Chap 004

Chapter 4 The Income Statement and Statement of Cash Flows
AACSB assurance of learning standards in accounting and business education require

documentation of outcomes assessment. Although schools, departments, and faculty may approach
assessment and its documentation differently, one approach is to provide specific questions on
exams that become the basis for assessment. To aid faculty in this endeavor, we have labeled each
question, exercise and problem in Intermediate Accounting, 5e with the following AACSB learning
skills:
Questions AACSB Tags Exercises AACSB Tags

(cont.)
4-1 Reflective thinking 4-6 Analytic
4-4 Reflective thinking 4-9 Analytic, Reflective thinking,
Communications
4-5 Reflective thinking 4-10 Analytic, Reflective thinking,
Communications
4-6 Reflective thinking 4-11 Reflective thinking
4-8 Reflective thinking 4-13 Diversity
4-11 Reflective thinking, Communications 4-16 Diversity, Communications
4-17 Reflective thinking CPA/CMA
Brief 4-3 Analytic
Exercises
4-1 Analytic 4-4 Analytic
4-2 Analytic 4-5 Reflective thinking
4-8 Analytic Problems
4-9 Reflective thinking, Communications 4-1 Analytic
4-10 Analytic, Communications 4-2 Analytic, Reflective thinking
4-11 Analytic 4-3 Analytic, Reflective thinking
© The McGraw-Hill Companies, Inc., 2009

Solutions Manual, Vol.1, Chapter 4 4-1
4-12 Analytic 4-4 Communications, Reflective
thinking
Exercises Problems
(cont.)

4-2 Intermediate Accounting, 5/e
QUESTIONS FOR REVIEW OF KEY TOPICS
Question 4-1
The income statement is a change statement that reports transactions — revenues, expenses,
gains and losses — that cause owners’ equity to change during a specified reporting period.
Question 4-2
Income from continuing operations includes the revenue, expense, gain, and loss transactions
that will probably continue in future periods. It is important to segregate the income effects of these
items because they are the most important transactions in terms of predicting future cash flows.
Question 4-3
Operating income includes revenues and expenses that are directly related to the principal
revenue generating activities of the company. Nonoperating income includes items that are not
directly related to these activities.
Question 4-4
The single-step format first lists all revenues and gains included in income from continuing
operations to arrive at total revenues and gains. All expenses and losses are then grouped and
subtotaled, subtracted from revenues and gains to arrive at income from continuing operations. The
multiple-step format reports a series (multiple) of intermediate totals such as gross profit, operating
income, and income before taxes. Very often income statements adopt variations of these formats,
falling somewhere in between the two extremes.
Question 4-5
The term earnings quality refers to the ability of reported earnings (income) to predict a
company’s future earnings. After all, an income statement simply reports on events that already
have occurred. The relevance of any historical-based financial statement hinges on its predictive
value.
Question 4-6
Restructuring costs include costs associated with shutdown or relocation of facilities or
downsizing of operations. They are reported as an operating expense in the income statement.
Question 4-7
The process of intraperiod tax allocation matches tax expense or tax benefit with each major
component of income, specifically continuing operations and any item reported below continuing
operations. The process is necessary to achieve the desired result of separating the total income
effects of continuing operations from the two separately reported items - discontinued operations
and extraordinary items, and also to show the after-tax effect of each of those two components.
Answers to Questions (continued)

Question 4-8
A component of an entity comprises operations and cash flows that can be clearly
distinguished, operationally and for financial reporting purposes.
The net-of-tax income effects of a discontinued operation must be disclosed separately in the
income statement, below income from continuing operations. The income effects include income
(loss) from operations and gain (loss) on disposal. The gain or loss on disposal must be disclosed
either on the face of the statement or in a disclosure note. If the component is held for sale but not
sold by the end of the reporting period, the income effects will include income (loss) from
operations and an impairment loss if the fair value less costs to sell is less than the book value of the
component’s assets. The income (loss) from operations of the component is reported separately in
discontinued operations on prior income statements presented for comparative purposes.
Question 4-9
Extraordinary items are material gains and losses that are both unusual in nature and infrequent
in occurrence, taking into account the environment in which the entity operates.
Question 4-10
Extraordinary gains and losses are presented, net of tax, in the income statement below
discontinued operations, if any.

Answers to Questions (continued)
Question 4-11
GAAP permit alternative treatments for similar transactions. Common examples are the
choice among FIFO, LIFO, and average cost for the measurement of inventory and the choice
among alternative revenue recognition methods. A change in accounting principle occurs when a
company changes from one generally accepted treatment to another.
In general, we report voluntary changes in accounting principles retrospectively. This means
revising all previous periods’ financial statements as if the new method were used in those periods.
In other words, for each year in the comparative statements reported, we revise the balance of each
account affected. Specifically, we make those statements appear as if the newly adopted accounting
method had been applied all along. Also, if retained earnings is one of the accounts whose balance
requires adjustment (and it usually is), we revise the beginning balance of retained earnings for the
earliest period reported in the comparative statements of shareholders’ equity (or statements of
retained earnings if they’re presented instead). Then we create a journal entry to adjust all account
balances affected as of the date of the change. In the first set of financial statements after the
change, a disclosure note would describe the change and justify the new method as preferable. It
also would describe the effects of the change on all items affected, including the fact that the
retained earnings balance was revised in the statement of shareholders’ equity.
An exception is a change in depreciation, amortization, or depletion method. These changes
are accounted for as a change in estimate, rather than as a change in accounting principle. Changes
in estimates are accounted for prospectively. The remaining book value is depreciated, amortized,
or depleted, using the new method, over the remaining useful life.
Question 4-12
A change in accounting estimate is accounted for in the year of the change and in subsequent
periods; prior years’ financial statements are not restated. A disclosure note should justify that the
change is preferable and should describe the effect of a change on any financial statement line items
and per share amounts affected for all periods reported.
Question 4-13
Prior period adjustments are accounted for by restating prior years’ financial statements when
those statements are presented again for comparison purposes. The beginning of period retained
earnings is increased or decreased on the statement of shareholders’ equity (or the statement of
retained earnings) in the year the error is discovered.

Answers to Questions (concluded)
Question 4-14
Earnings per share (EPS) is the amount of income achieved during a period for each share of
common stock outstanding. If there are different components of income reported below continuing
operations, their effects on earnings per share must be disclosed. If a period contains discontinued
operations and extraordinary items, EPS data must be reported separately for income from
continuing operations and net income. Per share amounts for discontinued operations and
extraordinary items would be disclosed on the face of the income statement.
Question 4-15
Comprehensive income is the total change in equity for a reporting period other than from
transactions with owners. Reporting comprehensive income can be accomplished with a separate
statement or by including the information in either the income statement or the statement of changes
in shareholders’ equity.
Question 4-16
The purpose of the statement of cash flows is to provide information about the cash receipts
and cash disbursements of an enterprise during a period. Similar to the income statement, it is a
change statement, summarizing the transactions that caused cash to change during a particular
period of time.
Question 4-17
The three categories of cash flows reported on the statement of cash flows are:
1. Operating activities — Inflows and outflows of cash related to the transactions entering
into the determination of net income from operations.
2. Investing activities — Involve the acquisition and sale of (1) long-term assets used in the
business and (2) nonoperating investment assets.
3. Financing activities — Involve cash inflows and outflows from transactions with creditors
and owners.
Question 4-18
Noncash investing and financing activities are transactions that do not increase or decrease
cash but are important investing and financing activities. An example would be the acquisition of
property, plant and equipment (an investing activity) by issuing either long-term debt or equity
securities (a financing activity). These activities are reported either on the face of the statement of
cash flows or in a disclosure note.
Question 4-19
The direct method of reporting cash flows from operating activities presents the cash effect of
each operating activity directly on the statement of cash flows. The indirect method of reporting
cash flows from operating activities is derived indirectly, by starting with reported net income and
adding and subtracting items to convert that amount to a cash basis.
BRIEF EXERCISES
Brief Exercise 4-1
PACIFIC SCIENTIFIC CORPORATION
Income Statement
For the Year Ended December 31, 2009
($ in millions)
Revenues and gains:
Sales .................................................................. $2,106
Gain on sale of investments .............................. 45
Total revenues and gains ............................... 2,151
Expenses and losses:

Cost of goods sold ............................................ $1,240
Selling................................................................ 126
General and administrative................................ 105
Interest............................................................... 35
Income tax expense* ........................................ 258
Total expenses and losses ............................. 1,764
Net income .......................................................... $ 387
*$2,151 – (1,240 + 126 + 105 + 35) = $645 x 40% = $258
(a) Sales revenue $2,106

Brief Exercise 4-2 Less: Cost of goods sold (1,240)
Gross profit 866
Less: Selling expenses (126)
General and administrative expenses (105)
Operating income $ 635
(b) Gain on sale of investments 45

Interest expense (35)
Nonoperating income $10
Brief Exercise 4-3

PACIFIC SCIENTIFIC CORPORATION
Income Statement
($ in millions)
Sales revenue ....................................................... $2,106
Cost of goods sold ............................................... 1,240
Gross profit .......................................................... 866
Operating expenses:
Selling................................................................ $126
General and administrative................................ 105
Total operating expenses ............................... 231
Operating income ................................................ 635
Other income (expense):

Gain on sale of investments .............................. 45
Interest expense ................................................ (35)
Total other income, net ................................. 10
Income before income taxes ............................... 645
Income tax expense* ........................................... 258
Net income .......................................................... $ 387
*$645 x 40%
(a) Sales revenue $300,000

Brief Exercise 4-4 Less: Cost of goods sold (160,000)
General and administrative expenses (40,000)
Restructuring costs (50,000)
Selling expenses (25,000)
Operating income $ 25,000
(b) Operating income $25,000

Add: Interest revenue 4,000
Deduct: Loss on sale of investments (22,000)
Income before income taxes and
Extraordinary item 7,000
Income tax expense (40%) (2,800)
Income before extraordinary item $ 4,200
(c) Income before extraordinary item $ 4,200

Extraordinary item:
Loss from flood damage, net of $20,000
tax benefit (30,000)
Net loss (25,800)

Brief Exercise 4-5
WHITE AND SONS, INC.
Partial Income Statement
Income before income taxes and extraordinary item........... $ 850,000

Income tax expense* .......................................................... 340,000
Income before extraordinary item ....................................... 510,000
Extraordinary item:
Loss from earthquake, net of $160,000 tax benefit.......... (240,000)
Net income .......................................................................... $ 270,000
Earnings per share:

Income before extraordinary item........................................ $ 5.10
Loss from earthquake ......................................................... (2.40)
Net income .......................................................................... $ 2.70
*$850,000 x 40%
Note: Restructuring costs, interest revenue, and loss on sale of investments are
included in income before income taxes and extraordinary item.
Brief Exercise 4-6

CALIFORNIA MICROTECH CORPORATION
Income from continuing operations before income taxes.... $ 5,800,000

Income tax expense* ........................................................... 1,740,000
Income from continuing operations .................................... $ 4,060,000
Discontinued operations:
Loss from operations of discontinued component
(including gain on disposal of $2,000,000)** .......................... (1,600,000)
Income tax benefit ............................................................ 480,000
Loss on discontinued operations ...................................... (1,120,000)
Net income .......................................................................... $ 2,940,000
* $5,800,000 x 30%
** Loss from operations of discontinued component:
Gain on sale of assets $ 2,000,000 ($10 million less $8 million)

Operating loss (3,600,000)
Total before-tax loss $(1,600,000)
Brief Exercise 4-7


Loss from operations of discontinued component** ....... (3,600,000)
Income tax benefit ............................................................ 1,080,000
Net income .......................................................................... $ 1,540,000
* $5,800,000 x 30%
** Includes only the operating loss. There is no impairment loss.
Brief Exercise 4-8


(including impairment loss of $1,000,000)** .......................... (4,600,000)
Income tax benefit ............................................................ 1,380,000
Net income .......................................................................... $ 840,000

* $5,800,000 x 30%
** Loss from operations of discontinued component:
Impairment loss ($8 million book value less

$7 million net fair value) $(1,000,000)
Operating loss (3,600,000)
Total before-tax loss $(4,600,000)
Brief Exercise 4-9 The change in inventory method is a change in

accounting principle. The depreciation method change is
considered to be a change in accounting estimate that is achieved by a change in
accounting principle and is accounted for prospectively, exactly as we would account
for any other change in estimate. The inventory method change, however, is
accounted for by retrospectively recasting prior years’ financial statements presented
with the current year for comparative purposes, applying the new inventory method
(FIFO in this case) in those years.
This is a change in accounting estimate.
Brief Exercise 4-10 When an estimate is revised as new information comes

to light, accounting for the change in estimate is quite
straightforward. We do not restate prior years' financial statements to reflect the new
estimate. Instead, we merely incorporate the new estimate in any related accounting
determinations from there on. If the after-tax income effect of the change in estimate
is material, the effect on net income and earnings per share must be disclosed in a
note, along with the justification for the change. Depreciation for 2009 is $25,000:
$300,000
Cost
$ 50,000 Old annual depreciation ($300,000 ÷ 6 years)
x 2 years 100,000 Depreciation to date (2007-2008)
200,000 Book value
__ ÷ 8 yrs. Estimated remaining life (10 years - 2 years)
$ 25,000 New annual depreciation

Brief Exercise 4-11
O’REILLY BEVERAGE COMPANY
Statement of Comprehensive Income
Net income .......................................................... $650,000

Other comprehensive income (loss):
Unrealized gains on investment securities,
net of tax ........................................................ $ 24,000
Deferred loss on derivatives, net of tax ............ (36,000)
Total other comprehensive loss ........................... (12,000)
Comprehensive income ....................................... $638,000
Brief Exercise 4-12Cash Flows from Operating Activities:

Collections from customers $ 660,000
Interest on note receivable 12,000
Interest on note payable (18,000)
Payment of operating expenses (440,000)
Net cash flows from operating activities $214,000
Only these four cash flow transactions relate to operating activities. The others are
investing and financing activities.
Brief Exercise 4-13Cash Flows from Investing Activities:

Sale of land $ 40,000
Purchase of equipment (120,000)
Net cash flows from investing activities $(80,000)
Cash Flows from Financing Activities:

Proceeds from note payable collection $100,000
Issuance of common stock 200,000
Payment of dividends (30,000)
Net cash flows from financing activities 270,000

Brief Exercise 4-14Cash Flows from Operating Activities:
Net income $45,000
Adjustments for noncash effects:
Depreciation expense 80,000
Changes in operating assets and liabilities:
Increase in prepaid rent (60,000)
Increase in salaries payable 15,000
Increase in income taxes payable 12,000
Net cash inflows from operating activities $92,000
EXERCISES
Exercise 4-1
Requirement 1
GREEN STAR CORPORATION

Income Statement
Revenues and gains:

Sales .................................................................. $1,300,000
Interest .............................................................. 30,000
Gain on sale of equipment ................................ 50,000
Total revenues and gains ............................... 1,380,000

Cost of goods sold ............................................ $720,000
Salaries............................................................... 160,000
Depreciation....................................................... 50,000
Interest............................................................... 40,000
Rent.................................................................... 25,000
Income tax ........................................................ 130,000
Total expenses and losses ............................. 1,125,000
Net income .......................................................... $ 255,000
Earnings per share ............................................... $2.55

Exercise 4-1 (concluded)
Requirement 2
GREEN STAR CORPORATION

Income Statement
Sales revenue ....................................................... $1,300,000

Cost of goods sold ............................................... 720,000
Gross profit .......................................................... 580,000
Operating expenses:
Salaries............................................................... $160,000
Depreciation....................................................... 50,000
Rent ................................................................... 25,000
Total operating expenses ............................... 235,000
Operating income ................................................ 345,000

Interest revenue ................................................. 30,000
Gain on sale of equipment ................................ 50,000
Interest expense ................................................ (40,000)
Total other income, net ................................. 40,000
Income before income taxes ............................... 385,000
Income tax expense ............................................. 130,000
Net income .......................................................... $ 255,000
Earnings per share ............................................... $2.55
Requirement 1
Exercise 4-2
GENERAL LIGHTING CORPORATION
Income Statement
Revenues and gains:

Sales .................................................................. $2,350,000
Rental revenue .................................................. 80,000
Total revenues and gains ............................... 2,430,000

Cost of goods sold ............................................ $1,200,300
Salaries .............................................................. 300,000
Depreciation....................................................... 100,000
Interest............................................................... 90,000
Rent ................................................................... 50,000
Loss on sale of equipment ................................ 22,500
Loss from inventory write-down ...................... 200,000
Income tax expense *........................................ 186,880
Total expenses and losses ............................. 2,149,680
Income before extraordinary item ....................... 280,320
Extraordinary item:
Loss from flood damage (net of $48,000 tax benefit) (72,000)
Net income .......................................................... $ 208,320
Earnings per share:

Income before extraordinary item ....................... $ .93
Extraordinary loss ............................................... (.24)
Net income .......................................................... $ .69
* 40% x $467,200

Requirement 2
GENERAL LIGHTING CORPORATION

Income Statement
Sales revenue ....................................................... $2,350,000
Cost of goods sold ............................................... 1,200,300
Gross profit .......................................................... 1,149,700
Operating expenses:
Salaries .............................................................. $300,000
Depreciation ...................................................... 100,000
Rent ................................................................... 50,000
Loss from inventory write-down ...................... 200,000
Total operating expenses ............................... 650,000
Operating income ................................................ 499,700
Rental revenue .................................................. 80,000
Loss on sale of equipment ................................ (22,500)
Interest expense ................................................ (90,000)
Total other income (expense), net ................. (32,500)
Income before taxes and extraordinary item ....... 467,200
Income tax expense *........................................... 186,880
Income before extraordinary item ....................... 280,320
Extraordinary item:
Loss from flood damage (net of $48,000 tax benefit) (72,000)
Net income .......................................................... $ 208,320
Earnings per share:

Income before extraordinary item ....................... $ .93
Extraordinary loss ............................................... (.24)
Net income .......................................................... $ .69
* 40% x $467,200
Exercise 4-3 LINDOR CORPORATION

Statement of Income and Comprehensive Income
Sales revenue .................................................................... $2,300,000
Cost of goods sold ............................................................ 1,400,000
Gross profit ....................................................................... 900,000
Operating expenses:
Selling and administrative.............................................. 420,000
Operating income ............................................................. 480,000

Interest expense ................................................................ (40,000)
Income before income taxes and extraordinary item ....... 440,000
Income tax expense *........................................................ 132,000
Income before extraordinary item .................................... 308,000
Extraordinary item:
Gain on litigation settlement (net of $120,000
tax expense) ................................................................... 280,000
Net income 588,000
Other comprehensive income:
Unrealized holding gains on investment securities,
net of tax .................................................................... 56,000
Comprehensive income .................................................... $644,000
Earnings per share:

Income before extraordinary item .................................... $ 0.31
Extraordinary gain ............................................................ 0.28
Net income ....................................................................... $ 0.59
* 30% x $440,000
Exercise 4-4
AXEL CORPORATION
Income Statement
Sales revenue .................................................................... $ 592,000

Cost of goods sold ............................................................ 325,000
Gross profit ....................................................................... 267,000
Operating expenses:
Selling .......................................................................... $67,000
Administrative .............................................................. 87,000
Restructuring costs ........................................................ 55,000
Total operating expenses ............................................ 209,000

Interest and dividends ................................................... 32,000
Interest expense ............................................................. (26,000)
Total other income, net ................................................. 6,000
Income before income taxes and extraordinary item ...... 64,000
Income tax expense* ........................................................ 25,600

Extraordinary item:
Gain on litigation settlement (net of $34,400
tax expense) ................................................................... 51,600
Net income ....................................................................... $ 90,000
Earnings per share:

Income before extraordinary item .................................... $ .38
Extraordinary gain ............................................................ .52
Net income ....................................................................... $0.90
* 40% x $64,000
Exercise 4-5
CHANCE COMPANY
Income from continuing operations .................................... $ 350,000

(including loss on disposal of $400,000)* ............................... (530,000)
Loss on discontinued operations ...................................... (318,000)
Net income .......................................................................... $ 32,000
Earnings per share:

Income from continuing operations .................................... $ 3.50
Loss from discontinued operations ..................................... (3.18)
Net income .......................................................................... $ .32
* Loss on discontinued operations:
Loss on sale of assets $(400,000)

Operating loss (130,000)
Total before-tax loss (530,000)
Less: Income tax benefit (40%) 212,000
Net-of-tax loss $(318,000)
Exercise 4-6
ESQUIRE COMIC BOOK COMPANY
Income from continuing operations * .................................. $ 552,000
Income from operations of discontinued component
(including loss on disposal of $350,000) .................................. 150,000
Income tax expense ........................................................... 60,000
Income on discontinued operations ................................... 90,000
Net income............................................................................ 642,000
* Income from continuing operations:
Income before considering additional items $1,000,000

Decrease in income due to restructuring costs (80,000)
Before-tax income from continuing operations 920,000
Income tax expense (40%) (368,000)
Income from continuing operations $ 552,000
Requirement 1
Exercise 4-7
KANDON ENTERPRISES, INC.
(including impairment loss of $50,000) * .............................. (190,000)
Income tax benefit............................................................. 76,000
Loss on discontinued operations ....................................... (114,000)
Net income .......................................................................... $ 286,000
* Loss on discontinued operations:

Operating loss $(140,000)
Impairment loss ($250,000 - 200,000) (50,000)
Net before-tax loss (190,000)
Income tax benefit (40%) 76,000
Net after-tax loss on discontinued operations $(114,000)
Requirement 2
KANDON ENTERPRISES, INC.

Loss from operations of discontinued component *......... (140,000)
Loss on discontinued operations ....................................... (84,000)
Net income .......................................................................... $ 316,000
*Includes only the operating loss during the year. There is no impairment loss.
Exercise 4-8 Pretax income from continuing operations$14,000,000

Income tax expense (5,600,000)
Income from continuing operations 8,400,000
Less: Net income 7,200,000
Loss from discontinued operations $1,200,000
$1,200,000 ÷ 60%* = $2,000,000 = before tax loss from discontinued

operations.
*1-tax rate of 40% = 60%
Pretax income of division $4,000,000

Add: Loss from discontinued operations 2,000,000
Impairment loss $6,000,000
Fair value of division’s assets $11,000,000

Add: Impairment loss 6,000,000
Book value of division’s assets $17,000,000

Requirement 1
Exercise 4-9 This is a change in accounting estimate.
Requirement 2
When an estimate is revised as new information comes to light, accounting for
the change in estimate is quite straightforward. We do not restate prior years'
financial statements to reflect the new estimate. Instead, we merely incorporate the
new estimate in any related accounting determinations from there on. If the after-tax
income effect of the change in estimate is material, the effect on net income and
earnings per share must be disclosed in a note, along with the justification for the
change.
Requirement 3
$800,000 Cost
$160,000 Old annual depreciation ($800,000 ÷ 5 years)
x 2 years 320,000 Depreciation to date (2007-2008)
480,000 Book value
__ ÷ 6 yrs. Estimated remaining life (8 years - 2 years)
$ 80,000 New annual depreciation
Requirement 1
Exercise 4-10 In general, we report voluntary changes in accounting principles
retrospectively. However, a change in depreciation method is considered a change in
accounting estimate resulting from a change in accounting principle. In other words, a
change in the depreciation method reflects a change in the (a) estimated future benefits
from the asset, (b) the pattern of receiving those benefits, or (c) the company’s
knowledge about those benefits, and therefore the two events should be reported the
same way. Accordingly, Canliss reports the change prospectively; previous financial
statements are not revised. Instead, the company simply employs the straight-line
method from now on. The undepreciated cost remaining at the time of the change
would be depreciated using the straight-line method over the remaining useful life. A
disclosure note should justify that the change is preferable and should describe the
effect of the change on any financial statement line items and per share amounts
affected for all periods reported.
Requirement 2
Asset’s cost $800,000
Accumulated depreciation to date ($320,000 + 192,000) (512,000)
To be depreciated over remaining 3 years $288,000

2009 straight-line depreciation: $288,000 ÷ 3 years = $96,000
Adjusting entry:
Depreciation expense (calculated above)...................... 96,000
Accumulated depreciation ....................................... 96,000
Earnings per share:

Exercise 4-11 Income from continuing
operations $5.00
Loss from discontinued operations (1.60)
Extraordinary gain 2.20
Net income $5.60
Requirement 1
Exercise 4-12
THE MASSOUD CONSULTING GROUP

Statement of Income and Comprehensive Income (in part)
Net income .......................................................... $1,354,000

Foreign currency translation gain, net of tax .... $168,000
Unrealized losses on investment securities,
net of tax ........................................................ (56,000)
Total other comprehensive income ..................... 112,000
Comprehensive income ....................................... $1,466,000
Requirement 2
THE MASSOUD CONSULTING GROUP

Statement of Comprehensive Income
Net income .......................................................... $1,354,000

Foreign currency translation gain, net of tax .... $168,000
Unrealized losses on investment securities
net of tax ........................................................ (56,000)
Total other comprehensive income ..................... 112,000
Comprehensive income ....................................... $1,466,000
Requirement 1
U.S. GAAP also permits the presentation of other
comprehensive income items in the statement of shareholders’
Exercise 4-13equity.
Requirement 2
IAS No. 1 also allows companies to report other comprehensive income items in either
a combined statement of income and comprehensive income or in a separate statement
of comprehensive income. Presentation in the statement of shareholders’ equity is not
permitted.
1.___ b Purchase of equipment for

Exercise 4-14cash.
2.___ a Payment of employee
salaries.
3. a_ Collection of cash from customers.
4. c_ Cash proceeds from a note payable.
5. b_ Purchase of common stock of another corporation for cash.
6. c_ Issuance of common stock for cash.
7. b_ Sale of machinery for cash.
8. a_ Payment of interest on note payable.
9. d_ Issuance of bonds payable in exchange for land and building.
10. c_ Payment of cash dividends to shareholders.
11. c_ Payment of principal on note payable.
Bluebonnet Bakers
Exercise 4-15 Statement of Cash Flows
Cash flows from operating activities:
Purchase of inventory (160,000)
Payment of salaries (90,000)
Cash flows from investing activities:
Collection of note receivable 50,000
Sale of investments 30,000
Net cash flows from investing activities (5,000)
Cash flows from financing activities:
Proceeds from note payable 100,000
Payment of note payable (25,000)
Net increase in cash 181,000
Cash and cash equivalents, January 1 17,000
Cash and cash equivalents, December 31 $ 198,000

Exercise 4-16 Cash collected for interest, considered an operating cash flow
by U.S. GAAP, could be classified as either an operating cash flow
or an investing cash flow according to International Accounting Standards.
Cash paid for interest, considered an operating cash flow by U.S. GAAP, could
be classified as either an operating cash flow or a financing cash flow according to
International Accounting Standards.
Cash paid for dividends, considered a financing cash flow by U.S. GAAP, could
be classified as either an operating cash flow or a financing cash flow according to
International Accounting Standards.
Accordingly, the statement of cash flows prepared according to IFRS could be
the same as under U.S. GAAP (E4-15) or could be presented as follows:
Bluebonnet Bakers
Statement of Cash Flows
Purchase of inventory (160,000)
Payment of salaries (90,000)
Collection of note receivable 50,000
Net cash flows from investing activities 1,000
Proceeds from note payable 100,000
Payment of note payable (25,000)
Cash and cash equivalents, December 31 $ 198,000

Exercise 4-17 Net income $17,300
Increase in accounts receivable (4,000)
Decrease in inventory 5,500
Decrease in prepaid insurance 1,200
Decrease in salaries payable (2,700)
Increase in interest payable 800
Requirement 1
Financing Investing Operating
Exercise 4-18 1. $300,000
2.  $(10,000)
3. 
4. 
5. $ (5,000)
6. (6,000)
7. (70,000)
8. 55,000
9. 
__________ __________ __________
$300,000 $(10,000) $(26,000) = $264,000

Requirement 2
Wainwright Corporation
For the Month Ended March 31, 2009

Payment of rent (5,000)
Payment of one-year insurance premium (6,000)
Payment to suppliers of merchandise for sale (70,000)
Net cash flows from operating activities $ (26,000)


Issuance of common stock 300,000
Cash and cash equivalents, March 1 40,000
Cash and cash equivalents, March 31 $ 304,000
Noncash investing and financing activities:
Acquired $40,000 of equipment by paying cash and issuing a note as follows:

Cost of equipment $40,000
Cash paid 10,000
Note issued $30,000
Tiger Enterprises
Exercise 4-19 Statement of Cash Flows
($ in thousands)
Net income $ 900
Depreciation expense 240
Decrease in accounts receivable 80
Increase in inventory (40)
Increase in prepaid insurance (30)
Decrease in accounts payable (60)
Decrease in administrative and other payables (100)
Increase in income taxes payable 50
Purchase of plant and equipment (300)
Proceeds from issuance of common stock 100
Proceeds from note payable 200
Payment of dividends (1) (940)
Net cash flows from financing activities(640)
Net increase in cash 100
Cash, January 1 200
Cash, December 31 $ 300
Retained earnings, beginning $540
(1) + Net income 900
- Dividends x x = $940
Retained earnings, ending $500
The T-account analysis of the transactions related to operating

Exercise 4-20cash flows is shown below. To derive the cash flows, the beginning
and ending balances in the related assets and liabilities are inserted,
together with the revenue and expense amounts from the income statements. In each
balance sheet account, the remaining (plug) figure is the other half of the cash
increases or decreases.

Cash Flows (Operating)
(a.) 7,080 (b.) 130
(c.) 3,460
(d.) 1,900
(e.) 550
Sales Revenue Accounts Receivable

1/1 830 (a.) 7,080
7,000 <-----------> 7,000
12/31 750
Prepaid Insurance Insurance Expense

1/1 20
(b.) 130 100 <-----------> 100
12/31 50
Accounts Payable Inventory Cost of Goods Sold

(c.) 3,460 1/1 360 1/1 600 3,360 <-----------> 3,360
3,400 <-----------> 3,400
12/31 300 12/31 640
Admin. & Other Payables Admin. & Other Expense

(d.) 1,900 1/1 400
1,800 <-----------> 1,800
12/31 300
Income Taxes Payable Income Tax Expense

(e.) 550 1/1 150
600 <-----------> 600
12/31 200
Based on the information in the T-accounts above, the operating activities section
of the SCF for Tiger Enterprises would be as shown next.

Tiger Enterprises
($ in thousands)
Prepayment of insurance (130)
Payment to inventory suppliers (3,460)
Payment for administrative & other exp. (1,900)
Payment of income taxes (550)
Net cash flows from operating activities $ 1,040
Exercise 4-21 List A List B

f 1. Intraperiod tax allocation a. Unusual, infrequent, and material gains and
losses.
g 2. Comprehensive income b. Starts with net income and works backwards to
convert to cash.
a 3. Extraordinary items c. Reports the cash effects of each operating
activity directly on the statement.
l 4. Operating income d. Correction of a material error of a prior period.
k 5. An operation (according to SFAS 144) e. Related to the external financing of the company.
j 6. Earnings per share f. Associates tax with income statement item.
d 7. Prior period adjustment g. Total nonowner change in equity.
e 8. Financing activities h. Related to the transactions entering into the
determination of net income.
h 9. Operating activities (SCF) i. Related to the acquisition and disposition of
long-term assets.
i 10. Investing activities j. Required disclosure for publicly traded
corporation.
c 11. Direct method k. A component of an entity.
b 12. Indirect method l. Directly related to principal revenue-generating
activities.

CPA / CMA REVIEW QUESTIONS
CPA Exam Questions
1. c. U.S. GAAP requires that discontinued operations be disclosed separately
below income from continuing operations.
2. d. Other than sales, COGS, and administrative expenses, only the gain or loss
from disposal of equipment is considered part of income from continuing
operations. Income from continuing operations was ($5,000,000 - 3,000,000
- 1,000,000 + 200,000) = $1,200,000.
3. a. In a single-step income statement, revenues include sales as well as other

revenues and gains.
Sales revenue $187,000

Interest revenue 10,200
Gain on sale of equipment 4,700
Total $201,900
The discontinued operations and the extraordinary gain are reported below
income from continuing operations.
4. a. The $400,000 impairment loss and the $1,000,000 loss from operations
should be combined for a total loss of $1,400,000.
5. d. The change in the estimate for warranty costs is based on new information
obtained from experience and qualifies as a change in accounting estimate.
A change in accounting estimate affects current and future periods and is not
accounted for by restating prior periods. The accounting change is a part of
continuing operations.
6. a. Dividends paid to shareholders is considered a financing cash flow, not an

operating cash flow.
7. c. Issuing common stock for cash is considered a financing cash flow, not an
investing cash flow.
CMA Exam Questions
1. c. The operating section of a retailer’s income statement includes all revenues

and costs necessary for the operation of the retail establishment, e.g., sales, cost
of goods sold, administrative expenses, and selling expenses.
2. d. Discontinued operations and extraordinary gains and losses are shown
separately in the income statement, below income from continuing
operations. The cumulative effect of most voluntary changes in accounting
principle is accounted for by retrospectively revising prior years’ financial
statements.
3. a. Extraordinary items should be presented net of tax after income from
operations.
PROBLEMS
Problem 4-1
REED COMPANY
Comparative Income Statements
For the Years Ended December 31
2009 2008
Sales revenue ........................................................[1] $4,000,000 [6] $3,000,000
Cost of goods sold .................................................[2] 2,570,000 [7] 1,680,000
Gross profit ........................................................... 1,430,000 1,320,000
Operating expenses:
Administrative ....................................................[3] 750,000 [8] 635,000
Selling .................................................................[4] 340,000 [9] 282,000
Loss from fire damage ......................................... 50,000 --
Loss from write-down of obsolete inventory ...... 35,000 --
Total operating expenses ................................ 1,175,000 917,000
Operating income .................................................. 255,000 403,000
Interest revenue .................................................... 150,000 140,000
Interest expense ................................................... (200,000) (200,000)
Total other expenses (net) ............................... (50,000) (60,000)
Income from continuing operations before
income taxes and extraordinary item............... 205,000 343,000
Income tax expense ............................................... 82,000 137,200
extraordinary item.............................................. 123,000 205,800
Income (loss) from operations of discontinued
component (including loss on disposal of
$50,000 in 2009) ............................................... (10,000) 110,000
Income tax benefit (expense)................................ 4,000 (44,000)
Income (loss) on discontinued operations .........[5] (6,000) 66,000
Income before extraordinary item ........................ 117,000 271,800
Extraordinary item:
Loss from earthquake (net of $40,000 tax benefit) . (60,000) --
Net income ............................................................ $ 57,000 $ 271,800
Earnings per share:
extraordinary item.................................................... $ .41 $ .69
Discontinued operations ............................................ (.02) .22
Extraordinary loss ...................................................... (.20) --
Net income .................................................................. $ .19 $ .91

Problem 4-1 (concluded)
[1] $4,400,000 - 400,000
[2] $2,860,000 - 290,000
[3] $800,000 - 50,000
[4] $360,000 - 20,000
[5] Loss in 2009:

Loss on sale of assets (50,000)
Loss before tax benefit (10,000)
Tax benefit (40% x $10,000) 4,000
Loss on discontinued operations, net of tax benefit $ (6,000)
[6] $3,500,000 - 500,000 (sales from discontinued operation)
[7] $2,000,000 - 320,000 (cost of goods sold from discontinued operation)
[8] $675,000 - 40,000 (administrative expenses from discontinued operations)
[9] $312,000 - 30,000 (selling expenses from discontinued operations)
Requirement 1
Problem 4-2
JACKSON HOLDING COMPANY
Comparative Income Statements (in part)
For the Years Ended December 31
2009 2008
income taxes [1] .......................................... $3,000,000 $1,300,000
Income tax expense ......................................... 1,200,000 520,000
Income from continuing operations ................. 1,800,000 780,000
Income from operations of discontinued
component (including gain on disposal of
$600,000 in 2009) [2] ....................................... 200,000 (300,000)
Income tax expense (benefit) ......................... 80,000 120,000
Income (loss) on discontinued operations ..... 120,000 (180,000)
Net Income ...................................................... $1,920,000 $ 600,000
[1] Income from continuing operations before income taxes:

2009 2008
Unadjusted $2,600,000 $1,000,000
Add: Loss from discontinued operation 400,000 300,000
Adjusted $3,000,000 $1,300,000
[2] Income from discontinued operations:

2009 2008
Operating loss $(400,000) $(300,000)
Gain on disposal 600,000 -
Total $ 200,000 $(300,000)

Requirement 2
The 2009 income from discontinued operations would include only the operating
loss of $400,000. Since no impairment loss is indicated ($5,000,000 – 4,400,000 =
$600,000 anticipated gain), none is included. The anticipated gain on disposal is not
recognized until it is realized, presumably in the following year.
Requirement 3
The 2009 income from discontinued operations would include the operating loss
of $400,000 as well as an impairment loss of $500,000 ($4,400,000 book value of
assets less $3,900,000 fair value).
Problem 4-3Requirement 1
MICRON CORPORATION

income taxes and extraordinary item........ [1] $1,300,000
Income tax expense .................................... 390,000
Income from continuing operations ............ 910,000
Loss from operations of discontinued
component (including loss on disposal of
$300,000) $ (140,000)
...................................................................
Income tax benefit (42,000)
...................................................................
Loss on discontinued operations ............... [2]

(98,000)
Income before extraordinary item ............... 812,000
Extraordinary item:
Loss from earthquake
(net of $240,000 tax benefit) ..................... (560,000)
Net Income ................................................. $ 252,000
[1] Income from continuing operations before taxes:

Unadjusted $1,200,000
Add: Gain from sale of factory 100,000
Adjusted $1,300,000
[2] Loss on discontinued operations:
Deduct: Loss on sale of assets (300,000)
Loss before tax (140,000)
Tax benefit (30% x $140,000) 42,000
Loss on discontinued operations $ (98,000)
Requirement 2
These events will not, or are unlikely to occur again in the near future. By
segregating them, users are better able to predict future cash flows.
1. Restructuring is an example of an event that is either unusual or
Problem 4-4 infrequent, but not both. Restructuring costs should be included
in income from continuing operations but reported as a separate
income statement component. The item is reported gross, not net of tax as with
extraordinary gains and losses.
2. The extraordinary gain should be presented, net of tax, in the income statement
below income from continuing operations. Also, earnings per share for income
from continuing operations and for the extraordinary item should be disclosed.
3. The correction of the error should be treated as a prior period adjustment to
beginning retained earnings, not as an adjustment to current year's cost of goods
sold. In addition, the 2008 financial statements should be restated to reflect the

correction, and a disclosure note is required that communicates the impact of the
error on 2008 income.
Problem 4-5
ALEXIAN SYSTEMS, INC.
Income Statement
($ in millions except per share date)

Net sales revenue ................................................. $425
Cost of goods sold ............................................... [1] 265
Gross profit .......................................................... 160
Operating expenses:
Selling and administrative ................................ [2] $128
Restructuring costs ........................................... 26
Total operating expenses ............................... 154
Operating income ................................................ 6
Other income:
Interest revenue ................................................. 3
Gain on sale of assets ....................................... 6
Total other income ........................................ 9
Income before income taxes and extraordinary
item .................................................................. 15
Income tax expense ............................................. [3] 6
Income before extraordinary item ....................... 9
Extraordinary gain (net of $48 in taxes) ..................... [4] 72
Net income .......................................................... $ 81
Earnings per share:

Income before extraordinary item ....................... $ 0.45
Extraordinary gain ............................................... 3.60
Net income .......................................................... $ 4.05
[1] $270 - 5 (prior period adjustment)
[2] $154 - 26 (restructuring costs)
[3] 40% x $15
[4] $120 less taxes of $48 (40% x $120)

Note: The difference in net income of $3 million ($81 million compared to $78 million on the
original income statement) is the effect of the inventory error of $5 million, less the 40% tax effect.
Problem 4-6
REMBRANDT PAINT COMPANY
Income Statement
($ in thousands, except per share
amounts)
Sales revenue .................................................................... $18,000
Cost of goods sold ............................................................ 10,500
Gross profit ....................................................................... 7,500
Operating expenses:
Selling and administrative ............................................ $2,500
Restructuring costs ........................................................ 800 3,300
Interest income (expense), net ......................................... (150)
Income from continuing operations before income taxes
and extraordinary item ................................................. 4,050
Income tax expense .......................................................... 1,215
Income from continuing operations before extraordinary
item ............................................................................... 2,835
(including gain on disposal of $2,000) .................................. 400
Income tax expense ....................................................... 120
Income on discontinued operations ............................. 280
Extraordinary gain (net of $900 tax expense) ..................... 2,100
Net income........................................................................ 5,215
Earnings per share:

item ................................................................................ $ 5.67
Income on discontinued operations .................................. .56
Extraordinary gain ............................................................ 4.20
Net income ....................................................................... $10.43

Problem 4-7
SCHEMBRI MANUFACTURING CORPORATION
Combined Statement of Income and Comprehensive Income
($ in 000s)
Sales revenue .................................................................. $15,300

Cost of goods sold ........................................................... 6,200
Gross profit ..................................................................... 9,100
Operating expenses:
Selling .......................................................................... $1,300
General and administrative .......................................... 800
Restructuring costs ....................................................... 1,200
Total operating expenses ........................................ 3,300
Operating income ............................................................ 5,800

Loss on sales of investments ........................................................... $(220)
Interest expense ...............................................................................
(180)
Interest revenue ............................................................................... 85
Other income (expense) ............................................................... (315)
Income from continuing operations before income taxes
and extraordinary item .................................................................... 5,485
Income tax expense ......................................................... 2,194
item .............................................................................. 3,291
(including gain on disposal of $1,400) ...................... 840
Income tax expense ...................................................... (336)
Income from discontinued operations ......................... 504
Income before extraordinary item .................................. 3,795
Extraordinary item:
Loss from earthquake (net of $800 tax benefit) .......... (1,200)
Net income....................................................................... 2,595
Other comprehensive income:
Unrealized gains from investments (net of $128 tax) 192
Loss from foreign currency translation (net of $96 (144) 48
tax)
Comprehensive income $2,643

Earnings per share:*
item $2.74
Discontinued operations .42
Extraordinary loss (1.00)
Net income $2.16
*Weighted-average shares = 1,000,000 + (400,000/2) = 1,200,000
Note:
The depreciation expense error is a prior period adjustment (to retained earnings) and is not
reported in the income statement.

Problem 4-8
DUKE COMPANY
Statement of Income and Comprehensive Income
Sales revenue .................................................................. $15,000,000
Cost of goods sold ........................................................... 9,000,000
Gross profit ..................................................................... 6,000,000
Operating expenses:
General and administrative .......................................... $1,000,000
Selling ......................................................................... 500,000
Restructuring costs ....................................................... 300,000
Loss from write-down of obsolete inventory 400,000
Total operating expenses .......................................... 2,200,000
Operating income ............................................................ 3,800,000

Interest expense ............................................................ (700,000)
Income before income taxes and extraordinary item ...... 3,100,000
Income tax expense ......................................................... 1,240,000
Income before extraordinary item .................................. 1,860,000
Extraordinary item:
Loss from expropriation of overseas plant (net
of $1,200,000 tax benefit) ........................................... (1,800,000)
Net Income....................................................................... 60,000
Foreign currency translation adjustment loss, net of tax (120,000)
Unrealized gains on investment securities, net of tax 108,000
Total other comprehensive loss (12,000)
Comprehensive income $ 48,000
Notes:
1. The restructuring costs and the loss from write-down of inventory are not extraordinary items.
2. The depreciation expense error is a prior period adjustment and is not reported in the
income statement.
Requirement 1
Problem 4-9 Diversified Portfolio Corporation

Collections from customers (1) $880,000
Payment of operating expenses (2) (660,000)
Payment of income taxes (3) (85,000)

Net cash flows from investing activities 50,000

Proceeds from issue of common stock 100,000
Increase in cash 205,000
Cash and cash equivalents, December 31 $275,000
(1) $900,000 in service revenue less $20,000 increase in accounts receivable.

(2) $700,000 in operating expenses less $30,000 in depreciation less $10,000 increase
in accounts payable.
(3) $80,000 in income tax expense plus $5,000 decrease in income taxes payable.

Requirement 2
Diversified Portfolio Corporation

Net income $120,000
Increase in accounts receivable (20,000)
Increase in accounts payable 10,000
Decrease in income taxes payable (5,000)
Requirement 1
Problem 4-10
2008 Cash:
2008 Cash + Net increase in cash = 2009 Cash
2008 Cash + 61 = 120
2008 Cash = 59
2009 A/R:
2008 A/R + Cr. Sales – Cash collections = 2009 A/R
84 + 80 – 71 = 93
2008 Inventory:
2008 A/P + Purchases – Cash Paid = 2009 A/P
30 + Purchases – 30 = 40
Therefore, Purchases = 40
2008 Inventory + Purchases – 2009 Inventory = Cost of goods sold
2008 Inventory + 40 – 60 = 32
2008 Inventory = 52
2008 Accumulated depreciation:

Gain on sale of equipment was 15; Cash received was 40; therefore, book value of
equipment was 25. Since the cost of equipment sold was 50 (200 - 150), accumulated
depreciation on equipment sold must have been 25.

2008 Accumulated depreciation + Depreciation expense – Accumulated depreciation on
equipment sold = 2009 Accumulated depreciation
2008 Accumulated depreciation + 10 – 25 = 40
2008 Accumulated depreciation = 30 + 25 = $55

Problem 4-10 (continued)
2008 Total assets:

$59 + 84 + 52 + 200 – 55 = $340
2009 Total assets:

$120 + 93 + 60 + 150 – 40 = $383
2008 Income taxes payable:

2008 Inc. taxes payable + Inc. tax expense – Income taxes paid =
2009 Inc. taxes payable
2008 Inc. taxes payable =2009 Inc. taxes payable + Taxes paid – Inc. tax expense
2008 Inc. taxes payable = 22 + 9 – 7 = $24
2009 Retained earnings:

2008 R/E + Net income – Dividends = 2009 R/E
47 + 28 – 3 = 72
2008 Total liabilities and shareholders’ equity:

$30 + 9 + 24 + 230 + 47 = $340
2009 Total liabilities and shareholders’ equity:

$40 + 9 + 22 + 240 + 72 = $383

Requirement 2
Grandview Corporation
($ in millions)
Net income $ 28
Depreciation expense 10
Gain on sale of equipment (15)
Increase in accounts receivable1 (9)
Increase in inventory2 (8)
Increase in accounts payable3 10
Decrease in income taxes payable4 (2)
Net cash flows from operating activities $14
1
$93 – 84
2
$60 – 52
3
$40 – 30
4
$22 – 24
Santana Industries
Problem 4-11 Statement of Cash Flows
($ in thousands)
Net income $ 3,850
Increase in accounts receivable (300)
Increase in inventory (1,000)
Decrease in prepaid rent 150
Increase in accounts payable 300
Increase in interest payable 100
Increase in unearned service revenue 200
Decrease in income taxes payable (250)
Sale of equipment 500
Proceeds from loan payable 5,000
Cash, January 1 2,200
Cash, December 31 $7,350
CASES
Judgment Case 4-1
Requirement 1
The term earnings quality refers to the ability of reported earnings (income) to
predict a company’s future earnings. After all, an income statement simply reports on
events that already have occurred. The relevance of any historical-based financial
statement hinges on its predictive value.
Requirement 2
To enhance predictive value, analysts try to separate a company’s transitory
earnings effects from its permanent earnings. Transitory earnings effects result from
transactions or events that are not likely to occur again in the foreseeable future, or
that are likely to have a different impact on earnings in the future.
Requirement 3
An often-debated contention is that, within GAAP, managers have the power, to a
limited degree, to manipulate reported company income. And the manipulation is not
always in the direction of higher income. Many believe that manipulating income
reduces earnings quality because it can mask permanent earnings.
Requirement 4
You would consider the size of the gain in relation to net income, the size of the
company’s investment portfolio, and the frequency of gains and losses from the sale

of investment securities in past years. The main objective is to determine the
likelihood of this type of gain occurring again in the future.
Requirement 1
Judgment Case 4-2 Restructuring costs include costs associated with
shutdown or relocation of facilities or downsizing of operations. Facility closings and
related employee layoffs translate into costs incurred for severance pay and relocation
costs as well as asset write-downs or write-offs.
Requirement 2
Prior to 2003, restructuring costs were recognized (expensed) in the period the
decision to restructure was made, not in the period or periods in which the actual
activities took place. Now, restructuring costs are expensed in the period(s) incurred.
Requirement 3
Restructuring costs would be included as an operating expense in a multi-step
income statement.
Requirement 4
An analyst must interpret restructuring charges in light of a company’s past
history in this area. Information in disclosure notes describing the restructuring and
management plans related to the business involved also can be helpful.
No. Companies generally prefer to report earnings that
Judgment Case 4-3follow a smooth, regular, upward path. They try to avoid
declines, but they also want to avoid increases that vary
wildly from year to year. It is better to have two years of 15% earnings increases
than a 30% gain one year and none the next. As a result, some companies “bank”
earnings by understating them in particularly good years and use the banked profits to
increase earnings in bad years.
Requirement 1
Real World Case 4-4 Companies often voluntarily provide a pro forma
earnings number when they announce annual or quarterly earnings calculated
according to GAAP. These pro forma earnings numbers are management’s view of
permanent earnings. These pro forma earnings numbers are controversial as they
represent management’s biased view of permanent earnings and should be interpreted
in that light.
Requirement 2
The term earnings quality refers to the ability of reported earnings (income) to
predict a company’s future earnings. Management believes that pro forma earnings
are of much higher quality than reported earnings because they are more indicative of
future profitability.

Requirement 3
There are some obvious reconciling items, to include restructuring costs and other
special charges of $1,170 million, inventory charges of $2,249 million and in-process
research and development of $109 million. Cisco offered the following reconciliation
($ in millions):
GAAP loss $(2,693)

Add:
Restructuring costs and other special charges $1,170
In-process research and development 109
Amortization of goodwill and other acquisition costs* 346
Payroll tax on stock options exercised 10
Inventory charges 2,249
Total adjustments 3,884
Tax effects (approximately 24.7% tax rate) 961
Net of tax adjustments 2,923
Pro forma net income $ 230
*New accounting standards discussed in Chapters 10 and 11 require that goodwill

no longer be amortized. This standard became effective after August of 2001.
The critical question that student groups should

Communication Case 4-5address is whether or not the gain on the sale of the
timber tracts should be reported as an extraordinary
item on the 2009 income statement. There is no right or wrong answer. The process
of developing the proposed solutions will likely be more beneficial than the solutions
themselves. Students should benefit from participating in the process, interacting first
with other group members, then with the class as a whole.
Solutions should address the following issues:
1. Is the gain material? A consensus should be reached that the gain is material.
2. Is the event both unusual and infrequent? Debate should center on the critical
issue of whether the event is likely to occur again in the foreseeable future.
3. If the event is deemed to require presentation as an extraordinary item, the
gain should be reported net of tax below income from continuing operations.
A disclosure note also is required and earnings per share disclosure should
reflect the income statement presentation.
As a real world example of a similar situation, in 1974 Johns Manville

Corporation, manufacturer of asbestos products, reported a $21 million extraordinary
gain from the sale of timber tracts. No disclosure note was provided to explain the
event, so we can only speculate as to the circumstances leading to the company's
presentation of the gain as extraordinary.
It is important that each student actively participate in the process. Domination
by one or two individuals should be discouraged. Students should be encouraged to
contribute to the group discussion by (a) offering information on relevant issues, and
(b) clarifying or modifying ideas already expressed, or (c) suggesting alternative
direction.
Suggested Grading Concepts and Grading
Communication Case 4-6 Scheme:
Content (70%)
_______ 10 Is the loss material?
_______ 25 Lists the alternative treatments.

______ Present before-tax amount as a separate line item.
______ Present the after-tax amount as an extraordinary item.
______ In either case, disclosure is required.
_______ 25 Cites the appropriate authoritative pronouncement,

APBO 30, and discusses the concepts of unusual
and infrequent in the context of the company’s environment.
_______ 10 A clear, well-supported recommendation is made.

______
_______ 70 points
Writing (30%)
_______ 6 Terminology and tone appropriate to the audience of a chief
financial officer.
_______ 12 Organization permits ease of understanding.

______ Introduction that states purpose.
______ Paragraphs that separate main points.
_______ 12 English
______ Sentences grammatically clear and well organized,
concise.
______ Word selection.
______ Spelling.
______ Grammar and punctuation.
______
_______ 30 points

Case 4-6 (continued)
The following is provided as an example.

August, 1990
TO: Chief Financial Officer, Carter Hawley Hale Stores (CHHS)
FROM: John Doe, Controller (CHHS)
RE: Income Statement treatment of October 17, 1989, earthquake damage costs.
A decision on the income statement treatment of the earthquake damage costs

involves a number of considerations. First, the damage costs are clearly material.
Inclusion of the costs in earnings results in an increase in the net loss for the fiscal
year ended August 4, 1990, from $9.47 million to $25.97 million. This leaves us only
two options for the income statement presentation of the loss:
1. Present the before-tax amount of the loss ($27.5 million) as a separate line
item in the income statement.
2. Present the after-tax effect of the loss ($16.5 million) as an extraordinary
item, below income from continuing operations.
In both cases, a disclosure note would be required to explain the loss.
The appropriate authoritative pronouncement pertaining to this case is

Accounting Principles Board Opinion No. 30. The opinion states that judgment is
required in determining whether or not an event warrants separate reporting in the
income statement as an extraordinary item. However, the following broad guideline is
provided:
“Extraordinary items are events and transactions
that are distinguished by their unusual nature and
by the infrequency of their occurrence.”(par. 20)
The opinion adds that the characteristics of unusual nature and infrequency of
occurrence must be considered in light of the environment in which the company
operates.
These characteristics are only aids in answering the important question: What is
the likelihood that this event will occur again in the foreseeable future? If it is not
likely to occur again, then this should be communicated to financial statement users
by segregating the income effect of the event as an extraordinary item. This will help
them in using the income statement to predict future cash flows.

Case 4-6 (concluded)
RECOMMENDATION
I recommend that the earthquake damage costs be treated as an extraordinary
loss, net of tax, in the income statement for the fiscal year ended August 4, 1990. In
addition, earnings per share for income both before and after the loss must be
presented. While many earthquakes do occur in California, extremely large
earthquakes causing significant amounts of damage are both unusual and infrequent. I
do not believe that this type of loss will occur again in the foreseeable future.
Discussion should include these elements.

Ethics Case 4-7
Facts:
The company incurred $10 million in expenses related to a product recall. The
company had experienced product recalls in the past and they do occur in the industry.
To show a profit from continuing operations, Jim Dietz, the controller, wants to report
the $10 million as an extraordinary loss, rather than as an expense included in
operating income. He tells the CEO that the company has never had a product recall
of this magnitude and that the company fixed the design flaw and upgraded quality
control.
Extraordinary items are gains and losses that are material, and result from events
that are both unusual and infrequent. These criteria must be considered in light of the
environment in which the entity operates. There obviously is a considerable degree of
subjectivity involved in the determination. The concepts of unusual and infrequent
require judgment. In making these judgments, an accountant should keep in mind the
overall objective of the income statement. The key question is how the event relates to
a firm’s future profitability. If it is judged that the event, because of its unusual nature
and infrequency of occurrence, is not likely to occur again, separate reporting as an
extraordinary item is warranted.
Ethical Dilemma:
It appears from the facts of the case that it would be difficult for the company to
come to the conclusion that a material product recall is not likely to occur again in the
foreseeable future. This type of event has occurred before and is common in the
industry. While a subjective judgment, extraordinary treatment of the $10 million
does not appear warranted. Is the obligation of Jim and the CEO to maximize income
from continuing operations, the company's position on the stock market and
management bonuses stronger than their obligation to fairly present accounting
information to the users of financial statements?
Who is affected?

Jim Dietz
CEO and other managers
Other employees
Shareholders
Potential shareholders from the stock market
Creditors
Company auditors
Requirement 1
Research Case 4-8 Most would agree that the events of September 11, 2001
were “extraordinary.” The terrorist attacks were unprecedented in terms of the
magnitude of the losses incurred, the number of entities affected, the unprecedented
federal ground stop order that closed the U.S. air travel system for over 24 hours, and
the unprecedented efforts undertaken by the U.S. and other nations to prevent future
terrorist attacks.
Requirement 3
The EITF was initially reluctant to address the issue because of its importance.
However, timely accounting guidance was necessary to help companies in deciding
how to measure and report the losses sustained as a result of the attacks. The Task
Force noted that without such guidance, financial statement preparers and auditors
would be faced with individually resolving the difficult questions presented by this
issue. The FASB’s elaborate process would have not provided the necessary guidance
in a timely manner.
Requirement 4
In EITF 01-10, the Task Force concluded that despite the incredible nature of the
September 11 events, extraordinary item financial reporting treatment would not be an
effective way to communicate the financial effects of those events and, therefore,
should not be used in this case. The Task Force noted that it would be impossible to
isolate and therefore distinguish, in a consistent way, the effects of the September 11
events in any single line item on companies’ financial statements because of the
inability to separate losses that are directly attributable to the events from those that
were not.
Financial Statement
Judgment Case 4-9 Presentation
Situation Treatment (a-g)
(CO, BC, or RE)
1. b CO
2. c RE
3. f CO
4. g CO
5. a BC
6. b CO
7. e BC
8. d. RE
1. The loss is not unusual or infrequent. It is included in

Judgment Case 4-10 income from continuing operations along with other
gains and losses.
2. The sale of the financing component is treated as a discontinued operation. The
gain or loss from the sale of the assets along with income or loss generated by the
component is presented below income from continuing operations.
3. A change in depreciation method is treated as a change in accounting estimate
achieved by a change in accounting principle. Changes in estimates are accounted
for prospectively. The remaining book value is depreciated, using the new method,
over the remaining useful life.
4. This event is not unusual but may be infrequent. It usually is presented as a
separate line item included in income from continuing operations.
5. The correction of an error is treated as a prior period adjustment. The effect of the
correction is not included in income, but as an adjustment to retained earnings.
Prior years’ financial statements are restated to correct the error.
6. This event requires no unusual treatment. The lipstick line does not qualify as a
component of an entity requiring treatment as a discontinued operation. The loss
on sale of the assets of the product line is included in continuing operations along
with other gains and losses.
Requirement 1
IFRS Case 4-11 U.S. GAAP, SFAS No. 144, considers a discontinued
operation to be a component of an entity whose operations and
cash flows can be clearly distinguished from the rest of the entity that has either been
disposed of or classified as held for sale. IFRS No. 5 also defines a discontinued
operation as a component of an entity that has been disposed of or is classified as held
for sale. What constitutes a component of an entity, however, differs considerably
between the international standard and SFAS No. 144. IFRS No. 5 considers a
component to be primarily either a major line of business or geographical area of
operations. The U.S. definition is much broader than its international counterpart.
Requirement 2
In 2006, Cadbury disposed of its South African beverage business. This would
qualify as a discontinued operation because the company is exiting a geographical
location. The disposal of this segment would most likely be an operation “whose
operations and cash flows can be clearly distinguished from the rest of the entity” thus
qualifying as a component of the entity according to U.S. GAAP as well.

Requirement 1
Judgment Case 4-12 1. a. As a component of operating income.
2. b. As a non-operating income item.
3. d. As an other comprehensive income item.
4. b. As a non-operating income item.
5. c. As a separately reported item.
6. a. As a component of operating income.
7. e. As an adjustment to retained earnings.
8. c. As a separately reported item.
Requirement 2
Situations 3, 5, and 8 would be reported in the statement of income and
comprehensive income net-of-tax. Also, the net-of-tax effect of the correction of the
amortization error, situation 7, would increase or decrease retained earnings.
It would be nice to think that management makes all

Judgment Case 4-13accounting choices in the best interest of fair and
consistent financial reporting. Unfortunately, other
motives influence the choices among accounting methods and whether to change
methods. It has been suggested that the effect of choices on management
compensation, on existing debt agreements, and on union negotiations each can affect
management’s selection of accounting methods. For instance, research has suggested
1
that managers of companies with bonus plans are more likely to choose accounting
methods that maximize their bonuses (often those that increase net income). Other 2
research has indicated that the existence and nature of debt agreements and other
aspects of a firm’s capital structure can influence accounting choices. Whether a 3
company is forbidden from paying dividends if retained earnings fall below a certain
level, for example, can affect the choice of accounting methods.
Choices made are not always those that tend to increase income. As you will
learn in Chapter 8, many companies use the LIFO inventory method because it
reduces income and therefore reduces the amount of income taxes that must be paid
1 Watts, R.L. and J.L. Zimmerman, “ Towards a Positive Theory of the Determination of Accounting Standards,” The
Accounting Review, January, 1978, and “Positive Accounting Theory: A Ten Year Perspective,” The Accounting
Review, January, 1990.
2 For example, see Healy, P.M., “The Effect of Bonus Schemes On Accounting Decisions,” Journal of Accounting and
Economics, April, 1985, and Dhaliwal, D.G. Salamon, and E. Smith, “The Effect of Owner Versus Management
Control On The Choice Of Accounting Methods,” Journal of Accounting and Economics, July, 1982.
3 Bowen, R.M., E.W. Noreen, and J.M. Lacy, “Determinants of the Corporate Decision To Capitalize Interest,”
Journal of Accounting and Economics,” August, 1981.
currently. Also, some very large and visible companies might be reluctant to report
high income that might render them vulnerable to union demands, government
regulations, or higher taxes. 4
(Note: This case requires the student to reference a journal

Research Case 4-14article.]
Requirement 2
The authors use the S&P 500 companies as their sample.
Requirement 3
77 percent in 2001 and only 54% in 2003.
Requirement 4
In 2001, 85% of firms have greater pro forma than GAAP earnings. This ratio
declined to 67% in 2003.
Requirement 5
In 2001, 136 firms reported “Restructuring Charges,” and the same number of
firms reported a “Divestiture/Sale of Business Units. In 2003, the most frequently
reported adjustment was “Amortization/Impairment of Goodwill and Other
Intangibles.”
Requirement 6
The authors’ main conclusions are that the introduction of pro forma regulation is
associated with a substantial change in firms’ pro forma reporting. Notably, far fewer
firms are reporting pro forma earnings, while those that continue to report appear to do
so in a manner consistent with the intention of the regulation, to provide useful
information, not to mislead.
DEFICIENCIES:
Integrating Case 4-15 Balance Sheet:
1. The asset section of the balance sheet should be
classified. Cash, short-term investments, accounts receivable, and inventories
should be included as current assets.
2. Accounts receivable should be shown net of the allowance for uncollectible
accounts.
3. Inventories - the method used to cost inventory should be disclosed in a note.
4. Marketable securities - $21,000 of investments ($78,000 - 57,000) should be
classified in a noncurrent investments category.
5. Property and Equipment - should be classified in a separate category. Original
cost should be disclosed along with the accumulated depreciation to arrive at
4 This “political cost’ motive is suggested by Watts, R.L. and J.L. Zimmerman, “ “Positive Accounting Theory: A Ten
Year Perspective,” The Accounting Review, January, 1990, and Zmijewski, M., and R. Hagerman, “An Income
Strategy Approach To The Positive Theory of Accounting Standard Setting/Choice,” Journal of Accounting and
Economics, August, 1981.
the net amount. Also, the method used to compute depreciation should be
disclosed in a note.
6. The liability and shareholders' equity section of the balance sheet should be
classified into (1) current liabilities, (2) long-term liabilities, and (3)
shareholders' equity.
7. Current liabilities should include accounts payable and accruals, notes payable
(the $80,000 note due in 2007 and the $60,000 installment on note # 2 due in
2007). The latter should be classified as current maturities of long-term debt.
Also, note disclosure is required for the notes providing information such as
payment terms, interest rates, and collateral pledged as security for the debt.
8. Long-term liabilities should include the $60,000 second installment on note
#2.
9. Common stock - the par value, if any, and the number of shares authorized,
issued and outstanding should be disclosed.
Income Statement:
1. The miscellaneous expense should be classified as an extraordinary item and
shown net of tax below income from continuing operations. A note should
describe the event.
2. Earnings per share disclosure is required.
3. The restructuring charges should be shown as a separate operating expense
item in the income statement and described in a note.
Requirement 1
Financial Analysis Case 4-16 2006 to 2007: ($4,203,720 - 3,077,446) ÷
$4,203,720 = 27% increase
2005 to 2006: ($3,077,446 – 1,465,397) ÷ $1,465,397 = 110% increase
Requirement 2
Provision for income taxes ÷ Income before taxes
$1,470,260 ÷ $5,673,980 = 26% = approximate income tax rate
Requirement 3
$4,203,720 ÷ $16,593,986 = 25%
Answers to the questions will, of course, vary
Real World Case 4-17because students will research financial statements of
different companies.
No specific standards dictate how income from continuing operations must be
displayed, so companies have considerable latitude in how they present the
components of income from continuing operations. This flexibility has resulted in a
considerable variety of income statement presentations. However, we can identify
two general approaches, the single-step and the multiple-step formats that might be
considered the two extremes, with the income statements of most companies falling
somewhere in between.
The presentation of separately reported items, however, is mandated and students
should be able to easily identify them.
A solution and extensive discussion

Trueblood Accounting Case 4-18materials can be obtained from the
Deloitte Foundation.


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Chapter 4 The Income Statement and Statement of Cash Flows

AACSB assurance of learning standards in accounting and business education require

Questions AACSB Tags Exercises AACSB Tags

© The McGraw-Hill Companies, Inc., 2009

© The McGraw-Hill Companies, Inc., 2009

Answers to Questions (continued)

© The McGraw-Hill Companies, Inc., 2009

© The McGraw-Hill Companies, Inc., 2009

Expenses and losses:

*$2,151 – (1,240 + 126 + 105 + 35) = $645 x 40% = $258

(a) Sales revenue $2,106

(b) Gain on sale of investments 45

Brief Exercise 4-3

Other income (expense):

(a) Sales revenue $300,000

(b) Operating income $25,000

(c) Income before extraordinary item $ 4,200

© The McGraw-Hill Companies, Inc., 2009

Income before income taxes and extraordinary item........... $ 850,000

Earnings per share:

Brief Exercise 4-6

Income from continuing operations before income taxes.... $ 5,800,000

Gain on sale of assets $ 2,000,000 ($10 million less $8 million)

Brief Exercise 4-7

Income from continuing operations before income taxes.... $ 5,800,000

Brief Exercise 4-8

Income from continuing operations before income taxes.... $ 5,800,000

© The McGraw-Hill Companies, Inc., 2009

Impairment loss ($8 million book value less

Brief Exercise 4-9 The change in inventory method is a change in

This is a change in accounting estimate.

Brief Exercise 4-10 When an estimate is revised as new information comes

© The McGraw-Hill Companies, Inc., 2009

Net income .......................................................... $650,000

Brief Exercise 4-12Cash Flows from Operating Activities:

Brief Exercise 4-13Cash Flows from Investing Activities:

Cash Flows from Financing Activities:

© The McGraw-Hill Companies, Inc., 2009

GREEN STAR CORPORATION

Revenues and gains:

Expenses and losses:

Earnings per share ............................................... $2.55

© The McGraw-Hill Companies, Inc., 2009

GREEN STAR CORPORATION

Sales revenue ....................................................... $1,300,000

Other income (expense):

Earnings per share ............................................... $2.55

Revenues and gains:

Expenses and losses:

Earnings per share:

Exercise 4-2 (concluded)

GENERAL LIGHTING CORPORATION

Earnings per share:

Exercise 4-3 LINDOR CORPORATION

© The McGraw-Hill Companies, Inc., 2009

Earnings per share:

Sales revenue .................................................................... $ 592,000

Other income (expense):

© The McGraw-Hill Companies, Inc., 2009

Earnings per share:

Income from continuing operations .................................... $ 350,000

Earnings per share:

* Loss on discontinued operations:

Loss on sale of assets $(400,000)