Business 30116 (sections 01, 02, & 85) Course Pack
Accounting and Financial Analysis I
Philip G. Berger
Wallace W. Booth Professor of Accounting
Booth School of Business
University of Chicago
Chicago, IL
Autumn 2012
Class Notes
Professor Berger
Chapter
B30116 – Table of Contents
Name of Item
Autumn 2012
page number
A.
First Class Assignment............................................
3
B.
Syllabus......................................................
7
C.
FASB and IFRS Standards Listing.....................................
15
1.
The Audit Report
1a.
Audit Report Notes.....................................
1b.
Blyth, Inc. (CASE #1)..................................
1c.
“New SEC Rules Will Likely Draw More 8-K Filings”......
1d.
“Not Everyone Hates SarbOx”............................
19
25
41
43
Income Taxes and Deferred Income Tax Accounting
2a.
Introduction to Deferred Taxes.........................
2b.
Details on Deferred Taxes..............................
2c.
Example of Temporary and Permanent Differences.........
2d.
MDC Manufacturing Problem..............................
2e.
Taxes – Lecture 1 Slides...............................
2f.
Taxes – Lecture 2 Slides...............................
2g.
Tax Disclosures – Cheat Sheet..........................
2h.
Monterey Pasta Company (CASE #2).......................
2i.
Self-Study Problem 1 – Anheuser-Busch..................
2j.
Solution to Self-Study Problem 1.......................
2k.
Self-Study Problem 2 – Illustrative Example............
2l.
Solution to Self-Study Problem 2.......................
47
49
53
55
57
69
73
77
89
95
97
99
Revenue Recognition & Securitization
3a.
Revenue Recognition Notes..............................
3b.
Self-Study Problem 3 – U.S. Air........................
3c.
Solution to Self-Study Problem 3.......................
3d.
Installment Method Notes...............................
3e.
Factoring of Accounts Receivable - Notes...............
3f.
Patten Corporation (CASE #3)...........................
3g-(i)Securitization Notes ..................................
3g-(ii)More Details on SPEs and Securitization...............
3h.
Overview of FASB Statement No. 140.....................
3i.
Navistar Financial (CASE #4) ..........................
107
111
121
123
127
131
161
171
181
185
Statement of Cash Flows Analysis
4a.
SCF Classification Issues..............................
203
Ratio and Profitability Analysis
5a.
Profitability Analysis.................................
5b.
Ratio Analysis.........................................
213
215
Capitalization and Write-Offs
6a.
Interest Capitalization – An Illustration..............
6b.
Long-Lived Assets Slides...............................
6c.
McCormick and Co. (CASE #5)............................
6d.
Sunbeam Corporation (A) (CASE #6)......................
221
223
231
237
2.
3.
4.
5.
6.
Professor Berger
Chapter
7.
8.
9.
10.
11.
12.
13.
14.
B30116 - Table of Contents (continued)
Name of Item
Autumn 2012
page number
Intercorporate Investments
7a.
Investments, Significant Influence & Control, Notes....
7b.
Purchase Accounting: A Simple Example .................
7c.
Purchase Accounting: A Simple Example (Solution Notes)
7d.
The Equity Method: A Simple Example....................
7e.
The Equity Method: A Simple Example (Solution Notes)...
7f.
“Mishmash Accounting” .................................
7g.
“The Real Thing: Bottling Plan Taps Coke's Profits” ...
7h.
“Firms Facing Rule to Include Results From Minor Stakes”
7i.
New FASB Rule on Accounting for Minority Stakes........
7j.
The Coca-Cola Company (CASE #7) .......................
265
271
273
275
277
281
283
285
287
291
Long-Term Debt Overview
8a. Long-Term Debt Obligations, Slides......................
8b. Bonds – Example Problem.................................
8c. Convertible Debentures – Example Problem................
8d. Super-LYONs.............................................
305
307
309
311
Long-Term Debt Application
9a.
“Kirk Kerkorian’s Personal Money Machine”...............
9b.
Metro-Goldwyn-Mayer (CASE #8) ..........................
315
319
Lease Accounting Overview
10a. Leases, Slides..........................................
10b. Transforming Capital to Operating Leases (& vice-versa).
10c. Leases – Example Problem................................
10d. Giant Food Inc. – Lessee Accounting (CASE #9) ..........
10e. Lessor Accounting.......................................
325
329
331
335
339
Capital Leases for the Lessor: Application
11a. Crime Control – Notes on how to solve question 2........
11b. “You Better Believe”....................................
11c. Crime Control (CASE #10)................................
343
345
347
Analysis of Earnings Quality
12a. Prototype Company – Income Statement Format............
12b. The Seven Financial Statement Shenanigans..............
12c. Red Flags of Questionable Earnings Quality.............
12d. The Role of Accounting Analysis........................
12e. Wired Wanda’s (CASE #11)...............................
377
379
381
383
385
Accounting and Organizational Form
13a. “The Squawk Over Boston Chicken”.......................
13b. Boston Chicken, Inc. (CASE #12)........................
397
401
Employee Stock Options and Earnings Per Share Calculations
14a. Notes on Employee Stock Options .......................
14b. Notes on EPS Calculations..............................
14c. Microsoft Corporation (CASE #13).......................
14d. Who Rules Accounting?..................................
419
425
427
437
Professor Berger
Chapter
B30116 - Table of Contents (continued)
Name of Item
Autumn 2012
page number
15.
Course Summary Notes..............................................
445
16.
Homework #1 Questions (Due Oct. 19th/20th)..........................
453
17.
Homework #1 Financial Statements......................................
463
18.
Homework #2 Questions (Due Nov. 9th/10th)............................
477
19.
Homework #2 Financial Statements......................................
489
20.
Homework #3 Questions (Due Dec. 7th/8th)............................
509
21.
Homework #3 Financial Statements......................................
519
22.
Sample Exam Problems..............................................
531
23.
Solutions to Sample Exam Problems.....................................
605
24.
Spring 2003 Midterm Exam Questions, Financial Statements, and Solutions...........
621
25.
Spring 2003 Final Exam Questions, Financial Statements, and Solutions..............
663
26.
Fall 2010 Midterm Exam Questions, Financial Statements, and Solutions.............
715
27.
Fall 2010 Final Exam Questions, Financial Statements, and Solutions................
743
University of Chicago
Graduate School of Business
Accounting and Financial Analysis I – B30116
Sections 01, 02, and 85 – Fall 2012
First Day Assignment:
As indicated on the syllabus in this course packet, please read the chapter 1 packet notes on The
Audit Report and then prepare a write-up for hand-in of CASE #1: BLYTH, INC . The
write-up should be about three (3) to five (5) pages long (using double spacing) and should
answer the four questions on the first page of the case. Please include your name and student
ID number on your case write-up. The write-up will count for 5% of your course grade, but
will be graded as much on effort as on correctness.
As described in the syllabus, the first day assignment write-up is to be done individually and I
will be cold-calling people on their case write-ups in class. Cold-calls count for 20% of your
course grade. You will be submitting your case via the Chalk, but you may also want to
bring a printed copy of your case with you to help in answering if you are called on.
B30116 – Berger
1.
Chapter 1 - The Audit Report
The Audit Report
I. Role of the Auditor
A. Auditors attest to the financial statements which are prepared by management.
1. Auditors do not attest to the quality of the firm as an investment.
2. Audits are not designed solely to detect fraud.
B. Who Audits the Auditors?
1. Auditors can be held liable for negligence.
2. After the Sarbanes-Oxley Act of 2002 (SOX), audits of publicly traded companies in
the United States are overseen by the Public Company Accounting Oversight Board
(PCAOB).
3. The value of an auditor to a client is based upon the auditor's reputation. Thus,
auditors' desire to maintain the value of their reputation by avoiding signing off on
statements that are subsequently revealed to be faulty.
II. The Audit Report
A. The Standard Report -- 4 items (the items are sometimes displayed as separate
paragraphs, but are sometimes grouped together in less than 4 paragraphs).
1. Item 1 -- What statements have been audited? Who is ultimately responsible for the
statements? What responsibility is the auditor assuming?
2. Item 2 -- What is the basis for the auditor’s opinion? What work was done?
3. Item 3 -- The auditor’s opinion regarding the financial statements.
a. unqualified -- statements in conformity with GAAP
b. qualified -- statements in conformity with GAAP except for some particular items
1. scope of the audit was limited -- statement of what balances were not audited
2. inadequate disclosure regarding some balances or events -- audit report
usually supplements the disclosure
3. GAAP violation regarding some balances -- audit report usually quantifies
magnitude of the violation
c. disclaimer of opinion -- scope of audit too limited to warrant an opinion
d. adverse -- deviations from GAAP are so extensive that a qualified opinion is not
even possible (extremely rare)
4. Item 4 – This paragraph was introduced after enactment of SOX [it became effective
for the first time for fiscal years ending after November 15, 2004]. In it, the auditor
Item 1a
Audit Report Notes
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B30116 – Berger
Chapter 1 - The Audit Report
offered [as of the time of the Blyth case] an opinion on both internal control
effectiveness and management’s assessment of internal control effectiveness [the
external auditor no longer expresses an opinion about management’s assessment of
the internal controls].
An example of the standard version of Item 4 as of the time of the Blyth case
follows (taken from Microsoft’s annual report for the year ended June 30, 2005):
We have also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the effectiveness of the Company’s internal control over
financial reporting as of June 30, 2005, based on the criteria established in Internal Control
Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission, and our report dated August 23, 2005 expressed an unqualified opinion on
management’s assessment of the effectiveness of the Company’s internal control over financial
reporting and an unqualified opinion on the effectiveness of the Company’s internal control over
financial reporting.
An example of the standard version of Item 4 as of today follows (taken from
Microsoft’s annual report for the year ended June 30, 2008):
We have also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the Company’s internal control over financial reporting as of
June 30, 2008, based on the criteria established in Internal Control—Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission and our
report dated July 31, 2008 expressed an unqualified opinion on the Company’s internal control
over financial reporting.
B. Additional Items (beyond the 4 standard items)
1. uncertainties highlighted
2. changes in accounting policy highlighted
3. emphasis of matter -- auditor wants to highlight a particular issue for the reader
4. going concern -- auditor wants to express doubt regarding the firm's ability to continue
for the next fiscal year. In other words, a going-concern opinion indicates that the
auditor thinks the company may not avoid bankruptcy during the next 12 months.
Item 1a
Audit Report Notes
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B30116 – Berger
Chapter 1 - The Audit Report
The Audit Report
Auditor Changes -- Some Observations
 Current SEC requirements [effective since August 23, 2004] require that upon a change in
auditor, a registrant must notify the public by filing certain information on Form 8-K within
four business days of the change [prior to August 23, 2004 the registrant had up to 15
calendar days to file the 8-K]. The 8-K filed for the auditor change must provide the
following [per SEC Regulation S-K, item 304(a)]:
o Whether the auditors resigned, declined to stand for reelection, or were dismissed, as
o
o
o
o
well as the date of the auditor change.
The type of audit report issued for the last two years, and whether it contained
anything other than an unqualified opinion (e.g., going concern, disclaimer, adverse
opinion, or scope limitation).
Whether the decision to change accountants was recommended or approved by the
board of directors or the audit committee.
Whether there were any disagreements with the auditors, and the nature of such
disagreements.
Whether any of the following reportable events occurred, and their nature:


Internal controls necessary to develop reliable financial statements don’t exist;
Management’s representation can’t be relied on, or the auditors are unwilling
to be associated with the financial statements prepared by management;
 Audit scope needs to be expanded; or
 Other information has arisen that materially impacts previous audit reports or
their underlying financial statements.
o The name of the newly engaged auditors, and the effective date of engagement.
o Any consultation with the new auditors regarding accounting principles, potential
opinions, or any matter that was subject to disagreements or reportable events with
the predecessor auditors. If any of these have occurred, the nature of each must be
described and possibly filed as an exhibit.
o The 8-K must be provided to the previous auditors. They must state their agreement
or disagreement with the filing and this response should be included with the 8-K as
an exhibit (previous auditors’ response letter is usually very brief to avoid
controversy and reduce lawsuits).
Item 1a
Audit Report Notes
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B30116 – Berger
Chapter 1 - The Audit Report
 Auditor changes result from either auditor resignations or client-initiated dismissals.
Auditor resignations are more likely to occur when litigation risk (with regard to the audit
report) increases or when the audited company’s financial health deteriorates. Clientinitiated dismissals occur more frequently over disagreements about such issues as internal
control weaknesses and the reliability of the audited company’s financial reporting.
 A study by Turner, Williams and Weirich (2005) of all auditor changes filed on form 8-K
during 2003 and 2004 reveals the following:
o Auditor changes are not infrequent, and have continued to increase in recent years.
There were 905 companies registered with the SEC that changed auditors in 2003 and
1,609 in 2004.
o Although the filings reveal whether the auditor resigned or was fired, the underlying
reason for the auditor change is not disclosed in about 2/3 of the filings. Thus,
investors should always be cautious when a company announces an auditor
change because it may be related to underlying but undisclosed problems in the
company’s financial reporting and accounting practices. Companies often
attempt to hide the real reason behind auditor changes, so investors often have
to read the disclosure carefully to “dig out” the reason(s).
o About 1/3 of registrants reporting changes in auditors also had a going concern
opinion included in the audit report of the departing auditor.
o About 2% of registrants reporting auditor changes in 2003 or 2004 also restated their
financial statements around the time of the auditor change. About half of these
companies also reported internal control weaknesses. All of these auditor changes
occurred after the restatements and appeared to be related to the restatements (which
may strain the auditor-client relationship).
o About 2% of registrants reporting auditor changes in 2003 or 2004 also reported
accounting disagreements with the departing auditor. Companies and their auditors
are required to report disagreements about accounting matters even if the
disagreement is subsequently resolved to the auditor’s satisfaction [think about why
the rule works in this manner]. Accounting disagreements are important because
they may indicate that the company is attempting to apply improper, aggressive, or
non-GAAP accounting that the auditor is unwilling to accept. A company will
Item 1a
Audit Report Notes
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B30116 – Berger
Chapter 1 - The Audit Report
sometimes fire an auditor that disagrees with it and subsequently hire a more
conciliatory one (this is often referred to as “opinion shopping”).
 On average, auditor changes, have not been consistently associated with significant negative
abnormal returns. (See, for example, Johnson and Lys (1990)).
 If switches are partitioned into those that occurred after a disagreement disclosed in an 8K
filing and those that reported no such disagreement, then the following average results are
attained. (See, for example, Dhaliwal, Schatzberg, and Trombley (1993))
o Negative abnormal returns are observed for the disagreement subsample around the
8K filing and positive abnormal returns are observed for the remaining subsample.
The magnitude of the negative abnormal return is larger.
o The disagreement subsample exhibits poorer financial performance and increasing
leverage before the disagreement, and deteriorating financial performance and
increasing leverage after, relative to the remaining subsample.
o The disagreement subsample has positive abnormal returns in the 12 month's after the
disclosure (greater than 15%) while the remaining subsample exhibits slightly
positive abnormal returns over the same period.
 The impact of having a going concern opinion included as an additional item in a firm’s audit
report has also been examined by a number of academic studies. These studies fall into five
categories – four types of stock market effect studies, and a fifth type of study that has
directly investigated how useful a going concern opinion is in predicting bankruptcy.
o (1) With regard to stock price reactions, there is a short-run negative stock price
reaction to the announcement of going concern opinions [Fleak and Wilson (1994);
Carlson, Glezen and Benefield (1998)].
o (2) The short-run reaction around the announcement underestimates the total
economic effect, however, as the studies above also find a negative price reaction in
the period leading up to the going concern announcement. This suggests that
information regarding the going concern status of the firm is leaking to the market in
the period prior to the issuance of the audit report.
o (3) In addition, the combined reaction during the pre-announcement plus
announcement periods may represent an under-reaction to the news content of the
Item 1a
Audit Report Notes
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B30116 – Berger
Chapter 1 - The Audit Report
going concern opinion, as the stock returns of firms receiving going concerns are
abnormally low for anywhere from one quarter to one year following the going
concern announcement [Elliott (1982); Taffler, Lu and Kausar (2004); Kausar, Taffler
and Tan (2009)].
o (4) A going concern audit opinion if not a prediction by the auditor about bankruptcy
and U.S. auditing standards are explicit in saying that users of financial statements
should not interpret a going concern opinion as a prediction of bankruptcy [why do
you think the auditor issues a going concern opinion if it is not an attempt to
make a prediction about bankruptcy?]. Nevertheless, going concern opinions do
indicate an increased likelihood of bankruptcy. This link has been studied indirectly
by examining how the stock price reaction to a bankruptcy announcement is affected
by having a preceding going concern audit opinion. Chen and Church (1996),
Holder-Webb and Wilkins (2000) and Tan (2000) all find that the negative price
reaction to a bankruptcy announcement is reduced when it is preceded by a going
concern audit opinion. This suggests that the going concern opinion causes investors
to increase the probability they assign to a bankruptcy for the firm.
o (5) Other papers directly examine how useful a going concern opinion is in predicting
bankruptcy. Hopwood, McKeown and Mutchler (1989) find that going concern audit
opinions provide useful information for predicting bankruptcy beyond what is
obtainable from financial statement data alone. While going concern opinions are a
useful addition to other variables in predicting bankruptcy, they do not have great
predictive power by themselves. Thus, Raghunandan and Subramanyam (2003) find
that traditional bankruptcy prediction models do a better job of forecasting
bankruptcy than the existence of a going concern audit opinion does.
The Audit Report – Summary
1. Auditor reports are useful because they contain information regarding the following.
.
.
.
.
What information was audited?
Highlights of accounting issues the auditor deems important.
Highlights of other information the auditor deems important.
Identification of the auditor allows the reader to infer auditor changes.
2.
Item 1a
Analyze auditor changes and attempt to assess the reasons for auditor changes.
Audit Report Notes
Page 6 of 6
B30116 – Berger
Chapter 1 - The Audit Report
CASE #1 Blyth, Inc.
1. The auditor's report for the fiscal 2003 (i.e., year ended January 31, 2004) financial statements of
Blyth, Inc. is on page 2 of the case. Items from the fiscal 2003 10-K filing that are related to the
auditor's report follow on pages 3 and 4.
a. What standard information relevant to users of Blyth's financial statements is contained in the
2003 auditor's report?
b. How does the 2003 audit report depart from the standard audit report? What is the purpose
served by the departure(s)?
c. What purposes are served by the additional items from the 10-K that follow the auditor’s report?
2. The auditor's report for the fiscal 2004 (i.e., year ended January 31, 2005) financial statements of
Blyth, Inc. is on page 5. An item from the fiscal 2004 10-K filing that is related to the auditor's report
is on pages 6 and 7, and a 10-K schedule mentioned in the fiscal 2004 audit report is on page 8. The
auditor's report for the fiscal 2005 (i.e., year ended January 31, 2006) financial statements of Blyth,
Inc. is on page 9 and a 10-K schedule mentioned in the fiscal 2005 audit report is on page 10. Repeat
questions a, b and c for the fiscal 2004 and 2005 audit reports and related items from the 10-K filings.
3. Three mandatory disclosures filed in Blyth’s 8-K reports are on pages 11 – 14 of the case. Why does
the SEC require each of the three disclosures? How are they useful? How might they be deficient?
4. Two newswire stories are on pages 15 and 16 of the case. Does the first article provide information
regarding the dismissal of PricewaterhouseCoopers (PwC) that is not in first of the 8-K mandatory
disclosures cited in question 3? Notice that the second newswire article is dated on April 14, 2004,
which is after the filing date of the first 8-K cited in question 3, but before the dates of the second and
third 8-Ks cited in question 3. Does the second newswire article provide information regarding the
dismissal of PwC that is not in the first of the three 8-K filings? Does it provide information
regarding PwC’s dismissal that is not in any of the three 8-K filings? Speculate as to why Blyth, Inc.
issued the press release on April 14, 2004 but did not file the closely related 8-K filing with the
Securities and Exchange Commission (SEC) until April 20.
Item 1b
Blyth, Inc. (CASE #1)
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B30116 – Berger
Chapter 1 - The Audit Report
BLYTH, INC. 10-K FOR YEAR ENDED JANUARY 31, 2004
BLYTH, INC. JANUARY 31, 2004
REPORT OF INDEPENDENT AUDITORS
To the Board of Directors and Stockholders of Blyth, Inc:
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of
earnings, stockholders equity and cash flows present fairly, in all material respects, the financial position
of Blyth, Inc. and Subsidiaries (the Company ) at January 31, 2004 and January 31, 2003, and the results
of their operations and their cash flows for each of the three years in the period ended January 31, 2004 in
conformity with accounting principles generally accepted in the United States of America. These
financial statements are the responsibility of the Company’s management; our responsibility is to express
an opinion on these financial statements based on our audits. We conducted our audits of these
statements in accordance with auditing standards generally accepted in the United States of America,
which require that we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements, assessing the accounting
principles used and significant estimates made by management, and evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 1 to the consolidated financial statements, the Company changed its method of
accounting for goodwill and intangible assets in fiscal 2003. As discussed in Note 1 to the consolidated
financial statements, the Company changed its method of accounting for derivative instruments and
hedging activities in fiscal 2002.
As discussed in Note 2 to the consolidated financial statements, the Company has restated its segment
disclosures for the years ended January 31, 2003 and January 31, 2002 to reflect a revision in its
reportable segments. Additionally, as also discussed in Note 2, the Company has restated its consolidated
financial statements for the year ended January 31, 2003 to reflect an increase in the cumulative effect of
the change in accounting relating to the adoption of SFAS 142 Goodwill and Other Intangible Assets.
PRICEWATERHOUSECOOPERS LLP
Stamford, Connecticut
April 26, 2004
Item 1b
Blyth, Inc. (CASE #1)
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B30116 – Berger
Chapter 1 - The Audit Report
BLYTH, INC. 10-K FOR YEAR ENDED JANUARY 31, 2004
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE
(a) Previous independent accountants
On March 16, 2004, the Board of Directors of the Company, acting upon the recommendation of the
Audit Committee, dismissed PricewaterhouseCoopers LLP ( PwC ) as the independent accountants of the
Company, effective as of April 26, 2004, the date of its report on the financial statements of the Company
as of January 31, 2004 and for the year then ended, which financial statements are included in this Annual
Report on Form 10-K.
PwC’s reports on the financial statements of the Company for the fiscal years ended January 31, 2003 and
2004 did not contain any adverse opinion or disclaimer of opinion and were not qualified or modified as
to uncertainty, audit scope or accounting principle.
In connection with its audits of the financial statements of the Company for the two most recent fiscal
years ended January 31, 2004, and through April 30, 2004, there were no disagreements with PwC on any
matter of accounting principles or practices, financial statement disclosure, or auditing scope or
procedure, which disagreements, if not resolved to PwC’s satisfaction, would have caused PwC to make
reference thereto in their reports on the Company’s financial statements for such fiscal years, except as
follows: In connection with its audit of the financial statements of the Company as of January 31, 2004
and for the year then ended, PwC advised the Company in early April, 2004, that it believed that the
Company’s then current designation of two reporting segments did not comply with the requirements of
Statement of Financial Accounting Standards No. 131 (Disclosures about Segments of an Enterprise and
Related Information), a position with which the Company did not agree. The Audit Committee has
discussed the subject of the designation of operating segments with PwC. The Company has authorized
PwC to respond fully to the inquiries of Deloitte & Touche LLP, the Company’s independent accountants
for the fiscal year ending January 31, 2005, concerning this disagreement.
In response to PwC’s advice that it believed that the Company’s designation of two reporting segments
did not comply with the requirements of SFAS 131, the Company reevaluated its reporting segments as at
the end of each of its fiscal years ended January 31, 2004, 2003 and 2002. As a result of such
reevaluation, the Company determined to report its financial results in five reporting segments in fiscal
2004, and four reporting segments in fiscal 2003 and fiscal 2002. This revision of segments had the
related effect of requiring changes in the Company’s reporting units for purposes of goodwill impairment
reviews under Statement of Financial Accounting Standards No. 142 (Goodwill and Other Intangible
Assets), retroactive to the February 1, 2002 adoption date of SFAS 142. This resulted in the need to
perform impairment reviews of several additional reporting units as of February 1, 2002, and each
subsequent year-end balance sheet date thereafter. These impairment reviews have indicated the need to
record additional impairment charges as of the February 1, 2002 adoption of SFAS 142, specifically to
write off $20.9 million in goodwill associated with the 1999 acquisition of the Gies Group and $6.3
million in goodwill associated with the 1999 acquisition of the Colony Group. Both of these businesses
are components of the Wholesale Home Fragrance reporting segment. The Company’s fiscal 2003
financial statements have been restated to reflect the recording of these $27.2 million in goodwill
impairment charges as part of the cumulative effect of adopting SFAS 142 as of February 1, 2002.
Item 1b
Blyth, Inc. (CASE #1)
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B30116 – Berger
Chapter 1 - The Audit Report
During each of the two years in the period ended January 31, 2004, and through April 30, 2004, there
were no reportable events (as defined in Regulation S-K Item 304(a)(1)(v)), except for the following
event: On April 21, 2004, PwC advised the Company that it had identified an internal control issue which
PwC considered to be a material weakness in that changes in circumstances, internal reporting and
management structures appeared not to have been properly evaluated by management or considered in
connection with ongoing compliance with SFAS 131 and SFAS 142 guidance. PwC recommended that
the Company should (A) have a process in place to evaluate changes in management structure and
reporting to the chief operating decision maker that would effect segment determination, (B) strengthen
procedures to monitor all changes in operations that impact accounting and reporting matters and (C)
ensure that it has sufficient staffing in its financial reporting function, with appropriate technical
qualifications and tasked with ensuring ongoing compliance with relevant accounting and financial
reporting requirements.
(b) New independent accountants
On March 16, 2004, the Board of Directors of the Company, acting upon the recommendation of the
Audit Committee, appointed Deloitte & Touche LLP as the independent accountants of the Company for
the fiscal year ending January 31, 2005.
ITEM 9A. CONTROLS AND PROCEDURES
(a) Evaluation of disclosure controls and procedures.
The Company’s management, with the participation of its principal executive officer and its principal
financial officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in
Securities Exchange Act of 1934 (Exchange Act) Rules 13a-15(e) or 15d-15(e)) as of the end of the
period covered by this report as required by paragraph (b) of Exchange Act Rules 13a-15 or 15d-15.
Based upon this evaluation, the Company’s principal executive officer and its principal financial officer
have concluded that our disclosure controls and procedures are effective as of the end of the period
covered by this report. Nonetheless, in light of PwC’s advice to the Company that it has identified an
internal control issue which PwC considers to be a material weakness, as described in Item 9(a) above,
the Company, and its principal executive officer and its principal financial officer, recognize that the
Company may need to make improvements in its internal controls, particularly insofar as they relate to
ongoing compliance with SFAS 131 and SFAS 142 guidance, having in mind the recommendations that
have been made by PwC, as described in Item 9(a) above. However, the Company and its principal
executive officer and its principal financial officer have not yet determined what action, if any, the
Company should take in response to PwC’s recommendations.
(b) Changes in internal control over financial reporting.
There was no change in the Company s internal control over financial reporting identified in connection
with the evaluation required by paragraph (d) of Exchange Act Rules 13a-15 or 15d-15 that occurred
during the fourth fiscal quarter of fiscal year 2004 that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting.
Item 1b
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BLYTH, INC. 10-K FOR YEAR ENDED JANUARY 31, 2005
BLYTH, INC. JANUARY 31, 2005
REPORT OF INDEPENDENT AUDITORS
To the Board of Directors and Stockholders of Blyth, Inc:
We have audited the accompanying consolidated balance sheet of Blyth, Inc. and subsidiaries (the
Company) as of January 31, 2005, and the related consolidated statements of earnings, stockholders
equity, and cash flows for the fiscal year then ended. Our audit also included the financial statement
schedule listed in the index in Item 15 in the Company’s Annual Report on Form 10-K for the year ended
January 31, 2005. These financial statements and financial statement schedule are the responsibility of the
Company’s management. Our responsibility is to express an opinion on the financial statements and
financial statement schedule based on our audit. The financial statements of Blyth, Inc. for the years
ended January 31, 2004 and 2003 were audited by other auditors whose report, dated April 26, 2004,
except for Note 18, as to which the date is April 8, 2005, on those statements expressed an unqualified
opinion and included an explanatory paragraph regarding the change in the Company’s method for
accounting for goodwill and intangible assets in fiscal 2003 as discussed in Note 1 to the financial
statements.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation. We believe that our audit
provides a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial
position of the Company as of January 31, 2005, and the results of its operations and its cash flows for the
period ended January 31, 2005, in conformity with accounting principles generally accepted in the United
States of America. Also, in our opinion, such financial statement schedule, when considered in relation to
the basic consolidated financial statements taken as a whole, presents fairly in all material respects the
information set forth therein.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight
Board (United States), the effectiveness of the Company s internal control over financial reporting as of
January 31, 2005, based on the criteria established in Internal Control-Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission and our report dated April 15,
2005 expressed an unqualified opinion on management’s assessment of the effectiveness of the
Company’s internal control over financial reporting and an adverse opinion on the effectiveness of the
Company’s internal control over financial reporting.
DELOITTE & TOUCHE LLP
April 15, 2005
Chicago, Illinois
Item 1b
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BLYTH, INC. 10-K FOR YEAR ENDED JANUARY 31, 2005
ITEM 9A. CONTROLS AND PROCEDURES
(d) Report of Independent Registered Public Accounting Firm
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of Blyth, Inc.:
We have audited management’s assessment, included in the accompanying Management’s Report on
Internal Control Over Financial Reporting ( Management s Report ), that Blyth, Inc. and subsidiaries (the
Company) did not maintain effective internal control over financial reporting as of January 31, 2005,
because of the effect of the material weakness identified in management’s assessment based on criteria
established in Internal Control-Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission. The Company’s management is responsible for maintaining
effective internal control over financial reporting and for its assessment of the effectiveness of internal
control over financial reporting. Our responsibility is to express an opinion on management s assessment
and an opinion on the effectiveness of the Company’s internal control over financial reporting based on
our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether effective internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over financial reporting,
evaluating management’s assessment, testing and evaluating the design and operating effectiveness of
internal control, and performing such other procedures as we considered necessary in the circumstances.
We believe that our audit provides a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed by, or under the supervision
of, the company’s principal executive and principal financial officers, or persons performing similar
functions, and effected by the company’s board of directors, management, and other personnel to provide
reasonable assurance regarding the reliability of financial reporting and the preparation of financial
statements for external purposes in accordance with generally accepted accounting principles. A
company’s internal control over financial reporting includes those policies and procedures that (1) pertain
to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and
dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded
as necessary to permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are being made only in
accordance with authorizations of management and directors of the company; and (3) provide reasonable
assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the
company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of
collusion or improper management override of controls, material misstatements due to error or fraud may
not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of
the internal control over financial reporting to future periods are subject to the risk that the controls may
Item 1b
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become inadequate because of changes in conditions, or that the degree of compliance with the policies or
procedures may deteriorate.
A material weakness is a significant deficiency, or combination of significant deficiencies, that results in
more than a remote likelihood that a material misstatement of the annual or interim financial statements
will not be prevented or detected. The following material weakness has been identified and included in
management’s assessment. At January 31, 2005, the Company had not designed and implemented
effective controls over: (1) the process to identify, quantify and account for income tax contingencies; and
(2) the reconciliation of the recorded amounts in the prior year of its tax accounts and balances to its tax
return. In addition, the Company’s controls over the reconciliation of its effective tax rate to its statutory
rate did not operate effectively. Although there were no misstatements identified, the combination of the
two design deficiencies and the operating deficiency results in more than a remote likelihood that a
material misstatement to the current and deferred tax asset and liability accounts, the income tax provision
and the related disclosures will not be prevented or detected in the annual or interim consolidated
financial statements.
This material weakness was considered in determining the nature, timing, and extent of audit tests applied
in our audit of the consolidated financial statements and financial statement schedule as of and for the
year ended January 31, 2005 of the Company and this report does not affect our report on such
consolidated financial statements and financial statement schedule.
In our opinion, management’s assessment that the Company did not maintain effective internal control
over financial reporting as of January 31, 2005, is fairly stated, in all material respects, based on the
criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission. Also in our opinion, because of the effect of the material
weakness described above on the achievement of the objectives of the control criteria, the Company has
not maintained effective internal control over financial reporting as of January 31, 2005, based on the
criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight
Board (United States), the consolidated financial statements and financial statement schedule.
DELOITTE & TOUCHE LLP
April 15, 2005
Chicago, Illinois
Item 1b
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BLYTH, INC. 10-K FOR YEAR ENDED JANUARY 31, 2005
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
For the years ended January 31, 2003, 2004 and 2005
(In thousands)
Description
Balance
at
Beginning
of Period
Acquired
Balances
Charged
to
Costs
and
Expenses
Deductions
$
$
$
$
Balance
at
End of
Period
2003
Allowance for
doubtful accounts
Income tax valuation
allowance
Inventory reserve
2,804
255
3,853
(2,819 ) $
4,093
1,841
-
500
(1,324 )
1,017
20,502
400
22,709
(16,466 )
27,145
2004
Allowance for
doubtful accounts
Income tax valuation
allowance
Inventory reserve
$
4,093
$
623
$
1,809
1,017
1,656
-
27,145
1,343
15,462
$
(2,055 ) $
(20,970 )
4,470
2,673
22,980
2005
Allowance for
doubtful accounts
Income tax valuation
allowance
Inventory reserve
$
4,470
$
538
$
1,371
$
(2,351 ) $
4,028
2,673
-
1,565
(200 )
4,038
22,980
1,730
14,130
(16,407 )
22,433
Page S-2
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BLYTH, INC. 10-K FOR YEAR ENDED JANUARY 31, 2006
BLYTH, INC. JANUARY 31, 2006
REPORT OF INDEPENDENT AUDITORS
To the Board of Directors and Stockholders of Blyth, Inc:
We have audited the accompanying consolidated balance sheets of Blyth, Inc. and subsidiaries (the
Company) as of January 31, 2006 and 2005, and the related consolidated statements of earnings,
stockholders equity, and cash flows for the fiscal years then ended. Our audits also included the financial
statement schedule for the fiscal years ended January 31, 2006 and 2005 listed in the Index at Item 15.
These financial statements and financial statement schedule are the responsibility of the Company’s
management. Our responsibility is to express an opinion on the financial statements and financial
statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation. We believe that our audits
provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial
position of the Company as of January 31, 2006 and 2005, and the results of its operations and its cash
flows for the fiscal years ended January 31, 2006 and 2005, in conformity with accounting principles
generally accepted in the United States of America. Also, in our opinion, such financial statement
schedule, when considered in relation to the basic consolidated financial statements taken as a whole,
presents fairly in all material respects the information set forth therein.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight
Board (United States), the effectiveness of the Company’s internal control over financial reporting as of
January 31, 2006, based on the criteria established in Internal Control-Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission and our report dated April 12,
2006 expressed an unqualified opinion on management s assessment of the effectiveness of the
Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the
Company’s internal control over financial reporting.
DELOITTE & TOUCHE LLP
Chicago, Illinois
April 12, 2006
Item 1b
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BLYTH, INC. 10-K FOR YEAR ENDED JANUARY 31, 2006
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
For the years ended January 31, 2004, 2005 and 2006
(In thousands)
Description
Balance
at
Beginning
of Period
Acquired
Balances
Charged
to
Costs
and
Expenses
Deductions
$
$
$
$
Balance
at
End of
Period
2004
Allowance for
doubtful accounts
Income tax valuation
allowance
Inventory reserve
4,093
623
1,809
1,017
1,656
-
27,145
1,343
15,462
(2,055 ) $
(20,970 )
4,470
2,673
22,980
2005
Allowance for
doubtful accounts
Income tax valuation
allowance
Inventory reserve
$
4,470
$
538
$
1,371
$
(2,351 ) $
4,028
2,673
-
1,565
(200 )
4,038
22,980
1,730
14,130
(16,407 )
22,433
2006
Allowance for
doubtful accounts
Income tax valuation
allowance
Inventory reserve
$
4,028
$
(78 ) $
2,189
4,038
-
767
22,433
-
16,961
$
(2,247 ) $
3,892
(
101 )
4,704
(17,075 )
22,319
Page S-2
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Item 1b
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BLYTH, INC. 8-K DATED MARCH 16, 2004 [FILED MARCH 25, 2004]
ITEM 4. CHANGES IN REGISTRANT’S CERTIFYING ACCOUNTANT
(a) Previous independent accountants
(i) On March 16, 2004, the Board of Directors of Blyth, Inc. (the Company ), acting upon the
recommendation of its Audit Committee, dismissed PricewaterhouseCoopers LLP (PwC) as the
independent accountants of the Company. The conclusion of PwC’s engagement as the Company’s
independent accountants is effective as of the date of its report on the financial statements of the
Company as of January 31, 2004 and for the year then ended, which financial statements will be included
in the Annual Report on Form 10-K for the fiscal year ended January 31, 2004.
(ii) PwC’s reports on the financial statements of the Company for the fiscal years ended January 31, 2002
and 2003 did not contain any adverse opinion or disclaimer of opinion and were not qualified or modified
as to uncertainty, audit scope or accounting principle.
(iii) In connection with its audits of the financial statements of the Company as of January 31, 2002 and
2003 and for the years then ended and through March 16, 2004, there were no disagreements with PwC
on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or
procedure, which disagreements, if not resolved to PwC’s satisfaction, would have caused or will cause
PwC to make reference thereto in their report on the Company s financial statements for such fiscal years.
(iv) During each of the two years in the period ended January 31, 2003 and through March 16, 2004, there
have been no reportable events (as defined in Regulation S-K Item 304(a)(1)(v)).
(v) The Company provided PwC with a copy of the foregoing disclosures and requested that PwC provide
a letter addressed to the SEC stating whether or not it agrees with the above statements. A copy of PwC’s
letter in response to that report, dated March 24, 2004, is attached hereto as Exhibit 16.
(b) New independent accountants
On March 16, 2004, the Board of Directors of the Company, acting upon the recommendation of its Audit
Committee, appointed Deloitte & Touche LLP as the independent accountants of the Company for the
fiscal year ending January 31, 2005.
ITEM 7. FINANCIAL STATEMENTS, PRO FORMA FINANCIAL INFORMATION AND EXHIBITS
Exhibit 16 Letter of PwC LLP dated March 24, 2004 re Change in Certifying Accountant.
Commissioners:
We have read the statements made by Blyth, Inc. (the Company ) (copy attached), which we understand
will be filed with the Commission, pursuant to Item 4 of Form 8-K, as part of the Company’s Form 8-K
report dated March 16, 2004. We agree with the statements concerning our Firm in such Form 8-K.
Very truly yours,
PRICEWATERHOUSECOOPERS LLP
Item 1b
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BLYTH, INC. 8-K DATED APRIL 14, 2004 [FILED APRIL 20, 2004]
ITEM 12. RESULTS OF OPERATIONS AND FINANCIAL CONDITION
On April 14, 2004, Blyth, Inc. issued a press release stating that it would file a Form 12b-25 Notification
of Late Filing with respect to its Form 10-K and reporting new Annual Meeting and record dates, which
press release also contained information for completed annual fiscal periods. A copy of the press release
is attached hereto as Exhibit 99.1 and is incorporated herein by reference.
BLYTH, INC. TO FILE FOR 15 DAY EXTENSION FOR 10-K
New Annual Meeting and Record Date Established
Management to Hold Conference Call at 5:30 PM Eastern Today
GREENWICH, CT, USA, April 14, 2004: Blyth, Inc. (NYSE:BTH), a leader in home decor and home
fragrance products, today announced that it will file Form 12b-25 with the Securities and Exchange
Commission to extend the filing period for its Form 10-K until April 30, 2004. On March 15, 2004, the
Company issued a press release in which it announced its financial results for the fiscal year ended
January 31, 2004. Thereafter, the Company learned that the Company’s independent accountants,
PricewaterhouseCoopers LLP, believed that the Company’s current designation of two operating
segments does not comply with the requirements of Statement of Financial Accounting Standards No.
131, Disclosures about Segments of an Enterprise and Related Information (SFAS 131). The Company
has determined that it will change its designation of operating segments for fiscal 2004 and potentially for
certain prior years, which will impact the number of reporting segments required in its SFAS 131 footnote
and related disclosures. During the past several years, the Company has reported financial information
with respect to two reporting segments, namely Candles & Home Fragrance and Creative Expressions. It
is now anticipated that the Company will report information in a greater number of segments.
The designation of additional operating segments on a retrospective basis, pursuant to SFAS 131, is also
anticipated to result, retrospectively, in a greater number of reporting units pursuant to Statement of
Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (SFAS 142).
Accordingly, the Company will need to reassess impairment reviews of goodwill required to be
performed as of the adoption date of SFAS 142 (2/1/02) and for the fiscal year thereafter. It is anticipated
that this will result in certain impairment charges not previously reported, and that prior year financial
statements will need to be restated.
The Company has begun extensive analyses required to identify properly its operating segments,
reporting segments and reporting units, and to assess potential impairments of goodwill for its re-defined
reporting units. This work, however, is not yet complete. As a result, the Company has not been able to
complete its financial statements or other portions of its annual report on Form 10-K in time for filing
within the prescribed time period.
The Company presently expects that the financial statements which it will file as part of its annual report
on Form 10-K will include SFAS 131 financial information with respect to an expanded number of
reporting segments for its fiscal year ended January 31, 2004, and, comparatively, for all prior fiscal years
presented. In addition, as a result of the change in its operating segments and reporting units, the
Company also expects that it will need to restate its financial statements for the fiscal year ended January
Item 1b
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31, 2003 so as to recognize an impairment loss pursuant to SFAS 142 with respect to the carrying value
of goodwill, particularly that which relates to its wholesale candle businesses. As analyses and valuations
are still in progress, the amount of such impairment charge is not yet finalized. However, based upon the
work done to date, the Company believes such impairment charge will be approximately $30 million, or
approximately $0.64 per share, which it expects will be recognized in fiscal 2003. The Company does not
expect that the change in its reported segments will have any effect upon the Company’s cash flows in
any reported period.
The Company expects that the change in the Company’s operating segments will not affect the
Company’s previously reported results of operations for fiscal 2004.
The 10-K filing extension necessitates a change in the Company’s record date and date of its Annual
Meeting of Shareholders, which were originally scheduled for March 19, 2004 and May 18, 2004,
respectively. A new record date of May 13, 2004 has been established, and Blyth’s Annual Meeting of
Shareholders will take place on June 24, 2004.
Management will conduct a conference call today at 5:30 p.m. Eastern time. The dial-in number is 1-877226-4265, and the passcode 6810886 is required. The international dial-in number is 1- 706-679-0668
and requires the same passcode. This call will be broadcast live via the Internet at www.blyth.com.
Item 1b
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BLYTH, INC. 8-K DATED APRIL 30, 2004 [FILED MAY 3, 2004]
ITEM 15. OTHER EVENTS
In connection with its audit of the financial statements of the Company as of January 31, 2004 and for the
year then ended, PricewaterhouseCoopers LLP (PwC) as the then independent accountants of the
Company, advised the Company in early April, 2004, that it believed that the Company’s then current
designation of two reporting segments did not comply with the requirements of Statement of Financial
Accounting Standards No. 131 (Disclosures about Segments of an Enterprise and Related Information), a
position with which the Company did not agree.
In response to PwC’s advice that it believed that the Company’s designation of two reporting segments
did not comply with the requirements of SFAS 131, the Company reevaluated its reporting segments as at
the end of each of its fiscal years ended January 31, 2004, 2003 and 2002. As a result of such
reevaluation, the Company determined to report its financial results in five reporting segments in fiscal
2004, and four reporting segments in fiscal 2003 and fiscal 2002. This revision of segments had the
related effect of requiring changes in the Company’s reporting units for purposes of goodwill impairment
reviews under Statement of Financial Accounting Standards No. 142 (Goodwill and Other Intangible
Assets), retroactive to the February 1, 2002 adoption date of SFAS 142. This resulted in the need to
perform impairment reviews of several additional reporting units as of February 1, 2002, and each
subsequent year-end balance sheet date thereafter. These impairment reviews have indicated the need to
record additional impairment charges as of the February 1, 2002 adoption of SFAS 142, specifically to
write off $20.9 million in goodwill associated with the 1999 acquisition of the Gies Group and $6.3
million in goodwill associated with the 1999 acquisition of the Colony Group. Both of these businesses
are components of the Wholesale Home Fragrance reporting segment. The Company’s fiscal 2003
financial statements have been restated to reflect the recording of these $27.2 million in goodwill
impairment charges as part of the cumulative effect of adopting SFAS 142 as of February 1, 2002. The
Company’s fiscal 2003 financial statements, as restated, appear in the Company s annual report on Form
10-K for the fiscal year ended January 31, 2004, which was filed with the Commission on April 30, 2004.
The Company intends to file as soon as practicable, but not later than June 30, 2004, amendments to its
quarterly reports on Form 10-K for the fiscal quarters ended April 30, 2003, July 31, 2003 and October
31, 2003, in which it will restate its financial statements for the corresponding quarters of the Company’s
fiscal 2003.
Item 1b
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Blyth, Inc. Appoints Deloitte & Touche LLP Auditors
586 words
23 March 2004
PrimeZone Media Network
English
Copyright (c) 2004 PrimeZone Media Network, Inc. All Rights Reserved.
GREENWICH, Conn., March 23, 2004 (PRIMEZONE) -- Blyth, Inc. (NYSE:BTH), a leader in home decor and
home fragrance products, announced today that its Board of Directors has appointed Deloitte & Touche LLP
as the Company's independent audit firm for the fiscal year ending January 31, 2005. Blyth expects to
continue to use PricewaterhouseCoopers LLP for tax consultation and other projects.
Blyth, Inc. To File For 15 Day Extension For 10-K
1221 words
14 April 2004
PrimeZone Media Network
English
Copyright (c) 2004 PrimeZone Media Network, Inc. All Rights Reserved.
GREENWICH, Conn., April 14, 2004 (PRIMEZONE) -- Blyth, Inc. (NYSE:BTH), a leader in home decor and
home fragrance products, today announced that it will file Form 12b-25 with the Securities and Exchange
Commission to extend the filing period for its Form 10-K until April 30, 2004. On March 15, 2004, the
Company issued a press release in which it announced its financial results for the fiscal year ended January
31, 2004. Thereafter, the Company learned that the Company's independent accountants,
PricewaterhouseCoopers LLP, believed that the Company's current designation of two operating segments
does not comply with the requirements of Statement of Financial Accounting Standards No. 131,
"Disclosures about Segments of an Enterprise and Related Information" ("SFAS 131").
The Company has determined that it will change its designation of operating segments for fiscal 2004 and
potentially for certain prior years, which will impact the number of reporting segments required in its SFAS
131 footnote and related disclosures. During the past several years, the Company has reported financial
information with respect to two reporting segments, namely Candles & Home Fragrance and Creative
Expressions. It is now anticipated that the Company will report information in a greater number of
segments.
The designation of additional operating segments on a retrospective basis, pursuant to SFAS 131, is also
anticipated to result, retrospectively, in a greater number of reporting units pursuant to Statement of
Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"). Accordingly,
the Company will need to reassess impairment reviews of goodwill required to be performed as of the
adoption date of SFAS 142 (2/1/02) and for the fiscal year thereafter. It is anticipated that this will result in
certain impairment charges not previously reported, and that prior year financial statements will need to be
restated.
The Company has begun extensive analyses required to identify properly its operating segments, reporting
segments and reporting units, and to assess potential impairments of goodwill for its re-defined reporting
units. This work, however, is not yet complete. As a result, the Company has not been able to complete its
financial statements or other portions of its annual report on Form 10-K in time for filing within the
prescribed time period.
The Company presently expects that the financial statements which it will file as part of its annual report on
Form 10-K will include SFAS 131 financial information with respect to an expanded number of reporting
segments for its fiscal year ended January 31, 2004, and, comparatively, for all prior fiscal years presented.
In addition, as a result of the change in its operating segments and reporting units, the Company also
Item 1b
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expects that it will need to restate its financial statements for the fiscal year ended January 31, 2003 so as
to recognize an impairment loss pursuant to SFAS 142 with respect to the carrying value of goodwill,
particularly that which relates to its wholesale candle businesses. As analyses and valuations are still in
progress, the amount of such impairment charge is not yet finalized. However, based upon the work done to
date, the Company believes such impairment charge will be approximately $30 million, or approximately
$0.64 per share, which it expects will be recognized in fiscal 2003. The Company does not expect that the
change in its reported segments will have any effect upon the Company's cash flows in any reported period.
The Company expects that the change in the Company's operating segments will not affect the Company's
previously reported results of operations for fiscal 2004.
The 10-K filing extension necessitates a change in the Company's record date and date of its Annual Meeting
of Shareholders, which were originally scheduled for March 19, 2004 and May 18, 2004, respectively. A new
record date of May 13, 2004 has been established, and Blyth's Annual Meeting of Shareholders will take
place on June 24, 2004.
Management will conduct a conference call today at 5:30 p.m. Eastern time. The dial-in number is 1-877226-4265, and the passcode 6810886 is required. The international dial-in number is 1-706-679-0668 and
requires the same passcode. This call will be broadcast live via the Internet at
www.blyth.com[http://www.blyth.com].
Item 1b
Blyth, Inc. (CASE #1)
Page
16 of 16
B30116 – Berger
Chapter 1 - The Audit Report
The Wall Street Journal
AUGUST 23, 2004
Page C3
New SEC Rules Will Likely Draw More 8-K Filings
WASHINGTON – Get out your reading glasses.
Securities and Exchange Commission rules that take effect today could more than double the number of
corporate regulatory filings known as Form 8-Ks, experts say. Publicly traded companies use these forms
to report material developments between quarterly or annual reports.
The SEC already receives about 80,000 8-Ks each year, but as part of broader corporate-governance
guidelines the agency approved, an additional 10 corporate events also should trigger companies to file an
8-K. Companies then must file faster, generating reports for most events within four business days rather
than the five business days or 15 calendar days they had been allowed.
Form “8-K reporting volumes are going to go up dramatically,” said David Copenhafer of Bowne & Co.,
a financial printer that helps companies send reports to the SEC’s Edgar system. Edgar, which stands for
Electronic Data Gathering, Analysis and Retrieval system, is the pipeline through which the SEC
distributes corporate filings to the public.
Until now, 12 events triggered an 8-K, including a change in a company’s public accountant, a
bankruptcy-protection filing, a director resignation and changes to a company’s fiscal year.
As of today, companies must report via 8-K on terminations of material agreements, notice of delisting
from a stock exchange and financial restatements, as well as other events. The rules also mandate
expanded disclosure involving director or officer resignations and appointments, and about amendments
to company bylaws and changes to fiscal years.
Mr. Copenhafer, director of Edgar Services at Browne, of New York, and a former SEC manager, said the
SEC expects an additional 60,000 8-K filings a year, but he anticipates volume will increase even more
than that.
Chris Hodges, a principal at Ashton Partners, an investor-relations consulting firm, agreed that 8-Ks may
double, at least in the short term, because companies “want to comply with the spirit of the law.” Mr.
Hodges said he already has noted an increase in 8-K filings this year, as companies began early
compliance.
However, Mr. Hodges and some other observers fear the new guidelines still are loose enough
that they will leave companies in the dark about whether to draft a filing. And the faster filing
times could exacerbate that confusion.
By Shira Ovide Dow Jones Newswires
Item 1c
New Rules for 8-K Filings
Page
1 of 1
B30116 – Berger
Item 1c
Chapter 1 - The Audit Report
New Rules for 8-K Filings
Page
2 of 1
B30116 – Berger
Chapter 1 - The Audit Report
Close Window
JANUARY 29, 2007
NEWS & INSIGHTS
Not Everyone Hates SarbOx
The much maligned new rules are a big hit with investors
There has been no shortage of public outcry over Sarbanes-Oxley, the controversial 2002
accounting reform legislation that requires top corporate executives to fill out reams of new
forms and personally certify their financial reports. SarbOx, say its critics, adds millions in
compliance costs, makes life miserable for corporate directors, and encourages companies to bolt
to foreign stock exchanges. The complaints have been so passionate that regulators are now
planning to loosen the rules, probably before the year is out.
Not so fast, says a growing chorus of investors. Lost amid all the boos over SarbOx, they say, are
some major benefits. The biggest: SarbOx and related reforms have produced much more
reliable corporate financial statements, which investors rely on when deciding whether to buy or
sell shares. For them, SarbOx has been a godsend.
What's more, says Duncan W. Richardson, chief equity investment officer at Eaton Vance (EV )
Management and overseer of $80 billion in stockholdings, even the act's much disparaged
requirements for testing internal financial controls could drive gains in corporate productivity
and profits. Says Donald J. Peters, a portfolio manager at T. Rowe Price Group (TROW ): "The
accounting reforms have been a win."
Earnings will be on investors' minds over the next several weeks as most corporations announce
yearend results. The numbers will include results tallied under generally accepted accounting
principles and, thanks to a Securities & Exchange Commission regulation adopted during the
reform years, they'll also come with reconciliations to any nonstandard or "pro forma" numbers
that companies use to try to spin their results. The reconciliations, says Peters, are
"extraordinarily" helpful. "It is [now] much easier for me to have a view of the true economics"
of a company, he says.
Beefed-up disclosure requirements have also meant that companies now deliver numbers with
fewer adjustments for unusual charges and write-offs, which in the past have been used to make
earnings look better. Thomson Financial's (TOC ) Earnings Purity Index, which tracks earnings
adjusted for such write-offs, shows improvements in each of the past four years. And now
earnings reports reflect expenses for incentive stock options, information investors like that
wasn't available before the big accounting scandals.
Item 1d
Not Everyone Hates Sarbox
Page
1 of 2
B30116 – Berger
Chapter 1 - The Audit Report
Just as important, executives appear to have a firmer grasp of costs when they talk about
operating margins, according to Richardson of Eaton Vance. He credits the improvement to the
infamous Section 404 of SarbOx, which requires documented testing of internal controls. "Even
not-so-good management teams have good controls now, and that leads to an ability to cut
costs," he says.
This isn't to say SarbOx is flawless. Section 404 is often applied unreasonably, causing costly
checks of minor book entries. It's bad, too, that small-scale businesses find fewer benefits
relative to the costs.
TRUE TEST
Nor do the reforms mean that investors can trust the numbers implicitly. These days, financial
reports increasingly include ad hoc performance measures other than closely regulated earnings,
says Marc Siegel, research director at the Center for Financial Research & Analysis. "Companies
are going to greater extents to hide" the true stories of their cash flows, order backlogs, bookings,
and same-store sales, he says. Siegel notes that Duke University scholars found executives will
go far to spin their numbers: Some three-fourths said that to meet earnings estimates, they will
sacrifice corporate value, even if it means postponing profitable investments, deferring
maintenance, or giving incentives to customers to buy before the end of a quarter.
Of course, the real test for how much earnings reporting has improved won't come until the next
economic downturn, says UBS (UBS ) stock strategist David Bianco. In downturns, the lack of
growth often exposes aggressive accounting estimates used to manipulate earnings. And that's
when some capital investments are revealed to have been hiding operating costs.
Still, the next round of abuses to surface will probably not be as bad as it would have been
without the reforms. Says Eaton Vance's Richardson: "You're always better going into any
downturn with tighter rules." For regulators eager to start tinkering, that's food for thought.
By David Henry
Copyright 2000- 2007 by The McGraw-Hill Companies Inc.
All rights reserved.
Item 1d
Not Everyone Hates Sarbox
Page
2 of 2
B30116
2.
Chapter 2 – Deferred Income Taxes
Income Taxes and Deferred Income Tax Accounting
Book income and taxable income
Pretax (or Book) Income:
Income computed for
financial reporting purposes
≠
 Intended to reflect increases in
the firm’s “well-offness”.
 Includes all earned inflows of
net assets, even when the
inflow is not immediately
convertible into cash.
 Reflects expenses as they
accrue, not just when they are
paid.
Item 2a
Introduction to Deferred Taxes
Taxable Income:
Income computed for
tax compliance purposes
 Governed by the “cons
receipt/ability to pay” d
 The timing of taxation u
(but not always) follow
inflow of cash or equiva
 Deductions generally a
allowed only when the
expenditures are made
a loss occurs.
Page 1 of 3
B30116
Chapter 2 – Deferred Income Taxes
Timing
Understanding
income
tax
differences:
Taxable Income
reporting:
Pretax (or Book)
Income
≠
 A timing difference results when a revenue (gain) or expense
(loss) enters book income in one period but affects taxable
income in a different (earlier or later) period.
Divergence complicates the way income taxes are reflected in financial reports
Item 2a
Introduction to Deferred Taxes
Page 2 of 3
B30116
Chapter 2 – Deferred Income Taxes
•
•
•
•
Depreciation expense
Bad debt expense
Installment sales
Revenues received in advance
 Permanent differences are caused by income items
that:
•
Pretax (or
Interest on state and municipal bonds.
Income
Book)
•
Executive life insurance
Understa
reporting
Permanent
Permanent
T
Permanent
differences
Item 2a
Introduction to Deferred Taxes
≠
Page 3 of 3
B30116
Chapter 2 – Deferred Income Taxes
Income Taxes -- Notes
Taxable income: Earnings subject to taxation as reported on the combined federal, state, and
foreign tax return. Used to compute current income tax expense (below).
Pretax income: Earnings before income taxes for financial reporting (i.e., book) purposes.
Reported on the income statement. Not used to compute provision for income taxes (below).
Permanent differences: Differences between taxable income and pretax income that will never
reverse: tax-free income and non-deductible expenses (e.g., executive life insurance).
Temporary differences: Differences between taxable income and pretax income that will reverse
in future periods: cash- vs. accrual-basis accounting, accelerated vs. straight-line depreciation of
fixed assets.
Current income tax expense: Amount of income taxes that are due all taxing authorities for the
period and reported on the combined federal, state, and foreign tax return. Based on taxable
income (above)
Provision for income taxes: The income tax expense for financial reporting purposes and
reported on the income statement. A negative expense is often called a benefit. A plug amount
based on current income tax expense and the net change in the balance of deferred tax assets (net
of any valuation allowance) and deferred tax liabilities:
EXP = CUR  (DEF_ASSET  ALLOW) + DEF_LIAB, where
EXP
CUR
DEF_ASSET
ALLOW
DEF_LIAB

=
=
=
=
=
=
provision for income taxes,
current income tax expense,
deferred income tax assets (gross),
valuation allowance,
deferred income tax liabilities, and
first-difference operator.
Deferred income tax asset: Arises if future taxable income (and hence future current income tax
expense) is expected to be less than future pretax income (and hence the future provision for
income taxes). Reflects temporary differences. The future journal entry (assuming positive
future pretax income) is:
Provision for income taxes (plug)
Deferred tax asset
Taxes payable / cash
Item 2b
y+x
x
y
Income Statement
Reversal (i.e., reduction) of asset
= Tax Return taxes
Details on Deferred Taxes
Page 1 of 3
B30116
Chapter 2 – Deferred Income Taxes
A deferred tax asset can also arise if taxable income is negative, in which case the company has
an operating loss carryforward which can be used to offset future tax payments (i.e., future
current income tax expense), provided it is not used to obtain a refund of tax payments for
previous years.
Valuation allowance: Contra-asset to deferred income tax assets (credit balance). The company
records a valuation allowance if it is more likely than not (i.e., probability greater than 50%) that
the company will not be able to use all or a portion of its deferred tax assets. Increases
(decreases) in the valuation allowance decrease (increase) deferred tax assets, which leads to an
increase (decrease) in the provision for income taxes. A company’s ability to use a deferred tax
asset depends on the source of the deferred tax asset. If the source is a temporary difference
(e.g., restructuring charge), the company must have positive future pretax income or, if future
pretax income is non-positive, deferred tax liabilities that can be used to offset the deferred tax
asset. On the other hand, if the source of the deferred tax asset is an operating loss carryforward
or a tax credit, then the company must have positive future taxable income which can be used to
absorb the operating losses or tax credits.
Deferred income tax liability: Arises if future taxable income (and hence future current income
tax expense) is expected to be greater than future pretax income(and hence the future provision
for income taxes). Reflects temporary differences. The future journal entry is:
Provision for income taxes (plug)
Deferred tax liability
Taxes payable / cash
Item 2b
yx
x
y
Income Statement
Reversal (i.e., reduction) of liability
= Tax Return taxes
Details on Deferred Taxes
Page 2 of 3
B30116
Chapter 2 – Deferred Income Taxes
Valuation Allowance
A valuation allowance is required when, based on available evidence, it is more likely than not
that some portion (or all) of the deferred tax asset will not be realized. A firm must consider all
available evidence, both positive and negative, to make the determination. Evidence includes:
 Information about a firm’s current financial position.
 Information about a firm’s results of operations for the current and preceding years.
 Information about a firm’s future operations.
A recent history of several years of losses is strong evidence that suggests a valuation
allowance is needed. Other evidence suggesting the need for a valuation allowance includes, but
is not limited to:
 A history of operating loss carryforwards that expire unused.
 Losses expected in future years.
 Circumstances that if unfavorably resolved would adversely affect future operations.
 A remaining carryback or carryforward period that is so short as to be of limited use in
realizing tax benefits if a large deductible temporary difference is expected to reverse in a
single year or if the firm operates in a highly cyclical business.



Positive evidence that a valuation allowance is not needed includes the following:
A history of profitability.
Existing contracts or firm sales backlog that will produce more than enough taxable income
to realize the deferred tax asset.
An excess of appreciated asset value over the tax basis of the assets sufficiently large to
realize the deferred tax asset.
Each of the above items provides information useful for estimating future taxable
income. If the amount expected for future taxable income is large enough to realize the deferred
tax asset, no valuation allowance is needed. Even if it is not, a valuation allowance might not be
required. If the deductible temporary difference that is creating the deferred tax asset is to
reverse soon enough that it can be carried to the current and prior years to realize the benefit, no
valuation allowance is required. Also, if the future reversals of taxable temporary differences
can offset deductible temporary differences by carryback and carryforward procedures, and the
taxable
temporary differences are large enough to cause the deferred tax assets to be realized, no
valuation allowance is needed. Finally, if there are prudent and feasible tax-planning strategies
that a firm could implement to prevent an operating loss or tax credit carryforward from expiring
or that in general would result in the realization of the deferred tax asset, then again a valuation
allowance is not needed.
Strong positive evidence from any one of the possible sources is sufficient to support a
conclusion that a valuation allowance is not necessary. If such evidence is available from one
source, other sources need not be considered.
Item 2b
Details on Deferred Taxes
Page 3 of 3
B30116
Chapter 2 – Deferred Income Taxes
Temporary and Permanent Tax Differences - Example
Revenue
CGS
Gross Margin
Restructuring charge
Interest income (tax-free)
Pretax income
Income tax expense (40%)
Net income
1994
$ 200
(120)
80
10
90
(32) a
$
58
Effective income tax rate
Income
Statement
1995
1996
$ 200
$ 200
(120)
(120)
80
80
(20)
60
80
(24) b
(32) c
$
36
$
48
35.6% d
40.0% e
40.0% f
1994
Revenue
$ 200
CGS
(120)
Gross Margin
80
Restructuring charge
Taxable income
80
Current income tax exp (40%)
(32) c
After-tax income
$
48
Tax Return
1995
$ 200
(120)
80
80
(32) c
$
48
1996
$ 200
(120)
80
(20)
60
(24) b
$
36
a 32 = 0.4 x (90 - 10) = 0.4 x 80
b 24 = 0.4 x 60
c 32 = 0.4 x 80
Item 2c
d 35.6 = 32 / 90 = inc tax exp / pretax inc
e 40.0 = 24 / 60
f 40.0 = 32 / 80
Tax Example
Page 1 of 2
B30116
Chapter 2 – Deferred Income Taxes
Temporary and Permanent Tax Differences - Example (cont)
Journal entry - 1994
Income tax expense
Taxes payable / cash
32
32
Income statement
Tax return
20
Expense taken in 1995 on the IS
but in 1996 on the tax return
32
Income statement
Temporary difference
Tax return
20
Expense taken in 1995 on the IS
but in 1996 on the tax return
8
24
Income statement
Temporary difference reversed
Tax return
Journal entries - 1995
Restructuring charge (IS)
Severance liability (BS)
20
Income tax expense
Deferred tax asset
Taxes payable / cash
24
8
Journal entries - 1996
Severance liability
Cash
20
Income tax expense
Deferred tax asset
Taxes payable / cash
32
Item 2c
Tax Example
Page 2 of 2
B30116
Chapter 2 – Deferred Income Taxes
MDC Manufacturing
Katherine Allison, assistant to the new president of MDC Manufacturing, had just finished
reviewing her notes from a recent meeting between herself, the controller of MDC, and the new
president, Julia Lynch. Julia was formerly head of engineering and product development for the
firm and has no background in accounting. After the meeting, she expressed concern to
Katherine about discrepancies between what the firm is reporting in its financial statements and
what the firm is reporting to the Internal Revenue Service.
A report presented by the controller at the meeting contained the following figures.
Income Tax Return
For the Year Ended
December 31, 1995
Earnings Before Taxes
Current Income Tax Liability
$2,025,000
730,000
The December 31, 1995 income statements contained the following values for earnings
before tax and earnings after tax.
December 31, 1995
Earnings Before Tax
Provision for Taxes
Net Earnings
$2,500,000
900,000
$1,600,000
The balance sheet for the year ended December 31, 19x5 showed the following balances for
income taxes.
December 31, 19x5
December 31, 19x4
Income Taxes Payable
Long-Term Liabilities
180,000
175,000
Deferred Income Taxes
170,000
0
Current Liabilities
Item 2d
MDC Manufacturing Problem
Page 1 of 2
B30116
Chapter 2 – Deferred Income Taxes
Katherine has summarized Julia's specific concerns in her notes from the meeting as follows:
i.
Why is there such a large difference between the income before tax in the financial
statements and the amounted reported for tax purposes?
ii.
The tax rate reported for tax purposes and employed for financial reporting purposes differ
from each other as well as the 40% statutory tax rate. How can this be the case?
iii.
There exists a line for income taxes payable and a line for deferred income tax on the
liabilities side of the end balance sheet. Neither corresponds the current income tax liability
on the tax return.
Julia has asked Katherine to clear up these concerns for her. In investigating the
discrepancies, Katherine received the following information from the controller.
>
>
>
>
>
Revenues from investments in municipal tax free bonds totaled $100,000.
Accelerated depreciation is being used for tax purposes while straight line depreciation is
being used for financial reporting purposes. The depreciation deduction reported on the tax
return exceed the depreciation expense on the financial statements by $900,000.
MDC received an $80,000 investment tax credit for equipment purchased during 19x5.
MDC paid life insurance premiums of $50,000 for policies on the lives of its top executives
in which MDC is listed as the designated beneficiary. For book purposes the premiums paid
are an expense. For tax purposes the premiums paid are not deductible.
During 19x5 the company sold a plant for $500,000 more than its book value and then had
leased it back for a 20 year period. The gain was deferred in accordance with GAAP and is
being amortized over the life of the lease. The amount of the deferred gain amortized during
the year totaled $25,000. In contrast to GAAP, the tax code required that the entire gain be
immediately included as taxable income for 19x5.
Required
1.
Prepare Katherine's report by filling in the appropriate blank areas in the document
“Accounting for Income Taxes, Lecture 1” on pages 2 to 5.
2. Be prepared to discuss the merits of presenting values for taxes on the financial report that
differ from the taxes due per the tax return.
Item 2d
MDC Manufacturing Problem
Page 2 of 2
B30116
Chapter 2 – Deferred Income Taxes
Accounting for Income Taxes, Lecture 1 Slides
Accounting for Income Taxes
Why Should You Care?
Income statement
Tax expense numbers may deviate significantly from taxes owed to the taxing authorities.
Tax expense numbers may deviate significantly from the cash demands for taxes.
Balance Sheet
Deferred income tax assets/liabilities may not be economic assets/liabilities.
Deferred income tax assets/liabilities may never be realized.
Deferred income tax assets/liabilities do not reflect present values.
Deferred income tax assets/liabilities may not be properly classified as current/noncurrent.
All components of a deferred income tax asset/liability are not the same.
Why is there a discrepancy between financial statement earnings before tax and earnings before
tax reported to the tax authority?
Earnings before tax reported to the tax authority (i.e., taxable income) is computed according to
the accounting rules as specified by the tax code.
GAAP earnings before tax is computed according to GAAP.
Item 2e
Taxes – Lecture 1 Slides
Page 1 of 14
B30116
Chapter 2 – Deferred Income Taxes
Reconciliation of MDC's earnings figures
GAAP earnings before tax
2500
Taxable income
2025
Reconciliation to 40% statutory tax rate
for Tax Return Numbers
Earnings before tax per tax return
times tax rate
Taxes before credits
less tax credits
Current income tax liability
2025
730
The Issues Arising from Differences in GAAP and Tax Accounting
What is the appropriate income tax expense for financial reporting (GAAP) purposes?
If income tax for GAAP  income taxes due to the government, what happens to the
difference?
Item 2e
Taxes – Lecture 1 Slides
Page 2 of 14
B30116
Chapter 2 – Deferred Income Taxes
Accounting for Taxes
GAAP mandates that tax expense should correspond to the income before tax reported on the
financial statements.
Example journal entry
Provision of income tax (e)
Income taxes payable (l)
Deferred income taxes (a or l)
x
y
x-y
Differences between GAAP and taxable income
Permanent differences:
affect GAAP earnings before tax but never taxable income (or visa versa)
Temporary differences:
affect GAAP earnings before tax and taxable income in different periods.
Only temporary differences give rise to deferred tax assets/liabilities on the balance sheet.
MDC example continued
Permanent differences
Temporary differences
Item 2e
Taxes – Lecture 1 Slides
Page 3 of 14
B30116
Chapter 2 – Deferred Income Taxes
Reconciliation to 40% statutory tax rate for GAAP Numbers
GAAP earnings before tax
Adjustments for permanent differences
times tax rate
40%
Taxes before credits
less tax credits
Current provision for income tax
900
Recording MDC's Income Tax Provision
To record provision for income tax:
Provision for income tax (e)
Income taxes payable (l)
Deferred income tax (l)
Why does income taxes payable only have a balance of 180?
An entry to record MDC's payment in the 1st quarter of 1995 for 4th quarter of 19x4 taxes
payable
Income taxes payable (l)
Cash (a)
An entry in 1995 to summarize MDC's quarterly payments for taxes payable arising during 19x5
is:
Income taxes payable (l)
Cash (a)
Item 2e
Taxes – Lecture 1 Slides
Page 4 of 14
B30116
Chapter 2 – Deferred Income Taxes
Reversals Illustrated
Assume that MDC has no temporary differences in subsequent years other than those that
originated in 19x5.
Assume that in 19x6, 19x7, and 19x8, depreciation expense for GAAP will exceed depreciation
expense for tax purposes by $300,000 in each period.
What will be the difference between the provision for taxes and the taxes payable recorded for
subsequent years?
What will happen to the ending balance of the deferred tax liability account over subsequent
years?
Reversals Illustrated continued
year
after
19x5
1
2
3
4
5
.
.
.
provision
less
payable
end of year net
balance for DIT
A or L
.
.
.
.
.
.
17
18
19
20
21
Item 2e
Taxes – Lecture 1 Slides
Page 5 of 14
B30116
Chapter 2 – Deferred Income Taxes
Accounting Issue #1
Changing Tax Rates
Liability Method Or Asset-Liability Approach is currently employed.
Push the effect of the change through income in the year that the change is known.
Accounting Issue #2
Current vs. Noncurrent
Classify the deferred tax asset or liability in the same manner as the related asset or liability.
If there is no related asset/liability, classify based upon the expected reversal date.
Accounting Issue #3
Deferred Tax Assets -- the Realization Issue.
Deferred tax assets are always allowed to be recorded if there are offsetting deferred tax
liabilities.
In addition, a deferred tax asset may be recorded even if there is not an offsetting liability. In
this case, the gross deferred tax asset is reduced if it is "more likely than not" that the entire asset
will not be recognized. This reduction is often called the valuation allowance.
Item 2e
Taxes – Lecture 1 Slides
Page 6 of 14
B30116
Chapter 2 – Deferred Income Taxes

Enter into taxable income but never affect book income.
 Because permanent differences do not reverse, they
give rise to deferred tax assets or liabilities.
Accounting Issue #4
Tax Carryforwards
Tax carryforwards arise when a firm receives a tax benefit in a period that will be realized in
future periods.
Tax carryforwards, if recognized, reduce (increase) the deferred tax liability (asset). Thus, these
reduce the computation of income tax expense and can result in the income tax expense being
negative (i.e., an increase to income).
Accounting Issue #4 continued
Tax Carryforwards
Item 2e
Taxes – Lecture 1 Slides
Page 7 of 14
B30116
Chapter 2 – Deferred Income Taxes
Under current rules, carryforwards are treated exactly like other deferred tax assets.
Current or Noncurrent?
Tax carryforwards are classified as current or noncurrent depending upon the expected
utilization date.
 Norman Corporation records a deferred tax asset in
to accrued warranty expenses:
• Statutory depletion in excess of
cost-based depletion
• Dividend received deduction
Net operating loss
Carrybacks and carryfor
DR Income
DR Income
tax expense
expense
($600,000
($315,000
.35)
 tax
In early
2009,
Norm
xasse
The
UDeferred
income
tax
$210,000
$115,000
Loss
incurred
2008
Years
2004
Item 2e
Taxes – Lecture 1 Slides
2005
2006
Page 8 of 14
2007
B30116
Chapter 2 – Deferred Income Taxes
Carry forward
Carry back
Carry forward
Item 2e
Taxes – Lecture 1 Slides
Page 9 of 14
B30116
Chapter 2 – Deferred Income Taxes
Accounting Issue #5
Separation of DIT Assets and Liabilities
Firm's must net current (noncurrent) DIT assets and liabilities for balance sheet presentation for
each tax jurisdiction and individual tax paying entity of the firm.
Implication
You might see 4 lines related to deferred taxes on the balance sheet: current DIT asset, current
DIT liability, noncurrent DIT asset, and noncurrent DIT liability.
Item 2e
Taxes – Lecture 1 Slides
Page 10 of 14
B30116
Chapter 2 – Deferred Income Taxes
Accounting Issue #6
Indefinite Reversals
Income from a subsidiary recognized for GAAP purposes may not be recognized for tax
purposes. In such cases, the income is not recognized for tax purposes until received in the form
of a dividend or consideration received in a taxable exchange.
If parent intends to "permanently reinvest" the subsidiary income or receive it in a tax free
liquidation, GAAP allows the parent to forego recording the DIT liability.
Item 2e
Taxes – Lecture 1 Slides
Page 11 of 14
B30116
Chapter 2 – Deferred Income Taxes
Conceptual Issue #1
Is it really an Asset or Liability?
Does the firm have a legal obligation (claim) associated with a deferred tax liability (asset)?
Conceptual Issue #2
Will DIT Assets/Liabilities ever be Realized?
Illustrative Example:
Consider a firm that buys a new machine for 50 each year. For tax purposes, the machine is fully
depreciated in the first year. For GAAP purposes, the machine is depreciated 25 each year. This
depreciation difference is the only source of GAAP/tax accounting differences.
What happens to the balance of DIT as time passes? (Assume a 40% tax rate.)
Conceptual Issue #2 continued
Will DIT Assets/Liabilities ever be Realized?
Example
year
of
operation
1
2
3
4
5
.
.
.
.
.
.
Item 2e
provision
less
payable
end of year net
balance for DIT
A or L
.
.
.
Taxes – Lecture 1 Slides
Page 12 of 14
B30116
Chapter 2 – Deferred Income Taxes
Conceptual Issue #3
Is the DIT Asset or Liability Properly Valued?
Example
Consider our previous example with the added assumption that the firm will stop buying
machines in year n.
What is the proper value of the DIT liability in year 1?
Conceptual Issue #4
Are DIT Assets/Liabilities Properly Classified as Current or Noncurrent
Recall that classification as current/noncurrent generally has nothing to do with the expected date
of reversals.
Therefore, the current/noncurrent designation cannot be blindly used to predict future tax
payments.
Conceptual Issue #5
Are all DIT Components Equivalent?
Other than being useful for projecting future cash flows for taxes, most DIT components do not
have direct cash flow implications.
Exception:
Net operating loss carryforwards that cannot be utilized by firm A currently may have immediate
cash flow implications for an acquirer of A.
Item 2e
Taxes – Lecture 1 Slides
Page 13 of 14
B30116
Chapter 2 – Deferred Income Taxes
Summary of What We Talked About
Why do accounting issues arise with respect to taxes?
Permanent vs. Temporary Differences
Accounting Issues
Conceptual Issues
Item 2e
Taxes – Lecture 1 Slides
Page 14 of 14
B30116
Chapter 2 – Deferred Income Taxes
Accounting for Income Taxes, Lecture 2 Slides
We have addressed the following questions:
What is on the balance sheet and income statement for income taxes?
What are some of the accounting and conceptual problems with the reported numbers?
We still have to address the following questions:
What is disclosed in the notes to the financial statements regarding taxes?
Why might the disclosure be useful for analysis?
What Is Disclosed?
Components of the deferred tax liabilities and assets
Amount of and change in the valuation allowance (i.e., DIT contra asset account for amounts that
are not expected to be realized)
DIT liabilities not recognized1
Current year effects of temporary differences
Components of income tax expense (federal, state, foreign)
Reconciliation of income tax expense to amount based upon statutory rate (amounts or
percentages)
Tax loss carryforwards and credits
1
In some cases firms forego recognizing DIT liabilities/assets. The most obvious case is when a firm has foreign
subsidiaries that are not consolidated for tax purposes but are consolidated for book purposes. In these cases,
the parent pays taxes related to subsidiary income only when the parent receives dividends or sells the
subsidiary. If the parent intends to permanently hold the subsidiary and reinvest the income of the subsidiary
(i.e., receive no dividends), then no DIT liability related to the subsidiary income are recorded. Firms must
disclose the amount of the unrecorded DIT liability.
Item 2f
Taxes – Lecture 2 Slides
Page 1 of 3
B30116
Chapter 2 – Deferred Income Taxes
MDC Example Disclosure
Components of deferred taxes
19x5
19x4
190
190
0
360
360
170
0
0
Assets
Gain on sale/lease-back
Total Assets
Liabilities
Depreciation
Total Liabilities
Net Liability
MDC Example Disclosure Continued
Components of deferred tax provision
Gain on sale/lease-back
Depreciation
Total
(
19x5
190 )
360
170
19x4
19x5
19x4
730
0
0
730
?
?
?
?
170
0
?
?
0
170
900
?
?
?
Current taxes
Federal
State
Foreign
Deferred taxes
Federal
State
Foreign
Provision for income taxes
0
MDC Example Disclosure Continued
Reconciliation of provision for income tax to the statutory rate of 40% is as follows:
Item 2f
Taxes – Lecture 2 Slides
Page 2 of 3
B30116
Chapter 2 – Deferred Income Taxes
Tax based upon statutory rate of 40%
Non-tax-deductible insurance premium
Tax-free interest income
Investment tax credits
Provision for taxes
(
(
19x5
1000
20
40 )
80 )
900
19x4
?
20
?
?
?
or, alternatively,
Statutory rate
Non-tax-deductible insurance premium
Tax-free interest income
Investment tax credits
Effective tax rate
(
(
40.0 %
.8
? %
?
1.6 )
3.2 )
36.0 %
?
?
?
Why is Tax Information Useful?
Explain why tax disclosure can help you answer the following questions.
1. Are overly optimistic assumptions being used for financial reporting purposes?
2. What are manager/auditor beliefs about the firm's ability to generate income in the near term?
3. What real assets (on or off the balance sheet) generate immediate cash flow implications for
an acquirer?
4. Is the current tax payable for the period indicative of what one might expect for the future?
5. Is the growth in firm income coming from domestic or foreign operations?
6.
What is the firm's capital investment strategy?
Item 2f
Taxes – Lecture 2 Slides
Page 3 of 3
B30116
Chapter 2 – Deferred Income Taxes
Tax Note Disclosures
Cheat Sheet
You will receive 3 or 4 tables in any income tax note. The key features of these tables are described
below.
Table 1
One table essentially gives you the generic journal entry for recording taxes for the period. For
example, a company called Winn Dixie had the following table for 1992.
Current
1992
Federal
State
Deferred
Amounts in thousands
Total
$ 119,006
8,785
(16,602)
371
102,404
9,156
$ 127,791
(16,231)
111,560
Therefore, the 1992 journal entry is:
Income tax expense
Deferred income taxes (in this case it is a debit)
Current taxes payable (or Income taxes payable)
111,560
16,231
127,791
Tables 2 and 3
One table gives you the causes (e.g., differences in depreciation) that gave rise to the deferred tax
asset/liability on the balance sheet. Another table (which is not always included) gives you the
causes of the flow or entry to the deferred tax account during the year.
Remember the following for temporary differences.
A deferred tax debit entry (i.e., increase in asset or decrease in liability) arises when
taxable income is greater than GAAP pretax income for the period (i.e., less revenue or
more expense has been recorded for GAAP purposes). Therefore, a deferred tax liability
associated with depreciation implies that the firm has recorded less depreciation expense
for GAAP purposes than for tax purposes since the beginning of time. A decrease in that
liability position over a single period implies that, for that period, the firm recorded more
depreciation expense for GAAP purposes than for tax purposes (i.e., the liability position
reversed during the period).
A deferred tax credit entry (i.e., decrease in asset or increase in liability) arises when
taxable income is less than GAAP pretax income for the period (i.e., more revenue or
less expense has been recorded for GAAP purposes). Therefore, a deferred tax asset
associated with revenue recognition implies that the firm has recorded less revenue for
GAAP purposes than for tax purposes since the beginning of time. A decrease in that
asset position over a single period implies that, for that period, the firm recorded more
revenue for GAAP purposes than for tax purposes (i.e., the asset position reversed during
Item 2g
Tax Disclosures – Cheat Sheet
Page 1 of 2
B30116
Chapter 2 – Deferred Income Taxes
the period).
In addition, note that amounts for net operating loss carryforwards and the valuation allowance
are included in these tables.
Table 4
The last table gives you a reconciliation from a tax expense number (or effective tax rate) using
just the federal statutory rate to the actual tax expense number (or effective tax rate) on the
GAAP income statement. The reconciling items include: adjustments for state and local taxes
net of the federal benefit, differences between foreign tax rates and the federal statutory rate,
permanent differences (e.g. nondeductible goodwill amortization), tax credits, and changes in the
valuation allowance.
Item 2g
Tax Disclosures – Cheat Sheet
Page 2 of 2
B30116
Chapter 2 – Deferred Income Taxes
Case #2 Monterey Pasta Company
The 'Growth With Value Fund' of the Capstone Group of Funds is an active investment Fund
with an investment philosophy of taking positions in stocks with excellent growth potential that
are trading at favorable prices. The Growth With Value Fund has taken a beating for the first
quarter of 1995 due in large part to a significant position in Monterey Pasta Company.
Monterey Pasta Co., based in California, processes a premium line of fresh gourmet pasta and
pasta sauces served through a chain of company-owned quick-serve "Monterey Pasta Company"
restaurants and distributed through retail grocery and club stores under the "Monterey Pasta
Company" brand name. The company's product line, which emphasizes all-natural ingredients,
includes such flavors as Snow Crab Ravioli, Sweet Red Pepper Fettuccini, and Sun Dried
Tomato Pesto Sauce. Retail grocery and club store distribution of the company's product line is
growing nationwide. The company's existing restaurants are located in upscale shopping and
financial centers in California, Colorado, Texas and Washington.
Monterey Pasta announced particularly poor results for the final quarter of 1994, precipitating a
20% decline in its stock price. You have been asked by the overseers of the Capstone Group of
Funds to apportion blame for the loss attributable to the position in Monterey Pasta between Joe
Lightweight, the Group's analyst responsible for following Monterey Pasta and Mary Contrary,
the manager of the Growth With Value Fund.
In addition to Monterey Pasta's financial results for the third quarter of 1994 and the full 1994
fiscal year (attached), you are provided with the following facts:
•
Joe Lightweight sent a report on Monterey Pasta to Mary Contrary following the release
of the company's results for the third quarter of 1994. He forecasted that Monterey Pasta
would break even in the fourth quarter (i.e., report earnings of zero cents per share) on
revenues of around $5 million. He expressed an optimistic longer-term outlook for
Monterey Pasta and attributed the company's losses for the first three quarters of 1994 to
investments in production and marketing infrastructure. His report recommended that
The Growth With Value Fund Continue to hold its existing position in Monterey Pasta.
•
After reading Joe's report, Mary Contrary was bullish on Monterey Pasta and thought the
company had terrific growth potential. However, she firmly believed that good sales and
earnings momentum were critical for Monterey Pasta's stock price to climb. Given Joe's
predictions that Monterey Pasta would come out of the red in the fourth fiscal quarter on
strong sales growth, she decided to double the Growth With Value Fund's existing
position in Monterey Pasta.
•
Joe blames Monterey Pasta's poor earnings for the fourth fiscal quarter on an "unusual
and unpredictable accounting charge that is unrelated to Monterey Pasta's true financial
performance". With the exception of this charge, he claims the analysis in his report was
pretty much on target. Mary points out that the stock price decline in Monterey Pasta
was directly attributable to the disappointing earnings results for the fourth fiscal quarter.
Item 2h
MONTEREY PASTA (CASE #2)
Page 1 of 13
B30116
Chapter 2 – Deferred Income Taxes
She claims that the blame rests with Joe because she would never have doubled the
Fund's position if she had known of the possibility of the accounting charge and that
predicting such charges is Joe's job.
Required:
Prepare a report that analyses whether Joe Lightweight was guilty of providing bad forecasts of
Monterey Pasta's fourth quarter earnings. Your report should include an analysis of Monterey
Pasta's fourth quarter results, including the identification and analysis of any unusual accounting
charges.
Item 2h
MONTEREY PASTA (CASE #2)
Page 2 of 13
B30116
Chapter 2 – Deferred Income Taxes
MONTEREY PASTA COMPANY
10Q for Quarter Ended October 2, 1994
CONSOLIDATED BALANCE SHEETS
ASSETS
December 31, 1993
October 2, 1994
(unaudited)
Current Assets:
Cash and cash equivalents…………………………...
Held-to-maturity securities…………………………..
Accounts receivable…………………………………
Inventories…………………………………………...
Prepaid expenses and other………………………….
Receivables from related parties…………………….
Deferred income taxes……………………………….
Total current assets………………………………
$10,602,397
--487,458
385,790
109,462
16,377
--11,601,484
$2,954,350
2,690,587
1,017,334
801,612
340,713
59,112
506,813
8,370,521
Property and equipment, net……………………………
Intangible assets, net……………………………………
Deposits and other……………………………………...
Total assets………………………………………
2,600,054
182,773
61,293
$14,445,604
10,374,743
1,036,641
704,410
$20,486,315
$
$
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current portion of long-term debt…………………..
Current portion of capital lease obligations………
Accounts payable…………………………………
Accrued liabilities…………………………………...
Income taxes payable……………………………….
Amounts due to related parties……………………...
Total current liabilities………………………...
Long-term debt…………………………………………
Capital lease obligations………………………………..
Deferred income taxes………………………………….
Commitments and contingencies………………………
Shareholders' equity:
Series A. Preferred Stock, no par value,
5,000,000 shares authorized, 1,200,000 and
0 shares issued and outstanding at December
31, 1993 and October 2, 1994, respectively……
Common stock, no par value, 10,000,000
shares authorized, 3,657,500 and 5,607,500
issued and outstanding at December 31, 1993
and October 2, 1994, respectively……………..
Retained earnings (deficit)…………………………
Total shareholders' equity……………………
Total liabilities and shareholders' equity………
90,245
63,883
478,972
339,395
28,000
37,930
1,038,425
46,802
--1,019,755
578,044
----1,644,601
113,347
202,369
9,400
---
92,644
---
---
13,042,807
39,256
13,082,063
$14,445,604
19,460,904
_(721,234)
18,739,670
$20,486,315
9,400
---
The accompanying notes are an integral part of these statements.
Item 2h
MONTEREY PASTA (CASE #2)
Page 3 of 13
B30116
Chapter 2 – Deferred Income Taxes
MONTEREY PASTA COMPANY
10Q for Quarter Ended October 2, 1994
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
Three Months Ended
9/30/1993
10/2/1994
Net Revenues:
Grocery and club stores
Restaurants
Total net revenues
Cost and expenses:
Cost of sales
Restaurant operating expenses
Selling, general and administrative
Depreciation and amortization
Income (loss) from operations
Interest (income) expense, net
Income (loss) before provision for
income taxes
Benefit for income taxes
Net income (loss)
Pro forma income tax provision
Net income after pro forma
income tax provision
Net loss per share
Pro forma net income per share
Weighted average common and common
equivalent shares outstanding
Nine Months Ended
9/30/1993
10/2/94
$ 1,236,084
81,504
1,317,588
$ 2,528,901
1,879,743
4,408,644
$ 3,038,548
81,504
3,120,052
$ 6,462,845
3,629,900
10,092,745
755,435
52,156
241,962
35,267
1,084,820
232,768
17,382
2,472,840
1,188,862
1,181,653
329,450
5,172,806
(764,161)
(67,294)
2,026,073
52,156
717,882
99,331
2,895,442
224,610
35,849
5,759,840
2,374,903
2,711,262
693,318
11,539,323
(1,446,578)
(179,275)
215,386
-215,386
88,123
(696,867)
(278,747)
$ (418,120)
188,761
-188,761
77,474
(1,267,303)
(506,813)
$ (760,490)
$ 127,263
$ 111,287
$
$
(,07)
.05
2,500,000
$
$
5,606,951
(.15)
.04
2,500,000
5,150,955
The accompanying notes are an integral part of these statements.
Item 2h
MONTEREY PASTA (CASE #2)
Page 4 of 13
B30116
Chapter 2 – Deferred Income Taxes
MONTEREY PASTA COMPANY
10Q for Quarter Ended October 2, 1994
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
Nine Months Ended
September 30, 1993
October 2, 1994
Cash flow from operating activities:
Net Income (loss)……………………………
$ 111,287
$ (760,490)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization……………
99,331
693,318
Unrealized interest income from
held-to-maturity securities……………..
-(120,286)
Loss on sale of property………………….
3,301
-Changes in assets and liabilities:
(Increase) in accounts receivable……..
(72,263)
(529,876)
(Increase) in inventories
(43,698)
(415,822)
(Increase) in prepaid expenses,
intangible assets and other…………...
(178,020)
(925,506)
Increase in accounts payable…………….
27,813
540,783
Increase in accrued liabilities……………
83,049
200,719
(Increase) in deferred income-tax benefit.
--(536,397)
Net cash provided by (used in) operating
activities…………………………….
30,800
(1,853,557)
Cash flows from investing activities:
Purchase of held-to-maturity securities….
--(5,069,147)
Redemption of held-to-maturity securities...
--2,500,000
Purchase of property and equipment, net…..
(480,703)
(7,563,472)
Net cash used in investing activities…..
(480,703)
(10,132,619)
Cash flow from financing activities:
Proceeds from long-term debt……………...
648,144
--Repayment of long-term debt and capital
(330,396)
lease obligations……………………………
(205,807)
Proceeds from issuance of common stock…
115,417
6,427,527
Issuance of note receivable (1)…………….
--(500,000)
Repurchase of common stock (1)………….
--(1,259,000)
Net cash provided by
financing activities………………...
557,484
4,338,129
Net increase (decrease) in cash………………...
107,581
(7,648,047)
Cash and cash equivalents at beginning of period...
3,381
10,602,397
Cash and cash equivalents at end of period……….
$ 110,962
$ 2,954,350
(1)
For supplemental disclosure of non cash financing activities see Note 7.
The accompanying notes are an integral part of these statements.
Item 2h
MONTEREY PASTA (CASE #2)
Page 5 of 13
B30116
Chapter 2 – Deferred Income Taxes
MONTEREY PASTA COMPANY
10Q for Quarter Ended October 2, 1994
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1:
ACCOUNTING POLICIES AND PROCEDURES
Change in Accounting Period
Effective June 1, 1994, the Company changed from a monthly reporting period to a 4-week, 4-week and 5week reporting period with the fiscal year ending on January 1, 1995. The Company reported its operating results in
prior periods on a calendar year basis. The Company has determined that the change to this accounting period will
not result in a material difference for comparable reporting periods.
Reclassification
Certain reclassifications have been made to prior period financial statements in order to be consistent with
the current period presentation.
NOTE 2:
INCOME TAXES
Effective July 1, 1990, the Company elected to be treated as an S corporation for federal and state income
tax reporting purposes. As an S corporation, all taxable income and available tax credits were passed from the
corporate entity to the individual shareholders. The S corporation election was automatically revoked upon the
issuance of preferred stock (second class of stock) on August 31, 1993 and the Company was thereafter taxed as a C
corporation.
The pro forma unaudited income tax adjustments presented in the accompanying consolidated statement of
operations represent the estimated difference between the historical income tax expense and income tax expense that
would have been reported had the Company been subject to federal and state income taxes based on tax laws in
effect during those periods.
In the third quarter of 1994, the Company benefited $278,747 for income tax purposes from its net
operating loss and accordingly, the deferred tax asset was increased by $278,747 with no valuation allowance
provided.
NOTE 3:
INVENTORIES
Inventories consist of the following:
Production-Ingredients
Production-Finished goods
Paper goods and packaging materials
Restaurant inventories
Item 2h
December 31, 1993
October 2, 1994
$ 127,616
111,333
136,328
10,513
$ 385,790
$ 195,623
$ 256,097
102,696
247,196
$ 801,612
MONTEREY PASTA (CASE #2)
Page 6 of 13
B30116
Chapter 2 – Deferred Income Taxes
MONTEREY PASTA COMPANY
10K for Year Ended January 1, 1995
CONSOLIDATED BALANCE SHEETS
ASSETS
December 31, 1993
Current assets:
Cash and cash equivalents……………………………..
$10,602,397
Held-to-maturity securities…………………………….
--Accounts receivable……………………………………
487,458
Inventories……………………………………………..
385,790
Prepaid expenses and other…………………………….
109,462
Receivables from related parties……………………….
16,377
Total current assets………………………………..
11,601,484
January 1, 1995
$3,117,566
1,711,133
1,109,927
1,146,101
646,556
59,650
7,790,933
Property and equipment, net……………………………...
Intangible assets, net……………………………………...
Deposits and other………………………………………..
Total assets
2,600,054
182,773
61,293
$14,445,604
13,526,959
1,040,230
644,300
$23,002,422
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable……………………………………...
Accrued liabilities……………………………………..
Current portion of long-term debt……………………..
Current portion of capital lease obligations…………...
Amounts due to related parties………………………..
Income taxes payable………………………………….
Total current liabilities
$478,972
339,395
90,245
63.883
37,930
37,400
1,047,825
$1,364,868
1,113,624
45,870
------2,524,362
Capital lease obligations………………………………….
Long-term debt……………………………………………
202,369
113,347
--81,044
Commitments and contingencies…………………………
---
---
---
---
13,042,807
39,256
13,082,063
$14,445,604
23,390,174
(2,993,158)
20,397,016
$23,002,422
Stockholders' equity:
Series A Convertible Preferred Stock, no par value,
5,000,000 shares authorized, 1,200,000 and 0 shares
issued and outstanding at December 31, 1993 and
January 1, 1995 respectively………………………..
Common stock, no par value, 10,000,000 shares
authorized , 3,657,500 and 6,057,500 issued and
outstanding at December 31, 1993 and January 1,
1995, respectively…………………………………..
Retained earnings (deficit)…………………………….
Total stockholders' equity…………………………..
Total liabilities and stockholders' equity…………
The accompanying notes are an integral part of these consolidated financial statements.
Item 2h
MONTEREY PASTA (CASE #2)
Page 7 of 13
B30116
Chapter 2 – Deferred Income Taxes
MONTEREY PASTA COMPANY
10K for Year Ended January 1, 1995
CONSOLIDATED STATEMENTS OF OPERATIONS
Net revenues:
Grocery and club stores…………………………
Restaurants………………………………………
Total net revenues…………………………...
Costs and expenses:
Cost of sales…………………………………….
Restaurant and operating expenses……………..
Selling, general and administrative……………..
Depreciation and amortization………………….
Income (loss) from operations……………………...
Interest (income) expense, net……………………
Other income, net…………………………………...
Income (loss) before provision for income taxes…..
Provision for income taxes…………………………
Net income (loss)…………………………………...
Pro forma income tax provision (unaudited)
Net income after pro forma
income tax provision (unaudited)……………
Net loss per share…………………………………...
Proforma net income per share (unaudited)………...
Weighed average common and common equivalent
shares outstanding…………………………………..
December 31,
1992
Years Ended
December 31,
1993
January 1,
1995
3,353,329
--3,353,329
$4,737,711
380,264
5,117,975
$9,281,740
6,068,879
15,350,619
2,035,149
--1,009,303
74,171
3,118,623
234,706
69,287
(11,955)
177,374
--177,374
62,080
$115,294
3,186,253
232,282
1,161,283
178,298
4,758,116
359,859
94,667
(21,991)
287,183
37,400
249,783
77,474
$172,309
9,126,475
4,044,576
4,371,993
1,124,581
18,667,626
(3,317,007)
(284,593)
--(3,032,414)
--$(3,032,414)
$
$
.05
$ . ,07
2,336,973
2,636,111
(.57)
5,303,811
The accompanying notes are an integral part of these consolidated financial statements.
Item 2h
MONTEREY PASTA (CASE #2)
Page 8 of 13
B30116
Chapter 2 – Deferred Income Taxes
MONTEREY PASTA COMPANY
10K for Year Ended January 1, 1995
CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash flows from operating activities:
Net income (loss)
Adjustments to reconcile net income to net cash
from operating activities:
Depreciation and amortization……………………………...
Unrealized interest income from held-to-maturity securities.
Loss on sale of property and equipment……………………
Change in assets and liabilities:
Increase in accounts receivable…………………………..
Increase in inventories……………………………………
(Increase) decrease in prepaid expenses,
intangible assets and other……………………………..
Increase (decrease) in income taxes payable……………..
Increase in accounts payable……………………………..
Increase in accrued expenses……………………………...
Net cash provided by (used in) operating activities……
Cash flows from investing activities:
Purchase of held-to-maturity securities……………………..
Redemption of held-to-maturity securities………………….
Purchase of property and equipment………………………..
Issuance of notes receivable………………………………...
Proceeds from sale of property and equipment……………..
Net cash used in investing activities…………………
Cash flow from financing activities:
Proceeds from long-term debt……………………………...
Repurchase of common stock……………………………
Repayment of long-term debt and capital lease obligations.
Proceeds from issuance of common stock and stock
subscription received……………………………………..
Net cash provided by (used in) financing activities….
Net increase (decrease) in cash………………………………
Cash and cash equivalents at beginning of period…………
Cash and cash equivalents at end of period………………….
December 31,
1992
Years Ended
December 31,
1993
January 1,
1995
$ 177,374
$ 249,783
$(3,032,414)
74,171
-----
$ 178,298
--2,629
1,124,582
(141,986)
---
(30,436)
(139,761)
(130,071)
(233,279)
(622,469)
(760,311)
16,026
--131,012
6,433
234,819
(160,678)
37,400
190,152
275,824
410,058
(1,230,828)
(37,400)
885,896
736,299
(3,078,631)
----(190,295)
----(190,295)
----(1,410,143)
--14,387
(1,395,756)
(5,069,147)
3,500,000
(11,082,490)
(500,000)
--(13,151,637)
114,861
--(158,086)
733,071
--(1,413,462)
--(1,259,000)
(342,930)
--(43,225)
1,299
2,082
$ 3,381
12,265,105
11,584,714
10,599,016
3,381
$ 10,602,397
10,347,367
8,745,437
(7,484,831)
10,602,397
$ 3,117,566
For supplemental disclosure of non cash financing activities see Note 12.
The accompanying notes are an integral part of these consolidated financial statements.
Item 2h
MONTEREY PASTA (CASE #2)
Page 9 of 13
B30116
Chapter 2 – Deferred Income Taxes
MONTEREY PASTA COMPANY
10K for Year Ended January 1, 1995
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1.
Basis of Presentation and Summary of Significant Accounting Policies
Basis of Presentation:
Monterey Pasta Company incorporated in the State of California on June 16, 1989 and is principally
engaged in the business of the production and distribution of specialty food products.
Effective August 31, 1993, the Company acquired all of the outstanding stock of Upscale Food Outlets,
Inc., a California corporation, which was incorporated on April 7, 1993 by stockholders of Monterey Pasta
Company. Upscale Food Outlets, Inc.'s principal business is the operation of restaurant facilities. The acquisition
was accounted for as a pooling of interests as the two entities were under common control since the inception of
Upscale Food Outlets, Inc.
On May 16, 1994, the Company formed a wholly owned subsidiary, Monterey Pasta Development
Company, for the purpose of franchising quick service pasta restaurants.
Collectively, Monterey Past Company, Upscale Food Outlets, Inc. and Monterey Pasta Development
Company are referred to as the "Company."
On August 31, 1993, the Company declared a 175.38 to 1 split of its common stock and a .9231 to 1
preferred stock dividend (accounted for as a stock split) to all common stockholders. The accompanying
consolidated financial statements have been retroactively restated to reflect the stock splits and preferred stock
dividend for all periods presented.
Principles of Consolidation:
The consolidated financial statements include the accounts of Monterey Pasta Company, together with its
wholly owned subsidiaries, Upscale Food Outlets, Inc. and Monterey Pasta Development Company. All significant
intercompany accounts and transactions have been eliminated in consolidation.
Cash and Cash Equivalents:
The Company considers all highly liquid investments purchased with an original maturity of three months
or less to be cash equivalents.
The Company maintains cash balances at various financial institutions. The Company's cash balances at
the financial institutions exceed the limits of $100,000 per account which is the account limit for full insurance by
the Federal Deposit Insurance Corporation.
Held to Maturity Securities:
During 1994, $2,727,532 of held-to-maturity securities were sold prior to maturity for working capital and
capital expenditure purposes. The sale of held-to-maturity securities resulted in an immaterial capital loss for the
year ended January 1, 1995.
Accounts Receivable:
Accounts receivable at December 31, 1993 and January 1, 1995 are net of allowances for doubtful accounts
Item 2h
MONTEREY PASTA (CASE #2)
Page 10 of 13
B30116
Chapter 2 – Deferred Income Taxes
of $5,472 and $10,038, respectively. At January 1, 1995, the accounts receivable balance is also net of a reserve for
returns of $49,621.
Inventories:
Inventories are stated at the lower of cost (using the first-in, first-out method) or market and consist
principally of component ingredients to the Company's fresh pasta and sauces, finished goods, paper goods and
packaging materials and restaurant inventories.
Advertising Costs:
The Company defers certain amortizable costs related to specific promotions. These costs are expensed
upon commencement of the related campaign.
Property and Equipment:
Property and equipment are recorded at cost. Depreciation is provided for on the straight-line method over
the estimated useful lives of the assets. Maintenance and repairs are charged to expense as incurred. Included in
property and equipment are pre-opening costs associated with the opening of Company restaurants. Pre-opening
costs consist of direct costs related to hiring and training of the initial workforce and other direct costs associated
with restaurant openings. The Company amortizes pre-opening costs over the twelve month period following
restaurant opening.
Intangible Assets:
Intangible assets consist of tradenames, covenants not to compete and goodwill recorded at cost, net of
accumulated amortization of $19,720 in 1993 and $117,879 in 1994. The costs are being amortized ratably over
periods of three or ten years.
Income Taxes:
Effective July 1, 1990, the Company elected to be treated as an S Corporation for federal and state tax
reporting purposes. As such, all taxable income and available tax credits are passed from the corporate entity to the
individual stockholders. It is the responsibility of the individual stockholders to report the taxable income and tax
credits, and pay the resulting taxes. The S Corporation election was revoked upon the issuance of preferred stock
on August 31, 1993 and the Company will be taxed as a C Corporation thereafter.
In conjunction with the termination of its S Corporation status, the Company adopted Statement of
Financial Accounting Standard No. 109, "Accounting for Income Taxes." The impact of this adoption was not
material to the Company. Under this method, deferred income taxes are provided based on the estimated future tax
effects of differences between financial statement carrying amounts and the tax bases of existing assets and
liabilities.
Cost of Sales:
Cost of sales includes food costs related to the retail and restaurant operations, packaging materials,
production labor, factory overhead and distribution costs.
Item 2h
MONTEREY PASTA (CASE #2)
Page 11 of 13
B30116
Chapter 2 – Deferred Income Taxes
Conversion into Common Stock:
Effective on July 7, 1994, 1,200,000 shares, no par, non-voting preferred shares were automatically
converted one for one to common stock as a result of the beneficial ownership of two principal stockholders being
reduced to less than 20% of the common stock outstanding.
Retained Earnings:
Prior to September 1, 1993, the Company operated as an S Corporation for federal and state tax reporting
purposes. Effective August 31, 1993, the Company terminated its S Corporation status and the undistributed
earnings of the Company, in the amount of $609,227, have been reclassified as contributed capital.
Common Stock Offerings:
Effective December 7, 1993, the Company completed an Initial Public Offering of 2,357,500 shares of
common stock at $6 per share.
Effective July 7, 1994, the Company issued 750,000 shares of its common stock to the public at a price of
$10.00 per share.
On December 6, 1994, the Company completed the sale of 450,000 shares of its common stock to investors
outside of the United States at a price of $9.20 per share.
11.
Income Taxes
The following is a summary of the components of income taxes from operations:
Federal - current
deferred
1992
$ 0
0
1993
$ 27,878
0
1994
$ 0
0
0
9,522
0
0
$ 37,400
$ 0
State
Total income taxes
$
A reconciliation between the Company's effective tax rate (shown as proforma for 1992 and 1993)
and U.S. federal income tax rate on earnings (loss) from continuing operations is as follows:
1992
34.0%
1993
34.0%
1994
(34.0%)
6.0%
6.0%
(6.0%)
(5.0%)
0.0%
0.0%
Losses for which no tax
benefit was recorded
in the current period
0.0%
0.0%
40.0%
Effective income tax rate
for the year
35.0%
40.0%
0.0%
Federal statutory rate
State income taxes
Losses not previously
benefitted
Item 2h
MONTEREY PASTA (CASE #2)
Page 12 of 13
B30116
Chapter 2 – Deferred Income Taxes
The pro forma unaudited income tax adjustments presented in the accompanying consolidated statements
of operations represent the estimated difference between the historical income tax expense and income tax expense
that would have been reported had the Company been a C corporation subject to federal and state income taxes
based on tax laws in effect during those periods.
Deferred income taxes reflect the next tax effects of temporary differences between the carrying amounts of
assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant
components of the Company's deferred tax liabilities and assets are as follows as of December 31, 1993 and January
1, 1995.
1993
1994
Deferred income tax liabilities
0
$
Deferred income tax assets:
Net operating loss carryforwards
Depreciation expense
Amortization expense
0
0
0
$1,357,366
185,308
(16,528)
Total deferred tax asset
0
1,526,146
Net deferred tax asset
Less: Valuation allowance
0
0
1,526,146
(1,526,146)
Net deferred tax asset
$
$
0
0
$
0
As of January 1, 1995, the Company had a tax net operating loss carryforward (NOL) of approximately
$3.4 million which expires in 2009. Should significant changes in the Company's ownership occur, the annual
amount of NOL carryforwards available for future use would be limited. Statement of Financial Accounting
Standard ("SFAS") No. 109 requires that the tax benefit of such NOL be recorded as an asset. However, SFAS No.
109 also requires that a valuation allowance be provided to the extent that management assesses that it is more likely
than not that some portion or all of the deferred tax assets will not be realized.
12.
Statement of Cash Flows
Non-Cash Investing and Financing Activities:
During the three years ended January 1, 1995, the Company engaged in investing and financing
activities that affected its assets and liabilities, but did not result in cash receipts or payments. These non-cash
activities are as follows:
During the year ended January 1, 1995, the Company acquired certain assets of Lucca's Pasta Bar, Inc. in
exchange for common stock of the Company and a promissory note. See Note 7 for further discussion. In addition,
common stock was issued for the acquisition of a subsidiary, Monterey Pasta Development Company.
During the year ended December 31, 1993, vehicles, machinery and equipment in the amount of $374,356,
were financed through notes payable and capital leases. In addition, stock subscriptions receivable in the amount of
$37,047, were paid through the reduction of a loan payable to a stockholder; the Company issued 1,200,000 shares
of Series A convertible preferred stock through a stock dividend (split); and common stock was issued for the
acquisition of a subsidiary, Upscale Food Outlets, Inc.
During the year ended December 31, 1992, vehicles, machinery and equipment in the amount of $244,825,
were financed through notes payable and capital leases, less trade-in amounts of $43,900.
Item 2h
MONTEREY PASTA (CASE #2)
Page 13 of 13
B30116
Chapter 2 – Deferred Income Taxes
Self-Study Problem #1
Refer to Anheuser-Busch Companies Inc.
1.
What entry was recorded by Anheuser-Busch to record the deferred tax
effects of the retroactively enacted increase in the federal statutory income
tax rate?
2.
What entry was recorded by Anheuser-Busch on 12/31/93 to record the
income tax provision for 1993?
3.
Why do fixed assets create a deferred tax liability? Why do accrued
postretirement benefits create a deferred tax asset?
4.
Assume the U.S. statutory tax rate (35%) was used to calculate deferred tax
liability related to fixed assets. How much additional depreciation was
reported on Anheuser-Busch's 1993 tax return (above that reported in the
financial statements)? Assume that there were no acquisitions of
companies accounted for by the purchase method (an advanced topic).
5.
If the accelerated depreciation methods used for tax purposes were also
used for financial accounting purposes for all years, what would be the
12/31/93 balance in accumulated depreciation? Assume that there were no
acquisitions of companies accounted for by the purchase method (an
advanced topic).
Item 2i
Self Study Problem 1 – Anheuser Busch
Page 1 of 5
B30116
Chapter 2 – Deferred Income Taxes
CONSOLIDATED BALANCE SHEET
ASSETS (In millions)
DECEMBER 31,
1993
1992
CURRENT ASSETS:
Cash and marketable securities
Accounts and notes receivable, less allowance
for doubtful accounts of $6.7 in 1993 and $4.9
in 1992
Inventories
Raw materials and supplies
Work in process
Finished goods
Total inventories
Other current assets
Total current assets
INVESTMENTS AND OTHER ASSETS:
Investments in and advances to affiliated
companies
Investment properties
Deferred charges and other non-current assets
Excess of cost over net assets of acquired
businesses, net
$
127.4
$
215.0
751.1
649.8
385.5
99.4
141.8
626.7
290.0
417.7
88.7
154.3
660.7
290.3
1,795.2
1,815.8
629.5
151.9
310.7
171.6
164.8
356.3
495.9
505.7
1,588.0
1,198.4
PLANT AND EQUIPMENT:
Land
Buildings
Machinery and equipment
Construction in progress
281.9
3,445.5
7,656.5
343.2
273.3
3,295.2
7,086.9
729.7
Accumulated depreciation
11,727.1
(4,230.0)
11,385.1
(3,861.4)
7,497.1
7,523.7
$10,880.3
$10,537.9
The accompanying statements should be read in conjunction with the Notes
to Consolidated Financial Statements.
Item 2i
Self Study Problem 1 – Anheuser Busch
Page 2 of 5
B30116
Chapter 2 – Deferred Income Taxes
CONSOLIDATED BALANCE SHEET (CONT'D)
LIABILITIES AND SHAREHOLDERS EQUITY (In millions)
DECEMBER 31,
1993
CURRENT LIABILITIES:
Accounts payable
$ 812.5
Accrued salaries, wages and benefits
243.9
Accrued interest payable
54.9
Due to customers for returnable containers
50.3
Accrued taxes, other than income taxes
121.7
Estimated income taxes
91.0
Restructuring accrual
189.2
Other current liabilities
252.1
Total current liabilities
1992
$
737.4
257.3
52.4
48.2
117.0
38.8
208.7
1,815.6
1,459.8
607.1
538.3
LONG-TERM DEBT
3,031.7
2,642.5
DEFERRED INCOME TAXES
1,170.4
1,276.9
COMMON STOCK AND OTHER SHAREHOLDERS EQUITY:
Common stock, $1.00 par value, authorized
800,000,000 shares
Capital in excess of par value
Retained earnings
Foreign currency translation adjustment
342.5
808.7
6,023.4
(33.0)
341.3
762.9
5,794.9
(1.4)
7,141.6
6,897.7
(2,479.6)
(1,842.9)
(406.5)
(434.4)
POSTRETIREMENT BENEFITS
Treasury stock, at cost
ESOP debt guarantee offset
COMMITMENTS AND CONTINGENCIES
Item 2i
4,255.5
4,620.4
-
-
$10,880.3
$10,537.9
Self Study Problem 1 – Anheuser Busch
Page 3 of 5
B30116
Chapter 2 – Deferred Income Taxes
CONSOLIDATED STATEMENT OF INCOME
(In millions, except per share data)
YEAR ENDED DECEMBER 31,
1993
1992
Sales
$13,185.1
$13,062.3
Less federal and state excise taxes
1,679.8
1,668.6
Net sales
Cost of products and services
1991
$12,634.2
1,637.9
11,505.3
7,419.7
11,393.7
7,309.1
10,996.3
7,148.7
Gross profit
4,085.6
4,084.6
3,847.6
Marketing, distribution and
administrative expenses
Restructuring charge
2,308.7
565.0
2,308.9
-
2,126.1
-
Operating income
1,211.9
1,775.7
1,721.5
Other income and expenses:
Interest expense
Interest capitalized
Interest income
Other income/(expense), net
(207.8)
36.7
5.2
4.4
Income before income taxes
1,050.4
Provision for income taxes:
Current
Deferred
Revaluation of deferred tax
liability (FAS 109)
PRIMARY EARNINGS PER SHARE:
Net income, before cumulative effect
Cumulative effect of accounting
changes
Net income
Item 2i
1,520.6
561.9
59.1
479.1
101.7
33.0
-
-
455.9
621.0
580.8
594.5
994.2
939.8
$
594.5
$
2.17
(76.7)
$
917.5
$
$
(238.5)
46.5
9.2
(18.1)
1,615.2
562.4
(139.5)
Net income, before cumulative effect
of accounting changes
Cumulative effect of changes in the
method of accounting for
postretirement benefits (FAS 106)
and income taxes (FAS 109), net of
tax benefit of $186.4 million
NET INCOME
(199.6)
47.7
7.1
(15.7)
2.17
3.48
$
939.8
$
(.26)
$
3.22
Self Study Problem 1 – Anheuser Busch
3.26
-
$
3.26
Page 4 of 5
B30116
Chapter 2 – Deferred Income Taxes
11-INCOME TAXES: The provision for income taxes consists of the following for
the three years ended December 31 (in millions):
1993
1992
1991
Current Tax Provision:
Federal
$459.5
$460.6 $386.7
State and foreign
102.9
101.3
92.4
Deferred Tax Provision:
Federal
State and foreign
562.4
561.9
479.1
(126.2)
(13.3)
50.3
8.8
93.3
8.4
(139.5)
59.1
101.7
$621.0
$580.8
$422.9
The deferred tax provision results from differences in the recognition
of income and expense for tax and financial reporting purposes. The
primary differences are related to fixed assets (tax effect of $51.5
million in 1993, $67.6 million in 1992 and $75.9 million in 1991) and
the restructuring charge benefit ($184 million) in 1993.
Under the liability method, at December 31, 1993 the company had
deferred tax liabilities of $1,759 million and deferred tax assets of
$588 million. The principal temporary differences included in deferred
tax liabilities are related to fixed assets ($1,548 million). The
principal temporary differences included in deferred tax assets are
related to accrued postretirement benefits ($232.2 million) and other
accruals and temporary differences ($355.9 million) which are not
deductible for tax purposes until paid or utilized.
On August 10, 1993, the Revenue Reconciliation Act of 1993 was signed
into law. As a result, the federal statutory income tax rate was
retroactively increased, effective January 1, 1993, by 1% to 35%. This
resulted in a $33 million non-recurring, after-tax, non-cash charge
related to revaluation of the deferred tax liability in accordance with
FAS 109.
The company's effective tax rate was 43.4% in 1993, 38.4% in 1992 and
38.2% in 1991. A reconciliation between the statutory rate and the
effective rate is presented below:
1993
1992
1991
Statutory rate
State income taxes, net of federal benefit
Revaluation of deferred tax liability
Other
35.0%
4.7
3.1
.6
34.0%
3.9
.5
34.0%
3.8
.4
Effective tax rate
43.4%
38.4%
38.2%
Item 2i
Self Study Problem 1 – Anheuser Busch
Page 5 of 5
B30116
Chapter 2 – Deferred Income Taxes
Self-Study Problem #1 Solution:
1.
2.
Anheuser-Busch -- Taxes
Income tax expense
Deferred income taxes
33
Income tax expense
Deferred income taxes
Income taxes payable
422.9
139.5
33
562.4
3.
A deferred tax liability is the result of the following type of journal
entry:
Income tax expense
Deferred income taxes
Income taxes payable
X
X-Y
Y
A deferred tax asset is the result of the following type of journal
entry:
Income tax expense
Deferred income taxes
Income taxes payable
X
Y-X
Y
4.
$51.5 / 0.35 = $147.1 million.
5.
Accumulated depreciation was $4,230 million at December 31, 1993. If
tax depreciation methods had been used, this balance would be higher by
$4,422.9, or:
$4,230 + 4,422.9 = $8,652.9 million (205% of the original amount).
Item 2j
Self Study Problem 1 – Solution
Page 1 of 1
B30116
Chapter 2 – Deferred Income Taxes
Self-Study Problem #2
Accounting for Income Taxes
An Illustrative Example
Part I
Simple firm buys equipment for cash that it uses to produce a product that it sells for
cash. It carries no inventory, payables, or receivables and operates in a tax jurisdiction in which
the tax rate is 40%. It started with $1000 cash that was raised through the sale of no par common
stock. It sells its product for $100 a piece. The materials used in the product cost $60 each.
During its first year of operations, it had the following sales revenues, materials expenditures,
and equipment purchases.
Year
1
Revenues
500
Materials Expenditures
300
Equipment Purchases
500
Simple firm uses cash basis accounting for tax purposes. For GAAP purposes, simple firm uses
accrual accounting. More specifically, the equipment purchased in the first year is to be
depreciated using the straight line method over a two year period with a full year’s depreciation
taken in the first year.
1. Prepare the firm’s tax return for year 1.
2. Prepare the firm’s GAAP income statement and tax note disclosure for year 1. Assume that
the firm is highly uncertain as to whether it will be able to use any tax benefits created in
year 1.
3. Prepare the firm’s GAAP income statement and tax note disclosure for year 1. Assume that
the firm is highly certain that it will be able to use any tax benefits created in year 1.
Part II
During its second year of operations, it had the following sales revenues, materials
expenditures, and equipment purchases.
Year
2
Revenues
1000
Materials Expenditures
600
Equipment Purchases
0
1. Prepare the firm’s tax return for year 2.
2. Assume the firm did its accounting in year 1 as in Part I question 2. Prepare the firm’s GAAP
income statement and tax note disclosure for year 2.
3. Assume the firm did its accounting in year 1 as in Part I question 3. Prepare the firm’s GAAP
income statement and tax note disclosure for year 2.
Item 2k
Self Study Problem 2 – Illustrative E.g.
Page 1 of 1
B30116
Chapter 2 – Deferred Income Taxes
Self-Study Problem #2 Solution:
Illustrative Example -- Taxes
Part I question 1
Tax Return
Revenues
Materials Expenditures
Equipment Expenditures
Taxable Income
Taxes Due
500
300
500
(300)
0
(40% of taxable income if taxable income is positive)
NOL carryforward is 300 (100% of taxable income if taxable income is negative.)
Item 2l
Self Study Problem 2 – Solution
Page
1 of 6
B30116
Part I question 2
Chapter 2 – Deferred Income Taxes
Income Statement
Revenues
Materials Expenditures
Depreciation
Earnings Before Tax
Tax Expense
Net Earnings
500
300
250
(50)
0
(50)
Note Disclosure
Provision for taxes on income:
Current
Deferred
Provision for Tax
0
0
0
Components of deferred taxes
Year 1
Assets
NOL
120
Liabilities
Depreciation
100
Valuation Allowance
20
Net Deferred Tax Asset (Liability)
0
Reconciliation of provision for income tax to the statutory rate of 40% is as follows:
Statutory rate
Unrecognized NOL benefit
Effective tax rate
Year 1
40%
(40%)
0%
The firm currently has 300 in unused NOL carryforwards. These carryforwards expire in Year
21.
Item 2l
Self Study Problem 2 – Solution
Page
2 of 6
B30116
Part I question 3
Chapter 2 – Deferred Income Taxes
Income Statement
Revenues
Materials Expenditures
Depreciation
Earnings Before Tax
Tax Expense
Net Earnings
500
300
250
(50)
(20)
(30)
Note Disclosure
Provision for taxes on income:
Current
Deferred
Provision for Tax
0
(20)
(20)
Components of deferred taxes
Year 1
Assets
NOL
120
Liabilities
Depreciation
100
Valuation Allowance
Net Deferred Tax Asset
0
20
Reconciliation of provision for income tax to the statutory rate of 40% is as follows:
Statutory rate
Effective tax rate
Year 1
40%
40%
The firm currently has 300 in unused NOL carryforwards. These carryforwards expire in Year
21.
Item 2l
Self Study Problem 2 – Solution
Page
3 of 6
B30116
Part II question 1
Chapter 2 – Deferred Income Taxes
Tax Return
Revenues
1000
Materials Expenditures
600
Equipment Expenditures
0
Taxable Income before carryforwards 400
NOL carryforward
(300)
Taxable Income
100
Taxes Due
40 (40% of taxable income if taxable income is positive)
NOL carryforward is 0. (100% of taxable income if taxable income is negative.)
Item 2l
Self Study Problem 2 – Solution
Page
4 of 6
B30116
Part II question 2
Chapter 2 – Deferred Income Taxes
Income Statement
Revenues
Materials Expenditures
Depreciation
Earnings Before Tax
Tax Expense
Net Earnings
1000
600
250
150
40
110
Note Disclosure
Provision for taxes on income:
Current
Deferred
Provision for Tax
Year 2
40
0
40
Year 1
0
0
0
Components of deferred taxes
Year 2
Year 1
Assets
NOL
0
120
Liabilities
Depreciation
0
100
Valuation Allowance
0
20
Net Deferred Tax Asset (Liability)
0
0
Reconciliation of provision for income tax to the statutory rate of 40% is as follows:
Statutory rate
Unrecognized NOL benefit
Recognition of prior period NOL benefit
Effective tax rate
Year 2
40%
0%
(13%)
27%
Year 1
40%
(40%)
0%
0%
The firm currently has 0 in unused NOL carryforwards.
Item 2l
Self Study Problem 2 – Solution
Page
5 of 6
B30116
Part II question 3
Chapter 2 – Deferred Income Taxes
Income Statement
Revenues
Materials Expenditures
Depreciation
Earnings Before Tax
Tax Expense
Net Earnings
1000
600
250
150
60
90
Note Disclosure
Provision for taxes on income:
Provision for taxes on income:
Current
Deferred
Provision for Tax
Year 2
40
20
60
Year 1
0
(20)
(20)
Components of deferred taxes
Year 2
Year 1
Assets
NOL
0
120
Liabilities
Depreciation
0
100
Valuation Allowance
0
0
Net Deferred Tax Asset (Liability) 0
20
Reconciliation of provision for income tax to the statutory rate of 40% is as follows:
Statutory rate
Effective tax rate
Year 2
40%
40%
Year 1
40%
40%
The firm currently has 0 in unused NOL carryforwards.
Item 2l
Self Study Problem 2 – Solution
Page
6 of 6
B30116 – Berger
3.
Chapter 3 – Revenue & Securitization
Revenue Recognition & Securitization
Determining when a firm should recognize revenue is a difficult conceptual and practical issue.
The purpose of our analysis of revenue recognition is to assist you by:
> making you aware of the conceptual shortcomings of GAAP’s revenue recognition principles
> helping you develop some skill at assessing the financial statement implications of a
particular revenue recognition policy
The fundamental issue of is timing: when should a firm recognize the increase in its net assets
arising from the process of making or buying assets and then selling those assets.
The set of options which most individuals would not find unappealing can be summarized as
follows: completion of production, time of sale, ir time cash is collected (i.e., any of the last 3
steps in the figure below of the Operating Cycle). You are well aware that GAAP generally
mandates recognizing revenue at the time of sale. This does not imply that GAAP is
conceptually better than the other two. In fact, none of the three options depicts reality exactly
since the process which creates revenue (i.e., the Operating Cycle) contains many steps and the
completion of no step constitutes a critical event after which revenue is earned and before which
revenue has not been earned.
Item 3a
Revenue Recognition Notes
Page 1 of 8
B30116 – Berger
Chapter 3 – Revenue & Securitization
2004
2005
2007
2008
Years
 Fir
ms
can
elec 1
Option
t
one
of
Carry forward
two
Loss
only
opti
ons:
Option 2
2006
Loss
Carry back

Item 3a
Revenue Recognition Notes
Page
B
o
t
h
c
a
r
r
y
b
2 of
a
c
k
8
B30116 – Berger
I.
Chapter 3 – Revenue & Securitization
When to Recognize Revenue -- General Guidelines
A. Revenue is recognized when it is:
1. Measurable – value to be received for the good or service is reasonably assured and
can be measured with a high degree of reliability (i.e., it is either cash or is a claim to
cash or other assets with future collection that is highly likely and with a current cash
equivalent value that can be estimated well); and
2. Earned -- selling firm has accomplished what it must do to be entitled to the value to
be received
B. Application of general guidelines
1. recognize revenue from sale of goods at date of sale (usually date of delivery)
2. recognize revenue from services provided when services have been performed and
are billable
3. recognize revenue from asset use (i.e., rentals, loans) as time passes or the assets are
used
4. recognize revenue from the disposal of assets (i.e., sales of fixed assets) at the date of
sale or trade-in
II. Exceptions to General Guidelines
Item 3a
Revenue Recognition Notes
Page 3 of 8
B30116 – Berger
Chapter 3 – Revenue & Securitization
Net operating losses:
Carrybacks and carryforwards example
Item 3a
Revenue Recognition Notes
Page 4 of 8
B30116 – Berger
 Or:
Chapter 3 – Revenue & Securitization
 Unfortunato Corporation experienced a $1 million p
operating loss in 2006. Under U.S. Income Tax Code
company can either:
Net operating losses:
Carryback and
carryforward entries
Item 3a
Revenue Recognition Notes
 Suppose Unfortunato h
following operating pro
 The following entry wou
reflect the carryback:
Page 5 of 8
B30116 – Berger
Chapter 3 – Revenue & Securitization
DR Deferred income tax asset
$87,500
CR Income tax expense (carryforward benefit)
$87,500
DR Income tax refund receivable
$262,500
CR Income tax expense (carryback benefit)
$262,500
Item 3a
Revenue Recognition Notes
Page 6 of 8
B30116 – Berger
Chapter 3 – Revenue & Securitization
 If future pre-tax operating profits are expected to excee
$250,000, then the carryforward entry would be :
Revenue recognition & operating cycle
Item 3a
Revenue Recognition Notes
Page 7 of 8
B30116 – Berger
Chapter 3 – Revenue & Securitization
Operating Cycle
Item 3a
Revenue Recognition Notes
Page 8 of 8
B30116 – Berger
Chapter 3 – Revenue & Securitization
Self-Study Problem #3
USAir: Revenue Recognition, Expense Recognition
USAir Group's primary business activity is conducted through its subsidiary USAir, Inc. ("USAir").
USAir is an air carrier engaged primarily in the business of transporting passengers, property and mail.
USAir enplaned more than 57 million passengers in 1995 and is the fifth largest United States air carrier
ranked by revenue passenger miles ("RPMs") flown.
Answer the following questions.
Revenue Recognition
1.
Explain why USAir does not account for the sales of passenger tickets at the time the customer
purchases the ticket.
2.
Assume that USAir accounted for the sales of passenger tickets at the time of the customer
purchased the tickets. Assume a 40% tax rate.
a. How would the 1995 ending balance sheet differ from the actual statement?
b. How would the 1995 income statement differ from the actual statement?
c. How would 1995 statement of cash flows differ from the actual statement?
Expense Recognition
Read the note and the discussion from the Management Discussion & Analysis (MD&A) regarding
USAir's Frequent Traveler Program (FTP) before addressing the following questions.
3. Provide a simple accounting rationale for USAir's policy for the FTP.
4.
Assume that the incremental cost per passenger for USAir is $40. What is the dollar amount on
USAir's balance sheet at the end of 1995 for its FTP liability. (Note: any amount is included in
the Accrued expenses line in the current liabilities section of the balance sheet.)
5.
Assume again that the incremental cost per passenger is $40. Assume that USAir accounts for
the FTP expenses as the costs are incurred. Assume a 40% tax rate.
a. How would the 1995 ending balance sheet differ from the actual statement?
b. How would the 1995 before tax income differ from the actual value?
Item 3b
Self Study Problem 3 – U.S. Air
Page
1 of 9
B30116 – Berger
Chapter 3 – Revenue & Securitization
6. A reasonable accountant might disagree with the following part of USAir's FTP accounting policy.
Mileage for FTP participants who have accumulated less than the minimum number
of mileage credits necessary to claim an award is excluded from the calculation of the
accrual.
Explain why the accountant might be concerned and provide a suggested change in policy that would
alleviate the accountant's concerns.
7. What impact would the January 1, 1995 and May 1, 1995 changes in the FTP awards program have
on 1995 net income and the 1995 ending accrued liability. A numerical answer is not expected.
8. Any accounting for the FTP program is likely to forego recording amounts representing one
opportunity cost to USAir for the program -- displaced paying passengers. USAir argues that little
revenue is lost due to the programs displacement of passengers. Provide one critique of the argument
presented by USAir.
Item 3b
Self Study Problem 3 – U.S. Air
Page
2 of 9
B30116 – Berger
Chapter 3 – Revenue & Securitization
USAir Group, Inc.
Consolidated Statements of Operations
Years Ended December 31,
(in thousands except per share amounts)
1995
1994
1993
$6,748,564
157,262
568,522
7,474,348
$6,357,547
163,598
476,049
6,997,194
$ 6,554,926
173,824
354,458
7,083,208
2,887,115
634,320
563,037
404,158
437,649
346,854
352,447
1,527,081
7,152,661
2,889,764
671,926
583,158
436,540
563,572
392,181
408,587
1,542,822
7,488,550
2,841,344
710,109
596,779
445,797
472,622
374,084
352,467
1,385,798
7,179,000
Operating income (loss)
321,687
(491,356)
(95,792)
Other Income (Expense)
Interest income
Interest expense
Interest capitalized
Other, net
51,624
(302,593)
8,781
48,773
27,088
(284,034)
13,760
49,619
12,632
(249,916)
17,763
(34,054)
Other income (expense), net
(193,415)
(193,567)
(253,575)
128,272
(684,923)
(349,367)
8,985
-
-
119,287
(684,923)
(349,367)
Operating Revenues
Passenger transportation
Cargo and freight
Other
Total operating revenues
Operating Expenses
Personnel costs
Aviation fuel
Commissions
Other rent and landing fees
Aircraft rent
Aircraft maintenance
Depreciation and amortization
Other, net
Total operating expenses
Income (loss) before taxes and cumulative
effect of accounting change
Income tax provision (credit)
Income (loss) before cumulative effect of
accounting change
Item 3b
Self Study Problem 3 – U.S. Air
Page
3 of 9
B30116 – Berger
Chapter 3 – Revenue & Securitization
USAir Group, Inc.
Consolidated Statements of Operations (continued)
Years Ended December 31,
(in thousands except per share amounts)
1995
1994
1993
-
-
(43,749)
Net income (loss)
119,287
(684,923)
(393,116)
Preferred dividend requirement
(84,904)
(78,036)
(73,651)
Net income (loss) applicable to common
stockholders
$ 34,383
$ (762,959)
$ (466,767)
Cumulative effect of change in method of accounting
for postemployment benefits in 1993
Income (loss) per common share before
accounting change
Effect of accounting change
Income (loss) per common share
Shares used for computation (000)
Item 3b
$
$
0.55
0.55
62,430
Self Study Problem 3 – U.S. Air
$
$
(12.73)
(12.73)
59,915
Page
$ (7.68)
(0.80)
$ (8.48)
55,070
4 of 9
B30116 – Berger
Chapter 3 – Revenue & Securitization
USAir Group, Inc.
Partial Consolidated Balance Sheets
December 31,
(dollars in thousands except per share amounts)
1995
ASSETS
Current Assets
Cash and cash equivalents
Short-term investments
Receivables, net
Materials and supplies, net
Prepaid expenses and other
$
881,854
19,831
322,122
248,144
111,131
$ 429,538
22,133
324,539
258,664
81,642
1,583,082
1,116,516
5,251,742
1,073,720
(2,301,059)
4,024,403
17,026
4,041,429
5,162,599
1,059,027
(2,085,499)
4,136,127
195,701
4,331,828
Total current assets
Property and Equipment
Flight equipment
Ground property and equipment
Less accumulated depreciation and amortization
Purchase deposits
Property and equipment, net
Other Assets
Goodwill, net
Other intangibles, net
Other assets, net
Total other assets
1994
510,562
312,786
507,149
526,615
319,711
513,372
1,330,497
1,359,698
$6,955,008
$6,808,042
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current Liabilities
Current maturities of long-term debt
Accounts payable
Traffic balances payable and unused tickets
Accrued expenses
$ 80,721
325,330
607,170
1,471,475
$ 85,538
275,847
568,215
1,330,453
Total current liabilities
2,484,696
2,260,053
Long-Term Debt, Net of Current Maturities
2,717,085
2,895,378
Deferred Credits and Other Liabilities
Deferred gains, net
Postretirement benefits other than pensions, non-current
Non-current employee benefit liabilities and other
386,947
1,015,623
427,726
413,961
958,956
417,878
1,830,296
1,790,795
Total deferred credits and other liabilities
…
Item 3b
Self Study Problem 3 – U.S. Air
Page
5 of 9
B30116 – Berger
Chapter 3 – Revenue & Securitization
USAir Group, Inc.
Consolidated Statements of Cash Flows
Years Ended December 31,
(in thousands)
1995
Cash and cash equivalents beginning of year
Cash flows from operating activities
Net income (loss)
Adjustments to reconcile net income (loss) to cash
provided by (used for) operating activities
Depreciation and amortization
Loss (gain) on disposition of property
Amortization of deferred gains and credits
Other
Changes in certain assets and liabilities
Decrease (increase) in receivables
Decrease (increase) in materials, supplies, prepaid
expenses and intangible pension assets
Increase (decrease) in traffic balances payable
and unused tickets
Increase (decrease) in accounts payable and
accrued expenses
Increase (decrease) in postretirement benefits
other than pensions, non-current
Net cash provided by (used for) operations
Cash flows from investing activities
Aircraft acquisitions and purchase deposits, net
Additions to other property
Proceeds from disposition of property
Change in short-term investments
Change in restricted cash and investments
Other
Net cash provided by (used for) investing activities
Item 3b
1994
1993
$ 429,538
$ 368,347
$ 296,038
119,287
(684,923)
(393,116)
352,447
(17,043)
(27,817)
6,294
408,587
(24,099)
(27,396)
(11,605)
352,467
10,328
(27,309)
24,635
2,417
41,101
(180,152)
(74,980)
74,663
24,234
38,955
(61,932)
35,517
120,422
235,105
84,787
56,667
51,613
65,967
576,649
1,114
(2,642)
(46,022)
(134,086)
75,075
(21,994)
2,578
1,110
(202,085)
(159,031)
178,387
(14,221)
(4,378)
(123,339)
(201,328)
(61,689)
(84,980)
222,325
2,430
71,980
(1,134)
148,932
Self Study Problem 3 – U.S. Air
Page
6 of 9
B30116 – Berger
Chapter 3 – Revenue & Securitization
USAir Group, Inc.
Consolidated Statements of Cash Flows (continued)
Years Ended December 31,
(in thousands)
1995
1994
1993
Cash flows from financing activities
Issuance of debt
Reduction of debt
Issuance of common stock
Issuance of preferred stock
Sale of treasury stock
Dividends paid
1,162
(283,160)
8,733
-
308,856
(87,073)
52
11,244
(49,663)
597,834
(889,872)
230,891
400,719
8,273
(71,566)
Net cash provided by (used for)
financing activities
(273,265)
183,416
276,279
452,316
61,191
72,309
$881,854
$ 429,538
$ 368,347
Net increase (decrease) in cash and
cash equivalents
Cash and cash equivalents end of year
Item 3b
Self Study Problem 3 – U.S. Air
Page
7 of 9
B30116 – Berger
Chapter 3 – Revenue & Securitization
USAir Group, Inc. Selected Notes to Consolidated Financial Statements
1. Summary of Significant Accounting Policies
...
(h) Passenger Revenue Recognition
Passenger ticket sales are recognized as revenue when the transportation service is rendered or
the ticket otherwise expires. At the time of sale, a liability is established (Traffic Balances
Payable and Unused Tickets) and subsequently eliminated either through carriage of the
passenger, through billing from another carrier which renders the service or by refund to the
passenger.
(i) Frequent Traveler Awards
USAir accrues the estimated incremental cost of providing outstanding travel awards earned by
participants in its Frequent Traveler Program ("FTP") when participants accumulate sufficient
miles to be entitled to claim award certificates for travel.
USAir Group, Inc. Selected Portion of MD&A
Frequent Traveler Program
Under USAir's Frequent Traveler Program ("FTP"), participants generally receive mileage
credits equal to the greater of actual miles flown or 500 miles, effective May 1, 1995 (750 miles
before May 1, 1995), for each paid flight segment on USAir or USAir Express, or actual miles
flown on one of USAir's FTP airline partners. Participants generally receive a minimum of 500
mileage credits, effective May 1, 1995, for each paid flight on USAir Shuttle (1,000 miles prior
to May 1, 1995). Participants flying on first or business class tickets generally receive additional
credits. Participants may also earn mileage credits by utilizing certain credit cards, staying at
participating hotels or by renting cars from participating car rental companies. Mileage credits
earned by FTP participants, which do not expire under current program guidelines, can be
redeemed for various travel awards, including fare discounts, first class upgrades and tickets on
USAir or other airlines participating in USAir's FTP. Certain awards also include hotel and car
rental awards. Awards may not be brokered, bartered or sold, and have no cash value.
USAir and its airline partners limit the number of seats allocated per flight for award recipients
through inventory management techniques. The number of seats available for frequent travelers
varies depending upon flight, day, season and destination. Award travel for all but USAir's most
frequent travelers generally is not permitted on blackout dates, which correspond to certain
holiday periods in the United States or peak travel dates to foreign destinations. USAir reserves
the right to terminate the FTP or portions of the program at any time, and the FTP's rules,
partners, special offers, blackout dates, awards and mileage levels are subject to change without
prior notice.
Item 3b
Self Study Problem 3 – U.S. Air
Page
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B30116 – Berger
Chapter 3 – Revenue & Securitization
USAir accounts for its FTP under the incremental cost method, whereby estimated future travel
awards are valued at the estimated average incremental cost of carrying one additional passenger.
Incremental costs include unit costs for passenger food, beverages and supplies, fuel,
reservations, communications, liability insurance and denied boarding compensation expenses.
No profit or overhead margin is included in the accrual for incremental costs. The Company
periodically reviews the assumptions made to calculate its FTP liability for reasonableness and
makes adjustments to these assumptions as necessary. No liability is recorded for airline, hotel or
car rental award certificates that are to be honored by other parties because there is no cost to
USAir for such awards.
Effective January 1, 1995, USAir increased the minimum mileage level required for a free
domestic flight from 20,000 to 25,000. FTP participants had accumulated mileage credits for
approximately 3,350,000 awards and 3,697,000 awards at December 31, 1995 and 1994,
respectively, at the 25,000 mile level required to earn an award. Because USAir expects that
some potential awards will never be redeemed, the calculations of the accrued liability for
incremental costs at December 31, 1995 and 1994 were based on approximately 87% and 86%,
respectively, of the accumulated credits. Mileage for FTP participants who have accumulated
less than the minimum number of mileage credits necessary to claim an award is excluded from
the calculation of the accrual. Incremental changes in FTP liability resulting from redeemed or
additional mileage credits are recorded as part of the regular review process.
USAir's customers redeemed approximately 1,160,000, 927,000 and 841,000 awards for free
travel on USAir in 1995, 1994 and 1993, respectively, representing approximately 9.0%, 7.0%
and 8.0% of USAir's revenue passenger miles ("RPMs") in those years, respectively. USAir
does not believe that usage of FTP awards results in any significant displacement of revenue
passengers. USAir's exposure to the displacement of revenue passengers is not significant, as the
number of USAir flights that depart 100% full is minimal. In the second quarter of 1995, the
quarter when the highest number of free frequent traveler trips were flown for the year, for
example, fewer than 6.5% of USAir's flights departed 100% full. During this same quarterly
period, approximately 5.2% of USAir's flights departed 100% full and also had one or more
passengers on board who were traveling on FTP award tickets. ....
Item 3b
Self Study Problem 3 – U.S. Air
Page
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B30116 – Berger
Chapter 3 – Revenue & Securitization
Self Study Problem #3 Solution – USAir: Revenue Recognition, Expense Recognition
1. Explain why USAir does not account for the sales of passenger tickets at the time the customer purchases the
ticket.
USAir has not provided the service.
2.
Assume that USAir accounted for the sales of passenger tickets at the time of the customer purchased the
tickets. Assume a 40% tax rate.
a.
How would the 1995 ending balance sheet differ from the actual statement?
traffic balances payable and unused tickets liability down 607170
deferred income tax liability (asset) up (down) 607170 x .40 = 242868
retained earnings up by 607170 x (1-.40) = 364302
b.
How would the 1995 income statement differ from the actual statement?
total operating revenues increases by the increase in the traffic balances payable and unused tickets liability
thus
total operating revenues rises by 607170 - 568215 = 38955
income before tax rises by 38955
income tax expense rises by 38955 x .4 = 15582
net income rises by 38955 x (1-.4) = 23373
Note that, if revenue is recognized earlier, there should be some expense accrued as well in order to satisfy
the matching concept. Thus, one might also adjust total operating expenses up by some proportion of the
additional revenues recognized.
c.
How would 1995 statement of cash flows differ from the actual statement?
The key point is that cash flows aren’t changed because of a change in revenue recognition, so operating,
investing, financing, and total cash flow remain the same. The first line item in the operating cash flow
section under the indirect method is, however, net income and it would be larger by the amount identified
in b (say 23373 for purposes of this part). Therefore, other items in the operating section must be smaller in
total by the same amount. Specifically, there would be no addback for the 38955 increase in traffic
balances payable and unused tickets. Finally, under “Changes in certain assets and liabilities” a line item
would be inserted that adds 15,582 to reflect the effect of the increase in income tax expense on creating a
deferred income tax liability. In sum, operating cash is unchanged, but net income rises by 23373, the
“Increase (decrease) in traffic balances payable and unused tickets” line falls by 38955, and a new line item
for the increase in deferred income tax liability rises by 15582.
3.
Provide a simple accounting rationale for USAir's policy for the FTP.
The benefit derived from the FTP is more revenue today and the cost is not fully incurred until awards are
exercised. Thus, to satisfy the matching concept, USAir accrues some expense.
4.
Assume that the incremental cost per passenger for USAir is $40. What is the dollar amount on USAir's
balance sheet at the end of 1995 for its FTP liability. (Note: any amount is included in the Accrued
expenses line in the current liabilities section of the balance sheet.)
The FTP liability on USAir's balance sheet, in thousands, is 40 x 3350 x 87% = 116580
Item 3c
Self Study Problem 3 – Solution
Page
1 of 2
B30116 – Berger
5.
Chapter 3 – Revenue & Securitization
Assume again that the incremental cost per passenger is $40. Assume that USAir accounts for the FTP
expenses as the costs are incurred. Assume a 40% tax rate.
a.
How would the 1995 ending balance sheet differ from the actual statement?
FTP liability drops by 116580, so accrued expenses falls by 116580 (the amount calculated in 4)
deferred income tax liability (asset) rises (falls) by 116580 x .40 = 46632
retained earnings rises by 116580 x (1-.4) = 69948
b.
How would the 1995 before tax income differ from the actual value?
change in income before tax = expense accrued less actual costs incurred
note:
expense accrued less actual costs incurred = end FTP liability - beg. FTP liability
thus, the change in income before tax = 116580-(40x3697x86%) = -10597
6.
A reasonable accountant might disagree with the following part of USAir's FTP accounting policy.
Mileage for FTP participants who have accumulated less than the minimum number of
mileage credits necessary to claim an award is excluded from the calculation of the accrual.
Explain why the accountant might be concerned and provide a suggested change in policy that would
alleviate the accountant's concerns.
Some of the FTP participants will ultimately accumulate an award. Therefore, an accountant might argue
that expenses be accrued for some proportion of FTP participants who have not yet earned an award.
7.
What impact would the January 1, 1995 and May 1, 1995 changes in the FTP awards program have on
1995 net income and the 1995 ending accrued liability. A numerical answer is not expected.
Because more miles must be accumulated for an award to be granted, and less minimum miles are awarded
per trip, the changes reduced the liability and increased income.
8.
Any accounting for the FTP program is likely to forego recording amounts representing one opportunity
cost to USAir for the program -- displaced paying passengers. USAir argues that little revenue is lost due
to the program’s displacement of passengers. Provide one critique of the argument presented by USAir.
USAir's argument does not consider the possibility that some passengers traveling on an award would have
been paying passengers. Thus, the opportunity cost for these displaced paying passengers is not
considered.
Item 3c
Self Study Problem 3 – Solution
Page
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B30116 – Berger
Chapter 3 – Revenue & Securitization
Installment Method
An Illustrative Example
PC is formed at the beginning of year 1 with $750 cash and common equity. During year 1, PC
acquires parcels of land for $750. On the last day of year 1, it sells the parcels of land for $1000. PC
finances the purchases with mortgage notes which are repaid in 2 payments of $576 beginning on the last
day of year 2. The effective interest rate on the notes is 10% (i.e., the present value of the 2 annual
payments of $576 assuming a 10% interest rate is $1000 on the last day of year 1). There are no taxes on
income.
Sales Basis Accounting
Year 1
Cash
Common Stock
750
Land Inventory
Cash
750
750
750
Notes Receivable
Sales Revenue
1000
Cost of Land Sold
Land Inventory
750
1000
750
Year 2
Cash
Interest Revenue
Notes Receivable
576
100
476
Year 3
Cash
Interest Revenue
Notes Receivable
Item 3d
576
52
524
Installment Method Notes
Page
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B30116 – Berger
Chapter 3 – Revenue & Securitization
Sales Basis Accounting
End of Year 1
End of Year 2
End of Year 3
Balance Sheet
Cash
Notes Receivable
Total Assets
Common Stock
Retained Earnings
Total Liabilities and Equity
0
1000
1000
750
250
1000
576
524
1100
750
350
1100
1152
0
1152
750
402
1152
1000
750
250
0
250
0
0
0
100
100
0
0
0
52
52
Income Statement
Sales Revenue
Cost of Land Sold
Gross Profit
Interest Revenue
Net Income
Item 3d
Installment Method Notes
Page
2 of 4
B30116 – Berger
Chapter 3 – Revenue & Securitization
Accounting under the Installment Method
Year 1
Cash
Common Stock
750
Land Inventory
Cash
750
750
750
Notes Receivable
Land Inventory
Deferred Gross Profit (xa or l)
1000
750
250
Year 2
Cash
Interest Revenue
Notes Receivable
576
100
476
Deferred Gross Profit
119
Gross Profit Realized On Installment Sales
Note: 119 = 476x[(1000-750)/1000]
119
Year 3
Cash
Interest Revenue
Notes Receivable
576
52
524
Deferred Gross Profit
131
Gross Profit Realized On Installment Sales
Note: 131 = 524x[(1000-750)/1000]
Item 3d
Installment Method Notes
131
Page
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B30116 – Berger
Chapter 3 – Revenue & Securitization
Accounting under the Installment Method
End of Year 1
End of Year 2
End of Year 3
0
1000
(250)
750
750
0
750
576
524
(131)
969
750
219
969
1152
0
0
1152
750
402
1152
0
0
0
119
100
219
131
52
183
Balance Sheet
Cash
Notes Receivable
Deferred Gross Profit
Total Assets
Common Stock
Retained Earnings
Total Liabilities and Equity
Income Statement
Gross Profit Realized On Installment Sales
Interest Revenue
Net Income
Item 3d
Installment Method Notes
Page
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B30116 – Berger
Chapter 3 – Revenue & Securitization
Factoring of Accounts Receivable
A Brief Explanation
Accounts Receivable (and other receivables) have a payment schedule which dictates when
credit customers must pay cash to the selling firm. What if the firm wants to accelerate cash
collection? It can do so, with the help of a financial institution, through either securitization or
factoring. Here we discuss factoring (securitization is discussed later in the chapter).
In factoring, the firm simply sells its receivables to a financial institution for cash. The
customers then pay off their account to the financial institution rather than the firm they
purchased from to originate the receivable.
Factoring without recourse means that the financial institution cannot seek payment from the
firm that sold it the receivable in the event that the receivable proves uncollectible. For example,
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if Retailer sells $100,000 of accounts receivable without recourse to Bank, and Bank charges a
3% fee, Retailer's journal entry is:
Cash
Interest Expense
Accounts Receivable
97,000
3,000
100,000
Why is the fee debited to interest expense? It represents the financing charge incurred to
accelerate the collection of cash.
Factoring with recourse means the firm that sold the receivables is willing to buy back any
uncollectible receivables from the financial institution. Suppose now that the sale of accounts
receivable described above was instead a sale with recourse. The fee is reduced to 1% to reflect
Bank's lower risk, but Bank withholds $2,000 of the cash payment to cover possible
noncollections of the accounts receivable (for which Retailer will remain responsible). Retailer's
journal entry is:
Cash
Interest Expense
Due from Bank
Accounts Receivable
97,000
1,000
2,000
100,000
Note that the asset account "Due from Bank" is unlikely to be entirely collected because it will
be reduced by any uncollectibles among the receivables sold with recourse to the bank. This
accounting is not misleading as long as Retailer has previously set up a normal "Allowance for
Uncollectibles" contra-asset against the receivables.
Finally, assume that all but $1,500 of the receivables are ultimately collected. Thus, Bank settles
the "Due from Bank" account at Retailer by paying only $500 to Retailer (i.e., 2,000 – 1,500).
As long as Retailer had previously set up a normal "Allowance for Uncollectibles" contra-asset
against the receivables, its final entry is:
Cash
500
Allowance for Uncollectibles
1,500
Due from Bank
2,000
As you can see, this entry effectively writes off the $1,500 of uncollectible receivables for which
Retailer was still responsible because its sale of receivables was with recourse.
What if Retailer had been using aggressive rather than conservative accounting and had not set
up a sufficiently large "Allowance for Uncollectibles" to absorb any of the uncollectible accounts
contained in the receivables it sold to Bank? Then the asset Due from Bank would have
overstated the real value of Retailer's assets, because it would not have been offset by any contraasset for anticipated uncollectibles. In this case, financial statement readers would only learn
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about the loss from uncollectibles after the fact, since Retailer's final journal entry would now
be:
Cash
Loss on Sale of Receivables
Due from Bank
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500
1,500
2,000
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The main protection financial statement readers have against being totally surprised by this type
of aggressive accounting is that a sale with recourse requires footnote disclosure of the
contingent liability, if it is material. Unfortunately, materiality is basically defined as something
large enough that, if disclosed, would change the financial statement reader's judgment about a
decision (such as investing in, or lending to, the firm). This definition is sufficiently vague that
companies sometimes fail to disclose anything about their factoring with recourse, arguing that
the contingent liability amounts involved are immaterial.
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