CHAPTER 15: SHORT-TERM LIABILITIES
QUESTIONS
2. Conceptually, how should a liability be measured?
Answer: Conceptually, a liability should be measured as the present value of all related
future cash flows discounted at a rate of interest consistent with the risk involved.
6. In evaluating a balance sheet, some bankers say the liability section is one of the most
important parts. What are the reasons justifying this position?
Answer: The primary reason is to assess the liquidity, and in the extreme, the solvency of
the company. For this assessment, one would need to know (a) the current versus long-term
liabilities and (b) their maturity dates, interest rates, and other terms. Also, liabilities are often
the most difficult of all the items listed on the balance sheet to ascertain with respect to their
existence. An individual, so inclined, can intentionally fail to report selected liabilities. Auditors
routinely conduct tests to detect unrecorded liabilities.
7. Some liabilities are reported at their maturity amount. In general, when should
liabilities, prior to maturity date, be reported at less than their maturity amount?
Answer: A liability will be reported at less than its maturity amount prior to the maturity date if
(a) it is a non-interest-bearing note, or (b) the stated rate of interest on the liability is lower
than the market rate of interest.
9. Define a current liability.
Answer: A current liability is an obligation that will be settled by using current assets or the
creation of other current liabilities. That is, it will be paid with current assets during the coming
year or next operating cycle, whichever is longer. Short-term obligations that will be paid with
noncurrent assets should not be classified with current liabilities.
11. Distinguish between the stated rate of interest and the effective rate of interest (yield)
on a debt.
Answer: Stated rate of interest—the rate specified in the debt agreement; it determines the
cash interest to be paid. Effective or yield rate—the true rate of interest based on the cash
equivalents received and the total cash equivalents paid back.
15. Are all declared dividends a liability between declaration and payment dates?
Explain.
Answer: A cash or property dividend is a liability between declaration and payment dates
because there is a contract to distribute assets. A stock dividend is not a liability because no
assets will be distributed.
16. Why is unearned revenue classified as a liability?
Answer: Unearned revenue, which is revenue collected in advance of being earned, is a
liability because goods or services must be expended in the future to earn the deferred
revenue.
Chapter 15
-1/27-
Short-Term Liabilities
17. What is compensated absence? When should the expense related to compensated
absences be recognized?
Answer: A compensated absence is time away from work (represented by vacation, holiday,
and sick leave) given to employees without reducing their salaries or wages. The related
expense should be recognized when earned and not when the time is taken off, if the two are
different.
18. What is the accounting definition of a contingency? What are the three characteristics
of a contingency? Why is the concept important?
Answer: A contingency, as defined in SFAS No. 5, is an existing condition, situation or set of
circumstances involving uncertainty as to possible gain (a gain contingency) or loss (a loss
contingency) to an enterprise that will ultimately be resolved when one or more future events
occur or fail to occur. Resolution of the uncertainty may confirm (1) the acquisition of an asset
or the reduction of a liability, or (2) impairment of an asset or the incurring of a liability.
The three characteristics of a contingency are (1) an existing condition, (2) uncertainty as to
the ultimate effect, and (3) its resolution depending on one or more future events.
The concept is important because it represents a potential future asset or liability that has
arisen as a result of an event or transaction that has already occurred. The high degree of
uncertainty results in extra caution in accounting for contingencies.
20. Briefly explain the accounting and reporting for loss contingencies.
Answer: Loss contingencies are either accrued or reported in a footnote, depending upon
the degree of uncertainty and whether they can be reasonably estimated. If probable and
measurable, they are accrued; if probable but not subject to reasonable estimation or if only
reasonably possible, they should be disclosed by footnote. If the possibility of their arising is
remote, no disclosure is required.
EXERCISES
E 15-1 Multiple Choice
1. On January 17, 1998, an explosion occurred at a Cord Company plant causing
extensive property damage to area buildings. Although no claims have yet been
asserted against Cord by March 10, 1998, Cord’s management and counsel concluded
that it was reasonably possible that Cord would be responsible for damages, and that
$2,500,000 would be a reasonable estimate of its liability. Cord’s $10,000,000
comprehensive public liability policy has a $500,000 deductible clause. In Cord’s
December 31, 1997 financial statements, which were issued on March 25, 1998, how
should this item be reported?
a. No footnote disclosure or accrual is necessary.
b. As a footnote disclosure indicating the possible loss of $500,000.
c. As an accrued liability of $500,000.
d. As a footnote disclosure indicating the possible loss of $2,500,000.
Chapter 15
-2/27-
Short-Term Liabilities
Answer: B. Per SFAS 5, a loss contingency should be accrued if it is probable that a liability
has been incurred at the balance sheet date and the amount of the loss is reasonably
estimable. Although the contingency is reasonably estimable, it is not probable. Therefore, no
loss is accrued. However, since the contingency is reasonably possible, it will be disclosed in
the footnotes to the 12/31/97 financial statements. The possible loss will be disclosed as
$500,000. The additional potential liability above the deductible would be covered by the
insurance policy and would not be a loss for Cord.
2. Tone Company is the defendant in a lawsuit filed by Witt in 1997 disputing the
validity of a copyright held by Tone. At December 31, 1997, Tone determined that
Witt would probably be successful against Tone for an estimated amount of
$800,000. Appropriately, an $800,000 loss was accrued by a charge to income for the
year ended December 31, 1997. On December 15, 1998, Tone and Witt agreed to a
settlement providing for cash payment of $500,000 by Tone to Witt and transfer of
Tone’s copyright to Witt. The carrying amount of the copyright on Tone’s accounting
records was $120,000 at December 15, 1998. What would be the effect of the
settlement of this liability on Tone’s income before income tax in 1998?
a. No effect.
b. $120,000 decrease.
c. $180,000 increase.
d. $300,000 increase.
Answer: C. At 12/31/97, the contingent liability from the lawsuit met SFAS 5’s criteria for
accrual (probable and reasonably estimable), so a loss and liability of $800,000 was
recognized. In 1998, the lawsuit was settled and the actual loss was $620,000 ($120,000
copyright transfer and $500,000 cash payment). This is a change in estimate which should be
accounted for in the period of change per APB Opinion 20, para. 31. Therefore the $180,000
difference will be reflected in 1998 income as a gain. The journal entry on 12/15/98 to record
the settlement would be:
Lawsuit liability .........................................................................
800,000
Gain from settlement of lawsuit .........................................
180,000
Cash ..................................................................................
500,000
Copyright ...........................................................................
120,000
3. A manufacturer of household appliances has potential losses due to the discovery of a
possible defect in one of its products. The occurrence of the loss is reasonably
possible and the costs can be reasonably estimated. The possible loss should be
a.
b.
c.
d.
Accrued
Disclosed
in Footnotes
No
No
Yes
Yes
No
Yes
Yes
No
Answer: B. Per SFAS 5, a loss contingency will be accrued only if its occurrence is probable
and the amount can be reasonably estimated. In this case the loss is not considered probable
and, therefore, should not be accrued. Although a contingent loss is not accrued if it is only
reasonably possible (not probable) it will be disclosed in the footnotes to the financial
statements. Therefore, the correct answer is B, the reasonably possible loss will not be
Chapter 15
-3/27-
Short-Term Liabilities
accrued but it will be disclosed. Such disclosure should include the nature of the contingency
and should give an estimate of the possible loss or range of loss or state that such an
estimate cannot be made.
4. An expropriation of assets which is imminent and for which the amount of loss can be
reasonably estimated should be
a.
b.
c.
d.
Accrued
Disclosed
in Footnotes
No
No
Yes
Yes
No
Yes
Yes
No
Answer: C. The requirement is to determine the proper treatment of an expected loss that is
imminent (probable) and the amount of which can be reasonably estimated. Answer (C) is
correct because, per SFAS No. 5, para. 8, an estimated loss from contingencies shall be
accrued and charged to income when it is probable that an asset has been impaired or a
liability incurred and when the amount of the loss can be reasonably estimated. Both of these
requirements are met by the expropriation of assets described in this question. Therefore,
this loss contingency should be accrued. Additionally, per para. 9, the nature of the
contingency should be disclosed in a note to the financial statements. Therefore, answers (a),
(b) and (c) are incorrect.
E 15-2 Multiple Choice
1. On December 31, 1998, Beal Company was involved in a tax dispute with the IRS.
Beal’s tax counsel believed that an unfavorable outcome was probable and a
reasonable estimate of additional taxes was $275,000, with a chance that the
additional taxes could be as much as $425,00. After the 1998 financial statements
were issued, Beal accepted the IRS settlement offer of $325,000. What amount of
additional taxes should have been accrued in 1998?
a. $425,000.
b. $325,000.
c. $275,000.
d. $0
Answer: C. The additional taxes must be accrued as a loss contingency in accordance with
SFAS No. 5 because an unfavorable outcome is probable and the amount of the loss is
reasonably estimable. Per FASB Interpretation 14, when a range of possible losses exists,
the best estimate in the range (in this case $275,000) is accrued. Since the $325,000
settlement occurred after the statements were issued, this information was not available
when the estimates were made. If, however, it had become available after the end of the
fiscal year but before the financial statements were issued, it would have been a Type 1
Subsequent Event and $325,000 would be accrued in 1998.
2. On November 5, 1997, a Dunn Corporation truck was in an accident with an
automobile driven by R. Bell. Dunn received notice on January 12, 1998 of a lawsuit
Chapter 15
-4/27-
Short-Term Liabilities
for $350,000 in damages for personal injuries suffered by Bell. Dun Corporation’s
counsel believes it is probable that Bell will be awarded an estimated amount in the
range between $100,000 and $225,000, and that $150,000 is a better estimate of
potential liability than any other amount. Dunn’s accounting year ends on December
31, and the 1997 financial statements were issued on March 2, 1998. What liability
should Dunn accrue at December 31, 1997?
a. $0.
b. $100,000.
c. $150,000.
d. $225,000.
Answer: C. Per SFAS 5, a loss contingency should be accrued if it is probable that a liability
has been incurred at the balance sheet date and the amount of the loss is reasonably
estimable. This loss must be accrued because it meets both criteria. Even though the lawsuit
was not initiated until 1/12/98, the liability was incurred on 11/5/97 when the accident
occurred. FASB Interpretation 14 requires that when some amount within an estimated range
is a better estimate than any other amount in the range, that amount is accrued. Therefore, a
loss of $150,000 should be accrued. If no amount within the range is a better estimate than
any other amount, the amount at the low end of the range is accrued and the amount at the
high end is disclosed.
3. The following information pertains to a fire insurance policy in effect during the
calendar year 1998, covering Vail Company’s inventory:
Face amount of policy.................................... $400,000
Deductible ......................................................
25,000
Amount of premium .......................................
2,000
Coinsurance clause.........................................
80%
Vail’s inventory averages $500,000 uniformly throughout the year. Vail’s income tax
rate is 40%. How much of a contingent liability should Vail accrue at December 31,
1998 to cover possible future fire losses?
a. $0.
b. $15,000.
c. $23,000.
d. $60,000.
Answer: A. The requirement is to determine the amount Vail should accrue as a contingent
liability at 12/31/98 to cover possible future fire losses. Answer (a) is correct because, per
SFAS 5, para. 8, a contingent liability shall only be accrued if the likelihood of its occurrence
is probable and the amount of the loss can be reasonably estimated. An event such as a
future fire loss is not considered probable at 2/31/98 based on the information given, nor can
an amount of the loss from such an event be reasonably estimated. Thus, no accrual is
required at 121/31/98.
Chapter 15
-5/27-
Short-Term Liabilities
4. When the occurrence of a gain contingency is reasonably possible and the amount can
be reasonably estimated, the gain contingency should be
a. Included in net income and disclosed.
b. Included in an appropriation of retained earnings.
c. Disclosed, but not included in net income.
d. Neither included in net income nor disclosed.
Answer: C. Per SFAS 5, para. 17, contingencies that might result in gains usually are not
reflected in the accounts since to do so might result in revenue being recognized prior to its
realization. Although adequate disclosure shall be made of contingencies that might result in
gains, care should be exercised to avoid misleading implications as to the likelihood of
realization. Therefore, answer (c) is correct. Answer (a) is incorrect because the gain
contingency should not be recognized in the income statement. Answer (b) is incorrect
because the gain contingency would not be reflected in any of the accounts. Answer (d) is
incorrect because the contingency should be disclosed in the notes to the financial
statements.
E 15-3 Multiple Choice
1. Robb Company requires advance payments with special orders from customers for
machinery constructed to their specification. Information for 1998 is:
Customer advances—balance 12/31/97 ........................$590,000
Advances received with orders in 1998 ..........................920,000
Advances applied to orders shipped in 1998 ..................820,000
Advances applicable to orders canceled in 1998 ............250,000
At December 31, 1998, what amount should Robb report as a current liability for
customer deposits?
a. $0.
b. $440,000.
c. $690,000.
d. $740,000
Answer: B. To determine the 12/31/98 balance of the liability for customer advances the
following adjustments are made to the beginning 12/31/97 credit balance:
12/31/97 Balance ..................................................... $590,000
1998 Advances Received ....................................... 920,000
Subtotal ................................................................. $1,510,000
Less:
1998 Advances Applied
(820,000)
1998 Advances Cancelled
(250,000)
12/31/98 Balance ..................................................... $440,000
When advances are received [$920,000], cash is debited and the liability account is credited.
When advances are applied to orders shipped [$820,000], the liability account is debited and
sales is credited. When an order is cancelled [$250,000], the liability account is debited and
Chapter 15
-6/27-
Short-Term Liabilities
either cash or a revenue account is credited, depending upon whether or not the deposit is
returned to the customer.
2. Cobb Company sells appliance service contracts to repair appliances for a two-year
period. Cobb’s past experience is that, of the total amount spent for repairs on service
contracts, 40% is incurred evenly during the first contract year and 60% evenly
during the second contract year. Receipts from service contract sales for the two years
ended December 31, 1998 are $250,000 in 1997 and $300,000 in 1998. Receipts from
contracts are credited to unearned service contract revenue. Assume that all contract
sales are made evenly during the year. What amount should Cobb report as unearned
service contract revenue at December 31, 1998?
a. $180,000.
b. $235,000.
c. $240,000.
d. $315,000.
Answer: D. All contract sales are made evenly during the year. Therefore, the 1997 contracts
range from one year expired (if sold on 12/31/97) to two years expired (if sold on 1/1/97), for
an average of 1½ years expired. Similarly, the 1998 contracts range from 0 years expired to 1
year expired, for and average of ½ year expired. The average unearned portion of the 1997
contracts is ½ year. The amount of unearned revenue related to the 1997 contracts is
calculated as follows:
$250,000 x 60% x ½ = $75,000
The average unearned portion of the 1998 contracts is 1½ years. The amount of unearned
revenue related to the 1998 contracts is calculated as follows:
$300,000 x 40% x ½ =
$300,000 x 60% =
$ 60,000
180,000
$240,000
Therefore, the total unearned revenue is $75,000 + $240,000 = $315,000.
3. In packages of its products, Curran Co. includes coupons that may be presented at
retail stores to obtain discounts on other Curran products. Retailers are reimbursed for
the face amount of coupons redeemed plus 10% of that amount for handling costs.
Curran honors requests for coupon redemption by retailers up to three months after
the consumer expiration date. Curran estimates that 70% of all coupons issued will
ultimately be redeemed. Information relating to coupons issued by Curran during
1998 is as follows: consumer expiration date, December 31, 1998; total face amount
of coupons issued, $300,000; and total payments to retailers as of December 31,
1998, $110,000. What amount should Curran report as a liability for unredeemed
coupons at December 1, 1998?
a. $0.
b. $100,000.
c. $121,000.
d. $154,000.
Answer: C. At 12/31/98, Curran should report a liability even though the coupons expired
12/31/98 because retailers may submit coupons to Curran for three months after the
Chapter 15
-7/27-
Short-Term Liabilities
expiration date. Thus, Curran will still have to redeem coupons until 3/31/99. Total expected
redemptions are $210,000 (.70 x $300,000), and on those redemptions Curran expects to
pay out $231,000 ($210,000 plus .10 x $210,000 for handling) As of 12/31/98, total payments
to retailers have been $110,000, which means a liability of $121,000 should be reported
($231,000 - $110,000).
4. An employer’s obligation relating to employees’ rights to receive compensation for
future absences is attributable to employees’ services already rendered. The payment
of compensation is probable and the amount of compensation can be reasonably
estimated. Employees’ compensation should be
a. Accrued if the obligation relates to rights that vest or accumulate.
b. Accrued if the obligation relates to rights that do not vest or accumulate.
c. Expensed when paid.
d. Disclosed but not accrued if the obligation relates to rights that vest or
accumulate.
Answer: A. SFAS 43, para. 6 requires employers to accrue a liability for future absences
when all of the following conditions are met:
1) The employees’ services have already been rendered.
2) The obligation relates to rights that vest or accumulate.
3) Payment is probable; and
4) The amount can be easily estimated.
E 15-4 Multiple Choice
1. Bloy Company pays all salaried employees on a biweekly basis. Overtime pay,
however, is paid in the next biweekly period. Bloy accrues salary expense only at its
December 31 year-end. Data relating to salaries earned in December 1998 are:
 Last payroll was paid on December 26, 1998, for the two-week period ended on
that day.
 Overtime pay earned in the two-week period ended December 26, 1998 was
$8,400.
 Remaining work days in 1998 were December 29,30, and 31, on which days there
was no overtime.
 The recurring biweekly salaries total $150,000.
Assuming a five-day workweek, Bloy should record a liability at December 31, 1998,
for accrued salaries of
a. $45,000.
b. $53,400.
c. $90,000.
d. $98,400.
Answer: B. the liability for accrued salaries at 12/31/98 should include all salaries expense
that has been accrued but not yet paid. This would include the overtime pay earned by
employees for the two-week period ended 12/26/98 ($8,400), which will not be paid until the
next pay period. Accrued salaries would also include the regular pay for the workdays
Chapter 15
-8/27-
Short-Term Liabilities
(December 29, 30, and 31). Since each biweekly pay period results in $150,000 regular pay
for 10 workdays (2 five-day weeks), the accrued salaries for three workdays would be 3/10 of
$150,000, $45,000. Therefore, the total liability for accrued salaries at 12/31/98 is $53,400
($45,000 + $8,400).
2. On September 1, 1997, the Pine Company issued a note payable to National Bank in
the amount of $900,000, bearing interest at 12%, and payable in three equal annual
principal payments of $300,000. On this date the bank’s prime rate was 11%. The
first interest and principal payment was made on September 1, 1998. At December
31, 1998, Pine should record interest payable of
a. $22,000.
b. $24,000.
c. $33,000.
d. $36,000.
Answer: B. Accrued interest payable at 12/31/98 is interest expense that has been incurred
by 12/31/98 but not yet paid. In this case, interest was last paid on September 1, 1998, so the
accrued interest payable includes interest expense incurred for 9/1 through 12/31 (4 months).
The original balance of the note was $900,000, but the 9/1/98 principal payment of $300,000
reduced the balance to $600,000. Therefore, the interest payable at 12/31/98 is $24,000.
$600,000 x .12 x 4/12 = $24,000
The stated rate of 12% is used rather than the bank’s prime rate of 11% because 12% is the
rate negotiated for this particular note.
3. Pam, Inc. has $500,000 of notes payable due June 15, 1999. At the financial
statement date of December 31, 1998, Pam signed an agreement to borrow up to
$500,000 to refinance the notes payable on a long-term basis. The financing
agreement called for borrowings not to exceed 80% of the face value of the collateral
that Pam was providing. At the date of issue of December 31, 1998 financial
statements, the value of the collateral was $600,000 and was not expected to fall
below this amount during 1999. In its December 31, 1998 balance, Pam should
classify notes payable as
Short-term
Obligations
a.
b.
c.
d.
$
0
$ 20,000
$100,000
$500,000
Long-term
Obligations
$500,000
$480,000
$400,000
$
0
Answer: B. All the notes are due 6/15/99 and normally the entire amount would be classified
as current. However, SFAS No. 6 states that a short-term obligation can be reclassified as
long-term if the enterprise intends to refinance the obligation on a long-term basis and the
intent is supported by the ability to refinance. Pam demonstrated its ability by entering into a
financing agreement before the statements are issued. SFAS No. 6 further states that the
amount to be excluded from current liabilities cannot exceed the amount available for
refinancing under the agreement. Pam expects to be able to refinance at least $480,000 (.80
x $600,000) of the notes. Therefore, that amount can be classified as long-term while the
remaining $20,000 must be classified as short-term.
Chapter 15
-9/27-
Short-Term Liabilities
4. Which of the following is classified as an accrued liability?
a.
b.
c.
d.
Liability for
Federal
Unemployment
Taxes
Liability for
Employer’s
Share of
FICA Taxes
Yes
Yes
No
No
Yes
No
No
Yes
Answer: A. Accrued liabilities include expenses that have been incurred but not yet paid.
Both federal unemployment taxes and the employer’s share of FICA taxes represent tax
expense that is incurred as employees earn wages, but which is only paid periodically.
Therefore, both types of expenses represent accrued liabilities.
E 15-7 Identifying Current Liabilities. Consider the following five items:
a.
b.
c.
d.
e.
Bank overdraft.
Retained earnings.
Long-term debt.
Cash dividends declared but not paid.
Customer payments for magazine subscriptions not yet delivered.
Required: Identify the current liabilities among these five items.
Answer:
Items a, d and e are current liabilities. Item b belongs with stockholders’ equity.
E 15-8 Identifying a Current Liability. Suppose a firm has an obligation that requires it
to pay another organization $500,000 two years from today.
Required: Normally such an obligation would be considered long-term. Is there any
situation in which this obligation could be considered a current liability.
Explain.
Answer:
Yes. If the business of the firm is such that a period longer than a year is necessary
for reporting purposes, such an obligation could be considered a current liability.
Examples often given of such cases are major construction activities including
shipbuilding, dams and the building of major plant or office buildings. Long-term
ventures might also qualify, such as the search for oil or for treasure. In these cases
the normal production or operating cycle exceeds a year and this longer period
dictates the reporting cycle.
Chapter 15
-10/27-
Short-Term Liabilities
E15-12 Analysis and Comparison of Interest-Bearing and Noninterest-Bearing Notes On
September 1, 1998, Dyer Company borrowed cash on a $100,000 note payable, principal and
interest due in one year. Assume the going rate of interest was 12 percent per year for this
particular level of risk. The accounting period ends December 31.
Required: Complete the following tabulation; round to the nearest dollar.
Assuming the Note Was
InterestBearing
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
Cash received
$
Cash paid at maturity date
$
Total interest paid (cash)
$
Interest expense in 1998
$
Interest expense in 1999
$
Amount of liabilities reported on 1998 balance sheet:
Note payable (net)
$
Interest payable
$
Principal amount
$
Face amount
$
Maturity value
$
Stated interest rate
$
Yield or effective interest rate
$
NoninterestBearing
_______
_______
_______
_______
_______
$
$
$
$
$
______
______
______
______
______
_______
_______
_______
_______
_______
_______
_______
$
$
$
$
$
$
$
______
______
______
______
______
______
______
Answer:
Assuming the Note Was
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
Chapter 15
Cash received ..........................................................
Cash paid at maturity date ......................................
Total interest paid (cash) .........................................
Interest expense in 1998 .........................................
Interest expense in 1999 .........................................
Amount of liabilities reported on 1998 balance sheet:
Note payable (net) ................................................
interest payable ....................................................
Principal amount ......................................................
Face amount ............................................................
Maturity value ...........................................................
Stated interest rate ..................................................
Yield or effective interest rate ..................................
-11/27-
InterestBearing
NoninterestBearing
$ 100,000
112,000
12,000
4,000
8,000
$ 89,286
100,000
10,714
3,571
7,143
100,000
4,000
100,000
100,000
100,000
12%
12%
92,857
-0
89,286
100,000
100,000
none
12%
Short-Term Liabilities
Computations:
1. $100,000 ÷ 1.12 = $89,286
2. $100,000 + ($100,000 x .12) = $112,000
3. $112,000 - $100,000 = $12,000
$100,000 - $89,286 = $10,714
4. $12,000 x 4/12 = $4,000
$10,714 x 4/12 = $3,571
5. $12,000 x 8/12 = $8,000
$10,714 x 8/12 = $7,143
6. $89,286 + $3,571 = $92,857
7. Cash received when the note was signed.
8. Given; same for both notes.
9. Maturity value is the amount due at maturity, excluding any separate interest
payments.
10. Given for interest-bearing; not applicable to noninterest- bearing note,
11. Same as stated rare on interest-bearing note; implicit (given as the going rate) on
noninterest-bearing note, 12%. Used to compute cash received,
E15-14 Current Liabilities: Original and Adjusting Entries Vintage Sales Company, a large
retail outlet, completed the following selected transactions during 1998 and 1999:
a. At the end of 1998, accrued wages that have not yet been recorded amounted to $40,000.
These accrued wages were paid in the January 15, 1999, payroll, which amounted to
$190,000 (disregard payroll taxes).
b. On November 1, 1998, rent revenue for the following six months was collected, $9,600.
c. On October 1, 1998, Vintage received $400 as a deposit from a customer for some special
containers that are to be returned on or about March 31, 1999. Vintage agreed to "give the
customer credit at an annual rate of 6 percent interest on the deposit." The containers were
returned on April 1, 1999.
Required: Give all of the required entries (omit closing and reversing entries) during 1998 and
1999 for each of the above transactions. The accounting period of Vintage ends on December 31.
Answers:
Transaction (a):
December 31, 1998—Adjusting entry:
Wage expense .........................................................................
Wages payable .................................................................
January 15, 1999—Payroll:
Wages payable (above) ....................................................
Wage expense($190,000 - $40,000) ................................
Cash (given) ...............................................................
Transaction (b):
November 1, 1998—Collected rent in advance:
Cash .................................................................................
Rent revenue collected in advance ............................
Chapter 15
-12/27-
40,000
40,000
40,000
150,000
190,000
9,600
9,600
Short-Term Liabilities
December 31, 1998—Adjusting entry:
Rent revenue collected in advance ...................................
Rent revenue ($9,600 x 2/6) .......................................
April 30, 1999— Recognize revenue earned:
Rent revenue collected in advance ..................................
Rent revenue ($9,600 x 4/6) .......................................
3,200
3,200
6,400
6,400
Transaction (c):
October 1, 1998—Deposit received:
Cash ..................................................................................
400
Liability, container deposit ..........................................
December 11, 1998—Accrued interest:*
Interest expense ($400 x .06 x 3/12) ...............................
6
Liability, container deposit ..........................................
April 1, 1999—Deposit returned:
Liability, container deposit ($400 + $6) ............................
406
Interest expense ($400 x .06 x 3/12)* ...............................
6
Cash ($400 + $6 + $6) ................................................
*Entry would probably not be made for $6 because the amount is not material.
400
6
412
E 15-15 Reporting Liabilities: Dividends and Secured Notes The records of the Fisk
Corporation provided the following information at December 31, 1998.
a. Notes payable (trade), short term (includes a $4,000 note given on
purchase of equipment that cost $20,000; assets were mortgaged
in connection with purchase) ........................................................................
b. Bonds payable ($30,000 due each April 1) ..................................................
c. Accounts payable (including $3,000 owed to president of the company) ....
d. Accrued property taxes (estimated) ..............................................................
e. Stock dividends issuable on 3/1/1999 (at par value) ....................................
f. Cash dividends declared, payable 3/1/1999 .................................................
g. Long-term note payable, maturity amount ($14,500 carrying value) ...........
h. Accrued interest on all bonds and notes .......................................................
$ 30,000
120,000
50,000
1,000
26,000
20,000
16,000
13,500
Required: Assuming that the fiscal year ends December 31, show how each of the above items
should be reported on the balance sheet at December 31, 1998.
Answer:
Current Liabilities:
Accounts payable (trade) .............................................................................
Notes payable (trade) ..................................................................................
Payable to company officer .........................................................................
Equipment notes payable (secured by equipment) .....................................
Current payment on bonds payable ............................................................
Estimated property taxes payable ...............................................................
Dividends payable (cash) ............................................................................
Interest payable (on notes and bonds) ........................................................
Chapter 15
-13/27-
$47,000
26,000
3,000
4,000
30,000
1,000
20,000
13,500
Short-Term Liabilities
Long-Term Liabilities:
Bonds payable (less current portion) ...........................................................
Note payable (maturity amount, $16,000) ...................................................
90,000
14,500
Operational Assets:
Equipment (pledged on 54,000 note) ................................................... 20,000
Stockholders' Equity:
Stock dividends issuable (at par) ........................................................ 26,000*
*Assuming an entry was made on issue date as follows:
Retained earnings ..................................................................
Stock dividends issuable ..................................................
26,000
26,000
Otherwise, simply disclose in a note to the financial statements stock dividends usually are not
recorded until issued.
E15-16 Entries to Record Payroll and Related Deductions Ryan company paid salaries for the
month amounting to $120,000. Of this amount, $30,000 was received by employees who had
already been paid the $53,400 maximum amount of annual earnings taxable in one year under
FICA laws (FICA rate: 7.65 percent).
Of the $120,000, $14,000 was paid to employees who had already reached the $7,000
maximum wages subject to unemployment taxes (rates: 5.4 percent state and 0.8 percent federal).
Withholding taxes amounted to $36,000, and $1,450 was withheld from the $120,000 for
investment in company stock per an agreement with certain employees.
Required: Give entries to record (a) salary payment and the liabilities for the deductions, (b)
employer payroll expenses, and (c) remittance of the taxes.
Answer:
(a) To record salaries and related deductions:
Salary expense ........................................................................
Withholding tax payable ....................................................
Employee stock investment payable .................................
FICA tax payable—-employees ........................................
Cash ..................................................................................
* ($120,000 - $30,000) x .0765 = $6,885
(b) To record employer payroll taxes:
Expense-payroll taxes .............................................................
FICA tax payable—employer ............................................
FUTA tax payable—federal ...............................................
SUTA tax -state .................................................................
(1)
($120,000 - $30,000) x .0765 = $6,885
(2)
($120,000 - $ 14,000) x .008 = $848
(3)
($120,000 - $ 14,000) x .054 = $5,724
Chapter 15
-14/27-
120,000
36,000
1,450
6,885 *
75,665
13,457
6,885
848
5,724
Short-Term Liabilities
(1)
(2)
(3)
(c) To record remittance of taxes:
Withholding tax payable ..........................................................
FICA tax payable—employees ................................................
FICA tax payable—employer...................................................
FUTA tax payable—federal* ....................................................
SUTA tax payable—state ........................................................
Cash ..................................................................................
*Paid annually.
36,000
6,885
6,885
848
5,724
56,342
E 15-17 Recording Payroll and Related Deductions Smiley Corporation paid salaries and
wages of $143,800. Of this amount, $3,860 was paid to employees who had already exceeded the
FICA maximum. Also, $43,800 was paid to employees who had already been paid the SUTA
maximum. Use the FICA and FUTA rates given in the chapter. Income tax withholding was
$35,000. Deductions: union dues (in conformity with the union agreement), $3,000, and
insurance premiums, $12,000.
Required: Give the entries to record liabilities for payroll deductions, payroll expenses, and
remittance of the deductions.
Answers:
(a) To record salaries and the related employee deductions:
Salary expense ..............................................................................
Withholding tax payable ..........................................................
Union dues payable ................................................................
Insurance premiums payable ..................................................
FICA tax payable ($143,800 - $3,800) x .0765 .......................
Cash ........................................................................................
(b) To record employer payroll taxes:
Expense-payroll taxes ...................................................................
FICA tax payable, employer ($143,800 - $3,800) x .0765 .......
FUTA tax payable, federal ($143,800 - $43,800) x .008..........
SUTA tax payable, state ($143,800 - $43,800) x .054 ............
(c) For remittance of taxes and other deductions:
Withholding tax payable (a) above .........................................
Union dues payable ................................................................
Insurance premiums payable .................................................
FICA tax payable, employees .................................................
FICA tax payable, employer ...................................................
FUTA tax payable, federal ......................................................
SUTA tax payable, state .........................................................
Cash ........................................................................................
143,800
35,000
3,000
12,000
10,710
83,090
16,910
10,710
800
5,400
35,000
3,000
12,000
10,710
10,710
800
5,400
77,620
E15-18 Compensated Absences: Entries and Reporting Tunacliff Mowers allows each
employee to earn 15 paid vacation days each year with full pay while on vacation. Unused
vacation time can be carried over to the next year; if not taken during the next year it is lost. By
Chapter 15
-15/27-
Short-Term Liabilities
the end of 1998, all but 3 of the 30 employees had taken their earned vacation time; these three
carried over to 1999 a total of 20 vacation days, which represented 1998 salary of $6,000. During
1999, each of these three used their 1998 vacation carryover; none of them had received a pay
rate change from 1998 to the time they used their carryover. Total cash wages paid: 1998,
$700,000; 1999, $740,000. There was no carryover of vacation time earned in 1999.
Required:
1. Give all of the entries for Tunacliff related to vacations during 1998 and 1999. Disregard
payroll taxes.
2. Compute the total amount of wage expense for 1998 and 1999. How would the vacation time
carried over from 1998 affect the 1998 balance sheet?
Answers:
Requirement 1:
December 31, 1998—Adjusting entry to accrue vacation salaries not yet taken or
paid:
Salary expense .................................................................
6,000
Liability for compensated absences ..........................
6,000
During 1999—Vacation time carryover taken and paid:
Liability for compensated absences ................................
Cash (included in payroll entry) ................................
6,000
6,000
Requirement 2
Total wage expense:
1998: $700,000 + $6,000
1999: $740,000 - $6,000 = $734,000
1998 Balance sheet position:
Current liabilities:
Liability for compensated absences ....................
$6,000
E15-19 Estimated Warranty Expense: Recording and Reporting Macy Furniture sells a line
of products that carry a three-year warranty against defects. Based on industry experience, the
estimated warranty costs related to dollar sales are the following: first year after sale, I percent of
sales: second year after sale, 3 percent of sales; and third year after sale, 5 percent. Sales and
actual warranty expenditures for the first three-year period were as follows:
Cash Sales Actual Warranty Expenditures
1998.
1999.
2000
Chapter 15
$ 80,000
110,000
120,000
$1,000
4,100
9,800
-16/27-
Short-Term Liabilities
Required:
1. Give entries for the three years for (a) the sales, (b) the estimated warranty expense, and (c)
the actual expenditures.
2. What amount should be reported its a liability on the balance sheet at the end of each year?
Answers:
Requirement 1
(a) & (b) To record sales and estimated warranty costs:
1998
1999
2000
Cash
80,000
110,000
120,000
Warranty expense
7,200 a
9,900 b
10,800 c
Sales
80,000
110,000
120,000
Estimated warranty liability
7,200
9,900
10,800
a
b
c
$80,000 x (.01 + .03 +.05) = $7,200
$110,000 x (.01 + .03 + .05) = $9,900
$120,000 x (.01 + .03 + .05) = $10,800
(c) To record actual expenditures:
Estimated warranty liability
Cash
1,000
4,100
1,000
9,800
4,100
9,800
Requirement 2
Balance in the liability account:
1998
($7,200 - $1,000) ................................................
1999
($6,200 + $9,900 - $4,100) .................................
2000
($12,000 + $10,800 - $9,800) ..............................
$6,200
12,000
13,000
E15-21 Loss Contingency—Three Cases: Entries and Explanation Canseco Company is
preparing the annual financial statements at December 31, 1999. During 1999, a customer fell
while riding on the escalator and has filed a lawsuit for $40,000 because of a claimed back injury.
The lawyer employed by the company has carefully assessed all of the implications. If the suit is
lost, the lawyer's reasonable estimate is that the $40,000 will be assessed by the court.
Required: How should the contingency be handled during 1999 in each of the following cases?
Give all necessary entries and any notes:
1. Assume that the lawyer and the management concluded that it is reasonably possible that the
company will be liable, and it is reasonably estimated that the amount will be $40,000.
2. Assume, instead, that the lawyer, the independent accountant, and management have
reluctantly concluded that it is probable that the suit will be successful.
3. Assume that the conclusion of the legal counsel and management is that the chance of a
contingency loss is remote. They believe the suit is without merit.
Chapter 15
-17/27-
Short-Term Liabilities
Answers:
Requirement 1
This "reasonably possible" and "reasonably estimated" loss contingency would be reflected only
in a footnote; accrual is not permitted. A suitable footnote is as follows:
Note:
A customer was injured on company premises. Although the litigation
has not been adjudicated, legal counsel and management have
concluded that it is reasonably possible that the court will assess
damages of approximately $40,000.
Requirement 2
This "probable" and "reasonably estimated" contingent loss must be accrued because (1) a loss
is probable and (2) it can be reasonably estimated:
Loss due to accident ...................................................
Estimated liability for damages (lawsuit) .......
Note:
40,000
40,000
A customer was injured on company premises. Although the litigation
has not been finally adjudicated, legal counsel and management believe
it is probable that damages of approximately $40,000 will be assessed
by the court.
Requirement 3
This "remote" and "reasonably estimated" contingent loss does not require accrual or note
disclosure. However, conservatism, coupled with the full-disclosure principle, suggests the
propriety of disclosing the situation in a note to the financial statements.
Comment:
The situation in Requirement 1, as a practical matter, probably
would seldom occur—they would settle out of court. The situation in
Requirement 2 probably would never occur for the same reason.
E 15-23 Ratio Analysis Suppose a firm issues short-term interest-bearing notes and uses the
proceeds to purchase inventories. Assume, further, that the decision turns out to be a good one for
the firm. Assume the firm's profits for the year remain unchanged.
Required: Indicate how the use of the notes would affect the indicated ratios immediately
following the decision unless otherwise indicated by the symbol *, which means indicate the
effect over the year but before any of the liability is repaid. Use the following symbols: U for up,
D for down, and NC for no change.
Chapter 15
-18/27-
Short-Term Liabilities
Ratio
a.
b.
c.
d.
e.
f.
g.
h.
Numerator
Effect on
Denominator
Ratio
______
______
______
______
______
______
______
______
______
______
______
______
______
______
______
______
_____
_____
_____
_____
_____
_____
_____
_____
Current ratio .............................................
Working capital to total assets ..................
Net cash to current liabilities ....................
Debt to equity ...........................................
Debt to total assets ....................................
Times interest earned* ..............................
Cash flow per share* ................................
Return on total assets* ..............................
Answer:
Ratio
a.
b.
c.
d.
e.
f.
g.
h.
Current ratio ....................................................
Working capital to total assets ........................
Net cash to current liabilities ...........................
Debt to equity..................................................
Debt to total assets .........................................
Times interest earned*....................................
Cash flow per share* ......................................
Return on total assets* ...................................
Numerator
Effect on
Denominator
U
NC
NC
U
U
D
?
NC
U
U
U
NC
U
U
NC
U
Ratio
D1
D
D2
U
U3
D
?
D
1
If current assets exceed current liabilities, the ratio will immediately fall and vice versa. The
former condition is the more likely. If we take a long-term view, assets, including current assets
would rise and the liability decline increasing the ratio. Here we assume the "good result" occurs
as we will elsewhere and examine only the short term.
2
The decision is a good one (given), but it is not clear whether the increased inflow will be in the
form of cash or some other asset in the short run such as accounts receivable. Hence cash flow
could even go down due the interest on the debt. The answer here assumes all the cash is
invested in inventories,
3
This result holds because debt is less than total assets.
P 15-1 Multiple Choice
1. Farr Company sells its products in expensive, reusable containers. The customer is charged a
deposit for each container delivered and receives a refund for each container returned within
two years after the year of delivery. Farr accounts for the containers not returned within the
time limit as a sale at the deposit amount. Information for 1998 is (dollar amounts represent
deposits received from customers):
Containers held by customers at December 31, 1997 from deliveries in
1996 ................. $150,000
1997 .................
430,000
$580,000
Containers delivered in 1998 ............... 780,000
Chapter 15
-19/27-
Short-Term Liabilities
Containers returned in1998, from deliveries in
1996 .................
$90,000
1997 .................
250,000
1998 .................
286,000
$626,000
What amount should Farr report as a liability for returnable containers at December 31, 1998?
a. $494,000.
b. $644,000.
c. $674,000.
d. $734,000.
Answer: (c) The requirement is the amount to reported as a liability for returnable containers
at 12/31/98. The solutions approach sets up a T-account for the liability.
1998 returns
1998 sales
Liability
|
580,000 12/31/97 balance
626,000 |
780,000 1998 deliveries
60,000 |
|
674,000 12/31/98 balance
When customers pay the deposit for a container, cash is debited and the liability is credited.
Therefore, at 12/31/97, the liability consists of deposits for containers still held by customers
from the last two years ($580,000). During 1998, the liability is increased for deposits on
containers delivered ($780,000). When containers are returned, the deposits are returned to
the customers; in 1998, the liability was debited and cash credited for $626,000. Also, at
12131/98, some customers still held containers from 1994 ($150,000 - $90,000 = $60,000).
The two-year time limit has expired on these, so the company no longer is obligated to return
the deposit. The containers are considered sold to the customers, so the liability account is
debited and sales credited for $60,000. These transactions result in a 12/31/98 liability
balance of $674,000.
2. Dunn Trading Stamp Company records stamp service revenue and provides for the cost of
redemptions in the year stamps are sold to licensees. Dunn's past experience indicates that
only 80 percent of the stamps sold to licensees will be redeemed. Dunn's liability for stamp
redemptions was $24,000,000 at December 31, 1997. Additional information for 1998 is:
Stamp service revenue from stamps sold to licensees .......... $16,000,000
Cost of redemptions (stamps sold prior to 1/1/98) ............... 11,000,000
If all the stamps sold in 1998 were presented for redemption in 1999, the redemption cost
would be $9,000,000. What amount should Dunn report as a liability for stamp redemptions
at December 31, 1998?
a. $13,000,000.
b. $20,200,000.
c. $22,000,000.
d. $29,000,000.
Answer: (b) The requirement is the amount to reported as a liability for stamp redemptions at
12/31/98. The solutions approach sets up a T-account for the liability.
Redemptions
Chapter 15
Liability
| 24,000,000 12/31/95 balance
11,000,000 | 7,200,000 Increase
| 20,200,000 12/31/98 balance
-20/27-
Short-Term Liabilities
When stamps are sold cash is debited and revenue is credited for the face amount
($16,000,000). Additionally, cost of redemptions is debited and the liability credited for the
estimated cost of redemption. This increase in the liability is computed by taking the total
possible redemption cost and multiplying by the expected redemption rate ($9,000,000 x .80
= $7,200,000) As redemptions actually occur, the liability is decreased. The cost of 1998
redemptions ($11,000,000) is debited to the liability account and credited to inventory.
3. Grey operates at; a retail furrier. Some customers pick out furs and place deposits with Grey
to set the furs aside for future delivery. Grey records the cash receipts on these transactions as
layaway plan sales. However, title to the fur passes to the customer only when the full sales
price is received by Grey. The average gross margin on the furs is 75 percent of sales. The
following pertinent data were taken from Grey's December 31, 1998 unadjusted trial balance:
Regular sales ........................................................................
Layaway plan sales...............................................................
Deposits from customers ......................................................
$5,000,000
$2,000,000
$-0-
An analysis of the layaway plan sales revealed that $1,200,000 was received in full payment
for furs delivered to customers during 1998. In Grey's December 31, 1998 balance sheet,
deposits from customers would be
a. $2,000,000.
b. $1,500,000.
c. $1,200,000.
d. $800,000.
Answer: (d) Prior to adjusting entries, Grey has balances of $2,000,000 in layaway plan
sales and $0 in deposits from customers. However, of the $2,000,000 balance in the sales
account, only $1,200,000 represents sales where payment has been made in full and title has
passed to the customers. The remaining $800,000 represents collections from customers.
who have not yet paid in full. At 12/31/98, an adjusting entry must be prepared to remove
$800,000 from the sales account and record it in the liability account, deposits from
customers.
4. During 1997, Ward Company introduced a new product carrying a two-year warranty against
defects. The estimated warranty costs related to dollar sales are 2 percent within 12 months
following sale and 4 percent in the second 12 months following sale. Sales and actual
warranty expenditures for the years ended December 31, 1997 and 1998 are:
Actual Warrant)
Sales
Expenditures
1997 ...........................................
1998 ...........................................
$ 600,000
1,000,000
$1,600,000
$ 9,000
30,000
$39,000
At December 31, 1998. Ward would report an estimated warranty liability of
a. $57,000.
b. $45,000.
c. $17,000.
d. $10,000.
Answer: (a) Each year, warranty expense is estimated at 6% of sales and recorded by
debiting the expense account and crediting the liability. As warranty expenditures are made,
the liability is debited and cash is credited. Note that the total estimated warranty cost for both
Chapter 15
-21/27-
Short-Term Liabilities
years [(.02 + .04) = .06] is recorded in the year of sale in compliance with the matching
principle.
Problem 15-2 Multiple Choice
1. A state requires quarterly sales tax returns to be filed with the sales tax bureau by the 20th
day following the end of the calendar quarter. However, the state further requires that sales
taxes collected be remitted to the sales tax bureau by the 20th day of the month following any
month such collections exceed $1,000. These payments can be taken as credits on the
quarterly sales tax return.
Taft Corporation operates a retail hardware store. All items are sold subject to a 6 percent
state sales tax, which Taft collects and records as sales revenue. The sales taxes paid by Tart
are charged against sales revenue. Taft pays the sales taxes when they are due.
Following is a monthly summary appearing in Taft's first-quarter 1998 sales revenue
account:
January .............................................
February ...........................................
March ...............................................
Debit
-0$1,200
-0$1,200
Credit
$21,200
14,840
19,080
$55,120
In its financial statements for the quarter ended March 31, 1998, Taft's sales revenue and
sales taxes payable would be
Sales
Sales Taxes
Revenue
Payable
a. $55,120
$3,120
b. $53,920
$1,200
c. $52,000
$3,120
d. $52,000
$1,920
Answer: (d) The amount reported for sales revenue should include amounts charged customers
when inventory is sold, but it should exclude amounts collected for sales taxes. To determine the
correct amount for sales revenue, Taft must divide the total of sales and sales taxes by 100%
plus the sales tax percentage (6%), as indicated below:
Month
January
February
March
Total
Total
$ 21,200
$ 14,840
$ 19,080



Percentage
1.06
1.06
1.06
Sales Revenue
$ 20,000
14,000
18,000
$ 52,000
Sales taxes payable would include all sales taxes collected, less any sales taxes already
remitted.
January sales taxes ($21,200 - $20,000) ................................
$ 1,200
February sales taxes ($14,840 - $14,000) ..............................
840
March sales taxes ($19,080 - $18,000) ...................................
1,080
Total ........................................................................................
3,120
Less taxes remitted for January sales .....................................
(1,200)
Sales taxes payable ................................................................
$1,920
Chapter 15
-22/27-
Short-Term Liabilities
2. In March 1998, an explosion occurred at Nilo Company's plant, causing damage to area
properties. By May 1998, no claims had yet been asserted against Nilo. However, Nilo's
management and legal counsel concluded that it was reasonably possible that Nilo would be
held responsible for negligence and that $1,500,000 was a reasonable estimate of the
damages. Nilo's $2,500,000 comprehensive public liability policy contains a $150,000
deductible clause. In Nilo's December 31, 1997 financial statements, for which the auditor's
field work was completed in April 1998, how should this casualty be reported?
a. As a footnote disclosing a possible liability of $1,500,000.
b. As in accrued liability of $150,000.
c. As a footnote disclosing a possible liability of $150,000.
d. No footnote disclosure or accrual is required for 1997 because the event occurred in 1998.
Answer: (c) Per SFAS 5, a loss contingency should he accrued if it is probable that a liability
has been incurred at the balance sheet date and the amount of the loss is reasonably
estimable. Although this contingency is reasonably estimable, it is not probable. Therefore,
no loss is accrued. However, since the contingency is reasonably possible, it will be disclosed
in the footnotes to the 12/31/97 financial statements. The possible loss will be disclosed as
$150,000. The additional potential liability above the deductible would be covered by the
insurance policy, and would not be a loss for Nilo.
3. The following information relating to compensated absences was available from Graf
Company's accounting records at December 31, 1998.
 Employees' rights to vacation pay vest and are attributable to services already rendered.
Payment is probable, and Graf's obligation was reasonably estimated at $220,000.
 Employees' rights to sick pay benefits do not vest but accumulate for possible future use.
The rights are attributable to services already rendered, and the total accumulated sick
pay was reasonably estimated at $100,000.
What amount is Graf required to report as the liability for compensated absences in its
December 31, 1998, balance sheet?
a. $320,000.
b. $220,000.
c. $100,000.
d. $0.
Answer: (b) SFAS No. 43 states that accrual of a liability for future vacation pay is required if
all of the conditions below are met:
1. Obligation arises from employee services already performed.
2. Obligation arises from vesting or accumulation of rights.
3. Payment is probable.
4. Amount can be reasonably estimated
These criteria are met for the vacation pay ($220,000). Accrual for sick pay is not required in
this case, however, because the third condition (probable payment) is not specified in the
problem. Therefore, the proper amount of the liability to be reported is $220,000.
4. Ruhl Company grants all employees two weeks' paid vacation for each full year of
employment, up to six weeks. Unused vacation time can be accumulated and carried forward
to succeeding years and will be paid at the salaries in effect when vacations are taken or when
employment is terminated. There was no employee turnover in 1998. Additional information
relating to the year ended December 31, 1998 is:
Chapter 15
-23/27-
Short-Term Liabilities
Liability for accumulated vacations at 12/31/97 ..................................
Pre-1998 accrued vacations taken from 1/1/198 to 9/30/98 (the
authorized period for vacations) ....................................................
Vacations earned for work in 1998 (adjusted to current rates).............
$50,000
30,000
40,000
Ruhl granted a 10 percent salary increase to all employees on October 1, 1999, its annual
salary-increase date. For the year ended December 31, 1998, Ruhl should report vacation pay
expense of
a. $42,000.
b. $45,000.
c. $60,000.
d. $70,000.
Answer: (a) Per SFAS No. 43, an employer is required to accrue a liability for employees'
rights to receive compensation for future absences, such as vacations, when certain
conditions are met. The Statement does not, however, specify how such liabilities are to be
measured. Since vacation time is paid by Ruhl Co. at the salaries in effect when vacations
are taken or when employment is terminated, Ruhl adjusts its vacation liability and expense
to current salary levels. Ruhl's 1998 vacation pay expense consists of vacations earned for
work in 1998 (adjusted to current rates) of $20,000 plus the amount necessary to adjust its
pre-1998 vacation liability for the 10% salary increase. The amount of this adjustment is
equal to ten percent of the pre-existing liability balance at December 31, 1998 [($50,000 $30,000) x .10 = $2,000]. Therefore, total vacation pay expense for the period is equal to
$42,000 ($40,000 + 2,000).
P 15-8 Compensated Absences: Entries and Reporting Aloha Company has a personnel
policy that allows each employee with at least one year's employment 20 days vacation time and
two holidays with regular pay. Unused days are carried over to the next year. If not taken during
the next year, the vacation and holiday times are lost. Aloha's accounting period ends December
31.
At the end of 1999, the personnel records showed the following:
Vacations Carried over to 2000
Total Days
Total Salaries
70
$16,800
Holidays Carried over to 2000
Total Days
Total Salaries
10
$2,580
During 2000, all of the 1999 vacation time and eight days of the holiday time, which were carried
over, were taken. Salary increases in 2000 for these employees relating to the days carried over
amounted to $1,600. Total cash wages paid: 1999, $1,780,000; 2000, $1,860,000.
Required:
1. Give all of the entries for Aloha Company related to vacations and holidays during 1999 and
2000. Disregard payroll taxes.
2. Show how the effects of the above transactions should be reported on the 1999 and 2000
financial statements of Aloha.
Chapter 15
-24/27-
Short-Term Liabilities
Answers:
Requirement 1
During 1999-Record payroll in usual manner:
Salary expense ...........................................................
Cash .....................................................................
1,780
1,780
December 31, 1999—Adjusting entry to accrue vacation and holiday time
carried over:
Salary expense ($16,800 + $2,580) ...........................
19,380
Liability for compensated absences .....................
19,380
During 2000—To record payment of 1999 vacation and holiday time
carried over to 2000:
Liability for compensated absences ...........................
19,390
Salary expense ($1,860,000 - $19,380) ..................... 1,840,620
Cash .....................................................................
1,860,000 *
* These amounts already include the $1,600 salary increase. See instructional note.
Requirement 2
1999
Income statement:
Salary expense ...........................................
Balance sheet:
Liability for compensated absences ..........
2000
$1,799,380 ** $1,840,620 ***
19,380
—
** $1,780,000 + $19,380 = $1,799,380
*** $1,860,000 - $19,380 = $1,840,620
Instructional note—Because some employees did not take two vacation days it had the effect of
reducing salary expense in 2000; the implicit entry is: debit liability for compensated absences
and credit salary expense.
A 15-1 Analysis of Current Liabilities Listed below are the current liability section and note
7 of the 1995 balance sheet of Amoco Corporation, a major oil firm.
1995
1994
Current liabilities
(millions of dollars)
Current portion of long-term obligations ......... $ 196
$ 94
Short-term obligations ......................................
226
112
Accounts payable .............................................
2,496
2,217
Accrued liabilities ............................................
948
1,124
Taxes payable (including income taxes) ..........
672
665
$4,538
$4,212
Chapter 15
-25/27-
Short-Term Liabilities
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
7. Short-Term Obligations
Amoco's short-term obligations consist of notes payable and commercial paper.
Notes payable as of December 31, 1995, totaled $36 million at an average annual
interest rate of 5.7 percent, compared with $7 million at an average annual
interest rate of 5.7 percent at year-end 1994. Commercial paper borrowings at
December 31, 1995, were $699 million at an average annual interest rate of 5.7
percent compared with $217 million at an average annual interest rate of 5.9
percent as of December 31, 1994.
Bank lines of credit available to support existing commercial paper
borrowings of the corporation amounted to $490 million at both December 31
1995 and 1994. All of these were supported by commitment fees.
The corporation also maintains compensating balances with a number of
banks for various purposes. Such arrangements do not legally restrict withdrawal
or usage of available cash funds. In the aggregate, they are not material in
relation to total liquid assets.
Required:
1. What amount of Amoco's long-term debt reflected in its current liabilities did Amoco pay off
in 1995?
2. Explain the origin of the $196 million figure.
3. During 1995, did Amoco reduce its average yearly interest requirements on its short-term
obligations described in note 7? Do you observe any interesting issues you might want to
learn more about? If so, what are they?
4. Do the lines of credit that Amoco holds at the end of 1995 appear as liabilities on its balance
sheet? Explain.
Answers:
Requirement 1
The company paid $94 million in 1995. They may also have elected to pay off additional longterm debt, but this is not disclosed.
Requirement 2
The $196 million is the portion of Amoco's long-term debt coming due in 1996 and which the
company expects to pay of off in 1996. This portion of the debt is shown as a current liability.
Requirement 3
The company increased its average interest obligations because short-term borrowings increased
even though the interest rates on the commercial paper declined. One might ask why commercial
paper was used in 1994 given that the interest rate was 5.9 versus 5.7 on notes.
Requirement 4
Lines of credit are not obligations of Amoco. The commitment fees to hold open these fines of
credit, which permit borrowing on demand, are expensed in the year they are due to the bank. It
would be useful to know the amounts required as compensating balances, as this is cash that
Chapter 15
-26/27-
Short-Term Liabilities
cannot be used in operations. For large firms, such as Amoco, these amounts are likely to be
immaterial.
A 15-3 An Unknown Company's Current Liabilities The following is the liability section of a
corporation's 1995 annual financial statement:
December 31
1995
1994
Liabilities
(millions)
Noninterest-bearing deposits in US offices ..................................... $13,388
$13,648
Interest-bearing deposits in US offices............................................
36,700
35,699
Noninterest-bearing deposits in offices outside the United States ..
8,164
7,212
Interest -bearing deposits in offices outside the United States ........ 108,879
99,167
Total deposits ............................................................................ $167,131 $155,726
Trading account liabilities (Note 1)* ...............................................
18,274
22,382
Purchased funds and other borrowings (Note 1)* ...........................
16,334
20,907
Acceptances outstanding .................................................................
1,559
1,440
Accrued taxes and other expenses (Note 8)* ..................................
5,719
5,493
Other liabilities ................................................................................
9,767
8,878
Long-term debt (Note 1)*................................................................
17,151
16,497
Subordinated capital notes (Note 1)* ..............................................
1,337
1,397
* The notes are not reproduced here.
Required:
1. What is unusual about the items included in the disclosure?
2. What do you believe would be included in "purchased funds and other borrowings"?
3. What type of corporation is this? How do you know?
Answers:
Requirement 1
First, there is no separate section for long-term liabilities. This should be a clue that the issuing
firm is a bank. Also, the liabilities include preferred stock.
Requirement 2
The content is shown in Note 1 of the company's report (not reproduced here). Perhaps the
reader could guess that this account includes:
a. Federal funds Purchased and securities is ties sold under repurchase agreements
b. Commercial paper issued by the parent company's and the Student Loan Corp.
c. Other borrowed funds
Requirement 3
This liability section is from Citicorp's, a major financial institution, 1995 balance sheet. This
corporation is a bank, which can be seen by the nature of the majority of its liabilities, that is,
deposits. Also, since the liabilities are not classified as to current or noncurrent, the reporting is
consistent with the format for financial institutions.
Chapter 15
-27/27-
Short-Term Liabilities
CHAPTER 16: LONG-TERM LIABILITIES
2. What are the primary distinctions between a debt security and an equity security?
Answer: The primary distinctions between debt and equity securities are:
a. Debt security—fixed principal and interest; no voting privileges; fixed maturity date; cash flow
dates and amounts are fixed.
b. Equity security—no fixed principal and interest; voting privileges (common stock); fixed cash flow
amounts and dates.
3. Explain the difference between the stated rate of interest and the effective rate on a long-term debt
security.
Answer: Stated rate of interest—contractual rate specified on the debt instrument; it determines the
amount of cash interest each interest period.
The effective rate of interest is the true interest rate on a debt security. It is determined by the market
and it is based on the resources received currently and the future resource flows. The effective rate is
often called the market rate of interest.
5. Briefly explain the effects on interest recognized when the stated and effective rates of interest are
different.
Answer: An effective interest rate above the stated rate causes a discount and the opposite cause, a
premium on the debt. A discount increases interest reported on the income statement and a premium
decreases interest reported on the income statement (compared with the effects of the stated rate).
8. What are the principal advantages and disadvantages of bonds versus common stock for (a) the issuer
and (b) the investor?
Answers:
a. From the issuer's point of view, a primary advantage of bonds versus common stock is that
interest payments are deductible as an expense for income tax purposes, whereas dividends paid
are not. The disadvantages are that interest payments on bonds constitute a legal and fixed
obligation that must be paid in cash, whereas dividends on common stock are paid only when
sufficient funds and retained earnings are available, and that bonds have a specific maturity date
but capital stock does not. Issuers expect to earn a higher rate of return on their investment (than
the return paid on bonds) to satisfy stockholders.
b. From the investor's point of view, bond investments usually have not been considered as good a
hedge against inflation as capital stock investments. Each investor weighs whether the
guaranteed fixed interest rate and maturity amount, or the potential for dividends and increase in
stock prices would be more advantageous. Stock investments usually are considered to be more
risky.
9. Distinguish between the par amount and the price of a bond. When are they the same? When
different? Explain.
Answers:
The face (i.e., par) amount of a bond is the maturity amount specified on the bond certificate.
The bond price represents the present value of the future cash flows (principal plus all interest
payments) at the effective rate of interest.
The face amount of bond and its price are the same if the bond has the same stated and effective
rates of interest when issued; otherwise, they will be different.
Chapter 16
-1/17-
Long-Term Liabilities
14. Under GAAP, when is it appropriate to use the (a) straight-line and (b) interest method of'
amortization for bond discount or premium?
Answer: Under generally accepted accounting principles (GAAP), it is acceptable to use the straightline method only if its results are not materially different in amount from the results produced by the
interest method. Otherwise, the interest method must be used.
18. Why is the accounting different for nonconvertible bonds with detachable stock purchase warrants
and nonconvertible bonds with nondetachable stock purchase warrants?
Answer: A detachable stock purchase warrant is separable from the nonconvertible bond to which it
relates; therefore, the warrants can be sold separately in the market. An objective valuation of the
bonds and the warrants separately can be made, making possible separate recording and reporting
of the debt and equity components.
In accounting for nonconvertible bonds with nondetachable stock purchase warrants, separate
accounting for debt and equity is not feasible due to the inseparability of the two different securities
(there will be no separate market for either the bond or the warrants). It is difficult to objectively assign
the amounts that should be allocated between the debt and equity components.
24. Interest rates have increased since a company issued its bonds. Why would the firm want to refund
the bonds with another issue of' bonds paying a higher rate?
Answer: When interest rates rise, the market value of bonds decreases, allowing the refunding of the
older bond issue at a gain, thus increasing earnings.
25. A firm retired a bond issue early at a loss. Is the firm in an economically worse position after the
retirement?
Answer: This question does not have a definite answer. However, the firm would not have retired the
bonds if it were not in its best interest. Also, the firm paid the market value of the bonds. Therefore,
one could argue that they are in an equivalent position before and after the retirement. In addition, the
loss occurred because interest rates have fallen. The firm may take this opportunity to issue lower
rate debt, reduce its future interest costs, and extend the maturity of its debt. This argument suggests
the firm is in a better economic position after the retirement.
27. Explain the classification of gains and losses from troubled debt restructuring.
Answer: In a settlement the debtor records a gain and the creditor a loss. The debtor's gain is
reported as extraordinary while the creditor's losses are reported as ordinary, unusual or infrequent,
or extraordinary in conformity with GAAP (as specified in APB 30). The debtor also has a gain in a
modification of terms if the sum of restructured flows is less than the debt book value.
28. Differentiate between a debt restructure in which debt is settled and one in which it continues after the
restructure.
Answer: In a debt restructure the agreement relaxes the payment requirements on the debtor. There
are two cases, as follows: (a) the debt is settled in full by the transfer of assets or equity interests of
the debtor that have a value below the carrying value of the debt (i.e., a concession); (b) the debt
provisions are relaxed for timing, interest, or principal (or any combination). In this case the debt
continues under the terms of the debt restructure.
Chapter 16
-2/17-
Long-Term Liabilities
E16-1 Bonds: Issue above, at and below Par Rowe Corporation authorized $600,000 of 8 percent
(interest payable semiannually), 10-year bonds. The bonds were dated January 1. 1998; interest dates are
June 30 and December 31.
Assume four different cases with respect to the sale of' the bonds: Case A-Sold on January 1, 1998 at
par; Case B—Sold on January 1, 1998 at 102; Case C—-Sold on January 1, 1998 at 98; Case D—Sold on
March 1, 1998 at par.
Required:
1. For each case, what amount of cash interest will be paid on the first interest date. June 30, 1998?
2. In what cases will the effective rate of interest be (a) the same, (b) higher, or (c) lower than the stated
rate?
3. After sale of the bonds, and prior to maturity date, in what cases will the carrying or book value of the
bonds (as reported on the balance sheet) be (a) the same, (b) higher, or (c) lower than the maturity or
face amount?
4. After the sale of the bonds, in Cases A, B and C, which case will report interest expense (a) the same,
(b) higher, or (c) lower than the amount of cash interest paid each period?
Answers:
Requirement 1
For all cases. cash interest paid each interest date will be: $600,000 x 4% = $24,000.
Requirement 2
The effective rate is the same as the stated rate in Cases A and D because the bonds sold at par. The
effective rate is higher than the stated rate in Case C because the bonds sold at a discount. The effective
rate is lower than the stated rate in Case B because the bonds sold at a premium
Requirement 3
After the sale of the bonds and prior to maturity date, the carrying or book value of the bonds will be the
same as the maturity or face amount in Cases A and D (sold at par); in Case B (sold at a premium). the
carrying or book value will be higher than the maturity or face amount, and in Case C (sold at a discount).
the carrying or book value will be lower than the maturity or face amount.
Requirement 4
Case A will report the same amount for interest expense and cash interest paid (sold at par); in Case B,
the amount of interest expense will be lower than the cash interest paid (sold at a premium); and in Case
C,. the amount of interest expense will be higher than the cash interest paid (sold at a discount).
E 16-5 Bonds at a Premium, Accrued Interest: Straight Line On September 1, 1998, Golf Company
issued to Youngblood Company $30,000, five-year, 9 percent (payable semiannually) bonds for $32,320
plus accrued interest. The bonds were dated July 1, 1998, and interest is payable each June 30 and
December 31. The accounting period for each company ends on December 31.
Required: In parallel columns, give entries for the issuer and the investor for the following dates:
September 1, 1998; December 31, 1998; and June 30, 1999. Assume that the difference between the
Chapter 16
-3/17-
Long-Term Liabilities
interest method and straight-line method amortization amounts is not material; therefore, use straight-line
amortization. Youngblood intends to hold the bonds to maturity.
Answer:
Issuer-Golf Company
investor-Youngblood Company
September 1, 1998:
Cash ............................. 32,770
Bonds payable .....................
Interest payable ...................
Premium on bonds
payable .............................
30,000
450 *
32,320
450
Cash ................................
Investment in bonds
Interest revenue ......
Interest receivable ..
1,350
160
Cash ................................
Investment in bonds
Interest revenue ......
1,350
240
32,770
2,320
*Accrued interest
($30,000 x 4½ x 2/6)
Price of bonds
Total cash
December 31, 1998:
Interest payable ...................
Interest expense ..................
Premium on bonds
payable .............................
Cash ...........................
Investment in bonds .........
Interest receivable ............
Cash ........................
$ 450
32,320
$32,770
450
740
160
750
450
1,350
$2,320 x 4/58 = $160 (Amortization period:
5 years minus 2 months = 58 months).
$30,000 x 4½% = $1,350.
June 30, 1999:
Interest expense ..................
Premium on bonds
payable .............................
Cash ...........................
1,110
240
1,110
1,350
E 16-6 Bonds, Accrued Interest, Issuer Entries: Straight Line Ryan Corporation sold and issued
$75,000 of three-year, 8 percent (payable semiannually) bonds payable for $78,200 plus accrued interest.
Interest is payable each February 28 and August 31. The bonds were dated March 1, 1998, and were sold
on July 1, 1998. The accounting period ends on December 31.
Required:
1. How much accrued interest should be recognized at date of sale?
2. How long is the amortization period?
3. Give entries for Ryan Corporation through February 1999. Use straight-line amortization.
4. Would the above amounts also be recorded by the investor if the intent was to hold the bonds to
maturity? Explain.
Chapter 16
-4/17-
Long-Term Liabilities
Answers:
Requirement 1
Accrued interest for March-June: $75,000 x 4% x 4/6 = $2,000.
Requirement 2
Amortization period: 3 years - 4 months = 32 months.
Requirement 3
Gross method and straight-line amortization:
July 1, 1998:
Cash ..........................................................................................
Bonds payable. ....................................................................
Premium on bonds payable .................................................
Interest payable (per Requirement 1) ..................................
*Price of bond ..........................................
Accrued interest per (1) ...........................
Cash ........................................................
80,200 *
75,000
3,200
2,000
$78,200
2,000
$80,200
August 31, 1998:
Interest payable .............................................................................
Interest expense ............................................................................
Premium on bonds payable ...........................................................
Cash .....................................................................................
2,000
800
200
3,000
$75,000 x 4% = $3,000.
$3,200 x 2/32 = $200 (amortization for July and August).
December 31, 1998 (adjusting entry):
Interest expense ............................................................................
Premium on bonds payable ...........................................................
Interest payable ...................................................................
1,600
400
2,000
$75,000 x 4% x 4/6 = $2,000.
$3,200 x 4/32 = $400 (amortization for September
through December).
February 28, 1999:
Interest expense ............................................................................
Premium on bonds payable ($3,200 x 2/32) .................................
Interest payable .............................................................................
Cash ..........................................................................................
800
200
2,000
3,000
Requirement 4
Yes, the above amounts would be recorded by the investor in the accounts that parallel those for the
issuer, Ryan Corporation. Asset and revenue accounts would be used instead of liability and expense
accounts.
Chapter 16
-5/17-
Long-Term Liabilities
E16-9 Multiple Choice Accounting for Bonds Choose the correct answer for each question.
1. A 6 percent bond issue has nine semiannual interest periods remaining in its term. Each $1,000 bond
in the issue was sold to yield 10 percent. The bonds were sold at 79 between interest dates. What is
the current book value under the interest and straight-line methods of amortization, as measured in
percentage of face value?
Interest Method
Straight-Line Method
a.
91.2
97.3
b.
85.8
Cannot be determined
c.
101.5
85.8
d.
87
Cannot be determined
Answer: b. Interest method book value
=
=
=
$1,000(PV1, .05, 9)
$1,000 (.64461)
$858
+
+
$30 (PVA, .05, 9)
$30 (7.10782)
The SL Method book value cannot be determined because the bond term is not given.
nor is the amount of the bond term expired as of the current date. Therefore, the amount
of unamortized discount remaining, or the amount of discount amortized to the current
date, cannot be determined.
2. On July 1, 1998, Center Company paid $599,000 for 10 percent, 20-year bonds with a face value of
$500,000. Interest is paid on December 31 and June 30. The bonds were purchased to yield 8 percent.
Center uses the interest method to recognize interest income from this investment. What is the
carrying amount of this investment in bonds in Center's December 31, 1998 balance sheet if Center
intends to hold the bonds to maturity?
a. $603,950.
b. $599,000.
c. $597,960.
d $596,525.
Answer: c.
Cost of investment ............................................................
Cash interest received 12/31/98 [(.05) ($500,000)] ..........
Interest revenue for 1998 [(.04) ($599,000)] ....................
Amortization of premium (reduces investment account) ..
December 31,1998 carrying amount ................................
$599,000
25,000
23,960
1,040
$597,960
3. Delia Company incurred costs of $6,600 when it issued, on August 31, 1998, five-year debenture
bonds dated April 1, 1998. What amount of bond issue expense should Delia report in its income
statement for the year ended December 31, 1998?
a. $440
b. $480
c. $990
d. $6,600
Answer: b. The bond term is 4 years, seven months, or 55 months. Bonds were outstanding 4
months in 1998. Amortization of issue costs in 1995: $6,600 (4/55) = $480.
4. The following information pertains to Hike Tours, Inc., issuance of bonds on July 1. 1998:
Face amount .....................................
Term .................................................
Stated interest rate ............................
Chapter 16
-6/17-
$400.000
10 years
6%
Long-Term Liabilities
Interest payment dates ..................... Annually on July 1
Yield ................................................
9%
What is the issue price for each $1,000 bond?
a. $1,000.
c. $807.
b. $864.
d. $700.
Answer: c. Total issue price = $1,000 (PV1, 9%, 10) + .06 ($1,000)(PVA, 9%, 10) =
$1,000 (.42241) + $60 (6.41766) = $807.
E16-11 Nonconvertible Bonds with Detachable Warrants Hardware Corporation issued $75,000 of 6
percent, 10-year, nonconvertible bonds with detachable stock purchase warrants. Each $1,000 bond
carried 20 detachable warrants, each of which was for one share of Hardware common stock, par $20, at a
specified option price of $60. The bonds sold at $102 including the warrants (no bond price ex-warrants
was available), and immediately after date of issuance the detachable stock purchase warrants were
selling at $4 each. The entire issue was acquired by Software Company as a long-term investment with
the intent to hold to maturity. All indicated transactions occurred in the same fiscal year.
Required:
1. Give entries for both the issuer and the investor at date of acquisition of' the bonds.
2. Give the entry for the investor assuming a subsequent sale of all of the warrants to another investor at
$5.50 each.
3. Disregard (2). Give the entries for the issuer and the investor assuming subsequent tender of all of the
warrants by the investor for exercise at the specified option price. At this date, the stock was selling at
$75 per share.
Answers:
Requirement 1
Issuer- Hardware Corporation
Cash ..............................
Discount on bonds
payable ......................
Bonds payable .....
Detachable stock
purchase warrants
outstanding
(1,500) ..............
Investor- Software Corporation
76,500 *
Bond investment ...........
Investment—detachable
stock purchase
warrants (1,500 x $4) .
Cash ....................
4,500
75,000
70,500
6,000
76,500
6,000 **
* $75,000 x 1.02 = $76,500
** 75 bonds x 20 warrants per bond x $4
= $6,000
Chapter 16
-7/17-
Long-Term Liabilities
Requirement 2
Issuer- Hardware Corporation
Investor- Software Corporation
No entry
Cash ..............................
Investment—
detachable stock
purchase warrants
(1,500 x $4) ......
Gain on sale of
stock purchase
warrants ...........
8,250
6,000
2,250 *
* 1,500 x ($5.50 - $4.00) = $2,250
Requirement 3
Issuer- Hardware Corporation
Cash (1,500 shares .......
$60 option price) ........
Detachable stock
purchase warrants
outstanding
(1,500 x $4) ................
Common stock
(1,500 shares x
$20 par) ............
Contributed capital in
excess of par ....
Investor- Software Corporation
Investment in common
stock ..........................
Investment
detachable stock
purchase warrants
(1,500 x $4) ......
Cash (1,500 x $60).
90,000
6,000
96,000
6,000
90,000
30,000
66,000
E16-27 Long-Term Note: Unrealistic Rate. Debtor and Creditor Cathy Company purchased a
machine at the beginning of 1998 with a three-year, $2,000, 5 percent note, payable in three equal annual
payments of $734 (including principal and interest) at each year-end The current market rate of interest
for this level of risk was 12 percent.
Required:
1. What was the cost of the machine to Cathy Company?
2. Give the entry by Cathy to record the purchase. Use the net approach.
3. Prepare the amortization schedule for the note.
4. Give the entries for both the debtor and the creditor at the end of each year (assuming that the
accounting year-end for the debtor and creditor coincides with the note's year-end).
Answer:
Requirement 1
Cost of the machine (rounded to (he nearest dollar):
$734 x (PVA, 12%, 3) (2.40183) = $1,763.
Chapter 16
-8/17-
Long-Term Liabilities
Requirement 2
Entry to record the purchase (net basis):
Machine ......................................................................
Note Payable ....................................................
1,763
1,763
Requirement 3
Amortization schedule:
Date
1998 (start) .......
1998 (end) ........
1999 (end) ........
2000 (end) .......
Total ...........
Cash
Payment
$ 734
734
734
$2,202
Interest (at 12%)
$1,763 x 12%
1,241 x 12%
656 x 12%
=
=
=
Reduction of
Principal
$212
149
80 *
$441
$ 522
585
656
$1,763
Principal
Balance
$1.763
1,241
656
-0-
*Rounded.
Requirement 4
Entries at year end:
1998
Debtor:
Note payable ...........................................
Interest expense ......................................
Cash ..............................................
Creditor:
Cash .......................................................
Note receivable .............................
Interest revenue ............................
Chapter 16
1999
522
212
585
149
734
734
656
80
734
734
522
212
-9/17-
2000
734
734
585
149
656
80
Long-Term Liabilities
E16-28 Appendix 16A: Multiple Choice-Troubled Debt Restructure Choose the correct answer for
each question.
1. Nano Corporation agreed to give Rewind Company a machine in full settlement of a note payable to
Rewind. The machine's original cost was $70,000. The note's face amount was $55,000. On the date
of the agreement,
• The note's carrying amount was $52,500 and its present value at the current market rate was
$48,000.
• The machine's carrying amount was $54,500, and its fair value was $48,000.
What amounts of gain (loss) should Nano recognize, and how should these be classified in its income
statement?
Extraordinary
Other
a.
$(2,000)
$0
b.
0
(2,000)
c.
2,500
(2,000)
d.
4,500
(6,500)
Answer: d.
Note carrying value ...........................................................
Machinery fair value..........................................................
Extraordinary gain on debt restructure .............................
$52,500
48,000
$4,500
Machinery carrying value ..................................................
Machinery fair value..........................................................
Loss on disposal ...............................................................
$54,500
48,000
$6,500
2. Wild Company. a debtor-in-possession under Chapter 11 of the Federal Bankruptcy Code, granted an
equity interest to a creditor in full settlement of a $56,000 debt owed to the creditor. At the date of
this transaction. which is considered an isolated transaction with respect to the bankruptcy
proceedings, the equity interest had a fair value of $50,000. What amount should Wild recognize as in
extraordinary gain on restructuring of debt?
a. $0.
b. $6,000.
c. $50,000.
d. $56,000.
Answer: b.
Debt book value ................................................................
Fair value of equity interest ..............................................
Extraordinary gain on debt restructure .............................
$56,000
50,000
$6,000
3. During 1998, Camellia Company experienced financial difficulties and was likely to default on a
$500,000, 15 percent, three-year note dated January 1, 1997, payable to Central National Bank. On
December 31, 1998, the bank agreed to settle the note and unpaid 1998 interest of $75,000 for
$410,000 cash payable on January 31, 1999. What is the amount of gain, before income taxes. from
the debt restructuring?
a. $0.
b. $75,000.
c. $90,000.
d. $165.000.
Answer: d.
Chapter 16
Debt book value ................................................................
Cash paid ..........................................................................
Extraordinary gain on debt restructure .............................
-10/17-
$575,000
410,000
$165,000
Long-Term Liabilities
4. In 1993, Marie Corporation acquired land by paying $37,500 down and signing a note with a maturity
value of $500,000. On the note's due date, December 31, 1998, Marie owed $20,000 of accrued
interest and $500,000 principal on the note. Marie was in financial difficulty and was unable to make
any payments. Marie and the bank agreed to amend the note as follows:
• The $20,000 of interest due on December 31, 1998 was forgiven.
• The principal of the note was reduced from $500,000 to $475,000, and the maturity date was
extended one year to December 31, 1999.
• Marie would be required to make one interest payment totaling $15,000 on December 31, 1999.
As a result of the troubled debt restructuring Marie should report a gain, before taxes, in its 1998
income statement of
a. $20,000.
b. $25,000.
c. $30,000.
d. $45,000.
Answer: c.
Debt book value ................................................................
Sum of restructured cash flows ........................................
Extraordinary gain .............................................................
* $475,000 - $15,000
$520,000
490,000 *
$30,000
E16-31 Appendix 16A: Restructure. Modification of Terms, Compute New Interest Rate, Entries
for Both Parties Brown Company owed City Bank a $50,000, 10 percent (payable each December 31),
four-year note dated January 1, 1995. Early in 1996, it became clear that Brown Company was
experiencing difficulty in making the annual interest payment, although the company did manage to make
the 1995 payment. Because of expected continuing difficulties, it appeared that there was a good chance
the company would default on the note (as well as on other obligations). On January 2, 1997 the two
parties agreed to restructure the debt by (a) reducing the remaining annual interest payments to $2,240
each and (b) reducing the principal amount (maturity amount) to $48,000. Brown paid the interest for
1996.
Required:
1. Compute the new yield or effective rate of interest to be used by Brown.
2. Give all entries required on date of restructure (January 2, 1997) for each company. If no entry is
required, explain the reason.
3. Give all entries required at December 31, 1997, and 1998, for each company. Assume that City Bank
uses the interest method
Answers:
Requirement 1
To determine the new effective rate, it is necessary to find the rate that causes the prerestructure carrying
value of the debt ($50,000) to equal the present value of the future cash flows (principal, $48,000 and the
interest payments of $2,240 each. Thus:
$50,000 = $48,000 (PV1, ?, 2) + $2,240 (PVA, ?, 2)
Chapter 16
-11/17-
Long-Term Liabilities
Present Value at
2%
Principal:
$48,000 x PV1 table for n=2
Interest:
$2,240 x PVA table for n=2
(2%
(2½%
(3%
=
=
=
.96117)
.95181)
.94260)
$46,136
(2%
(2½%
(3%
= 1.94156)
= 1.92742)
= 1.91347)
4,349
Total Present Value
2-½
3%
$45,687
45,245
______
$50,485
4,317
______
$50,004
4,286
$49,531
The new effective rate of interest is almost exactly 2½%.
Requirement 2
Brown Company
January 2, 1997, date of restructure—No entry is required by Brown because the total cash to be paid
($48,000 + $4,480 = $52,480) exceeds the prerestructure carrying value of the debt ($50,000). However,
Brown could choose to reclassify the note as restructured. The new note payable account balance is
$50,000.
City Bank
January 2, 1997, date of restructure, City Bank records a loan impairment.
New note carrying value
=
=
$48,000 (PV1, 10%, 2) + $2,240 (PVA, 10%, 2)
$48,000 (.82645) + $2,240 (1.73554) = $43,557
Bad debt expense ($50,000 - $43,557) ............................
Allowance for decline in note value .....................
Chapter 16
-12/17-
6,443
6,443
Long-Term Liabilities
Requirement 3
Brown Company (debtor)
December 31, 1997:
Interest expense ........
1,250
Note payable ..............
990
Cash ....................
$50,000 x 2½% = $1,250
$2,240 - $1,250 = $990
December 31, 1998 (maturity date):
Interest expense ........
1,225
Note payable ..............
1,015
Cash ....................
($50,000 - $990) x 2½% = $1,225
Note payable ..............
Cash ....................
City Bank (creditor)
Allowance for decline in
note value ..................
Cash ..............................
Interest revenue
(.10)($43,557) .....
2,240
2,116
2,240
4,356
Allowance for decline in
note value ..................
2,327
Cash ..............................
2,240
Interest revenue ..
* ($43,557 + $2,116) (.10)
2,240
4,567 *
48,000 *
48,000
Allowance for decline in
note value ..................
Cash ............................
Note receivable ...
2,000
48,000
50,000
* Cumulative balance: $50,000 - $990 - $1,015 = $47,995.
(Discrepancy of $5 due to inexact rate of 2½%
P16-12 Bond Issuance and Early Retirement, Interest Method Plenary, Inc., issued $100,000 of 8
percent bonds on January 1, 1998, to yield 6 percent. The bonds pay interest each June 30 and December
31, and mature 10 years from issuance. On January 1, 2006, when the bonds were yielding 12 percent.
Plenary retired the bond issue. Plenary uses the interest method.
Required:
1. Provide the entry for bond issuance.
2. Provide the entry for the June 30, 2004 interest payment without using an amortization schedule.
3. Provide the entry for bond retirement.
Answers:
Requirement 1
Issue proceeds =
$100,000 (PV1, .03, 20) + .08 (½) $100,000 (PVA, .03, 20) =
$100,000 (.55368) + .08 (½) $100,000 (14.87747) = $114,878
January 1. 1998
Cash ...........................................................................
Premium on bond payable ...................................
Bonds payable .....................................................
Chapter 16
-13/17-
114,878
14,878
100,000
Long-Term Liabilities
Requirement 2
June 30, 2004 is the end of the 13th semiannual interest period. At January 1, 2004 there are 8 interest
periods remaining.
Book value at January 1, 2004:
$100,000 (PV1, .03, 8) + .08 (½) $100,000 (PVA, .03, 8) =
$100,000 (.78941) + .08 (½) $100,000 (7.01969) = $107,020.
June 30, 2004:
Interest expense ($107,020) (.03) ..............................
Premium on bonds payable .......................................
Cash ($100,000) (.04) .........................................
3,211
789
4,000
Requirement 3
On January 1, 2006, 2 years or 4 semiannual periods remain in the bond term. Book value at January 1,
2006:
$100,000 (PV1, .03, 4) + .08 (½) $100,000 (PVA, .03, 4) =
$100,000 (.88849) + .08 (½) $100,000 (3.71710) = $103,717.
The market value of the bonds on that date is:
$100,000 (PV1, .06, 4) + .08 (½) $100,000 (PVA, .06, 4) =
$100,000 (.79209) + .08 (½) $100,000 (3.46511) = $93,069.
January 1, 2006:
Bonds payable ...........................................................
Premium on bonds payable .......................................
Extraordinary gain, bond retirement ....................
Cash ....................................................................
100,000
3,717
10,648
93,069
C16-5 Liabilities: Off-Balance-Sheet Risk The reported balances of certain liabilities carried on a
corporation's books do not always indicate the maximum obligation potentially facing the firm as a result
of past transactions. In addition, a firm may have potential obligations that are not recorded at all.
Required: For each of the following potential or actual liability items, briefly discuss in writing whether
the firm is subject to off-balance-sheet risk of accounting loss and, if so, whether that risk arises from
credit risk or market risk (or both), and why. Your discussion should be from the point of view of the
company named.
1. Fixed-rate mortgage payable by Wellco, Inc., secured by real estate owned by Wellco.
2. The guarantee by Jolko, Inc., of a $4 million loan obtained by one of Jolko's subsidiaries.
3. Bonds payable issued by Samson, Inc. at a discount, due in five years.
4. Convertible bonds issued by Coastal Company at a premium, due in two years.
5. Transfer of accounts receivable by Jenell Company, accounted for as a borrowing. The transfer is
with recourse to Jenell.
6. Variable-rate mortgage payable by Angeles, Inc., secured by real estate owned by Angeles.
Chapter 16
-14/17-
Long-Term Liabilities
7. A loan commitment made by BCCJ Bank to a computer manufacturer, guaranteeing a fixed line of
credit at a fixed rate of interest for one year from the commitment date.
Answers:
1. A fixed rate mortgage is carried at the present value of remaining future cash flows, discounted at the
effective interest rate at the date the property was mortgaged. The balance correctly reflects the
amount owed by Wellco at the balance date. There is no off-balance-sheet risk in this case because
no additional amounts are due under the contract.
2. Although Jolko probably would disclose the nature of the guarantee anyway, the firm has off-balancesheet risk of accounting loss because its subsidiary may be unable to pay its liability. SFAS No, 107
requires a discussion in the footnotes of Jolko as to the nature and amount of this potential loss,
which arises entirely from credit risk.
3. The balance of the bond payable account reflects the total liability to the issuer; therefore, there is no
additional off-balance-sheet risk of accounting loss.
4. The balance of the convertible bond payable account reflects the total liability to the issuer; therefore,
there is no additional off-balance-sheet risk of accounting loss.
5. Jenell maintains the receivables on its books and records a liability. Provided that the amount of
recourse to Jenell is limited to the amount of the liability recorded, there is no additional off-balancesheet risk of accounting loss in this situation.
6. The recorded mortgage liability reflects the most current interest rate adjustment for Angeles.
Although the interest rate may increase in the future, the balance of the mortgage payable continues
to reflect Angeles' liability, although possibly at a higher interest rate and higher payment than at the
origination of the mortgage. Therefore, there is no off-balance-sheet risk of accounting loss in this
situation.
7. The bank has committed to lending a fixed amount of money to another firm at a fixed rate. The bank
has off-balance-sheet risk of accounting loss from both credit and market risk. The amount of funds
committed represents exposure to credit risk because the computer manufacturer may be unable to
pay this amount in the event the line of credit is used. In addition, if the interest rate rises during the
commitment period, the bank must honor its pledge to loan money at a lower rate, thus incurring
market risk.
A16-3 Convertible Bonds Part of International Paper Company's long-term liability footnote to its 1995
financial statements disclosed the following:
Note 12: Long-Term Debt (millions)
1995
5 3/4% Convertible subordinated debentures
1994
$199
In July 1995, the 5¾ percent debentures were called by the company and converted into 5.8 million shares
of common stock.
Additional information:
1. The average market price per share of the firm's common stock was approximately $40 during 1995.
2. The par value of common stock is $1.
Required
1. Prepare the conversion entry, assuming the book value method is used.
Chapter 16
-15/17-
Long-Term Liabilities
2. Prepare the conversion entry, assuming the market value method.
3. Why might a company prefer to use the book value method? The market value method?
4. Why did the bondholders convert rather than accept the call price?
Answers:
Requirement 1
Convertible bonds ................................................
Common stock ...............................................
Contributed capital in excess of par ..............
199,000,000
5,800,000
193,200,000
Requirement 2
Convertible bonds ................................................
Loss on conversion of bonds ...............................
Common stock (5,800,000)($1) .....................
Contributed capital in excess of par ..............
199,000,000
33,000,000
5,800,000
226,200,000 *
* ($40 - $1) (5,800,000)
Requirement 3
Some firms chose the book value method to avoid recognizing a loss. Frequently, the market price of
stock has risen since the issuance of the convertible bonds such that the total market price of stock
issued exceeds the book value of the bonds convened (as in this case). The resulting loss under the
market value method records the opportunity cost to the firm of issuing the shares due to conversion
rather than for cash. Firms with a goal of income maximization prefer to avoid recognizing this opportunity
cost (for the same reason they wish to avoid recognizing the opportunity cost of employee stock options).
The loss did not cause an out-of-pocket cost to the firm. Their argument is that the loss is not a realized
loss. Also. the opportunity cost as measured by the market value method may be overstated if a
substantial number of shares is issued on conversion, relative to the number outstanding before
conversion.
The market value method would be preferred by firms planning to smooth income or to achieve an
earnings target. In this example, the effectively capitalized retained earnings (in the amount of the aftertax loss) to permanent contributed capital, thereby making that portion of retained earnings unavailable
for future dividends in many jurisdictions.
Requirement 4
The total market value of the stock issued upon conversion is $232 million (5.8 million shares x $40),
which most likely exceeds the amount which would have been paid under the call provision.
A16-5 Long-Term Liabilities Refer to the 1995 financial statements of the Coca-Cola Company that
appear at the end of this text, and respond to the following questions.
1. What was 1995 interest expense for Coca-Cola, and how much interest was paid in 1995?
2. Using 1995 interest expense and only the items listed in the long-term debt footnote, estimate an
average 1995 interest rate using the 1994 balances in long-term debt. What factors might contribute to
this rate's being considerably higher than the average rate implied by the interest rates listed for each
component of long-term debt?
Chapter 16
-16/17-
Long-Term Liabilities
3. What are some of the specific debt issuances contributing to the 1995 statement of cash flows
financing inflow "issuances of debt"?
4. What is the market value of Coke's long-term debt? What does this value imply about the current
market rate of interest relative to the average effective interest rate on Coke's long-term debt?
Answers:
(Amounts in $ millions)
1. From the income statement, $272 of interest expense was recognized, and from footnote 8, $275 was
paid in 1995.
2. The average interest rate using 1995 interest expense and the ending 1994 balance of long-term
debt: $272/$1,461 = 18.6%. The $1,461 figure includes the current portion of long-term debt which
would have been reclassified at year-end.
Yet the items listed in the long-term debt footnote imply 6% - 7% as the average interest rate.
Probably the main factor for the difference is that Coke has a substantial amount of debt other than
that listed under "long-term debt:" loans and notes payable, finance subsidiary notes payable, and
other liabilities. Interest on this debt, including current liabilities, is included in total interest expense
but not in long-term debt as classified by Coke. In footnote 8, the average interest rate on long-term
debt is noted as 6.5%.
Issuance of certain long-term debt items at a discount is a less likely explanation. Although this factor
would explain a higher rate of interest (effective rate exceeding stated rate), the amount of interest
recognized as expense and paid by Coke in 1995 are too similar in amount for this factor to be
significant.
3. The 1995 statement of cash flows indicates that $754 in cash was received from debt issuances. The
balance sheet and foot note 8 provide information about the effects of debt issuances in 1995:
Increase in loans and notes payable $2,371 - $2,048 ................................
Increase in German mark notes $175 - $161 ..............................................
Increase in 6% US dollar notes ...................................................................
$323
14
252
$589
In addition, "other liabilities" increased $111 ($966 - $855). However, the annual report is not
sufficiently detailed to independently corroborate the amount of cash received on debt issuances in
the statement of cash flows.
4. The market rate of long-term debt at the end of 1995 is $1,737 while the carrying value is listed as
$1,693 (footnote 9). This implies a slight decrease in market interest rates relative to the effective rate
at the issuance of Coke's debt. This possible explanation is consistent with the decline in interest
rates in the 1990s.
Chapter 16
-17/17-
Long-Term Liabilities
CHAPTER 17 ACCOUNTING FOR LEASES
QUESTIONS
4. Give the primary GAAP concepts of accounting for an operating lease by lessors and lessees.
Answer: Outline of generally accepted accounting methods for operating leases:
Lessor: Recognize rent revenue for rents earned on accrual basis.
Lessee: Recognize rent expense for lease payments on accrual basis.
5. Advance rental payments often are received under operating lease contracts that extend well beyond a
single fiscal .year. Give the acceptable accounting procedures that should be used for advance rentals.
Answer: Advance rental payments on operating leases should be credited to an unearned revenue
account (rent revenue collected in advance) by the lessor and debited to a prepaid expense account
by the lessee. The amount should be amortized over the term of the lease. Two approaches are
acceptable:
a. Straight line—a constant dollar amount is allocated to each lease period.
b. Interest method—conceptually sound. somewhat more difficult to compute. This approach
allocates the prepayments to the future periods on a constant percent basis per period.
7. From a lessee's standpoint. leases are classified as capital or operating leases. What criteria are used
to identify a capital lease?
Answer: If a lease meets any one of the following criteria. it is a capital lease for the lessee
(otherwise, the lease is an operating lease):
a. The lease transfers ownership of the property to the lessee by the end of the lease term.
b. The lease contains a bargain purchase option.
c. The lease term is equal to 75 percent or more or the estimated economic life of the property.
d. The present value of the minimum lease payments at the inception of the lease is equal to at
least 90 percent of the market value of the property.
8. From a lessor's view. a capital lease involves two types of leases. Identify the types and
distinguish between them.
Answer: From a lessor’s view. the types of leases are: direct financing and sales-type lease. The
basic difference between a sales-type lease and a direct finance lease is that in a direct financing
lease, the lessor recognizes only one kind of revenue—interest at each rental date. In contrast; in a
sales-type lease. the lessor recognizes two kinds of revenue—(1) manufacturer's or dealer's profit (at
lease inception date) and (2) interest revenue at each rental date.
10. How does a lessee determine what interest rate is appropriate for capitalization of a lease?
Answer: A lessee should use the lessee's incremental borrowing rate if. at the time the lease is
negotiated, the lessor's implicit rate for the lease is known and is higher than the lessee's incremental
borrowing rate. Incremental borrowing rate means the interest rate a lessee would have to pay to
borrow funds to finance acquisition of the leased property.
12. Briefly explain how inclusion of a provision of residual value guaranteed by a third party In a capital
lease can result in asymmetric accounting by lessor and lessee.
Answer: There are two cases to consider. First. the inclusion of guaranteed residual value by a third
party will make the minimum lease payments differ between the lessor and lessee. If the lease still
qualifies as a capital lease for both lessor and lessee. journal entries will be symmetrical but amounts
Chapter 17
-1/20-
Accounting for Leases
will differ (the lessor includes the guaranteed residual value in minimum lease payments, but the
lessee does not).
The second case arises when the lease does not meet any of the first three criteria given in the text in
Exhibit 17-2 for a capital lease. Inclusion of guaranteed residual value by a third party may make the
lease a capital lease for the lessor (it meets criterion 4 of Exhibit 17-2) because the present value of
the lease payments (including the guaranteed amount) exceeds 90 percent of the market value of the
asset at lease inception. However. the lease may not satisfy criterion 4 for the lessee because the
present value of the lease payments (excluding the guaranteed amount) does not exceed 90 percent
of the market value of the asset. In this case, the lease will be treated as a capital lease by the lessor
and an operating lease by the lessee.
15. When computing annual depreciation, what residual value should the lessee use for a leased asset
under a capital lease? Briefly explain each alternative.
Answer: The residual value used by the lessee to compute depreciation on a leased asset depends
on the lease contract. If the lease contains no bargain purchase option, does not transfer ownership
to the lessee at the end of the lease term, and the lessee does not guarantee the residual value, the
lessee ignores the residual value (uses a residual value of zero). If the lessee does guarantee the
residual value. the guaranteed amount must be used as the residual value.
If the lease contains a bargain purchase option or transfers the asset to the lessee at the end of the
lease term, the lessee must use the estimated residual value at the end of the useful life of the asset
(rather than at the end of the lease term.)
EXERCISES
E 17-1 Multiple Choice
1. Rent should be reported by the lessor as revenue over the lease term as it becomes receivable
according to the provisions of which of the following leases?
Direct Financing Lease Operating Lease
Sales-Type Lease
a.
Yes
Yes
Yes
b.
Yes
No
No
c.
No
Yes
No
d.
No
No
Yes
Answer: C Per SFAS No. 13. rent should be reported by the lessor as revenue over the lease term
for an operating lease as it becomes receivable according to the lease provisions. Both directfinancing and sales-type leases are types of capital leases. For these lease types. the lessor reports
interest income over the lease term rather than rental income. Therefore. answer (C) is correct. and
answers (A). (B). and (D) are incorrect.
2. The present value of minimum lease payments should be used by the lessee in determining the
amount of a lease liability under a lease classified by the lessee as which of the following?
Capital Lease
Operating Lease
a.
Yes
Yes
b.
Yes
No
c.
No
No
d.
No
Yes
Answer: B. Per SFAS No. 13. para 15. rental on an operating lease is to be charged to expense over
the lease term as it becomes payable, unless the payment pattern does not represent a systematic
Chapter 17
-2/20-
Accounting for Leases
and rational allocation over the lease term (in which case the straight-line method is recommended).
NO lease liability is established for operating leases. nor is a “lease asset" recognized. The statement
does. however. require the lessee in a capital leasing transaction to both establish a lease liability
equal to the present value of the minimum lease payments. and recognize the leased asset for the
same amount. Therefore. answer (B) is correct.
3. Lease Y does not contain a bargain purchase option, but the lease term is equal to 90 percent of the
estimated economic life of the leased property. Lease Z does not transfer ownership of the property to
the lessee by the end of the lease term. but the lease term is equal to 75 percent of the estimated
economic life of the leased property. How should the lessee classify these leases?
Lease Y
Lease Z
a.
Capital lease
Operating lease
b.
Capital lease
Capital lease
c.
Operating lease
Capital lease
d.
Operating lease
Operating lease
Answer: B Per SFAS No. 13. para 7, if a lease meets one or more of four criteria. the lease is
classified as a capital lease by the lessee. One of these criteria is that the lease term is equal to 75
percent or more of the estimated economic life of the leased property. Therefore, both leases Y and Z
in this problem should be classified as capital leases. Therefore. answers (A). (C), and (D) are
incorrect.
4. A lessee had a 10-year capital lease requiring equal annual payments. The reduction of the lease
liability in year 2 should equal
a. The current liability shown for the lease at the end of year 1.
b. The current liability shown for the lease at the end of year 2.
c. The reduction of the lease obligation in year 1.
d. One-tenth of the original lease liability.
Answer: A When a leasing agreement is accounted for as capital lease, the lessee recognizes a
liability on its books equal to the. present value of the minimum lease payments. The liability should
be divided between current and noncurrent based upon when each lease payment is due. At the end
of year 1. the current lease liability should equal the principal portion of' the lease payment due in
year 2. Therefore. when the lease payment is made in year 2. the reduction of the lease liability will
equal the current liability shown at the end of year 1.
E 17-2 Multiple Choice
1. The excess of the fair value of lease property at the inception of the lease over its cost or carrying
amount should be considered by the lessor as
a. Unearned income from a sales-type lease.
b. Unearned income from a direct financing lease.
c. Manufacturer's or dealer's profit from a sales type lease.
d. Manufacturer's or dealer's profit from a direct financing lease.
Answer: C. Per SFAS No. 13. para 17. the excess of the fair value of leased property at the inception
of the lease over the lessor's cost is defined as the manufacturer’s or dealer's profit. Answer (A) is
incorrect because the unearned income from a sales-type lease is defined as the difference between
the gross. investment in the lease and the sum of the present values of the components of the gross
investment. Answer (B) is incorrect because the unearned income from a direct-financing lease is
defined as the excess of the gross investment over the cost (also the PV of lease payments) of the
Chapter 17
-3/20-
Accounting for Leases
leased property. Answer (d) is incorrect because a sales-type lease involves a manufacturer’s or
dealer’s profit while a direct-financing lease does not.
2. A lease is recorded as a sales-type lease by the lessor. The difference between the gross investment in
the lease and the net receivable should be
a. Amortized over the period of lease as interest revenue by the interest method.
b. Amortized over the period of lease as interest revenue by the straight-line method.
c. Recognized in full as interest revenue at the lease's inception.
d. Recognized in full as manufacturer ' or dealer's profit at the lease's inception.
Answer: A. Per SFAS No. 13, para l7b. the difference between the gross investment in the lease
and the sum of the present values of the two components of the gross investment shall be recorded
as unearned income. The unearned income shall be amortized to income over the lease term so as to
provide a constant periodic rate of return on the net investment in the lease. Per APB No. 12. para
16. the objective of the interest method is to arrive at a level (i.e.. constant) effective rate (of interest).
Therefore. answers (B), (C), and (D) are incorrect.
3. In a lease that is recorded as a sales type lease by the lessor. interest revenue
a. Does not arise.
b. Should be recognized over the life of the lease by the interest method.
c. Should be recognized over the life of the lease by the straight-line method.
d. Should be recognized in full as revenue at the lease's inception.
Answer: B. Per SFAS No. 13, para 17b, revenue is to be recognized for a sales-type lease over the
lease term so as to produce a constant rate of return on the net investment in the lease. This requires
the use of the interest method. Therefore, answer (B) is correct and answer (C) is incorrect. Answer
(A) is incorrect because, per SFAS No. 13, interest revenue does arise in a sales-type lease. Answer
(D) is incorrect because the interest is to be earned over the life of the lease, not in full at the lease's
inception.
E 17-3 Multiple Choice
1. On January 1, 1998, Mill Corporation leased a machine to Ott Corporation for a five-year term at an
annual rental of $50,000. The lease is an operating lease. At the inception of the lease, Mill received
$100,000 covering the first year . s rent of $50.000 and a security deposit of $50,000. This deposit
will not be returned to Ott upon expiration of the lease but will instead be applied to payment of rent
for the last year of the lease. Mill properly reported rental revenue of $100,000 in its 1998 income tax
return. Mill's tax rate was 30 percent. In Mill's December 31. 1998, balance sheet, what portion of the
$100,000 should be reported as a liability?
a. $50,000.
b. $40,000.
c. $35,000.
d. $28,000.
Answer: A. Deposits and prepayments received for services to be provided in the future are
unearned revenues which should be recorded as a liability until earned. The first year's rent is
recorded as rent revenue, but the S50,000 deposit is recorded as rent collected in advance
(unearned rent) because Mil is required to render future services (use of the machine) to the lessee.
The rate (30%) does not affect the amount of the liability to the lessee, although a separate deferred
tax asset may he recorded in certain circumstances.
Chapter 17
-4/20-
Accounting for Leases
2. Beal, Inc., intends to lease a machine from Paul Corporation. Beal's incremental borrowing rate is 14
percent. The prime rate of interest is 8 percent. Paul's implicit rate in the lease is 10 percent, which is
known to Beal. Beal computes the present value of the minimum lease payments using what rate?
a. 8 percent.
b. 10 percent.
c. 12 percent.
d. 14 percent.
Answer: B. SFAS No. 13 states that the lessee should compute the PV of the minimum lease
payments using the lesser of the lessee's incremental borrowing rate (14% in this case) or the implicit
rate used by the lessor if known (10% in this case). The PV of the minimum lease payments should
be computed using we implicit rate of 10% because it is known by the lessee and is lower than the
incremental rate. The prime rate (8%) is never used unless it happens to be the same as the
incremental or implicit rate.
3. On January 2, 1998. Ashe Company entered into a 10-year noncancelable lease requiring year-end
payments of $100,000. Ashe's incremental borrowing rate is 12 percent. and the lessor's implicit
interest rate, known to Ashe, is 10 percent. Ownership of the property remains with the lessor at
expiration of the lease. There is no bargain purchase option. The leased property has an estimated
economic life of 12 years. What amount (rounded) should Ashe capitalize for this leased property on
January 2, 1998?
a. $1,000,000.
b. $614,500.
c. $565,000.
d. $0.
Answer: B. This is a capital lease for the lessee because the lease term (10 years) covers more than
75 % of the economic life of the leased asset (.75x 12 = 9 years). In a capital lease. the lessee
records the PV of the minimum lease payments as an asset and a liability. The lease payments are
discounted using the lesser of the lessee’s incremental borrowing rate or the: implicit rate used by the
lessor, if known. In this case, the lessee knows the implicit rate is 10%, which is lower than the
incremental rate of 12%. Thus. when the lease is signed. the PV amount recorded as in asset and
liability is $614,500 ($100,000 x (PVA, 10%, 10).
4. On December 30, 1997, Drew Company leased equipment under a capital lease for a period of 10
years. Drew contracted to pay $90.000 annual rent on December 31, 1997, and on December 31 of
each of the next nine years. The capital lease liability was appropriately recorded at $608,400 on
December 30, 1997, before the first payment. The leased equipment has a useful life of 12 years, and
the interest rate implicit in the lease is 10 percent. Drew, uses the straight-line method for
depreciating all equipment. In recording the December 31, 1998. payment. Drew should reduce the
capital lease liability by
a. $38,160.
b. $50,700.
c. $51,840.
d. $60,840.
Answer: A. The initial lease liability at 12/30/97, before the first lease payment, is $608,400. The
12/31/97 payment consists entirely of' principal, bringing the 12/31/97 balance down to $518.400
($608,400 - $90,000). The 12/31/98 payment consists of both principal and the interest incurred
during 1998. 1998 interest is $51,840 ($518,400 x 10%), so the principal portion of the 12/31/98
payment is $38.160 ($90,000 - $51,840).
Chapter 17
-5/20-
Accounting for Leases
E 17-4 Multiple Choice
1. On January 1, 1997. Kerr Company signed a 10-year non-cancelable lease for a new machine.
requiring $20.000 annual payments at the beginning of each year. The machine has a useful life of 15
years, with no salvage value. Title passes to Kerr at the lease expiration date. Kerr uses straight-line
depreciation for all of its plant assets. Aggregate lease payments have a present value on January 1.
1997. of $126.000. based on an appropriate rate of interest. For 1997, Kerr should record depreciation
(amortization) expense for the leased machine at
a. $20,000.
b. $12,600.
c. $8,400.
d. $0.
Answer: C. Since title passes to the lessee at the end of the lease, this is a capital lease for the
lessee. The lessee records the leased asset and lease liability at an amount equal to the lesser of the
FMV of the leased asset or the PV of the minimum lease payments ($126,000). This asset is
depreciated on a straight-line basis over its useful life of 15 years. resulting in a yearly depreciation
charge of $8,400 ($126,000  15). The asset is depreciated over its useful life rather than over the
lease term because title transfers to the lessee, allowing the lessee to use the asset for 15 years.
2. The lessee should amortize the capitalizable cost of the leased asset in a manner consistent with the
lessee’s normal depreciation policy for owned assets for leases that do which of the following?
Transfer 0wnership
of the Properly to the
Contain a Bargain
Lessee by the End of'
Purchase Option
the Lease Term
a.
No
No
b.
No
Yes
c.
Yes
Yes
d.
Yes
No
Answer: C. The requirement is to determine if a lessee should amortize the capitalizable cost of a
leased asset in a manner consistent with the lessee's normal depreciation policy for owned assets for
leases that contain a bargain purchase option and/or transfer ownership at the end of the lease term.
Transfer of ownership of the property to the lessee by the end of the lease term and a lease that
contains a bargain purchase option are properly classified as capital leases (SFAS No. 13. paras 7(a)
and 7(b)). Per SFAS No. 13. para 11(a), if the lease meets either of the above criteria, the asset
should be amortized in a manner consistent with the lessee's normal depreciation policy for owned
assets. Therefore. answers (A). (B). and (D) arc incorrect.
3. A lease contains a bargain purchase option. In determining the lessee's capitalizable cost at the
beginning of the lease term, the payment called for by the bargain purchase option would
a. Not be capitalized.
b. Be subtracted at its present value.
c. Be added at its exercise price.
d. Be added at its present value.
Answer: D. The requirement is to determine whether or not a bargain purchase option should be
capitalized as part of the minimum lease payments. Per SFAS No. 13. para 5. minimum lease
payments include the: rental payments plus the amount of the bargain purchase option, if it exists.
Per para 10, the amount to be capitalized is the present value of the minimum lease payments.
Therefore. the present value of the bargain purchase option would be added to the present value of
Chapter 17
-6/20-
Accounting for Leases
the rental payments (assumed to be previously calculated) in determining the lessee's capitalizable
cost.
4. On January 2. 1995. Wayne. Inc.. signed an eight-year lease for office space. Wayne has the option to
renew the lease for an additional four-year period on or before January 2. 2003. During January 1997,
two years after occupying the leased premises. Wayne made general improvements to the premises
costing $360.000 and having an estimated useful life of 10 years. At December 31. 1997. Wayne’s
intentions as to exercise of the renewal option are uncertain because they depend upon future office
space requirements. A full year's amortization expense is taken for calendar year 1997. Wayne should
record amortization of leasehold improvements for 1997 at
a. $30.000.
b. $36,000.
c. $S45,000.
d. $60,000.
Answer: D. The requirement is the amount of' 1997 amortization expense for leasehold
improvements. The cost of leasehold improvements ($360,000) should be amortized over the
remaining life of the lease, or the useful life of the improvements. whichever is shorter. When the
lease contains a renewal option, the life of the lease does not include the renewal period unless it is
probable that the option will be exercised. Therefore, in this case. the remaining life of the lease is six
years (8-year lease term less the two years gone by). The renewal period of four years is not
considered since exercise of the option is uncertain. The useful life of the improvements is ten years.
so the improvements are amortized over the remaining lease life of six years, This results in 1997
amortization of $60,000 ($360,000M  6 years).
E 17-5 Multiple Choice
1. In a sale-leaseback transaction the seller-lessee has retained the property. The gain on the sale should
be recognized at the time of the sale-leaseback if the lease is classified as which of the following?
Capital Lease
Operating Lease
a.
Yes
Yes
b.
No
No
c.
No
Yes
d.
Yes
No
Answer: B. Per SFAS No. 28. any profit related to a sale-Ieaseback transaction in which the seller
retains the property leased (i.e., the seller-lessee retains substantially all of the benefits and risks of
the ownership of the property sold), shall be deferred and amortized in proportion to the amortization
of the leased asset, if a capital lease. If it is an operating lease, the profit will be deferred in proportion
to the related gross rental charged to expense over the lease term. Losses, however, are recognized
immediately for either a capital or operating lease. Since the gain on the sale should be deferred in
either case, no gain is recognized at the time of the sale, and answer (B) is correct.
2. On December 1. 1998. Barr Company) leases office space for five years at a monthly rental of
$60,000. On that date, Barr pays the lessor, the following amounts:
First month's rent ........................................................................... $60,000
Last month’s rent (Dec. 2003) ......................................................... 60,000
Security deposit (refundable it lease expiration).............................. 80,000
Installation of new walls and offices.............................................. 360,000
Chapter 17
-7/20-
Accounting for Leases
Barr's December 1998 expense relating to its use of this office space is
a. $60,000.
b. $66,000.
c. $126.000.
d. $200.000.
Answer: B. The first month’s rent ($60,000) is expensed as incurred in December 1998. The
prepayment of the last month’s rent (also $60,000) is deferred and will be recognized as expense at
the end of the lease. The refundable security deposit ($80,000) is recorded as a long-term receivable,
since Barr can expect to receive the deposit back at the end of the lease term. The cost of installing
new walls and offices ($360,000) is recorded as an asset,. leasehold improvements. and amortized
over the lease term. The amortization for December is $6,000 ($360,000  60 months). Therefore,
total expense is $66,000 ($60,000 + $6,000).
3.
On December 31. 1997, Lane. Inc., sold equipment to Noll and simultaneously leased it back for 12
years. Pertinent information at this date is:
Sales price .................................................................................... $480,000
Carrying amount .......................................................................... $360,000
Estimated remaining economic life ............................................... 15 years
At December 31. 1997. how much should Lane report as a deferred gain from the sale of the
equipment?
a. $0.
b. $110,000.
c. $112.000.
d. $120.000.
Answer: D. According to SFAS No. 13, sale-leaseback arrangements are treated as though two
transactions were a single transaction, if the lease qualifies as a capital lease. Any gain or loss on the
sale is deferred and amortized over the lease term (if possession reverts to the lessor) or the
economic life (if ownership transfers to the lessee. In this case, the lease qualifies as a capital lease
because the lease term (12 years) is 80% of the remaining economic life of the leased property (15
years). Therefore, at 12/31/97, all of the gain ($480,000 - $360,000 = $120,000) would be deferred
and amortized over 12 years. Since the sale took place on 12/31/97, there is no amortization for
1997.
4. The following information relates to equipment sold by Bard Company to Kerr Company on
December 31, 1997:
Sale, price..................................................................................... $300,000
Book value ................................................................................... $100,000
Estimated remaining economic life ............................................... 20 years
Simultaneously with the sale, Bard leased back the equipment for a period of 16 years. How much of
the gain on the sale should Bard defer at December 31. 1997?
a. $200,000.
b. $12,500.
c. $10.000.
d. $0.
Answer: A. The requirement is to determine the amount of profit to be deferred by Bard Co., the
lessee is a sale-leaseback transaction. According to SFAS No. 13, sale and leaseback arrangements
are treated as though the two transactions were a single financing transaction if the lease qualifies as
a capital lease. Any gain or loss on the sale is deferred and amortized over the lease term if
possession remains with the lessor or economic life if ownership transfers to the lessee. In this case,
the lease qualifies as a capital lease because the lease term is 80% of the remaining economic life of
Chapter 17
-8/20-
Accounting for Leases
the leased property. Therefore, at December 31, 1997, all of the $200,000 ($300,000 - $100,000)
gain on sale of the equipment would be deferred by Bard Co. and amortized over 16 years. Since the
sale was on December 31, there is no amortization for 1997.
E 17-8 Lease: Apply Lease Criteria, Entries for Lessor and Lessee
Tam Leasing Company agreed with Lex Corporation to provide the latter with equipment under lease for
a three-year period. Thc equipment cost Tam $120,000 and will have no residual value when the lease
term ends. Tam expects to collect all payments from Lex and has no material cost uncertainties. The
carrying value of the equipment was $120,000 at the inception of the lease. The three equal annual
payments (amount to be determined) are to be paid each January 1. starting January 1, 1998 (at which
time the equipment was delivered). Lex has agreed to pay taxes, maintenance. and insurance throughout
the lease term as well as any other ownership costs. Tam expects a 20 percent return (known to Lex). The
accounting year of' both companies ends December 31.
Required: Round to the nearest dollar.
I.
What kind of lease is this to Lex? To Tam?
2. Compute the annual payments and prepare an amortization schedule reflecting the interest and
principal elements of Lex’s payments over the three-year term of the lease. Give all journal entries
relating to the lease for Lex Corporation for 1998 including year-end adjusting entries.
3.: Give all journal entries for Tam Leasing Company relating to the lease for 1998 including year-end
adjusting entries.
Answer:
Requirement 1
This is a capital lease to the lessee Lex, because the lease term is more that 75% of the economic useful
life of the leased asset.
The lease is a direct financing lease to lessor Tam, because (1) it meets the criterion for a capital lease
cited above, and (2) Tam expects to collect all rents from Lex and has no material cost uncertainties. The
market value equals the book value of the property at inception of the lease term (i.e., there is no
manufacturer’s or dealer’s profit as in a sales-type lease.)
Requirement 2
Annual lease payment (annuity due): $120,000  (PVAD, 20%, 3) = $120,000  (2.52778) = $47,472.
Amortization Schedule (annuity due basis):
Date
01/01/1998
01/01/1998
12/31/1998
01/01/1999
12/31/1999
01/01/2000
Lease
Payments*
Annual
Interest
at 20%
Lease Rec./Liab.
Dec. (inc.)
$
47,472
14,506 (c)
47,472
7,912 (e)
47,472
-047,472
14,506
47,472
7,912
47,472
Net
Lease Rec./Liab.
$ 120,000
72,528 (b)
87,034 (d)
39,562
47,474 *
-0-
(a) Annuity due. six calculation above
(b) $120,000 - $47,472 = $72,528
Chapter 17
-9/20-
Accounting for Leases
(c)
(d)
(e)
*
$72,528 (.20) = $14,506
$72,528 + $14,506 = $87,034
$39,562 (.20) = $7,912
Rounding error
Lex Corporation (lessee) entries:
January 1. 1998 (inception of lease):
Leased equipment................................................
Lease liability .................................................
(To record the lease)
120,000
120,000
January 1. 1998:
Lease liability ........................................................
Cash ..............................................................
(To record first payment)
47,472
47,472
December 31, 1998 (end of accounting year):
Interest expense ...................................................
Lease liability .................................................
(To accrue first year’s interest)
14,506
Depreciation expense ..........................................
Accumulated depreciation, leased equipment
(To record first year’s depreciation)
40,000
14,506
40,000
Requirement 3
Tam Co. (lessor) entries:
January 1. 1998 (inception of lease):
Lease receivable ($47,472 x 3) ............................
Equipment......................................................
Unearned interest revenue ............................
(To record the lease)
142,416
120,000
22,416
January 1. 1998:
Cash .....................................................................
Lease receivable ...........................................
(To record first payment)
47,472
47,472
December 31, 1998 (end of accounting year):
Unearned Interest revenue ..................................
Interest revenue .............................................
(To accrue interest revenue)
14,506
14,506
E 17-10 Lease: Financing or Sales Types, Schedule and Entries, Lessor and Lessee
Rex Corporation (lessor) and Lee Company (lessee) agreed to a non-cancelable lease. The following
information is available regarding the lease terms and the leased asset:
a. Rex's cost of the leased asset was S40,000. The asset was new at lease inception date.
Chapter 17
-10/20-
Accounting for Leases
b. Lease term is four years, beginning January 1. 1998. Lease payments are made each January 1.
beginning January 1, 1998.
c. Estimated useful life of leased asset is four years. Estimated residual value at end of lease is zero.
d. Sales price of leased asset on January 1, 1998, was $46,000.
e. Rex's implicit interest rate is 15 percent on retail price (known to Lee).
f. Rex expects to collect all payments from Lee, and there are no material cost uncertainties.
Required:
1.
2.
3.
4.
What kind of lease is this to Rex? To Lee?
Compute the annual lease payments.
Prepare an amortization schedule for the lease.
Give the journal entries for both parties on January 1, 1998, and December 31, 1998. Do not make
closing, entries.
Answers:
Requirement 1
This is a capital lease to Lessor Rex because (1) the estimated residual value of the leased property at
the end of the lease term is zero (i.e.. the lease term is equal to 100% of the estimated useful life of the
asset), and (2) Rex expects to collect all rentals from Lee and no material cost uncertainties exist. It is a
sales-type lease because the market sales price exceeds the lessor's cost; the manufacturer's or dealer's
profit is $6,000. It is a capital lease to Lee because of (1) above.
Requirement 2
Annual lease payment (annuity due basis)
=
=
=
$46,000  (PVAD, 15%, 4)
$46,000  3.28323
$14,011 (rounded)
Requirement 3
Date
01/01/1998
01/01/1998
12/31/1998
01/01/1999
12/31/1999
01/01/2000
12/31/2000
01/01/2000
(a)
(b)
(c)
*
Annual
Lease
Payments*
Decrease
(Increase) in
Lease Receivable
Liability
Annual
Interest
at 15%
Initial value
14,011 (a)
4,798 (c)
14,011
3,416
14,011
14,011
$ 56,044
1,830 *
_____
$ 10,044
14,011
(4,798)
14,011
(3,416)
14,011
(1,830)
14,011
$ 46,000
Lease
Receivable/
Liability
Balance
$ 46,000
31,989 (b)
36,787
22,776
26,192
12,181
14,011
-0-
Computed in requirement 2.
$46,000 - $14,011 = $31,989.
$31,989 (.15) = $4,798.
Rounded to balance out to last payment.
Chapter 17
-11/20-
Accounting for Leases
Requirement 4
Lessor
Lessee
January 1, 1998—inception of lease:
Lease receivable .................. 56,044 *
Cost of goods sold ............... 40,000
Sales revenue ............
Asset ..........................
Unearned interest
revenue ...................
Cash
................................
Lease receivable ........
Leased Property ...............
Lease liability ..........
46,000
Lease liability** .................
Cash ........................
14,011
Interest expense** ............
Lease liability ..........
4,798
Depreciation expense .......
Accumulated
depreciation .........
11,500
46,000
46,000
40,000
10,044
14,011
14,011
December 31, 1998—end of accounting period:
Unearned interest
Revenue ...........................
4,798
14,011
4,798
11,500
$46,000 ÷ 4 years = $11,500
* $14,011 x 4
** These two entries are often combined to yield:
Lease liability.................................................
Interest expense ............................................
Cash .......................................................
9,213
4,798
14,011
E 17-12 Overview of Special Lease Cases: Provide Explanations Select the best answer in each of the
following. Justify each choice that you make.
1. On the first day of' its accounting year. Lessor, Inc.. leased certain property at an annual payment of
$200.000 receivable ;at the beginning of each year for 10 years. The first payment was received
immediately. The leased property, which is new, cost $1,100,000 and has an estimated useful life of
12 years and no residual value. Lessor's implicit rate is 12 percent. Lessor had no other costs
associated with this lease. Lessor should have accounted for this lease as a sales-type lease but
mistakenly treated the lease as an operating lease. What was the effect on net income during the first
year of the lease of having treated this lease as an operating lease rather than as a sales-type lease.
a. No effect.
b. Overstatement.
c. Understatement.
d. The effect depends on the accounting method selected for income tax purposes.
Answer: C. If accounted for as an operating lease, earnings for the first year would be $108,334
)$200,000 revenue - $91,666 depreciation). If accounted for as a sales-type lease, the selling price is
$1.265.650 (present value of the future payments). The first year's earnings are calculated in the
schedule below. There would also be 12 percent interest on the $1,065,650 (i.e., $1,265,650 $200,000) receivable balance (this is an annuity due situation). Income would be understated by
$185,194 (i.e., $293,528 - $108,334).
Chapter 17
-12/20-
Accounting for Leases
Sale price ($200,000 (PVAD, 12%, 10) = $200,000 (6.32825) ................. $1,265,650
Cost ............................................................................................................ (1,100,000)
Gain on sale ................................................................................................... 165,650
12% x ($1,265,650 - $200,000) ..................................................................... 127,878
First year net earnings ................................................................................ $ 293,528
2. The appropriate valuation of leased assets under an operating lease on the balance sheet of a lessee is
which of the following?
a. Zero.
b. The absolute sum of the lease payments.
c. The sum of the present values of the lease payments discounted at an appropriate rate.
d. The market value of the asset as of the date of inception of the lease.
Answer: A. No value is recognized by lessees for leased assets under an operating lease. Leasehold
improvements, or long-term prepayments, can give rise to assets to be accounted for in connection
with such leases but the question does not imply the existence of this kind of asset.
3. What types of expenses does a lessee experience with a capital lease?
a. Rent expense, interest expense, amortization expense.
b. Interest expense, amortization expense, executory costs.
c. Amortization expense, executory costs, rent expense.
d. Executory costs, interest expense, rent expense.
Answer: B. Proper accounting for a capital lease by a lessee requires recognition of interest on the
unpaid liability balance. depreciation of the amount capitalized as the value of the lease, and possibly
also executory costs such as insurance. taxes. maintenance. and repairs. depending on the nature of
the property leased.
4. When the present value of future payments to be capitalized in connection with a capital lease is
measured, how should identifiable payments to cover taxes, insurance and maintenance be accounted
for?
a. Included with the future rent to be capitalized.
b. Excluded from future rentals to be capitalized.
c. Capitalized, but at a different rate and recorded in a different account from that for future
payments.
d. Capitalized, but at a different rate and during a different period from the rate and period used for
the future payments.
Answer: B. Under a capital lease. the lessor records a receivable (an asset) and earns interest on
that receivable. Expenses of ownership. such as maintenance. taxes. and insurance are shifted by
the lease contract to the lessee. Payments for such items should therefore not be capitalized by the
lessee nor included by the lessor in computing the periodic rentals.
5. GAAP requires that certain lease agreements be accounted for as purchases The theoretical basis for
this treatment is that a lease of this type
a. Effectively conveys most of the benefits and risks incident to the ownership of property.
b. Is an example of form over substance.
c. Provides the use of the leased asset to the lessee for a limited period of time.
d. Must be recorded in accordance with the matching concept.
Answer: A. When a lease agreement conveys all of the benefits and risks of ownership, it should be
accounted for as a purchase (i.e.. capitalized) by the lessee. b is wrong because when a lease
agreement is required to be capitalized, substance prevails over form, not the reverse. c is wrong
because many leases provide use of property for a relatively long time, often the entire life of the
leased asset. D is wrong because capitalization of leases reflects substance over form, not cause and
effect.
Chapter 17
-13/20-
Accounting for Leases
6. Your client constructed an office building at a cost of $500,000 and then sold the building to Jones for
a large gain. The client leased it back from Jones for a stipulated annual payment. How should this
gain be treated?
a. Recognized in full as an ordinary item in the year of the transaction.
b. Recognized in full as an extraordinary item in the year of the transaction.
c. Amortized as an adjustment of the rental cost over the life of the lease.
d. Amortized as an extraordinary item over the life of the lease.
Answer: C. The sale and leaseback constitutes a joint transaction because they cannot be evaluated
independently. Paragraph 33 of SFAS No. 13 provides that gains on such transaction must be
amortized over the life of the lease. A and b are wrong because they assume recognition of gain on
the sale as a separate transaction. D is wrong because it treats the gain as an extraordinary item.
E 17-20 Sale-Leaseback, Direct Financing Lease Rich Grocery owns the building it uses; it has a
current carrying value on January 1, 1998, of $450 000, a 10-year remaining life and no residual value.
On this date it was sold to investor Lucky for $500,000 cash. Simultaneously, the two parties executed a
10-year direct financing lease with a 12 percent implicit interest rate; each annual payment is due on
December 31 (end of their accounting periods).
Required:
1. Compute the annual payments to be made by Rich to Lucky.
2. Give the entries for the seller-lessee (Rich Grocery) for 1998. Use straight-line depreciation.
Answer:
Requirement 1
Computation of lease payments (ordinary annuity):
$500,000 ÷ (PVA, 12%. 10) = $500,000 ÷ (5.65022) = $88,492
Requirement 2
Entries for seller/lessee (Rich Grocery) during 1998:
]an. 1, 1998:
(a) To record sale of the asset:
Cash .....................................................................
Asset ..............................................................
Unearned gain, sale/leaseback .....................
(b) To record inception of the direct financing lease:
Leased asset (building) ........................................
Lease liability .................................................
500,000
450,000
50,000
500,000
500,000
Dec. 31, 1998:
(c) To record lease payment:
Interest expense ($500,000 x .12) .......................
Lease liability ($88,492 - $60.000) ................
Cash ..............................................................
Chapter 17
-14/20-
60,000
28,492
88,492
Accounting for Leases
(d) Adjusting entry-to record depreciation:
Depreciation expense ($500.000 ÷ 10) ................
Accumulated depreciation (leased asset) .....
(e) To amortize unearned gain:
Unearned gain on sale/leaseback ........................
Depreciation expense ....................................
$50,000 ÷ 10 years = $5,000.
50,000
50,000
5,000
5,000
E 17-22 Lease and Ratio Analysis Suppose a firm were required to place its operating leases on its
balance sheet; that is, the firm is required to capitalize its leases. What would be the impact on the
following ratios:
• Current ratio
• Working capital to total assets
• Asset turnover
• Debt to equity
• Cash flow per share
• Return on investment
• Dividend payout
(Assume normal ratio values exist before capitalization, such as a current ratio of at least one.)
Answers:
Current Ratio:
Decreases. Current assets are unchanged. but current liabilities will increase by the amount of the
current liability increase.
Working Capital to Total Assets:
Decreases. Working capital is lower due to the increase in current liabilities and total assets increases
due to capitalization of the lease assets. The increase in long-term assets exceeds the increase in
current liabilities.
Asset Turnover:
Decreases. Net assets remains the same. but average total assets increases.
Debt to Equity:
Increases. Debt increase. Depreciation of the leased asset plus interest now replace the rent expense
under a capital lease. The impact on debt dominates the impact on the ratio and this ratio increases.
Cash Flow per Share:
No change.
Return on Total Assets:
Decreases. Income is reduced as interest and depreciation replace rent expense while total assets
are also increased. (This answer assumes straight-line depreciation. If accelerated depreciation is
used. the answer holds for the initial years of the assets. but will eventually reverse.).
Dividend Payout:
Increases. The numerator is unchanged. but income declines.
Chapter 17
-15/20-
Accounting for Leases
P 17-2 Lease: Determine Type, Entries for Lessor and Lessee Crown leases a limo to Zap Productions
for four years on January 1, 1998, requiring equal annual payments on each January I and, in addition, a
single lump-sum prepayment of $3,000. The leased asset, recently purchased new, cost the lessor
$50,000. The estimated unguaranteed value of the asset at end of lease term is $20,000.
The annual lease payments were computed to yield Crown 12 percent (the implicit interest rate after
considering that the residual value is known to Zap Productions). The leased asset has an eight-year life
with zero residual value at the end of year 8. There is no bargain purchase option, and the asset is retained
by Crown at the end of the lease term. Depreciation will be on the straight-line basis. The accounting
period for both lessor and lessee ends December 31.
Required:
1. Compute the annual lease payment.
2. What type of lease is this? Explain.
3. In parallel columns for the lessor and lessee, give:
a. Entries at the inception of the lease, including the initial advance payment.
b. Adjusting and closing entries for the year ended December 31, 1998. Use straight-line
amortization for the prepayment.
Answers:
Requirement 1
Selling price of leased asset ..................................................................... $ 50,000
Deduct: PV of residual value $20.000* (at end of year 4)
(PV 1, 12%, 4) = $20,000 (.63552) ..............................................(12,710)
Prepayment .................................................................................. (3,000)
Net asset to be recovered ......... ............................................................... $ 34,290
Annual payment: $34,290 ÷ (PVAD, 12%, 4) = $34,290 ÷ 3.40183 ......... $ 10,080
Requirement 2
This is an operating lease because it does not meet any of the requirements for classification as a capital
lease.
(1) No transfer of ownership at the end of the lease term.
(2) No bargain purchase option.
(3) Lease term < 75% of the estimated useful life years < (.75 x 8 years = 6 years).
(4) PV of minimum lease payments < 90%. of market value at lease inception; ($34,290 + $3.000 =
$37,290) < (.90 x $50,000) = S45,000.
Requirement 3
Lessor
Lessee
(a) January 1. 1998 (inception of lease):
Cash ($10,080 + $3,000) .. 13,080
Rent revenue .................
10.080
Unearned rent revenue .
3,000
Chapter 17
Leasehold (or prepaid rent) . 3,000
Rent Expense ...................... 10,080
Cash .................................
13,080
-16/20-
Accounting for Leases
Lessor
Lessee
(b) December 31. 1998 (Adj and closing entries):
Unearned rent revenue .....
Rent revenue .................
$3.000 ÷ 4 years = $750
750
750
Depreciation expense ....... 6,250
Accumulated depreciation
$50.000 ÷ 8 years = $6,250.
6.250
Rent revenue .................... 10,830
Depreciation expense ....
Income summary ...........
$10,080 + $750 = $10,830
6,250
4,580
Rent expense ......................
Leasehold .........................
750
750
Income summary ................. 10,830
Rent expense ...................
10,830
$10,080 + $750 = $10,830
C 17-2 YOU MAKE THE CALL Concern about Debt-Equity Ratio and Third-Party Residual Value
Guarantees: Ethics. Speedware Corporation has entered into a debt agreement that restricts its debt-toequity ratio to less than two to one. The corporation is planning to expand its facilities. creating a need for
additional financing. The board of directors is considering leasing the additional facilities but is
concerned that leasing may violate its existing debt agreement; a violation would place the corporation in
default. The potential lessor insists that the lease be structured in such a way that it can be accounted for
as a capital lease by the lessor (the lessor is a dealer and wants to recognize the dealer's profit on the
transaction immediately). In addition, the lessor requires that the residual value of the leased asset be
guaranteed when it reverts to the lessor at the end of the lease term. Speedware's board has asked you to
analyze the following alternatives:
Alternative A—Speedware would enter into a lease that qualifies as a capital lease (to Speedware). If this
alternative is selected, Speedware's reported debt-to-owners'-equity ratio would be 1.9, and its ability to
issue debt in the future would be seriously constrained.
Alternative B—Speedware would enter into a lease and pay a third party to guarantee the residual value of
the leased property. The lease would be structured in such a way as to qualify as an operating lease to
Speedware and as a capital lease to the lessor. In this case, Speedware's reported debt-to-equity ratio
would be unaffected by the lease contract.
Required
Analyze and explain the consequences of each of the above alternatives in a one-page memo to your
superior. Do you see any ethical considerations?
Answer:
The relative merits of the two alternatives depend on (1) the likelihood that Speedware will require debt
financing in the immediate future, and (2) the cost of securing a third party guarantor of the residual value
of the leased property. If Speedware is unlikely to need additional financing immediately, the risk of
default on the existing debt agreement may be minimal, because the lease liability will be reduced
annually by the principal portion of the lease payment. Also, Speedware may be able to obtain capital
through the issuance of stock. rather than debt, which would improve its debt-to-owners' equity ratio.
In addition, paying a third party to act as guarantor of the lessor's residual value on the leased asset is
costly, and this cost must be compared to the benefits of reduced risk of default on existing debt. Selfinsurance (assumption of the residual value guarantee) by the lessee involves no out-of-pocket
expenditures until the end of the lease term and then only if the appraised residual value is less than the
guaranteed residual value.
Chapter 17
-17/20-
Accounting for Leases
The ethical issue is whether it is ethical to use a third party to guarantee the residual value to avoid
including a capital lease obligation on the balance sheet. If the acquisition is intended to be permanent
and this is simply a ploy to avoid capitalization, should the firm constitute the transaction using alternative
B?
A 17-3 Lease Calculations and Disclosures Turner Broadcasting Company sponsors CNN. Note 5 to
Turner's 1994 annual statements, dealing with long-term debt, includes the following information in part:
Note 5: Long-Term Debt
Long-term debt consists of:
December 31
1994
1993
(thousands)
Bank credit facilities ........................................................................................................ $1,490,000 $1,225,000
12% Senior Subordinated Debentures due October 15, 2001, net of
unamortized discount of $3,268 ...................................................................................
--536,732
8 3/8% Senior Notes due July 1. 2013, net of unamortized discount of
$2,619 and $2,675 ........................................................................................................
297,381
297,325
7.4% Senior Notes due 2004. net of unamortized discount of $363 ................................
249,637
--8.4% Senior Debentures due 2024. net of unamortized discount of $155 ........................
199,845
--Zero coupon subordinated convertible notes, 7.25% yield, due February 13,
2007, net of unamortized discount of $336,487 and $353,368.....................................
245,569
228,688
Convertible subordinated debentures of a wholly owned subsidiary ...............................
29,075
--Obligations under capital leases due in varying amounts through 1999,
net of imputed interest of $931 and $1,075 ..................................................................
6,200
6,353
Other debt, net of imputed interest of $1,175 and $29. due in varying amounts
through 2009. interest at fixed rates ranging from 6.00% to 9.49% .............................
1,386
2,510
$2,519,093 $2,296,608
Less current portion .........................................................................................................
1,345
2.051
$2,517,748 $2,294,557
Other information obtained from the notes to Turner Broadcasting Company's financial statements:
Included in the maturities of long-term debt amounts are obligations under capital lease of
$1,299,000; $1,273,000; $1,261,000: $1,376,000; and $1,016,000 for each of the five years
following December 31, 1994. Finally, assume that $565,000 of lease maturities exist for each of
the years 2000, 2001, and 2002 respectively.
Required:
Estimate the firm's average implicit interest rate on its lease obligations. Assume there are no further
long-term lease obligations after December 31, 2002. All payments are made at the end of the year.
Answers:
Turner Broadcasting Co.
Rather than use the more common payment schedule presentation for long-term debt and capital leases,
Turner discloses payment information in text format under “Other Obligations.” Yearly payment amounts
are termed maturities.
Chapter 17
-18/20-
Accounting for Leases
An estimate of the interest rate can be found by solving
8
 A n (PV1, i, n) = $6,200 =
n=1
$1,299(PV1, i, 1) + $1,273 (PV1, i, 2) + $1,261 (PV1, i, 3) +
8
$1,346 (PV1, i, 4) + $1,016 (PV1, i, 5) +[($6,200 + $931) ÷ (3)] (PV1, i, n)
n=6
where A n = Maturity Amount in year n and n=1 in 1995.
An HP12C calculator can easily solve this to yield 6.82%.
An alternative solution determines the interest rate for 1994 (assuming end-of-year payments) as follows:
Interest for 1994 = ($1,075 - $931) ÷ $6,353 = .02 of 2%.
This estimate appears too low.
A 17-6 Delta Airlines This problem requires access to the World Wide Web portion of the Internet. You
should use Delta's most recent 10-K annual report. To do so access the SEC's Electronic Data gathering,
Analysis, and Retrieval System (EDGAR) using the following steps:
a. URL: http://www.sec.gov/index.html
b. Click on EDGAR Database of Corporate Information
c. Click on Search for EDGAR Database
d. Click on Search for EDGAR Archives
e. Enter the company name in the search dialog box
f. Click on the listing for the most recent 10K annual report
Required: (It is possible that some of the data you may need to answer the questions may not be
available. If so, omit this portion of the requirements.)
1. What type of assets does Delta lease?
2. What method does Delta use to record rent expense on its operation leases? What entry did Delta
make in the most recent year to recognize rent expense on its operating leases?
3. What is the amount of leasehold and operating rights (excluding flight equipment) held by Delta at
the end of the last fiscal year?
4. What method does Delta use to measure the current portion of its capital lease obligation? How do
you know?
5. Provide your best estimate of 'the entries Delta would make to recognize its capital lease payments for
the coming fiscal year. (Use 10 percent as an estimate of Delta's average interest rate on its capital
leases.) How would you estimate this rate if it were necessary to do so with only the information
available on the I O-K?
Answer
The solution here is developed from Delta’s 1996 10-K report. The solution indicates how certain results
were obtained so the reader may duplicate them using the more recent financial statements. Leases are
covered in footnote 8 of the 1996 financial statements.
Chapter 17
-19/20-
Accounting for Leases
1. The company leases aircraft, airport terminal and maintenance facilities, ticket offices, and other
property and equipment. (From footnote 8)
2. Straight line. (Footnote 8)
3. $90(.0(0,000. (Footnote 8)
4. The decline in the present value of the lease obligation. and not the present vale of next year's
payment. This is likely to be the reason because:
a. Most firms use this approach.
b. The interest rate necessary to equate the current lease liability of $58 million with the payment
required next year of $101 million is much too large to be reasonable.
5. Operating leases
Rent expense .......................................................
871
Cash ..............................................................
(The operating lease payment due in 1997 indicated in footnote 8)
871
Capital leases
Capital Leases* ....................................................
Interest expense** ................................................
Cash*** ..........................................................
*
**
53
58
101
Balancing result
.10 ($580), the current lease liability.
*** Current payment due in 1997 from footnote 8
Chapter 17
-20/20-
Accounting for Leases
CHAPTER 18: ACCOUNTING FOR PENSIONS AND OTHER POSTEMPLOYMENT
BENEFITS
1. Distinguish between a defined contribution pension plan and a defined benefit pension plan.
Answer: A defined-contribution pension plan does not define specific benefits to be paid at employee
retirement. Rather, it specifies the periodic amount that the employer must pay into the pension fund. The
employees receive whatever benefits can be paid from the pension fund accumulation and its earnings. A
defined benefit plan specifies the way the amount of benefits to be received by employees after
retirement is calculated.
2. Distinguish the three parties involved in accounting and reporting for a pension plan.
Answer: The three primary accounting parties, are: (a) employer, (b) funding agency (trustee), and (c)
actuary. The employer must account for pension expense, cash contributions to the funding agency, and
pension liabilities. The funding agency accounts for the funds received from the employer, investment of
those funds. and payment of benefits to the retirees. The actuary provides an annual report of the
projected benefit obligation and related data.
3. What are the primary actuarial factors related to a pension plan?
Answer: Actuarial factors are the data used by an actuary to make estimates of projected benefits and
the present value of those benefits. The primary factors include the benefit formula, retirement ages,
mortality (i.e., life expectancies), number and ages of employees, turnover rates, future salary levels,
interest rates, gains and losses on pension funds, and vesting benefits.
4. Explain the three funding approaches that the employer can use for pension plans.
Answer: The three funding approaches are:
a. Internal pension fund: Cash is set aside by the company in a pension fund administered internally
by the company.
b. Independent pension fund: Cash is paid to an independent pension funding agency (trustee) who
administers the pension fund, invests the funds, and makes the payments to the retirees.
c.
Purchase of retirement annuity: Cash is paid to an insurance company to purchase retirement
annuities for the retirees. The insurance company then accepts full responsibility for paying the pension
benefits to the retirees.
14. What is the vested benefit obligation?
Answer: The vested benefit obligation is the present value of the current and future pension benefit rights
that are no longer contingent on remaining an employee of the company.
15. List and define the six components of net periodic pension expense.
Answer: Components of net periodic pension expense:
a. Service cost—the cost (at actuarial present value) of future pension benefits earned by
employees during the current accounting period.
b. Interest cost—the beginning balance of the projected benefit obligation multiplied by the
estimated interest rate used by the actuary.
c. Expected return on plan assets—the expected return on the pension plan investments plus the
change in the carrying value of OW Plan assets used in operations.
d.
Amortization of unrecognized prior service cost—prior service cost is caused by plan
amendments that are retroactive. The cost is not recognized in full immediately but is amortized (and
recognized) over future periods as expense.
e. Amortization of unrecognized gains or losses—due to (a) differences between expected and
actual returns on plan assets, and (b) other gains and losses due to changes in actuarial
assumptions. This cost is not recognized in full immediately, but is amortized (and recognized)
over future periods as expense.
Chapter 18
1/18
Pensions & Postemployment Benefits
f.
Amortization of unrecognized transition cost—a changeover cost that occurs when SFAS No. 87
is first adopted It occurs only once. The total amount is not recognized in full when incurred but is
amortized as expense over future periods.
16. Explain the additional minimum pension liability?
Answer: An additional minimum pension liability must be recognized if the total of plan assets at fair
value is less than the accumulated benefit obligation adjusted for any accrued/prepaid pension cost
recognized. It is recorded with a credit to additional minimum pension liability and debits to intangible
pension asset and unrealized capital accounts.
21. Explain the difference between the projected benefit obligation and the accumulated benefit
obligation.
Answer: The accumulated benefit obligation is exactly the same as the projected benefit obligation
except for one difference in the computations. The projected benefit obligation includes the effect of
estimated future changes in the average remuneration of the employees covered. The accumulated
benefit obligation does not include the effects of estimated changes in the average remuneration of
employees. The projected benefit provides basic data for pension accounting, while the accumulated
benefit obligation is used only for computing one amount, the additional minimum pension liability.
26. Explain the difference between expected postretirement benefit obligation (EPBO) and accumulated
postretirement benefit obligation (APBO) in accounting for postretirement benefits other than
pensions.
Answer: EPBO is the actuarial present value of benefits expected to be paid and takes into consideration
the expected service period of employees. APBO is the actuarial present value of benefits earned to a
particular date. Once an employee reaches full eligibility, the two measures are equal.
27. Explain how accounting for the transition amount for postretirement benefits is similar to and
different from that for pensions.
Answer: The accounting is similar in that the transition amount is computed the same way for both
pensions and postretirement benefits other than pensions. Amortization is also similar in that the
transition amount may be amortized over the average remaining service period of plan participants. The
accounting is different in that the pension transition amount can he amortized over 15 years if the service
period is less than 15 years, whereas for postretirement benefits other than pensions 20 years may be
used. Also, the transition amount for postretirement benefits other than pensions (only) may be
recognized immediately.
Chapter 18
2/18
Pensions & Postemployment Benefits
E-18-2 Multiple Choice: Choose the best answer from among the alternatives.
1. Service cost for 1998 for a pension plan whose pension benefit formula incorporates estimates of
future compensation levels is
a. The present value of benefits earned by employees in 1998 based on current salary levels.
b. The increase in ABO for 1998 less interest on the beginning balance in ABO.
c. The nominal value of benefits earned by employees in 1998 based on future salary level.
d.
The present value of benefits earned by employees in 1998 based on future salary levels.
Answer: d.
2. The following statements describe some aspect of accounting for defined benefit pension plans.
Choose the incorrect statement.
a.
When only the first three components of pension expense have occurred to date for a plan and
actual return has always equaled expected return, underfunded PBO at a reporting date equals the
balance in the accrued pension liability.
b. When only the first three components of pension expense have occurred to date for a plan and
actual return has always equaled expected return, pension expense reflects the true annual cost to
the company of providing future benefits earned in the current period, assuming all the actuarial
assumptions are correct.
c. Because the last three components of pension expense are derived from amortizing initial present
values on a straight-line or similar basis, the true total cost of these items is not reflected in
pension expense.
d. Pension expense can be negative.
Answer: c.
3. Choose the correct relationship among off-balance-sheet values and values reported in a balance sheet
relative to a pension plan.
a.
Underfunded PBO less amortization of unrecognized PSC equals the balance in accrued pension
cost.
h. Unrecognized PSC is an item that reconciles the balance in accrued pension cost and overfunded
PBO.
c. Sum of .pension expense to date equals PBO.
d. PBO less ABO equals balance in accrued pension cost.
Answer: b.
4. For external reporting purposes, assuming an underfunded ABO, the liability that must be reported in
the balance sheet is
a.
PBO less plan assets at fair value.
b. Balance in accrued pension cost.
c. The underfunded ABO.
d.. Additional minimum pension liability.
Answer: c.
5. Choose the correct statement concerning amortization of' unrecognized gain or loss:
a.
Some amortization must be recognized in a year that begins with a nonzero unrecognized gain or
loss.
Chapter 18
3/18
Pensions & Postemployment Benefits
b. The corridor is the maximum amortization allowed.
c. The corridor amount for 1998 is 10 percent of the greater of these two December 31, 1998 values:
PBO and plan assets at fair value.
d. The amortization of an unrecognized gain yields a reduction in pension expense and a reduction
in that unrecognized gain.
Answer: d.
6. Defined contribution plans and defined benefit plans are two common types of pension plans. Choose
the correct statement concerning these plans.
a.
The required annual contribution to the plan is determined by formula or contract in a defined
contribution plan.
b. Both plans provide the same retirement benefits.
c. The retirement benefit is usually determinable well before retirement in a defined contribution
plan.
d. In both types of' plans, pension expense is generally the amount funded during the year.
Answer: a.
7. PBO and plan assets at fair value are two values critical to the determination of the financial status of
defined benefit plan. Choose the correct statement regarding items to be included in each (none of
these statements is necessarily complete).
a.
Ending PBO includes total service cost to date, interest cost to date, net initial unamortized
actuarial gain or loss to date, and initial PSC.
b.. Ending PBO includes total service cost to date, interest cost to date, net initial unamortized
actuarial gain or loss to date,. initial PSC, and initial transition cost.
c. Ending fair value of plan assets includes funding to date and expected return to date, reduced by
benefits paid to date.
d. Ending PBO includes service cost to date, gross differences between expected and actual returns
to date, and net initial unamortized actuarial gain or loss to date, all less contributions to date.
Answer: a.
8. Which of the following is not one of the six components of pension expense (or part of a
component)?
a.
Initial transition asset.
b. Amortization of' unrecognized gain or loss.
c. Actual return on plan assets.
d. Growth (interest cost) in PBO since the beginning of the period.
Answer: a.
Chapter 18
4/18
Pensions & Postemployment Benefits
E 18-10 Compute Net Periodic Pension Expense and Underfunded or Overfunded PBO; Entries
The 1998 records of Jax Company provided the following data related to its noncontributory, defined
benefit pension plan (amounts in $000s):
a. Projected benefit obligation (report of actuary):
Balance. January 1. 1998 ............................................. $ 3,000
Service cost..................................................................... 1,200
Interest cost........................................................................ 240
Pension benefits paid ...................................................... (400)
Balance, December 31, 1998 ....................................... $ 4,040
b. Plan assets at fair value (report of trustee):
Balance, January 1, 1998 ............................................. $ 2,408
Actual return on plan assets ............................................... 168
Contributions, 1998 ........................................................ 1,016
Pension benefits paid ...................................................... (400)
Balance, December 31, 1998 ....................................... $ 3,192
Expected long-term rate of return of plan assets, 7 percent
c. January 1, 1998 balance of unrecognized prior service cost, gains and losses, and transaction cost is
zero.
Required:
1. Compute 1998 net periodic pension expense. Show the correct amount for each of the six
components.
2. Give the 1998 entry (entries) for Jax Company to record pension expense and funding.
3. Compute the under- or overfunded PBO at the beginning and end of 1998.
Answers:
Requirement 1
Net periodic pension expense:
Service cost (PBO) .....................................
Interest cost (proof, $3,000 x 8%) ..............
Expected return on plan assets ..................
Unrecognized loss (gain) on plan assets:
Actual return ............................................
Expected return ($2,408 x 7%)................
Unrecognized gain (amortization
starts next period) ................................
Transition cost ............................................
Prior service cost ........................................
Net periodic pension expense ...........................
$ 1,200
240
(168)
$ 168
168
$ -0-
-0-0-0$ 1,272
Requirement 2
December 31, 1998:
Pension expense .....................................
Cash .....................................................
Accrued pension cost ...........................
Chapter 18
1,272
1,016
256
5/18
Pensions & Postemployment Benefits
Requirement 3
Projected benefit obligation ...................
Pension plan assets (fair value) ............
Under (over) funded PBO .....................
January 1, 1998
December 31, 1998
$ 3,000
2,408
$ 592
$ 4,040
3,192
$ 848
E 18-13 Pension Spreadsheet: Underfunded and Accrued Pension Cost: Entries Gecko Company has
a defined benefit pension plan. At the end of the current reporting period, December 31, 1998, the
following information was available:
a. Projected benefit obligation (actuary’s report):
Balance, January 1, 1998 ............................................. $ 2,400
Service cost........................................................................ 312
Interest cost ($2,400 x 7% actuary’s rate) ......................... 168
Loss (gain) change in actuarial assumptions* ..................... 72
Pension benefits paid ...................................................... (160)
Balance, December 31, 1998 ....................................... $ 2,792
* Amortization to start in 1999
b. Status of fund assets (trustee’s report):
Balance, January 1, 1998 ............................................. $ 2,000
Actual return on plan assets (same as expected) ............... 120
Cash received from employer company ............................ 280
Pension benefits paid to retirees ..................................... (160)
Balance, December 31, 1998 ....................................... $ 2,240
c. From company records, unamortized pension cost
from prior years (amortize over a nine-year average
remaining service period)
Transition cost ............................................................... $ 72
Prior service cost ............................................................ 108
Losses (gains) ................................................................. 144
Total ......................................................................... $ 324
Required:
1. Set up and complete a spreadsheet or format of your choice to develop the pension data required
at the end of 1998.
2. Give the employer’s pension entry at December 31, 1998.
Chapter 18
6/18
Pensions & Postemployment Benefits
Answers:
Requirement 1
Comprehensive Pension Spreadsheet
Items
BEGINNING BALANCES, 1998
Changes in PBO during 1998:
Service cost
Interest cost ($2,400 x 7%)
Unrecognized costs (delayed):
Transition cost:
Unrecognized at beginning 1998
Increase (decrease) in 1998
Total unrecognized
Amortized in 1998 ($72/9)
Unrecognized balance at end 1998
Informal Record
Formal Record
Pension Unrecognized Net Periodic
(Accrued)
Plan
Pension
Pension
Prepaid
PBO
Assets
Cost
Expense
Cost
(actuary) (trustee) (by company) (by company) (by company)
$2,400
$2,000
312
168
Changes in plan assets during 1998:
Expected return $120
Actual return on plan assets
Cash received from company
Pension benefits paid to retirees
ENDING BALANCES, 1998
PBO
Plan assets
Under (over) funded PBO
Unrecognized pension costs
Net periodic pension expense
(Acrued)/prepaid pension cost
L
$72
0
$72
8
$64
L
L
$108
0
$108
12
$96
L
L
L
L
72
$144
72*
0
$216
16
$200
L
L
$0
(160)
$0
($76)
312
168
Prior service cost:
Unrecognized at beginning 1998
Increase (decrease) in 1998
Total unrecognized
Amortized in 1998 ($108/9)
Unrecognized balance at end 1998
Loss (gain);
Unrecognized at beginning 1998
Change from PBO 1998
Change from plan assets 1998
Total unrecognized
Amortized in 1998 ($144/9)
Unrecognized balance at end 1998
$324
8
12
16
(120)
120
280
(160)
280
$2,792
$2,240
$552
$360
$396
(396)
($192)
Proof: Beginning $2,400 - $2,000 - $324 = $76; Ending $2,792 - $2,240 - $360 = $192
* Amortization starts next period.
Requirement 2
Accounting entry
Chapter 18
Pension expense .....................................................
Accrued/prepaid pension cost ($76 - $192) ......
Cash ..................................................................
7/18
396
116
280
Pensions & Postemployment Benefits
E-18-16 Multiple Choice: Accounting for Pensions. Choose the correct statement for each question.
1. Which of the following defined benefit pension plan disclosures should be made in a company's
financial statements?
I. A description of the company's funding policies and types of assets held.
II. The amount of net periodic pension cost for the period.
III. The fair value of plan assets.
a. I and II.
b. I, II and III.
c. II and III.
d.
I only.
Answer: b.
2. Interest cost included in the net pension cost recognized by an employer sponsoring a defined benefit
pension plan represents the
a. Amortization of the discount on unrecognized prior service cost.
b. Increase in the fair value of plan assets due to the passage of time.
c. Increase in the projected benefit obligation due to the passage of time.
d.
Shortage between the expected and actual returns on plan assets.
Answer: c.
3. On July 31, 1998, Tumwater Company amended its single-employer defined benefit pension plan by
granting increased benefits for services provided prior to 1998. This prior service cost will be
reflected in the financial statement(s) for
a. Years before 1998 only.
b. 1998 only.
c. 1998 and years before and after 1998.
d.
1998 and the following years only.
Answer: d.
4. An employer sponsoring a defined benefit pension plan is subject to the minimum pension liability
recognition requirement. An additional liability must be recorded equal to the unfunded
a. Accumulated benefit obligation plus the previously recognized accrued pension cost.
b. Accumulated benefit obligation less the previously recognized accrued pension cost.
c. Projected benefit obligation plus the previously recognized accrued pension cost.
d.
Projected benefit obligation less the previously recognized accrued pension cost.
Answer: b.
Chapter 18
8/18
Pensions & Postemployment Benefits
E-18-18 Unrecognized Gains and Losses. On January 1, 1998, a company reported a $6,000
unrecognized gain in the informal record of its pension plan. During 1998 the following events occurred:
a. Actual return on plan assets was $8,000 and expected return was $10,000.
b. A gain of $4,000 was determined by the actuary at December 31, 1998, based on changes in actuarial
assumptions.
The company amortizes unrecognized gains and losses on the straight-line basis over the average
remaining service life of active employees (20 years). It does not recognize the minimum amortization.
Further information on this plan follows:
PBO............................................
Fair value of plan assets .............
Values At
January 1. 1998
December 31, 1998
$50,000
$56,000
30,000
34,000
Required: Compute amortization of unrecognized gain or loss for 1998 and 1999.
Answer:
Amortization of unrecognized gain, 1998 = $6,000/20 = $300
(decreases pension expense)
Unrecognized gain, 12/31/98:
Unrecognized gain, 1/1/98 .............................
Amortization in 1998 (requirement 1) ............
Excess of expected over actual return ..........
Actuarial gain, 12/31/98 .................................
Unrecognized gain, 12/31/98 .........................
($6,000)
300
2,000
(4,000)
($7,700)
Amortization of unrecognized gain, 1999 = $385
E-18-22 Minimum Liability: Three Cases: Entries Yates Company has a noncontributory, defined
benefit pension plan. It is December 31, 1998, end of the accounting year and measurement date for the
pension plan. The following are the data for three separate cases, as of the measurement dates (in $000s):
Items (at December 31, 1998)
a.
b.
c.
d.
e.
f.
g.
Case A
Case B
Case C
Projected benefit obligation ............ $1,000
Accumulated benefit obligation ......
800
Vested benefit obligation ................
360
Pension plan assets at book value ...
550
Pension fund assets at fair value .....
600
(Accrued) prepaid pension cost.......
0
Unrecognized prior service cost ......
220
$1,000
800
360
550
840
80
180
$1,000
800
360
550
600
(20)
150
Required:
1. For each case, compute the additional minimum pension liability that should be reported.
2. For each case, (a) explain whether a minimum liability must be reported and why, and (b) if one must
be reported, give the entry.
Chapter 18
9/18
Pensions & Postemployment Benefits
Answer:
Requirement 1
Items (at December 31, 1998)
Accumulated benefit obligation .........................................
Less: Plan assets at fair value ..........................................
Under (over) funded accumulated benefit obligation .....
Accrued/prepaid pension cost ........................................
Additional minimum pension liability required ...................
*
Case A
Case B
Case C
800
(600)
200
-0$200
800
(840)
$(40)
$80*
$-0-
800
(600)
200
(20)
$180
The accumulated benefit obligation is overfunded. Therefore, the balance of this account is irrelevant
because the APO is overfunded.
Requirement 2
Case A
(a) Must record $200 additional minimum liability because it is underfunded and no accrued/prepaid
pension cost was recorded. A contra stockholders' amount is not recorded because the additional
minimum liability ($200) is not in excess of the unrecognized prior service cost ($220).
(b) Entry:
Intangible pension asset ..............................................................................
Additional minimum pension liability .....................................................
200
200
Case B
(a) No additional minimum liability is required because the accumulated benefit obligation is overfunded.
(b) No entry.
Case C
(a) Must record a $180 additional minimum liability because the accumulated benefit obligation is
underfunded and the accrued pension cost is less than the underfunding. A contra stockholders' debit
is required because the minimum liability ($180) is in excess of the unrecognized prior service cost
($150).
(b) Entry:
Intangible pension asset ..............................................................................
Unrealized pension cost, contra stockholders’ equity ($180 - $150) ...........
Additional minimum pension liability .....................................................
*
150
30
180*
Notice that the total liabilities for pensions will be $180 + $20 (already recorded) = $200.
Chapter 18
10/18
Pensions & Postemployment Benefits
E-18-24 Accounting for Postretirement Benefits Other Than Pensions. Choose the correct statement
for each question.
1. The balance sheet in the accrued postretirement benefit cost account generally reflects which of the
following?
a. The underfunded accumulated postretirement benefit obligation.
b. The underfunded expected postretirement benefit obligation.
c. The excess of' cumulative postretirement benefit expense over cumulative funding.
d.
The excess of cumulative employer contributions over cumulative benefit payments.
Answer: c.
2. Which of the following statements correctly describes the relationship between expected post
retirement benefit obligation (EPBO) and accumulated postretirement benefit obligation (APBO)?
a. EPBO can be less than or equal to APBO, but never more.
b. EPBO and APBO are never equal.
c. EPBO and APBO are always equal.
d.
APBO can be less than or equal to EPBO, but never more.
Answer: d.
3. A firm has a transition obligation for postretirement benefits. The average remaining service period of
active plan participants is 15 years. Which of' the following options for recognizing the transition
obligation is open to this firm.
I. Immediate recognition in transition year.
II. Amortization over 15 years.
III. Amortization over 20 years.
IV. Amortization over 40 years.
a. I, II and III only.
b. I, II, III and IV.
c. I and II only.
d.
I only.
e. II only.
Answer: a.
4. At the end of the current year, a firm’s accumulated postretirement benefit obligation exceeds plan
assets by $20,000. However, the firm is reporting $10,000 of prepaid postretirement benefit cost.
Which of the following might explain why the firm can report an asset while having an underfunded
plan'?
a. The transition obligation was recognized immediately in the year of transition.
b. The firm has significant unrecognized amounts for past service cost and transition obligation.
c. The firm has a large unrecognized transition asset.
d.
The firm’s annual funding amount has never exceeded the amount recognized as annual
postretirement benefit expense.
Answer: b.
Chapter 18
11/18
Pensions & Postemployment Benefits
5. A firm reports an underfunded accumulated postretirement benefit obligation in its report of funded
status. This amount generally equals the
a. Amount by which cumulative postretirement benefit expense exceeds cumulative funding since
transition.
b. Amount by which the present value of benefit payments expected to be made exceeds the plan
assets at fair value.
c. Prepaid pension cost balance less amounts funded to date.
d.
Amount by which the present value of' benefit payments earned to date exceeds the plan assets at
fair value.
Answer: d.
E-18-26 Appendix: Postretirement Benefit Liabilities At December 31, 1998, Gypsum, Inc., estimated
the following net incurred claims costs for one of its employees. for each year of the employee’s
retirement period to which the plan applies:
Estimated Net Incurred
Claims Cost by Age
At Age
64
65
66
67
68
$4.194
4.640
1,284
1,421
1,577
The postretirement plan of Gypsum provides no benefits after age 68. For full eligibility, an employee
must serve 20 years. The employee in question is 51 years old at December 31, 1998, and has served 15
years at that date. The employee is expected to retire at age 63. Gypsum's discount rate for postretirement
benefit accounting purposes is 8 percent.
Required:
1. Determine the expected post retirement benefit obligation and accumulated postretirement benefit
obligation at December 31, 1998, for this employee.
2. Assuming that the employee works another five years after December 31, 1998, and that there are
no changes in expected net incurred claims costs, determine the expected postretirement benefit
obligation and accumulated postretirement benefit obligation at December 31, 2003, for this
employee.
Answer:
Requirement 1
EPBO at 12/31/98:
$4,194 (PV1, 8%, 13)
=
$4,194
$4,640 (PV1, 8%, 14)
=
$4,640
$1,284 (PV1, 8%, 15)
=
$1,284
$1,421 (PV1. 8%. 16)
=
$1,421
$1,577 (PV1, 8%, 17)
=
$1,577
EPBO at 12/31/98
APBO at 12/31/98 = (15/20) $4,368
(.36770)
(.34046)
(.31524)
(.29189)
(.27027)
=
=
=
=
=
=
$1,542
1,580
405
415
426
$4,368
$3,276
The employee has served 15/20 of the full eligibility period and is expected to reach the full eligibility date.
An equal amount of EPBO is attributed to each year of service from date of hire to the full eligibility date.
Chapter 18
12/18
Pensions & Postemployment Benefits
Requirement 2
The two obligation measures are equal at 12/31/03, the full eligibility date. The employee has served 20
years at that date.
EPBO and APBO at 12/31/03:
$4,194 (PV 1, 8 %, 8)
=
$4,640 (PV 1, 8%, 9)
=
$1,284 (PV 1. 8%, 10) =
$1,421 (PVI. 8%. 11)
=
$1,577 (PV 1, 8%.12)
=
EPBO and APBO at 12/31/03
$4,194
$4,640
$1,284
$1,421
$1.577
(.54027)
(.50025)
(.46319)
(.42888)
(.39711)
=
=
=
=
=
$2,266
2,321
595
609
626
$6,417
P-18-6 Multiple Choice: Accounting for Pensions. Choose the correct statement for each question.
1. The following information pertains to Lara Corporation’s defined benefit plan for 1998:
Service cost ..................................................................... $160,000
Actual and expected gain on plan assets ............................. 35,000
Unexpected increase in PBO incurred during 1998 ............ 40,000
Amortization of unrecognized prior service cost .................. 5,000
Annual interest on pension obligation ................................ 50,000
What amount should Lara report as pension expense in its 1998 income statement?
a. $250,000.
b. $220,000.
c. $210,000.
d. $180,000.
Answer: d. $180,000
Service cost ..................................................................... $160,000
Return ................................................................................ (35,000)
Amortization of PSC .............................................................. 5,000
Interest .............................................................................. 50,000
1998 pension expense ............................................ $ 180,000
(The earliest the PBO can be amortized is 1999.)
2. Nion Company sponsors a defined benefit plan covering all employees. Benefits are based on years of
service and compensation levels at the time of retirement. Nion determined that as of September 30,
1998, its accumulated benefit obligation was $380,000 and its plan assets had a $290,000 fair value.
Nion’s September 30, 1998 trial balance showed prepaid pension cost of $20,000. As of September
30, 1998, what is the balance of additional minimum pension liability?
a. $110,000
b. $360,000.
c. $ 90,000.
d. $400,000.
Chapter 18
13/18
Pensions & Postemployment Benefits
Answer: a. $110,000
ABO ................................................................................. $380,000
Plan assets ........................................................................ 290,000
Total minimum liability ......................................................... 90,000
Prepaid pension cost......................................................... 20,000
required additional pension liability balance .................. $ 110,000
3. Nebb Company implemented a defined benefit pension plan for its employees. Nebb’s contributions
fully funded the plan. The following data are provided for 1999 and 1998:
1999
Estimated
Projected benefit obligation, December 31 ..................... $187,500
Accumulated benefits obligation, December 31 ............... 130,000
Plan assets at fair value, December 31 .............................. 168,750
Pension expense .................................................................. 22,500
Employer’s contribution .............................................................. ?
1998
Actual
$175,000
125,000
150,000
18,750
12,500
What amount should Nebb contribute in order to report an accrued pension liability of $3,750 in its
December 31, 1999 balance sheet?
a. $12,500.
b. $15,000.
c. $18,750.
d. $25,000.
Answer: d. $25,000
At the beginning of 1998, the firm had no accrued pension cost account
because the plan was fully funded at that date.
1998 pension expense ...................................................... $18,750
1998 contribution ................................................................. 12,500
Ending 1998 accrued pension cost balance ......................... 6,250
Desired ending 1999 accrued pension cost balance ............ 3,750
Required decrease in accrued pension cost balance ........... 2,500
1999 pension expense ........................................................ 22,500
1999 contribution .............................................................. $ 25,000
4. On June 1, 1996, Ware Corporation established a defined benefit pension plan for its employees. The
following information was available on May 31, 1998:
Projected benefit obligation ......................................... $3,625,000
Accumulated benefit obligation ..................................... 3,000,000
Unfunded accrued benefit cost............................................ 50,000
Plan assets at fair market value ...................................... 1,750,000
Unrecognized prior service cost........................................ 637,500
To report the proper pension liability in Ware’s May 31, 1998 balance sheet, what is the required
balance in additional minimum pension liability?
a. $562,500.
b. $1,187,500.
c. $1,200,000.
d. $1,825,000.
Chapter 18
14/18
Pensions & Postemployment Benefits
Answer: c. $1,200,000
ABO ........................................................................................... $3,000,000
Plan assets .................................................................................. 1,750,000
Total liability to be recognized ..................................................... 1,250,000
Accrued pension cost ..................................................................
50,000
Additional minimum pension liability balance required ............ $ 1,200,000
C 18-5 Appendix: Differences Between Accounting for Pensions and Nonpension Postretirement
Benefits Accounting for pensions is similar to accounting for nonpension postretirement benefits in many
ways. However, there are some significant differences. In an e-mail message to a fellow student, list and
discuss some of these differences and their financial statement effects.
Answer:
1. Health care and other nonpension postretirement benefits are often more difficult to predict than
pension benefits. The amount of pension benefits is controllable to a greater extent. Predictions of
nonpension postretirement benefit payments (especially health care) are affected by the type of
benefit, technological changes, outside reimbursement, and many other factors.
2. There is no minimum liability recognition or disclosure for nonpension postretirement benefits.
3. There is no vested benefit disclosure for nonpension postretirement benefits.
4. The attribution period for pensions begins with the period in which the employee begins to earn
benefits and ends with retirement. For nonpension postretirement benefits, the attribution period may
end before retirement, on the date the employee becomes fully eligible for the benefits expected to be
received.
5. In contrast to pensions, nonpension postretirement benefit plans generally have been unfunded.
Therefore, postretirement benefit expense will be offset only marginally by the return component. In
addition, the APBO at transition is generally quite large, causing interest cost to be a greater
proportion of total expense.
6. Many companies must change their accounting systems to enable separation of the cost of benefits
payable during the term of employment from those payable after retirement.
7. There was no previous accounting pronouncement requiring accrual of nonpension postretirement
benefits. Therefore. the difference between the pre-SFAS No. 106 expense and post-SFAS No. 106
expense will be larger than was the case for pensions and SFAS No. 87.
8. The unrecognized transition obligation can be recognized immediately, or if delayed recognition is
chosen, 20 years can be used if the average remaining service period is less than 20 years.
Immediate recognition is not available for the unrecognized transition obligation in pensions. and only
15 years can be used if the average remaining service period is less than 15 years.
9. The unrecognized transition obligation is subject to additional amortization if the cumulative expense
under a pay-as-you-go approach would have exceeded that under SFAS No. 106 before the
additional amortization.
10. Nonpension postretirement benefit funds are generally taxable: therefore, the return component of
postretirement benefit expense must consider the tax rate.
11. Gains and losses can be recognized immediately, subject to certain constraints, for nonpension
postretirement benefit plans.
12. Postretirement benefit expense is more sensitive to changes in assumptions. One result of this
greater sensitivity is the requirement that the effect of a 1% change in future health care cost trend
rates on components of postretirement benefit expense and APBO be disclosed.
Chapter 18
15/18
Pensions & Postemployment Benefits
A-18-2 Funding and Pension Expense Components The Dole Food Company is one of the largest
international food processing and distribution companies. Portions of footnote 8 (pension benefits) to its
1995 annual report appear below.
The Company has qualified defined benefit pension plans covering most full-time employees.
The status of the plans was as follows (amounts in $ thousands):
1995
1994
Projected benefit obligation ...................... $239,855 $223,082
Plan assets at fair value. Primarily
stocks and bonds .................................... 238,730
206,326
Projected benefit obligation in excess
of plan assets .........................................
(1,125) (16,756)
Unrecognized net transition obligation .....
(942)
(1,087)
Unrecognized prior service cost................
2,662
1,714
Unrecognized net (gain) loss ................................ (83)
17,866
Additional minimum liability ...................
(1,941) (10,917)
Accrued pension liability .......................... $ (1,429) $ (9,180)
The expected long-term rate of return on assets was 9 percent in both
years. Pension expense included the following components:
1995
Service cost-benefits earned during
the year ..................................................
$ 8,114
Interest cost on projected benefit
obligation ...............................................
21,270
Actual (return) loss on plan assets ..................(46,944)
Net amortization and deferral ..........................28,337
Pension expense ........................................ $ 10,777
1994
$ 7,158
20,112
4,656
(22,980)
$ 8,946
Required:
1. What was Dole's contribution to the pension fund in 1995?
2. What might have caused the change from an unrecognized net loss in 1994 to an unrecognized net
gain in 1995?
Chapter 18
16/18
Pensions & Postemployment Benefits
Answer:
(Amounts in $thousands)
Requirement 1
The prepaid pension cost account (before additional minimum pension liability) decreased $1,225 during
1995:
Additional minimum liability, end of 1994 ..........................
Accrued pension liability, end of 1994 ..............................
Prepaid pension cost balance, end of 1994 ......................
$ 10,917
9,180
Additional minimum liability, end of 1995 ..........................
Accrued pension liability, end of 1995 ..............................
Prepaid pension cost balance, end of 1995 ......................
$ 1,941
1,429
$ 1,737
512
Decrease in prepaid pension cost during 1995 ................
$ 1,225
With pension expense amounting to $10,777 in 1995, Dole contributed $9,552 ($10,777 - $1,225) to the
pension fund.
Requirement 2
The $17,866 net unrecognized loss at the end of 1994 was completely wiped out, leaving a small net gain
at the end of 1995. A major contributing factor to this change was the excess of actual return on plan
assets in 1995 over expected return. 1995 expected return was $21,486 ($238,730 x .09) while actual
return as reported by Dole was $46,944, a difference of $25,458. The latter amount is treated as a gain
and gradually amortized over future periods (or absorbed by future losses, as was the 1994 net
unrecognized amount). The gain on assets is the largest factor explaining the change in the net
unrecognized amount from 1994 to 1995. The amortization, if any, of the net unrecognized loss at the end
of 1994 also contributed to the shift.
A18-6 Appendix: Postretirement Benefits Other than Pensions—The Dole Food Company Portions
of footnote 5 (postretirement benefits) to the 1992 annual report of the Dole Food Company appear
below.
In 1992. the Company implemented Statement of Financial Accounting Standards No. 106, "Employer's
Accounting for Postretirement Benefits Other than Pensions." This statement, among other changes,
requires companies to accrue for postretirement benefits during the employee's active service period. The
Company elected to immediately recognize the accumulated postretirement benefit obligation as of
December 29. 1991 of $82.5 million ($49.5 million, net of tax).
The status of the plans at January 2. 1993 was its follows (in $ thousands):
Accumulated postretirement benefit obligation .........
Unrecognized net loss ................................................
Accrued postretirement benefit cost ..........................
$85,885
(299)
$85,586
Net periodic postretirement benefit cost for 1992:
Service cost-benefits earned during the year .............
Interest cost on APBO ...............................................
Postretirement benefit cost.........................................
Chapter 18
17/18
$ 926
7,622
$ 8,548
Pensions & Postemployment Benefits
In prior years, the cost of postretirement benefits was recognized as payments were made.
These costs totaled $4.9 million and $4.3 million during 1991 and 1990, respectively.
This is a portion of Dole's comparative income statement:
1992
Income before cumulative effect of change in
accounting principle ...................................................
Cumulative effect of change in accounting principle .......
Net Income .......................................................................
1991
1990
$65,213 $133,726 $120,455
(49,492) ______
______
$ 15,721 $ 133,726 $ 120,455
Required:
1. Why might Dole Food Company have decided to recognize the postretirement benefit transition
amount immediately?
2. What was the approximate effect of implementing SFAS No. 106 on 1992 earnings before taxes?
3. What was the amount funded for the postretirement benefit plan in 1992?
Answer:
(Amounts in $millions)
Requirement 1
Dole, along with many other companies, may have recognized the entire transition liability immediately to
minimize the effect of past postretirement benefit costs on future earnings. Future postretirement benefit
expense amounts will be free of any transition amortization.
In addition, Dole's income from continuing operations was roughly half of earnings in each of the previous
two years. The firm thus had the incentive to recognize the large one-time change in an already lackluster year, rather than burden future years which may reflect better earnings performance.
Requirement 2
The total pretax effect of SFAS No. 106 on 1992 earnings equals the cumulative effect plus the change in
annual postretirement expense as a result of complying with SFAS No. 106. Although the 1992 expense
under the pay-as-you-go method is not given, considering the amounts of the 1990 and 1991
postretirement benefit costs (given), a reasonable estimate of payments to retirees in 1992 is $5 million.
Using this estimate, the pretax effect of SFAS No. 106 is:
Cumulative effect (immediate recognition of transition liability) ............... $82,500
Increase in annual postretirement benefit expense ($8.548 - $5.0) .........
3,548
Total decrease in pretax earnings ............................................................ $86,048
Requirement 3
Dole has not begun to fund the postretirement plan. No plan assets were given in the report of funded
status at the beginning of 1993. The accrued liability equals APBO less the one reconciling item.
Chapter 18
18/18
Pensions & Postemployment Benefits
CHAPTER 19: ACCOUNTING FOR INCOME TAXES
1. Briefly distinguish between interperiod tax allocation and intraperiod tax allocation.
Answer:
Interperiod income tax allocation-the allocation of income tax among periods to properly measure
income tax assets and income tax liabilities.
Intraperiod income tax allocation—the allocation of income tax expense to the components on the
income statement and retained earnings statement that caused the tax expense.
3. Explain why deferred income tax can be either an asset or a liability.
Answer: Deferred income tax is an asset when there is a future deductible that will reduce income
tax payable in future accounting periods. Deferred income tax is a liability when there is a future
taxable amount that will increase future periods' income tax payable.
5. Define an income tax difference. Identify and briefly define the two types of differences.
Answer: An income tax difference results from a transaction that causes a difference between pretax
accounting income and taxable income. The two types of differences are: (a) Temporary
differences—items that are on the income statement (under GAAP) in one period and in the tax return
(under tax law) in another period. Temporary differences will reverse or turn around in one or more
subsequent periods; they require interperiod income tax allocation. (b) Permanent differences—items
which are reported on the income statement or tax return but not on both. They do not reverse or turn
around; they are not subject to income tax allocation.
13. Define net operating loss (NOL), carrybacks, and carryforwards. Briefly explain the options available
to taxpayers.
Answer: Income tax law permits a taxpayer to offset some income tax losses (i.e., NOLs) in the
current period against earnings of the past and/or future; this may result in a cash refund, or
alternatively, a reduction of future tax payments. A carryback is the situation when such a loss is
offset against earnings of specified prior years (limited to three prior years). A carryforward is when
the loss is offset against future earnings. The two options are:
a. Carryback-carryforward—carry back three years then carry forward any unabsorbed loss (up to
15 years only).
b. Carryforward only—carry forward to future years (limited to 15 years) only. The benefit of the
carryforward amount can be recorded in advance of realization under SFAS No. 109.
15. Is deferred tax arising from an NOL carryforward classified as current or noncurrent?
Answer: The deferred tax asset arising from an NOL carryforward is classified as current or
noncurrent depending on when it is expected to be realized. If the firm estimates that it will have
taxable income in the following year (or operating cycle, if longer), then the portion of the deferred tax
asset that will be used in that year is considered current. Any amount not expected to be realized in
the following year or operating cycle is classified as noncurrent.
Chapter 19
1/18
Accounting for Income Taxes
E 19-2 Terminology Overview Listed below to the left are some terms frequently used in SFAS No. 109.
Brief definitions are listed to the right. Match the definitions with the terms by entering the appropriate
letters in the blanks.
___ 1. Deferred tax asset.
A. Income tax payable plus net changes in the deferred tax
___ 2. Taxable amount.
liability, deferred tax asset, and valuation allowance accounts.
___ 3. Permanent difference.
B. An amount used to compute income tax payable.
___ 4. Valuation allowance.
C. The difference between a current deferred tax asset and a
___ 5. Temporary difference.
current deferred tax liability when the latter is higher.
___ 6. Taxable income.
D. May result in a cash refund or a reduction of income tax
___ 7. Net current deferred tax liability.
___ 8. Income tax expense.
payable in future periods.
E. An amount used to compute deferred tax assets and liabilities,
___ 9. NOL carryback/carryforward
and a portion of income tax expense.
___ 10. Intraperiod income tax allocation.
F. A deferred tax amount that has a debit balance.
G. A tax difference that does not reverse, or turn around.
H. An allocation of tax among the components in the income
statement.
I. A contra account used to reduce deferred tax assets to the
portion more likely than not to be realized.
J. An amount that represents a difference between financial
accounting and tax accounting that will increase taxable
income in future periods.
Answer:
1. F;
2. J;
3.G;
4.I;
5.E;
6.B;
7.C;
8.A;
9.D;
10.H.
E 19-4 Recording and Reporting Income Tax Consequences for a Two-Year Period The records of
Star Corporation provided the following data related to accounting and taxable income:
Pretax accounting income .......................
Taxable income (tax return) ....................
Income tax rate .......................................
1997
1998
$200,000
220,000
35%
$220,000
200,000
35%
There are no existing temporary differences other than those reflected in this data.
Required:
1. Give the journal entry to record the income tax consequences for each year.
Chapter 19
2/18
Accounting for Income Taxes
2. Show how income tax expense, income tax payable, and deferred income tax should be reported on
the financial statements each year.
Answer:
Requirement 1
December 31, 1997 (origination entry):
Income tax expense ($77,000 - $7,000) ..........................
Deferred tax asset ($200,000 - $220,000) x .35 ...............
Income tax payable ($220,000 x .35) ........................
December 31, 1998 (reversing entry):
Income tax expense ($70,000 + $7,000) .........................
Deferred tax asset ($220,000 - $200,000) x .35.........
Income tax payable ($200,000 x .35) ........................
70,000
7,000
77,000
77,000
7,000
70,000
Requirement 2
Income statement:
Income tax expense ..........................................................
1997
1998
$70,000
77,000
Balance sheet:
Current asset:
Deferred income tax asset ..........................................
7,000*
Current liabilities:
Income taxes payable .................................................
77,000
*
77,000
The asset is recognized because it is more likely than not to be realized. The tax deductible amount
to be realized in 1998 could be carried back to 1997 to realize the tax benefit. No valuation allowance
is needed.
E 19-7 Analyze a Tax Liability: Entries and Reporting Stacy Corporation would have had identical
income before taxes on both its income tax returns and income statements for the years 1997 through
2000 except for an operational asset that cost $120,000. The asset was depreciated for income tax
purposes using the following amounts: 1997, $48,000; 1998, $36,000; 1999, $24,000; and 2000, $12,000.
However, for accounting purposes the straight-line method was used ([i.e., $30,000 per year; this is the
only temporary difference). The accounting and tax periods both end December 31. The operational asset
has a four-year estimated life and no residual value. Accounting income amounts before income taxes for
each of the four years are as follows:
1997
Accounting income before taxes .......... $30,000
1998
1999
2000
$50,000
$40,000
$40,000
Assume that the average and marginal income tax rate for each year was 30 percent.
Required:
1. Is this a temporary difference? Explain why.
Chapter 19
3/18
Accounting for Income Taxes
2. Reconcile pretax accounting and taxable income, calculate income tax payable, compute the balance
in the deferred tax liability account, and prepare journal entries for each year-end.
3. For each year show the deferred income tax amount that would be reported on the balance sheet.
Answer
Requirement 1
This is a temporary difference because the difference in pretax accounting income and taxable income in
the originating periods will subsequently reverse. The temporary difference at the end of the first year is a
future taxable amount of $18,000.
Requirement 2
Schedule of temporary differences
1997
Tax depreciation ............................................................. $48,000
Book depreciation .......................................................... 30,000
Originating (reversing) future taxable amount................ $18,000
Cumulative future taxable amount ................................. $18,000
1998
1999
2000
$36,000
30,000
$ 6,000
$24,000
$24,000
30,000
($ 6,000)
$18,000
$12,000
30,000
($18,000)
$-0-
Reconciliation of accounting and taxable income:
Effect on
Effect on
Effect on
Effect on
future years' income
future years' income
future years' income
future years' income
Current 1998 and 1998 and Current 1999 and 1999 and Current 2000 and 2000 and Current 2001 and 2001 and
Year thereafter: thereafter: Year thereafter: thereafter: Year thereafter: thereafter: Year thereafter: thereafter:
1997 deductible taxable
1998 deductible taxable
1999 deductible taxable
2000 deductible taxable
Pretax accounting income
Temporary differences
Depreciation
Net taxable income
Total temporary differences
Marginal tax rate
Taxes curently payable
$30,000
$50,000
(18,000)
$12,000
$18,000
$18,000
x .30
x .30
$3,600
Deferred tax asset, ending balance
Deferred tax liability, ending balance
Deferred tax asset, balance prior year
Deferred tax liability, balance prior year
Balance increase (decrease)
$40,000
(6,000)
$44,000
24,000
$24,000
x .30
x .30
$13,200
0
18,000
$18,000
x .30
x .30
$13,800
$0
$0
x .30
x .30
$17,400
0
$5,400
0
0
$5,400
18,000
$58,000
0
$7,200
0
$0
6,000
$46,000
0
$5,400
$40,000
$0
0
5,400
$1,800
$0
0
7,200
($1,800)
$0
5,400
($5,400)
Journal entry:
Tax expense
Deferred tax asset
Deferred tax liability
Taxes payable
9,000
15,000
5,400
3,600
12,000
1,800
13,200
12,000
1,800
5,400
13,800
17,400
Requirement 3
Noncurrent:
Deferred tax asset
Deferred tax liability
Net deferred asset (liability)
Chapter 19
1997
1998
1999
$0
(5,400)
($5,400)
$0
(7,200)
($7,200)
$0
(5,400)
($5,400)
4/18
2000
$0
0
$0
Accounting for Income Taxes
E 19-8 Asset/Liability Method with Change in Tax Rates Wittco Company reports pretax accounting
income in 1997, its first year of operations, of $100,000. Taxable income is $70,000, with temporary
differences arising in 1997 from the following sources:
a. Prepayment of 1998 rent in the amount of $24,000 in 1997.
b. An installment sale in the amount of $36,000, with cash collections expected in two equal amounts in
1999 and 2000.
The enacted tax rates all known in 1997 are 30 percent in 1997, 30 percent in 1998, and 40 percent in
1999 and thereafter.
Required:
1 Prepare the journal entry to record income taxes.
2. Repeat (1) above, assuming that a new tax law is passed in 1997 raising the statutory tax rate to 40
percent for 1997 and all years thereafter.
Answer:
Requirement 1
Under the asset/liability method, future tax rates are used in determining the deterred tax asset or liability
that is recorded.
Schedule: Temporary differences, taxes payable, and deferred tax balances
1997
Pretax accounting income ............................ $100,000
Temporary differences:
Prepayment of rent ................................
(24,000)
Installment receivable ............................
(36,000)
Taxable income ............................................. $ 40,000
Total deductible .............................................
Total taxable ..................................................
Times: Marginal tax rate................................
x .30
Taxes payable ............................................... $ 12,000
Deferred tax liability, December 31, 1997 .....
*
Future
Years
Effect on future
taxable income
Deductible
Taxable
$24,000
36,000
$24,000
36,000
______
______
$60,000
X*
$ 21,600
the future taxable amounts occur in years with different tax rates. The computation of the deferred tax
liability is:
1998 taxable amount ($24,000 prepaid rent) ..........................
1998 tax rate ...........................................................................
Deferred tax liability related to 1998 .......................................
1999 and 2000 taxable amount ..............................................
Enacted tax rate for 1999 and 2000 ........................................
Deferred tax liability.................................................................
Total deferred tax liability balance, December 31, 1997 ..
$ 24,000
.30
$ 7,200
$36,000
.40
14,400
$ 21,600
The beginning-of-period balances for deferred tax assets and liabilities are zero:
Chapter 19
5/18
Accounting for Income Taxes
End-of-period balance (computed above)......................
Less: Beginning-of-period balance (taken from
beginning- of-period balance sheet .........................
Debit (credit) to be made to account ..............................
Deferred tax
Asset
Deferred Tax
Liability
$-0-
$(21,600)
-0$-0-
-0$(21,600)
Computation of income tax expense:
Income taxes payable ....................................................
Increase (decrease) in deferred tax liability ...................
Income tax expense in 1997 ..........................................
The journal entry to record income taxes for 1997 is:
Income tax expense .......................................................
Income taxes payable ..............................................
Deferred tax liability .................................................
$12,000
21,600
$ 33,600
33,600
12,000
21,600
Requirement 2
Schedule: Temporary differences, taxes payable, and deferred tax balances
Future
Years
1997
Pretax accounting income ............................ $100,000
Temporary differences:
Prepayment of rent ................................
(24,000)
Installment receivable ............................
(36,000)
Taxable income ............................................. $ 40,000
Total deductible .............................................
Total taxable ..................................................
Times: Marginal tax rate................................
x .40
Taxes payable ............................................... $ 16,000
Deferred tax liability, December 31, 1997 .....
Effect on future
taxable income
Deductible
Taxable
$24,000
36,000
______
$24,000
36,000
______
$60,000
x.40
$ 24,000
The beginning-of-period balances for deferred tax assets and liabilities are zero:
End-of-period balance (computed above)......................
Less: Beginning-of-period balance. (taken from
beginning- of-period balance sheet) ........................
Debit (credit) to be made to account ..............................
Deferred tax
Asset
Deferred Tax
Liability
$-0-
$(24,000)
-0$-0-
-0$(24,000)
Computation of income tax expense:
Income taxes payable ....................................................
Increase (decrease) in deferred tax liability ...................
Income tax expense in 1997 ..........................................
The journal entry to record income taxes for 1997 is:
Income tax expense .......................................................
Income taxes payable ..............................................
Deferred tax liability .................................................
Chapter 19
6/18
$16,000
24,000
$ 40,000
40,000
16,000
24,000
Accounting for Income Taxes
E 19-10 Operating Carryback-Carryforward (NOL) Options: Choices, Entries, and Reporting
Tyson Corporation reported pretax income from operations in 1997 of $80,000 (the first year of
operations). In 1998, the corporation experienced a $40,000 pretax loss from operations (NOL).
Management is very confident the firm will have taxable income in excess of $50,000 in 1999. Assume
an income tax rate of 20 percent in 1997, increasing to 30 percent in 1998 and thereafter. Tyson has no
other temporary differences.
Required:
1. Assess Tyson's income tax situation for 1997 and 1998 separately. How should Tyson elect to handle
the loss in 1998? Which carry back/carry forward option should Tyson choose?
2. Based on your assessments in (1), give the 1997 and 1998 income tax entries that Tyson should make.
3. Show how all tax-related items would be reported on the 1997 and 1998 income statement and
balance sheet.
Answer:
Requirement 1
1997: Income tax payable (and expense) $80,000 x.20 = $16,000.
1998: Loss of $40,000 can be used as a NOL carryback to obtain a tax refund of $40.000 x .20 = $8,000,
or carryforward only for an expected benefit of $40,000 x.30 = $12,000.
Tyson should elect the carryforward only option, as it results in additional benefit of $4,000 within a year.
Requirement 2
1997:
Income tax expense .......................................................
Income tax payable .................................................
16,000
Deductible tax asset .......................................................
Income tax reduction from loss carryforward (a
component of income tax expense) ........................
12,000
16,000
1998:
12,000
Requirement 3
1997
Income statement:
Income tax expense: current portion .............................. $ 16,000
Income tax reduction from loss carryforward (a
credit component of income tax expense) .....................
None
Total ......................................................................... $ 16,000
Balance sheet:
Current assets:
Deferred tax assets .................................................
1998
$ -0(12,000)
$ (12,000)
None
12,000
Current liabilities:
Income tax payable (assuming no prepayments)....... 16,000
None
Chapter 19
7/18
Accounting for Income Taxes
E 19-12 Valuation Allowance, NOL Carryforward At December 31, 1997, Allsoap Corporation has a
deferred tax asset of $25,000, all of which arose as a result of temporary differences occurring in 1997.
Allsoap began operations in 1996. In its first year the company had a net operating loss of $10,000, which
was carried forward and used to reduce income taxes payable in 1997. In 1997, Allsoap had taxable
income before the use of the NOL carryforward of $40,000. The income tax rate is 40 percent. No
valuation allowance has been established.
Required:
1. Compute income taxes payable and income tax expense for 1997 before any consideration of
recording a valuation allowance. Show the journal entry to record income taxes assuming that no
valuation allowance is required.
2. Now assume Allsoap has encountered stiff competition and is uncertain whether it will have any
taxable income in the foreseeable future. Assume that the temporary differences that give rise to the
deferred tax asset are expected to reverse in 1998 and 1999. Determine what amount, if any, should
be recorded as a valuation allowance at December 31, 1997, and make the appropriate entry.
3. Show how the December 31, 1997, balance sheet and income statement would disclose the
information above, assuming that a valuation allowance is recorded.
Answers:
Requirement 1
In this problem we are given taxable income and are required to determine pretax accounting income.
This can be done using the same schedule format as when going from pretax accounting income to
taxable income:
Current
Year
1997
Taxable income before NOL ......................... $ 40,000
Temporary differences:
Future deductible amounts ..................... (62,500)*
* ($25,000)/.40)
Future
Years
Effect on future
taxable income
Taxable
Deductible
$ 62,500
$ 62,500
Pretax accounting income (loss) ................... $(22,500)
Taxable income before NOL ......................... $ 40,000
NOL Carryforward ......................................... (10,000)
Taxable income ............................................. $ 30,000
Future taxable amounts ................................
Future deductible amounts............................
Applicable tax rate .........................................
0.40
Tax payable ................................................... $12,000
Deferred tax liability.......................................
Deferred tax asset .........................................
_____
$ -00.40
8/18
$ 62,500
0.40
$ -0$ 25,000
Deferred tax
Liability
Ending balance ..............................................................
$-0Beginning balance* ........................................................
-0Debit (credit) to be made to account ..............................
$-0-
Chapter 19
_____
Deferred Tax
Asset
$25,000
4,000
$21,000
Accounting for Income Taxes
Journal entry:
Deferred tax asset ..........................................................
Income tax payable .................................................
Income tax expense** ..............................................
21,000
12,000
9,000
*
Arising from the $10,000 NOL in 1996. That is, the December 31, 1996 balance sheet includes a
deferred tax asset of $10,000 x .40 or $4,000.
**
Note that since the tax rate is constant over time and there are no permanent differences, the income
tax expense (benefit) should equal pretax accounting income (loss) times the tax rate: $22,500 x .40
= $9,000
Requirement 2
If Allsoap expects zero taxable income in future years. the realizability of the deferred tax is questionable.
However, one source—tax loss carrybacks to 1997—can be used to realize at least the amount of tax
benefit associated with the maximum that could be carried back:
Amount of deferred tax asset that is more likely than not to be realized:
Taxes paid in 1997 (realizable through NOL carryforward) ........................
Total amount of deferred tax asset .............................................................
Amount of valuation allowance needed ......................................................
Journal entry:
Income tax expense .......................................................
Valuation allowance ................................................
$ 12,000
25,000
13,000
13,000
13,000
Requirement 3
Current assets:
Deferred tax assets ........................................................ $ 25,000
Less: valuation allowance .............................................. 13,000
Net deferred assets ........................................................
$ 12,000
Current liabilities:
Income taxes payable ....................................................
$ 12,000
Income statement:
Pretax accounting income (loss) ....................................
Income tax expense:
Current portion ......................................................... $ 12,000
Deferred portion ....................................................... (21,000)
Increase in valuation allowance............................... 13,000
Total income tax expense ..............................................
Net income (loss) ...........................................................
Chapter 19
9/18
$ (22,500)
4,000
$ (26,500)
Accounting for Income Taxes
P 19-1 Operating Carryback-Carryforward (NOL) Options: Entries The financial statements of
Bixler Corporation for the first four years of operations reflected the following pretax amounts:
1997
Income statement (summarized):
Revenue
Expenses
Pretax income (loss)
$125,000
120,000
$ 5,000
1998
1999
$155,000 $180,000
195,000
160,000
$(40,000) $ 20,000
2000
$250,000
200,000
$ 50,000
There are no temporary differences other than those created by tax loss carryforwards. Assume an income
tax rate of 30 percent during 1997 and 1998 and 40 percent in 1999 and 2000. Assume that future
incomes are very uncertain at the end of each year, so a valuation allowance is needed for any deferred
tax asset. In 1998, management of Bixler Corporation elects the carryback-carryforward option in order to
obtain the immediate cash refund on the NOL carryback.
Required:
1. Recast Bixler's statements to incorporate the income tax effects as required by SFAS No. 109. Show
computations.
2. Give entries to record the NOL income tax effects for each year.
3. Explain the alternative option that Bixler might have considered. What are the primary considerations
that Bixler should assess in making its choice?
Answers:
Requirement 1
Income statement (partial)
1997
1998
1999
2000
Revenue ............................................. $125,000
Expenses ........................................... 120,000
Pretax income (loss) ..........................
$ 5,000
$155,000 $180,000
195,000
160,000
$(40,000) $ 20,000
$250,000
200,000
$ 50,000
Items included in income tax expense:
Taxes payable .............................
NOL carryback (tax refund) .........
NOL carryforward effect ..............
Valuation allowance .....................
Income tax expense .......................
Net Income .........................................
$ -0(1,500)
(14,000)
14,000
$ (1,500)
$ (38,500)
$ 14,000
-0(6,000)
6,000
$ 14,000
$ 36,000
$ 1,500
-0$ 1,500
$ 3,500
$ -0-0(8,000)
8,000
$ -0$ 20,000
The full amount of the NOL carryforward is recognized as a deferred tax asset in 1998. However, since it
is not likely to be realized, a valuation allowance is established which reverses the effect of recognizing
the NOL carryforward effects. Assuming the NOL carryforward effect continues to require a valuation
allowance for the remaining amount, the result is recognition of the NOL carryforward effect only when it
is actually realized.
Chapter 19
10/18
Accounting for Income Taxes
Requirement 2
1997 entries:
Income tax expense ..........................................................
Income tax payable ($5,000 x .30) .............................
1998 entries:
Record the receivable for a tax refund:
Receivable for refund of tax for 1997 .........................
Income tax expense (tax refund) .........................
Record the benefit of the remaining NOL carryforward:
Deferred tax asset ($35,000 x .40) .............................
Income tax expense (effect of tax loss carryforward)
1,500
1,500
1,500
1,500
14,000
14,000
Since the NOL carryforward benefit is not likely to be realized, establish a valuation allowance for
the amount not likely to be realized.
Income tax expense ...................................................
14,000
Valuation allowance .............................................
14,000
1999 entries:
The NOL carryforward is used in the amount of $20,000 to reduce taxable income; thus, taxable
income payable is reduced by $20,000 x .40 or $8,000. This is the amount of the deferred tax
asset realized, and the valuation allowance is reduced in the same amount. The net effect is that
income tax expense in 1999 is zero:
Computation of income tax expense:
Tax payable ................................................................
Decrease (increase) in deferred tax asset .................
(Decrease) increase in valuation allowance ...............
Income tax expense ..........................................................
$ -08,000
(8,000)
$ -0-
The entry in 1999 shows the reduction of the deferred tax asset balance and the reduction of the
valuation allowance:
Valuation allowance ....................................................
8,000
Deferred tax asset ................................................
8,000
2000 entries:
Computation of income tax expense:
Tax payable* ...............................................................
Decrease (increase) in deferred tax asset .................
(Decrease) increase in valuation allowance ...............
Income tax expense ..........................................................
Income tax expense ...................................................
Valuation allowance ....................................................
Deferred tax asset ................................................
Income tax payable ..............................................
*
Chapter 19
14,000
6,000
Taxable income before NOL ........................................
Less: Remaining NOL carryforward.............................
Taxable income............................................................
Tax rate ........................................................................
Taxes payable ..............................................................
11/18
$ 14,000
6,000
(6,000)
$ 14,000
6.000
14,000
$ 50,000
15,000
$ 35,000
x .40
$ 14,000
Accounting for Income Taxes
Requirement 3
Bixler is required to make an irrevocable choice between one of the following two options, at the end of
the year of NOL:
(a) Carryback-carryforward option—Under this option a loss can be carried back up to three years (in
order of year) as an offset against the income of prior years, to obtain a cash refund. If the
carryback does not fully absorb the loss, the balance can be carried forward 15 years as an offset
against future income as earned (in order of years).
(b) Carryforward-only option-Under this option (any carryback is forfeited) the loss can be carried
forward as earned (in order of year) for up to 15 years.
In choosing between the two options, Bixler should consider the following:
1. Under option (a), any carryback is certain and the tax refund is immediate. At least, the carryback
offset will be realized.
In contrast, under option (b) Bixler forgoes this advantage, presumably on the expectation that future
incomes and tax rates will be higher and thus enhance the effect of the offset.
2. Option (a) makes available a total of 18 years to offset the loss against income.
In contrast, option (b) allows only 15 years to offset the loss; however, this may provide sufficient time
and result in higher offsets.
3. Option (a) does not take full advantage of potential future higher income and tax rates that option (b)
offers.
4. The effect on any investment tax credit and/or tax credits of a tax carryback or a tax carryforward.
By choosing the carryback/carryforward option the total benefit realized was $15,500: an immediate
refund of $1,500, and tax savings of $8,000 in 1999 and $6,000 in 2000.
If Bixler had chosen the carryforward only option, the total benefit would have been $16,000: tax savings
of $8,000 in 1999 and $8,000 in 2000.
In summary, Bixler should carefully assess (a) future potential income (by year), (b) future income tax
rates, and (c) the level of certainly (or uncertainty) relative to those income and tax rate estimates. Also,
because the timing of cash flows (or cash savings) is an important consideration, the choice of options
should take into account the present values of those estimated future cash flows and other tax credits.
P 19-7 Recording and Reporting a Deferred Tax Liability and Change in Tax Rate The records of
Morgan Corporation provided the following data at the end of years 1 through 4 relating to income tax
allocation:
Year 1
Year 2
Year 3
Year 4
Pretax accounting income ..................
Taxable income (tax return) ...............
$58,000
28,000
$70,000
80,000
$80,000
90,000
$88,000
98,000
The above amounts include only one temporary difference; no other changes occurred. At the end of year
1, the company prepaid an expense of $30,000, which will be amortized for accounting purposes over the
next three years (straight-line). The full amount is included in year 1 for income tax purposes. At the end
of year 1, the enacted tax rate was 35%. During year 2, the enacted tax rate was changed to 30%,
retroactive to the beginning of year 2, and was to remain in effect through year 4.
Required:
1 Prepare a schedule of temporary differences at the end of year 1.
Chapter 19
12/18
Accounting for Income Taxes
2. Give the entry to record income taxes at the end of year 1.
3. Give any entry that should be made in year 2 to reflect the change in the enacted income tax rate.
If none is required, explain why.
4. Give the entry at the end of each year for years 2 through 4, assuming that the new enacted tax
rate is not changed.
5. Complete the following tabulation:
Year 1
Year 2
Year 3
Year 4
Income statement:
Income tax expense .....................
Balance sheet:
Liabilities:
Income tax payable ...............
Deferred tax liability .............
Answers:
Requirements 1 through 4
Schedule: Temporary differences, taxes payable, and deferred tax balances
Effect on
Effect on
Effect on
Effect on
future years' income
future years' income
future years' income
future years' income
Current Year 2 and Year 2 and Current Year 3 and Year 3 and Current Year 4 and Year 4 and Current Year 5 and Year 5 and
Year thereafter: thereafter: Year thereafter: thereafter: Year thereafter: thereafter: Year thereafter: thereafter:
1
deductible taxable
2
deductible taxable
3
deductible taxable
4
deductible taxable
Pretax accounting income
Temporary differences
Prepaid expenses
Net taxable income
Total temporary differences
Enacted tax rate
Taxes curently payable
$58,000
(30,000)
$28,000
x .35
$9,800
Deferred tax asset, ending balance
Deferred tax liability, ending balance
Deferred tax asset, balance prior year
Deferred tax liability, balance prior year
Increase (decrease) in balance
Journal entry:
Tax expense
Deferred tax asset
Deferred tax liability
Taxes payable
$70,000
$30,000
$0
x .35
$30,000
x .35
$80,000
10,000
$80,000
$20,000
$0
x .30
x .30
$24,000
$0
Year 1
$0
x .30
0
$10,500
$0
Year 2
$0
x .30
10,500
($4,500)
$0
$0
x .30
$0
$0
0
Year 3
0
6,000
($3,000)
$0
3,000
($3,000)
Year 4
26,400
3,000
24,000
x .30
$29,400
$0
$3,000
24,000
4,500
$10,000
x .30
10,000
$98,000
$0
0
19,500
10,500
9,800
x .30
$27,000
$10,000
$6,000
0
20,300
10,000
$90,000
$0
$10,500
$0
$20,000
x .30
$88,000
3,000
27,000
29,400
Note: The tax rate change which occurs in Year 2 is reflected in the Year 2 balances of the deferred tax
liability account. The direct effect of the tax rate change is computed as the amount of temporary
difference that exists at the time of the change (a future taxable amount of $30,000), multiplied by the
amount of the tax rate change (35% to 30%): $30,000 x (.35 - .30) = $1,500. The income tax expense for
Year 2 reflects the reduction of future taxes because of the tax rate reduction in the amount of $1,500.
The direct effect of the tax rate change must be disclosed.
Chapter 19
13/18
Accounting for Income Taxes
Requirement 5
Reporting on the financial statements:
Income statement:
Income tax expense ....................
Balance sheet:
Liabilities:
Income tax payable ...............
Deferred tax liability...............
Year 1
Year 2
Year 3
Year 4
$20,300
$19,500
$24,000
$26,400
9,800
10,500
24,000
6,000
27,000
3,000
29,400
-0-
P19-14 Operating Carryback-Carryforward (NOL) Options: Entries and Reporting Decker Corporation experienced a loss in 1997. The company reported taxable income (loss) for 1994 to 1997 and had
average tax rates as follows:
Taxable income (loss)
Income tax rate.........
1994
1995
1996
1997
$8,000
30%
$32,000
30%
$15,000
35%
($65,000)
40%
There were no temporary differences from 1994 to 1997.
Required:
1. Record income taxes for 1997 and 1998 assuming that Decker elects the carryback-carryforward
option. Also assume the following:
a. For 1997, any tax refund receivable is collected early in 1998.
b. For 1998, the company reported taxable income of $45,000 and pretax accounting income of
$50,000 (a $5,000 temporary difference). The income tax rate for 1998 is 45 percent.
2. List the accounts and amounts that should be reported on the income statements and balance sheet for
each of the above requirements.
3. Repeat (1) and (2) assuming that Decker elects the carryforward-only option, and no valuation
allowance is deemed necessary.
Answer:
Requirement 1
A. Entries to be made at the end of 1997, assuming the carryback/carryforward option is chosen:
Receivable for refund of taxes paid in 1994-96 (NOL refund) ...........
Income tax expense (tax refund from NOL carryback) ...............
17,250
Deferred tax asset .............................................................................
Income tax expense (NOL carryforward) ....................................
4,500
17,250
4,500
It is assumed that a valuation allowance is not required. If one were required, the amount of the
reduction in the operating loss would be reduced by the amount of the valuation allowance.
Chapter 19
14/18
Accounting for Income Taxes
Computation:
Carryback to 1994 ...................... $8,000
Carryback to 1995 ...................... 32,000
Carryback to 1996 ...................... 15,000
Total tax refund from NOL carryback
x
x
x
.30
.30
.35
=
=
=
Total loss in 1997 ..............................................................
Amount carried back in 1994-96 .......................................
Amount available for carryforward ....................................
$ 2,400
9,600
5,250
$ 17,250
$ 65,000
55,000
$ 10,000
B. Entries to be made at the end of 1998
Income tax expense ..........................................................................
Deferred tax asset ($10,000 x .45) .............................................
Deferred tax liability ($5,000 x .45) .............................................
Income tax payable ($45,000 - $10,000 carryforward) x .45 ......
22,500
4,500
2,250
15,750
Requirement 2
1997
Income statement:
Pretax accounting income .......................................................
Income tax expense (savings) (in 1997: $17,250 + $4,500) ...
Balance Sheet:
Current assets:
Receivable of tax refund ...................................................
Deferred tax asset ............................................................
Current liabilities:
Income tax payable ..........................................................
Noncurrent liabilities:
Deferred tax liability ..........................................................
1998
$(65,000)
(21,750)
$50,000
22,500
$17,250 *
4,500
$15,750
2,250
* Assumed to be collected in 1998.
Requirement 3
A. Entries to be made at the end of 1997, assuming the carryforward only option is chosen:
Deferred tax asset .............................................................................
Income tax expense (NOL carryforward) ....................................
29,250
29,250
It is assumed that a valuation allowance is not required. If one were required, the amount of the
reduction in the operating loss would be reduced by the amount of the valuation allowance,
Computation:
Carryforward to future periods ... $65,000
x
.45
Total deferred tax asset from NOL carryforward
=
$ 29,250
$ 29,250
B. Entries to be made at the end of 1998
Income tax expense ..........................................................................
Deferred tax asset ($45,000 x .45) .............................................
Deferred tax liability ($5,000 x .45) .............................................
Income tax payable ($45,000 - $45,000 carryforward) x .45 ......
22,500
20,250
2,250
-0-
At the end of 1998, there is $20,000 ($65,000 - $45,000) of NOL available for carryforward, and a
deferred tax asset in the amount of $9,000 ($20,000 x .45) on the balance sheet.
Chapter 19
15/18
Accounting for Income Taxes
C. Reporting and disclosures:
1997
Income statement:
Pretax accounting income .......................................................
Income tax expense ................................................................
Balance Sheet:
Current assets:
Deferred tax assets ..........................................................
Current liabilities:
Income tax payable ..........................................................
Noncurrent liabilities:
Deferred tax liability ..........................................................
1998
$(65,000)
(29,250)
$50,000
22,500
$29,250
9,000
$-02,250
If the deferred tax liability at the end of 1998 were to be classified as current, it would be netted
against the deferred tax asset, and a net deferred tax asset of $9,000 less $2,250, or $6,750 would
be reported.
C 19-5 Valuation Allowance for Deferred Tax Assets Soderstrom Company has a deferred tax asset of
$1,000,000 at December 31, 1997, arising from its recording of its liability for postretirement benefits
other than pensions Soderstrom's CPA asks management whether a valuation allowance to reduce the
deferred tax asset to zero should be recorded.
Required:
1. Why would Soderstrom not want to report a valuation allowance? Outline what evidence, assuming it
existed, Soderstrom might use to argue against recording a valuation allowance.
2. Suppose in the final analysis, it is determined that a valuation allowance of $400,000 is needed. How
would the company have arrived at this determination, and what effect will it have on net income in
fiscal 1997?
Answer:
1. Soderstrom, like most firms, would prefer not to report a valuation allowance which reduces net
assets and increases income tax expense. Soderstrom could produce evidence that the deferred tax
asset was more likely than not to be realized Such evidence would include:
• a history of profitability
• existing contracts or firm sales backlogs that will produce more than enough taxable income to
realize the deferred tax asset
• excess appreciated asset values over tax bases such that, if a tax planning strategy were used,
the deferred tax asset could be realized.
Soderstrom must show that it could use the carryback provisions of the tax code, have taxable
income in future years, or have future reversals of existing future taxable items to offset against future
deductible amounts, all of which result in realizing the benefit of the deferred tax asset and obviate
the need for a valuation allowance.
2. The valuation allowance is called for when “it is not more likely than not" that all of the deferred tax
asset will be realized. The company would apply the procedures and analysis outlined above, and
come to a judgment regarding the realizability of the deferred tax asset. When the valuation
allowance is recorded to reduce the carrying value of the deferred tax asset, it causes income tax
expense in the current period to increase by that amount, and therefore net income to decrease by
the same amount.
Chapter 19
16/18
Accounting for Income Taxes
A 19-2 Applied Technology Laboratories (ATL) ATL, a medical equipment manufacturer, reported a
loss before income taxes of $20.9 million in 1994, yet the income tax effect was a savings of only $0.7
million. The effective income tax rate is only 3.3 percent (0.7/20.9). ATL reported a loss before income
taxes of $1.7 million in 1993, yet had income tax expense of $1.6 million—an effective tax rate of 94.1
percent! Assume a statutory income tax rate of 35 percent.
This schedule from the notes to the 1994 ATL annual report explains its deferred tax assets and
deterred lax liabilities (in thousands):
Deferred tax assets
Receivables ..................................
Inventories....................................
Net operating loss carryforwards .....
State taxes.........................................
Compensation ...................................
Provision for litigation claim ............
Research and experimentation
credit carryforwards ......................
Other .................................................
Gross deferred tax assets ...............
Less valuation allowance ..............
Net deferred tax assets ..................
Deferred tax liabilities, primarily
depreciation and intangible assets ....
Net deferred income taxes ......................
1994
1995
$ 3,230
11,564
$ 2,936
8,800
3,969
3,106
2,623
1,700
3,157
2,087
2,171
-
6,602
3,032
$35,826
(27,249)
$ 8,577
6,425
3,107
$29,683
(19,709)
$ 8,974
(4,472)
$ 4,105
(4,628)
$ 4,346
Required:
1. What are some reasons why ATL’s effective tax rate might be so low in 1994?
2. Why might ATL show an income tax expense in a year when it has a loss before income taxes for
financial reporting?
3. In general terms, explain why ATL has such a large amount reported as a valuation allowance.
4. What effect did the increase in the valuation allowance from 1993 to 1994 have on ATL’s income tax
expense computation in fiscal 1994?
5. Using a tax rate of 35 percent, estimate the amount of net operating loss carryforwards that ATL has
as of' December 31, 1994.
6. Using a tax rate of 35 percent, estimate the amount of "research and experimentation credit
carryforwards" that ATL has as of December 31, 1994.
7. Using a tax rate of 35 percent, estimate the amount of accrued liability for litigation claim that ATL
has as of December 31, 1994.
Answers:
Requirement 1
Effective tax rates are different from statutory rates either because rates different than the U.S. statutory
rates are applied to some or all of the taxable income, or there are permanent differences affecting the
computation of the effective rate. Looking at the ATL data found in the Note, we see that the Company
has large amounts of deferred tax assets arising from NOL carryforwards and from "research and
experimentation tax credits." When such large amounts arise from these sources one must become
Chapter 19
17/18
Accounting for Income Taxes
concerned about whether the benefit they represent is likely to be realized. Looking further at the Note,
we see that ATL has a large valuation allowance, and more importantly, it increased by $7,540(000) in
1994. This entire amount increased income tax expense in 1994, and it is the most likely source of
causing the effective tax rate to decline in 1994.
Requirement 2
Once again, this has to arise because of permanent differences or an increase in the valuation allowance
(which is a form of permanent difference). We do not know the valuation allowance account balance at
the end of fiscal 1992, but it is likely that it was less than the fiscal 1993 balance. If so, then again income
tax expense is increased in 1993 because of the increasing of the valuation allowance. There could be
other permanent differences causing the effects on the effective tax rate, but the valuation allowance
change is the most likely source.
Requirement 3
The Company has "negative evidence" regarding the need to create a valuation allowance. We can see
from the data that ATL has had a series of years with net operating losses (NOLs), and this is strong
negative evidence. It would appear that ATL does not have other sources for generating taxable income
in the future; thus it must record the valuation allowance for the amount of the future benefit not expected
to be realized.
Requirement 4
The valuation allowance increased by $7,540,000. This amount would be credited to the valuation
allowance and debited to the deferred portion of income tax expense. Thus the full amount of S7,540,000
increases income tax expense in 1994.
Requirement 5
The tax effect of the carryforward is $3,969,000. Dividing by the statutory tax rate, which was used to
compute these tax effects, we determine the actual amount of carryforward to be $3,969,000/.35, or
$11,340,000.
Requirement 6
Tax credits are direct reductions to income taxes payable, hence the amount shown in the deferred tax
asset represents the entire amount of credit. The "research and experimentation tax credits total
$6,602,000.
Requirement 7
The deferred tax related to the litigation claim is $1,700,000, thus the estimated amount of the litigation
claim recorded is $1,700,000 divided by .35, or $4,857,000.
Chapter 19
18/18
Accounting for Income Taxes
CHAPTER 20 CORPORATIONS: CONTRIBUTED CAPITAL
1. Define public. private. open, closed, and publicly traded corporations.
Answer:
Public: Corporations are referred to as "public" when they relate to governmental units or business
operations owned by governmental units.
Private: Corporations are referred to as "private" when they are privately owned. Such corporations
may be non-stock (nonprofit organizations, such as colleges and churches) or stock (usually
organized for profit making).
Open: When the stock is available for purchase, the stock may be widely held. Also called “publicly
held.”
Closed: When the stock is not available for purchase; it is generally held by only a few shareholders.
Also called closely held.
Publicly traded: When the stock is available for purchase by investors. The stock can be traded on a
major stock exchange, or simply over-the-counter.
4. Describe the three main categories of stockholders' equity in accounting for corporate capital,
Answer: Accounting for corporate capital emphasizes the categories of capital usually thought of as
sources of capital. To apply this concept. corporate capital accounts are established in a manner
such that the apparent sources of the capital used in the enterprise are segregated. Source is
important because the laws of the several states relating to corporations frequently are specific
concerning sources of capital.
For example. dividends may be "paid” from certain sources and riot from others in the legal sense.
For legal reasons, the source is considered important for full disclosure in the financial statements.
Three main categories of stockholders' equity are: contributed capital, retained earnings, and
unrealized capital.
10. Explain the difference between cumulative and noncumulative preferred stock.
Answer: Noncumulative preferred stock provides that dividends not declared for any prior year, or
series of prior years, are lost permanently as far as the preferred stockholder is concerned.
Cumulative preferred stock provides that dividends passed (dividends in arrears) for any prior year, or
series of' prior years, accumulate and must he paid to the preferred shareholders when dividends are
declared, before the common stockholders are entitled to receive a dividend. In most states preferred
stock is cumulative unless otherwise stated.
11. Explain the differences between nonparticipating, partially participating, and fully participating
preferred stock.
Answer: The differences relate only to preferred stock.
Preferred stock is nonparticipating when the dividends for each year are limited in the charter to a
specified preference rate per share.
Partially participating stock means that the preferred shareholders participate above the preference
rate with the common shareholders, but only up to an additional fate which is specified in the charier
and on the stock certificates.
Chapter 20
1/16
Corporations: Contributed Capital
17. Briefly explain the two methods of accounting for stock issue costs.
Answer: Stock issue costs arise from expenditures made to sell and issue capital stock. Two
methods are used to account for these:
(a) Offset method—deducted from the proceeds of the sale of the stock by debiting (i.e., reducing)
contributed capital in excess of par.
(b) Deferred charge method—debit the expenditures to a deferred charge account (an intangible
asset) and amortize as expense over a period of not more than 40 years.
20. What is the effect on the amounts of asses, liabilities. and stockholders' equity of (a) the purchase of
treasury stock and (b) the sale of treasury stock?
Answer: Effects of treasury stock on total:
Purchase
(a) Assets...................................... Decrease
(b) Liabilities ................................. None
(c) Stockholders’ equity ................ Decrease
Sale
Increase
None
Increase
21. Explain the theoretical difference between the one-transaction concept and the dual-transaction
concept in accounting for treasury stock.
Answer: The one-transaction concept, which underlies the cost method, holds that the purchase and
subsequent sale of treasury stock are, in effect, one continuous capital transaction. Consequently,
under this concept, treasury stock is debited to the Treasury Stock account at cost and held in
suspense. in effect, as an unallocated reduction of total capital. When the treasury stock is resold or
retired, as the case may be, the capital transaction is completed, and at that time, the Treasury Stock
account is removed at cost, and the various effects on capital recognized.
The dual-transaction concept, which underlies the par-value method, holds that the purchase of
treasury stock and the subsequent resale of it constitute two separate and distinct transactions.
Consequently, under this concept, the Treasury Stock account is debited at par value upon purchase
of treasury stock and other appropriate capital accounts adjusted as though the selling stockholders'
equity were retired. Upon resale, the treasury stock shares are accounted for in the same manner as
the sale of any unissued capital stock.
25. How is treasury stock reported on the balance sheet (a) under the cost method and (b) under the par
value method?
Answer: Under the cost method, treasury stock is reported on the balance sheet as an unallocated
deduction from stockholders' equity plus retained earnings.
Under the par value method, the par value of the treasury stock is subtracted from the par value of
the issued shares to which it relates. Subtraction of the par value of the treasury shares from the
issued shares provides a difference which is designated as shares outstanding at par value. Under
the par value method. this approach is logical since the treasury shares are identified with a specific
value common to other shares of the same class of stock. that is, the par value.
Chapter 20
2/16
Corporations: Contributed Capital
E 20-4 Analysis of Stockholders’ Equity: Prepare Statement The following data are from the accounts
of Mitar Corporation at December 31, 1998 (amounts in thousands):
Subscriptions receivable (noncurrent) ...............................................................
Retained earnings, 1/l/1998 ...............................................................................
Capital stock, par ?, authorized 100,000 shares .................................................
Capital stock subscribed, 1,000 shares (to be issued upon collection in full) ....
Premium on capital stock ...................................................................................
Subscriptions receivable, capital stock (due in three months) ...........................
Bonds payable ....................................................................................................
Net income for 1998 (not included in retained earnings above) ........................
Dividends declared and paid during 1998..........................................................
$
10
900
1,000
20
400
4
200
190
80
Required:
1. Respond to the following (state any assumptions that you make):
a. Total retained earnings at end of 1998 is .......................................................
b. Retained earnings on I/l/1998 was .................................................................
c. Par value per share is .....................................................................................
d. Number of shares outstanding is ....................................................................
e. Legal capital is ...............................................................................................
f. Total stockholders' equity is. .........................................................................
g. Number of shares issued is. ...........................................................................
h. Average selling price per share including any shares subscribed was ...........
i. Number of shares sold including any shares subscribed was . . . . . . . . ........
$ ____________
$ ____________
$ ____________
____________
$ ____________
$ ____________
____________
$ ____________
____________
2. Prepare the stockholders' equity section of the balance sheet at December 31, 1998. Use good form,
complete with respect to details. Subscriptions receivable is to be recorded as an asset.
Answer:
Requirement I
a. Total retained earnings at end of 1998 (900 + (190 - 80)]...........................
b. Retained earnings on January 1. 1998. was (given) ...................................
c. Par value per share is .................................................................................
Based on capital stock subscribed: $20,000 ÷ 1,000 = $20 par
d. The number of shares outstanding is ..........................................................
$1,000,000 ÷ $20 par = 50,000 shares outstanding.
e. Legal capital is ($1,000 outstanding + $20 subscribed) ..............................
Assumed to be par value by state law. State laws vary as to
accounting for subscribed stock.
f. Total stockholders' equity is ($1,010 + $1,000 + $20 + $400) ....................
g. Number of shares issued ($1,000,000 ÷ $20) .............................................
There is no treasury stock; therefore, all shares issued are outstanding.
h. Average sale price per share.......................................................................
($400 + $1,000 + $20) ÷ 51,000 shares = $27.84. Include
50,000 issued plus the 1,000 shares subscribed.
i. Number of shares sold ................................................................................
(Includes the subscribed stock.)
Chapter 20
3/16
$
$
$
1,010
900
20.00
50,000 shares
$
$
$
1,020
2,430
50,000 shares
27.84
51,000 shares
Corporations: Contributed Capital
Requirement 2
MITAR CORPORATION
STOCKHOLDERS’ EQUITY
December 31, 1998
(000s)
Contributed Capital:
Capital stock:
Capital stock, par $20, authorized 100,000 shares, issued
and outstanding, 50,000 shares .............................................................
Capital stock subscribed, 1,000 shares ...................................................
Total capital stock .................................................................................
Other contributed capital:
Contributed capital in excess of par .........................................................
Total Contributed Capital ......................................................................
Retained earnings .......................................................................................
Total Stockholders' Equity ..............................................................
$1,000
20
$1,020
400
$1,420
1,010
$2,430
E 20-6 Compute Dividends: Preferred Stock, Four Cases Able Corporation has the following stock
outstanding:
Common, $50 par value—6.000 shares.
Preferred, 6 percent, $ 100 par value—1.000 shares.
Required: Compute the amount of dividends payable in total and per share on the common and preferred
stock for each separate case:
Case A Preferred is cumulative and nonparticipating, two years in arrears; dividends declared,
$34,000.
Case B Preferred is noncumulative and fully participating, dividends declared, $40,000.
Case C Preferred is cumulative and partially participating up to an additional 3 percent; three years
in arrears: dividends declared, $60.000.
Case D Preferred is cumulative and fully participating; three years in arrears; dividends declared,
$50,000.
Chapter 20
4/16
Corporations: Contributed Capital
Answer:
Preferred 6%
(1,000 shares
and $100,000
par value)
Case A (Preferred—-cumulative; nonparticipating)
Arrears ($100,000 x .06 x 2) ...............................
Current preference ($100,000 x .06)
(matching amount) ..........................................
Balance to common ............................................
Total .............................................................
Per share ..................................................
Case B (Preferred-noncumulative; fully
participating)
Current preference ($100,000 x .06) ..................
Common, to match ($300,000 x .06) ..................
Balance, ratio based on par value 1:3 ................
Total ............................................................
Per share .................................................
Case C (Preferred; cumulative; partially
participating)
Arrears ($100,000 x .06 x 3) ....................................
Current preference ($100,000 x .06) ........................
Common, to match $300,000 x .06) .........................
Preferred, additional 3% (x $100,000) .....................
Balance to common . . . . . . .....................................
Total .............................................................
Per share .................................................
Case D (Preferred; cumulative fully participating)
Arrears ($l00,000 x .06 x 3).......................................
Current preference ($100,000 x.06) ..........................
Common, to match ($300.000 x .06) ........................
Balance ratio to par 1:3 .............................................
Total .............................................................
Per share ..................................................
Dividends
Common
(6,000 shares
and $300,000
par value)
$12,000
6,000
______
$18,000
$18.00
$12.000
$16,000
$16,000
$2.67
$6.000
4,000
$10,000
$10.00
$18.000
12,000
$30,000
$5.00
$18,000
6,000
$18,000
3,000
______
$27,000
$27.00
15,000
$33.000
$5.50
$18,000
6,000
2,000
$26,000
$26.00
Total
$18,000
6,000
$24,000
$4.00
6.000
16,000
$34,000
$6,000
18,000
16,000
$40.000
$18,000
6.000
18,000
3,000
15,000
$60,000
$18,000
6,000
18,000
8,000
$50,000
E20-11 Common and Preferred Stock Issued: Four Transactions The charter of Gilmore Company
authorized 20,000 shares of common stock, par $2, and 20,000 shares of preferred stock par $10. The
following transactions were completed. Assume that each is completely independent.
a. Sold 400 shares of common and 200 shares of preferred stock for a lump sum of $12,300. The
common had been selling during the current week at $25 per share, and the preferred at $12 per share.
Chapter 20
5/16
Corporations: Contributed Capital
b. Issued 180 shares of preferred stock for some used equipment. The equipment had been appraised at
$2,400 and the book value shown by the seller was $1,200. A reliable market value on the preferred
stock has not been established.
c. A 10 percent assessment on par value was voted on both the common and preferred when 12,000
shares of common and 8,000 shares of preferred were outstanding. The assessment was collected in
full.
d. Sold 600 shares of common and 400 shares of preferred stock in one transaction for a total cash price
of $20,000. The common recently had been selling at $20 lea were no recent sales of the preferred.
Required: Give the journal entry for each transaction. State and justify any assumptions that you make.
Answers:
a. Cash ........................................................................................ 12,300
Preferred stock, par $10 (200 shares) ..............................
Common stock, par $2 (400 shares) .................................
Contributed capital in excess of par, preferred stock ........
Contributed capital in excess of par, common stock ........
Relative market values:
Common—400 x $25
Preferred—200 x $12
Total
Allocation of cost:
Common:
($10,000/$12,400) x $12,300 =
Preferred
($2,400/$12,400) x $12,300 =
Total Cost ......................................................
Computation of contributed capital:
Common:
$9,920 - $800
=
Preferred
$2,380 - $2,000
=
=
=
=
2,000
800
380
9,120
$10,000
2,400
$12,400
$9,920
2,380
$12,300
$9,120
$380
b. Equipment (used) ....................................................................
Preferred stock (180 shares x $10) ...................................
Contributed capital in excess of par, preferred stock ........
2,400
1,800
600
The appraisal is accepted as a reasonable measure of the market value of the machinery. The book
value reflected in the seller's books is irrelevant. A preferred alternative would be to use the current
market value of the stock (if available).
c.
Cash ........................................................................................ 10,400
Contributed capital—assessment on common stock ........
Contributed capital—assessment on preferred stock .......
Common: 12,000 shares x $2 x.10
Preferred: 8,000 shares x $10 x.10
=
=
2,400
8,000
$2,400
$8,000
d. Cash ................................................................................. 20,000
Common stock (600 shares x $2) .....................................
Preferred stock (400 shares x $10) ...................................
Contributed capital in excess of par, common stock
(600 shares x $24) .........................................................
Contributed capital in excess of par, preferred stock .......
1,200
4,000
14,400
400
The current market price of the common stock is accepted as realistic. The balance of the premium
was identified with the preferred stock because there were no recent market sales of the preferred.
Chapter 20
6/16
Corporations: Contributed Capital
E20-14 Treasury Stock, Cost and Par Value Methods Compared: Entries and Account Balances On
January 1. 1997, Johnson Soap Corporation issued 20,000 shares of $20 par value common stock at $50
per share. On January 15. 1997. Johnson purchased 50 shares of its own common stock at $55 per share.
On March 1, 1997, 20 of the treasury shares were resold at $58. The balance in retained earnings was
$25,000 prior to these transactions.
Required:
1. Give all entries indicated in parallel columns, assuming application of (a) the cost method and (b) the
par value method.
2. Give the resulting balance in each one of the stockholders' equity accounts for each method.
3. Assume that on March 30, 1997 all remaining treasury stock shares are retired. Show the journal
entries for (a) the cost method, and (b) the par value method.
Answers:
Requirement 1
Requirement (a)
Cost Method
Debit
Credit
To record original sale of 20,000 shares at $50:
Cash (x $50)
Contributed capital in excess of par (x $30)
Capital stock, par $20 (10,000 shares)
1,000,000
January 15—To record purchase of 50 shares
of treasury stock at $55:
Treasury stock (50 shares)
At cost (50 shares x $55)
At par (50 shares x $20)
Contributed capital in excess of par (50 shs x $30)
Retained earnings
Cash (50 shares x $55)
March 1—To record sale of 20 shares of treasury
stock at $58:
Cash (20 shares x $58)
Contributed capital from treasury stock
transactions
Contributed capital in excess of par
Treasury stock (20 shares x $55), cost
method and (@0 shares x $20) par
method
Chapter 20
Requirement (b)
Par Value Method
Debit
Credit
1,000,000
600.000
400,000
600,000
400,000
2,750
1,000
1,500
250
2,750
2,750
1,160
60
760
1,100
7/16
400
Corporations: Contributed Capital
Requirement 2
Cost Method
Shares
Amount
Account balances:
Capital stock issued (par $20) ...............................
20,000 $400,000
Treasury stock:
At cost, $55 .....................................................
(30)
(1,650)
At par, $20 .......................................................
Contributed capital in excess of par ......................
600,000
Contributed capital from treasury
stock transactions ...........................................
60
Retained earnings ................................................
25,000
Total . ...................................................................... $1,023,.410
Par Value Method
Shares
Amount
20,000 $400,000
(30)
(600)
599,.260
-024,750
$1,023,410
Requirement 3
(a) Entry to retire treasury stock accounted for by cost method:
Capital stock ($20 x 30 shares) ............................................................
Contributed capital in excess of par ($30 x 30 shares) ........................
Retained earnings ($5 x 30 shares) .....................................................
Treasury stock ............................................................................
600
900
150
1,650
(b) Entry to retire treasury stock accounted for by par value method:
Capital stock ($20 x 30 shares) ............................................................
Treasury stock ............................................................................
600
600
P 20-8 Compute Dividends: Five Cases The charter of' Crew Corporation authorized 5,000 shares of 6
percent preferred stock, par value $20 per share, and 8,000 shares of common stock, par value of $50 per
share. All of the authorized shares have been issued. In a five-year period, annual dividends paid in
chronological order were $4,000. $40,000. $32,000. $5,000. and $36,000, respectively.
Required: Compute the amount of dividends that would be paid to each class of stock for each year under
the following separate cases:
Case A—preferred stock is noncumulative and nonparticipating;
Case B—preferred stock is cumulative and nonparticipating;
Case C—preferred stock is noncumulative and fully participating;
Case D-preferred stock is cumulative and fully participating;
Case E—preferred stock is cumulative and partially participating up to an additional 2 percent;
also assume that the dividend for year 5 was $42,000 instead of $36300.
Chapter 20
8/16
Corporations: Contributed Capital
Answers:
Year
Total Paid
Preferred, 6%
Common
(Par $100,000) (Par $400,000)
Case A—Preferred, noncumulative, nonparticipating:
1 ..................................................
$ 4,000
$ 4,000
2 ..................................................
$ 40,000
$ 6,000
$ 34,000
3 ..................................................
$ 32,000
$ 6,000
$ 26,000
4 ..................................................
$ 5,000
$ 5,000
5 ..................................................
$ 36,000
$ 6,000
$ 30,000
Case B—Preferred, cumulative, nonparticipating:
1 ..................................................
$ 4,000
$ 4,000
2 Arrears ......................................
Current .....................................
Total..........................................
$ 2,000
38,000
$40,000
$ 2,000
6,000
$ 8,000
$ 32,000
$ 32,000
3 ..................................................
$ 32,000
$ 6,000
$ 26,000
4 ..................................................
$ 5,000
$ 5,000
5 Arrears ......................................
Current .....................................
Total..........................................
$ 1,000
35,000
$36,000
$ 1,000
6,000
$ 7,000
$ 29,000
$ 29,000
Case C—Preferred, noncumulative, fully participating:
1 Preferred, current .....................
$ 4,000
$ 4,000
2 Preferred, current .....................
$ 6,000
Common, to match ...................
24,000
Balance: preferred 1/5, common 4/5 10,000
Total..........................................
$ 40,000
$ 6,000
3 Preferred, current .....................
$6,000
Common, to match ...................
24,000
Balance: preferred 1/5, common 4/5
2,000
Total..........................................
$ 32,000
$6,000
400
$ 6,400
4 Preferred, current .....................
$ 5,000
$ 5,000
5 Preferred, current .....................
$ 6,000
Common, to match ...................
24,000
Balance: preferred 1/5, common 4/5
6,000
Total..........................................
$ 36,000
$ 6,000
Chapter 20
9/16
2,000
$ 8,000
1,200
$ 7,200
$ 24,000
8,000
$ 32,000
$ 24,000
1,600
$ 25,600
$ 24,000
4,800
$ 28,800
Corporations: Contributed Capital
Year
Total Paid
Preferred, 6%
Common
(Par $100,000) (Par $400,000)
Case D—Preferred, cumulative, fully participating:
1 Preferred, current (partial) ........
$ 4,000
$ 4,000
2 Preferred, in arrears .................
$ 2,000
Preferred, current .....................
6,000
Common, to match ...................
24,000
Balance: preferred 1/5, common 4/5
8,000
Total..........................................
$ 40,000
$ 2,000
6,000
3 Preferred, current .....................
$ 6,000
Common, to match ...................
24,000
Balance: preferred 1/5, common 4/5
2,000
Total..........................................
$ 32,000
$ 6,000
4 Preferred, current (partial) ........
$ 5,000
$ 5,000
5 Preferred, in arrears .................
$ 1,000
Preferred, current .....................
6,000
Common, to match ...................
24,000
Balance: preferred 1/5, common 4/5
5,000
Total..........................................
$ 36,000
$ 1,000
6,000
1,600
$ 9,600
400
$6,400
1,000
$ 8,000
$ 24,000
6,400
$ 30,400
$ 24,000
1,600
$ 25,600
$ 24,000
4,000
$ 28,000
Case E—Preferred, cumulative, partially participating up to an additional 2%:
1 Preferred, current (partial) ........
$ 4,000
$ 4,000
2 Preferred, in arrears .................
Preferred, current .....................
Common, to match ...................
Balance: preferred 1/5 (not to
exceed $100,000 x .02 =
$100,000), common 4/5 ...........
Total..........................................
$ 2,000
6,000
24,000
$ 2,000
6,000
8,000
$ 40,000
1,600
$ 9,600
24,000
3 Preferred, current .....................
Common to match ....................
Balance, preferred 1/5 (limit
$2,000), common 4/5 ...............
Total..........................................
$ 6,000
24,000
$ 6,000
2,000
$32,000
400
$ 6,400
4 Preferred, current (partial) ........
$ 5,000
$ 5,000
5 Preferred, in arrears .................
Preferred, current .....................
Common, to match ...................
Balance, preferred 1/5 (limit
$2,000), common 4/5 ...............
Total..........................................
$ 1,000
6,000
24,000
$ 1,000
6,000
11,000
$ 42,000
2,000
$ 9,000
Chapter 20
10/16
6,400
$ 30,400
$ 24,000
1,600
$ 25,600
$ 24,000
9,000
$ 33,000
Corporations: Contributed Capital
P 20-9 Treasury Stock, Cost and Par Value Methods Compared: Entries and Account Balances At
January 1, 1997, the records of Frazer Corporation provided the following:
Capital stock, par $10, 60,000 shares outstanding .................................
Contributed capital in excess of par.......................................................
Retained earnings...................................................................................
$ 600,000
240,000
160,000
During the year. the following transactions affecting shareholders' equity were recorded:
a. Purchased 1,000 shares of treasury stock at $20 per share.
b. Purchased 1,000 shares of treasury stock at $22 per share.
c. Sold 1,200 shares of treasury stock at $25 per share.
d. Net income for 1997 was $45,000.
State law places a restriction on retained earnings equal to the cost of treasury stock held.
Required:
1. Give entries for each of the above transactions, in parallel columns, assuming application of (a) the
cost method and (b) the par value method. Assume FIFO flow for treasury stock.
2. Give the resulting balances in each capital account. Include any required disclosure note related to the
treasury stock.
Answers:
Requirement 1
Entries:
Cost Method
a. To record purchase of 1.000
shares of treasury stock at $20:
Treasury stock: At cost ($20) ..........................
At par ($10) ....................................................
Contributed capital in excess of par
(1,000 shares x $4) ........................................
Retained earnings ...........................................
Cash .....................................................
20,000
10,000
4,000
6,000
20,000
b. To record purchase of 1,000 shares
of treasury stock at $22:
Treasury stock: At cost ($22) ..........................
At par ($10) .....................................................
Contributed capital in excess of
par (1,000 shares x $4) .................................
Retained earnings ...........................................
Cash (1,000 shares x $22) ..................
20,000
22,000
10,000
4,000
8,000
22,000
c. To record sale of 1,200 shares of
treasury stock at $25:
Cash (1,200 shares x $25) ..............................
Treasury stock: At FIFO cost
(1,000 x $20) + (200 x $22) .................
At par .............................................
Contributed capital from treasury
stock transactions .............................
Contributed capital in excess of par.....
Chapter 20
Par Value Method
30,000
22,000
30,000
24,400
12,000
5,600
18,000
11/16
Corporations: Contributed Capital
Cost Method
d. Income summary .............................................
Retained earnings ................................
45,000
Par Value Method
45,000
45,000
45,000
Requirement 2
Balances in capital accounts:
Capital stock issued ...................................................
Contributed capital in excess of par ...........................
Less: treasury stock (800 shares x par, $10) .............
Contrib capital from treasury stock transactions ........
Retained earnings (Note A) .......................................
Treasury stock (800 shares x cost, $22) ....................
Total..................................................................
(a)
$160,000 + $45,000 = $205,000.
(b)
$240,000 - $4,000 - $4,000 + $18,000 = $250,000.
(c)
$160,000 - $6,000 - $8,000 + $45,000 = $191,000.
Note A:
Cost
Method
Par Value
Method
$600,000
240,000
$600,000
250,000 (b)
(8,000)
-0191,000 (c)
________
$1,033,000
5,600
205,000 (a)
(17,600)
$1,033,000
By state law, the cost of treasury stock held, $17,600, is a restriction (or
appropriation) of retained earnings. This amount of retained earnings is not
available for dividends as long as this treasury stock is held.
C20-2 Issuance of' Capital Stock to Organizers: Valuation C. Banfield, an engineer, developed a
special safety device to be installed in backyard swimming pools: When turned on, it would set off an
alarm if anything should fall into the water. Over a two-year period. Banfield's spare time was spent
developing and testing the device. After receiving a patent, three of Banfield's friends, including a lawyer,
considered plans to produce and market the device, Accordingly. a charter wits obtained, which
authorized 200,000 shares of $10 par value stock. Each of the four organizers contributed $20,000, and
each received in return 2,000 shares of stock. They also agree that, for other consideration, each would
receive 5,000 additional shares. The remaining shares were to be held as unissued stock. Each organizer
made a proposal concerning how the additional 5,000 shares would be paid for. These individual
proposals were made independently; then the group considered them as a package. The four proposals
were:
Banfield: The patent would be turned over to the corporation as payment for the 5,000
shares. An independent appraisal of the patent could not be obtained.
Lawyer: 1,000 shares would be received for legal services already rendered during
organization, 1,000 shares would be received as advance payment for legal retainer fees
for the next three years, and the balance would be paid for in cash at par.
Friend No. 2: A small building. suitable for operations, would be given to the corporation
for the 5,000 shares of stock. It was estimated that $20,000 would be needed for
renovation prior to use. The owner estimates that the market value of the building is
$750,000 and there is a $580,000 loan on it to be assumed by the corporation.
Chapter 20
12/16
Corporations: Contributed Capital
Friend No. 3: To pay $10,000 cash on the stock and to give a 12 percent (the going rate)
interest-bearing note for the total price of $40.000 (subscriptions receivable) to be paid
out of dividends over the next five years.
Required: Write it short report answering the following questions.
1. How would the above proposals be recorded in the accounts? Assess the valuation basis for each,
including alternatives.
2. What are your recommendations for an agreement that would be equitable to each organizer? Explain
the basis for-such recommendations.
Answer:
Requirement 1
To record the proposals (other alternatives are possible):
To record authorization of the capital stock:
Memo entry: Capital stock, par $10, 200,000 shares authorized.
To record the cash sale of stock to the organizers (in four separate transactions):
Cash ........................................................................................
Capital stock, par $10 (8,000 shares) .............................
80,000
80,000
Banfield proposal:
Patent ......................................................................................
Capital stock, par $10 (5,000 shares) .............................
50,000
50,000
Valuation of the patent is based on the market value of the stock because the organizers have already
paid in this amount per share for 8,000 shares in four separate transactions. This $10 per share valuation
is debatable because the 8,000 shares may not have been issued to the promoters at market value (from
the viewpoint of an outsider, these may not be arm’s length transactions). However, the $10 per share is
the best estimate available of market value because so few capital transactions have occurred and no
appraisal is available.
Lawyer proposal:
Organization costs (1,000 shares x $10) ................................
Prepaid legal fees (1,000 shares x $10) .................................
Cash ........................................................................................
Capital stock, par $10 (5,000 shares) .............................
10,000
10,000
30,000
50,000
This entry is also based on the $10 per share market value for the reasons given above. In most states it
is illegal to issue stock for services not yet performed, which, if applicable, means that the equivalent
consideration by the lawyer is only $40,000.
Friend #2 proposal:
Building ...................................................................................
Capital stock, par $10 (5,000 shares) .............................
Mortgage payable, 12% (assumed by the corporation) ..
Chapter 20
13/16
630,000
50,000
580,000
Corporations: Contributed Capital
This entry presumes that the building is realistically valued on the basis of the market value of the stock
($10 per share) plus the PV of the mortgage. The $750,000 estimate by the owner is questionable
because there is no evidence that it was an independent appraisal. However, the cost principle has been
observed by recognizing cost as the sum of the market value of the stock (as explained above) plus the
present value of the debt. This rationale aside, the “friends” should insist on an independent appraisal.
Friend #3 proposal:
Cash ........................................................................................
Subscriptions receivable (12% interest-bearing note) ............
Capital stock subscribed .................................................
10,000
40,000
50,000
This proposal is sound in all respects and meets the requirements of the cost principle; the “going interest
rate was appropriately used. However, the proposal “to be paid out of dividends” is a problem under
GAAP; nothing is stipulated about what happens if dividends are deficient.
Requirement 2
An equitable recommendation that conforms with GAAP is:
1. Establish a $50,000 value to be paid by each party, because:
(a) a market value of $10 per share has already been set as a good measure by the prior
transactions (see comments above under Banfield), and
(b) Friend #3 has established a sound GAAP basis for $10 per share
2. Banfield—The $50,000 valuation on the patent is suspect. Insist upon two independent appraisals of
this patent—there are competent experts available. Insist upon cash or a note (like Friend #3) for any
difference between the appraisal and the $10,000 to be paid in.
3. Lawyer—Do not accept the $10,000 prepaid legal fees. Insist upon cash or a note like the one
proposed by Friend #3. Ascertain that the past legal fees are competitive.
4. Friend #2—Insist upon two independent appraisals. If the appraisals are lower than $630,000, require
cash, or a reduction of the loan assumed, for the difference.
5. Friend #3—Accept as is, except insist upon deletion of the stipulation “to be paid out of dividends
because (a) nothing is said about the responsibility for payment if dividends are inadequate, and (b) it
places an undue, and probably illegal, constraint on the board of directors in the future.
Chapter 20
14/16
Corporations: Contributed Capital
A20-3 Owners’ Equity Statement, Stuck Issue Costs Gtech Holdings Corporation is a computer and
communications services company. Its consolidated statements of shareholders’ equity for the three-year
period ending February 27, 1993, follow:
(Dollars in thousands)
Balance at February 24, 1990 ..........
Common stock issued .........................
Common stock issuance cost ..............
Purchase of 40,090 shares of common
stock ................................................
Net loss ...............................................
Foreign currency translation ...............
Balance at February 23, 1991 ..........
Common stock issued .........................
Common stock issued under stock
award plans .....................................
Net income..........................................
Foreign currency translation ...............
Balance at February 29, 1992 ..........
Purchase of 73,463 shares of
common stock .................................
Common stock issued .........................
Common stock issued under stock
award plans .....................................
Tax benefits from stock compensation
17,467
Net income..........................................
Foreign currency translation ...............
Balance, February 27, 1993 ................
Common Stock
Shares
Amount
30,060,003
4,529,040
$301
45
Additional
Retained
Paid-In
Earnings Treasury
Capital Other (deficit)
Stock
$ 22,199 $(6,978)
3,345
(182)
$(4,281)
$ 11,241
3,390
(182)
$ (30)
(3,986)
34,589,043
133,60
346
1
25,362
99
1,570,999
16
6,109
734
(6,244)
(8,267)
(30)
13,862
36,293,642
363
31,570
5,900,000
59
90,294
765,867
8
8,747
(539)
(6,783)
5,595
Total
(30)
(113)
(30)
(3,896)
734
11,167
100
6,125
13,862
(539)
30,715
(113)
90,353
8,755
17,467
_________
42,959,509
___
$430
_______
(816)
$148,078 $(7,599)
21,694
______
$27,289
21,694
___
(816)
$(143) $168,055
Required:
1. What is the par value of Gtech common stock?
2. During the fiscal year ending February .13. 1991, Gtech issued 4,529,040 shares of common stock.
Describe how the stock issue costs were accounted for. Is there an acceptable alternative treatment? If
so. describe it. What were the net proceeds from the issuance? What were the net proceeds per share?
3. What was the average price per share paid for treasury stock acquired during 1990? How is treasury
stock accounted for by Gtech?
4. What is the book value per share of Gtech at February 23, 1991 ? At February 27, 1993? Briefly
describe why book value per share changed so much from February 23, 1992, to February 27, 1993.
5. What was the average price per share paid for common shares acquired during the year ending
February 27, 1993? What were the average proceeds per share for shares issued, other than those
issued under stock award plans, during the year ending February 27, 1993? List any possible reasons
why these amounts might differ greatly.
Chapter 20
15/16
Corporations: Contributed Capital
Answers:
Requirement 1
Par value per share = $301,000/30,060,003 shares = $0.01
Requirement 2
The stock issue costs were essentially deducted from the gross proceeds of the stock issuance. The
statement shows a two-transaction approach, with gross proceeds being recorded first, then the stock
issue costs being deducted from additional paid-in capital. The net proceeds from the stock issue are:
Gross proceeds:
Common stock, par value ................................................. $ 45,000
Additional paid-in capital ................................................... 3,345,000
Less: stock issue costs ...........................................................
Net proceeds ...........................................................................
$3,390,000
182,000
$3,208,000
Proceeds per share = $3,208,000/4,529,040 = $0.71
Requirement 3
Purchase price per share = $30,000/40,090 shares = $0.75
Gtech is using the cost method to account for treasury stock.
Requirement 4
Book value per share at February 23, 1991:
$11,167,000/(34,589,043 – 40,090) = $0.32 per share
Book value per share at February 27, 1993:
$168,055,000/(42,959,509 – [40,090 + 73,463]) = $3.92 per share
Book value per share has increased more than tenfold over the two-year period. The primary source of
the increase is not in the profitability of the firm, but rather the issuance of 5,900,000 shares for more
than$90.0 million, an average price of $15.31 per share.
Requirement 5
The average price per share paid for treasury stock acquired during fiscal 1993 was:
$113,000/73,463 shares = $1.54 per share
The average proceeds per share for shares issued in 1993 were:
($59,000 = $90,294,000)/5,900,000 shares = $15.31 per share
The large difference between the cost of treasury stock and proceeds per share for newly acquired issues
is difficult to explain. Possible reasons include:
 Gtech has developed a product or made a discovery such that future prospects for
the company’s profitability have skyrocketed between the date the shares were
acquired and the shares issued.
 Some contingency (such as a major lawsuit) is resolved in favor of Gtech.
Chapter 20
16/16
Corporations: Contributed Capital
CHAPTER 21
CORPORATIONS: RETAINED EARNINGS AND STOCK OPTIONS
1. Explain what an appropriation of retained earnings is, and why it is. made.
Answer: An appropriation of retained earnings reduces the amount of retained earnings available
for dividends. Appropriations are established to protect the cash position of the corporation by
reducing the amount of cash dividends that might otherwise be paid. To the extent that the amount
of cash dividends is reduced because of inadequate retained earnings. cash is saved.
2. What are the principal sources and uses of retained earnings?
Answer: The principal source of retained earnings is income from operations (including
extraordinary gains). The primary uses of retained earnings are cash dividends. stock dividends,
recapitalizations, retirement of stock and treasury stock transactions, and absorption of losses.
4. What are the four important dates relative to dividends? Explain the significance of each.
Answer: Accounting for dividends involves four important dates: (1) declaration date; (2) record
date; (3) ex dividend date, and (4) payment date. The declaration date is the date on which the
corporation formally announces the dividend. As to cash and property dividends, it is the date on
which the dividend becomes irrevocable; therefore. on this date the dividends are recorded in the
accounts. The record date is the date on which the list of stockholders of record is prepared. No
entry is made in the accounts on this date. The ex dividend date is the day following the record
date. On this date, stock prices typically fall by the amount of the cash dividend. This is important
because it provides an empirical basis for the theoretical claim that dividend revenue is earned on
the date of declaration rather than on the date of record or on the payment date. The payment
date is the date on which the dividend is paid. On this date, an entry is made for the disbursement
of cash or other assets in payment of the dividend.
7. Explain the difference between intentional and unintentional liquidating dividends.
Answer: Intentional liquidating dividends occur when the board of directors declares dividends
which they know will constitute a return of contributed capital to the stockholders, as in the case
when the corporation is discontinuing operations or where there is excessive capitalization.
Unintentional liquidating dividends occur when net income. and as a result retained earnings, is
overstated through error or omission. For example, the omission or understatement of depreciation
charges, amortization, and depletion charges would cause retained earnings to be overstated. In
such cases, if reported retained earnings (prior to correction) were used in full as a basis for
dividends, part of the resulting dividend would represent a return of contributed capital (i.e., an
unintentional liquidating dividend).
11. Contrast the effects of a stock dividend (declared and issued) versus a cash dividend (declared and
paid) on assets. liabilities, and total stockholders’ equity.
Answer:
Dividend
Cash
Stock
Chapter 21
Assets
Decrease
No effect
Liabilities
No effect
No effect
1/17
Total Stockholders'
Equity
Decrease
No effect
Corporations: Retained Earnings &
Stock Options
12. Contrast the effects of a typical small stock dividend (declared and issued) versus a typical cash
dividend (declared and paid) on the components of stockholders' equity.
Answer:
Dividend
Cash
Stock, small
Capital
Stock
No effect
Increase
Additional Contributed
Capital
No effect
Increase
Retained
Earnings
Decrease
Decrease
14. Distinguish between a large stock dividend and a pure stock split.
Answer: A stock dividend involves the issuance of additional shares of stock to the stockholders in
proportion to the shares that they held prior to the dividend. It reduces retained earning. and
increases contributed capital by the same amounts, but does not change total stockholders equity.
In contrast. a pure stock split involves the replacing of the old shares with a larger number of new
shares with a proportionately lower par value per share. A pure stock split does not change the
components or total of stockholders’ equity. Neither a stock dividend nor a stock split requires the
disbursement of corporate assets; both reduce earnings per share.
15. What are the primary reasons for appropriating and for restricting retained earnings?
Answer: Fundamentally. retained earnings are appropriated and restricted to indicate that such
amounts are not available for dividends during the period of appropriation or restriction, thereby
protecting the working capital position of the corporation. However, such appropriations and
restrictions arise for a number of reasons. The primary reasons are:
(a) To fulfill a legal restriction.
(b) To fulfill a contractual restriction.
(c) To record a discretionary action by the board of directors to appropriate a portion of retained
earnings as an aspect of financial planning.
(d) To record a discretionary action by the board of directors to appropriate a portion of retained
earnings in anticipation of possible future losses.
16. Explain the distinction between (a) a bond sinking fund and (b) an appropriation of retained
earnings for a bond sinking fund.
Answer:
(a) A bond sinking fund is created by depositing cash in a special fund (like a savings account) and
recording it in a separate account as an investment. Usually the fund is under the control of a
trustee; the fund is an asset and is used at maturity to retire bonds.
(b) A restriction of retained earnings for a bond sinking fund is a constraint on retained earnings; it
does not directly involve assets nor does it change total stockholders' equity. The amount is
temporarily restricted from paying dividends; therefore, it serves to protect working capital by
preventing a noncurrent drain on cash for dividends. It provides a measure of security to the
bondholders.
20. What is the difference between stock rights and stock warrants?
Answer: Stock rights—provide the holder with an option to acquire a specified number of shares
of the capital stock of a company under specified conditions. Stock warrants—a certificate that
evidences ownership of one or more stock rights.
22. List the three important dates with respect to stock rights. When will the related stock sell (a) rights
on and (b) ex rights?
Answer: Rights—important dates and market status:
(a) Announcement date
(b) Issuance date
Stock sells-rights on
(c) Expiration date
Stock sells-ex rights
Chapter 21
2/17
Corporations: Retained Earnings &
Stock Options
25. Stock option incentive plans for employees may be either noncompensatory or compensatory.
Briefly explain each.
Answer: A noncompensatory plan is one that does not involve additional compensation to the
grantee and involves no cost to the corporation. It is characterized by the following four attributes:
(1) substantially all full-time employees who meet the limited employment qualifications may
participate (employees owning a specified percent of the outstanding shares and executives may
be excluded), (2) stock is offered to those eligible equally or based on a uniform percentage of
salary or wages (the number of shares of stock purchased by an employee may be limited), (3) the
time permitted for exercise of an option or purchase right is limited to a reasonable period, and (4)
the discount from market price is no greater than would be reasonable in an offer of stock to
stockholders or other outside parties (the discount varies up to 15 percent in practice).
All plans not possessing all four of the above attributes are classified as compensatory. They
involve a cost to the corporation and additional compensation to the employee.
30. What are stock appreciation right?
Answer: Stock appreciation rights (SARs) usually provide a cash bonus to the employee (grantee)
based upon the change in the market value of specified shares of capital stock from the date of
grant to the exercise date.
31. Discuss how SFAS No. 123. "Accounting, for Stock-Based Compensation," differs from APB
Opinion No. 25 in recording the compensation cost of fixed stock options with the exercise price set
equal to the grant-date market price of the stock.
Answer: Under APB Opinion No. 25, the cost of fixed options is measured at the market price of
the option stock as of the grant date. less the exercise price. multiplied by the number of shares.
When the exercise price is equal to the current stock price. the cost (which would normally be
expensed over the service period) is zero. Under the procedures specified in SFAS No. 123, the
cost of options is determined at the grant date using an option pricing model. In every case.
including options granted with exercise prices equal to or even greater than the current stock price.
the cost will be greater than zero. SFAS No. 123 increases the measured value of the options,
resulting in increased compensation expense.
E 21-2 Property Dividend Recorded: Common and Preferred Stock The records of Frost Corporation
showed the following at the end of 1998:
Preferred stock, 6 percent cumulative. Nonparticipating, par $20 ............ $200,000
Common stock, no par value (50,000 shares issued and outstanding)........ 240,000
Contributed capital in excess of par. preferred stock .................................... 30,000
Retained earnings ........................................................................................ 125,000
Investment in stock of Ace Corporation (500 shares at cost) ....................... 10,000
The preferred stock has dividends in arrears for 1996 and 1997. On January 15, 1998, the board of
directors approved the following resolution: "The 1998 dividend, to stockholders of record on. February
1, 1998, shall be 6 percent on the preferred stock and $1.00 per share on the common stock; the dividends
in arrears are to be paid on March 1. 1998, by issuing a property dividend using the requisite amount of
Ace Corporation stock. All current dividends for 1998 are to be paid in cash on March 1. 1998." On
January 15, 1998, the stock of Ace Corporation was selling at $60 per share, on February 1,. at $61 per
share, and at $62 on March 1. 1998.
Chapter 21
3/17
Corporations: Retained Earnings &
Stock Options
Required:
1. Compute the amount of the dividends to be paid to each class of stockholders, including the number
of shares of Ace Corporation stock and the amount of cash required by the declaration. Assume that
divisibility of the shares of Ace Corporation poses no problem.
2. Give the journal entries to record all aspects of the dividend declaration and its subsequent payment.
Answer:
Requirement 1
(a)
Number of Ace Corporation shares required for the dividends in arrears:
$200,000 x .06 x 2 years = $24.000
$24,000 ÷ $60 per share = 400 shares of Ace Corporation stock required for the property dividend to
preferred stockholders (in arrears).
(b)
Cash dividends for the current year:
Preferred:
Common:
$200,000 x .06
50.000 shares x $1.00
Total cash required
=
=
$12,000
50,000
$62,000
Requirement 2
January 15. 1998-declaration date:
Investment-Ace Corporation [400 shares x ($60 - $20)] ............... 16,000
Retained earnings ($24,000 + $62,000) ........................................ 86,000
Gain on disposal of stock of Ace Corporation ........................................... 16,000
Cash dividends payable ............................................................................. 62,000
Property dividends payable (Ace Corporation shares) .............................. 24,000
March 1. 1998-payment date:
Properly dividends payable ........................................................... 24,000
Cash dividends payable ................................................................ 62,000
Investments-Ace Corporation (400 shares x $60) ..................................... 24,000
Cash ........................................................................................................... 62,000
Note: The relevant market value of the Ace stock is at the date the dividend liability becomes effective,
that is, the declaration date.
E 21-6 Stock Dividend Recorded: Dates Cross Two Periods The records of Round Corporation
showed the following balances on November 1. 1998:
Capital stock, par $10 ..................................................... $300,000
Contributed capital in excess of par .................................. 102,000
Retained earnings .............................................................. 200.000
On November 5, 1998. the board of directors declared a stock dividend to the stockholders of
record as of December 20, 1998, of one additional share for each five shares already outstanding; issue
date, January 10, 1999. The market value of the stock immediately after the issuance was $18 per share.
The annual accounting period ends December 31.
Chapter 21
4/17
Corporations: Retained Earnings &
Stock Options
Required:
1. Give entries in parallel columns for the stock dividend assuming, for problem purposes, Case
A-market value is capitalized; Case B-par value is capitalized. and Case C-average paid in is
capitalized.
2. Explain when each value in (1) should be used.
3. With respect to the stock dividend, what should be reported on the balance sheet at December 31,
1998, assuming no intervening dividend transactions?
Answer:
Requirement 1
November 5, 1998- Declaration date of stock dividend: Memo entry only or entry (optional).
December 20, 1998--Record date; no entry; obtain fist of shareholders of record
December 31, 1998-End of accounting period; no entry.
January 10, 1999-Issue date:*
Amount Capitalized
Case A
Case B
Market Value Par Value
Retained earnings
Case C
Average Paid In
108,000
60.000
80,400
Capital stock, par $10
(6,000 shares)
60.000
60,000
60,000
Contributed capital in excess
of par
48.000
20.400
* $300,000 ÷ $10 = 30,000 shares; 30,000 shares ÷ 5 = 6,000 shares issued as a stock dividend.
Capitalize: Market value: 6,000 shares x $18 = $108,000.
Par value: 6,000 shares x $10 = $60,000.
Average paid in: $402.000 ÷ 30,000 shares = $13.40.
6.000 shares x S 13.40 = $80.400.
Requirement 2
Market value should be used when there is a "small" stock dividend; that is, when the issuance of
additional shares is not over 20 percent to 25 percent of the outstanding shares prior to the dividend. A
small stock dividend is believed to usually have a relatively small impact on the market price per share.
Par value should be used when there is a "large" stock dividend. that is. when the issuance of additional
shares is over 20 percent to 25 percent. It is believed that a large dividend usually is reflected in an
approximate proportional effect on the market price per share. In the fact situation given, this method
could not be used.
Average paid in, if no less than the statutory minimum, sometimes is used by management because it
meets the legal minimum and maintains the "average paid in" per share.
Chapter 21
5/17
Corporations: Retained Earnings &
Stock Options
Requirement 3
At the end of 1998, the only requirement is a disclosure note that explains the stock dividend: it is not a
liability. If "common stock issuable" is recorded on the declaration date. it would be reported under
stockholders' equity as a credit (the disclosure note also should be provided).
E21-8 Stock Dividend and Stock Split: Effects Compared Bailey Corporation has the following
stockholders' equity:
Capital stock, par $12; 20,000 shares outstanding ...................
Contributed capital in excess of par .........................................
Retained earnings .....................................................................
Total stockholders' equity..................................................
$240,000
70,000
500,000
$810,000
The corporation decided to triple the number of shares currently outstanding (to 60,000 shares) by taking
one of the following alternative and independent actions:
a. Issue a 200 percent (2-for-1) stock dividend (40,000 additional shares) and capitalize retained
earnings on the basis of par value.
b. Issue a pure stock split (3-for-1, that is, three new shares are issued for each old share replaced) by
changing par value per share proportionately.
c. Issue a 3-for-1 stock split and change the par value per share to $5.
Required:
1 . Give the journal entry that should be made for each alternative action. If none is necessary, explain
why. On the stock splits. the old shares are called in and the new shares are issued to replace them.
2. For each alternative. prepare a schedule that reflects the stockholders' equity immediately after the
change. For this requirement. complete the following schedule that compares the effects of the three
alternative actions:
Item
Shares/par value
Capital stock
Additional paid-in capital in excess of par
Total contributed capital
Retained earnings
Total stockholders' equity
Before
Change
Stock
Dividend
Pure Stock
Split (par $4)
Stock Split
(par $5)
________
$ _______
________
________
________
$ _______
________
$ _______
________
________
________
$ _______
________
$ _______
________
________
________
$ _______
________
$ _______
________
________
________
$ _______
Be prepared to explain and compare the effects among the four columns in the above schedule.
Answers:
Requirement 1
a. Stock dividend (20,000 shares x 2.00 = 40,000 additional shares):
Retained earnings (40,000 shares x $12) ...............................
Capital stock. par $12 (40,000 shares) ......................
480,000
480,000
b. Memo entry only because none of the components of stockholders' equity changed, except number of
shares increased; the 20,000 old shares were called in and replaced with 60,000 new shares, and par
Chapter 21
6/17
Corporations: Retained Earnings &
Stock Options
value changed from $12 to $12 ÷ 3 = $4 per share. Legal capital is 60,000 shares x $4 per share =
$240,000, as before.
c.
Stock split 20,000 old shares called in x 3 = 60,000 new shares; par changed from $12 to $5 per
share.
Entry to reflect new legal capital amount in the capital stock account:
Capital stock, par $12 (20,000 old shares) .............................
Contributed capital in excess of par ........................................
Capital stock, par $5 (60,000 new shares) .............................
240,000
60,000 *
300,000
* (60,000 shares x $5 = $300,000) - (20,000 shares x $12 = $240,000) = $60,000 debit.
Requirement 2
Item
Before
Change
Stock
Dividend
Shares/par value
20,000/$12
60,000/$12
60,000/$4
60,000/$5
$240,000
70,000
310,000
500,000
$810,000
$720,000
70,000
790,000
20,000
$810,000
$240,000
70,000
310,000
500,000
$810,000
$300,000
10,000
310,000
500,000
$810,000
Capital stock
Additional paid-in capital in excess of par
Total contributed capital
Retained earnings
Total stockholders' equity
Pure Stock
Split (par $4)
Stock Split
(par $5)
E21-12 Employee Stock Purchase Plan—Compensatory or Noncompensatory? Entries Rice
Corporation has a stock purchase plan with the following provisions:
Each full-time employee with a minimum of one year's service may acquire. from Rice
Corporation, its common stock, par $10, through payroll deductions at 10 percent below
the market price on the date selected by the employee for a stock purchase (the exercise
date). The exercise decision must be made within one year from the payroll deduction
date.
Assume Rice Corporation uses APB Opinion No. .25 as its method to account for stock-based compensation plans. Employee H. Adams signed a payroll deduction form on January 1, 1997, for $60 per month.
At that date, the market price of the stock was $27. Assume a monthly salary of $2,000 and other payroll
deductions in the aggregate of 18 percent. At the end of 1997, Adams requested that stock be purchased
equal to the amount accumulated to Adams' credit. A that ate, the market price of the stock was $25.
Required:
1. Is this a compensatory plan under APB Opinion No. 25.` If so. how much should be recorded as
additional compensation for Adams? Explain.
2. How many shares will Adams acquire for the 1997 deductions? Show computations.
3. Give entries to record (a) one monthly payroll and (b) issuance of the shares for the year, assuming
unissued shares are used.
4. If Rice Corporation were using SFAS No. 123, would this plan result in compensation cost? Why or
why not?
Chapter 21
7/17
Corporations: Retained Earnings &
Stock Options
Answers:
Requirement 1
Under APB Opinion No. 25, the plan is noncompensatory because there is no additional expense to the
company and there is no additional compensation income to the employee. It meets the following criteria:
(1) substantially all full-time employees may participate ("each full-time employee"). (2) the stock is
offered to each eligible employee equally, (3) the exercise time is limited to a reasonable period, and (4)
the discount of 10 percent is reasonable to offset selling costs. Adams will receive no additional
compensation because the discount from market approximates a reasonable commission on security
transaction. Therefore, this is not considered additional compensation.
Requirement 2
Adams is entitled to 32 shares computed as follows:
$60 per month x 12 months = $720 total credit to Adams.
$25 x .9 = $22.50.
$720 ÷ $22.50 = 32 shares.
Requirement 3
(a) Monthly payroll (each month):
Salary expense (given) .....................................................
Liability-Employee stock purchase plan (given) .........
Other (deductions) payables ($2,000 x .18) ...............
Cash ...........................................................................
(b) Issuance of the shares (Dec. 31, 1997):
Liability—Employee stock purchase plan ($60 x 12) ........
Common stock, par $10 (32 shares) ..........................
Contributed capital in excess of par ...........................
2.000
60
360
1,580
720
320
400
Requirement 4
It is likely that this plan would result in a positive amount of compensation cost under SFAS No. 123.
First, the stock can be acquired at a 10% discount, and under SFAS No. 123 the discount mentioned for a
plan to qualify as noncompensatory is 5%. SFAS No. 123 does provide for the possibility of the 10%
qualifying for noncompensatory status by noting that the 5% discount is considered to comply without
further justification, thus implying that a higher discount may qualify if justified. The justification would be
on the basis that stock with discounts of this size would be issued to shareholders, or that the discount is
less than the amount of stock issue costs in a public offering.
If the 10% discount were to be justified, the plan still would not qualify as a noncompensatory plan. The
employee has an option to exercise the option within one year of the payroll deduction date, turning this
into an option with an exercise period greater than 31 days.
E 21-13 Stock Incentive Plan—APB Opinion No. 25: Analysis :and Entries Rex Corporation is
authorized to i 300,000 shares of common stock, par $ 1, of which 140,000 shares have been issued. The
corporation initiated a stock bonus plan during 1998 for designated managers. Each manager will receive
stock options to purchase 1,000 shares of Rex common stock,. and the options vest with thc grantee if still
employed by the company . two years from the date of grant. The rights are nontransferable and expire
after December 31, 2002. The option price is $20 per share; the market price on the date of grant was $24.
Assume that manager Ruth Roe receives the stock options on January 1, 1998.
Rex uses APB Opinion No. 25 to account for stock-based compensation plans.
Chapter 21
8/17
Corporations: Retained Earnings &
Stock Options
Required:
1. Is this a noncompensatory plan? Explain.
2. What the measurement date? Explain.
3. What is the amount of total compensation cost for manager Roe?
4. Over what period should this compensation cost be assigned as expense? How much should be
assigned to 1998 and 1999? Explain.
5. What entry should be made on the date of grant to Roe?
6. What entry should be made on December 31, 1998 for Roe?
7. Give the entry to record the exercise of the option by Roe on December 31, 2002, when the market
price of the common stock was $80 per share.
8. How much actual value did manager Roe receive? How much additional compensation expense did
Rex Corporation report?
Answers:
Requirement 1
This is a compensatory plan because it involves additional compensation to the grantees and a cost to
the corporation. It does not meet 3 of the 4 characteristics of a noncompensatory plan: (1) it is not
applicable to all employees, (2) all employees are not given a uniform percentage, and (3) the price
discount is significant (more than 15%).
Requirement 2
He measurement date is the date of grant, January 1. 1998, because it is the date that both (a) the
number of optional shares that the managers are entitled to receive (1,000), and (b) the option price ($20)
are known.
Requirement 3
The total compensation cost for each manager is: ($24 - $20) x 1,000 shares = $4,000.
Requirement 4
Total compensation cost should be assigned as expense equally over the two-year service period from
January 1, 1998, through December 31, 1999; that is. $4,000 ÷ 2 years = $2,000 per year.
Requirement 5
On date of grant, January 1, 1998—Measurement date:
Deferred compensation expense ($24 - $20) x 1,000 shares ..............
Executive stock options outstanding (for 1,000 shares of
common stock)............................................................................
4,000
4,000
Requirement 6
December 31, 1998—Adjusting entry:
Executive compensation expense ($4,000 ÷ 5 years)..........................
Deferred compensation expense ...................................................
Chapter 21
9/17
2,000
2,000
Corporations: Retained Earnings &
Stock Options
Requirement 7
December 31, 2002—Exercise of stock options:
Cash (1,000 shares x $20) ................................................................... 20,000
Executive stock options outstanding .................................................... 4.000
Common stock, par $1 (1,000 shares) ...........................................
Contributed capital in excess of par ...............................................
1,000
23,000
Requirement 8
"Actual value" received by Roe (grantee):
($80 - $20) x 1,000 shares = $60,000.
Additional compensation expense reported by Rex Corporation (grantor):
($24 - $20) x 1,000 shares = $4,000.
E21-14 Stock Incentive Plan—SFAS No. 123: Analysis and Entries Assume-all the data given in
Exercise 21-13 with the following modifications and additional facts:
• Rex Corporation used SFAS No. 123 to account for stock-based compensation plans.
• Using an option pricing model and management estimates for input factors. the fair value of the
options granted to Ms. Roe is computed to be $12 per option.
• Ignore income tax considerations.
Required:
1. Compute the estimated total amount of compensation cost for the -grant made to Ms. Roe.
2. What entry should be made on the date of the grant?
3. What entry should be made at December 31. 1998?
4. Give the entry to record the exercising of the options held by Ms. Roe on December 3 1. 2002.
ANSWERS
1. The estimated total compensation cost = fair value of an option x number of options expected to vest.
Total compensation cost = $12 x 1,000 options = $12,000.
2. No entry is made on the grant date. Unlike APB Opinion No. 25, which would record the
compensation as a deferred compensation and treat as a component of stockholders' equity, SFAS
No. 123 records the compensation cost as it is earned by the employee.
3. The service period is 2 years; thus one-half of the estimated compensation cost is recognized in
1998:
Compensation cost (expensed) ..................................
Additional paid-in capital—stock options .............
6,000
6,000
(Note: This entry would be repeated in 1999, assuming Ms. Roe is still employed by Rex.)
Chapter 21
10/17
Corporations: Retained Earnings &
Stock Options
4. Entry to record the exercising of the options for 1.000 shares at an exercise price of S20:
Cash (1,000 x $20) .....................................................
Additional paid-in capital—stock options ....................
Common stock, at par ..........................................
Additional paid-in capital—common stock ...........
20.000
12,000
1,000
31,000
E21-17 Stock Appreciation Rights—APB Opinion No. 25: Analysis. Estimates and Entries On
January 1, 1997, Kelly Corporation established a stock appreciation rights plan that offers to selected
executives rights (SARs) that can be redeemed for cash equal to the difference between the market price
of the company's common stock at grant date and market price at the first exercise date. The rights can be
exercised three years from grant date and expire four years from grant date or when employment is
terminated, if earlier. The service period is considered to be three years because exercise is expected
(highly probable) to occur on December 31, 1999.
Executive Brown was granted 2,000 SARs on January 1, 1997 (when the common stock price was
$20) and exercised the rights on December 31, 1999. Relevant market prices at year-end on Kelly
common stock were 1997, $23; 1998, $27; 1999, $30; and 2000, $26.
Assume Kelly Corporation uses the intrinsic-value method of APB Opinion No. 25 to account for its
stock-based compensation plan.
Required:
1. Answer the following questions:
a. Is this plan compensatory? _____ Yes _____ No
b. The measurement date is ____________________
c. The service period is _______________________
d. Total compensation cost is $ _________________
e. Total cash paid by grantor to grantee is $ ______________
2. Give the appropriate journal entries from January 1, 1997, through December 31, 1999.
Answers:
Requirement 1
(a) Yes, compensatory because it is not available to all employees.
(b) Measurement date—exercise date—expected (highly probable) to occur on December 31, 1999.
Measurement date is after the date of grant.
(c) Service period—3 years (from grant date, January 1, 1997; to exercise date expected, December
31, 1999).
(d) ($30 - $20) x 2,000 SARs = $20,000 total compensation expense.
(e) $20,000 cash paid (same as total compensation expense).
Requirement 2
January 1, 1997-Date of grant:
Memo entry only.
Chapter 21
11/17
Corporations: Retained Earnings &
Stock Options
December 31, 1997—To record estimated compensation expense:
Compensation expense ...........................................................
Stock appreciation plan liability .........................................
[($23 - $20) x 2,000 SARs = $6,000] ÷ 3 years = $2,000 per year.
December 31. 1998-To record estimated compensation expense:
Compensation expense ...........................................................
Stock appreciation plan liability .........................................
[($27 - $20) x 2,000 SARs] = $14,000 total
2,000
2,000
7,332
7,332
$14,000 ÷ 3 years = $4,666 per year ......................... $4,666
Add 1994 catch-up, $4,666 - $2,000 .......................... 2,666
Total......................................................................... $7,332
December 31, 1999--To record actual compensation expense and exercise:
Compensation expense ...........................................................
10,668
Stock appreciation plan liability .........................................
($30 - $20) x 2,000 SARs = $20,000 total.
10.668
$20,000 ÷ 3 years = $6,666 per year ......................... $6,666
Catch-up: Year 1997, $6,666 - $2.000 ....................... 4,666
Year 1998: $6,666 - $7,332 .......................
(664)
Total .................................................................... $10,668
* Rounded to come out even.
Total compensation expense recorded:
$2,000 + $7,332 + $10.668 = $20,000.
Exercise:
Stock appreciation plan liability ($2,000 + $7,332 + $10,668) 20,000
Cash [($30 - $20) x 2,000 SARs] ......................................
20,000
E21-14 Stock Incentive Plan—Lapse of Rights: Analysis and Entries Stacy Corporation offered a
stock option incentive plan to six of its top executives. During the second year from date of grant, but
prior to the permissible exercise date, one of the six executives resigned and accepted employment with a
competitor. In accordance with the provisions of the incentive plan, the stock option for the resigned
executive lapsed. At the date of lapse, the relevant account balance for all six executives combined were
deferred compensation expense, $675,000; and executive stock options outstanding, $900,000. The
service period extends for three more years, including the second year.
Required:
1 . Briefly explain what account treatment should be accorded the one-sixth of these balances that relate
to the one resigned executive.
2. Give all journal entries directly related to the lapsed options.
Answers:
Requirement 1
The credit difference between these two accounts, that relates to the resigned executive, should be a
reduction of compensation expense as a change in accounting estimate for the current and any relevant
future periods.
Chapter 21
12/17
Corporations: Retained Earnings &
Stock Options
Requirement 1
(1) To clear the two relevant accounts:
Executive stock options outstanding ($900,000 x 1/6) .........
Deferred compensation expense ($675,000 x 1/6) .......
Accrued lapse expense, stock options* .........................
150,000
112,500
37.500
(2) To assign the lapse difference to the current and future periods
Year 2
Accrued lapse expense ........
Compensation expense,
stock options ..................
Year 3
12,500
Year 4
12,500
12,500
12,500
12,500
12,500
$37,500 ÷ 3 = $12,500.
*
A longer, but more descriptive title would be "Accrued compensation expense due to lapse of stock
options." This account would be reported in stockholders' equity as a contra account to Deferred
compensation cost.
Alternatively, Deferred compensation cost could be credited for the $150,000 in this entry, which
avoids setting out as a separate amount ($37,500). Proper amortization would produce the same
results as above. The alternative entries would be as follows:
(1) Executive stock options outstanding .................................
Deferred compensation cost.......................................
150,000
15,000
(2) Compensation expense [($675,000 - $150,000 = $525,000)
÷ 3 years]...........................................................................
175,000
Deferred compensation cost.......................................
175,000
Both methods produce the following results:
Income statement:
Compensation expense ....................................................
Balance Sheet:
Deferred compensation cost (net) .....................................
Year 2
Year 3
$175,000
$175,000
350,000
175,000
P21-4 Cash and Stock Dividends—Fractional Shares: Entries and Reporting On December 31. 1997.
the accounts for Quality Food Corporation (QFC) showed the following balances:
Stockholders' Equity
(in thousands)
Preferred stock, 7 percent. par value $25, noncumulative, authorized 20,000(XX) shares,
Outstanding 16,000 shares .............................................................................
$400
Common stock, no-par, stated value $10, authorized 40,000 shares, outstanding 24,000
shares..............................................................................................................240
Additional paid-in capital. Preferred.................................................................
30
Additional paid-in capital. Common.................................................................
60
Retained earnings ..............................................................................................
350
During, 1998, the following transactions, in order of date, were recorded relating to the capital accounts:
Chapter 21
13/17
Corporations: Retained Earnings &
Stock Options
a. Apr.1
A stock dividend was issued whereby (1) each holder of 10 preferred, shares received 1
share of common stock and (2) each holder of 6 shares of common stock received 1
additional share of common. The market price of the common stock was $15 per share
immediately after issuance of the stock dividend. In the issuance of the stock dividend.
5,400 shares of common stock and 1,000 fractional share rights were issued. Each fractional
share right represents one-tenth of a share of stock.
b. Nov. 1
All of the rights were redeemed except 200, which remained outstanding.
c. Dec. 15 A 7 percent cash dividend on the preferred shares and a $2.00 per share dividend on the
common shares were declared and paid.
d. Dec. 31 Reported net income was $140,000.
Required:
1. Give the journal entries for each of the above transactions during 1998.
2. Prepare the stockholders' equity section of the balance sheet at December 31, 1998.
3. Assume QFC paid cash to the stockholders in lieu of issuing fractional share rights. The cash
distribution was based on the market value of $15 per common share. Give the entry on April 1, 1998
to record the dividend transaction. What would be the total stockholders' equity of QFC on December
31. 1998, in this situation if all-other factors remain as they were given above'?
Answers:
Requirement 1
(a) April 1, 1998—Issuance o(the stock dividend:
Retained earnings (5,600 shares x $15) .....................................................
Common stock, no par, stated value $10 (5,400 shares x $10) ..............
Common stock rights outstanding (for 200** shares x $10) .....................
Contributed capital in excess of stated value, common (5600 x $5)........
84,000
54,000
2,000
28,000
* Computation of shares for the stock dividend:
Preferred, 16,000 shares ÷ 10
=
1,600 shares
Common, 24,000 shares ÷ 6
=
4,000 shares
Total common shares to be issued
as stock dividend
5,600 shares
** Shares issued—5,400 (given)
Rights issued—2,000 ÷ 10 = 200 shares to be issued upon surrender of rights
(b) November 1, 1998—Redeemed 1,800 rights:
Common stock rights outstanding [(2,000 - 200) ÷ 10 = 180 shares] .........
Common stock, no par (180 shares x $10) ..............................................
(c) December 15, 1998—Declared and paid cash dividend:
Retained earnings........................................................................................
Cash dividends payable, preferred ..........................................................
Cash dividends payable, common ...........................................................
Computation:
Preferred:
Common
16,000 shares x $25 x .07
(24,000 + 5,400 + 180) =
(29,580 shares) x $2.00
=
$28,000
=
59,160
$87,160
Total
Chapter 21
14/17
1,800
1,800
57,580
28,000
29,580
Corporations: Retained Earnings &
Stock Options
Cash dividends payable, preferred ..............................................................
Cash dividends payable, common...............................................................
Cash .........................................................................................................
28,000
59,160
87,160
(d) December 31, 1998:
Income summary ......................................................................................... 140,000
Retained earnings ....................................................................................
140,000
Requirement 2
Stockholders' Equity—December 31, 1998
Contributed Capital:
Capital stock:
Preferred stock, 7%, $25 par value, noncumulative, authorized
20,000 shares, issued and outstanding 16,000 shares .................
Common stock, no par, stated value $10 per share, authorized
40,000 shares, issued and outstanding, 29,580 shares
[(24,000 + 5,400 + 180 = 29,580) x $10] .......................................
Common stock rights outstanding (200 ÷ 10 = 20 shares x $10) .....
Total.........................................................................................
Other contributed capital:
In excess of par, preferred stock ...................................................
In excess of stated value, common stock ($60,000 + $28,000) ....
Total Contributed Capital .....................................................
Retained earnings ($350,000 - $84,000 - $87,160 + $140,000) ....................
Total Shareholders' Equity ............................................
$400,000
295,800
200
696,000
$30,000
88,000
118,000
814,000
318,840
$1,132,840
Requirement 3
April 1, 1998—Issuance of stock dividend:
Retained earnings (5,600 shares x $15) ........................................................
Common stock (5,400 shares x $10).......................................................
Contributed capital in excess of stated value (5,400 shares x $5) ..........
Cash (2,000 ÷ 10 = 200 shares x $15) ....................................................
December 31, 1998—Stockholders' equity:
Contributed capital:
Preferred stock, as above ........................................................................
Common stock [(24,000 = 5,400 shares) x $10] .....................................
Contributed capital in excess of par, preferred stock ..............................
Contributed capital in excess of par, common stock
($60,000 + $27,000) .............................................................................
Retained earnings, as above ...................................................................
Total Stockholders' Equity .............................................................
84,000
54,000
27,000
3,000
$400,000
294,000
$30,000
87,000
117,000
318,840
$1,129,840
The difference is $3,000 ($1,132,840 - $1,129,840), the amount of the asset reduction in the April 1 entry
immediately above. where fractional share rights were paid in cash and not converted into shares of
common stock.
C21-4Appendix: Quasi Reorganization Marks Corporation, a medium-size manufacturer, has
experienced operating losses for the past five years. Although operations for the current year ended also
resulted in a loss, several important changes made the fourth quarter a profitable one; as a result. future
operations of the company are expected to be profitable.
Chapter 21
15/17
Corporations: Retained Earnings &
Stock Options
The treasurer suggested a quasi reorganization to (a) eliminate the accumulated deficit of $325,000 in
retained earnings. (b) write up the $600,000 cost of operating land and buildings to their current market
value of $800.000, and (c) set up an asset of $175,000 representing the estimated future tax benefit of the
losses accumulated to date.
Required:
1. What are the characteristics of a quasi reorganization?
2. List the conditions under which a quasi reorganization would generally be justified.
3. Discuss the propriety of the treasurer's proposals to do the following:
a. Eliminate the deficit of $325,000.
b. Write up the value of the operating land and buildings of $600,000 to their current market value.
c. Set up an asset of $175,000 representing the future tax benefit of the losses accumulated to date.
Answers:
Note: The following is essentially the published -unofficial" response to this AICPA examination question.
Requirement 1
The primary purpose of a quasi-reorganization is to establish a new basis for accountability and a "fresh
start." The corporate entity and conditions of competition remain unchanged during a quasireorganization. However, the recorded values of assets may be restated downward to market value, the
equity accounts are restated in order to leave the Retained Earnings account with a zero balance, the
Retained Earnings account is "dated" for a period of time (from five to ten years) following the
reorganization, and full disclosure of the procedure and its effects are made in the financial statements. A
quasi -reorganization must be approved by the stockholders and creditors before it can be placed in
effect.
Requirement 2
In general. a quasi -reorganization is justified when (a) a large deficit from operations exists, (b) it is an
acceptable alternative to reorganization by legal proceedings, (c) the carrying value of the assets is
significantly more than realistic going-concern values, (d) a break in the continuity of the historical cost
basis is clearly needed so that realistic financial reporting is possible, (e) the balances of retained
earnings and contributed capital are inadequate to absorb the decreases in the going-concern asset
values, and (f) the accounting adjustment appears to be desirable to all parties concerned
Requirement 3
(a) Because the evidence indicates that the company has reached a turning point and that profitable
operations can be expected hereafter, a quasi -reorganization to eliminate the accumulated deficit
would be appropriate if the stockholders and creditors approve it. The purpose of eliminating the
deficit—and the purpose of a quasi-reorganization—is to relieve the company from the handicap of
reporting past losses which result in unfavorable reporting of current financial position even after
conditions resulting in the losses have changed significantly. Therefore, elimination of the deficit
appears acceptable.
(b) A company that elects a quasi -reorganization generally cannot show enough earning power to justify
a write-up of operating land and buildings and usually needs to write them down instead. Any figure
that is to be accepted as representing market value must stand all the economic tests of value,
including the ability of the company to earn a market return based on such values. In view of the
results of prior years' operations, to write up the recorded value of operating land and buildings would
not be appropriate, even though there is some evidence to justify greater expectations of future
benefits. Quasi-reorganizations that result in net write-ups are not in conformity with generally
Chapter 21
16/17
Corporations: Retained Earnings &
Stock Options
accepted accounting principles. The device is not intended for situations where changes in the
general price level or current value suggest an upward revision of asset values on the books.
However. Write-ups and write-downs within a group of assets that would not result in a net write-up
are acceptable.
(c) Because an "asset" contingent upon having enough income in the next 15 years to use the operating
loss carryforward should not be recorded unless there is a strong presumption-of realization, setting
up the asset at the time of the quasi-reorganization is not appropriate even though the future
operations for the company are expected to be profitable. Assets contingent upon the profitability of
the future should not be recorded at the time of quasi-reorganization.
Chapter 21
17/17
Corporations: Retained Earnings &
Stock Options
CHAPTER 22: EARNINGS PER SHARE
1. What is the fundamental difference in EPS computations and reporting between a simple capital
structure and a complex capital structure?
Answer: In a simple capital structure, a single presentation (if the basic amounts for earnings per
share is presented. A simple capital structure is one in which stockholders’ equity either consists only
of common stock or does not contain convertible securities, stock warrants, or other rights convertible
to common stock.
If a firm has a complex capital structure, it presents:
Fully diluted EPS—this calculation is based on common stock plus the number of shares of common
stock that would be issued assuming all convertible securities, warrants. etc. with dilutive effects are
converted to common stock. This calculation represents maximum dilution of EPS.
2. Is the annual dividend on cumulative convertible preferred stock outstanding all year subtracted from
net income in computing basic EPS? If so, why?
Answer: Yes, because basic EPS treats all preferred stock the same way. whether or not convertible.
The dividends reduce the actual return to common shareholders because the preferred was not
converted during the period.
3. Explain the treasury stock method.
Answer: The treasury stock method is used to compute the number of incremental equivalent
common shares when a complex capital structure includes stock rights, warrants, options, and other
similar securities. The treasury stock method assumes that the rights, etc., will be exercised and the
required number of common shares issued. The cash that would be received (at the option price)
from the recipients is assumed to be invested in the acquisition of treasury common shares (at the
average price for the period). The difference between the two amounts—the assumed number of
shares that would be issued and the assumed number of treasury shares that would be acquired—
represents the number of common stock equivalents associated with rights, etc., that must be added
to the weighted average number of common shares outstanding.
5. Briefly, how are stock dividends and splits reflected in the calculation of basic EPS if the dividend or
split occurs (a) before the balance sheet date, or (b) after the balance sheet date but before the
issuance of the statements?
Answer: Both situations are treated the same way in that all common stock transactions occurring
before the dividend or split are adjusted. The only difference is that substantive stock transactions
could occur after stock dividends and splits that are issued before the balance sheet date. Such
substantive stock transactions would not be adjusted. This could not occur for stock dividends and
splits occurring after the balance sheet date.
6. Why are dividends from dilutive convertible preferred stock added back to the numerator of basic
EPS without tax effect. but interest recognized on dilutive convertible bonds is added back to the
numerator on an after-tax basis?
Answer: There is no tax effect for dividends declared or paid. Interest reduces net income on an
after-tax basis. Therefore, the amount added back must also be after-tax.
7. What is the difference between a dilutive security and an antidilutive security? Why is the distinction
important in EPS computations?
Chapter 22
1/16
Earnings per Share
Answer: A dilutive security is a security that causes a reduction in the earnings per share amount. An
example is stock rights for which the market value of the stock exceeds the option price of the stock.
An antidilutive security is a security that causes the opposite effect, an increase in the earnings per
share amount above that which would otherwise be reported. An example is stock rights for which the
market value of the stock is less than the option price. The distinction is important in earnings per
share considerations because dilutive securities are included in the computation of diluted earnings
per share, whereas antidilutive securities are omitted from the computation.
13. What is the D/A method, and why is it useful?
Answer: The D/A method computes a ratio for each potentially dilutive security. The ratio is the
addition to income divided by the increased number of outstanding shares. By ordering these ratios,
smallest to largest, the dilutive securities can be used one by one until maximum dilution is achieved.
This occurs when the D/A ratio for the next security exceeds the calculation of EPS using all other
securities with lower D/A ratios (i.e., larger dilutive effects).
It is useful because it gives a means of proceeding one security at a time. For example, if there are
10 potentially dilutive securities, at most 10 calculations are required. Alternatively, 210 calculations
(1024) would be required to evaluate all possible sets.
16. Explain in general how to handle actual conversions of convertible dilutive securities EPS purposes
(denominator effect only).
Answer: Basic EPS reflects the shares from actual conversion weighted for the portion of the period
after conversion. Diluted EPS reflects the denominator effect from assumed conversion weighted for
the portion of the period before conversion.
E-22-1 EPS Calculations
1. On December 31, 1997, Case. Inc.. had 300,000 shares of common stock issued and outstanding.
Case issued a 10 percent stock dividend on July, 1, 1998. On October 1, 1998, Case purchased 24,000
shares of its common stock for treasury and recorded the purchase using the cost method. What is the
number of shares that should be used in computing primary earnings per share for the year ended
December 31, 1998?
a. 306,000.
b. 309,000.
c. 324,000.
d. 330,000.
Answer: C. The requirement is the number of shares to be used in computing 1999 earnings per
share (EPS). For EPS purposes, shares of stock issued as a result of stock dividends or splits should
be considered outstanding for the entire period in which they were issued. Therefore, both the original
300,000 shares and the additional .30,000 shares (.10 x 300,000) are treated as outstanding for the
entire year. The 10/1/98 purchase of 24,000 treasury shares results in a weighted average reduction
of 6,000 shares (3/12 x 24,000) because the shares were not outstanding for three months during
1998. Therefore, the number of shares for EPS computations is 324,000:
Outstanding 12/31/97 ........................... 300,000
Stock dividend (.10 x 300,000) ............ 30,000
10/1 purchase (3/12 x 24,000) .............
(6,000)
324,000
2. Seco Corporation was incorporated on January 2, 1997. The following information pertains to Seco's
common stock transactions:
Chapter 22
2/16
Earnings per Share
1997
January 2
Number of shares authorized. ........................................... 80,000
February 1 Number of shares issued . . . . . . . . . . . . . . . . ................... 60,000
July 1
Number of shares reacquired but not canceled .................
5,000
December 1 Two-for-one stock split
At December 31, 1997, the number of shares of Seco's common stock outstanding is
a. 150,000.
b. 120,000.
c. 115,000.
d. 110,000.
Answer: D. Before the stock split 60,000 shares of common stock were issued, of which 5,000
shares were reacquired. Any time stock is reacquired. it is not considered outstanding. Therefore,
there were 55,000 (60,000 –5,000) shares outstanding before the two-for-one stock split and 110,000
(55,000 x 2) shares outstanding after the stock split.
3. At December 31, 1998, and 1997. Gow Corporation had 100,000 shares of common stock and 10,000
shares of 5 percent. $100 par value cumulative preferred stock outstanding. No dividends were
declared on either the preferred or the common stock in 1998 or 1997. Net income for 1998 was
$1,000,000. For 1998. earnings per common share amounted to
a. $10.00.
b. $9.50.
c. $9.00.
d. $5.00.
Answer: B. The formula for earnings per common share is:
($1,000,000 net income - $50,000 preferred dividends)/(100,000 common shares outstanding) = $9.50
In calculating the numerator, the claims of preferred shareholders against 1998 earnings should be
deducted to arrive at the 1998 earnings attributable to common shareholders. This amount is $50,000
[(.05) ($100) x (10,000 shares)]. The $50,000 preferred dividends in arrears are not deducted to
compute the numerator in determining 1998 EPS. This is because the $50,000 dividends in arrears
are a claim of preferred shareholders against 1997 earnings and would reduce 1997 EPS.
4. Earnings per share data must be reported on the face of the income statement for which of the
following, assuming the company has an accounting principle change it reports?
Income from
Cumulative Effect of a Change
Continuing Operations
in Accounting Principle
a.
Yes
Yes
b.
Yes
No
c.
No
No
d.
No
Yes
Answer: B. Earnings per share data must be shown on the face of the income statement. Earnings
per share amounts must be presented for (1) income from continuing operations and (2) net income.
EPS for the cumulative effect of a change in accounting principle must be disclosed either on the face
of the income statement or in the notes to the financial statements.
5. Mann, Inc. had 30,000 shares of common stock issued and outstanding at December 31, 1996. On
July 1, 1997, an additional 50,000 shares of common stock were issued for cash. Mann also had
unexercised stock options to purchase 40,000 shares of common stock at $15 per share outstanding, at
the beginning and end of 1997. The average market price of Mann’s common stock was $20 during
Chapter 22
3/16
Earnings per Share
1997. What is the number of shares that should be used in computing diluted earnings per share for
the year ended December 31, 1997?
a. 325,000.
b. 335,000.
c. 360,000.
d. 365,000.
Answer: B. The requirement is to determine the number of diluted shares that should be used in
computing 1997 diluted earnings per share. The first step is to compute the weighted average
number of common shares outstanding. 300,000 shares were outstanding the entire year, and 50,000
more shares were outstanding for six months, resulting in a weighted average of 325,000 [300,000 +
(50,000 x 6/12)]. Second, because of the stock options, the denominator effect of the options must be
computed. This is done using the treasury stock method as illustrated below:
Assumed proceeds [40,000 x $15] ........................... $600,000
Shares issued ............................................................... 40,000
Shares required [$600,000 ÷ $20] ...............................(30,000)
Incremental shares ....................................................... 10,000
The stock options are dilutive because the exercise price is less than the market value. Therefore, the
number of shares used for computing diluted earnings per share is 335,000 [325,000 + 10,000].
E 22-2 Calculating Diluted EPS
1. Jones Corporation's capital structure is:
December 31
1997
1996
Outstanding shares of stock
Common
Convertible preferred
8 percent convertible bonds
110,000
10,000
$1,000,000
110,000
10,000
$1,000,000
During 1997, Jones paid dividends of $3.00 per share on its preferred stock. The preferred shares are
convertible into 20,000 shares of common stock. The 8 percent bonds are convertible into 30,000
shares common stock. Net income for 1997 is $850,000. Assume that the income tax rate is 30
percent. The diluted earnings per share for 1997 is
a. $5.48.
b. $5.66.
c. $5.81.
d. $6.26.
Answer: B. Diluted EPS is based on common stock and all dilutive securities. To determine if a
security is dilutive, EPS, including the effects of the security. must be compared to a benchmark EPS.
In this case. the benchmark or basic EPS is $7.45.
($850,000 net income - $30,000 preferred dividends)/(110,000 common shares outstanding) = $7.45
First, compute the D/A rate for each potentially dilutive security. The effect of the convertible bonds is
to increase the numerator by $56,000 [interest of $80,000 ($1,000,000 x .08) less $24,000 tax effect
($80,000 x .30)], and increase the denominator by 30,000 shares.
The effect of the convertible preferred stock is to increase the numerator by $30,000 [dividends,
10,000 shares x $3 per share] and increase the denominator by 20,000 shares.
Chapter 22
4/16
Earnings per Share
D/A ratio: convertible bonds = $56,000/30,000 = $1.87
D/A ratio: convertible preferred = $30,000/10,000 = $1.50
The convertible preferred is introduced first because its D/A ratio is the lowest, and it is less than
basic EPS.
Tentative DEPS = ($850,000 - $30,000 + $30,000)(110,000 + 20,000) = $6.54. The convertible bonds
are now introduced because $6.54 > $I.87. Final DEPS =
($850,000 - $30,000 + $56,000 + $30,000)/(110,000 + 30,000 + 20,000) = $5.66
2. Antidilutive stock options would generally be used in the calculation of
Basic Earnings per Share
Diluted Earnings per Share
a.
Yes
Yes
b.
Yes
No
c.
No
No
d.
No
Yes
Answer: C. Computations of diluted earnings per share should not give effect to common stock
equivalents or other contingent issues for any period in which their inclusion would have an
antidilutive effect (i.e., increase the earnings per share amount or decrease the loss per share
amount otherwise computed).
3. Cox Corporation had 1,200,000 shares of common stock outstanding on January 1 and December 31,
1997. In connection with the acquisition of a subsidiary company in June 1996. Cox is required to
issue 50,000 additional shares of its common stock on July 1, 1998 to the former owners of the
subsidiary. Cox paid $200,000 in preferred stock dividends in 1997 and reported net income of
$3,400,000 for the year. Cox's diluted earnings per share for 1997 should be
a. $2.83.
b. $2.72.
c. $2.67.
d. $2.56.
Answer: D. The requirement is to compute the diluted earnings per share (DEPS) for 1997. The
purpose of DEPS is to show the maximum potential dilution of current earnings per share (EPS) on a
prospective basis. Therefore, all contingent issuances of common stock that reduce current EPS
must be included in the computation. The formula for DEPS is:
Net income available to common shareholders
Weighted average common shares outstanding + Shares from dilutive securities
The net income available to common shareholders is $3,200,000. This is the net income of
$3,400,000 less the preferred stock dividend of $200,000. The weighted-average common shares
outstanding is 1,250,000. This is computed at the actual common shares outstanding for the full year
of 1,200,000 plus the contingent common shares of 50,000 which were outstanding for the full year
because the contingency is removed because of the passage of time.
Thus, DEPS = $3,200,000/1,250,000 = $2.56
Chapter 22
5/16
Earnings per Share
4. Newt Corporation had earnings per share of $12.00 for 1998, before taking, any dilutive securities
into consideration. No conversion or exercise of dilutive securities took place in 1998. However,
possible conversion of convertible preferred stock would have reduced earnings per share to $11.90.
The effect of possible exercise of common stock warrants would have reduced earnings per share by
an additional $0.05. For 1998, what must Newt report as diluted earnings per share?
a. $12.00.
b. $11.95.
c. $11.10.
d. $11.85.
Answer: D. The capital structure of the corporation is complex because it contains dilutive securities.
A complex capital structure requires a dual presentation of earnings per share. The diluted EPS is
$11.85 ($11.90 - $.05).
E 22-3 Diluted EPS
1. Dilutive stock options would generally be used in the calculation of which of the following?
Basic Earnings per Share
Diluted Earnings per Share
a.
No
No
b.
No
Yes
c.
Yes
Yes
d.
Yes
No
Answer: B. Basic earnings per share are computed based only on outstanding common stock, while
diluted earnings per share are based on common stock and all dilutive securities. Dilutive stock
options are only used in the calculation of diluted earnings per share.
2. The if-converted method of computing earnings per share data assumes conversion of convertible
securities as of the
a. Beginning of the earliest period reported (or at time of issuance, if later).
b. Beginning of the earliest period reported (regardless of time of issuance).
c. Middle of the earliest period reported (regardless of time of issuance).
d. Ending of the earliest period reported (regardless of time of issuance).
Answer: A. The if-converted method of computing earnings per share assumes that convertible
securities are converted at the beginning of the earliest period reported or at the time of issuance, if
that date is later.
3. Suppose a company's convertible debt is dilutive in determining earnings per share. What would be
the effect of considering the convertible debt in calculating the following?
Basic Earnings per Share
Diluted Earnings per Share
a.
Decrease
Decrease
b.
Increase
No effect
c.
No effect
Decrease
d.
Decrease
Increase
Answer: C. Basic earnings per share are computed based only on outstanding common stock, while
diluted earnings per share are based on common stock and all dilutive securities. Dilutive convertible
debt instruments are used only in the calculation of diluted earnings per share.
Chapter 22
6/16
Earnings per Share
4. In determining basic or diluted earnings per share, dividends on nonconvertible cumulative preferred
stock should be
a. Disregarded.
b. Added back to net income whether declared or not.
c. Deducted from net income only if declared.
d. Deducted from net income whether declared or not.
Answer: D. The requirement is to determine the treatment of nonconvertible cumulative preferred
dividends in determining basic and diluted EPS. Dividends on nonconvertible cumulative preferred
shares should be deducted from net income whether an actual liability exists or not, because
cumulative preferred stock owners must receive any dividends in arrears before future dividend
distributions can be made to common stockholders.
E 22-4 Analyze the Capital Structure: Average Shares, Compute EPS At the end of 1997 the records
of Block Corporation reflected the following:
Common stock, par $5, authorized 500,000 shares:
Outstanding 1/l/1997, 400,000 shares .....................................$2,000,000
Sold and issued 4/1/1997, 2,000 shares ..........................................10,000
Issued 5% stock dividend, 9/30/1997, 20,100 shares ...................100,500
Preferred stock, 6%. par $10, nonconvertible, noncumulative,
authorized 50,000 shares, outstanding during year, 20,000 shares200,000
Contributed capital in excess of par, common stock ........................180,000
Contributed capital in excess of par, preferred stock ........................100,000
Retained earnings (after the effects of current preferred dividends
declared during 1997) ...................................................................640,000
Bonds payable, 6-½%, nonconvertible, issued at par 1/l/97 ..........1,000,000
Income before extraordinary items ...................................................182,000
Extraordinary loss (net of tax) .......................................................... (18,000)
Net income ........................................................................................164,000
Average income tax rate ........................................................................ 40%
Required:
1. Is this a simple or complex capital structure? Explain.
2. What kind of EPS presentation is required? Explain.
3. Compute the required EPS amounts (show computations).
4. Compute the required EPS amounts, assuming that the preferred is cumulative.
Answers:
Requirement 1
This is a simple capital structure because (a) the preferred stock is nonconvertible, (b) the bonds payable
are nonconvertible, and (c) there are no rights, options, or other securities convertible to common stock.
Requirement 2
Chapter 22
7/16
Earnings per Share
Because this is a simple capital structure. only a single set of EPS amounts is presented for income
before extraordinary items and net income.
Requirement 3
Computations of EPS amounts:
(a) Preferred dividend claim for current year:
$200,000 x 6% = $12,000. Recognized on the noncumulative preferred stock because the current
year preferred dividend has been declared.
(b) Average number of common shares outstanding during year:
Time Period
Actual
Shares
January 1, shares outstanding
January 1 to March 31
April 1, sold additional shares
April 1 to September 30
Sept 30, 1995, 5% stock dividend
Sept 30 to December 31
400,000
400,000
2,000
402,000
20,100
422,100
Retroactive
Adjustment
Months
Outstanding
ShareMonths
x 1.05
x3 =
1,260,000
x 1.05
x6 =
2,532,600
x3 =
1,266,300
12
5,058,900
Total Share Months
Average number of shares outstanding, 5,058,900 ÷ 12 = 421,575
(c) Earnings per share on common stock:
Income before extraordinary items ($182,000 -$12,000*) ÷ 421,575 shares
Extraordinary loss**
($18,000) ÷ 421,575 shares
Net income
($164,000 - $12,000*) ÷ 421,575 shares
=
=
=
$.40
(.04)
$.36
* Preferred dividend claim.
** Net required to be shown on face of the income statement. But if not, the value must be in the
notes
Requirement 4
Assuming the preferred stock is cumulative, the EPS amounts, in this case, would be the same as
computed in Requirement 3 because (a) the current preferred dividend claim must be honored for
cumulative preferred stock whether declared or not and (b) the claim must be honored for noncumulative
preferred stock only if declared (the situation given in the problem data—see the notation for retained
earnings).
E 22-6 Compute EPS for Three Years: Stock Dividend and Split Rambo Corporation's accounting
year ends on December 31. During the following three years, its common shares outstanding changed as
follows:
Chapter 22
8/16
Earnings per Share
Shares outstanding, January 1
Sales of shares, 4/1/1996
25% stock dividend, 7/1/1997
2-for-1 stock split, 7/1/1998
Shares sold, 10/1/1998
Shares outstanding, December 31
Net Income
1998
1997
1996
150,000
120,000
100,000
20,000
30,000
150,000 *
50,000
350,000
$375,000
______
150,000
$330,000
______
120,000
$299,000
* For each share turned in, two new shares were issued so that the shares
doubled.
Required:
1. For purposes of calculating EPS at the end of each year, for each year independently, determine the
number of shares outstanding.
2. For purposes of calculating EPS at the end of 1998, when comparative statements are being prepared
on a three-year basis, determine the number of shares outstanding for each year.
3. Compute EPS for each year based on year computations in (2).
Answers:
Requirement 1
This is a simple capital structure. For 1996, because the 20,000 added shares were sold at the start of
the second quarter, on an equivalent basis they were outstanding ¾ of the year.
100,000 original shares + (3/4 x 20,000)
=
115,000
For 1997, because the only change was due to a stock dividend, regardless of when it occurred during
the year, the year-end figure of 150,000 shares outstanding would be used for EPS purposes as though
that number had been outstanding for all of 1997.
For 1998, it is important to note that the 2-for-1 stock split occurred on July 1 before the sale on October
1. Had the sale not occurred, for EPS purposes there would have been 300,000 shares outstanding for all
of 1998. The sale of 50,000 shares at the start of the fourth quarter adds an equivalency of 12,500
shares. Therefore, 300,000 shares + (1/4 x 50,000) = 312,500.
Requirement 2
1998: In the context of comparative statements, there would be no change in the 312,500 shares
calculated in Requirement 1 for 1998.
1997: The doubling of the number of shares during 1998 would project back to 1997, raising the 150,000
for 1997 (standing alone) to 300,000.
1996: For 1996, because the April 1 sale of 20,000 shares preceded the 25 percent stock dividend of
1997 and the 2-for-1 split of 1998, a multiplier effect of 2.5 (i.e., 1.25 x 2) applies to the 20,000 shares, as
well as to the original 100,000 shares, as shown below:
Chapter 22
9/16
Earnings per Share
Date
1996
Original
Shares
January 1
April 1
Totals
100,000
20,000
120,000
25%
Stock
Dividend
2-for-1
Stock
Split
Total
Months
Total
x 1.25
x 1.25
x2
x2
250,000
50,000
12
9
3,000,000
450,000
3,450,000
3,450,000 ÷ 12 months = 287,500 weighted average shares for comparative EPS purposes in the 1998
financial report.
Requirement 3
1998
Net Income ..................................................................... $375,000
Avg. shares outstanding (including stock divs and split) 312,500
Earnings per share .........................................................
$1.20
1997
$330,000
300,000
$1.10
1996
$299,000
287,500
$1.04
E 22-10 Complex Capital Structure and Reporting EPS The Omega Company reports the following:
Income from continuing operations ............................. $1,000.000
Extraordinary item ......................................................... 3,000,000
Net income ................................................................... $4.000.000
Shares outstanding:
For basic EPS ....................................... 1,000,000
For diluted EPS .................................... 1,500,000
Income adjustments to be made:
For diluted EPS
Income before
Extraordinary Item
Net Income
$200,000
$200,000
Required: What EPS figures would Omega report? What are their values?
Answer:
Basic EPS
Income before extraordinary item ($1,000,000/1,000,000 shs.) ..................... $1.00
Extraordinary item ($3,000,000/1,000,000 shs.) ............................................... 3.00*
Net income ($4,000,000/1,000,000 shs.) ........................................................ $4.00
DEPS
Income before extraordinary item ($1,200,000/1,500,000 shs.) ..................... $0.80
Extraordinary item ($3,000,000/1,000,000 shs.) ............................................... 2.00*
Net income ($4,200,000/1,500,000 shs.) ........................................................ $2.80
* May be reported in the notes.
Chapter 22
10/16
Earnings per Share
E 22-11 Complex Capital Structure and Reporting EPS The Jones Company reports the following:
Income before extraordinary item................................ $1,000.000
Extraordinary item .......................................................... (20,000)
Net income ...................................................................... $980.000
Shares outstanding:
For basic EPS ....................................... 1,000,000
For diluted EPS .................................... 1,100,000
Income adjustments to be made:
Income before
Extraordinary Item
Net Income
$80,000
$80,000
For diluted EPS
Required: What EPS figures would Omega report? What are their values?
Answer:
Basic EPS
Income before extraordinary item ($1,000,000/1,000,000 shs.) ..................... $1.00
Net income ($980,000/1,000,000 shs.) ........................................................... $0.98
DEPS
Income from continuing operations ($1,080,000/1,100,000 shs.) .................. $0.98
Net income ($1,060,000/1,100,000 shs.) ........................................................ $0.96
E 22-13 Options and the Computation of' EPS Rand Inc. had a net income from continuing operations
of $800,000. During the year in question, 200,000 shares were outstanding on average. During the year,
Rand's common stock sold at an average market price of $50. In addition, Rand had 20,000 options
outstanding to purchase a total of 20,000 shares at $25 for each option exercised.
Required:
1. Are the options dilutive? Compute basic EPS for income from continuing operations.
2. Compute diluted EPS.
Answer:
1. Since the option price of $25 is below the market price, the options are “in the money” and dilutive.
Basic EPS = $800,000/200,000 = $4.00.
2. Diluted EPS:
Number of Shares: 20,000
Additional cash on assumed exercise
(20,000) x $25 = $500,000
Chapter 22
11/16
Earnings per Share
Shares repurchased under Treasury Stock Method
$500,000/$50 = 10,000
Net additional shares
20,000 – 10,000 = 10,000
Diluted EPS = $800,000/(200,000 + 10,000)
= $3.81
E 22-14 Convertible Bonds and the Calculation of Diluted EPS Shaffer Corporation issued 100,
$1,000, 10 percent convertible bonds in 1996 at face value. Each bond is convertible into 100 shares of
common. Shaffer's net income from continuing operations for 1997 is $1,824,000 ($3,040,000 before
tax). The $1,824,000 reflects one year's interest after tax. If you consider all factors except convertible
bonds, average common shares outstanding for 1997 are 1,010,000.
Required:
1. Compute DEPS (test for dilution).
2. How would you answer (1) if the bonds were issued July 1, 1997?
3. Ignoring (2), how would the answer to (1) change if half the bonds were converted July 1, 1997?
Answer:
Requirement 1
Basic EPS = $1,824,000/1,010,000 = $1.81
The tax rate is 1 – ($1,824,000/3,040,000) = .40
Numerator effect of bonds = 100 ($1,000)(.10)(.60) = $6,000
Denominator effect of bonds = 100 (100) = 10,000
D/A ratio = $6,000/10,000 = $.60 < $1.81; therefore the bonds are dilutive.
DEPS = ($1,824,000 + $6,000)/(1,010,000 + 10,000) = $1.79
Requirement 2
Net income from continuing operations would be one-half a year’s after-tax interest larger, or $3,000
larger. The numerator and denominator effects would be halved but the D/A ratio would remain
unchanged.
Basic EPS = ($1,824,000 + $3,000)/1,010,000 = $1.81
DEPS = ($1,824,000 + $3,000)/(1,010,000 + 5,000) = $1.80
Requirement 3
Net income from continuing operations would be $1,824,000 + $6,000 (1/4) = $1,825,500. This $1,500
increase is the after-tax interest saved on the converted bonds for ½ year
($,000)(100)(.10)(.60)(1/2 year)(1/2 issue).
Basic EPS = $1,825,500/1,010,000 + 10,000 (1/4) = $1.80
Numerator effect: 50 ($1,000) (.10) (.60) + 50 ($1,000) (.10) (.60) (1/2) = $4,500
Chapter 22
12/16
Earnings per Share
Denominator effect: 5,000 + 5,000 (1/2) = 7,500. One-half of the issue was convertible bonds the entire
year, giving rise to 5,000 shares upon assumed conversion. The other half of the issue was convertible
bonds only one-half a year, giving rise to 2,500 shares on assumed conversion.
DEPS = ($1,825,500 + $4,500)/(1,010,000 + 2,500 + 7,500) = $1.79
E 22-15 Analyze Capital Structure: Stock Split, Convertible Securities, Compute EPS At the end of
1997, the records of Ruso Corporation reflected the following:
Common stock, no-par, authorized 250,000 shares: issued and outstanding
throughout the period to 12/l/1997, 60,000 shares. A stock split issued
12/1/1997 doubled outstanding shares ................................................. $840,000
Preferred stock, 5%, par $10, nonconvertible, cumulative, nonparticipating,
shares authorized, issued, and outstanding during year, 10,000 shares . 100,000
Contributed capital in excess of par, preferred stock .................................. 30,000
Retained earnings (no cash or property dividends during year) ................ 570,000
Bonds payable, 8%, issued 1/1/1997; each $1,000 bond is convertible into 60
shares of common stock after the stock split on 12/1/1997 (bonds initially
sold at par) .............................................................................................. 200,000
Income before extraordinary items .............................................................. 86,000
Extraordinary loss .......................................................................................(14,000)
Net income ................................................................................................... 72,000
Average income tax rate ................................................................................. 30%.
Required:
1. Is this a simple or a complex capital structure? Explain.
2. What kind of EPS presentation is required? Explain.
3. Compute the required EPS amounts (show computations, rounded to two decimal places, and assume
that all amounts are material).
Answers:
Requirement 1
This is a complex capital structure because of the convertible bonds. The preferred stock is
nonconvertible and cumulative.
Requirement 2
Because this is a complex capital structure, a dual set of EPS amounts—basic EPS and diluted EPS—is
reported for (a) income before extraordinary items, (b) extraordinary items, and (c) net income.
Requirement 3
(a) Nonconvertible preferred dividend claim for current year:
$100,000 x.05 = $5.000 (because cumulative, included whether declared or not).
Basic EPS = ($86,000 - $5,000)/120,000* = $0.68
Chapter 22
13/16
Earnings per Share
* Average shares outstanding + stock split = 60,000 + 60,000
(b) Dilution-antidilution (D/A) test on convertible bonds (conducted using income before extraordinary
items):
Compare D/A ratio amount for convertible bonds payable to Tentative EPS:
D/A ratio amount = ($200,000 x .08 x .70**)/12,000* = $0.93
* ($200,000 ÷ $1,000) x 60
** 100% - tax rate of 30%
Conclusion:
Since $0.93 exceeds $0.68, the convertible bonds payable are antidilutive. Do not include them in
computing diluted EPS. There is only one D/A test because there is only one convertible security.
DEPS = Basic EPS.
P 22-6 Analyze Capital Structure: Stock Dividend, Convertible Securities. Compute EPS At the end
of 1997, the records of Luholtz Corporation reflected the following:
Common stock, no par, authorized 500,000 shares; issued and outstanding
throughout period, 100,000 shares ....................................................... $680,000
Stock dividend issued, 12/31/1997, 50,000 shares (not included in the 100,000
shares above) .......................................................................................... 340,000
Retained earnings (after effect of dividends on all shares)........................ 500,000
Bonds payable, 4-½%; each $1,000 bond is convertible to 80 shares of common
stock after the stock dividend (bonds issued at par in 1995).................. 100,000
Bonds payable. 6-½%; each $1,000 bond is convertible to 90 shares of common
stock after the stock dividend (bonds issued at par in 1995) .................... .300,000
Income before extraordinary items ............................................................ 210,000
Extraordinary gain ....................................................................................... 12,000
Net income ................................................................................................. 222,000
Average income tax rate ................................................................................. 40%.
Required:
1. Is this a simple or a complex capital structure? Explain.
2. What kind of EPS presentation is required? Explain.
3. Prepare the required EPS disclosures.
Answers:
Requirement 1
This is a complex capital structure because there are convertible bonds payable.
Requirement 2
Because this is a complex capital structure, a dual set of EPS amounts—basic EPS and diluted EPS—is
reported for (a) income before extraordinary items, (b) extraordinary items, and (c) net income.
Chapter 22
14/16
Earnings per Share
Requirement 3
Computation of EPS amounts:
(a) Shares from assumed conversion of bonds:
Bonds payable, 4-½%, convertible, $100,000
($100,000 ÷ $1,000) x 80 = 8,000 shares
Bonds payable, 6-½%, convertible, $300,000
($300,000 ÷ $1,000) x 90 = 27,000 shares
(b) Basic EPS for income before extraordinary items:
($222,000 - $12,000)/(100,000 + 50,000) = $1.40
(c) Numerator effects:
4-½% bonds
$100,000 (.045) (1 - .4) =
6-½% bonds
$300,000 (.065) (1 - .4) = $11,700
(d) D/A ratios and ranking
$2,700
D/A
Rank
4-½% bonds:
$2,700/8,000 = $0.34
1
6-½% bonds:
$11,700/27,000 = $0.43
2
(e) D/A Tests
Enter the 4-½% bonds into tentative DEPS because $0.34 < $1.40 (Basic EPS). Tentative DEPS =
($210,000 + $2,700)/(150,000 + 8,000) = $1.35.
Enter the 6-½% bonds into tentative DEPS because $0.43 < $1.35 (previous tentative DEPS).
Tentative DEPS = final DEPS (there are no more potentially dilutive securities) = ($210,000 + $2,700
+ $11,700)/(150,000 + 8,000 + 27,000) = $224,400/185,000 = $1.21.
(f) Earnings per share
Basic:
Income before extraordinary gain ......................................... $1.40
Extraordinary gain ($12,000/150,000) .................................... .08
Net income ............................................................................ $1.48
Diluted:
income before extraordinary gain ......................................... $1.21
Extraordinary gain ($12,000/185,000) .................................... .06
Net income [($222,000 + $2,700 + $11,700)/185,000] ......... $1.27
Chapter 22
15/16
Earnings per Share
A 22-1 EPS Disclosures American Home Products Corporation (AHP), a large company in the health
care field, reported the following information (dollar amounts in thousands) in its December 31, 1995
consolidated statement of income:
Net income .................................................................. $ 1,680,418
Net income per share of common stock ............................... $ 5.42
Required:
1. Estimate the average number of common shares outstanding for 1995. Assume that AHP has
outstanding the entire year $108 thousand of $2 preferred stock, par value $2.50; 5 million shares
authorized. Indicate any assumptions you are making. The stock is not convertible.
2. Does AHP have a simple or complex capital structure?
3. Is AHP required to report EPS figures for the cumulative effect of an accounting change, if present, in
their income statement?
Answers:
Requirement 1
[$1,680,418 – ($108,000 ÷ $2.50) x $2]/$5.42 = 310,024,280 shares
Three important assumptions are:
a. The $5.42 is basic EPS.
b. The number of outstanding preferred shares did not change from 43,200 [$108,000 ÷ 2.50] during the
year.
c.
The preferred dividends were declared by the firm. (The preferred is not titled as cumulative.)
Requirement 2
Simple, because AHP has no potential common stock.
Requirement 3
No. The presentation of this figure may appear in the notes if the firm so wishes.
Chapter 22
16/16
Earnings per Share
CHAPTER 23: STATEMENT OF CASH FLOWS
1. Compare the purposes of the balance sheet, income statement, and statement of cash flows.
Answer: The purpose of the balance sheet is to report financial position (i.e.. assets. liabilities. and
owners' equity) as of a specified date (at the end of the reporting period). The purpose of die income
statement is to report the results of operations (i.e., revenues, expenses, gains and losses, and
extraordinary items) for the reporting period. It is a change statement because it reports the detailed
items that comprise net income. which causes owners' equity to change (i.e., retained earnings). Both
of these statements report accrual-basis amounts. In contrast, the statement of cash flows is a cash
flow statement. It reports cash flows for three different activities—operating. investing, and financing.
The primary purpose of the SCF is to provide cash flow information in a manner that maximizes its
usefulness to investors. creditors. and other interested parties in projecting future cash inflows related
to the enterprise.
2. Explain the basic difference between the three activities reported in the SCF: operating, investing, and
financing.
Answer: Operating activities—primarily relates to items reported on the income statement (cash
inflows and outflows); this relates to its primary operations. including gains and losses, interest. and
income tax.
Investing activities—primarily relates to obtaining productive facilities and investments in other noncash assets. These activities include both cash outflows, "investing." and cash inflows from
disposition of the "investments" previously made.
Financing activities—primarily relates to obtaining resources for the entity to use (cash inflows) and
the repayment of those "financing" activities (e.g., payment on debt principal), The primary sources
are borrowing and funds provided by the owners. I'm outflows do not include interest on debt.
8. Explain the basic difference between the direct and indirect methods of reporting on the SCF. Use net
income, $5,000, sales revenue, $100,000, and an increase in net accounts receivable, $10,000, to
illustrate the basic difference. Which method provides the most relevant information to investors and
creditors?
Answer: The difference between the direct and indirect methods relates only to the SCF
classification, cash flows from operating activities. The direct method reports individual cash inflows
front each major revenue and individual cash outflows for each major expense. The indirect method
reports a reconciliation of net income with net cash flow from operating activities. This reconciliation
reports changes in asset and liability accounts directly related to net income.
Illustration
Direct method
Cash inflow from sales (i.e., from customers) ..............................
$90,000
Indirect method:
Net income ....................................................................................
$5,000
Reconciliation
Net accounts receivable increase............................................
(10,000)
Etc.
Clearly, the information provided by the direct method would be the most relevant to investors and
creditors. The $10,000 change in accounts receivable is already shown on the comparative balance
sheets. Also, the reconciliation is a required disclosure for the direct method.
Chapter 23
1/17
Statement of Cash Flows
10. Explain why a $50,000 increase in inventory during the year must be considered when developing
disclosures for operating activities under both the direct and indirect methods.
Answer: The $50,000 increase in inventory must be used in the SCF calculations because it
increases the amount of cash outflows that otherwise would not have occurred, It is used as follows:
Direct method—added to cost of goods sold, accrual basis (the other adjustment would involve
accounts payable) to compute cost of goods sold, cash basis.
Indirect method—deducted from net income as a reconciling item with cash flows from operating
activities.
11. What three reconciling amounts must be reported at the bottom of the SCF? Which one must agree
with a key amount in another financial statement? Use assumed amounts for illustrative purposes.
Answer: The three reconciling lines are as follows:
Net increase (decrease) in cash during the period........................
Cash balance, beginning ...............................................................
Cash balance, ending ....................................................................
$(10,000)
50,000
$40,000
The $40,000 must agree with the ending cash (plus cash equivalents) amounts reported on the
balance sheet.
20. Is there an inconsistency in the classification of dividends received and dividends paid in the SCF?
Discuss your answer.
Answer: Dividends received are an operating cash inflow, yet are related to investments in common
stock, an investing activity. Dividends paid are payments to stockholders, a financing activity, and are
classified as financing cash outflows. The classification of dividends received appears to be counter
to the underlying nature of the activity.
21. How is a lease payment (after inception) on a capital lease classified in the SCF?
Answer: The interest portion of the lease payment is classified as an operating cash outflow,
because all interest is so classified. The principal portion of the payment is a financing cash outflow
because it is a partial extinguishment of a liability—a source of financing.
22. Trading securities and securities available for sale are treated differently in the statement of cash
flows. What are the major differences in treatment?
Answer: Purchases and proceeds from sales (and maturities) of trading securities (TS) are classified
as operating cash flows, whereas for securities available-for-sale (SAS), these cash flows are
classified as investing. Both types of investments are carried at market value.
The net change in the balance of investments in TS during a period (which would include any
unrealized gains or losses) is treated as a reconciling item in the reconciliation of net income and net
operating cash flow; therefore, neither realized nor unrealized gains and losses are reconciling items.
The change in TS during the period takes both types of gains and losses into account, as well as any
purchases or disposals.
The net change in investments in SAS during a period is not a reconciling item because such
investments are not considered an operating activity. Unrealized gains and losses do not affect
earnings or operating cash flow and therefore are not found in the reconciliation. Realized gains and
losses, however, are reconciliation adjustments because net income has been increased or
decreased without an associated operating cash flow.
Chapter 23
2/17
Statement of Cash Flows
E 23-2 SCF: Cash Flow Analysis of Sales The records of ZZ Hat Company showed sales revenue of
$100,000 (on the income statement) and a change in the balance of accounts receivable. To demonstrate
the effect of changes in accounts receivable on cash inflows from customers, five independent cases are
used. Complete the following tabulation for each independent case:
Sales
Revenue
Case (from income statement)
A
B
C
D
E
$100,000
100,000
100,000
100,000
100,000
Accounts
Receivable
Increase
(decrease)
$ -010,000
(10,000)
9,000 *
(9,000) *
Computation
Cash
Inflow
........................................
........................................
........................................
.........................................
.........................................
............
............
............
............
............
*Includes the effect of a $1,000 write-off of an uncollectible account.
Answer:
Sales
Revenue
Case (from income statement)
A
B
C
D
E
$100,000
100,000
100,000
100,000
100,000
Accounts
Receivable
Increase
(decrease)
Cash
Inflow
Computation
$ -010,000
(10,000)
9,000 *
(9,000) *
None
$100,000 - $10,000
$100,000 + $10,000
$100,000 – ($9,000 + $1,000)
$100,000 + ($9,000 - $1,000)
.$100,000
90,000
110,000
90.000
108,000
*Includes the effect of a $1,000 write-off of an uncollectible account.
E 23-5 Multiple Choice: Statement of Cash Flows Choose the correct response for each question.
1. In the statement of cash flows, which of the following would increase reported cash flows from
operating activities under the direct method? Ignore tax considerations.
a. Dividends received from investments.
b. Gain on sale of equipment.
c. Gain on early retirement of bonds.
d. Change from straight-line to accelerated depreciation.
Answer: a.
2. Which of the following cash flows per share should be reported in a statement of cash flows'?
a. Primary cash flows per share only.
b. Fully diluted cash flow per share only.
c. Both primary and fully diluted cash flows per share.
d. Cash flows per share should not be reported.
Answer: d.
Chapter 23
3/17
Statement of Cash Flows
3. Cantova Company sold used equipment for a cash amount equaling its carrying amount for both book
and tax purposes. A few days later. Cantova replaced the equipment by paying a cash down payment
and signing a note payable for new equipment. The cash down payment exceeded the cash received
for the old equipment. How should these equipment transactions be reported in Cantova's statement
of cash flows?
a. Cash outflow equal to the down payment less the cash received.
b. Cash outflow equal to the down payment and note payable less the cash received.
c. Cash inflow equal to the cash received and a cash outflow equal to the down payment and note
payable.
d. Cash inflow equal to the cash received and a cash outflow equal to the down payment,
Answer: d.
4. How should a gain from the sale of used equipment for cash be reported in a statement of cash flows
using the indirect method?
a. In investment activities as a reduction of the cash inflow from the sale.
b. In investment activities as a cash outflow.
c. In operating activities as a deduction from income.
d. In operating activities as an addition to income.
Answer: c.
5. Would the following be added back to net income in the reconciliation of net income and net
operating cash flow?
Excess of Treasury Stock Acquisition
Bond Discount
Cost over Sales Proceeds (cost method)
Amortization
a.
Yes
Yes
b.
No
No
c.
No
Yes
d.
Yes
No
Answer: c.
6. Malli Manufacturing Company purchased a three-month U.S. Treasury bill, to be classified as a cash
equivalent. In the preparation of Malli's statement of cash flows, this purchase would
a. Not be reported.
b. Be treated as an outflow from financing activities.
c. Be treated as an outflow from investing activities.
d. Be treated as an outflow from lending activities.
Answer: a.
Chapter 23
4/17
Statement of Cash Flows
E 23-7 SCF: Indirect Method Calexico Inc. reported the following comparative balance sheets for the
current year:
Balance Sheets
January 1
December 31
Cash ........................................................
Accounts receivable ................................
Equipment ...............................................
Accumulated depreciation ......................
Total assets..............................................
$ 4,000
3,000
10,000
(1,000)
$16,000
$ 10,750
2,000
15,000
(2,000)
$25,750
Salaries payable ......................................
Long-term notes payable.........................
Capital stock ...........................................
Retained earnings ....................................
Total liabilities and owners’ equity.........
$ 1,000
5,000
8,000
2,000
$16,000
$ 2,000
5,000
8,000
10,750
$25,750
Additional information:
1. Net income for the current year was $9,750.
2. No purchases or disposals of equipment took place during the year.
Required:
1
Prepare the indirect method statement of cash flows for Calexico.
2. What additional information would you need to prepare the direct method statement of cash flows for
this firm?
Answers:
Requirement 1
Calexico, Inc.
Statement of Cash Flows
For the Current Year Ended December 31
Operating activities
Net income ..........................................................
Depreciation expense ..........................................
Accounts receivable decrease.............................
Salary payable increase ......................................
Net cash inflow from operations .....................
Investing Activities
Purchase of equipment........................................
Net cash outflow from investing activities .......
Investing Activities
Dividends paid .....................................................
Net cash outflow from financing activities ......
Increase in cash .........................................................
Cash, January 1 .........................................................
Cash, December 31 ...................................................
*
Chapter 23
$9,750
1,000
1,000
1,000
$12,750
(5,000)
(5,000)
(1,000)
(1,000)
6,750
4,000
$10,750
$2,000 + $9,750 - $10,750
5/17
Statement of Cash Flows
Requirement 2
To prepare the direct method SCF, income statement information is required. Revenue and expense
data, when combined with the associated changes in operating balance sheet accounts, yield the
operating cash flows that would be reported under the direct method. The operating cash flows to be
determined for this problem would include collections from customers, payments to suppliers, and
payments to employees.
E 23-11 Transaction Analysis You are requested by the controller of a large company to determine the
appropriate disclosure for the following transactions in the SCF. Assume that all adjusting entries were
recorded.
a. The company wrote off a S4.000 account. During the year, gross accounts receivable increased
$100,000, and the allowance for doubtful accounts increased $10,000. All sales ($600,000) are on
account.
b. Pension expense is $100,000: the balance of accrued pension cost (cr.) increased $24,000.
c. Deferred tax liability increased $80,000, income taxes payable decreased $20,000, and income tax
expense was $220.000.
d. $20,000 of interest was capitalized. Interest expense is $100,000. There is no change in interest
payable.
e. The company sold short-term investments (cash equivalents) at a $4,000 gain, proceeds $16,000.
f. The company sold short-term investments in securities classified as available for sale at a $4,000
gain, proceeds $16,000. There was no valuation allowance balance on the securities, and market value
equaled cost at the beginning of the period.
Required:
Indicate the complete disclosure of each item in the SCF under (1) the direct method and (2) the indirect
method.
Answer:
The disclosure for the reconciliation of net income and net operating cash flow is given separately for
each item, because the reconciliation is reported under both the direct and indirect methods. The
amounts indicated for the direct and indirect methods reflect disclosures other than those for the
reconciliation.
a. Reconstructed entries:
Accounts receivable .............................................................
Sales ................................................................................
Allowance for doubtful accounts ...........................................
Accounts receivable .........................................................
Bad debt expense .................................................................
Allowance for doubtful accounts
Cash .....................................................................................
Accounts receivable .........................................................
Net cash effect = $496,000
Net income effect = $600,000 - $14,000 = $586,000
600,000
600,000
4,000
4,000
14,000
496,000
496,000
Direct method: $586,000 operating cash inflow, collections from customers
Indirect method: No disclosure other than in the reconciliation.
Chapter 23
6/17
Statement of Cash Flows
Reconciliation: Two different approaches may be used: (1) $90,000 subtraction adjustment, increase
in accounts receivable (this adjusts the income effect of $586,000 to equal the cash effect $496,000),
or (2) $14,000 addition adjustment, bad debt expense; $104,000 subtraction adjustment, increase in
gross accounts receivable before the write-off.
b. Direct method: $76,000 operating cash outflow, payment to pension trustee.
Indirect method: No disclosure other than in the reconciliation.
Reconciliation: $24,000 addition adjustment, increase in accrued pension cost.
c.
Reconstructed entries
Income tax expense .............................................................
Deferred tax liability .........................................................
Income tax payable..........................................................
230,000
Income tax payable ($140,000 + $20,000 decrease) ...........
Cash.................................................................................
160,000
80,000
140,000
160,000
Direct method: $160,000 operating cash outflow, income taxes paid.
Indirect method: No disclosure other than in the reconciliation.
Reconciliation: $80,000 addition adjustment, increase in deferred tax liability; $20,000 subtraction
adjustment, income tax payable decrease.
d. Direct method: $100,000 operating cash outflow, interest payments: $20,000 investing cash outflow,
payments for capitalized interest.
Indirect method: $20,000 investing cash outflow, payments for capitalized interest.
Reconciliation: No adjustment.
e. Direct method: $4,000 operating cash inflow, gain on sale of cash equivalents.
Indirect method: No disclosure.
Reconciliation: No adjustment.
(The $4,000 increase in cash and cash equivalents is reflected in earnings through the gain.)
f.
Direct and indirect methods: $16,000 investing cash inflow, proceeds from securities available for
sale.
Reconciliation: $4,000 subtraction adjustment, gain on sale of securities available for sale.
Chapter 23
7/17
Statement of Cash Flows
E 23-15 SCE Indirect Method: Prepare the Reconciliation for Operating Activities. The data given
below were provided by the accounting records of Darby Company. Prepare the reconciliation of net
income with cash flow from operations for inclusion in the SCF, indirect method.
Net income (accrual basis) ...................................................
Depreciation expense ...........................................................
Decrease in wages payable ..................................................
Decrease in trade accounts receivable .................................
Increase in merchandise inventory.......................................
Amortization of patent .........................................................
Increase in long-term liabilities ...........................................
Sale of capital stock for cash ...............................................
Amortization of premium on bonds payable .......................
Accounts payable increase ...................................................
Stock dividend issued ..........................................................
$ 40,000
$ 8,000
$ 1,200
$ 1,800
$ 2,500
$ 100
$ 10,000
$ 25,000
$ 200
$ 4,000
$10,000
Net income reported; accrual basis .....................................
Add (deduct) to reconcile net income to net cash flow:
Depreciation expense .......................................................
Decrease in wages payable ..............................................
Decrease in trade accounts receivable ............................
Increase in merchandise inventory ...................................
Amortization of patent .......................................................
Amortization of premium on bonds payable .....................
Accounts payable increase ...............................................
Net cash inflow from operating activities..............................
$40,000
Answer:
8,000
(1,200)
1,800
(2,500)
100
(200)
4,000
$50,000
E 23-17 SCF, Indirect Method Zepco Company’s recent comparative balance sheet and income
statement follow:
Comparative Balance Sheets
December 31
1998
Chapter 23
1997
Assets:
Cash ..................................................................
Accounts receivable ..........................................
Plant assets........................................................
Accumulated depreciation ................................
Total Assets ......................................................
$ 59,000 $ 60,000
34,000
24,000
277,000
247,000
(178,000) (167,000)
$192,000 $164,000
Liabilities and stockholders’ equity:
Bonds payable ..................................................
Dividends payable ............................................
Common stock, $1 par ......................................
Additional paid-in-capital .................................
Retained earnings .............................................
Total liabilities and stockholders’ equity..........
$ 49,000
8,000
22,000
9,000
104,000
$192,000
8/17
$ 46,000
5,000
19,000
3,000
91,000
$164,000
Statement of Cash Flows
Income Statement
For Year Ended December 31, 1998
Sales revenue ................................................
Cost of goods sold.........................................
Gross margin .................................................
Depreciation expense ....................................
Gain on sale of equipment ............................
Net income ....................................................
$155,000
(107,000)
48,000
(33,000)
13,000
$28,000
Additional information:
1. During 1998, equipment costing $40,000 was sold for cash.
2. During 1998, $20,000 of bonds payable were issued in exchange for property, plant and equipment.
There was no amortization of bond discount or premium.
Required: Prepare Zepco’s statement of cash flows under the indirect method.
Answer:
Zepco Corporation
Statement of Cash Flows
For the Year Ended December 31, 1998
Operating activities
Net income ..........................................................
Depreciation expense ..........................................
Accounts receivable increase ..............................
Gain on sale of equipment...................................
Net cash inflow from operations .....................
Investing Activities
Proceeds from sale of equipment ........................
Purchase of equipment........................................
Net cash outflow from investing activities .......
Investing Activities
Retirement of bonds ............................................
Dividends paid .....................................................
Issuance of common stock ..................................
Net cash outflow from financing activities ......
Net decrease in cash .................................................
Cash at beginning of year ..........................................
Cash at end of year ....................................................
$28,000
33,000
(10,000)
(13,000)
$38,000
$31,000a
(50,000)a
(19,000)
$(17,000)b
(12,000)c
9,000d
(20,000)
(1,000)
60,000
$59,000
Non-cash activity schedule:
Acquisition of plant assets through bond issuance $20,000
Chapter 23
9/17
Statement of Cash Flows
Computation:
a To
determine cash proceeds from sale of equipment and purchase of equipment:
Entry for sale of equipment:
Cash (derived) ......................................................................
Accumulated depreciation ....................................................
Plant assets .....................................................................
Gain .................................................................................
32,000
22,000 *
40,000
13,000
*$33,000 depreciation - $11,000 increase in accumulated depreciation
1/1 balance
acquisition (bonds)
acquisition (cash)—derived
12/31 balance
b $17,000
c To
Plant Assets
247,000 | 40,000 cost of assets sold
20,000 |
50,000 |
277,000 |
bond retirement = $20,000 bond issuance - $3,000 net increase in bonds payable.
determine dividends paid:
1998 dividends declared (derived)
1998 dividends paid
Retained Earnings
|
91,000 1/1 balance
15,000 |
28,000 1998 earnings
| 104,000 12/31 balance
Dividends Payable
|
5,000 1/1 balance
12,000 |
15,000 1998 dividends declared
| 104,000 12/31 balance
d $9,000
proceeds from common stock issuance = $3,000 change in common stock + $6,000 change in
additional paid-in capital.
Chapter 23
10/17
Statement of Cash Flows
P 23-6 SCF, Indirect Method The following is Orem Corporation's comparative balance sheets for 1998
and 1997.
December 31
1998
1997
Cash................................................................ $ 400,000 $ 350,000
Accounts receivable ....................................... 564,000 584,000
Inventories...................................................... 924,000 857,500
Property, plant and equipment ....................... 1,653,500 1,483,500
Accumulated depreciation ............................. (582,500) (520,000)
Investment in Belle Co................................... 152,500 137,500
Loan receivable .............................................. 135,000 _______
Total assets ..................................................$3,247,500$2,892,500
Accounts payable ........................................... $ 507,500 $ 477,500
Income taxes payable .....................................
15,000
25,000
Dividends payable ..........................................
40,000
45,000
Capital lease obligation .................................. 200,000
Capital stock, common, $1 par ...................... 250,000 250,000
Additional paid-in capital .............................. 750,000 750,000
Retained earnings ........................................... 1,485,000 1,345,000
Total liabilities and stockholders’ equity ....$3,247,500$2,892,500
Additional information:
1. On December 31, 1997, Orem acquired 25 percent of Belle Company's common stock for $137,500.
On that date, the carrying value of Belle's net assets and liabilities, which approximated fair value,
was $550,000. Belle reported income of $60,000 for the year ended December 31, 1998. No dividend
was paid on Belle's common stock during the year.
2. During 1998, Orem loaned $150,000 to Chase Company, an unrelated company. Chase made the first
semiannual principal repayment of $15,000, plus interest at 10 percent, on October 1, 1998.
3. On January 2, 1998, Orem sold equipment costing $30,000, with a carrying value of $17,500, for
$20,000 cash.
4. On December 31, 1998, Orem entered into a capital lease for an office building. The present value of
the annual rental payments is $200,000, which equals the fair value of the building. Orem made the
first rental payment of $30,000 when due on January 2, 1999.
5. Orem's net income for 1998 was $180,000.
6. Orem declared and paid cash dividends for 1998 and 1997 as follows:
Declared ........................
Paid ...............................
Amount .........................
Chapter 23
1998
Dec. 15, 1998
Feb. 28. 1999
$40,000
11/17
1997
Dec. 15. 1997
Feb. 28. 1998
$45,000
Statement of Cash Flows
Required: Prepare the 1998 statement of cash flows for Orem using the indirect method. Prepare relevant
supplemental schedules.
Answer:
Reconstructed 1998 entries front additional information:
1. Investment in Belle Co. $60,000 (.25) .......................
Investment income ...............................................
15,000
15,000
There was no goodwill on the purchase: $137,500 (cost of investment) = (.25) ($550,000 book value and
fair value of Belle's net assets at purchase of investment).
2. Loan receivable ..........................................................
Cash .....................................................................
150,000
Cash ...........................................................................
Interest revenue (.10) ($150,000) (1/2) ................
Loan receivable ....................................................
22,500
3. Cash ...........................................................................
Accumulated depreciation ..........................................
Property, plant and equipment .............................
Gain on sale of equipment ...................................
* $30,000 - $17,500
4. Property, plant and equipment ...................................
Capital lease obligation ........................................
150,000
7,500
15,000
20,000
12,500 *
30,000
2,500
200,000
200,000
Orem Corporation
Statement of Cash Flows
For the Year Ended December 31, 1998
Operating activities
Net income ...........................................................................
Adjustments to reconcile net income to net operating
cash flow
Undistributed earnings of Belle Co. ..................................
Gain on sale of equipment................................................
Depreciation expense .......................................................
Accounts receivable decrease..........................................
Inventories increase .........................................................
Accounts payable increase ...............................................
Income taxes payable decrease ........................................
Net operating cash flow .............................................
Investing Activities
Loan to Chase Company .....................................................
Proceeds from sale of equipment ........................................
Collection of principal payment on loan ...............................
Net investing cash flow ..............................................
Chapter 23
12/17
$180,000
(15,000)
(2,500)
75,000
20,000
(67,500)
30,000
(10,000)
$210,000
(150,000)
20,000
15,000
(115,000)
Statement of Cash Flows
Financing activities
Dividends paid .....................................................................
Net Financing cash flow .............................................
(45,000)
(45,000)
Net increase in cash ................................................................
Cash at beginning of year .......................................................
Cash at end of year .................................................................
50,000
350,000
$400,000
* Accumulated depreciation increased $62,500, net, during 1998, but was reduced
$12,500 on the sale of equipment. Therefore, depreciation expense was $75,000.
Non-cash activity schedule
Acquisition of office building through capital lease .....................................
$200,000
P 23-14 SCF. Indirect Method: Optional Spreadsheet The income statement, balance sheet, and
analysis of selected accounts of Summer Company are given below.
Balance Sheet
Debits
December 31
1997
1998
Cash plus short-term investments* ......... $ 80,000
Accounts receivable (net) .......................
120,000
Merchandise inventory (perpetual) .........
360,000
Prepaid insurance ....................................
4,800
Investments, long-term ...........................
60,000
Land ........................................................
20,000
Plant assets ..............................................
500,000
Patent (net) ..............................................
3,200
................................................................ $1,148,000
$
89,800
105,000
283,200
2,400
Increase
(decrease)
76,800
518,000
2,800
$1,078,000
$ 9,800
(15,000)
(76,800)
(2,400)
(60,000)
56,800
18,000
(400)
$(70,000)
$ 158,000
106,000
3,000
26,800
100,000
3,400
612,000
36,000
32,800
$1,078,000
$ 28,000
6,000
(1,000)
8,800
(100,000)
(6,600)
12,000
6,000
(23,200)
$(70,000)
Credits
Accumulated depreciation ...................... $ 130,000
Accounts payable ....................................
100,000
Wages payable ........................................
4,000
Income taxes payable ..............................
18,000
Bonds payable .........................................
200,000
Premium on bonds payable .....................
10,000
Common stock, par $10 ..........................
600,000
Contributed capital in excess of par ........
30,000
Retained earnings ....................................
56,000
................................................................ $1,148,000
Chapter 23
13/17
Statement of Cash Flows
Income Statement 1998
Sales revenue .............................................
Cost of goods sold......................................
Depreciation expense .................................
Patent amortization ....................................
Remaining expenses (including interest) ...
Extraordinary gain, net of $5,000 tax ........
Net income .................................................
$ 800,000
(448,800)
(28,000)
(400)
(287,800)
15,000
$ 50,000
Analysis of selected accounts and entries:
a. Purchased operational asset; cost, $18,000; payment by issuing 1,200 shares of stock.
b. Payment at maturity date to retire bonds payable, $100,600.
c. Sold the long-term investments for $80,000. The market value of these securities classified as
available for
sale had not changed until 1998.
d. Purchased land, $56,800; paid cash.
e. Further information:
Retained earnings, beginning balance..................................
Prior period adjustment, income tax, paid in 1998 ..............
Net income, 1998 .................................................................
Cash dividend paid...............................................................
Ending balance.....................................................................
$56,000
(13,200)
50,000
(60,000)
$32,800
Required: Prepare the SCF, indirect method.
Answer:
Spreadsheet:
Comparative
Balance Sheets
Balances
12/31/97
Cash and short-term investments ...
80,000
Accounts receivable, net .................
120,000
Merchandise inventory ....................
360,000
Prepaid insurance ...........................
4,800
Investments, long-term ...................
60,000
Land ................................................
20,000
Plant ................................................
500,000
Patent, net .......................................
3,200
Accumulated depreciation...............
(130,000)
Total Assets ................................ 1,018,000
Accounts payable ............................
100,000
Wages payable ...............................
4,000
Income taxes payable .....................
18,000
Bonds payable ................................
200,000
Premium on bonds payable ............
10,000
Common stock, $10 par ..................
600,000
Contrib capital in excess of par .......
30,000
Retained earnings ...........................
56,000
.................................................... ________
Total Liabs & Owners’ Equity ..... 1,018,000
Total Changes ............................
Chapter 23
14/17
Dr.
(q)
9,800
15,000
76,800
2,400
60,000
(m)
(l)
Balances
12/31/98
Cr.
(b)
(c)
(g)
(k)
56,800
18,000
400 (f)
28,000 (e)
6,000 (d)
(h)
1,000
8,800 (i)
(n) 100,000
(j)
6,600
(p)
(o)
60,000
13,200
_______
265,400
12,000 (l)
6,000 (l)
50,000 (a)
_______
265,400
89,800
105,000
283,200
2,400
76,800
518,000
2,800
(158,000)
920,000
106,000
3,000
26,800
100,000
3,400
612,000
36,000
32,800
_______
920,000
Statement of Cash Flows
Adjustments Leading to SCF:
Indirect Method
Dr.
Cr.
Operating Activities
Net income ......................................
Sales ...............................................
Cost of goods sold ..........................
........................................................
Depreciation ....................................
Patent amortization .........................
Remaining expenses ......................
........................................................
........................................................
........................................................
Extraordinary gain ...........................
Tax on extraordinary gain ...............
Prior period adjustment—tax pymt .
50,000
800,000
448,800
28,800
400
287,800
(a)
(b)
(c)
(d)
(e)
(f)
(g)
50,000
15,000
76,800
6,000
28,000
400
2,400
(i)
8,800
1,000 (h)
6,600 (j)
20,000 (k)
20,000
5,000
13,200 (o)
Investing Activities
Sale of investments .........................
Purchase of land .............................
(k)
80,000
56,800 (m)
Financing Activities
Retirement of bonds ........................
Dividends paid ................................
........................................................
Net cash increase ...........................
........................................................
_______
267,400
100,000 (n)
60,000 (p)
257,600
9,800 (q)
267,400
Summer Corporation
Statement of Cash Flows
For the Year Ended December 31, 1998
Cash flow from operating activities:
Net income ...........................................................................
Add (deduct) to reconcile net income to net cash flow
Depreciation expense .......................................................
Amortization of patent .......................................................
Extraordinary gain on long-term investment.....................
Decrease in prepaid insurance .........................................
Merchandise inventory decrease......................................
Amortization of bond premium..........................................
Accounts receivable decrease..........................................
Accounts payable increase ...............................................
Wages payable decrease .................................................
Income taxes payable increase ........................................
Payment on prior years’ income tax (prior period adj.) ....
Net cash inflow from operating activities .............................
Cash flow from investing activities:
Sold long-term investment ...................................................
Purchased land ....................................................................
Net cash inflow from investing activities (Note A) ...................
Chapter 23
15/17
$50,000
28,800
400
(20,000)
2,400
76,800
(6,600)
15,000
6,000
(1,000)
8,800
(13,200)
$146,600
80,000
(56,800)
23,200
Statement of Cash Flows
Cash flow from financing activities:
Cash dividends paid ............................................................
Bonds payable retired ..........................................................
Net cash outflow from financing activities ...............................
Net increase in cash and cash equivalents during 1998 ........
Cash and cash equivalents balance, January 1, 1998 ...........
Cash and cash equivalents balance, December 31, 1998 .....
Note A
(60,000)
(100,000)
(160,000)
9,800
80,000
$89,800
Purchased operational asset, cost $18,000; paid in full by issuing 1,200 shares
of common stock.
A 23-6 Using the World Wide Web: Statement of Cash Flows This problem requires access to the
World Wide Web portion of the Internet. The data for use in this problem is the most recent 10-K annual
report of Cisco Systems. To obtain that information, use the Securities and Exchange Commission's
Electronic Data Gathering, Analysis and Retrieval System (EDGAR) to retrieve Cisco's report. Steps to
access EDGAR on the World Wide Web:
a.
b.
c.
d.
e.
f.
g.
URL: http://www.sec.gov/index.html (the SEC's home page).
Click on EDGAR Database of Corporate Information.
Click on Search We EDGAR Database.
Click on Search the EDGAR Archives.
Enter the company name in the search dialog box.
Click on the listing for the most recent 10-K annual report.
Use Edit, Find in the toolbar to locate the statement of cash flows.
Required: Answer the following questions related to Cisco's statement of cash flows for the most recent
year available or for the period specified by your instructor.
1. What method does Cisco use to present its statement of cash flows?
2. Comment on the difference between net income and net operating cash flow for the three years
presented in the annual report. Which items caused the most significant differences between earnings
and net operating cash flow?
3. Describe Cisco's investment behavior, both in short-term investments and in other longer-term
investments.
4. How does Cisco report the difference between the earnings and the cash flow effects of accounts
receivable?
5. Comment on Cisco's use of leverage, and whether there is a trend in the use of long-term debt
financing,
6. Comment on the trend in capital expenditures and depreciation amounts shown in the SCF. Is there a
relationship -between the two?
Answers:
(Instructor's note: This solution is based on the 1996 10-K report of Cisco Systems, which was the latest
report available at the time of publication. Please inform your students as to the particular year you wish
to use for the problem. This solution provides a template for the year you choose. Although the numerical
values will be different in the solution for the current year, this solution should be a useful guide.)
Chapter 23
16/17
Statement of Cash Flows
1. Cisco uses the indirect method.
2. The difference between earnings and operating cash flow is relatively minor, although it increased
each year in the three-year period ending 1996. In particular, the difference grew from a few $million
in 1994 and 1995 to $149 million in 1996. However, compared to many other large firms, earnings
and operating cash flow are very similar in amount.
The item contributing the most to the difference between the two amounts changes across reporting
years, but the changes in inventories and receivables are consistently among the largest amounts.
Depreciation, tax benefits and the change in accrued liabilities also contribute significantly to the
difference.
3. Both purchases and proceeds from sale and maturity of short-term investments increased
dramatically over the period. The level of passive investment may at first seem unusual given Cisco's
growing dominance in its business. However. the firm is so successful it may be unable to find
appropriate acquisitions fast enough to deplete its cash horde. The firm also is increasing its longerterm investments including acquisitions and property and equipment.
4. Cisco does not use the single line-item method of adjusting earrings for the change in net accounts
receivable. The amount listed as the adjustment for the change in receivables in the reconciliation
does not equal the change in net accounts receivable. Apparently Cisco uses the change in gross
accounts receivable before write-offs, and then adds a second adjustment for bad debt expense
(listed as provision for doubtful accounts).
5. The SCF shows no debt issuances for the three-year period. Cisco only issued stock, and purchased
a similar amount of treasury stock during the period. The balance sheet lists no long-term debt at the
end of 1996! Cisco's only debt is classified as current.
6. Cisco is increasing its investment in plant and equipment, but the level of this investment is
significantly smaller than in other types of investments, both passive and strategic, as shown in the
SCF. The depreciation adjustments in the reconciliation are growing rapidly in magnitude, in part due
to the increased investment in plant and equipment, and in part due to the short average useful life of
between 2.5 and 5 years (footnote 1).
Chapter 23
17/17
Statement of Cash Flows
CHAPTER 24: ACCOUNTING CHANGES AND ERROR CORRECTIONS
3. Complete the following schedule:
Method of Reflecting the Effect*
(1) _______ (2) _______ (3)
a. Change in estimate
b. Change in principle
c. Correction of error
_______
_______
_______
_______
_______
_______
_____
_______
_______
_______
* Identify these three captions: then enter appropriate checkmark on each line.
Answer:
a. Change in estimate
b. Change in principle
c. Correction of error
Method of Reflecting the Effect*
(1)
(2)
(3)
Currently
Prospectively Retroactively
x
x
x
(exceptions)
x
5. Explain the basic difference between an accounting change and an error correction.
Answer: An accounting change involves a change in accounting (a) principle, (b) estimate, or (c)
entity. It is made with intent and by decision. Ali accounting error involves incorrect application of
accounting principles and estimates, and mathematical errors. Accounting errors usually are made
inadvertently and are not planned.
6. Why are the effects of changes from LIFO to other inventory flow methods accounted for
retroactively when changes to LIFO from another method are reflected as changes in the income of
the year the change is made?
Answer: During a period of increasing inventory costs. under LIFO the same quantity of inventory
retains the initial value assigned to it when LIFO was first adopted. Increasing costs coupled with the
passage of an extended time interval causes unrealistically low inventory carrying values under LIFO.
A switch to some other method in such circumstances could result in a large credit, which would
create "instant reported profits'* if the effect of the change were allowed to be reflected in current
income. Changing to LIFO from another method usually would have a negative effect on income in
the period of the change. Reporting such losses, but not gains, on the income statement can be
traced to the concept of conservatism.
7. Other than changing from LIFO to another inventory flow method (which must be reflected
retroactively), what other types of accounting changes must be accorded retroactive treatment rather
than being accounted for using the current approach?
Answer: Changes in the method of accounting for income on long-term construction contracts, a
change to or from the "full cost" method in extractive industries, a change in accounting principles
related to a forthcoming issuance of capital stock by closely-held company, a change required by an
APB or FASB pronouncement, and a change from retirement/replacement accounting to depreciation
accounting for railroad track structures, are accounted for retroactively as special exceptions to the
current approach.
11. What is the difference between a counterbalancing and a non-counterbalancing error? Why is the
distinction significant in the analysis of errors?
Chapter 24
1/11
Accounting Changes and Error Corrections
Answer: A counterbalancing (self-correcting) error results from failure to properly allocate an
expense or revenue item between two consecutive accounting periods. No error remains in retained
earnings or other balance sheet accounts at the end of the second period because the total revenue
and total expense to that date are correct. However, the interim reports are incorrect.
A non-counterbalancing (not self-correcting) error continues to affect the account balances and
reports beyond a two-year period.
This distinction is significant in the analysis of errors because the correcting entry depends upon
whether the error is counterbalancing or non-counterbalancing, as well as upon when the error is
corrected relative to when the error was made.
12. Complete the schedule below by entering a plus sign to indicate overstatement. a minus sign to
indicate understatement, or a zero for no effect.
Effect of Error On
Net
Income
Assets
Liabilities
Owners'
Equity
a. Ending inventory for 1997 understated:
1997 financial statements
0
1998 financial statements
b. Ending inventory for 1998 overstated:
1997 financial statements
1998 financial statements
c. Failed to record depreciation in 1997:
1997 financial statements
1998 financial statements
d. Failed to record a liability resulting from
revenue collected in advance at end of
1997; instead credited revenue in full
erroneously:
1997 financial statements
1998 financial statements
Answer:
Effect of Error On
a. Ending inventory for 1997 understated:
1997 financial statements
1998 financial statements
b. Ending inventory for 1998 overstated:0
1997 financial statements
1998 financial statements
c. Failed to record depreciation in 1997:
1997 financial statements
1998 financial statements
d. Failed to record a liability resulting from
revenue collected in advance at end of
1997; instead credited revenue in full
erroneously:
1997 financial statements
1998 financial statements
Chapter 24
Net
Income
Assets
Liabilities
Owners'
Equity
+
0
0
0
0
+
-
+
0
0
0
+
0
+
0
+
+
0
0
+
+
+
-
0
0
0
+
0
2/11
Accounting Changes and Error Corrections
E 24-1 Multiple Choice: Accounting Changes Choose the correct answer to each question.
1. Which of the following is a change in accounting principle?
a. Correction of an error using the retroactive approach.
b. Change from an incorrect method to a correct method.
c. Change in the application of an accounting principle.
d. Change in the number of total expected service miles for depreciating a truck.
Answer: c.
2. Which of the following is not the type of accounting change that reports a cumulative effect in the
income statement?
a. Change to the successful -efforts method of accounting for natural resources.
b. Change to LIFO for a firm in its second year that is able to reconstruct LIFO inventory layers.
c. Change in depreciation method.
d. Change in method of amortizing bond discount.
Answer: a.
3. Retroactive accounting treatment is used for which of the following?
a. Correcting errors and making estimate changes.
b. Changing to LIFO and correcting errors affecting income of prior years.
c. Changing to the completed-contract method of accounting for long-term contracts.
d. Correcting errors affecting prior years' income, but only if those prior years are disclosed on a
comparative basis with the current year.
Answer: c.
4. A company changed from percentage of completion (PC) to completed contract (CC) for financial
accounting purposes during 1998. Therefore:
a. Beginning January 1, 1998, CC should be used for construction accounting, and the difference
between the income under the two methods for years before 1998 is disclosed in the 1998 income
statement.
b. Beginning January 1, 1998, CC should be used for construction accounting, but no entry is made
for the effects of the change on years before 1998.
c. Beginning January 1, 1998, CC should be used for construction accounting. and the difference
between the income under the two methods for years before 1998 is an adjustment to the January
1, 1998 retained earnings balance.
d. Pro forma income amounts are disclosed in a schedule to the income statement for all years
before 1998 shown in the 1998 annual report.
Answer: c.
5. Choose the correct statement concerning comparative financial statements.
a. They are required by the APB.
b. They are required by the SEC.
c. The number of statements presented comparatively affects the recorded amount of a cumulative
effect of a change in accounting principle.
d. Firms generally do not disclose more than one year because financial statement users already
have access to the reports of previous years.
Answer: b.
Chapter 24
3/11
Accounting Changes and Error Corrections
6. One of the advantages of the current, or cumulative effect, change is
a. Consistency is maintained.
b. Prior years' income effects do not affect income in the year of change.
c. The statements of previous years shown comparatively do not disclose any information about the
effect of the change in those previous years.
d. Prior years' financial statements are not altered.
Answer: d.
7. Pro forma income numbers
a. Somewhat reduce the loss of comparability inherent in current, or cumulative effect. accounting
principle changes.
b. Are required only for the year of change.
c. Are required for changes in estimates.
d. Equal the effect of the accounting change on income for each year shown.
Answer: a.
8. Pro forma net income for the year of a change in accounting principle equals
a. Net income for the year of change.
b. Net income for the year of change under the new method.
c. Net income before extraordinary items for the year of change.
d. Net income before cumulative effect of changes in accounting principle for the year of change.
Answer: d.
E 24-2 Overview: Types of Accounting Changes and Errors Analyze each case and enter a letter code
in each column (type and approach) to indicate the basic accounting.
Type
Approach
P = Principle
E = Estimate C = Current
R = Entity
R = Retroactive
AE = Error P = Prospective
1.
2.
3.
4.
5.
6.
7.
8.
9.
Case (event or transaction)
Recorded expense, $870; should be $780. ...................................
Changed useful life of a machine.. ...............................................
Changed from single-company to consolidated financial statements..
Changed from straight-line to accelerated depreciation.. .............
Change in residual value of an intangible operational asset.. ......
Changed from cash basis to accrual basis in accounting for bad debts..
Changed from percentage of completion to completed contract for
long-term construction contracts.. ................................................
Changed from LIFO to FIFO for inventory.. ...............................
Changed to a new accounting principle required by the FASB.. .
Chapter 24
4/11
Accounting Changes and Error Corrections
Answer:
Type
P = Principle
E = Estimate
R = Entity
AE = Error
Case (event or transaction)
1.
2.
3.
4.
5.
6.
7.
Recorded expense, $870; should be $780. ............................................
Changed useful life of a machine............................................................
Changed from single-company to consolidated financial statements.. ...
Changed from straight-line to accelerated depreciation.. ........................
Change in residual value of an intangible operational asset.. .................
Changed from cash basis to accrual basis in accounting for bad debts .
Changed from percentage of completion to completed contract for
long-term construction contracts.. ...........................................................
8. Changed from LIFO to FIFO for inventory.. ............................................
9. Changed to a new accounting principle required by the FASB.. .............
Approach
C = Current
R = Retroactive
P = Prospective
AE
E
R
P
E
AE
R
P
not discussed
C
P
R
P
P
P
R
R
R
E 24-4 Change in Depreciation Method Four-H, Inc., changed from straight-line to an accelerated
depreciation method for book purposes only in 1998. Data for years affected by the change:
1998
Increase in depreciation due to change ............. $ 20,000
Income computed under the SL method* ......... 100,000
1997
1996
$25,000
90,000
$ 30,000
120,000
*After tax; the tax rate is 40%. The income amount shown for 1998 was computed before
considering the accounting change.
Required:
1. Provide the 1998 entry to record the accounting change.
2. What is reported net income for 1998?
3. What is the 1997 pro forma net income amount?
Answer:
Requirement 1
Cumulative effect of accounting change .......
33,000 **
Deferred income tax liability .................... ........... 22,000
Accumulated depreciation ............... ......
*
**
55,000*
$25,000 + $30,000
(1-.40) $55,000
Requirement 2
$100,000 - $20,000 (.60) - $33,000 = $55,000
Requirement 3
$90,000 - $25,000 (.6) = $75,000
Chapter 24
5/11
Accounting Changes and Error Corrections
E 24-8 Change in Estimated Useful Life and Salvage Value for a Plant Asset Bellico Company,
which has a calendar fiscal year, purchased its only depreciable plant asset on January 1, 1997, which has
the following characteristics:
Original cost ............................................
Estimated residual value .........................
Estimated useful life ..............................
Depreciation method ..............................
$10,000
1,000
three years
sum-of-years'-digits
In 1998, Bellico increased the estimated residual value to $2,000 and increased the total estimated useful
life to five years for financial accounting purposes. Additional information:
Revenue ...............................................................
Expenses other than depreciation and tax ............
Extraordinary loss before tax ...............................
Tax rate ................................................................
Common shares outstanding entire year ..............
1997
1998
$ 40,000
25,000
$ 50,000
30,000
5,000
30%
100,000
30%
100,000
Required:
1
Provide the 1998 entry(ies) for depreciation and the ending 1998 accumulated depreciation balance.
2. Provide the comparative 1997 and 1998 income statements, including disclosures related to the
accounting change.
Answers:
Requirement 1
1998 Depreciation before accounting change:
($10,000 - $1,000) x 2/6 ..............................................................................
1998 Depreciation after accounting change:
Book value, January 1, 1998 = $10,000 - ($9,000 x 3/6) = $5,500
1998 depreciation = ($5,500 - $2,000) x 4/10 = .........................................
(at January 1, 1998, four years remain)
Difference, before tax .................................................................................
1998 entry to record depreciation
Depreciation expense ............................................................
Accumulated depreciation ............................................
December 31. 1998 Accumulated Depreciation balance:
1997 depreciation ($9,000 x 3/6) ......................................
1998 depreciation .............................................................
1998 ending Accumulated Depreciation ....................
Chapter 24
6/11
$3,000
1.400
$1,600
1,400
1,400
$4,500
1,400
$5,900
Accounting Changes and Error Corrections
Requirement 2
BELLICO COMPANY
Income Statements
For Years Ended December 31
Revenues ..........................................................................
Expenses other than depreciation and tax: ......................
Depreciation expense ......................................................
Net income before extraordinary item and tax .................
Income tax expense (30%) ..............................................
Net income before extraordinary item ..............................
Extraordinary loss,, net of $1,500 tax ..............................
Net income .......................................................................
1997
1998
$40,000
(25,000)
(4,500)
10,500
(3, 150)
7,350
_____
$ 7,350
$50,000
(30,000)
(1,400)
19,600
(5,580)
13,020
(3,500)
$ 9,520
Net income before extraordinary item ............................................
$.07
$.13
Net income .....................................................................................
$.07
$.095
Footnote: During 1998, the estimated useful life and residual value on a plant asset were changed in
light of new information. The change increased net income before extraordinary items and net income
$1,120 ($1,600 x 70%) or $.01 per share.
E 24-13 Analysis of Seven Errors: Correcting Entries, Correct Pretax Income The 1997 income
statement of Burke Corporation has just been tentatively completed. It reflects pretax income for 1997 of
$85,000. The accounts have not been closed for the year ended December 31, 1997. A review of the
company's files and records revealed the following errors that have not been corrected:
a. Patent amortization of $3,000 per year was not recorded in 1996 and 1997.
b. The 1995 ending inventory was overstated by $4,000.
c. Machinery acquired on January 1, 1993, at a cost of $26,000 is being depreciated by the straight-line
method over 10 years. The good-faith estimate of its residual value of $6,000 has not been included in
the computation of depreciation expense.
d. Accrued wages of $1,500 at December 31, 1996, were not recognized.
e. A $1,000 cash shortage during 1997 was debited to retained earnings.
f. Ordinary repairs on the machinery in (c) above of $7,000, incurred during January 1997, were debited
to the machinery account.
g. During 1997, treasury stock that cost $8,000 was sold for $11,000. The difference was credited to
extraordinary gain. The company uses the cost method to account for treasury stock.
Required:
1. Give the correcting entry, if needed, for each of the above errors. Explain the basis and show
computations for each item. Ignore income tax considerations.
2. Compute the correct pretax income amount for 1997. Set up an appropriate schedule that reflects each
change and the correct 1997 pretax income.
Chapter 24
7/11
Accounting Changes and Error Corrections
Answers:
Requirement 1
Correcting entries:
a. Prior period adjustment correction (patent amortization, 1996) ...........
Patent amortization expense, 1997 .....................................................
Patent ......................................................................................... .....
3,000
3,000
6,000
b. No correcting entry because this error self-corrected by the end of 1996. For the 1997 comparative
financial statements (which include 1996), the $4,000 inventory (beginning) overstatement (for 1996)
would have to be incorporated into the 1996 statements for comparability reasons.
c.
Accumulated depreciation ($600 x 5 years) ........................................
Depreciation expense, 1997 .........................................................
Prior period adjustment, correction (depreciation. $600 x 4 yrs.) ..
3,000
600
2,400
Computations:
Depreciation per year ($26,000 ÷ 10 yrs.) ............................... $2,600
Correct amount of depreciation per year
[($26.000 - $6.000 = $20.000) ÷ 10 yrs.] ............................... 2,000
Depreciation overstatement per year .................................... $ 600
d. Prior period adjustment, correction (wages) .........................................
Wage expense, 1997 .....................................................................
1,500
e. Cash shortage(expense) ......................................................................
Retained earnings ..........................................................................
1,000
f.
To correct the entry made in January 1997:
Repair expense, 1997 ..........................................................................
Machinery .......................................................................................
1,500
1,000
7,000
7,000
Presumably the company recorded-depreciation based on the balance in the machinery account;
therefore, depreciation on this $7,000 was included in depreciation expense for 1997. The excess
depreciation must be reversed in 1997.
Accumulated depreciation ($7,000 ÷ 6 years remaining) .....................
Depreciation expense, 1997 ..........................................................
1,167
1,167
g. The difference between the cost and selling price of treasury stock is properly recorded as a change
in contributed capital. A corporation cannot recognize a gain (loss) by dealing in its own capital stock.
Extraordinary gain (treasury stock).......................................................
Contributed capital from treasury stock transactions .....................
Chapter 24
8/11
3,000
3,000
Accounting Changes and Error Corrections
Requirement 2
1997
Tentative pretax income (given) ............................................................
$85,000
Corrections:
a. Patent amortization (debit) .............................................................
b. No effect on net income ..................................................................
c. Depreciation expense (credit).........................................................
d. Wage expense (credit) ...................................................................
e. Cash shortage (debit) .....................................................................
f. Repair expense (debit) ...................................................................
Depreciation correction (credit) ......................................................
g. Extraordinary gain (debit) ...............................................................
Correct 1997 pretax income ...........................................................
(3,000)
-0600
1,500
(1,000)
(7,000)
1,167
(3,.000)
$74,267
P 24-1 Multiple Choice: Accounting Changes Choose the correct answer to each of the following
questions:
1. Immutable Company changed from the sum-of-years'-digits method (SYD) to the straight-line
method (SL) of depreciation in 1998. Depreciation under each method for the years affected follows:
Year
SYD
SL
1995
1996
1997
1998
$200
240
600
450
$150
160
450
500
Ignoring taxes, Immutable reports which of the following amounts in cumulative effect of change in
accounting principle in 1998?
a. $280 cr.
b. $230 cr.
c. $50 dr.
d. $320 dr.
Answer: a. ($200 + $240 + $600) - ($150 + $160 + $450) = $280
2. Quick Company changed depreciation methods for accounting purposes and correctly computed a
cumulative effect before tax of $600 (reduces income). The tax rate is 30 percent. The entry to record
the change in accounting principle includes
a. Cr. accumulated depreciation $420.
b. Dr. deferred tax liability $180.
c. Dr. income taxes payable $420.
d. Dr. cumulative effect $600.
Answer: b. 30% x $600 = $180
3. Fido Dog Food Company changed its method of accounting for inventory from LIFO to FIFO in 1998
for both tax and financial accounting purposes. The 1997 ending inventory was $40,000 under LIFO
and $55,000 under FIFO. Fido discloses 1997 and 1998 results comparatively. The tax rate is 30
percent. The entry to record the change in accounting principle includes
Chapter 24
9/11
Accounting Changes and Error Corrections
a.
b.
c.
d.
Cr. inventory $15,000.
Cr. retained earnings $10,500.
Cr. cumulative effect of change in accounting principle $10,500.
Insufficient information.
Answer: b. ($55,000 - $40,000) x 70% = $10,500
4. An asset purchased January 1, 1994, costing $10,000 with a 10-year useful life and no salvage value
was depreciated under the straight-line method during its first three years. During 1997, the total
useful life was re-estimated to be 17 years. What is depreciation in 1998?
a. $462.
b. $412.
c. $464.
d. $500.
Answer: d. Book value, January 1, 1007 = $10,000 – ($10,000/10) x 3 = $7,000
1998 depreciation = $7,000/(17 - 3) = $500
5. A company made a retroactive accounting change in 1998. Only the net incomes of 1997 and 1998
were affected. Therefore, the comparative retained earnings statements featuring both years disclose
which of the following?
a. A cumulative effect adjusting the January 1, 1997. retained earnings balance.
b. A cumulative effect adjusting the January 1, 1997, and 1998 retained earnings balances.
c. A cumulative effect adjusting the January 1, 1998, retained earnings balance.
d. No cumulative effect.
Answer: c.
C 24-2 Ethical Considerations: Accounting Changes In 1982, RTE Corporation, a manufacturer of
electric power transmission and distribution equipment, more than doubled its EPS by changing
depreciation methods. In justifying the change, the controller said, "We realized that, compared to our
competitors, our conservative method of depreciation might have hurt us with investors because of its
negative impact on net earnings" ("Double Standard," Forbes, November 22, 1982, p. 178).
Although difficult to prove, there is considerable evidence that accounting changes are made for
reasons other than improved financial reporting. GAAP is flexible in the initial selection of accounting
methods and in making subsequent changes. However, APB Opinion No. 20 specifically requires that
only changes to preferable accounting methods be made.
Required: Comment on the appropriateness of making accounting changes to fulfill financial reporting
objectives. Consider relevant ethical issues in your response.
Answer:
The accounting profession requires that accounting changes be made only if the change is preferable,
From APB Opinion No. 20, par. 16:
The presumption that an entity should not change an accounting principle may be overcome
only if the enterprise justifies the use of an alternative acceptable accounting principle on the
basis that it is preferable. The burden of justifying other changes rests with the entity proposing
the change. (author emphasis added).
Chapter 24
10/11 Accounting Changes and Error Corrections
In addition, auditors must make a judgment as to the acceptability of accounting changes. The profession,
in response to societal demands for accurate and representative financial reporting, is interested in the
integrity of the reporting process and has a vested interest in regulating accounting changes.
However, it would appear that many firms take advantage of the inherent inability to enforce the
preferability requirement. Many firms make accounting changes without appealing to the criterion of
"better reporting method." Indeed, the initial choice of method need riot be the "best" method; therefore it
is difficult to understand why the change must be to a better method. But some observers argue that
changes made to achieve financial reporting objectives while making the usual preferability statement
(e.g., "better matching") is a prevarication. and a breach of professional ethics.
Yet the flexibility of GAAP creates a considerable incentive when the need arises. Holding to a strict
interpretation of Opinion No. 20 would clearly prohibit many of the changes being made. However, it is
not feasible to hold firm to the requirement. Some argue that accounting changes per se are not unethical
and that financial statement users are riot fooled by purely "paper" changes. But the latter is no excuse to
make a change for one reason, and then imply it was made for a different reason. Certain changes could
place creditors who impose debt covenants on reporting companies at increased risk. If accounting
changes are the only way a company can maintain compliance with a debt covenant, these changes
should not be made.
Accounting changes made solely to increase management compensation are unethical and compromise
shareholder wealth. Bonus arrangements provide incentives for substantive accomplishments, not
accounting results. However, some companies, for example, may change to units of production methods
during hard times (low production) thus decreasing depreciation and increasing income and
compensation.
By contrast, companies intentionally may use conservative methods of accounting to maintain the
perception that their earnings are of high quality. However, when technological obsolescence suggests a
change to an accelerated depreciation method or a decreased useful life, such a change should be made
to maintain the integrity of the financial statements.
Although not directly applicable, the Standards of Ethical Conduct for Management Accountants (Institute
of Management Accountants) includes the following:
Accountants should:
Perform their professional duties in accordance with relevant laws, regulations. and technical
standards.
Refrain from either actively or passively subverting the attainment of the organization's
legitimate and ethical objectives.
Communicate unfavorable as well as favorable information and professional judgments or
opinions.
Communicate information fairly and objectively.
Disclose fully all relevant information that could reasonably be expected to influence an
intended user's understanding of the reports, comments, and recommendations presented.
Management accountants are directly involved in financial reporting. The above ethical principles argue
against making accounting changes solely for firm gain.
There is, of course, room for honest differences of opinion on accounting methods and estimates, and the
remarks in this solution do not pertain to such differences.
Chapter 24
11/11 Accounting Changes and Error Corrections
CHAPTER 25: SPECIAL TOPICS: DISCLOSURES, INTERIM REPORTING, AND
SEGMENT REPORTING
1. What are some sources of information about a company other than the financial statements?
Answer: There are numerous sources of information about a firm's activities in addition to its financial
statements. Even within the financial statement,;. it is very important to remember that the notes
provide vital information for the proper interpretation of the financial statements. The notes usually
also contain a number of supplementary disclosures, such as line-of-business reporting of potentially
great importance.
Beyond the statements themselves there area number of related sources of information. The
Management Discussion & Analysis section is useful for getting management's perspective in
interpreting the financial information. The CEO letter to the shareholders often contains insights about
interpreting the statements. and sometimes the CEO will comment on future plans and prospects.
Finally, the firm may provide news releases about various actions and activities of importance to the
future of the firm, and analysts often provide their interpretation of the future for the company. Thus,
financial statements are only one of many sources of potentially important information.
4. What is the purpose of notes to the financial statements?
Answer: Notes to the financial statements provide quantitative and qualitative explanations of various
items included or not included in the body of the financial statements that merit explanation under the
fill) disclosure principle. Thus, notes generally reflect application of the full-disclosure principle. They
also provide information for developing a better understanding of the quantitative information
contained in the body of the financial statements.
6. What is Form 10-K? What firms must prepare a Form 10-K? When must Form 10-K be filed? What
information items must be included in Form 10-K?
Answer: The Form 10-K is an annual report submitted by publicly traded companies to the SEC. It
includes all financial reporting information and a number of additional items.
All publicly-traded companies must file a Form 10-K with the SEC within 90 days of the company’s
fiscal year-end. The information items that must tic- included in the Form 10-K are:
Item
No.
Heading
Description
1. Business
History and description business, recent developments. principal
products and services, major industry segments.
2. Properties
Locations and general descriptions of plants and other physical
properties.
3. Legal
Description of pending legal proceedings. principal parties to the
Proceedings
proceedings, dates, allegations. and relief sought.
4. Voting Matters
Description of mailers submitted to voting security holders for
approval.
5. Market for
Identification of market(s) where corporation common stock is
Common Stock traded. including number of shares, frequency of trading, amounts
of dividends.
6. Selected
Five year summary including net sales, income (loss) from
Financial Data
continuing operations, EPS, total assets, cash dividends, and
long-term obligations.
7. Management
Discussion of liquidity, capital resources, results of operations,
Discussion
and impact of inflation as needed to understand the company's
Chapter 25
1/12
Special Topics, Disclosures, etc.
and Analysis
8.
9.
10.
11.
12.
13.
14.
15.
Financial
Statements and
Supplementary
Data
Disagreements
on accounting
disclosures
Directors and
Officers
Executive
Compensation
Security
Ownership
Certain
Relationships
Exhibits,
Schedules and
Reports
Signatures
financial condition, change in financial condition, and operating
results.
Consolidated financial statements including balance sheets for two
years. income statements, cash flow statements, and statements of
changes in stockholders' equity for three years, and related Notes.
Also, selected quarterly data and the auditor's opinion.
If and when auditors are changed due to disagreements on
accounting principles, a description of the disagreement and
summary of the effects on the financial statements.
Names, ages, and positions of directors and officers.
Salaries, stock options and other benefits for corporate officers
and selected others.
List of beneficial owners and management owners of corporate
securities.
Description of transactions with managers and related parties, and
for certain other business relationships.
Detailed supporting schedules, often specified in Regulation S-K.
Examples are marketable securities, property, plant and equipment,
including accumulated depreciation. short-term borrowings, and a
listing of subsidiaries.
The report must be signed by the Chief Executive Officer, the Chief
Financial Officer, and a majority of the Board of Directors.
7. In recent years, many firms regulated by the SEC have included' a management discussion and
analysis section in the annual report to shareholders. Describe what is included in the MDA section.
Answer: The management and discussion analysis (MDA) section includes a discussion provided
management of the company's financial condition. its change in financial condition, and its results of
operations for the periods covered in the report.
9.
What must a firm disclose about related party transactions?
Answer: A firm must disclose the following regarding related party transactions:
1. The nature of the relationship involved.
2. A description of the transaction, including transactions in which no amounts or nominal amounts
were involved. for each period for which income statements are presented.
3. The dollar amounts of transactions for each period for which income statements are presented.
4. Any amounts due to or from related parties as of the balance sheet date. and the terms and
manner of settlement planned.
10. What is the basic rationale for requiring segment reporting? What are reporting?
Answer: The rationale for segment reporting is to provide financial statement readers with
information on the relative proportions of a company's resources committed to various lines of
business. Knowing information on the success the company has experienced in each line of business
allows the financial statement reader to make a more informed decision than if they were to make
such decisions using only the aggregate financial information. Each line of business probably has
different risks and reward characteristics. Providing disaggregated information allows the financial
statement reader to better assess the risk and reward associated with each line of business, and also
for the company.
Chapter 25
2/12
Special Topics, Disclosures, etc.
There are two main arguments against segment reporting. First, gathering and providing segment
information is costly for firms and of little value to the financial statement reader. A second argument
against segment reporting is that it requires disclosure of proprietary information, that is, disclosing
the operating income and other information about a line of business provides a potential competitor
with valuable information that might work to the competitive disadvantage of the firm making the
segment disclosures.
14. Briefly describe the alternative tests for determining a reportable segment.
Answer: A reportable industry segment is an industry segment that meets one or more of the
following possible Criteria:
1. Its revenue is 10% or more of the combined revenue segments of the entity.
2. The absolute amount of its operating loss or profit is 10% or more of the greater, in absolute
amount, of:
a. The combined operating profit of all industry segments of the entity that did not incur an
operating loss, or
b. The combined operating loss of all industry segments of the entity that did incur an operating
loss.
3. Its identifiable assets are 10% or more of the combined identifiable assets of all industry
segments (of the entity).
16. What is the difference between the discrete view and the integral part view of interim financial
reporting periods?
Answer: The discrete view holds that each interim period is an independent period that stands alone.
As such, it is subject to the same principles and procedures for revenue and expense recognition,
accruals and deferrals as an annual period. The integral view holds each interim reporting period as
an integral part of the annual reporting period. Under this view, revenue and expense recognition,
accruals and deferrals for each interim period are affected by judgments about the results of
operations for the remainder of the annual reporting period. There can be and are allocations,
accruals and deferrals between the interim periods that would not be made between annual periods.
E 25-2 Interim Reporting In September 1998, Crystal Mountain Ski Resorts spent $300.000 for
advertising for the coming ski season. The ski season lasts from October through the following March.
with business expected to be spread evenly over this period. The fiscal year for Crystal Mountain ends
March 31, 1999.
Required: Determine the amount of expense that should be included in Crystal Mountain's interim
financial statements for September 30 and for December 31, 1998. Justify and explain your answer.
Answer: Since the advertising expenditure is expected to benefit the third and fourth quarters equally. it
should he allocated to these two quarters in equal amounts of $150.000 each quarter. Therefore, the
second quarter, which ends September 30, 1998, should not show any of the above as expense. The
entire amount would be capitalized as an intangible asset (prepaid advertising). The December 31, 1998,
interim report would expense $150,000 of the intangible asset, with the final $150,000 being expensed in
the fourth quarter.
Chapter 25
3/12
Special Topics, Disclosures, etc.
E 25-3 Interim Reporting The Proctor Company reported income before income taxes of $100,000 and
$150,000 in the first two quarters of 1998. Management's estimate of the annual effective tax rate was 35
percent at the end of the first quarter and 30 percent at the end of the second quarter.
Required: Determine the income tax expense for the first two quarters of 1998.
Answer:
The first quarter tax computations are:
Pretax accounting income ..............................................................
Appropriate tax rate ........................................................................
Income tax expense .......................................................................
$100,000
x .35
$ 35,000
At the end of ft second quarter, the estimated annual tax rate is reduced to 30%. The total income tax
expense obligation for the combined two quarters is determined:
Pretax accounting income .............................................................
Appropriate tax rate .......................................................................
Total income tax expense to date .................................................
$250,000
x 30
$ 75,000
The amount to be recorded as income tax expense in the second quarter is the difference between the
total year-to-date amount of obligation. less the amount recognized in prior interim periods:
Total income tax expense to date .................................................
Income tax expense recorded in earlier periods ...........................
Income tax expense to be reported in second period ...................
$75,000
35.000
$40,000
As of the end of the second quarter, the total amount of income tax expense recorded is $75,000.
E 25-5 Segment Reporting The Ullrich Products Corporation is organized in three major product
divisions: Health care products, Agricultural products, and Food products. Within the Health care
products division are three separately organized groups: pharmaceuticals, consumer health care, and
medical devices. The Health care products division manager receives separate financial information from
each group within the division for purposes of allocating resources and assessing performance. The chief
executive officer of the company. Jan Ullrich, make similar decisions for all three divisions. In 1998 the
company has revenues of $12,300,000, which includes interest revenue of $100,000 that is not allocated
to any of the divisions. Total company-wide income before taxes is $1,500,000 after deducting all
expenses, including some that are not allocated to the divisions. The corporation has total assets of
$22,000,000, some of which are headquarters facilities not included in any of the divisions. Intercompany
sales are priced at market prices, and profits on intersegment sales total $50,000 in 1998. The same
accounting procedures used for corporate financial reporting are used in measuring sales. profits, and
assets at the division and group level or the organization. Specific division and group level financial
information provided to management for 1998 is as follows (all amounts are in thousands):
Chapter 25
4/12
Special Topics, Disclosures, etc.
Health Care Products Groups
Consumer
Pharmaceuticals Health Care
Sales to external customers .............
$ 6,000
$3,000
Intersegment sales ...........................
500
0
Income (loss) before taxes ..............
1,800
200
Segment assets as of Dec. 31 ..........
10,000
3,500
Depreciation & amortization† .........
300
100
Capital expenditures* ......................
400
200
Sales to external customers .............
Intersegment sales ...........................
Income (loss) before taxes ..............
Segment assets as of Dec. 31 ..........
Depreciation & amortization† .........
Capital expenditures* ......................
Agricultural
Products
Division
$1,000
0
200
4,000
150
200
Total Health
Medical Care Products
Devices
Division
$1,200
$10,200
0
500
(400)
1,600
1,500
15,000
100
500
100
700
Food
Products
Division
$1,000
700
100
2,000
100
200
† An additional depreciation of $50 on headquarters facilities is not included in segment
amounts.
* An additional $200 of capital expenditures was incurred for facilities for headquarters.
Required
1. Assume all the groups within the Health care products division qualify as operating segments. as do
the Agricultural products and the Food products divisions. Determine which are the reportable
operating segments.
2. Show the quantitative information that is required to be reported under SFAS No. 131 for Ullrich for
1998. All revenues, expenses, or assets not included above as part of an operating segment are
unallocated corporate items.
Answer:
Requirement 1
Since all the groups within the Health care products divisions are considered operating segments, each
must be considered as a potentially reportable segment. Each group and the other two divisions must be
examined as to whether they meet the quantitative thresholds to require separate disclosure.
The revenue test is to report all operating segments with revenues (including external and internal
revenues) greater than 10% of ($10,200 + $500 + $2,000 + $700) = $1,320.
Pharmaceuticals, Consumer health care, and the Food products division meet this threshold (Note that
the Food products division does not meet the threshold if intersegment sales were not considered).
The profit test is 10% x $2,300 = $230. Pharmaceuticals and Medical Devices meet the threshold.
The segment assets test is 10% x $21,000 = $2,100. Pharmaceuticals, Consumer Health Care, and
Agricultural Products meet the threshold.
Chapter 25
5/12
Special Topics, Disclosures, etc.
Thus, all five operating segments meet one or more of the threshold quantities. All five are reportable
segments.
Requirement 2
Operating Segments Financial Information
Consumer
Health
Care
Medical
Devices
Agricultural
Products
Food
Products
Totals
$ 6,500
$ 3,000
$ 1,200
$ 1,000
$ 1,700
$ 13,400
Intersegment
revenues
500
—
—
—
700
1,200
Depreciation &
amortization
300
100
100
150
100
750
Segment profit
1,800
200
(400)
200
100
1,900
Segment assets
10,000
3,500
1,500
4,000
2,000
21,000
Expenditures for
segment assets
400
200
100
200
200
1,100
(Amounts in 000s) Pharmaceuticals
Total segment
revenues
Reconciliations:
Reconciliations for revenues, income before income taxes, total assets and other significant items are as
follows:
Revenues
Total revenues for reportable segments ..............
Other revenues ....................................................
Less: intersegment revenues ..............................
Total company reported revenues ................
$13,400
100
(1,200)
$12,300
Profit or loss
Total profit for reportable segments.....................
Elimination of intersegment profits ......................
Unallocated amounts:
Other corporate expenses ............................
Total company income before income taxes
$1,900
(50)
(350)
$1,500
Assets
Total assets for reportable segments ..................
Other unallocated costs .......................................
Company total assets....................................
$21,000
1,000
$22,000
Other significant items
Segment
Totals
Expenditures for assets .......................................
Depreciation and amortization .............................
Chapter 25
6/12
1,100
750
Adjustments
200
50
Company
Totals
1,300
800
Special Topics, Disclosures, etc.
E25-6 Identify Reporting Segments and Major Customers Keefe Corporation has expanded rapidly,
and segment reporting has become an accounting issue. The company has no intersegment sales. The
following data are available for the 1998 fiscal year which ended on December 31 (amounts in millions):
Operating Segments
A ............................
B.............................
C.............................
D ............................
E .............................
F .............................
G ............................
All others ...............
Total
Segment
Revenues
Operating
Profit
(Loss)
Identifiable
Assets
$620
100
340
190
180
70
120
380
$200
20
70
(30)
(25)
10
(20)
(25)
$400
80
300
140
180
120
140
140
The “all others” includes five operating segments. none with revenues or
assets greater than $80 million and none with an operating profit.
Operating segments A and B have very similar products and production
processes, but serve different customer types and use quite different
product distribution systems. This is partly because operating segment B
is in a regulated environment but operating segment A is not. Also.
Operating segments F and G have very similar products, production
processes, and product distribution systems, but are organized as separate
divisions because they serve substantially different types of customers.
Neither F nor G is in a regulated environment.
Required:
1. Determine what am reportable segments without regard to aggregation criteria.
2. If the requirements for reportable segments am not yet met, apply appropriate aggregation criteria to
identify additional reportable segments.
3. Assume Keefe has sales totaling $220 million to the U.S. Federal government primarily from
operating segments A and C. Other significant customers include annual revenues of $190 million
from Ikon Technology (primarily sales of segment D), and $100 million in sales by segment E to the
French government. What, if any, disclosures must Keefe make regarding major customers? Show the
disclosure Keefe must make.
Answers:
Requirement 1
Initially all reporting segments are examined using the quantitative thresholds to identify reportable
segments.
Chapter 25
7/12
Special Topics, Disclosures, etc.
Operating Segments
A .............................
B .............................
C .............................
D .............................
E .............................
F .............................
G ............................
All others ................
Totals .....................
Total
Segment
Revenues
$620
100
340
190
180
70
120
380
$2,000
Operating
Profit
(Loss)
$200
20
70
(30)
(25)
10
(20)
(25)
$200
Identifiable
Assets
$400
80
300
140
180
120
140
140
$1,500
Thus any operating segment with revenues equal to or greater than $200 million is a reportable segment
(segments A and C). Any segment with identifiable assets greater than $150 million is a reportable
segment (segments A, C, and E). The total operating profit for all the segments with operating profits
totals $300 million; thus any segment with an operating profit or loss equal to or greater than an absolute
amount of $30 million is a reportable segment (Segments A. C. and D). Thus, segments A. C. D. and F.
are reportable segments without regard to the aggregation criteria.
Requirement 2
Reportable segments must provide information on separate segments whose sum of revenue is at least
75 percent of the firm's total revenue. Segments A. C. D. and E have revenue of $1,330 million. which is
only 66.5% of the total revenue. If a majority of the aggregation criteria arc met by two segments, they
can be aggregated for purposes of identifying reportable segments. Segments A and B are candidates for
combining, but they have only 2 of the 5 criteria in common; thus they cannot be aggregated. Since
segments F and G are similar on four of the five criteria. they meet the majority test and can be
aggregated as a reportable segment as follows:
Segment F + G .......
190
(10)
300
With F + G considered a reportable segment, the total revenues included in reportable segments
increases to $1,520, or 76% of the total. The 75 percent requirement has been met.
Requirement 3
If any major customer contributes 10 percent or more to a firm’s revenues, this fact must be disclosed,
including the total amount of revenues from each such customer, and the segment or segments reporting
the revenues. The U.S. federal government contributes over 10% of Keefe's revenues and must be
reported. Neither of the other significant customers are major customers under the SFAS No. 131
criterion.
An example of disclosure:
Major Customers
Revenues from one customer of Keefe Corporation's segments A and C represent
approximately $220 million of the company’s total revenues.
Chapter 25
8/12
Special Topics, Disclosures, etc.
E 25-7 Interim Reporting: Application of Guidelines In the context of interim reporting, items may (a)
be recognized in the interim statements of the current interim period, (b) be recognized in the current
interim period but require- special disclosure, (c) be deferred in their entirety (that is, not recognized until
some later interim period, or not recognized at all), or (d) be amortized or accrued (recognized partly in
the current interim period and partly in subsequent interim periods). A number of items are listed below
that require a decision on how they should be inc6rporated on interim statements. Match the letters given
above with the numbered items given below to indicate how each item should be incorporated on the
interim statements.
1. Salaries allocable to services rendered during the current period.
Answer: A
2. Inventories estimated by use of the gross margin method.
Answer: B
3. Temporary declines in market value of inventories.
Answer: C
4. Short-term stock investment gains from recoveries of market value (not in excess of previously
recognized market declines).
Answer: A
5. Materials and wages allocable to products sold this period.
Answer: A
6. Costs benefiting two or more interim periods.
Answer: D
7. Increase in gross margin due to liquidation of a layer of LIFO-based inventory expected to be
replenished by year-end.
Answer: C
8. Quantity discounts allowed to customers based on the annual volume of their purchases.
Answer: B
9. Contingencies and other uncertainties that may affect fairness of presentation.
Answer: A
10. Income tax on income of first quarter where total income for the first quarter puts the company in a
low tax bracket; subsequent operations are expected to be sufficiently profitable that by end of second
quarter, and thereafter taxable income of the company will be in a higher bracket.
Answer: B
Chapter 25
9/12
Special Topics, Disclosures, etc.
A25-1 PepsiCo Inc. Excerpts from the Industry Segments disclosures in the 1995 PepsiCo Inc. annual
report follow:
Industry Segments
Growth Rate
Net Sales
1990-1995
1995
1994
1993
Beverages:
U.S ..................
International .....
7%
19%
10%
$ 6,977
.3,571
10,548
$6,541
3.146
9,687
$5,918
2.720
8,638
Snack Foods: U.S ..................
International .....
10%
19%
12%
5,495
3,050
8,545
5,011
3,253
8,264
4,365
2,662
7,027
Restaurants: U.S ..................
International .....
11%
25%
13%
9,202
2,126
11,328
8,694
1,827
10,521
8,026
1,330
9,356
Combined Segments
U.S ..................
International .....
By U.S. Restaurant Chain
Pizza Hut ..........
Taco Bell ..........
KFC ..................
9%
20%
12%
$21,674
8,747
30,421
$20,246 $18,309
8,226
6,712
28,472 25,021
8%
15%
9%
11%
$ 3,977
3,503
1,722
$ 9,202
$ 3,712
3,340
1,642
$ 8,694
$ 3,595
2,855
1,576
$ 8,026
Operating Profit
Beverages:
U.S ..................
International .....
11%
19%
12%
$ 1,145
164
1,309
$ 1,022
195
1,217
$ 937
172
1,109
Snack Foods: U.S ..................
International .....
9%
14%
10%
1,132
300
1,432
1,025
352
1,377
901
289
1,190
Restaurants: U.S ..................
International .....
10%
8%
9%
659
71
730
685
93
778
$ 2,523
554
3,077
451
(21)
430
Combined Segments
U.S ..................
International .....
Equity (Loss) Income..............
Unallocated expenses, Net ......
Operating Profit ......................
Chapter 25
10%
14%
10%
$ 2,728
433
3,171
$ 2,706
618
3,324
11%
(3)
(181)
$ 2,987
38
30
(161)
(200)
$ 3,201 $ 2,907
10/12
Special Topics, Disclosures, etc.
Combined Segments
Growth Rate
Net Sales
1990-1995
1995
By U.S. Restaurant Chain
Pizza Hut ..........
Taco Bell ..........
KFC ..................
9%
12%
7%
10%
$ 308
105
38
$ 451
1994
1993
$ 285
273
101
$ 659
$ 338
256
91
$ 685
Segment Operating
Net Sales
Profit (Loss)
Identifiable Assets
Geographic Areas 1995
1994
1993
1995
1994
1993
1995
1994
1993
United States .... $21,674 $20,246 18,309
$2,728 $2,706 $2,523
$14,505 $14,218 $13,590
Europe ..............
2,783 2,177 1,819
(65)
17
47
3,127 3,062 2,666
Mexico ............
1,228 2,023 1,614
80
261
223
637
995 1,217
Canada ............
1,299 1,244 1,206
86
82
102
1,344 1,342 1,.364
Other .............. .... 3,437 2,782 2,073
342
258
182
2,629 2,196 1,675
Combined Segments$30,421$28,472$25,021
$3,171 $3,324 $3,077
22,242 21,813 20,512
Investments in Unconsolidated Affiliates ............................................................. 1,635 1,295 1,091
Corporate .............................................................................................................. 1,555 1,684 2,103
$25,432 $24,792 $23,706
Beverages .........
9% $10,032 $9,566 $ 9,105 By U.S. Restaurant Chain
Snack Foods .....
7% 5,451 5,044 4,995 Pizza Hut..... 8%
$1,700 $1,832 $1,733
Restaurants .......
14% 6,759 7,203 6,412 Taco Bell..... 19%
2,276 2,327 2,060
Investments in UnconKFC ............ 7%
1,111 1,253 1,265
solidated Affiliates 9% 1,635 1,295 1,091 Total U.S. ..... 12%
5,087 5,412 5,058
Corporate .........
9% 1,555 1,684 2,103 International . 27%
1,672 1,791 1,354
8% $25,432 $24,792 $23,706
14%
$6,759 $7,203 $6,412
Required:
1 . In what different lines of business does PepsiCo report? For 1995, which line of business earned the
largest profit margin (operating profit as a percent of revenues)? The smallest profit margin? Which
of the restaurant chains has the highest profit margin?
2. In what lines of business does PepsiCo appear to be growing the most rapidly? How does this growth
relate to the profit margins of the various lines of business?
3. In general how important is international operations to PepsiCo? Comment on the relative profit
margin of U.S. versus international operations.
4. Consider another measure of profitability such as operating income divided by identifiable assets.
Evaluate the profitability of PepsiCo's various businesses.
Answer:
Comment: As a group assignment. this case can involve a great deal more analysis than that specifically
asked for in the assignment. For example, students could be asked to analyze operating margins and
return on investment for earlier years, looking for trends in the data. A more detailed profitability analysis
of each restaurant chain could be conducted. Finally, the importance of unconsolidated affiliates could be
analyzed. These areas are not specifically addressed in the assigned material, and thus are not
addressed here.
Chapter 25
11/12
Special Topics, Disclosures, etc.
Requirement 1
PepsiCo reports three lines of business: Beverages, Snack Foods, and Restaurants. It is also possible to
further break out each of these segments into U.S. and international components. The 1995 profit
margins for the three basic segments are:
Beverages
Snack Foods
Restaurants
$1,309/$10,548
$1,432/$8,545
$430/$11,328
12.4%
16.8%
3.8%
The snack foods segment has to highest margin at 16.8%, and the restaurant segment has the lowest at
3.8%.
The profit margins for the three restaurant chains are:
Pizza Hut
Taco Bell
KFC
$308/$3,977
$105/$3,503
$38/$I,722
7.7%
3.0%
2.2%
Pizza Hut has the highest margin.
Requirement 2
Somewhat surprising, sales growth in the restaurant segment is growing most rapidly, especially in the
international area (25% growth). Also, restaurants is the segment with the highest growth rate as
measured by Identifiable assets (growth over 1990-95 of 14%). This is riot the segment with the higher
margins, nor is it the segment with the highest return on investment (operating profit divided by
investments as measured by identifiable assets of the segment). It would be interesting to know why
PepsiCo is expanding most rapidly in this area.
Requirement 3
The majority of PepsiCo's sales and operating profit come from the U.S. geographical area—U.S. sales
are 71% of total sales, and account for 86% of the operating margin. PepsiCo is largely a U.S.-based
company, but with significant international operations.
A comparison of U.S. and International operating margins by segment is its follows:
Beverages
Snack Foods
Restaurants
U.S.
16.4%
20.8%
4.9%
International
4.6%
9.8%
(1.0)%
Again, the U.S. components of all the segments have the highest operating margin.
Requirement 4
Operating income (or operating profit as it is called by PepsiCo) divided by the book value of identifiable
assets is a measure of return on investment. This can be, computed for the three segments:
Beverages
Snack Foods
Restaurants
Computation Return on investment
$1,309/$10,032
13.0%
26.3%
6.4%
Again, it is the snack foods segment that is the most profitable. and the restaurant segment that is least
profitable.
It would not be surprising to find PepsiCo reevaluating its investment in the restaurant business. And in
fact, this is precisely what PepsiCo has started to do. As of the Spring of 1997. PepsiCo has announced
plans to spin-off its restaurant segment and focus its attention on the beverage and the snack food
business.
Chapter 25
12/12
Special Topics, Disclosures, etc.