Datasets:

kothasuhas

/

accounting-textbooks-6

like 1

Amortization of bond discount Income on investment in common stock Method Increase in deferred income tax liability using equity method Loss on investment in common stock using equity method Gain on sale of plant assets Loss on sale of plant assets Increase in receivables Loss on impairment of assets Increase in inventory Decrease in receivables Increase in prepaid expense Decrease in inventory Decrease in accounts payable Decrease in prepaid expense Decrease in accrued liabilities Increase in accounts payable Increase in accrued liabilities 5 Net Cash Flow from Operating Activities 1428 Chapter 23 Statement of Cash Flows The additions and deductions in Illustration 23-17 reconcile net income to net cash flow from operating activities, illustrating why the indirect method is also called the reconciliation method. Net Cash Flow from Operating Activities—Direct Method Two different methods are available to adjust income from operations on an accrual 7 LEARNING OBJECTIVE basis to net cash flow from operating activities. We showed the indirect method in the Contrast the direct and indirect Tax Consultants’ illustrations in the prior sections. methods of calculating net cash flow from operating activities. The direct method reports cash receipts and cash disbursements from operat- ing activities. The difference between these two amounts is the net cash flow from operating activities. In other words, the direct method deducts operating cash disburse- ments from operating cash receipts. The direct method results in the presentation of a condensed cash receipts and cash disbursements statement. As indicated from the accrual-based income statement (see Illustration 23-4 on page 1417), Tax Consultants reported revenues of $125,000. However, because the com- pany’s accounts receivable increased during 2013 by $36,000, the company collected only $89,000 ($125,000 2 $36,000) in cash from these revenues. Similarly, Tax Consultants reported operating expenses of $85,000. However, accounts payable increased during the period by $5,000. Assuming that these payables relate to operating expenses, cash operating expenses were $80,000 ($85,000 2 $5,000). Because no taxes payable exist at the end of the year, the company must have paid $6,000 income tax expense for 2013 in cash during the year. Tax Consultants computes net cash flow from operating activities as shown in Illustration 23-18. ILLUSTRATION 23-18 Cash collected from revenues $89,000 Computation of Net Cash payments for expenses 80,000 Cash Flow from Income before income taxes 9,000 Operating Activities, Cash payments for income taxes 6,000 Year 1—Direct Method Net cash provided by operating activities $ 3,000 “Net cash provided by operating activities” is the equivalent of cash basis net income. (“Net cash used by operating activities” is equivalent to cash basis net loss.) The FASB encourages use of the direct method and permits use of the indirect method. Yet, if the direct method is used, the Board requires that companies provide in a separate schedule a reconciliation of net income to net cash flow from operating activi- ties. Therefore, under either method, companies must prepare and report information from the indirect (reconciliation) method. Direct Method—Expanded Example Under the direct method, the statement of cash flows reports net cash flow from operat- ing activities as major classes of operating cash receipts (e.g., cash collected from customers and cash received from interest and dividends) and cash disbursements (e.g., cash paid to suppliers for goods, to employees for services, to creditors for interest, and to govern- ment authorities for taxes). We illustrate the direct method here in more detail to help you understand the difference between accrual-based income and net cash flow from operating activities. This example also illustrates the data needed to apply the direct method. Emig Com- pany, which began business on January 1, 2014, has the following selected balance sheet information. Illustrations—Tax Consultants Inc. 1429 ILLUSTRATION 23-19

December 31, January 1, Balance Sheet Accounts, 2014 2014 Emig Co. Cash $159,000 –0– Accounts receivable 15,000 –0– Inventory 160,000 –0– Prepaid expenses 8,000 –0– Property, plant, and equipment (net) 90,000 –0– Accounts payable 60,000 –0– Accrued expenses payable 20,000 –0– Emig Company’s December 31, 2014, income statement and additional information are as follows. ILLUSTRATION 23-20 Sales revenue $780,000 Income Statement, Cost of goods sold 450,000 Emig Co. Gross profit 330,000 Operating expenses $160,000 Depreciation 10,000 170,000 Income before income taxes 160,000 Income tax expense 48,000 Net income $112,000 Additional Information (a) Dividends of $70,000 were declared and paid in cash. (b) The accounts payable increase resulted from the purchase of merchandise. (c) Prepaid expenses and accrued expenses payable relate to operating expenses. Under the direct method, companies compute net cash provided by operating activities by adjusting each item in the income statement from the accrual basis to the cash basis. To simplify and condense the operating activities section, only major classes of operating cash receipts and cash payments are reported. As Illustration 23-21 shows, the difference between these major classes of cash receipts and cash payments is the net ILLUSTRATION 23-21 cash provided by operating activities. Major Classes of Cash Receipts and Payments Net Cash Provided Cash Receipts Minus Cash Payments Equals by Operating Activities To suppliers From sales of goods and services to To employees customers Net Cash Provided For operating expenses by Operating Activities From receipts of interest and dividends For interest on loans and investments For taxes 1430 Chapter 23 Statement of Cash Flows An efficient way to apply the direct method is to analyze the revenues and expenses reported in the income statement in the order in which they are listed. The company then determines cash receipts and cash payments related to these revenues and expenses. In the following sections, we present the direct method adjustments for Emig Company in 2014, to determine net cash provided by operating activities. Cash Receipts from Customers. The income statement for Emig Company reported revenues from customers of $780,000. To determine cash receipts from customers, the company considers the change in accounts receivable during the year. When accounts receivable increase during the year, revenues on an accrual basis are higher than cash receipts from customers. In other words, operations led to increased revenues, but not all of these revenues resulted in cash receipts. To determine the amount of increase in cash receipts, deduct the amount of the increase in accounts receivable from the total sales revenue. Conversely, a decrease in accounts receivable is added to sales revenue because cash receipts from customers then exceed sales revenue. For Emig Company, accounts receivable increased $15,000. Thus, cash receipts from customers were $765,000, computed as follows. Sales revenue $780,000 Deduct: Increase in accounts receivable 15,000 Cash receipts from customers $765,000 Emig could also determine cash receipts from customers by analyzing the Accounts Receivable account as shown below. Accounts Receivable 1/1/14 Balance –0– Receipts from customers 765,000 Sales revenue 780,000 12/31/14 Balance 15,000 Illustration 23-22 shows the relationships between cash receipts from customers, sales revenue, and changes in accounts receivable. ILLUSTRATION 23-22 Cash receipts 1 Decrease in accounts receivable Formula to Compute Sales from 5 or Cash Receipts from revenue customers 2 Increase in accounts receivable Customers e Cash Payments to Suppliers. Emig Company reported cost of goods sold on its income statement of $450,000. To determine cash payments to suppliers, the company first finds purchases for the year, by adjusting cost of goods sold for the change in inventory. When inventory increases during the year, purchases this year exceed cost of goods sold. As a result, the company adds the increase in inventory to cost of goods sold, to arrive at

purchases. In 2014, Emig Company’s inventory increased $160,000. The company computes purchases as follows. Cost of goods sold $450,000 Add: Increase in inventory 160,000 Purchases $610,000 After computing purchases, Emig determines cash payments to suppliers by adjust- ing purchases for the change in accounts payable. When accounts payable increase Illustrations—Tax Consultants Inc. 1431 during the year, purchases on an accrual basis are higher than they are on a cash basis. As a result, the company deducts from purchases the increase in accounts payable to arrive at cash payments to suppliers. Conversely, if cash payments to suppliers exceed purchases, Emig adds to purchases the decrease in accounts payable. Cash payments to suppliers were $550,000, computed as follows. Purchases $610,000 Deduct: Increase in accounts payable 60,000 Cash payments to suppliers $550,000 Emig also can determine cash payments to suppliers by analyzing Accounts Payable, as shown below. Accounts Payable Payments to suppliers 550,000 1/1/14 Balance –0– Purchases 610,000 12/31/14 Balance 60,000 Illustration 23-23 shows the relationships between cash paymeVnts to suppliers, cost of goods sold, changes in inventory, and changes in accounts payable. V ILLUSTRATION 23-23 1 Decrease in Formula to Compute 1 Increase in inventory accounts payable Cash payments Cost of Cash Payments to 5 or or to suppliers goods sold 2 Decrease in inventory 2 Increase in Suppliers accounts payable Cash Payments for Operating Expenses. Emig reported operating expenses of $160,000 on its income statement. To determine the cash paid for operating expenses, it must adjust this amount for any changes in prepaid expenses and accrued expenses payable. For example, when prepaid expenses increased $8,000 during the year, cash paid for operating expenses was $8,000 higher than operating expenses reported on the income statement. To convert operating expenses to cash payments for operating expenses, the company adds to operating expenses the increase of $8,000. Conversely, if prepaid expenses decrease during the year, it deducts from operating expenses the amount of the decrease. Emig also must adjust operating expenses for changes in accrued expenses payable. When accrued expenses payable increase during the year, operating expenses on an accrual basis are higher than they are on a cash basis. As a result, the company deducts from operating expenses an increase in accrued expenses payable, to arrive at cash pay- ments for operating expenses. Conversely, it adds to operating expenses a decrease in accrued expenses payable, because cash payments exceed operating expenses. Emig’s cash payments for operating expenses were $148,000, computed as follows. Operating expenses $160,000 Add: Increase in prepaid expenses 8,000 Deduct: Increase in accrued expenses payable 20,000 Cash payments for operating expenses $148,000 The relationships among cash payments for operating expenses, changes in prepaid expenses, and changes in accrued expenses payable are shown in Illustration 23-24 (page 1432). V V 1432 Chapter 23 Statement of Cash Flows ILLUSTRATION 23-24 1 Increase in 1 Decrease in accrued Formula to Compute Cash payments prepaid expense expenses payable Cash Payments for Operating for operating 5 or or Operating Expenses expenses expenses 2 Decrease in 2 Increase in accrued prepaid expense expenses payable Note that the company did not consider depreciation expense because it is a noncash charge. Cash Payments for Income Taxes. The income statement for Emig shows income tax expense of $48,000. This amount equals the cash paid. How do we know that? Because the comparative balance sheet indicated no income taxes payable at either the beginning or end of the year. Summary of Net Cash Flow from Operating Activities—Direct Method The following schedule summarizes the computations illustrated above. ILLUSTRATION 23-25 Add Accrual Basis to Cash Accrual Basis Adjustment (Subtract) Cash Basis Basis Sales revenue $780,000 2 Increase in accounts receivable $ (15,000) $765,000 Cost of goods sold 450,000 1 Increase in inventory 160,000

2 Increase in accounts payable (60,000) 550,000 Operating expenses 160,000 1 Increase in prepaid expenses 8,000 2 Increase in accrued expenses payable (20,000) 148,000 Depreciation expense 10,000 2 Depreciation expense (10,000) –0– Income tax expense 48,000 48,000 Total expense 668,000 746,000 Net income $112,000 Net cash provided by operating activities $ 19,000 Illustration 23-26 shows the presentation of the direct method for reporting net cash flow from operating activities for the Emig Company illustration. ILLUSTRATION 23-26 EMIG COMPANY Operating Activities STATEMENT OF CASH FLOWS (PARTIAL) Section—Direct Method, 2014 Cash flows from operating activities Cash received from customers $765,000 Cash payments: To suppliers $550,000 For operating expenses 148,000 For income taxes 48,000 746,000 Net cash provided by operating activities $ 19,000 If Emig Company uses the direct method to present the net cash flow from oper- ating activities, it must provide in a separate schedule the reconciliation of net income to net cash provided by operating activities. The reconciliation assumes the identical form and content of the indirect method of presentation, as the following shows. Illustrations—Tax Consultants Inc. 1433 ILLUSTRATION 23-27 EMIG COMPANY Reconciliation of Net RECONCILIATION Income to Net Cash Net income $112,000 Provided by Operating Adjustments to reconcile net income to net cash Activities provided by operating activities: Depreciation expense $ 10,000 Increase in accounts receivable (15,000) Increase in inventory (160,000) Increase in prepaid expenses (8,000) Increase in accounts payable 60,000 Increase in accrued expense payable 20,000 (93,000) Net cash provided by operating activities $ 19,000 When the direct method is used, the company may present this reconciliation at the bottom of the statement of cash flows or in a separate schedule. Evolving Issue DIRECT VERSUS INDIRECT The most contentious decision that the FASB faced related to Many companies indicate that they do not currently cash flow reporting was choosing between the direct method collect information in a manner that allows them to deter- and the indirect method of determining net cash flow from mine amounts such as cash received from customers or cash operating activities. Companies lobbied against the direct paid to suppliers directly from their accounting systems. But method, urging adoption of the indirect method. Commer- supporters of the direct method contend that the incremental cial lending officers expressed to the FASB a strong prefer- cost of determining operating cash receipts and payments is ence in favor of the direct method. What are the arguments in not significant. favor of each of the methods? In Favor of the Indirect Method In Favor of the Direct Method The principal advantage of the indirect method is that it The principal advantage of the direct method is that it shows focuses on the differences between net income and net operating cash receipts and payments. Thus, it is more con- cash flow from operating activities. That is, it provides a sistent with the objective of a statement of cash flows—to useful link between the statement of cash flows and the provide information about cash receipts and cash payments— income statement and balance sheet. than the indirect method, which does not report operating Many companies contend that it is less costly to adjust net cash receipts and payments. income to net cash flow from operating activities (indirect) Supporters of the direct method contend that knowledge than it is to report gross operating cash receipts and payments of the specific sources of operating cash receipts and the pur- (direct). Supporters of the indirect method also state that the poses for which operating cash payments were made in past direct method, which effectively reports income statement periods is useful in estimating future operating cash flows. information on a cash rather than an accrual basis, may errone- Furthermore, information about amounts of major classes of ously suggest that net cash flow from operating activities is as

operating cash receipts and payments is more useful than good as, or better than, net income as a measure of performance. information only about their arithmetic sum (the net cash In their joint financial statement presentation project, the flow from operating activities). Such information is more re- FASB and the IASB have proposed to allow only the direct vealing of a company’s ability (1) to generate sufficient cash method. However, there has been significant pushback on from operating activities to pay its debts, (2) to reinvest in its this proposal, which suggests that the choice of either the operations, and (3) to make distributions to its owners. [3] direct or indirect method will continue to be available. Source: See http://www.fasb.org; click on Projects and then on Inactive Joint FASB/IASB Projects. Special Reporting Rules Applying to Direct and Indirect Methods Companies that use the direct method are required, at a minimum, to report separately the following classes of operating cash receipts and payments: 1434 Chapter 23 Statement of Cash Flows International Receipts Perspective 1. Cash collected from customers (including lessees, licensees, etc.). Consolidated statements of cash 2. Interest and dividends received. fl ows may be of limited use to 3. Other operating cash receipts, if any. analysts evaluating multinational companies. Without disaggrega- Payments tion, users of such statements 1. Cash paid to employees and suppliers of goods or services (including are not able to determine “where suppliers of insurance, advertising, etc.). in the world” the funds are 2. Interest paid. sourced and used. 3. Income taxes paid. 4. Other operating cash payments, if any. The FASB encourages companies to provide further breakdowns of operating cash receipts and payments that they consider meaningful. Companies using the indirect method must disclose separately changes in inven- tory, receivables, and payables in order to reconcile net income to net cash flow from operating activities. In addition, they must disclose, elsewhere in the financial state- ments or in accompanying notes, interest paid (net of amount capitalized) and income taxes paid.6 The FASB requires these separate and additional disclosures so that users may approximate the direct method. Also, an acceptable alternative presentation of the indirect method is to report net cash flow from operating activities as a single line item in the statement of cash flows and to present the reconciliation details elsewhere in the financial statements. Finally, the FASB encourages the use of the direct method over the indirect method. If a company uses the direct method of reporting net cash flow from operating activities, the FASB requires that the company provide in a separate schedule a reconciliation of net income to net cash flow from operating activities. If a company uses the indirect method, it can either report the reconciliation within the statement of cash flows or can provide it in a separate schedule, with the statement of cash flows reporting only the net cash flow from operating activities. [4] SPECIAL PROBLEMS IN STATEMENT PREPARATION We discussed some of the special problems related to preparing the statement of LEARNING OBJECTIVE 8 cash flows in connection with the preceding illustrations. Other problems that arise Discuss special problems in preparing with some frequency in the preparation of this statement include the following. a statement of cash flows. 1. Adjustments to net income. 2. Accounts receivable (net). 3. Other working capital changes. 4. Net losses. 5. Signifi cant noncash transactions. 6Accounting Trends and Techniques—2012 reports that of the 500 companies surveyed, 207 disclosed interest paid in notes to the financial statements, 257 disclosed interest paid at the bottom of the statement of cash flows, 7 disclosed interest paid within the statement of cash flows, and 29 reported no separate amount. Income taxes paid during the year were disclosed in a manner similar to interest payments. Special Problems in Statement Preparation 1435

Adjustments to Net Income Depreciation and Amortization Depreciation expense is the most common adjustment to net income that companies make to arrive at net cash flow from operating activities. But there are numerous other noncash expense or revenue items. Examples of expense items that companies must add back to net income are the amortization of limited-life intangible assets such as patents, and the amortization of deferred costs such as bond issue costs. These charges to expense involve expenditures made in prior periods that a company amortizes currently. These charges reduce net income without affecting cash in the current period. Also, amortization of bond discount or premium on long-term bonds payable affects the amount of interest expense. However, neither affects cash. As a result, a company should add back discount amortization and subtract premium amortization from net income to arrive at net cash flow from operating activities. Postretirement Benefi t Costs If a company has postretirement costs such as an employee pension plan, chances are that the pension expense recorded during a period will either be higher or lower than the cash funded. It will be higher when there is an unfunded liability and will be lower when there is a pension asset. When the expense is higher or lower than the cash paid, the company must adjust net income by the difference between cash paid and the expense reported in computing net cash flow from operating activities. Changes in Deferred Income Taxes Changes in deferred income taxes affect net income but have no effect on cash. For example, Delta Airlines reported an increase in its liability for deferred taxes of ap- proximately $1.2 billion. This change in the liability increased tax expense and decreased net income, but did not affect cash. Therefore, Delta added back $1.2 billion to net in- come on its statement of cash flows. Equity Method of Accounting Another common adjustment to net income is a change related to an investment in common stock when recording income or loss under the equity method. Recall that under the equity method, the investor (1) debits the investment account and credits revenue for its share of the investee’s net income, and (2) credits dividends received to the investment account. Therefore, the net increase in the investment account does not affect cash flow. A company must deduct the net increase from net income to arrive at net cash flow from operating activities. Assume that Victor Co. owns 40 percent of Milo Inc. During the year, Milo reports net income of $100,000 and pays a cash dividend of $30,000. Victor reports this in its statement of cash flows as a deduction from net income in the following manner— Equity in earnings of Milo, net of dividends, $28,000 [($100,000 2 $30,000) 3 40%]. Losses and Gains Realized Losses and Gains. In the illustration for Tax Consultants, the company experi- enced a loss of $2,000 from the sale of equipment. The company added this loss to net income to compute net cash flow from operating activities because the loss is a noncash charge in the income statement. If Tax Consultants experiences a gain from a sale of equipment, it too requires an adjustment to net income. Because a company reports the gain in the statement of cash flows as part of the cash proceeds from the sale of equipment under investing activities, it deducts the gain from net income to avoid double-counting—once as part of net income and again as part of the cash proceeds from the sale. 1436 Chapter 23 Statement of Cash Flows To illustrate, assume that Tax Consultants had land with a carrying value of $200,000, which was condemned by the state government for a highway project. The condemna- tion proceeds received were $205,000, resulting in a gain of $5,000. In the statement of cash flows (indirect method), the company would deduct the $5,000 gain from net income in the operating activities section. It would report the $205,000 cash inflow from the condemnation as an investing activity, as follows. Cash flows from investing activities

Condemnation of land $205,000 Unrealized Losses and Gains. Unrealized losses and gains generally occur for debt investments and for equity investments. For example, assume that Target purchases the following two investments on January 10, 2014. 1. Debt investment for $1 million that is classifi ed as trading. During 2014, the debt investment has an unrealized holding gain of $110,000 (recorded in net income). 2. Equity investment for $600,000 that is classifi ed as available-for-sale. During 2014, the available-for-sale equity investment has an unrealized holding loss of $50,000 (recorded in other comprehensive income). For Target, the unrealized holding gain of $110,000 on the debt investment increases net income but does not increase net cash flow from operating activities. As a result, the unrealized holding gain of $110,000 is deducted from net income to compute net cash flow from operating activities. On the other hand, the unrealized holding loss of $50,000 that Target incurs on the available-for-sale equity investment does not affect net income or cash flows—this loss is reported in the other comprehensive income section. As a result, no adjustment to net income is necessary in computing net cash flow from operating activities. Thus, the general rule is that unrealized holding gains or losses that affect net income must be adjusted to determine net cash flow from operating activities. Conversely, unrealized holding gains or losses that do not affect net income are not adjusted to determine net cash flow from operating activities. Stock Options Recall for share-based compensation plans that companies are required to use the fair value method to determine total compensation cost. The compensation cost is then recognized as an expense in the periods in which the employee provides services. When Compensation Expense is debited, Paid-in Capital—Stock Options is often credited. Cash is not affected by recording the expense. Therefore, the company must increase net income by the amount of compensation expense from stock options in computing net cash flow from operating activities. To illustrate how this information should be reported on a statement of cash flows, assume that First Wave Inc. grants 5,000 options to its CEO, Ann Johnson. Each option entitles Johnson to purchase one share of First Wave’s $1 par value common stock at $50 per share at any time in the next two years (the service period). The fair value of the options is $200,000. First Wave records compensation expense in the first year as follows. Compensation Expense ($200,000 4 2) 100,000 Paid-in Capital—Stock Options 100,000 In addition, if we assume that First Wave has a 35 percent tax rate, it would recog- nize a deferred tax asset of $35,000 ($100,000 3 35%) in the first year as follows. Deferred Tax Asset 35,000 Income Tax Expense 35,000 Special Problems in Statement Preparation 1437 Therefore, on the statement of cash flows for the first year, First Wave reports the following (assuming a net income of $600,000). Net income $600,000 Adjustments to reconcile net income to net cash provided by operating activities: Share-based compensation expense 100,000 Increase in deferred tax asset (35,000) As shown in First Wave’s statement of cash flows, it adds the share-based compen- sation expense to net income because it is a noncash expense. The increase in the de- ferred tax asset and the related reduction in income tax expense increase net income. Although the negative income tax expense increases net income, it does not increase cash. Therefore, it should be deducted. Subsequently, if Ann Johnson exercises her options, First Wave reports “Cash pro- vided by exercise of stock options” in the financing section of the statement of cash flows.7 Extraordinary Items Companies should report either as investing activities or as financing activities cash flows from extraordinary transactions and other events whose effects are included in net income, but which are not related to operations. For example, assume that Tax Consultants had land with a carrying value of

$200,000, which was condemned by the state of Maine for a highway project. The con- demnation proceeds received were $205,000, resulting in an extraordinary gain of $5,000 less $2,000 of taxes. In the statement of cash flows (indirect method), the company would deduct the $5,000 gain from net income in the operating activities section. It would re- port the $205,000 cash inflow from the condemnation as an investing activity, as follows. Cash flows from investing activities Condemnation of land $205,000 Note that Tax Consultants handles the gain at its gross amount ($5,000), not Underlying Concepts net of tax. The company reports the cash received in the condemnation as an investing activity at $205,000, also exclusive of the tax effect. By rejecting the requirement The FASB requires companies to classify all income taxes paid as operating to allocate taxes to the various cash outflows. Some suggested that income taxes paid be allocated to investing activities, the FASB invoked the cost constraint. The information and financing transactions. But the Board decided that allocation of income would be benefi cial, but the cost taxes paid to operating, investing, and financing activities would be so complex of providing such information and arbitrary that the benefits, if any, would not justify the costs involved. would exceed the benefi ts of Under both the direct method and the indirect method, companies must providing it. disclose the total amount of income taxes paid.8 7Companies receive a tax deduction related to share-based compensation plans at the time employees exercise their options. The amount of the deduction is equal to the difference between the market price of the stock and the exercise price at the date the employee purchases the stock, which in most cases is much larger than the total compensation expense recorded. When the tax deduction exceeds the total compensation recorded, this provides an additional cash inflow to the company. For example, in a recent year Cisco Systems reported an additional cash inflow related to its stock-option plans equal to $537 million. Under GAAP, this tax-related cash inflow is reported in the financing section of the statement of cash flows. [5] 8For an insightful article on some weaknesses and limitations in the statement of cash flows, see Hugo Nurnberg, “Inconsistencies and Ambiguities in Cash Flow Statements Under FASB Statement No. 95,” Accounting Horizons (June 1993), pp. 60–73. Nurnberg identifies the inconsistencies caused by the three-way classification of all cash receipts and cash payments, gross versus net of tax, the ambiguous disclosure requirements for noncash investing and financing transactions, and the ambiguous presentation of third-party financing transactions. See also Paul B. W. Miller and Bruce P. Budge, “Nonarticulation in Cash Flow Statements and Implications for Education, Research, and Practice,” Accounting Horizons (December 1996), pp. 1–15; and Charles Mulford and Michael Ely, “Calculating Sustainable Cash Flow: A Study of the S&P 100,” Georgia Tech Financial Analysis Lab (October 2004). 1438 Chapter 23 Statement of Cash Flows Accounts Receivable (Net) Up to this point, we assumed no allowance for doubtful accounts—a contra account—to offset accounts receivable. However, if a company needs an allowance for doubtful accounts, how does that allowance affect the company’s determination of net cash flow from operating activities? For example, assume that Redmark Co. reports net income of $40,000. It has the accounts receivable balances as shown in Illustration 23-28. ILLUSTRATION 23-28 Change Accounts Receivable 2014 2013 Increase/Decrease Balances, Redmark Co. Accounts receivable $105,000 $90,000 $15,000 Increase Allowance for doubtful accounts (10,000) (4,000) 6,000 Increase Accounts receivable (net) $ 95,000 $86,000 9,000 Increase Indirect Method Because an increase in Allowance for Doubtful Accounts results from a charge to bad debt expense, a company should add back an increase in Allowance for Doubt- ful Accounts to net income to arrive at net cash flow from operating activities. Illustra-

tion 23-29 shows one method for presenting this information in a statement of cash flows. ILLUSTRATION 23-29 REDMARK CO. Presentation of STATEMENT OF CASH FLOWS (PARTIAL) Allowance for Doubtful FOR THE YEAR 2014 Accounts—Indirect Method Cash flows from operating activities Net income $40,000 Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable $(15,000) Increase in allowance for doubtful accounts 6,000 (9,000) $31,000 As we indicated, the increase in the Allowance for Doubtful Accounts balance results from a charge to bad debt expense for the year. Because bad debt expense is a noncash charge, a company must add it back to net income in arriving at net cash flow from operating activities. Instead of separately analyzing the allowance account, a short-cut approach is to net the allowance balance against the receivable balance and compare the change in accounts receivable on a net basis. Illustration 23-30 shows this presentation. ILLUSTRATION 23-30 REDMARK CO. Net Approach to STATEMENT OF CASH FLOWS (PARTIAL) Allowance for Doubtful FOR THE YEAR 2014 Accounts—Indirect Method Cash flows from operating activities Net income $40,000 Adjustments to reconcile net income to net cash provided by operating activities: Increase in accounts receivable (net) (9,000) $31,000 This short-cut procedure works also if the change in the allowance account results from a write-off of accounts receivable. This reduces both Accounts Receivable and Allowance for Doubtful Accounts. No effect on cash flows occurs. Because of its simplicity, use the net approach for your homework assignments. Special Problems in Statement Preparation 1439 Direct Method If using the direct method, a company should not net Allowance for Doubtful Accounts against Accounts Receivable. To illustrate, assume that Redmark Co.’s net income of $40,000 consisted of the items shown in Illustration 23-31. ILLUSTRATION 23-31 REDMARK CO. Income Statement, INCOME STATEMENT Redmark Co. FOR THE YEAR 2014 Sales revenue $100,000 Expenses Salaries $46,000 Utilities 8,000 Bad debts 6,000 60,000 Net income $ 40,000 If Redmark deducts the $9,000 increase in accounts receivable (net) from sales for the year, it would report cash sales at $91,000 ($100,000 2 $9,000) and cash payments for operating expenses at $60,000. Both items would be misstated: Cash sales should be re- ported at $85,000 ($100,000 2 $15,000), and total cash payments for operating expenses should be reported at $54,000 ($60,000 2 $6,000). Illustration 23-32 shows the proper presentation. ILLUSTRATION 23-32 REDMARK CO. Bad Debts—Direct STATEMENT OF CASH FLOWS (PARTIAL) Method FOR THE YEAR 2014 Cash flows from operating activities Cash received from customers $85,000 Salaries paid $46,000 Utilities paid 8,000 54,000 Net cash provided by operating activities $31,000 An added complication develops when a company writes off accounts receivable. Simply adjusting sales for the change in accounts receivable will not provide the proper amount of cash sales. The reason is that the write-off of the accounts receivable is not a cash collection. Thus, an additional adjustment is necessary. What do the numbers mean? NOT WHAT IT SEEMS The controversy over direct and indirect methods highlights years, automakers classifi ed lease receivables and other the importance that the market attributes to operating cash dealer-fi nancing arrangements as investment cash fl ows. fl ow. By showing an improving cash fl ow, a company can Thus, they reported an increase in lease or loan receivables give a favorable impression of its ongoing operations. For from cars sold as a use of cash in the investing section of the example, WorldCom concealed declines in its operations by statement of cash fl ows. The SEC objected and now requires capitalizing certain operating expenses—to the tune of $3.8 automakers to report these receivables as operating cash billion! This practice not only “juiced up” income but also fl ows, since the leases and loans are used to facilitate car made it possible to report the cash payments in the investing sales. At GM, these reclassifi cations reduced its operating

section of the cash fl ow statement rather than as a deduction cash fl ows from $7.6 billion to $3 billion in the year before the from operating cash fl ow. change. The SEC recently addressed a similar cash fl ow classifi ca- In the banking industry, how banks classify their invest- tion issue with automakers like Ford, GM, and Chrysler. For ments, deposits, and cash fl ow from acquisitions results 1440 Chapter 23 Statement of Cash Flows in huge swings in operating cash fl ows, both downward deposits should be accounted for under operating cash fl ow (Bank of America) and upward (KeyCorp). According to one (rather than as a fi nancing cash fl ow) since “the very health analyst, “As it stands now, banks can’t be reliably compared of a bank’s operations depends on its deposit base and its to each other by their recorded cash fl ow from operations . . . ability to attract a growing stream of deposits.” So while the operating cash fl ow for a bank is basically meaningless.” An- overall cash fl ow—from operations, investing, and fi nancing— other questionable cash fl ow classifi cation for banks is the remained the same, operating cash fl ow at these companies characterization of increases and decreases in deposits as looked better than it really was. fi nancing cash fl ow. Many analysts believe customer-driven Sources: Peter Elstrom, “How to Hide $3.8 Billion in Expenses,” BusinessWeek Online (July 8, 2002); Judith Burns, “SEC Tells US Automakers to Retool Cash-Flow Accounting,” Wall Street Journal Online (February 28, 2005); and Sarah Johnson, “Cash Flow: A Better Way to Know Your Bank?” CFO.com (July 9, 2009). Other Working Capital Changes Up to this point, we showed how companies handled all of the changes in working capital items (current asset and current liability items) as adjustments to net income in determining net cash flow from operating activities. You must be careful, however, because some changes in working capital, although they affect cash, do not affect net income. Generally, these are investing or financing activities of a current nature. One activity is the purchase of short-term available-for-sale securities. For exam- ple, the purchase of short-term available-for-sale securities for $50,000 cash has no effect on net income but it does cause a $50,000 decrease in cash. A company reports this trans- action as a cash flow from investing activities as follows. [6] Cash flows from investing activities Purchase of short-term available-for-sale securities $(50,000) What about trading securities? Because companies hold these investments principally for the purpose of selling them in the near term, companies should classify the cash flows from purchases and sales of trading securities as cash flows from operating activities. [7]9 Another example is the issuance of a short-term nontrade note payable for cash. This change in a working capital item has no effect on income from operations but it increases cash by the amount of the note payable. For example, a company reports the issuance of a $10,000 short-term note payable for cash in the statement of cash flows as follows. Cash flows from financing activities Issuance of short-term note $10,000 Another change in a working capital item that has no effect on income from opera- tions or on cash is a cash dividend payable. Although a company will report the cash dividends when paid as a financing activity, it does not report the declared but unpaid dividend on the statement of cash flows. Net Losses If a company reports a net loss instead of a net income, it must adjust the net loss for those items that do not result in a cash inflow or outflow. The net loss, after adjusting for 9If the basis of the statement of cash flows is cash and cash equivalents and the short-term investment is considered a cash equivalent, then a company reports nothing in the statement because the transaction does not affect the balance of cash and cash equivalents. The Board notes that cash purchases of short-term investments generally are part of the company’s cash manage-

ment activities rather than part of its operating, investing, or financing activities. Special Problems in Statement Preparation 1441 the charges or credits not affecting cash, may result in a negative or a positive cash flow from operating activities. For example, if the net loss is $50,000 and the total amount of charges to add back is $60,000, then net cash provided by operating activities is $10,000. Illustration 23-33 shows this computation. ILLUSTRATION 23-33 Net loss $(50,000) Computation of Net Adjustments to reconcile net income to net Cash Flow from cash provided by operating activities: Depreciation of plant assets $55,000 Operating Activities— Amortization of patents 5,000 60,000 Cash Infl ow Net cash provided by operating activities $ 10,000 If the company experiences a net loss of $80,000 and the total amount of the charges to add back is $25,000, the presentation appears as follows. ILLUSTRATION 23-34 Net loss $(80,000) Computation of Net Adjustments to reconcile net income to Cash Flow from net cash used by operating activities: Depreciation of plant assets 25,000 Operating Activities— Cash Outfl ow Net cash used by operating activities $(55,000) Although not illustrated in this chapter, a negative cash flow may result even if the company reports a net income. Signifi cant Noncash Transactions Because the statement of cash flows reports only the effects of operating, investing, and financing activities in terms of cash flows, it omits some significant noncash transac- tions and other events that are investing or financing activities. Among the more com- mon of these noncash transactions that a company should report or disclose in some manner are the following. 1. Acquisition of assets by assuming liabilities (including capital lease obligations) or by issuing equity securities. 2. Exchanges of nonmonetary assets. 3. Refi nancing of long-term debt. 4. Conversion of debt or preferred stock to common stock. 5. Issuance of equity securities to retire debt. A company does not incorporate these noncash items in the statement of cash flows. If material in amount, these disclosures may be either narrative or summarized in a separate schedule at the bottom of the statement, or they may appear in a separate note or supplementary schedule to the financial statements.10 Illustration 23-35 (page 1442) shows the presentation of these significant noncash transactions or other events in a separate schedule at the bottom of the statement of cash flows. 10Some noncash investing and financing activities are part cash and part noncash. Companies should report only the cash portion on the statement of cash flows. The noncash component should be reported at the bottom of the statement or in a separate note. 1442 Chapter 23 Statement of Cash Flows ILLUSTRATION 23-35 Net increase in cash $3,717,000 Schedule Presentation of Cash at beginning of year 5,208,000 Noncash Investing and Cash at end of year $8,925,000 Financing Activities Noncash investing and financing activities Purchase of land and building through issuance of 250,000 shares of common stock $1,750,000 Exchange of Steadfast, NY, land for Bedford, PA, land $2,000,000 Conversion of 12% bonds to 50,000 shares of common stock $500,000 Or, companies may present these noncash transactions in a separate note, as shown in Illustration 23-36. ILLUSTRATION 23-36 Note G: Significant noncash transactions. During the year, the company engaged in the following Note Presentation of significant noncash investing and financing transactions: Noncash Investing and Financing Activities Issued 250,000 shares of common stock to purchase land and building $1,750,000 Exchanged land in Steadfast, NY, for land in Bedford, PA $2,000,000 Converted 12% bonds to 50,000 shares of common stock $500,000 Companies do not generally report certain other significant noncash transactions or other events in conjunction with the statement of cash flows. Examples of these types of transactions are stock dividends, stock splits, and restrictions on retained earnings. Companies generally report these items, neither financing nor investing activities, in

conjunction with the statement of stockholders’ equity or schedules and notes pertain- ing to changes in capital accounts. What do the numbers mean? CASH FLOW TOOL By understanding the relationship between cash fl ow and from operations and operating income, they can get a clearer income measures, analysts can gain better insights into com- picture of developing problems in a company. pany performance. Because earnings altered through cre- For example, the following chart plots the ratio of operat- ative accounting practices generally do not change operating ing cash fl ows to earnings for Xerox Corp. in the years leading cash fl ows, analysts can use the relationship between earn- up to the SEC singling it out in 2000 for aggressive revenue ings and operating cash fl ow to detect suspicious accounting recognition practices on its leases. practices. Also, by monitoring the ratio between cash fl ow Ratio of Cash Flow to Operating Income 1.20 1.00 0.80 0.60 0.40 0.20 0.00 −0.20 −0.40 −0.60 −0.80 1994 1995 1996 1997 1998 1999 Use of a Worksheet 1443 Similar to W. T. Grant in the opening story, Xerox was recognition practices were revealed. The trend revealed in reporting earnings growth in the years leading up to its the graph should have given any analyst reason to investi- fi nancial breakdown in 2000 but teetering near bankruptcy in gate Xerox further. As one analyst noted, “Earnings growth 2001. However, Xerox’s ratio of cash fl ow to earnings showed that exceeds the growth in operating cash fl ow cannot a declining trend and became negative well before its revenue continue for extended periods and should be investigated.” Source: Adapted from Charles Mulford and Eugene Comiskey, The Financial Numbers Game: Detecting Creative Accounting Practices (New York: John Wiley & Sons, 2002), Chapter 11, by permission. USE OF A WORKSHEET When numerous adjustments are necessary or other complicating factors are pres- 9 LEARNING OBJECTIVE ent, companies often use a worksheet to assemble and classify the data that will Explain the use of a worksheet in appear on the statement of cash flows. The worksheet is merely a device that aids preparing a statement of cash flows. in the preparation of the statement. Its use is optional. Illustration 23-37 shows the skeleton format of the worksheet for preparation of the statement of cash flows using the indirect method. XXYYZZ CCOOMMPPAANNYY..xxllss ILLUSTRATION 23-37 Format of Worksheet for Home Insert Page Layout Formulas Data Review View Preparation of Statement P18 fx of Cash Flows A B C D E 1 XYZ COMPANY 2 Statement of Cash Flows for the Year Ended... 3 4 End of End of Prior Year Reconciling Items Current Year Balance Sheet Accounts Balances Debits Credits Balances 5 Debit balance accounts XX XX XX XX 6 XX XX XX XX 7 Totals XXX XXX 8 Credit balance accounts XX XX XX XX 9 XX XX XX XX 10 Totals XXX XXX 11 Statement of Cash Flows Effects 12 Opera!ng ac!vi!es 13 Net income XX 14 Adjustments XX XX 15 Inves!ng ac!vi!es 16 Receipts and payments XX XX 17 Financing ac!vi!es 18 Receipts and payments XX XX 19 Totals XXX XXX 20 Increase (decrease) in cash (XX) XX 21 Totals XXX XXX 22 The following guidelines are important in using a worksheet. 1. In the balance sheet accounts section, list accounts with debit balances separately from those with credit balances. This means, for example, that Accumulated Depreciation is listed under credit balances and not as a contra account under debit 1444 Chapter 23 Statement of Cash Flows balances. Enter the beginning and ending balances of each account in the appro- priate columns. Then, enter the transactions that caused the change in the account balance during the year as reconciling items in the two middle columns. After all reconciling items have been entered, each line pertaining to a balance sheet account should foot across. That is, the beginning balance plus or minus the reconciling item(s) must equal the ending balance. When this agreement exists for all balance sheet accounts, all changes in account balances have been reconciled. 2. The bottom portion of the worksheet consists of the operating, investing, and fi nanc-

ing activities sections. Accordingly, it provides the information necessary to prepare the formal statement of cash fl ows. Enter infl ows of cash as debits in the reconciling columns, and outfl ows of cash as credits in the reconciling columns. Thus, in this section, a company would enter the sale of equipment for cash at book value as a debit under infl ows of cash from investing activities. Similarly, it would enter the purchase of land for cash as a credit under outfl ows of cash from investing activities. 3. Do not enter in any journal or post to any account the reconciling items shown in the worksheet. These items do not represent either adjustments or corrections of the balance sheet accounts. They are used only to facilitate the preparation of the state- ment of cash fl ows. Preparation of the Worksheet The preparation of a worksheet involves the following steps. Step 1. Enter the balance sheet accounts and their beginning and ending balances in the balance sheet accounts section. Step 2. Enter the data that explain the changes in the balance sheet accounts (other than cash) and their effects on the statement of cash fl ows in the reconciling columns of the worksheet. Step 3. Enter the increase or decrease in cash on the cash line and at the bottom of the worksheet. This entry should enable the totals of the reconciling columns to be in agreement. To illustrate the preparation and use of a worksheet and to illustrate the reporting of some of the special problems discussed in the prior section, we present a comprehen- sive example for Satellite Corporation. Again, the indirect method serves as the basis for the computation of net cash provided by operating activities. Illustrations 23-38 and 23-39 (page 1446) present the balance sheet, combined statement of income and retained earnings, and additional information for Satellite Corporation. The discussion that follows provides additional explanations related to the prepara- tion of the worksheet. Analysis of Transactions The following discussion explains the individual adjustments that appear on the work- sheet in Illustration 23-40 (page 1450). Because cash is the basis for the analysis, Satellite reconciles the Cash account last. Because income is the first item that appears on the statement of cash flows, it is handled first. Change in Retained Earnings Net income for the period is $117,000. The entry for it on the worksheet is as follows. (1) Operating—Net Income 117,000 Retained Earnings 117,000 Use of a Worksheet 1445 SSAATTEELLLLIITTEE CCOORRPPOORRAATTIIOONN..xxllss ILLUSTRATION 23-38 Home Insert Page Layout Formulas Data Review View Comparative Balance Sheet, Satellite P18 fx Corporation A B C D 1 SATELLITE CORPORATION 2 3 Compara!ve Balance Sheet–December 31, 2014 and 2013 4 Increase Assets 2014 2013 or (Decrease) 5 Cash $ 59,000 $ 66,000 $ (7,000) 6 Accounts receivable (net) 104,000 51,000 53,000 7 Inventory 493,000 341,000 152,000 8 Prepaid expenses 16,500 17,000 (500) 9 Investment in Porter Co. (equity method) 18,500 15,000 3,500 10 Land 131,500 82,000 49,500 11 Equipment 187,000 142,000 45,000 12 Accumulated deprecia!on—equipment (29,000) (31,000) (2,000) 13 Buildings 262,000 262,000 – 14 Accumulated deprecia!on—buildings (74,100) (71,000) 3,100 15 Trademarks 7,600 10,000 (2,400) 16 Total assets $1,176,000 $884,000 17 Liabili!es 18 Accounts payable $ 132,000 $ 131,000 $ 1,000 19 Accrued liabili!es 43,000 39,000 4,000 20 Income taxes payable 3,000 16,000 (13,000) 21 Notes payable (long-term) 60,000 – 60,000 22 Bonds payable 100,000 100,000 – 23 Premium on bonds payable 7,000 8,000 (1,000) 24 Deferred tax liability (long-term) 9,000 6,000 3,000 25 Total liabili!es 354,000 300,000 26 Stockholders’ Equity 27 Common stock ($1 par) 60,000 50,000 10,000 28 Paid-in capital in excess of par—common stock 187,000 38,000 149,000 29 Retained earnings 592,000 496,000 96,000 30 Treasury stock (17,000) – 17,000 31 Total stockholders’ equity 822,000 584,000 32 Total liabili!es and stockholders’ equity $1,176,000 $884,000 33 Satellite reports net income on the bottom section of the worksheet. This is the

starting point for preparation of the statement of cash flows (under the indirect method). A stock dividend and a cash dividend also affected retained earnings. The retained earnings statement reports a stock dividend of $15,000. The worksheet entry for this transaction is as follows. (2) Retained Earnings 15,000 Common Stock 1,000 Paid-in Capital in Excess of Par—Common Stock 14,000 The issuance of stock dividends is not a cash operating, investing, or financing item. Therefore, although the company enters this transaction on the worksheet for recon- ciling purposes, it does not report it in the statement of cash flows. 1446 Chapter 23 Statement of Cash Flows ILLUSTRATION 23-39 SATELLITE CORPORATION Income and Retained COMBINED STATEMENT OF INCOME AND RETAINED EARNINGS Earnings Statements, FOR THE YEAR ENDED DECEMBER 31, 2014 Satellite Corporation Net sales $526,500 Other revenue 3,500 Total revenues 530,000 Expense Cost of goods sold 310,000 Selling and administrative expenses 47,000 Other expenses and losses 12,000 Total expenses 369,000 Income before income tax and extraordinary item 161,000 Income tax Current $47,000 Deferred 3,000 50,000 Income before extraordinary item 111,000 Gain on condemnation of land (net of $2,000 tax) 6,000 Net income 117,000 Retained earnings, January 1 496,000 Less: Cash dividends 6,000 Stock dividend 15,000 21,000 Retained earnings, December 31 $592,000 Per share: Income before extraordinary item $2.02 Extraordinary item .11 Net income $2.13 Additional Information (a) Other revenue of $3,500 represents Satellite’s equity share in the net income of Porter Co., an e quity investee. Satellite owns 22% of Porter Co. (b) An analysis of the equipment account and related accumulated depreciation indicates the following: Equipment Accum. Dep. Gain or Dr./(Cr.) Dr./(Cr.) (Loss) Balance at end of 2013 $142,000 $(31,000) Purchases of equipment 53,000 Sale of equipment (8,000) 2,500 $(1,500) Depreciation for the period (11,500) Major repair charged to accumulated depreciation 11,000 Balance at end of 2014 $187,000 $(29,000) (c) Land in the amount of $60,000 was purchased through the issuance of a long-term note; in addition, certain parcels of land costing $10,500 were condemned. The state government paid Satellite $18,500, resulting in an $8,000 gain which has a $2,000 tax effect. (d) The change in the Accumulated Depreciation—Buildings, Trademarks, and Premium on Bonds Payable accounts resulted from depreciation and amortization entries. (e) An analysis of the paid-in capital accounts in stockholders’ equity discloses the following. Common Paid-In Capital in Excess of Stock Par—Common Stock Balance at end of 2013 $50,000 $ 38,000 Issuance of 2% stock dividend 1,000 14,000 Sale of stock for cash 9,000 135,000 Balance at end of 2014 $60,000 $187,000 (f) Interest paid (net of amount capitalized) is $9,000; income taxes paid is $62,000. Use of a Worksheet 1447 The $6,000 cash dividend paid represents a financing activity cash outflow. Satellite makes the following worksheet entry: (3) Retained Earnings 6,000 Financing—Cash Dividends 6,000 The company reconciles the beginning and ending balances of retained earnings by entry of the three items above. Accounts Receivable (Net) The increase in accounts receivable (net) of $53,000 represents adjustments that did not result in cash inflows during 2014. As a result, the company would deduct from net in- come the increase of $53,000. Satellite makes the following worksheet entry. (4) Accounts Receivable (net) 53,000 Operating—Increase in Accounts Receivable (net) 53,000 Inventory The increase in inventory of $152,000 represents an operating use of cash. The incremen- tal investment in inventory during the year reduces cash without increasing the cost of goods sold. Satellite makes the following worksheet entry. (5) Inventory 152,000 Operating—Increase in Inventory 152,000 Prepaid Expense The decrease in prepaid expenses of $500 represents a charge in the income statement for which there was no cash outflow in the current period. Satellite should add that amount back to net income through the following entry. (6)

Operating—Decrease in Prepaid Expenses 500 Prepaid Expenses 500 Investment in Stock Satellite’s investment in the stock of Porter Co. increased $3,500. This amount reflects Satellite’s share of net income earned by Porter (its equity investee) during the current year. Although Satellite’s revenue and therefore its net income increased $3,500 by recording Satellite’s share of Porter Co.’s net income, no cash (dividend) was provided. Satellite makes the following worksheet entry. (7) Equity Investments (Porter Co.) 3,500 Operating—Equity in Earnings of Porter Co. 3,500 Land Satellite purchased land in the amount of $60,000 through the issuance of a long-term note payable. This transaction did not affect cash. It is a significant noncash investing/ financing transaction that the company would disclose either in a separate schedule below the statement of cash flows or in the accompanying notes. Satellite makes the following entry to reconcile the worksheet. (8) Land 60,000 Notes Payable 60,000 1448 Chapter 23 Statement of Cash Flows In addition to the noncash transaction involving the issuance of a note to purchase land, the Land account was decreased by the condemnation proceedings. The following worksheet entry records the receipt of $18,500 for land having a book value of $10,500. (9) Investing—Proceeds from Condemnation of Land 18,500 Land 10,500 Operating—Gain on Condemnation of Land 8,000 In reconciling net income to net cash flow from operating activities, Satellite deducts from net income the extraordinary gain of $8,000. The reason is that the transac- tion that gave rise to the gain is an item whose cash effect is already classified as an investing cash inflow. The Land account is now reconciled. Equipment and Accumulated Depreciation An analysis of Equipment and Accumulated Depreciation—Equipment shows that a number of transactions have affected these accounts. The company purchased equip- ment in the amount of $53,000 during the year. Satellite records this transaction on the worksheet as follows. (10) Equipment 53,000 Investing—Purchase of Equipment 53,000 In addition, Satellite sold at a loss of $1,500 equipment with a book value of $5,500. It records this transaction as follows. (11) Investing—Sale of Equipment 4,000 Operating—Loss on Sale of Equipment 1,500 Accumulated Depreciation—Equipment 2,500 Equipment 8,000 The proceeds from the sale of the equipment provided cash of $4,000. In addition, the loss on the sale of the equipment has reduced net income but did not affect cash. Therefore, the company adds back to net income the amount of the loss, in order to accurately report cash provided by operating activities. Satellite reported depreciation on the equipment at $11,500 and recorded it on the worksheet as follows. (12) Operating—Depreciation Expense—Equipment 11,500 Accumulated Depreciation—Equipment 11,500 The company adds depreciation expense back to net income because that expense reduced income but did not affect cash. Finally, the company made a major repair to the equipment. It charged this expen- diture, in the amount of $11,000, to Accumulated Depreciation—Equipment. This expenditure required cash, and so Satellite makes the following worksheet entry. (13) Accumulated Depreciation—Equipment 11,000 Investing—Major Repairs of Equipment 11,000 After adjusting for the foregoing items, Satellite has reconciled the balances in the Equipment and related Accumulated Depreciation—Equipment accounts. Building Depreciation and Amortization of Trademarks Depreciation expense on the buildings of $3,100 and amortization of trademarks of $2,400 are both expenses in the income statement that reduced net income but did not require cash outflows in the current period. Satellite makes the following worksheet entry. Use of a Worksheet 1449 (14) Operating—Depreciation Expense—Buildings 3,100 Operating—Amortization of Trademarks 2,400 Accumulated Depreciation—Buildings 3,100 Trademarks 2,400 Other Noncash Charges or Credits Analysis of the remaining accounts indicates that changes in the Accounts Payable,

Accrued Liabilities, Income Taxes Payable, Premium on Bonds Payable, and Deferred Tax Liability balances resulted from charges or credits to net income that did not affect cash. The company should individually analyze each of these items and enter them in the work- sheet. The following compound entry summarizes these noncash, income-related items. (15) Income Taxes Payable 13,000 Premium on Bonds Payable 1,000 Operating—Increase in Accounts Payable 1,000 Operating—Increase in Accrued Liabilities 4,000 Operating—Increase in Deferred Tax Liability 3,000 Operating—Decrease in Income Taxes Payable 13,000 Operating—Amortization of Bond Premium 1,000 Accounts Payable 1,000 Accrued Liabilities 4,000 Deferred Tax Liability 3,000 Common Stock and Related Accounts Comparison of the Common Stock balances and the Paid-in Capital in Excess of Par— Common Stock balances shows that transactions during the year affected these accounts. First, Satellite issues a stock dividend of 2 percent to stockholders. As the discussion of worksheet entry (2) indicated, no cash was provided or used by the stock dividend trans- action. In addition to the shares issued via the stock dividend, Satellite sold shares of common stock at $16 per share. The company records this transaction as follows. (16) Financing—Sale of Common Stock 144,000 Common Stock 9,000 Paid-in Capital in Excess of Par—Common Stock 135,000 Also, the company purchased shares of its common stock in the amount of $17,000. It records this transaction on the worksheet as follows. (17) Treasury Stock 17,000 Financing—Purchase of Treasury Stock 17,000 Final Reconciling Entry The final entry to reconcile the change in cash and to balance the worksheet is shown below. The $7,000 amount is the difference between the beginning and ending cash balance. (18) Decrease in Cash 7,000 Cash 7,000 Once the company has determined that the differences between the beginning and ending balances per the worksheet columns have been accounted for, it can total the 1450 Chapter 23 Statement of Cash Flows reconciling transactions columns, and they should balance. Satellite can prepare the statement of cash flows entirely from the items and amounts that appear at the bottom of the worksheet under “Statement of Cash Flows Effects,” as shown in Illustration 23-40. ILLUSTRATION 23-40 SSAATTEELLLLIITTEE CCOORRPPOORRAATTIIOONN..xxllss Completed Worksheet Home Insert Page Layout Formulas Data Review View for Preparation of P18 fx A B C D E F G Statement of Cash Flows, 1 Satellite Corporation 2 SATELLITE CORPORATION 3 Worksheet for Prepara!on of Statement of Cash Flows 4 for the Year Ended December 31, 2014 5 Balance Reconciling Items–2014 Balance 12/31/13 Dr. Cr. 12/31/14 6 Debits 7 Cash $ 66,000 (18) $ 7,000 $ 59,000 8 Accounts receivable (net) 51,000 (4) $ 53,000 104,000 9 Inventory 341,000 (5) 152,000 493,000 10 Prepaid expenses 17,000 (6) 500 16,500 11 Investment in Porter Co. (equity method) 15,000 (7) 3,500 18,500 12 Land 82,000 (8) 60,000 (9) 10,500 131,500 13 Equipment 142,000 (10) 53,000 (11) 8,000 187,000 14 Buildings 262,000 262,000 15 Trademarks 10,000 (14) 2,400 7,600 16 Treasury stock (17) 17,000 17,000 17 Total debits $986,000 $1,296,100 18 Credits 19 Accum. depr.–equipment $ 31,000 (11) 2,500 (12) 11,500 20 (13) 11,000 $ 29,000 21 Accum. depr.–buildings 71,000 (14) 3,100 74,100 22 Accounts payable 131,000 (15) 1,000 132,000 23 Accrued liabili!es 39,000 (15) 4,000 43,000 24 Income taxes payable 16,000 (15) 13,000 3,000 25 Notes payable -0- (8) 60,000 60,000 26 Bonds payable 100,000 100,000 27 Premium on bonds payable 8,000 (15) 1,000 7,000 28 Deferred tax liability 6,000 (15) 3,000 9,000 29 Common stock 50,000 (2) 1,000 30 (16) 9,000 60,000 31 Paid-in capital in excess of 38,000 (2) 14,000 32 par—common stock (16) 135,000 187,000 33 Retained earnings 496,000 (2) 15,000 (1) 117,000 34 (3) 6,000 592,000 35 Total credits $986,000 $1,296,100 36 Statement of Cash Flows Effects 37 Opera!ng ac!vi!es 38 Net income (1) 117,000 39 Increase in accounts receivable (net) (4) 53,000 40 Increase in inventory (5) 152,000

41 Decrease in prepaid expenses (6) 500 42 Equity in earnings of Porter Co. (7) 3,500 43 Gain on condemna!on of land (9) 8,000 44 Loss on sale of equipment (11) 1,500 45 Depr. expense–equipment (12) 11,500 46 Depr. expense–buildings (14) 3,100 47 Amor!za!on of trademarks (14) 2,400 48 Increase in accounts payable (15) 1,000 49 Increase in accrued liabili!es (15) 4,000 50 Increase in deferred tax liability (15) 3,000 51 Decrease in income taxes payable (15) 13,000 52 Amor!za!on of bond premium (15) 1,000 53 Inves!ng ac!vi!es 54 Proceeds from condemna!on of land (9) 18,500 55 Purchase of equipment (10) 53,000 56 Sale of equipment (11) 4,000 57 Major repairs of equipment (13) 11,000 58 Financing ac!vi!es 59 Payment of cash dividend (3) 6,000 60 Issuance of common stock (16) 144,000 61 Purchase of treasury stock (17) 17,000 62 Totals 697,500 704,500 63 Decrease in cash (18) 7,000 64 Totals $704,500 $704,500 65 Summary of Learning Objectives 1451 Preparation of Final Statement Illustration 23-41 presents a formal statement of cash flows prepared from the data com- piled in the lower portion of the worksheet. ILLUSTRATION 23-41 SATELLITE CORPORATION Statement of Cash Flows, STATEMENT OF CASH FLOWS Satellite Corporation FOR THE YEAR ENDED DECEMBER 31, 2014 Cash flows from operating activities Net income $117,000 Adjustments to reconcile net income to net cash used by operating activities: Depreciation expense $ 14,600 Amortization of trademarks 2,400 Amortization of bond premium (1,000) Equity in earnings of Porter Co. (3,500) Gain on condemnation of land (8,000) Loss on sale of equipment 1,500 Increase in deferred tax liability 3,000 Gateway to Increase in accounts receivable (net) (53,000) the Profession Increase in inventory (152,000) Decrease in prepaid expenses 500 Discussion of the Increase in accounts payable 1,000 T-Account Approach Increase in accrued liabilities 4,000 to Preparation of Decrease in income taxes payable (13,000) (203,500) the Statement of Net cash used by operating activities (86,500) Cash Flows Cash flows from investing activities Proceeds from condemnation of land 18,500 Purchase of equipment (53,000) Sale of equipment 4,000 Major repairs of equipment (11,000) Net cash used by investing activities (41,500) Cash flows from financing activities Payment of cash dividend (6,000) Issuance of common stock 144,000 Purchase of treasury stock (17,000) Net cash provided by financing activities 121,000 Net decrease in cash (7,000) You will Cash, January 1, 2014 66,000 want to Cash, December 31, 2014 $ 59,000 read IFRS INSIGHTS Supplemental Disclosures of Cash Flow Information: on pages 1480–1485 Cash paid during the year for: Interest (net of amount capitalized) $ 9,000 for discussion of Income taxes $ 62,000 IFRS related to Supplemental Schedule of Noncash Investing and Financing Activities: the statement of Purchase of land for $60,000 in exchange for a $60,000 long-term note. cash flows. KEY TERMS SUMMARY OF LEARNING OBJECTIVES cash equivalents, 1413(n) direct method, 1428 financing activities, 1413 1 Describe the purpose of the statement of cash flows. The primary pur- indirect method, 1418 pose of the statement of cash flows is to provide information about cash receipts and investing activities, 1413 cash payments of an entity during a period. A secondary objective is to report the entity’s operating activities, 1413 operating, investing, and financing activities during the period. 1452 Chapter 23 Statement of Cash Flows significant noncash 2 Identify the major classifications of cash flows. Companies classify cash transactions, 1441 flows as follows. (1) Operating activities—transactions that result in the revenues, statement of cash expenses, gains, and losses that determine net income. (2) Investing activities—lending flows, 1412 money and collecting on those loans, and acquiring and disposing of investments, plant assets, and intangible assets. (3) Financing activities—obtaining cash from creditors and repaying loans, issuing and reacquiring capital stock, and paying cash dividends. 3 Prepare a statement of cash flows. Preparing the statement involves three

major steps. (1) Determine the change in cash. This is the difference between the begin- ning and the ending cash balance shown on the comparative balance sheets. (2) Deter- mine the net cash flow from operating activities. This procedure is complex; it involves analyzing not only the current year’s income statement but also the comparative balance sheets and the selected transaction data. (3) Determine cash flows from investing and financing activities. Analyze all other changes in the balance sheet accounts to determine the effects on cash. 4 Differentiate between net income and net cash flow from operating activities. Companies must adjust net income on an accrual basis to determine net cash flow from operating activities because some expenses and losses do not cause cash outflows, and some revenues and gains do not provide cash inflows. 5 Determine net cash flows from investing and financing activities. Once a company has computed the net cash flow from operating activities, the next step is to determine whether any other changes in balance sheet accounts caused an increase or decrease in cash. Net cash flows from investing and financing activities can be deter- mined by examining the changes in noncurrent balance sheet accounts. 6 Identify sources of information for a statement of cash flows. The information to prepare the statement usually comes from three sources. (1) Comparative balance sheets: Information in these statements indicates the amount of the changes in assets, liabilities, and equities during the period. (2) Current income statement: Informa- tion in this statement is used in determining the cash provided by operations during the period. (3) Selected transaction data: These data from the general ledger provide addi- tional detailed information needed to determine how cash was provided or used during the period. 7 Contrast the direct and indirect methods of calculating net cash flow from operating activities. Under the direct approach, companies calculate the major classes of operating cash receipts and cash disbursements. Companies summarize the computations in a schedule of changes from the accrual- to the cash-basis income state- ment. Presentation of the direct approach of reporting net cash flow from operating activities takes the form of a condensed cash-basis income statement. The indirect method adds back to net income the noncash expenses and losses and subtracts the noncash revenues and gains. 8 Discuss special problems in preparing a statement of cash flows. These special problems are (1) adjustments to income (depreciation and amortization, postretirement benefit costs, change in deferred income taxes, equity method of accounting, losses and gains, stock options, extraordinary items); (2) accounts receiv- able (net); (3) other working capital changes; (4) net losses; and (5) significant noncash transactions. 9 Explain the use of a worksheet in preparing a statement of cash flows. When numerous adjustments are necessary or other complicating factors are present, companies often use a worksheet to assemble and classify the data that will appear on the statement of cash flows. The worksheet is merely a device that aids in the prepara- tion of the statement. Its use is optional. Demonstration Problem 1453 DEMONSTRATION PROBLEM Data presented below are from the records of Antonio Brasileiro Company. December 31, 2014 December 31, 2013 Cash $ 15,000 $ 8,000 Current assets other than cash 85,000 60,000 Long-term investments 10,000 53,000 Plant assets 335,000 215,000 $445,000 $336,000 Accumulated depreciation $ 20,000 $ 40,000 Current liabilities 40,000 22,000 Bonds payable 75,000 –0– Common stock 254,000 254,000 Retained earnings 56,000 20,000 $445,000 $336,000 Additional information: 1. In 2014, the company sold for $34,000 available-for-sale investments carried at a cost of $43,000 on December 31, 2014. The loss (not extraordinary) was incorrectly charged directly to Retained Earnings. 2. In 2014, the company sold for $8,000 plant assets that cost $50,000 and were 80% depreciated. The

loss (not extraordinary) was incorrectly charged directly to Retained Earnings. 3. Net income as reported on the income statement for the year was $57,000. 4. The company paid dividends totaling $10,000. 5. Depreciation charged for the year was $20,000. Instructions Prepare a statement of cash flows for the year 2014 using the indirect method. Solution ANTONIO BRASILEIRO COMPANY STATEMENT OF CASH FLOWS FOR THE YEAR ENDED DECEMBER 31, 2014 INDIRECT METHOD Cash flows from operating activities Net income ($57,000 2 $9,000 2 $2,000) $ 46,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense $ 20,000 Loss on sale of investments 9,000 Loss on sale of plant assets 2,000 Increase in current assets other than cash (25,000) Increase in current liabilities 18,000 24,000 Net cash provided by operating activities 70,000 Cash flows from investing activities Sale of plant assets 8,000 Sale of held-to-maturity investments 34,000 Purchase of plant assets* (170,000) Net cash used by investing activities (128,000) Cash flows from financing activities Issuance of bonds payable 75,000 Payment of dividends (10,000) Net cash provided by financing activities 65,000 Net increase in cash 7,000 Cash balance, January 1, 2014 8,000 Cash balance, December 31, 2014 $ 15,000 *Supporting computation (purchase of plant assets): Plant assets, December 31, 2014 $335,000 Less: Plant assets, December 31, 2013 215,000 Net change 120,000 Plant assets sold 50,000 Plant assets purchased $170,000 1454 Chapter 23 Statement of Cash Flows FASB CODIFICATION FASB Codification References [1] FASB ASC 230-10-10-2. [Predecessor literature: “The Statement of Cash Flows,” Statement of Financial Accounting Standards No. 95 (Stamford, Conn.: FASB, 1987), paras. 4 and 5.] [2] FASB ASC 230-10-45-18 through 21. [Predecessor literature: “Statement of Cash Flows—Exemption of Certain Enterprises and Classification of Cash Flows from Certain Securities Acquired for Resale (amended),” Statement of Financial Accounting Standards No. 102 (February 1989).] [3] FASB ASC 230-10-45-25. [Predecessor literature: “Statement of Cash Flows,” Statement of Financial Accounting Standards No. 95 (Stamford, Conn.: FASB, 1987), paras. 107 and 111.] [4] FASB ASC 230-10-45-31. [Predecessor literature: “The Statement of Cash Flows,” Statement of Financial Accounting Standards No. 95 (Stamford, Conn.: FASB, 1987), paras. 27 and 30.] [5] FASB ASC 230-10-45-14. [Predecessor literature: “Share-Based Payment,” Statement of Financial Accounting Standard No. 123(R) (Norwalk, Conn.: FASB, 2004), par. 68.] [6] FASB ASC 320-10-45-11. [Predecessor literature: “Accounting for Certain Investments in Debt and Equity Securities,” Statement of Financial Accounting Standards No. 115 (Norwalk, Conn.: 1993), par. 118.] [7] FASB ASC 320-10-45-11. [Predecessor literature: “Accounting for Certain Investments in Debt and Equity Securities,” Statement of Financial Accounting Standards No. 115 (Norwalk, Conn.: 1993), par. 118.] 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. CE23-1 Access the glossary (“Master Glossary”) to answer the following. (a) What are cash equivalents? (b) What are financing activities? (c) What are investing activities? (d) What are operating activities? CE23-2 Name five cash inflows that would qualify as a “financing activity.” CE23-3 How should cash flows from purchases, sales, and maturities of available-for-sale securities be classified and reported in the statement of cash flows? CE23-4 Do companies need to disclose information about investing and financing activities that do not affect cash receipts or cash payments? If so, how should such information be disclosed? An additional codification case can be found in the Using Your Judgment section, on page 1479. 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 is the purpose of the statement of cash flows? What 4. What are the major sources of cash (inflows) in a state- information does it provide? ment of cash flows? What are the major uses (outflows) of 2. Of what use is the statement of cash flows? cash? 3. Differentiate between investing activities, financing ac- 5. Identify and explain the major steps involved in prepar- ing the statement of cash flows. tivities, and operating activities. Brief Exercises 1455 6. Identify the following items as (1) operating, (2) investing, over 10 years with no estimated scrap value were sold or (3) financing activities: purchase of land, payment of for $4,000. dividends, cash sales, and purchase of treasury stock. (b) During the year, 10,000 shares of common stock with a 7. Unlike the other major financial statements, the statement stated value of $20 a share were issued for $41 a share. of cash flows is not prepared from the adjusted trial (c) Uncollectible accounts receivable in the amount of balance. From what sources does the information to pre- $22,000 were written off against Allowance for Doubt- pare this statement come, and what information does ful Accounts. each source provide? (d) The company sustained a net loss for the year of 8. Why is it necessary to convert accrual-based net income to $50,000. Depreciation amounted to $22,000, and a gain a cash basis when preparing a statement of cash flows? of $9,000 was realized on the sale of available-for-sale 9. Differentiate between the direct method and the indirect securities for $38,000 cash. method by discussing each method. 17. Classify the following items as (1) operating, (2) investing, 10. Broussard Company reported net income of $3.5 million (3) financing, or (4) significant non-cash investing and financing activities, using the direct method. in 2014. Depreciation for the year was $520,000; accounts receivable increased $500,000; and accounts payable in- (a) Cash payments to employees. creased $300,000. Compute net cash flow from operating (b) Redemption of bonds payable. activities using the indirect method. (c) Sale of building at book value. 11. Collinsworth Co. reported sales on an accrual basis of (d) Cash payments to suppliers. $100,000. If accounts receivable increased $30,000 and the (e) Exchange of equipment for furniture. allowance for doubtful accounts increased $9,000 after a write-off of $2,000, compute cash sales. (f) Issuance of preferred stock. 12. Your roommate is puzzled. During the last year, the com- (g) Cash received from customers. pany in which she is a stockholder reported a net loss of (h) Purchase of treasury stock. $675,000, yet its cash increased $321,000 during the same (i) Issuance of bonds for land. period of time. Explain to your roommate how this situa- (j) Payment of dividends. tion could occur. (k) Purchase of equipment. 13. The board of directors of Gifford Corp. declared cash (l) Cash payments for operating expenses. d ividends of $260,000 during the current year. If divi- dends payable was $85,000 at the beginning of the year 18. Stan Conner and Mark Stein were discussing the presenta- and $90,000 at the end of the year, how much cash was tion format of the statement of cash flows of Bombeck Co. paid in dividends during the year? At the bottom of Bombeck’s statement of cash flows was a 14. Explain how the amount of cash payments to suppliers is separate section entitled “Noncash investing and financ- ing activities.” Give three examples of significant non-cash computed under the direct method. transactions that would be reported in this section. 15. The net income for Letterman Company for 2014 was 19. During 2014, Simms Company redeemed $2,000,000 of $320,000. During 2014, depreciation on plant assets was bonds payable for $1,880,000 cash. Indicate how this $124,000, amortization of patent was $40,000, and the transaction would be reported on a statement of cash company incurred a loss on sale of plant assets of $21,000. flows, if at all.

Compute net cash flow from operating activities. 16. Each of the following items must be considered in prepar- 20. What are some of the arguments in favor of using the in- direct (reconciliation) method as opposed to the direct ing a statement of cash flows for Blackwell Inc. for the method for reporting a statement of cash flows? year ended December 31, 2014. State where each item is to be shown in the statement, if at all. 21. Why is it desirable to use a worksheet when preparing a (a) Plant assets that had cost $18,000 6½ years before statement of cash flows? Is a worksheet required to pre- and were being depreciated on a straight-line basis pare a statement of cash flows? BRIEF EXERCISES 5 BE23-1 Wainwright Corporation had the following activities in 2014. 1. Sale of land $180,000. 4. Purchase of equipment $415,000. 2. Purchase of inventory $845,000. 5. Issuance of common stock $320,000. 3. Purchase of treasury stock $72,000. 6. Purchase of available-for-sale securities $59,000. 1456 Chapter 23 Statement of Cash Flows Compute the amount Wainwright should report as net cash provided (used) by investing activities in its 2014 statement of cash flows. 5 BE23-2 Stansfield Corporation had the following activities in 2014. 1. Payment of accounts payable $770,000. 4. Collection of note receivable $100,000. 2. Issuance of common stock $250,000. 5. Issuance of bonds payable $510,000. 3. Payment of dividends $350,000. 6. Purchase of treasury stock $46,000. Compute the amount Stansfield should report as net cash provided (used) by financing activities in its 2014 statement of cash flows. 2 BE23-3 Novak Corporation is preparing its 2014 statement of cash flows, using the indirect method. Pre- sented below is a list of items that may affect the statement. Using the code below, indicate how each item will affect Novak’s 2014 statement of cash flows. Code Letter Effect A Added to net income in the operating section D Deducted from net income in the operating section R-I Cash receipt in investing section P-I Cash payment in investing section R-F Cash receipt in financing section P-F Cash payment in financing section N Noncash investing and financing activity Items ____ (a) Purchase of land and building. ____ (j) Increase in accounts payable. ____ (b) Decrease in accounts receivable. ____ (k) Decrease in accounts payable. ____ (c) Issuance of stock. ____ (l) Loan from bank by signing note. ____ (d) Depreciation expense. ____ (m) Purchase of equipment using a note. ____ (e) Sale of land at book value. ____ (n) Increase in inventory. ____ (f) Sale of land at a gain. ____ (o) Issuance of bonds. ____ (g) Payment of dividends. ____ (p) Redemption of bonds payable. ____ (h) Increase in accounts receivable. ____ (q) Sale of equipment at a loss. ____ (i) Purchase of available-for-sale investment. ____ (r) Purchase of treasury stock. 4 7 BE23-4 Bloom Corporation had the following 2014 income statement. Sales revenue $200,000 Cost of goods sold 120,000 Gross profi t 80,000 Operating expenses (includes depreciation of $21,000) 50,000 Net income $ 30,000 T he following accounts increased during 2014: Accounts Receivable $12,000; Inventory $11,000; Accounts Payable $13,000. Prepare the cash flows from operating activities section of Bloom’s 2014 statement of cash flows using the direct method. 4 7 BE23-5 Use the information from BE23-4 for Bloom Corporation. Prepare the cash flows from operating activities section of Bloom’s 2014 statement of cash flows using the indirect method. 7 BE23-6 At January 1, 2014, Eikenberry Inc. had accounts receivable of $72,000. At December 31, 2014, ac- counts receivable is $54,000. Sales revenue for 2014 total $420,000. Compute Eikenberry’s 2014 cash receipts from customers. 7 BE23-7 Moxley Corporation had January 1 and December 31 balances as follows. 1/1/14 12/31/14 Inventory $95,000 $113,000 Accounts payable 61,000 69,000 For 2014, cost of goods sold was $500,000. Compute Moxley’s 2014 cash payments to suppliers. 3 BE23-8 In 2014, Elbert Corporation had net cash provided by operating activities of $531,000; net cash used

by investing activities of $963,000; and net cash provided by financing activities of $585,000. At January 1, 2014, the cash balance was $333,000. Compute December 31, 2014, cash. Exercises 1457 4 7 BE23-9 Loveless Corporation had the following 2014 income statement. Revenues $100,000 Expenses 60,000 $ 40,000 In 2014, Loveless had the following activity in selected accounts. Allowance for Accounts Receivable Doubtful Accounts 1/1/14 20,000 1,200 1/1/14 Revenues 100,000 1,000 Write-offs Write-offs 1,000 1,840 Bad debt expense 90,000 Collections 12/31/14 29,000 2,040 12/31/14 Prepare Loveless’s cash flows from operating activities section of the statement of cash flows using (a) the direct method and (b) the indirect method. 4 BE23-10 Hendrickson Corporation reported net income of $50,000 in 2014. Depreciation expense was $17,000. The following working capital accounts changed. Accounts receivable $11,000 increase Available-for-sale securities 16,000 increase Inventory 7,400 increase Nontrade note payable 15,000 decrease Accounts payable 12,300 increase Compute net cash provided by operating activities. 4 BE23-11 In 2014, Wild Corporation reported a net loss of $70,000. Wild’s only net income adjustments were depreciation expense $81,000, and increase in accounts receivable $8,100. Compute Wild’s net cash pro- vided (used) by operating activities. 8 BE23-12 In 2014, Leppard Inc. issued 1,000 shares of $10 par value common stock for land worth $40,000. (a) Prepare Leppard’s journal entry to record the transaction. (b) Indicate the effect the transaction has on cash. (c) Indicate how the transaction is reported on the statement of cash flows. 9 BE23-13 Indicate in general journal form how the items below would be entered in a worksheet for the preparation of the statement of cash flows. (a) Net income is $317,000. (b) Cash dividends declared and paid totaled $120,000. (c) Equipment was purchased for $114,000. (d) Equipment that originally cost $40,000 and had accumulated depreciation of $32,000 was sold for $10,000. EXERCISES 2 E23-1 (Classification of Transactions) Red Hot Chili Peppers Co. had the following activity in its most recent year of operations. (a) Purchase of equipment. (g) Amortization of intangible assets. (b) Redemption of bonds payable. (h) Purchase of treasury stock. (c) Sale of building. (i) Issuance of bonds for land. (d) Depreciation. (j) Payment of dividends. (e) Exchange of equipment for furniture. (k) Increase in interest receivable on notes receivable. (f) Issuance of capital stock. (l) Pension expense exceeds amount funded. Instructions Classify the items as (1) operating—add to net income; (2) operating—deduct from net income; (3) investing; (4) financing; or (5) significant non-cash investing and financing activities. Use the indirect method. 2 4 E 23-2 (Statement Presentation of Transactions—Indirect Method) Each of the following items must be considered in preparing a statement of cash flows (indirect method) for Turbulent Indigo Inc. for the year ended December 31, 2014. 1458 Chapter 23 Statement of Cash Flows (a) Plant assets that had cost $20,000 6 years before and were being depreciated on a straight-line basis over 10 years with no estimated scrap value were sold for $5,300. (b) During the year, 10,000 shares of common stock with a stated value of $10 a share were issued for $43 a share. (c) Uncollectible accounts receivable in the amount of $27,000 were written off against Allowance for Doubtful Accounts. (d) The company sustained a net loss for the year of $50,000. Depreciation amounted to $22,000, and a gain of $9,000 was realized on the sale of land for $39,000 cash. (e) A 3-month U.S. Treasury bill was purchased for $100,000. The company uses a cash and cash equiv- alent basis for its cash flow statement. (f) Patent amortization for the year was $20,000. (g) The company exchanged common stock for a 70% interest in Tabasco Co. for $900,000. (h) During the year, treasury stock costing $47,000 was purchased. Instructions State where each item is to be shown in the statement of cash flows, if at all.

4 7 E 23-3 (Preparation of Operating Activities Section—Indirect Method, Periodic Inventory) The income statement of Vince Gill Company is shown below. VINCE GILL COMPANY INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2014 Sales revenue $6,900,000 Cost of goods sold Beginning inventory $1,900,000 Purchases 4,400,000 Goods available for sale 6,300,000 Ending inventory 1,600,000 Cost of goods sold 4,700,000 Gross profi t 2,200,000 Operating expenses Selling expenses 450,000 Administrative expenses 700,000 1,150,000 Net income $1,050,000 Additional information: 1. Accounts receivable decreased $360,000 during the year. 2. Prepaid expenses increased $170,000 during the year. 3. Accounts payable to suppliers of merchandise decreased $275,000 during the year. 4. Accrued expenses payable decreased $100,000 during the year. 5. Administrative expenses include depreciation expense of $60,000. Instructions Prepare the operating activities section of the statement of cash flows for the year ended December 31, 4 7 2014, for Vince Gill Company, using the indirect method. E 23-4 (Preparation of Operating Activities Section—Direct Method) Data for the Vince Gill Company are presented in E23-3. Instructions Prepare the operating activities section of the statement of cash flows using the direct method. 4 7 E 23-5 (Preparation of Operating Activities Section—Direct Method) Krauss Company’s income state- ment for the year ended December 31, 2014, contained the following condensed information. Service revenue $840,000 Operating expenses (excluding depreciation) $624,000 Depreciation expense 60,000 Loss on sale of equipment 26,000 710,000 Income before income taxes 130,000 Income tax expense 40,000 Net income $ 90,000 Exercises 1459 Krauss’s balance sheet contained the following comparative data at December 31. 2014 2013 Accounts receivable $37,000 $54,000 Accounts payable 41,000 31,000 Income taxes payable 4,000 8,500 (Accounts payable pertains to operating expenses.) Instructions Prepare the operating activities section of the statement of cash flows using the direct method. 4 7 E23-6 (Preparation of Operating Activities Section—Indirect Method) Data for Krauss Company are presented in E23-5. Instructions Prepare the operating activities section of the statement of cash flows using the indirect method. 4 7 E23-7 (Computation of Operating Activities—Direct Method) Presented below are two independent situations. Situation A: Annie Lennox Co. reports revenues of $200,000 and operating expenses of $110,000 in its first year of operations, 2014. Accounts receivable and accounts payable at year-end were $71,000 and $29,000, respectively. Assume that the accounts payable related to operating expenses. (Ignore income taxes.) Instructions Using the direct method, compute net cash provided by operating activities. Situation B: The income statement for Blues Traveler Company shows cost of goods sold $310,000 and operating expenses (exclusive of depreciation) $230,000. The comparative balance sheet for the year shows that inventory increased $26,000, prepaid expenses decreased $8,000, accounts payable (related to mer- chandise) decreased $17,000, and accrued expenses payable increased $11,000. Instructions Compute (a) cash payments to suppliers and (b) cash payments for operating expenses. 4 7 E23-8 (Schedule of Net Cash Flow from Operating Activities—Indirect Method) Ballard Co. reported $145,000 of net income for 2014. The accountant, in preparing the statement of cash flows, noted the follow- ing items occurring during 2014 that might affect cash flows from operating activities. 1. Ballard purchased 100 shares of treasury stock at a cost of $20 per share. These shares were then resold at $25 per share. 2. Ballard sold 100 shares of IBM common at $200 per share. The acquisition cost of these shares was $145 per share. This investment was shown on Ballard’s December 31, 2013, balance sheet as an available-for-sale security. 3. Ballard revised its estimate for bad debts. Before 2014, Ballard’s bad debt expense was 1% of its net sales. In 2014, this percentage was increased to 2%. Net sales for 2014 were $500,000, and net ac-

counts receivable decreased by $12,000 during 2014. 4. Ballard issued 500 shares of its $10 par common stock for a patent. The market price of the shares on the date of the transaction was $23 per share. 5. Depreciation expense is $39,000. 6. Ballard Co. holds 40% of the Nirvana Company’s common stock as a long-term investment. Nirvana Company reported $27,000 of net income for 2014. 7. Nirvana Company paid a total of $2,000 of cash dividends to all investees in 2014. 8. Ballard declared a 10% stock dividend. One thousand shares of $10 par common stock were distrib- uted. The market price at date of issuance was $20 per share. Instructions Prepare a schedule that shows the net cash flow from operating activities using the indirect method. Assume no items other than those listed above affected the computation of 2014 net cash flow from operat- ing activities. 7 E23-9 (SCF—Direct Method) Los Lobos Corp. uses the direct method to prepare its statement of cash flows. Los Lobos’s trial balances at December 31, 2014 and 2013, are as follows. 1460 Chapter 23 Statement of Cash Flows December 31 2014 2013 Debits Cash $ 35,000 $ 32,000 Accounts receivable 33,000 30,000 Inventory 31,000 47,000 Property, plant, and equipment 100,000 95,000 Unamortized bond discount 4,500 5,000 Cost of goods sold 250,000 380,000 Selling expenses 141,500 172,000 General and administrative expenses 137,000 151,300 Interest expense 4,300 2,600 Income tax expense 20,400 61,200 $756,700 $976,100 Credits Allowance for doubtful accounts $ 1,300 $ 1,100 Accumulated depreciation—plant assets 16,500 15,000 Accounts payable 25,000 15,500 Income taxes payable 21,000 29,100 Deferred tax liability 5,300 4,600 8% callable bonds payable 45,000 20,000 Common stock 50,000 40,000 Paid-in capital in excess of par 9,100 7,500 Retained earnings 44,700 64,600 Sales revenue 538,800 778,700 $756,700 $976,100 Additional information: 1. Los Lobos purchased $5,000 in equipment during 2014. 2. Los Lobos allocated one-third of its depreciation expense to selling expenses and the remainder to general and administrative expenses. 3. Bad debt expense for 2014 was $5,000, and write-offs of uncollectible accounts totaled $4,800. Instructions Determine what amounts Los Lobos should report in its statement of cash flows for the year ended Decem- ber 31, 2014, for the following items. (a) Cash collected from customers. (d) Cash paid for income taxes. (b) Cash paid to suppliers. (e) Cash paid for selling expenses. (c) Cash paid for interest. 2 8 E23-10 (Classification of Transactions) Following are selected balance sheet accounts of Allman Bros. Corp. at December 31, 2014 and 2013, and the increases or decreases in each account from 2013 to 2014. Also presented is selected income statement information for the year ended December 31, 2014, and additional information. Increase Selected balance sheet accounts 2014 2013 (Decrease) Assets Accounts receivable $ 34,000 $ 24,000 $ 10,000 Property, plant, and equipment 277,000 247,000 30,000 Accumulated depreciation—plant assets (178,000) (167,000) (11,000) Liabilities and stockholders’ equity Bonds payable $ 49,000 $ 46,000 $ 3,000 Dividends payable 8,000 5,000 3,000 Common stock, $1 par 22,000 19,000 3,000 Additional paid-in capital 9,000 3,000 6,000 Retained earnings 104,000 91,000 13,000 Selected income statement information for the year ended December 31, 2014 Sales revenue $155,000 Depreciation 33,000 Gain on sale of equipment 14,500 Net income 31,000 Exercises 1461 Additional information: 1. During 2014, equipment costing $45,000 was sold for cash. 2. Accounts receivable relate to sales of merchandise. 3. During 2014, $20,000 of bonds payable were issued in exchange for property, plant, and equipment. There was no amortization of bond discount or premium. Instructions Determine the category (operating, investing, or financing) and the amount that should be reported in the statement of cash flows for the following items. (a) Payments for purchase of property, plant, and equipment. (b) Proceeds from the sale of equipment. (c) Cash dividends paid.

(d) Redemption of bonds payable. 3 E23-11 (SCF—Indirect Method) Condensed financial data of Pat Metheny Company for 2014 and 2013 are presented below. PAT METHENY COMPANY COMPARATIVE BALANCE SHEET AS OF DECEMBER 31, 2014 AND 2013 2014 2013 Cash $1,800 $1,150 Receivables 1,750 1,300 Inventory 1,600 1,900 Plant assets 1,900 1,700 Accumulated depreciation (1,200) (1,170) Long-term investments (held-to-maturity) 1,300 1,420 $7,150 $6,300 Accounts payable $1,200 $ 900 Accrued liabilities 200 250 Bonds payable 1,400 1,550 Capital stock 1,900 1,700 Retained earnings 2,450 1,900 $7,150 $6,300 PAT METHENY COMPANY INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 2014 Sales revenue $6,900 Cost of goods sold 4,700 Gross margin 2,200 Selling and administrative expense 930 Income from operations 1,270 Other revenues and gains Gain on sale of investments 80 Income before tax 1,350 Income tax expense 540 Net income 810 Cash dividends 260 Income retained in business $ 550 Additional information: During the year, $70 of common stock was issued in exchange for plant assets. No plant assets were sold in 2014. Instructions Prepare a statement of cash flows using the indirect method. 1462 Chapter 23 Statement of Cash Flows 3 E23-12 (SCF—Direct Method) Data for Pat Metheny Company are presented in E23-11. Instructions Prepare a statement of cash flows using the direct method. (Do not prepare a reconciliation schedule.) 3 E23-13 (SCF—Direct Method) Brecker Inc., a greeting card company, had the following statements pre- pared as of December 31, 2014. BRECKER INC. COMPARATIVE BALANCE SHEET AS OF DECEMBER 31, 2014 AND 2013 12/31/14 12/31/13 Cash $ 6,000 $ 7,000 Accounts receivable 62,000 51,000 Short-term investments (available-for-sale) 35,000 18,000 Inventory 40,000 60,000 Prepaid rent 5,000 4,000 Equipment 154,000 130,000 Accumulated depreciation—equipment (35,000) (25,000) Copyrights 46,000 50,000 Total assets $313,000 $295,000 Accounts payable $ 46,000 $ 40,000 Income taxes payable 4,000 6,000 Salaries and wages payable 8,000 4,000 Short-term loans payable 8,000 10,000 Long-term loans payable 60,000 69,000 Common stock, $10 par 100,000 100,000 Contributed capital, common stock 30,000 30,000 Retained earnings 57,000 36,000 Total liabilities and stockholders’ equity $313,000 $295,000 BRECKER INC. INCOME STATEMENT FOR THE YEAR ENDING DECEMBER 31, 2014 Sales revenue $338,150 Cost of goods sold 175,000 Gross profi t 163,150 Operating expenses 120,000 Operating income 43,150 Interest expense $11,400 Gain on sale of equipment 2,000 9,400 Income before tax 33,750 Income tax expense 6,750 Net income $ 27,000 Additional information: 1. Dividends in the amount of $6,000 were declared and paid during 2014. 2. Depreciation expense and amortization expense are included in operating expenses. 3. No unrealized gains or losses have occurred on the investments during the year. 4. Equipment that had a cost of $20,000 and was 70% depreciated was sold during 2014. Instructions Prepare a statement of cash flows using the direct method. (Do not prepare a reconciliation schedule.) 3 E23-14 (SCF—Indirect Method) Data for Brecker Inc. are presented in E23-13. Instructions Prepare a statement of cash flows using the indirect method. Exercises 1463 3 E23-15 (SCF—Indirect Method) Presented below are data taken from the records of Alee Company. December 31, December 31, 2014 2013 Cash $ 15,000 $ 8,000 Current assets other than cash 85,000 60,000 Long-term investments 10,000 53,000 Plant assets 335,000 215,000 $445,000 $336,000 Accumulated depreciation $ 20,000 $ 40,000 Current liabilities 40,000 22,000 Bonds payable 75,000 202 Capital stock 254,000 254,000 Retained earnings 56,000 20,000 $445,000 $336,000 Additional information: 1. Held-to-maturity securities carried at a cost of $43,000 on December 31, 2013, were sold in 2014 for $34,000. The loss (not extraordinary) was incorrectly charged directly to Retained Earnings. 2. Plant assets that cost $50,000 and were 80% depreciated were sold during 2014 for $8,000. The loss (not extraordinary) was incorrectly charged directly to Retained Earnings.

3. Net income as reported on the income statement for the year was $57,000. 4. Dividends paid amounted to $10,000. 5. Depreciation charged for the year was $20,000. Instructions Prepare a statement of cash flows for the year 2014 using the indirect method. 2 4 E23-16 (Cash Provided by Operating, Investing, and Financing Activities) The balance sheet data of 5 Brown Company at the end of 2014 and 2013 follow. 2014 2013 Cash $ 30,000 $ 35,000 Accounts receivable (net) 55,000 45,000 Inventory 65,000 45,000 Prepaid expenses 15,000 25,000 Equipment 90,000 75,000 Accumulated depreciation—equipment (18,000) (8,000) Land 70,000 40,000 $307,000 $257,000 Accounts payable $ 65,000 $ 52,000 Accrued expenses 15,000 18,000 Notes payable—bank, long-term 202 23,000 Bonds payable 30,000 202 Common stock, $10 par 189,000 159,000 Retained earnings 8,000 5,000 $307,000 $257,000 Land was acquired for $30,000 in exchange for common stock, par $30,000, during the year; all equipment purchased was for cash. Equipment costing $10,000 was sold for $3,000; book value of the equipment was $6,000. Cash dividends of $10,000 were declared and paid during the year. Instructions Compute net cash provided (used) by: (a) Operating activities. (b) Investing activities. (c) Financing activities. 1464 Chapter 23 Statement of Cash Flows 3 E23-17 (SCF—Indirect Method and Balance Sheet) Jobim Inc. had the following condensed balance sheet at the end of operations for 2013. JOBIM INC. BALANCE SHEET DECEMBER 31, 2013 Cash $ 8,500 Current liabilities $ 15,000 Current assets other than cash 29,000 Long-term notes payable 25,500 Investments 20,000 Bonds payable 25,000 Plant assets (net) 67,500 Capital stock 75,000 Land 40,000 Retained earnings 24,500 $165,000 $165,000 During 2014, the following occurred. 1. A tract of land was purchased for $9,000. 2. Bonds payable in the amount of $15,000 were redeemed at par. 3. An additional $10,000 in capital stock was issued at par. 4. Dividends totaling $9,375 were paid to stockholders. 5. Net income was $35,250 after allowing depreciation of $13,500. 6. Land was purchased through the issuance of $22,500 in bonds. 7. Jobim Inc. sold part of its investment portfolio for $12,875. This transaction resulted in a gain of $2,000 for the company. The company classifies the investments as available-for-sale. 8. Both current assets (other than cash) and current liabilities remained at the same amount. Instructions (a) Prepare a statement of cash flows for 2014 using the indirect method. (b) Prepare the condensed balance sheet for Jobim Inc. as it would appear at December 31, 2014. 3 8 E23-18 (Partial SCF—Indirect Method) The accounts below appear in the ledger of Anita Baker Company. Retained Earnings Dr. Cr. Bal. Jan. 1, 2014 Credit Balance $ 42,000 Aug. 15 Dividends (cash) $15,000 27,000 Dec. 31 Net Income for 2014 $40,000 67,000 Equipment Dr. Cr. Bal. Jan. 1, 2014 Debit Balance $140,000 Aug. 3 Purchase of Equipment $62,000 202,000 Sept. 10 Cost of Equipment Constructed 48,000 250,000 Nov. 15 Equipment Sold $56,000 194,000 Accumulated Depreciation— Equipment Dr. Cr. Bal. Jan. 1, 2014 Credit Balance $ 84,000 Apr. 8 Extraordinary Repairs $21,000 63,000 Nov. 15 Accum. Depreciation on Equipment Sold 25,200 37,800 Dec. 31 Depreciation for 2014 $16,800 54,600 Instructions From the postings in the accounts above, indicate how the information is reported on a statement of cash flows by preparing a partial statement of cash flows using the indirect method. The loss on sale of equipment (November 15) was $5,800. 9 E23-19 (Worksheet Analysis of Selected Accounts) Data for Anita Baker Company are presented in E23-18. Instructions Prepare entries in journal form for all adjustments that should be made on a worksheet for a statement of cash flows. Exercises 1465 9 E23-20 (Worksheet Analysis of Selected Transactions) The transactions below took place during the year 2014. 1. Convertible bonds payable with a par value of $300,000 were exchanged for unissued common stock with a par value of $300,000. The market price of both types of securities was par.

2. The net income for the year was $410,000. 3. Depreciation expense for the building was $90,000. 4. Some old office equipment was traded in on the purchase of some dissimilar office equipment, and the following entry was made. Equipment 50,000 Accum. Depreciation—Equipment 30,000 Equipment 40,000 Cash 34,000 Gain on Disposal of Plant Assets 6,000 The Gain on Disposal of Plant Assets was credited to current operations as ordinary income. 5. Dividends in the amount of $123,000 were declared. They are payable in January of next year. Instructions Show by journal entries the adjustments that would be made on a worksheet for a statement of cash flows. 9 E23-21 (Worksheet Preparation) Below is the comparative balance sheet for Stevie Wonder Corporation. Dec. 31, Dec. 31, 2014 2013 Cash $ 16,500 $ 21,000 Short-term investments 25,000 19,000 Accounts receivable 43,000 45,000 Allowance for doubtful accounts (1,800) (2,000) Prepaid expenses 4,200 2,500 Inventory 81,500 65,000 Land 50,000 50,000 Buildings 125,000 73,500 Accumulated depreciation—buildings (30,000) (23,000) Equipment 53,000 46,000 Accumulated depreciation—equipment (19,000) (15,500) Delivery equipment 39,000 39,000 Accumulated depreciation—delivery equipment (22,000) (20,500) Patents 15,000 202 $379,400 $300,000 Dec. 31, Dec. 31, 2014 2013 Accounts payable $ 26,000 $ 16,000 Short-term notes payable (trade) 4,000 6,000 Accrued payables 3,000 4,600 Mortgage payable 73,000 53,400 Bonds payable 50,000 62,500 Capital stock 140,000 102,000 Paid-in capital in excess of par 10,000 4,000 Retained earnings 73,400 51,500 $379,400 $300,000 Dividends in the amount of $15,000 were declared and paid in 2014. Instructions From this information, prepare a worksheet for a statement of cash flows. Make reasonable assumptions as appropriate. The short-term investments are considered available-for-sale and no unrealized gains or losses have occurred on these securities. 1466 Chapter 23 Statement of Cash Flows EXERCISES SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of exercises. PROBLEMS 3 4 P23-1 (SCF—Indirect Method) The following are Sullivan Corp.’s comparative balance sheet accounts at 8 December 31, 2014 and 2013, with a column showing the increase (decrease) from 2013 to 2014. COMPARATIVE BALANCE SHEETS Increase 2014 2013 (Decrease) Cash $ 815,000 $ 700,000 $115,000 Accounts receivable 1,128,000 1,168,000 (40,000) Inventory 1,850,000 1,715,000 135,000 Property, plant, and equipment 3,307,000 2,967,000 340,000 Accumulated depreciation (1,165,000) (1,040,000) (125,000) Investment in Myers Co. 310,000 275,000 35,000 Loan receivable 250,000 — 250,000 Total assets $6,495,000 $5,785,000 $710,000 Accounts payable $1,015,000 $ 955,000 $ 60,000 Income taxes payable 30,000 50,000 (20,000) Dividends payable 80,000 100,000 (20,000) Lease liability 400,000 — 400,000 Common stock, $1 par 500,000 500,000 — Paid-in capital in excess of par—common stock 1,500,000 1,500,000 — Retained earnings 2,970,000 2,680,000 290,000 Total liabilities and stockholders’ equity $6,495,000 $5,785,000 $710,000 Additional information: 1. On December 31, 2013, Sullivan acquired 25% of Myers Co.’s common stock for $275,000. On that date, the carrying value of Myers’s assets and liabilities, which approximated their fair values, was $1,100,000. Myers reported income of $140,000 for the year ended December 31, 2014. No dividend was paid on Myers’s common stock during the year. 2. During 2014, Sullivan loaned $300,000 to TLC Co., an unrelated company. TLC made the first semi- annual principal repayment of $50,000, plus interest at 10%, on December 31, 2014. 3. On January 2, 2014, Sullivan sold equipment costing $60,000, with a carrying amount of $38,000, for $40,000 cash. 4. On December 31, 2014, Sullivan entered into a capital lease for an office building. The present value of the annual rental payments is $400,000, which equals the fair value of the building. Sullivan made the first rental payment of $60,000 when due on January 2, 2015. 5. Net income for 2014 was $370,000.

6. Sullivan declared and paid the following cash dividends for 2014 and 2013. 2014 2013 Declared December 15, 2014 December 15, 2013 Paid February 28, 2015 February 28, 2014 Amount $80,000 $100,000 Instructions Prepare a statement of cash flows for Sullivan Corp. for the year ended December 31, 2014, using the indirect method. (AICPA adapted) Problems 1467 3 6 P23-2 (SCF—Indirect Method) The comparative balance sheets for Hinckley Corporation show the following information. 8 December 31 2014 2013 Cash $ 33,500 $13,000 Accounts receivable 12,250 10,000 Inventory 12,000 9,000 Investments –0– 3,000 Buildings –0– 29,750 Equipment 45,000 20,000 Patents 5,000 6,250 $107,750 $91,000 Allowance for doubtful accounts $ 3,000 $ 4,500 Accumulated depreciation—equipment 2,000 4,500 Accumulated depreciation—building –0– 6,000 Accounts payable 5,000 3,000 Dividends payable –0– 5,000 Notes payable, short-term (nontrade) 3,000 4,000 Long-term notes payable 31,000 25,000 Common stock 43,000 33,000 Retained earnings 20,750 6,000 $107,750 $91,000 Additional data related to 2014 are as follows. 1. Equipment that had cost $11,000 and was 40% depreciated at time of disposal was sold for $2,500. 2. $10,000 of the long-term note payable was paid by issuing common stock. 3. Cash dividends paid were $5,000. 4. On January 1, 2014, the building was completely destroyed by a flood. Insurance proceeds on the building were $30,000 (net of $2,000 taxes). 5. Investments (available-for-sale) were sold at $1,700 above their cost. The company has made similar sales and investments in the past. 6. Cash was paid for the acquisition of equipment. 7. A long-term note for $16,000 was issued for the acquisition of equipment. 8. Interest of $2,000 and income taxes of $6,500 were paid in cash. Instructions Prepare a statement of cash flows using the indirect method. Flood damage is unusual and infrequent in that part of the country. 3 P23-3 (SCF—Direct Method) Mortonson Company has not yet prepared a formal statement of cash flows for the 2014 fiscal year. Comparative balance sheets as of December 31, 2013 and 2014, and a statement of income and retained earnings for the year ended December 31, 2014, are presented as follows. MORTONSON COMPANY STATEMENT OF INCOME AND RETAINED EARNINGS FOR THE YEAR ENDED DECEMBER 31, 2014 ($000 OMITTED) Sales revenue $3,800 Expenses Cost of goods sold $1,200 Salaries and benefi ts 725 Heat, light, and power 75 Depreciation 80 Property taxes 19 Patent amortization 25 Miscellaneous expenses 10 Interest 30 2,164 1468 Chapter 23 Statement of Cash Flows MORTONSON COMPANY STATEMENT OF INCOME AND RETAINED EARNINGS FOR THE YEAR ENDED DECEMBER 31, 2014 (CONTINUED) Income before income taxes 1,636 Income taxes 818 Net income 818 Retained earnings—Jan. 1, 2014 310 1,128 Stock dividend declared and issued 600 Retained earnings—Dec. 31, 2014 $ 528 MORTONSON COMPANY COMPARATIVE BALANCE SHEETS AS OF DECEMBER 31 ($000 OMITTED) Assets 2014 2013 Current assets Cash $ 333 $ 100 U.S. Treasury notes (available-for-sale) 10 50 Accounts receivable 780 500 Inventory 720 560 Total current assets 1,843 1,210 Long-term assets Land 150 70 Buildings and equipment 910 600 Accumulated depreciation—buildings and equipment (200) (120) Patents (less amortization) 105 130 Total long-term assets 965 680 Total assets $2,808 $1,890 Liabilities and Stockholders’ Equity Current liabilities Accounts payable $ 420 $ 330 Income taxes payable 40 30 Notes payable 320 320 Total current liabilities 780 680 Long-term notes payable—due 2016 200 200 Total liabilities 980 880 Stockholders’ equity Common stock 1,300 700 Retained earnings 528 310 Total stockholders’ equity 1,828 1,010 Total liabilities and stockholders’ equity $2,808 $1,890 Instructions Prepare a statement of cash flows using the direct method. Changes in accounts receivable and accounts payable relate to sales and cost of goods sold. Do not prepare a reconciliation schedule. (CMA adapted) 3 6 P23-4 (SCF—Direct Method) Michaels Company had available at the end of 2014 the information shown on the next page. 8 Problems 1469 MICHAELS COMPANY

COMPARATIVE BALANCE SHEETS AS OF DECEMBER 31, 2014 AND 2013 2014 2013 Cash $ 10,000 $ 4,000 Accounts receivable 20,500 12,950 Short-term investments 22,000 30,000 Inventory 42,000 35,000 Prepaid rent 3,000 12,000 Prepaid insurance 2,100 900 Supplies 1,000 750 Land 125,000 175,000 Buildings 350,000 350,000 Accumulated depreciation—buildings (105,000) (87,500) Equipment 525,000 400,000 Accumulated depreciation—equipment (130,000) (112,000) Patents 45,000 50,000 Total assets $910,600 $871,100 Accounts payable $ 22,000 $ 32,000 Income taxes payable 5,000 4,000 Salaries and wages payable 5,000 3,000 Short-term notes payable 10,000 10,000 Long-term notes payable 60,000 70,000 Bonds payable 400,000 400,000 Premium on bonds payable 20,303 25,853 Common stock 240,000 220,000 Paid-in capital in excess of par—common stock 25,000 17,500 Retained earnings 123,297 88,747 Total liabilities and stockholders’ equity $910,600 $871,100 MICHAELS COMPANY INCOME STATEMENT AND DIVIDEND INFORMATION FOR THE YEAR ENDED DECEMBER 31, 2014 Sales revenue $1,160,000 Cost of goods sold 748,000 Gross margin 412,000 Operating expenses Selling expenses $ 79,200 Administrative expenses 156,700 Depreciation/Amortization expense 40,500 Total operating expenses 276,400 Income from operations 135,600 Other revenues/expenses Gain on sale of land 8,000 Gain on sale of short-term investment 4,000 Dividend revenue 2,400 Interest expense (51,750) (37,350) Income before taxes 98,250 Income tax expense 39,400 Net income 58,850 Dividends to common stockholders (24,300) To retained earnings $ 34,550 Instructions Prepare a statement of cash flows for Michaels Company using the direct method accompanied by a recon- ciliation schedule. Assume the short-term investments are classified as available-for-sale. 1470 Chapter 23 Statement of Cash Flows 3 6 P23-5 (SCF—Indirect Method) You have completed the field work in connection with your audit of 8 Alexander Corporation for the year ended December 31, 2014. The balance sheet accounts at the beginning and end of the year are shown below. Increase Dec. 31, Dec. 31, or 2014 2013 (Decrease) Cash $ 277,900 $ 298,000 ($20,100) Accounts receivable 469,424 353,000 116,424 Inventory 741,700 610,000 131,700 Prepaid expenses 12,000 8,000 4,000 Investment in subsidiary 110,500 –0– 110,500 Cash surrender value of life insurance 2,304 1,800 504 Machinery 207,000 190,000 17,000 Buildings 535,200 407,900 127,300 Land 52,500 52,500 –0– Patents 69,000 64,000 5,000 Copyrights 40,000 50,000 (10,000) Bond discount and issue costs 4,502 –0– 4,502 $2,522,030 $2,035,200 $486,830 Income taxes payable $ 90,250 $ 79,600 $ 10,650 Accounts payable 299,280 280,000 19,280 Dividends payable 70,000 –0– 70,000 Bonds payable—8% 125,000 –0– 125,000 Bonds payable—12% –0– 100,000 (100,000) Allowance for doubtful accounts 35,300 40,000 (4,700) Accumulated depreciation—buildings 424,000 400,000 24,000 Accumulated depreciation—machinery 173,000 130,000 43,000 Premium on bonds payable –0– 2,400 (2,400) Common stock—no par 1,176,200 1,453,200 (277,000) Paid-in capital in excess of par—common stock 109,000 –0– 109,000 Retained earnings—unappropriated 20,000 (450,000) 470,000 $2,522,030 $2,035,200 $486,830 STATEMENT OF RETAINED EARNINGS FOR THE YEAR ENDED DECEMBER 31, 2014 January 1, 2014 Balance (defi cit) $(450,000) March 31, 2014 Net income for fi rst quarter of 2014 25,000 April 1, 2014 Transfer from paid-in capital 425,000 Balance –0– December 31, 2014 Net income for last three quarters of 2014 90,000 Dividend declared—payable January 21, 2015 (70,000) Balance $ 20,000 Your working papers from the audit contain the following information: 1. On April 1, 2014, the existing deficit was written off against paid-in capital created by reducing the stated value of the no-par stock. 2. On November 1, 2014, 29,600 shares of no-par stock were sold for $257,000. The board of directors voted to regard $5 per share as stated capital. 3. A patent was purchased for $15,000. 4. During the year, machinery that had a cost basis of $16,400 and on which there was accumulated depreciation of $5,200 was sold for $9,000. No other plant assets were sold during the year.

5. The 12%, 20-year bonds were dated and issued on January 2, 2002. Interest was payable on June 30 and December 31. They were sold originally at 106. These bonds were redeemed at 100.9 plus accrued interest on March 31, 2014. 6. The 8%, 40-year bonds were dated January 1, 2014, and were sold on March 31 at 97 plus accrued interest. Interest is payable semiannually on June 30 and December 31. Expense of issuance was $839. 7. Alexander Corporation acquired 70% control in Crimson Company on January 2, 2014, for $100,000. The income statement of Crimson Company for 2014 shows a net income of $15,000. 8. Extraordinary repairs to buildings of $7,200 were charged to Accumulated Depreciation—Buildings. 9. Interest paid in 2014 was $10,500 and income taxes paid were $34,000. Problems 1471 Instructions From the information given, prepare a statement of cash flows using the indirect method. A worksheet is not necessary, but the principal computations should be supported by schedules or general ledger accounts. The company uses straight-line amortization for bond interest. 3 4 P23-6 (SCF—Indirect Method, and Net Cash Flow from Operating Activities, Direct Method) Com- 7 8 parative balance sheet accounts of Marcus Inc. are presented below. MARCUS INC. COMPARATIVE BALANCE SHEET ACCOUNTS AS OF DECEMBER 31, 2014 AND 2013 December 31 Debit Accounts 2014 2013 Cash $ 42,000 $ 33,750 Accounts Receivable 70,500 60,000 Inventory 30,000 24,000 Investments (available-for-sale) 22,250 38,500 Machinery 30,000 18,750 Buildings 67,500 56,250 Land 7,500 7,500 $269,750 $238,750 Credit Accounts Allowance for Doubtful Accounts $ 2,250 $ 1,500 Accumulated Depreciation—Machinery 5,625 2,250 Accumulated Depreciation—Buildings 13,500 9,000 Accounts Payable 35,000 24,750 Accrued Payables 3,375 2,625 Long-Term Notes Payable 21,000 31,000 Common Stock, no-par 150,000 125,000 Retained Earnings 39,000 42,625 $269,750 $238,750 Additional data (ignoring taxes): 1. Net income for the year was $42,500. 2. Cash dividends declared and paid during the year were $21,125. 3. A 20% stock dividend was declared during the year. $25,000 of retained earnings was capitalized. 4. Investments that cost $25,000 were sold during the year for $28,750. 5. Machinery that cost $3,750, on which $750 of depreciation had accumulated, was sold for $2,200. Marcus’s 2014 income statement follows (ignoring taxes). Sales revenue $540,000 Less: Cost of goods sold 380,000 Gross margin 160,000 Less: Operating expenses (includes $8,625 depreciation and $5,400 bad debts) 120,450 Income from operations 39,550 Other: Gain on sale of investments $3,750 Loss on sale of machinery (800) 2,950 Net income $ 42,500 Instructions (a) Compute net cash flow from operating activities using the direct method. (b) Prepare a statement of cash flows using the indirect method. 3 6 P23-7 (SCF—Direct and Indirect Methods from Comparative Financial Statements) Chapman Com- 7 8 pany, a major retailer of bicycles and accessories, operates several stores and is a publicly traded company. The comparative balance sheet and income statement for Chapman as of May 31, 2014, are as follows. The company is preparing its statement of cash flows. 1472 Chapter 23 Statement of Cash Flows CHAPMAN COMPANY COMPARATIVE BALANCE SHEET AS OF MAY 31 2014 2013 Current assets Cash $ 28,250 $ 20,000 Accounts receivable 75,000 58,000 Inventory 220,000 250,000 Prepaid expenses 9,000 7,000 Total current assets 332,250 335,000 Plant assets Plant assets 600,000 502,000 Less: Accumulated depreciation—plant assets 150,000 125,000 Net plant assets 450,000 377,000 Total assets $782,250 $712,000 Current liabilities Accounts payable $123,000 $115,000 Salaries and wages payable 47,250 72,000 Interest payable 27,000 25,000 Total current liabilities 197,250 212,000 Long-term debt Bonds payable 70,000 100,000 Total liabilities 267,250 312,000 Stockholders’ equity Common stock, $10 par 370,000 280,000 Retained earnings 145,000 120,000 Total stockholders’ equity 515,000 400,000 Total liabilities and stockholders’ equity $782,250 $712,000 CHAPMAN COMPANY INCOME STATEMENT

FOR THE YEAR ENDED MAY 31, 2014 Sales revenue $1,255,250 Cost of goods sold 722,000 Gross profi t 533,250 Expenses Salaries and wages expense 252,100 Interest expense 75,000 Depreciation expense 25,000 Other expenses 8,150 Total expenses 360,250 Operating income 173,000 Income tax expense 43,000 Net income $ 130,000 The following is additional information concerning Chapman’s transactions during the year ended May 31, 2014. 1. All sales during the year were made on account. 2. All merchandise was purchased on account, comprising the total accounts payable account. 3. Plant assets costing $98,000 were purchased by paying $28,000 in cash and issuing 7,000 shares of stock. 4. The “other expenses” are related to prepaid items. 5. All income taxes incurred during the year were paid during the year. 6. In order to supplement its cash, Chapman issued 2,000 shares of common stock at par value. 7. Cash dividends of $105,000 were declared and paid at the end of the fiscal year. Problems 1473 Instructions (a) Compare and contrast the direct method and the indirect method for reporting cash flows from operating activities. (b) Prepare a statement of cash flows for Chapman Company for the year ended May 31, 2014, using the direct method. Be sure to support the statement with appropriate calculations. (A reconciliation of net income to net cash provided is not required.) (c) Using the indirect method, calculate only the net cash flow from operating activities for Chapman Company for the year ended May 31, 2014. 3 6 P23-8 (SCF—Direct and Indirect Methods) Comparative balance sheet accounts of Sharpe Company are 8 presented below. SHARPE COMPANY COMPARATIVE BALANCE SHEET ACCOUNTS AS OF DECEMBER 31 Debit Balances 2014 2013 Cash $ 70,000 $ 51,000 Accounts Receivable 155,000 130,000 Inventory 75,000 61,000 Investments (available-for-sale) 55,000 85,000 Equipment 70,000 48,000 Buildings 145,000 145,000 Land 40,000 25,000 Totals $610,000 $545,000 Credit Balances Allowance for Doubtful Accounts $ 10,000 $ 8,000 Accumulated Depreciation—Equipment 21,000 14,000 Accumulated Depreciation—Buildings 37,000 28,000 Accounts Payable 66,000 60,000 Income Taxes Payable 12,000 10,000 Long-Term Notes Payable 62,000 70,000 Common Stock 310,000 260,000 Retained Earnings 92,000 95,000 Totals $610,000 $545,000 Additional data: 1. Equipment that cost $10,000 and was 60% depreciated was sold in 2014. 2. Cash dividends were declared and paid during the year. 3. Common stock was issued in exchange for land. 4. Investments that cost $35,000 were sold during the year. 5. There were no write-offs of uncollectible accounts during the year. Sharpe’s 2014 income statement is as follows. Sales revenue $950,000 Less: Cost of goods sold 600,000 Gross profi t 350,000 Less: Operating expenses (includes depreciation expense and bad debt expense) 250,000 Income from operations 100,000 Other revenues and expenses Gain on sale of investments $15,000 Loss on sale of equipment (3,000) 12,000 Income before taxes 112,000 Income taxes 45,000 Net income $ 67,000 Instructions (a) Compute net cash provided by operating activities under the direct method. (b) Prepare a statement of cash flows using the indirect method. 1474 Chapter 23 Statement of Cash Flows 3 6 P23-9 (Indirect SCF) Dingel Corporation has contracted with you to prepare a statement of cash flows. 8 The controller has provided the following information. December 31 2014 2013 Cash $ 38,500 $13,000 Accounts receivable 12,250 10,000 Inventory 12,000 10,000 Investments –0– 3,000 Buildings –0– 29,750 Equipment 40,000 20,000 Copyrights 5,000 5,250 Totals $107,750 $91,000 Allowance for doubtful accounts $ 3,000 $ 4,500 Accumulated depreciation—equipment 2,000 4,500 Accumulated depreciation—buildings –0– 6,000 Accounts payable 5,000 4,000 Dividends payable –0– 5,000 Notes payable, short-term (nontrade) 3,000 4,000 Long-term notes payable 36,000 25,000 Common stock 38,000 33,000 Retained earnings 20,750 5,000 $107,750 $91,000 Additional data related to 2014 are as follows. 1. Equipment that had cost $11,000 and was 30% depreciated at time of disposal was sold for $2,500.

2. $5,000 of the long-term note payable was paid by issuing common stock. 3. Cash dividends paid were $5,000. 4. On January 1, 2014, the building was completely destroyed by a flood. Insurance proceeds on the building were $33,000 (net of $4,000 taxes). 5. Investments (available-for-sale) were sold at $1,500 above their cost. The company has made similar sales and investments in the past. 6. Cash and long-term note for $16,000 were given for the acquisition of equipment. 7. Interest of $2,000 and income taxes of $5,000 were paid in cash. Instructions (a) Use the indirect method to analyze the above information and prepare a statement of cash flows for Dingel. Flood damage is unusual and infrequent in that part of the country. (b) What would you expect to observe in the operating, investing, and financing sections of a statement of cash flows of: (1) A severely financially troubled firm? (2) A recently formed firm that is experiencing rapid growth? PROBLEMS SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of problems. CONCEPTS FOR ANALYSIS CA23-1 (Analysis of Improper SCF) The following statement was prepared by Maloney Corporation’s accountant. Concepts for Analysis 1475 MALONEY CORPORATION STATEMENT OF SOURCES AND APPLICATION OF CASH FOR THE YEAR ENDED SEPTEMBER 30, 2014 Sources of cash Net income $111,000 Depreciation and depletion 70,000 Increase in long-term debt 179,000 Changes in current receivables and inventories, less current liabilities (excluding current maturities of long-term debt) 14,000 $374,000 Application of cash Cash dividends $ 60,000 Expenditure for property, plant, and equipment 214,000 Investments and other uses 20,000 Change in cash 80,000 $374,000 The following additional information relating to Maloney Corporation is available for the year ended September 30, 2014. 1. Salaries and wages expense attributable to stock option plans was $25,000 for the year. 2. Expenditures for property, plant, and equipment $250,000 Proceeds from retirements of property, plant, and equipment 36,000 Net expenditures $214,000 3. A stock dividend of 10,000 shares of Maloney Corporation common stock was distributed to com- mon stockholders on April 1, 2014, when the per share market price was $7 and par value was $1. 4. On July 1, 2014, when its market price was $6 per share, 16,000 shares of Maloney Corporation common stock were issued in exchange for 4,000 shares of preferred stock. 5. Depreciation expense $ 65,000 Depletion expense 5,000 $ 70,000 6. Increase in long-term debt $620,000 Less: Redemption of debt 441,000 Net increase $179,000 Instructions (a) In general, what are the objectives of a statement of the type shown above for Maloney Corpora- tion? Explain. (b) Identify the weaknesses in the form and format of Maloney Corporation’s statement of cash flows without reference to the additional information. (Assume adoption of the indirect method.) (c) For each of the six items of additional information for the statement of cash flows, indicate the pref- erable treatment and explain why the suggested treatment is preferable. (AICPA adapted) CA23-2 (SCF Theory and Analysis of Improper SCF) Teresa Ramirez and Lenny Traylor are examining the following statement of cash flows for Pacific Clothing Store’s first year of operations. PACIFIC CLOTHING STORE STATEMENT OF CASH FLOWS FOR THE YEAR ENDED JANUARY 31, 2014 Sources of cash From sales of merchandise $ 382,000 From sale of capital stock 380,000 From sale of investment 120,000 From depreciation 80,000 From issuance of note for truck 30,000 From interest on investments 8,000 Total sources of cash 1,000,000 1476 Chapter 23 Statement of Cash Flows PACIFIC CLOTHING STORE STATEMENT OF CASH FLOWS FOR THE YEAR ENDED JANUARY 31, 2014 (CONTINUED) Uses of cash For purchase of fi xtures and equipment 330,000 For merchandise purchased for resale 253,000 For operating expenses (including depreciation) 170,000 For purchase of investment 95,000 For purchase of truck by issuance of note 30,000 For purchase of treasury stock 10,000

For interest on note 3,000 Total uses of cash 891,000 Net increase in cash $ 109,000 Teresa claims that Pacific’s statement of cash flows is an excellent portrayal of a superb first year, with cash increasing $109,000. Lenny replies that it was not a superb first year—that the year was an operating failure, the statement was incorrectly presented, and $109,000 is not the actual increase in cash. Instructions (a) With whom do you agree, Teresa or Lenny? Explain your position. (b) Using the data provided, prepare a statement of cash flows in proper indirect method form. The only noncash items in income are depreciation and the gain from the sale of the investment (purchase and sale are related). CA23-3 (SCF Theory and Analysis of Transactions) Ashley Company is a young and growing producer of electronic measuring instruments and technical equipment. You have been retained by Ashley to advise it in the preparation of a statement of cash flows using the indirect method. For the fiscal year ended October 31, 2014, you have obtained the following information concerning certain events and transactions of Ashley. 1. The amount of reported earnings for the fiscal year was $700,000, which included a deduction for an extraordinary loss of $110,000 (see item 5 below). 2. Depreciation expense of $315,000 was included in the income statement. 3. Uncollectible accounts receivable of $40,000 were written off against the allowance for doubtful accounts. Also, $51,000 of bad debt expense was included in determining income for the fiscal year, and the same amount was added to the allowance for doubtful accounts. 4. A gain of $6,000 was realized on the sale of a machine. It originally cost $75,000, of which $30,000 was undepreciated on the date of sale. 5. On April 1, 2014, lightning caused an uninsured building loss of $110,000 ($180,000 loss, less reduc- tion in income taxes of $70,000). This extraordinary loss was included in determining income as indicated in item 1 above. 6. On July 3, 2014, building and land were purchased for $700,000. Ashley gave in payment $75,000 cash, $200,000 market price of its unissued common stock, and signed a $425,000 mortgage note payable. 7. On August 3, 2014, $800,000 face value of Ashley’s 10% convertible debentures was converted into $150,000 par value of its common stock. The bonds were originally issued at face value. Instructions Explain whether each of the seven numbered items above is a cash inflow or outflow, and explain how it should be disclosed in Ashley’s statement of cash flows for the fiscal year ended October 31, 2014. If any item is neither an inflow nor an outflow of cash, explain why it is not, and indicate the disclosure, if any, that should be made of the item in Ashley’s statement of cash flows for the fiscal year ended October 31, 2014. CA23-4 (Analysis of Transactions’ Effect on SCF) Each of the following items must be considered in preparing a statement of cash flows for Cruz Fashions Inc. for the year ended December 31, 2014. 1. Fixed assets that had cost $20,000 61⁄ years before and were being depreciated on a 10-year basis, 2 with no estimated scrap value, were sold for $4,750. 2. During the year, goodwill of $15,000 was considered impaired and was completely written off to expense. 3. During the year, 500 shares of common stock with a stated value of $25 a share were issued for $32 a share. 4. The company sustained a net loss for the year of $2,100. Depreciation amounted to $2,000 and patent amortization was $400. 5. Uncollectible accounts receivable in the amount of $2,000 were written off against Allowance for Doubtful Accounts. Using Your Judgment 1477 6. Investments (available-for-sale) that cost $12,000 when purchased 4 years earlier were sold for $10,600. The loss was considered ordinary. 7. Bonds payable with a par value of $24,000 on which there was an unamortized bond premium of $2,000 were redeemed at 101. The gain was credited to ordinary income. Instructions For each item, state where it is to be shown in the statement and then how you would present the necessary

information, including the amount. Consider each item to be independent of the others. Assume that cor- rect entries were made for all transactions as they took place. CA23-5 (Purpose and Elements of SCF) GAAP requires the statement of cash flows be presented when financial statements are prepared. Instructions (a) Explain the purposes of the statement of cash flows. (b) List and describe the three categories of activities that must be reported in the statement of cash flows. (c) Identify and describe the two methods that are allowed for reporting cash flows from operations. (d) Describe the financial statement presentation of noncash investing and financing transactions. Include in your description an example of a noncash investing and financing transaction. CA23-6 (Cash Flow Reporting) Brockman Guitar Company is in the business of manufacturing top- quality, steel-string folk guitars. In recent years, the company has experienced working capital problems resulting from the procurement of factory equipment, the unanticipated buildup of receivables and inven- tories, and the payoff of a balloon mortgage on a new manufacturing facility. The founder and president of the company, Barbara Brockman, has attempted to raise cash from various financial institutions, but to no avail because of the company’s poor performance in recent years. In particular, the company’s lead bank, First Financial, is especially concerned about Brockman’s inability to maintain a positive cash position. The commercial loan officer from First Financial told Barbara, “I can’t even consider your request for capital financing unless I see that your company is able to generate positive cash flows from operations.” Thinking about the banker’s comment, Barbara came up with what she believes is a good plan: With a more attractive statement of cash flows, the bank might be willing to provide long-term financing. To “window dress” cash flows, the company can sell its accounts receivables to factors and liquidate its raw materials inventories. These rather costly transactions would generate lots of cash. As the chief accountant for Brockman Guitar, it is your job to tell Barbara what you think of her plan. Instructions Answer the following questions. (a) What are the ethical issues related to Barbara Brockman’s idea? (b) What would you tell Barbara Brockman? 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 P&G’s financial statements and the accompanying notes to answer the following questions. (a) Which method of computing net cash provided by operating activities does P&G use? What were the amounts of net cash provided by operating activities for the years 2009, 2010, and 2011? Which two items were most responsible for the decrease in net cash provided by operating activities in 2011? (b) What was the most significant item in the cash flows used for investing activities section in 2011? What was the most significant item in the cash flows used for financing activities section in 2011? (c) Where is “deferred income taxes” reported in P&G’s statement of cash flows? Why does it appear in that section of the statement of cash flows? (d) Where is depreciation reported in P&G’s statement of cash flows? Why is depreciation added to net income in the statement of cash flows? 1478 Chapter 23 Statement of Cash Flows 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 method of computing net cash provided by operating activities does Coca-Cola use? What method does PepsiCo use? What were the amounts of cash provided by operating activities reported

by Coca-Cola and PepsiCo in 2011? (b) What was the most significant item reported by Coca-Cola and PepsiCo in 2011 in their investing ac- tivities sections? What is the most significant item reported by Coca-Cola and PepsiCo in 2011 in their financing activities sections? (c) What were these two companies’ trends in net cash provided by operating activities over the period 2009 to 2011? (d) Where is “depreciation and amortization” reported by Coca-Cola and PepsiCo in their statements of cash flows? What is the amount and why does it appear in that section of the statement of cash flows? (e) Based on the information contained in Coca-Cola’s and PepsiCo’s financial statements, compute the following 2011 ratios for each company. These ratios require the use of statement of cash flows data. (These ratios were covered in Chapter 5.) (1) Current cash debt coverage. (2) Cash debt coverage. (f) What conclusions concerning the management of cash can be drawn from the ratios computed in (e)? Financial Statement Analysis Case Vermont Teddy Bear Co. Founded in the early 1980s, the Vermont Teddy Bear Co. designs and manufactures American-made teddy bears and markets them primarily as gifts called Bear-Grams or Teddy Bear-Grams. Bear-Grams are personalized teddy bears delivered directly to the recipient for special occasions such as birthdays and anniversaries. The Shelburne, Vermont, company’s primary markets are New York, Boston, and Chicago. Sales have jumped dramatically in recent years. Such dramatic growth has significant implications for cash flows. Provided below are the cash flow statements for two recent years for the company. Current Year Prior Year Cash fl ows from operating activities: Net income $ 17,523 $ 838,955 Adjustments to reconcile net income to net cash provided by operating activities Deferred income taxes (69,524) (146,590) Depreciation and amortization 316,416 181,348 Changes in assets and liabilities: Accounts receivable, trade (38,267) (25,947) Inventories (1,599,014) (1,289,293) Prepaid and other current assets (444,794) (113,205) Deposits and other assets (24,240) (83,044) Accounts payable 2,017,059 (284,567) Accrued expenses 61,321 170,755 Accrued interest payable, debentures — (58,219) Other — (8,960) Income taxes payable — 117,810 Net cash provided by (used for) operating activities 236,480 (700,957) Net cash used for investing activities (2,102,892) (4,422,953) Net cash (used for) provided by fi nancing activities (315,353) 9,685,435 Net change in cash and cash equivalents (2,181,765) 4,561,525 Other information: Current liabilities $ 4,055,465 $ 1,995,600 Total liabilities 4,620,085 2,184,386 Net sales 20,560,566 17,025,856 Using Your Judgment 1479 Instructions (a) Note that net income in the current year was only $17,523 compared to prior-year income of $838,955, but net cash flow from operating activities was $236,480 in the current year and a negative $700,957 in the prior year. Explain the causes of this apparent paradox. (b) Evaluate Vermont Teddy Bear’s liquidity, solvency, and profitability for the current year using cash flow-based ratios. Accounting, Analysis, and Principles The income statement for the year ended December 31, 2014, for Laskowski Manufacturing Company contains the following condensed information. LASKOWSKI CO. INCOME STATEMENT Revenues $6,583,000 Operating expenses (excluding depreciation) $4,920,000 Depreciation expense 880,000 5,800,000 Income before income tax 783,000 Income tax expense 353,000 Net income $ 430,000 Included in operating expenses is a $24,000 loss resulting from the sale of machinery for $270,000 cash. The company purchased machinery at a cost of $750,000. Laskowski reports the following balances on its comparative balance sheets at December 31. LASKOWSKI CO. COMPARATIVE BALANCE SHEETS (PARTIAL) 2014 2013 Cash $672,000 $130,000 Accounts receivable 775,000 610,000 Inventory 834,000 867,000 Accounts payable 521,000 501,000 Income tax expense of $353,000 represents the amount paid in 2014. Dividends declared and paid in 2014 totaled $200,000. Accounting

Prepare the statement of cash flows using the indirect method. Analysis Laskowski has an aggressive growth plan, which will require significant investments in plant and equip- ment over the next several years. Preliminary plans call for an investment of over $500,000 in the next year. Compute Laskowski’s free cash flow (from Chapter 5) and use it to evaluate the investment plans with the use of only internally generated funds. Principles How does the statement of cash flows contribute to achieving the objective of financial reporting? BRIDGE TO THE PROFESSION Professional Research: FASB Codifi cation As part of the year-end accounting process for your company, you are preparing the statement of cash flows according to GAAP. One of your team, a finance major, believes the statement should be prepared to report the change in working capital, because analysts many times use working capital in ratio analysis. Your supervisor would like research conducted to verify the basis for preparing the statement of cash flows. 1480 Chapter 23 Statement of Cash Flows 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) What is the primary objective for the statement of cash flows? Is working capital the basis for meeting this objective? (b) What information is provided in a statement of cash flows? (c) List some of the typical cash inflows and outflows from operations. 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 statement of cash flows is a required statement for IFRS. In addi- LEARNING OBJECTIVE 10 tion, the content and presentation of a U.S. statement of cash flows is similar to one Compare the statement of cash flows used for IFRS. However, the disclosure requirements related to the statement of under GAAP and IFRS. cash flows are more extensive under GAAP. IAS 7 (“Cash Flow Statements”) pro- vides the overall IFRS requirements for cash flow information. RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related to the statement of cash flows. Similarities • Both GAAP and IFRS require that companies prepare a statement of cash fl ows. • Both IFRS and GAAP require that the statement of cash fl ows should have three major sections—operating, investing, and fi nancing—along with changes in cash and cash equivalents. • Similar to GAAP, the cash fl ow statement can be prepared using either the indirect or direct method under IFRS. For both IFRS and GAAP, most companies use the indirect method for reporting net cash fl ow from operating activities. • The defi nition of cash equivalents used in IFRS is similar to that used in GAAP. Differences • A major difference in the defi nition of cash and cash equivalents is that in certain situ- ations, bank overdrafts are considered part of cash and cash equivalents under IFRS (which is not the case in GAAP). Under GAAP, bank overdrafts are classifi ed as fi nancing activities. • IFRS requires that non-cash investing and fi nancing activities be excluded from the statement of cash fl ows. Instead, these non-cash activities should be reported else- where. This requirement is interpreted to mean that non-cash investing and fi nancing activities should be disclosed in the notes to the fi nancial statements instead of in the fi nancial statements. Under GAAP, companies may present this information in the cash fl ow statement. IFRS Insights 1481 • One area where there can be substantive differences between IFRS and GAAP relates to the classifi cation of interest, dividends, and taxes. IFRS provides more alternatives for disclosing these items, while GAAP requires that except for dividends paid (which are classifi ed as a fi nancing activity), these items are all reported as operating activities. ABOUT THE NUMBERS Signifi cant Non-Cash Transactions

Because the statement of cash flows reports only the effects of operating, investing, and financing activities in terms of cash flows, it omits some significant non-cash transac- tions and other events that are investing or financing activities. Among the more com- mon of these non-cash transactions that a company should report or disclose in some manner are the following. 1. Acquisition of assets by assuming liabilities (including fi nance lease obligations) or by issuing equity securities. 2. Exchanges of non-monetary assets. 3. Refi nancing of long-term debt. 4. Conversion of debt or preference shares to ordinary shares. 5. Issuance of equity securities to retire debt. Investing and financing transactions that do not require the use of cash are excluded from the statement of cash flows. If material in amount, these disclosures may be either narrative or summarized in a separate schedule. This schedule may appear in a separate note or supplementary schedule to the financial statements. Illustration IFRS23-1 shows the presentation of these significant non-cash transac- tions or other events in a separate schedule in the notes to the financial statements. ILLUSTRATION Note G: Significant non-cash transactions. During the year, the company engaged in the following IFRS23-1 significant non-cash investing and financing transactions: Note Presentation of Issued 250,000 ordinary shares to purchase land and building $1,750,000 Non-Cash Investing and Exchanged land in Steadfast, New York, for land in Bedford, Pennsylvania $2,000,000 Converted 12% bonds to 50,000 ordinary shares $ 500,000 Financing Activities Companies do not generally report certain other significant non-cash transactions or other events in conjunction with the statement of cash flows. Examples of these types of transactions are share dividends, share splits, and restrictions on retained earnings. Companies generally report these items, neither financing nor investing activities, in conjunction with the statement of changes in equity or schedules and notes pertaining to changes in equity accounts. Special Disclosures IAS 7 indicates that cash flows related to interest received and paid, and dividends received and paid, should be separately disclosed in the statement of cash flows. IFRS allows flexibility in how these items are classified in the statement of cash flows. However, each item should be classified in a consistent manner from period to period as operating, investing, or financing cash flows. For homework purposes, classify interest received and paid and dividends received as part of cash flows from operating activities and dividends paid as cash flows from financing activities. The justification for reporting the first three items in cash flows from operating activities is that each item affects net income. Dividends paid, however, do not affect net income and are often considered a cost of financing. Companies should also disclose income taxes paid separately in the cash flows from operating activities unless they can be separately identified as part of investing or 1482 Chapter 23 Statement of Cash Flows financing activities. While tax expense may be readily identifiable with investing or financing activities, the related tax cash flows are often impracticable to identify and may arise in a different period from the cash flows of the underlying transaction. There- fore, taxes paid are usually classified as cash flows from operating activities. IFRS requires that the cash paid for taxes, as well as cash flows from interest and dividends received and paid, be disclosed. The category (operating, investing, or financing) that each item was included in must be disclosed as well. An example of such a disclosure from the notes to Daimler’s financial statements is provided in Illustration IFRS23-2. ILLUSTRATION Daimler IFRS23-2 Note Disclosure of Cash provided by operating activities includes the following cash flows: Interest, Taxes, and Dividends (in millions of €) 2012 2011 2010 Interest paid (894) (651) (1,541) Interest received 471 765 977

Income taxes paid, net (358) (898) (1,020) Dividends received 109 67 69 Other companies choose to report these items directly in the statement of cash flows. In many cases, companies start with income before income taxes and then show income taxes paid as a separate item. In addition, they often add back interest expense on an accrual basis and then subtract interest paid. Reporting these items in the operating activities section is shown for Mermel Company in Illustration IFRS23-3. ILLUSTRATION MERMEL COMPANY IFRS23-3 STATEMENT OF CASH FLOWS ($000,000) Reporting of Interest, (OPERATING ACTIVITIES SECTION ONLY) Taxes, and Dividends Income before income tax $ 4,000 in the Operating Section Adjustments to reconcile income before income tax to net cash provided by operating activities: Depreciation expense $1,000 Interest expense 500 Investment revenue (dividends) (650) Decrease in inventories 1,050 Increase in trade receivables (310) 1,590 Cash generated from operations 5,590 Interest paid (300) Income taxes paid (760) (1,060) Net cash provided by operating activities $ 4,530 Companies often provide a separate section to identify interest and income taxes paid. ON THE HORIZON Presently, the IASB and the FASB are involved in a joint project on the presentation and organization of information in the financial statements. With respect to the cash flow statement specifically, the notion of cash equivalents will probably not be retained. The definition of cash in the existing literature would be retained, and the statement of cash flows would present information on changes in cash only. In addition, the IASB and FASB favor presentation of operating cash flows using the direct method only. This approach is generally opposed by the preparer community. IFRS Insights 1483 IFRS SELF-TEST QUESTIONS 1. Which of the following is true regarding the statement of cash flows under IFRS? (a) The statement of cash flows has two major sections—operating and non-operating. (b) The statement of cash flows has two major sections—financing and investing. (c) The statement of cash flows has three major sections—operating, investing, and financing. (d) The statement of cash flows has three major sections—operating, non-operating, and financing. 2. In the case of a bank overdraft: (a) GAAP typically includes the amount in cash and cash equivalents. (b) IFRS typically includes the amount in cash equivalents but not in cash. (c) GAAP typically treats the overdraft as a liability, and reports the amount in the financing sec- tion of the statement of cash flows. (d) IFRS typically treats the overdraft as a liability, and reports the amount in the investing section of the statement of cash flows. 3. Under IFRS, significant non-cash transactions: (a) are classified as operating, if they are related to income items. (b) are excluded from the statement of cash flows and disclosed in a narrative form or summarized in a separate schedule. (c) are classified as an investing or financing activity. (d) are classified as an operating activity, unless they can be specifically identified with financing or investing activities. 4. For purposes of the statement of cash flows, under IFRS interest paid is treated as: (a) an operating activity in all cases. (b) an investing or operating activity, depending on use of the borrowed funds. (c) either a financing or investing activity. (d) either an operating or financing activity, but treated consistently from period to period. 5. For purposes of the statement of cash flows, under IFRS income taxes paid are treated as: (a) cash flows from operating activities unless they can be separately identified as part of investing or financing activities. (b) an operating activity in all cases. (c) an investing or operating activity, depending on whether a refund is received. (d) either operating, financing, or investing activity, but treated consistently to other companies in the same industry. IFRS CONCEPTS AND APPLICATION IFRS23-1 Where can authoritative IFRS related to the statement of cash flows be found?

IFRS23-2 Briefly describe some of the similarities and differences between GAAP and IFRS with respect to cash flow reporting. IFRS23-3 What are some of the key obstacles for the FASB and IASB within their accounting guidance in the area of cash flow reporting? Explain. IFRS23-4 Stan Conner and Mark Stein were discussing the statement of cash flows of Bombeck Co. In the notes to the statement of cash flows was a schedule entitled “Non-cash investing and financing activities.” Give three examples of significant non-cash transactions that would be reported in this schedule. IFRS23-5 Springsteen Co. had the following activity in its most recent year of operations. (a) Pension expense exceeds amount funded. (g) Amortization of intangible assets. (b) Redemption of bonds payable. (h) Purchase of treasury shares. (c) Sale of building at book value. (i) Issuance of bonds for land. (d) Depreciation. (j) Payment of dividends. (e) Exchange of equipment for furniture. (k) Increase in interest receivable on notes receivable. (f) Issuance of ordinary shares. (l) Purchase of equipment. Instructions Classify the items as (1) operating—add to net income, (2) operating—deduct from net income, (3) investing, (4) financing, or (5) significant non-cash investing and financing activities. Use the indirect method. 1484 Chapter 23 Statement of Cash Flows IFRS23-6 Following are selected statement of financial position accounts of Sander Bros. Corp. at D ecember 31, 2014 and 2013, and the increases or decreases in each account from 2013 to 2014. Also pre- sented is selected income statement information for the year ended December 31, 2014, and additional information. Increase Selected statement of fi nancial position accounts 2014 2013 (Decrease) Assets Property, plant, and equipment $277,000 $247,000 $30,000 Accumulated depreciation (178,000) (167,000) (11,000) Accounts receivable 34,000 24,000 10,000 Equity and liabilities Share capital—ordinary, $1 par $ 22,000 $ 19,000 $ 3,000 Share premium—ordinary 9,000 3,000 6,000 Retained earnings 104,000 91,000 13,000 Bonds payable 49,000 46,000 3,000 Dividends payable 8,000 5,000 3,000 Selected income statement information for the year ended December 31, 2014 Sales revenue $155,000 Depreciation 38,000 Gain on sale of equipment 14,500 Net income 31,000 Additional information: 1. During 2014, equipment costing $45,000 was sold for cash. 2. Accounts receivable relate to sales of merchandise. 3. During 2014, $25,000 of bonds payable were issued in exchange for property, plant, and equipment. There was no amortization of bond discount or premium. Instructions Determine the category (operating, investing, or financing) and the amount that should be reported in the statement of cash flows for the following items. (a) Payments for purchase of property, plant, and equipment. (b) Proceeds from the sale of equipment. (c) Cash dividends paid. (d) Redemption of bonds payable. IFRS23-7 Dingel Corporation has contracted with you to prepare a statement of cash flows. The controller has provided the following information. December 31 2014 2013 Buildings $ –0– $29,750 Equipment 45,000 20,000 Patents 5,000 6,250 Investments –0– 3,000 Inventory 12,000 9,000 Accounts receivable 12,250 10,000 Cash 33,500 13,000 $107,750 $91,000 Share capital—ordinary $ 43,000 $33,000 Retained earnings 20,750 6,000 Allowance for doubtful accounts 3,000 4,500 Accumulated depreciation on equipment 2,000 4,500 Accumulated depreciation on buildings –0– 6,000 Accounts payable 5,000 3,000 Dividends payable –0– 5,000 Long-term notes payable 31,000 25,000 Notes payable, short-term (non-trade) 3,000 4,000 $107,750 $91,000 IFRS Insights 1485 Additional data related to 2014 are as follows. 1. Equipment that had cost $11,000 and was 40% depreciated at time of disposal was sold for $2,500. 2. $10,000 of the long-term notes payable was paid by issuing ordinary shares. 3. Cash dividends paid were $5,000. 4. On January 1, 2014, the building was completely destroyed by a flood. Insurance proceeds on the building were $32,000. 5. Equity investments (non-trading) were sold at $1,700 above their cost.

6. Cash was paid for the acquisition of equipment. 7. A long-term note for $16,000 was issued for the acquisition of equipment. 8. Interest of $2,000 and income taxes of $6,500 were paid in cash. Instructions Prepare a statement of cash flows using the indirect method. Professional Research IFRS23-8 As part of the year-end accounting process for your company, you are preparing the statement of cash flows according to IFRS. One of your team, a finance major, believes the statement should be prepared to report the change in working capital because analysts many times use working capital in ratio analysis. Your supervisor would like research conducted to verify the basis for preparing the statement of cash flows. Instructions Access the IFRS authoritative literature at the IASB website (http://eifrs.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 is the primary objective for the statement of cash flows? Is working capital the basis for meet- ing this objective? (b) What information is provided in a statement of cash flows? (c) List some of the typical cash inflows and outflows from operations. International Financial Reporting Problem Marks and Spencer plc IFRS23-9 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) Which method of computing net cash provided by operating activities does M&S use? What were the amounts of net cash provided by operating activities for the years 2011 and 2012? Which two items were most responsible for the increase in net cash provided by operating activities in 2012? (b) What was the most significant item in the cash flows used for investing activities section in 2012? What was the most significant item in the cash flows used for financing activities section in 2012? (c) Where is “deferred income taxes” reported in M&S’s statement of cash flows? Why does it appear in that section of the statement of cash flows? (d) Where is depreciation reported in M&S’s statement of cash flows? Why is depreciation added to net income in the statement of cash flows? ANSWERS TO IFRS SELF-TEST QUESTIONS 1. c 2. c 3. b 4. d 5. a Remember to check the book’s companion website to fi nd additional resources for this chapter. Full Disclosure in Financial Reporting 1 Review the full disclosure principle and describe 5 Identify the major disclosures in the auditor’s implementation problems. report. 2 Explain the use of notes in financial statement 6 Understand management’s responsibilities preparation. for financials. 3 Discuss the disclosure requirements for related- 7 Identify issues related to financial forecasts party transactions, post-balance-sheet events, and projections. and major business segments. 8 Describe the profession’s response to fraudulent 4 Describe the accounting problems associated financial reporting. with interim reporting. High-Quality Financial Reporting—Always in Fashion Here are excerpts from leading experts regarding the importance of high-quality financial reporting: Warren E. Buffett, Chairman and Chief Executive Officer, Berkshire Hathaway Inc.: Financial reporting for Berkshire Hathaway, and for me personally, is the beginning of every decision that we make around here in terms of capital. I’m punching out 10-Ks and 10-Qs every single day. We look at the numbers and try to evaluate the quality of the financial reporting, and then we try to figure out what that means for the bonds and stocks that we’re looking at, and thinking of either buying or selling. Judy Lewent, Executive Vice President and Chief Financial Officer, Merck & Co., Inc.:

Higher standards, when properly implemented, drive excellence. I can make a parallel to the pharmaceutical industry. If you look around the world at where innovations come from, economists have studied and seen that where regulatory standards are the highest is where innovation is also the highest. Floyd Norris, Chief Financial Correspondent, New York Times: We are in a situation now in our society where the temptations to provide “bad” financial reporting are probably greater than they used to be. The need to get the stock price up, or to keep it up, is intense. So, the temptation to play games, the temptation to manage earnings—some of which can be legitimate and some of which cannot be—is probably greater than it used to be. Abby Joseph Cohen, Chair, Investment Policy Committee, Goldman, Sachs & Co.: High-quality financial reporting is perhaps the most important thing we can expect from companies. For investors to make good decisions—whether those investors are buying stocks or bonds or making private investments—they need to know the truth. And we think that when information is as clear as possible and is reported as frequently as makes sense, inves- tors can do their jobs as best they can. We can also get insight into the importance of high-quality reporting based on the market assessment of companies perceived to have poor-quality reporting. In a recent quarter, Coach, Inc. stopped reporting as separate items sales from regular stores (full price) and factory outlets. As a result, readers of its financial statements have a hard time determining the source of Coach’s sales growth. Analysts are especially concerned that the less-transparent reporting may obscure slowing sales at its regular stores, as consumers cut down on luxury goods in the sluggish economy. Did Coach’s stock price suffer as a result of this lower-quality reporting? You bet, as shown in the price graph on the next page. RETPAHC 24 LEARNING OBJECTIVES After studying this chapter, you should be able to: CONCEPTUAL FOCUS > See the Underlying Concepts on pages 1488, Out of Fashion 1490, 1496, 1503, 1514, 1520, 1522, and 1525. > Read the Evolving Issues on pages 1490 DOLLARS and 1507 for discussions on financial disclosure 55 and interim reporting. 50 Coach INTERNATIONAL FOCUS Stock Price 45 40 > See the International Perspectives on pages 1489, 1507, and 1523. 35 > Read the IFRS Insights on 30 pages 1548–1557 for a discussion of: —Differential disclosure 0 MAY ’07 MAY ’08 —Subsequent events Data: Bloomberg Financial Markets. —Interim reports In the year following the change in reporting, Coach’s stock price was down 34 percent. As one analyst noted, “It’s never a good sign when you reduce transparency . . . It’s a sign of weakness.” In short, the analyst’s comments above illustrate why high-quality reporting is always in fashion—for companies, investors, and the capital markets. And, as the Coach example illustrates, full disclosure is at the heart of high-quality reporting. Sources: Excerpts taken from video entitled “Financially Correct with Ben Stein,” Financial Accounting Standards Board (Norwalk, Conn.: FASB, 2002). By permission. See also J. Porter, “As Belts Tighten, Coach Feels the Pinch,” BusinessWeek (May 29, 2008), p. 66. As the opening story indicates, our markets will not function properly PREVIEW OF CHAPTER 24 without transparent, complete, and truthful reporting of financial performance. Investors and other interested parties need to read and understand all aspects of financial reporting—the financial statements, the notes, the president’s letter, and management’s discussion and analysis. In this chapter, we cover the full disclosure principle in more detail and examine disclosures that must accompany financial statements so that they are not misleading. The content and organization of this chapter are as follows. Full Disclosure in Financial Reporting Full Disclosure Notes to Financial Auditor’s and Current Reporting Disclosure Issues Principle Statements Management’s Reports Issues • Increase in reporting • Accounting policies • Special transactions • Auditor’s report • Reporting on

requirements • Common notes or events • Management’s forecasts and • Differential • Post-balance-sheet reports projections disclosure events • Internet financial • Diversified reporting companies • Fraudulent financial • Interim reports reporting • Criteria for accounting and reporting choices 1487 1488 Chapter 24 Full Disclosure in Financial Reporting FULL DISCLOSURE PRINCIPLE According to the FASB Conceptual Framework, some useful information is best LEARNING OBJECTIVE 1 provided in the financial statements, and some is best provided by means other than Review the full disclosure principle and in financial statements. For example, earnings and cash flows are readily available describe implementation problems. in financial statements—but investors might do better to look at comparisons to other companies in the same industry, found in news articles or brokerage house reports. FASB rules directly affect financial statements, notes to the financial statements, and supplementary information. Other types of information found in the annual report, such as management’s discussion and analysis, are not subject to FASB rules. Illustra- tion 24-1 indicates the various types of financial information. All Information Useful for Investment, Credit, and Similar Decisions Financial Reporting Area Directly Affected by Existing FASB Rules Basic Financial Statements Notes to the Other Means of Financial Supplementary Other Financial Financial Statements Information Information Statements Reporting • Balance Sheet Examples: Examples: Examples: Examples: • Statement of • Accounting • Changing Prices • Management’s • Discussion of Comprehensive Policies Disclosures Discussion and Competition and Income • Contingencies • Oil and Gas Analysis Order Backlog in SEC Forms • Statement of • Inventory Reserves • Letters to Information Stockholders • Analysts' Reports Cash Flows Methods • Economic • Statement of • Number of Statistics Changes in Shares of Stock Stockholders' Outstanding • News Articles about Company Equity • Alternative Measures (fair values of items carried at historical cost) ILLUSTRATION 24-1 As Chapter 2 indicated, the profession has adopted a full disclosure principle. The Types of Financial Information full disclosure principle calls for financial reporting of any financial facts significant enough to influence the judgment of an informed reader. In some situations, the benefits of disclosure may be apparent but the costs uncertain. In other instances, the costs may be certain but the benefits of disclosure not as apparent. For example, the SEC required companies to provide expanded disclosures Underlying Concepts about their contractual obligations. In light of the off-balance-sheet accounting Here is a good example of the frauds at companies like Enron, the benefits of these expanded disclosures seem trade-off between cost fairly obvious to the investing public. While no one has documented the exact considerations and the benefi ts costs of disclosure in these situations, they would appear to be relatively small. of full disclosure. On the other hand, the cost of disclosure can be substantial in some cases and the benefits difficult to assess. For example, at one time the Wall Street Journal reported that if segment reporting were adopted, a company like Fruehauf would have had to increase its accounting staff 50 percent, from 300 to 450 individuals. In this case, the cost of disclosure can be measured, but the benefits are less well defined. Some even argue that the reporting requirements are so detailed and substantial that users have a difficult time absorbing the information. These critics charge the pro- fession with engaging in information overload. Full Disclosure Principle 1489 Financial disasters at Microstrategy, PharMor, WorldCom, and Lehman highlight the difficulty of implementing the full disclosure principle. They raise the issue of why investors were not aware of potential problems. Was the information these companies presented not comprehensible? Was it buried? Was it too technical? Was it properly

presented and fully disclosed as of the financial statement date, but the situation later deteriorated? Or was it simply not there? In the following sections, we describe the elements of high-quality disclosure that will enable companies to avoid these disclosure pitfalls. Increase in Reporting Requirements Disclosure requirements have increased substantially. One survey showed that the size of many companies’ annual reports is growing in response to demands for increased transparency. For example, annual report page counts ranged from 70 pages for Gateway up to a whopping 244 pages in Eastman Kodak’s annual report. And annual report lengths continue to grow in the post-Sarbanes-Oxley environment, with the number of companies producing reports over 100 pages increasing from 19 percent to 37 percent—almost double.1 This result is not surprising. As illustrated throughout this textbook, the FASB has issued many pronouncements in recent years that have substantial disclosure provisions. The reasons for this increase in disclosure requirements are varied. Some of them are: • Complexity of the business environment. The increasing complexity of business operations magnifies the difficulty of distilling economic events into summarized reports. Such areas as derivatives, leasing, business combinations, pensions, fi- nancing arrangements, revenue recognition, and deferred taxes are complex. As a result, companies extensively use notes to the financial statements to explain these transactions and their future effects. • Necessity for timely information. Today, more than ever before, users are demand- ing information that is current and predictive. For example, users want more com- plete interim data. Also, the SEC recommends published financial forecasts, long avoided and even feared by management. • Accounting as a control and monitoring device. The government has recently sought public disclosure of such phenomena as management compensation, off-balance- sheet financing arrangements, and related-party transactions. An “Enronitis” con- cern is expressed in many of these newer disclosure requirements, and the SEC has selected accountants and auditors as the agents to assist in controlling and monitor- ing these concerns. Differential Disclosure A trend toward differential disclosure is also occurring. For example, the SEC International requires that companies report to it certain substantive information that is not Perspective found in annual reports to stockholders. Likewise, the FASB, recognizing that IFRS allows different accounting certain disclosure requirements are costly and unnecessary for certain compa- rules for small- and medium-sized nies, has eliminated reporting requirements for nonpublic enterprises in such entities. areas as fair value of financial instruments and segment reporting. 1MWW Group, MWW White Paper: Annual Report (Winter 2012). See also Final Report of the Advisory Committee on Improvements to Financial Reporting to the United States Securities and Exchange Commission (August 1, 2008) for discussion of the need to address the growing volume and complexity of the financial reports and disclosures. 1490 Chapter 24 Full Disclosure in Financial Reporting Some still complain that the FASB has not gone far enough. They note that Underlying Concepts certain types of companies (small or nonpublic) should not have to follow Surveys indicate that users complex GAAP requirements such as those for deferred income taxes, leases, differ in their needs for or pensions. This issue, often referred to as “big GAAP versus little GAAP,” information and that not all continues to be controversial.2 companies should report all The FASB has traditionally taken the position that there should be one set of elements of information. Thus, GAAP. However, due to the growing concern about differential costs and some contend that companies benefits of a “one size fits all” reporting package, the FASB is working with an should report only information advisory committee to explore ways that its standards can be more cost-effective

that users and preparers agree for all companies, regardless of size. The Board is studying such areas as fair is needed in the particular value measurement disclosures, and the accounting for consolidations, finan- circumstances. cial instruments, presentation of comprehensive income, and leases. In addi- tion, the FASB has initiated a project to develop a framework, including a set of decision criteria, for determining whether and when to adjust the requirements for recognition, measurement, presentation, disclosure, effective dates, and transition methods for financial accounting standards that apply to private companies.3 Evolving Issue DISCLOSURE—QUANTITY AND QUALITY There is no better illustration of the adage that both quality significantly change these amounts over time. This would and quantity are important than the issue of financial dis- encompass transactions recognized and measured in the closure. While the full disclosure principle holds that more is financial statements, as well as events and uncertainties that better, how much more and of what form? An evaluation of are not recorded. this issue requires careful analysis of costs and benefits. Fur- The FASB (and IASB) have responded to this recommen- thermore, as noted by one FASB member, the usefulness of dation by initiating a project with the objective and primary expanded required disclosure also depends on users’ ability focus of improving the effectiveness of disclosures in notes to to distinguish between the form of reporting (i.e., disclosed financial statements by clearly communicating the informa- versus recognized items in financial statements). Research to tion that is most important to users of each company’s financial date is inconclusive on this matter. So it is not just the amount statements. Achieving the objective of improving effective- but the quality. ness will require development of a framework that pro- Indeed, the SEC Committee on Improvement in Financial motes consistent decisions about disclosure requirements by Reporting recommended the development of a disclosure standard-setters and the appropriate exercise of discretion by framework that integrates existing SEC and FASB disclosure reporting companies. The FASB has issued an invitation to requirements into a cohesive whole to ensure meaningful comment, seeking input on whether and, if so, how to pro- communication and logical presentation of disclosures, vide guidance to improve the organization, formatting, and based on consistent objectives and principles. This would style of notes to financial statements. The FASB notes that eliminate redundancies and provide a single source of dis- while reducing the volume of the notes to financial state- closure guidance across all financial reporting standards. ments is not the primary focus, the Board hopes that a sharper Adopting such a framework should lead to disclosure of the focus on important information will result in reduced volume principal assumptions, estimates, and sensitivity analyses in most cases. That is, get the quantity as well as the quality that may impact a company’s business, as well as a qualita- of disclosure right. tive discussion of the key risks and uncertainties that could Sources: K. Schipper, “Required Disclosures in Financial Reports,” Presidential Address to the American Accounting Association Annual Meeting (San Francisco, Calif., August 2005); Final Report of the Advisory Committee on Improvements to Financial Reporting to the United States Securities and Exchange Commission (August 1, 2008); and FASB, Invitation to Comment: Disclosure Framework (July 12, 2012). 2In response to cost-benefit concerns, the SEC has exempted some small public companies from certain rules implemented in response to the Sarbanes-Oxley Act. For example, smaller compa- nies have more time to comply with the internal control rules required by the Sarbanes-Oxley law and have more time to file annual and interim reports. 3See “Private Company Decision-Making Framework: A Framework for Evaluating Financial

Accounting and Reporting Guidance for Private Companies,” FASB Invitation to Comment (July 31, 2012). Notes to the Financial Statements 1491 NOTES TO THE FINANCIAL STATEMENTS As you know from your study of this textbook, notes are an integral part of the 2 LEARNING OBJECTIVE financial statements of a business enterprise. However, readers of financial state- Explain the use of notes in financial ments often overlook them because they are highly technical and often appear in statement preparation. small print. Notes are the means of amplifying or explaining the items presented in the main body of the statements. They can explain in qualitative terms information pertinent to specific financial statement items. In addition, they can provide supplemen- tary data of a quantitative nature to expand the information in the financial statements. Notes also can explain restrictions imposed by financial arrangements or basic contrac- tual agreements. Although notes may be technical and difficult to understand, they provide meaningful information for the user of the financial statements. Accounting Policies Accounting policies are the specific accounting principles and methods a company currently uses and considers most appropriate to present fairly its financial statements. GAAP states that information about the accounting policies adopted by a reporting entity is essential for financial statement users in making economic decisions. It recommends that companies should present as an integral part of the financial statements a statement identifying the accounting policies adopted and followed by the reporting entity. Com- panies should present the disclosure as the first note or in a separate Summary of Signifi- cant Accounting Policies section preceding the notes to the financial statements. The Summary of Significant Accounting Policies answers such questions as: What method of depreciation is used on plant assets? What valuation method is employed on inventories? What amortization policy is followed in regard to intangible assets? How are marketing costs handled for financial reporting purposes? Refer to the financial statements and notes to the financial statements for The Procter & Gamble Company (available at the book’s companion website, www.wiley. com/college/kieso) for an illustration of note disclosure of accounting policies (Note 1) and other notes accompanying the audited financial statements. Analysts examine carefully the summary of accounting policies to determine whether a company is using conservative or liberal accounting practices. For example, depreciat- ing plant assets over an unusually long period of time is considered liberal. Using LIFO inventory valuation in a period of inflation is generally viewed as conservative. Companies that fail to adopt high-quality reporting policies may be heavily penalized by the market. For example, when Microstrategy disclosed that it would restate prior- year results due to use of aggressive revenue recognition policies, its share price dropped over 60 percent in one day. Investors viewed Microstrategy’s quality of earnings as low. Common Notes We have discussed many of the notes to the financial statements throughout this text- book, and will discuss others more fully in this chapter. The more common are as follows. MAJOR DISCLOSURES INVENTORY. Companies should report the basis upon which inventory amounts are stated (lower-of-cost-or-market) and the method used in determining cost (LIFO, FIFO, average-cost, etc.). Manufacturers should report, either in the balance sheet or in a separate schedule in the notes, the inventory composition (fi nished goods, work in process, raw materials). Unusual or signifi cant fi nancing arrangements relating to inventories that may 1492 Chapter 24 Full Disclosure in Financial Reporting require disclosure include transactions with related parties, product fi nancing arrange- ments, fi rm purchase commitments, involuntary liquidation of LIFO inventories, and pledging of inventories as collateral. Chapter 9 (pages 494–495) illustrates these disclosures.

PROPERTY, PLANT, AND EQUIPMENT. Companies should state the basis of valuation for property, plant, and equipment. It is usually historical cost. Companies also should dis- close pledges, liens, and other commitments related to these assets. In the presentation of depreciation, companies should disclose the following in the fi nancial statements or in the notes: (1) depreciation expense for the period; (2) balances of major classes of depreciable assets, by nature and function, at the balance sheet date; (3) accumulated depreciation, either by major classes of depreciable assets or in total, at the balance sheet date; and (4) a general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets. Finally, companies should explain any major impairments. Chapter 11 (pages 609–611) illustrates property, plant, and equipment. CREDITOR CLAIMS. Investors normally fi nd it extremely useful to understand the nature and cost of creditor claims. However, the liabilities section in the balance sheet can provide the major types of liabilities only in the aggregate. Note schedules regarding such obligations provide additional information about how a company is fi nancing its opera- tions, the costs that it will bear in future periods, and the timing of future cash outfl ows. Financial statements must disclose for each of the fi ve years following the date of the state- ments the aggregate amount of maturities and sinking fund requirements for all long-term borrowings. Chapter 14 (pages 785–787) illustrates these disclosures. EQUITYHOLDERS’ CLAIMS. Many companies present in the body of the balance sheet information about equity securities: the number of shares authorized, issued, and outstand- ing and the par value for each type of security. Or, companies may present such data in a note. Beyond that, a common equity note disclosure relates to contracts and senior securi- ties outstanding that might affect the various claims of the residual equityholders. An example would be the existence of outstanding stock options, outstanding convertible debt, redeemable preferred stock, and convertible preferred stock. In addition, it is necessary to disclose certain types of restrictions currently in force. Generally, these types of restrictions involve the amount of earnings available for dividend distribution. Examples of these types of disclosures are illustrated in Chapter 15 (pages 847–848) and Chapter 16 (pages 909–910). CONTINGENCIES AND COMMITMENTS. A company may have gain or loss contin- gencies that are not disclosed in the body of the fi nancial statements. These contingencies include litigation, debt and other guarantees, possible tax assessments, renegotiation of government contracts, and sales of receivables with recourse. In addition, companies should disclose in the notes commitments that relate to dividend restrictions, purchase agreements (through-put and take-or-pay), hedge contracts, and employment contracts. Disclosures of such items are illustrated in Chapter 7 (page 372), Chapter 9 (page 483), and Chapter 13 (pages 728–729). FAIR VALUES. Companies that have assets or liabilities measured at fair value must dis- close both the cost and the fair value of all fi nancial instruments in the notes to the fi nancial statements. Fair value measurements may be used for many fi nancial assets and liabilities, investments, impairments of long-lived assets, and some contingencies. Companies also provide disclosure of information that enables users to determine the extent of usage of fair value and the inputs used to implement fair value measurement. This fair value hierarchy identifi es three broad levels related to the measurement of fair values (Levels 1, 2, and 3). The levels indicate the reliability of the measurement of fair value information. Appendix 17C (pages 999–1003) discusses in detail fair value disclosures. Disclosure Issues 1493 DEFERRED TAXES, PENSIONS, AND LEASES. The FASB also requires extensive dis- closure in the areas of deferred taxes, pensions, and leases. Chapter 19 (pages 1138–1144),

Chapter 20 (pages 1204–1215), and Chapter 21 (pages 1300–1302) discuss in detail each of these disclosures. Users of fi nancial statements should carefully read notes to the fi nancial statements for information about off-balance-sheet commitments, future fi nancing needs, and the quality of a company’s earnings. CHANGES IN ACCOUNTING PRINCIPLES. The profession defi nes various types of accounting changes and establishes guides for reporting each type. Companies discuss, either in the summary of signifi cant accounting policies or in the other notes, changes in accounting principles (as well as material changes in estimates and corrections of errors). See Chapter 22 (pages 1363–1364). In earlier chapters, we discussed the disclosures listed above. The following sections of this chapter illustrate four additional disclosures of significance—special transactions or events, subsequent events, segment reporting, and interim reporting. What do the numbers mean? FOOTNOTE SECRETS Often, note disclosures are needed to give a complete picture How can you get better informed about note disclosures of a company’s fi nancial position. A good example of such that may contain important information related to your disclosures is the required disclosure of debt triggers that investments? Beyond your study in this class, a good Web may be buried in fi nancing arrangements. These triggers can resource for understanding the contents of note disclosures require a company to pay off a loan immediately if the debt is http://www.footnoted.org/. This site highlights “the things rating collapses; they are one of the reasons Enron crumbled companies bury in their SEC fi lings.” It notes that company so quickly. But few Enron stockholders knew about the debt reports are more complete of late, but only the largest compa- triggers until the gun had gone off. Companies are also dis- nies are preparing documents that are readable. As the editor closing more about their bank credit lines, liquidity, and any of the site noted, “[some companies] are being dragged kick- special-purpose entities. (The latter were major villains in the ing and screaming into plain English.” Enron drama.) Sources: Gretchen Morgenson, “Annual Reports: More Pages, but Better?” The New York Times (March 17, 2002); and D. Stead, “The Secrets in SEC Filings,” BusinessWeek (August 25, 2008), p. 12. DISCLOSURE ISSUES Disclosure of Special Transactions or Events Related-party transactions, errors and fraud, and illegal acts pose especially sensi- 3 LEARNING OBJECTIVE tive and difficult problems. The accountant/auditor who has responsibility for Discuss the disclosure requirements reporting on these types of transactions must take care to properly balance the for related-party transactions, post- rights of the reporting company and the needs of users of the financial statements. balance-sheet events, and major Related-party transactions arise when a company engages in transactions in business segments. which one of the parties has the ability to significantly influence the policies of the other. They may also occur when a nontransacting party has the ability to influence the policies of the two transacting parties.4 Competitive, free-market dealings may not exist 4Examples of related-party transactions include transactions between (a) a parent company and its subsidiaries; (b) subsidiaries of a common parent; (c) a company and trusts for the benefit of employees (controlled or managed by the enterprise); and (d) a company and its principal owners, management, or members of immediate families, and affiliates. Two classic cases of related-party transactions were Enron, with its misuse of special-purpose entities, and Tyco International, which forgave loans to its management team. 1494 Chapter 24 Full Disclosure in Financial Reporting in related-party transactions, and so an “arm’s-length” basis cannot be assumed. Trans- actions such as borrowing or lending money at abnormally low or high interest rates, real estate sales at amounts that differ significantly from appraised value, exchanges of

nonmonetary assets, and transactions involving enterprises that have no economic sub- stance (“shell corporations”) suggest that related parties may be involved. See the FASB In order to make adequate disclosure, companies should report the economic sub- Codification section stance, rather than the legal form, of these transactions. GAAP requires the following (page 1530). disclosures of material related-party transactions. [1] 1. The nature of the relationship(s) involved. 2. A description of the transactions (including transactions to which no amounts or nominal amounts were ascribed) for each of the periods for which income state- ments are presented. 3. The dollar amounts of transactions for each of the periods for which income state- ments are presented. 4. Amounts due from or to related parties as of the date of each balance sheet presented. Illustration 24-2, from the annual report of Harley-Davidson, Inc., shows disclosure of related-party transactions. ILLUSTRATION 24-2 Harley-Davidson, Inc. Disclosure of Related- Party Transactions 22. Related Party Transactions The Company has the following material related party transactions. A director of the Company is Chairman and Chief Executive Officer and an equity owner of Fred Deeley Imports Ltd. (Deeley Imports), the exclusive distributor of the Company’s motorcycles in Canada. The Company recorded motorcycles and related products revenue and financial services revenue from Deeley Imports during 2011, 2010 and 2009 of $155.2 million, $158.7 million and $177.2 million, respectively, and had finance receivables balances due from Deeley Imports of $14.5 million, $21.0 million and $13.9 million at December 31, 2011, 2010 and 2009, respectively. All such products were provided in the ordinary course of business at prices and on terms and conditions that the Company believes are the same as those that would result from arm’s- length negotiations between unrelated parties. Many companies are involved in related-party transactions. Errors, fraud (some- times referred to as irregularities), and illegal acts, however, are the exception rather than the rule. Accounting errors are unintentional mistakes, whereas fraud (misappro- priation of assets and fraudulent financial reporting) involves intentional distortions of financial statements.5 As indicated earlier, companies should correct the financial state- ments when they discover errors. The same treatment should be given fraud. The dis- covery of fraud, however, gives rise to a different set of procedures and responsibilities for the accountant/auditor.6 Illegal acts encompass such items as illegal political contributions, bribes, kickbacks, and other violations of laws and regulations.7 In these situations, the accountant/auditor 5“Consideration of Fraud in a Financial Statement Audit,” Statement on Auditing Standards No. 99 (New York: AICPA, 2002). We have an expanded discussion of fraudulent financial reporting later in this chapter. Since passage of the Sarbanes-Oxley Act, auditors of public companies are regulated by the Public Company Accounting Oversight Board (PCAOB). The PCAOB is now the audit standard-setter for auditors of public companies. It has adopted much of the prior auditing standards issued by the Auditing Standards Board of the AICPA. 6The profession became so concerned with certain management frauds that affect financial statements that it established a National Commission on Fraudulent Financial Reporting. The major purpose of this organization was to determine how fraudulent reporting practices could be constrained. Fraudulent financial reporting is discussed later in this chapter. 7“Illegal Acts by Clients,” Statement on Auditing Standards No. 54 (New York: AICPA, 1988). Disclosure Issues 1495 must evaluate the adequacy of disclosure in the financial statements. For example, if a company derives revenue from an illegal act that is considered material in relation to the financial statements, this information should be disclosed. The Sarbanes-Oxley Act is intended to deter these illegal acts. This law adds significant fines and longer jail time

for those who improperly sign off on the correctness of financial statements that include willing and knowing misstatements. Disclosure plays a very important role in these types of transactions because the events are more qualitative than quantitative and involve more subjective than objective evaluation. Users of the financial statements need some indication of the existence and nature of these transactions, through disclosures, modifications in the auditor’s report, or reports of changes in auditors. Post-Balance-Sheet Events (Subsequent Events) Notes to the financial statements should explain any significant financial events that took place after the formal balance sheet date, but before the statement is issued. These events are referred to as post-balance-sheet events, or just plain subsequent events. Illustration 24-3 shows a time diagram of the subsequent events period. ILLUSTRATION 24-3 Time Periods for Balance Financial Subsequent Events Sheet Statements Date Issue Date Financial Statement Period Subsequent Events Period Jan. 1, Dec. 31, Mar. 3, 2014 2014 2015 A period of several weeks, and sometimes months, may elapse after the end of the fiscal year but before the company issues financial statements. Various activities involved in closing the books for the period and issuing the statements all take time: taking and pricing the inventory, reconciling subsidiary ledgers with controlling accounts, preparing necessary adjusting entries, ensuring that all transactions for the period have been entered, obtaining an audit of the financial statements by independent certified public accountants, and printing the annual report. During the period between the balance sheet date and its distribution to stockholders and creditors, important transactions or other events may occur that materially affect the company’s financial position or operating situation. Many who read a balance sheet believe the balance sheet condition is constant, and they project it into the future. However, readers must be told if the company has expe- rienced a significant change—e.g., sold one of its plants, acquired a subsidiary, suffered extraordinary losses, settled significant litigation, or experienced any other important event in the post-balance-sheet period. Without an explanation in a note, the reader might be misled and draw inappropriate conclusions. Two types of events or transactions occurring after the balance sheet date may have a material effect on the financial statements or may need disclosure so that readers in- terpret these statements accurately: 1. Events that provide additional evidence about conditions that existed at the balance sheet date, including the estimates inherent in the process of preparing fi nancial statements. These events are referred to as recognized subsequent events and 1496 Chapter 24 Full Disclosure in Financial Reporting require adjustments to the fi nancial statements. All information available prior to the issuance of the fi nancial statements helps investors and creditors evaluate estimates previously made. To ignore these subsequent events is to pass up an opportunity to improve the accuracy of the fi nancial statements. This fi rst type of event encompasses information that an accountant would have recorded in the accounts had the information been known at the balance sheet date. For example, if a loss on an account receivable results from a customer’s bank- ruptcy subsequent to the balance sheet date, the company adjusts the fi nancial statements before their issuance. The bankruptcy stems from the customer’s poor fi nancial health existing at the balance sheet date. The same criterion applies to settlements of litigation. The company must adjust the fi nancial statements if the events that gave rise to the litigation, such as personal injury or patent infringement, took place prior to the balance sheet date. 2. Events that provide evidence about conditions that did not exist at the balance sheet date but arise subsequent to that date. These events are referred as nonrecog-

nized subsequent events and do not require adjustment of the fi nancial statements. To illustrate, a loss resulting from a customer’s fi re or fl ood after the balance sheet date does not refl ect conditions existing at that date. Thus, adjustment of the fi nan- cial statements is not necessary. A company should not recognize subsequent events that provide evidence about conditions that did not exist at the date of the balance sheet but that arose after the balance sheet date. The following are examples of nonrecognized subsequent events: (a) Sale of a bond or capital stock issued after the balance sheet date. Underlying Concepts (b) A business combination that occurs after the balance sheet date. A company also should consider (c) Settlement of litigation when the event giving rise to the claim took place supplementing the historical after the balance sheet date. fi nancial statements with pro (d) Loss of plant or inventories as a result of fire or natural disaster that forma fi nancial data. Occasionally, occurred after the balance sheet date. a nonrecognized subsequent (e) L osses on receivables resulting from conditions (such as a customer’s major event may be so signifi cant that casualty) arising after the balance sheet date. disclosure can best be made by (f) Changes in the quoted market prices of securities or foreign exchange rates means of pro forma fi nancial after the balance sheet date. data. (g) E ntering into sign fiicant commitments or contingent liabilities, for example, by issuing signifi cant guarantees after the balance sheet date. [2]8 Some nonrecognized subsequent events may have to be disclosed to keep the finan- cial statements from being misleading. For such events, a company discloses the nature of the event and an estimate of its financial effect. Illustration 24-4 presents an example of subsequent events disclosure, excerpted from the annual report of Commercial Metals Company. Many subsequent events or developments do not require adjustment of or disclo- sure in the financial statements. Typically, these are nonaccounting events or conditions 8The effects from natural disasters, like hurricanes Katrina, Rita, and Sandy, which occurred after the year-end for companies with August fiscal years, require disclosure in order to keep the statements from being misleading. Some companies may have to consider whether these disasters affect their ability to continue as going concerns. Accounting Trends and Techniques—2012 listed the following types of subsequent events and their frequency of occurrence among the 500 companies surveyed: acquisitions, 32; debt incurred, reduced, or refinanced, 31; business combinations pending or effected, 29; capital stock issued or purchased, 18; discontinued operations or asset disposals, 15; litigation, 14; and restructuring/bankruptcy, 13. Disclosure Issues 1497 ILLUSTRATION 24-4 Commercial Metals Company Disclosure of Subsequent NOTE 22. SUBSEQUENT EVENTS (August 31 Fiscal Year End) Events On October 7, 2011, The Company announced its decision to exit the business in CMCS by way of sale and/or closure. During 2011, the Company made operational improvements in the business but not to a level which would restore profitability for the long run. Additionally, delayed entry in the European Union, cyclical demand for tubular products, unsustainable losses and increased demand for capital resources resulted in the decision to exit the business. The operation will service any existing customer commitments and the Company expects to wind down operations and liquidate inventory over the next several months. In connection with this decision, the Company expects to incur severance and other closure costs between $25 million and $40 million in fiscal 2012. that management normally communicates by other means. These events include legisla- tion, product changes, management changes, strikes, unionization, marketing agreements, and loss of important customers. Reporting for Diversifi ed (Conglomerate) Companies In certain business climates, companies have a tendency to diversify their operations.

Take the case of conglomerate General Electric (GE), whose products include locomotives and jet engines, credit card services, and water purification systems. Or, consider cable giant Comcast; its NBC Universal subsidiary owns NBC TV, Telemundo, Universal Pictures, and Universal Parks and Resorts. When businesses are so diversified, investors and investment analysts want more information about the details behind conglomerate financial statements. Particularly, they want income statement, balance sheet, and cash flow information on the individual segments that compose the total income figure. Illustration 24-5 shows segmented (disaggregated) financial information of an office equipment and auto parts company. ILLUSTRATION 24-5 OFFICE EQUIPMENT AND AUTO PARTS COMPANY Segmented Income INCOME STATEMENT DATA Statement (IN MILLIONS) Office Auto Consolidated Equipment Parts Net sales $78.8 $18.0 $60.8 Manufacturing costs Inventories, beginning 12.3 4.0 8.3 Materials and services 38.9 10.8 28.1 Wages 12.9 3.8 9.1 Inventories, ending (13.3) (3.9) (9.4) 50.8 14.7 36.1 Selling and administrative expenses 12.1 1.6 10.5 Total operating expenses 62.9 16.3 46.6 Income before taxes 15.9 1.7 14.2 Income taxes (9.3) (1.0) (8.3) Net income $ 6.6 $ 0.7 $ 5.9 Much information is hidden in the aggregated totals. If the analyst has only the consolidated figures, he/she cannot tell the extent to which the differing product lines contribute to the company’s profitability, risk, and growth potential. For example, in Illustration 24-5, the office equipment segment looks like a risky venture. Segmented reporting would provide useful information about the two business segments and 1498 Chapter 24 Full Disclosure in Financial Reporting would be useful for making an informed investment decision regarding the whole company. In addition to the example of Coach, Inc. in the opening story, a classic situation that demonstrates the need for segmented data involved Caterpillar, Inc. The SEC cited Caterpillar because it failed to tell investors that nearly a quarter of its income in one year came from a Brazilian unit and was nonrecurring in nature. The company knew that different economic policies in the next year would probably greatly affect earnings of the Brazilian unit. But Caterpillar presented its financial results on a consolidated basis, not disclosing the Brazilian operations. The SEC found that Caterpillar’s failure to include information about Brazil left investors with an incomplete picture of the company’s financial results and denied investors the opportunity to see the company “through the eyes of management.” Companies have always been somewhat hesitant to disclose segmented data for various reasons: 1. Without a thorough knowledge of the business and an understanding of such important factors as the competitive environment and capital investment require- ments, the investor may fi nd the segmented information meaningless or may even draw improper conclusions about the reported earnings of the segments. 2. Additional disclosure may be helpful to competitors, labor unions, suppliers, and certain government regulatory agencies, and thus harm the reporting company. 3. Additional disclosure may discourage management from taking intelligent busi- ness risks because segments reporting losses or unsatisfactory earnings may cause stockholder dissatisfaction with management. 4. The wide variation among companies in the choice of segments, cost allocation, and other accounting problems limits the usefulness of segmented information. 5. The investor is investing in the company as a whole and not in the particular seg- ments, and it should not matter how any single segment is performing if the overall performance is satisfactory. 6. Certain technical problems, such as classifi cation of segments and allocation of seg- ment revenues and costs (especially “common costs”), are formidable. On the other hand, the advocates of segmented disclosures offer these reasons in support of the practice: 1. Investors need segmented information to make an intelligent investment decision

regarding a diversifi ed company. (a) Sales and earnings of individual segments enable investors to evaluate the dif- ferences between segments in growth rate, risk, and profi tability, and to forecast consolidated profi ts. (b) Segmented reports help investors evaluate the company’s investment worth by disclosing the nature of a company’s businesses and the relative size of the components. 2. The absence of segmented reporting by a diversifi ed company may put its unseg- mented, single product-line competitors at a competitive disadvantage because the conglomerate may obscure information that its competitors must disclose. The advocates of segmented disclosures appear to have a much stronger case. Many users indicate that segmented data are the most useful financial information provided, aside from the basic financial statements. As a result, the FASB has issued extensive reporting guidelines in this area. Disclosure Issues 1499 Objective of Reporting Segmented Information The objective of reporting segmented financial data is to provide information about the different types of business activities in which an enterprise engages and the different economic environments in which it operates. Meeting this objective will help users of financial statements do the following. (a) Better understand the enterprise’s performance. (b) Better assess its prospects for future net cash flows. (c) Make more informed judgments about the enterprise as a whole. Basic Principles Financial statements can be disaggregated in several ways. For example, they can be disaggregated by products or services, by geography, by legal entity, or by type of cus- tomer. However, it is not feasible to provide all of that information in every set of finan- cial statements. GAAP requires that general-purpose financial statements include selected information on a single basis of segmentation. Thus, a company can meet the segmented reporting objective by providing financial statements segmented based on how the company’s operations are managed. The method chosen is referred to as the management approach. [3] The management approach reflects how management segments the company for making operating decisions. The segments are evident from the components of the company’s organization structure. These components are called operating segments. Identifying Operating Segments An operating segment is a component of an enterprise: (a) That engages in business activities from which it earns revenues and incurs expenses. (b) Whose operating results are regularly reviewed by the company’s chief operating decision-maker to assess segment performance and allocate resources to the segment. (c) For which discrete financial information is available that is generated by or based on the internal financial reporting system. Companies may aggregate information about two or more operating segments only if the segments have the same basic characteristics in each of the following areas. (a) The nature of the products and services provided. (b) The nature of the production process. (c) The type or class of customer. (d) The methods of product or service distribution. (e) If applicable, the nature of the regulatory environment. After the company decides on the possible segments for disclosure, it makes a quan- titative materiality test. This test determines whether the segment is significant enough to warrant actual disclosure. An operating segment is deemed significant, and therefore a reportable segment, if it satisfies one or more of the following quantitative thresholds. 1. Its revenue (including both sales to external customers and intersegment sales or transfers) is 10 percent or more of the combined revenue of all the company’s oper- ating segments. 2. The absolute amount of its profi t or loss is 10 percent or more of the greater, in absolute amount, of (a) the combined operating profi t of all operating segments that 1500 Chapter 24 Full Disclosure in Financial Reporting did not incur a loss, or (b) the combined loss of all operating segments that did

report a loss. 3. Its identifi able assets are 10 percent or more of the combined assets of all operating segments. In applying these tests, the company must consider two additional factors. First, segment data must explain a significant portion of the company’s business. Specifi- cally, the segmented results must equal or exceed 75 percent of the combined sales to unaffiliated customers for the entire company. This test prevents a company from providing limited information on only a few segments and lumping all the rest into one category. Second, the profession recognizes that reporting too many segments may over- whelm users with detailed information. The FASB decided that 10 is a reasonable upper limit for the number of segments that a company must disclose. To illustrate these requirements, assume a company has identified six possible reporting segments, as shown in Illustration 24-6 (000s omitted). ILLUSTRATION 24-6 Total Revenue Operating Identifiable Data for Different Segments (Unaffiliated) Profit (Loss) Assets Possible Reporting A $ 100 $10 $ 60 Segments B 50 2 30 C 700 40 390 D 300 20 160 E 900 18 280 F 100 (5) 50 $2,150 $85 $970 The company would apply the respective tests as follows. Revenue test: 10% 3 $2,150 5 $215; C, D, and E meet this test. Operating profit (loss) test: 10% 3 $90 5 $9 (note that the $5 loss is ignored because the test is based on non-loss segments); A, C, D, and E meet this test. Identifiable assets tests: 10% 3 $970 5 $97; C, D, and E meet this test. The reporting segments are therefore A, C, D, and E, assuming that these four seg- ments have enough sales to meet the 75 percent of combined sales test. The 75 percent test is computed as follows. 75% of combined sales test: 75% 3 $2,150 5 $1,612.50. The sales of A, C, D, and E total $2,000 ($100 1 $700 1 $300 1 $900); therefore, the 75 percent test is met. Measurement Principles The accounting principles that companies use for segment disclosure need not be the same as the principles they use to prepare the consolidated statements. This flexibility may at first appear inconsistent. But, preparing segment information in accordance with generally accepted accounting principles would be difficult because some principles are not expected to apply at a segment level. Examples are accounting for the cost of company- wide employee benefit plans, accounting for income taxes in a company that files a consolidated tax return, and accounting for inventory on a LIFO basis if the pool includes items in more than one segment. The FASB does not require allocations of joint, common, or company-wide costs solely for external reporting purposes. Common costs are those incurred for the benefit of more than one segment and whose interrelated nature prevents a completely objective Disclosure Issues 1501 division of costs among segments. For example, the company president’s salary is difficult to allocate to various segments. Allocations of common costs are inherently arbitrary and may not be meaningful. There is a presumption that if companies allocate common costs to segments, these allocations are either directly attributable or reasonably allocable. Segmented Information Reported The FASB requires that an enterprise report the following. 1. General information about its operating segments. This includes factors that man- agement considers most signifi cant in determining the company’s operating seg- ments, and the types of products and services from which each operating segment derives its revenues. 2. Segment profi t and loss and related information. Specifi cally, companies must re- port the following information about each operating segment if the amounts are included in determining segment profi t or loss. (a) Revenues from transactions with external customers. (b) Revenues from transactions with other operating segments of the same enterprise. (c) Interest revenue. (d) Interest expense. (e) Depreciation, depletion, and amortization expense. (f) Unusual items. (g) Equity in the net income of investees accounted for by the equity method.

(h) Income tax expense or benefi t. (i) Extraordinary items. (j) Signifi cant noncash items other than depreciation, depletion, and amortization expense. 3. Segment assets. A company must report each operating segment’s total assets. 4. Reconciliations. A company must provide a reconciliation of the total of the seg- ments’ revenues to total revenues, a reconciliation of the total of the operating seg- ments’ profi ts and losses to its income before income taxes, and a reconciliation of the total of the operating segments’ assets to total assets. 5. Information about products and services and geographic areas. For each operating segment not based on geography, the company must report (unless it is impracti- cable): (1) revenues from external customers, (2) long-lived assets, and (3) expendi- tures during the period for long-lived assets. This information, if material, must be reported (a) in the enterprise’s country of domicile and (b) in each other country. 6. Major customers. If 10 percent or more of company revenue is derived from a single customer, the company must disclose the total amount of revenue from each such customer by segment. Illustration of Disaggregated Information Illustration 24-7 (page 1502) shows the segment disclosure for Johnson & Johnson. Interim Reports Another source of information for the investor is interim reports. As noted earlier, 4 LEARNING OBJECTIVE interim reports cover periods of less than one year. The stock exchanges, the SEC, Describe the accounting problems and the accounting profession have an active interest in the presentation of interim associated with interim reporting. information. The SEC mandates that certain companies file a Form 10-Q, in which a company discloses quarterly data similar to that disclosed in the annual report. It also requires 1502 Chapter 24 Full Disclosure in Financial Reporting Johnson & Johnson (notes excluded) Segments of Business and Geographic Areas Sales to Customers (Dollars in Millions) 2011 2010 2009 Consumer—United States $ 5,151 $ 5,519 $ 6,837 International 9,732 9,071 8,966 Total 14,883 14,590 15,803 Pharmaceutical—United States 12,386 12,519 13,041 International 11,982 9,877 9,479 Total 24,368 22,396 22,520 Medical Devices and Diagnostics—United States 11,371 11,412 11,011 International 14,408 13,189 12,563 Total 25,779 24,601 23,574 Worldwide total $65,030 $61,587 $ 61,897 Operating Profit Identifiable Assets (Dollars in Millions) 2011 2010 2009 2011 2010 2009 Consumer $ 2,096 $ 2,342 $ 2,475 $ 24,210 $ 23,753 $24,671 Pharmaceutical 6,406 7,086 6,413 23,747 19,961 21,460 Medical Devices and Diagnostics 5,263 8,272 7,694 23,609 23,277 22,853 Total 13,765 17,700 16,582 71,566 66,991 68,984 Less: Expense not allocated to segments 1,404 753 827 General corporate 42,078 35,917 25,698 Worldwide total $12,361 $16,947 $15,755 $113,644 $102,908 $94,682 Additions to Property, Depreciation and Plant & Equipment Amortization (Dollars in Millions) 2011 2010 2009 2011 2010 2009 Consumer $ 670 $ 526 $ 439 $ 631 $ 532 $ 513 Pharmaceutical 729 508 535 958 912 922 Medical Devices and Diagnostics 1,095 1,113 1,114 1,331 1,270 1,124 Segments total 2,494 2,147 2,088 2,920 2,714 2,559 General corporate 399 237 277 238 225 215 Worldwide total $2,893 $2,384 $2,365 $3,158 $2,939 $2,774 Sales to Customers Long-Lived Assets (Dollars in Millions) 2011 2010 2009 2011 2010 2009 United States $28,908 $29,450 $30,889 $ 23,529 $ 23,315 $22,399 Europe 17,129 15,510 15,934 19,056 16,791 17,347 Western Hemisphere excluding U.S. 6,418 5,550 5,156 3,517 3,653 3,540 Asia-Pacific, Africa 12,575 11,077 9,918 2,163 2,089 1,868 Segments total 65,030 61,587 61,897 48,265 45,848 45,154 General corporate 750 715 790 Other non long-lived assets 64,629 56,345 48,738 Worldwide total $65,030 $61,587 $61,897 $113,644 $102,908 $94,682 ILLUSTRATION 24-7 Segment Disclosure those companies to disclose selected quarterly information in notes to the annual finan- cial statements. Illustration 24-8 presents the selected quarterly disclosure of Tootsie Roll Industries, Inc. In addition to Form 10-Q, GAAP narrows the reporting alterna-

tives related to interim reports. [4] Because of the short-term nature of the information in these reports, there is consid- erable controversy as to the general approach companies should employ. One group, Disclosure Issues 1503 ILLUSTRATION 24-8 Tootsie Roll Industries, Inc. Disclosure of Selected For the Year Ended December 31, 2011 Quarterly Data (Thousands of dollars except per share data) First Second Third Fourth Total Net product sales $108,323 $104,884 $186,784 $128,378 $528,369 Product gross margin 34,799 33,898 54,554 39,893 163,144 Net earnings 8,330 6,486 18,855 10,267 43,938 Net earnings per share 0.14 0.11 0.33 0.18 0.76 Stock Prices Dividends 2011 2011 High Low 1st Qtr $29.45 $27.06 $0.08 2nd Qtr $29.68 $27.78 $0.08 3rd Qtr $29.80 $23.52 $0.08 4th Qtr $25.95 $22.85 $0.08 which favors the discrete approach, believes that companies should treat each Underlying Concepts interim period as a separate accounting period. Using that treatment, companies For information to be relevant, would follow the principles for deferrals and accruals used for annual reports. In it must be available to decision- this view, companies should report accounting transactions as they occur, and makers before it loses its expense recognition should not change with the period of time covered. capacity to infl uence their Another group, which favors the integral approach, believes that the interim decisions (timeliness). Interim report is an integral part of the annual report and that deferrals and accruals reporting is an excellent should take into consideration what will happen for the entire year. In this example of this concept. approach, companies should assign estimated expenses to parts of a year on the basis of sales volume or some other activity base. At present, many companies follow the discrete approach for certain types of ex- penses and the integral approach for others, because the standards currently employed in practice are vague and lead to differing interpretations. Interim Reporting Requirements Generally, companies should use the same accounting principles for interim reports and for annual reports. They should recognize revenues in interim periods on the same basis as they are for annual periods. For example, if Cedars Corp. uses the installment- sales method as the basis for recognizing revenue on an annual basis, then it should use the installment basis for interim reports as well. Also, Cedars should treat costs directly associated with revenues (product costs, such as materials, labor and related fringe benefits, and manufacturing overhead) in the same manner for interim reports as for annual reports. Companies should use the same inventory pricing methods (FIFO, LIFO, etc.) for interim reports and for annual reports. However, the following exceptions are appropri- ate at interim reporting periods. 1. Companies may use the gross profi t method for interim inventory pricing. But they must disclose the method and adjustments to reconcile with annual inventory. 2. When a company liquidates LIFO inventories at an interim date and expects to replace them by year-end, cost of goods sold should include the expected cost of replacing the liquidated LIFO base, rather than give effect to the interim liquidation. 1504 Chapter 24 Full Disclosure in Financial Reporting 3. Companies should not defer inventory market declines beyond the interim period unless they are temporary and no loss is expected for the fi scal year. 4. Companies ordinarily should defer planned variances under a standard cost system; such variances are expected to be absorbed by year-end. Companies often charge to the interim period, as incurred, costs and expenses other than product costs (often referred to as period costs). But companies may allocate these costs among interim periods on the basis of an estimate of time expired, benefit re- ceived, or activity associated with the periods. Companies display considerable latitude in accounting for these costs in interim periods, and many believe more definitive guidelines are needed.

Regarding disclosure, companies should report the following interim data at a minimum. 1. Sales or gross revenues, provision for income taxes, extraordinary items, and net income. 2. Basic and diluted earnings per share where appropriate. 3. Seasonal revenue, cost, or expenses. 4. Signifi cant changes in estimates or provisions for income taxes. 5. Disposal of a component of a business and extraordinary, unusual, or infrequently occurring items. 6. Contingent items. 7. Changes in accounting principles or estimates. 8. Signifi cant changes in fi nancial position. The FASB encourages, but does not require, companies to publish an interim bal- ance sheet and statement of cash flows. If a company does not present this information, it should disclose significant changes in such items as liquid assets, net working capital, long-term liabilities, and stockholders’ equity. Unique Problems of Interim Reporting GAAP reflects a preference for the integral approach. However, within this broad guide- line, a number of unique reporting problems develop related to the following items. Advertising and Similar Costs. The general guidelines are that companies should defer in an interim period costs such as advertising if the benefits extend beyond that period; otherwise, the company should expense those costs as incurred. But such a determina- tion is difficult, and even if the company defers the costs, how should it allocate them between quarters? Because of the vague guidelines in this area, accounting for advertising varies widely. At one time, some companies in the food industry, such as RJR Nabisco and Pillsbury, charged advertising costs as a percentage of sales and adjusted to actual at year-end, whereas General Foods and Kellogg expensed these costs as incurred. The same type of problem relates to such items as Social Security taxes, research and development costs, and major repairs. For example, should the company expense Social Security costs (payroll taxes) on highly paid personnel early in the year, or allocate and spread them to subsequent quarters? Should a major repair that occurs later in the year be anticipated and allocated proportionately to earlier periods? Expenses Subject to Year-End Adjustment. Companies often do not know with a great deal of certainty amounts of bad debts, executive bonuses, pension costs, and inventory Disclosure Issues 1505 shrinkage until year-end. They should estimate these costs and allocate them to interim periods as best they can. Companies use a variety of allocation techniques to accomplish this objective. Income Taxes. Not every dollar of corporate taxable income is taxed at the same rate; the tax rate is progressive. This aspect of business income taxes poses a problem in preparing interim financial statements. Should the company use the annualized approach, which is to annualize income to date and accrue the proportionate income tax for the period to date? Or should it follow the marginal principle approach, which is to apply the lower rate of tax to the first amount of income earned? At one time, companies generally followed the latter approach and accrued the tax applicable to each additional dollar of income. The profession now, however, uses the annualized approach. This requires that “at the end of each interim period the company should make its best estimate of the effec- tive tax rate expected to be applicable for the full fiscal year. The rate so determined should be used in providing for income taxes on income for the quarter.” [5]9 Because businesses did not uniformly apply this guideline in accounting for similar situations, the FASB issued authoritative guidance. GAAP now requires companies, when computing the year-to-date tax, to apply the estimated annual effective tax rate to the year-to-date “ordinary” income at the end of each interim period. Further, the interim period tax related to “ordinary” income shall be the difference between the amount so computed and the amounts reported for previous interim periods of the fiscal period. [6]10

Extraordinary Items. Extraordinary items consist of unusual and nonrecurring material gains and losses. In the past, companies handled them in interim reports in one of three ways: (1) absorbed them entirely in the quarter in which they occurred, (2) prorated them over four quarters, or (3) disclosed them only by note. The required approach now is to charge or credit the loss or gain in the quarter in which it occurs, instead of attempting some arbitrary multiple-period allocation. This approach is consistent with the way in which companies must handle extraordinary items on an annual basis. No attempt is made to prorate the extraordinary items over several years. Some favor the omission of extraordinary items from the quarterly net income. They believe that inclusion of extraordinary items that may be large in proportion to interim results distorts the predictive value of interim reports. Many, however, consider such an omission inappropriate because it deviates from actual results. Earnings per Share. Interim reporting of earnings per share has all the problems inherent in computing and presenting annual earnings per share, and then some. If a company issues shares in the third period, EPS for the first two periods will not reflect year-end EPS. If an extraordinary item is present in one period and the company sells new equity shares in another period, the EPS figure for the extraordinary item will change for the year. On an annual basis, only one EPS figure can be associated with an extraordinary item and that figure does not change; the interim figure is subject to change. For purposes of computing earnings per share and making the required disclosure determinations, each interim period should stand alone. That is, all applicable tests should be made for that single period. 9The estimated annual effective tax rate should reflect anticipated tax credits, foreign tax rates, percentage depletion, capital gains rates, and other available tax-planning alternatives. 10“Ordinary” income (or loss) refers to “income (or loss) from continuing operations before income taxes (or benefits)” excluding extraordinary items and discontinued operations. 1506 Chapter 24 Full Disclosure in Financial Reporting Seasonality. Seasonality occurs when most of a company’s sales occur in one short period of the year while certain costs are fairly evenly spread throughout the year. For example, the natural gas industry has its heavy sales in the winter months. In contrast, the beverage industry has its heavy sales in the summer months. The problem of seasonality is related to the expense recognition principle in accounting. Generally, expenses are associated with the revenues they create. In a sea- sonal business, wide fluctuations in profits occur because off-season sales do not absorb the company’s fixed costs (for example, manufacturing, selling, and administrative costs that tend to remain fairly constant regardless of sales or production). To illustrate why seasonality is a problem, assume the following information. ILLUSTRATION 24-9 Selling price per unit $1 Data for Seasonality Annual sales for the period (projected and actual) Example 100,000 units @ $1 $100,000 Manufacturing costs Variable 10¢ per unit Fixed 20¢ per unit or $20,000 for the year Nonmanufacturing costs Variable 10¢ per unit Fixed 30¢ per unit or $30,000 for the year Sales for four quarters and the year (projected and actual) were: ILLUSTRATION 24-10 Percent of Sales Sales Data for Seasonality 1st Quarter $ 20,000 20% Example 2nd Quarter 5,000 5 3rd Quarter 10,000 10 4th Quarter 65,000 65 Total for the year $100,000 100% Under the present accounting framework, the income statements for the quarters might be as shown in Illustration 24-11. ILLUSTRATION 24-11 1st Qtr 2nd Qtr 3rd Qtr 4th Qtr Year Interim Net Income for Sales $20,000 $ 5,000 $10,000 $65,000 $100,000 Seasonal Business— Manufacturing costs Discrete Approach Variable (2,000) (500) (1,000) (6,500) (10,000) Fixeda (4,000) (1,000) (2,000) (13,000) (20,000) 14,000 3,500 7,000 45,500 70,000 Nonmanufacturing costs

Variable (2,000) (500) (1,000) (6,500) (10,000) Fixedb (7,500) (7,500) (7,500) (7,500) (30,000) Net income $ 4,500 $(4,500) $ (1,500) $31,500 $ 30,000 aThe fixed manufacturing costs are inventoried, so that equal amounts of fixed costs do not appear during each quarter. bThe fixed nonmanufacturing costs are not inventoried, so equal amounts of fixed costs appear during each quarter. An investor who uses the first quarter’s results might be misled. If the first quarter’s earnings are $4,500, should this figure be multiplied by four to predict annual earnings of $18,000? Or, if first-quarter sales of $20,000 are 20 percent of the predicted sales for the year, would the net income for the year be $22,500 ($4,500 3 5)? Both figures are obvi- ously wrong, and after the second quarter’s results occur, the investor may become even more confused. Disclosure Issues 1507 The problem with the conventional approach is that the fixed nonmanufacturing costs are not charged in proportion to sales. Some enterprises have adopted a way of avoiding this problem by making all fixed nonmanufacturing costs follow the sales pattern, as shown in Illustration 24-12. ILLUSTRATION 24-12 1st Qtr 2nd Qtr 3rd Qtr 4th Qtr Year Interim Net Income for Sales $20,000 $ 5,000 $10,000 $65,000 $100,000 Seasonal Business— Manufacturing costs Integral Approach Variable (2,000) (500) (1,000) (6,500) (10,000) Fixed (4,000) (1,000) (2,000) (13,000) (20,000) 14,000 3,500 7,000 45,500 70,000 Nonmanufacturing costs Variable (2,000) (500) (1,000) (6,500) (10,000) Fixed (6,000) (1,500) (3,000) (19,500) (30,000) Net income $ 6,000 $ 1,500 $ 3,000 $19,500 $ 30,000 This approach solves some of the seasonality problems of interim reporting. Sales in the first quarter are 20 percent of total sales for the year, and net income in the first quarter is 20 percent of total income. In this case, as in the previous example, the inves- tor cannot rely on multiplying any given quarter by four but can use comparative data or rely on some estimate of sales in relation to income for a given period. The greater the degree of seasonality experienced by a company, the greater the possibility of distortion. Because there are no definitive guidelines for handling such items as the fixed nonmanufacturing costs, variability in income can be substantial. To alleviate this problem, the profession recommends that companies subject to material seasonal variations disclose the seasonal nature of their business and consider supple- menting their interim reports with information for 12-month periods ended at the International interim date for the current and preceding years. Perspective The two illustrations highlight the difference between the discrete and inte- IFRS requires that interim gral approaches. Illustration 24-11 represents the discrete approach, in which the fi nancial statements use the fixed nonmanufacturing expenses are expensed as incurred. Illustration 24-12 discrete method, except for shows the integral approach, in which expenses are charged to expense on the tax expenses. basis of some measure of activity. Evolving Issue IT’S FASTER BUT IS IT BETTER? The profession has developed some rules for interim report- its procedures than the annual audit, provides some assur- ing, but much still has to be done. As yet, it is unclear whether ance that the interim information appears to be in accord the discrete or the integral method, or some combination of with GAAP. (See “Interim Financial Information,” State- the two, will be settled on. ment on Auditing Standards No. 101 (New York: AICPA, Discussion also persists about the independent auditor’s 2002).) involvement in interim reports. Many auditors are reluctant Analysts and investors want financial information as to express an opinion on interim financial information, soon as possible, before it’s old news. We may not be far from arguing that the data are too tentative and subjective. On a continuous database system in which corporate financial the other hand, more people are advocating some examina- records can be accessed via the Internet. Investors might be

tion of interim reports. As a compromise, the SEC currently able to access a company’s financial records whenever they requires that auditors perform a review of interim financial wish and put the information in the format they need. information. Such a review, which is much more limited in Thus, they could learn about sales slippage, cost increases, 1508 Chapter 24 Full Disclosure in Financial Reporting or earnings changes as they happen, rather than waiting Finally, in a bid to increase Internet disclosure, the SEC until after the quarter has ended. encourages companies to post current, quarterly, and annual A step in this direction is the SEC’s mandate for compa- reports on their websites—or explain why they don’t. The nies to file their financial statements electronically with the Internet postings would have to be made by the day the com- SEC. The system, called EDGAR (electronic data gathering pany submits the information to the SEC, rather than within and retrieval), provides interested parties with computer 24 hours as current rules allow. access to financial information such as periodic filings, A steady stream of information from the company to the corporate prospectuses, and proxy materials. investor could be very positive because it might alleviate The SEC also believes that timeliness of information is of management’s continual concern with short-run interim extreme importance. First, the SEC has said that large public numbers. Today, many contend that U.S. management is too companies will have only 60 days to complete their annual oriented to the short-term. The truth of this statement is reports, down from 90 days. Quarterly reports must be done echoed by the words of the president of a large company within 40 days of the close of the quarter, instead of 45. In who decided to retire early: “I wanted to look forward to a addition, corporate executives and shareholders with more year made up of four seasons rather than four quarters.” than 10 percent of a company’s outstanding stock now have two days to disclose their sale or purchase of stock. AUDITOR’S AND MANAGEMENT’S REPORTS Auditor’s Report Another important source of information, which is often overlooked, is the auditor’s LEARNING OBJECTIVE 5 report. An auditor is an accounting professional who conducts an independent Identify the major disclosures in the examination of a company’s accounting data. auditor’s report. If satisfied that the financial statements present the financial position, results of operations, and cash flows fairly in accordance with generally accepted accounting principles, the auditor expresses an unqualified opinion. An example is shown in Illustration 24-13.11 In preparing the report, the auditor follows these reporting standards. 1. The report states whether the fi nancial statements are in accordance with generally accepted accounting principles. 2. The report identifi es those circumstances in which the company has not consistently observed such principles in the current period in relation to the preceding period. 3. Users are to regard the informative disclosures in the fi nancial statements as reason- ably adequate unless the report states otherwise. 4. The report contains either an expression of opinion regarding the fi nancial state- ments taken as a whole or an assertion to the effect that an opinion cannot be ex- pressed. When the auditor cannot express an overall opinion, the report should state the reasons. In all cases where an auditor’s name is associated with fi nancial statements, the report should contain a clear-cut indication of the character of the auditor’s examination, if any, and the degree of responsibility being taken. In most cases, the auditor issues a standard unqualified or clean opinion. That is, the auditor expresses the opinion that the financial statements present fairly, in all mate- rial respects, the financial position, results of operations, and cash flows of the entity in conformity with generally accepted accounting principles. 11This auditor’s report is in exact conformance with the specifications contained in “Reports on

Audited Financial Statements,” Statement on Auditing Standards No. 58 (New York: AICPA, 1988). The last paragraph refers to the assessment of the company’s internal controls, as required by the PCAOB. Auditor’s and Management’s Reports 1509 ILLUSTRATION 24-13 Best Buy Co., Inc. Auditor’s Report Report of Independent Registered Public Accounting Firm To the Board of Directors and Shareholders of Best Buy Co., Inc.: We have audited the accompanying consolidated balance sheets of Best Buy Co., Inc. and subsidiaries (the “Company”) as of March 3, 2012 and February 26, 2011 and the related consolidated statements of earnings, cash flows, and changes in shareholders’ equity for each of the three fiscal years in the period ended March 3, 2012. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Best Buy Co., Inc. and subsidiaries as of March 3, 2012 and February 26, 2011, and the results of their operations and their cash flows for each of the three fiscal years in the period ended March 3, 2012, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of March 3, 2012, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated May 1, 2012, expressed an unqualified opinion on the Company’s internal control over financial reporting. Minneapolis, Minnesota May 1, 2012 Certain circumstances, although they do not affect the auditor’s unqualified opin- ion, may require the auditor to add an explanatory paragraph to the audit report. Some of the more important circumstances are as follows. 1. Going concern. The auditor must evaluate whether there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, taking into consideration all available information about the future. (The future is at least, but not limited to, 12 months from the end of the reporting period.) If substan- tial doubt exists about the company continuing as a going concern, the auditor adds to the report an explanatory note describing the potential problem. [7]12 12The FASB has a project requiring certain disclosures when management concludes it is more likely than not that the company will not be able to meet its obligations in the ordinary course of business for a reasonable period of time. When management concludes it is probable that the entity will not be able to meet its obligations in the ordinary course of business for a reasonable period of time, a statement that there is substantial doubt about the entity’s ability to continue as

a going concern would also be required. Similar to auditing standards, the Board defines a reasonable period of time as 12 months from the balance sheet date. However, management would also consider events that are probable of resulting in an entity’s potential inability to meet its obligations beyond 12 months. The combined assessment period would not exceed 24 months. See http://www.fasb.org/; click on the Projects tab and scroll down to the Going Concern link. See also the project on liquidation accounting. 1510 Chapter 24 Full Disclosure in Financial Reporting 2. Lack of consistency. If a company has changed accounting principles or the method of their application in a way that has a material effect on the comparability of its fi nancial statements, the auditor should refer to the change in an explanatory para- graph of the report. Such an explanatory paragraph should identify the nature of the change and refer readers to the note in the fi nancial statements that discusses the change in detail. The auditor’s concurrence with a change is implicit unless the auditor takes exception to the change in expressing an opinion as to fair presentation in conformity with generally accepted accounting principles. 3. Emphasis of a matter. The auditor may wish to emphasize a matter regarding the fi nancial statements but nevertheless intends to express an unqualifi ed opinion. For example, the auditor may wish to emphasize that the entity is a component of a larger business enterprise or that it has had signifi cant transactions with related parties. The auditor presents such explanatory information in a separate paragraph of the report. In some situations, however, the auditor is required to express (1) a qualified opin- ion or (2) an adverse opinion, or (3) to disclaim an opinion. A qualified opinion contains an exception to the standard opinion. Ordinarily, the exception is not of sufficient magnitude to invalidate the statements as a whole; if it were, an adverse opinion would be rendered. The usual circumstances in which the auditor may deviate from the standard unqualified short-form report on financial state- ments are as follows. 1. The scope of the examination is limited or affected by conditions or restrictions. 2. The statements do not fairly present fi nancial position or results of operations because of: (a) Lack of conformity with generally accepted accounting principles and standards. (b) Inadequate disclosure. If confronted with one of the situations noted above, the auditor must offer a quali- fied opinion. A qualified opinion states that, except for the effects of the matter to which the qualification relates, the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows in conformity with generally accepted accounting principles. Illustration 24-14 shows an example of an auditor’s report with a qualified opinion. The auditor qualified the opinion because the company used an accounting principle at variance with generally accepted accounting principles. ILLUSTRATION 24-14 Helio Company Qualifi ed Auditor’s Report Independent Auditor’s Report (Same first and second paragraphs as the standard report) Helio Company has excluded, from property and debt in the accompanying balance sheets, certain lease obligations that, in our opinion, should be capitalized in order to conform with generally accepted accounting principles. If these lease obligations were capitalized, property would be increased by $1,500,000 and $1,300,000, long-term debt by $1,400,000 and $1,200,000, and retained earnings by $100,000 and $50,000 as of December 31, in the current and prior year, respectively. Additionally, net income would be decreased by $40,000 and $30,000 and earnings per share would be decreased by $.06 and $.04, respectively, for the years then ended. In our opinion, except for the effects of not capitalizing certain lease obligations as discussed in the preceding paragraph, the financial statements referred to above present fairly, in all material respects,

the financial position of Helio Company, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles. Auditor’s and Management’s Reports 1511 An adverse opinion is required in any report in which the exceptions to fair presen- tation are so material that in the independent auditor’s judgment, a qualified opinion is not justified. In such a case, the financial statements taken as a whole are not presented in accordance with generally accepted accounting principles. Adverse opinions are rare, because most companies change their accounting to conform with GAAP. The SEC will not permit a company listed on an exchange to have an adverse opinion. A disclaimer of an opinion is appropriate when the auditor has gathered so little information on the financial statements that no opinion can be expressed. The audit report should provide useful information to the investor. One investment banker noted, “Probably the first item to check is the auditor’s opinion to see whether or not it is a clean one—‘in conformity with generally accepted accounting principles’—or is qualified in regard to differences between the auditor and company management in the accounting treatment of some major item, or in the outcome of some major litigation.” What do the numbers mean? HEART OF THE MATTER As we discussed in the opening story, fi nancial disclosure is information. That is, while criminal sanctions can be effective one of a number of institutional features that contribute to in some circumstances, disclosure and other legal and regu- vibrant security markets. In fact, a recent study of disclosure latory elements encouraging good disclosure are the most and other mechanisms (such as civil lawsuits and criminal important determinants of highly liquid and deep securities sanctions) found that good disclosure is the most important markets. contributor to a vibrant market. The study, which compared These fi ndings hold for nations in all stages of economic disclosure and other legal and regulatory elements across 49 development, with particular importance for nations that countries, found that countries with the best disclosure laws are in the early stages of securities regulation. In addition, have the biggest stock markets. countries with fewer market protections likely will benefi t Countries with more successful market environments the most from adoption of international standards for market also tend to have regulations that make it relatively easy regulation and disclosure. The lesson: Disclosure is good for for private investors to sue corporations that provide bad your market. Sources: Rebecca Christie, “Study: Disclosure at Heart of Effective Securities Laws,” Wall Street Journal Online (August 11, 2003); and L. Hail, C. Leuz, and P. Wysocki, “Global Accounting Convergence and the Potential Adoption of IFRS by the U.S. (Part I): Conceptual Underpin- nings and Economic Analysis,” Accounting Horizons (September 2010). Management’s Reports Management’s Discussion and Analysis The SEC mandates inclusion of management’s discussion and analysis (MD&A). 6 LEARNING OBJECTIVE This section covers three financial aspects of an enterprise’s business—liquidity, Understand management’s capital resources, and results of operations. In it, management highlights favorable responsibilities for financials. or unfavorable trends and identifies significant events and uncertainties that affect these three factors. This approach obviously involves subjective estimates, opinions, and soft data. However, the SEC believes that the relevance of this information exceeds the potential lack of faithful representation. Illustration 24-15 (page 1512) presents an excerpt from the MD&A section (2009 “Business Risks” only) of PepsiCo’s annual report. The MD&A section also must provide information about the effects of inflation and changing prices, if they are material to financial statement trends. The SEC has not required specific numerical computations, and companies have provided little analysis

on changing prices. An additional disclosure provided in the MD&A of many companies is discussion of the company’s critical accounting policies. This disclosure identifies accounting 1512 Chapter 24 Full Disclosure in Financial Reporting ILLUSTRATION 24-15 PepsiCo, Inc. Management’s Discussion and Analysis MD&A Our business risks (in part) Risk Management Framework The achievement of our strategic and operating objectives will necessarily involve taking risks. Our risk management process is intended to ensure that risks are taken knowingly and purposefully. As such, we leverage an integrated risk management framework to identify, assess, prioritize, manage, monitor and communicate risks across the Company. This framework includes: • The PepsiCo Risk Committee (PRC), comprised of a cross-functional, geographically diverse, senior management group which meets regularly to identify, assess, prioritize and address strategic and reputational risks; • Division Risk Committees (DRCs), comprised of cross-functional senior management teams which meet regularly to identify, assess, prioritize and address division-specific operating risks; • PepsiCo’s Risk Management Office, which manages the overall risk management process, provides ongoing guidance, tools and analytical support to the PRC and the DRCs, identifies and assesses potential risks, and facilitates ongoing communication between the parties, as well as to PepsiCo’s Audit Committee and Board of Directors; • PepsiCo Corporate Audit, which evaluates the ongoing effectiveness of our key internal controls through periodic audit and review procedures; and • PepsiCo’s Compliance Department, which leads and coordinates our compliance policies and practices. Market Risks We are exposed to market risks arising from adverse changes in: • commodity prices, affecting the cost of our raw materials and energy, • foreign exchange rates, and • interest rates. In the normal course of business, we manage these risks through a variety of strategies, including productivity initiatives, global purchasing programs and hedging strategies. Ongoing productivity initiatives involve the identification and effective implementation of meaningful cost saving opportunities or efficiencies. Our global purchasing programs include fixed-price purchase orders and pricing a greements. policies that require management to make subjective judgments regarding uncertain- ties, resulting in potentially significant effects on the financial results.13 For example, in Gateway to its critical accounting policy disclosure, PepsiCo showed the impact on stock-based the Profession compensation expense in response to changes in estimated interest rates and stock Expanded Discussion return volatility. Through this voluntary disclosure, companies can expand on the infor- of Accounting for mation contained in the notes to the financial statements to indicate the sensitivity of the Changing Prices financial results to accounting policy judgments. Management’s Responsibilities for Financial Statements The Sarbanes-Oxley Act requires the SEC to develop guidelines for all publicly traded companies to report on management’s responsibilities for, and assessment of, the inter- nal control system. An example of the type of disclosure that public companies are now making is shown in Illustration 24-16.14 13See Cautionary Advice Regarding Disclosure about Critical Accounting Policies, Release Nos. 33-8040; 34-45149; FR-60 (Washington, D.C.: SEC); and Proposed Rule: Disclosure in Management’s Discussion and Analysis about the Application of Critical Accounting Policies, Release Nos. 33-8098; 34-45907; International Series Release No. 1258; File No. S7-16-02 (Washington, D.C.: SEC). 14As indicated in this disclosure, management is responsible for preparing the financial state- ments and establishing and maintaining an effective system of internal controls. The auditor provides an independent assessment of whether the financial statements are prepared in accordance with GAAP, and for public companies, whether the internal controls are effective

(see the audit opinion in Illustration 24-13 on page 1509). Current Reporting Issues 1513 ILLUSTRATION 24-16 Home Depot Report on Management’s Responsibilities Management’s Responsibility for Financial Statements The financial statements presented in this Annual Report have been prepared with integrity and objectivity and are the responsibility of the management of The Home Depot, Inc. These financial statements have been prepared in conformity with U.S. generally accepted accounting principles and properly reflect certain estimates and judgments based upon the best available information. The financial statements of the Company have been audited by KPMG LLP, an independent registered public accounting firm. Their accompanying report is based upon an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States). The Audit Committee of the Board of Directors, consisting solely of independent directors, meets five times a year with the independent registered public accounting firm, the internal auditors and representatives of management to discuss auditing and financial reporting matters. In addition, a telephonic meeting is held prior to each quarterly earnings release. The Audit Committee retains the independent registered public accounting firm and regularly reviews the internal accounting controls, the activities of the independent registered public accounting firm and internal auditors and the financial condition of the Company. Both the Company’s independent registered public accounting firm and the internal auditors have free access to the Audit Committee. Management’s Report on Internal Control over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of January 29, 2012 based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on our evaluation, our management concluded that our internal control over financial reporting was effective as of January 29, 2012 in providing reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. The effectiveness of our internal control over financial reporting as of January 29, 2012 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report which is included on page 28 in this Form 10-K. Francis S. Blake Carol B. Tomé Chairman & Chief Executive Officer Chief Financial Officer & Executive Vice President—Corporate Services CURRENT REPORTING ISSUES Reporting on Financial Forecasts and Projections In recent years, the investing public’s demand for more and better information has 7 LEARNING OBJECTIVE focused on disclosure of corporate expectations for the future.15 These disclosures Identify issues related to financial take one of two forms:16 forecasts and projections. • Financial forecasts. A financial forecast is a set of prospective financial state- ments that present, to the best of the responsible party’s knowledge and belief, a company’s expected financial position, results of operations, and cash flows. The 15Some areas in which companies are using financial information about the future are equipment lease-versus-buy analysis, analysis of a company’s ability to successfully enter new markets, and examination of merger and acquisition opportunities. In addition, companies also prepare forecasts and projections for use by third parties in public offering documents (requiring

financial forecasts), tax-oriented investments, and financial feasibility studies. Use of forward- looking data has been enhanced by the increased capability of microcomputers to analyze, compare, and manipulate large quantities of data. 16“Financial Forecasts and Projections” and “Guide for Prospective Financial Information,” Codification of Statements on Standards for Attestation Engagements (New York: AICPA 2006), paras. 3.04 and 3.05. 1514 Chapter 24 Full Disclosure in Financial Reporting responsible party bases a financial forecast on conditions it expects to exist and the course of action it expects to take. • Financial projections. Financial projections are prospective financial statements that present, to the best of the responsible party’s knowledge and belief, given one or more hypothetical assumptions, an entity’s expected financial position, results of operations, and cash flows. The responsible party bases a financial projection on conditions it expects would exist and the course of action it expects would be taken, given one or more hypothetical assumptions. The difference between a financial forecast and a financial projection is clear-cut. A forecast provides information on what is expected to happen, whereas a projection provides information on what might take place but is not necessarily expected to happen. Whether companies should be required to provide financial forecasts is the subject of intensive discussion with journalists, corporate executives, the SEC, financial ana- lysts, accountants, and others. Predictably, there are strong arguments on either side. Listed below are some of the arguments. Arguments for requiring published forecasts: 1. Investment decisions are based on future expectations. Therefore, information about the future facilitates better decisions. 2. Companies already circulate forecasts informally. This situation should be regulated to ensure that the forecasts are available to all investors. 3. Circumstances now change so rapidly that historical information is no longer adequate for prediction. Arguments against requiring published forecasts: 1. No one can foretell the future. Therefore, forecasts will inevitably be wrong. Worse, they may mislead, if they convey an impression of precision about the future. 2. Companies may strive only to meet their published forecasts, thereby failing to pro- duce results that are in the stockholders’ best interest. Underlying Concepts 3. If forecasts prove inaccurate, there will be recriminations and probably legal actions.17 The profession indicates that 4. D isclosure of forecasts will be detrimental to organizations, because fore- the legal environment discour- casts will inform competitors (foreign and domestic) as well as investors. ages companies from disclosing forward-looking information. The AICPA has issued a statement on standards for accountants’ Companies should not have to services on prospective financial information. This statement establishes expand reporting of forward- guidelines for the preparation and presentation of financial forecasts and pro- looking information unless there jections.18 It requires accountants to provide (1) a summary of significant are more effective deterrents to assumptions used in the forecast or projection and (2) guidelines for minimum unwarranted litigation. presentation. To encourage management to disclose prospective financial information, the SEC has a safe harbor rule. It provides protection to a company that presents an erroneous forecast, as long as the company prepared the forecast on a reasonable basis 17The issue is serious. Over a recent three-year period, 8 percent of the companies on the NYSE were sued because of an alleged lack of financial disclosure. Companies complain that they are subject to lawsuits whenever the stock price drops. And as one executive noted, “You can even be sued if the stock price goes up—because you did not disclose the good news fast enough.” 18Op. cit., par. 1.02. Current Reporting Issues 1515 and disclosed it in good faith.19 However, many companies note that the safe harbor rule

does not work in practice, since it does not cover oral statements, nor has it kept them from investor lawsuits. What do the numbers mean? GLOBAL FORECASTS Great Britain permits fi nancial forecasts, and the results have But such differences probably could be overcome if infl u- been fairly successful. Some signifi cant differences do exist ential interests in this country cooperated to produce between the English and the U.S. business and legal environ- an atmosphere conducive to quality forecasting. A typical ments. The British system, for example, does not permit litiga- British forecast adapted from a construction company’s report tion on forecasted information, and the solicitor (lawyer) is not to support a public offering of stock is as follows. permitted to work on a contingent-fee basis. Profits have grown substantially over the past 10 years and directors are confident of being able to continue this expansion. . . . While the rate of expansion will be dependent on the level of economic activity in Ireland and England, the group is well structured to avail itself of opportunities as they arise, particularly in the field of property development, which is expected to play an increasingly important role in the group’s future expansion. Profits before taxation for the half year ended 30th June were 402,000 pounds. On the basis of trading experiences since that date and the present level of sales and completions, the directors expect that in the absence of unforeseen circumstances, the group’s profits before taxation for the year to 31st December will be not less than 960,000 pounds. No dividends will be paid in respect of the current year. In a full financial year, on the basis of above forecasts (not including full year profits) it would be the intention of the board, assuming current rates of tax, to recommend dividends totaling 40% (of after-tax profits), which will be payable in the next two years. A general narrative-type forecast issued by a U.S. corporation might appear as follows. On the basis of promotions planned by the company for the second half of the fiscal year, net earnings for that period are expected to be approximately the same as those for the first half of the fiscal year, with net earnings for the third quarter expected to make the predominant contribution to net earnings for the second half of the year. As indicated, the U.S. version is much less specifi c in its forecasted information. Source: See “A Case for Forecasting—The British Have Tried It and Find That It Works,” World (New York: Peat, Marwick, Mitchell & Co., Autumn 1978), pp. 10–13. In a recent survey, U.K. companies remain stubbornly backward-looking. Just 5 percent of FTSE 100 companies address the future of the business in their discussion and analysis. See PricewaterhouseCoopers, “Guide to Forward-looking Information: Don’t Fear the Future” (2006). Questions of Liability What happens if a company does not meet its forecasts? Can the company and the audi- tor be sued? If a company, for example, projects an earnings increase of 15 percent and achieves only 5 percent, should stockholders be permitted to have some judicial recourse against the company? One court case involving Monsanto Chemical Corporation set a precedent. In this case, Monsanto predicted that sales would increase 8 to 9 percent and that earnings would rise 4 to 5 percent. In the last part of the year, the demand for Monsanto’s prod- ucts dropped as a result of a business turndown. Instead of increasing, the company’s earnings declined. Investors sued the company because the projected earnings figure was erroneous, but a judge dismissed the suit because the forecasts were the best esti- mates of qualified people whose intents were honest. As indicated earlier, the SEC’s safe harbor rules are intended to protect companies that provide good-faith projections. However, much concern exists as to how the SEC 19“Safe-Harbor Rule for Projections,” Release No. 5993 (Washington, D.C.: SEC, 1979). The Private Securities Litigation Reform Act of 1995 recognizes that some information that is useful to

investors is inherently subject to less certainty or reliability than other information. By providing safe harbor for forward-looking statements, Congress has sought to facilitate access to this information by investors. 1516 Chapter 24 Full Disclosure in Financial Reporting and the courts will interpret such terms as “good faith” and “reasonable assumptions” when erroneous forecasts mislead users of this information. Internet Financial Reporting Most companies now use the power and reach of the Internet to provide more useful information to financial statement readers. All large companies have Internet sites, and a large proportion of companies’ websites contain links to their financial statements and other disclosures. The popularity of such reporting is not surprising since it reduces the companies’ costs of printing and disseminating paper reports. Does Internet financial reporting improve the usefulness of a company’s financial reports? Yes, in several ways. First, dissemination of reports via the Web allows firms to communicate more easily and quickly with users than do traditional paper reports. In addition, Internet reporting allows users to take advantage of tools such as search engines and hyperlinks to quickly find information about the firm and to download the information for analysis. Finally, Internet reporting can help make financial reports more relevant by allowing companies to report expanded disaggregated data and more timely data than is possible through paper-based reporting. For example, some compa- nies voluntarily report weekly sales data and segment operating data on their websites. Given the widespread use of the Internet by investors and creditors, it is not surpris- ing that organizations are developing new technologies and standards to further enable and enhance Internet financial reporting. An example is the increasing use of eXtensible Business Reporting Language (XBRL). XBRL is a computer language adapted from the code of the Internet. It “tags” accounting data to correspond to financial reporting items that are reported in the balance sheet, income statement, and the cash flow statement. Once tagged, any company’s XBRL data can be easily processed using spreadsheets and other computer programs. In fact, the SEC is phasing in requirements for all companies and mutual funds to prepare their financial reports using XBRL, thereby allowing users to more easily search a company’s reports, extract and analyze data, and perform finan- cial comparisons within industries.20 To complement the implementation of XBRL use, the SEC has also announced a major upgrade to its EDGAR database. The new system is called IDEA (short for Inter- active Data Electronic Applications). This replacement of EDGAR marks the SEC’s tran- sition from collecting forms and documents to making the information itself freely available to investors in a timely form they can readily use. With IDEA, investors will be able to quickly collate information from thousands of companies and forms and create reports and analyses on the fly, in any way they choose. It is hoped that IDEA will open the door for both the SEC and investors to the new world of financial disclosure in interactive data (XBRL) format.21 20See SEC Interactive Data Rules for Operating Companies (http://www.sec.gov/rules/final/2009/33-9002. pdf); and C. Twarowski, “Financial Data ‘on Steroids’,” Washington Post (August 19, 2008), p. D01. See also www.xbrl.org/us/us/BusinessCaseForXBRL.pdf for additional information on XBRL. The IASB and the FASB are collaborating to implement XBRL with their standards. See http://www. ifrs.org/XBRL/XBRL/htm. 21See http://www.sec.gov/edgar/aboutedgar.htm. The SEC has implemented other regulations to ensure that investors get high-quality disclosures. For example, as discussed in Chapter 4, the SEC was concerned that companies may use pro forma reporting to deflect investor attention from bad news. In response, the SEC issued Regulation G, which requires companies to reconcile non-GAAP financial measures to GAAP. This regulation provides investors with a roadmap to

analyze adjustments companies make to their GAAP numbers to arrive at pro forma results. [See SEC Regulation G, “Conditions for Use of Non-GAAP Financial Measures,” Release No. 33-8176 (March 28, 2003).] Regulation FD (Release Nos. 33-7881) was issued in 2000 to address the concern that some analysts were receiving information sooner than the general public (e.g., during conference calls with analysts when earnings releases were discussed). Regulation FD requires that when relevant information is released, all have equal access to it. Current Reporting Issues 1517 What do the numbers mean? NEW FORMATS, NEW DISCLOSURE As indicated in earlier chapters in the IFRS Insights discus- that requests input on a proposed reformatting of the fi nan- sions, the FASB and the IASB are exploring better ways to cial statements. The table below provides a “snapshot” of the present information in the fi nancial statements. Recently, proposed changes (go to http://www.fasb.org to learn more these two standard-setters have issued a discussion paper about this joint international project). Statement of Financial Position Statement of Comprehensive Income Statement of Cash Flows Business Business Business • Operating assets and liabilities • Operating income and expenses • Operating cash fl ows • Investing assets and liabilities • Investing income and expenses • Investing cash fl ows Financing Financing Financing • Financing assets • Financing asset income • Financing asset cash fl ows • Financing liabilities • Financing liability expenses • Financing liability cash fl ows Income Taxes Income Taxes Income Taxes As indicated, each statement will use the same format. While statements. In addition, a new schedule reconciling cash the proposed changes will not affect the measurement of in- fl ows to comprehensive income will be provided. As part of dividual fi nancial statement elements, the use of a consistent this schedule, changes in fair value will be included. It is a format (e.g., Business, Financing, Income Taxes) will help good thing the timeline for the project is lengthy, as these users understand the interrelationships in the fi nancial changes in presentation are signifi cant. Fraudulent Financial Reporting Economic crime is on the rise around the world. A recent global survey of over 8 LEARNING OBJECTIVE 3,000 executives from 54 countries documented the types of economic crimes, as Describe the profession’s response to shown in Illustration 24-17 and Illustration 24-18 (page 1518). fraudulent financial reporting. ILLUSTRATION 24-17 Types of Economic Crime Asset Misappropriation 72 Accounting Fraud 24 Bribery and Corruption 24 Cybercrime 23 Money Laundering 9 IP Infringement 7 Illegal Insider Trading 6 Tax Fraud 4 Anti-Competitive Behavior 3 Espionage 2 Others 4 0 10 20 30 40 50 60 70 80 % Reported Frauds % Respondents who experienced economic crimes in the last 12 months. As indicated, a wide range of economic crimes are reported. As shown in Illustra- tion 24-18, while the trend for the top three areas is improving, accounting fraud consis- tently is in the top three. Fraudulent financial reporting is defined as “intentional or reckless conduct, whether act or omission, that results in materially misleading financial statements.”22 Fraudulent 22“Report of the National Commission on Fraudulent Financial Reporting” (Washington, D.C., 1987), page 2. Unintentional errors as well as corporate improprieties (such as tax fraud, employee embezzlements, and so on) which do not cause the financial statements to be mislead- ing are excluded from the definition of fraudulent financial reporting. 1518 Chapter 24 Full Disclosure in Financial Reporting ILLUSTRATION 24-18 Trends in Reported Fraud 72 67 Asset Misappropriation 70 62 24 36 Accounting Fraud 27 24 24 27 Bribery and Corruption 30 24 0 10 20 30 40 50 60 70 80 % Companies 2011 2009 2007 2005 Source: PricewaterhouseCoopers, The Global Economic Crime Survey: Economic Crime in a Downturn (November 2011). reporting can involve gross and deliberate distortion of corporate records (such as inven-

tory count tags), or misapplication of accounting principles (failure to disclose material transactions). Although frauds are unusual, recent events involving such well-known companies as Enron, WorldCom, Adelphia, and Tyco indicate that more must be done to address this issue. Causes of Fraudulent Financial Reporting Fraudulent financial reporting usually occurs because of conditions in a company’s internal or external environment. Influences in the internal environment relate to poor internal control systems, management’s poor attitude toward ethics, or perhaps a com- pany’s liquidity or profitability. Those in the external environment may relate to indus- try conditions, overall business environment, or legal and regulatory considerations. General incentives for fraudulent financial reporting vary. Common ones are the desire to obtain a higher stock price, to avoid default on a loan covenant, or to make a personal gain of some type (additional compensation, promotion). Situational pressures on the company or an individual manager also may lead to fraudulent financial report- ing. Examples of these situational pressures include the following. • Sudden decreases in revenue or market share for a single company or an entire industry. • Unrealistic budget pressures may occur when headquarters arbitrarily determines profit objectives (particularly for short-term results) and budgets without taking actual conditions into account. • Financial pressure resulting from bonus plans that depend on short-term economic performance. This pressure is particularly acute when the bonus is a significant component of the individual’s total compensation. Opportunities for fraudulent financial reporting are present in circumstances when the fraud is easy to commit and when detection is difficult. Frequently, these opportuni- ties arise from: 1. The absence of a board of directors or audit committee that vigilantly oversees the fi nancial reporting process. 2. Weak or nonexistent internal accounting controls. This situation can occur, for example, when a company’s revenue system is overloaded as a result of a rapid Current Reporting Issues 1519 expansion of sales, an acquisition of a new division, or the entry into a new, unfa- miliar line of business. 3. Unusual or complex transactions such as the consolidation of two companies, the divestiture or closing of a specifi c operation, and the purchase and sale of derivative instruments. 4. Accounting estimates requiring signifi cant subjective judgment by company management, such as the allowance for loan losses and the estimated liability for warranty expense. 5. Ineffective internal audit staffs resulting from inadequate staff size and severely limited audit scope. A weak corporate ethical climate contributes to these situations. Opportunities for fraudulent financial reporting also increase dramatically when the accounting princi- ples followed in reporting transactions are nonexistent, evolving, or subject to varying interpretations.23 The AICPA has issued numerous auditing standards in response to concerns of the accounting profession, the media, and the public.24 For example, the standard on fraudulent financial reporting “raises the bar” on the performance of financial statement audits by explicitly requiring auditors to assess the risk of material financial misstatement due to fraud.25 As indicated earlier, the Sarbanes-Oxley Act now raises the penalty substantially for executives who are involved in fraudulent financial reporting. What do the numbers mean? DISCLOSURE OVERLOAD As we discussed in Chapter 1 and throughout the textbook, 2. Death of LIFO. Last-in, fi rst-out (LIFO) inventory ac- IFRS is gaining popularity around the world. The U.S. Secu- counting is prohibited under IAS 2, so any U.S. company rities and Exchange Commission is still studying whether using the method will have to abandon it (and the tax benefi ts) and move to another methodology. Although and how to incorporate IFRS in the accounting rules used by LIFO is permitted under GAAP, the repeal of LIFO for

publicly traded companies in the United States. There is some tax purposes is an ongoing debate. debate on U.S. readiness to make the switch. For example, 3. Reversal of impairments. IAS 36 permits companies there are several areas in which the FASB and the IASB must to reverse impairment losses up to the amount of the iron out a number of technical accounting issues before they original impairment when the reason for the charge reach a substantially converged set of accounting standards. decreases or no longer exists. However, GAAP bans Here is a list of six important areas yet to be converged. reversal. 1. Error correction. According to IAS 8, it’s not always nec- 4. PP&E revaluation. IAS 16 allows for the revaluation of essary to retrospectively restate fi nancial results when property, plant, and equipment, but the entire asset class a company corrects errors, especially if the adjustment must be revalued. That means a company can choose to is impractical or too costly. GAAP, on the other hand, use the revaluation model if the asset class’s fair value requires restatements in many error-correction cases. can be measured reliably. But, it must choose to use one 23The discussion in this section is based on the Report of the National Commission on Fraudulent Financial Reporting, pp. 23–24 (2004). See also “2012 Report to the Nation on Occupational Fraud and Abuse, Association of Certified Fraud Examiners” (http://www.acfe.com/uploadedFiles/ ACFE_Website/Content/rttn/2012-report-to-nations.pdf), for fraudulent financial reporting causes and consequences. 24Because the profession believes that the role of the auditor is not well understood outside the profession, much attention has been focused on the expectation gap. The expectation gap is the gap between (1) the expectation of financial statement users concerning the level of assurance they believe the independent auditor provides, and (2) the assurance that the independent auditor actually does provide under generally accepted auditing standards. 25“Consideration of Fraud in a Financial Statement Audit,” Statement on Auditing Standards No. 99 (New York: AICPA, 2002). 1520 Chapter 24 Full Disclosure in Financial Reporting model or the other; both cannot be used at the same time. expensed. GAAP requires that all R&D costs be charged GAAP does not allow revaluation. to expense when incurred. 5. Component depreciation. Also under IAS 16, companies Some are already debating what will happen if and when must recognize and depreciate equipment components U.S. companies adopt these new standards. It is almost certain separately if the components can be physically separated that expanded disclosure will be needed to help users navigate from the asset and have different useful life spans. In accounting reports upon adoption of IFRS. As one accounting practical terms, that means controllers will have to rely on the operations side of the business to help assess analyst remarked, “Get ready for an avalanche of footnotes.” equipment components. GAAP allows component de- Since using IFRS requires more judgment than using GAAP, preciation, but it is not required. two to three times as many footnotes will be needed to explain 6. Development costs. Based on IAS 38, companies are the rationales for accounting approaches. So while principles- permitted to capitalize development costs as long as based standards should promote more comparability, they they meet six criteria. However, research costs are still require investors to dig into the disclosures in the footnotes. Source: Marie Leone, “GAAP and IFRS: Six Degrees of Separation,” CFO.com (June 30, 2010). Criteria for Making Accounting and Reporting Choices Underlying Concepts Throughout this textbook, we have stressed the need to provide information that is useful to predict the amounts, timing, and uncertainty of future cash The FASB concept statements flows. To achieve this objective, companies must make judicious choices be- on the objective of fi nancial tween alternative accounting concepts, methods, and means of disclosure. You

reporting, elements of fi nancial are probably surprised by the large number of choices that exist among accept- statements, qualitative characteristics of accounting able alternatives. information, and recognition You should recognize, however, as indicated in Chapter 1, that accounting and measurement are important is greatly influenced by its environment. It does not exist in a vacuum. steps in the right direction. Therefore, it is unrealistic to assume that the profession can entirely eliminate alternative presentations of certain transactions and events. Nevertheless, we are hopeful that the profession, by adhering to the conceptual framework, will be able to focus on the needs of financial statement users and eliminate diversity where appro- You will priate. The SEC’s and FASB’s projects on principles-based standards are directed at want to these very issues. They seek to develop guidance that will result in accounting and finan- read IFRS INSIGHTS cial reporting that reflects the economic substance of the transactions, not the desired on pages 1548–1557 financial result of management. The profession must continue its efforts to develop a sound foundation upon which to build financial standards and practice. As Aristotle for discussion of said, “The correct beginning is more than half the whole.” IFRS related to disclosure. KEY TERMS SUMMARY OF LEARNING OBJECTIVES accounting policies, 1491 adverse opinion, 1511 auditor, 1508 1 Review the full disclosure principle and describe implementation auditor’s report, 1508 problems. The full disclosure principle calls for financial reporting of any financial common costs, 1500 facts significant enough to influence the judgment of an informed reader. Implement- differential ing the full disclosure principle is difficult because the cost of disclosure can be disclosure, 1489 substantial and the benefits difficult to assess. Disclosure requirements have increased disclaimer of an because of (1) the growing complexity of the business environment, (2) the necessity opinion, 1511 for timely information, and (3) the use of accounting as a control and monitoring discrete approach, 1503 device. errors, 1494 2 Explain the use of notes in financial statement preparation. Notes are the financial forecast, 1513 accountant’s means of amplifying or explaining the items presented in the main body of the Summary of Learning Objectives 1521 statements. Notes can explain in qualitative terms information pertinent to specific financial financial projection, 1514 statement items, and can provide supplementary data of a quantitative nature. Common fraud, 1494 note disclosures relate to such items as accounting policies; inventories; property, plant, fraudulent financial and equipment; creditor claims; contingencies and commitments; and subsequent events. reporting, 1517 full disclosure 3 Discuss the disclosure requirements for related-party transactions, principle, 1488 post-balance-sheet events, and major business segments. In related-party illegal acts, 1494 transactions, one party has the ability to significantly influence the policies of the other. integral approach, 1503 As a result, GAAP requires disclosure of the relationship(s) involved, a description and interim reports, 1501 dollar amounts of the transactions, and amounts due from or to related parties. For management post-balance-sheet events, companies should disclose recognized subsequent events as well as nonrecognized subsequent events. Finally, aggregated figures hide much infor- approach, 1499 management’s discussion mation about the composition of these consolidated figures. There is no way to tell from and analysis the consolidated data the extent to which the differing product lines contribute to the (MD&A), 1511 company’s profitability, risk, and growth potential. As a result, the profession requires nonrecognized segment information in certain situations. subsequent event, 1496 4 Describe the accounting problems associated with interim reporting. notes to financial Interim reports cover periods of less than one year. Two viewpoints exist regarding statements, 1491

interim reports. The discrete approach holds that each interim period should be treated operating segment, 1499 as a separate accounting period. The integral approach is that the interim report is an post-balance-sheet integral part of the annual report and that deferrals and accruals should take into events, 1495 consideration what will happen for the entire year. qualified opinion, 1510 Companies should use the same accounting principles for interim reports that they recognized subsequent use for annual reports. A number of unique reporting problems develop related to the fol- event, 1495 lowing items: (1) advertising and similar costs, (2) expenses subject to year-end adjust- related-party ment, (3) income taxes, (4) extraordinary items, (5) earnings per share, and (6) seasonality. transactions, 1493 safe harbor rule, 1514 5 Identify the major disclosures in the auditor’s report. The auditor seasonality, 1506 expresses an unqualified opinion if satisfied that the financial statements present the subsequent events, 1495 financial position, results of operations, and cash flows fairly in accordance with gener- unqualified or clean ally accepted accounting principles. A qualified opinion contains an exception to the opinion, 1508 standard opinion; ordinarily the exception is not of sufficient magnitude to invalidate XBRL, 1516 the statements as a whole. An adverse opinion is required when the exceptions to fair presentation are so ma- terial that a qualified opinion is not justified. A disclaimer of an opinion is appropriate when the auditor has so little information on the financial statements that no opinion can be expressed. 6 Understand management’s responsibilities for financials. Manage- ment’s discussion and analysis (MD&A) section covers three financial aspects of an enterprise’s business: liquidity, capital resources, and results of operations. Management’s responsibility for the financial statements is often indicated in a letter to stockholders in the annual report. 7 Identify issues related to financial forecasts and projections. The SEC has indicated that companies are permitted (not required) to include profit forecasts in their reports. To encourage management to disclose such information, the SEC issued a safe harbor rule. The rule provides protection to a company that presents an erroneous forecast, as long as it prepared the projection on a reasonable basis and disclosed it in good faith. However, the safe harbor rule has not worked well in practice. 8 Describe the profession’s response to fraudulent financial reporting. Fraudulent financial reporting is intentional or reckless conduct, whether through act or omission, that results in materially misleading financial statements. Fraudulent financial reporting usually occurs because of poor internal control, management’s poor attitude toward ethics, poor performance, and so on. The Sarbanes-Oxley Act has numerous provisions intended to help prevent fraudulent financial reporting. 1522 Chapter 24 Full Disclosure in Financial Reporting APPENDIX 24A BASIC FINANCIAL STATEMENT ANALYSIS What would be important to you in studying a company’s financial statements? The LEARNING OBJECTIVE 9 answer depends on your particular interest—whether you are a creditor, stockholder, Understand the approach to financial potential investor, manager, government agency, or labor leader. For example, short- statement analysis. term creditors such as banks are primarily interested in the ability of the firm to pay its currently maturing obligations. In that case, you would examine the current assets and their relation to short-term liabilities to evaluate the short-run solvency of the firm. Bondholders, on the other hand, look more to long-term indicators, such as the enterprise’s capital structure, past and projected earnings, and changes in financial posi- tion. Stockholders, present or prospective, also are interested in many of the features considered by a long-term creditor. As a stockholder, you would focus on the earnings picture, because changes in it greatly affect the market price of your investment. You

also would be concerned with the financial position of the company, because it affects indirectly the stability of earnings. The managers of a company are concerned about the composition of its capital structure and about the changes and trends in earnings. This financial information has a direct influence on the type, amount, and cost of external financing that the company can obtain. In addition, the company managers find financial information useful on a day-to-day operating basis in such areas as capital budgeting, break-even analysis, vari- ance analysis, gross margin analysis, and for internal control purposes. PERSPECTIVE ON FINANCIAL STATEMENT ANALYSIS Readers of financial statements can gather information by examining relationships between items on the statements and identifying trends in these relationships. The rela- tionships are expressed numerically in ratios and percentages, and trends are identified through comparative analysis. A problem with learning how to analyze statements is that the means may Underlying Concepts become an end in itself. Analysts could identify and calculate thousands of Because fi nancial statements possible relationships and trends. If one knows only how to calculate ratios report on the past, they and trends without understanding how such information can be used, little emphasize the qualitative is accomplished. Therefore, a logical approach to financial statement analysis characteristic of feedback is necessary, consisting of the following steps. value. This feedback value is useful because it can be used to 1. Know the questions for which you want to fi nd answers. As indicated earlier, better achieve the qualitative various groups have different types of interest in a company. characteristic of predictive 2. Know the questions that particular ratios and comparisons are able to help value. answer. These will be discussed in this appendix. 3. Match 1 and 2 above. By such a matching, the statement analysis will have a logical direction and purpose. Several caveats must be mentioned. Financial statements report on the past. Thus, analysis of these data is an examination of the past. When using such information in a decision-making (future-oriented) process, analysts assume that the past is a reasonable basis for predicting the future. This is usually a reasonable approach, but its limitations should be recognized. Appendix 24A: Basic Financial Statement Analysis 1523 Also, ratio and trend analyses will help identify a company’s present International strengths and weaknesses. They may serve as “red flags” indicating problem Perspective areas. In many cases, however, such analyses will not reveal why things are Some companies outside the as they are. Finding answers about “why” usually requires an in-depth analysis United States provide “conve- and an awareness of many factors about a company that are not reported in the nience” fi nancial statements financial statements. for U.S. readers. These fi nancial Another caveat is that a single ratio by itself is not likely to be very useful. statements have been translated For example, analysts may generally view a current ratio of 2 to 1 (current assets into English, and they may also are twice current liabilities) as satisfactory. However, if the industry average is translate the currency units 3 to 1, such a conclusion may be invalid. Even given this industry average, one into U.S. dollars. However, the may conclude that the particular company is doing well if one knows the previ- statements are not restated ous year’s ratio was 1.5 to 1. Consequently, to derive meaning from ratios, ana- using U.S. accounting principles; fi nancial statement analysis lysts need some standard against which to compare them. Such a standard may needs to take this fact into come from industry averages, past years’ amounts, a particular competitor, or account. planned levels. Finally, awareness of the limitations of accounting numbers used in an analysis is important. We will discuss some of these limitations and their consequences

later in this appendix. RATIO ANALYSIS In analyzing financial statement data, analysts use various devices to bring out the 10 LEARNING OBJECTIVE comparative and relative significance of the financial information presented. These Identify major analytic ratios and devices include ratio analysis, comparative analysis, percentage analysis, and describe their calculation. examination of related data. No one device is more useful than another. Every situation is different, and analysts often obtain the needed answers only upon close examination of the interrelationships among all the data provided. Ratio analysis is the starting point. Ratios can be classified as follows. MAJOR TYPES OF RATIOS LIQUIDITY RATIOS. Measures of the company’s short-run ability to pay its maturing obligations. ACTIVITY RATIOS. Measures of how effectively the company is using the assets employed. PROFITABILITY RATIOS. Measures of the degree of success or failure of a given company or division for a given period of time. COVERAGE RATIOS. Measures of the degree of protection for long-term creditors and investors.26 We have integrated discussions and illustrations about the computation and use of these financial ratios throughout this book. Illustration 24A-1 (page 1524) summarizes all of the ratios presented in the book and identifies the specific chapters that presented that material. 26Some analysts use other terms to categorize these ratios. For example, liquidity ratios are sometimes referred to as solvency ratios; activity ratios as turnover or efficiency ratios; and coverage ratios as leverage or capital structure ratios. 1524 Chapter 24 Full Disclosure in Financial Reporting ILLUSTRATION 24A-1 SUMMARY OF RATIOS PRESENTED IN EARLIER CHAPTERS Summary of Financial Ratios Ratio Formula for Computation Reference I. Liquidity 1. Current ratio Current assets Chapter 13, p. 729 Current liabilities Cash, short-term investments, 2. Quick or acid-test and net receivables Chapter 13, p. 730 ratio Current liabilities Net cash provided by 3. Current cash debt operating activities Chapter 5, p. 234 coverage Average current liabilities II. Activity 4. Accounts receivable Net sales Chapter 7, p. 373 turnover Average trade receivables (net) 5. Inventory turnover Cost of goods sold Chapter 9, p. 496 Average inventory 6. Asset turnover Net sales Chapter 11, p. 611 Average total assets III. Profitability 7. Profit margin Net income Chapter 11, p. 612 on sales Net sales 8. Return on Net income Chapter 11, p. 612 assets Average total assets 9. Return on Net income minus preferred dividends Chapter 15, p. 849 common stock Average common stockholders’ equity equity 10. Earnings per share Net income minus preferred dividends Chapter 16, p. 900 Weighted-average number of shares outstanding 11. Payout ratio Cash dividends Chapter 15, p. 850 Net income IV. Coverage 12. Debt to assets Total liabilities Chapter 14, p. 787 ratio Total assets Income before income taxes 13. Times interest and interest expense Chapter 14, p. 787 earned Interest expense Net cash provided by 14. Cash debt coverage operating activities Chapter 5, p. 234 Average total liabilities 15. Book value Common stockholders’ equity Chapter 15, p. 850 per share Outstanding shares Gateway to You can find additional coverage of these ratios, accompanied by assignment the Profession material, at the book’s companion website, at www.wiley.com/college/kieso. This sup- Financial Analysis Primer plemental coverage takes the form of a comprehensive case adapted from the annual report of a large international chemical company that we have disguised under the name of Anetek Chemical Corporation. Limitations of Ratio Analysis The reader of financial statements must understand the basic limitations associ- LEARNING OBJECTIVE 11 ated with ratio analysis. As analytical tools, ratios are attractive because they are Explain the limitations of ratio analysis. simple and convenient. But too frequently, decision-makers base their decisions on Appendix 24A: Basic Financial Statement Analysis 1525 only these simple computations. The ratios are only as good as the data upon which

they are based and the information with which they are compared. One important limitation of ratios is that they generally are based on historical cost, which can lead to distortions in measuring performance. Inaccurate assessments of the enterprise’s financial condition and performance can result from failing to incorpo- rate fair value information. Also, investors must remember that where estimated items (such as depreciation and amortization) are significant, income ratios lose some of their credibility. For example, income recognized before the termination of a company’s life is an approximation. In ana- lyzing the income statement, users should be aware of the uncertainty surrounding the computation of net income. As one writer aptly noted, “The physicist has long since con- ceded that the location of an electron is best expressed by a probability curve. Surely an abstraction like earnings per share is even more subject to the rules of probability and risk.”27 Probably the greatest limitation of ratio analysis is the difficult problem of Underlying Concepts achieving comparability among firms in a given industry. Achieving compara- bility requires that the analyst (1) identify basic differences in companies’ Consistency and comparability accounting principles and procedures, and (2) adjust the balances to achieve com- are important concepts for parability. Basic differences in accounting usually involve one of the following areas. fi nancial statement analysis. If the principles and assumptions 1. Inventory valuation (FIFO, LIFO, average-cost). used to prepare the fi nancial statements are continually 2. Depreciation methods, particularly the use of straight-line versus acceler- changing, accurate assessments ated depreciation. of a company’s progress 3. Capitalization versus expensing of certain costs. become diffi cult. 4. Capitalization of leases versus noncapitalization. 5. Investments in common stock carried at equity versus fair value. 6. Differing treatments of postretirement benefi t costs. 7. Questionable practices of defi ning discontinued operations, impairments, and extraordinary items. The use of these different alternatives can make a significant difference in the ratios computed. For example, at one time Anheuser-Busch InBev noted that if it had used average-cost for inventory valuation instead of LIFO, inventories would have increased approximately $33,000,000. Such an increase would have a substantive impact on the current ratio. Several studies have analyzed the impact of different accounting methods on financial statement analysis. The differences in income that can develop are stagger- ing in some cases. Investors must be aware of the potential pitfalls if they are to be able to make the proper adjustments.28 Finally, analysts should recognize that a substantial amount of important informa- tion is not included in a company’s financial statements. Events involving such things as industry changes, management changes, competitors’ actions, technological devel- opments, government actions, and union activities are often critical to a company’s successful operation. These events occur continuously, and information about them must come from careful analysis of financial reports in the media and other sources. Indeed many argue, in what is known as the efficient-market hypothesis, that financial statements contain “no surprises” to those engaged in market activities. They contend that the effect of these events is known in the marketplace—and the price of the company’s stock adjusts accordingly—well before the issuance of such reports. 27Richard E. Cheney, “How Dependable Is the Bottom Line?” The Financial Executive (January 1971), p. 12. 28See, for example, Eugene A. Imhoff, Jr., Robert C. Lipe, and David W. Wright, “Operating Leases: Impact of Constructive Capitalization,” Accounting Horizons (March 1991). 1526 Chapter 24 Full Disclosure in Financial Reporting COMPARATIVE ANALYSIS Comparative analysis presents the same information for two or more different LEARNING OBJECTIVE 12

dates or periods, so that like items may be compared. Ratio analysis provides only Describe techniques of comparative a single snapshot, for one given point or period in time. In a comparative analysis, analysis. an investment analyst can concentrate on a given item and determine whether it appears to be growing or diminishing year by year and the proportion of such change to related items. Generally, companies present comparative financial statements. They typically include two years of balance sheet information and three years of income state- ment information. In addition, many companies include in their annual reports five- or ten-year sum- maries of pertinent data that permit readers to examine and analyze trends. As indi- cated in GAAP, “the presentation of comparative financial statements in annual and other reports enhances the usefulness of such reports and brings out more clearly the nature and trends of current changes affecting the enterprise.” Illustration 24A-2 pre- sents a five-year condensed statement, with additional supporting data, of Anetek Chemical Corporation. ILLUSTRATION 24A-2 Condensed Comparative Financial Information ANETEK CHEMICAL CORPORATION CONDENSED COMPARATIVE STATEMENTS (000,000 OMITTED) 10 Years 20 Years 2014 2013 2012 2011 2010 Ago 2004 Ago 1994 Sales and other revenue: Net sales $1,600.0 $1,350.0 $1,309.7 $1,176.2 $1,077.5 $636.2 $170.7 Other revenue 75.0 50.0 39.4 34.1 24.6 9.0 3.7 Total 1,675.0 1,400.0 1,349.1 1,210.3 1,102.1 645.2 174.4 Costs and other charges: Cost of sales 1,000.0 850.0 827.4 737.6 684.2 386.8 111.0 Depreciation and amortization 150.0 150.0 122.6 115.6 98.7 82.4 14.2 Selling and administrative expenses 225.0 150.0 144.2 133.7 126.7 66.7 10.7 Interest expense 50.0 25.0 28.5 20.7 9.4 8.9 1.8 Income taxes 100.0 75.0 79.5 73.5 68.3 42.4 12.4 Total 1,525.0 1,250.0 1,202.2 1,081.1 987.3 587.2 150.1 Net income for the year $ 150.0 $ 150.0 $ 146.9 $ 129.2 $ 114.8 $ 58.0 $ 24.3 Other Statistics Earnings per share on common stock (in dollars)a $ 5.00 $ 5.00 $ 4.90 $ 3.58 $ 3.11 $ 1.66 $ 1.06 Cash dividends per share on common stock (in dollars)a 2.25 2.15 1.95 1.79 1.71 1.11 0.25 Cash dividends declared on common stock 67.5 64.5 58.5 64.6 63.1 38.8 5.7 Stock dividend at approximate market value 46.8 27.3 Taxes (major) 144.5 125.9 116.5 105.6 97.8 59.8 17.0 Wages paid 389.3 325.6 302.1 279.6 263.2 183.2 48.6 Cost of employee benefits 50.8 36.2 32.9 28.7 27.2 18.4 4.4 Number of employees at year end (thousands) 47.4 36.4 35.0 33.8 33.2 26.6 14.6 Additions to property 306.3 192.3 241.5 248.3 166.1 185.0 49.0 aAdjusted for stock splits and stock dividends. Appendix 24A: Basic Financial Statement Analysis 1527 PERCENTAGE (COMMON-SIZE) ANALYSIS Analysts also use percentage analysis to help them evaluate and compare compa- 13 LEARNING OBJECTIVE nies. Percentage analysis consists of reducing a series of related amounts to a Describe techniques of percentage series of percentages of a given base. For example, analysts frequently express all analysis. items in an income statement as a percentage of sales or sometimes as a percentage of cost of goods sold. They may analyze a balance sheet on the basis of total assets. Percentage analysis facilitates comparison and is helpful in evaluating the relative size of items or the relative change in items. A conversion of absolute dollar amounts to percentages may also facilitate comparison between companies of different size. Illustration 24A-3 shows a comparative analysis of the expense section of Anetek for the last two years. ILLUSTRATION 24A-3 ANETEK CHEMICAL CORPORATION Horizontal Percentage HORIZONTAL COMPARATIVE ANALYSIS Analysis (000,000 OMITTED) % Change 2014 2013 Difference Inc. (Dec.) Cost of sales $1,000.0 $850.0 $150.0 17.6% Depreciation and amortization 150.0 150.0 0 0 Selling and administrative expenses 225.0 150.0 75.0 50.0 Interest expense 50.0 25.0 25.0 100.0 Income taxes 100.0 75.0 25.0 33.3 This approach, normally called horizontal analysis, indicates the proportionate change over a period of time. It is especially useful in evaluating trends, because

absolute changes are often deceiving. Another comparative approach, called vertical analysis, is the proportional expres- sion of each financial statement item in a given period to a base figure. For example, Anetek Chemical’s income statement using this approach appears in Illustration 24A-4. ILLUSTRATION 24A-4 ANETEK CHEMICAL CORPORATION Vertical Percentage INCOME STATEMENT Analysis (000,000 OMITTED) Percentage of Amount Total Revenue Net sales $1,600.0 96% Other revenue 75.0 4 Total revenue 1,675.0 100 Less: Cost of sales 1,000.0 60 Depreciation and amortization 150.0 9 Selling and administrative expenses 225.0 13 Interest expense 50.0 3 Income taxes 100.0 6 Total expenses 1,525.0 91 Net income $ 150.0 9% Vertical analysis is frequently called common-size analysis because it reduces all of the statement items to a “common size.” That is, all of the elements within each state- ment are expressed in percentages of some common number and always add up to 100 percent. Common-size (percentage) analysis reveals the composition of each of the financial statements. 1528 Chapter 24 Full Disclosure in Financial Reporting In the analysis of the balance sheet, common-size analysis answers such questions as: What percentage of the capital structure is stockholders’ equity, current liabilities, and long-term debt? What is the mix of assets (percentage-wise) with which the com- pany has chosen to conduct business? What percentage of current assets is in inventory, receivables, and so forth? Common-size analysis of the income statement typically relates each item to sales. It is instructive to know what proportion of each sales dollar is absorbed by various costs and expenses incurred by the enterprise. Analysts may use common-size statements to compare one company’s statements from different years, to detect trends not evident from comparing absolute amounts. Also, common-size statements provide intercompany comparisons regardless of size because they recast financial statements into a comparable common-size format. KEY TERMS SUMMARY OF LEARNING OBJECTIVES accounts receivable turnover, 1524 FOR APPENDIX 24A acid-test ratio, 1524 activity ratios, 1523 asset turnover, 1524 9 Understand the approach to financial statement analysis. Basic finan- book value per share, 1524 cial statement analysis involves examining relationships between items on the state- cash debt coverage, 1524 ments (ratio and percentage analysis) and identifying trends in these relationships common-size (comparative analysis). Analysis is used to predict the future, but ratio analysis is lim- analysis, 1527 ited because the data are from the past. Also, ratio analysis identifies present strengths comparative and weaknesses of a company, but it may not reveal why they are as they are. Although analysis, 1526 single ratios are helpful, they are not conclusive. For maximum usefulness, analysts coverage ratios, 1523 must compare them with industry averages, past years, planned amounts, and the like. current cash debt 10 Identify major analytic ratios and describe their calculation. Ratios are coverage, 1524 classified as liquidity ratios, activity ratios, profitability ratios, and coverage ratios. current ratio, 1524 (1) Liquidity ratio analysis measures the short-run ability of a company to pay its cur- debt to assets ratio, 1524 rently maturing obligations. (2) Activity ratio analysis measures how effectively a com- earnings per share, 1524 pany is using its assets. (3) Profitability ratio analysis measures the degree of success or horizontal analysis, 1527 failure of a company to generate revenues adequate to cover its costs of operation and inventory turnover, 1524 provide a return to the owners. (4) Coverage ratio analysis measures the degree of protec- liquidity ratios, 1523 tion afforded long-term creditors and investors. payout ratio, 1524 11 Explain the limitations of ratio analysis. Ratios are based on historical cost, percentage analysis, 1527 which can lead to distortions in measuring performance. Also, where estimated items profit margin on

are significant, income ratios lose some of their credibility. In addition, comparability sales, 1524 problems exist because companies use different accounting principles and procedures. profitability ratios, 1523 Finally, analysts must recognize that a substantial amount of important information is quick ratio, 1524 not included in a company’s financial statements. return on assets, 1524 12 Describe techniques of comparative analysis. Companies present compar- return on common stock ative data, which generally includes two years of balance sheet information and three years equity, 1524 of income statement information. In addition, many companies include in their annual times interest reports five- to ten-year summaries of pertinent data that permit the reader to analyze trends. earned, 1524 vertical analysis, 1527 13 Describe techniques of percentage analysis. Percentage analysis con- sists of reducing a series of related amounts to a series of percentages of a given base. Analysts use two approaches. Horizontal analysis indicates the proportionate change in financial statement items over a period of time; such analysis is most helpful in evaluat- ing trends. Vertical analysis (common-size analysis) is a proportional expression of each item on the financial statements in a given period to a base amount. It analyzes the Demonstration Problem 1529 composition of each of the financial statements from different years (a) to detect trends not evident from the comparison of absolute amounts and (b) to make intercompany comparisons of different-sized enterprises. DEMONSTRATION PROBLEM Konetzke Corporation, a publicly traded company, is preparing the interim financial data which it will i ssue to its stockholders and the Securities and Exchange Commission (SEC) for the fiscal year ending December 31, 2014. Your job as a member of the accounting team is to help determine the appropriate disclosures and any other potential year-end adjustments. You have collected the following information. 1. Konetzke is involved in four separate industries. The following information is available for each of the four industries. Konetzke wonders which segments are reportable. Operating Segment Total Revenue Operating Profi t (Loss) Identifi able Assets Badger $ 60,000 $15,000 $167,000 Spartan 10,000 1,500 83,000 Cornhusker 23,000 (2,000) 21,000 Hawkeye 9,000 1,000 19,000 $102,000 $15,500 $290,000 2. On February 3, 2015, one of Konetzke’s customers declared bankruptcy. At December 31, 2014, this company owed Konetzke $15,000, of which $3,000 was paid in January 2015. 3. On January 18, 2015, one of the three major plants of the client burned down. 4. On January 23, 2015, a strike was called at one of Konetzke’s largest plants, which halted 30% of its production. As of today (February 13), the strike has not been settled. 5. On February 1, 2013, the board of directors adopted a resolution accepting the offer of an invest- ment banker to guarantee the marketing of $1,200,000 of preferred stock. Instructions (a) State in each case how the 2014 financial statements would be affected, if at all. (b) Moving ahead to the first quarter of 2015, your team has compiled the following summarized revenue and expense data for the first quarter of the year. Sales revenue $30,000 Cost of goods sold 18,000 Variable selling expenses 500 Fixed selling expenses 1,500 Included in the fixed selling expenses was the single lump-sum payment of $800 for Internet advertise- ments for the entire year. Address the following with respect to the first quarter report. (1) Explain whether Konetzke should report its operating results for the quarter as if the quarter were a separate reporting period in and of itself, or as if the quarter were an integral part of the annual reporting period. (2) State how the sales revenue, cost of goods sold, and fixed selling expenses would be reflected in Konetzke’s quarterly report prepared for the first quarter of 2015. Solution (a) 1. Konetzke first conducts the following three tests: Revenue test: 10% 3 $102,000 5 $10,200. The Badger ($23,000) and Cornhusker ($60,000) segments both

meet this test. Operating profit (loss) test: 10% 3 ($15,000 1 $1,500 1 $1,000) 5 $1,750. The Badger ($15,000) and Corn- husker ($2,000 absolute amount) segments both meet this test. Identifiable assets test: 10% 3 $290,000 5 $29,000. The Badger ($167,000) and Spartan ($83,000) segments both meet this test. Thus, Konetzke has three reportable segments for which segment information should be disclosed. 1530 Chapter 24 Full Disclosure in Financial Reporting Regarding the post-balance-sheet events: 2. T he financial statements should be adjusted for the expected loss pertaining to the remaining re- ceivable of $12,000. Such adjustment should reduce accounts receivable to their realizable value as of December 31, 2015. 3. Report the fire loss in a footnote to the balance sheet and refer to it in connection with the income statement, since earnings power is presumably affected. 4. Strikes are considered general knowledge and therefore disclosure is not required. Many audi- tors, however, would encourage disclosure in all cases. 5. Report the action of the new stock issue in a footnote to the balance sheet. (b) 1. The company should report its quarterly results as if each interim period is an integral part of the annual period. 2. The company’s revenue and expenses would be reported as follows on its quarterly report prepared for the first quarter of 2015: Sales revenue $30,000 Cost of goods sold 18,000 Variable selling expenses 500 Fixed selling expenses Advertising ($800 4 4) 200 Other ($1,500 2 $800) 700 Sales revenue and cost of goods sold receive the same treatment as if this were an annual report. Costs and expenses other than product costs should be charged to expense in interim periods as incurred or allocated among interim periods. Consequently, the variable selling expenses and the portion of fixed selling expenses not related to Internet advertising should be reported in full. One-fourth of the Internet advertising is reported as an expense in the first quarter, a ssuming the advertising is constant throughout the year. These costs can be deferred within the fiscal period if the benefits of the expenditure clearly extend beyond the interim period in which the expenditure is made. FASB CODIFICATION FASB Codification References [1] FASB ASC 850-10-05 [Predecessor literature: “Related Party Disclosures,” Statement of Financial Accounting Standards No. 57 (Stamford, Conn.: FASB, 1982).] [2] FASB ASC 855-10-05 [Predecessor literature: “Subsequent Events,” Statement on Auditing Standards No. 1 (New York: AICPA, 1973), pp. 123–124.] [3] FASB ASC 280-10-05-3. [Predecessor literature: “Disclosures about Segments of an Enterprise and Related Information,” Statement of Financial Accounting Standards No. 131 (Norwalk, Conn.: FASB, 1997).] [4] FASB ASC 270-10. [Predecessor literature: “Interim Financial Reporting,” Opinions of the Accounting Principles Board No. 28 (New York: AICPA, 1973).] [5] FASB ASC 740-270-30-2 through 3. [Predecessor literature: “Interim Financial Reporting,” Opinions of the Accounting Principles Board No. 28 (New York: AICPA, 1973), par. 19.] [6] FASB ASC 740-270-35-4. [Predecessor literature: “Accounting for Income Taxes in Interim Periods,” FASB Interpretation No. 18 (Stamford, Conn.: FASB, March 1977), par. 9.] [7] FASB ASC 205-30 [Predecessor literature: “The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern,” Statement on Auditing Standards No. 59 (New York: AICPA, 1988).] 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. CE24-1 Access the glossary (“Master Glossary”) to answer the following. (a) What is the definition of “ordinary income” (loss)? (b) What is an error in previously issued financial statements? Questions 1531 (c) What is the definition of “earnings per share”? (d) What is a publicly traded company? CE24-2 What are some examples of related parties? CE24-3 What are the quantitative thresholds that would require a public company to report separately information about an

operating segment? CE24-4 If an SEC-registered company uses the gross profit method to determine cost of goods sold for interim periods, would it be acceptable for the company to state that it’s not practicable to determine components of inventory at interim peri- ods? Why or why not? An additional Codification case can be found in the Using Your Judgment section, on page 1548. 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. Note: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter. QUESTIONS 1. What are the major advantages of notes to the financial outstanding. Holland has since obtained representation statements? What types of items are usually reported in on the Board of Directors.” notes? “An affiliate of Holland Products Corporation acts as a food broker for Canon Packing in the greater New York 2. What is the full disclosure principle in accounting? Why City marketing area. The commissions for such services has disclosure increased substantially in the last 10 years? after August amounted to approximately $20,000.” 3. The FASB requires a reconciliation between the effective Why is this information disclosed? tax rate and the federal government’s statutory rate. Of 6. What are the major types of subsequent events? Indicate what benefit is such a disclosure requirement? how each of the following “subsequent events” would be 4. What type of disclosure or accounting do you believe is reported. necessary for the following items? (a) Collection of a note written off in a prior period. (a) Because of a general increase in the number of labor (b) Issuance of a large preferred stock offering. disputes and strikes, both within and outside the in- dustry, there is an increased likelihood that a com- (c) Acquisition of a company in a different industry. pany will suffer a costly strike in the near future. (d) Destruction of a major plant in a flood. (b) A company reports an extraordinary item (net of tax) (e) Death of the company’s chief executive officer (CEO). correctly on the income statement. No other mention (f) Additional wage costs associated with settlement of a is made of this item in the annual report. four-week strike. (c) A company expects to recover a substantial amount (g) Settlement of a federal income tax case at consider- in connection with a pending refund claim for a prior ably more tax than anticipated at year-end. year’s taxes. Although the claim is being contested, (h) Change in the product mix from consumer goods to counsel for the company has confirmed the client’s industrial goods. expectation of recovery. 7. What are diversified companies? What accounting prob- 5. The following information was described in a note of lems are related to diversified companies? Canon Packing Co. “During August, Holland Products Corporation 8. What quantitative materiality test is applied to determine purchased 311,003 shares of the Company’s common whether a segment is significant enough to warrant sepa- stock which constitutes approximately 35% of the stock rate disclosure? 1532 Chapter 24 Full Disclosure in Financial Reporting 9. Identify the segment information that is required to be presenting interim data when a LIFO inventory valuation disclosed by GAAP. is used. What problems are encountered with LIFO inven- 10. What is an operating segment, and when can information tories when quarterly data are presented? about two operating segments be aggregated? 19. What approaches have been suggested to overcome the 11. The controller for Lafayette Inc. recently commented, “If seasonality problem related to interim reporting? I have to disclose our segments individually, the only 20. What is the difference between a CPA’s unqualified opin- people who will gain are our competitors and the only ion or “clean” opinion and a qualified one? people that will lose are our present stockholders.” Evalu- 21. Jane Ellerby and Sam Callison are discussing the recent

ate this comment. fraud that occurred at LowRental Leasing, Inc. The fraud 12. An article in the financial press entitled “Important Infor- involved the improper reporting of revenue to ensure that mation in Annual Reports This Year” noted that annual the company would have income in excess of $1 million. reports include a management’s discussion and analysis What is fraudulent financial reporting, and how does it section. What would this section contain? differ from an embezzlement of company funds? 13. “The financial statements of a company are manage- *2 2. “The significance of financial statement data is not in the ment’s, not the accountant’s.” Discuss the implications of amount alone.” Discuss the meaning of this statement. this statement. *2 3. A close friend of yours, who is a history major and who 14. Olga Conrad, a financial writer, noted recently, “There are has not had any college courses or any experience in busi- substantial arguments for including earnings projections ness, is receiving the financial statements from companies in annual reports and the like. The most compelling is that in which he has minor investments (acquired for him by it would give anyone interested something now available his now-deceased father). He asks you what he needs to to only a relatively select few—like large stockholders, know to interpret and to evaluate the financial statement creditors, and attentive bartenders.” Identify some argu- data that he is receiving. What would you tell him? ments against providing earnings projections. *2 4. Distinguish between ratio analysis and percentage analy- 15. The following comment appeared in the financial press: sis relative to the interpretation of financial statements. “Inadequate financial disclosure, particularly with re- What is the value of these two types of analyses? spect to how management views the future and its role *2 5. In calculating inventory turnover, why is cost of goods in the marketplace, has always been a stone in the shoe. sold used as the numerator? As the inventory turnover After all, if you don’t know how a company views the increases, what increasing risk does the business assume? future, how can you judge the worth of its corporate strat- *2 6. What is the relationship of the asset turnover to the return egy?” What are some arguments for reporting earnings on assets? forecasts? *2 7. Explain the meaning of the following terms: (a) common- 16. What are interim reports? Why are balance sheets often size analysis, (b) vertical analysis, (c) horizontal analysis, not provided with interim data? and (d) percentage analysis. 17. What are the accounting problems related to the presenta- *2 8. Presently, the profession requires that earnings per share tion of interim data? be disclosed on the face of the income statement. What are 18. Dierdorf Inc., a closely held corporation, has decided to some disadvantages of reporting ratios on the financial go public. The controller, Ed Floyd, is concerned with statements? BRIEF EXERCISES 2 BE24-1 An annual report of Crestwood Industries states, “The company and its subsidiaries have long- term leases expiring on various dates after December 31, 2014. Amounts payable under such commitments, without reduction for related rental income, are expected to average approximately $5,711,000 annually for the next 3 years. Related rental income from certain subleases to others is estimated to average $3,094,000 annually for the next 3 years.” What information is provided by this note? 2 BE24-2 An annual report of Ford Motor Corporation states, “Net income a share is computed based upon the average number of shares of capital stock of all classes outstanding. Additional shares of common stock may be issued or delivered in the future on conversion of outstanding convertible debentures, exercise of outstanding employee stock options, and for payment of defined supplemental compensation. Had such additional shares been outstanding, net income a share would have been reduced by 10¢ in the current year

and 3¢ in the previous year. . . . As a result of capital stock transactions by the company during the current year (primarily the purchase of Class A Stock from Ford Foundation), net income a share was increased by 6¢.” What information is provided by this note? Exercises 1533 3 BE24-3 Morlan Corporation is preparing its December 31, 2014, financial statements. Two events that occurred between December 31, 2014, and March 10, 2015, when the statements were issued, are described below. 1. A liability, estimated at $160,000 at December 31, 2014, was settled on February 26, 2015, at $170,000. 2. A flood loss of $80,000 occurred on March 1, 2015. What effect do these subsequent events have on 2014 net income? 3 BE24-4 Tina Bailey, a student of intermediate accounting, was heard to remark after a class discussion on segment reporting, “All this is very confusing to me. First we are told that there is merit in presenting the consolidated results, and now we are told that it is better to show segmental results. I wish they would make up their minds.” Evaluate this comment. 3 BE24-5 Foley Corporation has seven industry segments with total revenues as follows. Penley $600 Cheng $225 Konami 650 Takuhi 200 KSC 250 Molina 700 Red Moon 275 Based only on the revenues test, which industry segments are reportable? 3 BE24-6 Operating profits and losses for the seven industry segments of Foley Corporation are: Penley $ 90 Cheng $ (20) Konami (40) Takuhi 34 KSC 25 Molina 150 Red Moon 50 Based only on the operating profit (loss) test, which industry segments are reportable? 3 BE24-7 Identifiable assets for the seven industry segments of Foley Corporation are: Penley $500 Cheng $200 Konami 550 Takuhi 150 KSC 250 Molina 475 Red Moon 400 Based only on the identifiable assets test, which industry segments are reportable? 10 *B E24-8 Answer each of the questions in the following unrelated situations. (a) The current ratio of a company is 5:1 and its acid-test ratio is 1:1. If the inventories and prepaid items amount to $500,000, what is the amount of current liabilities? (b) A company had an average inventory last year of $200,000 and its inventory turnover was 5. If sales volume and unit cost remain the same this year as last and inventory turnover is 8 this year, what will average inventory have to be during the current year? (c) A company has current assets of $90,000 (of which $40,000 is inventory and prepaid items) and current liabilities of $40,000. What is the current ratio? What is the acid-test ratio? If the company borrows $15,000 cash from a bank on a 120-day loan, what will its current ratio be? What will the acid-test ratio be? (d) A company has current assets of $600,000 and current liabilities of $240,000. The board of directors declares a cash dividend of $180,000. What is the current ratio after the declaration but before pay- ment? What is the current ratio after the payment of the dividend? 10 * BE24-9 Heartland Company’s budgeted sales and budgeted cost of goods sold for the coming year are $144,000,000 and $99,000,000, respectively. Short-term interest rates are expected to average 10%. If Heart- land can increase inventory turnover from its present level of 9 times a year to a level of 12 times per year, compute its expected cost savings for the coming year. EXERCISES 3 E24-1 (Post-Balance-Sheet Events) Madrasah Corporation issued its financial statements for the year ended December 31, 2014, on March 10, 2015. The following events took place early in 2015. (a) On January 10, 10,000 shares of $5 par value common stock were issued at $66 per share. (b) On March 1, Madrasah determined after negotiations with the Internal Revenue Service that income taxes payable for 2014 should be $1,270,000. At December 31, 2014, income taxes payable were recorded at $1,100,000. 1534 Chapter 24 Full Disclosure in Financial Reporting Instructions Discuss how the preceding post-balance-sheet events should be reflected in the 2014 financial statements. 3 E24-2 (Post-Balance-Sheet Events) For each of the following subsequent (post-balance-sheet) events, in-

dicate whether a company should (a) adjust the financial statements, (b) disclose in notes to the financial statements, or (c) neither adjust nor disclose. ______ 1. S ettlement of federal tax case at a cost considerably in excess of the amount expected at year-end. ______ 2. Introduction of a new product line. ______ 3. Loss of assembly plant due to fire. ______ 4. Sale of a significant portion of the company’s assets. ______ 5. Retirement of the company president. ______ 6. Prolonged employee strike. ______ 7. Loss of a significant customer. ______ 8. Issuance of a significant number of shares of common stock. ______ 9. Material loss on a year-end receivable because of a customer’s bankruptcy. ______ 10. Hiring of a new president. ______ 11. Settlement of prior year’s litigation against the company (no loss was accrued). ______ 12. Merger with another company of comparable size. 3 E24-3 (Segmented Reporting) Carlton Company is involved in four separate industries. The following information is available for each of the four industries. Operating Segment Total Revenue Operating Profi t (Loss) Identifi able Assets W $ 60,000 $15,000 $167,000 X 10,000 3,000 83,000 Y 23,000 (2,000) 21,000 Z 9,000 1,000 19,000 $102,000 $17,000 $290,000 Instructions Determine which of the operating segments are reportable based on the: (a) Revenue test. (b) Operating profit (loss) test. (c) Identifiable assets test. 10 *E 24-4 (Ratio Computation and Analysis; Liquidity) As loan analyst for Utrillo Bank, you have been pre- sented the following information. Toulouse Co. Lautrec Co. Assets Cash $ 120,000 $ 320,000 Receivables 220,000 302,000 Inventories 570,000 518,000 Total current assets 910,000 1,140,000 Other assets 500,000 612,000 Total assets $1,410,000 $1,752,000 Liabilities and Stockholders’ Equity Current liabilities $ 305,000 $ 350,000 Long-term liabilities 400,000 500,000 Capital stock and retained earnings 705,000 902,000 Total liabilities and stockholders’ equity $1,410,000 $1,752,000 Annual sales $ 930,000 $1,500,000 Rate of gross profi t on sales 30% 40% Each of these companies has requested a loan of $50,000 for 6 months with no collateral offered. Because your bank has reached its quota for loans of this type, only one of these requests is to be granted. Instructions Which of the two companies, as judged by the information given above, would you recommend as the better risk and why? Assume that the ending account balances are representative of the entire year. Exercises 1535 10 *E 24-5 (Analysis of Given Ratios) Picasso Company is a wholesale distributor of professional equipment and supplies. The company’s sales have averaged about $900,000 annually for the 3-year period 2012–2014. The firm’s total assets at the end of 2014 amounted to $850,000. The president of Picasso Company has asked the controller to prepare a report that summarizes the financial aspects of the company’s operations for the past 3 years. This report will be presented to the board of directors at their next meeting. In addition to comparative financial statements, the controller has decided to present a number of relevant financial ratios which can assist in the identification and interpretation of trends. At the request of the controller, the accounting staff has calculated the following ratios for the 3-year period 2012–2014. 2012 2013 2014 Current ratio 1.80 1.89 1.96 Acid-test (quick) ratio 1.04 0.99 0.87 Accounts receivable turnover 8.75 7.71 6.42 Inventory turnover 4.91 4.32 3.42 Debt to assets 51.0% 46.0% 41.0% Long-term debt to assets 31.0% 27.0% 24.0% Sales to fi xed assets (fi xed asset turnover) 1.58 1.69 1.79 Sales as a percent of 2012 sales 1.00 1.03 1.07 Gross margin percentage 36.0% 35.1% 34.6% Net income to sales 6.9% 7.0% 7.2% Return on assets 7.7% 7.7% 7.8% Return on common stock equity 13.6% 13.1% 12.7% In preparation of the report, the controller has decided first to examine the financial ratios independent of any other data to determine if the ratios themselves reveal any significant trends over the 3-year period. Instructions

(a) The current ratio is increasing while the acid-test (quick) ratio is decreasing. Using the ratios pro- vided, identify and explain the contributing factor(s) for this apparently divergent trend. (b) In terms of the ratios provided, what conclusion(s) can be drawn regarding the company’s use of financial leverage during the 2012–2014 period? (c) Using the ratios provided, what conclusion(s) can be drawn regarding the company’s net invest- ment in plant and equipment? 10 *E 24-6 (Ratio Analysis) Edna Millay Inc. is a manufacturer of electronic components and accessories with total assets of $20,000,000. Selected financial ratios for Millay and the industry averages for firms of similar size are presented below. 2014 Edna Millay Industry 2012 2013 2014 Average Current ratio 2.09 2.27 2.51 2.24 Quick ratio 1.15 1.12 1.19 1.22 Inventory turnover 2.40 2.18 2.02 3.50 Net sales to stockholders’ equity 2.71 2.80 2.99 2.85 Return on common stock equity 0.14 0.15 0.17 0.11 Total liabilities to stockholders’ equity 1.41 1.37 1.44 0.95 Millay is being reviewed by several entities whose interests vary, and the company’s financial ratios are a part of the data being considered. Each of the parties listed below must recommend an action based on its evaluation of Millay’s financial position. Archibald MacLeish Bank. The bank is processing Millay’s application for a new 5-year term note. Archibald MacLeish has been Millay’s banker for several years but must reevaluate the company’s financial position for each major transaction. Robert Lowell Company. Lowell is a new supplier to Millay and must decide on the appropriate credit terms to extend to the company. Robert Penn Warren. A brokerage firm specializing in the stock of electronics firms that are sold over- the-counter, Robert Penn Warren must decide if it will include Millay in a new fund being established for sale to Robert Penn Warren’s clients. Working Capital Management Committee. This is a committee of Millay’s management personnel chaired by the chief operating officer. The committee is charged with the responsibility of periodically review- ing the company’s working capital position, comparing actual data against budgets, and recommend- ing changes in strategy as needed. 1536 Chapter 24 Full Disclosure in Financial Reporting Instructions (a) Describe the analytical use of each of the six ratios presented on page 1535. (b) For each of the four entities described above, identify two financial ratios, from the ratios presented on page 1535, that would be most valuable as a basis for its decision regarding Millay. (c) Discuss what the financial ratios presented in the question reveal about Millay. Support your answer by citing specific ratio levels and trends as well as the interrelationships between these ratios. (CMA adapted) EXERCISES SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of exercises. PROBLEMS 3 P24-1 (Subsequent Events) Your firm has been engaged to examine the financial statements of Almaden Corporation for the year 2014. The bookkeeper who maintains the financial records has prepared all the unaudited financial statements for the corporation since its organization on January 2, 2009. The client provides you with the following information. ALMADEN CORPORATION BALANCE SHEET DECEMBER 31, 2014 Assets Liabilities Current assets $1,881,100 Current liabilities $ 962,400 Other assets 5,171,400 Long-term liabilities 1,439,500 Capital 4,650,600 $7,052,500 $7,052,500 An analysis of current assets discloses the following. Cash (restricted in the amount of $300,000 for plant expansion) $ 571,000 Investments in land 185,000 Accounts receivable less allowance of $30,000 480,000 Inventories (LIFO fl ow assumption) 645,100 $1,881,100 Other assets include: Prepaid expenses $ 62,400 Plant and equipment less accumulated depreciation of $1,430,000 4,130,000 Cash surrender value of life insurance policy 84,000 Unamortized bond discount 34,500 Notes receivable (short-term) 162,300 Goodwill 252,000 Land 446,200 $5,171,400

Current liabilities include: Accounts payable $ 510,000 Notes payable (due 2017) 157,400 Estimated income taxes payable 145,000 Premium on common stock 150,000 $ 962,400 Problems 1537 Long-term liabilities include: Unearned revenue $ 489,500 Dividends payable (cash) 200,000 8% bonds payable (due May 1, 2019) 750,000 $1,439,500 Capital includes: Retained earnings $2,810,600 Common stock, par value $10; authorized 200,000 shares, 184,000 shares issued 1,840,000 $4,650,600 The supplementary information below is also provided. 1. On May 1, 2014, the corporation issued at 95.4, $750,000 of bonds to finance plant expansion. The long-term bond agreement provided for the annual payment of interest every May 1. The existing plant was pledged as security for the loan. Use the straight-line method for discount amortization. 2. The bookkeeper made the following mistakes. (a) I n 2012, the ending inventory was overstated by $183,000. The ending inventories for 2013 and 2014 were correctly computed. (b) I n 2014, accrued wages in the amount of $225,000 were omitted from the balance sheet, and these expenses were not charged on the income statement. (c) In 2014, a gain of $175,000 (net of tax) on the sale of certain plant assets was credited directly to retained earnings. 3. A major competitor has introduced a line of products that will compete directly with Almaden’s primary line, now being produced in a specially designed new plant. Because of manufacturing in- novations, the competitor’s line will be of comparable quality but priced 50% below Almaden’s line. The competitor announced its new line on January 14, 2015. Almaden indicates that the company will meet the lower prices that are high enough to cover variable manufacturing and selling ex- penses, but permit recovery of only a portion of fixed costs. 4. You learned on January 28, 2015, prior to completion of the audit, of heavy damage because of a recent fire to one of Almaden’s two plants; the loss will not be reimbursed by insurance. The news- papers described the event in detail. Instructions Analyze the above information to prepare a corrected balance sheet for Almaden in accordance with proper accounting and reporting principles. Prepare a description of any notes that might need to be prepared. The books are closed and adjustments to income are to be made through retained earnings. 3 P24-2 (Segmented Reporting) Cineplex Corporation is a diversified company that operates in five differ- ent industries: A, B, C, D, and E. The following information relating to each segment is available for 2015. A B C D E Sales revenue $40,000 $ 75,000 $580,000 $35,000 $55,000 Cost of goods sold 19,000 50,000 270,000 19,000 30,000 Operating expenses 10,000 40,000 235,000 12,000 18,000 Total expenses 29,000 90,000 505,000 31,000 48,000 Operating profi t (loss) $11,000 $ (15,000) $ 75,000 $ 4,000 $ 7,000 Identifi able assets $35,000 $ 80,000 $500,000 $65,000 $50,000 Sales of segments B and C included intersegment sales of $20,000 and $100,000, respectively. Instructions (a) Determine which of the segments are reportable based on the: (1) Revenue test. (2) Operating profit (loss) test. (3) Identifiable assets test. (b) Prepare the necessary disclosures required by GAAP. 10 12 * P24-3 (Ratio Computations and Additional Analysis) Bradburn Corporation was formed 5 years ago through a public subscription of common stock. Daniel Brown, who owns 15% of the common stock, was one of the organizers of Bradburn and is its current president. The company has been successful, but it cur- rently is experiencing a shortage of funds. On June 10, 2014, Daniel Brown approached the Topeka National Bank, asking for a 24-month extension on two $35,000 notes, which are due on June 30, 2015, and September 30, 2015. Another note of $6,000 is due on March 31, 2016, but he expects no difficulty in paying this note on its 1538 Chapter 24 Full Disclosure in Financial Reporting due date. Brown explained that Bradburn’s cash flow problems are due primarily to the company’s desire to finance a $300,000 plant expansion over the next 2 fiscal years through internally generated funds.

The commercial loan officer of Topeka National Bank requested the following financial reports for the last 2 fiscal years. BRADBURN CORPORATION BALANCE SHEET MARCH 31 Assets 2015 2014 Cash $ 18,200 $ 12,500 Notes receivable 148,000 132,000 Accounts receivable (net) 131,800 125,500 Inventories (at cost) 105,000 50,000 Plant & equipment (net of depreciation) 1,449,000 1,420,500 Total assets $1,852,000 $1,740,500 Liabilities and Stockholders’ Equity Accounts payable $ 79,000 $ 91,000 Notes payable 76,000 61,500 Accrued liabilities 9,000 6,000 Common stock (130,000 shares, $10 par) 1,300,000 1,300,000 Retained earningsa 388,000 282,000 Total liabilities and stockholders’ equity $1,852,000 $1,740,500 aCash dividends were paid at the rate of $1 per share in fi scal year 2014 and $2 per share in fi scal year 2015. BRADBURN CORPORATION INCOME STATEMENT FOR THE FISCAL YEARS ENDED MARCH 31 2015 2014 Sales revenue $3,000,000 $2,700,000 Cost of goods solda 1,530,000 1,425,000 Gross margin 1,470,000 1,275,000 Operating expenses 860,000 780,000 Income before income taxes 610,000 495,000 Income taxes (40%) 244,000 198,000 Net income $ 366,000 $ 297,000 aDepreciation charges on the plant and equipment of $100,000 and $102,500 for fi scal years ended March 31, 2014 and 2015, respectively, are included in cost of goods sold. Instructions (a) Compute the following items for Bradburn Corporation. (1) Current ratio for fiscal years 2014 and 2015. (2) Acid-test (quick) ratio for fiscal years 2014 and 2015. (3) Inventory turnover for fiscal year 2015. (4) Return on assets for fiscal years 2014 and 2015. (Assume total assets were $1,688,500 at 3/31/13.) (5) Percentage change in sales, cost of goods sold, gross margin, and net income after taxes from fiscal year 2014 to 2015. (b) Identify and explain what other financial reports and/or financial analyses might be helpful to the commercial loan officer of Topeka National Bank in evaluating Daniel Brown’s request for a time extension on Bradburn’s notes. (c) Assume that the percentage changes experienced in fiscal year 2015 as compared with fiscal year 2014 for sales and cost of goods sold will be repeated in each of the next 2 years. Is Bradburn’s desire to finance the plant expansion from internally generated funds realistic? Discuss. (d) Should Topeka National Bank grant the extension on Bradburn’s notes considering Daniel Brown’s statement about financing the plant expansion through internally generated funds? Discuss. Problems 1539 13 *P 24-4 (Horizontal and Vertical Analysis) Presented below is the comparative balance sheet for Gilmour Company. GILMOUR COMPANY COMPARATIVE BALANCE SHEET AS OF DECEMBER 31, 2015 AND 2014 December 31 2015 2014 Assets Cash $ 180,000 $ 275,000 Accounts receivable (net) 220,000 155,000 Short-term investments 270,000 150,000 Inventories 1,060,000 980,000 Prepaid expenses 25,000 25,000 Plant & equipment 2,585,000 1,950,000 Accumulated depreciation (1,000,000) (750,000) $3,340,000 $2,785,000 Liabilities and Stockholders’ Equity Accounts payable $ 50,000 $ 75,000 Accrued expenses 170,000 200,000 Bonds payable 450,000 190,000 Capital stock 2,100,000 1,770,000 Retained earnings 570,000 550,000 $3,340,000 $2,785,000 Instructions (Round to two decimal places.) (a) Prepare a comparative balance sheet of Gilmour Company showing the percent each item is of the total assets or total liabilities and stockholders’ equity. (b) Prepare a comparative balance sheet of Gilmour Company showing the dollar change and the percent change for each item. (c) Of what value is the additional information provided in part (a)? (d) Of what value is the additional information provided in part (b)? 10 * P24-5 (Dividend Policy Analysis) Matheny Inc. went public 3 years ago. The board of directors will be meeting shortly after the end of the year to decide on a dividend policy. In the past, growth has been financed primarily through the retention of earnings. A stock or a cash dividend has never been declared. Presented below is a brief financial summary of Matheny Inc. operations. ($000 omitted)

2015 2014 2013 2012 2011 Sales revenue $20,000 $16,000 $14,000 $6,000 $4,000 Net income 2,400 1,400 800 700 250 Average total assets 22,000 19,000 11,500 4,200 3,000 Current assets 8,000 6,000 3,000 1,200 1,000 Working capital 3,600 3,200 1,200 500 400 Common shares: Number of shares outstanding (000) 2,000 2,000 2,000 20 20 Average market price $9 $6 $4 — — Instructions Gateway to (a) Suggest factors to be considered by the board of directors in establishing a dividend policy. the Profession (b) Compute the return on assets, profit margin on sales, earnings per share, price-earnings ratio, and Additional Financial current ratio for each of the 5 years for Matheny Inc. Statement Analysis (c) Comment on the appropriateness of declaring a cash dividend at this time, using the ratios com- Problems puted in part (b) as a major factor in your analysis. 1540 Chapter 24 Full Disclosure in Financial Reporting PROBLEMS SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of problems. CONCEPTS FOR ANALYSIS CA24-1 (General Disclosures; Inventories; Property, Plant, and Equipment) Koch Corporation is in the process of preparing its annual financial statements for the fiscal year ended April 30, 2015. Because all of Koch’s shares are traded intrastate, the company does not have to file any reports with the Securities and Exchange Commission. The company manufactures plastic, glass, and paper containers for sale to food and drink manufacturers and distributors. Koch Corporation maintains separate control accounts for its raw materials, work in process, and fin- ished goods inventories for each of the three types of containers. The inventories are valued at the lower- of-cost-or-market. The company’s property, plant, and equipment are classified in the following major categories: land, office buildings, furniture and fixtures, manufacturing facilities, manufacturing equipment, and leasehold improvements. All fixed assets are carried at cost. The depreciation methods employed depend on the type of asset (its classification) and when it was acquired. Koch Corporation plans to present the inventory and fixed asset amounts in its April 30, 2015, balance sheet as shown below. Inventories $4,814,200 Property, plant, and equipment (net of depreciation) 6,310,000 Instructions What information regarding inventories and property, plant, and equipment must be disclosed by Koch Corporation in the audited financial statements issued to stockholders, either in the body or the notes, for the 2014–2015 fiscal year? (CMA adapted) CA24-2 (Disclosures Required in Various Situations) Ace Inc. produces electronic components for sale to manufacturers of radios, television sets, and digital sound systems. In connection with her examination of Ace’s financial statements for the year ended December 31, 2015, Gloria Rodd, CPA, completed field work 2 weeks ago. Ms. Rodd now is evaluating the significance of the following items prior to preparing her audi- tor’s report. Except as noted, none of these items have been disclosed in the financial statements or notes. Item 1: A 10-year loan agreement, which the company entered into 3 years ago, provides that dividend payments may not exceed net income earned after taxes subsequent to the date of the agreement. The bal- ance of retained earnings at the date of the loan agreement was $420,000. From that date through December 31, 2015, net income after taxes has totaled $570,000 and cash dividends have totaled $320,000. On the basis of these data, the staff auditor assigned to this review concluded that there was no retained earnings restriction at December 31, 2015. Item 2: Recently Ace interrupted its policy of paying cash dividends quarterly to its stockholders. Divi- dends were paid regularly through 2014, discontinued for all of 2015 to finance purchase of equipment for the company’s new plant, and resumed in the first quarter of 2016. In the annual report, dividend policy is to be discussed in the president’s letter to stockholders. Item 3: A major electronics firm has introduced a line of products that will compete directly with Ace’s

primary line, now being produced in the specially designed new plant. Because of manufacturing innova- tions, the competitor’s line will be of comparable quality but priced 50% below Ace’s line. The competitor announced its new line during the week following completion of field work. Ms. Rodd read the announce- ment in the newspaper and discussed the situation by telephone with Ace executives. Ace will meet the lower prices that are high enough to cover variable manufacturing and selling expenses but will permit recovery of only a portion of fixed costs. Item 4: The company’s new manufacturing plant building, which cost $2,400,000 and has an estimated life of 25 years, is leased from Wichita National Bank at an annual rental of $600,000. The company is obligated Concepts for Analysis 1541 to pay property taxes, insurance, and maintenance. At the conclusion of its 10-year noncancelable lease, the company has the option of purchasing the property for $1. In Ace’s income statement, the rental payment is reported on a separate line. Instructions For each of the above items, discuss any additional disclosures in the financial statements and notes that the auditor should recommend to her client. (The cumulative effect of the four items should not be considered.) CA24-3 (Disclosures, Conditional and Contingent Liabilities) Presented below are three independent situations. Situation 1: A company offers a one-year warranty for the product that it manufactures. A history of warranty claims has been compiled, and the probable amounts of claims related to sales for a given period can be determined. Situation 2: Subsequent to the date of a set of financial statements but prior to the issuance of the financial statements, a company enters into a contract that will probably result in a significant loss to the company. The amount of the loss can be reasonably estimated. Situation 3: A company has adopted a policy of recording self-insurance for any possible losses resulting from injury to others by the company’s vehicles. The premium for an insurance policy for the same risk from an independent insurance company would have an annual cost of $4,000. During the period covered by the financial statements, there were no accidents involving the company’s vehicles that resulted in injury to others. Instructions Discuss the accrual or type of disclosure necessary (if any) and the reason(s) why such disclosure is appro- priate for each of the three independent sets of facts above. (AICPA adapted) CA24-4 (Post-Balance-Sheet Events) At December 31, 2014, Coburn Corp. has assets of $10,000,000, l iabilities of $6,000,000, common stock of $2,000,000 (representing 2,000,000 shares of $1 par common stock), and retained earnings of $2,000,000. Net sales for the year 2014 were $18,000,000, and net income was $800,000. As auditors of this company, you are making a review of subsequent events on February 13, 2015, and you find the following. 1. On February 3, 2015, one of Coburn’s customers declared bankruptcy. At December 31, 2014, this company owed Coburn $300,000, of which $60,000 was paid in January 2015. 2. On January 18, 2015, one of the three major plants of the client burned. 3. On January 23, 2015, a strike was called at one of Coburn’s largest plants, which halted 30% of its production. As of today (February 13), the strike has not been settled. 4. A major electronics enterprise has introduced a line of products that would compete directly with Coburn’s primary line, now being produced in a specially designed new plant. Because of manufac- turing innovations, the competitor has been able to achieve quality similar to that of Coburn’s prod- ucts but at a price 50% lower. Coburn officials say they will meet the lower prices, which are high enough to cover variable manufacturing and selling costs but which permit recovery of only a por- tion of fixed costs. 5. Merchandise traded in the open market is recorded in the company’s records at $1.40 per unit on December 31, 2014. This price had prevailed for 2 weeks, after release of an official market report

that predicted vastly enlarged supplies; however, no purchases were made at $1.40. The price throughout the preceding year had been about $2, which was the level experienced over several years. On January 18, 2015, the price returned to $2, after public disclosure of an error in the official calculations of the prior December, correction of which destroyed the expectations of excessive supplies. Inventory at December 31, 2015, was on a lower-of-cost-or-market basis. 6. On February 1, 2015, the board of directors adopted a resolution accepting the offer of an invest- ment banker to guarantee the marketing of $1,200,000 of preferred stock. Instructions State in each case how the 2014 financial statements would be affected, if at all. CA24-5 (Segment Reporting) You are compiling the consolidated financial statements for Winsor Corpo- ration International. The corporation’s accountant, Anthony Reese, has provided you with the segment information shown on the next page. 1542 Chapter 24 Full Disclosure in Financial Reporting Note 7: Major Segments of Business WCI conducts funeral service and cemetery operations in the United States and Canada. Substantially all revenues of WCI’s major segments of business are from unaffi liated customers. Segment information for fi scal 2015, 2014, and 2013 follows. (thousands) Funeral Floral Cemetery Real Estate Dried Whey Limousine Consolidated Revenues 2015 $302,000 $10,000 $ 73,000 $ 2,000 $7,000 $12,000 $406,000 2014 245,000 6,000 61,000 4,000 4,000 4,000 324,000 2013 208,000 3,000 42,000 3,000 1,000 3,000 260,000 Operating Income 2015 74,000 1,500 18,000 (36,000) 500 2,000 60,000 2014 64,000 200 12,000 (28,000) 200 400 48,800 2013 54,000 150 6,000 (21,000) 100 350 39,600 Capital Expenditures 2015 26,000 1,000 9,000 400 300 1,000 37,700 2014 28,000 2,000 60,000 1,500 100 700 92,300 2013 14,000 25 8,000 600 25 50 22,700 Depreciation and Amortization 2015 13,000 100 2,400 1,400 100 200 17,200 2014 10,000 50 1,400 700 50 100 12,300 2013 8,000 25 1,000 600 25 50 9,700 Identifi able Assets 2015 334,000 1,500 162,000 114,000 500 8,000 620,000 2014 322,000 1,000 144,000 52,000 1,000 6,000 526,000 2013 223,000 500 78,000 34,000 500 3,500 339,500 Instructions Determine which of the above segments must be reported separately and which can be combined under the category “Other.” Then, write a one-page memo to the company’s accountant, Anthony Reese, explain- ing the following. (a) What segments must be reported separately and what segments can be combined. (b) What criteria you used to determine reportable segments. (c) What major items for each must be disclosed. CA24-6 (Segment Reporting—Theory) Presented below is an excerpt from the financial statements of H. J. Heinz Company. Segment and Geographic Data The company is engaged principally in one line of business—processed food products—which represents over 90% of consolidated sales. Information about the business of the company by geographic area is presented in the table below. There were no material amounts of sales or transfers between geographic areas or between affi liates, and no material amounts of United States export sales. Foreign (in thousands of United Western U.S. dollars) Domestic Kingdom Canada Europe Other Total Worldwide Sales $2,381,054 $547,527 $216,726 $383,784 $209,354 $1,357,391 $3,738,445 Operating income 246,780 61,282 34,146 29,146 25,111 149,685 396,465 Identifi able assets 1,362,152 265,218 112,620 294,732 143,971 816,541 2,178,693 Capital expenditures 72,712 12,262 13,790 8,253 4,368 38,673 111,385 Depreciation expense 42,279 8,364 3,592 6,355 3,606 21,917 64,196 Instructions (a) Why does H. J. Heinz not prepare segment information on its products or services? (b) What are export sales, and when should they be disclosed? (c) Why are sales by geographical area important to disclose? Concepts for Analysis 1543 CA24-7 (Segment Reporting—Theory) The following article appeared in the Wall Street Journal. washington—The Securities and Exchange Commission staff issued guidelines for companies grappling

with the problem of dividing up their business into industry segments for their annual reports. An industry segment is defined by the Financial Accounting Standards Board as a part of an enterprise engaged in providing a product or service or a group of related products or services primarily to unaffili- ated customers for a profit. Although conceding that the process is a “subjective task” that “to a considerable extent, depends on the judgment of management,” the SEC staff said companies should consider . . . various factors . . . to determine whether products and services should be grouped together or reported as segments. Instructions (a) What does financial reporting for segments of a business enterprise involve? (b) Identify the reasons for requiring financial data to be reported by segments. (c) Identify the possible disadvantages of requiring financial data to be reported by segments. (d) Identify the accounting difficulties inherent in segment reporting. CA24-8 (Interim Reporting) Snider Corporation, a publicly traded company, is preparing the interim f inancial data which it will issue to its stockholders and the Securities and Exchange Commission (SEC) at the end of the first quarter of the 2014–2015 fiscal year. Snider’s financial accounting department has com- piled the following summarized revenue and expense data for the first quarter of the year. Sales revenue $60,000,000 Cost of goods sold 36,000,000 Variable selling expenses 1,000,000 Fixed selling expenses 3,000,000 Included in the fixed selling expenses was the single lump-sum payment of $2,000,000 for television adver- tisements for the entire year. Instructions (a) Snider Corporation must issue its quarterly financial statements in accordance with generally accepted accounting principles regarding interim financial reporting. (1) Explain whether Snider should report its operating results for the quarter as if the quarter were a separate reporting period in and of itself, or as if the quarter were an integral part of the annual reporting period. (2) State how the sales revenue, cost of goods sold, and fixed selling expenses would be reflected in Snider Corporation’s quarterly report prepared for the first quarter of the 2014–2015 fiscal year. Briefly justify your presentation. (b) What financial information, as a minimum, must Snider Corporation disclose to its stockholders in its quarterly reports? (CMA adapted) CA24-9 (Treatment of Various Interim Reporting Situations) The following statement is an excerpt from the FASB pronouncement related to interim reporting. Interim financial information is essential to provide investors and others with timely information as to the progress of the enterprise. The usefulness of such information rests on the relationship that it has to the annual results of operations. Accordingly, the Board has concluded that each interim period should be viewed primarily as an integral part of an annual period. In general, the results for each interim period should be based on the accounting principles and practices used by an enterprise in the preparation of its latest annual financial statements unless a change in an accounting practice or policy has been adopted in the current year. The Board has con- cluded, however, that certain accounting principles and practices followed for annual reporting pur- poses may require modification at interim reporting dates so that the reported results for the interim period may better relate to the results of operations for the annual period. Instructions Listed on the next page are six independent cases on how accounting facts might be reported on an indi- vidual company’s interim financial reports. For each of these cases, state whether the method proposed to be used for interim reporting would be acceptable under generally accepted accounting principles appli- cable to interim financial data. Support each answer with a brief explanation. 1544 Chapter 24 Full Disclosure in Financial Reporting (a) J. D. Long Company takes a physical inventory at year-end for annual financial statement purposes.

Inventory and cost of sales reported in the interim quarterly statements are based on estimated gross profit rates, because a physical inventory would result in a cessation of operations. Long Com- pany does have reliable perpetual inventory records. (b) Rockford Company is planning to report one-fourth of its pension expense each quarter. (c) Republic Company wrote inventory down to reflect lower-of-cost-or-market in the first quarter. At year-end, the market exceeds the original acquisition cost of this inventory. Consequently, manage- ment plans to write the inventory back up to its original cost as a year-end adjustment. (d) Gansner Company realized a large gain on the sale of investments at the beginning of the second quarter. The company wants to report one-third of the gain in each of the remaining quarters. (e) Fredonia Company has estimated its annual audit fee. It plans to pro rate this expense equally over all four quarters. (f) LaBrava Company was reasonably certain it would have an employee strike in the third quarter. As a result, it shipped heavily during the second quarter but plans to defer the recognition of the sales in excess of the normal sales volume. The deferred sales will be recognized as sales in the third quarter when the strike is in progress. LaBrava Company management thinks this is more represen- tative of normal second- and third-quarter operations. CA24-10 (Financial Forecasts) An article in Barron’s noted the following. Okay. Last fall, someone with a long memory and an even longer arm reached into that bureau drawer and came out with a moldy cheese sandwich and the equally moldy notion of corporate forecasts. We tried to find out what happened to the cheese sandwich—but, rats!, even recourse to the Freedom of Information Act didn’t help. However, the forecast proposal was dusted off, polished up and found quite serviceable. The SEC, indeed, lost no time in running it up the old flagpole—but no one was very eager to salute. Even after some of the more objectionable features—compulsory corrections and detailed explanations of why the estimates went awry—were peeled off the original proposal. Seemingly, despite the Commission’s smiles and sweet talk, those craven corporations were still afraid that an honest mistake would lead them down the primrose path to consent decrees and class action suits. To lay to rest such qualms, the Commission last week approved a “Safe Harbor” rule that, providing the forecasts were made on a reasonable basis and in good faith, protected corporations from litigation should the projections prove wide of the mark (as only about 99% are apt to do). Instructions (a) What are the arguments for preparing profit forecasts? (b) What is the purpose of the “safe harbor” rule? (c) Why are corporations concerned about presenting profit forecasts? CA24-11 (Disclosure of Estimates) Nancy Tercek, the financial vice president, and Margaret Lilly, the controller, of Romine Manufacturing Company are reviewing the financial ratios of the company for the years 2014 and 2015. The financial vice president notes that the profit margin on sales ratio has increased from 6% to 12%, a hefty gain for the 2-year period. Tercek is in the process of issuing a media release that emphasizes the efficiency of Romine Manufacturing in controlling cost. Margaret Lilly knows that the dif- ference in ratios is due primarily to an earlier company decision to reduce the estimates of warranty and bad debt expense for 2015. The controller, not sure of her supervisor’s motives, hesitates to suggest to Tercek that the company’s improvement is unrelated to efficiency in controlling cost. To complicate matters, the media release is scheduled in a few days. Instructions (a) What, if any, is the ethical dilemma in this situation? (b) Should Lilly, the controller, remain silent? Give reasons. (c) What stakeholders might be affected by Tercek’s media release? (d) Give your opinion on the following statement and cite reasons: “Because Tercek, the vice president, is most directly responsible for the media release, Lilly has no real responsibility in this matter.”

CA24-12 (Reporting of Subsequent Events) In June 2014, the board of directors for McElroy Enterprises Inc. authorized the sale of $10,000,000 of corporate bonds. Jennifer Grayson, treasurer for McElroy Enter- prises Inc., is concerned about the date when the bonds are issued. The company really needs the cash, but she is worried that if the bonds are issued before the company’s year-end (December 31, 2014) the addi- tional liability will have an adverse effect on a number of important ratios. In July, she explains to company president William McElroy that if they delay issuing the bonds until after December 31 the bonds will not affect the ratios until December 31, 2015. They will have to report the issuance as a subsequent event which Concepts for Analysis 1545 requires only footnote disclosure. Grayson expects that with expected improved financial performance in 2015, ratios should be better. Instructions (a) What are the ethical issues involved? (b) Should McElroy agree to the delay? * CA24-13 (Effect of Transactions on Financial Statements and Ratios) The transactions listed below relate to Wainwright Inc. You are to assume that on the date on which each of the transactions occurred, the corporation’s accounts showed only common stock ($100 par) outstanding, a current ratio of 2.7:1, and a substantial net income for the year to date (before giving effect to the transaction concerned). On that date, the book value per share of stock was $151.53. Each numbered transaction is to be considered completely independent of the others, and its related answer should be based on the effect(s) of that transaction alone. Assume that all numbered transactions occurred during 2015 and that the amount involved in each case is sufficiently material to distort reported net income if improperly included in the determination of net income. Assume further that each transac- tion was recorded in accordance with generally accepted accounting principles and, where applicable, in conformity with the all-inclusive concept of the income statement. For each of the numbered transactions you are to decide whether it: (a) Increased the corporation’s 2015 net income. (b) Decreased the corporation’s 2015 net income. (c) Increased the corporation’s total retained earnings directly (i.e., not via net income). (d) Decreased the corporation’s total retained earnings directly. (e) Increased the corporation’s current ratio. (f) Decreased the corporation’s current ratio. (g) Increased each stockholder’s proportionate share of total stockholders’ equity. (h) Decreased each stockholder’s proportionate share of total stockholders’ equity. (i) Increased each stockholder’s equity per share of stock (book value). (j) Decreased each stockholder’s equity per share of stock (book value). (k) Had none of the foregoing effects. Instructions List the numbers 1 through 9. Select as many letters as you deem appropriate to reflect the effect(s) of each transaction as of the date of the transaction by printing beside the transaction number the letter(s) that identifies that transaction’s effect(s). Transactions _____ 1. I n January, the board directed the write-off of certain patent rights that had suddenly and unexpectedly become worthless. _____ 2. T he corporation sold at a profit land and a building that had been idle for some time. Under the terms of the sale, the corporation received a portion of the sales price in cash immediately, the balance maturing at 6-month intervals. _____ 3. T reasury stock originally repurchased and carried at $127 per share was sold for cash at $153 per share. _____ 4. The corporation wrote off all of the unamortized discount and issue expense applicable to bonds that it refinanced in 2015. _____ 5. The corporation called in all its outstanding shares of stock and exchanged them for new shares on a 2-for-1 basis, reducing the par value at the same time to $50 per share. _____ 6. T he corporation paid a cash dividend that had been recorded in the accounts at time of declaration. _____ 7. Litigation involving Wainwright Inc. as defendant was settled in the corporation’s favor, with the

plaintiff paying all court costs and legal fees. In 2012, the corporation had appropriately established a special contingency for this court action. (Indicate the effect of reversing the contingency only.) _____ 8. The corporation received a check for the proceeds of an insurance policy from the company with which it is insured against theft of trucks. No entries concerning the theft had been made previously, and the proceeds reduce but do not cover completely the loss. _____ 9. Treasury stock, which had been repurchased at and carried at $127 per share, was issued as a stock dividend. In connection with this distribution, the board of directors of Wainwright Inc. had authorized a transfer from retained earnings to permanent capital of an amount equal to the aggregate market value ($153 per share) of the shares issued. No entries relating to this dividend had been made previously. (AICPA adapted) 1546 Chapter 24 Full Disclosure in Financial Reporting USING YOUR JUDGMENT FINANCIAL REPORTING Financial Reporting Problem The Procter & Gamble Company (P&G) As stated in the chapter, notes to the financial statements are the means of explaining the items presented in the main body of the statements. Common note disclosures relate to such items as accounting policies, segmented information, and interim reporting. 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 P&G’s financial statements and the accompanying notes to answer the following questions. (a) What specific items does P&G discuss in its Note 1—Summary of Significant Accounting Policies? (List the headings only.) (b) For what segments did P&G report segmented information? Which segment is the largest? Who is P&G’s largest customer? (c) What interim information was reported by P&G? 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) (1) W hat specific items does Coca-Cola discuss in its Note 1—Accounting Policies? (Prepare a list of the headings only.) (2) What specific items does PepsiCo discuss in its Note 2—Our Summary of Significant Accounting Policies? (Prepare a list of the headings only.) (b) For what lines of business or segments do Coca-Cola and PepsiCo present segmented information? (c) Note and comment on the similarities and differences between the auditors’ reports submitted by the independent auditors of Coca-Cola and PepsiCo for the year 2011. *Financial Statement Analysis Case RNA Inc. manufactures a variety of consumer products. The company’s founders have run the company for 30 years and are now interested in retiring. Consequently, they are seeking a purchaser who will con- tinue its operations, and a group of investors, Morgan Inc., is looking into the acquisition of RNA. To evaluate its financial stability and operating efficiency, RNA was requested to provide the latest financial statements and selected financial ratios. Summary information provided by RNA is as follows. RNA INC. INCOME STATEMENT FOR THE YEAR ENDED NOVEMBER 30, 2015 (IN THOUSANDS) Sales (net) $30,500 Interest income 500 Total revenue 31,000 Costs and expenses Cost of goods sold 17,600 Selling and administrative expenses 3,550 Depreciation and amortization expense 1,890 Interest expense 900 Total costs and expenses 23,940 Income before taxes 7,060 Income taxes 2,800 Net income $ 4,260 Using Your Judgment 1547 RNA INC. BALANCE SHEET AS OF NOVEMBER 30 (IN THOUSANDS) 2015 2014 Cash $ 400 $ 500 Short-term investments (at cost) 300 200 Accounts receivable (net) 3,200 2,900 Inventory 6,000 5,400 Total current assets 9,900 9,000 Property, plant, & equipment (net) 7,100 7,000 Total assets $17,000 $16,000 Accounts payable $ 3,700 $ 3,400 Income taxes payable 900 800 Accrued expenses 1,700 1,400 Total current liabilities 6,300 5,600

Long-term debt 2,000 1,800 Total liabilities 8,300 7,400 Common stock ($1 par value) 2,700 2,700 Paid-in capital in excess of par 1,000 1,000 Retained earnings 5,000 4,900 Total stockholders’ equity 8,700 8,600 Total liabilities and stockholders’ equity $17,000 $16,000 SELECTED FINANCIAL RATIOS Current RNA INC. Industry 2014 2013 Average Current ratio 1.61 1.62 1.63 Acid-test ratio .64 .63 .68 Times interest earned 8.55 8.50 8.45 Profi t margin on sales 13.2% 12.1% 13.0% Asset turnover 1.84 1.83 1.84 Inventory turnover 3.17 3.21 3.18 Instructions (a) Calculate a new set of ratios for the fiscal year 2015 for RNA based on the financial statements presented. (b) Explain the analytical use of each of the six ratios presented, describing what the investors can learn about RNA’s financial stability and operating efficiency. (c) Identify two limitations of ratio analysis. (CMA adapted) Accounting, Analysis, and Principles Savannah, Inc. is a company that manufactures and sells a single product. Unit sales for each of the four quarters of 2014 are projected as follows. Quarter Units First 80,000 Second 150,000 Third 550,000 Fourth 120,000 Annual Total 900,000 1548 Chapter 24 Full Disclosure in Financial Reporting Savannah incurs variable manufacturing costs of $0.40 per unit and variable nonmanufacturing costs of $0.35 per unit. Savannah will incur fixed manufacturing costs of $720,000 and fixed nonmanufacturing costs of $1,080,000. Savannah will sell its product for $4.00 per unit. Accounting Determine the amount of net income Savannah will report in each of the four quarters of 2014, assuming actual sales are as projected and employing the integral approach to interim financial reporting. (Ignore income taxes.) Analysis Compute Savannah’s profit margin on sales for each of the four quarters of 2014 under both the integral and discrete approaches. What effect does employing the integral approach instead of the discrete ap- proach have on the degree to which Savannah’s profit margin on sales varies from quarter to quarter? Principles Explain the conceptual rationale behind the integral approach to interim financial reporting. BRIDGE TO THE PROFESSION Professional Research: FASB Codifi cation As part of the year-end audit, you are discussing the disclosure checklist with your client. The checklist identifies the items that must be disclosed in a set of GAAP financial statements. The client is surprised by the disclosure item related to accounting policies. Specifically, since the audit report will attest to the state- ments being prepared in accordance with GAAP, the client questions the accounting policy checklist item. The client has asked you to conduct some research to verify the accounting policy disclosures. 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) In general, what should disclosures of accounting policies encompass? (b) List some examples of the most commonly required disclosures. 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 IFRS and GAAP disclosure requirements are similar in many regards. The IFRS LEARNING OBJECTIVE 14 addressing various disclosure issues are IAS 24 (“Related Party Disclosures”), Compare the disclosure requirements disclosure and recognition of post-statement of financial position events in IAS 10 under GAAP and IFRS. (“Events after the Balance Sheet Date”), segment reporting IFRS provisions in IFRS 8 (“Operating Segments”), and interim reporting requirements in IAS 34 (“Interim Financial Reporting”). RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related to disclosures. IFRS Insights 1549 Similarities • GAAP and IFRS have similar standards on post-statement of fi nancial position (sub- sequent) events. That is, under both sets of standards, events that occurred after the

statement of fi nancial position date, and which provide additional evidence of condi- tions that existed at the statement of fi nancial position date, are recognized in the fi nancial statements. • Like GAAP, IFRS requires that for transactions with related parties, companies disclose the amounts involved in a transaction; the amount, terms, and nature of the outstand- ing balances; and any doubtful amounts related to those outstanding balances for each major category of related parties. • Following the recent issuance of IFRS 8, “Operating Segments,” the requirements under IFRS and GAAP are very similar. That is, both standards use the management ap- proach to identify reportable segments, and similar segment disclosures are required. • Neither GAAP nor IFRS require interim reports. Rather, the SEC and securities exchanges outside the United States establish the rules. In the United States, interim reports generally are provided on a quarterly basis; outside the United States, six-month interim reports are common. Differences • Due to the broader range of judgments allowed in more principles-based IFRS, note disclosures generally are more expansive under IFRS compared to GAAP. • Subsequent (or post-statement of fi nancial position) events under IFRS are evaluated through the date that fi nancial instruments are “authorized for issue.” GAAP uses the date when fi nancial statements are “issued.” Also, for share dividends and splits in the subsequent period, IFRS does not adjust but GAAP does. • Under IFRS, there is no specifi c requirement to disclose the name of the related party, which is this case under GAAP. • Under IFRS, interim reports are prepared on a discrete basis; GAAP generally follows the integral approach. ABOUT THE NUMBERS Differential Disclosure A trend toward differential disclosure is occurring. The IASB has developed IFRS for small- and medium-sized entities (SMEs). SMEs are entities that publish general- purpose financial statements for external users but do not issue shares or other securi- ties in a public market. Many believe a simplified set of standards makes sense for these companies because they do not have the resources to implement full IFRS. Simplified IFRS for SMEs is a single standard of fewer than 230 pages. It is designed to meet the needs and capabilities of SMEs, which are estimated to account for over 95 percent of all companies around the world. Compared with full IFRS (and many national accounting standards), simplified IFRS for SMEs is less complex in a number of ways: • Topics not relevant for SMEs are omitted. Examples are earnings per share, interim fi nancial reporting, and segment reporting. • Simplifi ed IFRS for SMEs allows fewer accounting policy choices. Examples are no option to revalue property, equipment, or intangibles, and no corridor approach for actuarial gains and losses. • Many principles for recognizing and measuring assets, liabilities, revenue, and expenses are simplifi ed. For example, goodwill is amortized (as a result, there is no annual impairment test), and all borrowing and R&D costs are expensed. 1550 Chapter 24 Full Disclosure in Financial Reporting • Signifi cantly fewer disclosures are required (roughly 300 versus 3,000). • To further reduce standard overload, revisions to the IFRS for SMEs will be limited to once every three years. Thus, the option of using simplified IFRS helps SMEs meet the needs of their financial statement users while balancing the costs and benefits from a preparer perspective.29 Events after the Reporting Period (Subsequent Events) Notes to the financial statements should explain any significant financial events that took place after the formal statement of financial position date, but before the state- ments are authorized for issuance (hereafter referred to as the authorization date). These events are referred to as events after the reporting date, or subsequent events. Illustra- tion IFRS24-1 shows a time diagram of the subsequent events period. ILLUSTRATION IFRS24-1 Statement of Financial

Time Periods for Financial Position Statements Subsequent Events Date Authorization Date Financial Statement Period Subsequent Events Period Jan. 1, Dec. 31, Mar. 3, 2014 2014 2015 A period of several weeks, and sometimes months, may elapse after the end of the fiscal year but before the management or the board of directors authorizes issuance of the financial statements. Various activities involved in closing the books for the period and issuing the statements all take time: taking and pricing the inventory, reconciling subsidiary ledgers with controlling accounts, preparing necessary adjusting entries, ensuring that all transactions for the period have been entered, obtaining an audit of the financial statements by independent certified public accountants, and printing the annual report. During the period between the statement of financial position date and its authorization date, important transactions or other events may occur that materially affect the company’s financial position or operating situation. Many who read a statement of financial position believe the financial condition is constant, and they project it into the future. However, readers must be told if the com- pany has experienced a significant change—e.g., sold one of its plants, acquired a sub- sidiary, suffered unusual losses, settled significant litigation, or experienced any other important event in the post-statement of financial position period. Without an explana- tion in a note, the reader might be misled and draw inappropriate conclusions. Two types of events or transactions occurring after the statement of financial posi- tion date may have a material effect on the financial statements or may need disclosure so that readers interpret these statements accurately: 29In the United States, there has been a preference for one set of GAAP except in unusual situations. With the advent of simplified IFRS for SMEs, this position is under review. Both the FASB and the AICPA are studying the big GAAP/little GAAP issue to ensure that any kind of differential reporting is conceptually sound and meets the needs of users. As discussed in the chapter, the FASB has formed a Private Company Financial Reporting Committee, whose primary objectives are to provide recommendations on FASB standard-setting for privately held enterprises (see http://www.pcfr.org/). IFRS Insights 1551 1. Events that provide additional evidence about conditions that existed at the state- ment of fi nancial position date, including the estimates inherent in the process of preparing fi nancial statements. These events are referred to as adjusted subsequent events and require adjustments to the fi nancial statements. All information available prior to the authorization date of the fi nancial statements helps investors and creditors evaluate estimates previously made. To ignore these subsequent events is to pass up an opportunity to improve the accuracy of the fi nancial statements. This fi rst type of event encompasses information that an accountant would have recorded in the accounts had the information been known at the statement of fi nancial position date. For example, if a loss on an account receivable results from a customer’s bank- ruptcy subsequent to the statement of fi nancial position date, the company adjusts the fi nancial statements before their issuance. The bankruptcy stems from the customer’s poor fi nancial health existing at the statement of fi nancial position date. The same criterion applies to settlements of litigation. The company must adjust the financial statements if the events that gave rise to the litigation, such as personal injury or patent infringement, took place prior to the statement of financial position date. 2. Events that provide evidence about conditions that did not exist at the statement of fi nancial position date but arise subsequent to that date. These events are referred to as non-adjusted subsequent events and do not require adjustment of the fi nancial statements. To illustrate, a loss resulting from a customer’s fi re or fl ood

after the statement of fi nancial position date does not refl ect conditions existing at that date. Thus, adjustment of the fi nancial statements is not necessary. A company should not recognize subsequent events that provide evidence about conditions that did not exist at the date of the statement of fi nancial position but that arose after the statement of fi nancial position date. The following are examples of non-adjusted subsequent events: • A major business combination after the reporting period or disposing of a major subsidiary. • A nnouncing a plan to discontinue an operation or commencing the implementa- tion of a major restructuring. • M ajor purchases of assets, other disposals of assets, or expropriation of major as- sets by government. • T he destruction of a major production plant or inventories by a fi re or natural disaster after the reporting period. • M ajor ordinary share transactions and potential ordinary share transactions after the reporting period. • A bnormally large changes after the reporting period in asset prices, foreign exchange rates, or taxes. • Entering into signifi cant commitments or contingent liabilities, for example, by issuing signifi cant guarantees after the statement date.30 30The effects from natural disasters, like the recent eruption of the Icelandic volcano, which occurred after the year-end for companies with March fiscal years, require disclosure in order to keep the statements from being misleading. Some companies may have to consider whether these disasters affect their ability to continue as going concerns. 1552 Chapter 24 Full Disclosure in Financial Reporting Some non-adjusted subsequent events may have to be disclosed to keep the financial statements from being misleading. For such events, a company discloses the nature of the event and an estimate of its financial effect. Illustration IFRS24-2 presents an example of subsequent events disclosure, excerpted from the annual report of Magyar Telecom plc. ILLUSTRATION Magyar Telecom plc IFRS24-2 Disclosure of Subsequent Note 37. Events After the Reporting Period (in part) Events On March 1, 2011 the Hungarian Government announced that as part of its long-term effort to reduce the Hungarian budget deficit it intends to amend existing law that provides for a reduction in corporate tax rates from the current 19% to 10% starting in 2013. When the law reducing future corporate tax rates was enacted in 2010, the Group recalculated its deferred tax balances, resulting in the reversal of net deferred tax liabilities of HUF 14.5 billion (see Note 9.3) in the 2010 income statement of comprehensive income. The recent announcement of the intended cancellation of the scheduled reduction of the tax rate from 2013 is expected to cause the recognition of a substantially higher amount of net deferred tax liabilities in 2011 and result in a negative impact on deferred tax expense in 2011 equivalent in magnitude to the positive impact on net deferred tax expense in 2010. Many subsequent events or developments do not require adjustment of or disclosure in the financial statements. Typically, these are non-accounting events or conditions that management normally communicates by other means. These events include legislation, product changes, management changes, strikes, unionization, marketing agreements, and loss of important customers. Interim Reports Another source of information for the investor is interim reports. As noted earlier, interim reports cover periods of less than one year. The securities exchanges, market regulators, and the accounting profession have an active interest in the presentation of interim information. Because of the short-term nature of the information in these reports, there is consid- erable controversy as to the general approach companies should employ. One group, which favors the discrete approach, believes that companies should treat each interim period as a separate accounting period. Using that treatment, companies would follow the principles for deferrals and accruals used for annual reports. In this view, companies

should report accounting transactions as they occur, and expense recognition should not change with the period of time covered. Another group, which favors the integral approach, believes that the interim report is an integral part of the annual report and that deferrals and accruals should take into consideration what will happen for the entire year. In this approach, compa- nies should assign estimated expenses to parts of a year on the basis of sales volume or some other activity base. In general, IFRS requires companies to follow the discrete approach. Interim Reporting Requirements Under IFRS, companies should use the same accounting policies for interim reports and for annual reports. They should recognize revenues in interim periods on the same basis as they are for annual periods. For example, if Cedars Corp. uses the percentage- of-completion method as the basis for recognizing revenue on an annual basis, it should use the percentage-of-completion method for interim reports as well. Also, Cedars should treat costs directly associated with revenues (product costs, such as materials, IFRS Insights 1553 labor and related fringe benefits, and manufacturing overhead) in the same manner for interim reports as for annual reports. Companies should use the same inventory pricing methods (FIFO, average-cost, etc.) for interim reports and for annual reports. However, companies may use the gross profit method for interim inventory pricing. But, they must disclose the method and adjustments to reconcile with annual inventory. Discrete Approach. Following the discrete approach, companies record in interim reports revenues and expenses according to the revenue and expense recognition prin- ciples. This includes costs and expenses other than product costs (often referred to as period costs). No accruals or deferrals in anticipation of future events during the year should be reported. For example, the cost of a planned major periodic maintenance or overhaul for a company like Airbus or other seasonal expenditure that is expected to occur late in the year is not anticipated for interim reporting purposes. The mere inten- tion or necessity to incur expenditure related to the future is not sufficient to give rise to an obligation. Or, a company like Carrefour may budget certain costs expected to be incurred ir- regularly during the financial year, such as advertising and employee training costs. Those costs generally are discretionary even though they are planned and tend to recur from year to year. However, recognizing an obligation at the end of an interim financial reporting period for such costs that have not yet been incurred generally is not consis- tent with the definition of a liability. While year-to-date measurements may involve changes in estimates of amounts reported in prior interim periods of the current financial year, the principles for recog- nizing assets, liabilities, income, and expenses for interim periods are the same as in annual financial statements. For example, Wm Morrison Supermarkets plc records losses from inventory write-downs, restructurings, or impairments in an interim period similar to how it would treat these items in the annual financial statements (when incurred). However, if an estimate from a prior interim period changes in a subsequent interim period of that year, the original estimate is adjusted in the subse- quent interim period. Interim Disclosures. IFRS does not require a complete set of financial statements at the interim reporting date. Rather, companies may comply with the requirements by pro- viding condensed financial statements and selected explanatory notes. Because users of interim financial reports also have access to the most recent annual financial report, companies only need provide explanation of significant events and transactions since the end of the last annual reporting period. Companies should report the following interim data at a minimum. 1. Statement that the same accounting policies and methods of computation are followed in the interim fi nancial statements as compared with the most recent

annual fi nancial statements or, if those policies or methods have been changed, a description of the nature and effect of the change. 2. Explanatory comments about the seasonality or cyclicality of interim operations. 3. The nature and amount of items affecting assets, liabilities, equity, net income, or cash fl ows that are unusual because of their nature, size, or incidence. 4. The nature and amount of changes in accounting policies and estimates of amounts previously reported. 5. Issuances, repurchases, and repayments of debt and equity securities. 6. Dividends paid (aggregate or per share) separately for ordinary shares and other shares. 1554 Chapter 24 Full Disclosure in Financial Reporting 7. Segment information, as required by IFRS 8, “Operating Segments.” 8. Changes in contingent liabilities or contingent assets since the end of the last annual reporting period. 9. Effect of changes in the composition of the company during the interim period, such as business combinations, obtaining or losing control of subsidiaries and long- term investments, restructurings, and discontinued operations. 10. Other material events subsequent to the end of the interim period that have not been refl ected in the fi nancial statements for the interim period. If a complete set of financial statements is provided in the interim report, companies comply with the provisions of IAS 1, “Presentation of Financial Statements.” ON THE HORIZON Hans Hoogervorst, chairperson of the IASB, recently noted: “High quality financial in- formation is the lifeblood of market-based economies. If the blood is of poor quality, then the body shuts down and the patient dies. It is the same with financial reporting. If investors cannot trust the numbers, then financial markets stop working. For market- based economies, that is really bad news. It is an essential public good for market-based economies. . . . And in the past 10 years, most of the world’s economies—developed and emerging—have embraced IFRSs.” While the United States has yet to adopt IFRS, there is no question that IFRS and GAAP are converging quickly. We have provided expanded discussion in the International Perspectives and IFRS Insights to help you understand the issues surrounding convergence as they relate to intermediate accounting. After reading these discussions, you should realize that IFRS and GAAP are very similar in many areas, with differences in those areas revolving around some minor technical points. In other situations, the differences are major; for example, IFRS does not permit LIFO inventory accounting. Our hope is that the FASB and IASB can quickly complete their convergence efforts, resulting in a single set of high-quality accounting standards for use by companies around the world. IFRS SELF-TEST QUESTIONS 1. Which of the following is false? (a) In general, IFRS note disclosures are more expansive compared to GAAP. (b) GAAP and IFRS have similar standards on subsequent events. (c) Both IFRS and GAAP require interim reports although the reporting frequency varies. (d) Segment reporting requirements are very similar under IFRS and GAAP. 2. Differential reporting for small- and medium-sized entities: (a) is required for all companies less than a certain size. (b) omits accounting topics not relevant for SMEs, such as earnings per share, and interim and segment reporting. (c) has different rules for topics such as earnings per share, and interim and segment reporting. (d) requires significantly more disclosures, since more items are not recognized in the financial statements. 3. Subsequent events are reviewed through which date under IFRS? (a) Statement of financial position date. (b) Sixty days after the year-end date. (c) Date of independent auditor’s opinion. (d) Authorization date of the financial statements. IFRS Insights 1555 4. Under IFRS, share dividends declared after the statement of financial position date but before the end of the subsequent events period are: (a) accounted for similar to errors as a prior period adjustment. (b) adjusted subsequent events, because they are paid from prior year earnings.

(c) not adjusted in the current year’s financial statements. (d) recognized on a prospective basis from the date of declaration. 5. Interim reporting under IFRS: (a) is prepared using the discrete approach. (b) is prepared using a combination of the discrete and integral approach. (c) requires a complete set of financial statements for each interim period. (d) permits companies to omit disclosure of material events subsequent to the interim reporting date. IFRS CONCEPTS AND APPLICATION IFRS24-1 Where can authoritative IFRS be found related to the various disclosure issues discussed in the chapter? IFRS24-2 What are the major types of subsequent events? Indicate how each of the following “subsequent events” would be reported. (a) Collection of a note written off in a prior period. (b) Issuance of a large preference share offering. (c) Acquisition of a company in a different industry. (d) Destruction of a major plant in a flood. (e) Death of the company’s chief executive officer (CEO). (f) Additional wage costs associated with settlement of a four-week strike. (g) Settlement of an income tax case at considerably more tax than anticipated at year-end. (h) Change in the product mix from consumer goods to industrial goods. IFRS24-3 Morlan Corporation is preparing its December 31, 2014, financial statements. Two events that occurred between December 31, 2014, and March 10, 2015, when the statements were authorized for issue, are described below. 1. A liability, estimated at $160,000 at December 31, 2014, was settled on February 26, 2015, at $170,000. 2. A flood loss of $80,000 occurred on March 1, 2015. Instructions What effect do these subsequent events have on 2014 net income? IFRS24-4 Keystone Corporation’s financial statements for the year ended December 31, 2014, were autho- rized for issue on March 10, 2015. The following events took place early in 2015. (a) On January 10, 10,000 ordinary shares of $5 par value were issued at $66 per share. (b) On March 1, Keystone determined after negotiations with the taxing authorities that income taxes payable for 2014 should be $1,320,000. At December 31, 2014, income taxes payable were recorded at $1,100,000. Instructions Discuss how the preceding subsequent events should be reflected in the 2014 financial statements. IFRS24-5 For each of the following subsequent events, indicate whether a company should (a) adjust the financial statements, (b) disclose in notes to the financial statements, or (c) neither adjust nor disclose. ________ 1. Settlement of a tax case at a cost considerably in excess of the amount expected at year-end. ________ 2. Introduction of a new product line. ________ 3. Loss of assembly plant due to fire. ________ 4. Sale of a significant portion of the company’s assets. ________ 5. Retirement of the company president. 1556 Chapter 24 Full Disclosure in Financial Reporting ________ 6. Issuance of a significant number of ordinary shares. ________ 7. Loss of a significant customer. ________ 8. Prolonged employee strike. ________ 9. Material loss on a year-end receivable because of a customer’s bankruptcy. _______ 10. Hiring of a new president. _______ 11. Settlement of prior year’s litigation against the company (no loss was accrued). _______ 12. Merger with another company of comparable size. IFRS24-6 What are interim reports? Why is a complete set of financial statements often not provided with interim data? What are the accounting problems related to the presentation of interim data? IFRS24-7 Dierdorf Inc., a closely held corporation, has decided to go public. The controller, Ed Floyd, is concerned with presenting interim data when an inventory write-down is recorded. What problems are encountered with inventories when quarterly data are presented? IFRS24-8 Bill Novak is working on an audit of an IFRS client. In his review of the client’s interim reports, he notes that the reports are prepared on a discrete basis. That is, each interim report is viewed as a distinct period. Is this acceptable under IFRS? If so, explain how that treatment could affect comparisons to a