CHAPTER 15: SHORT-TERM LIABILITIES

QUESTIONS

2. Conceptually, how should a liability be measured?

Answer: Conceptually, a liability should be measured as the present value of all related future cash flows discounted at a rate of interest consistent with the risk involved.

6. In evaluating a balance sheet, some bankers say the liability section is one of the most important parts. What are the reasons justifying this position?

Answer: The primary reason is to assess the liquidity, and in the extreme, the solvency of the company. For this assessment, one would need to know (a) the current versus long-term liabilities and (b) their maturity dates, interest rates, and other terms. Also, liabilities are often the most difficult of all the items listed on the balance sheet to ascertain with respect to their existence. An individual, so inclined, can intentionally fail to report selected liabilities. Auditors routinely conduct tests to detect unrecorded liabilities.

7. Some liabilities are reported at their maturity amount. In general, when should liabilities, prior to maturity date, be reported at less than their maturity amount.

Answer: A liability will be reported at less than its maturity amount prior to the maturity date if (a) it is a non-interest-bearing note, or (b) the stated rate of interest on the liability is lower than the market rate of interest.

9. Define a current liability.

Answer: A current liability is an obligation that will be settled by using current assets or the creation of other current liabilities. That is, it will be paid with current assets during the coming year or next operating cycle, whichever is longer. Short-term obligations that will be paid with noncurrent assets should not be classified with current liabilities.

11. Distinguish between the stated rate of interest and the effective rate of interest (yield) on a debt.

Answer: Stated rate of interest—the rate specified in the debt agreement; it determines the cash interest to be paid. Effective or yield rate—the true rate of interest based on the cash equivalents received and the total cash equivalents paid back.

15. Are all declared dividends a liability between declaration and payment dates? Explain.

Answer: A cash or property dividend is a liability between declaration and payment ates because there is a contract to distribute assets. A stock dividend is not a liability because no assets will be distributed.

16. Why is unearned revenue classified as a liability?

Answer: Unearned revenue, which is revenue collected in advance of being earned, is a liability because goods or services must be expended in the future to earn the deferred revenue.

17. What is compensated absence? When should the expense related to compensated absences be recognized?

Answer: A compensated absence is time away from work (represented by vacation, holiday, and sick leave) given to employees without reducing their salaries or wages. The related expense should be recognized when earned and not when the time is taken off, if the two are different.

18. What is the accounting definition of a contingency? What are the three characteristics of a contingency? Why is the concept important?

Answer: A contingency, as defined in SFAS No. 5, is an existing condition, situation or set of circumstances involving uncertainty as to possible gain (a gain contingency) or loss (a loss contingency) to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. Resolution of the uncertainty may confirm (1) the acquisition of an asset or the reduction of a liability, or (2) impairment of an asset or the incurring of a liability.

The three characteristics of a contingency are (1) an existing condition, (2) uncertainty as to the ultimate effect, and (3) its resolution depending on one or more future events.

The concept is important because it represents a potential future asset or liability that has arisen as a result of an event or transaction that has already occurred. The high degree of uncertainty results in extra caution in accounting for contingencies.

20. Briefly explain the accounting and reporting for loss contingencies.

Answer: Loss contingencies are either accrued or reported in a footnote, depending upon the degree of uncertainty and whether they can be reasonably estimated. If probable and measurable, they are accrued; if probable but not subject to reasonable estimation or if only reasonably possible, they should be disclosed by footnote. If the possibility of their arising is remote, no disclosure is required.

EXERCISES

E 15-1 Multiple Choice

1. On January 17, 1998, an explosion occurred at a Cord Company plant causing extensive property damage to area buildings. Although no claims have yet been asserted against Cord by March 10, 1998, Cord’s management and counsel concluded that it was reasonably possible that Cord would be responsible for damages, and that $2,500,000 would be a reasonable estimate of its liability. Cord’s $10,000,000 comprehensive public liability policy has a $500,000 deductible clause. In Cord’s December 31, 1997 financial statements, which were issued on March 25, 1998, how should this item be reported?

a. No footnote disclosure or accrual is necessary.

b. As a footnote disclosure indicating the possible loss of $500,000.

c. As an accrued liability of $500,000.

d. As a footnote disclosure indicating the possible loss of $2,500,000.

Answer: B. Per SFAS 5, a loss contingency should be accrued if it is probable that a liability has been incurred at the balance sheet date and the amount of the loss is reasonably estimable. Although the contingency is reasonably estimable, it is not probable. Therefore, no loss is accrued. However, since the contingency is reasonably possible, it will be disclosed in the footnotes to the 12/31/97 financial statements. The possible loss will be disclosed as $500,000. The additional potential liability above the deductible would be covered by the insurance policy and would not be a loss for Cord.

2. Tone Company is the defendant in a lawsuit filed by Witt in 1997 disputing the validity of a copyright held by Tone. At December 31, 1997, Tone determined that Witt would probably be successful against Tone for an estimated amount of $800,000. Appropriately, a, $800,000 loss was accrued by a charge to income for the year ended December 31, 1997. On December 15, 1998, Tone and Witt agreed to a settlement providing for cash payment of $500,000 by Tone to Witt and transfer of Tone’s copyright to Witt. The carrying amount of the copyright on Tone’s acounting ecords was $120,000 at December 15, 1998. What would be the effect of the settlement of this liability on Tone’s income before income tax in 1998?

a. No effect.

b. $120,000 decrease.

c. $180,000 increase.

d. $300,000 increase.

Answer: C. At 12/31/97, the contingent liability from the lawsuit met SFAS 5’s criteria for acrual (probable and reasonably estimable, so a loss and liability of $800,000 was recognized. In 1998, the lawsuit was settled and the actual loss was $620,000 (($120,000 copyright transfer and $500,000 cash payment). This is a change in estimate which should be accounted for in the period of change per APB Opinion 20, para. 31. Therefore, the $180,000 difference will be reflected in 1998 income as a gain. The journal entry on 12/15/98 to record the settlement would be:

Lawsuit liability 800,000
Gain from settlement of lawsuit 180,000
Cash 500,000
Copyright 120,000

3. A manufacturer of household appliances has potential losses due to the discovery of a possible defect in one of its products. The occurrence of the loss is reasonably possible and the costs can be reasonably estimated. The possible loss should be

Disclosed
Accrued in Footnotes

a. No No

b. No Yes

c. Yes Yes

d. Yes No

Answer: B. Per SFAS 5, a loss contingency will be accrued only if its occurrence is probable and the amount can be reasonably estimated. In this case the loss is not considered probable and, therefore, should not be accrued. Although a contingent loss is not accrued if it is only reasonably possible (not probable) it will be disclosed in the footnotes to the financial statements. Therefore, the correct answer is B, the reasonably possible loss will not be accrued but it will be disclosed. Such disclosure should include the nature of the contingency and should give an estimate of the possible loss or range of loss or state that such an estimate cannot be made.

4. An expropriation of assets which is imminent and for which the amount of loss can be reasonably estimated should be

Disclosed
Accrued in Footnotes

a. No No

b. No Yes

c. Yes Yes

d. Yes No

Answer: C. The requirement is to determine the proper treatment of an expected loss that is imminent (probable) and the amount of which can be reasonably estimated. Answer (C) is correct because per SFAS No. 5, para. 8. an estimated loss from contingencies shall be accrued and charged to income when it is probable that an asset has been impaired or a liability incurred and when the amount of the loss can be reasonably estimated. Both of these requirements are met by the expropriation of assets described in this question. Therefore, this los contingency should be accrued. Additionally, per para. 9.the nature of the contingency should be disclosed in a note to the financial statements. Therefore, answers (a), (b) and (c) are incorrect.

E 15-2 Multiple Choice

1. On December 31, 1998, Beal Company was involved in a tax dispute with the IRS. Beal’s tax counsel believed that an unfavorable outcome was probable and a reasonable estimate of additional taxes was $275,000, with a chance that the additional taxes could be as much as $425,00. After the 1998 financial statements were issued, Beal accepted the IRS settlement offer of $325,000. What amount of additional taxes should have been accrued in 1998?

a. $425,000.

b. $325,000.

c. $275,000.

d. $0

Answer: C. The additional taxes must be accrued s a loss contingency in accordance with SFAS 5 because an unfavorable outcome is probable and the amount of the loss is reasonably estimable. Per FASB Interpretation 14, when a range of possible losses exists, the best estimate in the range (in this case $275,000) is accrued. Since the $325,000 settlement occurred after the statements were issued, this information was not available when the estimates were made. If, however, it had become available after the end of the fiscal year but before the financial statements were issued, it would have been a Type 1 Subsequent Event and $325,000 would be accrued in 1998.

2. On November 5, 1997, a Dunn Corporation truck was in an accident with an automobile driven by R. Bell. Dunn received notice on January 12, 1998 of a lawsuit for $350,000 in damages for personal injuries suffered by Bell. Dun Corporation’s counsel believes it is probable that Bell will be awarded an estimated amount in the range between $100,000 and $225,000, and that $150,000 is a better estimate of potential liability than any other amount. Dunn’s acounting year ends on December 31, and the 1997 financial statements were issued on March 2, 1998. What liability should Dunn accrue at December 31, 1997?

a. $0.

b. $100,000.

c. $150,000.

d. $225,000.

Answer: C. Per SFAS No. 5, a loss contingency should be accrued if it is probable that a liability has been incurred at the balance sheet date and the amount of the loss is reasonably estimable. This loss must be accrued because it meets both criteria. Even though the lawsuit was not initiated until 1/12/98, the liability was incurred on 11/5/97 when the accident occurred. FASB Interpretation 14 requires that when some amount within an estimated range is a better estimate than any other amount in the range, that amount is accrued. Therefore, a loss of $150,000 should be accrued. If no amount within the range is a better estimate than any other amount, the amount at the low end of the range is accrued and the amount at the high end is disclosed.

3. The following information pertains to a fire insurance policy in effect during the calendar year 1998, covering Vail Company’s inventory:

Face amount of policy $400,000
Deductible 25,000
Amount of premium 2,000
Coinsurance clause 80%

Vail’s inventory averages $500,000 uniformly throughout the year. Vail’s income tax rate is 40%. How much of a contingent liability should Vail accrue at ecember 31, 1998 to cover possible future fire losses?

a. $0.

b. $15,000.

c. $23,000.

d. $60,000.

Answer: A. The requirement is to determine the amount Vail should accrue as a contingent liability at 12/31/98 to cover possible future fire losses. Answer (a) is correct because per SFAS 5, para. 8, a contingent liability shall only be accrued if the likelihood of its occurrence is probable and the amount of the loss can be reasonably estimated. An event such as a future fire loss is not considered probable at 2/31/98 based on the information given, nor can an amount of the loss from such an event be reasonably estimated. Thus, no accrual is required at 121/31/98.

4. When the occurrence of a gain contingency is reasonably possible and the amount can be reasonably estimated, the gain contingency should be

a. Included in net income and disclosed.

b. Included in an appropriation of retained earnings.

c. Disclosed, but not included in net income.

d. Neither included in net income nor disclosed.

Answer: C. Per SFAS 5, para. 17, contingencies that might result in gains usually are not reflected in the accounts since to do so might result in revenue being recognized prior to its realization. Although adequate disclosure shall be made of contingencies that might result in gains, care should be exercised to avoid misleading implications as to the likelihood of realization. Therefore, answer (c) is correct. Answer (a) is incorrect because the gain contingency should not be recognized in the income statement. Answer (b) is incorrect because the gain contingency would not be reflected in any of the accounts. Answer (d) is incorrect because the contingency should be disclosed in the notes to the financial statements.

E 15-3 Multiple Choice

1. Robb Company requires advance payments with special orders from customers for machinery constructed to their specification. Information for 1998 is:

Customer advances—balance 12/31/97 $590,000
Advances received with orders in 1998 920,000
Advances applied to orders shipped in 1998 820,000
Advances applicable to orders canceled in 1998 250,000

At December 31, 1998, what amount should Robb report as a current liability for customer deposits?

a. $0.

b. $440,000.

c. $690,000.

d. $740,000

Answer: B. To determine the 12/31/98 balance of the liability for customer advances the following adjustments are made to the beginning 12/31/97 credit balance:

12/31/97 Balance $590,000
1998 Advances Received 920,000
Subtotal $1,510,000

Less:
1998 Advances Applied (820,000)
1998 Advances Cancelled (250,000)

12/31/98 Balance $440,000

When advances are received [$920,000], cash is debited and the liability account is credited. When advances are applied to orders shipped [$820,000], the liability account is debited and sales is credited. When an order is cancelled [$250,000], the liability account is debited and either cash or a revenue account is credited, depending upon whether or not the eposit is returned to the customer.

2. Cobb Company sells appliance service contracts to repair appliances for a two-year period. Cobb’s past experience is that, of the total amount spent for repairs on service contracts, 40% is incurred evenly during the first contract year and 60% evenly during the second contract year. Receipts from service contract sales for the two years ended December 31, 1998 are $250,000 in 1997 and $300,000 in 1998. Receipts from contracts are credited to unearned service contract revenue. Assume that all contract ales are made evenly during the year. What amount should Cobb report as unearned service contract revenue at December 31, 1998?

a. $180,000.

b. $235,000.

c. $240,000.

d. $315,000.

Answer: D. All contract sales are made evenly during the year. Therefore, the 1997 contracts range from one year expired (if sold on 12/31/97) to two years expired (if sold on 1/1/97), for an average of 1 years expired. Similarly, the 1998 contracts range from 0 years expired to 1 year expired, for and average of year expired. The average unearned portion of the 1997 contracts is year. The amount of unearned revenue related to the 1997 contracts is calculated as follows:

$250,000 x 60% x = $75,000

The average unearned portion of the 1998 contracts is 1 years. The amount of unearned revenue related to the 1998 contracts is calculated as follows:

$300,000 x 40% x = $ 60,000
$300,000 x 60% = 180,000
$240,000

Therefore, the total unearned revenue is $75,000 + $240,000 = $315,000.

3. In packages of its products, Curran Co. includes coupons that may be presented at retail stores to obtain discounts on other Curran products. Retailers are reimbursed for the face amount of coupons redeemed plus 10% of that amount for handling costs. Curran honors requests for coupon redemption by retailers up to three months after the consumer expiration date. Curran estimates that 70% of all coupons issued will ultimately be redeemed. Information relating to coupons issued by Curran during 1998 is as follows: consumer expiration date, December 31, 1998; total face amount of coupons issued, $300,000; and total payments to retailers as of December 31, 1998, $110,000. What amount should Curran report as a liability for unredeemed coupons at December 1, 1998?

a. $0.

b. $100,000.

c. $121,000.

d. $154,000.

Answer: C. At 12/31/98, Curran should report a liability even though the coupons expired 12/31/98 because retailers may submit coupons to Curran for three months after the expiration date. Thus, Curran will still have to redeem coupons until 3/31/99. Total expected redemptions are $210,000 (.70 x $300,000), and on those redemptions Curran expects to pay out $231,000 ($210,000 plus .10 x $210,000 for handling) As of 12/31/98, total payments to retailers have been $110,000, which means a liability of $121,000 should be eported ($231,000 - $110,000).

4. An employer’s obligation relating to employees’ rights to receive compensation for future absences is attributable to employees’ services already rendered. The payment of compensation is probable and the amount of compensation can be reasonably estimated. Employees’ compensation should be

a. Accrued if the obligation relates to rights that vest or accumulate.

b. Accrued if the obligation relates to rights that do not vest or accumulate.

c. Expensed when paid.

d. Disclosed but not accrued if the obligation relates to rights that vest or accumulate.

Answer: A. SFAS 43, para. 6 requires employers to accrue a liability for future absences when al of the following conditions are met:

1) The employees’ services have already been rendered.

2) The obligation relates to rights that vest or accumulate.

3) Payment is probable; and

4) The amount can be easily estimated.

E 15-4 Multiple Choice

1. Bloy Company pays all salaried employees on a biweekly basis. Overtime pay, however, is paid in the next biweekly period. Bloy accrues salary expense only at its December 31 year-end. Data relating to salaries earned in December 1998 are:

Last payroll was paid on December 26, 1998, for the two-week period ended on that day.

Overtime pay earned in the two-week period ended December 26, 1998 was $8,400.

Remaining work days in 1998 were December 29,30, and 31, on which days there was no overtime.

The recurring biweekly salaries total $150,000.

Assuming a five-day workweek, Bloy should record a liability at December 31, 1998, for accrued salaries of

a. $45,000.

b. $53,400.

c. $90,000.

d. $98,400.

Answer: B. the liability for accrued salaries at 12/31/98 should include all salaries expense that has been accrued but not yet paid. This would include the overtime pay earned by employees for the two-week period ended 12/26/98 ($8,400), which will not be paid until the next pay period. Accrued salaries would also include the regular pay for the workdays (December 29, 30, and 31). Since each biweekly pay period results in $150,000 regular pay for 10 workdays (2 five-day weeks), the accrued salaries for three workdays would be 3/10 of $150,000, $45,000. Therefore, the total liability for accrued salaries at 12/31/98 is $53,400 ($45,000 + $8,400).

2. On September 1, 1997, the Pine Company issued a note payable to National Bank in the amount of $900,000, bearing interest at 12%, and payable in three equal annual principal payments of $300,000. On this date the bank’s prime rate was 11%. The first interest and principal payment was made on September 1, 1998. At December 31, 1998, Pine should record interest payable of

a. $22,000.

b. $24,000.

c. $33,000.

d. $36,000.

Answer: B. Accrued interest payable at 12/31/98 is interest expense that has been incurred by 12/31/98 but not yet paid. In this case, interest was last paid on September 1, 1998, so the accrued interest payable includes interest expense incurred for 9/1 through 12/31 (4 months). The original balance of the note was $900,000, but the 9/1/98 principal payment of $300,000 reduced the balance to $600,000. Therefore, the interest payable at 12/31/98 is $24,000.

$600,000 x .12 x 4/12 = $24,000

The stated rate of 12% is used rather than the bank’s prime rate of 11% because 12% is the rate negotiated for this particular note.

3. Pam, Inc. has $500,000 of notes payable due June 15, 1999. At the financial statement date of December 31, 1998, Pam signed an agreement to borrow up to $500,000 to refinance the notes payable on a long-term basis. The financing agreement called for borrowings not to exceed 80% of the face value of the collateral that Pam was providing. At the ate of issue of December 31, 1998 financial statements, the value of the collateral was $600,000 and was not expected to fall below this amount during 1999. In its December 31, 1998 balance, Pam should classify notes payable as

Short-term Long-term
Obligations Obligations

a. $ 0 $500,000

b. $ 20,000 $480,000

c. $100,000 $400,000

d. $500,000 $ 0

Answer: B. All the notes are due 6/15/99 and normally the entire amount would be classified as current. However, SFAS No. 6 states that a short-term obligation can be reclassified as long-term if the enterprise intends to refinance the obligation on a long-term basis and the intent is supported by the ability to refinance. Pam demonstrated its ability by entering into a financing agreement before the statements are isud. SFAS No. 6 further states that the amount to be excluded from current liabilities cannot exceed the amount available for refinancing under the agreement. Pam expects to be able to refinance at leasr $480,000 (.80 x $600,000) of the notes. Therefore, that amount can be classified as long-term while the remaining $20,000 must be classified as short-term.

4. Which of the following is classified as an accrued liability?

Liability for Liability for

Federal Employer’s

Unemployment Share of

Taxes FICA Taxes

a. Yes Yes

b. Yes No

c. No No

d. No Yes

Answer: A. Accrued liabilities include expenses that have been incurred but not yet paid. Both federal unemployment taxes and the employer’s share of FICA taxes represent tax expense that is incurred as employees earn wages, but which is only paid periodically. Therefore, both types of expenses represent accrued liabilities.

E 15-7 Identifying Current Liabilities. Consider the following five items:

a. Bank overdraft.

b. Retained earnings.

c. Long-term debt.

d. Cash dividends declared but not paid.

e. Customer payments for magazine subscriptions not yet delivered.

Required: Identify the current liabilities among these five items.

Answer: Items a, d and e are current liabilities. Item b belongs with stockholders’ equity.

E 15-8 Identifying a Current Liability. Suppose a firm has an obligation that requires it to pay another organization $500,000 two years from today.

Required: Normally such an obligation would be considered long-term. Is there any situation in which this obligation could be considered a current liability. Explain.

Answer: Yes. If the business of the firm is such that a period longer than a year is necessary for reporting purposes, such an obligation could be considered a current liability. Examples often given of such cases are major construction activities including shipbuilding, dams and the building of major plant or office buildings. Long-term ventures might also qualify, such as the search for oil or for treasure. In these cases the normal production or operating cycle exceeds a year and this longer period dictates the reporting cycle.

E 15-12 Analysis and Comparison of' Interest-Bearing and Noninterest-Bearing Notes On September 1, 1998, Dyer Company borrowed cash on a $100,000 note payable due in one year. Assume the going rate of interest was 12 percent per year for this particular level of risk. The accounting period ends December 31.

Required: Complete the following tabulation; round to the nearest dollar.

Assuming the Note Was

Interest- Noninterest-
Bearing Bearing

1. Cash received $ $
2. Cash paid at maturity date $ $
3. Total interest paid (cash) $ $
4. Interest expense in 1998 $ $
5. Interest expense in 1999 $ $
6. Amount of liabilities reported on 1998 balance sheet:
Note payable (net) $ $
Interest payable $ $
7. Principal amount $ $
8. Face amount $ $
9. Maturity value $ $
10. Stated interest rate $ $
11. Yield or effective interest rate $ $

Answer:

Assuming the Note Was

Interest- Noninterest-
Bearing Bearing

1. Cash received $ 100,000 $ 89,286
2. Cash paid at maturity date 112,000 100,000
3. Total interest paid (cash) 12,000 10,714
4. Interest expense in 1998 4,000 1,571
5. Interest expense in 1999 8,000 7,143
6. Amount of liabilities reported on 1998 balance sheet:
Note payable (net) 100,000 92,857
interest payable 4,000 -0
7. Principal amount 100,000 89,286
8. Face amount 100,000 100,000
9. Maturity value 100,000 100,000
10. Stated interest rate 12% none
11. Yield or effective interest rate 12% 12%

Computations:

1. $100,000 1.12 = $89.286
2. $100,000 + ($100,000 x .12) = $112,000
3. $112,000 - $100,000 = $12,000
$100,000 - $89,286 = $10,714
4. $12,000 x 4/12 = $4,000
$10.714 x 4/12 = $3.571
5. $12,000 x 8/12 = $8,000
$10,714 x 8/12 = $7,143
6. $89,286 + $3,571 = $92,857
7. Cash received when the note was signed.
8. Given; same for both notes.
9. Maturity value is the amount due at maturity. excluding any separate interest payments.
10. Given for interest-bearing; nor applicable to noninterest- bearing note,
11. Same as stated rare on interest. bearing note; implicit (given as the going rate) on
noninterest-bearing note. 12%. Used to compute cash received,

E 15-14 Current Liabilities: Original and Adjusting Entries Vintage Sales Company, a large retail outlet, completed the following selected transactions during 1998 and 1999:

a. At the end of 1998, accrued wages that have not yet been recorded amounted to $40,000. These accrued wages were paid in the January 15, 1999, payroll, which amounted to $190,000 (disregard payroll taxes).

b. On November 1, 1998, rent revenue for the following six months was collected, $9,600.

c. On October 1, 1998, Vintage received $400 as a deposit from a customer for some special containers that are to be returned on or about March 31, 1999. Vintage agreed to "give the customer credit at an annual rate of 6 percent interest on the deposit." The containers were returned on April 1, 1999.

Required: Give all of the required entries (omit closing and reversing entries) during 1998 and 1999 for each of the above transactions. The accounting period of Vintage ends on December 31.

Answers:

Transaction (a):

December 31, 1998—Adjusting entry:
Wage expense ($70,176 x .14 x 9/12) 40,000
Wages payable 40,000

January 15. 1999—Payroll:
Wages payable (above) 40.000
Wage expense ($ 190.000 - $40.000) 150.000
Cash (given) 190,000

Transaction (b):

November 1, 1998—Collected rent in advance:
Cash 9,600
Rent revenue collected in advance 9,600

December 31, 1998—Adjusting entry:
Rent revenue collected in advance 3,200
Rent revenue ($9,600 x 2/6) 3,200

April 30, 1999— Recognize revenue earned:
Rent revenue collected in advance 6,400
Rent revenue ($9,600 x 4/6) 6,400

Transaction (c):

October 1. 1998—Deposit received:
Cash 400
Liability, container deposit 400

December 11. 1998—Accrued interest*:
Interest expense ($400 x .06 x 3/12) 6
Liability, container deposit 6

April 1. 1999—Deposit returned:
Liability, container deposit ($400 + $6) 406
Interest expense ($400 x .06 x 3/12)* 6
Cash ($400 + $6 + $6) 412

*Entry would probably not be made for $6 because the amount is not material.

E 15-15 Reporting Liabilities: Dividends and Secured Notes The records of the Fisk Corporation provided the following information at December 31, 1998.

a. Notes payable (trade), short term (includes a $4,000 note given on
purchase of equipment that cost $20,000; assets were mortgaged
in connection with purchase) $ 30.000

b. Bonds payable ($30,000 due each April 1) 120,000

c. Accounts payable (including $3,000 owed to president of the company) 50.000

d. Accrued property taxes (estimated) 1,000

e. Stock dividends issuable on 3/1/1999 (at par value) 26,000

f. Cash dividends declared. payable 3/1/1999 . 20,000

g. Long-term note payable, maturity amount ($14,500 carrying value) 16.000

h. Accrued interest on all bonds and notes 13,500

Required: Assuming that the fiscal year ends December 31, show how each of the above items should be reported on the balance sheet at December 31, 1998.

Answer:

Current Liabilities:
Accounts payable (trade) $47.000
Notes payable (trade) 26.000
Payable to company officer 3,000
Equipment notes payable (secured by equipment) 4,000
Current payment on bonds payable 30,000
Estimated property taxes payable 1,000
Dividends payable (cash) 20,000
Interest payable (on notes and bonds) 13.500

Long-Term Liabilities:
Bonds payable (less current portion) 90,000
Note payable (maturity amount, $16,000) 14.500

Operational Assets:
Equipment (pledged on 54.000 note) 20,000

Stockholders' Equity:
Stock dividends issuable (at par) 26,000*

*Assuming an entry was made on issue date as follows:
Retained earnings 26.000
Stock dividends issuable ............................ .......... 26,000

Otherwise. simply disclose in a note to the financial statements stock dividends usually are not recorded until issued.

E 15- 16 Entries to Record Payroll and Related Deductions Ryan company paid salaries for the month amounting to $120,000. Of this amount, $30,000 was received by employees who had already been paid the $53,400 maximum amount of annual earnings taxable in one year under FICA laws (FICA rate. 7.65 percent).

Of the $120,000, $14,000 was paid to employees who had already reached the $7,000 maximum wages subject to unemployment taxes (rates: 5.4 percent state and 0.8 percent federal). Withholding taxes amounted to $36,000, and $1,450 was withheld from the $120,000 for investment in company stock per an agreement with certain employees.

Required: Give entries to record (a) salary payment and the liabilities for the deductions. (b) employer payroll expenses, and (c) remittance of the taxes.

Answer:

(a) To record salaries and related deductions:
Salary expense 120,000
Withholding tax payable 36,000
Employee stock investment payable 1.450
FICA tax payable—-employees 6,885 *
Cash 75.665

* ($120,000 - $30,000) x .0765 = $6,885

(b) To record employer payroll taxes:
Expense-payroll taxes 13.457
FICA tax payable—employer 6,885 (1)
FUTA tax payable—federal 848 (2)
SUTA tax -state 5,724 (3)

(1) ($120,000 - $30,000) x .0765 = $6,885
(2) ($120,000 - $ 14,000) x .008 = $848
(3) ($120,000 - $ 14,000) x .054 = $5,724

(c) To record remittance of taxes:
Withholding tax payable 36,000
FICA tax payable—employees 6,885
FICA tax payable—employer 6,885
FUTA tax payable—federal* 848
SUTA tax payable—state 5,724
Cash 56,342

*Paid annually.

E 15-17 Recording Payroll and Related Deductions Smiley Corporation paid salaries and wages of $143,800. Of this amount, $3,860 was paid to employees who had already exceeded the FICA maximum. Also, $43,800 was paid to employees who had already been paid the SUTA maximum. Use the FICA and FUTA rates given in the chapter. Income tax withholding was $35,000. Deductions: union dues (in conformity with the union agreement), $3,000, and insurance premiums, $12,000.

Required: Give the entries to record liabilities for payroll deductions, payroll expenses, and remittance of the deductions.

Answers:

(a) To record salaries and the related employee deductions:
Salary expense ...................... 143,800
Withholding tax payable 35,000
Union dues payable 3,000
Insurance premiums payable 12,000
FICA tax payable ($143,800 - $3,800) x .0765 10.710
Cash 83,090

(b) To record employer payroll taxes:
Expense-payroll taxes 16,910
FICA tax payable, employer ($143,800 - $3,800) x .0765 10,710
FUTA tax payable, federal ($143,800 - $43,800) x .008 800
SUTA tax payable. state ($143.800 - $43,800) x .054 5,400

(c) For remittance of taxes and other deductions:
Withholding tax payable (a) above 35,000
Union dues payable 3,000
Insurance premiums payable 12,000
FICA tax payable. employees 10,710
FICA tax payable. employer 10,710
FUTA tax payable. federal 800
SUTA tax payable. state 5,400
Cash 77,620

E15-18 Compensated Absences: Entries and Reporting Tunacliff Mowers allows each employee to earn 15 paid vacation days each year with full pay while on vacation. Unused vacation time can be carried over to the next year; if not taken during the next year it is lost. By the end of 1998, all but 3 of the 30 employees had taken their earned vacation time; these three carried over to 1999 a total of 20 vacation days, which represented 1998 salary of $6,000. During 1999, each of these three used their 1998 vacation carryover; none of them had received a pay rate change from 1998 to the time they used their carryover. Total cash wages paid: 1998, $700,000; 1999, $740,000. There was no carryover of vacation time earned in 1999.

Required:

1. Give all of the entries for Tunacliff related to vacations during 1998 and 1999. Disregard payroll taxes.

2. Compute the total amount of wage expense for 1998 and 1999. How would the vacation time carried over from 1998 affect the 1998 balance sheet?

Answers:

Requirement 1:

December 31. 1998—Adjusting entry to accrue vacation salaries not yet taken or paid:
Salary expense 6.000
Liability for compensated absences 6,000

During 1999—Vacation time carryover taken and paid:
Liability for compensated absences 6,000
Cash (included in payroll entry) 6,000

Requirement 2

Total wage expense:
1998: $700,000 + $6,000
1999: $740,000 - $6,000 $734,000

1998 Balance sheet position:
Current liabilities:
Liability for compensated absences $6,.000

E15-19 Estimated Warranty Expense: Recording and Reporting Macy Furniture sells a line of products that carry a three-year warranty against defects. Based on industry experience. the estimated warranty costs related to dollar sales are the following: first year after sale, I percent of sales: second year after sale, 3 percent of sales; and third year after sale, 5 percent. Sales and actual warranty expenditures for the first three-year period were as follows:

Cash Sales Actual Warranty Expenditures

1998 . . . . . $ 80,000 $1,000
1999 . . . . . 110,000 4.100
2000 . . . . . 120,000 9.800

Required:

1. Give entries for the three years for (a) the sales, (b) the estimated warranty expense, and (c) the actual expenditures.

2. What amount should be reported its a liability on the balance sheet at the end of each year'!

Answers:

Requirement 1

(a) & (b) To record sales and estimated warranty costs:

1998 1999 2000

Cash 80,000 110,000 120,000
Warranty expense 7,200 a 9,900 b 10,800 c
Sales 80,000 110,000 120,000
Estimated warranty liability 7,200 9,900 10,800

a $80,000 x (.01 + .03 +.05) = $7,200
b $110,000 x (.01 + .03 + .05) = $9,900
c $120,000 x (.01 + .03 + .05) = $10,800

(c) To record actual expenditures:

Estimated warranty liability 1,000 4,100 9,800
Cash 1,000 4,100 9,800

Requirement 2

Balance in the liability account:

1998 ($7,200 - $1,000) $6,200
1999 ($6,200 + $9,900 - $4,100) 12,000
2000 ($12.000 + $10,800 - $9,800) 13,000

E 15-21 Loss Contingency—Three Cases: Entries and Explanation Canseco Company is preparing the annual financial statements at December 31, 1999. During 1999, a customer fell while riding on the escalator and has filed a lawsuit for $40,000 because of a claimed back injury. The lawyer employed by the company has carefully assessed all of the implications. If the suit is lost, the lawyer's reasonable estimate is that the $40,000 will be assessed by the court.

Required: How. should the contingency be handled during 1999 in each of the following cases? Give all necessary entries and any notes:

1. Assume that the lawyer and the management concluded that it is reasonably possible that the company will be liable, and it is reasonably estimated that the amount will be $40,000.

2. Assume, instead, that the lawyer, the independent accountant. and management have reluctantly concluded that it is probable that the suit will be successful.

3. Assume that the conclusion of the legal counsel and management is that the chance of a contingency loss is remote. They believe the suit is without merit.

Answers:

Requirement 1

This "reasonably possible" and "reasonably estimated" loss contingency would be reflected only in a footnote; accrual is not permitted. A suitable footnote is as follows:

Note: A customer was injured on company premises. Although the litigation has not been adjudicated, legal counsel and management have concluded that it is reasonably possible that the court will assess damages of approximately $40,000.

Requirement 2

This "probable" and -reasonably estimated" contingent loss must be accrued because (1) a loss is probable and (2) it can be reasonably estimated:

Loss due to accident 40,000
Estimated liability for damages (lawsuit) 40,000

Note: A customer was injured on company premises. Although the litigation has not been finally adjudicated, legal counsel and management believe it is probable that damages of approximately $40,000. will be assessed by the court.

Requirement 3

This "remote" and -reasonably estimated" contingent loss does not require accrual or note disclosure. However. conservatism, coupled with the full-disclosure principle, suggests the propriety of disclosing the situation in a note to the financial statements.

Comment: The situation in Requirement 1. as a practical matter. probably would seldom occur-they would settle out of court The situation in Requirement 2 probably would never occur for the same reasons.

E 15-23 Ratio Analysis Suppose a firm issues short-term interest-bearing notes and uses the proceeds to purchase inventories. Assume, further, that the decision turns out to be a good one for the firm. Assume the firm's profits for the year remain unchanged.

Required: Indicate how the use of the notes would affect the indicated ratios immediately following the decision unless otherwise indicated by the symbol *, which means indicate the effect over the year but before any of the liability is repaid. Use the following symbols: U for up, D for down, and NC for no change.

Effect on

Ratio Numerator Denominator Ratio

a. Current ratio
b. Working capital to total assets
c. Net cash to current liabilities
d. Debt to equity
e. Debt to total assets
f. Times interest earned*
g. Cash flow per share*
h. Return on total assets*

Answer:

Effect on

Ratio Numerator Denominator Ratio

a. Current ratio U U D1
b. Working capital to total assets NC U D
c. Net cash to current liabilities NC U D2
d. Debt to equity U NC U
e. Debt to total assets U U U3
f. Times interest earned* D U D
g. Cash flow per share* ? NC ?
h. Return on total assets* NC U D

1 If current assets exceed current liabilities, the ratio will immediately fall and vice versa. The former condition is the more likely. If we take a long-term view, assets, including current assets would rise and the liability decline increasing the ratio. Here we assume the "good result" occurs as we will elsewhere and examine only the short term.

2 The decision is a good one (given), but it is not clear whether the increased inflow will be in the form of cash or some other asset in the short run such as accounts receivable. Hence cash flow could even go down due the interest on the debt. The answer here assumes all the cash is invested in inventories,

3 This result holds because debt is less than total assets.

P 15-1 Multiple Choice

1. Farr Company sells its products in expensive. reusable containers. The customer is charged a deposit for each container delivered and receives a refund for each container returned within two year, after the year of delivery. Farr accounts for the containers not returned within the time limit as a sale at the deposit amount. Information for 1998 is (dollar amounts; represent deposit received from customers):

Containers held by customers at December 31, 1997 from deliveries in
1996 $150,000
1997 430,000 $580,000

Containers delivered in 1998 780,000

Containers returned in1998, from deliveries in
1996 $90,000
1997 250,000
1998 286,000 $626,000

What amount should Farr report as a liability for returnable containers at December 31. 1998?

a. $494,000.
b. $644,000.
c. $674,000.
d. $734,000.

Answer: (c) The requirement is the amount to reported as a liability for returnable containers at 12/31/98. The solutions approach sets up a T-account for the liability.

Liability

| 580,000 12/31/97 balance
1998 returns 626,000 | 780,000 1998 deliveries
1998 sales 60,000 |
| 674,000 12/31/98 balance

When customers pay the deposit for a container, cash is debited and the liability is credited. Therefore, at 12/31/97, the liability consists of deposits for containers still held by customers from the last two years ($580,000). During 1998, the liability is increased for deposits on containers delivered ($780,000). When containers are returned, the deposits are returned to the customers; in 1998, the liability was debited and cash credited for $626.000. Also, at 12131/98, some customers still held containers from 1994 ($150,000 - $90.000 = $60,000). The two-year time limit has expired on these, so the company no longer is obligated to return the deposit. The containers are considered sold to the customers. so the liability account is debited and sales credited for $60,000. These transactions result in a 12/31/98 liability balance of $674,000.

2. Dunn Trading Stamp Company records stamp service revenue and provides for the cost of redemptions in the year stamps are sold to licensees. Dunn's past experience indicates that only 80 percent of the stamps sold to licensees will be redeemed. Dunn's liability for stamp redemptions was $24.000,000 at December 31. 1997. Additional information for 1998 is:

Stamp service revenue from stamps sold to licensees $16,000,000
Cost of redemptions (stamps sold prior to 1/1/98) 11,000,000

If all the stamps sold in 1998 were presented for redemption in 1999, the redemption cost would be $9,000,000. What amount should Dunn report as a liability for stamp redemptions at December 31, 1998?

a. $13,000,000.
b. $20,200,000.
c. $22,000,000.
d. $29,000,000.

Answer: (b) The requirement is the amount to reported as a liability for stamp redemptions at 12/31/98. The solutions approach sets up a T-account for the liability.

Liability

| 24,000,000 12/31/95 balance
Redemptions 11,000,000 | 7,200,000 Increase
| 20,200,000 12/31/98 balance

When stamps are sold cash is debited and revenue is credited fly the face amount (16,000,000). Additionally, cost of redemptions is debited and the liability credited for the estimated cost of redemption. This increase in the liability is computed by taking the total possible redemption cost and multiplying by the expected redemption rate ($9,000,000 x .80 = $7,200,000) As redemptions actually occur, the liability is decreased. The cost of 1998 redemptions ($11,000,000) is debited to the liability account and credited to inventory.

3. Grey operates at; a retail furrier. Some customers pick out furs and place deposits with Grey to set the furs aside for future delivery. Grey records the cash receipts on these transactions as layaway plan sales. However. title to the fur passes to the customer only hen the full sales price is received by Grey. The average gross margin on the furs is 75 percent of sales. The following pertinent data were taken from Grey's December 31. 1998 unadjusted trial balance:

Regular sales $5,000,000
Layaway plan sales . $2,000,000
Deposits from customers $-0-

An analysis of the layaway plan sales revealed that $1,200,000 was received in full payment for furs delivered to customers during 1998. In Grey's December 31. 1998, balance sheet, deposits from customers would be

a. $2,000,000.
b. $1,500,000.
c. $1,200,000.
d. $800,000.

Answer: (d) Prior to adjusting entries, Grey has balances of $2,000,000 in layaway plan sales and $0 in deposits from customers. However, of the $2,000,000 balance in the sales account, only $1,200,000 represents sales where payment has been made in full and title has passed to the customers. The remaining $800,000 represents collections from customers. who have not yet paid in lull. At 12/31/98, an adjusting entry must be prepared to remove $800,000 from the sales account and record it in the liability account, deposits from customers.

4. During 1997, Ward Company introduced a new product carrying a two-year warranty against defects. The estimated warranty costs related to dollar sales are 2 percent within 12 months following sale and 4 percent in the second 12 months following sale. Sales and actual warranty expenditures for the years ended December 31. 1997 and 1998, are:

Actual Warrant)
Sales Expenditures

1997 $ 600,000 $ 9,000
1998 1,000,000 30,000
$1,600,000 $39,000

At December 31. 1998. Ward would report an estimated warranty liability of

a. $57,000.
b. $45,000.
c. $17,000.
d. $10,000.

Answer: (a) Each year. warranty expense is estimated at 6% of sales and recorded by debiting the expense account and crediting the liability. As warranty expenditures are made, the liability is debited and cash is credited. Note that the total estimated warranty cost for both years [(.02 + .04) = .06] is recorded in the year of sale in compliance with the matching principle.

Problem 15-2 Multiple Choice

1. A state requires quarterly sales tax returns to be filed with the sales tax bureau by the 20th day following the end of the calendar quarter. However, the state further requires that sales taxes collected be remitted to the sales tax bureau by the 20th day of the month following any month such collections exceed $1,000. These payments can be taken as credits on the quarterly sales tax return.

Taft Corporation operates a retail hardware store. All items are sold subject to a 6 percent state sales tax, which Taft collects and records as sales revenue. The sales taxes paid by Tart are charged against sales revenue. Taft pays the sales taxes when they are due.

Following is a monthly summary appearing in Taft's first-quarter 1998 sales revenue account:

Debit Credit

January -0- $21.200

February $1,200 14,840

March -0- 19,080

$1,200 $55,120

In its financial statements for the quarter ended March 31, 1998, Taft's sales revenue and sales taxes payable would be

Sales Sales Taxes
Revenue Payable

a. $55,120 $3,120
b. $53,920 $1,200
c. $52,000 $3,120
d. $52,000 $1,920

Answer: (d) The amount reported for sales revenue should include amounts charged customers when inventory is sold, but it should exclude amounts collected for sales taxes. To determine the correct amount for sales revenue, Taft must divide the total of sales and sales taxes by 100% plus the sales tax percentage (6%). as indicated below:

Month Total Percentage Sales Revenue

January $ 21,200 1.06 $ 20,000
February $ 14,840 1.06 14,000
March $ 19,080 1.06 18,000
Total $ 52,000

Sales taxes payable would include all sales taxes collected. less any sales taxes already remitted.

January sales taxes ($21,200 - $20,000) $ 1,200
February sales taxes ($14,840 - $14,000) 840
March sales taxes ($19,080 - $18,000) 1,080
Total 3.120

Less taxes remitted for January sales (1,200)

Sales taxes payable $1,920

2. In March 1998, an explosion occurred at Nilo Company's plant, causing damage to area properties. By May 1998, no claims had yet been asserted against Nilo. However, Nilo's management and legal counsel concluded that it was reasonably possible that Nilo would be held responsible for negligence and that $1,500,000 was a reasonable estimate of the damages. Nilo's $2,500,000 comprehensive public liability policy contains a $150,000 deductible clause. In Nilo's December 31. 1997. financial statements. for which the auditor's field work was completed in April 1998, how should this casualty be reported?

a. As a footnote disclosing- a possible liability of $1,500,000.
b. As in accrued liability of $150,000.
c. As a footnote disclosing a possible liability of $150,000.
d. No footnote disclosure or accrual is required for 1997 because the event occurred in 1998.

Answer: (c) Per SFAS 5, a loss contingency should he accrued if it is probable that a liability has been incurred at the balance sheet date and the amount of the loss is reasonably estimable. Although this contingency is reasonably estimable. it is not probable. Therefore, no loss is accrued. However, since the contingency is reasonably possible, it will be disclosed in the footnotes to the 12/31/97 financial statements. The possible loss will be disclosed as $150,000. The additional potential liability above the deductible would be covered by the insurance policy. and would not be a loss for Nilo.

3. The following information relating to compensated absences was available from Graf Company's accounting records at December 31, 1998.

Employees' rights to vacation pay vest and are attributable to services already rendered. Payment is probable, and Graf's obligation was reasonably estimated at $220,000.

Employees' rights to sick pay benefits do not vest but accumulate for possible future use. The rights are attributable to services already rendered, and the total accumulated sick pay was reasonably estimated at $100.000.

What amount is Graf required to report as the liability for compensated absences in its December 31. 1998. balance sheet?

a. $320,000.
b. $220,000.
c. $100,000.
d. $0.

Answer: (b) SFAS No. 43 states that accrual of a liability for future vacation pay is required if all of the conditions below are met:

1. Obligation arises from employee services already performed.

2. Obligation arises from vesting or accumulation of rights.

3. Payment is probable.

4. Amount can be reasonably estimated

These criteria are met fix the vacation pay ($220,000). Accrual for sick pay is riot required in this case, however, because the third condition (probable payment) is not specified in the problem. Therefore, the proper amount of the liability to be reported is $220,000.

4. Ruhl Company grants all employees two weeks' paid vacation for each full year of employment. up to six weeks. Unused vacation time can be accumulated and carried forward to succeeding years and will be paid at the salaries in effect when vacations are taken or when employment is terminated. There was no employee turnover in 1998. Additional information relating to the year ended December 31. 1998. is:

Liability for accumulated vacations at 12/31/97 $50,000
Pre-1998 accrued vacations taken from 1/1/198 to 9/30/98 (the
authorized period for vacations) 30,000
Vacations earned for work in 1998 (adjusted to current rates) 40.000

Ruhl granted a 10 percent salary increase to all employees on October 1, 1999. its annual salary-increase date. For the year ended December 31, 1998, Ruhl should report vacation pay expense of

a. $42,000.
b. $45,000.
c. $60,000.
d. $70,000.

Answer: (a) Per SFAS No. 43, an employer is required to accrue a liability for employees' rights to receive compensation for future absences, such as vacations, when certain conditions are met. The Statement does not, however, specify how such liabilities are to be measured. Since vacation time is paid by Ruhl Co. at the salaries in effect when vacations are taken or when employment is terminated, Ruhl adjusts its vacation liability and expense to current salary levels. Ruhl's 1998 vacation pay expense consists of vacations earned for work in 1998 (adjusted to current rates) of $20,000 plus the amount necessary to adjust its pre-1998 vacation liability for the 10% salary increase. The amount of this adjustment is equal to ten percent of the pre-existing liability balance at December 31, 1998 [($50,000 - $30,000) x. 10 = $2,000]. Therefore, total vacation pay expense for the period is equal to $42,000 ($40,000 + 2,000).

P 15-8 Compensated Absences: Entries and Reporting Aloha Company has a personnel policy that allows each employee with at least one year's employment 20 days vacation time and two holidays with regular pay. Unused days are carried over to the next year. If not taken during the next year, the vacation and holiday times are lost. Aloha's accounting period ends December 31.

At the end of 1999, the personnel records showed the following:

Vacations Carried over to 2000 Holidays Carried over to 2000

Total Days Total Salaries Total Days Total Salaries

70 $16,800 10 $2,580

During 2000, all of the 1999 vacation time and eight days of the holiday time, which were carried over, were taken. Salary increases in 2000 for these employees relating to the days carried over amounted to ($ 1,600. Total cash wages paid: 1999, $1,780,000; 2000, $1,860,000.

Required:

1. Give all of the entries for Aloha Company related to vacations and holidays during 1999 and 2000. Disregard payroll taxes.

2. Show how the effects of the above transactions should be reported on the 1999 and 2000 financial statements of Aloha.

Answers:

Requirement 1

During 1999-Record payroll in usual manner:
Salary expense 1,780
Cash 1,780

December 31. 1999—Adjusting entry to accrue vacation and holiday time
carried over:
Salary expense ($16,800 + $2.580) 19,380
Liability for compensated absences 19,380

During 2000—To record payment of 1999 vacation and holiday time
carried over to 2000:
Liability for compensated absences 19,390
Salary expense ($1,860,000 - $19,380) 1,840,620
Cash 1,860,000 *

* These amounts already include the $1600 salary increase. See instructional note.

Requirement 2

1999 2000

 

Income statement:
Salary expense $1,799,380 ** $1,840,620 ***

Balance sheet:
Liability for compensated absences 19,380 —

** $1,780,000 + $19,380 = $1,799.380

*** $1,860,000 - $19,380 = $1,840,620

Instructional note—Because some employees did not take two vacation days it had the effect of reducing salary expense in 2000; the implicit entry is: debit liability for compensated absences and credit salary expense.

A 15-1 Analysis of Current Liabilities Listed below are the current liability section and note 7 of the 1995 balance sheet of Amoco Corporation, a major oil firm.

1995 1994

Current liabilities (millions of dollars)

Current portion of long-term obligations $ 196 $ 94
Short-term obligations. 226 112
Accounts payable 2,496 2,217
Accrued liabilities 948 1,124
Taxes payable (including income taxes) . . . . . . 672 665

$4,538 $4,212

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

7. Short-Term Obligations

Amoco's short-term obligations consist of notes payable and commercial paper. Notes payable as of December 31, 1995, totaled $36 million at an average annual interest rate of 5.7 percent, compared with $7 million at an average annual interest rate of 5.7 percent at year-end 1994. Commercial paper borrowings at December 31, 1995, were $699 million at an average annual interest rate of 5.7 percent compared with $217 million at an average annual interest rate of 5.9 percent as of December 31, 1994.

Bank lines of credit available to support existing commercial paper borrowings of the corporation amounted to $490 million at both December 31 1995 and 1994. All of these were supported by commitment fees.

The corporation also maintains compensating balances with a number of banks for various purposes. Such arrangements do not legally restrict withdrawal or usage of available cash funds. In the aggregate, they are not material in relation to total liquid assets.

Required:

1. What amount of Amoco's long-term debt reflected in its current liabilities did Amoco pay off in 1995?

2. Explain the origin of the $196 million figure.

3. During 1995, did Amoco reduce its average yearly interest requirements on its short-term obligations described in note 7? Do you observe any interesting issues you might want to learn more about? If so, what are they?

4. Do the lines of credit that Amoco holds at the end of 1995 appear as liabilities on its balance sheet? Explain.

Answers:

Requirement 1

The company paid $94 million in 1995. They may also have elected to pay off additional long-term debt, but this is not disclosed.

Requirement 2

The $196 million is the portion of Amoco's long-term debt coming due in 1996 and which the company expects to pay of off in 1996. This portion of the debt is shown as a current liability.

Requirement 3

The company increased its average interest obligations because short-term borrowings increased even though the interest rates on the commercial paper declined. One might ask why commercial paper was used in 1994 given that the interest rate was 5.9 versus 5.7 on notes.

Requirement 4

Lines of credit are not obligations of Amoco. The commitment fees to hold open these fines of credit, which permit borrowing on demand, are expensed in the year they are due to the bank. It would be useful to know the amounts required as compensating balances, as this is cash that cannot be used in operations. For large firms, such as Amoco, these amounts are likely to be immaterial.

A 15-3 An Unknown Company's Current Liabilities The following is the liability section of a corporation's 1995 annual financial statement:

December 31

1995 1994

Liabilities (millions)

Noninterest-bearing deposits in US offices $13,388 $13,648
Interest-bearing deposits in US offices 36,700 35,699
Noninterest-bearing deposits in offices outside the United States 8,164 7.212
Interest -bearing deposits in offices outside the United States 108,879 99,167
Total deposits $167,131 $155,726
Trading account liabilities (Note 1)* 18,274 22,382
Purchased funds and other borrowings (Note 1)* . 16,334 20,907
Acceptances outstanding 1,559 1,440
Accrued taxes and other expenses (Note 8)* 5,719 5,493
Other liabilities 9,767 8,878
Long-term debt (Note 1)* 17,151 16,497
Subordinated capital notes (Note 1)* 1,337 1,397

* The notes are not reproduced here.

Required:

1. What is unusual about the items included in the disclosure?

2. What do you believe would be included in "purchased funds and other borrowings"?

3. What type of corporation is this? How do you know?

Answers:

Requirement 1

First, there is no separate section for long-term liabilities. This should be a clue that the issuing firm is a bank. Also, the liabilities include preferred stock.

Requirement 2

The content is shown in Note 1 of the company's report (not reproduced here). Perhaps the reader could guess that this account includes:

a Federal funds Purchased and securities is ties sold under repurchase agreements

b. Commercial paper issued by the parent company's and the Student Loan Corp.

c Other borrowed funds

Requirement 3

This liability section is from Citicorp's, a major financial institution, 1995 balance sheet. This corporation is a bank, which can be seen by the nature of the majority of its liabilities, that is, deposits. Also. since the liabilities are not classified as to current or noncurrent, the reporting is consistent with the format for financial institutions.

CHAPTER 16: LONG-TERM LIABILITIES

2. What are the primary distinctions between a debt security and all equity security?

Answer: The primary distinctions between debt and equity securities are:

a. Debt security—fixed principal and interest; no voting privileges. fixed maturity date; cash flow dates and amounts are fixed.

b. Equity security—no fixed principal and interest; voting privileges (common stock) fixed cash flow amounts and dates.

3. Explain the difference between the stated rate of interest and the effective rate on a long-term debt security.

Answer: Stated rate of interest—contractual rate specified on the debt instrument; it determines the amount of cash interest each interest period.

The effective rate of interest is the true interest rate on a debt security. It is determined by the market and it is based on the resources received currently and the future resource flows. The effective rate is often called the market rate of interest.

5. Briefly explain the effects on interest recognized when the stated and effective rates of interest are different.

Answer: An effective interest rate above the stated rate causes a discount and the opposite cause, a premium on the debt A discount increases interest reported on the income statement and a premium decreases interest reported on the income statement (compared with the effects of the stated rate).

8. What are the principal advantages and disadvantages of bonds versus common stock for (a) the issuer and (b) the investor?

Answers:

a. From the issuer's point of view, a primary advantage of bonds versus common stock is that interest payments are deductible as an expense for income tax purposes. whereas dividends paid are not. The disadvantages are that interest payments on bonds constitute a legal and fixed obligation that must be paid in cash. whereas dividends on common stock are paid only when sufficient funds and retained earnings are available, and that bonds have a specific maturity date but capital stock does not. Issuers expect to earn a higher rate of return on their investment (than the return paid on bonds) to satisfy stockholders.

b. From the investor's point of view, bond investments usually have not been considered as good a hedge against inflation as capital stock investments. Each investor weighs whether the guaranteed fixed interest rate and maturity amount. or the potential for dividends anti increase in stock prices would be more advantageous. Stock investments usually are considered to be more risky.

9. Distinguish between the par amount and the price of a bond. When are they the same? When different? Explain.

Answers:

The face (i.e., par) amount of a bond is the maturity amount specified on the bond certificate.

The bond price represents the present value of the future cash flows (principal plus all interest payments) at the effective rate of interest.

The face amount of bond and its price are the same if the bond has the same stated and effective rates of interest when issued: otherwise. they will be different.

14. Under GAAP, when is it appropriate to use the (a) straight-line and (b) interest method of' amortization for bond discount or premium?

Answer: Under generally accepted accounting principles (GAAP), it is acceptable to use the straight-line method only if its results are not materially different in amount from the results produced by the interest method. Otherwise. the interest method must he used.

18. Why is the accounting different for nonconvertible bonds with detachable stock purchase warrants and nonconvertible bonds with nondetachable stock purchase warrants?

Answer: A detachable stock purchase warrant is separable from the nonconvertible bond to which it relates; therefore, the warrants can be sold separately in the market. An objective valuation of the bonds and the warrants separately can be made, making possible separate recording and reporting of the debt and equity components.

In accounting for nonconvertible bonds with nondetachable stock purchase warrants, separate accounting for debt and equity is not feasible due to the inseparability of the two different securities (there will be no separate market for either the bond or the warrants). It is difficult to objectively assign the amounts that should be allocated between the debt and equity components.

24. Interest rates have increased since a company issued its bonds. Why would the firm want to refund the bonds with another issue of' bonds paying a higher rate?

Answer: when interest rates rise, the market value of bonds decreases, allowing the refunding of the older bond issue at a gain. thus increasing earnings.

25. A firm retired a bond issue early at a loss. Is the firm in an economically worse position after the retirement?

Answer: This question does not have a definite answer. However. the firm would not have retired the bonds if it were not in its best interest. Also, the firm paid the market value of the bonds. Therefore, one could argue that they are in an equivalent position before and after the retirement. In addition, the loss occurred because interest rates have fallen. The firm may take this opportunity to issue lower rule debt reduce its future interest costs. and extend the maturity of its debt, This argument suggests the firm is in a better economic position after the retirement.

27. Explain the classification of gains and losses from troubled debt restructuring.

Answer: In a settlement the debtor records a gain and the creditor a loss. The debtor's gain is reported as extraordinary while the creditor's losses are reported as ordinary, unusual or infrequent, or extraordinary in conformity with GAAP (as specified in APB 30). The debtor also has a gain in a modification of terms if the sum of restructured flows is less than the debt book value.

28. Differentiate between a debt restructure in which debt is settled and one in which it continues after the restructure.

Answer: In a debt restructure the agreement relaxes the payment requirements on the debtor. There are two cases, as follows: (a) the debt is settled in full by the transfer of assets or equity interests of the debtor that have a value below the carrying value of the debt (i.e., a concession); (b) the debt provisions are relaxed for timing, interest, or principal (or any combination). In this case the debt continues under the terms of the debt restructure.

E 16-1 Bonds: Issue above, at and below Par Rowe Corporation authorized $600,000 of 8 percent (interest payable semiannually), 10-year bonds. The bonds were dated January 1. 1998; interest dates are June 30 and December 31.

Assume four different cases with respect to the sale of' the bonds: Case A-Sold on January 1, 1998, at par; Case B—Sold on January 1. 1998. at 102; Case C—-Sold on January 1, 1998 at 98; Case D—Sold on March 1. 1998, at par.

Required:

1. For each case, what amount of cash interest will be paid on the first interest date. June 30, 1998?

2. In what cases will the effective rate of interest be (a) the same, (b) higher, or (c) lower than the stated rate?

3. After sale of the bonds, and prior to maturity date, in what cases will the carrying or book value of the bonds (as reported on the balance sheet) be (a) the same, (b) higher, or (c) lower than the maturity or face amount?

4. After the sale of the bonds, in Cases A, B and C, which case will report interest expense (a) the same, (b) higher, or (c) lower than the amount of cash interest paid each period?

Answers:

Requirement 1

For all cases. cash interest paid each interest date will be: $600,000 x 4% = $24,000.

Requirement 2

The effective rate is the same as the stated rate in Cases A and D because the bonds sold at par. The effective rate is higher than the stated rate in Case C because the bonds sold at a discount. The effective rate is lower than the stated rate in Case B because the bonds sold at a premium

Requirement 3

After the sale of the bonds and prior to maturity date, the carrying or book value of the bonds will be the same as the maturity or face amount in Cases A and D (sold at par); in Case B (sold at a premium). the carrying or book value will be higher than the maturity or face amount, and in Case C (sold at a discount). the carrying or book value will be lower than the maturity or face amount.

Requirement 4

Case A will report the same amount for interest expense and cash interest paid (sold at par); in Case B, the amount of interest expense will be lower than the cash interest paid (sold at a premium); and in Case C,. the amount of interest expense will be higher than the cash interest paid (sold at a discount).

E 16-7 Compute Bond Price: Amortization Schedule, Interest Method Radian Company Issued to Sievers Company $30,000 of four-year. 8 percent bonds dated June 1, 1998. Interest is payable semiannually on May 31 and November 30. The bonds were issued on March 1, 1999, for $28,371 plus accrued interest. The bonds would have sold at the effective rate on the next interest date for $28,478. The accounting period ends December 31 for both companies. The effective interest rate was 10 percent.

Required: Round to the nearest dollar.

1. Verify the bond price. Use straight-line interpolation between interest dates.

2. Prepare a bond amortization schedule. Use interest method amortization.

3. In parallel columns. give entries for the issuer and the investor for the following dates: March 1, 1999, and May 31. 1999. Use interest method amortization. and assume that Sievers will hold the bonds to maturity.

Answers:

Requirement 1

The PV is computed as follows:

PV at 12/1/1998 (n = 7; i = 5%) PV at 6/1/1999 (n = 6; i = 5%)

Prin: $30,000 x .71068 $21,320 Prin: $30,000 x .74622 $22,387
Int: $1,200 x 5.78637 6,944 Int: $1,200 x 5.07569 6,091

28,264 minus 28,478 = $214 x .5
+ 107 - 107 $107*
$28,371 (either) $28,371

*Straight-line interpolation; .5 represents 1/2 of an interest period; bonds were issued 3 months into an interest period.

Requirement 2

Bond Amortization Table
(Stated rate 4%; effective rate

Bond
Cash Effective Discount Discount Carrying
Date Payment Interest Amortization Balance Value

03/01/1999 $1,629 $28,371
05/31/1999 $1,200 $107 (a) 1,522 (a) 28,478 (a)
11/30/1999 1,200 $1,424 (b) 224 (c) 1,298 (d) 28,702 (e)
05/31/2000 1,200 1,435 235 1,063 28,937
11/30/2000 1,200 1,447 247 1,816 29,184
05/31/2001 1,200 1,459 259 1,557 29,443
11/30/2001 1,200 1,472 272 1,285 29,715
05/31/2002 1,200 1,485 * 285 -0- 30,000

(a) See Req. 1

(b) $28,478 x .05 = $1,424

(c) $1,424 - $1,200 = $224

(d) $1,522 - $224 = $1,298

(e) $28,478 + $224 = $28,702

* Rounded to come out even.

Requirement 3

Issuer—Radian Company Investor—Sievers Company

March 1, 1999:

Cash $28,971 * Investment in Bonds $28,371

Discount on bonds Interest receivable 600

payable 1,629 Cash 28,971

Bonds payable 30,000
Interest payable 600

* includes accrued interest:

($30,000 x 4% x 3/6) $ 600
Bond price (to yield 10%) 28,371
Total cash $28,971

May 31, 1999:

Interest payable $ 600 Cash $ 1,200

Interest expense 707 Investment in bonds 107

Discount on bonds payable 107 Interest revenue 707

Cash 1,200 Interest receivable 600

$30,000 x 4% = $1,200.

E16-9 Multiple Choice Accounting for Bonds Choose the correct answer for each question.

1. A 6 percent bond issue has nine semiannual interest periods remaining in its term. Each $1,000 bond in the issue was sold to yield 10 percent. The bonds were sold at 79 between interest dates. What is the current book value under the interest and straight-line methods of amortization, as measured in percentage of face value?

Interest Method Straight-Line Method

a. 91.2 97.3
b. 85.8 Cannot be determined
c. 101.5 85.8
d. 87 Cannot be determined

Answer: b. Interest method book value = $1,000(PV1, .05, 9) + $30 (PVA, .05, 9)
= $1,000 (.64461) + $30 (7.10782)
= $858

The SL Method book value cannot be determined because the bond term is not given. nor is the amount of the bond term expired as of the current date. Therefore, the amount of unamortized discount remaining, or the amount of discount amortized to the current date, cannot be determined.

2. On July 1, 1998, Center Company paid $599,000 for 10 percent, 20-year bonds with a face value of $500,000. Interest is paid on December 31 and June 30. The bonds were purchased to yield 8 percent. Center uses the interest method to recognize interest income from this investment. What is the carrying amount of this investment in bonds in Center's December 31, 1998 balance sheet if Center intends to hold the bonds to maturity?

a. $603,950.
b. $599,000.
c. $597,960.
d $596,525.

Answer: c. Cost of investment $559,000
Cash interest received 12/31/98 [(.05) ($500,000)] 25,000
Interest revenue for 1998 [(.04) ($599,000)] 23,960
Amortization of premium (reduces investment account) 1,040
December 31,1998 carrying amount $597,960

3. Delia Company incurred costs of $6,600 when it issued, on August 31. 1998, five-year debenture bonds dated April 1. 1998. What amount of bond issue expense should Delia report in its income statement for the year ended December 31, 1998?

a. $440
b. $480
c. $990
d. $6,600

Answer: b. The bond term is 4 years, seven months, or 55 months. Bonds were outstanding 4 months in 1998. Amortization of issue costs in 1995: $6,600 (4/55) = $480.

4. The following information pertains to Hike Tours, Inc., issuance of bonds on July 1. 1998:

Face amount $400.000
Term 10 years
Stated interest rate 6%
Interest payment dates Annually on July 1
Yield 9%

What is the issue price for each $1,000 bond?

a. $1,000. c. $807.
b. $864. d. $700.

Answer: c. Total issue price = $1,000 (PV1, 9%, 10) + .06 ($1,000)(PVA, 9%, 10) =
$1,000 (.42241) + $60 (6.41766) = $807.

E 16-11 Nonconvertible Bonds with Detachable Warrants Hardware Corporation issued $75,000 of 6 percent. 10-year, nonconvertible bonds with detachable stock purchase warrants. Each $1.000 bond carried 20 detachable warrants. each of which was for one share of Hardware common stock, par $20. at a specified option price of $60. The bonds sold at $102 including- the warrants (no bond price ex-warrants was available). and. immediately after date of issuance, the detachable stock purchase warrants were selling at $4 each. The entire issue was acquired by Software Company as a long-term investment with the intent to hold to maturity. All indicated transactions occurred in the same fiscal year.

Required:

1. Give entries for both the issuer and the investor at date of acquisition of' the bonds.

2. Give the entry for the investor assuming a subsequent sale of all of the warrants to another investor at $5.50 each.

3. Disregard (2). Give the entries for the issuer and the investor assuming subsequent tender of all of the warrants by the investor for exercise at the specified option price. At this date. the stock was selling at $75 per share.

Answers:

Requirement 1

Issuer- Hardware Corporation Investor- Software Corporation

Cash 76,500 * Bond investment 70,500

Discount on bonds Investment—detachable

payable 4,500 stock purchase
Bonds payable 75,000 warrants (1,500 x $4) 6,000

Detachable stock Cash 76,500
purchase warrants
outstanding

(1,500) 6,000 **

* $75,000 x 1.02 = $76,500

** 75 bonds x 20 warrants per bond x $4
= $6,000

Requirement 2

Issuer- Hardware Corporation Investor- Software Corporation

No entry Cash 8,250

Investment—
detachable stock
purchase warrants
(1,500 x $4) 6,000
Gain on sale of
stock purchase
warrants 2,250 *

* 1,500 x ($5.50 - $4.00) = $2,250

Requirement 3

Issuer- Hardware Corporation Investor- Software Corporation

Cash (1,500 shares Investment in common
$60 option price) 90,000 stock 96,000

Detachable stock Investment
purchase warrants detachable stock
outstanding purchase warrants

(1,500 x $4) 6,000 (1,500 x $4) 6,000

Common stock Cash (1,500 x $60) 90,000

(1,500 shares x
$20 par) 30,000
Contributed capital in
excess of par 66,000

E 16-27 Long-Term Note: Unrealistic Rate. Debtor and Creditor Cathy Company purchased a machine at the beginning of 1998 with a three-year, $2,000, 5 percent note, payable in three equal annual payments of $734 (including principal and interest) at each year-end The current market rate of interest for this level of risk was 12 percent.

Required:

1. What was the cost of the machine to Cathy Company?

2. Give the entry by Cathy to record the purchase. Use the net approach.

3. Prepare the amortization schedule for the note.

4. Give the entries for both the debtor and the creditor at the end of each year (assuming that the accounting year-end for the debtor and creditor coincides with the note's year-end).

Answer:

Requirement 1

Cost of the machine (rounded to (he nearest dollar):
$734 x (PVA, 12%, 3) (2.40183) = $1,763.

Requirement 2

Entry to record the purchase (net basis):
Machine 1,763
Note Payable 1,763

Requirement 3

Amortization schedule:

Cash Reduction of Principal
Date Payment Interest (at 12%) Principal Balance

1998 (start) $1.763
1998 (end) $ 734 $1,763 x 12% = $212 $ 522 1,241
1999 (end) 734 1,241 x 12% = 149 585 656
2000 (end) 734 656 x 12% = 80 * 656 -0-
Total $2,202 $441 $1,763

*Rounded.

Requirement 4

Entries at year end:

1998 1999 2000

Debtor
Note payable 522 585 656
Interest expense 212 149 80
Cash 734 734 734

Creditor
Cash 734 734 734
Note receivable 522 585 656
Interest revenue 212 149 80

E16-28 Appendix 16A: Multiple Choice-Troubled Debt Restructure Choose the correct answer for each question.

1. Nano Corporation agreed to give Rewind Company a machine in full settlement of a note payable to Rewind. The machine's original cost was $70,000. The note's face amount was $55,000. On the date of the agreement,

• The note's carrying amount was $52,500 and its present value at the current market rate was $48,000.

• The machine's carrying amount was $54,500, and its fair value was $48,000.

What amounts of gain (loss) should Nano recognize, and how should these be classified in its income statement?

Extraordinary Other

a. $(2,000) $ 0
b. 0 (2.000)
c. 2,500 (2.000)
d. 4,500 (6,500)

Answer: d. Note carrying value $52,500
Machinery fair value 48,000
Extraordinary gain on debt restructure $4,500

Machinery carrying value $54,500
Machinery fair value 48,000
Loss on disposal $6,500

2. Wild Company. a debtor-in-possession under Chapter 11 of the Federal Bankruptcy Code, granted an equity interest to a creditor in full settlement of a $56,000 debt owed to the creditor. At the date of this transaction. which is considered an isolated transaction with respect to the bankruptcy proceedings, the equity interest had a fair value of $50,000. What amount should Wild recognize as in extraordinary gain on restructuring of debt?

a. $0.
b. $6,000.
c. $50,000.
d. $56,000.

Answer: b. Debt book value $56,000
Fair value of equity interest 50,000
Extraordinary gain on debt restructure $6,000

3. During 1998, Camellia Company experienced financial difficulties and was likely to default on a $500,000, 15 percent, three-year note dated January 1, 1997, payable to Central National Bank. On December 31, 1998, the bank agreed to settle the note and unpaid 1998 interest of $75,000 for $410,000 cash payable on January 31, 1999. What is the amount of gain, before income taxes. from the debt restructuring?

a. $0.
b. $75,000.
c. $90,000.
d. $165.000.

Answer: d. Debt book value $575,000
Cash paid 410,000
Extraordinary gain on debt restructure $165,000

4. In 1993, Marie Corporation acquired land by paying $37.500 down and signing a note with a maturity value of $500.000. Oil the note's due date. December 31. 1998. Marie owed $20.000 of accrued interest and $500.000 principal on the note. Marie was in financial difficulty and was unable to make any payments. Marie and the bank agreed to amend the note as follows:

• The $20.000 of interest due on December 31, 1998, was forgiven.

• The principal of the note was reduced from $500,000 to $475.000, and the maturity date was extended one year to December 31. 1999.

• Marie would be required to make one interest payment totaling $15,000 on December 31, 1999.

As a result of the troubled debt restructuring Marie should report a gain, before taxes, in its 1998 income statement of

a. $20,000.
b. $25,000.
c. $30,000.
d. $45,000.

Answer: c. Debt book value $520,000
Sum of restructured cash flows 490,000 *
Extraordinary gain $30,000

* $475,000 - $15,000

E16-31 Appendix 16A: Restructure. Modification of Terms. Compute New Interest Rate. Entries for Both Parties Brown Company owed City Bank a $50,000, 10 percent payable each December 31), four-year note dated January 1. 1995. Early in 1996, it became clear that Brown Company Was experiencing difficulty in making the annual interest payment, although the company did manage to make the 1995 payment. Because of expected continuing difficulties, it appeared that there was a good chance the company would default on the note (as well as on other obligations). On January 2. 1997, the two parties agreed to restructure the debt by (a) reducing the remaining annual interest payments to $2,240 each and (b) reducing the principal amount (maturity amount) to $48,000. Brown paid the interest for 1996.

Required:

1. Compute the new yield or effective rate of interest it) be used by Brown.

2. Give all entries required on date of restructure (January 2. 1997) for each company. If no entry is required, explain the reason.

3. Give all entries required at December 31, 1997, and 1998, for each company. Assume that City Bank uses the interest method

Answers:

Requirement 1

To determine the new effective rate, it is necessary to find the rate that causes the prerestructure carrying value of the debt ($50,000) to equal the present value of the future cash flows (principal, $48,000 and the interest payments of $2,240 each. Thus:

$50,000 = $48,000 (PV1, ?, 2) + $2,240 (PVA, ?, 2)

Present Value at

2% 2- 3%

Principal:
$48,000 x PV1 table for n=2 (2% = .96117) $46,136
(2% = .95181) $45,687
(3% = .94260) 45,245

Interest:
$2,240 x PVA table for n=2 (2% = 1.94156) 4,349
(2% = 1.92742) 4,317
(3% = 1.91347) ______ ______ 4,286

Total Present Value $50,485 $50,004 $49,531

The new effective rate of interest is almost exactly 2%.

Requirement 2

Brown Company

January 2, 1996, date of restructure—No entry is required by Brown because the total cash to be paid ($48,000 + $4,480 = $52,480) exceeds the prerestructure carrying value of the debt ($50,000). However, Brown could choose to reclassify the note as restructured. The new note payable account balance is $50,000.

City Bank

January 2, 1997, date of restructure, City Bank records a loan impairment.

New note carrying value = $48,000 (PV1, 10%, 2) + $2,240 (PVA, 10%,2)
= $48,000 (.82645) + $2,240 (1.73554) = $43,557

Bad debt expense ($50,000 - $43,557) 6,443
Allowance for decline in note value 6,443

Requirement 3

Brown Company (debtor) City Bank (creditor)

December 31, 1997:
Interest expense 1,250 Allowance for decline in
Note payable 990 note value 2,116
Cash 2,240 Cash 2,240

$50,000 x 2% = $1,250 Interest revenue
$2,240 - $1,250 = $990 (.10)($43,557) 4,356

December 31, 1998 (maturity date):
Interest expense 1,225 Allowance for decline in
Note payable 1,015 note value 2,327
Cash 2,240 Cash 2,240

($50,000 - $990) x 2% = $1,225 Interest revenue 4,567 *
* ($43,557 + $2,116) (.10)

Note payable 45,000 *
Cash 45,000

Allowance for decline in
note value 2,000
Cash 48,000
Note receivable 50,000

* Cumulative balance: $50,000 - $990 - $1,015 = $47,995.

(Discrepancy of $5 due to inexact rate of 2%

P16-3 Bonds: Interest Method. Adjusting Entries Jones Corporation issued bonds, face amount $100,000, three-year, 8 percent (payable semiannually on June 30 and December 31). The bonds were dated January 1, 1998, and were sold on November 1, 1998 for $100,739 (including interest of $2,667 and a bond price of $98,072) at an effective interest rate of 9 percent. The bonds would have sold at the effective rate on December 31, 1998, for $98.206. The bonds mature on December 31, 2000. The bonds were purchased as a long-term investment by Smith Corporation. which intends to hold the bonds to maturity.

Required:

1. In parallel columns, give the entries at November 1. 1998. for the issuer and the investor.

2. Prepare a bond amortization schedule using the interest method.

3. In parallel columns, give the entries for both the issuer and investor for interest and amortization at the interest date, December 31. 1998. Use the interest method of amortization.

4. Assume that the accounting period for each party ends on February 28. In parallel columns, give the adjusting entries for each party on February 28, 1999. Assume the interest method of amortization.

5. Compute the amount of amortization per month for each party. assuming that straight-line amortization is used (i.e., the difference between the amortization amounts is not material).

Answers:

Requirement 1

Issuer—Jones Corporation Investor—Smith Corporation

November 1, 1998 (to record
sale/purchase):

Cash 100,739 Investment in bonds 98,072

Discount on bonds Interest receivable 2,667

Payable 1,928 * Cash 100,739
Interest payable
(4 months) 2,667
Bonds payable 100,000

* $100,000 - $98,072 = $1,928

Requirement 2

Balance Carrying
Cash Effective Discount unamortized value
Date Payment Interest amortization discount of bonds

11/01/1998 (Date sold) $1,928 $98,072

12/31/1998 $4,000 $4,134 (b) $134 (a) 1,794 98,206
06/30/1999 4,000 4,419 419 1,375 98,625
12/31/1999 4,000 4,438 438 1,937 99,063
06/30/2000 4,000 4,458 458 1,479 99,521
12/31/2000 4,000 4,479 (c) 479 -0- 100,000

(a) Bond price at next interest date (12/31/1998).
for 2 years $98,206
Bond price at date of sale (11/01/1998) (given) 98,072
Difference—amortization for first interest period $ 134

(b) Semiannual cash interest on 12/31/1998 $ 4,000
Discount amortization [2 months, (a)] 134
Total—effective interest (before accrual) $ 4,134

(c) $4,000 + $479 (discount for final period) = $4,479

Requirement 3

Interest expense for 1998: Effective interest, $4,134 minus interest accrued to date of bond transaction, $2,667, equals $1,467 (i.e., the net interest cost for the two-month holding period during 1998).

Issuer—Jones Corporation Investor—Smith Corporation

December 31, 1998 (to record semiannual interest payment and discount amortization for
2 months; see amortization table above):

Interest payable 2,667 Cash 4,000
Interest expense 1,467 Investment in bonds 134
Discount on bonds Interest revenue 1,467
payable 134 Interest receivable 2,667
Cash 4,000

Requirement 4

February 28, 1999 Adjusting entry—assuming accounting period ends February 28th:
Interest expense 1,473 Interest receivable 1,333

Discount on bond Investment in bonds 140

payable (b) 140 Interest revenue 1,473
Interest payable (a) 1,333

Computations:

(a) $100,000 x 4% x 2/6 = $1,333.

(b) $419 x 2/6 = $140.

Requirement 5

Straight-line amortization per month:

$1,928 26 months = $74.15.

P16-12 Bond Issuance and Early Retirement, Interest Method Plenary, Inc., issued $100,000 of 8 percent bonds on January 1, 1998, to yield 6 percent. The bonds pay interest each June 30 and December 31, and mature 10 years from issuance. On January 1, 2006, when the bonds were yielding 12 percent. Plenary retired the bond issue. Plenary uses the interest method.

Required:

1. Provide the entry for bond issuance.

2. Provide the entry for the June 30, 2004 interest payment without using an amortization schedule.

3. Provide the entry for bond retirement.

Answers:

Requirement 1

Issue proceeds =

$100,000 (PV1, .03, 20) + .08 () $100,000 (PVA, .03, 20) =
$100,000 (.55368) + .08 () $100,000 (14.87747) = $114,878

January 1. 1998
Cash 114,878
Premium on bond payable 14,878
Bonds payable 100,000

Requirement 2

June 30, 2004 is the end of the 13th semiannual interest period. At January 1, 2004 there are 8 interest periods remaining.

Book value at January 1. 2004:

$100,000 (PV1, .03, 8) + .08 () $100,000 (PVA, .03, 8) =
$100,000 (.78941) + .08 () $100,000 (7.01969) = $107,020.

June 30, 2004:
Interest expense ($107,020) (.03) 3,211
Premium on bonds payable 789
Cash ($100,000) (.04) 4,000

Requirement 3

On January 1, 2006, 2 years or 4 semiannual periods remain in the bond term. Book value at January 1, 2006:

$100,000 (PV1, .03, 4) + .08 () $100,000 (PVA, .03, 4) =
$100,000 (.88849) + .08 () $100,000 (3.71710) = $103,717.

The market value of the bonds on that date is:

$100,000 (PV1, .06, 4) + .08 () $100,000 (PVA, .06, 4) =
$100,000 (.79209) + .08 () $100,000 (3.46511) = $93,069.

January 1, 2006:
Bonds payable 100,000
Premium on bonds payable 3,717
Extraordinary gain, bond retirement 10,648
Cash 93,069

C16-5 Liabilities: Off-Balance-Sheet Risk The reported balances of certain liabilities carried on a corporation's books do not always indicate the maximum obligation potentially facing the firm as a result of past transactions. In addition, a firm may have potential obligations that are not recorded at all.

Required: For each of the following potential or actual liability items, briefly discuss in writing whether the firm is subject to off-balance-sheet risk of accounting loss and, if so, whether that risk arises from credit risk or market risk (or both), and why. Your discussion should be from the point of view of the company named.

1. Fixed-rate mortgage payable by Wellco, Inc., secured by real estate owned by Wellco.

2. The guarantee by Jolko, Inc., of a $4 million loan obtained by one of Jolko's subsidiaries.

3. Bonds payable issued by Samson, Inc. at a discount, due in live years.

4. Convertible bonds issued by Coastal Company at a premium, due in two years.

5. Transfer of accounts receivable by Jenell Company, accounted for as a borrowing. The transfer is with recourse to Jenell.

6. Variable-rate mortgage payable by Angeles, Inc., secured by real estate owned by Angeles.

7. A loan commitment made by BCCJ Bank to a computer manufacturer, guaranteeing a fixed line of credit :at a fixed rate of interest for one year from the commitment date.

Answers:

1. A fixed rate mortgage is carried at the present value of remaining future cash flows, discounted at the effective interest rate at the date the property was mortgaged. The balance correctly reflects the amount owed by Wellco at the balance date. There is no off-balance-sheet risk in this case because no additional amounts are due under the contract.

2. Although Jolko probably would disclose the nature of the guarantee anyway, the firm has off-balance-sheet risk of accounting loss because its subsidiary may be unable to pay its liability. SFAS No, 107 requires a discussion in the footnotes of Jolko as to the nature and amount of this potential loss, which arises entirely from credit risk.

3. The balance of the bond payable account reflects the total liability to the issuer; therefore. there is no additional off-balance-sheet risk of accounting loss.

4. The balance of the convertible bond payable account reflects the total liability to the issuer; therefore, there is no additional off-balance-sheet risk of accounting loss.

5. Jenell maintains the receivables on its books and records a liability. Provided that the amount of recourse to Jenell is limited to the amount of the liability recorded, there is no additional off-balance-sheet risk of accounting loss in this situation.

6. The recorded mortgage liability reflects the most current interest rate adjustment for Angeles. Although the interest rate may increase in the future, the balance of the mortgage payable continues to reflect Angeles' liability, although possibly at a higher interest rate and higher payment than at the origination of the mortgage. Therefore, there is no off-balance-sheet risk of accounting loss in this situation.

7. The bank has committed to lending a fixed amount of money to another firm at a fixed rate. The bank has off-balance-sheet risk of accounting loss from both credit and market risk. The amount of funds committed represents exposure to credit risk because the computer manufacturer may be unable to pay this amount in the event the line of credit is used. In addition, if the interest rate rises during the commitment period, the bank must honor its pledge to loan money at a lower rate, thus incurring market risk.

A16-3 Convertible Bonds Part of International Paper Company's long-term liability footnote to its 1995 financial statements disclosed the following:

Note 12: Long-Term Debt (millions) 1995 1994
5 3/4% Convertible subordinated debentures $199

In July 1995, the 5 percent debentures were called by the company and converted into 5.8 million shares of common stock.

Additional information:

1. The average market price per share of the firm's common stock was approximately $40 during 1995.

2. The par value of common stock is $1.

Required

1. Prepare the conversion entry, assuming the book value method is used.

2. Prepare the conversion entry, assuming the market value method.

3. Why might a company prefer to use the book value method? The market value method?

4. Why did the bondholders convert rather than accept the call price?

Answers:

Requirement 1

Convertible bonds 199,000,000
Common stock 5,800,000
Contributed capital in excess of par 193,200,000

Requirement 2

Convertible bonds 199,000,000
Loss on conversion of bonds 33,000,000
Common stock (5,800,000)($1) 5,800,000
Contributed capital in excess of par 226,200,000 *

* ($40 - $1) (5,800,000)

Requirement 3

Some firms chose the book value method to avoid recognizing a loss. Frequently, the market price of stock has risen since the issuance of the convertible bonds such that the total market price of stock issued exceeds the book value of the bonds convened (as in this case). The resulting loss under the market value method records the opportunity cost to the firm of issuing the shares due to conversion rather than for cash. Firms with a goal of income maximization prefer to avoid recognizing this opportunity cost (for the same reason they wish to avoid recognizing the opportunity cost of employee stock options). The loss did not cause an out-of-pocket cost to the firm. Their argument is that the loss is not a realized loss. Also. the opportunity cost as measured by the market value method may be overstated if a substantial number of shares is issued on conversion, relative to the number outstanding before conversion.

The market value method would be preferred by firms planning to smooth income or to achieve an earnings target. In this example. the effectively capitalized retained earnings (in the amount of the after-tax loss) to permanent contributed capital, thereby making that portion of retained earnings unavailable for future dividends in many jurisdictions.

Requirement 4

The total market value of the stock issued upon conversion is $232 million (5.8 million shares x $40), which most likely exceeds the amount which would have been paid under the call provision.

A16-5 Long-Term Liabilities Refer to the 1995 financial statements of the Coca-Cola Company that appear at the end of this text, and respond to the following questions.

1. What was 1995 interest expense for Coca-Cola, and how much interest was paid in 1995?

2. Using 1995 interest expense and only the items listed in the long-term debt footnote, estimate an average 1995 interest rate using the 1994 balances in long-term debt. What factors might contribute to this rate's being considerably higher than the average rate implied by the interest rates listed for each component of long-term debt?

3. What are some of the specific debt issuances contributing to the 1995 statement of cash flows financing inflow "issuances of debt"?

4. What is the market value of Coke's long-term debt? What does this value imply about the current market rate of interest relative to the average effective interest rate on Coke's long-term debt?

Answers:

(Amounts in $ millions)

1. From the income statement, $272 of interest expense was recognized, and from footnote 8, $275 was paid in 1995.

2. The average interest rate using 1995 interest expense and the ending 1994 balance of long-term debt: $272/$1,461 = 18.6%. The $1,461 figure includes the current portion of long-term debt which would have been reclassified at year-end.

Yet the items listed in the long-term debt footnote imply 6% - 7% as the average interest rate. Probably the main factor for the difference is that Coke has a substantial amount of debt other than that listed under "long-term debt:" loans and notes payable, finance subsidiary notes payable, and other liabilities. Interest on this debt, including current liabilities, is included in total interest expense but not in long-term debt as classified by Coke. In footnote 8, the average interest rate on long-term debt is noted as 6.5%.

Issuance of certain long-term debt items at a discount is a less likely explanation. Although this factor would explain a higher rate of interest (effective rate exceeding stated rate), the amount of interest recognized as expense and paid by Coke in 1995 are too similar in amount for this factor to be significant.

3. The 1995 statement of cash flows indicates that $754 in cash was received from debt issuances. The balance sheet and foot note 8 provide information about the effects of debt issuances in 1995:

Increase in loans and notes payable $2,371 - $2,048 $323
Increase in German mark notes $175 - $161 14
Increase in 6% US dollar notes 252

$589

In addition, "other liabilities" increased $111 ($966 - $855). However, the annual report is not sufficiently detailed to independently corroborate the amount of cash received on debt issuances in the statement of cash flows.

4. The market rate of long-term debt at the end of 1995 is $1,737 while the carrying value is listed as $1,693 (footnote 9). This implies a slight decrease in market interest rates relative to the effective rate at the issuance of Coke's debt. This possible explanation is consistent with the decline in interest rates in the 1990s.

CHAPTER 17 ACCOUNTING FOR LEASES

QUESTIONS

4. Give the primary GAAP concepts of accounting for an operating lease by lessors and lessees.

Answer: Outline of generally accepted accounting methods for operating leases:

Lessor: Recognize rent revenue for rents earned on accrual basis.

Lessee: Recognize rent expense for lease payments on accrual basis.

5. Advance rental payments often are received under operating lease contracts that extend well beyond a single fiscal .year. Give the acceptable accounting procedures that should be used for advance rentals.

Answer: Advance rental payments on operating leases should be credited to an unearned revenue account (rent revenue collected in advance) by the lessor and debited to a prepaid expense account by the lessee. The amount should be amortized over the term of the lease. Two approaches are acceptable:

a. Straight line—a constant dollar amount is allocated to each lease period.

b. Interest method—conceptually sound. somewhat more difficult to compute. This approach allocates the prepayments to the future periods on a constant percent basis per period.

7. From a lessee's standpoint. leases are classified as capital or operating leases. What criteria are used to identify a capital lease?

Answer: If a lease meets any one of the following criteria. it is a capital lease for the lessee (otherwise, the lease is an operating lease):

a. The lease transfers ownership of the property to the lessee by the end of the lease term.

b. The lease contains a bargain purchase option.

c. The lease term is equal to 75 percent or more or the estimated economic life of the property.

d. The present value of the minimum lease payments at the inception of the lease is equal to at least 90 percent of the market value of the property.

8. From a lessor's view. a capital lease involves two types of leases. Identify the types and distinguish between them.

Answer: From a lessor’s view. the types of leases are: direct financing and sales-type lease. The basic difference between a sales-type lease and a direct finance lease is that in a direct financing lease, the lessor recognizes only one kind of revenue—interest at each rental date. In contrast; in a sales-type lease. the lessor recognizes two kinds of revenue—(1) manufacturer's or dealer's profit (at lease inception date) and (2) interest revenue at each rental date.

10. How does a lessee determine what interest rate is appropriate for capitalization of a lease?

Answer: A lessee should use the lessee's incremental borrowing rate if. at the time the lease is negotiated, the lessor's implicit rate for the lease is known and is higher than the lessee's incremental borrowing rate. Incremental borrowing rate means the interest rate a lessee would have to pay to borrow funds to finance acquisition of the leased property.

12. Briefly explain how inclusion of a provision of residual value guaranteed by a third party In a capital lease can result in asymmetric accounting by lessor and lessee.

Answer: There are two cases to consider. First. the inclusion of guaranteed residual value by a third party will make the minimum lease payments differ between the lessor and lessee. If the lease still qualifies as a capital lease for both lessor and lessee. journal entries will be symmetrical but amounts will differ (the lessor includes the guaranteed residual value in minimum lease payments, but the lessee does not).

The second case arises when the lease does not meet any of the first three criteria given in the text in Exhibit 17-2 for a capital lease. Inclusion of guaranteed residual value by a third party may make the lease a capital lease for the lessor (it meets criterion 4 of Exhibit 17-2) because the present value of the lease payments (including the guaranteed amount) exceeds 90 percent of the market value of the asset at lease inception. However. the lease may not satisfy criterion 4 for the lease because the present value of the lease payments (excluding the guaranteed amount) does not exceed 90 percent of the market value of the asset. In this case, the lease will be treated as a capital lease by the lessor and an operating lease by the lessee.

15. When computing annual depreciation, what residual value should the lessee use for a leased asset under a capital lease? Briefly explain each alternative.

Answer: The residual value used by the lessee to compute depreciation on a leased asset depends on the lease contract. If the lease contains no bargain purchase option, does not transfer ownership to the lessee at the end of the lease term, and the lessee does not guarantee the residual value, the lessee ignores the residual value (uses a residual value of zero). If the lessee does guarantee the residual value. the guaranteed amount must be used as the residual value.

If the lease contains a bargain purchase option or transfers the asset to the lessee at the end of the lease term, the lessee must use the estimated residual value at the end of the useful life of the asset (rather than at the end of the lease term.)

EXERCISES

E 17-1 Multiple Choice

1. Rent should be reported by the lessor as revenue over the lease term as it becomes receivable according to the provisions of which of the following leases?

Direct Financing Lease Operating Lease Sales-Type Lease

a. Yes Yes Yes

b. Yes No No

c. No Yes No

d. No No Yes

Answer: C Per SFAS No. 13. rent should be reported by the lessor as revenue over the lease term for an operating lease as it becomes receivable according to the lease provisions. Both direct-financing and sales-type leases are types of capital leases. For these lease types. the lessor reports interest income over the lease term rather than rental income. Therefore. answer (C) is correct. and answers (A). (B). and (D) are incorrect.

2. The present value of minimum lease payments should be used by the lessee in determining the amount of a lease liability under a lease classified by the lessee as which of the following?

Capital Lease Operating Lease

a. Yes Yes

b. Yes No

c. No No

d. No Yes

Answer: B. Per SFAS No. 13. para 15. rental on an operating lease is to be charged to expense over the lease term as it becomes payable, unless the payment pattern does not represent a systematic and rational allocation over the lease term (in which case the straight-line method is recommended). NO lease liability is established for operating leases. nor is a "lease asset" recognized. The statement does. however. require the lessee in a capital leasing transaction to both establish a lease liability equal to the present value of the minimum lease payments. and recognize the leased asset for the same amount. Therefore. answer (B) is correct.

3. Lease Y does not contain a bargain purchase option, but the lease term is equal to 90 percent of the estimated economic life of the leased property. Lease Z does not transfer ownership of the property to the lessee by the end of the lease term. but the lease term is equal to 75 percent of the estimated economic life of the leased property. How should the lessee classify these leases?

Lease Y Lease Z

a. Capital lease Operating lease

b. Capital lease Capital lease

c. Operating lease Capital lease

d. Operating lease Operating lease

Answer: B Per SFAS No. 13. para 7, if a lease meets one or more of four criteria. the lease is classified as a capital lease by the lessee. One of these criteria is that the lease term is equal to 75 percent or more of the estimated economic life of the leased property. Therefore, both leases Y and Z in this problem should be classified as capital leases. Therefore. answers (A). (C), and (D) are incorrect.

4. A lessee had a 10-year capital lease requiring equal annual payments. The reduction of the lease liability in year 2 should equal

a. The current liability shown for the lease at the end of year 1.

b. The current liability shown for the lease at the end of year 2.

c. The reduction of the lease obligation in year 1.

d. One-tenth of the original lease liability.

Answer: A When a leasing agreement is accounted for as capital lease, the lessee recognizes a liability on its books equal to the. present value of the minimum lease payments. The liability should be divided between current and noncurrent based upon when each lease payment is due. At the end of year 1. the current lease liability should equal the principal portion of' the lease payment due in year 2. Therefore. when the lease payment is made in year 2. the reduction of the lease liability will equal the current liability shown at the end of year 1.

E 17-2 Multiple Choice

1. The excess of the fair value of lease property at the inception of the lease over its cost or carrying amount should be considered by the lessor as

a. Unearned income from a sales-type lease.

b. Unearned income from a direct financing lease.

c. Manufacturer's or dealer's profit from a sales type lease.

d. Manufacturer's or dealer's profit from a direct financing lease.

Answer: C. Per SFAS No. 13. para 17. the excess of the fair value of leased property at the inception of the lease over the lessor's cost is defined as the manufacturer’s or dealer's profit. Answer (A) is incorrect because the unearned income from a sales-type lease is defined as the difference between the gross. investment in the lease and the sum of the present values of the components of the gross investment. Answer (B) is incorrect because the unearned income from a direct-financing lease is defined as the excess of the gross investment over the cost (also the PV of lease payments) of the leased property. Answer (d) is incorrect because a sales-type lease involves a manufacturer’s or dealer’s profit while a direct-financing lease does not.

2. A lease is recorded as a sales-type lease by the lessor. The difference between the gross investment in the lease and the net receivable should be

a. Amortized over the period of lease as interest revenue by the interest method.

b. Amortized over the period of lease as interest revenue by tile straight-line method.

c. Recognized in full as interest revenue at the lease's inception.

d. Recognized in full as manufacturer ' or dealer's profit at the lease's inception.

Answer: A. Per SFAS No. 13, para l7b. the difference between the gross investment in the lease and the sum of the present values of the two components of the gross investment shall be recorded as unearned income. The unearned income shall be amortized to income over the lease term so as to provide a constant periodic rate of return on the net investment in the lease. Per APB No. 12. para 16. the objective of the interest method is to arrive at a level (i.e.. constant) effective rate (of interest). Therefore. answers (B), (C), and (D) are incorrect.

3. In a lease that is recorded as a sales type lease by the lessor. interest revenue

a. Does not arise.

b. Should be recognized over the life of the lease by the interest method.

c. Should be recognized over the life of the lease by the straight-line method.

d. Should be recognized in full as revenue at the lease's inception.

Answer: B. Per SFAS No. 13, para 17b, revenue is to be recognized for a sales-type lease over the lease term so as to produce a constant rate of return on the net investment in the lease. This requires the use of the interest method. Therefore, answer (B) is correct and answer (C) is incorrect. Answer (A) is incorrect because, per SFAS No. 13, interest revenue does arise in a sales-type lease. Answer (D) is incorrect because the interest is to be earned over the life of the lease, not in full at the lease's inception.

E 17-3 Multiple Choice

1. On January 1, 1998, Mill Corporation leased a machine to Ott Corporation for a five-year term at an annual rental of $50,000. The lease is an operating lease. At the inception of the lease, Mill received $100,000 covering the first year . s rent of $50.000 and a security deposit of $50,000. This deposit will not be returned to Ott upon expiration of the lease but will instead be applied to payment of rent for the last year of the lease. Mill properly reported rental revenue of $100,000 in its 1998 income tax return. Mill's tax rate was 30 percent. In Mill's December 31. 1998, balance sheet, what portion of the $100,000 should be reported as a liability?

a. $50,000.

b. $40,000.

c. $35,000.

d. $28,000.

Answer: A. Deposits and prepayments received for services to be provided in the future are unearned revenues which should be recorded as a liability until earned. The first year's rent is recorded as rent revenue, but the S50,000 deposit is recorded as rent collected in advance (unearned rent) because Mil is required to render future services (use of the machine) to the lessee. The rate (30%) does not affect the amount of the liability to the lessee, although a separate deferred tax asset may he recorded in certain circumstances.

2. Beal, Inc., intends to lease a machine from Paul Corporation. Beal's incremental borrowing rate is 14 percent. The prime rate of interest is 8 percent. Paul's implicit rate in the lease is 10 percent, which is known to Beal. Beal computes the present value of the minimum lease payments using what rate?

a. 8 percent.

b. 10 percent.

c. 12 percent.

d. 14 percent.

Answer: B. SFAS No. 13 states that the lessee should compute the PV of the minimum lease payments using the lesser of the lessee's incremental borrowing rate (14% in this case) or the implicit rate used by the lessor if known (10% in this case). The PV of the minimum lease payments should be computed using we implicit rate of 10% because it is known by the lessee and is lower than the incremental rate. The prime rate (8%) is never used unless it happens to be the same as the incremental or implicit rate.

3. On January 2, 1998. Ashe Company entered into a 10-year noncancelable lease requiring year-end payments of $100,000. Ashe's incremental borrowing rate is 12 percent. and the lessor's implicit interest rate, known to Ashe, is 10 percent. Ownership of the property remains with the lessor at expiration of the lease. There is no bargain purchase option. The leased property has an estimated economic life of 12 years. What amount (rounded) should Ashe capitalize for this leased property on January 2, 1998?

a. $1,000,000.

b. $614,500.

c. $565,000.

d. $0.

Answer: B. This is a capital lease for the lessee because the lease term (10 years) covers more than 75 % of the economic life of the leased asset (.75x 12 = 9 years). In a capital lease. the lessee records the PV of the minimum lease payments as an asset and a liability. The lease payments are discounted using the lesser of the lessee’s incremental borrowing rate or the: implicit rate used by the lessor, if known. In this case, the lessee knows the implicit rate is 10%, which is lower than the incremental rate of 12%. Thus. when the lease is signed. the PV amount recorded as in asset and liability is $614,500 ($100,000 x (PVA, 10%, 10).

4. On December 30, 1997, Drew Company leased equipment under a capital lease for a period of 10 years. Drew contracted to pay $90.000 annual rent on December 31, 1997, and on December 31 of each of the next nine years. The capital lease liability was appropriately recorded at $608,400 on December 30, 1997, before the first payment. The leased equipment has a useful life of 12 years, and the interest rate implicit in the lease is 10 percent. Drew, uses the straight-line method for depreciating all equipment. In recording the December 31, 1998. payment. Drew should reduce the capital lease liability by

a. $38,160.

b. $50,700.

c. $51,840.

d. $60,840.

Answer: A. The initial lease liability at 12/30/97, before the first lease payment, is $608,400. The 12/31/97 payment consists entirely of' principal, bringing the 12/31/97 balance down to $518.400 ($608,400 - $90,000). The 12/31/98 payment consists of both principal and the interest incurred during 1998. 1998 interest is $51,840 ($518,400 x 10%), so the principal portion of the 12/31/98 payment is $38.160 ($90,000 - $51,840).

E 17-4 Multiple Choice

1. On January 1, 1997. Kerr Company signed a 10-year non-cancelable lease for a new machine. requiring $20.000 annual payments at the beginning of each year. The machine has a useful life of 15 years, with no salvage value. Title passes to Kerr at the lease expiration date. Kerr uses straight-line depreciation for all of its plant assets. Aggregate lease payments have a present value on January 1. 1997. of $126.000. based on an appropriate rate of interest. For 1997, Kerr should record depreciation (amortization) expense for the leased machine at

a. $20,000.

b. $12,600.

c. $8,400.

d. $0.

Answer: C. Since title passes to the lessee at the end of the lease, this is a capital lease for the lessee. The lessee records the leased asset and lease liability at an amount equal to the lesser of the FMV of the leased asset or the PV of the minimum lease payments ($126,000). This asset is depreciated on a straight-line basis over its useful life of 15 years. resulting in a yearly depreciation charge of $8,400 ($126,000 15). The asset is depreciated over its useful life rather than over the lease term because title transfers to the lessee, allowing the lessee to use the asset for 15 years.

2. The lessee should amortize the capitalizable cost of the leased asset in a manner consistent with the lessee’s normal depreciation policy for owned assets for leases that do which of the following?

Transfer 0wnership
of the Properly to the
Contain a Bargain Lessee by the End of'
Purchase Option the Lease Term

a. No No

b. No Yes

c. Yes Yes

d. Yes No

Answer: C. The requirement is to determine if a lessee should amortize the capitalizable cost of a leased asset in a manner consistent with the lessee's normal depreciation policy for owned assets for leases that contain a bargain purchase option and/or transfer ownership at the end of the lease term. Transfer of ownership of the property to the lessee by the end of the lease term and a lease that contains a bargain purchase option are properly classified as capital leases (SFAS No. 13. paras 7(a) and 7(b)). Per SFAS No. 13. para 11(a), if the lease meets either of the above criteria, the asset should be amortized in a manner consistent with the lessee's normal depreciation policy for owned assets. Therefore. answers (A). (B). and (D) arc incorrect.

3. A lease contains a bargain purchase option. In determining the lessee's capitalizable cost at the beginning of the lease term, the payment called for by the bargain purchase option would

a. Not be capitalized.

b. Be subtracted at its present value.

c. Be added at its exercise price.

d. Be added at its present value.

Answer: D. The requirement is to determine whether or not a bargain purchase option should be capitalized as part of the minimum lease payments. Per SFAS No. 13. para 5. minimum lease payments include the: rental payments plus the amount of the bargain purchase option, if it exists. Per para 10, the amount to be capitalized is the present value of the minimum lease payments. Therefore. the present value of the bargain purchase option would be added to the present value of the rental payments (assumed to be previously calculated) in determining the lessee's capitalizable cost.

4. On January 2. 1995. Wayne. Inc.. signed an eight-year lease for office space. Wayne has the option to renew the lease for an additional four-year period on or before January 2. 2003. During January 1997, two years after occupying the leased premises. Wayne made general improvements to the premises costing $360.000 and having an estimated useful life of 10 years. At December 31. 1997. Wayne’s intentions as to exercise of the renewal option are uncertain because they depend upon future office space requirements. A full year's amortization expense is taken for calendar year 1997. Wayne should record amortization of leasehold improvements for 1997 at

a. $30.000.

b. $36,000.

c. $S45,000.

d. $60,000.

Answer: D. The requirement is the amount of' 1997 amortization expense for leasehold improvements. The cost of leasehold improvements ($360,000) should be amortized over the remaining life of the lease, or the useful life of the improvements. whichever is shorter. When the lease contains a renewal option, the life of the lease does not include the renewal period unless it is probable that the option will be exercised. Therefore, in this case. the remaining life of the lease is six years (8-year lease term less the two years gone by). The renewal period of four years is not considered since exercise of the option is uncertain. The useful life of the improvements is ten years. so the improvements are amortized over the remaining lease life of six years, This results in 1997 amortization of $60,000 ($360,000M 6 years).

E 17-5 Multiple Choice

1. In a sale-leaseback transaction the seller-lessee has retained the property. The gain on the sale should be recognized at the time of the sale-leaseback if the lease is classified as which of the following?

Capital Lease Operating Lease

a. Yes Yes

b. No No

c. No Yes

d. Yes No

Answer: B. Per SFAS No. 28. any profit related to a sale-Ieaseback transaction in which the seller retains the property leased (i.e., the seller-lessee retains substantially all of the benefits and risks of the ownership of the property sold), shall be deferred and amortized in proportion to the amortization of the leased asset, if a capital lease. If it is an operating lease, the profit will be deferred in proportion to the related gross rental charged to expense over the lease term. Losses, however, are recognized immediately for either a capital or operating lease. Since the gain on the sale should be deferred in either case, no gain is recognized at the time of the sale, and answer (B) is correct.

2. On December 1. 1998. Barr Company) leases office space for five years at a monthly rental of $60,000. On that date, Barr pays the lessor, the following amounts:

First month's rent $60,000
Last month’s rent (Dec. 2003) 60,000
Security deposit (refundable it lease expiration) 80,000
Installation of new walls and offices 360,000

Barr's December 1998 expense relating to its use of this office space is

a. $60,000.

b. $66,000.

c. $126.000.

d. $200.000.

Answer: B. The first month’s rent ($60,000) is expensed as incurred in December 1998. The prepayment of the last month’s rent (also $60,000) is deferred and will be recognized as expense at the end of the lease. The refundable security deposit ($80,000) is recorded as a long-term receivable, since Barr can expect to receive the deposit back at the end of the lease term. The cost of installing new walls and offices ($360,000) is recorded as an asset,. leasehold improvements. and amortized over the lease term. The amortization for December is $6,000 ($360,000 60 months). Therefore, total expense is $66,000 ($60,000 + $6,000).

3. On December 31. 1997, Lane. Inc., sold equipment to Noll and simultaneously leased it back for 12 years. Pertinent information at this date is:

Sales price $480,000
Carrying amount $360,000
Estimated remaining economic life 15 years

At December 31. 1997. how much should Lane report as a deferred gain from the sale of the equipment?

a. $0.

b. $110,000.

c. $112.000.

d. $120.000.

Answer: D. According to SFAS No. 13, sale-leaseback arrangements are treated as though two transactions were a single transaction, if the lease qualifies as a capital lease. Any gain or loss on the sale is deferred and amortized over the lease term (if possession reverts to the lessor) or the economic life (if ownership transfers to the lessee. In this case, the lease qualifies as a capital lease because the lease term (12 years) is 80% of the remaining economic life of the leased property (15 years). Therefore, at 12/31/97, all of the gain ($480,000 - $360,000 = $120,000) would be deferred and amortized over 12 years. Since the sale took place on 12/31/97, there is no amortization for 1997.

4. The following information relates to equipment sold by Bard Company to Kerr Company on December 31, 1997:

Sale, price $300,000
Book value $100,000
Estimated remaining economic life 20 years

Simultaneously with the sale, Bard leased back the equipment for a period of 16 years. How much of the gain on the sale should Bard defer at December 31. 1997?

a. $200,000.

b. $12,500.

c. $10.000.

d. $0.

Answer: A. The requirement is to determine the amount of profit to be deferred by Bard Co., the lessee is a sale-leaseback transaction. According to SFAS No. 13, sale and leaseback arrangements are treated as though the two transactions were a single financing transaction if the lease qualifies as a capital lease. Any gain or loss on the sale is deferred and amortized over the lease term if possession remains with the lessor or economic life if ownership transfers to the lessee. In this case, the lease qualifies as a capital lease because the lease term is 80% of the remaining economic life of the leased property. Therefore, at December 31, 1997, all of the $200,000 ($300,000 - $100,000) gain on sale of the equipment would be deferred by Bard Co. and amortized over 16 years. Since the sale was on December 31, there is no amortization for 1997.

E 17-8 Lease: Apply Lease Criteria, Entries for Lessor and Lessee

Tam Leasing Company agreed with Lex Corporation to provide the latter with equipment under lease for a three-year period. Thc equipment cost Tam $120,000 and will have no residual value when the lease term ends. Tam expects to collect all payments from Lex and has no material cost uncertainties. The carrying value of the equipment was $120,000 at the inception of the lease. The three equal annual payments (amount to be determined) are to be paid each January 1. starting January 1, 1998 (at which time the equipment was delivered). Lex has agreed to pay taxes, maintenance. and insurance throughout tile lease term as well as any other ownership costs. Tam expects a 20 percent return (known to Lex). The accounting year of' both companies ends December 31.

Required: Round to tile nearest dollar.

I. What kind of lease is this to Lex? To Tam?

2. Compute the annual 0ayments and prepare an amortization schedule reflecting the interest and principal elements of Lex’s payments over the three-year term of the lease. Give all journal entries relating to the lease for Lex Corporation for 1998 including year-end adjusting entries.

3.: Give all journal entries for Tam Leasing Company relating to the lease for 1998 including year-end adjusting entries.

Answer:

Requirement 1

This is a capital lease to the lessee Lex, because the lease term is more that 75% of the economic useful life of the leased asset.

The lease is a direct financing lease to lessor Tam, because (1) it meets the criterion for a capital lease cited above, and (2) Tam expects to collect all rents from Lex and has no material cost uncertainties. The market value equals the book value of the property at inception of the lease term (i.e., there is no manufacturer’s or dealer’s profit as in a sales-type lease.)

Requirement 2

Annual lease payment (annuity due): $120,000 (PVAD, 20%, 3) = $120,000 (2.52778) = $47,472.

Amortization Schedule (annuity due basis):

Annual
Lease Interest Lease Rec./Liab. Net
Date Payments* at 20% Dec. (inc.) Lease Rec./Liab.

01/01/1998 $ -0- $ 120,000
01/01/1998 47,472 47,472 72,528 (b)
12/31/1998 14,506 (c) 14,506 87,034 (d)
01/01/1999 47,472 47,472 39,562
12/31/1999 7,912 (e) 7,912 47,474 *
01/01/2000 47,472 47,472 -0-

(a) Annuity due. six calculation above

(b) $120,000 - $47,472 = $72,528

(c) $72,528 (.20) = $14,506

(d) $72,528 + $14,506 = $87,034

(e) $39,562 (.20) = $7,912

* Rounding error

Lex Corporation (lessee) entries:

January 1. 1998 (inception of lease):

Leased equipment 120,000
Lease liability 120,000

(To record the lease)

January 1. 1998:

Lease liability 47,472
Cash 47,472

(To record first payment)

December 31, 1998 (end of accounting year):

Interest expense 14,506
Lease liability 14,506

(To accrue first year’s interest)

Depreciation expense 40,000
Accumulated depreciation, leased equipment 40,000

(To record first year’s depreciation)

Requirement 3

Tam Co. (lessor) entries:

January 1. 1998 (inception of lease):

Lease receivable ($47,472 x 3) 142,416
Equipment 120,000
Unearned interest revenue 22,416

(To record the lease)

January 1. 1998:

Cash 47,472
Lease receivable 47,472

(To record first payment)

December 31, 1998 (end of accounting year):

Unearned Interest revenue 14,506
Interest revenue 14,506

(To accrue interest revenue)

E 17-10 Lease: Financing or Sales Types, Schedule and Entries, Lessor and Lessee

Rex Corporation (lessor) and Lee Company (lessee) agreed to a non-cancelable lease. The following information is available regarding the lease terms and the leased asset:

a. Rex's cost of the leased asset was S40,000. The asset was new at lease inception date.

b. Lease term is four years, beginning January 1. 1998. Lease payments are made each January 1. beginning January 1, 1998.

c. Estimated useful life of leased asset is four years. Estimated residual value at end of lease is zero.

d. Sales price of leased asset on January 1, 1998, was $46,000.

e. Rex's implicit interest rate is 15 percent on retail price (known to Lee).

f. Rex expects to collect all payments from Lee, and there are no material cost uncertainties.

Required:

1. What kind of lease is this to Rex? To Lee?

2. Compute the annual lease payments.

3. Prepare an amortization schedule for the lease.

4. Give the journal entries for both parties on January 1, 1998, and December 31, 1998. Do not make closing, entries.

Answers:

Requirement 1

This is a capital lease to Lessor Rex because (1) the estimated residual value of the leased property at the end of the lease term is zero (i.e.. the lease term is equal to 100% of the estimated useful life of the asset), and (2) Rex expects to collect all rentals from Lee and no material cost uncertainties exist. It is a sales-type lease because the market sales price exceeds the lessor's cost; the manufacturer's or dealer's profit is $60,000. It is a capital lease to Lee because of (1) above.

Requirement 2

Annual lease payment (annuity due basis) = $46,000 (PVAD, 15%, 4)
= $46,000 3.28323
= $14,011 (rounded)

Requirement 3

Decrease Lease
Annual Annual (Increase) in Receivable/
Lease Interest Lease Receivable Liability
Date Payments* at 15% Liability Balance

01/01/1998 Initial value $ 46,000
01/01/1998 14,011 (a) 14,011 31,989 (b)

12/31/1998 4,798 (c) (4,798) 36,787

01/01/1999 14,011 14,011 22,776

12/31/1999 3,416 (3,416) 26,192

01/01/2000 14,011 14,011 12,181

12/31/2000 1,830 * (1,830) 14,011

01/01/2000 14,011 _____ 14,011 -0-
$ 56,044 $ 10,044 $ 46,000

(a) Computed in requirement 2.

(b) $46,000 - $14,011 = $31,989.

(c) $31,989 (.15) = $4,798.

* Rounded to balance out to last payment.

E 17-12 Overview of Special Lease Cases: Provide Explanations Select the best answer in each of the following. Justify each choice that you make.

1. On the first day of' its accounting year. Lessor, Inc.. leased certain property at an annual payment of $200.000 receivable ;at the beginning of each year for 10 years. The first payment was received immediately. The leased property, which is new, cost $1,100,000 and has an estimated useful life of 12 years and no residual value. Lessor's implicit rate is 12 percent. Lessor had no other costs associated with this lease. Lessor should have accounted for this lease as a sales-type lease but mistakenly treated the lease as an operating lease. What was the effect on net income during the first year of the lease of having treated this lease as an operating lease rather than as a sales-type lease.

a. No effect.

b. Overstatement.

c. Understatement.

d. The effect depends on the accounting method selected for income tax purposes.

Answer: C. If accounted for as an operating lease, earnings for the first year would be $108,334 )$200,000 revenue - $91,666 depreciation). If accounted for as a sales-type lease, the selling price is $1.265.650 (present value of the future payments). The first year's earnings are calculated in the schedule below. There would also be 12 percent interest on the $1,065,650 (i.e., $1,265,650 - $200,000) receivable balance (this is an annuity due situation). Income would be understated by $185,194 (i.e., $293,528 - $108,334).

Sale price ($200,000 (PVAD, 12%, 10) = $200,000 (6.32825) $1,265,650

Cost (1,100,000)

Gain on sale 165,650
12 x ($1,265,650 - $200,000) 127,878
First year net earnings $ 293,528

2. The appropriate valuation of leased assets under an operating lease on the balance sheet of a lessee is which of the following?

a. Zero.

b. The absolute sum of the lease payments.

c. The sum of the present values of the lease payments discounted at an appropriate rate.

d. The market value of the asset as of the date of inception of the lease.

Answer: A. No value is recognized by lessees for leased assets under an operating lease. Leasehold improvements, or long-term prepayments, can give rise to assets to be accounted for in connection with such leases but the question does not imply the existence of this kind of asset.

3. What types of expenses does a lessee experience with a capital lease?

a. Rent expense, interest expense, amortization expense.

b. Interest expense, amortization expense, executory costs.

c. Amortization expense, executory costs, rent expense.

d. Executory costs, interest expense, rent expense.

Answer: B. Proper accounting for a capital lease by a lessee requires recognition of interest on the unpaid liability balance. depreciation of the amount capitalized as the value of the lease, and possibly also executory costs such as insurance. taxes. maintenance. and repairs. depending on the nature of the property leased.

4. When the present value of future payments to be capitalized in connection with a capital lease is measured, how should identifiable payments to cover taxes, insurance and maintenance be accounted for?

a. Included with the future rent to be capitalized.

b. Excluded from future rentals to be capitalized.

c. Capitalized, but at a different rate and recorded in a different account from that for future payments.

d. Capitalized, but at a different rate and during a different period from the rate and period used for the future payments.

Answer: B. Under a capital lease. the lessor records a receivable (an asset) and earns interest on that receivable. Expenses of ownership. such as maintenance. taxes. and insurance are shifted by the lease contract to the lessee. Payments for such items should therefore not be capitalized by the lessee nor included by the lessor in computing the periodic rentals.

5. GAAP requires that certain lease agreements be accounted for as purchases The theoretical basis for this treatment is that a lease of this type

a. Effectively conveys most of the benefits and risks incident to the ownership of property.

b. Is an example of form over substance.

c. Provides the use of the leased asset to the lessee for a limited period of time.

d. Must be recorded in accordance with the matching concept.

Answer: A. When a lease agreement conveys all of the benefits and risks of ownership, it should be accounted for as a purchase (i.e.. capitalized) by the lessee. b is wrong because when a lease agreement is required to be capitalized, substance prevails over form, not the reverse. c is wrong because many leases provide use of property for a relatively long time, often the entire life of the leased asset. D is wrong because capitalization of leases reflects substance over form, not cause and effect.

6. Your client constructed an office building at a cost of $500,000 and then sold the building to Jones for a large gain. The client leased it back from Jones for a stipulated annual payment. How should this gain be treated?

a. Recognized in full as an ordinary item in the year of the transaction.

b. Recognized in full as an extraordinary item in the year of the transaction.

c. Amortized as an adjustment of the rental cost over the life of the lease.

d. Amortized as an extraordinary item over the life of the lease.

Answer: C. The sale and leaseback constitutes a joint transaction because they cannot be evaluated independently. Paragraph 33 of SFAS No. 13 provides that gains on such transaction must be amortized over the life of the lease. A and b are wrong because they assume recognition of gain on the sale as a separate transaction. D is wrong because it treats the gain as an extraordinary item.

E 17-20 Sale-Leaseback, Direct Financing Lease Rich Grocery owns the building it uses; it has a current carrying value on January 1, 1998, of $450 000, a 10-year remaining life and no residual value. On this date it was sold to investor Lucky for $500,000 cash. Simultaneously, the two parties executed a 10-year direct financing lease with a 12 percent implicit interest rate; each annual payment is due on December 31 (end of their accounting periods).

Required:

1. Compute the annual payments to be made by Rich to Lucky.

2. Give the entries for the seller-lessee (Rich Grocery) for 1998. Use straight-line depreciation.

Answer:

Requirement 1

Computation of lease payments (ordinary annuity):

$500,000 (PVA, 12%. 10) = $500,000 (5.65022) = $88,492

Requirement 2

Entries for seller/lessee (Rich Grocery) during 1998:

]an. 1, 1998:

(a) To record sale of the asset:

Cash 500,000
Asset 450,000
Unearned gain, sale/leaseback 50,000

(b) To record inception of the direct financing lease:

Leased asset (building) 500,000
Lease liability 500,000

Dec. 31, 1998:

(c) To record lease payment:

Interest expense ($500,000 x .12) 60,000
Lease liability ($88,492 - $60.000) 28,492
Cash 88,492

(d) Adjusting entry-to record depreciation:

Depreciation expense ($500.000 10) 50,000
Accumulated depreciation (leased asset) 50,000

(e) To amortize unearned gain:

Unearned gain on sale/leaseback 5,000
Depreciation expense 5,000
$50,000 10 years = $5,000.

E 17-22 Lease and Ratio Analysis Suppose a firm were required to place its operating leases on its balance sheet; that is, the firm is required to capitalize its leases. What would be the impact on the following ratios:

• Current ratio

• Working capital to total assets

• Asset turnover

• Debt to equity

• Cash flow per share

• Return on investment

• Dividend payout

(Assume normal ratio values exist before capitalization, such as a current ratio of at least one.)

Answers:

Current Ratio:

Decreases. Current assets are unchanged. but current liabilities will increase by the amount of the current liability increase.

Working Capital to Total Assets:

Decreases. Working capital is lower due to the increase in current liabilities and total assets increases due to capitalization of the lease assets. The increase in long-term assets exceeds the increase in current liabilities.

Asset Turnover:

Decreases. Net assets remains the same. but average total assets increases.

Debt to Equity:

Increases. Debt increase. Depreciation of the leased asset plus interest now replace the rent expense under a capital lease. The impact on debt dominates the impact on the ratio and this ratio increases.

Cash Flow per Share:

No change.

Return on Total Assets:

Decreases. Income is reduced as interest and depreciation replace rent expense while total assets are also increased. (This answer assumes straight-line depreciation. If accelerated depreciation is used. the answer holds for the initial years of the assets. but will eventually reverse.).

Dividend Payout:

Increases. The numerator is unchanged. but income declines.

P 17-2 Lease: Determine Type, Entries for Lessor and Lessee Crown leases a limo to Zap Productions for four years on January 1, 1998, requiring equal annual payments on each January I and, in addition, a single lump-sum prepayment of $3,000. The leased asset, recently purchased new, cost the lessor $50.000. The estimated unguaranteed value of the asset at end of lease term is $20,000.

The annual lease payments were computed to yield Crown 12 percent (the implicit interest rate after considering that the residual value is known to Zap Productions). The leased asset has an eight-year life with zero residual value at the end of year 8. There is no bargain purchase option, and the asset is retained by Crown at the end of the lease term. Depreciation will be on the straight-line basis. The accounting period for both lessor and lessee ends December 31.

Required:

1. Compute the annual lease payment.

2. What type of lease is this? Explain.

3. In parallel columns for the lessor and lessee, give:

a. Entries at the inception of the lease, including the initial advance payment.

b. Adjusting and closing entries for the year ended December 31, 1998. Use straight-line amortization for the prepayment.

Answers:

Requirement 1

Selling price of leased asset $ 50,000

Deduct: PV of residual value $20.000* (at end of year 4)
(PV 1, 12%, 4) = $20,000 (.63552) (12,710)
Prepayment (3,000)

Net asset to be recovered ......... $ 34,290

Annual payment: $34,290 (PVAD, 12%, 4) = $34,290 3.40183 $ 10,080

Requirement 2

This is an operating lease because it does not meet any of the requirements for classification as a capital lease.

(1) No transfer of ownership at the end of the lease term.

(2) No bargain purchase option.

(3) Lease term < 75% of the estimated useful life years < (.75 x 8 years = 6 years).

(4) PV of minimum lease payments < 90%. of market value at lease inception; ($34,290 + $3.000 = $37,290) < (.90 x $50,000) = S45,000.

Requirement 3

Lessor Lessee

(a) January 1. 1998 (inception of lease):

Cash ($10,080 + $3,000) 13,080 Leasehold (or prepaid rent) 3,300
Rent revenue 10.080 Rent Expense 10,800
Unearned rent revenue 3,000 Cash 13,080

(b) December 31. 1998 (Adj and closing entries):

Unearned rent revenue 750 Rent expense 750
Rent revenue 750 Leasehold 750
$3.000 4 years = $750

Depreciation expense 6,250 Income summary 10,830
Accumulated depreciation 6.250 Rent expense 10,830
$50.000 8 years = $6,250. $10,080 + $750 = $10,830

Rent revenue 10,830
Depreciation expense 6,250
Income summary 4,580
$10,080 + $750 = $10,830

C 17-2 YOU MAKE THE CALL Concern about Debt-Equity Ratio and Third-Party Residual Value Guarantees: Ethics. Speedware Corporation has entered into a debt agreement that restricts its debt-to-equity ratio to less than two to one. The corporation is planning to expand its facilities. creating a need for additional financing. The board of directors is considering leasing the additional facilities but is concerned that leasing may violate its existing debt agreement; a violation would place the corporation in default. The potential lessor insists that the lease be structured in such a way that it can be accounted for as a capital lease by the lessor (the lessor is a dealer and wants to recognize the dealer's profit on the transaction immediately). In addition, the lessor requires that the residual value of the leased asset be guaranteed when it reverts to the lessor at the end of the lease term. Speedware's board has asked you to analyze the following alternatives:

Alternative A—Speedware would enter into a lease that qualifies as a capital lease (to Speedware). If this alternative is selected, Speedware's reported debt-to-owners'-equity ratio would be 1.9, and its ability to issue debt in the future would be seriously constrained.

Alternative B—Speedware would enter into a lease and pay a third party to guarantee the residual value of the leased property. The lease would be structured in such a way as to qualify as an operating lease to Speedware and as a capital lease to the lessor. In this case, Speedware's reported debt-to-equity ratio would be unaffected by the lease contract.

Required

Analyze and explain the consequences of each of the above alternatives in a one-page memo to your superior. Do you see any ethical considerations?

Answer:

The relative merits of the two alternatives depend on (1) the likelihood that Speedware will require debt financing in the immediate future, and (2) the cost of securing a third party guarantor of the residual value of the leased property. If Speedware is unlikely to need additional financing immediately, the risk of default on the existing debt agreement may be minimal, because the lease liability will be reduced annually by the principal portion of the lease payment. Also, Speedware may be able to obtain capital through the issuance of stock. rather than debt, which would improve its debt-to-owners' equity ratio.

In addition, paying a third party to act as guarantor of the lessor's residual value on the leased asset is costly, and this cost must be compared to the benefits of reduced risk of default on existing debt. Self-insurance (assumption of the residual value guarantee) by the lessee involves no out-of-pocket expenditures until the end of the lease term and then only if the appraised residual value is less than the guaranteed residual value.

The ethical issue is whether it is ethical to use a third party to guarantee the residual value to avoid including a capital lease obligation on the balance sheet. If the acquisition is intended to be permanent and this is simply a ploy to avoid capitalization, should the firm constitute the transaction using alternative B?

A 17-3 Lease Calculations and Disclosures Turner Broadcasting Company sponsors CNN. Note 5 to Turner's 1994 annual statements, dealing with long-term debt, includes the following information in part:

Note 5: Long-Term Debt
Long-term debt consists of:

December 31

1994 1993

(thousands)

Bank credit facilities $1,490,000 $1,225,000
12% Senior Subordinated Debentures due October 15, 2001, net of
unamortized discount of $3,268 --- 536,732
8 3/8% Senior Notes due July 1. 2013, net of unamortized discount of
$2,619 and $2,675 297,381 297,325
7.4% Senior Notes due 2004. net of unamortized discount of $363 249,637 ---
8.4% Senior Debentures due 2024. net of unamortized discount of $155 199,845 ---
Zero coupon subordinated convertible notes, 7.25% yield, due February 13,
2007, net of unamortized discount of $336,487 and $353,368 245,569 228,688
Convertible subordinated debentures of a wholly owned subsidiary 29,075 ---
Obligations under capital leases due in varying amounts through 1999,
net of imputed interest of $931 and $1,075 6,200 6,353
Other debt, net of imputed interest of $1,175 and $29. due in varying amounts
through 2009. interest at fixed rates ranging from 6.00% to 9.49% 1,386 2,510

$2,519,093 $2,296,608

Less current portion 1,345 2.051

$2,517,748 $2,294,557

Other information obtained from the notes to Turner Broadcasting Company's financial statements:

Included in the maturities of long-term debt amounts are obligations under capital lease of $1,299,000; $1,273,000; $1,261,000: $1,376,000; and $1,016,000 for each of the five years following December 31, 1994. Finally, assume that $565,000 of lease maturities exist for each of the years 2000, 2001, and 2002 respectively.

Required:

Estimate the firm's average implicit interest rate on its lease obligations. Assume there are no further long-term lease obligations after December 31, 2002. All payments are made at the end of the year.

Answers:

Turner Broadcasting Co.

Rather than use the more common payment schedule presentation for long-term debt and capital leases, Turner discloses payment information in text format under "Other Obligations." Yearly payment amounts are termed maturities.

An estimate of the interest rate can be found by solving

8

S A n (PV1, i, n) = $6,200 = $1,299(PV1, i, 1) + $1,273 (PV1, i, 2) + $1,261 (PV1, i, 3) +

n=1

8

$1,346 (PV1, i, 4) + $1,016 (PV1, i, 5) +S [($6,200 + $931) (3)] (PV1, i, n)

n=6

where A n = Maturity Amount in year n and n=1 in 1995.

An HP12C calculator can easily solve this to yield 6.82%.

An alternative solution determines the interest rate for 1994 (assuming end-of-year payments) as follows:

Interest for 1994 = ($1,075 - $931) $6,353 = .02 of 2%.

This estimate appears too low.

A 17-6 Delta Airlines This problem requires access to the World Wide Web portion of the Internet. You should use Delta's most recent 10-K annual report. To do so access the SEC's Electronic Data gathering, Analysis, and Retrieval System (EDGAR) using the following steps:

a. URL: http://www.sec.gov/index.html

b. Click on EDGAR Database of Corporate Information

c. Click on Search for EDGAR Database

d. Click on Search for EDGAR Archives

e. Enter the company name in the search dialog box

f. Click on the listing for the most recent 10K annual report

Required: (It is possible that some of the data you may need to answer the questions may not be available. If so, omit this portion of the requirements.)

1. What type of assets does Delta lease?

2. What method does Delta use to record rent expense on its operation leases? What entry did Delta make in the most recent year to recognize rent expense on its operating leases?

3. What is the amount of leasehold and operating rights (excluding flight equipment) held by Delta at the end of the last fiscal year?

4. What method does Delta use to measure the current portion of its capital lease obligation? How do you know?

5. Provide your best estimate of 'the entries Delta would make to recognize its capital lease payments for the coming fiscal year. (Use 10 percent as an estimate of Delta's average interest rate on its capital leases.) How would you estimate this rate if it were necessary to do so with only the information available on the I O-K?

Answer

The solution here is developed from Delta’s 1996 10-K report. The solution indicates how certain results were obtained so the reader may duplicate them using the more recent financial statements. Leases are covered in footnote 8 of the 1996 financial statements.

1. The company leases aircraft, airport terminal and maintenance facilities, ticket offices, and other property and equipment. (From footnote 8)

2. Straight line. (Footnote 8)

3. $90(.0(0,000. (Footnote 8)

4. The decline in the present value of the lease obligation. and not the present vale of next year's payment. This is likely to be the reason because:

a. Most firms use this approach.

b. The interest rate necessary to equate the current lease liability of $58 million with the payment required next year of $101 million is much too large to be reasonable.

5. Operating leases

Rent expense 871
Cash 871

(The operating lease payment due in 1997 indicated in footnote 8)

Capital leases

Capital Leases* 53
Interest expense** 58
Cash*** 101

* Balancing result

** .10 ($580), the current lease liability.

*** Current payment due in 1997 from footnote 8

CHAPTER 18: ACCOUNTING FOR PENSIONS AND OTHER POSTEMPLOYMENT BENEFITS

1. Distinguish between a defined contribution pension plan and a defined benefit pension plan.

Answer: A defined-contribution pension plan does not define specific benefits to be paid at employee retirement. Rather, it specifies the periodic amount that the employer must pay into the pension fund. The employees receive whatever benefits can be paid from the pension fund accumulation and its earnings. A defined benefit plan specifies the way the amount of benefits to be received by employees after retirement is calculated.

2. Distinguish the three parties involved in accounting and reporting for a pension plan.

Answer: The three primary accounting parties, are: (a) employer, (b) funding agency (trustee), and (c) actuary. The employer must account for pension expense, cash contributions to the funding agency, and pension liabilities. The funding agency accounts for the funds received from the employer, investment of those funds. and payment of benefits to the retirees. The actuary provides an annual report of the projected benefit obligation and related data.

3. What are the primary actuarial factors related to a pension plan?

Answer: Actuarial factors are the data used by an actuary to make estimates of projected benefits and the present value of those benefits. The primary factors include the benefit formula, retirement ages, mortality (i.e., life expectancies), number and ages of employees, turnover rates, future salary levels, interest rates, gains and losses on pension funds, and vesting benefits.

4. Explain the three funding approaches that the employer can use for pension plans.

Answer: The three funding approaches are:

a. Internal pension fund: Cash is set aside by the company in a pension fund administered internally by the company.

b. Independent pension fund: Cash is paid to an independent pension funding agency (trustee) who administers the pension fund, invests the funds, and makes the payments to the retirees.

c. Purchase of retirement annuity: Cash is paid to an insurance company to purchase retirement annuities for the retirees. The insurance company then accepts full responsibility for paying the pension benefits to the retirees.

14. What is the vested benefit obligation?

Answer: The vested benefit obligation is the present value of the current and future pension benefit rights that are no longer contingent on remaining an employee of the company.

15. List and define the six components of net periodic pension expense.

Answer: Components of net periodic pension expense:

a. Service cost—the cost (at actuarial present value) of future pension benefits earned by employees during the current accounting period.

b. Interest cost—the beginning balance of the projected benefit obligation multiplied by the estimated interest rate used by the actuary.

c. Expected return on plan assets—the expected return on the pension plan investments plus the change in the carrying value of OW Plan assets used in operations.

d. Amortization of unrecognized prior service cost—prior service cost is caused by plan amendments that are retroactive. The cost is not recognized in full immediately but is amortized (and recognized) over future periods as expense.

e. Amortization of unrecognized gains or losses—due to (a) differences between expected and actual returns on plan assets, and (b) other gains and losses due to changes in actuarial assumptions. This cost is not recognized in full immediately, but is amortized (and recognized) over future periods as expense.

f. Amortization of unrecognized transition cost—a changeover cost that occurs when SFAS No. 87 is first adopted It occurs only once. The total amount is not recognized in full when incurred but is amortized as expense over future periods.

16. Explain the additional minimum pension liability?

Answer: An additional minimum pension liability must be recognized if the total of plan assets at fair value is less than the accumulated benefit obligation adjusted for any accrued/prepaid pension cost recognized. It is recorded with a credit to additional minimum pension liability and debits to intangible pension asset and unrealized capital accounts.

21. Explain the difference between the projected benefit obligation and the accumulated benefit obligation.

Answer: The accumulated benefit obligation is exactly the same as the projected benefit obligation except for one difference in the computations. The projected benefit obligation includes the effect of estimated future changes in the average remuneration of the employees covered. The accumulated benefit obligation does not include the effects of estimated changes in the average remuneration of employees. The projected benefit provides basic data for pension accounting, while the accumulated benefit obligation is used only for computing one amount, the additional minimum pension liability.

26. Explain the difference between expected postretirement benefit obligation (EPBO) and accumulated postretirement benefit obligation (APBO) in accounting for postretirement benefits other than pensions.

Answer: EPBO is the actuarial present value of benefits expected to be paid and takes into consideration the expected service period of employees. APBO is the actuarial present value of benefits earned to a particular date. Once an employee reaches full eligibility, the two measures are equal.

27. Explain how accounting for the transition amount for postretirement benefits is similar to and different from that for pensions.

Answer: The accounting is similar in that the transition amount is computed the same way for both pensions and postretirement benefits other than pensions. Amortization is also similar in that the transition amount may be amortized over the average remaining service period of plan participants. The accounting is different in that the pension transition amount can he amortized over 15 years if the service period is less than 15 years, whereas for postretirement benefits other than pensions 20 years may be used. Also, the transition amount for postretirement benefits other than pensions (only) may be recognized immediately.

 

E-18-2 Multiple Choice: Choose the best answer from among the alternatives.

1. Service cost for 1998 for a pension plan whose pension benefit formula incorporates estimates of future compensation levels is

a. The present value of benefits earned by employees in 1998 based on current salary levels.

b. The increase in ABO for 1998 less interest on the beginning balance in ABO.

c. The nominal value of benefits earned by employees in 1998 based on future salary level.

d. The present value of benefits earned by employees in 1998 based on future salary levels.

Answer: d.

2. The following statements describe some aspect of accounting for defined benefit pension plans. Choose the incorrect statement.

a. When only the first three components of pension expense have occurred to date for a plan and actual return has always equaled expected return, underfunded PBO at a reporting date equals the balance in the accrued pension liability.

b. When only the first three components of pension expense have occurred to date for a plan and actual return has always equaled expected return, pension expense reflects the true annual cost to the company of providing future benefits earned in the current period, assuming all the actuarial assumptions are correct.

c. Because the last three components of pension expense are derived from amortizing initial present values on a straight-line or similar basis, the true total cost of these items is not reflected in pension expense.

d. Pension expense can be negative.

Answer: c.

3. Choose the correct relationship among off-balance-sheet values and values reported in a balance sheet relative to a pension plan.

a. Underfunded PBO less amortization of unrecognized PSC equals the balance in accrued pension cost.

h. Unrecognized PSC is an item that reconciles the balance in accrued pension cost and overfunded PBO.

c. Sum of .pension expense to date equals PBO.

d. PBO less ABO equals balance in accrued pension cost.

Answer: b.

4. For external reporting purposes, assuming an underfunded ABO, the liability that must be reported in the balance sheet is

a. PBO less plan assets at fair value.

b. Balance in accrued pension cost.

c. The underfunded ABO.

d.. Additional minimum pension liability.

Answer: c.

5. Choose the correct statement concerning amortization of' unrecognized gain or loss:

a. Some amortization must be recognized in a year that begins with a nonzero unrecognized gain or loss.

b. The corridor is the maximum amortization allowed.

c. The corridor amount for 1998 is 10 percent of the greater of these two December 31, 1998 values: PBO and plan assets at fair value.

d. The amortization of an unrecognized gain yields a reduction in pension expense and a reduction in that unrecognized gain.

Answer: d.

6. Defined contribution plans and defined benefit plans are two common types of pension plans. Choose the correct statement concerning these plans.

a. The required annual contribution to the plan is determined by formula or contract in a defined contribution plan.

b. Both plans provide the same retirement benefits.

c. The retirement benefit is usually determinable well before retirement in a defined contribution plan.

d. In both types of' plans, pension expense is generally the amount funded during the year.

Answer: a.

7. PBO and plan assets at fair value are two values critical to the determination of the financial status of defined benefit plan. Choose the correct statement regarding items to be included in each (none of these statements is necessarily complete).

a. Ending PBO includes total service cost to date, interest cost to date, net initial unamortized actuarial gain or loss to date, and initial PSC.

b.. Ending PBO includes total service cost to date, interest cost to date, net initial unamortized actuarial gain or loss to date,. initial PSC, and initial transition cost.

c. Ending fair value of plan assets includes funding to date and expected return to date, reduced by benefits paid to date.

d. Ending PBO includes service cost to date, gross differences between expected and actual returns to date, and net initial unamortized actuarial gain or loss to date, all less contributions to date.

Answer: a.

8. Which of the following is not one of the six components of pension expense (or part of a component)?

a. Initial transition asset.

b. Amortization of' unrecognized gain or loss.

c. Actual return on plan assets.

d. Growth (interest cost) in PBO since the beginning of the period.

Answer: a.

 

E 18-10 Compute Net Periodic Pension Expense and Underfunded or Overfunded PBO; Entries The 1998 records of Jax Company provided the following data related to its noncontributory, defined benefit pension plan (amounts in $000s):

a. Projected benefit obligation (report of actuary):
Balance. January 1. 1998 $ 3,000
Service cost 1,200
Interest cost 240

Pension benefits paid (400)

Balance, December 31, 1998 $ 4,040

b. Plan assets at fair value (report of trustee):
Balance, January 1, 1998 $ 2,408
Actual return on plan assets 168
Contributions, 1998 1,016

Pension benefits paid (400)

Balance, December 31, 1998 $ 3,192

Expected long-term rate of return of plan assets, 7 percent

c. January 1, 1998 balance of unrecognized prior service cost, gains and losses, and transaction cost is zero.

Required:

1. Compute 1998 net periodic pension expense. Show the correct amount for each of the six components.

2. Give the 1998 entry (entries) for Jax Company to record pension expense and funding.

3. Compute the under- or overfunded PBO at the beginning and end of 1998.

Answers:

Requirement 1

Net periodic pension expense:
Service cost (PBO) $ 1,200
Interest cost (proof, $3,000 x 8%) 240

Expected return on plan assets (168)

Unrecognized loss (gain) on plan assets:
Actual return $ 168
Expected return ($2,408 x 7%) 168
Unrecognized gain (amortization
starts next period) $ -0- -0-
Transition cost -0-
Prior service cost -0-

Net periodic pension expense $ 1,272

Requirement 2

December 31, 1998:
Pension expense 1,272
Cash 1,016
Accrued pension cost 256

Requirement 3

January 1, 1998 December 31, 1998

Projected benefit obligation $ 3,000 $ 4,040
Pension plan assets (fair value) 2,408 3,192
Under (over) funded PBO $ 592 $ 848

E 18-13 Pension Spreadsheet: Underfunded and Accrued Pension Cost: Entries Gecko Company has a defined benefit pension plan. At the end of the current reporting period, December 31, 1998, the following information was available:

a. Projected benefit obligation (actuary’s report):
Balance, January 1, 1998 $ 2,400
Service cost 312
Interest cost ($2,400 x 7% actuary’s rate) 168
Loss (gain) change in actuarial assumptions* 72

Pension benefits paid (160)

Balance, December 31, 1998 $ 2,792

* Amortization to start in 1999

b. Status of fund assets (trustee’s report):
Balance, January 1, 1998 $ 2,000
Actual return on plan assets (same as expected) 120
Cash received from employer company 280

Pension benefits paid to retirees (160)

Balance, December 31, 1998 $ 2,240

c. From company records, unamortized pension cost
from prior years (amortize over a nine-year average
remaining service period)
Transition cost $ 72
Prior service cost 108
Losses (gains) 144
Total $ 324

Required:

1. Set up and complete a spreadsheet or format of your choice to develop the pension data required at the end of 1998.

2. Give the employer’s pension entry at December 31, 1998.

Answers:

Requirement 1

Proof: Beginning $2,400 - $2,000 - $324 = $76; Ending $2,792 - $2,240 - $360 = $192

* Amortization starts next period.

Requirement 2

Accounting entry Pension expense 396
Accrued/prepaid pension cost ($76 - $192) 116
Cash 280

 

E-18-16 Multiple Choice: Accounting for Pensions. Choose the correct statement for each question.

1. Which of the following defined benefit pension plan disclosures should be made in a company's financial statements?

I. A description of the company's funding policies and types of assets held.

II. The amount of net periodic pension cost for the period.

III. The fair value of plan assets.

a. I and II.

b. I, II and III.

c. II and III.

d. I only.

Answer: b.

2. Interest cost included in the net pension cost recognized by an employer sponsoring a defined benefit pension plan represents the

a. Amortization of the discount on unrecognized prior service cost.

b. Increase in the fair value of plan assets due to the passage of time.

c. Increase in the projected benefit obligation due to the passage of time.

d. Shortage between the expected and actual returns on plan assets.

Answer: c.

3. On July 31, 1998, Tumwater Company amended its single-employer defined benefit pension plan by granting increased benefits for services provided prior to 1998. This prior service cost will be reflected in the financial statement(s) for

a. Years before 1998 only.

b. 1998 only.

c. 1998 and years before and after 1998.

d. 1998 and the following years only.

Answer: d.

4. An employer sponsoring a defined benefit pension plan is subject to the minimum pension liability recognition requirement. An additional liability must be recorded equal to the unfunded

a. Accumulated benefit obligation plus the previously recognized accrued pension cost.

b. Accumulated benefit obligation less the previously recognized accrued pension cost.

c. Projected benefit obligation plus the previously recognized accrued pension cost.

d. Projected benefit obligation less the previously recognized accrued pension cost.

Answer: b.

 

E-18-18 Unrecognized Gains and Losses. On January 1, 1998, a company reported a $6,000 unrecognized gain in the informal record of its pension plan. During 1998 the following events occurred:

a. Actual return on plan assets was $8,000 and expected return was $10,000.

b. A gain of $4,000 was determined by the actuary at December 31, 1998, based on changes in actuarial assumptions.

The company amortizes unrecognized gains and losses on the straight-line basis over the average remaining service life of active employees (20 years). It does not recognize the minimum amortization. Further information on this plan follows:

Values At

January 1. 1998 December 31, 1998

PBO $50,000 $56,000
Fair value of plan assets 30,000 34,000

Required: Compute amortization of unrecognized gain or loss for 1998 and 1999.

Answer:

Amortization of unrecognized gain, 1998 = $6,000/20 = $300
(decreases pension expense)

Unrecognized gain, 12/31/98:

Unrecognized gain, 1/1/98 ($6,000)

Amortization in 1998 (requirement 1) 300
Excess of expected over actual return 2,000

Actuarial gain, 12/31/98 (4,000)
Unrecognized gain, 12/31/98 ($7,700)

Amortization of unrecognized gain, 1999 = $385

E-18-22 Minimum Liability: Three Cases: Entries Yates Company has a noncontributory, defined benefit pension plan. It is December 31, 1998, end of the accounting year and measurement date for the pension plan. The following are the data for three separate cases, as of the measurement dates (in $000s):

Items (at December 31, 1998) Case A Case B Case C

a. Projected benefit obligation $1,000 $1,000 $1,000
b. Accumulated benefit obligation 800 800 800
c. Vested benefit obligation 360 360 360
d. Pension plan assets at book value 550 550 550
e. Pension fund assets at fair value 600 840 600

f. (Accrued) prepaid pension cost 0 80 (20)

g. Unrecognized prior service cost 220 180 150

Required:

1. For each case, compute the additional minimum pension liability that should be reported.

2. For each case, (a) explain whether a minimum liability must be reported and why, and (b) if one must be reported, give the entry.

Answer:

Requirement 1

Items (at December 31, 1998) Case A Case B Case C

Accumulated benefit obligation 800 800 800

Less: Plan assets at fair value (600) (840) (600)

Under (over) funded accumulated benefit obligation 200 $(40) 200

Accrued/prepaid pension cost -0- $80* (20)

Additional minimum pension liability required $200 $-0- $180

* The accumulated benefit obligation is overfunded. Therefore, the balance of this account is irrelevant because the APO is overfunded.

Requirement 2

Case A

(a) Must record $200 additional minimum liability because it is underfunded and no accrued/prepaid pension cost was recorded. A contra stockholders' amount is not recorded because the additional minimum liability ($200) is not in excess of the unrecognized prior service cost ($220).

(b) Entry:
Intangible pension asset 200
Additional minimum pension liability 200

Case B

(a) No additional minimum liability is required because the accumulated benefit obligation is overfunded.

(b) No entry.

Case C

(a) Must record a $180 additional minimum liability because the accumulated benefit obligation is underfunded and the accrued pension cost is less than the underfunding. A contra stockholders' debit is required because the minimum liability ($180) is in excess of the unrecognized prior service cost ($150).

(b) Entry:
Intangible pension asset 150
Unrealized pension cost, contra stockholders’ equity ($180 - $150) 30
Additional minimum pension liability 180*

* Notice that the total liabilities for pensions will be $180 + $20 (already recorded) = $200.

 

E-18-24 Accounting for Postretirement Benefits Other Than Pensions. Choose the correct statement for each question.

1. The balance sheet in the accrued postretirement benefit cost account generally reflects which of the following?

a. The underfunded accumulated postretirement benefit obligation.

b. The underfunded expected postretirement benefit obligation.

c. The excess of' cumulative postretirement benefit expense over cumulative funding.

d. The excess of cumulative employer contributions over cumulative benefit payments.

Answer: c.

2. Which of the following statements correctly describes the relationship between expected post retirement benefit obligation (EPBO) and accumulated postretirement benefit obligation (APBO)?

a. EPBO can be less than or equal to APBO, but never more.

b. EPBO and APBO are never equal.

c. EPBO and APBO are always equal.

d. APBO can be less than or equal to EPBO, but never more.

Answer: d.

3. A firm has a transition obligation for postretirement benefits. The average remaining service period of active plan participants is 15 years. Which of' the following options for recognizing the transition obligation is open to this firm.

I. Immediate recognition in transition year.

II. Amortization over 15 years.

III. Amortization over 20 years.

IV. Amortization over 40 years.

a. I, II and III only.

b. I, II, III and IV.

c. I and II only.

d. I only.

e. II only.

Answer: a.

4. At the end of the current year, a firm’s accumulated postretirement benefit obligation exceeds plan assets by $20,000. However, the firm is reporting $10,000 of prepaid postretirement benefit cost. Which of the following might explain why the firm can report an asset while having an underfunded plan'?

a. The transition obligation was recognized immediately in the year of transition.

b. The firm has significant unrecognized amounts for past service cost and transition obligation.

c. The firm has a large unrecognized transition asset.

d. The firm’s annual funding amount has never exceeded the amount recognized as annual postretirement benefit expense.

Answer: b.

5. A firm reports an underfunded accumulated postretirement benefit obligation in its report of funded status. This amount generally equals the

a. Amount by which cumulative postretirement benefit expense exceeds cumulative funding since transition.

b. Amount by which the present value of benefit payments expected to be made exceeds the plan assets at fair value.

c. Prepaid pension cost balance less amounts funded to date.

d. Amount by which the present value of' benefit payments earned to date exceeds the plan assets at fair value.

Answer: d.

E-18-26 Appendix: Postretirement Benefit Liabilities At December 31, 1998, Gypsum, Inc., estimated the following net incurred claims costs for one of its employees. for each year of the employee’s retirement period to which the plan applies:

Estimated Net Incurred
At Age Claims Cost by Age

64 $4.194
65 4.640
66 1,284
67 1,421
68 1,577

The postretirement plan of Gypsum provides no benefits after age 68. For full eligibility, an employee must serve 20 years. The employee in question is 51 years old at December 31, 1998, and has served 15 years at that date. The employee is expected to retire at age 63. Gypsum's discount rate for postretirement benefit accounting purposes is 8 percent.

Required:

1. Determine the expected post retirement benefit obligation and accumulated postretirement benefit obligation at December 31, 1998, for this employee.

2. Assuming that the employee works another five years after December 31, 1998, and that there are no changes in expected net incurred claims costs, determine the expected postretirement benefit obligation and accumulated postretirement benefit obligation at December 31, 2003, for this employee.

Answer:

Requirement 1

EPBO at 12/31/98:
$4,194 (PV1, 8%, 13) = $4,194 (.36770) = $1,542
$4,640 (PV1, 8%, 14) = $4,640 (.34046) = 1,580
$1,284 (PV1, 8%, 15) = $1,284 (.31524) = 405
$1,421 (PV1. 8%. 16) = $1,421 (.29189) = 415
$1,577 (PV1, 8%, 17) = $1,577 (.27027) = 426
EPBO at 12/31/98 $4,368
APBO at 12/31/98 = (15/20) $4,368 = $3,276

The employee has served 15/20 of the full eligibility period and is expected to reach the full eligibility date. An equal amount of EPBO is attributed to each year of service from date of hire to the full eligibility date.

Requirement 2

The two obligation measures are equal at 12/31/03, the full eligibility date. The employee has served 20 years at that date.

EPBO and APBO at 12/31/03:
$4,194 (PV 1, 8 %, 8) = $4,194 (.54027) = $2,266
$4,640 (PV 1, 8%, 9) = $4,640 (.50025) = 2,321
$1,284 (PV 1. 8%, 10) = $1,284 (.46319) = 595
$1,421 (PVI. 8%. 11) = $1,421 (.42888) = 609
$1,577 (PV 1, 8%.12) = $1.577 (.39711) = 626
EPBO and APBO at 12/31/03 $6,417

P-18-6 Multiple Choice: Accounting for Pensions. Choose the correct statement for each question.

1. The following information pertains to Lara Corporation’s defined benefit plan for 1998:

Service cost $160,000
Actual and expected gain on plan assets 35,000
Unexpected increase in PBO incurred during 1998 40,000
Amortization of unrecognized prior service cost 5,000
Annual interest on pension obligation 50,000

What amount should Lara report as pension expense in its 1998 income statement?

a. $250,000.

b. $220,000.

c. $210,000.

d. $180,000.

Answer: d. $180,000
Service cost $160,000

Return (35,000)

Amortization of PSC 5,000
Interest 50,000
1998 pension expense $ 180,000

(The earliest the PBO can be amortized is 1999.)

2. Nion Company sponsors a defined benefit plan covering all employees. Benefits are based on years of service and compensation levels at the time of retirement. Nion determined that as of September 30, 1998, its accumulated benefit obligation was $380,000 and its plan assets had a $290,000 fair value. Nion’s September 30, 1998 trial balance showed prepaid pension cost of $20,000. As of September 30, 1998, what is the balance of additional minimum pension liability?

a. $110,000

b. $360,000.

c. $ 90,000.

d. $400,000.

Answer: a. $110,000
ABO $380,000
Plan assets 290,000
Total minimum liability 90,000
Prepaid pension cost 20,000
required additional pension liability balance $ 110,000

3. Nebb Company implemented a defined benefit pension plan for its employees. Nebb’s contributions fully funded the plan. The following data are provided for 1999 and 1998:

1999 1998
Estimated Actual

Projected benefit obligation, December 31 $187,500 $175,000
Accumulated benefits obligation, December 31 130,000 125,000
Plan assets at fair value, December 31 168,750 150,000
Pension expense 22,500 18,750
Employer’s contribution ? 12,500

What amount should Nebb contribute in order to report an accrued pension liability of $3,750 in its December 31, 1999 balance sheet?

a. $12,500.

b. $15,000.

c. $18,750.

d. $25,000.

Answer: d. $25,000
At the beginning of 1998, the firm had no accrued pension cost account because the plan was fully funded at that date.
1998 pension expense $18,750
1998 contribution 12,500
Ending 1998 accrued pension cost balance 6,250
Desired ending 1999 accrued pension cost balance 3,750
Required decrease in accrued pension cost balance 2,500
1999 pension expense 22,500
1999 contribution $ 25,000

4. On June 1, 1996, Ware Corporation established a defined benefit pension plan for its employees. The following information was available on May 31, 1998:

Projected benefit obligation $3,625,000
Accumulated benefit obligation 3,000,000
Unfunded accrued benefit cost 50,000
Plan assets at fair market value 1,750,000
Unrecognized prior service cost 637,500

To report the proper pension liability in Ware’s May 31, 1998 balance sheet, what is the required balance in additional minimum pension liability?

a. $562,500.

b. $1,187,500.

c. $1,200,000.

d. $1,825,000.

Answer: c. $1,200,000
ABO $3,000,000
Plan assets 1,750,000
Total liability to be recognized 1,250,000
Accrued pension cost 50,000
Additional minimum pension liability balance required $ 1,200,000

C 18-5 Appendix: Differences Between Accounting for Pensions and Nonpension Postretirement Benefits Accounting for pensions is similar to accounting for nonpension postretirement benefits in many ways. However, there are some significant differences. In an e-mail message to a fellow student, list and discuss some of these differences and their financial statement effects.

Answer:

1. Health care and other nonpension postretirement benefits are often more difficult to predict than pension benefits. The amount of pension benefits is controllable to a greater extent. Predictions of nonpension postretirement benefit payments (especially health care) are affected by the type of benefit, technological changes, outside reimbursement, and many other factors.

2. There is no minimum liability recognition or disclosure for nonpension postretirement benefits.

3. There is no vested benefit disclosure for nonpension postretirement benefits.

4. The attribution period for pensions begins with the period in which the employee begins to earn benefits and ends with retirement. For nonpension postretirement benefits, the attribution period may end before retirement, on the date the employee becomes fully eligible for the benefits expected to be received.

5. In contrast to pensions, nonpension postretirement benefit plans generally have been unfunded. Therefore, postretirement benefit expense will be offset only marginally by the return component. In addition, the APBO at transition is generally quite large, causing interest cost to be a greater proportion of total expense.

6. Many companies must change their accounting systems to enable separation of the cost of benefits payable during the term of employment from those payable after retirement.

7. There was no previous accounting pronouncement requiring accrual of nonpension postretirement benefits. Therefore. the difference between the pre-SFAS No. 106 expense and post-SFAS No. 106 expense will be larger than was the case for pensions and SFAS No. 87.

8. The unrecognized transition obligation can be recognized immediately, or if delayed recognition is chosen, 20 years can be used if the average remaining service period is less than 20 years. Immediate recognition is not available for the unrecognized transition obligation in pensions. and only 15 years can be used if the average remaining service period is less than 15 years.

9. The unrecognized transition obligation is subject to additional amortization if the cumulative expense under a pay-as-you-go approach would have exceeded that under SFAS No. 106 before the additional amortization.

10. Nonpension postretirement benefit funds are generally taxable: therefore, the return component of postretirement benefit expense must consider the tax rate.

11. Gains and losses can be recognized immediately, subject to certain constraints, for nonpension postretirement benefit plans.

12. Postretirement benefit expense is more sensitive to changes in assumptions. One result of this greater sensitivity is the requirement that the effect of a 1% change in future health care cost trend rates on components of postretirement benefit expense and APBO be disclosed.

A-18-2 Funding and Pension Expense Components The Dole Food Company is one of the largest international food processing and distribution companies. Portions of footnote 8 (pension benefits) to its 1995 annual report appear below.

The Company has qualified defined benefit pension plans covering most full-time employees. The status of the plans was as follows (amounts in $ thousands):

1995 1994

Projected benefit obligation $239,855 $223,082
Plan assets at fair value. Primarily
stocks and bonds 238,730 206,326

Projected benefit obligation in excess
of plan assets (1,125) (16,756)
Unrecognized net transition obligation (942) (1,087)

Unrecognized prior service cost 2,662 1,714

Unrecognized net (gain) loss (83) 17,866

Additional minimum liability (1,941) (10,917)
Accrued pension liability $ (1,429) $ (9,180)

The expected long-term rate of return on assets was 9 percent in both years. Pension expense included the following components:

1995 1994

Service cost-benefits earned during
the year $ 8,114 $ 7,158
Interest cost on projected benefit
obligation 21,270 20,112

Actual (return) loss on plan assets (46,944) 4,656

Net amortization and deferral 28,337 (22,980)

Pension expense $ 10,777 $ 8,946

Required:

1. What was Dole's contribution to the pension fund in 1995?

2. What might have caused the change from an unrecognized net loss in 1994 to an unrecognized net gain in 1995?

 

Answer:

(Amounts in $thousands)

Requirement 1

The prepaid pension cost account (before additional minimum pension liability) decreased $1,225 during 1995:

Additional minimum liability, end of 1994 $ 10,917
Accrued pension liability, end of 1994 9,180
Prepaid pension cost balance, end of 1994 $ 1,737

Additional minimum liability, end of 1995 $ 1,941
Accrued pension liability, end of 1995 1,429
Prepaid pension cost balance, end of 1995 512

Decrease in prepaid pension cost during 1995 $ 1,225

With pension expense amounting to $10,777 in 1995, Dole contributed $9,552 ($10,777 - $1,225) to the pension fund.

Requirement 2

The $17,866 net unrecognized loss at the end of 1994 was completely wiped out, leaving a small net gain at the end of 1995. A major contributing factor to this change was the excess of actual return on plan assets in 1995 over expected return. 1995 expected return was $21,486 ($238,730 x .09) while actual return as reported by Dole was $46,944, a difference of $25,458. The latter amount is treated as a gain and gradually amortized over future periods (or absorbed by future losses, as was the 1994 net unrecognized amount). The gain on assets is the largest factor explaining the change in the net unrecognized amount from 1994 to 1995. The amortization, if any, of the net unrecognized loss at the end of 1994 also contributed to the shift.

A18-6 Appendix: Postretirement Benefits Other than Pensions—The Dole Food Company Portions of footnote 5 (postretirement benefits) to the 1992 annual report of the Dole Food Company appear below.

In 1992. the Company implemented Statement of Financial Accounting Standards No. 106, "Employer's Accounting for Postretirement Benefits Other than Pensions." This statement, among other changes, requires companies to accrue for postretirement benefits during the employee's active service period. The Company elected to immediately recognize the accumulated postretirement benefit obligation as of December 29. 1991 of $82.5 million ($49.5 million, net of tax).

The status of the plans at January 2. 1993 was its follows (in $ thousands):

Accumulated postretirement benefit obligation $85,885

Unrecognized net loss (299)

Accrued postretirement benefit cost $85,586

Net periodic postretirement benefit cost for 1992:

Service cost-benefits earned during the year $ 926
Interest cost on APBO 7,622
Postretirement benefit cost $ 8,548

In prior years, the cost of postretirement benefits was recognized as payments were made. These costs totaled $4.9 million and $4.3 million during 1991 and 1990, respectively.

This is a portion of Dole's comparative income statement:

1992 1991 1990

Income before cumulative effect of change in
accounting principle $65,213 $133,726 $120,455

Cumulative effect of change in accounting principle (49,492) ______ ______

Net Income $ 15,721 $ 133,726 $ 120,455

Required:

1. Why might Dole Food Company have decided to recognize the postretirement benefit transition amount immediately?

2. What was the approximate effect of implementing SFAS No. 106 on 1992 earnings before taxes?

3. What was the amount funded for the postretirement benefit plan in 1992?

Answer:

(Amounts in $millions)

Requirement 1

Dole, along with many other companies, may have recognized the entire transition liability immediately to minimize the effect of past postretirement benefit costs on future earnings. Future postretirement benefit expense amounts will be free of any transition amortization.

In addition, Dole's income from continuing operations was roughly half of earnings in each of the previous two years. The firm thus had the incentive to recognize the large one-time change in an already lack-luster year, rather than burden future years which may reflect better earnings performance.

Requirement 2

The total pretax effect of SFAS No. 106 on 1992 earnings equals the cumulative effect plus the change in annual postretirement expense as a result of complying with SFAS No. 106. Although the 1992 expense under the pay-as-you-go method is not given, considering the amounts of the 1990 and 1991 postretirement benefit costs (given), a reasonable estimate of payments to retirees in 1992 is $5 million. Using this estimate, the pretax effect of SFAS No. 106 is:

Cumulative effect (immediate recognition of transition liability) $82,500
Increase in annual postretirement benefit expense ($8.548 - $5.0) 3,548
Total decrease in pretax earnings $86,048

Requirement 3

Dole has not begun to fund the postretirement plan. No plan assets were given in the report of funded status at the beginning of 1993. The accrued liability equals APBO less the one reconciling item.

CHAPTER 19: ACCOUNTING FOR INCOME TAXES

1. Briefly distinguish between interperiod tax allocation and intraperiod tax allocation.

Answer:

Interperiod income tax allocation-the allocation of income tax among periods to properly measure income tax assets and income tax liabilities.

Intraperiod income tax allocation—the allocation of income tax expense to the components on the income statement and retained earnings statement that caused the tax expense.

3. Explain why deferred income tax can be either an asset or a liability.

Answer: Deferred income tax is an asset when there is a future deductible that will reduce income tax payable in future accounting periods. Deferred income tax is a liability when there is a future taxable amount that will increase future periods' income tax payable.

5. Define an income tax difference. Identify and briefly define the two types of differences.

Answer: An income tax difference results from a transaction that causes a difference between pretax accounting income and taxable income. The two types of differences are: (a) Temporary differences—items that are on the income statement (under GAAP) in one period and in the tax return (under tax law) in another period. Temporary differences will reverse or turn around in one or more subsequent periods; they require interperiod income tax allocation. (b) Permanent differences—items which are reported on the income statement or tax return but not on both. They do not reverse or turn around; they are not subject to income tax allocation.

13. Define net operating loss (NOL), carrybacks, and carryforwards. Briefly explain the options available to taxpayers.

Answer: Income tax law permits a taxpayer to offset some income tax losses (i.e., NOLs) in the current period against earnings of the past and/or future; this may result in a cash refund, or alternatively, a reduction of future tax payments. A carryback is the situation when such a loss is offset against earnings of specified prior years (limited to three prior years). A carryforward is when the loss is offset against future earnings. The two options are:

a. Carryback-carryforward—carry back three years then carry forward any unabsorbed loss (up to 15 years only).

b. Carryforward only—carry forward to future years (limited to 15 years) only. The benefit of the carryforward amount can be recorded in advance of realization under SFAS No. 109.

15. Is deferred tax arising from an NOL carryforward classified as current or noncurrent?

Answer: The deferred tax asset arising from an NOL carryforward is classified as current or noncurrent depending on when it is expected to be realized. If the firm estimates that it will have taxable income in the following year (or operating cycle, if longer), then the portion of the deferred tax asset that will be used in that year is considered current. Any amount not expected to be realized in the following year or operating cycle is classified as noncurrent.

 

E 19-2 Terminology Overview Listed below to the left are some terms frequently used in SFAS No. 109. Brief definitions are listed to the right. Match the definitions with the terms by entering the appropriate letters in the blanks.

1. Deferred tax asset. A. Income tax payable plus net changes in the deferred tax
2. Taxable amount. liability, deferred tax asset, and valuation allowance accounts.
3. Permanent difference. B. An amount used to compute income tax payable.
4. Valuation allowance. C. The difference between a current deferred tax asset and a
5. Temporary difference. current deferred tax liability when the latter is higher.
6. Taxable income. D. May result in a cash refund or a reduction of income tax
7. Net current deferred tax liability. payable in future periods.
8. Income tax expense. E. An amount used to compute deferred tax assets and liabilities,
9. NOL carryback/carryforward and a portion of income tax expense.
10. Intraperiod income tax allocation. F. A deferred tax amount that has a debit balance.

G. A tax difference that does not reverse, or turn around.
H. An allocation of tax among the components in the income
statement.
I. A contra account used to reduce deferred tax assets to the
portion more likely than not to be realized.
J. An amount that represents a difference between financial
accounting and tax accounting that will increase taxable
income in future periods.

Answer: 1. F; 2. J; 3.G; 4.I; 5.E; 6.B; 7.C; 8.A; 9.D; 10.H.

E 19-4 Recording and Reporting Income Tax Consequences for a Two-Year Period The records of Star Corporation provided the following data related to accounting and taxable income:

1997 1998

Pretax accounting income $200,000 $220,000
Taxable income (tax return) 220,000 200,000
Income tax rate 35% 35%

There are no existing temporary differences other than those reflected in this data.

Required:

1. Give the journal entry to record the income tax consequences for each year.

2. Show how income tax expense, income tax payable, and deferred income tax should be reported on the financial statements each year.

Answer:

Requirement 1

December 31, 1997 (origination entry):
Income tax expense ($77,000 - $7,000) 70,000
Deferred tax asset ($200,000 - $220,000) x .35 7,000
Income tax payable ($220,000 x .35) 77,000

December 31, 1998 (reversing entry):
Income tax expense ($70,000 + $7,000) 77,000
Deferred tax asset ($220,000 - $200,000) x .35 7,000
Income tax payable ($200,000 x .35) 70,000

Requirement 2

1997 1998

Income statement:
Income tax expense $70,000 77,000

Balance sheet:
Current asset:
Deferred income tax asset 7,000*

Current liabilities:
Income taxes payable 77,000 77,000

* The asset is recognized because it is more likely than not to be realized. The tax deductible amount to be realized in 1998 could be carried back to 1997 to realize the tax benefit. No valuation allowance is needed.

E 19-7 Analyze a Tax Liability: Entries and Reporting Stacy Corporation would have had identical income before taxes on both its income tax returns and income statements for the years 1997 through 2000 except for an operational asset that cost $120,000. The asset was depreciated for income tax purposes using the following amounts: 1997, $48,000; 1998, $36,000; 1999, $24,000; and 2000, $12,000. However, for accounting purposes the straight-line method was used ([i.e., $30,000 per year; this is the only temporary difference). The accounting and tax periods both end December 31. The operational asset has a four-year estimated life and no residual value. Accounting income amounts before income taxes for each of the four years are as follows:

1997 1998 1999 2000

Accounting income before taxes $30,000 $50,000 $40,000 $40,000

Assume that the average and marginal income tax rate for each year was 30 percent.

Required:

1. Is this a temporary difference? Explain why.

2. Reconcile pretax accounting and taxable income, calculate income tax payable, compute the balance in the deferred tax liability account, and prepare journal entries for each year-end.

3. For each year show the deferred income tax amount that would be reported on the balance sheet.

Answer

Requirement 1

This is a temporary difference because the difference in pretax accounting income and taxable income in the originating periods will subsequently reverse. The temporary difference at the end of the first year is a future taxable amount of $18,000.

Requirement 2

Schedule of temporary differences

1997 1998 1999 2000

Tax depreciation $48,000 $36,000 $24,000 $12,000
Book depreciation 30,000 30,000 30,000 30,000

Originating (reversing) future taxable amount $18,000 $ 6,000 ($ 6,000) ($18,000)

Cumulative future taxable amount $18,000 $24,000 $18,000 $-0-

Reconciliation of accounting and taxable income:

 

E 19-8 Asset/Liability Method with Change in Tax Rates Wittco Company reports pretax accounting income in 1997, its first year of operations, of $100,000. Taxable income is $70,000, with temporary differences arising in 1997 from the following sources:

a. Prepayment of 1998 rent in the amount of $24,000 in 1997.

b. An installment sale in the amount of $36,000, with cash collections expected in two equal amounts in 1999 and 2000.

The enacted tax rates all known in 1997 are 30 percent in 1997, 30 percent in 1998, and 40 percent in 1999 and thereafter.

Required:

1 Prepare the journal entry to record income taxes.

2. Repeat (1) above, assuming that a new tax law is passed in 1997 raising the statutory tax rate to 40 percent for 1997 and all years thereafter.

Answer:

Requirement 1

Under the asset/liability method, future tax rates are used in determining the deterred tax asset or liability that is recorded.

Schedule: Temporary differences, taxes payable, and deferred tax balances

Effect on future

Future taxable income

1997 Years Deductible Taxable

Pretax accounting income $100,000

Temporary differences:
Prepayment of rent (24,000) $24,000 $24,000
Installment receivable (36,000) 36,000 36,000

Taxable income $ 40,000 ______ ______
Total deductible
Total taxable $60,000

Times: Marginal tax rate x .30 X*

Taxes payable $ 12,000
Deferred tax liability, December 31, 1997 $ 21,600

* the future taxable amounts occur in years with different tax rates. The computation of the deferred tax liability is:

1998 taxable amount ($24,000 prepaid rent) $ 24,000
1998 tax rate .30
Deferred tax liability related to 1998 $ 7,200
1999 and 2000 taxable amount $36,000
Enacted tax rate for 1999 and 2000 .40
Deferred tax liability 14,400
Total deferred tax liability balance, December 31, 1997 $ 21,600

The beginning-of-period balances for deferred tax assets and liabilities are zero:

Deferred tax Deferred Tax
Asset Liability

End-of-period balance (computed above) $-0- $(21,600)

Less: Beginning-of-period balance (taken from
beginning- of-period balance sheet -0- -0-

Debit (credit) to be made to account $-0- $(21,600)

Computation of income tax expense:
Income taxes payable $12,000
Increase (decrease) in deferred tax liability 21,600
Income tax expense in 1997 $ 33,600

The journal entry to record income taxes for 1997 is:
Income tax expense 33,600
Income taxes payable 12,000
Deferred tax liability 21,600

Requirement 2

Schedule: Temporary differences, taxes payable, and deferred tax balances

Effect on future

Future taxable income

1997 Years Deductible Taxable

Pretax accounting income $100,000

Temporary differences:
Prepayment of rent (24,000) $24,000 $24,000
Installment receivable (36,000) 36,000 36,000

Taxable income $ 40,000 ______ ______
Total deductible
Total taxable $60,000

Times: Marginal tax rate x .40 x.40

Taxes payable $ 16,000
Deferred tax liability, December 31, 1997 $ 24,000

The beginning-of-period balances for deferred tax assets and liabilities are zero:

Deferred tax Deferred Tax
Asset Liability

End-of-period balance (computed above) $-0- $(24,000)

Less: Beginning-of-period balance. (taken from
beginning- of-period balance sheet) -0- -0-

Debit (credit) to be made to account $-0- $(24,000)

Computation of income tax expense:
Income taxes payable $16,000
Increase (decrease) in deferred tax liability 24,000
Income tax expense in 1997 $ 40,000

The journal entry to record income taxes for 1997 is:
Income tax expense 40,000
Income taxes payable 16,000
Deferred tax liability 24,000

E 19-10 Operating Carryback-Carryforward (NOL) Options: Choices, Entries, and Reporting Tyson Corporation reported pretax income from operations in 1997 of $80,000 (the first year of operations). In 1998, the corporation experienced a $40,000 pretax loss from operations (NOL). Management is very confident the firm will have taxable income in excess of $50,000 in 1999. Assume an income tax rate of 20 percent in 1997, increasing to 30 percent in 1998 and thereafter. Tyson has no other temporary differences.

Required:

1. Assess Tyson's income tax situation for 1997 and 1998 separately. How should Tyson elect to handle the loss in 1998? Which carry back/carry forward option should Tyson choose?

2. Based on your assessments in (1), give the 1997 and 1998 income tax entries that Tyson should make.

3. Show how all tax-related items would be reported on the 1997 and 1998 income statement and balance sheet.

Answer:

Requirement 1

1997: Income tax payable (and expense) $80,000 x.20 = $16,000.

1998: Loss of $40,000 can be used as a NOL carryback to obtain a tax refund of $40.000 x .20 = $8,000, or carryforward only for an expected benefit of $40,000 x.30 = $12,000.

Tyson should elect the carryforward only option, as it results in additional benefit of $4,000 within a year.

Requirement 2

1997:
Income tax expense 16,000
Income tax payable 16,000

1998:
Deductible tax asset 12,000
Income tax reduction from loss carryforward (a
component of income tax expense) 12,000

Requirement 3

1997 1998

Income statement:
Income tax expense: current portion $ 16,000 $ -0-

Income tax reduction from loss carryforward (a
credit component of income tax expense) None (12,000)
Total $ 16,000 $ (12,000)

Balance sheet:
Current assets:
Deferred tax assets None 12,000

Current liabilities:
Income tax payable (assuming no prepayments) 16,000 None

E 19-12 Valuation Allowance, NOL Carryforward At December 31, 1997, Allsoap Corporation has a deferred tax asset of $25,000, all of which arose as a result of temporary differences occurring in 1997. Allsoap began operations in 1996. In its first year the company had a net operating loss of $10,000, which was carried forward and used to reduce income taxes payable in 1997. In 1997, Allsoap had taxable income before the use of the NOL carryforward of $40,000. The income tax rate is 40 percent. No valuation allowance has been established.

Required:

1. Compute income taxes payable and income tax expense for 1997 before any consideration of recording a valuation allowance. Show the journal entry to record income taxes assuming that no valuation allowance is required.

2. Now assume Allsoap has encountered stiff competition and is uncertain whether it will have any taxable income in the foreseeable future. Assume that the temporary differences that give rise to the deferred tax asset are expected to reverse in 1998 and 1999. Determine what amount, if any, should be recorded as a valuation allowance at December 31, 1997, and make the appropriate entry.

3. Show how the December 31, 1997, balance sheet and income statement would disclose the information above, assuming that a valuation allowance is recorded.

Answers:

Requirement 1

In this problem we are given taxable income and are required to determine pretax accounting income. This can be done using the same schedule format as when going from pretax accounting income to taxable income:

Current Effect on future

Year Future taxable income

1997 Years Taxable Deductible

Taxable income before NOL $ 40,000

Temporary differences:
Future deductible amounts (62,500)* $ 62,500 $ 62,500

* ($25,000)/.40)

Pretax accounting income (loss) $(22,500)

Taxable income before NOL $ 40,000

NOL Carryforward (10,000) _____ _____

Taxable income $ 30,000
Future taxable amounts $ -0-
Future deductible amounts $ 62,500
Applicable tax rate 0.40 0.40 0.40
Tax payable $12,000
Deferred tax liability $ -0-
Deferred tax asset $ 25,000

Deferred tax Deferred Tax
Liability Asset

Ending balance $-0- $25,000
Beginning balance* -0- 4,000
Debit (credit) to be made to account $-0- $21,000

Journal entry:
Deferred tax asset 21,000
Income tax payable 12,000
Income tax expense** 9,000

* Arising from the $10,000 NOL in 1996. That is, the December 31, 1996 balance sheet includes a deferred tax asset of $10,000 x .40 or $4,000.

** Note that since the tax rate is constant over time and there are no permanent differences, the income tax expense (benefit) should equal pretax accounting income (loss) times the tax rate: $22,500 x .40 = $9,000

Requirement 2

If Allsoap expects zero taxable income in future years. the realizability of the deferred tax is questionable. However, one source—tax loss carrybacks to 1997—can be used to realize at least the amount of tax benefit associated with the maximum that could be carried back:

Amount of deferred tax asset that is more likely than not to be realized:

Taxes paid in 1997 (realizable through NOL carryforward) $ 12,000
Total amount of deferred tax asset 25,000
Amount of valuation allowance needed 13,000

Journal entry:
Income tax expense 13,000
Valuation allowance 13,000

Requirement 3

Current assets:
Deferred tax assets $ 25,000
Less: valuation allowance 13,000
Net deferred assets $ 12,000

Current liabilities:
Income taxes payable $ 12,000

Income statement:

Pretax accounting income (loss) $ (22,500)

Income tax expense:
Current portion $ 12,000

Deferred portion (21,000)

Increase in valuation allowance 13,000

Total income tax expense 4,000

Net income (loss) $ (26,500)

 

P 19-1 Operating Carryback-Carryforward (NOL) Options: Entries The financial statements of Bixler Corporation for the first four years of operations reflected the following pretax amounts:

1997 1998 1999 2000

Income statement (summarized):
Revenue $125,000 $155,000 $180,000 $250,000
Expenses 120,000 195,000 160,000 200,000

Pretax income (loss) $ 5,000 $(40,000) $ 20,000 $ 50,000

There are no temporary differences other than those created by tax loss carryforwards. Assume an income tax rate of 30 percent during 1997 and 1998 and 40 percent in 1999 and 2000. Assume that future incomes are very uncertain at the end of each year, so a valuation allowance is needed for any deferred tax asset. In 1998, management of Bixler Corporation elects the carryback-carryforward option in order to obtain the immediate cash refund on the NOL carryback.

Required:

1. Recast Bixler's statements to incorporate the income tax effects as required by SFAS No. 109. Show computations.

2. Give entries to record the NOL income tax effects for each year.

3. Explain the alternative option that Bixler might have considered. What are the primary considerations that Bixler should assess in making its choice?

Answers:

Requirement 1

Income statement (partial) 1997 1998 1999 2000

Revenue $125,000 $155,000 $180,000 $250,000
Expenses 120,000 195,000 160,000 200,000

Pretax income (loss) $ 5,000 $(40,000) $ 20,000 $ 50,000

Items included in income tax expense:
Taxes payable $ 1,500 $ -0- $ -0- $ 14,000

NOL carryback (tax refund) (1,500) -0- -0-

NOL carryforward effect (14,000) (8,000) (6,000)

Valuation allowance -0- 14,000 8,000 6,000

Income tax expense $ 1,500 $ (1,500) $ -0- $ 14,000

Net Income $ 3,500 $ (38,500) $ 20,000 $ 36,000

The full amount of the NOL carryforward is recognized as a deferred tax asset in 1998. However, since it is not likely to be realized, a valuation allowance is established which reverses the effect of recognizing the NOL carryforward effects. Assuming the NOL carryforward effect continues to require a valuation allowance for the remaining amount, the result is recognition of the NOL carryforward effect only when it is actually realized.

Requirement 2

1997 entries:

Income tax expense 1,500
Income tax payable ($5,000 x .30) 1,500

1998 entries:

Record the receivable for a tax refund:
Receivable for refund of tax for 1997 1,500
Income tax expense (tax refund) 1,500

Record the benefit of the remaining NOL carryforward:
Deferred tax asset ($35,000 x .40) 14,000
Income tax expense (effect of tax loss carryforward) 14,000

Since the NOL carryforward benefit is not likely to be realized, establish a valuation allowance for the amount not likely to be realized.

Income tax expense 14,000
Valuation allowance 14,000

1999 entries:

The NOL carryforward is used in the amount of $20,000 to reduce taxable income; thus, taxable income payable is reduced by $20,000 x .40 or $8,000. This is the amount of the deferred tax asset realized, and the valuation allowance is reduced in the same amount. The net effect is that income tax expense in 1999 is zero:

Computation of income tax expense:
Tax payable $ -0-
Decrease (increase) in deferred tax asset 8,000

(Decrease) increase in valuation allowance (8,000)

Income tax expense $ -0-

The entry in 1999 shows the reduction of the deferred tax asset balance and the reduction of the valuation allowance:

Valuation allowance 8,000
Deferred tax asset 8,000

2000 entries:

Computation of income tax expense:
Tax payable* $ 14,000
Decrease (increase) in deferred tax asset 6,000

(Decrease) increase in valuation allowance (6,000)

Income tax expense $ 14,000

Income tax expense 14,000
Valuation allowance 6,000
Deferred tax asset 6.000
Income tax payable 14,000

* Taxable income before NOL $ 50,000
Less: Remaining NOL carryforward 15,000
Taxable income $ 35,000
Tax rate x .40
Taxes payable $ 14,000

Requirement 3

Bixler is required to make an irrevocable choice between one of the following two options, at the end of the year of NOL:

(a) Carryback-carryforward option—Under this option a loss can be carried back up to three years (in order of year) as an offset against the income of prior years, to obtain a cash refund. If the carryback does not fully absorb the loss, the balance can be carried forward 15 years as an offset against future income as earned (in order of years).

(b) Carryforward-only option-Under this option (any carryback is forfeited) the loss can be carried forward as earned (in order of year) for up to 15 years.

In choosing between the two options, Bixler should consider the following:

1. Under option (a), any carryback is certain and the tax refund is immediate. At least, the carryback offset will be realized.

In contrast, under option (b) Bixler forgoes this advantage, presumably on the expectation that future incomes and tax rates will be higher and thus enhance the effect of the offset.

2. Option (a) makes available a total of 18 years to offset the loss against income.

In contrast, option (b) allows only 15 years to offset the loss; however, this may provide sufficient time and result in higher offsets.

3. Option (a) does not take full advantage of potential future higher income and tax rates that option (b) offers.

4. The effect on any investment tax credit and/or tax credits of a tax carryback or a tax carryforward.

By choosing the carryback/carryforward option the total benefit realized was $15,500: an immediate refund of $1,500, and tax savings of $8,000 in 1999 and $6,000 in 2000.

If Bixler had chosen the carryforward only option, the total benefit would have been $16,000: tax savings of $8,000 in 1999 and $8,000 in 2000.

In summary, Bixler should carefully assess (a) future potential income (by year), (b) future income tax rates, and (c) the level of certainly (or uncertainty) relative to those income and tax rate estimates. Also, because the timing of cash flows (or cash savings) is an important consideration, the choice of options should take into account the present values of those estimated future cash flows and other tax credits.

P 19-7 Recording and Reporting a Deferred Tax Liability and Change in Tax Rate The records of Morgan Corporation provided the following data at the end of years 1 through 4 relating to income tax allocation:

Year 1 Year 2 Year 3 Year 4

Pretax accounting income $58,000 $70,000 $80,000 $88,000
Taxable income (tax return) 28,000 80,000 90,000 98,000

The above amounts include only one temporary difference; no other changes occurred. At the end of year 1, the company prepaid an expense of $30,000, which will be amortized for accounting purposes over the next three years (straight-line). The full amount is included in year 1 for income tax purposes. At the end of year 1, the enacted tax rate was 35%. During year 2, the enacted tax rate was changed to 30%, retroactive to the beginning of year 2, and was to remain in effect through year 4.

Required:

1 Prepare a schedule of temporary differences at the end of year 1.

2. Give the entry to record income taxes at the end of year 1.

3. Give any entry that should be made in year 2 to reflect the change in the enacted income tax rate. If none is required, explain why.

4. Give the entry at the end of each year for years 2 through 4, assuming that the new enacted tax rate is not changed.

5. Complete the following tabulation:

Year 1 Year 2 Year 3 Year 4

Income statement:
Income tax expense
Balance sheet:
Liabilities:
Income tax payable
Deferred tax liability

Answers:

Requirements 1 through 4

Schedule: Temporary differences, taxes payable, and deferred tax balances

Note: The tax rate change which occurs in Year 2 is reflected in the Year 2 balances of the deferred tax liability account. The direct effect of the tax rate change is computed as the amount of temporary difference that exists at the time of the change (a future taxable amount of $30,000), multiplied by the amount of the tax rate change (35% to 30%): $30,000 x (.35 - .30) = $1,500. The income tax expense for Year 2 reflects the reduction of future taxes because of the tax rate reduction in the amount of $1,500. The direct effect of the tax rate change must be disclosed.

Requirement 5

Reporting on the financial statements:

Year 1 Year 2 Year 3 Year 4

Income statement:
Income tax expense $20,300 $19,500 $24,000 $26,400
Balance sheet:
Liabilities:
Income tax payable 9,800 24,000 27,000 29,400
Deferred tax liability 10,500 6,000 3,000 -0-

P19-14 Operating Carryback-Carryforward (NOL) Options: Entries and Reporting Decker Corporation experienced a loss in 1997. The company reported taxable income (loss) for 1994 to 1997 and had average tax rates as follows:

1994 1995 1996 1997

Taxable income (loss) $8,000 $32,000 $15,000 ($65,000)

Income tax rate 30% 30% 35% 40%

There were no temporary differences from 1994 to 1997.

Required:

1. Record income taxes for 1997 and 1998 assuming that Decker elects the carryback-carryforward option. Also assume the following:

a. For 1997, any tax refund receivable is collected early in 1998.

b. For 1998, the company reported taxable income of $45,000 and pretax accounting income of $50,000 (a $5,000 temporary difference). The income tax rate for 1998 is 45 percent.

2. List the accounts and amounts that should be reported on the income statements and balance sheet for each of the above requirements.

3. Repeat (1) and (2) assuming that Decker elects the carryforward-only option, and no valuation allowance is deemed necessary.

Answer:

Requirement 1

A. Entries to be made at the end of 1997, assuming the carryback/carryforward option is chosen:

Receivable for refund of taxes paid in 1994-96 (NOL refund) 17,250
Income tax expense (tax refund from NOL carryback) 17,250

Deferred tax asset 4,500
Income tax expense (NOL carryforward) 4,500

It is assumed that a valuation allowance is not required. If one were required, the amount of the reduction in the operating loss would be reduced by the amount of the valuation allowance.

Computation:

Carryback to 1994 $8,000 x .30 = $ 2,400
Carryback to 1995 32,000 x .30 = 9,600
Carryback to 1996 15,000 x .35 = 5,250
Total tax refund from NOL carryback $ 17,250

Total loss in 1997 $ 65,000
Amount carried back in 1994-96 55,000
Amount available for carryforward $ 10,000

B. Entries to be made at the end of 1998

Income tax expense 22,500
Deferred tax asset ($10,000 x .45) 4,500
Deferred tax liability ($5,000 x .45) 2,250
Income tax payable ($45,000 - $10,000 carryforward) x .45 15,750

Requirement 2

1997 1998

Income statement:
Pretax accounting income $(65,000) $50,000
Income tax expense (savings) (in 1997: $17,250 + $4,500) (21,750) 22,500
Balance Sheet:
Current assets:
Receivable of tax refund $17,250 *
Deferred tax asset 4,500
Current liabilities:
Income tax payable $15,750
Noncurrent liabilities:
Deferred tax liability 2,250

* Assumed to be collected in 1998.

Requirement 3

A. Entries to be made at the end of 1997, assuming the carryforward only option is chosen:

Deferred tax asset 29,250
Income tax expense (NOL carryforward) 29,250

It is assumed that a valuation allowance is not required. If one were required, the amount of the reduction in the operating loss would be reduced by the amount of the valuation allowance,

Computation:

Carryforward to future periods $65,000 x .45 = $ 29,250
Total deferred tax asset from NOL carryforward $ 29,250

B. Entries to be made at the end of 1998

Income tax expense 22,500
Deferred tax asset ($45,000 x .45) 20,250
Deferred tax liability ($5,000 x .45) 2,250
Income tax payable ($45,000 - $45,000 carryforward) x .45 -0-

At the end of 1998, there is $20,000 ($65,000 - $45,000) of NOL available for carryforward, and a deferred tax asset in the amount of $9,000 ($20,000 x .45) on the balance sheet.

C. Reporting and disclosures:

1997 1998

Income statement:
Pretax accounting income $(65,000) $50,000
Income tax expense (29,250) 22,500
Balance Sheet:
Current assets:
Deferred tax assets $29,250 9,000
Current liabilities:
Income tax payable $-0-
Noncurrent liabilities:
Deferred tax liability 2,250

If the deferred tax liability at the end of 1998 were to be classified as current, it would be netted against the deferred tax asset, and a net deferred tax asset of $9,000 less $2,250, or $6,750 would be reported.

C 19-5 Valuation Allowance for Deferred Tax Assets Soderstrom Company has a deferred tax asset of $1,000,000 at December 31, 1997, arising from its recording of its liability for postretirement benefits other than pensions Soderstrom's CPA asks management whether a valuation allowance to reduce the deferred tax asset to zero should be recorded.

Required:

1. Why would Soderstrom not want to report a valuation allowance? Outline what evidence, assuming it existed, Soderstrom might use to argue against recording a valuation allowance.

2. Suppose in the final analysis, it is determined that a valuation allowance of $400,000 is needed. How would the company have arrived at this determination, and what effect will it have on net income in fiscal 1997?

Answer:

1. Soderstrom, like most firms, would prefer not to report a valuation allowance which reduces net assets and increases income tax expense. Soderstrom could produce evidence that the deferred tax asset was more likely than not to be realized Such evidence would include:

• a history of profitability

• existing contracts or firm sales backlogs that will produce more than enough taxable income to realize the deferred tax asset

• excess appreciated asset values over tax bases such that, if a tax planning strategy were used, the deferred tax asset could be realized.

Soderstrom must show that it could use the carryback provisions of the tax code, have taxable income in future years, or have future reversals of existing future taxable items to offset against future deductible amounts, all of which result in realizing the benefit of the deferred tax asset and obviate the need for a valuation allowance.

2. The valuation allowance is called for when "it is not more likely than not" that all of the deferred tax asset will be realized. The company would apply the procedures and analysis outlined above, and come to a judgment regarding the realizability of the deferred tax asset. When the valuation allowance is recorded to reduce the carrying value of the deferred tax asset, it causes income tax expense in the current period to increase by that amount, and therefore net income to decrease by the same amount.

A 19-2 Applied Technology Laboratories (ATL) ATL, a medical equipment manufacturer, reported a loss before income taxes of $20.9 million in 1994, yet the income tax effect was a savings of only $0.7 million. The effective income tax rate is only 3.3 percent (0.7/20.9). ATL reported a loss before income taxes of $1.7 million in 1993, yet had income tax expense of $1.6 million—an effective tax rate of 94.1 percent! Assume a statutory income tax rate of 35 percent.

This schedule from the notes to the 1994 ATL annual report explains its deferred tax assets and deterred lax liabilities (in thousands):

1994 1995

Deferred tax assets
Receivables $ 3,230 $ 2,936
Inventories 11,564 8,800
Net operating loss carryforwards 3,969 3,157
State taxes 3,106 2,087
Compensation 2,623 2,171
Provision for litigation claim 1,700 -  
Research and experimentation
credit carryforwards 6,602 6,425
Other 3,032 3,107
Gross deferred tax assets $35,826 $29,683

Less valuation allowance (27,249) (19,709)

Net deferred tax assets $ 8,577 $ 8,974

Deferred tax liabilities, primarily
depreciation and intangible assets (4,472) (4,628)

Net deferred income taxes $ 4,105 $ 4,346

Required:

1. What are some reasons why ATL’s effective tax rate might be so low in 1994?

2. Why might ATL show an income tax expense in a year when it has a loss before income taxes for financial reporting?

3. In general terms, explain why ATL has such a large amount reported as a valuation allowance.

4. What effect did the increase in the valuation allowance from 1993 to 1994 have on ATL’s income tax expense computation in fiscal 1994?

5. Using a tax rate of 35 percent, estimate the amount of net operating loss carryforwards that ATL has as of' December 31, 1994.

6. Using a tax rate of 35 percent, estimate the amount of "research and experimentation credit carryforwards" that ATL has as of December 31, 1994.

7. Using a tax rate of 35 percent, estimate the amount of accrued liability for litigation claim that ATL has as of December 31, 1994.

Answers:

Requirement 1

Effective tax rates are different from statutory rates either because rates different than the U.S. statutory rates are applied to some or all of the taxable income, or there are permanent differences affecting the computation of the effective rate. Looking at the ATL data found in the Note, we see that the Company has large amounts of deferred tax assets arising from NOL carryforwards and from "research and experimentation tax credits." When such large amounts arise from these sources one must become concerned about whether the benefit they represent is likely to be realized. Looking further at the Note, we see that ATL has a large valuation allowance, and more importantly, it increased by $7,540(000) in 1994. This entire amount increased income tax expense in 1994, and it is the most likely source of causing the effective tax rate to decline in 1994.

Requirement 2

Once again, this has to arise because of permanent differences or an increase in the valuation allowance (which is a form of permanent difference). We do not know the valuation allowance account balance at the end of fiscal 1992, but it is likely that it was less than the fiscal 1993 balance. If so, then again income tax expense is increased in 1993 because of the increasing of the valuation allowance. There could be other permanent differences causing the effects on the effective tax rate, but the valuation allowance change is the most likely source.

Requirement 3

The Company has "negative evidence" regarding the need to create a valuation allowance. We can see from the data that ATL has had a series of years with net operating losses (NOLs), and this is strong negative evidence. It would appear that ATL does not have other sources for generating taxable income in the future; thus it must record the valuation allowance for the amount of the future benefit not expected to be realized.

Requirement 4

The valuation allowance increased by $7,540,000. This amount would be credited to the valuation allowance and debited to the deferred portion of income tax expense. Thus the full amount of S7,540,000 increases income tax expense in 1994.

Requirement 5

The tax effect of the carryforward is $3,969,000. Dividing by the statutory tax rate, which was used to compute these tax effects, we determine the actual amount of carryforward to be $3,969,000/.35, or $11,340,000.

Requirement 6

Tax credits are direct reductions to income taxes payable, hence the amount shown in the deferred tax asset represents the entire amount of credit. The "research and experimentation tax credits total $6,602,000.

Requirement 7

The deferred tax related to the litigation claim is $1,700,000, thus the estimated amount of the litigation claim recorded is $1,700,000 divided by .35, or $4,857,000.

CHAPTER 20 CORPORATIONS: CONTRIBUTED CAPITAL

1. Define public. private. open, closed, and publicly traded corporations.

Answer:

Public: Corporations are referred to as "public" when they relate to governmental units or business operations owned by governmental units.

Private: Corporations are referred to as "private" when they are privately owned. Such corporations may be non-stock (nonprofit organizations, such as colleges and churches) or stock (usually organized for profit making).

Open: When the stock is available for purchase, the stock may be widely held. Also called "publicly held."

Closed: When the stock is not available for purchase; it is generally held by only a few shareholders. Also called closely held.

Publicly traded: When the stock is available for purchase by investors. The stock can be traded on a major stock exchange, or simply over-the-counter.

4. Describe the three main categories of stockholders' equity in accounting for corporate capital,

Answer: Accounting for corporate capital emphasizes the categories of capital usually thought of as sources of capital. To apply this concept. corporate capital accounts are established in a manner such that the apparent sources of the capital used in the enterprise are segregated. Source is important because the laws of the several states relating to corporations frequently are specific concerning sources of capital.

For example. dividends may be "paid" from certain sources and riot from others in the legal sense. For legal reasons, the source is considered important for full disclosure in the financial statements. Three main categories of stockholders' equity are: contributed capital, retained earnings, and unrealized capital.

10. Explain the difference between cumulative and noncumulative preferred stock.

Answer: Noncumulative preferred stock provides that dividends not declared for any prior year, or series of prior years, are lost permanently as far as the preferred stockholder is concerned. Cumulative preferred stock provides that dividends passed (dividends in arrears) for any prior year, or series of' prior years, accumulate and must he paid to the preferred shareholders when dividends are declared, before the common stockholders are entitled to receive a dividend. In most states preferred stock is cumulative unless otherwise stated.

11. Explain the differences between nonparticipating, partially participating, and fully participating preferred stock.

Answer: The differences relate only to preferred stock.

Preferred stock is nonparticipating when the dividends for each year are limited in the charter to a specified preference rate per share.

Partially participating stock means that the preferred shareholders participate above the preference rate with the common shareholders, but only up to an additional fate which is specified in the charier and on the stock certificates.

17. Briefly explain the two methods of accounting for stock issue costs.

Answer: Stock issue costs arise from expenditures made to sell and issue capital stock. Two methods are used to account for these:

(a) Offset method—deducted from the proceeds of the sale of the stock by debiting (i.e., reducing) contributed capital in excess of par.

(b) Deferred charge method—debit the expenditures to a deferred charge account (an intangible asset) and amortize as expense over a period of not more than 40 years.

20. What is the effect on the amounts of asses, liabilities. and stockholders' equity of (a) the purchase of treasury stock and (b) the sale of treasury stock?

Answer: Effects of treasury stock on total:

Purchase Sale

(a) Assets Decrease Increase
(b) Liabilities None None
(c) Stockholders’ equity Decrease Increase

21. Explain the theoretical difference between the one-transaction concept and the dual-transaction concept in accounting for treasury stock.

Answer: The one-transaction concept, which underlies the cost method, holds that the purchase and subsequent sale of treasury stock are, in effect, one continuous capital transaction. Consequently, under this concept, treasury stock is debited to the Treasury Stock account at cost and held in suspense. in effect, as an unallocated reduction of total capital. When the treasury stock is resold or retired, as the case may be, the capital transaction is completed, and at that time, the Treasury Stock account is removed at cost, and the various effects on capital recognized.

The dual-transaction concept, which underlies the par-value method, holds that the purchase of treasury stock and the subsequent resale of it constitute two separate and distinct transactions. Consequently, under this concept, the Treasury Stock account is debited at par value upon purchase of treasury stock and other appropriate capital accounts adjusted as though the selling stockholders' equity were retired. Upon resale, the treasury stock shares are accounted for in the same manner as the sale of any unissued capital stock.

25. How is treasury stock reported on the balance sheet (a) under the cost method and (b) under the par value method?

Answer: Under the cost method, treasury stock is reported on the balance sheet as an unallocated deduction from stockholders' equity plus retained earnings.

Under the par value method, the par value of the treasury stock is subtracted from the par value of the issued shares to which it relates. Subtraction of the par value of the treasury shares from the issued shares provides a difference which is designated as shares outstanding at par value. Under the par value method. this approach is logical since the treasury shares are identified with a specific value common to other shares of the same class of stock. that is, the par value.

 

E 20-4 Analysis of Stockholders’ Equity: Prepare Statement The following data are from the accounts of Mitar Corporation at December 31, 1998 (amounts in thousands):

Subscriptions receivable (noncurrent) $ 10
Retained earnings, 1/l/1998 900
Capital stock, par ?, authorized 100,000 shares 1,000
Capital stock subscribed, 1,000 shares (to be issued upon collection in full) 20
Premium on capital stock 400
Subscriptions receivable, capital stock (due in three months) 4
Bonds payable 200
Net income for 1998 (not included in retained earnings above) 190
Dividends declared and paid during 1998 80

Required:

1. Respond to the following (state any assumptions that you make):

a. Total retained earnings at end of 1998 is $

b. Retained earnings on I/l/1998 was $

c. Par value per share is $

d. Number of shares outstanding is

e. Legal capital is $

f. Total stockholders' equity is. $

g. Number of shares issued is.

h. Average selling price per share including any shares subscribed was $

i. Number of shares sold including any shares subscribed was . . . . . . . .

2. Prepare the stockholders' equity section of the balance sheet at December 31, 1998. Use good form, complete with respect to details. Subscriptions receivable is to be recorded as an asset.

Answer:

Requirement I

a. Total retained earnings at end of 1998 (900 + (190 - 80)] $ 1,010

b. Retained earnings on January 1. 1998. was (given) $ 900

c. Par value per share is $ 20.00
Based on capital stock subscribed: $20,000 1,000 = $20 par

d. The number of shares outstanding is 50,000 shares
$1,000,000 $20 par = 50,000 shares outstanding.

e. Legal capital is ($1,000 outstanding + $20 subscribed) $ 1,020
Assumed to be par value by state law. State laws vary as to
accounting for subscribed stock.

f. Total stockholders' equity is ($1,010 + $1,000 + $20 + $400) $ 2,430

g. Number of shares issued ($1,000,000 $20) 50,000 shares
There is no treasury stock; therefore, all shares issued are outstanding.

h. Average sale price per share $ 27.84
($400 + $1,000 + $20) 51,000 shares = $27.84. Include
50,000 issued plus the 1,000 shares subscribed.

i. Number of shares sold 51,000 shares
(Includes the subscribed stock.)

Requirement 2

MITAR CORPORATION
STOCKHOLDERS’ EQUITY
December 31, 1998
(000s)

Contributed Capital:
Capital stock:
Capital stock, par $20, authorized 100,000 shares, issued
and outstanding, 50,000 shares $1,000
Capital stock subscribed, 1,000 shares 20
Total capital stock $1,020
Other contributed capital:
Contributed capital in excess of par 400
Total Contributed Capital $1,420
Retained earnings 1,010
Total Stockholders' Equity $2,430

E 20-6 Compute Dividends: Preferred Stock, Four Cases Able Corporation has the following stock outstanding:

Common, $50 par value—6.000 shares.

Preferred, 6 percent, $ 100 par value—1.000 shares.

Required: Compute the amount of dividends payable in total and per share on the common and preferred stock for each separate case:

Case A Preferred is cumulative and nonparticipating, two years in arrears; dividends declared, $34,000.

Case B Preferred is noncumulative and fully participating, dividends declared, $40,000.

Case C Preferred is cumulative and partially participating up to an additional 3 percent; three years in arrears: dividends declared, $60.000.

Case D Preferred is cumulative and fully participating; three years in arrears; dividends declared, $50,000.

 

Answer:

Dividends

Preferred 6% Common
(1,000 shares (6,000 shares
and $100,000 and $300,000
par value) par value) Total

Case A (Preferred—-cumulative; nonparticipating)
Arrears ($100,000 x .06 x 2) $12,000 $12.000
Current preference ($100,000 x .06)
(matching amount) 6,000 6.000
Balance to common ______ $16,000 16,000
Total $18,000 $16,000 $34,000
Per share $18.00 $2.67

Case B (Preferred-noncumulative; fully
participating)
Current preference ($100,000 x .06) $6.000 $6,000
Common, to match ($300,000 x .06) $18.000 18,000
Balance, ratio based on par value 1:3 4,000 12,000 16,000
Total $10,000 $30,000 $40.000
Per share $10.00 $5.00

Case C (Preferred; cumulative; partially
participating)
Arrears ($100,000 x .06 x 3) $18,000 $18,000
Current preference ($100,000 x .06) 6,000 6.000
Common, to match $300,000 x .06) $18,000 18,000
Preferred, additional 3% (x $100,000) 3,000 3,000
Balance to common . . . . . . ______ 15,000 15,000
Total $27,000 $33.000 $60,000
Per share $27.00 $5.50

Case D (Preferred; cumulative fully participating)
Arrears ($l00,000 x .06 x 3) $18,000 $18,000
Current preference ($100,000 x.06) 6,000 6,000
Common, to match ($300.000 x .06) $18,000 18,000
Balance ratio to par 1:3 2,000 6,000 8,000
Total $26,000 $24,000 $50,000
Per share $26.00 $4.00

E20-11 Common and Preferred Stock Issued: Four Transactions The charter of Gilmore Company authorized 20,000 shares of common stock, par $2, and 20,000 shares of preferred stock par $10. The following transactions were completed. Assume that each is completely independent.

a. Sold 400 shares of common and 200 shares of preferred stock for a lump sum of $12,300. The common had been selling during the current week at $25 per share, and the preferred at $12 per share.

b. Issued 180 shares of preferred stock for some used equipment. The equipment had been appraised at $2,400 and the book value shown by the seller was $1,200. A reliable market value on the preferred stock has not been established.

c. A 10 percent assessment on par value was voted on both the common and preferred when 12,000 shares of common and 8,000 shares of preferred were outstanding. The assessment was collected in full.

d. Sold 600 shares of common and 400 shares of preferred stock in one transaction for a total cash price of $20,000. The common recently had been selling at $20 lea were no recent sales of the preferred.

Required: Give the journal entry for each transaction. State and justify any assumptions that you make.

Answers:

a. Cash 12,300
Preferred stock, par $10 (200 shares) 2,000
Common stock, par $2 (400 shares) 800
Contributed capital in excess of par, preferred stock 380
Contributed capital in excess of par, common stock 9,120

Relative market values: Common—400 x $25 = $10,000
Preferred—200 x $12 = 2,400
Total = $12,400

Allocation of cost:
Common: ($10,000/$12,400) x $12,300 = $9,920
Preferred ($2,400/$12,400) x $12,300 = 2,380

Total Cost $12,300

Computation of contributed capital:
Common: $9,920 - $800 = $9,120
Preferred $2,380 - $2,000 = $380

b. Equipment (used) 2,400
Preferred stock (180 shares x $10) 1,800
Contributed capital in excess of par, preferred stock 600

The appraisal is accepted as a reasonable measure of the market value of the machinery. The book value reflected in the seller's books is irrelevant. A preferred alternative would be to use the current market value of the stock (if available).

c. Cash 10,400
Contributed capital—assessment on common stock 2,400
Contributed capital—assessment on preferred stock 8,000

Common: 12,000 shares x $2 x.10 = $2,400
Preferred: 8,000 shares x $10 x.10 = $8,000

d. Cash 20,000
Common stock (600 shares x $2) 1,200
Preferred stock (400 shares x $10) 4,000
Contributed capital in excess of par, common stock
(600 shares x $24) 14,400
Contributed capital in excess of par, preferred stock 400

The current market price of the common stock is accepted as realistic. The balance of the premium was identified with the preferred stock because there were no recent market sales of the preferred.

 

E20-14 Treasury Stock, Cost and Par Value Methods Compared: Entries and Account Balances On January 1. 1997, Johnson Soap Corporation issued 20,000 shares of $20 par value common stock at $50 per share. On January 15. 1997. Johnson purchased 50 shares of its own common stock at $55 per share. On March 1, 1997, 20 of the treasury shares were resold at $58. The balance in retained earnings was $25,000 prior to these transactions.

Required:

1. Give all entries indicated in parallel columns, assuming application of (a) the cost method and (b) the par value method.

2. Give the resulting balance in each one of the stockholders' equity accounts for each method.

3. Assume that on March 30, 1997 all remaining treasury stock shares are retired. Show the journal entries for (a) the cost method, and (b) the par value method.

Answers:

Requirement 1

Requirement (a) Requirement (b)
Cost Method Par Value Method

Debit Credit Debit Credit

To record original sale of 20,000 shares at $50:
Cash (x $50) 1,000,000 1,000,000
Contributed capital in excess of par (x $30) 600.000 600,000
Capital stock, par $20 (10,000 shares) 400,000 400,000

January 15—To record purchase of 50 shares
of treasury stock at $55:
Treasury stock (50 shares)
At cost (50 shares x $55) 2,750
At par (50 shares x $20) 1,000
Contributed capital in excess of par (50 shs x $30) 1,500
Retained earnings 250
Cash (50 shares x $55) 2,750 2,750

March 1—To record sale of 20 shares of treasury
stock at $58:
Cash (20 shares x $58) 1,160
Contributed capital from treasury stock
transactions 60
Contributed capital in excess of par 760
Treasury stock (20 shares x $55), cost
method and (@0 shares x $20) par
method 1,100 400

 

Requirement 2

Cost Method Par Value Method

Shares Amount Shares Amount

Account balances:
Capital stock issued (par $20) 20,000 $400,000 20,000 $400,000

Treasury stock:
At cost, $55 (30) (1,650)
At par, $20 (30) (600)

Contributed capital in excess of par 600,000 599,.260
Contributed capital from treasury
stock transactions 60 -0-
Retained earnings 25,000 24,750
Total . $1,023,.410 $1,023,410

Requirement 3

(a) Entry to retire treasury stock accounted for by cost method:

Capital stock ($20 x 30 shares) 600
Contributed capital in excess of par ($30 x 30 shares) 900
Retained earnings ($5 x 30 shares) 150
Treasury stock 1,650

(b) Entry to retire treasury stock accounted for by par value method:

Capital stock ($20 x 30 shares) 600
Treasury stock 600

P 20-8 Compute Dividends: Five Cases The charter of' Crew Corporation authorized 5,000 shares of 6 percent preferred stock, par value $20 per share, and 8,000 shares of common stock, par value of $50 per share. All of the authorized shares have been issued. In a five-year period, annual dividends paid in chronological order were $4,000. $40,000. $32,000. $5,000. and $36,000, respectively.

Required: Compute the amount of dividends that would be paid to each class of stock for each year under the following separate cases:

Case A—preferred stock is noncumulative and nonparticipating;

Case B—preferred stock is cumulative and nonparticipating;

Case C—preferred stock is noncumulative and fully participating;

Case D-preferred stock is cumulative and fully participating;

Case E—preferred stock is cumulative and partially participating up to an additional 2 percent; also assume that the dividend for year 5 was $42,000 instead of $36300.

 

Answers:

Preferred, 6% Common
Year Total Paid (Par $100,000) (Par $400,000)

Case A—Preferred, noncumulative, nonparticipating:

1 $ 4,000 $ 4,000

2 $ 40,000 $ 6,000 $ 34,000

3 $ 32,000 $ 6,000 $ 26,000

4 $ 5,000 $ 5,000

5 $ 36,000 $ 6,000 $ 30,000

Case B—Preferred, cumulative, nonparticipating:

1 $ 4,000 $ 4,000

2 Arrears $ 2,000 $ 2,000
Current 38,000 6,000 $ 32,000
Total $40,000 $ 8,000 $ 32,000

3 $ 32,000 $ 6,000 $ 26,000

4 $ 5,000 $ 5,000

5 Arrears $ 1,000 $ 1,000
Current 35,000 6,000 $ 29,000
Total $36,000 $ 7,000 $ 29,000

Case C—Preferred, noncumulative, fully participating:

1 Preferred, current $ 4,000 $ 4,000

2 Preferred, current $ 6,000 $ 6,000
Common, to match 24,000 $ 24,000
Balance: preferred 1/5, common 4/5 10,000 2,000 8,000
Total $ 40,000 $ 8,000 $ 32,000

3 Preferred, current $6,000 $6,000
Common, to match 24,000 $ 24,000
Balance: preferred 1/5, common 4/5 2,000 400 1,600
Total $ 32,000 $ 6,400 $ 25,600

4 Preferred, current $ 5,000 $ 5,000

5 Preferred, current $ 6,000 $ 6,000
Common, to match 24,000 $ 24,000
Balance: preferred 1/5, common 4/5 6,000 1,200 4,800
Total $ 36,000 $ 7,200 $ 28,800

 

Preferred, 6% Common
Year Total Paid (Par $100,000) (Par $400,000)

Case D—Preferred, cumulative, fully participating:

1 Preferred, current (partial) $ 4,000 $ 4,000

2 Preferred, in arrears $ 2,000 $ 2,000
Preferred, current 6,000 6,000
Common, to match 24,000 $ 24,000
Balance: preferred 1/5, common 4/5 8,000 1,600 6,400
Total $ 40,000 $ 9,600 $ 30,400

3 Preferred, current $ 6,000 $ 6,000
Common, to match 24,000 $ 24,000
Balance: preferred 1/5, common 4/5 2,000 400 1,600
Total $ 32,000 $6,400 $ 25,600

4 Preferred, current (partial) $ 5,000 $ 5,000

5 Preferred, in arrears $ 1,000 $ 1,000
Preferred, current 6,000 6,000
Common, to match 24,000 $ 24,000
Balance: preferred 1/5, common 4/5 5,000 1,000 4,000
Total $ 36,000 $ 8,000 $ 28,000

Case E—Preferred, cumulative, partially participating up to an additional 2%:

1 Preferred, current (partial) $ 4,000 $ 4,000

2 Preferred, in arrears $ 2,000 $ 2,000
Preferred, current 6,000 6,000
Common, to match 24,000 24,000
Balance: preferred 1/5 (not to
exceed $100,000 x .02 =
$100,000), common 4/5 8,000 1,600 6,400
Total $ 40,000 $ 9,600 $ 30,400

3 Preferred, current $ 6,000 $ 6,000
Common to match 24,000 $ 24,000
Balance, preferred 1/5 (limit
$2,000), common 4/5 2,000 400 1,600
Total $32,000 $ 6,400 $ 25,600

4 Preferred, current (partial) $ 5,000 $ 5,000

5 Preferred, in arrears $ 1,000 $ 1,000
Preferred, current 6,000 6,000
Common, to match 24,000 $ 24,000
Balance, preferred 1/5 (limit
$2,000), common 4/5 11,000 2,000 9,000
Total $ 42,000 $ 9,000 $ 33,000

P 20-9 Treasury Stock, Cost and Par Value Methods Compared: Entries and Account Balances At January 1, 1997, the records of Frazer Corporation provided the following:

Capital stock, par $10, 60,000 shares outstanding $ 600,000
Contributed capital in excess of par 240,000
Retained earnings 160,000

During the year. the following transactions affecting shareholders' equity were recorded:

a. Purchased 1,000 shares of treasury stock at $20 per share.

b. Purchased 1,000 shares of treasury stock at $22 per share.

c. Sold 1,200 shares of treasury stock at $25 per share.

d. Net income for 1997 was $45,000.

State law places a restriction on retained earnings equal to the cost of treasury stock held.

Required:

1. Give entries for each of the above transactions, in parallel columns, assuming application of (a) the cost method and (b) the par value method. Assume FIFO flow for treasury stock.

2. Give the resulting balances in each capital account. Include any required disclosure note related to the treasury stock.

Answers:

Requirement 1

Entries:

Cost Method Par Value Method

a. To record purchase of 1.000
shares of treasury stock at $20:
Treasury stock: At cost ($20) 20,000
At par ($10) 10,000
Contributed capital in excess of par
(1,000 shares x $4) 4,000
Retained earnings 6,000
Cash 20,000 20,000

b. To record purchase of 1,000 shares
of treasury stock at $22:
Treasury stock: At cost ($22) 22,000
At par ($10) 10,000
Contributed capital in excess of
par (1,000 shares x $4) 4,000
Retained earnings 8,000
Cash (1,000 shares x $22) 22,000 22,000

c. To record sale of 1,200 shares of
treasury stock at $25:
Cash (1,200 shares x $25) 30,000 30,000
Treasury stock: At FIFO cost
(1,000 x $20) + (200 x $22) 24,400
At par 12,000
Contributed capital from treasury
stock transactions 5,600
Contributed capital in excess of par 18,000

Cost Method Par Value Method

d. Income summary 45,000 45,000
Retained earnings 45,000 45,000

Requirement 2

Balances in capital accounts:

Cost Par Value
Method Method

Capital stock issued $600,000 $600,000
Contributed capital in excess of par 240,000 250,000 (b)

Less: treasury stock (800 shares x par, $10) (8,000)

Contrib capital from treasury stock transactions 5,600 -0-
Retained earnings (Note A) 205,000 (a) 191,000 (c)

Treasury stock (800 shares x cost, $22) (17,600) ________

Total $1,033,000 $1,033,000

(a) $160,000 + $45,000 = $205,000.

(b) $240,000 - $4,000 - $4,000 + $18,000 = $250,000.

(c) $160,000 - $6,000 - $8,000 + $45,000 = $191,000.

Note A: By state law, the cost of treasury stock held, $17,600, is a restriction (or appropriation) of retained earnings. This amount of retained earnings is not available for dividends as long as this treasury stock is held.

C20-2 Issuance of' Capital Stock to Organizers: Valuation C. Banfield, an engineer, developed a special safety device to be installed in backyard swimming pools: When turned on, it would set off an alarm if anything should fall into the water. Over a two-year period. Banfield's spare time was spent developing and testing the device. After receiving a patent, three of Banfield's friends, including a lawyer, considered plans to produce and market the device, Accordingly. a charter wits obtained, which authorized 200,000 shares of $10 par value stock. Each of the four organizers contributed $20,000, and each received in return 2,000 shares of stock. They also agree that, for other consideration, each would receive 5,000 additional shares. The remaining shares were to be held as unissued stock. Each organizer made a proposal concerning how the additional 5,000 shares would be paid for. These individual proposals were made independently; then the group considered them as a package. The four proposals were:

Banfield: The patent would be turned over to the corporation as payment for the 5,000 shares. An independent appraisal of the patent could not be obtained.

Lawyer: 1,000 shares would be received for legal services already rendered during organization, 1,000 shares would be received as advance payment for legal retainer fees for the next three years, and the balance would be paid for in cash at par.

Friend No. 2: A small building. suitable for operations, would be given to the corporation for the 5,000 shares of stock. It was estimated that $20,000 would be needed for renovation prior to use. The owner estimates that the market value of the building is $750,000 and there is a $580,000 loan on it to be assumed by the corporation.

Friend No. 3: To pay $10,000 cash on the stock and to give a 12 percent (the going rate) interest-bearing note for the total price of $40.000 (subscriptions receivable) to be paid out of dividends over the next five years.

Required: Write it short report answering the following questions.

1. How would the above proposals be recorded in the accounts? Assess the valuation basis for each, including alternatives.

2. What are your recommendations for an agreement that would be equitable to each organizer? Explain the basis for-such recommendations.

Answer:

Requirement 1

To record the proposals (other alternatives are possible):

To record authorization of the capital stock:
Memo entry: Capital stock, par $10, 200,000 shares authorized.

To record the cash sale of stock to the organizers (in four separate transactions):

Cash 80,000
Capital stock, par $10 (8,000 shares) 80,000

Banfield proposal:

Patent 50,000
Capital stock, par $10 (5,000 shares) 50,000

Valuation of the patent is based on the market value of the stock because the organizers have already paid in this amount per share for 8,000 shares in four separate transactions. This $10 per share valuation is debatable because the 8,000 shares may not have been issued to the promoters at market value (from the viewpoint of an outsider, these may not be arm’s length transactions). However, the $10 per share is the best estimate available of market value because so few capital transactions have occurred and no appraisal is available.

Lawyer proposal:

Organization costs (1,000 shares x $10) 10,000
Prepaid legal fees (1,000 shares x $10) 10,000
Cash 30,000
Capital stock, par $10 (5,000 shares) 50,000

This entry is also based on the $10 per share market value for the reasons given above. In most states it is illegal to issue stock for services not yet performed, which, if applicable, means that the equivalent consideration by the lawyer is only $40,000.

Friend #2 proposal:

Building 630,000
Capital stock, par $10 (5,000 shares) 50,000
Mortgage payable, 12% (assumed by the corporation) 580,000

This entry presumes that the building is realistically valued on the basis of the market value of the stock ($10 per share) plus the PV of the mortgage. The $750,000 estimate by the owner is questionable because there is no evidence that it was an independent appraisal. However, the cost principle has been observed by recognizing cost as the sum of the market value of the stock (as explained above) plus the present value of the debt. This rationale aside, the "friends" should insist on an independent appraisal.

Friend #3 proposal:

Cash 10,000
Subscriptions receivable (12% interest-bearing note) 40,000
Capital stock subscribed 50,000

This proposal is sound in all respects and meets the requirements of the cost principle; the "going interest rate was appropriately used. However, the proposal "to be paid out of dividends" is a problem under GAAP; nothing is stipulated about what happens if dividends are deficient.

Requirement 2

An equitable recommendation that conforms with GAAP is:

1. Establish a $50,000 value to be paid by each party, because:

(a) a market value of $10 per share has already been set as a good measure by the prior transactions (see comments above under Banfield), and

(b) Friend #3 has established a sound GAAP basis for $10 per share

2. Banfield—The $50,000 valuation on the patent is suspect. Insist upon two independent appraisals of this patent—there are competent experts available. Insist upon cash or a note (like Friend #3) for any difference between the appraisal and the $10,000 to be paid in.

3. Lawyer—Do not accept the $10,000 prepaid legal fees. Insist upon cash or a note like the one proposed by Friend #3. Ascertain that the past legal fees are competitive.

4. Friend #2—Insist upon two independent appraisals. If the appraisals are lower than $630,000, require cash, or a reduction of the loan assumed, for the difference.

5. Friend #3—Accept as is, except insist upon deletion of the stipulation "to be paid out of dividends because (a) nothing is said about the responsibility for payment if dividends are inadequate, and (b) it places an undue, and probably illegal, constraint on the board of directors in the future.

 

A20-3 Owners’ Equity Statement, Stuck Issue Costs Gtech Holdings Corporation is a computer and communications services company. Its consolidated statements of shareholders’ equity for the three-year period ending February 27, 1993, follow:

Additional Retained

Common Stock Paid-In Earnings Treasury

(Dollars in thousands) Shares Amount Capital Other (deficit) Stock Total

Balance at February 24, 1990 30,060,003 $301 $ 22,199 $(6,978) $(4,281) $ 11,241
Common stock issued 4,529,040 45 3,345 3,390

Common stock issuance cost (182) (182)
Purchase of 40,090 shares of common
stock $ (30) (30)
Net loss (3,986) (3,896)

Foreign currency translation 734 734

Balance at February 23, 1991 34,589,043 346 25,362 (6,244) (8,267) (30) 11,167

Common stock issued 133,60 1 99 100
Common stock issued under stock
award plans 1,570,999 16 6,109 6,125
Net income 13,862 13,862

Foreign currency translation (539) (539)

Balance at February 29, 1992 36,293,642 363 31,570 (6,783) 5,595 (30) 30,715

Purchase of 73,463 shares of
common stock (113) (113)
Common stock issued 5,900,000 59 90,294 90,353
Common stock issued under stock
award plans 765,867 8 8,747 8,755
Tax benefits from stock compensation 17,467 17,467
Net income 21,694 21,694

Foreign currency translation _________ ___ _______ (816) ______ ___ (816)

Balance, February 27, 1993 42,959,509 $430 $148,078 $(7,599) $27,289 $(143) $168,055

Required:

1. What is the par value of Gtech common stock?

2. During the fiscal year ending February .13. 1991, Gtech issued 4,529,040 shares of common stock. Describe how the stock issue costs were accounted for. Is there an acceptable alternative treatment? If so. describe it. What were the net proceeds from the issuance? What were the net proceeds per share?

3. What was the average price per share paid for treasury stock acquired during 1990? How is treasury stock accounted for by Gtech?

4. What is the book value per share of Gtech at February 23, 1991 ? At February 27, 1993? Briefly describe why book value per share changed so much from February 23, 1992, to February 27, 1993.

5. What was the average price per share paid for common shares acquired during the year ending February 27, 1993? What were the average proceeds per share for shares issued, other than those issued under stock award plans, during the year ending February 27, 1993? List any possible reasons why these amounts might differ greatly.

Answers:

Requirement 1

Par value per share = $301,000/30,060,003 shares = $0.01

Requirement 2

The stock issue costs were essentially deducted from the gross proceeds of the stock issuance. The statement shows a two-transaction approach, with gross proceeds being recorded first, then the stock issue costs being deducted from additional paid-in capital. The net proceeds from the stock issue are:

Gross proceeds:
Common stock, par value $ 45,000
Additional paid-in capital 3,345,000 $3,390,000
Less: stock issue costs 182,000
Net proceeds $3,208,000

Proceeds per share = $3,208,000/4,529,040 = $0.71

Requirement 3

Purchase price per share = $30,000/40,090 shares = $0.75

Gtech is using the cost method to account for treasury stock.

Requirement 4

Book value per share at February 23, 1991:

$11,167,000/(34,589,043 – 40,090) = $0.32 per share

Book value per share at February 27, 1993:

$168,055,000/(42,959,509 – [40,090 + 73,463]) = $3.92 per share

Book value per share has increased more than tenfold over the two-year period. The primary source of the increase is not in the profitability of the firm, but rather the issuance of 5,900,000 shares for more than$90.0 million, an average price of $15.31 per share.

Requirement 5

The average price per share paid for treasury stock acquired during fiscal 1993 was:

$113,000/73,463 shares = $1.54 per share

The average proceeds per share for shares issued in 1993 were:

($59,000 = $90,294,000)/5,900,000 shares = $15.31 per share

The large difference between the cost of treasury stock and proceeds per share for newly acquired issues is difficult to explain. Possible reasons include:

h Gtech has developed a product or made a discovery such that future prospects for the company’s profitability have skyrocketed between the date the shares were acquired and the shares issued.

h Some contingency (such as a major lawsuit) is resolved in favor of Gtech.

CHAPTER 21
CORPORATIONS: RETAINED EARNINGS AND STOCK OPTIONS

1. Explain what an appropriation of retained earnings is, and why it is. made.

Answer: An appropriation of retained earnings reduces the amount of retained earnings available for dividends. Appropriations are established to protect the cash position of the corporation by reducing the amount of cash dividends that might otherwise be paid. To the extent that the amount of cash dividends is reduced because of inadequate retained earnings. cash is saved.

2. What are the principal sources and uses of retained earnings?

Answer: The principal source of retained earnings is income from operations (including extraordinary gains). The primary uses of retained earnings are cash dividends. stock dividends, recapitalizations, retirement of stock and treasury stock transactions, and absorption of losses.

4. What are the four important dates relative to dividends? Explain the significance of each.

Answer: Accounting for dividends involves four important dates: (1) declaration date; (2) record date; (3) ex dividend date, and (4) payment date. The declaration date is the date on which the corporation formally announces the dividend. As to cash and property dividends, it is the date on which the dividend becomes irrevocable; therefore. on this date the dividends are recorded in the accounts. The record date is the date on which the list of stockholders of record is prepared. No entry is made in the accounts on this date. The ex dividend date is the day following the record date. On this date, stock prices typically fall by the amount of the cash dividend. This is important because it provides an empirical basis for the theoretical claim that dividend revenue is earned on the date of declaration rather than on the date of record or on the payment date. The payment date is the date on which the dividend is paid. On this date, an entry is made for the disbursement of cash or other assets in payment of the dividend.

7. Explain the difference between intentional and unintentional liquidating dividends.

Answer: Intentional liquidating dividends occur when the board of directors declares dividends which they know will constitute a return of contributed capital to the stockholders, as in the case when the corporation is discontinuing operations or where there is excessive capitalization. Unintentional liquidating dividends occur when net income. and as a result retained earnings, is overstated through error or omission. For example, the omission or understatement of depreciation charges, amortization, and depletion charges would cause retained earnings to be overstated. In such cases, if reported retained earnings (prior to correction) were used in full as a basis for dividends, part of the resulting dividend would represent a return of contributed capital (i.e., an unintentional liquidating dividend).

11. Contrast the effects of a stock dividend (declared and issued) versus a cash dividend (declared and paid) on assets. liabilities, and total stockholders’ equity.

Answer: Total Stockholders'
Dividend Assets Liabilities
Equity

Cash Decrease No effect Decrease
Stock No effect No effect No effect

12. Contrast the effects of a typical small stock dividend (declared and issued) versus a typical cash dividend (declared and paid) on the components of stockholders' equity.

Answer: Capital Additional Contributed Retained
Dividend Stock
Capital Earnings

Cash No effect No effect Decrease
Stock, small Increase Increase Decrease

14. Distinguish between a large stock dividend and a pure stock split.

Answer: A stock dividend involves the issuance of additional shares of stock to the stockholders in proportion to the shares that they held prior to the dividend. It reduces retained earning. and increases contributed capital by the same amounts, but does not change total stockholders equity. In contrast. a pure stock split involves the replacing of the old shares with a larger number of new shares with a proportionately lower par value per share. A pure stock split does not change the components or total of stockholders’ equity. Neither a stock dividend nor a stock split requires the disbursement of corporate assets; both reduce earnings per share.

15. What are the primary reasons for appropriating and for restricting retained earnings?

Answer: Fundamentally. retained earnings are appropriated and restricted to indicate that such amounts are not available for dividends during the period of appropriation or restriction, thereby protecting the working capital position of the corporation. However, such appropriations and restrictions arise for a number of reasons. The primary reasons are:

(a) To fulfill a legal restriction.

(b) To fulfill a contractual restriction.

(c) To record a discretionary action by the board of directors to appropriate a portion of retained earnings as an aspect of financial planning.

(d) To record a discretionary action by the board of directors to appropriate a portion of retained earnings in anticipation of possible future losses.

16. Explain the distinction between (a) a bond sinking fund and (b) an appropriation of retained earnings for a bond sinking fund.

Answer:

(a) A bond sinking fund is created by depositing cash in a special fund (like a savings account) and recording it in a separate account as an investment. Usually the fund is under the control of a trustee; the fund is an asset and is used at maturity to retire bonds.

(b) A restriction of retained earnings for a bond sinking fund is a constraint on retained earnings; it does not directly involve assets nor does it change total stockholders' equity. The amount is temporarily restricted from paying dividends; therefore, it serves to protect working capital by preventing a noncurrent drain on cash for dividends. It provides a measure of security to the bondholders.

20. What is the difference between stock rights and stock warrants?

Answer: Stock rights—provide the holder with an option to acquire a specified number of shares of the capital stock of a company under specified conditions. Stock warrants—a certificate that evidences ownership of one or more stock rights.

22. List the three important dates with respect to stock rights. When will the related stock sell (a) rights on and (b) ex rights?

Answer: Rights—important dates and market status:

(a) Announcement date

(b) Issuance date Stock sells-rights on

(c) Expiration date Stock sells-ex rights

25. Stock option incentive plans for employees may be either noncompensatory or compensatory. Briefly explain each.

Answer: A noncompensatory plan is one that does not involve additional compensation to the grantee and involves no cost to the corporation. It is characterized by the following four attributes: (1) substantially all full-time employees who meet the limited employment qualifications may participate (employees owning a specified percent of the outstanding shares and executives may be excluded), (2) stock is offered to those eligible equally or based on a uniform percentage of salary or wages (the number of shares of stock purchased by an employee may be limited), (3) the time permitted for exercise of an option or purchase right is limited to a reasonable period, and (4) the discount from market price is no greater than would be reasonable in an offer of stock to stockholders or other outside parties (the discount varies up to 15 percent in practice).

All plans not possessing all four of the above attributes are classified as compensatory. They involve a cost to the corporation and additional compensation to the employee.

30. What are stock appreciation right?

Answer: Stock appreciation rights (SARs) usually provide a cash bonus to the employee (grantee) based upon the change in the market value of specified shares of capital stock from the date of grant to the exercise date.

31. Discuss how SFAS No. 123. "Accounting, for Stock-Based Compensation," differs from APB Opinion No. 25 in recording the compensation cost of fixed stock options with the exercise price set equal to the grant-date market price of the stock.

Answer: Under APB Opinion No. 25, the cost of fixed options is measured at the market price of the option stock as of the grant date. less the exercise price. multiplied by the number of shares. When the exercise price is equal to the current stock price. the cost (which would normally be expensed over the service period) is zero. Under the procedures specified in SFAS No. 123, the cost of options is determined at the grant date using an option pricing model. In every case. including options granted with exercise prices equal to or even greater than the current stock price. the cost will be greater than zero. SFAS No. 123 increases the measured value of the options, resulting in increased compensation expense.

E 21-2 Property Dividend Recorded: Common and Preferred Stock The records of Frost Corporation showed the following at the end of 1998:

Preferred stock, 6 percent cumulative. Nonparticipating, par $20 $200,000
Common stock, no par value (50,000 shares issued and outstanding) 240,000
Contributed capital in excess of par. preferred stock 30,000
Retained earnings 125,000
Investment in stock of Ace Corporation (500 shares at cost) 10,000

The preferred stock has dividends in arrears for 1996 and 1997. On January 15, 1998, the board of directors approved the following resolution: "The 1998 dividend, to stockholders of record on. February 1, 1998, shall be 6 percent on the preferred stock and $1.00 per share on the common stock; the dividends in arrears are to be paid on March 1. 1998, by issuing a property dividend using the requisite amount of Ace Corporation stock. All current dividends for 1998 are to be paid in cash on March 1. 1998." On January 15, 1998, the stock of Ace Corporation was selling at $60 per share, on February 1,. at $61 per share, and at $62 on March 1. 1998.

Required:

1. Compute the amount of the dividends to be paid to each class of stockholders, including the number of shares of Ace Corporation stock and the amount of cash required by the declaration. Assume that divisibility of the shares of Ace Corporation poses no problem.

2. Give the journal entries to record all aspects of the dividend declaration and its subsequent payment.

Answer:

Requirement 1

(a) Number of Ace Corporation shares required for the dividends in arrears:

$200,000 x .06 x 2 years = $24.000
$24,000 $60 per share = 400 shares of Ace Corporation stock required for the property dividend to preferred stockholders (in arrears).

(b) Cash dividends for the current year:

Preferred: $200,000 x .06 = $12,000
Common: 50.000 shares x $1.00 = 50,000
Total cash required $62,000

Requirement 2

January 15. 1998-declaration date:

Investment-Ace Corporation [400 shares x ($60 - $20)] 16,000
Retained earnings ($24,000 + $62,000) 86,000
Gain on disposal of stock of Ace Corporation 16,000
Cash dividends payable 62,000
Property dividends payable (Ace Corporation shares) 24,000

March 1. 1998-payment date:

Properly dividends payable 24,000
Cash dividends payable 62,000
Investments-Ace Corporation (400 shares x $60) 24,000
Cash 62,000

Note: The relevant market value of the Ace stock is at the date the dividend liability becomes effective, that is, the declaration date.

E 21-6 Stock Dividend Recorded: Dates Cross Two Periods The records of Round Corporation showed the following balances on November 1. 1998:

Capital stock, par $10 $300,000
Contributed capital in excess of par 102,000
Retained earnings 200.000

On November 5, 1998. the board of directors declared a stock dividend to the stockholders of record as of December 20, 1998, of one additional share for each five shares already outstanding; issue date, January 10, 1999. The market value of the stock immediately after the issuance was $18 per share. The annual accounting period ends December 31.

Required:

1. Give entries in parallel columns for the stock dividend assuming, for problem purposes, Case A-market value is capitalized; Case B-par value is capitalized. and Case C-average paid in is capitalized.

2. Explain when each value in (1) should be used.

3. With respect to the stock dividend, what should be reported on the balance sheet at December 31, 1998, assuming no intervening dividend transactions?

Answer:

Requirement 1

November 5, 1998- Declaration date of stock dividend: Memo entry only or entry (optional).

December 20, 1998--Record date; no entry; obtain fist of shareholders of record

December 31, 1998-End of accounting period; no entry.

January 10, 1999-Issue date:* Amount Capitalized

Case A Case B Case C
Market Value Par Value Average Paid In

Retained earnings 108,000 60.000 80,400

Capital stock, par $10
(6,000 shares) 60.000 60,000 60,000

Contributed capital in excess
of par 48.000 20.400

* $300,000 $10 = 30,000 shares; 30,000 shares 5 = 6,000 shares issued as a stock dividend.

Capitalize: Market value: 6,000 shares x $18 = $108,000.

Par value: 6,000 shares x $10 = $60,000.

Average paid in: $402.000 30,000 shares = $13.40.

6.000 shares x S 13.40 = $80.400.

Requirement 2

Market value should be used when there is a "small" stock dividend; that is, when the issuance of additional shares is not over 20 percent to 25 percent of the outstanding shares prior to the dividend. A small stock dividend is believed to usually have a relatively small impact on the market price per share.

Par value should be used when there is a "large" stock dividend. that is. when the issuance of additional shares is over 20 percent to 25 percent. It is believed that a large dividend usually is reflected in an approximate proportional effect on the market price per share. In the fact situation given, this method could not be used.

Average paid in, if no less than the statutory minimum, sometimes is used by management because it meets the legal minimum and maintains the "average paid in" per share.

Requirement 3

At the end of 1998, the only requirement is a disclosure note that explains the stock dividend: it is not a liability. If "common stock issuable" is recorded on the declaration date. it would be reported under stockholders' equity as a credit (the disclosure note also should be provided).

E21-8 Stock Dividend and Stock Split: Effects Compared Bailey Corporation has the following stockholders' equity:

Capital stock, par $12; 20,000 shares outstanding $240,000
Contributed capital in excess of par 70,000
Retained earnings 500,000
Total stockholders' equity $810,000

The corporation decided to triple the number of shares currently outstanding (to 60,000 shares) by taking one of the following alternative and independent actions:

a. Issue a 200 percent (2-for-1) stock dividend (40,000 additional shares) and capitalize retained earnings on the basis of par value.

b. Issue a pure stock split (3-for-1, that is, three new shares are issued for each old share replaced) by changing par value per share proportionately.

c. Issue a 3-for-1 stock split and change the par value per share to $5.

Required:

1 . Give the journal entry that should be made for each alternative action. If none is necessary, explain why. On the stock splits. tile old shares are called in and the new shares are issued to replace them.

2. For each alternative. prepare a schedule that reflects the stockholders' equity immediately after the change. For this requirement. complete the following schedule that compares the effects of the three alternative actions:

Before Stock Pure Stock Stock Split
Item Change Dividend Split (par $4) (par $5)

Shares/par value
Capital stock $ $ $ $
Additional paid-in capital in excess of par
Total contributed capital
Retained earnings
Total stockholders' equity $ $ $ $

Be prepared to explain and compare the effects among the four columns in the above schedule.

Answers:

Requirement 1

a. Stock dividend (20,000 shares x 2.00 = 40,000 additional shares):
Retained earnings (40,000 shares x $12) 480,000
Capital stock. par $12 (40,000 shares) 480,000

b. Memo entry only because none of the components of stockholders' equity changed, except number of shares increased; the 20,000 old shares were called in and replaced with 60,000 new shares, and par value changed from $12 to $12 3 = $4 per share. Legal capital is 60,000 shares x $4 per share = $240,000, as before.

c. Stock split 20,000 old shares called in x 3 = 60,000 new shares; par changed from $12 to $5 per share.

Entry to reflect new legal capital amount in the capital stock account:

Capital stock, par $12 (20,000 old shares) 240,000
Contributed capital in excess of par 60,000 *
Capital stock, par $5 (60,000 new shares) 300,000

* (60,000 shares x $5 = $300,000) - (20,000 shares x $12 = $240,000) = $60,000 debit.

Requirement 2

Before Stock Pure Stock Stock Split
Item Change Dividend Split (par $4) (par $5)

Shares/par value 20,000/$12 60,000/$12 60,000/$4 60,000/$5

Capital stock $240,000 $720,000 $240,000 $300,000
Additional paid-in capital in excess of par 70,000 70,000 70,000 10,000
Total contributed capital 310,000 790,000 310,000 310,000
Retained earnings 500,000 20,000 500,000 500,000
Total stockholders' equity $810,000 $810,000 $810,000 $810,000

E21-12 Employee Stock Purchase Plan—Compensatory or Noncompensatory? Entries Rice Corporation has a stock purchase plan with the following provisions:

Each full-time employee with a minimum of one year's service may acquire. from Rice Corporation, its common stock, par $10, through payroll deductions at 10 percent below the market price on the date selected by the employee for a stock purchase (the exercise date). The exercise decision must be made within one year from the payroll deduction date.

Assume Rice Corporation uses APB Opinion No. .25 as its method to account for stock-based compensation plans. Employee H. Adams signed a payroll deduction form on January 1, 1997, for $60 per month. At that date, the market price of the stock was $27. Assume a monthly salary of $2,000 and other payroll deductions in the aggregate of 18 percent. At the end of 1997, Adams requested that stock be purchased equal to the amount accumulated to Adams' credit. A that ate, the market price of the stock was $25.

Required:

1. Is this a compensatory plan under APB Opinion No. 25.` If so. how much should be recorded as additional compensation for Adams? Explain.

2. How many shares will Adams acquire for the 1997 deductions? Show computations.

3. Give entries to record (a) one monthly payroll and (b) issuance of the shares for the year, assuming unissued shares are used.

4. If Rice Corporation were using SFAS No. 123, would this plan result in compensation cost? Why or why not?

Answers:

Requirement 1

Under APB Opinion No. 25, the plan is noncompensatory because there is no additional expense to the company and there is no additional compensation income to the employee. It meets the following criteria: (1) substantially all full-time employees may participate ("each full-time employee"). (2) the stock is offered to each eligible employee equally, (3) the exercise time is limited to a reasonable period, and (4) the discount of 10 percent is reasonable to offset selling costs. Adams will receive no additional compensation because the discount from market approximates a reasonable commission on security transaction. Therefore, this is not considered additional compensation.

Requirement 2

Adams is entitled to 32 shares computed as follows:

$60 per month x 12 months = $720 total credit to Adams.
$25 x .9 = $22.50.
$720 $22.50 = 32 shares.

Requirement 3

(a) Monthly payroll (each month):
Salary expense (given) 2.000
Liability-Employee stock purchase plan (given) 60
Other (deductions) payables ($2,000 x .18) 360
Cash 1,580

(b) Issuance of the shares (Dec. 31, 1997):
Liability—Employee stock purchase plan ($60 x 12) 720
Common stock, par $10 (32 shares) 320
Contributed capital in excess of par 400

Requirement 4

It is likely that this plan would result in a positive amount of compensation cost under SFAS No. 123. First, the stock can be acquired at a 10% discount, and under SFAS No. 123 the discount mentioned for a plan to qualify as noncompensatory is 5%. SFAS No. 123 does provide for the possibility of the 10% qualifying for noncompensatory status by noting that the 5% discount is considered to comply without further justification, thus implying that a higher discount may qualify if justified. The justification would be on the basis that stock with discounts of this size would be issued to shareholders, or that the discount is less than the amount of stock issue costs in a public offering.

If the 10% discount were to be justified, the plan still would not qualify as a noncompensatory plan. The employee has an option to exercise the option within one year of the payroll deduction date, turning this into an option with an exercise period greater than 31 days.

E 21-13 Stock Incentive Plan—APB Opinion No. 25: Analysis :and Entries Rex Corporation is authorized to i 300,000 shares of common stock, par $ 1, of which 140,000 shares have been issued. The corporation initiated a stock bonus plan during 1998 for designated managers. Each manager will receive stock options to purchase 1,000 shares of Rex common stock,. and the options vest with thc grantee if still employed by the company . two years from the date of grant. The rights are nontransferable and expire after December 31, 2002. The option price is $20 per share; the market price on the date of grant was $24. Assume that manager Ruth Roe receives the stock options on January 1, 1998.

Rex uses APB Opinion No. 25 to account for stock-based compensation plans.

Required:

1. Is this a noncompensatory plan? Explain.

2. What the measurement date? Explain.

3. What is the amount of total compensation cost for manager Roe?

4. Over what period should this compensation cost be assigned as expense? How much should be assigned to 1998 and 1999? Explain.

5. What entry should be made on the date of grant to Roe?

6. What entry should be made on December 31, 1998 for Roe?

7. Give the entry to record the exercise of the option by Roe on December 31, 2002, when the market price of the common stock was $80 per share.

8. How much actual value did manager Roe receive? How much additional compensation expense did Rex Corporation report?

Answers:

Requirement 1

This is a compensatory plan because it involves additional compensation to the grantees and a cost to the corporation. It does not meet 3 of the 4 characteristics of a noncompensatory plan: (1) it is not applicable to all employees, (2) all employees are not given a uniform percentage, and (3) the price discount is significant (more than 15%).

Requirement 2

He measurement date is the date of grant, January 1. 1998, because it is the date that both (a) the number of optional shares that the managers are entitled to receive (1,000), and (b) the option price ($20) are known.

Requirement 3

The total compensation cost for each manager is: ($24 - $20) x 1,000 shares = $4,000.

Requirement 4

Total compensation cost should be assigned as expense equally over the two-year service period from January 1, 1998, through December 31, 1999; that is. $4,000 2 years = $2,000 per year.

Requirement 5

On date of grant, January 1, 1998—Measurement date:
Deferred compensation expense ($24 - $20) x 1,000 shares 4,000
Executive stock options outstanding (for 1,000 shares of
common stock) 4,000

Requirement 6

December 31, 1998—Adjusting entry:
Executive compensation expense ($4,000 5 years) 2,000
Deferred compensation expense 2,000

Requirement 7

December 31, 2002—Exercise of stock options:
Cash (1,000 shares x $20) 20,000
Executive stock options outstanding 4.000
Common stock, par $1 (1,000 shares) 1,000
Contributed capital in excess of par 23,000

Requirement 8

"Actual value" received by Roe (grantee):
($80 - $20) x 1,000 shares = $60,000.

Additional compensation expense reported by Rex Corporation (grantor):
($24 - $20) x 1,000 shares = $4,000.

E21-14 Stock Incentive Plan—SFAS No. 123: Analysis and Entries Assume-all the data given in Exercise 21-13 with the following modifications and additional facts:

• Rex Corporation used SFAS No. 123 to account for stock-based compensation plans.

• Using an option pricing model and management estimates for input factors. the fair value of the options granted to Ms. Roe is computed to be $12 per option.

• Ignore income tax considerations.

Required:

1. Compute the estimated total amount of compensation cost for the -grant made to Ms. Roe.

2. What entry should be made on the date of the grant?

3. What entry should be made at December 31. 1998?

4. Give the entry to record the exercising of the options held by Ms. Roe on December 3 1. 2002.

ANSWERS

1. The estimated total compensation cost = fair value of an option x number of options expected to vest.

Total compensation cost = $12 x 1,000 options = $12,000.

2. No entry is made on the grant date. Unlike APB Opinion No. 25, which would record the compensation as a deferred compensation and treat as a component of stockholders' equity, SFAS No. 123 records the compensation cost as it is earned by the employee.

3. The service period is 2 years; thus one-half of the estimated compensation cost is recognized in 1998:

Compensation cost (expensed) 6,000
Additional paid-in capital—stock options 6,000

(Note: This entry would be repeated in 1999, assuming Ms. Roe is still employed by Rex.)

4. Entry to record the exercising of the options for 1.000 shares at an exercise price of S20:

Cash (1,000 x $20) 20.000
Additional paid-in capital—stock options 12,000
Common stock, at par 1,000
Additional paid-in capital—common stock 31,000

E21-17 Stock Appreciation Rights—APB Opinion No. 25: Analysis. Estimates and Entries On January 1, 1997, Kelly Corporation established a stock appreciation rights plan that offers to selected executives rights (SARs) that can be redeemed for cash equal to the difference between the market price of the company's common stock at grant date and market price at the first exercise date. The rights can be exercised three years from grant date and expire four years from grant date or when employment is terminated, if earlier. The service period is considered to be three years because exercise is expected (highly probable) to occur on December 31, 1999.

Executive Brown was granted 2,000 SARs on January 1, 1997 (when the common stock price was $20) and exercised the rights on December 31, 1999. Relevant market prices at year-end on Kelly common stock were 1997, $23; 1998, $27; 1999, $30; and 2000, $26.

Assume Kelly Corporation uses the intrinsic-value method of APB Opinion No. 25 to account for its stock-based compensation plan.

Required:

1. Answer the following questions:

a. Is this plan compensatory? _____ Yes _____ No

b. The measurement date is ____________________

c. The service period is _______________________

d. Total compensation cost is $ _________________

e. Total cash paid by grantor to grantee is $ ______________

2. Give the appropriate journal entries from January 1, 1997, through December 31, 1999.

Answers:

Requirement 1

(a) Yes, compensatory because it is not available to all employees.

(b) Measurement date—exercise date—expected (highly probable) to occur on December 31, 1999.
Measurement date is after the date of grant.

(c) Service period—3 years (from grant date, January 1, 1997; to exercise date expected, December 31, 1999).

(d) ($30 - $20) x 2,000 SARs = $20,000 total compensation expense.

(e) $20,000 cash paid (same as total compensation expense).

Requirement 2

January 1, 1997-Date of grant:
Memo entry only.

December 31, 1997—To record estimated compensation expense:
Compensation expense 2,000
Stock appreciation plan liability 2,000
[($23 - $20) x 2,000 SARs = $6,000] 3 years = $2,000 per year.

December 31. 1998-To record estimated compensation expense:
Compensation expense 7,332
Stock appreciation plan liability 7,332
[($27 - $20) x 2,000 SARs] = $14,000 total

$14,000 3 years = $4,666 per year $4,666
Add 1994 catchup, $4,666 - $2,000 2,666
Total $7,332

December 31, 1999--To record actual compensation expense and exercise:
Compensation expense 10,668
Stock appreciation plan liability 10.668
($30 - $20) x 2,000 SARs = $20,000 total.

$20,000 3 years = $6,666 per year $6,666
Catchup: Year 1997, $6,666 - $2.000 4,666

Year 1998: $6,666 - $7,332 (664)

Total $10,668

* Rounded to come out even.

Total compensation expense recorded:
$2,000 + $7,332 + $10.668 = $20,000.

Exercise:
Stock appreciation plan liability ($2,000 + $7,332 + $10,668) 20,000
Cash [($30 - $20) x 2,000 SARs] 20,000

E21-14 Stock Incentive Plan—Lapse of Rights: Analysis and Entries Stacy Corporation offered a stock option incentive plan to six of its top executives. During the second year from date of grant, but prior to the permissible exercise date, one of the six executives resigned and accepted employment with a competitor. In accordance with the provisions of the incentive plan, the stock option for the resigned executive lapsed. At the date of lapse, the relevant account balance for all six executives combined were deferred compensation expense, $675,000; and executive stock options outstanding, $900,000. The service period extends for three more years, including the second year.

Required:

1 . Briefly explain what account treatment should be accorded the one-sixth of these balances that relate to the one resigned executive.

2. Give all journal entries directly related to the lapsed options.

Answers:

Requirement 1

The credit difference between these two accounts, that relates to the resigned executive, should be a reduction of compensation expense as a change in accounting estimate for the current and any relevant future periods.

Requirement 1

(1) To clear the two relevant accounts:
Executive stock options outstanding ($900,000 x 1/6) 150,000
Deferred compensation expense ($675,000 x 1/6) 112,500
Accrued lapse expense, stock options* 37.500

(2) To assign the lapse difference to the current and future periods

Year 2 Year 3 Year 4

Accrued lapse expense 12,500 12,500 12,500
Compensation expense,
stock options 12,500 12,500 12,500

$37,500 3 = $12,500.

* A longer, but more descriptive title would be "Accrued compensation expense due to lapse of stock options." This account would be reported in stockholders' equity as a contra account to Deferred compensation cost.

Alternatively, Deferred compensation cost could be credited for the $150,000 in this entry, which avoids setting out as a separate amount ($37,500). Proper amortization would produce the same results as above. The alternative entries would be as follows:

(1) Executive stock options outstanding 150,000
Deferred compensation cost 15,000

(2) Compensation expense [($675,000 - $150,000 = $525,000)
3 years] 175,000
Deferred compensation cost 175,000

Both methods produce the following results:

Year 2 Year 3

Income statement:
Compensation expense $175,000 $175,000

Balance Sheet:
Deferred compensation cost (net) 350,000 175,000

P21-4 Cash and Stock Dividends—Fractional Shares: Entries and Reporting On December 31. 1997. the accounts for Quality Food Corporation (QFC) showed the following balances:

Stockholders' Equity

(in thousands)

Preferred stock, 7 percent. par value $25, noncumulative, authorized 20,000(XX) shares,
Outstanding 16,000 shares $400
Common stock, nopar, stated value $10, authorized 40,000 shares, outstanding 24,000 shares 240
Additional paid-in capital. Preferred 30
Additional paid-in capital. Common 60
Retained earnings 350

During, 1998, the following transactions, in order of date, were recorded relating to the capital accounts:

a. Apr.1 A stock dividend was issued whereby (1) each holder of 10 preferred, shares received 1 share of common stock and (2) each holder of 6 shares of common stock received 1 additional share of common. The market price of the common stock was $15 per share immediately after issuance of the stock dividend. In the issuance of the stock dividend. 5,400 shares of common stock and 1,000 fractional share rights were issued. Each fractional share right represents one-tenth of a share of stock.

b. Nov. 1 All of the richts were redeemed except 200, which remained outstanding.

c. Dec. 15 A 7 percent cash dividend on the preferred shares and a $2.00 per share dividend on the common shares were declared and paid.

d. Dec. 31 Reported net income was $140,000.

Required:

1. Give the journal entries for each of the above transactions during 1998.

2. Prepare the stockholders' equity section of the balance sheet at December 31, 1998.

3. Assume QFC paid cash to the stockholders in lieu of issuing fractional share rights. The cash distribution was based on the market value of $15 per common share. Give the entry on April 1, 1998 to record the dividend transaction. What would be the total stockholders' equity of QFC on December 31. 1998, in this situation if all-other factors remain as they were eiven above'?

Answers:

Requirement 1

(a) April 1, 1998—Issuance o(the stock dividend:
Retained earnings (5,600 shares x $15) 84,000
Common stock, no par, stated value $10 (5,400 shares x $10) 54,000
Common stock rights outstanding (for 200** shares x $10) 2,000
Contributed capital in excess of stated value, common (5600 x $5) 28,000

* Computation of shares for the stock dividend:
Preferred, 16,000 shares 10 = 1,600 shares
Common, 24,000 shares 6 = 4,000 shares
Total common shares to be issued
as stock dividend 5,600 shares

** Shares issued—5,400 (given)
Rights issued—2,000 10 = 200 shares to be issued upon surrender of rights

(b) November 1, 1998—Redeemed 1,800 rights:
Common stock rights outstanding [(2,000 - 200) 10 = 180 shares] 1,800
Common stock, no par (180 shares x $10) 1,800

(c) December 15, 1998—Declared and paid cash dividend:
Retained earnings 57,580
Cash dividends payable, preferred 28,000
Cash dividends payable, common 29,580

Computation:
Preferred: 16,000 shares x $25 x .07 = $28,000
Common (24,000 + 5,400 + 180) =
(29,580 shares) x $2.00 = 59,160
Total $87,160

Cash dividends payable, preferred 28,000
Cash dividends payable, common 59,160
Cash 87,160

(d) December 31, 1998:
Income summary 140,000
Retained earnings 140,000

Requirement 2

Stockholders' Equity—December 31, 1998

Contributed Capital:
Capital stock:
Preferred stock, 7%, $25 par value, noncumulative, authorized
20,000 shares, issued and outstanding 16,000 shares $400,000
Common stock, no par, stated value $10 per share, authorized
40,000 shares, issued and outstanding, 29,580 shares
[(24,000 + 5,400 + 180 = 29,580) x $10] 295,800
Common stock rights outstanding (200 10 = 20 shares x $10) 200
Total 696,000
Other contributed capital:
In excess of par, preferred stock $30,000
In excess of stated value, common stock ($60,000 + $28,000) 88,000 118,000
Total Contributed Capital 814,000

Retained earnings ($350,000 - $84,000 - $87,160 + $140,000) 318,840
Total Shareholders' Equity $1,132,840

Requirement 3

April 1, 1998—Issuance of stock dividend:
Retained earnings (5,600 shares x $15) 84,000
Common stock (5,400 shares x $10) 54,000
Contributed capital in excess of stated value (5,400 shares x $5) 27,000
Cash (2,000 10 = 200 shares x $15) 3,000

December 31, 1998—Stockholders' equity:
Contributed capital:
Preferred stock, as above $400,000
Common stock [(24,000 = 5,400 shares) x $10] 294,000
Contributed capital in excess of par, preferred stock $30,000
Contributed capital in excess of par, common stock
($60,000 + $27,000) 87,000 117,000
Retained earnings, as above 318,840
Total Stockholders' Equity $1,129,840

The difference is $3,000 ($1,132,840 - $1,129,840), the amount of the asset reduction in the April 1 entry immediately above. where fractional share rights were paid in cash and not converted into shares of common stock.

C21-4Appendix: Quasi Reorganization Marks Corporation, a medium-size manufacturer, has experienced operating losses for the past five years. Although operations for the current year ended also resulted in a loss, several important changes made the fourth quarter a profitable one; as a result. future operations of the company are expected to be profitable.

The treasurer suggested a quasi reorganization to (a) eliminate the accumulated deficit of $325,000 in retained earnings. (b) write up the $600,000 cost of operating land and buildings to their current market value of $800.000, and (c) set up an asset of $175,000 representing the estimated future tax benefit of the losses accumulated to date.

Required:

1. What are the characteristics of a quasi reorganization?

2. List the conditions under which a quasi reorganization would generally be justified.

3. Discuss the propriety of the treasurer's proposals to do the following:

a. Eliminate the deficit of $325,000.

b. Write up the value of the operating land and buildings of $600,000 to their current market value.

c. Set up an asset of $175,000 representing the future tax benefit of the losses accumulated to date.

Answers:

Note: The following is essentially the published -unofficial" response to this AICPA examination question.

Requirement 1

The primary purpose of a quasi-reorganization is to establish a new basis for accountability and a "fresh start." The corporate entity and conditions of competition remain unchanged during a quasi-reorganization. However, the recorded values of assets may be restated downward to market value, the equity accounts are restated in order to leave the Retained Earnings account with a zero balance, the Retained Earnings account is "dated" for a period of time (from five to ten years) following the reorganization, and full disclosure of the procedure and its effects are made in the financial statements. A quasi -reorganization must be approved by the stockholders and creditors before it can be placed in effect.

Requirement 2

In general. a quasi -reorganization is justified when (a) a large deficit from operations exists, (b) it is an acceptable alternative to reorganization by legal proceedings, (c) the carrying value of the assets is significantly more than realistic going-concern values, (d) a break in the continuity of the historical cost basis is clearly needed so that realistic financial reporting is possible, (e) the balances of retained earnings and contributed capital are inadequate to absorb the decreases in the going-concern asset values, and (f) the accounting adjustment appears to be desirable to all parties concerned

Requirement 3

(a) Because the evidence indicates that the company has reached a turning point and that profitable operations can be expected hereafter, a quasi -reorganization to eliminate the accumulated deficit would be appropriate if the stockholders and creditors approve it. The purpose of eliminating the deficit—and the purpose of a quasi-reorganization—is to relieve the company from the handicap of reporting past losses which result in unfavorable reporting of current financial position even after conditions resulting in the losses have changed significantly. Therefore, elimination of the deficit appears acceptable.

(b) A company that elects a quasi -reorganization generally cannot show enough earning power to justify a write-up of operating land and buildings and usually needs to write them down instead. Any figure that is to be accepted as representing market value must stand all the economic tests of value, including the ability of the company to earn a market return based on such values. In view of the results of prior years' operations, to write up the recorded value of operating land and buildings would not be appropriate, even though there is some evidence to justify greater expectations of future benefits. Quasi-reorganizations that result in net write-ups are not in conformity with generally accepted accounting principles. The device is not intended for situations where changes in the general price level or current value suggest an upward revision of asset values on the books. However. Write-ups and write-downs within a group of assets that would not result in a net write-up are acceptable.

(c) Because an "asset" contingent upon having enough income in the next 15 years to use the operating loss carryforward should not be recorded unless there is a strong presumption-of realization, setting up the asset at the time of the quasi-reorganization is not appropriate even though the future operations for the company are expected to be profitable. Assets contingent upon the profitability of the future should not be recorded at the time of quasi-reorganization.

CHAPTER 22: EARNINGS PER SHARE

1. What is the fundamental difference in EPS computations and reporting between a simple capital structure and a complex capital structure?

Answer: In a simple capital structure, a single presentation (if the basic amounts for earnings per share is presented. A simple capital structure is one in which stockholders’ equity either consists only of common stock or does not contain convertible securities, stock warrants, or other rights convertible to common stock.

If a firm has a complex capital structure, it presents:

Fully diluted EPS—this calculation is based on common stock plus the number of shares of common stock that would be issued assuming all convertible securities, warrants. etc. with dilutive effects are converted to common stock. This calculation represents maximum dilution of EPS.

2. Is the annual dividend on cumulative convertible preferred stock outstanding all year subtracted from net income in computing basic EPS? If so, why?

Answer: Yes, because basic EPS treats all preferred stock the same way. whether or not convertible. The dividends reduce the actual return to common shareholders because the preferred was not converted during the period.

3. Explain the treasury stock method.

Answer: The treasury stock method is used to compute the number of incremental equivalent common shares when a complex capital structure includes stock rights, warrants, options, and other similar securities. The treasury stock method assumes that the rights, etc., will be exercised and the required number of common shares issued. The cash that would be received (at the option price) from the recipients is assumed to be invested in the acquisition of treasury common shares (at the average price for the period). The difference between the two amounts—the assumed number of shares that would be issued and the assumed number of treasury shares that would be acquired—represents the number of common stock equivalents associated with rights, etc., that must be added to the weighted average number of common shares outstanding.

5. Briefly, how are stock dividends and splits reflected in the calculation of basic EPS if the dividend or split occurs (a) before the balance sheet date, or (b) after the balance sheet date but before the issuance of the statements?

Answer: Both situations are treated the same way in that all common stock transactions occurring before the dividend or split are adjusted. The only difference is that substantive stock transactions could occur after stock dividends and splits that are issued before the balance sheet date. Such substantive stock transactions would not be adjusted. This could not occur for stock dividends and splits occurring after the balance sheet date.

6. Why are dividends from dilutive convertible preferred stock added back to the numerator of basic EPS without tax effect. but interest recognized on dilutive convertible bonds is added back to the numerator on an after-tax basis?

Answer: There is no tax effect for dividends declared or paid. Interest reduces net income on an after-tax basis. Therefore, the amount added back must also be after-tax.

7. What is the difference between a dilutive security and an antidilutive security? Why is the distinction important in EPS computations?

Answer: A dilutive security is a security that causes a reduction in the earnings per share amount. An example is stock rights for which the market value of the stock exceeds the option price of the stock. An antidilutive security is a security that causes the opposite effect, an increase in the earnings per share amount above that which would otherwise be reported. An example is stock rights for which the market value of the stock is less than the option price. The distinction is important in earnings per share considerations because dilutive securities are included in the computation of diluted earnings per share, whereas antidilutive securities are omitted from the computation.

13. What is the D/A method, and why is it useful?

Answer: The D/A method computes a ratio for each potentially dilutive security. The ratio is the addition to income divided by the increased number of outstanding shares. By ordering these ratios, smallest to largest, the dilutive securities can be used one by one until maximum dilution is achieved. This occurs when the D/A ratio for the next security exceeds the calculation of EPS using all other securities with lower D/A ratios (i.e., larger dilutive effects).

It is useful because it gives a means of proceeding one security at a time. For example, if there are 10 potentially dilutive securities, at most 10 calculations are required. Alternatively, 210 calculations (1024) would be required to evaluate all possible sets.

16. Explain in general how to handle actual conversions of convertible dilutive securities EPS purposes (denominator effect only).

Answer: Basic EPS reflects the shares from actual conversion weighted for the portion of the period after conversion. Diluted EPS reflects the denominator effect from assumed conversion weighted for the portion of the period before conversion.

E-22-1 EPS Calculations

1. On December 31, 1997, Case. Inc.. had 300,000 shares of common stock issued and outstanding. Case issued a 10 percent stock dividend on July, 1, 1998. On October 1, 1998, Case purchased 24,000 shares of its common stock for treasury and recorded the purchase using the cost method. What is the number of shares that should be used in computing primary earnings per share for the year ended December 31, 1998?

a. 306,000.

b. 309,000.

c. 324,000.

d. 330,000.

Answer: C. The requirement is the number of shares to be used in computing 1999 earnings per share (EPS). For EPS purposes, shares of stock issued as a result of stock dividends or splits should be considered outstanding for the entire period in which they were issued. Therefore, both the original 300,000 shares and the additional .30,000 shares (.10 x 300,000) are treated as outstanding for the entire year. The 10/1/98 purchase of 24,000 treasury shares results in a weighted average reduction of 6,000 shares (3/12 x 24,000) because the shares were not outstanding for three months during 1998. Therefore, the number of shares for EPS computations is 324,000:

Outstanding 12/31/97 300,000
Stock dividend (.10 x 300,000) 30,000

10/1 purchase (3/12 x 24,000) (6,000)

324,000

2. Seco Corporation was incorporated on January 2, 1997. The following information pertains to Seco's common stock transactions:

1997

January 2 Number of shares authorized. 80,000
February 1 Number of shares issued . . . . . . . . . . . . . . . . 60,000
July 1 Number of shares reacquired but not canceled 5,000
December 1 Two-for-one stock split

At December 31, 1997, the number of shares of Seco's common stock outstanding is

a. 150,000.

b. 120,000.

c. 115,000.

d. 110,000.

Answer: D. Before the stock split 60,000 shares of common stock were issued, of which 5,000 shares were reacquired. Any time stock is reacquired. it is not considered outstanding. Therefore, there were 55,000 (60,000 –5,000) shares outstanding before the two-for-one stock split and 110,000 (55,000 x 2) shares outstanding after the stock split.

3. At December 31, 1998, and 1997. Gow Corporation had 100,000 shares of common stock and 10,000 shares of 5 percent. $100 par value cumulative preferred stock outstanding. No dividends were declared on either the preferred or the common stock in 1998 or 1997. Net income for 1998 was $1,000,000. For 1998. earnings per common share amounted to

a. $10.00.

b. $9.50.

c. $9.00.

d. $5.00.

Answer: B. The formula for earnings per common share is:

($1,000,000 net income - $50,000 preferred dividends)/(100,000 common shares outstanding) = $9.50

In calculating the numerator, the claims of preferred shareholders against 1998 earnings should be deducted to arrive at the 1998 earnings attributable to common shareholders. This amount is $50,000 [(.05) ($100) x (10,000 shares)]. The $50,000 preferred dividends in arrears are not deducted to compute the numerator in determining 1998 EPS. This is because the $50,000 dividends in arrears are a claim of preferred shareholders against 1997 earnings and would reduce 1997 EPS.

4. Earnings per share data must be reported on the face of the income statement for which of the following, assuming the company has an accounting principle change it reports?

Income from Cumulative Effect of a Change
Continuing Operations in Accounting Principle

a. Yes Yes

b. Yes No

c. No No

d. No Yes

Answer: B. Earnings per share data must be shown on the face of the income statement. Earnings per share amounts must be presented for (1) income from continuing operations and (2) net income. EPS for the cumulative effect of a change in accounting principle must be disclosed either on the face of the income statement or in the notes to the financial statements.

5. Mann, Inc. had 30,000 shares of common stock issued and outstanding at December 31, 1996. On July 1, 1997, an additional 50,000 shares of common stock were issued for cash. Mann also had unexercised stock options to purchase 40,000 shares of common stock at $15 per share outstanding, at the beginning and end of 1997. The average market price of Mann’s common stock was $20 during 1997. What is the number of shares that should be used in computing diluted earnings per share for the year ended December 31, 1997?

a. 325,000.

b. 335,000.

c. 360,000.

d. 365,000.

Answer: B. The requirement is to determine the number of diluted shares that should be used in computing 1997 diluted earnings per share. The first step is to compute the weighted average number of common shares outstanding. 300,000 shares were outstanding the entire year, and 50,000 more shares were outstanding for six months, resulting in a weighted average of 325,000 [300,000 + (50,000 x 6/12)]. Second, because of the stock options, the denominator effect of the options must be computed. This is done using the treasury stock method as illustrated below:

Assumed proceeds [40,000 x $15] $600,000

Shares issued 40,000

Shares required [$600,000 $20] (30,000)

Incremental shares 10,000

The stock options are dilutive because the exercise price is less than the market value. Therefore, the number of shares used for computing diluted earnings per share is 335,000 [325,000 + 10,000].

E 22-2 Calculating Diluted EPS

1. Jones Corporation's capital structure is:

December 31

1997 1996

Outstanding shares of stock
Common 110,000 110,000
Convertible preferred 10,000 10,000
8 percent convertible bonds $1,000,000 $1,000,000

During 1997, Jones paid dividends of $3.00 per share on its preferred stock. The preferred shares are convertible into 20,000 shares of common stock. The 8 percent bonds are convertible into 30,000 shares common stock. Net income for 1997 is $850,000. Assume that the income tax rate is 30 percent. The diluted earnings per share for 1997 is

a. $5.48.
b. $5.66.
c. $5.81.
d. $6.26.

Answer: B. Diluted EPS is based on common stock and all dilutive securities. To determine if a security is dilutive, EPS, including the effects of the security. must be compared to a benchmark EPS. In this case. the benchmark or basic EPS is $7.45.

($850,000 net income - $30,000 preferred dividends)/(110,000 common shares outstanding) = $7.45

First, compute the D/A rate for each potentially dilutive security. The effect of the convertible bonds is to increase the numerator by $56,000 [interest of $80,000 ($1,000,000 x .08) less $24,000 tax effect ($80,000 x .30)], and increase the denominator by 30,000 shares.

The effect of the convertible preferred stock is to increase the numerator by $30,000 [dividends, 10,000 shares x $3 per share] and increase the denominator by 20,000 shares.

D/A ratio: convertible bonds = $56,000/30,000 = $1.87
D/A ratio: convertible preferred = $30,000/10,000 = $1.50

The convertible preferred is introduced first because its D/A ratio is the lowest, and it is less than basic EPS.

Tentative DEPS = ($850,000 - $30,000 + $30,000)(110,000 + 20,000) = $6.54. The convertible bonds are now introduced because $6.54 > $I.87. Final DEPS =

($850,000 - $30,000 + $56,000 + $30,000)/(110,000 + 30,000 + 20,000) = $5.66

2. Antidilutive stock options would generally be used in the calculation of

Basic Earnings per Share Diluted Earnings per Share

a. Yes Yes

b. Yes No

c. No No

d. No Yes

Answer: C. Computations of diluted earnings per share should not give effect to common stock equivalents or other contingent issues for any period in which their inclusion would have an antidilutive effect (i.e., increase the earnings per share amount or decrease the loss per share amount otherwise computed).

3. Cox Corporation had 1,200,000 shares of common stock outstanding on January 1 and December 31, 1997. In connection with the acquisition of a subsidiary company in June 1996. Cox is required to issue 50,000 additional shares of its common stock on July 1, 1998 to the former owners of the subsidiary. Cox paid $200,000 in preferred stock dividends in 1997 and reported net income of $3,400,000 for the year. Cox's diluted earnings per share for 1997 should be

a. $2.83.
b. $2.72.
c. $2.67.
d. $2.56.

Answer: D. The requirement is to compute the diluted earnings per share (DEPS) for 1997. The purpose of DEPS is to show the maximum potential dilution of current earnings per share (EPS) on a prospective basis. Therefore, all contingent issuances of common stock that reduce current EPS must be included in the computation. The formula for DEPS is:

Net income available to common shareholders
Weighted average common shares outstanding + Shares from dilutive securities

The net income available to common shareholders is $3,200,000. This is the net income of $3,400,000 less the preferred stock dividend of $200,000. The weighted-average common shares outstanding is 1,250,000. This is computed at the actual common shares outstanding for the full year of 1,200,000 plus the contingent common shares of 50,000 which were outstanding for the full year because the contingency is removed because of the passage of time.

Thus, DEPS = $3,200,000/1,250,000 = $2.56

4. Newt Corporation had earnings per share of $12.00 for 1998, before taking, any dilutive securities into consideration. No conversion or exercise of dilutive securities took place in 1998. However, possible conversion of convertible preferred stock would have reduced earnings per share to $11.90. The effect of possible exercise of common stock warrants would have reduced earnings per share by an additional $0.05. For 1998, what must Newt report as diluted earnings per share?

a. $12.00.
b. $11.95.
c. $11.10.
d. $11.85.

Answer: D. The capital structure of the corporation is complex because it contains dilutive securities. A complex capital structure requires a dual presentation of earnings per share. The diluted EPS is $11.85 ($11.90 - $.05).

E 22-3 Diluted EPS

1. Dilutive stock options would generally be used in the calculation of which of the following?

Basic Earnings per Share Diluted Earnings per Share

a. No No

b. No Yes

c. Yes Yes

d. Yes No

Answer: B. Basic earnings per share are computed based only on outstanding common stock, while diluted earnings per share are based on common stock and all dilutive securities. Dilutive stock options are only used in the calculation of diluted earnings per share.

2. The if-converted method of computing earnings per share data assumes conversion of convertible securities as of the

a. Beginning of the earliest period reported (or at time of issuance, if later).
b. Beginning of the earliest period reported (regardless of time of issuance).
c. Middle of the earliest period reported (regardless of time of issuance).
d. Ending of the earliest period reported (regardless of time of issuance).

Answer: A. The if-converted method of computing earnings per share assumes that convertible securities are converted at the beginning of the earliest period reported or at the time of issuance, if that date is later.

3. Suppose a company's convertible debt is dilutive in determining earnings per share. What would be the effect of considering the convertible debt in calculating the following?

Basic Earnings per Share Diluted Earnings per Share

a. Decrease Decrease

b. Increase No effect

c. No effect Decrease

d. Decrease Increase

Answer: C. Basic earnings per share are computed based only on outstanding common stock, while diluted earnings per share are based on common stock and all dilutive securities. Dilutive convertible debt instruments are used only in the calculation of diluted earnings per share.

4. In determining basic or diluted earnings per share, dividends on nonconvertible cumulative preferred stock should be

a. Disregarded.
b. Added back to net income whether declared or not.
c. Deducted from net income only if declared.
d. Deducted from net income whether declared or not.

Answer: D. The requirement is to determine the treatment of nonconvertible cumulative preferred dividends in determining basic and diluted EPS. Dividends on nonconvertible cumulative preferred shares should be deducted from net income whether an actual liability exists or not, because cumulative preferred stock owners must receive any dividends in arrears before future dividend distributions can be made to common stockholders.

E 22-4 Analyze the Capital Structure: Average Shares, Compute EPS At the end of 1997 the records of Block Corporation reflected the following:

Common stock, par $5, authorized 500,000 shares:
Outstanding 1/l/1997, 400,000 shares $2,000,000
Sold and issued 4/1/1997, 2,000 shares 10,000
Issued 5% stock dividend, 9/30/1997, 20,100 shares 100,500
Preferred stock, 6%. par $10, nonconvertible, noncumulative,
authorized 50,000 shares, outstanding during year, 20,000 shares 200,000
Contributed capital in excess of par, common stock 180,000
Contributed capital in excess of par, preferred stock 100,000
Retained earnings (after the effects of current preferred dividends
declared during 1997) 640,000
Bonds payable, 6-%, nonconvertible, issued at par 1/l/97 1,000,000
Income before extraordinary items 182,000

Extraordinary loss (net of tax) (18,000)

Net income 164,000
Average income tax rate 40%

Required:

1. Is this a simple or complex capital structure? Explain.

2. What kind of EPS presentation is required? Explain.

3. Compute the required EPS amounts (show computations).

4. Compute the required EPS amounts, assuming that the preferred is cumulative.

Answers:

Requirement 1

This is a simple capital structure because (a) the preferred stock is nonconvertible, (b) the bonds payable are nonconvertible, and (c) there are no rights, options, or other securities convertible to common stock.

Requirement 2

Because this is a simple capital structure. only a single set of EPS amounts is presented for income before extraordinary items and net income.

Requirement 3

Computations of EPS amounts:

(a) Preferred dividend claim for current year:

$200,000 x 6% = $12,000. Recognized on the noncumulative preferred stock because the current year preferred dividend has been declared.

(b) Average number of common shares outstanding during year:

Actual Retroactive Months Share-
Time Period Shares Adjustment Outstanding Months

January 1, shares outstanding 400,000
January 1 to March 31 400,000 x 1.05 x 3 = 1,260,000
April 1, sold additional shares 2,000
April 1 to September 30 402,000 x 1.05 x 6 = 2,532,600
Sept 30, 1995, 5% stock dividend 20,100
Sept 30 to December 31 422,100 x 3 = 1,266,300

Total Share Months 12 5,058,900

Average number of shares outstanding, 5,058,900 12 = 421,575

(c) Earnings per share on common stock:

Income before extraordinary items ($182,000 -$12,000*) 421,575 shares = $.40
Extraordinary loss** ($18,000) 421,575 shares = (.04)
Net income ($164,000 - $12,000*) 421,575 shares = $.36

* Preferred dividend claim.

** Net required to be shown on face of the income statement. But if not, the value must be in the notes

Requirement 4

Assuming the preferred stock is cumulative, the EPS amounts, in this case, would be the same as computed in Requirement 3 because (a) the current preferred dividend claim must be honored for cumulative preferred stock whether declared or not and (b) the claim must be honored for noncumulative preferred stock only if declared (the situation given in the problem data—see the notation for retained earnings).

E 22-6 Compute EPS for Three Years: Stock Dividend and Split Rambo Corporation's accounting year ends on December 31. During the following three years, its common shares outstanding changed as follows:

1998 1997 1996

Shares outstanding, January 1 150,000 120,000 100,000
Sales of shares, 4/1/1996 20,000
25% stock dividend, 7/1/1997 30,000
2-for-1 stock split, 7/1/1998 150,000 *
Shares sold, 10/1/1998 50,000 ______ ______
Shares outstanding, December 31 350,000 150,000 120,000

Net Income $375,000 $330,000 $299,000

* For each share turned in, two new shares were issued so that the shares doubled.

Required:

1. For purposes of calculating EPS at the end of each year, for each year independently, determine the number of shares outstanding.

2. For purposes of calculating EPS at the end of 1998, when comparative statements are being prepared on a three-year basis, determine the number of shares outstanding for each year.

3. Compute EPS for each year based on year computations in (2).

Answers:

Requirement 1

This is a simple capital structure. For 1996, because the 20,000 added shares were sold at the start of the second quarter, on an equivalent basis they were outstanding of the year.

100,000 original shares + (3/4 x 20,000) = 115,000

For 1997, because the only change was due to a stock dividend, regardless of when it occurred during the year, the year-end figure of 150,000 shares outstanding would be used for EPS purposes as though that number had been outstanding for all of 1997.

For 1998, it is important to note that the 2-for-1 stock split occurred on July 1 before the sale on October 1. Had the sale not occurred, for EPS purposes there would have been 300,000 shares outstanding for all of 1998. The sale of 50,000 shares at the start of the fourth quarter adds an equivalency of 12,500 shares. Therefore, 300,000 shares + (1/4 x 50,000) = 312,500.

Requirement 2

1998: In the context of comparative statements, there would be no change in the 312,500 shares calculated in Requirement 1 for 1998.

1997: The doubling of the number of shares during 1998 would project back to 1997, raising the 150,000 for 1997 (standing alone) to 300,000.

1996: For 1996, because the April 1 sale of 20,000 shares preceded the 25 percent stock dividend of 1997 and the 2-for-1 split of 1998, a multiplier effect of 2.5 (i.e., 1.25 x 2) applies to the 20,000 shares, as well as to the original 100,000 shares, as shown below:

25% 2-for-1
Date Original Stock Stock
1996 Shares Dividend Split Total Months Total

January 1 100,000 x 1.25 x 2 250,000 12 3,000,000
April 1 20,000 x 1.25 x 2 50,000 9 450,000
Totals 120,000 3,450,000

3,450,000 12 months = 287,500 weighted average shares for comparative EPS purposes in the 1998 financial report.

Requirement 3

1998 1997 1996

Net Income $375,000 $330,000 $299,000
Avg shares outstanding (including stock divs and split) 312,500 300,000 287,500
Earnings per share $1.20 $1.10 $1.04

E 22-10 Complex Capital Structure and Reporting EPS The Omega Company reports the following:

Income from continuing operations $1,000.000
Extraordinary item 3,000,000
Net income $4.000.000

Shares outstanding:

For basic EPS 1,000,000
For diluted EPS 1,500,000

Income adjustments to be made:

Income before
Extraordinary Item Net Income

For diluted EPS $200,000 $200,000

Required: What EPS figures would Omega report? What are their values?

Answer:

Basic EPS

Income before extraordinary item ($1,000,000/1,000,000 shs.) $1.00
Extraordinary item ($3,000,000/1,000,000 shs.) 3.00*
Net income ($4,000,000/1,000,000 shs.) $4.00

DEPS

Income before extraordinary item ($1,200,000/1,500,000 shs.) $0.80
Extraordinary item ($3,000,000/1,000,000 shs.) 2.00*
Net income ($4,200,000/1,500,000 shs.) $2.80

* May be reported in the notes.

E 22-11 Complex Capital Structure and Reporting EPS The Jones Company reports the following:

Income before extraordinary item $1,000.000

Extraordinary item (20,000)

Net income $980.000

Shares outstanding:

For basic EPS 1,000,000
For diluted EPS 1,100,000

Income adjustments to be made:

Income before
Extraordinary Item Net Income

For diluted EPS $80,000 $80,000

Required: What EPS figures would Omega report? What are their values?

Answer:

Basic EPS

Income before extraordinary item ($1,000,000/1,000,000 shs.) $1.00
Net income ($980,000/1,000,000 shs.) $0.98

DEPS

Income from continuing operations ($1,080,000/1,100,000 shs.) $0.98
Net income ($1,060,000/1,100,000 shs.) $0.96

E 22-13 Options and the Computation of' EPS Rand Inc. had a net income from continuing operations of $800,000. During the year in question, 200,000 shares were outstanding on average. During the year, Rand's common stock sold at an average market price of $50. In addition, Rand had 20,000 options outstanding to purchase a total of 20,000 shares at $25 for each option exercised.

Required:

1. Are the options dilutive? Compute basic EPS for income from continuing operations.

2. Compute diluted EPS.

Answer:

1. Since the option price of $25 is below the market price, the options are "in the money" and dilutive. Basic EPS = $800,000/200,000 = $4.00.

2. Diluted EPS:

Number of Shares: 20,000

Additional cash on assumed exercise
(20,000) x $25 = $500,000

Shares repurchased under Treasury Stock Method
$500,000/$50 = 10,000

Net additional shares
20,000 – 10,000 = 10,000

Diluted EPS = $800,000/(200,000 + 10,000)
= $3.81

E 22-14 Convertible Bonds and the Calculation of Diluted EPS Shaffer Corporation issued 100, $1,000, 10 percent convertible bonds in 1996 at face value. Each bond is convertible into 100 shares of common. Shaffer's net income from continuing operations for 1997 is $1,824,000 ($3,040,000 before tax). The $1,824,000 reflects one year's interest after tax. If you consider all factors except convertible bonds, average common shares outstanding for 1997 are 1,010,000.

Required:

1. Compute DEPS (test for dilution).

2. How would you answer (1) if the bonds were issued July 1, 1997?

3. Ignoring (2), how would the answer to (1) change if half the bonds were converted July 1, 1997?

Answer:

Requirement 1

Basic EPS = $1,824,000/1,010,000 = $1.81

The tax rate is 1 – ($1,824,000/3,040,000) = .40

Numerator effect of bonds = 100 ($1,000)(.10)(.60) = $6,000
Denominator effect of bonds = 100 (100) = 10,000
D/A ratio = $6,000/10,000 = $.60 < $1.81; therefore the bonds are dilutive.

DEPS = ($1,824,000 + $6,000)/(1,010,000 + 10,000) = $1.79

Requirement 2

Net income from continuing operations would be one-half a year’s after-tax interest larger, or $3,000 larger. The numerator and denominator effects would be halved but the D/A ratio would remain unchanged.

Basic EPS = ($1,824,000 + $3,000)/1,010,000 = $1.81
DEPS = ($1,824,000 + $3,000)/(1,010,000 + 5,000) = $1.80

Requirement 3

Net income from continuing operations would be $1,824,000 + $6,000 (1/4) = $1,825,500. This $1,500 increase is the after-tax interest saved on the converted bonds for year
($,000)(100)(.10)(.60)(1/2 year)(1/2 issue).

Basic EPS = $1,825,500/1,010,000 + 10,000 (1/4) = $1.80

Numerator effect: 50 ($1,000) (.10) (.60) + 50 ($1,000) (.10) (.60) (1/2) = $4,500

Denominator effect: 5,000 + 5,000 (1/2) = 7,500. One-half of the issue was convertible bonds the entire year, giving rise to 5,000 shares upon assumed conversion. The other half of the issue was convertible bonds only one-half a year, giving rise to 2,500 shares on assumed conversion.

DEPS = ($1,825,500 + $4,500)/(1,010,000 + 2,500 + 7,500) = $1.79

E 22-15 Analyze Capital Structure: Stock Split, Convertible Securities, Compute EPS At the end of 1997, the records of Ruso Corporation reflected the following:

Common stock, nopar, authorized 250,000 shares: issued and outstanding
throughout the period to 12/l/1997, 60,000 shares. A stock split issued
12/1/1997 doubled outstanding shares $840,000
Preferred stock, 5%, par $10, nonconvertible, cumulative, nonparticipating,
shares authorized, issued, and outstanding during year, 10,000 shares 100,000
Contributed capital in excess of par, preferred stock 30,000
Retained earnings (no cash or property dividends during year) 570,000
Bonds payable, 8%, issued 1/1/1997; each $1,000 bond is convertible into 60
shares of common stock after the stock split on 12/1/1997 (bonds initially
sold at par) 200,000
Income before extraordinary items 86,000

Extraordinary loss (14,000)

Net income 72,000
Average income tax rate 30%.

Required:

1. Is this a simple or a complex capital structure? Explain.

2. What kind of EPS presentation is required? Explain.

3. Compute the required EPS amounts (show computations, rounded to two decimal places, and assume that all amounts are material).

Answers:

Requirement 1

This is a complex capital structure because of the convertible bonds. The preferred stock is nonconvertible and cumulative.

Requirement 2

Because this is a complex capital structure, a dual set of EPS amounts—basic EPS and diluted EPS—is reported for (a) income before extraordinary items, (b) extraordinary items, and (c) net income.

Requirement 3

(a) Nonconvertible preferred dividend claim for current year:

$100,000 x.05 = $5.000 (because cumulative, included whether declared or not).

Basic EPS = ($86,000 - $5,000)/120,000* = $0.68

* Average shares outstanding + stock split = 60,000 + 60,000

(b) Dilution-antidilution (D/A) test on convertible bonds (conducted using income before extraordinary items):

Compare D/A ratio amount for convertible bonds payable to Tentative EPS:

D/A ratio amount = ($200,000 x .08 x .70**)/12,000* = $0.93

* ($200,000 $1,000) x 60

** 100% - tax rate of 30%

Conclusion:

Since $0.93 exceeds $0.68, the convertible bonds payable are antidilutive. Do not include them in computing diluted EPS. There is only one D/A test because there is only one convertible security. DEPS = Basic EPS.

P 22-6 Analyze Capital Structure: Stock Dividend, Convertible Securities. Compute EPS At the end of 1997, the records of Luholtz Corporation reflected the following:

Common stock, no par, authorized 500,000 shares; issued and outstanding
throughout period, 100,000 shares $680,000
Stock dividend issued, 12/31/1997, 50,000 shares (not included in the 100,000
shares above) 340,000
Retained earnings (after effect of dividends on all shares) 500,000
Bonds payable, 4-%; each $1,000 bond is convertible to 80 shares of common
stock after the stock dividend (bonds issued at par in 1995) 100,000
Bonds payable. 6-%; each $1,000 bond is convertible to 90 shares of common
stock after the stock dividend (bonds issued at par in 1995) .300,000
Income before extraordinary items 210,000
Extraordinary gain 12,000
Net income 222,000
Average income tax rate 40%.

Required:

1. Is this a simple or a complex capital structure? Explain.

2. What kind of EPS presentation is required? Explain.

3. Prepare the required EPS disclosures.

Answers:

Requirement 1

This is a complex capital structure because there are convertible bonds payable.

Requirement 2

Because this is a complex capital structure, a dual set of EPS amounts—basic EPS and diluted EPS—is reported for (a) income before extraordinary items, (b) extraordinary items, and (c) net income.

Requirement 3

Computation of EPS amounts:

(a) Shares from assumed conversion of bonds:
Bonds payable, 4-%, convertible, $100,000
($100,000 $1,000) x 80 = 8,000 shares
Bonds payable, 6-%, convertible, $300,000
($300,000 $1,000) x 90 = 27,000 shares

(b) Basic EPS for income before extraordinary items:
($222,000 - $12,000)/(100,000 + 50,000) = $1.40

(c) Numerator effects:
4-% bonds $100,000 (.045) (1 - .4) = $2,700
6-% bonds $300,000 (.065) (1 - .4) = $11,700

(d) D/A ratios and ranking D/A Rank
4-% bonds: $2,700/8,000 = $0.34 1
6-% bonds: $11,700/27,000 = $0.43 2

(e) D/A Tests

Enter the 4-% bonds into tentative DEPS because $0.34 < $1.40 (Basic EPS). Tentative DEPS = ($210,000 + $2,700)/(150,000 + 8,000) = $1.35.

Enter the 6-% bonds into tentative DEPS because $0.43 < $1.35 (previous tentative DEPS). Tentative DEPS = final DEPS (there are no more potentially dilutive securities) = ($210,000 + $2,700 + $11,700)/(150,000 + 8,000 + 27,000) = $224,400/185,000 = $1.21.

(f) Earnings per share

Basic:
Income before extraordinary gain $1.40
Extraordinary gain ($12,000/150,000) .08
Net income $1.48

Diluted:
income before extraordinary gain $1.21
Extraordinary gain ($12,000/185,000) .06
Net income [($222,000 + $2,700 + $11,700)/185,000] $1.27

 

A 22-1 EPS Disclosures American Home Products Corporation (AHP), a large company in the health care field, reported the following information (dollar amounts in thousands) in its December 31, 1995 consolidated statement of income:

Net income $ 1,680,418
Net income per share of common stock $ 5.42

Required:

1. Estimate the average number of common shares outstanding for 1995. Assume that AHP has outstanding the entire year $108 thousand of $2 preferred stock, par value $2.50; 5 million shares authorized. Indicate any assumptions you are making. The stock is not convertible.

2. Does AHP have a simple or complex capital structure?

3. Is AHP required to report EPS figures for the cumulative effect of an accounting change, if present, in their income statement?

Answers:

Requirement 1

[$1,680,418 – ($108,000 $2.50) x $2]/$5.42 = 310,024,280 shares

Three important assumptions are:

a. The $5.42 is basic EPS.

b. The number of outstanding preferred shares did not change from 43,200 [$108,000 2.50] during the year.

c. The preferred dividends were declared by the firm. (The preferred is not titled as cumulative.)

Requirement 2

Simple, because AHP has no potential common stock.

Requirement 3

No. The presentation of this figure may appear in the notes if the firm so wishes.

CHAPTER 23: STATEMENT OF CASH FLOWS

1. Compare the purposes of the balance sheet, income statement, and statement of cash flows.

Answer: The purpose of the balance sheet is to report financial position (i.e.. assets. liabilities. and owners' equity) as of a specified date (at the end of the reporting period). The purpose of die income statement is to report the results of operations (i.e., revenues, expenses, gains and losses, and extraordinary items) for the reporting period. It is a change statement because it reports the detailed items that comprise net income. which causes owners' equity to change (i.e., retained earnings). Both of these statements report accrual-basis amounts. In contrast, the statement of cash flows is a cash flow statement. It reports cash flows for three different activities—operating. investing, and financing. The primary purpose of the SCF is to provide cash flow information in a manner that maximizes its usefulness to investors. creditors. and other interested parties in projecting future cash inflows related to the enterprise.

2. Explain the basic difference between the three activities reported in the SCF: operating, investing, and financing.

Answer: Operating activities—primarily relates to items reported on the income statement (cash inflows and outflows); this relates to its primary operations. including gains and losses, interest. and income tax.

Investing activities—primarily relates to obtaining productive facilities and investments in other non-cash assets. These activities include both cash outflows, "investing." and cash inflows from disposition of the "investments" previously made.

Financing activities—primarily relates to obtaining resources for the entity to use (cash inflows) and the repayment of those "financing" activities (e.g., payment on debt principal), The primary sources are borrowing and funds provided by the owners. I'm outflows do not include interest on debt.

8. Explain the basic difference between the direct and indirect methods of reporting on the SCF. Use net income, $5,000, sales revenue, $100,000, and an increase in net accounts receivable, $10,000, to illustrate the basic difference. Which method provides the most relevant information to investors and creditors?

Answer: The difference between the direct and indirect methods relates only to the SCF classification, cash flows from operating activities. The direct method reports individual cash inflows front each major revenue and individual cash outflows for each major expense. The indirect method reports a reconciliation of net income with net cash flow from operating activities. This reconciliation reports changes in asset and liability accounts directly related to net income.

Illustration

Direct method
Cash inflow from sales (i.e., from customers) $90,000

Indirect method:
Net income $5,000

Reconciliation
Net accounts receivable increase (10,000)
Etc.

Clearly, the information provided by the direct method would be the most relevant to investors and creditors. The $10,000 change in accounts receivable is already shown on the comparative balance sheets. Also, the reconciliation is a required disclosure for the direct method.

10. Explain why a $50,000 increase in inventory during the year must be considered when eveloping disclosures for operating activities under both the direct and indirect methods.

Answer: The $50,000 increase in inventory must be used in the SCF calculations because it increases the amount of cash outflows that otherwise would not have occurred, It is used as follows:

Direct method—added to cost of goods sold, accrual basis (the other adjustment would involve accounts payable) to compute cost of goods sold, cash basis.

Indirect method—deducted from net income as a reconciling item with cash flows from operating activities.

11. What three reconciling amounts must be reported at the bottom of the SCF? Which one must agree with a key amount in another financial statement? Use assumed amounts for illustrative purposes.

Answer: The three reconciling lines are as follows:

Net increase (decrease) in cash during the period $(10,000)

Cash balance, beginning 50,000
Cash balance, ending $40,000

The $40,000 must agree with the ending cash (plus cash equivalents) amounts reported on the balance sheet.

20. Is there an inconsistency in the classification of dividends received and dividends paid in the SCF? Discuss your answer.

Answer: Dividends received are an operating cash inflow, yet are related to investments in common stock, an investing activity. Dividends paid are payments to stockholders, a financing activity, and are classified as financing cash outflows. The classification of dividends received appears to be counter to the underlying nature of the activity.

21. How is a lease payment (after inception) on a capital lease classified in the SCF?

Answer: The interest portion of the lease payment is classified as an operating cash outflow, because all interest is so classified. The principal portion of the payment is a financing cash outflow because it is a partial extinguishment of a liability—a source of financing.

22. Trading securities and securities available for sale are treated differently in the statement of cash flows. What are the major differences in treatment?

Answer: Purchases and proceeds from sales (and maturities) of trading securities (TS) are classified as operating cash flows, whereas for securities available-for-sale (SAS), these cash flows are classified as investing. Both types of investments are carried at market value.

The net change in the balance of investments in TS during a period (which would include any unrealized gains or losses) is treated as a reconciling item in the reconciliation of net income and net operating cash flow; therefore, neither realized nor unrealized gains and losses are reconciling items. The change in TS during the period takes both types of gains and losses into account, as well as any purchases or disposals.

The net change in investments in SAS during a period is not a reconciling item because such investments are not considered an operating activity. Unrealized gains and losses do not affect earnings or operating cash flow and therefore are not found in the reconciliation. Realized gains and losses, however, are reconciliation adjustments because net income has been increased or decreased without an associated operating cash flow.

E 23-2 SCF: Cash Flow Analysis of Sales The records of ZZ Hat Company showed sales revenue of $100,000 (on the income statement) and a change in the balance of accounts receivable. To demonstrate the effect of changes in accounts receivable on cash inflows from customers, five independent cases are used. Complete the following tabulation for each independent case:

Accounts
Sales Receivable
Revenue Increase Cash
Case (from income statement) (decrease) Computation Inflow

A $100,000 $ -0- ........................................ ............
B 100,000 10,000 ........................................ ............

C 100,000 (10,000) ........................................ ............

D 100,000 9,000 * ......................................... ............

E 100,000 (9,000) * ......................................... ............

*Includes the effect of a $1,000 write-off of an uncollectible account.

Answer:

Accounts
Sales Receivable
Revenue Increase Cash
Case (from income statement) (decrease) Computation Inflow

A $100,000 $ -0- None .$100,000
B 100,000 10,000 $100,000 - $10,000 90,000

C 100,000 (10,000) $100,000 + $10,000 110,000

D 100,000 9,000 * $100,000 – ($9,000 + $1,000) 90.000

E 100,000 (9,000) * $100,000 + ($9,000 - $1,000) 108,000

*Includes the effect of a $1,000 write-off of an uncollectible account.

E 23-5 Multiple Choice: Statement of Cash Flows Choose the correct response for each question.

1. In the statement of cash flows, which of the following would increase reported cash flows from operating activities under the direct method? Ignore tax considerations.

a. Dividends received from investments.

b. Gain on sale of equipment.

c. Gain on early retirement of bonds.

d. Change from straight-line to accelerated depreciation.

Answer: a.

2. Which of the following cash flows per share should be reported in a statement of cash flows'?

a. Primary cash flows per share only.

b. Fully diluted cash flow per share only.

c. Both primary and fully diluted cash flows per share.

d. Cash flows per share should not be reported.

Answer: d.

3. Cantova Company sold used equipment for a cash amount equaling its carrying amount for both book and tax purposes. A few days later. Cantova replaced the equipment by paying a cash down payment and signing a note payable for new equipment. The cash down payment exceeded the cash received for the old equipment. How should these equipment transactions be reported in Cantova's statement of cash flows?

a. Cash outflow equal to the down payment less the cash received.

b. Cash outflow equal to the down payment and note payable less the cash received.

c. Cash inflow equal to the cash received and a cash outflow equal to the down payment and note payable.

d. Cash inflow equal to the cash received and a cash outflow equal to the down paynient,

Answer: d.

4. How should a gain from the sale of used equipment for cash be reported in a statement of cash flows using the indirect method?

a. In investment activities as a reduction of the cash inflow from the sale.

b. In investment activities as a cash outflow.

c. In operating activities as a deduction from income.

d. In operating activities as an addition to income.

Answer: c.

5. Would the following be added back to net income in the reconciliation of net income and net operating cash flow?

Excess of Treasury Stock Acquisition Bond Discount
Cost over Sales Proceeds (cost method) Amortization

a. Yes Yes

b. No No

c. No Yes

d. Yes No

Answer: c.

6. Malli Manufacturing Company purchased a three-month U.S. Treasury bill, to be classified as a cash equivalent. In the preparation of Malli's statement of cash flows, this purchase would

a. Not be reported.

b. Be treated as an outflow from financing activities.

c. Be treated as an outflow from investing activities.

d. Be treated as an outflow from lending activities.

Answer: a.

E 23-7 SCF: Indirect Method Calexico Inc. reported the following comparative balance sheets for the current year:

Balance Sheets January 1 December 31

Cash $ 4,000 $ 10,750
Accounts receivable 3,000 2,000
Equipment 10,000 15,000

Accumulated depreciation (1,000) (2,000)

Total assets $16,000 $25,750

Salaries payable $ 1,000 $ 2,000
Long-term notes payable 5,000 5,000
Capital stock 8,000 8,000
Retained earnings 2,000 10,750

Total liabilities and owners’ equity $16,000 $25,750

Additional information:

1. Net income for the current year was $9,750.

2. No purchases or disposals of equipment took place during the year.

Required:

1 Prepare the indirect method statement of cash flows for Calexico.

2. What additional information would you need to prepare the direct method statement of csh flows for this firm?

Answers:

Requirement 1

Calexico, Inc.
Statement of Cash Flows
For the Current Year Ended December 31

Operating activities
Net income $9,750
Depreciation expense 1,000
Accounts receivable decrease 1,000
Salary payable increase 1,000
Net cash inflow from operations $12,750

Investing Activities
Purchase of equipment (5,000)
Net csh outflow from investing activities (5,000)

Investing Activities
Dividends paid (1,000)
Net cash outflow from financing activities (1,000)

Increase in cash 6,750
Cash, January 1 4,000
Cash, December 31 $10,750

* $2,000 + $9,750 - $10,750

Requirement 2

To prepare the direct method SCF, income statement information is required. Revenue and expense data, when combined with the associated changes in operating balance sheet accounts, yield the operating cash flows that would be reported under the direct method. The operating cash flows to be determined for this problem would include collections from customers, payments to suppliers, and payments to employees.

E 23-11 Transaction Analysis You are requested by the controller of a large company to determine the appropriate disclosure for the following transactions in the SCF. Assume that all adjusting entries were recorded.

a. The company wrote off a S4.000 account. During the year, gross accounts receivable increased $100,000, and the allowance for doubtful accounts increased $10,000. All sales ($600,000) are on account.

b. Pension expense is $100,000: the balance of accrued pension cost (cr.) increased $24,000.

c. Deferred tax liability increased $80,000, income taxes payable decreased $20,000, and income tax expense was $220.000.

d. $20,000 of interest was capitalized. Interest expense is $100,000. There is no change in interest payable.

e. The company sold short-term investments (cash equivalents) at a $4,000 gain, proceeds $16,000.

f. The company sold short-term investments in securities classified as available for sale at a $4,000 gain, proceeds $16,000. There was no valuation allowance balance on the securities, and market value equaled cost at the beginning of the period.

Required:

Indicate the complete disclosure of each item in the SCF under (1) the direct method and (2) the indirect method.

Answer:

The disclosure for the reconciliation of net income and net operating cash flow is given separately for each item, because the reconciliation is reported under both the direct and indirect methods. The amounts indicated for the direct and indirect methods reflect disclosures other than those for the reconciliation.

a. Reconstructed entries:
Accounts receivable 600,000
Sales 600,000
Allowance for doubtful accounts 4,000
Accounts receivable 4,000
Bad debt expense 14,000
Allowance for doubtful accounts
Cash 496,000
Accounts receivable 496,000
Net cash effect = $496,000
Net income effect = $600,000 - $14,000 = $586,000

Direct method: $586,000 operating cash inflow, collections from customers

Indirect method: No disclosure other than in the reconciliation.

Reconciliation: Two different approaches may be used: (1) $90,000 subtraction adjustment, increase in accounts receivable (this adjusts the income effect of $586,000 to equal the cash effect $496,000), or (2) $14,000 addition adjustment, bad debt expense; $104,000 subtraction adjustment, increase in gross accounts receivable before the write-off.

b. Direct method: $76,000 operating cash outflow, payment to pension trustee.

Indirect method: No disclosure other than in the reconciliation.

Reconciliation: $24,000 addition adjustment, increase in accrued pension cost.

c. Reconstructed entries

Income tax expense 230,000
Deferred tax liability 80,000
Income tax payable 140,000

Income tax payable ($140,000 + $20,000 decrease) 160,000
Cash 160,000

Direct method: $160,000 operating cash outflow, income taxes paid.

Indirect method: No disclosure other than in the reconciliation.

Reconciliation: $80,000 addition adjustment, increase in deferred tax liability; $20,000 subtraction adjustment, income tax payable decrease.

d. Direct method: $100,000 operating cash outflow, interest payments: $20,000 investing cash outflow, payments for capitalized interest.

Indirect method: $20,000 investing cash outflow, payments for capitalized interest.

Reconciliation: No adjustment.

e. Direct method: $4,000 operating cash inflow, gain on sale of cash equivalents.

Indirect method: No disclosure.

Reconciliation: No adjustment.

(The $4,000 increase in cash and cash equivalents is reflected in earnings through the gain.)

f. Direct and indirect methods: $16,000 investing cash inflow, proceeds from securities available for sale.

Reconciliation: $4,000 subtraction adjustment, gain on sale of securities available for sale.

E 23-15 SCE Indirect Method: Prepare the Reconciliation for Operating Activities. The data given below were provided by the accounting records of Darby Company. Prepare the reconciliation of net income with cash flow from operations for inclusion in the SCF, indirect method.

Net income (accrual basis) $ 40,000
Depreciation expense $ 8,000
Decrease in wages payable $ 1,200
Decrease in trade accounts receivable $ 1,800
Increase in merchandise inventory $ 2,500
Amortization of patent $ 100
Increase in long-term liabilities $ 10,000
Sale of capital stock for cash $ 25,000
Amortization of premium on bonds payable $ 200
Accounts payable increase $ 4,000
Stock dividend issued $10,000

Answer:

Net income reported; accrual basis $40,000
Add (deduct) to reconcile net income to net cash flow:
Depreciation expense 8,000

Decrease in wages payable (1,200)

Decrease in trade accounts receivable 1,800

Increase in merchandise inventory (2,500)

Amortization of patent 100

Amortization of premium on bonds payable (200)

Accounts payable increase 4,000
Net cash inflow from operating activities $50,000

E 23-17 SCF, Indirect Method Zepco Company’s recent comparative balance sheet and income statement follow:

Comparative Balance Sheets
December 31

1998 1997

Assets:
Cash $ 59,000 $ 60,000
Accounts receivable 34,000 24,000
Plant assets 277,000 247,000

Accumulated depreciation (178,000) (167,000)

Total Assets $192,000 $164,000

Liabilities and stockholders’ equity:
Bonds payable $ 49,000 $ 46,000
Dividends payable 8,000 5,000
Common stock, $1 par 22,000 19,000
Additional paid-in-capital 9,000 3,000
Retained earnings 104,000 91,000

Total liabilities and stockholders’ equity $192,000 $164,000

Income Statement
For Year Ended December 31, 1998

Sales revenue $155,000

Cost of goods sold (107,000)

Gross margin 48,000

Depreciation expense (33,000)

Gain on sale of equipment 13,000

Net income $28,000

Additional information:

1. During 1998, equipment costing $40,000 was sold for cash.

2. During 1998, $20,000 of bonds payable were issued in exchange for property, plant and equipment. There was no amortization of bond discount or premium.

Required: Prepare Zepo’s statement of cash flows under the indirect method.

Answer:

Zepco Corporation
Statement of Cash Flows
For the Year Ended December 31, 1998

Operating activities
Net income $28,000
Depreciation expense 33,000

Accounts receivable increase (10,000)
Gain on sale of equipment (13,000)
Net cash inflow from operations $38,000

Investing Activities
Proceeds from sale of equipment $31,000a

Purchase of equipment (50,000)a
Net cash outflow from investing activities (19,000)

Investing Activities
Retirement of bonds $(17,000)b
Dividends paid (12,000)c

Issuance of common stock 9,000d
Net cash outflow from financing activities (20,000)

Net decrease in cash (1,000)

Cash at beginning of year 60,000
Cash at end of year $59,000

Non-cash activity schedule:
Acquisition of plant assets through bond issuance $20,000

Computation:
a To determine cash proceeds from sale of equipment and purchase of equipment:

Entry for sale of equipment:

Cash (derived) 32,000
Accumulated depreciation 22,000 *
Plant assets 40,000
Gain 13,000

*$33,000 depreciation - $11,000 increase in accumulated depreciation

Plant Assets

1/1 balance 247,000 | 40,000 cost of assets sold
acquisition (bonds) 20,000 |
acquisition (cash)—derived 50,000 |
12/31 balance 277,000 |

b $17,000 bond retirement = $20,000 bond issuance - $3,000 net increase in bonds payable.

c To determine dividends paid:

Retained Earnings

| 91,000 1/1 balance
1998 dividends declared (derived) 15,000 | 28,000 1998 earnings
| 104,000 12/31 balance

Dividends Payable

| 5,000 1/1 balance
1998 dividends paid 12,000 | 15,000 1998 dividends eclared
| 104,000 12/31 balance

d $9,000 proceeds from common stock issuance = $3,000 change in common stock + $6,000 change in additional paid-in capital.

 

P 23-6 SCF, Indirect Method The following is Orem Corporation's comparative balance sheets for 1998 and 1997.

December 31

1998 1997

Cash $ 400,000 $ 350,000
Accounts receivable 564,000 584,000
Inventories 924,000 857,500
Property, plant and equipment 1,653,500 1,483,500

Accumulated depreciation (582,500) (520,000)

Investment in Belle Co. 152,500 137,500
Loan receivable 135,000 _______

Total assets $3,247,500 $2,892,500

Accounts payable $ 507,500 $ 477,500
Income taxes payable 15,000 25,000
Dividends payable 40,000 45,000
Capital lease obligation 200,000
Capital stock, common, $1 par 250,000 250,000
Additional paid-in capital 750,000 750,000
Retained earnings 1,485,000 1,345,000

Total liabilities and stockholders’ equity $3,247,500 $2,892,500

Additional information:

1. On December 31, 1997, Orem acquired 25 percent of Belle Company's common stock for $137,500. On that date, the carrying value of Belle's net assets and liabilities, which approximated fair value, was $550,000. Belle reported income of $60,000 for the year ended December 31, 1998. No dividend was paid on Belle's common stock during the year.

2. During 1998, Orem loaned $150,000 to Chase Company, an unrelated company. Chase made the first semiannual principal repayment of $15,000, plus interest at 10 percent, on October 1, 1998.

3. On January 2, 1998, Orem sold equipment costing $30,000, with a carrying value of $17,500, for $20,000 cash.

4. On December 31, 1998, Orem entered into a capital lease for an office building. The present value of the annual rental payments is $200,000, which equals the fair value of the building. Orem made the first rental payment of $30,000 when due on January 2, 1999.

5. Orem's net income for 1998 was $180,000.

6. Orem declared and paid cash dividends for 1998 and 1997 as follows:

1998 1997

Declared Dec. 15, 1998 Dec. 15. 1997
Paid Feb. 28. 1999 Feb. 28. 1998
Amount $40,000 $45,000

Required: Prepare the 1998 statement of cash flows for Orem using the indirect method. Prepare relevant supplemental schedules.

Answer:

Reconstructed 1998 entries front additional information:

1. Investment in Belle Co. $60,000 (.25) 15,000
Investment income 15,000

There was no goodwill on the purchase: $137,500 (cost of investment) = (.25) ($550,000 book value and fair value of Belle's net assets at purchase of investment).

2. Loan receivable 150,000
Cash 150,000

Cash 22,500
Interest revenue (.10) ($150,000) (1/2) 7,500
Loan receivable 15,000

3. Cash 20,000
Accumulated depreciation 12,500 *
Property, plant and equipment 30,000
Gain on sale of equipment 2,500

* $30,000 - $17,500

4. Property, plant and equipment 200,000
Capital lease obligation 200,000

Orem Corporation
Statement of Cash Flows
For the Year Ended December 31, 1998

Operating activities
Net income $180,000

Adjustments to reconcile net income to net operating
cash flow
Undistributed earnings of Belle Co. (15,000)
Gain on sale of equipment (2,500)

Depreciation expense 75,000
Accounts receivable decrease 20,000

Inventories increase (67,500)

Accounts payable increase 30,000

Income taxes payable decrease (10,000)

Net operating cash flow $210,000

Investing Activities
Loan to Chase Company (150,000)

Proceeds from sale of equipment 20,000
Collection of principal payment on loan 15,000

Net investing cash flow (115,000)

Financing activities
Dividends paid (45,000)

Net Financing cash flow (45,000)

Net increase in cash 50,000
Cash at beginning of year 350,000
Cash at end of year $400,000

* Accumulated depreciation increased $62,500, net, during 1998, but was reduced $12,500 on the sale of equipment. Therefore, depreciation expense was $75,000.

Non-cash activity schedule
Acquisition of office building through capital lease $200,000

P 23-14 SCF. Indirect Method: Optional Spreadsheet The income statement, balance sheet, and analysis of selected accounts of Summer Company are given below.

Balance Sheet

December 31 Increase

Debits 1997 1998 (decrease)

Cash plus short-term investments* $ 80,000 $ 89,800 $ 9,800

Accounts receivable (net) 120,000 105,000 (15,000)
Merchandise inventory (perpetual) 360,000 283,200 (76,800)
Prepaid insurance 4,800 2,400 (2,400)
Investments, long-term 60,000 (60,000)

Land 20,000 76,800 56,800
Plant assets 500,000 518,000 18,000

Patent (net) 3,200 2,800 (400)
$1,148,000 $1,078,000 $(70,000)

Credits

Accumulated depreciation $ 130,000 $ 158,000 $ 28,000
Accounts payable 100,000 106,000 6,000

Wages payable 4,000 3,000 (1,000)

Income taxes payable 18,000 26,800 8,800

Bonds payable 200,000 100,000 (100,000)
Premium on bonds payable 10,000 3,400 (6,600)

Common stock, par $10 600,000 612,000 12,000
Contributed capital in excess of par 30,000 36,000 6,000

Retained earnings 56,000 32,800 (23,200)
$1,148,000 $1,078,000 $(70,000)

Income Statement 1998

Sales revenue $ 800,000

Cost of goods sold (448,800)
Depreciation expense (28,000)
Patent amortization (400)
Remaining expenses (including interest) (287,800)

Extraordinary gain, net of $5,000 tax 15,000

Net income $ 50,000

Analysis of selected accounts and entries:

a. Purchased operational asset; cost, $18,000; payment by issuing 1,200 shares of stock.

b. Payment at maturity date to retire bonds payable, $100,600.

c. Sold the long-term investments for $80,000. The market value of these securities classified as available for sale had not changed until 1998.

d. Purchased land, $56,800; paid cash.

e. Further information:

Retained earnings, beginning balance $56,000

Prior period adjustment, income tax, paid in 1998 (13,200)

Net income, 1998 50,000

Cash dividend paid (60,000)

Ending balance $32,800

Required: Prepare the SCF, indirect method.

Answer:

Spreadsheet:

Comparative Balances Balances
Balance Sheets 12/31/97 Dr. Cr. 12/31/98

Cash and short-term investments 80,000 (q) 9,800 89,800
Accounts receivable, net 120,000 15,000 (b) 105,000
Merchandise inventory 360,000 76,800 (c) 283,200
Prepaid insurance 4,800 2,400 (g) 2,400
Investments, long-term 60,000 60,000 (k)
Land 20,000 (m) 56,800 76,800
Plant 500,000 (l) 18,000 518,000
Patent, net 3,200 400 (f) 2,800

Accumulated depreciation (130,000) 28,000 (e) (158,000)

Total Assets 1,018,000 920,000

Accounts payable 100,000 6,000 (d) 106,000
Wages payable 4,000 (h) 1,000 3,000
Income taxes payable 18,000 8,800 (i) 26,800
Bonds payable 200,000 (n) 100,000 100,000
Premium on bonds payable 10,000 (j) 6,600 3,400
Common stock, $10 par 600,000 12,000 (l) 612,000
Contrib capital in excess of par 30,000 6,000 (l) 36,000
Retained earnings 56,000 (p) 60,000 50,000 (a) 32,800
________ (o) 13,200 _______
Total Liabs & Owners’ Equity 1,018,000 _______ _______ 920,000
Total Changes 265,400 265,400

Adjustments Leading to SCF:

Indirect Method

Operating Activities Dr. Cr.

Net income 50,000 (a) 50,000
Sales 800,000 (b) 15,000
Cost of goods sold 448,800 (c) 76,800
(d) 6,000
Depreciation 28,800 (e) 28,000
Patent amortization 400 (f) 400
Remaining expenses 287,800 (g) 2,400
1,000 (h)
(i) 8,800
6,600 (j)
Extraordinary gain 20,000 20,000 (k)
Tax on extraordinary gain 5,000
Prior period adjustment—tax pymt 13,200 (o)

Investing Activities

Sale of investments (k) 80,000
Purchase of land 56,800 (m)

Financing Activities

Retirement of bonds 100,000 (n)
Dividends paid 60,000 (p)
257,600
Net cash increase _______ 9,800 (q)
267,400 267,400

Summer Corporation
Statement of Cash Flows
For the Year Ended December 31, 1998

Cash flow from operating activities:
Net income $50,000

Add (deduct) to reconcile net income to net cash flow
Depreciation expense 28,800
Amortization of patent 400

Extraordinary gain on long-term investment (20,000)

Decrease in prepaid insurance 2,400
Merchandise inventory decrease 76,800

Amortization of bond premium (6,600)

Accounts receivable decrease 15,000
Accounts payable increase 6,000

Wages payable decrease (1,000)

Income taxes payable increase 8,800

Payment on prior years’ income tax (prior period adj.) (13,200)

Net cash inflow from operating activities $146,600

Cash flow from investing activities:
Sold long-term investment 80,000

Purchased land (56,800)

Net cash inflow from investing activities (Note A) 23,200

Cash flow from financing activities:
Cash dividends paid (60,000)
Bonds payable retired (100,000)

Net cash outflow from financing activities (160,000)

Net increase in cash and cash equivalents during 1998 9,800
Cash and cash equivalents balance, January 1, 1998 80,000
Cash and cash equivalents balance, December 31, 1998 $89,800

Note A Purchased operational asset, cost $18,000; paid in ful by issuing 1,200 shares of common stock.

A 23-6 Using the World Wide Web: Statement of Cash Flows This problem requires access to the World Wide Web portion of the Internet. The data for use in this problem is the most recent 10-K annual report of Cisco Systems. To obtain that information, use the Securities and Exchange Commission's Electronic Data Gathering, Analysis and Retrieval System (EDGAR) to retrieve Cisco's report. Steps to access EDGAR on the World Wide Web:

a. URL: http://www.sec.gov/index.html (the SEC's home page).

b. Click on EDGAR Database of Corporate Information.

c. Click on Search We EDGAR Database.

d. Click on Search the EDGAR Archives.

e. Enter the company name in the search dialog box.

f. Click on the listing for the most recent 10-K annual report.

g. Use Edit, Find in the toolbar to locate the statement of cash flows.

Required: Answer the following questions related to Cisco's statement of cash flows for the most recent year available or for the period specified by your instructor.

1. What method does Cisco use to present its statement of cash flows?

2. Comment on the difference between net income and net operating cash flow for the three years presented in the annual report. Which items caused the most significant differences between earnings and net operating cash flow?

3. Describe Cisco's investment behavior, both in short-term investments and in other longer-term investments.

4. How does Cisco report the difference between the earnings and the cash flow effects of accounts receivable?

5. Comment on Cisco's use of leverage, and whether there is a trend in the use of long-term debt financing,

6. Comment on the trend in capital expenditures and depreciation amounts shown in the SCF. Is there a relationship -between the two?

Answers:

(Instructor's note: This solution is based on the 1996 10-K report of Cisco Systems, which was the latest report available at the time of publication. Please inform your students as to the particular year you wish to use for the problem. This solution provides a template for the year you choose. Although the numerical values will be different in the solution for the current year, this solution should be a useful guide.)

1. Cisco uses the indirect method.

2. The difference between earnings and operating cash flow is relatively minor, although it increased each year in the three-year period ending 1996. In particular, the difference grew from a few $million in 1994 and 1995 to $149 million in 1996. However, compared to many other large firms, earnings and operating cash flow are very similar in amount.

The item contributing the most to the difference between the two amounts changes across reporting years, but the changes in inventories and receivables are consistently among the largest amounts. Depreciation, tax benefits and the change in accrued liabilities also contribute significantly to the difference.

3. Both purchases and proceeds from sale and maturity of short-term investments increased dramatically over the period. The level of passive investment may at first seem unusual given Cisco's growing dominance in its business. However. the firm is so successful it may be unable to find appropriate acquisitions fast enough to deplete its cash horde. The firm also is increasing its longer-term investments including acquisitions and property and equipment.

4. Cisco does not use the single line-item method of adjusting earrings for the change in net accounts receivable. The amount listed as the adjustment for the change in receivables in the reconciliation does not equal the change in net accounts receivable. Apparently Cisco uses the change in gross accounts receivable before write-offs, and then adds a second adjustment for bad debt expense (listed as provision for doubtful accounts).

5. The SCF shows no debt issuances for the three-year period. Cisco only issued stock, and purchased a similar amount of treasury stock during the period. The balance sheet lists no long-term debt at the end of 1996! Cisco's only debt is classified as current.

6. Cisco is increasing its investment in plant and equipment, but the level of this investment is significantly smaller than in other types of investments, both passive and strategic, as shown in the SCF. The depreciation adjustments in the reconciliation are growing rapidly in magnitude, in part due to the increased investment in plant and equipment, and in part due to the short average useful life of between 2.5 and 5 years (footnote 1).

CHAPTER 24: ACCOUNTING CHANGES AND ERROR CORRECTIONS

3. Complete the following schedule:

Method of Reflecting the Effect*

(1) (2) (3)

a. Change in estimate
b. Change in principle
c. Correction of error

* Identify these three captions: then enter appropriate checkmark on each line.

Answer:

Method of Reflecting the Effect*

(1) (2) (3)
Currently Prospectively Retroactively

a. Change in estimate x
b. Change in principle x x (exceptions)
c. Correction of error x

5. Explain the basic difference between an accounting change and an error correction.

Answer: An accounting change involves a change in accounting (a) principle, (b) estimate, or (c) entity. It is made with intent and by decision. Ali accounting error involves incorrect application of accounting principles and estimates, and mathematical errors. Accounting errors usually are made inadvertently and are not planned.

6. Why are the effects of changes from LIFO to other inventory flow methods accounted for retroactively when changes to LIFO from another method are reflected as changes in the income of the year the change is made?

Answer: During a period of increasing inventory costs. under LIFO the same quantity of inventory retains the initial value assigned to it when LIFO was first adopted. Increasing costs coupled with the passage of an extended time interval causes unrealistically low inventory carrying values under LIFO. A switch to some other method in such circumstances could result in a large credit, which would create "instant reported profits'* if the effect of the change were allowed to be reflected in current income. Changing to LIFO from another method usually would have a negative effect on income in the period of the change. Reporting such losses, but not gains, on the income statement can be traced to the concept of conservatism.

7. Other than changing from LIFO to another inventory flow method (which must be reflected retroactively), what other types of accounting changes must be accorded retroactive treatment rather than being accounted for using the current approach?

Answer: Changes in the method of accounting for income on long-term construction contracts, a change to or from the "full cost" method in extractive industries, a change in accounting principles related to a forthcoming issuance of capital stock by closely-held company, a change required by an APB or FASB pronouncement, and a change from retirement/replacement accounting to depreciation accounting for railroad track structures, are accounted for retroactively as special exceptions to the current approach.

11. What is the difference between a counterbalancing and a non-counterbalancing error? Why is the distinction significant in the analysis of errors?

Answer: A counterbalancing (self-correcting) error results from failure to properly allocate an expense or revenue item between two consecutive accounting periods. No error remains in retained earnings or other balance sheet accounts at the end of the second period because the total revenue and total expense to that date are correct. However, the interim reports are incorrect.

A non-counterbalancing (not self-correcting) error continues to affect the account balances and reports beyond a two-year period.

This distinction is significant in the analysis of errors because the correcting entry depends upon whether the error is counterbalancing or non-counterbalancing, as well as upon when the error is corrected relative to when the error was made.

12. Complete the schedule below by entering a plus sign to indicate overstatement. a minus sign to indicate understatement, or a zero for no effect.

Effect of Error On

Net Owners'
Income Assets Liabilities Equity

a. Ending inventory for 1997 understated:
1997 financial statements
0 1998 financial statements

b. Ending inventory for 1998 overstated:
1997 financial statements
1998 financial statements

c. Failed to record depreciation in 1997:
1997 financial statements
1998 financial statements

d. Failed to record a liability resulting from
revenue collected in advance at end of
1997; instead credited revenue in full
erroneously:
1997 financial statements
1998 financial statements

Answer:

Effect of Error On

Net Owners'
Income Assets Liabilities Equity

a. Ending inventory for 1997 understated:
1997 financial statements - - 0 -
1998 financial statements + 0 0 0

b. Ending inventory for 1998 overstated:0
1997 financial statements + + 0 +
1998 financial statements - 0 0 0

c. Failed to record depreciation in 1997:
1997 financial statements + + 0 +
1998 financial statements 0 + 0 +

d. Failed to record a liability resulting from
revenue collected in advance at end of
1997; instead credited revenue in full
erroneously:
1997 financial statements + 0 - +
1998 financial statements - 0 0 0

E 24-1 Multiple Choice: Accounting Changes Choose the correct answer to each question.

1. Which of the following is a change in accounting principle?

a. Correction of an error using the retroactive approach.

b. Change from an incorrect method to a correct method.

c. Change in the application of an accounting principle.

d. Change in the number of total expected service miles for depreciating a truck.

Answer: c.

2. Which of the following is not the type of accounting change that reports a cumulative effect in the income statement?

a. Change to the successful -efforts method of accounting for natural resources.

b. Change to LIFO for a firm in its second year that is able to reconstruct LIFO inventory layers.

c. Change in depreciation method.

d. Change in method of amortizing bond discount.

Answer: a.

3. Retroactive accounting treatment is used for which of the following?

a. Correcting errors and making estimate changes.

b. Changing to LIFO and correcting errors affecting income of prior years.

c. Changing to the completed-contract method of accounting for long-term contracts.

d. Correcting errors affecting prior years' income, but only if those prior years are disclosed on a comparative basis with the current year.

Answer: c.

4. A company changed from percentage of completion (PC) to completed contract (CC) for financial accounting purposes during 1998. Therefore:

a. Beginning January 1, 1998, CC should be used for construction accounting, and the difference between the income under the two methods for years before 1998 is disclosed in the 1998 income statement.

b. Beginning January 1, 1998, CC should be used for construction accounting, but no entry is made for the effects of the change on years before 1998.

c. Beginning January 1, 1998, CC should be used for construction accounting. and the difference between the income under the two methods for years before 1998 is an adjustment to the January 1, 1998 retained earnings balance.

d. Pro forma income amounts are disclosed in a schedule to the income statement for all years before 1998 shown in the 1998 annual report.

Answer: c.

5. Choose the correct statement concerning comparative financial statements.

a. They are required by the APB.

b. They are required by the SEC.

c. The number of statements presented comparatively affects the recorded amount of a cumulative effect of a change in accounting principle.

d. Firms generally do not disclose more than one year because financial statement users already have access to the reports of previous years.

Answer: b.

6. One of the advantages of the current, or cumulative effect, change is

a. Consistency is maintained.

b. Prior years' income effects do not affect income in the year of change.

c. The statements of previous years shown comparatively do not disclose any information about the effect of the change in those previous years.

d. Prior years' financial statements are not altered.

Answer: d.

7. Pro forma income numbers

a. Somewhat reduce the loss of comparability inherent in current, or cumulative effect. accounting principle changes.

b. Are required only for the year of change.

c. Are required for changes in estimates.

d. Equal the effect of the accounting change on income for each year shown.

Answer: a.

8. Pro forma net income for the year of a change in accounting principle equals

a. Net income for the year of change.

b. Net income for the year of change under the new method.

c. Net income before extraordinary items for the year of change.

d. Net income before cumulative effect of changes in accounting principle for the year of change.

Answer: d.

E 24-2 Overview: Types of Accounting Changes and Errors Analyze each case and enter a letter code in each column (type and approach) to indicate the basic accounting.

Type Approach

P = Principle
E = Estimate C = Current
R = Entity R = Retroactive
Case (event or transaction) AE = Error P = Prospective

1. Recorded expense, $870; should be $780.
2. Changed useful life of a machine..
3. Changed from single-company to consolidated financial statements..
4. Changed from straight-line to accelerated depreciation..
5. Change in residual value of an intangible operational asset..
6. Changed from cash basis to accrual basis in accounting for bad debts..
7. Changed from percentage of completion to completed contract for
long-term construction contracts..
8. Changed from LIFO to FIFO for inventory..
9. Changed to a new accounting principle required by the FASB..

Answer:

Type Approach

P = Principle
E = Estimate C = Current
R = Entity R = Retroactive
Case (event or transaction) AE = Error P = Prospective

1. Recorded expense, $870; should be $780. AE R
2. Changed useful life of a machine.. E P
3. Changed from single-company to consolidated financial statements.. R not discussed
4. Changed from straight-line to accelerated depreciation.. P C
5. Change in residual value of an intangible operational asset.. E P
6. Changed from cash basis to accrual basis in accounting for bad debts AE R
7. Changed from percentage of completion to completed contract for
long-term construction contracts.. P R
8. Changed from LIFO to FIFO for inventory.. P R
9. Changed to a new accounting principle required by the FASB.. P R

E 24-4 Change in Depreciation Method Four-H, Inc., changed from straight-line to an accelerated depreciation method for book purposes only in 1998. Data for years affected by the change:

1998 1997 1996

Increase in depreciation due to change $ 20,000 $25,000 $ 30,000
Income computed under the SL method* 100,000 90,000 120,000

*After tax; the tax rate is 40%. The income amount shown for 1998 was computed before considering the accounting change.

Required:

1. Provide the 1998 entry to record the accounting change.

2. What is reported net income for 1998?

3. What is the 1997 pro forma net income amount?

Answer:

Requirement 1

Cumulative effect of accounting change 33,000 **
Deferred income tax liability ........... 22,000
Accumulated depreciation ...... 55,000*

* $25,000 + $30,000
** (1-.40) $55,000

Requirement 2

$100,000 - $20,000 (.60) - $33,000 = $55,000

Requirement 3

$90,000 - $25,000 (.6) = $75,000

E 24-8 Change in Estimated Useful Life and Salvage Value for a Plant Asset Bellico Company, which has a calendar fiscal year, purchased its only depreciable plant asset on January 1, 1997, which has the following characteristics:

Original cost $10,000
Estimated residual value 1,000
Estimated useful life three years
Depreciation method sum-of-years'-digits

In 1998, Bellico increased the estimated residual value to $2,000 and increased the total estimated useful life to five years for financial accounting purposes. Additional information:

1997 1998

Revenue $ 40,000 $ 50,000
Expenses other than depreciation and tax 25,000 30,000
Extraordinary loss before tax 5,000
Tax rate 30% 30%
Common shares outstanding entire year 100,000 100,000

Required:

1 Provide the 1998 entry(ies) for depreciation and the ending 1998 accumulated depreciation balance.

2. Provide the comparative 1997 and 1998 income statements, including disclosures related to the accounting change.

Answers:

Requirement 1

1998 Depreciation before accounting change:
($10,000 - $1,000) x 2/6 $3,000
1998 Depreciation after accounting change:
Book value, January 1, 1998 = $10,000 - ($9,000 x 3/6) = $5,500
1998 depreciation = ($5,500 - $2,000) x 4/10 = 1.400
(at January 1, 1998, four years remain)
Difference, before tax $1,600

1998 entry to record depreciation
Depreciation expense 1,400
Accumulated depreciation 1,400

December 31. 1998 Accumulated Depreciation balance:
1997 depreciation ($9,000 x 3/6) $4,500
1998 depreciation 1,400
1998 ending Accumulated Depreciation $5,900

Requirement 2

BELLICO COMPANY
Income Statements
For Years Ended December 31

1997 1998

Revenues $40,000 $50,000

Expenses other than depreciation and tax: (25,000) (30,000)
Depreciation expense (4,500) (1,400)

Net income before extraordinary item and tax 10,500 19,600

Income tax expense (30%) (3, 150) (5,580)

Net income before extraordinary item 7,350 13,020

Extraordinary loss,, net of $1,500 tax _____ (3,500)

Net income $ 7,350 $ 9,520

Net income before extraordinary item $.07 $.13

Net income $.07 $.095

Footnote: During 1998, the estimated useful life and residual value on a plant asset were changed in light of new information. The change increased net income before extraordinary items and net income $1,120 ($1,600 x 70%) or $.01 per share.

E 24-13 Analysis of Seven Errors: Correcting Entries, Correct Pretax Income The 1997 income statement of Burke Corporation has just been tentatively completed. It reflects pretax income for 1997 of $85,000. The accounts have not been closed for the year ended December 31, 1997. A review of the company's files and records revealed the following errors that have not been corrected:

a. Patent amortization of $3,000 per year was not recorded in 1996 and 1997.

b. The 1995 ending inventory was overstated by $4,000.

c. Machinery acquired on January 1, 1993, at a cost of $26,000 is being depreciated by the straight-line method over 10 years. The good-faith estimate of its residual value of $6,000 has not been included in the computation of depreciation expense.

d. Accrued wages of $1,500 at December 31, 1996, were not recognized.

e. A $1,000 cash shortage during 1997 was debited to retained earnings.

f. Ordinary repairs on the machinery in (c) above of $7,000, incurred during January 1997, were debited to the machinery account.

g. During 1997, treasury stock that cost $8,000 was sold for $11,000. The difference was credited to extraordinary gain. The company uses the cost method to account for treasury stock.

Required:

1. Give the correcting entry, if needed, for each of the above errors. Explain the basis and show computations for each item. Ignore income tax considerations.

2. Compute the correct pretax income amount for 1997. Set up an appropriate schedule that reflects each change and the correct 1997 pretax income.

Answers:

Requirement 1

Correcting entries:

a. Prior period adjustment correction (patent amortization, 1996) 3,000
Patent amortization expense, 1997 3,000
Patent ..... 6,000

b. No correcting entry because this error self-corrected by the end of 1996. For the 1997 comparative financial statements (which include 1996), the $4,000 inventory (beginning) overstatement (for 1996) would have to be incorporated into the 1996 statements for comparability reasons.

c. Accumulated depreciation ($600 x 5 years) 3,000
Depreciation expense, 1997 600
Prior period adjustment, correction (depreciation. $600 x 4 yrs.) 2,400

Computations:
Depreciation per year ($26,000 10 yrs) $2,600
Correct amount of depreciation per year
[($26.000 - $6.000 = $20.000) 10 yrs.] 2,000
Depreciation overstatement per year $ 600

d. Prior period adjustment, correction (wages) 1,500
Wage expense, 1997 1,500

e. Cash shortage(expense) 1,000
Retained earnings 1,000

f. To correct the entry made in January 1997:
Repair expense, 1997 7,000
Machinery 7,000

Presumably the company recorded-depreciation based on the balance in the machinery account; therefore, depreciation on this $7,000 was included in depreciation expense for 1997. The excess depreciation must be reversed in 1997.

Accumulated depreciation ($7,000 6 years remaining) 1,167
Depreciation expense, 1997 1,167

g. The difference between the cost and selling price of treasury stock is properly recorded as a change in contributed capital. A corporation cannot recognize a gain (loss) by dealing in its own capital stock.

Extraordinary gain (treasury stock) 3,000
Contributed capital from treasury stock transactions 3,000

Requirement 2

1997

Tentative pretax income (given) $85,000

Corrections:

a. Patent amortization (debit) (3,000)

b. No effect on net income -0-
c. Depreciation expense (credit) 600
d. Wage expense (credit) 1,500

e. Cash shortage (debit) (1,000)
f. Repair expense (debit) (7,000)

Depreciation correction (credit) 1,167

g. Extraordinary gain (debit) (3,.000)

Correct 1997 pretax income $74,267

P 24-1 Multiple Choice: Accounting Changes Choose the correct answer to each of the following questions:

1. Immutable Company changed from the sum-of-years'-digits method (SYD) to the straight-line method (SL) of depreciation in 1998. Depreciation under each method for the years affected follows:

Year SYD SL

1995 $200 $150
1996 240 160
1997 600 450
1998 450 500

Ignoring taxes, Immutable reports which of the following amounts in cumulative effect of change in accounting principle in 1998?

a. $280 cr.

b. $230 cr.

c. $50 dr.

d. $320 dr.

Answer: a. ($200 + $240 + $600) - ($150 + $160 + $450) = $280

2. Quick Company changed depreciation methods for accounting purposes and correctly computed a cumulative effect before tax of $600 (reduces income). The tax rate is 30 percent. The entry to record the change in accounting principle includes

a. Cr. accumulated depreciation $420.

b. Dr. deferred tax liability $180.

c. Dr. income taxes payable $420.

d. Dr. cumulative effect $600.

Answer: b. 30% x $600 = $180

3. Fido Dog Food Company changed its method of accounting for inventory from LIFO to FIFO in 1998 for both tax and financial accounting purposes. The 1997 ending inventory was $40,000 under LIFO and $55,000 under FIFO. Fido discloses 1997 and 1998 results comparatively. The tax rate is 30 percent. The entry to record the change in accounting principle includes

a. Cr. inventory $15,000.

b. Cr. retained earnings $10,500.

c. Cr. cumulative effect of change in accounting principle $10,500.

d. Insufficient information.

Answer: b. ($55,000 - $40,000) x 70% = $10,500

4. An asset purchased January 1, 1994, costing $10,000 with a 10-year useful life and no salvage value was depreciated under the straight-line method during its first three years. During 1997, the total useful life was re-estimated to be 17 years. What is depreciation in 1998?

a. $462.

b. $412.

c. $464.

d. $500.

Answer: d. Book value, January 1, 1007 = $10,000 – ($10,000/10) x 3 = $7,000
1998 depreciation = $7,000/(17 - 3) = $500

5. A company made a retroactive accounting change in 1998. Only the net incomes of 1997 and 1998 were affected. Therefore, the comparative retained eamings statements featuring both years disclose which of the following?

a. A cumulative effect adjusting the January 1, 1997. retained earnings balance.

b. A cumulative effect adjusting the January 1, 1997, and 1998 retained earnings balances.

c. A cumulative effect adjusting the January 1, 1998, retained earnings balance.

d. No cumulative effect.

Answer: c.

C 24-2 Ethical Considerations: Accounting Changes In 1982, RTE Corporation, a manufacturer of electric power transmission and distribution equipment, more than doubled its EPS by changing depreciation methods. In justifying the change, the controller said, "We realized that, compared to our competitors, our conservative method of depreciation might have hurt us with investors because of its negative impact on net earnings" ("Double Standard," Forbes, November 22, 1982, p. 178).

Although difficult to prove, there is considerable evidence that accounting changes are made for reasons other than improved financial reporting. GAAP is flexible in the initial selection of accounting methods and in making subsequent changes. However, APB Opinion No. 20 specifically requires that only changes to preferable accounting methods be made.

Required: Comment on the appropriateness of making accounting changes to fulfill financial reporting objectives. Consider relevant ethical issues in your response.

Answer:

The accounting profession requires that accounting changes be made only if the change is preferable, From APB Opinion No. 20, par. 16:

The presumption that an entity should not change an accounting principle may be overcome only if the enterprise justifies the use of an alternative acceptable accounting principle on the basis that it is preferable. The burden of justifying other changes rests with the entity proposing the change. (author emphasis added).

In addition, auditors must make a judgment as to the acceptability of accounting changes. The profession, in response to societal demands for accurate and representative financial reporting, is interested in the integrity of the reporting process and has a vested interest in regulating accounting changes.

However, it would appear that many firms take advantage of the inherent inability to enforce the preferability requirement. Many firms make accounting changes without appealing to the criterion of "better reporting method." Indeed, the initial choice of method need riot be the "best" method; therefore it is difficult to understand why the change must be to a better method. But some observers argue that changes made to achieve financial reporting objectives while making the usual preferability statement (e.g., "better matching") is a prevarication. and a breach of professional ethics.

Yet the flexibility of GAAP creates a considerable incentive when the need arises. Holding to a strict interpretation of Opinion No. 20 would clearly prohibit many of the changes being made. However, it is not feasible to hold firm to the requirement. Some argue that accounting changes per se are not unethical and that financial statement users are riot fooled by purely "paper" changes. But the latter is no excuse to make a change for one reason, and then imply it was made for a different reason. Certain changes could place creditors who impose debt covenants on reporting companies at increased risk. If accounting changes are the only way a company can maintain compliance with a debt covenant, these changes should not be made.

Accounting changes made solely to increase management compensation are unethical and compromise shareholder wealth. Bonus arrangements provide incentives for substantive accomplishments, not accounting results. However, some companies, for example, may change to units of production methods during hard times (low production) thus decreasing depreciation and increasing income and compensation.

By contrast, companies intentionally may use conservative methods of accounting to maintain the perception that their earnings are of high quality. However, when technological obsolescence suggests a change to an accelerated depreciation method or a decreased useful life, such a change should be made to maintain the integrity of the financial statements.

Although not directly applicable, the Standards of Ethical Conduct for Management Accountants (Institute of Management Accountants) includes the following:

Accountants should:

Perform their professional duties in accordance with relevant laws, regulations. and technical standards.

Refrain from either actively or passively subverting the attainment of the organization's legitimate and ethical objectives.

Communicate unfavorable as well as favorable information and professional judgments or opinions.

Communicate information fairly and objectively.

Disclose fully all relevant information that could reasonably be expected to influence an intended user's understanding of the reports, comments, and recommendations presented.

Management accountants are directly involved in financial reporting. The above ethical principles argue against making accounting changes solely for firm gain.

There is, of course, room for honest differences of opinion on accounting methods and estimates, and the remarks in this solution do not pertain to such differences.

CHAPTER 25: SPECIAL TOPICS: DISCLOSURES, INTERIM REPORTING, AND SEGMENT REPORTING

1. What are some sources of information about a company other than the financial statements?

Answer: There are numerous sources of information about a firm's activities in addition to its financial statements. Even within the financial statement,;. it is very important to remember that the notes provide vital information for the proper interpretation of the financial statements. The notes usually also contain a number of supplementary disclosures, such as line-of-business reporting of potentially great importance.

Beyond the statements themselves there area number of related sources of information. The Management Discussion & Analysis section is useful for getting management's perspective in interpreting the financial information. The CEO letter to the shareholders often contains insights about interpreting the statements. and sometimes the CEO will comment on future plans and prospects. Finally, the firm may provide news releases about various actions and activities of importance to the future of the firm, and analysts often provide their interpretation of the future for the company. Thus, financial statements are only one of many sources of potentially important information.

4. What is the purpose of notes to the financial statements?

Answer: Notes to the financial statements provide quantitative and qualitative explanations of various items included or not included in the body of the financial statements that merit explanation under the fill) disclosure principle. Thus, notes generally reflect application of the full-disclosure principle. They also provide information for developing a better understanding of the quantitative information contained in the body of the financial statements.

6. What is Form 10-K? What firms must prepare a Form 10-K? When must Form 10-K be filed? What information items must be included in Form 10-K?

Answer: The Form 10-K is an annual report submitted by publicly traded companies to the SEC. It includes all financial reporting information and a number of additional items.

All publicly-traded companies must file a Form 10-K with the SEC within 90 days of the company’s fiscal year-end. The information items that must tic- included in the Form 10-K are:

Item
No. Heading Description

1. Business History and description business, recent developments. principal
products and services, major industry segments.

2. Properties Locations and general descriptions of plants and other physical
properties.

3. Legal Description of pending legal proceedings. principal parties to the
Proceedings proceedings, dates, allegations. and relief sought.

4. Voting Matters Description of mailers submitted to voting security holders for
approval.

5. Market for Identification of market(s) where corporation common stock is
Common Stock traded. including number of shares, frequency of trading, amounts
of dividends.

6. Selected Five year summary including net sales, income (loss) from
Financial Data continuing operations, EPS, total assets, cash dividends, and
long-term obligations.

7. Management Discussion of liquidity, capital resources, results of operations,
Discussion and impact of inflation as needed to understand the company's
and Analysis financial condition, change in financial condition, and operating
results.

8. Financial Consolidated financial statements including balance sheets for two
Statements and years. income statements, cash flow statements, and statements of
Supplementary changes in stockholders' equity for three years, and related Notes.
Data Also, selected quarterly data and the auditor's opinion.

9. Disagreements If and when auditors are changed due to disagreements on
on accounting accounting principles, a description of the disagreement and
disclosures summary of the effects on the financial statements.

10. Directors and Names, ages, and positions of directors and officers.
Officers

11. Executive Salaries, stock options and other benefits for corporate officers
Compensation and selected others.

12. Security List of beneficial owners and management owners of corporate
Ownership securities.

13. Certain Description of transactions with managers and related parties, and
Relationships for certain other business relationships.

14. Exhibits, Detailed supporting schedules, often specified in Regulation S-K.
Schedules and Examples are marketable securities, property, plant and equipment,
Reports including accumulated depreciation. short-term borrowings, and a
listing of subsidiaries.

15. Signatures The report must be signed by the Chief Executive Officer, the Chief
Financial Officer, and a majority of the Board of Directors.

7. In recent years, many firms regulated by the SEC have included' a management discussion and analysis section in the annual report to shareholders. Describe what is included in the MDA section.

Answer: The management and discussion analysis (MDA) section includes a discussion provided management of the company's financial condition. its change in financial condition, and its results of operations for the periods covered in the report.

9. What must a firm disclose about related party transactions?

Answer: A firm must disclose the following regarding related party transactions:

1. The nature of the relationship involved.

2. A description of the transaction, including transactions in which no amounts or nominal amounts were involved. for each period for which income statements are presented.

3. The dollar amounts of transactions for each period for which income statements are presented.

4. Any amounts due to or from related parties as of the balance sheet date. and the terms and manner of settlement planned.

10. What is the basic rationale for requiring segment reporting? What are reporting?

Answer: The rationale for segment reporting is to provide financial statement readers with information on the relative proportions of a company's resources committed to various lines of business. Knowing information on the success the company has experienced in each line of business allows the financial statement reader to make a more informed decision than if they were to make such decisions using only the aggregate financial information. Each line of business probably has different risks and reward characteristics. Providing disaggregated information allows the financial statement reader to better assess the risk and reward associated with each line of business, and also for the company.

There are two main arguments against segment reporting. First, gathering and providing segment information is costly for firms and of little value to the financial statement reader. A second argument against segment reporting is that it requires disclosure of proprietary information, that is, disclosing the operating income and other information about a line of business provides a potential competitor with valuable information that might work to the competitive disadvantage of the firm making the segment disclosures.

14. Briefly describe the alternative tests for determining a reportable segment.

Answer: A reportable industry segment is an industry segment that meets one or more of the following possible Criteria:

1. Its revenue is 10% or more of the combined revenue segments of the entity.

2. The absolute amount of its operating loss or profit is 10% or more of the greater, in absolute amount, of:

a. The combined operating profit of all industry segments of the entity that did not incur an operating loss, or

b. The combined operating loss of all industry segments of the entity that did incur an operating loss.

3. Its identifiable assets are 10% or more of the combined identifiable assets of all industry segments (of the entity).

16. What is the difference between the discrete view and the integral part view of interim financial reporting periods?

Answer: The discrete view holds that each interim period is an independent period that stands alone. As such, it is subject to the same principles and procedures for revenue and expense recognition, accruals and deferrals as an annual period. The integral view holds each interim reporting period as an integral part of the annual reporting period. Under this view, revenue and expense recognition, accruals and deferrals for each interim period are affected by judgments about the results of operations for the remainder of the annual reporting period. There can be and are allocations, accruals and deferrals between the interim periods that would not be made between annual periods.

E 25-2 Interim Reporting In September 1998, Crystal Mountain Ski Resorts spent $300.000 for advertising for the coming ski season. The ski season lasts from October through the following March. with business expected to be spread evenly over this period. The fiscal year for Crystal Mountain ends March 31, 1999.

Required: Determine the amount of expense that should be included in Crystal Mountain's interim financial statements for September 30 and for December 31, 1998. Justify and explain your answer.

Answer: Since the advertising expenditure is expected to benefit the third and fourth quarters equally. it should he allocated to these two quarters in equal amounts of $150.000 each quarter. Therefore, the second quarter, which ends September 30, 1998, should not show any of the above as expense. The entire amount would be capitalized as an intangible asset (prepaid advertising). The December 31, 1998, interim report would expense $150,000 of the intangible asset, with the final $150,000 being expensed in the fourth quarter.

E 25-3 Interim Reporting The Proctor Company reported income before income taxes of $100,000 and $150,000 in the first two quarters of 1998. Management's estimate of the annual effective tax rate was 35 percent at the end of the first quarter and 30 percent at the end of the second quarter.

Required: Determine the income tax expense for the first two quarters of 1998.

Answer:

The first quarter tax computations are:

Pretax accounting income $100,000
Appropriate tax rate x .35
Income tax expense $ 35,000

At the end of ft second quarter, the estimated annual tax rate is reduced to 30%. The total income tax expense obligation for the combined two quarters is determined:

Pretax accounting income $250,000
Appropriate tax rate x 30
Total income tax expense to date $ 75,000

The amount to be recorded as income tax expense in the second quarter is the difference between the total year-to-date amount of obligation. less the amount recognized in prior interim periods:

Total income tax expense to date $75,000
Income tax expense recorded in earlier periods 35.000
Income tax expense to be reported in second period $40,000

As of the end of the second quarter, the total amount of income tax expense recorded is $75,000.

E 25-5 Segment Reporting The Ullrich Products Corporation is organized in three major product divisions: Health care products, Agricultural products, and Food products. Within the Health care products division are three separately organized groups: pharmaceuticals, consumer health care, and medical devices. The Health care products division manager receives separate financial information from each group within the division for purposes of allocating resources and assessing performance. The chief executive officer of the company. Jan Ullrich, make similar decisions for all three divisions. In 1998 the company has revenues of $12,300,000, which includes interest revenue of $100,000 that is not allocated to any of the divisions. Total company-wide income before taxes is $1,500,000 after deducting all expenses, including some that are not allocated to the divisions. The corporation has total assets of $22,000,000, some of which are headquarters facilities not included in any of the divisions. Intercompany sales are priced at market prices, and profits on intersegment sales total $50,000 in 1998. The same accounting procedures used for corporate financial reporting are used in measuring sales. profits, and assets at the division and group level or the organization. Specific division and group level financial information provided to management for 1998 is as follows (all amounts are in thousands):

 

Health Care Products Groups

Total Health
Consumer Medical Care Products
Pharmaceuticals Health Care Devices Division

Sales to external customers $ 6,000 $3,000 $1,200 $10,200
Intersegment sales 500 0 0 500

Income (loss) before taxes 1,800 200 (400) 1,600

Segment assets as of Dec. 31 10,000 3,500 1,500 15,000
Depreciation & amortization† 300 100 100 500
Capital expenditures* 400 200 100 700

Agricultural Food
Products Products
Division Division

Sales to external customers $1,000 $1,000
Intersegment sales 0 700
Income (loss) before taxes 200 100
Segment assets as of Dec. 31 4,000 2,000
Depreciation & amortization† 150 100
Capital expenditures* 200 200

† An additional depreciation of $50 on headquarters facilities is not included in segment amounts.

* An additional $200 of capital expenditures was incurred for facilities for headquarters.

Required

1. Assume all the groups within the Health care products division qualify as operating segments. as do the Agricultural products and the Food products divisions. Determine which are the reportable operating segments.

2. Show the quantitative information that is required to be reported under SFAS No. 131 for Ullrich for 1998. All revenues, expenses, or assets not included above as part of an operating segment are unallocated corporate items.

Answer:

Requirement 1

Since all the groups within the Health care products divisions are considered operating segments, each must be considered as a potentially reportable segment. Each group and the other two divisions must be examined as to whether they meet the quantitative thresholds to require separate disclosure.

The revenue test is to report all operating segments with revenues (including external and internal revenues) greater than 10% of ($10,200 + $500 + $2,000 + $700) = $1,320.

Pharmaceuticals, Consumer health care, and the Food products division meet this threshold (Note that the Food products division does not meet the threshold if intersegment sales were not considered).

The profit test is 10% x $2,300 = $230. Pharmaceuticals and Medical Devices meet the threshold.

The segment assets test is 10% x $21,000 = $2,100. Pharmaceuticals, Consumer Health Care, and Agricultural Products meet the threshold.

Thus, all five operating segments meet one or more of the threshold quantities. All five are reportable segments.

Requirement 2

Operating Segments Financial Information

Consumer Medical Agricultural Food
(Amounts in 000s) Pharmaceuticals Health Devices Products Products Totals
Care

Total segment
revenues $ 6,500 $ 3,000 $ 1,200 $ 1,000 $ 1,700 $ 13,400

Intersegment
revenues 500 — — — 700 1,200

Depreciation &
amortization 300 100 100 150 100 750

Segment profit 1,800 200 (400) 200 100 1,900

Segment assets 10,000 3,500 1,500 4,000 2,000 21,000

Expenditures for
segment assets 400 200 100 200 200 1,100

Reconciliations:

Reconciliations for revenues, income before income taxes, total assets and other significant items are as follows:

Revenues

Total revenues for reportable segments $13,400
Other revenues 100

Less: intersegment revenues (1,200)

Total company reported revenues $12,300

Profit or loss

Total profit for reportable segments $1,900

Elimination of intersegment profits (50)
Unallocated amounts:
Other corporate expenses (350)

Total company income before income taxes $1,500

Assets

Total assets for reportable segments $21,000
Other unallocated costs 1,000
Company total assets $22,000

Other significant items

Segment Company
Totals Adjustments Totals

Expenditures for assets 1,100 200 1,300
Depreciation and amortization 750 50 800

E25-6 Identify Reporting Segments and Major Customers Keefe Corporation has expanded rapidly, and segment reporting has become an accounting issue. The company has no intersegment sales. The following data are available for the 1998 fiscal year which ended on December 31 (amounts in millions):

Total Operating
Segment Profit Identifiable
Operating Segments Revenues (Loss) Assets

A $620 $200 $400
B 100 20 80
C 340 70 300

D 190 (30) 140
E 180 (25) 180

F 70 10 120

G 120 (20) 140
All others 380 (25) 140

The "all others" includes five operating segments. none with revenues or assets greater than $80 million and none with an operating profit.

Operating segments A and B have very similar products and production processes, but serve different customer types and use quite different product distribution systems. This is partly because operating segment B is in a regulated environment but operating segment A is not. Also. Operating segments F and G have very similar products, production processes, and product distribution systems, but are organized as separate divisions because they serve substantially different types of customers. Neither F nor G is in a regulated environment.

Required:

1. Determine what am reportable segments without regard to aggregation criteria.

2. If the requirements for reportable segments am not yet met, apply appropriate aggregation criteria to identify additional reportable segments.

3. Assume Keefe has sales totaling $220 million to the U.S. Federal government primarily from operating segments A and C. Other significant customers include annual revenues of $190 million from Ikon Technology (primarily sales of segment D), and $100 million in sales by segment E to the French government. What, if any, disclosures must Keefe make regarding major customers? Show the disclosure Keefe must make.

Answers:

Requirement 1

Initially all reporting segments are examined using the quantitative thresholds to identify reportable segments.

Total Operating
Segment Profit Identifiable
Operating Segments Revenues (Loss) Assets

A $620 $200 $400
B 100 20 80
C 340 70 300

D 190 (30) 140
E 180 (25) 180

F 70 10 120

G 120 (20) 140
All others 380 (25) 140

Totals $2,000 $200 $1,500

Thus any operating segment with revenues equal to or greater than $200 million is a reportable segment (segments A and C). Any segment with identifiable assets greater than $150 million is a reportable segment (segments A, C, and E). The total operating profit for all the segments with operating profits totals $300 million; thus any segment with an operating profit or loss equal to or greater than an absolute amount of $30 million is a reportable segment (Segments A. C. and D). Thus, segments A. C. D. and F. are reportable segments without regard to the aggregation criteria.

Requirement 2

Reportable segments must provide information on separate segments whose sum of revenue is at least 75 percent of the firm's total revenue. Segments A. C. D. and E have revenue of $1,330 million. which is only 66.5% of the total revenue. If a majority of the aggregation criteria arc met by two segments, they can be aggregated for purposes of identifying reportable segments. Segments A and B are candidates for combining, but they have only 2 of the 5 criteria in common; thus they cannot be aggregated. Since segments F and G are similar on four of the five criteria. they meet the majority test and can be aggregated as a reportable segment as follows:

Segment F + G 190 (10) 300

With F + G considered a reportable segment, the total revenues included in reportable segments increases to $1,520, or 76% of the total. The 75 percent requirement has been met.

Requirement 3

If any major customer contributes 10 percent or more to a firm’s revenues, this fact must be disclosed, including the total amount of revenues from each such customer, and the segment or segments reporting the revenues. The U.S. federal government contributes over 10% of Keefe's revenues and must be reported. Neither of the other significant customers are major customers under the SFAS No. 131 criterion.

An example of disclosure:

Major Customers

Revenues from one customer of Keete Corporation's segments A and C represent approximately $220 million of the company’s total revenues.

E 25-7 Interim Reporting: Application of Guidelines In the context of interim reporting, items may (a) be recognized in the interim statements of the current interim period, (b) be recognized in the current interim period but require- special disclosure, (c) be deferred in their entirety (that is, not recognized until some later interim period, or not recognized at all), or (d) be amortized or accrued (recognized partly in the current interim period and partly in subsequent interim periods). A number of items are listed below that require a decision on how they should be inc6rporated on interim statements. Match the letters given above with the numbered items given below to indicate how each item should be incorporated on the interim statements.

1. Salaries allocable to services rendered during the current period.

Answer: A

2. Inventories estimated by use of the gross margin method.

Answer: B

3. Temporary declines in market value of inventories.

Answer: C

4. Short-term stock investment gains from recoveries of market value (not in excess of previously recognized market declines).

Answer: A

5. Materials and wages allocable to products sold this period.

Answer: A

6. Costs benefiting two or more interim periods.

Answer: D

7. Increase in gross margin due to liquidation of a layer of LIFO-based inventory expected to be replenished by year-end.

Answer: C

8. Quantity discounts allowed to customers based on the annual volume of their purchases.

Answer: B

9. Contingencies and other uncertainties that may affect fairness of presentation.

Answer: A

10. Income tax on income of first quarter where total income for the first quarter puts the company in a low tax bracket; subsequent operations are expected to be sufficiently profitable that by end of second quarter, and thereafter taxable income of the company will be in a higher bracket.

Answer: B

A25-1 PepsiCo Inc. Excerpts from the Industry Segments disclosures in the 1995 PepsiCo Inc. annual report follow:

Industry Segments

Growth Rate
Net Sales 1990-1995 1995 1994 1993

Beverages: U.S 7% $ 6,977 $6,541 $5,918
International 19% .3,571 3.146 2.720

10% 10,548 9,687 8,638

Snack Foods: U.S 10% 5,495 5,011 4,365
International 19% 3,050 3,253 2,662

12% 8,545 8,264 7,027

Restaurants: U.S 11% 9,202 8,694 8,026
International 25% 2,126 1,827 1,330

13% 11,328 10,521 9,356

Combined Segments

U.S 9% $21,674 $20,246 $18,309
International 20% 8,747 8,226 6,712

12% 30,421 28,472 25,021

By U.S. Restaurant Chain
Pizza Hut 8% $ 3,977 $ 3,712 $ 3,595
Taco Bell 15% 3,503 3,340 2,855
KFC 9% 1,722 1,642 1,576

11% $ 9,202 $ 8,694 $ 8,026

Operating Profit

Beverages: U.S 11% $ 1,145 $ 1,022 $ 937
International 19% 164 195 172

12% 1,309 1,217 1,109

Snack Foods: U.S 9% 1,132 1,025 901
International 14% 300 352 289

10% 1,432 1,377 1,190

Restaurants: U.S 10% 451 659 685

International 8% (21) 71 93

9% 430 730 778

Combined Segments

U.S 10% $ 2,728 $ 2,706 $ 2,523
International 14% 433 618 554

10% 3,171 3,324 3,077

Equity (Loss) Income (3) 38 30

Unallocated expenses, Net (181) (161) (200)

Operating Profit 11% $ 2,987 $ 3,201 $ 2,907

Combined Segments

Growth Rate
Net Sales 1990-1995 1995 1994 1993

By U.S. Restaurant Chain
Pizza Hut 9% $ 308 $ 285 $ 338
Taco Bell 12% 105 273 256
KFC 7% 38 101 91

10% $ 451 $ 659 $ 685

Segment Operating
Net Sales Profit (Loss) Identifiable Assets

Geographic Areas 1995 1994 1993 1995 1994 1993 1995 1994 1993

United States $21,674 $20,246 18,309 $2,728 $2,706 $2,523 $14,505 $14,218 $13,590

Europe 2,783 2,177 1,819 (65) 17 47 3,127 3,062 2,666

Mexico 1,228 2,023 1,614 80 261 223 637 995 1,217
Canada 1,299 1,244 1,206 86 82 102 1,344 1,342 1,.364
Other .... 3,437 2,782 2,073 342 258 182 2,629 2,196 1,675
Combined Segments $30,421 $28,472 $25,021 $3,171 $3,324 $3,077 22,242 21,813 20,512

Investments in Unconsolidated Affiliates 1,635 1,295 1,091

Corporate 1,555 1,684 2,103

$25,432 $24,792 $23,706

Beverages 9% $10,032 $9,566 $ 9,105 By U.S. Restaurant Chain
Snack Foods 7% 5,451 5,044 4,995 Pizza Hut 8% $1,700 $1,832 $1,733
Restaurants 14% 6,759 7,203 6,412 Taco Bell 19% 2,276 2,327 2,060
Investments in Uncon- KFC 7% 1,111 1,253 1,265
solidated Affiliates 9% 1,635 1,295 1,091 Total U.S. 12% 5,087 5,412 5,058
Corporate 9% 1,555 1,684 2,103 International 27% 1,672 1,791 1,354

8% $25,432 $24,792 $23,706 14% $6,759 $7,203 $6,412

Required:

1 . In what different lines of business does PepsiCo report? For 1995, which line of business earned the largest profit margin (operating profit as a percent of revenues)? The smallest profit margin? Which of the restaurant chains has the highest profit margin?

2. In what lines of business does PepsiCo appear to be growing the most rapidly? How does this growth relate to the profit margins of the various lines of business?

3. In general how important is international operations to PepsiCo? Comment on the relative profit margin of U.S. versus international operations.

4. Consider another measure of profitability such as operating income divided by identifiable assets. Evaluate the profitability of PepsiCo's various businesses.

Answer:

Comment: As a group assignment. this case can involve a great deal more analysis than that specifically asked for in the assignment. For example, students could be asked to analyze operating margins and return on investment for earlier years, looking for trends in the data. A more detailed profitability analysis of each restaurant chain could be conducted. Finally, the importance of unconsolidated affiliates could be analyzed. These areas are not specifically addressed in the assigned material, and thus are not addressed here.

Requirement 1

PepsiCo reports three lines of business: Beverages, Snack Foods, and Restaurants. It is also possible to further break out each of these segments into U.S. and international components. The 1995 profit margins for the three basic segments are:

Beverages $1,309/$10,548 12.4%
Snack Foods $1,432/$8,545 16.8%
Restaurants $430/$11,328 3.8%

The snack foods segment has to highest margin at 16.8%, and the restaurant segment has the lowest at 3.8%.

The profit margins for the three restaurant chains are:

Pizza Hut $308/$3,977 7.7%
Taco Bell $105/$3,503 3.0%
KFC $38/$I,722 2.2%

Pizza Hut has the highest margin.

Requirement 2

Somewhat surprising, sales growth in the restaurant segment is growing most rapidly, especially in the international area (25% growth). Also, restaurants is the segment with the highest growth rate as measured by Identifiable assets (growth over 1990-95 of 14%). This is riot the segment with the higher margins, nor is it the segment with the highest return on investment (operating profit divided by investments as measured by identifiable assets of the segment). It would be interesting to know why PepsiCo is expanding most rapidly in this area.

Requirement 3

The majority of PepsiCo's sales and operating profit come from the U.S. geographical area—U.S. sales are 71% of total sales, and account for 86% of the operating margin. PepsiCo is largely a U.S.-based company, but with significant international operations.

A comparison of U.S. and International operating margins by segment is its follows:

U.S. International

Beverages 16.4% 4.6%
Snack Foods 20.8% 9.8%
Restaurants 4.9% (1.0)%

Again, the U.S. components of all the segments have the highest operating margin.

Requirement 4

Operating income (or operating profit as it is called by PepsiCo) divided by the book value of identifiable assets is a measure of return on investment. This can be, computed for the three segments:

Computation Return on investment

Beverages $1,309/$10,032 13.0%
Snack Foods 26.3%
Restaurants 6.4%

Again, it is the snack foods segment that is the most profitable. and the restaurant segment that is least profitable.

It would not be surprising to find PepsiCo reevaluating its investment in the restaurant business. And in fact, this is precisely what PepsiCo has started to do. As of the Spring of 1997. PepsiCo has announced plans to spin-off its restaurant segment and focus its attention on the beverage and the snack food business.