Solution Manual for Financial Reporting and Analysis, 6th Edition

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CHAPTER 1THE ECONOMIC AND INSTITUTIONAL SETTINGFOR FINANCIAL REPORTINGCHAPTER OVERVIEWFinancial statements contain information about a company, its economic health, and its products thathelp users in their decision making, and make it possible to monitor managers’ activities. Therein liesthe demand for financial statements. Specifically, equity investors, analysts, and brokers use financialstatements to form opinions about the value of a company as a basis for their investment decisions orrecommendations to others. Creditors use financial information to assess the company’s ability to makeits debt payments and comply with loan covenants. Auditors use financial statements to help designmore effective audits by identifying areas of potential reporting abuses. Other users that demandfinancial informationinclude managers, employees, suppliers, customers, and government and regulatoryagencies. Flexibility and consistency are both desired when preparing financial statements. The changingeconomic environment demands the revision of standards and best practices that will best serve these twodiverse results.Investors, creditors, and other interested parties demand financial statements because the informationis useful. What governs the supply of financial information? Two answers are mandatory reporting andthe advantages ofvoluntary disclosure. Most companies in the U.S. and other developed countries arerequired to produce, distribute, and file financial reports with a governmental agency—the Securities andExchange Commission (SEC) in the U.S.—so that interested parties can view the statements. Voluntaryfinancial information that goes beyond the minimum requirements can benefit the company, its managers,and its owners.Voluntary disclosurebenefits and costs are likely to affect accounting policies andreportingstrategies. Therefore, the flexibility and discretion inherent in financial reporting standardsprovidemanagers with opportunities to shape financial statements to achieve specific reporting goals.Users of this information that understand financial reporting, managers’ incentives, and accountingflexibility are better informed and more likely to be able to use financial statements to their advantage inthe decision-making process.The accountant’s and analyst’s job is more challenging when financial reporting measurement anddisclosure rules differ across countries. Those rules may underscore the reporting culture that may haveevolved to reflect firms’ underlying economic performance. The FASB and IASB are working together toconverge U.S. GAAP and IFRS.CHAPTER OUTLINEI.WORLDCOM’S CURIOUS ACCOUNTINGAThere 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 timesthroughout the industry.”b.The company has $2.3 billion in cash, which translates into $20.50 book valueper share.2.The first-quarter results indicate sales of $8,120 million and $240 million in pre-taxoperating profits–a decline of 16% in sales and 40% in profits while other firms in theindustry 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 othercompanies are experiencing rising line costsas a percentage of sales.a.Does this suggest that WorldCom is adept at managing its excess capacity

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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 earlytrading. What do you do?

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II. WHY FINANCIAL STATEMENTS ARE IMPORTANTInvestors need adequate information to judge risk versus reward factors of investmentalternatives.1.A company’s financial statements are a critical source of information about thefinancial condition, operating results, and prospects for the future for anorganization.2.Financial statements can be used as an analytical tool, a management report card, an earlywarning 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 aneconomic history and are indispensable in developing an accurate profile of ongoing performanceandprospects.A.Untangling the Web atWorldCom?1.An internal audit discovered $3.8 billion in improper transfers of line cost expenses fromthe income statement to the balance sheet. Without these transfers the company wouldhave reported a loss for 2001 and in the first quarter of 2002.2.WorldCom stunned investors by announcing that it intended to restate financialstatements 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 previousyears.Teaching Tip:While fraud is different than the flexibility and discretion inherent in financialreporting 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 detectingfraud. Rather, the purpose of this text is to assist readers in understanding the financial flexibilityand discretion inherent in financial accounting rules in order that they may make more informeddecisions.III.ECONOMICS OF ACCOUNTING INFORMATIONA.Financial statements serve two key functions:1. To provide a way for company management to transfer information about businessactivities to people outside of the company, thereby solving the problem ofinformationasymmetry(problem of management having superior information that outsiders).2. Financial statement information is often included in contracts between the company andother parties since that improvescontract efficiency(e.g. management compensationcontracts).B.Demand for Financial Statements-The supply of financial statement information is guidedby the costs of producing and disseminating it and the benefits it will provide to the company.Financial statements aredemandedbecause of their value as a source of information about thecompany’s performance, financial condition, and stewardship of its resources. Below is a shortlist of outsiders whose decisions require financial statement information as a key input inmaking decisions:1.Shareholders and Investorsuse financial information to decide on a portfolio consistentwith their individual preferences for risk, return, dividend yield, and liquidity.a.Financial statements are crucial infundamental analysis.b.Many analysts look beyond thefinancial statement numbers to the “meaning behindthe numbers,” making footnote disclosures invaluable.

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c.Shareholders and investors use financial statement information to evaluate theperformance of the company’s top executives (stewardshipfunction of financialreports).2.Managers and Employeesuse financial information to monitor contracts such as bonusplans, profit-sharing plans, stock ownership plans, and to monitor the health of company-sponsored pension plans along with information that will assist in making decisionsconcerning the allocation of limited resources.3.Lenders and Suppliersuse financial information to assess the financial strength of abusiness to determine whether to make a loan (or extend credit), and then the amount,interest rate, and security (if any) that is needed.4.Customersuse financial information to monitor a supplier’s financial health as part of theprocess of checking out a product and the company that stands behind it.5.Government and Regulatory Agenciesdemand financial statement informationto assess compliance with laws and standards.a.Taxing authorities may use financial statement information as a basis for establishingtax policies designed to enhance social welfare.b.As customers of businesses, government agencies may use financial statementinformation to settle contractual payments.c.Regulatory intervention may be another source of demand for financial statementinformation.C.Disclosure Incentives and the Supply of Financial Information-Thesupplyof financialinformation is guided by the costs of producing and disseminating itand the benefits it willprovide to the company.1.Voluntary disclosure occurs so long as the incremental benefits to the company fromsupplying that information exceed the incremental costs of supplying that information.a.Some users, such as creditors, may have enough bargaining power to compelcompanies to deliver financial information that they need for analysis.b.Regulated financial reporting is designed to ensure that companies meet certainminimum levels of financial disclosure and transparency.2.Disclosure Benefits: Owners and managers have an economic incentive to supply theamount and type offinancial information that will enable them to raise capital at thelowest cost.3.Disclosure Costs:a.Costs associated with collecting, processing, and disseminating financial informationcan 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 againstthe company and its management for financial misrepresentations.d.Highly profitable—but politically vulnerable—firms may be subject to politicalinitiatives designed to impose “taxes” on them.Teaching Tip:Small businesses are often subject to less comprehensive reportingrequirementsbecause of the prohibitive costs referred to in (a.) above. Likewise, political costs (d. above) mayencourage firms to use accounting methods that appear less profitable. Much of the book isdevoted to providing students with the skills necessary to undo accounting methods or to convertfrom one method to another so that more meaningful comparisons between companies may bemade. Therefore, students gain insight into managers’ incentivesand become more informedreaders of financial statements.IV.A CLOSER LOOK AT PROFESSIONAL ANALYSTS

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A.Financial statement users have diverse information needs because they face different decisionsor may use different approaches to making the same kind of decision. The conflicting desiredresult 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 performancedata.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 decisionalternates for financial statement comparisons.5.The analyst needs to be able to compare financial results of diverse companies to helpinvestors decide where to allocate scarce resources.V.THE RULES OF THE FINANCIAL REPORTING GAMEA.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 representits 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 toproduce the data before extrapolating financial statement data into the future.B.Financial statements should possess certainqualitative characteristics.1.Financial information isrelevantif it makes a difference in the decision-making process.It is considered relevant if it has bothpredictive valueandconfirmatory value.2.Predictive value:The information improves the decision maker’s ability to forecast thefuture outcome of past or present events.3.Confirmatory value:The information confirms or alters the decision maker’s earlierbeliefs.4.Financial information istimelyif it reaches decision makers before it loses its capacity toinfluence their decisions.5.Financial information isreliableif it is reasonably free of error and bias, and truthfullyrepresents what it purports to represent.6.Financial information isrepresentationally faithfulwhen the accountingactuallyrepresents the underlying transaction or economic event. To achievefaithful representation, the financial information must have the qualities ofcompleteness(including all pertinent information),neutrality(informationcannot be selected to favor one set of interested parties over another), andfreefrom material error(Some minimum level of accuracy is necessary for anestimate to be a faithful representation of an economic event).7.Financial information isneutralwhen it does not favor one set of interested parties overanother.8.Other qualitative characteristics that enhance the decision usefulness and representationallyfaithful information arecomparability, verifiability, timeliness,andunderstandability.9.Financial information iscomparablewhen it is measured and reported in asimilar manner among different companies.10.Financial information isconsistentwhen the same accounting methods and disclosurepractices are used to describe similar events from period to period.

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11.Verifiabilitymeans that independent measurers should get similar results when using thesame yardstick.12.Timelinessrefers to information that is available to decision makers while it is still capableof influencing their decisions.13.Understandabilityis the characteristic of information that enables users to comprehend itsmeaning.Teaching Tip:Students often want to know which accounting alternative is “best.” Qualitativetrade-offs make it difficult to identify “good” accounting methods and disclosure practices. Forexample, market value may be relevant to the decision at hand, but representational faithfulnessmay bequestionable.C.Two additional conventions affect whether financial statements are complete, understandable,and helpful.1.Materialityis established when an omission or misstatement is important enough that thejudgment of a reasonable person is influenced by the omission or misstatement.2.Conservatismin accounting involves trying to ensure that business risks anduncertainties 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 inpreparing financial statements by publicly traded companies in the Unites States, but haslargely delegated itsauthority to the accounting profession’s Financial AccountingStandards Board(FASB).2.GAAP may also evolve from accounting practices over time.3.ThePublic Company Accounting Oversight Board(PCAOB) was established by theSarbanes-Oxley Act of 2002 to provide oversight of auditing procedures two waysa.establish standards for auditing and ethics at public accounting firmsb.inspect and investigate auditing practices of public accounting firms4.Financial reporting standards outside the U.S. are determined in some countries byprofessional accounting organizations, in other countries by commercial law and/or taxlaw requirements, and on a worldwide basis by theInternational Accounting StandardsBoard(IASB).5.A convergence project has a goal of providing one set of worldwide accounting standards toreconcile the IASB standards with those of the FASB.6.Due to the voluminous nature of accounting and financial reporting documents, the AICPAin 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 countriesis a political and technical process.1.Political pressure by interested parties continues to shape the surrounding sensitive andcontroversial U.S. accounting standards.2.While the intensity and frequency of political influence will persist in the future, it isimportant to remember that accounting standards reflect both:a. Sound concepts coupled with independent and objective decision making of standardsetters, andb. Compromises necessary to ensure that proposed standards aregenerallyacceptable.F.FASBAccounting Standards CodificationTM1.The growing number of accounting pronouncements made it difficult to find answers tofinancial accounting and reporting questions.2.In 2009, the FASB completed a five-year project to distill the existing GAAPliterature into a single database now called theAccounting StandardsCodification(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 thatorganizes pronouncements into topics, sections, subsections, and paragraphs.i. Topics are the broadest categorization of related guidance and are grouped intofour areas: presentation (financial statements or notes); financial statementaccounts (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 scopeiii. Sections are subdivisions such as Recognition, Measurement, or DisclosureVII.ADVERSARIAL NATUREOFFINANCIAL REPORTING.1.Managers frequently have reasons to exploit the flexibility and discretion allowed byaccounting standards since their interests may conflict with the interests of creditors andshareholders.2.The flexibility of GAAP financial reporting standards provides opportunities to useaccounting “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 firmsappear to be larger, more profitable, and less risky. Therefore, naive acceptance of financialstatement 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 andcomputers networks.b.The first accounting controversy regarding revenue recognition occurred when CAchanged how it books revenue from software licenses that were renegotiated duringthe licensing period. The net effect was to double count revenues when the licenseswere renegotiated. The impression was given that revenues were increasing overtime.c.The second accounting controversy stemmed from the company’s decision toroll out a subscription based business model and began reporting results usingnonstandardpro formaaccounting in its earnings announcements.d.The differences between the pro forma disclosures and the GAAP numbers weresubstantial. Under the pro forma disclosure, revenue was reported as $1.284 billionand operating income was $247 million while the GAAP numbers were $783million 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 theinvestment community to judge the company3.The Justice Department and the SEC brought suit against CA leading to lawsuits andcharges of fraud and obstruction of justice against company executives.Teaching Tip:Consider breaking the class into small groups and have them discuss the questionsposed in the “Questions to Consider” section of this chapter. This may be an excellent way toenforce the need to be consistent with the objectives of financial reporting and the role GAAP playsin meeting those objectives.I.Epilog-CA admitted in October 2003 that some software license contracts had been backdated, to maskdeclining 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 AnalystA.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 additionaldiversity into the financial reporting process.D.Benefits from increased use and lower cost of technology to assemble and analyze financialdataare muted by the increased complexity and dynamic environment in which firms operateVIII.AN INTERNATIONAL PERSPECTIVECountries’ reporting philosophy evolves from and reflects the specific legal, political, and financialinstitutions 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 theirborders to establish an expanded customer base.C.Many companies shift resources to take advantage of tax laws and incentives that vary country tocountry, state to state, and even on a local level.D.International Standards promulgated by the International Accounting Standards Board (IASB) havehad 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 reflectthe underlying firm economic performance.G.Sources of financing do shift over time. When this happens, changes in the financial reportingenvironment occur as well.H.Globalization and the Rise of IFRS-The FASB and the IASB are working toward eliminatingdifferences 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 areregistered with the SEC and use IFRS as a basis for their financial statements. Those firms do not haveto reconcile their financial statements to U. S. GAAP.J.International Accounting Standards Board (IASB)–Established by the IASB created in July 1973with four goals:a.To develop a single set of high-quality, understandable, enforceable, and globally acceptedinternational financial reporting standards (IFRS)b.To promote the use and rigorous application of those standardsc.To take account of the financial reporting needs of emerging economies and small andmedium-sized entitiesd.To promote and facilitate the adoption of IFRS through the convergence of nationalaccounting standards and IFRSK.IASB has issued 54 standards and 54 interpretations of the standards. Standards in use in 125 countriesworldwide. Compared to U.S. GAAP, IASB standards allow firms more flexibility and more of ageneralized overview approach.L.Critics of the IASB’sprinciples-based approachcontent that IFRS are so general and theimplementation guidance so ambiguous that company managers have excessive latitude in accountingchoices.M.Supporters of the IFRS argue that rigidity is less with IFRS where there are broad principles and not asdetailed as inrules-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-downsb.Extraordinary itemsc.Research and development costsIX.Appendix—GAAP IN THE UNITED STATESA.Early Developments:Corporate financial reporting in the U.S. prior to 1900 were primarilyintended 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 accountingpolicies and practices to be followed by SEC registered companies.B.Emergence of GAAP-TheSecurities Act of 1933 required companies selling publicly tradedstock and debt to providefinancial 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 annualfinancial reports with the SEC.B.The American Institute of Certified Public Accountants (AICPA) Committee on AccountingProcedures issued bulletins between 1938 and 1959 that set forth the framework for what thecommittee believed to be generally accepted accounting procedures.C.In 1959, the AICPA established the Accounting Principles Board (APB) to develop aconceptual framework and to issue statements to improve external financial reporting anddisclosure.1.The force of these pronouncements depended on general acceptance and persuasion.2.Critics cited numerous instances where net income could be manipulated by selectingamong several methods that were “generally accepted.”D.The Financial Accounting Standards Board (FASB)was created in 1973. It differed fromits 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 beCertified Public Accountants (CPA).4.Staff support was increased substantially.E.Current Institutional Structure in the United States:TheSEC still retains broadstatutory powers over financial reporting practices, but continues to relyon private sectororganizations (currently the FASB) to set accounting standards.1.The FASB has no authority to enforce compliance with generally accepted accountingprinciples (GAAP). That responsibility lies withmanagement, the accounting profession,the SEC, and the courts.2.The FASB follows a “due process” procedure in developing Accounting Standardsupdates. Most updates issued by the FASB go through three steps:a.Discussion-memorandum stageoutlines the key issues involved.b.Exposure-draft stageencourages further public comment that is evaluated.c.Voting stageis when the Board votes whether to issue an ASU describingamendments to the Accounting Standards Codification or to revise the proposed updateandreissue a new exposure draft.3.Public Company Accounting Oversight Board:The Public Company AccountingOversight Board (PCAOB) has a role in developing transparent financial statement and anincreased system of internal control. The PCAOB regulates accounting firms auditingcompanies that are listed on public exchanges

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4.Sox Compliance:The Sarbanes-Oxley Act (SOX) was enacted to reign in accountingabuses by strengthening auditor independence and improving financial reportingtransparency.a.CEOs and CFOs must certify the accuracy of financial statementsb.An annual evaluation of internal controls and procedures must be conducted.

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CHAPTER QUIZ1.During a period when a firm is under the direction of particular management, itsfinancialstatements will directly provide information about:a.Both firm performance and management performance.b.Management performance but not directly provide information about firmperformance.c.Firm performance but not directly provide information about managementperformance.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 isbased onprevious 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 thepastperformance of an enterprise.3.Which of the following is considered a pervasive constraint under generally acceptedaccountingprinciples?a.Benefits/costs.b.Conservatism.c.Timeliness.d.Verifiability.4.According to the FASB conceptual framework, the qualitative characteristic of neutralityis aningredient of:Faithful RepresentationRelevancea.YesYesb.YesNoc.NoYesd.NoNo5.According to the FASB conceptual framework, which of the following situationsviolates thequalitative 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 reportedtoanalysts estimating future profits.c.Financial statements included property reported at an increased amount thatreflectsmanagement’s estimate of market value.d.Management reports to stockholders regularly refer to new projects undertaken, butthefinancial statements never report project results.

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6.Factors that may influence a decision maker’s judgment as to what accounting informationis usefulinclude: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 thefinancial statements?a.Political costb.Litigation cost.c.Information collection and dissemination cost.d.Competitive disadvantage cost8.Employees demand financial statement information because the firm’s performance isoften linked toa.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 publiclytraded companiesin the United Statesrests 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 basedona.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 Question1.Define the expanded role of the PCAOB in the preparation of consistent and transparentfinancial statements.2. Why would it be beneficial to narrow international differences in accounting rules foraccounting and reporting?

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QUIZ ANSWERS:1.c. Financial reporting provides information about an enterprise’s performance during aperiod, butdoes notseparate the effect of a particular management’s performance from theeffects of priormanagement actions, general economic conditions, the supply and demandfor an enterprise’s inputsand 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 evaluationsof pastperformance.3.a. All accounting information is subject to two qualitative constraints: materiality andcost/benefit. The cost/benefit constraint states that benefits of information must exceed thecost of obtaining it.4.b. Faithful representation assures that information is reasonably free from error andbias and faithfully represents what it purports to represent. Its ingredients arecompleteness,verifiability, and neutrality. Neutrality is the absence of bias intended toreach a predetermined result or induce a certain behavior.5.c. Faithful representation is defined as the quality of information that provides assurancethat the information isreasonably free from error and bias. In accordance with GAAP, thecarrying value of propertyshould not be increased to market value.6.d. The judgment by a decision maker as to what accounting information can be usefulincludes the decision to be made, the information already possessed, and the decisionmaker’s capacity toprocess the information.7.a. Managers and employees use financial information to monitor employee contracts suchas 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 accountingstandards.10.d. According to the conceptual framework, one objective of financial reporting is toprovideinformation that is useful to present and potential investors, creditors, and otherusers in makinginvestment, credit, and similar decisions.RECOMMENDED EXHIBITS1.Figure 1.2—Desirable Characteristics of Accounting InformationSUGGESTED READINGS1.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 fornonfiction infinancial statements.Fortune(December 23), pp. 38-40.4.Kuttner, Robert, 1996. How a corporate watchdog nearly lost its bite. Business Week (May20), p.24.5.McConnell Jr., Donald K; Banks, George Y., 2003. How Sarbanes-Oxley will change theaudit 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.BusinessWeek(April 21), pp. 108-110.

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CHAPTER 2ACCRUAL ACCOUNTING AND INCOME DETERMINATIONCHAPTER OVERVIEWThis 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 cashdisbursements.The principles that govern expense recognition under accrual accounting aredesigned to alleviatethe mismatching of effort and accomplishment that occurs under cash-basisaccounting.Revenue is recognized whenboththe critical event and measurability conditions are met. Thecritical 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 ofassurance.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 therevenue, or that expire with the passage of time, are expensed. Relative to current operating cashflows, accrual earnings generally provide a more useful benchmark for predicting futurecashflows.Predicting future cash flows and earnings is critical to assessing the value of a firm’s sharesand itscreditworthiness. Multiple-step income statements are designed to facilitate thisforecasting process byisolating the more recurring or sustainable components of earnings fromthe nonrecurring or transitory earnings components.GAAP disclosure requirements for various types of accounting changes also facilitate theanalysis of company performance over time. All publicly traded companies must report EPSnumbers on the income statement. The basic EPS is based on the weighted average number ofshares actually outstanding during the period, while the diluted EPS is based on the “as if” allpotentially dilutive securities were converted into common shares.Occasionally, changes in assets and liabilities resulting from incomplete or open transactionsbypass the incomestatement and are reported as direct adjustments to stockholders’ equity andare calledother comprehensive income components.Joint deliberations of the FASB and IASB resulted in a recent Exposure Draft on financialstatement presentation that calls for displaying revenue and expense components for operating,investing, and financing sources. The proposed changes in presentation format are designed toenhance the predictive ability and decision usefulness of information presented in firms’statement of comprehensive income.CHAPTER OUTLINEI.CASH VERSUS ACCRUAL INCOME MEASUREMENTA.Accrual-basisincome measurement is the cornerstone of income measurement.1.Revenuesare recorded in the period when they are“earned”and become“measurable.”a.Revenues are “earned” when the seller has performed a service or conveyedan asset to a buyer.b.Revenues are “measurable” when the value to be received for that service orasset isreasonably 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 iscreated because the entity received cash or other assets in advance.ii.Accrued revenue is recorded when you provide a good or service but willnot receive cash or other assets until a later time.2.Expenses are the Expired costsor assets “used up” in producing thoserevenues and they are recorded in the same accounting period in which therevenues are recognized using the “matching principle.”a. Deferred expenses exist when an organization makes a payment in advancefor a product or service that will be used in several periods to createrevenue or cost offsets.b. Accrued expenses gradually build during the earnings process and are paidor used after the close of the accounting period.3.Accrual accountingdecouplesmeasured 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 receiptsrecognized).a.Accrual accounting revenues generally do not correspond to cash receipts forthe period, nor do reported expenses always correspond to cash outlays of theperiod.b.As a result, accrual accounting can produce large discrepancies betweenmeasuredearnings and the amount of cash generated from operations.c.However, accrual accounting earnings provide a more accurate measureof theeconomic value addedduring the period than do operating cashflows.B.Cash-basisincome measurement is straightforward.1.Revenuesare recorded when cash is received.2.Expensesare recorded when cash is paid.3.Because of differences in thetimingof when cash inflows and cash outflowsoccur, cash-basis income determination may distort one’s view of operatingperformance.a.Cash-basis income fails to properlymatcheffort and accomplishment.b.Cash-basis income may not provide areliable benchmarkfor predictingfuture 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 tosubscribers,who prepay the full subscription price.b.Canterbury takes out a three-year loan at the beginning of the three-yearsubscriptionperiod, but interest is payable at maturity of the loan.c.Costs to publish and distribute the magazine are paid in cash at thetime ofpublication.2.Cash-basis income determination distorts Canterbury’s operating performance.a.The entire cash inflow from subscription receipts would be treated as revenuein thefirst year when the subscriptions were sold.b.Operating expenses for publishing and distributing the magazine arerecorded inequal amounts in each of the three years.c.The entire cost of financing the operations (i.e., interest expense) is recordedin yearthree.d.Consequently, Canterbury would report relatively high profits in year one

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when thesubscriptions 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 forpredictingfuture operating results.3.Accrual-basis income determination is designed to alleviate the mismatchingproblems that exist undercash-basis accounting, making accrual earnings a moreuseful measure of a firm’s performance.a.Accrual-basis accounting allocates subscription revenue to each of the yearsas themagazine is delivered to the subscriber and the revenues are “earned.”b.Likewise, accrual accounting recognizes interest expense in each year thebank loanis outstanding, not just when the interest is paid.c.These modifications to the cash-basis results are made via a seriesof“deferral”and“accrual”adjustingentries.4.Accrual accounting better matches economic benefit with economic effort,thereby producing a measure of operating performance that provides a morerealistic picture of past economic activities.Teaching Tip:For-profit entities adopt accrual accounting because of its ability to provideinvestors and creditors with a more realistic picture of relevant economic events and their effects onfirm activities. Just the same, accrual accounting does not capture all of an entity’s relevanteconomic events as they occur. In addition, entities that do not have a profit motive may prefer acash-basis accounting system because of its simplicity.II.MEASUREMENT OF PROFIT PERFORMANCE: REVENUE AND EXPENSESA.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.Therevenue recognition principleestablishes when revenue is recorded.b.The recognition of revenue then triggers the second step—matching againstrevenuethe costs that expired (were used up) in generating that revenue.c.The difference between revenues and expired costs (expenses) is thenetincome(profit) recognized for the period.3.Due to the double-entry, self-balancing nature of accounting, important changesoccur innet assets(that is, assets minus liabilities) on the balance sheet.a.Thebasic accounting equation(Assets = Liabilities + Owners’ Equity) canbe usedto illustrate this point.i.Owners’ equity increases by the amount of the net income recognizedii.Netassets(that is, gross assets minus grossliabilities) increase by anidentical amount.ii.Expense matchingdecreasesnet assets and owners’ equity byidenticalamounts.b.As a result, net asset valuation and net income determination areinextricablyintertwined.B.A closer look at the revenue recognition criteria. Both the following conditions must besatisfied:1.The “critical event” (“Condition 1”) in the process of earning the revenue hastaken 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. Measurabilitymust be based on objective and verifiable evidence.3.In most instances thepoint of saleis the earliest moment in time at which bothconditions 1 and 2 are satisfied. This isthe dominant practice in most retail andmanufacturing industries.4.Under thepercentage-of-completion method(see Chapter 3), Conditions 1 and 2aresatisfiedpriorto 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 knownbuyer at aset price exists.Teaching Tip:Normally, once gross revenues for the period are determined, the next step indetermining net income is to accumulate and record the costs associated with generating therevenue. However, under the percentage-of-completion method, it is the recognition ofexpenses that drives the recognition of revenue.5.Under theinstallment sales method(see Chapter 3), Conditions 1 and 2 may not besatisfied untilafterthe point of sale—for instance, until cash is collected.6.Revenue earned is recognized during theproduction phasewhen: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, andthe expected costs of future services can be reliably estimated.c.An assessment of the customer’s credit standing permits a reasonably accurateestimate of the amount of cash that will be collected.7.Revenue earned may be recognized oncompletion of productionwhen: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 theproduct.8.Revenue earned is recognizedafter the point of salewhen one or more of thefollowing conditions are present:a.Extreme uncertainty exists regarding the amount of cash to be collectedfromcustomers. 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 toterminatethe exchange.iii.The customer has (and frequently exercises) the right to return theproduct.b.Future services to be provided are substantial, and their costs cannot beestimatedwith reasonable precision.9.Regardless of which basis of revenue recognition is used, the recognition ofexpenses 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) costsare costs that contribute directly to a particular saleor torevenues of a particular period.a.These costs are recorded as expenses in the same period that revenues arerecognized.b.An example of product costs is costs of goods sold.

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3.Period costsare important in generating revenue, but their contribution to a specificsaleor 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 CLASSIFICATIONA.Themultiple-step income statementis intended to subdivide income in a manner thatfacilitatesthe forecasting of future cash flows.1.Virtually all decision models in modern corporate finance are based on future cashflows.2.The intent of the multiple-step format is to classify separately income componentsthat are “transitory” and to clearly differentiate them from income componentsbelieved to be “sustainable” orlikely to be repeated in future reporting periods.3.This format isolates a key figure calledincome from continuing operations.a.Ideally, this component of income should include only the normal,recurring,presumably more sustainable, ongoing operating activities ofthe organization.b.This income number sometimes includes gains and lossesthat occursinfrequently—calledspecial or unusual items—but that arise from a firm’songoing, continuingoperations.c.Therefore, income from continuing operations is intended to serve as a startingpointfor forecasting future profits.4.Nonrecurring items are transitory and are disclosed separately below the incomefrom continuing operations line.B.Nonrecurring items, includingdiscontinued operations, and extraordinary items,are reported below income from continuingoperations net of income tax effects.1.This “net of tax treatment” is calledintraperiod income tax allocation.a.If income tax were not matched with the item giving rise to it, then totalreported income tax expense would combine taxes arising from both itemsthat 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 ofsingleoccurrence events would make it difficult for statement readers toforecast future tax outflows arising from ongoing events.2.Income tax associated with sustainable income from continuing operations isseparatelydisclosed from taxes arising from the transitory items.C.As defined in the U.S. GAAP,discontinued operations is acomponent 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. Twoconditions must be met for an entity to report discontinued operations:a. The operations and cash flows have been (will be) eliminated from the firm’songoing operations.b. Thefirm will not have any significant continuing involvement in theoperations of the component after the disposal transaction.Failure to meet above conditions results in a firm reporting the component’s operatingresults 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 beginningof 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) expectedgain orloss on operations from the date a formal plan to discontinueoperations is adoptedby 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 alwaysrecorded.ii.Expected net gains can berecordedto the extent that they offsetrealizedlosses.2.A firm must disclose the identity of segment and details of disposal in thefootnotes.3.As recently proposed by FASB (April 2013),discontinued operations is acomponent of a business that has either been disposed of, or is classified as held forsaleand represents a separate major line of business or major geographical area ofoperations, and is part of a single plan to dispose of a separate major line of businessor geographical area of operation or is a business that meets the criteria forclassification as held for sale upon acquisition.D.Extraordinary items.1.Extraordinary items must meetbothof the following criteria:a.The underlying event or transaction must beunusualin nature, i.e., possess ahigh degree of abnormality, considering its environment.b.The underlying event or transaction must beinfrequentin occurrence, i.e., itwouldnot reasonably be expected to recur in the foreseeable future.2.Events that meet one, but not both, of these criteria, are reported asincome fromcontinuing operations.3.FASB ASC Paragraph 470-50-45-1covers the reporting of gains orlosses from retirement of debt. This standard now allows for companiesthat routinely retire debt to record this economic event as part of pre-taxincome from continuing operations with a separate line-item disclosure.a.Ifmaterialin amount (i.e., of sufficient magnitude to make a difference inthedecision-making process) then the item must be disclosed as a separateitem in the“Special or unusual items” section of the income statement.b.Alternatively, a separate disclosure in the footnotes to the financialstatements 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 thetransitory earnings components on their income statement. Theses items tend tobe significantcomponents of earnings.2.About 57% of the firms reported “special orunusual items” in 2011 comparedto 52.5% in 2002.3.Discontinued operations appeared in about 13.5% of earnings statements in2011 compared to 12% in 2002.4.Firms reporting extraordinary items decreased from 13% in 2002 to less than0.2% in 2011.5.The majority of special or unusual items and extraordinary items (75.9% in2011) were losses.6.Special or unusual items are potential “red flags” for possible earningsmanagement. Managers have an incentive to label losses as “results fromspecial 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. Theincreased occurrence of these items heightens the speculative nature of these forecasts. It isimportant to remember that financial statements are designed to measure the economicconditions (micro and macro) and financial management of the company to assist users indetermining future cash flows. Companies doing well in a great economic environmentmay be in trouble during the next economic turn while a company that exceeds thecompetition results during a recession may emerge as a market leader.IV. REPORTINGACCOUNTINGCHANGES-Althoughdifficult to always achieve,consistency(using the same accounting methods from period to period), is a desired accountingoutcome. Firms do switch methods or revise estimates when such changes better reflect thefirm’s underlying economics. These changes fall into three categories.A.GAAP specifies to approaches for reporting accounting changes.Retrospective Approachis used for a change in accounting principle and change inreporting entity. Numbers in financial statements from prior years arerevisedto showthe impact of the change. This enhances comparability and consistency over time.Prospective Approachis used for changes in accounting estimates. No adjustmentsare made to prior year numbers on the financial statements. The new estimatedamounts are used in the year of change and future reporting periods.B.Changes in accounting principlesoccurs when a firm voluntarily changes from oneacceptable accounting method to another (voluntary change) or a new standard ispromulgated by GAAP that must be implemented (mandatory change).1.GAAP requires the use of theretrospective approachunless it is impractical.a.Prior years’ financial statements that are presented for comparative purposesin the year of the change are revised to reflect the impact of the change inaccounting principle using the same basis of accounting.2.The new principle is applied in computing income from continuing operations inthe year of the change.3.A journal entry is made to adjust all account balances to reflect what those amountswould 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 reflectthe cumulative effect of the accounting principle change on all prior periods.5.Disadvantage of this approach is that firms may use an aggressive accountingmethod in earlier years that overstates income and asset values in an effort to lowernew 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 appliedprospectively beginning with year of change and to all future years.Teaching Tip:Changes in accounting principles generally do not result in direct changes incashflows. The only exception is a change from the LIFO method of accounting forinventory (because of the LIFO conformity rule). Since changes in accounting principlesgenerally do notaffect the tax return, a change in principles used for financial reportingpurposes 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 newinformation or new experience)a.Changes in accounting estimates are handledprospectively—i.e., accounted forinthe year of change and in future periods–prior year income is not adjusted.b.A change occurs concurrently with a change in the economiccircumstancesunderlying an accounting estimate.2.Change in reporting entity(change in economic units that comprise thereporting entity).a. Comparative financial statements for prior years must berestated forcomparative purposes to reflect the new reporting entity as if it had been inexistence during all of the years presented.D.Earnings per share(EPS) data present the financial statement reader earnings datausing a “common size” number. The basic EPS and the diluted EPS should bepresented for the various components of earnings (income from continuing operations;discontinued operations; extraordinary items; and net income).V. Comprehensive Incomeis a change in equity (net assets) of a business entity that occursduring a reporting period from transactions or events from nonowner sources.A.Selected unrealized gains (or losses) arising fromincomplete (or open) transactionssometimes bypass the income statement and are reported as direct adjustments toowners’equity.1.Such items, called“other comprehensive income,”include unrealized gains(losses) on“available-for-sale”marketable securities,foreign currencytranslationgains (losses),unrealized losses resulting fromminimum pensionobligations,unrealized actuarial gains and lossesonpension assets andliabilities,and unrealized gains and losses on certainderivatives.2.Other Comprehensive Income components frequently arise from usingfair valuemeasurements for selected assets or liabilities.3.Items included in net income are considered to beclosed transactions.4.Open transactions occur when balance sheet carrying amounts are changed eventhough the transaction is not yet closed. For example, unrealized gains and losseson 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 orminus “other comprehensive income components.”C.GAAP requires firms to report comprehensive income in a statement with equalprominence as other financial statements. Comprehensive income is reported either asa separate statement or as part of a statement combined with the income statement.VI.GLOBAL VANTAGE POINTA.Both FASB and IASB enacted changes in presentation of comprehensive income.IAS 1allows firms to present a single statement of comprehensive income or alternativelypresent 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 ofchanges in stockholders’ equity is eliminated. GAAP requires a reclassificationadjustment from other comprehensive income to net income on the face of the financialstatements.VII.APPENDIX: REVIEW OF ACCOUNTING PROCEDURES AND T-ACCOUNTANALYSISA.Thebasic accounting equationis 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 ofthefirm’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 equalto thetotal of the financial claims against those assets held by either creditors orowners.B.Revenue and expense accounts that appear on the income statement are owners’equityaccounts.1.Revenues are owners’ equity increases since the owners benefit from the inflow ofassetsresulting from a sale.2.Expenses are owners’ equity decreases since the owners’ claims against the assetsof thecompany are reduced because the firm must relinquish an asset, inventory, inmaking thesale.C.Debit and credit basics.1.AssetsLiabilitiesEquityRevenuesExpensesdebitcreditdebitcreditdebitcreditdebitcreditdebitcredit+--+-+-++-2.The normal balance for an account isalwaysthe 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 thecredits.4.Assets always equal liabilities plus owners’ equity.D.Adjusting entriesare 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 prepaymentsare required because of the passage of time.i. Entries of this type generally require a debit to an expense account and acreditto an asset or contra-asset account.ii. Examples include prepaid rent, prepaid insurance, anddepreciation or amortization of long-term assets.b.Adjustments for unearned revenuerecognize that amountspaid in advance havebeen earned. Entries of this type generallyrequire a debit to a liability account and a credit to a revenue orsales account.c.Adjustments for accrued expensesrecognize that expenses are incurredwhen the underlying economic event occurs, not necessarily when the cashflows out. Entries of this type generally require a debit to an expense accountand a credit to a liabilityaccount.d.Adjustments for accrued revenuerecognize that revenue is earned when theunderlying services have been performed or when goods are exchanged, notnecessarily when cash is received. Entries of this type generally require a debitto 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 preparation1.The income statement is prepared first so that the net income amount can bedetermined.2.Net income is used to update the owners’ equity section in the balance sheet.F.Closing entriesare required to reset the revenue and expense accounts to zero in

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order toprepare the accounts for the next period’s transactions.1.All income statement accounts with debit balances are credited so that theirbalances are reset to zero.2.All income statement accounts with credit balances are debited so that their balancesarereset to zero.3.The debit or credit amount that is required to balance the two entries above is madetoretained earnings.

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CHAPTER QUIZ1.Thousand Trails, Inc. owns and operates membership resort campgrounds in the U.S.Membershipsallow a member’s family unlimited use of the company’s present and proposedcampgrounds over the lifetime of the member for an initial membership fee. Under the termsof the membership salesagreement,no refunds are available once memberships are sold,evenif additional campgrounds oradditional facilities at existing sites are not completed. Howshould Thousand Trails recognizemembership 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 issigned.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 everythreemonths) during the first year of the contract;•Applicants are entitled to discounted lift tickets and hotel room accommodations duringthe two-year membership period (including off-season room accommodations and lifttickets formountain biking).Based on experience, the club is able to estimate with reasonable accuracy its uncollectiblereceivables. If the club prepares quarterly income statements, what amount of membershiprevenuewill be reported in the first quarter during the first year of each membership?a.$125b.$250c.$1,000d.$2,0003.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 theiruseful lives.c.The reconciliation of net income and comprehensive income in a separate financialstatement.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 itaside in its inventory, and collects a cash deposit from the customer. The merchandisegenerally isnot released to the customer until the customer pays the full purchase price.When may TJXrecognize revenue for merchandise sold under its layaway program?a.TJX should recognize revenue under its layaway program upon delivery of themerchandise to the customer.b.TJX should recognize revenue under its layaway program as cash deposits arecollected.c.TJX should recognize revenue under its layaway program when the inventory is setaside.d.TJX should recognize revenue under its layaway program in equal amounts each monthduring the layaway period.

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5.A biotechnology firm provides research and development activities for a customer for aspecified term. The customer needs to use certain technology owned by the biotechnologyfirm for use in its research and development activities. The technology is not sold or licensedseparately without theresearch and development activities. Under the terms of thearrangement, the customer is required to pay a nonrefundable “technology access fee” inaddition to periodic payments for research and development activities over the term of thecontract. When is the technology access fee recognizedas 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 thatroutinely retire and reissue debt is treated as income from continuing operations.Companies retiring material amount of debt could account for these retirements asfollows:a.A separate item in the “special or unusual items” section of the income statementownership.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 andoccurs infrequently.d.All of the above.7.Extraordinary items, unusual gains and losses, and discontinued operations illustrate thedifficultyof deciding what constitutes income from continuing operations. In developing anestimate of a firm’s “earning power,” analysts normally exclude all items that are unusualor nonrecurring innature. As an analyst, is income from continuing operations your bestestimate of future earnings?a.Yes. Since income from continuing operations excludes nonrecurring items, it isthe best estimate of future earnings.b.No. One’s best estimate of future earnings should begin with income fromcontinuingoperations, but should exclude all of the unusual items as well.c.No. One’s best estimate of future earnings should begin with income fromcontinuingoperations, but should exclude all of the unusual items and thenonrecurringnon-operatingitems 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 incomefromcontinuing 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 threeyears.OnDecember 31, 2015, Key’s unadjusted trial balance showed $180 for prepaidinsurance and $8,820for insurance expense. Given that Key prepares financial statementsquarterly, what amounts shouldKey report for prepaid insurance and insurance expensein its December 31, 2015, financialstatements?Prepaid InsuranceInsurance Expensea.$6,600$2,400b.$6,800$2,400c.$6,800$2,200d.$6,980$2,02010.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 availableoncemembershipsare sold and the company isnotobligated to provide additional facilities.Therefore, it isappropriate to recognize revenue at the time the membership agreement issigned.2.a. Only $125 per membership will be recognized as revenue each quarter during the firstyear. Theremaining $125 per quarter will be revenue during the second year. Thisallocation of the cashreceipts is necessary since the revenue isearnedover the two-yearmembership period (as servicesare provided).3.b. Matching is the expense recognition principle of “associating cause and effect.” While adirectcause and effect relationship between depreciation expense and specific revenuesusually cannot be demonstrated, such costs are capable of being related to specificaccounting periods on the basis of a systematic and rational allocation among the periodsbenefited.4.a. Provided that the other criteria for revenue recognition are met, TJX should recognizerevenuefrom sales made under its layaway program upon delivery of the merchandise to thecustomer. Untilthen, the amount of cash received should be recognized as a liability. TJXshould not recognizerevenue upon receipt of the cash deposit since it retains the risks ofownership of the merchandise, receives only a deposit from the customer, and does not havean 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 thatrepresentthe culmination of a separate earnings process, the deferral of revenue isappropriate. In the situation described, signing the contract is not a discrete earnings event.The terms, conditions, andamounts of technology access fees typically are negotiated inconjunction with the pricing of all theelements of the R&D arrangement. The fact that thebiotechnology firm does not sell the initial rights separately supports deferral of revenue.Further, performing under the terms of thearrangements, not simply originating a revenue-generating arrangement, completes the earningsprocess.

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6.d. Current GAAP allows for a company to record the gain or loss on extinguishment of debtto be recorded as income from continuing operations if it does not meet the criteriaofunusualin nature and infrequency of occurrence.7.c. No. Operating/unusual items are shown “above the line” in the income statement.Therefore, ananalyst would have to adjust the income from continuing operations amountfor the effects ofnonrecurringnon-operating/unusual items. (However, note that some firmsthat report irregular items seem to be “accident prone” and report irregular items on aregular basis. Keep in mind thatalthough they are infrequent in nature, these events stillhave implications for the value of the firmand cannot be ignored altogether).8.d. The purpose of reporting nonrecurring items, net of related income taxes, below incomefromcontinuing operations is to help explain deviations in current year net income from pasttrends, 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 insuranceexpense for the entire $7,200 payment made on November 1. As of December 31, there arestill 34 monthsof coverage remaining. Therefore, $6,800 is the balance in prepaidinsurance. Insurance expense isthe $8,820 from the unadjusted trial balance minus the$6,800 moved into prepaid insurance plusthe $180 of prepaid insurance on the unadjustedtrial balance. In other words, the cost of theinsurance policy went up from $180 per monthto $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 EXHIBITS1.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 ChangesSUGGESTED READINGS1.Hatelstad, L. 1998. Measure for measure: Economic value added theory provides a new waytovalue 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 lettingfirms’book revenue from barteredads.The Wall Street Journal(January 26).

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CHAPTER 3ADDITIONAL TOPICS IN INCOME DETERMINATIONChapter OverviewThis chapter emphasizes the special accounting procedures used when revenue recognitiondoesn’t occur at the point of sale. The “critical event” and “measurability” conditions for revenuerecognition 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 iscollected. Thisapproach is used in instances where there is considerable uncertainty as to thecollectability of thesales price or where there are significant costs or uncertainties that may occur following the salethat 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 technicalsupport) pose particularly challenging revenue recognition issues and statement users need to beaware of the potential accounting abuses. The financial reporting must reflect the revenue whenit is earned. This earnings process may be as early as technological certainty or as late as whenthe support for the product expires.The broad criteria for revenue and expense recognition leaveroom for considerable latitude andjudgment. Management can sometimes exploit this flexibilityin GAAP to hide or misrepresent theunderlying economic performance of a company.Companies sometimes fail to adjust their revenue and expense recognition policies wheneconomic 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 undergenerally accepted accounting principles. This chapter outlines some of the more common ways ofmanaging earnings that have come under SEC scrutiny.Auditors and financial statement users must be aware of management’s incentives to manageearnings and the various ways it can be accomplished. Once discovered, errors and irregularitiesmust be corrected and disclosed. The errors and irregularities discovered in subsequent periods arecorrected 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 recognitionpractices, particularly percentage-of-completion for long-term construction contracts and multiple-element sales contracts.CHAPTER OUTLINEI.REVENUE RECOGNITION PRIOR TO SALEA.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-completionmethod recognizes revenue, cost, and gross profit asprogresstoward completion is made and is used primarily for long-termconstruction 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) = % completexestimated 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 therevised 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 recognizedprofit.g.Estimated losses on a contract are recognized in theirentiretyas soon as itbecomes 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, forexample, uses this method to record approximately 30 % of its revenues.2.Completed Contract Methodis used when it is not possible to determineexpected costs with a high degree of reliability. It is not a method that recognizesrevenue 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 theincomestatement until the project is completed.3.Long-termcontract losses(regardless of the revenue recognition method):a.Cost increases require current period adjustment of excess gross profitrecognized in earlier periods.b.With unprofitable contracts, theentire expected lossmust be recognized in thecurrent period (as well as the recovery of previously recognized revenue andgrossprofit).4.Revenue Recognition onCommodities:a.TheCompleted-Transaction (Sales) Methodrecognizes income when thecommodities aresold.b.TheMarket Price (Production) Methodrecognizes income when theagricultural commodities areharvested or when the natural resources areextracted.i.This alternative assumes that well-organized liquid markets exist for thecommodities.ii.Changes in the market value of the commodities while they are held instorage are reflected on both the balance sheet and income statement.c.Comparisonsof these two methods:i.The completed transaction (sales) method merges the results ofspeculative andoperating activity and does not reflect the separateresults of either.ii.The market price (production) method has the advantage of explicitlyrecognizing the separate results arising from operating andspeculative activities.II.REVENUE RECOGNITION SUBSEQUENT TO SALE—Conditions 1 and 2 are both satisfied subsequent tothe time of the sale.1.This treatment is acceptable only under highly unusual circumstances. Forexample, when the risk of noncollection is unusually high and when there isno reasonable basis for estimating the proportion of installment accounts likely

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