Datasets:

kothasuhas

/

accounting-textbooks-6

like 1

Other data: 1. Salaries expense is 70% selling and 30% administrative. 2. Rent expense and utilities expenses are 80% selling and 20% administrative. 3. $30,000 of notes payable are due for payment next year. 4. Maintenance and repairs expense is 100% administrative. 146 Chapter 3 The Accounting Information System Instructions (a) Journalize the adjusting entries. (b) Prepare an adjusted trial balance. (c) Prepare a multiple-step income statement and retained earnings statement for the year and a classi- fied balance sheet as of November 30, 2014. (d) Journalize the closing entries. (e) Prepare a post-closing trial balance. 5 P3-5 (Adjusting Entries) The accounts listed below appeared in the December 31 trial balance of the Savard Theater. Debit Credit Equipment $192,000 Accumulated Depreciation—Equipment $ 60,000 Notes Payable 90,000 Admissions Revenue 380,000 Advertising Expense 13,680 Salaries and Wages Expense 57,600 Interest Expense 1,400 Instructions (a) From the account balances listed above and the information given below, prepare the annual adjust- ing entries necessary on December 31. (Omit explanations.) (1) The equipment has an estimated life of 16 years and a salvage value of $24,000 at the end of that time. (Use straight-line method.) (2) The note payable is a 90-day note given to the bank October 20 and bearing interest at 8%. (Use 360 days for denominator.) (3) In December, 2,000 coupon admission books were sold at $30 each. They could be used for admission any time after January 1. (4) Advertising expense paid in advance and included in Advertising Expense $1,100. (5) Salaries and wages accrued but unpaid $4,700. (b) What amounts should be shown for each of the following on the income statement for the year? (1) Interest expense. (3) Advertising expense. (2) Admissions revenue. (4) Salaries and wages expense. 5 6 P3-6 (Adjusting Entries and Financial Statements) The following are the trial balance and the other infor- mation related to Yorkis Perez, a consulting engineer. YORKIS PEREZ, CONSULTING ENGINEER TRIAL BALANCE DECEMBER 31, 2014 Debit Credit Cash $ 29,500 Accounts Receivable 49,600 Allowance for Doubtful Accounts $ 750 Inventory 1,960 Prepaid Insurance 1,100 Equipment 25,000 Accumulated Depreciation—Equipment 6,250 Notes Payable 7,200 Owner’s Capital 35,010 Service Revenue 100,000 Rent Expense 9,750 Salaries and Wages Expense 30,500 Utilities Expenses 1,080 Offi ce Expense 720 $149,210 $149,210 Problems 147 1. Fees received in advance from clients $6,000. 2. Services performed for clients that were not recorded by December 31, $4,900. 3. Bad debt expense for the year is $1,430. 4. Insurance expired during the year $480. 5. Equipment is being depreciated at 10% per year. 6. Yorkis Perez gave the bank a 90-day, 10% note for $7,200 on December 1, 2014. 7. Rent of the building is $750 per month. The rent for 2014 has been paid, as has that for January 2015. 8. Office salaries and wages earned but unpaid December 31, 2014, $2,510. Instructions (a) From the trial balance and other information given, prepare annual adjusting entries as of Decem- ber 31, 2014. (Omit explanations.) (b) Prepare an income statement for 2014, a statement of owner’s equity, and a classified balance sheet. Yorkis Perez withdrew $17,000 cash for personal use during the year. 5 6 P3-7 (Adjusting Entries and Financial Statements) Rolling Hills Golf Inc. was organized on July 1, 2014. Quarterly financial statements are prepared. The unadjusted trial balance and adjusted trial balance on September 30 are shown here. ROLLING HILLS GOLF INC. TRIAL BALANCE SEPTEMBER 30, 2014 Unadjusted Adjusted Dr. Cr. Dr. Cr. Cash $ 6,700 $ 6,700 Accounts Receivable 400 1,000 Prepaid Rent 1,800 900 Supplies 1,200 180 Equipment 15,000 15,000 Accumulated Depreciation—Equipment $ 350 Notes Payable $ 5,000 5,000 Accounts Payable 1,070 1,070 Salaries and Wages Payable 600 Interest Payable 50 Unearned Rent Revenue 1,000 800 Common Stock 14,000 14,000 Retained Earnings 0 0 Dividends 600 600 Service Revenue 14,100 14,700 Rent Revenue 700 900 Salaries and Wages Expense 8,800 9,400

Rent Expense 900 1,800 Depreciation Expense 350 Supplies Expense 1,020 Utilities Expenses 470 470 Interest Expense 50 $35,870 $35,870 $37,470 $37,470 Instructions (a) Journalize the adjusting entries that were made. (b) Prepare an income statement and a retained earnings statement for the 3 months ending September 30 and a classified balance sheet at September 30. (c) Identify which accounts should be closed on September 30. (d) If the note bears interest at 12%, how many months has it been outstanding? 5 6 P3-8 (Adjusting Entries and Financial Statements) Vedula Advertising Agency was founded by Murali Vedula in January 2009. Presented on the next page are both the adjusted and unadjusted trial balances as of December 31, 2014. 148 Chapter 3 The Accounting Information System VEDULA ADVERTISING AGENCY TRIAL BALANCE DECEMBER 31, 2014 Unadjusted Adjusted Dr. Cr. Dr. Cr. Cash $ 11,000 $ 11,000 Accounts Receivable 16,000 19,500 Supplies 9,400 6,500 Prepaid Insurance 3,350 1,790 Equipment 60,000 60,000 Accumulated Depreciation—Equipment $ 25,000 $ 30,000 Notes Payable 8,000 8,000 Accounts Payable 2,000 2,000 Interest Payable 0 560 Unearned Service Revenue 5,000 3,100 Salaries and Wages Payable 0 820 Common Stock 20,000 20,000 Retained Earnings 5,500 5,500 Dividends 10,000 10,000 Service Revenue 57,600 63,000 Salaries and Wages Expense 9,000 9,820 Insurance Expense 1,560 Interest Expense 560 Depreciation Expense 5,000 Supplies Expense 2,900 Rent Expense 4,350 4,350 $123,100 $123,100 $132,980 $132,980 Instructions (a) Journalize the annual adjusting entries that were made. (b) Prepare an income statement and a retained earnings statement for the year ended December 31, and a classified balance sheet at December 31. (c) Identify which accounts should be closed on December 31. (d) If the note has been outstanding 10 months, what is the annual interest rate on that note? (e) If the company paid $10,500 in salaries and wages in 2014, what was the balance in Salaries and Wages Payable on December 31, 2013? 4 5 P3-9 (Adjusting and Closing) Presented below is the trial balance of the Crestwood Golf Club, Inc. as of December 31. The books are closed annually on December 31. 6 7 CRESTWOOD GOLF CLUB, INC. TRIAL BALANCE DECEMBER 31 Debit Credit Cash $ 15,000 Accounts Receivable 13,000 Allowance for Doubtful Accounts $ 1,100 Prepaid Insurance 9,000 Land 350,000 Buildings 120,000 Accumulated Depreciation—Buildings 38,400 Equipment 150,000 Accumulated Depreciation—Equipment 70,000 Common Stock 400,000 Retained Earnings 82,000 Dues Revenue 200,000 Green Fees Revenue 5,900 Rent Revenue 17,600 Utilities Expenses 54,000 Salaries and Wages Expense 80,000 Maintenance and Repairs Expense 24,000 $815,000 $815,000 Problems 149 Instructions (a) Enter the balances in ledger accounts. Allow five lines for each account. (b) From the trial balance and the information given below, prepare annual adjusting entries and post to the ledger accounts. (Omit explanations.) (1) The buildings have an estimated life of 30 years with no salvage value (straight-line method). (2) The equipment is depreciated at 10% per year. (3) Insurance expired during the year $3,500. (4) The rent revenue represents the amount received for 11 months for dining facilities. The Decem- ber rent has not yet been received. (5) It is estimated that 12% of the accounts receivable will be uncollectible. (6) Salaries and wages earned but not paid by December 31, $3,600. (7) Dues received in advance from members $8,900. (c) Prepare an adjusted trial balance. (d) Prepare closing entries and post. 4 5 P3-10 (Adjusting and Closing) Presented below is the December 31 trial balance of New York Boutique. 6 7 8 NEW YORK BOUTIQUE TRIAL BALANCE DECEMBER 31 Debit Credit Cash $ 18,500 Accounts Receivable 32,000 Allowance for Doubtful Accounts $ 700 Inventory, December 31 80,000 Prepaid Insurance 5,100 Equipment 84,000 Accumulated Depreciation—Equipment 35,000 Notes Payable 28,000 Common Stock 80,600 Retained Earnings 10,000 Sales Revenue 600,000 Cost of Goods Sold 408,000 Salaries and Wages Expense (sales) 50,000 Advertising Expense 6,700

Salaries and Wages Expense (administrative) 65,000 Supplies Expense 5,000 $754,300 $754,300 Instructions (a) Construct T-accounts and enter the balances shown. (b) Prepare adjusting journal entries for the following and post to the T-accounts. (Omit explanations.) Open additional T-accounts as necessary. (The books are closed yearly on December 31.) (1) Bad debt expense is estimated to be $1,400. (2) Equipment is depreciated based on a 7-year life (no salvage value). (3) Insurance expired during the year $2,550. (4) Interest accrued on notes payable $3,360. (5) Sales salaries and wages earned but not paid $2,400. (6) Advertising paid in advance $700. (7) Office supplies on hand $1,500, charged to Supplies Expense when purchased. (c) Prepare closing entries and post to the accounts. 9 * P3-11 (Cash and Accrual Basis) On January 1, 2014, Norma Smith and Grant Wood formed a computer sales and service company in Soapsville, Arkansas, by investing $90,000 cash. The new company, Arkansas Sales and Service, has the following transactions during January. 1. Pays $6,000 in advance for 3 months’ rent of office, showroom, and repair space. 2. Purchases 40 personal computers at a cost of $1,500 each, 6 graphics computers at a cost of $2,500 each, and 25 printers at a cost of $300 each, paying cash upon delivery. 150 Chapter 3 The Accounting Information System 3. Sales, repair, and office employees earn $12,600 in salaries and wages during January, of which $3,000 was still payable at the end of January. 4. Sells 30 personal computers at $2,550 each, 4 graphics computers for $3,600 each, and 15 printers for $500 each; $75,000 is received in cash in January, and $23,400 is sold on a deferred payment basis. 5. Other operating expenses of $8,400 are incurred and paid for during January; $2,000 of incurred expenses are payable at January 31. Instructions (a) Using the transaction data above, prepare (1) a cash-basis income statement and (2) an accrual-basis income statement for the month of January. (b) Using the transaction data above, prepare (1) a cash-basis balance sheet and (2) an accrual-basis balance sheet as of January 31, 2014. (c) Identify the items in the cash-basis financial statements that make cash-basis accounting inconsis- tent with the theory underlying the elements of financial statements. 5 6 *P 3-12 (Worksheet, Balance Sheet, Adjusting and Closing Entries) Cooke Company has a fiscal year end- 7 11 ing on September 30. Selected data from the September 30 worksheet are presented below. CCooookkee CCoo..xxllss Home Insert Page Layout Formulas Data Review View P18 fx A B C D E 1 2 COOKE COMPANY 3 Worksheet 4 For The Month Ended September 30, 2014 5 Trial Balance Adjusted Trial Balance 6 Account Titles Dr. Cr. Dr. Cr. 7 Cash 37,400 37,400 8 Supplies 18,600 4,200 9 Prepaid Insurance 31,900 3,900 10 Land 80,000 80,000 11 Equipment 120,000 120,000 12 Accumulated Deprecia!on—Equipment 36,200 42,000 13 Accounts Payable 14,600 14,600 14 Unearned Service Revenue 2,700 700 15 Mortgage Payable 50,000 50,000 16 Common Stock 107,700 107,700 17 Retained Earnings, Sept. 1, 2014 2,000 2,000 18 Dividends 14,000 14,000 19 Service Revenue 278,500 280,500 20 Salaries and Wages Expense 109,000 109,000 21 Maintenance and Repairs Expense 30,500 30,500 22 Adver!sing Expense 9,400 9,400 23 U!li!es Expenses 16,900 16,900 24 Property Tax Expense 18,000 21,000 25 Interest Expense 6,000 12,000 26 Totals 491,700 491,700 27 Insurance Expense 28,000 28 Supplies Expense 14,400 29 Interest Payable 6,000 30 Deprecia!on Expense 5,800 31 Property Taxes Payable 3,000 32 Totals 506,500 506,500 Using Your Judgment 151 Instructions (a) Prepare a complete worksheet. (b) Prepare a classified balance sheet. (Note: $10,000 of the mortgage payable is due for payment in the next fiscal year.) (c) Journalize the adjusting entries using the worksheet as a basis. (d) Journalize the closing entries using the worksheet as a basis. (e) Prepare a post-closing trial balance. PROBLEMS SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional

set of problems. USING YOUR JUDGMENT FINANCIAL REPORTING Financial Reporting Problem The Procter & Gamble Company (P&G) The financial statements of P&G are presented in Appendix 5B. The company’s complete annual report, including the notes to the financial statements, can be accessed at the book’s companion website, www. wiley.com/college/kieso. Instructions Refer to these financial statements and the accompanying notes to answer the following questions. (a) What were P&G’s total assets at June 30, 2011? At June 30, 2010? (b) How much cash (and cash equivalents) did P&G have on June 30, 2011? (c) What were P&G’s research and development costs in 2010? In 2011? (d) What were P&G’s revenues in 2010? In 2011? (e) Using P&G’s financial statements and related notes, identify items that may result in adjusting entries for deferrals and accruals. (f) What were the amounts of P&G’s depreciation and amortization expense in 2009, 2010, and 2011? Comparative Analysis Case The Coca-Cola Company and PepsiCo, Inc. Instructions Go to the book’s companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc. (a) Which company had the greater percentage increase in total assets from 2010 to 2011? (b) Using the Selected Financial Data section of these two companies, determine their 5-year average growth rates related to net sales and income from continuing operations. (c) Which company had more depreciation and amortization expense for 2011? Provide a rationale as to why there is a difference in these amounts between the two companies. Financial Statement Analysis Case Kellogg Company Kellogg Company has its headquarters in Battle Creek, Michigan. The company manufactures and sells ready-to-eat breakfast cereals and convenience foods including cookies, toaster pastries, and cereal bars. 152 Chapter 3 The Accounting Information System Selected data from Kellogg Company’s 2011 annual report follows (dollar amounts in millions). 2011 2010 2009 Sales $13,198.00 $12,397.00 $12,575.00 Gross profit % 41.28 42.66 42.87 Operating profit 1,976.00 1,990.00 2,001.00 Net cash flow less capital expenditures 1,001.00 534.00 1,266.00 Net earnings 1,231.00 1,247.00 1,212.00 In its annual reports, Kellogg Company has indicated that it plans to achieve sustainability of its operating results with operating principles that emphasize profit-rich, sustainable sales growth, as well as cash flow and return on invested capital. Kellogg believes its steady earnings growth, strong cash flow, and contin- ued investment during a multi-year period demonstrates the strength and flexibility of its business model. Instructions (a) Compute the percentage change in sales, operating profit, net cash flow less capital expenditures, and net earnings from year to year for the years presented. (b) Evaluate Kellogg’s performance. Which trend seems most favorable? Which trend seems least favorable? What are the implications of these trends for Kellogg’s sustainable performance objectives? Explain. Accounting, Analysis, and Principles The Amato Theater is nearing the end of the year and is preparing for a meeting with its bankers to discuss the renewal of a loan. The accounts listed below appeared in the December 31, 2014, trial balance. Debit Credit Prepaid Advertising $ 6,000 Equipment 192,000 Accumulated Depreciation—Equipment $ 60,000 Notes Payable 90,000 Unearned Service Revenue 17,500 Ticket Revenue 360,000 Advertising Expense 18,680 Salaries and Wages Expense 67,600 Interest Expense 1,400 Additional information is available as follows. 1. The equipment has an estimated useful life of 16 years and a salvage value of $40,000 at the end of that time. Amato uses the straight-line method for depreciation. 2. The note payable is a one-year note given to the bank January 31 and bearing interest at 10%. Interest is calculated on a monthly basis. 3. Late in December 2014, the theater sold 350 coupon ticket books at $50 each. One hundred fifty of these ticket books can be used only for admission any time after January 1, 2015. The cash received was re-

corded as Unearned Service Revenue. 4. Advertising paid in advance was $6,000 and was debited to Prepaid Advertising. The company has used $2,500 of the advertising as of December 31, 2014. 5. Salaries and wages accrued but unpaid at December 31, 2014, were $3,500. Accounting Prepare any adjusting journal entries necessary for the year ended December 31, 2014. Analysis Determine Amato’s income before and after recording the adjusting entries. Use your analysis to explain why Amato’s bankers should be willing to wait for Amato to complete its year-end adjustment process before making a decision on the loan renewal. Principles Although Amato’s bankers are willing to wait for the adjustment process to be completed before they re- ceive financial information, they would like to receive financial reports more frequently than annually or even quarterly. What trade-offs, in terms of relevance and faithful representation, are inherent in preparing financial statements for shorter accounting time periods? IFRS Insights 153 BRIDGE TO THE PROFESSION Professional Research Recording transactions in the accounting system requires knowledge of the important characteristics of the elements of financial statements, such as assets and liabilities. In addition, accountants must understand the inherent uncertainty in accounting measures and distinctions between related accounting concepts that are important in evaluating the effects of transactions on the financial statements. Instructions Go to http://aaahq.org/asclogin.cfm to log in and provide explanations for the following items. (Provide para- graph citations.) When you have accessed the documents, you can use the search tool in your Internet browser. (a) The three essential characteristics of assets. (b) The three essential characteristics of liabilities. (c) Uncertainty and its effect on financial statements. (d) The difference between realization and recognition. Additional Professional Resources See the book’s companion website, at www.wiley.com/college/kieso, for professional simulations as well as other study resources. IFRS INSIGHTS As indicated in this chapter, companies must have an effective accounting system. 12 LEARNING OBJECTIVE In the wake of accounting scandals at U.S. companies like Sunbeam, Rite-Aid, Compare the accounting information Xerox, and WorldCom, U.S. lawmakers demanded higher assurance on the quality systems under GAAP and IFRS. of accounting reports. Since the passage of the Sarbanes-Oxley Act of 2002 (SOX), companies that trade on U.S. exchanges are required to place renewed focus on their accounting systems to ensure accurate reporting. RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related to accounting information systems. Similarities • International companies use the same set of procedures and records to keep track of transaction data. Thus, the material in Chapter 3 dealing with the account, general rules of debit and credit, and steps in the recording process—the journal, ledger, and chart of accounts—is the same under both GAAP and IFRS. • Transaction analysis is the same under GAAP and IFRS but, as you will see in later chapters, different standards sometimes impact how transactions are recorded. • Both the FASB and IASB go beyond the basic defi nitions provided in this textbook for the key elements of fi nancial statements, that is, assets, liabilities, equity, revenues, and expenses. • A trial balance under IFRS follows the same format as shown in the textbook. As shown in the textbook, dollar signs are typically used only in the trial balance and the fi nancial statements. The same practice is followed under IFRS, using the currency of the country in which the reporting company is headquartered. 154 Chapter 3 The Accounting Information System Differences • Rules for accounting for specifi c events sometimes differ across countries. For exam- ple, European companies rely less on historical cost and more on fair value than U.S. companies. Despite the differences, the double-entry accounting system is the basis of

accounting systems worldwide. • Internal controls are a system of checks and balances designed to prevent and detect fraud and errors. While most public U.S. companies have these systems in place, many non-U.S. companies have never completely documented them nor had an inde- pendent auditor attest to their effectiveness. Both of these actions are required under SOX. These enhanced internal control standards apply only to large public companies listed on U.S. exchanges. ABOUT THE NUMBERS Accounting System Internal Controls There is continuing debate over whether foreign issuers should have to comply with the extra layer of regulation related to internal controls attestation.4 Companies find that internal control review is a costly process but needed. One study estimates the cost of compliance for U.S. companies at over $35 billion, with audit fees doubling in the first year of compliance. At the same time, examination of internal controls indicates linger- ing problems in the way companies operate. One study of first compliance with the in- ternal control testing provisions documented material weaknesses for about 13 percent of companies reporting in 2004 and 2005. Debate about requiring foreign companies to comply with SOX centers on whether the higher costs of a good information system are making the U.S. securities markets less competitive. Presented below are statistics for initial public offerings (IPOs) in the years since the passage of SOX. Share of IPO Proceeds: U.S., Europe, and China (U.S. $, billions) U.S. U.S. U.S. $39 $25.5 $25 20% 20% 28% China Europe China $597 China $22 $81 66% $133 17% 63% 69% Europe Europe $5.9, 6% 2009 $21.9, 11.3% 2010 2011 2009 IPOs 2010 IPOs 2011 IPOs U.S. 69 168 134 Europe 126 380 430 China 208 502 432 Source: PricewaterhouseCoopers, U.S. IPO Watch: 2011 Analysis and Trends. Note the U.S. share of IPOs has steadily declined. Some critics of the SOX provisions attribute the decline to the increased cost of complying with the internal control rules. Others, looking at these same trends, are not so sure about SOX being the cause of the relative decline of U.S. IPOs. These commentators argue that growth in non-U.S. markets is a natural consequence of general globalization of capital flows. 4See Greg Ip, Kara Scannel, and Deborah Solomon, “Trade Winds in Call to Deregulate Business, A Global Twist,” Wall Street Journal (January 25, 2007), p. A1. IFRS Insights 155 First-Time Adoption of IFRS As discussed in Chapter 1, IFRS is growing in acceptance around the world. For exam- ple, recent statistics indicate 40 percent of the Global Fortune 500 companies use IFRS. And the chair of the IASB predicts that IFRS adoption will grow from its current level of over 115 countries to nearly 150 countries in the near future. When countries accept IFRS for use as accepted accounting policies, companies need guidance to ensure that their first IFRS financial statements contain high-quality information. Specifically, IFRS 1 requires that information in a company’s first IFRS statements (1) be transparent, (2) provide a suitable starting point, and (3) have a cost that does not exceed the benefits. As a result, many companies will be going through a substantial conversion process to switch from their reporting standards to IFRS. The overriding principle in converting to IFRS is full retrospective application of IFRS. Retrospective application—recasting prior financial statements on the basis of IFRS—provides financial statement users with comparable information. As indicated, the objective of the conversion process is to present a set of IFRS statements as if the company always reported using IFRS. To achieve this objective, a company follows these steps: 1. Identify the timing of its fi rst IFRS statements. 2. Prepare an opening balance sheet at the date of transition to IFRS. 3. Select accounting principles that comply with IFRS, and apply these principles ret- rospectively. 4. Make extensive disclosures to explain the transition to IFRS. Once a company decides to convert to IFRS, it must decide on the transition date and

the reporting date. The transition date is the beginning of the earliest period for which full comparative IFRS information is presented. The reporting date is the closing bal- ance sheet date for the first IFRS financial statements. To illustrate, assume that FirstChoice Company plans to provide its first IFRS state- ments for the year ended December 31, 2016. FirstChoice decides to present compara- tive information for one year only. Therefore, its date of transition to IFRS is January 1, 2015, and its reporting date is December 31, 2016. The timeline for first-time adoption is presented in the following graphic. Last Statements under Prior GAAP Comparable Period First IFRS Reporting Period IFRS Financial Statements Date of Transition Beginning of First Reporting Date (Opening IFRS Statement IFRS Reporting Period of Financial Position) January 1, 2015 January 1, 2016 December 31, 2016 The graphic shows the following. 1. The opening IFRS statement of fi nancial position for FirstChoice on January 1, 2015, serves as the starting point (date of transition) for the company’s accounting under IFRS. 2. The fi rst full IFRS statements are shown for FirstChoice for December 31, 2016. In other words, a minimum of two years of IFRS statements must be presented before 156 Chapter 3 The Accounting Information System a conversion to IFRS occurs. As a result, FirstChoice must prepare at least one year of comparative fi nancial statements for 2016 using IFRS. 3. FirstChoice presents fi nancial statements in accordance with GAAP annually to December 31, 2015. Following this conversion process, FirstChoice provides users of the financial state- ments with comparable IFRS statements for 2015 and 2016. Upon first-time adoption of IFRS, a company must present at least one year of comparative information under IFRS. ON THE HORIZON The basic recording process shown in this textbook is followed by companies around the globe. It is unlikely to change in the future. The definitional structure of assets, lia- bilities, equity, revenues, and expenses may change over time as the IASB and FASB evaluate their overall conceptual framework for establishing accounting standards. In addition, high-quality international accounting requires both high-quality accounting standards and high-quality auditing. Similar to the convergence of GAAP and IFRS, there is a movement to improve international auditing standards. The International Auditing and Assurance Standards Board (IAASB) functions as an independent standard- setting body. It works to establish high-quality auditing and assurance and quality- control standards throughout the world. Whether the IAASB adopts internal control provisions similar to those in SOX remains to be seen. You can follow developments in the international audit arena at http://www.ifac.org/iaasb/. IFRS SELF-TEST QUESTIONS 1. Which statement is correct regarding IFRS? (a) IFRS reverses the rules of debits and credits, that is, debits are on the right and credits are on the left. (b) IFRS uses the same process for recording transactions as GAAP. (c) The chart of accounts under IFRS is different because revenues follow assets. (d) None of the above statements are correct. 2. Information in a company’s first IFRS statements must: (a) have a cost that does not exceed the benefits. (b) be transparent. (c) provide a suitable starting point. (d) All the above. 3. The transition date is the date: (a) when a company no longer reports under its national standards. (b) when the company issues its most recent financial statement under IFRS. (c) three years prior to the reporting date. (d) None of the above. 4. When converting to IFRS, a company must: (a) recast previously issued financial statements in accordance with IFRS. (b) use GAAP in the reporting period but subsequently use IFRS. (c) prepare at least three years of comparative statements. (d) use GAAP in the transition year but IFRS in the reporting year. 5. The purpose of presenting comparative information in the transition to IFRS is: (a) to ensure that the information is a faithful representation.

(b) in accordance with the Sarbanes-Oxley Act. (c) to provide users of the financial statements with information on GAAP in one period and IFRS in the other period. (d) to provide users of the financial statements with information on IFRS for at least two periods. IFRS Insights 157 IFRS CONCEPTS AND APPLICATION IFRS3-1 How is the date of transition and the date of reporting determined in first-time adoption of IFRS? IFRS3-2 What are the characteristics of high-quality information in a company’s first IFRS financial statements? IFRS3-3 What are the steps to be completed in preparing the opening IFRS statement of financial position? IFRS3-4 Becker Ltd. is planning to adopt IFRS and prepare its first IFRS financial statements at December 31, 2015. What is the date of Becker’s opening balance sheet, assuming one year of comparative informa- tion? What periods will be covered in Becker’s first IFRS financial statements? Professional Research IFRS3-5 Recording transactions in the accounting system requires knowledge of the important character- istics of the elements of financial statements, such as assets and liabilities. In addition, accountants must understand the inherent uncertainty in accounting measures and distinctions between related accounting concepts that are important in evaluating the effects of transactions on the financial statements. Instructions Access the IASB Framework at the IASB website (http://eifrs.iasb.org/). (Click on the IFRS tab and then reg- ister for free eIFRS access if necessary.) When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following items. (Provide paragraph citations.) (a) Provide the definition of an asset and discuss how the economic benefits embodied in an asset might flow to a company. (b) Provide the definition of a liability and discuss how a company might satisfy a liability. (c) What is “accrual basis”? How do adjusting entries illustrate application of the accrual basis? International Financial Reporting Problem Marks and Spencer plc IFRS3-6 The financial statements of Marks and Spencer plc (M&S) are available at the book’s com- panion website or can be accessed at http://annualreport.marksandspencer.com/_assets/downloads/Marks- and-Spencer-Annual-report-and-financial-statements-2012.pdf. Instructions Refer to M&S’s financial statements and the accompanying notes to answer the following questions. (a) What were M&S’s total assets at 31 March 2012? At 2 April 2011? (b) How much cash (and cash equivalents) did M&S have on 31 March 2012? (c) What were M&S’s selling and marketing expenses in 2012? In 2011? (d) What were M&S’s revenues in 2012? In 2011? (e) Using M&S’s financial statements and related notes, identify items that may result in adjusting entries for prepayments and accruals. (f) What were the amounts of M&S’s depreciation and amortization expense in 2011 and 2012? ANSWERS TO IFRS SELF-TEST QUESTIONS 1. b 2. d 3. d 4. a 5. d Remember to check the book’s companion website to fi nd additional resources for this chapter. Income Statement and Related Information 1 Understand the uses and limitations of an 5 Identify where to report earnings per share income statement. information. 2 Describe the content and format of the 6 Understand the reporting of accounting changes income statement. and errors. 3 Prepare an income statement. 7 Prepare a retained earnings statement. 4 Explain how to report various income items. 8 Explain how to report other comprehensive income. Financial Statements Are Changing The 2011 annual report of Groupon presents the following additional information in its financial statements regarding a calculation of its consolidated segment operating (loss) income (CSOI). Management of Groupon explained that CSOI is the consolidated operating (loss) income, after adjustment for acquisition- related costs and stock-based compensation expense. They explained, “We consider CSOI to be an important measure for management to evaluate the performance of our business as it excludes certain non-cash expenses. We believe it is important

to view CSOI as a complement to our entire consolidated statements of operations. When evaluating our performance, you should consider CSOI as a complement to other financial performance measures, including various cash flow metrics, net loss and our other U.S. GAAP results.” Why do companies report these adjusted income numbers (sometimes referred to as pro forma measures)? One major reason is that companies believe some items on the income statement are not representative of operating results. Here is another example, using Amazon.com. At one time, Amazon reported in a separate schedule adjustments to net income for items such as share-based compensation, amortization of goodwill and intangibles, impairment charges, and equity in losses of its subsidiaries. All these adjustments make the adjusted income measure higher than reported income. Amazon defends its pro forma reporting, saying it gives better insight into the fundamental operations of the business. However, while manage- ment asserts pro forma is useful to investors, others raise concerns. Skeptics of pro forma reporting often note that these adjustments generally lead to higher adjusted net income and, as a result, often report earnings before bad stuff (EBS). In Groupon’s case, the add-backs more than halved its operating loss in 2010 and resulted in an improving trend in operating performance over the two-year period. And pro forma puffery is not an isolated phenomenon. In a recent four-quarter earnings cycle, nearly 50 percent of S&P 500 companies also reported an income measure that they adjusted for certain items. Analysis of pro forma to GAAP numbers indicate that about 30 percent of the S&P 500 companies report pro forma income in excess of operating income. In general, pro forma profits were 18 percent higher than operating earnings. Another concern with pro forma is that it is difficult to compare these adjusted numbers RETPAHC 4 LEARNING OBJECTIVES After studying this chapter, you should be able to: The following is a reconciliation of CSOI to the most comparable U.S. GAAP measure, ‘‘Loss from operations,’’ for the years ended December 31, 2010 and 2011. Year Ended December 31, 2010 2011 (in thousands) Loss from operations $(420,344) $(233,386) Adjustments: Stock-based compensation 36,168 93,590 Acquisition-related costs 203,183 (4,537) Total adjustments 239,351 89,053 CSOI $(180,993) $(144,333) CONCEPTUAL FOCUS > See the Underlying Concepts on because companies have different views as to what is funda- pages 161 and 179. mental to their business. In many ways, the pro forma reporting practices by compa- > Read the Evolving Issue on page 185 for a nies like Groupon and Amazon represent implied criticisms of discussion of income reporting. certain financial reporting standards, including how the informa- tion is presented on the income statement. In response, the SEC INTERNATIONAL FOCUS issued Regulation G, which requires companies to reconcile non-GAAP financial measures to GAAP. This regulation provides > See the International Perspectives investors with a roadmap to analyze adjustments that compa- on pages 169, 174, and 183. nies make to their GAAP numbers to arrive at pro forma results. > Read the IFRS Insights on Regulation G helps investors compare one company’s pro forma measures with results reported by another company. pages 205–211 for a discussion of: The FASB (and IASB) are working on a joint project on finan- —Income reporting cial statement presentation to address users’ concerns about —Expense classifications these practices. Users believe too many alternatives exist for classifying and reporting income statement information. They note that information is often highly aggregated and inconsistently presented. As a result, it is difficult to assess the financial performance of the company and compare its results with other companies. This trend toward more transparent income reporting is encouraging, but managers still like pro forma reporting, as indicated by a recent survey in response to the FASB

financial statement presentation project. Over 55 percent polled indicated they would continue to practice pro forma reporting, even with a revised income statement format. Sources: A. Stuart, “A New Vision for Accounting: Robert Herz and FASB Are Preparing a Radical New Format for Financial Statements,” CFO Magazine (February 2008), pp. 49–53; SEC Regulation G, “Conditions for Use of Non-GAAP Financial Measures,” Release No. 33-8176 (March 28, 2003) and Compliance & Disclosure Interpretations: Non-GAAP Financial Measures (January 15, 2010), available at www.sec.gov/ divisions/corpfin/guidance/nongaapinterp.htm; and R. Cyran, A. Currie, and R. Cox, “Fuzzy Accounting Enriches Groupon,” The New York Times (June 12, 2011). As indicated in the opening story, companies are attempting to PREVIEW OF CHAPTER 4 provide income statement information they believe is useful for decision-making. Investors need complete and comparable infor- mation on income and its components to assess company profitability correctly. In this chapter, we examine the many different types of revenues, expenses, gains, and losses that affect the income statement and related information, as follows. Income Statement and Related Information Format of the Reporting Various Other Income Statement Income Statement Income Items Reporting Issues • Usefulness • Elements • Unusual gains and losses • Accounting changes • Limitations • Intermediate components • Discontinued operations and errors • Quality of earnings • Condensed income • Extraordinary items • Retained earnings statement statements • Noncontrolling interest • Comprehensive income • Single-step income • Earnings per share statements 159 160 Chapter 4 Income Statement and Related Information INCOME STATEMENT The income statement is the report that measures the success of company opera- LEARNING OBJECTIVE 1 tions for a given period of time. (It is also often called the statement of income or Understand the uses and limitations of statement of earnings.1) The business and investment community uses the income an income statement. statement to determine profitability, investment value, and creditworthiness. It provides investors and creditors with information that helps them predict the amounts, timing, and uncertainty of future cash flows. Usefulness of the Income Statement The income statement helps users of financial statements predict future cash flows in Ford Toyota a number of ways. For example, investors and creditors use the income statement < information to: Revenues Revenues – Expenses – Expenses $ Profits $ Profits 1. Evaluate the past performance of the company. Examining revenues and expenses indicates how the company performed and allows comparison of its performance to Which company did better its competitors. For example, analysts use the income data provided by Ford to last year? compare its performance to that of Toyota. 2. Provide a basis for predicting future performance. Information about past perfor- mance helps to determine important trends that, if continued, provide information about future performance. For example, General Electric at one time reported GE Profits consistent increases in revenues. Obviously, past success does not necessarily trans- late into future success. However, analysts can better predict future revenues, and hence earnings and cash fl ows, if a reasonable correlation exists between past and Hmmm... Where am I headed? future performance. 3. Help assess the risk or uncertainty of achieving future cash fl ows. Information on the IBM Recurring? Income for Year Ended various components of income—revenues, expenses, gains, and losses—highlights 12/31/14 Revenues the relationships among them. It also helps to assess the risk of not achieving a par- – Operating expenses Operating income Yes ticular level of cash fl ows in the future. For example, investors and creditors often ± Unusual or extraordinary items No segregate IBM’s operating performance from other nonrecurring sources of income $ Net Income ? because IBM primarily generates revenues and cash through its operations. Thus,

Recurring items are more results from continuing operations usually have greater signifi cance for predicting certain in the future. future performance than do results from nonrecurring activities and events. In summary, information in the income statement—revenues, expenses, gains, and losses—helps users evaluate past performance. It also provides insights into the likeli- hood of achieving a particular level of cash flows in the future. Limitations of the Income Statement Because net income is an estimate and reflects a number of assumptions, income state- ment users need to be aware of certain limitations associated with its information. Some ExpExp of these limitations include: RevRevRev Profits 1. Companies omit items from the income statement that they cannot measure reliably. U en ar re na il niz ge sd Brand value Current practice prohibits recognition of certain items from the determination of You left something out! income even though the effects of these items can arguably affect the company’s 1We will use the term income statement except in situations where a company reports other comprehensive income (discussed later in the chapter). In that case, we will use the term statement of comprehensive income. Income Statement 161 performance. For example, a company may not record unrealized gains and losses Income Using: on certain investment securities in income when there is uncertainty that it will Straight-Line ever realize the changes in value. In addition, more and more companies, like Depreciation Cisco Systems and Microsoft, experience increases in value due to brand recogni- tion, customer service, and product quality. A common framework for identifying Accelerated Depreciation and reporting these types of values is still lacking. 2. Income numbers are affected by the accounting methods employed. One company Hmm... Is the income the same? may depreciate its plant assets on an accelerated basis; another chooses straight-line depreciation. Assuming all other factors are equal, the fi rst company will report Estimates • High useful lives lower income. In effect, we are comparing apples to oranges. • Low warranty costs • Low bad debts 3. Income measurement involves judgment. For example, one company in good faith may estimate the useful life of an asset to be 20 years while another company uses a $ High Income 15-year estimate for the same type of asset. Similarly, some companies may make Hey...you might be too optimistic estimates of future warranty costs and bad debt write-offs, which result optimistic! in lower expense and higher income. In summary, several limitations of the income statement reduce the usefulness of its information for predicting the amounts, timing, and uncertainty of future cash flows. Quality of Earnings So far, our discussion has highlighted the importance of information in the Underlying Concepts income statement for investment and credit decisions, including the evaluation The income statement provides of the company and its managers.2 Companies try to meet or beat Wall Street important information to help expectations so that the market price of their stock and the value of manage- assess the amounts, timing, ment’s stock options increase. As a result, companies have incentives to manage and uncertainty of future cash income to meet earnings targets or to make earnings look less risky. fl ows—the central element of The SEC has expressed concern that the motivations to meet earnings tar- the objective of fi nancial gets may override good business practices. This erodes the quality of earnings reporting. and the quality of financial reporting. As indicated by one SEC chairperson, “Managing may be giving way to manipulation; integrity may be losing out to illu- sion.”3 As a result, the SEC has taken decisive action to prevent the practice of earnings management. What is earnings management? It is often defined as the planned timing of reve- nues, expenses, gains, and losses to smooth out bumps in earnings. In most cases, com- panies use earnings management to increase income in the current year at the expense

of income in future years. For example, they prematurely recognize sales in order to boost earnings. As one commentator noted, “it’s like popping a cork in [opening] a bottle of wine before it is ready.” Companies also use earnings management to decrease current earnings in order to increase income in the future. The classic case is the use of “cookie jar” reserves. Companies establish these reserves by using unrealistic assumptions to estimate liabilities for such items as loan losses, restructuring charges, and warranty returns. The companies then reduce these reserves in the future to increase reported income in the future. 2In support of the usefulness of income information, accounting researchers have documented an association between companies’ market prices and reported incomes. See W. H. Beaver, “Perspectives on Recent Capital Markets Research,” The Accounting Review (April 2002), pp. 453–474. 3A. Levitt, “The Numbers Game,” Remarks to NYU Center for Law and Business, September 28, 1998 (Securities and Exchange Commission, 1998). 162 Chapter 4 Income Statement and Related Information Such earnings management negatively affects the quality of earnings if it distorts the information in a way that is less useful for predicting future earnings and cash flows. Markets rely on trust. The bond between shareholders and the company must remain strong. Investors or others losing faith in the numbers reported in the financial state- ments will damage U.S. capital markets. As we mentioned in the opening story, we need heightened scrutiny of income measurement and reporting to ensure the quality of earnings and investors’ confidence in the income statement. What do the numbers mean? FOUR: THE LONELIEST NUMBER Managing earnings up or down adversely affects the quality cantly less often than would be expected by chance. This of earnings. Why do companies engage in such practices? effect is called “quadrophobia.” For the typical company in Some recent research concludes that many companies tweak the study, an increase of $31,000 in quarterly net income quarterly earnings to meet investor expectations. How do would boost earnings per share by a 10th of a cent. A more they do it? Research fi ndings indicate that companies tend to recent analysis of quarterly results for more than 2,600 com- nudge their earnings numbers up by a 10th of a cent or two. panies found that rounding up remains more common than That lets them round results up to the highest cent, as illus- rounding down. trated in the following chart. Another recent study reinforces the concerns about earn- ings management. Based on a survey of 169 public-company chief fi nancial offi cers (and with in-depth interviews of 12), Hitting the Target Digit Frequency of the Digit the study concludes that high-quality earnings are sustainable Companies are more 0 likely to round up when backed by actual cash fl ows and “avoiding unreliable earnings per share figures to the next- 1 long-term estimates.” However, about 20 percent of fi rms highest cent than to Round 2 manage earnings to misrepresent their economic performance. round down, a new down study found. The chart 3 And when they do manage earnings, it could move EPS by shows the frequency Least an average of 10 percent. of the digits in the 4 common 10th-of-a-cent place Is such earnings management a problem for investors? It 5 for nearly 489,000 is if they cannot determine the impact on earnings quality. quarterly reports from 1980 to 2006. 6 Indeed, the surveyed CFOs “believe that it is diffi cult for out- Round 7 side observers to unravel earnings management, especially up 8 when such earnings are managed using subtle unobservable choices or real actions.” What’s an investor to do? The survey 9 authors say the CFOs “advocate paying close attention to Source: Joseph Grundfest and Nadya 2 4 6 8 10 12% Malenko, Stanford University. the key managers running the fi rm, the lack of correlation between earnings and cash fl ows, signifi cant deviations What the research shows is that the number “4” appeared between fi rm and peer experience, and unusual behavior in

less often in the 10th’s place than any other digit and signifi - accruals.” Sources: S. Thurm, “For Some Firms, a Case of ‘Quadrophobia’,” Wall Street Journal (February 14, 2010); and H. Greenberg, “CFOs Concede Earnings Are ‘Managed’,” www.cnbc.com (July 19, 2012). (The study referred to is by I. Dichev, J. Graham, C. Harvey, and S. Rajgopal, “Earnings Quality: Evidence from the Field,” Emory University Working Paper (July 2012). FORMAT OF THE INCOME STATEMENT Elements of the Income Statement LEARNING OBJECTIVE 2 Describe the content and format of Net income results from revenue, expense, gain, and loss transactions. The income the income statement. statement summarizes these transactions. This method of income measurement, the transaction approach, focuses on the income-related activities that have Format of the Income Statement 163 occurred during the period.4 The statement can further classify income by customer, product line, or function, or by operating and nonoperating, continuing and discontin- ued, and regular and irregular categories.5 The following lists more formal definitions of income-related items, referred to as the major elements of the income statement. ELEMENTS OF FINANCIAL STATEMENTS REVENUES. Infl ows or other enhancements of assets of an entity or settlements of its liabilities during a period from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations. EXPENSES. Outfl ows or other using-up of assets or incurrences of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations. GAINS. Increases in equity (net assets) from peripheral or incidental transactions of an entity except those that result from revenues or investments by owners. LOSSES. Decreases in equity (net assets) from peripheral or incidental transactions of an entity except those that result from expenses or distributions to owners.6 Revenues take many forms, such as sales, fees, interest, dividends, and rents. Ex- penses also take many forms, such as cost of goods sold, depreciation, interest, rent, salaries and wages, and taxes. Gains and losses also are of many types, resulting from the sale of investments or plant assets, settlement of liabilities, and write-offs of assets due to impairments or casualty. The distinction between revenues and gains, and between expenses and losses, depend to a great extent on the typical activities of the company. For example, when McDonald’s sells a hamburger, it records the selling price as revenue. However, when McDonald’s sells land, it records any excess of the selling price over the book value as a gain. This difference in treatment results because the sale of the hamburger is part of McDonald’s regular operations. The sale of land is not. We cannot overemphasize the importance of reporting these elements. Most decision- makers find the parts of a financial statement to be more useful than the whole. As we indicated earlier, investors and creditors are interested in predicting the amounts, timing, and uncertainty of future income and cash flows. Having income statement elements shown in some detail and in comparison with prior years’ data allows decision-makers to better assess future income and cash flows. 4The most common alternative to the transaction approach is the capital maintenance approach to income measurement. Under this approach, a company determines income for the period based on the change in equity, after adjusting for capital contributions (e.g., investments by owners) or distributions (e.g., dividends). The main drawback associated with the capital maintenance approach is that the components of income are not evident in its measurement. The Internal Revenue Service uses the capital maintenance approach to identify unreported income and refers to this approach as the “net worth check.” 5The term “irregular” encompasses transactions and other events that are derived from develop-

ments outside the normal operations of the business. 6“Elements of Financial Statements,” Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.: FASB, 1985), paras. 78–89. 164 Chapter 4 Income Statement and Related Information Intermediate Components of the Income Statement It is common for companies to present some or all of the following sections and LEARNING OBJECTIVE 3 totals within the income statement as shown in Illustration 4-1. This format is often Prepare an income statement. referred to as the multiple-step income statement. ILLUSTRATION 4-1 Income Statement 1. O PERATING SECTION. A report of the revenues and expenses of the company’s prin- Sections cipal operations. (a) Sales or Revenue Section. A subsection presenting sales, discounts, allowances, returns, and other related information. Its purpose is to arrive at the net amount of sales revenue. (b) Cost of Goods Sold Section. A subsection that shows the cost of goods that were sold to produce the sales. (c) Selling Expenses. A subsection that lists expenses resulting from the company’s efforts to make sales. (d) Administrative or General Expenses. A subsection reporting expenses of general administration.7 2. NONOPERATING SECTION. A report of revenues and expenses resulting from secondary or auxiliary activities of the company. In addition, special gains and losses that are infrequent or unusual, but not both, are normally reported in this section. Generally these items break down into two main subsections: (a) Other Revenues and Gains. A list of the revenues recognized or gains incurred, generally net of related expenses, from nonoperating transactions. (b) Other Expenses and Losses. A list of the expenses or losses incurred, generally net of any related incomes, from nonoperating transactions. 3. INCOME TAX. A section reporting federal and state taxes levied on income from con- tinuing operations. 4. DISCONTINUED OPERATIONS. Material gains or losses resulting from the disposition of a component of the business. 5. EXTRAORDINARY ITEMS. Unusual and infrequent material gains and losses. 6. NONCONTROLLING INTEREST. Allocation of income to noncontrolling shareholders. 7. EARNINGS PER SHARE. As indicated, companies report all revenues, gains, expenses, and losses on the income statement. This statement separates operating transactions from nonoperating transac- tions, and matches costs and expenses with related revenues. It highlights certain inter- mediate components of income that analysts use to compute ratios for assessing the performance of the company. Companies present nonoperating revenues, gains, expenses, and losses in a separate section, before income taxes and income from operations. Companies report irregular items, such as discontinued operations of a component of a business and extraordinary items, as separate elements in the income statement. Segre- gating income with different characteristics and providing intermediate income figures helps readers evaluate earnings information in assessing the amounts, timing, and uncer- tainty of future cash flows. 7Although the content of the operating section is always the same, the organization of the material can differ. The breakdown above uses a natural expense classification. Manufacturing concerns and merchandising companies in the wholesale trade commonly use this. Another classification of operating expenses, recommended for retail stores, uses a functional expense classification of administrative, occupancy, publicity, buying, and selling expenses. Format of the Income Statement 165 Illustration 4-2 presents an income statement for Cabrera Company. Cabrera’s in- come statement includes all of the major items shown in Illustration 4-1, except for dis- continued operations, extraordinary items, and noncontrolling interest. In arriving at net income, the statement presents the following subtotals and totals: gross profit, income from operations, income before income tax, and net income.8 ILLUSTRATION 4-2 CABRERA COMPANY Multiple-Step Income INCOME STATEMENT

FOR THE YEAR ENDED DECEMBER 31, 2014 Statement Sales Sales revenue $3,053,081 Less: Sales discounts $ 24,241 Sales returns and allowances 56,427 80,668 Net sales 2,972,413 Cost of goods sold 1,982,541 Gross profit 989,872 Operating Expenses Selling expenses Sales salaries and commissions $202,644 Sales office salaries 59,200 Travel and entertainment 48,940 Advertising expense 38,315 Delivery expense 41,209 Shipping supplies and expense 24,712 Postage and stationery 16,788 Telephone and Internet expense 12,215 Depreciation of sales equipment 9,005 453,028 Administrative expenses Officers’ salaries 186,000 Office salaries 61,200 Legal and professional services 23,721 Utilities expense 23,275 Insurance expense 17,029 Depreciation of building 18,059 Depreciation of office equipment 16,000 Stationery, supplies, and postage 2,875 Miscellaneous office expenses 2,612 350,771 803,799 Income from operations 186,073 Other Revenues and Gains Dividend revenue 98,500 Rent revenue 72,910 171,410 357,483 Other Expenses and Losses Interest on bonds and notes 126,060 Income before income tax 231,423 Income tax 66,934 Net income for the year $ 164,489 Earnings per common share $1.74 The disclosure of net sales is useful because Cabrera reports regular revenues as a separate item. It discloses irregular or incidental revenues elsewhere in the income statement. As a result, analysts can more easily understand and assess trends in revenue from continuing operations. Similarly, the reporting of gross profit provides a useful number for evaluating per- formance and predicting future earnings. Statement readers may study the trend in gross 8Companies must include earnings per share or net loss per share on the face of the income statement. 166 Chapter 4 Income Statement and Related Information profits to determine how successfully a company uses its resources. They also may use that information to understand how competitive pressure affected profit margins. Finally, disclosing income from operations highlights the difference between regu- lar and irregular or incidental activities. This disclosure helps users recognize that incidental or irregular activities are unlikely to continue at the same level. Furthermore, disclosure of operating earnings may assist in comparing different companies and assessing operating efficiencies. What do the numbers mean? TOP LINE OR BOTTOM LINE? The importance of the components of income, as well as the The recent focus on the top line, revenue, arises because bottom line, is illustrated in the recent case of Chipotle. Its market expectations for revenues do not seem to jive with the stock had climbed fourfold in fi ve years and for good reason. companies’ optimistic profi t picture. For example, revenues The company had been reporting surprisingly high bottom- are expected to drop by about 2 percent in 2013 for compa- line income and investors were clamoring to buy. However, nies in the S&P 500. And while companies might report a in a recent month, that pattern was broken—that is, Chipotle surprise in earnings, analysts will be focusing on revenues. posted solid earnings, but investors sold. The reason? Companies have been able to cut costs to compensate— Analysts attribute the sell-off to Chipotle missing its target laying off workers, squeezing remaining staff, and using for revenues. The stock fell 21 percent, from $404 to $317, in a technology to run more effi ciently—but there’s a limit to day. And Chipotle was not alone. Six in 10 large companies how much you can squeeze your workers and use technol- reported results in that same quarter that missed revenue ogy to produce more. U.S. companies are just about as lean as targets. In response to the bad revenue news, Priceline.com any time in history. fell $117 to $562 after reporting revenue that was lower than As one analyst noted (in this economic environment), analysts had expected. The story has been the same for dozens “you won’t be able to grow earnings much faster than of companies across industries, from Coach, a luxury goods revenue. . . . Analysts will have to revise down their earn-

retailer, to Boston Scientifi c, which sells medical devices, to ings.” So watch the top line, as well as the bottom line. glass-container maker Owens-Illinois. Source: Associated Press, “Why Some Stocks Are Sinking Despite Big Profi ts,” The New York Times (August 12, 2012). Condensed Income Statements In some cases, a single income statement cannot possibly present all the desired expense detail. To solve this problem, a company includes only the totals of expense groups in the statement of income. It then also prepares supplementary schedules to support the totals. This format may thus reduce the income statement itself to a few lines on a single sheet. For this reason, readers who wish to study all the reported data on operations must give their attention to the supporting schedules. For example, consider the income statement shown in Illustration 4-3 for Cabrera Company. This statement is a condensed version of the more detailed multiple-step statement presented in Illustration 4-2 (page 165). It is more representative of the type found in practice. Illustration 4-4 then shows an example of a supporting schedule, cross-referenced as Note D and detailing the selling expenses. How much detail should a company include in the income statement? On the one hand, a company wants to present a simple, summarized statement so that readers can readily discover important factors. On the other hand, it wants to disclose the results of all activities and to provide more than just a skeleton report. As we showed in Illustra- tions 4-3 and 4-4, the income statement always includes certain basic elements, but com- panies can present them in various formats. Format of the Income Statement 167 ILLUSTRATION 4-3 CABRERA COMPANY Condensed Income INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2014 Statement Net sales $2,972,413 Cost of goods sold 1,982,541 Gross profit 989,872 Selling expenses (see Note D) $453,028 Administrative expenses 350,771 803,799 Income from operations 186,073 Other revenues and gains 171,410 357,483 Other expenses and losses 126,060 Income before income tax 231,423 Income tax 66,934 Net income for the year $ 164,489 Earnings per share $1.74 ILLUSTRATION 4-4 Note D: Selling expenses Sample Supporting Sales salaries and commissions $202,644 Sales office salaries 59,200 Schedule Travel and entertainment 48,940 Advertising expense 38,315 Delivery expense 41,209 Shipping supplies and expense 24,712 Postage and stationery 16,788 Telephone and Internet expense 12,215 Depreciation of sales equipment 9,005 Total selling expenses $453,028 Single-Step Income Statements In reporting revenues, gains, expenses, and losses, some companies often use a format known as the single-step income statement instead of a multiple-step income state- ment. The single-step statement consists of just two groupings: revenues and expenses. Expenses are deducted from revenues to arrive at net income or loss, hence the expres- sion “single-step.” Frequently, companies report income tax separately as the last item before net income to indicate its relationship to income before income tax. Illustra- tion 4-5 (page 168) shows the single-step income statement of Cabrera Company. Companies that use the single-step income statement in financial reporting typi- cally do so because of its simplicity. That is, the primary advantage of the single-step format lies in its simple presentation and the absence of any implication that one type of revenue or expense item has priority over another. This format thus eliminates potential classification problems.9 9Accounting Trends and Techniques (New York: AICPA) recently reported that of the 500 companies surveyed, 411 employed the multiple-step form, and 89 employed the single-step income statement format. This is a reversal from 1983, when 314 used the single-step form and 286 used the multiple-step form. 168 Chapter 4 Income Statement and Related Information ILLUSTRATION 4-5 CABRERA COMPANY Single-Step Income INCOME STATEMENT Statement FOR THE YEAR ENDED DECEMBER 31, 2014 Revenues Net sales $2,972,413

Dividend revenue 98,500 Rent revenue 72,910 Total revenues 3,143,823 Expenses Cost of goods sold 1,982,541 Selling expenses 453,028 Administrative expenses 350,771 Interest expense 126,060 Income tax expense 66,934 Total expenses 2,979,334 Net income $ 164,489 Earnings per common share $1.74 REPORTING VARIOUS INCOME ITEMS GAAP allows flexibility in the presentation of the components of income. How- LEARNING OBJECTIVE 4 ever, the FASB developed specific guidelines in two important areas: what to Explain how to report various income include in income and how to report certain unusual or irregular items. items. What should be reported in net income and where it should be reported is con- troversial. For example, should companies report a gain or loss on sale of an investment as part of net income or report it directly in retained earnings? Should a company report a loss on discontinued operations differently than interest expense? What we therefore need is consistent and comparable income reporting practices. Developing a framework for reporting income components is important to ensure useful information. Furthermore, as our opening story discusses, we need consistent and comparable income reporting practices to avoid “promotional” information reported by companies.10 Some users advocate a current operating performance approach to income reporting. These analysts argue that the most useful income measure reflects only regular and re- curring revenue and expense elements. Some irregular items do not reflect a company’s future earning power. In contrast, others warn that a focus on operating income potentially misses impor- tant information about a company’s performance. Any gain or loss experienced by the company, whether directly or indirectly related to operations, contributes to its long-run profitability. As one analyst notes, “write-offs matter. . . . They speak to the volatility of (past) earnings.”11 As a result, analysts can use some nonoperating items to assess the riskiness of future earnings. Furthermore, determining which items are operating and which are irregular or unusual requires judgment. This might lead to differences in the treatment of irregular items and to possible manipulation of income measures. 10The FASB and the IASB are working on a joint project on financial statement presentation, which is studying how to best report income as well as information presented in the balance sheet and the statement of cash flows. See http://www.fasb.org/project/financial_statement_presentation.shtml. 11D. McDermott, “Latest Profit Data Stir Old Debate Between Net and Operating Income,” Wall Street Journal (May 3, 1999). A recent survey of 500 large public companies (Accounting Trends and Techniques—2012 (New York: AICPA)) documented that 106 of the 500 survey companies reported a write-down of assets (see also Illustration 4-6 on page 169). This highlights the importance of good reporting for these irregular items. Reporting Various Income Items 169 So, what to do? The accounting profession has adopted a modified all- International inclusive concept. In this approach, companies record most items, including Perspective unusual or irregular ones, as part of net income.12 In addition, companies are In many countries, the “modifi ed required to highlight these items in the financial statements so that users can all-inclusive” income statement better determine the long-run earning power of the company. These income approach does not parallel that of items fall into four general categories, which we discuss in the following the United States. For example, sections: companies in these countries take some gains and losses 1. Unusual gains and losses. directly to owners’ equity 2. Discontinued operations. accounts instead of reporting 3. Extraordinary items. them on the income statement. 4. Noncontrolling interest. Unusual Gains and Losses The following items may need separate disclosure in the income statement to help users predict the amounts, timing, and uncertainty of future cash flows. • Losses on the write-down or write-off of receivables; inventories; property, plant,

and equipment; deferred research and development costs; or other intangible assets. • Gains or losses from exchange or translation of foreign currencies, including those relating to major devaluations and revaluations. • Restructuring charges. • Other gains or losses from sale or abandonment of property, plant, or equipment used in the business. See the FASB • Effects of a strike, including those against competitors and major suppliers. Codification section • Adjustment of accruals on long-term contracts. [1] (page 188). Illustration 4-6 identifies the most common types of unusual gains and losses reported in a survey of 500 large companies. Note that more than 40 percent of the surveyed firms reported restructuring charges, and nearly 60 percent of the companies reported write-downs or gains or losses on asset sales. ILLUSTRATION 4-6 500 Number of Unusual Items Reported in a 250 Recent Year by 500 Large 200 Companies 150 100 50 0 Companies sometimes show these unusual gains and losses with their normal recurring revenues and expenses. For example, PepsiCo, Inc. presented an unusual charge in its income statement, as Illustration 4-7 (page 170) shows. 12The FASB issued a statement of concepts that offers some guidance on this topic: “Recognition and Measurement in Financial Statements of Business Enterprises,” Statement of Financial Accounting Concepts No. 5 (Stamford, Conn.: FASB, 1984). seinapmoC fo rebmuN 289 202 Restructuring Write-Downs, Gains/Losses Charges on Asset Sales 170 Chapter 4 Income Statement and Related Information ILLUSTRATION 4-7 PepsiCo, Inc. Income Statement (in millions) Presentation of Unusual Net sales $20,917 Charges Costs and expenses, net Cost of sales 8,525 Selling, general, and administrative expenses 9,241 Amortization of intangible assets 199 Unusual items (Note 2) 290 Operating income $ 2,662 Note 2 (Restructuring Charge) Dispose and write down assets $183 Improve productivity 94 Strengthen the international bottler structure 13 Net loss $290 The net charge to strengthen the international bottler structure includes proceeds of $87 million associated with a settlement related to a previous Venezuelan bottler agreement, which were partially offset by related costs. Restructuring charges, like the one PepsiCo reported in Note 2 above, are common in recent years (see also Illustration 4-6 on page 169). A restructuring charge relates to a major reorganization of company affairs, such as costs associated with employee lay- offs, plant closing costs, write-offs of assets, and so on. A company should not report a restructuring charge as an extraordinary item because these write-offs are part of a com- pany’s ordinary and typical activities. Companies tend to report unusual items in a separate section just above “Income from operations before income taxes,” especially when there are multiple unusual items. For example, when General Electric experienced multiple unusual items in one year, it reported them in a separate “Unusual items” section of the income statement below “Income before unusual items and income taxes.” When preparing a multiple-step income statement for homework purposes, you should report unusual gains and losses in the “Other revenues and gains” or “Other expenses and losses” section unless you are instructed to prepare a separate unusual items section.13 Discontinued Operations A discontinued operation occurs when two things happen: (1) a company eliminates the results of operations of a component of the business, and (2) there is no significant involvement in that component after the disposal transaction. [2] To illustrate a component, S. C. Johnson manufactures and sells consumer prod- ucts. It has several product groups, each with different product lines and brands. For S. C. Johnson, a product group is the lowest level at which it can clearly distinguish the operations and cash flows from the rest of the company’s operations. Therefore, each product group is a component of the company. If a component were disposed of, S. C. Johnson would classify it as a discontinued operation.

13Many companies report “one-time items.” However, some companies take restructuring charges practically every year. Citicorp (now Citigroup) took restructuring charges six years in a row; Eastman Kodak Co. did so five out of six years. Research indicates that the market discounts the earnings of companies that report a series of “nonrecurring” items. Such evidence supports the contention that these elements reduce the quality of earnings. See J. Elliott and D. Hanna, “Repeated Accounting Write-Offs and the Information Content of Earnings,” Journal of Accounting Research (Supplement, 1996). Reporting Various Income Items 171 Here is another example. Assume that Softso Inc. has experienced losses with cer- tain brands in its beauty-care products group. As a result, Softso decides to sell that part of its business. It will discontinue any continuing involvement in the product group af- ter the sale. In this case, Softso eliminates the operations and the cash flows of the prod- uct group from its ongoing operations and reports it as a discontinued operation. On the other hand, assume Softso decides to remain in the beauty-care business but will discontinue the brands that experienced losses. Because Softso cannot differentiate the cash flows from the brands from the cash flows of the product group as a whole, it cannot consider the brands a component. Softso does not classify any gain or loss on the sale of the brands as a discontinued operation. Companies report as discontinued operations (in a separate income statement category) the gain or loss from disposal of a component of a business. In addition, companies report the results of operations of a component that has been or will be disposed of separately from continuing operations. Companies show the effects of discontinued operations net of tax as a separate category, after continuing operations. [3] To illustrate, Multiplex Products, Inc., a highly diversified company, decides to dis- continue its electronics division. During the current year, the electronics division lost $300,000 (net of tax). Multiplex sold the division at the end of the year at a loss of $500,000 (net of tax). Illustration 4-8 shows the reporting of discontinued operations for Multiplex. ILLUSTRATION 4-8 Income from continuing operations $20,000,000 Income Statement Discontinued operations Loss from operation of discontinued electronics Presentation of division (net of tax) $300,000 Discontinued Operations Loss from disposal of electronics division (net of tax) 500,000 (800,000) Net income $19,200,000 Companies use the phrase “Income from continuing operations” only when gains or losses on discontinued operations occur.14 A company that reports a discontinued operation must report per share amounts for discontinued operations either on the face of the income statement or in the notes to the financial statements. To illustrate, consider the income statement for Poquito Industries Inc., shown in Illustration 4-9 (page 172). Poquito had 100,000 shares outstanding for the entire year. Notice the order in which Poquito shows the data, with per share information at the bottom. The Poquito income statement, as Illustration 4-9 shows, is highly con- densed. Poquito would need to describe items such as “Other expenses and losses” and “Discontinued operations” fully and appropriately in the statement or related notes. Intraperiod Tax Allocation As indicated in Illustration 4-8, companies report discontinued operations on the income statement net of tax. The allocation of tax to this item is called intraperiod tax allocation, that is, allocation within a period. It relates the income tax expense (some- times referred to as the income tax provision) of the fiscal period to the specific items that give rise to the amount of the income tax provision. Intraperiod tax allocation helps financial statement users better understand the impact of income taxes on the various components of net income. For example, readers 14In practice, a company will generally report only one line on the income statement, such as

“Loss on discontinued operations,” and then in the notes explain the two components of the loss that total $800,000. For homework purposes, report both amounts on the face of the income statement, net of tax, if both amounts are provided. 172 Chapter 4 Income Statement and Related Information ILLUSTRATION 4-9 POQUITO INDUSTRIES INC. Income Statement INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2014 Sales revenue $1,420,000 Cost of goods sold 600,000 Gross profit 820,000 Selling and administrative expenses 320,000 Other revenues and gains Interest revenue $ 10,000 Other expenses and losses Loss on disposal of part of Textile Division (5,000) Loss on sale of investments (30,000) (25,000) Income from operations 475,000 Interest expense 15,000 Income before income tax 460,000 Income tax 184,000 Income from continuing operations 276,000 Discontinued operations Income from operations of Pizza Division, less applicable income tax of $24,800 54,000 Loss on disposal of Pizza Division, less applicable income tax of $41,000 (90,000) (36,000) Net income $240,000 Per share Income from continuing operations $2.76 Income from operations of discontinued division, net of tax 0.54 Loss on disposal of discontinued operation, net of tax (0.90) Net income $2.40 of financial statements will understand how much income tax expense relates to “Income from continuing operations” and how much to discontinued operations. This approach helps users to better predict the amount, timing, and uncertainty of future cash flows. In addition, intraperiod tax allocation discourages statement readers from using pretax measures of performance when evaluating financial results, and thereby recognizes that income tax expense is a real cost. Companies use intraperiod tax allocation on the income statement for the follow- ing items: (1) income from continuing operations, (2) discontinued operations, and (3) extraordinary items (discussed below). The general concept is “let the tax follow the income.” To compute the income tax expense attributable to “Income from continuing opera- tions,” a company computes the income tax expense related to both the revenue and expense transactions as well as other income and expense used in determining this income subtotal. (In this computation, the company does not consider the tax conse- quences of items excluded from the determination of “Income from continuing opera- tions.”) Companies then associate a separate tax effect (e.g., for discontinued operations). Here, we look in more detail at the calculation of intraperiod tax allocation for a discon- tinued gain or discontinued loss. Discontinued Operations (Gain) In applying the concept of intraperiod tax allocation, assume that Schindler Co. has income before income tax of $250,000. It has a gain of $100,000 from a discontinued operation. Assuming a 30 percent income tax rate, Schindler presents the following information on the income statement. Reporting Various Income Items 173 ILLUSTRATION 4-10 Income before income tax $250,000 Intraperiod Tax Income tax 75,000 Allocation, Discontinued Income from continuing operations 175,000 Operations Gain Gain on discontinued operations $100,000 Less: Applicable income tax 30,000 70,000 Net income $245,000 Schindler determines the income tax of $75,000 ($250,000 3 30%) attributable to “Income before income tax” from revenue and expense transactions related to this in- come. Schindler omits the tax consequences of items excluded from the determination of “Income before income tax.” The company shows a separate tax effect of $30,000 re- lated to the “Gain on discontinued operations.” Discontinued Operations (Loss) To illustrate the reporting of a loss from discontinued operations, assume that Schindler Co. has income before income tax of $250,000. It also has a loss from discontinued operations of $100,000. Assuming a 30 percent tax rate, Schindler presents the income tax on the income statement as shown in Illustration 4-11. In this case, the loss provides a positive tax benefit of $30,000. Schindler, therefore, subtracts it from the $100,000 loss.

ILLUSTRATION 4-11 Income before income tax $250,000 Intraperiod Tax Income tax 75,000 Allocation, Discontinued Income from continuing operations 175,000 Operations Loss Loss from discontinued operations $100,000 Less: Applicable income tax reduction 30,000 70,000 Net income $105,000 Companies may also report the tax effect of a discontinued item by means of a note disclosure, as illustrated below. ILLUSTRATION 4-12 Income before income tax $250,000 Note Disclosure of Income tax 75,000 Intraperiod Tax Income from continuing operations 175,000 Allocation Loss on discontinued operations, less applicable income tax reduction (Note 1) 70,000 Net income $105,000 Note 1: During the year, the Company suffered a loss on discontinuing operations of $70,000, net of applicable income tax reduction of $30,000. Extraordinary Items Extraordinary items are nonrecurring material items that differ significantly from a company’s typical business activities. The criteria for extraordinary items are as follows. Extraordinary items are events and transactions that are distinguished by their unusual nature and by the infrequency of their occurrence. Classifying an event or transaction as an extraordinary item requires meeting both of the following criteria: (a) Unusual nature. The underlying event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to, or only incidentally 174 Chapter 4 Income Statement and Related Information related to, the ordinary and typical activities of the company, taking into account the environment in which it operates. (b) Infrequency of occurrence. The underlying event or transaction should be of a type that the company does not reasonably expect to recur in the foreseeable future, taking into account the environment in which the company operates. [4] Only rarely does an event or transaction clearly meet the criteria for an International Perspective extraordinary item.15 For example, a company classifies gains or losses as extraordinary if they resulted directly from a major casualty (such as an earth- Special reporting for quake), an expropriation, or a prohibition under a newly enacted law or extraordinary items is prohibited regulation. Such circumstances clearly meet the criteria of unusual and infre- under IFRS. quent. For example, Weyerhaeuser Company (forest and lumber) incurred an extraordinary item (an approximate $36 million loss) as a result of volcanic ac- tivity at Mount St. Helens. The eruption destroyed standing timber, logs, buildings, equipment, and transportation systems covering 68,000 acres. In determining whether an item is extraordinary, a company must consider the environment in which it operates. The environment includes such factors as industry characteristics, geographic location, and the nature and extent of governmental regula- tions. Thus, the FASB accords extraordinary item treatment to the loss from hail dam- ages to a tobacco grower’s crops if hailstorm damage in its locality is rare. On the other hand, frost damage to a citrus grower’s crop in Florida does not qualify as extraordinary because frost damage normally occurs there every three or four years. Similarly, when a company sells the only significant security investment it has ever owned, the gain or loss meets the criteria of an extraordinary item. Another company, however, that has a portfolio of securities acquired for investment purposes would not report such a sale as an extraordinary item. Sale of such securities is part of its ordinary and typical activities. In addition, considerable judgment must be exercised in determining whether to report an item as extraordinary. For example, the government condemned the forest- lands of some paper companies to preserve state or national parks or forests. Is such an event extraordinary, or is it part of a paper company’s normal operations? Such deter- mination is not easy. Much depends on the frequency of previous condemnations, the expectation of future condemnations, materiality, and the like.16 Extraordinary Gains

To illustrate the reporting of an extraordinary gain, assume that Logan Co. has income before income tax and extraordinary item of $250,000. It has an extraordinary gain of $100,000 from a condemnation settlement received on one its properties. Assuming a 30 percent income tax rate, Logan presents the following information on the income statement. ILLUSTRATION 4-13 Income before income tax and extraordinary item $250,000 Extraordinary Gain Income tax 75,000 Income before extraordinary item 175,000 Extraordinary gain—condemnation settlement $100,000 Less: Applicable income tax 30,000 70,000 Net income $245,000 15Accounting Trends and Techniques—2012 (New York: AICPA) indicates that just 1 of the 500 companies surveyed reported an extraordinary item. 16Because assessing the materiality of individual items requires judgment, determining what is extraordinary is difficult. However, in making materiality judgments, companies should consider extraordinary items individually and not in the aggregate. [5] Reporting Various Income Items 175 Logan determines the income tax of $75,000 ($250,000 3 30%) attributable to “Income before income tax and extraordinary item” from revenue and expense transactions related to this income. Logan omits the tax consequences of items excluded from the determina- tion of “Income before income tax and extraordinary item.” The company shows a sepa- rate tax effect of $30,000 related to the “Extraordinary gain—condemnation settlement.” Extraordinary Losses To illustrate the reporting of an extraordinary loss, assume that Logan Co. has income before income tax and extraordinary item of $250,000. It suffers an extraordinary loss from a major casualty of $100,000. Assuming a 30 percent tax rate, Logan presents the income tax on the income statement as shown in Illustration 4-14. In this case, the loss provides a positive tax benefit of $30,000. Logan, therefore, subtracts it from the $100,000 loss. ILLUSTRATION 4-14 Income before income tax and extraordinary item $250,000 Intraperiod Tax Income tax 75,000 Allocation, Extraordinary Income before extraordinary item 175,000 Loss Extraordinary item—casualty loss $100,000 Less: Applicable income tax reduction 30,000 70,000 Net income $105,000 Companies may also report the tax effect of an extraordinary item by means of a note disclosure, as illustrated below. ILLUSTRATION 4-15 Income before income tax and extraordinary item $250,000 Note Disclosure of Income tax 75,000 Intraperiod Tax Income before extraordinary item 175,000 Allocation Extraordinary item —casualty loss, less applicable income tax reduction (Note 1) 70,000 Net income $105,000 Note 1: During the year, the Company suffered a major casualty loss of $70,000, net of applicable income tax reduction of $30,000. A presentation showing both discontinued operations and extraordinary items is shown in Illustration 4-19 (page 178).17 What do the numbers mean? EXTRAORDINARY TIMES No event better illustrates the diffi culties of determining Center and turned much of lower Manhattan including Wall whether a transaction meets the defi nition of extraordinary Street into a war zone, airlines, insurance companies, and than the fi nancial impacts of the terrorist attack on the World other businesses recorded major losses due to property dam- Trade Center on September 11, 2001. age, business disruption, and suspension of airline travel To many, this event, which resulted in the tragic loss of and of securities trading. lives, jobs, and in some cases entire businesses, clearly meets But, to the surprise of many, the FASB did not permit the criteria for unusual and infrequent. For example, in the extraordinary item reporting for losses arising from the wake of the terrorist attack that destroyed the World Trade terrorist attacks. The reason? After much deliberation, the 17As indicated earlier, discontinued operations and extraordinary items are shown net of tax, while unusual gains and losses are not reported net of tax. The Board specifically prohibited a net-of-tax treatment for these latter items, to ensure that users of financial statements can easily

differentiate extraordinary items—reported net of tax—from material items that are unusual or infrequent, but not both. 176 Chapter 4 Income Statement and Related Information Emerging Issues Task Force (EITF) of the FASB decided that that had little direct relationship to the attack. Indeed, energy measurement of the possible loss was too diffi cult. company AES and shoe retailer Footstar, which both were Take the airline industry as an example. What portion of experiencing profi t pressure before 9/11, put some of the the airlines’ losses after September 11 was related to the blame for their poor performance on the attack. The FASB terrorist attack, and what portion was due to the ongoing came to a similar conclusion—no extraordinary treatment— recession? Also, the FASB did not want companies to use the for the effects of the recent huricanes Katrina and Sandy. attack as a reason for reporting as extraordinary some losses Sources: Julie Creswell, “Bad News Bearers Shift the Blame,” Fortune (October 15, 2001), p. 44; and CFO Journal, “Companies Must Walk Fine Line in Accounting for Sandy,” Wall Street Journal (November 13, 2012). Noncontrolling Interest A company like The Coca-Cola Company owns substantial interests in other compa- nies. Coca-Cola generally consolidates the financial results of these companies into its own financial statements. In these cases, Coca-Cola is referred to as the parent, and the other companies are referred to as subsidiaries. Noncontrolling interest is then the por- tion of equity (net assets) interest in a subsidiary not attributable to the parent company. To illustrate, assume that Coca-Cola acquires 70 percent of the outstanding stock of Koch Company. Because Coca-Cola owns more than 50 percent of Koch, it consolidates Koch’s financial results with its own. Consolidated net income is then allocated to the controlling (Coca-Cola) and noncontrolling shareholders’ percentage of ownership in Koch. In other words, under this arrangement, the ownership of Koch is divided into two classes: (1) the majority interest represented by stockholders who own the control- ling interest and (2) the noncontrolling interest (sometimes referred to as the minority interest) represented by stockholders who are not part of the controlling group. When Coca-Cola prepares a consolidated income statement, GAAP requires that net income be allocated to the controlling and noncontrolling interest. This allocation is reported at the bottom of the income statement, after net income. An example of how Coca-Cola reports its noncontrolling interest is shown in Illus- tration 4-16. ILLUSTRATION 4-16 The Coca-Cola Company Presentation of Noncontrolling Interest Consolidated net income $8,634 Less: Net income attributable to noncontrolling interests 62 Net income attributable to shareowners of The Coca-Cola Company $8,572 The noncontrolling interest amounts are not an expense or dividend, but are alloca- tions of net income (loss) to the noncontrolling interest. [6] Summary of Various Income Items Because of the numerous intermediate income figures created by the reporting of irregular items, readers must carefully evaluate earnings information reported by the financial press. Illustration 4-17 summarizes the basic concepts that we previously dis- cussed. Although simplified, the chart provides a useful framework for determining the treatment of special items affecting the income statement. Reporting Various Income Items 177 Type of Situation Criteria Examples Placement on Income Statement Unusual gains or Material; character typical of the Write-downs of receivables, Show in separate section above losses, not customary business activities; inventories; adjustments of income before extraordinary items. considered unusual or infrequent but not accrued contract prices; gains or Often reported in “Other revenues extraordinary both. losses from fluctuations of foreign and gains” or “Other expenses exchange; gains or losses from and losses” section. (Not shown sales of assets used in business. net of tax.)

Discontinued Disposal of a component of a Sale by diversified company of Show in separate section after operations business for which the company major division that represents only continuing operations but before can clearly distinguish operations activities in electronics industry. extraordinary items. (Shown net and cash flows from the rest of Food distributor that sells of tax.) the company’s operations. wholesale to supermarket chains and through fast-food restaurants decides to discontinue the division that sells to one of two classes of customers. Extraordinary items Material, and both unusual and Gains or losses resulting from Show in separate section entitled infrequent (nonrecurring). casualties, an expropriation, or “Extraordinary items.” (Shown a prohibition under a new law. net of tax.) Noncontrolling Allocation of net income or loss Net profit (loss) attributable to Report as a separate item below interest divided between two classes: (1) noncontrolling shareholders. net income or loss as an the majority interest represented allocation of the net income or by the shareholders who own loss (not as an item of income the controlling interest, and (2) the or expense). noncontrolling interest (often referred to as the minority interest). ILLUSTRATION 4-17 Summary of Various Items in the Income Earnings per Share Statement A company customarily sums up the results of its operations in one important 5 LEARNING OBJECTIVE figure: net income. However, the financial world has widely accepted an even Identify where to report earnings per more distilled and compact figure as the most significant business indicator— share information. earnings per share (EPS). The computation of earnings per share is usually straightforward. Earnings per share is net income minus preferred dividends (income available to common stock- holders), divided by the weighted average of common shares outstanding.18 To illustrate, assume that Lancer, Inc. reports net income of $350,000. It declares and pays preferred dividends of $50,000 for the year. The weighted-average number of com- mon shares outstanding during the year is 100,000 shares. Lancer computes earnings per share of $3, as shown in Illustration 4-18. ILLUSTRATION 4-18 Net Income 2 Preferred Dividends 5 Earnings per Share Equation Illustrating Weighted Average of Common Shares Outstanding Computation of Earnings per Share $350,000 2 $50,000 5 $3 100,000 Note that EPS measures the number of dollars earned by each share of common stock. It does not represent the dollar amount paid to stockholders in the form of dividends. Prospectuses, proxy material, and annual reports to stockholders commonly use the “net income per share” or “earnings per share” ratio. The financial press, statistical 18In calculating earnings per share, companies deduct preferred dividends from net income if the dividends are declared or if they are cumulative though not declared. Only the net income attributable to the controlling interest should be used in computing earnings per share. 178 Chapter 4 Income Statement and Related Information services like Standard & Poor’s, and Wall Street securities analysts also highlight EPS. Because of its importance, companies must disclose earnings per share on the face of the income statement. A company that reports a discontinued operation or an extraor- dinary item must report per share amounts for these line items either on the face of the income statement or in the notes to the financial statements. [7] To illustrate, consider the income statement for Poquito Industries Inc. shown in Illustration 4-19. Notice the order in which Poquito shows the data, with per share infor- mation at the bottom. Assume that the company had 100,000 shares outstanding for the entire year. The Poquito income statement, as Illustration 4-19 shows, is highly con- densed. Poquito would need to describe items such as “Loss on disposal of part of Textile Division,” “Discontinued operations,” and “Extraordinary item” fully and appropri- ately in the statement or related notes.

ILLUSTRATION 4-19 POQUITO INDUSTRIES INC. Income Statement INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2014 Sales revenue $1,420,000 Cost of goods sold 600,000 Gross profit 820,000 Selling and administrative expenses 320,000 Income from operations 500,000 Other revenues and gains Interest revenue 10,000 Other expenses and losses Loss on disposal of part of Textile Division $ 5,000 Loss on sale of investments 45,000 50,000 Income from continuing operations before income tax 460,000 Income tax 184,000 Income from continuing operations 276,000 Discontinued operations Income from operations of Pizza Division, less applicable income tax of $24,800 54,000 Loss on disposal of Pizza Division, less applicable income tax of $41,000 90,000 36,000 Income before extraordinary item 240,000 Extraordinary item—loss from earthquake, less applicable income tax of $23,000 45,000 Net income $ 195,000 Per share of common stock Income from continuing operations $2.76 Income from operations of discontinued division, net of tax 0.54 Loss on disposal of discontinued operation, net of tax 0.90 Income before extraordinary item 2.40 Extraordinary loss, net of tax 0.45 Net income $1.95 Many corporations have simple capital structures that include only common stock. For these companies, a presentation such as “Earnings per common share” is appropri- ate on the income statement. In many instances, however, companies’ earnings per share are subject to dilution (reduction) in the future because existing contingencies permit the issuance of additional common shares. [8]19 19The earnings per share effects of noncontrolling interest should also be presented. In addition, the amounts of income from continuing operations and discontinued operations (if present) attributable to the controlling interest should be disclosed. We discuss the computational problems involved in accounting for these dilutive securities in earnings per share computations in Chapter 16. Other Reporting Issues 179 What do the numbers mean? DIFFERENT INCOME CONCEPTS As mentioned in the opening story, the FASB and the IASB What Metrics Do Analysts Create from the Income are collaborating on a joint project related to presentation of Statement? fi nancial statements. In 2008, these two groups issued an Net income exposure draft that presented examples of what these new fi nancial statements might look like. The Boards also con- 6%6%10% 7% EBITDA ducted fi eld tests on two groups: preparers and users. Pre- Comprehensive income 13% parers were asked to recast their fi nancial statements and Operating income 31% then comment on the results. Users examined the recast EBIT 27% statements and commented on their usefulness. Pretax income One part of the fi eld test asked analysts to indicate which Other primary performance metric they use or create from a com- pany’s income statement. They were provided with the fol- lowing options: (a) Net income; (b) Pretax income; (c) Income respondents use or create from a company’s income state- before interest and taxes (EBIT); (d) Income before interest, ment. A majority of the respondents identifi ed a primary taxes, depreciation, and amortization (EBITDA); (e) Operat- performance metric that uses net income as its foundation ing income; (f) Comprehensive income; and (g) Other. The (pretax income would be in this group). Clearly, users and adjacent chart highlights their responses. preparers look at more than just the bottom-line income As indicated, Operating income (31%) and EBITDA (27%) number, which supports the common practice of providing were identifi ed as the two primary performance metrics that subtotals within the income statement. Source: “FASB-IASB Report on Analyst Field Test Results,” Financial Statement Presentation Informational Board Meeting (September 21, 2009). OTHER REPORTING ISSUES In this section, we discuss reporting issues related to (1) accounting changes and 6 LEARNING OBJECTIVE errors, (2) retained earnings statement, and (3) comprehensive income. Understand the reporting of accounting changes and errors. Accounting Changes and Errors

Changes in accounting principle, change in estimates, and corrections of errors require unique reporting provisions. Changes in Accounting Principle Changes in accounting occur frequently in practice because important events or Underlying Concepts conditions may be in dispute or uncertain at the statement date. One type of ac- Companies can change princi- counting change results when a company adopts a different accounting principle. ples, but they must demonstrate Changes in accounting principle include a change in the method of inventory that the newly adopted principle pricing from FIFO to average-cost, or a change in accounting for construction con- is preferable to the old one. Such tracts from the percentage-of-completion to the completed-contract method. [9]20 changes result in lost consistency A company recognizes a change in accounting principle by making a retro- from period to period. spective adjustment to the financial statements. Such an adjustment recasts the prior years’ statements on a basis consistent with the newly adopted principle. The com- pany records the cumulative effect of the change for prior periods as an adjustment to beginning retained earnings of the earliest year presented. To illustrate, Gaubert Inc. decided in March 2014 to change from FIFO to weighted- average inventory pricing. Gaubert’s income before income tax, using the new weighted- average method in 2014, is $30,000. Illustration 4-20 (page 180) presents the pretax income data for 2012 and 2013 for this example. 2 0In Chapter 22, we examine in greater detail the problems related to accounting changes, and changes in estimates and errors. 180 Chapter 4 Income Statement and Related Information ILLUSTRATION 4-20 Excess of Calculation of a Change Weighted- FIFO in Accounting Principle Average over Weighted- Year FIFO Method Average Method 2012 $40,000 $35,000 $5,000 2013 30,000 27,000 3,000 Total $8,000 Illustration 4-21 shows the information Gaubert presented in its comparative income statements, based on a 30 percent tax rate. ILLUSTRATION 4-21 2014 2013 2012 Income Statement Income before income tax $30,000 $27,000 $35,000 Presentation of a Change Income tax 9,000 8,100 10,500 in Accounting Principle Net income $21,000 $18,900 $24,500 Thus, under the retrospective approach, the company recasts the prior years’ income numbers under the newly adopted method. This approach therefore preserves compara- bility across years. Changes in Accounting Estimates Changes in accounting estimates are inherent in the accounting process. For example, companies estimate useful lives and salvage values of depreciable assets, uncollectible receivables, inventory obsolescence, and the number of periods expected to benefit from a particular expenditure. Not infrequently, due to time, circumstances, or new informa- tion, even estimates originally made in good faith must be changed. A company ac- counts for such changes in estimates in the period of change if they affect only that period, or in the period of change and future periods if the change affects both. To illustrate a change in estimate that affects only the period of change, assume that DuPage Materials Corp. consistently estimated its bad debt expense at 1 percent of credit sales. In 2014, however, DuPage determines that it must revise upward the esti- mate of bad debts for the current year’s credit sales to 2 percent, or double the prior years’ percentage. The 2 percent rate is necessary to reduce accounts receivable to net realizable value. Using 2 percent results in a bad debt charge of $240,000, or double the amount using the 1 percent estimate for prior years. DuPage records the bad debt expense and related allowance at December 31, 2014, as follows. Bad Debt Expense 240,000 Allowance for Doubtful Accounts 240,000 DuPage includes the entire change in estimate in 2014 income because the change does not affect future periods. Companies do not handle changes in estimate retro- spectively. That is, such changes are not carried back to adjust prior years. Changes in estimate are not considered errors.

Corrections of Errors Errors occur as a result of mathematical mistakes, mistakes in the application of account- ing principles, or oversight or misuse of facts that existed at the time financial statements were prepared. In recent years, many companies have corrected for errors in their financial statements. The errors involved such items as improper reporting of revenue, accounting for stock options, allowances for receivables, inventories, and other provisions. Other Reporting Issues 181 Companies correct errors by making proper entries in the accounts and reporting the corrections in the financial statements. Corrections of errors are treated as prior period adjustments, similar to changes in accounting principles. Companies record a correction of an error in the year in which it is discovered. They report the error in the financial statements as an adjustment to the beginning balance of retained earnings. If a company prepares comparative financial statements, it should restate the prior state- ments for the effects of the error. To illustrate, in 2015, Hillsboro Co. determined that it incorrectly overstated its ac- counts receivable and sales revenue by $100,000 in 2014. In 2015, Hillsboro makes the following entry to correct for this error (ignore income taxes). Retained Earnings 100,000 Accounts Receivable 100,000 Beginning retained earnings is debited in 2015 because sales revenue, and therefore net income, was overstated in 2014 (hence, Retained Earnings was overstated). Accounts Receivable is credited to reduce this overstated balance to the correct amount. Summary The impact of changes in accounting principle and error corrections are debited or credited directly to retained earnings for the amounts related to prior periods. Illustra- tion 4-22 summarizes the basic concepts related to these two items, as well as the accounting and reporting for changes in estimates. Although simplified, the chart provides a useful framework for determining the treatment of special items affecting ILLUSTRATION 4-22 the income statement. Summary of Accounting Changes and Errors Type of Situation Criteria Examples Placement on Income Statement Changes in Change from one generally Change in the basis of inventory Recast prior years’ income accounting accepted accounting principle pricing from FIFO to average- statement on the same basis as principle to another. cost. the newly adopted principle. (Shown net of tax.) Changes in Normal, recurring corrections and Changes in the realizability of Show change only in the affected estimates adjustments. receivables and inventories; accounts in current and future changes in estimated lives of periods. (Not shown net of tax.) equipment, intangible assets; changes in estimated liability for warranty costs, income taxes, and salary payments. Corrections of Mistake, misuse of facts. Error in reporting income and Treat as prior period adjustment; errors expenses. restate prior years’ income statements to correct for error. (Shown net of tax.) Retained Earnings Statement Net income increases retained earnings. A net loss decreases retained earnings. 7 LEARNING OBJECTIVE Both cash and stock dividends decrease retained earnings. Changes in accounting Prepare a retained earnings statement. principles (generally) and prior period adjustments may increase or decrease retained earnings. Companies charge or credit these adjustments (net of tax) to the opening balance of retained earnings. This excludes the adjustments from the determi- nation of net income for the current period. Companies may show retained earnings information in different ways. For exam- ple, some companies prepare a separate retained earnings statement, as Illustration 4-23 (page 182) shows. 182 Chapter 4 Income Statement and Related Information ILLUSTRATION 4-23 STRICKER INC. Retained Earnings RETAINED EARNINGS STATEMENT Statement FOR THE YEAR ENDED DECEMBER 31, 2014 Retained earnings, January 1, as reported $1,050,000 Correction for understatement of net income in prior period (inventory error) 50,000 Retained earnings, January 1, as adjusted 1,100,000

Add: Net income 360,000 1,460,000 Less: Cash dividends $100,000 Stock dividends 200,000 300,000 Retained earnings, December 31 $1,160,000 The reconciliation of the beginning to the ending balance in retained earnings pro- vides information about why net assets increased or decreased during the year.21 The association of dividend distributions with net income for the period indicates what management is doing with earnings: It may be “plowing back” into the business part or all of the earnings, distributing all current income, or distributing current income plus the accumulated earnings of prior years. Restrictions of Retained Earnings Companies often restrict retained earnings to comply with contractual requirements, board of directors’ policy, or current necessity. Generally, companies disclose in the notes to the financial statements the amounts of restricted retained earnings. In some cases, companies transfer the amount of retained earnings restricted to an account titled Appropriated Retained Earnings. The retained earnings section may therefore report two separate amounts—(1) retained earnings free (unrestricted) and (2) retained earnings appropriated (restricted). The total of these two amounts equals the total retained earnings. Comprehensive Income Companies generally include in income all revenues, expenses, gains, and losses LEARNING OBJECTIVE 8 recognized during the period. These items are classified within the income state- Explain how to report other ment so that financial statement readers can better understand the significance of compre hensive income. various components of net income. Changes in accounting principles and correc- tions of errors are excluded from the calculation of net income because their effects relate to prior periods. In recent years, there is increased use of fair values for measuring assets and liabili- ties. Furthermore, possible reporting of gains and losses related to changes in fair value have placed a strain on income reporting. Because fair values are continually changing, some argue that recognizing these gains and losses in net income is misleading. The FASB agrees and has identified a limited number of transactions that should be recorded in other comprehensive income, which affects accumulated other comprehensive income reported in stockholders’ equity. One example is unrealized gains and losses on available- for-sale securities.22 These gains and losses are excluded from net income, thereby 21Accounting Trends and Techniques—2012 (New York: AICPA) indicates that most companies (490 of 500 surveyed) present changes in retained earnings either within the statement of stockholders’ equity (486 firms) or in a separate statement of retained earnings (4 firms). Only 1 of the 500 companies prepares a combined statement of income and retained earnings. 22We further discuss available-for-sale securities in Chapter 17. Additional examples of other comprehensive items are translation gains and losses on foreign currency, unrealized gains and losses on certain hedging transactions, and adjustments related to pensions. Corrections of errors and changes in accounting principles are not considered other comprehensive income items. Other Reporting Issues 183 reducing volatility in net income due to fluctuations in fair value. At the same time, disclosure of the potential gain or loss is provided. Companies include these items that bypass the income statement in a International measure called comprehensive income. Comprehensive income includes all Perspective changes in equity during a period except those resulting from investments by GAAP and IFRS are now owners and distributions to owners. Comprehensive income, therefore, in- converged with respect to cludes the following: all revenues and gains, expenses and losses reported comprehensive income in net income, and all gains and losses that bypass net income but affect stock- reporting. holders’ equity. These items—non-owner changes in equity that bypass the income statement—are referred to as other comprehensive income.

Companies must display the components of other comprehensive income in one of two ways: (1) a single continuous statement (one statement approach) or (2) two sepa- rate, but consecutive statements of net income and other comprehensive income (two statement approach). The one statement approach is often referred to as the statement of comprehensive income. The two statement approach uses the traditional term income statement for the first statement and the comprehensive income statement for the second statement. [10] Under either approach, companies display each component of net income and each component of other comprehensive income. In addition, net income and comprehensive income are reported. Companies are not required to report earnings per share informa- tion related to comprehensive income.23 We illustrate these two alternatives in the next two sections. In each case, assume that V. Gill Inc. reports the following information for 2014: sales revenue $800,000; cost of goods sold $600,000; operating expenses $90,000; and an unrealized holding gain on available-for-sale securities of $30,000, net of tax. One Statement Approach In this approach, the traditional net income is a subtotal, with total comprehensive income shown as a final total. The combined statement has the advantage of not requir- ing the creation of a new financial statement. However, burying net income as a sub- total on the statement is a disadvantage. Illustration 4-24 shows the one statement format for V. Gill. ILLUSTRATION 4-24 V. GILL INC. One Statement Format: STATEMENT OF COMPREHENSIVE INCOME Comprehensive Income FOR THE YEAR ENDED DECEMBER 31, 2014 Sales revenue $800,000 Cost of goods sold 600,000 Gross profit 200,000 Operating expenses 90,000 Net income 110,000 Other comprehensive income Unrealized holding gain, net of tax 30,000 Comprehensive income $140,000 23A company must display the components of other comprehensive income either (1) net of related tax effects, or (2) before related tax effects, with one amount shown for the aggregate amount of tax related to the total amount of other comprehensive income. Both alternatives must show each component of other comprehensive income, net of related taxes either in the face of the statement or in the notes. Accounting Trends and Techniques—2012 indicates that 89 of 490 surveyed companies reporting tax effects provided it in the notes. 184 Chapter 4 Income Statement and Related Information Two Statement Approach Illustration 4-25 shows the two statement format for V. Gill. Reporting comprehensive income in a separate statement indicates that the gains and losses identified as other comprehensive income have the same status as traditional gains and losses. ILLUSTRATION 4-25 V. GILL INC. Two Statement Format: INCOME STATEMENT Comprehensive Income FOR THE YEAR ENDED DECEMBER 31, 2014 Sales revenue $800,000 Cost of goods sold 600,000 Gross profit 200,000 Operating expenses 90,000 Net income $110,000 V. GILL INC. COMPREHENSIVE INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2014 Net income $110,000 Other comprehensive income Unrealized holding gain, net of tax 30,000 Comprehensive income $140,000 Statement of Stockholders’ Equity In addition to a comprehensive income statement, companies also present a statement of stockholders’ equity (often referred to as statement of changes in stockholders’ equity). This statement reports the changes in each stockholders’ equity account and in total stockholders’ equity during the year. Companies often prepare in columnar form the statement of stockholders’ equity. In this format, they use columns for each account and for total stockholders’ equity. Stockholders’ equity is generally com- prised of contributed capital (common and preferred stock and additional paid-in capital), retained earnings, and the accumulated balances in other comprehensive income. The statement reports the change in each stockholders’ equity account and in total stockholders’ equity for the period. The following items are disclosed in this statement. 1. Contributions (issuances of shares) and distributions (dividends) to owners.

2. Reconciliation of the carrying amount of each component of stockholders’ equity from the beginning to the end of the period. To illustrate, assume the same information for V. Gill (on page 183). The com- pany has the following stockholders’ equity account balances at the beginning of 2014: Common Stock $300,000, Retained Earnings $50,000, and Accumulated Other Comprehensive Income $60,000. No changes in the Common Stock account occurred during the year. Illustration 4-26 shows a statement of stockholders’ equity for V. Gill. Other Reporting Issues 185 ILLUSTRATION 4-26 V. GILL INC. Presentation of STATEMENT OF STOCKHOLDERS’ EQUITY Comprehensive Income FOR THE YEAR ENDED DECEMBER 31, 2014 in Stockholders’ Equity Accumulated Statement Other Retained Comprehensive Common Total Earnings Income Stock Beginning balance $410,000 $ 50,000 $60,000 $300,000 Net income 110,000 110,000 Other comprehensive income Unrealized holding gain, net of tax 30,000 30,000 Ending balance $550,000 $160,000 $90,000 $300,000 Balance Sheet Presentation Regardless of the display format used, V. Gill reports accumulated other comprehensive income of $90,000 in the stockholders’ equity section of the balance sheet as follows. ILLUSTRATION 4-27 V. GILL INC. Presentation of BALANCE SHEET Accumulated Other AS OF DECEMBER 31, 2014 Comprehensive Income (STOCKHOLDERS’ EQUITY SECTION) in the Balance Sheet Stockholders’ equity Common stock $300,000 Retained earnings 160,000 Accumulated other comprehensive income 90,000 You will Total stockholders’ equity $550,000 want to read the IFRS INSIGHTS on pages 205–211 By providing information on the components of comprehensive income, as well as for discussion of accumulated other comprehensive income, the company communicates information IFRS related to the about all changes in net assets. With this information, users will better understand the income statement. quality of the company’s earnings. Evolving Issue INCOME REPORTING As indicated in the chapter, information reported in the 1. Disaggregate information so that it is useful in pre- income statement is important to meeting the objective of dicting an entity’s future cash flows. Disaggregation financial reporting. However, there is debate over income means separating resources by the activity in which they reporting practices, be it the controversy over pro forma are used and by their economic characteristics. reporting or whether to report comprehensive income in a 2. Portray a cohesive financial picture of a company’s one statement or a two statement format. In response to these activities. A cohesive financial picture means that the debates and to differences between income reporting under relationship between items across financial statements is U.S. GAAP and IFRS, standard-setters are working on a clear and that a company’s financial statements comple- project to improve the usefulness of the income statement. ment each other as much as possible. Work to date has resulted in two core principles for financial statement presentation (for the income statement, Cohesiveness will be addressed by using the same clas- balance sheet, and the statement of cash flows) based on the sifications across the balance sheet, income statement, and objective of financial reporting: statement of cash flows. The proposed model classifies 186 Chapter 4 Income Statement and Related Information activities as business or financing, although some have Inactive Joint FASB/IASB Projects under the Projects tab), s uggested that each statement be segregated into operating, but it is expected to restart once the projects on financial investing, and financing activities. instruments, revenue recognition, and leases are completed. The statement presentation project is currently inactive on the Boards’ joint agenda (see www.fasb.org and click on KEY TERMS SUMMARY OF LEARNING OBJECTIVES accumulated other comprehensive income, 185 1 Understand the uses and limitations of an income statement. The Appropriated Retained Earnings, 182 income statement provides investors and creditors with information that helps them

predict the amounts, timing, and uncertainty of future cash flows. Also, the income capital maintenance approach, 163(n) statement helps users determine the risk (level of uncertainty) of not achieving particu- changes in accounting lar cash flows. The limitations of an income statement are as follows. (1) The statement estimates, 180 does not include many items that contribute to general growth and well-being of a changes in accounting company. (2) Income numbers are often affected by the accounting methods used. principle, 179 (3) Income measures are subject to estimates. comprehensive The transaction approach focuses on the activities that occurred during a given income, 183 period. Instead of presenting only a net change in net assets, it discloses the components current operating of the change. The transaction approach to income measurement requires the use of performance revenue, expense, loss, and gain accounts. approach, 168 2 Describe the content and format of the income statement. The major discontinued elements of the income statement are as follows. (1) Revenues: Inflows or other enhance- operation, 170 ments of assets of an entity or settlements of its liabilities during a period from deliver- earnings ing or producing goods, rendering services, or other activities that constitute the entity’s management, 161 ongoing major or central operations. (2) Expenses: Outflows or other using-up of assets earnings per share, 177 or incurrences of liabilities during a period from delivering or producing goods, render- extraordinary items, 173 ing services, or carrying out other activities that constitute the entity’s ongoing major or income statement, 160 central operations. (3) Gains: Increases in equity (net assets) from peripheral or inciden- intraperiod tax tal transactions of an entity except those that result from revenues or investments by allocation, 171 owners. (4) Losses: Decreases in equity (net assets) from peripheral or incidental transac- modified all-inclusive tions of an entity except those that result from expenses or distributions to owners. concept, 169 multiple-step income 3 Prepare an income statement. In a single-step income statement, just two statement, 164 groupings exist: revenues and expenses. Expenses are deducted from revenues to arrive noncontrolling (minority) at net income or loss—a single subtraction. Frequently, companies report income tax interest, 176 separately as the last item before net income. other comprehensive A multiple-step income statement shows two further classifications: (1) a separation income, 183 of operating results from those obtained through the subordinate or nonoperating prior period activities of the company, and (2) a classification of expenses by functions, such as adjustments, 181 merchandising or manufacturing, selling, and administration. quality of earnings, 162 4 Explain how to report various income items. Companies generally include single-step income irregular gains or losses or nonrecurring items in the income statement as follows. statement, 167 (1) Other items of a material amount that are of an unusual or nonrecurring nature and statement of are not considered extraordinary are separately disclosed as a component of continuing comprehensive operations. (2) Discontinued operations of a component of a business are classified as income, 160(n) a separate item, after continuing operations. (3) The unusual, material, nonrecurring statement of stockholders’ items that are significantly different from the customary business activities are shown in equity, 184 a separate section for extraordinary items, below discontinued operations. If a company transaction approach, 162 holds a noncontrolling interest in a subsidiary company, it must present an allocation of net income or loss that is attributable to the noncontrolling interest. Demonstration Problem 187 5 Identify where to report earnings per share information. Because of the inherent dangers of focusing attention solely on earnings per share, the profession con- cluded that companies must disclose earnings per share on the face of the income state-

ment. A company that reports a discontinued operation or an extraordinary item must report per share amounts for these line items either on the face of the income statement or in the notes to the financial statements. 6 Understand the reporting of accounting changes and errors. Changes in accounting principle and corrections of errors are adjusted through retained earnings. Changes in estimates are a normal part of the accounting process. The effects of these changes are handled prospectively, with the effects recorded in income in the period of change and in future periods without adjustment to retained earnings. 7 Prepare a retained earnings statement. The retained earnings statement should disclose net income (loss), dividends, adjustments due to changes in accounting principles, error corrections, and restrictions of retained earnings. 8 Explain how to report other comprehensive income. Companies report the components of other comprehensive income in one of two ways: (1) a single state- ment of comprehensive income (one statement format) or (2) in a second statement (two statement format). DEMONSTRATION PROBLEM Presented below are 11 income statement items from Braun Company for the year ended December 31, 2014. Sales revenue $2,700,000 Cost of goods sold 1,150,000 Interest revenue 15,000 Loss from abandonment of plant assets 45,000 Gain from extinguishment of debt 28,000 Unrealized holding loss on an available-for-sale investment, net of tax 12,000 Selling expenses 290,000 Administrative expenses 190,000 Effect of change in estimated useful lives of fi xed assets 35,000 Loss from earthquake (unusual and infrequent) 30,000 Gain on disposal of a component of Braun’s business 50,000 Instructions (a) Using the information above, prepare a condensed multiple-step income statement. Assume a tax rate of 30% and 100,000 shares of common stock outstanding during 2014. (b) Compute comprehensive income for Braun in 2014. Solution (a) BRAUN COMPANY INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2014 Sales revenue $2,700,000 Cost of goods sold 1,150,000 Gross profi t 1,550,000 Selling expenses $290,000 Administrative expenses 190,000 480,000 Income from operations 1,070,000 Other revenues and gains Interest revenue 15,000 Gain on debt extinguishment 28,000 43,000 188 Chapter 4 Income Statement and Related Information Other expenses and losses Loss from plant abandonment (45,000) Income before income taxes 1,068,000 Income taxes (30%) 320,400 Income from continuing operations 747,600 Discontinued operations Gain from disposal of component of business 50,000 Less: Applicable income tax 15,000 35,000 Income before extraordinary items 782,600 Extraordinary items Loss from earthquake 30,000 Less: Applicable income tax 9,000 (21,000) Net income $ 761,600 Per share of common stock Income from continuing operations $ 7.48 Discontinued operations 0.35 Income before extraordinary item 7.83 Extraordinary item, net of tax (0.21) Net income $ 7.61 (b) Net income $761,600 Unrealized holding loss on available-for-sale investment, net of tax 12,000 Comprehensive income $749,600 FASB CODIFICATION FASB Codification References [1] FASB ASC 225-20-45-4. [Predecessor literature: “Reporting the Results of Operations,” Opinions of the Accounting Principles Board No. 30 (New York: AICPA, 1973), par. 23, as amended by “Accounting for the Impairment or Disposal of Long-lived Assets,” Statement of Financial Accounting Standards No. 144 (Norwalk, Conn.: FASB, 2001).] [2] FASB ASC 224-20-45-2. [Predecessor literature: “Reporting the Results of Operations,” Opinions of the Accounting Principles Board No. 30 (New York: AICPA, 1973), par. 20.] [3] FASB ASC 205-20-45. [Predecessor literature: “Accounting for the Impairment or Disposal of Long-lived Assets,” Statement of Financial Accounting Standards No. 144 (Norwalk, Conn.: FASB, 2001), par. 4.] [4] FASB ASC 225-20-45-2. [Predecessor literature: “Reporting the Results of Operations,” Opinions of the Accounting Principles Board No. 30 (New York: AICPA, 1973), par. 20.] [5] FASB ASC 225-20-45-3. [Predecessor literature: “Reporting the Results of Operations,” Opinions of the Accounting Principles

Board No. 30 (New York: AICPA, 1973), par. 24, as amended by “Accounting for the Impairment or Disposal of Long-lived Assets,” Statement of Financial Accounting Standards No. 144 (Norwalk, Conn.: FASB, 2001).] [6] FASB ASC 810-10-45. [Predecessor literature: “Consolidated Financial Statements,” Accounting Research Bulletin No. 51 (August 1959).] [7] FASB ASC 260. [Predecessor literature: “Earnings Per Share,” Statement of Financial Accounting Standards No. 128 (Norwalk, Conn.: FASB, 1996).] [8] FASB ASC 260-10-10-2. [Predecessor literature: “Earnings Per Share,” Statement of Financial Accounting Standards No. 128 (Norwalk, Conn.: FASB, 1996), par. 11.] [9] FASB ASC 250. [Predecessor literature: “Accounting Changes and Error Corrections,” Statement of Financial Accounting Standards No. 154 (Norwalk, Conn.: FASB, 2005).] [10] FASB ASC 220. [Predecessor literature: “Reporting Comprehensive Income,” Statement of Financial Accounting Standards No. 130 (Norwalk, Conn.: FASB, 1997).] Exercises If your school has a subscription to the FASB Codification, go to http://aahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. Questions 189 CE4-1 Access the glossary (“Master Glossary”) to answer the following. (a) What is a change in accounting estimate? (b) How is a change in accounting principle distinguished from a “change in accounting estimate effected by a change in accounting principle”? (c) What is the formal definition of comprehensive income? CE4-2 What distinguishes an item that is “unusual in nature” from an item that is considered “extraordinary”? CE4-3 Enyart Company experienced a catastrophic loss in the second quarter of the year. The loss meets the criteria for extraor- dinary item reporting, but Enyart’s controller is unsure whether this item should be reported as extraordinary in the second quarter interim report. Advise the controller. CE4-4 What guidance does the SEC provide for public companies with respect to the reporting of the “effect of preferred stock dividends and accretion of carrying amount of preferred stock on earnings per share”? An additional Codification case can be found in the Using Your Judgment section, on page 205. Be sure to check the book’s companion website for a Review and Analysis Exercise, with solution. Brief Exercises, Exercises, Problems, and many more learning and assessment tools and resources are available for practice in WileyPLUS. QUESTIONS 1. What kinds of questions about future cash flows do inves- 10. What is the major distinction (a) between revenues and tors and creditors attempt to answer with information in gains and (b) between expenses and losses? the income statement? 11. What are the advantages and disadvantages of the single- 2. How can information based on past transactions be used step income statement? to predict future cash flows? 12. What is the basis for distinguishing between operating 3. Identify at least two situations in which important changes and nonoperating items? in value are not reported in the income statement. 13. Distinguish between the modified all-inclusive income 4. Identify at least two situations in which application of statement and the current operating performance income different accounting methods or accounting estimates statement. According to present generally accepted ac- results in difficulties in comparing companies. counting principles, which is recommended? Explain. 5. Explain the transaction approach to measuring income. 14. How should correction of errors be reported in the finan- Why is the transaction approach to income measurement cial statements? preferable to other ways of measuring income? 15. Discuss the appropriate treatment in the financial state- 6. What is earnings management? ments of each of the following. 7. How can earnings management affect the quality of (a) An amount of $113,000 realized in excess of the cash earnings? surrender value of an insurance policy on the life of one of the founders of the company who died during

8. Why should caution be exercised in the use of the net in- the year. come figure derived in an income statement? What are the objectives of generally accepted accounting principles in (b) A profit-sharing bonus to employees computed as a their application to the income statement? percentage of net income. 9. A Wall Street Journal article noted that Apple reported (c) Additional depreciation on factory machinery because of an error in computing depreciation for the previous higher income than its competitors by using a more aggres- year. sive policy for recognizing revenue on future upgrades to its products. Some contend that Apple’s quality of earnings (d) Rent received from subletting a portion of the office is low. What does the term “quality of earnings” mean? space. 190 Chapter 4 Income Statement and Related Information (e) A patent infringement suit, brought 2 years ago 21. Cooper Investments reported an unusual gain from the against the company by another company, was settled sale of certain assets in its 2014 income statement. How this year by a cash payment of $725,000. does intraperiod tax allocation affect the reporting of this unusual gain? (f) A reduction in the Allowance for Doubtful Accounts balance because the account appears to be consider- 22. Discuss the appropriate treatment in the income state- ably in excess of the probable loss from uncollectible ment for the following items: receivables. (a) Loss on discontinued operations. 16. Indicate where the following items would ordinarily (b) Noncontrolling interest allocation. appear on the financial statements of Boleyn, Inc. for the (c) Earnings per share. year 2014. (d) Gain on sale of equipment. (a) The service life of certain equipment was changed 2 3. Lebron Co. owns most but not all of the shares of its from 8 to 5 years. If a 5-year life had been used previ- subsidiary Bryant Inc. Lebron reported net income of ously, additional depreciation of $425,000 would have $124,700. The amount to be attributed to the noncontrol- been charged. ling interest in Bryant is $30,000. Indicate how Lebron will (b) In 2014, a flood destroyed a warehouse that had a report the noncontrolling interest in its income statement. book value of $1,600,000. Floods are rare in this locality. 24. What effect does intraperiod tax allocation have on (c) In 2014, the company wrote off $1,000,000 of inven- reported net income? tory that was considered obsolete. 25. Neumann Company computed earnings per share as (d) An income tax refund related to the 2011 tax year was follows. received. Net income (e) In 2011, a supply warehouse with an expected useful Common shares outstanding at year-end life of 7 years was erroneously expensed. Neumann has a simple capital structure. What possible (f) Boleyn, Inc. changed from weighted-average to FIFO errors might the company have made in the computation? inventory pricing. Explain. 17. Indicate the section of a multiple-step income statement 26. Qualls Corporation reported 2014 earnings per share in which each of the following is shown. of $7.21. In 2015, Qualls reported earnings per share as (a) Loss on inventory write-down. follows. (b) Loss from strike. On income before extraordinary item $6.40 On extraordinary item 1.88 (c) Bad debt expense. On net income $8.28 (d) Loss on disposal of a component of the business. (e) Gain on sale of machinery. Is the increase in earnings per share from $7.21 to $8.28 a (f) Interest revenue. favorable trend? (g) Depreciation expense. 27. What is meant by “tax allocation within a period”? What (h) Material write-offs of notes receivable. is the justification for such practice? 18. Perlman Land Development, Inc. purchased land for 28. When does tax allocation within a period become neces- $70,000 and spent $30,000 developing it. It then sold the sary? How should this allocation be handled? land for $160,000. Sheehan Manufacturing purchased 29. During 2014, Liselotte Company earned income of $1,500,000 land for a future plant site for $100,000. Due to a change in before income taxes and realized a gain of $450,000 on a

plans, Sheehan later sold the land for $160,000. Should government-forced condemnation sale of a division plant these two companies report the land sales, both at gains of facility. The income is subject to income taxation at the rate $60,000, in a similar manner? of 34%. The gain on the sale of the plant is taxed at 30%. 19. You run into Greg Norman at a party and begin discussing Proper accounting suggests that the unusual gain be financial statements. Greg says, “I prefer the single-step in- reported as an extraordinary item. Illustrate an appropriate come statement because the multiple-step format generally presentation of these items in the income statement. overstates income.” How should you respond to Greg? 30. On January 30, 2013, a suit was filed against Frazier 20. Santo Corporation has eight expense accounts in its gen- Corporation under the Environmental Protection Act. On eral ledger which could be classified as selling expenses. August 6, 2014, Frazier Corporation agreed to settle the Should Santo report these eight expenses separately in its action and pay $920,000 in damages to certain current income statement or simply report one total amount for and former employees. How should this settlement be selling expenses? reported in the 2014 financial statements? Discuss. Brief Exercises 191 31. Linus Paper Company decided to close two small pulp 34. State some of the more serious problems encountered mills in Conway, New Hampshire, and Corvallis, Oregon. in seeking to achieve the ideal measurement of periodic Would these closings be reported in a separate section net income. Explain what accountants do as a practical entitled “Discontinued operations after income from alternative. continuing operations”? Discuss. 35. What is meant by the terms elements and items as they 32. What major types of items are reported in the retained relate to the income statement? Why might items have to earnings statement? be disclosed in the income statement? 33. Generally accepted accounting principles usually require 36. What are the two ways that other comprehensive income the use of accrual accounting to “fairly present” income. If may be displayed (reported)? the cash receipts and disbursements method of account- 37. How should the disposal of a component of a business be ing will “clearly reflect” taxable income, why does this disclosed in the income statement? method not usually also “fairly present” income? BRIEF EXERCISES 3 BE4-1 Starr Co. had sales revenue of $540,000 in 2014. Other items recorded during the year were: Cost of goods sold $330,000 Salaries and wages expense 120,000 Income tax expense 25,000 Increase in value of company reputation 15,000 Other operating expenses 10,000 Unrealized gain on value of patents 20,000 Prepare a single-step income statement for Starr for 2014. Starr has 100,000 shares of stock outstanding. 3 BE4-2 Brisky Corporation had net sales of $2,400,000 and interest revenue of $31,000 during 2014. Expenses for 2014 were cost of goods sold $1,450,000; administrative expenses $212,000; selling expenses $280,000; and interest expense $45,000. Brisky’s tax rate is 30%. The corporation had 100,000 shares of com- mon stock authorized and 70,000 shares issued and outstanding during 2014. Prepare a single-step income statement for the year ended December 31, 2014. 3 BE4-3 Using the information provided in BE4-2, prepare a condensed multiple-step income statement for Brisky Corporation. 2 3 BE4-4 Finley Corporation had income from continuing operations of $10,600,000 in 2014. During 2014, it 4 disposed of its restaurant division at an after-tax loss of $189,000. Prior to disposal, the division operated at a loss of $315,000 (net of tax) in 2014. Finley had 10,000,000 shares of common stock outstanding during 2014. Prepare a partial income statement for Finley beginning with income from continuing operations. 2 3 BE4-5 Stacy Corporation had income before income taxes for 2014 of $6,300,000. In addition, it suffered an 4 unusual and infrequent pretax loss of $770,000 from a volcano eruption. The corporation’s tax rate is 30%.

Prepare a partial income statement for Stacy beginning with income before income taxes. The corporation had 5,000,000 shares of common stock outstanding during 2014. 6 BE4-6 During 2014, Williamson Company changed from FIFO to weighted-average inventory pricing. Pretax income in 2013 and 2012 (Williamson’s first year of operations) under FIFO was $160,000 and $180,000, respectively. Pretax income using weighted-average pricing in the prior years would have been $145,000 in 2013 and $170,000 in 2012. In 2014, Williamson Company reported pretax income (using weighted-average pricing) of $180,000. Show comparative income statements for Williamson Company, beginning with “Income before income tax,” as presented on the 2014 income statement. (The tax rate in all years is 30%.) 6 BE4-7 Vandross Company has recorded bad debt expense in the past at a rate of 1½% of net sales. In 2014, Vandross decides to increase its estimate to 2%. If the new rate had been used in prior years, cumulative bad debt expense would have been $380,000 instead of $285,000. In 2014, bad debt expense will be $120,000 instead of $90,000. If Vandross’s tax rate is 30%, what amount should it report as the cumulative effect of changing the estimated bad debt rate? 5 BE4-8 In 2014, Hollis Corporation reported net income of $1,000,000. It declared and paid preferred stock dividends of $250,000. During 2014, Hollis had a weighted average of 190,000 common shares outstanding. Compute Hollis’s 2014 earnings per share. 192 Chapter 4 Income Statement and Related Information 7 BE4-9 Portman Corporation has retained earnings of $675,000 at January 1, 2014. Net income during 2014 was $1,400,000, and cash dividends declared and paid during 2014 totaled $75,000. Prepare a retained earn- ings statement for the year ended December 31, 2014. 6 7 BE4-10 Using the information from BE4-9, prepare a retained earnings statement for the year ended December 31, 2014. Assume an error was discovered: land costing $80,000 (net of tax) was charged to main- tenance and repairs expense in 2011. 8 BE4-11 On January 1, 2014, Richards Inc. had cash and common stock of $60,000. At that date, the com- pany had no other asset, liability, or equity balances. On January 2, 2014, it purchased for cash $20,000 of equity securities that it classified as available-for-sale. It received cash dividends of $3,000 during the year on these securities. In addition, it has an unrealized holding gain on these securities of $4,000 net of tax. Determine the following amounts for 2014: (a) net income, (b) comprehensive income, (c) other compre- hensive income, and (d) accumulated other comprehensive income (end of 2014). EXERCISES 2 E4-1 (Computation of Net Income) Presented below are changes in all the account balances of Fritz Reiner Furniture Co. during the current year, except for retained earnings. Increase Increase (Decrease) (Decrease) Cash $ 79,000 Accounts Payable $ (51,000) Accounts Receivable (net) 45,000 Bonds Payable 82,000 Inventory 127,000 Common Stock 125,000 Investments (47,000) Paid-In Capital in Excess of Par—Common Stock 13,000 Instructions Compute the net income for the current year, assuming that there were no entries in the Retained Earnings account except for net income and a dividend declaration of $19,000 which was paid in the current year. 2 4 E4-2 (Compute Income Measures) Presented below is information related to Viel Company at December 31, 2014, the end of its first year of operations. Sales revenue $310,000 Cost of goods sold 140,000 Selling and administrative expenses 50,000 Gain on sale of plant assets 30,000 Unrealized gain on available-for-sale investments 10,000 Interest expense 6,000 Loss on discontinued operations 12,000 Allocation to noncontrolling interest 40,000 Dividends declared and paid 5,000 Instructions Compute the following: (a) income from operations, (b) net income, (c) net income attributable to Viel Company’s controlling shareholders, (d) comprehensive income, and (e) retained earnings balance at December 31, 2014. 2 4 E4-3 (Income Statement Items) Presented below are certain account balances of Paczki Products Co.

Rent revenue $ 6,500 Sales discounts $ 7,800 Interest expense 12,700 Selling expenses 99,400 Beginning retained earnings 114,400 Sales revenue 390,000 Ending retained earnings 134,000 Income tax expense 31,000 Dividend revenue 71,000 Cost of goods sold 184,400 Sales returns and allowances 12,400 Administrative expenses 82,500 Allocation to noncontrolling interest 17,000 Instructions From the foregoing, compute the following: (a) total net revenue, (b) net income, (c) dividends declared, and (d) income attributable to controlling stockholders. 2 3 E4-4 (Single-Step Income Statement) The financial records of LeRoi Jones Inc. were destroyed by fire at the end of 2014. Fortunately, the controller had kept certain statistical data related to the income statement as follows. Exercises 193 1. The beginning merchandise inventory was $92,000 and decreased 20% during the current year. 2. Sales discounts amount to $17,000. 3. 20,000 shares of common stock were outstanding for the entire year. 4. Interest expense was $20,000. 5. The income tax rate is 30%. 6. Cost of goods sold amounts to $500,000. 7. Administrative expenses are 20% of cost of goods sold but only 8% of gross sales. 8. Four-fifths of the operating expenses relate to sales activities. Instructions From the foregoing information prepare an income statement for the year 2014 in single-step form. 2 3 E4-5 (Multiple-Step and Single-Step) Two accountants for the firm of Elwes and Wright are arguing about the merits of presenting an income statement in a multiple-step versus a single-step format. The discussion involves the following 2014 information related to P. Bride Company ($000 omitted). Administrative expense Offi cers’ salaries $ 4,900 Depreciation of offi ce furniture and equipment 3,960 Cost of goods sold 60,570 Rent revenue 17,230 Selling expense Delivery expense 2,690 Sales commissions 7,980 Depreciation of sales equipment 6,480 Sales revenue 96,500 Income tax 9,070 Interest expense 1,860 Instructions (a) Prepare an income statement for the year 2014 using the multiple-step form. Common shares out- standing for 2014 total 40,550 (000 omitted). (b) Prepare an income statement for the year 2014 using the single-step form. (c) Which one do you prefer? Discuss. 2 3 E4-6 (Multiple-Step and Extraordinary Items) The following balances were taken from the books of 5 Maria Conchita Alonzo Corp. on December 31, 2014. Interest revenue $ 86,000 Accumulated depreciation—equipment $ 40,000 Cash 51,000 Accumulated depreciation—buildings 28,000 Sales revenue 1,380,000 Notes receivable 155,000 Accounts receivable 150,000 Selling expenses 194,000 Prepaid insurance 20,000 Accounts payable 170,000 Sales returns and allowances 150,000 Bonds payable 100,000 Allowance for doubtful accounts 7,000 Administrative and general expenses 97,000 Sales discounts 45,000 Accrued liabilities 32,000 Land 100,000 Interest expense 60,000 Equipment 200,000 Notes payable 100,000 Buildings 140,000 Loss from earthquake damage Cost of goods sold 621,000 (extraordinary item) 150,000 Common stock 500,000 Retained earnings 21,000 Assume the total effective tax rate on all items is 34%. Instructions Prepare a multiple-step income statement; 100,000 shares of common stock were outstanding during the year. 2 3 E4-7 (Multiple-Step and Single-Step) The accountant of Latifa Shoe Co. has compiled the following 5 information from the company’s records as a basis for an income statement for the year ended December 31, 2014. Rent revenue $ 29,000 Interest expense 18,000 Market appreciation on land above cost 31,000 Salaries and wages expense (selling) 114,800 Supplies (selling) 17,600 Income tax 37,400 Salaries and wages expense (administrative) 135,900 194 Chapter 4 Income Statement and Related Information Other administrative expenses $ 51,700 Cost of goods sold 496,000 Net sales 980,000 Depreciation on plant assets (70% selling, 30% administrative) 65,000 Cash dividends declared 16,000 There were 20,000 shares of common stock outstanding during the year. Instructions (a) Prepare a multiple-step income statement.

(b) Prepare a single-step income statement. (c) Which format do you prefer? Discuss. 3 4 E4-8 (Income Statement, EPS) Presented below are selected ledger accounts of Tucker Corporation as of December 31, 2014. 5 Cash $ 50,000 Administrative expenses 100,000 Selling expenses 80,000 Net sales 540,000 Cost of goods sold 210,000 Cash dividends declared (2014) 20,000 Cash dividends paid (2014) 15,000 Discontinued operations (loss before income taxes) 40,000 Depreciation expense, not recorded in 2013 30,000 Retained earnings, December 31, 2013 90,000 Effective tax rate 30% Instructions (a) Compute net income for 2014. (b) Prepare a partial income statement beginning with income from continuing operations before income tax, and including appropriate earnings per share information. Assume 10,000 shares of common stock were outstanding during 2014. 3 4 E4-9 (Multiple-Step Statement with Retained Earnings) Presented below is information related to Ivan 5 7 Calderon Corp. for the year 2014. Net sales $1,300,000 Write-off of inventory due to obsolescence $ 80,000 Cost of goods sold 780,000 Depreciation expense omitted by accident in 2013 55,000 Selling expenses 65,000 Casualty loss (extraordinary item) before taxes 50,000 Administrative expenses 48,000 Cash dividends declared 45,000 Dividend revenue 20,000 Retained earnings at December 31, 2013 980,000 Interest revenue 7,000 Effective tax rate of 34% on all items Instructions (a) Prepare a multiple-step income statement for 2014. Assume that 60,000 shares of common stock are outstanding. (b) Prepare a separate retained earnings statement for 2014. 5 E4-10 (Earnings per Share) The stockholders’ equity section of Tkachuk Corporation appears below as of December 31, 2014. 8% preferred stock, $50 par value, authorized 100,000 shares, outstanding 90,000 shares $ 4,500,000 Common stock, $1.00 par, authorized and issued 10 million shares 10,000,000 Additional paid-in capital 20,500,000 Retained earnings $134,000,000 Net income 33,000,000 167,000,000 $202,000,000 Net income for 2014 reflects a total effective tax rate of 34%. Included in the net income figure is a loss of $18,000,000 (before tax) as a result of a major casualty, which should be classified as an extraordinary item. Preferred stock dividends of $360,000 were declared and paid in 2014. Dividends of $1,000,000 were declared and paid to common stockholders in 2014. Instructions Compute earnings per share data as it should appear on the income statement of Tkachuk Corporation. 3 4 E4-11 (Condensed Income Statement—Periodic Inventory Method) The following are selected ledger 5 7 accounts of Spock Corporation at December 31, 2014. Exercises 195 Cash $ 185,000 Salaries and wages expense (sales) $284,000 Inventory 535,000 Salaries and wages expense (offi ce) 346,000 Sales revenue 4,275,000 Purchase returns 15,000 Unearned sales revenue 117,000 Sales returns and allowances 79,000 Purchases 2,786,000 Freight-in 72,000 Sales discounts 34,000 Accounts receivable 142,500 Purchase discounts 27,000 Sales commissions 83,000 Selling expenses 69,000 Telephone and Internet expense (sales) 17,000 Accounting and legal services 33,000 Utilities expense (offi ce) 32,000 Insurance expense (offi ce) 24,000 Miscellaneous offi ce expenses 8,000 Advertising expense 54,000 Rent revenue 240,000 Delivery expense 93,000 Extraordinary loss (before tax) 70,000 Depreciation expense (offi ce equipment) 48,000 Interest expense 176,000 Depreciation expense (sales equipment) 36,000 Common stock ($10 par) 900,000 Spock’s effective tax rate on all items is 34%. A physical inventory indicates that the ending inventory is $686,000. Instructions Prepare a condensed 2014 income statement for Spock Corporation. 7 E4-12 (Retained Earnings Statement) Eddie Zambrano Corporation began operations on January 1, 2011. During its first 3 years of operations, Zambrano reported net income and declared dividends as follows. Net Income Dividends Declared 2011 $ 40,000 $ –0– 2012 125,000 50,000 2013 160,000 50,000 The following information relates to 2014. Income before income tax $240,000

Prior period adjustment: understatement of 2012 depreciation expense (before taxes) $ 25,000 Cumulative decrease in income from change in inventory methods (before taxes) $ 35,000 Dividends declared (of this amount, $25,000 will be paid on Jan. 15, 2015) $100,000 Effective tax rate 40% Instructions (a) Prepare a 2014 retained earnings statement for Eddie Zambrano Corporation. (b) Assume Eddie Zambrano Corp. restricted retained earnings in the amount of $70,000 on December 31, 2014. After this action, what would Zambrano report as total retained earnings in its December 31, 2014, balance sheet? 5 E4-13 (Earnings per Share) At December 31, 2013, Shiga Naoya Corporation had the following stock outstanding. 10% cumulative preferred stock, $100 par, 107,500 shares $10,750,000 Common stock, $5 par, 4,000,000 shares 20,000,000 During 2014, Shiga Naoya did not issue any additional common stock. The following also occurred during 2014. Income from continuing operations before taxes $23,650,000 Discontinued operations (loss before taxes) $ 3,225,000 Preferred dividends declared $ 1,075,000 Common dividends declared $ 2,200,000 Effective tax rate 35% Instructions Compute earnings per share data as it should appear in the 2014 income statement of Shiga Naoya Corpo- ration. (Round to two decimal places.) 4 E4-14 (Change in Accounting Principle) Tim Mattke Company began operations in 2012 and for simplic- ity reasons, adopted weighted-average pricing for inventory. In 2014, in accordance with other companies in its industry, Mattke changed its inventory pricing to FIFO. The pretax income data is reported below. Weighted- Year Average FIFO 2012 $370,000 $395,000 2013 390,000 430,000 2014 410,000 450,000 196 Chapter 4 Income Statement and Related Information Instructions (a) What is Mattke’s net income in 2014? Assume a 35% tax rate in all years. (b) Compute the cumulative effect of the change in accounting principle from weighted-average to FIFO inventory pricing. (c) Show comparative income statements for Tim Mattke Company, beginning with income before income tax, as presented on the 2014 income statement. 3 8 E4-15 (Comprehensive Income) Roxanne Carter Corporation reported the following for 2014: net sales $1,200,000; cost of goods sold $750,000; selling and administrative expenses $320,000; and an unrealized holding gain on available-for-sale securities $18,000. Instructions Prepare a statement of comprehensive income, using (a) the one statement format, and (b) the two statement format. (Ignore income taxes and earnings per share.) 7 8 E4-16 (Comprehensive Income) C. Reither Co. reports the following information for 2014: sales revenue $700,000; cost of goods sold $500,000; operating expenses $80,000; and an unrealized holding loss on available-for-sale securities for 2014 of $60,000. It declared and paid a cash dividend of $10,000 in 2014. C. Reither Co. has January 1, 2014, balances in common stock $350,000; accumulated other comprehen- sive income $80,000; and retained earnings $90,000. It issued no stock during 2014. Instructions Prepare a statement of stockholders’ equity. 3 4 E4-17 (Various Reporting Formats) The following information was taken from the records of Roland Carlson Inc. for the year 2014. Income tax applicable to income from continuing operations $187,000; 5 7 income tax applicable to loss on discontinued operations $25,500; income tax applicable to extraordinary 8 gain $32,300; income tax applicable to extraordinary loss $20,400; and unrealized holding gain on available- for-sale securities $15,000. Extraordinary gain $ 95,000 Cash dividends declared $ 150,000 Loss on discontinued operations 75,000 Retained earnings January 1, 2014 600,000 Administrative expenses 240,000 Cost of goods sold 850,000 Rent revenue 40,000 Selling expenses 300,000 Extraordinary loss 60,000 Sales revenue 1,900,000 Shares outstanding during 2014 were 100,000. Instructions (a) Prepare a single-step income statement. (b) Prepare a comprehensive income statement for 2014, using the two statement format. (c) Prepare a retained earnings statement for 2014.

EXERCISES SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of exercises. PROBLEMS 3 4 P4-1 (Multiple-Step Income, Retained Earnings) The following information is related to Dickinson 5 7 Company for 2014. Retained earnings balance, January 1, 2014 $ 980,000 Sales revenue 25,000,000 Cost of goods sold 16,000,000 Interest revenue 70,000 Selling and administrative expenses 4,700,000 Write-off of goodwill 820,000 Income taxes for 2014 1,244,000 Gain on the sale of investments (normal recurring) 110,000 Loss due to fl ood damage—extraordinary item (net of tax) 390,000 Loss on the disposition of the wholesale division (net of tax) 440,000 Loss on operations of the wholesale division (net of tax) 90,000 Problems 197 Dividends declared on common stock $250,000 Dividends declared on preferred stock 80,000 Dickinson Company decided to discontinue its entire wholesale operations and to retain its manufacturing operations. On September 15, Dickinson sold the wholesale operations to Rogers Company. During 2014, there were 500,000 shares of common stock outstanding all year. Instructions Prepare a multiple-step income statement and a retained earnings statement. 3 5 P4-2 (Single-Step Income, Retained Earnings, Periodic Inventory) Presented below is the trial balance 7 of Thompson Corporation at December 31, 2014. THOMPSON CORPORATION TRIAL BALANCE DECEMBER 31, 2014 Debit Credit Purchase Discounts $ 10,000 Cash $ 189,700 Accounts Receivable 105,000 Rent Revenue 18,000 Retained Earnings 160,000 Salaries and Wages Payable 18,000 Sales Revenue 1,100,000 Notes Receivable 110,000 Accounts Payable 49,000 Accumulated Depreciation—Equipment 28,000 Sales Discounts 14,500 Sales Returns and Allowances 17,500 Notes Payable 70,000 Selling Expenses 232,000 Administrative Expenses 99,000 Common Stock 300,000 Income Tax Expense 53,900 Cash Dividends 45,000 Allowance for Doubtful Accounts 5,000 Supplies 14,000 Freight-In 20,000 Land 70,000 Equipment 140,000 Bonds Payable 100,000 Gain on Sale of Land 30,000 Accumulated Depreciation—Buildings 19,600 Inventory 89,000 Buildings 98,000 Purchases 610,000 Totals $1,907,600 $1,907,600 A physical count of inventory on December 31 resulted in an inventory amount of $64,000; thus, cost of goods sold for 2014 is $645,000. Instructions Prepare a single-step income statement and a retained earnings statement. Assume that the only changes in retained earnings during the current year were from net income and dividends. Thirty thousand shares of common stock were outstanding the entire year. 3 4 P4-3 (Irregular Items) Maher Inc. reported income from continuing operations before taxes during 2014 5 of $790,000. Additional transactions occurring in 2014 but not considered in the $790,000 are as follows. 1. The corporation experienced an uninsured flood loss (extraordinary) in the amount of $90,000 during the year. The tax rate on this item is 46%. 2. At the beginning of 2012, the corporation purchased a machine for $54,000 (salvage value of $9,000) that had a useful life of 6 years. The bookkeeper used straight-line depreciation for 2012, 2013, and 2014 but failed to deduct the salvage value in computing the depreciation base. 3. Sale of securities held as a part of its portfolio resulted in a loss of $57,000 (pretax). 198 Chapter 4 Income Statement and Related Information 4. When its president died, the corporation realized $150,000 from an insurance policy. The cash sur- render value of this policy had been carried on the books as an investment in the amount of $46,000 (the gain is nontaxable). 5. The corporation disposed of its recreational division at a loss of $115,000 before taxes. Assume that this transaction meets the criteria for discontinued operations. 6. The corporation decided to change its method of inventory pricing from average-cost to the FIFO method. The effect of this change on prior years is to increase 2012 income by $60,000 and decrease 2013 income by $20,000 before taxes. The FIFO method has been used for 2014. The tax rate on these items is 40%.

Instructions Prepare an income statement for the year 2014 starting with income from continuing operations before taxes. Compute earnings per share as it should be shown on the face of the income statement. Common shares out- standing for the year are 120,000 shares. (Assume a tax rate of 30% on all items, unless indicated otherwise.) 3 4 P4-4 (Multiple- and Single-Step Income, Retained Earnings) The following account balances were in- cluded in the trial balance of Twain Corporation at June 30, 2014. 5 6 7 Sales revenue $1,578,500 Depreciation expense (offi ce Sales discounts 31,150 furniture and equipment) $ 7,250 Cost of goods sold 896,770 Property tax expense 7,320 Salaries and wages expense (sales) 56,260 Bad debt expense (selling) 4,850 Sales commissions 97,600 Maintenance and repairs Travel expense (salespersons) 28,930 expense (administration) 9,130 Delivery expense 21,400 Offi ce expense 6,000 Entertainment expense 14,820 Sales returns and allowances 62,300 Telephone and Internet expense (sales) 9,030 Dividends received 38,000 Depreciation expense (sales equipment) 4,980 Interest expense 18,000 Maintenance and repairs expense (sales) 6,200 Income tax expense 102,000 Miscellaneous selling expenses 4,715 Depreciation understatement Offi ce supplies used 3,450 due to error—2011 (net of tax) 17,700 Telephone and Internet expense Dividends declared on (administration) 2,820 preferred stock 9,000 Dividends declared on common stock 37,000 T he Retained Earnings account had a balance of $337,000 at July 1, 2013. There are 80,000 shares of common stock outstanding. Instructions (a) Using the multiple-step form, prepare an income statement and a retained earnings statement for the year ended June 30, 2014. (b) Using the single-step form, prepare an income statement and a retained earnings statement for the year ended June 30, 2014. 3 4 P4-5 (Irregular Items) Presented below is a combined single-step income and retained earnings statement 5 6 for Nerwin Company for 2014. 7 (000 omitted) Net sales revenue $640,000 Costs and expenses Cost of goods sold $500,000 Selling, general, and administrative expenses 66,000 Other, net 17,000 583,000 Income before income tax 57,000 Income tax 19,400 Net income 37,600 Retained earnings at beginning of period, as previously reported 141,000 Adjustment required for correction of error (7,000) Retained earnings at beginning of period, as restated 134,000 Dividends on common stock (12,200) Retained earnings at end of period $159,400 Additional facts are as follows. 1. “Selling, general, and administrative expenses” for 2014 included a charge of $8,500,000 that was usual but infrequently occurring. Problems Set B 199 2. “Other, net” for 2014 included an extraordinary item (charge) of $6,000,000. If the extraordinary item (charge) had not occurred, income taxes for 2014 would have been $21,400,000 instead of $19,400,000. 3. “Adjustment required for correction of an error” was a result of a change in estimate (useful life of certain assets reduced to 8 years and a catch-up adjustment made). 4. Nerwin Company disclosed earnings per common share for net income in the notes to the financial statements. Instructions Determine from these additional facts whether the presentation of the facts in the Nerwin Company in- come and retained earnings statement is appropriate. If the presentation is not appropriate, describe the appropriate presentation and discuss its theoretical rationale. (Do not prepare a revised statement.) 4 6 P4-6 (Retained Earnings Statement, Prior Period Adjustment) Below is the Retained Earnings account 7 for the year 2014 for Acadian Corp. Retained earnings, January 1, 2014 $257,600 Add: Gain on sale of investments (net of tax) $41,200 Net income 84,500 Refund on litigation with government, related to the year 2011 (net of tax) 21,600 Recognition of income earned in 2013, but omitted from income statement in that year (net of tax) 25,400 172,700 430,300 Deduct: Loss on discontinued operations (net of tax) 35,000 Write-off of goodwill (net of tax) 60,000 Cumulative effect on income of prior years in changing from

LIFO to FIFO inventory valuation in 2014 (net of tax) 23,200 Cash dividends declared 32,000 150,200 Retained earnings, December 31, 2014 $280,100 Instructions (a) Prepare a corrected retained earnings statement. Acadian Corp. normally sells investments of the type mentioned above. FIFO inventory was used in 2014 to compute net income. (b) State where the items that do not appear in the corrected retained earnings statement should be shown. 3 4 P4-7 (Income Statement, Irregular Items) Wade Corp. has 150,000 shares of common stock outstanding. In 2014, the company reports income from continuing operations before income tax of $1,210,000. Addi- 5 6 tional transactions not considered in the $1,210,000 are as follows. 1. In 2014, Wade Corp. sold equipment for $40,000. The machine had originally cost $80,000 and had accumulated depreciation of $30,000. The gain or loss is considered ordinary. 2. The company discontinued operations of one of its subsidiaries during the current year at a loss of $190,000 before taxes. Assume that this transaction meets the criteria for discontinued operations. The loss from operations of the discontinued subsidiary was $90,000 before taxes; the loss from disposal of the subsidiary was $100,000 before taxes. 3. An internal audit discovered that amortization of intangible assets was understated by $35,000 (net of tax) in a prior period. The amount was charged against retained earnings. 4. The company had a gain of $125,000 on the condemnation of much of its property. The gain is taxed at a total effective rate of 40%. Assume that the transaction meets the requirements of an extraordinary item. Instructions Analyze the above information and prepare an income statement for the year 2014, starting with income from continuing operations before income tax. Compute earnings per share as it should be shown on the face of the income statement. (Assume a total effective tax rate of 38% on all items, unless otherwise indicated.) PROBLEMS SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of problems. 200 Chapter 4 Income Statement and Related Information CONCEPTS FOR ANALYSIS CA4-1 (Identification of Income Statement Deficiencies) O’Malley Corporation was incorporated and began business on January 1, 2014. It has been successful and now requires a bank loan for additional working capital to finance expansion. The bank has requested an audited income statement for the year 2014. The accountant for O’Malley Corporation provides you with the following income statement which O’Malley plans to submit to the bank. O’MALLEY CORPORATION INCOME STATEMENT Sales revenue $850,000 Dividends 32,300 Gain on recovery of insurance proceeds from earthquake loss (extraordinary) 38,500 920,800 Less: Selling expenses $101,100 Cost of goods sold 510,000 Advertising expense 13,700 Loss on obsolescence of inventories 34,000 Loss on discontinued operations 48,600 Administrative expense 73,400 780,800 Income before income tax 140,000 Income tax 56,000 Net income $ 84,000 Instructions Indicate the deficiencies in the income statement presented above. Assume that the corporation desires a single-step income statement. CA4-2 (Earnings Management) Bobek Inc. has recently reported steadily increasing income. The com- pany reported income of $20,000 in 2011, $25,000 in 2012, and $30,000 in 2013. A number of market analysts have recommended that investors buy the stock because they expect the steady growth in income to continue. Bobek is approaching the end of its fiscal year in 2014, and it again appears to be a good year. However, it has not yet recorded warranty expense. Based on prior experience, this year’s warranty expense should be around $5,000, but some managers have approached the controller to suggest a larger, more conservative warranty expense should be re- corded this year. Income before warranty expense is $43,000. Specifically, by recording a $7,000 warranty accrual this year, Bobek could report an increase in income for this year and still be in a position to cover

its warranty costs in future years. Instructions (a) What is earnings management? (b) Assume income before warranty expense is $43,000 for both 2014 and 2015 and that total warranty expense over the 2-year period is $10,000. What is the effect of the proposed accounting in 2014? In 2015? (c) What is the appropriate accounting in this situation? CA4-3 (Earnings Management) Charlie Brown, controller for Kelly Corporation, is preparing the com- pany’s income statement at year-end. He notes that the company lost a considerable sum on the sale of some equipment it had decided to replace. Since the company has sold equipment routinely in the past, Brown knows the losses cannot be reported as extraordinary. He also does not want to highlight it as a material loss since he feels that will reflect poorly on him and the company. He reasons that if the company had recorded more depreciation during the assets’ lives, the losses would not be so great. Since deprecia- tion is included among the company’s operating expenses, he wants to report the losses along with the company’s expenses, where he hopes it will not be noticed. Instructions (a) What are the ethical issues involved? (b) What should Brown do? Concepts for Analysis 201 CA4-4 (Income Reporting Items) Simpson Corp. is an entertainment firm that derives approximately 30% of its income from the Casino Knights Division, which manages gambling facilities. As auditor for Simpson Corp., you have recently overheard the following discussion between the controller and financial vice president. Vice President: I f we sell the Casino Knights Division, it seems ridiculous to segregate the results of the sale in the income statement. Separate categories tend to be absurd and confusing to the stockholders. I believe that we should simply report the gain on the sale as other income or expense without detail. Controller: P rofessional pronouncements would require that we report this information separately in the income statement. If a sale of this type is considered unusual and infrequent, it must be reported as an extraordinary item. Vice President: W hat about the walkout we had last month when employees were upset about their commission income? Would this situation not also be an extraordinary item? Controller: I am not sure whether this item would be reported as extraordinary or not. Vice President: O h well, it doesn’t make any difference because the net effect of all these items is immaterial, so no disclosure is necessary. Instructions (a) On the basis of the foregoing discussion, answer the following questions. Who is correct about han- dling the sale? What would be the correct income statement presentation for the sale of the Casino Knights Division? (b) How should the walkout by the employees be reported? (c) What do you think about the vice president’s observation on materiality? (d) What are the earnings per share implications of these topics? CA4-5 (Identification of Income Statement Weaknesses) The following financial statement was pre- pared by employees of Walters Corporation. WALTERS CORPORATION INCOME STATEMENT YEAR ENDED DECEMBER 31, 2014 Revenues Gross sales, including sales taxes $1,044,300 Less: Returns, allowances, and cash discounts 56,200 Net sales 988,100 Dividends, interest, and purchase discounts 30,250 Recoveries of accounts written off in prior years 13,850 Total revenues 1,032,200 Costs and expenses Cost of goods sold, including sales taxes 465,900 Salaries and related payroll expenses 60,500 Rent 19,100 Delivery expense and freight-in 3,400 Bad debt expense 27,800 Total costs and expenses 576,700 Income before extraordinary items 455,500 Extraordinary items Loss on discontinued styles (Note 1) 71,500 Loss on sale of marketable securities (Note 2) 39,050 Loss on sale of warehouse (Note 3) 86,350 Total extraordinary items 196,900 Net income $ 258,600 Net income per share of common stock $2.30 Note 1: New styles and rapidly changing consumer preferences resulted in a $71,500 loss on the disposal of discontinued styles and related accessories.

Note 2: The corporation sold an investment in marketable securities at a loss of $39,050. The corporation normally sells securities of this nature. Note 3: The corporation sold one of its warehouses at an $86,350 loss. 202 Chapter 4 Income Statement and Related Information Instructions Identify and discuss the weaknesses in classification and disclosure in the single-step income statement above. You should explain why these treatments are weaknesses and what the proper presentation of the items would be in accordance with GAAP. CA4-6 (Classification of Income Statement Items) As audit partner for Grupo and Rijo, you are in charge of reviewing the classification of unusual items that have occurred during the current year. The following material items have come to your attention. 1. A merchandising company incorrectly overstated its ending inventory 2 years ago. Inventory for all other periods is correctly computed. 2. An automobile dealer sells for $137,000 an extremely rare 1930 S type Invicta which it purchased for $21,000 10 years ago. The Invicta is the only such display item the dealer owns. 3. A drilling company during the current year extended the estimated useful life of certain drilling equipment from 9 to 15 years. As a result, depreciation for the current year was materially lowered. 4. A retail outlet changed its computation for bad debt expense from 1% to ½ of 1% of sales because of changes in its customer clientele. 5. A mining concern sells a foreign subsidiary engaged in uranium mining, although it (the seller) continues to engage in uranium mining in other countries. 6. A steel company changes from the average-cost method to the FIFO method for inventory costing purposes. 7. A construction company, at great expense, prepared a major proposal for a government loan. The loan is not approved. 8. A water pump manufacturer has had large losses resulting from a strike by its employees early in the year. 9. Depreciation for a prior period was incorrectly understated by $950,000. The error was discovered in the current year. 10. A large sheep rancher suffered a major loss because the state required that all sheep in the state be killed to halt the spread of a rare disease. Such a situation has not occurred in the state for 20 years. 11. A food distributor that sells wholesale to supermarket chains and to fast-food restaurants (two dis- tinguishable classes of customers) decides to discontinue the division that sells to one of the two classes of customers. Instructions From the foregoing information, indicate in what section of the income statement or retained earnings statement these items should be classified. Provide a brief rationale for your position. CA4-7 (Comprehensive Income) Willie Nelson, Jr., controller for Jenkins Corporation, is preparing the company’s financial statements at year-end. Currently, he is focusing on the income statement and deter- mining the format for reporting comprehensive income. During the year, the company earned net income of $400,000 and had unrealized gains on available-for-sale securities of $15,000. In the previous year, net income was $410,000, and the company had no unrealized gains or losses. Instructions (a) Show how income and comprehensive income will be reported on a comparative basis for the current and prior years, using the two statement format. (b) Show how income and comprehensive income will be reported on a comparative basis for the current and prior years, using the one statement format. (c) Which format should Nelson recommend? USING YOUR JUDGMENT FINANCIAL REPORTING Financial Reporting Problem The Procter & Gamble Company (P&G) The financial statements of P&G are presented in Appendix 5B. The company’s complete annual report, including the notes to the financial statements, can be accessed at the book’s companion website, www. wiley.com/college/kieso. Using Your Judgment 203 Instructions Refer to P&G’s financial statements and the accompanying notes to answer the following questions. (a) What type of income statement format does P&G use? Indicate why this format might be used to

present income statement information. (b) What are P&G’s primary revenue sources? (c) Compute P&G’s gross profit for each of the years 2009–2011. Explain why gross profit decreased in 2011. (d) Why does P&G make a distinction between operating and nonoperating revenue? (e) What financial ratios did P&G choose to report in its “Financial Summary” section covering the years 2001–2011? Comparative Analysis Case The Coca-Cola Company and PepsiCo, Inc. Instructions Go to the book’s companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc. (a) What type of income format(s) is used by these two companies? Identify any differences in income statement format between these two companies. (b) What are the gross profits, operating profits, and net incomes for these two companies over the 3-year period 2009–2011? Which company has had better financial results over this period of time? (c) Identify the irregular items reported by these two companies in their income statements over the 3-year period 2009–2011. Do these irregular items appear to be significant? Financial Statement Analysis Cases Case 1 Bankruptcy Prediction The Z-score bankruptcy prediction model uses balance sheet and income information to arrive at a Z-Score, which can be used to predict financial distress: Working capital Retained earnings EBIT Sales MV equity Z5 31.21 31.41 33.31 3.991 30.6 Total assets Total assets Total assets Total assets Total liabilities EBIT is earnings before interest and taxes. MV equity is the market value of common equity, which can be determined by multiplying stock price by shares outstanding. Following extensive testing, it has been shown that companies with Z-scores above 3.0 are unlikely to fail; those with Z-scores below 1.81 are very likely to fail. While the original model was developed for publicly held manufacturing companies, the model has been modified to apply to companies in various industries, emerging companies, and companies not traded in public markets. Instructions (a) Use information in the financial statements of a company like Walgreens or Deere & Co. to compute the Z-score for the past 2 years. (b) Interpret your result. Where does the company fall in the financial distress range? (c) The Z-score uses EBIT as one of its elements. Why do you think this income measure is used? Case 2 Dresser Industries Dresser Industries provides products and services to oil and natural gas exploration, production, trans- mission, and processing companies. The following is taken from a recent income statement. (Dollar amounts are in millions.) Sales revenue $2,697.0 Service revenue 1,933.9 Share of earnings of unconsolidated affi liates 92.4 Total revenues 4,723.3 Cost of sales 1,722.7 Cost of services 1,799.9 Total costs of sales and services 3,522.6 204 Chapter 4 Income Statement and Related Information Gross earnings $1,200.7 Selling, engineering, administrative and general expenses (919.8) Special charges (70.0) Other income (deductions) Interest expense (47.4) Interest earned 19.1 Other, net 4.8 Earnings before income taxes and other items below 187.4 Income taxes (79.4) Noncontrolling interest (10.3) Earnings from continuing operations 97.7 Discontinued operations (35.3) Earnings before extraordinary items 62.4 Extraordinary items (6.3) Net earnings $ 56.1 Instructions Assume that 177,636,000 shares of stock were issued and outstanding. Prepare the per share portion of the income statement. Remember to begin with “Earnings from continuing operations.” Case 3 P/E Ratios One of the more closely watched ratios by investors is the price/earnings (P/E) ratio. By dividing price per share by earnings per share, analysts get insight into the value the market attaches to a company’s earn- ings. More specifically, a high P/E ratio (in comparison to companies in the same industry) may suggest the stock is overpriced. Also, there is some evidence that companies with low P/E ratios are underpriced and tend to outperform the market. However, the ratio can be misleading.

P/E ratios are sometimes misleading because the E (earnings) is subject to a number of assumptions and estimates that could result in overstated earnings and a lower P/E. Some analysts conduct “revenue analysis” to evaluate the quality of an earnings number. Revenues are less subject to management estimates and all earnings must begin with revenues. These analysts also compute the price-to-sales ratio (PSR 5 price per share 4 sales per share) to assess whether a company is performing well compared to similar companies. If a company has a price-to-sales ratio significantly higher than its competitors, investors may be betting on a stock that has yet to prove itself. [Source: Janice Revell, “Beyond P/E,” Fortune (May 28, 2001), p. 174.] Instructions (a) Identify some of the estimates or assumptions that could result in overstated earnings. (b) Compute the P/E ratio and the PSR for Tootsie Roll and Hershey for 2011. (c) Use these data to compare the quality of each company’s earnings. Accounting, Analysis, and Principles Counting Crows Inc. provided the following information for the year 2014. Retained earnings, January 1, 2014 $ 600,000 Administrative expenses 240,000 Selling expenses 300,000 Sales revenue 1,900,000 Cash dividends declared 80,000 Cost of goods sold 850,000 Extraordinary gain 95,000 Loss on discontinued operations 75,000 Rent revenue 40,000 Unrealized holding gain on available-for-sale securities 17,000 Income tax applicable to continuing operations 187,000 Income tax benefi t applicable to loss on discontinued operations 25,500 Income tax applicable to extraordinary gain 32,300 Income tax applicable to unrealized holding gain on available-for-sale securities 2,000 Accounting Prepare (a) a single-step income statement for 2014, (b) a retained earnings statement for 2014, and (c) a statement of comprehensive income using the two statement format. Shares outstanding during 2014 were 100,000. IFRS Insights 205 Analysis Explain how a multiple-step income statement format can provide useful information to a financial state- ment user. Principles In a recent meeting with its auditor, Counting Crows’ management argued that the company should be able to prepare a pro forma income statement with some one-time administrative expenses reported simi- lar to extraordinary items and discontinued operations. Is such reporting consistent with the qualitative characteristics of accounting information as discussed in the conceptual framework? Explain. BRIDGE TO THE PROFESSION Professional Research: FASB Codifi cation Your client took accounting a number of years ago and was unaware of comprehensive income reporting. He is not convinced that any accounting standards exist for comprehensive income. Instructions Go to http://aahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. (a) What authoritative literature addresses comprehensive income? When was it issued? (b) Provide the definition of comprehensive income. (c) Define classifications within net income and give examples. (d) Define classifications within other comprehensive income and give examples. (e) What are reclassification adjustments? Additional Professional Resources See the book’s companion website, at www.wiley.com/college/kieso, for professional simulations as well as other study resources. IFRS INSIGHTS As in GAAP, the income statement is a required statement for IFRS. In addition, 9 LEARNING OBJECTIVE the content and presentation of an IFRS income statement is similar to the one Compare the accounting procedures for used for GAAP. IAS 1, “Presentation of Financial Statements,” provides general income reporting under GAAP and IFRS. guidelines for the reporting of income statement information. Subsequently, a number of international standards have been issued that provide additional guidance to issues related to income statement presentation. RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related to the income statement. Similarities

• Both GAAP and IFRS require companies to indicate the amount of net income attrib- utable to noncontrolling interest. 206 Chapter 4 Income Statement and Related Information • Both GAAP and IFRS follow the same presentation guidelines for discontinued opera- tions, but IFRS defi nes a discontinued operation more narrowly. Both standard-setters have indicated a willingness to develop a similar defi nition to be used in the joint project on fi nancial statement presentation. • Both GAAP and IFRS have items that are recognized in equity as part of comprehen- sive income but do not affect net income. Both GAAP and IFRS allow a one statement or two statement approach to preparing the statement of comprehensive income. Differences • Presentation of the income statement under GAAP follows either a single-step or multiple-step format. IFRS does not mention a single-step or multiple-step approach. In addition, under GAAP, companies must report an item as extraordinary if it is unusual in nature and infrequent in occurrence. Extraordinary items are prohibited under IFRS. • Under IFRS, companies must classify expenses by either nature or function. GAAP does not have that requirement, but the SEC requires a functional presentation. • IFRS identifi es certain minimum items that should be presented on the income state- ment. GAAP has no minimum information requirements. However, the SEC rules have more rigorous presentation requirements. • IFRS does not defi ne key measures like income from operations. SEC regulations defi ne many key measures and provide requirements and limitations on companies reporting non-GAAP/IFRS information. • Under IFRS, revaluation of property, plant, and equipment, and intangible assets is permitted and is reported as other comprehensive income. The effect of this differ- ence is that application of IFRS results in more transactions affecting equity but not net income. ABOUT THE NUMBERS Income Reporting Illustration IFRS4-1 provides a summary of the primary income items under IFRS. As indicated in the table, similar to GAAP, companies report all revenues, gains, expenses, and losses on the income statement and, at the end of the period, close them to Income Summary. They provide useful subtotals on the income statement, such as gross profit, income from operations, income before income tax, and net income. Companies classify discontinued operations of a component of a business as a separate item in the income statement, after “Income from continuing operations.” Companies present other income and expense in a separate section, before income from operations. Providing intermedi- ate income figures helps readers evaluate earnings information in assessing the amounts, timing, and uncertainty of future cash flows. Expense Classifi cations Companies are required to present an analysis of expenses classified either by their nature (such as cost of materials used, direct labor incurred, delivery expense, advertis- ing expense, employee benefits, depreciation expense, and amortization expense) or their function (such as cost of goods sold, selling expenses, and administrative expenses). IFRS Insights 207 Type of Situation Criteria Examples Placement on Income Statement Sales or service Revenue arising from the ordinary Sales revenue, service revenue Sales or revenue section revenues activities of the company Cost of goods sold Expense arising from the cost In a merchandising company, Deduct from sales (to arrive at gross of inventory sold or services cost of goods sold; in a service profi t) or service revenue provided company, cost of services Selling and Expenses arising from the ordinary Sales salaries, delivery expense, Deduct from gross profi t; if the administrative activities of the company rent, depreciation, utilities function-of-expense approach expenses is used, depreciation and amortization expense and labor costs must be disclosed Other income and Gains and losses and other Gain on sale of long-lived assets, Report as part of income from expense ancillary revenues and expenses impairment loss on intangible operations

assets, investment revenue, dividend and interest revenue, casualty losses Financing costs Separates cost of fi nancing from Interest expense Report in separate section operating costs between income from operations and income before income tax Income tax Levies imposed by governmental Taxes computed on income Report in separate section between bodies on the basis of income before income tax income before income tax and net income Discontinued A component of a company that A sale by diversifi ed company Report gains or losses on operations has either been disposed of or of a major division representing discontinued operations net of is classifi ed as held-for-sale its only activities in the tax in a separate section between electronics industry income from continuing operations Food distributor that sells and net income wholesale to supermarkets decides to discontinue the division in a major geographic area Non-controlling Allocation of net income of loss Net profi t (loss) attributable to Report as a separate item below net interest divided between two classes: non-controlling shareholders income or loss as an allocation of (1) the majority interest represented the net income or loss (not as an by the shareholders who own item of income or expense) the controlling interest, and (2) the non-controlling interest (often referred to as the minority interest) ILLUSTRATION IFRS4-1 Summary of Income Items under IFRS An advantage of the nature-of-expense method is that it is simple to apply because allocations of expense to different functions are not necessary. For manufacturing companies that must allocate costs to the product produced, using a nature-of- expense approach permits companies to report expenses without making arbitrary allocations. The function-of-expense method, however, is often viewed as more relevant because this method identifies the major cost drivers of the company and therefore helps users assess whether these amounts are appropriate for the revenue generated. As indicated, a disadvantage of this method is that the allocation of costs to the varying functions may be arbitrary and therefore the expense classification becomes misleading. To illustrate these two methods, assume that the accounting firm of Telaris Co. per- forms audit, tax, and consulting services. It has the following revenues and expenses. 208 Chapter 4 Income Statement and Related Information Service revenues $400,000 Cost of services Staff salaries (related to various services performed) 145,000 Supplies expense (related to various services performed) 10,000 Selling expenses Advertising costs 20,000 Entertainment expense 3,000 Administrative expenses Utilities expense 5,000 Depreciation on building 12,000 If Telaris Co. uses the nature-of-expense approach, its income statement presents each expense item but does not classify the expenses into various subtotals, as follows. TELARIS CO. INCOME STATEMENT FOR THE MONTH OF JANUARY 2014 Service revenues $400,000 Staff salaries 145,000 Supplies expense 10,000 Advertising costs 20,000 Utilities expense 5,000 Depreciation on building 12,000 Entertainment expense 3,000 Net income $205,000 If Telaris uses the function-of-expense approach, its income statement is as follows. TELARIS CO. INCOME STATEMENT FOR THE MONTH OF JANUARY 2014 Service revenues $400,000 Cost of services 155,000 Selling expenses 23,000 Administrative expenses 17,000 Net income $205,000 The function-of-expense method is generally used in practice although many com- panies believe both approaches have merit. These companies use the function-of-expense approach on the income statement but provide detail of the expenses (as in the nature-of- expense approach) in the notes to the financial statements. The IASB-FASB discussion paper on financial statement presentation also recommends the dual approach. ON THE HORIZON The IASB and FASB are working on a project that would rework the structure of financial statements. One stage of this project will address the issue of how to classify various items in the income statement. A main goal of this new approach is to provide information that

better represents how businesses are run. The FASB and IASB have issued a proposal to require comprehensive income be reported in a combined statement of comprehensive income. This approach draws attention away from just one number—net income. IFRS Insights 209 IFRS SELF-TEST QUESTIONS 1. Which of the following is not reported in an income statement under IFRS? (a) Discontinued operations. (b) Extraordinary items. (c) Cost of goods sold. (d) Income tax. 2. Which of the following statements is correct regarding income reporting under IFRS? (a) IFRS does not permit revaluation of property, plant, and equipment, and intangible assets. (b) IFRS provides the same options for reporting comprehensive income as GAAP. (c) Companies must classify expenses by nature. (d) IFRS provides a definition for all items presented in the income statement. 3. Which statement is correct regarding IFRS? (a) An advantage of the nature-of-expense method is that it is simple to apply because allocations of expense to different functions are not necessary. (b) The function-of-expense approach never requires arbitrary allocations. (c) An advantage of the function-of-expense method is that allocation of costs to the varying func- tions is rarely arbitrary. (d) IFRS requires use of the nature-of-expense approach. 4. The non-controlling interest section of the income statement is: (a) required under GAAP but not under IFRS. (b) required under IFRS but not under GAAP. (c) required under IFRS and GAAP. (d) not reported under GAAP or IFRS. 5. Which of the following is not an acceptable way of displaying the components of other comprehen- sive income under IFRS? (a) Within the statement of retained earnings. (b) Second income statement. (c) Combined statement of comprehensive income. (d) All of these choices are acceptable. IFRS CONCEPTS AND APPLICATION IFRS4-1 Explain the difference between the “nature-of-expense” and “function-of-expense” classifications. IFRS4-2 Discuss the appropriate treatment in the income statement for the following items: (a) Loss on discontinued operations. (b) Non-controlling interest allocation. IFRS4-3 Bradshaw Company experienced a loss that was deemed to be both unusual in nature and infre- quent in occurrence. How should Bradshaw report this item in accordance with IFRS? IFRS4-4 Presented below is information related to Viel Company at December 31, 2014, the end of its first year of operations. Sales revenue $310,000 Cost of goods sold 140,000 Selling and administrative expenses 50,000 Gain on sale of plant assets 30,000 Unrealized gain on non-trading equity securities 10,000 Interest expense 6,000 Loss on discontinued operations 12,000 Allocation to non-controlling interest 40,000 Dividends declared and paid 5,000 210 Chapter 4 Income Statement and Related Information Instructions Compute the following: (a) income from operations, (b) net income, (c) net income attributable to Viel Company controlling shareholders, (d) comprehensive income, and (e) retained earnings balance at December 31, 2014. (Ignore income taxes.) IFRS4-5 Below is the income statement for a British company, Avon Rubber plc. Avon prepares its finan- cial statements in accordance with IFRS. Avon Rubber plc Consolidated Income Statement for the Year Ended 30 September 2011 2010 Continuing operations Revenue 107,600 117,574 Cost of sales (77,892) (89,256) Gross profit 29,708 28,318 Distribution costs (4,832) (4,527) Administrative expenses (13,740) (14,536) Other operating income — — Operating profit/(loss) from continuing operations 11,136 9,255 Operating profit/(loss) is analysed as: Before depreciation, amortization and exceptional items 15,723 13,577 Depreciation and amortization (4,587) (4,322) Operating profit/(loss) before exceptional items 11,136 9,255 Exceptional operating items Finance income 5 16 Finance costs (486) (985) Other finance income (443) (1,152) Profit/(loss) before taxation 991 (12,391) Taxation (3,094) (2,808) Profit/(loss) for the year from continuing operations (2,103) (15,199) Discontinued operations Profit/(loss) for the year from discontinued operations — —

Loss for the year — — Earnings/(loss) per share Basic 25.2p 15.2p Diluted 23.3p 14.4p Earnings/(loss) per share from continuing operations Basic 25.2p 15.2p Diluted 23.3p 14.4p Instructions (a) Review the Avon Rubber income statement and identify at least three differences between the IFRS income statement and an income statement of a U.S. company as presented in the chapter. (b) Identify any irregular items reported by Avon Rubber. Is the reporting of these irregular items in Avon’s income statement similar to reporting of these items in U.S. companies’ income statements? Explain. Professional Research IFRS4-6 Your client took accounting a number of years ago and was unaware of comprehensive income reporting. He is not convinced that any accounting standards exist for comprehensive income. IFRS Insights 211 Instructions Access the IFRS authoritative literature at the IASB website (http://www.iasb.org/ ). (Click on the IFRS tab and then register for free eIFRS access if necessary.) When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.) (a) What IFRS addresses reporting in the statement of comprehensive income? When was it issued? (b) Provide the definition of total comprehensive income. (c) Explain the rationale for presenting additional line items, headings, and subtotals in the statement of comprehensive income. (d) What items of income or expense may be presented either in the statement of comprehensive income or in the notes? International Financial Reporting Problem Marks and Spencer plc IFRS4-7 The financial statements of Marks and Spencer plc (M&S) are available at the book’s compan- ion website or can be accessed at http://annualreport.marksandspencer.com/_assets/downloads/Marks-and- Spencer-Annual-report-and-financial-statements-2012.pdf. Instructions Refer to M&S’s financial statements and the accompanying notes to answer the following questions. (a) What type of income statement format does M&S use? Indicate why this format might be used to present income statement information. (b) What are M&S’s primary revenue sources? (c) Compute M&S’s gross profit for each of the years 2011 and 2012. Explain why gross profit increased in 2012. (d) Why does M&S make a distinction between operating and non-operating profit? (e) Does M&S report any non-GAAP measures? Explain. ANSWERS TO IFRS SELF-TEST QUESTIONS 1. b 2. b 3. a 4. c 5. a Remember to check the book’s companion website to fi nd additional resources for this chapter. Balance Sheet and Statement of Cash Flows RETPAHC 5 LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 Explain the uses and limitations of a balance sheet. 6 Prepare a basic statement of cash flows. 2 Identify the major classifications of the balance 7 Understand the usefulness of the statement of sheet. cash flows. 3 Prepare a classified balance sheet using the report 8 Determine which balance sheet information requires and account formats. supplemental disclosure. 4 Indicate the purpose of the statement of cash flows. 9 Describe the major disclosure techniques for the balance sheet. 5 Identify the content of the statement of cash flows. Hey, It Doesn’t Balance! A good accounting student knows by now that Total Assets 5 Total Liabilities 1 Total Equity. From this equation, we can also determine net assets, which are determined as follows: Total Assets 2 Total Liabilities 5 Net Assets. O.K., this is simple so far. But let’s look at the recent discussion paper by the FASB/IASB on how the statement of financial position (the balance sheet) should be structured. The statement of financial position is divided into five major parts, with many assets and liabilities netted against one another. Here is the general framework for the new statement of financial position: BUSINESS Operating assets and liabilities Investing assets and liabilities FINANCING Financing assets Financing liabilities INCOME TAXES DISCONTINUED OPERATIONS EQUITY The statement does look a bit different than the traditional balance sheet. Let’s put some numbers to the statement and see

how it works. (See the example on the facing page.) Well, it does balance—in that net assets equal equity—but isn’t it important to know total assets and total liabilities? As some have observed, the statement of financial position will not balance the way we expect it to. That is, assets won’t equal liabilities and equity. This is because the assets and liabilities are grouped into the business, financing, discontinued opera- tions, and income taxes categories. This new model raises a number of questions, such as: • Does separating “business activities from financing activities” provide information that is more decision-useful? • Does information on income taxes and discontinued operations merit separate categories? The FASB and IASB are working to get answers to these and other questions about this proposed model. One thing is for sure—adoption of the new financial statements will be a dramatic change but hopefully one for the better. CONCEPTUAL FOCUS > See the Underlying Concepts on STATEMENT OF FINANCIAL POSITION pages 227, 228, 237, 240, and 241. BUSINESS > Read the Evolving Issue on page 243 for a Operating discussion of balance sheet reporting. Inventories $ 400,000 Receivables 200,000 Total short-term assets $ 600,000 INTERNATIONAL FOCUS Property (net) 500,000 Intangible assets 50,000 Total long-term assets 550,000 > See the International Perspectives Accounts payable 30,000 on pages 231 and 242. Wages payable 40,000 Total short-term liabilities (70,000) > Read the IFRS Insights on Lease liability 10,000 pages 277–284 for a discussion of: Other long-term debt 35,000 Total long-term liabilities (45,000) — Classification in the statement Net operating assets 1,035,000 of financial position Investing Trading securities 45,000 —Equity Other securities 5,000 —Revaluation equity Total investing assets 50,000 —Fair presentation TOTAL NET BUSINESS ASSETS 1,085,000 FINANCING Financing assets Cash 30,000 Total financing assets 30,000 Financing liabilities Short- and long-term borrowing 130,000 Total financing liabilities (130,000) NET FINANCING LIABILITIES (100,000) DISCONTINUED OPERATIONS Assets held for sale 420,000 INCOME TAXES Deferred income taxes 70,000 NET ASSETS $1,475,000 EQUITY Share capital—ordinary $1,000,000 Retained earnings 475,000 TOTAL EQUITY $1,475,000 Sources: Marie Leone and Tim Reason, “How Extreme Is the Makeover?” CFO Magazine (March 1, 2009); and Preliminary Views on Financial Statement Presentation, FASB/IASB Discussion Paper (October 2008). As the opening story indicates, the FASB and IASB are working to PREVIEW OF CHAPTER 5 improve the presentation of financial information on the balance sheet, as well as other financial statements. In this chapter, we examine the many different types of assets, liabilities, and equity items that affect the balance sheet and the statement of cash flows. The content and organization of the chapter are as follows. Balance Sheet and Statement of Cash Flows Balance Sheet Statement of Cash Flows Additional Information • Usefulness • Purpose • Supplemental disclosures • Limitations • Content and format • Techniques of disclosure • Classification • Preparation overview • Format • Usefulness 213 214 Chapter 5 Balance Sheet and Statement of Cash Flows BALANCE SHEET The balance sheet, sometimes referred to as the statement of financial position, LEARNING OBJECTIVE 1 reports the assets, liabilities, and stockholders’ equity of a business enterprise at a Explain the uses and limitations of a specific date. This financial statement provides information about the nature and balance sheet. amounts of investments in enterprise resources, obligations to creditors, and the owners’ equity in net resources. It therefore helps in predicting the amounts, timing, and uncertainty of future cash flows. Usefulness of the Balance Sheet By providing information on assets, liabilities, and stockholders’ equity, the balance sheet provides a basis for computing rates of return and evaluating the capital structure of the enterprise. Analysts also use information in the balance sheet to assess a company’s

Liquidity risk1 and future cash flows. In this regard, analysts use the balance sheet to assess a Operations com Lp ia qn uy i’ ds il ti yq u di ed si cty ri, bs eo sl v “e tn hc ey a, man od u nfi tn oan f c tii mal ef l te hx aib t i il si t ey x. pected to elapse until an asset is realized or otherwise converted into cash or until a liability has to be paid.”2 Creditors are interested in short-term liquidity ratios, such as the ratio of cash (or near cash) to short-term liabilities. These ratios indicate whether a company, like Amazon.com, will have the resources to pay its current and maturing obligations. Similarly, stockholders How quickly will my assess liquidity to evaluate the possibility of future cash dividends or the buyback of assets convert to cash? shares. In general, the greater Amazon’s liquidity, the lower its risk of failure. Solvency refers to the ability of a company to pay its debts as they mature. For Solvency example, when a company carries a high level of long-term debt relative to assets, it has S.O.S lower solvency than a similar company with a low level of long-term debt. Companies with higher debt are relatively more risky because they will need more of their assets to meet their fixed obligations (interest and principal payments). Liquidity and solvency affect a company’s financial flexibility, which measures the Obligation Ocean “ability of an enterprise to take effective actions to alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities.”3 For example, a company We are drowning in a sea of debt! may become so loaded with debt—so financially inflexible—that it has little or no sources of cash to finance expansion or to pay off maturing debt. A company with a high degree of financial flexibility is better able to survive bad times, to recover from unexpected set- backs, and to take advantage of profitable and unexpected investment opportunities. Generally, the greater an enterprise’s financial flexibility, the lower its risk of failure. $ IOU Limitations of the Balance Sheet Some of the major limitations of the balance sheet are: $ IOU 1. Most assets and liabilities are reported at historical cost. As a result, the information provided in the balance sheet is often criticized for not reporting a more relevant $ IOU fair value. For example, Georgia-Pacifi c owns timber and other assets that may ap- Hmm... I wonder if they preciate in value after purchase. Yet, Georgia-Pacifi c reports any increase only if and will pay me back? when it sells the assets. 1Risk conveys the unpredictability of future events, transactions, circumstances, and results of the company. 2“Reporting Income, Cash Flows, and Financial Position of Business Enterprises,” Proposed Statement of Financial Accounting Concepts (Stamford, Conn.: FASB, 1981), par. 29. 3“Reporting Income, Cash Flows, and Financial Position of Business Enterprises,” Proposed Statement of Financial Accounting Concepts (Stamford, Conn.: FASB, 1981), par. 25. Balance Sheet 215 2. Companies use judgments and estimates to determine many of the items reported in the balance sheet. For example, in its balance sheet, Dell estimates the amount of receivables that it will collect, the useful life of its warehouses, and the number of computers that will be returned under warranty. Inventory PPE 3. The balance sheet necessarily omits many items that are of fi nancial value but that Cash AR a company cannot record objectively. For example, the knowledge and skill of Intel employees in developing new computer chips are arguably the company’s most Balance signifi cant assets. However, because Intel cannot reliably measure the value of its Sheet employees and other intangible assets (such as customer base, research superiority, Hey....we left out the and reputation), it does not recognize these items in the balance sheet. Similarly, value of the employees! many liabilities are reported in an “off-balance-sheet” manner, if at all. The bankruptcy of Enron, the seventh-largest U.S. company at the time, highlights

the omission of important items in the balance sheet. In Enron’s case, it failed to disclose certain off-balance-sheet financing obligations in its main financial statements.4 What do the numbers mean? GROUNDED The terrorist attacks of September 11, 2001, showed how we will be able to obtain the necessary fi nancing to meet vulnerable the major airlines are to falling demand for their those needs on acceptable terms, if at all.” services. Since that infamous date, major airlines have reduced These fi nancial fl exibility challenges have continued, capacity and slashed jobs to avoid bankruptcy. United exacerbated by ever-increasing fuel prices, labor costs, and Airlines, Northwest Airlines, US Airways, and several the economic downturn in response to the fi nancial crisis. smaller competitors fi led for bankruptcy in the wake of 9/11. Not surprisingly, several of the major airlines (Delta and Delta Airlines made the following statements in its Northwest, Continental and United, and Airtran and annual report issued shortly after 9/11: Southwest) merged recently as a way to build some com- “If we are unsuccessful in further reducing our operating petitive synergies and to bolster their fi nancial fl exibility. costs . . . we will need to restructure our costs under Others (American Airlines and US Airways) are exploring Chapter 11 of the U.S. Bankruptcy Code. . . . We have mergers. substantial liquidity needs and there is no assurance that Source: R. Seaney, “Airline Mergers: Good for Travelers?” http://abcnews.go.com/Travel/airline-merger-mania-cost/story?id516227892 (April 27, 2012). Classifi cation in the Balance Sheet Balance sheet accounts are classified. That is, balance sheets group together simi- 2 LEARNING OBJECTIVE lar items to arrive at significant subtotals. Furthermore, the material is arranged so Identify the major classifications of the that important relationships are shown. balance sheet. The FASB has often noted that the parts and subsections of financial state- ments can be more informative than the whole. Therefore, the FASB discourages the reporting of summary accounts alone (total assets, net assets, total liabilities, etc.). Instead, companies should report and classify individual items in sufficient detail to permit users to assess the amounts, timing, and uncertainty of future cash flows. Such 4We discuss several of these omitted items (such as leases and other off-balance-sheet arrange- ments) in later chapters. See Wayne Upton, Jr., Special Report: Business and Financial Reporting, Challenges from the New Economy (Norwalk, Conn.: FASB, 2001); and U.S. Securities and Exchange Commission, “Disclosure in Management’s Discussion and Analysis about Off-Balance Sheet Arrangements and Aggregate Contractual Obligations,” http://www.sec.gov/rules/final/33-8182.htm (May 2003). 216 Chapter 5 Balance Sheet and Statement of Cash Flows classification also makes it easier for users to evaluate the company’s liquidity, financial flexibility, profitability, and risk. To classify items in financial statements, companies group those items with similar characteristics and separate items with different characteristics.5 For example, compa- nies should report separately: 1. Assets that differ in their type or expected function in the company’s central opera- tions or other activities. For example, IBM reports merchandise inventories sepa- rately from property, plant, and equipment. 2. Assets and liabilities with different implications for the company’s fi nancial fl ex- ibility. For example, a company that uses assets in its operations, like Walgreens, should report those assets separately from assets held for investment and assets subject to restrictions, such as leased equipment. 3. Assets and liabilities with different general liquidity characteristics. For example, Boeing Company reports cash separately from inventories. The three general classes of items included in the balance sheet are assets, liabilities, and equity. We defined them in Chapter 2 as follows. ELEMENTS OF THE BALANCE SHEET

1. ASSETS. Probable future economic benefi ts obtained or controlled by a particular entity as a result of past transactions or events. 2. LIABILITIES. Probable future sacrifi ces of economic benefi ts arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. 3. EQUITY. Residual interest in the assets of an entity that remains after deducting its liabilities. In a business enterprise, the equity is the ownership interest.6 Companies then further divide these items into several subclassifications. Illustra- tion 5-1 indicates the general format of balance sheet presentation. ILLUSTRATION 5-1 Assets Liabilities and Owners’ Equity Balance Sheet Current assets Current liabilities Classifi cations Long-term investments Long-term debt Property, plant, and equipment Owners’ (stockholders’) equity Intangible assets Other assets A company may classify the balance sheet in some other manner, but in practice you usually see little departure from these major subdivisions. A proprietorship or partner- ship does present the classifications within the owners’ equity section a little differently, as we will show later in the chapter. 5“Reporting Income, Cash Flows, and Financial Positions of Business Enterprises,” Proposed Statement of Financial Accounting Concepts (Stamford, Conn.: FASB, 1981), par. 51. 6“Elements of Financial Statements of Business Enterprises,” Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.: FASB, 1985), paras. 25, 35, and 49. Balance Sheet 217 Current Assets Current assets are cash and other assets a company expects to convert into cash, sell, or consume either in one year or in the operating cycle, whichever is longer. The operating cycle is the average time between when a company acquires materials and supplies and when it receives cash for sales of the product (for which it acquired the materials and supplies). The cycle operates from cash through inventory, production, receivables, and back to cash. When several operating cycles occur within one year (which is generally the case for service companies), a company uses the one-year period. If the operating cycle is more than one year, a company uses the longer period. Current assets are presented in the balance sheet in order of liquidity. The five major items found in the current assets section, and their bases of valuation, are shown in Illustration 5-2. ILLUSTRATION 5-2 Item Basis of Valuation Current Assets and Basis Cash and cash equivalents Fair value of Valuation Short-term investments Generally, fair value Receivables Estimated amount collectible Inventories Lower-of-cost-or-market Prepaid expenses Cost A company does not report these five items as current assets if it does not expect to realize them in one year or in the operating cycle, whichever is longer. For example, a company excludes from the current assets section cash restricted for purposes other than payment of current obligations or for use in current operations. Generally, if a company expects to convert an asset into cash or to use it to pay a current liability within a year or the operating cycle, whichever is longer, it classifies the asset as current. This rule, however, is subject to interpretation. A company classifies an investment in common stock as either a current asset or a noncurrent asset depending on manage- ment’s intent. When it has small holdings of common stocks or bonds that it will hold long-term, it should not classify them as current. Although a current asset is well defined, certain theoretical problems also develop. For example, how is including prepaid expenses in the current assets section justified? The rationale is that if a company did not pay these items in advance, it would instead need to use other current assets during the operating cycle. If we follow this logic to its ultimate conclusion, however, any asset previously purchased saves the use of current assets during the operating cycle and would be considered current.

Another problem occurs in the current-asset definition when a company consumes plant assets during the operating cycle. Conceptually, it seems that a company should place in the current assets section an amount equal to the current depreciation charge on the plant assets, because it will consume them in the next operating cycle. However, this conceptual problem is ignored. This example illustrates that the formal distinction made between some current and noncurrent assets is somewhat arbitrary. Cash. Cash is generally considered to consist of currency and demand deposits (monies available on demand at a financial institution). Cash equivalents are short-term highly liquid investments that will mature within three months or less. Most companies use the caption “Cash and cash equivalents,” and they indicate that this amount approximates fair value. A company must disclose any restrictions or commitments related to the availability of cash. As an example, see the excerpt from the annual report of Alterra Healthcare Corp. in Illustration 5-3 (page 218). 218 Chapter 5 Balance Sheet and Statement of Cash Flows ILLUSTRATION 5-3 Alterra Healthcare Corp. Balance Sheet Presentation of Current assets Restricted Cash Cash $18,728,000 Restricted cash and investments (Note 7) 7,191,000 Note 7: Restricted Cash and Investments. Restricted cash and investments consist of certificates of deposit restricted as collateral for lease arrangements and debt service with interest rates ranging from 4.0% to 5.5%. Alterra Healthcare restricted cash to meet an obligation due currently. Therefore, Alterra included this restricted cash under current assets. If a company restricts cash for purposes other than current obligations, it excludes the cash from current assets. Illustration 5-4 shows an example of this, from the annual report of Owens Corning, Inc. ILLUSTRATION 5-4 Owens Corning, Inc. Balance Sheet (in millions) Presentation of Current and Noncurrent Current assets Restricted Cash Cash and cash equivalents $ 70 Restricted securities—Fibreboard—current portion (Note 23) 900 Other assets Restricted securities—Fibreboard (Note 23) 938 Note 23 (in part). The Insurance Settlement funds are held in and invested by the Fibreboard Settlement Trust (the “Trust”) and are available to satisfy Fibreboard’s pending and future asbestos related liabilities. . . . The assets of the Trust are comprised of cash and marketable securities (collectively, the “Trust Assets”) and are reflected on Owens Corning’s consolidated balance sheet as restricted assets. These assets are reflected as current assets or other assets, with each category denoted “Restricted securities— Fibreboard.” Short-Term Investments. Companies group investments in debt and equity securities into three separate portfolios for valuation and reporting purposes: Held-to-maturity: Debt securities that a company has the positive intent and ability to hold to maturity. Trading: Debt and equity securities bought and held primarily for sale in the near term to generate income on short-term price differences. Available-for-sale: Debt and equity securities not classified as held-to-maturity or trading securities. A company should report trading securities (whether debt or equity) as current assets. It classifies individual held-to-maturity and available-for-sale securities as cur- rent or noncurrent depending on the circumstances. It should report held-to-maturity See the FASB Codification section securities at amortized cost. All trading and available-for-sale securities are reported at (page 255). fair value. [1]7 7Under the fair value option, companies may elect to use fair value as the measurement basis for selected financial assets and liabilities. For these companies, some of their financial assets (and liabilities) may be recorded at historical cost, while others are recorded at fair value. [2] Balance Sheet 219 For example, Illustration 5-5 is an excerpt from the annual report of Intuit Inc. with respect to its available-for-sale investments. ILLUSTRATION 5-5 Intuit Inc.

Balance Sheet (in thousands) Presentation of Assets Investments in Securities Cash and cash equivalents $ 170,043 Short-term investments (Note 2) 1,036,758 Note 2 (in part). The following schedule summarizes the estimated fair value of our short-term investments (all available-for-sale): Corporate notes $ 50,471 Municipal bonds 931,374 U.S. government securities 54,913 Receivables. A company should clearly identify any anticipated loss due to uncollect- ibles, the amount and nature of any nontrade receivables, and any receivables used as collateral. Major categories of receivables should be shown in the balance sheet or the related notes. For receivables arising from unusual transactions (such as sale of prop- erty, or a loan to affiliates or employees), companies should separately classify these as long-term, unless collection is expected within one year. Stanley Black & Decker reported its receivables as shown in Illustration 5-6. ILLUSTRATION 5-6 Stanley Black & Decker Balance Sheet (in millions) Presentation of Receivables Current assets Cash and cash equivalents $ 906.9 Accounts and notes receivable, net 1,553.2 Inventories, net 1,438.6 Prepaid expenses 209.0 Other current assets 215.0 Total current assets 4,322.7 Note B (in part): Accounts and Notes Receivable Trade accounts receivable $1,484.0 Trade notes receivable 100.3 Other accounts receivables 32.8 Gross accounts and notes receivable 1,617.1 Allowance for doubtful accounts (63.9) Accounts and notes receivable, net $1,553.2 Inventories. To present inventories properly, a company discloses the basis of valuation (e.g., lower-of-cost-or-market) and the cost flow assumption used (e.g., FIFO or LIFO). A manufacturing concern (like Abbott Laboratories, shown in Illustration 5-7 on page 220) also indicates the stage of completion of the inventories. 220 Chapter 5 Balance Sheet and Statement of Cash Flows ILLUSTRATION 5-7 Abbott Laboratories Balance Sheet (in thousands) Presentation of Inventories, Showing Current assets Stage of Completion Inventories Finished products $ 772,478 Work in process 338,818 Materials 384,148 Total inventories 1,495,444 Note 1 (in part): Inventories. Inventories are stated at the lower-of-cost- (first-in, first-out basis) or- market. Weyerhaeuser Company, a forestry company and lumber manufacturer with sev- eral finished-goods product lines, reported its inventory as shown in Illustration 5-8. ILLUSTRATION 5-8 Weyerhaeuser Company Balance Sheet Presentation of Current assets Inventories, Showing Inventories—at FIFO lower of cost or market Product Lines Logs and chips $ 68,471,000 Lumber, plywood and panels 86,741,000 Pulp, newsprint and paper 47,377,000 Containerboard, paperboard, containers and cartons 59,682,000 Other products 161,717,000 Total product inventories 423,988,000 Materials and supplies 175,540,000 Prepaid Expenses. A company includes prepaid expenses in current assets if it will receive benefits (usually services) within one year or the operating cycle, whichever is longer. As we discussed earlier, these items are current assets because if they had not already been paid, they would require the use of cash during the next year or the operat- ing cycle. A company reports prepaid expenses at the amount of the unexpired or unconsumed cost. A common example is the prepayment for an insurance policy. A company classifies it as a prepaid expense because the payment precedes the receipt of the benefit of cover- age. Other common prepaid expenses include prepaid rent, advertising, taxes, and office or operating supplies. Hasbro, Inc., for example, listed its prepaid expenses in current assets as shown in Illustration 5-9. ILLUSTRATION 5-9 Hasbro, Inc. Balance Sheet (in thousands) Presentation of Prepaid Expenses Current assets Cash and cash equivalents $ 715,400 Accounts receivable, less allowances of $27,700 556,287 Inventories 203,337 Prepaid expenses and other current assets 243,291 Total current assets $1,718,315 Balance Sheet 221 Noncurrent Assets Noncurrent assets are those not meeting the definition of current assets. They include a

variety of items, as we discuss in the following sections. Long-Term Investments. Long-term investments, often referred to simply as invest- ments, normally consist of one of four types: 1. Investments in securities, such as bonds, common stock, or long-term notes. 2. Investments in tangible fi xed assets not currently used in operations, such as land held for speculation. 3. Investments set aside in special funds, such as a sinking fund, pension fund, or plant expansion fund. This includes the cash surrender value of life insurance. 4. Investments in nonconsolidated subsidiaries or affi liated companies. Companies expect to hold long-term investments for many years. They usually present them on the balance sheet just below “Current assets,” in a separate section called “Investments.” Realize that many securities classified as long-term investments are, in fact, readily marketable. But a company does not include them as current assets unless it intends to convert them to cash in the short-term—that is, within a year or in the operating cycle, whichever is longer. As indicated earlier, securities classified as available-for-sale are reported at fair value, and held-to-maturity securities are reported at amortized cost. Motorola, Inc. reported its investments section, located between “Property, plant, and equipment” and “Other assets,” as shown in Illustration 5-10. ILLUSTRATION 5-10 Motorola, Inc. Balance Sheet (in millions) Presentation of Long- Investments Term Investments Equity investments $ 872 Other investments 2,567 Fair value adjustment to available-for-sale securities 2,487 Total $5,926 Property, Plant, and Equipment. Property, plant, and equipment are tangible long- lived assets used in the regular operations of the business. These assets consist of phys- ical property such as land, buildings, machinery, furniture, tools, and wasting resources (timberland, minerals). With the exception of land, a company either depreciates (e.g., buildings) or depletes (e.g., timberlands or oil reserves) these assets. Mattel, Inc. presented its property, plant, and equipment in its balance sheet as shown in Illustration 5-11 (page 222). A company discloses the basis it uses to value property, plant, and equipment; any liens against the properties; and accumulated depreciation—usually in the notes to the financial statements. 222 Chapter 5 Balance Sheet and Statement of Cash Flows ILLUSTRATION 5-11 Mattel, Inc. Balance Sheet Presentation of Property, Property, plant, and equipment Plant, and Equipment Land $ 32,793,000 Buildings 257,430,000 Machinery and equipment 564,244,000 Capitalized leases 23,271,000 Leasehold improvements 74,988,000 952,726,000 Less: Accumulated depreciation 472,986,000 479,740,000 Tools, dies and molds, net 168,092,000 Property, plant, and equipment, net 647,832,000 Intangible Assets. Intangible assets lack physical substance and are not financial instru- ments (see page 238 for the definition of a financial instrument). They include patents, copyrights, franchises, goodwill, trademarks, trade names, and customer lists. A company writes off (amortizes) limited-life intangible assets over their useful lives. It periodically assesses indefinite-life intangibles (such as goodwill) for impairment. Intangibles can represent significant economic resources, yet financial analysts often ignore them, because valuation is difficult. PepsiCo, Inc. reported intangible assets in its balance sheet as shown in Illustra- tion 5-12. ILLUSTRATION 5-12 PepsiCo, Inc. Balance Sheet (in millions) Presentation of Intangible Assets Intangible assets Goodwill $3,374 Trademarks 1,320 Other identifiable intangibles 147 Total intangibles $4,841 Other Assets. The items included in the section “Other assets” vary widely in practice. Some include items such as long-term prepaid expenses, prepaid pension cost, and non- current receivables. Other items that might be included are assets in special funds, deferred income taxes, property held for sale, and restricted cash or securities. A com- pany should limit this section to include only unusual items sufficiently different from

assets included in specific categories. Liabilities Similar to assets, companies classify liabilities as current or long-term. Current Liabilities. Current liabilities are the obligations that a company reasonably expects to liquidate either through the use of current assets or the creation of other current liabilities. This concept includes: 1. Payables resulting from the acquisition of goods and services: accounts payable, wages payable, taxes payable, and so on. Balance Sheet 223 2. Collections received in advance for the delivery of goods or performance of services, such as unearned rent revenue or unearned subscriptions revenue. 3. Other liabilities whose liquidation will take place within the operating cycle, such as the portion of long-term bonds to be paid in the current period or short-term obligations arising from the purchase of equipment. At times, a liability that is payable within the next year is not included in the current liabilities section. This occurs either when the company expects to refinance the debt through another long-term issue [3] or to retire the debt out of noncurrent assets. This approach is used because liquidation does not result from the use of current assets or the creation of other current liabilities. Companies do not report current liabilities in any consistent order. In general, though, companies most commonly list notes payable, accounts payable, or short-term debt as the first item. Income taxes payable, current maturities of long-term debt, or other current liabilities are commonly listed last. For example, see Halliburton Company’s current liabilities section in Illustration 5-13. ILLUSTRATION 5-13 Halliburton Company Balance Sheet (in millions) Presentation of Current Current liabilities Liabilities Short-term notes payable $1,570 Accounts payable 782 Accrued employee compensation and benefits 267 Unearned revenues 386 Income taxes payable 113 Accrued special charges 6 Current maturities of long-term debt 8 Other current liabilities 694 Total current liabilities 3,826 Current liabilities include such items as trade and nontrade notes and accounts payable, advances received from customers, and current maturities of long-term debt. If the amounts are material, companies classify income taxes and other accrued items separately. A company should fully describe in the notes any information about a secured liability—for example, stock held as collateral on notes payable—to identify the assets providing the security. The excess of total current assets over total current liabilities is referred to as working capital (or sometimes net working capital). Working capital represents the net amount of a company’s relatively liquid resources. That is, it is the liquidity buffer avail- able to meet the financial demands of the operating cycle. Companies seldom disclose on the balance sheet an amount for working capital. But bankers and other creditors compute it as an indicator of the short-run liquidity of a company. To determine the actual liquidity and availability of working capital to meet current obligations, however, requires analysis of the composition of the current assets and their nearness to cash. 224 Chapter 5 Balance Sheet and Statement of Cash Flows What do the numbers mean? “SHOW ME THE ASSETS!” Before the dot-com bubble burst, concerns about liquidity Another recent bubble in the real estate market created and solvency led creditors of many dot-com companies to a working capital and liquidity crisis for no less a revered demand more assurances that these companies could pay fi nancial institution than Bear Stearns. What happened? their bills when due. A key indicator for creditors is the Bear Stearns was one of the biggest investors in mortgage- amount of working capital. For example, when a report pre- backed securities. But when the housing market cooled off and dicted that Amazon.com’s working capital would turn nega- the value of the collateral backing Bear Stearns’s mortgage tive, the company’s vendors began to explore steps that securities dropped dramatically, the market began to ques-

would ensure that Amazon would pay them. tion Bear Stearns’s ability to meet its obligations. The result: Some vendors demanded that their dot-com customers The Federal Reserve stepped in to avert a collapse of the sign notes stating that the goods shipped to them would company, backing a bailout plan that guaranteed $30 billion serve as collateral for the transaction. Other vendors began of Bear Stearns’s investments. This paved the way for a shipping goods on consignment—an arrangement whereby buy-out by JPMorgan Chase at $2 per share (later amended the vendor retains ownership of the goods until a third party to $10 a share)—quite a bargain since Bear Stearns had been buys and pays for them. trading above $80 a share just a month earlier. Source: Robin Sidel, Greg Ip, Michael M. Phillips, and Kate Kelly, “The Week That Shook Wall Street: Inside the Demise of Bear Stearns,” Wall Street Journal (March 18, 2008), p. A1. Long-Term Liabilities. Long-term liabilities are obligations that a company does not reasonably expect to liquidate within the normal operating cycle. Instead, it expects to pay them at some date beyond that time. The most common examples are bonds payable, notes payable, some deferred income tax amounts, lease obligations, and pension obligations. Companies classify long-term liabilities that mature within the current operating cycle as current liabilities if payment of the obligation requires the use of current assets. Generally, long-term liabilities are of three types: 1. Obligations arising from specifi c fi nancing situations, such as the issuance of bonds, long-term lease obligations, and long-term notes payable. 2. Obligations arising from the ordinary operations of the company, such as pension obligations and deferred income tax liabilities. 3. Obligations that depend on the occurrence or non-occurrence of one or more future events to confi rm the amount payable, the payee, or the date payable, such as service or product warranties and other contingencies. Companies generally provide a great deal of supplementary disclosure for long- term liabilities because most long-term debt is subject to various covenants and restric- tions for the protection of lenders.8 It is desirable to report any premium or discount separately as an addition to or subtraction from the bonds payable. Companies frequently describe the terms of all long-term liability agreements (including maturity date or dates, rates of interest, nature of obligation, and any security pledged to support the debt) in notes to the financial statements. Illustration 5-14 provides an example of this, taken from an excerpt from The Great Atlantic & Pacific Tea Company’s financials. 8Companies usually explain the pertinent rights and privileges of the various securities (both debt and equity) outstanding in the notes to the financial statements. Examples of information that companies should disclose are dividend and liquidation preferences, participation rights, call prices and dates, conversion or exercise prices or rates and pertinent dates, sinking fund requirements, unusual voting rights, and significant terms of contracts to issue additional shares. [4] Balance Sheet 225 ILLUSTRATION 5-14 The Great Atlantic & Pacific Tea Company, Inc. Balance Sheet Presentation of Long- Total current liabilities $978,109,000 Long-term debt (See note) 254,312,000 Term Debt Obligations under capital leases 252,618,000 Deferred income taxes 57,167,000 Other non-current liabilities 127,321,000 Note: Indebtedness. Debt consists of: 9.5% senior notes, due in annual installments of $10,000,000 $ 40,000,000 Mortgages and other notes due through 2011 (average interest rate of 9.9%) 107,604,000 Bank borrowings at 9.7% 67,225,000 Commercial paper at 9.4% 100,102,000 314,931,000 Less: Current portion (60,619,000) Total long-term debt $254,312,000 Owners’ Equity The owners’ equity (stockholders’ equity) section is one of the most difficult sections to prepare and understand. This is due to the complexity of capital stock agreements and the

various restrictions on stockholders’ equity imposed by state corporation laws, liability agreements, and boards of directors. Companies usually divide the section into six parts: STOCKHOLDERS’ EQUITY SECTION 1. CAPITAL STOCK. The par or stated value of the shares issued. 2. ADDITIONAL PAID-IN CAPITAL. The excess of amounts paid in over the par or stated value. 3. RETAINED EARNINGS. The corporation’s undistributed earnings. 4. ACCUMULATED OTHER COMPREHENSIVE INCOME. The aggregate amount of the other comprehensive income items. 5. TREASURY STOCK. Generally, the amount of ordinary shares repurchased. 6. NONCONTROLLING INTEREST (MINORITY INTEREST). A portion of the equity of subsidiaries not wholly owned by the reporting company. For capital stock, companies must disclose the par value and the authorized, issued, and outstanding share amounts. A company usually presents the additional paid-in capital in one amount although subtotals are informative if the sources of additional capital are varied and material. The retained earnings amount may be divided between the unappro- priated (the amount that is usually available for dividend distribution) and restricted (e.g., by bond indentures or other loan agreements) amounts. In addition, companies show any capital stock reacquired (treasury stock) as a reduction of stockholders’ equity. Accumu- lated other comprehensive income includes such items as unrealized gains and losses on available-for-sale investments and unrealized gains and losses on certain derivative trans- actions. Noncontrolling interest (discussed in Chapter 4 and sometimes referred to as minority interest) is also shown as a separate item (where applicable) as a part of equity. Illustration 5-15 (page 226) presents an example of the stockholders’ equity section from Las Vegas Sands Corporation. The ownership or stockholders’ equity accounts in a corporation differ considerably from those in a partnership or proprietorship. Partners show separately their permanent 226 Chapter 5 Balance Sheet and Statement of Cash Flows ILLUSTRATION 5-15 Las Vegas Sands Corporation Balance Sheet Presentation of Equity Stockholders’ Equity Preferred stock, $0.001 par value, 50,000,000 shares authorized, 3,614,923 shares issued and outstanding $ 207,356 Common stock, $0.001 par value, 1,000,000,000 shares authorized, 707,507,982 shares issued and outstanding 708 Capital in excess of par value 5,444,705 Accumulated other comprehensive income 129,519 Retained earnings 880,703 Total Las Vegas Sands Corp. stockholders’ equity 6,662,991 Noncontrolling interests 1,268,197 Total equity $7,931,188 capital accounts and the balance in their temporary accounts (drawing accounts). Proprietorships ordinarily use a single capital account that handles all of the owner’s equity transactions. What do the numbers mean? WARNING SIGNALS Analysts use balance sheet information in models designed by combining balance sheet and income measures in the to predict fi nancial distress. Researcher E. I. Altman pioneered following equation. a bankruptcy-prediction model that derives a “Z-score” Working capital Retained earnings Z 5 3 1.2 1 3 1.4 Total assets Total assets EBIT Sales MV equity 1 3 3.3 1 3 0.991 3 0.6 Total assets Total assets Total liabilities Following extensive testing, Altman found that compa- At one time, the use of Z-scores was virtually unheard of nies with Z-scores above 3.0 are unlikely to fail. Those with among practicing accountants. Today, auditors, management Z-scores below 1.81 are very likely to fail. consultants, and courts of law use this measure to help eval- Altman developed the original model for publicly held uate the overall fi nancial position and trends of a fi rm. In manufacturing companies. He and others have modifi ed the addition, banks use Z-scores for loan evaluation. While a low model to apply to companies in various industries, emerging score does not guarantee bankruptcy, the model has been companies, and companies not traded in public markets. proven accurate in many situations. Source: Adapted from E. I. Altman and E. Hotchkiss, Corporate Financial Distress and Bankruptcy, Third Edition (New York: John Wiley and

Sons, 2005). Balance Sheet Format One common arrangement that companies use in presenting a classified balance LEARNING OBJECTIVE 3 sheet is the account form. It lists assets, by sections, on the left side, and liabilities Prepare a classified balance sheet and stockholders’ equity, by sections, on the right side. The main disadvantage is using the report and account formats. the need for a sufficiently wide space in which to present the items side by side. Often, the account form requires two facing pages. To avoid this disadvantage, the report form lists the sections one above the other, on the same page. See, for example, Illustration 5-16, which lists assets, followed by liabili- ties and stockholders’ equity directly below, on the same page.9 9Accounting Trends and Techniques (New York: AICPA) recently indicates that all of the 500 compa- nies surveyed use either the “report form” (484) or the “account form” (16), sometimes collec- tively referred to as the “customary form.” Balance Sheet 227 ILLUSTRATION 5-16 SCIENTIFIC PR ODUCTS, INC. Classifi ed Report Form BALANCE SHEET Balance Sheet DECEMBER 31, 2014 Assets Current assets Cash $ 42,485 Investments (available-for-sale) 28,250 Accounts receivable $165,824 Underlying Less: Allowance for doubtful accounts 1,850 163,974 Concepts Notes receivable 23,000 Inventories—at average-cost 489,713 The presentation Supplies on hand 9,780 of balance sheet Prepaid expenses 16,252 information meets the Total current assets $ 773,454 objective of fi nancial Long-term investments reporting—to provide Equity investments 87,500 information about Property, plant, and equipment entity resources, Land—at cost 125,000 claims to resources, Buildings—at cost 975,800 and changes in them. Less: Accumulated depreciation 341,200 634,600 Total property, plant, and equipment 759,600 Intangible assets Goodwill 100,000 Total assets $1,720,554 Liabilities and Stockholders’ Equity Current liabilities Notes payable to banks $ 50,000 Accounts payable 197,532 Accrued interest on notes payable 500 Income taxes payable 62,520 Accrued salaries, wages, and other liabilities 9,500 Deposits received from customers 420 Total current liabilities $ 320,472 Long-term debt Twenty-year 12% debentures, due January 1, 2022 500,000 Total liabilities 820,472 Stockholders’ equity Paid in on capital stock Preferred, 7%, cumulative Authorized, issued, and outstanding, 30,000 shares of $10 par value $300,000 Common— Authorized, 500,000 shares of $1 par value; issued and outstanding, 400,000 shares 400,000 Additional paid-in capital 37,500 $737,500 Retained earnings 153,182 Accumulated other comprehensive income 8,650 Less: Treasury stock 12,750 Equity attributable to Scientific Products, Inc. 886,582 Equity attributable to noncontrolling interest 13,500 Total stockholders’ equity 900,082 Total liabilities and stockholders’ equity $1,720,554 228 Chapter 5 Balance Sheet and Statement of Cash Flows Infrequently, companies use other balance sheet formats. For example, companies sometimes deduct current liabilities from current assets to arrive at working capital. Or, they deduct all liabilities from all assets. STATEMENT OF CASH FLOWS Chapter 2 indicated that an important element of the objective of financial report- LEARNING OBJECTIVE 4 ing is “assessing the amounts, timing, and uncertainty of cash flows.” The three Indicate the purpose of the statement financial statements we have looked at so far—the income statement, the state- of cash flows. ment of stockholders’ equity, and the balance sheet—each present some informa- tion about the cash flows of an enterprise during a period. But they do so to a limited extent. For instance, the income statement provides information about resources pro- vided by operations but not exactly cash. The statement of stockholders’ equity shows Underlying Concepts the amount of cash used to pay dividends or purchase treasury stock. Com- parative balance sheets might show what assets the company has acquired or The statement of cash fl ows disposed of, and what liabilities it has incurred or liquidated.

meets the objective of fi nancial Useful as they are, none of these statements presents a detailed summary reporting—to help assess the of all the cash inflows and outflows, or the sources and uses of cash during the amounts, timing, and uncertainty period. To fill this need, the FASB requires the statement of cash flows (also of future cash fl ows. called the cash flow statement). [5] What do the numbers mean? WATCH THAT CASH FLOW Investors usually focus on net income measured on an Although W. T. Grant showed consistent profi ts and even accrual basis. However, information on cash fl ows can be some periods of earnings growth, its cash fl ow began to “go important for assessing a company’s liquidity, fi nancial fl ex- south” starting in about year 3. The company fi led for bank- ibility, and overall fi nancial performance. The graph below ruptcy shortly after year 7. Financial statement readers who shows W. T. Grant’s fi nancial performance over 7 years. studied the company’s cash fl ows would have found early warnings of its problems. The Grant experience is a classic case, illustrating the importance of cash fl ows as an early- warning signal of fi nancial p roblems. A more recent retailer case is Target. Although Target has shown good profi ts, some are concerned that a bit too much of its sales have been made on credit rather than cash. Why is this a problem? Like W. T. Grant, the earnings of profi table lenders can get battered in future periods if they have to start adding large amounts to their bad-loan reserve to catch up with credit losses. And if losses ramp up on Target-branded 1 Year credit cards, Target may get hit in this way. 10The FASB recommends the basis as “cash and cash equivalents.” Cash equivalents are liquid investments that mature within three months or less. srallod fo snoilliM 50 40 Income 30 0 Cash Flow from Operations −30 −60 2 3 4 5 6 7 Source: Peter Eavis, “Is Target Corp.’s Credit Too Generous?” Wall Street Journal (March 11, 2008), p. C1. Purpose of the Statement of Cash Flows The primary purpose of a statement of cash flows is to provide relevant information about the cash receipts and cash payments of an enterprise during a period. To achieve this purpose, the statement of cash flows reports the following: (1) the cash effects of operations during a period, (2) investing transactions, (3) financing transactions, and (4) the net increase or decrease in cash during the period.10 Statement of Cash Flows 229 Reporting the sources, uses, and net increase or decrease in cash helps investors, creditors, and others know what is happening to a company’s most liquid resource. Because most individuals maintain a checkbook and prepare a tax return on a cash basis, they can comprehend the information reported in the statement of cash flows. The statement of cash flows provides answers to the following simple but important questions: 1. Where did the cash come from during the period? 2. What was the cash used for during the period? 3. What was the change in the cash balance during the period? Content and Format of the Statement of Cash Flows Companies classify cash receipts and cash payments during a period into three dif- 5 LEARNING OBJECTIVE ferent activities in the statement of cash flows—operating, investing, and financing Identify the content of the statement activities, defined as follows. of cash flows. 1. Operating activities involve the cash effects of transactions that enter into the determination of net income. 2. Investing activities include making and collecting loans and acquiring and dis- posing of investments (both debt and equity) and property, plant, and equip- ment. 3. Financing activities involve liability and owners’ equity items. They include (a) obtaining resources from owners and providing them with a return on their investment, and (b) borrowing money from creditors and repaying the amounts borrowed. Illustration 5-17 shows the basic format of the statement of cash flows. ILLUSTRATION 5-17 STATEMENT OF CASH FLOWS Basic Format of Cash Cash flows from operating activities $XXX Flow Statement

Cash flows from investing activities XXX Cash flows from financing activities XXX Net increase (decrease) in cash XXX Cash at beginning of year XXX Cash at end of year $XXX Illustration 5-18 (page 230) graphs the inflows and outflows of cash classified by activity. The statement’s value is that it helps users evaluate liquidity, solvency, and finan- cial flexibility. As stated earlier, liquidity refers to the “nearness to cash” of assets and liabilities. Solvency is the firm’s ability to pay its debts as they mature. Financial flexi- bility is a company’s ability to respond and adapt to financial adversity and unexpected needs and opportunities. We have devoted Chapter 23 entirely to the detailed preparation and content of the statement of cash flows. The intervening chapters will cover several elements and com- plex topics that affect the content of a typical statement of cash flows. The presentation in this chapter is introductory—a reminder of the existence of the statement of cash flows and its usefulness. 230 Chapter 5 Balance Sheet and Statement of Cash Flows Operating Activities Investing Activities Financing Activities •When cash receipts •Sale of property, plant, and equipment. •Issuance of equity (revenues) exceed •Sale of debt or equity securities of securities. cash expenditures other entities. •Issuance of debt (expenses). •Collection of loans to other entities. (bonds and notes). Inflows of Cash Inflows of Cash Cash Pool Outflows of Cash Outflows of Cash Operating Activities Investing Activities Financing Activities •Purchase of property, plant, and •When cash expenditures •Payment of dividends. equipment. (expenses) exceed •Redemption of debt. •Purchase of debt and equity cash receipts •Reacquisition of capital securities of other entities. (revenues). stock. •Loans to other entities. ILLUSTRATION 5-18 Cash Infl ows and Overview of the Preparation of the Statement of Cash Flows Outfl ows Sources of Information Companies obtain the information to prepare the statement of cash flows from LEARNING OBJECTIVE 6 several sources: (1) comparative balance sheets, (2) the current income statement, Prepare a basic statement of cash and (3) selected transaction data. flows. The following simple example demonstrates how companies use these sources in preparing a statement of cash flows. On January 1, 2014, in its first year of operations, Telemarketing Inc. issued 50,000 shares of $1 par value common stock for $50,000 cash. The company rented its office space, furniture, and telecommunications equipment and performed marketing ser- vices throughout the first year. In June 2014, the company purchased land for $15,000. Illustration 5-19 shows the company’s comparative balance sheets at the beginning and end of 2014. ILLUSTRATION 5-19 TELEMARKETING INC. Comparative Balance BALANCE SHEETS Sheets Dec. 31, 2014 Jan. 1, 2014 Increase/Decrease Assets Cash $31,000 $–0– $31,000 Increase Accounts receivable 41,000 –0– 41,000 Increase Land 15,000 –0– 15,000 Increase Total $87,000 $–0– Liabilities and Stockholders’ Equity Accounts payable $12,000 $–0– 12,000 Increase Common stock 50,000 –0– 50,000 Increase Retained earnings 25,000 –0– 25,000 Increase Total $87,000 $–0– Statement of Cash Flows 231 Illustration 5-20 presents the income statement and additional information. ILLUSTRATION 5-20 TELEMARKETING INC. Income Statement Data INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2014 Revenues $172,000 Operating expenses 120,000 Income before income tax 52,000 Income tax 13,000 Net income $ 39,000 Additional information: Dividends of $14,000 were paid during the year. Preparing the Statement of Cash Flows Preparing the statement of cash flows from these sources involves four steps: 1. Determine the net cash provided by (or used in) operating activities. 2. Determine the net cash provided by (or used in) investing and fi nancing activities. 3. Determine the change (increase or decrease) in cash during the period. 4. Reconcile the change in cash with the beginning and the ending cash balances. Net cash provided by operating activities is the excess of cash receipts over cash

payments from operating activities. Companies determine this amount by converting net income on an accrual basis to a cash basis. To do so, they add to or deduct from net income those items in the income statement that do not affect cash. This procedure requires that a company analyze not only the current year’s income statement but also the comparative balance sheets and selected transaction data. Analysis of Telemarketing’s comparative balance sheets reveals two items that will affect the computation of net cash provided by operating activities: 1. The increase in accounts receivable refl ects a noncash increase of $41,000 in revenues. 2. The increase in accounts payable refl ects a noncash increase of $12,000 in expenses. Therefore, to arrive at net cash provided by operating activities, Telemarketing Inc. deducts from net income the increase in accounts receivable ($41,000), and it adds back to net income the increase in accounts payable ($12,000). As a result of these adjust- ments, the company determines net cash provided by operating activities to be $10,000, computed as shown in Illustration 5-21. ILLUSTRATION 5-21 Net income $39,000 Computation of Net Adjustments to reconcile net income Cash Provided by to net cash provided by operating activities: Increase in accounts receivable $(41,000) Operating Activities Increase in accounts payable 12,000 (29,000) Net cash provided by operating activities $10,000 International Next, the company determines its investing and financing activities. Perspective Telemarketing Inc.’s only investing activity was the land purchase. It had two IFRS requires a statement of financing activities. (1) Common stock increased $50,000 from the issuance of cash fl ows. Both IFRS and GAAP 50,000 shares for cash. (2) The company paid $14,000 cash in dividends. Knowing specify that the cash fl ows must the amounts provided/used by operating, investing, and financing activities, be classifi ed as operating, the company determines the net increase in cash. Illustration 5-22 (page 232) investing, or fi nancing. presents Telemarketing Inc.’s statement of cash flows for 2014. 232 Chapter 5 Balance Sheet and Statement of Cash Flows ILLUSTRATION 5-22 TELEMARKETING INC. Statement of Cash Flows STATEMENT OF CASH FLOWS FOR THE YEAR ENDED DECEMBER 31, 2014 Cash flows from operating activities Net income $39,000 Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable $(41,000) Increase in accounts payable 12,000 (29,000) Net cash provided by operating activities 10,000 Cash flows from investing activities Purchase of land (15,000) Net cash used by investing activities (15,000) Cash flows from financing activities Issuance of common stock 50,000 Payment of cash dividends (14,000) Net cash provided by financing activities 36,000 Net increase in cash 31,000 Cash at beginning of year –0– Cash at end of year $31,000 The increase in cash of $31,000 reported in the statement of cash flows agrees with the increase of $31,000 in cash calculated from the comparative balance sheets. Signifi cant Noncash Activities Not all of a company’s significant activities involve cash. Examples of significant non- cash activities are: 1. Issuance of common stock to purchase assets. 2. Conversion of bonds into common stock. 3. Issuance of debt to purchase assets. 4. Exchanges of long-lived assets. Significant financing and investing activities that do not affect cash are not reported in the body of the statement of cash flows. Rather, these activities are reported in either a separate schedule at the bottom of the statement of cash flows or in separate notes to the financial statements. Such reporting of these noncash activities satisfies the full dis- closure principle. Illustration 5-23 shows an example of a comprehensive statement of cash flows. Note that the company purchased equipment through the issuance of $50,000 of bonds, which is a significant noncash transaction. In solving homework assignments, you should present significant noncash activities in a separate schedule at the bottom of the statement of cash flows.

Usefulness of the Statement of Cash Flows “Happiness is a positive cash flow” is certainly true. Although net income pro- LEARNING OBJECTIVE 7 vides a long-term measure of a company’s success or failure, cash is its lifeblood. Understand the usefulness of the Without cash, a company will not survive. For small and newly developing com- statement of cash flows. panies, cash flow is the single most important element for survival. Even medium and large companies must control cash flow. Creditors examine the cash flow statement carefully because they are concerned about being paid. They begin their examination by finding net cash provided by operating activities. A high amount indicates that a company is able to generate sufficient cash from Statement of Cash Flows 233 ILLUSTRATION 5-23 NESTOR COMPANY Comprehensive STATEMENT OF CASH FLOWS Statement of Cash Flows FOR THE YEAR ENDED DECEMBER 31, 2014 Cash flows from operating activities Net income $320,750 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense $ 88,400 Amortization of intangibles 16,300 Gain on sale of plant assets (8,700) Increase in accounts receivable (net) (11,000) Decrease in inventory 15,500 Decrease in accounts payable (9,500) 91,000 Net cash provided by operating activities 411,750 Cash flows from investing activities Sale of plant assets 90,500 Purchase of equipment (182,500) Purchase of land (70,000) Net cash used by investing activities (162,000) Cash flows from financing activities Payment of cash dividend (19,800) Issuance of common stock 100,000 Redemption of bonds (50,000) Net cash provided by financing activities 30,200 Net increase in cash 279,950 Cash at beginning of year 135,000 Cash at end of year $414,950 Noncash investing and financing activities Purchase of equipment through issuance of $50,000 of bonds operations to pay its bills without further borrowing. Conversely, a low or negative amount of net cash provided by operating activities indicates that a company may have to borrow or issue equity securities to acquire sufficient cash to pay its bills. Consequently, creditors look for answers to the following questions in the company’s cash flow statements. 1. How successful is the company in generating net cash provided by operating activities? 2. What are the trends in net cash fl ow provided by operating activities over time? 3. What are the major reasons for the positive or negative net cash provided by operat- ing activities? You should recognize that companies can fail even though they report net income. The difference between net income and net cash provided by operating activities can be substantial. Companies such as W. T. Grant Company and Prime Motor Inn, for ex- ample, reported high net income numbers but negative net cash provided by operating activities. Eventually, both companies filed for bankruptcy. In addition, substantial increases in receivables and/or inventory can explain the difference between positive net income and negative net cash provided by operating activities. For example, in its first year of operations, Hu Inc. reported a net income of $80,000. Its net cash provided by operating activities, however, was a negative $95,000, as shown in Illustration 5-24 (page 234). Hu could easily experience a “cash crunch” because it has its cash tied up in receiv- ables and inventory. If Hu encounters problems in collecting receivables, or if inven- tory moves slowly or becomes obsolete, its creditors may have difficulty collecting on their loans. 234 Chapter 5 Balance Sheet and Statement of Cash Flows ILLUSTRATION 5-24 HU INC. Negative Net Cash NET CASH FLOW FROM OPERATING ACTIVITIES Provided by Operating Activities Cash flows from operating activities Net income $ 80,000 Adjustments to reconcile net income to net cash provided by operating activities: Increase in receivables $ (75,000) Increase in inventories (100,000) (175,000) Net cash provided by operating activities $(95,000) Financial Liquidity Readers of financial statements often assess liquidity by using the current cash debt

coverage. It indicates whether the company can pay off its current liabilities from its operations in a given year. Illustration 5-25 shows the formula for this ratio. ILLUSTRATION 5-25 Net Cash Provided by Operating Activities Current Cash Formula for Current 5 Average Current Liabilities Debt Coverage Cash Debt Coverage The higher the current cash debt coverage, the less likely a company will have l iquidity problems. For example, a ratio near 1:1 is good. It indicates that the company can meet all of its current obligations from internally generated cash flow. Financial Flexibility The cash debt coverage provides information on financial flexibility. It indicates a company’s ability to repay its liabilities from net cash provided by operating activities, without having to liquidate the assets employed in its operations. Illustration 5-26 shows the formula for this ratio. Notice its similarity to the current cash debt coverage. However, because it uses average total liabilities in place of average current liabilities, it takes a somewhat longer-range view. ILLUSTRATION 5-26 Net Cash Provided by Operating Activities Cash Debt Formula for Cash Debt 5 Average Total Liabilities Coverage Coverage The higher this ratio, the less likely the company will experience difficulty in meet- ing its obligations as they come due. It signals whether the company can pay its debts and survive if external sources of funds become limited or too expensive. Free Cash Flow A more sophisticated way to examine a company’s financial flexibility is to develop a free cash flow analysis. Free cash flow is the amount of discretionary cash flow a com- pany has. It can use this cash flow to purchase additional investments, retire its debt, purchase treasury stock, or simply add to its liquidity. Financial statement users calcu- late free cash flow as shown in Illustration 5-27. ILLUSTRATION 5-27 Net Cash Provided Formula for Free Cash Capital Free by Operating 2 2 Dividends 5 Flow Expenditures Cash Flow Activities Statement of Cash Flows 235 In a free cash flow analysis, we first deduct capital spending, to indicate it is the least discretionary expenditure a company generally makes. (Without continued efforts to maintain and expand facilities, it is unlikely that a company can continue to maintain its competitive position.) We then deduct dividends. Although a company can cut its dividend, it usually will do so only in a financial emergency. The amount resulting after these deductions is the company’s free cash flow. Obviously, the greater the amount of free cash flow, the greater the company’s financial flexibility. Questions that a free cash flow analysis answers are: 1. Is the company able to pay its dividends without resorting to external fi nancing? 2. If business operations decline, will the company be able to maintain its needed capital investment? 3. What is the amount of discretionary cash fl ow that can be used for additional investment, retirement of debt, purchase of treasury stock, or addition to liquidity? Illustration 5-28 is a free cash flow analysis using the cash flow statement for Nestor Company (shown in Illustration 5-23 on page 233). ILLUSTRATION 5-28 NESTOR COMPANY Free Cash Flow FREE CASH FLOW ANALYSIS Computation Net cash provided by operating activities $411,750 Less: Capital expenditures 252,500 Dividends 19,800 Free cash flow $139,450 This computation shows that Nestor has a positive, and substantial, net cash pro- vided by operating activities of $411,750. Nestor’s statement of cash flows reports that the company purchased equipment of $182,500 and land of $70,000 for total capital spending of $252,500. Nestor has more than sufficient cash flow to meet its dividend payment and therefore has satisfactory financial flexibility. As you can see from looking back at Illustration 5-23 (page 233), Nestor used its free cash flow to redeem bonds and add to its liquidity. If it finds additional investments that are profitable, it can increase its spending without putting its dividend or basic capital spending in jeopardy. Companies that have strong financial flexibility can take advan-

tage of profitable investments even in tough times. In addition, strong financial flexibil- ity frees companies from worry about survival in poor economic times. In fact, those with strong financial flexibility often fare better in a poor economy because they can take advantage of opportunities that other companies cannot. What do the numbers mean? “THERE OUGHT TO BE A LAW” As one manager noted, “There ought to be a law that before you alleged that Krispy Kreme may have been infl ating its can buy a stock, you must be able to read a balance sheet.” We revenues and not taking enough bad debt expense (which agree, and the same can be said for a statement of cash fl ows. infl ated both assets and income). In addition, Krispy Krispy Kreme Doughnuts provides an example of how Kreme’s operating cash fl ow was negative. Most fi nancially stunning earnings growth can hide real problems. Not long sound companies generate positive cash fl ow. ago, the doughnut maker was a glamour stock with a On the next page are additional examples of how one 60 percent earnings per share growth rate and a price- rating agency rated the earnings quality of some companies, earnings ratio around 70. Seven months later, its stock price using some key balance sheet and statement of cash fl ow had dropped 72 percent. What happened? Stockholders measurements. 236 Chapter 5 Balance Sheet and Statement of Cash Flows Earnings-Quality Earnings-Quality Earnings-Quality Earnings-Quality Winners Company Indicators Losers Company Indicators Avon Products Strong cash fl ow Ford Motor H igh debt and Capital One Conservatively underfunded Financial capitalized pension plan Ecolab G ood management Kroger H igh goodwill of working capital and debt Timberland M inimal off-balance- Ryder System N egative free cash sheet commitments fl ow Teco Energy S elling assets to meet liquidity needs Another rating organization uses a metric to adjust for declines (and falling stock prices). This was the case at Avon; shortcomings in amounts reported in the balance sheet. Just its strong cash fl ow rating subsequently declined, such that as improving balance sheet and cash fl ow information is its free cash fl ow was just 76 percent of net income. This a leading indicator of improved earnings, a deteriorating raised red fl ags about the results on foreign investments balance sheet and statement of cash fl ows warn of earnings by Avon. Sources: Adapted from Gretchen Morgenson, “How Did They Value Stocks? Count the Absurd Ways,” New York Times on the Web (March 18, 2001); K. Badanhausen, J. Gage, C. Hall, and M. Ozanian, “Beyond Balance Sheet: Earnings Quality,” Forbes.com (January 28, 2005); and H. Karp, “Avon’s Investments Fall Short,” Wall Street Journal (December 8, 2011). ADDITIONAL INFORMATION In both Chapter 4 and this chapter, we have discussed the primary financial LEARNING OBJECTIVE 8 statements that all companies prepare in accordance with GAAP. However, Determine which balance sheet the primary financial statements cannot provide the complete picture related information requires supplemental to the financial position and financial performance of the company. Additional disclosure. descriptive information in supplemental disclosures and certain techniques of disclosure expand on and amplify the items presented in the main body of the statements. Supplemental Disclosures The balance sheet is not complete if a company simply lists the assets, liabilities, and owners’ equity accounts. It still needs to provide important supplemental informa- tion. This may be information not presented elsewhere in the statement, or it may elaborate on items in the balance sheet. The four types of information that are usu- ally supplemental to account titles and amounts presented in the balance sheet are as follows. SUPPLEMENTAL BALANCE SHEET INFORMATION 1. CONTINGENCIES. Material events that have an uncertain outcome. 2. ACCOUNTING POLICIES. Explanations of the valuation methods used or the basic assumptions made concerning inventory valuations, depreciation methods, investments

in subsidiaries, etc. 3. CONTRACTUAL SITUATIONS. Explanations of certain restrictions or covenants attached to specifi c assets or, more likely, to liabilities. 4. FAIR VALUES. Disclosures of fair values, particularly for fi nancial instruments. Additional Information 237 Contingencies Underlying Concepts A contingency is an existing situation involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) that will ultimately be resolved The basis for including when one or more future events occur or fail to occur. In short, contingencies are additional information should material events with an uncertain future. Examples of gain contingencies are meet the full disclosure principle. tax operating-loss carryforwards or company litigation against another party. That is, the information should Typical loss contingencies relate to litigation, environmental issues, possible tax be of suffi cient importance to assessments, or government investigations. We examine the accounting and infl uence the judgment of an reporting requirements involving contingencies more fully in Chapter 13. informed user. Accounting Policies GAAP recommends disclosure for all significant accounting principles and methods that involve selection from among alternatives or those that are peculiar to a given in- dustry. [6] For instance, companies can compute inventories under several cost flow assumptions (e.g., LIFO and FIFO), depreciate plant and equipment under several ac- cepted methods (e.g., double-declining-balance and straight-line), and carry invest- ments at different valuations (e.g., cost, equity, and fair value). Sophisticated users of financial statements know of these possibilities and examine the statements closely to determine the methods used. Companies must also disclose information about the nature of their operations, the use of estimates in preparing financial statements, certain significant estimates, and vulnerabilities due to certain concentrations. [7] Illustration 5-29 shows an example of such a disclosure. ILLUSTRATION 5-29 Chesapeake Corporation Balance Sheet Disclosure Risks and Uncertainties. Chesapeake operates in three business segments which offer a diversity of of Signifi cant Risks and products over a broad geographic base. The Company is not dependent on any single customer, group Uncertainties of customers, market, geographic area or supplier of materials, labor or services. Financial statements include, where necessary, amounts based on the judgments and estimates of management. These estimates include allowances for bad debts, accruals for landfill closing costs, environmental remediation costs, loss contingencies for litigation, self-insured medical and workers’ compensation insurance and determinations of discount and other rate assumptions for pensions and postretirement benefit expenses. Disclosure of significant accounting principles and methods and of risks and uncer- tainties is particularly useful if given in a separate Summary of Significant Accounting Policies preceding the notes to the financial statements or as the initial note. Contractual Situations Companies should disclose contractual situations, if significant, in the notes to the financial statements. For example, they must clearly state the essential provisions of lease contracts, pension obligations, and stock option plans in the notes. Analysts want to know not only the amount of the liabilities but also how the different contractual provisions affect the company at present and in the future. Companies must disclose the following commitments if the amounts are material: commitments related to obligations to maintain working capital, to limit the payment of dividends, to restrict the use of assets, and to require the maintenance of certain finan- cial ratios. Management must exercise considerable judgment to determine whether omission of such information is misleading. The rule in this situation is, “When in doubt, disclose.” It is better to disclose a little too much information than not enough.

238 Chapter 5 Balance Sheet and Statement of Cash Flows What do the numbers mean? WHAT ABOUT YOUR COMMITMENTS? Many of the recent accounting scandals related to the ment discussion and analysis section of the company’s nondisclosure of signifi cant contractual obligations. In annual report. response, the SEC has mandated that companies disclose Presented below, as an example, is a disclosure from The contractual obligations in a tabular summary in the manage- Procter & Gamble Company. Contractual Commitments, as of June 30, 2011 (in millions of dollars) Less Than 1–3 3–5 After 5 Total 1 Year Years Years Years Recorded Liabilities Total debt $31,494 $ 9,933 $ 5,959 $5,095 $10,507 Capital leases 407 46 89 75 197 Uncertain tax positions (1) 77 77 — — — Other Interest payments relating to long-term debt 9,897 1,002 1,744 1,313 5,838 Operating leases (2) 1,499 264 416 314 505 Minimum pension funding (3) 1,070 391 679 — — Purchase obligations (4) 3,012 1,351 1,130 258 273 Total contractual commitments $47,456 $13,064 $10,017 $7,055 $17,320 (1)As of June 30, 2011, the Company’s Consolidated Balance Sheet refl ects a liability for uncertain tax positions of $2.4 billion, including $555 million of interest and penalties. Due to the high degree of uncertainty regarding the timing of future cash outfl ows of liabilities for uncertain tax positions beyond one year, a reasonable estimate of the period of cash settlement beyond twelve months from the balance sheet date of June 30, 2011 cannot be made. (2)Operating lease obligations are shown net of guaranteed sublease income. (3)Represents future pension payments to comply with local funding requirements. The projected payments beyond fi scal year 2014 are not currently determinable. (4)Primarily refl ects future contractual payments under various take-or-pay arrangements entered into as part of the normal course of business. Fair Values As we have discussed, fair value information may be more useful than historical cost for certain types of assets and liabilities. This is particularly so in the case of financial instru- ments. Financial instruments are defined as cash, an ownership interest, or a contrac- tual right to receive or obligation to deliver cash or another financial instrument. Such contractual rights to receive cash or other financial instruments are assets. Contractual obligations to pay are liabilities. Cash, investments, accounts receivable, and payables are examples of financial instruments. Given the expanded use of fair value measurements, as discussed in Chapter 2, GAAP also has expanded disclosures about fair value measurements. [8] To increase consistency and comparability in the use of fair value measures, companies follow a fair value hierarchy that provides insight into how to determine fair value. The hier- archy has three levels. Level 1 measures (the least subjective) are based on observable inputs, such as market prices for identical assets or liabilities. Level 2 measures (more subjective) are based on market-based inputs other than those included in Level 1, such as those based on market prices for similar assets or liabilities. Level 3 measures (most subjective) are based on unobservable inputs, such as a company’s own data or assumptions.11 For major groups of assets and liabilities, companies must make the following fair value disclosures: (1) the fair value measurement and (2) the fair value hierarchy level of the measurements as a whole, classified by Level 1, 2, or 3. Illustration 5-30 provides a disclosure for Devon Energy for its assets and liabilities measured at fair value. 11Level 3 fair value measurements may be developed using expected cash flow and present value techniques, as described in “Using Cash Flow Information and Present Value in Accounting,” Statement of Financial Accounting Concepts No. 7, as discussed in Chapter 6. Additional Information 239 ILLUSTRATION 5-30 Devon Energy Corporation Disclosure of Fair Values Note 7: Fair Value Measurements (in part). Certain of Devon’s assets and liabilities are reported at fair

value in the accompanying balance sheets. The following table provides fair value measurement information for such assets and liabilities. Fair Value Measurements Using: Quoted Significant Prices in Other Significant Active Observable Unobservable Total Markets Inputs Inputs Fair Value (Level 1) (Level 2) (Level 3) (In millions) Assets: Short-term investments $ 341 $ 341 $ — $ — Investment in Chevron common stock 1,327 1,327 — — Financial instruments 8 — 8 — Liabilities: Financial instruments 497 — 497 — Asset retirement obligation (ARO) 1,300 — — 1,300 GAAP establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. As presented in the table above, this hierarchy consists of three broad levels. Level 1 inputs on the hierarchy consist of unadjusted quoted prices in active markets for identical assets and liabilities and have the highest priority. Level 3 inputs have the lowest priority. Devon uses appropriate valuation techniques based on the available inputs to measure the fair values of its assets and liabilities. When available, Devon measures fair value using Level 1 inputs because they generally provide the most reliable evidence of fair value. In addition, companies must provide significant additional disclosure related to Level 3 measurements. The disclosures related to Level 3 are substantial and must iden- tify what assumptions the company used to generate the fair value numbers and any related income effects. Companies will want to use Level 1 and 2 measurements as much as possible. In most cases, these valuations should be very reliable, as the fair value measurements are based on market information. In contrast, a company that uses Level 3 measurements extensively must be carefully evaluated to understand the im- pact these valuations have on the financial statements. Techniques of Disclosure Companies should disclose as completely as possible the effect of various contin- 9 LEARNING OBJECTIVE gencies on financial condition, the methods of valuing assets and liabilities, and Describe the major disclosure the company’s contracts and agreements. To disclose this pertinent information, techniques for the balance sheet. companies may use parenthetical explanations, notes, cross-reference and contra items, and supporting schedules. Parenthetical Explanations Companies often provide additional information by parenthetical explanations follow- ing the item. For example, Illustration 5-31 shows a parenthetical explanation of the ILLUSTRATION 5-31 Ford Motor Company Parenthetical Disclosure Stockholders’ Equity (in millions) of Shares Issued—Ford Motor Company Common stock, par value $0.01 per share (1,837 million shares issued) $18 240 Chapter 5 Balance Sheet and Statement of Cash Flows number of shares issued by Ford Motor Company on the balance sheet under Underlying Concepts “Stockholders’ equity.” The user-specifi c quality of This additional pertinent balance sheet information adds clarity and com- understandability requires pleteness. It has an advantage over a note because it brings the additional infor- accountants to be careful in mation into the body of the statement where readers will less likely overlook it. describing transactions and Companies, however, should avoid lengthy parenthetical explanations, which events. might be distracting. Notes Companies use notes if they cannot conveniently show additional explanations as parenthetical explanations. Illustration 5-32 shows how International Paper Company reported its inventory costing methods in its accompanying notes. ILLUSTRATION 5-32 International Paper Company Note Disclosure Note 11 Inventories by major category were (millions): Raw materials $ 371 Finished pulp, paper and packaging products 1,796 Finished lumber and panel products 184 Operating supplies 351 Other 16 Total inventories $2,718 The last-in, first-out inventory method is used to value most of International Paper’s U.S. inventories. Approximately 70% of total raw materials and finished products inventories were valued using this

method. If the first-in, first-out method had been used, it would have increased total inventories balances by approximately $170 million. Companies commonly use notes to disclose the following: the existence and amount of any preferred stock dividends in arrears, the terms of or obligations imposed by pur- chase commitments, special financial arrangements and instruments, depreciation policies, any changes in the application of accounting principles, and the existence of contingencies. Notes therefore must present all essential facts as completely and succinctly as pos- sible. Careless wording may mislead rather than aid readers. Notes should add to the total information made available in the financial statements, not raise unanswered questions or contradict other portions of the statements. The note disclosures in Illustra- tion 5-33 show the presentation of such information. ILLUSTRATION 5-33 Alberto-Culver Company More Note Disclosures Note 3: Long-Term Debt. Various borrowing arrangements impose restrictions on such items as total debt, working capital, dividend payments, treasury stock purchases and interest expense. The company was in compliance with these arrangements and $68 million of consolidated retained earnings was not restricted as to the payment of dividends and purchases of treasury stock. Additional Information 241 ILLUSTRATION 5-33 (Continued) Apple Inc. Note 7: Commitments and Contingencies. Other Commitments As of September 24, 2011, the Company had outstanding off-balance sheet commitments for outsourced manufacturing and component purchases of $13.9 billion. Additionally, other outstanding obligations were $2.4 billion as of September 24, 2011, and were comprised mainly of commitments under long term Underlying supply agreements to make additional inventory component prepayments and to acquire capital equipment, commitments to acquire product tooling and manufacturing process equipment, and Concepts commitments related to advertising, research and development, Internet and telecommunications services and other obligations. The FASB recently issued an invitation to comment on disclosure effectiveness, in order to get input on how disclosures in the Willamette Industries, Inc. footnotes can be made more useful. Note 4: Property, Plant, and Equipment (partial): The company changed its accounting estimates relating to depreciation. The estimated service lives for most machinery and equipment were extended five years. The change was based upon a study performed by the company’s engineering department, comparisons to typical industry practices, and the effect of the company’s extensive capital investments which have resulted in a mix of assets with longer productive lives due to technological advances. As a result of the change, net income was increased $51,900, or $0.46 per diluted share. Cross-Reference and Contra Items Companies “cross-reference” a direct relationship between an asset and a liability on the balance sheet. For example, as shown in Illustration 5-34, on December 31, 2014, a company might show the following entries—one listed among the current assets, and the other listed among the current liabilities. ILLUSTRATION 5-34 Current Assets (in part) Cross-Referencing and Cash on deposit with sinking fund trustee for Contra Items redemption of bonds payable—see Current liabilities $800,000 Current Liabilities (in part) Bonds payable to be redeemed in 2015—see Current assets $2,300,000 This cross-reference points out that the company will redeem $2,300,000 of bonds payable currently, for which it has only set aside $800,000. Therefore, it needs additional cash from unrestricted cash, from sales of investments, from profits, or from some other source. Alternatively, the company can show the same information parenthetically. Another common procedure is to establish contra or adjunct accounts. A contra account on a balance sheet reduces either an asset, liability, or owners’ equity ac- count. Examples include Accumulated Depreciation and Discount on Bonds Pay- able. Contra accounts provide some flexibility in presenting the financial informa-

tion. With the use of the Accumulated Depreciation account, for example, a reader of the statement can see the original cost of the asset as well as the depreciation to date. 242 Chapter 5 Balance Sheet and Statement of Cash Flows An adjunct account, on the other hand, increases either an asset, liability, or owners’ equity account. An example is Premium on Bonds Payable, which, when added to the Bonds Payable account, describes the total bond liability of the company. Supporting Schedules Often a company needs a separate schedule to present more detailed information about certain assets or liabilities, as shown in Illustration 5-35. ILLUSTRATION 5-35 Property, plant, and equipment Disclosure through Use Land, buildings, equipment, and other fixed assets—net (see Schedule 3) $643,300 of Supporting Schedules SCHEDULE 3 LAND, BUILDINGS, EQUIPMENT, AND OTHER FIXED ASSETS Other Fixed Total Land Buildings Equip. Assets Balance January 1, 2014 $740,000 $46,000 $358,000 $260,000 $76,000 Additions in 2014 161,200 120,000 38,000 3,200 901,200 46,000 478,000 298,000 79,200 Assets retired or sold in 2014 31,700 27,000 4,700 Balance December 31, 2014 869,500 46,000 478,000 271,000 74,500 Depreciation taken to January 1, 2014 196,000 102,000 78,000 16,000 Depreciation taken in 2014 56,000 28,000 24,000 4,000 252,000 130,000 102,000 20,000 Depreciation on assets retired in 2014 25,800 22,000 3,800 Depreciation accumulated December 31, 2014 226,200 130,000 80,000 16,200 Book value of assets $643,300 $46,000 $348,000 $191,000 $58,300 International Terminology Perspective The account titles in the general ledger do not necessarily represent the best terminology for balance sheet purposes. Companies often use brief account Internationally, accounting terminology is a problem. titles and include technical terms that only accountants understand. But many Confusion arises even between persons unacquainted with accounting terminology examine balance sheets. nations that share a language. Thus, balance sheets should contain descriptions that readers will generally For example, U.S. investors understand and clearly interpret. normally think of “stock” as For example, companies have used the term “reserve” in differing ways: to “equity” or “ownership.” To describe amounts deducted from assets (contra accounts such as accumulated the British, “stocks” means depreciation and allowance for doubtful accounts), as a part of the title of con- inventory. In the United States, tingent or estimated liabilities, and to describe an appropriation of retained “fi xed assets” generally refers earnings. Because of the different meanings attached to this term, misinterpre- to “property, plant, and equip- tation often resulted from its use. Therefore, the profession has recommended ment.” In Britain, the category that companies use the word reserve only to describe an appropriation of retained includes more items. earnings. The use of the term in this narrower sense—to describe appropriated Summary of Learning Objectives 243 retained earnings—has resulted in a better understanding of its significance when it You will appears in a balance sheet. However, the term “appropriated” appears more logical, want to and we encourage its use. read the For years, the profession has recommended that the use of the word surplus IFRS INSIGHTS be discontinued in balance sheet presentations of stockholders’ equity. The use of the on pages 277–284 terms capital surplus, paid-in surplus, and earned surplus is confusing. Although con- for discussion of demned by the profession, these terms appear all too frequently in current financial IFRS related to statements. the balance sheet and statement of cash flows. Evolving Issue BALANCE SHEET REPORTING: GROSS OR NET? In addition to the issue of financial statement presentation Implementation of these new rules in the United States discussed in the opening story, a second area of controversy would result in a dramatic “grossing up” of balance sheets for balance sheet reporting is the issue of offsetting (or net- (particularly for financial institutions). For example, one

ting) of assets and liabilities. It is generally accepted that study estimated that the new rules would gross up U.S. offsetting of recognized assets and recognized liabilities banks’ balance sheets by $900 billion (or an average of 68%, detracts from the ability of users both to understand the ranging from a 31.4% increase for Citigroup to 104.7% for transactions and conditions that have occurred and to assess Morgan Stanley).* Not surprisingly, the FASB received sig- the company’s future cash flows. In other words, providing nificant push-back from some of its constituents (particularly information on assets, liabilities, and stockholders‘ equity financial institutions) to the proposed rules. helps users to compute rates of return and evaluate capital As a result, to date the Boards have not been able to structure. However, netting assets and liabilities limits a agree on a converged standard, thereby stalling this project. user’s ability to assess the future economic benefits and obli- However, the Boards have issued converged disclosure gations. That is, offsetting hides the existence of assets and requirements. The disclosure rules require companies to liabilities, making it difficult to evaluate liquidity, solvency, disclose both gross information and net information about and financial flexibility. As a result, GAAP does not permit instruments and transactions that are eligible for offset in the the reporting of summary accounts alone (e.g., total assets, balance sheet. While the Boards have not been able to de- net assets, and total liabilities). velop a converged set of criteria for offsetting, the informa- Recently, the IASB and FASB have worked to develop tion provided under the new converged disclosure rules common criteria for offsetting on the balance sheet. Current should enable users of a company’s financial statements to offsetting rules under IFRS are more restrictive than GAAP. evaluate the effects of netting arrangements on its financial The rules proposed would allow offsetting only in rare cir- position. In doing so, the new rules support the full disclo- cumstances (e.g., when right of offset is legally enforceable). sure principle. *See Y. N’Diaye, “S&P: Accounting Rule Could Boost Bank Balance Sheets by Average 68%,” https://mninews.deutsche-boerse.com (September 22, 2011). KEY TERMS SUMMARY OF LEARNING OBJECTIVES account form, 226 adjunct account, 242 available-for-sale 1 Explain the uses and limitations of a balance sheet. The balance sheet investments, 218 provides information about the nature and amounts of investments in a company’s balance sheet, 214 resources, obligations to creditors, and owners’ equity. The balance sheet contributes to cash debt coverage, 234 financial reporting by providing a basis for (1) computing rates of return, (2) evaluating contingency, 237 the capital structure of the enterprise, and (3) assessing the liquidity, solvency, and contra account, 241 financial flexibility of the enterprise. 244 Chapter 5 Balance Sheet and Statement of Cash Flows current assets, 217 Three limitations of a balance sheet are as follows. (1) The balance sheet does not current cash debt reflect fair value because accountants use a historical cost basis in valuing and reporting coverage, 234 most assets and liabilities. (2) Companies must use judgments and estimates to deter- current liabilities, 222 mine certain amounts, such as the collectibility of receivables and the useful life of long- financial flexibility, 214 term tangible and intangible assets. (3) The balance sheet omits many items that are financial instruments, 238 of financial value to the business but cannot be recorded objectively, such as human resources, customer base, and reputation. financing activities, 229 free cash flow, 234 2 Identify the major classifications of the balance sheet. The general ele- held-to-maturity ments of the balance sheet are assets, liabilities, and equity. The major classifications of investments, 218 assets are current assets; long-term investments; property, plant, and equipment; intan-

intangible assets, 222 gible assets; and other assets. The major classifications of liabilities are current and long- investing activities, 229 term liabilities. The balance sheet of a corporation generally classifies owners’ equity as liquidity, 214 capital stock, additional paid-in capital, and retained earnings. long-term 3 Prepare a classified balance sheet using the report and account investments, 221 formats. The report form lists liabilities and stockholders’ equity directly below assets long-term liabilities, 224 on the same page. The account form lists assets, by sections, on the left side, and liabili- operating activities, 229 ties and stockholders’ equity, by sections, on the right side. owners’ (stockholders’) equity, 225 4 Indicate the purpose of the statement of cash flows. The primary pur- property, plant, and pose of a statement of cash flows is to provide relevant information about a company’s equipment, 221 cash receipts and cash payments during a period. Reporting the sources, uses, and net report form, 226 change in cash enables financial statement readers to know what is happening to a company’s most liquid resource. reserve, 242 solvency, 214 5 Identify the content of the statement of cash flows. In the statement of statement of cash cash flows, companies classify the period’s cash receipts and cash payments into three flows, 228 different activities. (1) Operating activities: Involve the cash effects of transactions that trading investments, 218 enter into the determination of net income. (2) Investing activities: Include making and working capital, 223 collecting loans, and acquiring and disposing of investments (both debt and equity) and of property, plant, and equipment. (3) Financing activities: Involve liability and owners’ equity items. Financing activities include (a) obtaining capital from owners and provid- ing them with a return on their investment, and (b) borrowing money from creditors and repaying the amounts borrowed. 6 Prepare a basic statement of cash flows. The information to prepare the statement of cash flows usually comes from comparative balance sheets, the current in- come statement, and selected transaction data. Companies follow four steps to prepare the statement of cash flows from these sources. (1) Determine the net cash provided by (or used in) operating activities. (2) Determine the net cash provided by (or used in) investing and financing activities. (3) Determine the change (increase or decrease) in cash during the period. (4) Reconcile the change in cash with the beginning and ending cash balances. 7 Understand the usefulness of the statement of cash flows. Creditors examine the statement of cash flows carefully because they are concerned about being paid. The net cash flow provided by operating activities in relation to the company’s liabilities is helpful in making this assessment. Two ratios used in this regard are the current cash debt ratio and the cash debt ratio. In addition, the amount of free cash flow provides creditors and stockholders with a picture of the company’s financial flexibility. 8 Determine which balance sheet information requires supplemental disclosure. Four types of information normally are supplemental to account titles and amounts presented in the balance sheet. (1) Contingencies: Material events that have an uncertain outcome. (2) Accounting policies: Explanations of the valuation methods used or the basic assumptions made concerning inventory valuation, depreciation methods, investments in subsidiaries, etc. (3) Contractual situations: Explanations of certain restric- tions or covenants attached to specific assets or, more likely, to liabilities. (4) Fair values: Disclosures related to fair values, particularly related to financial instruments. Appendix 5A: Ratio Analysis—A Reference 245 9 Describe the major disclosure techniques for the balance sheet. Com- panies use four methods to disclose pertinent information in the balance sheet. (1) Par- enthetical explanations: Parenthetical information provides additional information or

description following the item. (2) Notes: A company uses notes if it cannot conveniently show additional explanations or descriptions as parenthetical explanations. (3) Cross- reference and contra items: Companies “cross-reference” a direct relationship between an asset and a liability on the balance sheet. (4) Supporting schedules: Often a company uses a separate schedule to present more detailed information than just the single summary item shown in the balance sheet. APPENDIX 5A RATIO ANALYSIS—A REFERENCE USING RATIOS TO ANALYZE PERFORMANCE Analysts and other interested parties can gather qualitative information from 10 LEARNING OBJECTIVE financial statements by examining relationships between items on the statements Identify the major types of financial and identifying trends in these relationships. A useful starting point in developing ratios and what they measure. this information is ratio analysis. A ratio expresses the mathematical relationship between one quantity and another. Ratio analysis expresses the relationship among pieces of selected financial statement data, in a percentage, a rate, or a simple proportion. To illustrate, IBM Corporation recently had current assets of $46,970 million and current liabilities of $39,798 million. We find the ratio between these two amounts by dividing current assets by current liabilities. The alternative means of expression are: Percentage: Current assets are 118% of current liabilities. Rate: Current assets are 1.18 times as great as current liabilities. Proportion: The relationship of current assets to current liabilities is 1.18:1. To analyze financial statements, we classify ratios into four types, as follows. MAJOR TYPES OF RATIOS LIQUIDITY RATIOS. Measures of the company’s short-term ability to pay its maturing obligations. Gateway to ACTIVITY RATIOS. Measures of how effectively the company uses its assets. the Profession PROFITABILITY RATIOS. Measures of the degree of success or failure of a given company Expanded Discussion or division for a given period of time. of Financial Statement Analysis COVERAGE RATIOS. Measures of the degree of protection for long-term creditors and investors. In Chapter 5, we discussed three measures related to the statement of cash flows (current cash debt coverage, cash debt coverage, and free cash flow). Throughout the remainder of the textbook, we provide ratios to help you understand and interpret the 246 Chapter 5 Balance Sheet and Statement of Cash Flows information presented in financial statements. Illustration 5A-1 presents the ratios that we will use throughout the textbook. You should find this chart helpful as you examine these ratios in more detail in the following chapters. An appendix to Chapter 24 further discusses financial statement analysis. ILLUSTRATION 5A-1 A Summary of Financial Ratios Ratio Formula Purpose or Use I. Liquidity 1. Current ratio Current assets Measures short-term debt-paying ability Current liabilities 2. Quick or acid-test Cash, short-term investments, Measures immediate short-term liquidity ratio and net receivables Current liabilities 3. Current cash debt Net cash provided by Measures a company’s ability to pay off its coverage operating activities current liabilities in a given year from its Average current liabilities operations II. Activity 4. Accounts receivable Net sales Measures liquidity of receivables turnover Average trade receivables (net) 5. Inventory turnover Cost of goods sold Measures liquidity of inventory Average inventory 6. Asset turnover Net sales Measures how efficiently assets are used to Average total assets generate sales III. Profitability 7. Profit margin on Net income Measures net income generated by each dollar sales Net sales of sales 8. Return on Net income Measures overall profitability of assets assets Average total assets 9. Return on Net income minus preferred dividends Measures profitability of owners’ investment common stock Average common stockholders’ equity equity 10. Earnings per share Net income minus preferred dividends Measures net income earned on each share of

Weighted-average number of shares outstanding common stock 11. Price-earnings ratio Market price of stock Measures the ratio of the market price per share Earnings per share to earnings per share 12. Payout ratio Cash dividends Measures percentage of earnings distributed in Net income the form of cash dividends IV. Coverage 13. Debt to assets Total liabilities Measures the percentage of total assets Total assets provided by creditors 14. Times interest earned Income before income taxes and interest expense Measures ability to meet interest payments as Interest expense they come due 15. Cash debt coverage Net cash provided by operating activities Measures a company’s ability to repay its total Average total liabilities liabilities in a given year from its operations 16. Book value per share Common stockholders’ equity Measures the amount each share would receive Outstanding shares if the company were liquidated at the amounts reported on the balance sheet 17. Free cash flow Net cash provided by operating Measures the amount of discretionary cash flow activities 2 Capital expenditures 2 Dividends Appendix 5B: Specimen Financial Statements: The Procter & Gamble Company 247 KEY TERMS SUMMARY OF LEARNING OBJECTIVE activity ratios, 245 FOR APPENDIX 5A coverage ratios, 245 liquidity ratios, 245 profitability ratios, 245 10 Identify the major types of financial ratios and what they measure. ratio analysis, 245 Ratios express the mathematical relationship between one quantity and another, expressed as a percentage, a rate, or a proportion. Liquidity ratios measure the short-term ability to pay maturing obligations. Activity ratios measure the effectiveness of asset usage. Profit- ability ratios measure the success or failure of an enterprise. Coverage ratios measure the degree of protection for long-term creditors and investors. SPECIMEN FINANCIAL STATEMENTS: 5B APPENDIX THE PROCTER & GAMBLE COMPANY The Procter & Gamble Company (P&G) manufactures and markets a range of con- sumer products in various countries throughout the world. The company markets over 300 branded products in more than 160 countries. It manages its business in six product segments: Fabric and Home Care, Baby and Family Care, Beauty Care, Health Care, Snacks, and Pet Care and Grooming. The content and organization of corporate annual reports have become fairly stan- dardized. Excluding the public relations part of the report (pictures, products, etc.), the following are the traditional financial portions of the annual report: • Letter to the Stockholders • Financial Highlights • Management’s Discussion and Analysis • Management Certification of Financial Statements • Management’s Report on Internal Control • Auditor’s Reports • Financial Statements • Notes to the Financial Statements • Supplementary Financial Information (e.g., 10-year financial summary) The following pages contain excerpts from the president’s letter and the financial statements from P&G’s 2011 annual report. The complete P&G annual report can be accessed at the book’s companion website, www.wiley.com/college/kieso. You will see examples of the standard annual report elements by examining the P&G annual report. We do not expect that you will comprehend P&G’s financial statements and the ac- companying notes in their entirety at your first reading. But we expect that by the time you complete the material in this textbook, your level of understanding and interpretive ability will have grown enormously. At this point, we recommend that you go online and take 20 to 30 minutes to scan the annual report, especially the financial statements and notes. Your goal should be to familiarize yourself with the contents and accounting elements. Throughout the follow- ing 19 chapters, when you are asked to refer to specific parts of P&G’s financial state- ments, do so! Then, when you have completed reading this textbook, we challenge you to reread P&G’s financials to see how much greater and more sophisticated your under- standing of them has become. 248 Chapter 5 Balance Sheet and Statement of Cash Flows

Letter to Shareholders Dear Shareholders, Last year, I described P&G’s Purpose-inspired Growth Strategy, of our peers—the best performing consumer products companies which is to touch and improve more consumers’ lives in more parts in the world. To do this, we must deliver the Company’s long-term of the world more completely. I told you that we intend to deliver total annual growth goals, which are to: shareholder return that consistently ranks P&G among the top third • Grow organic sales 1% to 2% faster than market growth in the categories and countries where we compete. • Deliver core earnings per share (core EPS) growth of high single to low double digits. • Generate free cash flow productivity of 90% or greater. We made meaningful progress toward these long-term goals for fiscal 2011, despite significant external challenges. • Organic sales grew 4%. Organic volume grew 5%. • Core earnings per share grew 8%. • Free cash flow productivity was 84% of net earnings. We increased our quarterly dividend by 9%, making this the 121st stock. Based on our current market capitalization, dividends and consecutive year that P&G has paid a dividend and the 55th con- share repurchase, we provided shareholders with an effective cash secutive year that the dividend has increased. yield of nearly 7%, with additional potential for capital appreciation. Over the past 55 years, P&G’s dividend has increased at an This is good performance in a very demanding business and eco- annual compound average rate of approximately 9.5%. In total, we nomic environment. It is not yet great performance. I am confident, paid approximately $5.8 billion in dividends in fiscal 2011. We also however, that we will continue to grow our business on the strength returned $7.0 billion to shareholders through the repurchase of P&G of our Purpose-inspired Growth Strategy: • We are executing the strategy as planned, with unrelenting focus on innovation. • We are increasing productivity, which frees up resources to invest in innovation. • We continue to strengthen our portfolio of businesses. • We are tackling growth challenges head on. • We have solid, executable plans in place to capture the enormous growth potential that our strategy creates. Further, P&G people are inspired and are performing heroically to improve lives, to grow our business, and to create value for our shareholders. Robert A. McDonald Chairman of the Board, President and Chief Executive Officer Financials Net Sales ($ billions) Operating Cash Flow ($ billions) Diluted Net Earnings (per common share) 11 $82.6 11 $13.2 11 $3.93 10 $78.9 10 $16.1 10 $4.11 09 $76.7 09 $14.9 09 $4.26 08 $79.3 08 $15.0 08 $3.64 07 $72.4 07 $13.4 07 $3.04 Financial Highlights (Unaudited) Amounts in millions, except per share amounts 2011 2010 2009 2008 2007 Net Sales $82,559 $78,938 $76,694 $79,257 $72,441 Operating Income 15,818 16,021 15,374 15,979 14,485 Net Earnings 11,797 12,736 13,436 12,075 10,340 Net Earnings Margin from Continuing Operations 14.3% 13.9% 13.9% 14.2% 13.3% Diluted Net Earnings per Common Share from Continuing Operations $ 3.93 $ 3.53 $ 3.39 $ 3.40 $ 2.84 Diluted Net Earnings per Common Share 3.93 4.11 4.26 3.64 3.04 Dividends per Common Share 1.97 1.80 1.64 1.45 1.28 Appendix 5B: Specimen Financial Statements: The Procter & Gamble Company 249 Consolidated Statements of Earnings Amounts in millions except per share amounts; Years ended June 30 2011 2010 2009 NET SALES $82,559 $78,938 $76,694 Cost of products sold 40,768 37,919 38,690 Selling, general and administrative expense 25,973 24,998 22,630 OPERATING INCOME 15,818 16,021 15,374 Interest expense 831 946 1,358 Other non-operating income/(expense), net 202 (28) 397 EARNINGS FROM CONTINUING OPERATIONS BEFORE INCOME TAXES 15,189 15,047 14,413 Income taxes on continuing operations 3,392 4,101 3,733 NET EARNINGS FROM CONTINUING OPERATIONS 11,797 10,946 10,680 NET EARNINGS FROM DISCONTINUED OPERATIONS — 1,790 2,756 NET EARNINGS $11,797 $12,736 $13,436 BASIC NET EARNINGS PER COMMON SHARE: Earnings from continuing operations $ 4.12 $ 3.70 $ 3.55

Earnings from discontinued operations — 0.62 0.94 BASIC NET EARNINGS PER COMMON SHARE 4.12 4.32 4.49 DILUTED NET EARNINGS PER COMMON SHARE: Earnings from continuing operations 3.93 3.53 3.39 Earnings from discontinued operations — 0.58 0.87 DILUTED NET EARNINGS PER COMMON SHARE 3.93 4.11 4.26 DIVIDENDS PER COMMON SHARE $ 1.97 $ 1.80 $ 1.64 250 Chapter 5 Balance Sheet and Statement of Cash Flows Consolidated Balance Sheets Amounts in millions; June 30 Assets 2011 2010 CURRENT ASSETS Cash and cash equivalents $ 2,768 $ 2,879 Accounts receivable 6,275 5,335 INVENTORIES Materials and supplies 2,153 1,692 Work in process 717 604 Finished goods 4,509 4,088 Total inventories 7,379 6,384 Deferred income taxes 1,140 990 Prepaid expenses and other current assets 4,408 3,194 TOTAL CURRENT ASSETS 21,970 18,782 PROPERTY, PLANT AND EQUIPMENT Buildings 7,753 6,868 Machinery and equipment 32,820 29,294 Land 934 850 Total property, plant and equipment 41,507 37,012 Accumulated depreciation (20,214) (17,768) NET PROPERTY, PLANT AND EQUIPMENT 21,293 19,244 GOODWILL AND OTHER INTANGIBLE ASSETS Goodwill 57,562 54,012 Trademarks and other intangible assets, net 32,620 31,636 NET GOODWILL AND OTHER INTANGIBLE ASSETS 90,182 85,648 OTHER NONCURRENT ASSETS 4,909 4,498 TOTAL ASSETS $138,354 $128,172 Liabilities and Shareholders’ Equity 2011 2010 CURRENT LIABILITIES Accounts payable $ 8,022 $ 7,251 Accrued and other liabilities 9,290 8,559 Debt due within one year 9,981 8,472 TOTAL CURRENT LIABILITIES 27,293 24,282 LONG-TERM DEBT 22,033 21,360 DEFERRED INCOME TAXES 11,070 10,902 OTHER NONCURRENT LIABILITIES 9,957 10,189 TOTAL LIABILITIES 70,353 66,733 SHAREHOLDERS’ EQUITY Convertible Class A preferred stock, stated value $1 per share (600 shares authorized) 1,234 1,277 Non-Voting Class B preferred stock, stated value $1 per share (200 shares authorized) — — Common stock, stated value $1 per share (10,000 shares authorized; shares issued: 2011 — 4,007.9, 2010 — 4,007.6) 4,008 4,008 Additional paid-in capital 62,405 61,697 Reserve for ESOP debt retirement (1,357) (1,350) Accumulated other comprehensive income/(loss) (2,054) (7,822) Treasury stock, at cost (shares held: 2011 — 1,242.2, 2010 — 1,164.1) (67,278) (61,309) Retained earnings 70,682 64,614 Noncontrolling interest 361 324 TOTAL SHAREHOLDERS’ EQUITY 68,001 61,439 TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY $138,354 $128,172 Appendix 5B: Specimen Financial Statements: The Procter & Gamble Company 251 Consolidated Statements of Shareholders’ Equity Accumulated Common Additional Reserve for Other Non- Shares Common Preferred Paid-In ESOP Debt Comprehensive controlling Treasury Retained Dollars in millions/Shares in thousands Outstanding Stock Stock Capital Retirement Income/(loss) Interest Stock Earnings Total BALANCE JUNE 30, 2008 3,032,717 $4,002 $1,366 $60,307 $(1,325) $ 3,746 $290 $(47,588) $48,986 $69,784 Net earnings 13,436 13,436 Other comprehensive income: Financial statement translation (6,151) (6,151) Hedges and investment securities, net of $452 tax 748 748 Defined benefit retirement plans, net of $879 tax (1,701) (1,701) Total comprehensive income $ 6,332 Cumulative impact for adoption of new accounting guidance (1) (84) (84) Dividends to shareholders: Common (4,852) (4,852) Preferred, net of tax benefits (192) (192) Treasury purchases (98,862) (6,370) (6,370) Employee plan issuances 16,841 5 804 428 1,237 Preferred stock conversions 4,992 (42) 7 35 — Shares tendered for Folgers coffee subsidiary (38,653) (2,466) (2,466) ESOP debt impacts (15) 15 — Noncontrolling interest (7) (7) BALANCE JUNE 30, 2009 2,917,035 4,007 1,324 61,118 (1,340) (3,358) 283 (55,961) 57,309 63,382 Net earnings 12,736 12,736 Other comprehensive income: Financial statement translation (4,194) (4,194) Hedges and investment securities, net of $520 tax 867 867 Defined benefit retirement plans, net of $465 tax (1,137) (1,137) Total comprehensive income $ 8,272 Dividends to shareholders: Common (5,239) (5,239) Preferred, net of tax benefits (219) (219) Treasury purchases (96,759) (6,004) (6,004) Employee plan issuances 17,616 1 574 616 1,191

Preferred stock conversions 5,579 (47) 7 40 — ESOP debt impacts (10 ) 27 17 Noncontrolling interest (2) 41 39 BALANCE JUNE 30, 2010 2,843,471 4,008 1,277 61,697 (1,350) (7,822 ) 324 (61,309) 64,614 61,439 Net earnings 11,797 11,797 Other comprehensive income: Financial statement translation 6,493 6,493 Hedges and investment securities, net of $711 tax (1,178) (1,178) Defined benefit retirement plans, net of $302 tax 453 453 Total comprehensive income $17,565 Dividends to shareholders: Common (5,534) (5,534) Preferred, net of tax benefits (233) (233) Treasury purchases (112,729) (7,039) (7,039) Employee plan issuances 29,729 — 702 1,033 1,735 Preferred stock conversions 5,266 (43) 6 37 — ESOP debt impacts (7) 38 31 Noncontrolling interest — 3 7 37 BALANCE JUNE 30, 2011 2,765,737 $4,008 $1,234 $62,405 $(1,357) $(2,054) $361 $(67,278) $70,682 $68,001 (1) Cumulative impact of adopting new accounting guidance relates to split-dollar life insurance arrangements. 252 Chapter 5 Balance Sheet and Statement of Cash Flows Consolidated Statements of Cash Flows Amounts in millions; Years ended June 30 2011 2010 2009 CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR $ 2,879 $ 4,781 $ 3,313 OPERATING ACTIVITIES Net earnings 11,797 12,736 13,436 Depreciation and amortization 2,838 3,108 3,082 Share-based compensation expense 414 453 516 Deferred income taxes 128 36 596 Gain on sale of businesses (203) (2,670) (2,377) Change in accounts receivable (426) (14) 415 Change in inventories (501) 86 721 Change in accounts payable, accrued and other liabilities 358 2,446 (742) Change in other operating assets and liabilities (1,190) (305) (758) Other 16 196 30 TOTAL OPERATING ACTIVITIES 13,231 16,072 14,919 INVESTING ACTIVITIES Capital expenditures (3,306) (3,067) (3,238) Proceeds from asset sales 225 3,068 1,087 Acquisitions, net of cash acquired (474) (425) (368) Change in investments 73 (173) 166 TOTAL INVESTING ACTIVITIES (3,482) (597) (2,353) FINANCING ACTIVITIES Dividends to shareholders (5,767) (5,458) (5,044) Change in short-term debt 151 (1,798) (2,420) Additions to long-term debt 1,536 3,830 4,926 Reductions of long-term debt (206) (8,546) (2,587) Treasury stock purchases (7,039) (6,004) (6,370) Impact of stock options and other 1,302 721 681 TOTAL FINANCING ACTIVITIES (10,023) (17,255) (10,814) EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS 163 (122) (284) CHANGE IN CASH AND CASH EQUIVALENTS (111) (1,902) 1,468 CASH AND CASH EQUIVALENTS, END OF YEAR $ 2,768 $ 2,879 $ 4,781 SUPPLEMENTAL DISCLOSURE Cash payments for: Interest $ 806 $ 1,184 $ 1,226 Income taxes 2,992 4,175 3,248 Assets acquired through non-cash capital leases 13 20 8 Divestiture of coffee business in exchange for shares of P&G stock — — 2,466 Demonstration Problems 253 DEMONSTRATION PROBLEMS Demonstration Problem 1: Assume that Sanchez Company has the following accounts at the end of the current year. 1. Common Stock. 15. Accumulated Other Comprehensive Income. 2. Discount on Bonds Payable. 16. Cash Restricted for Plant Expansion. 3. Treasury Stock (at cost). 16. Land Held for Future Plant Site. 4. Notes Payable (short-term). 17. Noncontrolling Interest. 5. Raw Materials. 18. Allowance for Doubtful Accounts— 6. Preferred Stock Investments (long-term). Accounts Receivable. 7. Unearned Rent Revenue. 19. Retained Earnings. 8. Work in Process. 20. Paid-in Capital in Excess of Par—Common 9. Copyrights. Stock. 10. Buildings. 21. Unearned Subscriptions Revenue. 11. Notes Receivable (short-term). 22. Receivables—Officers (due in one year). 12. Cash. 23. Finished Goods. 13. Salaries and Wages Payable. 24. Accounts Receivable. 14. Accumulated Depreciation—Buildings. 25. Bonds Payable (due in 4 years). Instructions Prepare a classified balance sheet in good form. (No monetary amounts are necessary.) Solution to Demonstration Problem 1 SANCHEZ COMPANY BALANCE SHEET DECEMBER 31, 20XX Assets Liabilities and Stockholders’ Equity Current assets Current liabilities Cash (less cash restricted for plant Salaries and wages payable $XXX expansion) $XXX Notes payable (short-term) XXX

Accounts receivable $XXX Unearned subscriptions revenue XXX Less: Allowance for doubtful Unearned rent revenue XXX accounts XXX XXX Total current liabilities $XXX Notes receivable XXX Long-term debt Receivables—offi cers XXX Inventory Bonds payable (due in four years) XXX Finished goods XXX Discount on bonds payable (XXX) XXX Work in process XXX Total liabilities XXX Raw materials XXX XXX Total current assets $XXX Stockholders’ equity Capital stock: Long-term investments Common stock $XXX Preferred stock investments XXX Additional paid-in capital: Land held for future plant site XXX Paid in capital in excess of par— Cash restricted for plant expansion XXX common stock XXX Total long-term investments XXX Total paid-in capital XXX Retained earnings XXX Property, plant, and equipment Accumulated other comprehensive Buildings XXX income XXX Less: Accumulated depreciation— Treasury stock (at cost) (XXX) buildings XXX XXX Total equity attributable to Sanchez shareholders XXX Intangible assets Equity attributable to noncontrolling Copyrights XXX interest XXX Total assets $XXX Total liabilities and stockholders’ equity $XXX 254 Chapter 5 Balance Sheet and Statement of Cash Flows Demonstration Problem 2: Cassy Corporation’s balance sheet at the end of 2013 included the following items. Current assets $282,000 Current liabilities $180,000 Land 36,000 Bonds payable 120,000 Buildings 144,000 Common stock 216,000 Equipment 108,000 Retained earnings 52,800 Accumulated depreciation—buildings (36,000) Total $568,800 Accumulated depreciation—equipment (13,200) Patents 48,000 Total $568,800 The following information is available for 2014. 1. Treasury stock was purchased at a cost of $13,200. 2. Cash dividends of $36,000 were declared and paid. 3. A long-term investment in stock was purchased for $19,200. 4. Current assets other than cash increased by $34,800. Current liabilities increased by $15,600. 5. Depreciation expense was $4,800 on the building and $10,800 on equipment. 6. Net income was $66,000. 7. Bonds payable of $60,000 were issued. 8. An addition to the building was completed at a cost of $32,400. 9. Patent amortization was $3,000. 10. Equipment (cost $24,000 and accumulated depreciation $9,600) was sold for $12,000. Instructions (a) Prepare a balance sheet at December 31, 2014. (b) Prepare a statement of cash flows for 2014. Solution to Demonstration Problem 2 (a) CASSY CORPORATION BALANCE SHEET DECEMBER 31, 2014 Assets Current assets ($282,000 1 $34,800 1 $39,000) $355,800 Long-term investments 19,200 Property, plant, and equipment Land $ 36,000 Buildings ($144,000 1 $32,400) $176,400 Less: Accumulated depreciation—buildings ($36,000 1 $4,800) 40,800 135,600 Equipment ($108,000 2 $24,000) 84,000 Less: Accumulated depreciation—equipment ($13,200 2 $9,600 1 $10,800) 14,400 69,600 Total 241,200 Intangible assets—patents ($48,000 2 $3,000) 45,000 Total assets $661,200 Liabilities and Stockholders’ Equity Current liabilities ($180,000 1 $15,600) $195,600 Long-term liabilities Bonds payable ($120,000 1 $60,000) 180,000 Total liabilities 375,600 FASB Codifi cation 255 Stockholders’ equity Common stock $216,000 Retained earnings ($52,800 1 $66,000 2 $36,000) 82,800 Total 298,800 Less: Cost of treasury stock (13,200) Total stockholders’ equity 285,600 Total liabilities and stockholders’ equity $661,200 Notes: The amount determined for current assets is computed last and is a “plug” fi gure. That is, total liabilities and stockholders’ equity is computed because information is available to determine this amount. Because the total assets amount is the same as the total liabilities and stockholders’ equity amount, the amount of total assets is determined. Information is available to compute all the asset amounts except current assets. Therefore, current assets can be determined by deducting the total of all the other asset balances from the total asset balance (i.e., $661,200 2 $45,000 2 $241,200 2 $19,200). (b) CASSY CORPORATION STATEMENT OF CASH FLOWS FOR THE YEAR ENDED DECEMBER 31, 2014 Cash fl ows from operating activities Net income $66,000

Adjustments to reconcile net income to net cash provided by operating activities: Loss on sale of equipment $ 2,400 Depreciation expense 15,600 Patent amortization 3,000 Increase in current liabilities 15,600 Increase in current assets (other than cash) (34,800) 1,800 Net cash provided by operating activities 67,800 Cash fl ows from investing activities Sale of equipment 12,000 Addition to building (32,400) Investment in stock (19,200) Net cash used by investing activities (39,600) Cash fl ows from fi nancing activities Issuance of bonds 60,000 Payment of dividends (36,000) Purchase of treasury stock (13,200) Net cash provided by fi nancing activities 10,800 Net increase in cash $39,000 FASB CODIFICATION FASB Codification References [1] FASB ASC 320-10-35-1. [Predecessor literature: “Accounting for Certain Investments in Debt and Equity Securities,” Statement of Financial Accounting Standards No. 115 (Norwalk, Conn.: FASB, 1993).] [2] FASB ASC 825-10-25-1. [Predecessor literature: “The Fair Value Option for Financial Assets and Liabilities, Including an Amendment of FASB Statement No. 115,” Statement of Financial Accounting Standards No. 159 (Norwalk, Conn.: FASB, February 2007).] [3] FASB ASC 470-10-05-6. [Predecessor literature: “Classification of Short-term Obligations Expected to Be Refinanced,” Statement of Financial Accounting Standards No. 6 (Stamford, Conn.: FASB, 1975).] [4] FASB ASC 505-10-50. [Predecessor literature: “Disclosure of Information about Capital Structure,” Statement of Financial Accounting Standards No. 129 (Norwalk: FASB, 1997), par. 4).] 256 Chapter 5 Balance Sheet and Statement of Cash Flows [5] FASB ASC 230-10-05. [Predecessor literature: “Statement of Cash Flows,” Statement of Financial Accounting Standards No. 95 (Stamford, Conn.: FASB, 1987).] [6] FASB ASC 235-10-05. [Predecessor literature: “Disclosure of Accounting Policies,” Opinions of the Accounting Principles Board No. 22 (New York: AICPA, 1972).] [7] FASB ASC 275-10-05. [Predecessor literature: “Disclosure of Certain Significant Risks and Uncertainties,” Statement of Position 94-6 (New York: AICPA, 1994).] [8] FASB ASC 820-10-15. [Predecessor literature: “Fair Value Measurement,” Statement of Financial Accounting Standards No. 157 (Norwalk, Conn.: FASB, September 2006).] Exercises If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE5-1 Access the Codification glossary (“Master Glossary”) to answer the following. (a) What is the definition provided for current assets? (b) What is the definition of an intangible asset? In what section of the Codification are intangible assets addressed? (c) What are cash equivalents? (d) What are financing activities? CE5-2 What guidance does the Codification provide on the classification of current liabilities? CE5-3 What guidance does the Codification provide concerning the format of accounting disclosures? CE5-4 What are the objectives related to the statement of cash flows? An additional Codification case can be found in the Using Your Judgment section, on page 277. Be sure to check the book’s companion website for a Review and Analysis Exercise, with solution. Brief Exercises, Exercises, Problems, and many more learning and assessment tools and resources are available for practice in WileyPLUS. QUESTIONS 1. How does information from the balance sheet help users (c) Buildings. of the financial statements? (d) Short-term investments. 2. What is meant by solvency? What information in the (e) Accounts receivable. balance sheet can be used to assess a company’s solvency? 7. What are the major limitations of the balance sheet as a 3. A recent financial magazine indicated that the airline source of information? industry has poor financial flexibility. What is meant by 8. Discuss at least two items that are important to the value financial flexibility, and why is it important? of companies like Intel or IBM but that are not recorded

4. Discuss at least two situations in which estimates could in their balance sheets. What are some reasons why these affect the usefulness of information in the balance sheet. items are not recorded in the balance sheet? 5. Perez Company reported an increase in inventories in the 9. How does separating current assets from property, plant, past year. Discuss the effect of this change on the current and equipment in the balance sheet help analysts? ratio (current assets 4 current liabilities). What does this 10. In its December 31, 2014, balance sheet Oakley Corpo- tell a statement user about Perez Company’s liquidity? ration reported as an asset, “Net notes and accounts 6. What is meant by liquidity? Rank the following assets receivable, $7,100,000.” What other disclosures are from one to five in order of liquidity. necessary? (a) Goodwill. 11. Should available-for-sale securities always be reported as (b) Inventory. a current asset? Explain. Questions 257 12. What is the relationship between current assets and cur- 20. The creditors of Chester Company agree to accept promis- rent liabilities? sory notes for the amount of its indebtedness with a pro- 13. The New York Knicks, Inc. sold 10,000 season tickets at viso that two-thirds of the annual profits must be applied to their liquidation. How should these notes be reported $2,000 each. By December 31, 2014, 16 of the 40 home on the balance sheet of the issuing company? Give a games had been played. What amount should be reported reason for your answer. as a current liability at December 31, 2014? 14. What is working capital? How does working capital relate 21. What is the purpose of a statement of cash flows? How does it differ from a balance sheet and an income statement? to the operating cycle? 15. In what section of the balance sheet should the following 22. The net income for the year for Genesis, Inc. is $750,000, but the statement of cash flows reports that the net cash items appear, and what balance sheet terminology would provided by operating activities is $640,000. What might you use? account for the difference? (a) Treasury stock (recorded at cost). 23. Net income for the year for Carrie, Inc. was $750,000, but (b) Checking account at bank. the statement of cash flows reports that net cash provided (c) Land (held as an investment). by operating activities was $860,000. What might account (d) Sinking fund. for the difference? (e) Unamortized premium on bonds payable. 24. Differentiate between operating activities, investing ac- (f) Copyrights. tivities, and financing activities. (g) Pension fund assets. 25. Each of the following items must be considered in prepar- ing a statement of cash flows. Indicate where each item is (h) Premium on capital stock. to be reported in the statement, if at all. Assume that net (i) Long-term investments (pledged against bank loans income is reported as $90,000. payable). (a) Accounts receivable increased from $34,000 to $39,000 16. Where should the following items be shown on the from the beginning to the end of the year. balance sheet, if shown at all? (b) During the year, 10,000 shares of preferred stock with (a) Allowance for doubtful accounts. a par value of $100 per share were issued at $115 per (b) Merchandise held on consignment. share. (c) Advances received on sales contract. (c) Depreciation expense amounted to $14,000, and bond (d) Cash surrender value of life insurance. premium amortization amounted to $5,000. (e) Land. (d) Land increased from $10,000 to $30,000. (f) Merchandise out on consignment. 26. Sergey Co. has net cash provided by operating activities of $1,200,000. Its average current liabilities for the period are (g) Franchises. $1,000,000, and its average total liabilities are $1,500,000. (h) Accumulated depreciation of equipment. Comment on the company’s liquidity and financial (i) Materials in transit—purchased f.o.b. destination. flexibility, given this information. 17. State the generally accepted accounting principle appli- 27. Net income for the year for Tanizaki, Inc. was $750,000,

cable to balance sheet valuation of each of the following but the statement of cash flows reports that net cash pro- assets. vided by operating activities was $860,000. Tanizaki also (a) Trade accounts receivable. reported capital expenditures of $75,000 and paid divi- dends in the amount of $30,000. Compute Tanizaki’s free (b) Land. cash flow. (c) Inventories. 28. What is the purpose of a free cash flow analysis? (d) Trading securities (common stock of other companies). 29. What are some of the techniques of disclosure for the (e) Prepaid expenses. balance sheet? 18. Refer to the definition of assets on page 216. Discuss how 30. What is a “Summary of Significant Accounting Policies”? a leased building might qualify as an asset of the lessee (tenant) under this definition. 31. What types of contractual obligations must be disclosed 19. Kathleen Battle says, “Retained earnings should be in great detail in the notes to the balance sheet? Why do you think these detailed provisions should be disclosed? reported as an asset, since it is earnings which are rein- vested in the business.” How would you respond to 32. What is the profession’s recommendation in regard to the Battle? use of the term “surplus”? Explain. 258 Chapter 5 Balance Sheet and Statement of Cash Flows BRIEF EXERCISES 3 BE5-1 Harding Corporation has the following accounts included in its December 31, 2014, trial balance: Accounts Receivable $110,000; Inventory $290,000; Allowance for Doubtful Accounts $8,000; Patents $72,000; Prepaid Insurance $9,500; Accounts Payable $77,000; Cash $30,000. Prepare the current assets section of the balance sheet, listing the accounts in proper sequence. 3 BE5-2 Koch Corporation’s adjusted trial balance contained the following asset accounts at December 31, 2014: Cash $7,000; Land $40,000; Patents $12,500; Accounts Receivable $90,000; Prepaid Insurance $5,200; Inventory $30,000; Allowance for Doubtful Accounts $4,000; Equity Investments (trading) $11,000. Prepare the current assets section of the balance sheet, listing the accounts in proper sequence. 3 BE5-3 Included in Outkast Company’s December 31, 2014, trial balance are the following accounts: Prepaid Rent $5,200; Debt Investments (trading) $56,000; Unearned Fees $17,000; Land (held for invest- ment) $39,000; Notes Receivable (long-term) $42,000. Prepare the long-term investments section of the balance sheet. 3 BE5-4 Lowell Company’s December 31, 2014, trial balance includes the following accounts: Inventory $120,000; Buildings $207,000; Accumulated Depreciation—Equipment $19,000; Equipment $190,000; Land (held for investment) $46,000; Accumulated Depreciation—Buildings $45,000; Land $71,000; Timberland $70,000. Prepare the property, plant, and equipment section of the balance sheet. 3 BE5-5 Crane Corporation has the following accounts included in its December 31, 2014, trial balance: Equity Investments (trading) $21,000; Goodwill $150,000; Prepaid Insurance $12,000; Patents $220,000; Franchises $130,000. Prepare the intangible assets section of the balance sheet. 3 BE5-6 Patrick Corporation’s adjusted trial balance contained the following asset accounts at Decem- ber 31, 2014: Prepaid Rent $12,000; Goodwill $50,000; Franchise Fees Receivable $2,000; Franchises $47,000; Patents $33,000; Trademarks $10,000. Prepare the intangible assets section of the balance sheet. 3 BE5-7 Thomas Corporation’s adjusted trial balance contained the following liability accounts at December 31, 2014: Bonds Payable (due in 3 years) $100,000; Accounts Payable $72,000; Notes Payable (due in 90 days) $22,500; Salaries and Wages Payable $4,000; Income Taxes Payable $7,000. Prepare the current liabili- ties section of the balance sheet. 3 BE5-8 Included in Adams Company’s December 31, 2014, trial balance are the following accounts: A ccounts Payable $220,000; Pension Liability $375,000; Discount on Bonds Payable $29,000; Unearned Rent Revenue $41,000; Bonds Payable $400,000; Salaries and Wages Payable $27,000; Interest Payable $12,000; Income Taxes Payable $29,000. Prepare the current liabilities section of the balance sheet.

3 BE5-9 Use the information presented in BE5-8 for Adams Company to prepare the long-term liabilities section of the balance sheet. 3 BE5-10 Hawthorn Corporation’s adjusted trial balance contained the following accounts at December 31, 2014: Retained Earnings $120,000; Common Stock $750,000; Bonds Payable $100,000; Paid-in Capital in Excess of Par—Common Stock $200,000; Goodwill $55,000; Accumulated Other Compre- hensive Loss $150,000; Noncontrolling Interest $35,000. Prepare the stockholders’ equity section of the balance sheet. 3 BE5-11 Stowe Company’s December 31, 2014, trial balance includes the following accounts: Investment in Common Stock $70,000; Retained Earnings $114,000; Trademarks $31,000; Preferred Stock $152,000; Common Stock $55,000; Deferred Income Taxes $88,000; Paid-in Capital in Excess of Par—Common Stock $174,000; Noncontrolling Interest $63,000. Prepare the stockholders’ equity section of the balance sheet. 6 BE5-12 Keyser Beverage Company reported the following items in the most recent year. Net income $40,000 Dividends paid 5,000 Increase in accounts receivable 10,000 Increase in accounts payable 7,000 Purchase of equipment (capital expenditure) 8,000 Depreciation expense 4,000 Issue of notes payable 20,000 Exercises 259 Compute net cash provided by operating activities, the net change in cash during the year, and free cash flow. 6 BE5-13 Ames Company reported 2014 net income of $151,000. During 2014, accounts receivable increased by $13,000 and accounts payable increased by $9,500. Depreciation expense was $44,000. Prepare the cash flows from operating activities section of the statement of cash flows. 6 BE5-14 Martinez Corporation engaged in the following cash transactions during 2014. Sale of land and building $191,000 Purchase of treasury stock 40,000 Purchase of land 37,000 Payment of cash dividend 95,000 Purchase of equipment 53,000 Issuance of common stock 147,000 Retirement of bonds 100,000 Compute the net cash provided (used) by investing activities. 6 BE5-15 Use the information presented in BE5-14 for Martinez Corporation to compute the net cash used (provided) by financing activities. 7 BE5-16 Using the information in BE5-14, determine Martinez’s free cash flow, assuming that it reported net cash provided by operating activities of $400,000. EXERCISES 2 3 E5-1 (Balance Sheet Classifications) Presented below are a number of balance sheet accounts of Deep Blue Something, Inc. (a) Investment in Preferred Stock. (h) Interest Payable. (b) Treasury Stock. (i) Deficit. (c) Common Stock. (j) Equity Investments (trading). (d) Dividends Payable. (k) Income Taxes Payable. (e) Accumulated Depreciation—Equipment. (l) Unearned Subscriptions Revenue. (f) Construction in Process. (m) Work in Process. (g) Petty Cash. (n) Salaries and Wages Payable. Instructions For each of the accounts above, indicate the proper balance sheet classification. In the case of borderline items, indicate the additional information that would be required to determine the proper classification. 2 3 E5-2 (Classification of Balance Sheet Accounts) Presented below are the captions of Faulk Company’s balance sheet. (a) Current assets. (f) Current liabilities. (b) Investments. (g) Noncurrent liabilities. (c) Property, plant, and equipment. (h) Capital stock. (d) Intangible assets. (i) Additional paid-in capital. (e) Other assets. (j) Retained earnings. Instructions Indicate by letter where each of the following items would be classified. 1. Preferred stock. 11. Cash surrender value of life insurance. 2. Goodwill. 12. Notes payable (due next year). 3. Salaries and wages payable. 13. Supplies. 4. Accounts payable. 14. Common stock. 5. Buildings. 15. Land. 6. Equity investments (trading). 16. Bond sinking fund. 7. Current maturity of long-term debt. 17. Inventory. 8. Premium on bonds payable. 18. Prepaid insurance. 9. Allowance for doubtful accounts. 19. Bonds payable. 10. Accounts receivable. 20. Income taxes payable. 260 Chapter 5 Balance Sheet and Statement of Cash Flows 2 3 E5-3 (Classification of Balance Sheet Accounts) Assume that Fielder Enterprises uses the following

headings on its balance sheet. (a) Current assets. (f) Current liabilities. (b) Investments. (g) Long-term liabilities. (c) Property, plant, and equipment. (h) Capital stock. (d) Intangible assets. (i) Paid-in capital in excess of par. (e) Other assets. (j) Retained earnings. Instructions Indicate by letter how each of the following usually should be classified. If an item should appear in a note to the financial statements, use the letter “N” to indicate this fact. If an item need not be reported at all on the balance sheet, use the letter “X.” 1. Prepaid insurance. 12. Twenty-year issue of bonds payable that will 2. Stock owned in affiliated companies. mature within the next year. (No sinking fund 3. Unearned service revenue. exists, and refunding is not planned.) 4. Advances to suppliers. 13. Machinery retired from use and held for sale. 5. Unearned rent revenue. 14. Fully depreciated machine still in use. 6. Preferred stock. 15. Accrued interest on bonds payable. 7. Additional paid-in capital on preferred 16. Salaries that company budget shows will be stock. paid to employees within the next year. 8. Copyrights. 17. Discount on bonds payable. (Assume related 9. Petty cash fund. to bonds payable in item 12.) 10. Sales taxes payable. 18. Accumulated depreciation—buildings. 11. Accrued interest on notes receivable. 19. Noncontrolling interest. 2 3 E5-4 (Preparation of a Classified Balance Sheet) Assume that Denis Savard Inc. has the following accounts at the end of the current year. 1. Common Stock. 14. Accumulated Depreciation—Buildings. 2. Discount on Bonds Payable. 15. Restricted Cash for Plant Expansion. 3. Treasury Stock (at cost). 16. Land Held for Future Plant Site. 4. Notes Payable (short-term). 17. Allowance for Doubtful Accounts. 5. Raw Materials. 18. Retained Earnings. 6. Preferred Stock Investments (long-term). 19. Paid-in Capital in Excess of Par—Common Stock. 7. Unearned Rent Revenue. 20. Unearned Subscriptions Revenue. 8. Work in Process. 21. Receivables—Officers (due in one year). 9. Copyrights. 22. Inventory (finished goods). 10. Buildings. 23. Accounts Receivable. 11. Notes Receivable (short-term). 24. Bonds Payable (due in 4 years). 12. Cash. 25. Noncontrolling Interest. 13. Salaries and Wages Payable. Instructions Prepare a classified balance sheet in good form. (No monetary amounts are necessary.) 3 E5-5 (Preparation of a Corrected Balance Sheet) Uhura Company has decided to expand its operations. The bookkeeper recently completed the balance sheet presented below in order to obtain additional funds for expansion. UHURA COMPANY BALANCE SHEET FOR THE YEAR ENDED 2014 Current assets Cash $230,000 Accounts receivable (net) 340,000 Inventory (lower-of-average-cost-or-market) 401,000 Equity investments (trading)—at cost (fair value $120,000) 140,000 Property, plant, and equipment Buildings (net) 570,000 Equipment (net) 160,000 Land held for future use 175,000 Exercises 261 Intangible assets Goodwill 80,000 Cash surrender value of life insurance 90,000 Prepaid expenses 12,000 Current liabilities Accounts payable 135,000 Notes payable (due next year) 125,000 Pension obligation 82,000 Rent payable 49,000 Premium on bonds payable 53,000 Long-term liabilities Bonds payable 500,000 Stockholders’ equity Common stock, $1.00 par, authorized 400,000 shares, issued 290,000 290,000 Additional paid-in capital 160,000 Retained earnings ? Instructions Prepare a revised balance sheet given the available information. Assume that the accumulated depreciation balance for the buildings is $160,000 and for the equipment, $105,000. The allowance for doubtful accounts has a balance of $17,000. The pension obligation is considered a long-term liability. 2 3 E5-6 (Corrections of a Balance Sheet) The bookkeeper for Geronimo Company has prepared the following balance sheet as of July 31, 2014. GERONIMO COMPANY BALANCE SHEET AS OF JULY 31, 2014 Cash $ 69,000 Notes and accounts payable $ 44,000 Accounts receivable (net) 40,500 Long-term liabilities 75,000 Inventory 60,000 Stockholders’ equity 155,500 Equipment (net) 84,000 $274,500

Patents 21,000 $274,500 The following additional information is provided. 1. Cash includes $1,200 in a petty cash fund and $15,000 in a bond sinking fund. 2. The net accounts receivable balance is comprised of the following two items: (a) accounts receivable $44,000 and (b) allowance for doubtful accounts $3,500. 3. Inventory costing $5,300 was shipped out on consignment on July 31, 2014. The ending inventory balance does not include the consigned goods. Receivables in the amount of $5,300 were recognized on these consigned goods. 4. Equipment had a cost of $112,000 and an accumulated depreciation balance of $28,000. 5. Income taxes payable of $6,000 were accrued on July 31. Geronimo Company, however, had set up a cash fund to meet this obligation. This cash fund was not included in the cash balance but was offset against the income taxes payable amount. Instructions Prepare a corrected classified balance sheet as of July 31, 2014, from the available information, adjusting the account balances using the additional information. 3 E5-7 (Current Assets Section of the Balance Sheet) Presented below are selected accounts of Yasunari Kawabata Company at December 31, 2014. Inventory (fi nished goods) $ 52,000 Cost of Goods Sold $2,100,000 Unearned Service Revenue 90,000 Notes Receivable 40,000 Equipment 253,000 Accounts Receivable 161,000 Inventory (work in process) 34,000 Inventory (raw materials) 207,000 Cash 37,000 Supplies Expense 60,000 Equity Investments (short-term) 31,000 Allowance for Doubtful Accounts 12,000 Customer Advances 36,000 Licenses 18,000 Restricted Cash for Plant Expansion 50,000 Additional Paid-in Capital 88,000 Treasury Stock 22,000 262 Chapter 5 Balance Sheet and Statement of Cash Flows The following additional information is available. 1. Inventories are valued at lower-of-cost-or-market using LIFO. 2. Equipment is recorded at cost. Accumulated depreciation, computed on a straight-line basis, is $50,600. 3. The short-term investments have a fair value of $29,000. (Assume they are trading securities.) 4. The notes receivable are due April 30, 2016, with interest receivable every April 30. The notes bear interest at 6%. (Hint: Accrued interest due on December 31, 2014.) 5. The allowance for doubtful accounts applies to the accounts receivable. Accounts receivable of $50,000 are pledged as collateral on a bank loan. 6. Licenses are recorded net of accumulated amortization of $14,000. 7. Treasury stock is recorded at cost. Instructions Prepare the current assets section of Yasunari Kawabata Company’s December 31, 2014, balance sheet, with appropriate disclosures. 2 E5-8 (Current vs. Long-term Liabilities) Frederic Chopin Corporation is preparing its December 31, 2014, balance sheet. The following items may be reported as either a current or long-term liability. 1. On December 15, 2014, Chopin declared a cash dividend of $2.50 per share to stockholders of record on December 31. The dividend is payable on January 15, 2015. Chopin has issued 1,000,000 shares of common stock, of which 50,000 shares are held in treasury. 2. At December 31, bonds payable of $100,000,000 are outstanding. The bonds pay 12% interest every September 30 and mature in installments of $25,000,000 every September 30, beginning September 30, 2015. 3. At December 31, 2013, customer advances were $12,000,000. During 2014, Chopin collected $30,000,000 of customer advances; advances of $25,000,000 should be recognized in income. Instructions For each item above, indicate the dollar amounts to be reported as a current liability and as a long-term liability, if any. 2 3 E5-9 (Current Assets and Current Liabilities) The current assets and current liabilities sections of the balance sheet of Allessandro Scarlatti Company appear as follows. ALLESSANDRO SCARLATTI COMPANY BALANCE SHEET (PARTIAL) DECEMBER 31, 2014 Cash $ 40,000 Accounts payable $ 61,000 Accounts receivable $89,000 Notes payable 67,000 Less: Allowance for $128,000 doubtful accounts 7,000 82,000 Inventory 171,000 Prepaid expenses 9,000 $302,000 The following errors in the corporation’s accounting have been discovered:

1. January 2015 cash disbursements entered as of December 2014 included payments of accounts payable in the amount of $39,000, on which a cash discount of 2% was taken. 2. The inventory included $27,000 of merchandise that had been received at December 31 but for which no purchase invoices had been received or entered. Of this amount, $12,000 had been received on consignment; the remainder was purchased f.o.b. destination, terms 2/10, n/30. 3. Sales for the first four days in January 2015 in the amount of $30,000 were entered in the sales journal as of December 31, 2014. Of these, $21,500 were sales on account and the remainder were cash sales. Exercises 263 4. Cash, not including cash sales, collected in January 2015 and entered as of December 31, 2014, totaled $35,324. Of this amount, $23,324 was received on account after cash discounts of 2% had been deducted; the remainder represented the proceeds of a bank loan. Instructions (a) Restate the current assets and current liabilities sections of the balance sheet in accordance with good accounting practice. (Assume that both accounts receivable and accounts payable are recorded gross.) (b) State the net effect of your adjustments on Allessandro Scarlatti Company’s retained earnings balance. 2 3 E5-10 (Current Liabilities) Norma Smith is the controller of Baylor Corporation and is responsible for the preparation of the year-end financial statements. The following transactions occurred during the year. (a) On December 20, 2014, a former employee filed a legal action against Baylor for $100,000 for wrong- ful dismissal. Management believes the action to be frivolous and without merit. The likelihood of payment to the employee is remote. (b) Bonuses to key employees based on net income for 2014 are estimated to be $150,000. (c) On December 1, 2014, the company borrowed $600,000 at 8% per year. Interest is paid quarterly. (d) Credit sales for the year amounted to $10,000,000. Baylor’s expense provision for doubtful accounts is estimated to be 3% of credit sales. (e) On December 15, 2014, the company declared a $2.00 per share dividend on the 40,000 shares of common stock outstanding, to be paid on January 5, 2015. (f) During the year, customer advances of $160,000 were received; $50,000 of this amount was earned by December 31, 2014. Instructions For each item above, indicate the dollar amount to be reported as a current liability. If a liability is not reported, explain why. 3 E5-11 (Balance Sheet Preparation) Presented below is the adjusted trial balance of Kelly Corporation at December 31, 2014. Debit Credit Cash $ ? Supplies 1,200 Prepaid Insurance 1,000 Equipment 48,000 Accumulated Depreciation—Equipment $ 4,000 Trademarks 950 Accounts Payable 10,000 Salaries and Wages Payable 500 Unearned Service Revenue 2,000 Bonds Payable (due 2021) 9,000 Common Stock 10,000 Retained Earnings 25,000 Service Revenue 10,000 Salaries and Wages Expense 9,000 Insurance Expense 1,400 Rent Expense 1,200 Interest Expense 900 Total $ ? $ ? Additional information: 1. Net loss for the year was $2,500. 2. No dividends were declared during 2014. Instructions Prepare a classified balance sheet as of December 31, 2014. 264 Chapter 5 Balance Sheet and Statement of Cash Flows 3 E5-12 (Preparation of a Balance Sheet) Presented below is the trial balance of Scott Butler Corporation at December 31, 2014. Debit Credit Cash $ 197,000 Sales Revenue $ 8,100,000 Debt Investments (trading) (at cost, $145,000) 153,000 Cost of Goods Sold 4,800,000 Debt Investments (long-term) 299,000 Equity Investments (long-term) 277,000 Notes Payable (short-term) 90,000 Accounts Payable 455,000 Selling Expenses 2,000,000 Investment Revenue 63,000 Land 260,000 Buildings 1,040,000 Dividends Payable 136,000 Accrued Liabilities 96,000 Accounts Receivable 435,000 Accumulated Depreciation—Buildings 152,000 Allowance for Doubtful Accounts 25,000 Administrative Expenses 900,000 Interest Expense 211,000 Inventory 597,000 Gain (extraordinary) 80,000 Notes Payable (long-term) 900,000 Equipment 600,000 Bonds Payable 1,000,000 Accumulated Depreciation—Equipment 60,000

Franchises 160,000 Common Stock ($5 par) 1,000,000 Treasury Stock 191,000 Patents 195,000 Retained Earnings 78,000 Paid-in Capital in Excess of Par 80,000 Totals $12,315,000 $12,315,000 Instructions Prepare a balance sheet at December 31, 2014, for Scott Butler Corporation. (Ignore income taxes.) 5 E5-13 (Statement of Cash Flows—Classifications) The major classifications of activities reported in the statement of cash flows are operating, investing, and financing. Classify each of the transactions listed below as: 1. Operating activity—add to net income. 2. Operating activity—deduct from net income. 3. Investing activity. 4. Financing activity. 5. Reported as significant noncash activity. The transactions are as follows. (a) Issuance of common stock. (h) Payment of cash dividends. (b) Purchase of land and building. (i) Exchange of furniture for office equipment. (c) Redemption of bonds. (j) Purchase of treasury stock. (d) Sale of equipment. (k) Loss on sale of equipment. (e) Depreciation of machinery. (l) Increase in accounts receivable during the year. (f) Amortization of patent. (m) Decrease in accounts payable during the year. (g) Issuance of bonds for plant assets. 6 E5-14 (Preparation of a Statement of Cash Flows) The comparative balance sheets of Constantine Cavamanlis Inc. at the beginning and the end of the year 2014 are as follows. Exercises 265 CONSTANTINE CAVAMANLIS INC. BALANCE SHEETS Assets Dec. 31, 2014 Jan. 1, 2014 Inc./Dec. Cash $ 45,000 $ 13,000 $32,000 Inc. Accounts receivable 91,000 88,000 3,000 Inc. Equipment 39,000 22,000 17,000 Inc. Less: Accumulated depreciation—equipment 17,000 11,000 6,000 Inc. Total $158,000 $112,000 Liabilities and Stockholders’ Equity Accounts payable $ 20,000 $ 15,000 5,000 Inc. Common stock 100,000 80,000 20,000 Inc. Retained earnings 38,000 17,000 21,000 Inc. Total $158,000 $112,000 Net income of $44,000 was reported, and dividends of $23,000 were paid in 2014. New equipment was purchased and none was sold. Instructions Prepare a statement of cash flows for the year 2014. 6 7 E5-15 (Preparation of a Statement of Cash Flows) Presented below is a condensed version of the com- parative balance sheets for Zubin Mehta Corporation for the last two years at December 31. 2014 2013 Cash $177,000 $ 78,000 Accounts receivable 180,000 185,000 Investments 52,000 74,000 Equipment 298,000 240,000 Accumulated depreciation—equipment (106,000) (89,000) Current liabilities 134,000 151,000 Common stock 160,000 160,000 Retained earnings 307,000 177,000 Additional information: Investments were sold at a loss (not extraordinary) of $10,000; no equipment was sold; cash dividends paid were $30,000; and net income was $160,000. Instructions (a) Prepare a statement of cash flows for 2014 for Zubin Mehta Corporation. (b) Determine Zubin Mehta Corporation’s free cash flow. 6 7 E5-16 (Preparation of a Statement of Cash Flows) A comparative balance sheet for Shabbona Corpora- tion is presented below. December 31 Assets 2014 2013 Cash $ 73,000 $ 22,000 Accounts receivable 82,000 66,000 Inventory 180,000 189,000 Land 71,000 110,000 Equipment 260,000 200,000 Accumulated depreciation—equipment (69,000) (42,000) Total $597,000 $545,000 Liabilities and Stockholders’ Equity Accounts payable $ 34,000 $ 47,000 Bonds payable 150,000 200,000 Common stock ($1 par) 214,000 164,000 Retained earnings 199,000 134,000 Total $597,000 $545,000 266 Chapter 5 Balance Sheet and Statement of Cash Flows Additional information: 1. Net income for 2014 was $125,000. No gains or losses were recorded in 2014. 2. Cash dividends of $60,000 were declared and paid. 3. Bonds payable amounting to $50,000 were retired through issuance of common stock. Instructions (a) Prepare a statement of cash flows for 2014 for Shabbona Corporation. (b) Determine Shabbona Corporation’s current cash debt coverage, cash debt coverage, and free cash flow. Comment on its liquidity and financial flexibility. 3 6 E5-17 (Preparation of a Statement of Cash Flows and a Balance Sheet) Grant Wood Corporation’s balance sheet at the end of 2013 included the following items.

Current assets $235,000 Current liabilities $150,000 Land 30,000 Bonds payable 100,000 Buildings 120,000 Common stock 180,000 Equipment 90,000 Retained earnings 44,000 Accum. depr.—buildings (30,000) Total $474,000 Accum. depr.—equipment (11,000) Patents 40,000 Total $474,000 The following information is available for 2014. 1. Net income was $55,000. 2. Equipment (cost $20,000 and accumulated depreciation $8,000) was sold for $10,000. 3. Depreciation expense was $4,000 on the building and $9,000 on equipment. 4. Patent amortization was $2,500. 5. Current assets other than cash increased by $29,000. Current liabilities increased by $13,000. 6. An addition to the building was completed at a cost of $27,000. 7. A long-term investment in stock was purchased for $16,000. 8. Bonds payable of $50,000 were issued. 9. Cash dividends of $30,000 were declared and paid. 10. Treasury stock was purchased at a cost of $11,000. Instructions (Show only totals for current assets and current liabilities.) (a) Prepare a statement of cash flows for 2014. (b) Prepare a balance sheet at December 31, 2014. 6 7 E5-18 (Preparation of a Statement of Cash Flows, Analysis) The comparative balance sheets of Madrasah Corporation at the beginning and end of the year 2014 appear below. MADRASAH CORPORATION BALANCE SHEETS Assets Dec. 31, 2014 Jan. 1, 2014 Inc./Dec. Cash $ 20,000 $ 13,000 $ 7,000 Inc. Accounts receivable 106,000 88,000 18,000 Inc. Equipment 39,000 22,000 17,000 Inc. Less: Accumulated depreciation—equipment 17,000 11,000 6,000 Inc. Total $148,000 $112,000 Liabilities and Stockholders’ Equity Accounts payable $ 20,000 $ 15,000 5,000 Inc. Common stock 100,000 80,000 20,000 Inc. Retained earnings 28,000 17,000 11,000 Inc. Total $148,000 $112,000 Net income of $44,000 was reported, and dividends of $33,000 were paid in 2014. New equipment was purchased and none was sold. Instructions (a) Prepare a statement of cash flows for the year 2014. Problems 267 (b) Compute the current ratio (current assets 4 current liabilities) as of January 1, 2014, and December 31, 2014, and compute free cash flow for the year 2014. (c) In light of the analysis in (b), comment on Madrasah’s liquidity and financial flexibility. EXERCISES SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of exercises. PROBLEMS 3 P5-1 (Preparation of a Classified Balance Sheet, Periodic Inventory) Presented below is a list of accounts in alphabetical order. Accounts Receivable Inventory—Ending Accumulated Depreciation—Buildings Land Accumulated Depreciation—Equipment Land for Future Plant Site Accumulated Other Comprehensive Income Loss from Flood Advances to Employees Noncontrolling Interest Advertising Expense Notes Payable (due next year) Allowance for Doubtful Accounts Paid-in Capital in Excess of Par—Preferred Stock Bond Sinking Fund Patents Bonds Payable Payroll Taxes Payable Buildings Pension Liability Cash (in bank) Petty Cash Cash (on hand) Preferred Stock Cash Surrender Value of Life Insurance Premium on Bonds Payable Commission Expense Prepaid Rent Common Stock Purchase Returns and Allowances Copyrights Purchases Debt Investments (trading) Retained Earnings Dividends Payable Salaries and Wages Expense (sales) Equipment Salaries and Wages Payable Freight-In Sales Discounts Gain on Disposal of Equipment Sales Revenue Interest Receivable Treasury Stock (at cost) Inventory—Beginning Unearned Subscriptions Revenue Instructions Prepare a classified balance sheet in good form. (No monetary amounts are to be shown.) 3 P5-2 (Balance Sheet Preparation) Presented below are a number of balance sheet items for Montoya, Inc., for the current year, 2014. Goodwill $ 125,000 Accumulated depreciation—equipment $ 292,000 Payroll taxes payable 177,591 Inventory 239,800 Bonds payable 300,000 Rent payable (short-term) 45,000 Discount on bonds payable 15,000 Income taxes payable 98,362 Cash 360,000 Rent payable (long-term) 480,000 Land 480,000 Common stock, $1 par value 200,000 Notes receivable 445,700 Preferred stock, $10 par value 150,000 Notes payable (to banks) 265,000 Prepaid expenses 87,920

Accounts payable 490,000 Equipment 1,470,000 Retained earnings ? Equity investments (trading) 121,000 Income taxes receivable 97,630 Accumulated depreciation—buildings 270,200 Notes payable (long-term) 1,600,000 Buildings 1,640,000 Instructions Prepare a classified balance sheet in good form. Common stock authorized was 400,000 shares, and pre- ferred stock authorized was 20,000 shares. Assume that notes receivable and notes payable are short-term, unless stated otherwise. Cost and fair value of equity investments (trading) are the same. 3 P5-3 (Balance Sheet Adjustment and Preparation) The adjusted trial balance of Eastwood Company and other related information for the year 2014 are presented as follows. 268 Chapter 5 Balance Sheet and Statement of Cash Flows EASTWOOD COMPANY ADJUSTED TRIAL BALANCE DECEMBER 31, 2014 Debit Credit Cash $ 41,000 Accounts Receivable 163,500 Allowance for Doubtful Accounts $ 8,700 Prepaid Insurance 5,900 Inventory 208,500 Equity Investments (long-term) 339,000 Land 85,000 Construction in Process (building) 124,000 Patents 36,000 Equipment 400,000 Accumulated Depreciation—Equipment 240,000 Discount on Bonds Payable 20,000 Accounts Payable 148,000 Accrued Liabilities 49,200 Notes Payable 94,000 Bonds Payable 200,000 Common Stock 500,000 Paid-in Capital in Excess of Par—Common Stock 45,000 Retained Earnings 138,000 $1,422,900 $1,422,900 Additional information: 1. The LIFO method of inventory value is used. 2. The cost and fair value of the long-term investments that consist of stocks and bonds is the same. 3. The amount of the Construction in Progress account represents the costs expended to date on a building in the process of construction. (The company rents factory space at the present time.) The land on which the building is being constructed cost $85,000, as shown in the trial balance. 4. The patents were purchased by the company at a cost of $40,000 and are being amortized on a straight-line basis. 5. Of the discount on bonds payable, $2,000 will be amortized in 2015. 6. The notes payable represent bank loans that are secured by long-term investments carried at $120,000. These bank loans are due in 2015. 7. The bonds payable bear interest at 8% payable every December 31, and are due January 1, 2025. 8. 600,000 shares of common stock of a par value of $1 were authorized, of which 500,000 shares were issued and outstanding. Instructions Prepare a balance sheet as of December 31, 2014, so that all important information is fully disclosed. 3 P5-4 (Preparation of a Corrected Balance Sheet) The balance sheet of Kishwaukee Corporation as of December 31, 2014, is as follows. KISHWAUKEE CORPORATION BALANCE SHEET DECEMBER 31, 2014 Assets Goodwill (Note 2) $ 120,000 Buildings (Note 1) 1,640,000 Inventory 312,100 Land 950,000 Accounts receivable 170,000 Treasury stock (50,000 shares) 87,000 Cash on hand 175,900 Assets allocated to trustee for plant expansion Cash in bank 70,000 Debt investments (held-to-maturity) 138,000 $3,663,000 Problems 269 Equities Notes payable (Note 3) $ 600,000 Common stock, authorized and issued, 1,000,000 shares, no par 1,150,000 Retained earnings 803,000 Noncontrolling interest 55,000 Appreciation capital (Note 1) 570,000 Income tax payable 75,000 Reserve for depreciation recorded to date on the building 410,000 $3,663,000 Note 1: Buildings are stated at cost, except for one building that was recorded at appraised value. The excess of appraisal value over cost was $570,000. Depreciation has been recorded based on cost. Note 2: Goodwill in the amount of $120,000 was recognized because the company believed that book value was not an accurate representation of the fair value of the company. The gain of $120,000 was credited to Retained Earnings. Note 3: Notes payable are long-term except for the current installment due of $100,000. Instructions Prepare a corrected classified balance sheet in good form. The notes above are for information only. 3 P5-5 (Balance Sheet Adjustment and Preparation) Presented below is the balance sheet of Sargent Corporation for the current year, 2014.

SARGENT CORPORATION BALANCE SHEET DECEMBER 31, 2014 Current assets $ 485,000 Current liabilities $ 380,000 Investments 640,000 Long-term liabilities 1,000,000 Property, plant, and equipment 1,720,000 Stockholders’ equity 1,770,000 Intangible assets 305,000 $3,150,000 $3,150,000 The following information is presented. 1. The current assets section includes cash $150,000, accounts receivable $170,000 less $10,000 for allowance for doubtful accounts, inventories $180,000, and unearned rent revenue $5,000. Inventoy is stated on the lower-of-FIFO-cost-or-market. 2. The investments section includes the cash surrender value of a life insurance contract $40,000; investments in common stock, short-term (trading) $80,000 and long-term (available-for-sale) $270,000; and bond sinking fund $250,000. The cost and fair value of investments in common stock are the same. 3. Property, plant, and equipment includes buildings $1,040,000 less accumulated depreciation $360,000; equipment $450,000 less accumulated depreciation $180,000; land $500,000; and land held for future use $270,000. 4. Intangible assets include a franchise $165,000; goodwill $100,000; and discount on bonds payable $40,000. 5. Current liabilities include accounts payable $140,000; notes payable—short-term $80,000 and long- term $120,000; and income taxes payable $40,000. 6. Long-term liabilities are composed solely of 7% bonds payable due 2022. 7. Stockholders’ equity has preferred stock, no par value, authorized 200,000 shares, issued 70,000 shares for $450,000; and common stock, $1.00 par value, authorized 400,000 shares, issued 100,000 shares at an average price of $10. In addition, the corporation has retained earnings of $320,000. Instructions Prepare a balance sheet in good form, adjusting the amounts in each balance sheet classification as affected by the information given above. 270 Chapter 5 Balance Sheet and Statement of Cash Flows 3 6 P5-6 (Preparation of a Statement of Cash Flows and a Balance Sheet) Lansbury Inc. had the following balance sheet at December 31, 2013. 7 LANSBURY INC. BALANCE SHEET DECEMBER 31, 2013 Cash $ 20,000 Accounts payable $ 30,000 Accounts receivable 21,200 Notes payable (long-term) 41,000 Investments 32,000 Common stock 100,000 Plant assets (net) 81,000 Retained earnings 23,200 Land 40,000 $194,200 $194,200 During 2014, the following occurred. 1. Lansbury Inc. sold part of its investment portfolio for $15,000. This transaction resulted in a gain of $3,400 for the firm. The company classifies its investments as available-for-sale. 2. A tract of land was purchased for $18,000 cash. 3. Long-term notes payable in the amount of $16,000 were retired before maturity by paying $16,000 cash. 4. An additional $20,000 in common stock was issued at par. 5. Dividends of $8,200 were declared and paid to stockholders. 6. Net income for 2014 was $32,000 after allowing for depreciation of $11,000. 7. Land was purchased through the issuance of $30,000 in bonds. 8. At December 31, 2014, Cash was $32,000, Accounts Receivable was $41,600, and Accounts Payable remained at $30,000. Instructions (a) Prepare a statement of cash flows for 2014. (b) Prepare an unclassified balance sheet as it would appear at December 31, 2014. (c) How might the statement of cash flows help the user of the financial statements? Compute two cash flow ratios. 1 3 P5-7 (Preparation of a Statement of Cash Flows and Balance Sheet) Aero Inc. had the following balance 6 7 sheet at December 31, 2013. AERO INC. BALANCE SHEET DECEMBER 31, 2013 Cash $ 20,000 Accounts payable $ 30,000 Accounts receivable 21,200 Bonds payable 41,000 Investments 32,000 Common stock 100,000 Plant assets (net) 81,000 Retained earnings 23,200 Land 40,000 $194,200 $194,200 During 2014, the following occurred. 1. Aero liquidated its available-for-sale investment portfolio at a loss of $5,000. 2. A tract of land was purchased for $38,000. 3. An additional $30,000 in common stock was issued at par. 4. Dividends totaling $10,000 were declared and paid to stockholders. 5. Net income for 2014 was $35,000, including $12,000 in depreciation expense.

6. Land was purchased through the issuance of $30,000 in additional bonds. 7. At December 31, 2014, Cash was $70,200, Accounts Receivable was $42,000, and Accounts Payable was $40,000. Instructions (a) Prepare a statement of cash flows for the year 2014 for Aero. (b) Prepare the unclassified balance sheet as it would appear at December 31, 2014. (c) Compute Aero’s free cash flow and current cash debt coverage for 2014. (d) Use the analysis of Aero to illustrate how information in the balance sheet and statement of cash flows helps the user of the financial statements. Concepts for Analysis 271 PROBLEMS SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of problems. CONCEPTS FOR ANALYSIS CA5-1 (Reporting the Financial Effects of Varied Transactions) In an examination of Arenes Corporation as of December 31, 2014, you have learned that the following situations exist. No entries have been made in the accounting records for these items. 1. The corporation erected its present factory building in 1999. Depreciation was calculated by the straight-line method, using an estimated life of 35 years. Early in 2014, the board of directors conducted a careful survey and estimated that the factory building had a remaining useful life of 25 years as of January 1, 2014. 2. An additional assessment of 2013 income taxes was levied and paid in 2014. 3. When calculating the accrual for officers’ salaries at December 31, 2014, it was discovered that the accrual for officers’ salaries for December 31, 2013, had been overstated. 4. On December 15, 2014, Arenes Corporation declared a cash dividend on its common stock outstanding, payable February 1, 2015, to the common stockholders of record December 31, 2014. Instructions Describe fully how each of the items above should be reported in the financial statements of Arenes Corporation for the year 2014. CA5-2 (Identifying Balance Sheet Deficiencies) The assets of Fonzarelli Corporation are presented below (000s omitted). FONZARELLI CORPORATION BALANCE SHEET (PARTIAL) DECEMBER 31, 2014 Assets Current assets Cash $ 100,000 Unclaimed payroll checks 27,500 Debt investments (trading) (fair value $30,000) at cost 37,000 Accounts receivable (less bad debt reserve) 75,000 Inventory—at lower-of-cost- (determined by the next-in, fi rst-out method) or-market 240,000 Total current assets 479,500 Tangible assets Land (less accumulated depreciation) 80,000 Buildings and equipment $800,000 Less: Accumulated depreciation 250,000 550,000 Net tangible assets 630,000 Long-term investments Stocks and bonds 100,000 Treasury stock 70,000 Total long-term investments 170,000 Other assets Discount on bonds payable 19,400 Sinking fund 975,000 Total other assets 994,400 Total assets $2,273,900 272 Chapter 5 Balance Sheet and Statement of Cash Flows Instructions Indicate the deficiencies, if any, in the foregoing presentation of Fonzarelli Corporation’s assets. CA5-3 (Critique of Balance Sheet Format and Content) Presented below is the balance sheet of Sameed Brothers Corporation (000s omitted). SAMEED BROTHERS CORPORATION BALANCE SHEET DECEMBER 31, 2014 Assets Current assets Cash $26,000 Marketable securities 18,000 Accounts receivable 25,000 Inventory 20,000 Supplies 4,000 Stock investment in subsidiary company 20,000 $113,000 Investments Treasury stock 25,000 Property, plant, and equipment Buildings and land 91,000 Less: Reserve for depreciation 31,000 60,000 Other assets Cash surrender value of life insurance 19,000 Total assets $217,000 Liabilities and Stockholders’ Equity Current liabilities Accounts payable $22,000 Reserve for income taxes 15,000 Customers’ accounts with credit balances 1 $ 37,001 Deferred credits Unamortized premium on bonds payable 2,000 Long-term liabilities Bonds payable 60,000 Total liabilities 99,001 Common stock Common stock, par $5 85,000 Earned surplus 24,999 Cash dividends declared 8,000 117,999 Total liabilities and stockholders’ equity $217,000 Instructions Evaluate the balance sheet presented. State briefly the proper treatment of any item criticized.

CA5-4 (Presentation of Property, Plant, and Equipment) Carol Keene, corporate comptroller for Dumaine Industries, is trying to decide how to present “Property, plant, and equipment” in the balance sheet. She realizes that the statement of cash flows will show that the company made a significant invest- ment in purchasing new equipment this year, but overall she knows the company’s plant assets are rather old. She feels that she can disclose one figure titled “Property, plant, and equipment, net of depreciation,” and the result will be a low figure. However, it will not disclose the age of the assets. If she chooses to show the cost less accumulated depreciation, the age of the assets will be apparent. She proposes the following. Property, plant, and equipment, net of depreciation $10,000,000 rather than Property, plant, and equipment $50,000,000 Less: Accumulated depreciation 40,000,000 Net book value $10,000,000 Concepts for Analysis 273 Instructions Answer the following questions. (a) What are the ethical issues involved? (b) What should Keene do? CA5-5 (Cash Flow Analysis) The partner in charge of the Kappeler Corporation audit comes by your desk and leaves a letter he has started to the CEO and a copy of the cash flow statement for the year ended December 31, 2014. Because he must leave on an emergency, he asks you to finish the letter by explaining: (1) the disparity between net income and cash flow, (2) the importance of operating cash flow, (3) the renewable source(s) of cash flow, and (4) possible suggestions to improve the cash position. KAPPELER CORPORATION STATEMENT OF CASH FLOWS FOR THE YEAR ENDED DECEMBER 31, 2014 Cash fl ows from operating activities Net income $ 100,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense $ 10,000 Amortization expense 1,000 Loss on sale of fi xed assets 5,000 Increase in accounts receivable (net) (40,000) Increase in inventory (35,000) Decrease in accounts payable (41,000) (100,000) Net cash provided by operating activities –0– Cash fl ows from investing activities Sale of plant assets 25,000 Purchase of equipment (100,000) Purchase of land (200,000) Net cash used by investing activities (275,000) Cash fl ows from fi nancing activities Payment of dividends (10,000) Redemption of bonds (100,000) Net cash used by fi nancing activities (110,000) Net decrease in cash (385,000) Cash balance, January 1, 2014 400,000 Cash balance, December 31, 2014 $ 15,000 Date President Kappeler, CEO Kappeler Corporation 125 Wall Street Middleton, Kansas 67458 Dear Mr. Kappeler: I have good news and bad news about the financial statements for the year ended December 31, 2014. The good news is that net income of $100,000 is close to what we predicted in the strategic plan last year, indicating strong performance this year. The bad news is that the cash balance is seriously low. Enclosed is the Statement of Cash Flows, which best illustrates how both of these situations occurred simultaneously . . . Instructions Complete the letter to the CEO, including the four components requested by your boss. 274 Chapter 5 Balance Sheet and Statement of Cash Flows USING YOUR JUDGMENT FINANCIAL REPORTING Financial Reporting Problem The Procter & Gamble Company (P&G) The financial statements of P&G are presented in Appendix 5B. The company’s complete annual report, including the notes to the financial statments, can be accessed at the book’s companion website, www.wiley.com/college/kieso. Instructions Refer to P&G’s financial statements and the related information in the annual report to answer the following questions. (a) What alternative formats could P&G have adopted for its balance sheet? Which format did it adopt? (b) Identify the various techniques of disclosure P&G might have used to disclose additional pertinent financial information. Which technique does it use in its financials? (c) In what classifications are P&G’s investments reported? What valuation basis does P&G use to report its investments? How much working capital did P&G have on June 30, 2011? On June 30, 2010?

(d) What were P&G’s cash flows from its operating, investing, and financing activities for 2011? What were its trends in net cash provided by operating activities over the period 2009 to 2011? Explain why the change in accounts payable and in accrued and other liabilities is added to net income to arrive at net cash provided by operating activities. (e) Compute P&G’s (1) current cash debt coverage, (2) cash debt coverage, and (3) free cash flow for 2011. What do these ratios indicate about P&G’s financial condition? Comparative Analysis Case The Coca-Cola Company and PepsiCo, Inc. Instructions Go to the book’s companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc. (a) What format(s) did these companies use to present their balance sheets? (b) How much working capital did each of these companies have at the end of 2011? Speculate as to their rationale for the amount of working capital they maintain. (c) What is the most significant difference in the asset structure of the two companies? What causes this difference? (d) What are the companies’ annual and 5-year (2007–2011) growth rates in total assets and long-term debt? (e) What were these two companies’ trends in net cash provided by operating activities over the period 2007–2011? (f) Compute both companies’ (1) current cash debt coverage, (2) cash debt coverage, and (3) free cash flow. What do these ratios indicate about the financial condition of the two companies? Financial Statement Analysis Cases Case 1: Uniroyal Technology Corporation Uniroyal Technology Corporation (UTC), with corporate offices in Sarasota, Florida, is organized into three operating segments. The high-performance plastics segment is responsible for research, develop- ment, and manufacture of a wide variety of products, including orthopedic braces, graffiti-resistant seats for buses and airplanes, and a static-resistant plastic used in the central processing units of micro- computers. The coated fabrics segment manufactures products such as automobile seating, door and instrument panels, and specialty items such as waterproof seats for personal watercraft and stain-resistant, easy-cleaning upholstery fabrics. The foams and adhesives segment develops and manufactures products used in commercial roofing applications. The following items relate to operations in a recent year. 1. Serious pressure was placed on profitability by sharply increasing raw material prices. Some raw materials increased in price 50% during the past year. Cost containment programs were instituted and Using YourL Jausdtg Hmeeandt 227755 product prices were increased whenever possible, which resulted in profit margins actually improving over the course of the year. 2. The company entered into a revolving credit agreement, under which UTC may borrow the lesser of $15,000,000 or 80% of eligible accounts receivable. At the end of the year, approximately $4,000,000 was outstanding under this agreement. The company plans to use this line of credit in the upcoming year to finance operations and expansion. Instructions (a) Should investors be informed of raw materials price increases, such as described in item 1? Does the fact that the company successfully met the challenge of higher prices affect the answer? Explain. (b) How should the information in item 2 be presented in the financial statements of UTC? Case 2: Sherwin-Williams Company Sherwin-Williams, based in Cleveland, Ohio, manufactures a wide variety of paint and other coatings, which are marketed through its specialty stores and in other retail outlets. The company also manufactures paint for automobiles. The Automotive Division has had financial difficulty. During a recent year, five branch locations of the Automotive Division were closed, and new management was put in place for the branches remaining. The following titles were shown on Sherwin-Williams’s balance sheet for that year. Accounts payable Machinery and equipment Accounts receivable, less allowance Other accruals

Accrued taxes Other capital Buildings Other current assets Cash and cash equivalents Other long-term liabilities Common stock Postretirement obligations other than pensions Employee compensation payable Retained earnings Finished goods inventories Short-term investments Intangibles and other assets Taxes payable Land Work in process and raw materials inventories Long-term debt Instructions (a) Organize the accounts in the general order in which they would have been presented in a classified balance sheet. (b) When several of the branch locations of the Automotive Division were closed, what balance sheet accounts were most likely affected? Did the balance in those accounts decrease or increase? Case 3: Deere & Company Presented below is the SEC-mandated disclosure of contractual obligations provided by Deere & Company in a recent annual report. Deere & Company reported current assets of $27,208 and total current liabilities of $15,922 at year-end. All dollars are in millions. Aggregate Contractual Obligations The payment schedule for the company’s contractual obligations at year-end in millions of dollars is as follows: Less More than 2&3 4&5 than Total 1 year years years 5 years Debt Equipment operations $ 2,061 $ 130 $ 321 $1,610 Financial services 19,598 8,515 7,025 $3,003 1,055 Total 21,659 8,645 7,346 3,003 2,665 Interest on debt 3,857 941 1,102 557 1,257 Purchase obligations 3,212 3,172 26 9 5 Operating leases 358 100 120 58 80 Capital leases 29 3 6 4 16 Total $29,115 $12,861 $8,600 $3,631 $4,023 227766 CChhaapptteerr 55 BBaallaannccee SShheeeett aanndd SSttaatteemmeenntt ooff CCaasshh FFlloowwss Instructions (a) Compute Deere & Company’s working capital and current ratio (current assets 4 current liabilities) with and without the contractual obligations reported in the schedule. (b) Briefly discuss how the information provided in the contractual obligation disclosure would be useful in evaluating Deere & Company for loans (1) due in one year and (2) due in five years. Case 4: Amazon.com The incredible growth of Amazon.com has put fear into the hearts of traditional retailers. Amazon’s stock price has soared to amazing levels. However, it is often pointed out in the financial press that it took the company several years to report its first profit. The following financial information is taken from a recent annual report. ($ in millions) Current Year Prior Year Current assets $ 3,373 $2,929 Total assets 4,363 3,696 Current liabilities 2,532 1,899 Total liabilities 3,932 3,450 Cash provided by operations 702 733 Capital expenditures 216 204 Dividends paid 0 0 Net income(loss) 190 359 Sales 10,711 8,490 Instructions (a) Calculate free cash flow for Amazon for the current and prior years, and discuss its ability to finance expansion from internally generated cash. Thus far Amazon has avoided purchasing large ware- houses. Instead, it has used those of others. It is possible, however, that in order to increase customer satisfaction the company may have to build its own warehouses. If this happens, how might your impression of its ability to finance expansion change? (b) Discuss any potential implications of the change in Amazon’s cash provided by operations from the prior year to the current year. Accounting, Analysis, and Principles Early in January 2015, Hopkins Company is preparing for a meeting with its bankers to discuss a loan request. Its bookkeeper provided the following accounts and balances at December 31, 2014. Debit Credit Cash $ 75,000 Accounts Receivable (net) 38,500 Inventory 65,300 Equipment (net) 84,000 Patents 15,000 Notes and Accounts Payable $ 52,000 Notes Payable (due 2016) 75,000 Common Stock 100,000 Retained Earnings 50,800 $277,800 $277,800 Except for the following items, Hopkins has recorded all adjustments in its accounts. 1. Cash includes $500 petty cash and $15,000 in a bond sinking fund. 2. Net accounts receivable is comprised of $52,000 in accounts receivable and $13,500 in allowance for doubtful accounts. 3. Equipment had a cost of $112,000 and accumulated depreciation of $28,000.

4. On January 8, 2015, one of Hopkins’ customers declared bankruptcy. At December 31, 2014, this customer owed Hopkins $9,000. IFRLSa Isnts Higehatds 227777 Accounting Prepare a corrected December 31, 2014, balance sheet for Hopkins Company. Analysis Hopkins’ bank is considering granting an additional loan in the amount of $45,000, which will be due December 31, 2015. How can the information in the balance sheet provide useful information to the bank about Hopkins’ ability to repay the loan? Principles In the upcoming meeting with the bank, Hopkins plans to provide additional information about the fair value of its equipment and some internally generated intangible assets related to its customer lists. This information indicates that Hopkins has significant unrealized gains on these assets, which are not reflected on the balance sheet. What objections is the bank likely to raise about the usefulness of this information in evaluating Hopkins for the loan renewal? BRIDGE TO THE PROFESSION Professional Research: FASB Codifi cation In light of the full disclosure principle, investors and creditors need to know the balances for assets, liabil- ities, and equity as well as the accounting policies adopted by management to measure the items reported in the balance sheet. Instructions If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. (a) Identify the literature that addresses the disclosure of accounting policies. (b) How are accounting policies defined in the literature? (c) What are the three scenarios that would result in detailed disclosure of the accounting methods used? (d) What are some examples of common disclosures that are required under this statement? Additional Professional Resources See the book’s companion website, at www.wiley.com/college/kieso, for professional simulations as well as other study resources. IFRS INSIGHTS As in GAAP, the balance sheet and the statement of cash flows are required state- 11 LEARNING OBJECTIVE ments for IFRS. In addition, the content and presentation of an IFRS statement of Compare the accounting procedures financial position (balance sheet) and cash flow statement are similar to those used related to the balance sheet under for GAAP. In general, the disclosure requirements related to the balance sheet and GAAP and IFRS. the statement of cash flows are much more extensive and detailed in the United States. IAS 1, “Presentation of Financial Statements,” provides the overall IFRS require- ments for balance sheet information. IAS 7, “Cash Flow Statements,” provides the over- all IFRS requirements for cash flow information. IFRS insights on the statement of cash flows are presented in Chapter 23. 278 Chapter 5 Balance Sheet and Statement of Cash Flows RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related to the balance sheet. Similarities • Both IFRS and GAAP allow the use of title “balance sheet” or “statement of fi nancial position.” IFRS recommends but does not require the use of the title “statement of fi nancial position” rather than balance sheet. • Both IFRS and GAAP require disclosures about (1) accounting policies followed, (2) judgments that management has made in the process of applying the entity’s ac- counting policies, and (3) the key assumptions and estimation uncertainty that could result in a material adjustment to the carrying amounts of assets and liabilities within the next fi nancial year. Comparative prior period information must be presented and fi nancial statements must be prepared annually. • IFRS and GAAP require presentation of non-controlling interests in the equity section of the balance sheet. Differences • IFRS requires a classifi ed statement of fi nancial position except in very limited situ- ations. IFRS follows the same guidelines as this textbook for distinguishing between current and non-current assets and liabilities. However, under GAAP, public com-

panies must follow SEC regulations, which require specifi c line items. In addition, specifi c GAAP mandates certain forms of reporting for this information. • Under IFRS, current assets are usually listed in the reverse order of liquidity. For example, under GAAP cash is listed fi rst, but under IFRS it is listed last. • IFRS has many differences in terminology that you will notice in this textbook. For example, in the sample statement of fi nancial position illustrated on page 279, notice in the equity section common stock is called share capital—ordinary. • Use of the term “reserve” is discouraged in GAAP, but there is no such prohibition in IFRS. ABOUT THE NUMBERS Classifi cation in the Statement of Financial Position Statement of financial position accounts are classified. That is, a statement of financial position groups together similar items to arrive at significant subtotals. Furthermore, the material is arranged so that important relationships are shown. The IASB indicates that the parts and subsections of financial statements are more informative than the whole. Therefore, the IASB discourages the reporting of summary accounts alone (total assets, net assets, total liabilities, etc.). Instead, companies should report and classify individual items in sufficient detail to permit users to assess the amounts, timing, and uncertainty of future cash flows. Such classification also makes it easier for users to evaluate the company’s liquidity and fi- nancial flexibility, profitability, and risk. Companies then further divide these items into several subclassifications. A representative statement of financial position presentation is shown on the next page. IFRS Insights 279 SCIENTIFIC PRODUCTS, INC. STATEMENT OF FINANCIAL POSITION DECEMBER 31, 2014 Assets Non-current assets Long-term investments Investments in held-for-collection securities $ 82,000 Land held for future development 5,500 $ 87,500 Property, plant, and equipment Land 125,000 Buildings $975,800 Less: Accumulated depreciation 341,200 634,600 Total property, plant, and equipment 759,600 Intangible assets Capitalized development costs 6,000 Goodwill 66,000 Other identifiable intangible assets 28,000 100,000 Total non-current assets 947,100 Current assets Inventories 489,713 Prepaid expenses 16,252 Accounts receivable 165,824 Less: Allowance for doubtful accounts 1,850 163,974 Short-term investments 51,030 Cash and cash equivalents 52,485 Total current assets 773,454 Total assets $1,720,554 Equity and Liabilities Equity Share capital—preference $300,000 Share capital—ordinary 400,000 Share premium—preference 10,000 Share premium—ordinary 27,500 Retained earnings 153,182 Accumulated other comprehensive income 8,650 Less: Treasury shares 12,750 Equity attributable to Scientific Products, Inc. $886,582 Equity attributable to non-controlling interest 13,500 Total equity $ 900,082 Non-current liabilities Bond liabilities due January 31, 2022 425,000 Provisions related to pensions 75,000 Total non-current liabilities 500,000 Current liabilities Notes payable 80,000 Accounts payable 197,532 Interest payable 20,500 Salary and wages payable 5,560 Provisions related to warranties 12,500 Deposits received from customers 4,380 Total current liabilities 320,472 Total liabilities 820,472 Total equity and liabilities $1,720,554 The statement presented is in “report form” format. Some companies use other state- ment of financial position formats. For example, companies sometimes deduct current liabilities from current assets to arrive at working capital. Or, they deduct all liabilities 280 Chapter 5 Balance Sheet and Statement of Cash Flows from all assets. Some companies report the subtotal net assets, which equals total assets minus total liabilities. Equity The equity (also referred to as shareholders’ equity) section is one of the most difficult sec- tions to prepare and understand. This is due to the complexity of ordinary and preference share agreements and the various restrictions on equity imposed by corporation laws, liabil- ity agreements, and boards of directors. Companies usually divide the section into six parts:

EQUITY SECTION 1. SHARE CAPITAL. The par or stated value of shares issued. It includes ordinary shares (sometimes referred to as common shares) and preference shares (sometimes referred to as preferred shares). 2. SHARE PREMIUM. The excess of amounts paid-in over the par or stated value. 3. RETAINED EARNINGS. The corporation’s undistributed earnings. 4. ACCUMULATED OTHER COMPREHENSIVE INCOME. The aggregate amount of the other comprehensive income items. 5. TREASURY SHARES. Generally, the amount of ordinary shares repurchased. 6. NON-CONTROLLING INTEREST (MINORITY INTEREST). A portion of the equity of subsidiaries not owned by the reporting company. For ordinary shares, companies must disclose the par value and the authorized, issued, and outstanding share amounts. The same holds true for preference shares. A company usually presents the share premium (for both ordinary and preference shares) in one amount, although subtotals are informative if the sources of additional capital are varied and material. The retained earnings amount may be divided between the unappropriated (the amount that is usually available for dividend distribution) and restricted (e.g., by bond indentures or other loan agreements) amounts. In addition, companies show any shares reacquired (treasury shares) as a reduction of equity. Accumulated other comprehensive income (sometimes referred to as reserves or other reserves) includes such items as unrealized gains and losses on non-trading equity investments and unrealized gains and losses on certain derivative transactions. Non-controlling interest, sometimes referred to as minority interest, is also shown as a separate item (where applicable) as a part of equity. Delhaize Group presented its equity section as follows. Delhaize Group (000,000) Share capital € 50 Share premium 2,725 Treasury shares (56) Retained earnings 2,678 Other reserves (1,254) Shareholders’ equity 4,143 Minority interests 52 Total equity € 4,195 IFRS Insights 281 Many companies reporting under IFRS often use the term “reserve” as an all-inclusive catch-all for items such as retained earnings, share premium, and accumulated other comprehensive income. Revaluation Equity GAAP and IFRS differ in the IFRS provision for balance sheet revaluations of property, plant, and equipment. Under the revaluation model, revaluations are recorded and re- ported as part of equity. To illustrate, Richardson Company uses IFRS and has property and equipment on an historical cost basis of $2,000,000. At the end of the year, Richardson appraises its property and equipment and determines it had a revaluation increase of $243,000. Richardson records this revaluation under IFRS with an increase to property and equipment as well as a valuation reserve in equity. A note to the financial statements explains the change in the revaluation equity account from one period to the next, as shown below for Richardson Company, assuming a beginning balance of $11,345,000. Note 30. Reserves (in part) ( ,000) 2014 Properties Revaluation Reserve Balance at beginning of year $11,345 Increase (decrease) on revaluation of plant and equipment 243 Impairment losses — Reversals of impairment losses — Balance at end of year $11,588 Fair Presentation Companies must present fairly the financial position, financial performance, and cash flows of the company. Fair presentation means the faithful representation of transac- tions and events using the definitions and recognition criteria in the IASB conceptual framework. It is presumed that the use of IFRS with appropriate disclosure results in financial statements that are fairly presented. In other words, inappropriate use of ac- counting policies cannot be overcome by explanatory notes to the financial statements. In some rare cases, as indicated in Chapter 2, companies can use a “true and fair” over- ride. This situation develops, for example, when the IFRS for a given company appears to conflict with the objective of financial reporting. This situation might occur when a regulatory body indicates that a specific IFRS may be misleading. As indicated earlier, a

true and fair override is highly unlikely in today’s reporting environment. One recent and highly publicized exception is the case of Société Générale (SocGen), a French bank. The bank used the true and fair rule to justify reporting losses that occurred in 2008 in the prior year. Although allowed under the true and fair rule, such reporting was questioned because it permitted the bank to “take a bath,” that is, record as many losses as possible in 2007, which was already a bad year for the bank. As a result, SocGen’s 2008 reports looked better. [See F. Norris, “SocGen Changes Its Numbers,” The New York Times (May 13, 2008).] ON THE HORIZON The FASB and the IASB are working on a project to converge their standards related to financial statement presentation. A key feature of the proposed framework is that each of the statements will be organized, in the same format, to separate an entity’s financing 282 Chapter 5 Balance Sheet and Statement of Cash Flows activities from its operating and investing activities and, further, to separate financing activities into transactions with owners and creditors. Thus, the same classifications used in the statement of financial position would also be used in the statement of com- prehensive income and the statement of cash flows. The project has three phases. You can follow the joint financial presentation project at the following link: http://www.fasb. org/project/financial_statement_ presentation.shtml. IFRS SELF-TEST QUESTIONS 1. Which of the following statements about IFRS and GAAP accounting and reporting requirements for the balance sheet is not correct? (a) Both IFRS and GAAP distinguish between current and non-current assets and liabilities. (b) The presentation formats required by IFRS and GAAP for the balance sheet are similar. (c) Both IFRS and GAAP require that comparative information be reported. (d) One difference between the reporting requirements under IFRS and those of the GAAP balance sheet is that an IFRS balance sheet may list long-term assets first. 2. Current assets under IFRS are listed generally: (a) by importance. (b) in the reverse order of their expected conversion to cash. (c) by longevity. (d) alphabetically. 3. Companies that use IFRS: (a) may report all their assets on the statement of financial position at fair value. (b) are not allowed to net assets (assets 2 liabilities) on their statement of financial positions. (c) may report non-current assets before current assets on the statement of financial position. (d) do not have any guidelines as to what should be reported on the statement of financial position. 4. Franco Company uses IFRS and owns property, plant, and equipment with a historical cost of $5,000,000. At December 31, 2013, the company reported a valuation reserve of $690,000. At Decem- ber 31, 2014, the property, plant, and equipment was appraised at $5,325,000. The valuation reserve will show what balance at December 31, 2014? (a) $365,000. (b) $325,000. (c) $690,000. (d) $0. 5. A company has purchased a tract of land and expects to build a production plant on the land in ap- proximately 5 years. During the 5 years before construction, the land will be idle. Under IFRS, the land should be reported as: (a) land expense. (b) property, plant, and equipment. (c) an intangible asset. (d) a long-term investment. IFRS CONCEPTS AND APPLICATION IFRS5-1 Where can authoritative IFRS guidance be found related to the statement of financial position (balance sheet) and the statement of cash flows? IFRS5-2 Briefly describe some of the similarities and differences between GAAP and IFRS with respect to statement of financial position (balance sheet) reporting. IFRS5-3 Briefly describe the convergence efforts related to financial statement presentation. IFRS5-4 Rainmaker Company prepares its financial statements in accordance with IFRS. In 2014, Rain- maker recorded the following revaluation adjustments related to its buildings and land: The company’s building increased in value by $200,000; its land declined by $35,000. How will these revaluation adjust-

ments affect Rainmaker’s balance sheet? Will the reporting differ under GAAP? Explain. IFRS Insights 283 International Reporting Case IFRS5-5 Presented below is the balance sheet for Tomkins plc, a British company. Tomkins plc Consolidated Balance Sheet (amounts in £ millions) Non-current assets Goodwill 436.0 Other intangible assets 78.0 Property, plant and equipment 1,122.8 Investments in associates 20.6 Trade and other receivables 81.1 Deferred tax assets 82.9 Post-employment benefit surpluses 1.3 1,822.7 Current assets Inventories 590.8 Trade and other receivables 753.0 Income tax recoverable 49.0 Available-for-sale investments 1.2 Cash and cash equivalents 445.0 1,839.0 Assets held for sale 11.9 Total assets 3,673.6 Current liabilities Bank overdrafts 4.8 Bank and other loans 11.2 Obligations under finance leases 1.0 Trade and other payables 677.6 Income tax liabilities 15.2 Provisions 100.3 810.1 Non-current liabilities Bank and other loans 687.3 Obligations under finance leases 3.6 Trade and other payables 27.1 Post-employment benefit obligations 343.5 Deferred tax liabilities 25.3 Income tax liabilities 79.5 Provisions 19.2 1,185.5 Total liabilities 1,995.6 Net assets 1,678.0 Capital and reserves Ordinary share capital 79.6 Share premium account 799.2 Own shares (8.2) Capital redemption reserve 921.8 Currency translation reserve (93.0) Available-for-sale reserve (0.9) Accumulated deficit (161.9) Shareholders’ equity 1,536.6 Minority interests 141.4 Total equity 1,678.0 284 Chapter 5 Balance Sheet and Statement of Cash Flows Instructions (a) Identify at least three differences in balance sheet reporting between British and U.S. firms, as shown in Tomkins’ balance sheet. (b) Review Tomkins’ balance sheet and identify how the format of this financial statement provides useful information, as illustrated in the chapter. Professional Research IFRS5-6 In light of the full disclosure principle, investors and creditors need to know the balances for as- sets, liabilities, and equity, as well as the accounting policies adopted by management to measure the items reported in the statement of financial position. Instructions Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/). (If necessary, click on the IFRS tab and then register for eIFRS free access.) When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.) (a) Identify the literature that addresses the disclosure of accounting policies. (b) How are accounting policies defined in the literature? (c) What are the guidelines concerning consistency in applying accounting policies? (d) What are some examples of common disclosures that are required under this statement? International Financial Reporting Problem Marks and Spencer plc IFRS5-7 The financial statements of Marks and Spencer plc (M&S) are available at the book’s compan- ion website or can be accessed at http://annualreport.marksandspencer.com/_assets/downloads/Marks- and-Spencer-Annual-report-and-financial-statements-2012.pdf. Instructions Refer to M&S’s financial statements and the accompanying notes to answer the following questions. (a) What alternative formats could M&S have adopted for its statement of financial position? Which format did it adopt? (b) Identify the various techniques of disclosure M&S might have used to disclose additional perti- nent financial information. Which technique does it use in its financials? (c) In what classifications are M&S’s investments reported? What valuation basis does M&S use to report its investments? How much working capital did M&S have on 31 March 2012? On 2 April 2011? (d) What were M&S’s cash flows from its operating, investing, and financing activities for 2012? What were its trends in net cash provided by operating activities over the period 2011 to 2012? Explain why the change in accounts payable and in accrued and other liabilities is added to net income to arrive at net cash provided by operating activities. (e) Compute M&S’s (1) current cash debt coverage, (2) cash debt coverage, and (3) free cash flow for