Solution Manual for Financial Reporting and Analysis, 6th Edition

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CHAPTER 1
THE ECONOMIC AND INSTITUTIONAL SETTING
FOR FINANCIAL REPORTING
CHAPTER OVERVIEW
Financial statements contain information about a company, its economic health, and its products that
help users in their decision making, and make it possible to monitor managers’ activities. Therein lies
the demand for financial statements. Specifically, equity investors, analysts, and brokers use financial
statements to form opinions about the value of a company as a basis for their investment decisions or
recommendations to others. Creditors use financial information to assess the company’s ability to make
its debt payments and comply with loan covenants. Auditors use financial statements to help design
more effective audits by identifying areas of potential reporting abuses. Other users that demand
financial information include managers, employees, suppliers, customers, and government and regulatory
agencies. Flexibility and consistency are both desired when preparing financial statements. The changing
economic environment demands the revision of standards and best practices that will best serve these two
diverse results.
Investors, creditors, and other interested parties demand financial statements because the information
is useful. What governs the supply of financial information? Two answers are mandatory reporting and
the advantages of voluntary disclosure. Most companies in the U.S. and other developed countries are
required to produce, distribute, and file financial reports with a governmental agency—the Securities and
Exchange Commission (SEC) in the U.S.—so that interested parties can view the statements. Voluntary
financial information that goes beyond the minimum requirements can benefit the company, its managers,
and its owners. Voluntary disclosure benefits and costs are likely to affect accounting policies and
reporting strategies. Therefore, the flexibility and discretion inherent in financial reporting standards
provide managers with opportunities to shape financial statements to achieve specific reporting goals.
Users of this information that understand financial reporting, managers’ incentives, and accounting
flexibility are better informed and more likely to be able to use financial statements to their advantage in
the decision-making process.
The accountant’s and analyst’s job is more challenging when financial reporting measurement and
disclosure rules differ across countries. Those rules may underscore the reporting culture that may have
evolved to reflect firms’ underlying economic performance. The FASB and IASB are working together to
converge U.S. GAAP and IFRS.
CHAPTER OUTLINE
I. WORLDCOM’S CURIOUS ACCOUNTING
A There are several “facts” to consider (stepping back in time to May 2002).
1. The market price of WorldCom is $2.00 per share and declining.
a. Stock analysts state that WorldCom is doing “surprisingly well despite tough times
throughout the industry.”
b. The company has $2.3 billion in cash, which translates into $20.50 book value
per share.
2. The first-quarter results indicate sales of $8,120 million and $240 million in pre-tax
operating profits – a decline of 16% in sales and 40% in profits while other firms in the
industry are reporting even steeper sales and earnings decreases.
3. The company has $104 billion in assets and $44 billion in debt.
4. WorldCom’s “line costs” are holding steady at about 42% of sales while other
companies are experiencing rising line costs as a percentage of sales.
a. Does this suggest that WorldCom is adept at managing its excess capacity

problems during a period of slack demand?
b. Is this a cautionary warning signal of problems at the company?
4. You call your broker and find that the stock has declined to $1.75 per share in early
trading. What do you do?

II. WHY FINANCIAL STATEMENTS ARE IMPORTANT
Investors need adequate information to judge risk versus reward factors of investment
alternatives.
1. A company’s financial statements are a critical source of information about the
financial condition, operating results, and prospects for the future for an
organization.
2. Financial statements can be used as an analytical tool, a management report card, an early
warning signal, a basis for prediction, and as a measure of accountability.
Teaching Tip: While financial statements are not as timely as press releases, they do provide an
economic history and are indispensable in developing an accurate profile of ongoing performance
and prospects.
A. Untangling the Web at WorldCom?
1. An internal audit discovered $3.8 billion in improper transfers of line cost expenses from
the income statement to the balance sheet. Without these transfers the company would
have reported a loss for 2001 and in the first quarter of 2002.
2. WorldCom stunned investors by announcing that it intended to restate financial
statements for 2001 and the first quarter of 2002. .
3. The stock price fell to $.06 per share.
4. Members of management were convicted of fraud and imprisoned.
5. The company defaulted on a $4.25 billion credit line and filed for bankruptcy.
6. The company acknowledged more than $7 billion in accounting errors over the previous
years.
Teaching Tip: While fraud is different than the flexibility and discretion inherent in financial
reporting rules, analytical review of financial statements may help one uncover fraud.
Teaching Tip: This text does not focus on assisting readers of financial statements in detecting
fraud. Rather, the purpose of this text is to assist readers in understanding the financial flexibility
and discretion inherent in financial accounting rules in order that they may make more informed
decisions.
III. ECONOMICS OF ACCOUNTING INFORMATION
A. Financial statements serve two key functions:
1. To provide a way for company management to transfer information about business
activities to people outside of the company, thereby solving the problem of information
asymmetry (problem of management having superior information that outsiders).
2. Financial statement information is often included in contracts between the company and
other parties since that improves contract efficiency (e.g. management compensation
contracts).
B. Demand for Financial Statements - The supply of financial statement information is guided
by the costs of producing and disseminating it and the benefits it will provide to the company.
Financial statements are demanded because of their value as a source of information about the
company’s performance, financial condition, and stewardship of its resources. Below is a short
list of outsiders whose decisions require financial statement information as a key input in
making decisions:
1. Shareholders and Investors use financial information to decide on a portfolio consistent
with their individual preferences for risk, return, dividend yield, and liquidity.
a. Financial statements are crucial in fundamental analysis.
b. Many analysts look beyond the financial statement numbers to the “meaning behind
the numbers,” making footnote disclosures invaluable.

c. Shareholders and investors use financial statement information to evaluate the
performance of the company’s top executives (stewardship function of financial
reports).
2. Managers and Employees use financial information to monitor contracts such as bonus
plans, profit-sharing plans, stock ownership plans, and to monitor the health of company-
sponsored pension plans along with information that will assist in making decisions
concerning the allocation of limited resources.
3. Lenders and Suppliers use financial information to assess the financial strength of a
business to determine whether to make a loan (or extend credit), and then the amount,
interest rate, and security (if any) that is needed.
4. Customers use financial information to monitor a supplier’s financial health as part of the
process of checking out a product and the company that stands behind it.
5. Government and Regulatory Agencies demand financial statement information
to assess compliance with laws and standards.
a. Taxing authorities may use financial statement information as a basis for establishing
tax policies designed to enhance social welfare.
b. As customers of businesses, government agencies may use financial statement
information to settle contractual payments.
c. Regulatory intervention may be another source of demand for financial statement
information.
C. Disclosure Incentives and the Supply of Financial Information - The supply of financial
information is guided by the costs of producing and disseminating it and the benefits it will
provide to the company.
1. Voluntary disclosure occurs so long as the incremental benefits to the company from
supplying that information exceed the incremental costs of supplying that information.
a. Some users, such as creditors, may have enough bargaining power to compel
companies to deliver financial information that they need for analysis.
b. Regulated financial reporting is designed to ensure that companies meet certain
minimum levels of financial disclosure and transparency.
2. Disclosure Benefits: Owners and managers have an economic incentive to supply the
amount and type of financial information that will enable them to raise capital at the
lowest cost.
3. Disclosure Costs:
a. Costs associated with collecting, processing, and disseminating financial information
can be large.
b. Competitors may use the information against the company providing the disclosure
(competitive disadvantage).
c. Litigation costs result when financial statement users initiate court actions against
the company and its management for financial misrepresentations.
d. Highly profitable—but politically vulnerable—firms may be subject to political
initiatives designed to impose “taxes” on them.
Teaching Tip: Small businesses are often subject to less comprehensive reporting requirements
because of the prohibitive costs referred to in (a.) above. Likewise, political costs (d. above) may
encourage firms to use accounting methods that appear less profitable. Much of the book is
devoted to providing students with the skills necessary to undo accounting methods or to convert
from one method to another so that more meaningful comparisons between companies may be
made. Therefore, students gain insight into managers’ incentives and become more informed
readers of financial statements.
IV. A CLOSER LOOK AT PROFESSIONAL ANALYSTS

A. Financial statement users have diverse information needs because they face different decisions
or may use different approaches to making the same kind of decision. The conflicting desired
result of flexibility and consistency may be problematic to standard setters.
B. The text focuses on “analysts”, defined broadly to include investors, creditors, financial advisors,
and auditors.
C. Analysts’ Decision - Information needs of analysts include:
1. Quarterly and annual financial statements and nonfinancial operating and performance
data.
2. Management’s analysis of financial and nonfinancial data, including reasons for change
(management discussion and analysis).
3. Information making it possible to identify future opportunities and risks.
4. Footnotes are important to analysts to obtain a transparent accounting of decision
alternates for financial statement comparisons.
5. The analyst needs to be able to compare financial results of diverse companies to help
investors decide where to allocate scarce resources.
V. THE RULES OF THE FINANCIAL REPORTING GAME
A. Generally accepted accounting principles (GAAP) are a network of conventions,
rules, guidelines, and procedures.
1. The goal of GAAP is to ensure that a company’s financial statements represent
its economic condition and performance.
2. Professional analysts are forward looking. GAAP reports what has occurred.
2. Therefore, analysts must first understand the accounting measurement rules used to
produce the data before extrapolating financial statement data into the future.
B. Financial statements should possess certain qualitative characteristics.
1. Financial information is relevant if it makes a difference in the decision-making process.
It is considered relevant if it has both predictive value and confirmatory value.
2. Predictive value: The information improves the decision maker’s ability to forecast the
future outcome of past or present events.
3. Confirmatory value: The information confirms or alters the decision maker’s earlier
beliefs.
4. Financial information is timely if it reaches decision makers before it loses its capacity to
influence their decisions.
5. Financial information is reliable if it is reasonably free of error and bias, and truthfully
represents what it purports to represent.
6. Financial information is representationally faithful when the accounting
actually represents the underlying transaction or economic event. To achieve
faithful representation, the financial information must have the qualities of
completeness (including all pertinent information), neutrality (information
cannot be selected to favor one set of interested parties over another), and free
from material error (Some minimum level of accuracy is necessary for an
estimate to be a faithful representation of an economic event).
7. Financial information is neutral when it does not favor one set of interested parties over
another.
8. Other qualitative characteristics that enhance the decision usefulness and representationally
faithful information are comparability, verifiability, timeliness, and understandability.
9. Financial information is comparable when it is measured and reported in a
similar manner among different companies.
10. Financial information is consistent when the same accounting methods and disclosure
practices are used to describe similar events from period to period.

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11. Verifiability means that independent measurers should get similar results when using the
same yardstick.
12. Timeliness refers to information that is available to decision makers while it is still capable
of influencing their decisions.
13. Understandability is the characteristic of information that enables users to comprehend its
meaning.
Teaching Tip: Students often want to know which accounting alternative is “best.” Qualitative
trade-offs make it difficult to identify “good” accounting methods and disclosure practices. For
example, market value may be relevant to the decision at hand, but representational faithfulness
may be questionable.
C. Two additional conventions affect whether financial statements are complete, understandable,
and helpful.
1. Materiality is established when an omission or misstatement is important enough that the
judgment of a reasonable person is influenced by the omission or misstatement.
2. Conservatism in accounting involves trying to ensure that business risks and
uncertainties are adequately reflected in the financial reports.
D. Who Determines the Rules?
1. The SEC has the ultimate legal authority to determine the rules to be followed in
preparing financial statements by publicly traded companies in the Unites States, but has
largely delegated its authority to the accounting profession’s Financial Accounting
Standards Board (FASB).
2. GAAP may also evolve from accounting practices over time.
3. The Public Company Accounting Oversight Board (PCAOB) was established by the
Sarbanes-Oxley Act of 2002 to provide oversight of auditing procedures two ways
a. establish standards for auditing and ethics at public accounting firms
b. inspect and investigate auditing practices of public accounting firms
4. Financial reporting standards outside the U.S. are determined in some countries by
professional accounting organizations, in other countries by commercial law and/or tax
law requirements, and on a worldwide basis by the International Accounting Standards
Board (IASB).
5. A convergence project has a goal of providing one set of worldwide accounting standards to
reconcile the IASB standards with those of the FASB.
6. Due to the voluminous nature of accounting and financial reporting documents, the AICPA
in SAS 69 developed a hierarchy for different types of documents.
E. The Politics of Accounting Standards: - Standard setting in the U.S. and most other countries
is a political and technical process.
1. Political pressure by interested parties continues to shape the surrounding sensitive and
controversial U.S. accounting standards.
2. While the intensity and frequency of political influence will persist in the future, it is
important to remember that accounting standards reflect both:
a. Sound concepts coupled with independent and objective decision making of standard
setters, and
b. Compromises necessary to ensure that proposed standards are generally acceptable.
F. FASB Accounting Standards Codification TM
1. The growing number of accounting pronouncements made it difficult to find answers to
financial accounting and reporting questions.
2. In 2009, the FASB completed a five-year project to distill the existing GAAP
literature into a single database now called the Accounting Standards
Codification (ASC).
3. The codification does not remove GAAP but reorganizes it for easy accessibility.

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4. ASC Topical Structure and Referencing - The ASC uses a structure that
organizes pronouncements into topics, sections, subsections, and paragraphs.
i. Topics are the broadest categorization of related guidance and are grouped into
four areas: presentation (financial statements or notes); financial statement
accounts (such as Receivables, Inventory, etc); broad transactions (e.g.
Business combinations and derivatives); and industries (specialized GAAP).
ii. Subtopics represent subdivisions of a topic and distinguished by type or scope
iii. Sections are subdivisions such as Recognition, Measurement, or Disclosure
VII. ADVERSARIAL NATURE OF FINANCIAL REPORTING.
1. Managers frequently have reasons to exploit the flexibility and discretion allowed by
accounting standards since their interests may conflict with the interests of creditors and
shareholders.
2. The flexibility of GAAP financial reporting standards provides opportunities to use
accounting “tricks” to make a company appear less risky than it really is, or to “smooth”
earnings by strategically timing the recognition of revenues and expenses.
Teaching Tip: For example, the choice to capitalize, rather than expense amounts, will make firms
appear to be larger, more profitable, and less risky. Therefore, naive acceptance of financial
statement data may be dangerous.
H. Aggressive Financial Reporting: A Case Study - Computer Associates International (CA)
embraces aggressive financial reporting practice.
1. The Accounting Issues: There are several facts to the case.
a. This company is a global leader in the software market for managing mainframe and
computers networks.
b. The first accounting controversy regarding revenue recognition occurred when CA
changed how it books revenue from software licenses that were renegotiated during
the licensing period. The net effect was to double count revenues when the licenses
were renegotiated. The impression was given that revenues were increasing over
time.
c. The second accounting controversy stemmed from the company’s decision to
roll out a subscription based business model and began reporting results using
nonstandard pro forma accounting in its earnings announcements.
d. The differences between the pro forma disclosures and the GAAP numbers were
substantial. Under the pro forma disclosure, revenue was reported as $1.284 billion
and operating income was $247 million while the GAAP numbers were $783
million for software revenue and operating income was a loss of $342 million.
2. The discrepancy between the pro forma and GAAP numbers made it tough for the
investment community to judge the company
3. The Justice Department and the SEC brought suit against CA leading to lawsuits and
charges of fraud and obstruction of justice against company executives.
Teaching Tip: Consider breaking the class into small groups and have them discuss the questions
posed in the “Questions to Consider” section of this chapter. This may be an excellent way to
enforce the need to be consistent with the objectives of financial reporting and the role GAAP plays
in meeting those objectives.
I. Epilog - CA admitted in October 2003 that some software license contracts had been backdated, to mask
declining performance and meet Wall Street forecasts. After an investigation, CA restated $2.2 billion in sales.

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Company spent $30 million on the investigation. CA agreed to pay $225 million in restitution to shareholders.
Top executives are serving prison sentences of up to 12 years each.
J. Challenges Confronting the Analyst
A. Financial statements have become increasingly more complex.
B. Service firms and e-commerce companies now represent a major portion of business activities.
C. Global competition for products, services, capital, and customers has introduced yet additional
diversity into the financial reporting process.
D. Benefits from increased use and lower cost of technology to assemble and analyze financial
data are muted by the increased complexity and dynamic environment in which firms operate
VIII. AN INTERNATIONAL PERSPECTIVE
Countries’ reporting philosophy evolves from and reflects the specific legal, political, and financial
institutions within the country as well as social customs.
A. Multinational companies shift resources around the world to take advantage of labor markets.
B. Global competition is prevalent in most industries today, and many companies look outside their
borders to establish an expanded customer base.
C. Many companies shift resources to take advantage of tax laws and incentives that vary country to
country, state to state, and even on a local level.
D. International Standards promulgated by the International Accounting Standards Board (IASB) have
had an increasing role in the setting of standards that are consistent throughout the global economy.
E. Why Do Reporting Philosophies Differ Across Countries?
The financial reporting philosophies of countries have evolved over many years from the legal,
political, and financial institutions, as well as social customs. This evolution creates a business culture,
which may determine the informational needs of the various stakeholders (market).
F. Foreign investors and other potential capital providers demand transparent financial reports that reflect
the underlying firm economic performance.
G. Sources of financing do shift over time. When this happens, changes in the financial reporting
environment occur as well.
H. Globalization and the Rise of IFRS - The FASB and the IASB are working toward eliminating
differences between U.S. GAAP and IRFS.
I. The SEC permits foreign companies to list their securities on a U.S. stock exchange as long as they are
registered with the SEC and use IFRS as a basis for their financial statements. Those firms do not have
to reconcile their financial statements to U. S. GAAP.
J. International Accounting Standards Board (IASB) – Established by the IASB created in July 1973
with four goals:
a. To develop a single set of high-quality, understandable, enforceable, and globally accepted
international financial reporting standards (IFRS)
b. To promote the use and rigorous application of those standards
c. To take account of the financial reporting needs of emerging economies and small and
medium-sized entities
d. To promote and facilitate the adoption of IFRS through the convergence of national
accounting standards and IFRS
K. IASB has issued 54 standards and 54 interpretations of the standards. Standards in use in 125 countries
worldwide. Compared to U.S. GAAP, IASB standards allow firms more flexibility and more of a
generalized overview approach.
L. Critics of the IASB’s principles-based approach content that IFRS are so general and the
implementation guidance so ambiguous that company managers have excessive latitude in accounting
choices.
M. Supporters of the IFRS argue that rigidity is less with IFRS where there are broad principles and not as
detailed as in rules-based U.S. GAAP approach.
N. The March Toward Convergence: Cross-border comparisons are difficult without convergence.
Some success on convergence has been achieved but some important differences still remain such as:

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a. Reversal of inventory write-downs
b. Extraordinary items
c. Research and development costs
IX. Appendix—GAAP IN THE UNITED STATES
A. Early Developments: Corporate financial reporting in the U.S. prior to 1900 were primarily
intended to provide accounting information for management’s use. The NYSE,
established in 1792, was the primary mechanism for trading ownership in corporations.
The securities trading ups and downs led to the need for a standardized accounting
policies and practices to be followed by SEC registered companies.
B. Emergence of GAAP - The Securities Act of 1933 required companies selling publicly traded
stock and debt to provide financial information.
1. The Act was amended in 1934 to create the Securities and Exchange Commission (SEC).
2. Firms with stock or debt listed on organized exchanges were required to file annual
financial reports with the SEC.
B. The American Institute of Certified Public Accountants (AICPA) Committee on Accounting
Procedures issued bulletins between 1938 and 1959 that set forth the framework for what the
committee believed to be generally accepted accounting procedures.
C. In 1959, the AICPA established the Accounting Principles Board (APB) to develop a
conceptual framework and to issue statements to improve external financial reporting and
disclosure.
1. The force of these pronouncements depended on general acceptance and persuasion.
2. Critics cited numerous instances where net income could be manipulated by selecting
among several methods that were “generally accepted.”
D. The Financial Accounting Standards Board (FASB) was created in 1973. It differed from
its predecessors in several important ways.
1. There were seven board members (APB had eighteen).
2. All Board members were required to sever ties with their previous employer.
3. Broader representation was achieved since board members did not have to be
Certified Public Accountants (CPA).
4. Staff support was increased substantially.
E. Current Institutional Structure in the United States: The SEC still retains broad
statutory powers over financial reporting practices, but continues to rely on private sector
organizations (currently the FASB) to set accounting standards.
1. The FASB has no authority to enforce compliance with generally accepted accounting
principles (GAAP). That responsibility lies with management, the accounting profession,
the SEC, and the courts.
2. The FASB follows a “due process” procedure in developing Accounting Standards
updates. Most updates issued by the FASB go through three steps:
a. Discussion-memorandum stage outlines the key issues involved.
b. Exposure-draft stage encourages further public comment that is evaluated.
c. Voting stage is when the Board votes whether to issue an ASU describing
amendments to the Accounting Standards Codification or to revise the proposed update
and reissue a new exposure draft.
3. Public Company Accounting Oversight Board: The Public Company Accounting
Oversight Board (PCAOB) has a role in developing transparent financial statement and an
increased system of internal control. The PCAOB regulates accounting firms auditing
companies that are listed on public exchanges

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CHAPTER QUIZ
1. During a period when a firm is under the direction of particular management, its
financial statements will directly provide information about:
a. Both firm performance and management performance.
b. Management performance but not directly provide information about firm
performance.
c. Firm performance but not directly provide information about management
performance.
d. Neither firm performance nor management performance.
2. Which of the following statements reflects the basic purpose of financial reporting?
a. The primary focus of financial reporting is information about a firm’s resources.
b. The best indication of a firm’s ability to generate favorable cash flow information is
based on
previous cash receipts and payments.
c. Financial accounting is expressly designed to directly measure the value of a firm.
d. Investment and credit decisions often are based, at least in part, on evaluations of the
past
performance of an enterprise.
3. Which of the following is considered a pervasive constraint under generally accepted
accounting principles?
a. Benefits/costs.
b. Conservatism.
c. Timeliness.
d. Verifiability.
4. According to the FASB conceptual framework, the qualitative characteristic of neutrality
is an ingredient of:
Faithful Representation Relevance
a. Yes Yes
b. Yes No
c. No Yes
d. No No
5. According to the FASB conceptual framework, which of the following situations
violates the qualitative characteristic of faithful representation?
a. Financial statements were issued nine months late.
b. Data on business segments having the same expected risks and growth rates are reported
to analysts estimating future profits.
c. Financial statements included property reported at an increased amount that
reflects management’s estimate of market value.
d. Management reports to stockholders regularly refer to new projects undertaken, but
the financial statements never report project results.

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6. Factors that may influence a decision maker’s judgment as to what accounting information
is useful include:
a. The decision to be made.
b. The information already possessed.
c. The decision maker’s capacity to process the information.
d. All of the above answers are correct.
7. Which one of the following types of disclosure costs is the cost of the audit of the
financial statements?
a. Political cost
b. Litigation cost.
c. Information collection and dissemination cost.
d. Competitive disadvantage cost
8. Employees demand financial statement information because the firm’s performance is
often linked to
a. Employee stock ownership plans.
b. Social security benefits.
c. Disability plan benefits.
d. Workmen’s compensation benefits.
9. The primary current source of generally accepted accounting principles for publicly
traded companies in the United States rests with the:
a. Securities and Exchange Commission.
b. New York Stock Exchange.
c. Financial Accounting Standards Board.
d. American Institute of Certified Public Accountants.
10. According to the FASB conceptual framework, the objectives of financial reporting are based
on
a. The need for conservatism.
b. Reporting on management’s stewardship and performance.
c. Generally accepted accounting principles.
d. The needs of the users of the information.
Essay Question
1. Define the expanded role of the PCAOB in the preparation of consistent and transparent
financial statements.
2. Why would it be beneficial to narrow international differences in accounting rules for
accounting and reporting?

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QUIZ ANSWERS:
1. c. Financial reporting provides information about an enterprise’s performance during a
period, but does not separate the effect of a particular management’s performance from the
effects of prior management actions, general economic conditions, the supply and demand
for an enterprise’s inputs and outputs, price changes, and other events.
2. d. Although investment and credit decisions reflect expectations about future performance,
those expectations are based, in part, on evaluations of past performance.
3. a. All accounting information is subject to two qualitative constraints: materiality and
cost/benefit. The cost/benefit constraint states that benefits of information must exceed the
cost of obtaining it.
4. b. Faithful representation assures that information is reasonably free from error and
bias and faithfully represents what it purports to represent. Its ingredients are
completeness, verifiability, and neutrality. Neutrality is the absence of bias intended to
reach a predetermined result or induce a certain behavior.
5. c. Faithful representation is defined as the quality of information that provides assurance
that the information is reasonably free from error and bias. In accordance with GAAP, the
carrying value of property should not be increased to market value.
6. d. The judgment by a decision maker as to what accounting information can be useful
includes the decision to be made, the information already possessed, and the decision
maker’s capacity to process the information.
7. a. Managers and employees use financial information to monitor employee contracts such
as bonus plans, profit–sharing plans, and pension plans.
8. c. Audit costs are associated with information collection and dissemination costs.
9. c. The FASB is charged with the responsibility of establishing financial accounting
standards.
10. d. According to the conceptual framework, one objective of financial reporting is to
provide information that is useful to present and potential investors, creditors, and other
users in making investment, credit, and similar decisions.
RECOMMENDED EXHIBITS
1. Figure 1.2—Desirable Characteristics of Accounting Information
SUGGESTED READINGS
1. Bartlett, Sarah, 1998. Who can you trust? Business Week (October 5), pp. 135.
2. Beyer, A.; D. Cohen, T. Lys, and B. Walther, 2010. The Financial Reporting Environment:
Review of Recent Literature. Journal of Accounting and Economics.
3. Fox, Justin, 1996. The glamorous world of accounting standards: Searching for
nonfiction in financial statements. Fortune (December 23), pp. 38-40.
4. Kuttner, Robert, 1996. How a corporate watchdog nearly lost its bite. Business Week (May
20), p. 24.
5. McConnell Jr., Donald K; Banks, George Y., 2003. How Sarbanes-Oxley will change the
audit process. Journal of Accountancy, Sep. 2003, Vol 196 Issue 3, pp. 49-56.
6. Zweig, Phillip, and Dean Foust, 1997. Corporate America is fed up with FASB. Business
Week (April 21), pp. 108-110.

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CHAPTER 2
ACCRUAL ACCOUNTING AND INCOME DETERMINATION
CHAPTER OVERVIEW
This chapter highlights the key differences between cash and accrual income measurement,
and why the latter generally provides a better measure of operating performance. In most cases,
accrual-basis revenues do not equal cash receipts, nor do accrual expenses equal cash
disbursements. The principles that govern expense recognition under accrual accounting are
designed to alleviate the mismatching of effort and accomplishment that occurs under cash-basis
accounting.
Revenue is recognized when both the critical event and measurability conditions are met. The
critical event establishes when the entity has done something to “earn” the asset being received,
and measurability is established when the revenue can be measured with a reasonable degree of
assurance. These conditions may be satisfied before, on, or after the point of sale.
The matching principle determines how and when the assets “used up” in generating the
revenue, or that expire with the passage of time, are expensed. Relative to current operating cash
flows, accrual earnings generally provide a more useful benchmark for predicting future cash
flows.
Predicting future cash flows and earnings is critical to assessing the value of a firm’s shares
and its creditworthiness. Multiple-step income statements are designed to facilitate this
forecasting process by isolating the more recurring or sustainable components of earnings from
the nonrecurring or transitory earnings components.
GAAP disclosure requirements for various types of accounting changes also facilitate the
analysis of company performance over time. All publicly traded companies must report EPS
numbers on the income statement. The basic EPS is based on the weighted average number of
shares actually outstanding during the period, while the diluted EPS is based on the “as if” all
potentially dilutive securities were converted into common shares.
Occasionally, changes in assets and liabilities resulting from incomplete or open transactions
bypass the income statement and are reported as direct adjustments to stockholders’ equity and
are called other comprehensive income components.
Joint deliberations of the FASB and IASB resulted in a recent Exposure Draft on financial
statement presentation that calls for displaying revenue and expense components for operating,
investing, and financing sources. The proposed changes in presentation format are designed to
enhance the predictive ability and decision usefulness of information presented in firms’
statement of comprehensive income.
CHAPTER OUTLINE
I. CASH VERSUS ACCRUAL INCOME MEASUREMENT
A. Accrual-basis income measurement is the cornerstone of income measurement.
1. Revenues are recorded in the period when they are “earned” and become
“measurable.”
a. Revenues are “earned” when the seller has performed a service or conveyed
an asset to a buyer.
b. Revenues are “measurable” when the value to be received for that service or
asset is reasonably assured and can be measured with a high degree of

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reliability.
i. Deferred revenue exists when a liability to provide a good or service is
created because the entity received cash or other assets in advance.
ii. Accrued revenue is recorded when you provide a good or service but will
not receive cash or other assets until a later time.
2. Expenses are the Expired costs or assets “used up” in producing those
revenues and they are recorded in the same accounting period in which the
revenues are recognized using the “matching principle.”
a. Deferred expenses exist when an organization makes a payment in advance
for a product or service that will be used in several periods to create
revenue or cost offsets.
b. Accrued expenses gradually build during the earnings process and are paid
or used after the close of the accounting period.
3. Accrual accounting decouples measured earnings (i.e., revenues less expenses)
from the amount of cash generated from operations because of both deferrals
(payments or receipts postponed) and accruals (payments or receipts
recognized).
a. Accrual accounting revenues generally do not correspond to cash receipts for
the period, nor do reported expenses always correspond to cash outlays of the
period.
b. As a result, accrual accounting can produce large discrepancies between
measured earnings and the amount of cash generated from operations.
c. However, accrual accounting earnings provide a more accurate measure
of the economic value added during the period than do operating cash
flows.
B. Cash-basis income measurement is straightforward.
1. Revenues are recorded when cash is received.
2. Expenses are recorded when cash is paid.
3. Because of differences in the timing of when cash inflows and cash outflows
occur, cash-basis income determination may distort one’s view of operating
performance.
a. Cash-basis income fails to properly match effort and accomplishment.
b. Cash-basis income may not provide a reliable benchmark for predicting
future operating results.
C. The Canterbury Publishing example demonstrates the differences noted above.
1. There are several “facts” to consider.
a. Canterbury sells three-year subscriptions of a quarterly publication to
subscribers, who prepay the full subscription price.
b. Canterbury takes out a three-year loan at the beginning of the three-year
subscription period, but interest is payable at maturity of the loan.
c. Costs to publish and distribute the magazine are paid in cash at the
time of publication.
2. Cash-basis income determination distorts Canterbury’s operating performance.
a. The entire cash inflow from subscription receipts would be treated as revenue
in the first year when the subscriptions were sold.
b. Operating expenses for publishing and distributing the magazine are
recorded in equal amounts in each of the three years.
c. The entire cost of financing the operations (i.e., interest expense) is recorded
in year three.
d. Consequently, Canterbury would report relatively high profits in year one

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when the subscriptions are sold and collected, followed by operating “losses”
in years two and three.
e. None of the cash-basis earnings figures provide a reliable benchmark for
predicting future operating results.
3. Accrual-basis income determination is designed to alleviate the mismatching
problems that exist under cash-basis accounting, making accrual earnings a more
useful measure of a firm’s performance.
a. Accrual-basis accounting allocates subscription revenue to each of the years
as the magazine is delivered to the subscriber and the revenues are “earned.”
b. Likewise, accrual accounting recognizes interest expense in each year the
bank loan is outstanding, not just when the interest is paid.
c. These modifications to the cash-basis results are made via a series of
“deferral” and “accrual” adjusting entries.
4. Accrual accounting better matches economic benefit with economic effort,
thereby producing a measure of operating performance that provides a more
realistic picture of past economic activities.
Teaching Tip: For-profit entities adopt accrual accounting because of its ability to provide
investors and creditors with a more realistic picture of relevant economic events and their effects on
firm activities. Just the same, accrual accounting does not capture all of an entity’s relevant
economic events as they occur. In addition, entities that do not have a profit motive may prefer a
cash-basis accounting system because of its simplicity.
II. MEASUREMENT OF PROFIT PERFORMANCE: REVENUE AND EXPENSES
A. Income is earned as the result of several (complex, multiple-stage processes) activities.
1. The critical issue then becomes the timing (stage) of income recognition.
2. The accounting process of recognizing income is comprised of two distinct steps.
a. The revenue recognition principle establishes when revenue is recorded.
b. The recognition of revenue then triggers the second step—matching against
revenue the costs that expired (were used up) in generating that revenue.
c. The difference between revenues and expired costs (expenses) is the net
income (profit) recognized for the period.
3. Due to the double-entry, self-balancing nature of accounting, important changes
occur in net assets (that is, assets minus liabilities) on the balance sheet.
a. The basic accounting equation (Assets = Liabilities + Owners’ Equity) can
be used to illustrate this point.
i. Owners’ equity increases by the amount of the net income recognized
ii. Net assets (that is, gross assets minus gross liabilities) increase by an
identical amount.
ii. Expense matching decreases net assets and owners’ equity by
identical amounts.
b. As a result, net asset valuation and net income determination are
inextricably intertwined.
B. A closer look at the revenue recognition criteria. Both the following conditions must be
satisfied:
1. The “critical event” (“Condition 1”) in the process of earning the revenue has
taken place (revenue has been earned). It may vary from industry to industry.
2. (“Condition 2”) – The amount of revenue that will be collected is reasonably

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assured and is measurable with a reasonable degree of reliability. Measurability
must be based on objective and verifiable evidence.
3. In most instances the point of sale is the earliest moment in time at which both
conditions 1 and 2 are satisfied. This is the dominant practice in most retail and
manufacturing industries.
4. Under the percentage-of-completion method (see Chapter 3), Conditions 1 and 2
are satisfied prior to the point of sale (i.e., transfer of title).
a. Condition 1 (critical event) is satisfied over time as the project progresses.
b. Condition 2 (measurability) is satisfied since a firm contract with a known
buyer at a set price exists.
Teaching Tip: Normally, once gross revenues for the period are determined, the next step in
determining net income is to accumulate and record the costs associated with generating the
revenue. However, under the percentage-of-completion method, it is the recognition of
expenses that drives the recognition of revenue.
5. Under the installment sales method (see Chapter 3), Conditions 1 and 2 may not be
satisfied until after the point of sale—for instance, until cash is collected.
6. Revenue earned is recognized during the production phase when:
a. A specific customer is identified and an exchange price is agreed upon.
b. A significant portion of the services to be performed has been performed, and
the expected costs of future services can be reliably estimated.
c. An assessment of the customer’s credit standing permits a reasonably accurate
estimate of the amount of cash that will be collected.
7. Revenue earned may be recognized on completion of production when:
a. The product is immediately saleable at quoted market prices.
b. The units are homogeneous.
c. No significant uncertainty exists regarding the costs of distributing the
product.
8. Revenue earned is recognized after the point of sale when one or more of the
following conditions are present:
a. Extreme uncertainty exists regarding the amount of cash to be collected
from customers. This uncertainty may be attributable to:
i. The precarious financial position of the customer.
ii. Contingencies in the sales agreement that allow the buyer or seller to
terminate the exchange.
iii. The customer has (and frequently exercises) the right to return the
product.
b. Future services to be provided are substantial, and their costs cannot be
estimated with reasonable precision.
9. Regardless of which basis of revenue recognition is used, the recognition of
expenses must always adhere to the matching principle.
C. Matching expenses with revenues earned.
1. The recognition of expenses generally follows the recognition of revenue.
2. Traceable (product) costs are costs that contribute directly to a particular sale
or to revenues of a particular period.
a. These costs are recorded as expenses in the same period that revenues are
recognized.
b. An example of product costs is costs of goods sold.

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3. Period costs are important in generating revenue, but their contribution to a specific
sale or to revenues in a particular period is more difficult to quantify.
a. These costs are associated with the time period in which they occur.
b. An example of period costs is advertising expense.
III. INCOME STATEMENT FORMAT AND CLASSIFICATION
A. The multiple-step income statement is intended to subdivide income in a manner that
facilitates the forecasting of future cash flows.
1. Virtually all decision models in modern corporate finance are based on future cash
flows.
2. The intent of the multiple-step format is to classify separately income components
that are “transitory” and to clearly differentiate them from income components
believed to be “sustainable” or likely to be repeated in future reporting periods.
3. This format isolates a key figure called income from continuing operations.
a. Ideally, this component of income should include only the normal,
recurring, presumably more sustainable, ongoing operating activities of
the organization.
b. This income number sometimes includes gains and losses that occurs
infrequently—called special or unusual items—but that arise from a firm’s
ongoing, continuing operations.
c. Therefore, income from continuing operations is intended to serve as a starting
point for forecasting future profits.
4. Nonrecurring items are transitory and are disclosed separately below the income
from continuing operations line.
B. Nonrecurring items, including discontinued operations, and extraordinary items,
are reported below income from continuing operations net of income tax effects.
1. This “net of tax treatment” is called intraperiod income tax allocation.
a. If income tax were not matched with the item giving rise to it, then total
reported income tax expense would combine taxes arising from both items
that were transitory as well as from other items that were more sustainable.
b. Mixing together the tax effect of continuing activities with the tax effect of
single occurrence events would make it difficult for statement readers to
forecast future tax outflows arising from ongoing events.
2. Income tax associated with sustainable income from continuing operations is
separately disclosed from taxes arising from the transitory items.
C. As defined in the U.S. GAAP, discontinued operations is a component of an entity,
which comprises operations and cash flows that can be clearly distinguished,
operationally and for financial reporting purposes, from the rest of the entity. Two
conditions must be met for an entity to report discontinued operations:
a. The operations and cash flows have been (will be) eliminated from the firm’s
ongoing operations.
b. The firm will not have any significant continuing involvement in the
operations of the component after the disposal transaction.
Failure to meet above conditions results in a firm reporting the component’s operating
results as part of the continuing operations and prior year’s results are not restated.
1. Two components of discontinued operations are reported:
a. Operating income or loss from operating the component from the beginning
of the reporting period to the disposal date, net of related tax effects.

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b. “Gain or loss on disposal (net of tax)” has two components: (1) expected
gain or loss on operations from the date a formal plan to discontinue
operations is adopted by a firm’s board of directors to the disposal date, and
(2) expected gain or loss on the sale of assets.
i. Expected net losses are always recorded.
ii. Expected net gains can be recorded to the extent that they offset
realized losses.
2. A firm must disclose the identity of segment and details of disposal in the
footnotes.
3. As recently proposed by FASB (April 2013), discontinued operations is a
component of a business that has either been disposed of, or is classified as held for
sale and represents a separate major line of business or major geographical area of
operations, and is part of a single plan to dispose of a separate major line of business
or geographical area of operation or is a business that meets the criteria for
classification as held for sale upon acquisition.
D. Extraordinary items.
1. Extraordinary items must meet both of the following criteria:
a. The underlying event or transaction must be unusual in nature, i.e., possess a
high degree of abnormality, considering its environment.
b. The underlying event or transaction must be infrequent in occurrence, i.e., it
would not reasonably be expected to recur in the foreseeable future.
2. Events that meet one, but not both, of these criteria, are reported as
income from continuing operations.
3. FASB ASC Paragraph 470-50-45-1 covers the reporting of gains or
losses from retirement of debt. This standard now allows for companies
that routinely retire debt to record this economic event as part of pre-tax
income from continuing operations with a separate line-item disclosure.
a. If material in amount (i.e., of sufficient magnitude to make a difference in
the decision-making process) then the item must be disclosed as a separate
item in the “Special or unusual items” section of the income statement.
b. Alternatively, a separate disclosure in the footnotes to the financial
statements is allowed.
E. Frequency and magnitude of various categories of transitory income statement items.
1. In the period between 2001-2011, about 60% of firms reported at least one of the
transitory earnings components on their income statement. Theses items tend to
be significant components of earnings.
2. About 57% of the firms reported “special or unusual items” in 2011 compared
to 52.5% in 2002.
3. Discontinued operations appeared in about 13.5% of earnings statements in
2011 compared to 12% in 2002.
4. Firms reporting extraordinary items decreased from 13% in 2002 to less than
0.2% in 2011.
5. The majority of special or unusual items and extraordinary items (75.9% in
2011) were losses.
6. Special or unusual items are potential “red flags” for possible earnings
management. Managers have an incentive to label losses as “results from
special or unusual circumstances” than they do gains.
Teaching Tip: In forecasting future cash flows, a reader of the financial statements must

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determine whether the “special or unusual items” are sustainable or transitory. The
increased occurrence of these items heightens the speculative nature of these forecasts. It is
important to remember that financial statements are designed to measure the economic
conditions (micro and macro) and financial management of the company to assist users in
determining future cash flows. Companies doing well in a great economic environment
may be in trouble during the next economic turn while a company that exceeds the
competition results during a recession may emerge as a market leader.
IV. REPORTING ACCOUNTING CHANGES - Although difficult to always achieve,
consistency (using the same accounting methods from period to period), is a desired accounting
outcome. Firms do switch methods or revise estimates when such changes better reflect the
firm’s underlying economics. These changes fall into three categories.
A. GAAP specifies to approaches for reporting accounting changes.
Retrospective Approach is used for a change in accounting principle and change in
reporting entity. Numbers in financial statements from prior years are revised to show
the impact of the change. This enhances comparability and consistency over time.
Prospective Approach is used for changes in accounting estimates. No adjustments
are made to prior year numbers on the financial statements. The new estimated
amounts are used in the year of change and future reporting periods.
B. Changes in accounting principles occurs when a firm voluntarily changes from one
acceptable accounting method to another (voluntary change) or a new standard is
promulgated by GAAP that must be implemented (mandatory change).
1. GAAP requires the use of the retrospective approach unless it is impractical.
a. Prior years’ financial statements that are presented for comparative purposes
in the year of the change are revised to reflect the impact of the change in
accounting principle using the same basis of accounting.
2. The new principle is applied in computing income from continuing operations in
the year of the change.
3. A journal entry is made to adjust all account balances to reflect what those amounts
would have been under the new method as of the beginning of the current year.
4. An adjustment is also made to the beginning balance of retained earnings to reflect
the cumulative effect of the accounting principle change on all prior periods.
5. Disadvantage of this approach is that firms may use an aggressive accounting
method in earlier years that overstates income and asset values in an effort to lower
new debt or equity financing costs and later change to a more conservative method.
6. When the cumulative effect cannot be determined, the new method is applied
prospectively beginning with year of change and to all future years.
Teaching Tip: Changes in accounting principles generally do not result in direct changes in
cash flows. The only exception is a change from the LIFO method of accounting for
inventory (because of the LIFO conformity rule). Since changes in accounting principles
generally do not affect the tax return, a change in principles used for financial reporting
purposes affects only income tax expense and deferred income taxes.
C. Accounting changes.

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1. Changes in accounting estimates (revisions of estimates because new
information or new experience)
a. Changes in accounting estimates are handled prospectively—i.e., accounted for
in the year of change and in future periods – prior year income is not adjusted.
b. A change occurs concurrently with a change in the economic
circumstances underlying an accounting estimate.
2. Change in reporting entity (change in economic units that comprise the
reporting entity).
a. Comparative financial statements for prior years must be restated for
comparative purposes to reflect the new reporting entity as if it had been in
existence during all of the years presented.
D. Earnings per share (EPS) data present the financial statement reader earnings data
using a “common size” number. The basic EPS and the diluted EPS should be
presented for the various components of earnings (income from continuing operations;
discontinued operations; extraordinary items; and net income).
V. Comprehensive Income is a change in equity (net assets) of a business entity that occurs
during a reporting period from transactions or events from nonowner sources.
A. Selected unrealized gains (or losses) arising from incomplete (or open) transactions
sometimes bypass the income statement and are reported as direct adjustments to
owners’ equity.
1. Such items, called “other comprehensive income,” include unrealized gains
(losses) on “available-for-sale” marketable securities, foreign currency
translation gains (losses), unrealized losses resulting from minimum pension
obligations, unrealized actuarial gains and losses on pension assets and
liabilities, and unrealized gains and losses on certain derivatives.
2. Other Comprehensive Income components frequently arise from using fair value
measurements for selected assets or liabilities.
3. Items included in net income are considered to be closed transactions.
4. Open transactions occur when balance sheet carrying amounts are changed even
though the transaction is not yet closed. For example, unrealized gains and losses
on marketable securities are not closed because the securities have not been sold.
B. Comprehensive income is the net income from the traditional income statement plus or
minus “other comprehensive income components.”
C. GAAP requires firms to report comprehensive income in a statement with equal
prominence as other financial statements. Comprehensive income is reported either as
a separate statement or as part of a statement combined with the income statement.
VI. GLOBAL VANTAGE POINT
A. Both FASB and IASB enacted changes in presentation of comprehensive income. IAS 1
allows firms to present a single statement of comprehensive income or alternatively
present a net income statement and a statement of comprehensive income. Under GAAP,
the option to report component of other comprehensive income as part of the statement of
changes in stockholders’ equity is eliminated. GAAP requires a reclassification
adjustment from other comprehensive income to net income on the face of the financial
statements.
VII. APPENDIX: REVIEW OF ACCOUNTING PROCEDURES AND T-ACCOUNT
ANALYSIS
A. The basic accounting equation is the foundation of financial reporting.

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1. A = L + OE.
2. At all times the dollar sum of a firm’s assets (A) must be equal to the dollar sum of
the firm’s liabilities (L) plus its owners’ equity (OE).
3. Creditors or owners finance assets.
4. The total resources a firm owns or controls (its assets) must by definition be equal
to the total of the financial claims against those assets held by either creditors or
owners.
B. Revenue and expense accounts that appear on the income statement are owners’
equity accounts.
1. Revenues are owners’ equity increases since the owners benefit from the inflow of
assets resulting from a sale.
2. Expenses are owners’ equity decreases since the owners’ claims against the assets
of the company are reduced because the firm must relinquish an asset, inventory, in
making the sale.
C. Debit and credit basics.
1. Assets Liabilities Equity Revenues Expenses
debit credit debit credit debit credit debit credit debit credit
+ - - + - + - + + -
2. The normal balance for an account is always the same as the increase side.
a. Assets and expenses generally have debit balances.
b. Liabilities, equity, and revenues generally have credit balances.
3. For each transaction, the dollar total of the debits must equal the dollar total of the
credits.
4. Assets always equal liabilities plus owners’ equity.
D. Adjusting entries are made whenever financial statements are prepared.
1. Insures that economic events that have occurred are reflected in the accounts.
2. There are four types of adjusting entries.
a. Adjustments for prepayments are required because of the passage of time.
i. Entries of this type generally require a debit to an expense account and a
credit to an asset or contra-asset account.
ii. Examples include prepaid rent, prepaid insurance, and
depreciation or amortization of long-term assets.
b. Adjustments for unearned revenue recognize that amounts
paid in advance have been earned. Entries of this type generally
require a debit to a liability account and a credit to a revenue or
sales account.
c. Adjustments for accrued expenses recognize that expenses are incurred
when the underlying economic event occurs, not necessarily when the cash
flows out. Entries of this type generally require a debit to an expense account
and a credit to a liability account.
d. Adjustments for accrued revenue recognize that revenue is earned when the
underlying services have been performed or when goods are exchanged, not
necessarily when cash is received. Entries of this type generally require a debit
to an asset account and a credit to a revenue or sales account.
3. The financial statements are prepared after all adjusting entries have been made.
E. Financial statement preparation
1. The income statement is prepared first so that the net income amount can be
determined.
2. Net income is used to update the owners’ equity section in the balance sheet.
F. Closing entries are required to reset the revenue and expense accounts to zero in

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CHAPTER QUIZ
1. Thousand Trails, Inc. owns and operates membership resort campgrounds in the U.S.
Memberships allow a member’s family unlimited use of the company’s present and proposed
campgrounds over the lifetime of the member for an initial membership fee. Under the terms
of the membership sales agreement, no refunds are available once memberships are sold, even
if additional campgrounds or additional facilities at existing sites are not completed. How
should Thousand Trails recognize membership revenue?
a. Membership sales should be recognized as revenue over the life of each member.
b. Membership sales should be recognized as revenue over the estimated life of an
“average member,” based on a membership profile.
c. Membership sales should be recognized as revenue when the membership agreement is
signed.
d. Membership sales should be recognized based on members’ actual use of the facilities.
2. A local ski club offers membership for a two-year period under the following terms:
• Applicants pay the entire membership fee in four quarterly installments (i.e., $250 every
three months) during the first year of the contract;
• Applicants are entitled to discounted lift tickets and hotel room accommodations during
the two-year membership period (including off-season room accommodations and lift
tickets for mountain biking).
Based on experience, the club is able to estimate with reasonable accuracy its uncollectible
receivables. If the club prepares quarterly income statements, what amount of membership
revenue will be reported in the first quarter during the first year of each membership?
a. $125
b. $250
c. $1,000
d. $2,000
3. The matching principle encourages:
a. The recognition of expenses when cash is paid for supplies.
b. The recognition of depreciation expense for property, plant, and equipment over their
useful lives.
c. The reconciliation of net income and comprehensive income in a separate financial
statement.
d. The recording of period costs on the balance sheet.
4. TJX is a retailer that offers “layaway” sales to its customers. TJX retains the merchandise,
sets it aside in its inventory, and collects a cash deposit from the customer. The merchandise
generally is not released to the customer until the customer pays the full purchase price.
When may TJX recognize revenue for merchandise sold under its layaway program?
a. TJX should recognize revenue under its layaway program upon delivery of the
merchandise to the customer.
b. TJX should recognize revenue under its layaway program as cash deposits are
collected.
c. TJX should recognize revenue under its layaway program when the inventory is set
aside.
d. TJX should recognize revenue under its layaway program in equal amounts each month
during the layaway period.

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5. A biotechnology firm provides research and development activities for a customer for a
specified term. The customer needs to use certain technology owned by the biotechnology
firm for use in its research and development activities. The technology is not sold or licensed
separately without the research and development activities. Under the terms of the
arrangement, the customer is required to pay a nonrefundable “technology access fee” in
addition to periodic payments for research and development activities over the term of the
contract. When is the technology access fee recognized as revenue?
a. When the agreement is signed.
b. When the research activity begins.
c. When the research activity is completed.
d. Systematically over the periods that the research is performed.
6. Under the current GAAP, gains and losses from retirement of debt for companies that
routinely retire and reissue debt is treated as income from continuing operations.
Companies retiring material amount of debt could account for these retirements as
follows:
a. A separate item in the “special or unusual items” section of the income statement
ownership.
b. A special disclosure in the footnotes to the financial statements.
c. As an extraordinary item if meets the criteria of being unusual in nature and
occurs infrequently.
d. All of the above.
7. Extraordinary items, unusual gains and losses, and discontinued operations illustrate the
difficulty of deciding what constitutes income from continuing operations. In developing an
estimate of a firm’s “earning power,” analysts normally exclude all items that are unusual
or nonrecurring in nature. As an analyst, is income from continuing operations your best
estimate of future earnings?
a. Yes. Since income from continuing operations excludes nonrecurring items, it is
the best estimate of future earnings.
b. No. One’s best estimate of future earnings should begin with income from
continuing operations, but should exclude all of the unusual items as well.
c. No. One’s best estimate of future earnings should begin with income from
continuing operations, but should exclude all of the unusual items and the
nonrecurring non-operating items as well.
d. No. Net income is the best starting point for estimating future earnings.
8. The purpose of reporting nonrecurring items, net of related income taxes, below income
from continuing operations is:
a. These items help explain deviations in current year net income from past trends.
b. These items assist in the task of predicting the timing and amount of future cash flows.
c. Neither a. nor b.
d. Both a. and b.

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9. On November 1, 2015, Key Co. paid $7,200 to renew its insurance policy for three
years. On December 31, 2015, Key’s unadjusted trial balance showed $180 for prepaid
insurance and $8,820 for insurance expense. Given that Key prepares financial statements
quarterly, what amounts should Key report for prepaid insurance and insurance expense
in its December 31, 2015, financial statements?
Prepaid Insurance Insurance Expense
a. $6,600 $2,400
b. $6,800 $2,400
c. $6,800 $2,200
d. $6,980 $2,020
10. Other comprehensive income components:
a. Are shown net of their related tax effects.
b. Include all changes in equity that do not affect the income statement.
c. Include realized gains and losses.
d. Eliminate the effects that unrealized gains and losses have on the financial statements.
QUIZ ANSWERS:
1. c. Under the terms of the membership sales agreement, no refunds are available once
memberships are sold and the company is not obligated to provide additional facilities.
Therefore, it is appropriate to recognize revenue at the time the membership agreement is
signed.
2. a. Only $125 per membership will be recognized as revenue each quarter during the first
year. The remaining $125 per quarter will be revenue during the second year. This
allocation of the cash receipts is necessary since the revenue is earned over the two-year
membership period (as services are provided).
3. b. Matching is the expense recognition principle of “associating cause and effect.” While a
direct cause and effect relationship between depreciation expense and specific revenues
usually cannot be demonstrated, such costs are capable of being related to specific
accounting periods on the basis of a systematic and rational allocation among the periods
benefited.
4. a. Provided that the other criteria for revenue recognition are met, TJX should recognize
revenue from sales made under its layaway program upon delivery of the merchandise to the
customer. Until then, the amount of cash received should be recognized as a liability. TJX
should not recognize revenue upon receipt of the cash deposit since it retains the risks of
ownership of the merchandise, receives only a deposit from the customer, and does not have
an enforceable right to the remainder of the purchase price.
5. d. Unless the up-front fee is in exchange for products delivered or services performed that
represent the culmination of a separate earnings process, the deferral of revenue is
appropriate. In the situation described, signing the contract is not a discrete earnings event.
The terms, conditions, and amounts of technology access fees typically are negotiated in
conjunction with the pricing of all the elements of the R&D arrangement. The fact that the
biotechnology firm does not sell the initial rights separately supports deferral of revenue.
Further, performing under the terms of the arrangements, not simply originating a revenue-
generating arrangement, completes the earnings process.

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6. d. Current GAAP allows for a company to record the gain or loss on extinguishment of debt
to be recorded as income from continuing operations if it does not meet the criteria of
unusual in nature and infrequency of occurrence.
7. c. No. Operating/unusual items are shown “above the line” in the income statement.
Therefore, an analyst would have to adjust the income from continuing operations amount
for the effects of nonrecurring non-operating/unusual items. (However, note that some firms
that report irregular items seem to be “accident prone” and report irregular items on a
regular basis. Keep in mind that although they are infrequent in nature, these events still
have implications for the value of the firm and cannot be ignored altogether).
8. d. The purpose of reporting nonrecurring items, net of related income taxes, below income
from continuing operations is to help explain deviations in current year net income from past
trends, and to assist in the task of predicting the timing and amount of future cash flows.
9. c. Given the amounts on the unadjusted trial balance, it is clear that Key debited insurance
expense for the entire $7,200 payment made on November 1. As of December 31, there are
still 34 months of coverage remaining. Therefore, $6,800 is the balance in prepaid
insurance. Insurance expense is the $8,820 from the unadjusted trial balance minus the
$6,800 moved into prepaid insurance plus the $180 of prepaid insurance on the unadjusted
trial balance. In other words, the cost of the insurance policy went up from $180 per month
to $200 per month. Therefore, 2010 has 10 months of coverage under the old policy ($1,800)
and two months of coverage under the new policy ($400).
10. a. Comprehensive income components are shown net of their related tax effects.
RECOMMENDED EXHIBITS
1. Figure 2.1—Canterbury Publishing comparison of accrual and cash-basis income.
2. Figure 2.2—The revenue recognition process.
3. Figure 2.5—Proportion of firms reporting nonrecurring items (2002-2011).
4. Exhibit 2.4- Types of Accounting Changes
SUGGESTED READINGS
1. Hatelstad, L. 1998. Measure for measure: Economic value added theory provides a new way
to value companies. Where does high tech fit in? The Red Herring (January), pp. 46-48.
2. Kahn, J. 2000. Presto chango! Sales are huge! Fortune (March 20).
3. MacDonald, E. 2000. Fess-uptime. Forbes (September 18).
4. MacDonald, E. 2000. Panel leaves untouched rule letting firms’ book revenue from bartered
ads. The Wall Street Journal (January 26).

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CHAPTER 3
ADDITIONAL TOPICS IN INCOME DETERMINATION
Chapter Overview
This chapter emphasizes the special accounting procedures used when revenue recognition
doesn’t occur at the point of sale. The “critical event” and “measurability” conditions for revenue
recognition are typically satisfied at the point of sale. However, there are circumstances—long-
term construction contracts, production of natural resources, and agricultural commodities—
where it is appropriate to recognize revenue prior to sale. Alternatively, revenue (and profit)
recognition may be delayed until after the sale—specifically, when cash is collected. This
approach is used in instances where there is considerable uncertainty as to the collectability of the
sales price or where there are significant costs or uncertainties that may occur following the sale
that are difficult to predict. Franchise sales, sales with a right of return, and bundled sales
(especially technology sales that bundle software and hardware products along with technical
support) pose particularly challenging revenue recognition issues and statement users need to be
aware of the potential accounting abuses. The financial reporting must reflect the revenue when
it is earned. This earnings process may be as early as technological certainty or as late as when
the support for the product expires. The broad criteria for revenue and expense recognition leave
room for considerable latitude and judgment. Management can sometimes exploit this flexibility
in GAAP to hide or misrepresent the underlying economic performance of a company.
Companies sometimes fail to adjust their revenue and expense recognition policies when
economic conditions change. In addition, management of an organization may try to reach short-
term earnings projections by manipulating the flexibility of income and expense recognition under
generally accepted accounting principles. This chapter outlines some of the more common ways of
managing earnings that have come under SEC scrutiny.
Auditors and financial statement users must be aware of management’s incentives to manage
earnings and the various ways it can be accomplished. Once discovered, errors and irregularities
must be corrected and disclosed. The errors and irregularities discovered in subsequent periods are
corrected through a prior period adjustment to retained earnings.
While IFRS and U.S. GAAP rules for revenue recognition and measurement largely overlap,
important differences exist for long-term construction contracts and for installment sales contracts.
A current Exposure Draft, if adopted, would substantially change current revenue recognition
practices, particularly percentage-of-completion for long-term construction contracts and multiple-
element sales contracts.
CHAPTER OUTLINE
I. REVENUE RECOGNITION PRIOR TO SALE
A. Revenue recognition prior to sale—Condition 1 (the “critical event”) and Condition 2
(“measurability”) from Chapter 2 are both satisfied prior to the time of the sale.
1. Percentage-of-completion method recognizes revenue, cost, and gross profit as
progress toward completion is made and is used primarily for long-term
construction contracts.
a. This method requires fairly good estimates of progress.
b. Cost-to-cost ratio: % complete = costs incurred to date ÷ estimate of total costs.
c. Current revenue (gross profit) = % complete x estimated total revenue (gross

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profit) - revenue (gross profit) recognized in previous years.
d. A change in cost estimate is accounted for in a cumulative catch-up manner,
i.e., accounted for such that the balance sheet is as it would have been if the
revised estimate had been the original estimate.
e. A current asset results when total costs and recognized profit exceed billings.
f. A current liability results when billings exceed total costs and recognized
profit.
g. Estimated losses on a contract are recognized in their entirety as soon as it
becomes known that a loss will ensue.
Teaching Tip: Consulting firms use the percentage-of-completion method for fixed price,
fixed period contracts. The Information Technology Professional Services sector, for
example, uses this method to record approximately 30 % of its revenues.
2. Completed Contract Method is used when it is not possible to determine
expected costs with a high degree of reliability. It is not a method that recognizes
revenue and profits prior to sale.
a. Therefore, no interim revenue, costs, or gross profit are recorded.
b. These items are accumulated on the balance sheet, but not reflected on the
income statement until the project is completed.
3. Long-term contract losses (regardless of the revenue recognition method):
a. Cost increases require current period adjustment of excess gross profit
recognized in earlier periods.
b. With unprofitable contracts, the entire expected loss must be recognized in the
current period (as well as the recovery of previously recognized revenue and
gross profit).
4. Revenue Recognition on Commodities:
a. The Completed-Transaction (Sales) Method recognizes income when the
commodities are sold.
b. The Market Price (Production) Method recognizes income when the
agricultural commodities are harvested or when the natural resources are
extracted.
i. This alternative assumes that well-organized liquid markets exist for the
commodities.
ii. Changes in the market value of the commodities while they are held in
storage are reflected on both the balance sheet and income statement.
c. Comparisons of these two methods:
i. The completed transaction (sales) method merges the results of
speculative and operating activity and does not reflect the separate
results of either.
ii. The market price (production) method has the advantage of explicitly
recognizing the separate results arising from operating and
speculative activities.
II. REVENUE RECOGNITION SUBSEQUENT TO SALE
—Conditions 1 and 2 are both satisfied subsequent to the time of the sale.
1. This treatment is acceptable only under highly unusual circumstances. For
example, when the risk of noncollection is unusually high and when there is
no reasonable basis for estimating the proportion of installment accounts likely

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