecember 5% and 1une 5.. 7he bonds were purchased to yield - percent.
Center uses the interest method to recogni,e interest income from this investment. What is the
carrying amount of this investment in bonds in CenterKs $ecember 5%, %##- balance sheet if Center
intends to hold the bonds to maturity?
a. 46.5,#(..
b. 4(##,....
c. 4(#!,#6..
d 4(#6,(2(.
Answer: $8 Cost of investment............................................................ 6)55,777
Cash interest received (+*0(*59 C(.7)) (6)77,777)D.......... +),777
1nterest revenue for (559 C(.7@) (6)55,777)D..................... +0,5:7
"morti.ation of premium (reduces investment account)... (,7@7
Iecember 0(,(559 carryin amount................................ 6)5,,5:7
5. $elia Company incurred costs of 46,6.. when it issued, on )ugust 5%, %##-, fiveCyear debenture
bonds dated )pril %, %##-. What amount of bond issue e+pense should $elia report in its income
statement for the year ended $ecember 5%, %##-?
a. 499.
b. 49-.
c. 4##.
d. 46,6..
Answer: '8 The bond term is @ years, seven months, or )) months. ;onds were outstandin @
months in (559. "morti.ation of issue costs in (55)= 6:,:77 (@*))) G 6@97.
9. 7he following information pertains to ?ike 7ours, Inc., issuance of bonds on 1uly %. %##-<
=ace amount..................................... 49......
7erm................................................. %. years
"tated interest rate............................ 6>
Chapter (: !:*(,! -on!Term -iabilities
Interest payment dates...................... )nnually on 1uly %
8ield................................................. #>
What is the issue price for each 4%,... bond?
a. 4%,.... c. 4-.!.
b. 4-69. d. 4!...
Answer: $8 Total issue price G 6(,777 (3A(, 5F, (7) H .7: (6(,777)(3A", 5F, (7) G
6(,777 (.@++@() H 6:7 (:.@(,::) G 697,.
E12-11 Noncon1e#ti&le ,ond' ;ith 0et%ch%&le -%##%nt' ?ardware Corporation issued 4!(,... of 6
percent, %.Cyear, nonconvertible bonds with detachable stock purchase warrants. *ach 4%,... bond
carried 2. detachable warrants, each of which was for one share of ?ardware common stock, par 42., at a
specified option price of 46.. 7he bonds sold at 4%.2 including the warrants &no bond price e+Cwarrants
was available', and immediately after date of issuance the detachable stock purchase warrants were
selling at 49 each. 7he entire issue was ac@uired by "oftware Company as a longCterm investment with
the intent to hold to maturity. )ll indicated transactions occurred in the same fiscal year.
Required:
%. Iive entries for both the issuer and the investor at date of ac@uisition ofK the bonds.
2. Iive the entry for the investor assuming a subse@uent sale of all of the warrants to another investor at
4(.(. each.
5. $isregard &2'. Iive the entries for the issuer and the investor assuming subse@uent tender of all of the
warrants by the investor for e+ercise at the specified option price. )t this date, the stock was selling at
4!( per share.
Answers:
Re(uirement 1
Issuer - H"r1w"re Cr#r"tin In2estr - S.tw"re Cr#r"tin
Cash.............................. ,:,)77 N ;ond investment........... ,7,)77
Iiscount on bonds 1nvestment$detachable
payable...................... @,)77 stock purchase
;onds payable..... ,),777 warrants ((,)77 x 6@). :,777
Ietachable stock Cash.................... ,:,)77
purchase warrants
outstandin
((,)77).............. :,777 NN
N 6,),777 x (.7+ G 6,:,)77
NN ,) bonds x +7 warrants per bond x 6@
G 6:,777
Chapter (: !,*(,! -on!Term -iabilities
Re(uirement )
?o entry Cash.............................. 9,+)7
1nvestment$
detachable stock
purchase warrants
((,)77 x 6@)...... :,777
>ain on sale of
stock purchase
warrants............ +,+)7 N
N (,)77 x (6).)7 ! 6@.77) G 6+,+)7
Re(uirement -
Cash ((,)77 shares....... 1nvestment in common
6:7 option price)........ 57,777 stock........................... 5:,777
Ietachable stock 1nvestment
purchase warrants detachable stock
outstandin purchase warrants
((,)77 x 6@)................ :,777 ((,)77 x 6@)...... :,777
Common stock Cash ((,)77 x 6:7). 57,777
((,)77 shares x
6+7 par)............ 07,777
Contributed capital in
excess of par.... ::,777
E12-27 $on"-Te#+ Note. Un#e%li'tic R%te( 0e&to# %nd C#edito# Cathy Company purchased a machine
at the beginning of %##- with a threeCyear, 42,..., ( percent note, payable in three e@ual annual payments
of 4!59 &including principal and interest' at each yearCend 7he current market rate of interest for this level
of risk was %2 percent.
Required:
%. What was the cost of the machine to Cathy Company?
2. Iive the entry by Cathy to record the purchase. Jse the net approach.
5. Frepare the amorti,ation schedule for the note.
9. Iive the entries for both the debtor and the creditor at the end of each year &assuming that the
accounting yearCend for the debtor and creditor coincides with the noteKs yearCend'.
Answer:
Re(uirement 1
Cost of the machine (rounded to (he nearest dollar)=
6,0@ x (3A", (+F, 0) (+.@7(90) G 6(,,:0.
Re(uirement )
&ntry to record the purchase (net basis)=
Kachine...................................................................... (,,:0
?ote 3ayable.................................................... (,,:0
Re(uirement -
"morti.ation schedule=
C"sh Re1u$tin . Prin$i#"/
D"te P"0ment Interest %"t 1)9& Prin$i#"/ B"/"n$e
(559 (start)....... 6(.,:0
(559 (end)........ 6 ,0@ 6(,,:0 x (+F G 6+(+ 6 )++ (,+@(
(555 (end)........ ,0@ (,+@( x (+F G (@5 )9) :):
+777 (end) ....... ,0@ :): x (+F G 97 N :): !7!
Total........... 6+,+7+ 6@@( 6(,,:0
N/ounded.
Re(uirement 4
&ntries at year end=
1**+ 1*** ),,,
Iebtor=
?ote payable........................................... )++ )9) :):
1nterest expense..................................... +(+ (@5 97
Cash.............................................. ,0@ ,0@ ,0@
Creditor=
Cash ...................................................... ,0@ ,0@ ,0@
?ote receivable............................. )++ )9) :):
1nterest revenue............................ +(+ (@5 97
E12-2) *ppendi5 12*. Multiple Choice-T#ou&led 0e&t Re't#uctu#e Choose the correct answer for
each @uestion.
%. 6ano Corporation agreed to give :ewind Company a machine in full settlement of a note payable to
:ewind. 7he machineKs original cost was 4!.,.... 7he noteKs face amount was 4((,.... 0n the date
of the agreement,
M 7he noteKs carrying amount was 4(2,(.. and its present value at the current market rate was
49-,....
M 7he machineKs carrying amount was 4(9,(.., and its fair value was 49-,....
What amounts of gain &loss' should 6ano recogni,e, and how should these be classified in its income
statement?
E5t#%o#din%#! Othe#
a. 4&2,...' 4 .
b. . &2,...'
c. 2,(.. &2,...'
d. 9,(.. &6,(..'
Answer: 18 ?ote carryin value........................................................... 6)+,)77
Kachinery fair value......................................................... @9,777
&xtraordinary ain on debt restructure............................. 6@,)77
Kachinery carryin value.................................................. 6)@,)77
Kachinery fair value......................................................... @9,777
-oss on disposal............................................................... 6:,)77
2. Wild Company. a debtorCinCpossession under Chapter %% of the =ederal /ankruptcy Code, granted an
e@uity interest to a creditor in full settlement of a 4(6,... debt owed to the creditor. )t the date of this
transaction. which is considered an isolated transaction with respect to the bankruptcy proceedings,
the e@uity interest had a fair value of 4(.,.... What amount should Wild recogni,e as in
e+traordinary gain on restructuring of debt?
a. 4..
b. 46,....
c. 4(.,....
d. 4(6,....
Answer: '8 Iebt book value................................................................ 6):,777
Fair value of equity interest............................................... )7,777
&xtraordinary ain on debt restructure............................. 6:,777
5. $uring %##-, Camellia Company e+perienced financial difficulties and was likely to default on a
4(..,..., %( percent, threeCyear note dated 1anuary %, %##!, payable to Central 6ational /ank. 0n
$ecember 5%, %##-, the bank agreed to settle the note and unpaid %##- interest of 4!(,... for
49%.,... cash payable on 1anuary 5%, %###. What is the amount of gain, before income ta+es. from
the debt restructuring?
a. 4..
b. 4!(,....
c. 4#.,....
d. 4%6(.....
Answer: 18 Iebt book value................................................................ 6),),777
Cash paid......................................................................... @(7,777
&xtraordinary ain on debt restructure............................. 6(:),777
Chapter (: !(7*(,! -on!Term -iabilities
9. In %##5, 2arie Corporation ac@uired land by paying 45!,(.. down and signing a note with a maturity
value of 4(..,.... 0n the noteKs due date, $ecember 5%, %##-, 2arie owed 42.,... of accrued
interest and 4(..,... principal on the note. 2arie was in financial difficulty and was unable to make
any payments. 2arie and the bank agreed to amend the note as follows<
M 7he 42.,... of interest due on $ecember 5%, %##- was forgiven.
M 7he principal of the note was reduced from 4(..,... to 49!(,..., and the maturity date was
e+tended one year to $ecember 5%, %###.
M 2arie would be re@uired to make one interest payment totaling 4%(,... on $ecember 5%, %###.
)s a result of the troubled debt restructuring 2arie should report a gain, before ta+es, in its %##-
income statement of
a. 42.,....
b. 42(,....
c. 45.,....
d. 49(,....
Answer: $8 Iebt book value................................................................ 6)+7,777
#um of restructured cash flows........................................ @57,777 N
&xtraordinary ain............................................................ 607,777
N 6@,),777 ! 6(),777
E12-31 *ppendi5 12*. Re't#uctu#e( Modiic%tion o Te#+'< Co+pute Ne; Inte#e't R%te< Ent#ie' o#
,oth 3%#tie' /rown Company owed City /ank a 4(.,..., %. percent &payable each $ecember 5%', fourC
year note dated 1anuary %, %##(. *arly in %##6, it became clear that /rown Company was e+periencing
difficulty in making the annual interest payment, although the company did manage to make the %##(
payment. /ecause of e+pected continuing difficulties, it appeared that there was a good chance the
company would default on the note &as well as on other obligations'. 0n 1anuary 2, %##! the two parties
agreed to restructure the debt by &a' reducing the remaining annual interest payments to 42,29. each and
&b' reducing the principal amount &maturity amount' to 49-,.... /rown paid the interest for %##6.
Required:
%. Compute the new yield or effective rate of interest to be used by /rown.
2. Iive all entries re@uired on date of restructure &1anuary 2, %##!' for each company. If no entry is
re@uired, e+plain the reason.
5. Iive all entries re@uired at $ecember 5%, %##!, and %##-, for each company. )ssume that City /ank
uses the interest method
Answers:
Re(uirement 1
To determine the new effective rate, it is necessary to find the rate that causes the prerestructure carryin
value of the debt (6)7,777) to equal the present value of the future cash flows (principal, 6@9,777 and the
interest payments of 6+,+@7 each. Thus=
6)7,777 G 6@9,777 (3A(, Q, +) H 6+,+@7 (3A", Q, +)
Chapter (: !((*(,! -on!Term -iabilities
Present :"/ue "t
)9 )-; -9
Prin$i#"/:
6@9,777 x 3A( table for nG+ (+F G .5:((,) 6@:,(0:
(+EF G .5)(9() 6@),:9,
(0F G .5@+:7) @),+@)
Interest:
6+,+@7 x 3A" table for nG+ (+F G (.5@():) @,0@5
(+EF G (.5+,@+) @,0(,
(0F G (.5(0@,) TTTTTT TTTTTT @,+9:
Total 3resent Aalue 6)7,@9) 6)7,77@ 6@5,)0(
The new effective rate of interest is almost exactly +EF.
Re(uirement )
;rown Company
Manuary +, (55,, date of restructure$?o entry is required by ;rown because the total cash to be paid
(6@9,777 H 6@,@97 G 6)+,@97) exceeds the prerestructure carryin value of the debt (6)7,777). 4owever,
;rown could choose to reclassify the note as restructured. The new note payable account balance is
6)7,777.
City ;ank
Manuary +, (55,, date of restructure, City ;ank records a loan impairment.
?ew note carryin value G 6@9,777 (3A(, (7F, +) H 6+,+@7 (3A", (7F, +)
G 6@9,777 (.9+:@)) H 6+,+@7 ((.,0))@) G 6@0,)),
;ad debt expense (6)7,777 ! 6@0,)),)............................ :,@@0
"llowance for decline in note value...................... :,@@0
Chapter (: !(+*(,! -on!Term -iabilities
Re(uirement -
Brwn Cm#"n0 %1e'tr& Cit0 B"n< %$re1itr&
De$em'er -1= 1**>:
1nterest expense........ (,+)7 "llowance for decline in
?ote payable.............. 557 note value.................. +,((:
Cash.................... +,+@7 Cash.............................. +,+@7
6)7,777 x +EF G 6(,+)7 1nterest revenue
6+,+@7 ! 6(,+)7 G 6557 (.(7)(6@0,)),)...... @,0):
Iecember 0(, (559 (maturity date)=
1nterest expense........ (,++) "llowance for decline in
?ote payable.............. (,7() note value.................. +,0+,
Cash.................... +,+@7 Cash.............................. +,+@7
(6)7,777 ! 6557) x +EF G 6(,++) 1nterest revenue... @,):, N
N (6@0,)), H 6+,((:) (.(7)
?ote payable.............. @9,777 N
Cash.................... @9,777
"llowance for decline in
note value.................. +,777
Cash ............................ @9,777
?ote receivable.... )7,777
N Cumulative balance= 6)7,777 ! 6557 ! 6(,7() G 6@,,55).
(Iiscrepancy of 6) due to inexact rate of +EF
312-12 ,ond I''u%nce %nd E%#l! Reti#e+ent< Inte#e't Method Flenary, Inc., issued 4%..,... of -
percent bonds on 1anuary %, %##-, to yield 6 percent. 7he bonds pay interest each 1une 5. and $ecember
5%, and mature %. years from issuance. 0n 1anuary %, 2..6, when the bonds were yielding %2 percent.
Flenary retired the bond issue. Flenary uses the interest method.
Required:
%. Frovide the entry for bond issuance.
2. Frovide the entry for the 1une 5., 2..9 interest payment without using an amorti,ation schedule.
5. Frovide the entry for bond retirement.
Answers:
Re(uirement 1
1ssue proceeds G
6(77,777 (3A(, .70, +7) H .79 (E) 6(77,777 (3A", .70, +7) G
6(77,777 (.))0:9) H .79 (E) 6(77,777 ((@.9,,@,) G 6((@,9,9
Manuary (. (559
Cash........................................................................... ((@,9,9
3remium on bond payable................................... (@,9,9
;onds payable..................................................... (77,777
Chapter (: !(0*(,! -on!Term -iabilities
Re(uirement )
Mune 07, +77@ is the end of the (0
th
semiannual interest period. "t Manuary (, +77@ there are 9 interest
periods remainin.
;ook value at Manuary (, +77@=
6(77,777 (3A(, .70, 9) H .79 (E) 6(77,777 (3A", .70, 9) G
6(77,777 (.,95@() H .79 (E) 6(77,777 (,.7(5:5) G 6(7,,7+7.
Mune 07, +77@=
1nterest expense (6(7,,7+7) (.70).............................. 0,+((
3remium on bonds payable........................................ ,95
Cash (6(77,777) (.7@).......................................... @,777
Re(uirement -
<n Manuary (, +77:, + years or @ semiannual periods remain in the bond term. ;ook value at Manuary (,
+77:=
6(77,777 (3A(, .70, @) H .79 (E) 6(77,777 (3A", .70, @) G
6(77,777 (.999@5) H .79 (E) 6(77,777 (0.,(,(7) G 6(70,,(,.
The market value of the bonds on that date is=
6(77,777 (3A(, .7:, @) H .79 (E) 6(77,777 (3A", .7:, @) G
6(77,777 (.,5+75) H .79 (E) 6(77,777 (0.@:)(() G 650,7:5.
Manuary (, +77:=
;onds payable........................................................... (77,777
3remium on bonds payable........................................ 0,,(,
&xtraordinary ain, bond retirement..................... (7,:@9
Cash.................................................................... 50,7:5
C12-5 $i%&ilitie'. O-,%l%nce-Sheet Ri'= 7he reported balances of certain liabilities carried on a
corporationKs books do not always indicate the ma+imum obligation potentially facing the firm as a result
of past transactions. In addition, a firm may have potential obligations that are not recorded at all.
Re?ui#ed. =or each of the following potential or actual liability items, briefly discuss in writing whether
the firm is subect to offCbalanceCsheet risk of accounting loss and, if so, whether that risk arises from
credit risk or market risk &or both', and why. 8our discussion should be from the point of view of the
company named.
%. =i+edCrate mortgage payable by Wellco, Inc., secured by real estate owned by Wellco.
2. 7he guarantee by 1olko, Inc., of a 49 million loan obtained by one of 1olkoKs subsidiaries.
5. /onds payable issued by "amson, Inc. at a discount, due in five years.
9. Convertible bonds issued by Coastal Company at a premium, due in two years.
(. 7ransfer of accounts receivable by 1enell Company, accounted for as a borrowing. 7he transfer is with
recourse to 1enell.
6. ;ariableCrate mortgage payable by )ngeles, Inc., secured by real estate owned by )ngeles.
Chapter (: !(@*(,! -on!Term -iabilities
!. ) loan commitment made by /CC1 /ank to a computer manufacturer, guaranteeing a fi+ed line of
credit at a fi+ed rate of interest for one year from the commitment date.
Answers:
(. " fixed rate mortae is carried at the present value of remainin future cash flows, discounted at the
effective interest rate at the date the property was mortaed. The balance correctly reflects the
amount owed by Bellco at the balance date. There is no off!balance!sheet risk in this case because
no additional amounts are due under the contract.
+. "lthouh Molko probably would disclose the nature of the uarantee anyway, the firm has off!balance!
sheet risk of accountin loss because its subsidiary may be unable to pay its liability. #F"# ?o, (7,
requires a discussion in the footnotes of Molko as to the nature and amount of this potential loss,
which arises entirely from credit risk.
0. The balance of the bond payable account reflects the total liability to the issuer% therefore, there is no
additional off!balance!sheet risk of accountin loss.
@. The balance of the convertible bond payable account reflects the total liability to the issuer% therefore,
there is no additional off!balance!sheet risk of accountin loss.
). Menell maintains the receivables on its books and records a liability. 3rovided that the amount of
recourse to Menell is limited to the amount of the liability recorded, there is no additional off!balance!
sheet risk of accountin loss in this situation.
:. The recorded mortae liability reflects the most current interest rate ad2ustment for "neles.
"lthouh the interest rate may increase in the future, the balance of the mortae payable continues
to reflect "nelesS liability, althouh possibly at a hiher interest rate and hiher payment than at the
oriination of the mortae. Therefore, there is no off!balance!sheet risk of accountin loss in this
situation.
,. The bank has committed to lendin a fixed amount of money to another firm at a fixed rate. The bank
has off!balance!sheet risk of accountin loss from both credit and market risk. The amount of funds
committed represents exposure to credit risk because the computer manufacturer may be unable to
pay this amount in the event the line of credit is used. 1n addition, if the interest rate rises durin the
commitment period, the bank must honor its plede to loan money at a lower rate, thus incurrin
market risk.
*12-3 Con1e#ti&le ,ond' Fart of International Faper CompanyKs longCterm liability footnote to its %##(
financial statements disclosed the following<
Note 12. $on"-Te#+ 0e&t @millions7 1445 1444
( 5B9> Convertible subordinated debentures 4%##
In 1uly %##(, the (N percent debentures were called by the company and converted into (.- million
shares of common stock.
)dditional information<
%. 7he average market price per share of the firmKs common stock was appro+imately 49. during %##(.
2. 7he par value of common stock is 4%.
Required
%. Frepare the conversion entry, assuming the book value method is used.
Chapter (: !()*(,! -on!Term -iabilities
2. Frepare the conversion entry, assuming the market value method.
5. Why might a company prefer to use the book value method? 7he market value method?
9. Why did the bondholders convert rather than accept the call price?
Answers:
Re(uirement 1
Convertible bonds................................................ (55,777,777
Common stock.............................................. ),977,777
Contributed capital in excess of par.............. (50,+77,777
Re(uirement )
Convertible bonds................................................ (55,777,777
-oss on conversion of bonds............................... 00,777,777
Common stock (),977,777)(6()..................... ),977,777
Contributed capital in excess of par.............. ++:,+77,777 N
N (6@7 ! 6() (),977,777)
Re(uirement -
#ome firms chose the book value method to avoid reconi.in a loss. Frequently, the market price of
stock has risen since the issuance of the convertible bonds such that the total market price of stock
issued exceeds the book value of the bonds convened (as in this case). The resultin loss under the
market value method records the opportunity cost to the firm of issuin the shares due to conversion
rather than for cash. Firms with a oal of income maximi.ation prefer to avoid reconi.in this opportunity
cost (for the same reason they wish to avoid reconi.in the opportunity cost of employee stock options).
The loss did not cause an out!of!pocket cost to the firm. Their arument is that the loss is not a reali.ed
loss. "lso. the opportunity cost as measured by the market value method may be overstated if a
substantial number of shares is issued on conversion, relative to the number outstandin before
conversion.
The market value method would be preferred by firms plannin to smooth income or to achieve an
earnins taret. 1n this example, the effectively capitali.ed retained earnins (in the amount of the after!
tax loss) to permanent contributed capital, thereby makin that portion of retained earnins unavailable
for future dividends in many 2urisdictions.
Re(uirement 4
The total market value of the stock issued upon conversion is 6+0+ million ().9 million shares x 6@7),
which most likely exceeds the amount which would have been paid under the call provision.
*12-5 $on"-Te#+ $i%&ilitie' :efer to the %##( financial statements of the CocaCCola Company that
appear at the end of this te+t, and respond to the following @uestions.
%. What was %##( interest e+pense for CocaCCola, and how much interest was paid in %##(?
2. Jsing %##( interest e+pense and only the items listed in the longCterm debt footnote, estimate an
average %##( interest rate using the %##9 balances in longCterm debt. What factors might contribute to
this rateKs being considerably higher than the average rate implied by the interest rates listed for each
component of longCterm debt?
Chapter (: !(:*(,! -on!Term -iabilities
5. What are some of the specific debt issuances contributing to the %##( statement of cash flows
financing inflow Hissuances of debtH?
9. What is the market value of CokeKs longCterm debt? What does this value imply about the current
market rate of interest relative to the average effective interest rate on CokeKs longCterm debt?
Answers:
("mounts in 6 millions)
(. From the income statement, 6+,+ of interest expense was reconi.ed, and from footnote 9, 6+,) was
paid in (55).
+. The averae interest rate usin (55) interest expense and the endin (55@ balance of lon!term
debt= 6+,+*6(,@:( G (9.:F. The 6(,@:( fiure includes the current portion of lon!term debt which
would have been reclassified at year!end.
Jet the items listed in the lon!term debt footnote imply :F ! ,F as the averae interest rate.
3robably the main factor for the difference is that Coke has a substantial amount of debt other than
that listed under Plon!term debt=P loans and notes payable, finance subsidiary notes payable, and
other liabilities. 1nterest on this debt, includin current liabilities, is included in total interest expense
but not in lon!term debt as classified by Coke. 1n footnote 9, the averae interest rate on lon!term
debt is noted as :.)F.
1ssuance of certain lon!term debt items at a discount is a less likely explanation. "lthouh this factor
would explain a hiher rate of interest (effective rate exceedin stated rate), the amount of interest
reconi.ed as expense and paid by Coke in (55) are too similar in amount for this factor to be
sinificant.
0. The (55) statement of cash flows indicates that 6,)@ in cash was received from debt issuances. The
balance sheet and foot note 9 provide information about the effects of debt issuances in (55)=
1ncrease in loans and notes payable 6+,0,( ! 6+,7@9................................ 60+0
1ncrease in >erman mark notes 6(,) ! 6(:(............................................. (@
1ncrease in :F '# dollar notes.................................................................. +)+
6)95
1n addition, Pother liabilitiesP increased 6((( (65:: ! 69))). 4owever, the annual report is not
sufficiently detailed to independently corroborate the amount of cash received on debt issuances in
the statement of cash flows.
@. The market rate of lon!term debt at the end of (55) is 6(,,0, while the carryin value is listed as
6(,:50 (footnote 5). This implies a sliht decrease in market interest rates relative to the effective rate
at the issuance of CokeSs debt. This possible explanation is consistent with the decline in interest
rates in the (557s.
Chapter (: !(,*(,! -on!Term -iabilities
CHAPTER 1> ACCO?NTIN6 3OR LEASES
QUESTIONS
9. Iive the primary I))F concepts of accounting for an operating lease by lessors and lessees.
Answer: <utline of enerally accepted accountin methods for operatin leases=
-essor= /econi.e rent revenue for rents earned on accrual basis.
-essee= /econi.e rent expense for lease payments on accrual basis.
(. )dvance rental payments often are received under operating lease contracts that e+tend well beyond a
single fiscal .year. Iive the acceptable accounting procedures that should be used for advance rentals.
Answer: "dvance rental payments on operatin leases should be credited to an unearned revenue
account (rent revenue collected in advance) by the lessor and debited to a prepaid expense account
by the lessee. The amount should be amorti.ed over the term of the lease. Two approaches are
acceptable=
a. #traiht line$a constant dollar amount is allocated to each lease period.
b. 1nterest method$conceptually sound. somewhat more difficult to compute. This approach
allocates the prepayments to the future periods on a constant percent basis per period.
!. =rom a lesseeKs standpoint. leases are classified as capital or operating leases. What criteria are used
to identify a capital lease?
Answer: 1f a lease meets any one of the followin criteria. it is a capital lease for the lessee
(otherwise, the lease is an operatin lease)=
a. The lease transfers ownership of the property to the lessee by the end of the lease term.
b. The lease contains a barain purchase option.
c. The lease term is equal to ,) percent or more or the estimated economic life of the property.
d. The present value of the minimum lease payments at the inception of the lease is equal to at
least 57 percent of the market value of the property.
-. =rom a lessorKs view. a capital lease involves two types of leases. Identify the types and
distinguish between them.
Answer: From a lessor8s view. the types of leases are= direct financin and sales!type lease. The
basic difference between a sales!type lease and a direct finance lease is that in a direct financin
lease, the lessor reconi.es only one kind of revenue$interest at each rental date. 1n contrast% in a
sales!type lease. the lessor reconi.es two kinds of revenue$(() manufacturerSs or dealerSs profit (at
lease inception date) and (+) interest revenue at each rental date.
%.. ?ow does a lessee determine what interest rate is appropriate for capitali,ation of a lease?
Answer: " lessee should use the lesseeSs incremental borrowin rate if. at the time the lease is
neotiated, the lessorSs implicit rate for the lease is known and is hiher than the lesseeSs incremental
borrowin rate. 1ncremental borrowin rate means the interest rate a lessee would have to pay to
borrow funds to finance acquisition of the leased property.
%2. /riefly e+plain how inclusion of a provision of residual value guaranteed by a third party In a capital
lease can result in asymmetric accounting by lessor and lessee.
Answer: There are two cases to consider. First. the inclusion of uaranteed residual value by a third
party will make the minimum lease payments differ between the lessor and lessee. 1f the lease still
qualifies as a capital lease for both lessor and lessee. 2ournal entries will be symmetrical but amounts
Chapter (, !(*+7! "ccountin for -eases
will differ (the lessor includes the uaranteed residual value in minimum lease payments, but the
lessee does not).
The second case arises when the lease does not meet any of the first three criteria iven in the text in
&xhibit (,!+ for a capital lease. 1nclusion of uaranteed residual value by a third party may make the
lease a capital lease for the lessor (it meets criterion @ of &xhibit (,!+) because the present value of
the lease payments (includin the uaranteed amount) exceeds 57 percent of the market value of the
asset at lease inception. 4owever. the lease may not satisfy criterion @ for the lessee because the
present value of the lease payments (excludin the uaranteed amount) does not exceed 57 percent
of the market value of the asset. 1n this case, the lease will be treated as a capital lease by the lessor
and an operatin lease by the lessee.
%(. When computing annual depreciation, what residual value should the lessee use for a leased asset
under a capital lease? /riefly e+plain each alternative.
Answer: The residual value used by the lessee to compute depreciation on a leased asset depends
on the lease contract. 1f the lease contains no barain purchase option, does not transfer ownership
to the lessee at the end of the lease term, and the lessee does not uarantee the residual value, the
lessee inores the residual value (uses a residual value of .ero). 1f the lessee does uarantee the
residual value. the uaranteed amount must be used as the residual value.
1f the lease contains a barain purchase option or transfers the asset to the lessee at the end of the
lease term, the lessee must use the estimated residual value at the end of the useful life of the asset
(rather than at the end of the lease term.)
EXERCISES
%. :ent should be reported by the lessor as revenue over the lease term as it becomes receivable
according to the provisions of which of the following leases?
0i#ect Ain%ncin" $e%'e Ope#%tin" $e%'e S%le'-T!pe $e%'e
a. 8es 8es 8es
b. 8es 6o 6o
c. 6o 8es 6o
d. 6o 6o 8es
Answer: C 3er #F"# ?o. (0. rent should be reported by the lessor as revenue over the lease term
for an operatin lease as it becomes receivable accordin to the lease provisions. ;oth direct!
financin and sales!type leases are types of capital leases. For these lease types. the lessor reports
interest income over the lease term rather than rental income. Therefore. answer (C) is correct. and
answers ("). (;). and (I) are incorrect.
2. 7he present value of minimum lease payments should be used by the lessee in determining the
amount of a lease liability under a lease classified by the lessee as which of the following?
C%pit%l $e%'e Ope#%tin" $e%'e
a. 8es 8es
b. 8es 6o
c. 6o 6o
d. 6o 8es
Answer: B. 3er #F"# ?o. (0. para (). rental on an operatin lease is to be chared to expense over
the lease term as it becomes payable, unless the payment pattern does not represent a systematic
Chapter (, !+*+7! "ccountin for -eases
and rational allocation over the lease term (in which case the straiht!line method is recommended).
?< lease liability is established for operatin leases. nor is a Ulease assetP reconi.ed. The statement
does. however. require the lessee in a capital leasin transaction to both establish a lease liability
equal to the present value of the minimum lease payments. and reconi.e the leased asset for the
same amount. Therefore. answer (;) is correct.
5. Eease 8 does not contain a bargain purchase option, but the lease term is e@ual to #. percent of the
estimated economic life of the leased property. Eease O does not transfer ownership of the property to
the lessee by the end of the lease term. but the lease term is e@ual to !( percent of the estimated
economic life of the leased property. ?ow should the lessee classify these leases?
$e%'e B $e%'e C
a. Capital lease 0perating lease
b. Capital lease Capital lease
c. 0perating lease Capital lease
d. 0perating lease 0perating lease
Answer: B 3er #F"# ?o. (0. para ,, if a lease meets one or more of four criteria. the lease is
classified as a capital lease by the lessee. <ne of these criteria is that the lease term is equal to ,)
percent or more of the estimated economic life of the leased property. Therefore, bot! leases J and V
in this problem should be classified as capital leases. Therefore. answers ("). (C), and (I) are
incorrect.
9. ) lessee had a %.Cyear capital lease re@uiring e@ual annual payments. 7he reduction of the lease
liability in year 2 should e@ual
a. 7he current liability shown for the lease at the end of year %.
b. 7he current liability shown for the lease at the end of year 2.
c. 7he reduction of the lease obligation in year %.
d. 0neCtenth of the original lease liability.
Answer: A Bhen a leasin areement is accounted for as capital lease, the lessee reconi.es a
liability on its books equal to the. present value of the minimum lease payments. The liability should
be divided between current and noncurrent based upon when each lease payment is due. "t the end
of year (. the current lease liability should equal the principal portion ofS the lease payment due in
year +. Therefore. when the lease payment is made in year +. the reduction of the lease liability will
equal the current liability shown at the end of year (.
%. 7he e+cess of the fair value of lease property at the inception of the lease over its cost or carrying
amount should be considered by the lessor as
a. Jnearned income from a salesCtype lease.
b. Jnearned income from a direct financing lease.
c. 2anufacturerKs or dealerKs profit from a sales type lease.
d. 2anufacturerKs or dealerKs profit from a direct financing lease.
Answer: C. 3er #F"# ?o. (0. para (,. the excess of the fair value of leased property at the inception
of the lease over the lessorSs cost is defined as the manufacturer8s or dealerSs profit. "nswer (") is
incorrect because the unearned income from a sales!type lease is defined as the difference between
the ross. investment in the lease and the sum of the present values of the components of the ross
investment. "nswer (;) is incorrect because the unearned income from a direct!financin lease is
defined as the excess of the ross investment over the cost (also the 3A of lease payments) of the
Chapter (, !0*+7! "ccountin for -eases
leased property. "nswer (d) is incorrect because a sales!type lease involves a manufacturer8s or
dealer8s profit while a direct!financin lease does not.
2. ) lease is recorded as a salesCtype lease by the lessor. 7he difference between the gross investment in
the lease and the net receivable should be
a. )morti,ed over the period of lease as interest revenue by the interest method.
b. )morti,ed over the period of lease as interest revenue by the straightCline method.
c. :ecogni,ed in full as interest revenue at the leaseKs inception.
d. :ecogni,ed in full as manufacturer K or dealerKs profit at the leaseKs inception.
Answer: A. 3er #F"# ?o. (0, para l,b. the difference between the ross investment in the lease
and the sum of the present values of the two components of the ross investment shall be recorded
as unearned income. The unearned income shall be amorti.ed to income over the lease term so as to
provide a constant periodic rate of return on the net investment in the lease. 3er "3; ?o. (+. para (:.
the ob2ective of the interest method is to arrive at a level (i.e.. constant) effective rate (of interest).
Therefore. answers (;), (C), and (I) are incorrect.
5. In a lease that is recorded as a sales type lease by the lessor. interest revenue
a. $oes not arise.
b. "hould be recogni,ed over the life of the lease by the interest method.
c. "hould be recogni,ed over the life of the lease by the straightCline method.
d. "hould be recogni,ed in full as revenue at the leaseKs inception.
Answer: B. 3er #F"# ?o. (0, para (,b, revenue is to be reconi.ed for a sales!type lease over the
lease term so as to produce a constant rate of return on the net investment in the lease. This requires
the use of the interest met!od. Therefore, answer (;) is correct and answer (C) is incorrect. "nswer
(") is incorrect because, per #F"# ?o. (0, interest revenue does arise in a sales!type lease. "nswer
(I) is incorrect because the interest is to be earned over the life of the lease, not in full at the leaseSs
inception.
%. 0n 1anuary %, %##-, 2ill Corporation leased a machine to 0tt Corporation for a fiveCyear term at an
annual rental of 4(.,.... 7he lease is an operating lease. )t the inception of the lease, 2ill received
4%..,... covering the first year . s rent of 4(..... and a security deposit of 4(.,.... 7his deposit
will not be returned to 0tt upon e+piration of the lease but will instead be applied to payment of rent
for the last year of the lease. 2ill properly reported rental revenue of 4%..,... in its %##- income ta+
return. 2illKs ta+ rate was 5. percent. In 2illKs $ecember 5%. %##-, balance sheet, what portion of the
4%..,... should be reported as a liability?
a. 4(.,....
b. 49.,....
c. 45(,....
d. 42-,....
Answer: A. Ieposits and prepayments received for services to be provided in the future are
unearned revenues which should be recorded as a liability until earned. The first yearSs rent is
recorded as rent revenue, but the #)7,777 deposit is recorded as rent collected in advance
(unearned rent) because Kil is required to render future services (use of the machine) to the lessee.
The rate (07F) does not affect the amount of the liability to the lessee, althouh a separate deferred
tax asset may he recorded in certain circumstances.
Chapter (, !@*+7! "ccountin for -eases
2. /eal, Inc., intends to lease a machine from Faul Corporation. /ealKs incremental borrowing rate is %9
percent. 7he prime rate of interest is - percent. FaulKs implicit rate in the lease is %. percent, which is
known to /eal. /eal computes the present value of the minimum lease payments using what rate?
a. - percent.
b. %. percent.
c. %2 percent.
d. %9 percent.
Answer: B. #F"# ?o. (0 states that the lessee should compute the 3A of the minimum lease
payments usin the lesser of the lesseeSs incremental borrowin rate ((@F in this case) or the implicit
rate used by the lessor if known ((7F in this case). The 3A of the minimum lease payments should
be computed usin we implicit rate of (7F because it is known by the lessee and is lower than the
incremental rate. The prime rate (9F) is never used unless it happens to be the same as the
incremental or implicit rate.
5. 0n 1anuary 2, %##-. )she Company entered into a %.Cyear noncancelable lease re@uiring yearCend
payments of 4%..,.... )sheKs incremental borrowing rate is %2 percent. and the lessorKs implicit
interest rate, known to )she, is %. percent. 0wnership of the property remains with the lessor at
e+piration of the lease. 7here is no bargain purchase option. 7he leased property has an estimated
economic life of %2 years. What amount &rounded' should )she capitali,e for this leased property on
1anuary 2, %##-?
a. 4%,...,....
b. 46%9,(...
c. 4(6(,....
d. 4..
Answer: B. This is a capital lease for the lessee because the lease term ((7 years) covers more than
,) F of the economic life of the leased asset (.,)x (+ G 5 years). 1n a capital lease. the lessee
records the 3A of the minimum lease payments as an asset and a liability. The lease payments are
discounted usin the lesser of the lessee8s incremental borrowin rate or the= implicit rate used by the
lessor, if known. 1n this case, the lessee knows the implicit rate is (7F, which is lower than the
incremental rate of (+F. Thus. when the lease is sined. the 3A amount recorded as in asset and
liability is 6:(@,)77 (6(77,777 x (3A", (7F, (7).
9. 0n $ecember 5., %##!, $rew Company leased e@uipment under a capital lease for a period of %.
years. $rew contracted to pay 4#..... annual rent on $ecember 5%, %##!, and on $ecember 5% of
each of the ne+t nine years. 7he capital lease liability was appropriately recorded at 46.-,9.. on
$ecember 5., %##!, before the first payment. 7he leased e@uipment has a useful life of %2 years, and
the interest rate implicit in the lease is %. percent. $rew, uses the straightCline method for
depreciating all e@uipment. In recording the $ecember 5%, %##-. payment. $rew should reduce the
capital lease liability by
a. 45-,%6..
b. 4(.,!...
c. 4(%,-9..
d. 46.,-9..
Answer: A8 The initial lease liability at (+*07*5,, before the first lease payment, is 6:79,@77. The
(+*0(*5, payment consists entirely ofS principal, brinin the (+*0(*5, balance down to 6)(9.@77
(6:79,@77 ! 657,777). The (+*0(*59 payment consists of both principal and the interest incurred
durin (559. (559 interest is 6)(,9@7 (6)(9,@77 x (7F), so the principal portion of the (+*0(*59
payment is 609.(:7 (657,777 ! 6)(,9@7).
Chapter (, !)*+7! "ccountin for -eases
%. 0n 1anuary %, %##!. Perr Company signed a %.Cyear nonCcancelable lease for a new machine.
re@uiring 42..... annual payments at the beginning of each year. 7he machine has a useful life of %(
years, with no salvage value. 7itle passes to Perr at the lease e+piration date. Perr uses straightCline
depreciation for all of its plant assets. )ggregate lease payments have a present value on 1anuary %.
%##!. of 4%26..... based on an appropriate rate of interest. =or %##!, Perr should record depreciation
&amorti,ation' e+pense for the leased machine at
a. 42.,....
b. 4%2,6...
c. 4-,9...
d. 4..
Answer: C. #ince title passes to the lessee at the end of the lease, this is a capital lease for the
lessee. The lessee records the leased asset and lease liability at an amount equal to the lesser of the
FKA of the leased asset or the 3A of the minimum lease payments (6(+:,777). This asset is
depreciated on a straiht!line basis over its useful life of () years. resultin in a yearly depreciation
chare of 69,@77 (6(+:,777 ()). The asset is depreciated over its useful life rather than over the
lease term because title transfers to the lessee, allowin the lessee to use the asset for () years.
2. 7he lessee should amorti,e the capitali,able cost of the leased asset in a manner consistent with the
lessee3s normal depreciation policy for owned assets for leases that do which of the following?
T#%n'e# 9;ne#'hip
o the 3#ope#l! to the
Cont%in % ,%#"%in $e''ee &! the End o>
3u#ch%'e Option the $e%'e Te#+
a. 6o 6o
b. 6o 8es
c. 8es 8es
d. 8es 6o
Answer: C. The requirement is to determine if a lessee should amorti.e the capitali.able cost of a
leased asset in a manner consistent with the lesseeSs normal depreciation policy for owned assets for
leases that contain a barain purchase option and*or transfer ownership at the end of the lease term.
Transfer of ownership of the property to the lessee by the end of the lease term and a lease that
contains a barain purchase option are properly classified as capital leases (#F"# ?o. (0. paras ,(a)
and ,(b)). 3er #F"# ?o. (0. para (((a), if the lease meets either of the above criteria, the asset
should be amorti.ed in a manner consistent with the lesseeSs normal depreciation policy for owned
assets. Therefore. answers ("). (;). and (I) arc incorrect.
5. ) lease contains a bargain purchase option. In determining the lesseeKs capitali,able cost at the
beginning of the lease term, the payment called for by the bargain purchase option would
a. 6ot be capitali,ed.
b. /e subtracted at its present value.
c. /e added at its e+ercise price.
d. /e added at its present value.
Answer: D. The requirement is to determine whether or not a barain purchase option should be
capitali.ed as part of the minimum lease payments. 3er #F"# ?o. (0. para ). minimum lease
payments include the= rental payments plus the amount of the barain purchase option, if it exists.
3er para (7, the amount to be capitali.ed is the present value of the minimum lease payments.
Therefore. the present value of the barain purchase option would be added to the present value of
Chapter (, !:*+7! "ccountin for -eases
the rental payments (assumed to be previously calculated) in determinin the lesseeSs capitali.able
cost.
9. 0n 1anuary 2. %##(. Wayne. Inc.. signed an eightCyear lease for office space. Wayne has the option to
renew the lease for an additional fourCyear period on or before 1anuary 2. 2..5. $uring 1anuary %##!,
two years after occupying the leased premises. Wayne made general improvements to the premises
costing 456..... and having an estimated useful life of %. years. )t $ecember 5%. %##!. Wayne3s
intentions as to e+ercise of the renewal option are uncertain because they depend upon future office
space re@uirements. ) full yearKs amorti,ation e+pense is taken for calendar year %##!. Wayne should
record amorti,ation of leasehold improvements for %##! at
a. 45......
b. 456,....
c. 4"9(,....
d. 46.,....
Answer: D. The requirement is the amount ofS (55, amorti.ation expense for leasehold
improvements. The cost of leasehold improvements (60:7,777) should be amorti.ed over the
remainin life of the lease, or the useful life of the improvements. whichever is shorter. Bhen the
lease contains a renewal option, the life of the lease does not include the renewal period unless it is
probable that the option will be exercised. Therefore, in this case. the remainin life of the lease is six
years (9!year lease term less the two years one by). The renewal period of four years is not
considered since exercise of the option is uncertain. The useful life of the improvements is ten years.
so the improvements are amorti.ed over the remainin lease life of six years, This results in (55,
amorti.ation of 6:7,777 (60:7,777K : years).
%. In a saleCleaseback transaction the sellerClessee has retained the property. 7he gain on the sale should
be recogni,ed at the time of the saleCleaseback if the lease is classified as which of the following?
C%pit%l $e%'e Ope#%tin" $e%'e
a. 8es 8es
b. 6o 6o
c. 6o 8es
d. 8es 6o
Answer: B. 3er #F"# ?o. +9. any profit related to a sale!1easeback transaction in which the seller
retains the property leased (i.e., the seller!lessee retains substantially all of the benefits and risks of
the ownership of the property sold), shall be deferred and amorti.ed in proportion to the amorti.ation
of the leased asset, if a capital lease. 1f it is an operatin lease, the profit will be deferred in proportion
to the related ross rental chared to expense over the lease term. -osses, however, are reconi.ed
immediately for either a capital or operatin lease. #ince the ain on the sale should be deferred in
either case, no ain is reconi.ed at the time of the sale, and answer (;) is correct.
2. 0n $ecember %. %##-. /arr Company' leases office space for five years at a monthly rental of
46.,.... 0n that date, /arr pays the lessor, the following amounts<
=irst monthKs rent...........................................................................46.,...
East month3s rent &$ec. 2..5'.........................................................6.,...
"ecurity deposit &refundable it lease e+piration'..............................-.,...
Installation of new walls and offices.............................................56.,...
Chapter (, !,*+7! "ccountin for -eases
/arrKs $ecember %##- e+pense relating to its use of this office space is
a. 46.,....
b. 466,....
c. 4%26.....
d. 42.......
Answer: B. The first month8s rent (6:7,777) is expensed as incurred in Iecember (559. The
prepayment of the last month8s rent (also 6:7,777) is deferred and will be reconi.ed as expense at
the end of the lease. The refundable security deposit (697,777) is recorded as a lon!term receivable,
since ;arr can expect to receive the deposit back at the end of the lease term. The cost of installin
new walls and offices (60:7,777) is recorded as an asset,. leasehold improvements. and amorti.ed
over the lease term. The amorti.ation for Iecember is 6:,777 (60:7,777 :7 months). Therefore,
total expense is 6::,777 (6:7,777 H 6:,777).
5. 0n $ecember 5%. %##!, Eane. Inc., sold e@uipment to 6oll and simultaneously leased it back for %2
years. Fertinent information at this date is<
"ales price...................................................................................49-.,...
Carrying amount..........................................................................456.,...
*stimated remaining economic life...............................................%( years
)t $ecember 5%. %##!. how much should Eane report as a deferred gain from the sale of the
e@uipment?
a. 4..
b. 4%%.,....
c. 4%%2.....
d. 4%2......
Answer: D. "ccordin to #F"# ?o. (0, sale!leaseback arranements are treated as thouh two
transactions were a sinle transaction, if the lease qualifies as a capital lease. "ny ain or loss on the
sale is deferred and amorti.ed over the lease term (if possession reverts to the lessor) or the
economic life (if ownership transfers to the lessee. 1n this case, the lease qualifies as a capital lease
because the lease term ((+ years) is 97F of the remainin economic life of the leased property (()
years). Therefore, at (+*0(*5,, all of the ain (6@97,777 ! 60:7,777 G 6(+7,777) would be deferred
and amorti.ed over (+ years. #ince the sale took place on (+*0(*5,, there is no amorti.ation for
(55,.
9. 7he following information relates to e@uipment sold by /ard Company to Perr Company on
$ecember 5%, %##!<
"ale, price....................................................................................45..,...
/ook value..................................................................................4%..,...
*stimated remaining economic life...............................................2. years
"imultaneously with the sale, /ard leased back the e@uipment for a period of %6 years. ?ow much of
the gain on the sale should /ard defer at $ecember 5%. %##!?
a. 42..,....
b. 4%2,(...
c. 4%......
d. 4..
Answer: A. The requirement is to determine the amount of profit to be deferred by ;ard Co., the
lessee is a sale!leaseback transaction. "ccordin to #F"# ?o. (0, sale and leaseback arranements
are treated as thouh the two transactions were a sinle financin transaction if the lease qualifies as
a capital lease. "ny ain or loss on the sale is deferred and amorti.ed over the lease term if
possession remains with the lessor or economic life if ownership transfers to the lessee. 1n this case,
the lease qualifies as a capital lease because the lease term is 97F of the remainin economic life of
the leased property. Therefore, at Iecember 0(, (55,, all of the 6+77,777 (6077,777 ! 6(77,777) ain
on sale of the equipment would be deferred by ;ard Co. and amorti.ed over (: years. #ince the sale
was on Iecember 0(, there is no amorti.ation for (55,.
E 17-) $e%'e. *ppl! $e%'e C#ite#i%< Ent#ie' o# $e''o# %nd $e''ee
7am Eeasing Company agreed with Ee+ Corporation to provide the latter with e@uipment under lease for
a threeCyear period. 7hc e@uipment cost 7am 4%2.,... and will have no residual value when the lease
term ends. 7am e+pects to collect all payments from Ee+ and has no material cost uncertainties. 7he
carrying value of the e@uipment was 4%2.,... at the inception of the lease. 7he three e@ual annual
payments &amount to be determined' are to be paid each 1anuary %. starting 1anuary %, %##- &at which
time the e@uipment was delivered'. Ee+ has agreed to pay ta+es, maintenance. and insurance throughout
the lease term as well as any other ownership costs. 7am e+pects a 2. percent return &known to Ee+'. 7he
accounting year ofK both companies ends $ecember 5%.
Required: :ound to the nearest dollar.
I. What kind of lease is this to Ee+? 7o 7am?
2. Compute the annual payments and prepare an amorti,ation schedule reflecting the interest and
principal elements of Ee+3s payments over the threeCyear term of the lease. Iive all ournal entries
relating to the lease for Ee+ Corporation for %##- including yearCend adusting entries.
5.< Iive all ournal entries for 7am Eeasing Company relating to the lease for %##- including yearCend
adusting entries.
Answer:
Re(uirement 1
This is a capital lease to the lessee -ex, because the lease term is more that ,)F of the economic useful
life of the leased asset.
The lease is a direct financin lease to lessor Tam, because (() it meets the criterion for a capital lease
cited above, and (+) Tam expects to collect all rents from -ex and has no material cost uncertainties. The
market value equals the book value of the property at inception of the lease term (i.e., there is no
manufacturer8s or dealer8s profit as in a sales!type lease.)
Re(uirement )
"nnual lease payment (annuity due)= 6(+7,777 (3A"I, +7F, 0) G 6(+7,777 (+.)+,,9) G 6@,,@,+.
"morti.ation #chedule (annuity due basis)=
Annu"/
Le"se Interest Le"se Re$8@Li"'8
D"te P"0mentsA "t ),9 De$8 %in$8&
7(*7(*(559 6 !7! 6 (+7,777
7(*7(*(559 @,,@,+ @,,@,+ ,+,)+9 (b)
(+*0(*(559 (@,)7: (c) (@,)7: 9,,70@ (d)
7(*7(*(555 @,,@,+ @,,@,+ 05,):+
(+*0(*(555 ,,5(+ (e) ,,5(+ @,,@,@ N
7(*7(*+777 @,,@,+ @,,@,+ !7!
(a) "nnuity due. six calculation above
(b) 6(+7,777 ! 6@,,@,+ G 6,+,)+9
(c) 6,+,)+9 (.+7) G 6(@,)7:
(d) 6,+,)+9 H 6(@,)7: G 69,,70@
(e) 605,):+ (.+7) G 6,,5(+
N /oundin error
LeB Cr#r"tin %/essee& entries:
Manuary (. (559 (inception of lease)=
-eased equipment............................................... (+7,777
-ease liability................................................. (+7,777
(To record the lease)
Manuary (. (559=
-ease liability....................................................... @,,@,+
Cash.............................................................. @,,@,+
(To record first payment)
Iecember 0(, (559 (end of accountin year)=
1nterest expense.................................................. (@,)7:
-ease liability................................................. (@,)7:
(To accrue first year8s interest)
Iepreciation expense.......................................... @7,777
"ccumulated depreciation, leased equipment @7,777
(To record first year8s depreciation)
Re(uirement -
T"m C8 %/essr& entries:
Manuary (. (559 (inception of lease)=
-ease receivable (6@,,@,+ x 0)............................ (@+,@(:
&quipment..................................................... (+7,777
'nearned interest revenue............................ ++,@(:
(To record the lease)
Manuary (. (559=
Cash.................................................................... @,,@,+
-ease receivable........................................... @,,@,+
(To record first payment)
Iecember 0(, (559 (end of accountin year)=
'nearned 1nterest revenue.................................. (@,)7:
1nterest revenue............................................ (@,)7:
(To accrue interest revenue)
E 17-19 $e%'e. Ain%ncin" o# S%le' T!pe'< Schedule %nd Ent#ie'< $e''o# %nd $e''ee
:e+ Corporation &lessor' and Eee Company &lessee' agreed to a nonCcancelable lease. 7he following
information is available regarding the lease terms and the leased asset<
a. :e+Ks cost of the leased asset was "9.,.... 7he asset was new at lease inception date.
Chapter (, !(7*+7! "ccountin for -eases
b. Eease term is four years, beginning 1anuary %. %##-. Eease payments are made each 1anuary %.
beginning 1anuary %, %##-.
c. *stimated useful life of leased asset is four years. *stimated residual value at end of lease is ,ero.
d. "ales price of leased asset on 1anuary %, %##-, was 496,....
e. :e+Ks implicit interest rate is %( percent on retail price &known to Eee'.
f. :e+ e+pects to collect all payments from Eee, and there are no material cost uncertainties.
!e"#ired$
%. What kind of lease is this to :e+? 7o Eee?
2. Compute the annual lease payments.
5. Frepare an amorti,ation schedule for the lease.
9. Iive the ournal entries for both parties on 1anuary %, %##-, and $ecember 5%, %##-. $o not make
closing, entries.
Answers:
%e&uirement '
This is a capital lease to -essor /ex because (() the estimated residual value of the leased property at
the end of the lease term is .ero (i.e.. the lease term is equal to (77F of the estimated useful life of the
asset), and (+) /ex expects to collect all rentals from -ee and no material cost uncertainties exist. 1t is a
sales!type lease because the market sales price exceeds the lessorSs cost% the manufacturerSs or dealerSs
profit is 6:,777. 1t is a capital lease to -ee because of (() above.
%e&uirement (
"nnual lease payment (annuity due basis) G 6@:,777 (3A"I, ()F, @)
G 6@:,777 0.+90+0
G 6(@,7(( (rounded)
%e&uirement )
De$re"se
Annu"/ Annu"/ %In$re"se& in
Le"se Interest Le"se Re$ei2"'/e
D"te P"0mentsA "t 159 Li"'i/it0
7(*7(*(559 1nitial value 6 @:,777
7(*7(*(559 (@,7(( (a) (@,7(( 0(,595 (b)
(+*0(*(559 @,,59 (c) (@,,59) 0:,,9,
7(*7(*(555 (@,7(( (@,7(( ++,,,:
(+*0(*(555 0,@(: (0,@(:) +:,(5+
7(*7(*+777 (@,7(( (@,7(( (+,(9(
(+*0(*+777 (,907 N ((,907) (@,7((
7(*7(*+777 (@,7(( TTTTT (@,7(( !7!
6 ):,7@@ 6 (7,7@@ 6 @:,777
(a) Computed in requirement +.
(b) 6@:,777 ! 6(@,7(( G 60(,595.
(c) 60(,595 (.()) G 6@,,59.
N /ounded to balance out to last payment.
Chapter (, !((*+7! "ccountin for -eases
%e&uirement *
Lessor Lessee
-anuary () (**+/inception o& lease:
-ease receivable.................. ):,7@@ N -eased 3roperty............... @:,777
Cost of oods sold............... @7,777 -ease liability.......... @:,777
#ales revenue............ @:,777
"sset.......................... @7,777
'nearned interest
revenue................... (7,7@@
Cash ................................ (@,7(( -ease liabilityNN................. (@,7((
-ease receivable........ (@,7(( Cash....................... (@,7((
'ecember ,() (**+/end o& accounting period:
'nearned interest 1nterest expenseNN............ @,,59
/evenue........................... @,,59 -ease liability.......... @,,59
Iepreciation expense....... ((,)77
"ccumulated
depreciation......... ((,)77
6@:,777 L @ years G 6((,)77
N 6(@,7(( x @
NN These two entries are often combined to yield=
-ease liability................................................. 5,+(0
1nterest expense............................................ @,,59
Cash....................................................... (@,7((
E 17-12 O1e#1ie; o Speci%l $e%'e C%'e'. 3#o1ide E5pl%n%tion' "elect the best answer in each of the
following. 1ustify each choice that you make.
%. 0n the first day ofK its accounting year. Eessor, Inc.. leased certain property at an annual payment of
42...... receivable Dat the beginning of each year for %. years. 7he first payment was received
immediately. 7he leased property, which is new, cost 4%,%..,... and has an estimated useful life of
%2 years and no residual value. EessorKs implicit rate is %2 percent. Eessor had no other costs
associated with this lease. Eessor should have accounted for this lease as a salesCtype lease but
mistakenly treated the lease as an operating lease. What was the effect on net income during the first
year of the lease of having treated this lease as an operating lease rather than as a salesCtype lease.
a. 6o effect.
b. 0verstatement.
c. Jnderstatement.
d. 7he effect depends on the accounting method selected for income ta+ purposes.
Answer: C. 1f accounted for as an operatin lease, earnins for the first year would be 6(79,00@ )
6+77,777 revenue ! 65(,::: depreciation). 1f accounted for as a sales!type lease, the sellin price is
6(.+:).:)7 (present value of the future payments). The first yearSs earnins are calculated in the
schedule below. There would also be (+ percent interest on the 6(,7:),:)7 (i.e., 6(,+:),:)7 !
6+77,777) receivable balance (this is an annuity due situation). 1ncome would be understated by
6(9),(5@ (i.e., 6+50,)+9 ! 6(79,00@).
Chapter (, !(+*+7! "ccountin for -eases
#ale price (6+77,777 (3A"I, (+F, (7) G 6+77,777 (:.0+9+)).................6(,+:),:)7
Cost........................................................................................................... ((,(77,777)
>ain on sale.................................................................................................. (:),:)7
(+F x (6(,+:),:)7 ! 6+77,777).....................................................................(+,,9,9
First year net earnins................................................................................6 +50,)+9
2. 7he appropriate valuation of leased assets under an operating lease on the balance sheet of a lessee is
which of the following?
a. Oero.
b. 7he absolute sum of the lease payments.
c. 7he sum of the present values of the lease payments discounted at an appropriate rate.
d. 7he market value of the asset as of the date of inception of the lease.
Answer: A. ?o value is reconi.ed by lessees for leased assets under an operatin lease. -easehold
improvements, or lon!term prepayments, can ive rise to assets to be accounted for in connection
with such leases but the question does not imply the existence of this kind of asset.
5. What types of e+penses does a lessee e+perience with a capital lease?
a. :ent e+pense, interest e+pense, amorti,ation e+pense.
b. Interest e+pense, amorti,ation e+pense, e+ecutory costs.
c. )morti,ation e+pense, e+ecutory costs, rent e+pense.
d. *+ecutory costs, interest e+pense, rent e+pense.
Answer: B. 3roper accountin for a capital lease by a lessee requires reconition of interest on the
unpaid liability balance. depreciation of the amount capitali.ed as the value of the lease, and possibly
also executory costs such as insurance. taxes. maintenance. and repairs. dependin on the nature of
the property leased.
9. When the present value of future payments to be capitali,ed in connection with a capital lease is
measured, how should identifiable payments to cover ta+es, insurance and maintenance be accounted
for?
a. Included with the future rent to be capitali,ed.
b. *+cluded from future rentals to be capitali,ed.
c. Capitali,ed, but at a different rate and recorded in a different account from that for future
payments.
d. Capitali,ed, but at a different rate and during a different period from the rate and period used for
the future payments.
Answer: B. 'nder a capital lease. the lessor records a receivable (an asset) and earns interest on
that receivable. &xpenses of ownership. such as maintenance. taxes. and insurance are shifted by
the lease contract to the lessee. 3ayments for such items should therefore not be capitali.ed by the
lessee nor included by the lessor in computin the periodic rentals.
(. I))F re@uires that certain lease agreements be accounted for as purchases 7he theoretical basis for
this treatment is that a lease of this type
a. *ffectively conveys most of the benefits and risks incident to the ownership of property.
b. Is an e+ample of form over substance.
c. Frovides the use of the leased asset to the lessee for a limited period of time.
d. 2ust be recorded in accordance with the matching concept.
Answer: A. Bhen a lease areement conveys all of the benefits and risks of ownership, it should be
accounted for as a purchase (i.e.. capitali.ed) by the lessee. b is wron because when a lease
areement is required to be capitali.ed, substance prevails over form, not the reverse. c is wron
because many leases provide use of property for a relatively lon time, often the entire life of the
leased asset. I is wron because capitali.ation of leases reflects substance over form, not cause and
effect.
6. 8our client constructed an office building at a cost of 4(..,... and then sold the building to 1ones for
a large gain. 7he client leased it back from 1ones for a stipulated annual payment. ?ow should this
gain be treated?
a. :ecogni,ed in full as an ordinary item in the year of the transaction.
b. :ecogni,ed in full as an e+traordinary item in the year of the transaction.
c. )morti,ed as an adustment of the rental cost over the life of the lease.
d. )morti,ed as an e+traordinary item over the life of the lease.
Answer: C. The sale and leaseback constitutes a 2oint transaction because they cannot be evaluated
independently. 3araraph 00 of #F"# ?o. (0 provides that ains on such transaction must be
amorti.ed over the life of the lease. " and b are wron because they assume reconition of ain on
the sale as a separate transaction. I is wron because it treats the ain as an extraordinary item.
E 17-29 S%le-$e%'e&%c=< 0i#ect Ain%ncin" $e%'e :ich Irocery owns the building it usesD it has a
current carrying value on 1anuary %, %##-, of 49(. ..., a %.Cyear remaining life and no residual value.
0n this date it was sold to investor Eucky for 4(..,... cash. "imultaneously, the two parties e+ecuted a
%.Cyear direct financing lease with a %2 percent implicit interest rateD each annual payment is due on
$ecember 5% &end of their accounting periods'.
Required:
%. Compute the annual payments to be made by :ich to Eucky.
2. Iive the entries for the sellerClessee &:ich Irocery' for %##-. Jse straightCline depreciation.
Answer:
%e&uirement '
Computation of lease payments (ordinary annuity)=
6)77,777 L (3A", (+F. (7) G 6)77,777 L ().:)7++) G 699,@5+
0e$uirement 1
&ntries for seller*lessee (/ich >rocery) durin (559=
Dan. (, (559=
(a) To record sale of the asset=
Cash.................................................................... )77,777
"sset............................................................. @)7,777
'nearned ain, sale*leaseback..................... )7,777
(b) To record inception of the direct financin lease=
-eased asset (buildin)........................................ )77,777
-ease liability................................................. )77,777
Iec. 0(, (559=
(c) To record lease payment=
1nterest expense (6)77,777 x .(+)....................... :7,777
-ease liability (699,@5+ ! 6:7.777)................ +9,@5+
Cash.............................................................. 99,@5+
Chapter (, !(@*+7! "ccountin for -eases
(d) "d2ustin entry!to record depreciation=
Iepreciation expense (6)77.777 L (7)................ )7,777
"ccumulated depreciation (leased asset)...... )7,777
(e) To amorti.e unearned ain=
'nearned ain on sale*leaseback........................ ),777
Iepreciation expense.................................... ),777
6)7,777 L (7 years G 6),777.
E 17-22 $e%'e %nd R%tio *n%l!'i' "uppose a firm were re@uired to place its operating leases on its
balance sheetD that is, the firm is re@uired to capitali,e its leases. What would be the impact on the
following ratios<
M Current ratio
M Working capital to total assets
M )sset turnover
M $ebt to e@uity
M Cash flow per share
M :eturn on investment
M $ividend payout
&)ssume normal ratio values e+ist before capitali,ation, such as a current ratio of at least one.'
Answers:
Current /atio=
Iecreases. Current assets are unchaned. but current liabilities will increase by the amount of the
current liability increase.
Borkin Capital to Total "ssets=
Iecreases. Borkin capital is lower due to the increase in current liabilities and total assets increases
due to capitali.ation of the lease assets. The increase in lon!term assets exceeds the increase in
current liabilities.
"sset Turnover=
Iecreases. ?et assets remains the same. but averae total assets increases.
Iebt to &quity=
1ncreases. Iebt increase. Iepreciation of the leased asset plus interest now replace the rent expense
under a capital lease. The impact on debt dominates the impact on the ratio and this ratio increases.
Cash Flow per #hare=
?o chane.
/eturn on Total "ssets=
Iecreases. 1ncome is reduced as interest and depreciation replace rent expense while total assets
are also increased. (This answer assumes straiht!line depreciation. 1f accelerated depreciation is
used. the answer holds for the initial years of the assets. but will eventually reverse.).
Iividend 3ayout=
1ncreases. The numerator is unchaned. but income declines.
Chapter (, !()*+7! "ccountin for -eases
3 17-2 $e%'e. 0ete#+ine T!pe< Ent#ie' o# $e''o# %nd $e''ee Crown leases a limo to Oap Froductions
for four years on 1anuary %, %##-, re@uiring e@ual annual payments on each 1anuary I and, in addition, a
single lumpCsum prepayment of 45,.... 7he leased asset, recently purchased new, cost the lessor 4(.,....
7he estimated unguaranteed value of the asset at end of lease term is 42.,....
7he annual lease payments were computed to yield Crown %2 percent &the implicit interest rate after
considering that the residual value is known to Oap Froductions'. 7he leased asset has an eightCyear life
with ,ero residual value at the end of year -. 7here is no bargain purchase option, and the asset is retained
by Crown at the end of the lease term. $epreciation will be on the straightCline basis. 7he accounting
period for both lessor and lessee ends $ecember 5%.
Required:
%. Compute the annual lease payment.
2. What type of lease is this? *+plain.
5. In parallel columns for the lessor and lessee, give<
a. *ntries at the inception of the lease, including the initial advance payment.
b. )dusting and closing entries for the year ended $ecember 5%, %##-. Jse straightCline
amorti,ation for the prepayment.
Answers:
Re(uirement 1
#ellin price of leased asset....................................................................6 )7,777
Ieduct= 3A of residual value 6+7.777N (at end of year @)
(3A (, (+F, @) G 6+7,777 (.:0))+)..............................................((+,,(7)
3repayment................................................................................. (0,777)
?et asset to be recovered .......................................................................6 0@,+57
"nnual payment= 60@,+57 L (3A"I, (+F, @) G 60@,+57 L 0.@7(90..........6 (7,797
Re(uirement )
This is an operatin lease because it does not meet any of the requirements for classification as a capital
lease.
(() ?o transfer of ownership at the end of the lease term.
(+) ?o barain purchase option.
(0) -ease term W ,)F of the estimated useful life years W (.,) x 9 years G : years).
(@) 3A of minimum lease payments W 57F. of market value at lease inception% (60@,+57 H 60.777 G
60,,+57) W (.57 x 6)7,777) G #@),777.
Re(uirement -
Lessr Lessee
(a) Manuary (. (559 (inception of lease)=
Cash (6(7,797 H 60,777).. (0,797 -easehold (or prepaid rent). 0,777
/ent revenue................. (7.797 /ent &xpense...................... (7,797
'nearned rent revenue. 0,777 Cash................................. (0,797
Chapter (, !(:*+7! "ccountin for -eases
Lessr Lessee
(b) Iecember 0(. (559 ("d2 and closin entries)=
'nearned rent revenue..... ,)7 /ent expense...................... ,)7
/ent revenue................. ,)7 -easehold......................... ,)7
60.777 L @ years G 6,)7
Iepreciation expense....... :,+)7 1ncome summary................. (7,907
"ccumulated depreciation :.+)7 /ent expense................... (7,907
6)7.777 L 9 years G 6:,+)7. 6(7,797 H 6,)7 G 6(7,907
/ent revenue.................... (7,907
Iepreciation expense.... :,+)7
1ncome summary........... @,)97
6(7,797 H 6,)7 G 6(7,907
C 17-2 YOU MAKE THE CALL Conce#n %&out 0e&t-E?uit! R%tio %nd Thi#d-3%#t! Re'idu%l 8%lue
Du%#%ntee'. Ethic'( "peedware Corporation has entered into a debt agreement that restricts its debtCtoC
e@uity ratio to less than two to one. 7he corporation is planning to e+pand its facilities. creating a need for
additional financing. 7he board of directors is considering leasing the additional facilities but is
concerned that leasing may violate its e+isting debt agreementD a violation would place the corporation in
default. 7he potential lessor insists that the lease be structured in such a way that it can be accounted for
as a capital lease by the lessor &the lessor is a dealer and wants to recogni,e the dealerKs profit on the
transaction immediately'. In addition, the lessor re@uires that the residual value of the leased asset be
guaranteed when it reverts to the lessor at the end of the lease term. "peedwareKs board has asked you to
analy,e the following alternatives<
Alternati%e AA"peedware would enter into a lease that @ualifies as a capital lease &to "peedware'. If this
alternative is selected, "peedwareKs reported debtCtoCownersKCe@uity ratio would be %.#, and its ability to
issue debt in the future would be seriously constrained.
Alternati%e &"peedware would enter into a lease and pay a third party to guarantee the residual value of
the leased property. 7he lease would be structured in such a way as to @ualify as an operating lease to
"peedware and as a capital lease to the lessor. In this case, "peedwareKs reported debtCtoCe@uity ratio
would be unaffected by the lease contract.
Required
)naly,e and e+plain the conse@uences of each of the above alternatives in a oneCpage memo to your
superior. $o you see any ethical considerations?
Answer:
The relative merits of the two alternatives depend on (() the likelihood that #peedware will require debt
financin in the immediate future, and (+) the cost of securin a third party uarantor of the residual value
of the leased property. 1f #peedware is unlikely to need additional financin immediately, the risk of
default on the existin debt areement may be minimal, because the lease liability will be reduced
annually by the principal portion of the lease payment. "lso, #peedware may be able to obtain capital
throuh the issuance of stock. rather than debt, which would improve its debt!to!ownersS equity ratio.
1n addition, payin a third party to act as uarantor of the lessorSs residual value on the leased asset is
costly, and this cost must be compared to the benefits of reduced risk of default on existin debt. #elf!
insurance (assumption of the residual value uarantee) by the lessee involves no out!of!pocket
expenditures until the end of the lease term and then only if the appraised residual value is less than the
uaranteed residual value.
Chapter (, !(,*+7! "ccountin for -eases
The ethical issue is whether it is ethical to use a third party to uarantee the residual value to avoid
includin a capital lease obliation on the balance sheet. 1f the acquisition is intended to be permanent
and this is simply a ploy to avoid capitali.ation, should the firm constitute the transaction usin alternative
;Q
* 17-3 $e%'e C%lcul%tion' %nd 0i'clo'u#e' 7urner /roadcasting Company sponsors C66. 6ote ( to
7urnerKs %##9 annual statements, dealing with longCterm debt, includes the following information in part<
Note 5. $on"-Te#+ 0e&t
EongCterm debt consists of<
0ece+&e# 31
1444 1443
(tho#sands)
/ank credit facilities........................................................................................................ 4%,9#.,... 4%,22(,...
%2> "enior "ubordinated $ebentures due 0ctober %(, 2..%, net of
unamorti,ed discount of 45,26-................................................................................... CCC (56,!52
- 5B-> "enior 6otes due 1uly %. 2.%5, net of unamorti,ed discount of
42,6%# and 42,6!(....................................................................................................... 2#!,5-% 2#!,52(
!.9> "enior 6otes due 2..9. net of unamorti,ed discount of 4565................................. 29#,65! CCC
-.9> "enior $ebentures due 2.29. net of unamorti,ed discount of 4%((........................ %##,-9( CCC
Oero coupon subordinated convertible notes, !.2(> yield, due =ebruary %5,
2..!, net of unamorti,ed discount of 4556,9-! and 45(5,56-..................................... 29(,(6# 22-,6--
Convertible subordinated debentures of a wholly owned subsidiary................................ 2#,.!( CCC
0bligations under capital leases due in varying amounts through %###,
net of imputed interest of 4#5% and 4%,.!(.................................................................. 6,2.. 6,5(5
0ther debt, net of imputed interest of 4%,%!( and 42#. due in varying amounts
through 2..#. interest at fi+ed rates ranging from 6...> to #.9#>............................. %,5-6 2,(%.
42,(%#,.#5 42,2#6,6.-
Eess current portion......................................................................................................... %,59( 2..(%
42,(%!,!9- 42,2#9,((!
0ther information obtained from the notes to 7urner /roadcasting CompanyKs financial statements<
Included in the maturities of longCterm debt amounts are obligations under capital lease of
4%,2##,...D 4%,2!5,...D 4%,26%,...< 4%,5!6,...D and 4%,.%6,... for each of the five years
following $ecember 5%, %##9. =inally, assume that 4(6(,... of lease maturities e+ist for each of
the years 2..., 2..%, and 2..2 respectively.
Required.
*stimate the firmKs average implicit interest rate on its lease obligations. )ssume there are no further longC
term lease obligations after $ecember 5%, 2..2. )ll payments are made at the end of the year.
Answers:
Turner ;roadcastin Co.
/ather than use the more common payment schedule presentation for lon!term debt and capital leases,
Turner discloses payment information in text format under U<ther <bliations.X Jearly payment amounts
are termed maturities.
"n estimate of the interest rate can be found by solvin
9
" n (3A(, i, n) G 6:,+77 G 6(,+55(3A(, i, () H 6(,+,0 (3A(, i, +) H 6(,+:( (3A(, i, 0) H
nG(
9
6(,0@: (3A(, i, @) H 6(,7(: (3A(, i, )) HC(6:,+77 H 650() L (0)D (3A(, i, n)
nG:
where " n G Katurity "mount in year n and nG( in (55).
"n 43(+C calculator can easily solve this to yield :.9+F.
"n alternative solution determines the interest rate for (55@ (assumin end!of!year payments) as follows=
1nterest for (55@ G (6(,7,) ! 650() L 6:,0)0 G .7+ of +F.
This estimate appears too low.
* 17-2 0elt% *i#line' 7his problem re@uires access to the World Wide Web portion of the Internet. 8ou
should use $eltaKs most recent %.CP annual report. 7o do so access the "*CKs *lectronic $ata gathering,
)nalysis, and :etrieval "ystem &*$I):' using the following steps<
a. J:E< http<BBwww.sec.govBinde+.html
b. Click on *$I): $atabase of Corporate Information
c. Click on "earch for *$I): $atabase
d. Click on "earch for *$I): )rchives
e. *nter the company name in the search dialog bo+
f. Click on the listing for the most recent %.P annual report
Required: &It is possible that some of the data you may need to answer the @uestions may not be
available. If so, omit this portion of the re@uirements.'
%. What type of assets does $elta lease?
2. What method does $elta use to record rent e+pense on its operation leases? What entry did $elta
make in the most recent year to recogni,e rent e+pense on its operating leases?
5. What is the amount of leasehold and operating rights &e+cluding flight e@uipment' held by $elta at
the end of the last fiscal year?
9. What method does $elta use to measure the current portion of its capital lease obligation? ?ow do
you know?
(. Frovide your best estimate of Kthe entries $elta would make to recogni,e its capital lease payments for
the coming fiscal year. &Jse %. percent as an estimate of $eltaKs average interest rate on its capital
leases.' ?ow would you estimate this rate if it were necessary to do so with only the information
available on the I 0CP?
Answer
The solution here is developed from Ielta8s (55: (7!Y report. The solution indicates how certain results
were obtained so the reader may duplicate them usin the more recent financial statements. -eases are
covered in footnote 9 of the (55: financial statements.
(. The company leases aircraft, airport terminal and maintenance facilities, ticket offices, and other
property and equipment. (From footnote 9)
+. #traiht line. (Footnote 9)
0. 657(.7(7,777. (Footnote 9)
@. The decline in the present value of the lease obliation. and not the present vale of next yearSs
payment. This is likely to be the reason because=
a. Kost firms use this approach.
b. The interest rate necessary to equate the current lease liability of 6)9 million with the payment
required next year of 6(7( million is much too lare to be reasonable.
). <peratin leases
/ent expense....................................................... 9,(
Cash.............................................................. 9,(
(The operatin lease payment due in (55, indicated in footnote 9)
Capital leases
Capital -easesN.................................................... )0
1nterest expenseNN............................................... )9
CashNNN.......................................................... (7(
N ;alancin result
NN .(7 (6)97), the current lease liability.
NNN Current payment due in (55, from footnote 9
Chapter (, !+7*+7! "ccountin for -eases
C:*3TER 1). *CCOUNTIND AOR 3ENSIONS *N0 OT:ER 3OSTEM3$OBMENT
,ENEAITS
%. $istinguish between a defined contribution pension plan and a defined benefit pension plan.
Answer: " defined!contribution pension plan does not define specific benefits to be paid at employee
retirement. /ather, it specifies the periodic amount that the employer must pay into the pension fund.
The employees receive whatever benefits can be paid from the pension fund accumulation and its
earnins. " defined benefit plan specifies the way the amount of benefits to be received by
employees after retirement is calculated.
2. $istinguish the three parties involved in accounting and reporting for a pension plan.
Answer: The three primary accountin parties, are= (a) employer, (b) fundin aency (trustee), and
(c) actuary. The employer must account for pension expense, cash contributions to the fundin
aency, and pension liabilities. The fundin aency accounts for the funds received from the
employer, investment of those funds. and payment of benefits to the retirees. The actuary provides an
annual report of the pro2ected benefit obliation and related data.
5. What are the primary actuarial factors related to a pension plan?
Answer: "ctuarial factors are the data used by an actuary to make estimates of pro2ected benefits
and the present value of those benefits. The primary factors include the benefit formula, retirement
aes, mortality (i.e., life expectancies), number and aes of employees, turnover rates, future salary
levels, interest rates, ains and losses on pension funds, and vestin benefits.
9. *+plain the three funding approaches that the employer can use for pension plans.
Answer: The three fundin approaches are=
a. 2nternal pension &und: Cash is set aside by the company in a pension fund administered internally
by the company.
b. 2ndependent pension &und: Cash is paid to an independent pension fundin aency (trustee) who
administers the pension fund, invests the funds, and makes the payments to the retirees.
c. 3urc!ase o& retirement annuity: Cash is paid to an insurance company to purchase retirement
annuities for the retirees. The insurance company then accepts full responsibility for payin the
pension benefits to the retirees.
%9. What is the vested benefit obligation?
Answer: The vested benefit obliation is the present value of the current and future pension benefit
rihts that are no loner continent on remainin an employee of the company.
%(. Eist and define the si+ components of net periodic pension e+pense.
Answer: Components of net periodic pension expense=
a. Service cost$the cost (at actuarial present value) of future pension benefits earned by
employees durin the current accountin period.
b. 2nterest cost$the beinnin balance of the pro2ected benefit obliation multiplied by the
estimated interest rate used by the actuary.
c. #4pected return on plan assets$the expected return on the pension plan investments plus the
chane in the carryin value of <B 3lan assets used in operations.
d. Amorti5ation o& unrecogni5ed prior service cost$prior service cost is caused by plan
amendments that are retroactive. The cost is not reconi.ed in full immediately but is amorti.ed
(and reconi.ed) over future periods as expense.
e. Amorti5ation o& unrecogni5ed gains or losses$due to (a) differences between expected and
actual returns on plan assets, and (b) other ains and losses due to chanes in actuarial
Chapter (9 (*(9 3ensions O 3ostemployment ;enefits
assumptions. This cost is not reconi.ed in full immediately, but is amorti.ed (and reconi.ed)
over future periods as expense.
f. Amorti5ation o& unrecogni5ed transition cost$a chaneover cost that occurs when SFAS No. +6
is first adopted 1t occurs only once. The total amount is not reconi.ed in full when incurred but is
amorti.ed as expense over future periods.
%6. *+plain the additional minimum pension liability?
Answer: "n additional minimum pension liability must be reconi.ed if the total of plan assets at fair
value is less than the accumulated benefit obliation ad2usted for any accrued*prepaid pension cost
reconi.ed. 1t is recorded with a credit to additional minimum pension liability and debits to intanible
pension asset and unreali.ed capital accounts.
2%. *+plain the difference between the proected benefit obligation and the accumulated benefit
obligation.
Answer: The accumulated benefit obliation is exactly the same as the pro2ected benefit obliation
except for one difference in the computations. The pro2ected benefit obliation includes the effect of
estimated future chanes in the averae remuneration of the employees covered. The accumulated
benefit obliation does not include the effects of estimated chanes in the averae remuneration of
employees. The pro2ected benefit provides basic data for pension accountin, while the accumulated
benefit obliation is used only for computin one amount, the additional minimum pension liability.
26. *+plain the difference between e+pected postretirement benefit obligation &*F/0' and accumulated
postretirement benefit obligation &)F/0' in accounting for postretirement benefits other than
pensions.
Answer: &3;< is the actuarial present value of benefits expected to be paid and takes into
consideration the expected service period of employees. "3;< is the actuarial present value of
benefits earned to a particular date. <nce an employee reaches full eliibility, the two measures are
equal.
2!. *+plain how accounting for the transition amount for postretirement benefits is similar to and
different from that for pensions.
Answer: The accountin is similar in that the transition amount is computed the same way for both
pensions and postretirement benefits other than pensions. "morti.ation is also similar in that the
transition amount may be amorti.ed over the averae remainin service period of plan participants.
The accountin is different in that the pension transition amount can he amorti.ed over () years if the
service period is less than () years, whereas for postretirement benefits other than pensions +7
years may be used. "lso, the transition amount for postretirement benefits other than pensions (only)
may be reconi.ed immediately.
Chapter (9 +*(9 3ensions O 3ostemployment ;enefits
E-1)-2 Multiple Choice. Choose the best answer from among the alternatives.
%. "ervice cost for %##- for a pension plan whose pension benefit formula incorporates estimates of
future compensation levels is
a. 7he present value of benefits earned by employees in %##- based on current salary levels.
b. 7he increase in )/0 for %##- less interest on the beginning balance in )/0.
c. 7he nominal value of benefits earned by employees in %##- based on future salary level.
d. 7he present value of benefits earned by employees in %##- based on future salary levels.
Answer: 1.
2. 7he following statements describe some aspect of accounting for defined benefit pension plans.
Choose the incorrect statement.
a. When only the first three components of pension e+pense have occurred to date for a plan and
actual return has always e@ualed e+pected return, underfunded F/0 at a reporting date e@uals the
balance in the accrued pension liability.
b. When only the first three components of pension e+pense have occurred to date for a plan and
actual return has always e@ualed e+pected return, pension e+pense reflects the true annual cost to
the company of providing future benefits earned in the current period, assuming all the actuarial
assumptions are correct.
c. /ecause the last three components of pension e+pense are derived from amorti,ing initial present
values on a straightCline or similar basis, the true total cost of these items is not reflected in
pension e+pense.
d. Fension e+pense can be negative.
Answer: $.
5. Choose the correct relationship among offCbalanceCsheet values and values reported in a balance sheet
relative to a pension plan.
a. Jnderfunded F/0 less amorti,ation of unrecogni,ed F"C e@uals the balance in accrued pension
cost.
h. Jnrecogni,ed F"C is an item that reconciles the balance in accrued pension cost and overfunded
F/0.
c. "um of .pension e+pense to date e@uals F/0.
d. F/0 less )/0 e@uals balance in accrued pension cost.
Answer: '8
9. =or e+ternal reporting purposes, assuming an underfunded )/0, the liability that must be reported in
the balance sheet is
a. F/0 less plan assets at fair value.
b. /alance in accrued pension cost.
c. 7he underfunded )/0.
d.. )dditional minimum pension liability.
Answer: $8
Chapter (9 0*(9 3ensions O 3ostemployment ;enefits
(. Choose the correct statement concerning amorti,ation ofK unrecogni,ed gain or loss<
a. "ome amorti,ation must be recogni,ed in a year that begins with a non,ero unrecogni,ed gain or
loss.
b. 7he corridor is the ma+imum amorti,ation allowed.
c. 7he corridor amount for %##- is %. percent of the greater of these two $ecember 5%, %##- values<
F/0 and plan assets at fair value.
d. 7he amorti,ation of an unrecogni,ed gain yields a reduction in pension e+pense and a reduction
in that unrecogni,ed gain.
Answer: 18
6. $efined contribution plans and defined benefit plans are two common types of pension plans. Choose
the correct statement concerning these plans.
a. 7he re@uired annual contribution to the plan is determined by formula or contract in a defined
contribution plan.
b. /oth plans provide the same retirement benefits.
c. 7he retirement benefit is usually determinable well before retirement in a defined contribution
plan.
d. In both types ofK plans, pension e+pense is generally the amount funded during the year.
Answer: "8
!. F/0 and plan assets at fair value are two values critical to the determination of the financial status of
defined benefit plan. Choose the correct statement regarding items to be included in each &none of
these statements is necessarily complete'.
a. *nding F/0 includes total service cost to date, interest cost to date, net initial unamorti,ed
actuarial gain or loss to date, and initial F"C.
b.. *nding F/0 includes total service cost to date, interest cost to date, net initial unamorti,ed
actuarial gain or loss to date,. initial F"C, and initial transition cost.
c. *nding fair value of plan assets includes funding to date and e+pected return to date, reduced by
benefits paid to date.
d. *nding F/0 includes service cost to date, gross differences between e+pected and actual returns
to date, and net initial unamorti,ed actuarial gain or loss to date, all less contributions to date.
Answer: "8
-. Which of the following is not one of the si+ components of pension e+pense &or part of a
component'?
a. Initial transition asset.
b. )morti,ation ofK unrecogni,ed gain or loss.
c. )ctual return on plan assets.
d. Irowth &interest cost' in F/0 since the beginning of the period.
Answer: "8
Chapter (9 @*(9 3ensions O 3ostemployment ;enefits
E 1)-19 Co+pute Net 3e#iodic 3en'ion E5pen'e %nd Unde#unded o# O1e#unded 3,OE Ent#ie'
7he %##- records of 1a+ Company provided the following data related to its noncontributory, defined
benefit pension plan &amounts in 4...s'<
a. Froected benefit obligation &report of actuary'<
/alance. 1anuary %. %##-.............................................4 5,...
"ervice cost....................................................................%,2..
Interest cost.......................................................................29.
Fension benefits paid..................................................... &9..'
/alance, $ecember 5%, %##-.......................................4 9,.9.
b. Flan assets at fair value &report of trustee'<
/alance, 1anuary %, %##-.............................................4 2,9.-
)ctual return on plan assets..............................................%6-
Contributions, %##-........................................................%,.%6
Fension benefits paid..................................................... &9..'
/alance, $ecember 5%, %##-.......................................4 5,%#2
*+pected longCterm rate of return of plan assets, ! percent
c. 1anuary %, %##- balance of unrecogni,ed prior service cost, gains and losses, and transaction cost is
,ero.
Required:
%. Compute %##- net periodic pension e+pense. "how the correct amount for each of the si+
components.
2. Iive the %##- entry &entries' for 1a+ Company to record pension e+pense and funding.
5. Compute the underC or overfunded F/0 at the beginning and end of %##-.
Answers:
%e&uirement '
?et periodic pension expense=
#ervice cost (3;<)..................................... 6 (,+77
1nterest cost (proof, 60,777 x 9F).............. +@7
&xpected return on plan assets.................. ((:9)
'nreconi.ed loss (ain) on plan assets=
"ctual return............................................ 6 (:9
&xpected return (6+,@79 x ,F)............... (:9
'nreconi.ed ain (amorti.ation
starts next period)................................ 6 !7! !7!
Transition cost............................................ !7!
3rior service cost........................................ !7!
?et periodic pension expense.......................... 6 (,+,+
%e&uirement (
Iecember 0(, (559=
3ension expense.................................... (,+,+
Cash.................................................... (,7(:
"ccrued pension cost.......................... +):
Chapter (9 )*(9 3ensions O 3ostemployment ;enefits
%e&uirement )
C"nu"r0 1= 1**+ De$em'er -1= 1**+
3ro2ected benefit obliation................... 6 0,777 6 @,7@7
3ension plan assets (fair value)............ +,@79 0,(5+
'nder (over) funded 3;<...................... 6 )5+ 6 9@9
E 1)-13 3en'ion Sp#e%d'heet. Unde#unded %nd *cc#ued 3en'ion Co't. Ent#ie' Iecko Company has
a defined benefit pension plan. )t the end of the current reporting period, $ecember 5%, %##-, the
following information was available<
a. Froected benefit obligation &actuary3s report'<
/alance, 1anuary %, %##-.............................................4 2,9..
"ervice cost.......................................................................5%2
Interest cost &42,9.. + !> actuary3s rate'.........................%6-
Eoss &gain' change in actuarial assumptionsL.....................!2
Fension benefits paid..................................................... &%6.'
/alance, $ecember 5%, %##-.......................................4 2,!#2
L )morti,ation to start in %###
b. "tatus of fund assets &trustee3s report'<
/alance, 1anuary %, %##-.............................................4 2,...
)ctual return on plan assets &same as e+pected'................%2.
Cash received from employer company............................2-.
Fension benefits paid to retirees..................................... &%6.'
/alance, $ecember 5%, %##-.......................................4 2,29.
c. =rom company records, unamorti,ed pension cost
from prior years &amorti,e over a nineCyear average
remaining service period'
7ransition cost...............................................................4 !2
Frior service cost............................................................%.-
Eosses &gains'................................................................%99
7otal.........................................................................4 529
Required:
%. "et up and complete a spreadsheet or format of your choice to develop the pension data re@uired
at the end of %##-.
2. Iive the employer3s pension entry at $ecember 5%, %##-.
Chapter (9 :*(9 3ensions O 3ostemployment ;enefits
Answers:
%e&uirement '
Cm#rehensi2e Pensin S#re"1sheet
In.rm"/ Re$r1 3rm"/ Re$r1
Pensin ?nre$gniDe1 Net Peri1i$ %A$$rue1&
P/"n Pensin Pensin Pre#"i1
PBO Assets Cst EB#ense Cst
Items %"$tu"r0& %trustee& %'0 $m#"n0& %'0 $m#"n0& %'0 $m#"n0&
;&>1??1?> ;"-"?C&#, (559 6+,@77 6+,777 60+@ 67 (6,:)
Chanes in 3;< durin (559=
#ervice cost 0(+ 0(+
1nterest cost (6+,@77 x ,F) (:9 (:9
'nreconi.ed costs (delayed)=
Transition cost=
'nreconi.ed at beinnin (559 - 6,+
1ncrease (decrease) in (559 7
Total unreconi.ed 6,+
"morti.ed in (559 (6,+*5) 9 9
'nreconi.ed balance at end (559 - 6:@
3rior service cost=
'nreconi.ed at beinnin (559 - 6(79
1ncrease (decrease) in (559 7
Total unreconi.ed - 6(79
"morti.ed in (559 (6(79*5) (+ (+
'nreconi.ed balance at end (559 - 65:
-oss (ain)%
'nreconi.ed at beinnin (559 - 6(@@
Chane from 3;< (559 ,+ - ,+N
Chane from plan assets (559 7
Total unreconi.ed - 6+(:
"morti.ed in (559 (6(@@*5) (: (:
'nreconi.ed balance at end (559 - 6+77
Chanes in plan assets durin (559=
&xpected return 6(+7 67 ((+7)
"ctual return on plan assets (+7
Cash received from company +97 +97
3ension benefits paid to retirees ((:7) ((:7)
&?I1?> ;"-"?C&#, (559
3;< 6+,,5+
3lan assets 6+,+@7
'nder (over) funded 3;< 6))+
'nreconi.ed pension costs 60:7
?et periodic pension expense 605: (05:)
("crued)*prepaid pension cost (6(5+)
3roof= ;einnin 6+,@77 ! 6+,777 ! 60+@ G 6,:% &ndin 6+,,5+ ! 6+,+@7 ! 60:7 G 6(5+
N "morti.ation starts next period.
%e&uirement (
"ccountin entry 3ension expense.................................................... 05:
"ccrued*prepaid pension cost (6,: ! 6(5+)...... ((:
Cash................................................................. +97
Chapter (9 ,*(9 3ensions O 3ostemployment ;enefits
E-1)-12 Multiple Choice. *ccountin" o# 3en'ion'( Choose the correct statement for each @uestion.
%. Which of the following defined benefit pension plan disclosures should be made in a companyKs
financial statements?
I. ) description of the companyKs funding policies and types of assets held.
II. 7he amount of net periodic pension cost for the period.
III. 7he fair value of plan assets.
a. I and II.
b. I, II and III.
c. II and III.
d. I only.
Answer: '8
2. Interest cost included in the net pension cost recogni,ed by an employer sponsoring a defined benefit
pension plan represents the
a. )morti,ation of the discount on unrecogni,ed prior service cost.
b. Increase in the fair value of plan assets due to the passage of time.
c. Increase in the proected benefit obligation due to the passage of time.
d. "hortage between the e+pected and actual returns on plan assets.
Answer: $8
5. 0n 1uly 5%, %##-, 7umwater Company amended its singleCemployer defined benefit pension plan by
granting increased benefits for services provided prior to %##-. 7his prior service cost will be
reflected in the financial statement&s' for
a. 8ears before %##- only.
b. %##- only.
c. %##- and years before and after %##-.
d. %##- and the following years only.
Answer: 18
9. )n employer sponsoring a defined benefit pension plan is subect to the minimum pension liability
recognition re@uirement. )n additional liability must be recorded e@ual to the unfunded
a. )ccumulated benefit obligation plus the previously recogni,ed accrued pension cost.
b. )ccumulated benefit obligation less the previously recogni,ed accrued pension cost.
c. Froected benefit obligation plus the previously recogni,ed accrued pension cost.
d. Froected benefit obligation less the previously recogni,ed accrued pension cost.
Answer: '8
E-1)-1) Un#eco"niFed D%in' %nd $o''e'( 0n 1anuary %, %##-, a company reported a 46,...
unrecogni,ed gain in the informal record of its pension plan. $uring %##- the following events occurred<
a. )ctual return on plan assets was 4-,... and e+pected return was 4%.,....
b. ) gain of 49,... was determined by the actuary at $ecember 5%, %##-, based on changes in actuarial
assumptions.
7he company amorti,es unrecogni,ed gains and losses on the straightCline basis over the average
remaining service life of active employees &2. years'. It does not recogni,e the minimum amorti,ation.
=urther information on this plan follows<
8%lue' *t
G%nu%#! 1( 144) 0ece+&e# 31< 144)
F/0........................................... 4(.,... 4(6,...
=air value of plan assets............. 5.,... 59,...
Required: Compute amorti,ation of unrecogni,ed gain or loss for %##- and %###.
Answer:
"morti.ation of unreconi.ed ain, (559 G 6:,777*+7 G 6077
(decreases pension expense)
'nreconi.ed ain, (+*0(*59=
'nreconi.ed ain, (*(*59............................. (6:,777)
"morti.ation in (559 (requirement ()............ 077
&xcess of expected over actual return........... +,777
"ctuarial ain, (+*0(*59................................. (@,777)
'nreconi.ed ain, (+*0(*59......................... (6,,,77)
"morti.ation of unreconi.ed ain, (555 G 609)
E-1)-22 Mini+u+ $i%&ilit!. Th#ee C%'e'. Ent#ie' 8ates Company has a noncontributory, defined
benefit pension plan. It is $ecember 5%, %##-, end of the accounting year and measurement date for the
pension plan. 7he following are the data for three separate cases, as of the measurement dates &in 4...s'<
Ite+' @%t 0ece+&e# 31< 144)7 C%'e * C%'e , C%'e C
a. Froected benefit obligation............ 4%,... 4%,... 4%,...
b. )ccumulated benefit obligation...... -.. -.. -..
c. ;ested benefit obligation................ 56. 56. 56.
d. Fension plan assets at book value. . . ((. ((. ((.
e. Fension fund assets at fair value..... 6.. -9. 6..
f. &)ccrued' prepaid pension cost....... . -. &2.'
g. Jnrecogni,ed prior service cost...... 22. %-. %(.
Required:
%. =or each case, compute the additional minimum pension liability that should be reported.
2. =or each case, (a) e+plain whether a minimum liability must be reported and why, and (b) if one must
be reported, give the entry.
Answer:
%e&uirement '
Items %"t De$em'er -1= 1**+& C"se A C"se B C"se C
"ccumulated benefit obliation......................................... 977 977 977
-ess= 3lan assets at fair value.......................................... (:77) (9@7) (:77)
'nder (over) funded accumulated benefit obliation..... +77 6(@7) +77
"ccrued*prepaid pension cost....................................... !7! 697N (+7)
"dditional minimum pension liability required................... 6+77 6!7! 6(97
N The accumulated benefit obliation is overfunded. Therefore, the balance of this account is irrelevant
because the "3< is overfunded.
%e&uirement (
$ase A
(a) Kust record 6+77 additional minimum liability because it is underfunded and no accrued*prepaid
pension cost was recorded. " contra stockholdersS amount is not recorded because the additional
minimum liability (6+77) is not in excess of the unreconi.ed prior service cost (6++7).
(b) &ntry=
1ntanible pension asset............................................................................. +77
"dditional minimum pension liability.................................................... +77
$ase +
(a) ?o additional minimum liability is required because the accumulated benefit obliation is overfunded.
(b) ?o entry.
$ase $
(a) Kust record a 6(97 additional minimum liability because the accumulated benefit obliation is
underfunded and the accrued pension cost is less than the underfundin. " contra stockholdersS debit
is required because the minimum liability (6(97) is in excess of the unreconi.ed prior service cost
(6()7).
(b) &ntry=
1ntanible pension asset............................................................................. ()7
'nreali.ed pension cost, contra stockholders8 equity (6(97 ! 6()7)........... 07
"dditional minimum pension liability.................................................... (97N
N ?otice that the total liabilities for pensions will be 6(97 H 6+7 (already recorded) G 6+77.
Chapter (9 (7*(9 3ensions O 3ostemployment ;enefits
E-1)-24 *ccountin" o# 3o't#eti#e+ent ,eneit' Othe# Th%n 3en'ion'( Choose the correct statement
for each @uestion.
%. 7he balance sheet in the accrued postretirement benefit cost account generally reflects which of the
following?
a. 7he underfunded accumulated postretirement benefit obligation.
b. 7he underfunded e+pected postretirement benefit obligation.
c. 7he e+cess ofK cumulative postretirement benefit e+pense over cumulative funding.
d. 7he e+cess of cumulative employer contributions over cumulative benefit payments.
Answer: $8
2. Which of the following statements correctly describes the relationship between e+pected post
retirement benefit obligation &*F/0' and accumulated postretirement benefit obligation &)F/0'?
a. *F/0 can be less than or e@ual to )F/0, but never more.
b. *F/0 and )F/0 are never e@ual.
c. *F/0 and )F/0 are always e@ual.
d. )F/0 can be less than or e@ual to *F/0, but never more.
Answer: 18
5. ) firm has a transition obligation for postretirement benefits. 7he average remaining service period of
active plan participants is %( years. Which ofK the following options for recogni,ing the transition
obligation is open to this firm.
I. Immediate recognition in transition year.
II. )morti,ation over %( years.
III. )morti,ation over 2. years.
I;. )morti,ation over 9. years.
a. I, II and III only.
b. I, II, III and I;.
c. I and II only.
d. I only.
e. II only.
Answer: "8
9. )t the end of the current year, a firm3s accumulated postretirement benefit obligation e+ceeds plan
assets by 42.,.... ?owever, the firm is reporting 4%.,... of prepaid postretirement benefit cost.
Which of the following might e+plain why the firm can report an asset while having an underfunded
planK?
a. 7he transition obligation was recogni,ed immediately in the year of transition.
b. 7he firm has significant unrecogni,ed amounts for past service cost and transition obligation.
c. 7he firm has a large unrecogni,ed transition asset.
d. 7he firm3s annual funding amount has never e+ceeded the amount recogni,ed as annual
postretirement benefit e+pense.
Answer: '8
Chapter (9 ((*(9 3ensions O 3ostemployment ;enefits
(. ) firm reports an underfunded accumulated postretirement benefit obligation in its report of funded
status. 7his amount generally e@uals the
a. )mount by which cumulative postretirement benefit e+pense e+ceeds cumulative funding since
transition.
b. )mount by which the present value of benefit payments e+pected to be made e+ceeds the plan
assets at fair value.
c. Frepaid pension cost balance less amounts funded to date.
d. )mount by which the present value ofK benefit payments earned to date e+ceeds the plan assets at
fair value.
Answer: 18
E-1)-22 *ppendi5. 3o't#eti#e+ent ,eneit $i%&ilitie' )t $ecember 5%, %##-, Iypsum, Inc., estimated
the following net incurred claims costs for one of its employees. for each year of the employee3s
retirement period to which the plan applies<
E'ti+%ted Net Incu##ed
*t *"e Cl%i+' Co't &! *"e
69 49.%#9
6( 9.69.
66 %,2-9
6! %,92%
6- %,(!!
7he postretirement plan of Iypsum provides no benefits after age 6-. =or full eligibility, an employee
must serve 2. years. 7he employee in @uestion is (% years old at $ecember 5%, %##-, and has served %(
years at that date. 7he employee is e+pected to retire at age 65. IypsumKs discount rate for postretirement
benefit accounting purposes is - percent.
Required:
%. $etermine the e+pected post retirement benefit obligation and accumulated postretirement benefit
obligation at $ecember 5%, %##-, for this employee.
2. )ssuming that the employee works another five years after $ecember 5%, %##-, and that there are
no changes in e+pected net incurred claims costs, determine the e+pected postretirement benefit
obligation and accumulated postretirement benefit obligation at $ecember 5%, 2..5, for this
employee.
Answer:
Re(uirement 1
EPBO "t 1)@-1@*+:
6@,(5@ (3A(, 9F, (0) G 6@,(5@ (.0:,,7) G 6(,)@+
6@,:@7 (3A(, 9F, (@) G 6@,:@7 (.0@7@:) G (,)97
6(,+9@ (3A(, 9F, ()) G 6(,+9@ (.0()+@) G @7)
6(,@+( (3A(. 9F. (:) G 6(,@+( (.+5(95) G @()
6(,),, (3A(, 9F, (,) G 6(,),, (.+,7+,) G @+:
&3;< at (+*0(*59 6@,0:9
"3;< at (+*0(*59 G (()*+7) 6@,0:9 G 60,+,:
Chapter (9 (+*(9 3ensions O 3ostemployment ;enefits
The employee has served ()*+7 of the full eliibility period and is expected to reach the full eliibility date.
"n equal amount of &3;< is attributed to each year of service from date of hire to the full eliibility date.
Re(uirement )
The two obliation measures are equal at (+*0(*70, the full eliibility date. The employee has served +7
years at that date.
EPBO "n1 APBO "t 1)@-1@,-:
6@,(5@ (3A (, 9 F, 9) G 6@,(5@ (.)@7+,) G 6+,+::
6@,:@7 (3A (, 9F, 5) G 6@,:@7 (.)77+)) G +,0+(
6(,+9@ (3A (. 9F, (7) G 6(,+9@ (.@:0(5) G )5)
6(,@+( (3A1. 9F. (() G 6(,@+( (.@+999) G :75
6(,),, (3A (, 9F.(+) G 6(.),, (.05,(() G :+:
&3;< and "3;< at (+*0(*70 6:,@(,
3-1)-2 Multiple Choice. *ccountin" o# 3en'ion'( Choose the correct statement for each @uestion.
%. 7he following information pertains to Eara Corporation3s defined benefit plan for %##-<
"ervice cost.....................................................................4%6.,...
)ctual and e+pected gain on plan assets.............................5(,...
Jne+pected increase in F/0 incurred during %##-............9.,...
)morti,ation of unrecogni,ed prior service cost..................(,...
)nnual interest on pension obligation................................(.,...
What amount should Eara report as pension e+pense in its %##- income statement?
a. 42(.,....
b. 422.,....
c. 42%.,....
d. 4%-.,....
Answer: 1. 6(97,777
#ervice cost....................................................................6(:7,777
/eturn................................................................................ (0),777)
"morti.ation of 3#C.............................................................),777
1nterest.............................................................................. )7,777
(559 pension expense............................................6 (97,777
(The earliest the 3;< can be amorti.ed is (555.)
2. 6ion Company sponsors a defined benefit plan covering all employees. /enefits are based on years of
service and compensation levels at the time of retirement. 6ion determined that as of "eptember 5.,
%##-, its accumulated benefit obligation was 45-.,... and its plan assets had a 42#.,... fair value.
6ion3s "eptember 5., %##- trial balance showed prepaid pension cost of 42.,.... )s of "eptember
5., %##-, what is the balance of additional minimum pension liability?
a. 4%%.,...
b. 456.,....
c. 4 #.,....
d. 49..,....
Answer: ". 6((7,777
";<................................................................................ 6097,777
3lan assets.......................................................................+57,777
Total minimum liability.........................................................57,777
3repaid pension cost........................................................ +7,777
required additional pension liability balance...................6 ((7,777
5. 6ebb Company implemented a defined benefit pension plan for its employees. 6ebb3s contributions
fully funded the plan. 7he following data are provided for %### and %##-<
1444 144)
E'ti+%ted *ctu%l
Froected benefit obligation, $ecember 5%.....................4%-!,(.. 4%!(,...
)ccumulated benefits obligation, $ecember 5%...............%5.,... %2(,...
Flan assets at fair value, $ecember 5%..............................%6-,!(. %(.,...
Fension e+pense.................................................................22,(.. %-,!(.
*mployer3s contribution..............................................................? %2,(..
What amount should 6ebb contribute in order to report an accrued pension liability of 45,!(. in its
$ecember 5%, %### balance sheet?
a. 4%2,(...
b. 4%(,....
c. 4%-,!(..
d. 42(,....
Answer: 1. 6+),777
"t the beinnin of (559, the firm had no accrued pension cost account
because the plan was fully funded at that date.
(559 pension expense......................................................6(9,,)7
(559 contribution................................................................(+,)77
&ndin (559 accrued pension cost balance.........................:,+)7
Iesired endin (555 accrued pension cost balance............0,,)7
/equired decrease in accrued pension cost balance...........+,)77
(555 pension expense........................................................++,)77
(555 contribution.............................................................6 +),777
9. 0n 1une %, %##6, Ware Corporation established a defined benefit pension plan for its employees. 7he
following information was available on 2ay 5%, %##-<
Froected benefit obligation.........................................45,62(,...
)ccumulated benefit obligation.....................................5,...,...
Jnfunded accrued benefit cost...........................................(.,...
Flan assets at fair market value......................................%,!(.,...
Jnrecogni,ed prior service cost........................................65!,(..
7o report the proper pension liability in Ware3s 2ay 5%, %##- balance sheet, what is the re@uired
balance in additional minimum pension liability?
a. 4(62,(...
b. 4%,%-!,(...
c. 4%,2..,....
d. 4%,-2(,....
Chapter (9 (@*(9 3ensions O 3ostemployment ;enefits
Answer: $. 6(,+77,777
";<.......................................................................................... 60,777,777
3lan assets................................................................................. (,,)7,777
Total liability to be reconi.ed.....................................................(,+)7,777
"ccrued pension cost................................................................. )7,777
"dditional minimum pension liability balance required............6 (,+77,777
C 1)-5 *ppendi5. 0ie#ence' ,et;een *ccountin" o# 3en'ion' %nd Nonpen'ion 3o't#eti#e+ent
,eneit' )ccounting for pensions is similar to accounting for nonpension postretirement benefits in many
ways. ?owever, there are some significant differences. In an eCmail message to a fellow student, list and
discuss some of these differences and their financial statement effects.
Answer:
(. 4ealth care and other nonpension postretirement benefits are often more difficult to predict than
pension benefits. The amount of pension benefits is controllable to a reater extent. 3redictions of
nonpension postretirement benefit payments (especially health care) are affected by the type of
benefit, technoloical chanes, outside reimbursement, and many other factors.
+. There is no minimum liability reconition or disclosure for nonpension postretirement benefits.
0. There is no vested benefit disclosure for nonpension postretirement benefits.
@. The attribution period for pensions beins with the period in which the employee beins to earn
benefits and ends with retirement. For nonpension postretirement benefits, the attribution period may
end before retirement, on the date the employee becomes fully eliible for the benefits expected to be
received.
). 1n contrast to pensions, nonpension postretirement benefit plans enerally have been unfunded.
Therefore, postretirement benefit expense will be offset only marinally by the return component. 1n
addition, the "3;< at transition is enerally quite lare, causin interest cost to be a reater
proportion of total expense.
:. Kany companies must chane their accountin systems to enable separation of the cost of benefits
payable durin the term of employment from those payable after retirement.
,. There was no previous accountin pronouncement requirin accrual of nonpension postretirement
benefits. Therefore. the difference between the pre!SFAS No. (.7 expense and post!SFAS No. (.7
expense will be larer than was the case for pensions and SFAS No. +6.
9. The unreconi.ed transition obliation can be reconi.ed immediately, or if delayed reconition is
chosen, +7 years can be used if the averae remainin service period is less than +7 years.
1mmediate reconition is not available for the unreconi.ed transition obliation in pensions. and only
() years can be used if the averae remainin service period is less than () years.
5. The unreconi.ed transition obliation is sub2ect to additional amorti.ation if the cumulative expense
under a pay!as!you!o approach would have exceeded that under SFAS No. (.7 before the
additional amorti.ation.
(7. ?onpension postretirement benefit funds are enerally taxable= therefore, the return component of
postretirement benefit expense must consider the tax rate.
((. >ains and losses can be reconi.ed immediately, sub2ect to certain constraints, for nonpension
postretirement benefit plans.
(+. 3ostretirement benefit expense is more sensitive to chanes in assumptions. <ne result of this
reater sensitivity is the requirement that the effect of a (F chane in future health care cost trend
rates on components of postretirement benefit expense and "3;< be disclosed.
Chapter (9 ()*(9 3ensions O 3ostemployment ;enefits
*-1)-2 Aundin" %nd 3en'ion E5pen'e Co+ponent' 7he $ole =ood Company is one of the largest
international food processing and distribution companies. Fortions of footnote - &pension benefits' to its
%##( annual report appear below.
7he Company has @ualified defined benefit pension plans covering most fullCtime employees.
7he status of the plans was as follows &amounts in 4 thousands'<
1445 1444
Froected benefit obligation...................... 425#,-(( 4225,.-2
Flan assets at fair value. Frimarily
stocks and bonds................................... 25-,!5. 2.6,526
Froected benefit obligation in e+cess
of plan assets ........................................ &%,%2(' &%6,!(6'
Jnrecogni,ed net transition obligation..... &#92' &%,.-!'
Jnrecogni,ed prior service cost............... 2,662 %,!%9
Jnrecogni,ed net &gain' loss.................................&-5' %!,-66
)dditional minimum liability................... &%,#9%' &%.,#%!'
)ccrued pension liability.......................... 4 &%,92#' 4 &#,%-.'
7he e+pected longCterm rate of return on assets was # percent in both
years. Fension e+pense included the following components<
1445 1444
"ervice costCbenefits earned during
the year.................................................. 4 -,%%9 4 !,%(-
Interest cost on proected benefit
obligation.............................................. 2%,2!. 2.,%%2
)ctual &return' loss on plan assets..................&96,#99' 9,6(6
6et amorti,ation and deferral..........................2-,55! &22,#-.'
Fension e+pense....................................... 4 %.,!!! 4 -,#96
Required:
%. What was $oleKs contribution to the pension fund in %##(?
2. What might have caused the change from an unrecogni,ed net loss in %##9 to an unrecogni,ed net
gain in %##(?
Chapter (9 (:*(9 3ensions O 3ostemployment ;enefits
Answer:
("mounts in 6thousands)
%e&uirement '
The prepaid pension cost account (before additional minimum pension liability) decreased 6(,++) durin
(55)=
"dditional minimum liability, end of (55@.......................... 6 (7,5(,
"ccrued pension liability, end of (55@............................... 5,(97
3repaid pension cost balance, end of (55@...................... 6 (,,0,
"dditional minimum liability, end of (55).......................... 6 (,5@(
"ccrued pension liability, end of (55)............................... (,@+5
3repaid pension cost balance, end of (55)...................... )(+
Iecrease in prepaid pension cost durin (55)................. 6 (,++)
Bith pension expense amountin to 6(7,,,, in (55), Iole contributed 65,))+ (6(7,,,, ! 6(,++)) to the
pension fund.
%e&uirement (
The 6(,,9:: net unreconi.ed loss at the end of (55@ was completely wiped out, leavin a small net ain
at the end of (55). " ma2or contributin factor to this chane was the excess of actual return on plan
assets in (55) over expected return. (55) expected return was 6+(,@9: (6+09,,07 x .75) while actual
return as reported by Iole was 6@:,5@@, a difference of 6+),@)9. The latter amount is treated as a ain
and radually amorti.ed over future periods (or absorbed by future losses, as was the (55@ net
unreconi.ed amount). The ain on assets is the larest factor explainin the chane in the net
unreconi.ed amount from (55@ to (55). The amorti.ation, if any, of the net unreconi.ed loss at the end
of (55@ also contributed to the shift.
*1)-2 *ppendi5. 3o't#eti#e+ent ,eneit' Othe# th%n 3en'ion'6The 0ole Aood Co+p%n! Fortions
of footnote ( &postretirement benefits' to the %##2 annual report of the $ole =ood Company appear
below.
In %##2. the Company implemented Statement of Finan'ial A''o#nting Standards No( ).6, H*mployerKs
)ccounting for Fostretirement /enefits 0ther than Fensions.H 7his statement, among other changes,
re@uires companies to accrue for postretirement benefits during the employeeKs active service period. 7he
Company elected to immediately recogni,e the accumulated postretirement benefit obligation as of
$ecember 2#. %##% of 4-2.( million &49#.( million, net of ta+'.
7he status of the plans at 1anuary 2. %##5 was its follows &in 4 thousands'<
)ccumulated postretirement benefit obligation.......... 4-(,--(
Jnrecogni,ed net loss................................................ &2##'
)ccrued postretirement benefit cost........................... 4-(,(-6
6et periodic postretirement benefit cost for %##2<
"ervice costCbenefits earned during the year.............. 4 #26
Interest cost on )F/0................................................ !,622
Fostretirement benefit cost......................................... 4 -,(9-
Chapter (9 (,*(9 3ensions O 3ostemployment ;enefits
In prior years, the cost of postretirement benefits was recogni,ed as payments were made.
7hese costs totaled 49.# million and 49.5 million during %##% and %##., respectively.
7his is a portion of $oleKs comparative income statement<
1442 1441 1449
Income before cumulative effect of change in
accounting principle................................................... 46(,2%5 4%55,!26 4%2.,9((
Cumulative effect of change in accounting principle........ &9#,9#2' GGGGGG GGGGGG
6et Income....................................................................... 4 %(,!2% 4 %55,!26 4 %2.,9((
Required:
%. Why might $ole =ood Company have decided to recogni,e the postretirement benefit transition
amount immediately?
2. What was the appro+imate effect of implementing SFAS No( )*+ on %##2 earnings before ta+es?
5. What was the amount funded for the postretirement benefit plan in %##2?
Answer:
("mounts in 6millions)
%e&uirement '
Iole, alon with many other companies, may have reconi.ed the entire transition liability immediately to
minimi.e the effect of past postretirement benefit costs on future earnins. Future postretirement benefit
expense amounts will be free of any transition amorti.ation.
1n addition, IoleSs income from continuin operations was rouhly half of earnins in each of the previous
two years. The firm thus had the incentive to reconi.e the lare one!time chane in an already lack!
luster year, rather than burden future years which may reflect better earnins performance.
%e&uirement (
The total pretax effect of #F"# ?o. (7: on (55+ earnins equals the cumulative effect plus the chane in
annual postretirement expense as a result of complyin with #F"# ?o. (7:. "lthouh the (55+ expense
under the pay!as!you!o method is not iven, considerin the amounts of the (557 and (55(
postretirement benefit costs (iven), a reasonable estimate of payments to retirees in (55+ is 6) million.
'sin this estimate, the pretax effect of #F"# ?o. (7: is=
Cumulative effect (immediate reconition of transition liability) ................ 69+,)77
1ncrease in annual postretirement benefit expense (69.)@9 ! 6).7).......... 0,)@9
Total decrease in pretax earnins ............................................................ 69:,7@9
%e&uirement )
Iole has not beun to fund the postretirement plan. ?o plan assets were iven in the report of funded
status at the beinnin of (550. The accrued liability equals "3;< less the one reconcilin item.
CHAPTER 1*: ACCO?NTIN6 3OR INCOME TAEES
%. /riefly distinguish between interperiod ta+ allocation and intraperiod ta+ allocation.
Answer:
1nterperiod income tax allocation!the allocation of income tax amon periods to properly measure
income tax assets and income tax liabilities.
1ntraperiod income tax allocation$the allocation of income tax expense to the components on the
income statement and retained earnins statement that caused the tax expense.
5. *+plain why deferred income ta+ can be either an asset or a liability.
Answer: Ieferred income tax is an asset when there is a future deductible that will reduce income
tax payable in future accountin periods. Ieferred income tax is a liability when there is a future
taxable amount that will increase future periodsS income tax payable.
(. $efine an income ta+ difference. Identify and briefly define the two types of differences.
Answer: "n income tax difference results from a transaction that causes a difference between pretax
accountin income and taxable income. The two types of differences are= (a) Temporary differences$
items that are on the income statement (under >""3) in one period and in the tax return (under tax
law) in another period. Temporary differences will reverse or turn around in one or more subsequent
periods% they require interperiod income tax allocation. (b) 3ermanent differences$items which are
reported on the income statement or tax return but not on both. They do not reverse or turn around%
they are not sub2ect to income tax allocation.
%5. $efine net operating loss &60E', carrybacks, and carryforwards. /riefly e+plain the options available
to ta+payers.
Answer: 1ncome tax law permits a taxpayer to offset some income tax losses (i.e., ?<-s) in the
current period aainst earnins of the past and*or future% this may result in a cash refund, or
alternatively, a reduction of future tax payments. " carryback is the situation when such a loss is offset
aainst earnins of specified prior years (limited to three prior years). " carryforward is when the loss
is offset aainst future earnins. The two options are=
a. Carryback!carryforward$carry back three years then carry forward any unabsorbed loss (up to
() years only).
b. Carryforward only$carry forward to future years (limited to () years) only. The benefit of the
carryforward amount can be recorded in advance of reali.ation under SFAS No. (.*.
%(. Is deferred ta+ arising from an 60E carryforward classified as current or noncurrent?
Answer: The deferred tax asset arisin from an ?<- carryforward is classified as current or
noncurrent dependin on when it is expected to be reali.ed. 1f the firm estimates that it will have
taxable income in the followin year (or operatin cycle, if loner), then the portion of the deferred tax
asset that will be used in that year is considered current. "ny amount not expected to be reali.ed in
the followin year or operatin cycle is classified as noncurrent.
Chapter (5 (*(9 "ccountin for 1ncome Taxes
E 14-2 Te#+inolo"! O1e#1ie; Eisted below to the left are some terms fre@uently used in "=)" 6o. %.#.
/rief definitions are listed to the right. 2atch the definitions with the terms by entering the appropriate
letters in the blanks.
GGGGG %. $eferred ta+ asset. ). Income ta+ payable plus net changes in the deferred ta+
GGGGG 2. 7a+able amount. liability, deferred ta+ asset, and valuation allowance accounts.
GGGGG 5. Fermanent difference. /. )n amount used to compute income ta+ payable.
GGGGG 9. ;aluation allowance. C. 7he difference between a current deferred ta+ asset and a
GGGGG (. 7emporary difference. current deferred ta+ liability when the latter is higher.
GGGGG 6. 7a+able income. $. 2ay result in a cash refund or a reduction of income ta+
GGGGG !. 6et current deferred ta+ liability. payable in future periods.
GGGGG -. Income ta+ e+pense. *. )n amount used to compute deferred ta+ assets and liabilities,
GGGGG #. 60E carrybackBcarryforward and a portion of income ta+ e+pense.
GGGGG%.. Intraperiod income ta+ allocation. =. ) deferred ta+ amount that has a debit balance.
I. ) ta+ difference that does not reverse, or turn around.
?. )n allocation of ta+ among the components in the income
statement.
I. ) contra account used to reduce deferred ta+ assets to the
portion more likely than not to be reali,ed.
1. )n amount that represents a difference between financial
accounting and ta+ accounting that will increase ta+able
income in future periods.
Answer: (. F% +. M% 0.>% @.1% ).&% :.;% ,.C% 9."% 5.I% (7.4.
E 14-4 Reco#din" %nd Repo#tin" Inco+e T%5 Con'e?uence' o# % T;o-Be%# 3e#iod 7he records of
"tar Corporation provided the following data related to accounting and ta+able income<
1447 144)
Freta+ accounting income....................... 42..,... 422.,...
7a+able income &ta+ return'.................... 22.,... 2..,...
Income ta+ rate ...................................... 5(> 5(>
7here are no e+isting temporary differences other than those reflected in this data.
Required:
%. Iive the ournal entry to record the income ta+ conse@uences for each year.
Chapter (5 +*(9 "ccountin for 1ncome Taxes
2. "how how income ta+ e+pense, income ta+ payable, and deferred income ta+ should be reported on
the financial statements each year.
Answer:
%e&uirement '
Iecember 0(, (55, (oriination entry)=
1ncome tax expense (6,,,777 ! 6,,777) .......................... ,7,777
Ieferred tax asset (6+77,777 ! 6++7,777) x .0)............... ,,777
1ncome tax payable (6++7,777 x .0)) ........................ ,,,777
Iecember 0(, (559 (reversin entry)=
1ncome tax expense (6,7,777 H 6,,777) ......................... ,,,777
Ieferred tax asset (6++7,777 ! 6+77,777) x .0)......... ,,777
1ncome tax payable (6+77,777 x .0)) ........................ ,7,777
%e&uirement (
',,- ',,.
1ncome statement=
1ncome tax expense.......................................................... 6,7,777 ,,,777
;alance sheet=
Current asset=
Ieferred income tax asset......................................... ,,777N
1ncome taxes payable................................................ ,,,777 ,,,777
N The asset is reconi.ed because it is more likely than not to be reali.ed. The tax deductible amount
to be reali.ed in (559 could be carried back to (55, to reali.e the tax benefit. ?o valuation allowance
is needed.
E 14-7 *n%l!Fe % T%5 $i%&ilit!. Ent#ie' %nd Repo#tin" "tacy Corporation would have had identical
income before ta+es on both its income ta+ returns and income statements for the years %##! through
2... e+cept for an operational asset that cost 4%2.,.... 7he asset was depreciated for income ta+
purposes using the following amounts< %##!, 49-,...D %##-, 456,...D %###, 429,...D and 2..., 4%2,....
?owever, for accounting purposes the straightCline method was used &Qi.e., 45.,... per yearD this is the
only temporary difference'. 7he accounting and ta+ periods both end $ecember 5%. 7he operational asset
has a fourCyear estimated life and no residual value. )ccounting income amounts before income ta+es for
each of the four years are as follows<
1447 144) 1444 2999
)ccounting income before ta+es.......... 45.,... 4(.,... 49.,... 49.,...
)ssume that the average and marginal income ta+ rate for each year was 5. percent.
Required:
%. Is this a temporary difference? *+plain why.
Chapter (5 0*(9 "ccountin for 1ncome Taxes
2. :econcile preta+ accounting and ta+able income, calculate income ta+ payable, compute the balance
in the deferred ta+ liability account, and prepare ournal entries for each yearCend.
5. =or each year show the deferred income ta+ amount that would be reported on the balance sheet.
Answer
%e&uirement '
This is a temporary difference because the difference in pretax accountin income and taxable income in
the oriinatin periods will subsequently reverse. The temporary difference at the end of the first year is a
future taxable amount of 6(9,777.
%e&uirement (
#chedule of temporary differences
1**> 1**+ 1*** ),,,
Tax depreciation............................................................ 6@9,777 60:,777 6+@,777 6(+,777
;ook depreciation.......................................................... 07,777 07,777 07,777 07,777
<riinatin (reversin) future taxable amount............... 6(9,777 6 :,777 (6 :,777) (6(9,777)
Cumulative future taxable amount................................. 6(9,777 6+@,777 6(9,777 6!7!
/econciliation of accountin and taxable income=
E..e$t n E..e$t n E..e$t n E..e$t n
.uture 0e"rsF in$me .uture 0e"rsF in$me .uture 0e"rsF in$me .uture 0e"rsF in$me
Current 1**+ "n1 1**+ "n1 Current 1*** "n1 1*** "n1 Current ),,, "n1 ),,, "n1 Current ),,1 "n1 ),,1 "n1
7e"r there".ter: there".ter: 7e"r there".ter: there".ter: 7e"r there".ter: there".ter: 7e"r there".ter: there".ter:
1**> 1e1u$ti'/e t"B"'/e 1**+ 1e1u$ti'/e t"B"'/e 1*** 1e1u$ti'/e t"B"'/e ),,, 1e1u$ti'/e t"B"'/e
3retax accountin income 607,777 6)7,777 6@7,777 6@7,777
Temporary differences
Iepreciation ((9,777) 6(9,777 (:,777) +@,777 :,777 (9,777 (9,777
?et taxable income 6(+,777 6@@,777 6@:,777 6)9,777
Total temporary differences 6(9,777 6+@,777 6(9,777 67
Karinal tax rate x .07 x .07 x .07 x .07 x .07 x .07 x .07 x .07
Taxes curently payable 60,:77 6(0,+77 6(0,977 6(,,@77
Ieferred tax asset, endin balance 7 7 7 7
Ieferred tax liability, endin balance 6),@77 6,,+77 6),@77 67
Ieferred tax asset, balance prior year 7 7 7 7
Ieferred tax liability, balance prior year 7 ),@77 ,,+77 ),@77
;alance increase (decrease) 67 6),@77 67 6(,977 67 (6(,977) 67 (6),@77)
Mournal entry=
Tax expense 5,777 (),777 (+,777 (+,777
Ieferred tax asset
Ieferred tax liability ),@77 (,977 (,977 ),@77
Taxes payable 0,:77 (0,+77 (0,977 (,,@77
%e&uirement )
',,- ',,. ',,, (///
?oncurrent=
Ieferred tax asset 67 67 67 67
Ieferred tax liability (),@77) (,,+77) (),@77) 7
?et deferred asset (liability) (6),@77) (6,,+77) (6),@77) 67
Chapter (5 @*(9 "ccountin for 1ncome Taxes
E 14-) *''etH$i%&ilit! Method ;ith Ch%n"e in T%5 R%te' Wittco Company reports preta+ accounting
income in %##!, its first year of operations, of 4%..,.... 7a+able income is 4!.,..., with temporary
differences arising in %##! from the following sources<
a. Frepayment of %##- rent in the amount of 429,... in %##!.
b. )n installment sale in the amount of 456,..., with cash collections e+pected in two e@ual amounts in
%### and 2....
7he enacted ta+ rates all known in %##! are 5. percent in %##!, 5. percent in %##-, and 9. percent in
%### and thereafter.
Required:
) Frepare the ournal entry to record income ta+es.
2. :epeat &%' above, assuming that a new ta+ law is passed in %##! raising the statutory ta+ rate to 9.
percent for %##! and all years thereafter.
Answer:
%e&uirement '
'nder the asset*liability method, future tax rates are used in determinin the deterred tax asset or liability
that is recorded.
#chedule= Temporary differences, taxes payable, and deferred tax balances
Effect on future
Future ta"able income
',,- 0ears Deductible !a"able
3retax accountin income............................ 6(77,777
Temporary differences=
3repayment of rent................................ (+@,777) 6+@,777 6+@,777
1nstallment receivable............................ (0:,777) 0:,777 0:,777
Taxable income............................................. 6 @7,777 TTTTTT TTTTTT
Total deductible.............................................
Total taxable.................................................. 6:7,777
Times= Karinal tax rate................................ x .07 ZN
Taxes payable............................................... 6 (+,777
Ieferred tax liability, Iecember 0(, (55,...... 6 +(,:77
N the future taxable amounts occur in years with different tax rates. The computation of the deferred tax
liability is=
(559 taxable amount (6+@,777 prepaid rent).......................... 6 +@,777
(559 tax rate........................................................................... .07
Ieferred tax liability related to (559........................................ 6 ,,+77
(555 and +777 taxable amount............................................... 60:,777
&nacted tax rate for (555 and +777........................................ .@7
Ieferred tax liability................................................................. (@,@77
Total deferred tax liability balance, Iecember 0(, (55,. . . 6 +(,:77
The beinnin!of!period balances for deferred tax assets and liabilities are .ero=
Chapter (5 )*(9 "ccountin for 1ncome Taxes
Deferred ta" Deferred !a"
Asset Liability
&nd!of!period balance (computed above)..................... 6!7! 6(+(,:77)
-ess= ;einnin!of!period balance (taken from
beinnin! of!period balance sheet......................... !7! !7!
Iebit (credit) to be made to account.............................. 6!7! 6(+(,:77)
Computation of income tax expense=
1ncome taxes payable.................................................... 6(+,777
1ncrease (decrease) in deferred tax liability................... +(,:77
1ncome tax expense in (55,.......................................... 6 00,:77
The 2ournal entry to record income taxes for (55, is=
1ncome tax expense...................................................... 00,:77
1ncome taxes payable............................................. (+,777
Ieferred tax liability................................................. +(,:77
%e&uirement (
Effect on future
Future ta"able income
',,- 0ears Deductible !a"able
3retax accountin income............................ 6(77,777
3repayment of rent................................ (+@,777) 6+@,777 6+@,777
1nstallment receivable............................ (0:,777) 0:,777 0:,777
Taxable income............................................. 6 @7,777 TTTTTT TTTTTT
Total deductible.............................................
Total taxable.................................................. 6:7,777
Times= Karinal tax rate................................ x .@7 x.@7
Taxes payable............................................... 6 (:,777
Ieferred tax liability, Iecember 0(, (55,...... 6 +@,777
The beinnin!of!period balances for deferred tax assets and liabilities are .ero=
Asset Liability
&nd!of!period balance (computed above)..................... 6!7! 6(+@,777)
-ess= ;einnin!of!period balance. (taken from
beinnin! of!period balance sheet)........................ !7! !7!
Iebit (credit) to be made to account.............................. 6!7! 6(+@,777)
1ncome taxes payable.................................................... 6(:,777
1ncrease (decrease) in deferred tax liability................... +@,777
1ncome tax expense in (55,.......................................... 6 @7,777
The 2ournal entry to record income taxes for (55, is=
1ncome tax expense...................................................... @7,777
1ncome taxes payable............................................. (:,777
Ieferred tax liability................................................. +@,777
Chapter (5 :*(9 "ccountin for 1ncome Taxes
E 14-19 Ope#%tin" C%##!&%c=-C%##!o#;%#d @NO$7 Option'. Choice'< Ent#ie'< %nd Repo#tin"
7yson Corporation reported preta+ income from operations in %##! of 4-.,... &the first year of
operations'. In %##-, the corporation e+perienced a 49.,... preta+ loss from operations &60E'.
2anagement is very confident the firm will have ta+able income in e+cess of 4(.,... in %###. )ssume an
income ta+ rate of 2. percent in %##!, increasing to 5. percent in %##- and thereafter. 7yson has no other
temporary differences.
Required:
%. )ssess 7ysonKs income ta+ situation for %##! and %##- separately. ?ow should 7yson elect to handle
the loss in %##-? Which carry backBcarry forward option should 7yson choose?
2. /ased on your assessments in &%', give the %##! and %##- income ta+ entries that 7yson should make.
5. "how how all ta+Crelated items would be reported on the %##! and %##- income statement and
balance sheet.
Answer:
%e&uirement '
(55,= 1ncome tax payable (and expense) 697,777 x.+7 G 6(:,777.
(559= -oss of 6@7,777 can be used as a ?<- carryback to obtain a tax refund of 6@7.777 x .+7 8 69,777,
or carryforward only for an expected benefit of 6@7,777 x.07 G 6(+,777.
Tyson should elect the carryforward only option, as it results in additional benefit of 6@,777 within a year.
%e&uirement (
(55,=
1ncome tax expense...................................................... (:,777
1ncome tax payable................................................. (:,777
(559=
Ieductible tax asset...................................................... (+,777
1ncome tax reduction from loss carryforward (a
component of income tax expense)........................ (+,777
%e&uirement )
',,- ',,.
1ncome statement=
1ncome tax expense= current portion............................. 6 (:,777 6 !7!
1ncome tax reduction from loss carryforward (a
credit component of income tax expense)..................... ?one ((+,777)
Total........................................................................ 6 (:,777 6 ((+,777)
;alance sheet=
Current assets=
Ieferred tax assets................................................. ?one (+,777
1ncome tax payable (assumin no prepayments)....... (:,777 ?one
Chapter (5 ,*(9 "ccountin for 1ncome Taxes
E 14-12 8%lu%tion *llo;%nce< NO$ C%##!o#;%#d )t $ecember 5%, %##!, )llsoap Corporation has a
deferred ta+ asset of 42(,..., all of which arose as a result of temporary differences occurring in %##!.
)llsoap began operations in %##6. In its first year the company had a net operating loss of 4%.,..., which
was carried forward and used to reduce income ta+es payable in %##!. In %##!, )llsoap had ta+able
income before the use of the 60E carryforward of 49.,.... 7he income ta+ rate is 9. percent. 6o
valuation allowance has been established.
Required:
%. Compute income ta+es payable and income ta+ e+pense for %##! before any consideration of
recording a valuation allowance. "how the ournal entry to record income ta+es assuming that no
valuation allowance is re@uired.
2. 6ow assume )llsoap has encountered stiff competition and is uncertain whether it will have any
ta+able income in the foreseeable future. )ssume that the temporary differences that give rise to the
deferred ta+ asset are e+pected to reverse in %##- and %###. $etermine what amount, if any, should
be recorded as a valuation allowance at $ecember 5%, %##!, and make the appropriate entry.
5. "how how the $ecember 5%, %##!, balance sheet and income statement would disclose the
information above, assuming that a valuation allowance is recorded.
Answers:
%e&uirement '
1n this problem we are iven taxable income and are required to determine pretax accountin income.
This can be done usin the same schedule format as when oin from pretax accountin income to
taxable income=
$urrent Effect on future
0ear Future ta"able income
',,- 0ears !a"able Deductible
Taxable income before ?<-.......................... 6 @7,777
Future deductible amounts...................... (:+,)77)N 6 :+,)77 6 :+,)77
N (6+),777)*.@7)
3retax accountin income (loss)................... 6(++,)77)
Taxable income before ?<-.......................... 6 @7,777
?<- Carryforward......................................... ((7,777) TTTTT TTTTT
Taxable income............................................. 6 07,777
Future taxable amounts................................. 6 !7!
Future deductible amounts............................ 6 :+,)77
"pplicable tax rate......................................... 7.@7 7.@7 7.@7
Tax payable................................................... 6(+,777
Ieferred tax liability....................................... 6 !7!
Ieferred tax asset......................................... 6 +),777
Liability Asset
&ndin balance.............................................................. 6!7! 6+),777
;einnin balanceN........................................................ !7! @,777
Iebit (credit) to be made to account.............................. 6!7! 6+(,777
Mournal entry=
Ieferred tax asset......................................................... +(,777
1ncome tax payable................................................. (+,777
1ncome tax expenseNN............................................. 5,777
N "risin from the 6(7,777 ?<- in (55:. That is, the Iecember 0(, (55: balance sheet includes a
deferred tax asset of 6(7,777 x .@7 or 6@,777.
NN ?ote that since the tax rate is constant over time and there are no permanent differences, the income
tax expense (benefit) should equal pretax accountin income (loss) times the tax rate= 6++,)77 x .@7
G 65,777
%e&uirement (
1f "llsoap expects .ero taxable income in future years. the reali.ability of the deferred tax is questionable.
4owever, one source$tax loss carrybacks to (55,$can be used to reali.e at least the amount of tax
benefit associated with the maximum that could be carried back=
"mount of deferred tax asset that is more likely than not to be reali.ed=
Taxes paid in (55, (reali.able throuh ?<- carryforward)......................... 6 (+,777
Total amount of deferred tax asset............................................................. +),777
"mount of valuation allowance needed...................................................... (0,777
Mournal entry=
1ncome tax expense...................................................... (0,777
Aaluation allowance ............................................... (0,777
%e&uirement )
Current assets=
Ieferred tax assets....................................................... 6 +),777
-ess= valuation allowance.............................................. (0,777
?et deferred assets....................................................... 6 (+,777
1ncome taxes payable.................................................... 6 (+,777
1ncome statement=
3retax accountin income (loss)................................... 6 (++,)77)
1ncome tax expense=
Current portion........................................................ 6 (+,777
Ieferred portion...................................................... (+(,777)
1ncrease in valuation allowance.............................. (0,777
Total income tax expense.............................................. @,777
?et income (loss)........................................................... 6 (+:,)77)
3 14-1 Ope#%tin" C%##!&%c=-C%##!o#;%#d @NO$7 Option'. Ent#ie' 7he financial statements of
/i+ler Corporation for the first four years of operations reflected the following preta+ amounts<
1447 144) 1444 2999
Income statement &summari,ed'<
:evenue 4%2(,... 4%((,... 4%-.,... 42(.,...
*+penses %2.,... %#(,... %6.,... 2..,...
Freta+ income &loss' 4 (,... 4&9.,...' 4 2.,... 4 (.,...
7here are no temporary differences other than those created by ta+ loss carryforwards. )ssume an income
ta+ rate of 5. percent during %##! and %##- and 9. percent in %### and 2.... )ssume that future
incomes are very uncertain at the end of each year, so a valuation allowance is needed for any deferred
ta+ asset. In %##-, management of /i+ler Corporation elects the carrybackCcarryforward option in order to
obtain the immediate cash refund on the 60E carryback.
Required:
%. :ecast /i+lerKs statements to incorporate the income ta+ effects as re@uired by SFAS No( )*,. "how
computations.
2. Iive entries to record the 60E income ta+ effects for each year.
5. *+plain the alternative option that /i+ler might have considered. What are the primary considerations
that /i+ler should assess in making its choice?
Answers:
%e&uirement '
1ncome statement (partial) 1**> 1**+ 1*** ),,,
/evenue............................................. 6(+),777 6()),777 6(97,777 6+)7,777
&xpenses........................................... (+7,777 (5),777 (:7,777 +77,777
3retax income (loss).......................... 6 ),777 6(@7,777) 6 +7,777 6 )7,777
1tems included in income tax expense=
Taxes payable.............................. 6 (,)77 6 !7! 6 !7! 6 (@,777
?<- carryback (tax refund).......... ((,)77) !7! !7!
?<- carryforward effect............... ((@,777) (9,777) (:,777)
Aaluation allowance..................... !7! (@,777 9,777 :,777
1ncome tax expense....................... 6 (,)77 6 ((,)77) 6 !7! 6 (@,777
?et 1ncome......................................... 6 0,)77 6 (09,)77) 6 +7,777 6 0:,777
The full amount of the ?<- carryforward is reconi.ed as a deferred tax asset in (559. 4owever, since it
is not likely to be reali.ed, a valuation allowance is established which reverses the effect of reconi.in
the ?<- carryforward effects. "ssumin the ?<- carryforward effect continues to require a valuation
allowance for the remainin amount, the result is reconition of the ?<- carryforward effect only when it
is actually reali.ed.
Chapter (5 (7*(9 "ccountin for 1ncome Taxes
%e&uirement (
1**> entries:
1ncome tax expense.......................................................... (,)77
1ncome tax payable (6),777 x .07)............................. (,)77
1**+ entries:
/ecord the receivable for a tax refund=
/eceivable for refund of tax for (55,......................... (,)77
1ncome tax expense (tax refund)......................... (,)77
/ecord the benefit of the remainin ?<- carryforward=
Ieferred tax asset (60),777 x .@7)............................. (@,777
1ncome tax expense (effect of tax loss carryforward) (@,777
#ince the ?<- carryforward benefit is not likely to be reali.ed, establish a valuation allowance for
the amount not likely to be reali.ed.
1ncome tax expense................................................... (@,777
Aaluation allowance............................................. (@,777
1*** entries:
The ?<- carryforward is used in the amount of 6+7,777 to reduce taxable income% thus, taxable
income payable is reduced by 6+7,777 x .@7 or 69,777. This is the amount of the deferred tax
asset reali.ed, and the valuation allowance is reduced in the same amount. The net effect is that
income tax expense in (555 is .ero=
Tax payable................................................................ 6 !7!
Iecrease (increase) in deferred tax asset.................. 9,777
(Iecrease) increase in valuation allowance............... (9,777)
1ncome tax expense.......................................................... 6 !7!
The entry in (555 shows the reduction of the deferred tax asset balance and the reduction of the
valuation allowance=
Aaluation allowance.................................................... 9,777
Ieferred tax asset............................................... 9,777
),,, entries:
Tax payableN............................................................... 6 (@,777
Iecrease (increase) in deferred tax asset.................. :,777
(Iecrease) increase in valuation allowance............... (:,777)
1ncome tax expense.......................................................... 6 (@,777
1ncome tax expense................................................... (@,777
Aaluation allowance.................................................... :,777
Ieferred tax asset............................................... :.777
1ncome tax payable.............................................. (@,777
N Taxable income before ?<-........................................ 6 )7,777
-ess= /emainin ?<- carryforward............................. (),777
Taxable income............................................................ 6 0),777
Tax rate........................................................................ x .@7
Taxes payable.............................................................. 6 (@,777
Chapter (5 ((*(9 "ccountin for 1ncome Taxes
%e&uirement )
;ixler is required to make an irrevocable choice between one of the followin two options, at the end of
the year of ?<-=
(a) Carryback!carryforward option$'nder this option a loss can be carried back up to three years (in
order of year) as an offset aainst the income of prior years, to obtain a cash refund. 1f the
carryback does not fully absorb the loss, the balance can be carried forward () years as an offset
aainst future income as earned (in order of years).
(b) Carryforward!only option!'nder this option (any carryback is forfeited) the loss can be carried
forward as earned (in order of year) for up to () years.
1n choosin between the two options, ;ixler should consider the followin=
(. 'nder option (a), any carryback is certain and the tax refund is immediate. "t least, the carryback
offset will be reali.ed.
1n contrast, under option (b) ;ixler foroes this advantae, presumably on the expectation that future
incomes and tax rates will be hiher and thus enhance the effect of the offset.
+. <ption (a) makes available a total of (9 years to offset the loss aainst income.
1n contrast, option (b) allows only () years to offset the loss% however, this may provide sufficient time
and result in hiher offsets.
0. <ption (a) does not take full advantae of potential future hiher income and tax rates that option (b)
offers.
@. The effect on any investment tax credit and*or tax credits of a tax carryback or a tax carryforward.
;y choosin the carryback*carryforward option the total benefit reali.ed was 6(),)77= an immediate
refund of 6(,)77, and tax savins of 69,777 in (555 and 6:,777 in +777.
1f ;ixler had chosen the carryforward only option, the total benefit would have been 6(:,777= tax savins
of 69,777 in (555 and 69,777 in +777.
1n summary, ;ixler should carefully assess (a) future potential income (by year), (b) future income tax
rates, and (c) the level of certainly (or uncertainty) relative to those income and tax rate estimates. "lso,
because the timin of cash flows (or cash savins) is an important consideration, the choice of options
should take into account the present values of those estimated future cash flows and other tax credits.
3 14-7 Reco#din" %nd Repo#tin" % 0ee##ed T%5 $i%&ilit! %nd Ch%n"e in T%5 R%te 7he records of
2organ Corporation provided the following data at the end of years % through 9 relating to income ta+
allocation<
Be%# 1 Be%# 2 Be%# 3 Be%# 4
Freta+ accounting income.................. 4(-,... 4!.,... 4-.,... 4--,...
7a+able income &ta+ return'............... 2-,... -.,... #.,... #-,...
7he above amounts include only one temporary differenceD no other changes occurred. )t the end of year
%, the company prepaid an e+pense of 45.,..., which will be amorti,ed for accounting purposes over the
ne+t three years &straightCline'. 7he full amount is included in year % for income ta+ purposes. )t the end
of year %, the enacted ta+ rate was 5(>. $uring year 2, the enacted ta+ rate was changed to 5.>,
retroactive to the beginning of year 2, and was to remain in effect through year 9.
Required:
) Frepare a schedule of temporary differences at the end of year %.
Chapter (5 (+*(9 "ccountin for 1ncome Taxes
2. Iive the entry to record income ta+es at the end of year %.
5. Iive any entry that should be made in year 2 to reflect the change in the enacted income ta+ rate.
If none is re@uired, e+plain why.
9. Iive the entry at the end of each year for years 2 through 9, assuming that the new enacted ta+
rate is not changed.
(. Complete the following tabulation<
Be%# 1 Be%# 2 Be%# 3 Be%# 4
Income statement<
Income ta+ e+pense.....................
/alance sheet<
Eiabilities<
Income ta+ payable...............
$eferred ta+ liability.............
Answers:
%e&uirements ' through *
E..e$t n E..e$t n E..e$t n E..e$t n
.uture 0e"rsF in$me .uture 0e"rsF in$me .uture 0e"rsF in$me .uture 0e"rsF in$me
Current 7e"r ) "n1 7e"r ) "n1 Current 7e"r - "n1 7e"r - "n1 Current 7e"r 4 "n1 7e"r 4 "n1 Current 7e"r 5 "n1 7e"r 5 "n1
7e"r there".ter: there".ter: 7e"r there".ter: there".ter: 7e"r there".ter: there".ter: 7e"r there".ter: there".ter:
1 1e1u$ti'/e t"B"'/e ) 1e1u$ti'/e t"B"'/e - 1e1u$ti'/e t"B"'/e 4 1e1u$ti'/e t"B"'/e
3retax accountin income 6)9,777 6,7,777 697,777 699,777
Temporary differences
3repaid expenses (07,777) 607,777 (7,777 6+7,777 (7,777 6(7,777 (7,777 67
?et taxable income 6+9,777 697,777 657,777 659,777
Total temporary differences 67 607,777 67 6+7,777 67 6(7,777 67 67
&nacted tax rate x .0) x .0) x .0) x .07 x .07 x .07 x .07 x .07 x .07 x .07 x .07 x .07
Taxes curently payable 65,977 6+@,777 6+,,777 6+5,@77
Ieferred tax asset, endin balance 67 67 67 67
Ieferred tax liability, endin balance 6(7,)77 6:,777 60,777 67
Ieferred tax asset, balance prior year 7 7 7 7
Ieferred tax liability, balance prior year 7 (7,)77 :,777 0,777
1ncrease (decrease) in balance 67 6(7,)77 67 (6@,)77) 67 (60,777) 67 (60,777)
Curn"/ entr0: 0ear ' 0ear ( 0ear ) 0ear *
Tax expense +7,077 (5,)77 +@,777 +:,@77
Ieferred tax asset
Ieferred tax liability (7,)77 @,)77 0,777 0,777
Taxes payable 5,977 +@,777 +,,777 +5,@77
1ote: The tax rate chane which occurs in Jear + is reflected in the Jear + balances of the deferred tax
liability account. The direct effect of the tax rate chane is computed as the amount of temporary
difference that exists at the time of the chane (a future taxable amount of 607,777), multiplied by the
amount of the tax rate chane (0)F to 07F)= 607,777 x (.0) ! .07) G 6(,)77. The income tax expense for
Jear + reflects the reduction of future taxes because of the tax rate reduction in the amount of 6(,)77.
The direct effect of the tax rate chane must be disclosed.
%e&uirement 2
/eportin on the financial statements=
7e"r 1 7e"r ) 7e"r - 7e"r 4
1ncome statement=
1ncome tax expense..................... 6+7,077 6(5,)77 6+@,777 6+:,@77
;alance sheet=
-iabilities=
1ncome tax payable............... 5,977 +@,777 +,,777 +5,@77
Ieferred tax liability............... (7,)77 :,777 0,777 !7!
P1*-14 O#er"ting C"rr0'"$<-C"rr0.rw"r1 %NOL& O#tins: Entries "n1 Re#rting Iecker Corpor!
ation experienced a loss in (55,. The company reported taxable income (loss) for (55@ to (55, and had
averae tax rates as follows=
1**4 1**5 1**5 1**>
7a+able income &loss' 4-,... 452,... 4%(,... &46(,...'
Income ta+ rate......... 5.> 5.> 5(> 9.>
7here were no temporary differences from %##9 to %##!.
Required:
%. :ecord income ta+es for %##! and %##- assuming that $ecker elects the carrybackCcarryforward
option. )lso assume the following<
a. =or %##!, any ta+ refund receivable is collected early in %##-.
b. =or %##-, the company reported ta+able income of 49(,... and preta+ accounting income of
4(.,... &a 4(,... temporary difference'. 7he income ta+ rate for %##- is 9( percent.
2. Eist the accounts and amounts that should be reported on the income statements and balance sheet for
each of the above re@uirements.
5. :epeat &%' and &2' assuming that $ecker elects the carryforwardConly option, and no valuation
allowance is deemed necessary.
Answer:
%e&uirement '
". &ntries to be made at the end of (55,, assumin the carryback*carryforward option is chosen=
/eceivable for refund of taxes paid in (55@!5: (?<- refund)........... (,,+)7
1ncome tax expense (tax refund from ?<- carryback)............... (,,+)7
Ieferred tax asset............................................................................ @,)77
1ncome tax expense (?<- carryforward).................................... @,)77
1t is assumed that a valuation allowance is not required. 1f one were required, the amount of the
reduction in the operatin loss would be reduced by the amount of the valuation allowance.
Chapter (5 (@*(9 "ccountin for 1ncome Taxes
Computation=
Carryback to (55@...................... 69,777 x .07 G 6 +,@77
Carryback to (55)...................... 0+,777 x .07 G 5,:77
Carryback to (55:...................... (),777 x .0) G ),+)7
Total tax refund from ?<- carryback 6 (,,+)7
Total loss in (55,.............................................................. 6 :),777
"mount carried back in (55@!5:....................................... )),777
"mount available for carryforward.................................... 6 (7,777
;. &ntries to be made at the end of (559
1ncome tax expense.......................................................................... ++,)77
Ieferred tax asset (6(7,777 x .@))............................................. @,)77
Ieferred tax liability (6),777 x .@))............................................. +,+)7
1ncome tax payable (6@),777 ! 6(7,777 carryforward) x .@)...... (),,)7
%e&uirement (
1**> 1**+
1ncome statement=
3retax accountin income....................................................... 6(:),777) 6)7,777
1ncome tax expense (savins) (in (55,= 6(,,+)7 H 6@,)77).... (+(,,)7) ++,)77
;alance #heet=
Current assets=
/eceivable of tax refund................................................... 6(,,+)7 N
Ieferred tax asset............................................................ @,)77
1ncome tax payable........................................................... 6(),,)7
?oncurrent liabilities=
Ieferred tax liability.......................................................... +,+)7
N "ssumed to be collected in (559.
%e&uirement )
". &ntries to be made at the end of (55,, assumin the carryforward only option is chosen=
Ieferred tax asset............................................................................ +5,+)7
1ncome tax expense (?<- carryforward).................................... +5,+)7
1t is assumed that a valuation allowance is not required. 1f one were required, the amount of the
reduction in the operatin loss would be reduced by the amount of the valuation allowance,
Computation=
Carryforward to future periods....6:),777 x .@) G 6 +5,+)7
Total deferred tax asset from ?<- carryforward 6 +5,+)7
;. &ntries to be made at the end of (559
1ncome tax expense.......................................................................... ++,)77
Ieferred tax asset (6@),777 x .@))............................................. +7,+)7
Ieferred tax liability (6),777 x .@))............................................. +,+)7
1ncome tax payable (6@),777 ! 6@),777 carryforward) x .@)...... !7!
"t the end of (559, there is 6+7,777 (6:),777 ! 6@),777) of ?<- available for carryforward, and a
deferred tax asset in the amount of 65,777 (6+7,777 x .@)) on the balance sheet.
Chapter (5 ()*(9 "ccountin for 1ncome Taxes
C. /eportin and disclosures=
1**> 1**+
1ncome statement=
3retax accountin income....................................................... 6(:),777) 6)7,777
1ncome tax expense................................................................ (+5,+)7) ++,)77
;alance #heet=
Current assets=
Ieferred tax assets........................................................... 6+5,+)7 5,777
1ncome tax payable........................................................... 6!7!
?oncurrent liabilities=
Ieferred tax liability.......................................................... +,+)7
1f the deferred tax liability at the end of (559 were to be classified as current, it would be netted
aainst the deferred tax asset, and a net deferred tax asset of 65,777 less 6+,+)7, or 6:,,)7 would
be reported.
C 14-5 8%lu%tion *llo;%nce o# 0ee##ed T%5 *''et' "oderstrom Company has a deferred ta+ asset of
4%,...,... at $ecember 5%, %##!, arising from its recording of its liability for postretirement benefits
other than pensions "oderstromKs CF) asks management whether a valuation allowance to reduce the
deferred ta+ asset to ,ero should be recorded.
Required:
%. Why would "oderstrom not want to report a valuation allowance? 0utline what evidence, assuming it
e+isted, "oderstrom might use to argue against recording a valuation allowance.
2. "uppose in the final analysis, it is determined that a valuation allowance of 49..,... is needed. ?ow
would the company have arrived at this determination, and what effect will it have on net income in
fiscal %##!?
Answer:
(. #oderstrom, like most firms, would prefer not to report a valuation allowance which reduces net
assets and increases income tax expense. #oderstrom could produce evidence that the deferred tax
asset was more likely than not to be reali.ed #uch evidence would include=
[ a history of profitability
[ existin contracts or firm sales backlos that will produce more than enouh taxable income to
reali.e the deferred tax asset
[ excess appreciated asset values over tax bases such that, if a tax plannin stratey were used,
the deferred tax asset could be reali.ed.
#oderstrom must show that it could use the carryback provisions of the tax code, have taxable
income in future years, or have future reversals of existin future taxable items to offset aainst future
deductible amounts, all of which result in reali.in the benefit of the deferred tax asset and obviate
the need for a valuation allowance.
+. The valuation allowance is called for when Uit is not more likely than notP that all of the deferred tax
asset will be reali.ed. The company would apply the procedures and analysis outlined above, and
come to a 2udment reardin the reali.ability of the deferred tax asset. Bhen the valuation
allowance is recorded to reduce the carryin value of the deferred tax asset, it causes income tax
expense in the current period to increase by that amount, and therefore net income to decrease by
the same amount.
Chapter (5 (:*(9 "ccountin for 1ncome Taxes
* 14-2 *pplied Technolo"! $%&o#%to#ie' @*T$7 )7E, a medical e@uipment manufacturer, reported a
loss before income ta+es of 42..# million in %##9, yet the income ta+ effect was a savings of only 4..!
million. 7he effective income ta+ rate is only 5.5 percent &..!B2..#'. )7E reported a loss before income
ta+es of 4%.! million in %##5, yet had income ta+ e+pense of 4%.6 millionAan effective ta+ rate of #9.%
percentR )ssume a statutory income ta+ rate of 5( percent.
7his schedule from the notes to the %##9 )7E annual report e+plains its deferred ta+ assets and
deterred la+ liabilities &in thousands'<
1994 1995
$eferred ta+ assets
:eceivables.................................. 4 5,25. 4 2,#56
Inventories.................................... %%,(69 -,-..
6et operating loss carryforwards...... 5,#6# 5,%(!
"tate ta+es........................................ 5,%.6 2,.-!
Compensation................................... 2,625 2,%!%
Frovision for litigation claim............ %,!.. C
:esearch and e+perimentation
credit carryforwards...................... 6,6.2 6,92(
0ther................................................ 5,.52 5,%.!
Iross deferred ta+ assets............... 45(,-26 42#,6-5
Eess valuation allowance.............. &2!,29#' &%#,!.#'
6et deferred ta+ assets.................. 4 -,(!! 4 -,#!9
$eferred ta+ liabilities, primarily
depreciation and intangible assets. . . . &9,9!2' &9,62-'
6et deferred income ta+es...................... 4 9,%.( 4 9,596
Required:
%. What are some reasons why )7E3s effective ta+ rate might be so low in %##9?
2. Why might )7E show an income ta+ e+pense in a year when it has a loss before income ta+es for
financial reporting?
5. In general terms, e+plain why )7E has such a large amount reported as a valuation allowance.
9. What effect did the increase in the valuation allowance from %##5 to %##9 have on )7E3s income ta+
e+pense computation in fiscal %##9?
(. Jsing a ta+ rate of 5( percent, estimate the amount of net operating loss carryforwards that )7E has
as ofK $ecember 5%, %##9.
6. Jsing a ta+ rate of 5( percent, estimate the amount of Hresearch and e+perimentation credit
carryforwardsH that )7E has as of $ecember 5%, %##9.
!. Jsing a ta+ rate of 5( percent, estimate the amount of accrued liability for litigation claim that )7E
has as of $ecember 5%, %##9(
Answers:
%e&uirement '
&ffective tax rates are different from statutory rates either because rates different than the '.#. statutory
rates are applied to some or all of the taxable income, or there are permanent differences affectin the
computation of the effective rate. -ookin at the "T- data found in the ?ote, we see that the Company
has lare amounts of deferred tax assets arisin from ?<- carryforwards and from Presearch and
experimentation tax credits.P Bhen such lare amounts arise from these sources one must become
Chapter (5 (,*(9 "ccountin for 1ncome Taxes
concerned about whether the benefit they represent is likely to be reali.ed. -ookin further at the ?ote,
we see that "T- has a lare valuation allowance, and more importantly, it increased by 6,,)@7(777) in
(55@. This entire amount increased income tax expense in (55@, and it is the most likely source of
causin the effective tax rate to decline in (55@.
%e&uirement (
<nce aain, this has to arise because of permanent differences or an increase in the valuation allowance
(which is a form of permanent difference). Be do not know the valuation allowance account balance at
the end of fiscal (55+, but it is likely that it was less than the fiscal (550 balance. 1f so, then aain income
tax expense is increased in (550 because of the increasin of the valuation allowance. There could be
other permanent differences causin the effects on the effective tax rate, but the valuation allowance
chane is the most likely source.
%e&uirement )
The Company has Pneative evidenceP reardin the need to create a valuation allowance. Be can see
from the data that "T- has had a series of years with net operatin losses (?<-s), and this is stron
neative evidence. 1t would appear that "T- does not have other sources for eneratin taxable income in
the future% thus it must record the valuation allowance for the amount of the future benefit not expected to
be reali.ed.
%e&uirement *
The valuation allowance increased by 6,,)@7,777. This amount would be credited to the valuation
allowance and debited to the deferred portion of income tax expense. Thus the full amount of #,,)@7,777
increases income tax expense in (55@.
%e&uirement 2
The tax effect of the carryforward is 60,5:5,777. Iividin by the statutory tax rate, which was used to
compute these tax effects, we determine the actual amount of carryforward to be 60,5:5,777*.0), or
6((,0@7,777.
%e&uirement 3
Tax credits are direct reductions to income taxes payable, hence the amount shown in the deferred tax
asset represents the entire amount of credit. The Presearch and experimentation tax credits total
6:,:7+,777.
%e&uirement -
The deferred tax related to the litiation claim is 6(,,77,777, thus the estimated amount of the litiation
claim recorded is 6(,,77,777 divided by .0), or 6@,9),,777.
C:*3TER 29 COR3OR*TIONS. CONTRI,UTE0 C*3IT*$
%. $efine public. private. open, closed, and publicly traded corporations.
Answer:
Pu'/i$: Corporations are referred to as PpublicP when they relate to overnmental units or business
operations owned by overnmental units.
Pri2"te: Corporations are referred to as PprivateP when they are privately owned. #uch corporations
may be non!stock (nonprofit orani.ations, such as collees and churches) or stock (usually
orani.ed for profit makin).
O#en: Bhen the stock is available for purchase, the stock may be widely held. "lso called Upublicly
held.X
C/se1: Bhen the stock is not available for purchase% it is enerally held by only a few shareholders.
"lso called closely held.
Pu'/i$/0 tr"1e1: Bhen the stock is available for purchase by investors. The stock can be traded on a
ma2or stock exchane, or simply over!the!counter.
9. $escribe the three main categories of stockholdersK e@uity in accounting for corporate capital,
Answer: "ccountin for corporate capital emphasi.es the cateories of capital usually thouht of as
sources of capital. To apply this concept. corporate capital accounts are established in a manner such
that the apparent sources of the capital used in the enterprise are sereated. #ource is important
because the laws of the several states relatin to corporations frequently are specific concernin
sources of capital.
For example. dividends may be PpaidX from certain sources and riot from others in the leal sense.
For leal reasons, the source is considered important for full disclosure in the financial statements.
Three main cateories of stockholdersS equity are= contributed capital, retained earnins, and
unreali.ed capital.
%.. *+plain the difference between cumulative and noncumulative preferred stock.
Answer: ?oncumulative preferred stock provides that dividends not declared for any prior year, or
series of prior years, are lost permanently as far as the preferred stockholder is concerned.
Cumulative preferred stock provides that dividends passed (dividends in arrears) for any prior year, or
series ofS prior years, accumulate and must he paid to the preferred shareholders when dividends are
declared, before the common stockholders are entitled to receive a dividend. 1n most states preferred
stock is cumulative unless otherwise stated.
%%. *+plain the differences between nonparticipating, partially participating, and fully participating
preferred stock.
Answer: The differences relate only to preferred stock.
3referred stock is nonparticipatin when the dividends for each year are limited in the charter to a
specified preference rate per share.
3artially participatin stock means that the preferred shareholders participate above the preference
rate with the common shareholders, but only up to an additional fate which is specified in the charier
and on the stock certificates.
Chapter 2. %B%6 Corporations< Contributed Capital
%!. /riefly e+plain the two methods of accounting for stock issue costs.
Answer: #tock issue costs arise from expenditures made to sell and issue capital stock. Two
methods are used to account for these=
(a) O..set meth1$deducted from the proceeds of the sale of the stock by debitin (i.e., reducin)
contributed capital in excess of par.
(b) De.erre1 $h"rge meth1$debit the expenditures to a deferred chare account (an intanible
asset) and amorti.e as expense over a period of not more than @7 years.
2.. What is the effect on the amounts of asses, liabilities. and stockholdersK e@uity of &a' the purchase of
treasury stock and &b' the sale of treasury stock?
Answer: &ffects of treasury stock on total=
4urchase Sale
(a) "ssets..................................... Iecrease 1ncrease
(b) -iabilities................................. ?one ?one
(c) #tockholders8 equity................ Iecrease 1ncrease
2%. *+plain the theoretical difference between the oneCtransaction concept and the dualCtransaction
concept in accounting for treasury stock.
Answer: The one!transaction concept, which underlies the cost method, holds that the purchase and
subsequent sale of treasury stock are, in effect, one continuous capital transaction. Consequently,
under this concept, treasury stock is debited to the Treasury #tock account at cost and held in
suspense. in effect, as an unallocated reduction of total capital. Bhen the treasury stock is resold or
retired, as the case may be, the capital transaction is completed, and at that time, the Treasury #tock
account is removed at cost, and the various effects on capital reconi.ed.
The dual!transaction concept, which underlies the par!value method, holds that the purchase of
treasury stock and the subsequent resale of it constitute two separate and distinct transactions.
Consequently, under this concept, the Treasury #tock account is debited at par value upon purchase
of treasury stock and other appropriate capital accounts ad2usted as thouh the sellin stockholdersS
equity were retired. 'pon resale, the treasury stock shares are accounted for in the same manner as
the sale of any unissued capital stock.
2(. ?ow is treasury stock reported on the balance sheet &a' under the cost method and &b' under the par
value method?
Answer: 'nder the cost method, treasury stock is reported on the balance sheet as an unallocated
deduction from stockholdersS equity plus retained earnins.
'nder the par value method, the par value of the treasury stock is subtracted from the par value of
the issued shares to which it relates. #ubtraction of the par value of the treasury shares from the
issued shares provides a difference which is desinated as shares outstandin at par value. 'nder
the par value method. this approach is loical since the treasury shares are identified with a specific
value common to other shares of the same class of stock. that is, the par value.
Chapter 2. 2B%6 Corporations< Contributed Capital
E 29-4 *n%l!'i' o Stoc=holde#'I E?uit!. 3#ep%#e St%te+ent 7he following data are from the accounts
of 2itar Corporation at $ecember 5%, %##- &amounts in thousands'<
"ubscriptions receivable &noncurrent'............................................................... 4 %.
:etained earnings, %BlB%##-.............................................................................. #..
Capital stock, par ?, authori,ed %..,... shares................................................ %,...
Capital stock subscribed, %,... shares &to be issued upon collection in full'.... 2.
Fremium on capital stock.................................................................................. 9..
"ubscriptions receivable, capital stock &due in three months'........................... 9
/onds payable.................................................................................................. 2..
6et income for %##- &not included in retained earnings above'........................ %#.
$ividends declared and paid during %##-......................................................... -.
Required:
%. :espond to the following &state any assumptions that you make'<
a. 7otal retained earnings at end of %##- is....................................................... 4 GGGGGGGGGGGGGG
b. :etained earnings on IBlB%##- was................................................................. 4 GGGGGGGGGGGGGG
c. Far value per share is..................................................................................... 4 GGGGGGGGGGGGGG
d. 6umber of shares outstanding is.................................................................... GGGGGGGGGGGGGG
e. Eegal capital is.............................................................................................. 4 GGGGGGGGGGGGGG
f. 7otal stockholdersK e@uity is.......................................................................... 4 GGGGGGGGGGGGGG
g. 6umber of shares issued is............................................................................ GGGGGGGGGGGGGG
h. )verage selling price per share including any shares subscribed was............ 4 GGGGGGGGGGGGGG
i. 6umber of shares sold including any shares subscribed was . . . . . . . .......... GGGGGGGGGGGGGG
2. Frepare the stockholdersK e@uity section of the balance sheet at $ecember 5%, %##-. Jse good form,
complete with respect to details. "ubscriptions receivable is to be recorded as an asset.
Answer:
%e&uirement #
a. Total retained earnins at end of (559 (577 H ((57 ! 97)D........................... 6 (,7(7
b. /etained earnins on Manuary (. (559. was (iven).................................. 6 577
c. 3ar value per share is ................................................................................ 6 +7.77
;ased on capital stock subscribed= 6+7,777 L (,777 G 6+7 par
d. The number of shares outstandin is......................................................... )7,777
.............................................................................................................. shares
6(,777,777 L 6+7 par G )7,777 shares outstandin.
e. -eal capital is (6(,777 outstandin H 6+7 subscribed).............................. 6 (,7+7
"ssumed to be par value by state law. #tate laws vary as to
accountin for subscribed stock.
f. Total stockholdersS equity is (6(,7(7 H 6(,777 H 6+7 H 6@77)..................... 6 +,@07
. ?umber of shares issued (6(,777,777 L 6+7)............................................ )7,777
.............................................................................................................. shares
There is no treasury stock% therefore, all shares issued are outstandin.
h. "verae sale price per share...................................................................... 6 +,.9@
(6@77 H 6(,777 H 6+7) L )(,777 shares G 6+,.9@. 1nclude
)7,777 issued plus the (,777 shares subscribed.
i. ?umber of shares sold............................................................................... )(,777
.............................................................................................................. shares
(1ncludes the subscribed stock.)
%e&uirement (
MITAR CORPORATION
STOCGHOLDERSH EI?IT7
De$em'er -1= 1**+
%,,,s&
Contributed Capital=
Capital stock=
Capital stock, par 6+7, authori.ed (77,777 shares, issued
and outstandin, )7,777 shares............................................................ 6(,777
Capital stock subscribed, (,777 shares................................................... +7
Total capital stock................................................................................. 6(,7+7
<ther contributed capital=
Contributed capital in excess of par........................................................ @77
Total Contributed Capital...................................................................... 6(,@+7
/etained earnins...................................................................................... (,7(7
Total #tockholdersS &quity.............................................................. 6+,@07
E 29-2 Co+pute 0i1idend'. 3#ee##ed Stoc=< Aou# C%'e' )ble Corporation has the following stock
outstanding<
Common, 4(. par valueA6.... shares.
Freferred, 6 percent, 4 %.. par valueA%.... shares.
Required: Compute the amount of dividends payable in total and per share on the common and preferred
stock for each separate case<
C%'e * Freferred is cumulative and nonparticipating, two years in arrearsD dividends declared,
459,....
C%'e , Freferred is noncumulative and fully participating, dividends declared, 49.,....
C%'e C Freferred is cumulative and partially participating up to an additional 5 percentD three years
in arrears< dividends declared, 46......
C%'e 0 Freferred is cumulative and fully participatingD three years in arrearsD dividends declared,
4(.,....
Answer:
Di5idends
4referred 36 $ommon
7'8/// shares 738/// shares
and 9'//8/// and 9)//8///
par 5alue: par 5alue: !otal
$ase A (3referred$!cumulative% nonparticipatin)
"rrears (6(77,777 x .7: x +)............................... 6(+,777 6(+.777
Current preference (6(77,777 x .7:)
(matchin amount).......................................... :,777 :.777
;alance to common........................................... TTTTTT 6(:,777 (:,777
Total............................................................. 6(9,777 6(:,777 60@,777
3er share.................................................. 6(9.77 6+.:,
$ase + (3referred!noncumulative% fully
participatin)
Current preference (6(77,777 x .7:).................. 6:.777 6:,777
Common, to match (6077,777 x .7:).................. 6(9.777 (9,777
;alance, ratio based on par value (=0................ @,777 (+,777 (:,777
Total ............................................................ 6(7,777 607,777 6@7.777
3er share ................................................. 6(7.77 6).77
$ase $ (3referred% cumulative% partially
participatin)
"rrears (6(77,777 x .7: x 0) .................................... 6(9,777 6(9,777
Current preference (6(77,777 x .7:) ........................ :,777 :.777
Common, to match 6077,777 x .7:) ......................... 6(9,777 (9,777
3referred, additional 0F (x 6(77,777) ..................... 0,777 0,777
;alance to common . . . . . . ..................................... TTTTTT (),777 (),777
Total............................................................. 6+,,777 600.777 6:7,777
3er share ................................................. 6+,.77 6).)7
$ase D (3referred% cumulative fully participatin)
"rrears (6l77,777 x .7: x 0)...................................... 6(9,777 6(9,777
Current preference (6(77,777 x.7:).......................... :,777 :,777
Common, to match (6077.777 x .7:)........................ 6(9,777 (9,777
;alance ratio to par (=0............................................. +,777 :,777 9,777
Total............................................................. 6+:,777 6+@,777 6)7,777
3er share.................................................. 6+:.77 6@.77
E29-11 Co++on %nd 3#ee##ed Stoc= I''ued. Aou# T#%n'%ction' 7he charter of Iilmore Company
authori,ed 2.,... shares of common stock, par 42, and 2.,... shares of preferred stock par 4%.. 7he
following transactions were completed. )ssume that each is completely independent.
a. "old 9.. shares of common and 2.. shares of preferred stock for a lump sum of 4%2,5... 7he
common had been selling during the current week at 42( per share, and the preferred at 4%2 per share.
Chapter 2. (B%6 Corporations< Contributed Capital
b. Issued %-. shares of preferred stock for some used e@uipment. 7he e@uipment had been appraised at
42,9.. and the book value shown by the seller was 4%,2... ) reliable market value on the preferred
stock has not been established.
c. ) %. percent assessment on par value was voted on both the common and preferred when %2,...
shares of common and -,... shares of preferred were outstanding. 7he assessment was collected in
full.
d. "old 6.. shares of common and 9.. shares of preferred stock in one transaction for a total cash price
of 42.,.... 7he common recently had been selling at 42. lea were no recent sales of the preferred.
Required: Iive the ournal entry for each transaction. "tate and ustify any assumptions that you make.
Answers:
a. Cash........................................................................................ (+,077
3referred stock, par 6(7 (+77 shares).............................. +,777
Common stock, par 6+ (@77 shares)................................. 977
Contributed capital in excess of par, preferred stock........ 097
Contributed capital in excess o& par, common stock......... 5,(+7
/elative market values= Common$@77 x 6+) G 6(7,777
3referred$+77 x 6(+ G +,@77
Total G 6(+,@77
"llocation of cost=
Common= (6(7,777*6(+,@77) x 6(+,077 G 65,5+7
3referred (6+,@77*6(+,@77) x 6(+,077 G +,097
Total Cost...................................................... 6(+,077
Computation of contributed capital=
Common= 65,5+7 ! 6977 G 65,(+7
3referred 6+,097 ! 6+,777 G 6097
b. &quipment (used).................................................................... +,@77
3referred stock ((97 shares x 6(7)................................... (,977
Contributed capital in excess of par, preferred stock........ :77
The appraisal is accepted as a reasonable measure of the market value of the machinery. The book
value reflected in the sellerSs books is irrelevant. " preferred alternative would be to use the current
market value of the stock (if available).
c. Cash........................................................................................ (7,@77
Contributed capital$assessment on common stock........ +,@77
Contributed capital$assessment on preferred stock....... 9,777
Common= (+,777 shares x 6+ x.(7 G 6+,@77
3referred= 9,777 shares x 6(7 x.(7 G 69,777
d. Cash ................................................................................. +7,777
Common stock (:77 shares x 6+)..................................... (,+77
3referred stock (@77 shares x 6(7)................................... @,777
Contributed capital in excess of par, common stock
(:77 shares x 6+@)......................................................... (@,@77
Contributed capital in excess of par, preferred stock ....... @77
The current market price of the common stock is accepted as realistic. The balance of the premium
was identified with the preferred stock because there were no recent market sales of the preferred.
E29-14 T#e%'u#! Stoc=< Co't %nd 3%# 8%lue Method' Co+p%#ed. Ent#ie' %nd *ccount ,%l%nce' 0n
1anuary %. %##!, 1ohnson "oap Corporation issued 2.,... shares of 42. par value common stock at 4(.
per share. 0n 1anuary %(. %##!. 1ohnson purchased (. shares of its own common stock at 4(( per share.
0n 2arch %, %##!, 2. of the treasury shares were resold at 4(-. 7he balance in retained earnings was
42(,... prior to these transactions.
Required:
%. Iive all entries indicated in parallel columns, assuming application of &a' the cost method and &b' the
par value method.
2. Iive the resulting balance in each one of the stockholdersK e@uity accounts for each method.
5. )ssume that on 2arch 5., %##! all remaining treasury stock shares are retired. "how the ournal
entries for &a' the cost method, and &b' the par value method.
Answers:
Re(uirement 1
%e&uirement 7a: %e&uirement 7b:
$ost ;ethod 4ar <alue ;ethod
Debit Cre1it Debit $re1it
To record oriinal sale of +7,777 shares at 6)7=
Cash (x 6)7) (,777,777 (,777,777
Contributed capital in excess of par (x 607) :77.777 :77,777
Capital stock, par 6+7 ((7,777 shares) @77,777 @77,777
Manuary ()$To record purchase of )7 shares
of treasury stock at 6))=
Treasury stock ()7 shares)
"t cost ()7 shares x 6))) +,,)7
"t par ()7 shares x 6+7) (,777
Contributed capital in excess of par ()7 shs x 607) (,)77
/etained earnins +)7
Cash ()7 shares x 6))) +,,)7 +,,)7
Karch ($To record sale of +7 shares of treasury
stock at 6)9=
Cash (+7 shares x 6)9) (,(:7
Contributed capital from treasury stock
transactions :7
Contributed capital in excess of par ,:7
Treasury stock (+7 shares x 6))), cost
method and (\7 shares x 6+7) par
method (,(77 @77
Chapter 2. !B%6 Corporations< Contributed Capital
Re(uirement )
$ost ;ethod 4ar <alue ;ethod
Sh"res Amunt Sh"res Amunt
"ccount balances=
Capital stock issued (par 6+7)............................... +7,777 6@77,777 +7,777 6@77,777
Treasury stock=
"t cost, 6))..................................................... (07) ((,:)7)
"t par, 6+7....................................................... (07) (:77)
Contributed capital in excess of par...................... :77,777 )55,.+:7
Contributed capital from treasury
stock transactions........................................... :7 !7!
/etained earnins ................................................ +),777 +@,,)7
Total ...................................................................... 6(,7+0,.@(7 6(,7+0,@(7
Re(uirement -
(a) &ntry to retire treasury stock accounted for by cost method=
Capital stock (6+7 x 07 shares)............................................................ :77
Contributed capital in excess of par (607 x 07 shares)........................ 577
/etained earnins (6) x 07 shares)..................................................... ()7
Treasury stock............................................................................ (,:)7
(b) &ntry to retire treasury stock accounted for by par value method=
Capital stock (6+7 x 07 shares)............................................................ :77
Treasury stock............................................................................ :77
3 29-) Co+pute 0i1idend'. Ai1e C%'e' 7he charter ofK Crew Corporation authori,ed (,... shares of 6
percent preferred stock, par value 42. per share, and -,... shares of common stock, par value of 4(. per
share. )ll of the authori,ed shares have been issued. In a fiveCyear period, annual dividends paid in
chronological order were 49,.... 49.,.... 452,.... 4(,.... and 456,..., respectively.
!e"#ired$ Compute the amount of dividends that would be paid to each class of stock for each year under
the following separate cases<
Case )Apreferred stock is noncumulative and nonparticipatingD
Case /Apreferred stock is cumulative and nonparticipatingD
Case CApreferred stock is noncumulative and fully participatingD
Case $Cpreferred stock is cumulative and fully participatingD
Case *Apreferred stock is cumulative and partially participating up to an additional 2 percentD
also assume that the dividend for year ( was 492,... instead of 4565...
Chapter 2. -B%6 Corporations< Contributed Capital
Answers:
4referred8 36 $ommon
0ear !otal 4aid 74ar 9'//8///: 74ar 9*//8///:
C"se A$3referred, noncumulative, nonparticipatin=
( .................................................. 6 @,777 6 @,777
+ .................................................. 6 @7,777 6 :,777 6 0@,777
0 .................................................. 6 0+,777 6 :,777 6 +:,777
@ .................................................. 6 ),777 6 ),777
) .................................................. 6 0:,777 6 :,777 6 07,777
C"se B$3referred, cumulative, nonparticipatin=
( .................................................. 6 @,777 6 @,777
+ "rrears...................................... 6 +,777 6 +,777
Current...................................... 09,777 :,777 6 0+,777
Total.......................................... 6@7,777 6 9,777 6 0+,777
0 .................................................. 6 0+,777 6 :,777 6 +:,777
@ .................................................. 6 ),777 6 ),777
) "rrears...................................... 6 (,777 6 (,777
Current...................................... 0),777 :,777 6 +5,777
Total.......................................... 60:,777 6 ,,777 6 +5,777
C"se C$3referred, noncumulative, fully participatin=
( 3referred, current...................... 6 @,777 6 @,777
+ 3referred, current...................... 6 :,777 6 :,777
Common, to match................... +@,777 6 +@,777
;alance= preferred (*), common @*) (7,777 +,777 9,777
Total.......................................... 6 @7,777 6 9,777 6 0+,777
0 3referred, current...................... 6:,777 6:,777
Common, to match................... +@,777 6 +@,777
;alance= preferred (*), common @*) +,777 @77 (,:77
Total.......................................... 6 0+,777 6 :,@77 6 +),:77
@ 3referred, current...................... 6 ),777 6 ),777
) 3referred, current...................... 6 :,777 6 :,777
Common, to match................... +@,777 6 +@,777
;alance= preferred (*), common @*) :,777 (,+77 @,977
Total.......................................... 6 0:,777 6 ,,+77 6 +9,977
Chapter 2. #B%6 Corporations< Contributed Capital
4referred8 36 $ommon
0ear !otal 4aid 74ar 9'//8///: 74ar 9*//8///:
C"se D$3referred, cumulative, fully participatin=
( 3referred, current (partial)......... 6 @,777 6 @,777
+ 3referred, in arrears.................. 6 +,777 6 +,777
3referred, current...................... :,777 :,777
Common, to match................... +@,777 6 +@,777
;alance= preferred (*), common @*) 9,777 (,:77 :,@77
Total.......................................... 6 @7,777 6 5,:77 6 07,@77
0 3referred, current...................... 6 :,777 6 :,777
Common, to match................... +@,777 6 +@,777
;alance= preferred (*), common @*) +,777 @77 (,:77
Total.......................................... 6 0+,777 6:,@77 6 +),:77
@ 3referred, current (partial)......... 6 ),777 6 ),777
) 3referred, in arrears.................. 6 (,777 6 (,777
Common, to match................... +@,777 6 +@,777
;alance= preferred (*), common @*) ),777 (,777 @,777
Total.......................................... 6 0:,777 6 9,777 6 +9,777
C"se E$3referred, cumulative, partially participatin up to an additional +F=
( 3referred, current (partial)......... 6 @,777 6 @,777
+ 3referred, in arrears.................. 6 +,777 6 +,777
Common, to match................... +@,777 +@,777
;alance= preferred (*) (not to
exceed 6(77,777 x .7+ G
6(77,777), common @*)............ 9,777 (,:77 :,@77
Total.......................................... 6 @7,777 6 5,:77 6 07,@77
0 3referred, current...................... 6 :,777 6 :,777
Common to match.................... +@,777 6 +@,777
;alance, preferred (*) (limit
6+,777), common @*)................ +,777 @77 (,:77
Total.......................................... 60+,777 6 :,@77 6 +),:77
@ 3referred, current (partial)......... 6 ),777 6 ),777
) 3referred, in arrears.................. 6 (,777 6 (,777
Common, to match................... +@,777 6 +@,777
;alance, preferred (*) (limit
6+,777), common @*)................ ((,777 +,777 5,777
Total.......................................... 6 @+,777 6 5,777 6 00,777
Chapter 2. %.B%6 Corporations< Contributed Capital
3 29-4 T#e%'u#! Stoc=< Co't %nd 3%# 8%lue Method' Co+p%#ed. Ent#ie' %nd *ccount ,%l%nce' )t
1anuary %, %##!, the records of =ra,er Corporation provided the following<
Capital stock, par 4%., 6.,... shares outstanding................................. 4 6..,...
Contributed capital in e+cess of par...................................................... 29.,...
:etained earnings.................................................................................. %6.,...
$uring the year. the following transactions affecting shareholdersK e@uity were recorded<
a. Furchased %,... shares of treasury stock at 42. per share.
b. Furchased %,... shares of treasury stock at 422 per share.
c. "old %,2.. shares of treasury stock at 42( per share.
d. 6et income for %##! was 49(,....
"tate law places a restriction on retained earnings e@ual to the cost of treasury stock held.
Required:
%. Iive entries for each of the above transactions, in parallel columns, assuming application of &a' the
cost method and &b' the par value method. )ssume =I=0 flow for treasury stock.
2. Iive the resulting balances in each capital account. Include any re@uired disclosure note related to the
treasury stock.
Answers:
Re(uirement 1
Entries:
Cst Meth1 P"r :"/ue Meth1
a. To record purchase of (.777
shares of treasury stock at 6+7=
Treasury stock= "t cost (6+7)........................... +7,777
"t par (6(7) .................................................... (7,777
Contributed capital in excess of par
((,777 shares x 6@)....................................... @,777
/etained earnins........................................... :,777
Cash.................................................... +7,777 +7,777
b. To record purchase of (,777 shares
of treasury stock at 6++=
Treasury stock= "t cost (6++)........................... ++,777
"t par (6(7)..................................................... (7,777
Contributed capital in excess of
par ((,777 shares x 6@)................................. @,777
/etained earnins........................................... 9,777
Cash ((,777 shares x 6++)................... ++,777 ++,777
c. To record sale of (,+77 shares of
treasury stock at 6+)=
Cash ((,+77 shares x 6+)).............................. 07,777 07,777
Treasury stock= "t F1F< cost
((,777 x 6+7) H (+77 x 6++)................. +@,@77
"t par............................................. (+,777
Contributed capital from treasury
stock transactions............................. ),:77
Contributed capital in excess of par..... (9,777
Chapter 2. %%B%6 Corporations< Contributed Capital
Cst Meth1 P"r :"/ue Meth1
d. 1ncome summary............................................ @),777 @),777
/etained earnins................................ @),777 @),777
Re(uirement )
B"/"n$es in $"#it"/ "$$unts:
Cost 3ar Aalue
Kethod Kethod
Capital stock issued................................................... 6:77,777 6:77,777
Contributed capital in excess of par........................... +@7,777 +)7,777
(b)
-ess= treasury stock (977 shares x par, 6(7).............. (9,777)
Contrib capital from treasury stock transactions......... ),:77 !7!
/etained earnins (?ote ")........................................ +7),777
(a)
(5(,777
(c)
Treasury stock (977 shares x cost, 6++)..................... ((,,:77) TTTTTTTT
Total.................................................................. 6(,700,777 6(,700,777
(a)
6(:7,777 H 6@),777 G 6+7),777.
(b)
6+@7,777 ! 6@,777 ! 6@,777 H 6(9,777 G 6+)7,777.
(c)
6(:7,777 ! 6:,777 ! 69,777 H 6@),777 G 6(5(,777.
?ote "= ;y state law, the cost of treasury stock held, 6(,,:77, is a restriction (or
appropriation) of retained earnins. This amount of retained earnins is not
available for dividends as lon as this treasury stock is held.
C29-2 I''u%nce o> C%pit%l Stoc= to O#"%niFe#'. 8%lu%tion C. /anfield, an engineer, developed a
special safety device to be installed in backyard swimming pools< When turned on, it would set off an
alarm if anything should fall into the water. 0ver a twoCyear period. /anfieldKs spare time was spent
developing and testing the device. )fter receiving a patent, three of /anfieldKs friends, including a lawyer,
considered plans to produce and market the device, )ccordingly. a charter wits obtained, which
authori,ed 2..,... shares of 4%. par value stock. *ach of the four organi,ers contributed 42.,..., and
each received in return 2,... shares of stock. 7hey also agree that, for other consideration, each would
receive (,... additional shares. 7he remaining shares were to be held as unissued stock. *ach organi,er
made a proposal concerning how the additional (,... shares would be paid for. 7hese individual
proposals were made independentlyD then the group considered them as a package. 7he four proposals
were<
anfield$ 7he patent would be turned over to the corporation as payment for the (,...
shares. )n independent appraisal of the patent could not be obtained.
La-.er$ %,... shares would be received for legal services already rendered during
organi,ation, %,... shares would be received as advance payment for legal retainer fees
for the ne+t three years, and the balance would be paid for in cash at par.
Friend No( /$ ) small building. suitable for operations, would be given to the corporation
for the (,... shares of stock. It was estimated that 42.,... would be needed for
renovation prior to use. 7he owner estimates that the market value of the building is
4!(.,... and there is a 4(-.,... loan on it to be assumed by the corporation.
Chapter 2. %2B%6 Corporations< Contributed Capital
Friend No( 5< 7o pay 4%.,... cash on the stock and to give a %2 percent &the going rate'
interestCbearing note for the total price of 49..... &subscriptions receivable' to be paid
out of dividends over the ne+t five years.
Required: Write it short report answering the following @uestions.
%. ?ow would the above proposals be recorded in the accounts? )ssess the valuation basis for each,
including alternatives.
2. What are your recommendations for an agreement that would be e@uitable to each organi,er? *+plain
the basis forCsuch recommendations.
Answer:
Re(uirement 1
To record the proposals (other alternatives are possible)=
To record authori.ation of the capital stock=
Kemo entry= Capital stock, par 6(7, +77,777 shares authori.ed.
To record the cash sale of stock to the orani.ers (in four separate transactions)=
Cash........................................................................................ 97,777
Capital stock, par 6(7 (9,777 shares)............................. 97,777
+anfield proposal:
3atent...................................................................................... )7,777
Capital stock, par 6(7 (),777 shares)............................. )7,777
Aaluation of the patent is based on the market value of the stock because the orani.ers have already
paid in this amount per share for 9,777 shares in four separate transactions. This 6(7 per share valuation
is debatable because the 9,777 shares may not have been issued to the promoters at market value (from
the viewpoint of an outsider, these may not be arm8s lenth transactions). 4owever, the 6(7 per share is
the best estimate available of market value because so few capital transactions have occurred and no
appraisal is available.
Lawyer proposal:
<rani.ation costs ((,777 shares x 6(7)................................. (7,777
3repaid leal fees ((,777 shares x 6(7).................................. (7,777
Cash........................................................................................ 07,777
This entry is also based on the 6(7 per share market value for the reasons iven above. 1n most states it
is illeal to issue stock for services not yet performed, which, if applicable, means that the equivalent
consideration by the lawyer is only 6@7,777.
Friend =( proposal:
;uildin................................................................................... :07,777
Kortae payable, (+F (assumed by the corporation)... )97,777
This entry presumes that the buildin is realistically valued on the basis of the market value of the stock
(6(7 per share) plus the 3A of the mortae. The 6,)7,777 estimate by the owner is questionable
because there is no evidence that it was an independent appraisal. 4owever, the cost principle has been
observed by reconi.in cost as the sum of the market value of the stock (as explained above) plus the
present value of the debt. This rationale aside, the UfriendsX should insist on an independent appraisal.
Friend =) proposal:
Cash........................................................................................ (7,777
#ubscriptions receivable ((+F interest!bearin note)............. @7,777
Capital stock subscribed................................................. )7,777
This proposal is sound in all respects and meets the requirements of the cost principle% the Uoin interest
rate was appropriately used. 4owever, the proposal Uto be paid out of dividendsX is a problem under
>""3% nothin is stipulated about what happens if dividends are deficient.
Re(uirement )
"n equitable recommendation that conforms with >""3 is=
(. &stablish a 6)7,777 value to be paid by each party, because=
(a) a market value of 6(7 per share has already been set as a ood measure by the prior
transactions (see comments above under ;anfield), and
(b) Friend ]0 has established a sound >""3 basis for 6(7 per share
+. ;anfield$The 6)7,777 valuation on the patent is suspect. 1nsist upon two independent appraisals of
this patent$there are competent experts available. 1nsist upon cash or a note (like Friend ]0) for any
difference between the appraisal and the 6(7,777 to be paid in.
0. -awyer$Io not accept the 6(7,777 prepaid leal fees. 1nsist upon cash or a note like the one
proposed by Friend ]0. "scertain that the past leal fees are competitive.
@. Friend ]+$1nsist upon two independent appraisals. 1f the appraisals are lower than 6:07,777, require
cash, or a reduction of the loan assumed, for the difference.
). Friend ]0$"ccept as is, except insist upon deletion of the stipulation Uto be paid out of dividends
because (a) nothin is said about the responsibility for payment if dividends are inadequate, and (b) it
places an undue, and probably illeal, constraint on the board of directors in the future.
*29-3 O;ne#'I E?uit! St%te+ent< Stuc= I''ue Co't' Itech ?oldings Corporation is a computer and
communications services company. Its consolidated statements of shareholders3 e@uity for the threeCyear
period ending =ebruary 2!, %##5, follow<
*ddition%l Ret%ined
Co++on Stoc= 3%id-In E%#nin"' T#e%'u#!
(Dollrs in !"ousnds# Sh%#e' *+ount C%pit%l Othe# @deicit7 Stoc= Tot%l
,%l%nce %t Ae&#u%#! 24< 1449........... 5.,.6.,..5 45.% 4 22,%## 4&6,#!-' 4&9,2-%' 4 %%,29%
Common stock issued......................... 9,(2#,.9. 9( 5,59( 5,5#.
Common stock issuance cost.............. &%-2' &%-2'
Furchase of 9.,.#. shares of common
stock................................................. 4 &5.' &5.'
6et loss................................................ &5,#-6' &5,-#6'
=oreign currency translation............... !59 !59
,%l%nce %t Ae&#u%#! 23< 1441........... 59,(-#,.95 596 2(,562 &6,299' &-,26!' &5.' %%,%6!
Common stock issued......................... %55,6. % ## %..
Common stock issued under stock
award plans...................................... %,(!.,### %6 6,%.# 6,%2(
6et income.......................................... %5,-62 %5,-62
=oreign currency translation............... &(5#' &(5#'
,%l%nce %t Ae&#u%#! 24< 1442........... 56,2#5,692 565 5%,(!. &6,!-5' (,(#( &5.' 5.,!%(
Furchase of !5,965 shares of
common stock.................................. &%%5' &%%5'
Common stock issued......................... (,#..,... (# #.,2#9 #.,5(5
Common stock issued under stock
award plans...................................... !6(,-6! - -,!9! -,!((
7a+ benefits from stock compensation %!,96! %!,96!
6et income.......................................... 2%,6#9 2%,6#9
=oreign currency translation............... GGGGGGGGG GGG GGGGGGG &-%6' GGGGGG GGG &-%6'
/alance, =ebruary 2!, %##5................ 92,#(#,(.# 495. 4%9-,.!- 4&!,(##' 42!,2-# 4&%95' 4%6-,.((
Required:
%. What is the par value of Itech common stock?
2. $uring the fiscal year ending =ebruary .%5. %##%, Itech issued 9,(2#,.9. shares of common stock.
$escribe how the stock issue costs were accounted for. Is there an acceptable alternative treatment? If
so. describe it. What were the net proceeds from the issuance? What were the net proceeds per share?
5. What was the average price per share paid for treasury stock ac@uired during %##.? ?ow is treasury
stock accounted for by Itech?
9. What is the book value per share of Itech at =ebruary 25, %##% ? )t =ebruary 2!, %##5? /riefly
describe why book value per share changed so much from =ebruary 25, %##2, to =ebruary 2!, %##5.
(. What was the average price per share paid for common shares ac@uired during the year ending
=ebruary 2!, %##5? What were the average proceeds per share for shares issued, other than those
issued under stock award plans, during the year ending =ebruary 2!, %##5? Eist any possible reasons
why these amounts might differ greatly.
Chapter 2. %(B%6 Corporations< Contributed Capital
Answers:
Re(uirement 1
3ar value per share G 607(,777*07,7:7,770 shares G 67.7(
Re(uirement )
The stock issue costs were essentially deducted from the ross proceeds of the stock issuance. The
statement shows a two!transaction approach, with ross proceeds bein recorded first, then the stock
issue costs bein deducted from additional paid!in capital. The net proceeds from the stock issue are=
>ross proceeds=
Common stock, par value................................................. 6 @),777
"dditional paid!in capital................................................... 0,0@),777 60,057,777
-ess= stock issue costs........................................................... (9+,777
?et proceeds........................................................................... 60,+79,777
3roceeds per share G 60,+79,777*@,)+5,7@7 G 67.,(
Re(uirement -
3urchase price per share G 607,777*@7,757 shares G 67.,)
>tech is usin the cost method to account for treasury stock.
Re(uirement 4
;ook value per share at February +0, (55(=
6((,(:,,777*(0@,)95,7@0 ^ @7,757) G 67.0+ per share
;ook value per share at February +,, (550=
6(:9,7)),777*(@+,5)5,)75 ^ C@7,757 H ,0,@:0D) G 60.5+ per share
;ook value per share has increased more than tenfold over the two!year period. The primary source of
the increase is not in the profitability of the firm, but rather the issuance of ),577,777 shares for more
than657.7 million, an averae price of 6().0( per share.
Re(uirement 5
The averae price per share paid for treasury stock acquired durin fiscal (550 was=
6((0,777*,0,@:0 shares G 6(.)@ per share
The averae proceeds per share for shares issued in (550 were=
(6)5,777 G 657,+5@,777)*),577,777 shares G 6().0( per share
The lare difference between the cost of treasury stock and proceeds per share for newly acquired issues
is difficult to explain. 3ossible reasons include=
>tech has developed a product or made a discovery such that future prospects for
the company8s profitability have skyrocketed between the date the shares were
acquired and the shares issued.
#ome continency (such as a ma2or lawsuit) is resolved in favor of >tech.
C:*3TER 21
COR3OR*TIONS. RET*INE0 E*RNINDS *N0 STOCJ O3TIONS
%. *+plain what an appropriation of retained earnings is, and why it is. made.
Answer: "n appropriation of retained earnins reduces the amount of retained earnins available
for dividends. "ppropriations are established to protect the cash position of the corporation by
reducin the amount of cash dividends that miht otherwise be paid. To the extent that the amount
of cash dividends is reduced because of inadequate retained earnins. cash is saved.
2. What are the principal sources and uses of retained earnings?
Answer: The principal source of retained earnins is income from operations (includin
extraordinary ains). The primary uses of retained earnins are cash dividends. stock dividends,
recapitali.ations, retirement of stock and treasury stock transactions, and absorption of losses.
9. What are the four important dates relative to dividends? *+plain the significance of each.
Answer: "ccountin for dividends involves four important dates= (() declaration date% (+) record
date% (0) ex dividend date, and (@) payment date. The 1e$/"r"tin 1"te is the date on which the
corporation formally announces the dividend. "s to cash and property dividends, it is the date on
which the dividend becomes irrevocable% therefore. on this date the dividends are recorded in the
accounts. The re$r1 1"te is the date on which the list of stockholders of record is prepared. ?o
entry is made in the accounts on this date. The eB 1i2i1en1 1"te is the day followin the record
date. <n this date, stock prices typically fall by the amount of the cash dividend. This is important
because it provides an empirical basis for the theoretical claim that dividend revenue is earned on
the date of declaration rather than on the date of record or on the payment date. The #"0ment 1"te
is the date on which the dividend is paid. <n this date, an entry is made for the disbursement of
cash or other assets in payment of the dividend.
!. *+plain the difference between intentional and unintentional li@uidating dividends.
Answer: 1ntentional liquidatin dividends occur when the board of directors declares dividends
which they know will constitute a return of contributed capital to the stockholders, as in the case
when the corporation is discontinuin operations or where there is excessive capitali.ation.
'nintentional liquidatin dividends occur when net income. and as a result retained earnins, is
overstated throuh error or omission. For example, the omission or understatement of depreciation
chares, amorti.ation, and depletion chares would cause retained earnins to be overstated. 1n
such cases, if reported retained earnins (prior to correction) were used in full as a basis for
dividends, part of the resultin dividend would represent a return of contributed capital (i.e., an
unintentional liquidatin dividend).
%%. Contrast the effects of a stock dividend &declared and issued' versus a cash dividend &declared and
paid' on assets. liabilities, and total stockholders3 e@uity.
Answer: !otal Stoc>holders?
Di5idend Assets Liabilities E(uit0
Cash Iecrease ?o effect Iecrease
#tock ?o effect ?o effect ?o effect
Chapter +( (*(, Corporations= /etained &arnins O
#tock <ptions
%2. Contrast the effects of a typical small stock dividend &declared and issued' versus a typical cash
dividend &declared and paid' on the components of stockholdersK e@uity.
Answer: $apital Additional $ontributed %etained
Di5idend Stoc> C"#it"/ E"rnings
Cash ?o effect ?o effect Iecrease
#tock, small 1ncrease 1ncrease Iecrease
%9. $istinguish between a large stock dividend and a pure stock split.
Answer: " stock dividend involves the issuance of additional shares of stock to the stockholders in
proportion to the shares that they held prior to the dividend. 1t reduces retained earnin. and
increases contributed capital by the same amounts, but does not chane total stockholders equity.
1n contrast. a pure stock split involves the replacin of the old shares with a larer number of new
shares with a proportionately lower par value per share. " pure stock split does not chane the
components or total of stockholders8 equity. ?either a stock dividend nor a stock split requires the
disbursement of corporate assets% both reduce earnins per share.
%(. What are the primary reasons for appropriating and for restricting retained earnings?
Answer: Fundamentally. retained earnins are appropriated and restricted to indicate that such
amounts are not available for dividends durin the period of appropriation or restriction, thereby
protectin the workin capital position of the corporation. 4owever, such appropriations and
restrictions arise for a number of reasons. The primary reasons are=
(a) To fulfill a leal restriction.
(b) To fulfill a contractual restriction.
(c) To record a discretionary action by the board of directors to appropriate a portion of retained
earnins as an aspect of financial plannin.
(d) To record a discretionary action by the board of directors to appropriate a portion of retained
earnins in anticipation of possible future losses.
%6. *+plain the distinction between &a' a bond sinking fund and &b' an appropriation of retained
earnings for a bond sinking fund.
Answer:
(a) " bond sinkin fund is created by depositin cash in a special fund (like a savins account) and
recordin it in a separate account as an investment. 'sually the fund is under the control of a
trustee% the fund is an asset and is used at maturity to retire bonds.
(b) " restriction of retained earnins for a bond sinkin fund is a constraint on retained earnins% it
does not directly involve assets nor does it chane total stockholdersS equity. The amount is
temporarily restricted from payin dividends% therefore, it serves to protect workin capital by
preventin a noncurrent drain on cash for dividends. 1t provides a measure of security to the
bondholders.
2.. What is the difference between stock rights and stock warrants?
Answer: St$< rights$provide the holder with an option to acquire a specified number of shares
of the capital stock of a company under specified conditions. St$< w"rr"nts$a certificate that
evidences ownership of one or more stock rihts.
22. Eist the three important dates with respect to stock rights. When will the related stock sell (a) rights
on and (b) e+ rights?
Answer: /ihts$important dates and market status=
(a) "nnouncement date
(b) 1ssuance date #tock sells!rihts on
(c) &xpiration date #tock sells!ex rihts
Chapter +( +*(, Corporations= /etained &arnins O
#tock <ptions
2(. "tock option incentive plans for employees may be either noncompensatory or compensatory.
/riefly e+plain each.
Answer: " nn$m#ens"tr0 plan is one that does not involve additional compensation to the
rantee and involves no cost to the corporation. 1t is characteri.ed by the followin four attributes=
(() substantially all full!time employees who meet the limited employment qualifications may
participate (employees ownin a specified percent of the outstandin shares and executives may
be excluded), (+) stock is offered to those eliible equally or based on a uniform percentae of
salary or waes (the number of shares of stock purchased by an employee may be limited), (0) the
time permitted for exercise of an option or purchase riht is limited to a reasonable period, and (@)
the discount from market price is no reater than would be reasonable in an offer of stock to
stockholders or other outside parties (the discount varies up to () percent in practice).
"ll plans not possessin all four of the above attributes are classified as $m#ens"tr0. They
involve a cost to the corporation and additional compensation to the employee.
5.. What are stock appreciation right?
Answer: #tock appreciation rihts (#"/s) usually provide a cash bonus to the employee (rantee)
based upon the chane in the market value of specified shares of capital stock from the date of
rant to the exercise date.
5%. $iscuss how SFAS No( )/0( H)ccounting, for "tockC/ased Compensation,H differs from A1
O2inion No( /3 in recording the compensation cost of fi+ed stock options with the e+ercise price set
e@ual to the grantCdate market price of the stock.
Answer: 'nder "3; Opinion No. 15) the cost of fixed options is measured at the market price of
the option stock as of the rant date. less the exercise price. multiplied by the number of shares.
Bhen the exercise price is equal to the current stock price. the cost (which would normally be
expensed over the service period) is .ero. 'nder the procedures specified in SFAS No. (1,) the
cost of options is determined at the rant date usin an option pricin model. 1n every case.
includin options ranted with exercise prices equal to or even reater than the current stock price.
the cost will be reater than .ero. SFAS No. (1, increases the measured value of the options,
resultin in increased compensation expense.
E 21-2 3#ope#t! 0i1idend Reco#ded. Co++on %nd 3#ee##ed Stoc= 7he records of =rost Corporation
showed the following at the end of %##-<
Freferred stock, 6 percent cumulative. 6onparticipating, par 42.............42..,...
Common stock, no par value &(.,... shares issued and outstanding'........29.,...
Contributed capital in e+cess of par. preferred stock....................................5.,...
:etained earnings.......................................................................................%2(,...
Investment in stock of )ce Corporation &(.. shares at cost'........................%.,...
7he preferred stock has dividends in arrears for %##6 and %##!. 0n 1anuary %(, %##-, the board of
directors approved the following resolution< H7he %##- dividend, to stockholders of record on. =ebruary
%, %##-, shall be 6 percent on the preferred stock and 4%... per share on the common stockD the dividends
in arrears are to be paid on 2arch %. %##-, by issuing a property dividend using the re@uisite amount of
)ce Corporation stock. )ll current dividends for %##- are to be paid in cash on 2arch %. %##-.H 0n
1anuary %(, %##-, the stock of )ce Corporation was selling at 46. per share, on =ebruary %,. at 46% per
share, and at 462 on 2arch %. %##-.
Chapter +( 0*(, Corporations= /etained &arnins O
#tock <ptions
Required:
%. Compute the amount of the dividends to be paid to each class of stockholders, including the number
of shares of )ce Corporation stock and the amount of cash re@uired by the declaration. )ssume that
divisibility of the shares of )ce Corporation poses no problem.
2. Iive the ournal entries to record all aspects of the dividend declaration and its subse@uent payment.
Answer:
Re(uirement 1
(a) ?umber of "ce Corporation shares required for the dividends in arrears=
6+77,777 x .7: x + years G 6+@.777
6+@,777 L 6:7 per share G @77 shares of "ce Corporation stock required for the property dividend to
preferred stockholders (in arrears).
(b) Cash dividends for the current year=
3referred= 6+77,777 x .7: G 6(+,777
Common= )7.777 shares x 6(.77 G )7,777
Total cash required 6:+,777
Re(uirement )
Manuary (). (559!declaration date=
1nvestment!"ce Corporation C@77 shares x (6:7 ! 6+7)D................(:,777
/etained earnins (6+@,777 H 6:+,777)........................................9:,777
>ain on disposal of stock of "ce Corporation...........................................(:,777
Cash dividends payable............................................................................:+,777
3roperty dividends payable ("ce Corporation shares)..............................+@,777
Karch (. (559!payment date=
3roperly dividends payable...........................................................+@,777
Cash dividends payable................................................................:+,777
1nvestments!"ce Corporation (@77 shares x 6:7).....................................+@,777
Cash................................................................................................. ........:+,777
Nte: The relevant market value of the "ce stock is at the date the dividend liability becomes effective,
that is, the declaration date.
E 21-2 Stoc= 0i1idend Reco#ded. 0%te' C#o'' T;o 3e#iod' 7he records of :ound Corporation showed
the following balances on 6ovember %. %##-<
Capital stock, par 4%......................................................45..,...
Contributed capital in e+cess of par..................................%.2,...
:etained earnings.............................................................2......
0n 6ovember (, %##-. the board of directors declared a stock dividend to the stockholders of
record as of $ecember 2., %##-, of one additional share for each five shares already outstandingD issue
date, 1anuary %., %###. 7he market value of the stock immediately after the issuance was 4%- per share.
7he annual accounting period ends $ecember 5%.
Chapter +( @*(, Corporations= /etained &arnins O
#tock <ptions
Required:
%. Iive entries in parallel columns for the stock dividend assuming, for problem purposes, Case
)Cmarket value is capitali,edD Case /Cpar value is capitali,ed. and Case CCaverage paid in is
capitali,ed.
2. *+plain when each value in &%' should be used.
5. With respect to the stock dividend, what should be reported on the balance sheet at $ecember 5%,
%##-, assuming no intervening dividend transactions?
Answer:
Re(uirement 1
?ovember ), (559! Ieclaration date of stock dividend= Kemo entry only or entry (optional).
Iecember +7, (559!!/ecord date% no entry% obtain fist of shareholders of record
Iecember 0(, (559!&nd of accountin period% no entry.
Manuary (7, (555!1ssue date=N Amount $apitali@ed
$ase A $ase + $ase $
;ar>et <alue 4ar <alue A5erage 4aid #n
/etained earnins (79,777 :7.777 97,@77
Capital stock, par 6(7
(:,777 shares) :7.777 :7,777 :7,777
Contributed capital in excess
of par 9+.... 1..9..
N 6077,777 L 6(7 G 07,777 shares% 07,777 shares L ) G :,777 shares issued as a stock dividend.
Capitali.e= Karket value= :,777 shares x 6(9 G 6(79,777.
3ar value= :,777 shares x 6(7 G 6:7,777.
"verae paid in= 6@7+.777 L 07,777 shares G 6(0.@7.
:.777 shares x # (0.@7 G 697.@77.
Re(uirement )
Karket value should be used when there is a PsmallP stock dividend% that is, when the issuance of
additional shares is not over +7 percent to +) percent of the outstandin shares prior to the dividend. "
small stock dividend is believed to usually have a relatively small impact on the market price per share.
3ar value should be used when there is a PlareP stock dividend. that is. when the issuance of additional
shares is over +7 percent to +) percent. 1t is believed that a lare dividend usually is reflected in an
approximate proportional effect on the market price per share. 1n the fact situation iven, this method
could not be used.
"verae paid in, if no less than the statutory minimum, sometimes is used by manaement because it
meets the leal minimum and maintains the Paverae paid inP per share.
Chapter +( )*(, Corporations= /etained &arnins O
#tock <ptions
Re(uirement -
"t the end of (559, the only requirement is a disclosure note that explains the stock dividend= it is not a
liability. 1f Pcommon stock issuableP is recorded on the declaration date. it would be reported under
stockholdersS equity as a credit (the disclosure note also should be provided).
E21-) Stoc= 0i1idend %nd Stoc= Split. Eect' Co+p%#ed /ailey Corporation has the following
stockholdersK e@uity<
Capital stock, par 4%2D 2.,... shares outstanding.................. 429.,...
Contributed capital in e+cess of par........................................ !.,...
:etained earnings.................................................................... (..,...
7otal stockholdersK e@uity................................................. 4-%.,...
7he corporation decided to triple the number of shares currently outstanding &to 6.,... shares' by taking
one of the following alternative and independent actions<
a. Issue a 2.. percent &2CforC%' stock dividend &9.,... additional shares' and capitali,e retained
earnings on the basis of par value.
b. Issue a pure stock split &5CforC%, that is, three new shares are issued for each old share replaced' by
changing par value per share proportionately.
c. Issue a 5CforC% stock split and change the par value per share to 4(.
Required:
% . Iive the ournal entry that should be made for each alternative action. If none is necessary, e+plain
why. 0n the stock splits. the old shares are called in and the new shares are issued to replace them.
2. =or each alternative. prepare a schedule that reflects the stockholdersK e@uity immediately after the
change. =or this re@uirement. complete the following schedule that compares the effects of the three
alternative actions<
,eo#e Stoc= 3u#e Stoc= Stoc= Split
Ite+ Ch%n"e 0i1idend Split @p%# K47 @p%# K57
"haresBpar value GGGGGGGGGG GGGGGGGGGG GGGGGGGGGG GGGGGGGGGG
Capital stock 4GGGGGGGGG 4GGGGGGGGG 4GGGGGGGGG 4GGGGGGGGG
)dditional paidCin capital in e+cess of par GGGGGGGGGG GGGGGGGGGG GGGGGGGGGG GGGGGGGGGG
7otal contributed capital GGGGGGGGGG GGGGGGGGGG GGGGGGGGGG GGGGGGGGGG
:etained earnings GGGGGGGGGG GGGGGGGGGG GGGGGGGGGG GGGGGGGGGG
7otal stockholdersK e@uity 4GGGGGGGGG 4GGGGGGGGG 4GGGGGGGGG 4GGGGGGGGG
/e prepared to e+plain and compare the effects among the four columns in the above schedule.
Answers:
Re(uirement 1
a. #tock dividend (+7,777 shares x +.77 G @7,777 additional shares)=
/etained earnins (@7,777 shares x 6(+)............................... @97,777
Capital stock. par 6(+ (@7,777 shares)....................... @97,777
b. Kemo entry only because none of the components of stockholdersS equity chaned, except number of
shares increased% the +7,777 old shares were called in and replaced with :7,777 new shares, and par
Chapter +( :*(, Corporations= /etained &arnins O
#tock <ptions
value chaned from 6(+ to 6(+ L 0 G 6@ per share. -eal capital is :7,777 shares x 6@ per share G
6+@7,777, as before.
c. #tock split +7,777 old shares called in x 0 G :7,777 new shares% par chaned from 6(+ to 6) per
share.
&ntry to reflect new leal capital amount in the capital stock account=
Capital stock, par 6(+ (+7,777 old shares).............................. +@7,777
Contributed capital in excess of par........................................ :7,777 N
Capital stock, par 6) (:7,777 new shares).............................. 077,777
N (:7,777 shares x 6) G 6077,777) ! (+7,777 shares x 6(+ G 6+@7,777) G 6:7,777 debit.
Re(uirement )
Be.re St$< Pure St$< St$< S#/it
Item Ch"nge Di2i1en1 S#/it %#"r J4& %#"r J5&
#hares*par value +7,777*6(+ :7,777*6(+ :7,777*6@ :7,777*6)
Capital stock 6+@7,777 6,+7,777 6+@7,777 6077,777
"dditional paid!in capital in excess of par ,7,777 ,7,777 ,7,777 (7,777
Total contributed capital 0(7,777 ,57,777 0(7,777 0(7,777
/etained earnins )77,777 +7,777 )77,777 )77,777
Total stockholdersS equity 69(7,777 69(7,777 69(7,777 69(7,777
E21-12 E+plo!ee Stoc= 3u#ch%'e 3l%n6Co+pen'%to#! o# Nonco+pen'%to#!L Ent#ie' :ice
Corporation has a stock purchase plan with the following provisions<
*ach fullCtime employee with a minimum of one yearKs service may ac@uire. from :ice
Corporation, its common stock, par 4%., through payroll deductions at %. percent below
the market price on the date selected by the employee for a stock purchase &the e+ercise
date'. 7he e+ercise decision must be made within one year from the payroll deduction
date.
)ssume :ice Corporation uses A1 O2inion No( (/3 as its method to account for stockCbased compenC
sation plans. *mployee ?. )dams signed a payroll deduction form on 1anuary %, %##!, for 46. per month.
)t that date, the market price of the stock was 42!. )ssume a monthly salary of 42,... and other payroll
deductions in the aggregate of %- percent. )t the end of %##!, )dams re@uested that stock be purchased
e@ual to the amount accumulated to )damsK credit. ) that ate, the market price of the stock was 42(.
Required:
%. Is this a compensatory plan under )F/ 0pinion 6o. 2(.S If so. how much should be recorded as
additional compensation for )dams? *+plain.
2. ?ow many shares will )dams ac@uire for the %##! deductions? "how computations.
5. Iive entries to record (a) one monthly payroll and (b) issuance of the shares for the year, assuming
unissued shares are used.
9. If :ice Corporation were using SFAS No( )/0, would this plan result in compensation cost? Why or
why not?
Chapter +( ,*(, Corporations= /etained &arnins O
#tock <ptions
Answers:
Re(uirement 1
'nder A3: Opinion No. 15) the plan is noncompensatory because there is no additional expense to the
company and there is no additional compensation income to the employee. 1t meets the followin criteria=
(() substantially all full!time employees may participate (Peach full!time employeeP). (+) the stock is
offered to each eliible employee equally, (0) the exercise time is limited to a reasonable period, and (@)
the discount of (7 percent is reasonable to offset sellin costs. "dams will receive no additional
compensation because the discount from market approximates a reasonable commission on security
transaction. Therefore, this is not considered additional compensation.
Re(uirement )
"dams is entitled to 0+ shares computed as follows=
6:7 per month x (+ months G 6,+7 total credit to "dams.
6+) x .5 G 6++.)7.
6,+7 L 6++.)7 G 0+ shares.
Re(uirement -
(a) Konthly payroll (each month)=
#alary expense (iven)..................................................... +.777
-iability!&mployee stock purchase plan (iven)......... :7
<ther (deductions) payables (6+,777 x .(9)............... 0:7
Cash........................................................................... (,)97
(b) 1ssuance of the shares (Iec. 0(, (55,)=
-iability$&mployee stock purchase plan (6:7 x (+)........ ,+7
Common stock, par 6(7 (0+ shares).......................... 0+7
Contributed capital in excess of par........................... @77
Re(uirement 4
1t is likely that this plan would result in a positive amount of compensation cost under SFAS No. (1,. First,
the stock can be acquired at a (7F discount, and under SFAS No. (1, the discount mentioned for a plan
to qualify as noncompensatory is )F. SFAS No. (1, does provide for the possibility of the (7F qualifyin
for noncompensatory status by notin that the )F discount is considered to comply without further
2ustification, thus implyin that a hiher discount may qualify if 2ustified. The 2ustification would be on the
basis that stock with discounts of this si.e would be issued to shareholders, or that the discount is less
than the amount of stock issue costs in a public offerin.
1f the (7F discount were to be 2ustified, the plan still would not qualify as a noncompensatory plan. The
employee has an option to exercise the option within one year of the payroll deduction date, turnin this
into an option with an exercise period reater than 0( days.
E 21-13 Stoc= Incenti1e 3l%n6*3, Opinion No( 25. *n%l!'i' .%nd Ent#ie' :e+ Corporation is
authori,ed to i 5..,... shares of common stock, par 4 %, of which %9.,... shares have been issued. 7he
corporation initiated a stock bonus plan during %##- for designated managers. *ach manager will receive
stock options to purchase %,... shares of :e+ common stock,. and the options vest with thc grantee if still
employed by the company . two years from the date of grant. 7he rights are nontransferable and e+pire
after $ecember 5%, 2..2. 7he option price is 42. per shareD the market price on the date of grant was 429.
)ssume that manager :uth :oe receives the stock options on 1anuary %, %##-.
:e+ uses A1 O2inion No( /3 to account for stockCbased compensation plans.
#tock <ptions
Required:
)( Is this a noncompensatory plan? *+plain.
2. What the measurement date? *+plain.
5. What is the amount of total compensation cost for manager :oe?
9. 0ver what period should this compensation cost be assigned as e+pense? ?ow much should be
assigned to %##- and %###? *+plain.
(. What entry should be made on the date of grant to :oe?
6. What entry should be made on $ecember 5%, %##- for :oe?
!. Iive the entry to record the e+ercise of the option by :oe on $ecember 5%, 2..2, when the market
price of the common stock was 4-. per share.
-. ?ow much actual value did manager :oe receive? ?ow much additional compensation e+pense did
:e+ Corporation report?
Answers:
Re(uirement 1
This is a compensatory plan because it involves additional compensation to the rantees and a cost to
the corporation. 1t does not meet 0 of the @ characteristics of a noncompensatory plan= (() it is not
applicable to all employees, (+) all employees are not iven a uniform percentae, and (0) the price
discount is sinificant (more than ()F).
Re(uirement )
4e measurement date is the date of rant, Manuary (. (559, because it is the date that both (a) the
number of optional shares that the manaers are entitled to receive ((,777), and (b) the option price (6+7)
are known.
Re(uirement -
The total compensation cost for each manaer is= (6+@ ! 6+7) x (,777 shares G 6@,777.
Re(uirement 4
Total compensation cost should be assined as expense equally over the two!year service period from
Manuary (, (559, throuh Iecember 0(, (555% that is. 6@,777 L + years G 6+,777 per year.
Re(uirement 5
<n date of rant, Manuary (, (559$Keasurement date=
Ieferred compensation expense (6+@ ! 6+7) x (,777 shares.............. @,777
&xecutive stock options outstandin (for (,777 shares of
common stock)........................................................................... @,777
Re(uirement 5
&xecutive compensation expense (6@,777 L ) years).......................... +,777
Ieferred compensation expense................................................... +,777
#tock <ptions
Re(uirement >
Iecember 0(, +77+$&xercise of stock options=
Cash ((,777 shares x 6+7)................................................................... +7,777
&xecutive stock options outstandin.................................................... @.777
Common stock, par 6( ((,777 shares).......................................... (,777
Contributed capital in excess of par............................................... +0,777
Re(uirement +
P"ctual valueP received by /oe (rantee)=
(697 ! 6+7) x (,777 shares G 6:7,777.
"dditional compensation expense reported by /ex Corporation (rantor)=
(6+@ ! 6+7) x (,777 shares G 6@,777.
E21-14 Stoc= Incenti1e 3l%n6$%A$ &o' 1(): *n%l!'i' %nd Ent#ie' )ssumeCall the data given in
*+ercise 2%C%5 with the following modifications and additional facts<
M :e+ Corporation used SFAS No( )/0 to account for stockCbased compensation plans.
M Jsing an option pricing model and management estimates for input factors. the fair value of the
options granted to 2s. :oe is computed to be 4%2 per option.
M Ignore income ta+ considerations.
Required:
%. Compute the estimated total amount of compensation cost for the Cgrant made to 2s. :oe.
2. What entry should be made on the date of the grant?
5. What entry should be made at $ecember 5%. %##-?
9. Iive the entry to record the e+ercising of the options held by 2s. :oe on $ecember 5 %. 2..2.
A1SAE%S
(. The estimated total compensation cost G fair value of an option x number of options expected to vest.
Total compensation cost G 6(+ x (,777 options G 6(+,777.
+. ?o entry is made on the rant date. 'nlike A3: Opinion No. 15) which would record the
compensation as a deferred compensation and treat as a component of stockholdersS equity, SFAS
No. (1, records the compensation cost as it is earned by the employee.
0. The service period is + years% thus one!half of the estimated compensation cost is reconi.ed in
(559=
Compensation cost (expensed).................................. :,777
"dditional paid!in capital$stock options.............. :,777
(?ote= This entry would be repeated in (555, assumin Ks. /oe is still employed by /ex.)
Chapter +( (7*(, Corporations= /etained &arnins O
#tock <ptions
@. &ntry to record the exercisin of the options for (.777 shares at an exercise price of #+7=
Cash ((,777 x 6+7)..................................................... +7.777
"dditional paid!in capital$stock options.................... (+,777
Common stock, at par.......................................... (,777
"dditional paid!in capital$common stock........... 0(,777
E21-17 Stoc= *pp#eci%tion Ri"ht'6*3, Opinion No( 25. *n%l!'i'( E'ti+%te' %nd Ent#ie' 0n
1anuary %, %##!, Pelly Corporation established a stock appreciation rights plan that offers to selected
e+ecutives rights &"):s' that can be redeemed for cash e@ual to the difference between the market price
of the companyKs common stock at grant date and market price at the first e+ercise date. 7he rights can be
e+ercised three years from grant date and e+pire four years from grant date or when employment is
terminated, if earlier. 7he service period is considered to be three years because e+ercise is e+pected
&highly probable' to occur on $ecember 5%, %###.
*+ecutive /rown was granted 2,... "):s on 1anuary %, %##! &when the common stock price was
42.' and e+ercised the rights on $ecember 5%, %###. :elevant market prices at yearCend on Pelly
common stock were %##!, 425D %##-, 42!D %###, 45.D and 2..., 426.
)ssume Pelly Corporation uses the intrinsicCvalue method of A1 O2inion No( /3 to account for its
stockCbased compensation plan.
Required:
%. )nswer the following @uestions<
a. Is this plan compensatory? GGGGG 8es GGGGG 6o
b. 7he measurement date is GGGGGGGGGGGGGGGGGGGG
c. 7he service period is GGGGGGGGGGGGGGGGGGGGGGG
d. 7otal compensation cost is 4 GGGGGGGGGGGGGGGGG
e. 7otal cash paid by grantor to grantee is 4 GGGGGGGGGGGGGG
2. Iive the appropriate ournal entries from 1anuary %, %##!, through $ecember 5%, %###.
Answers:
Re(uirement 1
(a) Jes, compensatory because it is not available to all employees.
(b) Keasurement date$exercise date$expected (hihly probable) to occur on Iecember 0(, (555.
Keasurement date is after the date of rant.
(c) #ervice period$0 years (from rant date, Manuary (, (55,% to exercise date expected, Iecember
0(, (555).
(d) (607 ! 6+7) x +,777 #"/s G 6+7,777 total compensation expense.
(e) 6+7,777 cash paid (same as total compensation expense).
Re(uirement )
Manuary (, (55,!Iate of rant=
Kemo entry only.
Chapter +( ((*(, Corporations= /etained &arnins O
#tock <ptions
Iecember 0(, (55,$To record estimated compensation expense=
Compensation expense.......................................................... +,777
#tock appreciation plan liability......................................... +,777
C(6+0 ! 6+7) x +,777 #"/s G 6:,777D L 0 years G 6+,777 per year.
Iecember 0(. (559!To record estimated compensation expense=
Compensation expense.......................................................... ,,00+
#tock appreciation plan liability......................................... ,,00+
C(6+, ! 6+7) x +,777 #"/sD G 6(@,777 total
6(@,777 L 0 years G 6@,::: per year......................... 6@,:::
"dd (55@ catch!up, 6@,::: ! 6+,777.......................... +,:::
Total........................................................................ 6,,00+
Iecember 0(, (555!!To record actual compensation expense and exercise=
Compensation expense.......................................................... (7,::9
#tock appreciation plan liability......................................... (7.::9
(607 ! 6+7) x +,777 #"/s G 6+7,777 total.
6+7,777 L 0 years G 6:,::: per year......................... 6:,:::
Catch!up= Jear (55,, 6:,::: ! 6+.777........................ @,:::
Jear (559= 6:,::: ! 6,,00+........................ (::@)
Total ................................................................... 6(7,::9
N /ounded to come out even.
Total compensation expense recorded=
6+,777 H 6,,00+ H 6(7.::9 G 6+7,777.
&xercise=
#tock appreciation plan liability (6+,777 H 6,,00+ H 6(7,::9) +7,777
Cash C(607 ! 6+7) x +,777 #"/sD...................................... +7,777
E21-14 Stoc= Incenti1e 3l%n6$%p'e o Ri"ht'. *n%l!'i' %nd Ent#ie' "tacy Corporation offered a
stock option incentive plan to si+ of its top e+ecutives. $uring the second year from date of grant, but
prior to the permissible e+ercise date, one of the si+ e+ecutives resigned and accepted employment with a
competitor. In accordance with the provisions of the incentive plan, the stock option for the resigned
e+ecutive lapsed. )t the date of lapse, the relevant account balance for all si+ e+ecutives combined were
deferred compensation e+pense, 46!(,...D and e+ecutive stock options outstanding, 4#..,.... 7he
service period e+tends for three more years, including the second year.
Required:
% . /riefly e+plain what account treatment should be accorded the oneCsi+th of these balances that relate
to the one resigned e+ecutive.
2. Iive all ournal entries directly related to the lapsed options.
Answers:
Re(uirement 1
The credit difference between these two accounts, that relates to the resined executive, should be a
reduction of compensation expense as a chane in accountin estimate for the current and any relevant
future periods.
Chapter +( (+*(, Corporations= /etained &arnins O
#tock <ptions
Re(uirement 1
(() To clear the two relevant accounts=
&xecutive stock options outstandin (6577,777 x (*:)......... ()7,777
Ieferred compensation expense (6:,),777 x (*:)........ ((+,)77
"ccrued lapse expense, stock optionsN......................... 0,.)77
(+) To assin the lapse difference to the current and future periods
7e"r ) 7e"r - 7e"r 4
"ccrued lapse expense......... (+,)77 (+,)77 (+,)77
Compensation expense,
stock options................... (+,)77 (+,)77 (+,)77
60,,)77 L 0 G 6(+,)77.
N " loner, but more descriptive title would be P"ccrued compensation expense due to lapse of stock
options.P This account would be reported in stockholdersS equity as a contra account to Ieferred
compensation cost.
"lternatively, Ieferred compensation cost could be credited for the 6()7,777 in this entry, which
avoids settin out as a separate amount (60,,)77). 3roper amorti.ation would produce the same
results as above. The alternative entries would be as follows=
(() &xecutive stock options outstandin................................. ()7,777
Ieferred compensation cost...................................... (),777
(+) Compensation expense C(6:,),777 ! 6()7,777 G 6)+),777)
L 0 yearsD.......................................................................... (,),777
Ieferred compensation cost...................................... (,),777
;oth methods produce the followin results=
7e"r ) 7e"r -
1ncome statement=
Compensation expense.................................................... 6(,),777 6(,),777
;alance #heet=
Ieferred compensation cost (net)..................................... 0)7,777 (,),777
321-4 C%'h %nd Stoc= 0i1idend'6A#%ction%l Sh%#e'. Ent#ie' %nd Repo#tin" 0n $ecember 5%. %##!.
the accounts for Tuality =ood Corporation &T=C' showed the following balances<
Stoc=holde#'> E?uit!
(in tho#sands)
Freferred stock, ! percent. par value 42(, noncumulative, authori,ed 2.,...&UU' shares,
0utstanding %6,... shares............................................................................. 49..
Common stock, noCpar, stated value 4%., authori,ed 9.,... shares, outstanding 29,...
shares..............................................................................................................29.
)dditional paidCin capital. Freferred................................................................. 5.
)dditional paidCin capital. Common................................................................. 6.
:etained earnings.............................................................................................. 5(.
$uring, %##-, the following transactions, in order of date, were recorded relating to the capital accounts<
Chapter +( (0*(, Corporations= /etained &arnins O
#tock <ptions
a. )pr.% ) stock dividend was issued whereby &%' each holder of %. preferred, shares received %
share of common stock and &2' each holder of 6 shares of common stock received %
additional share of common. 7he market price of the common stock was 4%( per share
immediately after issuance of the stock dividend. In the issuance of the stock dividend.
(,9.. shares of common stock and %,... fractional share rights were issued. *ach fractional
share right represents oneCtenth of a share of stock.
b. 6ov. % )ll of the rights were redeemed e+cept 2.., which remained outstanding.
c. $ec. %( ) ! percent cash dividend on the preferred shares and a 42... per share dividend on the
common shares were declared and paid.
d. $ec. 5% :eported net income was 4%9.,....
Required:
%. Iive the ournal entries for each of the above transactions during %##-.
2. Frepare the stockholdersK e@uity section of the balance sheet at $ecember 5%, %##-.
5. )ssume T=C paid cash to the stockholders in lieu of issuing fractional share rights. 7he cash
distribution was based on the market value of 4%( per common share. Iive the entry on )pril %, %##-
to record the dividend transaction. What would be the total stockholdersK e@uity of T=C on $ecember
5%. %##-, in this situation if allCother factors remain as they were given aboveK?
Answers:
Re(uirement 1
(a) "pril (, (559$1ssuance o(the stock dividend=
/etained earnins (),:77 shares x 6())..................................................... 9@,777
Common stock, no par, stated value 6(7 (),@77 shares x 6(7).............. )@,777
Common stock rihts outstandin (for +77NN shares x 6(7).................... +,777
Contributed capital in excess of stated value, common ():77 x 6))....... +9,777
NComputation of shares for the stock dividend=
3referred, (:,777 shares L (7 G (,:77 shares
Common, +@,777 shares L : G @,777 shares
Total common shares to be issued
as stock dividend ),:77 shares
NN #hares issued$),@77 (iven)
/ihts issued$+,777 L (7 G +77 shares to be issued upon surrender of rihts
(b) ?ovember (, (559$/edeemed (,977 rihts=
Common stock rihts outstandin C(+,777 ! +77) L (7 G (97 sharesD......... (,977
Common stock, no par ((97 shares x 6(7)............................................. (,977
(c) Iecember (), (559$Ieclared and paid cash dividend=
/etained earnins...................................................................................... ),,)97
Cash dividends payable, preferred.......................................................... +9,777
Cash dividends payable, common.......................................................... +5,)97
Computation=
3referred= (:,777 shares x 6+) x .7, G 6+9,777
Common (+@,777 H ),@77 H (97) G
(+5,)97 shares) x 6+.77 G )5,(:7
Total 69,,(:7
Chapter +( (@*(, Corporations= /etained &arnins O
#tock <ptions
Cash dividends payable, preferred............................................................. +9,777
Cash dividends payable, common.............................................................. )5,(:7
Cash........................................................................................................ 9,,(:7
(d) Iecember 0(, (559=
1ncome summary........................................................................................ (@7,777
/etained earnins................................................................................... (@7,777
Re(uirement )
St$<h/1ersF E(uit0KDe$em'er -1= 1**+
Contributed Capital=
Capital stock=
3referred stock, ,F, 6+) par value, noncumulative, authori.ed
+7,777 shares, issued and outstandin (:,777 shares................. 6@77,777
Common stock, no par, stated value 6(7 per share, authori.ed
@7,777 shares, issued and outstandin, +5,)97 shares
C(+@,777 H ),@77 H (97 G +5,)97) x 6(7D....................................... +5),977
Common stock rihts outstandin (+77 L (7 G +7 shares x 6(7)...... +77
Total........................................................................................ :5:,777
<ther contributed capital=
1n excess of par, preferred stock.................................................... 607,777
1n excess of stated value, common stock (6:7,777 H 6+9,777)..... 99,777 ((9,777
Total Contributed Capital...................................................... 9(@,777
/etained earnins (60)7,777 ! 69@,777 ! 69,,(:7 H 6(@7,777).................... 0(9,9@7
Total #hareholdersS &quity............................................. 6(,(0+,9@7
Re(uirement -
"pril (, (559$1ssuance of stock dividend=
/etained earnins (),:77 shares x 6())........................................................ 9@,777
Common stock (),@77 shares x 6(7)...................................................... )@,777
Contributed capital in excess of stated value (),@77 shares x 6)).......... +,,777
Cash (+,777 L (7 G +77 shares x 6()).................................................... 0,777
Iecember 0(, (559$#tockholdersS equity=
Contributed capital=
3referred stock, as above....................................................................... 6@77,777
Common stock C(+@,777 G ),@77 shares) x 6(7D..................................... +5@,777
Contributed capital in excess of par, preferred stock............................... 607,777
Contributed capital in excess of par, common stock
(6:7,777 H 6+,,777)............................................................................. 9,,777 ((,,777
/etained earnins, as above................................................................... 0(9,9@7
Total #tockholdersS &quity.............................................................. 6(,(+5,9@7
The difference is 60,777 (6(,(0+,9@7 ! 6(,(+5,9@7), the amount of the asset reduction in the "pril ( entry
immediately above. where fractional share rihts were paid in cash and not converted into shares of
common stock.
C21-4*ppendi5. Qu%'i Reo#"%niF%tion 2arks Corporation, a mediumCsi,e manufacturer, has
e+perienced operating losses for the past five years. )lthough operations for the current year ended also
resulted in a loss, several important changes made the fourth @uarter a profitable oneD as a result. future
operations of the company are e+pected to be profitable.
Chapter +( ()*(, Corporations= /etained &arnins O
#tock <ptions
7he treasurer suggested a @uasi reorgani,ation to &a' eliminate the accumulated deficit of 452(,... in
retained earnings. &b' write up the 46..,... cost of operating land and buildings to their current market
value of 4-......, and &c' set up an asset of 4%!(,... representing the estimated future ta+ benefit of the
losses accumulated to date.
Required:
%. What are the characteristics of a @uasi reorgani,ation?
2. Eist the conditions under which a @uasi reorgani,ation would generally be ustified.
5. $iscuss the propriety of the treasurerKs proposals to do the following<
a( *liminate the deficit of 452(,....
b( Write up the value of the operating land and buildings of 46..,... to their current market value.
'( "et up an asset of 4%!(,... representing the future ta+ benefit of the losses accumulated to date.
Answers:
?ote= The followin is essentially the published !unofficialP response to this "1C3" examination question.
Re(uirement 1
The primary purpose of a quasi!reorani.ation is to establish a new basis for accountability and a Pfresh
start.P The corporate entity and conditions of competition remain unchaned durin a quasi!
reorani.ation. 4owever, the recorded values of assets may be restated downward to market value, the
equity accounts are restated in order to leave the /etained &arnins account with a .ero balance, the
/etained &arnins account is PdatedP for a period of time (from five to ten years) followin the
reorani.ation, and full disclosure of the procedure and its effects are made in the financial statements. "
quasi !reorani.ation must be approved by the stockholders and creditors before it can be placed in
effect.
Re(uirement )
1n eneral. a quasi !reorani.ation is 2ustified when (a) a lare deficit from operations exists, (b) it is an
acceptable alternative to reorani.ation by leal proceedins, (c) the carryin value of the assets is
sinificantly more than realistic oin!concern values, (d) a break in the continuity of the historical cost
basis is clearly needed so that realistic financial reportin is possible, (e) the balances of retained
earnins and contributed capital are inadequate to absorb the decreases in the oin!concern asset
values, and (f) the accountin ad2ustment appears to be desirable to all parties concerned
Re(uirement -
(a) ;ecause the evidence indicates that the company has reached a turnin point and that profitable
operations can be expected hereafter, a quasi !reorani.ation to eliminate the accumulated deficit
would be appropriate if the stockholders and creditors approve it. The purpose of eliminatin the
deficit$and the purpose of a quasi!reorani.ation$is to relieve the company from the handicap of
reportin past losses which result in unfavorable reportin of current financial position even after
conditions resultin in the losses have chaned sinificantly. Therefore, elimination of the deficit
appears acceptable.
(b) " company that elects a quasi !reorani.ation enerally cannot show enouh earnin power to 2ustify
a write!up of operatin land and buildins and usually needs to write them down instead. "ny fiure
that is to be accepted as representin market value must stand all the economic tests of value,
includin the ability of the company to earn a market return based on such values. 1n view of the
results of prior yearsS operations, to write up the recorded value of operatin land and buildins would
not be appropriate, even thouh there is some evidence to 2ustify reater expectations of future
benefits. _uasi!reorani.ations that result in net write!ups are not in conformity with enerally
Chapter +( (:*(, Corporations= /etained &arnins O
#tock <ptions
accepted accountin principles. The device is not intended for situations where chanes in the
eneral price level or current value suest an upward revision of asset values on the books.
4owever. Brite!ups and write!downs within a roup of assets that would not result in a net write!up
are acceptable.
(c) ;ecause an PassetP continent upon havin enouh income in the next () years to use the operatin
loss carryforward should not be recorded unless there is a stron presumption!of reali.ation, settin
up the asset at the time of the quasi!reorani.ation is not appropriate even thouh the future
operations for the company are expected to be profitable. "ssets continent upon the profitability of
the future should not be recorded at the time of quasi!reorani.ation.
Chapter +( (,*(, Corporations= /etained &arnins O
#tock <ptions
CHAPTER )): EARNIN6S PER SHARE
%. What is the fundamental difference in *F" computations and reporting between a simple capital
structure and a comple+ capital structure?
Answer: 1n a simple capital structure, a sinle presentation (if the basic amounts for earnins per
share is presented. " simple capital structure is one in which stockholders8 equity either consists only
of common stock or does not contain convertible securities, stock warrants, or other rihts convertible
to common stock.
1f a firm has a complex capital structure, it presents=
Fully diluted &3#$this calculation is based on common stock plus the number of shares of common
stock that would be issued assumin all convertible securities, warrants. etc. with dilutive effects are
converted to common stock. This calculation represents maximum dilution of &3#.
2. Is the annual dividend on cumulative convertible preferred stock outstanding all year subtracted from
net income in computing basic *F"? If so, why?
Answer: Jes, because basic &3# treats all preferred stock the same way. whether or not convertible.
The dividends reduce the actual return to common shareholders because the preferred was not
converted durin the period.
5. *+plain the treasury stock method.
Answer: The treasury stock method is used to compute the number of incremental equivalent
common shares when a complex capital structure includes stock rihts, warrants, options, and other
similar securities. The treasury stock method assumes that the rihts, etc., will be exercised and the
required number of common shares issued. The cash that would be received (at the option price)
from the recipients is assumed to be invested in the acquisition of treasury common shares (at the
averae price for the period). The difference between the two amounts$the assumed number of
shares that would be issued and the assumed number of treasury shares that would be acquired$
represents the number of common stock equivalents associated with rihts, etc., that must be added
to the weihted averae number of common shares outstandin.
(. /riefly, how are stock dividends and splits reflected in the calculation of basic *F" if the dividend or
split occurs &a' before the balance sheet date, or &b' after the balance sheet date but before the
issuance of the statements?
Answer: ;oth situations are treated the same way in that all common stock transactions occurrin
before the dividend or split are ad2usted. The only difference is that substantive stock transactions
could occur after stock dividends and splits that are issued before the balance sheet date. #uch
substantive stock transactions would not be ad2usted. This could not occur for stock dividends and
splits occurrin after the balance sheet date.
6. Why are dividends from dilutive convertible preferred stock added back to the numerator of basic
*F" without ta+ effect. but interest recogni,ed on dilutive convertible bonds is added back to the
numerator on an afterCta+ basis?
Answer: There is no tax effect for dividends declared or paid. 1nterest reduces net income on an
after!tax basis. Therefore, the amount added back must also be after!tax.
!. What is the difference between a dilutive security and an antidilutive security? Why is the distinction
important in *F" computations?
Chapter ++ (*(: &arnins per #hare
Answer: " dilutive security is a security that causes a reduction in the earnins per share amount. "n
example is stock rihts for which the market value of the stock exceeds the option price of the stock.
"n antidilutive security is a security that causes the opposite effect, an increase in the earnins per
share amount above that which would otherwise be reported. "n example is stock rihts for which the
market value of the stock is less than the option price. The distinction is important in earnins per
share considerations because dilutive securities are included in the computation of diluted earnins
per share, whereas antidilutive securities are omitted from the computation.
%5. What is the $B) method, and why is it useful?
Answer: The I*" method computes a ratio for each potentially dilutive security. The ratio is the
addition to income divided by the increased number of outstandin shares. ;y orderin these ratios,
smallest to larest, the dilutive securities can be used one by one until maximum dilution is achieved.
This occurs when the I*" ratio for the next security exceeds the calculation of &3# usin all other
securities with lower I*" ratios (i.e., larer dilutive effects).
1t is useful because it ives a means of proceedin one security at a time. For example, if there are
(7 potentially dilutive securities, at most (7 calculations are required. "lternatively, +(7 calculations
((7+@) would be required to evaluate all possible sets.
%6. *+plain in general how to handle actual conversions of convertible dilutive securities *F" purposes
&denominator effect only'.
Answer: ;asic &3# reflects the shares from actual conversion weihted for the portion of the period
after conversion. Iiluted &3# reflects the denominator effect from assumed conversion weihted for
the portion of the period before conversion.
E-22-1 E3S C%lcul%tion'
%. 0n $ecember 5%, %##!, Case. Inc.. had 5..,... shares of common stock issued and outstanding.
Case issued a %. percent stock dividend on 1uly, %, %##-. 0n 0ctober %, %##-, Case purchased 29,...
shares of its common stock for treasury and recorded the purchase using the cost method. What is the
number of shares that should be used in computing primary earnings per share for the year ended
$ecember 5%, %##-?
a. 5.6,....
b. 5.#,....
c. 529,....
d. 55.,....
Answer: C. The requirement is the number of shares to be used in computin (555 earnins per
share (&3#). For &3# purposes, shares of stock issued as a result of stock dividends or splits should
be considered outstandin for the entire period in which they were issued. Therefore, both the oriinal
077,777 shares and the additional .07,777 shares (.(7 x 077,777) are treated as outstandin for the
entire year. The (7*(*59 purchase of +@,777 treasury shares results in a weihted averae reduction
of :,777 shares (0*(+ x +@,777) because the shares were not outstandin for three months durin
(559. Therefore, the number of shares for &3# computations is 0+@,777=
<utstandin (+*0(*5,.......................... 077,777
#tock dividend (.(7 x 077,777)............ 07,777
(7*( purchase (0*(+ x +@,777)............. (:,777)
0+@,777
2. "eco Corporation was incorporated on 1anuary 2, %##!. 7he following information pertains to "ecoKs
common stock transactions<
Chapter ++ +*(: &arnins per #hare
199*
1anuary 2 6umber of shares authori,ed............................................ -.,...
=ebruary % 6umber of shares issued . . . . . . . . . . . . . . . .................... 6.,...
1uly % 6umber of shares reac@uired but not canceled................. (,...
$ecember % 7woCforCone stock split
)t $ecember 5%, %##!, the number of shares of "ecoKs common stock outstanding is
a. %(.,....
b. %2.,....
c. %%(,....
d. %%.,....
Answer: D. ;efore the stock split :7,777 shares of common stock were issued, of which ),777
shares were reacquired. "ny time stock is reacquired. it is not considered outstandin. Therefore,
there were )),777 (:7,777 ^),777) shares outstandin before the two!for!one stock split and ((7,777
()),777 x +) shares outstandin after the stock split.
5. )t $ecember 5%, %##-, and %##!. Iow Corporation had %..,... shares of common stock and %.,...
shares of ( percent. 4%.. par value cumulative preferred stock outstanding. 6o dividends were
declared on either the preferred or the common stock in %##- or %##!. 6et income for %##- was
4%,...,.... =or %##-. earnings per common share amounted to
a. 4%.....
b. 4#.(..
c. 4#....
d. 4(....
Answer: B. The formula for earnins per common share is=
(6(,777,777 net income ! 6)7,777 preferred dividends)@((77,777 common shares outstandin) G 65.)7
1n calculatin the numerator, the claims of preferred shareholders aainst (559 earnins should be
deducted to arrive at the (559 earnins attributable to common shareholders. This amount is 6)7,777
C(.7)) (6(77) x ((7,777 shares)D. The 6)7,777 preferred dividends in arrears are not deducted to
compute the numerator in determinin (559 &3#. This is because the 6)7,777 dividends in arrears
are a claim of preferred shareholders aainst (55, earnins and would reduce (55, &3#.
9. *arnings per share data must be reported on the face of the income statement for which of the
following, assuming the company has an accounting principle change it reports?
Inco+e #o+ Cu+ul%ti1e Eect o % Ch%n"e
Continuin" Ope#%tion' in *ccountin" 3#inciple
a. 8es 8es
b. 8es 6o
c. 6o 6o
d. 6o 8es
Answer: B. &arnins per share data must be shown on the face of the income statement. &arnins
per share amounts must be presented for (() income from continuin operations and (+) net income.
&3# for the cumulative effect of a chane in accountin principle must be disclosed either on the face
of the income statement or in the notes to the financial statements.
(. 2ann, Inc. had 5.,... shares of common stock issued and outstanding at $ecember 5%, %##6. 0n
1uly %, %##!, an additional (.,... shares of common stock were issued for cash. 2ann also had
une+ercised stock options to purchase 9.,... shares of common stock at 4%( per share outstanding, at
the beginning and end of %##!. 7he average market price of 2ann3s common stock was 42. during
Chapter ++ 0*(: &arnins per #hare
%##!. What is the number of shares that should be used in computing diluted earnings per share for
the year ended $ecember 5%, %##!?
a. 52(,....
b. 55(,....
c. 56.,....
d. 56(,....
Answer: B. The requirement is to determine the number of diluted shares that should be used in
computin (55, diluted earnins per share. The first step is to compute the weihted averae number
of common shares outstandin. 077,777 shares were outstandin the entire year, and )7,777 more
shares were outstandin for six months, resultin in a weihted averae of 0+),777 C077,777 H
()7,777 x :*(+)D. #econd, because of the stock options, the denominator effect of the options must be
computed. This is done usin the treasury stock method as illustrated below=
"ssumed proceeds C@7,777 x 6()D...........................6:77,777
#hares issued..............................................................@7,777
#hares required C6:77,777 L 6+7D...............................(07,777)
1ncremental shares.......................................................(7,777
The stock options are dilutive because the exercise price is less than the market value. Therefore, the
number of shares used for computin diluted earnins per share is 00),777 C0+),777 H (7,777D.
E 22-2 C%lcul%tin" 0iluted E3S
%. 1ones CorporationKs capital structure is<
$ecember 5%
%##! %##6
0utstanding shares of stock
Common %%.,... %%.,...
Convertible preferred %.,... %.,...
- percent convertible bonds 4%,...,... 4%,...,...
$uring %##!, 1ones paid dividends of 45... per share on its preferred stock. 7he preferred shares are
convertible into 2.,... shares of common stock. 7he - percent bonds are convertible into 5.,...
shares common stock. 6et income for %##! is 4-(.,.... )ssume that the income ta+ rate is 5.
percent. 7he diluted earnings per share for %##! is
a. 4(.9-.
b. 4(.66.
c. 4(.-%.
d. 46.26.
Answer: B. Iiluted &3# is based on common stock and all dilutive securities. To determine if a
security is dilutive, &3#, includin the effects of the security. must be compared to a benchmark &3#.
1n this case. the benchmark or basic &3# is 6,.@).
(69)7,777 net income ! 607,777 preferred dividends)@(((7,777 common shares outstandin) G 6,.@)
First, compute the I*" rate for each potentially dilutive security. The effect of the convertible bonds is
to increase the numerator by 6):,777 Cinterest of 697,777 (6(,777,777 x .79) less 6+@,777 tax effect
(697,777 x .07)D, and increase the denominator by 07,777 shares.
The effect of the convertible preferred stock is to increase the numerator by 607,777 Cdividends,
(7,777 shares x 60 per shareD and increase the denominator by +7,777 shares.
Chapter ++ @*(: &arnins per #hare
I*" ratio= convertible bonds G 6):,777*07,777 G 6(.9,
I*" ratio= convertible preferred G 607,777*(7,777 G 6(.)7
The convertible preferred is introduced first because its I*" ratio is the lowest, and it is less than
basic &3#.
Tentative I&3# G (69)7,777 ! 607,777 H 607,777)(((7,777 H +7,777) G 6:.)@. The convertible bonds
are now introduced because 6:.)@ ` 61.9,. Final I&3# G
(69)7,777 ! 607,777 H 6):,777 H 607,777)*(((7,777 H 07,777 H +7,777) G 6).::
2. )ntidilutive stock options would generally be used in the calculation of
,%'ic E%#nin"' pe# Sh%#e 0iluted E%#nin"' pe# Sh%#e
a. 8es 8es
b. 8es 6o
c. 6o 6o
d. 6o 8es
Answer: C. Computations of diluted earnins per share should not ive effect to common stock
equivalents or other continent issues for any period in which their inclusion would have an
antidilutive effect (i.e., increase the earnins per share amount or decrease the loss per share amount
otherwise computed).
5. Co+ Corporation had %,2..,... shares of common stock outstanding on 1anuary % and $ecember 5%,
%##!. In connection with the ac@uisition of a subsidiary company in 1une %##6. Co+ is re@uired to
issue (.,... additional shares of its common stock on 1uly %, %##- to the former owners of the
subsidiary. Co+ paid 42..,... in preferred stock dividends in %##! and reported net income of
45,9..,... for the year. Co+Ks diluted earnings per share for %##! should be
a. 42.-5.
b. 42.!2.
c. 42.6!.
d. 42.(6.
Answer: D. The requirement is to compute the diluted earnins per share (I&3#) for (55,. The
purpose of I&3# is to show the maximum potential dilution of current earnins per share (&3#) on a
prospective basis. Therefore, all continent issuances of common stock that reduce current &3# must
be included in the computation. The formula for I&3# is=
?et income available to common shareholders
Beihted averae common shares outstandin H #hares from dilutive securities
The net income available to common shareholders is 60,+77,777. This is the net income of
60,@77,777 less the preferred stock dividend of 6+77,777. The weihted!averae common shares
outstandin is (,+)7,777. This is computed at the actual common shares outstandin for the full year
of (,+77,777 plus the continent common shares of )7,777 which were outstandin for the full year
because the continency is removed because of the passae of time.
Thus, I&3# G 60,+77,777*(,+)7,777 G 6+.):
Chapter ++ )*(: &arnins per #hare
9. 6ewt Corporation had earnings per share of 4%2... for %##-, before taking, any dilutive securities
into consideration. 6o conversion or e+ercise of dilutive securities took place in %##-. ?owever,
possible conversion of convertible preferred stock would have reduced earnings per share to 4%%.#..
7he effect of possible e+ercise of common stock warrants would have reduced earnings per share by
an additional 4...(. =or %##-, what must 6ewt report as diluted earnings per share?
a. 4%2....
b. 4%%.#(.
c. 4%%.%..
d. 4%%.-(.
Answer: D. The capital structure of the corporation is complex because it contains dilutive securities.
" complex capital structure requires a dual presentation of earnins per share. The diluted &3# is
6((.9) (6((.57 ! 6.7)).
E 22-3 0iluted E3S
%. $ilutive stock options would generally be used in the calculation of which of the following?
a. 6o 6o
b. 6o 8es
c. 8es 8es
d. 8es 6o
Answer: B. ;asic earnins per share are computed based only on outstandin common stock, while
diluted earnins per share are based on common stock and all dilutive securities. Iilutive stock
options are only used in the calculation of diluted earnins per share.
2. 7he ifCconverted method of computing earnings per share data assumes conversion of convertible
securities as of the
a. /eginning of the earliest period reported &or at time of issuance, if later'.
b. /eginning of the earliest period reported &regardless of time of issuance'.
c. 2iddle of the earliest period reported &regardless of time of issuance'.
d. *nding of the earliest period reported &regardless of time of issuance'.
Answer: A. The if!converted method of computin earnins per share assumes that convertible
securities are converted at the beinnin of the earliest period reported or at the time of issuance, if
that date is later.
5. "uppose a companyKs convertible debt is dilutive in determining earnings per share. What would be
the effect of considering the convertible debt in calculating the following?
a. $ecrease $ecrease
b. Increase 6o effect
c. 6o effect $ecrease
d. $ecrease Increase
Answer: C. ;asic earnins per share are computed based only on outstandin common stock, while
diluted earnins per share are based on common stock and all dilutive securities. Iilutive convertible
debt instruments are used only in the calculation of diluted earnins per share.
Chapter ++ :*(: &arnins per #hare
9. In determining basic or diluted earnings per share, dividends on nonconvertible cumulative preferred
stock should be
a. $isregarded.
b. )dded back to net income whether declared or not.
c. $educted from net income only if declared.
d. $educted from net income whether declared or not.
Answer: D. The requirement is to determine the treatment of nonconvertible cumulative preferred
dividends in determinin basic and diluted &3#. Iividends on nonconvertible cumulative preferred
shares should be deducted from net income whether an actual liability exists or not, because
cumulative preferred stock owners must receive any dividends in arrears before future dividend
distributions can be made to common stockholders.
E 22-4 *n%l!Fe the C%pit%l St#uctu#e. *1e#%"e Sh%#e'< Co+pute E3S )t the end of %##! the records
of /lock Corporation reflected the following<
Common stock, par 4(, authori,ed (..,... shares<
0utstanding %BlB%##!, 9..,... shares.....................................42,...,...
"old and issued 9B%B%##!, 2,... shares..........................................%.,...
Issued (> stock dividend, #B5.B%##!, 2.,%.. shares...................%..,(..
Freferred stock, 6>. par 4%., nonconvertible, noncumulative,
authori,ed (.,... shares, outstanding during year, 2.,... shares2..,...
Contributed capital in e+cess of par, common stock........................%-.,...
Contributed capital in e+cess of par, preferred stock........................%..,...
:etained earnings &after the effects of current preferred dividends
declared during %##!'...................................................................69.,...
/onds payable, 6CV>, nonconvertible, issued at par %BlB#!..........%,...,...
Income before e+traordinary items...................................................%-2,...
*+traordinary loss &net of ta+'...........................................................&%-,...'
6et income........................................................................................%69,...
)verage income ta+ rate.........................................................................9.>
Required:
%. Is this a simple or comple+ capital structure? *+plain.
2. What kind of *F" presentation is re@uired? *+plain.
5. Compute the re@uired *F" amounts &show computations'.
9. Compute the re@uired *F" amounts, assuming that the preferred is cumulative.
Answers:
%e&uirement '
This is a simple capital structure because (a) the preferred stock is nonconvertible, (b) the bonds payable
are nonconvertible, and (c) there are no rihts, options, or other securities convertible to common stock.
%e&uirement (
Chapter ++ ,*(: &arnins per #hare
;ecause this is a simple capital structure. only a sinle set of &3# amounts is presented for income
before extraordinary items and net income.
%e&uirement )
Computations of &3# amounts=
(a) 3referred dividend claim for current year=
6+77,777 x :F G 6(+,777. /econi.ed on the noncumulative preferred stock because the current
year preferred dividend has been declared.
(b) "verae number of common shares outstandin durin year=
A$tu"/ Retr"$ti2e Mnths Sh"re-
Time Peri1 Sh"res A1Lustment Outst"n1ing Mnths
Manuary (, shares outstandin @77,777
Manuary ( to Karch 0( @77,777 x (.7) x 0 G (,+:7,777
"pril (, sold additional shares +,777
"pril ( to #eptember 07 @7+,777 x (.7) x : G +,)0+,:77
#ept 07, (55), )F stock dividend +7,(77
#ept 07 to Iecember 0( @++,(77 x 0 G (,+::,077
Total #hare Konths (+ ),7)9,577
"verae number of shares outstandin, ),7)9,577 L (+ G @+(,),)
(c) &arnins per share on common stock=
1ncome before extraordinary items (6(9+,777 !6(+,777N) L @+(,),) shares G 6.@7
&xtraordinary lossNN (6(9,777) L @+(,),) shares G (.7@)
?et income (6(:@,777 ! 6(+,777N) L @+(,),) shares G 6.0:
N 3referred dividend claim.
NN ?et required to be shown on face of the income statement. ;ut if not, the value must be in the
notes
%e&uirement *
"ssumin the preferred stock is cumulative, the &3# amounts, in this case, would be the same as
computed in /equirement 0 because (a) the current preferred dividend claim must be honored for
cumulative preferred stock whether declared or not and (b) the claim must be honored for noncumulative
preferred stock only if declared (the situation iven in the problem data$see the notation for retained
earnins).
E 22-2 Co+pute E3S o# Th#ee Be%#'. Stoc= 0i1idend %nd Split :ambo CorporationKs accounting year
ends on $ecember 5%. $uring the following three years, its common shares outstanding changed as
follows<
199+ 199* 199,
"hares outstanding, 1anuary % %(.,... %2.,... %..,...
"ales of shares, 9B%B%##6 2.,...
2(> stock dividend, !B%B%##! 5.,...
2CforC% stock split, !B%B%##- %(.,... L
"hares sold, %.B%B%##- (.,... GGGGGG GGGGGG
"hares outstanding, $ecember 5% 5(.,... %(.,... %2.,...
6et Income 45!(,... 455.,... 42##,...
L =or each share turned in, two new shares were issued so that the shares
doubled.
Required:
%. =or purposes of calculating *F" at the end of each year, for each year independently, determine the
number of shares outstanding.
2. =or purposes of calculating *F" at the end of %##-, when comparative statements are being prepared
on a threeCyear basis, determine the number of shares outstanding for each year.
5. Compute *F" for each year based on year computations in &2'.
Answers:
%e&uirement '
This is a simple capital structure. For (55:, because the +7,777 added shares were sold at the start of the
second quarter, on an equivalent basis they were outstandin a of the year.
(77,777 oriinal shares H (0*@ x +7,777) G ((),777
For (55,, because the only chane was due to a stock dividend, reardless of when it occurred durin
the year, the year!end fiure of ()7,777 shares outstandin would be used for &3# purposes as thouh
that number had been outstandin for all of (55,.
For (559, it is important to note that the +!for!( stock split occurred on Muly ( before the sale on <ctober
(. 4ad the sale not occurred, for &3# purposes there would have been 077,777 shares outstandin for all
of (559. The sale of )7,777 shares at the start of the fourth quarter adds an equivalency of (+,)77
shares. Therefore, 077,777 shares H ((*@ x )7,777) G 0(+,)77.
%e&uirement (
1**+: 1n the context of comparative statements, there would be no chane in the 0(+,)77 shares
calculated in /equirement ( for (559.
1**>: The doublin of the number of shares durin (559 would pro2ect back to (55,, raisin the ()7,777
for (55, (standin alone) to 077,777.
1**5: For (55:, because the "pril ( sale of +7,777 shares preceded the +) percent stock dividend of
(55, and the +!for!( split of (559, a multiplier effect of +.) (i.e., (.+) x +) applies to the +7,777 shares, as
well as to the oriinal (77,777 shares, as shown below=
)59 )-.r-1
D"te Origin"/ St$< St$<
1**5 Sh"res Di2i1en1 S#/it Tt"/ Mnths Tt"/
Manuary ( (77,777 x (.+) x + +)7,777 (+ 0,777,777
"pril ( +7,777 x (.+) x + )7,777 5 @)7,777
Totals (+7,777 0,@)7,777
0,@)7,777 L (+ months G +9,,)77 weihted averae shares for comparative &3# purposes in the (559
financial report.
%e&uirement )
',,. ',,- ',,3
?et 1ncome.................................................................... 60,),777 6007,777 6+55,777
"v. shares outstandin (includin stock divs and split) 0(+,)77 077,777 +9,,)77
&arnins per share........................................................ 6(.+7 6(.(7 6(.7@
E 22-19 Co+ple5 C%pit%l St#uctu#e %nd Repo#tin" E3S 7he 0mega Company reports the following<
Income from continuing operations.............................4%,.......
*+traordinary item.........................................................5,...,...
6et income..................................................................49........
"hares outstanding<
=or basic *F".......................................%,...,...
=or diluted *F"....................................%,(..,...
Income adustments to be made<
Inco+e &eo#e
E5t#%o#din%#! Ite+ Net Inco+e
=or diluted *F" 42..,... 42..,...
Required: What *F" figures would 0mega report? What are their values?
Answer:
;asic &3#
1ncome before extraordinary item (6(,777,777*(,777,777 shs.).....................6(.77
&xtraordinary item (60,777,777*(,777,777 shs.)...............................................0 .77N
?et income (6@,777,777*(,777,777 shs.)........................................................6@ .77
I&3#
1ncome before extraordinary item (6(,+77,777*(,)77,777 shs.).....................67.97
&xtraordinary item (60,777,777*(,777,777 shs.)...............................................+ .77N
?et income (6@,+77,777*(,)77,777 shs.)........................................................6+ .97
N Kay be reported in the notes.
Chapter ++ (7*(: &arnins per #hare
E 22-11 Co+ple5 C%pit%l St#uctu#e %nd Repo#tin" E3S 7he 1ones Company reports the following<
Income before e+traordinary item................................4%,.......
*+traordinary item.......................................................... &2.,...'
6et income.....................................................................4#-.....
"hares outstanding<
=or basic *F".......................................%,...,...
=or diluted *F"....................................%,%..,...
Income adustments to be made<
Inco+e &eo#e
E5t#%o#din%#! Ite+ Net Inco+e
=or diluted *F" 4-.,... 4-.,...
Required: What *F" figures would 0mega report? What are their values?
Answer:
;asic &3#
1ncome before extraordinary item (6(,777,777*(,777,777 shs.).....................6(.77
?et income (6597,777*(,777,777 shs.)...........................................................67.59
I&3#
1ncome from continuin operations (6(,797,777*(,(77,777 shs.)...................67.59
?et income (6(,7:7,777*(,(77,777 shs.)........................................................67.5:
E 22-13 Option' %nd the Co+put%tion o> E3S :and Inc. had a net income from continuing operations
of 4-..,.... $uring the year in @uestion, 2..,... shares were outstanding on average. $uring the year,
:andKs common stock sold at an average market price of 4(.. In addition, :and had 2.,... options
outstanding to purchase a total of 2.,... shares at 42( for each option e+ercised.
Required:
%. )re the options dilutive? Compute basic *F" for income from continuing operations.
2. Compute diluted *F".
Answer:
(. #ince the option price of 6+) is below the market price, the options are Uin the moneyX and dilutive.
;asic &3# G 6977,777*+77,777 G 6@.77.
+. Iiluted &3#=
?umber of #hares= +7,777
"dditional cash on assumed exercise
(+7,777) x 6+) G 6)77,777
Chapter ++ ((*(: &arnins per #hare
#hares repurchased under Treasury #tock Kethod
6)77,777*6)7 G (7,777
?et additional shares
+7,777 ^ (7,777 G (7,777
Iiluted &3# G 6977,777*(+77,777 H (7,777)
G 60.9(
E 22-14 Con1e#ti&le ,ond' %nd the C%lcul%tion o 0iluted E3S "haffer Corporation issued %..,
4%,..., %. percent convertible bonds in %##6 at face value. *ach bond is convertible into %.. shares of
common. "hafferKs net income from continuing operations for %##! is 4%,-29,... &45,.9.,... before
ta+'. 7he 4%,-29,... reflects one yearKs interest after ta+. If you consider all factors e+cept convertible
bonds, average common shares outstanding for %##! are %,.%.,....
Required:
%. Compute $*F" &test for dilution'.
2. ?ow would you answer &%' if the bonds were issued 1uly %, %##!?
5. Ignoring &2', how would the answer to &%' change if half the bonds were converted 1uly %, %##!?
Answer:
%e&uirement '
;asic &3# G 6(,9+@,777*(,7(7,777 G 6(.9(
The tax rate is ( ^ (6(,9+@,777*0,7@7,777) G .@7
?umerator effect of bonds G (77 (6(,777)(.(7)(.:7) G 6:,777
Ienominator effect of bonds G (77 ((77) G (7,777
I*" ratio G 6:,777*(7,777 G 6.:7 W 6(.9(% therefore the bonds are dilutive.
I&3# G (6(,9+@,777 H 6:,777)*((,7(7,777 H (7,777) G 6(.,5
%e&uirement (
?et income from continuin operations would be one!half a year8s after!tax interest larer, or 60,777
larer. The numerator and denominator effects would be halved but the I*" ratio would remain
unchaned.
;asic &3# G (6(,9+@,777 H 60,777)*(,7(7,777 G 6(.9(
I&3# G (6(,9+@,777 H 60,777)*((,7(7,777 H ),777) G 6(.97
%e&uirement )
?et income from continuin operations would be 6(,9+@,777 H 6:,777 ((*@) G 6(,9+),)77. This 6(,)77
increase is the after!tax interest saved on the converted bonds for E year
(6,777)((77)(.(7)(.:7)((*+ year)((*+ issue).
;asic &3# G 6(,9+),)77*(,7(7,777 H (7,777 ((*@) G 6(.97
?umerator effect= )7 (6(,777) (.(7) (.:7) H )7 (6(,777) (.(7) (.:7) ((*+) G 6@,)77
Chapter ++ (+*(: &arnins per #hare
Ienominator effect= ),777 H ),777 ((*+) G ,,)77. <ne!half of the issue was convertible bonds the entire
year, ivin rise to ),777 shares upon assumed conversion. The other half of the issue was convertible
bonds only one!half a year, ivin rise to +,)77 shares on assumed conversion.
I&3# G (6(,9+),)77 H 6@,)77)*((,7(7,777 H +,)77 H ,,)77) G 6(.,5
E 22-15 *n%l!Fe C%pit%l St#uctu#e. Stoc= Split< Con1e#ti&le Secu#itie'< Co+pute E3S )t the end of
%##!, the records of :uso Corporation reflected the following<
Common stock, noCpar, authori,ed 2(.,... shares< issued and outstanding
throughout the period to %2BlB%##!, 6.,... shares. ) stock split issued
%2B%B%##! doubled outstanding shares..................................................4-9.,...
Freferred stock, (>, par 4%., nonconvertible, cumulative, nonparticipating,
shares authori,ed, issued, and outstanding during year, %.,... shares. .%..,...
Contributed capital in e+cess of par, preferred stock...................................5.,...
:etained earnings &no cash or property dividends during year'.................(!.,...
/onds payable, ->, issued %B%B%##!D each 4%,... bond is convertible into 6.
shares of common stock after the stock split on %2B%B%##! &bonds initially
sold at par'...............................................................................................2..,...
Income before e+traordinary items..............................................................-6,...
*+traordinary loss.......................................................................................&%9,...'
6et income...................................................................................................!2,...
)verage income ta+ rate..................................................................................5.>.
Required:
%. Is this a simple or a comple+ capital structure? *+plain.
5. Compute the re@uired *F" amounts &show computations, rounded to two decimal places, and assume
that all amounts are material'.
Answers:
%e&uirement '
This is a complex capital structure because of the convertible bonds. The preferred stock is
nonconvertible and cumulative.
%e&uirement (
;ecause this is a complex capital structure, a dual set of &3# amounts$basic &3# and diluted &3#$is
reported for (a) income before extraordinary items, (b) extraordinary items, and (c) net income.
%e&uirement )
(a) ?onconvertible preferred dividend claim for current year=
6(77,777 x.7) G 6).777 (because cumulative, included whether declared or not).
;asic &3# G (69:,777 ! 6),777)*(+7,777N G 67.:9
Chapter ++ (0*(: &arnins per #hare
N "verae shares outstandin H stock split G :7,777 H :7,777
(b) Iilution!antidilution (I*") test on convertible bonds (conducted usin income before extraordinary
items)=
Compare I*" ratio amount for convertible bonds payable to Tentative &3#=
I*" ratio amount G (6+77,777 x .79 x .,7NN)*(+,777N G 67.50
N (6+77,777 L 6(,777) x :7
NN (77F ! tax rate of 07F
Conclusion=
#ince 67.50 exceeds 67.:9, the convertible bonds payable are antidilutive. Io not include them in
computin diluted &3#. There is only one I*" test because there is only one convertible security.
I&3# G ;asic &3#.
3 22-2 *n%l!Fe C%pit%l St#uctu#e. Stoc= 0i1idend< Con1e#ti&le Secu#itie'( Co+pute E3S )t the end
of %##!, the records of Euholt, Corporation reflected the following<
Common stock, no par, authori,ed (..,... sharesD issued and outstanding
throughout period, %..,... shares........................................................46-.,...
"tock dividend issued, %2B5%B%##!, (.,... shares &not included in the %..,...
shares above'...........................................................................................59.,...
:etained earnings &after effect of dividends on all shares'........................(..,...
/onds payable, 9CV>D each 4%,... bond is convertible to -. shares of common
stock after the stock dividend &bonds issued at par in %##('..................%..,...
/onds payable. 6CV>D each 4%,... bond is convertible to #. shares of common
stock after the stock dividend &bonds issued at par in %##('.....................5..,...
Income before e+traordinary items............................................................2%.,...
*+traordinary gain........................................................................................%2,...
6et income.................................................................................................222,...
)verage income ta+ rate..................................................................................9.>.
Required:
%. Is this a simple or a comple+ capital structure? *+plain.
5. Frepare the re@uired *F" disclosures.
Answers:
%e&uirement '
This is a complex capital structure because there are convertible bonds payable.
%e&uirement (
;ecause this is a complex capital structure, a dual set of &3# amounts$basic &3# and diluted &3#$is
reported for (a) income before extraordinary items, (b) extraordinary items, and (c) net income.
Chapter ++ (@*(: &arnins per #hare
%e&uirement )
Computation of &3# amounts=
(a) #hares from assumed conversion of bonds=
;onds payable, @!EF, convertible, 6(77,777
(6(77,777 L 6(,777) x 97 G 9,777 shares
;onds payable, :!EF, convertible, 6077,777
(6077,777 L 6(,777) x 57 G +,,777 shares
(b) ;asic &3# for income before extraordinary items=
(6+++,777 ! 6(+,777)*((77,777 H )7,777) G 6(.@7
(c) ?umerator effects=
@!EF bonds 6(77,777 (.7@)) (( ! .@) G 6+,,77
:!EF bonds 6077,777 (.7:)) (( ! .@) G 6((,,77
(d) I*" ratios and rankin ';A 0an
@!EF bonds= 6+,,77*9,777 G 67.0@ (
:!EF bonds= 6((,,77*+,,777 G 67.@0 +
(e) I*" Tests
&nter the @!EF bonds into tentative I&3# because 67.0@ W 6(.@7 (;asic &3#). Tentative I&3# G
(6+(7,777 H 6+,,77)*(()7,777 H 9,777) G 6(.0).
&nter the :!EF bonds into tentative I&3# because 67.@0 W 6(.0) (previous tentative I&3#).
Tentative I&3# G final I&3# (there are no more potentially dilutive securities) G (6+(7,777 H 6+,,77
H 6((,,77)*(()7,777 H 9,777 H +,,777) G 6++@,@77*(9),777 G 6(.+(.
(f) &arnins per share
;asic=
1ncome before extraordinary ain.........................................6(.@7
&xtraordinary ain (6(+,777*()7,777).................................... .79
?et income........................................................................... 6(.@9
Iiluted=
income before extraordinary ain.........................................6(.+(
&xtraordinary ain (6(+,777*(9),777).................................... .7:
?et income C(6+++,777 H 6+,,77 H 6((,,77)*(9),777D..........6(.+,
Chapter ++ ()*(: &arnins per #hare
* 22-1 E3S 0i'clo'u#e' )merican ?ome Froducts Corporation &)?F', a large company in the health
care field, reported the following information &dollar amounts in thousands' in its $ecember 5%, %##(
consolidated statement of income<
6et income.................................................................4 %,6-.,9%-
6et income per share of common stock...............................4 (.92
Required:
%. *stimate the average number of common shares outstanding for %##(. )ssume that )?F has
outstanding the entire year 4%.- thousand of 42 preferred stock, par value 42.(.D ( million shares
authori,ed. Indicate any assumptions you are making. 7he stock is not convertible.
2. $oes )?F have a simple or comple+ capital structure?
5. Is )?F re@uired to report *F" figures for the cumulative effect of an accounting change, if present, in
their income statement?
Answers:
%e&uirement '
C6(,:97,@(9 ^ (6(79,777 L 6+.)7) x 6+D*6).@+ G 0(7,7+@,+97 shares
Three important assumptions are=
a. The 6).@+ is basic &3#.
b. The number of outstandin preferred shares did not chane from @0,+77 C6(79,777 L +.)7D durin the
year.
c. The preferred dividends were declared by the firm. (The preferred is not titled as cumulative.)
%e&uirement (
#imple, because "43 has no potential common stock.
%e&uirement )
?o. The presentation of this fiure may appear in the notes if the firm so wishes.
Chapter ++ (:*(: &arnins per #hare
C:*3TER 23. ST*TEMENT OA C*S: A$O-S
%. Compare the purposes of the balance sheet, income statement, and statement of cash flows.
Answer: The purpose of the balance sheet is to report financial position (i.e.. assets. liabilities. and
ownersS equity) as of a specified date (at the end of the reportin period). The purpose of die income
statement is to report the results of operations (i.e., revenues, expenses, ains and losses, and
extraordinary items) for the reportin period. 1t is a chane statement because it reports the detailed
items that comprise net income. which causes ownersS equity to chane (i.e., retained earnins). ;oth
of these statements report accrual!basis amounts. 1n contrast, the statement of cash flows is a cash
flow statement. 1t reports cash flows for three different activities$operatin. investin, and financin.
The primary purpose of the #CF is to provide cash flow information in a manner that maximi.es its
usefulness to investors. creditors. and other interested parties in pro2ectin future cash inflows related
to the enterprise.
2. *+plain the basic difference between the three activities reported in the "C=< operating, investing, and
financing.
Answer: <peratin activities$primarily relates to items reported on the income statement (cash
inflows and outflows)% this relates to its primary operations. includin ains and losses, interest. and
income tax.
1nvestin activities$primarily relates to obtainin productive facilities and investments in other non!
cash assets. These activities include both cash outflows, Pinvestin.P and cash inflows from
disposition of the PinvestmentsP previously made.
Financin activities$primarily relates to obtainin resources for the entity to use (cash inflows) and
the repayment of those PfinancinP activities (e.., payment on debt principal), The primary sources
are borrowin and funds provided by the owners. 1Sm outflows do not include interest on debt.
-. *+plain the basic difference between the direct and indirect methods of reporting on the "C=. Jse net
income, 4(,..., sales revenue, 4%..,..., and an increase in net accounts receivable, 4%.,..., to
illustrate the basic difference. Which method provides the most relevant information to investors and
creditors?
Answer: The difference between the direct and indirect methods relates only to the #CF
classification, cash flows from operatin activities. The direct method reports individual cash inflows
front each ma2or revenue and individual cash outflows for each ma2or expense. The indirect method
reports a reconciliation of net income with net cash flow from operatin activities. This reconciliation
reports chanes in asset and liability accounts directly related to net income.
1llustration
Iirect method
Cash inflow from sales (i.e., from customers).............................. 657,777
1ndirect method=
?et income................................................................................... 6),777
/econciliation
?et accounts receivable increase........................................... ((7,777)
&tc.
Clearly, the information provided by the direct method would be the most relevant to investors and
creditors. The 6(7,777 chane in accounts receivable is already shown on the comparative balance
sheets. "lso, the reconciliation is a required disclosure for the direct method.
Chapter 25 %B%! "tatement of Cash =lows
%.. *+plain why a 4(.,... increase in inventory during the year must be considered when developing
disclosures for operating activities under both the direct and indirect methods.
Answer: The 6)7,777 increase in inventory must be used in the #CF calculations because it
increases the amount of cash outflows that otherwise would not have occurred, 1t is used as follows=
Iirect method$added to cost of oods sold, accrual basis (the other ad2ustment would involve
accounts payable) to compute cost of oods sold, cash basis.
1ndirect method$deducted from net income as a reconcilin item with cash flows from operatin
activities.
%%. What three reconciling amounts must be reported at the bottom of the "C=? Which one must agree
with a key amount in another financial statement? Jse assumed amounts for illustrative purposes.
Answer: The three reconcilin lines are as follows=
?et increase (decrease) in cash durin the period........................ 6((7,777)
Cash balance, beinnin............................................................... )7,777
Cash balance, endin.................................................................... 6@7,777
The 6@7,777 must aree with the endin cash (plus cash equivalents) amounts reported on the
balance sheet.
2.. Is there an inconsistency in the classification of dividends received and dividends paid in the "C=?
$iscuss your answer.
Answer: Iividends received are an operatin cash inflow, yet are related to investments in common
stock, an investin activity. Iividends paid are payments to stockholders, a financin activity, and are
classified as financin cash outflows. The classification of dividends received appears to be counter
to the underlyin nature of the activity.
2%. ?ow is a lease payment &after inception' on a capital lease classified in the "C=?
Answer: The interest portion of the lease payment is classified as an operatin cash outflow,
because all interest is so classified. The principal portion of the payment is a financin cash outflow
because it is a partial extinuishment of a liability$a source of financin.
22. 7rading securities and securities available for sale are treated differently in the statement of cash
flows. What are the maor differences in treatment?
Answer: 3urchases and proceeds from sales (and maturities) of tradin securities (T#) are classified
as operatin cash flows, whereas for securities available!for!sale (#"#), these cash flows are
classified as investin. ;oth types of investments are carried at market value.
The net chane in the balance of investments in T# durin a period (which would include any
unreali.ed ains or losses) is treated as a reconcilin item in the reconciliation of net income and net
operatin cash flow% therefore, neither reali.ed nor unreali.ed ains and losses are reconcilin items.
The chane in T# durin the period takes both types of ains and losses into account, as well as any
purchases or disposals.
The net chane in investments in #"# durin a period is not a reconcilin item because such
investments are not considered an operatin activity. 'nreali.ed ains and losses do not affect
earnins or operatin cash flow and therefore are not found in the reconciliation. /eali.ed ains and
losses, however, are reconciliation ad2ustments because net income has been increased or
decreased without an associated operatin cash flow.
Chapter 25 2B%! "tatement of Cash =lows
E 23-2 SCA. C%'h Alo; *n%l!'i' o S%le' 7he records of OO ?at Company showed sales revenue of
4%..,... &on the income statement' and a change in the balance of accounts receivable. 7o demonstrate
the effect of changes in accounts receivable on cash inflows from customers, five independent cases are
used. Complete the following tabulation for each independent case<
*ccount'
S%le' Recei1%&le
Re1enue Inc#e%'e C%'h
C%'e @#o+ inco+e 't%te+ent7 @dec#e%'e7 Co+put%tion Inlo;
) 4%..,... 4 C.C ........................................ ............
/ %..,... %.,... ........................................ ............
C %..,... &%.,...' ........................................ ............
$ %..,... #,... L ......................................... ............
* %..,... &#,...' L ......................................... ............
LIncludes the effect of a 4%,... writeCoff of an uncollectible account.
Answer:
A$$unts
S"/es Re$ei2"'/e
Re2enue In$re"se C"sh
C"se %.rm in$me st"tement& %1e$re"se& Cm#ut"tin In./w
" 6(77,777 6 !7! ?one .6(77,777
; (77,777 (7,777 6(77,777 ! 6(7,777 57,777
C (77,777 ((7,777) 6(77,777 H 6(7,777 ((7,777
I (77,777 5,777 N 6(77,777 ^ (65,777 H 6(,777) 57.777
& (77,777 (5,777) N 6(77,777 H (65,777 ! 6(,777) (79,777
N1ncludes the effect of a 6(,777 write!off of an uncollectible account.
E 23-5 Multiple Choice. St%te+ent o C%'h Alo;' Choose the correct response for each @uestion.
%. In the statement of cash flows, which of the following would increase reported cash flows from
operating activities under the direct method? Ignore ta+ considerations.
a. $ividends received from investments.
b. Iain on sale of e@uipment.
c. Iain on early retirement of bonds.
d. Change from straightCline to accelerated depreciation.
Answer: "8
2. Which of the following cash flows per share should be reported in a statement of cash flowsK?
a. Frimary cash flows per share only.
b. =ully diluted cash flow per share only.
c. /oth primary and fully diluted cash flows per share.
d. Cash flows per share should not be reported.
Answer: 18
5. Cantova Company sold used e@uipment for a cash amount e@ualing its carrying amount for both book
and ta+ purposes. ) few days later. Cantova replaced the e@uipment by paying a cash down payment
and signing a note payable for new e@uipment. 7he cash down payment e+ceeded the cash received
for the old e@uipment. ?ow should these e@uipment transactions be reported in CantovaKs statement
of cash flows?
a. Cash outflow e@ual to the down payment less the cash received.
b. Cash outflow e@ual to the down payment and note payable less the cash received.
c. Cash inflow e@ual to the cash received and a cash outflow e@ual to the down payment and note
payable.
d. Cash inflow e@ual to the cash received and a cash outflow e@ual to the down payment,
Answer: 18
9. ?ow should a gain from the sale of used e@uipment for cash be reported in a statement of cash flows
using the indirect method?
a. In investment activities as a reduction of the cash inflow from the sale.
b. In investment activities as a cash outflow.
c. In operating activities as a deduction from income.
d. In operating activities as an addition to income.
Answer: $8
(. Would the following be added back to net income in the reconciliation of net income and net
operating cash flow?
E-.ess o/ Tresur0 $!o.1 A.quisi!ion 2ond Dis.oun!
Cos! o3er $les 4ro.eeds (.os! me!"od# Amor!i5!ion
a. 8es 8es
b. 6o 6o
c. 6o 8es
d. 8es 6o
Answer: $8
6. 2alli 2anufacturing Company purchased a threeCmonth J.". 7reasury bill, to be classified as a cash
e@uivalent. In the preparation of 2alliKs statement of cash flows, this purchase would
a. 6ot be reported.
b. /e treated as an outflow from financing activities.
c. /e treated as an outflow from investing activities.
d. /e treated as an outflow from lending activities.
Answer: "8
E 23-7 SCA. Indi#ect Method Cale+ico Inc. reported the following comparative balance sheets for the
current year<
,%l%nce Sheet' G%nu%#! 1 0ece+&e# 31
Cash........................................................ 4 9,... 4 %.,!(.
)ccounts receivable................................ 5,... 2,...
*@uipment............................................... %.,... %(,...
)ccumulated depreciation...................... &%,...' &2,...'
7otal assets.............................................. 4%6,... 42(,!(.
"alaries payable...................................... 4 %,... 4 2,...
EongCterm notes payable......................... (,... (,...
Capital stock........................................... -,... -,...
:etained earnings.................................... 2,... %.,!(.
7otal liabilities and owners3 e@uity......... 4%6,... 42(,!(.
%. 6et income for the current year was 4#,!(..
2. 6o purchases or disposals of e@uipment took place during the year.
Required:
% Frepare the indirect method statement of cash flows for Cale+ico.
2. What additional information would you need to prepare the dire't method statement of cash flows for
this firm?
Answers:
%e&uirement '
C"/eBi$= In$8
St"tement . C"sh 3/ws
3r the Current 7e"r En1e1 De$em'er -1
Operating activities
?et income........................................................... 65,,)7
Iepreciation expense.......................................... (,777
"ccounts receivable decrease............................. (,777
#alary payable increase....................................... (,777
?et cash inflow from operations...................... 6(+,,)7
2nvesting Activities
3urchase of equipment........................................ (),777)
?et cash outflow from investin activities........ (),777)
Iividends paid..................................................... ((,777)
?et cash outflow from financin activities....... ((,777
1ncrease in cash......................................................... :,,)7
Cash, Manuary (......................................................... @,777
Cash, Iecember 0(................................................... 6(7,,)7
N 6+,777 H 65,,)7 ! 6(7,,)7
Chapter 25 (B%! "tatement of Cash =lows
%e&uirement (
To prepare the direct method #CF, income statement information is required. /evenue and expense data,
when combined with the associated chanes in operatin balance sheet accounts, yield the operatin
cash flows that would be reported under the direct method. The operatin cash flows to be determined for
this problem would include collections from customers, payments to suppliers, and payments to
employees.
E 23-11 T#%n'%ction *n%l!'i' 8ou are re@uested by the controller of a large company to determine the
appropriate disclosure for the following transactions in the "C=. )ssume that all adusting entries were
recorded.
a. 7he company wrote off a "9.... account. $uring the year, gross accounts receivable increased
4%..,..., and the allowance for doubtful accounts increased 4%.,.... )ll sales &46..,...' are on
account.
b. Fension e+pense is 4%..,...< the balance of accrued pension cost &cr.' increased 429,....
c. $eferred ta+ liability increased 4-.,..., income ta+es payable decreased 42.,..., and income ta+
e+pense was 422......
d. 42.,... of interest was capitali,ed. Interest e+pense is 4%..,.... 7here is no change in interest
payable.
e. 7he company sold shortCterm investments &cash e@uivalents' at a 49,... gain, proceeds 4%6,....
f. 7he company sold shortCterm investments in securities classified as available for sale at a 49,...
gain, proceeds 4%6,.... 7here was no valuation allowance balance on the securities, and market value
e@ualed cost at the beginning of the period.
Required:
Indicate the complete disclosure of each item in the "C= under &%' the direct method and &2' the indirect
method.
Answer:
The disclosure for the reconciliation of net income and net operatin cash flow is iven separately for
each item, because the reconciliation is reported under both the direct and indirect methods. The
amounts indicated for the direct and indirect methods reflect disclosures other than those for the
reconciliation.
a. /econstructed entries=
"ccounts receivable............................................................. :77,777
#ales............................................................................... :77,777
"llowance for doubtful accounts.......................................... @,777
"ccounts receivable........................................................ @,777
;ad debt expense................................................................ (@,777
"llowance for doubtful accounts
Cash.................................................................................... @5:,777
"ccounts receivable........................................................ @5:,777
?et cash effect G 6@5:,777
?et income effect G 6:77,777 ! 6(@,777 G 6)9:,777
Iirect method= 6)9:,777 operatin cash inflow, collections from customers
1ndirect method= ?o disclosure other than in the reconciliation.
/econciliation= Two different approaches may be used= (() 657,777 subtraction ad2ustment, increase
in accounts receivable (this ad2usts the income effect of 6)9:,777 to equal the cash effect 6@5:,777),
or (+) 6(@,777 addition ad2ustment, bad debt expense% 6(7@,777 subtraction ad2ustment, increase in
ross accounts receivable before the write!off.
b. Iirect method= 6,:,777 operatin cash outflow, payment to pension trustee.
/econciliation= 6+@,777 addition ad2ustment, increase in accrued pension cost.
c. /econstructed entries
1ncome tax expense............................................................. +07,777
Ieferred tax liability......................................................... 97,777
1ncome tax payable......................................................... (@7,777
1ncome tax payable (6(@7,777 H 6+7,777 decrease)........... (:7,777
Cash................................................................................ (:7,777
Iirect method= 6(:7,777 operatin cash outflow, income taxes paid.
/econciliation= 697,777 addition ad2ustment, increase in deferred tax liability% 6+7,777 subtraction
ad2ustment, income tax payable decrease.
d. Iirect method= 6(77,777 operatin cash outflow, interest payments= 6+7,777 investin cash outflow,
payments for capitali.ed interest.
1ndirect method= 6+7,777 investin cash outflow, payments for capitali.ed interest.
/econciliation= ?o ad2ustment.
e. Iirect method= 6@,777 operatin cash inflow, ain on sale of cash equivalents.
1ndirect method= ?o disclosure.
/econciliation= ?o ad2ustment.
(The 6@,777 increase in cash and cash equivalents is reflected in earnins throuh the ain.)
f. Iirect and indirect methods= 6(:,777 investin cash inflow, proceeds from securities available for
sale.
/econciliation= 6@,777 subtraction ad2ustment, ain on sale of securities available for sale.
Chapter 25 !B%! "tatement of Cash =lows
E 23-15 SCE Indi#ect Method. 3#ep%#e the Reconcili%tion o# Ope#%tin" *cti1itie'( 7he data given
below were provided by the accounting records of $arby Company. Frepare the reconciliation of net
income with cash flow from operations for inclusion in the "C=, indirect method.
6et income &accrual basis'................................................... 4 9.,...
$epreciation e+pense........................................................... 4 -,...
$ecrease in wages payable.................................................. 4 %,2..
$ecrease in trade accounts receivable.................................. 4 %,-..
Increase in merchandise inventory....................................... 4 2,(..
)morti,ation of patent......................................................... 4 %..
Increase in longCterm liabilities............................................ 4 %.,...
"ale of capital stock for cash............................................... 4 2(,...
)morti,ation of premium on bonds payable........................ 4 2..
)ccounts payable increase................................................... 4 9,...
"tock dividend issued.......................................................... 4%.,...
Answer:
?et income reported% accrual basis...................................... 6@7,777
"dd (deduct) to reconcile net income to net cash flow=
Iepreciation expense....................................................... 9,777
Iecrease in waes payable.............................................. ((,+77)
Iecrease in trade accounts receivable............................. (,977
1ncrease in merchandise inventory................................... (+,)77)
"morti.ation of patent....................................................... (77
"morti.ation of premium on bonds payable...................... (+77)
"ccounts payable increase............................................... @,777
?et cash inflow from operatin activities.............................. 6)7,777
E 23-17 SCA< Indi#ect Method Oepco Company3s recent comparative balance sheet and income
statement follow<
Co+p%#%ti1e ,%l%nce Sheet'
0ece+&e# 31
144) 1447
)ssets<
Cash.................................................................. 4 (#,... 4 6.,...
)ccounts receivable......................................... 59,... 29,...
Flant assets....................................................... 2!!,... 29!,...
)ccumulated depreciation................................ &%!-,...' &%6!,...'
7otal )ssets...................................................... 4%#2,... 4%69,...
Eiabilities and stockholders3 e@uity<
/onds payable.................................................. 4 9#,... 4 96,...
$ividends payable............................................ -,... (,...
Common stock, 4% par...................................... 22,... %#,...
)dditional paidCinCcapital................................. #,... 5,...
:etained earnings............................................. %.9,... #%,...
7otal liabilities and stockholders3 e@uity.......... 4%#2,... 4%69,...
Chapter 25 -B%! "tatement of Cash =lows
Inco+e St%te+ent
Ao# Be%# Ended 0ece+&e# 31< 144)
"ales revenue................................................. 4%((,...
Cost of goods sold......................................... &%.!,...'
Iross margin................................................. 9-,...
$epreciation e+pense.................................... &55,...'
Iain on sale of e@uipment............................. %5,...
6et income.................................................... 42-,...
%. $uring %##-, e@uipment costing 49.,... was sold for cash.
2. $uring %##-, 42.,... of bonds payable were issued in e+change for property, plant and e@uipment.
7here was no amorti,ation of bond discount or premium.
:e@uired< Frepare Oepco3s statement of cash flows under the indirect method.
Answer:
Me#$ Cr#r"tin
3r the 7e"r En1e1 De$em'er -1= 1**+
Operating activities
?et income........................................................... 6+9,777
Iepreciation expense.......................................... 00,777
"ccounts receivable increase.............................. ((7,777)
>ain on sale of equipment................................... ((0,777)
?et cash inflow from operations...................... 609,777
3roceeds from sale of equipment........................ 60(,777
a
3urchase of equipment........................................ ()7,777)
a
?et cash outflow from investin activities........
((5,777)
/etirement of bonds............................................ 6((,,777)
b
Iividends paid..................................................... ((+,777)
c
1ssuance of common stock.................................. 5,777
d
?et cash outflow from financin activities....... (+7,777
?et decrease in cash.................................................. ((,777)
Cash at beinnin of year.......................................... :7,777
Cash at end of year.................................................... 6)5,777
?on!cash activity schedule=
"cquisition of plant assets throuh bond issuance 6+7,777
Chapter 25 #B%! "tatement of Cash =lows
Computation=
a
To determine cash proceeds from sale of equipment and purchase of equipment=
&ntry for sale of equipment=
Cash (derived)..................................................................... 0+,777
"ccumulated depreciation.................................................... ++,777 N
3lant assets.................................................................... @7,777
>ain................................................................................ (0,777
N600,777 depreciation ! 6((,777 increase in accumulated depreciation
4lant Assets
(*( balance +@,,777 N @7,777 cost of assets sold
acquisition (bonds) +7,777 R
ac$uisition <cas!=/derived 5.)... R
(+*0( balance +,,,777 R
b
6(,,777 bond retirement G 6+7,777 bond issuance ! 60,777 net increase in bonds payable.
c
To determine dividends paid=
%etained Earnings
R 5(,777 (*( balance
(**+ dividends declared <derived= (5)... R +9,777 (559 earnins
R (7@,777 (+*0( balance
Di5idends 4ayable
R ),777 (*( balance
(**+ dividends paid (1)... R (),777 (559 dividends declared
R (7@,777 (+*0( balance
d
65,777 proceeds from common stock issuance G 60,777 chane in common stock H 6:,777 chane in
additional paid!in capital.
Chapter 25 %.B%! "tatement of Cash =lows
3 23-2 SCA< Indi#ect Method 7he following is 0rem CorporationKs comparative balance sheets for %##-
and %##!.
0ece+&e# 31
144) 1447
Cash................................................................ 4 9..,... 4 5(.,...
)ccounts receivable....................................... (69,... (-9,...
Inventories...................................................... #29,... -(!,(..
Froperty, plant and e@uipment....................... %,6(5,(.. %,9-5,(..
)ccumulated depreciation............................. &(-2,(..' &(2.,...'
Investment in /elle Co................................... %(2,(.. %5!,(..
Eoan receivable.............................................. %5(,... GGGGGGG
7otal assets..................................................45,29!,(..
........................................................42,-#2,(..
)ccounts payable........................................... 4 (.!,(.. 4 9!!,(..
Income ta+es payable..................................... %(,... 2(,...
$ividends payable.......................................... 9.,... 9(,...
Capital lease obligation.................................. 2..,...
Capital stock, common, 4% par...................... 2(.,... 2(.,...
)dditional paidCin capital.............................. !(.,... !(.,...
:etained earnings........................................... %,9-(,... %,59(,...
7otal liabilities and stockholders3 e@uity....45,29!,(..
........................................................42,-#2,(..
%. 0n $ecember 5%, %##!, 0rem ac@uired 2( percent of /elle CompanyKs common stock for 4%5!,(...
0n that date, the carrying value of /elleKs net assets and liabilities, which appro+imated fair value,
was 4((.,.... /elle reported income of 46.,... for the year ended $ecember 5%, %##-. 6o dividend
was paid on /elleKs common stock during the year.
2. $uring %##-, 0rem loaned 4%(.,... to Chase Company, an unrelated company. Chase made the first
semiannual principal repayment of 4%(,..., plus interest at %. percent, on 0ctober %, %##-.
5. 0n 1anuary 2, %##-, 0rem sold e@uipment costing 45.,..., with a carrying value of 4%!,(.., for
42.,... cash.
9. 0n $ecember 5%, %##-, 0rem entered into a capital lease for an office building. 7he present value of
the annual rental payments is 42..,..., which e@uals the fair value of the building. 0rem made the
first rental payment of 45.,... when due on 1anuary 2, %###.
(. 0remKs net income for %##- was 4%-.,....
6. 0rem declared and paid cash dividends for %##- and %##! as follows<
144) 1447
$eclared........................ $ec. %(, %##- $ec. %(. %##!
Faid............................... =eb. 2-. %### =eb. 2-. %##-
)mount......................... 49.,... 49(,...
Chapter 25 %%B%! "tatement of Cash =lows
Required: Frepare the %##- statement of cash flows for 0rem using the indirect method. Frepare relevant
supplemental schedules.
Answer:
/econstructed (559 entries front additional information=
(. 1nvestment in ;elle Co. 6:7,777 (.+))....................... (),777
1nvestment income............................................... (),777
There was no oodwill on the purchase= 6(0,,)77 (cost of investment) G (.+)) (6))7,777 book value and
fair value of ;elleSs net assets at purchase of investment).
+. -oan receivable.......................................................... ()7,777
Cash.................................................................... ()7,777
Cash........................................................................... ++,)77
1nterest revenue (.(7) (6()7,777) ((*+)................ ,,)77
-oan receivable................................................... (),777
0. Cash........................................................................... +7,777
"ccumulated depreciation.......................................... (+,)77N
3roperty, plant and equipment............................. 07,777
>ain on sale of equipment................................... +,)77
N 607,777 ! 6(,,)77
@. 3roperty, plant and equipment.................................... +77,777
Capital lease obliation........................................ +77,777
Orem Cr#r"tin
<peratin activities
?et income........................................................................... 6(97,777
"d2ustments to reconcile net income to net operatin
cash flow
'ndistributed earnins of ;elle Co................................... ((),777)
>ain on sale of equipment................................................ (+,)77)
Iepreciation expense....................................................... ,),777
"ccounts receivable decrease.......................................... +7,777
1nventories increase.......................................................... (:,,)77)
"ccounts payable increase............................................... 07,777
1ncome taxes payable decrease......................................... ((7,777)
?et operatin cash flow.............................................. 6+(7,777
1nvestin "ctivities
-oan to Chase Company..................................................... (()7,777)
3roceeds from sale of equipment........................................ +7,777
Collection of principal payment on loan............................... (),777
?et investin cash flow............................................... (((),777)
Chapter 25 %2B%! "tatement of Cash =lows
Financin activities
Iividends paid..................................................................... (@),777)
?et Financin cash flow............................................. (@),777)
?et increase in cash................................................................ )7,777
Cash at beinnin of year....................................................... 0)7,777
Cash at end of year................................................................. 6@77,777
N "ccumulated depreciation increased 6:+,)77, net, durin (559, but was reduced
6(+,)77 on the sale of equipment. Therefore, depreciation expense was 6,),777.
1on-cash acti5ity schedule
"cquisition of office buildin throuh capital lease..................................... 6+77,777
3 23-14 SCA( Indi#ect Method. Option%l Sp#e%d'heet 7he income statement, balance sheet, and
analysis of selected accounts of "ummer Company are given below.
,%l%nce Sheet
0ece+&e# 31 Inc#e%'e
0e&it' 1447 144) @dec#e%'e7
Cash plus shortCterm investmentsL......... 4 -.,... 4 -#,-.. 4 #,-..
)ccounts receivable &net'....................... %2.,... %.(,... &%(,...'
2erchandise inventory &perpetual'......... 56.,... 2-5,2.. &!6,-..'
Frepaid insurance.................................... 9,-.. 2,9.. &2,9..'
Investments, longCterm........................... 6.,... &6.,...'
Eand........................................................ 2.,... !6,-.. (6,-..
Flant assets.............................................. (..,... (%-,... %-,...
Fatent &net'.............................................. 5,2.. 2,-.. &9..'
................................................................ 4%,%9-,... 4%,.!-,... 4&!.,...'
C#edit'
)ccumulated depreciation...................... 4 %5.,... 4 %(-,... 4 2-,...
)ccounts payable.................................... %..,... %.6,... 6,...
Wages payable........................................ 9,... 5,... &%,...'
Income ta+es payable.............................. %-,... 26,-.. -,-..
/onds payable......................................... 2..,... %..,... &%..,...'
Fremium on bonds payable..................... %.,... 5,9.. &6,6..'
Common stock, par 4%........................... 6..,... 6%2,... %2,...
Contributed capital in e+cess of par........ 5.,... 56,... 6,...
:etained earnings.................................... (6,... 52,-.. &25,2..'
................................................................ 4%,%9-,... 4%,.!-,... 4&!.,...'
Inco+e St%te+ent 144)
"ales revenue............................................. 4 -..,...
Cost of goods sold...................................... &99-,-..'
$epreciation e+pense................................. &2-,...'
Fatent amorti,ation.................................... &9..'
:emaining e+penses &including interest'.... &2-!,-..'
*+traordinary gain, net of 4(,... ta+......... %(,...
6et income................................................. 4 (.,...
)nalysis of selected accounts and entries<
a. Furchased operational assetD cost, 4%-,...D payment by issuing %,2.. shares of stock.
b. Fayment at maturity date to retire bonds payable, 4%..,6...
c. "old the longCterm investments for 4-.,.... 7he market value of these securities classified as
available for sale had not changed until %##-.
d. Furchased land, 4(6,-..D paid cash.
e. =urther information<
:etained earnings, beginning balance.................................. 4(6,...
Frior period adustment, income ta+, paid in %##-............... &%5,2..'
6et income, %##-................................................................. (.,...
Cash dividend paid.............................................................. &6.,...'
*nding balance.................................................................... 452,-..
Required: Frepare the "C=, indirect method.
Answer:
#preadsheet=
Cm#"r"ti2e B"/"n$es B"/"n$es
B"/"n$e Sheets 1)@-1@*> Dr8 Cr8 1)@-1@*+
Cash and short!term investments... 97,777 (q) 5,977 95,977
"ccounts receivable, net................. (+7,777 (),777 (b) (7),777
Kerchandise inventory.................... 0:7,777 ,:,977 (c) +90,+77
3repaid insurance........................... @,977 +,@77 () +,@77
1nvestments, lon!term................... :7,777 :7,777 (k)
-and............................................... +7,777 (m) ):,977 ,:,977
3lant............................................... )77,777 (l) (9,777 )(9,777
3atent, net...................................... 0,+77 @77 (f) +,977
"ccumulated depreciation.............. ((07,777) +9,777 (e) (()9,777
Total "ssets................................ (,7(9,777 5+7,777
"ccounts payable........................... (77,777 :,777 (d) (7:,777
Baes payable............................... @,777 (h) (,777 0,777
1ncome taxes payable..................... (9,777 9,977 (i) +:,977
;onds payable................................ +77,777 (n) (77,777 (77,777
3remium on bonds payable............ (7,777 (2) :,:77 0,@77
Common stock, 6(7 par.................. :77,777 (+,777 (l) :(+,777
Contrib capital in excess of par....... 07,777 :,777 (l) 0:,777
/etained earnins.......................... ):,777 (p) :7,777 )7,777 (a) 0+,977
................................................... TTTTTTTT (o) (0,+77 TTTTTTT
Total -iabs O <wners8 &quity...... (,7(9,777 TTTTTTT TTTTTTT 5+7,777
Total Chanes............................ +:),@77 +:),@77
"d2ustments -eadin to #CF=
In1ire$t Meth1
O#er"ting A$ti2ities Dr8 Cr8
?et income..................................... )7,777 (a) )7,777
#ales............................................... 977,777 (b) (),777
Cost of oods sold.......................... @@9,977 (c) ,:,977
....................................................... (d) :,777
Iepreciation................................... +9,977 (e) +9,777
3atent amorti.ation......................... @77 (f) @77
/emainin expenses...................... +9,,977 () +,@77
....................................................... (,777 (h)
....................................................... (i) 9,977
....................................................... :,:77 (2)
&xtraordinary ain.......................... +7,777 +7,777 (k)
Tax on extraordinary ain............... ),777
3rior period ad2ustment$tax pymt. (0,+77 (o)
#n5esting Acti5ities
#ale of investments........................ (k) 97,777
3urchase of land............................. ):,977 (m)
Financing Acti5ities
/etirement of bonds....................... (77,777 (n)
Iividends paid................................ :7,777 (p)
....................................................... +),,:77
?et cash increase........................... TTTTTTT 5,977 (q)
....................................................... +:,,@77 +:,,@77
Summer Cr#r"tin
$ash flow from operating acti5ities:
?et income........................................................................... 6)7,777
"dd (deduct) to reconcile net income to net cash flow
Iepreciation expense....................................................... +9,977
"morti.ation of patent....................................................... @77
&xtraordinary ain on lon!term investment..................... (+7,777)
Iecrease in prepaid insurance......................................... +,@77
Kerchandise inventory decrease...................................... ,:,977
"morti.ation of bond premium.......................................... (:,:77)
"ccounts receivable decrease.......................................... (),777
"ccounts payable increase............................................... :,777
Baes payable decrease................................................. ((,777)
1ncome taxes payable increase........................................ 9,977
3ayment on prior years8 income tax (prior period ad2.)...... ((0,+77)
?et cash inflow from operatin activities.............................. 6(@:,:77
$ash flow from in5esting acti5ities:
#old lon!term investment................................................... 97,777
3urchased land.................................................................... ():,977)
?et cash inflow from investin activities (?ote ").................... +0,+77
Chapter 25 %(B%! "tatement of Cash =lows
$ash flow from financing acti5ities:
Cash dividends paid............................................................. (:7,777)
;onds payable retired.......................................................... ((77,777)
?et cash outflow from financin activities............................... ((:7,777
?et increase in cash and cash equivalents durin (559......... 5,977
Cash and cash equivalents balance, Manuary (, (559............ 97,777
Cash and cash equivalents balance, Iecember 0(, (559...... 695,977
?ote " 3urchased operational asset, cost 6(9,777% paid in full by issuin (,+77 shares
of common stock.
* 23-2 U'in" the -o#ld -ide -e&. St%te+ent o C%'h Alo;' 7his problem re@uires access to the
World Wide Web portion of the Internet. 7he data for use in this problem is the most recent %.CP annual
report of Cisco "ystems. 7o obtain that information, use the "ecurities and *+change CommissionKs
*lectronic $ata Iathering, )nalysis and :etrieval "ystem &*$I):' to retrieve CiscoKs report. "teps to
access *$I): on the World Wide Web<
a. J:E< http<BBwww.sec.govBinde+.html &the "*CKs home page'.
b. Click on *$I): $atabase of Corporate Information.
c. Click on "earch We *$I): $atabase.
d. Click on "earch the *$I): )rchives.
e. *nter the company name in the search dialog bo+.
f. Click on the listing for the most recent %.CP annual report.
g. Jse *dit, =ind in the toolbar to locate the statement of cash flows.
Required: )nswer the following @uestions related to CiscoKs statement of cash flows for the most recent
year available or for the period specified by your instructor.
%. What method does Cisco use to present its statement of cash flows?
2. Comment on the difference between net income and net operating cash flow for the three years
presented in the annual report. Which items caused the most significant differences between earnings
and net operating cash flow?
5. $escribe CiscoKs investment behavior, both in shortCterm investments and in other longerCterm
investments.
9. ?ow does Cisco report the difference between the earnings and the cash flow effects of accounts
receivable?
(. Comment on CiscoKs use of leverage, and whether there is a trend in the use of longCterm debt
financing,
6. Comment on the trend in capital e+penditures and depreciation amounts shown in the "C=. Is there a
relationship Cbetween the two?
Answers:
(1nstructorSs note= This solution is based on the (55: (7!Y report of Cisco #ystems, which was the latest
report available at the time of publication. 3lease inform your students as to the particular year you wish
to use for the problem. This solution provides a template for the year you choose. "lthouh the numerical
values will be different in the solution for the current year, this solution should be a useful uide.)
(. Cisco uses the indirect method.
+. The difference between earnins and operatin cash flow is relatively minor, althouh it increased
each year in the three!year period endin (55:. 1n particular, the difference rew from a few 6million
in (55@ and (55) to 6(@5 million in (55:. 4owever, compared to many other lare firms, earnins
and operatin cash flow are very similar in amount.
The item contributin the most to the difference between the two amounts chanes across reportin
years, but the chanes in inventories and receivables are consistently amon the larest amounts.
Iepreciation, tax benefits and the chane in accrued liabilities also contribute sinificantly to the
difference.
0. ;oth purchases and proceeds from sale and maturity of short!term investments increased
dramatically over the period. The level of passive investment may at first seem unusual iven CiscoSs
rowin dominance in its business. 4owever. the firm is so successful it may be unable to find
appropriate acquisitions fast enouh to deplete its cash horde. The firm also is increasin its loner!
term investments includin acquisitions and property and equipment.
@. Cisco does not use the sinle line!item method of ad2ustin earrins for the chane in net accounts
receivable. The amount listed as the ad2ustment for the chane in receivables in the reconciliation
does not equal the chane in net accounts receivable. "pparently Cisco uses the chane in ross
accounts receivable before write!offs, and then adds a second ad2ustment for bad debt expense
(listed as provision for doubtful accounts).
). The #CF shows no debt issuances for the three!year period. Cisco only issued stock, and purchased
a similar amount of treasury stock durin the period. The balance sheet lists no lon!term debt at the
end of (55:b CiscoSs only debt is classified as current.
:. Cisco is increasin its investment in plant and equipment, but the level of this investment is
sinificantly smaller than in other types of investments, both passive and strateic, as shown in the
#CF. The depreciation ad2ustments in the reconciliation are rowin rapidly in manitude, in part due
to the increased investment in plant and equipment, and in part due to the short averae useful life of
between +.) and ) years (footnote ().
Chapter 25 %!B%! "tatement of Cash =lows
CHAPTER )4: ACCO?NTIN6 CHAN6ES AND ERROR CORRECTIONS
5. Complete the following schedule<
Method o Relectin" the EectM
&%' GGGGGGGG &2' GGGGGGGG &5' GGGGGGG
a. Change in estimate GGGGGGGG GGGGGGGG GGGGGGGG
b. Change in principle GGGGGGGG GGGGGGGG GGGGGGGG
c. Correction of error GGGGGGGG GGGGGGGG GGGGGGGG
L Identify these three captions< then enter appropriate checkmark on each line.
Answer:
Meth1 . Re./e$ting the E..e$tA
%1& %)& %-&
Current/0 Prs#e$ti2e/0 Retr"$ti2e/0
a. Chane in estimate B
b. Chane in principle B B (exceptions)
c. Correction of error B
(. *+plain the basic difference between an accounting change and an error correction.
Answer: "n accountin chane involves a chane in accountin (a) principle, (b) estimate, or (c)
entity. 1t is made with intent and by decision. "li accountin error involves incorrect application of
accountin principles and estimates, and mathematical errors. "ccountin errors usually are made
inadvertently and are not planned.
6. Why are the effects of changes from EI=0 to other inventory flow methods accounted for
retroactively when changes to EI=0 from another method are reflected as changes in the income of
the year the change is made?
Answer: Iurin a period of increasin inventory costs. under -1F< the same quantity of inventory
retains the initial value assined to it when -1F< was first adopted. 1ncreasin costs coupled with the
passae of an extended time interval causes unrealistically low inventory carryin values under -1F<.
" switch to some other method in such circumstances could result in a lare credit, which would
create Pinstant reported profitsSN if the effect of the chane were allowed to be reflected in current
income. Chanin to -1F< from another method usually would have a neative effect on income in
the period of the chane. /eportin such losses, but not ains, on the income statement can be
traced to the concept of conservatism.
!. 0ther than changing from EI=0 to another inventory flow method &which must be reflected
retroactively', what other types of accounting changes must be accorded retroactive treatment rather
than being accounted for using the current approach?
Answer: Chanes in the method of accountin for income on lon!term construction contracts, a
chane to or from the Pfull costP method in extractive industries, a chane in accountin principles
related to a forthcomin issuance of capital stock by closely!held company, a chane required by an
"3; or F"#; pronouncement, and a chane from retirement*replacement accountin to depreciation
accountin for railroad track structures, are accounted for retroactively as special exceptions to the
current approach.
%%. What is the difference between a counterbalancing and a nonCcounterbalancing error? Why is the
distinction significant in the analysis of errors?
Chapter +@ (*(( "ccountin Chanes and &rror Corrections
Answer: " counterbalancin (self!correctin) error results from failure to properly allocate an expense
or revenue item between two consecutive accountin periods. ?o error remains in retained earnins
or other balance sheet accounts at the end of the second period because the total revenue and total
expense to that date are correct. 4owever, the interim reports are incorrect.
" non!counterbalancin (not self!correctin) error continues to affect the account balances and
reports beyond a two!year period.
This distinction is sinificant in the analysis of errors because the correctin entry depends upon
whether the error is counterbalancin or non!counterbalancin, as well as upon when the error is
corrected relative to when the error was made.
%2. Complete the schedule below by entering a plus sign to indicate overstatement. a minus sign to
indicate understatement, or a ,ero for no effect.
Eect o E##o# On
Net O;ne#'>
Inco+e *''et' $i%&ilitie' E?uit!
a. *nding inventory for %##! understated<
%##! financial statements
. %##- financial statements
b. *nding inventory for %##- overstated<
%##- financial statements
c. =ailed to record depreciation in %##!<
d. =ailed to record a liability resulting from
revenue collected in advance at end of
%##!D instead credited revenue in full
erroneously<
Answer:
E..e$t . Errr On
Net OwnersF
In$me Assets Li"'i/ities E(uit0
a. &ndin inventory for (55, understated=
(55, financial statements ! ! 7 !
(559 financial statements H 7 7 7
b. &ndin inventory for (559 overstated=7
(55, financial statements H H 7 H
(559 financial statements ! 7 7 7
c. Failed to record depreciation in (55,=
(55, financial statements H H 7 H
(559 financial statements 7 H 7 H
d. Failed to record a liability resultin from
revenue collected in advance at end of
(55,% instead credited revenue in full
erroneously=
(55, financial statements H 7 ! H
(559 financial statements ! 7 7 7
Chapter +@ +*(( "ccountin Chanes and &rror Corrections
E 24-1 Multiple Choice. *ccountin" Ch%n"e' Choose the correct answer to each @uestion.
%. Which of the following is a change in accounting principle?
a. Correction of an error using the retroactive approach.
b. Change from an incorrect method to a correct method.
c. Change in the application of an accounting principle.
d. Change in the number of total e+pected service miles for depreciating a truck.
Answer: $8
2. Which of the following is not the type of accounting change that reports a cumulative effect in the
income statement?
a. Change to the successful Cefforts method of accounting for natural resources.
b. Change to EI=0 for a firm in its second year that is able to reconstruct EI=0 inventory layers.
c. Change in depreciation method.
d. Change in method of amorti,ing bond discount.
Answer: "8
5. :etroactive accounting treatment is used for which of the following?
a. Correcting errors and making estimate changes.
b. Changing to EI=0 and correcting errors affecting income of prior years.
c. Changing to the completedCcontract method of accounting for longCterm contracts.
d. Correcting errors affecting prior yearsK income, but only if those prior years are disclosed on a
comparative basis with the current year.
Answer: $8
9. ) company changed from percentage of completion &FC' to completed contract &CC' for financial
accounting purposes during %##-. 7herefore<
a. /eginning 1anuary %, %##-, CC should be used for construction accounting, and the difference
between the income under the two methods for years before %##- is disclosed in the %##- income
statement.
b. /eginning 1anuary %, %##-, CC should be used for construction accounting, but no entry is made
for the effects of the change on years before %##-.
c. /eginning 1anuary %, %##-, CC should be used for construction accounting. and the difference
between the income under the two methods for years before %##- is an adustment to the 1anuary
%, %##- retained earnings balance.
d. Fro forma income amounts are disclosed in a schedule to the income statement for all years
before %##- shown in the %##- annual report.
Answer: $8
(. Choose the correct statement concerning comparative financial statements.
a. 7hey are re@uired by the )F/.
b. 7hey are re@uired by the "*C.
c. 7he number of statements presented comparatively affects the recorded amount of a cumulative
effect of a change in accounting principle.
d. =irms generally do not disclose more than one year because financial statement users already
have access to the reports of previous years.
Answer: '8
Chapter +@ 0*(( "ccountin Chanes and &rror Corrections
6. 0ne of the advantages of the current, or cumulative effect, change is
a. Consistency is maintained.
b. Frior yearsK income effects do not affect income in the year of change.
c. 7he statements of previous years shown comparatively do not disclose any information about the
effect of the change in those previous years.
d. Frior yearsK financial statements are not altered.
Answer: 18
!. Fro forma income numbers
a. "omewhat reduce the loss of comparability inherent in current, or cumulative effect. accounting
principle changes.
b. )re re@uired only for the year of change.
c. )re re@uired for changes in estimates.
d. *@ual the effect of the accounting change on income for each year shown.
Answer: "8
-. Fro forma net income for the year of a change in accounting principle e@uals
a. 6et income for the year of change.
b. 6et income for the year of change under the new method.
c. 6et income before e+traordinary items for the year of change.
d. 6et income before cumulative effect of changes in accounting principle for the year of change.
Answer: 18
E 24-2 O1e#1ie;. T!pe' o *ccountin" Ch%n"e' %nd E##o#' )naly,e each case and enter a letter code
in each column &type and approach' to indicate the basic accounting.
T!pe *pp#o%ch
F W Frinciple
* W *stimate C W Current
: W *ntity : W :etroactive
C%'e @e1ent o# t#%n'%ction7 )* W *rror F W Frospective
%. :ecorded e+pense, 4-!.D should be 4!-.....................................
2. Changed useful life of a machine.................................................
5. Changed from singleCcompany to consolidated financial statements..

9. Changed from straightCline to accelerated depreciation...............
(. Change in residual value of an intangible operational asset.........
6. Changed from cash basis to accrual basis in accounting for bad debts..

!. Changed from percentage of completion to completed contract for
longCterm construction contracts..................................................
-. Changed from EI=0 to =I=0 for inventory..................................
#. Changed to a new accounting principle re@uired by the =)"/... .
Chapter +@ @*(( "ccountin Chanes and &rror Corrections
Answer:
T0#e A##r"$h
3 G 3rinciple
& G &stimate C G Current
/ G &ntity / G /etroactive
C"se %e2ent r tr"ns"$tin& "& G &rror 3 G 3rospective
(. /ecorded expense, 69,7% should be 6,97.............................................. "& /
+. Chaned useful life of a machine............................................................ & 3
0. Chaned from sinle!company to consolidated financial statements...... / not discussed
@. Chaned from straiht!line to accelerated depreciation.......................... 3 C
). Chane in residual value of an intanible operational asset................... & 3
:. Chaned from cash basis to accrual basis in accountin for bad debts.. "& /
,. Chaned from percentae of completion to completed contract for
lon!term construction contracts.............................................................. 3 /
9. Chaned from -1F< to F1F< for inventory............................................... 3 /
5. Chaned to a new accountin principle required by the F"#;................ 3 /
E 24-4 Ch%n"e in 0ep#eci%tion Method =ourC?, Inc., changed from straightCline to an accelerated
depreciation method for book purposes only in %##-. $ata for years affected by the change<
144) 1447 1442
Increase in depreciation due to change............. 4 2.,... 42(,... 4 5.,...
Income computed under the "E methodL......... %..,... #.,... %2.,...
L)fter ta+D the ta+ rate is 9.>. 7he income amount shown for %##- was computed before
considering the accounting change.
Required:
%. Frovide the %##- entry to record the accounting change.
2. What is reported net income for %##-?
5. What is the %##! pro forma net income amount?
Answer:
%e&uirement '
Cumulative effect of accountin chane........ 00,777 NN
Ieferred income tax liability ............................... ++,777
"ccumulated depreciation ...................... )),777N
N 6+),777 H 607,777
NN ((!.@7) 6)),777
%e&uirement (
6(77,777 ! 6+7,777 (.:7) ! 600,777 G 6)),777
%e&uirement )
657,777 ! 6+),777 (.:) G 6,),777
Chapter +@ )*(( "ccountin Chanes and &rror Corrections
E 24-) Ch%n"e in E'ti+%ted U'eul $ie %nd S%l1%"e 8%lue o# % 3l%nt *''et /ellico Company,
which has a calendar fiscal year, purchased its only depreciable plant asset on 1anuary %, %##!, which has
the following characteristics<
0riginal cost........................................... 4%.,...
*stimated residual value......................... %,...
*stimated useful life .............................. three years
$epreciation method .............................. sumCofCyearsKCdigits
In %##-, /ellico increased the estimated residual value to 42,... and increased the total estimated useful
life to five years for financial accounting purposes. )dditional information<
1447 144)
:evenue............................................................... 4 9.,... 4 (.,...
*+penses other than depreciation and ta+............ 2(,... 5.,...
*+traordinary loss before ta+............................... (,...
7a+ rate................................................................ 5.> 5.>
Common shares outstanding entire year.............. %..,... %..,...
Required:
% Frovide the %##- entry&ies' for depreciation and the ending %##- accumulated depreciation balance.
2. Frovide the comparative %##! and %##- income statements, including disclosures related to the
accounting change.
Answers:
%e&uirement '
(559 Iepreciation before accountin chane=
(6(7,777 ! 6(,777) x +*:............................................................................. 60,777
(559 Iepreciation after accountin chane=
;ook value, Manuary (, (559 G 6(7,777 ! (65,777 x 0*:) G 6),)77
(559 depreciation G (6),)77 ! 6+,777) x @*(7 G ......................................... (.@77
(at Manuary (, (559, four years remain)
Iifference, before tax ................................................................................ 6(,:77
(**+ entry to record depreciation
Iepreciation expense ............................................................ (,@77
"ccumulated depreciation ............................................ (,@77
Iecember 0(. (559 "ccumulated Iepreciation balance=
(55, depreciation (65,777 x 0*:)...................................... 6@,)77
(559 depreciation............................................................. (,@77
(559 endin "ccumulated Iepreciation..................... 6),577
Chapter +@ :*(( "ccountin Chanes and &rror Corrections
%e&uirement (
BELLICO COMPAN7
In$me St"tements
3r 7e"rs En1e1 De$em'er -1
1**> 1**+
/evenues......................................................................... 6@7,777 6)7,777
&xpenses other than depreciation and tax=....................... (+),777) (07,777)
Iepreciation expense ...................................................... (@,)77) ((,@77)
?et income before extraordinary item and tax ................. (7,)77 (5,:77
1ncome tax expense (07F) .............................................. (0, ()7) (),)97)
?et income before extraordinary item .............................. ,,0)7 (0,7+7
&xtraordinary loss,, net of 6(,)77 tax .............................. TTTTT (0,)77)
?et income ...................................................................... 6 ,,0)7 6 5,)+7
?et income before extraordinary item............................................ 6.7, 6.(0
?et income.................................................................................... 6.7, 6.75)
3tnte: Iurin (559, the estimated useful life and residual value on a plant asset were chaned in
liht of new information. The chane increased net income before extraordinary items and net income
6(,(+7 (6(,:77 x ,7F) or 6.7( per share.
E 24-13 *n%l!'i' o Se1en E##o#'. Co##ectin" Ent#ie'< Co##ect 3#et%5 Inco+e 7he %##! income
statement of /urke Corporation has ust been tentatively completed. It reflects preta+ income for %##! of
4-(,.... 7he accounts have not been closed for the year ended $ecember 5%, %##!. ) review of the
companyKs files and records revealed the following errors that have not been corrected<
a. Fatent amorti,ation of 45,... per year was not recorded in %##6 and %##!.
b. 7he %##( ending inventory was overstated by 49,....
c. 2achinery ac@uired on 1anuary %, %##5, at a cost of 426,... is being depreciated by the straightCline
method over %. years. 7he goodCfaith estimate of its residual value of 46,... has not been included in
the computation of depreciation e+pense.
d. )ccrued wages of 4%,(.. at $ecember 5%, %##6, were not recogni,ed.
e. ) 4%,... cash shortage during %##! was debited to retained earnings.
f. 0rdinary repairs on the machinery in &c' above of 4!,..., incurred during 1anuary %##!, were debited
to the machinery account.
g. $uring %##!, treasury stock that cost 4-,... was sold for 4%%,.... 7he difference was credited to
e+traordinary gain. 7he company uses the cost method to account for treasury stock.
Required:
%. Iive the correcting entry, if needed, for each of the above errors. *+plain the basis and show
computations for each item. Ignore income ta+ considerations.
2. Compute the correct preta+ income amount for %##!. "et up an appropriate schedule that reflects each
change and the correct %##! preta+ income.
Chapter +@ ,*(( "ccountin Chanes and &rror Corrections
Answers:
%e&uirement '
Correctin entries=
a. 3rior period ad2ustment correction (patent amorti.ation, (55:)............ 0,777
3atent amorti.ation expense, (55, ..................................................... 0,777
3atent ......................................................................................... ..... :,777
b. ?o correctin entry because this error self!corrected by the end of (55:. For the (55, comparative
financial statements (which include (55:), the 6@,777 inventory (beinnin) overstatement (for (55:)
would have to be incorporated into the (55: statements for comparability reasons.
c. "ccumulated depreciation (6:77 x ) years) ........................................ 0,777
Iepreciation expense, (55, ......................................................... :77
3rior period ad2ustment, correction (depreciation. 6:77 x @ yrs.)... +,@77
Computations=
Iepreciation per year (6+:,777 L (7 yrs.)................................6+,:77
Correct amount of depreciation per year
C(6+:.777 ! 6:.777 G 6+7.777) L (7 yrs.D................................+,777
Iepreciation overstatement per year ....................................6 :77
d. 3rior period ad2ustment, correction (waes)......................................... (,)77
Bae expense, (55,..................................................................... (,)77
e. Cash shortae(expense)...................................................................... (,777
/etained earnins......................................................................... (,777
f. To correct the entry made in Manuary (55,=
/epair expense, (55,.......................................................................... ,,777
Kachinery...................................................................................... ,,777
3resumably the company recorded!depreciation based on the balance in the machinery account%
therefore, depreciation on this 6,,777 was included in depreciation expense for (55,. The excess
depreciation must be reversed in (55,.
"ccumulated depreciation (6,,777 L : years remainin)..................... (,(:,
Iepreciation expense, (55,.......................................................... (,(:,
. The difference between the cost and sellin price of treasury stock is properly recorded as a chane
in contributed capital. " corporation cannot reconi.e a ain (loss) by dealin in its own capital stock.
&xtraordinary ain (treasury stock)...................................................... 0,777
Contributed capital from treasury stock transactions..................... 0,777
%e&uirement (
(55,
Tentative pretax income (iven)........................................................... 69),777
Corrections:
a. 3atent amorti.ation (debit)............................................................ (0,777)
b. ?o effect on net income................................................................. !7!
c. Iepreciation expense (credit)........................................................ :77
d. Bae expense (credit)................................................................... (,)77
e. Cash shortae (debit).................................................................... ((,777)
f. /epair expense (debit).................................................................. (,,777)
Iepreciation correction (credit)...................................................... (,(:,
. &xtraordinary ain (debit).............................................................. (0,.777)
Correct (55, pretax income.......................................................... 6,@,+:,
3 24-1 Multiple Choice. *ccountin" Ch%n"e' Choose the correct answer to each of the following
@uestions<
%. Immutable Company changed from the sumCofCyearsKCdigits method &"8$' to the straightCline
method &"E' of depreciation in %##-. $epreciation under each method for the years affected follows<
Be%# SB0 S$
%##( 42.. 4%(.
%##6 29. %6.
%##! 6.. 9(.
%##- 9(. (..
Ignoring ta+es, Immutable reports which of the following amounts in cumulative effect of change in
accounting principle in %##-?
a. 42-. cr.
b. 425. cr.
c. 4(. dr.
d. 452. dr.
Answer: ". (6+77 H 6+@7 H 6:77) ! (6()7 H 6(:7 H 6@)7) G 6+97
2. Tuick Company changed depreciation methods for accounting purposes and correctly computed a
cumulative effect before ta+ of 46.. &reduces income'. 7he ta+ rate is 5. percent. 7he entry to record
the change in accounting principle includes
a. Cr. accumulated depreciation 492..
b. $r. deferred ta+ liability 4%-..
c. $r. income ta+es payable 492..
d. $r. cumulative effect 46...
Answer: '. 07F x 6:77 G 6(97
5. =ido $og =ood Company changed its method of accounting for inventory from EI=0 to =I=0 in %##-
for both ta+ and financial accounting purposes. 7he %##! ending inventory was 49.,... under EI=0
and 4((,... under =I=0. =ido discloses %##! and %##- results comparatively. 7he ta+ rate is 5.
percent. 7he entry to record the change in accounting principle includes
a. Cr. inventory 4%(,....
b. Cr. retained earnings 4%.,(...
c. Cr. cumulative effect of change in accounting principle 4%.,(...
d. Insufficient information.
Answer: '. (6)),777 ! 6@7,777) x ,7F G 6(7,)77
9. )n asset purchased 1anuary %, %##9, costing 4%.,... with a %.Cyear useful life and no salvage value
was depreciated under the straightCline method during its first three years. $uring %##!, the total
useful life was reCestimated to be %! years. What is depreciation in %##-?
a. 4962.
b. 49%2.
c. 4969.
d. 4(...
Answer: 1. ;ook value, Manuary (, (77, G 6(7,777 ^ (6(7,777*(7) x 0 G 6,,777
(559 depreciation G 6,,777*((, ! 0) G 6)77
(. ) company made a retroactive accounting change in %##-. 0nly the net incomes of %##! and %##-
were affected. 7herefore, the comparative retained earnings statements featuring both years disclose
which of the following?
a. ) cumulative effect adusting the 1anuary %, %##!. retained earnings balance.
b. ) cumulative effect adusting the 1anuary %, %##!, and %##- retained earnings balances.
c. ) cumulative effect adusting the 1anuary %, %##-, retained earnings balance.
d. 6o cumulative effect.
Answer: $.
C 24-2 Ethic%l Con'ide#%tion'. *ccountin" Ch%n"e' In %#-2, :7* Corporation, a manufacturer of
electric power transmission and distribution e@uipment, more than doubled its *F" by changing
depreciation methods. In ustifying the change, the controller said, HWe reali,ed that, compared to our
competitors, our conservative method of depreciation might have hurt #s with investors because of its
negative impact on net earningsH &H$ouble "tandard,H Forbes4 6ovember 22, %#-2, p. %!-'.
)lthough difficult to prove, there is considerable evidence that accounting changes are made for
reasons other than improved financial reporting. I))F is fle+ible in the initial selection of accounting
methods and in making subse@uent changes. ?owever, A1 O2inion No( /* specifically re@uires that only
changes to preferable accounting methods be made.
!e"#ired$ Comment on the appropriateness of making accounting changes to fulfill financial reporting
obectives. Consider relevant ethical issues in your response.
Answer:
The accountin profession requires that accountin chanes be made only if the chane is preferable,
From A3: Opinion No. 1., par. (:=
The presumption that an entity should not chane an accountin principle may be overcome
only if the enterprise 2ustifies the use of an alternative acceptable accountin principle on the
basis that it is preferable. T!e burden o& >usti&ying ot!er c!anges rests %it! t!e entity proposing
t!e c!ange. (author emphasis added).
Chapter +@ (7*(( "ccountin Chanes and &rror Corrections
1n addition, auditors must make a 2udment as to the acceptability of accountin chanes. The profession,
in response to societal demands for accurate and representative financial reportin, is interested in the
interity of the reportin process and has a vested interest in reulatin accountin chanes.
4owever, it would appear that many firms take advantae of the inherent inability to enforce the
preferability requirement. Kany firms make accountin chanes without appealin to the criterion of
Pbetter reportin method.P 1ndeed, the initial choice of method need riot be the PbestP method% therefore it
is difficult to understand why the chane must be to a better method. ;ut some observers arue that
chanes made to achieve financial reportin ob2ectives while makin the usual preferability statement
(e.., Pbetter matchinP) is a prevarication. and a breach of professional ethics.
Jet the flexibility of >""3 creates a considerable incentive when the need arises. 4oldin to a strict
interpretation of Opinion No. 1. would clearly prohibit many of the chanes bein made. 4owever, it is not
feasible to hold firm to the requirement. #ome arue that accountin chanes per se are not unethical
and that financial statement users are riot fooled by purely PpaperP chanes. ;ut the latter is no excuse to
make a chane for one reason, and then imply it was made for a different reason. Certain chanes could
place creditors who impose debt covenants on reportin companies at increased risk. 1f accountin
chanes are the only way a company can maintain compliance with a debt covenant, these chanes
should not be made.
"ccountin chanes made solely to increase manaement compensation are unethical and compromise
shareholder wealth. ;onus arranements provide incentives for substantive accomplishments, not
accountin results. 4owever, some companies, for example, may chane to units of production methods
durin hard times (low production) thus decreasin depreciation and increasin income and
compensation.
;y contrast, companies intentionally may use conservative methods of accountin to maintain the
perception that their earnins are of hih quality. 4owever, when technoloical obsolescence suests a
chane to an accelerated depreciation method or a decreased useful life, such a chane should be made
to maintain the interity of the financial statements.
"lthouh not directly applicable, the #tandards of &thical Conduct for Kanaement "ccountants (1nstitute
of Kanaement "ccountants) includes the followin=
"ccountants should=
3erform their professional duties in accordance with relevant laws, reulations. and technical
standards.
/efrain from either actively or passively subvertin the attainment of the orani.ationSs
leitimate and ethical ob2ectives.
Communicate unfavorable as well as favorable information and professional 2udments or
opinions.
Communicate information fairly and ob2ectively.
Iisclose fully all relevant information that could reasonably be expected to influence an
intended userSs understandin of the reports, comments, and recommendations presented.
Kanaement accountants are directly involved in financial reportin. The above ethical principles arue
aainst makin accountin chanes solely for firm ain.
There is, of course, room for honest differences of opinion on accountin methods and estimates, and the
remarks in this solution do not pertain to such differences.
Chapter +@ ((*(( "ccountin Chanes and &rror Corrections
C:*3TER 25. S3ECI*$ TO3ICS. 0ISC$OSURES< INTERIM RE3ORTIND< *N0
SEDMENT RE3ORTIND
%. What are some sources of information about a company other than the financial statements?
Answer: There are numerous sources of information about a firmSs activities in addition to its financial
statements. &ven within the financial statement,%. it is very important to remember that the notes
provide vital information for the proper interpretation of the financial statements. The notes usually
also contain a number of supplementary disclosures, such as line!of!business reportin of potentially
reat importance.
;eyond the statements themselves there area number of related sources of information. The
Kanaement Iiscussion O "nalysis section is useful for ettin manaementSs perspective in
interpretin the financial information. The C&< letter to the shareholders often contains insihts about
interpretin the statements. and sometimes the C&< will comment on future plans and prospects.
Finally, the firm may provide news releases about various actions and activities of importance to the
future of the firm, and analysts often provide their interpretation of the future for the company. Thus,
financial statements are only one of many sources of potentially important information.
9. What is the purpose of notes to the financial statements?
Answer: ?otes to the financial statements provide quantitative and qualitative explanations of various
items included or not included in the body of the financial statements that merit explanation under the
fill) disclosure principle. Thus, notes enerally reflect application of the full!disclosure principle. They
also provide information for developin a better understandin of the quantitative information
contained in the body of the financial statements.
6. What is =orm %.CP? What firms must prepare a =orm %.CP? When must =orm %.CP be filed? What
information items must be included in =orm %.CP?
Answer: The Form (.-? is an annual report submitted by publicly traded companies to the #&C. 1t
includes all financial reportin information and a number of additional items.
"ll publicly!traded companies must file a Form (7!Y with the #&C within 57 days of the company8s
fiscal year!end. The information items that must tic! included in the Form (7!Y are=
Item
N8 He"1ing Des$ri#tin
(. ;usiness 4istory and description business, recent developments. principal
products and services, ma2or industry sements.
+. 3roperties -ocations and eneral descriptions of plants and other physical
properties.
0. -eal Iescription of pendin leal proceedins. principal parties to the
3roceedins proceedins, dates, alleations. and relief souht.
@. Aotin Katters Iescription of mailers submitted to votin security holders for
approval.
). Karket for 1dentification of market(s) where corporation common stock is
Common #tock traded. includin number of shares, frequency of tradin, amounts
of dividends.
:. #elected Five year summary includin net sales, income (loss) from
Financial Iata continuin operations, &3#, total assets, cash dividends, and
lon!term obliations.
,. Kanaement Iiscussion of liquidity, capital resources, results of operations,
Iiscussion and impact of inflation as needed to understand the companySs
Chapter +) (*(+ #pecial Topics, Iisclosures, etc.
and "nalysis financial condition, chane in financial condition, and operatin
results.
9. Financial Consolidated financial statements includin balance sheets for two
#tatements and years. income statements, cash flow statements, and statements of
#upplementary chanes in stockholdersS equity for three years, and related ?otes.
Iata "lso, selected quarterly data and the auditorSs opinion.
5. Iisareements 1f and when auditors are chaned due to disareements on
on accountin accountin principles, a description of the disareement and
disclosures summary of the effects on the financial statements.
(7. Iirectors and ?ames, aes, and positions of directors and officers.
<fficers
((. &xecutive #alaries, stock options and other benefits for corporate officers
Compensation and selected others.
(+. #ecurity -ist of beneficial owners and manaement owners of corporate
<wnership securities.
(0. Certain Iescription of transactions with manaers and related parties, and
/elationships for certain other business relationships.
(@. &xhibits, Ietailed supportin schedules, often specified in /eulation #!Y.
#chedules and &xamples are marketable securities, property, plant and equipment,
/eports includin accumulated depreciation. short!term borrowins, and a
listin of subsidiaries.
(). #inatures The report must be sined by the Chief &xecutive <fficer, the Chief
Financial <fficer, and a ma2ority of the ;oard of Iirectors.
!. In recent years, many firms regulated by the "*C have includedK a management discussion and
analysis section in the annual report to shareholders. $escribe what is included in the 2$) section.
Answer: The manaement and discussion analysis (KI") section includes a discussion provided
manaement of the companySs financial condition. its chane in financial condition, and its results of
operations for the periods covered in the report.
#. What must a firm disclose about related party transactions?
Answer: " firm must disclose the followin reardin related party transactions=
(. The nature of the relationship involved.
+. " description of the transaction, includin transactions in which no amounts or nominal amounts
were involved. for each period for which income statements are presented.
0. The dollar amounts of transactions for each period for which income statements are presented.
@. "ny amounts due to or from related parties as of the balance sheet date. and the terms and
manner of settlement planned.
%.. What is the basic rationale for re@uiring segment reporting? What are reporting?
Answer: The rationale for sement reportin is to provide financial statement readers with
information on the relative proportions of a companySs resources committed to various lines of
business. Ynowin information on the success the company has experienced in each line of business
allows the financial statement reader to make a more informed decision than if they were to make
such decisions usin only the areate financial information. &ach line of business probably has
different risks and reward characteristics. 3rovidin disareated information allows the financial
statement reader to better assess the risk and reward associated with each line of business, and also
for the company.
Chapter +) +*(+ #pecial Topics, Iisclosures, etc.
There are two main aruments aainst sement reportin. First, atherin and providin sement
information is costly for firms and of little value to the financial statement reader. " second arument
aainst sement reportin is that it requires disclosure of proprietary information, that is, disclosin
the operatin income and other information about a line of business provides a potential competitor
with valuable information that miht work to the competitive disadvantae of the firm makin the
sement disclosures.
%9. /riefly describe the alternative tests for determining a reportable segment.
Answer: " reportable industry sement is an industry sement that meets one or more of the
followin possible Criteria=
(. 1ts revenue is (7F or more of the combined revenue sements of the entity.
+. The absolute amount of its operatin loss or profit is (7F or more of the reater, in absolute
amount, of=
a. The combined operatin profit of all industry sements of the entity that did not incur an
operatin loss, or
b. The combined operatin loss of all industry sements of the entity that did incur an operatin
loss.
0. 1ts identifiable assets are (7F or more of the combined identifiable assets of all industry
sements (of the entity).
%6. What is the difference between the discrete view and the integral part view of interim financial
reporting periods?
Answer: The discrete view holds that each interim period is an independent period that stands alone.
"s such, it is sub2ect to the same principles and procedures for revenue and expense reconition,
accruals and deferrals as an annual period. The interal view holds each interim reportin period as
an interal part of the annual reportin period. 'nder this view, revenue and expense reconition,
accruals and deferrals for each interim period are affected by 2udments about the results of
operations for the remainder of the annual reportin period. There can be and are allocations,
accruals and deferrals between the interim periods that would not be made between annual periods.
E 25-2 Inte#i+ Repo#tin" In "eptember %##-, Crystal 2ountain "ki :esorts spent 45...... for
advertising for the coming ski season. 7he ski season lasts from 0ctober through the following 2arch.
with business e+pected to be spread evenly over this period. 7he fiscal year for Crystal 2ountain ends
2arch 5%, %###.
Required: $etermine the amount of e+pense that should be included in Crystal 2ountainKs interim
financial statements for "eptember 5. and for $ecember 5%, %##-. 1ustify and e+plain your answer.
Answer: #ince the advertisin expenditure is expected to benefit the third and fourth quarters equally. it
should he allocated to these two quarters in equal amounts of 6()7.777 each quarter. Therefore, the
second quarter, which ends #eptember 07, (559, should not show any of the above as expense. The
entire amount would be capitali.ed as an intanible asset (prepaid advertisin). The Iecember 0(, (559,
interim report would expense 6()7,777 of the intanible asset, with the final 6()7,777 bein expensed in
the fourth quarter.
Chapter +) 0*(+ #pecial Topics, Iisclosures, etc.
E 25-3 Inte#i+ Repo#tin" 7he Froctor Company reported income before income ta+es of 4%..,... and
4%(.,... in the first two @uarters of %##-. 2anagementKs estimate of the annual effective ta+ rate was 5(
percent at the end of the first @uarter and 5. percent at the end of the second @uarter.
Required: $etermine the income ta+ e+pense for the first two @uarters of %##-.
Answer:
The first quarter tax computations are=
3retax accountin income............................................................. 6(77,777
"ppropriate tax rate....................................................................... x .0)
1ncome tax expense...................................................................... 6 0),777
"t the end of ft second quarter, the estimated annual tax rate is reduced to 07F. The total income tax
expense obliation for the combined two quarters is determined=
3retax accountin income ............................................................ 6+)7,777
"ppropriate tax rate ...................................................................... x 07
Total income tax expense to date ................................................. 6 ,),777
The amount to be recorded as income tax expense in the second quarter is the difference between the
total year!to!date amount of obliation. less the amount reconi.ed in prior interim periods=
Total income tax expense to date ................................................. 6,),777
1ncome tax expense recorded in earlier periods ........................... 0).777
1ncome tax expense to be reported in second period ................... 6@7,777
"s of the end of the second quarter, the total amount of income tax expense recorded is 6,),777.
E 25-5 Se"+ent Repo#tin" 7he Jllrich Froducts Corporation is organi,ed in three maor product
divisions< ?ealth care products, )gricultural products, and =ood products. Within the ?ealth care
products division are three separately organi,ed groups< pharmaceuticals, consumer health care, and
medical devices. 7he ?ealth care products division manager receives separate financial information from
each group within the division for purposes of allocating resources and assessing performance. 7he chief
e+ecutive officer of the company. 1an Jllrich, make similar decisions for all three divisions. In %##- the
company has revenues of 4%2,5..,..., which includes interest revenue of 4%..,... that is not allocated
to any of the divisions. 7otal companyCwide income before ta+es is 4%,(..,... after deducting all
e+penses, including some that are not allocated to the divisions. 7he corporation has total assets of
422,...,..., some of which are head@uarters facilities not included in any of the divisions. Intercompany
sales are priced at market prices, and profits on intersegment sales total 4(.,... in %##-. 7he same
accounting procedures used for corporate financial reporting are used in measuring sales. profits, and
assets at the division and group level or the organi,ation. "pecific division and group level financial
information provided to management for %##- is as follows &all amounts are in thousands'<
Chapter +) @*(+ #pecial Topics, Iisclosures, etc.
:e%lth C%#e 3#oduct' D#oup'
Tot%l :e%lth
Con'u+e# Medic%l C%#e 3#oduct'
3h%#+%ceutic%l' :e%lth C%#e 0e1ice' 0i1i'ion
"ales to e+ternal customers............. 4 6,... 45,... 4%,2.. 4%.,2..
Intersegment sales........................... (.. . . (..
Income &loss' before ta+es............... %,-.. 2.. &9..' %,6..
"egment assets as of $ec. 5%.......... %.,... 5,(.. %,(.. %(,...
$epreciation X amorti,ationY......... 5.. %.. %.. (..
Capital e+pendituresL...................... 9.. 2.. %.. !..
*"#icultu#%l Aood
3#oduct' 3#oduct'
0i1i'ion 0i1i'ion
"ales to e+ternal customers............. 4%,... 4%,...
Intersegment sales........................... . !..
Income &loss' before ta+es............... 2.. %..
"egment assets as of $ec. 5%.......... 9,... 2,...
$epreciation X amorti,ationY......... %(. %..
Capital e+pendituresL...................... 2.. 2..
Y )n additional depreciation of 4(. on head@uarters facilities is not included in segment
amounts.
L )n additional 42.. of capital e+penditures was incurred for facilities for head@uarters.
Required
%. )ssume all the groups within the ?ealth care products division @ualify as operating segments. as do
the )gricultural products and the =ood products divisions. $etermine which are the reportable
operating segments.
2. "how the @uantitative information that is re@uired to be reported under SFAS No( )0) for Jllrich for
%##-. )ll revenues, e+penses, or assets not included above as part of an operating segment are
unallocated corporate items.
Answer:
%e&uirement '
#ince all the roups within the 4ealth care products divisions are considered operatin sements, each
must be considered as a potentially reportable sement. &ach roup and the other two divisions must be
examined as to whether they meet the quantitative thresholds to require separate disclosure.
The revenue test is to report all operatin sements with revenues (includin external and internal
revenues) reater than (7F of (6(7,+77 H 6)77 H 6+,777 H 6,77) G 6(,0+7.
3harmaceuticals, Consumer health care, and the Food products division meet this threshold (?ote that
the Food products division does not meet the threshold if intersement sales were not considered).
The profit test is (7F x 6+,077 G 6+07. 3harmaceuticals and Kedical Ievices meet the threshold.
The sement assets test is (7F x 6+(,777 G 6+,(77. 3harmaceuticals, Consumer 4ealth Care, and
"ricultural 3roducts meet the threshold.
Chapter +) )*(+ #pecial Topics, Iisclosures, etc.
Thus, all five operatin sements meet one or more of the threshold quantities. "ll five are reportable
sements.
%e&uirement (
O#er"ting Segments 3in"n$i"/ In.rm"tin
Cnsumer Me1i$"/ Agri$u/tur"/ 31
%Amunts in ,,,s& Ph"rm"$euti$"/s He"/th De2i$es Pr1u$ts Pr1u$ts Tt"/s
C"re
Total sement
revenues 6 :,)77 6 0,777 6 (,+77 6 (,777 6 (,,77 6 (0,@77
1ntersement
revenues )77 $ $ $ ,77 (,+77
Iepreciation O
amorti.ation 077 (77 (77 ()7 (77 ,)7
#ement profit (,977 +77 (@77) +77 (77 (,577
#ement assets (7,777 0,)77 (,)77 @,777 +,777 +(,777
&xpenditures for
sement assets @77 +77 (77 +77 +77 (,(77
0econciliations:
/econciliations for revenues, income before income taxes, total assets and other sinificant items are as
follows=
/evenues
Total revenues for reportable sements............... 6(0,@77
<ther revenues.................................................... (77
-ess= intersement revenues............................... ((,+77)
Total company reported revenues................. 6(+,077
3rofit or loss
Total profit for reportable sements..................... 6(,577
&limination of intersement profits....................... ()7)
'nallocated amounts=
<ther corporate expenses............................. (0)7)
Total company income before income taxes.. 6(,)77
"ssets
Total assets for reportable sements................... 6+(,777
<ther unallocated costs....................................... (,777
Company total assets.................................... 6++,777
<ther sinificant items
Segment Cm#"n0
Tt"/s A1Lustments Tt"/s
&xpenditures for assets....................................... (,(77 +77 (,077
Iepreciation and amorti.ation............................. ,)7 )7 977
Chapter +) :*(+ #pecial Topics, Iisclosures, etc.
E25-2 Identi! Repo#tin" Se"+ent' %nd M%/o# Cu'to+e#' Peefe Corporation has e+panded rapidly,
and segment reporting has become an accounting issue. 7he company has no intersegment sales. 7he
following data are available for the %##- fiscal year which ended on $ecember 5% &amounts in millions'<
Tot%l Ope#%tin"
Se"+ent 3#oit Identii%&le
Ope#%tin" Se"+ent' Re1enue' @$o''7 *''et'
)............................. 462. 42.. 49..
/............................. %.. 2. -.
C............................. 59. !. 5..
$............................. %#. &5.' %9.
*............................. %-. &2(' %-.
=............................. !. %. %2.
I............................. %2. &2.' %9.
)ll others................ 5-. &2(' %9.
7he Zall others[ includes five operating segments. none with revenues or
assets greater than 4-. million and none with an operating profit.
0perating segments ) and / have very similar products and production
processes, but serve different customer types and use @uite different
product distribution systems. 7his is partly because operating segment /
is in a regulated environment but operating segment ) is not. )lso.
0perating segments = and I have very similar products, production
processes, and product distribution systems, but are organi,ed as separate
divisions because they serve substantially different types of customers.
6either = nor I is in a regulated environment.
Required:
%. $etermine what am reportable segments without regard to aggregation criteria.
2. If the re@uirements for reportable segments am not yet met, apply appropriate aggregation criteria to
identify additional reportable segments.
5. )ssume Peefe has sales totaling 422. million to the J.". =ederal government primarily from
operating segments ) and C. 0ther significant customers include annual revenues of 4%#. million
from Ikon 7echnology &primarily sales of segment $', and 4%.. million in sales by segment * to the
=rench government. What, if any, disclosures must Peefe make regarding maor customers? "how the
disclosure Peefe must make.
Answers:
%e&uirement '
1nitially all reportin sements are examined usin the quantitative thresholds to identify reportable
sements.
Chapter +) ,*(+ #pecial Topics, Iisclosures, etc.
Tt"/ O#er"ting
Segment Pr.it I1enti.i"'/e
O#er"ting Segments Re2enues %Lss& Assets
"............................. 6:+7 6+77 6@77
;............................. (77 +7 97
C............................. 0@7 ,7 077
I............................. (57 (07) (@7
&............................. (97 (+)) (97
F............................. ,7 (7 (+7
>............................. (+7 (+7) (@7
"ll others................. 097 (+)) (@7
Totals...................... 6+,777 6+77 6(,)77
Thus any operatin sement with revenues equal to or reater than 6+77 million is a reportable sement
(sements " and C). "ny sement with identifiable assets reater than 6()7 million is a reportable
sement (sements ", C, and &). The total operatin profit for all the sements with operatin profits
totals 6077 million% thus any sement with an operatin profit or loss equal to or reater than an absolute
amount of 607 million is a reportable sement (#ements ". C. and I). Thus, sements ". C. I. and F.
are reportable sements without reard to the areation criteria.
%e&uirement (
/eportable sements must provide information on separate sements whose sum of revenue is at least
,) percent of the firmSs total revenue. #ements ". C. I. and & have revenue of 6(,007 million. which is
only ::.)F of the total revenue. 1f a ma2ority of the areation criteria arc met by two sements, they
can be areated for purposes of identifyin reportable sements. #ements " and ; are candidates for
combinin, but they have only + of the ) criteria in common% thus they cannot be areated. #ince
sements F and > are similar on four of the five criteria. they meet the ma2ority test and can be
areated as a reportable sement as follows=
#ement F H >....... (57 ((7) 077
Bith F H > considered a reportable sement, the total revenues included in reportable sements
increases to 6(,)+7, or ,:F of the total. The ,) percent requirement has been met.
%e&uirement )
1f any ma2or customer contributes (7 percent or more to a firm8s revenues, this fact must be disclosed,
includin the total amount of revenues from each such customer, and the sement or sements reportin
the revenues. The '.#. federal overnment contributes over (7F of YeefeSs revenues and must be
reported. ?either of the other sinificant customers are ma2or customers under the SFAS No. (,(
criterion.
"n example of disclosure=
M"Lr Custmers
/evenues from one customer of Yeefe CorporationSs sements " and C represent
approximately 6++7 million of the company8s total revenues.
E 25-7 Inte#i+ Repo#tin". *pplic%tion o Duideline' In the conte+t of interim reporting, items may &a'
be recogni,ed in the interim statements of the current interim period, &b' be recogni,ed in the current
interim period but re@uireC special disclosure, &c' be deferred in their entirety &that is, not recogni,ed until
some later interim period, or not recogni,ed at all', or &d' be amorti,ed or accrued &recogni,ed partly in
the current interim period and partly in subse@uent interim periods'. ) number of items are listed below
that re@uire a decision on how they should be inc6rporated on interim statements. 2atch the letters given
above with the numbered items given below to indicate how each item should be incorporated on the
interim statements.
%. "alaries allocable to services rendered during the current period.
Answer: A
2. Inventories estimated by use of the gross margin method.
Answer: B
5. 7emporary declines in market value of inventories.
Answer: C
9. "hortCterm stock investment gains from recoveries of market value &not in e+cess of previously
recogni,ed market declines'.
Answer: A
(. 2aterials and wages allocable to products sold this period.
Answer: A
6. Costs benefiting two or more interim periods.
Answer: D
!. Increase in gross margin due to li@uidation of a layer of EI=0Cbased inventory e+pected to be
replenished by yearCend.
Answer: C
-. Tuantity discounts allowed to customers based on the annual volume of their purchases.
Answer: B
#. Contingencies and other uncertainties that may affect fairness of presentation.
Answer: A
%.. Income ta+ on income of first @uarter where total income for the first @uarter puts the company in a
low ta+ bracketD subse@uent operations are e+pected to be sufficiently profitable that by end of second
@uarter, and thereafter ta+able income of the company will be in a higher bracket.
Answer: B
*25-1 3ep'iCo Inc( *+cerpts from the Industry "egments disclosures in the %##( FepsiCo Inc. annual
report follow<
Indu't#! Se"+ent'
D#o;th R%te
Net S%le' 1449-1445 1445 1444 1443
/everages< J." .................. !> 4 6,#!! 46,(9% 4(,#%-
International..... %#> .5,(!% 5.%96 2.!2.
%.> %.,(9- #,6-! -,65-
"nack =oods< J." .................. %.> (,9#( (,.%% 9,56(
International..... %#> 5,.(. 5,2(5 2,662
%2> -,(9( -,269 !,.2!
:estaurants< J." .................. %%> #,2.2 -,6#9 -,.26
International..... 2(> 2,%26 %,-2! %,55.
%5> %%,52- %.,(2% #,5(6
Co+&ined Se"+ent'
J." .................. #> 42%,6!9 42.,296 4%-,5.#
International..... 2.> -,!9! -,226 6,!%2
%2> 5.,92% 2-,9!2 2(,.2%
/y J.". :estaurant Chain
Fi,,a ?ut.......... -> 4 5,#!! 4 5,!%2 4 5,(#(
7aco /ell.......... %(> 5,(.5 5,59. 2,-((
P=C.................. #> %,!22 %,692 %,(!6
%%> 4 #,2.2 4 -,6#9 4 -,.26
Ope#%tin" 3#oit
/everages< J." .................. %%> 4 %,%9( 4 %,.22 4 #5!
International..... %#> %69 %#( %!2
%2> %,5.# %,2%! %,%.#
"nack =oods< J." .................. #> %,%52 %,.2( #.%
International..... %9> 5.. 5(2 2-#
%.> %,952 %,5!! %,%#.
:estaurants< J." .................. %.> 9(% 6(# 6-(
International..... -> &2%' !% #5
#> 95. !5. !!-
Co+&ined Se"+ent'
J." .................. %.> 4 2,!2- 4 2,!.6 4 2,(25
International..... %9> 955 6%- ((9
%.> 5,%!% 5,529 5,.!!
*@uity &Eoss' Income............. &5' 5- 5.
Jnallocated e+penses, 6et...... &%-%' &%6%' &2..'
0perating Frofit...................... %%> 4 2,#-! 4 5,2.% 4 2,#.!
Chapter +) (7*(+ #pecial Topics, Iisclosures, etc.
Co+&ined Se"+ent'
D#o;th R%te
Net S%le' 1449-1445 1445 1444 1443
/y J.". :estaurant Chain
Fi,,a ?ut.......... #> 4 5.- 4 2-( 4 55-
7aco /ell.......... %2> %.( 2!5 2(6
P=C.................. !> 5- %.% #%
%.> 4 9(% 4 6(# 4 6-(
Se"+ent Ope#%tin"
Net S%le' 3#oit @$o''7 Identii%&le *''et'
Deo"#%phic *#e%' 1445 1444 1443 1445 1444 1443 1445 1444 1443
Jnited "tates.... 42%,6!9 42.,296 %-,5.# 42,!2- 42,!.6 42,(25 4%9,(.( 4%9,2%- 4%5,(#.
*urope.............. 2,!-5 2,%!! %,-%# &6(' %! 9! 5,%2! 5,.62 2,666
2e+ico ............ %,22- 2,.25 %,6%9 -. 26% 225 65! ##( %,2%!
Canada ............ %,2## %,299 %,2.6 -6 -2 %.2 %,599 %,592 %,.569
0ther.................. 5,95! 2,!-2 2,.!5 592 2(- %-2 2,62# 2,%#6 %,6!(
Combined "egments45.,92%42-,9!242(,.2% 45,%!% 45,529 45,.!! 22,292 2%,-%5 2.,(%2
Investments in Jnconsolidated )ffiliates............................................................. %,65( %,2#( %,.#%
Corporate............................................................................................................. %,((( %,6-9 2,%.5
42(,952 429,!#2 425,!.6
/everages......... #> 4%.,.52 4#,(66 4 #,%.( /y J.". :estaurant Chain
"nack =oods..... !> (,9(% (,.99 9,##( Fi,,a ?ut..... -> 4%,!.. 4%,-52 4%,!55
:estaurants....... %9> 6,!(# !,2.5 6,9%2 7aco /ell..... %#> 2,2!6 2,52! 2,.6.
Investments in JnconC P=C............. !> %,%%% %,2(5 %,26(
solidated )ffiliates #> %,65( %,2#( %,.#% 7otal J."....... %2> (,.-! (,9%2 (,.(-
Corporate.......... #> %,((( %,6-9 2,%.5 International. . 2!> %,6!2 %,!#% %,5(9
-> 42(,952 429,!#2 425,!.6 %9> 46,!(# 4!,2.5 46,9%2
Required:
% . In what different lines of business does FepsiCo report? =or %##(, which line of business earned the
largest profit margin &operating profit as a percent of revenues'? 7he smallest profit margin? Which
of the restaurant chains has the highest profit margin?
2. In what lines of business does FepsiCo appear to be growing the most rapidly? ?ow does this growth
relate to the profit margins of the various lines of business?
5. In general how important is international operations to FepsiCo? Comment on the relative profit
margin of J.". versus international operations.
9. Consider another measure of profitability such as operating income divided by identifiable assets.
*valuate the profitability of FepsiCoKs various businesses.
Answer:
Cmment: "s a roup assinment. this case can involve a reat deal more analysis than that specifically
asked for in the assinment. For example, students could be asked to analy.e operatin marins and
return on investment for earlier years, lookin for trends in the data. " more detailed profitability analysis
of each restaurant chain could be conducted. Finally, the importance of unconsolidated affiliates could be
analy.ed. These areas are not specifically addressed in the assined material, and thus are not
addressed here.
Chapter +) ((*(+ #pecial Topics, Iisclosures, etc.
%e&uirement '
3epsiCo reports three lines of business= ;everaes, #nack Foods, and /estaurants. 1t is also possible to
further break out each of these sements into '.#. and international components. The (55) profit
marins for the three basic sements are=
;everaes 6(,075*6(7,)@9 (+.@F
#nack Foods 6(,@0+*69,)@) (:.9F
/estaurants 6@07*6((,0+9 0.9F
The snack foods sement has to hihest marin at (:.9F, and the restaurant sement has the lowest at
0.9F.
The profit marins for the three restaurant chains are=
3i..a 4ut 6079*60,5,, ,.,F
Taco ;ell 6(7)*60,)70 0.7F
YFC 609*61,,++ +.+F
3i..a 4ut has the hihest marin.
%e&uirement (
#omewhat surprisin, sales rowth in the restaurant sement is rowin most rapidly, especially in the
international area (+)F rowth). "lso, restaurants is the sement with the hihest rowth rate as
measured by 1dentifiable assets (rowth over (557!5) of (@F). This is riot the sement with the hiher
marins, nor is it the sement with the hihest return on investment (operatin profit divided by
investments as measured by identifiable assets of the sement). 1t would be interestin to know why
3epsiCo is expandin most rapidly in this area.
%e&uirement )
The ma2ority of 3epsiCoSs sales and operatin profit come from the '.#. eoraphical area$'.#. sales
are ,(F of total sales, and account for 9:F of the operatin marin. 3epsiCo is larely a '.#.!based
company, but with sinificant international operations.
" comparison of '.#. and 1nternational operatin marins by sement is its follows=
?8S8 Intern"tin"/
;everaes (:.@F @.:F
#nack Foods +7.9F 5.9F
/estaurants @.5F ((.7)F
"ain, the '.#. components of all the sements have the hihest operatin marin.
%e&uirement *
<peratin income (or operatin profit as it is called by 3epsiCo) divided by the book value of identifiable
assets is a measure of return on investment. This can be, computed for the three sements=
Cm#ut"tin Return n in2estment
;everaes 6(,075*6(7,70+ (0.7F
#nack Foods +:.0F
/estaurants :.@F
"ain, it is the snack foods sement that is the most profitable. and the restaurant sement that is least
profitable.
1t would not be surprisin to find 3epsiCo reevaluatin its investment in the restaurant business. "nd in
fact, this is precisely what 3epsiCo has started to do. "s of the #prin of (55,. 3epsiCo has announced
plans to spin!off its restaurant sement and focus its attention on the beverae and the snack food
business.
Chapter +) (+*(+ #pecial Topics, Iisclosures, etc.

Chapter 15: Short-Term Liabilities Questions

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CHAPTER 15: SHORT-TERM LIABILITIES

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